Accounting

Identifiable assets

tangible and intangible assets. IFRS3: the acquirer must recognize these intangibles separately from goodwill.

Average Collection Period (Efficiency)

the average accounts receivable balance divided by average credit sales per day. • sometimes called days' sales outstanding. represents the average length of time that a company must wait after making a sale before receiving cash. debtors/(sales/365)

Transformed means of production

work-in-progress and finished goods that have not yet been released to the P&L account. If they are released, these costs turn into expenses as no further benefit is anticipated from these costs

Sole Trader

• Can start trading at any time with the assets at his disposal • Has to distinguish between transactions that are domestic (own salary) and those that pertain to his business • Has unlimited liability (any body cane sue him) • No requirement to make public the P&L account and the balance sheet each year • Will have to make an annual tax return and will be taxed on the profit

What is cash?

• Cash balances • Bank balances • Cash equivalents (Temporary investments of cash not required at the moment by the business. These investments are readily convertible into cash, or, if left alone would mature within 3 month.)

When is accomplishment achieved?

• Enquiry: too early, order may not emerge • Order: too early, cost too uncertain, customer may walk away before delivery • Inventory of finished goods: too early, unsold goods may never sell. Also the ultimate sales price may be unknown • Ship • Invoice: about right, goods are normally invoiced at the time of shipment • Cash received: unnecessarily late, unless there is evidence that customers will not pay for goods

Inventory Valuation Methods

• FIFO • LIFO • Average Method

Partnership

• Group of individuals contribute various assets • Is usually governed by an agreement that among others specifies the method for sharing the annual profit. • Have unlimited liability • No requirement to make public the P&L account and the balance sheet each year

Types of Profit

(1) Gross profit (sales - cost of sales) (2) Net profit (gross profit minus period costs) (3) Net profit before interest charges and taxes (4) Net profit after interest charges but before taxes (to non-shareholders) (5) Net profit after interest charges and taxes: bottom line.

Times Interest Earned (Capital Structure)

(EBIT) / interest • Uses the profit and loss account in order to measure the gearing position and margin of safety in relation to earnings measures the extent to which earnings can decline without the company finding itself unable to meet the annual interest costs.

The principal features of depreciation

(a) Depreciation is the allocation of the cost of assets purchased in one accounting period over the accounting periods in which they are used (b) Depreciation is a cost of production (c) The selection of method influences the amount of cost allocated to each accounting period, thus affects profit (d) Depreciation, by itself, does not provide cash for the replacement of the assets, but it has a positive effect on the cash flow of the business because the firm pays less taxes

The accounting policies section of the notes to the financial statements should describe the following:

(a) The measurement basis used in preparing the financial statements (b) Policies necessary for an understanding of the financial statements

Accounting conventions underlying the measurement of effort include...

- Matching Convention - Allocation Convention - Cost Convention

The measurement of accomplishment can occur when...

- Time of Sales Orders - Time of Production - Time of Collection

Allocation Convention (measurement of effort)

- determine how much of each means of production in money terms was consumed during the accounting period (cost determination). - determine how much of each means of production should be matched with sales revenue and how much should be added to the inventory of unfinished and finished goods.

Reducing Balance Depreciation

1- Assumes that a fixed asset is more efficient in generating revenue in the early years of it's life. 2- Repair also tends to be lower in the earlier year in the live of an asset so early high depreciation counterbalances high later repair cost. D = C ( 1 - (V/C)^(1/n)) C = Cost V = Residual value n =Periods

The cost of sales adjustment is calculated as follows

1- Given the index relating to the specific raw materials and supplies (get the average) 2- Revision of inventory balances Opening inventor= opening inventory value*average index/index at the beginning of the year Closing inventor= closing inventory value*average index/index at the end of the year 3- Calculate Current cost of goods sold=Opining stock + purchased-closing stock 4- Calculate Cost of sales adjustment=Historic cost of goods sold-Current cost of goods sold

Financing the Net Assets

1- Ownership Equity are internally generated assets, original equity introduced by the owner(s), and the retained profit generated through operation. 2- Long term loans are generally the most important external source of funds. Lenders (unlike shareholders) have an enforceable right for annual fixed interest payments.

Valuation of Inventories

1- the valuation is based on the 'lower of the cost or current market value' rule; 2- cost is defined as direct manufacturing cost plus a share of manufacturing overhead (period cost such as administration overhead are not included in inventory) 3- Inventory valuation methods can influence the value of the inventory and any changes in valuation methods has to be properly disclosed

The major categories of cash flow

1. Cash flow from operating activities(including Increase & decreases in INVENTORIES, DEBTORS, CREDITORS) 2. Cash flow from return on investments and servicing of finance (dividends received, interest on borrowed money (loans, overdrafts)) 3. Taxation 4. Capital investment (fixed assets) 5. Acquisitions and disposals(purchases and sales of subsidiaries, associated companies, joint ventures etc) 6. Equity dividends paid to shareholders 7. Management of liquid resources 8. Financing (debts[loan stock] & shareholders' funds)

Types of inventory

1. Finished goods inventory FGI 2. Work-in-progress inventory WIP 3. Raw materials and supplies inventory RMI

Sources of Disclosure Requirements:

1. Government legislation (e.g. in the form of the Companies Acts 1985 and 1989 for GB) 2. The accounting profession's rules of procedure contained in Accounting Standards and International Accounting Standards 3. The requirements of the Stock Exchange Listing Agreement for companies whose ordinary shares are listed on the Stock Exchange

A company may choose to lease a portion of its assets, for a number of reasons...

1. Leasing avoids a substantial outflow of cash which would be required in an outright purchase. 2. As a consequence, the company spreads the cash outflows into relatively small ones over the years of the asset's life. 3. The company can replace the leased asset with an up-to-date model 4. The asset's maintenance costs are usually covered by the lease agreement

Where does cash go?

1. Loss from operations (not including bad debt or depreciation) 2. Capital repayments 3. Decrease in creditors 4. Purchase of fixed assets 5. Repayment of loans 6. Increase in inventories 7. Increase in debtors

Sources of Cash

1. Profit from operations adjustmented for : (a) Items charged as an expense against Sales but which do not affect cash (depreciation and bad debt) (b) Recorded gains which do not affect cash: increase in market price of an asset 2. Capital introduction (injection of cash from their owners by owners) 3. Increase in creditors (business is owing this money to its suppliers and for a short period is able to use the money for other business purposes) 4. Sales of fixed assets 5. Loans 6. Decrease in inventories (releases cash tied up in these items) 7. Decrease in debtors (A reduction in debtors can only be achieved by debtors paying their bills)

Accomplishment is generally measured at the first point in the operating cycle for which the following conditions are met...

1. The principal revenue-producing service has been performed, i.e. the product has been made and delivered against a firm order. 2. All costs that are necessary to create the revenue have been either incurred, or, if not yet incurred, are either negligible or can be predicted within an acceptable degree of accuracy. 3. The amount ultimately collectable in cash can be estimated within an acceptable range of error.

What is needed to draw up the cash flow statement?

1. The profit and loss account for the period 2. The balance sheet at the start of the period 3. The balance sheet at the end of the period 4. Supplementary notes to the financial statements

Determining the consumption of the means of production

1. Use of raw materials 2. Labour 3. Depreciation of fixed assets

Called-up share capital

: Companies are usually authorized to raise a certain sum of money through selling of ordinary shares. This amount is normally fixed at a sum far greater than required for ongoing operations, thus enabling the company to finance an expansion should that be deemed appropriate. When the amount issues reach the authorized limit, the company will petition the courts to raise the limits on authorized share capital.

Gearing ratios (Capital Structure)

A company with a high gearing ratio may be more vulnerable to economic downturns. This is because it has to make interest payments The flipside of this argument is that leverage works well during good times

Time of Sales Orders

A measurement of accomplishment when receiving an order (a delay between order and shipment during which time the customer can change his mind). Orders would only be recognized as a measure of accomplishment if: (a) the goods which are ordered are in inventory when the order is received, (b) all major costs have already been incurred (c) the number and timing of cancelled orders are known not to vary significantly.

Accounting

A series of processes and techniques used to identify, measure and communicate economic information which users find helpful in making decisions.

capitalizing the fees, associated with land

Accountants capitalizse the acquisition cost together with the legal fees and the cost of preparing the land. As the value of land changes accountants might not apply the cost convention anymore but rather reevaluate the value of the asset and add/subtract the difference from the shareholder's equity. The P&L of a company is not affected by this reevaluation.

Amortization

Accounting procedure that gradually reduces the cost value of a limited life or intangible asset through periodic charges to income. For fixed assets the terms used is DEPRECIATION, and for wasting assets (natural resources) it is depletion, both terms meaning essentially the same thing as amortization.

Product cost

All costs that are involved in acquiring or making a product. In the case of manufactured goods, these costs consist of direct materials, direct labor, and manufacturing overhead.

means of production

All the capital and equipment needed to make and exchange goods

The balance sheet

Also known as the statement of financial conditions...basically tells you how much a company owns (its assets) and how much it owes (its liabilities). The difference is its equity...also commonly called net assets, stockholder's equity, or net worth.

Bad debt expense

An entry found on a business's income statement that represents the amount of noncollectable accounts receivable that occurs in a given period. In terms of accounting entries, every time an amount increases bad debt expense, an equivalent amount is credited to the business's allowance for bad debts (owner's equity held for the purpose of covering bad debt) - The profit and loss account is charged with an initial provision (a general allowance based on past experience) for bad debts as if it represented real bad debts in the accounting period in which the provision is set up. - In succeeding periods, only the incremental adjustment in provision is entered in the profit and loss account.

Goodwill

Arises when a business is valued at or sold for more than the balance sheet value of its assets. It is the difference between the purchase paid for an acquired company and the net asset price, it represents the value of the asset (brand name..), goodwill is embedded in Intangible assets in the balance sheet.

revaluation reserve

Assets at current value (usually replacement cost) less total accumulated depreciation, adjusted for the new value, so that the profit & loss account does not show any gains or losses for revaluation, which is after all not profit from operations.

Fixed Assets not owned by the company

Assets leased under the terms of a finance lease are listed on the balance sheet; the asset is listed under "fixed assets" and the future payments under "creditors"

Current assets

Assets that are either currently in the form of cash or are close to being converted into cash within a short period of time (usually a year).

The basic accounting equation

Assets will always equal the sum of liabilities and equity: Equity + Liabilities = Assets

Consumption Method Depreciation

Assumes that the greater the number of running hours of the asset the greater the wear and tear on the machine. D= (Ta/Tt)*(C-V) Ta - Total annual running hours Tt - Total annual hours C = Cost V = Residual value

Realization Convention ( an accounting determining the what is included in the measurement of sales accomplishment)

Only products that have been sold are measured as sales. Recognize costs immediately and revenue only when it is certain

Accruals Convention ( an accounting determining the what is included in the measurement of sales accomplishment)

Cash does not have to be received to create value; an obligation from a creditworthy customer is good enough to be called a sale. Also covers the situation where an entity pays an invoice for a product or service which covers a certain time period that stretches beyond the date of the reporting statement

Quick Ratio (sometimes called the Acid Test) (liquidity)

Current assets - inventory/ current liabilities • current assets sometimes includes inventory that is slow moving • quick ratio backs inventory out of the calculation • The industrial average is slightly greater than the widely accepted rule of thumb of 1 times

Current Ratio (liquidity)

Current assets / current liabilities • position of a company to meet its current obligations • It is often stated as a rule of thumb that a current ratio of 2 indicates a sound financial situation Not necessarily as there are many ways to access financing (particularly the marketability of stock) - but it is definitely a good sign

Straight Line Depreciation

D = (C - V)/n C = Cost V = Residual value n = Periods

Financial accounting

Depicts the total picture for a firm in the accounting period (e.g. total sales, total costs, total profits, and total asset structure). The information is compiled after the accounting period is over and the books of account have been closed. It derives from the legal obligation of the management to report to the owners how they have used the resources during the accounting period.

Use of raw materials

Determined by deducting the physical quantity of raw materials at the end of the year (or accounting period) from the sum of opening inventory and purchases during the year (or accounting period).

"top-up" depreciation

Due to inflation the replacement cost will not be the historic cost. This is the amount added to the depreciation charge each year to bring the depreciation calculation in line with the current replacement cost for the fixed asset.

A profit and loss

Financial report for a specific period of time summarizing income received an expenses paid with an indication of the resulting profit or loss

What is the typical UK structure of a balance sheet?

Fixed Assets Current Assets Less: Current Liabilities Net Current Assets Assets less Liabilities Represented by: OE Profit

Fixed to Current Asset Ratio (Capital Structure)

Fixed assets / current assets examines the asset structure of the company

Gearing

Gearing = Long term debt / total assets(owner equity+ long term debt) In years of healthy profits shareholders will receive better return on their money in a high geared company, but when profits dip the heavy burden of debt has a more dramatic effect on their return than in a low-geared company.

The effect of debt financing on ownership and control

If the owners have provided only a small proportion of total financing, the risks of the enterprise are borne mainly by the creditors. On the other hand, by raising funds through debt, the owners gain the benefits of maintaining control of the firm with a limited investment of their own.

Time of Production

In some industries like shipbuilding, the accomplishment is recognized when the product is produced, only if: (a) no significant amount of services is required following the production effort (b) the amount of collection is reasonably certain (c) the timing of shipping is more uncertain than the timing of production

Who are the users of accounting information?

Internal users: Directors, Senior Executives, Managers, Employees (and trade unions) External users: Shareholders, Analysts, Creditors, Tax Authorities, the public

Categories of current assets

Inventories Cash

FIFO

It is favored by many businesses because it is consistent with the physical flow of goods and the balance sheet inventory is carried at realistic values (provided the stock turns over quickly). Problem is that reported income during periods of rising prices is relatively high as lower cost of sales in the past has been offset against sales revenue.

Why Are Cash Flow Statements Needed?

It is possible for an organisation either to report a healthy profit but be running out of cash or to report a worrying loss but have plenty of cash. Users of financial statements need a reconciliation between profits and cash

Net Assets

Net Current Assets (Net Current Liabilities) = Current Assets - Current Liabilities Net Assets of the Enterprise = Net Current Assets + Fixed Assets

Return on Specific Assets (return on inventory) (Profitability)

Net profit after taxes / Inventory • Could show a company is carrying too much inventory, locking up cash in inventory, the greater the risk of some part of it becoming obsolete Could also mean the company is carrying more in inventory to give them a trading advantage for example a stocking-up in advance of a major sales drive, or a rise in raw material price, or a risk of irregular and short supplies

Return on Owners' Equity (Profitability)

Net profit after taxes / owners' equity • Perhaps the most important profitability ratio • investors are more concerned with relating their returns with the current market price of their shares rather than with the 'book value' of their investment. one normally considers an increase in this ratio to be a good sign but further analysis is required to determine whether or not a disproportionate increase in debt caused the improvement in this ratio.

Return on Total Assets (Profitability)

Net profit after taxes / total assets • Profit is not only a function of sales but also closely related to the assets employed by the company to produce the profit. • Note: total assets are normally used: a case can be made for using just the productive assets, omitting such items as goodwill and investments. The industrial sector the average is calculated on total assets.

Acquisition accounting (purchase method accounting):

Normal takeovers where predator (holding company) acquires >50% of the equity share capital of the target (subsidiary).

Current liabilities

Obligations that a company must meet in cash within a short period of time (usually a year).

Merger accounting (pooling of interests)

Presumes agreement. The accounting statements in the merger accounting portray the two companies as if they always had been one.

Matching Convention (measurement of effort)

Profit is arrived at by matching the effort (or cost) with the units shipped and invoiced to the customers (sales) during the period. Efforts are all cost involved in producing saleable products and the costs involved in actually selling the products which are recognized in the measurement of sales accomplishment.

Management accounting

Provides information, such as actual and projected costs and prices of individual products, projected sources and uses of cash, projected and actual costs of departments and processes, etc. in order to enable management to analyze past and predict future events and act appropriately

Fixed assets

Relatively long life and are generally used in the production of goods and services rather than be held for resale

The cost of sales adjustment

Removes the holding gains (profit from holding inventory while it rises in value) from reported profit. It can be calculated using an averaging method. The current cost of sales can be computed by revising the reported cost of opening and closing inventory to the average current cost for the year, and the cost of sales adjustment will be the difference between the current cost of inventory at the date of the sale and the the amount charged in computing the historical cost.

Inventory Turnover (Efficiency)

Sales / Inventory • Sales occur over the entire year, whereas the inventory figure is taken from the closing balance sheet. Different industries have significantly different inventory turnovers. Metals and engineering are slow because of the length of the production process; retail shops are very rapid, indicating that they need low inventories to service their sales levels.

Fixed Assets Turnover (Efficiency)

Sales / fixed assets Fixed assets are acquired by a company to produce sellable products: it is therefore not unreasonable to relate the investment in fixed assets to the level of sales generated from them.

Merger accounting conventions

Share capital - Company 1 + Company 2 Distribution reserves - of both companies added together Goodwill and premium - Does not exist

Acquisition accounting conventions

Share capital - Holding + subsidiary Distribution reserves - those of the holding company Goodwill and premium - Exists

Disclosure

Sole traders and partnerships are liable for all debts no obligation to disclose Companies, the liability of the shareholders is limited to the extent of their shareholdings, companies have to disclose (normally once a year) in order to help creditors assess the creditworthiness (the law affords them a measure of protection). Large companies with many shareholders the law requires the publishing of financial information in order to protect the shareholders in a similar way than the creditors.

IFRS3 Business Combinations has outlawed merger accounting

TRUE, the amount actually paid by the acquirer is conveniently obscured from view. It requires the acquirer specific the purchase method i.e. to recognize the acquiree's identifiable assets, liabilities & contingent liabilities at their fair values at the acquisition date and also recognize goodwill, which is subsequently tested for impairment rather than amortized.

Fair value

The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction. Fair Value for: 1- Finished Goods= Selling price - cost of disposal + profit margin. 2- Work-in-progress= Selling price of finished goods-sum of costs to complete +profit margin. 3- Raw Material = current replacement cost.

Cost Convention (measurement of effort)

The cost used for means of production is the historical price (also called acquisition price) paid for them when they were acquired.

Profit

The difference between the sales which the enterprise made during the period under review and all the costs which had been incurred to bring the goods sold to the market place ready for sale. Costs can be either, direct costs of manufacture or preparation (Raw material,...) or indirect costs (advertising,...) The profit is the result of the transformation processes a company is engaged in a given time period and can be viewed as the difference between • a measure of accomplishment (what has been achieved in sales) and • a measure of effort (what these sales have cost).

Accomplishment

The number of products shipped and invoiced to customers during the accounting period (not before, because the production is not guaranteed to be accepted from the customer after production)

A cash flow statement

The sources of cash (i.e. loans, collections) and uses of cash (i.e. purchasing inventory, paying off debt) over a period of time. It portrays only those economic events of a business that affect the cash flow.

Installment plans

The usual provisions are: (a) a relatively small down payment is required; (b) the payment period is long and requires monthly or weekly payments. (c) the seller retains conditional title to the goods. The effect of these provisions is that there is a relatively high risk of reclaims of the merchandise because of non-payment

Average Method

The weighted average unit cost of the goods available for sale is applied to the units sold to calculate the cost of goods sold and the ending inventory of goods. Appropriate when units identical or near identical.

Debt Ratio (Capital Structure)

Total debt / total assets This ratio measures the proportion of assets that are financed by debt. Debt includes current liabilities and all loans and bonds.

Profit Margin (Profitability)

Typically, net profit after taxes / sales. • Some analysts therefore are beginning to move towards Gross Profit Margin net profit before taxes

LIFO

Using this valuation method lower profit is reported in times of rising prices and replacement of inventories is therefore made easier. However many managers do not like the resulting lower profit figure. It is no longer permitted by IAS 2

Period Cost

are incurred so that a company's products can be sold but typically do not add value to the products unsold at the end of the accounting period. (Marketing, Advertising, Finance). They are fully set off against revenue in the P&L account, none are associated with inventory.

So often 'brands' are seen to be the same as trademarks and other marks, but IAS 38 Intangible Assets states that brands are to be regarded as ...

general marketing terms that are used to refer to a collection of complementary assets such as trademarks and names, formulas and recipes if each single asset cannot be measured reliably.

The exact distinction whether an expense is a product or a period cost ...

is not universally agreed upon.

Untransformed means of production

land, buildings, plant, machinery, and raw materials

Current Liabilities

liabilities in the short term. Examples are: creditors, bank overdraft, taxes payable, dividends payable, accruals, deferred revenue :revenue received by the company in advance of providing the goods or services

Three factors have to be taken into account to define every depreciation model used

o Actual historic (acquisition) cost, including installation charges o Estimated net residual amount that can be obtained when the asset is disposed of o Estimated useful life of asset to current owner

Capitalize Costs

to record the amount of an item in a balance sheet account as opposed to the income statement. it will be reported in the balance sheet. Its cost will be depreciated over the item's useful life through the use of amortization (for intangible assets) or depreciation (for tangible assets).

Categories of fixed assets

• Land, usually not depreciated since it has an infinite life and thus does not normally decrease in value. • Buildings are sometimes shown together with land. Other companies depreciate buildings over time as they have a limited lifespan. • Plant and Equipment: The selection of a slower depreciation rate reduces the impact of depreciation on profits • Fixed Assets not owned by the company: Assets leased under the terms of a finance lease (one where ownership will revert to the lessee at the end of the lease)

Corporation

• Limits the liability of the owners (called shareholders) to the amount of equity (share capital) paid into the company • Must make public it's annual accounts which must be audited by a registered auditor • The share capital is split into small units (e.g. $1), the face value of the share, called the par value, or nominal value. The market might value a share higher than the nominal value, however, that does not influence the accounting equation, as the company still has access to the original paid in capital.

groups of financial ratios

• Liquidity ratios. • Profitability ratios. • Capital structure ratios. • Efficiency ratios.

Limitation to Managements ability to select the accounting policies:

• True and fair view: financial statements produced reflect a true and fair view • External auditors: The external auditors must approve the selection • Consistency: Once chosen, management must consistently apply the policies from year to year unless material conditions have changed significantly. In such an event the change in accounting policies must be disclosed.