Accounting policies Revision Notes

International accounting standards provide a framework that influences how businesses select their accounting policies. These standards aim to harmonise financial reporting across different countries and companies, ensuring that financial statements are prepared consistently and transparently.

When choosing accounting policies, businesses must align with these standards to produce financial information that users can trust and compare. For example, standards may dictate how to recognise revenue or value inventory, affecting the policies a company adopts.

Adhering to international standards helps prevent arbitrary choices that could mislead stakeholders or distort financial results. It also facilitates cross-border investment decisions by providing comparable financial data.

• Standards promote consistency in accounting methods across entities.
• They limit the range of acceptable accounting policies to those that meet quality criteria.
• Compliance ensures financial statements are credible and comparable internationally.

When selecting accounting policies, businesses aim to meet four key objectives: comparability, relevance, reliability, and understandability.

Comparability means that financial information should be prepared using consistent policies over time and across similar entities, enabling users to identify trends and differences.

Relevance ensures that the information provided influences economic decisions by helping users evaluate past, present, or future events. Irrelevant data can obscure important insights and reduce decision usefulness. Reliability means the information is free from significant error or bias and faithfully represents the transactions and events it purports to depict. Reliable data builds user confidence in the financial statements. Understandability requires that financial information is presented clearly and concisely so that users with reasonable knowledge can comprehend it without undue effort. Complex or ambiguous policies can hinder this objective.

• Comparability allows meaningful analysis across periods and companies.
• Relevance ensures information impacts decision-making.
• Reliability builds trust in reported figures.
• Understandability makes financial data accessible to users.

Profitability ratios assess how effectively a business generates profit relative to sales or capital employed. They help investors and managers evaluate operational efficiency and profit margins.

Gross Margin shows the percentage of revenue remaining after covering the cost of sales. It is calculated as (Gross Profit ÷ Revenue) × 100. For example, if revenue is £200,000 and cost of sales is £120,000, gross profit is £80,000. Gross Margin = (80,000 ÷ 200,000) × 100 = 40%. This means 40p of every £1 of sales is gross profit.

Mark Up indicates how much the cost of sales is increased to arrive at the selling price. It is (Gross Profit ÷ Cost of Sales) × 100. Using the same figures: (80,000 ÷ 120,000) × 100 = 66.7%. This means the selling price is 66.7% higher than the cost of sales, reflecting the margin added to costs to set prices.

• Gross Margin = (Gross Profit ÷ Revenue) × 100
• Mark Up = (Gross Profit ÷ Cost of Sales) × 100
• Higher ratios generally indicate better profitability but must be compared within industry context.

Profit Margin measures the net profit as a percentage of revenue, showing overall profitability after all expenses. It is (Profit for the Year ÷ Revenue) × 100. For example, if profit for the year is £30,000 on revenue of £200,000, Profit Margin = (30,000 ÷ 200,000) × 100 = 15%.

Return on Capital Employed (ROCE) evaluates how efficiently capital invested in the business generates profit before interest. It is (Net Profit before Interest ÷ Capital Employed) × 100. Capital Employed equals issued shares plus reserves plus non-current liabilities. For instance, if net profit before interest is £40,000 and capital employed is £200,000, ROCE = (40,000 ÷ 200,000) × 100 = 20%.

These ratios provide insight into profitability from different perspectives: operational efficiency, overall profit, and capital utilisation.

• Profit Margin = (Profit for the Year ÷ Revenue) × 100
• ROCE = (Net Profit before Interest ÷ Capital Employed) × 100
• Capital Employed = Issued Shares + Reserves + Non-Current Liabilities

Liquidity ratios measure a company's ability to meet short-term obligations using its current assets.

The Current Ratio is Current Assets ÷ Current Liabilities. For example, if current assets are £150,000 and current liabilities are £100,000, the ratio is 1.5:1, meaning the company has £1.50 in current assets for every £1 of current liabilities.

The Liquid Ratio (or Quick Ratio) refines this by excluding inventory, which may not be quickly convertible to cash. It is (Current Assets − Inventory) ÷ Current Liabilities. If inventory is £50,000, Liquid Ratio = (150,000 − 50,000) ÷ 100,000 = 1.0:1, indicating just enough liquid assets to cover liabilities.

• Current Ratio = Current Assets ÷ Current Liabilities
• Liquid Ratio = (Current Assets − Inventory) ÷ Current Liabilities
• Ratios above 1 generally indicate good liquidity, but excessively high ratios may suggest inefficient asset use.

Rate of Inventory Turnover shows how many times inventory is sold and replaced over a period. It is Cost of Goods Sold ÷ Average Inventory. For example, if cost of goods sold is £240,000 and average inventory is £40,000, turnover = 240,000 ÷ 40,000 = 6 times per year.

Trade Receivables Turnover measures how quickly credit sales are collected. It is (Trade Receivables ÷ Credit Sales) × 365 days. If trade receivables are £30,000 and credit sales are £180,000, turnover = (30,000 ÷ 180,000) × 365 ≈ 61 days, meaning it takes about two months to collect debts.

Trade Payables Turnover indicates how long the business takes to pay its suppliers. It is (Trade Payables ÷ Credit Purchases) × 365 days. If trade payables are £20,000 and credit purchases are £120,000, turnover = (20,000 ÷ 120,000) × 365 ≈ 61 days, showing payment terms or delays.

• Inventory Turnover = Cost of Goods Sold ÷ Average Inventory
• Trade Receivables Turnover = (Trade Receivables ÷ Credit Sales) × 365
• Trade Payables Turnover = (Trade Payables ÷ Credit Purchases) × 365
• These ratios help assess operational efficiency and cash flow management.