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Chapter 2 - Financial, managerial accounting and reporting Chapter objectives Structure of the chapter The basic principles Use of the accounting equation to find profit Manufacturing account Trading account The profit and loss account The balance sheet Stocks and work-in-progress The interpretation of company accounts-ratio analysis The main types of ratio Other useful ratios Financial measures of business unit performance Key terms The two principle statements which form a set of accounts are: Other less important statements are the manufacturing account and the trading account.
It is absolutely essential to any marketer to understand what the profit and loss statement and balance sheet mean. Both documents are vital, not only to show the corporate health of the organisation, but also as an indication to various shareholders of how well or badly the organisation is performing, as proof to potential investors or lenders for the raising of capital and as a statutory record for taxation and other purposes. Chapter objectives This chapter is intended to provide: Structure of the chapter This chapter is structured in a logical way, building up from the basic tenets of financial analysis - the dual effect and the accounting equation.
From this, the chapter looks at the construction of manufacturing, trading and profit and loss accounts and the drawing up of a balance sheet. Ratio analysis is a particularly powerful technique aimed at helping marketers to compare sets of figures over time and between companies. This is dealt with in considerable detail. The basic principles All aspects of accounts are governed by these two principles. Dual effect Every transaction has two effects, not one, e. If the Dairiboard Company of Zimbabwe sells milk to a retailer, it has: The accounting equation The second principle stems from the first.
Every transaction has two effects; these two are equal and balance each other. Thus, at any given moment the net assets of a business are equal to the funds which the owner or proprietor has invested in the business. Use of the accounting equation to find profit We normally arrive at a business's profit or loss by means of a profit and loss account, but where information about income and expenditure is lacking, the accounting equation can be a useful way of finding profit.
If three of these four amounts are known, the fourth can be calculated. Manufacturing account There are many firms, whether parastatal, sole trader, partnership or limited company, which manufacture the final product to be sold from raw materials, e. In this instance, a manufacturing account is required in order to arrive at the final cost of manufacture. The manufacturing organisation will still need a trading and profit and loss account.
The only major difference is that, in the trading account, the entry for purchases is replaced by the cost of manufacture. The cost of manufacture is calculated using a manufacturing account. Two important factors need to be taken into account: The main or direct costs are those of raw materials and labour which together are known as the prime cost, although any expense which can be traced directly to any unit of production is also a direct cost.
The indirect costs are those associated with production but cannot be traced directly to a particular production unit. These costs will include the general factory overheads such as light, heat and power, rent, rates, insurance, depreciation of production machinery, etc. Certain labour costs, such as supervision by foremen or factory managers, will also be indirect costs because they are not directly traceable to a production unit but are absorbed as a general overhead.
Rent and rates, x light, heat and power x Indirect wages x Depreciation of Prod. These adjustments can be seen in the pro forma manufacturing account which follows. Gross profit is the difference between the sale proceeds of goods and what those goods cost the seller to buy, or cost of sales. The cost of sales for this purpose includes the amount which has been debited for them to the purchases account plus the cost of getting them to the place of sale, which is usually the seller's premises, i.
Preparing a trading account The trading account is calculated by using a sequence of steps. It is essential that these steps are carried out in the order indicated. The opening stock is obviously the same as the closing stock of the previous period; in the first year of trading, of course, there will be no opening stock. Add the carriage to the total arrived at in c above.
This gives the total cost of goods available for sale. Any item deducted from the debit side of an account is, in effect, credited to the account. Deducting closing stock from the debit side of the trading account is therefore crediting it to that account. The corresponding double entry will therefore be to the debit of stock account: We have now arrived at the cost of sales.
The debit to stock account for closing stock is the value of the current asset of closing stock which will be included in the balance sheet, as we shall see later. When the opening stock is credited to the stock account in the next period, it will balance off the stock account. Net sales turnover and net purchases: Goods which have been returned by customers are represented by a debit balance on the sales return account. This must be transferred to the trading account, otherwise the sales and gross profit in that account will both be overstated.
Following the same reasoning that allows us to deduct closing stock on the debit side of the trading account, we may deduct the debit balance on the sales returns account from the sales credited in the trading account. In this way, we show the net sales for the year. Net sales are known as turnover. Similarly, we show the credit balance on the purchases returns account as a deduction from purchases in the trading account to show the net cost of purchases.
Goods which have been returned to suppliers must not be included in the cost of sales. The order of items is most important. Sales returns must be deducted from sales; purchases returns must be deducted from purchases; carriage inwards, if any, must be debited in the account before closing stock is deducted. A trading account is prepared very much like a manufacturing account but substituting the production cost of completed goods for the usual purchasing figure see exercise 2.
Now attempt exercise 2. Smith at 31 December 19X8. The remaining nominal accounts in the ledger represent non-trading income, gains and profits of the business in the case of credit balances, e. Debit balances represent expenses and losses of the business and are known as overheads, e. These must now be transferred to the profit and loss account so that we can calculate the net profit of the business from all its activities.
The profit and loss income statement presents a summary of the revenues and costs for an organisation over a specific period of time. Such a statement is generally developed on a monthly, quarterly and yearly basis. The profit and loss statement enables a marketer to examine overall and specific revenues and costs over similar time periods and analyses the organisation's profitability.
Monthly and quarterly statements enable the firm to monitor progress towards goals and revise performance standards if necessary. When examining a profit and loss statement, it is important to recognise one difference between manufacturers and retailers.
For manufacturers the cost of goods sold involves the cost of manufacturing products raw materials, labour and overheads. For retailers, the cost of goods sold involves the cost of merchandise purchased for resale purchase price plus freight charges. The balance sheet shows that the profit for an accounting period increases proprietor's funds.
The trading and profit and loss account shows, in detail, how that profit or loss has arisen. The profit and loss statement consists of these major components: Discounts received x Commission received x Rent received x x xx Less: The following provides an explanation. This is done by comparing sales to the costs which generated those sales.
A retailer, for example, will purchase various items from various suppliers, and add a profit margin. This will give him the selling price of the goods and this, minus the cost of goods sold, will be the gross profit. Cost of goods sold is calculated by: This gives the cost of goods which were sold. Sales and cost of goods sold should relate to the same number of units. Capital and revenue expenditure Only revenue expenditure e. The amount of revenue expenditure charged against the profits for the year or period is the amount incurred whether cash has or has not been paid.
This applies with sales as well. Even if cash for sales has not been received in the year or period under review, sales will be included in the trading account. This is the "accruals" concept. Capital expenditure is not charged to the profit and loss account as the benefits are spread over a considerable period of time.
The business started on 1 August 19X6. The following is a summary of the transactions for the first year: The balance sheet Introduction: The balance sheet is a statement of the financial position of a business at a given date. It is, therefore, only a "snapshot" in time. When comparing business performance, therefore, a number of years and time periods may be more suitable. The balance sheet is the accounting equation but set out in a vertical form in order to be more readily, understood i.
Capital at 1 January x Profit for the year x x Less: These are fixed accounts, current accounts, current liabilities and funds: They are normally valued at cost less accumulated depreciation. D Net current assets: This can also be called working capital.
F This total is the total of the business's net assets. G This total is the total of proprietor's funds, i. Within these main headings the following items should be noted. Prepayments are items paid before the balance sheet date but relating to a subsequent period. Accrued charges are amounts owed by the business, but not yet paid, for other expenses at the date of the balance sheet.