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3 Major Financial Statements, The statement of financial position,…
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Expenses and Revenue
Cost of sales can be identified by matching the cost of each sale to the particular sale or by adding the goods bought during a period by the opening and closing inventories
Classifying expenses is often a matter of judgement, although there are rules for businesses that trade as limited complanies
Revenue is recognised when a business has performed it's obligations, which is when control of the goods or services is passed to the customer
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An expense reported in the income statement may not be the same as the cash paid. This can result in accruals or prepayments appearing in the statement of financial position
The materiality convention states that where the amounts are immaterial, we should consider only what is expedient
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Costing Inventories
The way this is done is important to the calculation of profit and the presentation of financial position
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When prices are rising, FIFO gives the lowest sales figure and the highest closing inventories (other way around for LIFO). AVCO gives figures for cost of sales that lie between the two
When prices are falling, the position of FIFO and LIFO are reversed
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When a particular method of accounting, such as depreciation method, is selected, it should be applied consistently over time
Multi-product business
Where units of output are not identical, it is necessary to divide the cost into two categories - Direct and Indirect (overheads)
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Indirect cost is difficult to relate to individual cost units - arbitrary bases are used and there's no single correct method
Traditionally, indirect cost is seen as the cost of providing a 'service' to cost units
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Break-even analysis
The break-even point (BEP) is the level of activity (in units of output or sales revenue) at which total cost (fixed + variable) - total sales revenue
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Margin of safety = excess of planned volume (or sales revenue) of activity over volume (or sales revenue) at BEP
Operating gearing is the extent to which the total cost of some activity is fixed rather than variable
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Activity based costing
is an approach to dealing with overheads (in full costing) that treats all costs as been caused or driven by activities
Advocates argue that is more relevant to modern commercial environments than the traditional approach
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Identification of the cost drivers can lead to more relevant indirect cost treatment in full costing
Critics argue that it is time-consuming and expensive to apply. Not justified by the possible improvement in the quality of the information
Full cost information is seen by some as not very useful because it can be backward looking - it includes information relevant to decision making, but excludes some relevant information
Budgets
A budget is a short-term, mainly expressed in financial terms
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The budgets for each area are summarised in master budgets (budgeted income statement and statement of financial position)
Budgets are plans, rather than forecasts
Asset Valuation
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Fair values may be used provided they can be reliably obtained. Rarely possible for intangible non-current assets
Non-current with infinite useful lives should be shown at cost (or fair value), less any accumulated depreciation (amortisation)
Where the value of a non-current asset is impaired, it should be written down to its recoverable amount
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Ratio analysis
Compares two related figures, usually both from the same set of financial statements
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Usually requires the business' performance for past periods, the performance of similar businesses and/or planned performance as benchmark ratios
Can benefit from a brief overview of financial statements to provide insights that may not be revealed in ratios and/or may help in the interpretation of them
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Preparing budgets
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They are usually prepared in columnar form, with a column for each month (or similarly short period)
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The starting point for preparing budgets is to identify the limiting factor. This will determine the overall level of activity
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Marginal Analysis
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Using scarce resources - the limiting factor is most effectively used by maximising its contribution per unit
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Money Measurement
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Certain resources, such as goodwill, product brands and human resources are difficult to measure. An "arm's length" transaction is normally required before such assets can be reliably measured and reported on
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Providing a service
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To do this, it must posses certain qualities:
Relevance
Faithful representation
Comparability
Verifiability
Timeliness
Understandability
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Cost behaviour
Fixed cost is independent of the level of activity (for example, rent)
Variable cost varies with the level of activity (for example, raw materials)
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Weakness of BE Analysis
There are non-linear relationships between costs, revenues and volume
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Accounting Conventions
Are the rules of accounting that have evolved to deal with practical problems by those preparing financial statements
Main conventions relating to the financial statement are business entity, historic cost, prudence, going concern and dual aspect
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Profitability ratios
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Most commonly found in practice are the return on ordinary shareholders' funds (RSOF), return on capital employed (ROCE), operating profit margin and gross profit margin.
Efficiency ratios
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Most commonly found are the average inventories turnover period, average settlement period for trade receivables, average settlement period for trade payables, sales revenue to capital employed asn sales revenue per employee
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Investment ratios
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Common ones are dividend payout ratio, dividend yield ratio, earnings per share (EPS) and price/earnings ratio
Uses of ratios
Individual ratios can be tracked to detect trends, for example plotting them on a graph
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Effective budget control
Good budgetary control requires establishing systems and routines to ensure such things as a clear distinction between individual managers' areas of responsibility . Prompt, frequent and relevant variance reporting and senior management commitment
Behavioural aspects of control relating to management style, participation in setting and the failure to meet budget targets should be taken into account be senior managers
Bad debts
Where it is reasonably certain that a credit customer will not pay, the debt is regarded as 'bad' and written off
Cost
The amount of resources, usually measured in monetary terms, sacrificed to achieve a particular objective
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Batch costing
A variation of job costing where each job cosists of a number of identical (or near identical) cost units
Cost per unit = Cost of the batch (direct and indirect / Number of units in the batch
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