Sixthedition

AccountingAn Introduction

Eddie McLaneyandPeter Atrill

PEARSON

Harlow, England • London • New York • Boston • San Francisco • Toronto • SydneyAuckland • Singapore • Hong Kong • Tokyo • Seoul • Taipei • New DelhiCape Town • Sao Paulo • Mexico City • Madrid • Amsterdam • Munich • Paris • Milan

Detailed contents

Preface xxiHow to use this book xxiiGuided tour of the book xxivGuided tour of MyAccountingLab xxviAcknowledgements xxviii

Introduction to accounting and finance 1Introduction 1Learning outcomes 1

What are accounting and finance? 2Who are the users of accounting information? 3The conflicting interests of users 5How useful is accounting information? 5

Evidence on the usefulness of accounting 6

Providing a service 7Further qualities 8Weighing up the costs and benefits 9Accounting as an information system 12Financial accounting and management accounting 13Scope of this book 16Has accounting become too interesting? 16The changing face of accounting 17Why do I need to know anything about accounting and finance? 18Accounting for business 19What is the purpose of a business? 19What kinds of business ownership exist? 21

Sole proprietorship 21Partnership .. 21Limited company 22

How are businesses organised? 23"How are businesses managed? 27What is the financial objective of a business? 27Balancing risk and return 30Not-for-profit organisations 31

Summary 32Key terms 34References 35Further reading 35Review questions 36

DETAILED CONTENTS

Part 1 Financial accounting

Measuring and reporting financial position 39Introduction . 39Learning outcomes 39

Making financial decisions 40The major financial statements - an overview 40The statement of financial position 45

Assets 45Claims 48

The effect of trading transactions 52Classifying assets 54

Current assets 54Non-current assets 55

Classifying claims 56Current liabilities 56Non-currentiiabilities 57

Statement layouts 57Capturing a moment in time 60The role of accounting conventions 60

Business entity convention 60Historic cost convention 61Prudence convention 62Going concern convention 63Dual aspect convention 63

Money measurement 64Goodwill and brands 65Human resources 66Monetary stability 66

Valuing assets 67Non-current assets 67Non-current assets with finite lives 67Non-current assets with indefinite lives 68Fair values 68The impairment of non-current assets 70Inventories 71

Meeting user needs 72

Summary 73Key terms 75Further reading 75Review questions 76Exercises 76

Measuring and reporting financial performance 79Introduction 79Learning outcomes 79

DETAILED CONTENTS

What does it mean? 80The income statement 80Different roles 82Income statement layout 83

Gross profit 83Operating profit 84Profit for the period . 84

Further issues 84Cost of sales 84Classifying expenses 86The reporting period 87

Recognising revenue 87Long-term contracts 90Services 91

Recognising expenses 92When the expense for the period is more than the cash

paid during the period 93When the amount paid during the period is more than

the full expense for the periodProfit, cash and accruals accounting

DepreciationCalculating the depreciation expenseImpairment and depreciationDepreciation and asset replacementDepreciation and judgement

Costing inventoriesInventories - some further issues

Trade receivables problemsUses and usefulness of the income statement

SummaryKey termsFurther readingReview questionsExercises

Accounting for limited companies (1)IntroductionLearning outcomes

Why limited companies?The main features of limited companies

Legal naturePerpetual lifeLimited liabilityLegal safeguardsPublic and private companiesTaxationTransferring share ownership: the role of the Stock Exchange

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118120120121121

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126126126127128129129132132

DETAILED CONTENTS

Managing a company 133Strengthening the framework of rules 134The UK Corporate Governance Code 135

Financing limited companies 140Equity (the owners' claim) 140The basic division 140Share capital 141Reserves 143Bonus shares 145Share capital jargon 147

Raising share capital 148Borrowings . 148Withdrawing equity 150The main financial statements 154

The income statement 155The statement of financial position 155

Dividends 156.Accounting for groups of companies 157

Summary 162Key terms 164Reference 164Further reading 164Review questions 165Exercises 165

Accounting for limited companies (2) 170Introduction 170Learning outcomes 170

The directors' duty to account 171The need for accounting rules 172Sources of accounting rules 174

The growing authority of the IASB 175Adopting IFRSs 175

f Presenting the financial statements 177Fair representation ' 178Statement of financial position 179Statement of comprehensive income 179Statement of changes in equity 182Statement of cash flows 183Notes 183General points 183

The need for a conceptual framework 183The IASB framework 184

The auditors' role 185Directors' report 186Segmental financial reports 187

Segmental reporting rules 187

DETAILED CONTENTS

Segmental disclosure 188Segmental reporting problems 189

Business review 191The reporting framework 192The quality of business reviews 196

Summary financial statements 197Creative accounting 197

Creative accounting methods 198Checking for creative accounting 203Creative accounting and economic growth 203

Summary 204Key terms 206Reference 206Further reading 206Review questions 207Exercises • 207

Measuring and reporting cash flows 210Introduction 210Learning outcomes 210The statement of cash flows 211Why is cash so important? 212The main features of the statement of cash flows 214

A definition of cash and cash equivalents 214The relationship between the main financial statements 215The form of the statement of cash flows 215The normal direction of cash flows 217

Preparing the statement of cash flows 219Deducing net cash flows from operating activities 219Deducing the other areas of the statement of cash flows 224

What does the statement of cash flows tell us? 227Problems with IAS 7 228Summary 231Key terms 232Reference 232Further reading 232Review questions 233Exercises 233

Analysing and interpreting financial statements 240Introduction 240Learning outcomes 240

Financial ratios 241Financial ratio classifications 242The need for comparison 243

Past periods 243Similar businesses 244Planned performance 244

DETAILED CONTENTS

Calculating the ratios 244A brief overview 246Profitability 247

Return on ordinary shareholders' funds (ROSF) 248Return on capital employed (ROCE) 249Operating profit margin 251Gross profit margin 252

Efficiency 254Average inventories turnover period 255Average settlement period for trade receivables 256Average settlement period for trade payables 257Sales revenue to capital employed 258Sales revenue per employee 259

Relationship between profitability and efficiency 260Liquidity 262

Current ratio 262Acid test ratio 263Cash generated from operations to maturing obligations ratio 264

Financial gearing . , 265Gearing ratio 268Interest cover ratio 268

Investment ratios 272Dividend payout ratio 272Dividend yield ratio 273Earnings per share 274Cash generated from operations per share 275Price/earnings (P/E) ratio 275

Financial ratios and the problem of overtrading 279Trend analysis 281Using ratios to predict financial failure 282

Using single ratios 282Using combinations of ratios 283Z-score models 285

Limitations of ratio analysis 287

/ Summary 289' Key terms 291

References 291Further reading 291Review questions 292Exercises 292

Part 2 Management accounting

Relevant costs for decision making 301Introduction 301Learning outcomes 301

DETAILED CONTENTS

What is meant by 'cost'? 302Relevant costs: opportunity and outlay costs 304Sunk costs and committed costs 309Qualitative factors of decisions 310Using relevant cost as a basis for setting prices 310

Summary 312Key terms 313Further reading 313Review questions 314Exercises 314

Cost-volume-profit analysis 319Introduction 319Learning outcomes 319

Cost behaviour 320Fixed cost 320Variable cost 322Semi-fixed (semi-variable) cost 323

Analysing semi-fixed (semi-variable) costs 324

Finding the break-even point 325Contribution 331

Contribution margin ratio 331

Margin of safety 332Achieving a target profit 334Operating gearing 335

Operating gearing and its effect on profit 336

Profit-volume charts 337The economist's view of the break-even chart 338Failing to break even 339Weaknesses of break-even analysis 340Using contribution to make decisions: marginal analysis 343

Pricing/assessing opportunities to enter contracts 344The most efficient use of scarce resources , 347Make-or-buy decisions 349Closing or continuation decisions 350

Summary - 353Key terms 354Further reading 354Review questions 355Exercises 355

Full costing 359Introduction 359Learning outcomes 359

Why do managers want to know the full cost? 360What is full costing? 361

DETAILED CONTENTS

Single-product businesses 362Multi-product businesses 363

Direct and indirect cost 363Job costing 365Full (absorption) costing and the behaviour of cost 366The problem of indirect cost 367

Overheads as service Tenderers 367Job costing: a worked example 368Selecting a basis for charging overheads 372Segmenting the overheads 374Dealing with overheads on a cost centre basis 375Batch costing 385Non-manufacturing overheads 386The forward-looking nature of full (absorption) costing 386

Using full (absorption) cost information 389Full cost (cost-plus) pricing 391

Price makers and price takers 391Using cost-plus information by price takers 392

Criticisms of full (absorption) costing 394Full (absorption) costing versus variable costing 394

Which method is better? 396

Summary 398Key terms 399Reference 399Further reading 400Review questions 401Exercises r 401

o Costing and performance evaluation in a competitiveenvironment 405Introduction 405Learning outcomes 405

Cost determination in the changed business environment 406Costing and pricing: the traditional way 406

/ Costing and pricing: the new environment 407

Cost management systems 407The problem of overheads 408Taking a closer look 408

Activity-based costing 409Attributing overheads 410Benefits of ABC 410ABC versus the traditional approach 411ABC and service industries 411Criticisms of ABC 415

Other costing approaches in the modern environment 419Total (or whole) life-cycle costing 419Total quality management 422

o

DETAILED CONTENTS

Costing quality procedures 424Target costing 424Kaizen costing 426Value chain analysis 427Benchmarking 428

Non-financial measures of performance 430The balanced scorecard 431Scorecard problems 437

Measuring shareholder value 437The quest for shareholder value 438How can shareholder value be created? 438The need for new measures 439Economic value added (EVA®) 440

Summary 445Key terms 447References • 447Further reading 447Review questions 448Exercises 448

Budgeting 453Introduction 453Learning outcomes , 453How budgets link with strategic plans and objectives 454

Exercising control 455

Time horizon of plans and budgets 457Limiting factors . 458Budgets and forecasts 458Periodic and continual budgets 458How budgets link to one another 459How budgets help managers 462The budget-setting process 464Using budgets in practice 467Incremental and zero-base budgeting 469Preparing the cash budget 472Preparing other budgets 475Activity-based budgeting - 478Non-financial measures in budgeting 481Budgets and management behaviour 481Who needs budgets? 481Beyond conventional budgeting 483Long live budgets! 485

Summary 488Key terms 489References 489Further reading 489Review questions 490Exercises 490

DETAILED CONTENTS

© Accounting for control 496Introduction 496Learning outcomes 496

Budgeting for control 497Types of control 498Variances from budget 500

Flexing the budget 501Sales volume variance 501Sales price variance 504Materials variances 505Labour variances 507Fixed overhead variance 508

Reasons for adverse variances 513Variance analysis in service industries 514Non-operating profit variances 514Investigating variances 515Compensating variances 518Making budgetary control effective 519Behavioural issues 519

The impact of management style 521Failing to meet the budget 522Budgets and innovation 523

Standard quantities and costs 524Setting standards 525

Who sets the standards? 525How is information gathered? 525What kind of standards should be used? 526The learning-curve effect 526

Other uses for standard costing 528Some problems . . . 528The new business environment 530

Summary 532Key terms 533References 533

/ Further reading 534Review questions 535Exercises 535

Part 3 Financial management

Making capital investment decisions 541Introduction 541Learning outcomes 541

The nature of investment decisions 542Investment appraisal methods 543

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DETAILED CONTENTS

Accounting rate of return (ARR) 545ARR and ROCE 546Problems with ARR 547

Payback period (PP) 549Problems with PP 551

Net present value (NPV) 554Interest lost 554Risk 555Inflation 556What will logical investors do? 556Using present value tables 559Why NPV is better 560NPV's wider application 561

Internal rate of return (IRR) 562Problems with IRR 566

Some practical points 567Investment appraisal in practice 571Investment appraisal and strategic planning 574Dealing with risk 575

Sensitivity analysis 575

Managing investment projects 579Stage 1: Determine investment funds available 580Stage 2: Identify profitable project opportunities 581Stage 3: Evaluate the proposed project 581Stage 4: Approve the project 581Stage 5: Monitor and control the project 582

Summary 584Key terms 586Reference 586Further reading 586Review questions 587Exercises 587

Financing a business 592Introduction 592Learning outcomes . 592

Sources of finance 593Internal sources of finance 593"Internal sources of long-term finance 594

Retained earnings 594

Internal sources of short-term finance 595Tighter credit control 595Reducing inventories levels 596Delaying payment to trade payables 596Some final points 596

External sources of finance 597

DETAILED CONTENTS

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External sources of long-term finance 597Ordinary shares 598Preference shares 598Borrowings 599Forms of borrowing 603Finance leases 606Sale-and-leaseback arrangements 609Hire purchase 610Securitisation 611

External sources of short-term finance 613Bank overdrafts 613Debt factoring 613Invoice discounting 616

Long-term versus short-term borrowing 617Gearing and the long-term financing decision 618Raising long-term finance 621Share issues 621

Rights issues 621Offers for sale and public issues . 625Private placings 625Bonus issues 626

The role of the Stock Exchange 626Advantages of a listing 627Disadvantages of a listing 628

The Alternative Investment Market 630Providing long-term finance for the small business 631

Venture capital / 631Business angels 632Government assistance 633

Summary 635Key terms 637Reference 637Further reading 637Review questions 638Exercises 638

Managing working capital 643Introduction _ . 643Learning outcomes 643

What is working capital? 644

Managing working capital 645

The scale of working capital 645

Managing inventories 648Budgeting future demand 651Financial ratios 651Recording and reordering systems 651Levels of control 653Inventories management models 654

DETAILED CONTENTS

Managing trade receivables 660Which customers should receive credit and how much should they be

offered? 660Length of credit period 662Cash discounts 665Debt factoring and invoice discounting 666Credit insurance 666Collection policies and reducing the risk of non-payment 666

Managing cash 670Why hold cash? 670How much cash should be held? 671Controlling the cash balance 672Cash budgets and managing cash 673Operating cash cycle 673Cash transmission 677Bank overdrafts 677

Managing trade payables 678Controlling trade payables •* 680

Summary . 681Key terms 683Further reading 683Review questions 684Exercises , 684

Part 4 Supplementary information

Appendix A Recording financial transactions 693Introduction 693Learning outcomes 693

The basics of double-entry bookkeeping 694Recording trading transactions 696Balancing accounts and the trial balance 699Preparing the financial statements (final accounts) 703The ledger and its division 706

Summary 707Key terms 708Further reading 708Exercises 709

Appendix B Glossary of key terms 712Appendix C Solutions to self-assessment questions 728Appendix D Solutions to review questions 745Appendix E Solutions to selected exercises 760Appendix F Present value table 809

Index 811