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Financial Accounting

This part of the course examines the formal financial statements which all businesses produce, usually on an annual basis. There are fairly strict rules and conventions surrounding them.

The two main statements which you will come across are the Profit and Loss Account and the Balance Sheet. These are both summaries of where a business stands financially at a given point in time – usually at the end of a year, quarter or month. In addition you will also see reference to the Cash Flow statement.

Activity

If possible, obtain a copy of your organisation’s most recent Annual Financial Report. It may be available from the University website. If this is not possible then download a copy of the report of another university!

As you work through the following parts of the course, refer back to these reports.

Example

Let us take a very simple example. Art student Jo decides to make some money making and selling Christmas cards.

CASH FLOW

As its name implies, this is simply a record of the movement of cash in and out of a business over the course of a specified period of time. Jo spends £25 on buying materials and uses all the material to make 100 cards and sell them for £1 each..

The flow of cash in and out of this venture is very simple.

Opening balance (cash introduced)

£25

Add cash from sales of cards

£100

Total money in

£125

Less cash paid to purchase materials

£25

Closing balance of cash

£100

PROFIT AND LOSS

The purpose of the Profit and Loss (often abbreviated to P & L) account is to show whether, at a point in time, the business has made an operating profit or loss over the preceding period.

For Jo’s card-making, the P & L would look like this:

Sales

£100

Less Cost of Sales

£25

Profit

£75

Note

The not-for-profit sector often prefers to refer to a ‘surplus’ rather than a ‘profit’.

If, unfortunately there are not many customers and Jo decides to sell the cards off for 20p each to avoid taking them home at the end of term, then Jo would  end up with the following, which shows that more money was spent on materials than was made in selling the finished cards.

Sales

£20

Less Cost of Sales

£25

Profit (Loss)

(£5)

Note

There is a convention to put negative figures in brackets ().

But let us suppose that everyone liked the cards. A number of people have asked Jo to make special cards for them, and others just like to look through the stock and choose some. Jo also decides to print some leaflets to hand out and to display on noticeboards etc. Finally Jo is saving up for an iPhone so for each one-off card sold 50p goes into the piggy-bank and 10p for each card bought from stock.

At the end of the month Jo decides to review how the card business is doing. This time there are more things to take into account, such as the cost of printing the leaflets.

Of course Jo has had to buy more material.

Here are the records Jo kept of all the transactions

Date

Item

Per item

Number

Cash in

Cash out

02/01

Card

20p per sheet

20 sheets

 

£4

02/01

Glue

80p per tube

3 tubes

 

£2.40

02/01

Decorations

£1.50 per pack

5 packs

 

£7.50

03/01

Photocopy leaflets

4p per page

100

 

£4

05/01

Card for Ali

£2

1

£2

 

05/01

To piggy bank

50p

1

 

50p

15/01

Cards from stock

£1

10

£10

 

15/01

To piggy bank

10p

10

 

£1

20/01

Card for Jaz

£2

2

£4

 

20/01

To piggy bank

50p

2

 

£1

30/01

Card for Paul M

£2

1

£2

 

30/01

To piggy bank

50p

1

 

50p

30/01

Cards from stock

£1

25

£25

 

30/01

To piggy bank

20p

25

 

£4

Now, as well as the cost of sales – the materials and labour, there is something which cannot be directly related to each card made and sold - the cost of copying leaflets. Such things are variously called ‘indirect costs’, ‘expenses’ or ‘overheads’. They are discussed in more detail later.

Now the P & L might look something like this.

Sales

£43

Less Cost of Sales

£13.90

Gross Profit

£29.10

Less Overheads

£4

Profit

£25.10

Profit distributed to owner

£7

Profit retained

£18.10

This assumes that Jo has used up all the materials which have been bought in making and selling the cards.

THE BALANCE SHEET

The balance sheet will show the whole worth of the business at a point in time. So on 30th January it would look like this:

Cash

£18.10

Other things owned by the business

Zero

Total business wealth

£18.10

One important thing to note here is that the cash figure does not include the money in the piggy bank (‘distributed to the owner’). This is because this is money which has been removed from the business and given to Jo as an individual. In this case, of course, Jo could choose to break into the piggy bank and spend the money on more materials for the business. But the principle that the business is an entity in itself, separate from its owner is an important accounting convention known as the business entity convention.

But suppose that on 31st Jo spends another £13.90 of the profit on more materials but has not made the cards yet. This figure will then appear on the balance sheet.

Cash

£4.20

Stock materials

£13.90

Total

£18.10

Exercise

Student Lee decides to sell time planners to students to help them juggle their studies, work and social lives. He invests £50 of his own money in to the business and also borrows £50. Lee buys 50 time planners at £2 each – getting a discount for bulk – and by the end of the first week Lee has sold 30 of them for £3.50 each. Draw up the cash flow, balance sheet and profit and loss statements for the end of week one.

At the end of a second week, Lee has sold all the planners getting £3.50 for each of them. How much is the total profit – or loss?