Why accounts exist

Final accounts are financial statements that summarise a business’s financial performance and financial position for users inside and outside the organisation. They’re not produced just because accountants like tidy columns. They help reduce uncertainty for people who need to make decisions about the business.

A stakeholder is a person or group that has an interest in, or is affected by, the activities and decisions of a business. The same accounts can answer quite different questions, depending on who is reading them:

• Shareholders are owners of shares in a limited company who use accounts to judge profit, dividends and the value of their investment.
• Managers are decision-makers inside the business who use accounts to monitor performance, compare years, set budgets and decide strategy.
• Employees are workers who use accounts as a rough indicator of job security, wage prospects and the ability of the business to continue operating.
• Lenders are providers of borrowed finance who use accounts to assess whether interest and loan repayments are likely to be made.
• Suppliers are businesses that provide goods or services to another business and may use accounts before offering trade credit.
• The government is the public authority that uses accounts to check taxable profit and legal compliance.
• Potential investors are people or institutions considering buying shares or investing funds; they use accounts to judge risk and expected return.
• Customers may use accounts where continuity matters, for example if they need warranties, after-sales service or a reliable long-term supplier.

Stakeholder groups and how they use final accounts

Purpose matters here. A profitable business might please shareholders, reassure employees and attract investors, while also leading the government to expect higher tax payments. So good accounts can support better decisions, but only when they’re prepared honestly. Accounting ethics is the application of honesty, objectivity and professional judgement to financial reporting so that users are not misled. If managers manipulate accounts to make the business look healthier than it really is, stakeholders may act on false confidence and make poor decisions.

The two final accounts you must recognise

The syllabus centres on two final accounts: the profit and loss account and the balance sheet. They do different jobs, so keep them separate.

A profit and loss account is a financial statement that records a business’s revenues, costs and profit over a period of time, usually one year. It is also called an income statement. Focus on over a period: think of it as a film of trading activity.

A balance sheet is a financial statement that shows a business’s assets, liabilities and equity at one specific date. It is also called a statement of financial position. Here the key idea is at a date: more like a photograph of what the business owns and owes.

Profit and loss account

A profit is a financial surplus that occurs when revenue is greater than costs. A loss is a financial deficit that occurs when costs are greater than revenue. In a not-for-profit organisation, the equivalent of profit is normally called a surplus, which is an excess of income over expenditure used to support the organisation’s aims rather than distributed to owners.

For IB-style presentation, use a clear order: sales revenue first, then cost of goods sold, then gross profit, then expenses, then net profit before interest and tax. If figures are given in thousands or millions, state the unit clearly; 400, 400 thousand and 400 million are not the same thing.

Profit and loss account with two-year comparison

Interpretation means reading the movement between the lines. Sales revenue might rise while gross profit falls; in that case, look at cost of goods sold. Gross profit might rise while net profit before interest and tax falls; then expenses are the place to check. This is how the profit and loss account helps managers and investors spot where performance is improving or weakening.

Balance sheet

An asset is a resource owned or controlled by a business that is expected to provide future economic benefit. A fixed asset is an asset used by the business for more than one year, such as premises, vehicles or machinery. A current asset is an asset expected to be converted into cash, sold or used up within one year, such as cash, inventories and debtors.

A liability is a financial obligation that a business owes to another party. A current liability is a debt due within one year, such as creditors, overdrafts or tax payable. A long-term liability is a debt due after more than one year, such as a long-term bank loan.

Equity is the owners’ claim on the business after liabilities have been deducted from assets. In a company, equity is usually made up of share capital, which is finance raised from issuing shares, and retained profit, which is profit kept in the business rather than paid out to shareholders as dividends.

A simple balance sheet should balance, because the assets must have been financed somehow: either by liabilities or by equity. If net assets do not match equity, something has been put in the wrong section or calculated incorrectly.

Balance sheet template showing key items and matching net assets and equity.

Liquidation is a process in which a business’s assets are sold to repay its debts. This is why lenders and owners pay attention to the balance sheet: it gives a structured view of what could be used to meet obligations, even though accounting values are not always the same as actual selling prices.

Assets you cannot touch, but must not ignore

An intangible asset is a non-physical resource controlled by a business that can add economic value. It has no physical form, unlike machinery or inventory, which makes its value harder to measure and compare.

The main types to distinguish are trademarks, patents, copyright and goodwill.

A trademark is a legally protected sign, name, logo or symbol that identifies a business’s products and sets them apart from competitors’ products. A strong trademark helps customers recognise the business and may support customer loyalty.

A patent is a legal right granted to an inventor or business that stops others from making, using or selling an invention for a set period. Patents are especially significant in industries where innovation is expensive and imitation would be easy without protection.

Copyright is a legal right that protects original creative works, such as written material, music, software, designs or media content, from unauthorised copying. Businesses based on creative or digital output rely on it heavily.

Goodwill is an intangible asset that represents the extra value of a business beyond the value of its identifiable assets and liabilities, often arising from reputation, customer relationships, location or brand strength. Watch this one: goodwill does not just mean “being nice”; it means the commercial value of reputation and relationships.

Comparison of the main intangible assets and what gives each one value.

Intangible assets can make a business worth far more than its physical assets suggest. A software business, for example, may own few machines but still carry high value because of its copyright, brand and customer base. Valuation is the hard part. A delivery van can be priced using a market value, but the value of a brand or customer loyalty is less certain.

What depreciation records

Depreciation is an accounting expense that records the fall in value of a fixed asset over time or through use. It does not mean the business is paying cash at that moment. In most cases, the cash was paid when the asset was bought; depreciation allocates the cost of using the asset to the periods that benefit from it.

Two common causes are wear and tear, where repeated use physically reduces the asset’s condition, and obsolescence, where the asset becomes outdated because newer technology or methods appear.

Straight line method

The straight line method is a depreciation method that charges the same depreciation expense in each year of an asset’s useful life. It treats the asset’s value as being used up evenly over time.

$$\text{Annual depreciation} = \frac{\text{original cost} - \text{residual value}}{\text{expected useful life of asset}}$$

For example, if equipment costs $40 000, has a residual value of $4 000 and an expected useful life of six years, annual depreciation is:

$$\frac{40\,000 - 4\,000}{6} = 6\,000$$

So the annual depreciation expense is $6 000. After two years, accumulated depreciation is $12 000 and the net book value is $28 000. The same amount is charged each year, so the method is easy to apply and easy to understand.

Units of production method

The units of production method is a depreciation method that charges depreciation according to how much the asset is used or how many units it produces. It assumes the asset loses value mainly through activity, rather than simply through the passing of time.

First calculate the depreciation rate per unit of output:

$$\text{Units of production rate} = \frac{\text{original cost} - \text{residual value}}{\text{expected total units of production}}$$

Then calculate the depreciation expense for the period:

$$\text{Depreciation expense} = \text{units of production rate} \times \text{actual units produced}$$

Using the same equipment, suppose it is expected to produce 120 000 units in total. The rate is:

$$\frac{40\,000 - 4\,000}{120\,000} = 0.30$$

The depreciation rate is $0.30 per unit. If 18 000 units are produced in a year, depreciation for that year is:

$$0.30 \times 18\,000 = 5\,400$$

So the depreciation expense is $5 400 for that year. A busier year receives a higher depreciation charge; a quieter year receives a lower one.

Choosing the method is a judgement, not just a calculation

The right depreciation method depends on why the asset is losing value, and how dependable the information is. In evaluation, link the method to the asset in the case. Don’t rely on a memorised sentence.

The straight line method works when the asset gives benefits fairly evenly over time. It fits assets where time causes more of the value loss than usage, or where usage can’t be measured accurately. It is simple and predictable, and it helps with budgeting because the same depreciation expense is recorded each year.

The drawback is that it can look unrealistic when assets are used unevenly. A machine might run almost continuously in one year and barely at all in the next, yet straight line depreciation still records the same expense in both years. It may also be a weaker choice when an asset becomes obsolete quickly, or when it loses more value in some years than others.

The units of production method fits better when wear and tear depends mainly on usage and output can be measured reliably. It can match depreciation more fairly to the revenue the asset generates: heavy use gives a higher charge, while light use gives a lower one. This often helps with production machinery, vehicles or equipment that has clear usage records.

Its weakness is the need for good estimates of total lifetime output and accurate records of actual use. If future output is uncertain, the depreciation rate may rest on a poor estimate. It is also less useful when obsolescence is the main issue: a machine can become outdated even if it has not produced many units.

There is an ethical angle too. Depreciation affects reported profit because it is recorded as an expense in the profit and loss account. It also affects net book value in the balance sheet. A business should not choose a method just to make profit look higher or lower in a convenient year. The method should be reasonable, consistently applied and appropriate to the asset’s pattern of use.