Chapter 29 Accounting Fundamentals

Question 1

why keep accounting records?

Answer 1

All businesses have to keep detailed records of purchases, sales and other financial transactions. Accounts are financial records of business transactions, which are needed to provide essential information to groups both within and outside the organisation.

Question 2

What are the internal uses of accounting information?

Answer 2

1 Business managers

Question 3

What are the external uses of accounting information?

Answer 3

1 Banks
2 Creditors, such as suppliers 
3 Customers
4 Government and tax authorities
5 Investors, such as shareholders in the company
6 Workforce
7 Local community

Question 4

Internal Uses of accounting information:Explain how Business managers use this information

Answer 4

1 To measure the performance of the business to compare against targets, previous time records and competitors
2 To help them take decisions, such as new investments, closing branches and launching new products
3 To control and monitor the operation of each department and division of the business
4 To set targets or budgets for the future and review these against actual performance

Question 5

External Uses of accounting information: Explain how Banks use this information

Answer 5

1 To decide whether to lend money to the business
2 To assess whether to allow an increase in overdraft facilities
3 To decide whether to continue an overdraft facility or a loan

Question 6

External Uses of accounting information: Explain how Creditors use this information

Answer 6

1 To see if the business is secure and liquid enough to pay off its debts
2 To assess whether the business is a good credit risk
3 To decide whether to press for early repayment of outstanding debts

Question 7

External Uses of accounting information: Explain how Customers use this information

Answer 7

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

Question 8

External Uses of accounting information: Explain how Government and tax authorities use this information

Answer 8

1 To calculate how much tax is due from the business
2 To determine whether the business is likely to expand and create more jobs and be of increasing importance to the country’s economy
3 To assess whether the business is in danger of closing down, creating economic problems
4 To confirm that the business is staying within the law in terms of accounting regulations

Question 9

External Uses of accounting information: Explain how Investors, such as shareholders in the company use this information

Answer 9

1 To assess the value of the business and their investment in it
2 To establish whether the business is becoming more or less profitable
3 To determine what share of the profits investors are receiving
4 To decide whether the business has potential for growth
5 If they are potential investors, to compare details with those from other businesses before making a decision to buy shares in a company
6 If they are actual investors, to decide whether to consider selling all or part of their holding

Question 10

External Uses of accounting information: Explain how Workforce use this information

Answer 10

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

Question 11

External Uses of accounting information: Explain how Local community use this information

Answer 11

1 To see if the business is profitable and likely to expand, which could be good for the local economy
2 To determine whether the business is making losses and whether this could lead to closure

Question 12

What are Limitations of published accounts?

Answer 12

1 Details of the sales and profitability of each good or service produced by the company and of each department or division
2 The research and development plans of the business and proposed new products
3 The precise future plans for expansion or rationalization of the business
4 Evidence of the company’s impact on the environment and local community – although this social and environmental audit is sometimes included voluntarily by companies
5 Future budgets or financial plans

Question 13

What is window dressing?

Answer 13

Window dressing is presenting the company accounts in a favourable light – to flatter the business performance

Question 14

What are the most common ways of window dressing?

Answer 14

1 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 then be leased or rented back by the business
2 reducing the amount of depreciation of fixed assets, such as machines or vehicles, in order to increase declared profit and increase asset values
3 ignoring the fact that some customers (debtors_ who have not paid for goods delivered may, in fact, never pay – they are ‘bad debts’
4 giving stock levels a higher value than they are probably worth
5 delaying paying bills or incurring expenses until after the accounts have been published

Question 15

What are the different final accounts?

Answer 15

1 The income statement
2 The balance sheet
3 Cash-flow statement

Question 16

What it shows in the Income statement?

Answer 16

The gross and net profit of the company. Details of how the net profit is split up (or appropriated) between dividends to shareholders and retained profits.

Question 17

What it shows in the Balance sheet?

Answer 17

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

Question 18

What it shows in the Cash-flow statement?

Answer 18

Where cash was received from and what it was spent on.

Question 19

What is in the trading account section of the Income statement?

Answer 19

This shows how gross profit (or loss) has been made from the treading activities of the business

Question 20

How to calculate gross profit?

Answer 20

Gross profit = Sales revenue – less cost of sales

Question 21

what is sales revenue and how to calculate it?

Answer 21

Sales revenue (or sales turnover) is the total value of sales made during the trading period

Sales revenue = Selling price x quantity sold

Question 22

What is cost of sales and how to calculate it?

Answer 22

Cost of sales (or cost of goods sold) is the direct cost of purchasing the goods that were sold during the financial year

Cost of sales = (opening stocks + purchases) – closing stocks

Question 23

What is in the profit and loss section of the Income statement?

Answer 23

This section of the income statement calculates both the net profit (or profit before interest and tax) and the profit after tax of the business.

Question 24

How to calculate net profit?

Answer 24

Net profit (operating profit) = Gross profit – overhead expenses

Question 25

How to calculate Profit after tax?

Answer 25

Profit after tax = Operating profit – (interest costs + corporation tax)

Question 26

What is in the Appropriation section of the Income statement?

Answer 26

This final section of the income statement (which is not always shown in published accounts) shows how the profits after tax of the business are distributed between the owners – in the form of dividends to company shareholders –and as retained profits.

1 Dividends are the share of the profits paid to shareholders as a return for investing in the company

2 Retained profit is the profit left after all deductions, including dividends, have been made. This is ‘ploughed back’ into the company as a source of finance

Question 27

What is found in the Balance sheet?

Answer 27

1 Balance sheet is an accounting statement that records the values of a business’s assets, liabilities and shareholders’ equity at one point of time
2 An asset is an item of monetary value that is owned by a business
3 A liability is a financial obligation of a business that is required to pay in the future
4 Shareholders’ equity = Total value of assets – total value of liabilities
5 Share capital is the total value of capital raised from shareholders by the issue of shares
6 Non-current assets are assets to be kept and used by the business for more than one year. Used to be referred to as ‘fixed assets’.
7 Intangible assets are items of value that do not have a physical presence, such as patents and trademarks
8 Current assets are assets that are likely to be turned into cash before the next balance-sheet date
9 Inventories are stocks held by a business in the form of materials, work in progress and finished goods.
10 Accounts receivables (debtors) are the value of payments to be received from customers who have brought goods on credit., Also known as ‘trade receivables’.
11 Current liabilities are debts of the business that will usually have to be paid within one year
12 Accounts payable (creditors) is the value of debts for goods bought on credit payable to suppliers. Also known as ‘trade payables’.
13 Non-current liabilities is the value of debts of the business that will be payable after more than one year

Question 28

What are profitability ratios?

Answer 28

These are used to assess how successful the management of a business has been at converting sales revenue into both gross profit and net profit.

Question 29

What is gross profit margin and how to calculate it?

Answer 29

The gross profit margin compares gross profit (profit before deduction of overheads) with sales turnover.

Gross profit margin (%) = Gross profit X 100
Sales revenue

Question 30

What is the net profit margin and how to calculate it?

Answer 30

The net profit margin compares net profit (profit after all costs have been accounted for but before interest and tax have been deducted) with sales turnover.

Net profit margin (%) = Net profit X 100
Sales revenue

Question 31

Method to increase profit margin?

Answer 31

1 Increase gross and net profit margin by reducing direct costs
2 Increase gross and net profit margin by increasing price
3 Increase gross and net profit margin by increasing price

Question 32

Increase gross and net profit margin by reducing direct costs, Examples?

Answer 32

1 Using cheaper materials, e.g. rubber not leather soles on shoes.
2 Cutting labour costs, e.g. relocating production to low-labour-cost countries.
3 Cutting labour costs by increasing productivity through automation in production.
4 Cutting wage costs by reducing workers’ pay

Question 33

Increase gross and net profit margin by reducing direct costs, Evaluation of method

Answer 33

1 Consumers’ perception of quality may be damaged and this could hit the product’s reputation. Consumers may expect lower prices, which may cut gross profit margin.
2 Quality may be at risk; communication problems with distant factories.
3 Purchasing machinery will increase overhead costs (gross profit could rise but net profit fall), remaining staff will need retraining – short-term profits may be cut due to these costs
4 Motivation levels might fall, which could reduce productivity and quality.

Question 34

Increase gross and net profit margin by increasing price, Examples

Answer 34

1 Raising the price of the product with no significant increase in variable costs.
2 Petrol companies increasing prices by more than the price of oil has risen

Question 35

Increase gross and net profit margin by increasing price, Evaluation of method

Answer 35

1 Total profit could fall if too many consumers switch to competitors – this links with price elasticity.
2 Consumers may consider this to be a ‘profiteering’ decision and the long-term image of the business may be damaged.

Question 36

Increase net profit margin by reducing overhead costs, Examples

Answer 36

Cutting overhead costs, such as rent, promotion costs or management costs but maintaining sales levels, e.g.:

1 moving to a cheaper head office location
2 reducing promotion costs
3 delaying the organisation

Question 37

Increase net profit margin by reducing overhead costs, Evaluation of method

Answer 37

1 Lower rental costs could mean moving to a cheaper area, which could damage image, e.g. for a restaurant.
2 Cutting promotional costs could lead to sales falling by more than fixed costs.
3 Fewer managers – or lower salaries – could reduce the efficient operation if the business.

Question 38

What are liquidity ratios?

Answer 38

These ratios assess the ability of the firm to pay its short-term debts. They are an important measure of the short-term debts. They are not concerned with profits, but with the working capital of the business. If there is too little working capital, then the business could become illiquid and be unable to settle short-term debts. If it has too much money tied in working capital., then this could be used more effectively and profitability by investing in other assets

Question 39

What is Liquidity?

Answer 39

Liquidity is the ability if a firm to pay its short-term debts

Question 40

What is the current ratio and how to calculate it?

Answer 40

The current ratio compares the current assets with the current liabilities of the business

Current ratio = Current assets
Current liabilities

Question 41

What is the acid test ratio and how to calculate it?

Answer 41

The acid-test ratio (also known as the quick ratio) compares the current assets minus inventories (stocks) with the current liabilities of the business

Acid-test ratio = Current assets – Inventories (stocks)
Current liabilities

Question 42

what are the Method to increase liquidity?

Answer 42

1 Sell off fixed assets for cash – could lease these back if still needed by the business
2 Sell off inventories for cash; this will improve the acid-test ratio, but not the current ratio
3 Increase loans to inject cash into the business and increase working capital

Question 43

Sell off fixed assets for cash – could lease these back if still needed by the business, examples

Answer 43

Land and property could be sold to a leasing company

Question 44

Sell off fixed assets for cash – could lease these back if still needed by the business, Evaluation of method

Answer 44

1 If assets are sold quickly, they might not raise their true value
2 If assets are still needed by the business, then leasing charges will add to overheads and reduce net profit margins

Question 45

Sell off inventories for cash; this will improve the acid-test ratio, but not the current ratio, examples

Answer 45

1 Stocks of finished goods could be sold off at a discount to raise cash.
2 JIT stock management will achieve this objective.

Question 46

Sell off inventories for cash; this will improve the acid-test ratio, but not the current ratio, Evaluation of method

Answer 46

1 This will reduce the gross profit margin if inventories are sold at a discount.
2 Consumers may doubt the image of the brand if inventories are sold off cheaply.
3 Inventories might be needed to meet changing customer demand levels – JIT might be difficult to adopt in some industries.

Question 47

Increase loans to inject cash into the business and increase working capital, examples

Answer 47

Long-term loans could be taken out if the bank is confident of the company’s prospects

Question 48

Increase loans to inject cash into the business and increase working capital, Evaluation of method

Answer 48

1 These will increase the gearing ratio

2 These will increase interest costs