16 Introduction to Accounting

8/11/2019 16 Introduction to Accounting

1/23

I N T R O D U C T I O N T O A C C O U N T I N GIntroduction

It is not easy to provide a concise definition of accounting since the word has a broadapplication within businesses and applications.

The American Accounting Association define accounting as follows:

"the process of identifying, measuring and communicating economic information to permitinformed judgements and decisions by users of the information!.

This definition is a good place to start. Let's look at the key words in the above definition:

- It suggests that accounting is about providing information to others. Accounting informationis economic information- it relates to the financial or economic activities of the business ororganisation.

- Accounting information needs to be identified and measured. This is done by way of a set of

accounts"! based on a system of accounting known as double-entry bookkeepin. Theaccounting system identifies and records accountin transactions".

- The "measurement"of accounting information is not a straight-forward process. it involvesmaking "udgements about the value of assets owned by a business or liabilitiesowed by abusiness. it is also about accurately measuring how much profit or loss has been made by abusiness in a particular period. As we will see! the measurement of accounting informationoften re#uires sub!ectie !udement to come to a conclusion

- The definition identifies the need for accounting information to be communicated. The wayin which this communication is achieved may vary. There are several forms of accountingcommunication $e.g. annual report and accounts! management accounting reports% each ofwhich serve a slightly different purpose. The communication need is about understanding #$o

needs the accounting information! and #$at they need to know&

Accounting information is communicated using financial statements

%$at is t$e purpose of financial statements&

There are two main purposes of financial statements:

$% To report on the financial position of an entity $e.g. a business! an organisation%(

$)% To show how the entity has performed $financially% over a particularly period of time $anaccounting period%.

The most common measurement of performance is profit.

It is important to understand that financial statements can be historical or relate to the future.

Accountability

Accounting is about ACCOUNTA'I(T)


2/23

*ost organisations are e*ternally accountable in some way for their actions and activities.They will produce reports on their activities that will reflect their ob"ectives and the people towhom they are accountable.

The table below provides e+amples of different types of organisations and how accountability islinked to their differing organisational ob"ectives:

,rganisation ,b"ectives Accountable to $e+amples%

Private or publiccompany$e.g. ! Tesco%

- *aking of profit- /reation of wealth

- 0hareholders- ,ther stakeholders $e.g.employees! customers! suppliers%

Charities$e.g. 0ave the /hildren%

- Achievement of charitable aims- *a+imise spending on activities

- /harity commissioners- 1onors

Local Authorities$e.g. Leeds /ity /ouncil%

- rovision of local services- ,ptimal allocation of spendingbudget

- Local electorate- 2overnment departments

Public services (e.g.transport, health)$e.g. 3ational 4ealth0ervice!rison 0ervice%

- rovision of public service $oftenre#uired by law%- 4igh #uality and reliability ofservices

- 2overnment ministers- /onsumers

Quasi-governmentalagencies$e.g. 1ata rotection5egistrar! 0cottish Arts/ouncil%

- 5egulation or instigation ofsome public action- /oordination of public sectorinvestments

- 2overnment ministers- /onsumers

All of the above organisations have a significant roles to play in society and have multiplestake$oldersto whom they are accountable.

All re#uire systems of financial management to enable them to produce accountinginformation.

+o# accountin information $elps businesses be accountable

As we have said in our introductory definition! accounting is essentially an informationprocess that serves several purposes:

- roviding a record of assets owned! amounts owed to others and monies invested(

- roviding reports showing the financial position of an organisation and the profitability of itsoperations

- 4elps management actually manage the organisation

- rovides a way of measuring an organisation's effectiveness $and that of its separate parts andmanagement%

- 4elps stakeholders monitor an organisations activities and performance

- 6nables potential investors or funders to evaluate an organisation and make decisions

There are many potential users of accountin Information, including shareholders! lenders!customers! suppliers! government departments $e.g. Inland 5evenue%! employees and their
http://www.bp.com/http://www.tesco.com/http://www.savethechildren.org.uk/http://www.lga.gov.uk/http://www.leeds.gov.uk/http://www.nhs.uk/http://www.nhs.uk/http://www.hmprisonservice.gov.uk/http://www.hmprisonservice.gov.uk/http://www.cabinet-office.gov.uk/quango/index/qorg.htmhttp://www.cabinet-office.gov.uk/quango/index/qorg.htmhttp://www.dataprotection.gov.uk/http://www.dataprotection.gov.uk/http://www.sac.org.uk/http://www.sac.org.uk/http://www.tesco.com/http://www.savethechildren.org.uk/http://www.lga.gov.uk/http://www.leeds.gov.uk/http://www.nhs.uk/http://www.nhs.uk/http://www.hmprisonservice.gov.uk/http://www.cabinet-office.gov.uk/quango/index/qorg.htmhttp://www.cabinet-office.gov.uk/quango/index/qorg.htmhttp://www.dataprotection.gov.uk/http://www.dataprotection.gov.uk/http://www.sac.org.uk/http://www.sac.org.uk/http://www.bp.com/


3/23

organisations! and society at large. Anyone with an interest in the performance and activitiesof an organisation is traditionally called a stake$older

7or a business or organisation to communicate its results and position to stakeholders! it needsa language that is understood by all in common. 4ence! accounting has come to be known asthe "lanuae of business"

There are two broad types of accounting information:

$% 7inancial Accounts: geared toward e+ternal users of accounting information$)% *anagement Accounts: aimed more at internal users of accounting information

Although there is a difference in the type of information presented in financial andmanagement accounts! the underlying ob"ective is the same - to satisfy the information needsof the user. These needs can be described in terms of the following overall informationob"ectives:

Collection/ollection in money terms of information relating to transactions that

have resulted from business operations

Recordin andClassifyin

5ecording and classifying data into a permanent and logical form. Thisis usually referred to as "'ook-keepin"

.ummarisin0ummarising data to produce statements and reports that will be usefulto the various users of accounting information - both e+ternal andinternal

Interpretin andCommunicatin

Interpreting and communicating the performance of the business to themanagement and its owners

/orecastin and0lannin

7orecasting and planning for future operation of the business byproviding management with evaluations of the viability of proposedoperations. The key forecasting and planning tool is the "'udet"

The process by which accounting information is collected! reported! interpreted and actionedis called "/inancial 1anaement". Taking a commercial business as the most commonorganisational structure! the key ob"ectives of financial management would be to:

$% /reate wealth for the business$)% 2enerate cash! and$8% rovide an ade#uate return on investment bearing in mind the risks that the business istaking and the resources invested

In preparing accounting information! care should be taken to ensure that the informationpresents an accurate and true view of the business performance and position. To impose someorder on what is a sub"ective task! accounting has adopted certain conventions and concepts

which should be applied in preparing accounts.

7or financial accounts! the regulation or control of what kind of information is prepared andpresented goes much further. 9 and international companies are re#uired to comply with awide range of Accountin .tandardswhich define the way in which business transactions aredisclosed and reported. These are applied by businesses through their Accountin 0olicies.


4/23

T$e main financial accountin statements

The purpose of financial accounting statements is mainly to show the financial position of abusiness at a particular point in time and to show how that business has performed over aspecific period.

The three main financial accounting statements that help achieve this aim are:

$% The profit and loss account for the reporting period

$)% A balance sheet for the business at the end of the reporting period

$8% A cash flow statement for the reporting period

A balance sheet shows at a particular point in time what resources are owned by a business$assets% and what it owes to other parties $liabilities%. It also shows how much has beeninvested in the business and what the sources of that investment finance were.

It is often helpful to think of a balance sheet as a "snap-s$ot" of the business - a picture of thefinancial position of the business at a specific point. ;hilst this is a useful picture to have!every time an accounting transaction takes place! the snap-shot picture will have changed.

y contrast! the profit and loss account provides a perspective on a longer time-period. If thebalance sheet is a digital snap-shot of the business! then think of the profit and loss accountas the 1


5/23

User Interest in 2 Use of Accountin Information

Inestors Investors are concerned about risk and return in relation to their investments.They re#uire information to decide whether they should continue to invest in abusiness. They also need to be able to assess whether a business will be able topay dividends! and to measure the performance of the business' managementoverall. The key accounting information for an investor is therefore:

- Information about growth - sales! volumes- rofitability $profit margins! overall level of profit%- Investment $amounts invested! assets owned%- usiness value $share price%- /omparative information of competitors

(enders anks and loan stockholders who lend money to a business re#uire informationthat helps them determined whether loans and interest will be paid when due.The key accounting information for lenders is therefore:

- /ash flow- 0ecurity of assets against which the lending may be secured

- Investment re#uirements in the businessCreditors 0uppliers and trade creditors re#uirement information that helps them

understand and assess the short-term li#uidity of a business. Is the businessable to pay short-term debt when it falls due= /reditors will! therefore! belooking for information on:

- /ash flow- *anagement of working capital- ayment policy

Debtors /ustomers and trade debtors re#uire information about the ability of thebusiness to survive and prosper. As customers of the company's products! theyhave a long-term interest in the company's range of products and services.They may even be dependent on the business for certain products or services./ustomer will be particularly interested in:

- 0ales growth- 3ew product development- Investment in the business $e.g. production capacity%

3mployees 6mployees $and organisations that represent them - e.g. trade unions% re#uireinformation about the stability and continuing profitability of the business.They are crucially interested in information about employment prospects andthe maintenance of pension funding and retirement benefits. They are alsolikely to interested in the pay and benefits obtained by senior management&.6mployees will! therefore look for information on:

- 5evenue and profit growth- Levels of investment in the business- ,verall employment data $numbers employed! wage and salary costs%- 0tatus and valuation of company pension schemes > levels of companypension contributions


6/23

Goernment There are many government agencies and departments that are interested inaccounting information. 7or e+ample! the Inland 5evenue needs information onbusiness profitability in order to levy and collect /orporation Ta+. /ustoms ?6+cise need accounting information to verify


7/23

.eparate 3ntity This convention seeks to ensure that private transactions and mattersrelating to the owners of a business are segregated from transactions thatrelate to the business.

Realisation ;ith this convention! accounts recognise transactions $and any profits arisingfrom them% at the point of sale or transfer of legal ownership - rather than"ust when cash actually changes hands. 7or e+ample! a company that makes

a sale to a customer can recognise that sale when the transaction is legal - atthe point of contract. The actual payment due from the customer may notarise until several weeks $or months% later - if the customer has been grantedsome credit terms.

1ateriality An important convention. As we can see from the application of accountingstandards and accounting policies! the preparation of accounts involves ahigh degree of "udgement. ;here decisions are re#uired about theappropriateness of a particular accounting "udgement! the materialityconvention suggests that this should only be an issue if the "udgement issignificant or material to a user of the accounts. The concept ofmateriality is an important issue for auditors of financial accounts.

Accountin Concepts

7our important accounting concepts underpin the preparation of any set of accounts:

Goin Concern Accountants assume! unless there is evidence to the contrary! that a companyis not going broke. This has important implications for the valuation of assetsand liabilities.

Consistency Transactions and valuation methods are treated the same way from year toyear! or period to period. 9sers of accounts can! therefore! make moremeaningful comparisons of financial performance from year to year. ;hereaccounting policies are changed! companies are re#uired to disclose this factand e+plain the impact of any change.

0rudence rofits are not recognised until a sale has been completed. In addition! acautious view is taken for future problems and costs of the business $the are

provided for in the accounts as soon as their is a reasonable chance thatsuch costs will be incurred in the future.

1atc$in 4or"Accruals"5

Income should be properly matched with the e+penses of a given accountingperiod.

6ey C$aracteristics of Accountin Information

There is general agreement that! before it can be regarded as useful in satisfying the needs ofvarious user groups! accounting information should satisfy the following criteria:

Criteria %$at it means for t$e preparation of accountin information

nderstandabilityThis implies the e+pression! with clarity! of accounting information in such away that it will be understandable to users - who are generally assumed tohave a reasonable knowledge of business and economic activities

#elevance This implies that! to be useful! accounting information must assist a user toform! confirm or maybe revise a view - usually in the conte+t of making adecision $e.g. should I invest! should I lend money to this business= 0hould Iwork for this business=%


8/23

Consistency This implies consistent treatment of similar items and application ofaccounting policies

Comparability This implies the ability for users to be able to compare similar companies inthe same industry group and to make comparisons of performance overtime. *uch of the work that goes into setting accounting standards is based

around the need for comparability.

#eliability This implies that the accounting information that is presented is truthful!accurate! complete $nothing significant missed out% and capable of beingverified $e.g. by a potential investor%.

$b%ectivity This implies that accounting information is prepared and reported in aneutral way. In other words! it is not biased towards a particular usergroup or vested interest

b u s i n e s s s t a k e $ o l d e r s

in terms of understanding the ob"ectives of a business or other organisation! there are twotraditional views:

$% The 0hareholder /oncept

$)% The 0takeholder /oncept

.$are$older Concept - 1a*imisin .$are$older %ealt$

In the theory of accounting and finance! it is assumed that the ob"ective of the business is toma+imise the value of a company. ut simply! this means that the managers of a business

should create as much wealth as possible for the shareholders. 2iven this ob"ective! anyfinancing or investment decision that is e+pected to improve the value of the shareholder'sstake in the business is acceptable. In short! the ob"ective for managers running a businessshould be profit ma+imisation. both in the short and long-term.

.take$older Concept - A %ider Rane of Ob!ecties

In recent years! a wider variety of goals have been suggested for a business. These include thetraditional ob"ective of profit ma+imisation $in other words - the shareholder concept has notbeen abandoned%. 4owever! they also include goals relating to earnings per share! total sales!numbers employed! measures of employee welfare! manager satisfaction! environmentalprotection and many others.

A ma"or reason for increasing adoption of a 0takeholder /oncept in setting business ob"ectivesis the recognition that businesses are affected by the environment in which they operate.usinesses come into regular contact with customers! suppliers! government agencies! familiesof employees! special interest groups. 1ecisions made by a business are likely to affect one ormore of these stakeholder groups. 0ome e+amples are given below

'usiness Decision .take$olders Affected

Relocation of- 6mployees in London: potential redundancies( concerns about family(


9/23

+ead Office from(ondon to %ales

housing( change in living standards

- 3ew employees in ;ales: "ob opportunities( training

- /ustomers: impact on supply of product or service(

- 0uppliers: impact on supply costs( loss of trade for London-based suppliers

- 2overnment agencies: regional development agencies( agencies providingother grants( employment training agencies

- ,ther groups: environmental impact in ;ales $e.g. traffic%

The stakeholder concept suggests that the managers of a business should take into accounttheir responsibilities to other groups - not "ust the shareholder group - when making decisions.The concept suggests that businesses can benefit significantly from cooperating withstakeholder groups! incorporating their needs in the decision-making process.

3*amples of .tated 'usiness Ob!ecties t$at Incorporate t$e .take$older Concept

Company .take$older .tatement

ritish Telecom ;e aim to be at the heart of the information society - a communications-rich world in which everyone! irrespective of nationality! culture! ethnicity!class! creed or education! has access to the benefits of information andcommunications technology $I/T%.

In practical terms! that means we are committed to doing business in a waythat:

- ma+imise's the benefits of I/T for individuals-contributes to the communities in which we operate- minimi@es any adverse impact that we might have on the environment.-It means doing business in a way that will persuade customers to buy fromus! investors to back us! the best people to work for us and communities tohave us around.

If we had to say what we believe in a single sentence! it would be this:better communications help create a better world.

*arks and 0pencer ,ur commitment to society is nothing new. ;e've always known that as wellas providing the right products! a sustainable retail business needs thesupport of healthy communities and a high #uality environment. 0ince the8Bs! *arks ? 0pencer has been actively involved in improving the #ualityof life for a wide range of communities. ;e've always tried to make anactive contribution to the needs of our stakeholders! whether as customers!

employees! investors! suppliers! partners or neighbours.

6ntering the )st century our commitment remains as strong as ever! butthe world is changing. usiness is becoming global! society more diverse andour environment is under greater threat than at any time before. /ompaniesare having to consider how their actions impact on an increasinglyconnected set of issues.

;e aim to be the most trusted retailer wherever we trade by demonstratinga clear sense of social responsibility and consistency in our decision making
http://www.btplc.com/Betterworld/Asummaryandhighlights/index.htmhttps://www2.marksandspencer.com/thecompany/ourcommitmenttosociety/index.shtmlhttp://www.btplc.com/Betterworld/Asummaryandhighlights/index.htmhttps://www2.marksandspencer.com/thecompany/ourcommitmenttosociety/index.shtml


10/23

and behaviour.

2la+o0mithline 2la+o0mithline is one of the world's leading pharmaceutical companies. Itsglobal #uest is to improve the #uality of human life by enabling people todo more! feel better and live longer. 20's strategic intent is to become theindisputable leader in its industry - not simply in terms of si@e! but in how ituses that si@e to achieve its mission. Through its 2lobal /ommunity

artnerships function and /orporate 1onations /ommittee! 20 partnerswith and supports organisations whose goals and ob"ectives reflect itsmission of improving the #uality of human life.

k e y c $ a r a c t e r i s t i c s o f a c c o u n t i n i n f o r m a t i o n

There is general agreement that! before it can be regarded as useful in satisfying the needs ofvarious user groups! accounting information should satisfy the following criteria:

Understandability

This implies the e+pression! with clarity! of accounting information in such a way that it will beunderstandable to users - who are generally assumed to have a reasonable knowledge ofbusiness and economic activities

Releance

This implies that! to be useful! accounting information must assist a user to form! confirm ormaybe revise a view - usually in the conte+t of making a decision $e.g. should I invest! should Ilend money to this business= 0hould I work for this business=%

Consistency

This implies consistent treatment of similar items and application of accounting policies

Comparability

This implies the ability for users to be able to compare similar companies in the same industrygroup and to make comparisons of performance over time. *uch of the work that goes intosetting accounting standards is based around the need for comparability.

Reliability

This implies that the accounting information that is presented is truthful! accurate! complete$nothing significant missed out% and capable of being verified $e.g. by a potential investor%.

Ob!ectiity

This implies that accounting information is prepared and reported in a neutral way. In otherwords! it is not biased towards a particular user group or vested interest.
http://www.gsk.com/community/index.htmhttp://www.gsk.com/community/index.htm


11/23

c o m p a r i s o n o f f i n a n c i a l a n d m a n a e m e n t a c c o u n t i n

There are two broad types of accounting information:

C 7inancial Accounts: geared toward e+ternal users of accounting information

C *anagement Accounts: aimed more at internal users of accounting information

Although there is a difference in the type of information presented in financial andmanagement accounts! the underlying ob"ective is the same - to satisfy the information needsof the user.

Financial Accounts Management Accounts

7inancial accounts describe the performanceof a business over a specific period and thestate of affairs at the end of that period.The specific period is often referred to as theTrading eriod and is usually one year

long.The period-end date as the alance0heet 1ate

*anagement accounts are used to helpmanagement record! plan and control theactivities of a business and to assist in thedecision-making process.They can beprepared for any period $for e+ample! many

retailers prepare daily management informationon sales! margins and stock levels%.

/ompanies that are incorporated under the/ompanies Act D are re#uired by law toprepare and publish financial accounts.Thelevel of detail re#uired in these accountsreflects the si@e of the business with smallercompanies being re#uired to prepare onlybrief accounts.

There is no legal re#uirement to preparemanagement accounts! although few $if any%well-run businesses can survive without them.

The format of published financial accounts isdetermined by several different regulatoryelements:

/ompany Law

Accounting 0tandards

0tock 6+change

There is no pre-determined format formanagement accounts.They can be asdetailed or brief as management wish.


12/23

Financial Accounts Management Accounts

7inancial accounts concentrate on thebusiness as a whole rather than analysing thecomponent parts of the business.7ore+ample! sales are aggregated to provide afigure for total sales rather than publish adetailed analysis of sales by product! marketetc.

*anagement accounts can focus on specificareas of a business' activities.7or e+ample!they can provide insights into performance of:

roducts

0eparate business locations $e.g. shops%

1epartments > divisions

*ost financial accounting information is of amonetary nature

*anagement accounts usually include a widevariety of non-financial information.7ore+ample! management accounts often includeanalysis of:

- 6mployees $number! costs! productivity etc.%

- 0ales volumes $units sold etc.%

/ustomer transactions $e.g. number of calls

received into a call centre%

y definition! financial accounts present ahistoric perspective on the financialperformance of the business

*anagement accounts largely focus on analysinghistorical performance.4owever! they alsousually include some forward-looking elements -e.g. a sales budget( cash-flow forecast.

i n t r o d u c t i o n t o f i n a n c i a l a c c o u n t s

There are two main forms of accounting information:

$% 7inancial Accounts! and

$)% *anagement Accounts

7inancial Accounts - A 1efinition

7inancial accounts are concerned with classifying! measuring and recording the transactions ofa business. At the end of a period $typically a year%! the following financial statements areprepared to show the performance and position of the business:

Proit and LossAccount

1escribing the trading performance of the business over the accountingperiod

&alance 'heet 0tatement of assets and liabilities at the end of the accounting period $a
http://tutor2u.net/business/accounts/balance_sheet.htmhttp://tutor2u.net/business/accounts/balance_sheet.htm


13/23

snapshot% of the business

Cash lo!'tatement

1escribing the cash inflows and outflows during the accounting period

otes to theAccounts

Additional details that have to be disclosed to comply with Accounting0tandardsand the /ompanies Act

*irectors+ #eport

1escription by the 1irectors of the performance of the business during the

accounting period E various additional disclosures! particularly in relation todirectors' shareholdings! remuneration etc

7inancial accounts are geared towards e+ternal users of accounting information. To answertheir needs! financial accountants draw up the profit and loss account! balance sheet and cashflow statement for the company as a whole in order for users to answer #uestions such as:

- 0hould I invest my money in this company=

- 0hould I lend money to this business=

- ;hat are the profits on which this company must pay ta+=

/ompany Law 5e#uirements for 7inancial Accounts

6very 9 company registered under the /ompanies Act is re#uired to prepare a set of accountsthat give a true and fair view of its profit or loss for the year and of its state of affairs at theyear end. Annual accounts for /ompanies Act purposes generally include:

- A directorsF report- An audit report- A profit and loss account- A balance sheet- A statement of total recogni@ed gains and losses- A cash flow statement- 3otes to the accounts

If the company is a "parent company"! $in other words! the company also owns othercompanies - subsidiaries% then "consolidated accounts" must also be prepared. Again there aree+ceptions to this re#uirement $see consolidated accounts%.

/omparative figures should also be given for almost all items and analysis given in the year endfinancial statements. 6+ceptions to this rule are given individually. 7or e+ample! there is nore#uirement to give comparative figures for the notes detailing the movements in the year onfi+ed asset or reserves balances.

i n t r o d u c t i o n t o t $ e b a l a n c e s $ e e t

Definition

A balance sheet is a statement of the total assets and liabilities of an organisation at aparticular date- usually the last date of an accounting period.

The balance sheet is split into two parts:
http://tutor2u.net/business/accounts/accounting_conventions_concepts.htmhttp://tutor2u.net/business/accounts/accounting_conventions_concepts.htmhttp://tutor2u.net/business/accounts/accounting_conventions_concepts.htmhttp://tutor2u.net/business/accounts/accounting_conventions_concepts.htm


14/23

$% A statement of fi*ed assets! current assetsand the liabilities $sometimes referred to asNet Assets%

$)% A statement showing how the 3et Assets have been financed! for e+ample through sharecapital and retained profits.

The /ompanies Act re#uires the balance sheet to be included in the published financialaccounts of all limited companies. In reality! all other organisations that need to prepareaccounting information for e+ternal users $e.g. charities! clubs! partnerships% will also producta balance sheet since it is an important statement of the financial affairs of the organisation.

A balance sheet does not necessary value a company! since assets and liabilities are shown at"$istorical cost" and some intangible assets $e.g. brands! #uality of management! marketleadership% are not included.

3*ample 'alance .$eet

0et out below is a summarised balance sheet for Tesco plc to illustrate the main elements ofthe balance sheet.

Tesco plc: alance 0heet $amounts shown in G'millions%

78 /ebruary 799: 7; /ebruary 7999

7IH61 A006T0 :9,97?

/urrent Assets :,;@8 :,,


15/23

(on-term and Current

To provide additional information to the user! assets and liabilities are usually classified in thebalance sheet as:

- /urrent: those due to be repaid or converted into cash within ) months of the balance sheet

date(

- Long-term: those due to be repaid or converted into cash more than ) months after thebalance sheet date(

/i*ed Assets

A further classification other than long-term or current is also used for assets. A fi+ed asset isan asset which is intended to be of a permanent nature and which is used by the business toprovide the capability to conduct its trade. 6+amples of "tanible fi*ed assets"include plant ?machinery! land ? buildings and motor vehicles. "Intanible fi*ed assets" may includegoodwill! patents! trademarks and brands - although they may only be included if they havebeen ac#uired. Investments in other companies which are intended to be held for the long-term can also be shown under the fi+ed asset heading.

Definition of Capital

As well as borrowing from banks and other sources! all companies receive finance from theirowners. This money is generally available for the life of the business and is normally onlyrepaid when the company is wound up. To distinguish between the liabilities owed to thirdparties and to the business owners! the latter is referred to as the "capital" or "euity capital"of the company.

In addition! undistributed profits are re-invested in company assets $such as stocks! e#uipmentand the bank balance%. Although these retained profits may be available for distribution to

shareholders - and may be paid out as dividends as a future date - they are added to the e#uitycapital of the business in arriving at the total "euity s$are$oldersB funds".

At any time! therefore! the capital of a business is e#ual to the assets $usually cash% receivedfrom the shareholders plus any profits made by the company through trading that remainundistributed.

i n t r o d u c t i o n t o f i n a n c i a l r a t i o s

In our introduction to interpreting financial information we identified five main areas forinvestigation of accounting information. The use of ratio analysis in each of these areas isintroduced below:

0rofitability Ratios

These ratios tell us whether a business is making profits - and if so whether at an acceptablerate. The key ratios are:

5atio /alculation /omments


16/23

rossProitargin

2ross rofit >5evenueJ + BB$e+pressed as apercentage

This ratio tells us something about the business's abilityconsistently to control its production costs or to manage themargins its makes on products its buys and sells. ;hilst salesvalue and volumes may move up and down significantly! thegross profit margin is usually #uite stable $in percentageterms%. 4owever! a small increase $or decrease% in profit

margin! however caused can produce a substantial change inoverall profits.

$peratingProitargin

,perating rofit >5evenueJ + BB$e+pressed as apercentage%

Assuming a constant gross profit margin! the operating profitmargin tells us something about a company's ability tocontrol its other operating costs or overheads.

#eturn oncapitalemployed("#$C")

3et profit before ta+!interest and dividends$6IT% > total assets$or total assets lesscurrent liabilities

5,/6 is sometimes referred to as the primary ratio( it tellsus what returns management has made on the resourcesmade available to them before making any distribution ofthose returns.

3fficiency ratios

These ratios give us an insight into how efficiently the business is employing those resourcesinvested in fi+ed assets and working capital.


'ales/Capitalmployed

0ales > /apitalemployed

A measure of total asset utilisation. 4elps to answer the#uestion - what sales are being generated by each pound'sworth of assets invested in the business. 3ote! whencombined with the return on sales $see above% it generatesthe primary ratio - 5,/6.

'ales orProit /i0edAssets

0ales or profit > 7i+edAssets

This ratio is about fi+ed asset capacity. A reducing sales orprofit being generated from each pound invested in fi+edassets may indicate overcapacity or poorer-performinge#uipment.

'toc12urnover

/ost of 0ales >Average 0tock $0ales%% +8K

The debtor days ratio indicates whether debtors are beingallowed e+cessive credit. A high figure $more than theindustry average% may suggest general problems with debtcollection or the financial position of ma"or customers.

Creditta1en /"Creditor

*ays"

$$Trade creditors Eaccruals% > $cost ofsales E other

purchases%% + 8K

A similar calculation to that for debtors! giving an insightinto whether a business i taking full advantage of tradecredit available to it.

(iuidity Ratios

Li#uidity ratios indicate how capable a business is of meeting its short-term obligations as theyfall due:



17/23

Current#atio

/urrent Assets >/urrent Liabilities

A simple measure that estimates whether the business canpay debts due within one year from assets that it e+pects toturn into cash within that year. A ratio of less than one isoften a cause for concern! particularly if it persists for anylength of time.

Quic1 #atio

(or "Acid2est"

/ash and near cash

$short-terminvestments E tradedebtors%

3ot all assets can be turned into cash #uickly or easily. 0ome

- notably raw materials and other stocks - must first beturned into final product! then sold and the cash collectedfrom debtors. The Muick 5atio therefore ad"usts the /urrent5atio to eliminate all assets that are not already in cash $ornear-cash% form. ,nce again! a ratio of less than one wouldstart to send out danger signals.

.tability Ratios

These ratios concentrate on the long-term health of a business - particularly the effect of thecapital>finance structure on the business:


earing orrowing $all long-

term debts E normaloverdraft% > 3etAssets $or0hareholders' 7unds%

2earing $otherwise known as leverage% measures the

proportion of assets invested in a business that are financedby borrowing. In theory! the higher the level of borrowing$gearing% the higher are the risks to a business! since thepayment of interest and repayment of debts are notoptional in the same way as dividends. 4owever! gearingcan be a financially sound part of a business's capitalstructure particularly if the business has strong! predictablecash flows.

3nterestcover

,perating profitbefore interest >Interest

This measures the ability of the business to service itsdebt. Are profits sufficient to be able to pay interest andother finance costs=

Inestor Ratios

There are several ratios commonly used by investors to assess the performance of a business asan investment:


arningsper share("P'")

6arnings $profits%attributable toordinary shareholders> ;eighted averageordinary shares inissue during the year

A re#uirement of the London 0tock 6+change - an importantratio. 60 measures the overall profit generated for eachshare in e+istence over a particular period.

Price-arnings

#atio ("P/#atio")

*arket price ofshare > 6arnings per

0hare

At any time! the >6 ratio is an indication of how highly themarket rates or values a business. A >6 ratio is best

viewed in the conte+t of a sector or market average to get afeel for relative value and stock market pricing.

*ividend4ield

$Latest dividend perordinary share >current market priceof share% + BB

This is known as the payout ratio. It provides a guide as tothe ability of a business to maintain a dividend payment. Italso measures the proportion of earnings that are beingretained by the business rather than distributed asdividends.


18/23

i n t e r p r e t a t i o n a n d a n a l y s i s o f a c c o u n t i n i n f o r m a t i o n

Introduction

7inancial information is always prepared to satisfy in some way the needs of various interestedparties $the users of accounts%. 0takeholders in the business $whether they are internal or

e+ternal% seek information to find out three fundamental #uestions:

$% 4ow is the business doing=

$)% 4ow is the business placed at present=

$8% ;hat are the future prospects of the business=

7or outsiders! published financial accounts are an important source of information to enablethem to answer the above #uestions.

T$e 6ey uestions

To some degree or other! all interested parties will want to ask #uestions about financialinformation which are likely to fall into one or other of the following categories! and be about:

0erformance Area 6ey Issues

0rofitability Is the business making a profit= Is it enough=

3fficiency Is the business making best use of its resources= Is it generatingade#uate sales from its investment in e#uipment and people= Is itmanaging its working capital properly=

(iuidity Is the business able to meet its short-term obligations as they fall duefrom cash resources immediately available to it=

.tability ;hat about the long-term prospects of the business= Is the businessgenerating sufficient resources to repay long-term liabilities and re-invest in re#uired new technology= ;hat is the overall structure of thebusinesses' finance - does it place a burden on the business=

Inestment Return ;hat return can investors or lender e+pect to get out of the business=4ow does this compare with similar! alternative investments in otherbusinesses=

T$e 1ain Tools of Reie#

The answers to the #uestions above $and others% will come from a careful! analytical review offinancial information:

Area for Reie# Comments

Reie# of t$e'usiness C$airmanBsand C3OBs Reie#

The accounts of all #uoted companies $and many private companies%include some commentary from senior management on the strategy andperformance of the business. This is often the most useful place tostart. The statements $usually one each from the /hairman! /6, and7inance 1irector% will reveal many #ualitative things about thebusiness. These include a description of the business activities!ob"ectives! developments and competitive environment. olitical!environmental and macro-economic issues may also be raised.


19/23

Cas$ flo# statement The cash flow statement will reveal where the company's resources havecome from and how they have been applied during the year.

Calculation ofsinificant ratiosbet#een fiures int$e accounts

5atio analysis is an important tool for understanding and comparingbusiness performance. 4owever! ratios and other financial calculationsare rarely useful when looked at in isolation. it is important to carry outcalculations of ratios and other significant financial figures with

previous years $many companies publish five or ten year summaries aspart of their annual reports% in order to identify positive or adversetrends%. /omparison with other! relevant competitors and industrynorms is also important.

i n t r o d u c t i o n t o t $ e p r o f i t a n d l o s s a c c o u n t

5ichard owett introduces the important concept of the profit and loss account:

Introduction - t$e 1eanin of 0rofit

The starting point in understanding the profit and loss account is to be clear about the meaningof "profit"

rofit is the incentie for business( without profit people wouldn'tFt bother. rofit is thereward for taking risk( generally speaking high risk N high reward $or loss if it goes wrong% andlow risk N low reward. eople wonFt take risks without reward. All business is risky $some morethan others% so no reward means no business. 3o business means no "obs! no salaries and nogoods and services.

This is an important but simple point. It is often forgotten when people complain aboute+cessive profits and rewards! or when there are appeals for more ta+es to pay for eg morepolicemen on the streets.

rofit also has an important role in allocatin resources$land! labour! capital and enterprise%.ut simply! falling profits $as in a business coming to an end eg black-and-white T


20/23

75 1easurin t$e resultThis is the OfinancialF part of accounting. If we say Oprofits are highFthis begs the #uestion Ohigh compared to what=F $Pou can look at this idea in more detail whencovering 5atio Analysis%

rofits are OspentF in three ways.

% Retained for future investment and growth.)% Returned to owners eg a OdividendF.8% 0aidas ta+.

0arts of t$e 0rofit and (oss Account

The rofit ? Loss Account aims to monitor profit. It has three parts.

:5 T$e Tradin Account

This records the money in $revenue% and out $costs% of the business as a result of the businessFOtradingF ie buying and selling. This might be buying raw materials and selling finished goods( it

might be buying goods wholesale and selling them retail. The figure at the end of this section isthe Gross 0rofit.

75 T$e 0rofit and (oss Account proper

This starts with the 2ross rofit and adds to it any further costs and revenues! includingoverheads. These further costs and revenues are from any other activities not directly relatedto trading. An e+ample is income received from investments.


21/23


22/23

The benefits that a business obtains from a fi+ed asset e+tend over several years. 7or e+ample!a company may use the same piece of production machinery for many years! whereas acompany-owned motor car used by a salesman probably has a shorter useful life.

y accepting that the life of a fi+ed asset is limited! the accounts of a business need torecognise the benefits of the fi+ed asset as it is consumed over several years.

This consumption of a fi+ed asset is referred to as depreciation.

Definition of depreciation

7inancial 5eporting 0tandard $covering the accounting for tangible fi+ed assets% definesdepreciation as follows:

"the wearing out, using up, or other reduction in the useful economic life of a tangible fiedasset whether arising from use, effluion of time or obsolescence through either changes intechnology or demand for goods and services produced by the asset.

A portion of the benefits of the fi+ed asset will be used up or consumed in each accountingperiod of its life in order to generate revenue. To calculate profit for a period! it is necessaryto match e+penses with the revenues they help earn.

In determining the e+penses for a period! it is therefore important to include an amount torepresent the consumption of fi+ed assets during that period $that is! depreciation%.

In essence! depreciation involves allocating the cost of the fi+ed asset $less any residual value%over its useful life. To calculate the depreciation charge for an accounting period! the followingfactors are relevant:

- the cost of the fi+ed asset(

- the $estimated% useful life of the asset(

- the $estimated% residual value of the asset.

%$at is t$e releant cost of a fi*ed asset&

The cost of a fi+ed asset includes all amounts incurred to ac#uire the asset and any amountsthat can be directly attributable to bringing the asset into working condition.

1irectly attributable costs may include:

- 1elivery costs

- /osts associated with ac#uiring the asset such as stamp duty and import duties

- /osts of preparing the site for installation of the asset

- rofessional fees! such as legal fees and architects' fees


23/23

3ote that general overhead costs or administration costs would not be included as part of thetotalcosts of a fi+ed asset $e.g. the costs of the factory building in which the asset is kept! or thecost of the maintenance team who keep the asset in good working condition%

The cost of subse#uent e+penditure on a fi+ed asset will be added to the cost of the asset

provided that this e+penditure enhances the benefits of the fi+ed asset or restores any benefitsconsumed.

This means that ma"or improvements or a ma"or overhaul may be capitalised and included aspart of the cost of the asset in the accounts.

4owever! the costs of repairs or overhauls that are carried out simply to maintain e+istingperformance will be treated as e+penses of the accounting period in which the work is done!and charged in full as an e+pense in that period.

%$at is t$e Useful (ife of a fi*ed asset&

An asset may be seen as having a physical life and an economic life.

*ost fi+ed assets suffer physical deterioration through usage and the passage of time. Althoughcare and maintenance may succeed in e+tending the physical life of an asset! typically it will!eventually! reach a condition where the benefits have been e+hausted.

4owever! a business may not wish to keep an asset until the end of its physical life. There maybe a point when it becomes uneconomic to continue to use the asset even though there is stillsome physical life left.

The economic life of the asset will be determined by such factors as technological progress andchanges in demand. 7or purposes of calculating depreciation! it is the estimated economic liferather than the potential physical life of the fi+ed asset that is used.

%$at about t$e Residual Falue of a fi*ed asset&

At the end of the useful life of a fi+ed asset the business will dispose of it and any amountsreceived from the disposal will represent its residual value. This! again! may be difficult toestimate in practice. 4owever! an estimate has to be made. If it is unlikely to be a significantamount! a residual value of @ero will be assumed.

The cost of a fi+ed asset less its estimated residual value represents the total amount to bedepreciated over its estimated useful life.

Documents

16 Introduction to Accounting