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Financial Accounting / Statements

Financial accounting can be defined as the process of recording, summarising and reporting financial transactions of a business. Using guidelines, such transactions are recorded, summarised and presented in financial statements such as the balance sheet or an income statement.

Double entry

Double entry booking keeping system lies at the heart of the financial accounting. Double entry is classification of items into one of the five categories: assets, liabilities, equity, income or expense.

  • Assets could be defined as the resources owned by a business entity from which future economic benefits are expected to flow to the entity (IFRS, 2012). Typical examples of assets include inventory, plant and machinery and land.
  • Liabilities could be defined as an obligation arising from a past event, the settlement of which would lead to an outflow of the future economic benefits from an entity (IFRS, 2012). Typical examples of liabilities include accounts payables and loans.
  • Equity could be defined as the residual interest of the owners of the business in its assets after deducting the liabilities (IFRS, 2012).
  • Income could be defined as the increases in the economic benefits during the accounting period in the form of increase in assets or reduction of liabilities (IFRS, 2012). Typical examples of income include revenue generated from sales of products or services and interest income earned on financial investments.
  • Expenses could be defined as the decreases in the economic benefits during the accounting period in the form of reduction of assets or increase in liabilities (IFRS, 2012). Typical examples of expenses include costs of procuring goods for selling and marketing, selling and administrative expenses.

The objective of this module is to help you understand the application double entry accounting techniques to a range of simple transactions. You will also learn about concepts such as accruals and prepayments.

Accruals concept of accounting underpins the accounting technique of double entry system. The accruals concept of accounting states that a transaction is recorded at the time when it takes place, not when the settlement is made. On the other hand, a prepayment is the payment of an obligation or instalment payment before its due date.

By the end of this module, you will be able to prepare ledger accounts as well as a trial balance. Ledger accounts are a systematic refection of all transactions in a particular account.

Financial Statements

The module also covers the main financial statements that appear on a company’s annual report including: the income statement, the balance sheet and the cashflow statement. You will understand how to structure and read an Income Statement, which essentially represents the financial performance of a business over a period of time. It provides a summary of a company’s revenue and expenses from operating and non-operating activities.

The structure of an income statement is as follows:

Income Statement of ABC Plc for the year ending 31st March 2017

Sales

Cost of Sales

Gross Profit

Selling and Distribution Expenses

Administrative Expenses

Other Expenses

Operating Profit

Finance Income

Finance Cost

Profit before tax

Income Tax

Net Profit

Where:

  • Sales represent the total amount that a business has realised by selling its products and services to the customers.
  • Cost of sales could be defined as those costs that are directly attributable to selling a product or a service. Mathematically cost of sales could be expressed as: Opening stock + Purchases - Closing Stock
  • Gross profit could be expressed as the difference between the sales and the cost of sales.
  • Selling and distribution expenses are those costs that are incurred for selling and distributing products and services. Typical examples of selling and distribution costs are marketing expenses.
  • Administrative expenses refer to those expenses that are incurred on day-to-day activities of a business. Typical examples of administrative expenses include salaries paid to the employees.
  • Other expenses refer to those costs that could neither be classified as the selling or distribution nor as administrative expenses. Typical examples of other expenses include warranty costs.
  • Operating profit is the profit made by a business after deducting cost of sales and overhead expenses.
  • Finance income refers to the income earned on the investments made by a business. Typical example of finance income includes interest income earned on bank deposits.
  • Finance expense refers to expenses incurred on raising finance for a business. Typical examples of finance expense include interest paid on a loan.
  • Profit before tax is the profit that a business makes after deducting direct and indirect overheads and net finance costs.
  • Income tax is the amount of corporation tax that a business has to pay on its profits.
  • Net profit is arrived at after deducting all expenses and income tax. It reflects the net profit that a business makes from its operations.

You will understand what a balance sheet is and how to compete one. In short, a balance sheet reflects the position of a company’s assets and liabilities at a particular point of time.

The structure of a balance sheet is as follows:

Balance Sheet of ABC Plc at 31st March 2017

Non Current assets

Property plant and equipment

Investments

Current Assets

Stock

Debtors

Cash

Total Assets

Non Current Liabilities

Loan

Pension Liabilities

Current Liabilities

Bank overdraft

Creditors

Accruals

Equity

Share Capital

Retained Earnings

Total Liabilities and Equity

Where:

  • Non current assets are those from which future economic benefits are expected to flow to the entity over a period of time that is greater than 12 months. Typical examples of non-current assets include property plant and equipment and investments. When a business invests in a plant and machinery, it expects to benefit from it for a period of time that is significantly greater than one year. Furthermore, investments that mature after 12 months can be classified as non-current assets.
  • Current assets are those from which future economic benefits are expected to flow to the entity for a period of time that is typically less than 12 months. Typical examples of current assets include debtors and inventory. Although debtors could be classified as long-term assets if the period of credit granted by a business is more than 12 months, the usual practice with most businesses is to grant credit period of less than 12 months. Inventories are classified as current assets because businesses typically expect to sell their inventories over a period of time that is less than 12 months because unsold inventory for a period of more than 12 months could be indicative of obsolescence. Nonetheless, like debtors, inventory could be classified as non-current assets under exceptional circumstances.
  • Non-current liabilities are those from which future economic benefits are expected to flow out from the entity after a period of twelve months. Loans are typical examples of non-current liabilities as the principal amount borrowed needs to be repaid after one year.
  • Current liabilities are those from which future economic benefits are expected to flow out from the entity over a period of time that is less than 12 months. Typical examples of current liabilities include accruals and creditors because usually the credit terms offered by most suppliers is significantly less than 12 months.
  • Equity reflects the residual interest belonging to the owners of the company after deducting liabilities from the assets. Share capital reflects the amount of money that is repayable to the shareholders of the company upon liquidation and the retained earnings reflects the cumulative profits or losses made by a business till the date of the preparation of the balance sheet.

The last financial statement examined is the cash flow statement. This is a financial statement that illustrates how changes in the balance sheet and income affect a company’s cash flows. Specifically, the cash flow statement breaks the analysis down to three areas: operating, investing and financing activities.

The structure of the indirect method of cash flow is as follows:

Cash flow statement of ABC Plc for the year ending 31st March 2017

Cash flow from operating activities

Profit before Tax

Add:

Net Finance Expense

Non cash items

Decrease in current assets

Increase in current liabilities

Less:

Decrease in current liabilities

Increase in current assets

Tax paid during the year

Net cash flow from operating activities

Cash flow from investing activities

Add:

Proceeds from sale of fixed assets

Less:

Purchase of fixed assets

Investments

Net cash flow from investing activities

Cash flow from financing activities

Add:

Proceeds from issue of shares

Less:

Redemption of debentures

Interest paid

Dividend Paid

Net Cash flow from financing activities

Change in cash and cash equivalents during the year

Cash and cash equivalents at the beginning of the period

Cash and cash equivalents at the end of the period

The indirect method of cash flow is prepared by taking profit before tax from the income statement and adjusting it for non-cash items such as depreciation or amortisation.

Thereafter, the profit figure is adjusted for the changes in the current assets and current liabilities over a period of time to arrive at the net cash flow from the operations. For example, if the debtors’ balance has increased compared to the previous year, it is indicative of a negative impact on cash, as more items would have been sold on credit. Net cash flow from operations is indicative of the ability of a business to generate cash flows from its operations.

Cash from investing activities reflects the cash performance of the business in the investments. Any investments that result in cash outflow from the business are subtracted and those that result in cash inflow are added to arrive at the net cash flow from investment activities.

Lastly, cash from financing activities reflects the sources and uses of cash flow for financing the business. Like cash flow from investing activities, any activities that result in cash outflow from the business are subtracted and those that result in cash inflow are added to arrive at the net cash flow from financing activities 

The net amount of the cash flow from operating, investing and financing activities should reflect the difference in the cash balance between two consecutive years.

For the purposes of cash flow statements, cash equivalents such as short-term deposits are also considered cash. Cash equivalents could be defined as highly liquid assets that could be readily converted into cash without a significant change in value.

Ratio Analysis

Ratios are an expression of one number in terms of another. This form of analysis facilitates comparison between the financial performances of different businesses or industries. Ratio, vertical and horizontal analysis are commonly used by financial analysts because they are useful tools for planning, controlling and monitoring an organisational performance. A range of financial ratios are explored in this module, including: liquidity, solvency, profitability, efficiency and investor ratios.

Advantages of ratio analysis include:

  • Ratio analysis enables the users of the financial statement to make comparisons between the financial performances of two or more businesses, even if they are of different sizes or from different industries, by converting financial numbers into standardised form using pre-defined formulas.
  • Ratios are easy to calculate and do not consume significant amount of time
  • Ratio analysis is a useful tool to monitor and control a business organisation’s performance. The users of the financial statements are often interested in assessing the profitability margins, liquidity and solvency position of a business.

Disadvantages of ratio analysis include:

  • One of the primary disadvantages of ratio analysis is that it is underpinned by numbers contained within the financial statements. Thus, if the numbers contained within the financial statements were subject to management bias, ratio analysis would give inaccurate results.
  • The lack of ideal ratios makes it difficult for the users of the financial statements to assess whether a particular ratio is good or bad. For instance, higher the current ratio, the better it is. Nonetheless, a business with exceptionally high current ratio could be reflective of the inability of a business to use its funds efficiently. Thus, the absence of any definitive guidelines regarding its interpretation limits its utility in the real world.
  • Since different businesses adopt different accounting policies and estimates, the comparison between two businesses would not yield effective results if the accounting policies and estimates adopted by the two businesses are different.
  • Ratio analysis is historical in nature, whereas most users of financial statements are interested in acquiring information about the future.

Bibliography

Adedeji, E., 2014, A tool for measuring organisation performance using ratio analysis, Research Journal of Finance and Accounting, vol. 5 (no. 19), pp. 16-22.

Gracia, L., 2013, Introduction to Financial Accounting, Custom Edition, London, McGraw Hill.

Grewal, T., 2014, Analysis of Financial Statements, New Delhi: Sultan Chand.

ICAEW, 2012, Financial Accounting Study Manual, 6th Edition, Exeter, Polestar Wheatons.

ICAEW, 2012a, Financial Reporting Study Manual, 6th Edition, Exeter, Polestar Wheatons.

IFRS, 2012, International Financial Reporting Standards, Part A, London, International Accounting Standards Board

Robertson, J., 2007, Financial Ratio Analysis, 3rd edition. Lancaster: John Robertson.


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