The Annual Report (1/2)

The Annual Report (1/2)

In this lesson, you’re expected to learn about:
– the different types of accounts and reports
– assets and stock
– trade debtors and doubtful debts

Financial statements are produced as a means of communicating information. The information contained must therefore be interpreted by the user in order to be of any value.

The figures themselves give a certain amount of information but a greater insight may be gained by analysing them in depth.

Different Types of Accounts

1) Management accounts are the accounts companies prepare for the use of their directors and management. These accounts are based on the fundamental principle of accounting and the two concepts we discussed last week (the accruals basis and the going concern assumption).

There are no other requirements as to how they should be laid out, how much detail there should be etc. this is up to the company to decide. They are normally not available to the public (unless the company chooses to publish them)

2) Statutory accounts are the accounts which companies have to file each year and make available to shareholders. There are many rules for such accounts and in fact there are different sets of rules for different categories of a company.

[Optional] Difference Between Statutory Accounts and Management Accounts
The Reports

Strategic Report

A strategic report is meant to provide shareholders with information that will enable them to assess how the directors have performed their duty to promote the success of the company. The report should explain:

• the company’s business model, strategy and objectives
• the principal risks faced by the company
• the company’s past performance

Director’s Report 

All companies are required by law to provide a directors’ report with their annual accounts.

Auditors’ Report 

Most big companies have to have their annual accounts audited. This means that an accounting firm makes an independent examination of the company’s books.

When the accounts are produced for the shareholders, the auditors have to provide a report, expressing their opinion on the company’s financial statements.

The most important part of the annual report is the three main financial statements and the notes to those statements.

We’ll start by looking at the balance sheet – the assets and claims in particular. 

Tangible Fixed Assets

Recall that fixed assets are assets used by the business on a long-term continuing basis.

Tangible fixed assets are, as the name implies, fixed assets that you can touch such as land, buildings, machinery, vehicles etc.

Referring to the balance sheet below, we can see how the tangible assets increased from Year 4 to Year 5.
This table provides much more detail about tangible fixed assets. Notice that the fixed assets have been separated into three different categories (columns), which are then added together in the fourth column to give the total.
In the bottom right-hand corner, you can see the net book value, which is simply the cost of the assets less the total depreciation on the assets up to that point in time.
Let’s look at the Cost section. This section shows what the company originally paid for its fixed assets.
• At start of Year 5: the company had fixed assets which had cost it a total of £6,492k to buy.
• Additions: during the year, the company bought fixed assets that cost another £1,391k.
• Disposals: some fixed assets were sold during the year. These assets had originally cost £35k. Note that this is what they cost not what the company received for the assets when it sold them.
The next section Depreciation shows how the total cumulative depreciation to date was arrived at.
• At start of Year 5: the fixed assets were £2,047k less than when they were new.
• On Disposals: since some fixed assets were sold during the year and the company no longer owns the assets, we must remove the relevant depreciation (£20k) from our calculations.
• We then have to add the depreciation charge for the year. This is made up of depreciation on the assets, which were owned at the start of the year, plus some depreciation on the assets bought during the year.
Manufacturers vs. Companies 

When making changes to stock for a manufacturer, the accounting process is slightly different. This is due to the fact that a manufacturer buys raw materials, producing things with those raw materials and then puts the finished goods into a warehouse to sell to customers.

Thus, a manufacturer has three types of stock:
• Raw material
• Work in progress (goods that are partially manufactured)
• Finished goods (ready for sale)

Accounting for raw materials is simple – we can treat them in the same way as we did for a company’s stock.
Production Costs 

When we manufacture goods using raw materials, this involves costs such as rent, electricity, employee wages, depreciation of fixed assets. These costs collectively are known as production costs.

What should the accounting entries be for these costs?   
Let’s use employee wages as an example and assume the employees have been paid during the accounting period. So we must decrease the cash entry. Since these production costs have been incurred in turning the raw materials into a more valuable asset, we must increase the value of the stock.

Matching

You make sure that you match costs to revenues in any accounting period. If you had simply reduced retained profit by the production cost even though the stock had not ben sold, you would have had cost in this accounting period but no associated sales.

During a subsequent accounting period, you would have had sales but your only cost would have been the cost of raw materials. Therefore, in neither of these two accounting periods do you have a clear picture of how much profit the company made.

The Average Method & FIFO
What happens when two lots of identical stock are purchased at different prices?

Accounting for the purchase is easy but how much would the cost of goods sold be for this transaction?

It depends – different companies use different ways of dealing with this question. Two of the most common ways are the average method and FIFO.

Let’s use an example to understand these two methods.   

Assume that a business owner David buys two lots of identical stock at different prices as follows:

50 units at a price of 20 = total of €1000
100 units at a price of 23 = total of €2300

Therefore, the total increase in stock is €3300 (€1000 + €2300). If David then sold 75 units to a customer for €40 per unit, total sales would be €3000.

How much would his cost of goods sold be for this transaction?

Average Method 

We simply take the average cost of stock during the period.

In our example, this would be:
(50 x 20) + (100 x 23) / 150 = €22 per unit

Total cost of goods sold = €22 x 75 = €1650

FIFO stands for first in, first out. This means that the oldest stock (i.e. stock purchased first) is ‘used’ first.

In our example, the oldest stock was purchased for €20. Since we only have 50 units of this stock, we then use some of the next oldest stock.

The cost of goods sold is therefore: (50 x 20) + (25 x 23) = €1,575

As you can see, the sales are the same in each case but the cost of goods sold is different which means that you’ll get different profit figures.

This explains why two identical companies could have different accounts. However, companies are obliged to use the same method every year so that their accounts are comparable from one year to the next.

[Optional] First-In, First-Out (FIFO) Method
Trade Debtors & Doubtful Debts

One thing you need to consider is the effect of bad debts or doubtful debts. If you know that one of your customers has gone bust owing you money which they will not be able to pay, or you have reason to believe that one of them is likely to go bust and not be able to pay you, then you should make an allowance for those non-payments.

If you know for certain that you will not get paid, then you write off the debt. If you only think you might not get paid, then you should make a provision against the debt.

Whether you are writing off a debt or just making a provision, the accounting is the same:
• Decrease debtors
• Decrease retained profit

What if you make a provision against a debt that you think may not be paid, but subsequently it is? 
In this case, you need to reverse the transaction. Effectively, it will show up as an additional profit in your next set of accounts.

[Optional] How to write off a bad debt
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