Financial Statements

Preparation of Statements

Preparing financial statements is a bit like writing a detailed story about your business's financial performance and position over a certain period. These statements are crucial for everyone involved in the business, from owners to investors, and even lenders, to understand how the business is doing. Let's dive into why these statements are needed, how to make adjustments to them, and explore some examples, especially focusing on small businesses and food trucks.

Need and Purpose of Financial Statements

Financial statements give a snapshot of a business's financial health. They include:

Income Statement (Profit or Loss Statement): Shows how much money the business made and spent over a period, highlighting profit or loss.
Balance Sheet (Statement of Financial Position): A picture of what the business owns (assets), what it owes (liabilities), and the value left over for the owners (equity) at a specific point in time.
Cash Flow Statement: Tracks the inflow and outflow of cash, explaining how the business’s cash position changes over time.

For a food truck, these statements can help track sales trends, manage costs, and make decisions about future investments or changes.

Adjustments to Draft Financial Statements

Before finalizing financial statements, you might need to make some adjustments for things like:

Accruals and Prepayments

Accruals: Expenses or income that have been incurred but not yet paid or received by the end of the accounting period. If "Gourmet on Wheels" used electricity in December but didn't get the bill until January, they'd need to account for this expense in December's financial statements.
Prepayments: Payments for expenses that will benefit more than one accounting period. If the food truck paid a full year's insurance premium in advance, the portion covering months beyond the current financial year should be accounted as a prepayment.

Irrecoverable Debts and Allowance for Irrecoverable Debts

Sometimes customers can't or won't pay what they owe (irrecoverable debts). An allowance for irrecoverable debts is a prediction of future bad debts based on past experience. Adjusting for these helps ensure income statements don't overstate income.

Depreciation

Reflects the decrease in value of long-term assets like the truck or equipment. Adjusting for depreciation ensures the balance sheet accurately reflects the assets' value and the income statement includes the cost of using these assets.

Inventory Valuation

Adjusting inventory to the lower of cost or net realizable value ensures the balance sheet reflects a realistic value for inventory, and the income statement correctly accounts for the cost of goods sold.

Correction of Errors

Mistakes happen, but they need to be corrected before finalizing financial statements. This could involve adjusting entries to correct misposted transactions or overlooked expenses.

How to Calculate and Record Adjustments

Let's consider "Gourmet on Wheels" at the end of the year:

They realize they forgot to account for December's electricity use. They estimate the cost based on previous months and create an accrual.
They review their accounts receivable and decide some debts are unlikely to be paid. They calculate an allowance for irrecoverable debts based on this review.
They assess their equipment for depreciation, applying the appropriate method to find the year's expense.
They evaluate their inventory, adjusting the value down for items that have lost value or can't be sold at their original cost.
They find a mistake in how they recorded sales in November. They make the necessary correction to ensure sales are accurately reported.

Each of these adjustments involves:

Identifying the need for adjustment.
Calculating the correct amounts.
Creating journal entries to record the adjustments (debiting and crediting the relevant accounts).
Reflecting these adjustments in the draft financial statements to ensure they present an accurate view of the business's financial situation.

Statements for Sole Proprietors

When it comes to managing the finances of a sole trader business, like a food truck, preparing financial statements is like drawing a detailed map of where the money comes from, where it goes, and where the business stands financially at a specific point in time. Let's explore the steps to create these statements, focusing on both trading and service businesses, and understand the adjustments needed to ensure they accurately reflect the business's financial health.

Preparing Income Statements

An Income Statement shows the business's revenue and expenses over a period, leading to the net profit or loss.

For Trading Businesses (like a food truck selling burgers): Start with sales revenue, subtract the cost of goods sold (COGS) to find the gross profit, then subtract operating expenses to get the net profit.
For Service Businesses (like a food truck offering catering services): The process is similar but without the COGS. Revenue from services provided minus operating expenses gives the net profit.

Understanding the Statement of Financial Position

The Statement of Financial Position (Balance Sheet) shows what the business owns (assets) and owes (liabilities) at a specific date, plus the owner's equity.

Content of a Statement of Financial Position:

Non-Current Assets: Long-term assets like the food truck and kitchen equipment.
Intangible Assets: Non-physical assets, like trademarks or patents.
Current Assets: Short-term assets, such as inventory (food supplies) and cash in hand.
Current Liabilities: Short-term debts, like money owed to suppliers.
Non-Current Liabilities: Long-term debts, such as a loan taken to purchase the truck.
Capital: The owner's investment in the business, adjusted for profits or losses and any drawings (money taken out by the owner).

Inter-Relationship of Items in the Statement of Financial Position

Each element is connected. For example, buying a new freezer (an asset) might increase Non-Current Assets and Current Liabilities (if bought on credit). Profits increase Capital, while drawings decrease it.

Adjustments to Financial Statements

Adjustments ensure the statements accurately reflect the business's financial situation.

Depreciation: Reflects the decrease in value of assets.
- Straight Line Method: Deducts the same amount each year.
- Reducing Balance Method: Deducts a percentage of the remaining value each year.
- Revaluation Method: Adjusts the asset's value to its current market value.
Accrued/Prepaid Expenses and Income: Adjust for expenses incurred or income earned but not yet paid or received, ensuring they're recorded in the correct period.
Irrecoverable Debts and Provisions for Doubtful Debts: Adjust for money owed to the business that won't be collected and estimate future bad debts.
Goods Taken by the Owner: If the owner takes inventory for personal use, it's recorded as drawings, reducing inventory and capital.

Mini-Case Study

Imagine "Gourmet on Wheels" is wrapping up its fiscal year:

They calculate depreciation on their food truck using the reducing balance method, acknowledging the truck's heavy use.
They adjust for the insurance premium paid in advance (prepaid expense) and for the winter heating bill received but not yet paid (accrued expense).
They write off a bad debt from a catering event that won't pay and set aside a provision for doubtful debts based on past experience.
The owner took some beverages for a family event, recorded as drawings.

Each adjustment ensures the final financial statements—both the income statement and the statement of financial position—accurately reflect "Gourmet on Wheels'" true financial status.

Statements for Limited Companies

Unlike sole traders, limited companies have more complex structures, especially when it comes to their capital. Let's delve into the capital structure of limited companies, understand different types of share capital, and explore how to prepare and adjust financial statements.

Capital Structure of a Limited Company

The capital structure of a limited company involves various components:

Preference Share Capital: These shares give owners certain advantages, like receiving dividends before ordinary shareholders and having priority over company assets if the company winds down. However, they usually don't have voting rights.
Ordinary Share Capital: Ordinary shares represent ownership in the company. Shareholders typically have voting rights and may receive dividends, but only after preference shareholders have been paid.
General Reserve: This is money set aside from profits for future use, like expanding the business or paying off debt.
Retained Earnings: These are profits that have been re-invested into the company instead of being paid out as dividends.

Issued, Called-Up, and Paid-Up Share Capital

Issued Share Capital: This is the total value of shares that the company has actually offered for sale and have been purchased by shareholders.
Called-Up Share Capital: Sometimes, a company doesn't require the full amount of the issued share capital to be paid immediately. The amount that shareholders are asked to pay is called the called-up share capital.
Paid-Up Share Capital: This is the amount of the called-up share capital that has been paid by shareholders. If it's less than the called-up amount, the company may have some called-up but unpaid share capital.

Share Capital vs. Loan Capital

Share Capital (both preference and ordinary shares) represents ownership in the company. Shareholders might receive dividends and possibly have voting rights, but these are not guaranteed and depend on the company's profitability.

Loan Capital typically comes from debentures, which are long-term loans to the company. Debenture holders are creditors, not owners, and are entitled to regular interest payments regardless of the company's profit levels.

Preparing Financial Statements for Limited Companies

Income Statements

Think of the Income Statement as a summary of the company's financial performance over a specific period, usually a year. It lists all the money the company made (revenue) and subtracts what it spent (costs and expenses). What's left is either the net profit (if revenue exceeds costs) or net loss (if costs exceed revenue).

Revenue: Money earned from selling goods or services.
Costs and Expenses: Money spent in the process of earning revenue, including the cost of goods sold, salaries, rent, and utilities.
Net Profit or Loss: The final result, showing if the company made more money than it spent.

Statements of Changes in Equity

This statement provides a detailed look at what happened to the company's equity (the value left for owners after liabilities are subtracted from assets) during the accounting period. It tracks:

Shares Issued: New shares sold by the company to raise money.
Dividends Paid: Profits returned to shareholders.
Retained Earnings: Profits kept in the company to reinvest in operations or save for future use. This part shows how the company's decisions affect its worth from one period to the next.

Statements of Financial Position (Balance Sheets)

The Balance Sheet is like a snapshot of the company's financial situation at a specific point in time. It shows:

Assets: Everything the company owns that has value, including cash, inventory, and equipment.
Liabilities: What the company owes to others, like loans and accounts payable.
Equity: The value left over for the owners after all liabilities are paid off. It's the "net worth" of the company.

The Balance Sheet must balance, meaning the total assets always equal the sum of liabilities and equity.

Statement of Cash Flows

This statement tracks how much cash comes into and goes out of the company, divided into three main activities:

Operating Activities: Cash generated or spent on day-to-day operations.
Investing Activities: Cash spent on or received from buying or selling long-term assets like equipment.
Financing Activities: Cash received from issuing shares or borrowed, minus cash used to pay dividends or repay loans.

It shows if the company is generating enough cash to sustain and grow its operations or if it's relying on external financing.

Schedule of Non-Current Assets

This detailed list shows the company's long-term investments, which are not expected to be converted into cash within the next year. It includes:

Acquisitions: New assets purchased.
Disposals: Assets sold or discarded.
Depreciation: The reduction in value of assets over time due to use or obsolescence.
Revaluations: Adjustments to the book value of assets to reflect their current market value.

This schedule helps track the aging, upgrading, and overall management of the company's long-term assets.

Adjustments to Financial Statements

Just like for sole traders, adjustments are necessary for accuracy:

Accruals and Prepayments: Adjusting for expenses incurred or income earned but not yet paid or received.
Depreciation: Accounting for the decrease in value of non-current assets.
Inventory Valuation: Adjusting inventory to the lower of cost or net realisable value.
Irrecoverable Debts: Adjusting for debts that are unlikely to be collected.

Using Incomplete Records

Disadvantages of Not Maintaining a Full Set of Accounting Records

Financial Uncertainty: Without complete records, it's hard to know the exact financial status of the business, including profits, losses, and cash flow.
Taxation Issues: Inaccurate records can lead to incorrect tax filings, resulting in penalties or legal issues.
Difficulty in Securing Loans: Lenders often require detailed financial statements. Incomplete records make it harder to prove the business's viability.
Poor Decision Making: Without clear financial insights, making informed decisions about pricing, inventory management, and expansion becomes challenging.

Advantages of Maintaining a Full Set of Accounting Records

Clear Financial Picture: Complete records provide a detailed view of the business's financial health, enabling better strategy and planning.
Compliance and Tax Efficiency: Accurate bookkeeping ensures compliance with tax laws and can help minimize tax liabilities.
Easier Access to Financing: Detailed financial statements can make it easier to secure loans or attract investors.
Improved Management: Knowing exactly where the business stands financially aids in managing cash flow, inventory, and pricing decisions effectively.

Dealing with Incomplete Records

Sometimes, especially with small businesses like food trucks, records might not be fully detailed. Here's how to handle that:

Prepare Opening and Closing Statements of Affairs

These statements provide a snapshot of the business's assets, liabilities, and capital at the beginning and end of a period. They can help estimate financial performance over that time.

Calculate Profit or Loss from Changes in Capital

If you know the capital at the start and end of a period (from statements of affairs), and how much the owner has drawn or invested in between, you can estimate the profit or loss.

Use Incomplete Information to Estimate Figures

Even with gaps in the records, you can use what you do have to estimate important figures like sales, purchases, and gross profit. For instance, if you know the inventory levels at the start and end of the period and the purchases made, you can estimate the cost of goods sold and, by extension, gross profit.

Prepare Financial Statements from Incomplete Records

By piecing together the available information and making educated estimates, you can prepare basic income statements and balance sheets. These won't be as precise as those from complete records but can still offer valuable insights.

Make Adjustments as Needed

Just like with full records, you may need to adjust for things like depreciation, inventory valuation, and irrecoverable debts to refine your estimates.

Apply Mark-up, Margin, and Inventory Turnover Techniques

These calculations can help fill in missing figures:

Mark-up: The percentage added to the cost of goods to determine the selling price. If you know the cost and the mark-up, you can find the sales price.
Margin: The percentage of the selling price that is profit. Knowing the sales price and margin allows you to calculate profit.
Inventory Turnover: This shows how quickly inventory is sold and replaced over a period. It can help estimate sales based on the cost of goods sold and inventory levels.

Mini-Case Study

Let's look at "Gourmet on Wheels," a food truck business that has incomplete records for the year. We'll use actual numbers to illustrate how to work with what we have and still come up with useful financial estimates.

Starting Point

At the beginning of the year, "Gourmet on Wheels" had:

Cash: $5,000
Inventory (food supplies): $2,000
Equipment (net of depreciation): $15,000
Accounts Payable (money owed to suppliers): $3,000
Capital: $19,000

During the year, the owner took $4,000 for personal use (drawings) but also invested an additional $2,000 into the business.

End of Year

At the end of the year, the available figures are:

Cash: $8,000
Inventory: $2,500
Accounts Receivable (money owed by customers): $1,500
Accounts Payable: $4,000

The owner knows they spent $10,000 on new supplies throughout the year and estimates the food truck's equipment has depreciated by $3,000.

Calculating Gross Profit and Net Profit

First, we need to find the cost of goods sold (COGS) and then the gross profit. We're missing direct sales figures, but let's work with what we've got:

Opening Inventory: $2,000
Purchases: $10,000
Closing Inventory: $2,500

COGS = Opening Inventory + Purchases - Closing Inventory = $2,000 + $10,000 - $2,500 = $9,500

Assuming the food truck operates with a mark-up of 50% on its COGS (meaning they sell their food for 50% more than it costs to make), we can estimate sales. A 50% mark-up means the COGS ($9,500) represents 66.67% of sales (because 100% - 33.33% mark-up = 66.67%).

Estimated Sales = COGS / 66.67% = $9,500 / 0.6667 ≈ $14,250

Gross Profit = Sales - COGS = $14,250 - $9,500 = $4,750

Now, let's find the net profit, accounting for the depreciation expense:

Depreciation Expense: $3,000
Net Profit (excluding other expenses for simplicity) = Gross Profit - Depreciation = $4,750 - $3,000 = $1,750

Preparing the Statement of Financial Position

Now, let's update the capital and prepare a simplified statement of financial position:

Capital at start = $19,000

Add: Net Profit = $1,750
Less: Drawings = $4,000

Additional Investment = $2,000 New Capital = $18,750

Assets:

Cash: $8,000
Accounts Receivable: $1,500
Inventory: $2,500
Equipment (original $15,000 - depreciation $3,000): $12,000 Total Assets: $24,000

Liabilities:

Accounts Payable: $4,000

Equity:

Capital: $18,750 Total Liabilities and Equity: $22,750

Adjustments and Final Notes

In reality, we'd also need to adjust for any other known expenses (like wages, utilities, or rent), accrued expenses (like an electricity bill not yet paid), and any other income (like interest earned). These adjustments would refine our net profit figure and the equity in the statement of financial position.