Overstate the profit in the Income Statement as the Revenue (which has been recognised) will not result in any future benefit.

Developing Skills for Business Leadership (Finance)
SESSION 2
© Fergal Meaney 2019This Evening’s Session
Summary of Previous Session
Class Exercise
Profit & Loss/Balance Sheet Adjustments
Operating Cash Cycle (OCC)
© Fergal Meaney 2019P&L, B/Sheet Adjustments
Additional P&L and Balance Sheet Adjustments:
(1) Accruals
(2) Prepayments
(3) Fixed Assets/Depreciation
(4) Stock/Write-Downs
(5) Debtors/Bad Debt Provision
(6) Intangible Assets/Amortisation
© Fergal Meaney 2019FIXED ASSETS – REMINDER
Fixture & Fittings
Office Equipment
Motor Vehicles
Buildings
Computer Equipment
Land
Computer Software
Leasehold Improvements
Machinery
Intangible Assets
Goodwill
© Fergal Meaney 2019FIXED ASSETS – COST
Cost of Fixed Assets:
Includes all costs to bring the asset to its required location and to make it ready for use.
Includes delivery costs, installation costs, legal costs incurred in the transfer of legal title.
© Fergal Meaney 2019FIXED ASSETS – FAIR VALUE
Fair Value of Fixed Assets:
This is the exchange value that could be obtained in an arm’s-length transaction.
Assets can only be revalued to fair value if it can be measured reliably.
When a revaluation is carried out, all items within the same class must be revalued and revaluations must be kept up to date.
Note: Think of the property bubble and the impact on companies who had revalued their properties, many ended up with below cost valuations.
© Fergal Meaney 2019DEPRECIATION
Most Fixed Assets are eventually used up in the process of generating revenue for the business.
DEPRECIATION is an attempt to measure the portion of the cost (or fair value) of a Fixed Asset that has been used up in generating the Revenue recognised during a particular period.
To calculate the Depreciation Charge for a period, 4 factors have to be considered:
(1)The Cost (or fair value) of the asset.
(2)The Useful Life of the asset.
(3)The Residual Value of the asset.
(4)The Depreciation Method.
© Fergal Meaney 2019DEPRECIATION
(1) The Cost (or fair value) of the asset.
(2) The Useful Life of the asset:
(a) Physical Life
Exhausted through the effects of wear and tear and/or the passage of time.
(b) Economic Life
-Decided by the effects of technological progress and by changes in demand.
-After a while the benefits of using the asset may be less than the costs involved.
-The economic life may be lass than the useful life (a computer may have a useful life of 8 years but an economic life of 3 years).
© Fergal Meaney 2019DEPRECIATION
(3) The Residual Value of the asset:
-The disposal value of an asset after sale.
(4) The Depreciation Method:
2 methods in practice:
(i)Straight Line -allocates amount evenly over the useful life of the asset.
(ii)Reducing Balance – applies a fixed % rate of depreciation to the carrying amount of an asset leave.
© Fergal Meaney 2019EXAMPLES OF DEPRECIATION CALCULATION
© Fergal Meaney 2019EXAMPLES OF ASSET USEFUL LIFE AND DEPRECIATION RATE
FIXED ASSET TYPE
ASSET USEFUL LIFE (YEARS)
DEPRECIATION %
Freehold Premises
50
2%
Short Leasehold land and buildings
Period of Lease
Fixture & Fittings
7
14%
Equipment
4
25%
Retail Store Improvements
10
10%
Other Equipment and vehicles
6
17%
Manufacturing Plant and Machinery
12
8%
Computer Hardware
3
33%
Computer Software and licences
5
20%
Motor Vehicles
4
25%
© Fergal Meaney 2019FIXED ASSET – QUICK CHECK
•What kinds of judgments must be made to calculate a depreciation charge for a period?
•The expected residual or disposal value of the asset (D)
•The expected useful life of the asset (U)
•The choice of Depreciation Method (D)
•Think of DUD!
© Fergal Meaney 2019INVENTORY
•What is Inventory?
•Essentially serves as a buffer between a company’s sales of goods and its production or purchase of goods.
•Types of Inventory
•Very much dependent on the type of business
•Raw Materials
•Work In Progress
•Finished Goods
© Fergal Meaney 2019INVENTORY
•How much inventory to hold?
•Balancing act in holding the proper amount of inventory.
•Too Little:
•Risk of lost sales
•Disruption to Production
•Too Much:
•Stock Obsolescence
•Storage Costs
•Finance Costs – strain on Cash
© Fergal Meaney 2019INVENTORY – COSTING
3 basis of Costing:
(a)First In First Out (FIFO)
– The earliest inventories held are the first to be used.
(b)Last In First Out (LIFO)
– The latest inventories held are the first to be used.
(c)Weighted Average (AVCO) Last In First Out (LIFO)
– Average cost of each batch of inventories bought.
© Fergal Meaney 2019EXAMPLES OF INVENTORY COSTING
© Fergal Meaney 2019INVENTORY – VALUATION
•Inventory is valued at the lower of Cost and Net Realisable Value (NRV).
•What is NRV?
•NRV = Estimated Selling Price less any further costs that may be necessary to complete the goods and any costs involved in selling and distributing the goods.
•Normally the cost price appears in the Balance Sheet.
© Fergal Meaney 2019INVENTORY – VALUATION
•Can you think of any circumstances where the Net Realisable Value (NRV) will be lower than the cost of inventories held?
•Goods have deteriorated or become obsolete.
•There has been a fall in the market value of the goods.
•Seasonality.
•The goods are being used as a “Loss leader.”
•Bad Buying decisions have been made.
© Fergal Meaney 2019INVENTORY – VALUATION
•Example 1:
•Stock of Newly Purchased Mobile phones at 31 December 2018:
•Cost €300
•RSP €700
•Example 2:
•Stock of Christmas Decorations at 31 December 2018:
•Cost €300
•RSP €100
•Other Examples:
•Out Of Date Stock e.g. Expiration of Best Before Dates
•Designer Clothes going out of fashion
© Fergal Meaney 2019INVENTORY – NON MOVING STOCK
•Good Company practice is to have a stock write-down policy.
•Example:
•ABC Ltd. has a policy that any stock not moving over a 2 year period is fully written off.
•This write-down policy is staged so that any stock not moving over a 6 month period is written down by 25%.
•If not moving over a 12 month period then is written down by another 25% and so on.
•Having a stock write down policy should focus the business on selling slow or non moving stock.
•Auditors will review non-moving stock and may insist on a stock provision being made for slow or non-moving stock.
© Fergal Meaney 2019ACCURACY OF STOCK QUANTITY
•Audit requirement:
•Inventory must be counted at least once a year.
•Auditors will attend stocktake during the year.
•Annual Stocktake:
•Once a year counting of Inventory.
•Cycle Counting:
•Ongoing systematic cycle counting
•All inventory covered at least once during the year
•Fast Moving, High Value or Fashionable items may be counted a number of times during the year.
© Fergal Meaney 2019Remember from Saturday Workshop:
Cost of Sales =
Opening Stock
+
Purchases
–
Closing Stock
© Fergal Meaney 2019INVENTORY – NOTES
•COST > NRV
•STOCK TAKE SHORTAGE
•These will reduce the Closing Stock and as such will be reflected in the Income Statement in Cost of Sales.
© Fergal Meaney 2019CONSISTENCY CONVENTION
Basically holds that:
Once method of Depreciation selected
for example:
Straight Line
Computer Software (5 years, 20%)
Once Inventory Costing basis selected e.g. FIFO
It should be consistently applied over time unless exceptional circumstances make it appropriate.
© Fergal Meaney 2019ACCOUNTS RECEIVABLES (DEBTORS)
Most businesses sell goods and services on credit.
Revenue/Sales will often be recognised before the customer pays the amount owing.
© Fergal Meaney 2019BAD DEBT
There is a risk that the customer may not pay the amount due (regardless of how reliable they seemed to be at time of sale).
When it becomes reasonably certain that the customer will never pay, the debt is considered to be “Bad”.
The Bad Debt must be taken into account when preparing the Financial Statements, it must be “written off”.
© Fergal Meaney 2019BAD DEBT – Why take into Consideration?
What is the effect on the Income Statement and Balance Sheet of not taking into account the fact that a Debt is bad?
Answer:
Overstate the Current Assets (Trade Receivables).
Overstate the profit in the Income Statement as the Revenue (which has been recognised) will not result in any future benefit.
© Fergal Meaney 2019WRITING OFF A BAD DEBT
This will involve:
Reducing the Trade Receivables
and
Increase the Income Statement Expenses (known as Bad Debts written off” by the amount of the Bad Debt.
The Bad Debt is written off in the same period as the sale that gave rise to the debt is recognised (remember the matching principle).
© Fergal Meaney 2019DOUBTFUL DEBTS
It may not be possible during a period to identify all Bad Debts.
Some Debtor balances (or part of them) may be doubtful – we are not fully sure if they will be paid or not.
An Allowance for Trade Receivables (or Bad Debt Provision) is created.
© Fergal Meaney 2019BAD DEBT PROVISION/WRITE-OFF
Review of Example
Important Considerations:
Impact on Income Statement
Impact on Balance Sheet
Impact on Cashflow/Business
Importance of Credit Control
© Fergal Meaney 2019Operating Cash Cycle (OCC)
Payments for inventories acquired on credit occurs some time after those inventories have been purchased.
No immediate Cash Outflow from Purchases.
Cash receipts from credit customers will occur some time after the sale is made.
No immediate Cash Inflow from Purchases.
OCC is the time period between the payment made to the supplier for the goods and the cash received from the credit customer.
© Fergal Meaney 2019Calculating the Operating Cash Cycle (OCC)
Calculate the Operating Cash Cycle for Flush Ltd. which has the following:
Average Settlement Period for Trade Payables is 54.3 days.
Average Inventories Holding period is 56.7 days.
Average Settlement Period for Trade Receivables is 37.2 days.
Answer: 39.6 days (56.7 + 37.2 – 54.3 = 39.6)
© Fergal Meaney 2019Operating Cash Cycle (OCC)
The Operating Cash Cycle has a significant influence on the financing requirements of the business.
The longer the Operating Cash Cycle:
The greater the financing requirements of the business.
The greater the financial risk of the business.
© Fergal Meaney 2019Calculating the Operating Cash Cycle (OCC)
Different business/industry have different OCC:
Manufacturing:
Inventory (Raw materials, Work in Progress, Finished Goods).
Non Credit Sale Business e.g. McDonalds
Domestic v Far Eastern Suppliers
© Fergal Meaney 2019Ways of Improving the Operating Cash Cycle (OCC)
Suppliers
Get suppliers to accept a longer debt repayment period e.g. 30 to 60 days.
Risky and may rebound.
Will generally only work where the supplier is smaller and more dependent on your business.
Payment from end of month rather than date of invoice – commonly used in practice.
Use of bank Letters of Credit
Customers
Don’t delay invoicing process (e.g. invoice on date of sale rather than waiting until end of week or end of month).
Ensure efficient invoicing system.
Reduce credit terms e.g. from 60 days to 30 days.
Offer discount for early payment.
Use of Invoice Discounting facilities from financial institutions.
© Fergal Meaney 2019Ways of Improving the Operating Cash Cycle (OCC)
Inventory
Inventory optimisation technology.
Ensure that the correct quantities of the correct inventory is being held.
Reduction/elimination of slow moving stock.
Have suppliers hold inventory levels for your company.
Just in Time approach works well for the larger companies(puts a lot of the onus for holding inventory with their suppliers).
© Fergal Meaney 2019