Accounting and finance for non specialists 5e by peter atrill and eddie mclaney

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Now in its fifth edition, this successful text introduces the basic principles and underlying
concepts of accounting and finance. It adopts a practical, non-technical approach, making it the
ideal text for students from non-accounting disciplines.

fifth
edition

The fifth edition has been fully updated and revised throughout and has the
following key features:
• A lively presentational style with extracts from newspapers and company
reports to provide a real-life context.

for

• Real World boxes demonstrate the practical application and value of
concepts and techniques learnt.

Non-Specialists

ACCOUNTING AND FINANCE

The text is written from a ‘user’ perspective, demonstrating ways in which accounting
statements and financial information can be used to improve the quality of decision making.

• An ‘open-learning’ approach with numerous activities, worked examples
and questions interspersed throughout the text to aid understanding
makes the book ideal for self-study.
• The decision-making focus on the use of accounting information rather
than the preparation is highly appropriate for tomorrow’s business
managers.
• An extensive range of additional resources, including further exercises,
innovative case studies, and multiple-choice questions.

Peter Atrill is a freelance academic and author
working with leading institutions in the UK, Europe
and SE Asia. He was previously Head of Business and
Management at the University of Plymouth Business
School.
Eddie McLaney is Visiting Fellow in Accounting and
Finance at the University of Plymouth.

Atrill & McLaney

The authors
Accounting and Finance for
Non-Specialists, fifth edition
is aimed primarily at students
who are not majoring in
accounting or finance but
who are studying introductory
level accounting as part of
their course.

fifth edition

ACCOUNTING AND FINANCE
for

Non-Specialists

Peter Atrill &
Eddie McLaney

ISBN 0-273-70244-0

Additional student support at
www.pearsoned.co.uk/atrillmclaney

9 780273 702443
An imprint of

Cover image:
© Getty Images/PhotoAlto

www.pearson-books.com

Additional student support at
www.pearsoned.co.uk/atrillmclaney


AAF_A01.qxd 3/30/06 11:08 AM Page i

ACCOUNTING AND FINANCE

for Non-Specialists

Visit the Accounting and Finance for Non-Specialists, fifth edition
Companion Website at www.pearsoned.co.uk/atrillmclaney to find
valuable student learning material including:
n

Multiple choice questions to test your learning

n

Solutions to end of chapter review questions

n

Revision questions to help you check your understanding

n

Extensive links to valuable resources on the web

n

An online glossary to explain key terms


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We work with leading authors to develop the strongest
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Fifth Edition

ACCOUNTING AND FINANCE
for Non-Specialists
Peter Atrill and Eddie McLaney


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Pearson Education Limited
Edinburgh Gate
Harlow
Essex CM20 2JE
England
and Associated Companies throughout the world
Visit us on the World Wide Web at:

www.pearsoned.co.uk

First published in 1995 by Prentice Hall Europe
Second edition in 1997
Third edition published in 2001 by Pearson Education Limited
Fourth edition in 2004
Fifth edition in 2006
© Pearson Education Limited 2006
The rights of Peter Atrill and Eddie McLaney to be identified as authors of
this work have been asserted by them in accordance with the Copyright,
Designs and Patents Act 1988.
All rights reserved. No part of this publication may be reproduced, stored
in a retrieval system, or transmitted in any form or by any means, electronic,
mechanical, photocopying, recording or otherwise, without either the prior
written permission of the publisher or a licence permitting restricted copying
in the United Kingdom issued by the Copyright Licensing Agency Ltd,
90 Tottenham Court Road, London W1T 4LP.
ISBN-13: 978-0-273-70244-3
ISBN-10: 0-273-70244-0
British Library Cataloguing-in-Publication Data
A catalogue record for this book is available from the British Library
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A catalogue record for this book is available from the Library of Congress
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Printed and bound in Great Britain by Ashford Colour Press, Hampshire
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Contents
Preface

xiii

Guided tour of the book

xvi

Acknowledgements

xix

1

Introduction to accounting and finance
Introduction
Learning outcomes
What are accounting and finance?
Accounting and user needs
Not-for-profit organisations
Accounting as a service function
The threshold of materiality
Costs and benefits of accounting information

Accounting as an information system
Planning and control
Management and financial accounting
The scope of this book
Has accounting become too interesting?
Why do I need to know anything about accounting and finance?
Business objectives
Summary
Key terms
Further reading
Review questions

1
1
1
2
3
5
6
8
8
9
11
13
15
15
17
18
20
21

22
22

Part 1 FINANCIAL ACCOUNTING
2 Measuring and reporting financial position
Introduction
Learning outcomes
The major financial statements – an overview
The balance sheet

25
25
25
26
30

v


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Contents

The effect of trading operations on the balance sheet
The classification of assets
The classification of claims
Balance sheet formats
The balance sheet as a position at a point in time
Accounting conventions and the balance sheet
Accounting for goodwill and product brands

The basis of valuation of assets on the balance sheet
Interpreting the balance sheet
Summary
Key terms
Further reading
Review questions
Exercises

3 Measuring and reporting financial performance

61

Introduction
Learning outcomes
The income statement (profit and loss account)
Relationship between the income statement and the balance sheet
The format of the income statement
The income statement – some further aspects
Profit measurement and the recognition of revenue
Profit measurement and the recognition of expenses
Profit measurement and the calculation of depreciation
Profit measurement and inventories (stock) costing methods
Profit measurement and the problem of bad and doubtful debts
Interpreting the income statement
Summary
Key terms
Further reading
Review questions
Exercises

61
61
62
64
64
66
69
71
76
86
89
93
93
95
95
96
96

4 Accounting for limited companies
Introduction
Learning outcomes
Generating wealth through limited companies
Managing a company – corporate governance and the role of directors
Financing limited companies
Raising share capital
Loans and other sources of finance

vi

37

39
41
42
45
46
51
52
56
56
57
58
58
59

1 00
1 00
1 00
101
1 07
1 10
1 17
1 18


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Contents

Restriction on the right of shareholders to make drawings of their claim
Accounting for limited companies

The directors’ duty to account
The need for accounting rules
The main sources of accounting rules
Directors’ report
Auditors
Accounting rules and the quality of financial statements
Summary
Key terms
Further reading
Reference
Review questions
Exercises

1 19
1 22
1 26
1 26
1 26
1 27
1 28
1 29
1 32
1 34
1 34
1 35
1 35
1 35

5 Measuring and reporting cash flows

1 39

Introduction
Learning outcomes
The cash flow statement
The main features of the cash flow statement
Preparing the cash flow statement
What does the cash flow statement tell us?
Summary
Key terms
Further reading
Review questions
Exercises

1 39
1 39
1 40
1 42
1 49
1 56
1 59
1 60
1 60
161
161

6 Analysing and interpreting financial statements
Introduction
Learning outcomes
Financial ratios

Financial ratio classifications
The need for comparison
Calculating the ratios
A brief overview
Profitability
Efficiency
The relationship between profitability and efficiency
Liquidity
Financial gearing
Investment ratios

1 67
1 67
1 67
1 68
1 69
1 70
171
1 73
1 74
1 80
1 85
1 87
1 89
1 95

vii


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Contents

Trend analysis
Ratios and prediction models
Limitations of ratio analysis
Summary
Key terms
Further reading
Review questions
Exercises

203
205
205
207
208
208
209
209

Part 2 MANAGEMENT ACCOUNTING
7 Cost–volume–profit analysis
Introduction
Learning outcomes
The behaviour of costs
Fixed costs
Variable costs
Semi-fixed (semi-variable) costs
Break-even analysis

Contribution
Margin of safety and operating gearing
Profit-volume charts
Failing to break even
Weaknesses of break-even analysis
The popularity of break-even analysis
Marginal analysis
Accepting/rejecting special contracts
The most efficient use of scarce resources
Make-or-buy decisions
Closing or continuation decisions
Summary
Key terms
Further reading
Review questions
Exercises

8 Full costing
Introduction
Learning outcomes
The nature of full costing

viii

217
217
217
218
218
22 1

222
223
228
228
232
233
233
234
235
237
238
240
242
244
245
245
245
246
249
249
249
250


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Contents

Deriving full costs in a single-product operation
Deriving full costs in multi-product operations

Activity-based costing (ABC)
Uses of full-cost information
Criticisms of full costing
Summary
Key terms
Further reading
References
Review questions
Exercises

9 Budgeting
Introduction
Learning outcomes
Budgets, long-term plans and corporate objectives
Time horizon of plans and budgets
Budgets and forecasts
The interrelationship of various budgets
The uses of budgets
The extent to which budgets are prepared
Preparing the cash budget
Preparing other budgets
Using budgets for control
Comparing the actual performance with the budget
Standard quantities and costs
Reasons for adverse variances
Investigating variances
Compensating variances
Making budgetary control effective
Limitations of the traditional approach to control through
variances and standards

Behavioural aspects of budgetary control
Summary
Key terms
Further reading
References
Review questions
Exercises

250
25 1
267
272
274
274
276
276
276
277
277
280
280
280
28 1
282
283
284
286
288
289
293

298
300
31 1
312
313
315
316
316
317
319
320
320
32 1
32 1
32 1

ix


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Contents

Part 3 FINANCIAL MANAGEMENT
10 Making capital investment decisions
Introduction
Learning outcomes
The nature of investment decisions
Methods of investment appraisal
Accounting rate of return (ARR)

Payback period (PP)
Net present value (NPV)
Why NPV is superior to ARR and PP
Internal rate of return (IRR)
Some practical points
Investment appraisal in practice
Summary
Key terms
Further reading
References
Review questions
Exercises

327
327
328
329
33 1
336
340
347
348
352
356
359
36 1
36 1
36 1
362
362

11 Managing working capital

367

Introduction
Learning outcomes
The nature and purpose of working capital
The scale of working capital
Managing inventories (stock)
Managing receivables (debtors)
Managing cash
Managing trade payables (creditors)
Summary
Key terms
Further reading
Review questions
Exercises

x

327

367
367
368
370
37 1
38 1
389

396
398
400
400
40 1
40 1


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Contents

12 Financing the business

406

Introduction
Learning outcomes
Sources of finance
Internal sources of financing
Long-term sources of internal finance
Short-term sources of internal finance
Sources of external finance
Long-term sources of external finance
Gearing and the long-term financing decision
Share issues
The role of the Stock Exchange
Short-term sources of external finance
Providing long-term finance for the small business
Summary

Key terms
Further reading
Review questions
Exercises

406
406
407
407
407
409
41 1
412
425
429
433
439
443
448
449
450
450
450

Present value table

455

Glossary of key terms

456

Relevant websites

468

Appendix A: Solutions to self-assessment questions

474

Appendix B: Solutions to review questions

486

Appendix C: Solutions to selected exercises

499

Index

525

xi


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Supporting resources
Visit www.pearsoned.co.uk /atrillmclaney to find valuable online resources
Companion Website for students

Multiple choice questions to test your learning
n Solutions to end of chapter review questions
n Revision questions to help you check your understanding
n Extensive links to valuable resources on the web
n An online glossary to explain key terms
n

For instructors
n Complete, downloadable Instructor’s manual
n PowerPoint slides that can be downloaded and used as OHTs
n Progress tests, consisting of various questions and exercise material with solutions
n Tutorial/seminar questions and solutions
n Solutions to individual chapter exercises
Also: The Companion Website provides the following features:
n Search tool to help locate specific items of content
n E-mail results and profile tools to send results of quizzes to instructors
n Online help and support to assist with website usage and troubleshooting
For more information please contact your local Pearson Education sales representative
or visit www.pearsoned.co.uk /atrillmclaney

OneKey: All you and your students need to succeed
OneKey is an exclusive new resource for instructors and
students, giving you access to the best online teaching and
learning tools 24 hours a day, 7 days a week.
OneKey means all your resources are in one place for
maximum convenience, simplicity and success.

Convenience. Simplicity. Success.

A OneKey product is available for Accounting and Finance for Non-Specialists,

fifth edition for use with Blackboard™, WebCT and CourseCompass. It contains:
Interactive Study Guide with exercises to enhance your understanding and assess
your progress
n Interactive online flashcards that enable you to check definitions against key terms
during revision
n All resources available to students through the Companion Website
n All teaching resources available to instructors
n

For more information about the OneKey product please contact your local Pearson
Education sales representative or visit www.pearsoned.co.uk/onekey


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Preface
This text provides an introduction to accounting and finance. It is aimed primarily at
students who are not majoring in accounting or finance but who are, nevertheless,
studying introductory level accounting and finance as part of their course in business,
economics, hospitality management, tourism, engineering or some other area. Students
who are majoring in either accounting or finance should, however, find the book
useful as an introduction to the main principles, which can serve as a foundation for
further study. The text does not focus on the technical aspects, but rather examines
the basic principles and underlying concepts, and the ways in which accounting
statements and financial information can be used to improve the quality of decision
making. To support this practical approach, there are, throughout the text, numerous
illustrative extracts with commentary from company reports, survey data and other
sources.
The text is written in an ‘open-learning’ style. This means that there are numerous
integrated activities, worked examples and questions throughout the text to help you

to understand the subject fully. You are expected to interact with the material and to
check your progress continuously in a way not typically found in textbooks. Irrespective
of whether you are using the book as part of a taught course or for personal study, we
have found that this approach is more ‘user-friendly’ and makes it easier for you to learn.
We recognise that most of you will not have studied accounting or finance before,
and we have therefore tried to write in a concise and accessible style, minimising the
use of technical jargon. We have also tried to introduce topics gradually, explaining
everything as we go. Where technical terminology is unavoidable we try to provide
clear explanations. In addition, you will find all the key terms highlighted in the text,
and then listed at the end of each chapter with a page reference to help you rapidly
revise the main techniques and concepts. All these key terms are also listed alphabetically with a concise definition in the glossary towards the end of the book, so providing a convenient and single point of reference from which to revise.
A further important consideration in helping you to understand and absorb the
topics covered is the design of the text itself. The page layout and colour scheme have
been carefully considered to allow for the easy navigation and digestion of material.
The layout features a large page format, an open design, and clear signposting of the
various features and assessment material.

xiii


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Preface

How to use this book
We have organised the chapters to reflect what we consider to be a logical sequence
and, for this reason, we suggest that you work through the text in the order in which
it is presented. We have tried to ensure that earlier chapters do not refer to concepts
or terms that are not explained until a later chapter. If you work through the chapters
in the ‘wrong’ order, you will probably encounter concepts and terms that were

explained previously.
Irrespective of whether you are using the book as part of a lecture/tutorial-based
course or as the basis for a more independent mode of study, we advocate following
broadly the same approach.

Integrated assessment material
Interspersed throughout each chapter are numerous Activities. You are strongly advised
to attempt all these questions. They are designed to simulate the sort of quick-fire
questions that your lecturer might throw at you during a lecture or tutorial. Activities
serve two purposes:
n

n

to give you the opportunity to check that you have understood what has been
covered so far;
to encourage you to think about the topic just covered, either to see a link between
that topic and others with which you are already familiar, or to link the topic just
covered to the next.

The answer to each Activity is provided immediately after the question. This answer
should be covered up until you have deduced your solution, which can then be compared with the one given.
Towards the middle/end of each chapter, except for Chapter 1, there is a Selfassessment question. This is more comprehensive and demanding than any of the
activities, and is designed to give you an opportunity to check and apply your understanding of the core coverage of the chapter. The solution to each of these questions
is provided at the end of the book. As with the activities, it is important that you
attempt each question thoroughly before referring to the solution. If you have
difficulty with a self-assessment question you should go over the chapter again.

End-of-chapter assessment material
At the end of each chapter there are four Review questions. These are short questions

requiring a narrative answer or discussion within a tutorial group. They are intended
to help you assess how well you can recall and critically evaluate the core terms and
concepts covered in each chapter. Solutions to all of these questions can be found at
the end of the book.
At the end of each chapter, except for Chapter 1, there are five Exercises. These are
mostly computational, and are designed to reinforce your knowledge and under-

xiv


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Preface

standing. The exercises are graded according to their level of difficulty. The basic-level
questions are fairly straightforward; the more advanced ones can be quite demanding,
but are capable of being successfully completed if you have worked conscientiously
through the chapter and have attempted the basic exercises. Solutions to three of the
exercises in each chapter are provided at the end of the book and are identified by a
coloured question number. Here, too, a thorough attempt should be made to answer
each question before referring to the solution. Solutions to the other two exercises are
available to lecturers on the Companion Website.

xv


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Guided tour of the book
A head

Chapter 2

Measuring
and reporting
financial
position

Introduction
We saw in the previous chapter that accounting has two distinct strands – financial
accounting and management accounting. This chapter, and Chapters 3 to 5, examine
the three major financial statements that form the core of financial accounting. We begin
by providing an overview of these statements to reveal how each contributes towards
an assessment of the overall financial position and performance of a business.

Learning outcomes
Bullet points at the start of each chapter
show what you can expect to learn from that
chapter, and highlight the core coverage.

Following this overview, we commence a more detailed examination by turning our
attention towards one of these financial statements – the balance sheet. We shall see
how it is prepared, and examine the principles underpinning this statement. We shall
also consider its value for decision-making purposes.

Learning outcomes
When you have completed this chapter, you should be able to:
n

explain the nature and purpose of the three major financial statements;

n

prepare a simple balance sheet and interpret the information that it contains;

n

discuss the accounting conventions underpinning the balance sheet;

n

discuss the limitations of the balance sheet in portraying the financial position
of a business.

Chapter 2 Measuring and reporting financial position

25

‘

n

the capital figure must be analysed according to how each part of the capital first
arose. For example, companies must make a distinction between that part of the
capital that arose from retained profits and that part that arose from the owners
putting in cash to start up the business.
Liabilities. Liabilities represent the claims of all other individuals and organisations,
apart from the owner(s). Liabilities must have arisen from past transactions or
events such as supplying goods or lending money to the business.

Once a claim has been incurred by a business, it will remain as an obligation until it
is settled.
Now that the meaning of the terms assets and claims has been established, we can
go on and discuss the relationship between the two. This relationship is quite simple
and straightforward. If a business wishes to acquire assets, it will have to raise the
necessary funds from somewhere. It may raise the funds from the owner(s) or from
other outside parties or from both. To illustrate the relationship let us take the example
of a business, as set out in Example 2.2.

Key terms
The key concepts and techniques in each
chapter are highlighted in colour where they
are first introduced, with an adjacent icon in
the margin to help you refer back to the most
important points.

Example 2.2
Jerry and Co. deposits £20,000 in a bank account on 1 March in order to commence business. Let us assume that the cash is supplied by the owner (£6,000) and
by a lender (£14,000) and paid into the business bank account. The raising of
the funds in this way will give rise to a claim on the business by both the owner
(capital) and the lender (liability). If a balance sheet of Jerry and Co. is prepared
following the above transactions, the assets and claims of the business will appear
as follows:

Examples
At frequent intervals throughout most chapters,
there are numerical examples that give you
step-by-step workings to follow through to the
solution.

Jerry and Co.
Balance sheet as at 1 March
£
Assets
Cash at bank

20,000

£
Claims
Capital
Liability – loan

20,000

6,000
14,000
20,000

We can see from the balance sheet that has been prepared that the total claims are
the same as the total assets. Thus:
Assets = Capital + Liabilities
This equation – which is often referred to as the balance sheet equation – will always
hold true. Whatever changes may occur to the assets of the business or the claims
against the business, there will be compensating changes elsewhere that will

34

xvi

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Guided tour of the book

The basis of valuation of assets on the balance sheet

‘Real World’ illustrations
Integrated throughout the text, these illustrative
examples highlight the practical application of
accounting concepts and techniques by real
businesses, including extracts from company
reports and financial statements, survey data
and other interesting insights from business.

Real World 2.3

Retailer marks up land and buildings
The balance sheet of Marks and Spencer plc, a major high street retailer, as at 3 April 2004
reveals land and buildings at a net book value, or carrying amount, of £2,151.9m. These land and
buildings are shown at an open market value and were valued by a firm of independent surveyors. If the land and buildings of the business had not been valued in this way, the net book
value at 3 April 2004 would have been £1,482.8m. The effect of using market values was, therefore, to increase the net book value of these assets by £669.1m. This represents almost 20% of
the net book value of all the tangible non-current assets of the business.
Source: Marks and Spencer plc, Annual Report 2004, www.marksandspencer.com

Activity 2.15
Refer to the vertical format balance sheet of Brie Manufacturing shown earlier
(page 44). What would be the effect of revaluing the freehold land to a figure of £110,000
on the balance sheet?
The effect on the balance sheet would be to increase the freehold land to £110,000 and the

gain on revaluation (that is, £110,000 − £45,000 = £65,000) would be added to the capital
of the owner, as it is the owner who will benefit from the gain. The revised balance sheet
would therefore be as follows:
Brie Manufacturing
Balance sheet as at 31 December 2005
£000
Non-current assets
Freehold premises
Plant and machinery
Motor vans
Current assets
Inventories (stock)
Trade receivables (debtors)
Cash at bank
Less Current liabilities
Trade payables (creditors)

Activities
These short questions, integrated throughout
each chapter, allow you to check your understanding as you progress through the text. They
comprise either a narrative question requiring
you to review or critically consider topics, or a
numerical problem requiring you to deduce a
solution. A suggested answer is given
immediately after each activity.

£000
110
30
19

159

23
18
12
53
37
16
175

Total assets less current liabilities
Less Non-current liabilities
Loan
Net assets
Capital
Opening balance
Add Revaluation gain
Profit

50
125
50
65
14
129
4
125

Less Drawings

53

Bullet point chapter summary
Each chapter ends with a ‘bullet point’ summary.
This highlights the material covered in the
chapter and can be used as a quick reminder
of the main issues.

Summary

Chapter 5 Measuring and reporting cash flows

?

Self-assessment question 5.1

Summary

Touchstone plc’s income statements for the years ended 31 December 2005 and 2006 and
the balance sheets as at 31 December 2005 and 2006 are as follows:

The main points of this chapter may be summarised as follows:

Ratio analysis:
Income statements for the years ended 2005 and 2006

Revenue
Cost of sales
Gross profit
Distribution costs

Administrative expenses
Other operating income
Operating profit
Interest payable
Profit on ordinary activities before taxation
Tax on profit on ordinary activities
Profit on ordinary activities after taxation
Retained profit brought forward from last year
Less Dividend paid on ordinary shares
Retained profit carried forward

2005
£m
173
(96)
77
(18)
(24)
35
3
38
(2)
36
(8)
28
16
44
14
30

2006
£m
207
(101)
106
(20)
(26)
60
4
64
(4)
60
(16)
44
30
74
18
56

Balance sheets as at 31 December 2005 and 2006
2005
£m
Non-current assets
Property, plant and equipment
Land and buildings
Plant and machinery
Current assets
Inventories
Treasury bills (short-term investments)
Trade receivables

Cash at bank and in hand
Less Current liabilities
Trade payables
Corporation tax
Net current assets
Total assets less current liabilities
Less Non-current liabilities
Debenture loans (10%)

94
53
147

2006
£m

110
62
172

25
–
16
4
45

24
15
26
4

69

38
4
42
3
150

37
8
45
24
196

20
130

40
156

n

Compares two related figures, usually both from the same set of financial
statements.

n

Is an aid to understanding what the financial statements portray.

n

Is an inexact science so results must be interpreted cautiously.

n

Past periods, the performance of similar businesses and planned performance are
often used to provide benchmark ratios.

n

A brief overview of the financial statements can often provide insights that may
not be revealed by ratios and/or may help in the interpretation of them.

Profitability ratios – concerned with effectiveness at generating profit:
n

Return on ordinary shareholders’ funds (ROSF).

n

Return on capital employed (ROCE).

n

Net profit margin.

n

Gross profit margin.

Efficiency ratios – concerned with efficiency of using assets/resources:
n

Average inventories turnover period.

n

Average settlement period for receivables.

n

Average settlement period for payables.

n

Sales revenue to capital employed.

n

Sales revenue per employee.

Liquidity ratios – concerned with the ability to meet short-term obligations:
n

Current ratio.

n

Acid test ratio.

Gearing ratios – concerned with relationship between equity and debt
financing:
n

Gearing ratio.

n

Interest cover ratio.

Investment ratios – concerned with returns to shareholders:
n

Dividend payout ratio.

n

Dividend yield ratio.

n

Earnings per share.

n

Price/earnings ratio.

‘

158

207

Self-assessment questions
Towards the end of most chapters you will encounter one of these questions, allowing you to
attempt a comprehensive question before tackling the end-of-chapter assessment material.
To check your understanding and progress, solutions are provided at the end of the book.

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Guided tour of the book

Chapter 6 Analysing and interpreting financial statements

Individual ratios can be tracked (for example, plotted on a graph) to
detect trends.
Ratios can be used to predict financial failure.
Limitations of ratio analysis:
n

Ratios are only as reliable as the financial statements from which they derive.

n

Ratios have restricted vision.

n

It can be difficult to find a suitable benchmark (for example, another business) to
compare with.

n

Some ratios could mislead due to the ‘snapshot’ nature of the balance sheet.

‘

Key terms

return on ordinary shareholders’ funds
(ROSF) p. 174
return on capital employed (ROCE)
p. 175
net profit margin ratio p. 177
gross profit margin ratio p. 178
average inventories turnover period
p. 180
average settlement period for
receivables p. 181
average settlement period for payables
p. 182
sales revenue to capital employed ratio
p. 183

sales revenue per employee ratio
p. 184
current ratio p. 187

acid test ratio p. 188
financial gearing p. 189
gearing ratio p. 192
interest cover ratio p. 193
dividend payout ratio p. 195
dividend cover ratio p. 196
dividend yield ratio p. 196
dividend per share p. 197
earnings per share p. 197
price/earnings ratio p. 198

Further reading
If you would like to explore the topics covered in this chapter in more depth, we
recommend the following books:
Elliott, B. and Elliott, J. Financial Accounting and Reporting, 9th edn, Financial Times
Prentice Hall, 2004, Chapters 28 and 29.
Revsine, L., Collins, D. and Bruce Johnson, W. Financial Reporting and Analysis, 3rd edn,
Prentice Hall, 2004, Chapter 5.
Sutton, T. Corporate Financial Accounting and Reporting, 2nd edn, Financial Times
Prentice Hall, 2004, Chapter 19.
Wild, J., Subramanyam, K. and Halsey, R. Financial Statement Analysis, 8th edn,
McGraw Hill, 2003, Chapters 8, 9 and 11.

Key terms summary
At the end of each chapter, there is a listing
(with page reference) of all the key terms,
allowing you to easily refer back to the most
important points.
Further reading
This section comprises a listing of relevant

chapters in other textbooks that you might
refer to in order to pursue a topic in more
depth or gain an alternative perspective.

208

Exercises

Review questions
These short questions encourage you to review
and/or critically discuss your understanding of
the main topics covered in each chapter, either
individually or in a group. Solutions to these
questions can be found at the end of the book.

?

Review questions

Answers to these questions can be found at the back of the book (p. 000).

6.1 Some businesses operate on a low net profit margin (for example, a supermarket chain).
Does this mean that the return on capital employed from the business will also be low?

6.2 What potential problems arise for the external analyst from the use of balance sheet figures in the calculation of financial ratios?

6.3 Two businesses operate in the same industry. One has an inventories turnover period that
is higher than the industry average. The other has an inventories turnover period that is
lower than the industry average. Give three possible explanations for each business’s
inventories turnover period ratio.

6.4 Identify and discuss three reasons why the P/E ratio of two businesses operating within
the same industry may differ.

Exercises
These comprehensive questions appear at the
end of most chapters. The more advanced
questions are separately identified. Solutions
to some of the questions (those with coloured
numbers) are provided at the end of the book,
enabling you to assess your progress. Solutions
to the remaining questions are available online
for lecturers only. Additional exercises can be
found on the Companion Website at
www.pearsoned.co.uk/atrillmclaney.

]

Exercises

Exercises 6.4 and 6.5 are more advanced than 6.1 to 6.3. Those with a coloured number
have an answer at the back of the book (p. 000).
If you wish to try more exercises, visit the students’ side of the companion website

6.1 Jiang Ltd has recently produced its financial statements for the current year. The directors are concerned that the return on capital employed (ROCE) had decreased
from 14 per cent last year to 12 per cent for the current year.
The following reasons were suggested as to why this reduction in ROCE had occurred:
(i)
(ii)
(iii)

(iv)
(v)
(vi)

an increase in the gross profit margin;
a reduction in sales revenue;
an increase in overhead expenses;
an increase in amount of inventories held;
the repayment of a loan at the year end; and
an increase in the time taken for credit customers (trade receivables) to pay.

Required:
Taking each of these six suggested reasons in turn, state, with reasons, whether each of
them could lead to a reduction in ROCE.

‘
209

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Acknowledgements

We are grateful to the following for permission to reproduce copyright material:
Newcastle United Plc for an extract adapted from the Newcastle United Plc Annual
Report 2004; Marks and Spencer Plc for an extract adapted from the Marks and
Spencer Annual Report 2004; O2 Plc for an extract from the O2 Plc Annual Report and
Accounts 2003; Thorntons Plc for an extract from the Thorntons Plc Annual Report

2004; Aurum Press for an extract from Arnold Weinstock and the Making of GEC 1997 by
Stephen Aris; and Rolls Royce Plc for an extract from the Rolls Royce Plc Annual
Report and Accounts 2004.
Figure 9.4 from Financial Management and Working Capital Practices in UK SMEs by
Chittenden, F., Michaelas, N., and Poutziouris, P. 1999, Fig. 16 on Page 22. Reproduced
by permission © Francis Chittenden.
p. 1 Corbis/Thom Lang; p. 23 Corbis/L. Clarke; p. 25 Corbis/Matthias Kulka; p. 61
Getty/Royalty Free; p. 100 Corbis/James Leynse; p. 139 Corbis/Gary Houlder; p. 167
Alamy/Lisa Moore; p. 215 Getty/Taxi/Charly Franklin; p. 217 Corbis/George B. Diebold;
p. 249 Corbis/Setboun; p. 280 Alamy/Royalty Free; p. 325 D. & T. Hebden Photography/
PhotographersDirect.com; p. 327 Corbis/Rob Howard; p. 367 Getty/Kelvin Murray;
p. 406 Comstock.
We are grateful to the Financial Times for permissions to reprint the following material:
Tsunami: finding the right figures for disaster, © Financial Times, 7 March 2005;
Morrison in an uphill battle to integrate Safeway, © Financial Times, 27 May 2005; Fair
shares?, FT Weekend Magazine, © Financial Times, 11 June 2005; Profit without
honour, Financial Times Weekend, © Financial Times, 29/30 June 2002; CRH purchase of
Cementbouw gets approval, © Financial Times, 1 October 2003; Household debt adds
to rise in bank write-offs, © Financial Times, 28 March 2005; Monotub industries in a
spin as founder gets Titan for £1, © Financial Times, 23 January 2003; Markets week
world ‘Clinton Cards’, © Financial Times, 4 October 2003; Eurotunnel takes £1.3bn
impairment charge, FT.com, © Financial Times, 9 February 2004; WaterfordWedgwood
face some intense questions over its cash flow, © Financial Times, 17 June 2004; Sony
sets more steps to raise profit margins, FT.com, © Financial Times, 6 October 2003;
Jaguar struggles to break even, © Financial Times, 6 May 2005; Shell’s Sakhalin-2 gas
project hit by eight-month delay and $10bn cost rise, © Financial Times, 15 July 2005;
Satellites need space to earn, © Financial Times, 14 July 2003; New appetite develops

xix

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Acknowledgements

for Eurobonds, © Financial Times, 18 September 2004; Bulmer warns of breach of
covenants, © Financial Times, 25 January 2003; Travelodge to raise £400m via sale and
leaseback plan, © Financial Times, 12 July 2004; Tesco raises £810m in placing as sales
rise, FT.com, © Financial Times, 13 January 2004; Benfield earmarks almost 10 per cent
for fees in £100m flotation, © Financial Times, 9 June 2003.
In some instances we have been unable to trace the owners of copyright material, and
we would appreciate any information that would enable us to do so.

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Chapter 1

Introduction to
accounting and
finance

Introduction
Welcome to the world of accounting and finance! In this opening chapter, we provide
a broad outline of these subjects. We begin by considering the roles of accounting
and finance and we shall see that both can be valuable tools for decision-making
purposes. We shall identify the main users of accounting information and discuss
the ways in which accounting can improve the quality of the decisions that they

make. In subsequent chapters, we develop this decision-making theme by
considering in some detail the kinds of financial reports and methods used
to aid decision making.
For many of you, accounting and finance are not the main focus of your studies
and you may well be asking ‘Why do I need to study these subjects?’ So, after we have
considered the key features of accounting and finance, we shall go on to discuss why
some understanding of these subjects is likely to be relevant to you.

Learning outcomes
When you have completed this chapter, you should be able to:
n

explain the nature and roles of accounting and finance;

n

identify the main users of financial information and discuss their needs;

n

distinguish between financial and management accounting;

n

explain why an understanding of accounting is likely to be relevant to your needs.

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Chapter 1

Introduction to accounting and finance

What are accounting and finance?
‘

Let us start our study of accounting and finance by trying to understand the purpose
of each. Accounting is concerned with collecting, analysing and communicating
financial information. This information is useful for those who need to make decisions
and plans about businesses, and for those who need to control those businesses. For
example, the managers of businesses may need accounting information to decide
whether to:
n

n

n

n

n

develop new products or services (such as a computer manufacturer developing a
new range of computers);
increase or decrease the price or quantity of existing products or services (such as a
telecommunications business changing its mobile phone call and text charges);
borrow money to help finance the business (such as a supermarket wishing to
increase the number of stores it owns);

increase or decrease the operating capacity of the business (such as a beef farming
business reviewing the size of its herd);
change the methods of purchasing, production or distribution (such as a clothes
retailer switching from UK to overseas suppliers).

The information provided should help in identifying and assessing the financial consequences of such decisions.
Though managers working within a particular business are likely to be significant
users of accounting information about that particular business, they are by no means
the only ones. There are those outside the business (whom we shall identify later) who
may need information to decide whether to:
n
n
n
n

‘

2

invest or disinvest in the ownership of the business;
lend money to the business;
offer credit facilities;
enter into contracts for the purchase of products or services.

Sometimes the impression is given that the purpose of accounting is simply to prepare financial reports on a regular basis. While it is true that accountants undertake
this kind of work, the preparation of financial reports does not represent an end in
itself. The ultimate purpose of the accountant’s work is to give people better information on which to base their decisions. This decision-making perspective of accounting fits in with the theme of this book and shapes the way in which we deal with
each topic.
Finance, like accounting, exists to help decision makers. It is concerned with the
ways in which funds for a business are raised and invested. This lies at the very

heart of what a business is about. In essence, a business exists to raise funds from
investors (owners and lenders) and then to use those funds to make investments
(equipment, premises, inventories and so on) in an attempt to make the business, and
its owners, wealthier. It is important that funds are raised in a way that is appropriate


AAF_C01.qxd 3/30/06 11:10 AM Page 3

Accounting and user needs

to the particular needs of the business and an understanding of finance should help
in identifying:
n
n
n
n

the
the
the
the

main forms of finance available;
costs and benefits of each form of finance;
risks associated with each form of finance;
role of financial markets in supplying finance.

Once the funds are raised, they must be invested in a way that will provide the business with a worthwhile return. An understanding of finance should help in evaluating:
n
n

the returns from an investment;
the risks associated with an investment.

Businesses tend to raise and invest funds in large amounts for long periods of time.
The quality of the investment decisions made can, therefore, have a profound impact
on the fortunes of the business.
There is little point in trying to make a sharp distinction between accounting and
finance. We have already seen that both are concerned with the financial aspects of
decision making. There is considerable overlap between the two subjects and, in this
book, we shall not emphasise the distinctions.

Accounting and user needs
For accounting information to be useful, the accountant must be clear for whom the
information is being prepared and for what purpose the information will be used. There
are likely to be various groups of people (known as ‘user groups’) with an interest in
a particular organisation, in the sense of needing to make decisions about it. For
the typical private sector business, the most important of these groups are shown in
Figure 1.1. Take a look at this figure and then try Activity 1.1 below.

Activity 1.1
Ptarmigan Insurance plc (PI) is a large motor insurance business. Taking the user groups
identified below, suggest what sort of decisions each group is likely to make about PI.
Your answer may be as follows:
User group

Decision

Customers

Whether to take further motor policies with PI. This would probably involve an assessment of PI’s ability to continue in business
and to supply customers’ needs. Customers (policy holders) would
be concerned about the ability of PI to be able to meet any claims
made by them.

‘
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Chapter 1

Introduction to accounting and finance

Competitors

How best to compete against PI or, perhaps, whether to leave the
market on the grounds that it is not possible to compete profitably with PI. This might involve using PI’s performance in various
aspects as a ‘benchmark’ when evaluating their own performance.
They might also try to assess PI’s competitive strength and to
identify significant changes that may signal PI’s future actions (for
example, expanding its ability to provide its service as a prelude to
market expansion).

Employees

Whether to take up or to continue in employment with PI.
Employees might assess this by considering the ability of the business to continue to provide employment and to reward employees
adequately for their labour.

Government

Whether PI should pay tax and, if so, how much, whether it complies with agreed pricing policies, whether financial support is
needed and so on. In making these decisions an assessment of its
profits, sales revenues and financial strength would be made.

Community
representatives

Whether to allow PI to expand its premises or whether to provide
economic support for PI. To assess these, PI’s ability to continue
to provide employment for the community, to use community
resources and to help fund environmental improvements might be
considered.

Investment analysts Whether or not to advise clients to invest in PI. This would involve
an assessment of the likely risks and returns associated with PI.
Suppliers

Whether to continue to supply PI and, if so, whether to supply on
credit. This would involve an assessment of PI’s ability to pay for
any goods and services supplied.

Lenders

Whether to lend money to PI and/or whether to require repayment
of any existing loans. To assess this, PI’s ability to meet its obligations
to pay interest and to repay the principal would be considered.

Managers

Whether the performance of the business requires improvement.
Here performance to date would be compared with earlier plans
or some other ‘benchmark’ to decide whether action needs to be
taken. Whether there should be a change in PI’s future direction.
In making such decisions, management will need to look at PI’s
ability to perform and at the opportunities available to it.

Owners

Whether to invest more in PI or to sell all, or part, of the investment
currently held. This would involve an assessment of the likely risks
and returns associated with PI. Owners would also be involved with
decisions on the employment of senior managers. Here past performance of the business would be assessed.

You may have thought of other reasons why each group would find accounting information
useful.

4