Intro to accounting sem1 Flashcards
Accounting definition
identifying, measuring and communicating economic info to allow informed decisions by the info users.
Investors needs
Timing mismatch between investments (cash outflows) and returns (cash inflows); SOPL fixes this
Investors needed reporting that focused on the commercial substance of transactions rather than cash flows;
Created the need for a Statement of Profit and Loss bringing revenues and expenses together to give meaningful values for profit compare potential investment
Need for accounting standards:
Accountability- consistent definitions means management cannot defraud owners (regular reports rules empowered by legal force)
Investors need to compare firm performance- ensures running of the economy as allocation of resources rely heavily on credible info
Need for cost-effective financial reporting (efficiency) since preparers and auditors only need to learn one set of rules
Features of U.S GAAP
U.S standard
FASB branch of the us sec
Rules based
25,000 pages
Features of IFRS
IAS(International accounting standard) not for profit board in London financed by firms
EU initiative now international
144 out of 167 judiciaries across Asia, Africa and Eu require use of the IFRS
Principles based
2000 pages
IFRS Standards are developed in the context of a framework which sets out
Objectives of financial reporting and principal user groups;
Key financial statements;
Qualitative characteristics of useful information;
Fundamental concepts, principles and conventions.
User groups
Investors, current and potential
Fixed income (bond) investors
Commercial banks
Suppliers
Three primary financial reports
Statement of financial position
Statement of profit and loss
Statement of cashflow
Features of the statement of financial position
Oldest statement
At a moment in time
Assets=liabilities +equity
What the firm has? (left side)
Non-current assets
Investments
Current assets
Where did the money come from? (right side)
Current liabilities
Noncurrent liabilities
Equity and reserves
Features of the Statement of Profit and loss
Based on commercial substance rather than cashflows
For a stated period of time- an accounting period
Revenue
Expenses
Profit
Statement of cashflow features
Cashflows into and out of the business
For an accounting period
Cashflows from operating activities
Cashflows form investing activities
Cashflows from financing activities
Entity concept
bus money and owner money are separate
Going concern assumption-
investors should be safe for the foreseeable future
Historical cost convention
assets, liabilities, and equity to be recorded at their original purchase cost, rather than their current market value or any adjusted value
Accrued Income
Money owed from customers (no invoice)
Trade Receivable
Money owed from customers (invoiced)
Why is accounting needed
accountability
Investment
Benefits of international accounting standards
Investment diversification
MNCS facilitates the process for preparing financial reports for subsidiaries
Maintenance of accounting standards- due to constant evolution and financial innovation maintenance requires expensive specialists skills it is more efficient for adaptation to be carried out by a single international body
Accrual principle
Revenue and expenses are recognized as they are earned and incurred irrespective of when they change hands
Principle of prudence
Revenue should only be recognized when there is reasonable certainty it will be received assets should not be overstated and expenses and liabilities should not be understated
Financial accounting
Backward looking
Key users are outside the firm
Reports are highly standardised and regulated
Published according to regular schedule
Management accounting
Forward looking
Key users inside the firm
Free-form report and unregulated
Ad hoc, real time or published when required
Internal audit
Controls and procedures for recordkeeping and to protect and safeguard assets
Deter, prevent and detect fraud
Give reasonable assurance
Ensures financial reports are accurate and inline with regulation
Role of the external audit
Provides an opinion further assurance that financial reports are all inline
review work of the internal audit
report any major problems
Accounting equation
Assets=liabilities + equity
Assets
What the firm has
Liabilities and equity
Where the money comes from
Asset recognition requirements
Controlled by the firm (in many cases ownership but not necessarily)
Measurable value or cost those that cant be quantified can not be included
The entity concept
A business is a separate legal person from it’s owners they are treated as two separate parties
Business transactions for the firm/ assets/liabilities are separate to the owner
Financial statements represent firm affairs of the firm
Importance of the entity concept
Expenses- owner could use private expenses as firm expenses reducing profit and tax liability
To protect creditors- due to disposal proceeds going to the firm and withdrawals have to be treated as a loan or reduction in equity as this needs to be subject to legal restrictions
Double entry
Every transaction affects at least two accounts so the same amount must be recorded at least twice
The going concern principle
assume that the business will operate for the foreseeable future .
What the statement of profit and loss shows
Snapshot of cumulative assets, liabilities and equities of a company
Summary of a company’s revenue and costs over a period
Not directly linked to cashflows
Statement of profit and loss
financial report showing the revenue and other income that a firm has earned as well as expenses incurred during an accounting period.
Why can’t we use cashflows as a reliable indicator of profit?
The timing mismatch between payments from sales and the related costs make it impossible to use as a meaningful indicator of profit
IFRS revenue recognition requirements
Based on satisfying contractual obligations
The rights to all economic benefits from a product or service and risks have been transferred to the buyer
The amount of revenue and associated costs can be measured reliable
For goods the transfer usually requires delivery.
Payment means for goods and services
Cash on delivery- paid at the time goods and services are consumed/received
Paid in arrears- goods and services consumed delivered and paid later effects on statement- invoice at time of delivery revenue in SPL and trade receivables
Paid in advance- goods/services ordered and paid in advance
Types of cost
Product costs
All the costs expended on a good or service that are needed to generate revenue
For goods this comprises of: direct costs(labour and raw materials) and manufacturing overheads
Period costs
Not easily linked to direct production processes therefore difficult to match to revenue
Corporate overheads(rental costs of head office) and manufacturing overheads
How are credit losses accounted as
Impairment allowance (reduce gross trade receivables)
Impairment charge (expenses in spl)
How are un-invoiced credit sales accounted as
supplier- Estimated amount recorded as accrued income revenue on SPL and accrued income as current asset SFP
Customer- estimated record as accrued expense on SPL accrued expense SFP
How is prepayments accounted
Supplier- unearned income (Current liability on SFP) cash increase on SFP
Customer- prepaid expense current asset on SFP
Cash reduction on SFP
Value of PPE
Value given at original cost if PPE used in trading activities
Original cost depends on how firm acquired the asset: historic purchase cost or construction cost
If assets are acquired through mergers or takeovers they are recorded at appraised value
How is PPE treated
Is a cost
Annual depreciation charge recognised as operating expense to reduce revenue in SoPL
Depreciation (accumulated depreciation) reduces gross value of PPE to show net asset value in SoFP
Assets held at fair value and right of use assets
Property can be held for trading or investment purposes
Investment properties will be reported at the current appraised value with gains or losses taken through financial statements
Right of use (leased) assets
Lessee owns leased asset thus should be recognised as an asset in the statement of financial position
Substance of lease agreement is as a collateralised loan therefore a matching liability is created
Intangible assets
No physical form but whose value is measurable, but the firm can be expected to gain future economic benefit
If developed internally can not be measure as an asset as costs can not be measure easily
Goodwill
Internally generated goodwill can not be recognised as an asset
If the goodwill is acquired from business combination it represents the difference between the price paid by the acquirer- net assets of the target
Issues with LIFO
Does not reflect business practices since
part of firm’s inventory is never sold
Understated inventory and book values
Investment comparison harder
Incentivises bad inventory management since it incentivises larger stock to keep a Lifo buffer
Mo Kudus
Why use LIFO
FIFO and AVCO are both permitted under IFRS and US GAAP
LIFO permitted in the US but prohibited under IFRS
Most US oil firms chose LIFO
Lower profits to pay tax on
Unrealized gains
An increase in the value of an asset that has not been sold
Why a business may sell stock for less than it costs
Physical impairment
Fall in value
Net realisable value
Value of an asset that sellers expect to get minus cost or expenses on selling or disposing of an asset
Statement of cashflow
Shows net cash flow form operating, financing and investment activities
Not based on accrual principle
Harder to manipulate
Statement of cashflow benefits
Helps to assess liquidity and solvency
Assesses financial adaptability
Future cash flows
Highlights how cash is being generated
Drawbacks of statement of cashflow
Historic cashflows no info on future
No interpretation of SOCF is provided within the accounts
Noncash transactions i.e. depreciation are not highlighted in SOCF
What’s cash under IAS 7
Cash
Cash equivalents- highly liquid, insignificant value change and held with purpose of meeting (not investment purposes)
Short-term borrowing from bank
Structure of statement of cash flows
Cash flow from operating activities
Cash flow from investing activities
Cash flow from financing activities
Indirect method of cash flow
Start with PBIT
minus investment income
Minus interest paid
Add back
non cash charges(depreciation)
Adjust for changes to non-cash working capital
The direct method
Cash inflows from customers and outflows to suppliers, employees and tax authorities
Benefits of direct method
allows analysts to work out how much reported revenue and costs has been paid in cash
Rationale for indirect method
Cashflow will be equal to operating profits less tax if:
All revenue and expenses are paid for in cash when earned or incurred
All inventory is sold in the period when its produced
It has no current assets investment income or disposable gains/ losses
Advantage of indirect method
Shows the relationship between cash flows that have been generated directly from trading activities and those that have come from changes in non cash working capital
Why is indirect method used most
inertia/costs of switching
Commercial sensitivity- allows competition to see what they receive form customers and pay to suppliers
Avoid investment scrutiny
Features of Revenue disclosure
Not standardised analysts have to work with what firm discloses
Some firms provide multiple disclosures
Can be challenging to compare firms directly
Why firms in the same industry have different operating margin
Different operating efficiency
Econs of scale
Overhead rate
Overhead rate the percentage of revenue that goes on paying for the costs of running the business
Cost income ratio
the percentage of gross profits that go on running the business
Operating cost ratio dependents
Econs of scale
Different business models i.e. innovation, automation, location etc
Economic conditions
Working capital
Current asset-current liability= working capital
Operating asset
reflects the assets a company uses in its core business to generate revenue
Asset turnover
Measures how good companies operating assets are at generating revenue
Factors that may affect asset turnover:
Marketing and sales
Utilisation of PPE
Inventory management
ROCE
Key measure for comparing performance between firm’s
ROCE can be used to evaluate a company’s profitability and efficiency in using capital
As cap employed is equal to operating assets, ROCE also shows profitability of operating assets.
Tensions between components of ROCE
Actions to increase profit margin may have a negative impact on sales turnover
Low margin high turnover
High margin low turnover
What does return on equity show
Annual accounting return to the owners of the firm
How does gearing affect ROE
Higher gearing larger ROE but at the cost of a higher break even point
Day sales outstanding
Shows how many days on average it takes the firms customers to pay them only meaningful when most sales are on credit
High days purchasing analysis
Large credit risk
How to approach days sales/purchasing outstanding
Planned or unplanned
likely reasons
Impact on firm
What a current ratio shows
whether working capital operations require financing (above one) or is a source of financing
True view
Financial statements are factually correct
Prepared in accordance with financial standards
No errors/omissions
fair view
No bias portrays economic reality
Limitations of financial reporting
Backwards looking- statements are for past accounting periods
Asset values reflect forward looking assumptions i.e. trade receivables
Partial- some items not shown in financial statements i.e. employees
Subjective so is prone to manipulations/ fraud
Objective values
one value regardless of who does the counting
subjective values
value can be determined in several ways
How current assets are subjective
trade receivables, accrued income depend on “satisfying contractual obligations
impairment allowances
Inventory (FIFO or AVCO), method of overhead allocation and imapirments
Pre-paid expenses- supplier ability to deliver
Noncurrent asset subjectivity PP&E
Historic vs fair value
Initial recognition- purchase cost, construction cost and appraised value
Choice of depreciation value- residual value, useful economic life and or depreciation rate
How are Intangible assets subjective
Accounting treatment (in house/purchased)
Intellectual property
Software
Goodwill
Subjectivity and liabilities
Most liabilities represent contractual obligations
Unearned income- dependent on revenue recognition rules
Non-current liabilities- fair value, historic cost
Subjectivity implications for profit
Revenue driven by revenue recognition rules with management judgement of when performance have been discharged
Expenses driven by asset costs- inventory, PP&E, depreciation and impairments
Fraud triangle model
Incentives- greed
Opportunity- subjectivity, bad internal controls or lack of owner participation
Attitudes or rationalization- corporate culture, fear or compensates for low salary
Common reporting goals
Higher profits, cashflows from operating activities and higher book values by:
Bring forward revenue recognition
Push back expense recognition
Proactive management of non-cash working capital.
How can management improve end of year results?
Operational methods- Accelerating revenue recognition, early delivery of goods that have already been ordered, reduce unnecessary spending and gains from non-recurring disposals (selling securities at historic cost for a profit while holding on to the ones showing a loss)
Window dressing
Accounting fraud:
Management and insiders
Misrepresentation
Overstating earnings
Going concern assumption
Revenue recognition fraud
Delaying closing books
Bring forward revenues not yet earned
Booking revenues from fictitious sales
Selling of goods to a third party with buy back agreement
Booking loans received as revenue
Bundling one-off gains into items reported as recurring income
Failing to recognise receivable impairments
PP&E and intangibles fraud
Accounting estimates and impairments inflated
Selling toxic assets with repurchase agreements
Inventory fraud
Falsifying stock, ignoring obsolescence/ impairment
Expenses fraud
Treating expenses as prepayments
Capitalising expenses
Bundling recurring expenses into one off charges
Role of the board of directors
Strategic direction
Responsibilities
Safeguarding assets
Record keeping
Accounting policies and estimates
Report presentation
Going concern assumption
EU law true and fair view
Financial statements sign off
Audit committee
Independent of the main board
Non-executive independent directors
Oversees audit and compliance functions
Audit tenders
Recommend appointment/ reappointment of the external auditor
Appointments approved by share holders
Auditors responsible to shareholders
External auditor’s roles
Review firms financial systems, risk management and internal controls
Obtain info to form an opinion and review
Why we need auditors
Conflict of interests- check statements are true and fair
Consequences of errors- users of statements wish to know whether info is reliable and safe to work on
Practicality and remoteness
An audit will be deemed to have failed if:
Financial statements have material misstatements
They fail to comply with regulation
The auditor signed of the directors going concern assumption without qualification
Why audits fail
self interest
Familiarity threat
which statements are based on the accrual principle (values are the full amount regardless of when they come out)
Statement of cashflow is what has actually been paid
Income statement is the total regardless of when paid except advance sales where its what has been delivered
How to calculate unrealised gains
replacement cost-actual value
5How to calculate realised gains
profit at replacement-inventory valuation
