Topic 2: Financial Statements (Balance Sheets) Flashcards
What is the Accounting Equation?
Assets - Liabilities = Equity
What is the definition of an Asset?
Something that is owned and used by the business
Examples: Stock, Buildings, Debtors (Accounts receivable)
What is the definition of a Liability?
A debt that the business owes to external parties
Examples: Loans, Mortgage and Creditors (Accounts Payable)
What is the definition of Equity?
Owners financial interest in the business.
* Owner’s worth at the start of the accounting period is called Capital.
What are the only two things owners do in relation to business transactions during the year?
- Take money/stock out of the business (Drawings)
2. Inject money/stock into the business (Additional Capital)
Why is profit recorded under the statement of Changes in Equity?
Profit goes to the owner/s of the business
What are Current Assets?
Assets that the business owns and uses that can be turned into cash within a 12 month period.
What are Non-Current Assets?
Assets that the business owns and uses, and plan to retain for a period of longer than 12 months.
What are Current Liabilities?
Debts the business expects to pay back within 12 months.
What are Non-Current Liabilities?
Debts that the business will not be able to pay off in the current accounting period and will have for longer than 12 months.
What is the definition of the Return on Equity Ratio and what does the ‘*’ represent?
Measures the rate of return that is made from the owner’s investment in the business. (expressed as %)
‘*’ - Average Owners Equity (Opening Value + Closing Value)/2
What is the acceptable range for the Return on Equity Ratio?
The higher the result the better.
*Needs to be compared to past performances and the industry average.
What is the definition of the Working Capital Ratio?
Measures the business ability to repay its short-term debts within 12 months.
* Result : 1 (2 dp)
What is the acceptable range for the Working Capital Ratio? What happens below and above the acceptable range?
Between 1 - 2
Below 1: business does not have enough assets to cover debts within 12 months. (Bad)
Above 2: business can easily cover its debts, too much idle cash
What is the definition of the Quick Ratio?
Measures the business ability to repay its immediate term debts within 90 days.
*Result : 1 (2 dp)
What is liquidity?
The business ability to repay debts and have money to operate the business on a day to day basis.
- Working Capital and Quick Ratios measure liquidity.
- If Industry Average is given, then WCR & QR should aim to reach the industry average result.
What is the recording procedure for doubtful debts and accumulated depreciation values in a Balance Sheet?
First column is used
- Doubtful Debts MUST be directly beneath Debtors
- Accumulated Depreciation values MUST be directly beneath item
What are the three ways assets can be valued in?
- Historical Cost**
- Replacement Value
- Market Value
What is the historical cost?
The original/actual price a firm pays for an asset plus any additional costs for installations and modifications.
- Repairs is not included.
- Objective Value - backed by proof
- Only used in NON-CURRENT Assets
What is the replacement value?
Subjective Value
*Always gonna change
What is the Market Value?
Current price asset will fetch in the market place.
*Subjective Value (estimated)
Why do accountants prefer to use Historical Cost when recording assets in Balance sheets?
- Backed by clear and verifiable evidence (receipt/invoice)
- Does not change with time
- Easier and Faster to use (no time spend on estimations)
What is vertical Analysis?
Analysing items from the same statement from ONE particular year
What is Horizontal Analysis?
Comparing and Analysing reports over TWO years.
What is trend Analysis?
Comparing and Analysing reports over at least THREE years.
What is the definition of the Prudence Assumption?
Prudence is using care and caution in the valuation of assets and the measuring of profit.
Example: Allowance Doubtful Debts
What are some advantages of the Prudence Assumption?
- More cautious value of assets
- Allows for more conservative decision making
What are the disadvantages of the Prudence Assumption?
- Based on subjective values (estimations)
- Time consuming with research and calculations in statements
- Being too cautious can affect decision making
Why is Accumulated Depreciation not an example of Prudence?
Deprecation of an asset is necessary as the asset is used and the value of the asset must to be reduced.
What is the definition of Duality?
Duality is every transaction has a two-sided effect on the accounting equation to maintain the balance of the accounting equation. (A - L = E)
Why is analysis and interpretation of financial information important?
To help form trends and patterns, which helps us make better decisions.
Define a Balance Sheet:
A general Purpose report that summarises the financial position of a firm on a particular day.
