Accounting: An Introduction, 4th Edition [4th Revised edition] 0273711369, 978-0-273-71136-0, 9781408212158, 1408212153

Citation preview

Accounting An Introduction

Fourth Edition Fourth Edition

Accounting An Introduction

Eddie McLaney Peter Atrill Fourth Edition

Audience

Features

Suitable for all those studying an introductory course in accounting, who are seeking an understanding of basic principles and underlying concepts without detailed technical knowledge.

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Progress checks: numerous activities and exercises enable you to constantly test your understanding and reinforce learning.

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Lively and relevant examples from the real world demonstrate the practical application and value of concepts and techniques learnt.

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Interactive ‘open learning’ style is ideal for self study.

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Decision making focus on the use of accounting information rather than its preparation is highly appropriate for tomorrow’s business managers.

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Fully incorporates International Financial Reporting Standards, which are crucial in the European and world business arena.

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Key terms, glossary and bulleted summaries are excellent revision aids.

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Clearer distinctions between process costing and job order costing.

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More extensive coverage of corporate governance and ethics issues.

Authors Eddie McLaney is Visiting Fellow in Accounting and Finance at the University of Plymouth. Peter Atrill is a freelance academic and author working with leading institutions in the UK, Europe and SE Asia. He was previously Head of Business and Management at the University of Plymouth Business School. Visit the companion website at www.pearsoned.co.uk/mclaney

Eddie McLaney Peter Atrill

The text is supported by MyAccountingLab, a completely new type of educational resource. MyAccountingLab complements student learning by presenting the user with a study plan that adapts and customises to the student’s individual requirements as they progress through online tests. Students can also practice problems before taking tests, and because most of these are algorithmically driven, they can practice over and over again without repetition. Additionally, students have access to an eBook, animated guides to various key topics, and guided solutions, all of which are designed to help them overcome the most difficult concepts. Both students and lecturers have access to gradebooks that allow them to track progress, and lecturers will have the ability to create new tests and activities using the large number of problems available in the question database.

Accounting An Introduction

Accounting: An Introduction 4th edition is renowned for its clear, accessible and uncluttered style. It provides a comprehensive introduction to the main principles of financial accounting, management accounting, and the core elements of financial management. With a clear and unequivocal focus on how accounting information can be used to improve the quality of decision making by managers, combined with a strong practical emphasis, this book provides the ideal grounding for a career in management.

Eddie McLaney Peter Atrill

Accounting An Introduction Visit the Accounting: An Introduction, fourth edition Companion Website at www.pearsoned.co.uk/mclaney to find valuable student learning material including: ● ● ● ● ●

Multiple choice questions to help test your learning Additional exercises and review questions Solutions to end of chapter review questions Links to relevant sites on the web An online glossary to explain key terms

We work with leading authors to develop the strongest educational materials in Accounting, bringing cutting-edge thinking and best learning practice to a global market. Under a range of well-known imprints, including Financial Times Prentice Hall, we craft high quality print and electronic publications which help readers to understand and apply their content, whether studying or at work. To find out more about the complete range of our publishing, please visit us on the World Wide Web at: www.pearsoned.co.uk

4th edition

Accounting An Introduction Eddie McLaney and

Peter Atrill

Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE England and Associated Companies throughout the world Visit us on the World Wide Web at: www.pearsoned.co.uk

First published 1999 by Prentice Hall Europe Second edition published 2002 Third edition published 2005 Fourth edition published 2008 © Prentice Hall Europe 1999 © Pearson Education Limited 2002, 2005, 2008 The rights of Eddie McLaney and Peter Atrill to be identified as authors of this work have been asserted by them in accordance with the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the publisher or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6–10 Kirby Street, London EC1N 8TS. All trademarks used herein are the property of their respective owners. The use of any trademark in this text does not vest in the author or publisher any trademark ownership rights in such trademarks, nor does the use of such trademarks imply any affiliation with or endorsement of this book by such owners. ISBN 978-0-273-71136-0 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library 10 9 8 7 6 5 4 3 2 1 11 10 09 08 07 Typeset in 9.5/12.5pt Stone Serif by 35 Printed and bound by Mateu Cromo Artes Graficas, Spain The publisher’s policy is to use paper manufactured from sustainable forests.

Brief contents

Preface • How to use this book • Guided tours • Acknowledgements

1

Introduction to accounting and finance

Part 1 Financial accounting 2 3 4 5 6 7

Measuring and reporting financial position Measuring and reporting financial performance Accounting for limited companies (1) Accounting for limited companies (2) Measuring and reporting cash flows Analysing and interpreting financial statements

xxi–xxviii 1 35 37 71 115 159 192 221

Part 2 Management accounting

277

8 9 10 11 12 13

279

Relevant costs for decision making Cost–volume–profit analysis Full costing Costing and pricing in a competitive environment Budgeting Accounting for control

297 332 372 430 470

Part 3 Financial management

507

14 Making capital investment decisions 15 Financing the business 16 Managing working capital

509

Part 4 Supplementary information

657

Appendix A Appendix B Appendix C Appendix D Appendix E Appendix F

659

Index

Recording financial transactions Glossary of key terms Solutions to self-assessment questions Solutions to review questions Solutions to selected exercises Present value table

566 614

677 693 709 723 787 789

Detailed contents

Preface How to use this book Guided tour of the book Guided tour MyAccountingLab Acknowledgements

1

Introduction to accounting and finance Introduction Learning outcomes What are accounting and finance? Who are the users of accounting information? The conflicting interests of users How useful is accounting information? Evidence on the usefulness of accounting Providing a service But . . . is it material? Weighing up the costs and benefits Accounting as an information system Management and financial accounting Scope of this book Has accounting become too interesting? The changing face of accounting Why do I need to know anything about accounting and finance? Accounting for business What is the purpose of a business? What kinds of business ownership exist? Sole proprietorship Partnership Limited company How are businesses organised? How are businesses managed? What is the financial objective of a business? Balancing risk and return Not-for-profit organisations Summary Key terms References Further reading Review questions

xxi xxii xxiv xxvi xxviii 1 1 1 2 3 5 5 6 7 8 9 11 13 15 15 16 17 18 18 19 19 20 20 22 24 25 28 28 30 32 32 32 33

viii

CONTENTS

Part 1 Financial accounting 2 Measuring and reporting financial position

37

Introduction Learning outcomes

37 37

The major financial statements – an overview The balance sheet Assets Claims

38 42 42 44

The effect of trading operations on the balance sheet The classification of assets Current assets Non-current assets

47 49 50 50

The classification of claims Balance sheet layouts The balance sheet and time Accounting conventions and the balance sheet Business entity convention Historic cost convention Prudence convention Going concern convention Dual aspect convention

52 52 55 55 55 56 56 57 57

Money measurement Goodwill and brands Human resources Monetary stability

58 59 60 60

Valuing assets on the balance sheet Tangible non-current assets (property, plant and equipment) Intangible non-current assets The impairment of non-current assets Inventories (stock)

61 61 63 63 64

Interpreting the balance sheet

65

Summary Key terms Further reading Review questions Exercises

66 67 67 68 68

3 Measuring and reporting financial performance

71

Introduction Learning outcomes

71 71

The income statement The income statement and the balance sheet Income statement layout Some further issues Cost of sales

72 73 74 75 76

CONTENTS

Classification of expenses The accounting period

77 78

Recognising revenue Long-term contracts Services

79 80 81

Recognising expenses When the expense for the period is more than the cash paid during the period When the amount paid during the year is more than the full expense for the period Profit, cash and accruals accounting

82

Depreciation Tangible non-current assets (property, plant and equipment) Depreciating intangible assets Depreciation and the replacement of non-current assets Depreciation and judgement

87 87 93 94 95

83 85 86

Costing inventories First in, first out (FIFO) Last in, first out (LIFO) Weighted average cost (AVCO) Inventories – some further issues

97 97 98 98 100

Dealing with trade receivables’ problems Interpreting the income statement

101 107

Summary Key terms Further reading Review questions Exercises

107 109 109 110 110

4 Accounting for limited companies (1)

115

Introduction Learning outcomes

115 115

The main features of limited companies Legal nature Perpetual life Limited liability Legal safeguards Public and private companies Taxation Transferring share ownership: the role of the Stock Exchange

116 116 116 117 119 119 121 122

Managing a company Strengthening the framework of rules The Combined Code

123 124 124

Financing limited companies The owners’ claim The basic division

128 128 129

ix

x

CONTENTS

Share capital Reserves

130 131

Altering the nominal value of shares Bonus shares Share capital jargon

133 134 136

Raising share capital Borrowings Withdrawing equity The main financial statements The income statement The balance sheet

136 137 139 142 144 144

Dividends Accounting for groups of companies

145 145

Summary Key terms Reference Further reading Review questions Exercises

150 152 152 152 153 153

5 Accounting for limited companies (2)

159

Introduction Learning outcomes

159 159

The directors’ duty to account The need for accounting rules Sources of accounting rules Presenting the financial statements Income statement Balance sheet Statement of changes in equity Cash flow statement Explanatory notes General points

160 161 161 164 165 166 166 168 168 168

The framework of principles The IASB framework

169 169

The auditors’ role Directors’ report Segmental financial reports Segmental reporting rules Segmental disclosure Problems of segmental reporting

170 171 171 172 173 174

Narrative reporting The OFR framework The business review and RS 1

175 176 179

Summary financial statements Creative accounting Creative accounting methods

180 180 180

CONTENTS

Checking for creative accounting Creative accounting and economic growth Summary Key terms Further reading Review questions Exercises

6 Measuring and reporting cash flows

184 185 185 187 187 188 188 192

Introduction Learning outcomes

192 192

The cash flow statement (or statement of cash flows) Why is cash so important? The main features of the cash flow statement A definition of cash and cash equivalents The relationship between the primary financial statements The form of the cash flow statement The normal direction of cash flows

193 194 195 195 196 197 199

Preparing the cash flow statement Deducing net cash flows from operating activities Deducing the other areas of the cash flow statement

201 201 204

What does the cash flow statement tell us?

208

Summary Key terms Further reading Review questions Exercises

211 212 212 213 213

7 Analysing and interpreting financial statements

221

Introduction Learning outcomes

221 221

Financial ratios Financial ratio classifications The need for comparison Past periods Similar businesses Planned performance

222 223 223 224 224 224

Calculating the ratios A brief overview Profitablility Return on ordinary shareholders’ funds (ROSF) Return on capital employed (ROCE) Operating profit margin Gross profit margin

225 227 228 228 229 230 231

Efficiency Average inventories turnover period Average settlement period for trade receivables

233 233 234

xi

xii

CONTENTS

Average settlement period for trade payables Sales revenue to capital employed Sales revenue per employee

235 236 237

Relationship between profitablility and efficiency Liquidity Current ratio Acid test ratio Cash generated from operations to maturing obligations

238 240 240 241 241

Financial gearing Gearing ratio Interest cover ratio

242 244 245

Investment ratios Dividend payout ratio Dividend yield ratio Earnings per share Cash generated from operations per share Price/earnings (P/E) ratio

248 248 249 250 250 251

Financial ratios and the problem of overtrading Trend analysis Using ratios to predict financial failure Using single ratios Using combinations of ratios Z score models

256 258 260 260 262 263

Limitations of ratio analysis

264

Summary Key terms References Further reading Review questions Exercises

266 268 268 268 269 269

Part 2 Management accounting 8 Relevant costs for decision making

279

Introduction Learning outcomes

279 279

What is meant by ‘cost’? Relevant costs: opportunity and outlay costs Sunk costs and committed costs Qualitative factors of decisions

280 282 286 287

Summary Key terms Further reading Review questions Exercises

289 290 290 291 291

CONTENTS

9 Cost–volume–profit analysis

297

Introduction Learning outcomes

297 297

The behaviour of costs Fixed costs Variable costs Semi-fixed (semi-variable) costs Estimating semi-fixed (semi-variable) costs

298 298 300 301 302

Finding the break-even point Contribution Margin of safety Operating gearing Operating gearing and its effect on profit

303 307 308 311 311

Profit–volume charts The economist’s view of the break-even chart Failing to break even Weaknesses of break-even analysis Using contribution to make decisions: marginal analysis Accepting/rejecting special contracts The most efficient use of scarce resources Make-or-buy decisions Closing or continuation decisions Summary Key terms Further reading Review questions Exercises

313 313 315 315 317 318 319 322 323 325 326 326 327 327

10 Full costing

332

Introduction Learning outcomes Why do managers want to know the full cost? What is full costing? Single-product businesses Multi-product businesses Direct and indirect costs Job costing Full (absorption) costing and the behaviour of costs The problem of indirect costs

332 332 333 334 334 335 336 337 338 340

Overheads as service renderers Job costing: a worked example Selecting a basis for charging overheads Segmenting the overheads Dealing with overheads on a departmental basis Batch costing Full (absorption) cost as the break-even price The forward-looking nature of full (absorption) costing

340 340 344 347 348 358 359 359

xiii

xiv

CONTENTS

Using full (absorption) cost information Criticisms of full (absorption) costing Full (absorption) costing versus variable costing Which method is better?

360 362 362 363

Summary Key terms References Further reading Review questions Exercises

364 366 366 366 367 367

11 Costing and pricing in a competitive environment

372

Introduction Learning outcomes

372 372

Costing and the changed business environment Costing and pricing in the traditional way Costing and pricing in the new environment

373 373 374

Activity-based costing An alternative approach to full costing What drives the costs? Cost pools ABC and service industries Criticisms of ABC

374 375 376 376 377 381

Other approaches to cost management Total (or whole) life-cycle costing Target costing Costing quality control Kaizen costing Value chain analysis Benchmarking

385 385 388 389 390 390 392

Non-financial measures of performance The Balanced Scorecard

393 394

Measuring shareholder value The quest for shareholder value How can shareholder value be created? The need for new measures Economic value added (EVA®)

401 401 401 402 403

Pricing Economic theory Some practical considerations Full cost (cost-plus) pricing Pricing on the basis of relevant/marginal cost Target pricing Pricing strategies

409 409 416 417 420 422 422

Summary Key terms References

423 425 425

CONTENTS

Further reading Review questions Exercises

12 Budgeting

425 426 426 430

Introduction Learning outcomes

430 430

How budgets link with strategic plans and objectives Collecting information on performance and exercising control

431 432

Time horizon of plans and budgets Limiting factors Budgets and forecasts Periodic and continual budgets How budgets link to one another How budgets help managers The budget-setting process Using budgets in practice Incremental and zero-base budgeting Preparing the cash budget Preparing other budgets Activity-based budgeting Non-financial measures in budgeting Budgets and management behaviour Who needs budgets? Beyond conventional budgeting Long live budgets!

432 434 434 434 435 437 440 443 446 447 451 454 455 455 456 457 460

Summary Key terms References Further reading Review questions Exercises

461 462 462 462 463 463

13 Accounting for control

470

Introduction Learning outcomes

470 470

Budgeting for control Types of control Variances from budget Flexing the budget Sales volume variance Sales price variance Materials variance Labour variances Fixed overhead variance

471 472 473 474 474 477 478 479 480

Reasons for adverse variances Non-operating-profit variances Investigating variances

484 486 486

xv

xvi

CONTENTS

Compensating variances Making budgetary control effective Behavioural issues The impact of management style Reservations about the Hopwood study Failing to meet the budget

489 490 490 491 492 492

Standard quantities and cost Setting standards What kinds of standards should be used? Information gathering The learning-curve effect

494 494 494 495 496

Other uses for standard costing Some problems . . . The new business environment

497 497 498

Summary Key terms References Further reading Review questions Exercises

499 501 501 501 502 502

Part 3 Financial management 14 Making capital investment decisions

509

Introduction Learning outcomes

509 509

The nature of investment decisions Investment appraisal methods Accounting rate of return (ARR) ARR and ROCE Problems with ARR

510 511 513 515 515

Payback period (PP) Problems with PP

518 520

Net present value (NPV) Interest lost Risk Inflation What will a logical investor do? Using discount tables Why NPV is better NPV’s wider application

522 523 523 524 524 527 529 530

Internal rate of return (IRR) Problems with IRR

530 533

Some practical points

534

CONTENTS

Investment appraisal in practice Dealing with risk Assessing the level of risk Reacting to the level of risk

537 541 541 551

Managing investment projects Stage 1: Determine investment funds available Stage 2: Identify profitable project opportunities Stage 3: Evaluate the proposed project Stage 4: Approve the project Stage 5: Monitor and control the project

552 553 554 554 555 555

Summary Key terms References Further reading Review questions Exercises

557 559 559 559 560 560

15 Financing the business

566

Introduction Learning outcomes

566 566

Sources of finance Sources of internal finance Long-term sources of internal finance Retained profits

567 567 568 568

Short-term sources of internal finance Tighter credit control Reducing inventories levels Delaying payment to trade payables

569 569 570 570

Sources of external finance Long-term sources of external finance Ordinary shares Preference shares Loans (borrowings) Finance leases and sale-and-leaseback arrangements Hire purchase

570 570 571 572 573 580 582

Gearing and the long-term financing decision Share issues Rights issue Offer for sale and public issue Private placing Bonus issue

583 586 586 589 590 590

The role of the Stock Exchange Advantages of a listing Disadvantages of a listing

590 592 594

Alternative Investment Market Short-term sources of external finance Bank overdraft

596 597 597

xvii

xviii

CONTENTS

Debt factoring Invoice discounting

597 598

Long-term versus short-term borrowing Providing long-term finance for the small business Venture capital Business angels Government assistance

600 601 601 603 603

Summary Key terms Further reading Review questions Exercises

605 607 607 608 608

16 Managing working capital

614

Introduction Learning outcomes

614 614

The nature and purpose of working capital Managing working capital

615 616

The scale of working capital Managing inventories Budgeting future demand Financial ratios Recording and reordering systems Levels of control Inventories management models

616 618 620 620 620 622 622

Managing receivables Which customers should receive credit and how much should they be offered? Length of credit period Cash discounts Debt factoring and invoice discounting Collection policies and reducing the risk of non-payment

627 627 629 631 632 632

Managing cash Why hold cash? How much cash should be held? Controlling the cash balance Cash budgets and managing cash Operating cash cycle Cash transmission Bank overdrafts

635 635 636 636 638 638 641 642

Managing trade payables Controlling trade payables

642 643

Working capital problems of the small business Managing inventories Credit management Managing cash Managing credit suppliers

644 644 644 645 645

CONTENTS

Summary Key terms Reference Further reading Review questions Exercises

646 648 648 648 649 649

Part 4 Supplementary information Appendix A Recording financial transactions Introduction Learning outcomes The basics of double-entry bookkeeping Recording trading transactions Balancing acccounts and the trial balance Preparing the financial statements (final accounts) The ledger and its division

660 662 665 669 672

Summary Key terms Further reading Exercises

673 673 674 675

Appendix B Appendix C Appendix D Appendix E Appendix F Index

659 659 659

Glossary of key terms Solutions to self-assessment questions Solutions to review questions Solutions to selected exercises Present value table

677 693 709 723 787 789

xix

Supporting resources Visit www.pearsoned.co.uk/mclaney to find valuable online resources Companion Website for students ● Multiple choice questions to help test your learning ● Additional exercises and review questions ● Solutions to end of chapter review questions ● Links to relevant sites on the web ● An online glossary to explain key terms For instructors ● Complete, downloadable Instructor’s Manual ● PowerPoint slides that can be downloaded and used for presentations ● Case study material with solutions ● Progress tests, consisting of various questions and exercise material with solutions ● Tutorial/seminar questions and solutions ● Solutions to end of chapter review questions Also: The Companion Website provides the following features: ● Search tool to help locate specific items of content ● E-mail results and profile tools to send results of quizzes to instructors ● Online help and support to assist with website usage and troubleshooting For more information please contact your local Pearson Education sales representative or visit www.pearsoned.co.uk/mclaney

Preface

This text provides a comprehensive introduction to financial accounting, management accounting and core elements of financial management. It is aimed both at students who are not majoring in accounting or finance and at those who are. Those studying introductory level accounting and/or financial management as part of their course in business, economics, hospitality management, tourism, engineering or some other area should find that the book provides complete coverage of the material at the level required. Students who are majoring in either accounting or finance should find the book useful as an introduction to the main principles, which can serve as a foundation for further study. The text does not focus on technical issues, but rather examines basic principles and underlying concepts. The primary concern throughout is the ways in which financial statements and information can be used to improve the quality of decision making. To reinforce this practical emphasis, there are, throughout the text, numerous illustrative extracts with commentary from real life, including company reports, survey data and other sources. In this fourth edition we have taken the opportunity to make improvements that have been suggested by students and lecturers who used the previous edition. We have also brought up to date and expanded the number of examples from real life. From 2005, most of the larger UK companies have had to adopt a new set of international rules relating to their main financial statements. These new rules form the basis of the section of the book that deals specifically with accounting for limited companies. The text is written in an ‘open-learning’ style. This means that there are numerous integrated activities, worked examples and questions throughout the text to help you to understand the subject fully. You are encouraged to interact with the material and to check your progress continually. Irrespective of whether you are using the book as part of a taught course or for personal study, we have found that this approach is more ‘user friendly’ and makes it easier for you to learn. We recognise that most readers will not have studied accounting or finance before, and we have therefore tried to write in a concise and accessible style, minimising the use of technical jargon. We have also tried to introduce topics gradually, explaining everything as we go. Where technical terminology is unavoidable we try to provide clear explanations. In addition, you will find all of the key terms highlighted in the text. These are then listed at the end of each chapter with a page reference. They are also listed alphabetically, with a concise definition, in the glossary given in Appendix B towards the end of the book. This should provide a convenient point of reference from which to revise. A further important consideration in helping you to understand and absorb the topics covered is the design of the text itself. The page layout and colour scheme have been carefully considered to allow for the easy navigation and digestion of material. The layout features a large page format, an open design, and clear signposting of the various features and assessment material. More detail about the nature and use of these features is given in the ‘How to use this book’ section; and the main points are also summarised, using example pages from the text, in the guided tour. We hope that you will find the book readable and helpful. Eddie McLaney Peter Atrill

How to use this book

We have organised the chapters to reflect what we consider to be a logical sequence and, for this reason, we suggest that you work through the text in the order in which it is presented. We have tried to ensure that earlier chapters do not refer to concepts or terms that are not explained until a later chapter. If you work through the chapters in the ‘wrong’ order, you will probably encounter concepts and terms that were explained previously. Irrespective of whether you are using the book as part of a lecture/tutorial-based course or as the basis for a more independent mode of study, we advocate following broadly the same approach.

Integrated assessment material Interspersed throughout each chapter are numerous Activities. You are strongly advised to attempt all of these questions. They are designed to simulate the sort of quick-fire questions that your lecturer might throw at you during a lecture or tutorial. Activities serve two purposes: ●

●

To give you the opportunity to check that you understand what has been covered so far. To encourage you to think about the topic just covered, either to see a link between that topic and others with which you are already familiar, or to link the topic just covered to the next.

The answer to each Activity is provided immediately after the question. This answer should be covered up until you have deduced your solution, which can then be compared with the one given. Towards the middle/end of each chapter there is a Self-assessment question. This is more comprehensive and demanding than any of the Activities, and is designed to give you an opportunity to check and apply your understanding of the core coverage of the chapter. The solution to each of these questions is provided in Appendix C at the end of the book. As with the Activities, it is important that you attempt each question thoroughly before referring to the solution. If you have difficulty with a self-assessment question, you should go over the relevant chapter again.

End-of-chapter assessment material At the end of each chapter there are four Review questions. These are short questions requiring a narrative answer or discussion within a tutorial group. They are intended to help you assess how well you can recall and critically evaluate the core terms and concepts covered in each chapter. Answers to these questions are provided in the student access Companion Website. At the end of each chapter, except for Chapter 1, there are

HOW TO USE THIS BOOK

eight Exercises. These are mostly computational and are designed to reinforce your knowledge and understanding. Exercises are graded as ‘basic’ and ‘more advanced’, according to their level of difficulty. The basic-level questions are fairly straightforward; the more advanced ones can be quite demanding but are capable of being successfully completed if you have worked conscientiously through the chapter and have attempted the basic exercises. Solutions to five of the exercises in each chapter are provided in Appendix D at the end of the book. A coloured exercise number identifies these five questions. Here, too, a thorough attempt should be made to answer each exercise before referring to the solution. Solutions to the other three exercises and to the review questions in each chapter are provided in a separate Instructors’ Manual. To familiarise yourself with the main features and how they will benefit your study from this text, an illustrated Guided tour is provided on pages xxiv–xxv.

Content and structure The text comprises 16 chapters organised into three core parts: financial accounting, management accounting and financial management. A brief introductory outline of the coverage of each part and its component chapters is given in the opening double-page spread which precedes each part. The market research for this text revealed a divergence of opinions, given the target market, on whether or not to include material on double-entry bookkeeping techniques. So as to not interrupt the flow and approach of the financial accounting chapters, Appendix A on recording financial transactions (including Activities and three Exercise questions) has been placed in Part 4.

MyAccountingLab Remember to create your own personalised Study Plan MyAccountingLab supports this book. This banner reminds students to complete the chapter pre-test to create their personal Study Plan. The results of the test determine the Study Plan going forward.

Now check your progress in your personal Study Plan This banner reminds students to complete the chapter post-test in MyAccountingLab to track their progress and mastery of the topics included in each chapter. Their Study plan will adapt according to the results of the test. This icon indicates that there is a Key Concept Animation relevant to the topic covered in the text at that point. Animations of all the Key Concepts are accessible through MyAccountingLab. This icon indicates that there is an interactive Study Guide covering the topic at hand available in MyAccountingLab. The Study Guide contains diagrams, video clips and short self test quizzes designed to guide and reinforce the student's learning.

xxiii

Guided tour of the book

38

CHAPTER

1

MEASURING AND REPORTING FINANCIAL POSITION

CHAPTER 2

The major financial statements – an overview The major financial accounting statements aim to provide a picture of the financial position and performance of a business. To achieve this, a business’s accounting system will normally produce three particular statements on a regular, recurring basis. These three are concerned with answering the following questions:

Introduction to accounting and finance

●

●

●

What cash movements (that is, cash in and cash out) took place over a particular period? How much wealth (that is, profit) was generated, or lost, by the business over that period? (Profit (loss) is defined as the increase (decrease) in wealth arising from trading activities.) What is the accumulated wealth of the business at the end of that period and what form does the wealth take?

To address each of the above questions, there is a separate financial statement. The financial statements are:

Introduction ➔ ➔ ➔

n this opening chapter we begin by considering the roles of accounting and finance. We shall see that both can be valuable tools for decision-making purposes. We shall identify the main users of accounting and financial information and discuss the ways in which this information can improve the quality of decisions that those users make. In subsequent chapters, we develop this decision-making theme by considering in some detail the kinds of financial reports and methods used to aid decision making. Since this book is concerned with accounting and financial decision making for privatesector businesses, we shall devote some time to examining the business environment. We shall, therefore, consider the purpose of a private-sector business, the main forms of business enterprise and the ways in which a business may be structured. We shall also consider what the key financial objective of a business is likely to be. These factors are important as they all exert an influence on the kind of accounting and financial information produced.

I

● ● ●

the cash flow statement the income statement (also known as the profit and loss account) the balance sheet (also known as the statement of financial position).

When taken together, they provide an overall picture of the financial health of the business. Perhaps the best way to introduce these financial statements is to look at an example of a very simple business. From this we shall be able to see the sort of information that each of the statements can usefully provide. It is, however, worth pointing out that, while a simple business is our starting point, the principles that we consider apply equally to the largest and most complex businesses. This means that we shall frequently encounter these principles again in later chapters.

Example 2.1 Paul was unemployed and unable to find a job. He therefore decided to embark on a business venture. Christmas was approaching, and so he decided to buy gift wrapping paper from a local supplier and to sell it on the corner of his local high street. He felt that the price of wrapping paper in the high street shops was excessive. This provided him with a useful business opportunity. He began the venture with £40 in cash. On Monday, Paul’s first day of trading, he bought wrapping paper for £40 and sold three-quarters of it for £45 cash.

Learning outcomes When you have completed this chapter, you should be able to: ●

Explain the nature and roles of accounting and finance.

●

Identify the main users of financial information and discuss their needs.

●

Identify and discuss the characteristics that make accounting information useful.

●

Explain the purpose of a business and describe how businesses are organised and structured.

●

What cash movements took place during Monday? For Monday, a cash flow statement showing the cash movements for the day can be prepared as follows: Cash flow statement for Monday Opening balance (cash introduced) Add Cash from sales of wrapping paper

Remember to create your own personalised Study Plan

Less Cash paid to buy wrapping paper Closing balance of cash

Key terms The key concepts and techniques in each chapter are highlighted in colour where they are first introduced, with an adjacent icon in the margin to help you refer back to them. Examples At frequent intervals throughout most chapters, there are numerical examples that give you stepby-step workings to follow through to the solution.

£ 40 45 85 40 45

Introductions A brief introduction, detailing the topics covered in the chapter, and also showing how chapters are linked together. Learning outcomes Bullet points at the start of each chapter show what you can expect to learn from the chapter, and provide a brief checklist of the core issues.

CREATIVE ACCOUNTING

181

196

MEASURING AND REPORTING CASH FLOWS

CHAPTER 6

be designed to bend the rules or may be designed to break the rules. Below we consider some of the more important ways in which rules may be bent or broken.

Activity 6.2

Overstating revenue

At the end of its accounting period, Zeneb plc’s balance sheet included the following items:

Some creative accounting methods are designed to overstate the revenue for a period. These methods often involve the early recognition of sales revenue or the reporting of sales transactions that have no real substance. Real World 5.8 provides examples of both types of revenue manipulation.

1 A bank deposit account where one month’s notice of withdrawal is required. This deposit was made because the business has a temporary cash surplus that it will need to use in the short term for operating purposes; 2 Ordinary shares in Jones plc (a Stock Exchange listed business). These were acquired because the business has a temporary cash surplus and Zeneb plc’s directors believed that the share represented a good short-term investment. The funds invested will need to be used in the short term for operating purposes. 3 A bank deposit account that is withdrawable instantly. This represents an investment of surplus funds that are not seen as being needed in the short term. 4 An overdraft on the business’s bank current account.

Real World 5.8 Overstating revenue Hollow swaps: telecoms companies sell useless fibre optic capacity to each other in order to generate revenues on their income statements. Example: Global Crossing. Channel stuffing: a company floods the market with more products than its distributors can sell, artificially boosting its sales. SSL, the condom maker, shifted £60 million in excess inventories on to trade customers. Also known as ‘trade loading’. Round tripping: also known as ‘in-and-out trading’. Used to notorious effect by Enron. Two or more traders buy and sell energy among themselves for the same price and at the same time. Inflates trading volumes and makes participants appear to be doing more business than they really are. Pre-dispatching: goods such as carpets are marked as ‘sold’ as soon as an order is placed. . . . This inflates sales and profits.

Which (if any) of these four items would be included in the figure for cash and cash equivalents?

Your response should have been as follows: 1 A cash equivalent because the deposit is part of the business’s normal cash management activities and there is little doubt about how much cash will be obtained when the deposit is withdrawn. 2 Not a cash equivalent. Although the investment was made as part of normal cash management, there is a significant risk that the amount expected (hoped for!) when the shares are sold may not actually be forthcoming. 3 Not a cash equivalent because this represents an investment rather than a short-term surplus amount of cash. 4 This is cash itself, though a negative amount of it. The only exception to this classification would be where the business is financed in the longer term by an overdraft, when it would be part of the financing of the business.

Note that some of the techniques used, such as round tripping, may inflate the sales revenue for a period but will not inflate reported profits. Nevertheless, this may still benefit the business. Sales revenue growth has become an important yardstick of performance for some investors and can affect the value they place on the business. Source: ‘Dirty laundry: how companies fudge the numbers’, The Times, Business Section, 22 September 2002.

The manipulation of revenue has been at the heart of many of the accounting scandals recently exposed. Given its critical role in the measurement of performance, this is, perhaps, not surprising. Real World 5.9 provides an example of the impact of the early recognition of revenue on the financial results of one well-known business.

As can be seen from the responses to Activity 6.2, whether a particular item falls within the definition of cash and cash equivalent depends on two factors: ●

Real World 5.9

●

the nature of the item; and why it has arisen.

In practice, it is not usually difficult to decide whether an item is a cash equivalent.

Not to be copied One case of overstating revenue is alleged to have been carried out by the Xerox Corporation, a large US company and a leading player in the photocopying business. It is alleged that the company brought forward revenues in order to improve reported profits as its fortunes declined in the late 1990s. These revenues related to copier equipment sales, particularly in Latin America. To correct for the overstatement of revenues, Xerox had to restate its equipment sales revenue figures for a five-year period. The result was a reversal in reported revenues of a staggering $6.4bn, although $5.1bn was reallocated to other revenues as a result. This restatement was one of the largest in US corporate history. In June 2002 the company paid a fine of $10m but denied any wrongdoing. Sources: Based on information in ‘Can’t tell the scandals without a scorecard’, Wall Street Journal Europe, October 2003, p. A5; and ‘Xerox acts to put itself on a firmer footing’, FT.com, 28 June 2002.

The relationship between the primary financial statements The cash flow statement is now accepted, along with the income statement, the statement of changes in equity and the balance sheet, as a primary financial statement. The relationship between the four statements is shown in Figure 6.1. The balance sheet reflects the combination of assets (including cash) and claims (including the owners’ claim) of the business at a particular point in time. The cash flow statement, the income statement and the statement of changes in equity explain the changes over a period to two of the items in the balance sheet. The cash flow statement explains the changes to cash. The income statement, together with the statement of changes in equity, explains changes to the owners’ claim (equity).

‘Real World’ illustrations Integrated throughout the text, these illustrative examples highlight the practical application of accounting concepts and techniques by real businesses, including extracts from company reports and financial statements, survey data and other insights from business.

Activities These short questions, integrated throughout each chapter, allow you to check your understanding as you progress through the text. They comprise either a narrative question requiring you to review or critically consider topics, or a numerical problem requiring you to deduce a solution. A suggested answer is given immediately after each activity.

GUIDED TOUR OF THE BOOK

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Self-assessment questions Towards the end of most chapters you will encounter one of these questions, allowing you to attempt a comprehensive question before tackling the end-of-chapter assessment material. To check your understanding and progress, solutions are provided in Appendix C.

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CHAPTER 11

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COSTING AND PRICING IN A COMPETITIVE ENVIRONMENT

CHAPTER 16

Psilis Ltd makes a product in two qualities, called Basic and Super. The business is able to sell these products at a price that gives a standard profit mark-up of 25 per cent of full cost. Management is concerned by the lack of profit. Full cost for one unit of a product is calculated by charging overheads to each type of product on the basis of direct labour hours. The costs are as follows: Basic £ 40 15

Direct labour (all £10/hour) Direct material

The main points of this chapter may be summarised as follows. Working capital ● Working capital is the difference between current assets and current liabilities. ● That is, working capital = inventories + receivables + cash − payables − bank overdrafts. ● An investment in working capital cannot be avoided in practice – typically large amounts are involved.

Super £ 60 20

Inventories There are costs of holding inventories, which include: – lost interest – storage cost – insurance cost – obsolescence. ● There are also costs of not holding sufficient inventories, which include: – loss of sales and customer goodwill – production dislocation – loss of flexibility – cannot take advantage of opportunities – reorder costs – low inventories imply more frequent ordering. ● Practical points on inventories management include: – identify optimum order size – models can help with this – set inventories reorder levels – use budgets – keep reliable inventories records – use accounting ratios (for example, inventories turnover period ratio) – establish systems for security of inventories and authorisation – consider just-in-time (JIT) inventories management. ●

The total overheads are £1,000,000. Based on experience over recent years, in the forthcoming year the business expects to make and sell 40,000 Basics and 10,000 Supers. Recently, the business’s management accountant has undertaken an exercise to try to identify cost drivers in an attempt to be able to deal with the overheads on a more precise basis than had been possible before. This exercise has revealed the following analysis of the annual overheads: Activity (and cost driver)

Number of machine set-ups Number of quality-control inspections Number of sales orders processed General production (machine hours) Total

Cost

Annual number of activities

£000

Total

Basic

Super

280 220 240 260 1,000

100 2,000 5,000 500,000

20 500 1,500 350,000

80 1,500 3,500 150,000

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●

Bullet point chapter summary Each chapter ends with a bullet point summary, highlighting the material covered in the chapter and serving as a quick reminder of the key issues.

Trade receivables When assessing which customers should receive credit, the five Cs of credit can be used: – capital – capacity – collateral – condition – character. ● The costs of allowing credit include: – lost interest – lost purchasing power – costs of assessing customer creditworthiness – administration cost – bad debts – cash discounts (for prompt payment). ● The costs of denying credit include: – loss of customer goodwill. ● Practical points on receivables management: – establish a policy – assess and monitor customer creditworthiness – establish effective administration of receivables – establish a policy on bad debts – consider cash discounts ●

The management accountant explained the analysis of the £1,000,000 overheads as follows: ●

MANAGING WORKING