Constructing (More) Financial Accounts

Being able to understand a set of financial accounts is imperative when it comes to looking at income producing companies. Although we have looked at each section individually within other Fundamental Analysis tutorials, it is useful to construct a simple set of accounts for a series of transactions so it is possible to see how each of the three statements are put together. Understanding the nature of accrual accounting makes explaining and looking at other accounting concepts, red flags and financial ratios easier. In this tutorial we will look at one last example, looking at how a number of different concepts affect the three parts of a set of financial statements.

Below we will look at a second series of fictitious transactions and then proceed to look at how they come together to form the three financial statements. This is a second example of how to construct a set of financial accounts. The first tutorial can be found HERE.

The Transactions

Nine transactions are detailed below for and were completed during the 12 months to December 31st 2014.

1. Share issue of 200,000 shares at a £0.25 premium to a nominal £1 per share (i.e. £1.25 per share)
2. Bank loan of £30,000 obtained on January 1st 2014. It carries a 5% interest and this will be paid after year-end
3. £25,000 worth of inventories bought in cash. £11,000 of inventories were unsold at year-end
4. £90,000 worth of goods sold on credit terms to customers. At year-end, £23,000 had not been paid and 5% of the unpaid value had been written off as unrecoverable
5. Rent for 12 months paid, for £15,000
6. Overheads run at £3,000/month and are paid on the final day of each month
7. Van bought for £7,000. It has a useful life of 4 years and a residual value of £2,000. It is depreciated straight line
8. 2p/share dividend paid during the year
9. No tax payable under a special government scheme

Constructing the Cash Flow Statement

As before, constructing the cash flow statement is relatively simple. All it entails is adding up all the tangible cash inflows into the company, and subtracting all the real cash outflows.

The only point of note is the sales figure again. Remember that £23,000 of the £90,000 of sales have not been paid yet so there has not been that real cash movement. We only record the sales (revenues) that have been collected, which amount to £67,000.

Constructing the Income Statement

Constructing the income statement is slightly different. The key difference is that it looks at Accruals Accounting. This is where we record expenses and sales at the time they are incurred rather than at the time when the cash for that expense/sale changes hands.

There are two key figures to look at here.

Firstly we should look at the depreciation figure and how it was obtained. Remember that the purpose of depreciation is to decrease the value of a tangible non-current asset over time. In this case we need to decrease the value of a van from £7,000 down to its residual value of £2,000 over its useful life of 4 years. That means the value of the van needs to drop by £5,000 over four years. Under straight line depreciation, this works out at £1,250 per year.

Secondly we should look at the provision figure. A provision is a bad debt, or receivables that are not recoverable (i.e. the customer will is unlikely to ever pay). We set this out as a charge on the income statement as per the image; 5% of the £23,000 of receivables amounts to £1,150 and this is the amount we expense.

Constructing the Balance Sheet

The final component of the accounts is to create the balance sheet. The key rule for constructing the balance sheet is that the Total Assets figure should equal the Total Liabilities + Total Equity figure.

As we can see in the example above, the key rule holds at a value of 298,600, so no mistakes have been made during the construction of the accounts. If this does not hold, a component of any of the three financial statements is incorrect.

The Three Accounts Complete

This is essentially the simple method of translating a series of transactions into the three key financial statements. In reality, there are many more variants of components that can alter these statements, but the same principles apply. The three financial statements for the above example are shown below.

Click image to enlarge