Diploma in Insurance M92 Insurance Business and Finance Chapter 6: Accounting principles and practices

Introduction Purpose and function of financial accounting Financial and management accounting Users of financial information and their information requirements Basic financial concepts and the accounting equation Receipts and payments The balance sheet (statement of financial position)

The income statement (profit and loss account) Insurance broker accounts Insurance company accounts Cash flow statements Management accounting Interpreting management accounting information

Learning objectives By the end of this module, you should be able to: Explain the purpose and function of financial accounting Distinguish between financial and management accounting Describe the users of financial information and their information requirements Apply the basic financial concepts and the accounting equation Describe accounting for receipts and payments Interpret a balance sheet and an income statement (profit and loss account) Explain the uses, format and presentation of cash flow statements Explain the principles of management accounting Interpret management accounts

Which document will best give an indication of a company’s liquidity? A. Auditor’s report. B. Cash flow statement. C. Directors’ report. D. Income statement

A company purchased a machine with a useful life of eight years for £24,000.  Its residual value at  the end of this period is estimated to be £2,000.  When  using straight line depreciation, how much depreciation is shown in the  accounts solely for year two of this period?    A. £2,750 B. £3,000 C. £5,500 D. £6,000

A figure has been inserted in a company’s balance sheet in respect of machinery.  Under which  heading will this normally appear?   A. Current assets. B. Current liabilities. C. Non‐current assets. D. Non‐current liabilities.

Where will you find money received and paid? A. Accounting equation B. Balance sheet C. Cash book D. Income statement

‘Something lost and something gained’ ‘Something lost and something gained’. What type of book keeping should this remind you of?  Balanced Double entry Either or Profit and loss

What is the basis of the balance sheet? Accounting equation Cashflow statement Management accounting Profit and loss account

A retailer has stock for resale A retailer has stock for resale. Under which heading will this appear in the balance sheet?  A.  Current assets.  B.  Current liabilities.  C.  Non‐current assets.  D.  Non‐current liabilities.

What is calculated as current assets minus current liabilities? Cash flow Gross profit Shareholder’s equity Working capital What is this also known as? Net current assets

What is Turnover – Cost of Sales ? Gross profit Net profit Net turnover Revenue

What is usually the main source of revenue for insurance intermediaries? Administration fees Brokerage Dividends Premiums

What is likely to be the most significant current liability for an insurance broker? Loan Mortgage Overdraft Premiums owed to insurers

The income statement (profit and loss account) Insurance broker accounts Insurance company accounts Cash flow statements Management accounting Interpreting management accounting information

Insurance Company accounts Gross written premiums Outward reinsurance premium Net earned premium Net investment return Claims incurred net of reinsurance Acquisition costs Other operating expenses Tax Reconciliation of changes in equity Provision for unearned premium Provision for losses and loss adjustment expenses Reinsurance liabilities Investments Reinsurers’ share of insurance contract liabilities Deferred acquisition costs Debtors

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Insurance Company accounts Gross written premiums Outward reinsurance premium Net earned premium Net investment return Claims incurred net of reinsurance Acquisition costs Other operating expenses Tax Reconciliation of changes in equity Provision for unearned premium Provision for losses and loss adjustment expenses Reinsurance liabilities Investments Reinsurers’ share of insurance contract liabilities Deferred acquisition costs Debtors

Gross written premium Gross amounts of premium paid by policyholders during the accounting period Gross of commission Net of IPT Includes: Renewals Premiums payable by instalments Estimated pipeline premiums from binding authorities Adjustment premiums

Net earned premium Must understand the difference between Gross Written Premium and Net Earned Premium. General Insurance premium paid by the customer usually covers 12 months. A good example might be a household insurance premium: Mr and Mrs House pay £500 for household insurance cover in advance. At this point the Insurer has received the money (the Gross Premium) but have not actually earned it yet, as they have not provided the cover. After providing cover for 6 months the insurer has earned £250 of the premium (net earned premium). Only after providing cover for the full 12 months has the insurer earned the full £500 paid at the outset. Suppose end period financial accounts prepared by the insurance company coincides exactly with the point in time Mr and Mrs House have received 6 months cover.

Year 2017   Gross Premium £500 Less unearned premium (£250) Earned Premium £250 The unearned premium will then be brought forward into the 2018 accounts. How do you think that this will be displayed in the year 2018 accounts?

Net earned premium

Net investment return Gains and losses Includes dividends, interest, rental income Unrealised gains losses show on balance sheet but not income statement Held to maturity – seen in income statements Effective return from date asset purchased to date it matures Fair value through profit or loss – seen in income statement if classified as such E.g. Assets held for trading

Tax Current tax = Tax payable Includes adjustments from previous years Deferred tax = Tax that will be included in a future tax return Deals with timing differences in showing income and expenses and when tax will be due

Reconciliation of changes in equity IFRS requires a statement reconciling equity from previous year to current year Profit for the year per Dividends due to shareholders Unrealised gains from investments classified as a available for sale Dividend is not a liability on the balance sheet until approved by the shareholders Interim dividend approved by the board but not yet paid is a liability Reconciliation of changes in equity

Insurance Company accounts Gross written premiums Outward reinsurance premium Net earned premium Net investment return Claims incurred net of reinsurance Acquisition costs Other operating expenses Tax Reconciliation of changes in equity Provision for unearned premium Provision for losses and loss adjustment expenses Reinsurance liabilities Investments Reinsurers’ share of insurance contract liabilities Deferred acquisition costs Debtors

Provision for losses and adjustment expenses Gross losses shown as a liability Expected reinsurance returns shown as an asset Estimated ultimate cost of claims and includes: IBNR’s IBNER’s Provision for losses and adjustment expenses

Insurance Company accounts Gross written premiums Outward reinsurance premium Net earned premium Net investment return Claims incurred net of reinsurance Acquisition costs Other operating expenses Tax Reconciliation of changes in equity Provision for unearned premium Provision for losses and loss adjustment expenses Reinsurance liabilities Investments Reinsurers’ share of insurance contract liabilities Deferred acquisition costs Debtors

The income statement (profit and loss account) Insurance broker accounts Insurance company accounts Cash flow statements Management accounting Interpreting management accounting information

Cash flow statements Profit and cash flow are not the same thing. Profit is based on all revenue even if it has not been received yet. If customer defaults then the money may never be received. Revenue = Total value of all invoices. Outflows of money may not reflect in the income statement. Remember depreciation?   Important that the cash flow of the business is recorded. Stakeholders want to scrutinise both profitability and the company cash position Businesses can face into trouble through lack of cash so the cash flow statement is important

Three headings in this statement Operating activities How much income the business generates or consumes through trading activities Includes tax paid Investment activities Cash inflows and outflows from investments Includes sale of investments and cost of investments made Financing activities Changes to loans and share capital Dividends paid to shareholders New loans/shares are shown as inflow Paying off loans or redeeming shares shown as outflow

The income statement (profit and loss account) Insurance broker accounts Insurance company accounts Cash flow statements Management accounting Interpreting management accounting information

Purpose of management accounting Helps managers to: Make sound business decisions Take corrective action Starts with strategic objectives Projects future outcomes and performance Used to set plans and targets – through the budgeting process Monitors performance

Manufacturing company may include Productivity of the factory Drills down to productivity of individual lines/ even machines Quality of goods being produced Cost of producing goods (broken down to various elements - raw materials, labour, etc.) The capital being absorbed by the business whilst work is in progress

Service company may include Quality of service Customer satisfaction Cost of service Financial performance of each distribution channel The capital being absorbed by the business whilst work is in progress

Costing and activity based costing Profits and contribution to overall profits Needs a good costing system Share of centralised functions costs allocated to each cost centre Drawback – managers have no control over centralised costs Costing Establishes the activities which drive the costs Costs centres charged according to the amount of activity from central functions Individual managers more incentive to control costs Activity based costing

The income statement (profit and loss account) Insurance broker accounts Insurance company accounts Cash flow statements Management accounting Interpreting management accounting information

Interpreting management accounting information Helps management make best decision on available information Uncertainties always exist Comparisons with external information helps Used as a basis for enquiries rather than giving solutions and actions

What should you ask? Why is Line C unprofitable? How has it developed or how is it expected to develop? What could be done to improve this? What would be the effect of closing down Line C? Ask finance team to produce a projection on Lines A and B, if C was closed?

Machine Finance team have identified that a machine commissioned last year machinery is operating at a loss. What are you going to do about it?

You have received a proposal to start a new line of business You have received a proposal to start a new line of business. Expected revenues and costs look reasonable What else would you need to know before deciding whether to go ahead? New line of business

What are the pros and cons of each report?