ACCOUNTING FOR DECISION MAKERS

Sanjaya BandaraB. Sc (Accountancy) Sp, FCA, ACMA, MBA

COURSE CONTENT

Introduction to accounting.Accounting concepts.Preparation of financial statements.Financial statement analysis.Working capital management.Budgeting.Breakeven analysis.

ASSESMENT STRUCTURE.Close book examination. Two exam papers. 1) MCQ Paper - 1.5 Hours , 40 questions.2) Paper for 2.5 Hours , 3 questions

RECOMMENDED READING.Peter atril “Finance for Non finance specialists”

What is accounting ? Accounting is all about collecting,

analyzing and communicating financial information to the stake holders of organizations. For example, the managers of business may need accounting information to decide whether to: Increase or decrease the price or

quantity of existing products or services Borrow money to help finance the

business Change the methods of purchasing,

production or distribution

What are accounting and finance? (Contd……..)

Though managers working within a particular business are likely to be significant users of accounting information about that particular business, they are by no means the only ones. There are those outside the business (whom we shall identify later) who may need information to decide whether to:

invest or disinvest in the ownership of the business;

Lend money to the business; Offer credit facilities; Enter into contracts for the purchase of

products or services.

• Owners / Shareholders• Management• Employees• Government• Potential investors• Suppliers• Lending organizations• Managers• competitors

USERS OF ACCOUNTING INFORMATION(STAKE HOLDERS)

Accounting as a service functionOne way of viewing accounting is as a form of

service. The quality of the service provided would be determined by the extent to which the information needs of the various user groups have been met. It can be argued that, to be useful, accounting information should posses certain key qualities, or characteristics. They are called qualitative characteristics of financial statements.

Relevance. Accounting information must have the ability to influence decisions. Unless this characteristic is present, there is really no point in producing the information.

Accounting as a service function (Contd………..)

Reliability. Accounting should be free from significant error or bias. It should be capable of being relied upon by users to represent what it is supposed to represent.

Comparability. This quality will enable users to identify changes in the business over time. It will also help users to evaluate the performance of the business in relation to other similar businesses. Comparability is achieved by treating items that are basically the same in the same manner for accounting purposes. Comparability tends also to be enhanced by making clear the policies that have been adopted in measuring and presenting the information.

Accounting as a service function (Contd………..)

Understandability. Accounting reports should be expressed as clearly as possible and should be understood by those at whom the information is aimed.

MEASURING AND REPROTING FINACIAL POSITION

The major financial statements – an overviewThe objective of the major financial accounting statements is to provide a picture of the overall financial position and performance of the business. To achieve this objective, the business’s accounting system will normally produce the following statements on a regular, recurring basis. The statement of comprehensive income The statement of financial position The cash flow statement Statement of changes in equity , notes to the

fin.statements and accounting policies.Taken together, they provide an overall picture of the financial health of the business.

The purpose of the this statement is simply to set out the financial position of a business at a particular moment in time.

We can, however, be more specific about the nature of the balance sheet by saying that it sets out the assets of the business on the one hand, and the claims against the business on the other.

Statement of Financial position

Assets

An asset is essentially a resource held by the business. For a particular item to be treated as an asset for accounting purposes it should have the following characteristics:

A probable future benefit must exist. This simply means that the item must be expected to have some future monetary value. This value can arise through its use within the business or through its hire or sale.

Assets (Contd………….) The business must have an exclusive right

to control the benefit / ownership of the asset.

The assets must be capable of measurement in monetary terms. Unless the item can be measured in monetary terms, with a reasonable degree of reliability, it will not be regarded as an asset for inclusion on the balance sheet.Note that all of these conditions must apply. If one of them is missing, the item will not be treated as an asset, for accounting purposes, and will not appear on the balance sheet.

The sorts of items that often appear as assets in the balance sheet of a business include: freehold premises; Machinery and equipment; Fixtures and fittings; Patents and trademarks; Receivables (debtors); investments

Note that an asset does not have to be a physical item – it may also be a non-physical right to certain benefits. Assets that have a physical substance and can be touched are referred to as tangible assets. Assets have no physical substance but which, nevertheless, provide expected future benefits (such as patents) are referred to as intangible assets.

Capital/ Equity This represents the claim of the owner(s) against the business. This claim is sometimes referred to as the owner’s equity.

Liabilities. Liabilities represent the claims of all other individuals and organizations, apart from the owner(s). Liabilities must have arisen from past transactions or events such as supplying goods or lending money to the business.

Once a claim has been incurred by a business, it will remain as an obligation until it is settled.

The classification of assets

To help users to understand more clearly the information that is presented, assets and liabilities are usually grouped into categories. Assets may be categorized as being either current or non-current.

Current AssetsCurrent assets are basically assets that are held for the short term. To be more precise, they are assets that meet any one of four criteria. These are: They are held for sale or consumption in the

normal course of a business’s operating cycle; They are for the short term They are held primarily for trading They are cash, or near cash such as easily

marketable, short-term investments.The most common current assets are inventories (or stock), customers who owe money for goods or services supplied on credit (known as trade receivables of debtors), and cash.

Non-current assets

They are held for the long-term operations of the business. Essentially, they are the ‘tools’ of the business and are held with the objective of generating wealth.

Examples of assets that may be defined as being non-current are:

freehold premises; Plant and machinery Motor vehicles patents

The classification of liabilities

Liabilities can be divided into,

• Current liabilities are basically amounts due for settlement in the short term.

• Non-current liabilities represent those amounts due to outside parties that are not current liabilities.

Accounting Conventions / concepts

Accounting is based on a number of rules or conventions that have evolved over time. They have evolved as attempts to deal with practical problem experienced by preparers and users, rather than to reflect some theoretical ideal.

Business entity convention

For accounting purposes, the business and its owner(s) are treated as being quite separate and distinct. This is why owners are treated as being claimants against their own business in respect of their investment in the business. The business entity convention must be distinguished from the legal position that may exist between businesses and their owners.

Money measurement convention

Accounting normally deals with only those items that are capable of being expressed in monetary terms.

Accrual basis of accountingAn entity shall prepare its financial

statements using the accrual basis of accounting.

Historic Cost Convention

Assets are shown on the balance sheet at a value that is based in their historic cost (that is, acquisition cost). This method of measuring asset value has been adopted by accountants in preference to methods based on some form of current value. Many people find the historic cost convention difficult to support, as outdated historic costs are unlikely to help in the assessment of current financial position.

Going Concern Convention

The going concern convention holds that the financial statements should be prepared on the assumption that the business will continue operations for the foreseeable future, unless this is known not to be true. In other words, it is assumed that there is no intention, or need, to sell of the non-current assets of the business.

Dual aspects convention

The dual aspect convention asserts that each transaction has two aspects, both of which will affect the balance sheet. Thus the purchase of a motor car for cash results in an increase in one asset (motor car) and a decrease in another (cash). The repayment of a loan result in the decrease in a liability (loan) and the decrease in an asset (cash /bank)

Prudence Convention

The prudence is the inclusion of a degree of caution in the exercise of the judgments needed in making the estimates required under conditions of uncertainty , such that assets or income will are not overstated and liabilities and or expense are not understated.

Substance over formIf information is to represent

faithfully the transactions and other events that it purports to represent, it is necessary that they are accounted for and presented in accordance with their substance and economic reality and not merely the legal form.

Objectivity Convention

The objectively convention seeks to reduce personal bias in financial statements. As far as possible, financial statements should be based on objective verifiable evidence rather than on matters of opinion.

The basis of valuation of assets on the balance sheet

It was mentioned earlier that, when preparing the balance sheet, the historic cost convention is normally applied for the reporting of assets. However, this point requires further elaboration as, in practice, it is not simply a matter of recording each asset n the balance sheet at its original cost.

The basis of valuation of assets on the balance sheet

It was mentioned earlier that, when preparing the balance sheet, the historic cost convention is normally applied for the reporting of assets. However, this point requires further elaboration as, in practice, it is not simply a matter of recording each asset on the balance sheet at its original cost.

Tangible non-current assets (property, plant and equipment)

Tangible non-current assets tend to be referred to as property, plant and equipment. Items of property, plant and equipment should be measured initially at their historic cost. However, they will normally be used up over time as a result of wear and tear, obsolescence and so on. The amount used up, which is referred to as depreciation, must be measured for each accounting period that the assets are held.

Tangible non-current assets (property, plant and equipment) (Contd………)

Although using depreciated cost is the ‘benchmark treatment’ for these assets, an alternative is allowed. Property, plant and equipment can be measured using fair values provided that these values can be measured reliably. The ‘fair values’, in this case, are usually the current market values.

By using fair value, a more up-to-date figure than the depreciated cost figure is provided to users, which may be more relevant to their needs.

Intangible non-current assets

The ‘benchmark treatment’ is that they are measured initially at historic cost and any depreciation (or amortization as it is usually termed in the context of intangible non-current assets) incurred following acquisition will be deducted to obtain a net book value. Once again, the alternative or revaluing intangible assets using fair values is available. However, this can only be used where fair values can be properly determined by reference to an active market.

The impairment of non-current assets

There is always a risk that both types of non-current asset (tangible and non-tangible) may suffer a significant fall in value. This may be due to factors such as changes in market conditions, technological obsolescence and so on. In some cases, this fall in value may lead to the net book value, or carrying amount, of the asset being higher than the amount that could be recovered from the asset through its continued use. When this situation arises, the asset figure on the balance sheet should be reduced to its recoverable amount. Unless this is done, the asset will be over stated on the balance sheet.

MEASURING AND REPORTING FINANCIAL PERFORMANCE

The statement of comprehensive income

Businesses exist for the primary purpose of generating wealth, profit, and it is the profit generated during a period that is the main concern of many users of financial statements. Although the amount of profit generated is of particular interest to the owners of a business, other groups such as managers, employees and suppliers will also have an interest in the profit-making ability of the business. The purpose of the income statement – or profit and loss account, as it is sometimes called – is to measure and report how much profit (wealth) the business has generated over a period.

The statement of comprehensive income (Contd…….)

The measurement of profit requires that the total revenue of the business, generated during a particular period, be identified. Revenue is simply a measure of the inflow of economic benefits arising form the ordinary activities of a business.

The total expenses relation to each accounting period must also be identified. Expenses is really the opposite of revenue. It represents the outflow of economic benefits arising form the ordinary activities of a business.

The statement of comprehensive income (Contd…….)

The income statement for a particular period simply shows the total revenue generated during the period and deducts from this the total expenses incurred in generating that revenue. The difference the total revenue and total expenses will represent either profit or loss