Introduction to Accounting for Business BF1120 PDF

Introductory to Accounting for Business - BF1120 Week 1: Luca Paciolo - an italian mathematician - is regarded as the father of accounting What is Accounting It is a systematic process of Identification(Select economics events(transactions)), Recording(Record, classify, and summarise),Communication...

Introductory to Accounting for Business - BF1120 Week 1: Luca Paciolo - an italian mathematician - is regarded as the father of accounting What is Accounting It is a systematic process of Identification(Select economics events(transactions)), Recording(Record, classify, and summarise),Communication(Prepare accounting reports)..financial information. Language of Business Based on Double Entry Accounting - ie recorded twice Purpose of accounting Provide useful accounting information Assist users make informed decisions Managers - fire/hire staff - open/close branch Customer - continue buying or stop buying a certain product Lenders - to lend or not to lend Business produce financial reports to inform external stakeholders of the business’s financial performance and position Users of accounting information Could be anyone - users affected by the businesses decisions Interest Group Internal/External Interests Decisions Shareholders/Owner External Dividends and Growth Sell/buy more shares Potential Investors External Future plans, potential Investment, buy shares Trade Creditors External Cash and Time Selling, receive payment Lenders e.g Banks External Cash and Security Repayment Customers External Products and Prices Continuity Government External Profits and Sales VAT,Tax Trade Unions External Rights of employee Continuity Employees Internal Pay, progression, stability Continuity, performance Management Internal Pay, shares, promotion Continuity, performance Internal comes from within the organisation Owner can be both - privately owned small business are typically internal - bigger businesses may be external Stakeholders - BBC Bitesize Video Context - Atlantis Resources LTD. have been making ‘big waves’ in the renewable energy sector. Underwater wind farm - use the forces of the tide to generate electricity which is exported to the National Grid. National Grid as a customer has a key interest in the success of the project - thus considered an external stakeholder Stakeholder - defined as any group or any person who has an interest in a business Stakeholders can influence how a business operates. Internal Stakeholders - Owners - Shareholders - Managers - Employees Large variety of Stakeholders - such as environmental stakeholders - banks - financers - local communities - landowners (The Crown Estate) Satisfying the environmental stakeholders can increase costs for a business - this may not be popular with financial stakeholders but may be with customers, local communities etc. Employees: Pay,progression, business stability to decide whether to stay in the company or leave Customers: Product availability, quality and prices for purchasing decision Management: Pay, share, promotion to manage performance and decide on continuation working there or elsewhere Potential Investors: Business Stability, future plans and growth prospects to decide whether to buy or invest Lenders: Cash and security to ensure receipt of repayment on time Government: Profit and sales revenue for tax revenue purpose Trade Creditors: Cash Flows to determine possibility to receive payment on time and payment track record to decide whether to keep trading with the business or to revise credit terms - 이것 뭐예요? Trade Unions: Rights of employees to protect and advance the interest of its members in the workplace Shareholders: Dividends growth capital appreciation to decide whether to keep investment in the business add more investment or move their fund elsewhere Quality of Accounting Information To be useful the information should possess certain qualities: There are two fundamental qualities that determine the usefulness of accounting information.In addition there are four qualities that enhance the usefulness of accounting information. The benefits of providing the information, however, should outweigh the costs.이것 뭐예요 Influences users’ decisions; Material Accounting Information should be Relevant - if the decision does not change by the omission of the information that it is not relevant. To be relevant it must have either predictive or confirmatory value. Predictive Value: Helps users make prediction about future outcomes Confirmatory Value: Provides feedback about previous evaluations Complete, Neutral, error-free Complete: All necessary information is included Neutral: Free from bias Free from error: Accurate and reliable Enhancing qualities Comparability - performance over time - competitor - industry - across different companies Timeliness - produced in time to ensure usefulness - can influence decisions in time - although some information make continue to be timely- like data identifying trends Verifiability - independent observers should be able to reach a consensus that the information is faithfully represented - hard evidence - attestable - faithful representation Understandability - clear and concise Financial vs Management accounting Financial Accounting Management Accounting - Introduction to accounting, - Product costing and pricing Accounting Principles and the - Cost - Volume - Profit (CVP) financial statements analysis for decision making - Statement of Financial - Using relevant costs for Position(SoFP) decisions - Income Statement (IS or - Cash and profit budgets P&L) - Budgetary control using - Cash Flow Statement variances and Key Performance - Introducing key accounting Indicators (KPIs) treatments on.. - Current assets - Inventory valuation - Provisions - Interpretation of financial information - Introduction to the socio-political context of accounting a.k.a Sustainability Accounting Management accounting provides information for managers of an organisation who direct and control its operations. Concerned with providing financial and non-financial information to a company’s management - to aid them in decision making Seeks to meet the accounting needs of managers Financial accounting provides information to shareholders,creditors and others who are outside the organisation. Focuses on recording, summarising and reporting the financial transactions of a business over a specific period - balance sheet - income statement Primary goal is to provide accurate financial information to external stakeholders such as investors, creditors, regulator agencies, lenders. Seeks to meet the needs of owners and lenders and other uses More future looking with management accounting. Financial accounting - only reports financial transactions in the past - serves the interest of external users. Management more private whilst financial has more public information. Differences seen in the purpose of accounting where financial accounting aims to provide a true and fair view of the financial position through external parties. Whilst management seeks to aid internal decision making. The periodicity is also different whereby the financial year, annually is when the reports are generated in financial reporting. Management is generated when needed - could be weekly, could be monthly. Financial accounting is highly regulated whilst management accounting is highly flexible - not bound by standards. Financial is to report past performance - Management is for future planning - projection information. Financial reports are generalised whilst management are detailed and specific -?? Financial statements are public - management is not published. Will read further on the ‘Income Statement’ Further reading on: What distinguishes Accounting and Finance: Accounting: refers to the system of recording, summarising and reporting financial information about a business. Such information is useful to a wide range of stakeholders who make decisions about their business. Finance: refers to the ways in which funding is raised and invested by a business. Without finance, businesses would not be able to purchase the resources necessary to produce their goods and provide their services. Finance is supplied either by the owners of the business or the lenders. Remuneration?? External stakeholders require high level, summary reports that reflect the financial performance and position of the business and they do not need this information as frequently as internal stakeholders, such as management. Financial statements are used to meet these needs. Internal stakeholders, i.e. management, need more detailed information in order to make informed, timely operational decisions; they use management accounts to support this function Management accounting is the provision of reports for use in a managerial capacity. Financial accounting is the provision of external financial reports. The conceptual Framework for Financial Reporting(2010) identifies three primary users of financial accounting reports: - Investors - Retain or sell current investments - Whether to invest further - Approval of managements reward package - Lenders - Whether to offer funding to a business - What interest rate to change (greater risk generally results in greater interest) - Whether to try and recover a loan if there is doubt about a business’ financial position - Creditors - Whether to continue trading with a company - How much credit to offer - Whether to take action to try and recover monies(?) owned The flow of accounting information: Step 1 - Identification: Step 2 - Accounting entry: Step 3 - Making information manageable: Step 4 - Making information understandable: The trial balance is a summary of all of the separate accounts of an organisation; its purpose is to provide a list of the total of each account held by the organisation, which can then be used to create the financial statements of a company. The trial balance is not presented in any particular structure or format and would not create particularly useful information to a user of the accounts as it would not be easy to identify figures such as total assets and total liabilities, for example. Ultimately the trial balance is a crucial step in the creation of the financial statements provided to users but is not itself a report given to them. Introduction to the Financial Statements: Financial statements must portray financial effects of transaction and other events by grouping them into broad classes according to their characteris…. BF1120 - Introduction to Financial Accounting: Accounting concepts (rules and regulation) Major Financial Statements Statement of profit and loss(Income Statement) Statement of Financial Position Statement of Cash flows You’ve been left a significant sum of money - You want to invest the money in shares to provide you with a dividend income. How would you decide which shares to invest in - Shoe Zone or JD Sports.. Businesses produce financial reports to inform external stakeholders of the business’s financial performance and position Stakeholders use these statement s to make decisions about the allocation of their resources(mostly cash) Example of decisions made using accounting information Should I buy/sell shares in a business Should I lend money to a business Should I buy/sell products from a business Should I work for this business Financial Accounting Basic accounting concepts and principles Introduction to the main Financial Statements Income Statement Statement of Financial Position Statement of Cash Flows The accounting entity concept defines the entity for which accounting data is collected Separation between business vs owner Owner must identify and treat business cost and private cost separately Only business transactions to be changed into company’s financial statements Accounting period concept The accounting period concept defines the unit of time for which accounting data is collected The main accounting period is usually considered to be 12 months (or 52 weeks). Some large business may choose or be required to produce interim(?) financial statement for periods of less than one year Accounts are prepared at the end of this period. Business transactions that incurred within these 12 months must be reported within this accounting period. Business transactions that incurred before (after) that 12 months must be reported within the past (future) accounting period. My guess is that JD Sports’ accounting period is from 30/29/28(end of) January to 30/29/28 January the next year. 1.3 Accrual basis of accounting The accrual basis of accounting adopts the view that the effects of transactions are recognised when they occur (not as when cash is received or paid). Only expenses and income generated in that accounting period to be recognized in that period,regardless if they were paid or not yet paid. Monies(?) paid or received during the current account period which belong to another period are not accounted for in the current accounting period (accounted in the next period or past period if they belong there). Confusing - but my guess is - it will be in the next account period from 01/01/2024 1.4 Matching Concept The matching principle in accounting is a process that involves matching a company’s expenses with its corresponding revenues in the same accounting period. This ensures accurate financial reporting and adherence to generally accepted accounting principles. Q1 - (b) Q2 - (b) 1.5 Going concern assumption An assumption that a business has: The resources needed to continue operating indefinitely until it provides to the contrary No threat of bankruptcy Accounts / financial statements are prepared according to the assumption that the business is a going concern. If this is not the case (i.e. the business is not likely to continue in the future) then different accounting procedures would be adopted. Example: XYZ Ltd has an asset valued after depreciation at £1,000. Saleable value(?) at current period is £500. If the business is a going concern, the asset will be recorded as £1,000 in its Financial Statements. If the business is not going concern , the asset is recorded as £500 in its Financial Statements. Overview of the Major Financial Statements Income Statements - (Profit and Loss Account/Statement) Statement of Financial Position (Balance sheet) Statement of cash flows Guess/Try Example - you are looking for extra cash to buy a new smartphone - sell balloons to buy it - Business transaction on the 24th September 2024: Invest £40 Bought 50 balloons form supplier, paid cash £40 Sold 40 balloons, received cash £60 Questions - How much are your: Selling a balloon for £1.50 even though costs £0.80 1. Cash balance as at the end 24th September 2024 a. 60 2. Profit/loss generated on 24th September 2024 a. 28 profit 3. Assets as at 24th September 2024 a. ? 4. Equity as at 24th September 2024  a. ? 2. Overview of the Major Financial Statements Income Statement - (Profit and Loss Account/Statement) Revenues, income and Expenses How much profit (wealth) was generated? Measures financial performance over a period Statement of Financial Position - SOFP, SFP (Balance Sheet) Assets Liabilities and Equity What is the accumulated wealth of a business at the end of a period and what form does it take? Provides a snapshot of financial position at a given date Cash Flow Statement What cash movements took place? Shows a breakdown of the reasons for changes in cash during a specific period Main elements of income Statement: INCOME - increases in economic benefits during the reporting period in the form of inflows or enhancements in liabilities , that result in increases in equity, other than those relating to contributions from equity investors. EXPENSES - decreases in economics benefits during the reporting period in the form of outflows or depletion of assets, or incurrences of liabilities that result in decreases in equity, other than those relating to distribution to equity investors. PROFIT/LOSS = INCOME - EXPENSES SOFP elements ASSET A resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. LIABILITY A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. EQUITY The residual (owner’s) interest in the assets of the entity after deducting all its liabilities Financial year 2022 : Statement of cash flows A financial document that provides a detailed summary of the cash inflows and outflows for a company over a specific period. The main function of the cash flow statement is to give insights into a company’s liquidity and solvency - showing how well it manages its cash position. Main components Operating activities Investing activities Financing activities Components Description Example Cash Example Cash Inflows Outflows Operating Cash receipt from/paid Receipts from sales, Payments to activities for business activities interest received suppliers, wages, that generate revenue interest, taxes and incur expenses Investing Cash spent on and Proceeds from sale Purchases of activities generated from of assets assets (property, investment-related equipment, activities during patents), invest in a specific period. securities (stocks, bonds,financial instruments Financing Cash spent on and Proceeds from Repayment of activities generated from issuing shares, loans, dividends, capital raising activities borrowing funds repurchase of and investor relation shares, payment of dividends 2. Prudence Convention/Concept We should be conservative in the preparation of our accounts Only recognise revenues when we are reasonably sure they will be received  Understate profits / revenues / assets Overstate costs / liabilities Prudence concept is important when thinking about the collapse of Enron in 2001 Accounting issues including revenue recognition issues contributed to the collapse of Enron which had significant consequences including: Employees - 4,500 employees lost their jobs Shareholders - loss of $60 billion of share value Auditors - Arthur Andersen lost their auditing accreditation after conviction pf obstruction of justice relating to the Enron audit Pension holders - lost their pension funds Financial reporting rules improved - Sarbanes-Oxley Act This practice was against the prudence concept Example - my lemonade enterprise In early September 2024 - you signed a catering contract: Oct to Dec: 150 each month A possible increase to 250 (extra 100) in Dec should you are chosen to cater the client’s Christmas party Q: How much revenue should you recognise from this contract in Oct to Dec 2024: Oct 2024 = 150 Nov = 150 Dec = 150 The extra 100 in Dec is uncertain To be prudent, you must not recognise that extra in Dec yet. —------------------------------------------------------------------------------------------------------------------------ _________________________________________________________________________ Manager studying Accounting and Finance: Why Accounting/finance function is a central part of business management system - accounting information is the language of business Managers must understand financial statements - involved in planning and decision making Prepare forward looking financial statements Set financial targets Allocation of limited resources - cost vs benefit Communicate with the other departments and clients Understand the impact these financial decisions have on financial statements and operation Personal financial management Track income and expenses Budgeting, saving and making decisions Decision making - e.g investment Tax compliance Business insights Understand financial statements Manage cash flows Decision - investment, purchase and sales etc Comply with regulation - e.g tax Not duped by your finance personnel/department Enhance career advancement Understand the financial aspect of your role —------------------------------------------------------------------------------------------------------------------------ _________________________________________________________________________ Seminar - 03/10/24 Multiple Choice Questions: The purpose of accounting a)Providing useful accounting information b)Providing information that will enable users to make informed decisions c)Identification, recording and communication of business activities d)All of the above Answ=d 2.The foundations of accounting are based upon what kind of bookkeeping ? a)Single entry b)Double entry c)Triple entry d)Cash Accounting Answ=b 3.The Finance Director of Screen Plc required junior accounting staff to take great care in assessing whether the company has enough cash to pay its bills as they fall due. This is justified primarily by which accounting concept? a)Going concern b)Materiality c)Profit d)Matching Answ=a What is accrual accounting? a)A method of financial reporting where revenue and expenses are recognized when earned or incurred. b)A method of financial reporting where revenue and expenses are recognized only when cash is received or paid partly or full. c)A method of financial reporting where revenue and expenses are recognized only after cash is received or paid in full. d)A method of financial reporting where revenue and expenses are recognized randomly. Answ=a 5.Why is accrual accounting important? a)It provides a more accurate representation of a company's financial position and performance b)It helps companies increase their profits. c)It is a legal requirement for all businesses. d)It is a method of tax evasion. Answ=a 6.Which of the following reflects the effect on the accounting equation of a purchase of an item of plant and equipment, for cash? a)Assets increase: ownership interest decreases. b)Assets decrease: ownership interest increases. c)Assets unchanged: ownership interest unchanged. d)Assets decrease: ownership interest unchanged. Answ=? Answ=c* Name three internal users of accounting information Mangagers, Employees, Name five external users of accounting information Shareholders, Lenders, Government, Trade creditors,Potential investors, (Trade Unions) What are the three main financial statements? Briefly describe each of their roles Income statement = the financial performance of business over time Cash flow statement = shows the breakdown for reasons in changes of cash over a specific period Statement of financial position = ASSET = LIABILITY + EQUITY Current assets Non-current Current Non-current Equity assets liabilities liabilities 10,000 68,250 15,000 28,000 35,250 6,000 17,000 8,000 2,500 12,500 17,800 52,000 17,000 25,000 27,800 25,000 75,000 35,000 13,000 52,000 20,500 47,800 13,850 28,850 Case study: Users of accounting information TechCorp’s decision to sell its AI technology to InnovateX isn’t shocking, but the timing and price are surprising. TechCorp, once valued at £200 billion, sold the AI technology for less than £10 billion. This is unexpected because TechCorp seemed to be doing well with its AI products, especially the smart home device ‘AIhelp’, which launched last spring. Priced under £100, it gained popularity in South-East Asia and North America. The AIhelp series did well because competitors didn’t focus on the sub-£200 market. So, why sell now? It might be because the smart home device sales dropped so much that TechCorp had to act quickly. Their smart home devices did well in 2022 but struggled against cheaper Android devices in 2023. The latest £50-80 smart home devices from Google’s partners might have hurt TechCorp’s business, forcing them to sell. Apple’s new budget HomePod could also pressure TechCorp’s high-end AI Assistant sales. (Adapted from: https://www.theregister.com/2024/05/05/Microsoft_Nokia_anniversary/) List what your concerts would be about this story if you were: Stakeholders Concerns A holder of TechCorp shares A holder of InnovateX shares A supplier to TechCorp A TechCorp business customer  A TechCorp employee A government authority in a country where TechCorp operates A bank who lends large amounts of capital to TechCorp The management of TechCorp Discuss how financial accounting information might help you address those concerns What other information would you like to help you address those concerns… —------------------------------------------------------------------------------------------------------------------------ _________________________________________________________________________ Income Statement - 04/10/24 - On campus lecture (Didn’t do prework - don’t know what she's on about..) —------------------------------------------------------------------------------------------------------------------------ _________________________________________________________________________ Week 2.1 Income statement Income statement/Statement of Profit and Loss Measures financial performance of the business over the accounting period Revenues and expenses for the period Three measures of profit Gross profit Operating profit Net profit or Profit for the period, i.e (Total revenue less total expenses) Profit of Loss for the period Formula sheet for your keeping Gross profit = Revenue - Cost of sales Operating profit = Gross profit - operating and administrative costs Net profit = Operating profit + other income - other expenses - taxation Net profit - Total revenue - total expenses Other terms for Net profit - Profit for the year - Profit available/distributable to shareholders - Earnings after taxation - Etc - i.e the FINAL ultimate profit for the year Week 2.2 Revenue Represents the inflow of economic benefits arising from ordinary operations of a business Results in either Increases in assets (cash inflow) Decrease in liabilities Week 2.3 COS Expenses Cost of sales or cost of goods and operational expenses Administrative and operational expenses Represents the outflow of economic benefits arising from ordinary operations of a business Resulting from Decrease in assets (e.g. outflow of cash to settle obligation) Increase in liabilities (e.g. amounts owed to suppliers to settle in future) Main categories: Cost of sales (COS) / cost of goods sold (COGS) – directly related to sales Expenses – operation, administrative cost Could be cash or non – cash e.g. Depreciation(non-cash expense e.g value of machinery\), Allowance for Doubtful Debts are non-cash expense 3.1 Cost of sales or Cost of goods sold Costs which are directly incurred in achieving the sales income. Costs that can be directly associated with the sale of the good in question. The cost of buying or making the goods that are sold during the period concern e.g. raw materials, direct labour wages Other examples Industry (Usual) Cost of sales Manufacturing Direct Labour: Wages paid to workers directly involved in production, such as assembly line workers. Direct Materials: Raw materials used in production, like steel for car manufacturing or fabric for clothing Service Direct Labour: Salaries of employees providing the service, such as consultants or technicians. Supplies: Materials used in delivering the service, like cleaning supplies for a cleaning service Retail Inventory costs: Cost of goods purchased for resale Technology Direct Labour: Salaries of software developers and IT support staff. Hardware and Software: Costs of equipment and software used in development 2.4 Calculation of COS and GP How to find COS or COGS Opening Inventory Values of supplies at start of the business or value of supplies carried forward from the last period (+) Purchase How much value of new purchase made in the period ( - ) Closing Inventory Value of the remaining supplies at the end of the month. Will become opening inventory in the next period Opening Inventory (+) Purchase ( - ) Closing Inventory = COS or COGS How to find Gross profit Revenue Revenue is the total amount of money a company earns from selling its products or services before any costs or expenses are deduced. ( - ) COS or CGOS Total direct costs incurred in producing or purchasing the goods that a company sells =Gross profit/Loss Excess revenue over COS = Gross profit Excess of COS over revenue = Gross loss  Revenue ( - ) COS or CGOS = Gross profit/Loss Week 2.5 Operating expenses and profit Operating / administrative expenses Cost incurred in day-to-day operation of the business Supporting units - e.g office, clerical Examples Salaries (of office and administrative employee) Rent (office) Rates Utilities - Heat, light and water(not for office?) Telephone bills / broadband Insurance Motor vehicle running cost e.g fuel, maintenance Depreciation of assets Marketing Permit / licensing How to find operating profit Gross profit Revenue - COS or CGOS Total operating and administrative expenses Total costs incurred in day-to-day operation of the business =Operating profit Excess of Gross profit over total operating cost = operating profit Excess of total operating cost over gross profit = operating loss Gross profit - Total operating and administrative expenses = operating profit Net profit Net profit = Operating profit + other income - other expenses - taxation Net profit = Total revenue or total income - total expenses Week 2.6 Revenue recognition Accounting convention/concept/rules in: 1. Revenue recognition 2. Prudence 3. Matching revenue and expenses Basic Revenue Recognition Criteria The amount of revenue must be able to be measured reliably It is probable that economic benefit will be received Additional criterion Ownership and control of the items should pass tp the buyers (in the case of sale of goods) Recognise revenue in the accounting period in which the performance obligation is satisfied Revenue recorded in Sep 2024 Week 2.7 Prudence Prudence Convention /Concept We should be conservative in the preparation of our accounts Only recognise revenues when we are reasonably sure they will be received UNDERSTATE PROFITS/REVENUES/ASSETS OVERSTATE COSTS/LIABILITIES Accounting issues including revenue recognition issues contributed to the collapse of Enron which had significant consequences including Employees: 4,500 employees lost their jobs Shareholders: loss of $60 billion (US) of share value Auditors: Arthur Andersen lost their auditing accreditation after conviction of obstruction of justice relating to shredding and doctoring documents relating to the Enron audit Pension holders: lost their pension funds  Financial reporting rules improved: Sarbanes-Oxley Act Enormous profit reported which led to increase in shareholder sentiment - but actually they reported future revenue and did not report any losses made Unless you have documentation or an invoice.. Week 2.8 Matching Principle The matching principle in accounting is a process that involves matching a company’s expenses with its corresponding revenues in the same accounting period This ensures accurate financial reporting and adherence to generally accepted accounting principles Application of matching principles in cost of sales and revenue Inventories are assets Held for sale in the normal course of business (i.e finished goods) In the process of production for sale (i.e work in progress) or In the form of materials to be consumed of goods for sale (i.e raw materials) Cost of sales includes the costs of the inventory sold during the period. This is an application of the ‘matching principle’ i.e the revenues earned from selling inventories are matched to the costs of the inventories sold. The costs associated with the inventory that remains unsold are carried forward ( as current assets to the next year where they will be recognised when the inventory is sold Recognising expenses on Income Statement Match expenses with revenues in the period when the business generated those revenues Recording expenses when they are incurred Means that expenses reported in the SPL may not be the same as the cash paid during the period The expense may be more or less This gives to prepaid expense or accrued expenses According to matching principle Match expenses with revenue in the period when the business generated those revenues Trading licence and permit for july cost £20 - this support revenue generation in July 2024 - Therefore we can only recognise £20 as expense in July 2024 Recording expenses when they are incurred and not when paid £20 is the monthly trading licence and permit - we only pay this much to enable us to trade in July - while £240 is for the whole year - £220 (£240-£20) does not incur yet in july 2024 because this cost cover Aug 2024 - June 2025 - hence we only recognise 20 in July (...and £20 in Aug, £20 in Sep…) This is a prepaid expense - expenses paid in the current year for the next year. Depreciation - non-cash expense Businesses use non-current assets ( fixed assets) to generate revenues The matching principle requires us to match the cost of using up of these assets to the revenue the business generates in each period We do this through depreciation, spreading of the cost over the life of the asset Depreciation - non-cash expense The allocation of the cost of a plant asset to expense in the periods in which services are received from the asset Videos - What is depreciation - Straight line depreciation method -Reducing balance depreciation method Week 2.9 Relationship between Income Statement and Statement of Financial Position How does profit fit with the statement of financial position The owners have taken the risk, put money in, so they own the profit that comes out (They are also liable for losses) The statement of Financial Position has a section for showing the ownership interest in the company - equity So, the net profit or loss is added to this section under the heading ‘retained earnings’ Net profit - IS and Equity-SFP Assets = Liabilities + Equity Chapter 3, Atrill McLaney Accounting for non=specialists (2022) Week 2 Lecture notes - also need to rewatch lecture.. Income statement Financial Statement Analysis Financial Statement Analysis is a technique used by analysis to achieve information useful for decision making including: - Assessing the financial health of a business - To compare current performance with past performance - To compare and benchmark against industry competitors and even across other industries Objectives of Financial Statement Analysis Investors use financial statement analysis to - Predict expected returns - Assess the risks associated with those returns Investors are more concerned with profitability and future security prices Creditors are primarily concerned with - Short-term liquidity - how much cash a company has on hand to meet current payments when due - Long-term solvency - a company’s ability to generate cash to repay What is financial statement analysis Relative figures (instead of absolute figures) Single items on financial statements don’t tell the whole story For critical analysis we need relative figures i.e ratios… Why ratio? Absolute numbers don't tell us a lot E.g size of company, assets employed will impact the perception of whether an increase in profits means that performance has improved. ‘Can we tell if Sainsbury’s financial performance is better than Tesco’s’ Why ratio: Current year’s profit needs to be compared with other information such as (e.g:) Last year’s profit The current year’s sales The profits of other entities in the same industry The value of assets used to generate the profit Comparative Analysis Types of useful comparative information: INTRA-entity basis: Comparison of single entity past performance with the current performance ( detects changes in financial relationships and trends) INTER-entity basis: Between other entities(indicates competitive position) May also include comparisons to industry average (determines position relative to others) Uses of Financial Ratio Analysis Provides quick and simpler means of assessing the financial health of a business In comparison to past years In comparison with competitors In comparison to plan/budget Provide a starting point for further investigations. Which questions to ask Highlights strength and weaknesses of the question Limitations of Ratio Analysis Ratio analysis indicate problems, it won’t necessarily recommend solutions Only a detailed investigation will reveal the underlying reasons Financial statements are historic in nature ( backward rather than forward looking/out of date) Comparison of results made difficult by: Use of different accounting policies One off items that distort results ( e.g large bad debt, restructure, redundancy) Definition used (e.g ROCE, Gearing, capital employed)  Year end balances not always representative of period as a whole (e.g: high inventory levels before Xmas) Co has different accounting period Profitability Ratio - Shoe Zone Pic Profitability ratios Gross profit ratio Operating profit ratio Net profit ratio Important* Ratio Formula Measures Gross (Gross Relates Gross profit to the revenue Profit Profit/Revenue)*100 How much profit an organisation makes on each sale? How well the cost of sales (manufacturing or purchased costs) are managed by a company? Operating (Operating Measures how well a company has controlled its Profit Profit/Revenue)*100 operating expenses. Changes may be due to: Changes in revenues Changes in operating expenses Net Profit (Net Profit/Revenue)*100 Measures a company's profitability after all Ratio expenses (including taxes) relative to its revenue Return on (operating profit/ capital Measures of how well a company is at generating Capital employed) profit against the total amount invested in the employed company. Measures the efficiency with which capital employed has been utilised Capital Total Assets - current Capital employed in this ratio equals long-term employed liabilities OR funds so it includes equity and long-term liabilities, Total equity + non current or value of available assets liabilities Revenue increases more (6.1%) then increases in cost of sales (4.2%). Suggest more sales, or higher sales prince per unit of both More efficient control of cost of sales (e.g. cheaper purchases? Less waste? etc) Revenue increase is contributed by significant increase in digital (online sales) and other sales May suggest that Shoezone now focus on online rather than in store sales, hence reducing store related expenses contributing to lower COS? Operating Profit Ratio —------------------------------------------------------------------------------------------------------------------------ --------------------------------------------------------------------------------------------------------------------------- BFF1120: Seminar 2 week 3 1.What is the Matching Principle? (a)The matching principle is an accounting principle that requires revenues to be recorded in the same period as the expenses they generate. (b)The matching principle is an accounting principle that allows expenses to be recorded in a different period than the revenues they generate. (c)The matching principle is an accounting principle that requires expenses to be recorded after the revenues they generate. (d)The matching principle is an accounting principle that only applies to non-operating expenses. Answ= a 2.A business has opening inventory of £13,000 and closing inventory of £12,000. Purchases for the year were £24,000. The figure for cost of sale is: (a) £50,000 (b) £26,000 (c) £25,000 (d) £24,000 Answ= c 3.On 1 April 2012 a company paid £2,800 in advance for one year's fire insurance. At the balance sheet date of 31 December 2012 what is the correct accounting treatment for this information? (a)Insurance expense of £700: Current liability of £2,100 (b)Insurance expense of £2,100: Current asset of £700 (c)Insurance expense of £2,100: Current liability of £700 (d)Insurance expense of £1,400: Current asset of £1,400 Answ= b 4.Which of the following phrases best describes the purpose of the annual charge for depreciation within the historic cost accounting method? (a)To allocate the cost of an asset over its useful life. (b)To measure the fall in the second-hand price of the asset. (c)To measure obsolescence as it arises. (d)To lower the reported profit on grounds of prudence. Answ=a 5.A landlord collects six months rent in advance from a tenant on the 30th September 2018, and the reporting date is the 31st December 2018. This is a / an: (a)Accrued Expense (b)Credit Sale (c)Prepaid Expense (d)Unearned Revenue Answ=d 6.What is the prudence concept in accounting? (a)Recording revenues when they are earned, regardless of when they are received. (b)Recognizing expenses and liabilities as soon as possible, but only recognizing revenues and assets when they are certain. (c)Recording transactions at their historical cost. (d)Matching expenses with revenues in the period they are incurred. Answ = d Answ= a 7.Which of the following best illustrates the application of the prudence concept? (a)Recording a sale when the order is received. (b)Estimating and recording a potential bad debt expense. (c)Recognizing revenue when cash is received. (d)Recording inventory at its selling price. Answ = b Answ= c 8.Which of the following is correct? (a)Profit does not change capital (equity) (b)Profit reduces capital (equity) (c)Capital (equity) can only come from profit (d)Profit increases capital (equity) Answ=d 9.In determining the profit of an entity, which of the following measurement principles states that revenue and expenses are recognised as they are earned or incurred and not as money is received or paid? (a)Completeness. (b)Prudence. (c)Consistency. (d)Accruals. Answ=d Answ=b 10.Which of the following statements is/are true? (1).Accrued expenses are expenses which relate to the current accounting period but have not been paid for. They are shown in the income statement for the current period in accordance with the accruals concept. (2). Prepaid expenses are expenses which have already been paid in the current period but relate to a future accounting period. They are shown in the income statement for the current period in accordance with the prudence concept. (a)1 only (b)2 only (c)Both 1 and 2 (d)Neither statement is true Answ=a Section 2: Profitability ratio calculation Shoezone and JD Sport Ratio Formula Shoezone JD Sport 2023 2022 2023 2022 Gross profit Gross £40,852 / £36,400 / 4839.70/ 4,208/8563 ratio profit/revenue £165,657 £156,164 = 10,125 = = 49.1% =24.7% 23.3% 47.8% Operating Operating £16,750 £14,676 / 1060.30/ 1013.70/856 Profit Ratio profit/revenue /£165,657 £156,164 = 10125 = 3 = 11.8% =10.1% 9.4% 10.5% Net profit Net profit/revenue £13,220 £10,845 / 226.70/1 459.60/8563 ratio /£165,657 £156,164 = 0125 = = 5.37% =8.0% 6.9% 2.23% 2. Briefly summarise your observation regarding profitability of JD Sport in 2023 compared to 2022. JD sport - lower gross profit ratio despite higher revenue - possible higher cost of sales —------------------------------------------------------------------------------------------------------------------------ --------------------------------------------------------------------------------------------------------------------------- Week 3 lecture - BFF1120: Statement of Financial Position - 11/10/2024 Rewatching Lecture: BF1120 Statement of Financial Position - Week 3 - 13/10/24 Snapshot of the company’s financial position at a specific moment in time (usually the month end or year-end - e.g Ryanair plc as at December 31st, 2023) Reports the assets of the business and the claims against the business ;liabilities and equity Relies on the Accounting Equation Financial ratios Profitability Liquidity Efficiency Capital structure Profitability Ratio ROCE (Return on capital employed) looks at how much operating profit was generated using long term funds available in the business in that period How efficient the business uses its capital/resources to generate profit? Operating Profit/Capital employed * 100 1.Measures of how well a company is at generating profit against the total amount invested in the company. 2.Measures the efficiency with which capital employed has been utilised. 3.Capital employed refers to the total amount of capital that a company uses to generate profits. It provides insight into how a company is investing its money. 4.Capital employed calculation: Total assets – current liabilities OR Equity + Non Current Liabilities Cash and cash equivalents have decreased - leading to a decrease in ability to pay back debt and pay obligations Two ways to calculate Capital employed Method 1: Total assets - current liabilities = Capital employed Method 2: Equity + Non-current liabilities = Capital employed Liquidity ratio - Current ratio - Acid test (quick) Ratio Liquidity Looks at how easy and quickly it is for a business to turn current assets to into cash How efficient or easily an asset can be turned into cash A measure of a business’ ability to honour short term (current) liabilities, using their current assets Current asset are usually listed in order of liquidity - inventory (least liquid, accounts receivables, bank/cash (most liquid) - these are the most liquid assets - influences cash and cash equivalents Current liabilities - often include Trade payables, Corporation tax and bank overdraft In SOFP current assets are usually listed in order of liquidity - inventory first as least liquid Liquidity Ratios Businesses expect to use their current assets to set their current liabilities hence liquidity is measured by comparing ca and cl Liquidity ratio compares current assets vs current liabilities It measures short-term ability of company to pay its debts Firms can make losses in the short term and still survive - as long as have a sufficient funds to pay their bills Companies can only survive if they can pay their bills Liquidity ratio measures the ability of the firm to pay is short-term obligation - this makes it liquidity ratios important - important information to suppliers and to lenders like banks - Indicates: Whether the business is generating sufficient cash to pay its short-term obligation Whether there any trends or signals towards insolvency or poor asset management It indicates signals towards insolvency or poor asset management Ratio Formula Current Current assets/current How much current assets available to settle each £1 of ratio liability current liability Acid test (Current assets - How much very liquid current assets available to settle (quick ) Inventory)/ Current each £1 of current liability? Ratio liability Inventory is the least liquid asset and take longer time to convert into £(cash) hence excluded Liquid ratio less than 1 to 1 - indicates not able to pay creditor on time Comment in Shoezone’s liquidity: Liquidity has deteriorated in 2023 in comparison to 2022 Shoezone has £1.40 current asset for £1 current liability in 2023 (compared to 2022….?) Shoezone has £0.50 very liquid asset for £1 current liability in 2023 (compared to 2022…?) Question Does Shoezone has enough current asset to meet short term obligation? Yhh kind of - but not really - looking Current ratio and Acid test ( What factors contribute to its worsening liquidity state? Current liabilities has decreased which should have improved liquidity situation However current assets has decreased more Liquidity Ratio Cash has decreased by almost 15% - significant Purchase of non current assets £11.372M (+118%) Share buy back £7.125M (+638%) Dividend payment £8.2M (+556%) Trade and other receivables has decreased by 47% Inventory has increased by 5%(reducing acid test ratio) Efficiency ratio Inventory turnover period Trade receivable turnover period Trade payable turnover period Efficiency ratio measures how efficient the business manages its working capital which is current assets and current liabilities How efficient does the business manage its assets and working capital (WC =CA-CL) Effective management of the above will lead to lower cost = higher profit! Efficiency ratio Ratio Formula Inventory turnover (Inventory*365)/Cost of No. of days on avg taken sales(COS) to turn inventory into sales Trade receivables (Trade No. of days on avg taken turnover receivables*365)/Credit to collect cash trade sales(revenue if credit receivables (customers) sales is not available) Trade payables turnover (Trade No. of days on avg taken payable*365)/purchase (or to pay trade payables COS is purchase is not (suppliers0 available) Sometimes these ratios were calculated using average balance (Opening balance + closing balance) Trade receivables: the amount owed to a business by its customers following the sale of products or services on credit Inventory turnover period How efficiently does the business turn its inventory into sales? Longer cycle (low turnover, more days, slow conversion) suggest more resources are tied up in inventory which incur costs to business: Storing Safety Risk of being damaged / obsolete Higher inventory turnover (faster sales) is generally preferable, however: Risk of running out of inventory and miss potential sales! Risk of purchase price went up Ratio tells you how long the business takes to sell inventory since it was produced - the longer the cycle, the higher the cost to the business to store inventory safely and the higher risk it is exposed to of being damaged or obsolete Inventory Turnover = (Closing inventory/Cost of sales) * 365 days Efficiency Ratio Comment: Inventory took 1 day longer to sell in 2023 in comparison to 2022 → worsened performance Took longer due to increase of 5% in inventory COS increases are smaller - 4.2% Largely consistent with 2002, though took too long to convert inventory into sales Trade receivables turnover How long does a business take to collect payment from trade receivables (i.e credit sales) Higher ratio (days) Slower in collecting cash - if trend keeps increasing may lead to bad debts - this impacts profitability and cash flows Longer to collect outstanding payments Rising ratio Bad debts Problems in managing credit control policy Deliberate Lower ratio(days) - desirable Cash is returned to the business at faster rate Often examined with trade payable turnover Efficiency Ratio Comment: Improved performance Shoezone took 2 days shorter to collect amount due from trade receivables (credit customers) in 2023 in comparison to 2022. Cash received faster and can be used to invest in new assets towards revenue generation/ to settle obligation Trade receivables reduced by (£1,250 - £411 = 67%) Very quick in collecting amount owed from customer – largely due to nature of the business (customer paid upon purchasing item) Trade Payable turnover This ratio measures how many days taken by the business to pay the amount sue from its trade payables(creditors) How long a business takes to settle (pay) the amounts owing to its Trade Payables (creditors) Higher ratio (days) Longer to settle outstanding amounts due to TP. Is this deliberate? Is this due to a cash problem? Lower ratio (days) Cash left the business at faster rate Will this impact cash flow for operations? Often examined with Trade receivables turnover for more meaningful interpretations. Efficiency ratio Comment Took 5 days longer to pay trade payables (creditors/suppliers) Due to higher increase in trade payables, com[pared to COS It could be deliberate (e.g to keep cash longer, invested and earn interest income Allowed by credit term It could be due to cash shortage (cash balance has reduced by £1635 in 2023 (£24,427 in 2022) = - 33% Relationship between TP and TR turnover TP days < TR days TP days > TR days The business is paying it debts faster The business is collecting its amount than it is collecting cash from credit due from customer faster than it is customers paying its suppliers Potential cash flow Receiving money quicker paying ensure Run out of money - in short term sufficient liquid resources for short-term operation - this shoezone Capital structure (debt) ratio Gearing Interest cover Gearing ratio (Non-current liabilities/Capital employed)*100 Capital Employed = NCL + Equity Gearing ratio measures how much of a company's operations are funded using debt (external source – e.g. bank loan) versus equity (internal – owners via e.g. sale of shares). Measure riskiness of a firms capital structure! Higher ratio suggest higher risk profile Highly geared business = high proportion of long-term capital financed by debts than by equity. E.g. if gearing > 50%: Long term lenders (e.g. bank) have invested more in the business than shareholders and have more to lose in the event of business failure. Businesses are seen as a riskier investment. Profit may not completely cover interest payments. Risk attached to external finance Interest costs (impact profit & cash flows) Principal payments (impact cash flows) Gearing Ratio Interest cover ratio (times) Measures a company’s ability to pay interest on its outstanding debt Interest cover = Profit from operation / Interest payment Indicates how many times a company can cover its interest obligations with its earnings Measures the amount of profit available to cover the interest payments.  E.g. interest cover = 4 times means £4 profit available to cover for £1 interest expense. Higher ratio is better, as it suggests lower risk. Concern if ratio falls below 1, it means the profit is not enough to pay interest expense due. Interest Cover ratio (times) Important when a firm is highly geared, because such firm has higher probability to go bankrupt if it unable to meet interest payment. E.g. Firm A and Firm B has 50% gearing ratio. Both firms have same level of risk in terms of gearing, but Firm B is riskier because it generated less profit than A which means it has greater risk of not having sufficient profits to cover interest. —----------------------------------------------------------------------------------------------------------------------- --------------------------------------------------------------------------------------------------------------------------