Chapter 2 - Financial Accounting Flashcards
Useful information derived from financial accounts
- Debtors terms
- What kind of profit is being made
- Allows for comparison between firms
Role of accountants
- meet statutory reporting requirements
- ensure adequate money is available to continue operation
- contribute to the decision-making process of management
Going-concern principle
assume that the economic system is ongoing, i.e. the firm is not about to close. For example they assume that remaining inventory is of value to be used later
matching principle
— match transactions in the same period of time, e.g. matching sales with the costs of manufacturing the goods sold
— Accountants try to maintain consistency within and between accounting periods of time
Objectivity principle
require supporting evidence (usually written such as receipts for wages, invoices for material, bank statements, physical validation of inventory etc.) called source documents for their initial entries
cost principle
add costs when they occur. For example they value work-in-progress or finished goods are at cost.
revenue recognition principle
They exclude any profit until the sale takes place; recognizing revenue when sales are transacted. The accountant takes profit when sales are made (all previous transactions are made on a cost basis).
Income
— Revenue
— extraordinary gains
Expenses
— ordinary disembersements
— extraordinary disembersements
Assets
controlled resources from which future econome benefits are expected to flow
Liabilities
A measure of obligations from which future econome benefits are expected to leave the system
Equity
Obligations the firm has to shareholders
Accounting depreciation
— The reduction in the value of an asset over time
— generally accepted to depreciate over the lifetime of the asset
What causes an asset to depreciate?
- Wear and tear. As an asset is used moving parts wear. In addition weathering leads to rust and rot.
- Higher running costs. With age, efficiency drops and output may reduce; and labour and other costs may rise.
- Higher maintenance cost.
With usage more parts become defective and maintenance costs
nIse. - Obsolescence of the asset. Technological advances lead to new machines, which produce better goods, are cheaper to operate, or cost less to maintain. This makes existing machinery inadequate.
- Obsolescence of products. Changes in demand may lead to a drop in or elimination of the line produced by a particular asset
Straight line depreciation
Equal instalments written off each year
Diminishing balance depreciation
Fixed % of book value written off each year
—> postpones taxation
Income tax depreciation method
Subject to negotiation with tax authorities
—> done to stimulate investment in capital
First In First Out (FIFO)
• Charges production at the price of the oldest inventory on hand
• inventory (stock) is closest to market value
• values inventory in the statement of financial position closest to the current prices
Last In First Out (LIFO)
• Charges production at the price of most recent purchases
• inventory is a historic value
• income statement is closer to current prices (gives a closer income statement cost of materials)
Financial ratios need to be compared to be considered useful. What are the different types of comparison?
- those of the firm’s preceding years
- results with those of the firm’s competitors or similar firms
- results with the average available results of all firms operating in the same industry
- results of firms generally
- budgeted or standard ratios which have been developed by a firm and set out in its
objectives - rule-of-thumb standards which businessmen adopt
Current ratio
Current assets divided by Current liabilities
—> tests ability to meet current obligations to current assets
Acid test
=(current assets - inventory and payments in advance)/current liabilities
—> tests ability to meet sudden demands of the firm
Age of debtors
=(net debtors/net credit sales per year) x 365
—> indicates the number of days taken to collect debtors
Inventory turnover
=cost of materials sold/average inventory
—> indicates the number of times inventory was sold over the year
Working capital turnover
=Net Sales/Average Working Capital
—>indicates the effectiveness of working capital in generating sales
Payout ratio
=(Net income after tax - preference dividend)/Ordinary dividend
—> how much profit the firm makes to how much it passes onto it’s shareholders
Times interest earned
=(net income before tax + interest paid)/interest paid
—> extent which income covers interest obligations
Price per earnings
=Market Price of a Share/Earnings per Share
—> the price the market pays for a share vs the value of the share
Earnings yield
=100/Price per earnings
Dividend yield
=(Dividend per share/Market price per share) x 100
Return on sales
= (Income after tax + interest)/Sales
Income to assets
= (Income after tax + interest)/Average total assets
Income to shareholders interest
= income after tax /Average shareholders’ fund
