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Conservatism Convention

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Accounting
Basics
ASSETS = OWNER’S EQUITY + LIABILITIES
Creditors are a liability. (You owe them.) = Payables.
Increase of creditors is a source of cash.
Debtors are an asset. (They owe you.) = Receivables.
Increase of debtors is a consumption of cash.
Net Profit = Change in Owner’s Equity.
Gross Profit = Sales less Cost of Sales.
Matching Convention: Profit is calculated by matching costs with the revenue recognized during the period.
Allocation Convention: First, determine all costs. Second, allocate costs to sales, inventory, etc.
Cost Convention: Items are valued at the historical cost of all input factors.
Conservatism Convention: Recognize costs immediately and revenue only when it is certain.
Accruals Convention: An obligation from a credit worthy customer may be regarded as a sale.
Cost of Raw Materials in P/L Account = Opening Inventory + Purchases Closing Inventory
Valuation of Closing Inventory can be done by FIFO, LIFO or Average Value.
High Valuation of Closing Inventory = High Profits, because low valuation of matched materials cost.
Types of inventory: Raw Materials, Work-In-Progress, Finished Goods.
Reserves are unallocated profits. Reserves would be a part of owner’s equity, except for some reason are being held back
from recognition as such. Bad debt reserves are owner’s equity held for the purpose of covering bad debt that may arise in
future periods.
Depreciation
Straight Line: Depreciation = (Purchase Cost Expected Residual Value) / Service Life
Reducing Balance: Depreciation = Current Book Value * Calculated Rate
Calculated Rate =
n
pc
rv
1
where n = years of service, rv = residual value, pc = purchase cost.
Consumption: Depreciation =
rvpc
rh
rh
l
y
where rh
y
= running hours this year, rh
l
= lifetime running hours.
Current Cost Accounting
Four adjustments need to be made to convert Historic Cost (normal) statements to Current Cost statements.
Adjustment 1: Fixed Assets & Depreciation
1. List assets at current value (usually replacement cost) less total accumulated depreciation, adjusted for the new value.
The current cost revaluation reserve is credited the difference, so that the profit & loss account does not show any gains
or losses for revaluation, which is after all not profit from operations.
2. The depreciation charge to be accounted for this year is the difference between the new total accumulated depreciation
desired, and the total accumulated depreciation as of last year. The “current consumption” depreciation is calculated per
normal practice and reflected on the profit & loss statement. The remaining “backlog” or “top-up” depreciation is
DEBITED from the current cost revaluation reserve, because it reflects a lower starting book value of the asset in
question than is otherwise shown.

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Adjustment 2: Cost of Sales
1. Find a suitable price index for the beginning of the year, end of the year and average through the year. Convert all prices
from historic dollars to index-average dollars by dividing by the index at the relevant time and multiplying by the
average index.
2. Determine current cost of sales by: (opening inventory + purchases) closing inventory, all in adjusted current values.
3. Cost of Sales Adjustment is the difference between historic cost of sales and current cost of sales. This adjustment is
added to cost of sales (reducing profit) and also added to the current cost revaluation reserve.
4. Closing inventory value must be listed at the current prices. Adjust closing inventory value by the appropriate price
index, and add the resulting adjustment to the valuation on the balance sheet and also to the current cost revaluation
reserve.
Adjustment 3: Monetary Working Capital
1. Determine the opening and closing MWC (debtors etc. less creditors etc., but not including cash because cash is not
WORKING capital). Subtract opening from closing to determine this year’s change in MWC.
2. Isolate the volume change component of the change in MWC by taking the difference of the opening and closing values
as expressed in current dollars. (Convert to current dollars using indexes as in the Cost of Sales adjustment.)
3. Find the price increase component by subtracting the volume change component from the total change from step 1.
4. Deduct the price increase component from operating profit and add it to the current cost revaluation reserve.
Adjustment 4: Gearing Ratio Adjustment
1. Determine the gearing ratio. Find net borrowings (loans less cash but not including creditors) and net operating assets
(net borrowings plus owner’s equity plus all reserves). Gearing ratio is net borrowings divided by net operating assets
and is usually expressed as a percentage.
2. Multiply the three previous adjustments by the gearing ratio to determine the amount which should be “backed out”
(because loan payments are fixed at historical price levels).
3. Credit this amount to operating profits and debit this amount from the current cost revaluation reserve.
Ratio Analysis
Liquidity Ratios:
Current Ratio = Current Assets / Current Liabilities. Measures ability to pay bills. Rule of thumb: 2.
Quick Ratio = (Current Assets Inventory) / Current Liabilities. Measures ability to pay bills NOW. Rule of thumb: 1.
Profitability Ratios:
Profit Margin = Profit after interest and taxes / Sales.
Return on Total Assets = Profit after interest and taxes / Total assets.
Return on Specific Assets = Profit after interest and taxes / Inventory.
Return on Owner’s Equity = Profit attributable to parent company / Owner’s equity.
Return On Investment (from Dupont Chart) = Profit/Sales x Total Asset Turnover.
Capital Structure Ratios:
Fixed to Current Asset Ratio = Fixed assets / Current assets. Meaningless without industry average to compare to.
Debt Ratio = Total debt / Total assets. Also known as the gearing or leverage ratio.
Times Interest Earned = (Profit before tax + Interest charges) / Interest charges. Measures the company’s ability to weather
loss of profit or increase in interest rates without defaulting on loan obligations.
Efficiency Ratios:
Inventory Turnover = Sales / Inventory. Measures number of times inventory is turned over during a year.
Average Collection Period = Debtors / Sales per day. Calculates the average number of days a debtor goes before paying.
Fixed Assets Turnover = Sales / Fixed assets. Measures how hard assets are worked. Be careful about asset valuation. If a
company has more up-to-date (therefore higher) asset values on the books, their ratio will look worse.
Stock Market Ratios:
Earnings Per Share = Profit after tax, minority interests and extraordinary items / Number of ordinary shares in issue.
Price to Earnings = Market price / EPS. Measures how many years of profit you must spend to buy a share.

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