Introduction To Accounting - Final Exam Notes PDF

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Introduction to Accounting – Final Exam notes: Different Definitions: • Definition: Accounting – “the process or work of keeping financial accounts” • Definition: Account – “a report or description of an event or experience”, or – “a record or statement of financial expenditure and receipts relating to a particular period or purpose” Textbook definitions: • “[A]ccounting is a service provided for those who need information about an entity’s financial performance, its assets and its liabilities” – Dyson (2010: 4) • “[A]ccounting is concerned with collecting, analysing and communicating financial information. This information is useful for those who need to make decisions and plans about businesses...” Professional Definition:  The objective of financial statements is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions” Who uses Accounting?

Types of Accounting: • • •

Financial accounting – ‘the measuring and reporting of financial information for external users (those users other than the managers of the business)’ Management accounting – ‘the measuring and reporting of financial information for the managers of a business’ Financial management – the process of informing the financing and investment decisions of a business

Accounting and Company Needs: • •

•

The role of accounting will also vary across company type Generally there are 4 types of company – Sole trader – Partnerships – Limited Liability Company (ltd) – Public Limited Company (plc) Each type has specific rules and requirements that should be followed

Financial Accounting and Practices: • • • • • •

Practices are developed for reporting to those who are not part of the day-today running of the business Practices of accounting are regulated to ensure fairness in reporting: – These are called Accounting Standards and form part of Generally Accepted Accounting Principles (GAAP) In UK, regulatory body is Accounting Standards Board (ASB): – Responsible for setting standards and regulatory matters Public listed companies (plc) in UK must also prepare accounts in accordance with international accounting standards – Requirements set by International Accounting Standards Board (IASB) Any company listed on NYSE must also prepare a set of accounts in line with US GAAP Non-US based companies might also be required to prepare an audited US GAAP reconciliation

Financial Statements: • Financial performance and position contained in three financial statements: – Income Statement – Balance Sheet – Cash Flow Statement • Contained as part of company’s annual report: – All companies must prepare these annually, and send to all shareholders – Some content is required by law or accounting regulation – Other content discretionary • Only a small amount of annual report is made up of financial statements: – This part is regulated and is subject to annual audit Cost behavior: • 3 basic types of cost: – Variable: costs that vary according to output – Fixed: costs which do not vary in relation to output – Semi-variable: costs which have a fixed component and a variable component • Think of examples for any business? • These can be graphed to show relationship between cost and output

Additional Terminology: • •

Direct cost – Expenditure, which can be economically identified with, and specifically measured in respect to, a relevant cost object. Indirect cost (or overhead) – Expenditure on labour, materials or services which cannot be economically identified with a specific saleable cost unit, (In the USA, ‘burden’ = ‘overhead’)

Alternative Cost Analyses:

• • • • • • • •

Different cost object estimates provide different total costs; AND Different cost analysis produces different total costs Why does this matter? Profit = Sales Revenue less Costs If cost estimates can change, so too does profit Understanding cost behaviour is important, as managers can see how shifts in types of costs affects profit levels A change in variable costs = change in profit Becomes important to manage and control costs to maintain profit levels Can also help determine cost levels

Qualitative characteristics of Financial Statements: • Understandability • Relevance – Materiality

• Reliability – Faithful representation Substance over form NeutralityPrudence Completeness

• Comparability- TimeOther entities Statement of Financial Position: Also known as balance sheet • Provides information on: – Financial position of a business entity at a particular moment in time – Wealth (value of assets) – Obligations due by the entity to external parties • Measures the value of assets as balanced (or represented by) the value of liabilities and equity Assets: A resource held by the company– A probable future benefit must exist • Inventories will be sold for cash– Must be exclusively controlled by the business • Example?– Benefit from a past transaction or event • Factory must have been purchased, not just agreement to buy – Must be measurable in monetary terms• Value of workforce cannot be included as an asset Valuation of assets : • Usually included at historic cost • Non-current assets – depreciated each year, over their expected useful lives – Can be revalued to current market value • Eg rise in property prices – If significant drop in value, reduce figure to recoverable amount • Drop in value of shares owned by a company

Equity • Owner’s claim against the business

• Remember business entity convention

• Comprise funds paid into the business by the owners, less funds taken out by owners plus any profits made by the business

Liabilities • Claims of anyone else against the business, such as: Loans Trade payables Tax due • Current liabilities– Due for settlement in the short-term (1 year) Measuring and reporting financial performance • Income statement • Profit (or loss) = total revenue for the period minus total expenses for the period • Provides information on: – How effective the business has been in generating wealth – How the profit was made

Accounting Equation

• Balance sheet is designed to show:

– Assets = Liabilities + Equity

Also written as: Assets less liabilities = equity (usually in older textbooks)

• Idea is that each accounting transaction affects at least one part of the equation

Adjustments • However, there are usually some adjustments that are required when preparing financial statements • Consider accruals, prepayments and depreciation... Accruals Accrued expenses (accruals) – Arise when the expense for the period is more than the cash paid during the period – Example: •

Company A paid £4,000 electricity in the year to 31 Dec 2010. At the year end, it had not paid its final electricity bill which arrived in January 2011, amounting to £1,500. Must increase electricity expense by £1,500, and create a new current liability called accrued expenses of £1,500 • Prepaid expenses (prepayments)– Arise when the amount paid for the period is more than the expense for the period – Example: Company B also has a year end of 31 December 2010. During the year, it paid £24,000 for an annual insurance premium, which covers the period 1 April 2010 until 31 March 2011. Must reduce insurance expense by £6,000, and create a new current asset called prepaid expenses of £6,000

Depreciation

• • •

Spreads the cost of an asset over its estimated useful life Avoids under or over stating profit Example: company usually makes £10,000 profit each year. It buys a lorry costing £30,000 in year 4.

Calculating Depreciation Car purchased for £10,000. Estimated useful life 5 years, with no scrap value anticipated…

Effect of depreciation on accounts: • Each year, the depreciation charge is included as an expense in the income statement • The asset in the balance sheet is reduced by the same amount • Over several years, the written-down value of an asset will get lower and lower

If the asset has a residual (scrap) value, that should be deducted from the cost of the asset (straight-line method only)

• Intangible assets area mortised rather than depreciated – technique identical • Selecting a depreciation method: – Each business can choose an appropriate method – Best to match depreciation expense with economic benefits provided by asset • Building – straight-line • Motor vehicle – reducing balance

Introduction: Ratio Analysis • Ratios enable progress to be monitored

• Externally–published accounts

• Internally–management accounts

• Knowledge of starting position is essential in order to plan improvements

• Understanding ratios is essential for good financial management

Who might use ratio analysis? • Managers: – Internal purposes to monitor efficiency and resource usage – Examine performance over time – Poor performance identifies areas of investigation, e.g. why is company less profitable? Are expenses too high or have costs increased? Etc. – Make forecasts based on previous performance trends • Financial investors: – To assess performance over a given period – If performance has improved, investment is likely – Probability of financial problems

How Financial Ratios can be Used? Using the Profit Margin ratio as an example: • actual ratios compared with budget ratios – Is business as profitable as planned?

• actual ratios compared with competitors’ actual ratios – Is business as profitable as competitors?

• actual ratios compared with those of previous years – Is business performance improving?– Any trends identifiable?

Areas of use Typically 6 areas of ratio analysis:Profitability / liquidity / efficiency/ gearing/ cash flow and investment

Profitability Ratios Return on Capital Employed Is the company able to generate a profit? This ratio considers how efficiently a company uses its capital employed to generate profit.

Evaluation and Benchmarking: • The higher the better. • ROCE of a company can be compared with other companies and over time with itself. • • •

Profitability Ratios Gross Profit Margin It indicates the percentage of revenue available to cover operating and other expenses and to generate profit.

Profitability Ratios Net Profit Ratio It indicates the percentage of revenue available to generate profit.

Evaluation and Benchmarking: this ratio reflects the effects on profitability of all the business transactions. It is useful to compare this ratio with the one of competitors.

Efficiency Ratios A company improves its efficiency when • produces more units of output with the same units of input or • produces the same units of output with less input. Trade Receivables Collection Period (Debtors Collection Period) It measures how long customers take to pay their debts.

Evaluation and Benchmarking:

Efficiency Ratios Inventory Turnover Ratio (Stock Turnover Ratio)  This ratio effectively measures the speed with which inventory moves through the business.

Liquidity Ratios Current Ratio Liquidity ratios measures a company’s ability to meet its short-term obligations This ratio tests whether the short-term assets cover the short-term liabilities. If they do not, then there will be insufficient liquid funds to pay current liabilities as they fall due.

Quick Ratio (Acid Test) The quick ratio excludes inventory, the least liquid of the current assets, to arrive at an immediate test of a company’s liquidity.

Further Ratios • Main areas of interpretation are: Profitability/liquidity/efficiency – But there are other areas, such as financial stability, investment/market performance • Stability has a focus upon long term financing arrangements of a business – Ratios include: Gearing and interest cover – See textbook for explanation of these ratios • Investment ratios used by investors to determine if investment is worthwhile: – Ratios include: Earnings per share and price-earnings ratio Earnings Per Share • •

Used to compare financial results of plcs Useful for investors to determine changes in earnings over a period of time

• Usually expressed in the form £ per share (i.e. £1.50 in income is gained per £1 of share)   

Can also be used to measure “profit” per share However, be cautious when using this method US GAAP and FASB requires that all US companies produce and publish this measure on a frequent basis – it is one of the most monitored measures of performance...

Price-Earnings Ratio

Usefulness of Ratios

Assume Company A has €100,000 of net income and Company B has €200,000 of net income. Which of two companies was more profitable? Company B generated twice as much income as Company A, but Company A has €2,000,000 of revenue and Company B has €6,000,000 of revenue. Expressing net income as a percentage of revenue clarifies the relationship:Company A  Net Income/Revenue x 100 = 5%Company B  Net Income/Revenue x 100 = 3.33% For each €100 of revenue, Company A earns €5 in net income, whereas Company B earns only €3.33 for each €100 of revenue.

Limitations How accurate is the picture painted by ratio analysis? Effect of accounting conventions: • if inflation is high, historic cost convention may distort amount of capital employed • Prudence is overstatement of liabilities/expenses, may distort profit ratios Also, capital employed figure depends on choice of depreciation method and other accounting policies Past performance is not always a good indicator of future performance due to rate of change in business environment Ratios quantify what has happened, not why Their auditors certified Enron’s accounts correct! Tesco’s recent accounts also: http://www.bbc.co.uk/news/business-29357840...