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

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

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

4. 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.

5. 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.

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

7. 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,

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

9. 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.

10. “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

11. 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

12. 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

13. Types of Asset
Fixed Assets
Current Assets

14. 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

15. 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

16. 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

17. 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

18. 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.

19. 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

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

21. 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).

22. 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

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

24. 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

25. 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.

26. 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

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

28. 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.

29. 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.

30. 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.

31. 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

32. 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.

33. 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;

34. 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.

35. 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

36. 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)

37. 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

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

39. 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.)

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

41. Vertical Form: Balance Sheet
(£) (£)
Fixed Assets
Premises ,000
Vehicle , ,000
Current Assets
Stock ,000
Debtors ,000
Cash ,000
Less Current Liabilities
Creditors ,000
Working Capital ,000
Net Capital Employed ,000
Less long term liabilities
Net Assets ,000
Financed by
Issue Capital ,000
Retentions ,000
43,000

42. 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 £ ;
£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.)

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

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