Business Management Module (subject CB3)

Business game
Pre-course reading material – Accounts
Students will need a basic knowledge of balance sheets and profit and loss
accounts when taking part in the business game.

The material below provides the knowledge required and must be read
participation in the Business Game. Students only need to understand the
basic principles applying to balance sheets and profit and loss accounts. The
other information below has been included to help put these items in context.

Students should not need to spend more than an hour to understand this pre-
course reading which should be read in conjunction with the ‘Players Briefing
Paper’ for the game.

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1 Typical contents of an annual report

The annual report of a company listed on the Stock Exchange can easily run
to 60 or 70 pages. Much of this is “promotional” material which is published
on a voluntary basis. The core of the report is, however, subject to stringent
rules imposed by the Companies Act 1985 and the detailed regulations
imposed by the accountancy profession.

The annual report of a UK-based multinational ran to 96 pages. This

comprised:
Page
1 Contents
2–3 The directors’ biographical details.
4 A page of “highlights” of financial statements including the profit and
dividend figures and some key trends.
5 An analysis of turnover & profit by product area and geographical area.
6–9 The chairman’s statement to members, including a personal review of the
year gone past and the company’s future.
10–11 A map showing the company’s world-wide operations.
12–13 Statistics showing a thirty year financial record.
14–48 A review of operations comprising a series of descriptive analyses of each
of the company’s main business segments.
49–52 Disclosure of matters relating to corporate governance issues such as
directors’ remuneration.
53–59 The directors’ report, which is actually a list of miscellaneous disclosures
required by the Companies Act 1985.
60–61 A statement of the accounting policies which were used in compiling the
profit and loss account and balance sheet.
62–66 The accounting statements themselves: profit & loss account, balance
sheets, cash flow statement, statement of total recognised gains & losses,
etc.
67 A statement of the directors’ responsibilities for the financial statements
and the auditors’ report.
68–90 Notes to the accounts
91–96 A list of the company’s principal UK and overseas subsidiaries.

There is no need to learn the detailed content of a typical annual report. It is,
however, almost impossible to make any sense of these rules in a vacuum.
The best way to obtain some understanding of the contents of the financial
statements is to obtain one or two sets. The easiest way to do so in the UK is
to use the service provided by the Financial Times. This is described in the
inside back pages of the Companies and Markets section of the newspaper.

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2 The balance sheet

The balance sheet summarises the company’s financial position. Effectively,

the balance sheet consists of two lists:
1. A list of everything owned by the business
2. A list of the various sources of finance used to fund these acquisitions
Everything of value which is owned by a business is called an “asset”.
Finance can be provided by the owners of the business (“capital”) or by third
parties (“liabilities”).

Logically, everything owned by the business must have been paid for by
someone. Similarly, all amounts invested in or loaned to the business must be
represented by something. There is, therefore, a simple relationship between
assets, liabilities and capital:
Assets = Capital + Liabilities
This is called the balance sheet equation.

The following is a typical balance sheet format.

£ £
Fixed Assets
Intangible Assets x
Tangible Assets x
Investments x
x
Current Assets
Stocks x
Debtors x
Investments x
Cash at bank x
x
Creditors: amounts falling due
Within one year (x)
Net Current Assets x
Total assets less current liabilities x

Creditors: Amounts falling due

After more than one year (x)
Provisions for liabilities and charges (x)
x
Capital and Reserves
Called-up share capital x
Share premium account x
Revaluation reserve x
Other reserves x
Profit and Loss Account x
x

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Effectively, this presentation restates the balance sheet equation by
subtracting liabilities from assets. The first section shows net assets (i.e.
assets minus liabilities) and the second deals with capital.

2.1 Fixed assets

The distinction between fixed and current assets has more to do with the
motive behind their acquisition than their nature. Fixed assets usually have
long lives and are bought with the intention of using them in the business.

There is usually a great deal of information about the figure for tangible fixed
assets.

Tangible fixed assets are generally valued at cost less depreciation.

Depreciation has very little to do with reflecting the “true” value of the assets in
the balance sheet. Instead, it is an attempt to write the cost of the assets off
as an expense over their estimated useful life.

Intangible fixed assets are fixed assets that literally cannot be touched. The
most common type of intangible fixed asset is goodwill. This arises when a
company buys another company for more than the residual balance sheet
value of the target company. The difference between the price paid and the
balance sheet value is the goodwill. Possible intangible assets include:
development costs, concessions, patents, trade marks and brand names.

Fixed asset investments may consist of interests in other companies, in the

form of shares, loan stock, debentures, or straight loans. They are normally
shown at cost.

The problems associated with the valuation of assets at cost less depreciation
can be reduced slightly by the regular revaluation of fixed assets, most
notably land and buildings.

Thus, the balance sheet total for fixed assets may consist of a mixture of costs
and valuations, dating from a variety of accounting periods, and all less
depreciation charged since the date of acquisition or valuation. The figure
will, therefore, have an arithmetic precision but will usually be absolutely
meaningless for decision-making purposes.

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2.2 Current assets
Current assets are cash and items which will be converted into cash in the
normal course of business.

In accounts, the term stocks includes raw materials, consumables, work in

progress and finished goods awaiting sale. Stocks are shown in the balance
sheet at the lower of cost and net realisable value.

Debtors are the amounts which the company is owed by its customers. The
debtors heading may also include amounts due under bills of exchange
receivable.

Under current assets, the investment heading might include, for example,
money held on short term deposit.

The figures for stocks and debtors should be adjusted to take into account any
anticipated losses due to obsolescence or deterioration in the case of stocks
and likelihood of default in the case of debtors.

2.3 Liabilities
Liabilities are analysed according to their date of maturity.

Balances which are due within one year are classified as “current”. They are
subtracted from current assets to reflect the fact that they represent a charge
on the company’s liquid resources.

Liabilities which are not due within one year are classified as long term. The
figure in respect of “Provisions for liabilities and charges” consists of the
estimated liabilities in respect of deferred taxation and other matters such as
pension commitments. These differ from the term loans and obligations under
finance leases in that the actual amounts and timing of these payments are
subject to some uncertainty. They are, nevertheless, liabilities and should be
shown as such in the balance sheet.

2.4 Capital (“Equity”)

Shareholders’ equity can arise in a number of different ways. Some is
contributed directly in the form of payments made for the purchase of shares.
Most of the remainder will be generated from trading activities. This consists
of profits which have not been distributed in the form of dividends or share
buy-backs.

The revaluation reserve consists of amounts added to the value of fixed

assets. This will be discussed in Unit 10.

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3 The profit and loss account

The profit and loss account provides an insight into a company’s trading
activities. It compares the income generated from trading with the costs
associated with earning that income, the difference being the profit or loss for
the year.

A simplified profit and loss account would appear as follows:

£000
Turnover 1,000
Cost of sales 300
Gross profit 700
Expenses 200
Operating profit 500
Non trading income (net of expenses) 100
Net profit before tax 600
Taxation 220
Net profit after tax 380
Dividend 250
Retained profit for the year 130
Retained profit brought forward 460
Retained profit carried forward 590
Earnings per share 47 pence

3.1 Cost of sales

Cost of sales reflects the raw material, components, wages and salaries
expended in producing the goods sold. Changes in stock levels (both finished
goods and raw materials) will need to be included, as will the charges for
depreciation (see Unit 10 below).

3.2 Categories of profit

The profit figure is normally calculated in three stages. Gross profit is the
difference between the selling price of the goods and services which provide
the basis for the company’s main trading activities and the cost of sales.
Operating profit is usually defined as profit earned after all expenses (except
interest) arising from trading activities. Net profit is the operating profit
adjusted for non-trading income and expenditure and for any interest received
or paid.

The gross profit figure gives an insight into the company’s pricing policies.
The difference between cost and selling prices represents the contribution
toward the non-trading expenses and profit. While this information can be
useful, it is possible to prepare the financial statements without differentiating
between trading and non-trading expenses.

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3.3 Expenses
Expenses include costs associated with sales, distribution, advertising and
administration (including associated wages and salaries) and directors’
remuneration.

3.4 Taxation
The tax charge in the profit and loss account arises because companies pay
corporation tax on their adjusted net profit figures. These adjustments may be
disputed by the Tax Authorities and may be revised after the publication of the
accounting statements. The estimate for corporation tax forms the core of the
charge in the profit and loss account, although there are usually additional
charges.

3.5 Dividends and retained profits

The final profit figure for the year is used to pay dividends. It would be
unusual for the company to distribute all of the profit in this way. Profit may
also be distributed by the company buying back shares. The remainder is
“retained” within the business as part of the owners’ capital.

We will see later in this unit that profits and cash flows are two quite different
things. Thus, the link between retained profits and bank balances is, at best,
tenuous.

3.6 Earnings per share

Companies are obliged to calculate the earnings per share (EPS) figure and
disclose it on the face of their profit and loss accounts. EPS is equal to the
earnings attributable to the ordinary shareholders divided by the number of
ordinary shares in issue.

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4 The cash flow statement

The cash flow statement is intended to supplement the profit and loss account
and balance sheet. The profit and loss account and balance sheet are useful
statements in their own right. They do not, however, provide a sufficient
insight into movements in cash balances. This is unfortunate because even
profitable companies will collapse if they are not sufficiently liquid. Very few
businesses could survive a prolonged cash outflow.

The profit figure for the year is unlikely to bear any resemblance to the
increase or decrease in the company’s bank balance or total for working
capital over that period. Several entries in the profit and loss account, such as
depreciation, do not involve funds. Furthermore, the profit and loss account
recognises credit sales and purchases before any cash changes hands.
Conversely, many receipts and payments, such as the proceeds of share
issues and loan repayments, have no immediate impact on profit. It is
possible for a company to trade profitably and still run into liquidity problems.

The bank balance is, of course, disclosed in the balance sheet. It is easy to
see whether the balance has changed since the end of the previous year. It
is, however, difficult to identify the major causes of such changes.
Shareholders and other readers require a more structured description of the
cash flows.

The cash flow statement is intended to answer the following types of question:
 Why has the bank overdraft increased, despite the company having
had a profitable year?
 Is the company capable of generating cash, as opposed to profit, from
its trading activities?
 What was done with the loan which was taken out during the year?

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The following is an example of a cash flow statement:
Reconciliation of operating profit to net cash inflow from
operating activities
£000
Operating profit 12,044
Depreciation charges 1,798
Increase in stocks – 388
Increase in debtors – 144
Increase in creditors 468
Net cash inflow from operating activities 13,778

CASH FLOW STATEMENT

Net cash inflow from operating activities 13,778
Returns on investments and servicing of finance 5,998
Taxation – 5,844
Capital expenditure – 3,050
10,882
Equity dividends paid – 4,834
6,048
Management of liquid resources – 900
Financing 114
Increase in cash 5,262

The first part of the statement shows that the company generated cash inflows
of £13.778m from its trading activities. The profit figure in the profit and loss
account includes an accounting adjustment in respect of depreciation. The
cash flow related to that expense occurred when the fixed assets were
purchased. The company’s trading activities also include transactions
involving stock, debtors and creditors. These can affect cash flows without
affecting profits. If, for example, the company was owed £100 by its debtors
at the start of the year, made sales of £1,000 during the year and was owed
£150 at the year end it would have received cash from its debtors of £100 +
1,000  150 = £950. Thus, it would report income of £1,000 even though
cash takings were less because some of the sales had resulted in an increase
in debtors rather than an inflow of cash.

The other headings on the statement deal with cash flows which arise from
non-trading activities. These are made up as follows:
 Receipts of dividends and receipts and payments of interest
 Payments of taxation
 Purchase and sale of fixed assets
 Payment of dividends to the company’s shareholders
 Transactions involving “liquid” assets other than cash, such as short
term investments in securities
 Cash flows arising from the repayment of loans and from fresh
borrowing and the issue of shares