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Accounting

Niall Lothian
John Small

AC-A4-engb 1/2014 (1001)

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Accounting
The Accounting programme is written by Niall Lothian, formerly Professor at Edinburgh Business School,
Heriot-Watt University, and John Small, Professor Emeritus at Heriot-Watt University. Both have
previously occupied chairs in the Universitys Department of Accountancy and Finance.
Professor Lothian has taught at IMEDE (now IMD) in Lausanne and is currently a member of the
visiting faculty of INSEAD, Fontainebleau; the European School of Management and Technology, Berlin;
and Duke Corporate Education. He has conducted seminars and managerial briefings in Europe, Africa
and China, the latter under the auspices of the United Nations Industrial Development Organisation.
Professor Lothian has been consultant to British government agencies such as the Ministry of Defence
and the Cabinet Office and to numerous international companies.
His current research and consulting interests include the study of managerial controls over R&D expenditure, a field in which he has published widely, and the accounting implications of flexible manufacturing
systems. A chartered accountant by professional training, he is a Past President of the Institute of
Chartered Accountants of Scotland. He was the inaugural chairman of the audit advisory board of the
Scottish Parliamentary Corporate Body and is chairman of Inspiring Scotland, a venture philanthropy
trust. Professor Lothian was made an Officer of the Order of the British Empire in the New Years
Honours 2012.
Professor Small was Chairman of the Accounts Commission in Scotland from 1982 to 1991. The
Accounts Commission is responsible for arranging the audit of local government in Scotland and ensuring
the proper steps are taken to achieve economy, efficiency and effectiveness. He has recently served on
the board of Scottish Homes.
He is a member of the Council of the Chartered Association of Certified Accountants and was its
President in 1982/83. He has been Chairman of the Education Committee of the International Federation
of Accountants and a member of the executive Board of the Union Europenne des Experts Comptables,
Economiques et Financiers. He is an honorary member of the Arab Society of Certified Accountants. He
has also held visiting professorships and external examinerships at various universities and business
schools.
His special interest is in the use of financial information in decision making for planning and control. In this
area he is a consultant to a number of organisations and has advised companies and government agencies
in the UK and abroad.
Professor Small was made a Commander of the Order of the British Empire in the Queens Birthday
Honours, 1991.

First Published in Great Britain in 1991.


Niall Lothian and John Small 1991, 1998, 2001, 2003, 2007, 2014.
The rights of Niall Lothian and John Small to be identified as Authors of this Work have been asserted in
accordance with the Copyright, Designs and Patents Act 1988.
All rights reserved; no part of this publication may be reproduced, stored in a retrieval system, or
transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise
without the prior written permission of the Publishers. This book may not be lent, resold, hired out or
otherwise disposed of by way of trade in any form of binding or cover other than that in which it is
published, without the prior consent of the Publishers.

Contents
PART 1

FINANCIAL ACCOUNTING FOR MANAGERS

Module 1

An Introduction to Accounting and the Accounting Equation

1/1

1.1
Approaching Accounting
1/2
1.2
The Reality of Accounting
1/2
1.3
What Accounting Is
1/3
1.4
Focus on Profit-Seeking Businesses
1/5
1.5
Who Are the Users of a Companys Accounting Information?
1/6
1.6
For What Sort of Decisions Do these Users Value Accounting Information? 1/6
1.7
Common Information Requirements among Users
1/8
1.8
The Accounting Equation
1/9
1.9
The Accounting Statements
1/12
1.10 Sole Trader versus MBA
1/23
1.11 Accounting: The External and Internal Functions
1/24
1.12 Accounting Principles
1/25
Review Questions
1/26
Case Study 1.1
1/31
Module 2

The Income Statement


2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8

Introduction
What Is Profit?
The Measurement of Accomplishment
Another Reason for Opting for Ship and Invoice
Conventions Underlying Measurement of Sales Accomplishment
The Measurement of Effort
Task One: Determining the Consumption of the Means of Production
Task Two: Determining the Value of Closing Work-in-Progress and
Inventories
2.9
Types of Inventory in a Manufacturing Company
2.10 Inventory Valuation Methods
2.11 Valuation of Work-in-Progress and Finished Goods
2.12 Interpreting Profit
Learning Summary
Review Questions
Case Study 2.1
Case Study 2.2
Case Study 2.3

Accounting Edinburgh Business School

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Contents

Module 3

The Balance Sheet

3/1

3.1
Introduction
3.2
The Anatomy of the Balance Sheet
3.3
Non-Current Assets
3.4
Current Assets
3.5
Current Liabilities
3.6
A Matter of Judgement
3.7
Gearing (or Leverage)
3.8
Why Does a Balance Sheet always Balance?
Learning Summary
Review Questions
Case Study 3.1
Case Study 3.2
Module 4

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The Cash Flow Statement

4/1

4.1
Introduction
4.2
Why Are Cash Flow Statements Needed?
4.3
What Is Cash in a Cash Flow Statement?
4.4
Cash: Where Does It Come From? Where Does It Go To?
4.5
Three Major Categories of Cash Flow
Learning Summary
Review Questions
Case Study 4.1
Case Study 4.2
Module 5

The Framework for Financial Reporting


5.1
5.2
5.3
5.4
5.5
5.6
5.7
5.8
5.9
5.10
5.11
5.12
5.13

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Introduction
The Concept of Disclosure
Sources of Disclosure Requirements
Government Legislation
Accounting Standards
Stock Exchange Requirements
Financial Reporting in Action
An Introductory Note on Groups of Companies
Abstract of Annual Reports: The MBA Company and the Award Company
The Accounting Policies
The Consolidated (or Group) Income Statement
(or Profit and Loss Account)
The Consolidated (or Group) Balance Sheet
Provisions, Contingent Liabilities and Contingent Assets

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Edinburgh Business School Accounting

Contents

5.14 A Concluding Note on MBAs Balance Sheet


5.15 Group Cash Flow Statement
5.16 Detailed Disclosure Requirements for Selected Items
5.17 Lessons to Be Learned
5.18 Fundamental Accounting Principles
5.19 Management Commentary
5.20 Reporting on Corporate Social Responsibility
5.21 The External Auditor
Learning Summary
Appendix 5.1: Extract from MBA Group Annual Report 20x2
Appendix 5.2: Extract from Award Group Annual Report 20x2
Review Questions
Case Study 5.1
Module 6

Interpretation of Financial Statements


6.1
Introduction
6.2
Ratio Analysis
6.3
Group 1: Liquidity Ratios
6.4
Group 2: Profitability Ratios
6.5
Group 3: Capital Structure Ratios
6.6
Group 4: Efficiency Ratios
6.7
Other Possible Ratios
6.8
Window Dressing
6.9
Putting it all Together: The Dupont Chart
6.10 A One Hundred Per Cent Statement
6.11 Basic Stock Market Ratios
Learning Summary
Review Questions
Case Study 6.1
Case Study 6.2

Module 7

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How to Understand and Analyse a Banks Annual Financial Statements 7/1


7.1
Introduction
7/1
7.2
A Line-by-Line Description of a Banks Income Statement and Balance Sheet 7/2
7.3
Additional Information Provided by Banks for the Purposes of Analysis
7/6
7.4
Ratio Analysis
7/8
7.5
A Few Highlights and Key Topics in the Industry
7/14
Learning Summary
7/42
Appendix 7.1: Historical Accounting Data for Bute Bank plc
7/42
Review Questions
7/46
Case Study 7.1
7/50

Accounting Edinburgh Business School

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Contents

PART 2

MANAGEMENT ACCOUNTING FOR DECISION MAKING

Module 8

An Introduction to Cost and Management Accounting


8.1
What Accounting Is: A Refresher
8.2
Management Accounting Looks Forward
8.3
Where Accounting Fits into a Company
8.4
A Brief Note on What a Manager Does
8.5
The Role of Accounting Information
8.6
Management Accounting in MBA
8.7
Differences between Management Accounting and Financial Accounting
8.8
Management Accounting and Cost Accounting
8.9
Where Costs Come from and an Overview of the Modules to Follow
8.10 Process Costing
8.11 Costs Relevant to Management Decisions
8.12 Other Topics in the Management Accounting Course
Learning Summary
Review Questions

Module 9

Cost Characteristics and Behaviour

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9/1

9.1
Introduction
9.2
Cost: A Deceptively Simple Word
9.3
Variable and Fixed Costs
9.4
Beware the Unitising of Fixed Costs!
9.5
Direct and Indirect Costs
9.6
Traceable and Common Costs
9.7
Product Costs and Period Costs
9.8
Controllable and Non-Controllable Costs
9.9
Standard and Actual Costs
9.10 Engineered and Discretionary Costs
9.11 Another Look at Variable and Fixed Costs: The Break-Even Chart
9.12 Profit from Different Cost Structures
9.13 The Break-Even Chart: An Alternative Display
9.14 Other Ways of Calculating Break-Even Points
9.15 Break-Even Analysis and the Multi-Product Firm
9.16 Contribution and Limiting Factors of Production
9.17 Assumptions Underpinning CostVolumeProfit Analysis
Learning Summary
Review Questions
Case Study 9.1
Case Study 9.2
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Edinburgh Business School Accounting

Contents

Module 10

Allocating Costs to Jobs and Processes


10.1 Introduction
10.2 Cost Gathering
10.3 Where Do These Costs Come From?
10.4 Plantwide versus Departmental Rates
10.5 Joint Products and By-Products
10.6 Process Costing
10.7 Process Costing and the Equivalent Unit
10.8 Cost per Equivalent Unit
10.9 Activity-Based Costing
10.10 Traditional Costing versus ABC
Learning Summary
Review Questions
Case Study 10.1
Case Study 10.2
Case Study 10.3

Module 11

Costs for Decision Making


11.1 Introduction
11.2 The Dilemma of the Denominator
11.3 Managerial Implications of Absorption versus Variable Costing
11.4 Cost Information for Management Decisions
11.5 Routine and Non-Routine Decisions
11.6 Developing an Analytical Framework
11.7 Finding the Relevant Costs
11.8 The Pitfalls of Full Costing
11.9 Opportunity Costs
11.10 Department versus Company
11.11 Sunk Costs
11.12 Management Decisions in Action
11.13 Closing down a Unit
11.14 The Special Sales Order
11.15 Should we Process Further?
Learning Summary
Review Questions
Case Study 11.1
Case Study 11.2

Accounting Edinburgh Business School

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Contents

Module 12

Budgeting

12/1

12.1 Introduction
12.2 Why Bother with Budgets?
12.3 Why Budgeting Gets a Bad Name
12.4 Budgeting in Action: The Go-Straight Trolley Company
12.5 Discretionary Expenditure and Zero-Base Budgeting
Learning Summary
Review Questions
Case Study 12.1
Module 13

Standard Costing

13/1

13.1 Introduction
13.2 Setting Standards
13.3 A Word about Motivation
13.4 Flexible Budgets
13.5 The Anatomy of Variances: Materials and Labour
13.6 Responsibility for Variances
13.7 Variable and Fixed Overhead Analysis
13.8 Investigation of Variances
13.9 Sales Variances
13.10 Pulling It All Together
Learning Summary
Review Questions
Case Study 13.1
Case Study 13.2
Module 14

Accounting for Divisions

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14.1 Introduction
14.2 Why Divisionalise?
14.3 Types of Divisions
14.4 Defining Profits and Investments
14.5 Asset Base Valuation
14.6 Residual Income: An Alternative to ROI
14.7 The Imputed Rate of Interest Does Matter!
14.8 A Cautionary Note about Performance Measures
14.9 Transfer Pricing
14.10 Criteria for Establishing a Transfer Price
14.11 The International Dimension
Learning Summary
Review Questions
x

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Edinburgh Business School Accounting

Contents

Case Study 14.1


Module 15

Investment Decisions
15.1 Introduction
15.2 The Investment Process
15.3 Concept of Present Value
15.4 Discounted Cash Flow Approach
15.5 Net Present Value (NPV)
15.6 Discounted Cash Flow (DCF) Rate of Return
15.7 Comparison of Net Present Value and DCF Rate of Return
15.8 Investment Appraisal in Non-Revenue and Not-for-Profit Situations
15.9 Risk and Uncertainty and Inflation
15.10 Risk and Uncertainty
15.11 Payoff or Payback Period
15.12 Sensitivity Analysis
15.13 Risk Analysis
15.14 The Key Investment Factors
15.15 Projected Weighted Average Cost of Capital
15.16 Weighted Average Cost of Capital
15.17 Opportunity Cost, Risk and the Cost of Capital
15.18 Investment Appraisal and Inflation
15.19 Post-Assessment/Continuous Post-Audit of Capital Expenditure Projects
Learning Summary
Appendix 15.1: Present Value Table
Appendix 15.2: The Calculation of the Internal Rate of Return
Review Questions
Case Study 15.1

Module 16

Alternative Techniques to Measure Efficiency and Performance


16.1 Introduction
16.2 Target Costing
16.3 Life Cycle Costing
16.4 Throughput Accounting
16.5 Costing for Competitive Advantage
16.6 The Balanced Scorecard
16.7 Time-Driven Activity-Based Costing
Learning Summary
Review Questions
Case Study 16.1
Case Study 16.2

Accounting Edinburgh Business School

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Contents

Appendix 1

Practice Final Examinations and Worked Solutions


Practice Final Examination 1
Practice Final Examination 2

Appendix 2

Glossary
Index

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A1/1
1/1
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Answers to Review Questions

A2/1

Module 1
Module 2
Module 3
Module 4
Module 5
Module 6
Module 7
Module 8
Module 9
Module 10
Module 11
Module 12
Module 13
Module 14
Module 15
Module 16

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Edinburgh Business School Accounting

PART 1

Financial Accounting for Managers


Module 1 An Introduction to Accounting and the
Accounting Equation
Module 2 The Income Statement
Module 3 The Balance Sheet
Module 4 The Cash Flow Statement
Module 5 The Framework for Financial Reporting
Module 6 Interpretation of Financial Statements
Module 7 How to Understand and Analyse a Banks
Annual Financial Statements

Accounting Edinburgh Business School

Module 1

An Introduction to Accounting and


the Accounting Equation
Contents
1.1
1.2
1.3
1.4
1.5
1.6

Approaching Accounting .......................................................................1/2


The Reality of Accounting .....................................................................1/2
What Accounting Is ................................................................................1/3
Focus on Profit-Seeking Businesses ......................................................1/5
Who Are the Users of a Companys Accounting Information? .........1/6
For What Sort of Decisions Do these Users Value Accounting
Information? ............................................................................................1/6
1.7
Common Information Requirements among Users ...........................1/8
1.8
The Accounting Equation ......................................................................1/9
1.9
The Accounting Statements............................................................... 1/12
1.10 Sole Trader versus MBA ..................................................................... 1/23
1.11 Accounting: The External and Internal Functions ........................... 1/24
1.12 Accounting Principles .......................................................................... 1/25
Review Questions ........................................................................................... 1/26
Case Study 1.1................................................................................................. 1/31

Learning Objectives
By the end of this module you should understand:
the value to various groups in society of a knowledge of accounting;
the role of accounting in management;
the need for, and use of, accounting information in decision making within any
organisation;
the accounting equation;
the basic layout of the income statement (sometimes called the profit and loss
account), the balance sheet and the cash flow statement;
the distinction between financial accounting and management accounting.

Accounting Edinburgh Business School

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Module 1 / An Introduction to Accounting and the Accounting Equation

1.1

Approaching Accounting
Few subjects in a masters degree course in Business Administration are approached
by students with a greater sense of awe than accounting. Put another way, of all the
subjects typically on offer in an MBA programme, accounting is the one that
students would most prefer to avoid! Why should this be? Here are some reasons
that may reflect the readers thinking as he or she embarks on this course.
Unlike many other MBA disciplines, such as marketing, economics and organisational behaviour, which are viewed as being intuitive that is, the reader has a
fairly good idea of what the subject is about without prior study accounting is
non-intuitive, requiring the mastery of rules from the outset.
Accounting is seen to deal exclusively with numbers; many people prefer to deal
with words and ideas.
Because of its concentration on numbers, accounting is considered to be
concerned with precision and accuracy, both of which require a highly developed
mathematical mind.
Accounting is solely concerned with applying arbitrary rules and conventions,
such as International Accounting Standards, and is therefore mechanistic and
requires only good memory.
Readers know friends and relatives who have studied for a degree or professional
qualification in accounting; since these people spent many years studying, how
can an MBA course deal with complexities so quickly?
Accounting and accountants are treated by society as being dull and boring! The
image, bolstered by the perceived obsession with numbers and accuracy, is
picked up by TV scriptwriters and producers, who stereotype the accountant as
being humourless, repetitive, pedantic, unimaginative and incapable of forming
close personal relationships!
In an effort to put the readers mind at ease at the outset of the course, two
points should be made.
1. Virtually everyone (whether studying for an MBA or not) who is not a trained
accountant views accounting and accountants as set out above.
2. They are all wrong!

1.2

The Reality of Accounting


All business disciplines, including marketing, economics and organisational behaviour, are based on fundamental concepts and relationships that must be appreciated
from an early stage. The fact that a novice believes he knows what is involved in
these subjects does not remove the need to study the underlying principles in as
rigorous a manner as he would be required to do in accounting.
Accounting is indeed concerned with numbers, but it is concerned with many
more aspects besides; the presentation and communication of financial information
is just as important as the numbers themselves. More attention is being paid today
to the use of accounting numbers in the decision-making process than ever before.

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Edinburgh Business School Accounting

Module 1 / An Introduction to Accounting and the Accounting Equation

Major companies currently issue to shareholders an abbreviated set of annual


accounts (perhaps only a few pages) instead of the full set; companies websites
often display shortened versions of their annual reports as well as the full version.
Indeed, an increasing number of companies have stopped circulating automatically
their annual reports to shareholders; instead, shareholders are supplied with the web
address at which they can access the main features of the years results. They are
doing this not to save money but in recognition of the fact that the important
accounting numbers, such as turnover, profit for the year and dividends payable, are
not easily discernible in the full set. Shareholders need this information so that they
can assess the performance of the company in which they have a stake. A simple
presentation and the medium of communication are as important to accounts as the
financial message.
Accounting numbers attempt to reflect economic activity in an organisation. But
there is no one given view of this activity; two people can form different views. It
follows that there can be no one given set of accounting numbers that must be used.
Choice, judgement and the reconciliation of vested interest prevent the accountant
from ever becoming dull and boring.

Example
A company purchased a residential house in 19x1 in the Georgian New Town of
Edinburgh for use by its senior executives when on company business in Scotland. It
cost 100000. In 20x1 the companys property advisers consider the house would sell
for 1500000. The companys insurers require buildings insurance to be based on its
replacement value of 2000000. Which value should the companys accountant select
for recording the asset in the 20x1 accounts?

Precision, accuracy and the need for a mathematical turn of mind may be desirable but not essential. So often these attributes are confused with numeracy, the skills
of reading and handling numbers and applying to them the basic arithmetical rules
of addition and subtraction. A modestly priced calculator will prove to be invaluable! This course is written not only for those studying for a degree by distance
learning but also for managers and others who need to use accounting numbers in
their work. The underlying methodology of accounting will be explained only where
it is essential to the readers understanding of the concepts and his or her appreciation of how to apply the techniques in the world of business.

1.3

What Accounting Is
Accounting may be defined as a series of processes and techniques used to
identify, measure and communicate economic information that users find
helpful in making decisions.
A definition is like a completed jigsaw: the whole picture is readily visible, but it is
not nearly as interesting as the process of fitting all the pieces together. What are the
constituent pieces of the definition?

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Module 1 / An Introduction to Accounting and the Accounting Equation

1.3.1

Accounting Is a Service Function


Accounting is not an end in itself: it provides information to decision makers.
Whether an entity is oriented towards making profits, such as a company, a partnership or a sole trader, or towards meeting goals other than profits, such as a political
party, a charity, a club or a church, accounting information is universally employed
by decision makers.

Example
A cathedral is planning to replace its organ. The organ committee has asked the
treasurer for the following financial information: the range of competitive tenders in
money terms; the potential impact of exchange rates on overseas organ builders
tenders; the cost of old organ removal and preparatory site works; and the impact on
power and maintenance costs as compared with the existing organ. But this information
is only one factor in the committees decision-making process; ultimately the decision
will also take into account musical and liturgical issues.

1.3.2

Accounting Deals with Economic Information


Within organisations there exists a bewildering range of information on all sorts of
subjects. Accounting confines itself to economic information and is usually expressed in money values. However, accountants also deal with such things as tons of
raw materials used, number of hours worked, capacity of machinery used and units
of output produced.

Example
The governments defence procurement establishment is weighing up the potential of
placing a long-term contract with one of three civilian suppliers of laser equipment.
Alongside the results of the militarys experiences with the prototypes under simulated
battlefield conditions, the accountants will lay their estimates of costs of production, the
suppliers requirements for capital equipment to build the production models, the rate
at which equipment will depreciate and the pricing formulae being used by the suppliers.

1.3.3

Economic Activity Must Be Identified, then Measured


Some economic events, like the sale of a unit of production, e.g. a car, are relatively
easy to identify and to measure. Others are easy to identify but are difficult to
measure: the robotic equipment used in the car-assembly process depreciates
through use and the passage of time, but accountants can only guess at how quickly
this cost should be recognised; each guess produces a different cost figure, which, in
turn, produces a different profit figure. Of course, the range of guesses is curtailed
by the exercise of commercial judgement and professional precedent. Some events
may have an economic impact on the organisation that is so difficult to identify and
measure that it escapes the accountants attention.

Example
The charismatic founder and chief executive of a recently stock-exchange-quoted
company suffered a near-fatal coronary thrombosis while golfing two weeks before the
financial year-end. On the same day, one of the companys sales reps replaced the two
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Edinburgh Business School Accounting

Module 1 / An Introduction to Accounting and the Accounting Equation

rear tyres on his company car. Because the accountant can identify and measure the
economic impact of the latter event, it is accounted for, while the former event, one
that could have a long-term negative effect on the performance of the company, escapes
recording.

1.3.4

Accounting Is a Communication Device


Accounting information can help decision makers reach their objectives. It follows
that accountants must know what sort of economic information decision makers
want: accounting information must be relevant for the purposes for which it is
designed. Then, of course, the accountant must communicate the information in
such a way that the users can understand it.

Example
A national charity is about to launch a fund-raising campaign. The financial controller
compiles financial information in a pie-chart format, which reveals that all but a small
percentage of income is spent directly on the charitys objectives; on the other hand the
information required by the governments tax authorities requires accounting numbers
to be presented in a totally different manner. It would not be unfair to say that accountants have a lot of work still to do to improve their communication skills: too often
accountants forget that users cannot understand accounting numbers as easily as they
can.

1.4

Focus on Profit-Seeking Businesses


What do the following persons have in common?

The chairman of a football club


A chief executive in the local brewery
A minister of finance
A financial controller of a university
The senior partner of a law firm
The medical director of a hospice
The answer is that they are all concerned with the raising and spending of money
and the control of scarce resources through budgets. To this extent, accounting is a
universally applicable management tool employing universally applicable principles.
But the detailed procedures and rules governing, say, a brewery and a government
department are so diverse that it would be wise to focus on only one sector during
this course. We have selected the profit-seeking private sector, and specifically the
manufacturing industry within this sector. We do this for three reasons.
1. Managers and other readers who work for the not-for-profit sector very often
have personal investments in profit-seeking private sector companies and are
interested in tracking the performance of their investments.
2. The thrust of governments financial management in many countries today is
towards privatisation, i.e. adopting the techniques and performance measures of
the private sector.

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3. We believe that a manufacturing industry setting enables students to grasp the


principles and procedures of accounting more easily than any other. Once these
principles are understood, they can be applied in other commercial and social
settings. Reference will be made to other settings where appropriate.

1.5

Who Are the Users of a Companys Accounting


Information?
Take MBA as an example of an industrial company. We will use the fictitious
financial statements of MBA throughout the text for analytical use and for illustration. MBA is based on one of the worlds largest engineering companies. It has a
presence in every continent and its activities span every aspect of technology; it also
provides financial services to its distributors and customers. Who are the users of
MBAs accounting information? They can be grouped as internal users and external
users.
Internal users

Directors
Senior executives
Managers
Employees (and trade unions)

External users

1.6

Shareholders
Analysts
Creditors
Tax authorities
The public

For What Sort of Decisions Do these Users Value


Accounting Information?
All the users of company accounting information are faced with choices between
alternative courses of action. If they make decisions without adequate information
(which happens all too often), they are likely to find that their expectations are not
fulfilled.
Directors

1/6

Has the company been employing its resources in the most


effective way to maximise the profit earned for our shareholders? Is it maximising shareholder value?
Has the company been a good corporate citizen, i.e. have all
our industrial processes been friendly to the environment?
If not, how much is being spent on improving the flawed
processes?
Edinburgh Business School Accounting

Module 1 / An Introduction to Accounting and the Accounting Equation

Senior executives

Managers

Employees

Shareholders

Are we managing our money efficiently? For example, are


we confident that a subsidiary company in Australia is not
borrowing money at 20 per cent to fund an expansion when
the subsidiary in Japan is building up a cash balance in the
bank earning 12 per cent interest?
Is our manager-remuneration scheme sufficiently rigorous
to promote effort and commitment while at the same time
being competitive with other multinationals?
Would it be cheaper to make a component ourselves or buy
it in from an outside supplier?
Are all our lines profitable?
How much should we claim in the next wage round?
What are the security and prospects of employment in this
company?
Should we buy (or sell or hold) shares in this company?
How much dividend has been paid last year compared with
profits earned?

MBA provides a breakdown of its shareholders in 20x2 as follows.

Size of holding
1100
1011000
1001100 000
100 001250000
250 001500000
500 0011000000
Over 1 000000
All holdings

Number of
ordinary
shareholders
accounts
4770
41386
69002
475
275
187
335
116430

Number of
shares
(millions)
2
5
66
17
23
31
478
622

Percentage of
issued share
capital
0.3
0.8
10.6
2.7
3.7
5.0
76.9
100.0

The law recognises all shareholders as being equal, but note that the 335 shareholders (institutional investors like pension funds) who own over one million shares
each combine to own just under 77 per cent of the entire share capital, while the
4770 shareholders who each own fewer than 100 shares possess just 0.3 per cent on
this scale!

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Analysts

Creditors

Tax authorities

The public

Should we advise shareholders and potential shareholders


to buy, sell or hold shares in the company?
Is the performance of the company this year superior to
that of its competitors?
Should we advise a switch of holding to a company with a
more promising prospect?
Should we extend our credit to this company, or should we
press to recover our debts?
In the longer term will the company be able to supply us
with business?
How much tax can we expect to receive from the company?
Note that a multinational company will file tax returns in
every country in which it operates.
The public is a loose phrase that includes, inter alia,
environmental pressure groups and consumer groups. Such
parties ask a variety of questions, including ones directed at
a companys profitability, efficiency, contributions to
political organisations and transactions with overseas
governments.
Is the company fulfilling its obligations to society by, for
instance, minimising environmental pollution, or by abiding
by international guidelines for trading in Third World
countries?

Sound answers to these questions require accounting information, sometimes of


a most sophisticated kind.

1.7

Common Information Requirements among Users


Answers to all the questions above require knowledge of a companys profits and cash
position. Providing information about profitability and liquidity (the professional
jargon for cash position) is seen by many to be the goal of the accounting system.
Although the emphasis in this course will be on the informational requirements
of managers, a good manager should be concerned with all the questions posed by
all the interest groups set out above. He or she should be as concerned with
shareholder value as the shareholders, as aware of the companys debt-paying
abilities as the creditors and as sensitive to environmental matters as either the
directors or the external consumer lobby. The course is designed to assist the
manager in interpreting and understanding accounting information, not to instruct
him or her in how to prepare it. However, each manager should be familiar with the
basic mechanics of the accounting process before he or she tries to gain an appreciation of what the accounting numbers mean.

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Edinburgh Business School Accounting

Module 1 / An Introduction to Accounting and the Accounting Equation

1.8

The Accounting Equation


Before proceeding to a more detailed analysis of the concepts and objectives of
accounting, we will examine the accounting recording system, which produces
information on profits and cash.
The accounting recording system is based on the simple, not to say self-evident,
notion that all economic resources acquired by an entity must be funded from
somewhere. Entities do not simply acquire resources out of thin air: resources must
be provided by someone (usually the owner) in the first instance. Later, other people
such as creditors or banks may put up money to provide further resources for the
company.
The relationship between resources and the funds provided to acquire these
resources is expressed in accounting like this:
Assets = Owners equity + Liabilities

or
Assets Liabilities = Owners equity

This accounting equation underpins the entire accounting recording system. A


simple example will show how this equation works, by examining a series of actions
through a period of time. For illustration, we use the economic events associated
with an individual starting up in business rather than using the more complex world
of companies like MBA. But exactly the same accounting equation would be used to
record the activities of MBA or any company or partnership as the one we will
employ below.
Action 1

An individual commences his business on 1 January with 20000


cash. The accounting equation of the business would record:
= Owners equity 20000
Assets (Cash) 20 000

The amount of owners equity signifies the owners claim over the assets of the
enterprise. At the conclusion of this action, the individuals stake in the business is
worth 20000, represented by cash of 20000.
Action 2

Out of these cash resources he purchases plant and equipment for


12000. Only one side of the equation needs adjustment:
Cash 8000 + Plant
= Owners equity 20000
12000

Action 3

Inventories of raw materials are purchased on credit for 6000.


Cash 8000 + Plant
= Owners equity 20000 + Creditors
6000
12000 + Raw material
inventories 6000

Here we see an acquisition of another asset, inventories, financed by the suppliers


of the inventories. Eventually the business will have to pay this amount in cash; until
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Module 1 / An Introduction to Accounting and the Accounting Equation

it does, the creditors remain a liability. How much is the owner now worth? Still
20000, represented by assets totalling 26000 less 6000 owed to his creditors.
Action 4

500 worth of inventory is processed at a labour cost of 20 to


form finished goods inventory.
Cash 7980 + Plant
= Owners equity 20000 + Creditors
12000 + Raw material
6000
inventory 5500 +
Finished goods inventory
520

Here, the 20 cash spent on labour is assumed to add value to the raw material
inventory of 500, all of which the business would hope to recover in the eventual
selling price.
Action 5

The accountant, an employee of the business, is paid his wage of


10 in cash.
Cash 7970 + Plant
= Owners equity 19990 + Creditors
6000
12000 + Raw material
inventories 5500 +
Finished goods
inventories 520

It is important to distinguish between the wages paid to production workers in


Action 4 (which increase the value of the inventory to be sold) and those of an
administrative nature (which do not increase the value of assets and which do not
vary with output). This overhead is a charge against profits that have not yet been
earned, so it is deducted from the original capital in the interim. At the end of this
action the individuals stake in his business has been reduced by 10 to 19990.
When profit is made, it will be added to the owners equity.
Action 6

The entire finished goods inventory is sold for 750 on credit.


Cash 7970 + Plant
= Owners equity 20220 + Creditors
6000
12000 + Raw material
inventories 5500 +
Debtors 750

The finished goods inventory has been reduced to zero. The company has made
230 profit on this transaction, which increases the owners equity. An asset called
Debtors is created because cash has not yet been received for the sales. On its own
the above transaction looks like this:
Change in finished goods inventories (520) + Change in debtors (+750) =
Change in owners equity (+230)

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Module 1 / An Introduction to Accounting and the Accounting Equation

Action 7

3000 of the amount due to suppliers is paid along with an


advertising bill of 10.
= Owners equity 20210 +
Cash 4960 + Plant 12 000
Creditors 3000
+ Raw material inventories
5500 + Debtors 750

The payments to suppliers are a straightforward matter, reducing cash and creditors by the amount of 3000 paid over. The advertising bill is paid in cash too and
must reduce the owners equity this is an expense of being in business, just like the
accountants fee.
At this stage, or any earlier one for that matter, it is possible to determine the
profit made by comparing the owners equity at the beginning of the period under
review with the balance on the owners equity at the end of the period. If it has
increased, the owner has made a profit; if it has decreased, he has made a loss. In
the example the profit is 210 (20210 less 20000).
The accounting equation is a collection of balances after each transaction has
been completed and recorded. Note that the accounting entries involve a mixture of
cash-driven items and judgement-driven items. This equation can also be laid out in
a more meaningful fashion, called a balance sheet.
Students may find a spreadsheet approach to the accounting equation more flexible. A worked solution is also provided.

Action
1
2
3
4a
4b
5
6a
6b
7a
7b
Totals

Plant and
equipment

Raw
material
inventory

Finished
goods

0
Total assets:

0
0

Accounting Edinburgh Business School

Debtors

Cash

Owners
equity

Creditors

0
Equity & debt:

0
0

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Module 1 / An Introduction to Accounting and the Accounting Equation

Worked Solution

Action
1
2
3
4a
4b
5
6a
6b
7a
7b
Totals

1.9

Plant and
equipment

Raw
material
inventory

Finished
goods

Debtors

12000
6 000
500

Cash
20 000
12 000

Owners
equity
20 000

6000
500
20

20
10

520
750

5 500

Total assets:

23 210

12000

Creditors

750

10
520
750

3 000
10

10

3000

4 960

20 210
Equity &
debt:

3000
23 210

The Accounting Statements


Balance sheet at the end of Action 7

Assets
Cash
Plant and equipment
Inventories
Debtors

4 960
12 000
5 500
750
23 210

Owners equity

20210

Creditors

3000
23210

The layout of this balance sheet could be improved to give a clearer picture of
the financial position of the company at the end of Action 7:

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Non-current assets
Plant and equipment at cost
Current assets
Inventories
Debtors
Cash
Less: Current liabilities
Creditors
Net assets of the company
Represented by:
Capital introduced
Profits earned
Owners equity

12000

5500
750
4960
11210
3000

8210
20210

20000
210
20210

This layout highlights some fundamental points that should be noted.


1. The owners equity of a company is represented by the net assets (non-current
assets + net current assets) of the company; the original cash introduced by the
owners is consumed in the purchase of assets and in the trading activities for
which the company was set up. (NB: net current assets are defined as current
assets less current liabilities.)
2. Assets of the company can be split into non-current assets, which are of relatively
long life and are generally used in the production of goods and services rather
than being held for resale (some companies refer to non-current assets as fixed
assets), and current assets, which are either currently in the form of cash or are
close to being converted into cash within a short period of time, usually a year.
Current liabilities are those obligations that a company must meet, in cash, within a
short time, again usually one year.
The straight comparison of owners equity figures provides an arithmetically
accurate figure of profit, but it does not tell how that profit was made, i.e. how
many sales were recorded, what the cost of these sales was or what expenses were
incurred in the accounting period.
The detailed items that affected owners equity were:
Action
5
Accountants wage
6
Profit on sale of finished goods
7
Advertising bill
Net increase in equity

Accounting Edinburgh Business School

10
+230
10
+210

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An accounting statement, which is more meaningful than the accounting equation, is constructed. This accounting statement is called the income statement (or the
profit and loss account) for an accounting period:
Income statement for the period Actions 17

Sales
Less: Cost of sales

Materials
Labour

Gross profit
Less: Selling and administrative costs
Advertising
Salaries
Net profit

500
20

10
10

750
520
230

20
210

As can be seen, profit is simply the excess of sales revenue over costs incurred in
generating the revenue. Items of expenditure accounted for via the income statement we call revenue expenditure; items of expenditure accounted for via the balance
sheet we call capital expenditure. In the example the income statement has been
created from the preceding data relatively easily. However, this procedure can
become very complex in a multi-product, multi-plant company engaging in thousands of transactions daily. Accountants have therefore devised a continuous
recording system based on the double-entry procedure encountered in the
previous section which eliminates the need to calculate the effect on profit and
owners equity after every transaction but which will continue to provide the useful
information in income statement format whenever it is required. These detailed
procedures of bookkeeping are the job of the accountant, not of the manager.
So far the two accounting statements have produced information on:
(a) the profitability of the company for the seven actions listed; and
(b) the financial position of the business at the end of Action 7.
Neither statement, however, reveals anything about the cash position, which is
important to many users of financial information:
Directors
Senior executives
Managers
Employees
Shareholders
Creditors
Tax authorities

Money spent on major process improvements


Cross-national money switching
Cash saved in buying in components
Wage increases
Dividends
Payment of debts
Payment of taxes

Profit is not the same as cash. There are many reasons for this: one such reason
can be readily understood by considering the nature of the sales figure of 750,
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which gives rise to the reported profit. The business has not received payment for
the sales at the time the income statement is drawn up, but, provided the owner
believes the debtors will pay the amount shortly, it is an accounting convention that
recognises this figure as if the money has been received when calculating profit.
Also, depreciation is a deduction from sales revenue before profit is determined but
has no effect on cash.
A third accounting statement, the cash flow statement, portrays only those economic
events of a business that affect cash flows. For the example above the cash flow
statement would be as follows:
Cash flow statement for the period to Action 7

Net profit
Changes in working capital:
Increase in debtors
Increase in inventories
Increase in creditors
Cash from operating activities

750
5500
+3000

210

3250
3040

Purchase of non-current assets


Cash from investing activities

12000
12000

Equity injection from owners


Cash from financing activities

20000
20000

Change (increase) in cash between Actions 1 and 7

4960

The figure of 4960 can be checked by subtracting the balance of cash at the end
of Action 7 (4960) with the opening balance of cash (0) when the business
started.
Note the following points.
1. The first source of cash should always be the operations of the business. (If it is
not so, then sooner rather than later the business will go bust!) In a start-up situation, such as in the example, the main source of cash is usually by way of
original capital injection or by bank borrowings.
2. The profit figure is the most useful starting point for determining the amount of
cash generated by operations. Changes in working capital are then calculated.
Working capital is the cash required to keep a business running until the customers pay for the goods and services they have received. Working capital typically
comprises debtors, creditors and inventories.
3. An increase of creditors is a source of cash. For the short period the business is
owing the money, it is able to use the money for other business purposes. Therefore the businesss creditors can be seen to provide cash to the business.
4. The reverse is true with the increase in debtors. When customers dont pay cash
for goods and services, this weakens the financial state of the business for a
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short period. The business is therefore paying out cash to support its credit customers businesses for a short period of time. Similarly, with inventories, if a
company builds its inventory levels during a period it consumes cash to do so.
5. The significance of the cash flow statement is that it breaks down the accounting
conventions that separate economic events into either the balance sheet or the
income statement. Cash is cash whether the event affects the balance sheet or
the income statement. In another situation a company can report healthy profits
in the income statement but the cash flow statement can reveal a rapidly deteriorating liquidity position.
6. Despite the emphasis on the income statement and balance sheet, many managers and analysts consider the cash flow statement to be equally informative.
Note that the layouts of the cash flow statement above, and the income statement and balance sheet before it, are skeletal and simplistic. Readers will be guided
through more realistic layouts of the three financial statements in the next three
modules.

DIY Example
For each action for Forth Enterprises below you should construct the accounting equation that reflects the transaction(s). At the end of Action 12 draw up a
balance sheet, income statement and cash flow statement, adopting the layouts
given in the text.
Students may find a spreadsheet format useful instead of writing out a fresh
accounting equation each time. A pro forma spreadsheet with all relevant
accounting headings inserted is laid out at the end of this example.
Action 1
Fred Forth commences business with 40000 from his own savings and a
further 10000 cash from his cousin as a loan. His cousin informs Forth that he
is not looking for interest or early repayment.
Action 2
Forth buys the following assets: plant and equipment 5000 cash, factory and
warehouse 25000 cash, and raw materials 8000 (half by cash, half by credit).
Action 3
Before the equipment can function properly, it requires a post-installation
lubrication costing 200. Forth pays for this in cash. Raw materials worth 4000
are then processed into finished goods at a labour cost of 400.
Action 4
Forth pays his creditors in full and sells half of the finished goods (recorded at
cost of 2200) for 4000 credit.
Action 5
Forth buys a second-hand delivery van for 3000 on credit and a desktop
computer for his secretary for 200 cash.

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Action 6
Forth sells the remainder of the finished goods (recorded at a cost of 2200)
for 4000 cash, and receives payment of 3900 from his earlier debtors.
Action 7
The delivery van breaks down and requires 100 of repairs, which Forth pays
for in cash. He buys further raw materials for 6000 cash and processes the
remainder of his first batch of raw materials (which had cost 4000) at a cash
cost for labour of 300.
Action 8
At Christmas, Forth buys his wife a food mixer costing 100 and his secretary a
designer evening gown costing 1200. He pays for both items using his personal
credit card.
Action 9
He sells his second batch of finished goods (which are recorded at a cost of
4300) for 6000, receiving half of the money in cash and giving credit for the
other half. He pays off his creditors.
Action 10
Forth pays 400 cash for advertising and 200 cash for audit fees; he also has all
his raw materials (cost 6000) processed, his labour force incurring 1000
wages in so doing.
Action 11
His auditors advise him that he should write off the debt of 100 that has been
outstanding since Action 4; in their opinion this debt is now irrecoverable.
Action 12
Forth considers that one-fifth of his factory and warehouse space is excessive for
his needs; he sells that part for 7000 in cash. He withdraws 3000 in cash for
personal needs.

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Module 1 / An Introduction to Accounting and the Accounting Equation


Action

F&W

P&E

MV

RMI

FGI

Total assets:

Debtors

Cash

OE Creditors

LTL

1
2
3a
3b
3c
4a
4b
4c
5a
5b
6a
6b
6c
7a
7b
7c
7d
8
9a
9b
9c
10a
10b
10c
10d
11
12a
12b
12c
Totals

Owners equity
and debt:

F&W = Factory and warehouse; P&E = Plant and equipment; MV = Motor vehicle; RMI = Raw material inventory;
FGI = Finished goods inventory; OE = Owners equity; LTL = Long-term loan.

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Worked Solution
Action 1
Cash 50000 = Owners equity (OE) 40000 + Long-term loan (LTL) 10000.
Action 2
Plant and equipment (P&E) 5000 + Factory and warehouse (F&W) 25000 +
Raw material inventory (RMI) 8000 + Cash 16000 = OE 40000 + LTL
10000 + Creditors 4000.
Action 3
P&E 5200 + F&W 25000 + RMI 4000 + Finished goods inventory (FGI)
4400 + Cash 15400 = OE 40000 + LTL 10000 + Creditors 4000.
Note that the post-installation lubrication has been capitalised. We can gather
from the action that the equipment would not work without this lubrication,
and so we can add this cost to the original purchase price. Any further maintenance on this equipment would be expensed, i.e. written off against owners
equity.
Action 4
P&E 5200 + F&W 25000 + RMI 4000 + FGI 2200 + Debtors 4000 +
Cash 11400 = OE 41800 + LTL 10000 + Creditors 0.
Action 5
P&E 5400 + F&W 25000 + Motor vehicles (MV) 3000 + RMI 4000 + FGI
2200 + Debtors 4000 + Cash 11200 = OE 41800 + LTL 10000 +
Creditors 3000.
Action 6
P&E 5400 + F&W 25000 + MV 3000 + RMI 4000 + FGI 0 + Debtors
100 + Cash 19100 = OE 43600 + LTL 10000 + Creditors 3000.
Action 7
P&E 5400 + F&W 25000 + MV 3000 + RMI 6000 + FGI 4300 + Debtors
100 + Cash 12700 = OE 43500 + LTL 10000 + Creditors 3000.
Action 8
No change from Action 7. This action represents personal expenditure and
does not affect Freds business records.
Action 9
P&E 5400 + F&W 25000 + MV 3000 + RMI 6000 + FGI 0 + Debtors
3100 + Cash 12700 = OE 45200 + LTL 10000 + Creditors 0.
Action 10
P&E 5400 + F&W 25000 + MV 3000 + RMI 0 + FGI 7000 + Debtors
3100 + Cash 11100 = OE 44600 + LTL 10000.
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Module 1 / An Introduction to Accounting and the Accounting Equation

Action 11
P&E 5400 + F&W 25000 + MV 3000 + FGI 7000 + Debtors 3000 +
Cash 11100 = OE 44500 + LTL 10000.
Action 12
P&E 5400 + F&W 20000 + MV 3000 + FGI 7000 + Debtors 3000 +
Cash 15100 = OE 43500 + LTL 10000.

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Action

F&W

P&E

25000

5000

MV

RMI

FGI

Debtors

1
2
3a

Cash

OE

50000

40000

34000

8000

200
4000

3c

10000
4000

4000
400

400

4a

4000

4b

4000

4c

4000
4000

2200

2200

3000

5b

LTL

200

3b

5a

Creditors

3000

200

200

6a

4000

6b

2200

6c

3900

7a

3900
100

7b

6000

7c

4000

7d

4000
2200
100

6000
4000
300

300

8
9a

3000

9b

3000

10a
10b
10c

6000

10d

400

200

200

1000

1000
100

12a

100
7000

5000

7000
5000

12c
20000

3000

400
6000

11

Totals

6000
4300

9c

12b

3000

4300

5400
Total
assets:

Accounting Edinburgh Business School

3000
53500

7000

3000

3000

3000

15100

43500

10000

Owners equity and debt:

53500

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Module 1 / An Introduction to Accounting and the Accounting Equation

Income statement for the period to Action 12

Sales
Less: Cost of sales

Raw materials
Labour

8 000
700

Gross profit

14000
8700
5300

General expenses

Motor repairs
Advertising
Bad debt
Audit
Net profit from operations
Profit from sale of factory (see note)

100
400
100
200

Net profit

800
4500
2000
6500

Note: The sale of a non-current asset produces a gain (or loss) when the
proceeds received by the business exceed (or are less than) net book value
that is, purchase price less depreciation charged to date. Such gains (or losses)
are not part of the normal profits from operations and should be shown
separately in the income statement.
Balance sheet at the end of Action 12

Non-current assets
Factory and warehouse
Plant and equipment
Motor vehicles
Current assets
Finished goods
Debtors
Cash
Less: Current liabilities

7 000
3 000
15 100

20 000
5 400
3 000

28400

25 100

25100

Net assets of the company


Represented by:
Capital introduced
Profit

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53500

Less: Drawings

40 000
6 500
46 500
3 000

Owners equity
Long-term loan

43 500
10 000

53500

Edinburgh Business School Accounting

Module 1 / An Introduction to Accounting and the Accounting Equation

Cash flow statement for the period to Action 12

Net profit from operations


Changes in working capital:
Increase in inventories (07 000)
Increase in debtors (03 000)
Cash from operating activities
Purchase of non-current assets
Sale of surplus factory space
Cash from investing activities

1.10

7000
3000

4500

10000
5500

33400
7000
26400

Equity injection from investors


Less drawings

40000
3000

Long-term loan

37000
10000

Cash from financing activities

47000

Change in cash during the year (015100)

15100

Sole Trader versus MBA


Businesses can be set up in a number of forms. Each is different, but all use the
same accounting equation.

1.10.1

Sole Trader
A sole trader like the individual in the example (Actions 1 to 7) can start trading at any
time with assets at his disposal. He must, however, distinguish between the transactions that pertain to his business and those that are domestic in nature. For example
he would record as business expenditure petrol for his delivery van, but his weekly
groceries would not go through his books of account. The link between the two
would be the drawings or salary he paid himself out of the business profits.
In law he has unlimited liability. This means that, if a customer or supplier or
other person connected with his business sues him for poor workmanship or
providing goods that are dangerous, not only are his business assets at risk but so
too are his personal assets, such as his home and domestic possessions. Because his
creditors can pursue him beyond the limit of his business, there is no requirement
for him to make public his income statement and balance sheet each year. He will,
of course, make an annual tax return to the tax authorities and be taxed on his yearly
profit.

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Module 1 / An Introduction to Accounting and the Accounting Equation

1.10.2

Partnership
A partnership is very similar to the situation of a sole trader. Here a number of
individuals agree to set up business together, bringing to the partnership assets in
varying proportions. Before they start trading, they will normally draw up a partnership agreement that sets out, inter alia, how they will share the annual profit. As
with the sole trader, a partnership need not make public its annual results, because
its creditors can pursue the partners beyond the limit of their equity in the partnership. Some worldwide accounting partnerships are facing legal actions from clients
that, if successful, may put in jeopardy the continuance of the partnerships. One
such firm, Arthur Andersen, has already gone out of business over its work with
Enron. Various defences are currently being mounted by the Big Four accounting
firms, including pressing governments to permit proportional liability and limited
liability partnerships.

1.10.3

Company
A company structure avoids the risk of unlimited liability described above by limiting
the liability of the owners (called shareholders) to the amount of equity (called share
capital) paid into the company. In the event of legal action being taken against the
company, shareholders cannot lose any more money than the sum paid for the
shares (provided the full face value of the shares has been called up by the company).
To protect creditors and others against abuse of this legal privilege, companies
must make public their annual accounts, which must be audited by a registered firm
of auditors. This is an expensive procedure and forces disclosure of business
activities, which sole traders and partnerships do not experience.
A companys owners equity is termed share capital and is split into individual
shares usually expressed in small units of, say, 1. This small amount is the face
value of the share, called the par value, or nominal value (MBAs nominal value is 1).
When a company grows in size and number of shareholders, its accounting equation
is unaffected by any market transaction in its shares, even though the price struck
between buyer and seller is considerably in excess of par value. The company still
has access to the original paid-in capital.

1.11

Accounting: The External and Internal Functions


The accounting statements depicted in the previous section report the total picture
of the firm for an accounting period: total sales, total costs, total profits and total
asset structure. This information is compiled after the accounting period is over and
the books of account have been closed. This part of accounting is called financial
accounting or financial reporting and derives from the legal obligation on directors and
managers to report to the owners of the business (the shareholders) how they have
used the resources at their disposal during the accounting period under review
(usually annual).

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Edinburgh Business School Accounting

Module 1 / An Introduction to Accounting and the Accounting Equation

Most of the needs of the users described earlier are largely satisfied by the information contained in financial accounts. One major exception is managements
needs. While financial reporting and an analysis of financial accounts are important
for managers for a variety of decisions they have to make, the information contained therein is of little value in helping them to plan and control the day-to-day
activities of the business. The secret of good management lies in predicting the
future, in plotting a course today that will steer the business through the turbulent
seas of uncertainty lying ahead. To enable them to do this, management need
detailed and relevant information. From the accounting process they need actual
and projected costs and prices of individual products; actual and projected costs of
individual departments and individual processes; projected sources and uses of cash;
proposals for major investment in plant and equipment; and many other details.
This information is called management accounting.
The first seven modules of this course are devoted to financial accounting for
managers; the following nine modules address management accounting for decision
making.

1.12

Accounting Principles
The construction of financial statements is not just governed by preparers decisions
on which account to increase or decrease. There are overriding principles that
accountants must work within. It is too early to introduce these at this time
Module 1 is complex enough! but readers might like to look at Section 5.18 for a
quick preview.

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Review Questions
Multiple Choice Questions

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1.1

There are several views of the role of accounting.


i. Accounting provides information for decision makers.
ii. Accounting demands a high degree of mathematical precision.
iii. Accounting handles only economic information.
iv. Accounting requires only the mastery of a strict set of rules.
Which of the following is correct?
A. (i) and (ii) only.
B. (i) and (iii) only.
C. (ii) and (iv) only.
D. (iii) and (iv) only.

1.2

Accounting information is used by different groups of people for different primary


purposes. They are
i. shareholders concerned with the level of employee remuneration;
ii. managers concerned with the profitability of product lines;
iii. creditors concerned with the companys ability to settle debts on time;
iv. analysts concerned with the companys environmental record.
Which of the following is correct?
A. (i) and (ii) only.
B. (i) and (iv) only.
C. (ii) and (iii) only.
D. (ii) and (iv) only.

1.3

Which of the following reflects the effects on the accounting equation of a payment to
creditors?
A. Assets decrease; owners equity decreases.
B. Assets decrease; owners equity increases.
C. Assets increase; liabilities decrease.
D. Assets decrease; liabilities decrease.

1.4

Which of the following reflects the effect on the accounting equation of a sale of finished
goods inventory, on credit?
A. Assets decrease; owners equity unchanged.
B. Assets decrease; owners equity increases.
C. Assets increase; owners equity increases.
D. Assets increase; owners equity decreases.

Edinburgh Business School Accounting

Module 1 / An Introduction to Accounting and the Accounting Equation

1.5

Which of the following reflects the effect on the accounting equation of a purchase of an
item of plant, for cash?
A. Assets increase; owners equity decreases.
B. Assets unchanged; owners equity increases.
C. Assets decrease; owners equity unchanged.
D. Assets unchanged; owners equity unchanged.

1.6

Which of the following economic actions reduces the amount of owners equity?
A. A payment of administration wages.
B. A receipt of cash from debtors.
C. A receipt of a loan from the owners brother.
D. A payment for production wages.

1.7

Which of the following economic actions increases the amount of owners equity?
A. A purchase of raw material inventory, on credit.
B. A sale of finished goods, on credit.
C. A payment for a motor vehicle.
D. A payment to creditors.

1.8

Which of the following economic actions increases the amount of current assets?
A. A receipt of cash from debtors.
B. A purchase of raw material inventory, on credit.
C. A purchase of raw material inventory, for cash.
D. A payment to creditors.

1.9

Which of the following economic actions decreases the amount of current assets?
A. A payment for production wages.
B. A purchase of plant, on credit.
C. A purchase of plant, for cash.
D. A receipt of cash, from debtors.
The following information applies to Questions 1.10 to 1.22.
Action 1
T. Harding & Co. has commenced business with a start-up cash balance of 15000,
comprising the initial owners equity. His first action is to purchase a van, costing 5000,
for cash; he then acquires 8000 of raw materials inventory, on credit.

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Module 1 / An Introduction to Accounting and the Accounting Equation

1.10 What is the amount of current assets after Action 1?


A. 5000.
B. 8000.
C. 15000.
D. 18000.
1.11 What is the amount of owners equity after Action 1?
A. 10000.
B. 15000.
C. 23000.
D. 28000.
Action 2
Plant is purchased at a cost of 4000, on credit, and 200 is paid in wages to the
production staff for the conversion of the raw materials into finished goods inventory,
half of which is sold for cash of 7000.
1.12 What is the amount of cash after Action 2?
A. 8800.
B. 16800.
C. 21800.
D. 24800.
1.13 What is the amount of non-current assets after Action 2?
A. 4000.
B. 5000.
C. 9000.
D. 24000.
1.14 What is the amount of owners equity after Action 2?
A. 17900.
B. 22000.
C. 27000.
D. 29900.
Action 3
Payment of 5000 is made to creditors. The van breaks down, incurring repair costs of
350, paid for in cash.

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Edinburgh Business School Accounting

Module 1 / An Introduction to Accounting and the Accounting Equation

1.15 What is the amount of finished goods inventory after Action 3?


A. 3700.
B. 4100.
C. 4500.
D. 4850.
1.16 What is the amount of non-current assets after Action 3?
A. 4350.
B. 8650.
C. 9000.
D. 9350.
1.17 What is the amount of owners equity after Action 3?
A. 12 550.
B. 12 900.
C. 17 550.
D. 18 250.
Action 4
The remaining finished goods inventory is sold for 8500, on credit. Payments of
administration wages of 500 are made, together with a further 2000 to creditors.
1.18 What is the amount of cash after Action 4?
A. 8950.
B. 9350.
C. 17 050.
D. 22 450.
1.19 What is the amount of owners equity after Action 4?
A. 12 950.
B. 21 450.
C. 21 950.
D. 25 550.
1.20 What is the amount of current assets after Action 4?
A. 17 050.
B. 17 450.
C. 17 650.
D. 18 000.

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Module 1 / An Introduction to Accounting and the Accounting Equation

1.21 What is the amount of creditors after Action 4?


A. 1000.
B. 3000.
C. 5000.
D. 7900.
1.22 If an income statement were to be prepared at the end of Action 4, what should be the
amount of sales?
A. 7000.
B. 8200.
C. 8500.
D. 15500.
1.23 Which of the following is equal to owners equity?
A. Current assets + Current liabilities.
B. Non-current assets + Current assets.
C. Non-current assets + Current liabilities.
D. Non-current assets + Net current assets.
1.24 Which of the following defines gross profit in a manufacturing company?
A. Sales less Selling costs.
B. Sales less Material costs.
C. Sales less Cost of sales.
D. Sales less Administrative costs.
1.25 Which of the following should be the primary source of cash in the preparation of a
cash flow statement?
A. Profit from operations.
B. Decrease in debtors.
C. Increase in creditors.
D. Introduction of capital.
1.26 In which of the following is owners equity divided into individual shares with a nominal
value?
A. A university.
B. A partnership.
C. A company.
D. A sole trader.

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Case Study 1.1


Peter Brown opened his business for trading on 1 January with 25000 cash from his
own resources. During his first six months of trading, the following economic actions
occurred.
1. Paid six months rent of 2000 for the premises.
2. Purchased equipment for 10000 and an estate car for 6000.
3. Acquired 8000 of manufacturing materials, on credit, half of which was paid in June.
4. Paid 2000 in manufacturing wages in converting 75 per cent of the materials into
finished goods.
5. Sold 60 per cent of the finished products for 12000, of which only 7500 was
received in cash.
6. Paid 600 for office staff wages and 300 for petrol.
Required
1

Prepare the accounting equations after each of these economic actions.

Prepare an income statement for the six months to 30 June and a balance sheet as at
that date.

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