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Chapter 6 Accounting for Managers – Paul M.

Collier

Summary

Financial accounting

Accounting provides an account – an explanation or report in financial terms – about the


transactions of an organization. Accounting enables managers to satisfy the stakeholders in
the organization (owners, government, financiers, suppliers, customers, employees etc.)
that they have acted in the best interests of stakeholders rather than themselves.

These explanations are provided to stakeholders through financial statements or reports,


often referred to as the company’s ‘accounts’. The main financial reports are the Income
Statement, the Statement of Financial Position and the Cash Flow statement.

The financial reports must comply with the Companies Act 1985 to represent s ‘true and fair
view’ of the state of the affairs of the company and its profits.

There is a legal requirement for the financial statements of companies (other than very
small ones) to be audited. Auditors are professionally qualified accountants who have to
conduct an audit – an independent examination of the financial statements – and form an
opinion as to whether the financial statements form a true and fair view and have been
prepared in accordance with the Companies Act.
Accounting standards are principles to which accounting reports should conform. They are
aimed at:
 achieving comparability between companies, through reducing the variety of
accounting practice;
 providing full disclosure of material (i.e. significant) factors through the judgements
made by the preparers of those financial reports; and
 ensuring that the information provided is meaningful for the users of financial
reports.
A Financial Reporting Review Panel has the power to seek revision of a company’s accounts
where those accounts do not comply with the standards and if necessary to seek a court
order to ensure compliance.

 Reporting profitability – Income Statement


Businesses exist to make a profit. Thus, as we saw in Chapter 3, the basic accounting
concept is that: profit = income – expenses
However, business profitability is determined by the matching principle – matching income
earned with the expenses incurred in earning that income. Income is the value of sales of
goods or services produced by the business. Expenses are all the costs incurred in buying,
making or providing those goods or services and all the marketing and selling, production,
logistics, human resource, IT, financing, administration and management costs involved in
operating the business.
The profit (or loss) of a business for a financial period is reported in an Income Statement.
The turnover is the business income or sales of goods and services. The cost of sales is
either:
 the cost of providing a service; or
 the cost of buying goods sold by a retailer; or
Chapter 6 Accounting for Managers – Paul M.Collier

 the cost of raw materials and production costs for a product manufacturer.
However, not all the goods a retailer bought or used in production are sold in the same
period as the sales are made. The matching principle---the cost of sales is the cost of goods
sold, not the ones produced.
Gross profit is the difference between the selling price and the purchase (or production)
cost of the goods or services sold.
gross profit = sales − cost of sales
Expenses will include all the other (selling, administration, finance etc.) costs of the
business, that is those not directly concerned with buying, making or providing goods or
services, but supporting that activity. The same retailer may treat the rent of the store,
salaries of employees, distribution and computer costs and so on as expenses in order to
determine the operating profit.
operating profit = gross profit − expenses
The operating profit is one of the most significant figures because it represents the profit
generated from the ordinary operations of the business. It is also called net profit, profit
before interest and taxes (PBIT) or earnings before interest and taxes (EBIT).
 Reporting financial position – Statement of Financial Position
The second financial statement is the Statement of Financial Position. This shows the
financial position of the business – its assets, liabilities and capital – at the end of a financial
period.

Some business payments are to acquire assets. Non-current assets are things that the
business owns and uses as part of its infrastructure.

There are two types of non-current assets: tangible and intangible. Tangible non-current
assets comprise those physical assets that can be seen and touched, such as buildings,
machinery, vehicles, computers etc. Intangible non-current assets comprise non-physical
assets such as the customer goodwill of a business or its intellectual property, e.g. its
ownership of patents and trademarks.
Current assets include money in the bank, debtors (the sales to customers on credit, but
unpaid) and inventory (the stock of goods bought or manufactured, but unsold). The word
current in accounting means 12 months, so current assets are those that will change their
form during the next year.

Sometimes assets are acquired or expenses incurred without paying for them immediately.
In doing so, the business incurs liabilities.
Liabilities are debts that the business owes. Liabilities – called payables in the Statement of
Financial Position – may be current liabilities such as bank overdrafts, trade creditors
(purchases of goods on credit, but unpaid) and amounts due for taxes etc. As for assets, the
word current means that the liabilities will be repaid within 12 months. Current liabilities
also form part of working capital. Long-term liabilities or payables due after more than one
year cover loans to finance the business that are repayable after 12 months and certain
kinds of provisions. Capital is a particular kind of liability, as it is the money invested by the
owners in the business. As mentioned above, capital is increased by the retained profits of
the business (the profit after paying interest, tax and dividends).
Chapter 6 Accounting for Managers – Paul M.Collier

In the Statement of Financial Position the accounting equation is as follows:


assets = liabilities + capital

The matching (or accruals) principle recognizes income when it is earned and recognizes expenses
when they are incurred (accrual accounting), not when money is received or paid out (cash
accounting). While cash is very important in business, the accruals method provides a more
meaningful picture of the financial performance of a business from year to year.

Accruals accounting
Unlike a system of cash accounting, where receipts are treated as income and payments as expenses
(which is common in not-for-profit organizations), the matching principle requires a system of
accrual accounting, which takes account of the timing differences between receipts and payments
and when those cash flows are treated as income earned and expenses incurred for the calculation
of profit. Accruals accounting makes adjustments for:
 prepayments;
 accruals;
 provisions.
The matching principle requires that certain cash payments made in advance are treated as
prepayments, i.e. made in advance of when they are treated as an expense for profit purposes.
Other expenses are accrued, i.e. treated as expenses for profit purposes even though no cash
payment has yet been made.
A good example of a prepayment is insurance, which is paid 12 months in advance. Assume that a
business which has a financial year ending 31 March pays its 12 months insurance premium of
£12,000 in advance on 1 January. At its year end, the business will only treat £3,000 (3/12 of
£12,000) as an expense and will treat the remaining £9,000 as a prepayment (a current asset in the
Balance Sheet). A good example of an accrual is electricity, which like most utilities is paid (often
quarterly) in arrears. If the same business usually receives its electricity bill in May (covering the
period March to May) it will need to accrue an expense for the month of March, even if the bill has
not yet been received. If the prior year’s bill was £2,400 for the same quarter (allowing for seasonal
fluctuations in usage) then the business will accrue £800 (1/3 of £2,400).

Provisions are estimates of possible liabilities that may arise. An example of a possible future liability
is a provision for warranty claims that may be payable on sales of products. The estimate will be
based on the likely costs to be incurred in the future. Other types of provisions cover reductions in
asset values. The main examples are:
 Doubtful debts: customers may experience difficulty in paying their accounts and a provision
may be made based on experience that a proportion of debtors will never pay.
 Inventory: some stock may be obsolete but still held in the store. A provision reduces the
value of the obsolete stock to its sale or scrap value (if any).
 Depreciation: this is a charge against profits, intended to write off the value of each non-
current asset over its useful life.
Provisions for likely future liabilities are shown in the Statement of Financial Position as liabilities,
while provisions that reduce asset values are shown as deductions from the cost of the asset. The
most important provision, because it typically involves a large amount of money, is for depreciation.

Depreciation
Non-current assets are capitalized in the Statement of Financial Position so that the purchase of non-
current assets does not affect profit. However, depreciation is an expense that spreads the cost of
the asset over its useful life. The following example illustrates the matching principle in relation to
depreciation.
Chapter 6 Accounting for Managers – Paul M.Collier

An asset costs £100,000. It is expected to have a life of four years and have a resale value of £20,000
at the end of that time. The depreciation charge is:
(asset cost − resale value)/ expected life x (100,000 − 20,000)/ 4 = 20,000 p.a.

A type of depreciation used for certain assets, such as goodwill or leasehold property improvements,
is called amortization, which has the same meaning and is calculated in the same way as
depreciation. In reporting profits, some companies show the profit before depreciation (or
amortization) is deducted, because it can be a substantial cost, but one that does not result in any
cash flow. A variation of EBIT (see earlier in this chapter) is EBITDA: earnings before interest, taxes,
depreciation and amortization.

Reporting cash flow – Cash Flow Statement


The third financial statement is the cash flow. The Cash Flow statement shows the movement in
cash for the business during a financial period. It includes:
 cash flow from operations;
 interest receipts and payments;
 income taxes paid;
 capital expenditure (i.e. the purchase of new fixed assets);
 dividends paid to shareholders;
 new borrowings or repayment of borrowings.
The cash flow from operations differs from the operating profit because of:
 depreciation, which as a non-cash expense is added back to profit (since operating profit is
the result after depreciation is deducted);
 increases (or decreases) in working capital (e.g. debtors, inventory, prepayments, creditors
and accruals), which reduce (or increase) available cash.