Accounting - 1
Accounting – Introduction
Definitions
Accounting Concepts refer to the axioms or basic assumptions
underlying the financial accounts (Going concern, Accruals,).
Credit is an entry recording a sum received, listed on the right-hand side
or column of an account.
Debit is an entry recording a sum owed, listed on the left-hand side or
column of an account.
T-account is an informal term for a set of financial records that use
double-entry bookkeeping.
Short vs. Long-term A liability or an asset is categorised as long-term
when the company expects to benefit from it in over a year.
Assets are resources controlled by business for business activity.
Liabilities are obligations to owners and third parties.
Equity is the owners interest in the business.
Cash Flow is the movement of money into and out of a business.
Dividends are the proportion of profit given out to shareholders.
Concepts
Going Concern
Company continues to trade in foreseeable future and fixed assets and
stock will be used in the normal course of trade (Justify depreciation)
Accruals
Matching revenues with associated expenses when transaction is made
(cash has not been received).
Consistency
Similar items are treated with the same method from one period to the
next to enable comparability.
Prudence
Revenues and profits are only recognised when realised AND expenses
and losses are recognised whether amount is known with certainty, or its
best estimate. This ensures that profits and assets are not overstated,
and losses and liabilities are not understated.
Accounting - 2
Separate Valuation
Every item on financial statement should be valued independently and
offset should be avoided.
Qualitative Characteristics of financial statements (4 objects)
Relevance: Predicting Future or Confirming past/present
Reliability: Transactions are represented faithfully, information is neutral,
free from errors, compete, estimates are made with caution.
Comparability: Facilitates cross section comparison, e.g. consistency
Understandability: Users with reasonable knowledge should be able to
understand financial statements
There is a conflict between relevance and reliability because cross-checking
everything to free data from error takes time and becomes less relevant to user
when published.
Accounting - 3
Balance Sheet
Snapshot
Shows the net number of, e.g. receivables (usually calculated in the T-
accounts)
What does the company own, owe and its net-worth
o Assets = Liability+ Net Worth
o Uses of funds = Sources of funds
Analyse company’s performance
o Analyse relationship between assets and liabilities
Liquidity (current assets and current liabilities)
o Relationship between output and resources
Profitability/Efficiency
Ratio Analysis
Limitations
o Certain point of time
o Opportunity cost of assets not taken into account
o Off-balance sheet activities
o Real Value of business depends on its ability to generate income
and not on the individual asset and liability values.
Assets (current or short-term)
Capable of generation cash within a year
Examples:
o Inventories (stock): Final product/merchandise
o Trade receivables (debtors): Money owed by customers (credit
sales)
o Cash/Bank deposits
o Short-term financial investments
o Prepayments: Expenses paid in advance.
Assets (non-current, long-term or fixed)
To be used for more than a year.
Examples:
o Tangible: Property, plant, equipment and depreciation
o Intangible: no physical form, e.g. goodwill, patents, trademarks
o Long-term financial investments
Accounting - 4
Liabilities (current or short-term)
Payable within a year
Examples:
o Trade payables (creditors): Money owed to supplier
o Accruals: Services received but not yet paid for, e.g. rent
o VAT and taxes payable
o Bank overdrafts
Liabilities (non-current or long-term)
Payable in more than a year
Examples:
o Long-term loans
o Bonds and debentures
o Mortgages
Shareholders Equity/Capital/Net Worth
Amount invested in firm
Par value of shared
o Share Premium: Excess paid over the par value of shares
Retained Profits: Portion of profits re-invested in the business
Accounting - 5
Profit & Loss Account
Activity of a company for a given period
States revenue, expenses and profit (loss) during a specific period
Accounting standards
o Revenue and Expenses incurred during the period
Underlies accruals concept
Follows a general form
Determines:
o EPS (Earnings per share)
o Amount of dividend
o Retained earnings
o Changes in equity
Limitations
o Different accounting principles and different identification of
capital/asset and liability structures across firms
o Profit not the same as cash flow and it’s not enough to know only
about the profit
Structure and Terminology: Profit and Loss Account
Terminology
o Revenues/Turnover
Total amount of sales for the period
o COGS (Cost of Goods Sold)
Openings Inventory + Purchases – Closing Inventory
o Gross Profit
Revenues – COGS
Excludes inventory
o Operating
Distribution Costs (of products)
Administration expenses
Not tied to manufacturing/production or sales but to
the organization, e.g. salaries
Depreciation
o Operation Profit/EBIT (Earnings before interest and tax)
Gross Profit – (SUM of Operation Expenses)
o Finance income
Interest received
o Financing costs
Accounting - 6
Interest paid
o Profit before tax/EBT (Earnings before tax)
EBIT + finance income – finance expenses
o Tax payable
o Profit after Tax
Profit for the period
EBT – Tax payable
Feeds organic growth
Depreciation
Purchase of non-current assets not immediately treated as expense
o An investment into an asset will become an expense through
depreciation only when it helps to generate revenue for the
company
Cost allocation
o Each year a portion of the cost is shown in the income statement
as expense
Straight line method
o Takes into account: Initial Cost, Useful Life and Salvage Price
Diminishing Balance Method
o Takes into account: Initial Cost, Percentage of yearly depreciation
o Higher depreciation in early years and lower depreciation in later
years
Accounting - 7
Cash Flow Statement
Cash Flow vs. profit
o Profit is not determined by cash inflows – cash outflows is not
profit
o Increasing cash balance does not imply success, e.g. massive
borrowing
o Decreasing cash balance does not imply failure, e.g. investment in
assets
Aggregate data on all cash inflows and cash outflows
Facilitates reconciliation (viewing under compatible circumstances)
between “amount of cash generated during period” and “amount by
which cash balances have increased or decreased during period”
The following activities generate cash
o Operating, Investing and Financing
There are two ways to present cashflow statements:
o direct and indirect (more complex)
Terminology and Structure: Cash Flow Statement
Cash start of year + Cash inflows – Cash outflows = Cash at the end of
year
Operating Activities
o Cash Inflows
EBIT (If positive)
Depreciation
Added back as it is not a cash outflow
We add it back to cancel the effect in EBIT because
the cashflow statement shows money that goes in
and out of a business for a period BUT the money
has not been paid.
Add interest received
Changes in working capital
Add decrease in inventories and receivables
o We add it back to cancel the effect on EBIT
Add increase in payables
o We add it back to cancel the effect on EBIT
Add tax rebate
Accounting - 8
o Cash Outflows
EBIT (If negative)
Deduct Interest paid
Changes in working capital
Deduct increase in inventories and receivables
Deduct decrease in payables
Deduct tax paid
Deduct dividends paid
(Operating Activities: Changes in working Capital)
o What are the cash effects of changes in working capital items?
o WC = Current Assets – Current Liabilities
o Inventory increase means cash spent
o Receivables decrease means cash received
o Payables decrease means cash spent
Investing Activities
o Any transaction related to acquisition or sale of non-current assets
o Cash Inflows
Sale of property plant or e&Netquipment
Collection of loans to other entities
Sale of non-cash equivalent securities
o Cash outflows
Purchase of property plant or equipment
Lending of money to subsidiary
Purchase of non-cash equivalent securities
Financing Activities
o Any transaction related to borrowing from creditors or involving
owners
o Cash Inflows
Share issues, e.g. additional capital
Short term borrowing, e.g. bonds, mortgages
o Cash Outflows
Payment of cash dividends
Share repurchases
