CHAPTER 1

 Fundamental qualities of accounting information

(must contain BOTH qualities for accounting information to be useful)
 Relevance
o Predict future events, confirm past events or both
o Accounting information is relevant if crosses a threshold of materiality
o Item is material if its omission will affect the users’ decision
 Faithful representation
o Complete – providing all the information needed to understand
o Neutral – without bias
o Free from error – No errors in the way estimates have been prepared and described

 Kinds of business ownership

 Sole proprietorships
o Individual is the sole owner
o Often quite small (by sales revenue or number of staff)
o No formal procedures required to set up
o Operations can commence immediately (unless special permission required i.e. License)
o Owner decides the way in which the business conducts and had flexibility to restructure the
business
o The sole-proprietor business is not separate from the owner
o Must produce accounting information for taxation authorities
o No legal requirement to produce accounting information for other user groups but they may
demand (i.e. Bank requiring accounting information on a regular basis as condition of a loan)
o Unlimited liability meaning no distinction between the proprietor’s personal wealth and that of
the business if there are business debts to be paid
 Partnership
o Two or more individuals carry on a business together with the intention of making profit
o Often small (but some can be large i.e. Accountants and Solicitors)
o No formal procedures required to set up
o Not even necessary to have a written agreement between the partners
o Can agree the way in which the business conducts and had flexibility to restructure the
business
o Unlimited liability
o Contracts with third parties must contain the name of individual partners
 Limited Company
o Range in size from small to large
o Number of individuals who contribute capital and become owners is unlimited
o This provides the opportunity to create a very large-scale business (but many are quite small)
o Liability of owners is LIMITED – those individuals contributing capital to the company are
liable only for debts incurred by the company up to the amount that they have invested/agreed
to invest
o Formal procedures required to start up – documents of incorporation must be prepared that
set out the objectives of the business (among other things)
o Framework of regulations – Companies need to be aware of the way they conduct their affairs
 Annual financial reports must be available to owners and lenders
 An annual general meeting should be held to approve the reports
 Copy of the annual financial reports must be lodged with the Registrar of Companies for
public inspection
 Annual financial reports to be subject to an audit (EXCEPT small companies)
 Hybrid form – Limited Liability Partnership (LLP)
o Same attributes as normal partnership
o Difference: LLP, rather than the individual partners, is responsible for any debts incurred
CHAPTER 2
 Financial frameworks for financial statements
 The major financial accounting statements aim to provide a picture of the financial position and
performance of a business

 Three financial statements (final accounts of the business)

o Statement of cash flows (cash movements)
 Cash – the “lifeblood” of a business – is required to meet debts that become due and to
acquire other resources
 Measures the flow of cash only
o Income statement (profit and loss account)
 Measure the flow of wealth
o Statement of financial position (balance sheet)
 Measuring the amount of wealth at a particular moment in time
 Requires the Statement of cash flows and Income statement

 Equity = injections of funds by the owner PLUS any accumulated profits

 For external users, these statements are normally backward looking because they are based on
information concerning past events and transactions
o Useful in providing feedback on past performance and in identifying trends that provide
clues to future performance

 Assets
 An asset is essentially a resource held by a business
 Characteristics (all 4 of these conditions must apply):
o Probable future economic benefit must exist (future monetary value)
o Benefit must arise from some past transaction or event (i.e. Agreed and in use)
o The business must have the right to control the resource
o The asset must be capable of measurement in monetary terms

 Once an asset has been acquired by a business, it will continue to be considered an asset until the
benefits are exhausted or the business disposes of it
 Examples:
o Inventories
o Cash (checks)
o Property
o Plant and equipment
o Fixtures and fittings
o Patents and trademarks
o Trade receivables
o Investments outside the business

 A marketing director would not be considered an asset

o Business does not have exclusive right of control over the director
o Value of the director cannot be measured in monetary terms with any degree of reliability

 A machine that is purchased but not yet paid for is still an asset
o The amount outstanding would be shown as a claim

 Tangible assets: assets with physical substance

o (i.e.) inventories
 Intangible assets: no physical substance but provide expected future benefits
o (i.e.) patents
 Claims
 A claim is an obligation of the business to provide cash, or some other form of benefit, to an
outside party

 Two types of claims against a business:

 Equity represents the claim of the owners against the business
o Referred to as the owner’s capital
o Any funds contributed by the owner will be seen as coming from outside the business and
will appear as a claim

 Liabilities represent the claims of all individuals and organisations, apart from the owner
 Once a claim from the owners or outsiders has been incurred by a business, it will remain as an
obligation until it is settled

 The Accounting Equation

Assets = Equity + Liabilities

 The effect of trading transactions

 The business sold their inventories for 5000 and received cash
o Inventories now disappear from the ASSETS section (3000-3000) but there will be an
increase in CASH
o EQUITY increases by (5000-3000=2000) reflecting the fact that wealth generated (profit)

 Any funds introduced or withdrawn by the owners also affect equity

o If the owner withdrew 1500 for their own use, the equity will fall by 1500

 The amount of equity is cumulative

o This means that any profit not taken out as drawings by the owner remains in the business
o These retained (or ploughed back) earnings have the effect of expanding the business

 Classifying assets
 Current assets are assets that are held for the short term
o Held for sale or consumption during the business’s normal operating cycle
o Expected to be sold within the next year
o Held principally for trading
o Cash, or near cash such as easily marketable, short term investments
 Example: Inventories, Trade receivables, Cash

 Non-current assets (fixed assets) are assets that do not meet the definition of current assets
o Held for long term operations to generate profits (usually more than one year)
o Not for sale in ordinary course of business
o Tangible or intangible
 Example: Property, plant and equipment
o Land, buildings, motor vehicles, fixtures and fittings

 Assets are listed in reverse order of liquidity (nearness of cash) in the balance sheet
o Assets that are furthest from cash come first
(i.e. Property – Non-current asset AND Inventories – Current assets)
o Less liquid -> More liquid
 Net assets (equity) = Assets - Liability
 Classifying claims
 Current liabilities are amounts due for settlement in the short term
o Expected to be settled within the business’s normal operating cycle
o Held principally for trading purposes
o Due to be settled within a year after the date of the relevant statement of financial position
o No right to defer settlement beyond a year after the date of the relevant statement of
financial position
 Example: trade payables, bank overdraft

 Non-current liabilities represent amounts due that do not meet the definition of current liabilities
and so represent longer term liabilities
 Example: bank loans

 It is quite common for non-current liabilities to become current liabilities

o Borrowings to be repaid 18months after the date of a particular statement will appear as a
non-current liability
o Those same borrowings however appear as current liability in the statement at the end of
the following year, by which time they would be due for repayment after six months
 This classification of liabilities (current and non-current)
o Highlights those financial obligations that must shortly be met (maturing obligations)
o Helps highlight proportion of total long term finance that is raised through borrowings
rather than equity

 Accounting conventions
 Business entity convention must be distinguished from the legal position that may exist between
businesses and their owners
o For limited companies, there is a clear legal distinction between the business and its
owners
 Historic cost convention holds that the value of assets shown on the statement of financial position
should be based on their acquisition cost (that is historic cost)
o Many argue however that historic costs soon become outdated and so are unlikely to help
in the assessment of current financial position
o The term ‘current value’ can be defined in different ways
 Current replacement cost
 Current realizable value (selling price) of an asset
 Prudence convention holds that caution should be exercised when making accounting judgments
o Application of this convention normally involves recording all losses at once and in full
o Profits, on the other hand, are recognized only when they actually arise
o This convention evolved to counteract the excessive optimism of some managers and is
designed to prevent an overstatement of financial position and performance
 Going concern convention holds that the financial statements should be prepared on the
assumption that a business will continue operations for the foreseeable future, unless there is
evidence to the contrary
o It is assumed that there is no intention, or need, to sell the non-current assets of the
business
o However, when a business is in financial difficulties, the non-current assets may have to be
sold to repay those with claims against the business
 the realizable value of many non-current assets is often much lower than the values
reported in the balance sheet because the value to the business of the assets, were it
to continue operating, is higher than their immediate realizable value
 Dual aspect convention assets that each transaction has two aspects, both of which will affect the
statement of financial position
o i.e. Increase in asset (motor car) and decrease in another (cash) [Investment]
o i.e. Repayment of borrowings – decrease in liability (borrowings) and decrease asset (cash)
 Money measurement (Measuring assets in monetary terms)
 Some resources of a business such as goodwill, brands, human resources and monetary stability
cannot be measured in monetary terms thus are excluded from the statement of financial position
 As a result, the scope of the statement of financial position is limited
 Unreliable measurement can lead to inconsistency in reporting and can create uncertainty among
users of the financial statements

 Goodwill and brands:

o Goodwill covers various attributes such as quality of the products, the skill of the
employees and the relationship with customers
o Product brands is used to cover attributes such as brand image, the quality of the product,
trademark
 An ‘arms-length transaction’ is normally required before such assets can be reliably measured and
reported on the statement of financial position
o Arms-length transaction is one that is undertaken between two unconnected parties
 Human resources have been attempted to be placed with monetary measurement with failure
 Monetary stability: in the past years, high rates of inflation have resulted in statement of financial
position which were prepared on a historic cost basis reflecting figures for assets that were much
lower than if current values were employed

 Asset valuation
 We mentioned earlier that when preparing the statement of financial position the historic cost
convention is normally applied for the reporting of assets
o However in reality there are more complications in the process and the key rules are
considered below
 Non-current assets have lives that are either finite or indefinite
o Finite life assets provide benefits to a business for a limited period of time
 Example: Plant, equipment, motor vehicle, computers
o Indefinite life assets provide benefits without a foreseeable time limit
 Example: Patent
o These two types of assets apply to both tangible and intangible assets

 Non-current assets with finite lives

o Initially non-current assets are recorded at their historic cost, which will include any
amounts spent on getting them ready for use
o The amount used up for a non-current finite life asset is referred to as depreciation
(amortization in the case of intangible non-current assets)
o Depreciation must be reflected in the statement of financial position
o The total depreciation that has accumulated over the period since the asset was acquired
must be deducted from its cost
 This net figure (cost of the asset less the total depreciation to date) is referred to as
the carrying amount
 Or net book value (NBV) or written down value
o This procedure above is a recognition of the fact that a proportion of the historic cost of the
non-current asset has been consumed in the process of generating benefits for the business

 Non-current assets with indefinite lives

o Property (real estate) is usually an example of a tangible non-current asset with an
indefinite life
o Purchased goodwill could be an example of an intangible one
o These assets are not subject to routine annual depreciation over time
 Fair values
o Non-current assets may be recorded using fair values provided by that these values can be
measured reliably
o The fair values, in this case, are the current market values
o The use of fair values, rather than cost figures, whether depreciated or not, can provide
users with more up to date information, which may well be more relevant to their needs
o It may also place the business in a better light, as assets such as property may have
increased significantly in value over time
o However, the upwardly revaluing non-current assets with finite lives increase depreciation
charges
 Because the depreciation charge is now based on the new (increased) value of the
asset
o Once non-current assets are revalued, the frequency of revaluation becomes an important
issue
o When an item of property, plant or equipment is revalued on the basis of fair values, all
assets within that particular group must be revalued
 Although this rule is sort of consistent within a particular group of assets, it does
NOT prevent mixture of valuations in the balance sheet
o Intangible assets are not usually revalued to fair values
 Revaluations can only occur where there is an active market, thereby permitting fair
values to be properly determined

 The impairment of non-current assets

o The amount by which the asset value is reduced is known as impairment loss
o May be due to changes in market conditions, technological obsolescence etc.
 Some cases, this fall in value may lead to the carrying amount of the asset is higher
than the amount that could be recovered from continued use of the asset
 When this occurs, the asset is said to be impaired
o This is different with routine depreciation of assets with finite lives
o Where the value of a non-current asset is impaired, it should be written down to its
recoverable amount

 Inventories
o It is not only non-current assets that run the risk of a significant fall in value
o The inventories of a business could also suffer this fate because of changes in market taste,
obsolescence, deterioration etc.
o Inventories are shown at the lower of cost or net realizable value (selling price less any
selling costs)
o If the net realizable value falls below the historic cost of inventories held, the former should
be used as the basis of valuation
 Prudence convention

 The usefulness of the statement of financial position

 It shows how finance has been raised and how it has been deployed
o Example: Show how much finance is contributed by the owners and outside lenders
 Provides a basis for valuing the business, though it can only be a starting point
 Relationships between various items can usefully be explored
o Example: Relationship between how much wealth is tied up in current assets and how
much is owed in short term (current liabilities)
 From this we can see if the business has sufficient short-term assets to cover its
maturing obligations
 Relationships between wealth generated and wealth invested can be helpful indicators of business
effectiveness
o Example: Relationship between profit earned and value of net assets
CHAPTER 3

 Income statement
 The income statement (profit and loss account) measures and reports how much profit (wealth) a
business has generated over a period

 Revenue is simply a measure of the inflow of economic benefits arising from the ordinary
operations of a business
o Sales of goods
o Fees for services (ex. of a solicitor)
o Subscriptions
o Interest received
 Expense represents the outflow of economic benefits arising from the ordinary operations of a
business
o Cost of sales/ cost of goods sold (Cost of buying or making the goods that are sold during
the period concerned)
o Salaries and wages
o Rent and rates
o Motor vehicle running expenses
o Insurance
o Printing and stationery
o Heat and light
 The income statement simply shows the total revenue generated during a particular period and
deducts from this the total expenses incurred in generating that revenue

Profit (or Loss) = total revenue – total expenses

 The period over which profit or loss is normally measured is known as the reporting period,
sometimes called the “accounting period” or “financial period”

 Balance sheet and Income statement are not substitutes for one another
o Balance sheet: Sets out the wealth held by the business at a SINGLE MOMENT in time
o Income statement: Concerned with the FLOW of wealth over a period

 Assuming owner makes no injections or withdrawals of equity during the period, the effect on the
balance sheet of making a profit (or loss) can extend the accounting equation
o Assets (at the end of the period) = Equity (amount of the start of the period
+ (Revenue – Expenses) i.e. profit/loss for the period)
+ Liabilities (at the end of the period)

 Gross profit
 Gross profit represents the profit from buying and selling goods, without taking in to account any
other revenues or expenses associated with the business
o Goss Profit = Sales Revenue – Cost of goods sold (Cost of sales)

 Operating profit
 Operating profit is calculated by deducting from the gross profit the operating expenses incurred
in running the business (salaries and wages, rent and rates)
o Operating Profit = Gross Profit – Operating Expenses

 It DOES NOT take account of income from other activities

o Interest received on some spare cash that the business has invested is not part of its
operating profit
o Cost of financing the business are also ignored in the calculation
 Profit for the period
 Having established operating profit, we add any non-operating income (such as interest receivable)
and deduct any interest payable on borrowings to arrive at the profit for the period (or Net Profit)
o Net Profit = Operating Profit + Non-operating Income – Non-operating Expense

 This final measure of wealth generated represents the amount attributable to the owners and will
be added to the equity figure in the statement of financial position
 It is a residual: amount remaining after deducting all expenses incurred in generating the sales
revenue and taking account of non-operating income

 Cost of sales
 Cost of sales (or cost of goods sold) for a period can be identified in different ways
 It represents the cost of goods that were SOLD during the period rather than the cost of goods that
were bought during the period
 Part of the goods bought during the periods may remain, as inventories, at the end of the period
o Which will be normally be sold at the next period
 Cost of sales = Total goods available for resale – Closing Inventories
o Sometimes shown on the face of the income statement

 Recognizing revenue
 The key issue in measurement of profit concerns the point at which revenue is recognized
 The main criteria for recognizing revenue from sale of goods is:
o Amount of revenue can be measured reliably
o It is probable that economic benefits will be received
o Ownership and control of items should pass to the buyer
 This must be applied where the revenue comes from the sale of goods
 The business recognizes revenue when the goods are passed to, and accepted by the customer
 A sale on credit is recognized before the cash is received
o the total sales revenue will often therefore be DIFFERENT from the cash received from
sales during the period
 for cash sales (Sales where cash is paid at the same time as the goods are transferred) there will be
the SAME in timing between reporting sales revenue and cash received

 Long term contracts

 Some contracts for goods or services may take more than one reporting period to complete
 It is possible to recognize revenue before the contract for the goods is completed, PROVIDED that
the work can be broken down into a number of stages and each stage can be measured reliably
o Each stage can be awarded a separate price with the total for all the stages being equal to
the total price for the entire contract
o As each stage is completed, the supplier of the goods or services can recognise the price for
that stage as revenue and bill the customer accordingly PROVIDED the outcome of the
contract can be estimated reliably

 Continuous services
 The benefits from providing the services are usually assumed to arise evenly over time and so
revenue is recognized evenly over the subscription period
 Revenue is normally recognized after the service is completed
o Revenue for providing services is often recognized before the cash is received
 A business may demand cash in advance of a service being provided
o Examples:
 Rent received from letting premises
 Telephone line rental charges
 TV license or subscription fees
 Recognizing expenses
 The matching convention states that expenses should be matched to the revenue that they helped
to generate
o Expenses associated with a particular item of revenue must be taken into account in the
SAME reporting period as that in which the item of revenue is included
o Applying this convention often means that an expenses reported in the income statement
for a period may not be the same as the cash paid for that item during the period

1) When expense for the period is more than the cash paid during the period
 Sales revenue generated was 300,000 and commissions to be paid was 6000
 However, the business only paid 5000 yet
 This will be remedied as follows:
o Sales commission expenses will include the amount paid plus amount outstanding
(1000+5000=6000)
o Amount outstanding (1000) represents an outstanding liability at the end of the
year and will be included under the heading accrued expenses (or “accruals”) in the
statement of financial position (current liability as it will be paid within one year
period)
o The cash will ALREADY have been reduced to reflect the commission paid (5000)
during the period
 Once the outstanding (1000) is PAID
o Cash (1000)
o Amount of accrued expenses (1000) as shown in the balance sheet
 Other examples of accrued expenses may be:
o Rent and rates
o Insurance
o Interest payments

2) When the amount paid during the period is more than the full expense for the period
 If the company pay rents quarterly in advance
 By the end of the financial period it would have paid five quarters’ rent
 This will be marked as:
o Rent for four quarters are show in the income statement (4*4000=16000)
o Cash would have already been paid for five quarters (5*4000=20,000)
o Show the quarter’s rent paid in advance (4000) as prepaid expense under assets of
the statement of financial position
o Rent paid in advance will appear as a current asset under the heading prepaid
expenses or prepayments
 In the next reporting period, this prepayment will cease to be an asset and will become an
expense in the income statement of that period

 Materiality convention
 In practice, the treatment of accruals and prepayments will be SUBJECT to the materiality
convention
 This convention states that where the amounts involved are immaterial, we should consider only
what is expedient (practical although improper)
o Treating an item as an expense in the period in which it is acquired, rather than strictly
matching it to the revenue to which it relates.
 Example: A business at the end of a reporting period holds £2 worth of unused
stationery
 Time and effort taken to record this as a prepayment would outweigh the negligible
effect on the measurement of profit or financial position
 Thus, it would be treated as an expense of the current period and ignored in the
following period
 Accruals convention
 Accruals convention asserts that PROFIT is the excess of revenue over expenses for a period, not
the excess of cash receipts over cash payments

 The approach to accounting that is based on the accruals convention is frequently referred to as
accruals accounting

 The statement of cash flows is NOT prepared on accruals accounting basis

o Simply deals with cash receipts and payments

 Depreciation
 Depreciation is an attempt to measure that portion of the Cost (or Fair Value) of non-current asset
that has been depleted in generating the revenue recognized during a particular period

 In the case of intangibles, we usually refer to the expenses as amortization

 To calculate a depreciation expense for a period we have four factors to consider

o Cost (or fair value) of the asset
 Include ALL cost incurred by the business to bring the asset to its required location
and to make it ready for use
 Addition cost of transport, installation, legal costs will be included as part of the total
cost of the asset
 Assets may be revalued to fair value only if this can be measured reliably

o Useful life of the asset

 Non-current asset has both physical and economic life

o Residual value of the asset

 When a business disposes of a non-current asset that may still be of value to others,
some payments may be received called residual value or disposal value
 To calculate the total amount to be depreciated, the residual value must be deducted
from the cost (or fair value) of the asset
 Once the depreciation (or Accumulated depreciation) for that period is deducted
from the cost of the asset this is the carrying amount / written-down value / net
book value

o Accumulated Depreciation is the sum of the depreciations at the end of a financial period

o DEPRECIATION method:

1) Straight line method: simply allocates the amount to be depreciated evenly over the
useful life of the asset

Cost of Machine – Estimated Residual Value

Straight Line Drepreciation =
Estimated Useful Life (Number of years)

2) Reducing balance method: applies a fixed percentage rate of depreciation to the

carrying amount of the asset each year

Cost of Machine
Reducing Balance Depreciation = 2 ( )
Number of Years
 Cost of inventories
 An assumption must be made about the physical flow of inventories through the business to
calculate the cost of inventories

 Three common assumptions:

o First in, first out (FIFO) assumes that inventories acquired earliest are the first to be used
o Last in, first out (LIFO) assumes that inventories acquired latest are the first to be used
o Weighted average cost (AVCO) assumes that inventories acquired lose their separate
identity and go into a “pool”
 The average cost of the total inventories will be used

 Convention of prudence requires that inventories be valued at the lower of cost and net realizable
value
o Net realizable value of inventories =
Estimated selling price – Any further costs necessary to complete the goods – Any costs
involved in selling and distributing them

 In theory, this means that the valuation method applied to inventories could switch each year,
depending on which of cost and net realizable value is lower

 In practice, however, the cost of inventories held is usually below the current net realizable value,
particularly during a period of rising prices
o Therefore, it is the cost figure that will normally appear in the statement of financial
position

 Costing inventories and depreciation provide two examples where the consistency convention
should be applied
o Consistency convention holds that once a particular method of accounting is selected, it
should be applied consistently over time
o To help users make valid comparisons of performance and position between periods

 Trade receivable problems

 We have seen that when businesses sell goods or services on credit, revenue will usually be
recognized before the customer pays the amounts owing

 Recording the dual aspect of a credit sale will involve increasing sales revenue and increasing
trade receivables by the amount of the revenue from the credit sale

 With this type of sale there is always a risk that the customer will not pay the amount due

 Bad debt refers to where it becomes reasonably certain that the customer will not pay the amount
owed, which must be taken into account when preparing the financial statements
o Bad debt must be “written off” by reducing the trade receivables and increasing expenses
o By creating an EXPENSE known as ‘bad debt written off’
o The matching convention requires that the bad debt is written off in the same period as the
sale that gave rise to the debt is recognized
 Doubtful debts
 At the end of the period, it may be IMPOSSIBLE to identify, with certainty, ALL bad debts incurred
during the period

 However, the business must try to determine the amount of trade receivables that are doubtful
(prudence convention)

 Once a figure has been derived, an expense known as an allowance for trade receivables should be
recognized

 This will be shown as an expense in the income statement and deducted from the total trade
receivables in the statement of financial position

 In this way, the ‘doubtful’ trade receivables can be treated BUT

o Slight difference would be:
 Bad debts
 Reduce trade receivables directly in the balance sheet
 Written off as expenses in the income statement

 Doubtful debts are separately DEDUCTED

 Allowance for trade receivables in the balance sheet
 Allowance for trade receivables as an EXPENSE in the income statement

 If in the next period, in fact, part of the trade receivables (26000 out of the 30000) considered
doubtful proved to be irrecoverable
o Reduce trade receivables by 26000 and reduce allowances for trade receivables by 26000
o However, the other part of the allowances for trade receivables of 4000 remain which
represents an overestimate made in the last period
o This overestimate must be ‘written back’ this reporting period and treated as revenue for
this year
o Reduce allowances for trade receivables by 4000 and increase revenue by 4000

 Usefulness of the income statement

 Provides measure of profit generated during a period
o Reveals the “profit of the period” or “bottom line”

 Provides information on how the profit was derived

o Reveals the level of sales revenue and, the nature and amount of expenses incurred, which
can help in understanding how profit was derived
CHAPTER 7
 Provisions
 Provision is a liability where the timing or amount involved is uncertain
o There is an obligation arising from a past event
o An outflow of resources is probably needed to settle the obligation
o A reliable estimate of the obligation can be made
 The degree of uncertainty with provision is higher than other liabilities such as accruals

 Contingent liability
 Refers to
1. A possible obligation that arises from past events and whose existence will be confirmed
only by the occurrence or non-occurrence of one or more uncertain future events not
wholly within the control of the company, or
2. A present obligation that is not recognised because the future expenditure is not probable
or the obligation cannot be measured with sufficient reliability

 NOT recognised in the statement of financial position (balance sheet), but disclosed in the notes to
the financial statements

 Intangible Non-Current Asset Valuation: Goodwill, Brand Valuation, Capitalised Expenditure

 Pay Cash of £4million for a business with actual asset value of £3m you pay £1m for ‘goodwill’
which can be placed on the balance sheet and held at the ‘purchased price’ and then re-valued each
year. If it ‘goes down’ there is an IMPAIRMENT charged against profits as an expense.

 Sometimes BRANDS are valued and placed on the balance sheet, with Reserves (aka Retained
Profits) taking the notional profit. If they go down, as with Goodwill there is an Impairment charge

 Research & Development costs might be capitalised and placed on balance sheet and amortised
against future sales

Appendix A – The Trial Balance

 The Basics of Double-Entry Bookkeeping
 When recording accounting transaction by hand, use double-entry bookkeeping
o Does not use plus and minus entries
 An account is a record of one or more transactions relating to a particular item
o Cash
o Property, plant and equipment
o Borrowings
o Sales revenue
 An account for an ASSET will show increases on the LHS (debit) of the account and decreases on
the RHS (credit)
 CLAIMS (Equity and liabilities) is the opposite
o An increase in the account for E/L will be shown on the RHS (credit) and a decrease will be
shown on the LHS (debit)
 Double-entry Bookkeeping: When recording a particular transaction, two separate accounts will
be affected because each transaction has two aspects
o Example: Owner puts £5,000 into a newly opened business bank account, as initial equity
 Increase in CASH account on the LHS (debit)
 Increase in EQUITY account on the RHS (credit)
 Every DEBIT must have a CREDIT
 The words “DEBIT” and “CREDIT” are no more than accounting jargon for LEFT and RIGHT
 Recording Trading Transactions
 Rearranged extended accounting equation

Assets + Expenses = Equity + Revenues + Liabilities

 Expenses will act the same way as assets, increase on LHS (debit) and decrease on RHS (credit)

 Balancing Accounts and The Trial Balance

 Double-entry Bookkeeping does not show the cash balance but we can easily deduce by adding up
the debit (receipts) column and deducting the sum of the credit (payments) column

 To summarise or balance:
o Add up the LARGER column and put this total on BOTH SIDES of the account
o On the SMALLER sum column, put in the figure the will make that side add up to the total
(LARGER) sum – This figure is the Balance carried down (“c/d”) at the end of one period
o To preserve the double entry rule, also put this figure on the other side of the same account,
this figure is the Balance brought down (“b/d”) at the beginning of one period

 Adding up the debit and credit balances separately should expect the figures to be EQUAL since
every debit entry was matched by an equal-sized credit entry
o Creating a statement of this is known as a Trial Balance

 Errors that can occur from the Trial Balance even though it balances
o Transaction was completely omitted from the accounts so no entries were made
o Amount was misread but then correctly balanced
o The correct amount was incorrectly debited/credited

 Debtors owe money because they have a debit balance, and Creditors are owed money because
they have a credit balance

 Preparing the Financial Statements (Final Accounts)

 Going through individual accounts, identifying those amounts that represent revenue and
expenses of the period, and transferring them to the income statement, which is itself also part of
the double-entry system (Textbook page 482 for examples)

 The balances on the following accounts represent straightforward revenue and expenses
o Sales Revenue
o Cost of Sales
o Wages

 The balances of these accounts will be transferred to (Balanced in) the income statement
(Textbook page 484)

 The book in which accountants are traditionally kept is known as the LEDGER, and “accounts” are
sometimes referred to as “ledger accounts”, even when they are computerised
CHAPTER 4
 Managing a company
 A limited company has limited liability for owners but can impose obligations on the way a
company conducts its affairs
 The most senior level of management of a company is the board of directors
 The shareholders elect directors to manage the company on a day to day basis on behalf of those
share holders
 Below the board of directors of the typical large company could be several layers of management
comprising thousands of people
 The issue of corporate governance has generated much debate in recent years due to the principle
agent problem
o The directors may be more concerned with pursuing their own interests such as increasing
their pay and improving job security
o As a result, there will be a conflict of interest between shareholders and directors

 Financing Limited companies

Equity (the owner’s claim)
 With a company, equity is divided between shares (ex. original investment) and reserves (profits
and gains subsequently made)
 There is also possibility that there will be more than one type of shares and reserves
 Thus, within the basic divisions of share capital and reserves, there will be further subdivisions

The basic division

 When a company is first formed, those who take steps to form it will decide how much needs to be
raised by the potential shareholders to set the company up with the necessary assets to operate
 The nominal value (or par value/face value) is the price of the shares when issued
 The profit generated from last year through revenue is known as revenue reserve
o It has been added to the equity section as reserves this year
o We do not merge with the share capital but keep it separate
o Because there is a legal restriction on the maximum drawings of their equity (ex. as a
dividend) that the shareholders can make

 Share Capital
1) Ordinary shares are often known as equities and represent the basic units of ownership of a
business
o The nominal value of ordinary shares is at the discretion of the people who start up the
company
o But this value need not be permanent
o At a later date, the shareholders can decide to change it
 If the company halved value of shares from 1pound to 50p, they would issue each
shareholder exactly twice as many shares (splitting shares)
 The opposite, reducing the number of shares and increasing their nominal value per
share to compensate is known as consolidating shares
o All shares must have equal value
 Companies issue other classes of shares in addition to ordinary shares, preference shares being
the most common
2) Preference shares guarantee that if a dividend is paid, the preference shareholders will be entitled
to the first part of it up to a maximum value
o This maximum is normally defined as a fixed percentage of the nominal value of the
preference shares
 The ordinary shareholders are the primary risk-takers as they are entitled to share in the profits of
the company only after other claims have been satisfied
o However, because of this, usually only the ordinary shareholders are able to vote on issues
that affect the company such as deciding on directors
 Share capital jargons
 Share capital that has been issued to shareholders is known as the issued share capital (or
allocated share capital)

 Sometimes a company may not require shareholders to pay the whole amount that is due to be
paid for shares at the time of issue – where company does not need the money all at once
o Some money would normally be paid at the time of issue and the company would ‘call’ for
further instalments until the shares were fully paid shares
o That part of the total issue price that has been called is known as the called-up share capital
o That part that has been called and paid is known as the paid-up share capital

 Reserves
 Reserves are profits and gains that a company has made and which still form part of the
shareholders’ equity
o One reason that past profits and gains may no longer continue to be part of equity is if they
were paid out to shareholders (i.e. As dividends)
o Another reason could be that reserves will be reduced by the amount of any losses that the
company might suffer

 Reserve is a claim or part of one, on the assets of the company, so it is NOT cash

 Reserves are classified as either revenue reserves or capital reserves

1) Revenue reserves as defined earlier represents the company’s retained trading profits and gains
on the disposal of non-current assets
o Retained earnings, as they are most often called, represent overwhelmingly the largest
source of new finance for UK companies

2) Capital reserves arise for two main reasons:

o Issuing shares at above their nominal value

 Once a company has traded and has been successful the shares would normally be
worth more than the nominal value at which they were issued
 If additional shares are to be issued to new shareholders to raise finance for further
expansion, unless they are issued at a value higher than the nominal value, the new
shareholders will be gaining at the expense of the original ones

o Upwards revaluing of non-current assets

 In the case of issuing new shares which are worth more now than its nominal value, things could
be made fair between the two sets of shareholders (original and new)
o By issuing new shares at £1.5 (instead of nominal value of £1) now we would issue 400,000
(company wishes to raise £0.6million of cash)
o £1 a share for 400,000 shares will be included with the share capital in the statement of
financial position
o the remaining £0.5 is a share premium, which will be shown as a capital reserve known as
the share premium account (£200,000)
 Bonus Shares
 It is always open to a company to take reserves of any kind and turn them into share capital
o This will involve transferring the desired amount from the reserve concerned to share
capital and then distributing the appropriate number of new shares to the existing
shareholders
 New shares arising from such a conversion are known as bonus shares
 Issue of bonus shares used to be quite frequently encountered in practice, but recently much less
common
 “The directors decide that the company will issue existing shareholders with one new share for
every share currently owned by each shareholder”
o double the share capital (50,000 + 50,000)
o decrease the reserves by how much the share capital has increased (78,000 – 50,000)
 Since the company’s assets and liabilities have not changed as a result of the bonus issue, each
share is now worth half as much as it used to be
 The transaction has no effect on the company’s assets or liabilities so there is no effect on
shareholders’ wealth
 Note that a bonus issue is not the same as a share split: a split does not affect the reserves
 Then why would a company might want to make bonus issues?
o Share Price
 To lower value of each share without reducing the shareholders’ collective or
individual wealth (similar effect to share splitting)
o Shareholder Confidence
 Provide shareholders with feel good factor, adding to their confidence (although
wealth has not improved)
o Lender Confidence
 Effect of taking that portion of equity that could be withdrawn by shareholders and
locking it up

 Borrowings
 Most companies borrow money to supplement that raised from share issues and ploughed back
profits
 Company borrowing is often on long term basis
 Lenders may be banks and other professional providers of loan finance
 Loan notes (loan stock or debentures) may be large in total, but can be bought and sold through
stock exchange
o This means investors do not have to wait the full term of their loan to obtain repayment,
but can sell their slice of it to another would be lender
o Note that shares and loan notes are not the same thing
 Shareholders own the company and therefore who share in its losses and profits
 Holders of loan notes lend money to the company under a legally binding contract
that normally specifies the rate of interest, the interest payment dates and the date
of repayment of the loan itself
 Usually long term loans are secured on assets of the company
o This will give the lender the right to seize the assets concerned, sell them and satisfy the
repayment obligation, should the company fail to settle either its interest payments or the
repayment of the loan
 Companies derive their long-term finance from three sources
o New share issues
o Retained earnings
o Long term borrowings
 For a typical company, the sum of new share issues and retained earnings (jointly known as equity
finance) exceeds long term borrowings
 Retained earnings usually exceed either of the other two
 Raising share capital
 Once the company has made its initial share issue to start trading, it may decide to raise additional
funds by making further issues of new shares
 Common methods of share issues:
o Bonus Issues
o Right Issues
 Issuing new shares to existing shareholders
 Company law gives existing shareholders the first right of refusal to buy any new
shares issued by the company
 When the existing shareholders agree to WAIVE their right, then the shares can be
offered to the investing public
 The business would typically prefer that existing shareholders buy the shares
through right issue, irrespective of the legal position
1. The ownership of the business remains in the same hands; there is no
‘dilution’ of control
2. The cost of making the issue tend to be less
o Offers for sale AND Public Issues
 When a business wishes to sell new shares to the public
 Offers for sale – The shares are sold to an issuing house (a wholesaler of new shares)
 Advantage is that the sale proceeds of the shares are certain
 Public Issues – The shares are sold by the business making share issue direct to
potential investors
 Net effect is much the same for both methods
 Some share issues by Stock Exchange listed businesses arise from the
initial listing of the business – Initial Public Offering (IPO)
o Private Placings
 A private placing does not involve an invitation to the public to subscribe for shares
 Shares are ‘placed’ with selected investors, such as large financial institutions
 Quick and cheap form of raising funds because savings can be made in advertising
and legal costs
 However, it can result in the ownership of the business being concentrated in a few
hands
 Unlisted businesses will make this form of issue to get small amounts of cash

 Withdrawing Equity
 We have seen that companies are legally obliged to distinguish, on the statement of financial
position, between the part of the shareholder’s equity which may be withdrawn and that part
which may not

1) Withdrawable part consists of profits arising from trading and from disposal of non-current assets
(revenue reserves)
 The company paying dividends to all its shareholders is the most usual way of enabling
shareholders to withdraw part of their equity
 An alternative is for the company to buy its own shares from those of its shareholders who may
wish to sell them (share repurchase)
 It is important to appreciate that the total of revenue reserves appearing in the statement of
financial position is rarely the total of all trading profits and profits on disposals of non-current
assets generated by the company
 Because this total will normally have been reduced by at least one of the following three factors:
o Corporation tax paid on those profits
o Any dividends paid or amounts paid to (share repurchase) purchase company’s own shares
o Any losses from trading and from disposal of non-current assets
2) The non-withdrawable part consists of share capital and profits arising from shareholders buying
shares in the company and from upward revaluations of assets still held
 Represented in the balance sheet as share capital and capital reserves
 The law does not specify how large the non-withdrawable part of equity should be
o However, when seeking to impress prospective lenders and credit suppliers, the larger this
part, the better

Total Equity = Share Capital + Capital Reserves (Not Withdrawable)

+ Revenue Reserves (Withdrawable)

 Financial statement of limited company

Income statement
 We can see that following the calculation of operating profit, two further measures of profit are
shown:
o Profit before taxation (net profit): interest rates are deducted from the operating profit to
derive this figure
o Profit for the period: Profit after tax, this measure of profit represents the amount that is
available for the shareholders

 Audit fee is commonly see in the income statement as expense of a company

The statement of financial position

 Taxation in current liabilities shows that £12 is still to be paid and on the income statement an
expense of £24 as taxation has been deducted

 This means that out of the total taxation of 24, half has been already paid by cash and the other
half hasn’t been paid yet

 Still on income statement the total expense through taxation of 24 is deducted

 Other reserves include any reserves that are not separately identified on the face of the statement
of financial position
o May include general reserve (which normally consists of trading profits that have been
transferred to this separate reserve for reinvestment – ‘ploughing back’)

 But it is not necessary to set up a separate reserve for this purpose

o It seems like the directors feel that placing profits in a separate reserve indicates an
intention to invest the funds represented by the reserve permanently in the company, and
therefore are not intended to be paid as dividends or fund share repurchases

 Retained earnings are also indeed reserves but are put separately in this balance sheet

 Dividends
 We have already seen that dividends represent drawings by the shareholders of the company

 They are paid out of the revenue reserves and should be deducted from these reserves (usually
retained earnings) when preparing the statement of financial position

 Shareholders are often paid an annual dividend, which may be in two parts, with an ‘interim’
dividend being paid part way through the year and a ‘final’ dividend shortly after the year end
Dividend policy
 The fact that directors of profitable businesses can decide the amount of dividends to be paid to
shareholders raises the question of how large each year’s dividend should be

 The traditional view is that dividend payment should be maximized

o That higher the dividend payments, the more attractive the ordinary shares will become
thus will lead to higher share prices and more wealthy shareholders
o However, this view has been challenged since the 1950s

 The main thrust of the critics’ argument is that since the business is owned by the shareholders,
why should transferring some of the business’s assets shareholders through a cash dividend make
them better off?
 An alternative view is that interest of shareholders is best served by the directors retaining and
investing such funds that would generate higher returns than the shareholders could earn from
reinvesting dividends that they might otherwise receive
o This means that the director should only retain earnings where they can be invested at a
rate at least as high as the shareholders’ opportunity cost of funds

Chapter 6
 Why is cash so important?
 The importance of cash lies in the fact that people will only normally accept cash in settlement of
their claims

 Cash generation is vital for business to survive and to be able to take advantage of commercial
opportunities

 The Statement of cash flows

 Statement of cash flows is specifically designed to reveal movements in cash over a period
o Summarises the inflows and outflows of cash and cash equivalents for a business
o We follow the requirements of international accounting standard IAS 7 statement of cash
flows
 Cash movements cannot be readily detected from the income statement, which focuses on revenue
and expenses rather than on cash inflows and outflows

 Increase in wealth could be in cash or trade receivables as consumers pay by credit

 Thus, profit and cash generated for a period will rarely go hand in hand

 Cash is defined as notes and coins in hand and deposits in banks and similar institutions that are
accessible to the business on demand

 Cash equivalents are short term, highly liquid investments that are readily convertible to known
amounts of cash which are subject to an insignificant risk of changes of value

 Statement of cash flows is now accepted, along with the income statement and the statement of
financial position, as a major financial statement

 The financial position shows the various assets and claims of the business at a particular point of
time

 The statement of cash flows and the income statement explain the changes over a period
o Statement of cash flows explain changes to cash
o The income statement explains changes to equity arising from trading operations
 Layout of statement of cash flows
 Categories in a cash flow:

1) Cash flows from operating activities

o NOTE: Two approaches can be used to derive this figure, direct and indirect method
o These represent cash inflows and outflows arising from normal day to day trading activities,
after taking account of the tax paid and the financing costs (equity and borrowings)
o Cash inflows: Amounts received from trade receivables and those from cash sales for
period
o Cash outflows: Amounts paid for inventories, operating expenses (rent and wages),
corporation tax, interest, dividends
o Notice it is the cash that is ACTUALLY paid in the period instead of revenue or expenses
o NOTE: By the end of each year, half of the tax will have been paid and the remaining half
will still be outstanding
 This means that the tax payment during a year is normally equal to half of the
previous year’s tax charge and half of that of the current year

2) Cash flows from investing activities

o These include cash outflows to acquire non-current assets and cash inflows from the
disposal of non-current assets
o In addition to the normal items such as buildings and machinery, non-current assets might
include financial investments made in loans or shares in another company
o Also include cash inflows rising from financial investments
 Interest on loans made by the business and dividends from shares in other
companies

3) Cash flows from financing activities

o These represent cash inflows and outflows relating to the long-term financing of the
business
o Includes cash movements relating to the raising and redemption of long term borrowings
and to shares
o Under IAS 7, it is permissible to include dividend payments made by the business here, as
an alternative to including them in ‘cash flows from operating activities’

 Net increase or decrease in cash and cash equivalents

o The final total shown on the statement will be the net increase or decrease in cash and cash
equivalents over period
o The calculation above is the normal direction of cash flow for a typical business

 The Normal Direction of Cash Flows

o Normally, ‘operating activities’ provide positive cash flows and therefore, increase the
business’s cash resources
o There are two broad reasons for negative cash flow:
 The business is unprofitable
 This is alarming because the major expenses for most businesses is depreciation
but it is NOT even included in the cash flow statements
 So, negative operating cash flow might well indicate much larger trading loss
 Business is expanding its activities (level of sales revenue)
 Cash spent on acquiring more assets to accommodate increased demand
o Investing activities typically cause net negative cash flows
o Because many non-current assets depreciate or become obsolete and need to be replaced
o Financing activities can go in either direction, depending on the financing strategy at the
time
 Deducing net cash flows from operating activities
 The direct method involves an analysis of the cash records of the business for the period, picking
out all payments and receipts relating to operating activities
o Rarely done by any businesses

 The indirect method relies on the fact that, sooner or later, sales revenue gives rise to cash inflows
and expenses give rise to outflows
o This means that the figure for profit for the year will be linked to the net cash flows
from operating activities

 We can deduce the cash inflows from sales using the income statement and statement of financial
position for the business
o Statement of financial position will tell us how much was owed in respect of credit sales
at the beginning and end of reporting period (trade receivables)
o Income statement tells us the sales revenue figure

Cash inflow from sales = Sales revenue figure − Trade receivables

 In deducing information from the income statement and statement of financial position, for the
cash flow statement:
o We can take Profit Before Taxation for the year and ADD BACK the depreciation and
interest expense charged in arriving at that profit, and adjust this total by movements in
inventories, trade receivables and payments
o If we then go on to deduct payments made during the report period for taxation,
interest on borrowings and dividends, we have the net cash from operating activities

Net Cash from Operating Activities = Profit BEFORE Tax

+ (Depreciation + Interest Expense)
± (Inventories, Trade Receivable and Payments)
− (Payments + Taxation + Interest[Actually Paid] + Dividends)

o Reason for adding back depreciation is because since depreciation is not a cash flow but
has already been deducted out of the profit before taxation, we need to eliminate the
impact of depreciation by adding it back
o The reason why we add back interest expenses is because the FIRST is the interest
expense for the reporting period, whereas the SECOND is the amount of cash actually
paid out for interest during that period
o NOTE: Working Capital = Current Assets – Current Liabilities
o Flow chart on page 198 Textbook and good Example 6.3 on page 200

 What does the statement of cash flows tell us?

 The statement of cash flow tells us how the business has generated cash during the period and
where that cash has gone
 It may help predict likely behaviour of the business

 Problems with IAS7

 Its critics argue that the standard is too permissive in the description and classification of
important items
 Some believe that the standard would inspire greater confidence among users if it insisted that
only the direct method be used to calculate cash flows from operating activities
o However, it should be said that the indirect approach may help to shed light on the quality
of reported profits by reconciling profit with the net cash from operating activities for a
period
 It is also criticised for failing to require cash flows to be reconciled with movements in net debt
Chapter 8
 Financial Analysis
 Traditional analysis is relevant comparison over time or in space
1) Time series analysis: comparing company performance over time
o Horizontal analysis
 Comparing just two years may be misleading
 Inflation may affect monetary values

o Using multi-year information base

o Trend percentage
 Select a base year and set item amounts of that year =100%
 Corresponding amount of each following year=% of base mount

2) Cross-sectional analysis: comparing company performance with other companies in the same
industry (or industry average)

3) Planned performance: compare ratios with targets that management have developed before
the start of the period under review

 In making financial analysis

o First identify users and their information needs
o Second select and calculate appropriate ratios
o Third interpret and evaluate the results
 Compare with targets for the year, with competitors’, industry averages and with
previous years

 Tools of Analysis
1. Financial Ratios
2. Management performance ratios
3. Financial strength ratios
4. Common-size financial statements

 Financial ratios
 Financial ratios provide a quick and relatively simple means of assessing the financial health of a
business

 It allows comparison of the financial health of different businesses

o Direct comparison would be misleading as differences may exist due to the scale of
operations
o Ratios can help eliminate the problem of scale between businesses

 Ratios help to highlight financial strengths and weaknesses of a business, but they cannot by
themselves, explain why those strengths or weaknesses exist or why certain changes have
occurred

 Ratios can be expressed in various forms (percentage or as a proportion) and the way it is
presented depends on the needs
 Financial Ratio Classification
 Profitability ratios provide insights relating to the degree of success in achieving the purpose of
creating wealth
o They express the profit made (or figure bearing on profit such as sales revenue or
overheads) in relation to other key figures in the financial statements or to some business
resource
 Efficiency ratios may be used to measure the efficiency with which particular resources have been
used within the business
o Also, referred to as Activity ratios
 Liquidity ratios examine the relationship between liquid resources held and amounts due for
payments in the near future (maturing obligations)
o Sufficient liquid resources are vital in the survival of a business
 Financial gearing ratios is the relationship between the contribution to financing the business
made by the owners of the business and the amount contributed by others, in the form of loans
 Investment ratios are concerned with assessing the returns and performance of shares in a
particular business from the perspective of shareholders who are not involved with the
management of the business

 The Need for Comparison

 Past periods
o Comparing the calculated ratio with a previous period is possible to detect whether there
has been an improvement or deterioration in performance
o Useful to track particular ratios over time for a possibility to detect trends
o Problems when comparing with different periods
 Possible that trading conditions were quite different in the periods being compared
 When comparing performance of a single business over time, operating inefficiencies
may not be clearly exposed
 Example: The fact that sales revenue per employee has risen by 10% over the
previous period may at first sight appear to be satisfactory. However similar
businesses could have an improvement in 50% for the same period or had much
better sales revenue per employee ratios to start with
 Inflation may have distorted the figures which can lead to an overstatement of profit
and an understatement of asset values

 Similar businesses
o A business should consider its performance in relation to that of other businesses operating
in the same industry
 Survival may depend on its ability to achieve comparable levels of performance
o Useful to compare a particular ratio with a similar business in the same period BUT
 Competitors may have different year ends and so trading conditions may not be
identical,
 Different accounting policies (i.e. Different method of calculating depreciation),
 Difficult to obtain the financial statements of competitor businesses
 Sole proprietorships and partnerships are not obliged to make their financial
statements available to public
 A diversified business may not provide a breakdown of activities that is
sufficiently detailed to enable analysts to compare the activities with other
businesses

 Planned performance
o Ratios may be compared with targets that management have developed before the start of
the period under review
o The comparison of planned and actual performance may be useful in assessing the level of
achievement attained – Planned performance must be based on realistic assumptions
 Profitability Ratios
 Return on ordinary shareholders’ funds (ROSF) or Return on Equity (ROE)

Profit for the year (less any preference dividend)

ROSF = × 100%
Ordinary share capital (The average of opening and closing figures) + Reserves

o Profit for the year (less any preference dividend) is the figure representing the amount of
profit that is attributable to the owners

o Note that the AVERAGE of the figures for opening and closing figures of the year have been
used to calculate the ordinary shareholders’ funds
 So, if we are calculating a ratio for 2013
 Opening would be from 2012 and closing from 2013

o Averaging is normally appropriate for all ratios that combined a figure for a period (such as
profit for the year) with one taken at a point in time (such as shareholders’ funds)

o Broadly, businesses seek to generate as high a value as possible for this ratio
 If it is not achieved at the expense of jeopardising future returns

 Return on Capital Employed (ROCE)

Operating Profit [Earnings Before Interest and Tax (EBIT)]

ROCE = × 100%
Average of {(Share capital + Reserves)[𝐸𝑞𝑢𝑖𝑡𝑦] + Noncurrent liabilities}

o Fundamental measure of business performance

o This ratio expresses the relationship between the operating profit generated during a period
and the AVERAGE long term capital invested (opening and closing figures of the year) in the
business

o The long-term capital employed = (Total Equity + Non-current liabilities)

o ROCE is considered by many to be a primary measure of profitability because it compares

inputs (capital invested) with outputs (operating profit)

o This comparison is vital in assessing the effectiveness with which funds have been deployed

 Operating profit margin

Operating Profit
Operating profit margin = × 100%
Sales Revenue

o It compares the output of the business (operating profit) with another output (sales revenue)

o The ratio can vary considerably between types of business

o Operating profit margin of a business can be influenced by factors such as the degree of
competition, the type of customer, economic climate and industry characteristics (level of risk)

o Analysis: For every £1 of sales revenue an average of 1.8p (operating profit margin = 1.8%)
was left as operating profit, after paying the cost of carpets sold and other expenses operating
the business
 Gross profit margin

Gross profit (Sales revenue – Cost of sales)

Gross profit margin = × 100%
Sales revenue

o The ratio is therefore a measure of profitability in buying (or producing) and selling goods or
services before any other expenses are considered
o The decline in this ratio means that gross profit was lower relative to sales revenue
 Which means the cost of sales was higher relative to sales revenue
 This could mean that sales prices were lower and/or that the purchase price of carpets had
increased
 It is possible that both had increased/decreased but the rate relative to each other is
different

 Mark up

Gross profit
Mark up = × 100%
Cost of sales

 Efficiency
 Average inventories turnover period

Average inventories held

Average inventories turnover period = × 365
Cost of sales

o Take a simple average of the opening and closing inventories

[Inventories at the end of the year (B/S) – Increase in inventories levels of year (Cash Flow)]
(monthly would be preferred to take account seasonal business, if it is available)
o The ratio can be expressed in various time periods
 Multiplying 365 would give days (i.e. 52-days, 12-months)
o If the figure above was calculated to 56.6days, this means that on average, the inventories held
are being ‘turned over’ every 56.6days
o A business would normally prefer a short inventories turnover period as holding inventories
can have costs such as opportunity cost

 Average settlement period for trade receivables

Average trade receivables

Average settlement period for trade receivables = × 365
Credit sales revenue

o Again, the trade receivable an average and business prefers shorter settlement period
o Funds are being tied up which may be used for more profitable purposes
o It is important to remember that this is an average figure for the number of days for which
debts are outstanding which can be easily distorted
 Example: A few large customers who are very slow or very fast payers

 Average settlement period for trade payables

Average trade payables

Average settlement period for trade payables = × 365
Credit purchases

o Ratio can be distorted by the payment period for one or two large suppliers
o Business would try not to increase their settlement period too much as it can result in loss of
goodwill of suppliers
 Sales revenue to capital employed or Net asset turnover ratio or Asset utilisation

Sales revenue
Sales revenue to capital employed ratio =
Share capital + Reserves
Average of { }
+Noncurrent liabilities
(Total assets − Current liabilites)

o Measures how effectively the assets of the business are being used to generate sales revenue
o Generally, higher sales revenue to capital employed ratio is preferred as it suggests assets are
being used more productively
o However, a very high ratio may suggest that the business is ‘overtrading’ on its assets
 Means it has insufficient assets to sustain the level of sales revenue achieved
o Calculated figures can be interpreted as sales revenue generated for each £1 of capital
employed
o Unit: times

 Sales revenue per employee

Sales revenue
Sales revenue per employee =
Number of employees

o Measurement of the productivity of workforce

 Non-current asset turnover or Fixed asset turnover

Sales revenue
Fixed asset turnover =
Noncurrent assets

o Unit: times

 Relationship between profitability and efficiency

 ROCE = Operating Profit Margin ratio times Net Asset Turnover ratio

Operating profit Sales revenue

ROCE = ×
Sales revenue Long term capital employed

o Overall return on funds employed within the business will be determined both by the
profitability of sales and by efficiency in the use of capital

 Liquidity Ratios: Ability of the business to meet its short-term financial obligations
 Current ratio

Current assets
Current ratio =
Current liabilities

o Compares the liquid assets (cash and those assets held that will soon be turned into cash) of
the business with the current liabilities
o Some business’s ideal current ratio is usually 2 times but depends
o Higher the ratio, the more liquid the business is considered to be, which may seem preferable
o However, if a business has a very high ratio, it may be that excessive funds are tied up in cash
or other liquid assets and are not therefore being used as productively
o Unit: times
 Acid test ratio or Quick ratio

Current assets (excluding inventories)

Acid test ratio =
Current liabilities

o Like the current ratio but it represents a more stringent (strict) test of liquidity in that it
excludes inventories because inventories are not as liquid
o minimum level for this ratio is often stated as 1 times but depends
o Unit: times

 Cash generated from operations to maturing obligations or No credit interval

Cash generated from operations

Cash generated from operations to maturing obligations =
Current liabilities

o Cash generated from operations is taken from the statement of cash flows
o Provides a further indication of the ability of the business to meet its maturing obligations
o The higher the ratio is, the better the liquidity of the business
o This ratio has the advantage over the current ratio that the operating cash flows for a period
usually provide a more reliable guide to the liquidity of a business than do the current assets
held at the statement of financial position date

 Operating Cash Cycle (Working Capital Cycle, WC Cycle)

 When assessing the liquidity of a business, it is important to be aware of the operating cash cycle
(OCC) of the business
 The OCC is the period between the payment made to the supplier, for the goods concerned, and the
cash received from the credit customer
 The OCC is important because it has a significant influence on the financing requirements of the
business
 Broadly, the longer the cycle, the greater will be the financing requirements and the greater the
financial risks
 Thus, a business may want to reduce the OCC to the minimum as possible

 Managing the Working Capital Cycle (WC Cycle)

 Management of the WC cycle demands minimum investment of money in working capital and
maximum speed of cash through the cycle
 It is monitored via Liquidity and Efficiency ratios:
o Current ratio and Acid/Quick test ratio
(Opening inventories + Closing inventories)/2
o Average inventories turnover = × 365
Cost of sales
 Inventory (Stock) days
 On average, how long do we ‘hold’ inventory in stock before it leaves and goes to
customers?
Trade receivables
o Average settlement period for trade receivables = × 365
Credit sales
 Receivables (Debtors) days
 On average, how long does it take to collect sales monies from credit customers?
Trade payables
o Average payment period for trade payables = Credit purchases × 365
 Payable (Creditors) days
 On average, how long does it take to settle bills to credit suppliers?

 It is usual to use AVERAGE balance sheet figures for receivables, inventories, payable days
 Note: If you cannot calculate Purchases for ALL years you are comparing, then use the COGS figure
for ALL years as the next best alternative
 Cash Conversion Cycle
 This is the Operating Cycle or Working Capital Cycle

OCC (WC Cycle or CCC) = Inventory days + Receivable days − Payable days

 Overtrading
 Overtrading occurs where a business is operating at a level of activity that cannot be supported by
the amount of finance that has been committed

 The reasons may be:

o Expanding businesses face rapid increase in demand for goods and services
o Managers have miscalculated the level of expected sales
o Financing is not available
o Inflation has eroded the value of money and thus more monetary working capital support is
required for the same level of sales

 Overtrading results in liquidity problems

o Exceeding borrowing limits, or slow repayment of borrowing and trade payables
o Result in suppliers withholding supplies, making it difficult to meet customer needs
o Managers might be forced to direct all their efforts to dealing with immediate problems
 Finding cash to meet interest charges due or paying wages
 Longer-term planning becomes difficult as managers spend their time gong from
crisis to crisis
o Ultimately, the business may fail because it cannot meet its maturing obligations

 If a business is unable to raise new finance, it should cut back its level of operations

 5 of the working capital related ratios above are key as monitoring devices

 Financial Gearing
 Financial gearing occurs when a business is financed, at least in part, by borrowing instead of by
finance provided by the owners (the shareholders) as equity

 A business’s level of gearing is an important factor in assessing risk

 Where the borrowing is heavy, this can be a significant financial burden and the business will have
the risk of becoming insolvent (unable to pay debts owed)

 Reasons a business would want to take on gearing:

o Owners could have insufficient funds
o Increase the returns to owners provided that the returns generated from borrowed funds
exceed the cost of paying interest
 For a highly-geared business, a small decline in operating profit will bring about a
much greater decline in the return to shareholders (ROSF ratio)

 Gearing seems to be beneficial to shareholders because interest rates for

borrowings are lower than the returns that the typical business can earn

 Also, interest expenses are tax-deductible so this makes the effective cost of
borrowing cheap
 The Effect of Financial Gearing
 Gearing Ratio or Leverage or Capital gearing
o Can be expressed in 3 expressions

Long term (noncurrent) liabilities [External funding]

Gearing ratio = × 100%
Share capital + Reserves + Long term (noncurrent) liabilities

Equity
Leverage = × 100%
Total Capital Employed

External Funding
Debt to Equity Ratio = × 100%
Equity

o Measures the contribution of long term lenders to the long-term capital structure of a
business

 Interest Cover Ratio

Operating profit
Interest cover ratio =
Interest payable

o Measures the amount of operating profit available to cover interest payable

o Unit: times
o The lower the level of operating profit coverage, the greater the risk to lenders that interest
payments will not be met
 Which can cause greater risk to the shareholders that the lenders will act against the
business to recover the interest due

Chapter 9
 Investment Ratios
 Dividend Pay-out Ratio

Dividends announced for the year

Dividend payout ratio = × 100%
Earnings for the year available for dividends
(Less any preference dividends)

o Measures the proportion of earnings that a business pays out to shareholders in the form of
dividends
o In the case of ordinary shares, the earnings available for dividend will normally be the profit
for the year (profit after taxation) less any preference dividends relating to the year

 Dividend Cover Ratio

Earnings for the year available for dividends

(𝐿𝑒𝑠𝑠 𝑎𝑛𝑦 𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠)
Dividend cover ratio = × 100%
Dividends announced for the year

o Dividend payout ratio can also be calculated slightly differently as the Dividend cover ratio
o Unit: times
o If the figure was 4times, it means that the earnings available for dividend cover the actual
dividend paid by four times
 Dividend Yield Ratio

Dividend per share/(1 − t)

Dividend yield = × 100%
Market value per share

o Relates the cash return from a share to its current market value
o Help investors assess the cash return on their investment in the business

o Dividend per share = £40 dividend / (300 x 2 [because 1 share is only worth £0.5]) shares
o Therefore, the number of shares when calculating Dividend per share should be worth £1

o t = Dividend tax credit rate of income tax

 In the UK, investors who receive a dividend from a business also receive a tax credit so
the dividends are effectively issued net of income tax

 Earnings per Share (EPS)

Earnings available to ordinary shareholders

(𝐿𝑒𝑠𝑠 𝑎𝑛𝑦 𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑)
Earnings per share =
Number of ordinary shares in issue

o Relates the earnings generated by the business, and available to the shareholders, during a
period to the number of shares in in issue

o Earnings available to ordinary shareholders is represented by the profit for the year (profit
after taxation) less any preference dividend where applicable

o This is regarded as a fundamental measure of share performance

o Used to help assess the investment potential of a business’s shares

o Although it is possible to make total profit rise through ordinary shareholders investing more
in the business, this will not mean that the profitability per share will rise as a result

o It is not usually not very helpful to compare the EPS of one business with that of another
o However, it can be very useful to monitor the changes that occur in this ratio for a business
over time
o Unit: £ and if £0.018, then can write as 1.8p

 Cash generated from operation (CGO) per share

Cash generated from operations

less preference dividend (if any)
Cash generated from operation per share =
Number of ordinary shares in issue

o In the short term, cash generated from operation provides a good guide to the ability of a
business to pay dividends and to undertake planned expenditures

o Many see cash generation measure more useful in this context than the earnings per share
figure

o The CGO per share is usually higher than the earnings per share
 Not unusual because the effect of adding back depreciation to derive the CGO figures
will often ensure that a higher figure is derived
 Price/earnings Ratios (P/E ratios)

Market value per share

P/E ratio =
Earnings per share

o Figure calculated indicates that the market value of the share is 9.1times higher than its
current level of earnings

o The ratio is a measure of market confidence in the future of a business

o The higher the PE ratio the greater the confidence in the future earning power of the business
and consequently, the more investors are prepared to pay in relation to the earnings stream of
the business

o It provides a useful guide to market confidence about the future and they can, therefore be
helpful when comparing difference businesses

o However, differences in accounting policies between business can distort comparisons

o Unit: times

 Market Value to Book Value ratio

 Market Value (MV) is market capitalization

 Book Value (BV) is total equity

 The market value to book ratio can be used to determine if a share is undervalued or overvalued

 If a share is undervalued (BV>MV) the price is expected to rise

 And if is overvalued, the price is expected to fall

 Investors looking for value shares often look for low market to book companies

 Grouping of Ratios
 Core Profitability ratios – concerned with effectiveness at generating profit
o Return on Equity (ROE) aka Return on Shareholders’ Funds (ROSF)
o Return on capital employed (ROCE)
o Operating profit margin
o Gross profit margin
o Mark-up %

 Core Efficiency ratios – concerned with efficiency of using assets/resources

o Average inventory days
o Average trade receivables (debtors) days
o Average trade payables (creditors) days
o Net Asset (Total Capital Employed) turn aka Sales to capital employed
 Note: We refer to Net Assets (Total Assets – Current Liabilities) the same as TCE

 Core Liquidity – concerned with the ability to meet short-term obligations

o Current ratio
o Quick/Acid test ratio
o Cash generated from operations to maturing obligations
 Debt management – concerned with relationship between equity and debt financing
o Capital Gearing (Leverage)
o Interest cover

 Core Investment – concerned with returns to shareholders

o Dividend cover ratio
o Dividend yield ratio
o Earnings per share
o Price/earnings ratio

 Trend Analysis
 Key ratios can be plotted on a graph to provide a simple visual display of changes occurring over
time
 The trends occurring within a business may be plotted against trends for rival businesses or for
the industry as a whole for comparison purposes

 Key Performance Indicators (KPIs)

 Key performance indicators help measure the degree of success achieved in carrying out their
operations

 Often include financial ratios and other measures of performance (i.e. Ratios that compare a figure
on the financial statements with a particular business resource)

 May also include non-financial measures of performance

 Common-Size Financial Statements

 Common-size financial statements are financial statements that are expressed in terms of some
basic figure

 Presenting financial statements in this way makes better comparisons

o Allow comparison of companies of different size
o Allow internal structural analysis of the financial statements of a company

 Vertical Analysis
o One approach to common-size statements is to express all figures in a particular statements
in terms of one of the figures in that statement
 Sales revenue in an income statement
 Total long-term funds in a statement of financial position
 Cash flow from operating activities in the statement of cash flow

o This ‘base’ figure is typically one that is seen as a key figure in the statement
 Treat all the figures in each statement as a percentage of a figure in that statement

o Not much can be discerned from looking at just one common-size statement, need some
benchmark for comparison
 Other accounting periods for the same business can be used as benchmarks
 Do not have to be for the same business

o Problem with vertical analysis:

 It is not possible to see that revenue values are different from one year or business to
the next
 Normally a vertically analysed common-size I/S shows the revenue figure as 100 for all
years or businesses
 Horizontal Analysis
o All figures appearing in a particular financial statement are expressed as a base figure (such
as 100%) and the equivalent figures appearing in similar statements are expressed as a
percentage of this base figure
 EXAMPLE:
Year 1 is the base year so all the figures in Year 1 income statement are 100.
All the figures for the other years are that year’s figure divided by the Year 1 figure
(ACTUAL figure, not the base figure) for the same item and then expressed as a
percentage.
Year 4 profit before tax divided by the profit before tax for Year 1 was 104.5%

o Alternative to the vertical analysis and overcomes the problem with vertical analysis
 Revenue figures are expressed in terms of one particular year or one particular
business
 This makes differences in revenue levels crystal clear
 Unfortunately, this approach makes comparison within a particular year’s or a
particular business’s statement rather difficult

 To conclude, producing two sets of common-size statements, one analysed vertically and one
horizontally, will be the best.

 Cross-sectional Analysis (Further Analysis)

 Comparison with other companies in the same industry for the same year
o Things to watch out for…
 Differences in company characteristics should always be accounted for in interpretation

 Comparison with industry averages

o Things to watch out for…
 Multi-product companies
 Definition and size of industry groupings

 Using Ratios to Predict Financial Failure

 Financial ratios based on current or past performance are often used to help predict the financial
failure of a business but dependent on the judgement and the opinion of the analyst
o Financial failure: A business either being forced out of business or being severely adversely
affected by its inability to meet its financial obligations

o Often referred to as ‘going bust’ or ‘going bankrupt’ however, note in the UK bankruptcy is
the term used for individuals and the term insolvency is used for businesses

 Using Single Ratios

o Certain ratios exhibited a marked difference between the failed and non-failed businesses
for up to five years prior to failure
 Cash flow/Total debt
 Net income (profit)/Total assets
 Total debt/Total assets
 Working capital/Total assets
 Current ratio
 No credit interval (Cash generated from operation to maturing obligations)

o Univariate analysis – Looks at one ratio at a time

 Using combinations of ratios
o One approach to model development is Multiple Discriminate Analysis (MDA)
 A statistical technique that is similar to regression analysis and which can be used to
draw a boundary between those businesses that fail and those businesses that do not
 This boundary is Discriminate Function
 Unlike regression analysis, MDA assumes that the observations come from two different
populations (i.e. Failed and Non-failed businesses)

o To illustrate this approach, let us assume that we wish to test whether two ratios (say, the
current ratio and ROCE) can help to predict future.

o To do this, we can calculate these ratios, first for a sample of failed businesses and then for
a matched sample of non-failed ones.

o From these sets of data, we can produce a scatter diagram that plots each business
according to these ratios to produce a single coordinate

o Then try to identify the boundary (Diagonal line) between the failed and the non-failed
businesses from the scatter plot

 Z-score Models
 Altman’s revised model, the Z-score model, is based on five financial ratios

Z = 0.717a + 0.847b + 3.107c + 0.420d + 0.998e

Where:
o a = Working Capital/Total Assets
o b = Accumulated Retained Profits/Total Assets
o c = Operating Profit/Total Assets
o d = Book value of ordinary and preference shares/
Total Liabilities at Book value
o e = Sales Revenue/Total Assets

 Book value = Balance sheet value for ordinary & preference shares this is just the total Equity
figure
 The coefficients in the above model are constants that reflect the importance to the Z-score of each
of the ingredients (a to e)
 The lower the score the greater the probability of failure
 Z-score of less than 1.23 tend to fail
 Z-score higher than 4.14 tend not to fail
 In between 1.23 and 4.14 occupied a ‘zone of ignorance’ and are difficult to classify

 Limitations of ratio analysis

 Quality of financial statements
o Results of ratio analysis are dependent on the quality of the financial statement
o Thus, ratios will inherit the limitations of the financial statements on which they are based
 Failure to include all resources controlled by the business
(i.e. Internally generated goodwill and brands)
 Problem of creative accounting – Making the financial statements misleading

 Inflation
o Generally, the reported value of assets will be understated in current terms during a period of
inflation as they are usually reported at their original cost (less any amounts written off for
depreciation)
 Restricted view of ratios
o Ratios only measure relative performance and position so provide only part of the picture
o When comparing two businesses it will often be useful to assess the absolute size of profits, as
well as the relative profitability of each business

 The basis for comparison

o No two businesses are identical
 The greater the differences between the businesses being compared, the greater are the
limitations of ratio analysis
 Any differences in accounting policies, financing methods (gearing levels) and financial
year ends will add to the problems of making comparisons between businesses

 Ratios relating to the statement of financial position

o Any ratios based on figures may not be representative of the financial position of the business
for the year as a whole
 Balance sheet only gives a ‘snapshot’ of the business at a particular moment in time
o A more representative picture of liquidity can only really be gained by taking additional
measurements at other points in the year
Chapter 5 (partly)
 The Need for Accounting Rules
 Accounting rules can narrow area of differences and reduce that variety of accounting methods
o This should help businesses treat similar transactions in a similar way

 Accounting rules should help to provide greater confidence in the integrity of financial statements
o May help a business to raise funds and to build stronger relationships with customers and
suppliers

 No two businesses are identical and accounting policies may vary between businesses for valid
reasons

 Sources of Accounting Rules

 When a common set of rules is followed, users of financial statements should be better placed to
compare the financial health of companies based in different countries

 Existence of such rules should also relieve international companies of some of the burden of
preparing financial statements
o Different financial statements will not have to be prepared to comply with the rules of the
various countries in which a particular company operates

 The International Accounting Standards Board (IASB) is an independent body that is at the
forefront of the move towards harmonization

 Conceptual Framework
 Conceptual frameworks prescribe the nature, function and limits of financial accounting and
reporting

 Central goal in establishing a conceptual framework is to generate consensus on such things as

o What types of entities should produce general purpose financial statements
o What knowledge of accounting that financial statement users are expected to have
o The scope and objectives of financial reporting
o The qualitative characteristics that financial information should posses
o Elements of financial reporting together with their recognition criteria

 The IASB Conceptual Framework is undergoing amendment. In 2010, it was renamed to become
the Conceptual Framework for Financial Reporting

 The Conceptual Framework is NOT an accounting standard

 It provides guidance at a general level
 It should be followed when specific guidance is not covered by an accounting standard
 Development of the conceptual framework should follow a set sequence

 Benefits from Having a Conceptual Framework

 Accounting standards would be more consistent and logical because they are developed from a
clearly developed set of concepts

 Increased international comparability of financial information

 Should result in the International Accounting Standards Board (IASB) being more accountable for
their standard-setting decisions

 Enhanced process of communication between the IASB and constituents

 More economical accounting standard development
 Components of Conceptual Framework
 The users of financial statements
o Conceptual frameworks need to identify potential users of financial statements and the main
information needed
 Many existing and potential investors, lenders and other creditors cannot require
reporting entities to provide information directly to them and must rely on general
purpose financial reports for much of the financial information they need
 Consequently, they are the primary users to whom general purpose financial reports
are directed (IASB, Conceptual Framework, 2010)

 Other potential users, such as regulators and members of the public other than
investors, lenders and other creditors, may also find general purpose financial reports
useful
 However, those reports are not primarily directed to these other groups

 Objectives of General Purpose Financial Statements (GPFS’s)

o According to the IASB Conceptual Framework
 The objective of general purpose financial reporting is to provide financial information
about the reporting entity that is useful to existing and potential investors, lenders and
other creditors in making decisions about providing resources to the entity

 Those decisions involve buying, selling or holding equity and debt instruments, and
providing or settling loans and other forms of credit

 Qualitative Characteristics (Chapter 1)

o Two “fundamental qualitative characteristics”: Relevance and Faithful representation

o In discussing the need for information to be relevant and faithfully represented, the IASB
Conceptual Framework states
 Information must be both relevant and faithfully represented if it is to be useful

 Neither a faithful representation of an irrelevant phenomenon nor an unfaithful

representation of a relevant phenomenon helps users make good decisions

o Relevance
 Relevant financial information is capable of making a difference in the decisions made
by users.

 Information may be capable of making a difference in a decision even if some users

choose not to take advantage of it or are already aware of it from other sources.

 Relevant information should have both predictive value and confirmatory value (or
feedback value) and should be material

o Faithful Representation
 To be a perfectly faithful representation, a depiction would have three characteristics
 Complete
 Neutral
 Free from error…
o Further qualities to enhance the usefulness of information that is both relevant and faithfully
represented
 Comparability
 To facilitate the comparison of the financial statements of different entities (and that
of the financial statements of a single entity over time)

 Methods of measurement and disclosure must be consistent, but should be changed

if no longer relevant to an entity’s circumstances

 There are advantages in restricting the number of accounting methods that can be
used by reporting entities

 However, the restrictions (that assist comparability) may lead to reductions in the
efficiency with which organisations operate

 The restrictions may therefore result in a reduction in the efficiency with which
external parties can monitor the performance of the entity

 Verifiability
 Verifiability refers to the ability, through consensus among measurers, to ensure that
information represents what it purports (claims) to represent, or that the chosen
method of measurement has been used without error or bias

 IASB Conceptual Framework states:

Verifiability means that different knowledgeable and independent observers could
reach consensus, although not necessarily complete agreement, that a particular
depiction is a faithful representation

 Timeliness
 The more ‘timely’ (or up-to-date) that financial information is, the more useful it will
be
 IASB Conceptual Framework states:
Timeliness means having information available to decision-makers in time to be
capable of influencing their decisions. Generally, the older the information is the less
useful it is

 Understandability
 Information is considered to be understandable if it is likely to be understood by
users with some business and accounting knowledge

 Therefore, the expectation is that financial information is not understandable by

everybody

 IASB Conceptual Framework states:

Financial reports are prepared for users who have a reasonable knowledge of business
and economic activities and who review and analyse the information diligently. At
times, even well-informed and diligent users may need to seek the aid of an adviser to
understand information about complex economic phenomena
Chapter 11
 Corporate Governance
 If managing is about running the company, corporate governance is about ensuring the company is
run properly
 Accountability is a key component of corporate governance
 Involves the monitoring, evaluation and control of organisational agents to ensure that they
behave in the interests of shareholders and other stakeholders
o The interaction between a range of participants in the conduct of an organisation’s activities
and affairs
 If a large company, the separation of ownership and day to day control of the business may arise a
conflict of interest between directors and shareholders (Agency Issue)

 Corporate Governance: Views

 The narrow view has its origins in commercial corporations, restricted to the relationship between
a company and its shareholders

 Roots in traditional agency theory, reflecting the finance paradigm

o Directors appointed by shareholders to direct and control the company on behalf of the
shareholders

 A broader and more inclusive view takes account of a range of other shareholders in addition to
shareholders
o Resulting in a web of relationships between those shareholders, the directors, employees,
suppliers, customers, communities to name but a few

 Corporate Governance: Agency Issue

 With directors acting as agents of the principal – the shareholders, and with often a large of
separation
o Some directors and their appointed managers pursue their own perceived best interests
o This is known as Agency Issue
 Promotion of short-term interests over long-term benefits
 Actions which are best questionable and at worst unethical, and on occasions illegal
 Challenge to shareholders is to identify ways in which they can exercise control over the
directors

 Corporate Governance: Stakeholders

 The underlying rationale is that organisations have potentially huge impacts on communities,
business and/or social
o and have at least a moral obligation or duty to enact accountability to others than merely
shareholders

 One challenge is to define who and what are included under the heading of business and social
communities
o Whoever is included, there is a view which is increasingly accepted that annual report of
organizations should include other reports in addition to the conventional financial statements

 External Audit
 Company law requires that the directors prepare annual financial statements which involve:
o Selecting suitable accounting policies and applying them consistently
o Making estimates and judgments that are prudent and practical
o Stating whether appropriate accounting standards have been adopted
o Applying the going concern convention where appropriate to do so
 Internal Audit
 Usually involves a review of:
o Internal control systems to see whether they safeguard the company’s assets and help prevent
errors and fraud
o Accounting systems to see whether they provide reliable information
o Internal operations and processes to see whether they are efficient and provide value for
money

 The Role of the Audit Committee

 The UK Code of Corporate Governance sets out the role of the audit committee as:
o To monitor the integrity (honesty) of the financial statements
o To review the company’s internal controls
o To make recommendations concerning the appointment and removal of the external auditor
o To review the independence, objectivity and effectiveness of the external auditor
o To establish policies concerning the supply of non-audit services by the external auditor

 When reviewing the financial statements the following should be considered:

o Accounting policies adopted
o Changes to accounting policies
o Estimates and judgments made in key areas
o Any unusual items
o Any unusual trends

 Board of Directors
 Remuneration
o The UK Corporate Governance Code states
 The level of director’s remuneration should be sufficient to attract, retain and motivate
individuals of the right quality
o The code also states that remuneration should be linked to long-term performance and to the
risk policy of the company

 Tenure and Service

o The UK code recommends that all directors submit themselves for re-election by shareholders
at regular intervals
o Although directors are normally given service contracts these DO NOT provide a shield from
the consequences of poor performance
o Where a director has underperformed, the Board should consider dismissal

 The chairman: Senior director, head of the board

o Elected by other directors and chairs board meetings

 Executive directors
o Salaried employees with senior management responsibilities
o In addition to being a board member and taking part in board decisions, this individual is
responsible for managing the finance function within the company

 Non-executive directors (monitory, advisory role)

o They are not full time employees
o Majority of directors in the board of directors are non-executive
1) Audit Committee
2) Nomination Committee
3) Remuneration Committee
 Tasks of the board
 Decide on the strategic direction of the company

 Exercise control
o Carrying out the strategic plan
 Executive committee will be in charge of successful implementation
o Checking the integrity of financial statements
 The UK Corporate Governance Code states that a separate board committee known as
the audit committee should be set up to promote reliability of financial reporting
systems
o Evaluating and managing risk
 Audit committee may take this responsibility
o Nominating and remunerating directors
 The UK Corporate Governance Code states that a nomination committee and a
remuneration committee should each be established to help provide formal and
transparent procedures in these areas
o Assessing board performance

 Maintain external relations