Ebook Financial accounting Part 1

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Jagdish Kothari
Elisabetta Barone

Financial Accounting
An International Approach

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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 2006
© Jagdish Kothari and Elisabetta Barone 2006
The rights of Jagdish Kothari and Elisabetta Barone 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.
All trademarks used herein are the property of their respective owners. The use of any
trademark in this text does not vest in the author or publisher any trademark ownership
rights in such trademarks, nor does the use of such trademarks imply any affiliation with or
endorsement of this book by such owners.
ISBN-13: 978-0-27369-319-2
ISBN-10: 0-27369-319-0
British Library Cataloguing-in-Publication Data
A catalogue record for this book is available from the British Library
Library of Congress Cataloging-in-Publication Data
A catalog record for this book is available from the Library of Congress
10
10

9 8 7 6 5 4
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Typeset in 9.25/12pt Stone Serif by 35
Printed by Ashford Colour Press Ltd., Gosport
The publisher’s policy is to use paper manufactured from sustainable forests.

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Contents

List of figures

ix

List of tables

xi

Foreword

xiv

Preface

xvi

Guided tour of the book
Acknowledgements

xx

Part One The framework of financial reporting

1

1

Introduction to financial accounting
Objectives
1.1 Introduction
1.2 History of accounting
1.3 Accounting, accountability and the accounts
1.4 Forms of business units
1.5 Objectives of enterprises in society
1.6 Main users of financial information of an enterprise
1.7 Management accounting and financial accounting
1.8 Notes on terminology
Summary
References and research
Questions
Case study

2

Key accounting concepts
Objectives
2.1 Introduction
2.2 The accounting harmonisation process in the EU
2.3 The objective of financial statements

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xviii

3
3
3
3
6
7
9
13
15
17
18
18
19
20

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Contents

2.4 Underlying assumptions
2.5 Qualitative characteristics of financial information
2.6 Constraints on relevant and reliable information
2.7 Hierarchy of concepts
Summary
References and research
Questions
Case study

Part Two Financial position and financial performance
3

Balance sheet: an overall view
Objectives
3.1 Introduction
3.2 Purpose of a balance sheet
3.3 The effect of trading operations on a balance sheet
3.4 Balance sheet layouts
3.5 Accounting conventions and the balance sheet
3.6 Balance sheet structure and ratio analysis
Summary
References and research
Questions
Case study

4

Income statement: an overall view

Objectives
4.1 Introduction
4.2 Nature and purpose of an income statement
4.3 The effect of trading operations on the income statement
4.4 Income statement layouts
4.5 Accounting conventions and the income statement
4.6 Ratios relating to the income statement
Summary
References and research
Questions
Case study

5

Revenues and trade receivables
Objectives
5.1 Introduction
5.2 Realisation convention
5.3 Accounting for revenues
5.4 Trade receivables and bad debt provisions
5.5 Construction contracts
5.6 Ratios relating to revenues and trade receivables

25
25
29
30
32
32
33

33

35
37
37
37
41
44
51
60
61
64
64
65
67

69
69
69
70
71
75
77
82
82
83
83
86

87

87
87
89
92
94
95
96

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Contents

Summary
References and research
Questions
Case study

6

Inventories and cost of sales
Objectives
6.1 Introduction
6.2 Inventories, cost of sales and accounting equation
6.3 Main valuation methods
6.4 Gross profit resulting from different valuation methods
6.5 Lower of cost and net realisable value

6.6 Characteristics and consequences of LIFO
6.7 Effects of inventory misstatements
6.8 Ratios relating to inventory
Summary
References and research
Questions
Case study

7

Tangible and intangible assets
Objectives
7.1 Introduction
7.2 Tangible assets – property, plant and equipment (PPE)
7.3 Leased assets
7.4 Intangible assets
7.5 Impairment losses
7.6 Depletion of natural resources
7.7 Ratios relating to tangible and intangible assets
Summary
References and research
Questions
Case study

8

Liabilities
Objectives
8.1 Introduction
8.2 Accounting for long-term borrowings

8.3 Liabilities, provisions and contingent liabilities
8.4 Accounting for income taxes
8.5 Ratios relating to liabilities
Summary
References and research
Questions
Case study

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v

97
98
98
100

102
102
102
103
105
107
108
110
111
113
114
115
115

117

118
118
118
121
128
131
135
137
137
139
140
140
143

144
144
144
145
148
151
158
160
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Contents

9

Owners’ equity
Objectives
9.1 Introduction
9.2 Components of the owners’ equity
9.3 Statement of changes in shareholders’ equity
9.4 Ratios relating to equity
Summary
References and research
Questions
Case study

Part Three Preparation of financial statements
10

How to record transactions and prepare financial
statements for a single enterprise
Objectives
10.1 Introduction
10.2 The basics of double-entry bookkeeping
10.3 The recording process
10.4 Trial balance
10.5 Trial balance and recording errors

10.6 Preparation of financial statements from a trial balance
Summary
References and research
Questions
Case study

11

Financial statements for a group of enterprises
Objectives
11.1 Introduction
11.2 Preparation of consolidated financial statements at
the date of acquisition
11.3 Preparation of consolidated financial statements after
the date of acquisition
11.4 Accounting for associated companies (equity method)
11.5 Accounting for joint ventures (proportionate consolidation)
11.6 Accounting for minority ownerships
Summary
References and research
Questions
Case study

12

Measuring and reporting cash flows
Objectives
12.1 Introduction
12.2 Corporate liquidity and the cash flow cycle
12.3 Objectives of a cash flow statement and its relationship

with the income statement and balance sheet

164
164
164
165
171
171
175
175
175
177

179
181
181
181
182
185
199
200
200
202
202
202
205

207
207
207

208
218
223
224
227
229
229
230
232

234
234
234
235
239

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Contents

12.4 Cash and cash equivalents
12.5 Activities affecting cash
12.6 How to prepare a cash flow statement
Summary
References and research
Questions

Case study

Part Four Analysis and interpretation of financial
statements
13

Trends and common-size statements
Objectives
13.1 Introduction
13.2 Objectives of financial analysis
13.3 Financial analysis tools
13.4 Evaluation of trends: an illustration
Summary
References and research
Questions
Case study

14

15

Corporate liquidity and solvency

265
267
267
267
268
269
269

279
279
279
282

283
283
283
284
290
290
291
291
292

Operating performance

293

Investment ratios
Objectives
16.1 Introduction
16.2 Earnings per share (EPS)

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240
241
243
260

260
261
263

Objectives
14.1 Introduction
14.2 Short-term liquidity
14.3 Long-term solvency
Summary
References and research
Questions
Case study

Objectives
15.1 Introduction
15.2 Return on total assets (ROTA)
15.3 Relationship between ROE, ROTA and leverage
15.4 A note on income tax effect
Summary
References and research
Questions
Case study

16

vii

293
293
294

297
301
302
303
303
306

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308
308
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Contents

16.3 Price earnings ratio (P/E)
16.4 Other stock-market-related ratios
Summary
References and research
Questions
Case study

Part Five Current developments in corporate
governance
17

Corporate reporting and corporate governance
Objectives
17.1 Introduction
17.2 The loss of credibility in financial reporting
17.3 Financial reporting supply chain and its participants’ roles
17.4 Financial reporting supply chain and its weaknesses
Summary
References and research
Questions
Case study

18

Public trust in corporate reporting
Objectives
18.1 Introduction
18.2 The three key elements of public trust
18.3 Credibility as an international issue
18.4 The seeds of change
18.5 The traditional reporting model
18.6 The three-tier model of corporate transparency
18.7 A framework for reporting the full array of information
18.8 Conclusions
Summary
References and research
Questions
Case study

313

314
317
317
317
319

323
325
325
325
327
331
334
339
339
340
340

343
343
343
344
345
346
353
357
360
366
368
368

369
369

Glossary

372

Index

398

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List of figures

1.1
1.2
1.3
2.1
2.2
2.3
3.1
3.2
3.3
3.4

3.5
3.6
4.1
5.1
5.2
6.1
6.2
7.1
7.2
7.3
8.1
8.2
9.1
10.1
10.2
10.3
10.4
10.5
10.6
10.7

..

Examples of corporate purposes of leading multinationals
Novo Nordisk’s economic stakeholder model
An enterprise and the users of its financial information
Qualitative characteristics of financial information
The characteristics that influence the usefulness of financial
information
The pyramid of accounting concepts and rules in the IASs/IFRSs

Relationship between the balance sheet, income statement and
cash flow statement
Format of a horizontal balance sheet: adidas-Salomon
Format of a vertical balance sheet (Alternative 1): adidas-Salomon
Format of a vertical balance sheet (Alternative 2): adidas-Salomon
Format of a vertical balance sheet (Alternative 3): adidas-Salomon
Austrian Airlines’ consolidated balance sheet
Operating cycle
Major accounting issues
Receivables
Relationship between inventory and cost of sales
Inventory valuation method applied by Puma
Expenditures: current and non-current
Accounting policies of long-lived assets of Puma
Valuation of tangible and intangible (non-current) assets
Sources of funds
Provision or contingent liability?
Earnings per share: an example
A T account
Steps for the recording process
Funny Sun’s first three transactions recorded in general journal
and posted to general ledger accounts
Connection between retained earnings, total expenses and
total revenues
Rules for debit and credit and balance of accounts
General journal of Funny Sun
General ledger of Funny Sun

11
13

14
26
30
31
40
53
54
54
55
62
70
88
94
103
107
119
120
135
145
149
174
183
185
188
192
195
196
197

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List of figures

10.8
10.9
11.1
11.2
11.3

General ledger of Funny Sun with the balances for each account
Trial balance, income statement and balance sheet
Different forms of groups
Financial reporting alternatives for investments in other enterprises
Consolidation at the date of acquisition (no goodwill
on acquisition)
11.4
Consolidation including goodwill at the date of acquisition
12.1
Working capital cash flow cycle
12.2
Operating cash cycle and the role of profit, depreciation and
amortisation
12.3
Non-operating cash outflows
12.4
Non-operating cash inflows

12.5
Relationship between the balance sheet, income statement and
cash flow statement
12.6
Cash and cash equivalents
12.7
Sources and applications of funds and cash reconciliation statement
12.8
Long- and short-term sources and applications of funds
12.9
Pattern of cash flows
12.10 An ideal pattern of cash flows
12.11 Reporting cash flows from operating activities – the indirect
method
12.12 Main headings of a corporate cash flow statement under IAS 7
13.1
Puma’s comparative income statements (2000–2004)
13.2
Puma’s actual sales and CAGR (2000–2004)
13.3
Puma’s gross profit and gross profit margin
13.4
Puma’s operating expenses as percentage of sales
13.5
Puma’s EBIT
13.6
Puma’s EAT
13.7
Puma’s equity ratio and total assets
14.1

Definition of liquidity ratios
14.2
DIO, DSO and DPO combined together
15.1
The components of ROTA
15.2
The components of Puma’s ROTA
15.3
The pyramid of ratios
15.4
The components of ROTA in different enterprises
15.5
Leverage and ROE
17.1
Number of restatements of American corporate results following
accounting errors
17.2
Share prices from 1996 through July 2005
17.3
Financial reporting supply chain
18.1
Road to reform: the legislative response
18.2
The resources of 21st century enterprises
18.3
The three-tier model of corporate transparency
18.4
ValueReporting™ Framework
18.5
Market overview: an example

18.6
Strategy and structure: an example
18.7
Managing for value: an example
18.8
Performance: an example

198
201
208
209
211
214
235
236
238
239
240
241
246
247
248
248
249
254
270
272
273
273
274

274
276
286
289
295
296
297
298
300
327
328
331
347
356
357
360
362
363
365
367

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List of tables

1.1
3.1
3.2
3.3
3.4
3.5
3.6
3.7
3.8
3.9
3.10
4.1
4.2
4.3
4.4
4.5
6.1
6.2
6.3
6.4
6.5
7.1
9.1
9.2
10.1
10.2
10.3
12.1
12.2
13.1

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Examples of the UK, US and IASB terms
Consolidated balance sheet of adidas-Salomon as at
31 December 2004
Resources and claims view
Sources and uses of funds view
Interpretation of a balance sheet
Effect of initial investment on a balance sheet
Transaction analysis: summary
Format for a balance sheet recommended by IAS 1
Consolidated balance sheet of Puma as at 31 December 2004
Puma consolidated balance sheet
Data available
Paolo’s income statement for the period 1–11 January
Income statement for the year ended 31 December 2004
(illustrating the classification of expenses by function)
adidas-Salomon income statement for 2004
Puma management income statement for 2004
Cash receipts and disbursements for July
Purchases and sales of Harbor Electronics
Cost of sales, gross profit and ending inventory using FIFO and LIFO
Annual and cumulative effects of LIFO reserve
Ending inventory understated
Ending inventory overstated
Types of non-current assets
Illustration of the statement of changes in equity
Statement of changes in equity: an example
Chart of accounts for Funny Sun

Funny Sun, trial balance at 3 January
Funny Sun, trial balance at 11 January
Puma consolidated cash flow statement for the years ended
31 December 2004 and 2003
Puma cash flow statement for the years ended 31 December 2004
and 2003
Puma’s comparative income statements (2000–2004)

17
41
43
44
44
44
52
56
59
62
67
75
75
76
76
86
110
110
111
112
113
120

170
172
189
199
199
263
264
270


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List of tables

13.2 Puma’s common-size and trend analysis of income statements
(2000–2004)
13.3 Puma’s comparative balance sheets (2000–2004)
13.4 Puma’s common-size and trend analysis of assets, liabilities and
equity (2000–2004)
15.1 Degrees of leverage and impact on ROE
15.2 Kerry Group’s income statement for the year ended
31 December 2004
15.3 Kerry Group’s consolidated balance sheet at 31 December 2004
18.1 Industry-specific performance measures

271
275

276
300
306
307
359

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

Full answers to the activities found in the text
Multiple choice questions to test your learning
Summary problems to help you check your understanding
Extensive links to valuable resources on the web
Glossary to explain key terms

For instructors
• PowerPoint slides that can be downloaded and used as OHTs

• Progress exercises, consisting of material from the text and additional
material exclusive to the website
• A solutions manual providing answers to selected questions posed in the text
Also: The Companion Website provides the following features:
• Search tool to help locate specific items of content
• E-mail results and profile tools to send results of quizzes to instructors
• 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/kothari

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Foreword

In 2000, the European Commission committed itself to making international accounting standards mandatory from 2005 for listed companies within the European Union.
It has happened and this year has seen the greatest revolution in financial reporting
for a generation. A set of International Financial Reporting Standards (IFRSs), promulgated by the International Accounting Standards Board (IASB), has come into
force for listed companies in all member countries of the European Union and in
many other countries around the world.
This accounting reform is more than bookkeeping exercises. It will influence the
way companies do business, improve market efficiencies and lower risk premiums.
Harmonising global accounting standards will also stimulate more cross-border
transactions.
The free flow of capital across borders will contribute to the wealth of nations by
allocating capital more effectively and so lowering its cost to companies, institutions

and individuals. Yet today’s markets are far from global.
One reason for this situation is related to the incompatibility of the world’s various
accounting standards. This matters because disjunctive standards prevent market
participants from efficiently comparing investment opportunities across borders. For
companies, different accounting standards represent a burden that prevents them
from having access to international funding. There is a clear need for global accounting standards which provide that businesses undertaking similar activities should be
subject to broadly the same accounting treatment wherever they are.
After a period of transition, mutually acceptable and compatible accounting
standards across borders will deliver tangible benefits. Comparable and transparent
corporate reports and accounts will foster deeper and more liquid financial markets
and will bolster investor confidence and hence global financial stability.
The IASB and the Financial Accounting Standards Board (FASB), the US standardsetting body, are aiming to achieve convergence between their two systems by 2007,
removing the reconciliation between US generally accepted accounting principles
and international standards. Once this convergence is achieved the harmonisation
process will be complete and the resultant benefits for investors all over the world
will be enormous.
This book, aimed at those students who wish to pursue careers as managers,
focuses on the use of financial information rather than technical procedures. Recent
scandals have clearly underlined the fact that managers today need to have a basic

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Foreword

xv

understanding of the concepts and principles of financial accounting. This book
addresses these recent scandals and enables students to understand why they arose
and how such scandals can be avoided in the future.
The book has a strong European focus, addressing the needs of students across
Europe; and it is also aimed at students whose first language is not English.
It is based on the lectures given by the authors in the course of Accounting and
Financial Statements Analysis for the Degree in International Economics and Management at Bocconi University, which is committed to providing internationally
recognised education to its students from all over the world.
Prof Angelo Provasoli
Dean of Università Commerciale Luigi Bocconi
Milan, October 2005

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Preface

Why this book?
The introduction of International Financial Reporting Standards (IFRSs) formerly
known as International Accounting Standards (IASs) has globally happened!
In the European Union and its applicant member countries, listed companies
from 1 January 2005 are required to adopt IASs/IFRSs. Some 7,000 companies in
the European Union are affected. Australia, the Russian Federation, Japan and other
countries have introduced IASs/IFRSs. Many countries around the world also require/
encourage foreign listed companies to apply IASs/IFRSs with or without reconciliation to national accounting standards.
This book is written to reflect this new situation and its implications. A basic

understanding of the requirements of the IASs/IFRSs is now essential for anyone
studying financial accounting and reporting.
The style of this book is practical and interactive, as one of the authors has
considerable experience of business and accounting practices of multinationals.
Thus, we illustrate the importance of concepts such as net operating cash flows, core
earnings or EBITDA, trade or operating working capital, etc. which are widely discussed and used today by the financial community.
We adopt a user approach that focuses on the use of financial information rather
than on bookkeeping and its mechanics. We illustrate some of the fundamental
accounting issues through examples of recent accounting failures in well-known listed
companies.
This book is for non-accountants. It is intended primarily for students who are
required to study accounting as part of a non-accounting degree or professional
studies course. This book is therefore suitable for undergraduate and postgraduate
students who are undertaking courses in accounting with an aim to pursue careers
as non-financial managers and thus need a sound understanding of the role of
financial accounting in their organisations. The book is particularly appropriate
for required core courses in financial accounting, in which many of the students
are not planning to take further elective accounting courses. It should also be of
practical use to those working in commerce, industry, legal practices and government agencies that deal with financial information in their work.

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Preface

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Accounting books written specifically for non-accountants are often extremely
demanding. The subject needs to be covered in such a way that non-accounting
students do not become confused by too much technical information. They do not
require the same detailed analysis that is essential for professional accountants. Some
accounting books specially written for non-accountants go to the opposite extreme.
They outline the subject so superficially that they are of little practical help.
The aim of this book is to offer a sound introduction to the study of financial
accounting. We adopt a gradual progression in the level of rigour. We begin with a
conceptual framework. The ground rules of double-entry bookkeeping (i.e. debits
and credits) come later in the book in order not to distract the readers from the
underlying concepts. This approach should help students to develop a proper understanding of these concepts. What we emphasise is the importance of understanding
as opposed to the rote memorisation of procedures and terminology. This sequence
provides a framework whereby readers can assimilate and appraise financial accounting, which is so critical for the proper functioning of the market economy. Only
with such an overall understanding will the reader be able to follow and play an
active part in the managerial role in whichever organisation they are employed.
Accounting textbooks are often not easily comprehensible to those from nonEnglish-speaking backgrounds, because of the complexity of the language used. Many
of the examples and questions in typical accounting books rely on strong knowledge
of the nuances of the English language to interpret the questions, before students
can attempt to answer them. This book adopts a plain English style that addresses
the needs of students studying in a non-Anglo-Saxon environment.

Structure and pedagogy
The book is arranged in five parts. Part one investigates the fundamental principles
and conventions that form the basics of accounting thought and practice. Part two
outlines the primary financial statements and basic valuation issues. Part three provides tools for the preparation of financial reports both for a single entity and for a
group of enterprises. Part four outlines the techniques of financial statement analysis.
In Part five, issues relating to corporate reporting and corporate governance practices are presented and discussed, as we consider that readers should be aware of the
importance of reliable and timely financial information for the smooth functioning
of capital markets.

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Guided tour of the book
44

3: Balance sheet: an overall view
Table 3.3 Sources and uses of funds view

2

Key accounting concepts

Objectives
When you have completed this chapter you should be able to:

2.1

•

explain what drives the international convergence of accounting
standards

•

explain the main purposes of financial reporting

•

outline fundamental concepts underlying all financial reporting

•

define concepts/conventions to be found in the IASB Framework

•

explain the various levels of concepts, their interrelationship and
inconsistencies.

Introduction
As a result of the globalisation of the world economy and international capital
flows, convergence of accounting systems is becoming an important issue to be
resolved. What are the benefits of convergence?
Financial reports are the most fundamental way in which a company communicates its operating results and financial condition to outsiders. If an enterprise
intends to invest in a foreign country or raise funds on the international capital
market, it must provide financial statements that its business partners or investors
can understand. If these financial statements are prepared or provided only in conformity with its national accounting standards, it may be difficult for investors to
review and understand and compare them with other investment opportunities they
are considering. Communicating solely on the basis of national accounting principles can affect the capital raising activities of an enterprise. However, this problem

108

6: Inventories and cost of sales

Example

Inventory valuation and gross profit
Suppose that the 9,000 tonnes of coal referred to in the pervious example were sold
at EUR 15 per tonne. The gross profit for the period under each of the three methods
is shown below:

Sales
Cost of sales
Gross profit
Ending inventory

FIFO
EUR
135,000
98,000
37,000
60,000

%
100
73
27

LIFO
EUR
135,000
106,000
29,000

%
100

79
21

52,000

AVCO
EUR
%
135,000
100
101,570
75
33,430
25

Key terms are
highlighted in colour
where they are
first introduced, and
definitions can be
found in the glossary
at the end of the book.

Worked examples
provide you with a
clear explanation of
key techniques and
methods.

56,430

As you can see, FIFO will give the highest gross profit, because sales are matched
with the earlier (and cheaper) purchases.
LIFO will give the lowest gross profit because sales are matched against the more
recent (and dearer) purchases.
The AVCO method will normally give a figure that is closer to FIFO than LIFO.
The ending inventory figure in the balance sheet will be highest under the FIFO
method, because the cost of goods still held will be based on the more recent (and
dearer) purchases.
LIFO will give the lowest ending inventory figure as the goods unsold held at
the end of an accounting period will be based on the earlier (and cheaper) goods
purchased.
Once again, the AVCO method will normally give a figure that is closer to FIFO
than LIFO.
Remember that during a period of rising prices, FIFO yields higher inventory and
higher gross profit than does LIFO. This result is consistent with the accounting
equation that requires that:
Assets = Liabilities + Owners’ equity
If inventory is higher under FIFO (higher assets) and the equation should balance,
either liabilities or owners’ equity would be higher. Higher gross profit under FIFO
implies higher net profit and higher owners’ equity.

Note that all methods analysed are based on the same basic numbers. Nothing in
our choice of methods affects trade payables. We record purchases at cost and account
for the related liability in the same way under all three methods. All that changes is
how we allocate those costs between inventory and cost of sales.

6.5

Bullet pointed

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

Lower of cost and net realisable value
Often inventory items for reasons of obsolescence, fashion, seasonality, imperfect
quality, etc. cannot be sold at prices higher than their historical cost. Therefore, the

3.3

Left side of the balance sheet

Right side of the balance sheet

Uses of funds (applications)

Sources of funds

The effect of trading operations on a balance sheet
As we have seen in the previous section, a balance sheet is a document designed to
show the state of affairs of an enterprise at a particular date. Reduced to its simplest,
a balance sheet consists of two lists. The first is a list of the resources owned by the
enterprise concerned – it is a list of assets. An asset is a resource owned by an enterprise as a result of past events and from which future economic benefits are expected
to flow to the enterprise (IASB Framework).
The second list shows where the assets came from, i.e. the monetary amounts
of the sources from which the enterprise obtained its resources. Since those sources
will require repayment or recompense in some way, it follows that this second list

can also be regarded as a list of claims against the resources. The enterprise will have
to settle these claims some time, and this second list can therefore be regarded as
amounts payable to others.
The first list could also be regarded as the ways in which those sources have been
applied at a point in time, that is, as a list of applications. These terms are summarised
in the next table.
Table 3.4 Interpretation of a balance sheet

Left side of the balance sheet

Right side of the balance sheet

Resources owned

Sources

Assets

Where they came from

Applications

Claims

When an enterprise is formed, the starting position is that there is no balance
sheet because there was no enterprise. The enterprise will be owned by someone.
This outside person or body will put cash (a resource) into the enterprise as capital.
Capital is the source of the cash which the enterprise now owns. So, after this first
transaction, we can prepare our balance sheet – our lists of resources and claims – as
in Table 3.5.

Table 3.5 Effect of initial investment on a balance sheeet

Resources/Applications

Claims/Sources

Cash

Capital

Earnings per share (EPS)

311

Example
Adjusting the number of shares used in the basic EPS calculation
in the event of a share split
Refer to the data provided in Activity 16.1. Assume that XYZ plc split the 1,000,000
shares of EUR 0.50 each into 2,000,000 shares of EUR 0.25 each. As 2004 basic EPS
would be calculated using 2,000,000 shares, it would seem that the basic EPS had
halved in 2004.
This is misleading and 2003 basic EPS is therefore restated using 2,000,000 shares.
The total market capitalisation of XYZ is therefore restated using 2,000,000 shares.
The total market capitalisation of XYZ would remain unchanged. For example, if
prior to the split, each share had a market value of EUR 4 and the company had a
total market capitalisation of EUR 4,000,000, after the split each share would have
a market price of EUR 2, and the company’ market capitalisation would remain
unchanged at EUR 4,000,000.

New issue of shares

Activities are practical
questions, integrated
throughout most chapters,
allowing you to check your
understanding as you progress
through the text. Answers can
be found on the book’s
companion website at
www.pearsoned.co.uk/kothari.

Issuing more shares to raise additional capital should generate additional earnings.
In this situation we have a real change in the company’s capital and there is no need
to adjust any comparative figures. However, a problem arises in the year in which
the issue took place. Unless the issue occurred on the first day of the financial year,
the new funds would have been available to generate profits for only a part of the
year. It would therefore be misleading to calculate the EPS figure by dividing the
earnings generated during the year by the number of shares in issue at the end of
the year. The method adopted to counter this is to use a time-weighted average for
the number of shares.

Activity 16.2 Time-weighted number of
shares for the basic EPS calculation
Assume that the following information is available for XYZ plc:
Number of shares (nominal value EUR 0.50 each)
in issue at 1 July 2004:
Number of shares issued for cash at market price
on 31 December 2004:

1,000,000

500,000

Question:
Determine the time-weighted number of shares for EPS calculation at 30 June
2005.
Solutions to activities can be found at www.pearsoned.co.uk/kothari

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Guided tour of the book

270

13: Trends and common-size statements

Questions

Table 13.1 Puma’s comparative income statements (2000 –2004)

Amounts in millions of euro
Sales
Cost of sales
Gross profit

2004

2003

2002

2001

2000

1,530.3
(736.4)
793.9

1,274.0
(654.0)
620.0

909.8
(512.9)
396.9

598.1
(347.5)
250.6

462.4
(286.0)
176.4

43.7
(453.4)

40.3
(377.1)

44.9
(304.3)

37.2
(220.5)

28.9
(175.7)

384.2
(19.3)
364.9
5.7
370.6

283.3
(20.1)
263.2
0.9
264.1

137.5
(12.5)
125.0
(0.6)
124.4

67.3
(8.3)
59.0
(1.6)
57.4

29.6
(6.8)
22.8
(1.6)
21.2

(111.7)
258.9
(1.7)

(84.2)
179.9
(0.6)

(39.8)
84.6
0.2

(17.3)
40.1
(0.4)

(6.7)

14.5
0.0

257.2

179.3

84.9

39.7

17.5

Royalty and commission income
SG&A
EBITDA
Depreciation and amortisation
EBIT
Financial result
EBT
Taxes
Earnings before minority interests
Minority interests

xix

EAT

Examples of real
accounts are included

to demonstrate how
what you have learnt
is applied in the real
world.

279

Summary
• Investors need to understand what financial data reveal about an enterprise’s
economic activities and financial condition. They should also know how to adjust
the reported numbers, when necessary, to overcome distortions caused by the
accounting standards adopted or by management’s accounting and disclosure
choices.
• Financial analysts use common-size and trend statements to help spot changes in
an enterprise’s cost structure and profit performance.
• Common-size income statements recast each statement item as a percentage of
sales. Common-size balance sheets recast each item as a percentage of total assets.
• Trend statements also recast each income statement and balance sheet item in
percentage terms, but they do so using a base year number rather than sales or
total assets.
• CAGR or compound annual growth rate provides a smoothed rate of growth of
financial statement items or investment yields.

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.

Figure 13.1 PUMA’s comparative income statements (2000–2004)
Source: Puma Annual Reports 2000–2004

In Table 13.2(A) we show each income statement item as a percentage of sales.
This is the common-size analysis of income statement. In Table 13.2(B), we took the
data of 2000 as the base of our trend analysis and recast each income statement item
in percentage terms using that base.

Sales

Research and references
The following of books and articles take the issues of this chapter further:
• Stephen N. Penman, Financial Statement Analysis and Security Valuation, McGraw-Hill, 2004
• Lawrence Revsine, Daniel W. Collins and W. Bruce Johnson, Financial Reporting & Analysis,
2nd Edition, Prentice Hall, 2002
• Rick Wayman, CAGR: the Good, the Bad and the Ugly, />c/cagr.asp
• Gerald I. White, Ashwinpaul C. Sondhi and Dov Fried, The Analysis and Use of Financial
Statements, 3rd Edition, Wiley, 2003, Chapters 3 and 4

Questions
13.1 The first step to informed financial statement analysis is a careful evaluation of
the quality of the reported accounting numbers. No tool of financial statement
analysis is completely immune to distortions caused by accounting standards
or by management’s reporting choices. Discuss.
13.2 (a) Give three sources of information for investors besides accounting
information.
(b) Explain what CAGR is.

Sales represent a high-growth driver increasing by EUR 1,067.9 million or 231 per
cent from EUR 462.4 million in 2000 to EUR 1,530.3 million in 2004.

Research and References provide full details of sources of
information referred to in the chapter, and suggestions for
further reading, in order to pursue a topic in more depth
or gain an alternative perspective.

Questions

303

References and research
The following are examples of books that take the issues of this chapter further:
• Stephen N. Penman, Financial Statement Analysis and Security Valuation, McGraw-Hill, 2004
• Lawrence Revsine, Daniel W. Collins and W. Bruce Johnson, Financial Reporting & Analysis,
3rd Edition, Prentice Hall, 2002
• Ciaran Walsh, Key Management Ratios, 3rd Edition, Prentice Hall, 2003.
• Gerald I. White, Ashwinpaul C. Sondhi and Dov Fried, The Analysis and Use of Financial
Statements, 2nd Edition, Wiley, 2003

Questions
15.1 Which measures of operating performance are combined to give ROTA?
15.2 ‘The tax law discriminates against share capital but favours of debt.’ Do you
agree? Explain why.
15.3 As the manager of Lene division of Elenia SpA, you are interested in determining
the division’s return on investment. As division manager you have no control
over financing assets, but you control acquisition and disposition of assets.
The division controller has given you the following data for the division to aid
you in calculating return on investment:

Accounting period 1 January–31 December 2004 (amounts in thousands of euro)
Total assets (1 January)
800
Total assets (31 December)
1,050
Non-current liabilities (1 January)
150
Non-current liabilities (31 December)
192
Equity (1 January)
556
Equity (31 December)
606
EAT
108
Interest expense on non-current liabilities
8.4
Tax rate = 30%

Case study

Each chapter concludes
with a case study
based on a real
example, and includes
questions to test
your application of
accounting skills and
techniques. Solutions
are available for

lecturers only on the
companion website.

Which method would be most appropriate for calculating the division’s return
on investment? Why? Using this method, what is the return on investment
for 2004?
15.4 Casa Comfort is a leading retailer in the home improvement industry. Certain
data from its financial statements for the years ended 31 March 2004 and
31 March 2005 follow (euro in millions):
Sales
EBIT
EAT
PPE – net
TA
Equity

2005
38,434
3,795
2,320
10,227
17,081
12,341

2004
30,219
2,661
1,614
8,160
13,465

8,740

There are approximately six questions at the
end of each chapter. These are designed to test
your understanding of the chapter and to help
you practice for exams. Solutions to selected
questions are available for lecturers only on the
companion website.

..

Case study

117

Quiang and his accounting course (B)

Because an earlier discussion with the accounting professor (see Case study in
Chapter 5) had cleared up some puzzling matters, Quiang decided to prepare
a new list of problems as a basis for a second discussion. As before, he knew
that the professor expected students to have worked out tentative answers to
their questions prior to the meeting. The professor also required students to
use whenever possible numerical examples to illustrate the issues they were
raising. The list follows:
1. Evidently, there are two ways of handling purchase discounts. They can
be either deducted from the cost of the purchased goods, or reported as
other income. But is the effect on net profit not the same under all these
methods? If so, why argue about which is preferable?
2. It is said that the LIFO method assumes that the goods purchased last are
sold first. If this is so, the assumption is clearly unrealistic because companies

ordinarily sell their oldest merchandise first. Can a method based on such
an unrealistic assumption be supported, other than as a tax gimmick?
3. Are the following generalisations valid?
(a) The difference between LIFO and FIFO is relatively small if inventory
turnover is relatively high.
(b) The AVCO method will result in net profit that is somewhere between
that produced by the LIFO method and that produced by the FIFO
method.
(c) If prices rise in one year and fall by an equal amount the next year, the
total income for the two years is the same under the FIFO method as
under the LIFO method.
4. A distillery manufactured bourbon whiskey, which it aged in charred,
white oak barrels for four years before bottling and selling it. Whiskey was
carried in inventory at approximately EUR 3 per litre, which was the cost
of ingredients, labour, and factory overhead of the manufacturing process.
Barrels, which could not be reused, cost EUR 1 per litre. The distillery
incurred EUR 0.50 of warehousing costs per litre per year, including costs
involved in moving and testing the barrels. It also incurred EUR 0.30 per litre
of interest costs per year. The costs of barrels, warehousing and interest were
charged directly to the income statement. If the distillery had consistently
earned pre-tax profit of EUR 1.5 million per year on annual production
and sale of 1 million litres, what would happen to profit if it increased
production to 1.2 million litres per year? At what amounts should it carry
its whiskey in inventory?
Give your answers to the issues just discussed, supporting them with calculations.


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Acknowledgements

Our thanks go to Angelo Provasoli and Alfredo Viganò for their active encouragement to write this book. Also, to Paul De Sury and Andrea Nappa for their valuable
input into Parts one and four respectively.
We should also like to thank our editors, Justinia Seaman, Matthew Smith and
Sarah Wild, and their colleagues at Pearson Education for all the hard work that
they have put into producing this book. It has been tough going for everyone
involved in the process. We can only hope that the results will prove that it was all
worthwhile.
Finally there is a personal acknowledgement we would like to make to Mary
Kothari. Thank you for your encouragement and your help with the review of the
manuscript: this book is dedicated to you.

Publisher’s acknowledgements
We are grateful to the following for permission to reproduce copyright material:
Table 1.1 adapted from Alexander and Nobes (2004) Financial Accounting: An
International Approach, 2nd edition, with permission from Pearson Education Ltd.;
Figures 1.1a, 5.2, 9.1, 14.1 and Tables 3.1, 4.3 from adidas-Salomon Annual Report
2004, with permission of Adidas-Salomon AG, Herzogenaurach, Germany; Figures 1.2,
18.7 and 18.8 from Novo Nordisk Annual Report 2004, with permission from Novo
Nordisk; Figures 6.2, 7.2, 13.3, 13.4, 13.5, 13.6, 13.7, 18.5 and 18.6, and Tables 3.8,
3.9, 4.4, 12.1, 12.2 and Table in Activity 5.3 from Puma 2004 Annual Report, with
permission of Puma AG, Herzenogaurach, Germany; Figure 3.6 from Austrian
Airlines Group Annual Report 2004, with permission of Austrian Airlines, Vienna,
Austria; Figure 5.1 and Figure 17.1 from 2004 Review of Financial Reporting Matters,
March 2005. © Huron Consulting Services LLC, 2005, all rights reserved; Figure 6.1
and Tables 6.1, 6.2 and 6.3 from Horngren Charles T., Sundem Gary L. and Elliot
John A., Introduction to Financial Accounting, 8th edn. © 2002. Adapted by permission
of Pearson Education Inc., Upper Saddle River, NJ, USA; Table 9.2 from the Henkel

Annual Report 2004, Henkel KgaA, Dusseldorf, Germany, with permission; Figures 4.1,
12.1, 12.2, 12.3, 12.4, 12.7, 12.8, 12.9, 12.10, 12.12, 15.4, 15.5, Table 15.1 and

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Acknowledgements

xxi

Figures on pp. 237, 243 and 244 adapted from Walsh (2002) Key Management Ratios:
Master the Management Metrics that Drive and Control your Business, 3rd edition, with
permission from Pearson Education Ltd.; Income statement on p. 280 from Deutsche
Post Annual Report 2004, with permission of Deutsche Post; Tables 15.2 and 15.3
from Kerry Group plc Annual Report 2004, Kerry Group, Tralee, Ireland, with permission.
We are also grateful to the following for permission to reproduce textual material:
John Wiley and Sons Inc for an extract from International Accounting and Multinational Enterprises by Radebaugh and Gray; Sagalyn Literary Agency for an extract
from What Management Is, How it Works, and Why It’s Everyone’s Business by Joan
Magretta; and The Economist for ‘Badly In Need of Repair’ published in The
Economist 2nd May 2002, and ‘The Lessons of the Parmelat Scandal’ published in The
Economist 15th January 2004.
Part of the text of Chapter 17 is an extract from ‘Rebuilding Public Confidence in
Financial Reporting: An International Perspective’ of the Task Force on Rebuilding
Public Confidence in Financial Reporting, published by the International Federation
of Accountants (IFAC) in July 2003 and is used with permission.
Parts of the text in Chapter 18 have been reproduced from PricewaterhouseCoopers
publications and are used with permision.

Some material has been drawn from publications by the International Accounting
Standards Board (IASB) and is reproduced with permission. Copyright © 2004
International Accounting Standards Committee Foundation. All rights reserved. No
permission granted to reproduce or distribute. The specific material is listed here:
Chapter 1 includes material drawn from IASB’s Framework for the Preparation and
Presentation of Financial Statements: paragraphs 9, 10 and 11.
Chapter 2 includes material drawn from IASB’s Framework for the Preparation and
Presentation of Financial Statement: paragraphs 12, 13, 14, 22, 23, 25, 26, 27, 28, 29,
30, 31, 32, 33, 34, 35, 36, 37, 38, 39, 40, 41, 42, 43, 44, 45; and IAS 1.
Chapter 3 includes material drawn from IASB’s Framework for the Preparation and
Presentation of Financial Statement: paragraph 49(b).
Chapter 4 includes Table from IAS 1.
Chapter 5 includes material drawn from IASB’s IAS 18: paragraphs 14, 15, 16, 17, 18
and 19.
Chapter 7 includes material drawn from IASB’s IAS 16: paragraphs 6, 16, 17; IAS 38:
paragraphs 8, 9, 11, 13, 19, 20, 22, 24, 25, 26, 27, 44, 45, 46, 47, 79, 80, 88.
Chapter 8 includes material drawn from IASB’s Framework for the Preparation and
Presentation of Financial Statement: paragraph 49(b); Figure 8.2 from IAS 37.
Chapter 9 includes Table 9.1 from IAS 1.
Chapter 11 includes material drawn from IASB’s IAS 28: paragraph 7; IAS 31:
paragraph 10.
Chapter 12 includes material drawn from IASB’s IAS 7: paragraphs 14, 16, 17, 19,
20(a), 20(b), 20(c).
Glossary includes some definitions from IASB’s Glossary.

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xxii

Acknowledgements

We are grateful to the Financial Times Limited for permission to reprint the following material:
Case Study Chapter 11 Branding – the bean counters get into creative accounting,
© Financial Times, 31 August 2004; Case Study Chapter 16 A very secretive success
story, © Financial Times, 17 August 2004; Case Study Chapter 18 Good ethics means
more than ticking boxes, © Financial Times, 23 August 2005; Extract on p. 337 from
We have to prove our own quality, © Financial Times, 21 July 2005.
We are grateful to the following for permission to use copyright material:
Extract on p. 23 from Sir David Tweedie – Standard bearer-in-chief from The
Financial Times Limited, 14 November 2003, © Rod Newing; Extract on p. 329 from
Accounts harmony is too big a prize to let go from The Financial Times Limited,
12 February 2004; © Jon Symonds; Extract on p. 337 from The best safeguard against
financial scandal from The Financial Times Limited, 12 March 2004, © Thomas
Healey; Extract on p. 348 from Sarbanes-Oxley has let fresh air into boardroom from
The Financial Times Limited, 29 July 2005, © Thomas Healey and Robert Steel.
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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Part One The framework of

financial reporting

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Introduction to financial
accounting

1
Objectives

When you have completed this chapter you should be able to:

1.1

•

explain why financial accounting is important

•

identify the main forms of business enterprise

•

identify and discuss the main objectives of an enterprise

•

identify the main users of financial information and their needs.

Introduction
What is ‘accounting’? And what is it for?
Before answering these questions, we should look at the history and development
of accounting, as this is fundamental to our understanding of present practices.
Much of the regulatory and legal framework that we have today has resulted from
past events. We will also see that the objectives of enterprises in society and the
needs of users of financial information may influence that framework.

1.2

History of accounting

1.2.1 The origins of accounting
The precise origins of accountancy are difficult to trace. However, there is certainly
evidence of some sort of record-keeping in many civilisations such as the Babylonian,

..