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Shanghai University of Finance & Economics. Accounting/Business Diploma Programmes Principles of Accounting. Definition of Financial Accounting.

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shanghai university of finance economics

Shanghai University of Finance & Economics

Accounting/Business Diploma Programmes

Principles of Accounting

definition of financial accounting
Definition of Financial Accounting
  • Financial accounting is the process of identifying, measuring and communicating economic information about a business organisation in order to permit informed judgements by users of that information.

[American accounting association]

the process of financial accounting
The Process of Financial Accounting

& classifying the assets, liabilities, capital, income & expenses

recording each transaction of the business

in the form of periodic financial statements

to users/stakeholders in the business

IDENTIFYING

SUMMARISING

COMMUNICATING

who are the stakeholders
Who are the Stakeholders ?

Suppliers

Managers

Shareholders/

investors

Investment analysts

Accounting information

Employees

General public

Competitors

Lenders/

creditors

Customers

Government

how will stakeholders use accounting information
How will Stakeholders use accounting information ?
  • Review their past decisions & commitments

to the business

  • Use past financial performance information

as a ”guide” to forming expectations of the

future

  • Make decisions based upon those

expectations to maintain, increase or

withdraw their commitment / interest in

the business

necessary qualities of financial information
Necessary qualities of financial information.

accuracy

clarity

Accounting

Information

reliability

consistency

timeliness

relevance

main forms of business enterprise entity
Main forms of business enterprise [entity].

Non - profit co-op charity public body

Sole trader

Business

organisation

partnership

Private limited liability company

Public limited liability company [plc]

accounting concepts
Accounting Concepts
  • Accounting statements could be prepared in a variety of ways which would be confusing
  • Therefore, they are regulated by both law and by professional standards
  • These laws and standards are based on underlying concepts
    • The most important is for accounting statements to give a true and fair view
    • This means they should disclose all relevant information for stakeholders to be able to act with confidence
accounting statements
Accounting Statements
  • Profit and Loss Account
  • Look at account on page 29
  • What is the final profit
  • What is the value of sales
  • Sales can be for cash or credit
  • Costs/expenses should match the period over which sales are made
  • Total Revenues – Total Expenses = Net Profit
the balance sheet
The Balance Sheet
  • Look at the Balance Sheets on page 31
  • Compare the date headings of the balance sheets with the profit and loss accounts
    • What is the main difference ?
  • The balance sheet shows
    • The Assets owned
    • The Liabilities owed
    • The Value of the owners’ investment in the Business
balance sheet items
Balance Sheet Items
  • Assets are things the business owns
    • Fixed Assets are used in the business and are not for resale. They are usually depreciated
    • Current Assets are cash or assets expected to be turned into cash within one year
financial accounting concepts
Financial Accounting Concepts
  • Entity
    • Separates business and personal affairs
  • Read example 1 – page 39
  • J Soap’s business is all that is shown – the other £20,000 is irrelevant
  • In fact he would be personally liable for any business debts
  • Contrast this with limited companies whose shareholders are not personally liable
money measurement
Money Measurement
  • Accounts include only information which can be expressed in monetary terms
  • This seems an obvious fact but read Example 3 – page 40
  • The message is clearly that not all important information can be shown in the accounts
going concern
Going Concern
  • Assets in the Accounts are valued on the basis that the business will continue for the foreseeable future
  • This is very important as assetsd may have very different values if business closed
  • Read Example 4 – Page 41
  • Clearly this value is only justified by the continued mining for gold
cost concept
Cost concept
  • Often referred to as historic cost
  • The assets of a business are shown at their cost of purchase and may not represent their “true” value
  • Some assets will have this historic cost written off over time as depreciation
realisation concept
Realisation Concept
  • Accounts will record profit when a sale is made.
    • This means that general increases in asset values are not recorded
    • Also means that cash does not have to exchanged
  • Read example 8 – page 45
  • Accounts would record the sale on Jan 1
accruals concept
Accruals Concept
  • Revenues and expenses are included in accounts NOT to the extent that they have been paid but to the extent that they relate to the period of account
  • E.g. A company hires new machinery and pays £50,000 per year in advance on 1st July 2003. Only £25,000 expenses should be included in accounts to 31st December 2003
matching concept
Matching Concept
  • In calculating profit, revenues should be matched with their relevant expenses
  • Read Example 11 – page 46
  • Only the expenses to buy the 1,000 tins which have actually been sold are included in the calculation of profit
periodicity concept
Periodicity Concept
  • Accounts cover a period of time – typically one year
  • Read Example 13 – page 48
  • The accounting profit will necessarily only reflect transactions completed in the period
  • This may not reflect the longer term financial position
consistency prudence concepts
Consistency/Prudence Concepts
  • Consistency is desirable as it allows accounts to be compared for different years and for different businesses
  • Prudence means that generally accounts should avoid overstating asset values, should not anticipate profits and should provide for losses
the accounting equation
The Accounting Equation.

ASSETS = LIABILITIES + CAPITAL

Resources Who supplied funding to

buy the resources

the accounting equation22
The Accounting Equation.

ASSETS - LIABILITIES = CAPITAL

What What What

business businessbusiness

owns owesis worth

total assets
Total Assets

Land & buildings

machinery

vehicles

goodwill

FIXED

ASSETS

TOTAL

ASSETS

CURRENT

ASSETS

Stocks

Debtors

Investments

Cash

total liabilities
Total Liabilities

debentures / loan stock

LONG MATURING

TOTAL

LIABIL - ITIES

CURRENT

LIABILITIES

trade creditors

overdraft

tax & dividend due

capital
Capital

SHAREHOLDER

OWNERSHIP

CAPITAL

REVENUE

Retained profit

REVALUATION

RESERVES

exercises
Exercises
  • Now try questions 1 & 2 on page 94
  • These questions will help us to understand the accounting equation and the financial statements
next step
Next Step
  • Now we understand the accounting equation and the general format of the Profit & Loss Account and Balance Sheet
  • The next step is to look at the process of recording financial transactions
principles of accounting

Principles of Accounting

Recording Accounting Transactions

transactions the accounting equation
Transactions & the Accounting Equation
  • It is possible to use the Accounting Equation to show a new Balance Sheet after each transaction
  • Look at pages 76 – 78 to demonstrate this
  • Many businesses have thousands of transactions so we do not want to draw up a Balance Sheet after each one
  • Instead we use double-entry bookkeeping
double entry system t account
DOUBLE ENTRY SYSTEM ‘T’ - ACCOUNT

“ACCOUNT NAME”

DEBIT £CREDIT £

date referencedate reference

double entry system t account31
DOUBLE ENTRY SYSTEM ‘T’ - ACCOUNT

RECORD DEBIT CREDIT

ASSETSINCREASE DECREASE

LIABILITIES DECREASE INCREASE

CAPITAL DECREASEINCREASE

double entry system link with balance sheet equation
DOUBLE ENTRY SYSTEM LINK WITH BALANCE SHEET EQUATION

ASSETS = LIABILITIES + CAPITAL

+ DEBIT

- CREDIT

+ DEBIT + CREDIT

- CREDIT - DEBIT

+ DEBIT + CREDIT

- CREDIT - DEBIT

the concept of flows
The concept of flows
  • An easy way to understand the process is to think of it as a flow
  • The flow outwards is shown on the right hand side of the account (credit)
  • The flow inwards is shown on the left hand side of the account (debit)
rules for double entry system
Rules for double entry system
  • The most important rule is that ALL transactions will have two entries
    • A credit entry and a debit entry
  • This means that all the flows of money stay within the accounting system
  • This also means that at any time the total of all debits and all credits must be equal
calculating the balances on accounts
Calculating the balances on Accounts
  • To calculate the balance on the account, simply add up both sides of the account and calculate the difference
  • After the accounts are balanced (usually at the end of accounting period) this balance is brought down on the other side of the account
  • We can look at an example
double entry system t account36
DOUBLE ENTRY SYSTEM ‘T’ - ACCOUNT

BANK ACCOUNT

Debit £Credit £

date capital a/c 160 000 datepremises 90 000

datevehicle 20 000

date purchases 60 000

class exercise
Class Exercise
  • Now let’s try a class exercise to practice making double entries and calculating balances
  • See attached notes for Tom Watson exercise
double entry system period end trial balance
DOUBLE ENTRY SYSTEM PERIOD END TRIAL BALANCE

Each debit or credit balance from each individual account is listed in a columnar TRIAL BALANCE.

The debit balances are listed on the left and the credit balances on the right

It is from the Trial balance that the Profit & Loss Account and Balance Sheet are constructed.

errors in the accounts
Errors in the Accounts
  • If the Trial Balance does not balance then an error has been made in the process of inputting data
  • However not all errors will have this result
    • E.g. if a transaction is completely overlooked
class exercises
Class Exercises
  • Bringing accounts to Trial Balance stage is a very important part of Financial Accounting
  • Pages 90 – 93 give a long example which we should study
    • Look at how we deal with opening balances
  • Class exercises to practice are questions 3, 6 and 7 on pages 94 - 96
principles of accounting41

Principles of Accounting

Periodic Measurement

introduction
Introduction
  • Double-entry bookkeeping is a system for recording accounting transactions
  • Business usually continues through time (i.e. it does not stop) but there is a general requirement for measurement of its performance at set time intervals
  • This is done by Profit & Loss Account (for the year) and Balance Sheet (at the year end)
main problems
Main problems
  • 1. Must identify the revenues for the year
  • And – need to match expenses to these revenues
  • 2. Need to make adjustments to determine whether revenues > expenses (profit) or expenses > revenues (loss)
  • These adjustments may involve use of judgement
revenues expenses
Revenues & Expenses
  • The Trial Balance is the base for calculating profit
  • Look at the Trial Balance on Page 101
  • Which are the flows for profits and which are capital flows ?
  • Which expenditure is directly to earn revenue and which to purchase assets ?
revenue expenses
Revenue & Expenses
  • Revenue is money arising from the trading activities of the business
  • Revenue expenses are the costs of running the business during the accounting period (the period being measured)
  • Look at the figures on page 102 – do they match these definitions
the accruals concept
The Accruals Concept
  • Now we have to make sure the revenues and expenses relate to this accounting period. This is the accruals concept
  • Expenses may have been paid in advance (prepayments) or may be due but not yet paid (accruals)
  • It is also possible that revenue may have accrued
accrued income
Accrued Income
  • This is much less common than accrued expenses
  • It can apply to income other than sales
    • E.g. rent receivable
  • As this area is less important we can briefly review the workings on pages 103 - 104
accrued expenses
Accrued expenses
  • This is a very important area
  • When possible businesses will delay payments
  • We have to check whether there are extra amounts due in accounts such as rent, wages and electricity
  • It is also possible that money may have been paid in advance
  • Two adjustments
    • Accruals for expenses of the year not yet paid
    • Exclude any payements already made that relate to the next year (these are prepayments)
examples
Examples
  • The example on pages 104 – 108 demonstrates how this works
  • Once we understand this we can try Question 2 on page 112 – 113
  • These is a further example of these principles on pages 109 - 110
stock adjustments
Stock Adjustments
  • Most businesses buy goods for resale at a profit
    • Sometimes as finished items and sometimes as raw materials requiring further work
  • In our current system these goods will be showing as an expense under purchases
  • We should only charge this expense to profit to the extent that these goods have been sold and generated revenue (the matching concept)
  • Those purchases which are not sold should not be an expense against profit but should be recorded as stock
  • See page 110 – 111 and attempt question 1 on page 112
  • Finally we should try question 4 on page 113
fixed assets
FIXED ASSETS

REVENUE EXPENDITURE

Charged in full to P / L Account in period incurred

CAPITAL EXPENDITURE

Spread over expected useful economic life of fixed asset

fixed assets52
FIXED ASSETS

Fixed Asset “at cost”

Include all costs incurred up to point where asset is ready for use

depreciation
DEPRECIATION

Annual charge to P/L Account representing the “cost” of using asset during the period to generate revenue and profit.

depreciation54
DEPRECIATION
  • Depreciation depends upon :
  • initial cost of the asset
  • the expected useful economic life of the asset
  • anticipated residual / scrap value of the asset
straight line method
STRAIGHT-LINE METHOD

Annual charge =CostminusResidual value

Expected life

Constant annual charge over the life of asset

straight line method56
STRAIGHT-LINE METHOD

Motor vehicles

Annual charge =CostminusResidual value

Expected life

Annual charge =£125 000minus£25 000

4 years

= £25 000 per year

recording fixed asset
RECORDING FIXED ASSET

Acquisition

Debt : “Fixed Asset at cost Account”

Credit : “Bank Account” or

“General creditor Account”

recording fixed asset58
RECORDING FIXED ASSET

Annual Depreciation Charge:

Debit : “Profit & Loss Account”

Credit : “Fixed Asset Depreciation Account”

in the balance sheet
IN THE BALANCE SHEET

Fixed assetsCostAccumulated Net Book

DepreciationValue

££ £

reducing balance method
REDUCING BALANCE METHOD

Annual Depreciation Charge =

Net Book Value% Annual

of the asset at theXDepreciation

start of the periodRate

reducing balance method61
REDUCING BALANCE METHOD

Results in a higher annual depreciation charge in the early years of the life of the asset.

Amount of annual depreciation charges falls over the life of the asset

reducing balance rate
Reducing Balance Rate
  • You may be given this rate in the question
    • E.g. Depreciation on motor vehicles is 25% reducing balance
  • However the rate can also be calculated by the following formula
  • r = 1 – n * sq root (s/c) – see page 122
  • Now try depreciation questions 1 & 2 on page 134
fixed asset disposal
Fixed asset disposal

To record disposal create a “Fixed Asset Disposal Account”

Debit : Disposal Account

Credit : Fixed Asset at Cost Account

to write the asset out of the books

fixed asset disposal64
Fixed asset disposal

To record disposal create a “Fixed Asset Disposal Account”

Debit : Fixed asset depreciation account

Credit : Disposal account

with the accumulated depreciation charged to date on the asset

fixed asset disposal65
Fixed asset disposal

To record disposal create a “Fixed Asset Disposal Account” (also called asset realization account in text book)

Debit : Bank Account

Credit : Disposal account

with the cash proceeds from the disposal

fixed asset disposal66
Fixed asset disposal

If a debit side balance remains on the Disposal Account then the asset was disposed of at a Profit.

If a credit side balance remains on the Disposal Account then the asset was disposed of at a Loss.

examples67
Examples
  • Pages 126 – 127 show an example of this
  • We can now try question 3 on page 134
bad debts
Bad debts
  • When a company knows it cannot recover money owed to them they have to write the debt off as a bad debt.
  • The bad debt will be shown in the expense section of the profit and loss account.
bad debts69
Bad debts
  • How you deal with the bad debt depends on whether it has been recorded in the ledger system or not.
  • If the bad debts are listed in the trial balance then they have been recorded and you simply show them in the expense section of the P&L a/c and that is the end of it.
bad debts70
Bad debts
  • If the bad debts are listed in the adjustments section of a questions it means that they have not been recorded in the ledger system yet but are still relevant to this accounting period. Therefore you will list them as an expense in the P&L a/c and you will also deduct the bad debt from the debtors in the balance sheet (current assets).
bad debts71
Bad debts
  • How do you record the bad debts in the double entry accounting system?
  • Example: You sold £500 worth of goods to Sally Newstead on 31/5/02, unfortunately they went bankrupt in July and therefore can not pay you.
bad debts72
Bad debts

Sally Newstead (debtor)

31/5/02 Sales £500

31/6/02 Bad debts £500

Sales

31/5/02 Sally Newstead £500

bad debts73
Bad debts

Bad debts account

31/6/02 Sally Newstead £500

31/12/02 P&L a/c £500

Profit and loss account

31/12/01 Bad debts £500

provision for doubtful debtors bad debts
Provision for doubtful debtors (bad debts)
  • One of the accounting concepts that we apply to the financial statements is prudence, we should not overstate anything.
  • Therefore if we have many debtors it is realistic that some of those debtors will not be able to pay. Therefore the company has to estimate how many debtors will not pay and make a provision for them.
provision for doubtful debtors bad debts75
Provision for doubtful debtors (bad debts)
  • How do you calculate them in a question?
  • You look in the trial balance and see what the provision was previously. You then look in the notes and see if there has been an increase or decrease in the provision for doubtful debtors.
  • You calculate the new provision by multiplying the percent (decided by directors) by the debtors figure in your trial balance.
provision for doubtful debtors bad debts76
Provision for doubtful debtors (bad debts)
  • When you have calculated the new provision you subtract the provision that you located in the trial balance.
  • If your answer is positive it means the provision has increased therefore you need to insert the difference in as an expense in the P&L a/c. You then subtract the whole amount of the new provision from the debtors in the balance sheet.
provision for doubtful debtors bad debts77
Provision for doubtful debtors (bad debts)
  • If your result is negative it means that the provision has decreased, you would then add the difference to the gross profit and then subtract the new provision from the debtors in the trial balance.
provision for doubtful debtors bad debts78
Provision for doubtful debtors (bad debts)
  • How do you deal with the provision for doubtful debtors (bad debts) in the double entry accounting system?
  • Example: In the year 2000 you have £100,000 worth of debtors, it has been estimated by the directors and accountant, from previous experience that 3% of these debtors will not be able to pay you.
provision for doubtful debtors bad debts79
Provision for doubtful debtors (bad debts)
  • Three percent of £100,000 is £3,000.

Provision for doubtful debtors (bad debts)

31/12/00 P&L a/c £3000

P&L a/c

31/12/00 Provision for bad

debts £3000

provision for doubtful debtors bad debts80
Provision for doubtful debtors (bad debts)
  • How do you increase the provision?
  • Example : the following year 2001 your debtors have increase to £120,000 but your estimated percentage remains at 3%
  • The provision for this year should be £3,600, an increase of £600.
provision for doubtful debtors bad debts81
Provision for doubtful debtors (bad debts)

P&L a/c

31/12/01 Provision for doubtful debtors (bad debts) £600

Provision for doubtful debtors (bad debts)

1/1/01 Balance b/d £3000

31/12/01 Balance c/d £3,600

31/12/01 P&L a/c £600

£3,600

3,600

provision for doubtful debtors bad debts82
Provision for doubtful debtors (bad debts)
  • How do you reduce the balance?
  • Example: the following year 2002, the company’s debtors have decreased to £80,000, the estimated percentage of doubtful debtors remains the same.
  • Therefore the provision for this year should be £2,400
provision for doubtful debtors bad debts83
Provision for doubtful debtors (bad debts)

P&L a/c

31/12/02 Provision for doubtful debtors (bad debts), reduction £1,200

Provision for doubtful debtors (bad debts)

1/1/02 Bal b/d £3,600

31/12/02 P&L a/c £1,200

31/12/02 Bal c/d £2,400

3,600

3,600

31/12/02 Bal b/d £2,400

bad doubtful debts examples
Bad/ Doubtful Debts Examples
  • We can now try Question 5 on page 135
  • Summary
  • All the adjustments we have looked will be relevant for the calculation of the financial statements
  • This is our next topic
principles of accounting85

Principles of Accounting

Preparation of the Financial Statements

summary
Summary
  • So far we have looked at :
    • Preparation of Trial Balance
    • Various adjustments to balances in the Trial Balance
  • We can now bring all this together in producing the Profit & Loss Account and the Balance Sheet
calculation of profit
Calculation of Profit
  • Let us look at the example on pages 138 – 143
  • This demonstrates how the various adjustments are made
  • However, the Profit & Loss Account is normally presented using the layout on Page 144
    • We should make sure we learn this layout
key points
Key Points
  • The basic structure is :

Sales

Cost of Sales

Gross Profit

Other Income

Total Profit

Expenses

Net Profit

(Note that there is no opening stock as this is the first year of trading)

the balance sheet89
The Balance Sheet
  • Once the Profit & Loss Account has been prepared all remained Debit balances will be Assets
  • These are divided into :
    • Long-term assets (often depreciated)
    • Short-term (current) assets such as stocks, debtors, prepayments and cash
  • All credit balances will be capital or liabilities such as creditors, accrued expenses and bank overdraft
balance sheet format
Balance Sheet Format
  • The Balance Sheet shows these groupings
    • Fixed Assets
    • Current Assets
    • Current Liabilities
    • Capital Employed and any long-term loans
  • The format is on page 147
practising forming financial statements
Practising forming Financial Statements
  • The handout contains a summary of the important information for the financial statements
  • There are also four practice questions which we can work on
celebrations ltd95
Celebrations ltd
  • Adjustments to the accounts:
  • Stock as at 30/1/01 was valued at £9,000
  • Company directors have announced a final dividend of 4p per share.
  • Bad debts have been exposed of £1,500, which have not been recorded yet.
  • There are accruals of £500 and £300 for heat and light and salaries and wages respectively
celebrations ltd96
Celebrations Ltd

5)There are prepayments for professional fees of £200 and insurance of £50.

6) Tax has been calculated to be £2,500 for the year.

7) The debenture interest is set at a rate of 5%.

8) Provision for doubtful debtors has been set at a rate of 6%.

celebrations ltd97
Celebrations ltd

9) Depreciation for fixtures and fittings is at a rate of 10% on a reducing balance method, whilst vehicles is set at 2.5% on a straight line method.

You are required: to produce a profit and loss account and balance sheet for the accounting period 30/10/00 – 30/10/01

calculate depreciation of vehicles straight line method
Calculate depreciation of vehicles (straight line method)
  • Find original cost of vehicle in your trail balance = £6,500
  • Then calculate 25% of the original cost (tells you to do this in note 9)
  • £6.500* 0.25 = £1625
  • The £1625 is this years depreciation, which belongs in your profit and loss account.
calculation of depreciation of fixture and fittings reducing
Calculation of depreciation of fixture and fittings (reducing)
  • Find the original cost in trial balance of Fixture and fittings = £10,000.
  • Find the accumulated depreciation for fixture and fittings in trail balance = £ 3,000
  • Subtract the Acc. Depreciation from the original cost.
  • £10,000 - £3,000 = £7,000
  • Calculate 10% of the balance (tells you in note 9)
  • £7,000 * 0.10 = £700
  • £700 is the amount that belongs in your P&L a/c
calculate provision for doubtful debtors
Calculate provision for doubtful debtors
  • Read note number eight, calculate 6 % of your debtors figure, which is in your trial balance. (Debtors = £8,000)
  • £8,000 * 0.06 = £480
  • Find last year provision for doubtful debtors, which is in your trial balance (400)
  • Subtract last years provision from this years (which you have just calculated)
  • £480 - £400 = £80
  • £80 is what belongs in your P&L a/c
  • The £480 belongs in your balance sheet, you subtract it from your debtors balance.
celebrations ltd108
Celebrations Ltd

Financed by:

Ordinary shares

46,150

Retained profits

32,399

78,549

principles of accounting109

Principles of Accounting

Company Financial Statements

company accounts
Company Accounts
  • There are a number of legal requirements for company accounts
  • On this course we do not have to learn most of these
  • Generally Company Accounts follow the same principles as sole trader accounts
  • However, there are likely to be few extra items which we should learn
capital structure
Capital Structure
  • A sole trader has a personal capital account and may also raise money from loans
  • A company will have shareholders and these shareholders also own the retained profit in the company
  • This will show in the bottom section of the Balance Sheet
financed by
Financed by :
  • This section will show as follows using Q4 on Page 227 as an example :
  • Financed by :
  • Issued Share Capital 560
  • Profit & Loss Account 180
  • (Retained profit)
  • However, further adjustments must be made
further adjustments
Further adjustments
  • Share Premium Account
  • This is also part of Share Capital and appears in the same section
  • It is that part of a share issue which is above the nominal value of the shares
  • We can treat it as though it is Share Capital
  • Also we must add (subtract) any retained profit (loss) for the current year
preference shares
Preference Shares
  • A further category of Share Capital is Preference Shares although these are less common than previously
  • They are still shareholders but they receive a fixed dividend and take priority over ordinary shareholders (although they come behind interest paying capital)
new format
New Format
  • This now becomes
  • Financed by :
  • Issued Share Capital 560
  • Share Premium Account 140
  • Preference Share Capital
  • Profit & Loss Account 180 + profit for year
loan capital
Loan Capital
  • A popular way of raising capital for companies is to issue debentures
  • These represent a loan to the company and bear a rate of interest which relates to their nominal value (they are likely to trade on financial markets at different values)
  • This item is shown at the end of the top section of the balance sheet
  • You may also have to add accrued interest (although example on page 227 shows full charge)
dividends
Dividends
  • Shareholders (and preference shareholders) are entitled to receive dividends
  • The full dividend is declared after the year end as Final Dividend
    • This will not be in the Trial Balance
  • This should be subtracted from Net Profit after Interest and Tax to give retained profit
  • The company may make early payment of an interim dividend
    • This will be in the Trial Balance
    • You need to accrue the difference between the Final Dividend and the Interim Dividend
taxation
Taxation
  • Interest is an allowable expense against taxation
  • Dividends are not an allowable expense
  • Therefore taxation is shown after Profit after Interest
  • It is again likely that some or all of the taxation charge will need to be accrued
other items
Other Items
  • Directors remuneration (emoluments)
  • Companies must have directors
  • Remuneration means salaries and this must be shown as a separate expense
  • Audit Fee
  • It is a legal requirement that companies are audited and the fee is an expense against profit
    • Again watch out for possible accrual as it may be paid after year end
final points
Final Points
  • Deferred taxation
    • This appears on page 227 example
    • We can ignore this on this course
  • Other issues
    • In practice, companies are required to produce a number of detailed notes to support their accounts
    • Again, we will ignore this for this course
practice questions
Practice Questions
  • One question on the test will be like this
  • Two questions are attached
  • I have put all the headings for the answer to the first question
    • I have put them twice so if you make mistakes when you try it we can put the correct answer in the second part
  • You have to do these yourselves for the second question as in the test
principles of accounting122

Principles of Accounting

Analysis of Financial Statements

ratio analysis
Ratio Analysis
  • Now we know how to construct financial statements
  • Next we need to know how to use this information to interpret and compare performance
  • Many ratios can be calculated to help us to do this
use of ratios
Use of Ratios
  • Although absolute values can be useful, ratios are most useful for comparisons
    • Either over time or across different companies
  • E.g Gross Profit Margin = 25%
  • Is this good or bad ?
  • Impossible to tell and varies widely
  • If 2001 : 31%, 2002 : 27%, 2003 : 25%
  • Then perhaps there is a problem
    • But even then may be related to whole industry
calculation of ratios
Calculation of Ratios
  • We shall use the accounts on pages 246 & 247 of the textbook
  • Notice that current share price is 2 pounds per share
  • Ratios are split into different categories
  • It is important to understand them as well as calculate them
profitability ratios
Profitability Ratios
  • Gross Margin = Gross Profit/Sales * 100%
  • 142/350 * 100% = 40.6%
  • Net Margin = Net Profit (before interest and tax)/Sales * 100%
  • (28+4)/350 * 100% = 9.1%
  • These ratios can give an indication of profitability but really need to compare trends
liquidity solvency ratios
Liquidity/Solvency Ratios
  • Current Ratio = Current Assets/Current Liabilities
  • 92/51 = 1.8 : 1
  • Gives some indication of ability to meet debts
  • But may be difficult to sell stock quickly so
  • Quick Ratio = (Current Assets – stock)/Current Liabilities
  • (92 – 45)/51 = 0.92 : 1
  • Sometimes also called ‘acid test’
working capital activity ratios
Working Capital/Activity Ratios
  • Look at relationship between current assets/liabilities and cash
  • These affect a company’s working capital requirement
  • Stock Turnover = Cost of Goods Sold/Average Stock
  • 208/((35 + 45)/2 ) = 5.2 times
  • ( 365 days/5.2 times = 70 days)
continued
Continued
  • Collection Period = (Trade Debtors * 365)/ Sales
  • (40 * 365)/ 350 = 42 days
  • Should be compared with credit terms
  • Payment period = (Trade Creditors * 365)/Cost of Sales
  • (23 * 365) / 208 = 40 days
  • If this ratio is growing it may show cash problems
long term solvency ratios
Long-term Solvency Ratios
  • Shareholders Equity Ratio
  • Shareholder Equity/Total Assets * 100%
  • (80 + 31) / (130 + 92) *100 % = 50%
  • Related to Gearing ratio and is indicator of financial stability
  • Higher ratios can more easily allow for changes in profits
continued131
continued
  • Interest Coverage Ratio (Interest Cover)
  • Profit before Interest & Tax/Interest Charges
  • (28 + 4) / 4 = 8 times
  • Gives an indication of the risk of not being able to pay interest
financial performance ratio
Financial Performance Ratio
  • Most important is usually considered to be
  • Return on Capital Employed
  • Operating Profit (before interest and tax)/ Total Assets less current liabilities * 100%
  • 32/171 * 100 % = 18.7%
  • This ratio can be broken down in order to better understand it
return on capital employed roce
Return on Capital Employed (ROCE)
  • ROCE = (Sales/Capital Employed) * (Profit/Sales) * 100%
  • 350/171 * 32/350 * 100% = 18.7%
  • 2.05 times & 9.1%
  • Have a look at this expression
    • Sales will cancel so it is the same as previously
  • The two components analyse different things
    • How effectively are assets used to generate sales
    • How profitable are sales
  • Page 253 shows how this breakdown can be taken even further
investment ratios
Investment Ratios
  • Earnings per Share (EPS)
  • Companies are required to show this calculation in their accounts
  • EPS = Profit attributable to ordinary shareholders/ Average number of shares in issue
  • 12/80 = 15 pence per share
  • Useful to establish trends and to calculate Price/Earnings P/E ratios
p e ratio
P/E ratio
  • P/E ratio = share price/earnings per share
  • 2 pounds/ 15 pence = 13.3
  • This is a very popular ratio
    • It measures the numbers of years earnings (profits) represented by the share price
  • It measures investors’ expectations for the future
  • Financial Press will often show a forward P/E ratio
    • This is based on forecast profits rather than historic profits
dividend ratios
Dividend Ratios
  • Dividend Yield = Dividend per ordinary share/ Market Price of share
  • (5,000/80,000)/2 = 6.25 pence/2 pounds = 3.1%
  • This ratio has become more important since the end of the Bull Market
  • Dividend Cover = Profits attributable to ordinary shareholders/Total ordinary dividend
    • 12,000/5,000 = 2.4 times
  • This gives some indication of risk of not maintaining dividend and can be used with Dividend Yield
practice of calculation and analysis
Practice of Calculation and Analysis
  • This is a very important area which needs a lot of practice
  • First calculate the ratios in Q1, pages 260 –261 and then we can analyse them
  • 2002 2001
  • Current Ratio
  • Acid Test (Quick)
practice of calculation and analysis138
Practice of Calculation and Analysis
  • Next try Question 3, page 262
  • Calculate the following :
    • Return on Capital Employed, Sales/Capital Employed, Net Profit/Sales, Current Ratio, Quick Ratio, Stock Turnover, Debtor Collection Period, Creditor Payment Period
  • Next we can analyse these together
  • Finally we can try question 4
principles of accounting139

Principles of Accounting

Cash Flow Statements

background
Background
  • Purpose of Cash Flow Statements
    • To report the cash receipts and payments of an accounting period
    • Remember the Profit & Loss Account is produced on a matching and accruals basis
  • In the UK, the first Financial Reporting Standard, FRS 1 “Cash Flow Statements” introduced this requirement in 1991
use of cash flow statements
Use of Cash Flow Statements
  • Financial Reporting should help users to make decisions about the company
  • Finance theory says that decisions relating to investment in a company should be related to that company’s future cash flows
  • Historical cash flow information (Cash Flow Statements) may provide a guide to future cash flows
use of cash flow statements142
Use of Cash Flow Statements
  • Other users may make decisions based on liquidity and viability (ability to survive)
  • Usually the Balance Sheet is used for this purpose (maybe by calculating ratios)
  • However, this only refers to a single period in time
    • Cash Flow Statements show a whole period and can improve understanding of liquidity
the theory for changes in cash
The theory for changes in Cash
  • Fixed Assets + Current Assets = Long-term creditors + short-term creditors + capital and reserves
  • This can be rewritten as :
  • Cash = long-term creditors + short-term creditors + capital and reserves – fixed assets – stocks – debtors
  • This equation shows the main inflows and outflows of cash and forms the basis of the Cash Flow Statement
headings for reporting
Headings for Reporting
  • 1. Operating Activities
  • The cash effects of normal trading activities
    • Profit adjusted for non-cash items such as depreciation, profit/(loss) on asset disposals and working capital movements
  • 2. Returns on Investments and servicing of finance
    • Mainly dividends received and interest both paid and received
headings for reporting145
Headings for Reporting
  • 3. Taxation
    • Shows tax actually paid (Profit & Loss Figure is likely to be different due to accruals)
  • 4. Capital Expenditure
    • P & L A/C spreads cost by depreciation. Here we identify cash flows to purchase and from disposal of fixed assets and investments
headings for reporting146
Headings for Reporting
  • 6. Dividends paid
    • As with taxation likely to differ from the P & L A/C figure
  • 7. Financing
    • Receipts from or repayments to external providers of finance
    • Includes receipts from share issues and from new debentures/loans taken out (but NOT bank overdraft)
    • Payments includes repayments of loans and repurchase of own shares
reconciliation of net debt
Reconciliation of Net Debt
  • This is shown as a separate section after the Cash Flow Statement
  • It explains how the company cash balance has changed and should balance with the Cash Flow Statement
  • Essentially this shows movements in cash and bank balances
producing cash flow statements
Producing Cash Flow Statements
  • We shall do two examples
  • I have included the working headings as part of the cash flow statements to make it easier for you to understand
  • Q2, Pages 239 – 240 : We will do this question together to understand the method
  • Q4, Pages 241 – 242 : Now, you do this question using the headings in the handout