Business Accounting - Study Guide

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Study GuideBUSINESS ACCOUNTING

Content

This module deals primarily with the study of the two main branches of business accountingwhich are financial accounting and management accounting. The first part of the coursecovers the basics of financial accounting. Topics included here are double entry book-keeping and the preparation of basic financial statements and financial analysis. The second

part of the course covers management accounting techniques for planning, control and

decision-making.

Module Aims

The aims of this module are to:

1. Introduce the accounting cycle and how accounting data impacts on businessdecisions.

2. Give an understanding to participants on the preparation and analysis of financialstatements.

3. Develop participants abilities to use accounting methods within specific enterprisesfor the purposes of managerial control and decision making.

Learning Outcomes

On completion of this module, a participant will typically be able to:

1. Show a detailed knowledge and understanding of:

i) The accounting equation and accounting rules.

ii) The classification of accounts.iii) Bookkeeping and the accounting cycle.iv) The relation between the principal financial statements.v) The interpretation of financial statements, the analysis of profitability, of solvency

and gearing.vi) Cost behavior and product costs under competing assumptions.vii) The construction and use of budgets inside enterprises.


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2. Demonstrate module specific skills with respect to:

i) Preparing a simple balance sheet from financial information.ii) Forecasting financial statements for simple cases and adjusting financial statements

for transactions.iii) Citing, explaining, selecting, and applying formats/models to solve numerical

problems in such areas as: analysis of financial statements; cost assignment andallocation; pricing and production decisions; and developing budgets.

3. Show cognitive skills with respect to:

i) Integrating and synthesizing between module topics to discuss coherent approaches tothe key issues faced in planning and controlling a business from the accounting

perspective.ii) Developing familiarity and confidence with accounting / financial arithmetic.iii) Applying accounting models in a real world context.

4. Demonstrate transferable skills in:

i) Information retrieval and numerical analysis.ii) Analytical reasoning.iii) Communication and presentation.iv) Accounting in context.v) Problem formulation and decision making.vi) Working with others.


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Delivery of Module and Lesson Plan

Session Topics Session Learning Outcomes

At the completion of this session,participants will be able to:

Prescribed

Text,

Readingsand/or

Activities

1. Introduction toAccounting

1. Explain the nature and role ofaccounting and finance.

2. Explain the role of accounting inplanning and controlling abusiness.

3. Distinguish between financial andmanagement accounting.

4. Explain the accounting equationand accounting rules.

McLaney andAtrill,Chapter1

2. Bookkeeping and theAccounting Cycle

1. Explain the major groups ofaccounts (invested capital, retainedearnings, revenue, expenses,owners withdrawal).

2. Complete the accounting cycle:journalize entries, post to generalledger, check accuracy by use of atrial balance, adjust accounts, and

close of accounts.3. Explain the nature and purpose ofthe three financial reports.

4. Discuss the accountingconventions underpinning the

balance sheet.5. Discuss the limitations of the

balance sheet in portrayingfinancial position.


3. Measuring andReporting Financial

Performance

1. Discuss the nature and purpose ofthe profit and loss account.

2. Prepare a profit and loss accountfrom relevant financial informationand interpret the results.

3. Discuss the main measurementissues that must be consideredwhen preparing the profit and lossaccount.

4. Explain the main accountingconventions underpinning the

McLaney andAtrill,Chapter

3


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profit and loss account.

4. Accounting forLimited Companies

1. Discuss the nature of a limitedcompany.

2. Explain the role of directors oflimited companies.

3. Describe the main features ofowners claim of limitedcompanies.

4. Draw up a set of financialstatements for a simple limitedcompany.

5. Explain how the income statementand balance sheet of a limitedcompany differ from that of sole

proprietorships and partnerships.


5. Reporting for

Limited Companies

1. Describe the responsibilities of

directors and auditors concerningthe annual financial statements

provided to shareholders andothers.

2. Outline the statutory regulationssurrounding accounting for limitedcompanies.

3. Outline the non-statutoryregulations surroundingaccounting for limited companies.

4. Prepare an income statement,

balance sheet and statement ofchanges in equity for a limitedcompany in accordance withInternational Financial ReportingStandards.

McLaney and

Atrill,Chapter5

6. Measuring andReporting CashFlows

1. Explain the role that cash plays inenterprise.

2. Explain the nature of the statementof cash flows and how it can helpin identifying cash flow problems.

3. Draw up a simple cash flow

statement.4. Interpret a statement of cash

flows.


7. Analysis of FinancialStatements

1. Establish the usefulness offinancial reports to various interestgroups.

2. Identify the major categories ofratios which may be used for

McLaney andAtrill,Chapter 7


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analysis.3. Calculate a range of accounting

ratios and explain theirsignificance and limitations.

4. Explain the importance of gearingto an enterprise and its owners.

8. Budgeting 1. Define a budget and show howbudgets, corporate objectives andlong-term plans are related.

2. Explain the interlinking of thevarious budgets within a business.

3. Indicate the uses of budgeting andconstruct various budgets,including the cash budget.

4. Discuss the criticisms that aremade of budgeting.

McLaney andAtrill, Chapter12

9. Accounting forControl

1. Discuss the role and limitations ofbudgets for performanceevaluation and control.

2. Undertake variance analysis anddiscuss possible reasons for thevariances calculated.

3. Discuss the issues that should betaken into account when designingan effective system of budgetarycontrol.

4. Explain the nature, role and

limitations of standard costing.


10. Full Costing andMarginal Costing

1. Deduce the full (absorption) costof a unit of output in a single

product environment.2. Deduce the full (absorption) cost

of a unit of output in a multi-product environment.

3. Discuss the problems of deducingfull (absorption) costs in practice.

4. Distinguish between full(absorption) and variable costing.

5. Discuss the usefulness of full(absorption) cost information(versus variable costing) tomanagers.


11. Cost-profit-volumeAnalysis

1. Bearing in mind the distinctionbetween fixed costs and variablecosts, explain the relationship

between costs, volume and profit.



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Fundamentals of Corporate Finance, Columbus, Ohio:McGraw-Hill Irwin.

Online Journals Use of online databases like EBSCO and references to:Financial Management, the Journal of Chartered Institute of

Management Accountants, Journal of Accounting,

Accountancy, Journal of the Institute of Chartered Accountantsin England and Wales, Accounting Review and Harvard

Business Review.

Assessment/Coursework

All assessments must comply with the SIM Rules and Regulations. To satisfy module

requirements, students must:

1) Satisfactorily complete and present on due dates their completed assignment. Apenalty of 20% of the total marks will be imposed for late submission. More than onecalendar will get zero marks.

2) Complete all assignments and the final examination in a satisfactory manner.3) Must reference all their work and observe SIMs policy on plagiarism. Students found

guilty of plagiarism will be dealt with severely.

4) Adopt either the Harvard or APA (American Psychological Association) ReferencingStyles.

5) Spend at least 100 hours (including class attendance and assignments) on the modulein order to fare reasonably.

Specific for this module are the following requirements:

Weighting between components A and B - A: 70% B: 30%

Element Description Element Type % of Assessment

Component A (Controlled

Conditions)Examination (180 minutes) Summative 70%

Component B (Assignments)1. Class test. Summative 15%

Session 7

2. Exercises/scenarios in financialaccounting.

Summative 15%Due: Session 10

Total 100%

ACKNOWLEDGEMENTS

The following notes (from session 1 to session 12) are abridged, adapted and customized from the textbookand its accompanying instructors manual: Eddie McLaney and Peter Atrill (2008), Accounting: AnIntroduction,NJ: Pearson Education.


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Session 1

Introduction to Accounting and Finance

At the end of the session, students should be able to:

1. Explain the nature and role of accounting and finance.2. Distinguish accounting users and characteristics of accounting information.3. Distinguish between financial and management accounting.4. Explain different business structures

_____________________________________________________________________

1.1 WHAT IS ACCOUNTING AND FINANCE?

Accounting is concerned with collecting, analyzing and communication financialinformation. The information is useful for businesses to make decisions and to plan.

The accounting information system has features that are common to all validinformation systems. These are:

a) identify and capturing relevant informationb) recording the information collectedc) analyze and interpret the information collectedd) report the information in a manner suitable for the targeted users

For every firm, there are those who are within the company and those who are outsidethe companies. Both will need accounting information for decision making.

Those who are in the company will need the accounting information to makedecisions on:a) developing new products or services

b) prices changes on their products or servicesc) financing planningd) expansion of business

Those who are outside of the company will need this information to decide whetherto:a) invest or disinvest in the company

b) lend money to the companyc) offer credit facilities to the company

d) enter into business contracts

Finance like accounting is also for decision making. It focuses on the way in whichfunds for a business are raised and invested. Businesses raise funds from investors(owners and lenders) and then use these funds to make investments (i.e. buyequipments, machines and inventories) to generate income or wealth for the investors.

Finance is concerned with:a) the forms of finance available


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b) the costs and benefits of each form of financec) the risks associated with each form of financed) the role the financial markets in supplying finance

1.2 ACCOUNTING USERS AND ACCOUNTING INFORMATION

The users of accounting information can be internal or external to the company. Thefollowing are possible users you can consider.

a) Ownersb) Managersc) Employeesd) Customerse) Suppliersf) Competitorsg) Government

Are you able to think of reasons why each of the above is keen to have the accounting

information?

Good accounting information must have some characteristics or key qualities to be ofvalue to the users. The 4 main key characteristics are:

a) Relevance means the ability to influence decision making. This implies theinformation must be available and sufficiently critical to change a decision e.g. toinvest or not to invest in a company. For information to be relevant, it has to betimely as well.

b) Reliability means that the information should be free from significant errors orbias. However, a reliable information may not be relevant for decision making anda relevant information may be unreliable

c) Comparability this is a quality that enables a user to identify changes in thebusiness over a time frame. Making accounting procedures used to measure andpresent information the same each year will allow easy comparison

d) Understandability Accounting reports should be expressed as clearly aspossible and should be understood by the users of the information.

While good information should have the above characteristics, it must also satisfy twoother criteria for information recording. The first is materiality whether omission or

misrepresentation of the information would lead to a change in decision making. Thesecond is the cost-benefit ratio this considers the benefit gained by the effort ingathering the data. If the cost is greater than the benefit, it is not reasonable to beaccurate with no benefit to the users.


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1.3 DIFFERENCE BETWEEN FINANCIAL ACCOUNTING ANDMANAGERIAL ACCOUNTING

Financial accounting seeks to meet the needs of all the users (both internal andexternal) already identified above and to assist them in their decision making.Managerial accounting is targeted at internal users such as the managers who will

need the information for business decision making.

The following summarized the differences:

Financial Accounting

Managerial

Accounting

1 Users External users Internal users

2 Time focus Historical perspective Future emphasis

3

Verifiability versus

relevance

Emphasis on

verifiability Emphasis on relevance

4Precision versus

timelinessEmphasis on precision Emphasis on timeliness

5 SubjectFocus on the whole

organizationFocus on segments of a

company

6 GAAP Must follow GAAP Need not follow GAAP

7 Requirements Mandatory Not Mandatory

1.4 Types of business ownership

The form of business ownership is important for accounting and it is useful to knowthe main forms of ownership that exists.

The three basic arrangements are:a) Sole proprietorship

b) Partnershipc) Limited company

Characteristics of a sole-proprietorship

Single owner

Limited capital requirements Small scale of operations Combined ownership and management Legal or professional restrictions (must operate as sole trader or partnership) Professional responsibility (in terms of unlimited liability) Minimal regulation and minimal external record keeping requirements Taxation advantages Unrestricted ability to sell


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Characteristics of a partnership Access to additional capital Complementary skills and services Flexible management Economies of scale Limited scale of operations

Legal or professional restrictions (must operate as sole trader or partnership) Professional responsibility (in terms of having unlimited liability) Tax sharing advantages Moderate regulation Minimal external record keeping requirements

Characteristics of Limited Company:

Access to significant capital (type and amount) Separation of ownership and management Continuity of operations Limited liability Possible taxation advantages

Unlimited level of activity

While one can memorized the above as characteristics for each of the business entity,it will be worth your learning process to view the information as advantages ordisadvantages for each business structure

Review QuestionsSource: Atrill , McLaney, Harvey, Jenner (2006): Accounting : An Introduction, NJ: Pearson

Education.

1) What is the purpose of producing accounting information?

2) Relevance and reliability are two key characteristics of accounting information. Explainwhat they mean and are they in conflict?

3) Distinguish between financial accounting and management accounting.

4) A sole proprietor converts to a limited liability company. What are the potentialadvantage to the owner and the potential disadvantage to the suppliers of the company?

5) Discuss the advantage and disadvantages of companies compared to other entitystructures.


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The Horizontal Format

Assets

Liabilities

Equity(Capital)

A = L + E

The Vertical Format

Assets

Total Assets

Liabilities

Equity (Capital)

Total Liabilities + Equity

Now let us focus on each category. It is important that you know the definition ofeach category because this will enable you to place items into their respective groupfor presentation.


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AssetsThese are essentially a resources held by the company.

To be an asset, the following characteristics should exist;a) A probable future economic benefit implies it is expected to generate some

future monetary value

b) Business has exclusive right or control over the benefit implies that while thebusiness may not fully own the asset, it can use it to generate future monetarybenefit for itself

c) Economic benefit must arise from past event or transaction implies that atransaction or event must have occurred to allow the business to enjoy the benefit.

d) It must be capable of being measured in monetary terms implies the possibilityof placing a value to it.

Note that assets can be either short term or long term. Accountants use one year (12months) as the general accepted time frame for classifying assets as either short term(we call them Current Assets) or long term (Non-Current Assets)

Current assets are basically assets that meet any of the following conditions:a) held for sale or consumption in the normal course of business operating cycle

b) expected to be sold within the next yearc) are held primarily for tradingd) are cash or near cash items such as marketable short term investments

Examples of current assets are cash, accounts receivables, inventory, prepayments etc.

Non-Current Assets (also called Fixed Assets) are those that do not meet theconditions of a current asset. Generally speaking, they are held for long termoperations.

Examples of non-current assets are machinery, building, property, vehicles, fixturesetc.

Most non-current assets have physical substance. This means that one can see andtouch the assets. However, some assets do not have physical substance and we termthem as Intangible Non-current assets. Examples of such assets are copyrights,goodwill, trademarks etc.

Liabilities and Equity (Capital)While the company has control of the assets (whether current or non-current), the

financing came from the liabilities and equity (capital). Liabilities and Equity(Capital) are sources of financing provided by parties outside the business entity.These are the Claims by outside parties on the company.

So a claimis an obligation on the part of the business to provide cash or some otherform of benefit to these outside parties.


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Equity or Capital are the claims by the business owners. Why? The business ownersare the ones who contributed either cash (most common) or personal assets into thecompany to start the business operations.

Besides the owners, the business also has claims by third parties other than thebusiness owners. We called them Liabilities. Liabilities must arise from past

transactions or events such as supplying goods or lending money to the business.Once a liability is settled, it will normally be through an outflow of assets (usuallycash)

Like assets, liabilities are also classified as short term (current liabilities) or long term(non-current liabilities).

Short term liabilities should meet any of the following criteria:a) they are expected to be settled within the normal course of the business operating

cycleb) they are due to be settled within 12 months following the date of the balance sheet

on which they appear

c) they are held primarily for trading purposesd) there is no right to defer settlement beyond 12 months following the date of the

balance sheet on which they appear

Non-current liabilities represent amounts due to third parties but doe not meet thedefinition of current liabilities.

Examples of current liabilities are account payables, unearned revenue (income), bankoverdraft.

Examples of non-current liabilities are long term loans, mortgage etc.

A sample of a balance sheet in horizontal format

Balance sheet as at 31 December 2009

$ $

Non-current assetsVehicles 30,000Premises 46,000Plant - cost 50,000Less acc. depreciation (8,000) 42,000

CapitalBalance at 31 December 2009 102,000

Current assetsInventories 23,000Trade receivables 21,000Cash at bank 11,000

Non-current liabilitiesBorrowings from CommercialLoan Company 45,000

Current liabilitiesTrade payables 26,000

173,000 173,000


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Note: One can also present the current asset above the non-current assets, theliabilities above the capital.

2.3 ACCOUNTING CONVENTIONS AND THE BALANCE SHEET

Accounting has a number of rules or conventions and we will focus on the following

few listed below.

Business Entity Convention this convention implies there is a legal separationbetween businesses and the owners. For limited companies, there is a clear legaldistinction between the owners (investors) and the company. However, for sole

proprietorship and partnerships, the law does not make any distinction.

Historical Cost Convention indicates that the value of assets shown on the balancesheet should be based on their acquisition cost (that is, historical costs).

Prudence Convention this convention holds that caution should be exercised whenmaking accounting judgments. Example: Income is considered earned only when they

actually occur and not when discussions are held. This convention allows reporting tobe fairly presented for users.

Going Concern Convention this convention indicates that the financial statementsshould be prepared on the assumption that the business will continue operations intothe foreseeable future, unless this is known to be untrue.

Dual Aspect Convention This convention asserts that every transaction will havetwo aspects and both will affect the balance sheet. Thus a purchase of a vehicle withcash payments will result in an increase in the non-current asset (a vehicle) but adecrease in the current asset (cash outflow). A settlement of a loan will result in adecrease in an asset (cash outflow) and a decrease in a liability (loan is settled andnow owe the third party less).

While accounting conventions exist, there will be circumstances where a firm maydeviate slightly in order to present the financial statements in a manner for theinvestors can understand the firm better.


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Review Questions

1) Discuss the main characteristics of assets? What do we mean by current in theclassification?

2) The balance sheet indicates that there are two types of claims on the assets of a firm.

What are the two types of claims and how are they different?

3) Discuss two accounting conventions discussed in this session.

4) Using a vertical format, prepare a balance sheet with the following information.

Inventory $208,000Property $350,000Accounts Receivables $135,000Accounts Payables $180,000Vehicles $110,000Bank Loan $200,000

Bank Overdraft $120,000Heavy Equipment $150,000


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Session 3

Measuring and Reporting Financial Performance


1. Explain the nature and purpose of the profit and loss statement2. Prepare a simple profit and loss statement3. Understand the recognition and measurement of income4. Understand main accounting convention for the income statement

_____________________________________________________________________

3.1 THE NATURE AND PURPOSE OF THE PROFIT AND LOSS STATEMENTOR THE INCOME STATEMENT

The purpose of the profit and loss statement is to measure and report how muchwealth (in terms of profit) the business has generated over a period. We term this

period as the accounting period and while is usually reported using a year, it can alsobe monthly, quarterly or semi-annually.

What is accounting profit? Profit is the difference between revenue and total expensesfor the accounting period under consideration.

In short, the income statement is made up of the following 3 major items.

RevenueLess ExpensesProfit or Loss

Revenue is the measure of the inflow of economic benefits arising from ordinaryactivities of the firm and Expenses are essentially the opposite of revenue. Theymeasure the economic outflow of benefits arising from ordinary business activities. Ifthe revenue is larger than expenses, the result is PROFIT which will increase thewealth of the owners and this amount will enhance (increase) the equity (capital) inthe balance sheet. If the revenue is lesser than expenses, it will result in a loss whichwill reduce the total value of the equity in the balance sheet.

Examples of revenues are sale of goods by a manufacturer, providing a service by alawyer, subscriptions collected by a club or earning interests from an investment or

bank deposit.

Expenses can be further detailed into several groups. The first groupis the Cost ofSales (sometimes referred to as Cost of Goods Sold). This will exist mainly formanufacturers or retailers. Then we have the Operating Expenseswhich are incurredto run the business. Examples of operating expenses are salary, rental, insurance,utilities, telephone and postage, printing and stationery. The following section showsthe appropriate presentation.


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3.2 PREPARING A PROFIT AND LOSS STATEMENT

The format of the statement takes the following form and it is important that youremember the format well.

Revenue (Sales)

Less Cost of Goods SoldGross Profit

Less Operating Expenses (e.g. salary, rental)Less Marketing Expenses (e.g. commission, advertisement)Less Administrative Expenses (e.g. postage, utility)Less Financial Expenses (e.g. interests expense)

Operating Profit (Net Profit before Tax)Add Other Income (e.g. interests earned)

Profit for the year

From the format above, gross profitis the net earnings from sales after deducting thecosts of the items sold. Profit for the year is the Operating income together with

other income through activities which are not the normal day to day operations.

For the sole proprietor or the partnership, the profit for the year is taxed at theirmarginal tax rate and thus taxes will not appear in the statement. The profits are thentheir residual earnings. This will increase the wealth of the owners. If the owners didnot do any withdrawals from the earnings (i.e. not distributed back to the owners), theearnings amount will increase the equity (capital) values in the balance sheet.

Cost of Sales(or cost of goods sold): If the cost of sales is not given, we can derivethe cost of sales from other information provided.

Illustration:On the 1stJan 2009, the company has $30,000 worth of inventory whichwas purchased the year before. They are acquired for the purpose of trading to make a

profit. During different months in 2009, the company purchased additional $75,000worth of inventory. During the year, the accountant recorded each sale as it occurred.Inventories were exchanged for the sales. At the end of the year, a stock-count wasconducted and the amount left in the warehouse is $29,000. What is the cost of goodssold? If the total revenue is $120,000, what is the gross profit?

Thought process: The company has $30,000 worth of inventory at the beginning andit bought $75,000 more. This means that the company has a total of $30,000 +$75,000 = $105,000 worth of stocks on hand to sell during the year.

Note that while the sales are recorded, the cost of the items sold were not. Firmsusually do a stock-take at year end (can also be monthly or quarterly) whichdetermines what is left in the warehouse. Those in the warehouse remains your assetsand those that are not are assumed SOLD.

Thus, the COGS is ($105,000 - $29,000) = $76,000.So theCOGS = Beginning Inventory + Purchases Ending Inventory(Note: Beg Inventory + Purchases = Amount Available for Sale)


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Presentation of a Profit and Loss Statement

Total Revenue (Sales) $120,000

Beg Inv $ 30,000Purchases $ 75,000

Less End Inv ($29,000)COGS $ 76,000Gross Profit $ 44,000

3.3 RECOGNITION AND MEASUREMENT OF PROFIT

In the profit and loss, the key issue is the measurement of profit and so it is importantto the point where revenueis considered earnedand when expensesare consideredincurred.

Recognizing RevenueThere are three points where associated revenue could be recognized:

a) at the time that the order is placed by the customerb) at the time the purchased item is collected by the customer (or services enjoyed by

the customer)c) at the time the customer pays for the purchased item or services.

While these points can be far apart, the main criteria for recognizing revenue are that:a) the amount of revenue can be measured reliably

b) it is probable that the economic benefits will be received.c) Ownership and control of the items is passed to the buyer

It is important to know that revenue is considered earned (realized) and must berecorded in the profit and loss statement when the above criteria are met. This meansthat even if cash is not paid yet, the revenue is earned as the items are collected by the

buyer or the services are already provided. An example is a Credit Sale which is acompleted sale but the client is allowed to pay at a later date.

Recognizing ExpensesThe matching convention in accounting provides guidance concerning therecognition of expenses. This convention states that the expenses should be matchedto the revenue that they help to generate.


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Example: A company incurred $50,000 of salesmen salary and commission inJanuary to generate sales. Based on the matching convention, the salary must bededucted as expenses against the revenue generated when computing the profitsearned. Note that we recognize the full amount as January expenses even if a portionof the salary or commissions are paid the following month.

The above example will result in the expenses recorded in the profit/loss statement ismore than the cash paid during the period. Accountants termed it as AccruedExpenses (Accrued payables). If the company pays $45,000 of the $50,000 inJanuary, it would have owed the remaining $5,000. The records will show a $50,000expense with a $45,000 outflow of cash payment and a $5,000 liability (accruedexpense) in the balance sheet.

Example:A company pays $12,000 for insurance premiums for the full year of 2009.This means that monthly insurance expense is $1,000.

Based on the transaction, the cash outflow is $12,000. But the company cannotrecognize the full $12,000 as January insurance expense immediately because it is for

the full year and not January only.

As the amount was paid in advance before the expenses are incurred, accountantstermed these types of transactions as Prepaid Expenses (prepayments). For January,we will record $1,000 as insurance expense, $11,000 as Prepaid Expenses (CurrentAsset) and an outflow of $12,000 cash payments.

3.4 ACCOUNTING CONVENTION FOR PROFIT/LOSS STATEMENT

There are several accounting convention required to calculate expenses that affect theperformance statements. These affect the non-current asset like machinery and thecurrent assets such as the inventory and the account receivables. We will considerthem now.

Depreciation ExpensesNon-current assets like machinery, vehicles etc will last a long period whilegenerating revenue for the firm. As they are used to generate the revenue, their valueswill decline due to usage, age, wear and tear. Accounting termed this decline invalues for the non-current assets as depreciation expenses.

Depreciation is defined as the rational allocation of cost over the period where theasset is used to generate revenue.

Calculating Depreciation ExpensesTo calculate a depreciation charge for a period, four factors are considered:

The cost (or fair value) of the asset includes the purchased price plus all costsincurred to make the asset ready for use. This includes delivery, installation,testing, legal costs etc.

The useful life of the asset A non-current asset has physical and economic life.Physical life will be exhausted through the effects of wear and tear but economiclife is decided by the effects of technology.


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The residual value of the asset this is the disposal value when the asset is nomore required. Past sale value of similar assets can be a guide to estimating theresidual value.

The depreciation method we will discuss two methods listed below.

Depreciation Methods: Straight Line Method and Reducing Balance Method.

The Straight Line methodallocates the cost of the asset equally over the time it isused to generate revenue. It is based on the following formula:

Depreciation Exp Per Year = (Cost of Asset Residual Value) / Useful life

The Reducing Balance method uses a fixed percentage to calculate the yearlydepreciation expense based on the reduced asset value at the beginning of each year.

Example: An asset costs $40,000 and is expected to have a useful life of 4 year. Theestimated residual value is $1,024. A fixed percentage of 60% is used for the reducing

balance method. Calculate the depreciation expense per year under both methods.

Using Straight Line, the depreciation expense per year will be($40,000 -$1,024) / 5 = $9,744 per year

So, the depreciation expense from years 2 to 4 will also be $9,744 per year.

Using Reducing Balance method To use this method, one must determine the NetBook Value (NBV) of the asset at the beginning of each accounting period. Thedepreciation expense for each year is calculated by using the (NBV x fixed

percentage).

The NBV is the computed using (Cost Accumulated Depreciation) andAccumulated Depreciation is the total of depreciation expense incurred to date.

NBV at Beg Dep Exp Acc DepYear 1 40,000 (40,000 x 0.6) = 24,000 24,000Year 2 16,000 (16,000 x 0.6) = 9,600 33,600Year 3 6,400 (6,400 x 0.6) = 3,840 37,440Year 4 2,560 (2,560 x 0.6) = 1,536 38,976

The final net book value (residual value) will be ($40,000 $38,976) = $1,024


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Costing Inventory It is important to know that different methods of costinginventory will result in different cost of goods sold and thus will affect the final profitor loss for the year.

There are three cost flow assumptions used in computing cost of inventory. The firstis First in, First Out (FIFO) assumption. This assumes that the earliest inventories are

the first to be used. Note the concept here is focusing on the cost of the item and notthe physical distribution of items to clients.

The next is the Last In, First Out (LIFO) assumption. This assumes that the latestinventories bought or held are the first to be used first. This method, however, maynot be accepted in practice.

The last approach is the Weighted Average Cost (AVCO) method which used theaveraging method to calculate the cost of each unit of inventory.

Example: A business has the following stock information and sold 9,000 units duringthe year.

Beginning Inventory 1,000 units at $10 per unitFirst purchase 5,000 units at $11 per unitSecond purchase 8,000 units at $12 per unit

With 9,000 units sold, the ending inventory will be (Beg Inv + Purchases UnitsSold) = End Inventory

So the ending inventory will be 5,000 units.

What is the cost of the 9,000 units sold? It depends on the inventory assumptionsused.

a) First In First Out Cost Flow Assumption

Units sold first will be Beginning Inventory 1,000 x $10 = $10,000Then the first purchase 5,000 x $11 = $55,000Then 3,000 units of the last purchase 3,000 x $12 = $36,000Total Cost of Goods Sold (FIFO) 9,000 units = $101,000

The ending inventory is from the last purchase that is not sold yet and is 5,000x $12 = $60,000

b) Last In First Out Cost Flow Assumption

Units sold first will be second purchase 8,000 x $12 = $96,000Then 1,000 units of the first purchase 1,000 x $11 = $11,000Total Cost of Goods Sold (FIFO) 9,000 units = $107,000

The ending inventory is 4,000 units from the first purchase and 1,000 in thebeginning inventory. So the ending inventory cost is (4,000 x $11) + (1,000x$10) = $ 54,000


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c) Weighted Average Cost (AVCO)

First, find the average cost per unit.The total inventory cost = $161,000The total number of units = 14,000 units

So the average cost is $11.50 per unit

Thus, the cost of goods sold is 9,000 x $11.50 = $103,500And the ending inventory is 5,000 x $11.50 = $ 57,500

Trade receivables issuesBusinesses usually sell their products or provide services on credit. With thisarrangement, there will be a volume of accounts receivables outstanding at eachaccounting year end.

With the outstanding receivables, there are risks that customers may not settle theamounts due. When it becomes reasonable certain that the client will never pay, the

debt owed is considered bad and must be written off in the income statement as baddebts expense.

Since the accounts receivables cannot be collected anymore, it will have to be reducedin the balance sheet.

Example:Current Accounts Receivables outstanding is $135,000. A client who owes$6,000 is determined a bankrupt.

The accountant will record the $6,000 as bad debt expense (affect PL statement) andreduce the AR by $6,000 giving a final AR outstanding of $129,000.

There is also the Allowance Methodwhich estimates an amount of uncollectible inthe coming year.The estimate can be based on outstanding AR or Sales.

Example:Current AR outstanding is $135,000 at year end. The company estimatesthat 4% of the AR may be uncollectible in the coming year. Compute the bad debtsand show the balance sheet presentation.

Using 4%, the estimated bad debts is ($135,000 x 0.04) = $5,400

As in the above, the profit and loss will show $5,400 of bad debt expense.

The balance sheet will be presented as follows:

Accounts Receivables $135,000Allowance for trade receivables ($ 5,400)

Net Account Receivables $129,600

Note : Under the Allowance Method, the provision of $5,400 is shown as it is only anestimated amount and not a definite uncollectible. The AR is not directly reduced.


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Review Questions

1) What does the word income means in acccounting ? Discuss the condition ofrecognition.

2) Explain the meaning of costs and differentiate it with the word expense in

accounting.

3) An equipment was purchased at the beginning of the year at a cost of $160,000.Straight line method is used and the equipment is expected to have a useful life of 15years and residual value of $17,500.

a) What is the depreciation for the first year?b) If the equipment is sold for $90,000 at the end of the sixth year, determine the

profit or loss on the sale of the equipment.

4) Ex 3.4 of recommended text.


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Session 4

Accounting for Limited Company


1. Discuss the nature of the limited company2. Explain the role of directors of limited companies3. Describe the main features of the owners claim in a limited company4. Explain how the income statement and the balance sheet of a limited company differ from

other business structure_____________________________________________________________________

4.1 DISCUSS THE NATURE OF THE LIMITED COMPANY

A limited company has features that do not exist in sole proprietorship or partnership.The following section will examine and discuss each feature of a limited company.

Legal Nature: A limited company can be deemed to be an artificial person that hasbeen created by law. This means that it has as many rights and obligations as a personand therefore can sue others or be sued by others, can enter into contracts in its ownname. The owners of the limited company are considered as the shareholders(investors) and own the shares of the company. There are generally two types ofshares ordinary shares and preferred shares.

Perpetual Life: A business entity is considered to be an on-going concern unlessproven otherwise. But unlike a sole proprietorship or a partnership that ends when theowner or a partner dies, a limited company is granted perpetual existence and willcontinue as an entity when a shareholder dies.

This is possible as the shares of the deceased can be transferred to his/herbeneficiaries. The ownership can also be transferred through buying and selling of theshares and these transactions will not affect the company status.

Limited Liability: A sole proprietor or partners are personally responsible for theliabilities and claims on the business. The limited company as a legal person in itsown right is also responsible for the third party claims. As it is legally separated fromthe owners of the shares, the liabilities do not extend to the personal assets of theshareholders. Once the shareholders agree to pay for the shares, their obligation to thecompany or its creditors are limited to the amount paid.

While limited liability is a good feature for the shareholders, it is a disadvantage tothose who may have claims on the company. Supplies for example would have tocarefully consider the amount of credit extended to the limited companies as therewill not be payments if the company pays only what is available within theorganization. This is why some suppliers insist on cash payments or limit the creditlimits.To limit their risks, lenders to the firms (suppliers or banks) can place restrictions onthe ability of shareholders to withdraw their investment from the company. Example


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is to limit the amount of dividends paid to shareholders. Another procedure is torequire limited company to present their annual statements and make them publiclyavailable. This allows anyone interested to deal with the organization an opportunityto assess the firm before entering into any business relationships.

Taxation: As a limited company, it will be accountable to the tax authorities for the

taxes on their profits and gains. The profits earned are not tax to the shareholders attheir personal marginal tax rates.

4.2 EXPLAIN THE ROLES OF DIRECTORS

A limited company is a legal entity but it is not a human being capable of makingdecisions and running the operations on a daily basis. There is then the need to haveindividuals to undertake the management duties and planning. The most senior levelof management is the Board of Directors.

Who elect the board of directors?The shareholders will elect the board to managethe company on a daily basis on their behalf. Depending on the size of the limited

company, the board can be one director to several directors elected. It is not necessaryfor the directors to be shareholders.

Why the need for a board of directors?The owners (investors) of the firms ownsthe shares but are not personally involve in the running of the business or activelycontributing to the strategic planning of the firm. As the control of the businessactivities are managed by senior management or managers, there is the need to havethe board of directors to ensure the best interests of the owners are protected.

While the objective is for the Board to protect the investors, this main objective maynot be met in practice as the Board may pursue their own interests through highsalaries or benefits in the form of perks.

What are the guidelines to monitor directors? The guidelines and rules to monitor thedirectors are based on the following principles.

a) Principle of Disclosures this is the heart of good corporate governance. Properdisclosures by board of directors on the firm and providing adequate and timelyinformation about corporate performance will allow investors to make inform

buy-sell decisions and help the market to value the firm under the currentmanagement. Thus, investing in made a little more transparent.

b) Principle of Accountability This requires the directors to act in the best interest

of the shareholders. They are not to use their position and knowledge of the firmto benefit themselves at the expense of the shareholders. They are also required tohave the financial statements audited and report the performance of the entity in atrue and fair manner.

c) Principle of Fairness As the board of directors, they have privilegedinformation on the firm. We deemed their status as insiders and having insiderinformation, they can reap abnormal benefits at the expense of the shareholders.


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To ensure this does not happen, restrictions are placed on the board of directorsability to sell or buy the firms shares.

4.3 DESCRIBE THE MAIN FEATURES OF THE OWNERS CLAIM

Similar to the balance sheet of a sole proprietor or a partnership, the EQUITY sectionrepresents the value owned by the shareholders.

In the equity section of a limited company, the likely items shown are the ShareCapital, the Reserves (or Retained Earnings).

Let us focus on each of this independently.

Share Capital:shares are the basic units of ownership of a business. Ordinary shares(OS) are usually issued and are known as equity. The number of ordinary sharesissued will depend on a per-share value and the total amount of financing raisedthrough ordinary shares.

If a firm wants to raise $10,000 through ordinary shares, it will be to issue 10,000shares if each share is $1/share, or issue 20,000 shares if each share is $0.50/share or

just 1 share if the only share issued is $10,000 per share.

Besides ordinary shares, some companies have preferred shares (PS) which areguaranteed a dividend payment when dividends are declared. They have priorityclaims above ordinary shares. This means that if the company liquidates, the preferredshares must be paid first before the ordinary shareholders are paid. Thus, the ordinaryshareholders have higher risks in their ownership of the firm.

The following show how the equity section of the balance sheet is presented.

EquityShare capital: 100,000 shares at $1 each $100,000Share premium $ 30,000Revaluation Reserve $ 40,000Retained Earnings $ 60,000Total Equity $230,000

Share Premium: While the share basic or par value is $1 each, the issued price canbe higher resulting in a premium collected. Based on the above illustration, thepremium per share is $0.30 ($30,000 / 100,000 shares)

Reserves:

The first type of reserves is the Retained Earnings which are the profits and gains thatthe company has made since its inception. As they are not distributed to theshareholders as dividends, they remain in the balance sheet. The reserves are theclaims of the shareholders since the profits earned are for them. Do note that whilereserves (retained earnings) can be reduced through dividend payments, it can also be


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reduced because the firm has losses instead of profits during the year. Earning relatedreserves are also classified as Revenue Reserves.

A second type of reserve is known as Capital Reserve. It arises out of issuing sharesat above their nominal or par value or a revaluation upwards of non-current assets.

Revaluation Reserveoccurs when the firm revalues the non-current assets upwards.This usually applies to property held by the firm.

A share with a nominal value of $0.50 cents can be issued to the public at $0.70. If10,000 shares are issued, the equity section with a revenue reserve of $2,000 will lookas follows:

Share capital10,000 shares at 0.50 each $5,000Capital Reserve $1,000Revenue Reserve $2,000Total Equity $8,000

Other issues related to share capital

Stock split a stock split is basically breaking each share into smaller numbers.Example: a $1 share is split 5 for 1 implies that if I own 1 share before the split, I will

be holding an equivalent of 5 shares at $0.20 per share. Note that the total value I ownstill remains at $1.00

Cash Dividends firms usually pays cash dividends on a yearly basis and this is thenormal inducement to attract investors. To distribute cash dividends, the firm musthave strong cash flows to initiate the payment. Cash dividends, however, can only be

paid out of revenue reserve (thus reducing the amount) and not from the capitalreserves in the balance sheet.

Bonus shares firms usually pays cash dividends to their shareholders. However,some firms can give bonus shares instead of cash as dividends. In this case, thenumber of shares in the market will increase. Like cash dividends that reduces therevenue reserves, bonus shares also affect the revenue reserve in the same way.


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4.4 HOW THE INCOME STATEMENT AND BALANCE SHEET DIFFER FROMOTHER BUSINESS STRUCTURES

Generally, the financial statements are of limited companies are based on the sameprinciples as those of the sole proprietor or partnership. There are some differenceswhich we will highlight below.

The Income Statement:

The income statement has three measures of profit displayed after the gross profit.They are the operating profit, the net profit before tax and the net profit after tax (ornet profit for the year)

There is also the audit fee and the corporation tax on the profits for the year

Example of presentation:

Revenue $123,000

Cost of sales ($56,000)Gross Profit $ 57,000

Administration expenses ($28,000)Distribution expenses ($ 9,000)

Net Profit before tax $ 30,000Taxation ($ 12,000)

Net Profit after tax $ 18,000

Attributed to:Equity holder of the parent $ 16,000Minority interest $ 2,000

The net profit after tax is split between the parent company and minority interest (if itexists).

The Balance Sheet:

While the assets and liabilities are similar to the sole proprietorship and partnerships,the equity section has more detailed items. Instead of just capital, the share capital,the revenue reserves and the capital reserves are shown.

Unlike the sole proprietorship and partnership, payment of dividends will not appear

as drawings in the equity section for the limited company. This is because it issummarized in the Statement of Changes in Equity.

Statement of Changes in Equity.

Beginning Retained Earnings 1/1/2010 $100,000Net Profit after tax for the year ended 31/12/2010 $ 50,000Dividends declared ($ 20,000)Ending Retained Earnings 31/12/2010 $ 30,000


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Review Questions

1) Limited liability is the key feature of a limited company. Is it necessary an advantage?

2) Discuss the guidelines and rules that govern the actions of directors.

3) A firm has 50,000 shares at $1.00 each. During the initial issue, a premium of $0.20 pershare is collected. For the first year, the gross profit is $80,000 which is 40% of sales.The operating expenses are 35,000. The tax rate is 20%.

In the middle of the year, there is a stock split of 1:2. A property the firm owns wasrevalued upward by $30,000. At year end, there is a dividend of $0.30 per sharedeclared and paid.

Present the Income Statement and the Equity Section of the firm

4) Differentiate between bonus shares and cash dividends. Explain how the balance sheetwill be affected.


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Session 5

Reporting for Limited Company


1. Describe the responsibilities of directors and auditors concerning the annual financialstatements provided to shareholders and others.

2. Outline the statutory regulations surrounding accounting for limited companies.3. Outline the non-statutory regulations surrounding accounting for limited companies.4. Prepare an income statement, balance sheet and statement of changes in equity for a

limited company in accordance with International Financial Reporting Standards_____________________________________________________________________

5.1 DESCRIBE THE RESPONSIBILITIES OF AUDITORS AND DIRECTORS

Shareholders while owning the firm through their shares do not get involve with theday to day operations of the companies. The appointed directors are to act in the

interests of the shareholders. The separation of ownership and control requires thisappointment.

Stewardship is the prime responsibilities of the directors. The law requires thedirectors to (a) maintain appropriate accounting records and (b) prepare annualfinancial statements with a directors report and (c) make these reports available to theshareholders and the public.

To maintain accounting records, the need for a framework of rules regarding howstatements should be prepared is required. While accounting framework assists inmaking statements comparable and understood by users, directors can adopt policiesand practices that present an unrealistic position of the company. Regulations cannot

possibly eradicate all manipulations or concealment of truths but can, at least, reducethe possibility.

To enhance understanding and to help investors appreciate accounting reports ofdifferent companies across different countries, the trend towards internationalharmonization on reporting prevails.

These rules, known as International Accounting Standards or International FinancialReporting Standards, deal with the following key issues:

what information should be disclosed how information should be presented

how assets should be valued how profit should be measured

The responsibility of the auditors is to report whether in their opinion, the financialstatements presents a true and fair view of the firm according to the relevantaccounting rules and policies.


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To make such an opinion, auditors are to scrutinize the statements and the evidenceupon which they are based. Their opinion and statement must be in the financialstatements presented to the shareholders and the Registrar of Companies.

While the directors are elected by the shareholders to give account of the company,the auditors are elected by the directors to give an independent view of the firm to the

shareholders.

5.2 STATUTORY REGULATIONS FOR LIMITED COMPANIES

The auditors report provides and opinion by an independent auditor concerningwhether the financial statements provide a true and fair view of the financial health ofthe business. They are to present an independent view of the firm to the shareholders.

The directors reportcontains information of both financial and non-financial naturewhich goes beyond that contained in the financial statements. Some information may

be details of the directors, their financial interests in the firm, employment policies ordonations etc. The auditors do not audit the directors report.

5.3 NON-STATUTORY REGULATIONS FOR LIMITED COMPANIES

Segmental reports disaggregate information on the financial statements to help usersbetter understand the information contained in the statements. Segment reports can beclassified according to products or services and according to geographical regions.

IASB requires listed companies to disclose segment information according to eachbusiness unit and to each geographical region.

Why is the business segmentation of the reports important? This is important to usersas it is a part of the business that can be separately identified and which provides acertain product or services or a group of product or services.

Why is geographical region important? Like business segment, a geographical regionalso is a separately identified area where a particular product or service is providedunder certain economic environment. Region can be a country or a group of countries.

Basis of reporting: To report a business segment or a region, it must be of asignificant size. A 10 percent or more of the businesss revenue, operating income ortotal revenue is used to determine whether a segment is considered significant.

Directors are to decide whether the report is to be presented based on the products orservices offered or based on the geographical region. The one that has greater impactis the primary segment. This shows the risks transparently and the users can assess thecompany accordingly.


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Segmental Disclosures:The standards require the following items to be presented:

Revenue separate revenue from external customers and revenue from othersegments

Total Assets Capital Expenditure for the period Depreciation, impairment losses and other non-cash items Segment operating results Total Liabilities

5.4 PREPARING THE INCOME STATEMENT, THE BALANCE SHEET ANDTHE CHANGES IN EQUITY FOR A LIMITED COMPANY

According to the International Accounting Standard IAS 1,Presentation of FinancialStatements, the financial statements consists of (a) an income statement, (b) a balancesheet, (c) a statement of changes in equity (d) a cash flow statement and (e) notes on

accounting policies and other explanatory notes.

To do all the above, the overriding requirement is for the financial statements toprovide a true and fair viewof the companys financial performance, position andcash flows. The IAS presumes this will be achieved if statements are drawn based onthe IAS standards issued. Only under unusual circumstances, the standards do notresult in a fair presentation of the company.

Besides the true and fair view, there are other contrasting considerations in preparingfinancial reports. These include the concept of relevance, the feature of timeliness ofinformation, the degree of details required and the quality of understandability offinancial data.

The financial report preparation process largely depends on who are the users andwhy the report is being prepared. Thus, some trade offs will inevitably be required tomeet the needs of the users.

The Income Statement:The IAS sets out the minimum that must be reported on the face of the incomestatement. The items include: Revenue, Finance costs, gains or losses on sale ofassets, settlements of liabilities arising from discontinued operations, tax expenses and

profit or loss.

There are two recommended ways to present expenses. They can be presented

according to their natures e.g. interests, salaries, depreciation or their function e.g.marketing costs, financial costs, selling costs, administrative costs etc.

The standards also require separate disclosure of material items. Material items arethose will affect the decision of an investor. They do not have to be on the face of theincome statement and can appear as notes to the financial statements.

Examples of material information that require separate disclosures are:

write-down of inventories to net realizable value


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write-down or disposal of property, plant or equipment disposal of investments restructuring costs discontinued operations litigation settlements

The Balance SheetThe IAS does not have a prescribed format for the Balance Sheet but state theminimum information required. This includes the following:

Property, Plant and Equipment Investment Property Intangible assets Financial assets Inventories

Trade and other receivables Cash and cash equivalents Trade and trade payables Provisions Financial liabilities not included in the above Tax liabilities Issued share capital and reserves

Assets and liabilities normally are presented in their Current and Non-current formatin the balance sheet. However, the firm is also permitted to present the assets andliabilities according to liquidity if it considers that this format presents a more reliableand relevant position of the firm.

The Statement of Changes in Equity

This statement is useful for users to understand the changes in share capital and thereserves that took place during the accounting period. As capital and reserves can beincreased or decreased, this statement reconciles the beginning balance to the closing

balance of the year.

While the income statement shows the realized gains and losses, there are unrealizedgains and losses that do not go through the operating income. Example of unrealizedgains and losses are currency exchange effects. A firm can revalue the assets, e.g. a

property, upwards or downwards and asset revaluation reserve is affected in the

equity.

You are encouraged to access the audit report of a listed company on the stockexchange and understand how the equity section of the balance sheet is presented forinvestors.

The Cash Flow StatementThe IAS 7 states the requirements for presenting the cash flow statement. Thisstatement explains how the firm generates or access funds and how it uses the cash


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during the accounting period. Thus, it helps the users to access the liquidity of thefirm.

The details workings of the statements will be covered in detail during the nextlecture.

Besides the above, explanatory notes also help users to understand the financialstatements. Explanatory notes normally contain the following information:

a statement that the financial statements comply with the relevant IFRS summary of the measurement bases and accounting policies used. Supporting information to the three major statements Other disclosures e.g. future contractual obligations not recognized yet or

managements objectives and policies

Review Questions

Source : Eddie McLaney and Peter Atrill (2008),Accounting : An Introduction,NJ: Pearson Education.

1) The size of annual financial reports published by listed companies has increasedsteadily over the years. What are likely reasons that cause this apart from the increasingvolume of accounting regulations?

2) What problems are likely to be encountered when preparing summary financialstatements for shareholders?

3) Prepare an income statement according to the requirement of IAS.

Interest payable 40,000,000Cost of sales 460,000,000Distribution costs 110,000,000Revenue 943,000,000Administrative costs 212,000,000Other expenses 25,000,000

The corporate tax is 25% of the profits available to the shareholders.

4) Visit www.sgx.comand select a company that has segment reporting. Present a briefsummary of the company.

5) Explain the purpose of the auditors report and the directors report in the financial

statements


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Session 6

Measuring and Reporting Cash Flows


1. Explain the role of cash in an enterprise2. Explain the nature of the cash flow statement and its usefulness3. Prepare a simple Cash Flow Statement4. Interpreting a Statement of Cash Flows

_____________________________________________________________________

6.1 THE ROLE OF CASH IN AN ENTERPRISE

While cash is a current asset and is like any other assets the company has, it iscritically important as it allows the company to function well. With all purchases,cash is required for payments. Suppliers who are unfamiliar with the firm will requirecash for transactions. Even it credit is given, the time frame will be short and cash

will still be needed to meet obligations. Thus, the use of cash is transactional.

When unexpected opportunities occur, the firm can only take advantage of them ifcash is required for payment and the firm has sufficient funds at that point.

Cash allows the firm to be sustainable and most businesses failed because of cashflow problems.

6.2 THE NATURE OF THE CASH FLOW STATEMENT AND ITS USEFULNESS

The cash flow statement summarizes the cash receipts and payments over the periodconcern. It explains the firms sources of cash and how they are used during the year.The net cash flow which is the total receipts less the payments explains the change inthe cash position for the year. This figure is the reconciling amount between the

beginning cash and the ending cash in the balance sheet. This will be illustrated later.

The accounting standards define cash as notes and coins on hand and deposits inbanks. Cash equivalents are short-term, highly liquid investments that can be easilyconverted to cash without significant changes in values. Cash equivalents are held forthe purpose of meeting short term obligations and not for long term investments.

The cash flow statement focuses on the receipts of cash from sales and other incomeand payments of cash to creditors and for operational expenses. It is different from

the principle of accrual where revenues are recorded when earned and expenses arerecorded when incurred.

6.3 A SIMPLE CASH FLOW STATEMENT

The standard cash flow statement consists of three main sections. They are Cash Flowfrom Operating Activities, Cash Flow from Investing Activities and the Cash Flowfrom Financing Activities. The individual subtotal of each of the sections may be

positive or negative depending on the flow of cash.


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The total of the three sections shows the net increase or decrease in cash and cashequivalents over the period.

Cash Flow from Operating Activities:Operating activities are the transactions that

attempt to increase the profits of the company. Therefore, revenue and expenseswhich result in receiving cash or payment of cash will be included in this section ofthe cash flow statement.

Note that this section records the amount of cash received from sales or accountsreceivables and not the actual sales recorded. Likewise, the cash paid for operationalcosts is determined here.

As operating activities will affect the current asset or current liability, the balancesheet is out source of working out the cash flow.

This section is generally presented in the following format:

Net Profit before tax XXXAdd back non cash expenses

(e.g. depreciation, bad debts) XXXAdd back loss on sale of NCA XXXMinus gain on sale of NCA (XXX)

Changes in Current Assets (e.g. AR, Inventory, Prepayments)If CA increases from last year to this year (XXX)If CA decreases from last year to this year XXX

Changes in Current Liabilities (e.g. AP, Accrued Expenses)If CL increases from last year to this year XXXIf CL decreases from last year to this year (XXX)

.Net cash flow from Operating Activities XXXXX

Cash Flow from Investing Activities:This section focus on cash used to pay foracquiring non-current assets and cash received from the sale of non-current assets. So,if the company purchases a $10,000 machine, we will be recording the $10,000 as acash outflow.

If an equipment costing $35,000 and net book value of $7,000 was sold for $5,000,the cash received from the sale i.e. $5,000 will be recorded as cash inflow. The$2,000 loss on the sale ($5,000 - $7,000) is not cash and will not be considered in thecash flow statement here.

Cash Flow from Financing Activities:Financing activities focus on how the firmraise funds or settle their long term obligations. Firms can raise funds through non-current liabilities (e.g. long term loans) or issue new shares (where investors pay cashfor the shares). These are inflow of cash.


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Repayment of loan results in cash outflows. Similarly paying dividends is anothercash outflow and it is considered as a financing activity since it is a return of cash tothe investors. Note that while a $10,000 dividend may be declared, the cash paid may

be different if $2,000 is recorded as dividend payable. In this case, the actual cashpaid for dividends is only $8,000

Example: Preparing a simple cash flow statement

31 Dec 2010 31 Dec 2009$ $

Cash 91,000 20,000Accounts receivable 90,000 65,000Inventory 62,000 58,000Prepaid Expense 12,000 10,000Premises 90,000 80,000Plant and machinery 320,000 280,000

Accumulated Depreciation (92,000) (60,000)573,000 453,000

Accounts Payable 38,000 35,000Mortgage loan 200,000 160,000Share Capital 240,000 210,000Retained Earnings 95,000 48,000

573,000 453,000

Additional information:

There was no disposal of premises during the year.

A machine costing $50,000 with accumulated depreciation of $20,000 was soldfor $25,000. Net Profit for the year after interest and tax was $117,000. Mortgage loan of $25,000 was settled through issue of shares. A dividend of $70,000 was paid during the year.


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Solution:

ABC Ltd

Statement of Cash Flows

For the year ended December 31, 2010

$ $

Cash flows from operating activities:Net income 117,000

Adjustments to reconcile net income to net cash flow fromoperating activities:

Depreciation 52,000

Loss on sale of machine 5,000

Changes in current operating assets and liabilities

Increase in accounts receivables (25,000)

Increase in inventories (4,000)

Increase in prepaid expense (2,000)

Increase in accounts payable 3,000

Net cash flow from operating activities 146,000

Cash flow from investing activities:

Cash paid for purchase of premises (10,000)

Cash received from sales of machine 25,000

Cash paid for purchase of machine (90,000)

Net cash flow used for investing activities (75,000)

Cash flows from financing activities:

Cash received from sale of common shares 5,000Cash paid for dividends (70,000)

Cash received from mortgage loan 65,000

Net cash flow provided by financing activities 0

Increase in cash 71,000

Cash at the beginning of the year 20,000

Cash at the end of the year 91,000

6.4 INTERPRETING A CASH FLOW STATEMENT

The cash flow statement tells us how the business has generated cash during theperiod and where the cash has gone. Thus, the statement tells us the lifeblood of thecompany.

Understanding and interpreting the cash flows allow one to make judgments about thefuture behavior of the firm.


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Using the above example, we can see the following:

The cash flow from operating activities of $146,000 is strong. This indicates thatwhile there are increases in accounts receivables and inventories, the firm is stillcollecting most of the sales and managing the payment of operational expenses verywell.

The cash flow from investing activities of ($75,000) should not be a large concern asthe information shows that company is renewing their non-current assets for futuregrowth. While there is no indication of business expansion, renewal of assets is a

positive sign.

The cash flow from financing activities with zero effect shows an increase in fundingthrough loans and most of the amounts were used to fund the dividend payments.

Overall, the company is healthy with an overall net increase of $71,000

Review Questions

1) In accounting, there are non-cash transactions. Give examples.

2) A business owner cannot understand the low amount of cash balance at the end ofaccounting period when there are high revenues and profits reported in the incomestatement. Explain the apparent discrepancies

3) Which segment of the cash flow statement is affected by the following transactions?

a) Depreciation expense for the yearb) Purchasing of a new equipmentc) Issue dividends through bonus sharesd) The bank extends another $100,000 loan to the firme) Selling an old asset at a gain of $5,000. The selling price is $50,000f) Accounts receivables decrease by $10,000g) The firm issue new shares in exchange for a piece of landh) Decrease in accounts payable by $7,000

4) Aquatech Pte Ltd is a supplier of water purification equipment for home andcommercial use. The company is in an aggressive expansion program and will continueto expand if adequate financing can be obtained from its bank. The companys balancesheets for the last 2 years are as follows:


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Balance sheetsDecember 31, 2009 and 2010

Assets 2010 2009Current Assets

Cash (9,000) 21,000

Accounts receivable, net 140,000 100,000Inventory 300,000 250,000Prepaid expenses 7,000 9,000

Total current assets 438,000 380,000

Plant and equipment 700,000 620,000Less accumulated depreciation 180,000 150,000

Net plant and equipment 520,000 470,000Goodwill 42,000 50,000

Total Assets 1,000,000 900,000

Liabilities and Stockholders EquityCurrent Liabilities

Accounts payable 190,000 163,000Accrued Liabilities 10,000 17,000

Total current liabilities 200,000 180,000

Long term debt 100,000 90,000

Shareholders equityCommon stock 300,000 285,000Retained earnings 400,000 345,000

Total stockholders equity 700,000 630,000

Total Liabilities and stockholders equity 1,000,000 900,000

The companys income statement for the year ended 2010 is given below:

Sales $1,500,000Cost of goods sold 900,000Gross margin 600,000Operating expenses 510,000

Net income $ 90,000

The following additional information is available for 2010.

Equipment that had cost $60,000 new and on which there was accumulateddepreciation of $42,000 was sold for its book value of $18,000. The goodwill is being amortized against earnings. The company declared and paid $35,000 in cash dividends.

After seeing the negative position in Aquatechs cash account, the companys bank asked fora cash flow statement in order to determine why cash dropped so sharply during the year.You are to prepare the statement for the bank.


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Session 7

Analysis of Financial Statements


1. Establish the usefulness of financial ratios to various interest groups2. Identify the major categories of ratios3. Calculating ratios and explaining their significance4. Explain the importance of gearing to an enterprise and owners5. Limitations of ratios

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7.1 ESTABLISH THE USEFULNESS OF FINANCIAL RATIOS

While different users may have different needs, financial ratios can be used toexamine various aspects of the performance and position of companies and are widelyused in planning and control purposes.

Ratios provide a quick and simple way to assess the health status of firms. Thisallows users to use them without requiring too much of in-depth knowledge.

Ratios also allow users to compare companies of different industries as well as size ofestablishments. It uses a common denominator for comparison. Example, the revenuein dollar may vary a lot but using percentages make all amounts relativelycomparable.

Ratios can be presented in different form percentages, ratio or number of timesrelative to a key figure. The only requirement is consistency in usage so thatreasonable comparison can be achieved.

7.2 THE MAJOR CATEGORIES OF RATIOS

Ratios are grouped into categories with each relating to a particular aspect of financialperformance or position. There are five broad categories as follows:

Profitability Ratios since businesses exist for profits, these ratios provideinsights the firms success in achieving its primary goal. The expressed profits interms of other key figures in the financial statements

Efficiency Ratios as assets are invested to achieve the primary goal of profit

making, these ratios analyze how efficient is the firm in using the assets orresources within the organization. They are also referred to as activity ratios.

Liquidity Ratios firms collapse when they become illiquid. The liquidity ratiosexamine the ability of the firm to pay their obligations when they are due andshow the relationship of liquid assets to liabilities.

Financial Gearing Ratios a firm gets its financing source from shareholders(owners of business) and outside parties in the form of loans. This result in the


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relationship between liability and equity term as leverage or gearing. The level ofgearing shows the extent the firm borrows and with higher leverage, there arehigher risks.

Investment Ratios these are concern with assessing the returns andperformance of shares in a particular business.

Different users will have different needs and thus the analyst need to be clear who arethe target users and why they need the information. We will consider the computationof the ratios in the next section.

7.3 CALCULATING RATIOS AND THEIR SIGNIFICANCE

To understand the ratios, their computations and the interpretations, we will use thefollowing statements as illustration. All figures are from the statements.


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Balance Sheet of Amazing Action Pte Ltd

As at 31 December (amounts in thousands)

31-Dec-08 31-Dec-09

Current Assets

Cash 18 12Accounts Receivables 32 32

Inventories 24 60

Prepayments 28 4

Total Current Assets 102 108

Non-Current Assets

Land and Building 290 290

Machinery 70 82

Equipment 100 100Total Non-Current Assets 460 472

Total Assets 562 580

Current Liabilities

Accounts Payables 35 17

Accruals 7 3

Total Current Liabilities 42 20

Non Current LiabilitiesLong Term Loan due 2013 160 160

Total Liabilities 202 180

Equity

Share Capital ($1 par) 200 200Retained Profits 160 200

Total Equity 360 400

Total Liabilities and Equity 562 580


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Profit and Loss Statement of Amazing Action Pte LtdFor the years ended 31 December (amounts in

thousands)

31-Dec-08 31-Dec-09

Revenue 380 415

less Cost of Goods Sold 227 235

Gross Profit 153 180

Selling Expenses 68 66

Administrative Expenses 31 30

Operating Profit 54 84

Interest Cost 18 14

Profit before tax 36 70

less tax 5 10Net Profit 31 60

Dividends declared 16 20

Other information

Market Price per share $1.60 $1.85

Average Credit Purchases 255 280

Number of employee 1250 1350

Cash flow from operations 100 125

Profitability Ratios: The 4 basic profitability ratios are return on shareholdersfunds, return on capital employed, gross profit margin and operating profitmargin.

Return on shareholders funds

Profit for the year less preference dividend (if any) x 100Average [ Ordinary share capital + Reserves ]

= $60 / ($ 360 + $ 400) = 15.6%

This ratio implies that for each dollar invested, the return is $0.156 cents perdollar.

Return on capital employed

Operating profit x 100 .Average [Share capital + Reserves + Non-current liabilities]


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= $60 / ($ 562 + $ 580) = 10.5%

The computed ratio of 10.5% means that for each dollar invested, the firm is ableto generate $ 0.105 cents of operating profit.

Gross profit margin

Operating profit x 100Sales revenue

= $84 / $415 = 20.2 %

For a firm, one would naturally prefer this number to be large. At 20.2%, the firmis having a $0.202 cents return for every dollar sale generated.

Operating profit margin

Gross profit x 100

Sales revenue

= $180 / $415 = 43.3 %

The gross profit is computed by deducting the cost of goods sold. So a high43.3% implies that for each dollar of sale, the net after cost of sale is $0.433 cents

per dollar. The higher the figure is naturally better for the firm.

Efficiency Ratios the efficiency ratios measures how well the resources areused and thus the basic efficiency ratios are average inventory turnover period,average trade receivables turnover period, average trade payables turnover period,sales revenue to capital employed and sales revenue per employee.

Average Inventories turnover period

Average inventories held x 365Cost of sales

= ($24 + $60) / $235 x 365 days = 65.23 days

This ratio measures how long the firm is keeping its raw material, work in processor finished goods before selling them. The longer the time frame implies slowmoving stocks.

Average settlement period for trade receivables

Average Trade receivables x 365Credit sales revenue

= ($32 + $32 ) / $415 x 365 days = 28.14 daysThis ratio computes the number of days before an accounts receivable iscollected. The firm will prefer shorter time frame as it means they are collecting


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faster from the customers, have better cash flow and avoid possibility of baddebts.

Average trade payables turnover period

Average Trade payables x 365

Credit purchases

= ($35 + $17) / $280 x 365 days = 33.89 days

Cash flow is affected by how fast the firm pays others too. While we prefer tocollect our accounts receivables fast, paying suppliers is managed for cash flow

purposes. Having a very long payable turnover period can be bad for the firmsreputation too.

Sales revenue to capital employed

Sales revenue

Share capital + Reserves + Non-current liabilities

= $ 415 / $580 = 71.6 %

The firm gets its funds from long term liabilities and shareholders equity. Thisratio measures how much sale for each dollar of financing raised by the firm. Inthe above computation, every dollar of financing can generate $0.716 cents ofrevenue.

Sales revenue per employee

Sales revenueNumber of employees

= $ 415 / 1350 employees = 0.307 per employee

The sales revenue per employee ratio measures efficiency of staff in generatingsales for the firm.

Liquidity Ratios the 3 fundamental liquidity ratios are the current ratio, thequick ratio and the operating cash flows to maturing obligations.

Current ratio

Current assetsCurrent liabilities

= $ 102 / $ 108 = 0.94

The current ratio measure the ability of the firm to pay off its short term liabilitieswhen they become due. In the above computed ratio, the firm has only 0.94 cents


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of current asset to back each dollar of liability. We prefer the figure to be greaterthan 1.

Quick ratio

Current assets (excluding inventories and prepayments)

Current liabilities

= ($ 18 + $ 32) / $108 = 0.463

The quick ratio is very similar to the current ratio in the purpose of measure.However, it only considers the liquid current assets. Thus, the less liquid currentassets like inventories and prepayments are ignored.

Operating cash flows to maturing obligations

Cash generated from operations

Current liabilities

= $ 125 / $108 = 1.19

This ratio compares the amount of cash generated from operations to the currentobligations. Since the firm will need cash to pay off the liabilities, the cashgenerated from operations is the basic source of funds.

Financial Gearing Ratios Gearing ratios measures the contribution of longterm lends to the long term capital structure of the business. With gearing, thereare interest costs. Thus, the two basic ratios are gearing ratio and the interestcover ratio.

Gearing ratio

Long-term (non-current) liabilities x 100Share capital + Reserves + Long-term (non-current) liabilities

= $160 / $580 = 0.276

The firm needs to be constantly aware of the sources of funding. Having toomuch long term debt would be over leveraging and risky for the firm. This ratioshows the relationship of long term debt to total funding. One would prefer this

figure to be less than 50%.

Interest cover ratio

Operating profitInterest payable

= $ 60 / $14 = 4.29


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Interest cover ratio shows the ability of the firm to pay off the interest incurred inthe borrowing process. Based on the figure computed, it implies that the firm has4.29 years of operating income to pay off the interest incurred.

Investment Ratios these for investors to assess the return on their investments.

The basic ratios are dividend payout ratio, dividend yield ratio, earnings pershare, price earnings per share and operating cash flow per share.

Dividend payout ratio

Dividends announced for the year x 100Earnings for the year available for dividends

= $20 / $60 x100 = 33%

All shareholders look forward to dividends. The payout ratio indicated whatpercentage of each years earnings is distributed to the shareholders.

Dividend yield ratio

Net Dividend per share/(1 tax rate) x 100Market value per share

= 0.10 per share / $1.85 x 100 = 5.4 %

This ratio calculates the yield for holding the shares. It is similar to the return ofinvestment measurement.

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