AC102

Valuation Role

demand for accounting info investors who seek to predict future cash flows

sole proprietorship (bus=ownder)

owned by one person,

usually small,

easy to set up,

no legal obligation to publish accounts,

owner has unlimited liability

partneship (bus=owner)

-ownded by 2 or more ppl

-small in terms of size (some can be large)

-can be restructured or dissolved bu agreement of partners

-partners have unlimited liability

limited company (bus ≠ owner)

-could have large no. shareholders

-continuity of lofe

-ownders have limited liability

-requirements for publishing audited financial statements

Historical cost convention

value of assets shown on statement of financial position should be based on historical cost (acquisition cost) --> problems of measurement reliability are minimized

Fair value convention

market based measure

Going concern convention

Financial statements should be prepared on the assumption that the business will continue operations for the foreseeable future.

Business entity convention

the business and its owner(s) are treated as being quite separate and distinct.

Prudence (=conservatism) convention

reflects caution when making accounting judgments so that losses and obligations are not understated, and profits and resources are not overstated.

asymmetric prudence/conservatism reflects:

Recognizing losses immediately • Recognizing gains only when they are realized (i.e., if a good is sold)

Dual aspect convention

Each transaction has two aspects, both of which affect the company's position.

Money measurement convention

A resource will be included in the entity's financial statements if it can be measured reliably in monetary terms

Accruals convention

Revenues and expenses are recognized when they are earned or incurred rather than when the cash is received or paid.

The matching principle

Expenses should be "matched" to the revenue that they help generate ▪ In practice, this means: expenses ≠ cash paid!

Financial statements: Balance sheet

The purpose of the balance sheet is to report the financial position (amount of assets, liabilities, and shareholders' equity) of an entity at a particular point in time.

Financial statements: Income statement

Income statement reports the primary measure of financial performance of a business - revenues less expenses - during the accounting period.

Financial statements: cash flow statement

Cash flow statement describes the flows of cash into and out of an organization during an accounting period. The cash flows are classified as arising from operating, financing, or investing activities

accounting equation

assets = equity + liabilities

assets e.g.s

buildings, plants and machinery, fixtures and fittings, patents and trademarks, trade recievables, inventories, investment, cash at bank/in and

trade recievables

Money owed to a company by customers who received goods but haven't paid for them yet.

inventory

Merchandise that a company has available for sale to customers

Liabilities:bank loans

A bank loan is an example of a long-term liability. Companies may obtain a bank loan if they need more resources for their operations.

Equity

Equity is the residual interest in the assets of the entity after deducting all its liabilities.

Equity =Assets -Liabilities

Drawings

A drawing account is a contra owner's equity account used to record the withdrawals of cash or other assets made by an owner from the enterprise for its personal use during the year. Drawings are a deduction from capital and will reduce owner's equity

Current assets:

(Assets that are held for the short term ) They are expected to be sold within the next year and are cash or near cash such as marketable short-term investments.

E.G. inventory, trade recievables, cash

Non-Current assets (fixed assets):

(Assets that are held for long term operations ) They may be either tangible or intangible.

E.G. PPE, buildings, computers, motor vehicles

Current liabilities:

Amounts due for settlement in the short term) They are due to be settled within a year after the date of the statement of financial position.

e.g. accounts payable, trade payables, bank loans that are due within the next yr

Non-Current liabilities:

(Amounts due for settlement in the long term) They represent amounts due that don't meet the definition of current liabilities

E.G. LT borrowing, trade payables, lease liabilities

debit

left hand entry

credit

right hand entry

T accounts

used to record all changes in a particular account

Left side of T account

Debit. records increases in assets and expenses and decreases in income, liability and equity

Right side of T account

Credit. records increases in revenue, liability, equity and decreases in assets and expenses

assets, expenses, drawings dr vs cr

dr : transactions that increase value

cr: transactions that decrease value

liability, equity, revenue

dr: transactions that decrease value

cr: transactions that increase value

net income

income - expenses

Cash Basis Accounting

records only transactions with cash:

cash receipts and cash payments. When cash is received, revenues are recorded.

When cash is paid, expenses are recorded.

As a result, revenues are recorded only when cash is received and expenses are recorded only when cash is paid

Accrual basis accounting

records the effect of each transaction as it occurs—that is, revenues are recorded when earned and expenses are recorded when incurred.

Revenues are considered to be earned when the services or goods are provided to the customers.

Under accrual basis accounting, it is irrelevant when cash is received or paid.

Accrued expenses (eg, electricity)

• Expenses that have been incurred, but not yet recorded (not invoiced) • i.e, services/goods received from suppliers, but payment has not been made yet

Prepaid expenses (eg, insurance)

Future expenses that have been paid in advance • Cash has been paid, but services/goods have not been received yet

A C C R U E D E X P E N S E or A C C R U A L S ( C U R R E N T LIA B ILITY )

C os ts tha t ar e a pplica ble to th e cur r ent a c c ou n t in g pe ri od but h a ve no t yet b e e n r eco r de d a s e xp e nse s

Contra accounts

These are special accounts that are established to reduce the balance in another account indirectly. They preserve the identity of the primary account.

COST OF SALES

OPENING INVENTORY +PURCHASES - CLOSING INVENTORY =COST OF GOODS SOLD

receivable

the right to receive cash in the future from a current transaction.

It is something the business owns; therefore, it is an asset.

Each receivable transaction involves two parties:

• The creditor, who receives a receivable (an asset). The creditor will collect cash from the customer or borrower.

• The debtor, the party to a credit transaction who takes on an obligation/payable (a liability). The debtor will pay cash later.

Property, plant and equipment are tangible assets that:

-are held for use in the production or supply of goods or services, for rental to others or for administrative purposes

- are expected to be used during more than one period (IAS 16)

PPE is initially measured at cost. The cost of an item of PPE includes

1. the purchase price

2. all costs incurred in order to bring the asset into a location and condition ready for use, eg:

• cost of site preparation

• installation costs

• delivery costs

• related professional fees (eg, for architects and engineers)

Capital expenditure

Cash spent to purchases assets

▪ The asset is expected to provide future benefits, items last for more than a year

▪ Another term is 'capitalized costs'

▪ Examples: - Plant and machinery - Factory buildings - IT systems

Revenue expenditure

Cash spent on day-to day operations

▪ Is consumed within an accounting year

▪ Entire amount is charged to income statement

▪ Examples: - Wages and salaries - COS - Marketing costs

To calculate depreciation, four factors need to be considered:

1. cost (or fair value) of an asset

2. useful life of an asset

3. residual value of an asset

4. depreciation method

Depreciable amount =

Initial Cost − Residual Value

Depr. expense = straight line method

(Initial Cost − Residual Value)/ Useful Economic Life

Depr. expense = reducing balance method

Depreciation rate x NBV at the start of the year

Impairment losses

An asset may suffer a significant fall in value.

In some cases, this fall in value may lead to the net book value of the asset being higher than the amount that could be recovered from the asset; either through its continued use or through its sale.

Prudence: The general rule is to reduce the asset on the balance sheet to its recoverable amount and recognize an impairment loss.

Impairment loss: double entry

Impairment losses are recorded in the Income Statement regardless of which method the company uses: historic cost or fair value

Gain/Loss on disposal =

Disposal proceeds (i.e. cash received) NBV -

Intangible assets

An intangible asset is an identifiable non-monetary asset without physical substance.

To recognise an intangible asset the asset must be:

1. Identifiable:

▪ Separable, ie, capable of being separated and sold, licensed, transferred, exchanged or rented separately, without selling the whole business; or ▪ Arises from contractual or other legal rights

▪ fulfil the recognition criteria for an asset 2. Control 3. economic benefits

4. For any item to be recognized in the financial statements, its cost or value must be measurable with sufficient reliability.

There are three principal ways in which a company may obtain an intangible asset:

1. Separate acquisition

2. Acquisition as part of a business combination

3. Internally generated intangibles.

Separate Acquisition

The cost can be measured = price paid. It is identifiable, since it could be bought/sold

Acquisition as part of a business combination

When a company buys another company and they produce a combined balance sheet, they have to include intangible assets (like brand names or customer lists) in the balance sheet, even if the company they bought didn't recognise these intangibles in their separate balance sheet

Internally generated intangibles

Intangible assets should be recognised only if their cost can be reliably measured and it is probable that expected future benefits will flow to the business

Share premium

when shares are issued at above their par values)

interim dividend

paid halfway through the accounting year, when the profit for the first six months is known. The amount is decided by the directors.

final dividend

additional to the interim dividend and, although it relates to the same accounting year, is paid just after the end of the year. The final dividend has to be approved by the equity shareholders at the annual general meeting (AGM), and this is always held after the end of the accounting year when the profit for the year is known.

Why do we add back depreciation to the profit before taxation?

Depreciation is a non-cash expense that reduces profit but does not affect actual cash flow.

Interest paid (cash outflow) is calculated as follows:

Opening interest liability (interest payable, SOFP) + Income Statement charge (i.e. interest expense) - Closing interest liability (interest payable, SOFP)

Tax paid (cash outflow) is calculated as follows:

Opening tax liability (tax payable, SOFP) + Income Statement charge (i.e. tax expense) - Closing tax liability (interest payable, SOFP)

When calculating cash flow from operations, why is the change in accounts receivable added or subtracted from profit before taxation?

To adjust for revenue earned but not yet received in cash, as it affects actual cash flow.

When calculating cash flow from operations, why is the change in inventory added or subtracted from profit before taxation?

Because an increase in inventory represents a cash outflow that hasn't affected profit but reduces cash flow.

ROCE (return on capital employed)

ROCE assesses the effectiveness of total capital employed.

Capital employed represents the debt and equity with which the company generates profits.

• ROCE is generally considered to be the primary profitability ratio as it shows how well a business has generated profit from its long-term financing.

• An increase in ROCE is generally considered to be an improvement

ROCE =

profit before interest and tax/avg cap employed x 100

gross profit margin =

Gross profit /sales revenue x 100

Operating profit margin=

Operating profit / sales revenue x 100

Mark-up =

Gross profit / cost of sales x 100

Margin =

gross profit/sales

inventory days measures...

how long it takes on average for inventory to be sold.

inventory days =

acg inventories held/ cost of sales x 365 days

Receivables days: shows

how long on average credit customers take to pay the amounts they owe to the business

Receivables days =

avg trade receivables/credit sales x 365 days

Payables days: shows

how long the entity takes to pay creditors

Payables days =

avg trade payables/credit purchases x 365 days

Net asset turnover ratio shows

how effectively the entity uses its resources [capital employed] to generate sales

Net Asset turnover ratio =

sales rev/avg cap employed

ROE (return on equity)

profit for the yr/(ordinary share capital+reserves) x100

working capital=

current assets - current liabilities

Liquidity Ratios

ability to generate cash for working capital needs and immediate debt repayments.

Solvency Ratios

long-term ability to generate cash internally or externally to satisfy capacity needs, fuel growth and repay debts.

current ratio

current assets/current liabilities

acid test ratio

more rigorous measure of liquidity as it excludes inventory

acid ratio=

(currentassets-inventory)/current liabilities

gearing ratio, what does it measure

contribution of LT debt to capital structure of company

gearing ratio=

non-current liabs/(share capital+reserves+non-current liabs)

debt to equity?

alternative formula for measuring level of gearing

debt-to-equity

non-current liabs/total equity

interest cover ratio?

shows amount of profit available to cover interest

interest cover ratio=

operating profit/interest expense

dividend payout ratio?

shows proportion of profits paid out as dividends to shareholders

dividend payout ratio=

(dividend announced for the yr)/(profit after tax less any preference dividends) x 100

dividend cover ratio?

measures a company's ability to maintain dividend payments. shows how many times the dividends could be paid out of profits

dividend cover ratio=

earnings for the yr available for dividend/dividends announced for the yr