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IB 1240 Introduction to Financial Accounting 2015 – 16

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Table of Contents Table of Contents.................................................................................................................................. 2 Accounting ............................................................................................................................................ 3 Statement of financial position ............................................................................................................ 4 Income Statement ................................................................................................................................. 6 Double-entry bookkeeping ................................................................................................................... 6 Matching Concept................................................................................................................................. 7 Depreciation .......................................................................................................................................... 7 Recognition and de-recognition ........................................................................................................... 8 Inventory valuation ............................................................................................................................... 8 Types of businesses .............................................................................................................................. 9 Share capital ........................................................................................................................................10 Presentation of company financial statements ..................................................................................10 Statement of financial position .......................................................................................................... 11 Statement of comprehensive income .................................................................................................13 Creative Accounting ....................................................................................................................... 14 Agency Theory ...............................................................................................................................14 Regulatory Framework ................................................................................................................... 14 Cash Flow Statements ........................................................................................................................15 Classification of cash flows ...........................................................................................................15 Statement of cash flows......................................................................................................................16 Interpretation cash-flows statements .................................................................................................17 Interpretation of financial statement ..................................................................................................17 Ratios ................................................................................................................................................... 18

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Accounting ⇒ “language of business” ⇒ the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by the users of the information. ⇒ Works on double-entry bookkeeping (luca pacioli) ⇒ Many users of information: • Investors • Lenders • Suppliers • Customers • Employees • Government • Public • Management ⇒ From stewardship function now more to towards decision-usefulness. Information summarised in a relevant manner and it presents what it purports to represent. ⇒ Three main statements: • Statement of financial position (balance sheet) • Income statement (profit and loss) • Statement of cashflows ⇒ Information: restricted to business entity, measured in monetary terms and involves periodicity (reproduced regularly). ⇒ Under pinning assumption: business will continue trading into foreseeable future.

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Statement of financial position ⇒ Financial snapshot of a business at a particular moment in time. ⇒ Represented by: • Assets • Resource controlled by the business • Result of past events • From which we expect future economic benefits (infow) • Liabilities • Obligation of the business • Result of past events • From which we expect outflow of economic benefits • Capital • Residual interest of the owners of the business • Assets= Liabilities + Capital

Structure of SoFP SoFP at xx.xx.xxxx Business name

Noncurrent assets Current assets

xxx xxx

Total Assets

xxx*

Capital

xxx

Noncurrent Liabilities Current Liabilities

xxx xxx

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Assets •

•

Non-current (fixed) o For long-term use o Result of capital expenditure o Land and buildings, machinery, office furniture etc. Current o Held for sale/consumption o Expected to be sold within the next year o Inventories, bank, cash balance.

Liabilities •

•

Current o Due for repayment under one year o Owed to suppliers, bank overdrafts Non-current (fixed) o Due for repayment in more than one year (become current if due date is under 1 year) o Long-term loans.

Capital • • •

Amounts invested by the owner Drawings reduce capital Profits increase and losses decrease capital.

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Income Statement Shows profit/loss made by a business over a period of time Profit= revenue-expenses Expenses: ⇒ Ongoing costs= revenue expenditure ⇒ Irregular costs= capital expenditure • Different from cash-flow statement- there does not need to be cash involved in order to record transactions • Cost of sales= opening inventory + purchases – closing inventory. • •

Structure Business name IS for the year ended xx.xx.xxxx Sales

xxx

Less cost of sales

(xxx)

Gross profit Less expenses Net profit

xxx (xxx) xxx

Double-entry bookkeeping • • •

Need to ensure that the equation still balances Assets = capital + (income- expenses) +liabilities Takes place only in the nominal ledger. Accounts:

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•

•

•

Rules: 1. Identify accounts affected by transaction 2. Identify their type 3. Identify which increases and which decreases. 4. Debit= Credit. Balancing accounts ⇒ Finding misbalance on ledger and carry down to next year (and to trial balance). Then, open next year with same amount as brought down. Trial balance= from it we prepare SoFP and IS. DEBIT= CREDIT

Matching Concept • • •

Transactions are recorded for in the period in which they occur, even if resulting cash receipts and payments occurs in different period. Expenses are recognised in the income statement on the basis of a direct association between the costs incurred and the earning of specific items of income. When the association with income can be only broadly or indirectly determined, expenses are recognised in the income statement on the basis of systematic and rational allocation procedures. (Accruals and prepayments). ⇒ Accruals: increase expenses, are current liabilities. ⇒ Prepayments: decrease expenses, are current assets. ⇒ Both are SoFP accounts ⇒ At the start of the next period they are cleared by reversing entries.

Depreciation • • • •

•

Intangible non-current assets: wear out/ become obsolete. Matching economic benefits by depreciation. Intangible non-current assets: economic life sometimes pre-determined or hard to measure (patents, licenses, good will). Also known as amortisation. Can be valued at: historical cost or re-valued amount. Principles: ⇒ NC assets are used up during the process of generating the revenues recognised during a specific period of time. ⇒ Need to match the economic benefits consumed against the revenues recognised in the IS. ⇒ Need to reduce the carrying amount of the asset in SoFP. ⇒ All tangible NC assets are depreciated (e.g. land) ⇒ DEPRECIATION IS ACCOUTNING ALLOCATION NOT CASH FLOW. Methods: decided by the useful life, residual value and pattern of consumption. ⇒ Straight-line: depreciated evenly over economic useful life. 7

• • •

⇒ Reducing balance: depreciation calculated by applying a fixed percentage rate to the net book value of the asset each year. Accounted for/as: Depreciation expense (IS) and accumulated depreciation (SoFP). When selling asset, this is compared to the net book value and the difference is profit/loss on disposal (IS) Net book value= cost – accumulated depreciation.

Recognition and de-recognition • • • •

•

For receivables, they are measured in selling price and are recognised when sale takes place, not when customers pay. If asset has no economic value, it has to be written off with corresponding reduction in earnings. When there is a risk of non-payment, debt has to be treated either as bad or doubtful. Bad debts are written off as loss ⇒ Dr Bad debt account (Dr income statement) ⇒ Cr trade receivables (Cr bad debt account) For doubtful debt, there needs to be a provision • Increase/create provision ⇒ Dr income statement account ⇒ Cr provision for doubtful debt • Decrease provision ⇒ Dr provision for doubtful debt ⇒ Cr Income statement account

Inventory valuation Inventories are valued at the lower of purchase cost and the net realizable value. Problem with tangible inventories: same products purchased at different prices, that cannot be distinguished (i.e. raw materials) • Methods: ⇒ FIFO (first in first out)- most common ⇒ LIFO (last in first out)- discouraged but permitted ⇒ AVCO (average cost)- approved. With rising prices, profit: FIFO > AVCO > LIFO • •

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Types of businesses • • •

Sole trader: unincorporated, one owner, unlimited liability. Partnership: unincorporated, more owners, jointly liable. Limited company: limited liability

Soletraders vs. limited companies Sole trader No separate legal entity Unlimited liability Owner puts funds/assets Increased by profits Decreased by loss/ drawings Owner= manager Drawings (Not expense, reduce capital) As above Capital= Capital increased by profit decreased by drawings.

Limited company Separate legal entity Limited liability Shareholders buy shares. Interest compensated by dividends Shareholders own Directors run Receive dividend (Capital gains) Salary= expense Capital= Equity Increased by retained earning

Feature Legal entity Liability Ownership/ interest

Management Remuneration for owners Remuneration for manager Owners interest

Public vs. private companies Public (plc): • Can raise capital at large • May/ may not be listed • Issue capital > 50,000 GBP Private (Ltd.): any other limited company.

Accounting requirements Sole trader: no format, just concepts Listed companies: IFRS Unlisted companies: UK GAAP.

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Share capital •

⇒ ⇒ ⇒ • •

• •

Equity: Ordinary Owners of the company Vote attached No entitlement to dividend Risker Capital gains

Preference Essentially lenders No vote Entitlement to fixed dividend Less risky No capital gains

Redeemable preference shares- NC liability Convertible preference shares- part liability/ part equity Irredeemable preference shares- equity. Authorised share capital= maximum that can be issued ⇒ Specified in nominal value – original issue price. Dividends: ⇒ Preference- finance cost ⇒ Equity- distribution of profits Shares: traded at nominal value (IPO) + share premium Equity= ordinary share capital, retained earnings (accumulated), other reserves (share premium, revaluation)

Presentation of company financial statements Financial statements: • Statement of financial position • Statement of comprehensive income • Statement of cash flows • Statement of changes in equity • Notes to the accounts Income statement disclosures in notes: ⇒ Directors salaries and remuneration ⇒ Auditors fees and expenses ⇒ Interest on debentures and loans

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Statement of financial position Company name Statement of financial position at xx.xx.xxxx Non-current Assets Property, plant and equipment Goodwill Other intangible assets Available for sale investments Current Assets Inventories Trade receivables Other current assets Cash and cash equivalents Total Assets Non-current liabilities Long-term borrowing Deferred tax Long-term provisions Current liabilities trade and other payables short-term borrowing Current portion of long-term borrowing Current tax payable Short-term provision Total liabilites Equity Equity share capital Retained earnings Other components of equity Total equity and liabilities

xxx xxx xxx xxx xxx xxx xxx xxx xxx xxx XXX

xxx xxx xxx xxx xxx xxx xxx xxx xxx xxx xxx

xxx xxx xxx xxx XXX

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Equity share dividends: ⇒ Not in IS, they are not expense ⇒ Dedudced from retained earnings when paid ⇒ Included in statement of changes in equity

Equity reserves ⇒ Revenue reserves- distributable as dividends. o Retained earnings o General reserves (dealing with inflation) ⇒ Capital reserves- not distributable as dividends o Share premiums o Revaluation reserve (for NC assets) o Capital redemption (for share buybacks)

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Statement of comprehensive income Company name Comprehensive IS for the year ended xx.xx.xxxx Revenue Cost of sales Gross pro fit Other income Distribution costs Administrative expenses Other expenses Finance costs Profit before tax Tax expense Profit for the year Other comprehensive income Gains on property revaluation Exchange differences in translating foreign operations Tax on comprehensive income Other comprehensive income net of tax Total comprehensive income for the year

xxx (xxx) xxx xxx (xxx) (xxx) (xxx) (xxx) xxx (xxx) xxx xxx xxx xxx (xxx) xxx xxx

Long-term capital structure • •

•

Ordinary shares – variable dividends (appropriations of profit after tax) Reserves o revenue (from profit)(can be dividends) o capital (cannot be dividends) Preference shares + Debentures o Fixed Dividend o Finance cost before tax

Other narrative reports included ⇒ ⇒ ⇒ ⇒ ⇒ ⇒ ⇒ ⇒

Chairman’s/ CEO’s statemen ts Strategic reviews and KPIs Financial review/ CFO statement Director’s report (statutory) Business review (statutory) Director’s remuneration (statutory) Statement of corporate governance (mandatory) Statement of corporate responsibility 13

Creative Accounting • •

• •

Manipulating accounting methods to achieve desired results Methods o Accounting policy choice o Estimation and judgement choice o Disclosure choice Referred to as earnings management Incentives o Management bonuses o Capital market considerations o Accounting based covenants (gearing) o Corporate control (takeovers, IPOs) o Tax considerations o Regulatory considerations o Competitive considerations (margins, R&D spending)

Agency Theory • •

Principal-agent problem between managers and shareholders Independent auditors reduce the risk of managers acting in their own interest

Regulatory Framework 1) Company Law – Company Accounts give time and fair view 2) Accounting Standards - UK + EU legislation 3) Stock exchange rules – IFRS • • • • •

•

Accounting standards o Foundation in UK, now heavily influenced by US Reduce accounting choice (and creative accounting) Improve comparability Based on concepts Improve disclosures Auditor: gives opinion on financial statements o Whether the statements are prepared in accordance to applicable reporting framework o It give time and fair view o Do not detect or prevent fraud

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Cash Flow Statements • •

Provides information on liquidity, viability and financial adaptability Statement of sources and uses of cash over accounting period Sources Uses • Customers • Supplies • Interest received • Wages & Salaries • Dividends received • Overheads • Receipts of loans • Interest • Sale of NC assets • Dividends • Issue of shares • Loan repayments • Purchase of NC Assets • Corporation tax

Classification of cash flows Operating activities • Cash flow from trading/ operation, not of tax and interest Investing activities Cash paid for NCA (property, plant, equipment) Cash received on sale of NCA Cash paid for investments in or loans for other enterprises (eg. Financial institutions) Cash received for sale of investments or repayment of loans from other enterprises (eg. Financial institutions) • Interest/ dividends received on investment/ loans Financing activities • • • •

• Issue of equity • Issue of loans and other loan and short term borrowing (eg. Bank overdrafts cash) • Repayments of borrowing tax overdraft • Capital elements of financial payments • Share buybacks Net increase in cash and cash equivalents over the period •

Standard layout of cash flow

Cash flow from operating activities •

Direct Method o Shows actual cash flows o Does not have to be included 15

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Indirect method o Reconciles operating profits with operating cash flows o Has to be included

Statement of cash flows Company name Statement of cash flow for the year ended xx.xx.xxxx Profit from operations Add back non -cash expenses • Depreciation Movement in receivables • Closing – Opening • If increase (-) • If decrease (+) Movement in inventory • Closing – Opening • If increase (-) • If decrease (+) Movement in payables • Closing – Opening • If increase (+) • If decrease (-) Cash flow from operating activities Adjust for interest paid Adjust for corporation tax • Closing tax liability – Opening tax liability + Corporation tax Net Cash flow from operations Investing activities • Purchase of NC assets (Closing – Opening NC Assets) Financing activities • Issue of shares (Closing – Opening Share Capital) Repayment of debentures • Closing – Opening NC Liabilities) Dividends paid • From ROCE

xxx xxx

(xxx) xxx

(xxx) xxx

xxx (xxx) xxx (xxx) (xxx) xxx (xxx)

xxx

(xxx) (xxx)

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CFS Technique 1) Work through opening and closing SoFP and IS for the year 2) In SoFP, mark O (Operating), I (Investing), F (Financing) 3) State if + for inflow, - for outflow, x – profit adjustment (eg. Depreciation)

Interpretation cash-flows statements • • • • • • •

There should be enough cash flow from operating activates to cover CAPEX for replacement. Shouldn’t be financed through overdraft (short-term borrowing) In general helps users to assess ability of company to generate cash and shows how it is used. Cash flow not affected by different accountancy policies= easy to compare different companies Historical cash flows are indicators of future ones. Shows how investment is financed. Best used for long-term ability (because profit is smoothed)

Interpretation of financial statement • • • •

• • • •

Different users have different needs Most valuable is comparison to previous years and seeing trends. Best to compare in percentages – gives sense to figures Ratio analysis: ¾ Good to detect trends ¾ Compare to the other companies/ industry ¾ However have to be approached with caution profitability ratios – how effective is a company in generating profits investor ratios- stock market decisions capital structure- assessment of risk and sustainability (long-term) liquidity/ efficiency ratios – ability to meet short-term obligatio...