Business Awareness Practical Exam (subject

CT9)
Business game – The Way Forward
Pre-exam reading material – Accounts
You will need a basic knowledge of balance sheets and profit and loss
accounts when taking part in the business game during the 2-day Business
Awareness Practical Exam.

The material below, which has been extracted from the core reading for
subject CT2 (Finance and Financial Reporting), provides the knowledge
required and must be read before attending the practical exam. You 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.

You should not need to spend more than an hour to understand this pre-exam
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
As an example, the annual report of a company listed on the UK 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 the stringent rules imposed by
the Companies Act 1985 and the detailed regulations imposed by the accountancy profession,
as discussed above.

The annual report of a particular 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
income statement and balance sheet.
62–66 The accounting statements themselves: income statement, balance sheet,
cash flow statement, statement of changes in equity 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. Most
large companies will have financial statements available on their websites.

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

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(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.

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The following is a balance sheet format which complies with the international standards.

ASSETS
Non-current assets

Property, plant & equipment x

Intangible assets x
x
Current assets
Inventories x
Trade receivables x
Other current assets x
Cash x
x
Total assets x

EQUITY AND LIABILITIES

Share capital x
Other reserves x
Retained earnings x
Total equity x

Non-current liabilities
Long-term borrowings x
Long-term provisions x
Total non-current liabilities x

Current liabilities
Trade and other payables x
Short-term borrowings x
Current portion of long-term borrowings x
Current tax payable x
Short-term provisions x
Total current liabilities x

Total liabilities x

Total equity and liabilities x

The above format follows the balance sheet equation overleaf and contrasts with the UK
standard approach which divides into net assets (assets minus liabilities) and capital. There
are also differences in terminology, including non-current assets — fixed assets, inventories
— stocks, trade receivables — debtors.

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2.1 Non-current assets
The distinction between non-current and current assets has more to do with the motive behind
their acquisition than their nature. Non-current 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 non-current assets.

Tangible non-current 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 non-current assets are non-current assets that literally cannot be touched. The most
common type of intangible 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: research and development costs, concessions, patents, trade
marks and brand names.

Non-current 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 market value
(see Section 5.1).

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

Thus, the balance sheet total for non-current 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.

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 inventories (or stocks) includes raw materials, consumables, work in
progress and finished goods awaiting sale. Inventories are shown in the balance sheet at the
lower of cost and net realisable value.

Trade receivables (or debtors) are the amounts which the company is owed by its customers.
The trade receivables heading may also include amounts due under bills of exchange
receivable.

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

The figures for inventories and trade receivables 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 Equity

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 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 (share capital). 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 (retained earnings).

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

Balances which are due within one year are classified as “current”.

Liabilities which are not due within one year are classified as non-current (or long-term). The
figure in respect of long-term provisions will include 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 (included in long-term borrowings) 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.

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3 The income statement
The income statement 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.

The following is an income statement format which complies with the international standards.

Revenue X
Cost of sales (x)
Gross profit X
Other operating income X
Distribution costs (x)
Administrative expenses (x)
Operating profit X
Finance income X
Finance costs (x)
Net Profit before tax X
Tax expense (x)
Profit after tax X
Profit for the period attributable to equity holders of the company X
Earnings per share for profit attributable to equity holders X

A dividend of xp per share was paid to ordinary shareholders during the year.

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 11).

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 finance costs (interest). Net profit before tax is the operating profit
adjusted for financing (interest) costs and income. Profit after tax is this net profit after
deduction of tax.

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.

3.3 Distribution costs and Administrative expenses

Distribution costs include costs associated with sales, distribution and

advertising. Administrative expenses include associated wages and
salaries and directors’ remuneration.

3.4 Tax expense

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 The tax charge in the income statement 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 income statement, although there are usually additional
charges.

3.5 Dividends paid

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 way dividends are shown has changed in the recent past:

• For accounting periods starting on or after 1 January 2005, dividends proposed

(dividends announced by the company’s directors but not yet approved by the
shareholders, which are planned to be paid after the company’s year end) are
disclosed only in a note to the accounts as they cannot be treated as definite until
approved at the company’s Annual General Meeting.

• Dividends paid should be shown as a note at the bottom of the income statement, in
the statement of changes in equity, in the cash flow statement and in the notes to the
accounts.

The profit for the period is “retained” within the business as part of the owners’ capital and
transferred to the Retained earnings part of the balance sheet.

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 income statements. EPS is equal to the earnings attributable to the ordinary
shareholders divided by the number of ordinary shares in issue.

3.7 Revaluation of assets/liabilities

As mentioned in Section 5, the move towards “fair value” accounting, with the recognising of
revaluations in the income statement has proved controversial. As an example, if you look at
income statements for an investment institution you will see items such as “Gains from
investments held at fair value” split into “Revenue” for income and realised capital gains and
“Capital” for unrealised gains in the income statement.

4 The cash flow statement

The cash flow statement is intended to supplement the income statement and balance sheet.
The income statement 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.

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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 income statement, such as depreciation, do not involve funds. Furthermore, the income
statement 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:

£’000
Cash flows from operating activities
Cash generated from operations 33,100
Interest paid (9,200)
Tax paid (14,500)
Net cash generated from operating activities 9,400

Cash flows from investing activities

Purchases of property, plant and equipment (9,800)
Proceeds from sale of property, plant and equipment 6,400
Purchases of intangible assets (3,000)
Loans granted to related parties (1,300)
Loan repayments received from related parties 100
Interest received 1,200
Net cash used in investing activities (6,400)

Cash flows from financing activities

Proceeds from issuance of ordinary shares 1,000
Proceeds from borrowings 8,500
Repayments of borrowings (10,000)
Dividends paid to company’s shareholders (11,000)
Net cash used in financing activities (11,500)

Net (decrease)/increase in cash, cash equivalents and bank overdrafts (8,500)

Cash, cash equivalents and bank overdrafts at beginning of the year 30,000
Cash, cash equivalents and bank overdrafts at end of the year 21,500
where the cash generated from operations is determined as:

Operating profit 33,000

Adjustments for
- Depreciation 18,000
Changes in working capital
- Inventories (7,000)
- Trade and other receivables (1,500)
- Trade and other payables (9,400)
Cash generated from operations 33,100

This shows that the company generated cash inflows of £9.4m from its trading activities. The
operating profit figure in the income statement includes an accounting adjustment in respect
of depreciation. The cash flow related to that expense occurred when the non-current assets
were purchased. The company’s trading activities also include transactions involving
inventories (stock), trade receivables (debtors), and trade payables (creditors). These can
affect cash flows without affecting profits. If, for example, the company received £100 from
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, investing activities and financing activities. These can include the following:

Investing activities

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 • purchase and sale of non-current assets, property, plant and equipment plus intangible
assets, like patents

• receipts of interest and dividends from investments

• transactions involving “liquid” assets other than cash, such as short term investments
in securities

Financing activities

• payment of dividends to the company’s shareholders

• cash flows arising from the repayment of loans and from fresh borrowing and the
issue of shares

END

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