Accountancy 1A revision notes PDF

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Accountancy 1A (Revision Notes) 3 ways to look at the finances of individuals/organistations:  How much they made in a year o Calculate Net Income=Income less expenses  What they are worth today o Calculate Net Worth= Assets less liabilities  What has been the cash flow situation for the yearo Net Cash Flow= Cash inflows less cash outflows 3 Types of financial statements can be used to answer the questions above: 1. Income Statement (profit and loss account) 2. Statement of financial position (balance sheet) 3. Statement of cash flows The accounting Equation:  Assets = Liabilities + Capital  Assets – Liabilities = Capital Important Definitions:  Assets: A present economic resources controlled by the entity as a result of past events  Liabilities: A present obligation of the entity to transfer an economic resource as a result of past events  Capital/Equity : Residual interest in assets of the entity after deducting all its liabilities What is profit? Profit = Income – Expenses and 2 things can be done with the profit 1. Take it out of the business in either dividends or drawings 2. Leave it in the business (retained profits) Forms of :  Non-Current Assets 1. Property 2. Plant and equipment 3. Patents 4. Copyrights 5. Brands investments 

Current assets 1. Inventory 2. Accountes receivable (money owed to the business) 3. Prepayments 4. Bank

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Non-Current Liabilities 1. Loan 2. Provisions

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Current Liabilities: 1. Accounts Payable 2. Accruals 3. Provisions 4. Bank Overdraft

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Capital and Reserve/Equity 1. Share Capital 2. Share Premium 3. Retained Earnings 4. Other Reserves

Any account that is part of the income statement is closed at the year end and is resit to nil, where as anything that is a part of the statement of financial position isn’t closed at the year end.

Week 4 Definitions:  Assent: a present economic resource controlled by the entity as a result of past events  Economics Resource: A right that has the potential to produce economic benefits  Current Asset: Satisfies any of the following criteria; 1. Held primarily to be traded 2. Expected to be realised within 12 months after statement of financial position 3. Is cash or cash equivalent 4. Expected to be realised or is intended for sale or is intended for consumption within the normal operating cycle of the firm 5. Examples include inventory, trade receivables, prepayments, cash in hand

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Due to changes in prices of the goods in inventory, inventory is usually valued at the LOWER of cost or Net Realisable Value (NRV) Due to changes in prices, it is difficult to calculate the price of goods in inventory especially fi they were bought in batches and eatc batch had a different price 3 ways to measure the velue inventory 1. FIFO (First In First Out) 2. LIFO (Last In First Out) 3. Average FIFO- If this method is used, it is assumed that the batch that was bought first, is the batch that is sold first LIFO- In this method, it is assumed that the batch that as bought last is sold first Average- This just involves calculating the average Cost of sales = Opening inventory + Purchases – Closing Inventory Depending on which method is used to calculate the inventory, the value of closing inventory would be different therefore affecting cost of sales and affecting profit Inventory write offs will reduce closing inventory value and therefore increase cost of sales and so reduce gross profit

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Cost Of sales Calculation: o Basic COS= Opening Inventory + Purchases -Closing Inventory o COS incorporating returns in and out  COS= Opening Inventory + (Purchases – Retursn out + Carriage in) – Closing Inventory Exam Tip: o Don’t confuse RETURNS OUT (returns to suppliers) with RETURNS IN (returns from customers) o Don’t confuse CARRIAGE IN ( transportation of purchases) with CARRIAGE OUT ( transportation of sales)

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Recievables (Debtors) o AN accountant knows that some customers will default and may not pay back therefore she makes an estimate of the amount of these DOUBTFUL DEBTS o The Journal Entry to record the provision for doubtful debts:  Debit Bad Debts Expense  Credit Provision for Bad/Doubtful debts o When we know a customer has gone bankrupt and wont be paying back we write of the debt and below is its journal entry  Debit Bad Debts Expense  Credit Revievables/Debtors

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Prepayments: o Prepayments result from paying an expense in advance o The amount of the expense that is not used up will show as a current asset- Prepayment o As it is used up during the NEXT accounting period- it becomes an expense in THAT period o A prepayment is a current asset because there will be future economic benefit

Week 5: Definitions:  Liability: present obligation of the entity to transfer an economic resource as a result of past events

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Current Liability- satisfies any of the following criteria o Expected to be settled in the entity’s normal operating cycle o Held primarily to be traded o Due to be settled within 12 months after balance sheet date

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Non-Current Liability- Any liability that does not satisfy the criteria for a current liability o Examples: Trade payables, Other Payables, Accruals, Provisions for liabilities, Short term loans, Bank Overdraft

Recognition: o Assets:  Risk of OVERSTATEMENT  Asset Valuations being too HIGH  So NET WORTH of business being OVERSTATED o Liabilities:  Risk of UNDERSTATEMENT  Liabilities being omitted so being too LOW  SO Net worth of business being overstated o o o

A liability is recognised when sufficient evidence exists that a liability has been created and cost/value can be measured with sufficient reliability If there is insufficient evidence or if it can’t be reliably measured, it can be shown as a CONTINGENT LIABILITY Contingent liabilities are not included in the SFP totals, they are simply provided as additional information in the Notes to the Accounts

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Provisions: A provision is a liability of UNCERTAIN timing or amount, there are two types o Type 1:  Provision for depreciation of tangible non-current asset  Provision for amortisation of intangible asset  Provision for impairment  Provision for bad/doubtful debts  Provision for damaged/obsolete inventory  These Provisions DO NOT show as a liability on the SFP/Balance sheet but they are DEDUCTED from the carrying amount of the asset o Type 2:  Provision for outstanding litigation/legal damages claim  Provision for future warranty claims  Provision for environmental damage clean-up costs  These provision amounts DO show as a liability on the SFP/Balance Sheet

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Ownership Interest/Equity/Capital & Reserves: o Definition:  Residual amount of Assets minus Liabilities o What causes changes in Equity:  Making a profit/loss through business operations  Issuing new shares  As asset, which increases/decreases in value  A liability which increases or decreases in value

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Issue of Shares:

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Company issues shares, people buy it and become shareholders and cash is paid to the company Below is a worked example showing journal entries of Issuing Shares

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Issue of Further Shares: o Rights Issue  Company offers further shares, at a given price, to existing shareholders, in proportion to their shareholding  Impact: 1. New shares created 2. New money is raised for the company 3. Net worth of the company will increase by the extra money raised  Why? 1. First refusal to existing shareholders 2. Non dilution of voting rights 3. Change in market value of shares 4. Commitment to company 5. Company needs money to invest in a new project o Bonus Issue  Company gives free shares to all ordinary shareholders in proportion to existing shareholding e.g ‘2 for 1’ bonus issue  Impact: 1. New shares created 2. No money is raised 3. Net worth of company is unchanged 4. Reserves (ie retained earnings are cinverted to share capital)  Why? 1. Shares are more marketable on the stock exchange 2. Retained earnings are being reinvested in business rather than dividends Issue of Further Shares: o Rights Issue  Company offers further shares, at a given price, to existing shareholders, in proportion to their shareholding  Impact: 1. New shares created 2. New money is raised for the company 3. Net worth of the company will increase by the extra money raised  Why? 1. First refusal to existing shareholders 2. Non dilution of voting rights 3. Change in market value of shares 4. Commitment to company

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Company needs money to invest in a new project

Bonus Issue  Company gives free shares to all ordinary shareholders in proportion to existing shareholding e.g. ‘2 for 1’ bonus issue  Impact: 1. New shares created 2. No money is raised 3. Net worth of company is unchanged 4. Reserves (i.e. retained earnings are converted to share capital)  Why? 1. Shares are more marketable on the stock exchange 2. Retained earnings are being reinvested in business rather than dividends

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Journal Entries and its Purposes o Journal entries to record business transactions  Day to day entries to record the regular transactions of a business such as: purchasing NCA, purchasing goods for resale, making sales to customers, issue shares o Journal entries to record period end adjusting entries  Period end entries to adjust the Trial balance figures to take account of: 1. NCA falling in value (depreciation. Amortisation, Impairment) 2. Current assets falling in value = (receivables or inventory) 3. Adjustments of expenses (prepayments and accruals) 4. Creating provisions for estimated liabilities (based on past events) o Journal entries to correct any errors discovered  Transactions close to the year-end that have not yet been recorded  Transactions that were incorrectly recorded at any time during the year

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NET PROFIT is calculated in the same way for all 3 types of businesses but for a company there will be an additional expense (TAX)

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Taxation of a business:

Sole traders and partnerships  The entity itself is not subject to taxation BUT the individual owners/partners pay tax on their earnings o Companies  Corporate entities are subject to a tax charge on their profits, this will show on their income statement o Taxable Profits vs Accounting Profits  Some expenses are disallowed by the tax authorities PROFITS o Sole Trader  Profits added to retained profits therefore Capital & reserves is increased  The owner decided how much to leave in business and how much to take out  Any withdrawals decrease capital & reserves o Company  Profits of a company are added to retained earnings which therefore increases Capital and Withdrawals  Board of Directors decide how much to leave in business and how much to distribute to the owners (shareholders) as dividends  Dividends therefore decrease Capital & reserves o

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Partnership  Profits of the partnership business might be divided between the partners in accordance with the partnership agreement  Partners may not always be entitled to an equal share in the profit  Once the profits are split, they are added to each partners Capital which therefore increases Capital & reserves  The partners decide how much to leave in the business and how much to withdraw.  Withdrawals will decrease Capital and reserves

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Ensuring the Quality of Financial Statements o The conceptual framework describes the objective of and concepts for financial reporting, its important as it shapes the decisions that the IASB makes when developing future standards

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Regulations: The Audit Report o Auditors are employed by shareholders to investigate the company’s financial records and gain an opinion on whether financial statements show a ‘true and fair view’ o Regulation is necessary in order to protect the interests of shareholders and to provide rules for issues open to variety of interpretations

Impression Management:

Week 7: chapter 14: Reporting Corporate Performance; Narrative reports in Annual Reports Strategic Report in the UK:  Purpose; o To provide insight into the entity’s business model and its main strategy and objectives o To describe the principal risks, the entity faces and how they might affect its future prospects o To provide an analysis of the entity’s past performance

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Strategy relates to the development, performance, position and future prospects of an entity Business model should dexcrive what the business does, why; and how its different to its competitors Disclosing this information allows shareholders to asses directors performance

Corporate Governance:  Corporate governance erefers to the way in which companies are directed and controlled  Companies must explain how the UK Corperate Governance Code is applied in their annual reports and accounts  Main Principles of the Uk Corportae Governance Code o Leadership o Effectiveness o Accountabiltiy o Remuneration o Relations with shareholders Impression Management:  Impression manage,ment refers to the inclination of humans to provide a afavourable impression in social interaction  In financial reporting, imporession management is the study of suing accounting narratives or information in a selective or biaswed way  Methods of Impression Management: o Accounting Narratives  Written qualitative parts of a report: strategic report  Stress the positive, downplay the negative  Baffle the reader  Differential reporting- profitable and unprofitable companies use different reporting straetegies. When performance is good, show results against historical performance. When performance is bad, focus on the future  Attribution- managers associate themselves with goodp performance, but bad news is caused by environmental factors o Graphs  Pictorial representation can be distorted or selective information

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Photographs  To influence the impression on the reader

Week 8: Ratio Analysis-Chapter 13 

In monitoring performance, the expert analysts and fund managers will use ratios rather than absolute amounts

Systematic approach to ratio analysis:  A systematic approach to ratio analysis seeks to establish a broader picture first of all and then break that broad picture down  Four key headings are commonly encountered in ratio analysis: o Investor Ratios: Ratios in this category provide some measures of how the price of a share in the stock market compares ti key indicators of the performance of the company o Analysis of management Performance: Ratios in this category indicate how well the company is being run in terms if using assets to generate sales (revenue) and how effective it is in controlling costs and producing profits based on goods and services sold o Liquidity and Current Assets: The management of cash and current assets and the preservation of an adequate but not excessive level of liquidity is an essential feature of a business survival especially in difficult economic circumstances o Gearing (leverage): gearing is a measure of the extent to which there is financial risk indicated in the statement of financial position and in the income statement. Financial risk means the risk associated with having to pay interest and having an obligation to repay a loan.

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Investor Ratios: o The profit of the period (earnings) and dividend are two ways to measure the benefit to investors o Earnings per share = Profit after tax for ordinary equity holders/number of issued ordinary shares  EPS is the most frequently quoted measure of company performance and progress. The % change from a year to year should be monitored for trend. Criticisms is that focus on annual earnings may cause ‘short termism’ among investors and among company managers o Price-Earnings Ratio = Share Price/Earnings per share  P/E ratio compares the amount invested in one share with the earnings per share. The P/E reflects the market confidence in future prospects of the company. The higher the ratio, the longer is the period for which the market believes the current level of earnings may be sustained. P/E ratio for company should be compared with average P/E ratio for the industry to put things into perspective o Dividend per share = Dividend of the period/number of issued ordinary shares  The figure of dividend per share is the cash amount paid by the company. o Dividend Cover = Earnings per share/Dividends per share OR Profit after tax for ordinary equity holders/total dividend for ordinary equity holders  Dividend cover shows the number of times the dividend has been covered by the profits of this year. The higher the dividend cover, the safer the dividend. On the other hand, it could also be argued that a high dividend cover means that the company is keeping ne wealth to itself, perhaps to be used in buying new assets rather than distributing it amongst its shareholders. Dividends are thought to carry a signal to the market of the strength and stability of the company. o Dividend Yield = (Dividend per share/share price) *100

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The dividend yield compares dividend per share with the current market price of a share. It indicates the relationship between what the investor can expect to receive form the shares and the amount which is invested in the shares Analysis of management performance: o Management of a business if about careful use of resources for the benefit of the owners. 2 central questions to test this use of resources:  How well did the management make use of the investment in assets to create sales(revenue)?  How carefully did the management control costs so as to maximise the profit derived from the sales (revenue)? o Return on shareholders’ equity(ROE) = (Profit after tax/(share capital +reserves))*100  A key measure of success, from the viewpoint of shareholders, is the success of the company in using the funds provided by shareholders to generate profit. That profit will provide new wealth to cover their dividend and to finance future expansion of the business. ROE is therefore a measure of a company performance from the shareholders perspective. o Return on Capital Employed = (Ordinary profit (before interest and tax) /(total assets – current liabilities))*100  ROCE is a broader measure than ROE. It measures the performance of a company as a whole in using all sources of long term finance. ROCE is seen as a measure of management efficiency. The ratio is a measure of how well the long-term finance is being sued to generate operating profit o Return on total assets = (Operating profit/total assets)*100  Another way of measuring how well the assets of the business are used to generate profit before deducting interest and tax o Operating profit as a % of sales (revenue): (Operating profit/sales) *100  Also, referred to as the operation margin. Aim of successful businesses is to make the margins high as possible. The margin reflects the degree of competitiveness in the market, the economic situation, the ability to differentiate products and the ability to control expenses. o Gross Profit Percentage: (gross Profit/Sales) *100  Also, referred to as the gross margin. This concentrates on costs of making goods and services ready for sale. Small changes in this ratio can be highly significant. As it is a sensitive measure, many companies try to keep secret from their competitors and customers the detailed breakdown as they don’t want to give competitors any clues on how much to undercut prices and don’t want to give customers a chance to complain about excessive profits. o Total assets usage = Sales/Total assets  Indicates how well a company has used its fixed and current assets to generate revenues. Such a ratio is probably mos...