Understanding and Managing Finance Seminar 4

Assets and Claims

Assets & Claims We have already established previously that:  Assets are items which the organisations OWNS  Claims are items which the organisation OWES QUESTIONS  What are the 4 main characteristics of an Asset.?  Can you give some examples of Assets?  What are the two main types of Asset?  What are the two different types of Claim?  Can you give some examples of Claims?

Assets Major characteristics A probable future benefit exists The business has an exclusive right to control the benefit The benefit must arise from some past transaction or event The asset must be capable of measurement in monetary terms Assets are items of value owned by the business. In accounting terms, the term ‘assets’ has a very narrow meaning, defined by these four characteristics:

Examples of Assets 1.Money in the bank. 2.Debts owed to the business by its customers 3.Land and property 4.Machinery, mechanical and electrical equipment 5.Stock, 6.Service agreements and contracts 7.Goodwill, patents and other ‘intangibles’ which can have a monetary value attached to them.

Fixed Assets These are items owned and used by the organisation on a long-term basis  Tangible Assets = equipment, buildings, land  Intangible Assets = brands, logos, patents, goodwill  Goodwill = quality of workforce, reputation, management, location, relationship with customers. Goodwill only tends to be included when purchased at an agreed price  Fixed Assets are normally valued at Cost less Depreciation (The amount lost through ‘wear & tear’).

Current Assets These are Items which can easily be converted into cash (e.g. cash, stock, debtors)  Generally listed in the order in which they can be converted into cash  Valued at cost or market price (whichever is the lower)  Often includes “Provision for loss” (safeguard against unsold goods or bad debts) and Prepayments (items which have been paid for in advance)

Cash Trade debtors Stock The cyclic nature of current assets Current assets are cyclic; there is movement between the cash, stock, and debtors items.  The stock is sold on credit to Trade Debtors  Trade Debtors pay for the goods with Cash  The Cash is used to buy more stock.

Claims Claims are what a business ‘owes’. They are obligations on the business to give cash or benefit to some external party. There are two forms of claims: 1.Capital: This is the owner’s (shareholders’) investment in the business. 2.Liabilities: These are claims on the business made by external individuals and organisations, and include:  Trade Creditors  Bank and other Loans  Unpaid Tax

Examples of Claims 1.Bank Overdrafts. 2.Debts owed by the business to its suppliers. 3.Bank Loans 4.Corporation Tax 5.Shareholder’s Capital 6.Profit 7.Dividends.

Current liabilities  Current Liabilities (claims) - debts which the organisation is likely to have to pay within one year  Examples include creditors, bank overdraft, loan interest due in next 12 months, VAT and PAYE, dividends owed to shareholders.

Long-term liabilities  Long-term Liabilities (Fixed Liabilities) - debts which the organisation will not have have to pay within one year  Examples include hire purchase loans, mortgage and long-term bank loans

Shareholders Funds This is the most permanent form of funding, often called the shareholder’s Claim, but sometimes classed as a “Liability”,  Issued Share Capital - value of shares actually issued  Authorised Share Capital - value of shares company may legally issue  Retained Profit (or Earned Surplus) - profit left after all deductions have been made  Capital Surplus - money earned on disposal of Fixed Assets  Capital employed - all the capital put into the business (share capital, long-term loans, retained profit)

Accounting Standards and Conventions

Accounting standards & conventions  Company Law requires that accounting statements provide a “true and fair view”  Accounting Standards (established by UK accounting professions) try to define what a “true and fair view” is in different situations QUESTION:  Describe some of the Accounting Standards, Principles & Conventions which relate to the balance sheet

Accounting conventions and the balance sheet Accounting conventions 1. Business entity 2. Money measurement 3. Historic cost 4. Going concern 5. Dual aspect 6. Prudence 7. Stable monetary unit 8. Objectivity Click on the boxes to view the conventions

1. Business Entity Convention  The Business & its owners are seen as distinct entities.  Information is restricted to the business entity being examined.  Information is restricted to a given period of time (“periodicity”)

2. Money Measurement Convention  Information is restricted to data which can be measured easily (“quantitative”)  Information that cannot be expressed in monetary terms cannot be included in accounting statements

3. Historic Cost Convention  Assets are shown at a value based on their cost when acquired, NOT current market value or potential value to the organisation  This can mean that the Balance Sheet does not represent the true value of the organisation  Some assets may have higher value than is shown (e.g. where property has increased in value through rises in property prices)  Revaluation of assets can bring the valuation of assets closer to true market value

4. Going Concern Convention  Assumption is made that the organisation is a “Going concern” - it will continue operations into the future.  It is: Financially viable in the short term Competitive Well-structured financially for long term  The Business is solvent, therefore no intention to sell off fixed assets to cover claims.  Fixed assets can be shown as previously recorded values (historic costs).

5. Dual Aspect Convention  Every entry has two aspects, both affecting the Balance Sheet  e.g. Purchase of a piece of equipment - increases Fixed Assets and decreases Current Assets (Bank Balance) or increases Liabilities (Loan)  Saving on costs increases Bank Balance and increases Retained Profits

6. Prudence Convention  Figures should always err on the side of caution  “Anticipate no profit and provide for all future losses”  For example, stock value is shown at cost or market value - whichever is the lower  Where an asset has increased in value, the increase may not be shown until the asset is disposed of  The value of a sale should not be credited to the accounts until it has been delivered to the client

7. Stable Monetary Unit Convention  Accounting tends to assume that the value of money remains constant - i.e.. there is no inflation

8. Objectivity Convention  Accounting should be as free from personal bias as possible, and based on facts, not opinions.  Accounts should be consistent in the methods and values used. Changes of policy must be made openly, and in order to improve “true & fair view”  Values should be arrived at objectively and supported by evidence.

Other Principles There are three other principles which are used in Balance Sheet Accounting: –The Realisation PrincipleThe Realisation Principle –The Matching PrincipleThe Matching Principle –The Materiality PrincipleThe Materiality Principle Click on each of the principles above

The Realisation Principle  Revenue (Income) should be included in the accounts (“realised”) at the point when: The amount can be measured accurately The work is substantially completed It is reasonably certain that cash will be received  This is generally taken to be the point when a client takes delivery of service or goods  Revenue (Income) is unlikely therefore to be the same as cash received

Matching Principle  Revenue (Income) and Expenses (Costs) must be included together in the same period’s accounts wherever possible  This should enable the assessment of the net effect on profit which a particular activity produces  Entries may therefore be incorporated into the accounts to allow for costs which have been incurred in producing income, but which have not yet been paid, or for which invoices have not yet been received. These are called Accrued Expenses.

The Materiality Principle  Unimportant items are considered not to be “material” and need not be disclosed.  Other accounting rules may be ignored when dealing with immaterial items  Level of materiality varies from one organisation to another

Interpretation  When we look at a balance sheet, to inspect the health of a company, what sorts of things should we be looking for?

Interpreting the Balance Sheet When Looking at a Balance Sheet for a particular business, we should examine:  Liquidity (the ability of the business to meet its short-term obligations: Is there enough current assets to match current liabilities?).  Mix of Assets (The relationship between the fixed assets and the current assets: Is the long-term investment in plant, machinery sufficient to support the current level of trading?)  Financial Structure (The proportion of the financing of the business which has come through loans as opposed to shareholder capital: Has sufficient financing been raised through shares, rather than loans?)