Business Accounting and Finance, Fifth Edition
Catherine Gowthorpe
Contents
Figures xi
Preface to the fifth edition xiii
1 The role of accounting
in business 1
Aim of the chapter 1
Learning outcomes 1
Introduction 1
1.0.1 Special Notes for the Suspicious 1
1.0.2 Legal and Reporting Requirements 2
Content of this Chapter 2
1.1 Forms of Business Organization 2
1.1.1 Sole Trader Businesses 3
1.1.2 Partnerships 3
1.1.3 Limited Companies 4
1.2 Sole Traders, Partnerships and Limited Companies
Contrasted 5
1.2.1 Sole Trader – Advantages 5
1.2.2 Sole Trader – Drawbacks 6
1.2.3 Partnership – Advantages 6
1.2.4 Partnership – Drawbacks 6
1.2.5 Limited Company – Advantages 6
1.2.6 Limited Company –Drawbacks 6
1.3 Finance for Business 7
1.3.1 Existing Resources 7
1.3.2 Retained Profits 8
1.3.3 Borrowing Money 8
1.3.4 Leasing and Hire Purchase 8
1.3.5 Grant Finance 9
1.3.6 Financing Companies:Share Issues 9
1.3.7 Financing Companies: Venture Capital 9
1.4 Short-, Medium- and Long-term Finance 9
1.5 Fundamentals of Taxation 10
1.5.1 Income Taxes (Personal Taxation) 10
1.5.2 Corporation Tax 10
1.5.3 Capital Gains Tax 10
1.5.4 Value Added Tax 10
1.6 The Need for Accounting Information 11
1.6.1 Sole Trader 11
1.6.2 Partnership 12
1.6.3 Limited Company 13
1.7 Users of Accounting Information 15
1.7.1 Access to Information 16
1.8 Characteristics of Useful Financial Information 16
1.9 Financial Accounting and Management Accounting 16
1.10 The Role of the Accountant in Business
Organizations 18
1.10.1 The Accounting Profession 18
1.11 Accounting Ethics 18
1.11.1 Ethical Responsibilities for Accountants 18
1.11.2 The Ethical Code: Ethical Principles 19
1.11.3 The Ethical Code: Threats to the Ethical
Principles 19
1.11.4 Consequences of Ethical Failures 20
1.11.5 Ethics and Law 21
1.11.6 Business Ethics 21
1.12 Organization of the Remainder of this Book 21
Chapter Summary 22
Internet Resources 22
Exercises: Answers at the End of the Book 23
Exercises: Answers Available on the Instructors’ Section
of the Book’s Website 25
SECTION I
Financial Accounting
and Reporting 27
2 The statement of financial position 28
Aim of the chapter 28
Learning outcomes 28
Introduction 28
2.1 Basics of Business Accounting: The Three Principal
Financial Statements 28
2.2 The Statement of Financial Position: Definitions
of Elements 31
2.2.1 Assets 31
2.2.2 Liabilities 31
2.2.3 Capital 31
2.2.4 Terminology 31
2.3 The Accounting Equation 32
2.3.1 The Statement of Financial Position Format 32
2.4 Drawing up a Statement of Financial Position 34
2.4.1 Changing the Value of Capital 37
2.5 More Practice with Statements of Financial
Position 37
2.6 Communicating Meaning: What does the Statement
of Financial Position Say? 39
2.6.1 Characteristics of Useful Financial
Information 40
2.7 Financial Reporting by Large Companies 40
Chapter Summary 41
Internet Resources 41
Exercises: Answers at the End of the Book 42
Exercises: Answers Available on the Instructors’ Section
of the Book’s Website 45
3 The statement of profit or loss 48
Aim of the chapter 48
Learning outcomes 48
Introduction 48
3.1 The Statement of Profit or Loss: Terminology 49
3.2 Categories of Commercial Activity 49
3.3 Statement of Profit or Loss for a Sole Trader 49
3.4 Movements in Inventory 51
3.5 Calculating Cost of Sales 52
3.6 Calculating Net Profit 53
3.6.1 Typical Business Expenses 53
3.7 What does the Statement of Profit or Loss Mean? 54
3.7.1 Gross Profit Analysis 55
3.7.2 Net Profit Analysis 56
3.8 Analyzing Financial Information in Large Companies 56
3.9 Statement of Profit or Loss Accounting in a Service
Business 57
3.10 Preparing both the Statement of Profit or Loss and
the Statement of Financial Position 58
Chapter Summary 62
Internet Resources 62
Exercises: Answers at the End of the Book 63
Exercises: Answers Available on the Instructors’ Section
of the Book’s Website 66
4 Applying accounting conventions 68
Aim of the chapter 68
Learning outcomes 68
Introduction 68
4.1 Returns of Goods, Discounts and Delivery Charges 68
4.1.1 Returns 69
4.1.2 Discounts 69
4.1.3 Delivery Charges 70
4.1.4 Relevance for Service Businesses 70
4.2 Accounting Conventions 74
4.2.1 Going Concern 74
4.2.2 Recognition 74
4.2.3 Accruals (Matching) 75
4.3 Comprehensive Example: Accruals 76
4.4 Current Asset Measurement: Inventory
and Trade Receivables 79
4.4.1 Inventory 79
4.4.2 Trade Receivables 81
Chapter Summary 84
Internet Resources 85
Exercises: Answers at the End of the Book 85
Exercises: Answers Available on the Instructors’ Section
of the Book’s Website 90
5 Depreciation and amortization 94
Aim of the chapter 94
Learning outcomes 94
Introduction 94
5.1 Accounting for the Use of Non-current
Assets 94
5.2 Impact of Depreciation on the Financial
Statements 96
5.3 Intangible Assets and Amortization 97
5.3.1 What about the Staff? 98
5.4 Accounting for Amortization 99
5.5 Another Method of Depreciation 100
5.6 Land and Buildings 102
5.7 The Role of Judgement in Estimating
Depreciation 102
5.8 Sale of a Non-current Asset 103
5.9 Buying and Selling Assets During the Year 104
Chapter Summary 104
Internet Resources 105
Exercises: Answers at the End of the Book 105
Exercises: Answers Available on the Instructors’ Section
of the Book’s Website 109
6 The statement of cash flows 112
Aim of the chapter 112
Learning outcomes 112
Introduction 112
6.1 The Distinction Between Profit and Cash 112
6.2 Preparing a Statement of Cash Flows 114
6.2.1 Preparing a Statement of Cash Flows: A
Business Start-up 114
6.3 Direct and Indirect Approaches to Cash Flow 119
6.4 Statements of Cash Flow in an Established
Business 120
6.5 The High Profit/No Cash Paradox 125
6.6 Statements of Cash Flow in Large Businesses 128
Chapter Summary 129
Internet Resources 129
Exercises: Answers at the End of the Book 130
Exercises: Answers Available on the Instructors’ Section
of the Book’s Website 133
7 Financial reporting by limited
companies 138
Aim of the chapter 138
Learning outcomes 138
Introduction 138
7.1 The Limited Company 138
7.2 Limited Liability 139
7.3 Information Needs of Company Creditors 141
7.4 Information Needs of Company Shareholders 141
7.5 Information Needs of People Other than Shareholders
and Creditors 141
7.6 Regulation of Company Accounting and Other
Issues 141
7.6.1 Companies Acts 141
7.6.2 Company Formation and Types of Company 142
7.6.3 Company Constitutional Arrangements Including
the Issue of Shares 142
7.6.4 Shares 142
7.6.5 Role of Directors 144
7.6.6 Publication and Presentation of Accounting
Information 145
7.6.7 The Audit of Companies 146
7.6.8 Accounting Standards 146
7.6.9 International Financial Reporting Standards 146
7.7 Accounting for Limited Companies 147
7.7.1 Components of a Set of Limited Company
Accounts 147
7.7.2 Presentation of Accounting Information 148
7.8 Accounting for Listed Companies: Additional
Requirements 151
7.8.1 Regulations for Listed Companies 151
7.8.2 The Annual Report for a Listed Company 151
7.9 Accounting for Listed Companies: Non-financial
Information 152
7.9.1 Advantages of Publishing Non-financial
Information 152
7.9.2 Drawbacks of Publishing Non-financial
Information 152
7.9.3 The Strategic Report 152
7.10 Corporate Reporting on the Internet 153
7.11 Corporate Governance 153
7.11.1 What are the Important Issues in Corporate
Governance? 154
7.11.2 How Can Good Corporate Governance be
Assured? 154
7.11.3 Board Leadership and Company
Purpose 155
7.11.4 Division of Responsibilities 155
7.11.5 Composition, Success and Evaluation 156
7.11.6 Audit, Risk and Internal Control 156
7.11.7 Remuneration 156
7.11.8 Reporting 156
7.11.9 Conclusion on Corporate Governance 156
Chapter Summary 157
Internet Resources 157
Exercises: Answers at the End of the Book 158
Exercises: Answers Available on the Instructors’ Section
of the Book’s Website 161
8 Understanding financial reports:
trend analysis 164
Aim of the chapter 164
Learning outcomes 164
Introduction 164
8.1 Usefulness of Financial Reports to Various Interest
Groups 165
8.1.1 Owners and Investors 165
8.1.2 Potential Investors in a Business 165
8.1.3 Creditors 166
8.2 Analytical Techniques: Changes in Figures 166
8.3 Analytical Techniques: Horizontal and Trend
Analysis 167
8.3.1 Some Problems with Horizontal
Analysis 168
8.4 Analytical Techniques: Vertical Analysis and Common
Size Analysis 169
8.5 Comparing Businesses with each Other 171
8.5.1 Problems in Comparison 171
8.6 Segment Analysis 174
Chapter Summary 175
Internet Resources 176
Exercises: Answers at the End of the Book 176
Exercises: Answers Available on the Instructors’ Section
of the Book’s Website 178
using accounting ratios 181
Aim of the chapter 181
Learning outcomes 181
Introduction 181
9.1 Financial Ratio Analysis Techniques 181
9.1.1 A Word of Caution about Financial Ratio
Analysis 182
9.2 Performance Ratios 182
9.2.1 Return on Capital Employed (ROCE) 182
9.3 Liquidity Ratios 185
9.4 Efficiency Ratios 186
9.5 Investor Ratios 190
9.5.1 Market Capitalization 192
9.6 Lending Ratios 193
9.6.1 Gearing 193
9.6.2 Interest Cover 193
9.7 The Effects of Gearing 194
9.7.1 Why are Ordinary Shareholders Interested
in Gearing? 194
9.8 Preparing an Analysis of Financial Statements 196
9.8.1 Collecting the Data 196
9.8.2 The Focus of the Analysis 196
9.8.3 The Analysis 197
9.8.4 Limitations of the Analysis 197
Chapter Summary 198
Internet Resources 199
Exercises: Answers at the End of the Book 200
Exercises: Answers Available on the Instructors’ Section
of the Book’s Website 206
SECTION II
Management Accounting 211
10 Management and cost accounting
information 212
Aim of the chapter 212
Learning outcomes 212
Introduction 212
10.1 What is Management and Cost
Accounting? 212
10.1.1 Characteristics of Management Accounting
Information 213
10.1.2 Some Useful Features of Cost and
Management Accounting Information 214
10.2 Definitions of Management Accounting
and Cost Accounting 215
10.3 The Management Accounting Process 215
10.3.1 The Objectives of the Organization 216
10.3.2 The Effect of Uncertainty 216
10.4 Organization of the Rest of the Book 217
Chapter Summary 218
Internet Resources 218
Exercises: Answers at the End of the Book 218
Exercises: Answers Available on the Instructors’ Section
of the Book’s Website 219
11 Costing: overview
and basic techniques 221
Aim of the chapter 221
Learning outcomes 221
Introduction 221
11.1 Costing in Business 221
11.2 Product Costing 222
11.2.1 Cost Classification: Product and Period
Costs 225
11.3 Approaches to Costing 225
11.3.1 Materials Costs 227
11.3.2 Labour Costs 229
Chapter Summary 231
Internet Resources 231
Exercises: Answers at the End of the Book 232
Exercises: Answers Available on the Instructors’ Section
of the Book’s Website 233
12 Costing: accounting
for overheads 236
Aim of the chapter 236
Learning outcomes 236
Introduction 236
12.1 Production Overheads: Allocation and
Apportionment 237
12.1.1 Allocation to Cost Centres 237
12.1.2 Apportionment to Cost Centres 237
12.2 Overhead Absorption 240
12.2.1 Overhead Absorption Rates: Some Other
Approaches 242
12.3 Costing of Services 243
12.4 Costing of Public Sector Services 245
12.5 Activity-based Costing (ABC) 245
12.5.1 Principles of ABC 246
12.5.2 Applying ABC in a Manufacturing Business 246
12.5.3 Applying ABC in a Service Industry 249
12.5.4 ABC: Benefits and Problems 249
Chapter Summary 250
Internet Resources 250
Exercises: Answers at the End of the Book 250
Exercises: Answers Available on the Instructors’ Section
of the Book’s Website 253
13 Pricing 257
Aim of the chapter 257
Learning outcomes 257
Introduction 257
13.1 The Relationship Between Price and Quantity 257
13.1.1 Elasticity and Inelasticity 258
13.1.2 Problems in Applying the Economic Model
to the Real World 258
13.2 Competition in the Market 259
13.2.1 Price Setters and Price Takers 260
13.3 How do Producers Decide on Prices? 260
13.3.1 Market-based Pricing 260
13.3.2 Cost-based Pricing 261
13.4 Special Cases 263
13.4.1 Tendering 263
13.4.2 Highly Restricted Supply of Unique
Products 263
13.4.3 Target Pricing and Costing 264
13.4.4 Discounting 264
13.4.5 Auction 265
13.5 More Issues in Pricing Decisions 265
13.5.1 Product Life Cycle 265
13.5.2 Product Life Cycle Issues 266
13.6 Pricing in Context 266
13.6.1 Building Contractor 266
13.6.2 Toothpaste Manufacturer 267
13.6.3 Writer 267
13.6.4 Solicitors 267
Chapter Summary 269
Internet Resources 269
Exercises: Answers at the End of the Book 269
Exercises: Answers Available on the Instructors’ Section
of the Book’s Website 270
14 Marginal costing and
decision making 272
Aim of the chapter 272
Learning outcomes 272
Introduction 272
14.1 Issues in Decision Making 273
14.1.1 Relevant Costs and Revenues 273
14.2 Cost Variability 274
14.2.1 Variable Costs 274
14.2.2 Fixed Costs 275
14.2.3 Stepped Costs 276
14.2.4 Semi-variable Costs 277
14.2.5 Typical Cost Behaviour in Different Business
Sectors 278
14.3 Marginal Costing for Decision Making 280
14.3.1 Contribution 280
14.3.2 Break-even 281
14.4 Cost–Volume–Profit Analysis 281
14.4.1 Break-even Charts 281
14.4.2 Break-even Analysis Using Formulae 283
14.5 Further Applications of Break-even in Practice 284
14.5.1 Target Profit 284
14.5.2 Margin of Safety 285
14.6 Special Decisions 286
14.6.1 Accepting Contracts 286
14.6.2 Major Increases in Activity Levels 287
14.6.3 Limiting Factors 287
14.7 Limitations of Analysis Based on Marginal Costing 289
Chapter Summary 289
Internet Resources 290
Exercises: Answers at the End of the Book 290
Exercises: Answers Available on the Instructors’ Section
of the Book’s Website 294
15 Capital investment decisions 297
Aim of the chapter 297
Learning outcomes 297
Introduction 297
15.1 Capital Investment in Context 298
15.1.1 Capital Rationing 298
15.2 Simple Appraisal Techniques 299
15.2.1 Accounting Rate of Return 301
15.2.2 Payback 302
15.3 More Complex Appraisal Techniques 304
15.3.1 The Time Value of Money 304
15.3.2 Net Present Value (NPV) 306
15.3.3 Machine A 307
15.3.4 Machine B 307
15.3.5 Machine A 308
15.3.6 Machine B 308
15.3.7 Internal Rate of Return (IRR) 308
15.4 Choosing Between Projects 311
15.5 Strengths and Weaknesses of the Common
Investment Appraisal Techniques 311
15.5.1 Accounting Rate of Return (ARR) 312
15.5.2 Payback 312
15.5.3 Net Present Value (NPV) 312
15.5.4 Internal Rate of Return (IRR) 312
15.5.5 The Best Technique? 313
Chapter Summary 313
Internet Resources 313
Exercises: Answers at the End of the Book 314
Exercises: Answers Available on the Instructors’ Section
of the Book’s Website 316
16 Budgets 319
Aim of the chapter 319
Learning outcomes 319
Introduction 319
16.1 The Relationship Between Strategy and Budget
Setting 320
16.2 Principal Types of Budget 321
16.2.1 Approaches to Budgeting 321
16.3 The Budget Process 322
16.3.1 Who Sets the Budget? 322
16.3.2 Imposition of Budgets 323
16.3.3 Participative Approach 323
16.3.4 Stages Involved in Setting a Budget 324
16.4 Setting the Budget: A Practical Example 325
16.5 Monitoring Outcomes 332
16.6 Budgeting: Its Benefits and Drawbacks 332
16.6.1 Benefits 332
16.6.2 Drawbacks 333
16.7 A Radical Alternative 334
16.7.1 Beyond Budgeting 334
Chapter Summary 335
Internet Resources 335
Exercises: Answers at the end of the book 336
Exercises: Answers Available on the Instructors’ Section
of the Book’s Website 338
17 Accounting for control 342
Aim of the chapter 342
Learning outcomes 342
Introduction 342
17.1 Standard Costing, Flexible Budgeting and Variance
Analysis 342
17.2 Standard Costing 343
17.2.1 Establishing Standard Costs 344
17.3 Overhead Variances 351
17.4 Investigating the Reasons for Variances 355
17.4.1 Deciding which Variances Merit
Investigation 355
17.4.2 Principal Reasons for the Occurrence
of Variances 355
17.5 Standard Costing: Issues and Problems 356
Chapter Summary 357
Internet Resources 357
Exercises: Answers at the End of the Book 357
Exercises: Answers Available on the Instructors’ Section
of the Book’s Website 361
18 Performance measurement 364
Aim of the chapter 364
Learning outcomes 364
Introduction 364
18.1 Performance Reporting and Organizational
Objectives 365
18.2 Divisional Responsibility in Large Business
Organizations 366
18.2.1 Centralization and Decentralization 367
18.3 Assessing Divisional Performance 367
18.3.1 Cost/Revenue Centre 368
18.3.2 Profit Centre 368
18.3.3 Investment Centre 370
18.3.4 Determining Investment in Net Assets 370
18.3.5 Determining Divisional Net Profit 372
18.3.6 Residual Income 373
18.4 Non-financial Performance Measures 373
18.5 The Balanced Scorecard 375
18.5.1 The Four Key Perspectives of the Balanced
Scorecard 376
18.5.2 The Balanced Scorecard in Practice 377
18.5.3 Is the Balanced Scorecard Successful? 378
Chapter Summary 378
Internet Resources 378
Exercises: Answers at the End of the Book 378
Exercises: Answers Available on the Instructors’ Section
of the Book’s Website 380
SECTION III
Financial Management 383
19 The management
of working capital 384
Aim of the chapter 384
Learning outcomes 384
Introduction 384
19.1 Elements of Working Capital 385
19.1.1 Management and Mismanagement of
Working Capital 385
19.2 Asset and Liability Components in
Practice 386
19.3 The Management of Inventories 386
19.3.1 Holding Costs 388
19.3.2 Economic Order Quantity 389
19.3.3 Other Approaches to the Management of
Inventories 390
19.4 The Management of Trade Receivables 391
19.4.1 Addressing the Risks of Offering Credit to
Customers 391
19.4.2 The Credit Control Function 392
19.5 The Management of Cash, Overdrafts and
Trade Payables 394
19.5.1 The Operating Cycle 394
19.5.2 Managing Cash and Overdrafts 396
19.5.3 Managing Trade Payables 396
Chapter Summary 396
Internet Resources 396
Exercises: Answers at the End of the Book 397
Exercises: Answers Available on the Instructors’ Section
of the Book’s Website 399
20 Financing the business 403
Aim of the chapter 403
Learning outcomes 403
Introduction 403
20.1 Financing the Small Business 403
20.1.1 Sources of Finance for a New Business
Start-up 404
20.1.2 The Business Plan 406
20.1.3 Why Do Businesses Fail (and Why Do Some
of Them Succeed)? 406
20.2 Stages in Business Growth and Expansion 406
20.2.1 Employing People 407
20.2.2 Developing the Business
Organization 408
20.2.3 Sources of Finance for the Growing
Business 409
20.3 Sources of Finance for Large Businesses 410
20.3.1 Issue of Shares 410
20.3.2 Rights of Shareholders 410
20.3.3 Benefits of Limited Companies 410
20.3.4 The London Stock Exchange (LSE) 411
20.3.5 Organization and Operation of
the LSE 411
20.3.6 Flotation and Other Types of Share
Issue 413
20.3.7 To List or Not to List? 415
Chapter Summary 415
Internet Resources 416
Exercises: Answers at the End of the Book 416
Exercises: Answers Available on the Instructors’ Section
of the Book’s Website 418
Answers to self-test questions 420
Answers to exercises 441
Glossary 505
Index 511