Unit 5 Introduction to Accounting
Name: Shannon Somford
Unit: Unit 5 Introduction to Accounting
First Date: Friday 13-03-2009
List of contents
This activity covers the requirements for the P1 and P2 grading criteria.
- P1. Describe the purpose of accounting.
The main purpose of accounting is to give information that is needed in the process of economic decision-making that will help to create sound and feasible decision. It focuses on the process of preparing different financial reports that will show the information regarding the performance of the company or organization to the external parties or stakeholders that are involved with the company or organization such as investors, creditors, tax authorities etc. On the other hand, the management accounting focuses on the different issues that are related and important to the overall internal process of decision making. Furthermore, the two is also different in terms of the influence of the impact of the standard setting bodies in the decision making process or regarding their creation of laws and regulations. The financial accounting is being affected greatly by the different organizations and authorities in different countries, while the management accounting varies from different perspective of different organizations and companies.
The accounting process of different companies and organization in the world is considered as one of the most important factors, due to the fact that it enables them to see as well as control the financial flow inside and outside of their business or organization. It is also important to the different stakeholders of that organization, in order for them to know the current financial situation of the entire establishments. Because of the different factors such as technology and globalization, the process of accounting is facing different dilemmas and changes. Due to the said factors, internationalization of accounting standards is considered as a significant and essential part of the rapidly globalization economy.
Accurate records are essential. If documents are lost of the business, the business could forget to demand payment for some jobs that already are done or another problem could be the payment of bills. These problems must be avoided at all costs because it could lead to bankruptcy.
Monitoring activity and controlling the business
Sound record keeping allows managers to keep track of orders, sales and bills. So this means that they could have a good idea of how well the company is doing.
Helping the management of the business
Well prepared accounting statements will inform planning decisions and allows the directors and managers to monitor the progress of the company and to keep better control over its activities.
Measure the financial performance of the business
Getting on top of financial measures of your performance is an important part of running a growing business.
It will be much easier to invest and manage for growth if you understand how to drill into your management accounts to find out what's working for your business and to identify possible opportunities for future expansion.
Measuring your profitability
Most growing businesses ultimately target increased profits, so it's important to know how to measure profitability. The key standard measures are:
- Gross profit margin - this measures how much money is made after direct costs of sales have been taken into account, or the contribution as it is also known.
- Operating margin - the operating margin lies between the gross and net measures of profitability. Overheads are taken into account, but interest and tax payments are not. For this reason, it is also known as the EBIT (earnings before interest and taxes) margin.
- Net profit margin - this is a much narrower measure of profits, as it takes all costs into account, not just direct ones. So all overheads, as well as interest and tax payments, are included in the profit calculation.
- Return on capital employed (ROCE) - this calculates net profit as a percentage of the total capital employed in a business. This allows you to see how well the money invested in your business is performing compared to other investments you could make with it, like putting it in the bank.
Other key accounting ratios
There are a number of other commonly used accounting ratios that provide useful measures of business performance. These include:
- liquidity ratios, which tell you about your ability to meet your short-term financial obligations
- efficiency ratios, which tell you how well you are using your business assets
- financial leverage or gearing ratios, which tell you how sustainable your exposure to long-term debt is
Bear in mind that even though you are likely to use an increasing number of financial measures as your business grows, one of the most familiar cashflow remains of fundamental importance.
Cashflow can be a particular concern for growing businesses, as the process of expansion can burn up financial resources more quickly than profits are able to replace them.
Capital income is the money that is used to set up a business. This money can be sourced from any where such as the before stated. Capital income is most commonly used for acquiring fixed assets, however this money is not used for the constant replacement of equipment or furniture.
A sole trader is a business that is owned by one person. It may have one or more employees. It is the most common form of ownership.
The main advantages of setting up as a sole trader are:
- Total control of the business by the owner.
- Cheap and easy to start up – few forms to fill in and to start trading the sole trader does not need to employ any specialist services, other than setting up a bank account and informing the tax offices.
- Keep all the profit – as the owner, all the profit belongs to the sole trader.
- Business affairs are private – competitors cannot see what you are earning, so will know less about how the business works and how it succeeds.
This is a preview of the whole essay
The reasons why sole traders are often successful are:
- Can offer specialist services to customers – appliance repair specialists.
- Can be sensitive to the needs of customers – since they are closer to the customer and will react more quickly, because they are the decision makers too.
- Can cater for the needs of local people – a small business in a local area can build up a following in the community due to trust, if people can see the owner they feel more comfortable than if the owner is in some far off town, not able to hear the views of the local community.
The legal requirements of a sole trader are to:
Keep proper business accounts and records for the Inland Revenue (who collect the tax on profits) and if necessary VAT accounts.
Comply with legal requirements that concern protection of the customer (Sale of Goods Act)
The main disadvantages of being a sole trader are:
- Unlimited liability.
- Can be difficult to raise finance, because they are small, banks will not lend them large sums and they will not be able to use any other form of long-term finance unless they change their ownership status.
- Can be difficult to enjoy economies of scale, lower costs per unit due to higher levels of production. A sole trader, for instance, may not be able to buy in bulk and enjoy the same discounts as larger businesses.
- There is a problem of continuity if the sole trader retires or dies
The reasons for being a sole trader are often a balance between business and personal costs and benefits. Many will prefer the satisfaction of running a business with little paper work against the risks, pressure and probably long working hours.
A sole trader is liable for any debts that the business incurs. This means that any money that the owner has put into the business could be lost, if the business continues to incur further costs then the owner has to pay these as well. In some cases they may have sell some of their own possessions to pay creditors.
Such a risk often puts potential sole traders off setting up businesses, but also makes them consider the other forms of business structure.
If a partner is introduced to a new company that person should need to bring some money to increase the amount of capital available.
A unit of ownership interest in a corporation or financial asset. While owning shares in a business does not mean that the shareholder has direct control over the business's day-to-day operations, being a shareholder does entitle the possessor to an equal distribution in any profits, if any are declared in the form of dividends. The two main types of shares are common shares and preferred shares.
In the past, shareholders received a physical paper stock certificate that indicated that they owned "x" shares in a company. Today, brokerages have electronic records that show ownership details. Owning a paperless share makes conducting trades a simpler and more streamlined process, which is a far cry from the days were stock certificates needed to be taken to a brokerage before a trade could be conducted.
While shares are often used to refer to the stock of a corporation, shares can also represent ownership of other classes of financial assets, such as mutual funds.
Ordinary shares are also known as equity shares and they are the most common form of share. An ordinary share gives the right to its owner to share in the profits of the company (dividends) and to vote at general meetings of the company.
Since the profits of companies can vary wildly from year to year, so can the dividends paid to ordinary shareholders. In bad years, dividends may be nothing whereas in good years they may be substantial. Some businesses may choose to pay out a dividend even if it has had a difficult trading year and has made a loss. Ordinary shareholders can vote on all of the issues raised at a general meeting of the company including:
- Appointment of directors and auditors
- Whether to accept the dividend proposed
- Changes to the company's constitution
The nominal value of a share is the issue value of the share - it is the value written on the share certificate that all shareholders will be given by the company in which they own shares.
The market value of a share is the amount at which a share is being sold on the stock exchange and may be radically different from the nominal value.
When they are issued, shares are usually sold for cash, at par and/or at a premium. Shares sold at par are sold for their nominal value only - so if a 10 pence share is sold at par, the company selling the share will receive 10 pence for every share it issues.
If a share is sold at a premium, then the issue price will be the par value plus an additional premium. So if a 10 pence nominal value share is issued at £1, then the par value is 10 pence and the premium is £0.90 per share. The company issuing the shares will receive £1 for each share issued.
Ordinary shares are the riskiest form of investment in a company since there may be no dividends paid and the market value of shares might fall after they have been bought.
Preference shares are legally shares, but they are very different from ordinary shares. The economic effect of preference shares is more like that of bonds. Like convertibles, they are regarded as hybrids of debt and equity:
- Dividends on preference shares have to be paid before dividends on ordinary shares.
- Dividends on ordinary shares may not be paid unless the fixed dividends on preference shares are paid first.
- Dividends are fixed like bond coupons, although there are usually provisions to not pay or delay payments.
- Preference shareholders have a higher priority if a company is liquidated than ordinary shareholders, although a lower priority than debt holders.
- In the case of cumulative preference shares, if the dividend is not paid in full, the unpaid amount is added to the next dividend due.
- Preference dividends are fixed, so they do not participate in increases or decreases in profits as ordinary shareholders do.
The effect of these is to make the income stream from preference shares more similar to that from debt than that from ordinary shares. Most importantly, fixed dividends are similar to interest payments. However, they are legally shares and are subject to the same tax treatment.
Deferred shares are those that have fewer rights in some way than ordinary shares. The rights are often restricted to such an extent as deliberately to make the shares worthless, this happens in the course of a capital restructuring and such deferred shares are usually eventually cancelled.
The ways in which deferred shares have lesser rights can ordinary shares include:
- no voting rights,
- rank lower for repayment of capital in the event of insolvency,
- dividends may not be paid until a certain date or until some triggering event has taken place,
- dividends may not be paid until after other classes of shares have been paid,
- the shares may not be tradable until a certain date or event. This may happen, for example, when shares issued to employees as part of their remuneration may not be immediately traded in order to give them a long term interest in the company.
Deferred can mean the opposite of preferred, but the variations possible mean that it is not really an exact opposite.
Loans from the banks are one of the most flexible and accessible sources for businesses. The amounts can defer from a few thousand pounds till up to a few hundred thousand pounds. This depends on different factors. Like the project where it’s being used for and the amount of security available to back the loan. Loans are most of the time granted for an extended period for purchase of capital items. A normal business could get a loan for 5 years, but there can be negotiated for the period, this depends on the scale of the project. The personal loans are often unsecured, it means that the borrower does not have to cover the loan if they do not repay it, very little business lending is done in this way. Most of the banks require the entrepreneur to offer some security for any loans they have granted. It could be there house, car or even savings. The borrower needs to sign a legal document which gives the bank the power to seize the asset offered if the loan does not get repaid.
A mortgage is a large loan, normally it is given for the purchase of property. A normal mortgage will last for over 25 years and it is secured on the property that is being purchased. If a person or company owns a property that is mortgage-free, or if the mortgage is significantly less than the value of the property, a mortgage may be raised for purposes other than property purchase, such as starting up a new business.
- P2. Explain the difference between capital and revenue items of income and expenditure.
A capital expenditure is an amount spent to acquire or improve a long-term asset such as equipment or buildings. Usually the cost is recorded in an account classified as Property, Plant and Equipment. The cost except for the cost of land will then be charged to depreciation expense over the useful life of the asset.
A revenue expenditure is an amount that is expensed immediately thereby being matched with revenues of the current accounting period. Routine repairs are revenue expenditures because they are charged directly to an account such as Repairs and Maintenance Expense. Even significant repairs that do not extend the life of the asset or do not improve the asset (the repairs merely return the asset back to its previous condition) are revenue expenditures.
Revenue is an income earned by the company by selling products or providing services.
Sales can be for cash or can be as credit transactions. Cash sales are often best because the company receives the money for the sale immediately. Businesses will often need to offer credit facilities to encourage growth in sales. Credit sales involve the business supplying the goods or service to the customer but allowing the customer time to pay for the item. This will mostly be 28 days.
If a business owns property and rents out to another company or person, the rental income received will be a source of revenue income for that business. If there are unused rooms in a company’s premises or buildings that they do not currently need, it makes sense to earn some income for the business by renting these out.
A business could sell products or services on behalf of another company and may receive a commission for the work they have done. For example you could think of a dealer from Volvo or a mobile phone shop that sells a contract to a customer it receives commission from the network operator, such as Orange or Vodafone. That is an important form of revenue income for many businesses.
Capital expenditure is the amount a company spends on buying fixed assets, other than as part of acquisitions.
As this expenditure is an investment it is not immediately shown. The amount of cash expenditure is shown in the cash flow statement and the effects of Capital expenditure obviously show on the balance sheet. Most companies also comment on Capital expenditure in their results.
It can be difficult to distinguish between maintenance Capital expenditure to keep existing operations going at their current levels and investment made to drive future growth. Investors may be able to infer a certain amount from comments and by looking at a company's circumstances and track record. Capital expenditure that is continuously high which has not lead to high growth is likely to be maintenance Capital expenditure.
Apparent profits or operating cash flows are not actually making shareholders, if high maintenance Capital expenditure requirements soak up the money. This is why investors should look at measures such as free cash flow.
A long-term tangible piece of property that a firm owns and uses in the production of its income and is not expected to be consumed or converted into cash any sooner than at least one year's time.
Fixed assets are sometimes collectively referred to as plant.
Buildings, real estate, equipment and furniture are good examples of fixed assets.
Generally, intangible long-term assets such as trademarks and patents are not categorized as fixed assets but are more specifically referred to as fixed intangible assets.
An asset that is not physical in nature. Corporate intellectual property items such as patents, trademarks, copyrights, business methodologies, goodwill and brand recognition are all common intangible assets in today's marketplace. An intangible asset can be classified as either indefinite or definite depending on the specifics of that asset. A company brand name is considered to be an indefinite asset, as it stays with the company as long as the company continues operations. However, if a company enters a legal agreement to operate under another company's patent, with no plans of extending the agreement, it would have a limited life and would be classified as a definite asset.
While intangible assets don't have the obvious physical value of a factory or equipment, they can prove very valuable for a firm and can be critical to its long-term success or failure. For example, companies such as Coca-Cola wouldn’t be nearly as successful were it not for the high value obtained through its brand-name recognition. Although brand recognition is not a physical asset you can see or touch, its positive effects on bottom-line profits can prove extremely valuable to firms such as Coca-Cola, whose brand strength drives global sales year after year.
If you are buying an existing business you are also buying the reputation of that business. The brand image of the products, the skills of the workforce and the customer base that they build up. All these factors contribute to the success of the business. It isn’t unreasonable to expect payment for these when buying the business. When they are calculating the sale price, the owner will most of the time add an amount on top of the value of the assets. He does that to take account of the factors. That has been known as goodwill and appears as an intangible asset in the accounts firm.
A patent is a legal document that allows an inventor the exclusive rights to produce an invention/ product. A company that owns the patent of an invention will clearly own the valuable asset, this because it could lead to a unique product that will sell. A business could buy a patent and that becomes an intangible asset.
A trademark could be a symbol or a name that represents the company, a logo could be a great example for this. A trademark is a powerful marketing tool, a strong brand name and logo can guarantee sales for a business. Since many people consistently buy products from names that they feel that they can trust. This is another intangible asset.
Revenue expenditure is a reserve of money used by an establishment to acquire or upgrade physical assets. Revenue expenditure is beneficial for the current business year.
Revenue expenditure is the reserve of money used by an establishment to develop or raise physical assets like equipments, industrial buildings or properties. The operations of an establishment include everything from constructing structures to repairing parts of the building.
Any business establishment incurs an appreciable number of expenses to steadily maintain its business operations. There are two broad categories of business expenditure a company can incur. The first category of business expenditure comprises items incurred for running everyday operations of the establishment. Examples of day to day operations include expenditure on rent incurred, factory expenses, salary payment to employees, administrative expenses and sales commissions.
The second category of expenditure comprises assets bought by the company. This results in increased productivity and enhanced efficiency of the establishment. Some of the important examples of this kind of expenditure include purchase of office automation equipments, purchase of office vehicles and purchase of furniture and computer equipments.
Some of the regular bills are associated with the premises from which business operates:
- Rent – if the business does not own the premises a regular payment of rent must be made to the owner.
- Rates – most of the businesses must pay business rates, these are a form of tax paid to the local authority and which contribute to the services provided by that authority.
- Heating and lightning – the gas and electricity bills must be paid to the company supplying the service.
- Insurance – Insurance is a legal requirement. The actual building of the company needs to be insured against perils such as a fire and explosion. The contents must also be insured separately. Public liability insurance may also be payable.
The administrative costs simple but important expenses on items such as a telephone bill, postage, printing and stationary.
Staff costs are mostly the biggest expense that a business will have:
- Salaries – if employees are salaried they receive a set amount of money each week or month. You could see a job advertisement with the salary of €24,000, which means that if the salary is paid monthly, the employee will receive €2000 every month (less tax, National Insurance, pension contributions, etc.)
- Wages – an employee who is waged will often be paid on an hourly basis or payment could be made according to how much the worker produces. A waged employee may earn more in some weeks than others, this depends on how much work they do.
- Training – training is a key part for a company, but it isn’t cheap, especially if it is intended to deliver specialist skills. Simple part-time courses at a local college may cost several hundreds of pounds and more specialist short courses run by consultants can cost £1000 per day to run. That’s why it isn’t surprising that businesses will try to train their own employees whenever it’s possible.
- Insurance – all employees must take out Employer’s Liability Insurance. If an employee sustains an injury while working for you, this insurance protects you from a legal damage claims and court costs claimed against you or your company. Employers should need to consider buying Public Liability Insurance. If a member of staff causes injury to a person or damage to property while at work this will insure the business owners against damage claims.
- Pensions – most businesses are required by law to provide some form of pension to their employees. There are many types of scheme, some of these involve contributions by both the employer and the employee, in this case the pension becomes another expense for the company.
Selling and distribution costs
There is also a range of costs associated with selling the products or services which a business produces. The most common are shown below:
- Salaries – paid to sales staff
- Carriage – the cost of delivering the product
- Marketing – such as advertising and promotion costs
Just a few businesses can operate without a bank account, but there are further expenses associated with this.
Bank charges can become very expensive for business customers. The individuals mostly benefit from free banking, meaning that as long as the account does not go overdrawn all the transactions will be free. But that isn’t always the case for businesses. Many banks charge a transaction for every business, every cheque paid in and every time cash and coins are paid in over the bank counter as well as all standing orders and direct debits the bank pays for the business. There is often a different charge a separate charge for each of these items and since large organisations carry out many transactions each day and may pay in many cheques and/ or lots of cash and coin most days, these charges can run into hundreds of pounds every month. So it is wise to shop around the banks for the best deals to ensure that the expense is kept to the minimum.
Overdraft, loan and mortgage interest
Any form of bank borrowing will also incur interest charges that must be paid, the best advice is to compare the different deals offered by banks as some will cost more than others.
Purchase of stock or raw materials
Business that sell products need stock to sell and this is invariable a large expense. When the business first starts up most of the payments for stock or raw materials will have to be made immediately, these known as cash transactions. Once the firm has established a good reputation with suppliers it may be possible to negotiate some credit. Credit transactions mean the business receives the stock or raw materials but does have to pay immediately for them. Mostly 28 days credit may be offered.
This activity covers the requirements for the P3, M1 and D1 gradin criteria.
- P3. Prepare a 12 month cash flow forecast to enable an organisation to manage its cash.
- M1. Analyse the cash flow problems a business might experience.
If a business would have more outflows than inflows, they will have a serious problem and will end up in a negative balance. It means that they will have insufficient cash to meet the payments that are due. They clearly need to avoid this problem. It should not be to difficult if the business owners know the understanding of the cash flow cycle for their business, can anticipate problems and implement strategies to deal with the problems. The first thing to accept is that a business will not necessarily be in a positive cash position all the time. Because of seasonal fluctuations in business activity, sometimes the cash position will be positive and sometimes it will be negative.
A bank will usually be happy to provide assistance to help the business deal with negative periods of cash flow.
Dear Mister A. Hull,
- D1. Recommend and justify actions a business might take when experiencing cash flow problems.
If you approach a bank for business overdraft facilities you will be asked how much you will need and you will then have to give some evidence that:
- The amount you have asked for will be sufficient
- The amount will show cycles of balances with periods when the account is in credit.
The best evidence for this is a cash flow forecast and this is what the bank will ask to see.
An overdraft is a short-term solution but interest rates on overdrafts are usually much higher than other sources of finance, such as a loan.
A pre-arranged overdraft facility is therefore a good way of overcoming short-term cash flow problems as it allows the firm to draw out more when necessary. Armed with a cash flow forecast, however, it is possible to consider other options for solving the problems, as shown below:
Anticipating cash flow needs gives the managers of a business time to make these changes to their business plans. However, if managers do not plan and examine the finances carefully problems may occur which may then be much harder to solve.
This activity covers the requirements for the P4 grading criteria.
- P4. Explain the component parts of a profit and loss account and balance sheet in a given organisation.
Profit and Loss Account
The purpose of the profit and loss account is to:
Show whether a business has made a profit or loss over a financial year.
Describe how the profit or loss arose. By categorising costs between costs of sales and operating costs.
A profit and loss account starts with the trading account and then takes into account all the other expenses associated with the business.
The trading account shows the income from sales and the direct costs of making those sales. It includes the balance of stocks at the start and end of the year. Trading is a basic process of business. The trading account shows how much profit the organisation makes by the basic process. The profit earned by this kind of process is called gross profit.
An example of the trading account of a business would look this:
Trading account for Kimman B.V. for the year ended 31 March 2008
Category € €
Opening Stock 150.000
Less Closing Stock (220.000)
Cost of Sales 330.000 (330.000)
Other Costs (70.000)
Gross profit 800.000
The closing stock figure would appear in the balance sheet under Stock.