1 Accounting The Balance Sheet. 2 Clive Vlieland-Boddy FCA FCCA MBA EADA 2008

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Accounting

The Balance Sheet

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Clive Vlieland-Boddy

FCA FCCA MBA

EADA 2008

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4 Fundamental Accounting Concepts again!

Going Concern - That the business will continue and not be liquidated.

Accruals (or Matching) - That income is matched with expenditure. You match the sale with the cost of that sale.

Consistency - What you did last year you do this. Otherwise figures would be meaningless.

Prudence - Caution is essential. Note “Prudence must prevail”

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What is a Balance Sheet

It is like a photograph taken on a given date of the financial position of the company.

……”Click”…….

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What is a Balance Sheet

FLASH

Need Picture of assets liabilities and equity

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The Accounting Equation

The Assets = Liabilities + Shareholders ( Owners)Equity.

Assets = Liabilities & Equity

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A Balance Sheet…..

Assets

Current

Non Current

Investments

Intangibles

Liabilities

Current

Non Current

Shareholders Equity

Shares

Retained Earnings

An Asset

Has a present or future economic value. It MUST be worth something. If NOT it is

NOT an asset

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Assets

There are 4 basic categories of Assets. Current Assets Non Current Assets Intangibles Investments

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Current Assets

Current Assets - Those that are used for the day to day trading of the company and are expected to be consumed within 12 months.

E.g.: Accounts Receivable and Inventories.

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Current Assets Should be...

Expected to be realised, consumed, sold or settled within 12 months.

Held primarily for trading purposes or short term.

Is Cash or Cash Equivalents which are not restricted.

Current Assets

Bank Balances and Cash Marketable Securities Accounts Receivable Prepayments Inventories

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Cash or Cash Equivalents

If a bank account is held and there is a positive balance then this is treated as a current asset.

If it is negative it is a current liability. Cash Equivalents means investments

immediately convertible into cash such as a bank deposit account.

Marketable Securities

Very Short Term and highly liquidable investments.

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Current Assets Accounts Receivable ( DEBTORS) A firm often sells goods where the buyer pays

for them some time later. The firm has to recognise that it has sold something but as yet not been paid for it.

This therefore represents an asset of the firm being money that it will receive from the sale of goods or services that it has already made.

Note that any of these that are likely to fail to pay, should be deducted and recognised as a bad debt in the Income Statement.

Accounts Receivable

Money due from customers. Sometimes called Debtors. Bad Debts are those that are unlikely to be

recovered.

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Current Assets Inventories ( Stocks & WIP)

Companies that manufacture goods or buy and sell will normally have to acquire the goods to be sold before selling them. They normally hold these until a customers acquires them. These goods are called inventories or stocks.

There are several different classes of Inventories based on the state of the goods.

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3 Classes of Inventories

Raw Materials - The basic materials before any production.

Work in Progress - where goods are being converted to finished items.

Finished Goods - Items ready for sale.

Valuation of Inventories

The lower of Cost or Net realisable value. Must adjust for any further costs required to

enable these to be sold. For example. A car dealer has a new BMW in

stock. It cost €20,000. However it is now only worth €18,000 and requires €800 to be spent on it to enable it to be sold. Inventory value = 18,000 – 800 = 17,200.

Slow Moving or Obsolete

Must adjust for these

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LIFO vs FIFO Last In First Out is where you account for

stocks on the basis that the last item acquired is the first item out. This tends to under value the stocks as it means that the remaining stocks are the oldest which probably costs less when purchased.

First In First Out is where you expect to consume the oldest items first. This is now generally accepted as more reasonable but the USA still use LIFO.

LIFO vs FIFO

FIFO now the only accepted method under IFRS.

See 10.2.7

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10.3.1

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Sundry Prepayments These represent items which have been paid

in an accounting period but at the Balance Sheet date, have not been fully consumed. Here the Accruals(Matching) concept requires us to recognise this.

Example: The company pays its 12 months vehicle insurance one month before the year end. You would accept to charge one month in the Revenue Statement and take 11 months in The Balance Sheet so as to match against next years income.

Prepayments Example: A Company pays its annual insurance for the 12

months from 1st December 2006 of £12,000. At the 31st December, it has only consumed 1/12 of this expenditure. The matching concept requires to match 1/12 in the closed year and to take the remaining 11/12 forward to match it against the next year. These non-consumed expenditures are classified as prepayments in Current Assets in the Balance Sheet.

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10.5.1

Non Current Assets NCA’s (Fixed Assets)

Tangible Intangible Investments

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Tangible (NCA)

Those that are held to enable the company to function. E.g. Plant and Equipment vehicles and buildings.

Depreciation

NCA’s lose value as they are used. This loss in value is called depreciation. (We will return to this later)

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10.7.1

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NCA’s Intangible Assets

Like Goodwill, know how, trade marks & Patents. ( we will deal with later)

Intangibles Generally

Have value but value can be easily lost. Should be written off as quickly as possible.

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Investments

A company may acquire shares in other companies. These will represent assets and be shown in the Balance Sheet as Investments. Normally held for a long time.

Short Term Investments in say Government Stocks can be shown as Current Assets so long as they can be easily converted into cash.

Accounting For Leased Assets

Financing Lease - Essentially a way of buying the asset. Substance over legal form.

Operating Lease - Just a daily or weekly hire. (Short term)

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Leased Assets

Some leased assets are essentially a loan and in real terms the asset is under the ownership of the lessee ( The person who uses the asset) These are called Financing Leases and should recognise the real issues… ie “substance over legal form” Finance leases should be capitalised.

Operating leases are basic, normally short term, rental agreements. They should not be capitalised.

Financing Leases

Treated as if it had been bought by the company.

The asset is shown in the Balance Sheet along with the total commitments outstanding to the leasing Company

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10.10.1

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Liabilities

Represent an obligation of the business arising from past events. The settlement of this is expected to result in an outflow from the recourses of the business having itself created economic benefit.

It we are never going to write out a cheque then it is not a liability.

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Liabilities

A liability is what its name says. It is a responsibility of the enterprise and is some form of debt. There are 2 essential categories of these.

Current Liabilities - Non Current Liabilities -

Current Liabilities

Those that are to be settled within 12 months. E.g.

Accounts Payable Bank overdraft. Dividends Payable Tax Payable Sundry Accruals Current Proportion of Long Term Loans

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Accounts Payable (Creditors)

Most companies buy materials and supplies on credit paying for them weeks or even months later. Thus the accounts must show that there is a liability outstanding when the goods are received / Invoiced, until they are actually paid for.

Dividends Payable

The amount that is due to be paid as dividends to shareholders.

Tax Payable

Current Tax payable to the government.

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Tax & Deferred Tax

Tax is divided into two categories. Tax that has to be paid to the government and tax that is delayed due to certain concessions or tax incentives.

Tax that is payable to the government is shown as a current liabilities as this will have to be paid quickly.

Deferred tax is a Non Current Liability as it is not payable for at least 12 months.

Deferred Tax

Tax that is not payable within 12 months.

Example:

ABC LimitedExtract Income Statement

2006 2005

EBIT 650,000 575,000Deduct: Interest 60,000 50,000Profit Before Tax 590,000 525,000Deduct: Taxation at 40% (See Note 23) 236,000 210,000Deduct: Dividends 100,000 90,000Retained Reserves For Year 136,000 120,000

Note to The accounts No 23.

Taxation 2006 2005

Mainstream Tax Liability 156,000 180,000Deferred Taxation 80,000 30,000

Total Tax Provision 236,000 210,000

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Sundry Accruals

In order to comply with the Matching Concept, it is necessary to make adjustments for items that have yet to be invoiced but are due and need to be matched with the year or accounting period to which they relate.

Example: A company receives its 3 month telephone bill one week after the year end. The whole bill relates to the closed year. This would need to shown as an Accrual.

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11.2.1

Non Current Liabilities

Those that are due to be settled after one year.

E.g. Loans with maturity more than 12 months

away. Mortgages Deferred Tax

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Long Term Loans

Loans repayable more than 12 months away are treated as Non Current Liabilities. Any portion repayable within 12 months will be shown as a current liability.

Proportion of Loans repayable within 12 months

Example: A Company has a bank loan of $90k

repayable over the next 9 years by equal installments of $10k. Thus in Current Liabilities would be $10k and in Non Current Liabilities would be $80k.

Current & Non Current Liabilities

Loan of €90,000 Repayable over 9 years by equal installements

10,000 80,000Current Liability

Non Current Laibility

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Dividends payable.

Dividends which are due and payable within 12 moths are normally shown separately under current liabilities.

Provisions More than 50% likely we will have to write out a

cheque. Must show as a liability in the Balance Sheet. Examples:

Warranty

Bad Debts (Accounts Receivable that might well not pay)

Proposed Management Bonuses or Audit Fees.

Litigation where the outcome is likely to be adverse..

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Contingencies

Possible obligation from past events not within the companies control.

The present obligation may not have any financial effect or as yet not determinable.

If a contingency is more that 50% likely to happen then it is a provision and needs to be included in the Balance Sheet.

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Contingencies - Accounting Treatment

Should be disclosed in a note to the accounts.

A description given even in the notes. Reasons for any uncertainty. Attempt to quantify.

Pension Liabilities

Most companies separate these out. If still there then should show as Non Current

Liability except the amounts payable to retired staff within next 12 months which are shown as Current Liabilities.

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Shareholders Equity

Limited Liability Companies require investors to provide capital. Initially in the form of shares and then by leaving their profits in the firm. ( Called retained earnings)

Share Capital & Reserves

The companies capital structure is initially written down in its foundation documents called Memorandum & Articles of Association.

Different Types of Shares

Common or Ordinary Shares - These are the real owners of the company ( Once you have 50% plus you own and control the company)

Preference Shares - Basically a loan. Normally no voting rights.

Authorised, Issued and Paid up

Authorised is the number and amount that the Memorandum permits. This can be changed upwards, normally by application to the Court.

Issued is the number of shares actually purchased.

Paid up is the number actually paid for. Difference is that sometimes shares can

remain unpaid.

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Shareholders FundsRetained Earnings

The company will not normally pay all its profits to the shareholders as dividends. They will retain some to fund the activities and growth of the business. There profits not distributed are called “Retained Earnings”.

Share Premium

Shares sold by the company at a premium. The premium is collected here.

Share Premium

Where shares are say $1 each, often a company will sell them for say $1.50 or more. This premium is shown as a separate item in the Shareholders Equity.

Revaluation Reserve

NCA’s can be revalued. If they are, the increase should be recorded

here. Note that under IFRS these reserves cannot

be distributed as dividends.

Capital Reserves

These are revaluation reserves generated by re-valuing a Non Current Asset or the disposal of a Non Current Asset.

Treasury Stock

Shares that the company has bought back. Many issues over how to show these in the

financial statements.

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After Balance Sheet Events

Activities occurring after the Balance Sheet date may or may not require adjustment or a note. Such events may be favourable or not.

Either provide evidence of conditions that existed at the Balance Sheet date or

indicate conditions that occurred after the Balance Sheet date but make a material effect to the possible future outcome.

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Off Balance Sheet Finance

Examples Sale and lease back of a Fixed Asset along

with its associated borrowings to a Special Purpose Vehicle (SPV) e.g.Enron!!!

Buying loss making companies via a SPV until they become profitable.

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Creative Accounting

This represents manipulating the figures for a desired result.

Example: a company may try to improve the picture so as to inflate share price or gain beneficial loan arrangements. Alternatively, if tax was high, then possibly reducing profits so as to pay less tax. Often such adjustments are done at the year end by issuing invoices early or delaying until the next year.

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11.10.1

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ABC Limited Balance Sheet as at 31st May 2006

Current Assets

Accounts Receivable 200,000

Inventories 150,000

Bank Balance 125,000

Total Current Assets 475,000

Non Current Assets

Plant & Equipment 100,000

Less: Depreciation -50,000

Total Non Current Assets 50,000

Investments 25,000

Total Assets 550,000

Current Liabilities

Accounts Payable 150,000

Tax Payable 50,000

Current Proportion of Loan 25,000

Total Current Liabilities 225,000

Non Current Liabilities

Bank Loan 250,000

Shareholders Equity

Shares 25,000

Retained Earnings 50,000

Total Shareholders Equity 75,000

Total Liabs & Equity 550,000

Consolidated Balance Sheet

Where you have a group of Companies, the parent will consolidate its subsidiaries into its own accounts.

It will add all the groups assets and liabilities together.

Minority Interest is the % that is not owned by the group.

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Stanley tools

www.stanleyworks.com

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Quiz Time

Exercise 1.

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Exercise 2

Lets work this together

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Prepare for next class

Exercise 3. We will work this together when we next meet.

Group Study ResearchYou should each look at 2 companies and evaluate for

qualitative purposes. (See end of Chapter 6) This should include the following:

Industry Overview Risk management Corporate Governance Corporate Social Responsibility Transparency and clarity of the company financial information Strategy – clear sustainable and achievable Management strengths Readability of the reported information Additional shareholder tools and reports.

Group Study ResearchOnce you have reviewed these 2 companies each,

you should aim to eliminate one on the grounds that it fails for certain reasons against benchmarks that you have set. ( See end of chapter 6).

Then as a group you should evaluate these companies preparing a 30-40 minute presentation which will be made on the final session at the end of this course.

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The End…

to be continued…..