Accounting Workbook

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    Accounting

    Workbook

    Developed by Matt Davies

    Aston Business School

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    Contents

    Part 1: Study Material1.1 What is accounting !

    1." #nderstanding accounting in$or%ation and

    &argon ' ( 1)

    Part ": *+ercises

    ".1 ,esco key $inancial ratios 1- ( 1"." Cash v pro$it "/ ( "0

    ".0 Manage%ent accounting "! ( "

    Part 0: Solutions to *+ercises0.1 Cash v pro$it " ( 01

    0." Manage%ent accounting 0" ( 0'

    Part !: 2e$erence %aterial!.1 ,esco $inancial state%ents 0 ( !1

    Part ': 3lossary o$ ter%s3lossary o$ ter%s !0 ( '-

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    Part 1:

    Study Material

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    1. What is accounting

    Accounting can be defined as the process of measuring, analysing and reporting financial

    information about a business to enable to the user of that information to make better judgements and

    decisions.

    There are two main branches to accounting: financial accounting and management accounting.

    Financial accounting is the process of generating and reporting financial information to eternal

    users such as shareholders, the bank, suppliers, customers, and so on. !anagement accounting on

    the other hand is the process of generating and reporting financial information to management to

    assist them in running the business.

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    ". #nderstanding Accounting 4n$or%ation and 5argon

    The "alance #heet, $ncome #tatement %or &rofit and 'oss Account( and )ash Flow #tatement are

    traditionally regarded as the three key financial statements for a business.

    As the diagram below illustrates, the "alance #heet represents the financial position of a business at

    a single point in time, which for the companys annual published accounts is as at the companys

    financial year*end.

    The $ncome #tatement and )ash Flow #tatement, on the other hand, report the financial

    performance of a business during a period of time, for eample for the year*ended +st-ecember, or

    for a specific month or for the year*to*date for a companys internal management accounts. The

    $ncome #tatement reports the business performance in terms of generating sales reenue in ecess

    of epenses for a period, whereas the )ash Flow #tatement reports the business performance in

    generating cash flows for a period.

    /e will now eplore the content and format of these three statements in more detail.

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    ".1. ,he Balance Sheet

    First the "alance #heet which, as we hae already established, reports the financial position of a

    business at a snapshot in time.

    $t contains information on three key items:

    Assets: which in simple terms are items of alue to the business

    which the business either owns or controls %for eample

    ia a long*term lease contract(.

    'iabilities: which are the amounts the business owes.

    01uity: which include the amounts paid into the business by the

    shareholders for the purchase of ordinary shares plus the amounts that

    the business has retained on the shareholders behalf %for eample, allprofits earned by the business during its eistence that hae not been

    paid out to shareholders as diidends, which are known as retained

    earnings(.

    To understand a "alance #heet re1uires an understanding of the relationship between these three

    items:

    Assets 6 7iabilities 8 *9uity

    $n other words, the financial alue of the assets in the "alance #heet must e1ual the sum of thealue of the business liabilities plus the e1uity.

    &ut simply, the assets represent what has been done with the money and the liabilities plus e1uity

    represent where the money came from.

    To illustrate, imagine you wanted to buy a factory %an asset( to start up a business that would cost

    2m. The purchase of this asset would need to be financed either through borrowing money from a

    bank or through your own money. 'ets assume the business borrowed 2344,444 and you inested

    2544,444 of your own cash. The business "alance #heet would then be as follows:

    Assets 6 'iabilities 7 01uity

    2m 6 2344,444 7 2544,444

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    Another way of arranging the "alance #heet relationship is to say:

    Assets ( 7iabilities 6 *9uity

    This is not fundamentally different of course, but the "alance #heet this time balances to 8et

    Assets %sometimes called 8et /orth(.

    9eturning to our preious eample, the business 8et Assets can be found as follows:

    8et Assets 6 Assets 'iabilities 6 2m * 24.3m 6 24.5m

    /e will now look at the three categories of information contained in a "alance #heet in more detail.

    ".1.1. Assets

    Assets are subdiided into two types: 8on )urrent %Fied( Assets and )urrent Assets.

    ".1.1.1. on Current ;ome*grown goodwill, howeer, cannot be included on the

    "alance #heet. This leads to an important conclusion: the "alance #heet does not measure the true

    alue of a business?

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    All 8on )urrent Assets %ecept for land, inestments and goodwill( must be either depreciated %if

    Tangible( or amortised %if $ntangible( oer their useful economic lies. For eample, we buy a

    machine for 244,444 with a 4*year economic life. Assuming the straight*line depreciation

    method is used, whereby an e1ual charge for depreciation is made each year, then the depreciation

    charge will be 24,444 per annum. $n the "alance #heet, 8on )urrent Assets are recorded after

    deducting the accumulated deprecation charged to date %which gies what is called the net book

    alue of the 8on )urrent Asset(.

    @sing the machine introduced aboe to illustrate, after years the machine will be recorded in the

    "alance #heet at:

    244,444 24,444 6 2B4,444

    ".1.1.". Current Assets

    )urrent Assets are those assets that are used*up or turned oer regularly and fre1uently in the

    course of business. $n other words, while 8on )urrent Assets represent the long*term assets, these

    are the short*term assets of a business. )urrent Assets include inentories %raw materials, work in

    progress and finished goods(, receiables %the amounts owed by customers for goods receied but

    not paid for at the year*end( and cash. %$nentories are sometimes called #tock and 9eceiables

    are sometimes called -ebtors(.

    ".1.". 7iabilities

    'iabilities are subdiided into two types: )urrent 'iabilities and 8on )urrent 'iabilities.

    ".1.".1. Current 7iabilities

    )urrent 'iabilities are those obligations of the business that are due for payment within 5 months

    of the "alance #heet date.

    )urrent 'iabilities include: Accounts &ayable %the amounts owed to suppliers for goods and

    serices receied before the year*end, for which inoices hae been receied but not paid(, @npaid

    /ages and #alaries %if employees hae not been paid by the year*end for all of the work

    performed(, Accruals %amounts owed to suppliers for which inoices hae not been receied at the

    time the time the financial statements are prepared( and @npaid Taes. %Accounts &ayable is

    sometimes called Trade )reditors(.

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    ".1.".". on Current 7iabilities

    8on )urrent 'iabilities are those obligations of the business that are due for payment in more than

    5 months after the "alance #heet date.

    0amples of long*term liabilities include loans and other forms of long*term borrowing %including

    amounts owed under long*term lease arrangements(.

    ".1.0. *9uity ;Capital and 2eserves=

    This section of the "alance #heet records the shareholders inestment in the company. The main

    items to be found in the 01uity section of a "alance #heet are as follows:

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    ".1.'. 4nterpreting a Balance Sheet

    The interpretation of a "alance #heet focuses on three key aspects of a business financial position:

    ".1.'.1. ,he %i+ o$ on Current Assets and >Working Capital? invest%ent

    First, we are interested in whether a business has inested in the right mi of long*term and short*

    term assets. This is reealed by a comparison of the leel of 8on )urrent Assets compared with

    the 8et )urrent Assets of the business %which is also known as /orking )apital(. 8et )urrent

    Assets is the difference between )urrent Assets and )urrent 'iabilities.

    The total leel of 8on )urrent Assets plus /orking )apital is referred to as the business )apital

    0mployed.

    ".1.'.". 7i9uidity

    #econd, we are also interested in the business ability to meet its short*term obligations when they

    fall due for payment. This is reealed by the comparison of )urrent Assets to )urrent 'iabilities.

    As a general rule, we are generally relaed about a business li1uidity if it has more )urrent Assets

    than )urrent 'iabilities.

    ".1.'.0. Stability

    Finally, we are also interested in the business long*term stability or solency. This is reealed by

    the comparison of the amount of -ebt %borrowings and other fied*income sources of finance(

    ersus the 01uity that is used to finance the business. The greater the reliance on -ebt finance, thegreater the risk that the business will be unable to meet its obligations to pay interest and repay the