CH 30 - Accounting Fundamentals

CH 30 - Accounting Fundamentals

1. Income Statement

   • The trading account: shows how gross profit has been made from the trading activities of a business.
     • Gross profit: equal to sales revenue less cost of sales.
     • Revenue: (formerly called sales turnover) is the total value of sales made during trading period = selling price x quantity sold.
     • Cost of sales (or cost of goods sold) is the dire
   • Profit and loss account: calculates both the operating profit (profit before interest and tax) and profit of the year (profit after tax)
     • Operating profit = gross profit - overhead expenses
     • Profit of the year = operating profit - interest cost - corporation tax
     • note: limited companies pay corporation tax on their profits before they pay dividends or keep profits within the business.
     • Uses of income statement include:
       • Can be used to measure and compare the performance of a business over time or with other firms.
         • The actual profit data can be compared with the expected profit levels of the business.
           • Bankers and creditors of the business will need the information to help decide whether to lend money to the business
             • Prospective investors may assess the value of putting money into a business from the level of profit being made,
               • Low-quality profit: one-off profit that cannot be easily repeated or sustained.
               • High-quality profit: profit that can be repeated and sustained.
   • Appropriation account: shows how profit of the year of the company is distributed between the owners, in the form of:
     • Dividends is the share of profits paid to shareholders as a return for investing in the company.
     • Retained earnings: the profit left after all deductions, including dividends, have been made, this is ploughed back into the company as a source of finance

2. Statement of Financial Positions/balance sheet

   • Content
     • Shareholder's equity: total value of assets - total value of liabilities
     • Asset: an item of monetary value that is required to pay in the future
       • Non-current asset: assets to be kept and used by the business for more than one year. Also called 'fixed assets'.
         • Patents
         • Trademarks
         • Copyrights
         • Goodwill: arises when a business is valued at or sold for more than the balance sheet value of its assets.
       • Current asset: assets that are likely to be turned into cash before the next balance sheet date.
         • Trade receivable (debtors): the value of payment to be received from customers who have bought goods on credit.
         • Inventories: Stock held by the business in the form of materials, work in progress and finished goods.
       • Intangible assets: items of value that do not have a physical presence, such as patents, trademarks and current assets.
         • Intellectual capital or property: the amount by which the market value of a firm exceeds its tangible assets less liabilities - an intangible asset.
     • Liability: A financial obligation of a business that it is required to pay in the future.
       • Non-current liabilities: value of debts of the business that will be payable after more than one year.
         • Loans, commercial mortgages, debentures.
       • Current liabilities: debts of the business that will usually have to be paid within one year.
         • Trade payable (creditors): value of debts for goods bought on credit payable to suppliers, also known as 'trade payables'.
     • Share capital: the total value of capital raised from shareholders by the issue of shares.
   • Aim: to record the net wealth or shareholder's equity of a business at one moment in time by raising value of the business assets more than any increase in the value of liabilities. Shareholder's equity comes from two main sources:
     • Share capital
     • Retained earnings accumulated over time through operations.
   • Other informations in published accounts
     • The cash flow statement: focuses on how the company's cash position changed over the past year.
     • The Chairman's statement: general report of the major achievements of the company over the past year/
     • The Chief Executive's Report: detailed analysis of the last financial year.
     • The Auditors' Report: report of the accuracy of the accounts and validity of accounting method's used.
     • Notes to the accounts: basic information needed to assess the position of the company.

3. Accounting ratio analysis

   • Profitabiltiy ratios
     • Gross profit margin %: (gross profit/revenue)x100
     • Operating profit margin %: (operating profit/revenue) x 100
   • liquidity ratios
     • Current ratio: current assets/current liabilties
       • <1 not enough cash for short term debt
       • >1 = good indicator
     • Acid-test ratio: liquid assets/current liabilities
   • Limitations of ratio analysis: 1. needs to be compared with results from other similar businesses 2. poor ratio results highlight potential business problem 3. comparison must be done with caution because some accounts may be window dressed.
     • Window dressing (Limitations of Published accounts) : presenting the company accounts in a favourable light to flatter business performances.
       • Selling assets
       • Reducing amount of depreciation of fixed assets
       • Ignoring the fact that some customers have not paid for the goods
       • Giving stock levels a higher value than they are probably worth
       • Delaying paying bills or incurring expenses until after account is published

4. Internal and External users of accounts

   • Business managers
   • Banks
   • Creditors
   • Customers
   • Government and tax authorities
   • Investors
   • Workforce
   • Local community

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