accounting fundamentals Flashcards
the work of financial accountants
is to prepare the published accounts of a business in keeping with legal requirements
work of management accountants
is to prepare detailed and frequent information for internal use by the managers of the business who need financial data to control the firm and take decisions for future success.
It is important for accountants all over the world to base business accounts on the same basic principles.
what are these principles
The double-entry principle- Every time a business engages in a transaction, for example buying materials or selling goods to a customer, there are two sides to the transaction. Th is means that the accounts of the business must include it twice to ensure that the accounts balance.
Accruals- Accruals arise when services have been supplied to a business but have not yet been paid for at the time the accounts are drawn up, such as an electricity bill. If no adjustment was made for this accrued expense, then the profits in the current accounting period will be overstated
The money-measurement principle-Accountants need a common form of measuring the wealth and performance of the businesses they work for. All accounting data are converted into money– hence the principle of money measurement
Why stakeholders need accounting information
problems and groups affected
Problem
- How much did we buy from our suppliers and have they been paid yet?
* Managers and suppliers (creditors) - How much profit did the business make last year?
* Managers, shareholders and the tax authorities - Is the business able to repay the loan to the bank
* Managers and the bank
The different work of financial and management accountants
financial accountants
- Collection of data on daily transactions. 2.Preparation of the published report and accounts of a business– Statement of financial position, income statement and cash statement.
- Information is used by external groups.
- Accounts usually prepared once or twice a year.
management accounting 1.Information is only made available to managers of the business– internal users.
- Preparation of information for managers on any financial aspect of a business, its departments and products.
- Analysing internal accounts such as departmental budgets
Income statement
records the revenue, costs and profit (or loss) of a business over a given period of time.
Final accounts of limited companies − what they contain
1.Income statement (formerly known as profit and loss account)
*meaning
The gross and operating profit of the company. Details of how the operating profit is split up (or appropriated) between dividends to shareholders and retained earnings (profit).
2.Statement of financial position (formerly known as the balance sheet)
*meaning
The net worth or equity of the company. This is the difference between the value of what a company owns (assets) and what it owes (liabilities).
3.Cash-flow statement
*meaning
Where cash was received from and what it was spent on.
Gross profit
equal to sales revenue less cost of sales.
Revenue
(formerly called sales turnover): the total value of sales made during the trading period = selling price × quantity sold.
cost of sales
The formula used is:
cost of sales = opening stocks plus purchases minus closing stocks
This can be laid out as: Opening stocks (at the start of the year) $500 Purchases during the year
$2,500 Total stock (available for sale) $3,000 Closing stocks (at the end of the year) ($750) Cost of goods sold $2,250
Cost of sales
(or cost of goods sold): this is the direct cost of the goods that were sold during the financial year
Operating profit
(formerly referred to as net profit): gross profit minus overhead expenses
Profit for the year
(profit aft er tax): operating profit minus interest costs and corporation tax
Dividends
the share of the profits paid to shareholders as a return for investing in the company.
Retained earnings (profit):
the profit left aft er all deductions, including dividends, have been made, this is ‘ploughed back’ into the company as a source of finance
The uses of income statements The information contained in income statements can be used in a number of ways
■ It can be used to measure and compare the performance of a business over time or with other firms
■ The actual profit data can be compared with the expected profit levels of the business.
■ Bankers and creditors of the business will need the information to help decide whether to lend money to the business.
Non-current assets
assets to be kept and used by the business for more than one year. Used to be referred to as ‘fixed assets’.
Intangible assets
items of value that do not have a physical presence, such as patents, trademarks and current assets.
Current assets
assets that are likely to be turned into cash before the next balance-sheet date
Inventories
stocks held by the business in the form of materials, work in progress and finished goods
Trade receivables (debtors
the value of payments to be received from customers who have bought goods on credit.
Current liabilities
debts of the business that will usually have to be paid within one year.
Accounts payable (creditors):
value of debts for goods bought on credit payable to suppliers; also known as ‘trade payables’.
Non-current liabilities
value of debts of the business that will be payable after more than one year.
Shareholders’ equity comes from two main sources
■ The first and original source was the capital originally invested in the company through the purchase of shares. This is called share capital.
■ The second source is the retained earnings of the company accumulated over time through its operations. These are sometimes referred to as reserves, which is rather misleading as they do not represent reserves of cash
The Statement of financial position
■ Companies have to publish the income statement and the Statement of financial position for the previous financial year as well in order to allow easy comparison. These have not been included in the above examples for reasons of clarity.
■ The titles of both accounts are very important as they identify both the account and the company.
Businesses can also own intangible assets– these cannot be seen but still have value in the business. Examples are:
These items make up what is known as the ‘intellectual property’ of the business
■ patents
■ trademarks
■ copyrights
■ goodwill
NB*These intangible assets can be very
important for an IT-based or knowledge-based business. The reputation and prestige of a business that has been operating for some time also give value to the business over and above the value of its physical assets. This is called the goodwill of a business and should normally only feature on a Statement of financial position just after it has been purchased for more than its assets are worth, or when the business is being prepared for sale
Cash-flow statement
record of the cash received by a business over a period of time and the cash outflows from the business.
Apart from the three main accounting statements, other information is required by law to be included in company published accounts. Some of the most important sections are:
1 The cash-flow statement
2 The Chairman’s Statement
3 The Chief Executive’s Report- This is a more detailed analysis of the last financial year, often broken down by area of main product divisions.
4 The Auditors’ Report- Th is is the report by an independent firm of accountants on the accuracy of the accounts and the validity of the accounting methods used
Gross profit margin
This ratio compares gross profit (profit before deduction of overheads) with revenue.
gross profit margin % = gross profit divided by revenue × 100
accounting ratio analysis
two main ratios are studied
1 Profitability ratios: These include the profit margin ratios, which compare the profits of the business with revenue
2 Liquidity ratios: These give a measure of how easily a business could meet its short-term debts or liabilities
Current ratio =
current assets divided by current liabilities
ways to increase profit margins
- Increase gross and operating profit margin by reducing direct costs
- Increase gross and operating profit margin by increasing price
- Increase operating profit margin by reducing overhead costs
Acid-test ratio
Also known as the quick ratio, this is a stricter test of a fi rm’s liquidity. It ignores the least liquid of the fi rm’s current assets– inventories (stocks).
how to calculate acid-test ratio
liquid assets divided by current liabilities
Liquid assets
current assets – inventories (stocks) = liquid assets.
Limitations of ratio analysis
1 The four ratios studied give an incomplete analysis of a company’s financial position.
2 One ratio result on its own is of very limited value– it needs to be compared with results from other similar businesses and with results from previous years to be more informative.
3.Poor ratio results only highlight a potential business problem– they cannot by themselves analyse the cause of it or suggest potential solutions to the problem
ways to increase liquidity
- Sell off fixed assets for cash– could lease these back if still needed by the business
- Sell off inventories for cash (note: this will improve the acid-test ratio, but not the current ratio
- Increase loans to inject cash into the business and increase working capital
list and details of all users of accounts and the reasons why they need accounting data
Business managers:
■ to measure the performance of the business to compare against targets, previous time periods and competitors
■ to help them take decisions, such as new investments, closing branches and launching new products
Banks:
■ to decide whether to lend money to the business
■ to assess whether to allow an increase in overdraft facilities
Workforce:
■ to assess whether the business is secure enough to pay wages and salaries
■ to determine whether the business is likely to expand or be reduced in size
published accounts Information that does not have to be published in a company’s annual report and accounts includes:
■ details of the sales and profitability of each good or service produced by the company and of each division or department
■ the research and development plans of the business and proposed new products
■ the precise future plans for expansion or rationalisation of the business
■ the performance of each department or division
Common ways of window-dressing accounts include:
■ selling assets, such as buildings, at the end of the financial year, to give the business more cash and improve the liquidity position– these assets could then be leased or rented back by the business
■ reducing the amount of depreciation of fixed assets, such as machines or vehicles, in order to increase declared profit and increase asset values ■ ignoring the fact that some customers (trade receivables) who have not paid for goods delivered may, in fact, never pay– they are ‘bad debts’
