17. Financial and Management Accounting 1 - Basic Financial Accounting

What is Accounting

The information identification, recording, analysis and reporting of economic information.

Four fundamental qualities of accounting:

Relevance
Comparability: between organizations or between years
Understandability: understandable to all stakeholders
Reliability: able to be validated

Stakeholders:

Internal: owners, managers, employees
External: suppliers (can they pay us?), customers (mainly for long-term projects), investment analysts, government

There are two types of accounting:

Financial accounting provides information about business entities in a standardized format for primary users. It is typically done annually and looks back at previous performance
Management accounting provides information related to resource deployment (would this change, investment, project etc. make us money?). It is:
- Special purpose
- Has fewer restrictions
- Is forwards-looking
- Done more frequently
- Often contains non-monetary items with less objective constraints

Financial decisions of an entity:

Capital budgeting decisions: what to buy?
Financing decisions: how to fund the purchases?
Working capital management decisions: how to run the business?

Generally Accepted Accounted Principles (GAPP)

Accounting rules/standards that companies must adhere to when preparing financial statements and reports. Standardized by country.

Fundamental Accounting Principles

Assumption of Arm’s Length Transaction

Two parties involved in an economic transaction arrive at a decision independently and rationally

i.e. no collusion between parties (e.g. transfer of assets between subsidiary companies, between family members).

The Cost Principle

The value of most assets are recorded at their historical cost, even if it has increased in value since its purchase.

Some exceptions (e.g. securities held for trading, asset impairment) allow the recorded cost to be set to its fair market value.

The Revenue Recognition Principle

Revenue is recognized when a transaction is completed (e.g. the product is sold), even if the money is not received until later.

The Going Concern Assumption

Assumption that the company will continue to operate indefinitely unless there is evidence to the contrary.

Three Core Financial Statements

Income Statement

The Statement of Financial Performance.

Covers revenue, expenses and profit (or loss):

Revenue:

The money does not need to be received to be recognized as revenue
Credit sales are recognized as revenue at the point of sale

Expenses:

Costs incurred in the process of earning revenue
The costs do not need to have been paid

\begin{aligned} \text{Gross profit} &= \text{Revenue} - \text{cost of sales} \\ \text{Net profit} &= \text{Gross profit} - \text{expenses} \end{aligned}

Cost of Sales in Manufacturing

Direct costs (DC) are materials and labour that can be charged directly.

Indirect costs (ID)/overhead/burden are the costs involved in operating the organization but not directly involved in manufacturing the product:

Manufacturing overhead: materials, labour costs and other costs that cannot be charged directly (e.g. supervisors, janitors)
Administrative overhead: head office costs, rent, distribution costs, selling/marketing costs

\text{Cost of goods sold} = \text{direct costs} + \text{manufacturing overhead}

i.e. cost directly invested into good being sold.

EBIT and EBITDA

Measures of a company’s ability to earn profit through its operations - separates out profitability.

Non-operating revenues and expenses are excluded from these measures.

EBITDA: Earnings Before Interest, Taxes, Depreciation and Amortization.

EBIT: Earnings Before Interest and Taxes. Hence, this includes depreciation and amortization - basic costs required for operation.

Interest: on loans.

Depreciation: money set aside every year for a tangible asset (machine, computer) used in the task that generates the revenue under the assumption that after the end of the equipment life (some known time period), it will have to be replaced.

Amortization: depreciation, but for intangible assets. Patents, copyright, loans etc… Also includes goodwill - agreement to buy a product you pay for later (no interest but delayed payment, so you must carry that duty to pay into the future).

By removing these things, it separates profitability and efficiency of operations from the effects of how you are funded (interest rates vary, taxes vary a lot by region etc.) and how you account for your assets (depreciation and amortization varies by company depending on the amount of assets).

Cash Flow Statement

This is an overall statement of cash that flows through the organization.

The Statement of Financial Performance shows revenue earned and expenses incurred.

The Statement of Cash Flow shows revenue received and expenses paid.

Inputs:

Equity capital (from owners)
Debt capital (from lenders)
Revenue (from customers)
Interest earned (from financial interests through investments)

Outputs:

Dividends/drawings (to owners)
Repayments/interest (to lenders)
Purchases of assets (from suppliers)
Taxes/charges (to the government)

Covers all activities undertaken that cause a flow of cash through the organization. Includes operating activities, investments, financial activities.

NB: net income accounts for taxes and interest.

Balance Sheet

Also known as the Statement of Financial Position.

One of the longer itemized sheets.

Attempts to identify:

Total assets
Total liabilities
Total shareholders’ equities

Assets:

Anything of value owned by the business or owed to it
Current assets: cash, or anything that can be easily converted to cash within a year
- Includes inventory, accounts receivable (money owed to us), short-term investments
Non-current (Long-term) assets:
- Fixed (capital) assets - tangible (e.g. buildings, plants, equipment)
- Investments - tangible (e.g. government stock, shares, long-term deposits)
- Intangible assets (e.g. goodwill, patents, brands, franchises)

Inventory is comprised of raw materials, work-in-progress and finished goods.

Valuing Capital Assets

Market value: value at which you would buy it today
Book value: depreciated value as it is used
Salvage value: value when sold at the end of its useful life
Scrap value: value when broken down for parts and sold

Methods of Depreciation

Given market value $P$ , scrap value $S$ and life time $n$ :

Straight line: line from $(P, 0)$ to $(S, n)$ : $\text{value} = P - \frac{n}{P - S} \cdot \text{year}$
Diminishing value: value depreciates by a fixed percentage each year

The money withheld by depreciation is called Reserve accumulation.

Liabilities

Amounts owed by the business to both outside parties and those within the business.

Current/short-term liabilities:

Monies owing and due for repayment within an accounting period
Includes accounts payable, accrued taxes

Non-current/long-term liabilities:

Includes long-term borrowing, mortgages, long-term service leave for employees

Shareholder’s Equity

Financial interest of the owner in the entity (owner’s claim to the business). This includes:

Contributed capital (cash and other resources contributed by the owners)
Retained earnings
- Profit minus distributions (distributions is dividends and drawings)

Equity is the value if all assets were liquidated and all debts paid off:

\text{equity} = \text{total assets} - \text{total liabilities}

Ratio Analysis

Relationships between values found in Statements of Financial Performance and Position.

It can be used compare the performance of an organization between years, other organizations, accepted benchmarks or published industry norms.

Leverage

AKA Gearing, Solvency.

Leverage ratios shows how heavily the company is in debt and its ability to meet long-term liability obligations.

\begin{aligned} \text{long-term debt ratio} &= \frac{\text{long-term debt}}{\text{long-term debt} + \text{equity}} \\ \\ \text{debt-equity ratio} &= \frac{\sout{\text{long-term debt}}\text{ total liabilities}}{\text{equity}} \\ \\ \text{total debt ratio} &= \frac{\text{total liabilities}}{\text{total assets}} \\ \\ \text{times interest earned} &= \frac{\text{EBIT}}{\text{interest payments}} \end{aligned}

Debt-equity ratio: long-term debt in lecture notes, total liabilities elsewhere
Total debt ratio: what portion of assets are financed from non-shareholder sources
- If it can be assumed that all assets are financed by equity or debt, total assets is just total debts + equity
Times interest earned: how many times it can pay its interest payments using its earnings (EBIT)

Liquidity

Liquidity ratios measure how easily the firm can get cash (in unforeseen circumstances) and meet its short-term liability obligations.

\begin{aligned} \text{quick ratio (acid test)} &= \frac{\text{cash} + \text{marketable securities} + \text{receivables}}{\text{current liabilities}} \\ &= \frac{\text{current assets} - \text{inventory} }{\text{current liabilities}} \end{aligned}

It is not always possible to quickly convert inventory to cash, especially in unforeseen circumstances, so the quick ratio is an indication of if it can meet its immediate debts (within a quarter).

Typically, a ratio close to $1$ is healthy; a ratio a lot larger means they are carrying too much cash while a small ratio means they may not be able to meet its obligations.

There are also two other liquidity ratios of note:

\begin{aligned} \text{current ratio (working capital ratio)} &= \frac{\text{current assets}}{\text{current liabilities}} \\ \\ \text{cash ratio} &= \frac{\text{cash} + \text{marketable securities}}{\text{current liabilities}} \end{aligned}

Compared to the current ratio, the quick ratio excludes inventory and the cash ratio excludes receivables.

Efficiency

Efficiency/turnover ratios measure how productively the firm is using its assets.

\begin{aligned} \text{asset turnover} &= \frac{\text{sales}}{\text{total assets}} \\ \\ \text{inventory turnover} &= \frac{\text{cost of goods sold}}{\text{inventory}} \end{aligned}

Asset turnover: how much of the asset are you using to generate sales?

Revenue is sometimes not broken down. In this case, use the revenue number as sales
The total assets may be the average total assets over the past few years

Inventory turnover:

How many times your inventory you sell over a given period
Uses the cost of goods sold - the direct cost
- This may be called ‘Cost of Revenue’
Organizations using Kanban/just-in-time will have minimal inventory and hence a very high ratio

Profitability

AKA earning power.

Profitability ratios measure the organization’s return on investments.

\begin{aligned} \text{gross profit margin} &= \frac{\text{net sales} - \text{cost of sales}}{\text{net sales}} \\ \\ \text{net profit margin} &= \frac{\text{net profit after tax (NPAT)}}{\text{net sales}} \\ \\ \text{return on assets (ROA)} &= \frac{\text{EBIT}}{\text{total assets}} \\ \\ \text{return on equity (ROE)} &= \frac{\text{net profit after tax}}{\text{total equity}} \\ &= \frac{\text{net profit after tax}}{\text{assets - debts}} \end{aligned}

These ratios may require the income statement.

Gross profit margin:

Does not include any expenses (e.g. taxes, depreciation, interest paid)
Differs by product and industry; restaurants may have a ratio of 300%, infrastructure organizations in the 15-20% range

Net profit margin:

‘Net profit after tax’ may be called ‘Net income after tax’

Return on assets:

Uses current and long-term assets

Return on equity:

Equity: money invested into organization by the owner
May include money the owners have re-invested into the organization