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«Paul M. Collier Aston Business School, Aston University Accounting for Managers Accounting for Managers: Interpreting accounting information for ...»

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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).

The distinction between cost of sales and expenses can vary between industries and organizations. A single store may treat only the product cost as the cost of sales, and salaries and rent as expenses. A large retail chain may include the salaries of staff and the store rental as cost of sales with expenses covering the head office, corporate costs. For any particular business, it is important to determine the demarcation between cost of sales and expenses.

From operating profit, a company must pay interest to its lenders, income tax to the government and a dividend to shareholders (for their share of the profits as they – unlike lenders – do not receive an interest rate for their investment). The remaining profit is retained by the business as part of its capital (see Table 6.2).

Reporting financial position Not all business transactions appear in the Profit and Loss account. The second financial statement is the Balance Sheet. 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. Fixed assets are things that the business owns and uses as part of its infrastructure. There are two types of fixed assets: tangible and intangible. Tangible fixed assets comprise those physical assets that can be seen and touched, such as buildings, machinery, vehicles, computers etc. Intangible fixed 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 (see working capital later in this chapter).

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 creditors in the Balance Sheet – 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 creditors due after more than one year cover loans to finance the business that are repayable after 12 months and certain kinds of provisions (see later in this chapter). 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).

The Balance Sheet will typically appear as in Table 6.3. In the Balance Sheet, the assets must agree with the total of liabilities and capital, because what the business owns is represented by what it owes to outsiders (liabilities) and to the owners

–  –  –

However, the capital of the business does not represent the value of the business – it is the result of the application of a number of accounting principles. In addition to the Financial Reporting Standards and Statements of Standard Accounting Practice referred to earlier, there are some basic accounting principles that are generally accepted by the accounting profession as being important in preparing accounting reports. These were described in Chapter 3. However, an important principle that is particularly relevant to the interpretation of accounting reports is the matching principle.

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:

ž prepayments;ž accruals; andž 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).

The effect of prepayments and accruals on profit, the Balance Sheet and cash flow is shown in Table 6.4.

A further example of the matching principle is in the creation of provisions.

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:

ž 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.

ž 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).

ž Depreciation: this is a charge against profits, intended to write off the value of each fixed asset over its useful life.

Provisions for likely future liabilities are shown in the Balance Sheet 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 Fixed assets are capitalized in the Balance Sheet so that the purchase of fixed 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.

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:

–  –  –

It is important to recognize that the cash outflow of £100,000 occurs when the asset is bought. The depreciation charge of £20,000 per annum is a non-cash expense each year. However, the value of the asset in the Balance Sheet reduces each year

as a result of the depreciation charge, as follows:

–  –  –

If the asset is then sold, any profit or loss on sale is treated as a separate item in the Profit and Loss account. Alternatively, the asset can be depreciated to a nil value in the Balance Sheet even though it is still in use.

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 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:

ž cash flow from operations;

ž interest receipts and payments;

ž income taxes paid;

ž capital expenditure (i.e. the purchase of new fixed assets);

ž dividends paid to shareholders;

ž new borrowings or repayment of borrowings.

The cash flow from operations differs from the operating profit because of:

ž depreciation, which as a non-cash expense is added back to profit (since operating profit is the result after depreciation is deducted);

ž increases (or decreases) in working capital (e.g. debtors, inventory, prepayments, creditors and accruals), which reduce (or increase) available cash.


–  –  –

An example of a cash flow statement is shown in Table 6.5.

The management of working capital is a crucial element of cash management.

Working capital Working capital is the difference between current assets and current liabilities (or creditors). In practical terms, we are primarily concerned with stock and debtors, although prepayments are a further element of current assets. Current liabilities

–  –  –

comprise creditors and accruals. The other element of working capital is bank, representing either surplus cash (a current asset) or short-term borrowing through a bank overdraft facility (a creditor).

The working capital cycle is shown in Figure 6.1. Money tied up in debtors and stock puts pressure on the firm, either to reduce the level of that investment or to seek additional borrowings. Alternatively, cash surpluses can be invested to generate additional income through interest earned.

Managing working capital is essential for success, as the ability to avoid a cash

crisis and pay debts as they fall due depends on:

ž managing debtors through effective credit approval, invoicing and collection activity;

ž managing stock through effective ordering, storage and identification of stock;

ž managing trade creditors by negotiation of trade terms and through taking advantage of settlement discounts; and ž managing cash by effective forecasting, short-term borrowing and/or investment of surplus cash where possible.

Managing debtors The main measure of how effectively debtors are managed is the number of days’

sales outstanding. Days’ sales outstanding is:

–  –  –

Using the previous example, the firm has sales of £2 million and debtors of £300,000. Average daily sales are £5,479 (£2 million/365). There are therefore 54.75 average days’ sales outstanding (£300,000/£5,479).

The target number of days’ sales outstanding will be a function of the industry, the credit terms offered by the firm and its efficiency in both credit approval and collection activity. Management of debtors will aim to reduce days’ sales outstanding over time and minimize bad debts.

Acceptance policies will aim to determine the creditworthiness of new customers before sales are made. This can be achieved by checking trade and bank references, searching company accounts and consulting a credit bureau for any adverse reports. Credit limits can be set for each customer.

Collection policy should ensure that invoices and statements are issued quickly and accurately, that any queries are investigated as soon as they are identified, and that continual follow-up (by telephone and post) of late-paying customers should take place. Discounts may be offered for settlement within credit terms.

Bad debts may occur because a customer’s business fails. For this reason, firms establish a provision (see earlier in this chapter) to cover the likelihood of customers not being able to pay their debts.


Managing stock The main measure of how effectively stock is managed is the stock turnover (or

stock turn). Stock turn is:

cost of sales stock Using our example, cost of sales is £1.5 million and stock is £200,000. The stock turn is therefore 7.5 (£1,500,000/£200,000). This means that stock turns over 7.5 times per year, or on average every 49 days (365/7.5).

Sound management of stock requires an accurate and up-to-date stock control system. Often in stock control the Pareto principle (also called the 80/20 rule) applies.

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