Basics of Accounting

151030002
Lecture 1
Dr Muhammad Tahir
Room 548
mt109@soas.ac.uk
Learning Outcomes

 Define and explain accounting

 Explain and understand conceptual framework
 Understand the different business units
 Categorise the users (and uses) of accounting information
 Definition of Accounting
 Accounting is the process of identifying, measuring
and communicating financial information about an
entity to permit informed judgements and decisions
by users of the information.
 Fundamentals of Accounting
 Assets
 Current assets
 Non-current (fixed) assets
 Liabilities
 Current Liabilities
 Non-current liabilities
 Equity (Capital)
 Revenue (Income)
 Expense
 The Development of a Conceptual Framework
 A conceptual framework for accounting is a statement
of principles which provide generally accepted
guidance for the development of new reporting
practices and for challenging and evaluating the
existing practices.
 The Development of a Conceptual Framework
 Who are the users of financial statements?
 What are the information needs of users?
 What types of financial statements will best satisfy their needs?
 What are the characteristics of financial statements which meet
these needs?
 What are the principles for defining and recognizing items in financial
statements?
 What are the principles for measuring items in financial statements?
 External Reporting
 A conceptual framework is particularly important when
practices are being developed for reporting to those who are
not part of the day-to-day running of the business.
 This is called external reporting or financial accounting.
 Internal Reporting
 For those who are managing the business on a day-to-day
basis, special techniques have been developed.
 This is called internal reporting or management accounting.
Types of Business Entity

 Sole trader
 Partnership
 Limited liability company
Sole Trader
 An individual may enter into business alone, either selling goods or
providing a service.
 If cash is not available, the sole trader may borrow from a bank to
start the business.
 Sole trader’s business may be very much intertwined with the
personal life.
 For accounting purposes, the business is regarded as a separate
economic entity, of which the sole trader is the owner who takes the
risk of the bad times and the benefit of the good times.
Sole Trader
 The owner may hardly feel any great need for accounting
information because he or she knows the business very closely, but
accounting information will be needed by:
 Government (HM Revenue and Customs) for tax collecting
purposes.
 The bank for the purposes of lending money to the business.
 A person intending to buy the business when the existing owner
retires.
 Partnership

 Sole trader may expand to enter into partnership with one or

more people.
 Permits a pooling of skills or may allow one person with
ideas to work with another who has the money to provide
the resources needed to turn the ideas into a profit.
 But there are real financial risks if the business is
unsuccessful.
 Partnership

 For accounting purposes, the partnership is seen as a

separate economic entity, owned by the partners.
 One partner may be required to meet all the obligations of
the partnership if the other partner does not have sufficient
personal property, possessions and cash.
 This is described in law as joint and several liability.
 Partnership
 Need for accounting information:
 Partners wishing to be sure that they are receiving a fair share of the
partnership profits.
 HM Revenue and Customs.
 Banks who provide finance.
 Other persons who may be invited to join the partnership.
 The major risk attached to either a sole trader or partnership is that of
losing their personal property and possessions including the family home,
if the business fails.
Limited Liability Company
 To encourage the development of large business
entities, owners needed the protection of limited
liability.
 This meant that if the business failed, then the
owners might lose all the money they had put into the
business, but their personal wealth would be safe.
 LTD and PLC
 A private limited company has the word ‘Limited’ (abbreviated as
‘Ltd’) in its title.
 A public limited company has the abbreviation ‘plc’ in its title.
 A private limited company is prohibited by law from offering its
shares to the public (appropriate to a family-controlled
business).
 The public limited company is permitted to offer its shares to the
public. In return, it has to satisfy more onerous regulations.
Differences between a Partnership and a Limited
Liability Company
Formation
Partnership Limited Liability Company

Partnerships are formed by Formed by several people,

agreement but not necessarily in registering the company under the
writing. Companies Act.
Memorandum and Articles of
association set out the powers
allowed to the company.
Differences between a Partnership and a Limited
Liability Company
Running the business
Partnership Limited Liability Company
All partners are entitled to share in the Shareholders appoint directors to run the
running of the business. business.

Accounting Information
Partnership Limited Liability Company
Partnerships are not obliged to make Companies must make accounting
accounting information available to the information available to the public through
public. the Registrar of Companies Annual
Financial Statement (The Accounts).
Differences between a Partnership and a Limited
Liability Company
Meeting Obligations
Partnership Limited Liability Company

All members of a general partnership The personal liability of the owners is

are jointly and severally liable for limited to the amount they have
money owed by the firm. agreed to pay for shares.
Users and Their Information Needs

 Management:
 Concerned with running the business, using assets
to generate profit.
 Need information on performance and position.
Users and Their Information Needs
 Owners as investors:
 In larger companies there is separation of ownership from
management.
 Owners as investors check whether the return from the
investment, at present and in the future, is adequate, make
decisions about buying, holding and selling shares and are
interested in the entity's financial performance and financial
position.
 Most shares of listed companies are traded by fund managers of
financial institutions on the advice of equity analysts.
Users and Their Information Needs
 Employees:
 Check ability of employers to pay wages and provide continuity of
employment.
 Have issues associated with the working environment.

 Lenders:
 Lenders (potential and existing) require information on economic
stability, the risk of default and consequences.
 Users and Their Information Needs
 Suppliers or trade creditors:
 Will the company pay for supplies delivered on credit terms?

 Customers or trade debtors:

 Continuity of supply.
 Users and Their Information Needs
 Governments and their agencies:
 Governmental planning, national statistics, taxation and regulation
of utilities.

 Public interest:
 Impact on local economy, for example by providing employment or
using local supplies. A recent and strong element of public interest
is environmental concerns.
 General Purpose or Specific Purpose?
 Each user group has its specific information needs.
 But there is a view that a general-purpose financial
statement can be designed which is useful to more than one
user group.
 Owners and long-term lenders regarded as primary users,
but all potential users are interested in financial performance
and financial position of the reporting entity.
Accounting Equation

151030002
Lecture 2
Dr Muhammad Tahir
Room 548
mt109@soas.ac.uk
Learning Outcomes

 Define and explain the accounting equation

 Understand the concepts of assets, liabilities and ownership
interest
 The Accounting Equation

 Statement of Financial Position

 Assets – Liabilities = Ownership Interest
 The ownership interest is the residual claim after
liabilities to third parties have been satisfied.
 The Accounting Equation

 Alternative ways of expressing the accounting

equation Statement of Financial Position
 Assets = Liabilities + Ownership Interest
 Assets and Liabilities

 Assets:
 Resources available to the business.
 Liabilities:
 Obligations of the business.
 Measurement

 Historical cost is amount paid for an asset or agreed

for a liability on the date the transaction first occurs.
 Fair value is the price that would be received to sell
an asset or paid to transfer a liability in an orderly
transaction between market participants at the
measurement date.
 Definition of an Asset

 It is a present economic resource controlled by the

entity as a result of past events.
 An economic resource is a right that is capable of
producing economic benefits.
 Analysis of Definition

 A present economic resource: Is it capable of

producing economic benefit?
 Controlled by the entity: Can we restrict access to
the item?
 Past events: Has an agreement or event taken place
that has resulted in the organisation obtaining control
of the item?
 Examples of Assets

 Land and buildings owned by the business.

 Raw materials owned by the business.
 Cash held in a bank account.
 Amounts due from customers with a promise to pay.
 Investment in shares in other companies.
 Recognition
 An asset is recognised as an asset, i.e., reported in
the statement of financial position when:
 It meets the definition of an asset.
 The resulting information is relevant and gives
faithful representation.
 Costs of providing information do not exceed
benefits.
 Recognise or not?
 Recognise:
 Land and buildings Relative certainty
Why?
 Raw materials of future benefit

 Not recognise: Uncertainty of benefits:

 Workforce lack of evidence that
Why? cash will flow to the
 Advertising campaign
business in the future
 Definition of a Liability

 It is a present obligation of the entity to transfer an

economic resource as a result of past events.
 Analysis of Definition

 Present obligation: legal or as a result of

commercial reality.
 Transfer an economic resource: cash or other
resource leaving the business.
 Past events: normally receiving goods or services or
borrowing money.
 Recognition of Liability

 Meets the definition of a liability.

 Resulting information is relevant and provides a
faithful representation.
 Costs of providing information do not exceed
benefits.
 Examples of Liability

 Bank borrowing by the business.

 Sales tax (VAT) payable by the business based on
past sales.
 Liabilities not recognised

 An item that fails the recognition test (not reported in

the balance sheet) might well be reported in the
notes to the accounts as a ‘contingent liability’.
 Example of the ‘prudent’ nature of financial reporting
practice.
 For example, potential liability for defective products.
(Will a legal action actually be undertaken?)
 Ownership Interest

 The ownership interest is the residual amount found

by deducting all of the entity’s liabilities from all of the
entity’s assets.
 The term net assets is used as a shorter way of
saying ‘total assets less total liabilities’.
 Recognition is totally dependent on the recognition of
assets and liabilities.
 Changes in the Ownership Interest

 Compare the financial position of the business at two

points in time.
 At time t = 0
 Assets(t0) − Liabilities(t0) = Ownership interest(t0
 At time t = 1
 Assets(t1) − Liabilities(t1) = Ownership interest(t1)
 Changes in the Ownership Interest

Change in (assets − liabilities)

Change in ownership
or = interest
Change in net assets
 Causes of change in 01

 Normal business transactions: supplying goods and

services to customers.
 Owner contributing resources to the business (invest
cash in the business) or owner withdrawing
resources from the business (withdraw cash from the
business).
 Revenue and Expense

 Revenue: increase in the ownership interest (i.e.

increase in net assets). Providing a service to a
customer for which payment is made.
 Expense: decrease in the ownership interest (i.e.
decrease in net assets). Cost of providing a service
to a customer.
Net impact of business transactions

Revenue - expenses = Profit

 Equation for change in Ownership Interest

Ownership interest at the

Assets minus liabilities at the = start of the period plus
end of the period capital
contributed/withdrawn in
the period plus revenue of
the period minus expenses
of the period
 Rules
1. Ask yourself: Is this item an asset, a liability or a part of the
ownership interest?
Assets
Liability

Ownership interest
 Rules

2. Ask yourself: Has the item increased or decreased?

3. Choose the box that contains the answer.

Assets Increase Decrease

Liability Decrease Increase

Ownership interest Decrease Increase

 Rules

4. Make a debit entry or a credit entry.

Assets Increase Decrease
Liability Decrease Increase

Ownership interest Decrease Increase

Action to take Debit entries in a Credit entries in a

ledger account ledger account
Ownership Interest
Debit entries in a Debit entries in a
ledger account ledger account
Left-hand side of the equation

Asset Increase Decrease

Right-hand side of the equation

Liability Decrease Increase

Ownership interest Expense Revenue

Capital withdrawn Capital contributed

Conceptual Framework of Financial Statement

151030002
Lecture 3
Dr Muhammad Tahir
Room 548
mt109@soas.ac.uk
Learning Outcomes
 Understand the main sections of the IASB Framework
 The objective of financial statements
 Underlying assumptions
 Qualitative characteristics of financial statements
 Measurement of the elements of financial statements
 Objective of Financial Statements
 The IASB Framework states that the objective of
financial statements is "to provide information about
the financial position (statement of financial
position), performance (statement of comprehensive
income) and changes in financial position
(statement of cash flows) of an entity that is useful
to a wide range of users in making economic
decisions".
The Conceptual Framework
 Sets out the fundamental concepts for financial reporting that
guide the Board in developing IFRS Standards.
 It helps to ensure that the Standards are conceptually consistent
and that similar transactions are treated the same way, so as to
provide useful information for investors, lenders and other
creditors.
 Assists companies in developing accounting policies when no
IFRS Standard applies to a particular transaction, and more
broadly, helps stakeholders to understand and interpret the
Standards.
 The 2018 revised Conceptual Framework
 The objective of general purpose financial reporting;
 The qualitative characteristics of useful financial information;
 A description of the reporting entity and its boundary;
 Definitions of an asset, a liability, equity, income and expenses and
guidance supporting these definitions;
 Criteria for including assets and liabilities in financial statements
(recognition) and guidance on when to remove them (derecognition);
 Measurement bases and guidance on when to use them;
 Concepts and guidance on presentation and disclosure; and
 Concepts relating to capital and capital maintenance.
 Underlying Assumptions
 Accrual basis.
 Going concern.
 Accrual Basis
 It is assumed that financial statements are normally
prepared on the accrual basis, not the cash basis.
 Under this basis, transactions are recognised when
they occur (not necessarily when cash is received or
paid) and are reported in the financial statements of
the periods to which they relate.
 Going Concern

 Financial statements are normally prepared on

the assumption that the entity concerned will
continue in operation for the foreseeable future
and has neither the intention nor the need either
to close down or to reduce materially the scale
of its operations.
 Qualitative Characteristics of Financial Statements

 The Framework states that there are four "qualitative

characteristics" which make the information provided
in financial statements useful. These are:
 Understandability.
 Relevance.
 Comparability.
 Reliability
 Understandability
 It is clearly essential that the information provided in financial
statements should be understandable by users. Incomprehensible
information would have little value.
 The Framework suggests that the information provided in financial
statements should be understandable by users who have "a
reasonable knowledge of business and economic activities and
accounting and a willingness to study the information with
reasonable diligence".
 It is also stated that relevant information should not be excluded
from the financial statements merely because it may be too difficult
for some users to understand.
 Relevance
 To be useful, information must be relevant to users' decision-
making needs. Irrelevant information would be of no help.
 In particular, information will be relevant if it helps users to
evaluate past, present or future events or to confirm past
evaluations.
 Information which helps users to evaluate future events has
"predictive value" and may be used as a basis for predicting
matters in which users are interested, such as future financial
performance.
 Relevance
 The relevance of information is affected not only by its
nature but also by its level of materiality.
 Materiality is mainly concerned with the size or monetary
amount of an item.
 Information is "material" if it is of sufficient size that its
omission or mis-statement could influence users' decisions.
An item which is so small as to be immaterial will not usually
be relevant to users' needs.
 Comparability
 Users should be able to compare the financial statements of an
entity through time, so as to identify trends in its financial position
and performance. Similarly, users should also be able to compare
the financial statements of different entities.
 Comparability will be improved if:
 Financial statements show comparative information for preceding
accounting periods.
 Consistency: entities adopt accounting policies that are consistent
over time and, as far as possible, are consistent with accounting
policies adopted by other entities.
 Comparability
 Comparability will be improved if:
 Users are informed of the accounting policies adopted by an entity
and are also informed of any changes in those policies and the
effects of those changes.
 Compliance with international standards should improve the
consistency (and therefore the comparability) of financial
statements.
 Reliability
 To be useful, the information provided in financial statements must also be
reliable. Unreliable information would be misleading.
 Information does not have to be 100% accurate to be reliable but it must be free
of material error.
 Characteristics of reliability are:
 Faithful representation
 Substance over form
 Neutrality
 Prudence
 Completeness
 Characteristics of Reliability
 Faithful representation:
 To be reliable, information must represent faithfully
the transactions and other events it purports to
represent or could reasonably be expected to
represent.
 Characteristics of Reliability
 Substance over form:
 To be reliable, financial information must represent the substance and
economic reality of transactions and other events, not merely their legal
form.
 The legal form of a transaction may sometimes be very different from
its substance and this situation might be deliberately contrived.
 For instance, an entity may dispose of an asset to another party in such
a way that legal ownership of the asset is transferred but (in actual fact)
the entity continues to enjoy the economic benefits associated with the
asset. In these circumstances, reporting this transaction as the sale of
an asset would not faithfully represent the reality of the situation.
 Characteristics of Reliability
 Neutrality:
 To be reliable, the information provided in financial
statements must be neutral (i.e. free from bias).
Financial statements are not neutral if they are
prepared so as to achieve a predetermined result.
 Characteristics of Reliability
 Prudence:
 Prudence is defined in the Framework as "the inclusion of a
degree of caution in the exercise of the judgements needed in
making the estimates required under conditions of uncertainty,
such that assets or income are not overstated and liabilities or
expenses are not understated".
 It has to be said that the notion of prudence rather seems to clash
with the notion of neutrality. An accounting system which (in
conditions of uncertainty) always favours a prudent approach can
hardly be said to be neutral.
 Characteristics of Reliability
 Completeness:
 To be reliable, the information provided in financial
statements must be complete within the bounds of
materiality and cost. In fact, the omission of material
information reduces both the reliability and the relevance
of the financial statements.
 Constraints on Relevant and Reliable Information
 The IASB Framework identifies constraints which may prevent the information
provided in financial statements from being completely relevant and reliable.
These are as follows:
 Timeliness. In order to avoid undue delay in providing information (which would
make it less relevant to users) it may be necessary to report the information
before all of its aspects are known, so reducing its reliability. It is necessary to
achieve a balance between relevance and reliability which best meets the needs
of users.
 Cost. The benefits derived from information should exceed the cost of providing
it. Clearly it is not worth incurring additional costs in order to make information
more relevant or reliable if those costs outweigh the benefits to users. However,
it is difficult to apply a cost-benefit analysis in practice, since costs and benefits
often cannot be measured with substantial accuracy.
 Measurement of the Elements of Financial Statements

 Measurement is the process of determining the monetary

amount at which an element is to be recognised and shown
in the financial statements. The IASB Framework identifies
four different measurement bases which are:
 Historical cost.
 Current cost.
 Realisable value.
 Present value.
 Measurement of the Elements of Financial Statements

 Historical cost:
 Assets are recorded at the amount paid to acquire them.
Liabilities are recorded at the amount of proceeds received
in exchange for the obligation, or in some circumstances
(e.g. tax liabilities) at the amount expected to be paid to
satisfy the obligation in the normal course of business.
 Measurement of the Elements of Financial Statements

 Current cost:
 Assets are shown at the amount that would have to be
paid to acquire an equivalent asset currently (i.e.
replacement cost).
 Liabilities are shown at the undiscounted amount which
would be required to settle the obligation currently.
 Measurement of the Elements of Financial Statements

 Realisable value:
 Assets are shown at the amount which could be obtained
by selling the asset in an orderly disposal. Liabilities are
shown at the undiscounted amount expected to be paid to
satisfy the obligation in the normal course of business.
 Measurement of the Elements of Financial Statements

 Present value:
 Assets are shown at the present discounted value of the
future net cash inflows that the asset is expected to
generate in the normal course of business. Liabilities are
shown at the present discounted value of the future net
cash outflows that are expected to be required to settle the
liability in the normal course of business.
 Homework

 The main role of the International Accounting Standards

Board (IASB) is to devise and publish International
Financial Reporting Standards (IFRSs) and revised
versions of International Accounting Standards (IASs). IASs
were originally published by the IASB's predecessor body,
the International Accounting Standards Committee (IASC).
However, the IASC also published its Framework for the
Preparation and Presentation of Financial Statements in
1989 and this was adopted by the IASB in 2001. This
document is not an accounting standard.
 Homework
Required:
a. Explain the main purposes of the Framework document.
b. Identify the objective of financial statements, as stated in the Framework.
c. List SEVEN distinct user groups of company financial information and explain what
information each user group would be seeking from the financial statements.
d. Identify and explain the TWO assumptions which (according to the Framework) underlie
the preparation of financial statements.
e. Identify and explain the FOUR qualitative characteristics that make the information
provided in financial statements useful.
f. Explain why it is not always possible to produce financial statements which possess all
of the qualitative characteristics discussed in (e) above.
Non-Current (Fixed) Assets and Depreciation

151030002
Lecture 5
Dr Muhammad Tahir
Room 548
mt109@soas.ac.uk
Learning Outcomes

 Understand the non-current (fixed) assets

 Understand the methods to calculate depreciation
Definitions
 Assets: Resource… capable of producing economic
benefits.
 Non-current (fixed) assets:
 Held for use in profit generating process.
 On a continuing basis.
 Not for sale in ordinary course of business.
Classification
 Property, plant and equipment, also called tangible non-current
(fixed) assets.
 Intangible non-current (fixed) assets.
 Investments held long term.
 Intangible: No physical substance
 Patents.
 Trademarks.
 Development costs.
 Goodwill.
Valuation – Historical Cost
 Initially at cost.
 Subsequently:
 Cost less accumulated depreciation equals NET BOOK
VALUE (NBV).
 Also called depreciated cost.
 OR may choose fair value
Valuation – Fair Value
 In subsequent years company may choose Revaluation of
non-current (fixed) assets:
 Fair value at date of revaluation.
 Usually applied to land and buildings.
 Revaluation is a choice for the company.
 If used, revaluations must be updated regularly.
Cost of Non-Current (Fixed) Assets
 At acquisition:
 Purchase price of an asset plus the cost of preparing it for
use:
 Legal costs of acquisition and installation and
commissioning costs.
Improvements after purchase
 Improvement expenditure may extend the asset’s annual output capacity:
 Increasing its economic life.
 Reducing associated running costs.
 Improving the quality of its output.
 Costs incurred to improve on the asset’s original condition, for example:
 Extension to a building.
 Rebuilding shop fittings to attract new type of customer.
 These costs should be added to the original cost of the asset and depreciated
over the remainder of its useful life.
 Repairs and Restoration
 Costs incurred to maintain, repair or restore the asset to its
original condition – treated as an expense and charged to
the profit and loss account, for example:
 Replacing roof damaged in storm.
 Replacing engine in bus.
 Depreciation

 Non-current (fixed) assets are gradually used up in

providing goods and services over time.
 Purpose of accounting depreciation is to spread the cost of
a non-current (fixed) asset over its expected useful life.
 Depreciation is a method of allocating cost.
 Achieves a matching of costs against the related revenues.
 Depreciation

 In historical cost (traditional) accounting:

 The net book value (NBV) is the result of
a calculation.
 (Original cost − Accumulated depreciation)
 It is not intended to represent the asset’s market value.
 Yearly Depreciation – Accumulated depreciation

 Each year that a non-current (fixed) asset is in use, a

portion of its cost is deducted from the SFP. That portion of
cost is ‘matched’ against the revenues of that year. This
gives the depreciation charge of the year (P&L).
 The depreciation of the non-current (fixed) asset
in each year is added to the depreciation of earlier years to
arrive at the Accumulated depreciation (SFP).
 Calculation of Depreciation

 Requires three items of information:

 The cost of the non-current (fixed) asset.
 The estimated useful life.
 The estimated residual value (the value remaining at the
end of the useful life).
 Total Depreciation

 Total depreciation of the non-current (fixed) asset is equal to

the cost of the non-current (fixed) asset minus the estimated
residual value.
 Purpose and Methods

 The purpose of the depreciation calculation is to spread the

total depreciation over the estimated useful life.
 Methods of depreciation:
 Straight-line method.
 Reducing balance method.
 Straight-line Method

 Those who believe that a non-current (fixed) asset is used

evenly over time apply a method of calculation called
straight-line depreciation.
 The formula is:
Cost – expected residual value / expected life
 Reducing balance Method

 Those who believe that the non-current (fixed) asset

depreciates faster in the earlier years of its life would
calculate the depreciation.
 The formula is:
Fixed percentage x net book value at the start of the year
Current Assets

151030002
Lecture 6
Dr Muhammad Tahir
Room 548
mt109@soas.ac.uk
Learning Outcomes

 Understand the concept of current asset and its application

 Explain working capital cycle and its operation.
 Understand the treatment of adjusting entries in the financial
statements
Definitions
 A current asset is a present economic resource controlled
by the entity as a result of past events.
 It is an asset that has been acquired with the intention of
sale, or conversion into cash, within a relatively short space
of time, usually less than twelve months.
Examples
 Raw materials.
 Work in progress.
 Finished goods.
 Trade receivables (debtors).
 Amounts owed by other companies in a group.
 Prepayments and accrued income.
 Investments held as current assets.
 Short-term bank deposits.
 Bank current account (also called ‘cash at bank’).
 Cash in hand.
 Working Capital Cycle - Definition
 Working capital is the amount of finance, which a business
must provide to finance the current assets of a business, to
the extent that these are not covered by current liabilities. It
is calculated by deducting current liabilities from current
assets.
 Working Capital Cycle

 The working capital cycle of a business is the

sequence of transactions and events, involving
current assets and current liabilities, through which
the business makes a profit.
 Working capital cycle

Inventories
(stocks)

Acquire goods for use Sell goods or

in production, for resale or for use service to
in providing a service customers on credit

Payables Receivables
(creditors) (debtors)

Pay suppliers who

Collect cash
have allowed time to pay

Cash
Working Capital Cycle
 Calculated as current assets minus current liabilities.
 If the working capital is low, then the business has a close
match between current asset and current liabilities but may
risk not being able to pay its liabilities as they fall due.
Working Capital Cycle
 If current assets are very much greater than current
liabilities, then the business has a large amount of finance
tied up in the current assets when perhaps that finance
would be better employed in the acquisition of more non-
current (fixed) assets to expand the profit-making capacity
of the operations.
 Recognition
 Inventories (stocks), receivables (debtors), investments and
cash are commonly recognised in a statement of financial
position (balance sheet), but element of doubt may be
attached to the expectation of economic benefit and the
reliability of measurement.
Inventories – finished goods
 Finished goods: The future economic benefit is selling
price, which exceeds the cost of purchase or manufacture,
that makes a profit and increases the ownership interest,
but prudence dictates that profit should not be anticipated.
 Finished goods are therefore measured at the cost of
purchase or manufacture.
Inventories – finished goods
 Where there is strong doubt about the expected selling
price, such that it might be less than the cost of purchase or
manufacture, the asset of finished goods inventory (stock) is
valued at the net realisable value.
 Work in progress
 Partly completed finished goods.
 Risks often greater than for finished goods because of the
risk of non-completion, to add to all the risks faced when the
goods are completed and awaiting sale.
 There is a reliable measurement, in the cost of work
completed at the date of the financial statements, but
careful checking is required by the managers of the
business to ensure that this is a reliable measure.
 Raw materials

 The approach to recognition is the same as that for finished

goods.
 Raw materials are expected to create a benefit by being
used in manufacture of goods for sale.
 On grounds of prudence, the profit is not anticipated, and
the raw materials are recognised at the lower of cost and
net realisable value.
 Receivables (debtors)
 Debtors are persons who owe money to a business.
 Trade debtors are customers who buy goods on credit but have not yet paid. In
the statement of financial position, the trade debtors may be described as trade
receivables.
 Other debtors:
 Loans made to another enterprise to help that enterprise in its activities.
 Loans to employees to cover removal and relocation expenses or advances
on salaries.
 Refund due of overpaid tax.
 Receivables (debtors) – recognition

 Trade receivables (debtors) meet the recognition conditions

because there is an expectation of benefit when the
customer pays. Trade receivables (debtors) are measured
at the selling price of the goods.
 Profit is recognised in the income statement (profit and loss
account) when the goods or services have been supplied to
the customer.
 Doubtful debts

 There is a risk that the customer will not pay.

 The risk of non-payment is dealt with by reducing the
reported value of the asset by an estimate for doubtful
debts.
 Bad and doubtful debts

 Where there is doubt about the value of an asset, the

directors should be invited to consider making provision
against the loss of the asset.
 Where it is known that the debt is bad (because the
customer has declared himself/herself bankrupt), the debtor
should be removed from the record as a bad debt.
Prepayments

 Amounts of expenses paid in advance.

 For example:
 Rental.
 Insurance premiums.
Investments

 Held as current assets are usually highly marketable

and readily convertible into cash.
 Expectation of future economic benefit is therefore
usually clear.
 Measured at fair value (also called marking to
market) – more relevant.
 The change in fair value is reported in the income
statement (profit and loss account).
Cash

 Cash at bank (e.g., current account and instant access

deposit account) or cash in hand.
 The amount is known either by counting cash in hand or by
looking at a statement from the bank that is holding the
business bank account.
Structure of Financial Statements

151030002
Lecture 4
Dr Muhammad Tahir
Room 548
mt109@soas.ac.uk
Learning Outcomes

 Explain the purpose and the format of the statement of

financial position (balance sheet), the profit and loss
account (income statement) and the statement of cash
flows.
Primary Financial Statements
Primary financial statements Purpose is to report

Statement of financial position Financial position

(balance sheet)

Income statement Financial performance

(profit and loss account)

Statement of cash flows Financial adaptability

Primary Financial Statements
TRANSACTIONS AND EVENTS
↓
Practice of bookkeeping
↓
ACCOUNTING RECORDS
↓
Rules of measurement and disclosure
↓
FINANCIAL STATEMENTS
Statement of Financial Position (Balance Sheet)
 The statement of financial position (balance sheet) reflects the
accounting equation in the form:
 Assets minus Liabilities equals Ownership interest.
Statement of Financial Position (Balance Sheet)
 Statement of financial position is usually presented as:
Assets
minus
Liabilities
equals
Ownership interest
 Subdivisions
 Assets are subdivided into non-current (fixed) assets and
current assets.
 Liabilities are subdivided into current liabilities (due within
one year) and non-current liabilities (due after one year).
 Ownership interest may also be subdivided.
 Current assets and current liabilities are grouped close to
each other.
Structure
Non-current assets
plus
Current assets
minus
Current liabilities
Minus
Non-current liabilities
equals
Capital at start of year
plus/minus
Capital contributed or withdrawn
plus
Profit of the period
Other format of Statement of Financial Position - Horizontal

Liabilities plus
Assets equal Ownership Interest
Other format of Statement of Financial Position - Vertical

Assets

equal

Liabilities

plus

Ownership interest
 Profit and Loss Account (Income Statement)
 The profit and loss account (income statement)
reflects that part of the accounting equation which
defines profit:
 Profit equals Revenue minus Expenses.
Profit and Loss Account (Income Statement)

Revenue

minus

Expenses

equals

Profit
 Statement of Cash Flows

 Liquidity is measured by the cash and near-cash

assets and the change in those assets, so a financial
statement which explains cash flows should be of
general interest to user groups.
 Cash flow = Cash inflows to the enterprise minus
Cash outflows from the enterprise.
Statement of Cash Flows

Cash inflows
minus
Cash outflows
equals

Change in cash and similar liquid assets

 Subdivisions of Cash Flows
 Operating activities: Provision of services, and the
manufacturing, buying and selling of goods for
resale.
 Investing activities: Buying and selling non-current
(fixed) assets for long-term purposes.
 Financing activities: Raising and repaying the long-
term finance of the business.
Statement of Cash Flows
Operating activities: Cash inflows minus cash outflows
plus
Investing activities: Cash inflows minus cash outflows
plus
Financing activities: Cash inflows minus cash outflows
equal
Change in cash assets
 Profit does not equal cash

 Working capital:
 Some sales are made on credit, customers pay later.
 Some purchases are made on credit, pay suppliers later.
 Cash is used to buy inventory (stock) which is sold later.
Working capital cycle

Invento
ry

Payables Receiva
(CREDITO bles
RS) (DEBTO
RS)

Cash
 Profit does not equal cash
 Cash is used to buy more non-current (fixed) assets.
 Cash is used to buy investments.
 Cash is used to repay loans.
 Cash is raised from issuing shares.
 Cash is raised from borrowing.
Debit and Credit Recording
Debit entries in a Credit entries in a
ledger account ledger account

Left-hand side of
the equation
Asset Increase Decrease
Right-hand side
of the equation
Liability Decrease Increase

Ownership interest Expense Revenue

Capital withdrawn Capital contributed

Statement of Cash Flows

151030002
Lecture 7
Dr Muhammad Tahir
Room 548
mt109@soas.ac.uk
Learning Outcomes

 Understand the various sections of the statement of

cashflows – Operating, Investing and Financing activities
 Prepare the statement of cashflows using the appropriate
format for presentation
The value of Statement of Cash flows
 Cash is important for the long-term survival of an entity
 Profit is good but does NOT equal cash
 Cash flow statements break down and analyse the
movement in the bank account of an entity
 Note: The accruals basis of accounting does not apply to
statements of cash flows, so only cash received and paid is
shown
Cash Flow Statement
 The Statement of Cash flows is divided into 3 main sections:
1. Cash flows from operating activities
2. Cash flows from investing activities
3. Cash flows from financing activities
Definitions
 Cash comprises cash on hand and demand deposits.
 Cash equivalents are short-term, highly liquid investments
that are readily convertible to known amounts of cash and
which are subject to an insignificant risk of changes in value.
Cash flows from operating activities
 Cash used/generated from operating activities.
 Cash inflows:
 from sales
 Cash outflows:
 spending on trading and operational activities (cost of sales)
 distribution and selling costs
 administration expenses
 Two alternative approaches to presenting cash flows from operating
activities – Direct method and Indirect method
Cash flows from operating activities
 The Direct Method:
 Total operating cash inflows and outflows:
 + Cash inflows from sales
 – Cash outflows for purchases (cost of sales)
 – Cash outflows for other operating expenses
 = Cash flows from operating activities
Cash flows from operating activities
 The Indirect Method:
 + Operating profit/ – Operating loss
 +/– increases or decreases in working capital +/– adjustments for
the effect of non-cash transactions in the income statement
 = Cash flows from operating activities
 This is the preferred method for this module.
Which to choose – direct or indirect?
 Both are allowed by IAS 7.
 Both give the same answer for operating cash flow.
 Indirect method emphasises management of working
capital.
 Direct method gives information not available
elsewhere in the annual report.
Cash flows from investing activities
 Expanding businesses invest in new non-current assets to
generate more income
 Cash inflows:
 old, worn out or surplus assets are sold for cash
 interest/dividends received on non-current and current asset
investments (finance income)
 Cash outflows:
 payments to acquire new property, plant and equipment,
intangible assets and investments
Cash flows from financing activities
 Cash from sourcing or repaying finances such as owner’s
equity and borrowings.
 Cash inflows:
 from issuing share capital or increasing borrowings
 Cash outflows:
 dividends paid on share capital
 interest paid on borrowings (finance expense)
 repayment of borrowings
Increase/Decrease in Cash and Cash Equivalents
Cash flows from operating activities
+
Cash flows from investing activities
+
Cash flows from financing activities
=
Net increase/decrease in cash and cash equivalents for
the accounting period
Indirect method – operating cash flow
£m £m

1 Cash flows from operating activities

2 Profit before taxation xx
3 Adjustment for items not involving a flow of cash:
4 Depreciation, amortisation, gain or loss on disposal of non-current assets, etc.
xx
5 Adjusted profit xx
6 (Increase)/decrease in inventories xx
7 (Increase)/decrease in trade receivables xx
8 (Increase)/decrease in prepayments xx
9 Increase/(decrease) in cash due to
(increases)/decreases in current assets xx
10 Increase/(decrease) in trade payables xx
11 Increase/(decrease) in accruals xx
12 Increase/(decrease) in cash due to
increases/(decreases) in liabilities xx
13 Increase/(decrease) in cash due to working capital changes
xx
Indirect method – operating cash flow (Cont..)
15 Interest paid (xx)
16 Taxes paid (xx)
17 Net cash inflow from operating activities xx
Indirect method – cash flows from investing
18 Cash flows from investing activities
19 Purchase of non-current assets xx
20 Proceeds from sale of non-current assets xx
21 Interest received xx
22 Dividends received xx
23 Net cash used in investing activities xx
Indirect method – cash flows from financing

24 Cash flows from financing activities

25 Proceeds from issue of share capital xx
26 Proceeds from long-term borrowing xx
27 Dividends paid xx
28 Net cash used in financing activities xx
29 Increase/(decrease) in cash and cash equivalents xx
30 Cash and cash equivalents at the start of the period xx

31 Cash and cash equivalents at the end of the period xx

Direct method – operating cash flow
Line £m
£m
1 Cash flows from operating activities
2 Cash receipts from customers xx
3 Cash paid to suppliers xx
4 Cash paid to employees xx
5–13 (Lines not used)
14 Cash generated from operations xx
15 Interest paid (xx)
16 Taxes paid (xx)
17 Net cash inflow from operating activities xx
Direct method
 Are the same as those for indirect method.
 Investing cash flows.
 Financing cash flows.
 Working capital management
 Various activities in the operating activities has either
positive (increasing cash) or negative (reducing cash) effect
on cash.
 Such activities present in the operating activities are
referred to as working capital.
 Working capital items refers to Trade Payables, Trade
Receivables and Inventories.
Interpretation of Financial Statements

151030002
Lecture 8
Dr Muhammad Tahir
Room 548
mt109@soas.ac.uk
Learning Outcomes

 Understand and calculate the Profitability Ratios of a limited

company
 Understand and calculate the Liquidity and Efficiency Ratios
of a limited company
 Understand and calculate the Financial Gearing Ratios of a
limited company
 Understand and calculate the Investment Ratios of a limited
company
 Use of Financial Ratios

 Assessment of financial health of a company

 Identify strengths and weaknesses
 Help in comparison with competitors
 Assist in company decision making
 Inform stakeholders of stability of their interest
Ratios Benchmarks
 Ratios may be compared with:
 Past periods – reveals changes over time
 Similar business during the same period – comparison
with competitors’ same ratios
 Planned performance – how do ratios compare with
targets?
Classification of Ratios
 Profitability
 Liquidity and efficiency
 Financial gearing
 Investment
Classification of Ratios
 Profitability:
• Return on ordinary shareholders’ funds
• Return on capital employed
• Gross profit margin
• Operating profit margin
 Liquidity and efficiency:
• Current
• Acid test
• Inventory turnover
• Debtors’ collection period
• Creditors’ payment period
Classification of Ratios
 Financial gearing:
• Gearing
• Interest cover
 Investment
• Dividend payout
• Dividend yield
• Earnings per share
• Price/earnings
• Book value per share
Profitability Ratios
 Return on ordinary shareholders’ funds:
 Represents profit for the year attributable to owners
 Calculated on average value of shareholders’ funds over the year

Profit for the year x100

Average shareholders’ equity
Profitability Ratios
 Return on capital employed:
 Demonstrates how good a company is at turning capital into
profits
 Uses operating profit (profit before interest and taxation)
 Capital employed is total equity plus long-term debt
Operating profit x100
Average capital employed
Profitability Ratios
 Gross profit margin:
 A measure of profitability in buying and selling goods and services
 Relates gross profit (before other business expenses) to sales
revenue
 Changes in this ratio can have significant effect on final ‘bottom
line’

Gross profit x100

Revenue
Profitability Ratios
 Operating profit margin:
 Operating profit margin relates the operating profit to sales
revenue
 Operating profit is after deducting all expenses except interest and
tax

Operating profit x100

Revenue
Liquidity and Efficiency Ratios
 Current ratio:
 Relates to the ability of a company to pay its current debts
 A very low ratio (one or less) implies that a company would have
difficulty in paying its obligations
 A very high ratio (over three) suggests that a company is not using
its current assets efficiently
Current assets
Current liabilities
Liquidity and Efficiency Ratios
 Acid test ratio:
 Similar to current ratio, but excludes inventory
 A more stringent test of liquidity
 If acid test ratio is much lower than current ratio it indicates that
current assets are highly dependent on inventory
 Acceptable acid test ratio will vary from industry to industry but
generally should not be below one
Current assets - inventory
Current liabilities
Liquidity and Efficiency Ratios
 Inventory turnover:
 This ratio shows how quickly inventory is turned over during the
year
 Slow turnover means that funds are unnecessarily tied up and
inventory in storage may deteriorate

Average inventory x 365

Cost of sales
Liquidity and Efficiency Ratios
 Debtors’ collection period:
 Indicates how long on average a business takes to collect money
owed by its trade debtors
 Extended credit terms may distort comparison
 Generous discounts may encourage prompt payment, but will
reduce net sales

Average trade receivables x 365

Credit sales
Liquidity and Efficiency Ratios
 Creditors’ payment period:
 Shows the average time a business takes to settle its debts with
trade supplier
 Indicates how well business is taking advantage of available trade
credit
 However, slow payment to suppliers may mean that there is a
problem in finding sufficient cash
Average trade payables x 365
Credit purchases
Financial Gearing Ratios
 Gearing:
 Measures how much long-term lenders contribute to the overall
long-term capital of a business
 Is an indication of stability of a company
 Levels below 50% are considered to be acceptable - anything
higher means the company is relying too much on debt
Long-term debt x100
Equity + long-term debt
Financial Gearing Ratios
 Interest Cover:
 Determines how easily a company can pay interest on debt as it
becomes due
 A high level of cover gives confidence to both lenders and
shareholders
 A low level interest coverage ratio is a warning of risk
Operating profit
Interest charges
Investment Ratios
 Dividend Payout:
 Indicates the percentage of profit paid out to ordinary
shareholders as dividend
 Undistributed profit is carried forward as ‘retained earnings’ for
future investment
 The amount of dividend will be determined by the company
according to its needs
Dividend announced for the year x100
Profit for the year
Investment Ratios
 Dividend Yield:
 Measures amount of cash dividend paid to ordinary shareholders
relative to the market value of shares
 Used by shareholders to assess the cash return of their
investment

Dividend per share x100

Market value per share
Investment Ratios
 Earnings Per Share (EPS):
 Shows how much profit the company is making per share issued
 Useful ratio to shareholders to reveal trend or for comparison with
other businesses
 Regarded by analysts as a fundamental measure of firm
performance

Profit for the year

Number of ordinary shares issued
Investment Ratios
 Price/Earnings (P/E):
 Compares current market price of shares with per-share earnings

 Shows growth prospects of firm

 Shows investor confidence in firm and management
 May show prospects of takeover

Market value per share

Earnings per share
P/E Ratio – A Practical Example

Oil & Gas Development Company Limited (OGDCL)

2008 2009 (F)
Earnings per share 10.31 12.91
Dividend per share 9.5 8.25
Book value 25.43 29.34
P/E (x) 10.75
P/E (x) - Before freeze 10.22
P/E (x) - During freeze (Sep - Dec) 3.25
Investment Ratios
 Book Value Per Share:
 Shows the per share value of a company based on equity
available to its ordinary shareholders
 A good starting point to investigate the health of a company
 Indicates whether a company has sufficient resources to repay
shareholders in the event of financial difficulty
Shareholders’ equity
Number of ordinary shares issued
 Limitations of Ratio Analysis
 Depend on quality of financial statements
 If inflation is ignored comparisons may be distorted
 Gives a restricted view of business performance
 Basis of accounting must be same when comparing with different
companies
 Statement of financial position ratios only show situation at date of
statement
 Ratios are an aid to good management – not a substitute