1. Accounts and Finance 3.3 a Final Accounts

2. The Purpose of Accounts: To provide information for stakeholders  Shareholders progress of their investment  Government tax liability  Suppliers credit worthiness  Customers long term future of the business  Prospective Investors decision making  Potential bidders in acquisition activity  Trade Unions negotiations with the company  Management monitor performance of the business  Employees their position in the business (they may well also be shareholders!)

3. the main principles Accounting cycle Balance sheet Profit and Loss Cash Flow

4. Accounting Cycle Source document Analyse transaction  Which two accounts and how are they affected? Effect of transaction on balance sheet Journalize entry Post to ledger/book of accounts Trial balance Financial statements  Balance sheet, Profit and Loss

5. Accounting Equation Assets = Liabilities + Shareholder’s Equity Shareholder’s equity is also known as  Capital  Owner’s Equity

6. Balance Sheet a statement of a firm's assets, liabilities and owners' equity at a specific date  it is a "snapshot" of the financial strength of a business on a specific date Provides record of capital expenditure The two sides of the account must always balance  This is known as the accounting equation A = L + OE

7. Balance Sheet: Assets Assets: What Business Owns  Fixed assets  Current Assets

8. Balance Sheet: Fixed Assets A ‘life’ of longer than 12 months  Tangible fixed assets physical items known as ‘capital expenditure’  Intangible fixed non-physical items very difficult to place a value on brand assets: names, goodwill and patents  Financial fixed assets investments such as shares and debentures in other companies

9. Balance Sheet: Fixed Assets Depreciation Purpose  To record the decrease in the value of the fixed asset Wear and tear, obsolescence, lack of maintenance, time  Details are shown in the notes section of the balance sheet Implications  Matches benefit of asset over its life, rather than writing off the entire cost in the first year  Without depreciation, accounts are inaccurate Methods of calculating  Straight-line depreciation Original cost – residual value divided by expected life in years

10. Balance Sheet: Current Assets likely to be realised in the form of cash within 12 months Cash in the bank Cash on the premises ("petty cash") Debtors or Accounts Receivable Stock or Inventory Prepayments

11. Balance Sheet: Liabilities Liabilities: What Business Owes  Long-term liabilities  Current liabilities

12. Long-term liabilities borrowing that will exist on the balance sheet for more than 12 months Bank loans Mortgages Debentures

13. Current liabilities money owed to third parties which will be settled within 12 months Bank overdraft Creditors Accruals debts for which a bill has not yet been received Corporation tax owed to the Government Dividends payable.

14. Balance Sheet: Shareholder’s Equity Shareholders funds  Also called Capital and Owner’s Equity  Assets – Liabilities= OE  Reserves a residual claim on the assets  does not have a definite date by which it is to be repaid  is not a fixed amount  can fluctuate in value

15. Vertical Balance Sheet Fixed assets + Current assets minus current liabilities (CA – CL = working capital) = Net Assets or Assets Employed = Which are Represented by “Capital employed”  Long Term Liabilities  Shareholder’s equity  Reserves/retained earnings

16. Note the Difference Working Capital and Capital Employed are DIFFERENT! Working capital  Current Assets – Current Liabilities Capital Employed  Long Term Liabilities + Shareholder’s equity + Reserves or retained earnings

17. Return on Capital Employed

19. Working Capital Calculate  Current assets minus current liabilities Current Assets include  Stocks (inventory) Stock valuation  Lower of cost and net realisable value  FIFO  LIFO debtor control (accounts receivable)

20. Profit and Loss Statement Revenue -Cost of Goods Sold cogs sometimes called direct costs =Gross Profit - Expenses includes fixed costs and variable costs = Net Profit (Loss)

21. Profit and loss account Shows revenue business has received over a given period of time Shows corresponding expenses which have been paid Calculates the profit of the business

22. Revenue The result of sales of stock  Be aware of the difference between stock shares and inventory stock Revenue also called income Revenue also called turnover Recorded at the time of the sale, not when the cash is received Increases capital/owner’s equity

23. Revenue Sources: cash sales credit sales people who owe us money are called debtors Interest income royalties dividends that the business receives on its investments in other corporations

24. Trading Account Calculates Gross Profit Sales Revenue - Cost of Goods Sold Calculation of Cost of goods sold: Beginning stock inventory or opening stock + purchases of stock inventory – ending stock inventory or closing stock = Gross Profit

25. Expenses Known as revenue expenditure Decrease capital/owner’s equity Fixed and Variable Costs Expired costs  costs from which all benefits have been extracted during an accounting period  Examples wages and utility bills

26. Window Dressing Two key variables that a business may like its shareholders to believe are stronger than they really are: liquidity profitability

27. Window Dressing ‘Window dressing’ refers to attempts by business to present its accounts in the best light Has become more of a necessity as pressure to please shareholders and the City increases It is NOT illegal Deliberate deception in the accounts is fraud

28. Window Dressing How do firms ‘massage’ the accounts? Timing of reporting Balance sheet – snapshot of a business at a point in time, therefore:  Delay major payment  Include large injection of cash/assets Exploit accounting procedures – often a wide range in the definition

29. Window Dressing Sales and lease back  to boost appearance of liquidity Inventory/stock valuation  cost, realisable value, LIFO, FIFO, average Depreciation method  straight line, declining balance, accelerated Inflated brand valuations  boosting intangible assets

30. Window Dressing Exploiting other definitions – extraordinary items – what counts as ‘extraordinary’? Depreciation – different results gained using different methods – which is the ‘best’ and the most accurate?  Residual values – could be altered

31. Profitability Profitability window dressing  can be improved by bringing some of the revenue for the next financial year’s confirmed orders into the current financial year. This artificially boosts ‘sales revenue’ along with the profit figure for the business. The business will not be able to count the money again for the next financial year when the orders are dispatched  the profit figure for the following year will be depleted This window dressing ignores cause of low profit Is it a quality profit?

32. Cash Flow difference between the cash flowing into the business (e.g. through sales revenue) and the cash flowing out of the business (e.g. expenses) Cash is the most liquid asset  it represents the bank balance  also represents the cash that the business has available on the premises (otherwise known as ‘petty cash’).

33. Cash Flow Statement shows the cash inflows and the cash outflows for a business over the past 12 months indicates periods of any cash flow crisis highlight those months in which the business was cash-rich Allows forecast for the forthcoming year

34. Cash Flow Statement

35. Problems Overtrading  where the business attempts to expand too rapidly, without a sufficient financial base. Too much money invested in stocks. Allowing too much credit Unexpected changes in demand Over borrowing  having large monthly loan repayments

36. Handling Deteriorating Liquidity Possibilities  sell off fixed assets Problem: It does improve the liquidity, but the ‘fixed asset’ figure on the balance sheet will have fallen after the sale  ‘sale and leaseback’ scheme. The business still retains the use of the asset, but no longer owns it. Above moves are temporary fix  Implies to the readers of the accounts that cash is readily available  Business is not tackling the cause of the liquidity problem.

37. What to do in liquidity crisis Offer price discounts  boost sales and sales revenue. Sell off fixed assets ‘Sale and lease back’ arrangement Chase debtors for the monies owed Secure short term loan Sell off stocks  liquidation sale

38. Depreciation When businesses buy fixed assets (those that will last longer than one year) the value of the asset will change Depreciation seeks to take account of such changes in the accounts An imprecise science allows different interpretations

39. Depreciation Take the machine here:  What is its life span?  How much did it cost originally?  How much will it be worth at the end of its useful life?  What will be its value after 1 year?  After 2 years, 4 years, 15 years?  Would anyone else want to buy it?  How specialised is it?  What would it cost to replace after 5 years? Mill Drill Machine Copyright: Kenn Kiser, http://www.sxc.hu

40. Methods Key terms: Historical Value - initial purchase price Value at the end of the life of the asset - the Residual Value (RV) Life span of the asset Straight Line  Historic cost - RV/Useful life Declining Balance  Depreciating assets at a constant rate each year