Ch 30 Accounting fundamentals

Question 1

What are the 3 accounts?

Answer 1

• The income statement
• The balance sheet/ Statement of financial position
• Cash flow statement

Question 2

What does the income statement show?

Answer 2

The gross and net profit of the company. Details of how the net profit is split up between dividends and retained profits

Question 3

What does the balance sheet show?

Answer 3

The net worth of the company. This is the difference between the value of what a company owns and what it owes

Question 4

What does the cash flow statement show?

Answer 4

Where cash was received from and what it was spent on

Question 5

Definition of income statement

Answer 5

Records the revenue, costs and profit (or loss) of a business over a given period of time

Question 6

What are the elements of an income statement?

Answer 6

cost of sales, gross profit, operating profit, profit for the year, retained earnings

Question 7

What are the three sections of an income statement?

Answer 7

The trading account
The profit and loss account
Appropriation account

Question 8

What are the 2 elements of the trading account and what does it show?

Answer 8

Gross profit: equal to sales revenue minus cost of sales
Sales revenue
Cost of sales: direct cost of purchasing the goods that were sold during the year. opening stocks plus purchases minus closing stocks
The account shows how gross profit or loss has been made from the trading activities

Question 9

What are the elements of the profit and loss account and what does it show?

Answer 9

Net profit: gross profit minus overhead expenses
Profit after tax: operating profit minus interest costs and corporation tax
Overheads are costs or expenses of the business that are not directly related to the number of items made or sold - rent, management salaries, depreciation
Limited companies pay corporation tax before they pay dividends or keep profits

Question 10

What are the elements of the appropriation account and what does it show?

Answer 10

Dividends: the share of the profits paid to shareholders as a return for investing in the company
Retained profits: the profit left after all deductions, including dividends, have been made. This is ploughed back into the compant as a source of finance

Question 11

Definition of low quality profit

Answer 11

one off profit that cannot easily be repeated or sustained

Question 12

Definition of high quality profit

Answer 12

Profit that can be repeated and sustained

Question 13

Define balance sheet (statement of financial position)

Answer 13

An accounting statement that records the values of a business’ assets, liabilities and shareholders’ equity at one point in time

Question 14

Define asset

Answer 14

An item of monetary value that is owned by a business

Question 15

Define liability

Answer 15

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

Question 16

Define shareholders’ equity

Answer 16

total value of assets - total value of liabilities
Comes from 2 main sources: share capital and retained earnings
All net wealth belongs to the shareholders

Question 17

Define share capital

Answer 17

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

Question 18

Define non-current assets

Answer 18

Assets to be kept and used by the business for more than one year. Used to be referred as fixed assets
Examples: land, machinery (tangible), patents, trademark, copyrights and goodwill: arises when a business is valued at or sold for more than the balance sheet value of its assets (intangible)

Question 19

Define current assets

Answer 19

Assets that are likely to be turned into cash before the next balance-sheet date
E.g. accounts receivables, cash, inventory

Question 20

Define inventories

Answer 20

Stocks held by the business in the form of materials, work in progress and finished goods

Question 21

Define accounts receivables (debtors)

Answer 21

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

Question 22

Define accounts payable (creditors)

Answer 22

Value of debts for goods bought on credit payable to suppliers

Question 23

Define current liabilities

Answer 23

debts of the business that will usually have to be paid within a year
accounts payable, bank overdraft, unpaid dividends

Question 24

Define non-current liabilities

Answer 24

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

Question 25

Define working capital

Answer 25

net current assets

current assets - current liabilities

Question 26

What are the 2 main types of ratios and define them?

Answer 26

Profitability ratios: include the gross profit margin and net profit margin which compares the profits of the business with sales revenue (AS Level) and ROCE which compares net profit with capital employed (A Level)
Liquidity ratios include current/liquid ratio and acid test ratio. Measure of how easily a business could meet its current liabilities

Question 27

What does current/liquidity ratio show?

Answer 27

At what rate (how many times) can the business afford to pay current liabilities out of its current assets.

Question 28

What does acid test ratio show?

Answer 28

At what rate (how many times) can the business afford to pay current liabilities out of its current assets minus stock since it is the least liquid assets

Question 29

Methods to increase liquidity

Answer 29

Sell off fixed assets. If business still needs it => lease it but leasing charges will add to overheads
Sell off inventories => alter consumer’s perceptions of brand as they are cheaper, inventories might be needed to meet changing customer demand levels
Loans => increase interests cost

Question 30

What does gross profit margin show?

Answer 30

Shows how much gross profit a business makes for $1 of sales. Shows performance of the business. Shows managing ability of consistently controlling the business’s production costs and the margin between what to buy and sell.

Question 31

What does net profit margin show?

Answer 31

Shows how much net profit a business makes for $1 of sales. Shows performance of the business. Shows management ability and control of expenses/ overheads.

Question 32

Method to increase profit margins

Answer 32

Reducing direct costs. e.g. cheaper materials, cut wage, increase productivity to cut labour costs => quality may be damaged, motivation might fall
Increase price => total profit could fall if consumers switch to competitors, reputation
Reducing overheads costs. e.g. delayering the organisation, reducing promotion => fall in slaes, fewer workers => adverse effects on productivity

Question 33

Limitations of ratio analysis

Answer 33

Give incomplete analysis of a company’s financial position
One ratio result on its own is gives limited info, needs to be compared with results from previous years or other businesses
Can only measure quantitative performance not qualitative
Can identify potential business problem but cannot analyse the cause of it or suggest potential solutions

Question 34

What are the uses of the income statement?

Answer 34

• 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 info to help decide whether to lend money to the business
• Prospective investors may assess the value of putting money into a business from the level of profits being made
• Detailed income statement is usually produced for internal use. Produced frequently
• A less detailed summary will appear in the published accounts of companies for external users. Produced once a year

Question 35

What do external users want to know?

Answer 35

• Suppliers: Want to know whether the business generates enough to pay for the supplies.
• Customers: Want to make sure of they are not being charged too much (If their profits are too high).
• Tax collectors: In order to calculate the business’s tax on profits that is needed to be collected.
• Lenders: Want to know that the business is able to pay interests and repay any loans

Question 36

What do internal users want to know?

Answer 36

• Owners/Shareholders: They want to know that their investment is being used properly.
• Managers: Want to check the profitability of the business, whether they are doing a good job.
• Employees: Want to know the job security; whether the business is financially stable and can pay wages.

Question 37

Define window dressing

Answer 37

presenting the company accounts in a favourable light - to flatter the business performance

Question 38

Limitations of published accounts

Answer 38

historical
may not reflect the future
may be out of date
does not reflect qualitative aspects of a business
possibility of ‘window dressing’
may not have details of the performance of individual parts of a business