Accounts demystified

Whether you are a manager on the way up,

a trainee accountant, an entrepreneur, a

student or an investor – this book is for you.

In fact, it is for anybody who wants to be

able to look at a balance sheet, profit and

loss account or cash flow statement and

understand, digest and talk about the

numbers with confidence. In this 4th edition

of the classic Accounts Demystified,

Anthony Rice makes accounting

astonishingly simple and pain-free.

Accounts Demystified Anthony Rice

About the author

Anthony Rice is not an accountant. He

learned his accounting the hard way – by

keeping the accounts for his own company.

It wasn’t until the fifth consecutive

weekend in the office struggling with the

accounting system that he realised, quite

suddenly, how simple it all is. From that

day, accounting lost its mystery. Over the

next couple of years, he also found that, by

focusing on the balance sheet and using

diagrams, he could quickly demystify

fellow sufferers. Having subsequently

spent much of his time analysing

companies, first as a strategy consultant

and more recently when looking for

businesses to buy, he has some valuable

insights into financial analysis. He now

divides his time between his businesses

and demystifying other subjects that ‘just

can’t be as hard as they seem’. His next

book, Statistics Demystified, is available

from Prentice Hall Business in spring

2003.

Accounts Demystified

how to understand financial accounting and analysis

“An excellent primer on accounting, this book explains in simple

language how to understand balance sheets, profit and loss

accounts and cash flow statements. It also has useful chapters

covering important subjects like return on capital employed, gearing

and book values as well as providing insight into the tricks of the

accounting trade.”

Jim Slater, investment guru and best selling author of The Zulu Principle

“You won’t find a better explanation of the fundamentals of accounting

and financial analysis than this. Trust me – no other book makes the

subject as simple and clear.”

Jamie Reeve, Lynx Capital Ventures

“Explains what many people find a complicated subject in very clear and

simple terms. I will be recommending this book to all our new trainees.”

Jonathan Munday, Partner, Rees Pollock Accountants

Accounting is generally viewed as a highly technical and complex subject. In

truth, it is actually based on an incredibly simple principle that is hundreds

of years old. Once you understand this principle and how it is applied, you

will find accounting and financial analysis easy.

In this straightforward, easy to read book, the author guides you with

extraordinary clarity through this principle and onto all the major

accounting concepts. Using simple diagrams and everyday analogies, this

book will help you really understand:

• balance sheets, profit and loss accounts and cash flow statements

• how they all work together

• the meaning of all the major features of annual reports

• how to analyse a company’s financial performance

• why return on capital employed is the measure that matters

• how creative accountants cook the books and how to spot it.

Accounts Demystified is the definitive, user-friendly guide to the

fundamental principles of accounting that no novice user of accounts can

do without.

Prentice

Hall

BUSINESS

Prentice

Hall

BUSINESS

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Cover photograph © Stone 2003

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Accounts

Demystified

Prentice

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BUSINESS

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Accounts

Demystified

How to understand financial

accounting and analysis

an imprint of Pearson Education

London • New York • Toronto • Sydney • Tokyo • Singapore • Hong Kong • Cape Town

New Delhi • Madrid • Paris • Amsterdam • Munich • Milan • Stockholm

ANTHONY RICE

PEARSON EDUCATION LIMITED

Head Office:

Edinburgh Gate

Harlow CM20 2JE

Tel: +44 (0)1279 623623

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Tel: +44 (0)20 7447 2000

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Website: www.business-minds.com

____________________________

First published in Great Britain in 1993

© Anthony Rice 2003

The right of Anthony Rice to be identified as Author of this Work has been asserted

by him in accordance with the Copyright, Designs and Patents Act 1988.

ISBN 0 273 66334 8

British Library Cataloguing in Publication Data

A CIP catalogue record for this book can be obtained from the British Library

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 Publishers or a

licence permitting restricted copying in the United Kingdom issued by the Copyright

Licensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP. This book may not be

lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or

cover other than that in which it is published, without the prior consent of the Publishers.

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Typeset by Northern Phototypesetting Co. Ltd, Bolton

Printed and bound in Great Britain by Bell & Bain Ltd, Glasgow

The Publishers’ policy is to use paper manufactured from sustainable forests.

Preface ix

Acknowledgements xi

Prologue xiii

Introduction xv

Part I: The basics of accounting

1 The balance sheet and the fundamental

principle 3

● Assets, liabilities and balance sheets 3

● Sarah’s ‘personal’ balance sheet 4

● The balance sheet of a company 7

● The balance sheet chart 11

● Summary 14

2 Creating a balance sheet 17

● Procedure for creating a balance sheet 17

● SBL’s balance sheet 18

● The different forms of balance sheet 48

● Basic concepts of accounting 50

● Summary 53

3 The profit & loss account and cash flow

statement 55

● The profit & loss account 55

● The cash flow statement 57

● ‘Definitive’ vs ‘descriptive’ statements 59

● Summary 61

v

Contents

4 Creating the profit & loss account and

cash flow statement 63

● Creating the profit & loss account 63

● Creating the cash flow statement 67

● Summary 78

5 Book-keeping jargon 81

● Basic terminology 81

● The debt and credit convention 84

Part II: Interpretation of accounts

6 Wingate’s annual report 95

● Accounting rules 96

● The reports 97

● Assets 99

● Liabilities 107

● Shareholders’ equity 114

● The P&L and cash flow statement 115

● The notes to the accounts 118

● Summary 119

7 Further features of company accounts 121

● Investments 122

● Associates and subsidiaries 124

● Accounting for associates 125

● Accounting for subsidiaries 127

● Funding 128

● Debt 129

● Equity 131

● Revaluation reserves 134

● Statement of recognised gains and losses 135

● Note of historical cost profits and losses 135

CONTENTS

vi

● Intangible fixed assets 137

● Leases 137

● Corporation tax 140

● Exchange gains and losses 141

● Fully diluted earnings per share 143

● Summary 146

Part III: Analysing company accounts

8 Financial analysis – introduction 149

● The ultimate goal 150

● The two components of a company 153

● The general approach to financial analysis 162

● Wingate’s highlights 163

● Summary 166

9 Analysis of the enterprise 169

● Return on capital employed (ROCE) 169

● The components of ROCE 173

● Where do we go from here? 177

● Expense ratios 177

● Capital ratios 184

● Summary 192

10 Analysis of the funding structure 195

● The funding structure ratios 195

● Lenders’ perspective 199

● Gearing 201

● Shareholders’ perspective 205

● Liquidity 211

● Summary 215

CONTENTS

vii

11 Valuation of companies 217

● Book value vs market value 217

● Valuation techniques 220

● Summary 225

12 Tricks of the trade 227

● Self-serving presentation 228

● Creative accounting 230

● Why bother? 249

● Summary 252

Glossary 253

Appendix 275

Index 286

CONTENTS

viii

A glance at the accounts of most of Britain’s larger companies could

lead you to conclude that accounting is a very complex and technical

subject.

While it can be both of these things, accounting is actually based on an

incredibly simple principle which was devised more than 500 years ago

and has remained unchanged ever since. The apparent complexity of

many companies’ accounts results from the rules and terminology that

have developed around this fundamental principle to accommodate

modern business practices.

I believe that, once you really understand the fundamental principle

and how it is applied, you will find that the rules and terminology

follow logically and easily. This view determines the arrangement of the

chapters in Accounts Demystified and it is important, therefore, to read

them chronologically. You may, however, omit Chapter Five, which dis￾cusses book-keeping jargon and Chapter Seven, which concentrates on

more sophisticated areas of accounting, without losing the thread of

the book.

May I also suggest that, before you reach Chapter Six, you photocopy

the key parts of Wingate Foods’ accounts (pages 278 to 285). From

Chapter Six onwards, the text refers to these pages frequently and you

will find it much easier with copies in front of you.

If you have any comments on the book, you are welcome to email me

at [email protected]

Anthony Rice

ix

Preface

This book is dedicated

to Charlotte

x

A number of people have contributed to this book.

I am especially grateful to Jonathan Munday and Simon Rees, partners

of accountants Rees Pollock. Jonathan reviewed this edition in detail

and helped update the book for the large number of new rules that have

been instituted since first publication. In some cases, I have decided

to live with technical errors and omissions in the interests of clarity.

For such decisions I am solely responsible.

I would also like to thank the following who volunteered to read this

book and all of whom made valuable comments and suggestions:

Michael Gaston, Debbie Hastings-Henry, Steve Holt, Alex Johnstone,

Keith Murray, Jamie Reeve, Brian Rice, Clive Richardson, David

Tredrea, Martin Whittle, Charlie Wrench.

Anthony Rice

xi

Acknowledgements

xiii

Sarah

Sarah is the owner and sole employee of a company called Silk

Bloomers Limited (known as SBL). Just over a year ago, she went on a

business trip to the Far East where, by chance, she came across a com￾pany producing silk plants and flowers of exceptional quality. On her

return to the UK she immediately quit her job and set up SBL (with

£10,000 of her own money) to import and distribute these silk plants.

Sarah is a born entrepreneur and the prospects for her business look

extremely good. Her only problem is that, since the company has just

finished its first year, she has to produce the annual accounts. She has

kept good records of all the transactions the company made during the

year, but she doesn’t know how to translate them into the required

financial statements. She is determined not to pay her accountants a big

fee to do it for her.

Tom

Tom has two problems.

The first relates to his employer, Wingate Foods, where he is sales

manager. Wingate manufactures confectionery and chocolate biscuits,

mostly for the big supermarkets to sell under their own names. Four

years ago, the company appointed a new managing director who

immediately embarked on an aggressive expansion programme.

Tom’s concern is that the managing director seems to want to win

orders at almost any cost. Simultaneously, the company is spending a

lot of money on new offices and machinery. The managing director is

Prologue

brimming with confidence and continually refers to the steady rise in

sales, profits and dividends. Nonetheless, Tom has the nagging suspi￾cion that something is badly wrong. He just can’t put his finger on it.

Tom’s other ‘problem’ is that he has some spare cash which is currently

on deposit at the bank. Tom doesn’t have Sarah’s entrepreneurial spirit

and there’s no chance of him risking his money on starting a business.

He feels, though, that he should perhaps risk a small amount on the

stock market. He has been given a couple of ‘tips’ but would like to

check them out for himself.

Tom has therefore decided it is time to learn how to read company

accounts so he can form his own opinion of both Wingate and his

prospective investments.

Chris

Chris is a financial journalist for a national newspaper who, although

not an accountant, can read and analyse company accounts with

confidence.

This was not always the case. Chris used to be one of the thousands of

people who understand a profit and loss account but find the balance

sheet a total mystery. A few years ago, however, a friend explained the

fundamental principle of accounting to him and showed him how

everything else follows logically from it. Within hours, his understand￾ing of balance sheets and everything else to do with company accounts

was transformed.

Recently, Tom and Sarah mentioned their respective accounting prob￾lems to Chris. Chris began enthusing about the approach he had been

taught and how easy it all was once you really understood the basics.

Sarah, never one to miss an opportunity, immediately demanded that

Chris should give up his weekend to share the ‘secret’ with Tom and

herself.

PROLOGUE

xiv