Learning Objectives•Understand the need for having accounting system both forinternal and external purpose•Understand the accounting equation•Distinguish between debits and credits•Understand what a balance sheet illustrates about a company•Know how an income statement is put together•Able to read and interpret accounts, accounting reports andfinancial statements,•Conduct ratio analysis of financial performance of an entity(profitability, financial conditions, efficiency).
Sub-chapter 5: Outline Basic accounting framework Definition of Financial Statements What does Financial statements consist of? Balance Sheet Income Statement Cash flow Statement Application and preparation of financial Statement Financial ratios Issues relating to Financial Statements and the analysis.
Nature of accounting Financial statements are necessary sources of information about companies for a wide variety of users. Users includes company management teams, investors, creditors, governmental agencies and the Internal Revenue Service. Users of financial statement information do not necessarily need to know everything about accounting to use the information in basic statements Accounting is defined as the provision of information of financial nature to interested parties for the purpose of assisting in their decision making. 2 types of accounting: Financial Accounting Management Accounting
What is in accounting?• What Information: • Financial position – assets & liabilities • Cash flow • Profitability • Comparison • Aspect of decision making includes; Who Why require info? - Decision • Management e.g. to produce or not, to sell? • Employees Possibility of more bonus? • Investor To invest in the company? • Public Co spent to protect environment? • Government Change law to increase tax?
Financial vs Management Accounting Criteria / Financial Management AccountingNature Geared towards the Providing relevant preparation of information information to the needs of for external users/decision internal users/decision makers makers (i.e. management) at various level.Purposes Decision making Decision making Meeting legal requirementsUsers External InternalDetail Less detailed More detailedStandard Subject to Accounting No standard, as long as meet Standards the requirement of users / management
Basic accounting concept and principles1. Accounting entity – any accounting system and consequently its accounting reports is concerned with the life of one particular entity (e.g. company, partnership, group of companies). Different entities can be distinguished by; Ownership and/or control – public or private, partnership Size – Groups of companies, big or small company Reason of existence – profit or non profit making Type of activity – trading, manufacturing, services2. Accounting transactions - the recording of economic events.3. Accounting principles Double entry Accrual concept (to capture all costs relevant to a period even not billed yet) Matching principle (match income and related expenses in an accounting period)
Accounting transactions External Decision Makers Economic Environment Internal Data Internal decision makers collection External data Information collection Data Processing Information Observation Accounting Information & selectionExamples:Sales of spare parts, Classify, compute and Financial Government,Purchase of machineries, summarise (Manual or statements investors,Pay staff salaries computerised accounting auditorsPay tax Accounting system) Management transactions Extract from: Management for Engineers, 3rd edition, Edited by Danny Samsom, 2001 Prentice Hall
Financial statements are prepared from numerous accounting entries Accounting entries Trial Balance Financial Statement Accounts Debit Credit (RM) (RM) • Income StatementPurchase a building: Building 2,000,000 • Cash flow StatementDr Building A/C 2,000,000Cr Creditors A/C 2,000,000 Creditor 2,000,000 • Balance SheetSales receipt: Bank 300,000Dr Bank A/C 300,000 Sales 300,000Cr Sales A/C 300,000 Total Total debit Total credit The financial statements are prepared from the Trial Balance
Accounts balances from Trial Balance are transferred to IncomeStatement & Balance Sheet Accounts Debit (RM) Credit (RM) Income Statement Balance SheetCapital 20 000 YesDrawings 2 500 YesSales 100 000Stocks as at 1 January 2009: Finished goods (at cost) 6 200 Yes Work in progress (at prime cost) 3 500 Yes Raw materials 5 000 YesPurchases of raw materials 14 400 YesWages 22 100 YesOffice salaries 17 800 YesGeneral expenses 4 120 YesHeat and light 2,300 YesInsurance 980 YesBad debts 550 YesDiscount received 1 800 YesCarriage outwards 290 YesDirect expenses 820 Yes Non-current assets at cost: Plant & M 24 800 Yes Motor vehicles 14 340 Accumulated depreciation:Plant & M 4 000 Yes Yes Motor vehicles 2 000Cash 8 200 YesDebtors and creditors 7 800 8 900 YesTotal 136 700 136 700
Financial ReportsThe 3 main reports is known as Financial Statements1. Income Statement – A statement of operation performance / profitability2. Balance Sheet – A statement of financial position of an entity at a specific date3. Cash flow Statement – A statement of changes in financial position (i.e. how fund in the company is sourced and used)Audited Accounts: Nature Prepared for whom? Report by whom?
Legal requirement Companies Act, 1965 requires all registered companies to submit annual audited financial statements prepared in accordance to approved accounting standard, to Companies Commission of Malaysia (Suruhanjaya Syarikat Malaysia) With changes in reporting environment, corporate governance and globalisation economies, there is a move towards presenting high quality financial information which is international comparable. Companies or reporting enterprise must adhere to the accounting standards and regulations set by; Bursa Malaysia, CCM, Securities Commission, MASB, and Bank Negara for financial institutions. Accounting Standards are issued by MASB after consultations with various parties.
Basic Guidelines The Accounting Equation Assets = Liabilities + Owners Equity It is an essential notion in financial accounting which is derived from assets and claims on assets. Assets : what a company owns - equipment - buildings and - inventory. Claims on assets: - liabilities (what a company owes such as notes payable, trade accounts payable and bonds. )and - owners equity (the claims of owners against the business.)
Debit & Credit For every transaction that is recorded in a business, there have to be two components that make up an entry—a debit and a credit (double entry) : whenever a "transaction" occurs Debit - an increase in an asset item(liabilities and owners equity) - a decrease in a claim or expense item Credit - an increase in a claim item - a decrease in an asset or revenue item.Assets and Claims on Assets Example : A businesswoman uses her cash to buy a sawing machine for her business. Hence; 1. Debit : equipment account (because an asset was increased) 2. Credit : Cash account (due to payment made on purchase) Generally, debits are listed first and credits second. The dollar amount of the debit appears on the left and the dollar amount of the credit appears on the right. Debit Credit Debit Credit Increases in Assets Decreases in Assets Equipment $XXX Decreases in Claims Increases in Claims Cash $XXX Expense Items Revenue Items
1. represent everything that has value(cash, fixtures, intangibles) 2. 2. Subject to claims by the creditors and the owners 1. Allow the owners to seek a higher claim in the assets because their profits have increased. increases the owners equity1. Represent contra revenues2. Reduces the amount of profit to Assets = Liabilities + Owners Equity which an owner lays claim. Debit = Credit
1. Balance Sheet (B/S)• B/S is a statement of financial position of an entity at a specific date. Wealth that an entity has over its resources, or financial size of the entity Financial structure, information on various type of resources / assets controlled by this entity Solvency, assessment of how well the entity can meet its liability (i.e. able to pay debt/loan) Capacity for adaption, assessment on how the entity can meet future challenges, e.g. economic down turn (e.g. enough cash to survive if there is no sales?) Equation: Assets (A) = Liabilities (L) + Equity (E) Assets include Current Assets (short term, within 12 months) and Non Current Assets (long term or fixed assets) Liabilities include Current Liabilities (short term, within 12 months) and Long term Liabilities (loan/ mortgage) Capital / Shareholders’ Equity include Paid up capital (Ordinary shares or Preference Shares), Retained Earnings and other Reserves.
Example - Balance sheet As at 31 December 2010 RM’ 000 Remarks Non Current /Long term Asset Property, Plant & Equipment 330,690 Value of NCA in B/S is the net book value, Motor Vehicles 500 which cost of NCA less the accumulated Buildings 14,500 depreciation. Total Non Current Asset 345,690 Current Assets Cash at bank 2,000 Value of Accounts receivable is net of Accounts Receivable/debtors 3,200 provision of bad debt and bad debt written Materials stock/inventories 190 off. Inventories are reported in B/S at the Finished goods inventories 670 lower of cost or net realizable value. Prepaid expenses 250 Total Current Assets 6,310 Total Assets 352,000
Cont. RM’ 000 RemarksLong term Liabilities Loans/ Debentures 200,000 Mortgage 120,000Total Long term Liabilities 320,000Shareholders’ equity Paid up capital, RM1 ordinary shares 1,000 Shareholders’ equity may include Retained earnings 30,000 preference shares.Total Shareholders’ equity 351,000 Retained earnings is the balance after adding the net profit for the year.Current Liabilities Accounts payable/ creditors 450 Accrued expenses 200 Income tax payable 350Total Current Liabilities 1,000Total Liabilities and equity 352,000• Accrued expenses: Charges incurred but no invoice is received then these charges are referred to as accruals (they accrue or increase in value). A typical example is interest payable on a loan where you have not yet received a bank statement. These items (or an estimate of their value) should still be included in the profit & loss account. When the real invoice is received, an adjustment can be made to correct the estimate. Accruals can also apply to the income side.
2. Income Statement Also known as Profit & Loss, statement of operations, or statement of income. It is prepared for a period (the month, quarter, year ended dd.mm.yy) Items in Income Statement include; Revenue Expenses (Operating expenses, General & Admin, Finance and includes accruals, i.e. expenses incurred for the period but has not received invoiced) Profit (gain) and losses for the period Earnings per share Matching principle – Revenue for the period is matched with expenses for the period. the bottom line of the income statement indicates a net loss (-ve) - a banker/lender/creditor may be hesitant to extend additional credit to Various concept of profit the company. On the other hand, a company that has operated Gross profit profitably- the bottom line of the income statement indicates a net income (+ve) - demonstrated its ability to use borrowed and invested Net Profit funds in a successful manner Profit before tax and Profit after tax Profit will increase owner’s equity/share of the company.
Revenue and expenses are posted to Income Statement andcategories into different nature of expenses. Income Statement for year ended 31 December RM’ 000 Remarks 2010 Revenue 30,000 - Income/cost of sales (direct cost) Cost of sales (15,000) from main activities. Gross profit 15,000 Other income 2,000 - Other income include rental Other operating expenses (1,250) /interest. Administration expenses (600) - General and admin expenses include salary, travel, repair etc. Operating profit 15,150 Finance costs (350) - e.g. interest on loan, bank charges. Share of profit/(loss) from associates or jointly 500 - Share of profit from non controlled controlled entities subsidiaries Profit before tax 15,300 Income tax expense (3,500) Profit for the year 11,800 Attributable to: - Equity holders of the Company 11,300 Attributable is only relevant for - Minority interests 500 group’s income statement. Income Statement prepared for the management will have detailed information on the revenue and expenses, including the production cost per unit .
Or.. Sales Income Statement For the Five Months Ended May 31, 2010 $100,000 Cost of Goods Sold 75,000 Gross Profit 25,000 Operating Expenses Selling Expenses Advertising Expense 2,000 Commissions Expense 5,000 7,000 Administrative Expenses Office Supplies Expense 3,500 Office Equipment Expense 2,500 6,000 Total Operating Expenses 13,000 Operating Income 12,000 Non-Operating or Other Interest Revenues 5,000 Gain on Sale of Investments 3,000 Interest Expense (500) Loss from Lawsuit (1,500) Total Non-Operating 6,000 Net Income $ 18,000
Or.. Income Statement in Contribution Margin Format For the Five Months Ended May 31, 2010 Product Product Total Line 1 Line 2 Sales $100,000 $70,000 $30,000 Variable Expenses Cost of Goods Sold 75,000 50,000 25,000 Commissions Expense 5,000 5,000 0 Total Variable Expenses 80,000 55,000 25,000 Contribution Margin 20,000 15,000 5,000 Fixed Expenses - Prod. Line 6,000 4,000 2,000 Subtotal 14,000 11,000 3,000 Fixed Expenses - Common 2,000 Operating Income $12,000 Remember that this format is not acceptable for distribution outside of the company—its accessibility should be limited to the members of the companys management. In fact, this type of income statement is usually covered as part of managerial accounting, not financial accounting
Income Statement shows the profitability of a company during the time interval specified in its heading. "The Four Weeks Ended December 27, 2010" (The period of November 29 through December 27, 2010.) An important concept in understanding the income statement is Earnings Per Share (EPS). The EPS for a company is net income divided by the number of shares of common stock outstanding. It represents the bottom line for a company. Companies continually make decisions on how their bottom line will be impacted since shareholders in the company are concerned with how management decisions affect individual shareholder position
3. Cash flow Statement summarizes the major sources anduses of funds for the accounting period Cash flow statement for year ended RM’ 000 Remarks 31 December 2010 Cash flow from operating activities Cash receipts from customers 9 950 Include funds from activities that Cash paid to suppliers and employees (7 800) contribute to the profit of the co. Cash flows from operating activities 200 The amount does not include Taxes paid (430) amount due from customers and amount due to suppliers (i.e. Net cash from operating activities 1,920 unpaid amount) Cash flow from investing activities Acquisition of subsidiary (50) Proceed from the sales of non-current 850 assets Purchase of property, plant and equipment (2 980) Investment in associate (100) Dividend received from associate 50 companies Net cash used in investing activities (2,230) Example Sapura Crest Petroleum Bhd (Pg. 77 - Sapura Crest FS 2010.pdf )
Cash flow Statement summarises the major sources anduses of funds for the accounting period – cont’d Cash flow statement for year ended RM’ 000 Remarks 31 December 2010 Cash flow from financing activities Proceeds from issue of share capital 800 Proceed from issue of debentures/loans 200 Dividend paid by holding company 0 Dividend paid to minority shareholders (320) Net cash inflow from financing activities 680 Net increase in cash and cash equivalents 370 Cash and cash equivalents at beginning of 1,630 Cash at beginning and at the year end of the year should tally Cash and cash equivalents at end of the 2,000 with the Cash balances in year B/S.
Notes to the Accounts Is part of the financial statements and being audited. Notes to the Accounts must be read together with the other financial statements. Some of the Notes are; Significant Accounting Policy Revenue Non Current Assets Inter related transaction
Various methods available to analyse and interpret the financialperformance of a company The financial information by itself may meaningless. Thus, it is normal for users to perform further analysis on the financial information, for decision making. Eg. Company Net Profit (RM) Sales (RM) Profit margin (%) Rating A 200,000 848,000 23.58 B 300,000 1,252,000 23.96 C 500,000 1,927,500 25.94 In performing the analyses, management accountants can be more detailed in their analysis as they have more information available as compared to that of the financial accountants.
Various methods available to analyse and interpret the financialperformance of a company Some of analyses used are; Ratios Comparison with preceding periods (intra company) Trending Benchmark with other companies (inter company) Similar size Similar industry Similar economic conditions / economy When looking at ratios, need to consider the timing of transactions and date of accounts of the entities being compared.
Different Ratios are used for different assessments Profitability ratio is a measure of profitability Net profit ratio : Net Profit divided by Net sales (%) Return on total assets : Net Profit divided by Total assets (%) Return on capital employed: Net Profit / Average capital employed Return on shareholders equity: Net Profit / Shareholders’ Equity (%) Earnings per share: (RM) Net profit after interest, tax and preference dividend No. of ordinary shares issued Measures of resources used - Assessment of efficiency of assets used or utilised. Total assets turnover: Total sales / total assets
Different Ratios are used for different assessments –cont’d Liquidity ratio which measure financial conditions - Assessment of an entity’s ability to meet its commitment (e.g. to pay its creditors, loan) Current (or working capital) ratio: Current assets / Current liabilities (ratio should be more than 1) Quick Asset (or liquid) or acid test ratio:Current assets less Stock Current liabilities (ratio should be more than 0.5) Debt Equity ratio (leverage): Liabilities / Owner’s Equity (High leverage company indicate higher risk in servicing debts) No matter how profitable a business is, if it is not adequately liquid, it may fail.
Different Ratios are used for different assessments –cont’d Efficiency ratio measure the efficiency of a business maintaining a specific level of inventories., or control over the level of inventories. Inventory turnover: Cost of Sales / Average inventory (of finished (Rate of inventories turnover) goods) Eg. Company Cost of sales (RM) Average inventory (RM) Turnover A 96,000 (34+30)k /2 3 times B 96,000 (46+50)k /2 2 times A reduction in inventory turnover can mean that the business is slowing down. Piling up and unsold inventory may lead to liquidity issue. Accounts receivable/ Sales ratio: Accounts receivable/Credit Sales x 365 days • This measures the no. of days it takes for debtors to pay / collection. The lower the number, the better collection and better for liquidity. Accounts Payable / Purchases ratio: Accounts Payable/ Purchases x 365 • This measures the no. of days it takes for the business to pay its creditors / credit term. The higher the number the better as the business may use its available fund for other purchase sand get longer credit free from its creditor.
Users of ratios Ratio categories Example of interested groups (internal & external)Profitability Shareholders, management, employees, creditors, competitors, potential investorsLiquidity Shareholders, employees, creditors, competitorsEfficiency Shareholders, management, employees, potential purchasers and competitorsShareholders Shareholders, potential investorsCapital structure Shareholder, lenders, creditors, potential investors.Q. How are the ratios useful to them?When deciding what the ratios tells you, you need to consider below;- What the norm in the industry?- Is this company above or below norm?- If so, can it be justified after an analysis of the nature of the business and its assets and liabilities?
Issues on ratio analysis Ratios can be misleading if not used and interpreted appropriately. Comparison of ratios for a company should be done with a similar companies, else the comparison can be meaningless (e.g. co with same accounting policy). The ratio may be applicable at that particular time and can be out dated if not used timely.
Advantages and disadvantages of ratios Advantages DisadvantagesRatios are easily understood by all Ratios merely indicate the areas ofusers weaknesses and strength but does not indicate the cause of such.They are useful for comparison Meaningful, only if used intelligentlyImportant ratios will bring focus on the Ratio are relative figures, they do notattention of management/investors indicate the volume/size of the business.Remedial actions could be taken on Using ratio for comparison may not beweaknesses revealed through ratio meaningful if the accounting policyanalysis adopted by businesses are not the same. (i.e. not comparing like with like)
Issues relating to Financial Statements Application and preparation of Financial Statement can be time consuming Audit requirement on financial statements of companies, additional costs to companies. Standards set by MASB are to ensure comparability of the accounts prepared with minimum information provided. Companies must prepare accounts in accordance to the accounting standards set by MASB, can be time consuming, requires skilled staff and costly.
Clarifications, Questions •Any Questions up to this point?
References Wood, F. Sangster, A (2008). Business Accounting 1, 11th Edition, Prentice Hall (Pearson Education) Management for Engineers, 3rd edition, Edited by Danny Samson, Melbourne University, (2001), Prentice Hall Malaysian Accounting Standard Board - webpage Malaysian Institute of Accountants - webpage Security Commission, Malaysia - webpage Bursa Malaysia - webpage Glossary of Accounting Terms - http://www.accountz.com/glossary.html