29 - Accounting Fundamentals

Question 0

Why might a business manager want accounting records?

Answer 0

• To measure the firms performance and compare it to previous performances or the competition
• To help make decisions such as new investments, closing branches and launching new products
• To control and monitor the operation of each department and decision within the firm
• To set targets or budgets for the future and review these against actual performance

Question 1

Why should a firm keep accounting records?

Answer 1

The following reasons:
-To avoid overspending and avoid running out of working capital

• To find out if they have finance for important expenditures
• To avoid bankruptcy and law suits from debtors
• The information is needed by stakeholder groups both in and out of the business (e.g. Government, shareholders, managers, customers and banks)

Question 2

Why might banks want a firms accounting records?

Answer 2

• To decide whether to lend money to the business
• To assess whether to allow an increase in overdraft facilities
• To decide whether to continue an overdraft facility or a load

Question 3

Why might creditors such as suppliers want a firms accounting records?

Answer 3

• To see if the business is secure and liquid enough to payback it’s debts
• To assess whether the business is a good credit risk
• To decide whether to press for early payment of outstanding debts

Question 4

Why might customers want to see a firms accounting records?

Answer 4

• To assess whether the business is secure
• To determine whether they will be assured of future supplies of the goods they are purchasing
• To establish whether there will be security of spare parts and service facilities

Question 5

Why might the workforce want to see their own businesses accounting records?

Answer 5

• To assess whether the firm is secure enough pay their wages and salaries
• To determine whether the business is likely to expand or be reduced in size
• To determine whether jobs are secure
• To find out if profits are rising and if a wage increase can be afforded
• To find out how the average wage in the business compares with the salaries of directors

Question 6

What are the limitations of published accounting records?

Answer 6

• Other business structures (such as partnerships and soletraders) don’t have to publish their accounts but may be asked to provide them by banks
• Companies will only release the bare minimum of information that is required by law, therefore directors would avoid releasing sensitive information
• They only show a snapshot of the businesses financial state

Question 7

What information doesn’t have to be published in accounting records or annual reports?

Answer 7

• Details of the sales and profitability of each good or service produced by the company
• The research and development plans of the business and proposed new products
• The precise future plans for expansion of the business
• The performance of the different departments
• Evidence of the company’s impact on the environment and the local community

Question 8

What is window dressing?

Answer 8

This is presenting the company accounts in a favourable light - to flatter the businesses performance

• This can be done over the precise value of unsold stock or the value of intangible assets
• It can be done to influence banks to lend more money or to encourage potential investors to buy shares in the company

Question 9

What are the ways in which accountants can boost the short term performance of a business?

Answer 9

There are several ways in which accountants might boost the short term performance of a firm without breaking the law regarding

• Selling assets at the end of the financial year, giving the firm more money and improving their liquidity position. These assets can be leased back
• Reducing depreciation of fixed assets in order to increase declared profit and increase asset value
• Ignoring the fact that some debtors who have not payed for goods delivered, may never pay the debt - they are bad debts

Question 10

What is a financial accountant?

Answer 10

This is an accountant who prepares the published accounts of a business in keeping with legal requirements

Question 11

What is a management accountant?

Answer 11

This is an accountant who prepares detailed and frequent information for internal use by the managers of the business. These managers need financial data to control the firm and take decisions for future success

Question 12

What are the responsibilities of a financial accountant?

Answer 12

• The collection of data on daily transactions
• Preparation of the published report and accounts of a business - balance sheet, income statement and cash statements
• Preparing information for external use
• Accounts usually prepared once or twice a year
• These accountants are bound by the rules and concepts of the accounting profession. Company accounts must observe the requirements of the companies acts
• Covers past periods of time

Question 13

What are the responsibilities of management accountants?

Answer 13

• Preparation of information for managers on any financial aspect of a business, it’s departments and products
• Analysing internal accounts such as departmental budgets
• Information is only made available to managers of the business - internal use
• Accounting reports and data prepared as and when required b managers and owners
• No set rules - accountants will produce information in the form requested
• Preparing informations with few rules and regulations

Question 14

What is the cash flow statement?

Answer 14

This is a document that shows where cash was received from and what it is spent on

Question 15

What is gross profit?

Answer 15

This is equal to sales revenue munis the cost of sales

• This is profit before the deduction of overheads
• Equation: Sales revenue - cost of sales

Question 16

What is sales revenue or sales turnover?

Answer 16

This is the total value of sales made during the trading period

Equation: Selling price x quantity sold

Question 17

What is an income statement?

Answer 17

This is a statement that records the revenue, costs and profit (or loss) of a business over a given period of time

-This shows the gross and net profit of a company. Details of the net profit is split up between dividends to shareholders and retained profit

–A detailed income statesmen is usually produced for internal use by managers, as they will need as much information as possible. It would be produced as frequently as required by managers

-A less detailed income statement will appear in the published accounts of companies for external user and will be produced less frequently but at least once a year

Question 18

What is the balance sheet?

Answer 18

This is a statement that records the values of a firms assets, liabilities and shareholders’ equity at a point in time

• This shows the net worth of the company. This is the difference between the value of what a company owns (assets) and what is owes (liabilities)
• It records the net wealth or shareholders’ equity of a business

Question 19

What is the cash flow statement?

Answer 19

This is a document that shows where cash was received from and what it is spent on

Question 20

What is sales revenue or sales turnover?

Answer 20

This is the total value of sales made during the trading period

Equation: Selling price x quantity sold

Question 21

What are dividends?

Answer 21

The share of profits paid shareholders as a return for investing into the company

Question 22

What is retained profit?

Answer 22

This is the profit left over after all deductions (including dividends) have been made. This is ploughed back into the company as a source of finance

Question 23

What is net profit?

Answer 23

This is what’s left over after deducting overheads from gross profit

• Net profit = Gross profit - Overheads
• This is profit after all costs have been encountered for but before interest and tax have been deducted

Question 24

What is profit after tax?

Answer 24

This is the operating profit after interest costs and corporation tax has been deducted

Question 25

What is low quality profit?

Answer 25

One-off profit that cannot easily be repeated or sustained

Question 26

What is high quality profit?

Answer 26

Profit that can be repeated and sustained

Question 27

What is an asset?

Answer 27

An item of monetary value that is owned by a business

Question 28

What is a liability?

Answer 28

A financial obligation of a business that is required to pay in the future

Question 29

What is shareholders’ equity?

Answer 29

This is the remainder when the total value of liabilities has been deducted from the total value of assets

-Total value of assets - total value of liabilities

Question 30

What is share capital?

Answer 30

The total value of capital raised from shareholders by the issue of shares

Question 31

What are non-current assets?

Answer 31

Assets to be kept and used by the business for more than a year. Used to be referred to as fixed assets

Question 32

What are intangible assets?

Answer 32

These are items of value that do not have a physical presence, such as experience and trademarks

Question 33

What are current assets?

Answer 33

These are assets that are likely to be turned into cash within a year

-These are what make a business liquid. Firms would not be able to survive without them as they wouldn’t be able to pay short term debts or take advantage of opportunities as they fall due

Question 34

What is inventory?

Answer 34

The stock held by the business in the form of materials, works in progress and finished goods

Question 35

What are account receivables (debtors/trade recievables)?

Answer 35

The value of payments to be received from customers who have bought goods on credit

Question 36

What are current liabilities?

Answer 36

These are debts of the business that will usually have to be paid within one year

Examples include:

• Account payables
• Overdrafts
• Unpaid dividends
• Tax

Question 37

What are account payables (creditors / trade payables)?

Answer 37

The value of debts for goods bought on credit, payable to supplier

Question 38

What are non current liabilities?

Answer 38

The value of debts of the business that will be payable after more than one year

Question 39

What is good will?

Answer 39

This is what arises when a business is valued at or sold for a higher value than that of its assets (according to its balance sheet)

Question 40

What is the cash flow statement?

Answer 40

This is a record of the cash inflows and outflows of a business over a period of time

-It indicates where the company’s cash has come from during the year and how it has been spent

Question 41

What is the gross profit margin?

Answer 41

This is a ratio that compares gross profit with sales turnover

• Gross profit merging (%) = gross profit \ sales revenue x 100
• This is a good indicator of how effectively managers have added value to the cost of sales

Question 42

What is the net profit margin?

Answer 42

This is a ratio that compares the net profit with sales revenue

-Net profit margin (%) = net profit / sales revenue x 100

Question 43

What is liquidity?

Answer 43

The ability of a firm to pay its short term debts as they fall due

-This is measured by liquidity ratios. If a firm has too much working capital, they would be losing out on investment opportunities that could make them more money. If the working capital is too little the firm would become illiquid

Question 44

What is the current ratio?

Answer 44

This is a ratio that shows a firms liquidity

• Current ratio = current assets / current liabilities
• There is no particular result that is considered the universal and reliable guide to a businesses liquidity. Many accountants recommend a current ratio of 1.5 - 2

Question 45

What are some of the methods of increasing profit margins?

Answer 45

Reducing direct costs

• Using cheaper materials, this quality may be reduced and customers may expect lower prices which could cut profit margins
• May reduce consumers perception of quality and reduce the products reputation

Reducing labour costs

• Relocating to low labour cost countries would save money on wages and increase profit margins
• Quality could be at risk, also there could be communication breakdown with distant factories

Using more machinery

• This would lower labour costs and increase productivity and lead to an increase in output and increase revenue
• Purchasing machinery will increase overhead costs and this would reduce net profit margins but increase gross profit margins
• Redundancies would need to be paid for unneeded employees and remaining members of staff would need retraining. This would lead to an increase in costs

Reducing workers pay
-This would reduce wage costs but motivator levels may fall, which would reduce productivity and quality

Question 46

What is the acid test ratio (quick ratio)?

Answer 46

This is a stricter test of a firms liquidity that doesn’t take not account the least liquid current assets, such as stock. The equation is liquid assets / current liabilities

• This tests whether a firm would be able to pay short term debts if they don’t sell any stock
• Results below 1 are often viewed with caution as it means that they have less than $1 to pay each $1 short term debt.
• The ratio is only useful when there is something to compare it to, past performances must be looked at

Question 47

What are liquid assets?

Answer 47

These are assets that can be turned into cash in the short term. These exclude inventory as it is the furthest from being turned into cash

-Liquid assets = current assets - inventory (stock)

Question 48

What are the limitations of ratio analysis?

Answer 48

• The four ratios give an incomplete image of the firms financial position and there is the possibility of window dressing
• One ratio result on its own is of very limited value as it needs to be compared to previous results
• Comparing businesses that are in different legal structures or different industries could lead to an inaccurate representation of those businesses
• They only highlight the issues of a firm, they do not indicate the possible causes of them or suggest a solution

Question 49

What are the methods of increasing liquidity?

Answer 49

-Sale and lease back of land or property can inject the business with cash. The leasing could add to a firms overheads and reduce their net profits

-Sale of inventory through discounting and using just in time stock management will make a firm more liquid as they hold less stock. Discount sales will reduce gross profit margins.
Customers may doubt the image of the brand if inventory is sold cheaply
Inventory levels might be needed to meet changing customer demand levels

Question 50

What is the significance of profit margin ratios?

Answer 50

They can be used to assess how successful the management of a business has been at converting sales revenue into both gross profit and net profit

-It is misleading to compare the ratios of firms in different industries because the level of risk and gross profit margin will differ greatly

Question 51

What are the uses of an income statement?

Answer 51

• Measuring and comparing the performance of a business over time with other firms
• The actual profit data can be compared with expected profit levels and used to determine whether or not set goals have been reached
• Bankers and creditors will need the information to decide whether or not to lend the firm money or allow credit sales
• Prospective (potential) investors may assess the value of putting money into a business from the level of profit being made

Question 52

What is the cost of sales (or cost of goods sold)?

Answer 52

This is the direct cost of purchasing the goods that were used in order to produce or sell a company’s final product during the financial year