Final Accounts: The Profit and Loss Account and the Balance Sheet
- Final accounts provide a comprehensive overview of a business’s financial performance and position.
- They help stakeholders assess profitability, financial health, and decision-making strategies. The two key components of final accounts are:
- The Profit and Loss Account (Statement of Profit or Loss) – Shows a company’s financial performance over a period.
- The Balance Sheet – Presents a snapshot of a company’s financial position at a specific date.
The Profit and Loss Account (Statement of Profit or Loss)
- The Profit and Loss Account helps stakeholders understand how efficiently the business operates by measuring revenue, expenses, and overall profitability.
- It is divided into three sections:
The Trading Account
A Trading Account is a financial statement that forms part of the final accounts of a business. It is prepared to determine the gross profit or gross loss of a company during an accounting period.
The profit and loss account
A financial statement showing a company's revenues, expenses, and profits over a specific period.
Profit and loss appropriation account
A Profit and Loss Appropriation Account is an extension of the Profit and Loss Account that shows how a company or partnership allocates its net profit at the end of an accounting period. It is mainly used by partnership firms and companies to distribute profits among partners, shareholders, or reserves.
The term "Profit and Loss Account" is used in your IB exams, but in IFRS terminology, it is commonly known as the Statement of Profit or Loss or Income Statement.
Format and Example
Statement of Profit and Loss for Company X for the year ended 31st December 2024:
| $ | |
|---|---|
| Sales revenue | 750,000 |
| Cost of sales | (240,000) |
| Gross profit | 510,000 |
| Expenses | (300,000) |
| Profit before interest and tax | 210,000 |
| Interest (financing costs) | (20,000) |
| Profit before tax | 190,000 |
| Tax on profits | (47,000) |
| Profit for period | 143,000 |
| Dividends | (43,000) |
| Retained profit | 100,000 |
Cost of Sales / Cost of Goods Sold
The direct costs associated with producing or purchasing goods that a company sells during a period, including raw materials and labour.
Gross profit only considers direct costs, whereas net profit includes all expenses, giving a full picture of profitability.
- Students often confuse gross profit and net profit.
- Gross profit is calculated before expenses like rent and wages, while net profit accounts for all operating costs.
Profit and Loss Account for Non-Profit Organisations (NPOs)
- Non-profits do not generate profits but instead record surplus or deficit.
- The major differences between profit and non-profit organisation (NPO) formats are:
- In an NPO, profit is replaced by surplus and loss is replaced by deficit.
- Generally, there is no dividend given in case of NPO.
| $ | |
|---|---|
| Sales revenue | 750,000 |
| Cost of sales | (240,000) |
| Gross Surplus | 510,000 |
| Expenses | (300,000) |
| Surplus before interest and tax | 210,000 |
| Interest (financing costs) | (20,000) |
| Surplus before tax | 190,000 |
| Tax on surplus | (47,000) |
| Surplus for period | 143,000 |
| Retained Surplus | 143,000 |
- Think of an NPO like a school fundraiser.
- Instead of distributing profits, any extra money raised is reinvested into school projects.
Profit and Loss Account Formulae
$$\text{Gross Profit = Sales Revenue - Cost of Goods Sold}$$
$$\text{Cost of Goods Sold = Opening Stock + Purchases - Closing Stock}$$
$$\text{Net Profit = Gross Profit - Expenses}$$
Limitations of Profit and Loss Account
- The P&L account is based on historic data and hence it cannot guarantee future performance of the organization.
- The lack of standardization globally also makes it difficult to compare track records.
- Some organisations may do window dressing to manipulate their final accounts and keep their stakeholders satisfied.
Window dressing
The practice of manipulating financial statements to make a company's financial position appear stronger than it actually is.
Historic data
The original purchase price of an asset, recorded in accounting records, without adjustments for inflation or market value changes.
Understanding the Flow of the P&L
The Balance Sheet: A Snapshot of Financial Health
The Balance Sheet
A financial statement that presents a company’s financial position at a specific point in time, listing assets, liabilities, and equity.
The balance sheet must always balance: Total Assets = Total Liabilities + Equity.
Format and Example
Statement of Financial Position for Jojo Ltd. (31st December 2023)
| Statement of Financial Position for Jojo Ltd., 31 December 2023 | ||
|---|---|---|
| $000s | $000s | |
| Non-Current Assets | ||
| Property, Plant, and Equipment | 10,015 | |
| Accumulated Depreciation | (1,047) | |
| Non-Current Assets | 8,968 | |
| Current Assets | ||
| Cash | 546 | |
| Stock | 565 | |
| Debtors | 104 | |
| Current Assets | 1,215 | |
| Total Assets | 10,183 | |
| Current Liabilities | ||
| Bank Overdraft | 326 | |
| Trade Creditors | 1,001 | |
| Other Short-Term Loans | 522 | |
| Current Liabilities | 1,849 | |
| Non-Current Liabilities | ||
| Long-Term Borrowings | 4,626 | |
| Non-Current Liabilities | 4,626 | |
| Total Liabilities | 6,475 | |
| Net Assets | 3,708 | |
| Equity | ||
| Share Capital | 1,999 | |
| Retained Profits | 1,709 | |
| Total Equity | 3,708 |
Net Assets
The total assets of a business minus its total liabilities, representing the owners’ equity.
Always check that net assets match total equity to ensure the balance sheet is accurate.
Key Components of the Balance Sheet
- Assets: Resources owned by the business, divided into:
- Non-Current Assets (Fixed assets): Long-term assets held for over a year, such as property, equipment, and vehicles.
- Current Assets: Short-term assets convertible to cash within a year, such as cash, inventory, and accounts receivable.
- Debtors: People or other organisations from whom money is yet to be received.
- Cash: The money held by the organisation in their cashbox/safe and at bank.
- Stocks: Unsold supplies of raw materials, finished goods and semi-finished goods.
- Liabilities: Debts owed by the business, divided into:
- Current Liabilities: Short-term debts payable within a year, such as overdrafts and accounts payable.
- Creditors: People or other organisation to whom money is yet to be paid.
- Bank overdrafts: When an organisation withdraws over and above its balance. Here, the bank balance is negative.
- Non-Current Liabilities: Long-term debts, such as loans and mortgages.
- Equity: The owner's stake in the business, including share capital and retained profits.
Balance Sheet Formulae
$$\text{Net assets = (Non-current assets + current assets) - (Non-current liabilities + current liabilities)}$$
$$\text{Total assets - total liabilities = net assets (total equity)}$$
Limitations of Balance Sheet
- Balance sheet states the financial position on a particular date.
- The numbers may change the very next day.
- The value of certain assets like premises are based on an estimate.
- Hence, the book value may differ from the market value.
- There is no specific universal format for the balance sheet and hence the comparision gets difficult.
- Intangible assets and human capital are not included in the balance sheet.
- This may become difficult to assess especially in case of sports clubs that pay higher fees to their players.
Book Value
The value of an asset as recorded in a company's financial statements, usually the original cost minus depreciation, amortization, or impairment costs.
The Relationship Between the Profit and Loss Account and Balance Sheet
- Retained Profits: Net profit from the Profit and Loss Account is added to the equity section of the Balance Sheet.
- Depreciation: Deducted as an expense in the Profit and Loss Account, reducing non-current asset values in the Balance Sheet.
- Short-Term Borrowing: Interest appears as an expense in the Profit and Loss Account, while the loan itself is recorded as a liability in the Balance Sheet.
How do our biases and assumptions influence the way we interpret financial data? For example, do we focus more on profits than on ethical considerations like fair wages or environmental impact?
