Company financial statements

by Neil Stein
25 Apr 2003

Any candidate taking Paper 1.1, Preparing Financial Statements or CAT Paper C1, Drafting Financial Statements should be ready for a question on the preparation of company financial statements. Candidates should make themselves familiar with the use of the formats in the Companies Act 1985 (UK) or in IAS 1 ‘Presentation of Financial Statements’ (International).

The normal study route to company financial statements for publication is:

Stage 1
Master sole traders’ accounts, including adjustments for stock / inventory, accruals, prepayments, bad debts and depreciation.

Stage 2
Learn the additional items required for company accounts – share capital, reserves, dividends and debentures.

Stage 3
Understand how the detailed accounts in Stage 2 are presented in the summarised formats required for publication.

It is clear from Paper 1.1 examination scripts that too many candidates are stuck at Stage 2, because they make no attempt to use the proper formats (see my examiner’s report on page 40 of this issue of student accountant).

The main purpose of this article is to deal with the transition from Stage 2 to Stage 3. Some points from Stage 1 and Stage 2 will be picked up in the process. In this article we deal only with the profit and loss account / income statement. We’ll look first at the formats, then move to a typical examination question and the technique for answering it.

The formats
What may put some candidates off here is that some textbooks reproduce the full horror of the UK formats straight out of the Companies Act 1985. For Papers 1.1 and C1 a lot of the detail is quite irrelevant.

Here are two simplified formats suitable for these examinations:

UK format
Profit and loss account for the year ended…

	£m
Turnover	X
Cost of sales	(X)
Gross profit	X
Distribution costs	(X)
Administrative expenses	(X)
Operating profit	X
Interest payable	(X)
Investment income	X
Profit on ordinary activities before taxation	X
Taxation	(X)
Profit on ordinary activities after taxation	X
Extraordinary items	(X)
Profit for the financial year	X
Dividends paid and proposed	(X)
Retained profit for the financial year	X

International
Income statement for the year ended...

	$m
Revenue	X
Cost of sales	(X)
Gross profit	X
Distribution costs	(X)
Administrative expenses	(X)
Profit from operations	X
Finance cost	(X)
Investment income (see Note 2 below)	X
Profit before tax	X
Income tax expense	(X)
Net profit from ordinary activities	X
Extraordinary items	X
Net profit for the year	X

Notes on the formats

The operating expenses are classified under three headings – cost of sales, distribution costs and administrative expenses. This actually makes the use of the format easier and quicker than preparing a detailed profit and loss account / income statement, as shown in Figure 2.
The item ‘investment income’ does not actually appear in the IAS 1 format but the position shown for it is logical.
Taxation / income tax expense, if it appears at all, will always be very simple, with a given figure to be treated like any other accrual (charge in the profit and loss account / income statement and a current liability in the balance sheet).
Extraordinary items are rarer now than they used to be, and will feature infrequently in the examination in this type of question.
The UK format includes dividends paid and proposed as a deduction from profit, because the Companies Act 1985 requires them to be shown in the profit and loss account. There are two differences in the International format. First of all, proposed equity dividends will rarely arise because IAS 10 ‘Events After the Balance Sheet Date’ prohibits their inclusion unless they have been proposed or declared before the balance sheet date. Secondly, the IAS format for financial statements puts dividends paid in the statement of changes in equity.
Both the UK and International rules have a second format in which the expenses are analysed differently. These alternative formats are examinable but will appear less frequently in the examination than the formats used here.

An illustrative question
Figure 1 on is Question 1 from Section B of the paper examination in December 2002. (The UK version is used – the International version differs only in terminology).

Figure 1
The following items have been extracted from the trial balance of Cronos Limited as at 30 September 2002.

		Reference to notes	£	£
Opening stock			186,400
Purchases			1,748,200
Carriage inwards			38,100
Carriage outwards		2	47,250
Sales				3,210,000
Trade debtors			318,000
Wages and salaries		2 and 3	694,200
Sundry administrative expenses		2	381,000
Provision for doubtful debts as at 1 October 2001		4		18,200
Bad debts written off during the year		4	14,680
Office equipment as at 1 October 2001:
	Cost	5	214,000
	Accumulated depreciation	5		88,700
Office equipment:
	additions during year	5	48,000
	proceeds of sale of items during year	5		12,600
Interest paid		2	30,000

Notes

Closing stock amounted to £219,600

Prepayments and accruals

	Prepayments £	Accruals £
Carriage outwards		1,250
Wages and salaries		5,800
Sundry administrative expenses	4,900	13,600
Interest payable		30,000

Wages and salaries cost is to be allocated:
cost of sales 10%
distribution costs 20%
administrative expenses 70%
Further bad debts totalling £8,000 are to be written off, and the closing provision for doubtful debts is to be equal to 5% of the final trade debtors figure. The bad and doubtful debt expense is to be included in administrative expenses.
Office equipment:
Depreciation is to be provided at 20% per annum on the straight line basis, with a full year’s charge in the year of purchase and none in the year of sale. During the year equipment which had cost £40,000, with accumulated depreciation of £26,800, was sold for £12,600.

Required:
Prepare the company’s profit and loss account for publication, in accordance with the Companies Act 1985, using the headings in Format 1. Notes to the profit and loss account are not required.
(12 marks)

Discussion
The question calls for a profit and loss account / income statement only. A major part of the answer is a working to analyse the operating expenses into the three headings required, so set that up early. Three columns are needed:

Cost of sales	Distribution costs	Administrative expenses
£	£	£

Before completing the working, let’s go through the question and see what to do with each item – firstly the notes. You may need to mark with a cross the items in the trial balance extract affected by them, but this is not necessary here as the Examiner has included references to the notes.

The first step is to set up your profit and loss account with a proper heading, starting at the top of a page, and on another facing page the expense analysis working described above. Now go through the trial balance from the top, entering the items appropriately. See Figure 2.

Figure 2

Opening stock	Enter straight to the three-column working under cost of sales
Purchases	As above.
Carriage inwards	As above (in the exam, a surprising number of candidates decided that carriage inwards was actually returns inwards and had to be deducted from sales).
Carriage outwards	Enter under distribution costs.
Sales	Enter as the first item in your profit and loss account (no adjustments affect this item).
Trade debtors	You are given this figure only to enable you to calculate the provision for doubtful debts so don’t enter it anywhere.
Wages and salaries	Split the figure 10:20:70 and enter in the three columns of your working. Two things to note here: 1 If you’re alert, you’ll have noticed that the inclusion of the accrued wages £5,800 gives a nice round figure of £700,000 to be allocated, simplifying the arithmetic. If you don’t notice this, it doesn’t matter. 2 Accrued wages have to be added to the trial balance figure. In the exam, many deducted £5,800.
Sundry administrative expenses	Enter to the admin column, (if you want to, you can adjust for the prepayment and accrual, but it is just as easy, if not easier, to enter them into the admin column later).
Provision for doubtful debts	Here you have to pause and do a calculation. You want a and bad debts written off single figure for bad and doubtful debts expense for the admin during the year expenses column.

Here is the working:

Bad and doubtful debts
	£		£
Bad debts written off	14,680	Opening provision	18,200
Bad debts written off	8,000
Closing provision (5% x (318,000 - 8,000))	15,500	Profit and loss account (balancing figure)	19,980
	38,180		38,180

Surprisingly, few candidates got to £19,980. A popular mistake was to forget to deduct the £8,000 in calculating the closing provision, leading to an answer of £20,380.

Office equipment (four items)	We pause again to do a calculation of the depreciation charge for the year and the profit or loss on the disposal. Depreciation: 20% x (214,000 + 48,000 - 40,000) = £44,400 Profit or loss on sale: 40,000 - 26,800 = 13,200; minus 12,600 = £600 loss Enter both figures in the appropriate column – admin expenses
Interest paid	Leave it for now – come back to it when you’re ready.
Closing stock	Enter as a deduction under Cost of sales.
Prepayments and accruals	Enter in the appropriate columns: Carriage outwards – Distribution costs. Wages and salaries – across the columns 10:20:70 unless already dealt with. Sundry admin expenses – admin expenses Interest – leave it for now.

We now total up the three-column working (see below) and complete the profit and loss account, not forgetting to insert the interest (£30,000 + £30,000 = £60,000) at the correct point.

The completed working.

		Cost of sales £	Distribution costs £	Administrative expenses £
Opening stock		186,400
Purchases		1,748,200
Carriage inwards		38,100
Carriage outwards			47,250
Wages and salaries 10:20:70		69,420	138,840	485,940
Sundry admin expenses				381,000
Bad and doubtful debts (working)				19,980
Depreciation (working)				44,400
Loss on sale (working)				600
Closing stock		(219,600)
Prepayments				(4,900)
Accruals:
	Carriage out		1,250
	Wages and salaries 10:20:70	580	1,160	4,060
	Admin expenses			13,600
		1,823,100	188,500	944,680

Cronos Limited: Profit and loss account for the year ended 30 September 2002

	£	£
Sales		3,210,000
Cost of sales		(1,823,100)
Gross profit		1,386,900
Distribution costs	(188,500)
Administrative expenses	(944,680)	(1,133,180)
Operating profit		253,720
Interest payable (30,000+30,000)		(60,000)
Profit for the financial year		193,720

That concludes our look at company profit and loss accounts / income statements for publication. Later articles will deal with other aspects – balance sheet, the FRS 3 statements (UK) and the statement of changes in equity (International).

Neil Stein is Examiner for Paper 1.1

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Company financial statements