FMA exam prep

Financial accounting

This is the classification and recording of monetary transactions of an entity in accordance with the accounting principles, concepts, standards and legal requirements, and their presentation in the form of income statements, balance sheets and cash flow statements during and at the end of an accounting period

Purpose of financial accounting

1. How is the company financed

2. Who owes the company

3. Who is owed by the company

4. Performance over time

5. What assets does the company own

Financial accounting information is important to 1. Fulfill legal requirements 2. To assist managers to plan , budget and make decisions

Types of business entities

Sole traders, Partnerships, Limited companies, Cooperatives

Sole trader

The business entity is owned by one person who is the main financial contributor, can have employees

Advantages- fast decision making, no shared profits, requires little capital needed to start up, operational flexibility, no obligation to publish financial records

Disadvantages- no sharing of loss, relative difficulty in sourcing funds, no separation between owner and entity, less credibility, increased workload

Partnership

This is an entity that is owned by at least 2 people who come together with a common business goal

NB: it is important to have an agreement that discusses how much each is putting, each’s responsibility in the entity, work hours , and how profits and losses are shared

Advantages- pooling of funds, shared losses, shared workload , pooling of ideas, no need for auditing , no need to disclose financial records

Disadvantages- share profit, no separation between entity and owners, risk of conflict, it’s much difficult to sell a partnership , dependency on the other partner

What is a company

This is an association where two or more people come together for a common business goal. It has separate legal personality meaning its liabilities cannot be transferred to shareholders , it has the capacity, power, rights and privileges as an individual

Forms of limited companies

1. Public company

2. Private company- limited by shares, limited by guarantee, unlimited

Public company

This is a company that can invite the public to buy shares, they list their shares on the stock exchange. Always ends with PLC and has a minimum capital of k1 million in Zambia

Private company

This is a registered company formed and owned by individuals and not the public, do not invite the public to buy shares

Minimum number of owners or directors is 2

Always ends with the word ‘limited’

Limited liability companies advantages and disadvantages

Advantages- Limited liability, No limit on number of shareholders, easy to raise funds from shareholders , tax advantages , ease of share transfer from one person to another

Disadvantages- need for auditing, need to disclose financial records, financial statements need to comply with legal requirements, difficult to reduce share capital

Users of accounting information

Internal- employees, directors, managers, shareholders

External- government, journalists,suppliers,lenders,trade unions, competitors, potential investors, customers, local authorities

What is management accounting

It is the identification, measurement, accumulation, preparation, analysis, interpretation, and communication of information that is useful to management in terms of planning, evaluating and controlling within an entity and to assure appropriate use of and accountability of its resources

Information is used to create budgets and plan future activities of the entity, to compare actual performance with budgets and try corrective action when appropriate

Comparison of FA and MA

FA is prepared for both external and internal users while MA is for internal users

FA shows information about past performance over a certain period while MA shows historic performance compared to budgets plus projections for the future

FA is a legal requirement while MA is not

FA format is determined by the law and IAS/IFRS while MA format is at the discretion of the managers

FA information is mostly monetary while MA information is both monetary and non monetary measures of performance

The regulatory system of financial accounting

The legislation

The International Financial Reporting Standards

The Stock Exchange Rules

What are accounting standards

These are authoritative pronouncements that explain how to deal with specific accounting problems e.g valuation of closing stock, measurement of property, plant and equipment

Why do we need Accounting standards

To have common form and content of accounting records

Users need to be assured that the information can be relied on

What is the Conceptual framework for Financial reporting

This is a comprehensive set of concepts for financial reporting issued by the IFRS Board

Purpose: to assist the board to develop the IFRS based on consistent concepts resulting in financial information that is useful to lenders,investors and creditors

To allow preparers of financial reports to develop consistent accounting policies for transactions and other events where no standard apply or a standard allows a choice of accounting policies

To assist all parties to understand and interpret standards

Conceptual framework of financial reporting (triangle)- OBJECTIVE

To provide financial information about the reporting entity that is useful to present and future investors, lenders, creditors in their capacity as capital providers

This helps investors to assess prospective net cash inflow to the entity and well as assessing the management’s stewardship of their economic resources

Qualitative characteristics

Fundamental characteristics

1. Relevance- confirmatory value, predictive value, materiality

2. Faithful representation- free from error, free from bias/ neutrality, complete

Enhancing characteristics

1. Verifiability- financial information should be reproducible given the same data and assumptions

2. Comparability - financial information should be easy to compare with past performance as well as other entities

3. Timeliness- financial information should be produced in a timely manner

4. Understandability- complex issues should not be left out of financial reports

Elements

Assets an present economic resource that an entity has control over

Liabilities- a present obligation that the entity has to transfer an economic resource as a result of past events

Expenses

Income

Capital

Assumptions

Going concern- this is the assumption that the company will continue to operate and not close or be sold

Time principle - this is the assumption that the life of a business is divided into time periods eg months or years

Monetary unit - all transactions and events are expressed in money,monetary or units

Reporting entity- this is the assumption that reporting entity is a distinct and separate economic unit from owners and other subsidiaries

Principles

Cost - financial information is based on actual cost and is objective

Revenue recognition- revenue is recognized when it’s earned , it is recorded as cash value and cash value of goods received

Full disclosure- a reporting company needs to disclose relevant information behind financial statements

Matching - the entity needs to record expenses incurred to generate the revenue recorded

Constraints

Prudence/conservatism - this cautions when stating estimates and judgement under uncertainty. Do not overstate income/assets and don’t understate liabilities or expenses

Cost benefit- the benefit of financial report needs to justify the cost of producing and disseminating them

Industry practice- this allows for deviation from standard guideline in industries with unique operations that justify the deviation

Materiality- information is material if its omission or misstatement can influence the decision making process by users

Recognition

- the process of capturing for inclusion in the financial reports of an element

Derecognition

This is the removal of part of or an asset or liability from the financial reports eg when an asset is no longer under the control of an entity or when a liability or part of it has been settled

Measurement bases

The method of how to measure an asset or liability

1. Historic cost- provides information derived at least in part from the cost of the transaction or event that led to the rise of that which is being measured

2. Current value- contains information updated to reflect conditions at the time of measurement

   Fair value - the price that would be received to sell an asset or paid to settle a liability in a proper transaction between 2 market participants at the measurement date

   value in use- reflects entity specific current expectations about the amount , timing and uncertainty of future cash inflow

   current cost- reflects the current amount that would be paid to acquire an equivalent asset or to

Accounting cycle

The Accounting process→ accounting information system → decision makers → economic activities → then back

Book keeping

the process of recording transactions in the books of accounts, reconciling them and preparing financial reports from the books of accounts

Steps in the accounting cycle

Analyse source documents→journalize transactions in a journal → post transactions to ledger accounts→ prepare trial balance→prepare financial statements → prepare management reports

Posting

Copying transactions from the journal to the ledger accounts

Account

The record of increases and decreases in an element

A general ledger contains all accounts used by the company

Accounting equation

Assets = Capital + Liabilities

Double entry system

Debit the receiver, credit the giver

To increase assets and expenses , debit them . To increase capital ,income and liabilities credit them. The opposite is true when decreasing them

Costing

The application of principles, methods and techniques to ascertain and manage costs

Cost

Resources sacrificed or foregone to achieve specific objectives

It is the amount of expenditure incurred on or attributable to a specific product/service or activity

Classification methods/ techniques

Nature of cost

Functional

Behavioral

Nature of cost- costs can be classified into material, labour or expense cost

Product cost classification

Direct costs- these are cost that can specifically be identified with the output of the organization whether product or service eg direct labour, direct material

Indirect costs- those costs that cannot be identified as direct costs eg indirect labour, material or expense

Product cost

Prime cost- direct labour , direct material , direct expense

Conversion costs- direct labour, indirect material, indirect expense

Behavioral cost classification

This is the relationship between cost and level of activity/ output

Fixed cost- the cost remains the same despite a change in the level of activity/ output

Variable cost- cost that vary with the level of activity/output

Semi fixed / semi variable- an in between category

BASIC COST BEHAVIOUR PATTERN

Total fixed costs - do not respond to changes in unit level cost drivers within a period

Total variable costs - increase in proportion to increase in unit level cost drivers

Total mixed costs- contain fixed and variable cost elements. They increase but not in direct proportion to increases in unit level cost drivers, also called semi variable costs

Labour costing

Time based systems

Output based systems

Incentive/ PMS systems

Profit sharing

Material and stores costing

Materials purchased for use in production without storing them- allocated directly for production

Materials being kept in stores before use

Stores/ material cost methods include:

First in first out

Last in last out

Weighted average methods

Standard price methods

FIFO METHOD

Costs stores issues in the strict order in which they were taken into the stores

Oldest stock issued first

Issued at the actual cost of purchase

Applicable to store items that can be identified separately

Closing stock values reflect latest price

LIFO METHOD

Latest stock issued first

Closing stock is a reflection of oldest price

Weighted average methods

Stock is issued at average cost of purchases

Stocks cannot be separated

Standard price methods

Issued at a cost predetermined in a manager’s meeting beforehand

Classification by function of expenses

Production costs- direct material, direct labour, direct expenses, fixed and variable production overheads

Non production costs- administrative costs, selling costs, finance costs, distribution costs

Cost ascertainment/ accumulation

Looks at methods used to determine the cost of jobs, products, services, etc

Done for stock valuation processes, for cost control, to determine selling prices of goods or services

Cost accounting techniques

Marginal costing

Absorption costing

Activity based costing

Marginal costing

A costing system that treats only the variable manufacturing cost as the product cost . The fixed manufacturing overheads are regarded as period costs and recorded in the P&L as expenses

Absorption costing

Overheads need to be included in the product cost. The process of including them is called overhead absorption/recovery

Absorption costing/ full costing

Allocating all manufacturing costs to products regardless of whether they are fixed or variable

Activity bases approach

It is an approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs

Pricing decision factors

Costs and non costs factors eg supply & demand

Aim:

To maximize profits where total revenue less cost of sales is greatest

Where marginal cost = marginal revenue

Pricing methods

Full cost pricing

Marginal pricing

Rate of return pricing

Full cost pricing

All costs are charged to the product

Selling prices = direct cost+ share of indirect costs + profit margin

Rate of return pricing

Selling price= Full costs + ROCE

Marginal cost pricing

The selling price is set based on variable costs per unit and profit margin only

Selling prices per unit= variable cost per unit + contribution per unit

Break even Analysis

Also known as Cost Volume Profit (CVP) analysis

It is the study of the relationships between selling prices, fixed costs, variable costs, sales volumes and profits at different levels of activity

Uses of break even analysis

1. To find level of activity when total sales = total costs ie zero profit - break even point

2. To find level of activity where target profit will be achieved

3. Determine margin of safety

4. Visualize the effect of a change in any variable on the BEP and profit

5. Determining contribution levels as indicators for product profitability

Calculating the levels of operating gearing as an indicator of the effect on profit of a given change in sale

Break even point

It is a level of activity where total costs = total revenue (no profit)

Assumptions of the break even point analysis

Assumption of breakeven point analysis

•Relevant range- The relevant range is the range of an activity over which the fixed cost will remain fixed in total and the variable cost per unit will remain constant

•Fixed cost- Total fixed cost are assumed to be constant in total

•Variable cost- Total variable cost will increase with increasing number of units produced

•Sales revenue- The total revenue will increase with the increasing number of units produced

Margin of safety

This is the amount by which sales can fall from the current level to the break even point

Budget

This is a plan quantified in monetary terms , prepared and approved prior to a specified period indicating planned income to be generated and or expenditure to be incurred during that period and capital to be employed to achieve certain goals

Advantages of budgeting

1. Define goals and objectives

2. Communicate plans

3. Coordinate activities

4. Allocation of resources

5. Identify potential bottlenecks

6. Plan for the future

Types of budgets

1. Long term budget framework

2. Capital budget

3. Recurrent budget

4. Project budget

Methods of budgeting

1. Incremental budget

2. Activity based budgets

3. Zero based budgets

Incremental budget

Start with prior year’s performance data to date, adjust for anticipated changes in activity, inflation, interest rates, exchange rates

Only applicable if:

The initial basis of allocation of expenses were a true reflection of the organization’s priorities

If the priorities haven’t changed

If the service that is being spent on is still justifiable and provided in a cost effective manner

If the cost of inputs is increasing at the same rate across the board

Advantage and disadvantage

Simple and widely used

Given the constantly changing economic and technological environment, it becomes irrelevant very quickly

May promote carrying forward insufficiencies

Zero based budget

The income and expenditure incurred in the previous year, is ignored

Budget is made as if company has just started operating, each item of expenditure has to be justified in its own right

Activity based budgets

Classifies income and expenditure by objective rather that by department

Budget preparation steps

Determine the principal budget factor / key budget/ budget limiting factor- this limits activities that can be undertaken by limiting output

Sales budget

Involves real sales forecasting, prepared in units of each product and in sales value

Methods of sales forecasting

1. Sales force opinion

2. Statistical methods

3. Market research

4. Mathematical methods

Factors to consider when doing sales forecast

Estimates made by sales force, past sales performance, market research studies, advertising and sales promotions plans, production capacity, changes in product mix, changes in firm prices, general condition of the economy, competitor’s actions

Production budget

It is expressed in quantitative terms only and is geared to the sale budget

Materials purchases budgets both quantitatively and qualitatively

Materials usage budget is in quantities

Materials purchases budgets both quantitatively is in both quantitatively and financial

Factors influencing direct materials budget

Production requirements

Planning stock levels

Storage space

Trends of material prices

Labour budget

Both quantitative and financial

Influenced by : production requirements, wage rates, grades of labour required ,man hours available , need for incentives

Manufacturing overhead budget

A schedule of all non production expenditure expected to happen during a budget period

Production cost budget

Summarises the cost of resources used in each separate production department

Cash plan

A cash plan for a defined period, summarizes all cash receipts and payments for a certain period

Cash flow position and what to do

Short term deficit- organize bank overdraft, reduce debtors and stock, increase creditors

Long term deficit- organize long term financing loan capital and share capital

Shirt term surplus- invest short loans, increase stock and debtors, pay creditors early to get discounts

Long term loan- invest in long term assets or replace them, expand or diversify production