Accounting
Module 1 – Intro to Accounting
· 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
· Accounting is a service function. It provides information to decision makers
· Accounting deals with economic information it confines itself to economic information as is usually expressed monetary. However it can deal in tons of raw materials, # of hours worked capacity of machinery, etc.
· Economic activity must be identified then measured
· CIO hearts attack vs. sales rep company car tires. – The latter only can be measure and identified so it was considered
· Accounting is a communication device – information must be relevant for the purposed for which it is designed. The accountant must communicate the information in a way y that the user can understand.
· Users of accounting information
· Internal, Directors, Executives, Managers, and employees
· External – shareholders, analysts, creditors, tax authorities and the public
· The accounting equation
· All economic resources acquired by an entity must be funded from somewhere
· Assets = owners equity + liabilities
Or Assets – liabilities = owners equity
· Owner’s equity of a company is represented by the net assets (fixed plus net current = Assets – Liabilities = owner equity)
· Assets of the company can be split into fixed (long life) and current (easier to convert to cash)
· Current liabilities are those obligations which a company must meet in cash in a short time usually less than a year
Profit Loss statement
· Profit is the excess sales revenue over the costs incurred in generating the revenue. Expenses accounted via the profit/loss statement are revenue expenditure vs. expenses via the balance sheet are capital expenditure
· Depreciation is a deduction from sales revenue before profit is determined but has no effect on cash
· Cash flow statement – shows only those events of a business which affect cash flows.
· First sources of cash should always be the operations of the business
· The profit is the most useful starting point for determining the amount of cash generated by operations.
· An increase of creditors is a source of cash
· An increases in debtors is potentially not – if they don’t pay
· The cash flow statement breaks down the accounting conventions of each event into either the balance sheet of the profit and loss accounts
Types of businesses
· Sole Trader
· Unlimited liability
· Business and personal assets are at risk
· No requirement for him to make public his profit and loss account
Partnership
Normally a partnership agreement is written up
Partnership need not make public its annual results because Business and personal assets are at risk
Company
A company structure avoids unlimited liability by limiting the liability of the owners – shareholders to the amount of equity paid into the company. Shareholders cannot lose any more money than the sum paid for the share
For this privilege companies must make pubic there annual accounts which must be audited by a registered auditors.
Financial accounting – the past – repots to the owners of the business how they have used resources during the accounting period. Usually annually
Management accounting - the current/future – actual and projected costs of departments, products, processes and projection on cash, investments etc.
Module 2
Profit and loss Account
Profit is the difference between the sales and all the costs incurred to bring the goods to market.
Two types of costs
Direct costs – raw materials, wages of workers in transformation the goods, and depreciation
Indirect costs – advertising salaries of service support staff
Profit is the difference of the measure of accomplishment (sales) less the measure of effort (what the sales cost)
Accomplishment is measure at the first point in the operating cycle which all the following conditions are met
- Principal revenue product./service has been performed – product made and delivered against a firm order
- All costs that are necessary to create the revenue are incurred or if not yet incurred are negligible or can be accurately predicted
3 – Amount collectible in cash that can be estimated with an acceptable range of error.
Justification of shipping and invoicing measure of accomplishment is the first point in the cycle at which all three criteria are met
Three other possible choices
Time of sales orders – can be challenging when there is a delay between order and shipment in which customer can change mind or change the specifications.
Time of Production – sales may not materialize in one period due to no orders in that period. I.e. shipbuilding, construction.
Time of collection. -- Installment plans for goods.
Provisions on an installment plan – small down payment required
The payment period is long and requires payments of principal and interest
The seller has conditional title to the goods
High risk of reclaims of the product because of non payment...
Revenue is recognized as cash is collected.
Costs of merchandise sold on installment are carried in inventory in the balance sheet.
Profit loss is transferred after payment has been received
Accounting Conventions - Conventions underlying measurement of sales accomplishment
Realization convention – Only sold goods are recognized as Sales
Accruals convention – Cash does not have to be received to create value
An obligation of a creditworthy customer is good enough for a sale
Measurement of Effort
Profit equals the measurement of sales minus measurement of effort – costs – What sales had cost
Three conventions
Matching convention – arrived by matching the effort (costs) with the units shipped and invoiced to customers (sales) for the period: both cost of products and selling and admin
Allocation convention – two tasks
How much of each means of products express in money was used during that period
Second task to determine how much means of production in money should be matched with sales revenue and how much to work in progress inventory and finished goods inventory
Cost convention – accountants used historical cost the price paid for them when they were bought.
Determining the means of Production
Labor, Raw materials, Depreciation of Fixed Assets
Labor – annual, monthly, weekly payroll
Deprecation of Fixed assets
Deprecation is based on rule of thumb devised by engineers and accountants to affect the use of plant and machinery.
Three common types
Actual historical (acquisition cost including installation
The estimated net residual amount once disposed.
Estimated useful like of the asset to the present however,
1 – Straight line – equal portion of the acquit ions cost less estimated residual value allocated to the accounting period. During the asserts life
2 – Reducing Balance Deprecation
Large amounts of deprecation in earlier years then tapered off. Basis is fixed asset is more efficient in generating revenue early years and repair expenditure is low in early years.
3 – Consumption Method – running hours of the machine – more hours more wear and tear
Comparison of the three
Depreciation is the allocation of the costs of assets purchased in one period over the account periods in which they are used
Deprecation is a cost of production like raw materials and labor costs
Dependant on method used then the amount of deprecation allocated effects profit
Deprecation does not provide cash for a replacement of the fixed asset. This cost reduces reported profit and the less cash potentionally lowers tax and diveneds
Determining the value of existing work in progress and inventory
Types of inventory
Raw material’s ns supplies inventory – bought by purchase to use in the manufacturing processes
Work in progress – goods being made into the final saleable products – finished goods
Finished goods – goods manufactured, completed and ready for sale
Inventory valuation methods
The higher the Inventory value, the higher the reported profit.
Once counted is valued either by the Cost or Conservatism convention.
Cost - sum of expenditure either directly or indirectly incurred
Conservatism - if the goods are not sold and a reduced price is to be realized, the sale price less the cost of the sale gives the value for the inventory.
FIFO – First in First Out
The older unit costs (first purchased) are first ones sold. Inventory at the end of the period are the latest purchased
Negatives – reported income is high during periods of rising prices because the older and lower costs which have been set off against sales.
AS prices rise, companies find it difficult to replace physical volume of inventory used
LIFO – Last in First out
Most recent materials processed and sold
Opposite of FIFO – lower profit in times of rising prices and replacement inventory is easier
Average Method.
Weighted average unit cost – all costs incurred during the entire period/ divided by the number of goods rather than at the beginning or end costs like FIFO and LIFO
Valuation of Work in Process and finished goods
Products costs – costs traced directly to the products being manufactured – raw materials, labor,
Indirect costs – wages of supervisors, ware house staff, those whom do directly work on the production of goods. Could include factory overheads – heat light, depreciation
Three types of inventory
Raw materials – cost of raw materials
Work in process – product costs accumulated for those products started but not completed at the end of the period
Finished Goods – goods ready for sale
Period costs are selling, distribution and marketing costs, general adm costs – TTS, PFME
The more costs a company puts into product costs the more the inventory is worth. The higher the inventory the higher reported profit
Interpreting Profit
Gross Profit- Sales less Cost of sales measures efficiency of the transformation process.
Net Profit before Taxes and Interest - Gross profit less Product costs measures overall managerial efficiency.
Net Profit after Interest - measures the financial efficiency of the company
Net Profit after taxes and interest - tells very little.
Summary
The Profit and Loss account or Income statement therefore measures the Sales less the Cost of Sales.
Module 3 – The balance sheet
Assets are either
Untransformed means of production – Land, buildings, plant machinery, raw materials
Transformed – work in progress and finished goods which are not released to profit. /loss
The BALANCE SHEET
Fixed assets –
· Are those that a company will keep for several periods – land buildings, plants or equipment.
Expenditures to Fixed Assets – Maintenance expenses are those charged against profits in the period of outlay
Depreciation is the allocation of the outlay for the asset, operating and is deducted from the Balance Sheet over the life of the asset. Expenses for maintaining the asset are deducted from the profit in the P&L as account.
· Both have the same impact on the profit and loss account
Land - is not usually depreciated as it has infinite life and does not normally diminish.
Capitalizing - Acquisition costs together with legal fees are included in the land value.
Writing off – costs written against profit and loss statement
Accountants take conservative position and write off expenditures unless it is clearly related to acquisitions of the asset. – needed to get the asset
Buildings
It can be depreciated.
Plant and equipment – a slower depreciation rate reduces the impact of deprecation on profits.
Fixed assets not company owned.
Finance Lease - Assets leased under the terms of a finance lease (ownership reverts to the lessee at end of lease) are put on the balance sheet as a fixed asset and on the opposite side the future lease payments under creditors
Operating Lease- ownership remains with the finance company. The leased item does not have to appear, as an asset nor do the payments have to appear as a liability, though these costs are charged to the P&L account.
Advantages are -
Avoids large outflow of cash for purchase
Spreads cash flow over a period
Replacement of the asset without sale and purchase
Maintenance cost are normally covered in the lease
Payments are charged to the P&L account and therefore deductible before tax is incurred
Current Assets
Assets expected to be sold/consumed during a normal op cycle – i.e. one year
Includes raw materials, WIP inventories, finished goods, debtors (accounts receivable)
Inventories
· Value of inventory based on lower of cost or market value
· Cost is direct manufacturing cost plus share of manufacture overhead. Admin overheads are not normally in this
· Reported profit can be changed by the type of valuation of inventory.
· If valuation method is switched you must tell shareholders and users of financial stament’s so a proper analysis can be made.
Debtors
Customers at the end of the period have been billed by company but have not yet paid.
To take care of potential bad debts and the matching convention not being realized
A provision for bad debts is made.
Size of provision is made by considering
· Risks attached to each customer
· Severity with which the company will go after debtors
· Economic environment – interest rate changes
Cash – must ensure that company has cash to meet operating needs and investment plans. However, idle cash produces no revenue
Current Liabilities
Considered to be those debts owed by the company which expects to pay in the next 12 months.
Ex - Creditors, bank overdraft, taxes payable on profits.
Deferred revenue – advanced revenue is placed in the balance sheet as a current liability because the company has not fulfilled the service yet