Wednesday, 29 May 2013

Understanding the balance sheet: The Basic Balance Sheet

All public companies and large proprietary companies are required by law to prepare a balance sheet as part of their formal annual financial report that complies with Australian Accounting Standards.

The balance sheet states a companies assets, liabilities and equity (net worth). It is also known as a "statement of financial position". Last weeks post discussed in detail the definitions of assets and liabilities.

The balance sheet provides a good picture of the financial health of a business and is a tool used to evaluate a business's liquidity. It helps a small business owner identify trends and quickly grasp the financial strength and capabilities of their business.
How the Balance Sheet Works
The balance sheet is divided into two parts that, based on the following equation, must equal each other, or balance each other out. The main formula behind balance sheets is:

Assets = Liabilities + Shareholders\' Equity

This means that assets, or the means used to operate the company, are balanced by a company's financial obligations, along with the equity investment brought into the company and its retained earnings.

  • Current assets:
    are items of value that are expected to be consumed or converted into cash within the next 12 months. Examples include cash, inventory that is turning over regularly and accounts receivable.
  • Non-current assets:
    are not expected to be consumed or converted into cash within the next 12 months. Examples include assets that the business would generally keep for more than one year such as plant and equipment, cars and buildings.

Working Example:

Saturday, 25 May 2013

Statement of Financial Position: AKA The Balance Sheet

A financial statement (or financial report) is a formal record of the financial activities of a business, person, or other entity. It contains a snap shot of the assets, liabilities and equity position of the entity at a particular point in time

In company law—a financial statement is often referred to as an account, although the term financial statement is also used, particularly by accountants.
For a business enterprise, all the relevant financial information, presented in a structured manner and in a form easy to understand, are called the financial statements. They typically include four basic financial statements, accompanied by amanagement discussion and analysis:

  1. Statement of financial position: also referred to as a balance sheet, reports on a company's assets, liabilities, andownership equity at a given point in time.
  2. Statement of comprehensive income: also referred to as a profit and loss statement (or a "P&L"), reports on a company's income, expenses, and profits over a period of time. A profit and loss statement provides information on the operation of the enterprise. These include sales and the various expenses incurred during the processing state.
  3. Statement of changes in equity: explains the changes of the company's equity throughout the reporting period
  4. Statement of cash flows: reports on a company's cash flow activities, particularly its operating, investing and financing activities.

Classification of assets and liabilities into significant groups in the  balance sheet is governed by the end uses of the financial statement. 

Items such as freehold premises, machinery (capital), Fixtures, Trademarks. Note assets may be tangible or intangible.

Australian Accounting Standards Board (AASB Framework, para. 49a) Defines assets as: A resource controlled by the entity as a result of past events & from which future economic benefits are expected to flow to the entity.
  • Classified primarily according to degree of liquidity 
  • Divided into current and non-current 
Future sacrifices of economic benefits that the entity is presently obliged to make to other entities as a result of past transactions or other past events. Examples include overdraft, bills payable, and debentures.

AASB Framework (para. 49b): A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.
  • Shown in order of repayment or maturity date 
  • Divided into current and non-current
[Assets – Liabilities = Equity]

Owners Equity: 
    The residual interest in the assets of the entity after deduction of its liabilities (AASB framework para. 49c)

  • Residual interest in the Assets after deducting Liability
Major aspects of equity are:

1. That it ranks after payment of all other liabilities in the event of winding up.
2. It is not separately identifiable like other liabilities - net position of residual.
The Vertical Layout of a Balance Sheet

The Horizontal Layout of a Balance Sheet

Reserves, Bonus Shares, and Rights Issue

In financial accounting, the term reserve is most commonly used to describe any part of shareholders' equity, except for basic share capital. In nonprofit accounting, an "operating reserve" is commonly used to refer to unrestricted cash on hand available to sustain an organization, and nonprofit boards usually specify a target of maintaining several months of operating cash or a percentage of their annual income, called an Operating Reserve Ratio.


•Profits and gains made by the company that have not been distributed to shareholders
•Most common type of reserve is earned by the company that are held back for use within the company
•Other reserves may be created in certain circumstances - a reserve is created (asset revaluation reserve) when assets are re-valued at greater than their book value
•‘retained profits’ ,i.e. profits

Bonus issue of shares simply takes one form of shareholders’ equity (reserves) and transforms it into another form (share capital)

Bonus shares are additional shares a shareholder receives for an existing holding of shares in a company. If you dispose of bonus shares received on or after 20 September 1985, you may make a capital gain. You may also have to modify the cost base and the reduced cost base of your existing shares in the company if you receive bonus shares.

A rights issue is an issue of rights to buy additional securities in a company made to the company's existing security holders. When the rights are for equity securities, such asshares, in a public company, it is a way to raise capital under a seasoned equity offering. Rights issues are sometimes carried out as a shelf offering. With the issued rights, existing security-holders have the privilege to buy a specified number of new securities from the firm at a specified price within a specified time. 

In a public company, a rights issue is a form of public offering (different from most other types of public offering, where shares are issued to the general public).

Share Capital

Share capital or capital stock refers to the portion of a company's equity that has been obtained (or will be obtained) by trading stock to a shareholder for cash or an equivalent item of capital value. For example, a company can issue shares in exchange for computer servers, instead of purchasing the servers with cash.

For example, suppose ABC Inc. raised $2 billion from its initial public offering. Over the next year, the total value of its shares increases to $5 billion. In this case, the value of the share capital is still only $2 billion because ABC Inc. had received only $2 billion from the sale of its securities to the investing public.

Dividends: transfers of assets made by a company to its shareholders
Partly-paid shares: shares on which the full issue price has not been paid, but the balance is to be paid in a series of installments or ‘calls’
Fully paid shares: shares on which the shareholders have paid the full issue price
Preference shares: shares which have a fixed rate of dividend that must be paid before any ordinary share dividends can be paid. These have higher priority in the event of the company going in to liquidation

Corporate Governance and The Directors

Corporate governance refers to the system by which corporations are directed and controlled.

A board of directors is a body of elected or appointed members who jointly oversee the activities of a company or organization. Other names include board of governors, board of managers, board of regents, board of trustees, and board of visitors. It is often simply referred to as "the board".

The Australian Securities Exchange (ASX) Corporate Governance Council has developed Corporate Governance Principles for Australian listed entities. Companies listed on the ASX must comply with these Corporate Governance Principles on an ‘if not, why not’ basis. Although non-ASX listed companies are not required to comply with the ASX’s Corporate Governance Principles, they provide a useful framework for identifying those behaviours that are considered to be good corporate governance practices.

By Australian standards, a good corporate governance system would generally be expected to encompass the following characteristics:

  • A formalisation of the functions reserved to the board and those delegated to management.
  • A majority of the board would be independent directors. The chairperson would also be an independent director.
  • The chairperson and the Chief Executive Officer would not be the same person.
  • An established code of conduct for company officers.
  • An established trading policy for company officers.
  • An established audit committee.
  • Established policies for the oversight and management of material business risks.
  • An established remuneration policy for executives and non-executive directors.

Further details regarding corporate governance principles may be obtained from ASX’s website

The governance promotes disclosure, accountability and fairness. All large companies publish reports and have corporate govance schemes in place that adhere to these principals. 

•Public companies and ‘large’ proprietary companies must prepare annual financial reports - including financial statements and directors’ reports
•‘Small’ proprietary companies do not have these requirements unless requested by ASIC or by at least 5% of members
•To be ‘small’, they must satisfy at least 2 of:
Consolidated gross operating revenue < $25 million
Consolidated gross assets at end of year < $12.5 million
Must employ < 50 employees at end of year

Company name includes
‘Pty Ltd’
Public sale of shares
Typical size
Extent of regulation
Raise monies from public
Some restrictions
Subject to reporting requirements
Depends on size

Types of Business Entity: Australia Corporations Act 2001

Sole Proprietorship
A Sole Proprietorship represents a form of business that has a single owner (called the proprietorship). From a legal perspective there is no distinction between the owner and the business. However, from an accounting perspective we distinguish clearly between the owner and the business.

The main features are:

  • No separate legal entity.
  • Limited life.
  • Unlimited liability.
  • Minimum reporting regulations (compared to other entities).
  • Limited access to funds.
  • Low establishment costs.
  • It is easy to organize and needs only a small amount of capital.
  • Minimal financial reporting requirements.
  • Quick decision making.
  • Combination of ownership and management.
  • Unlimited liability, in credit actions. 
  • Personal property may be tied in the debt if creditors recall. 
  • On the death of the owner, continuation is difficult. 
  • Limited resources. 
A partnership may be described as the relationship existing between two or more persons carrying on a business with the aim of generating financial profit. The relationship may be established by a formal partnership agreement or an informal arrangement between the parties, or it may be inferred by the actions of two or more individuals. 

The partnership maintains records of each individual partners transactions according to resource contribution, resource withdrawals, or share of undistributed profits. 

The main features are:
  • No separate legal entity.
  • Limited life.
  • Unlimited liability. 
  • Mutual agency. 
  • Co-ownership of assets and profits. 
  • Limited memberships (the number of partners).
  • Increased Regulation (Partnerships Acts). 
Partnership agreements are in place and have a detailed and formal agreement so that most potential problems can be avoided. Issues not covered by the agreement are generally covered by law. Such legal rules are equal shares, and no entitlement of a partner to a salary or wage. 

A company is an association or collection of individuals people or "warm-bodies" or else contrived "legal persons" (or a mixture of both). Company members share a common purpose and unite in order to focus their various talents and organize their collectively availableskills or resources to achieve specific, declared goals.

Ownership interest is broken down into 'shares' hence 'shareholders' to describe the owners who have invested. 

The main features are:

  • Separate legal entity.
  • Unlimited life.
  • Limited liability. 
  • Company ownership of assets.
  • Profits belong to shareholders.
  • Extensive membership (think Telstra shareholders).
  • Separation of ownership and management. 
  • Extensive regulation. 
Company advantages:
  • Separation of ownership and management. 
  • Perpetual existence.
  • Separate legal entity. 
  • Limited liability of the owners. 
  • Greater access to ownership funding. 
  • Potentially greater access to debt funding. 
  • Potential tax advantages. 
  • Potential increases in share values when listed on the ASX.
Company disadvantages:
  • Extensive regulation. 
  • Higher establishment costs. 
  • Subject to more public scrutiny. 
  • Owners not able to watch everything.
  • Pressure for short term performance. 
  • Loss or dilution of original ownership. 
  • Income tax paid on every dollar earned. No tax-free threshold. 

Sunday, 5 May 2013

Money Trees, and their effect on inflation

An introduction to inflation

Inflation has the effect of increasing the level of prices for goods and services over time. One benefit of inflation is that the government don't have to worry about those large loans they took out years ago, because that $100k has become easy to get hold of.  

Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply. Negative effects of inflation include an increase in the cost of holding money, uncertainty over future inflation which may discourage investment and savings, and if inflation is rapid enough, there will be a shortage of goods, prices may change on a daily basis. Positive effects include ensuring that central banks can adjust their real interest rates, making debt cheaper, and encouraging investment in non-monetary capital projects. 

Inflation is the rate of increase in the general price level, so a 10% inflation rate means prices overall are 10% higher than a year ago. One example would be post war Germany. 

After world war 1 german was ordered to repay all the debts they had accumulated in funding the war machine. By November 1923, the American dollar was worth 4,210,500,000,000 German marks. Because war reparations were required to be repaid in hard currency and not the rapidly depreciating Papiermark, one strategy Germany employed was the mass printing of bank notes to buy foreign currency which was in turn used to pay reparations, greatly exacerbating inflation rates of the mark. 

Today the popular way to cause inflation is to get the Central Bank such as the United States Federal Reserve or the Bank of England to hike up interest rates thus promoting savings and reducing the velocity of the money (how quickly it changes hand)and thus prices. This could have the adverse effect that as many people have debts, their expenditure increases with a interest rate rise, yet their cutting out of unnecessary items still doesnt meet the usurious rates, so the wages have upward pressure applied and this would fuel inflation itself.

At one time there was the 'gold standard' in practice in many countries. This is where the price of money is linked directly to the gold it is worth, in effect the Federal Reserve technically would have to keep the gold equivalent to the cash in circulation. During the Great Depression every major currency abandoned the gold standard. The earliest to do so was the Bank of England in 1931 as speculators demanded gold in exchange for currency, threatening the solvency of the British monetary system. This pattern repeated throughout Europe and North America. In the United States, the Federal Reserve was forced to raise interest rates in order to protect the gold standard for the US dollar, worsening already severe domestic economic pressures.

Today most currencies adhere to the fiat system (latin for let it be) which means the cash is unbacked by any physical asset. A holder of a federal reserve note has no right to demand an asset such as gold or silver from the government in exchange for a note. Consequently, some proponents of the theory of value believe that the near-zero marginal cost of production of the current fiat dollar detracts from its attractiveness as a medium of exchange and store of value because a fiat currency without a marginal cost of production is easier to debase via overproduction and the subsequent inflation of the money supply.

The inflation rate is widely calculated by calculating the movement or change in a price index. The consumer price index measures movements in prices of a fixed basket of goods and services purchased by a "typical consumer". The inflation rate is the percentage rate of change of a price index over time. The Retail Price Index is the term of measure in the UK. It is broader than the CPI and contains a larger basket of goods and services. The one thing that remains the same is the amount you can work in a day, so a persons time is the only certainty in the prices of items.

Most countries' central banks will try to sustain an inflation rate of 2-3%.