Financial Accounting is the guide-post for the management. The financial score of the firm is kept by the financial accounting system

2. Financial Accounting
Financial Accounting is the guide-post for the
management. The financial score of the firm
is kept by the financial accounting system.
It points out the problem faced or likely to be
faced by the firm. It also brings to its notice
opportunities that are likely to arise. The end
product of Financial Accounting is financial
statements.
Financial information is communicated to
the users through financial statements.
The financial statements are:-
2

3. 1. THE BALANCE SHEET
The purpose of the balance sheet is simply to set out the
financial position of a business at a particular moment in
time. It sets out the assets of the business on the one
hand and the claims against the business on the other.
Balance sheet contains information about resources and
the obligations of the entity and about its owners’ interests
in the business at a particular point of time i.e. assets,
liabilities and owners’ equity. It provides a snapshot of the
financial position of the firm at the close of the firm’s
accounting period. The relationship between assets,
liabilities and owners’ equity can be shown in the form of
Accounting Equation i.e. A=L+O.
The Balance sheet is the detailed presentation of the
accounting equation.
3

4. Assets
An asset is essentially a resource held by the
business. It has following characteristics:
A probable future benefit must exist
The business must have an exclusive right to
control the benefit
The benefit must arise from some past
transaction or event
The asset must be capable of measurement in
monetary terms
4

5. Example of Assets
Premises, machinery, equipment, fixtures and
fittings, patents and trademarks receivables,
investments, motor-vehicles, inventory, computers,
printers, cash
Patents & trademarks are intangible assets while
others are tangible assets
5

6. The classification of Assets
1. Current Assets, and
2. Non-current Assets
 Current Assets: These assets are held for short
term. These assets meet anyone of four criteria:
i. Held for sale or consumption in the normal
course of business operating cycle;
ii. To be sold within next year;
iii. Held primarily for trading;
iv. They are cash or nearly cash
 e.g. cash, inventorying, receivables, short
term investments, prepaid expenses
6

7. Non-current Assets (Fixed Assets)
These are held for the purpose of generating wealth
and are held for the long-term operations of the
business such as premises, plant, motor vehicles,
patents
7

8. Claims
A claim is an obligation on the part of the
business to provide cash or some other form of
benefit, to an outside party.
There are essentially two types of claims against a
business:
Capital: This represents the claim of the
owner(s) against the business. This claim is
sometimes referred to as the owner’s equity. The
business is viewed as being quite separate from
the owner(s).
8

9. Liabilities: Liabilities represent the claims of all
other individuals apart from the owners and must
have arisen from past transactions.
Claims remain as obligations until they are settled.
9

10. The Classification of claims
Capital (owner’s claim); and
liabilities (claims of outsiders)
Liabilities are further classified into two groups:

11. Current Liabilities
 Amounts due for settlement in the short term.
They meet anyone of the four criteria:
 Expect to be settled within the normal course of
business operating cycle;
 Due to be settled within 12 months of the balance
sheet date
 Primarily held for trading purposes,
 The business does not have the right to defer
settlement beyond 12 months after the balance sheet
date
11

12. Non-Current Liabilities:
Represent those amounts due to outside parties that are
not current liabilities.
To gain insight into the ability of the business to meet its
maturing obligations, the value of current liabilities is
compared with current assets, if the current assets are
higher the business is in a position to pay off its current
debts.
The classification of liabilities also helps to highlight how
the long term finance of the business is raised – through
debt or owners’ equity. Debts will bring commitment to
make interest payments and Principal amount repayments
i.e. the financial risk would be there. The business must
strike the balance between the two i.e. equity & debt
finance
12

13. Balance Sheet Formats
Basically the balance sheet can be prepared in any one of
the format i.e. Horizontal layout where the assets are
shown one side, and the liabilities and the owners’ equity
on the other side. The vertical form of layout rearranges
the equation.
Horizontal layout A = L + O i.e
 Non current Assets + Current Assets = capital + Non-
current Liabilities +Current liabilities
Vertical layout = Non-Current Assets + current Assets –
Current Liabilities – Non-Current liabilities = capital
13

14. National Mitumba store
(Horizontal Format) Balance sheet as at 30th June 2013
Assets (in 000) Liabilities & O. E (in 000)
Non-Current Assets: Capital 80,000
 Premises 30,000 Add: Profit 12,000
 Plant 28,000 92,000
Furniture 14,000 Less Drawings 6,000
86,000
Motor Vehicles 12,000
Computers 4,000 88,000
Current Assets Non- Current Liabilities
Inventories 38,000
T .Receivable 15,000 Loan 50,000
Cash 7,000 60,000 Current Liabilities
T.Payables 12,000
62,000
148,000
148,000
14

15. National Mitumba Store Balance sheet as at 30th June 2013
(Vertical Format)
Non-Current Assets Shs (in 000) Shs (in 000)
Premises 30,000
Plant 28,000
Furniture 14,000
Motor vehicles 12,000
Computers 4,000
88,000
Current Assets
Inventories 38,000
T. Receivables 15,000
Cash 7,000 60,000
Less: current liabilities:
T. Payables 12,000 48,000
Total Assets 136,000
Less: Non-Current Liabilities
Loan 50,000
Net Assets 86,000
Capital 80,000
Add Profit 12,000 92,000
Less Drawings 6,000 86,000
15

16. Accounting Conventions
Accounting is a language of business and is followed
throughout the world. Hence certain accounting
conventions have been developed and followed
internationally. These are:-
Business Entity Convention
The business and its owners are treated as being quite
separate and distinct. That is why owners are treated as
being claimants against their own business in respect of
their investment in business.
Money Measurement convention:-
Accounting normally deals with only those items that are
capable of being expressed in monetary terms.
16

17. Accounting Conventions
 Historic cost convention
 Assets are shown on the balance sheet at a value that is based on
their historic cost (acquisition cost) less accumulated depreciation.
 Going concern convention
 The financial statements should be prepared on the assumption
that the business will continue operations for the foreseeable
future, unless this is known not to be true.
 Dual Aspect Convention
 This convention asserts that each transaction has two aspects, both
of which will affect the balance sheet
 Prudence convention
 The convention requires the recording of all losses in full and
applies to both actual losses and expected losses. Profits on the
other hand, are not recognized until they are realized.
17

18. Cont….
 Stable Monetary Unit Convention
 This convention holds that the money is stable
and the inflation has no impact on the balance
sheet items though it is not true.
 Objectivity convention
 Financial statements should be based on
objective verifiable evidence rather than on
matters of opinion.
 Goodwill and product brands value can be
shown in the balance sheet, if these have been
acquired from third party
18

19. Question 01
19

20. 2. Income Statement
Profit and Loss Account (Measuring and Reporting
Financial Performance)
The Profit and Loss Account is a ‘score-board’ of the
firm’s performance during a period of time. The profit
and loss account presents the summary of revenues,
expenses and net income/loss of a firm during the
accounting period. It serves as a measure of the firm’s
profitability. To determine the net income earned
during the accounting period, expenses incurred are
matched against revenues earned
20

21. Income Statement: What to
Consider?
1) How the income statement is prepared,
2)how it links with the balance sheet, and
3)What key measurement problems are faced when
preparing this statement ?
21

22. Relationship between the income
statement and the balance sheet
The balance sheet is a ‘snapshot’ of the stock of
wealth held by the business at a single moment on
time while the income statement is concerned with
the flow of wealth over a period of time.
The amount of profit or loss for the period affects the
balance sheet as an adjustment to capital.
A= 0+(Sales Revenue – Exp)+Liabilities (go to
Situation 01)
The income statement can be prepared either in
Horizontal format or vertical format. However the
most commonly used format is vertical.

23. Shs:000
Sales Revenue xxx
Less: Cost of sales* xxx
Gross Profit xx
Add: Income from Renting premises xx
Gross Profit after other Income xx
Less: Operating Expenses
Salaries & Wages xx
Light xx
Telephone xx
Insurance xx
Interest on loan xx
Dep. – Furniture xx
Dep. – Plant xx (xx)
Net Profit for the year xx
 * Cost of Sales
Opening inventory xx
Add Purchases of Inventory xx
Inventory available for sale xx
Less closing inventory (xx)
Cost of goods sold xx 23
Might include other
direct Expenses

24. Cont……
The first part of the income statement is concerned
calculating the gross profit for the period. The difference
between the sales and cost of sales is known as gross
profit.
Any additional source of revenue, if any, is added to the
gross profit e.g. income from rent/interest etc. From this
other expenses are deducted to arrive at net profit or
wealth generated during the period.
The Reporting Period
A financial reporting cycle of one year is the norm, though
some large businesses will produce a half yearly, quarterly
or monthly.
24

25. Recognition of Revenue & Expenses
Revenue is normally recognized at the point of sale.
The matching convention in accounting is designed
to provide guidance concerning recognition of
expenses. This convention states expenses must be
taken into account in the same income statement in
which the revenue from the associated sale is
included in the total sales revenue figure.
The treatment of accruals and prepayments will be
subject to the materiality convention of accounting.
The balance sheet and the income statement are both
prepared on the basis of accrual accounting and not
on the cash basis system
25

26. Treatment of Depreciation
 Depreciation is an attempt to measure that
portion of the cost of non-current asset that has
been used up in generating the revenue
recognized during a particular period.
 To calculate a depreciation charged for a
period, four factors have to be considered:-
 - The cost of the fixed asset
-The useful life of the asset
 The residual value of the asset
 the depreciation method
26

27. Methods of charging Depreciation
To calculate depreciation two methods are very common:-
(i) Straight-line method
This method simply allocates the amount to be
depreciated evenly over the useful life of the asset. An
equal amount of depreciation will be charged for each year
the asset is held i.e.
 Depreciation = cost-residual value
Estimated useful life
(ii) Reducing-balance method: This method applies a
fixed percentage rate of depreciation to the written-down
value of an asset each year.
Depreciation = cost (at diminishing balance) * rate
Rate = 1 - (Scrap / Cost of Machine)1/Years
27

28. Profit Measurement and inventories costing methods
FIFO - the earliest inventories held are
the first to be sold
AVCO - weighted average cost method –
the quantity purchased is treated as weights
also in use = Lower of cost or Net realizable value
28

29. Situation 02
29

30. Consistency convention
Once a method of charging depreciation and valuation of
inventory is selected it has to be applied consistently
Profit Measurement and the problem of Bad and
Doubtful debts
The bad debts must be written off. A prudent convention
requires a provision for doubtful debts to be made against
P/L Account
Dr P/L A/C
Cr Provision for Doubtful Debts
(A Provision created)
30

31. END OF DAY ONE

32. 3. CASH FLOW STATEMENT
Cash flow statement reveals the movement of cash
over a period and the effect of these movements on
the cash position of the business.
Cash is important to the survival of the business.
Without cash no business can operate.
32

33. The Main features of cash flow statement
The cash flow statement is a summary of cash receipts and cash
payments over the period concerned. The net result of the statement
is the net increase or decrease of the cash and cash equivalents of the
business over the period.
A definition of cash and cash equivalents
IAS 7 defines cash as notes and coins in hand and deposits in banks
and similar institutions that are accessible to the business on demand.
Cash equivalents are short-term, highly liquid investments that are
readily convertible to known amounts of cash and which are subject
to an insignificant risk of changes of value. Cash equivalents are held
for the purpose of meeting short term cash commitments rather than
for investment or other purposes.
33

34. The form of cash flow statement
It has 4 sections:
i.. cash flow from operating activities
This is the net inflow or outflow from trading operations, after tax and
financing costs
ii. Cash flow from investing activities
This section is concerned with the cash payments made to acquire
additional non-current assets and with cash receipts from the disposal
of non-current assets
iii. Cash flow from financing activities
This section is concerned with the long-term financing of the
business. This category is concerned with redemption or repayment
of finance as well as with the raising of it. It is permissible to include
dividends payment as well or dividend can be shown in operating
activities.
iv. Net Increase or Decrease in cash and cash equivalents.
34

35. Cash flow statement for the period ending on 30th June 2009
 Cash flows from operating activitie Shs. Shs.
 Net profit after interest before tax xx
 Plus depreciation expenses xx
 Plus interest expenses xx
 Plus decrease in inventories xx
 Plus decrease in receivables xx Plus
increase in payables xx Less increase
in inventories (xx) Less increase in
receivables (xx) Less decrease in payables
(xx) Less interest paid
(xx) Less tax paid (xx)
Less dividend paid (xx)
xx (i)Net cash flow from operating xx
35

36. Cont…..
Cash flows activities from investing activities
 Disposal of non-current assets xx
Acquisition of non-current assets (XX)
Interest received on investment xx
Net cash flows from investing activities xxx
Cash flows from financing activities
 Issue of debenture stock xx
 Repayments of debenture stock (xx)
 Issue of ordinary shares xx
Net cash flow in financing activity xxx
Net cash & cash equivalents xxx
Add opening Bal. of cash & cash Equivalent xx
Closing bal. cash & cash equivalents xxxx
36

37. EXAMPLE 1. The relevant information from the financial statements of Dido plc for last year
is as follows: £m
 Net profit, after interest, before taxation 122
 Depreciation charged in arriving at net profit 34
 Interest expense 6
 At the beginning of the year
 Inventories 15
 Trade receivables 24
 Trade payables 18
 At the end of the year
 Inventories 17
 Trade receivables 21
 Trade payables 19
 The following further information is available about payments during last year:
 m
 Corporation tax paid 32
 Interest paid 5
 Dividends paid 9
37

38. The cash flow from operating activities is derived as
follows:
 £m
 Net profit, after interest, before taxation 122
 Add Depreciation 34
 Add Interest expenses 6
 40
 162
 Less Increase in inventories (17-15) (2)
 Add Decrease in trade receivables
 (21-24) 3
 Add Increase in trade payables (19-18) 1
 4
Cash generated from
operations 164
 Less Interest paid 5
Less Corporation tax paid 32
 Less Dividends paid 9
 (46)
Net cash from operating activities 118
38

39. Example 2.0 The relevant information from the financial statements of Pluto plc for last year is as
follows:
 £m
 Net profit, after interest, before tax 165
 Depreciation charged in arriving at net operating profit 41
 Interest expense 21
 At the beginning of the year:
 Inventories 22
 Trade receivables 18
 Trade payables 15
 At the end of the year;
 Inventories 23
 Trade receivables 21
 Trade payables 17
 The following further information is available about payments
 during the year; £m
Corporation tax paid 49
 Interest paid 25
 Dividends paid 28
 What figure should appear in the cash flow statement for ‘Cash flows from operating
activities’?
39

40. Net cash inflows from operating activities:
 £m
Net profit (after interest, before tax) 165
Add Depreciation 41
Add Interest expense 21
 62
 227
Less Increase in inventories (23-22) (1)
Less Increase in trade receivables (21-18) (3)
 (4)
Add increase in trade payables (17 – 15) 2
Cash generated from operations 225
Less Interest paid 25
 Less Corporation tax paid 49
Less Dividends paid 28
 (102)
Net cash from operating activities 123
40

41. The Importance of cash flow
Profits are not necessarily a reliable measure of a
company’s performance. A cash flow statement enables
the analyst to gain insights into the business. It offers the
analyst the opportunity to consider the following:-
Whether the Co. is cash generator or cash sink
If a Co. is able to produce cash in excess of its needs, it is
known as a cash generator; conversely it is a cash sink. A
cash neutral company is one when its cash inflows and out
flows broadly balance.
41

42. Cash generator or cash sink
42

43. 43

44. Is cash being produced absorbed from operating or non –
operating activities?
 The cash position of a Co. may improve
through non–operating activities such as asset
disposal or may worsen its cash position by
acquisition of business assets.
The cash generating capacity through the Co’s
operating activities is of much importance. Where
operating activities are absorbing cash, it is
important to see how long and to what extent the
Co. will be cash sink.
44

45. Net cash inflow
How the Co. is financing a cash shortfall or a
absorbing a cash surplus.
 If the Co. is cash generated it will use the surplus
cash generate either to repay borrowings, increasing
cash reserves, or buying its own securities? If the Co. is
cash deficit it may borrow funds, issue new equity or
run down it cash reserves.
45

46. Quality of company’s Profit
 The profit generated by the firm can be compared
with its net cash inflow if it is negative then there is a
possibility that the profits have been inflated through
the use of creative accounting.
If the cash inflow & the profit converge in the short–
term is better, the ability of the business to generate
cash is a better guide.
46

47. The Difference between Profit & cash
 The differences arise because of:-
 Timing differences when the cash is received or paid
and when the transactions appear in the P/L a/c –
Accruals i.e. credit purchases, credit sales, outstanding
expenses, or Accrued revenues: the actual payment of
dividend & Tax may be different than what are shown
in the P/L a/c.
 The effect of depreciation: Is shown as an expense
but does not involve movement of cash. The effect of
depreciation is to deflate reported profit, but is to leave
cash flow unaffected.
47

48. Cont….
 Accounting transactions directly appearing in B/S
without going through the P/L a/c: writing off
goodwill against reserve. All cash transactions appear in
cash flow statement even without going through the
P/L a/c such as acquisitions that is why the profit
differs from cash flow.
 Changes in W.C: Valuation methods of inventory
changes the value of stock, hence reported profit will
change. Increase in credit from suppliers will bring
changes in W.C (stock, debtors, creditors) will
influence the cash flow but the impact on profits will
differ.
48

49. How to use the cash flow statement
 It assists the analyst to understand the company’s underlying
cash position and financial implication of its strategy.
Ten questions are to be answered
Whether the Co. managed to increase the net cash inflow from
its operating activities: In comparison to previous year, if yes,- by
how much in view of the rate of inflation explanation for the change –
changes in dep. policy, better control of working capital requirement,
change in operating profit
Is the company able to pay dividends: without effecting much their
cash reserves as the cash is needed for reinvestment
How much cash is being used to service borrowings:
- As it is a drain on company’s cash resources-comparison with
previous year figure
49

50. Cont….
 Volume of spending on fixed asset
 - Level of spending is rising or declining – if rising compare it
with the amount set aside for depreciation (replacement).
 - Cash flow problem – it should be restricted. Strategy why to
spend money?
 Impact of Disposal of fixed asset/ business on generating
funds?
 - It is a distress sale, getting poor price.
 - Is it to the advantage of the Co.?
 Is the Co. making acquisitions
 - The rationale for the acquisition
 - The reasons advanced provide an adequate justification
50

51. Cont…
 What is the funding need?
 - If the net cash flow is negative how the Co. is going to
finance, or the cash reserves exist
 Has the Co. raised new share capital?
 – What is the amount? Is it being frequently done? The
stock market may not be conducive. Is it the right issue
or a placement?
 To what extent the Co. increased borrowings
 - What is the new debt ratio? Is it short term
borrowings will the Co. be able to improve the cash
generation?
 How has the Co.’s cash position changed
 - Has it improved or deteriorated
51

52. Financial Ratios and the statement of cash
flows:-
Cash flow to Current Notes Payable
= Cash flow from operating activities before non recurring items
 Current notes payable
The higher the ratio, the better it is
Cash flow to Total Debt
= Cash flow from operating activities before non – recurring items
 Total Debt
Cash flow per share
= Cash flow from operating activities before non – recurring item
 No. of Equity shares.
52