Key Features of Final Accounts

After studying this section you should be able to:

• distinguish between the profit and loss account and the balance sheet
• explain the purpose, and effect, of depreciation in final accounts
• outline the reasons for distinguishing between capital and revenue expenditure

The financial statements

UK law recognises a company as a separate legal ‘person’, an entity that is distinct from its owners. It can therefore sue and be sued, and take out contracts in its own name. Sole traders and partnerships, however, are not separate entities from their owners in the eyes of the law. In financial accounting, the (business) entity concept requires accountants to treat all businesses – including sole traders and partnerships – as separate entities from their owners.

The main financial statements are the profit and loss account and the balance sheet.

Profit and loss account

• is an income statement
• shows calculation of profit
• information from expense and revenue accounts

Balance sheet

• shows net assets and capital employed
• summarises the financial position
• information from asset and liability accounts

Depreciation in financial statements

The consistency concept ensures that the same calculation method – straight line, reducing balance and revaluation are the most popular ones – will normally be used for similar assets. The accruals concept, where costs are matched to the period to which they refer, means that each year’s profit will be charged with its own share of the total depreciation. The firm can change its depreciation policy and method of calculation, but only for good reason.

The purpose of applying depreciation is therefore to adjust annual profits, to avoid charging the full amount of depreciation in a single year (which would distort that year’s profits). This leads to a fairer comparison between the profit figures for the years over which the asset is owned.

Depreciation is subjective: the accountant has to decide which method of calculation to use. If selecting the straight-line method, decisions must be made concerning two of the three figures involved in the calculation (the estimated life of the asset, and its expected resale value); if the reducing balance method is used, the percentage written down each year must be decided.

Since depreciation is a provision, an adjustment will be made when the asset is disposed of. The firm will make either a loss or a profit on sale, which is recorded in the profit and loss account. Over the full life of the asset, the total depreciation charged will be the same regardless of method selected and amounts charged, because of this final adjustment. For this reason, total profits over the asset’s life will also be the same, even though the individual figures will vary.

Capital and revenue expenditure in financial statements

• Capital expenditure appears in the balance sheet
• Revenue expenditure appears in the profit and loss account

This is an important distinction in the financial statements because:

If revenue expenditure is wrongly classified as capital expenditure:

• expenses will be understated
• net profit will be overstated

If capital expenditure is wrongly  classified as revenue expenditure:

• expenses will be overstated
• net profit will be understated

KEY POINT - Capital expenditure does not affect profit calculation: revenue expenditure does.