CONSTRUCTING FINANCIAL STATEMENTS

CHAPTER AND THE FRAMEWORK OF ACCOUNTING

THREE
DISCUSSION POINTS:
 Conceptual Framework for Financial Reporting
 Reporting profitability: The Income Statement.
 Reporting financial position: The Balance
Sheet.
 Reporting cash flow: The Cash Flow
Statement.
 Accruals accounting.
 Depreciation
 Working capital.
 Managing receivables.
 Managing inventory.
 Managing payables.
1
3.1. Conceptual Framework for Financial Reporting
• Financial statements are prepared and presented by many
entities around the world.
• Although such financial statements may appear to be similar
from country to country, there are differences that have
probably been caused by a variety of social, economic, and legal
circumstances and by each country having to consider the needs
of different users of financial statements when setting national
requirements.
• These different circumstances have led to the use of
a variety of definitions of the elements of financial
statements, such as assets, liabilities, equity, income, and
expenses.
different criteria for the recognition of items in the financial
statements and in different bases of measurement.
• The scope of the financial statements and the disclosures made
in them have also been affected. 2
• The purpose of the Conceptual Framework is to narrow the
differences outlined above by seeking to harmonize regulations,
accounting standards, and procedures relating to the
preparation and presentation of financial statements.
• The Conceptual Framework is used when an accounting policy is
needed and there is no appropriate standard to choose.
• A conceptual framework can be defined as a system of ideas
and objectives that lead to the creation of a consistent set of
rules and standards.
• Conceptual Framework establishes the concepts that underlie
financial reporting.
• There is a move towards the harmonization of accounting
standards between countries through the work of the
International Accounting Standards Board (IASB).
• A Conceptual Framework enables IASB to issue more useful and
consistent pronouncements over time.
• All IFRS are based on the Conceptual Framework. 3
• The Conceptual Framework sets out the concepts underlying
the preparation and presentation of financial reports for
external users such as existing and potential investors, lenders,
and other creditors; however, financial statements can also be
used by employees, customers, governments and their agents,
and by the public in general.
• Importantly, management is not defined as a user in terms of
financial reports. This is because management has the ability to
determine the form and content of additional information to
meet its needs.
• The Conceptual Framework deals with
1) The objectives of financial reporting
2) The qualitative characteristics of useful financial
information
3) The definition, recognition, and measurement of the
elements from which financial statements are constructed
4
Three levels of conceptual frame-work:

First Level = Basic objective of financial reporting

Second Level = Qualitative characteristics and

elements of financial statements

Third Level = Recognition, measurement, and

disclosure concepts

5
 3.2.1. Objectives Of Financial Statements
• The objective of financial reporting is to provide financial
information about the reporting entity that is helpful to the users in
making decisions about providing resources to the entity (that is,
“decision usefulness”). Those decisions involve buying, selling, or
holding equity and debt instruments, and for providing or settling
loans and other forms of credit.
• Many existing and potential investors, lenders, and other creditors
cannot require that reporting entities provide information directly to
them and must rely on financial statements for much of the financial
information they need. Consequently, they are the primary users to
whom financial statements are directed.
• Financial statements are not designed to show the value of a
reporting entity, but they provide information to help existing and
potential investors, lenders, and other creditors to estimate its value.
• The financial statements also show the results of the stewardship or
accountability of managers for the resources entrusted to them by
shareholders.
6
• A complete set of financial reports includes
• Statement of financial position: to show information about
financial position of a firm.
• Statement of comprehensive income: to indicate about
performance of a firm over a period of time
• Statement of changes in shareholders' equity: shows
changes in shareholders' equity that can provide information
on how the shareholders' funds changed during a specific
period
• Statement of cash flows: shows how much cash flowed into
and out of the company during a specific period
• Notes to the financial statements: contain explanatory notes
and further details about the amounts in the financial
statements

7
 Objective Of Financial Reporting
“To provide financial information about the reporting entity
that is useful to present and potential equity investors, lenders,
and other creditors in making decisions in their capacity as
capital providers.”

 Provided by issuing general-purpose financial statements.

 Assumption is that users have reasonable knowledge of business
and financial accounting matters to understand the information.

8
3.2.2. Qualitative Characteristics of Financial Statements

• IASB identified the Qualitative Characteristics of accounting

information (fundamental and enhancing) that distinguish
better (more useful) information from inferior (less useful)
information for decision-making purposes.
• The qualitative characteristics that make the information useful
to users are the following:
1. Relevance. Information must be relevant to the decision-making
needs of users.
• Relevant financial information can make a difference in the
decisions made by users if it has predictive value, confirmatory
value, or both.

9
Relevance is one of the two fundamental qualities that make
accounting information useful for decision-making.

10
• Financial information has predictive value if it can be used to
predict future outcomes, and it need not be a prediction or
forecast to have predictive value. Financial information with
predictive value is employed by users in making their own
predictions.
• Financial information has confirmatory value if it provides
feedback about (confirms or changes) previous evaluations.
Information that has predictive value often also has
confirmatory value. For example, the current year's revenue
information can be compared to previous years' revenue
predictions, and it can be used to predict the revenue of future
years.
• The relevance of information is affected by its nature and
materiality. Information is material if its omission or
misstatement could influence the economic decisions of users
made on the basis of financial reports.
11
2. Faithful Representation: it means that the numbers and
descriptions match what really existed or happened.
• To be represented faithfully, it is necessary that transactions
are accounted for and presented in accordance with their
substance and economic reality.
• To be useful and reliable, financial information must be
faithfully represent the events that it purports to represent.

12
• Complete refers to the fact that the financial statements
include all necessary descriptions and explanations to make
them useful for the user.
• Neutral means that the financial information is not slanted or
manipulated to increase the probability that it will be received
favourably or unfavourably.
• Free from error does not mean that the information is perfectly
accurate in all respects. It means there are no errors or
omissions in the information and the process used to produce it
has been applied with no errors.

13
Enhancing Qualities: Distinguish more-useful information from
less-useful information.

14
1.Comparability. Users must be able to compare the financial
reports of an entity through time and also able to compare the
financial reports of different entities in order to evaluate their
relative financial position, performance, and changes in financial
position.
• Measurement and presentation must therefore be consistent
throughout an entity and over time.
• It is important that users be informed of the accounting
policies employed in the preparation of financial reports, any
changes in those policies, and the effects of those changes.
• It is not appropriate for an entity to leave its accounting
policies unchanged when more relevant and reliable
alternatives exist, but corresponding information for the
preceding period is essential for comparability.

15
2.Verifiability. It means that different knowledgeable and
independent observers could reach consensus, although not
necessarily a complete agreement, that a particular depiction is
a faithful representation.
3.Timeliness. It means having information available to decision
makers in time to be of value in influencing their decisions.
• Generally, older information is less useful, and it may lose its
relevance and reliability if there is undue delay in reporting.
4.Understandability. Financial information is understandable if it
is classified, characterized, and presented in a clear format.
• Users are assumed to have a reasonable knowledge of
business, economic activities, and accounting and are
assumed to analyze the information diligently.

16
 3.2. Elements Of Financial Statements
• Financial statements portray the financial effects of transactions by grouping
them into broad classes according to their economic characteristics.
• These broad classes are financial report elements. The elements related to
the measurement of financial position in the statement of financial position
are assets, liabilities, and equity, and those related to the measurement of
performance in the statement of comprehensive income are income and
expenses.
• The Conceptual Framework for Financial Reporting defines these elements
as follows:
1. Assets. An asset is a resource controlled by the entity as a result of past
events and from which future economic benefits are expected to flow to
the entity.
2. Liabilities. A liability is a present obligation of the entity arising from past
events, the settlement of which is expected to result in an outflow from the
entity of resources embodying economic benefits.
3. Equity. Equity is the residual interest of the shareholders in the assets of
the entity after deducting all of its liabilities.
17
4. Income. Income is increases in economic benefits during
the accounting period in the form of inflows or enhancements
of assets or decreases of liabilities, other than those relating
to contributions from shareholders, that result in increases in
equity.
• Income is, in other words, the value of sales of goods or
services produced by the business.
• The definition of income includes both revenue and gains.
• Revenue arises in the ordinary course of business (for
example, sales, fees, interest, dividends, royalties, and
rent). Gains represent other items, such as income from the
disposal of non-current assets or revaluations of
investments, and are usually disclosed separately in the
financial reports.

18
5. Expenses. Expenses are decreases in economic benefits during
the accounting period in the form of outflows or depletions of
assets or incurrences of liabilities that result in decreases in equity,
other than those relating to distributions to shareholders.
• Put simply, expenses are all of the costs incurred in buying,
making, or providing goods or services, and all the marketing and
selling, production, distribution, human resource, IT, financing,
administration, and management costs involved in operating the
business.
• The definition of expenses includes expenses that arise in the
ordinary course of business (for example, salaries and
advertising) as well as losses.
• Losses represent other items such as those resulting from
disasters such as fire and flood, the disposal of non-current
assets, or losses following from changes in foreign exchange
rates.
• Losses are usually disclosed separately in the financial reports.
19
 3.3. Recognition, Measurement And Disclosure Concepts of
the Elements of Financial Statements

• Recognition is the process of incorporating into the statement of

financial position or statement of comprehensive income an item
that meets the definition of an element.
• Recognition involves depiction of an item in words and a monetary
amount, and the inclusion of that figure in the statement of
financial position or statement of comprehensive income totals.
• An item that meets the definition of an element should be
recognized if both of the following are true:
1) It is probable that any future economic benefit associated
with the item will flow to or from the entity.
2) The item has a cost or value that can be measured with
reliability.
• An item that has the characteristics of an element but does not
meet these criteria for recognition may warrant disclosure in a note
to the financial reports.
20
• Measurement is the process of determining the monetary
amounts at which the elements of the financial reports are to
be recognized and carried in the statement of financial position
and statement of comprehensive income.
• There are four bases of measurement:
1) Historical cost. Assets are recorded at the cash or fair value
consideration given at the time of their acquisition.
2) Current cost. Assets are carried at the cash value that would
have to be paid if the same or equivalent assets were acquired
currently.
3) Realizable value. Assets are carried at the cash value that could
currently be obtained by selling the assets.
4) Present value. Assets are carried at the present discounted
value of the future net cash inflows that the assets are
expected to generate.

21
• Different elements of the financial statements are measured
at different costs. Some common examples follow:
 Property, plant, and equipment are normally shown at
historical cost, although they can sometimes be shown
at a revaluation value.
 Accounts receivable and payable are shown at fair
market value.
 Inventories are usually carried at the lower of cost and
net realizable value.
 Marketable investments may be carried at market value.
 Non-current liabilities are normally shown at present
value.

22
3.5. Reporting Profitability: The Statement of
Comprehensive Income
• Businesses exist to make a profit. Thus, the basic accounting concept
is that Profit = Income − Expenses
• If expenses exceed income, the result is a loss.
• The profit (or loss) of a business for a financial period is reported in a
statement of comprehensive income.
• Exhibit 3.1 Sample Statement of Comprehensive Income
•

23
• Business profitability is determined by the matching principle—
matching income earned with the expenses incurred in earning
that income.
• In both financial accounting and management accounting, we
distinguish between gross profit and operating (or net) profit.
• Gross profit is the difference between the selling price and the
purchase (or production) cost of the goods or services sold. Using
a simple example, a retailer selling baked beans may buy each can
for 50 cents and sell it for 80 cents. The gross profit is 30 cents per
can.
• Gross profit = Sales − Cost of goods sold
• COGS = Beginning Inventory + Purchases During the Period – Ending Inventory
• Gross margin is gross profit expressed as a percentage of sales. So
in our baked beans example, the gross margin is 37.5% (30
cents/80 cents).
• The cost of goods sold is the cost of one of the following:
 Providing a service
 Buying goods sold by a retailer 24
• The matching principle requires that the business adjusts for
increases or decreases in inventory—goods bought or
produced for resale but not yet sold.
• It is, therefore, the cost of goods sold, not the cost of goods
produced, that is recorded as an expense in the statement of
comprehensive income.
• Expenses deducted from gross profit will include all of the
other costs of the business, such as selling, administration,
and finance; that is, costs not directly concerned with buying,
making, or providing goods or services but supporting that
activity. The same retailer may treat such items as the rent of
the store, the salaries of employees, and distribution and
computer costs as expenses in order to determine the
operating profit.
• Operating profit = Gross profit − Expenses
25
• The operating profit is one of the most significant figures
because it represents the profit generated from the ordinary
operations of the business.
• It is also called net profit, profit before interest and taxes
(PBIT), or earnings before interest and taxes (EBIT).
• From operating profit, a company must pay interest to its
lenders, income tax to the government and a dividend to
shareholders (for their share of the profits, as they—unlike
lenders—do not receive an interest amount for their
investment).
• The statement of comprehensive income can also stop at
profit after taxes, or net profit.
 In such cases, the dividends paid and the balance of retained
earnings are shown in the statement of changes in
shareholders' equity.

26
 Exhibit 3.2 Sample Statement of Comprehensive Income (extended)

• .

27
 3.6.Reporting Financial Position: The Statement of
Financial Position
• The second financial statement is the statement of financial
position. This shows the financial position of the business—its
assets, liabilities, and equity—at the end of a financial period.
• Some business payments are to acquire assets in order to
produce goods or services that are capable of satisfying
customer needs.
• The statement of financial position has to distinguish between
current and non-current assets. An entity must classify an asset
as current when
It expects to realize the asset, or intends to sell or consume
it, in its normal operating cycle or within 12 months after the
reporting period, whichever is the longest.
It holds the asset primarily for the purpose of trading.
The asset is cash or a cash equivalent.

28
• Current assets include money in the bank, accounts receivable
(sales to customers on credit, but unpaid), and inventory (goods
bought or manufactured, but unsold).
 The word current in accounting means 12 months, so current assets are those
that will change their form during the next year.
• Non-current assets are all assets that are not current.
 assets do not normally change their form in the ordinary course of
business; as infrastructure, they have a longer-term role.
 Physical form is not essential.
 Non-current assets are things that the business normally keeps for
longer than one year and uses as part of its infrastructure.
• There are two types of noncurrent assets: tangible and intangible.
 Tangible assets comprise those physical assets that can be seen and
touched, such as buildings, machinery, vehicles, and computers. These
are generally referred to as property, plant, and equipment.
 Intangible assets comprise non-physical assets, such as customer
goodwill or a business's intellectual property; for example its ownership
of patents and trademarks.
29
• Sometimes assets are acquired or expenses incurred without paying for
them immediately. In doing so, the business incurs liabilities, debts that
the business owes.
• Current liabilities include accounts payable (purchases from suppliers on
credit, but unpaid), loans due to be repaid, and amounts due for taxes.
Just as for assets, the word current means that the liabilities will be repaid
within 12 months. Current liabilities also form part of working capital.
• Working capital refers to the net current assets or liabilities; that is,
current assets less current liabilities. This is an important number as it
gives an indication of the current assets that will be left if all current
liabilities have to be paid immediately.
• Non-current liabilities include loans to finance the business that are
repayable after 12 months, other amounts owing that are not current,
and certain kinds of provisions.
• Equity (or capital) is the money invested by the owners in the business.
As mentioned above, equity is increased by the retained profits of the
business (the profit after paying interest, taxes, and dividends). In a
company, capital or equity is often called shareholders' equity in the
statement of financial position.
30
• The statement of financial position will typically appear as in
Exhibit 3.3.
• In this statement, equity (sometimes referred to as net assets) is
the difference between total assets and total liabilities. This is
called the accounting equation, which can be shown in a number
of different ways:
• Net assets = Total assets − Total liabilities (as shown in a statement of
financial position)
• Assets = Liabilities + Equity or
• Assets − Liabilities = Equity
• Importantly, the capital of the business does not represent the
value of the business. It represents the funds initially invested by
owners (or the shareholders in a company) plus the retained
profits (after payment of taxes and dividends).
• In Exhibit 3.3, share capital represents the initial investment, and
retained earnings include all of the retained profits since the
business commenced.
• An example of a statement of financial position for Via Rail is shown in Exhibit 3.4. 31
 Exhibit 3.3 Sample Statement of Financial Position

•.

32
Exhibit 3.4 Via Rail, 2011 Statement of Financial Position
•.

33
•.

34
3.7. Accrual Accounting
• The accrual basis keeps in place the matching principle.
• An important principle that is particularly relevant to the
interpretation of accounting reports is the matching principle.
• The matching (or accrual) principle recognizes income when it is
earned and expenses when they are incurred (this is called
accrual accounting), not when money is received or paid out (a
method called cash accounting).
• Accrual accounting provides a more meaningful calculation of
profit for a specific period, as revenues earned during the period
are matched with the expenses that were incurred to generate
the revenue, irrespective of whether the expenses have been
paid.
• While cash is very important in business, the accruals method
provides a more meaningful picture of the financial performance
of a business from year to year.
35
• Adjusting entries are required at the end of each accounting
period for accrual-basis accounting, prior to preparing the
financial statements.
• Accrual accounting makes adjustments for
Prepayments: Cash payments made in advance of when they
are treated as an expense for profit purposes.
Accruals: Items treated as expenses for profit purposes even
though no cash payment has yet been made.
Provisions: Estimates of possible liabilities that may arise, but
where there is uncertainty as to timing or the amount of
money involved.

36
• The matching principle requires that certain cash payments
made in advance must be treated as prepayments; that is,
payments made in advance of when they are treated as an
expense for profit purposes.

A good example of a prepayment is insurance, which is paid 12

months in advance. Assume that a business with a financial year
ending March 31 pays its 12 months' insurance premium of
$12,000 in advance, on January 1. At its year-end, the business
will treat only $3,000 (3/12 of $12,000) as an expense and will
treat the remaining $9,000 as a prepayment (a current asset in
the statement of financial position).

37
• Other expenses are accrued; that is, treated as expenses for
profit purposes even though no cash payment has yet been
made.

A good example of an accrual is electricity, which like most

utilities is paid (often quarterly) in arrears. If the same business
usually receives its electricity bill in May (covering the period
March to May), it will need to accrue an expense for the month
of March, even if the bill has not yet been received. If the prior
year's bill was $2,400 for the same quarter (allowing for seasonal
fluctuations in usage), then the business will accrue $800 (1/3 of
$2,400).
• The effect of prepayments and accruals on profit, the statement
of financial position, and cash flow is shown in Exhibit 4.5.
38
 Exhibit 3.5 Prepayments and Accruals

• A further example of the matching principle is in the creation of

provisions. Provisions are estimates of liabilities that may arise, but
where there is uncertainty as to timing or the amount of money.
An example of a possible future liability is a provision for warranty
claims that may be payable on sales of products. The estimate will
be based on the likely costs to be incurred in the future.
39
• Other types of provisions cover reductions in asset values. The
main examples are
Doubtful accounts (or bad debts). Customers may experience difficulty
in paying their accounts and a provision may be made, based on
experience, that a proportion of debtors will never pay.
Inventory. Some inventory may be obsolete but still held by
the company. A provision reduces the value of the obsolete
stock to its sale or scrap value (if any).
Depreciation. Depreciation is a charge against profits,
intended to write off the value of each non-current asset over
its useful life.
• Provisions for likely future liabilities (for example, warranty
claims) are shown in the statement of financial position as
liabilities, while provisions that reduce asset values (for example,
doubtful debts, inventory, and depreciation) are shown as
deductions from the cost of the asset.
40
3.8. Depreciation
• Non-current assets are capitalized in the statement of financial
position so that their purchase does not affect profit. They may be
measured at their historical cost or revalued, also known as
depreciated (see below).
• Depreciation is an expense that spreads the cost of the asset over
its useful life.
• There are four methods of computing the depreciation expense
for fixed assets:
a) Straight Line Method
b) Reducing Balance Method/Diminishing Balance
Method
c) Sum of Digits Method/Sum of The Years’ Digits Method
d) Production Output Method/Units of Production
Method
41
• Among these depreciation methods, Straight Line Method is
simple and easy to apply. Thus, annual depreciation for an
asset using this method is computed as:
Depreciation = Cost of Asset – Estimated Residual Value
Estimated Useful Economic Life

• The following example illustrates the matching principle in

relation to depreciation. A non-current asset costs $100,000.
It is expected to have a life of four years and resale or
residual value of $20,000 at the end of that time. The
depreciation charge is

42
• It is important to recognize that the cash outflow of $100,000
occurs when the asset is bought. The depreciation charge of
$20,000 per annum is a non-cash expense each year. However,
the value of the asset in the statement of financial position
reduces each year as a result of the depreciation charge, as
Exhibit 4.6 shows.
• The asset can be depreciated to a nil value in the statement of
financial position even though it is still in use.
• If the asset is sold, any profit or loss on the sale is treated as a
separate item in the statement of comprehensive income.

43
Exhibit 4.6 Statement of Financial Position: Effect of Depreciation Charges

• A type of depreciation used for intangible assets, such as

patents or copyrights, is called amortization, which has the
same meaning and is calculated in the same way as
depreciation. 44
3.9. Reporting Cash Flow: The Statement of Cash Flows

• The third financial statement is the statement of cash flows,

which shows the movement in cash for the business during a
financial period. It includes
Cash flow from operations
Interest receipts and payments
Income taxes paid
Capital expenditure (that is, the purchase of new non-
current assets)
Dividends paid to shareholders
New borrowings or repayment of borrowings

45
• The cash flow from operations differs from the operating profit
because of
Depreciation, which as a non-cash expense is added back to
profit (since operating profit is the result after depreciation is
deducted)
Increases (or decreases) in working capital (for example,
trade receivables, inventory, prepayments, trade payables,
and accruals), which reduce (or increase) available cash
• An example of a statement of cash flows is shown in Exhibit 3.7.

46
 STATEMENT OF CASH FLOWS (DIRECT APPROACH)
.

47
Format
Format of
of the
the Statement
Statement of
of Cash
Cash Flows
Flows

48
• Sample Statement of cash flows, 2014—direct method
 2. Indirect Method
Adjust net income (the lump sum amount of all revenues and expenses) for
all differences between income flows and cash flows.

1. Operating Cash Flows

•Net Income
+ Noncash expenses, such as depreciation expense, amortization, or
depletion.
- Gains that resulted from investing and financing activities.
+ Losses that resulted from investing and financing activities.
+ Any increase in current Liabilities (except for Notes Payable (N/P))
+ Any decrease in current assets (except for cash and Notes Receivables (N/R))
- Any decrease in current liabilities (except for N/P)
- Any increase in current assets (except for cash and N/R)

50
2. Investing Cash Flows
 Inflows: decrease in noncurrent assets (i.e., long-
term investments, P.P.E.) and certain current assets
(i.e., trading securities, N/R).
 Outflows: increases in noncurrent assets and certain
current assets, N/R.
3. Financing Cash Flows
 Inflows: increases in noncurrent liabilities (i.e., B/P,
N/P), stockholders’ equity and certain current
liability (i.e., N/P).
 Outflows: decreases in noncurrent liabilities,
stockholders’ equity, certain current liability and
dividend payment.
51
STATEMENT OF CASH FLOWS (INDIRECT
APPROACH

52

52
CASH FLOWS (CONT’D)

53

53
.
 3.10. Working Capital
• Working capital is the difference between current assets and
current liabilities (or creditors).
• In practical terms, we are primarily concerned with stock and
debtors, although prepayments are a further element of current
assets.
• Current liabilities comprise creditors and accruals. The other
element of working capital is bank, representing either surplus
cash (a current asset) or short-term borrowing through a bank
overdraft facility (a creditor).The working capital cycle is shown
in below.

55
• Money tied up in debtors and stock puts pressure on the firm,
either to reduce the level of that investment or to seek
additional borrowings. Alternatively, cash surpluses can be
invested to generate additional income through interest earned.
• Managing working capital is essential for success, as the ability
to avoid a cash crisis and pay debts as they fall due depends on:
managing debtors through effective credit approval, invoicing and
collection activity;
managing stock through effective ordering, storage and
identification of stock;
managing trade creditors by negotiation of trade terms and
through taking advantage of settlement discounts; and
managing cash by effective forecasting, short-term borrowing
and/or investment of surplus cash where possible.

56
 3.11. Managing Debtors (Receivables)
• The main measure of how effectively debtors are managed is the number
of days’ sales outstanding (DSO). Days’ sales outstanding is:
debtors/average daily sales

• The DSO represents the average length of time that the firm must
wait after making a sale before receiving cash, which is the average
collection period.
• Example, If the firm has sales of £2 million and debtors of £300,000.
Average daily sales are £5,479 (£2 million/365). There are therefore, 54.75
average days’ sales outstanding (£300,000/£5,479).
• The target number of days’ sales outstanding will be a function of the
industry, the credit terms offered by the firm and its efficiency in both
credit approval and collection activity. 57
• Management of debtors will aim to reduce days’ sales
outstanding over time and minimize bad debts.
• Acceptance policies will aim to determine the creditworthiness
of new customers before sales are made. This can be achieved
by checking trade and bank references, searching company
accounts and consulting a credit bureau for any adverse reports.
Credit limits can be set for each customer.
• Collection policy should ensure that invoices and statements are
issued quickly and accurately, that any queries are investigated
as soon as they are identified, and that continual follow-up (by
telephone and post) of late-paying customers should take place.
Discounts may be offered for settlement within credit terms.
• Bad debts may occur because a customer’s business fails. For
this reason, firms establish a provision to cover the likelihood of
customers not being able to pay their debts.

58
 3.12. Managing Stock (Inventory)
• The main measure of how effectively stock is managed is the stock turnover (or
stock turn). Stock turn is: cost of sales/stock
• Example, cost of sales is £1.5 million and stock is £200,000. The stock turn is
therefore 7.5 (£1,500,000/£200,000). This means that stock turns over 7.5
times per year, or on average every 49 days (365/7.5).
• Sound management of stock requires an accurate and up-to-date stock control
system.
• In stock control, ABC analysis takes the approach that, rather than attempt to
manage all stock items equally, efforts should be made to prioritize the ‘A’
items that account for most value, then ‘B’ items and only if time permits the
many smaller-value ‘C’ items. Some businesses adopt just-in-time (JIT) methods
to minimize stockholding, treating any stock as a wasted resource.
• JIT requires sophisticated production planning, inventory control and supply
chain management so that stock is only received as it is required for production
or sale.
• Stock may be written off because of stock losses, obsolescence or damage. For
this reason, firms establish a provision to cover the likelihood of writing off part
of the value of stock.
59
 3.13. Managing Creditors (Payables)
• Just as it is important to collect debts from customers, it is also
essential to ensure that suppliers are paid within their credit terms.
• As for debtors, the main measure of how effectively creditors are
managed is the number of days’ purchases outstanding.
• Days’ purchases outstanding is: creditors/average daily purchases
• Example, the firm has cost of sales (usually its main credit
purchases) of £1.5 million and creditors of £300,000. Average daily
purchases are £4,110 (£1.5 million/365). There are therefore 73
average days’ purchases outstanding (£300,000/£4,110).
• The number of days’ purchases outstanding will reflect credit terms
offered by the supplier, any discounts that may be obtained for
prompt payment and the collection action taken by the supplier.
• Failure to pay creditors may result in the loss or stoppage of supply,
which can then affect the ability of a business to satisfy its
customers’ orders.
60
61