Business Funding & Financial Awareness Basic Accounting Principles and Statements J R Davies May 2011

Primary Financial Statements (1) Balance Sheet Profit and Loss Account Cash Flow Statement

Primary Financial Statements (2) Balance Sheet Balance Sheet Profit and Loss Account Cash Flow Statement time

Balance Sheet It specifies the costs of the assets owned by the company, the amounts owed by the company to other parties (liabilities), and the capital subscribed by its shareholders It provides a summary statement of the financial position of a company at a point in time based on the company’s past transactions.

Nature of Balance Sheet Assets Liabilities & Capital The resources owned by the company The ways in which the company has obtained the funds to acquire its resources.

Developing A Balance Sheet Assets Hotel and fittings Stocks etc Liabilities and Capital Liabilities Shareholders’ Capital Bank loan Capital subscribed by owners

Interpretation of Balance Sheet Items What is an asset? Any item of value owned by the company: value stem from the future benefits that the asset is expected to generate through its use in the business to produce, directly or indirectly, revenues. What is a liability? An obligation or debt that has been incurred by the company. What is the shareholders’ capital ? The risk capital subscribed by the company’s shareholders, The risk capital accumulated through the retention of earnings,

Classification of Balance Sheet Items Liabilities and Capital Current Liabilities Long term liabilities Shareholders capital Assets Fixed Assets Current Assets

The “balancing” of the Balance Sheet Each transaction undertaken by a company will leave the accounting equation unchanged Assets = Liabilities + Capital Every transaction must affect at least two items in the balance sheet in an offsetting fashion.

“Economic” Balance Sheets Also Balance Balance sheets also balance in a more fundamental sense than implied by the recording of transactions - if the shareholders interests (capital) is perceived as a residual or balancing item. Any development affecting the values of assets and liabilities that do not offset each other will be balanced by a change in the shareholders interests. Assets = Liabilities + Shareholders’ interests Assets - Liabilities = Shareholders’ interests

How is balancing achieved? Every transaction has two sides An increase in one asset may be associated with a decrease in another asset. An increase in an asset may be associated with an increase in a liability or in the shareholders’ equity asset other asset asset liability asset shareholders’ equity

stock of raw materials, finished goods stocks of components Examples of Assets machines buildings land stock of raw materials, finished goods stocks of components debtors or accounts receivable

Types of Asset Fixed Assets Current Assets

Fixed Assets A fixed asset is any asset, tangible or intangible, acquired by a company on the expectation that it will provide services for the business over more than one time period. It is not an asset that is held for the purpose of resale by the company in the course of its normal trading activities. (Vehicles owned by a car hire company are classified as fixed assets, while those held for sale by motor trader are not classified as fixed assets but as stock.) Examples: Land, buildings, machines, brand name

Fixed Assets : tangible and intangible A tangible asset has a physical presence eg a machine An intangible asset has no physical presence but may still be highly valuable to a company – examples include brand names patents company organisation or infrastructure experienced and efficient workforce Not all intangible assets are recognised in the balance sheet

Intangible assets - goodwill Goodwill is generally thought of as representing customer loyalty etc In the balance sheet Goodwill tends to stem from acquisitions and is is not the same as reputation and value of customer following! Difference between the (historic) cost of assets acquired, less liabilities, and payment made for them [ a balancing item] Goodwill arising from acquisitions can be written off (amortised) in the same way as tangible assets are depreciated

Current Assets Assets that are held by business on a temporary basis, although they are expected to be systematically replaced through the normal course of business. It is generally assumed that these assets will be turned into cash within one year. Examples: stocks of materials finished goods being held for sale debtors cash

Valuation of Assets Assets are usually valued at their historic cost, ie. the cost at which the assets are acquired or developed. These values are referred to as book values and are based on transaction values that can be verified – these values can be considered to be derived on an objective basis. Book values may differ from the economic or resale values. Accountants have to constantly consider the trade off between objectivity and relevance in developing a company’s accounts.

Liabilities Short term liabilities are those that will fall due for payment over the next year, for example, Creditors Tax payable Interest payable Long term liabilities include loans maturing more than one year in the future

Shareholders’ Capital Capital subscribed Share premium account Revaluation reserve Profit and loss account or retentions

Reliability of Balance Sheet Values (1) historic cost and transactions based values objective and verifiable data objectivity may conflict with relevance asset values can change over time due to factors such as changes in technology developments in the markets in which a company’s products or services are sold inflation wear and tear at a different rate to that allowed for by the depreciation charge ( the cost recognised in the accounts of using a fixed asset for a period of time- stemming from the fall in the value of the asset through wear and tear etc).

Balance Sheet and Reliability (2) Most reliable values creditors Debtors (though it is difficult to estimate bade debts) cash Least reliable values land, buildings machines long term loans shareholders’ interest Missing values reputation and brand names organisation value future growth opportunities

Accounting Conventions and the Balance Sheet Money Measurement Convention Historic Cost Convention Going Concern Convention Prudence Convention Objectivity Convention

Value of an Asset: Different Definitions and Perspectives purchase price purchase price reduced by an allowance for wear and tear (depreciation) replacement cost resale value value in use deprival value

Profit and Loss Account Measures how much wealth the business has created (or destroyed) in its normal business activities during a period (eg a year) Profit is measured by the Revenues generated during a period less the Expenses incurred in the process Revenues are the sales made during a period, either for cash or on credit and the expenses measure the resources used to provide these goods and services.

Profit Concepts Net Profit = Gross Profit – Expenses Gross Profit = Sales less the Cost of Goods/Services Sold Net Profit = Gross Profit – Expenses Expenses include wages, rents etc. and interest and depreciation charges

Relationship Between the Balance Sheet and the Profit/Loss Account Assets = Liabilities + Capital + Profit Assets = Liabilities + Capital + (Revenues –Expenses)

Accrual Accounting An attempt to provide an assessment of the profit generated over a particular period (eg. a year) when the activities of the business are on going and the financial position of the company depends in part on transactions/activities in previous periods and in part on transactions/activities to be completed in future time periods.

Accrual Accounting: Accounting and Cash Flow Concepts (1) Identify revenues when products and services are sold or provided, not when they are paid for Identify expenses associated with these revenues rather than cash expenditures or payments.

Operating versus Capital Expenditures: Accounting and Cash Flow Concepts (2) Operating versus Capital Expenditures: It is only those expenditures on inputs required for the production of goods ad services sold in the current period that should be treated as operating expenses Expenditure on assets that create benefits over several periods are initially recognised in the balance sheet, and are written off (in the form of a depreciation or amortization charge) over those periods in which they contribute to the generation of revenues.

Profit and Loss Accounting : Recognition of Revenues and Expenses Realisation convention The activities necessary to justify the revenues are complete The amount can be objectively measured Revenues received or there is reasonable certainty of receipts in the future Matching convention The expenses recognised should be a measure of the resources employed to generate the revenues for the period

Matching Convention The calculation of profit requires: Determination of the revenue for the period; Determination of the relevant expenses, and their subtraction from revenue cost of purchasing the goods sold to customers other expenses incurred (wages, rent, etc.) The relevant expenses are those associated with, or matched with, the goods or services sold during the period.

Profit and Loss Account: Timing of recognition of costs/benefits – a summary (1) Recognise in each period some of the cost of a fixed asset - spread the cost out over its expected working life in the form of a depreciation charge; When sales are made on credit the revenues (benefits) are recognised in the period in which the sale was completed;

Profit and Loss Account: Timing of recognition of costs/benefits – a summary (2) the expense of using materials bought on credit is recognised in the period in which the products they are used to produce are sold, and not necessarily in the period when purchased or payment made; materials used to produce an item sold in the current period may be paid for in the next period; material paid for in the current period but held in stock at the end of year will be recognised as an expense in some subsequent period when sales are made.

Accrual Accounting and Constraints on the Exercise of Judgement Accounting principles and standards limit the ability of managers in different companies to record similar economic transactions in dissimilar ways accounting principles/standards are an attempt to ensure that given transactions are recorded similarly across companies and within a company over time External audit provides a check on the exercise of discretion and its consistency overtime

Accrual Accounting and Recognition of Transactions Balance Sheet Balance Sheet PROFIT AND LOSS ACCOUNT Use Materials in Production of Goods Supplied to Customer during this period (P&L) Receive Payment for Goods Supplied Last Year (BS) Buy Machine (BS) Sell some goods on credit -to be paid next year (P&L, BS)

Nature of Depreciation The measure of the cost of using a fixed asset for a particular period Cost is defined as the fall in the value of the asset as a result of wear and tear and obsolescence Obsolescence can arise as a result of Technological change Changes in the nature of demand

Calculating Depreciation (some common methods) Straight line depreciation Reducing balance

Straight Line Depreciation Example: A machine that is expected to be used for 4 years is purchased for £50,000 and it is anticipated it will have a residual value of £2,000 at the end of its working life (will not always correspond with the recognition of depreciation for tax purposes.)

Vertical Balance Sheet Fixed Assets + Current Assets - Current Liabilities equal - Long Term Liabilities Capital

Vertical Form: Balance Sheet (£) (£) Fixed Assets Premises 20,000 Vehicle 13,000 33,000 Current Assets Stock 12,000 Debtors 6,000 Cash 7,000 Less Current Liabilities Creditors 15,000 Working Capital 10,000 Net Capital Employed 43,000 Less long term liabilities - - - - Net Assets 43,000 Financed by Issue Capital 40,000 Retentions 3,000 43,000

Example of Development of a Balance Sheet: Startup Co. Company set up and issues 500,000 shares for cash at £1 each, resulting in cash holdings (bank) of £500.000; £200,000 is spent on the purchase of premises, payment is made in cash (cheque); £45,000 spent on the purchase of fittings; Takes delivery of £5,000 of vegetables, purchased on credit (These transactions are recorded in the company’s balance sheet as shown in the next slide.)

Startup Co. Balance Sheet Liabilities & Shareholder Capital Shareholders capital £500,000 Assets Cash £500,000

Startup Co. Balance Sheet Liabilities & Shareholder Capital Shareholders capital £500,000 Accounts payable 5,000 Assets Cash £500,000 Premises £200,000 Cash £300,000 Fittings £45,000 Cash £255,000 Stocks £5000