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Marc Delingat Accounting Course Summary Table of Contents Table of Contents............................................................................................................................ 2 Course Summary............................................................................................................................. 3 Module 1: An Introduction to Accounting and the Accounting Equation.................................. 3 Module 2: The Profit and Loss Account..................................................................................... 4 Task One: Determining the consumption of the means of production................................... 5 Task Two: Determining the Value of the Closing Work in Progress and Inventories ........... 6 Module 3: The Balance Sheet..................................................................................................... 8 Module 4: The Cash Flow Statement.......................................................................................... 9 Module 5: The Framework for Financial Reporting................................................................. 10 Accounting Concepts............................................................................................................ 11 Audit Methodology............................................................................................................... 12 Module 6: Interpretation of Financial Statements .................................................................... 12 Module 7: Emerging Issues and Managerial Options in Financial Reporting.......................... 16 Module 8: An Introduction to Cost and Management Accounting........................................... 18 Module 9: Cost Characteristics and Behavior .......................................................................... 19 Break-even Analysis............................................................................................................. 21 Module 10: Allocating Costs to Jobs and Processes................................................................. 23 Cost Statements (Where do costs come from?).................................................................... 23 Plantwide vs. Departmental Rates ........................................................................................ 24 Joint Products and By-Products............................................................................................ 24 Process Costing and the Equivalent Unit.............................................................................. 25 Activity-Based Costing......................................................................................................... 25 Module 11: Cost for Decision Making ..................................................................................... 26 Absorption and Variable Cost Accounting........................................................................... 26 Cost Information for Management Decision ........................................................................ 27 Module 12: Budgeting .............................................................................................................. 28 Module 13: Standard Costing ................................................................................................... 30 Module 14: Accounting for Divisions ...................................................................................... 32 Divisions............................................................................................................................... 32 Transfer Pricing .................................................................................................................... 33 Module 15: Investment Decisions ............................................................................................ 34 Module 16: New Developments in Management Accounting.................................................. 38 Target Costing....................................................................................................................... 38 Life Cycle Costing................................................................................................................ 38 Throughput Accounting........................................................................................................ 39 Costing for Competitive Advantage ..................................................................................... 39 Thanks and Revision History........................................................................................................ 40 Page 2 of 40
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Marc Delingat Accounting Course Summary Course Summary Module 1: An Introduction to Accounting and the Accounting Equation Accounting may be defined as a series of processes and techniques used to identify, measure and communicate economic information which users find helpful in making decisions. What is accounting? • Accounting is a service function, not an end to itself. • Accounting deals with economic information and is usually expressed in money values. • Economic activity must be identified, then measured. • Accounting is a communication device (the information must be relevant to the purpose for which it is designed). Who are the users of accounting information? Internal users: Directors, Senior Executives, Managers, Employees (and trade unions) External users: Shareholders, Analysts, Creditors, Tax Authorities, the public Accounting Equation Assets = Owner’s Equity + Liabilities The balance sheet is a collection of balances after each transaction has been completed and recorded. Accounting entries involve a mixture of cash-driven items and judgment-driven items. Items for expenditure accounted for via the balance sheet are called capital expenditure. Fixed assets are of relatively long life and are generally used in the production of goods and services rather than be held for resale. Current assets are assets that are either currently in the form of cash or are close to being converted into cash within a short period of time (usually a year). Current liabilities are those obligations that a company must meet in cash within a short period of time (usually a year). A profit and loss account shows how a company’s profit was made. Profit is the excess in sales revenue over cost incurred in generating the revenue. Items of expenditure accounted for via the profit and loss account are called revenue expenditure. A cash flow statement portrays only those economic events of a business that affect the cash flow. Why is the cash flow statement so important? It breaks the conventions separating the balance sheet and the P&L account and states all events that affect the cash flow. Acronym Meaning OE Owner’s Equity LTL Long Term Loan P&E Plant & Equipment Page 3 of 40
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Marc Delingat Accounting Course Summary F&W Factory and Warehouse RMI Raw Material Inventory FGI Finished Goods Inventory MV Motor Vehicles Sole Trader • Can start trading at any time with the assets at his disposal • Has to distinguish between transactions that are domestic and those that pertain to his business • Has unlimited liability • No requirement to make public the P&L account and the balance sheet each year • Will have to make an annual tax return and will be taxed on the profit Partnership • Group of individuals contribute various assets • Is usually governed by a partnership agreement that among others specifies the method for sharing the annual profit. • The partners have unlimited liability • No requirement to make public the P&L account and the balance sheet each year Corporation • Limits the liability of the owners (called shareholders) to the amount of equity (share capital) paid into the company • Must make public it’s annual accounts which must be audited by a registered auditor • The share capital is split into small units (e.g. $1), the face value of the share, called the par value, or nominal value. The market might value a share higher than the nominal value, however, that does not influence the accounting equation, as the company still has access to the original paid in capital. Financial accounting or financial reporting depicts the total picture for a firm in the accounting period (e.g. total sales, total costs, total profits, and total asset structure). The information is compiled after the accounting period is over and the books of account have been closed. It derives from the legal obligation of the management to report to the owners how they have used the resources during the accounting period. Management accounting provides information, such as actual and projected costs and prices of individual products, projected sources and uses of cash, projected and actual costs of departments and processes, etc. in order to enable management to analyze past and predict future events and act appropriately. Module 2: The Profit and Loss Account The profit is the result of the transformation processes a company is engaged in a given time period and can be viewed as the difference between • a measure of accomplishment (what has been achieved in sales) and Page 4 of 40
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Marc Delingat Accounting Course Summary • a measure of effort (what these sales have cost). Accomplishment is generally measured at the first point in the operating cycle for which the following conditions are met: 1. The principal revenue producing service has been performed, i.e. the product has been made and delivered against a firm order. 2. All costs that are necessary to create the revenue have been either incurred, or, if not yet incurred, are either negligible or can be predicted within an acceptable degree of accuracy. 3. The amount ultimately collectable in cash can be estimated within an acceptable range of error. When is accomplishment achieved? • Enquiry: too early, order may not emerge • Order: too early, cost too uncertain, customer may walk away before delivery • Inventory of finished goods: too early, unsold goods may never sell. Also the ultimate sales price may be unknown • Ship • Invoice: about right, goods are normally invoiced at the time of shipment • Cash received: unnecessarily late, unless there is evidence that customers will not pay for goods Accounting conventions underlying the measurement of sales accomplishment: Realization Convention: Only products that have been sold are measured as sales. Products that are completed or partially completed and have not realized value for the business are not included. Accruals Convention: Cash does not have to be received to create value; an obligation from a creditworthy customer is good enough to be called a sale. The accruals convention also covers the situation where an entity pays an invoice for a product or service which covers a certain time period that stretches beyond the date of the reporting statement. Accounting conventions underlying the measurement of effort: Matching Convention: Profit is arrived at by matching the effort (or cost) with the units shipped and invoiced to the customers (sales) during the period. Efforts are al cost involved in producing saleable products and the costs involved in actually selling the products which are recognized in the measurement of sales accomplishment. Allocation Convention: the first task is to determine how much of each means of production in money terms was consumed during the accounting period (cost determination). Not all means of production are consumed during the accounting period. The second task is to determine how much of each means of production should be matched with sales revenue and how much much should be added to the inventory of unfinished and finished goods. Cost Convention: The cost used for different means of production is the historical price (also called acquisition price) paid for them when they were acquired. Task One: Determining the consumption of the means of production • Use of raw materials: determined by deducting the physical quantity of raw materials at the end of the year (or accounting period) from the sum of opening inventory and purchases during the year (or accounting period). Page 5 of 40
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Marc Delingat Accounting Course Summary • Labor: the payroll for the time period is the usual source of he measurement of labor effort used and is in money terms • Depreciation of fixed assets: the consumption (or decline in value) of the fixed assets used in the production has to be considered as a cost. Three factors have to be taken into account to define every depreciation model used: o Actual historic (acquisition) cost, including installation charges o Estimated net residual amount that can be obtained when the asset is disposed of o Estimated useful life of asset to current owner Depreciation Methods C −V Straight Line Depreciation D = end Simple and reasonable methods for many assets annual n V Reducing Balance Depreciation D = C1− n end Assumes that a fixed asset is more annual C efficient in generating revenue in the early years of it’s life. Repair also tends to be lower in the earlier year in the live of an asset so early high depreciation counterbalances high later repair cost. t ( ) Consumption Method D = annual C −V Assumes that the greater the number of running annual t end total hours of the asset the greater the wear and tear on the machine. Dannual: annual depreciation amount C: acquisition cost Vend: scrap value (or estimated value when asset is sold) tannual: annual running hours ttotal: total running hours Task Two: Determining the Value of the Closing Work in Progress and Inventories The closing inventories of work in progress and finished goods have to be deducted from the total cost measured in Task One: the balance is set off as a charge in the profit and loss account. Types of inventory in a manufacturing company: 1. Finished goods inventory 2. Work-in-progress inventory 3. Raw materials and supplies inventory Inventory Valuation Methods: Inventory, once physically counted, is valued using a mixture of the cost and conservatism convention; inventory is valued at the lower of cost or net realizable value. • FIFO: It is favored by many businesses because it is consistent with the physical flow of goods and the balance sheet inventory is carried at realistic values (provided the stock turns over quickly). Problem is that reported income during periods of rising prices is relatively high as lower cost of sales in the past have been offset against sales revenue. Page 6 of 40
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Marc Delingat Accounting Course Summary • LIFO: Using this valuation method lower profit is reported in times of rising prices and replacement of inventories is therefore made easier. However many managers do not like the resulting lower profit figure. • Average Method: The weighted average unit cost of the goods available for sale is applied to the units sold to calculate the cost of goods sold and the ending inventory of goods. Product cost (such as raw material and labor) can be traced directly to the products being manufactured or to the production process. Product costs can include indirect costs (managers, supervisors, warehouse staff, heat, light, etc.) from expenses not directly involved in the manufacturing process, but whose services are connected to the manufacturing process. Period costs are incurred so that a company’s products can be sold, and the money collected from the customer, but they typically do not add value to the products unsold at the end of the accounting period. Period costs are fully set off against revenue in the P&L account, none are associated with inventory. The exact distinction whether an expense is a product or a period cost is not universally agreed upon. Raw Direct Factory Selling Admin Financial Material Labor Overhead Product Cost Period Cost Closing Inventory Cost of Sales Balance Sheet Profit and Loss Account Types of Profit Gross profit (sales – cost of sales) is a good measure of the transformation (manufacturing) process. Net profit (gross profit minus period costs) is a good measure of managerial efficiency against previous periods as well as other companies in the same space Net profit before interest charges and taxes: is a good measure of management’s efficiency of manufacturing, selling and distributing unaffected by the financial arrangements. Net profit after interest charges but before taxes and interest payments (to non-shareholders) are good measures of the company’s financial structure. Impact of changing value of money • Depreciation: due to inflation the replacement cost will not be the historic cost so a company could choose to use replacement cost instead of the historic cost to calculate the annual depreciation amount. The “top-up” depreciation is the amount added to the depreciation charge each year to bring the depreciation calculation in line with the current replacement cost for the fixed asset. Page 7 of 40
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Marc Delingat Accounting Course Summary • Cost of Sales: the cost of sales adjustment removes the holding gains (profit from holding inventory while it rises in value) from reported profit. One way to calculate the cost of sales adjustment is the averaging method. The current cost of sales can be computed by revising the reported cost of opening and closing inventory to the average current cost for the year, and the cost of sales adjustment will be the difference between the current cost of inventory at the date of the sale and the the amount charged in computing the historical cost. Module 3: The Balance Sheet Asset Classification: • Untransformed means of production: land, buildings, plant, machinery, and raw materials • Transformed means of production: work-in-progress and finished goods that have not yet been released to the P&L account. If they are released, these costs turn into expenses as no further benefit is anticipated from these costs. Fixed assets are assets that the company keeps for a substantial period of time and that are not intended for resale but used in the course of business. It is the intention of management as to the use of the asset that determines whether an asset is a fixed asset. Categories of fixed assets: • Land, usually not depreciated since it has an infinite life and thus does not normally decrease in value. Accountants record the acquisition cost together with the legal fees and the cost of preparing the land. This action is called capitalizing the fees and preparation expenditures compared with writing them off against profit in the period of incurrence. As the value of land changes accountants might not apply the cost convention anymore but rather reevaluate the value of the asset and add/subtract the difference from the shareholder’s equity. The P&L of a company is not affected by this reevaluation. • Buildings are sometimes shown together with land. Other companies depreciate buildings over time as they have a limited lifespan. • Plant and Equipment • Fixed Assets not owned by the company: Assets leased under the terms of a finance lease (one where ownership will revert to the lessee at the end of the lease) on the balance sheet; the asset is listed under “fixed assets” and the future payments under “creditors” Current Assets are assets which are expected to be sold or consumed during the normal operating cycle of the company (usually one year). Categories of current assets are: • Inventories: the valuation is based n the ‘lower of the cost or current market value’ rule; cost is defined as direct manufacturing cost plus a share of manufacturing overhead (period cost such as administration overhead are not included in inventory); inventory valuation methods can influence the value of the inventory and any changes in valuation methods has to be properly disclosed • Debtors: payment by debtors is expected shortly after the start of the next accounting period. Provisions for bad debts are entered at the beginning in the P&L account and subsequently changes in those provisions and actual bad debts are entered in the P&L account. Page 8 of 40
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Marc Delingat Accounting Course Summary • Cash Current Liabilities are liabilities which is plans to meet in the short term by the payment of cash. Examples are: creditors, bank overdraft, taxes payable, dividends payable, accruals, deferred revenue. Net Assets Net Current Assets (Net Current Liabilities) = Current Assets – Current Liabilities Net Assets of the Enterprise = Net Current Assets + Fixed Assets Ownership Equity are internally generated assets are the original equity introduced by the owner(s) and the retained profit generated through operation. Long term loans are generally the most important external source of funds. Lenders (unlike shareholders) have an enforceable right for annual fixed interest payments. Gearing = Long term debt / total assets In years of healthy profits shareholders will receive better return on their money in a high geared company, but when profits dip the heavy burden of debt Module 4: The Cash Flow Statement Users of financial statements, including Managers, need a reconciliation between profits and cash; this reconciliation is provided by the cash flow statement. They are used to “unstitch” the accounting principles applied to compile balance sheet and income statement. The cash flow statement reveals whether the entity has sufficient cash to finance future operations and ambitions to pay dividends and interest to investors, lenders, and owners of the company. What is cash? • Cash balances • Bank balances • Cash equivalents (Temporary investments of cash not required at the moment by the business. These investments are readily convertible into cash, or, if left alone would mature within 3 month.) Source of cash: • Profit from operations (Profit after depreciation plus depreciation added back in results in cash from operations) • Capital introduction (by owners) • Increase in creditors • Sales of fixed assets • Loans • Decrease in inventories • Decrease in debtors Where does cash go? Page 9 of 40
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Marc Delingat Accounting Course Summary • Loss from operations (If loss after depreciation plus depreciation added back in still results in a negative number this is the cash consumed by operations) • Capital repayments • Decrease in creditors • Purchase of fixed assets • Repayment of loans • Increase in inventories • Increase in debtors The major categories of cash from (according to Financial Reporting Standard) 1. Cash flow from operating activities 2. Cash flow from return on investments and servicing of finance 3. Taxation 4. Capital investment 5. Acquisitions and disposals 6. Equity dividends paid to shareholders 7. Management of liquid assets 8. Financing What is needed to draw up the cash flow statement? 1. The profit and loss account for the period 2. The balance sheet at the start of the period 3. The balance sheet at the end of the period 4. Supplementary notes to the financial statements Module 5: The Framework for Financial Reporting Disclosure Sole traders and partnerships are liable at law for the full extend of any debts that they might incur. Therefore there is no obligation by law for those entities to disclose a statement of their financial affairs on a periodic basis. At companies are the liability extends solely to the extend of the shareholdings in the company. Therefore companies regularly have to disclose statements on their financial affairs regularly (normally once a year) in order to help creditors assess the creditworthiness. For large companies with many shareholders the law requires the publishing of financial information in order to protect the shareholders in a similar way than the creditors. Sources of Disclosure Requirements: 1. Government legislation (e.g. in the form of the Companies Acts 1985 and 1989 for GB) 2. The accounting profession’s rules of procedure contained in Accounting Standards and International Accounting Standards 3. The requirements of the Stock Exchange Listing Agreement for companies whose ordinary shares are listed on the Stock Exchange Limitation to Managements ability to select the accounting policies: Page 10 of 40
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Marc Delingat Accounting Course Summary • True and fair view: Management has to choose policies so that the financial statements produced reflect a true and fair view of the state of affairs of their company • External auditors: The external auditors must approve the selection of the accounting policies • Consistency: Once chosen, management must consistently apply the policies from year to year unless material conditions have changed significantly. In such an event the change in accounting policies must be disclosed. Called-up share capital: Companies are usually authorized to raise a certain sum of money through selling of ordinary shares. This amount is normally fixed at a sum far greater than required for ongoing operations, thus enabling the company to finance an expansion should that be deemed appropriate. When the amount issues reaches the authorized limit, the company will petition the courts to raise the limits on authorized share capital. Share premium account: The difference between the face value of a share and the price at which it was sold in the market is recorded by the company in the share premium account. Comments on financial statements: 1. Disclosure requirements are numerous and complex and require detailed interpretation by company management, accountants and lawyers, and by the auditors. 2. A corporate tradition has been built up to disclose the absolute minimum information required. Very rarely does company publish information that is not required. 3. Despite rigorous application of disclosure requirements, large gaps in information can still be detected by interested parties. Accounting Concepts Going Concern Concept: If there is no evidence to the contrary a company assumes that it will continue to do business for the foreseeable future. This assumption allows management to write down the assets of a company (depreciate the assets) in an orderly manner over time, predict continuous inventory disposal, sales, and payment of creditors. Any know, significant, likely occurrence which may jeopardize the company’s future must be reflected immediately in the accounts (which would usually lead to an accelerated write-down of assets). Accruals Concept: A company does not necessarily need to wait for cash to change hands before accounting for revenue and costs. As an example, revenue can be recognized when the product has been shipped and invoiced and there is reasonable expectation to get paid. Consistency Concept: Unless there are pressing reasons to change accounting techniques and methods (such changes being disclosed) it is assumed that the treatment of like items between one year and another is the same. Prudence Concept: Revenues and Profits are not recognized until virtually all efforts have been expended and the customer is likely to pay; all costs and losses, actual and expected, are recognized immediately. Non-Aggregation Concept: In determining the aggregate amount of any item the amount of each individual asset or liability that falls to be taken into account shall be determined separately. For example, a company might be tempted to disclose a figure for net current assets only; the non- aggregation concept requires separate disclosure of current assets and current liabilities. Page 11 of 40
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Marc Delingat Accounting Course Summary Role of an external auditor: The auditor provides a report on the accounts examined by them to the shareholders. The report forms part of the published financial statements. The report shall state, whether, in the auditors opinion, • the accounts give the information required by the legislation (e.g. the Companies Act 1985) in a manner required by the legislation, • a true and fair view is given of the profit (loss) for the year, • a true and fair view is given of the balance sheet at the year-end, • in case of a holding company submitting group accounts they have been properly prepared as to give a true and fair view of the state of affairs of the profit and loss of the company and it’s subsidiaries so far as concerns the members of the company. The auditors have to also state in their reports if: • they have been unable to obtain all the information and explanations which they require • proper books of account have not been kept • proper returns adequate for the purpose of their audit have not been received from branches or subsidiaries not visited • the accounts are not in agreement with the books The auditors report is usually unqualified, meaning that they have no reason to deviate from the above opinion. If the report is qualified the qualification should state specifically and positively the reason why, and the extent to which the auditor is not satisfied. It should also state the effect on the accounts and, wherever possible, the amounts involved. Audit Methodology 1. Examination of the systems of bookkeeping, accounting, and internal control to ascertain whether it is appropriate for the business and properly records all transactions. Followed by such tests and enquiries necessary to ascertain whether the system is properly carried out. 2. Comparison of the balance sheet and profit and loss account and other statements with the underlying records to see that they are in accordance therewith. 3. Verification of the title, existence, and, value of the assets appearing in the balance sheet. 4. Verification of the amount of the liabilities appearing in the balance sheet. 5. Verification that the results in the profit and loss account are fairly stated. 6. Confirmation that the statutory requirements have been complied with and that the relevant accounting standards have been applied correctly. Internal control is a term used to describe all the various measures taken by the owners and managers of a company to direct and control their employees. The level of materiality is the threshold that external auditors set themselves for transactions amounts under which they will not examine in depth. Module 6: Interpretation of Financial Statements Liquidity Ratios are designed to measure a company’s ability to meet maturing short term obligations. Page 12 of 40
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Marc Delingat Accounting Course Summary Current Ratio = Current Assets/Current Liabilities A company is in good financial position to meet it’s future obligations if current assets exceed current liabilities by a comfortable margin (rule of thumb: Current Ratio >2). Quick Ratio = (Current Assets- Inventory)/Current Liabilities The Quick Ratio (also called the “Acid test”) removes inventory, which is sometimes slow moving, from the calculation and thus provides a more rigorous test of the company’s ability to pay its maturing liabilities. If a company finds itself with a quick ratio inferior to the industrial average but its current ratio matches the average the management should re-consider the amount of inventory that the company carries. Profitability Ratios strike at the heart of a companies activities, namely whether it controls expenses and earns a reasonable return on funds invested. Gross Profit Margin = Gross Profit/Sales A company must earn a significant gross profit margin to be able to bear the burden of other corporate overhead. Profit Margin = Profit Before Interest and Taxes/Sales As the tax charge in company accounts is often distorted by a variety of fiscal provisions and often reflects tax liabilities incurred in earlier accounting periods, the profit before taxes is sometimes a better indicator. Return on Total Assets = Profit before Interest and Taxes/Total Assets Sometimes the return on assets is calculated using only the productive assets (excluding goodwill (if any), and investments). If the return on assets is low, the company should look into shedding unproductive assets. Return on Inventory = Profit Before Interest and Taxes/Inventory Sometimes it is important to review the return on a specific asset, such as inventory to compare against other companies in the industry. Return on Capital Employed = Before Interest and Taxes/Capital Employed Capital Employed is usually defined as total assets minus the current liabilities. Alternatively the sum of the owner’s equity and the long term loans and provisions could be used. The Return on Capital employed shows the magnitude of the resources locked up in the business and working for the Page 13 of 40
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Marc Delingat Accounting Course Summary Return on Owner’s Equity = Profit Attributable to Shareholders/Owners Equity The share of the profit attributed to minority interests is deducted (not attributed to the shareholders). Normally an increase in the Return on Equity is a good sign, but it might also point to a problem with the company relying too heavily on debt. Capital Structure Ratios examine the percentage of a company’s total assets which are contributed by shareholders and the effect and risk of such percentage on earnings. Fixed to Current Asset Ratio = Fixed Assets/Current Assets This ratio by itself does not provide a major insight into the company. It’s value lies in comparing it with the ratio of other companies. Debt Ratio (Gearing) = Total Debt/Total Assets Total debt can be defined as all non-equity financing without minority interests. Debt to Equity Ratio = Total Debt/Total Equity Shareholder perspective on gearing: A low-geared company protects its shareholders in times of economic hardship but by the same token fails to allow them to cash in on bumper rewards when the business turns up. When the business is good the growth has to pay dividends that are high to the shareholders. If the gearing was higher in high grow times the shareholders would receive a higher portion of the profits as the interest paid on the loans would still remain the same. Times Earned Interest = (Profit Before Tax + Interest Charges)/Interest Charges Measures the extent to which earnings can decline without the company finding itself unable to meet the annual interest costs. Efficiency Ratios measure a company’s asset management. Inventory Turnover = Sales/Inventory Inventory is an asset that companies require to invest in to act as a buffer for raw materials and supplies as well as finished goods. The number has to be evaluated against a variety of different factors specific to an industry. In general if the inventory is low, lower costs of maintaining it as well as better return on assets will result. Average Collection Period (day sales outstanding) = Debtors/Sales per day The shorter the average collection period, the more stringent the credit management of the company regarding it’s customers. A short average collection period avoids companies having to borrow to finance ongoing operations due to outstanding payments from customers. Page 14 of 40
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Marc Delingat Accounting Course Summary Fixed Asset Turnover = Sales/Fixed Assets Again, as will all the other ratios the number is only meaningful when compared to other companies or past accounting periods. A low Fixed Asset Turnover shows that either a company is more efficient at using the assets it has to produce revenue, or that other companies are valuing their fixed assets higher (e.g. a more recent re-evaluation of the value of the land and buildings). Dupont Chart Return Total Assets Cost of Distribution R&D Administrati Inventories Debtors Investments Cash Sales on + + Operating Current Sales Fixed Assets Costs Asset - - Trading Sales Sales Total Assets Profit / / Total Asset Profit/Sales Turnover * Return on Total Assets (ROTA) One Hundred Percent Statement The On Hundred Percent Statement is a frequently used technique for profitability and cost control analysis. All items of cost are expressed as percentage of sales. Basic Stock Market Ratios Earnings per share (EPS) = Net Profit for the financial year/Number of ordinary shares in issue Price/Earnings Ratio (PE Ratio) = Market Price/EPS Dividend Yield = Dividend per share/Market Price per share Dividend Cover = Net profit of the year/Dividend payout Page 15 of 40
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Marc Delingat Accounting Course Summary The dividend ratio is designed to draw attention to overgenerous management decisions to pay out too much in dividends. A company does not need to earn profits to pay a dividend but if it does not, it will erode reserves and this action can not go on indefinitely. Module 7: Emerging Issues and Managerial Options in Financial Reporting Capitalization vs. write off for research and development (R&D) expenditures: Research costs should be written off as there is no guarantee how much of each years expenditure will bear fruit. Development cost may be capitalized given that: • there is a clearly defined project; • the related expenditure is separately identifiable; • the outcome of the project has been assessed with reasonable certainty as to its technical feasibility and its ultimate commercial viability (considering factors such as market conditions and competition, public opinion, consumer and environmental legislation); • the aggregate of the deferred and further development cost, related production, sales, and administrative cost is reasonable expected to be less than the total related sales (or other revenue) • adequate resources are (or will be) available to complete the project and provide the resulting increase in working capital Off-Balance-Sheet Transactions can be described as financing schemes deliberately designed to persuade the reader of a company’s accounts that the company’s financial structure is something other than it is. • Quasi-Subsidiaries: A subsidiary must be consolidated into the group profit and loss account and balance sheet; its assets and debts are added to those of the holding company for disclosure purposes. An investing company can so engineer the share capital and voting rights of another company that it avoids owning more than 50% but retains control of managerial decisions. Financial regulation requires consolidation of quasi-subsidiaries as the control (that is ability to direct financial and operating activities in order to gain an economic benefit) is still with the parent company. • Consignment Inventories: e.g. manufacturers sending dealers cars that are only paid for by the dealer when the car is actually sold. The manufacturer retains title of the vehicle. The dealer is able to not show a large part of it’s assets on the balance sheet. Financial regulation requires that if the unsold goods can be returned without a significant penalty, the dealer does not have to show the vehicles on his balance sheet. • Sale and Re-purchase Agreements: Company may decide to sell a certain asset (e.g. aging whiskey at a distillery) to a bank with the goal of moving the asset off it’s balance sheet. At the same time the company enters a re-purchase agreement to but the asset back at a time in the future. Financial regulation is concerned with the “substance of the sale”. If the risks and rewards of owning the assets are not really transferred, the agreement should be accounted for as a financing deal. • Debt Factoring: Companies sometimes sell outstanding debt to a finance house for debt collection at a value that is less than the face value of the debt. Problems arise, when, as part of the factoring deal, the finance house has recourse to the company when any of the Page 16 of 40
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Marc Delingat Accounting Course Summary debts prove to be irrecoverable. Financial regulation requires that in that case the originating company to keep a proportion of the “sold” debts on the balance sheet together with a matching liability to the finance house. Only when the debts have been recovered by the finance house should both items be taken off. Accounting for Acquisitions and Mergers can be done using acquisition accounting or merger accounting (also called business combination or “pooling of interest” accounting method). Acquisition accounting is used when the holding company acquires more than 50% of the equity share capital of the subsidiary for cash, or shares in the holding company, or a combination of both. Sometimes a sizeable minority of original shareholders remains in the subsidiary. Merger accounting presumes agreement between the two parties to pool their interests rather than for one to hand over the assets to another. The accounting statements of in merger accounting attempt to portray this harmonious coming together by restating both companies accounts as if the companies had always been one. Under acquisition accounting the balance sheet of the holding company will have increases in goodwill and the share premium account. Goodwill should not be carried as an asset on the balance sheet beyond it’s useful life. Writing off goodwill systematically has a negative impact on profits; writing it off through the reserves of the company may reduce them dramatically as well. Merger accounting avoids the problem of goodwill. However merger accounting can only be adopted when the following conditions are met: • None of the parties sees itself as acquirer or acquired • None of the parties dominates the management of the combined entity • The relative sizes of the entities are not so disparate that one company dominates the combined entity by virtue of its relative size • Each of the parties in the combination receives primarily equity shares • No equity shareholders of any of the combining entities retain any material interest in the future performance of only part of the combined entity When a company takes over another company’s assets and liabilities there have to be recorded in the holding companies books at the fair value rather than the book value. Goodwill comprises “that extra something” that acquirers see hidden in the business activities of the acquirees which has value to them. Goodwill is an intangible asset – value locked up in one company which another company is prepared to pay for because it will yield future economic benefits. Goodwill can be accounted for in two ways: • Writing off the purchased goodwill at the moment of the acquisition against group reserves • Capitalize the amount paid as an asset and depreciate the asset over the lower of its useful economic life or 20 years At all times management is required to subject goodwill to an impairment test, a detailed consideration of the inherent value underlying the number. Brands can be accounted for as intangible assets on the balance sheet. There are (among many others) two ways by which to account for brands as intangible assets: • Historic costs: Previously written off costs (such as marketing, advertising, R&D, etc.) are written back into the financial statements through the reserves. In effect the Page 17 of 40
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Marc Delingat Accounting Course Summary management is telling its shareholders that their stake in the company is now worth more than last year as the management now has the view that the cost incurred last year was expended to build up the brands. • Earnings Method: under this method management must attempt to attribute the actual earnings of a company to specific brands and then apply a multiplier to this figure which reflects the brand’s strength over the foreseeable future. This method his highly subjective as it might be very hard to attribute sales and cost figures to specific brands. In addition the multiplier is entirely subjective. An operating review gives the financial director scope to highlight difficulties that she had in abiding by a certain accounting standard and is meant to provide an opportunity to produce a clear, balanced, and analytical discussion of the company’s performance over the last year and a view of the future opportunities and difficulties that face the company. An operating review could include discussion on the following: • Changes in market conditions • New products and/or services introduced • Changes in market share • New activities, discontinued activities, and other acquisitions and disposals • Scarcity of raw material and labor skills • Environmental protection costs and potential environmental liabilities • Training programs • Financial contributions from the different business units • Any subjective judgments to which the financial statements are particularly sensitive A financial review could contain the following discussions: • Capital structure of the business (maturity profile of debt, type of capital instruments used, currency and interest rates) • Capital funding and treasury policies as well as sensitive items such as financial instruments for hedging purposes • Cash generated from operations and other cash inflows during the period • Restrictions on the ability to transfer funds within the group • Debt covenants which could have the effect of restricting the use of credit facilities • Strength and resources of the business whose value is not fully reflected on the balance sheet. An example could be any amount spent on R&D that has not yet been capitalized Module 8: An Introduction to Cost and Management Accounting Management Accounting Financial Accounting Structure No formal structure, can be Highly structured around the designed to suit many purposes, accounting equation each with its own set of guidelines Rules No externally imposed rules. Rigid Hemmed in by general accounting handling of asset valuations, principles to enable comparison overhead allocation and revenue across companies. recognition is relaxed. Page 18 of 40
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Marc Delingat Accounting Course Summary Compulsory No, but few succeed without a Yes, companies are obliged by law system, however informal. No to produce external accounts. value in maintaining one if it is not useful. Money terms Not exclusively Yes, financial statements are drawn up exclusively in money terms Time Spans Information tends to be future Records and reports past events as oriented. Management might accurately as the underlying compromise precision for speed accounting principles permit Whole or By its nature fragmented. Focuses Reports the events of the company parts on product lines, departments, as a whole processes, etc. Information can be reworked in many different ways Audit Strictly speaking, no, although the Yes, accounts have to be audited external auditors may with to test by a registered auditor the internal controls by examining aspects of the management accounting system. An internal audit function might use the management accounting system as it’s basis Cost accounting is a major and essential part of management accounting. Cost accounting deals with the classification, collection, and analysis of costs. Management accounting serves management in the following ways: 1. It is the primary source of information to assist management in planning 2. Provides skilled staff to assist management in interpreting the accounting and non- accounting numbers produced 3. Management accounting information pervades the whole company and therefore acts as a good communicator. It does this by involving many people in the planning process and then by informing them of actual operating performance by means of feedback and control reports. Module 9: Cost Characteristics and Behavior Fixed Costs do not change with a change in production levels. Variable Costs change proportionately with the production levels. Page 19 of 40
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Marc Delingat Accounting Course Summary Fixed Cost Variable Cost Semi-Variable Cost Beware of the possible calculation error that when fixed costs have been unitized, that is associated with each unit for production for a certain number of units. Example: Fixed costs/unit=$2 (when 100 units are produced), variable cost/unit=$2, for a total unit cost of $4. When production is raised to 200 units, the fixed cost per unit does not stay the same; it is now $1/unit as it is now spread across 200 units. When looking at per unit cost, it is not always clear whether fixed costs have been unitized or not. Costs that are seen to be incurred only because of the item is manufactured is termed direct costs. All other costs are indirect costs. Indirect costs are seen by the accountants as being costs incurred in support of the fundamental activities of manufacturing, buying, and selling; they are not attributable to a single product or range of products. Traceable costs are those costs than can be traced into the cost item. Common costs are the indirect costs incurred by a business to support the production. Without qualification traceable and common costs are the same as direct and indirect costs. A company with just one product line will not have any common costs as all costs can be traced to that one product (line). Product costs are costs that can be attached to the cost item without undue difficulty; period costs are those costs which, although incurred ultimately in the support of the product, are best controlled in time periods. Controllable costs are costs that are controllable by a certain manager (supervisor, etc.) in a certain timeframe who can be held accountable for the costs being measured. Non-Controllable costs can not be controlled by that manager or can not be controlled by the manager in a certain timeframe. For example overtime can be controlled by a project manager, while business insurance cost can generally not be controlled by him. Managers should only be measured by costs that they can control. Standard cost is the budgeted cost for one cost item which is based not on engineering studies but on recent experience. Against this norm the actual cost is measured period by period. Standard Cost would comprise variable and a share of the fixed cost. Costs that can not be avoided in the production of a cost item (such as the raw material and the labor it takes to produce the item), that is costs that are engineered into the product are called engineering costs. All other costs, e.g. machine maintenance, R$D, etc., must not necessarily be incurred in every accounting period; these costs are called discretionary costs. Discretionary costs can be reduced rather quickly if the business faces a decline. Page 20 of 40
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