Accounting and Financial Statements

Text 2

As you read the text, focus on the main types of financial statements.

In accounting, it is always assumed that a business is a going concern, i.e. that it will continue indefinitely into the future, which means that the current market value of its fixed assets is irrelevant, as they are not for sale. Consequently, the most common accounting system is historical cost accounting, which records assets at their original purchase price, minus accumulated depreciation charges. In times of inflation, this understates the value of appreciating assets such as land, but overstates profits as it does not record the replacement cost of plant or stock (GB) or inventory (US). The value of a business's assets under historical cost accounting – purchase price minus depreciation - is known as its net book value. Countries with persistently high inflation often prefer to use current cost or replacement cost accounting, which values assets (and related expenses like depreciation) at the price that would have to be paid to replace them (or to buy a more modern equivalent) today.

Company law specifies that shareholders (GB) or stockholders (US) must be given certain financial information. Companies generally include three financial statements in their annual reports.

The profit and loss account (GB) or income statement (US) shows revenue or earnings or income and expenditure. It usually gives figures for total sales or turnover, and costs and overheads (GB) or overhead (US). The first figure should obviously be higher than the second, i.e. there should be a profit. Part of the profit goes to the government in taxation, part is usually distributed to shareholders (stockholders) as a dividend, and part is retained by the company.

The balance sheet shows a company's financial situation on a particular date, generally the last day of the financial year. It lists the company's assets, its liabilities, and shareholders' (stockholders') funds. A business's assets include debtors (GB) or accounts receivable (US) as it is assumed that these will be paid. Liabilities include creditors (GB) or accounts payable (US), as these will have to be paid. Negative items on financial statements, such as creditors, taxation, and dividends paid, are usually enclosed in brackets.

In accordance with the principle of double-entry bookkeeping (that all transactions are entered as a credit in one account and as a debit in another), the basic accounting equation is Assets = Liabilities + Owners' (or Shareholders') Equity. This can be rewritten as Assets - Liabilities = Owners' Equity or Net Assets. This includes share capital (money received from the issue of shares), share premium (GB) or paid-in surplus (US) (any money realized by selling shares at above their nominal value), and the company's reserves, including the year's retained profits. Shareholders' equity or net assets are generally less than a company’s market capitalization (the total value of its shares at any given moment, i.e. the number of shares times their market price), because net assets do not record items such as goodwill.

The third financial statement has various names, including the source and application of funds statement, and the statement of changes in financial-position. This shows the flow of cash in and out of the business between balance sheet dates. Sources of funds include trading profits, depreciation provisions, sales of assets, borrowing, and the issuing of shares.

Applications of funds include purchases of fixed or financial assets, payment of dividends, repayment of loans, and - in a bad year - trading losses.

Ex. 1. Complete the following sentences using the text from the Exercise 1.

1. Companies record their fixed assets at historical cost because...

2. Historical cost accounting usually underestimates,...

3. Countries with a regularly high rate of...

4. Company profits are usually split,...

5. Double-entry bookkeeping requires that...

6. A company's net assets consist of...

7. A company's stock market capitalization...

8. Flows of cash both in and out of the company...

Ex. 2. Speak on:

1. The difference between historical cost accounting and current cost accounting.

2. The main business statements.

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