BASIC ACCOUNTING

Set 1 – Some aspects of accounting

• Accountants may follow different techniques, but the basic principles remain the same.
• Value of goods should be compared to others only in the same period.
• Accountants estimate the value of goods
• Balance Sheets of companies may vary in outlook but the principles remain the same.

Set 2 – What is a Balance Sheet?                                       

• A Balance Sheet is a statement of those assets and liabilities of a business enterprise that can be given a value in terms of money.

A Balance Sheet must have

• Name of the enterprise
• Date to which the figures in the balance sheet refer to.

A Balance Sheet is one of the financial statements of a company and needs to be supported by

• Profit and Loss Account (income statement).
• Sources and use of funds statement.
• Notes to the financial statements.
• Auditor’s certificate.

• Liabilities indicate what money has been made available to the enterprise and from where. It is the sums of money the enterprise owes. Money obtained from banks and shareholders, money subscribed by the shareholders is owed to the shareholders and is therefore the company’s liabilities.

• Assets show how the enterprise has used the money made available to it. Assets are things that the business enterprise owns.

• Total Asset = Total Liabilities

Set 3 – Type of Assets and Liquidities

• Assets are of two major types – Fixed and Current

• Fixed Assets are acquired for long term use, they do not vary greatly from day to day, ad are only infrequently converted to cash in the life of the enterprise.

• Current Assets include customers’ accounts, cash, inventories that are converted into cash during the operation cycle of the business.

• Liquidity is the ease with which assets can be converted into cash thus current assets is more liquid than fixed assets.

• Quick assets are current assets that can be most quickly be converted into cash.

• The asset side of the balance sheet will have head like Customer Accounts that is also known as Debtors or Accounts Receivable.

• When companies make contracts they often have to deposit money as guarantee that they will fulfill the contracts. These deposits will normally be returned in cash and therefore be included in the Current Asset.

• Raw Materials are likely to be processed and sold during the operating cycle of the business are classified as Current Assets.

• Current Assets are
• Cash in Bank
• Marketable Securities
• Customer Accounts
• Finished Products
• Raw Material

• Customer Accounts are part of the group of Current Assets know as Quick Assets. Deposits, employee and other accounts and prepaid expenses are also under Quick Assets.

Set 4 – Valuation of Assets

• Valuation of assets is always an estimate. The relevant accounting concepts for such estimates of value are described in the ‘generally accepted accounting standards’ of a country. In come countries such standards are required by law.

• If there is a choice between higher and lower values of assets, almost always choose the lower value.

• Current assets are generally valued at the cost or market value whichever is lower.

• Fixed assets are generally valued at cost or revaluation, less accumulated depreciation.

• Quick assets include cash and other assets that can be quickly converted into cash. They do not include inventories of finished products or stocks. They usually include customer accounts, marketable securities and other securities.

• Marketable securities could be shown at cost or current value. However, the market value of these securities can fluctuate widely so they are usually shown on the balance sheet as cost, but the balance sheet should also indicate it’s current market value.

• Suppose part of the cash of the quick asset in foreign currency, then the rates of exchange vary from time to time, so the value of cash will also vary.

• Valuation of Inventories

• A company can never be certain that it will make profit on the sale of it’s goods, so it is unwise to value it’s inventories at cost greater than the original cost.

• However, if the market value of the inventories at the date of the balance sheet is less than the cost, then a cautious management will value its inventories at market value. Thus inventories of raw material, finished goods etc are usually valued at cost or current market value, whichever is lower.

• Valuation of Fixed Assets

• Fixed assets are valuated on a different terms than the current assets. Most fixed assets like buildings, machinery, tools will wear down due to use and their value will be depreciated.

• Generally fixed assets are shown on a balance sheet at their original cost with an amount subtracted to allow for the fact that their value has decreased or depreciated. This allowance is known as depreciation.

• Most fixed assets, then, are normally values at cost less depreciation. The value shown on the balance sheet for land, however, remains at cost. Usually no increase or decrease in the value of land is recorded on the balance sheet unless the land is actually sold or reevaluated.

• Depreciation reduces the original cost of the fixed assets by a certain amount each year over the working life of the asset. That amount is charged as an expense in the profit and loss account. The amount of depreciation charged in anyone year will therefore affect the overall profit before income tax. It will thus affect the amount of tax to be paid by the company. The taxation laws of many countries therefore control the rate at which the fixed asset can be depreciated.

• Goodwill in an intangible asset and there is nothing to show for it. It means the advantage or benefit that comes from the enterprise’s reputation, from it good relation with it’s customers and so on. Because goodwill is intangible it is difficult to value.

• Intangible Assets are normally included on a balance sheet only when they have been purchased. If an enterprise is bought as a going concern (active business), the price paid may include a certain amount of goodwill, and this would then be shown on the balance sheet. Goodwill that has not been bought from someone else will normally not appear on the balance sheet.

• Intangible Assets may be shown separately or as fixed assets. When intangible assets are first purchased, they are shown on the balance sheet as cost. When law permits, like most other fixed assets they are subsequently depreciated.

Set 5 – Current Liabilities and Fixed Liabilities

·         Company’s liabilities are listed on the Balance Sheet in 3 main groups

        o        Current Liabilities

        o        Fixed Liabilities

        o        Shareholders’ Funds (owners equity)

·         The shareholders are the owners of the company. On the Balance Sheet the funds they provide are shown separately from those of ‘outside’ who have loaned money to the company.

·         Current and Fixed liabilities are together known as ‘Outside Liabilities’.

·         Fixed liabilities represent the companies long-term finance, and include items on which interest is payable, such as long term loans from development banks and mortgage loans.

·         Current liabilities represent the company’s short-term finance and include items like bank short-term loans, bank overdrafts and trade accounts payable.

·         Interest always has to be paid on bank loans, but most other current liabilities do not require the payment of interest. Apart from bank financing, then, current liabilities generally represent low-cost finance for the company (unless cash discount are lost).

·         Current liabilities are met from the short-term or current assets. This means that the company should generally have enough to cover the current liabilities.

·         Interest sometimes has to be paid on trade accounts if they are not met within a certain time. However, the only current liability that always involves the payment of interest is bank overdrafts. Apart from bank overdrafts, then, the current liabilities generally represent low-cost finance for the company. As a general rule the company will try to obtain as much low cost finance as possible.

·         Fixed liabilities include long-term and mortgage loans. To obtain long-term loans and enterprise has to offer some of its property as security. This means that if the enterprise cannot repay the loans when it is due then the property may be sold to repay the loan.

·         In developed countries the interest rate on long-term loans are relatively low. In developing countries, on the other hand, they tend to be higher.

·         Where there are not sufficient fixed assets to offer as security, the interest to be paid on long-term loans, or fixed liabilities is usually high.

Set 6 – Current Liabilities and Fixed Liabilities

·         Capital Issued – The money which shareholders put into the company by the way of buying shares of the company is described on the balance sheet as Capital Issued.

·         In return, at the discretion of the directors the company makes payments to the shareholders out of the profits made by the company, this is known as Dividend.

·         Shareholders’ Funds include

        o        Capital Issued – it can be regarded as permanent finance.

        o        Capital Surplus

        o        Earned Surplus

·         Earned Surplus – is the profit made in the course of the company’s normal operation.

·         Capital Surplus – is the profit that is not made for normal operations. They may result from the sale of fixed assets and other things like increased value from revaluation of fixed assets.

·         Capital & Earned Surplus represent the profits retained in the business and not paid to the shareholders.

·         As shareholders are the owners of the business, any profit retained in the business, together with the capital issued are in theory owed to the shareholders. Thus Capital Issued and the Profits retained (Capital and Earned Surplus) appear on the Balance Sheet as liabilities and together makeup the Shareholders’ Funds.

·         Shareholders’ Dividends – When there are sufficient profits, the shareholders will naturally expect compensation for the money they have made available to the company, in the form of dividends. The shareholders are compensated by payments known as shareholder dividends.

·         Ordinary Shareholders - Different classes of share have different rights. Ordinary shareholders are the basic owners of the company but run the risk of loosing some/all of their money if the company were to fail. The claims of all the creditors and other investors have priority over the claim of the ordinary shareholders. Their claim to any funds remaining in the company would be the last to be met. They will therefore expect to get bigger returns on their money than that is paid on long-term loans. Though they have the right to share the profits but do not have the right to a fixed dividend each year.

·         Dividends can only be made out of the profits made by the company, thus the size of the dividend will also depend on the size of the profit. The directors decide how much dividend (if any) is to be given.

Set 7 – Capital Surplus & Earned Surplus; Capital Authorized & Capital Issued

·         The amount on the balance sheet for Earned Surplus and Capital Surplus do not reflect the amount made during the year. Rather, they are the accumulative total for several years up to the date of the balance sheet.

·         Capital Authorized – Every properly constituted company is legally able to issue a certain amount of share capital known as it’s Capital Authorized. However, a company may not need all the share capital it is authorized to issue, and the company invites shareholders to contribute only as much money as it actually it needs (Capital Issued). The Capital Issued is always less than or equal to the Capital Authorized.

·         Dividends are paid to the shareholders only out of the Earned Surplus and not out of the Capital Surplus.

·         Net Profit of a company is the profit remaining after all expenses have been deducted from income. First all the profit is taxed, thus some part of the profit is to be put aside for the tax. Of the net profit remaining after tax, some may be paid to shareholders in the form of dividend. Any net profit retained in the business increases the earned surplus on the balance sheet.

·         Suppose a company has made a contract with a supplier which is committed to make certain purchase for the next ten years, we would not be able to learn of the purchase commitment from the liabilities on the balance sheet but from the notes to the financial statements. The balance sheet would only have the amount due at the date of the balance sheet. Balance sheets do not include the enterprises’ obligation for the future.

Set 8 – Financial Structure

• To understand the financial structure of a company, it is important to know the way in which the assets (current and fixed) are financed by the shareholders’ funds and outside liabilities. By comparing the balance sheet figures for various groups of assets and liabilities we can determine whether or not the company is ‘solvent’ or ‘liquid’.

• The enterprise is Solvent if the assets are greater than the outside liabilities.

• The enterprise is Liquid if it can meet its current liabilities out of the current assets.

• Working Capital is Current Assets less Current Liabilities.

• Gearing refers to the ratio of shareholders’ funds to borrowed money (loan capital). Gearing of 4:1 is low because 4/5^th i.e. 80% of assets are financed by shareholders’ funds and only 1/5^th i.e. 20% is financed by borrowed money. Sometimes gearing is calculated as the ratio of shareholders’ funds to long-term loan capital only (fixed liabilities).

Set 9 – Sources and Uses of Funds

• The sources and uses of funds statement is developed by comparing the current balance sheet with that of the previous period and using some other data.

• The sources and uses of funds statement shows the changes that have taken place in the period between the two balance sheet in items of new funds available to the business and how they have been used. It shows where new money has come from and how it has been used.

• Sources of new funds maybe any of the following –
• Net profit (after depreciation)
• Depreciation
• New share capital issued
• Sale of fixed assets
• New Loans

• The Uses of funds maybe any of the following –
• Payment of dividends
• Purchase of fixed assets
• Repayment of loans or capital
• Increase in net working capital

• Sources of funds always equal uses. Any funds not used for the special purpose above result in changes in the net working capital. Sources and Uses of funds statement is also known as Funds Flow Statement and is often attached to the balance sheet and gives info about the sources and uses of new money which has come into the company since the time of the previous balance sheet.

• The Sources and Uses of funds statement will show changes that have taken place in the company’s finance in respect of the share capital, long-term loans, fixed assets and depreciation, net profit, dividend and working capital.

• The figure we enter on the Sources and uses of funds statement are calculated from the valuation of fixed assets before depreciation has been deducted.

• Sources of Funds –

• Although deprecation is a sum of money deducted from the valuation of fixed assets on the balance sheet, this money is actually not spent but retained in the company. It is a provision made on the balance sheet for the expense that will be involved when new equipment has to be bought to replace he old equipment. The money does not leave the business until new assets are actually bought, then the company has the funds identified as depreciation available to it. The figure for depreciation therefore affects the sources of funds.

• The figure on the balance sheet for earned surplus reflects the accumulated profits of a company after dividends have been paid. An increase in the earned surplus from one year to the next reflects profits retained in the business and this is clearly sources of funds.

• Uses of Funds –

• Money paid out as dividends represent an outflow of money and would be reflected as sources and uses of funds statement as one of uses of funds.

• Current assets can increase by increase inventory, increased receivables. In either case money is not coming in but rather is being used for some purpose. Thus an increase in the current assets will usually be an increase in the Working Capital; therefore increase in the working capital would be entered on the sources and uses of funds statement as uses of funds.

• When Current Assets decrease working capital also decreases so the decrease in the working capital means inflow of funds and any decrease in working capital would be entered on the Sources and Uses of funds statement as sources of funds.

• Current Assets decrease when for example inventories and receivable become lower. However if one current asset changes for another (e.g. accounts receivable are settled for cash), this does not change the total current assets. Thus only a decrease in current assets causes on inflow of funds
  
  

  Set 10 – The Profit and Loss Account

  • The Profit & Loss Account or Income Statement is a document that shows activity related to sales, cost, profits and loss made during the financial year to the date of the balance sheet. The Profit & Loss Account is attached to the balance sheet.
    
    
  • There are four different types of profits in the Profit & Loss Account
  • Gross Profit
  • Operating Profit
  • Profit Before Tax
  • Net Profit After Tax
    
    
  • A company generally gets profit from the sales of goods and services. Some of this money is however has to be spent on raw materials, wages and factory overheads costs for producing the goods and services. The difference between the money received from sales and the cost directly involved in the producing the items sold (cost of sales) is known as Gross Profit.
  Gross Profit = Sales – Cost of Sales
  
  
  • Additional expenses are incurred in running the business enterprise as a whole, for e.g. office stationery, telephone charges, sales force and so on. These are termed as Operating Expenses.
  Operating Profits = Gross Profits – Operating Expenses
  
  
  • A business may incur further expenses not directly connected with its day-to-day operations, e.g. interest payments on loans, purchase of goodwill, losses on the sale of investments and fixed assets are termed as Non-Operating Expenses.
  Profit Before Tax = Operating Profits – Non-Operating Expenses
  
  
  • Income Tax must be paid on the profits of a company in most countries, this further reduces the final amount of profit which is available for distribution to shareholders and dividends or which are retained in the company and carried over as earned surplus.

  Net Profit = Profit Before Tax – Income Tax

  • A separate statement, the statement of earned surplus (or retained earnings) records the earned surplus brought forward, plus the net profit for the year, less the dividends paid. The balance in figure for the earned surplus that is carried forward to the next year on the balance sheet. Any other charges noted in this statement of earned surplus must be investigated and are probably explained in the notes to the financial statement.
    
    
    

  Set 11 – Two measures of Profitability

  • Return On Total Investment (ROTI) – expressed as percentage (%)
  ROTI = [Profit Before Tax + Interest on Fixed Liabilities] X 100 / Total Investment*

  * Total Investment = (Total Assets – Current Liabilities) OR (Fixed Liabilities + Shareholders’ Funds)

  • Return On Shareholders’ Funds (ROSF) – expressed as percentage (%)

  ROSF = [Net Profit After Tax] X 100 / Shareholders’ Funds

  • Financial Ratio – is like the temperature of a business. It is healthy when it complies with the normal accepted ratios for the industry that are usually published each year by the chambers of commerce, industrial associates or the government.
    
    
  • Profits retained in the company are credited to the shareholders. They are added to the Shareholders’ Funds and can be regarded as part of the shareholders’ investment in the company.
    
    
  • ROTI is the measure of skill of the management in exploiting the funds made available by the investors.
    
    
  • ‘Profit Before Tax’ (PBT) is the correct measure of profitability of an organization, as the management has no control over the amount of profit tax that has to be paid on the profit. It includes the compensation to be paid to the shareholders for their investment but does not include interest to be paid on Fixed Liabilities.

• Assessing the value of an enterprise is a complicated procedure. We cannot value a business simply by examining it's balance sheet. A business enterprise can be valued either as a 'going concern' or as an enterprise that will be wound up. For either purpose the information on the Balance Sheet is inadequate.

• If a business is to be wound up, wee need to know how much cash will be left when the assets have been sold and all the liabilities have been paid. The balance sheet will not help us because the fixed assets of a going concern are valued at cost less accumulated depreciation, this may be more or less than the realizable market value.

  Similarly, the assets that are valued at cost or in the case of inventories at cost or market value, whichever is lower - in ordinary course of business but not in liquidation. Therefore the Balance Sheet will not allow us to assess the Net Worth of an enterprise to be wound up.

• If the business is to continue as a going concern, the value of it's assets will be of lesser importance than it's future profitability. In addition to the past performance, there are many factors not expressed in terms on money on the Balance Sheet or Profit & Loss Account that have an enormous effect on the future profitability of the company.

• Overall the value of a business is determined only when it is actually sold. The sales prices maybe more or less than the shareholders' funds on the latest Balance Sheet. The value depends on the future profitability and the realizable value of assets if the business is to be wound up.

• Net Worth of an Enterprise = Total Assets - Outside Liabilities

• Future Profitability depends on a number of factors including
  o Quality of Product
  o Activities of Competitors
  General Economic Situation