Month: April 2020

Final Accounts are the accounts, which are prepared at the end of a fiscal year. It gives a precise idea of the financial position of the business/organization to the owners, management, or other interested parties. Financial statements are primarily recorded in a journal; then transferred to a ledger; and thereafter, the final account is prepared (as shown in the illustration).

Usually, a final account includes the following components:

• Trading Account
• Manufacturing Account
• Profit and Loss Account
• Balance Sheet

1. Trading Account

Trading accounts represents the Gross Profit/Gross Loss of the concern out of sale and purchase for the particular accounting period.

Study of Debit side of Trading Account

(a) Opening Stock: Unsold closing stock of the last financial year is appeared in debit side of the Trading Account as “To Opening Stock“ of the current financial year.

(b) Purchases: Total purchases (net of purchase return) including cash purchase and credit purchase of traded goods during the current financial year appeared as “To Purchases” in the debit side of Trading Account.

(c) Direct Expenses: Expenses incurred to bring traded goods at business premises/warehouse called direct expenses. Freight charges, cartage or carriage charges, custom and import duty in case of import, gas, electricity fuel, water, packing material, wages, and any other expenses incurred in this regards comes under the debit side of Trading Account and appeared as “To Particular Name of the Expenses”.

(d) Sales Account: Total Sale of the traded goods including cash and credit sales will appear at outer column of the credit side of Trading Account as “By Sales.” Sales should be on net releasable value excluding Central Sales Tax, Vat, Custom, and Excise Duty.

(e) Closing Stock: Total Value of unsold stock of the current financial year is called as closing stock and will appear at the credit side of Trading Account.

Closing Stock = Opening Stock + Net Purchases – Net Sale

(f) Gross Profit: Gross profit is the difference of revenue and the cost of providing services or making products. However, it is calculated before deducting payroll, taxation, overhead, and other interest payments. Gross Margin is used in the US English and carries same meaning as the Gross Profit.

Gross Profit = Sales – Cost of Goods Sold

(g) Operating Profit: Operating profit is the difference of revenue and the costs generated by ordinary operations. However, it is calculated before deducting taxes, interest payments, investment gains/losses, and many other non-recurring items.

Operating Profit = Gross Profit – Total Operating Expenses

(h) Net Profit: Net profit is the difference of total revenue and the total expenses of the company. It is also known as net income or net earnings.

Net Profit = Operating Profit – (Taxes + Interest)

2. Manufacturing Account

Manufacturing account prepared in a case where goods are manufactured by the firm itself. Manufacturing accounts represent cost of production. Cost of production then transferred to Trading account where other traded goods also treated in a same manner as Trading account.

Important Point Related to Manufacturing Account

Apart from the points discussed under the section of Trading account, there are a few additional important points that need to be discuss here:

(a) Raw Material: Raw material is used to produce products and there may be opening stock, purchases, and closing stock of Raw material. Raw material is the main and basic material to produce items.

(b) Work-in-Progress: Work-in-progress means the products, which are still partially finished, but they are important parts of the opening and closing stock. To know the correct value of the cost of production, it is necessary to calculate the correct cost of it.

(c) Finished Product: Finished product is the final product, which is manufactured by the concerned business and transferred to trading account for sale.

Raw Material Consumed (RMC) − It is calculated as.

RMC = Opening Stock of Raw Material + Purchases – Closing Stock

3. Profit and Loss Account

Profit & Loss account represents the Gross profit as transferred from Trading Account on the credit side of it along with any other income received by the firm like interest, Commission, etc.

Debit side of profit and loss account is a summary of all the indirect expenses as incurred by the firm during that particular accounting year. For example, Administrative Expenses, Personal Expenses, Financial Expenses, Selling, and Distribution Expenses, Depreciation, Bad Debts, Interest, Discount, etc.

4. Balance Sheet

A balance sheet reflects the financial position of a business for the specific period of time. The balance sheet is prepared by tabulating the assets (fixed assets + current assets) and the liabilities (long term liability + current liability) on a specific date.

Assets

Assets are the economic resources for the businesses. It can be categorized as:

(a) Fixed Assets: Fixed assets are the purchased/constructed assets, used to earn profit not only in current year, but also in next coming years. However, it also depends upon the life and utility of the assets. Fixed assets may be tangible or intangible. Plant & machinery, land & building, furniture, and fixture are the examples of a few Fixed Assets.

(b) Current Assets: The assets, which are easily available to discharge current liabilities of the firm called as Current Assets. Cash at bank, stock, and sundry debtors are the examples of current assets.

(c) Fictitious Assets: Accumulated losses and expenses, which are not actually any virtual assets called as Fictitious Assets. Discount on issue of shares, Profit & Loss account, and capitalized expenditure for time being are the main examples of fictitious assets.

(d) Cash & Cash Equivalents: Cash balance, cash at bank, and securities which are redeemable in next three months are called as Cash & Cash equivalents.

(e) Wasting Assets: The assets, which are reduce or exhausted in value because of their use are called as Wasting Assets. For example, mines, queries, etc.

(f) Tangible Assets: The assets, which can be touched, seen, and have volume such as cash, stock, building, etc. are called as Tangible Assets.

(g) Intangible Assets: The assets, which are valuable in nature, but cannot be seen, touched, and not have any volume such as patents, goodwill, and trademarks are the important examples of intangible assets.

(h) Accounts Receivables: The bills receivables and sundry debtors come under the category of Accounts Receivables.

(i) Working Capital: Difference between the Current Assets and the Current Liabilities are called as Working Capital.

The final accounts for a sole trader business are the Income Statement (Trading and Profit & loss Account) and the Balance Sheet. The final accounts give a picture of the financial position of your business. It shows where or not your business has made a profit or loss during the accounting period and whether you are able to pay your debts as they become due.

Objectives

Upon the completion of this topic you should be able to
1. understand how profit/loss is calculated
2. calculate the cost of goods sold, gross profit and net profit,
3. transfer net profit and drawings to the capital account at the end of the period, and
4. prepare an Income Statement from a trial balance.

Final Accounts

After your trial balance is completed your final accounts are prepared. The final accounts of a sole trader business include the Income Statement (trading and Profit & loss account) and the balance sheet. Remember that your trial balance is the summary of the balances in all your accounts. Some of these balances (those from your nominal accounts) affect the profit and are transferred to the Income statement; the others (real and personal accounts) are transferred to your balance sheet. The Income Statement and the Balance Sheet are prepared at the end of each financial period to record how well the business operated during that financial period.

Income Statement

One of the most important financial statements of any business is the Income Statement. It is used to determine the following:
1. how profitable a business is being run; and
2. comparing the results received with the results expected.

The Income Statement can be divided into two sections the trading account and the Profit & loss account. The gross profit which is the amount of profit made before the expenses are deducted is calculated in the trading account. The purpose of the trading account is to determine the gross profit made from sales. Therefore the accounts that are directly related to buying and selling (trading) will be transferred to the trading account. The accounts directly related to trading are:

• Sales
• Purchase
• Sales Return
• Purchases Return
• Carriage Inwards

Gross profit is calculated as:

Gross Profit = Net Sales – Cost of Goods Sold (COGS)
Along with gross profit the net sales, cost of goods sold (COGS) and the cost of goods available for sale(COGAFS) is also calculated in the trading account:

Net Sales = Sales – Sales Return (Return Inwards)

Net sales are the total sales figure after allowances have been made for sales returned to the business.

COGS = Cost of goods available for sale (COGAFS) – Closing Stock

COGAFS = Opening Stock + (Purchases – Purchases Return) + Carriage Inwards

The net profit of your business is calculated in the Profit & loss account. Net profit is the balance of profit after allowance is made for revenue and expenses. It is calculated as:

Net Profit = Gross profit + Revenue – expenses

The revenue and expense charged to the Profit & loss account are those that are not directly related to trading but more to do with the running of the business. Some of these accounts are:

• Rent
• Telephone
• Carriage outwards
• Discount allowed
• Discount received
• Commission received
• Commission paid
• Salary

In Unit Two these accounts were closed off and transferred to the income statement. The income statement can be shown horizontally or vertically.

Balance Sheet
The other half of our final accounts is the Balance Sheet. The Balance Sheet is a financial statement showing the book values of the assets, liabilities and capital at the end of the financial period. It shows what the business owes and what it owns.
The assets of the business is divided into two categories and recorded as follows
1. Non-Current Assets are assets that:

• Are expected to be of use in the business for long time;
• Are to be used in the business; and
• Were not bought only for the purpose of resale.

Non-current assets are recorded in the balance sheet starting with those assets that will in the business the longest down to those that will be kept for a shorter period. Example of non-current assets and the order of record are:

• Land and Buildings.
• Fixtures and Fittings.
• Machinery
• Motor Vehicles.

2. Current Assets are recorded next. These are assets will change within the next twelve months. They are recorded as follows:

• Stock (goods bought for resale)
• Cash at Bank.
• Cash in Hand.

3. Non-current Liability: Sometime referred to as long term liability are those debts that take more than a year to settle. This includes large loans and mortgages.
4. Current Liability: are debts that will be settled in one year or less. This includes creditors and small loans.

Let’s now prepare the final accounts from the trial balance on the below

Example 3.5A

The following should be considered on 31 December 2011
1) Stock $36,420
a) Expenses owing
b) Sundry expenses $62
2) Motor expenses $33
3) prepayments
a) Rates $166
4) Provision for bad debts to be reduced to $580
5) Depreciation for motors to be $2,100 for the year
6) Part of the premises were let to a tenant who owed $250 at 31 December 2011
7) Loan interest owing to P. Holland, $4,000

Prepare the Income Statement and Balance Sheet as at 31 December 2011.

Horizontal presentation of the Income Statement and Balance Sheet

Vertical presentation of the Income Statement and the Balance Sheet.

The vertical presentation is the most common method of presenting final accounts today. In the vertical presentation of the balance sheet the working capital is indicated. This is calculated as:

Working Capital = Current Assets – Current Liabilities

The working capital indicates the liquidity of your business. This means the ability of your business to pay its debts when they become due. It gives an idea of the amount of funds available to run the business on a day to day basis.

At the end of every accounting period, trading firms which buy ready-made goods and resell them at a profit, prepare the Trading and Profit and Loss Accounts.  However, for those firms which manufacture the goods they sell, a Manufacturing Account is prepared in addition to these two final accounts.

The Manufacturing Account is prepared to determine the total manufacturing or production cost of goods completed during the accounting period.  The production cost includes all costs incurred in converting raw materials into finished goods, i.e. cost of raw materials, direct labour and direct expenses, and factory overhead expenses.

Manufacturing or Production Cost

Production cost can be divided into two categories, i.e. prime cost and factory overhead expenses.  Both these costs are charged to the Manufacturing Account for the calculation of production cost.  The following is a description of the different components which make up prime cost and factory overhead expenses.

Prime Cost

Prime cost includes all costs which relate directly to the manufacturing process.  They include raw materials, labour and expenses which are traceable to the particular unit of goods manufactured.. These prime costs will vary with the units of output produced.  Increasing output means using mere raw materials, direct labour and direct expenses, e.g. if production is increased by 50%, the cost of raw materials, manufacturing wages and direct expenses will rise by approximately the same extent.

Cost of Raw Materials

The cost of raw materials used to make the finished good represents one of the major prime costs.  The opening and closing stock of raw materials, together with the purchase of raw materials must be taken into account when calculating the cost of raw materials.

Any other costs incurred in the purchases of raw materials, like duty, freight or carriage, should be added to the net purchases of the raw materials.

Direct Labour Cost

These refer to the wages paid to labour which is directly involved in the manufacture of goods.  These wages paid to workers who are employed on the actual production line are called direct wages.

Direct Expenses

Besides raw materials and labour cost, other expenses directly related to manufacturing may be incurred.  These include expenses for water and electricity that can be traced by the units of goods produced, e.g. the amount of water used in the production of bottled drinks and the amount of electricity consumed in the baking of bread can be computed by each unit of goods produced.

Direct expenses may include royalties which are payments made to the patentee for the right to use the patent for each unit of goods produced.

A patent confers upon its holder, the right to be the only producer of a certain product for a particular period of time.

Factory Overhead Expenses

These costs are not directly related to the actual manufacturing of goods but more so to the general operations of running of the factory where production is carried on.

Overhead expenses do not vary with output.  Even if output is increased or decreased, the overhead expenses remain relatively fixed.

Factory overhead costs include:

1. rent and rates of factory
2. insurance of factory
3. factory power and lighting
4. repairs and maintenance of plant and machinery
5. depreciation of tools, plant and machinery
6. indirect labour cost: wages and salaries paid to those employed in the general operations of the factory and who are indirectly associated with actual production,  factory engineer, supervisor, manager, forklift and crane drivers, cleaners and security personnel.

Production Cost

Production cost measures the total cost of goods produced during the period and is made up of prime cost and factory overhead expenses used in production.

Work in Progress

In the above example, it is assumed that all the work that started in the factory was finished by the end of the year and that there was no partly finished goods.  It is possible for a manufacturing firm to have work-in-progress which is partly completed goods at the end of the accounting period.

Where there is work-in-progress, production cost incurred during the accounting period will cover both the finished and unfinished goods.

If we wish to know the cost of manufacturing only the finished goods during the year, we must deduct the work-in-progress at the end of the year from the production cost.  The work-in-progress is valued according to the cost of materials, labour, factory overhead expenses and other expenses that have gone into it.

Where there is work-in-progress at the beginning of the accounting period, this must be added to the production cost before deducting the work-in-progress at the end of the year to give the cost value of finished goods for the year.

Cost Flows in the Manufacturing Account and the Determination of the manufacturing Profit

• The following steps are taken by the manufacturer to arrive at his net profit figure:
• Calculation of production cost by setting up a Manufacturing Account: Production Cost = Prime Costs (raw materials cost + direct labour and direct expenses) + Factory Overhead Expenses
• Calculation of gross manufacturing profit by comparing the market price of goods manufactured with the production cost in the Manufacturing Account: Gross Manufacturing Profit = Market Price of Goods Manufactured – Production Cost
• Calculation of gross trading profit by setting up a Trading Account: Gross Trading Profit = Net Sales – Cost of Sales
• Calculation of net profit by setting up a Profit and Loss Account: Net Profit = Gross Manufacturing Profit + Gross Trading Profit + Any Gains – Expenses
• To the Manufacturing Account, charge all manufacturing expenses incurred in the production of finished goods.
• To the Trading Account, charge all buying expenses incurred in the purchase of goods for resale.
• To the Profit and Loss Account, charge all selling expenses incurred in the sale and distribution of goods including all administrative expenses.

Express conditions and warranties are which, are expressly provided in the contract. Implied conditions and warranties are those which are implied by law or custom; these shall prevail in a contract of sale unless the parties agree to the contrary.

1. Condition as to title

In every contract of sale, unless the circumstances of the contract are such as to show a different intention, there is an implied condition on the part of the seller, that:-

• In case of a sale, he has a right to sell the goods, and
• In case of an agreement to sell, he will have a right to sell the goods at the time when the property is to pass.

The words ‘right to sell’ contemplate not only that the seller has the title to what he purports to sell, but also that the seller has the right to pass the property. If the seller’s title turns out to be defective, the buyer may reject the goods.

2. Condition as to Description

In a contract of sale by description, there is an implied condition that the goods shall correspond with the description. The term ‘ sale by description’ includes the following situation:-

• Where the buyer has not seen the goods and buys them relying on the description given by the seller.
• Where the buyer has seen the goods but he relies not on what he has seen but what was stated to him and the deviation of the goods from the description is not apparent.
• Packing of goods may sometimes be a part of the description. Where the goods do not conform to be method of packing described (by the buyer or the seller) in the contract, the buyer can reject the goods.

3. Condition as to Quality or Fitness

Where the buyer, expressly or by implication, makes known the seller the particular purpose for which goods are required, so as to show that the buyer relies on the seller’s skill or judgment and the goods are of a description which it is in the course of the seller’s business to supply (whether or not as the manufacturer of producer), there is an implied condition that the goods shall be reasonably fit for such purpose. In other words, this condition of fitness shall apply, if:

• The buyer makes known to the seller the particular purpose for which the goods are required,
• The buyer relies on the seller’s skill or judgment,
• The goods are of a description which he sellers ordinarily supplies in the course of his business, and
• The goods supplied are not reasonably fit for the buyer’s purpose.

4. Condition as to Merchantability

Where the goods are bought by description from a seller, who deals in goods of that description (whether or not as the manufacturer or producer) there is an implied condition that the goods shall be of merchantable quality.

Merchantable quality ordinarily means that the goods should be such as would be commercially saleable under the description by which they are known in the market at their full value.

5. Condition as to Wholesomeness

In case of sale of eatable provisions and foodstuff, there is another implied condition that the goods shall be wholesome. Thus, the provisions or foodstuff must not only correspond to their description, but must also be merchantable and wholesome. By ‘wholesomeness’ it means that goods must be for human consumption.

6. Condition Implied by Custom or Trade Usage

An implied warranty or condition as to quality or fitness for a particular purpose may be annexed by the usage of trade. In certain sale contracts, the purpose for which the goods are purchased may be implied from the conduct of the parties or from the nature or description of the goods. In such cases, the parties enter into the contract with reference to those known usage. For instance, if a person buys a perambulator or a medicine the purpose for which it is purchased is implied from the thing itself; the buyer need not disclose the purpose to the seller.

7. Conditions in a Sale by Sample

A contract of sale is a contract for sale by sample where there is a term in the contract, express or implied to that effect. Usually, a sale by sample is implied when a sample is shown and the parties intend that the goods should be of he kind and quality as the sample is.

8. Conditions in a sale by Sample as well as by Description

A vast majority of cases where samples are shown, are sales by sample as well as by description. In a contract for sale by sample as well as by description, the goods supplied must correspond both with the sample as well as with the description.

Implied Warranties

A condition becomes a warranty when:

(i) the buyer waives the conditions or opts to treat the breach of the condition as a breach of warranty.

(ii) The buyer accepts the goods or a part thereof, or is not in a position to reject the goods.

• Implied Warranty of Quiet Possession: In every contract of sale, unless there is a contrary intention, there is implied warranties that the buyer’s shall have and enjoy quiet possession of the goods. If the buyer’s right to possession and enjoyment of the goods is in any way disturbed as consequences of the seller’s defective title, the buyer may sue the seller for damages for breach of this warranty.
• Implied Warranty of Freedom from Encumbrances: The buyer is entitled to a further warranty that the goods shall be free from any charge or encumbrance in favor of any third party not declared or known to buyer before or at the time when the contract is made. If the buyer is required to discharge the amount of the encumbrance it shall be a breach of this warranty and the buyer shall be entitled to damages for the same.

A breach of contract is a violation of any of the agreed-upon terms and conditions of a binding contract. The breach could be anything from a late payment to a more serious violation such as the failure to deliver a promised asset. A contract is binding and will hold weight if taken to court. To successfully claim a breach of contract, it is imperative to be able to prove that the breach occurred.

A breach of contract is when one party breaks the terms of an agreement between two or more parties. This includes when an obligation that is stated in the contract is not completed on time you are late with a rent payment, or when it is not fulfilled at all a tenant vacates their apartment owing six-months’ back rent.

Types of Breach of Contract

1. Partial Breach

A partial breach, or failure to perform or provide some immaterial provision of the contract, may allow the aggrieved party to sue, though only for “actual damages.”

For example:  A homeowner hires a contractor to put a pond in his backyard, showing the contractor the black liner her would like installed under the sand. The contractor instead installs a blue liner of the same design and thickness, which is totally hidden from view. The contractor may have breached the precise terms of the contract, but the homeowner cannot ask that the contractor be ordered to take out the pond and start over with the black liner.

The homeowner could ask that the contractor be ordered to refund the difference in price between the requested black liner and the installed blue liner. In this case, because the color of the liner has no affect on functionality, and the price was basically the same, the difference in value, or “actual damages,” is zero.

2. Material Breach of Contract

Failure of one party to perform his obligations under the contract in such a way that the value of the contract is destroyed, exposes that party to liability for breach of contract damages. For example, if the contractor in the above example had used thin plastic not intended for the rigors of maintaining a pond, which could not be expected to last as long as the pond liner, the homeowner might recover the actual cost to correct the material breach, which would include removing the pond and replacing the liner.

A material breach of contract may relieve the aggrieved party of his own obligations under the contract, and give him the right to sue for damages. Such a total breakdown of the material provisions of a contract may be referred to as a “fundamental” or “repudiatory” breach.

3. Anticipatory Breach of Contract

Anticipatory breach, also known as “anticipatory repudiation,” occurs when one party to a contract stops acting in accordance with the contract, leading the other party to believe he has no intention of fulfilling his part of the agreement. In this case, the breaching party may give such an impression by his actions, or failure to act, such as failing to produce an ordered item, refusing to accept payment, or somehow making it obvious that he cannot or will not fulfill the terms of the contract. An anticipatory breach of contract enables the non-breaching party to end the contract and sue for breach of contract damages without waiting for the actual breach to occur. For example:

Jane agrees to sell her antique sewing machine to Amanda, and the two agree on the purchase price of $1,000, the sale to occur on May 1st. On April 25th, Amanda tells Jane that she cannot come up with the money on time. Following this communication, Jane can reasonably assume that Amanda is in anticipatory breach. This enables Jane to sell the sewing machine to someone else, or potentially file a lawsuit against Amanda for breach of contract.

4. Specific Performance

In certain cases, an aggrieved party may not be made whole through the award of monetary damages. He may instead request the court to order “specific performance” of the terms of the contract. Specific performance may be any court-ordered action, forcing the breaching party to perform or provide exactly what was agreed to in the contract. Specific performance is most often ordered in a contract involving something for which a value is difficult to determine, such as land or an unusual or rare item of personal property.

Sometimes the process for dealing with a breach of contract is written in the original contract. For example, a contract may state that in the event of late payment, the offender must pay a $25 fee along with the missed payment. If the consequences for a specific violation are not included in the contract, then the parties involved may settle the situation among themselves, which could lead to a new contract, adjudication, or another type of resolution.