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© 2005, Monash University, Australia CSE5806 Telecommunications Management Lecturer: Dr Carlo Kopp, PEng Lectures 13-14 Overview of Accounting Principles
© 2005, Monash University, Australia Reference Sources NOTE: These sources are indicative - there are many other good texts available in libraries. They are referenced here as this presentation draws on them extensively. Introductory Accounting and Finance Bell, Althea (1990) Publisher: Thomas Nelson Australia Monash University Library: 657 B433.I Company Accounting in Australia Leo & Hoggett (fourth edition 1998) (Publisher: Jacaranda Wiley Limited Monash University Library: U657.950994 L576C4
© 2005, Monash University, Australia Why Look at Accounting? For some function or functional area, “Management” is the: Planning, Organising, Leading, and Controlling the activity. It is not performing the work of the functional area, although ‘leadership’ and ‘working managers’ are important Accounting is a very important part of management, as it addresses the financial aspects of ‘management’. Remember the Golden rule – “the one who controls the gold makes the rule” Technical Managers need some accounting knowledge to: avoid being made look an idiot, and to avoid being totally beholden to accountants
© 2005, Monash University, Australia Basic Accounting Equation Much of Accounting is driven by the equation: Assets = Proprietor’s equity plus Debtors less Creditors sometimes “Debtors less Creditors” is termed nett liabilities This can be restated: What is OWNED (the Assets) = Money From Owners (Proprietors) PLUS Money Owed By Others (Debtors) LESS Money Owed To Others (Creditors) or Use Of Funds = Equity less Debt or What is Owned minus What is Owed = Net Worth (proprietorship)
© 2005, Monash University, Australia Example A company buys goods for $100 using borrowed money. At this stage, the accounting equation is: Assets ($100 goods) = Prop.($0) plus Debtors($0) less Creditors($100 loan) Now sell the goods for $120 Assets($120 cash) = Liabilities($100 debt) + Proprietrship($20 profit) Then repay the borrowing ($100), plus $2 loan interest A($18 cash) = L($0) + P($18 retained profit)
© 2005, Monash University, Australia Double entry concepts In effect, every transaction is recorded twice, once on either side of the "=". This is a (simple) example of "double entry" accounting. Double entry accounting is believed to have originated in the 15th century in Italy. It has some important advantages : highlights the essential balance between Assets and Liabilities provides a cross-check, as both sides of the "ledger" must balance. Computerised bookkeeping programs such as ‘Money’, ‘MYOB’, ‘Quick Books’ or ‘Quicken’ may appear to be only ‘single entry’, but these also use double-entry techniques
© 2005, Monash University, Australia Accounting Statements There are a number of basic accounting documents, including: Balance Sheet Profit Statement Revenue Statement Statement of Income & Expenditure Operating Statement Profit & Loss Statement Funds Statement A manager who does not understand these is fundamentally a poor manager, held back by the lack of financial understanding
© 2005, Monash University, Australia The Balance Sheet The Balance Sheet is a statement of financial position at a particular point in time, normally at the end of an accounting period/financial year can be at any time (sometimes termed a ‘trial balance’) may be at half or quarter year intervals may be created at particular time for a special purpose eg major sale or purchase of another company Balance Sheet statement is: usually constructed with "assets" and "liabilities" lists usually listed in order of declining liquidity. Ie. The items listed first are those most easily converted into cash
© 2005, Monash University, Australia Balance Sheet Terminology Accountancy work, like engineering, is conducted according to “Industry Standards” and governance Many accounting standards covering all aspects Significant governance from accounting bodies and regulattions Standard terms are used on statements such as Balance Sheets – (and like engineering, these are subject to “interpretation”) Current Assets: cash & convertibles within 12 months, including stock & debtors Fixed Assets: purchased with the intention of using/working outside 12 months Current Liabilities: bills to be paid in less than 12 months Deferred Liabilities: bills to be paid in more than 12 months
© 2005, Monash University, Australia Balance Sheet (1) Assets As at some particular date (which should be stated) ASSETS (Matters of value to the company) CURRENT Assets (within 12 months) Cash (incl. bank accounts) Stock Debtors Investments made by the company/organisation Listed, Unlisted, Debentures FIXED NON-CURRENT Assets (outside 12 months) Land, Buildings Plant/Equipment, Motor vehicles INTANGIBLE Assets Goodwill (effectivly the reputation of the organisation or company)
© 2005, Monash University, Australia Balance Sheet (2) Liabilities LIABILITIES (matters the company is required to pay at some time) CURRENT Liabilities - (within 12 months) Creditors Overdraft Loans Accrued Wages DEFERRED Liabilities - (outside 12 months) Accrued Interest Provision for Tax Provision for Dividends SHAREHOLDERS FUNDS - see next page
© 2005, Monash University, Australia Balance Sheet (3) Shareholders Funds SHAREHOLDERS' FUNDS The funds held by the company on behalf of the shareholders (or owners) Paid-up capital (#shares x issue price) NOTE The price base used is the initial price of the shares, not their present market value (which reflects how much people want them) Retained Profits (from previous years) Capital Reserve
© 2005, Monash University, Australia Uses of a Balance Sheet Enables comparison of assets with current liabilities Can provide a picture of long-term financial position, e.g. around 1980 BHP had approx. 70% of liabilities in shareholders' funds Enables ratio analyses, e.g. are (deferred liabilities + shareholders' funds > fixed assets Better way to consider it: are (deferred liabilities + shareholders' funds)/fixed assets > 1? In general long-term fund sources should be greater than long-term fund usage. (“borrow short, lend long” problem)
© 2005, Monash University, Australia Problems with Balance Sheets Only an instantaneous snapshot of financial position Many items need detailed scrutiny Prepared on a "historical cost" basis, rather than ‘future estimates’ Some companies revise value of land holdings, some do not Most companies leave ‘plant’ values at (invoice cost - depreciation) rather than resale value Value of "work in progress" (WIP) can be a problem eg “90% of software is reported as 90% complete for 90% of its development time”
© 2005, Monash University, Australia Depreciation Definition: The process of allocating the cost of a fixed asset over its effective service life in a systematic and rational manner. Process: in each accounting period the value of each depreciable asset is reduced by its depreciation amount. to match this, the depreciation amounts are added to a "depreciation reserve" in the long-term liabilities. Australian Tax Office ((http://www.ato.gov.au/) gives standard depreciation rates and methods for different classes of items
© 2005, Monash University, Australia Misconceptions about depreciation Misconception - “It is a ‘Hidden Profit’” Not really - it is an annual allocation of the costs of an item used over some years Misconception - “Lean year/Good year charge” Misconception - ‘”Provides money for replacement of assets” (can be partly true) Misconception - ‘”Provides for the reduction in the value of assets” The real situation: Depreciation is an acknowledgement that the value of an asset goes down over time, due to wear and tear, obsolescence etc
© 2005, Monash University, Australia Depreciation Methods There are many formulas which could be used - eg. straight line (fixed fraction/year) eg 25% of purchase price pa same depreciation each year until book value = zero diminishing value eg 30% of previously depreciated value greater depreciation in early years, asset never reaches zero value accelerated eg 50% in year 1, 25% in year 2 etc allows rapid depreciation in early years etc. Next slide shows graphs of depreciated value versus years of ownership
© 2005, Monash University, Australia Depreciation (2) - Approaches
© 2005, Monash University, Australia Depreciation (3) An important driver is what is accepted by the taxation laws, and Australian Tax Office only allows certain methods 2003 rules Low value items (< $300) can be written off immediately Items less than $1000 can be ‘pooled’ Other special cases for horticulture (plants) and mining For all other items - annual depreciation is calculated as: Diminishing value method - (base value at start of year) * ((150%) / (Asset’s effective life)) effectively 30% for a nominal asset life of five years Prime Cost method (a straight line method) - (Original purchase price) *(100% / (Asset’s effective life)) NOTE: Whatever method is chosen must be used for the life of the asset
© 2005, Monash University, Australia Business Expenses: Capital Expenses: Do not appear in the profit statement Items may or may not be depreciated Operating Expenses: Appear in the profit statement Include the current year's depreciation (even though it is not a cash outgoing in that year.)
© 2005, Monash University, Australia Profit Statement Need to distinguish between cash (what we actually receive) and income (what we issue invoices for). Eg the customer may not pay the amount shown on the invoice Customer defaults (does not pay at all) Pays less than the amount eg “prompt payment discount”, or disputes the amount Need to address the accounting period e.g. financial year financial half year, or quarter calendar year etc Accounting statements are usually biased to present a picture favourable to the reason for their creation–
© 2005, Monash University, Australia Profit Statement (Trading Company) 1. Sales Income (Cash received during period - Previous year's debtors + Year-end debtors) less Cost of Sales (starting stock + purchases - closing stock) resulting in Gross Profit (less sales expenses of advertising, sales-people, vehicles etc) Less 2. General Expenses of the business 3. Financial Expenses bad debts Interest taxation Insurance etc. 4. Depreciation Expense resulting in Nett Profit (or Loss)
© 2005, Monash University, Australia Statement of Retained Profit Should show: Opening Balance (at start of financial year) Plus Net Profit for the financial year less dividends paid to shareholders less taxation paid to government Equals Retained Profit Retained profit is a form of shareholder funds held by the company - often used for expansion or re-vitalisation of the business, sometimes simply held as a reserve for bad times
© 2005, Monash University, Australia Investment Capital (1) Investment Capital is needed to buy new equipment or assets, replace old equipment, for operating funds etc. Where does it come from? 1. Shareholders Shareholders are the joint owners of the business - their proportion of the company is the ratio of shares that they own compared to the number issued. placements – effectively creating additional shares and selling them to one or more buyers thus diluting the value of existing shares rights issues - diluting the company’s share base, but giving existing shareholders the ‘rights’ to buy a proportion of the new shares - thus preserving their proportion of ownership calls – where shares are issued as ‘partly paid’, a call is a request for a further payment towards the full issue price of the shares. Non-payment negates the current shareholding.
© 2005, Monash University, Australia Investment Capital (2) 2. Borrowing from public or Financial institutions debentures - debt backed by the general credit of the company bank loans - usually money loaned against specific assets convertible notes - a form of IOU trade credit - eg 30 days credit when paying bills is really a loan to the value of the bill for 30 days. 3. Internal Sources of investment capital profit - retained profits from previous activity increase in working capital - eg shuffling money from one heading to another sale of assets selling off surplus (or non-profitable) assets (equipment, buildings, stocks, etc)
© 2005, Monash University, Australia Funds Statement (US terminology: “Change of Financial Position”) Effectively a comparison of two balance sheets Concentrates on current assets & liabilities Some questions: What happened to profits? How debts were financed? How plant expansion and replacement was financed? The extent of internal funding of activities?
© 2005, Monash University, Australia Gearing and Leverage Gearing: Definition: The proportion of prior-charge debt to equity Service of loans (payment of interest) takes priority (by law), but it can be cheap capital because the interest expense is tax deductible. Leverage: The advantage (disadvantage) obtained from gearing. Upward: borrowing for less than you get in return. Downward: borrowing for more than you get in return. Gearing or Leverage is a performance amplifier.
© 2005, Monash University, Australia Leverage example Consider financing strategies for a particular situation. $2000 is needed, expected net profit is $240 pa. Consider: Option A as using a new share issue for financing, Option B as a mixture of shares and debentures Option C is financed on debentures alone (Example only - this concept would rely on financial backing and support from other parts of the organisation): NOTE We could simply add an “K” (or “M” or “B”) at the end of all $ values - sums still OK
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