Transcript Slide 1
Shanghai University of Finance & Economics
Accounting/Business Diploma Programmes Principles of Accounting 1
Definition of Financial Accounting
Financial accounting is the process of identifying, measuring and communicating economic information about a business organisation in order to permit informed judgements by users of that information.
[American accounting association]
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The Process of Financial Accounting
IDENTIFYING & classifying the assets, liabilities, capital, income & expenses recording each transaction of the business SUMMARISING in the form of periodic financial statements COMMUNICATING to users/stakeholders in the business
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Who are the Stakeholders ?
Managers Suppliers Shareholders/ investors Investment analysts Accounting information Employees General public Competitors Lenders/ creditors Government Customers
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How will Stakeholders use accounting information ?
Review their past decisions & commitments to the business Use past financial performance information as a ”guide” to forming expectations of the future Make decisions based upon those expectations to maintain, increase or withdraw their commitment / interest in the business
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Necessary qualities of financial information.
clarity accuracy consistency relevance Accounting Information reliability timeliness
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Main forms of business enterprise [entity].
Non profit co-op charity public body Business organisation Sole trader partnership Public limited liability company [plc] Private limited liability company
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Accounting Concepts
Accounting statements could be prepared in a variety of ways which would be confusing Therefore, they are regulated by both law and by professional standards These laws and standards are based on underlying concepts The most important is for accounting statements to give a true and fair view This means they should disclose all relevant information for stakeholders to be able to act with confidence 8
Accounting Statements
Profit and Loss Account Look at account on page 29 What is the final profit What is the value of sales Sales can be for cash or credit Costs/expenses should match the period over which sales are made Total Revenues – Total Expenses = Net Profit 9
The Balance Sheet
Look at the Balance Sheets on page 31 Compare the date headings of the balance sheets with the profit and loss accounts What is the main difference ?
The balance sheet shows The Assets owned The Liabilities owed The Value of the owners’ investment in the Business 10
Balance Sheet Items
Assets are things the business owns Fixed Assets are used in the business and are not for resale. They are usually depreciated Current Assets are cash or assets expected to be turned into cash within one year 11
Financial Accounting Concepts
Entity Separates business and personal affairs Read example 1 – page 39 J Soap’s business is all that is shown – the other £20,000 is irrelevant In fact he would be personally liable for any business debts Contrast this with limited companies whose shareholders are not personally liable 12
Money Measurement
Accounts include only information which can be expressed in monetary terms This seems an obvious fact but read Example 3 – page 40 The message is clearly that not all important information can be shown in the accounts 13
Going Concern
Assets in the Accounts are valued on the basis that the business will continue for the foreseeable future This is very important as assetsd may have very different values if business closed Read Example 4 – Page 41 Clearly this value is only justified by the continued mining for gold 14
Cost concept
Often referred to as historic cost The assets of a business are shown at their cost of purchase and may not represent their “true” value Some assets will have this historic cost written off over time as depreciation 15
Realisation Concept
Accounts will record profit when a sale is made.
This means that general increases in asset values are not recorded Also means that cash does not have to exchanged Read example 8 – page 45 Accounts would record the sale on Jan 1 16
Accruals Concept
Revenues and expenses are included in accounts NOT to the extent that they have been paid but to the extent that they relate to the period of account E.g. A company hires new machinery and pays £50,000 per year in advance on 1 st July 2003. Only £25,000 expenses should be included in accounts to 31 st December 2003 17
Matching Concept
In calculating profit, revenues should be matched with their relevant expenses Read Example 11 – page 46 Only the expenses to buy the 1,000 tins which have actually been sold are included in the calculation of profit 18
Periodicity Concept
Accounts cover a period of time – typically one year Read Example 13 – page 48 The accounting profit will necessarily only reflect transactions completed in the period This may not reflect the longer term financial position 19
Consistency/Prudence Concepts
Consistency is desirable as it allows accounts to be compared for different years and for different businesses Prudence means that generally accounts should avoid overstating asset values, should not anticipate profits and should provide for losses 20
The Accounting Equation.
ASSETS = LIABILITIES + CAPITAL Resources Who supplied funding to buy the resources
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The Accounting Equation.
ASSETS LIABILITIES = CAPITAL What What business business owns owes What business is worth
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TOTAL ASSETS
Total Assets
FIXED ASSETS Land & buildings machinery vehicles goodwill CURRENT ASSETS Stocks Debtors Investments Cash
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TOTAL LIABIL - ITIES
Total Liabilities
LONG MATURING debentures / loan stock CURRENT LIABILITIES trade creditors overdraft tax & dividend due
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CAPITAL
Capital
SHAREHOLDER OWNERSHIP RESERVES REVENUE Retained profit REVALUATION
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Exercises
Now try questions 1 & 2 on page 94 These questions will help us to understand the accounting equation and the financial statements 26
Next Step
Now we understand the accounting equation and the general format of the Profit & Loss Account and Balance Sheet The next step is to look at the process of recording financial transactions 27
Principles of Accounting
Recording Accounting Transactions 28
Transactions & the Accounting Equation
It is possible to use the Accounting Equation to show a new Balance Sheet after each transaction Look at pages 76 – 78 to demonstrate this Many businesses have thousands of transactions so we do not want to draw up a Balance Sheet after each one Instead we use double-entry bookkeeping 29
DOUBLE ENTRY SYSTEM ‘T’ - ACCOUNT
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ACCOUNT NAME” DEBIT £ date reference CREDIT £ date reference
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DOUBLE ENTRY SYSTEM ‘T’ - ACCOUNT
RECORD DEBIT CREDIT ASSETS LIABILITIES CAPITAL INCREASE DECREASE DECREASE INCREASE DECREASE INCREASE
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DOUBLE ENTRY SYSTEM LINK WITH BALANCE SHEET EQUATION
ASSETS + DEBIT = LIABILITIES - CREDIT + DEBIT + CREDIT + CAPITAL - CREDIT - DEBIT + DEBIT + CREDIT - CREDIT - DEBIT
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The concept of flows
An easy way to understand the process is to think of it as a flow The flow outwards is shown on the right hand side of the account (credit) The flow inwards is shown on the left hand side of the account (debit) 33
Rules for double entry system
The most important rule is that ALL transactions will have two entries A credit entry and a debit entry This means that all the flows of money stay within the accounting system This also means that at any time the total of all debits and all credits must be equal 34
Calculating the balances on Accounts
To calculate the balance on the account, simply add up both sides of the account and calculate the difference After the accounts are balanced (usually at the end of accounting period) this balance is brought down on the other side of the account We can look at an example 35
DOUBLE ENTRY SYSTEM ‘T’ - ACCOUNT
BANK ACCOUNT Debit £ Credit £ date capital a/c 160 000 date premises 90 000 date vehicle 20 000 date purchases 60 000
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Class Exercise
Now let’s try a class exercise to practice making double entries and calculating balances See attached notes for Tom Watson exercise 37
DOUBLE ENTRY SYSTEM PERIOD END TRIAL BALANCE
Each debit or credit balance from each individual account is listed in a columnar TRIAL BALANCE.
The debit balances are listed on the left and the credit balances on the right It is from the Trial balance that the Profit & Loss Account and Balance Sheet are constructed.
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Errors in the Accounts
If the Trial Balance does not balance then an error has been made in the process of inputting data However not all errors will have this result E.g. if a transaction is completely overlooked 39
Class Exercises
Bringing accounts to Trial Balance stage is a very important part of Financial Accounting Pages 90 – 93 give a long example which we should study Look at how we deal with opening balances Class exercises to practice are questions 3, 6 and 7 on pages 94 - 96 40
Principles of Accounting
Periodic Measurement 41
Introduction
Double-entry bookkeeping is a system for recording accounting transactions Business usually continues through time (i.e. it does not stop) but there is a general requirement for measurement of its performance at set time intervals This is done by Profit & Loss Account (for the year) and Balance Sheet (at the year end) 42
Main problems
1. Must identify the revenues for the year And – need to match expenses to these revenues 2. Need to make adjustments to determine whether revenues > expenses (profit) or expenses > revenues (loss) These adjustments may involve use of judgement 43
Revenues & Expenses
The Trial Balance is the base for calculating profit Look at the Trial Balance on Page 101 Which are the flows for profits and which are capital flows ?
Which expenditure is directly to earn revenue and which to purchase assets ?
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Revenue & Expenses
Revenue is money arising from the trading activities of the business Revenue expenses are the costs of running the business during the accounting period (the period being measured) Look at the figures on page 102 – do they match these definitions 45
The Accruals Concept
Now we have to make sure the revenues and expenses relate to this accounting period. This is the accruals concept Expenses may have been paid in advance (prepayments) or may be due but not yet paid (accruals) It is also possible that revenue may have accrued 46
Accrued Income
This is much less common than accrued expenses It can apply to income other than sales E.g. rent receivable As this area is less important we can briefly review the workings on pages 103 - 104 47
Accrued expenses
This is a very important area When possible businesses will delay payments We have to check whether there are extra amounts due in accounts such as rent, wages and electricity It is also possible that money may have been paid in advance Two adjustments Accruals for expenses of the year not yet paid Exclude any payements already made that relate to the next year (these are prepayments) 48
Examples
The example on pages 104 – 108 demonstrates how this works Once we understand this we can try Question 2 on page 112 – 113 These is a further example of these principles on pages 109 - 110 49
Stock Adjustments
Most businesses buy goods for resale at a profit Sometimes as finished items and sometimes as raw materials requiring further work In our current system these goods will be showing as an expense under purchases We should only charge this expense to profit to the extent that these goods have been sold and generated revenue (the matching concept) Those purchases which are not sold should not be an expense against profit but should be recorded as stock See page 110 – 111 and attempt question 1 on page 112 Finally we should try question 4 on page 113 50
FIXED ASSETS
REVENUE EXPENDITURE Charged in full to P / L Account in period incurred CAPITAL EXPENDITURE Spread over expected useful economic life of fixed asset
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FIXED ASSETS
Fixed Asset “at cost” Include all costs incurred up to point where asset is ready for use
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DEPRECIATION
Annual charge to P/L Account representing the “cost” of using asset during the period to generate revenue and profit
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DEPRECIATION
Depreciation depends upon :
initial cost of the asset
the expected useful economic life of the asset
anticipated residual / scrap value of the asset
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STRAIGHT-LINE METHOD
Annual charge = Cost minus Residual value Expected life Constant annual charge over the life of asset
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STRAIGHT-LINE METHOD
Motor vehicles Annual charge = Cost minus Residual value Expected life Annual charge = £125 000 minus £25 000 4 years = £25 000 per year
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RECORDING FIXED ASSET
Acquisition Debt : “Fixed Asset at cost Account” Credit : “Bank Account” or “General creditor Account”
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RECORDING FIXED ASSET
Annual Depreciation Charge: Debit : “Profit & Loss Account” Credit : “Fixed Asset Depreciation Account”
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IN THE BALANCE SHEET
Fixed assets Cost Accumulated Net Book £ Depreciation £ Value £
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REDUCING BALANCE METHOD Annual Depreciation Charge =
Net Book Value of the asset at the start of the period X % Annual Depreciation Rate
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REDUCING BALANCE METHOD
Results in a higher annual depreciation charge in the early years of the life of the asset.
Amount of annual depreciation charges falls over the life of the asset
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Reducing Balance Rate
You may be given this rate in the question E.g.
Depreciation on motor vehicles is 25% reducing balance However the rate can also be calculated by the following formula r = 1 – n * sq root (s/c) – see page 122 Now try depreciation questions 1 & 2 on page 134 62
Fixed asset disposal
To record disposal create a “Fixed Asset Disposal Account” Debit : Disposal Account Credit : Fixed Asset at Cost Account to write the asset out of the books
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Fixed asset disposal
To record disposal create a “Fixed Asset Disposal Account” Debit : Fixed asset depreciation account Credit : Disposal account with the accumulated depreciation charged to date on the asset
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Fixed asset disposal
To record disposal create a “Fixed Asset Disposal Account” (also called asset realization account in text book) Debit : Bank Account Credit : Disposal account with the cash proceeds from the disposal
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Fixed asset disposal
If a debit side balance remains on the Disposal Account then the asset was disposed of at a Profit.
If a credit side balance remains on the Disposal Account then the asset was disposed of at a Loss.
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Examples
Pages 126 – 127 show an example of this We can now try question 3 on page 134 67
Bad debts
When a company knows it cannot recover money owed to them they have to write the debt off as a bad debt.
The bad debt will be shown in the expense section of the profit and loss account.
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Bad debts
How you deal with the bad debt depends on whether it has been recorded in the ledger system or not.
If the bad debts are listed in the trial balance then they have been recorded and you simply show them in the expense section of the P&L a/c and that is the end of it.
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Bad debts
If the bad debts are listed in the adjustments section of a questions it means that they have not been recorded in the ledger system yet but are still relevant to this accounting period. Therefore you will list them as an expense in the P&L a/c and you will also deduct the bad debt from the debtors in the balance sheet (current assets).
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Bad debts
How do you record the bad debts in the double entry accounting system?
Example: You sold £500 worth of goods to Sally Newstead on 31/5/02, unfortunately they went bankrupt in July and therefore can not pay you.
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Bad debts
Sally Newstead (debtor) £500 31/6/02 Bad debts 31/5/02 Sales £500 Sales 31/5/02 Sally Newstead £500 72
Bad debts
Bad debts account 31/6/02 Sally Newstead £500 31/12/02 P&L a/c £500 Profit and loss account 31/12/01 Bad debts £500 73
Provision for doubtful debtors (bad debts)
One of the accounting concepts that we apply to the financial statements is prudence, we should not overstate anything.
Therefore if we have many debtors it is realistic that some of those debtors will not be able to pay. Therefore the company has to estimate how many debtors will not pay and make a provision for them.
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Provision for doubtful debtors (bad debts)
How do you calculate them in a question?
You look in the trial balance and see what the provision was previously. You then look in the notes and see if there has been an increase or decrease in the provision for doubtful debtors.
You calculate the new provision by multiplying the percent (decided by directors) by the debtors figure in your trial balance.
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Provision for doubtful debtors (bad debts)
When you have calculated the new provision you subtract the provision that you located in the trial balance.
If your answer is positive it means the provision has increased therefore you need to insert the difference in as an expense in the P&L a/c. You then subtract the whole amount of the new provision from the debtors in the balance sheet.
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Provision for doubtful debtors (bad debts)
If your result is negative it means that the provision has decreased, you would then add the difference to the gross profit and then subtract the new provision from the debtors in the trial balance.
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Provision for doubtful debtors (bad debts)
How do you deal with the provision for doubtful debtors (bad debts) in the double entry accounting system?
Example: In the year 2000 you have £100,000 worth of debtors, it has been estimated by the directors and accountant, from previous experience that 3% of these debtors will not be able to pay you.
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Provision for doubtful debtors (bad debts)
31/12/00 P&L a/c £3000 31/12/00 Provision for bad debts £3000 P&L a/c 79
Provision for doubtful debtors (bad debts)
How do you increase the provision?
Example : the following year 2001 your debtors have increase to £120,000 but your estimated percentage remains at 3% The provision for this year should be £3,600, an increase of £600.
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Provision for doubtful debtors (bad debts)
P&L a/c 31/12/01 Provision for doubtful debtors (bad debts) £600 31/12/01 Provision for doubtful debtors (bad debts) Balance c/d £3,600 £3,600 1/1/01 Balance b/d £3000 31/12/01 P&L a/c £600 3,600 81
Provision for doubtful debtors (bad debts)
How do you reduce the balance?
Example: the following year 2002, the company’s debtors have decreased to £80,000, the estimated percentage of doubtful debtors remains the same.
Therefore the provision for this year should be £2,400 82
Provision for doubtful debtors (bad debts)
P&L a/c 31/12/02 Provision for doubtful debtors (bad debts), reduction £1,200 31/12/02 Provision for doubtful debtors (bad debts) P&L a/c £1,200 31/12/02 Bal c/d £2,400 3,600 1/1/02 Bal b/d 31/12/02 Bal b/d £3,600 3,600 £2,400 83
Bad/ Doubtful Debts Examples
We can now try Question 5 on page 135 Summary All the adjustments we have looked will be relevant for the calculation of the financial statements This is our next topic 84
Principles of Accounting
Preparation of the Financial Statements 85
Summary
So far we have looked at : Preparation of Trial Balance Various adjustments to balances in the Trial Balance We can now bring all this together in producing the Profit & Loss Account and the Balance Sheet 86
Calculation of Profit
Let us look at the example on pages 138 – 143 This demonstrates how the various adjustments are made However, the Profit & Loss Account is normally presented using the layout on Page 144 We should make sure we learn this layout 87
Key Points
The basic structure is : Sales Cost of Sales Gross Profit Other Income Total Profit Expenses Net Profit (Note that there is no opening stock as this is the first year of trading) 88
The Balance Sheet
Once the Profit & Loss Account has been prepared all remained Debit balances will be Assets These are divided into : Long-term assets (often depreciated) Short-term (current) assets such as stocks, debtors, prepayments and cash All credit balances will be capital or liabilities such as creditors, accrued expenses and bank overdraft 89
Balance Sheet Format
The Balance Sheet shows these groupings Fixed Assets Current Assets Current Liabilities Capital Employed and any long-term loans The format is on page 147 90
Practising forming Financial Statements
The handout contains a summary of the important information for the financial statements There are also four practice questions which we can work on 91
Celebrations Ltd - question
Ordinary shares @£1 46,150 Sales 100,000 8,000 Debtors Creditors Purchases Salaries and wages Interim dividends Debenture Sales returns Purchase returns 23,000 25,000 2,000 1,500 9,000 30,000 500 92
Celebration Ltd
Carriage inwards 300 Carriage outwards 200 Heat and light Stationary Professional fees Discount received Discount allowed Advertising Vehicle expenses Building at cost 400 250 1,250 250 100 950 100,000 750 93
Celebrations ltd
Insurance 350 Vehicles at cost Dep. On vehicles as at 30/10/00 6,500 Fixtures and fitting 10,000 Dep. On F&F at 30/10/00 Opening stock 12,000 Provision for doubtful debtors Cash Bank overdraft 3,000 195,050 3,250 3,000 400 2,000 195,050
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Celebrations ltd
1.
2.
3.
4.
Adjustments to the accounts:
Stock as at 30/1/01 was valued at £9,000 Company directors have announced a final dividend of 4p per share.
Bad debts have been exposed of £1,500, which have not been recorded yet.
There are accruals of £500 and £300 for heat and light and salaries and wages respectively 95
Celebrations Ltd
5) There are prepayments for professional fees of £200 and insurance of £50.
6) Tax has been calculated to be £2,500 for the year.
7) The debenture interest is set at a rate of 5%.
8) Provision for doubtful debtors has been set at a rate of 6%.
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Celebrations ltd
9) Depreciation for fixtures and fittings is at a rate of 10% on a reducing balance method, whilst vehicles is set at 2.5% on a straight line method.
You are required: to produce a profit and loss account and balance sheet for the accounting period 30/10/00 – 30/10/01 97
Sales Less sales returns Less cost of goods sold Opening stock Add purchases Less purchase returns Add carriage inwards Less closing stock Gross profit Add discount received £ 12,000 23,000 (500) 300 (9000) £ 100,000 (1,500) 98,500 (25,800) 72,700 750 73,450 98
Celebrations Ltd
Less expenses: Salaries and wages (25,000 + 300) Carriage outwards Heat and light ( 400+500) Stationary Professional fees (1,250 –200) Discount allowed Advertising Vehicle expenses Insurance (350 –50) Depreciation of vehicles Depreciation of fixture and fittings Provision for doubtful debtors ( 480-400) Bad debts 25,300 200 900 250 1,050 250 100 950 300 1,625 700 80 1,500 (33,205) 99
Calculate depreciation of vehicles (straight line method)
Find original cost of vehicle in your trail balance = £6,500 Then calculate 25% of the original cost (tells you to do this in note 9) £6.500* 0.25 = £1625 The £1625 is this years depreciation, which belongs in your profit and loss account.
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Calculation of depreciation of fixture and fittings (reducing)
Find the original cost in trial balance of Fixture and fittings = £10,000.
Find the accumulated depreciation for fixture and fittings in trail balance = £ 3,000 Subtract the Acc. Depreciation from the original cost.
£10,000 - £3,000 = £7,000 Calculate 10% of the balance (tells you in note 9) £7,000 * 0.10 = £700 £700 is the amount that belongs in your P&L a/c 101
Calculate provision for doubtful debtors
Read note number eight, calculate 6 % of your debtors figure, which is in your trial balance. (Debtors = £8,000) £8,000 * 0.06 = £480 Find last year provision for doubtful debtors, which is in your trial balance (400) Subtract last years provision from this years (which you have just calculated) £480 - £400 = £80 £80 is what belongs in your P&L a/c
The £480 belongs in your balance sheet, you
subtract it from your debtors balance.
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Celebrations Ltd
Profit on ordinary activities before interest, tax and dividends Debenture interest Profit on ordinary activities before tax + divs Less taxation Profit on ordinary tax before dividends Less dividends (2000+1846) Net profit (retained) 40,245 (1,500) 38,745 (2,500) 36,245 (3846) 32,399 103
Celebrations Ltd
Balance sheet for “Celebrations Ltd” as at 30/10/01 Original cost Accumulated depreciation Fixed assets Motor vehicle Fixtures
Building at cost 6,500 10,000 100,000 4,875 3,700
Net book value
1,625 6,300 100,000 107,925 104
Celebrations Ltd
Current asset
Stock Debtors Less bad debts Less provision Prepayment insurance Prepayment – professional fees cash £ 8,000 (1,500) (4,80) £ 9,000 6,020 50 200 3,000 18,270 £ 105
Celebration Ltd
Current liability
Creditors Accrual – proposed dividend Accrual – Tax Accrual – salaries and wages Accrual – Heat and light Accrual – debenture interest Overdraft £ 9,000 1,846 2,500 300 500 1,500 2,000 £ (17,646) £ 106
Celebrations Ltd
Net current assets Total assets less current liability
Less long term liabilities
Less Debenture Net assets 624 108,549 (30,000) 78,549 107
Celebrations Ltd
Financed by: Ordinary shares Retained profits 46,150 32,399 78,549 108
Principles of Accounting
Company Financial Statements 109
Company Accounts
There are a number of legal requirements for company accounts On this course we do not have to learn most of these Generally Company Accounts follow the same principles as sole trader accounts However, there are likely to be few extra items which we should learn 110
Capital Structure
A sole trader has a personal capital account and may also raise money from loans A company will have shareholders and these shareholders also own the retained profit in the company This will show in the bottom section of the Balance Sheet 111
Financed by :
This section will show as follows using Q4 on Page 227 as an example : Financed by : Issued Share Capital Profit & Loss Account 560 180 (Retained profit) However, further adjustments must be made 112
Further adjustments
Share Premium Account This is also part of Share Capital and appears in the same section It is that part of a share issue which is above the nominal value of the shares We can treat it as though it is Share Capital Also we must add (subtract) any retained profit (loss) for the current year 113
Preference Shares
A further category of Share Capital is Preference Shares although these are less common than previously They are still shareholders but they receive a fixed dividend and take priority over ordinary shareholders (although they come behind interest paying capital) 114
New Format
This now becomes Financed by : Issued Share Capital Share Premium Account Preference Share Capital Profit & Loss Account profit for year 560 140 180 + 115
Loan Capital
A popular way of raising capital for companies is to issue debentures These represent a loan to the company and bear a rate of interest which relates to their nominal value (they are likely to trade on financial markets at different values) This item is shown at the end of the top section of the balance sheet You may also have to add accrued interest (although example on page 227 shows full charge) 116
Dividends
Shareholders (and preference shareholders) are entitled to receive dividends The full dividend is declared after the year end as Final Dividend This will not be in the Trial Balance This should be subtracted from Net Profit after Interest and Tax to give retained profit The company may make early payment of an interim dividend This will be in the Trial Balance You need to accrue the difference between the Final Dividend and the Interim Dividend 117
Taxation
Interest is an allowable expense against taxation Dividends are not an allowable expense Therefore taxation is shown after Profit after Interest It is again likely that some or all of the taxation charge will need to be accrued 118
Other Items
Directors remuneration (emoluments) Companies must have directors Remuneration means salaries and this must be shown as a separate expense Audit Fee It is a legal requirement that companies are audited and the fee is an expense against profit Again watch out for possible accrual as it may be paid after year end 119
Final Points
Deferred taxation This appears on page 227 example We can ignore this on this course Other issues In practice, companies are required to produce a number of detailed notes to support their accounts Again, we will ignore this for this course 120
Practice Questions
One question on the test will be like this Two questions are attached I have put all the headings for the answer to the first question I have put them twice so if you make mistakes when you try it we can put the correct answer in the second part You have to do these yourselves for the second question as in the test 121
Principles of Accounting
Analysis of Financial Statements 122
Ratio Analysis
Now we know how to construct financial statements Next we need to know how to use this information to interpret and compare performance Many ratios can be calculated to help us to do this 123
Use of Ratios
Although absolute values can be useful, ratios are most useful for comparisons Either over time or across different companies E.g Gross Profit Margin = 25% Is this good or bad ?
Impossible to tell and varies widely If 2001 : 31%, 2002 : 27%, 2003 : 25% Then perhaps there is a problem But even then may be related to whole industry 124
Calculation of Ratios
We shall use the accounts on pages 246 & 247 of the textbook Notice that current share price is 2 pounds per share Ratios are split into different categories It is important to understand them as well as calculate them 125
Profitability Ratios
Gross Margin = Gross Profit/Sales * 100% 142/350 * 100% = 40.6% Net Margin = Net Profit (before interest and tax)/Sales * 100% (28+4)/350 * 100% = 9.1% These ratios can give an indication of profitability but really need to compare trends 126
Liquidity/Solvency Ratios
Current Ratio = Current Assets/Current Liabilities 92/51 = 1.8 : 1 Gives some indication of ability to meet debts But may be difficult to sell stock quickly so Quick Ratio = (Current Assets – stock)/Current Liabilities (92 – 45)/51 = 0.92 : 1 Sometimes also called ‘acid test’ 127
Working Capital/Activity Ratios
Look at relationship between current assets/liabilities and cash These affect a company’s working capital requirement Stock Turnover = Cost of Goods Sold/Average Stock 208/((35 + 45)/2 ) = 5.2 times ( 365 days/5.2 times = 70 days) 128
Continued
Collection Period = (Trade Debtors * 365)/ Sales (40 * 365)/ 350 = 42 days Should be compared with credit terms Payment period = (Trade Creditors * 365)/Cost of Sales (23 * 365) / 208 = 40 days If this ratio is growing it may show cash problems 129
Long-term Solvency Ratios
Shareholders Equity Ratio Shareholder Equity/Total Assets * 100% (80 + 31) / (130 + 92) *100 % = 50% Related to Gearing ratio and is indicator of financial stability Higher ratios can more easily allow for changes in profits 130
continued
Interest Coverage Ratio (Interest Cover) Profit before Interest & Tax/Interest Charges (28 + 4) / 4 = 8 times Gives an indication of the risk of not being able to pay interest 131
Financial Performance Ratio
Most important is usually considered to be Return on Capital Employed Operating Profit (before interest and tax)/ Total Assets less current liabilities * 100% 32/171 * 100 % = 18.7% This ratio can be broken down in order to better understand it 132
Return on Capital Employed (ROCE)
ROCE = (Sales/Capital Employed) * (Profit/Sales) * 100% 350/171 * 32/350 * 100% = 18.7% 2.05 times & 9.1% Have a look at this expression Sales will cancel so it is the same as previously The two components analyse different things How effectively are assets used to generate sales How profitable are sales Page 253 shows how this breakdown can be taken even further 133
Investment Ratios
Earnings per Share (EPS) Companies are required to show this calculation in their accounts EPS = Profit attributable to ordinary shareholders/ Average number of shares in issue 12/80 = 15 pence per share Useful to establish trends and to calculate Price/Earnings P/E ratios 134
P/E ratio
P/E ratio = share price/earnings per share 2 pounds/ 15 pence = 13.3
This is a very popular ratio It measures the numbers of years earnings (profits) represented by the share price It measures investors’ expectations for the future Financial Press will often show a forward P/E ratio This is based on forecast profits rather than historic profits 135
Dividend Ratios
Dividend Yield = Dividend per ordinary share/ Market Price of share (5,000/80,000)/2 = 6.25 pence/2 pounds = 3.1% This ratio has become more important since the end of the Bull Market Dividend Cover = Profits attributable to ordinary shareholders/Total ordinary dividend 12,000/5,000 = 2.4 times This gives some indication of risk of not maintaining dividend and can be used with Dividend Yield 136
Practice of Calculation and Analysis
This is a very important area which needs a lot of practice First calculate the ratios in Q1, pages 260 –261 and then we can analyse them 2002 2001 Current Ratio Acid Test (Quick) 137
Practice of Calculation and Analysis
Next try Question 3, page 262 Calculate the following : Return on Capital Employed, Sales/Capital Employed, Net Profit/Sales, Current Ratio, Quick Ratio, Stock Turnover, Debtor Collection Period, Creditor Payment Period Next we can analyse these together Finally we can try question 4 138
Principles of Accounting
Cash Flow Statements 139
Background
Purpose of Cash Flow Statements To report the cash receipts and payments of an accounting period Remember the Profit & Loss Account is produced on a matching and accruals basis In the UK, the first Financial Reporting Standard, FRS 1 “Cash Flow Statements” introduced this requirement in 1991 140
Use of Cash Flow Statements
Financial Reporting should help users to make decisions about the company Finance theory says that decisions relating to investment in a company should be related to that company’s future cash flows Historical cash flow information (Cash Flow Statements) may provide a guide to future cash flows 141
Use of Cash Flow Statements
Other users may make decisions based on liquidity and viability (ability to survive) Usually the Balance Sheet is used for this purpose (maybe by calculating ratios) However, this only refers to a single period in time Cash Flow Statements show a whole period and can improve understanding of liquidity
The theory for changes in Cash
Fixed Assets + Current Assets = Long-term creditors + short-term creditors + capital and reserves This can be rewritten as : Cash = long-term creditors + short-term creditors + capital and reserves – fixed assets – stocks – debtors This equation shows the main inflows and outflows of cash and forms the basis of the Cash Flow Statement 143
Headings for Reporting
1. Operating Activities The cash effects of normal trading activities Profit adjusted for non-cash items such as depreciation, profit/(loss) on asset disposals and working capital movements 2. Returns on Investments and servicing of finance Mainly dividends received and interest both paid and received 144
Headings for Reporting
3. Taxation Shows tax actually paid (Profit & Loss Figure is likely to be different due to accruals) 4. Capital Expenditure P & L A/C spreads cost by depreciation. Here we identify cash flows to purchase and from disposal of fixed assets and investments 145
Headings for Reporting
6. Dividends paid As with taxation likely to differ from the P & L A/C figure 7. Financing Receipts from or repayments to external providers of finance Includes receipts from share issues and from new debentures/loans taken out (but NOT bank overdraft) Payments includes repayments of loans and repurchase of own shares 146
Reconciliation of Net Debt
This is shown as a separate section after the Cash Flow Statement It explains how the company cash balance has changed and should balance with the Cash Flow Statement Essentially this shows movements in cash and bank balances 147
Producing Cash Flow Statements
We shall do two examples I have included the working headings as part of the cash flow statements to make it easier for you to understand Q2, Pages 239 – 240 : We will do this question together to understand the method Q4, Pages 241 – 242 : Now, you do this question using the headings in the handout 148