Topic 3: Accounting and Financial Statements

                       

A. TERMS, THEORIES AND DEFINITIONS                             

Prepareation of the accounts

The accounting process starts with inputs, and these are things such as sales documents (e.g. invoices), purchasing documents (e.g. receipts), payroll records, bank records, travel and entertainment records. The data in these inputs is then processed by a specialized software:

1. Entries are recorded chronologically into “journals”.

2. Information from the journals is posted/transferred into “ledger”, where it accumulates in specific categories (e.g. cash account, sales account, or account for one particular customer).

3. A “trial balance” is prepared at the end of each accounting period: this is a summary of the ledger information to check whether the figures are accurate. It is used directly to prepare the main financial statements (income statement, balance sheet and cash flow statement).

The financial statements of large companies have to be checked by a external firm of auditors, who “sign off
on the accounts” (officially declare the accounts are correct). They are publicly available, and appear in the company’s annual report. Users of financial statements include: shareholders, potential shareholders, creditors (lenders, e.g. banks), customers, suppliers, journalists, financial analysts, government agencies, etc.

Profit and Loss Account

The profit and loss account (P&L, = income statement) summarizes business activity over a period of time. It begins with total sales/revenue generated during a month, quarter or year. Subsequent lines then deduct/subtract all of the costs related to producing that revenue.

Balance Sheet

The balance sheet reports the company’s financial condition on a specific date. The basic equation that has to balance is: Assets = Liabilities + Shareholders’ Equity.

- An “asset” is anything of value owned by business.

- A “liability” is any amount owed to a creditor.

- Shareholders’ equity/owners’ equity is what remains from the assets after all ceditors have theoretically been paid. It is made up of two elements: share capital (presenting the original investment in the business when shares were first issued) plus any retained profit (=reserve) that has accumulated over time.

Note the order in which items are listed:

- Assets are listed according to how easily they can be turned into cash, with “current assets” being more liquid than “fixed assets”.

- Liabilities are listed according to how quickly creditors have to be paid, with “current liabilites” (bank debt, owed to suppliers, unpaid salaries and bills) being paid before “long – term liabilities”.

Cash Flow Statement

Companies need a separate record of cash receipts and cash payments. Why is this? Firstly for the reason given above – it shows the real cash that is available to keep the business running day to day (profits are only on paper until the money actually comes in). Secondly, there are many sophisticated techniques that accountants can use to manipulate profit, whereas cash is real money. It’s cash that pays the bills, not profits.

There are many reasons why companies can have a problem with cash flow, even if the business is doing well. Among them are:

- Unexpected late payments and non – payments (bad debts).

- Unforeseen costs: a larger than expected tax bill, a strikes, etc.

- An unexpected drop in demand.

- Investing too much in fixed assets.

Solutions might include:

- Credit control: chasing overdue accounts.

- Stock control: keeping low levels of stock, minimizing work – in – progress, delivering to customers more quickly.

- Expenditure control: delaying spending on capital equipment.

- A sales promotion to generate cash quickly.

- Using an outside company to recover a debt (called “factoring”).

Vocabulary in financial statements is suprisingly non – standard, with many companies using a mixture of US and Europe terms.

Profit and Loss Account (Income Statement)

Revenue (= income / turnover / sales / the top line)

Cost of good sold (= direct costs) includes manufacturing costs, salaries of manual (blue – collar) workers etc.

Operating expenses (= indirect costs / overhead) include salaries of sales and office staff, marketing costs, utility bills etc.

Non – operating income includes profits from investments in other companies.

EBIT stands for Ernings before Interest and Tax

EBITDA stands for Ernings before Interest, Tax, Depreciation and Amortization.

Depreciation and Amortization are very similar, and are often used in the same way. However, ‘depreciation’ can refer to the loss in value of a tangible asset (e.g. a vehicle), and ‘amortization’ to the loss in value of an intangible asset (e.g. the purchase of a license or trademark). This loss over time is treated as a cost and written of (= subtracted from the profit) over several years.

Interest refers to money paid to the bank for loans (or received from the bank for cash balances).

Dividends are money paid to shareholders.

Retained profit is transferred to the Balance Sheet, where it joins the amounts from previous years.

Balance Sheet

Accounts receivable is the amount owed to the business by customers ( = creditors)

Inventory is the vaule of raw materials and stock.

Marketable securities are securities intended for disposal within one year.

Accounts payable is the money owed to suppliers.

Mortgage is a long – term bank loan to buy a property.

Share capital (= common stock, AmE) is amount raised at initial flotation on the stock market.

Retained profit (= reserves / retained ernings) is transferred from the income statement as mentioned.

Cash flow statement

B. VOCABULARY EXERCISES

1. Put the words into the correct column

accounts payable               cost of goods sold                ledger                                            shareholders’ equity                   EBTDA              trial balance                       invoices                    operating expenses                             current assets
Preparation of accounts	Profit and loss account	Balance sheet

2. Fill in the missing letters

a. On a balance sheet, ‘assets’ are what you ow_  and ‘liabilities’ are what you ow_.

b. The loss in value of a tangible asset over time is called ‘d_ _ _ _ _ _ _ _ _ _n’. This loss is ‘w_ _ _ _en o_ _’ in the accounts over several years. The loss in value of an intangible asset is called ‘am_ _ _ _ _ _ _ _ _n’.

c. The term ‘debtor’ is now often replaced with ‘accounts  _ _ _ _ _ _able’ and ‘creditor’is often replaced with ‘accounts  _ _ _able’.

d. The total value of raw materials + work – in – progress + finished goods is called ‘in_ _ _ _ _ _ _’

e. Expenses that have been incurred but are not yet paid are called ‘acc_ _ _d  expenses’.

f. The extent to which a firm relies on debt financing rather than equity financing is called its ‘lev_ _ age’.

3. Underline the correct words from those in italics

The terms ‘direct costs’ and ‘variable costs’ are close synonyms. They both refer to things like raw materials costs and the wages of manual workers. But to emphasize costs which increase in proportion to any rise in output, say (1) direct costs / variable costs; to emphasize costs which can be identified with one particular product, say (2) direct costs / variable costs.

Similarly, the terms ‘fixed costs’, ‘indirect costs’ and ‘operating costs’ are close synonyms. They all refer to things like advertising, rent and the salaries of office staff. But to emphasize costs which stay the same at all levels of output in the short term, say (3) fixed costs / operating costs; to emphasize costs which result from the whole business (rent, utilities, etc.), not any particular products, say (4) indirect costs / operating costs, a synonyms here is ‘overhead(s)’; to emphasize costs resulting from the day – to – day activities of the business (products and processes), say (5) fixed costs / operating costs.

C. READING

Companies are required by law to give their shareholders certain financial information. Most companies include three financial statements in their annual reports.

The profit and losst account shows revenue ans expenditure. It gives figures for total sales or turnover (the amount of business done by the company during the year), and for costs and overheads. The first figure should be greater than the second: there should generally be a profit – a excess of income over expenditure. Part of the profit is paid to the government in taxation, part is usually distributed to shareholders as a dividend, and part is retained by the company to finance further growth, to repay debts, to allow for future lossess, and so on.

The balance sheet shows the financial situation of the company on a particular date, generally the last of of its financial year. It lists the company’s assets, its liabilities, and shareholders’ funds. A business’s assets consists of its cash investments and property (buildings, machines, and so on), and debtors – amounts of money owed by customers for goods or services purchased on credit. Liabilities consist of all the money that a company will have to pay to someone else, such as taxes, debts, interest and mortgage payments, as well as money owed to suppliers for purchases made on credit, which are grouped together on the balance sheet as creditors. Negative items on financial statements such as creditors, taxation, and dividends paid are ussually printed in brackets thus: (5200).

The basic accounting equation, in accordance with the priciple of double – entry bookkeeping, is that Assets = Liabilities + Owners’ Equity. This can of course, also be written as Assets - Liabilities = Owners’ Equity. An alternative term for Shareholders’ Equity is Net Assets. This includes share capital (money received from the issue of shares), sometimes share premium (money realized by selling shares at above their nominal value), and the company’s reserves, including the year’s retained profits. A company’s market capitalization – the total value of its shares at any given moment, equal to the number of shares times their market price – is generally higher than shareholders’ equity or net assets, because items such as goodwill are not recorded under net assets.

A third financial statement has several names: the source and application of funds statement, the sources and uses of funds statement, the funds flow statement, the cash flow statement, the movements of funds statements, or in the USA the statement of chages in financial position. As all these alternative names suggest, this statement shows the flow of cash in and out of the business between balance sheet dates, Sources of funds include trading profits, depreciation provisions, borrowing, the sales of assets, the issuing of shares. Applications of funds include the purchase of fixed or financial assets, the payment of dividends and the repayment of loans, and, in a bad year, trading losses.

If a company has a majority interest in other companies, the balance sheets and profit and loss accounts of the parent company and the subsidiaries are normally conbined in consolidated accounts.

D. READING COMPREHENSION EXERCISES

1. According to the text, are the following TRUE or FALSE?

a. Company profits are generally divided three ways.

b. Balance sheets show a company’s financial situation on 31^st December.

c. The totals in balance sheets generally include sums of money that have not yet been paid.

d. Assets are what you own, liabilites are what you owe.

e. Ideally, managers would like financial statements to contain no items in brackets.

f. Limited companies cannot make a loss because assets always equal shareholders’ equity.

g. A company’s shares are often worth more than its assets.

h. The two sides of a funds flow statement show trading profits and losses.

i. Depreciation is a source rather than a use of funds.

k. A consolidated account is a combination of a balance sheet and a profit and loss account.

2. Match the following words and phrases with their synonyms:

1. financial reports	a. net assets
2. total sales	b. retained ernings
3. owners’ equity	c. sources of funds
4. flow of cash in	d. financial statements
5. reserves	e. revenue

E. GUIDE

1.

a	b	c	d	e	f	g	h	i	k
T	F	T	T	F	F	F	F	T	F

2.

1 – d, 2 – e, 3 – a, 4 – c, 5 – b

F. FURTHER STUDY

1. Watching and reading:

IFRS and US GAAP: similarities and differences