Accounting Policies, Estimates and Errors - For Beginners

ACCOUNTING POLICIES

Accounting policies are the principles, bases, conventions, rules and practices applied by a Company which specify how the effects of the transactions and other events are reflected in the financial statements

By now you should familiarize about my blog for Understanding Financial Statements for Beginners

http://egaykenriquez.blogspot.co.uk/2013/01/understanding-financial-statements-for.html

International Accounting Standards (IAS) 8 “Accounting Policies, Estimates and Errors” requires a Company to select and apply appropriate accounting policies complying with International Financial Reporting Standards (IFRS) and Interpretations to ensure the financial statements provide information that is:

1) Relevant to the decision-making needs of users

Who are the users of the financial statements?

- Shareholders – they are concerned with receiving adequate return on their investment

- Banks – they are concerned of their loan to the business, if any

- Management - their main concerned is the trend and level of profits since this is the main measure of their success

2) Reliable in that they:

- Represent faithfully the results and financial position of the entity

-      Reflect the economic substance of events and transactions and not merely the legal form

-     Are neutral, i.e. free from bias

-     Are prudent

-     Are complete in all material aspects

 

CHANGE IN ACCOUNTING POLICIES

IAS8 requires accounting policies to be change only if the change is:

-    Required by IFRSs or

-    Will result in a reliable and more relevant presentation of events or transactions

A change in accounting policy occurs if there has been a change in:

- Recognition, e.g. A pre-operating expenses is now recognized as expense rather than asset

-     - Presentation, e.g. A depreciation expense is now charged in cost of sales rather than administrative expenses, or

-     - Measurement basis, e.g. stating assets at replacement cost rather than historical cost

Accounting treatment

- The change should be applied retroactively, with an adjustment to the opening balance of retained earnings in the statement of changes in equity


ACCOUNTING ESTIMATE

Is a method adopted by an entity to arrive at estimated amounts for the financial statements

Most figures in the FS require some estimation:

- The exercise of the judgment based on the latest information available at the time

-     At a later date, the estimates may have to be revised as a result of the availability of new information, more experience or subsequent developments

 

CHANGE IN ACCOUNTING ESTIMATES

The requirements of IAS 8 are:

-     The effects of a change in accounting estimate should be included in the statement of income in the period of the change and, if subsequent periods are affected, in those subsequent periods.

Example of change in accounting estimates is change in:

- The useful lives of non-currents; e.g. the Company change the life of its computer equipment from 5 years to 3 years because of technology advancement.


PRIOR PERIOD ERRORS

Are omissions from and misstatements in the financial statements for one or more periods arising from a failure to use information that:

-    -  was available when the FS for those periods were authorized for issue and

-    - could reasonably expected to have been taken into account in preparing those financial statements

Such errors include mathematical mistakes, mistakes in applying accounting policies, oversights and fraud.

Current period errors that are discovered in that period should be corrected before the financial statements are authorized for issue.

Correction of prior period errors:

-     Restating the opening balance of assets, liabilities and equity as if the error had never occurred, and presenting the necessary adjustment to the opening balance of Retained Earnings in the statement of changes in equity

 

UNDERLYING ASSUMPTIONS

The framework identifies the underlying assumption governing financial statements the accrual basis of accounting and going-concern

Accrual Basis
-    The accrual basis of accounting means that the effect of transactions and the over events are recognized as they occur and not as cash or its equivalent is received or paid

Going Concern

-     -    The going-concern basis assumes that the Company has neither the need nor the intention to liquidate or curtail materially the scale of the operations.

Accural Basis and Going Concern must be taken into account by an entity when deciding on accounting policies and estimates.


HISTORICAL COST

Traditionally, accounts have been presented using the historical cost convention:

-     Assets are stated in the statement of the financial position at their cost

-      Less any amounts written off (e.g. depreciation in the case of tangible non-currents assets)

The objective of financial statements is to provide information about the reporting entity’s financial performance and position that is useful to a wide range of users for assessing the stewardship of management and for making economic decisions.


OTHER ASSET VALUES

-     Replacement Cost is the cost to the business of replacing the asset

-     Net Realisable value (NRV) is the estimated sales proceeds less any costs involved in selling the asset.

-     Economic value is the present value of future cash flows from an asset.

 

FAIR VALUES

A further method of valuing assets which is particularly relevant to financial assets is that of fair value.

Fair value is the amount at which an asset or liability could be exchanged in an arm’s length transaction between informed and willing parties, other than is a forced or liquidation sale.

Fair value is sometimes known as current value.

Example: If the item is quoted on an active market, then its FV is its market value on that market e.g. the shares in public companies are quoted on stock exchanges. The FV of 1,000 shares in Company AB quoted at $7 each would be $7,000.

FAIR PRESENTATION

When do financial statements show fair presentation?

- Financial statements will generally show a fair presentation when

-    - They conform with accounting standards

-    - They conform with any relevant legal requirements

-    - They have applied the qualitative characteristics from the Framework

Jersey, Channel Islands: My 5th Destination, no more Mr. Nice Guy and British Airways Review

 
     The island of Jersey is the largest of the Channel Islands. It is not part of the United Kingdom but United Kingdom is constitutionally responsible for the defence of Jersey. Jersey is a self-governing parliamentary democracy under a constitutional monarchy, has its own financial, legal and judicial systems.

    This is my 5^thdestination and was able to work here for a while. It's memorable since this is the place that opens the door for me to work internationally. I still remember when the British Airways landed in Jersey airport with the weather of gloomy and chilly and I was collected by my South African buddy sent by the Office where I will be working. In our office, we have 27 different nationalities working. It’s like the United Colours of Benetton commercial. I have still friends from this office and saw one last Christmas and he promised me that he will tour me around the African Safari in the future. Hhmm, I am looking forward to that

  
     During my 3rd month in Jersey, Channel Islands, I am feeling the homesickness, I invited my mother and she stayed here for more than 3 months to be with me. She arrived in July and left until mid-November. She experience the UK summer, fall and almost winter. She became a Church Choir member and walking to High Street to shop just to make herself busy but during the month of November she can’t go outside since it is very cold.

     I do miss my circle of friends there and hopefully I can meet them again. During Friday nights, my drinking buddies and I will eat and drink until 4AM of Saturdays. One of them told me that someone called me the "nice guy" because she knows me but does not know my name and that stated it all. Throughout the night, they are calling me Mr. Nice Guy and we are all laughing. Most of the time, before going home between 3-4 AM, we cook Knorr’s Crab and Corn soup so we can have hot soup for the refreshing feeling after drinking alcohols and will wake up Saturday afternoon. Oh, I miss that. Even I am alone walking going home at 4AM in the morning, I feel safe.

    Tip 1:

    There are places to visit when in Jersey:

Mount Orgueil Castle

     This is a stunning castle overlooking the harbour of Gorey and is also known as the Gorey Castle. During World War II the Germans actually put modern look-out posts on the castle.

                                                                   Elizabeth Castle                                                                       

     This was built off the coast of Saint Helier in the late 16th century. The Governors of Jersey moved their official residence to the castle for more protection.

La Corbiere Lighthouse

    This is famous photography lighthouse along the coast of Jersey that was built in 1874 in Saint Brelade.

     If there is a chance to be back in Jersey I will reconsider it but I prefer London since there are many activities to do here and many choices to become busy to lessen the homesickness.

    To my friends there in Jersey, Channel Islands; “Until we meet again and no more Mr. Nice Guy, lol.”


    Tip 2 - British Airways review:

    This is less than one-hour flight for London Gatwick to Jersey, Channel Islands. Extremely worn out plane, some of the seats are not in good shape. They serve different drinks which most of the time I asked for a small bottle of red wine. They serve cold sandwiches and sometimes peanuts only. Maybe it depends on the time of travel. During mornings they give cold sandwiches and in the evening they give peanuts. Book your flight early since it is too expensive if you book 3 days before your flight. The problem before with this airline is there are dates that the union crew members are on work strike so there are flights cancellations but since last year (2012) I have never heard of any strikes from them.

 

Interpretation of Financial Statements for Beginners

    Why Businesses prepare Financial Statements? My first answer is; “it is the report submitted by the Accountants to the owners of the Companies and to show the income of the cash invested by the owners.” But owners are not the only users of the financial statements.

   Who are the users of the financial statements?

-      - Shareholders– they are concerned with receiving adequate return on their investment

   - Banks –they are concerned of their loan to the business, if any

-       - Management- their main concerned is the trend and level of profits since this is the main measure of their success

     If there is a financial statements, we can compute some ratios that will be useful in interpreting the Company’s profitability, liquidity, stability and investor ratios. The ratios presented below are the basics of interpreting the financial statements.

     You should familiarise with the terminologies use in my blog for Financial Statement Beginners to use the use the different accounts; cash, receivables, etc. to use the ratios for interpretation.

http://egaykenriquez.blogspot.co.uk/2013/01/understanding-financial-statements-for.html

    For Ratio Analysis:

    There are number of ratios that can be calculated to assist interpret the financial statements namely:

  - Profitability ratios

-     - Liquidity ratios

-     - Long-term financial stability ratios

-      - Investor ratios

1) PROFITABILITY RATIOS

Gross Profit Margin		=	Gross Profit		x	100%
			Sales

 

Net Profit Margin		=	Profit before income tax				X	100%
			Sales

    Low margins may suggest poor performance but maybe due to new product launch or trying to increase its market share.

    The ratios that business makes on its Sales

ROCE	=	Profit			x	100%
		Capital Employed

    ROCE = Return of Capital Employed

    Profit is measured before deducting income tax expense

    Capital Employed is equity PLUS long-term loans

Net Asset Turnover		=	Sales			=	times pa
			Capital Employed

     This is a ratio that measures management‘s efficiency in generating revenue from the net assets at its disposal. The higher, the better

     There is a trade-off exist between asset turnover and margin

     - Low-margin businesses – e.g. Sale of detergent soaps which have a high asset turnover but low margin

-         - Capital-intensive manufacturing industries - e.g. Sale of mobile phones which have a high margins but low asset turnover

     Two completely different strategies can achieve the same ROCE

    - Selling of Expensive Perfume: sell goods at a high profit margin with sales volume remaining low

-       - Selling of Detergent Soap: sell goods at a low profit margin with very high sales volume

     2) LIQUIDITY RATIOS

Current or Working	=	Current assets	:	1
Capital Ratio		Current liabilities

     This measures the adequacy of current assets to meet the liabilities as they fall due. But if there is a high-cash level, it could be better to use if invested in non-current assets.

Quick Ratio		=	Current Assets - Inventory			:	1
			Current Liabilities

     Also known as the acid test ratio. Not to include inventory from current assets since inventory is considered not cash readily available as compared to Cash and Receivables

Inventory turnover period			=	Inventory			x	365 days
				Cost of Sales

     This is expressed in days. As an alternative is to compute the inventory period as a number of times:

Cost of Sales		=	times pa
Inventory

     An increasing number of days mean that inventory is turning over less quickly which is not a good sign which may indicate

    - not popular products

-       - poor inventory control

   - increase in storage cost

Receivable collection period			=	Trade Receivables		x	365 days
				Credit Sales

     Increasing accounts receivable collection period is not a good sign suggesting lack of proper credit control which may lead to irrecoverable debts. But sometimes in business, there is a “Bread and butter” customer who could lead to extension of credit terms which favours the said customers.

Payable payment period			=	Trade Payables	x	365 days
				Credit Purchases

     The credit period taken by the Company from its suppliers. A long credit period may be good for the Company but may develop a poor reputation as a slow payer and may lose current and incoming suppliers.

3) LONG-TERM FINANCIAL STABILITY

     Gearing ratios indicate the degree of risk attached to the company

    Measuring Gearing

Debt/equity ratio			=	Loans + Preference Share Capital
				Ordinary Share Capital + Reserves + Non-controlling interest
Percentage of capital employed			=	Loans + Preference Share Capital
represented by borrowings:				Ordinary Share Capital + Reserves + Non-controlling interest
				PLUS Loans +Preference Share Capital

   Interest Cover

Interest Cover			=	Profit Before Income Tax
				Interest Payable

    This indicates the ability of a Company to pay interest out of income

   4) INVESTOR RATIOS

(EPS) Earnings Per Share			=	Earnings
				Share

     This is regarded as the most important indicator of a Company’s performance.

Profit/Equity Ratio			=	Current Share Price
				Latest Earnings Per Share

     This represents the market’s view of the future prospects of the share.

Dividend Yield			=	Dividend per Share
				Current Share Price

     This can be compared to the yields available on other investment possibilities

Dividend Cover			=	Profit after tax
				Dividends

     This is the relationship between available profits and the dividends payable out of the income