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Learning Aim f

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This section covers two essential financial statements used by businesses to evaluate financial performance: the Statement of Comprehensive Income (Profit & Loss statement) and the Statement of Financial Position (Balance Sheet). You will learn how to prepare these documents and use them to assess a business’s financial health.

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Statement of Comprehensive Income (Profit & Loss Statement)

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What is it?

A Statement of Comprehensive Income shows a business’s revenues and expenses over a specific period, typically one financial year. It helps businesses determine whether they have made a profit or incurred a loss.

This statement provides insights into operational efficiency by breaking down sales, costs, and expenses, which allows management to adjust their strategies accordingly.

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Key Components

Sales Revenue: This is the total income a business earns from selling its goods or services before any expenses are deducted.

Example: A bakery sells 10,000 cakes at £5 each. The sales revenue would be £50,000.

Cost of Goods Sold (COGS): These are the direct costs associated with the production of goods or services, such as raw materials and labour.

Example: A business has £15,000 in opening inventory, buys £25,000 of stock during the year, and has £10,000 left in closing inventory. The COGS would be £30,000.

Gross Profit: This is the profit a business makes after deducting the cost of goods sold from sales revenue.

Example: A business with sales revenue of £50,000 and COGS of £30,000 will have a gross profit of £20,000.

Operating Expenses: These are the costs required to run the business, such as rent, utilities, marketing, and employee wages.

Example: A business incurs £5,000 in rent, £2,000 in marketing, and £8,000 in wages. The total operating expenses would be £15,000.

Net Profit: This is the final profit after deducting all operating expenses, interest, and taxes. It reflects the business’s overall profitability.

Example: If the gross profit is £20,000 and the operating expenses are £15,000, the net profit would be £5,000.

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Statement of Comprehensive Income (Year Ended April 2023)
Sales Revenue	£100,000
Less: Cost of Goods Sold	£30,000
Gross Profit	£70,000
Operating Expenses
Rent	£12,000
Wages	£20,000
Utilities	£5,000
Marketing	£8,000
Insurance	£3,000
Depreciation	£2,000
Total Operating Expenses	£50,000
Net Profit	£20,000

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Why is it Used?

The Statement of Comprehensive Income helps businesses evaluate profitability, operational efficiency, and make informed decisions regarding pricing, cost control, and financial planning.

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Statement of Financial Position (Balance Sheet)

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What is it?

The Statement of Financial Position, commonly known as a Balance Sheet, provides a snapshot of a business’s financial condition at a specific point in time. It details the company’s assets, liabilities, and equity, giving an overview of what the business owns and what it owes.

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Assets

Assets represent the resources owned by the business that are expected to generate future economic benefits. Assets are divided into two categories:

– **Current Assets**: These are assets expected to be converted into cash or used within one year, such as Cash, Accounts Receivable, Inventory, and Prepaid Expenses.

Example: A retail business may have £20,000 in cash, £30,000 in accounts receivable, £40,000 in inventory, and £5,000 in prepaid expenses, totaling £95,000 in current assets.

– **Non-Current Assets**: These are long-term investments or assets that are expected to provide value to the business over more than one year. They include Property, Plant, and Equipment (PPE), Intangible Assets, and Long-Term Investments.

Example: A company might own £150,000 worth of buildings and £50,000 worth of machinery, totaling £200,000 in non-current assets.

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Liabilities

Liabilities are the obligations or debts of a business that it needs to pay in the future. Liabilities are divided into two categories:

– **Current Liabilities**: Debts or obligations due within one year, such as Accounts Payable, Short-Term Loans, and Accrued Expenses.

Example: A business may owe £10,000 in accounts payable and £5,000 in short-term loans, giving it £15,000 in current liabilities.

– **Non-Current Liabilities**: Debts or obligations that are due after one year, such as Long-Term Loans, Mortgages, and Deferred Tax Liabilities.

Example: A business may have a £100,000 mortgage and a £50,000 long-term loan, resulting in £150,000 in non-current liabilities.

Equity

Equity represents the owners’ claims on the business after all liabilities have been deducted from assets. It is calculated as Total Assets minus Total Liabilities.

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Statement of Financial Position (as of December 2023)
Assets
Current Assets
Cash	£20,000
Accounts Receivable	£15,000
Inventory	£40,000
Prepaid Expenses	£5,000
Total Current Assets	£80,000
Non-Current Assets
Property, Plant, and Equipment	£150,000
Long-Term Investments	£50,000
Total Non-Current Assets	£200,000
Liabilities
Current Liabilities
Accounts Payable	£10,000
Short-Term Loans	£5,000
Total Current Liabilities	£15,000
Non-Current Liabilities
Mortgage	£100,000
Long-Term Loans	£50,000
Total Non-Current Liabilities	£150,000
Equity
Share Capital	£80,000
Retained Earnings	£35,000
Total Equity	£115,000
Total Liabilities and Equity	£280,000

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dEPRECIATION

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Definition

Depreciation is the method of allocating the cost of a tangible asset over its useful life. Businesses use depreciation to reflect the reduction in value of assets like machinery and vehicles over time.

Purpose of Depreciation

The main purpose of depreciation is to match the expense of using an asset with the revenue it generates over time. For instance, if a business purchases a piece of machinery that will be used for five years, it wouldn’t make sense to record the full cost of the machine in the first year because the machine will help generate revenue over several years.

Depreciation ensures that:

Income Statements accurately reflect the expense of using an asset each year.
Balance Sheets show a more realistic value of long-term assets after considering wear and tear.

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Types of Depreciation Methods

There are several methods of calculating depreciation, with two of the most commonly used being Straight-Line Depreciation and Reducing Balance Depreciation. Each method affects financial statements differently, and businesses may choose one method over another based on the type of asset and how they expect it to lose value.

A. Straight-Line Depreciation

Straight-Line Depreciation is the simplest and most commonly used method. It spreads the cost of an asset evenly over its useful life. This means that the same amount is depreciated each year, regardless of how much the asset is used.

Formula:

$\text{Annual Depreciation} = \frac{\text{Cost of the Asset} – \text{Residual Value}}{\text{Useful Life of the Asset}}$

$Annual Depreciation = \frac{Cost of the Asset - Residual Value}{Useful Life of the Asset}$

Where:

Cost of the Asset is the price paid to acquire the asset.
Residual Value (also called salvage value) is the estimated value of the asset at the end of its useful life.
Useful Life is the expected time period over which the asset will be used by the business.

Example:
If a company buys a delivery van for £30,000, expects it to last for 5 years, and estimates it will be worth £5,000 at the end of those 5 years, the annual depreciation expense will be:

$\frac{£30,000 – £5,000}{5} = £5,000$

$£30 , 000 - £5 , 000 = £5, 000$

Thus, the business would record £5,000 in depreciation expense each year for 5 years.

B. Reducing Balance Depreciation (Diminishing Balance)

Reducing Balance Depreciation allocates a higher depreciation expense in the earlier years of an asset’s life, which reflects the fact that many assets lose more value in the early years of use. The depreciation amount decreases over time as the asset’s book value (remaining value) gets smaller.

This method is often used for assets that experience rapid declines in value, such as computers, vehicles, and machinery.

Formula:

$\text{Depreciation for the Year} = \text{Book Value at Beginning of the Year} \times \text{Depreciation Rate (\%)}$

$Depreciation for the Year = Book Value at Beginning of the Year \times Depreciation Rate (%)$

Example:
If a company purchases a machine for £50,000 and applies a 20% reducing balance depreciation rate, the depreciation for the first year would be:

$£50,000 \times 20\% = £10,000$

$£50, 000 \times 20% = £10, 000$

For the second year, the book value is now £50,000 – £10,000 = £40,000. Depreciation for the second year will be:

$£40,000 \times 20\% = £8,000$

$£40, 000 \times 20% = £8, 000$

Thus, the depreciation amount decreases each year.