ACCT1501 Notes

Chapter 1 Introduction to Financial Accounting

Cheryl Mew

The basic purpose of financial accounting is to produce useful info which is used in many and varied ways. People use the info generated by financial accounting to improve their decision-making in allocating scarce resources.

1.2 Financial Accounting Accounting is a process of identifying, measuring and communicating economic information to allow informed decisions by the users of that information. Financial Accounting periodic financial statements to external decision makers (investors, creditors) Financial accounting measures performance and position Management accounting information for planning and performance reports (internal decision makers) Financial performance generating new resources from day-to-day operations over a period of time Financial position the enterprises set of financial resources and obligations at a point in time Financial Statements reports describing financial performance and position Notes part of the statements, adding explanations to numbers

1.3 The Social Setting of Financial Accounting Financial accounting: o Helps stock market investors buy/sell/hold o Helps banks and lenders lend? o Helps mangers run enterprises (in addition to help from management acct) o Provides basic financial records for day-to-day mgmt, control, insurance and fraud prevention o Used by govt in monitoring actions of enterprises and in taxes, e.g. GST Accounting is not a passive force within the social setting it tells us what is going on, and in doing so, affects decision making

1.4 The People Involved in Financial Accounting Main Participants: Information users, information preparers, auditors

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Users

Cheryl Mew

User is someone who makes decisions on his own behalf, or on behalf of an org Users main demand is for the credible periodic reporting of an enterprises financial position and performance Main groups of users: Owners, Potential Owners, Creditors and potential creditors, Managers, Employees, Regulators/govt, Financial and market analysts, Competitors, Accounting researchers, customers, miscellaneous third parties

Preparers (Decision Facilitators) Main groups: Managers, Bookkeepers and clerks, Accountants

Auditors (Credibility Enhancers) Auditors report on the credibility of the enterprises financial statements, on behalf of owners and others. Assists users by verifying financial statements have been prepared fairly Internal and external auditors Role is to scrutinise the preparation process External auditors are appointed by the owners not allowed to be owner or manager, ensuring that auditor is independent from companys objectivity Accounting firms offer external auditing, advice on income tax, accounting, comp systems and many other financial and business topics

1.5 Accrual Accounting Accrual accounting system, impact of transactions is recognised in the time period the transactions and expenses occur, rather than when the cash is received or paid Revenue sales of goods or services Expenses the costs of services or resources in the process of generating revenues

Accrual Accounting versus Cash Accounting Cash accounting records revenues and expenses when the cash is received or paid. Problem: timing of cash flow is in a different accounting period to the substance of transaction affected by interest rates, exchange rates, depreciation

Using Accrual Accounting to prepare financial statements Include all the cash receipts and payments that have already happened; for example, cash sale, cash payment for wages Incorporate future cash receipts and payments that should be expected, based on existing transactions

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Measure the value of incomplete transactions (amount of remaining loans can be recorded as an expense) Estimate figures when exact amounts are unknown (interest on loans) Make an economically meaningful overall assessment of awkward problems

Cheryl Mew

1.6 The Key Financial Statements Balance Sheet shows an organisations resources and claims on resources at a particular point in time. Income Statement measures financial performance over a defined period Cash Flow Statement shows the sources and uses of cash during the period Retained Profits Note

Balance Sheet Assets future economic benefits as a result of past transactions or other past events needs to be measured in monetary terms Assets cash, accounts receivable, inventory, property Liabilities future sacrifices of economic benefits that an organisation is presently obliged to make to other organisations as a result of past events Liabilities goods on credit, bank loans, mortgages, long service leave, warranty Liabilities accounts payable, wages payable, provision for employee entitlements, long term loans Shareholders Equity excess of assets over liabilities share capital and retained profits Shared capital amount that owners have directly invested into the company Retained profits total cumulative amounts of profits that the company has retained in the business rather than distributed as dividends Assets = Liabilities + Owners Equity

Income Statement Provides info on an organisations profitability for a period of time Previously called the profit and loss statement Gross profit = Sales revenue cost of goods Income statement Sales revenue, Costs of goods sold, Gross profit, Operating expense, profit before tax, profit after tax

Statement of cash flows Shows the changes of cash during the period in one balance sheet accounting Shows receipts and payments of cash Revenues reported usually do not equal cash collected and expenses do not equal cash paid, net profit is different from the change in cash for the period Individual transactions split into: o operating activities (G&S),

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o o investing activities (NCA/capital), financing activities (equity and certain borrowings)

Cheryl Mew

1.7 Relationships between the financial statements The cash flow statement explains the change in cash in the balance sheet. Net profit appears in income statement, also reflected in retained profits note.

1.8 Information use scenarios Evaluation of CEOs performance by member of board of directors Preparation of buy/sell/hold shares recommendations by financial analyst Review of companys borrow status by bank lending officer Development of supply contract with the company by a stationery suppliers sales manager.

Demands on the quality of financial accounting information Relevance useful, valuable, and timely manner Reliability objective, undue error, not deliberately misleading Materiality assessing whether omissions, misstatement of disclosure of info can affect decisions. Judged by size of error compared to net profit, total assets. Time. GAAP (general accepted accounting principles) to assure accepted methods are followed, auditors opinion is that the statement have been prepared in accordance with the GAAP, and that the resulting figures are appropriate to its circumstances. Prudence controversial criterion that A, R, P should not be overstated and L, E, Losses, should not be understated if there is uncertainty. Cautiousness Disclosure make clear to reader which acct methods was followed, provide supplementary info on debts, share capital, commitments and other necessities in understanding statements Understandability reports should be prepared to regard to interests of users, and making sure they have the ability to comprehend and contempt. Accounting practices Comparability financial statements should be prepared in a comparable way so companies can determine their performance, as absolute sense is ambiguous Consistency Keeping same accounting methods Following GAAP, changes in method will be recorded, or record significant events that might have affected the trend.

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AASB (Australian Accounting Standards Board) Framework Understandability Relevance - Materiality Reliability - Faithful representation (represents what really existed/happened) - Substance over form (substance and economic reality) - Neutrality (objectivity, freedom from bias) - Prudence (caution in estimates) - Completeness (material info not omitted, not misleading) Comparability

Cheryl Mew

Tradeoffs among accounting principles Prudence is a bias, interfering with neutrality and reliability New AASB to conform with GAAP will mean lack of comparability with other companies that didnt previously use this standard For the sake of comparability, if other companies change acct methods, a comp has to decide whether to change or not reliability or costs, time, relevance

1.9 Financial Statement Assumptions Accrual basis accrual accounting Going concern organisation will continue operations as a going concern in the foreseeable future Accounting equity separate and distinguishable from owners personal equity Accounting period discrete equal periods annual or half yearly or quarterly Monetary Measured in common denominator AUD Historical Cost

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Chapter 2 Measuring and Evaluating Financial Position and Performance

Cheryl Mew

2.1 Introduction to the Balance Sheet Contains 2 lists that have the same dollar total Describe enterprises financial position at a particular date List 1: resources/assets List 2: Liabilities (existing obligations to be paid in future), Shareholders equity (amounts received from owners, involve permanent financing but do not have to be repaid, and any past accrual profits) Assets = Liabilities + Owners Equity Must have Company Name and Balance Sheet as at DATE 2 styles side by side: vertical:
Assets: Useful Financial Resources Liabilities: Obligations to be paid Equity: Owners Investment Assets: Useful Financial Resources

Liabilities: Obligations to be paid Equity: Owners Investment

2.2 Explanations of the three Balance Sheet Categories: Assets, Liabilities and Equity

Assets Assets are resources controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. Three essential characteristics future economic benefits, control by the entity, occurrence of past transactions of past events Future economic benefits as assets are used to provide G&S for exchange, aiming to generate net cash flows Control by entity relates to whether an entity can benefit from asset, and to deny or regulate access of others public good

Cheryl Mew Occurrence of past transactions or other past events means that the transaction giving the entity control over benefits must have occurred Other assets may include happy employees or safe working environment However they do not count into balance sheet - Cannot verify dollar cost - Difficult to measure reliability how much more productive? - Enterprise does not own employees dont have economic control Expenditure on market research not an asset impossible to calculate future benefits at date of expenditure. Current assets sold / used / collected within 1 year.

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Liabilities Liabilities are present obligations of the entity arising from past events, the settlements of which are expected to result in an outflow from the entity of resources embodying economic benefits. Two essential characteristics A present obligation exists and involves settlement in the future via the sacrifice of future economic benefits. - Legally enforceable contracts money borrowed, credit - Imposed on entity e.g. tax payable, or damages awarded by courts - Normal business transactions to maintain a good e.g. warranty Adverse financial consequences for the entity, in that the entity is obliged to sacrifice economic benefits to one or more entries Requirement of obligation means that liability occurs if enterprise has already received a benefit, e.g. received cash from bank

Equity Equity is the owners interest in the enterprise. Can be direct contributions from shareholders/owners Can be derived from profit that are not collected e.g. dividends that have not been distributed Assets represent pool of resources provided by all sources regardless of whether it is provided by owners or not. Book value of enterprise = residual or net concept of equity Book value is arithmetically valid idea, but does not tell very much. Impractical when companies go out of business, because equity (money returned to owners) will not simply be calculated by the difference between A and L. Shareholders equity is generally based on historical transactions, and does not, except by coincidence, equal the current market value of business. Retained profits or retained earnings represent past accrual profit not yet given to owners.

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Earning profit means more assets (e.g. cash) or fewer liabilities, so profit is a source of assets

Cheryl Mew

2.3 Some preliminary analysis of the sound and light balance sheet Soundly financed? - Assets come from liabilities look at where assets come from - Debt to equity ratio L/E Pay bills on time? - Able to turn current assets to cash - Look at current liabilities and cash - Current assets current liabilities = ___ in working capital - Working capital / current ratio CA/CL Companys ability to sell inventory to pay for bills - Quick ratio/ Acid test ratio Cash + AR / CL - If less than 1, then that means company has to sell inventory to get pay L All ratios are only indicators Should owners declare for dividend? - By taking out dividend, decreasing retained profits, they decrease cash. - This can create cash strain - Most retained earnings are reinvested in land, equipment, inventories, so less cash Equipment / Depreciation: - In calculating profit, accumulated depreciation counts as an expense - Net book value of equipment = cost of equipment accumulated depreciation - Accumulated depreciation is a negative asset

2.4 A closer look at the balance sheet Comparative balance sheets: - Contains figures for 2 periods, to help users recognise changes. - Recent on the left, closer to words Remember to look for notes when studying financial statements Buildings (net) means the accumulated depreciation has been deducted Prepayments are prepaid expenses that have been paid for, for which the benefits have not been received. Intangible assets noncurrent assets that have no physical substance copyrights, patents, trademarks, brand names and good will. Accrued expenses relate to expenses that have been incurred during the year, but not yet paid wages, electricity bills Employee entitlements can be current or non-current

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Where do the figures come from? Accounting is generally a historical measurement system Assets are generally valued at what they cost when they were acquired Liabilities are generally valued at what was promised when the obligation arose

Cheryl Mew

Other terms/notes Usually, accrued expenses and accounts payable is joint into payables account, but will be separated in the notes Sometimes use different terms payables liabilities (no interest) and interestbearing liabilities (such as loans, which incur interest) Current tax liabilities estimate of the amount of income tax to be paid in next financial year Deferred tax liabilities - current profit > profit reported on tax return, liability for income tax is implied for later - current profit < profit reported on tax return, deferred tax asset govt has to pay tax paid back Derivative financial instruments used to reduce exposure to foreign exchange and interest rate risks

2.5 Maintaining the accounting equation Assets = Liabilities + Owners Equity Double entry system where accounting equation is always in balance

2.6 Managers and the Balance Sheet Balance sheets are important, because outsiders read it. Balance sheet reports what the organisations position is at a point in time. Shows assets that management has chosen to acquire Provides useful picture of the state of organisation Balance sheet does not state how management has performed in using assets to earn profit

2.7 The Income Statement Might measure companys fin performance by closing it down, selling it, paying off liabilities and see whether money left was more than money owners put in

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But this is too drastic just to find out performances. Income statement uses accrual accounting to measure financial performance over a period of time, usually a year, 6 months, 3 months. Net profit for the period = Revenues Expenses

Cheryl Mew

Revenues Increase in companys wealth arising from the provision of G/S Wealth increases due to increase in cash, promise for cash or pay with other forms of wealth, such as providing other assets, or forgiving debts Interests and dividends Test for revenue whether the good or services have been rendered (provided)

Expenses Expenses are the opposite of revenues Decreases in companys wealth incurred in order to earn revenue Wealth decreases due to costs of G/S, giving assets to customers, and wear and tear of long term assets 2 cases when goods are sold enterprise is better off because of revenue gained and enterprise is worse off because of cost of goods and services customer takes away Start with asset account of inventory of unsold goods, transferred to expense account of cost of goods sold Whether the firm makes profit depends on whether R > E. Separate account of Expenses with Revenue

Profit Net profit = net inflow of wealth to the company during the period If net profit is negative = net outflow of wealth = loss Expenses include costs of earning revenue taxes (not including dividends), depreciation...

The relationship of profit for the period to retained profits Retained profits is the sum of past net profits since the firm began, minus dividends declared (even if not yet paid) Through retained profits, balance sheet can be said to reflect everything that happened from the beginning a historical information system Transactions with owners are taken out of RP, not an expense Owners can be creditors too, if they are owed dividends, or if they lent the company money in addition to shares they bought

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2.8 Connecting Balance Sheets and Income Statements CA + NCA

Cheryl Mew = CL + NCL

2.9 A close look at the income statement Income statement covers period in time not point in time Subsidiary is considered a controlled entity when parent company has the capacity to dominate decision-making Consolidation basically involves totalling revenues and expenses of parent entity and all the subsidiaries after eliminating any transactions between these entities When calculating retained profits, use profit AFTER tax.

2.10 Capital Markets, Managers and Performance Evaluation Importance placed on bottom line profit figure and components The Australian or the Australian Financial Review show announcements of companys annual or half yearly profits. Emphasis on profit never any data on non-financial performance, LT issues, or managerial efforts Announcement show sales, profits before and after tax (net), earnings per share (EPS), interim and financial dividends per share data (ff, p), present share price Per share data used by investors e.g. own n shares, so earn 0.355n $ Share market prices and profit announcements tend to end up moving in the same direction, so they are correlated Managers should be conversant about how his or her performance is measured in the income statement

2.11 Capital Markets, Managers and Performance Evaluation Public sector organisations are required to provide balance sheets that discloses the A,L, E of the govt department Also an income statement (before June 2001, was called operating statement) Accumulated surplus or deficit = retained profits for private companies Reserves

Income Statement Emphasis on cost of services Operating revenue is separate and deducted from operating expenses After net cost of services are included, other revenues are included Liabilities such as super is included in employee entitlements in addition to salaries

Cheryl Mew When govt takes over liability, providing an appropriation, therefore recorded as revenue The income statement enables users to identify: - cost of services provided by the department during the year - extent to which costs were covered by revenue - source of revenue - changes in resources controlled during the period as a result of operations

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Chapter 2 Appendix Background: Sole Traders, Partnerships, Companies and Financing

A2.1 Four Kinds of Business Organisation Two general kinds of equity: - Directly contributed equity owners provide money or other assets to enterprise - Indirectly contributed equity owners allowed profits to remain, to help earn more profits in the future... Types of owners depends on what type of business organisation

Sole Trader One owner (the proprietor) Unincorporated does not legally exist separately from owner Cannot distinguish between the owners direct contributions to the business and the indirect contributions by retained profits both lumped together as owners capital Balance sheet: Owners equity Owners capital $XXXX

Partnership More than one owners Unincorporated Not separate legal entities, and all partners are all personally responsible for debts of partnership Since owners personal assets can be claimed by business creditors, there is somewhat arbitrary distinction between business and personal affairs Similar to sole trader, lumped together as owners capital

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As with sole traders, partnerships are not legal entities, but are considered separate entity from partners Balance sheet: Owners equity Partners capital: Partner A $XXXX Partner B $XXXX Partner C $XXXX Total Capital $XXXX

Cheryl Mew

Company Legal entities under corporations law Capital is divided into shares owners = shareholders Separate legal entities can buy, sell, own assets, enter contracts and sue and be sued Limited liability in the event of failure shareholders are not liable for debts once shares have been paid for in full Ease of transfer of ownership and increased borrowing powers Shares can be sold freely, and transfer of ownership does not affect continuity of operations Companies may issue debentures or unsecured notes. Debenture document that evidences an undertaking by comp to repay particular amount at or before an agreed date, and to pay interest at an agreed rate a specific intervals Debt may be secured over floating charge or all assets, or specific charge over certain assets Public company can invite public to subscribe to their share capital by prospectus (listed ones are on ASX) Private companies (Pty Ltd) cannot invite public and has a limit on number of shareholders (50) and other restrictions and transferability of shares.

Company: Forms of Share Capital When shares are first issued, money received comes in as shared capital Second time sold, money is not received by company but shareholder Therefore, the millions of transactions on ASX that occur do not affect companys financial statement Several classes of shares: Ordinary shares owners votes basically residual owners, deciding who will be on the board of directors and managers Preference shares or otherwise special shares owners usually do not vote, but in return they have rights, such as receiving fixed dividend, or preference in asset distribution if company liquidates Class A, Class B and other categorisations vague terms, because complexity of rights often prevents simple categorisation such as ordinary or preference

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Face of balance sheet or notes will list all kinds of shares, and specify rights Cash received is property of company owners have no right to get money back, except in specific circumstances

Cheryl Mew

Company: Retained profits Profits can be paid to owners in the form of dividend or retained within company. Balance sheet: Shareholders equity $ Share capital: Class A Shares XXXX Class B Shares XXXX Total issued capita XXXX Retained Profits XXXX Total Shareholders equity XXXX

Corporate Group Groups of many companies E.g. Woolworths, BHP Billiton, Commonwealth Bank Balance sheet represent what group looks like as a consolidated economic entity, although there is no such legal entity Looks like that of single company, with shareholders equity section representing equity of primary, parent, company in grouo

A2.2 Business Financing Non - Current Liabilities (debts due more than a year in the future) Mortgages and other debts extending several years Special loans from owners, LT tax estimates, estimated liabilities to be paid to employees in the future

Owners equity Sole trader and Partnership owners capital Company shared capital received for each kind of share + retained profits (+ other items if legal or accounting complexities require them)

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Chapter 3 The Double Entry System

Cheryl Mew

3.1 Transaction Analysis + 3.2 Transaction Analysis Extended A CA + NCA CA + NCA CA + NCA Set out: - Assets Cash, AR, Inventory, Land and Building, Equipment - Liabilities AP, Notes Payable, Wages Payable, LT Loans - Equity SC, R, E, Dividend = = = = L CL + NCL CL + NCL CL + NCL

3.3 Recording Transactions: Double-entry Bookkeeping System of debits and credits Balancing Equation : A = L + SE CA + NCA A+E+D D, C = = CL + NCL + L

SC + Op. R

+ SC + C, D

Resources = Assets Sources = Liabilities / Equity Therefore sum of credits must = sum of debits Transactions measured in terms of countrys currency (AUD) Recording transactions = entry Records of transactions = journals / journal entries Entries are transferred and summarised in accounts, which lie behind all amounts and descriptions shown on balance sheet All accounts collected together = ledger accounts Accountants makes a list of account balances from ledger to make sure Dr = Cr. (this list is called the trial balance) All accounts put together = balance sheet Each double entry record names one (or more) account that is debited, and one (or more) that is credited Double entry records = journal entries each journal entry, sum Dr = sum Cr

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3.4 More about Accounts

Cheryl Mew

An account is a record of the dollar amounts comprising a particular A, L, E, R or Exp. Net effect of these amounts is debit or credit, and is called the accounts balance

3.5 How Debits and Credits Work Negative asset = contra asset has credit balance, e.g. accumulated depreciation

3.6 Debits and Credits, Revenues and Expenses Accounting accumulates information about activities Financial statements are prepared from the accounts that are produced as the information is accumulated Double entry recording system creates a set of accounts which is in balance (Dr = Cr) From these accounts are produced: - The income statement - A note to the accounts showing a statement of retained profits, the bottom line (ending retained profits), which transfers to - The balance sheet, which summarises all accounts

3.7 Arranging accounts on the balance sheet Placement of CA, NCA, CL, NCL, E allows for calculation of meaningful ratios and other analysis Thus balance sheet is classified because it is classified into meaningful categories Moving items around within Balance sheet is called reclassification Reclassification done by accountants whenever it is thought to improve informativeness of financial statement

Three examples of account classification Current and Non-current portions of noncurrent liabilities - Liabilities e.g. mortgages, bonds, debentures - Thus accountants need to reclassify the amount to be paid on principal within the next year (to Current) and the residual to non current - Interest owing but not paid is a separate liability

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Bank overdrafts - E.g. bank overdraft of $500 - This means bank allowed company to remove $500 more cash from account than there was in it, in effect, lending comp $500 Two ways of representing this: - Other assets of $12400 minus bank overdraft of $500 = L & E of $11900 - Other assets of $12400 = L&E of $11900 + bank overdraft of $500 Negative amounts left as deductions - Some negative amounts are left as deductions unlike the bank overdraft - E.g. accumulated depreciation left as a negative deduction for asset Three ways of representing this: - Shown on RHS of balance sheet (before it was, and in some countries still is) - Separate disclosure as a deduction on LHS of balance sheet, but since many types of assets and depreciation amounts can make sheet clustered - Could be deducted from assets cost, so net book value of assets could be disclosed on balance sheet, but not the accumulated depreciation This method is becoming more popular, accompanied by note to fin statements, listing cost and accumulated depreciation amounts separately

Cheryl Mew

3.9 Cash versus accrual accounting revisited Accrual accounting Cash sale would increase by revenue and cash in that period Credit sale will AR and R in that period When the cash is paid, AR , Cash

Way accrual financial accounting info is assembled: - Cash - Credit transactions - ST/LT adjustments are needed to prepare financial statements, unless the comps accounting system is sophisticated enough to have already built them in - Extensive narrative and supplementary disclosures (e.g. notes to financial statements)

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Cheryl Mew

3.10 Example: Simones Jewellery Business Difficulties of accrual accounting: Accrual profit requires extra calculation more complex cause confusion as it leaves more room for error than the simpler calculation Accrual profit differ from cash profit, differ from change in amount in bank Accrual accounting can be a lot more complicated tax, rent, time...

3.11 Public Sector Issues During 1990s, all govt moved from cash based acct system to accrual based acct system

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Chapter 4 Record Keeping

Cheryl Mew

4.1 The Importance of Good Records Complete and accurate records provide observations and history of enterprise This is used by investors, managers to plan for future Records cost money Records provide: The basis for extrapolations into the future Info for evaluating and rewarding performance Basis of internal control over existence and quality of enterprises assets

4.2 Financial Accountings Transactional Filter Accounting is an info system to filter and summarise data. Economically efficient to have 1 system organise data into information on behalf of the various users E.g. of summarising and organising daily newspaper Like newspaper, info system e.g. financial acct is limited. Only report what sensors pick up as it seeks out data or filters data Data bank: ledgers, journals (the books) and supporting records Recording Classifying... = Bookkeeping Information = accounting or reporting

Accounting reports are limited by the collected data Transaction recorded Not transaction routine accounting system ignores event Two general kinds of transactions cash transactions or credit transactions Non transactions natural disasters/ incidents, future delivery, land value /

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Financial accounting transaction fundamental eco or legal characteristics: - Exchange must involve exchange of G/S, $, legal promises, items of eco value - Past exchange must have happened - External exchange must be between entity and another party Supplementary characteristics needed for accountings record-keeping: - Evidence must be some documentation paper/electronic - Dollars must be measured in the currency relevant in country where transaction happens (AUD) Following transaction characteristics define nature and value of fin acct info: 1. Transactions linked to legal and economic concept of exchange (bounded by legal contract including $ transactions) 2. Constitute large part of underlying rationale for historical cost basis of accounting, founded on accounting (history has to have happened) 3. Characteristics of transaction provide basis on which records can be verified (audited) later as part of the process of ensuring info is credible 5 key points exchange, past exchange, external party, evidence, dollars Adjustments/ adjusting journal entries in data bank when accountant is not satisfied with set of data and wishes to alter some event which is important RHS information deciding on adjustments, deciding on reporting format, making supplementary notes...

Cheryl Mew

4.3 Accountings Books and Records Accounting cycle 1. 2. 3. 4. 5. 6. 7. 8. 9. Source documents Prepare journal entries Post to ledgers Prepare trial balance (collection of ledger accounts Dr = Cr) Prepare adjusting journal entries Prepare adjusted trial balance Prepare closing journal entries (close revenue, expenses and dividends to RP) Prepare post-closing trial balance Prepare financial statements

Source Documents and transactional style Source documents show that transactions have occurred Documents are kept so that the accounting records can be checked and verified to correct errors; permit auditing; used for disputes; support income tax claims and other legal action.

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Discounts after ordering: cheque will be less than amount owed Debit AP, Cr Cash discounts received (other revenue account)

Cheryl Mew

Journal Entries Record accounting transactions When business event is first recorded by acct system Basic transactional records are often called books of original entry A journal entry can list as many accounts as are needed to record transaction, but each journal entry must be recorded, so sum of debits equals sum of credits Dr left, Cr right Omit $ Traditional to write short explanation called narration below each entry as a memorandum of what the recorded transaction was about (not compulsory) Every journal entry must be dated and is usually numbered Posting reference is given to indicate the ledger account to which each journal entry is posted. Number obtained from companys chart of accounts. Enterprises with many transactions to record do not create separate entry for each transaction, but instead use special records for each routine kind of transaction... e.g. sales journal, cash receipt journal, cash payment journal and purchases journal

Posting to ledgers Ledgers are books or computer records that have a separate page or account code for each individual account referred in the books of original entry Where T accounts come in to illustrate simpler version of ledger accounts General ledgers collection of all the A, L, E, R, Exp, summarising the entire operations of business Subsidiary ledgers AR, AP balance isnt based on Dr, Cr, but sum equal amount in primary account in general ledger

Trial Balance Balanced journal entries > general ledger accounts > balanced balance sheet There is always a little uncertainty on whether standard bookkeeping procedure ensures that ledger adds up all Dr and Cr and makes sure they equal Therefore calculation is called trial balance What to do when trial balance doesnt balance? Re-add trial balance Check posted journal entries to correct side of ledger accounts Check that each ledger account is balanced correctly

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Check that each journal entry balances (Dr = Cr) Determine difference between Dr and Cr and look for account with that amount maybe left out ledger balance Difference / 2 and look for that amount means posted to wrong side of ledger account If difference is divisible by 9, maybe transposition error 21 instead of 12, 72 instead of 27 Sometimes trial balance cannot pick up error

Cheryl Mew

Adjusting Entries At end of each acct period, it is necessary to adjust Rev and Exp accounts Splitting between accounting periods e.g. prepayments for insurance

Closing entries Needed to facilitate preparation of financial statements Needed to prepare accounting records to begin next period Closing entries formally transfer the balances of the revenue and expense accounts to a profit and loss summary, then to retained profits Closing entries also reset the rev and exp account balances to zero to being records for the next accounting period P&L summary account to decreases everything to 0 Debit sales account to zero, credit expenses account Debit profit and loss summary account Then, to balance P&L account, clear it by debiting P&L Credit retained profits

Post closing trial balance Put together ledger accounts to see if Dr = Cr

Financial Statements P&L summary account > Income statement Post-closing trial balance > Balance sheet

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4.4 An Example: Northern Star Theatre Company Source documents General Journal General Ledger General Ledger trial balance General Journal (with adjustments) General Ledger General Ledger trial balance Closing entries returning everything to 0, dr revenue, cr P&L Financial statements Retained profits, income statement, balance sheet

Cheryl Mew

4.6 Electronic Commerce Electronic commerce (e-commerce) is a challenge to financial accounting and internal control, because of the absence of paper trail that has traditionally supported accounting records. E.g. moving away from cash and cheque, but using lots of credit cards or EFTPOS. Employees are being paid by deposits in personal bank accounts Implications of e-commerce - Needs to be compatibility between computing systems for proper recognition of accounting systems on both sides of transactions Trust in electronic media to make system work - Tendency for records and payments to be speedier and separate from movements of product, means in-transit items can be a challenge to control and reconcile - Not only financial statements must be right, but also the underlying records for business partners enquiries to be answered reliably Paradox: e-commerce works without paper but demands a good trail of evidence

4.7 Managers, Bookkeeping and Control (Importance of bookkeeping to managers) Bookkeeping and its associated record keeping: - Provide underlying data on which accounting info is built Decisions and evaluations may be constrained on nature of underlying data - Provide data and systems used in meeting managements important responsibilities to safeguard assets and generally keep the business under control

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4.8 Public Sector Issues The process of accounting also applies to public sector organisations Accumulated funs = Public sector equity Recurrent appropriation = govt revenue User charges = revenue Grants and subsidies = expense

Cheryl Mew

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Chapter 5 Revenue and Expense Recognition in Accrual Accounting

Cheryl Mew

5.1 Conceptual Foundation of Accrual Accounting Revenues are inflows of economic resources from customers earned through providing goods or services. Expenses are outflows of economic resources to employees, suppliers, taxation authorities and others, resulting from business activities, to generate revenue and serve customers. Incurring expenses are the cost of earning revenues. Net profit is the difference between revenues and expenses over time. Net profit is the measure of success in generating more revenue and it costs to do so. Features Revenue and expenses refer to inflows and outflows of economic resources. Involve phenomena that arise before or after cash changes hands, as well as the point of cash flows Net profit is dependent on how revenues and expenses are measured.

A conceptual system for accrual profit measurement Need system that recognises revenue and expense before, at the same time and after cash flows. Accrual method includes cash accounting

Summary Revenue before cash collection form asset account (e.g. Accounts receivable) Expense before cash payment form liability account (e.g. Accounts payable) Unearned revenue liability Expense after cash payment asset Before cash Rev Exp Asset Liability After cash Liability Asset

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5.2 Accrual Accounting Adjustments

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Adjustments involved implementation of routine accruals, such as those mentioned above Sophisticated accounting systems go beyond transactional records and routinely include many adjustments Simpler systems make adjustments at year end in a special set of journals Many small companies dont bother until financial statements are needed Follow double entry format: - After each adjustments, A=L+E still balances - Sum of credit = sum of debit Adjusting journal entries purpose: augment transaction based figures, add story told by transactional records. Objective of accrual accounting improve measurement of financial performance and position Accrual > cash provides more complete record, more representative of economic performance Four main types of routine adjustments: - Expiration of assets (after prepayments) - Unearned revenues - Accrual of unrecorded expenses - Accrual of unrecorded revenues

Expiration of assets Prepayments assets that arise because an expenditure has been made, but there is still value extending into the future Usually current assets Arise whenever payment schedule for an expense does not match the companys financial period e.g. insurance premiums where policy date doesnt match financial year Prepaid expenses do not have market value, but they have economic value because future resources will not have to be used E.g. insurance, advertisements Prepayment Cash Prepayment Expense Prepayment DR CR DR CR Prepayment Expense Cash Prepayment Prepayment Expense DR CR DR CR

OR

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Unearned Revenues Unearned Revenue future revenue where the cash has been received before earning revenue (deposits) E.g. newspaper or magazine subscription companies, or airline, phone, membership Cash Unearned Revenue Unearned Revenue Sales Revenue DR CR DR CR

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Accrual of unrecorded expenses Involves determining which expenses have been incurred by the organisation (but not paid in cash) during a particular time period Involves checking which invoices have been received from suppliers, incorporating that info into accounting systems (e.g. AP), and making estimates for expenses for which invoices have not yet been received Accrued expenses E.g. wage expense end of pay period and end of financial period occur on different days Wages Expense Accrued expense Accrued expense Cash DR CR DR CR

Accrual of unrecorded revenues Accrued revenue Occurs when a service has been provided but cash will not be received until the following period Interest revenue, unbilled revenues, commissions earned Accrued Revenue Revenue Cash Accrued Revenue DR CR DR CR

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Multicolumn Worksheets Useful device to help prepare financial statements Pre adjusted Trial Balance Adjusting Entries Adjusted Trial Balance Income statement numbers

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Balance sheet numbers

5.3 The Financial Period As businesses run continuously, financial statements are prepared at specific points or periods in time 2009 net profit is a measure of economic value added by the project during that year IF there are 2 cash inflows 2008 and 2009: - If 08 cash > 08 revenue, then unearned revenue will be set up - If 08 cash < 08 revenue, then account received set up Companies have initial choices about when the financial year begin and end. Once they made their choice, reasons relating to habit, legal and tax rules force them to stay with the choice Australia 30 June is most common US, Canada, Singapore 31 December UK, NZ, Japan 31 March Possible in Australia to use substituted accounting period for taxation purposes

5.4 Introduction to Accounting for Inventory Several different methods for controlling inventory Most popular perpetual inventory control method (compared to periodic) Under perpetual method, inventory is an asset - Inventory bought debit inventory account - Inventory sold debit cost of goods sold, credit inventory - 2 entries are required for sales (revenue and cost of goods expense) - Return of sales also require 2 entries

5.5 Contra Accounts Just about every balance sheet account can be considered a control account Amounts in accounts should be supported by detailed lists or subsidiary ledgers Sometimes want to change account, and at the same time reluctant to.

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Worried that company might not be able to collect all money back from customers. Want to recognise bad debts. However that means crediting accounts receivable. But at the same, since we have not given up on collecting debts, we should not do that. Property and plan are being used up economically. Want to record depreciation expense. But do not want to change asset cost account, because costs are not changing, but rather economic value is being used. Contra account set up to allow recognition of expense and related value changes without changing control account Contra accounts have balances that are in opposite direction to those of the control account in which they are associated Contra accounts only have meaning in conjunction with the control accounts to which they match. Most common: accumulated depreciation (amortisation), doubtful debts receivable

Accumulated Depreciation (Amortisation) Accumulate depreciation on fixed assets (e.g. buildings and equipments) DR Depreciation Expense CR Accumulated Depreciation Accumulated Depreciation relates to asset account of buildings Showing both allows users to make rough guess on age of asset Depreciation expense shows how much depreciated during that period Accumulated depreciation shows total amount the buildings have depreciated by Net book value = cost accumulated depreciation Contra account is only meaningful in comparison to the cost. When the asset is gone/sold, neither account is needed anymore. E.g. Truck bought at 50,000. Depreciates at 8,000 each year. Sold at end of 2nd year for 37,000 Net book value of truck = 50,000 16,000 = 34,000 Journal Entry for selling truck: Cash 37,000 Truck asset 50,000 Accumulated Depreciation Revenue on sale of truck 34,000 3,000

When non-physical assets, e.g. goodwill, patents and trademarks are amortised, the accumulated amortisation account is used instead of accumulated depreciation

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5.6 Accounts Receivable and Contra Accounts Accounts receivable when revenue is recognised but uncollected DR accounts receivable, CR sales revenue Such receivables are often called trade receivables

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Valuation of accounts receivable Receivables are valued on BS at lower of cost (original transaction value + interest charges) or net realisable value (amount expected to be collected) If collectable amount < expected amount, receivable must be reduced to an estimated collectable amount. This is done by subtracting an allowance for doubtful accounts from the accounts receivable balance Estimated amount collectable = Trade receivables allowance for doubtful debts Therefore allowance adjusts net value down to the lower of cost and current estimated collectable amount

Other receivables 2 other main types of receivables. If they are large, they are shown separately. If they are not large, together, theyre called other debtors Notes receivable - Supported by signed contract specifying payment schedule, interest rate and often other legal details. - Used for large or long term receivables, e.g. motor cars, house, appliances and loans by banks and finance comps Other receivables: - Loans to employees, officers and shareholders, associated companies, tax Refunds Company is waiting for and other receivables not arising from revenue transactions. - Accounted for and valued same as AR and notes receivable. - Usually arise from peculiar circumstances, where company disclose reasons.

Allowance for doubtful debts There is always a risk where customers will fail to pay Therefore portion of debts will be doubtful and portion should be deducted from revenue in determining profit for the period To recognise expense: DR Bad Debts Expense CR Allowance for doubtful debts

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Reason for not deducting directly to keep balance between accounts receivable and list of individual accounts. Company may still try to collect on the accounts After pursuing non-paying customer for months, company may decide to write off account. Then: DR Allowance for doubtful debts CR Accounts Receivable Allowance can be seen as a temporary holding account for amounts the company believes will not be collected, based on past experience and an assessment of outstanding accounts. Another way of writing: Direct write off method DR Bad Debts Expense CR Accounts Receivable Used when company has few accounts receivable or when large account not included in allowance suddenly goes bad Purposes of contra accounts are to provide useful information to the readers of financial statements or to assist in accountings internal control functions

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5.8 Managers and Accrual Accounting Assumptions Accrual accountings purpose: to move beyond cash flows towards a broader economic concept of profit and financial position. Implications from a managers point of view: - Fair evaluation of managerial performance - Limitation accrual accounting, basing on history reflects on the past rather than looking into the future, as managers are inclined to do - Only look at the resulted actions, not the reason why mangers initiated action - Evidenced based accounting procedures for recognition of profit and expenses may not relate very well to economic concepts of earnings, or managers struggles to increase the value of their companies - To managers seeking even handed evaluation of their performance, accounting may seem downwardly biased in its measures - Criteria for revenue and expenses recognition is subjective some managers manipulate, some managers find it too loose and flexible - The shorter the time period, the more mismatch the figures are between cash flow and accrual profit Accrual accounting has many advantages and is very widely used, but managers should not accept it uncritically

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5.9 Accrual Accounting in the public sector Since 1995, local governments in Australia have been required to produce financial statements using accrual accounting Since 1994 NSW govt. 1999 all govt Key differences with accrual accounting: Non-cash assets and depreciation Value of receivables and payables Liabilities (employee entitlements) Changing value of financial assets and liabilities (exchange rate) Cost and revenue of government activities Cost of consuming assets expense (e.g. depreciation) Value of goods and services received for free from other bodies (revenue)

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Chapter 5 Appendix Special Journals, Subsidiary Ledgers and Control Accounts

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Business with small set of transactions initially recorded in general journal, then posted to general ledger Complex business rather than info captured in 1 journal and posted to 1 ledger, system of special journals, subsidiary ledgers used Special journals allow easy recording of the most common transactions undertaken by a business Subsidiary ledgers present detailed analysis of info that is eventually transferred to general ledger account Sales invoice >>> Journal Entries + Subsidiary ledger AR >>> General Ledger, Trial Balance General ledger account called debtors or Accounts receivable

A5.1 Prime Entry Records: Special Journals Special Journal : Sales Purchases Cash receipts Cash payments Transaction Recorded: Credit sales of inventory Credit purchases of inventory All cash inflows (including cash sales) All cash outflows (including cash purchases)

Each entry represents a transaction that belongs to the same class as others in the same journal Transactions not in special journal are recorded in general journal Advantages of Special Journals: - Recording efficiency - Amounts posted from special journals to general ledger as totals, rather than individual journal entries - More than one user can update accounting system, because it consists a number of related subsystems - Nature of transaction eliminates need for narrations - Info such as receipt or invoice number may be recorded for narrations - Additional info can be added for convenience as it is available from source documents, e.g. discounts

A5.2 Subsidiary Ledgers and Control Accounts Most common way of accommodating need for detailed records in the accounting system, without grossly expanding number of separate general ledger accounts

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Subsidiary ledger a set of ledger accounts that collectively represents a detailed analysis of one general ledger account classification Relevant account in general ledger is called the control account Accounts in subsidiary ledger can be periodically checked against total data and balance in control account Examples of general ledger accounts that have subsidiary ledgers: - Debtors/Accounts Receivable separate account for each debtor - Creditors/Accounts payable separate account for each creditor - Property, plant and equipment Asset Register separate for each piece - Raw materials Inventory Separate records of each type of raw material - Finished goods inventory Separate record of each type of finished good Advantages for subsidiary accounts Check on accuracy (as subsidiary account and general account balances should =) Enable any desired amount of detail to be maintained to explain composition of selected general ledger account, without overloading general ledger

A5.3 Trade discount and Cash discount Both Trade discount and cash discounts represents a reduction in the amount that a customer ultimately pays a vendor for gods and services supplied Differ in the way they are recorded

Trade Discount Trade discounts are a means of adjusting the actual price charged to a customer from a standard list price. Usually determined by category of customer or normal volume of businesses Manufacturer may sell at list price to general public, 40% off for retainers and 55% off to wholesalers Most enterprises record only net amount of transaction Effect of trade discount is merely to set an actual price for transaction

Cash Discount Cash discounts are conditional adjustment after determining the actual selling price at which the transaction takes place NOT a change in price of original sales transaction generally recorded as an additional transaction Credit terms 2.5/10, n/30 2.5% deducted if money was paid within first 10 days, the net amount must be paid within the next 30 days Discounts recorded as Discounts allowed (EXPENSE), or Discounts Received (REVENUE)

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A5.4 Operation of Special Journals and Subsidiary Ledgers Sales Purpose of special journals is to eliminate need for such detailed recording in a general journal and the general ledger Totals of special journals posted to control account, because CA only record aggregates Sales journal updated everyday Sales journal posted to AR, Sales revenue, COGS, Inventory Subsidiary ledger may be established for each customer who buys on credit Posting reference S1 indicates info comes from page S1 of sales journal Tick in posting reference indicates that the amount has been posted to the subsidiary ledger End of period total of subsidiary ledgers can be checked against balance of AR control account. I.e. sum of balance in each debtor should = balance of AR control account

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Purchases Purchases only used for recording the acquisition of goods, on credit, intended for resale Source document purchase invoice from supplier, matched against delivery docket and copy of official purchase order Even with discounts, the full amount owing is recorded If discounts are received, then this is recorded in CPJ discount revenue, when items are paid for Purchases journal updated every day for each creditor of each item of inventory Credit transactions involving acquisition of fixed assets or items to be charged to expense accounts, such as repairs, maintenance, printing and stationery, are often recorded in general journal.

Cash Receipts Source document: evidence of cash receipt, list of cheques received or direct deposit recorded on bank account statement Cash receipts journals are designed to meet specific needs of an enterprise Most businesses include payments from debtors, possibly cash sales Also sundry or miscellaneous column for cash receipts not otherwise identified by specific column that represents a particular general ledger account E.g. proceeds from sale of fixed assets, refunds by creditors, new capital or mortgage funding Discount expense column not sundry

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Cash Payments

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Source documents: duplicate of cheque or cheque butt, statement and invoices from creditors, receipt issued by recipient or payroll analysis certified as correct by responsible staff member Bank statement evidence of interest charged on any overdraft, together with info about other bank charges and fees Minimise postings and provide analysis of payments, separate columns may be provided to record entries affecting those ledger accounts frequently involved Sundry or miscellaneous column might be needed. DO NOT POST total of sundry column Desirable in all books of prime entry (journals) to provide reference to source document for each entry Done by recording cheque number In addition to postings to general ledger made at end of period, each individual item in the creditors column will be posted as a debit to the creditors account

A5.5 Role of General Journal and General Ledger General journal used to record a number of important transactions: Sales and purchase returns Credit transactions other than those related to inventory, such as the purchase of equipment Adjusting entries Closing entries Each entry in general journal is individually posted to appropriate account in general ledger At the end of a period, all financial information will be posted to general ledger, either as an individual entry sourced from general journal (including sundry from special journal), or in aggregate from columns of various special journals

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Chapter 6 Financial Reporting Principles, Accounting Standards and Auditing

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6.2 Accounting Principles and the use of Accounting Information Doing accounting takes expert knowledge, considerable experience and continuous attention to new problems and solutions. Concepts and principles are important, as they form logical structure that practising accountants use every day to consider problems to make recommendations GAAP (Generally Accepted Accounting Principles) applied differently for different entities Rules, standards and usual practices that companies are expected to follow when preparing financial statements Stock market crash of 1929 brought GAAP AASB (Aust Accounting Standards Board) IASB (International Accounting Standards Board) AASB uses IASB as foundation, but includes more details applicable to Aust environment SACS Statement of Accounting concepts SAVS established for general concepts and principles to be used in preparing financial statements SAC 1 Definition of a Reporting Entity SAC 2 Objective of General Purpose Financial Reporting SAC 3 Qualitative Characteristics of Financial Information SAC 4 Definition and Recognition of the Elements of Financial Statements Now, SAC 3 and SAC 4 is replaced with Framework for Preparation and Presentation of Financial Statements

FYI: Difficulties that face accounting and managers by GAAP Difference in company structures e.g. ABC = not for profit, publicly owned. Should ABC use same methods as other profit seeking organisations? Qantas / UNSW employees are not assets. But for sports team, such as Sydney Swans millions are paid to have certain players on the team. Are they assets or expenses? Should they be amortised? Comparing movies net profits hard to measure profitability of certain movies e.g. star wars attracted many viewers when it was first released. However, due to its popularity, it continues to generate revenue, through video, dvd, toys, books

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6.3 Framework for the Preparation and Presentation of Financial Statements

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Framework includes the coverage of: - objectives of financial reports - assumptions underlying financial reports - qualitative characteristics that determine the usefulness of financial reports assets and liabilities - definition of the elements from which financial reports are constructed: assets, liabilities, equity, income and expenses - recognition and measurement of the elements of financial statements Framework makes distinction between general purpose financial report (for most users who rely on this as main source of info) and special purpose financial report (list for issues of shares outside scope of Framework).

Users of financial reports Investors info on risk and return, including shareholders buy, hold or sell? Employees including unions stability and profitability and whether company can afford employee benefits Lenders whether interest and loans will be able to be paid off Suppliers and other trade creditors whether amounts owing can be paid Customers continuance of entity, e.g. with warranties Governments and their agencies allocation of resources & tax Public substantial contribution to public e.g. employment Framework regards investors as the majority of users, so satisfy most the needs of investors

The objective of financial reports Objective: provide information about financial position, financial performance and cash flows that is useful to users in making economic decisions Users need evaluations of cash generation due to its liquidity to buy inventory, pay wages, distribute shares etc Users need info on financial position, financial performance and cash flows to evaluate this Financial position balance sheet economic resources (NCA), financial structure (who finances assets), information on liquidity and solvency (L & ratios) Financial performance income statement profitability, employment of resources, potential chances in assets controlled by the entity Movement in cash cash flow statement operating, investing and financing decisions

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Underlying Assumptions Accrual basis of accounting Going Concern - entity will continue to operate in the foreseeable future - book value = cost accumulated depreciation - liquidation value can be a lot less than book value - this is because when companies close down, they may not be able to sell off its assets at the book value Other authors also regard accounting entity, accounting period and monetary assumptions as key underlying assumptions.

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Key Qualitative Attributes Understandability concern on complexity of financial statements that could not be understood by experts. Pozen committee examined US financial reporting system and made recommendations on the usefulness of reports Relevance Pozen committee suggests that the increased complexity has led to less relevant info to users evolution of business strategies and businesses do not want investors to know about their liabilities - materiality Reliability Pozen Committee suggests detailed rules in standards permit structuring of transactions to achieve particular accounting results, even if results are inconsistent with transactions - Faithful representation real existence - Substance over form inaccordance with substance and economic reality - Neutrality freedom from bias - Prudence degree of caution in exercise of judgements - Completeness material info is not omitted Comparability Pozen Committee notes that GAAP contain many detailed rules with several industry exceptions and alternative accounting policies for same transactions

Elements of Financial Statements Assets resources controlled by the entity as a result of past events, and from which future economic benefits are expected to flow from the entity Asset recognition - It is probable that any future economic benefits associated with the item will flow to the entity

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Liabilities 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 Liability Recognition - probable that any future sacrifice of economic benefits associated with the item will flow to or from the entity - the item has a cost or value that can be measured reliably Equity residual interest in the assets of the entity after the deduction of its liabilities SE = A L Equity ranks after liabilities as a claim to the assets of an entity Income increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases in liabilities that result in increase in equity Issues of shares are not included 2 main components revenue and assets/liabilities Expenses decreases in economic benefits during the accounting period in the form of outflows of assets, depletion of assets or incurrences of liabilities that result in decreases in equity mainly COGS, wages and depreciation

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Measurement of the elements of financial statements Measurement determining the monetary amounts that the elements of the financial statements are to be recognised at and included in the balance sheet and the income statement Historical cost assets are recorded at the time of acquisition Current cost assets are carried at the amount that would have to be paid if it was bought currently Realisable (settlement) value assets are carried at the amount that could currently be obtained by selling the asset in an orderly disposal Present value assets carried at present discounted value of future net cash inflows that the item is expected to general in the normal course of business

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6.4 Assets and Liabilities: Valuation and Measurement Five basic methods to measure or value assets and liabilities - Historical cost - Price-level-adjusted historical cost - Current or market value - Value in use (or present value) - Liquidation value Asset: Whether market values are better than historical cost? Liability: Whether present value or estimation of future cash flows?

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Historical cost Acquisition cost values assets at the amount paid or promised to acquire the assets, and values liabilities at the amount of any associate promises Ability to document cost of asset through receipts, invoices or contracts An asset valued at historical costs is valued at its expected lowest or most conservative value of future benefits at the date of acquisition At the point of acquisition, historical cost = market value = value in use (present value), in most cases. writing down of unproductive assets lower of cost or market rule

Price level adjusted historical cost Adjusts for changes in the value of the dollar, rather than the changes of the values of the assets Lack of popularity because if historical cost is unsatisfactory compared to current values, adjusting the cost for inflation still makes it unsatisfactory, only now less understandable

Current Price or Market Value (value in exchange) Records assets and liabilities at their current particular market value focuses on the individual values of the assets and liability items assumes that value is market-determined and that profit should be measured using changes over time in market values. Input market value entry value refers to the amount it would cost to bring the asset into the company if it were not currently in it. Output market value exit value amount an asset is worth if it were sold now (net realisable value) Fair value alternative asset valuation method amount of the consideration that would be agreed upon in an arms length transaction between knowledgeable, willing parties who are under no compulsion to act.

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Value in use (present value) Considers that value flow from the generation of cash flows from the asset Estimated by calculating the net present value of future cash inflows cash flows minus lost interest expected to be generated by the asset Present value future cash flow future interest implied by waiting for the cash Present value = future cash payment / (1+r)

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Liquidation Value going out of business, sell it for what you can business presumes the entity is not a going concern

6.5 Accounting Regulation in Australia CLERP Act 1999 Corporate Law Economic Reform Program Act modified institutional arrangements for the setting of accounting standards in Australia, recognising that financial reporting requirements can play an important role in Australia companies ability to compete effectively and efficiently in a global environment FRC Financial Reporting Council

6.6 International Accounting Standards IASB (International Accounting Standards Board) have issued more than 40 individual standards. Aim: develop common standards that could be used by companies operating in several countries, and eventually that all countries could use within their borders CONVERGENCE Horror stories of 1 company with huge profits in one country also with huge losses according to another countrys acct standards are an embarrassment to the accounting profession and awkward for regulators such as SEC (security exchange commission) to deal with Challenge to IAS is the attempt to make even the Canadian, US and Mexican accounting systems similar, given that the 3 countries have signed the NAFTA. VERY different in accounting standards, as govts have passed laws that set strict requirements for financial accounting in accordance with national priorities and culture

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6.7 The Annual Report and Financial Statements

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The standard set of financial statements has five components: - balance sheet - income statement - statement of changes in equity - statement of cash flows - notes to the financial statements Statement of changes in equity reports the profit or loss in equity Notes to the financial statements provide additional detail on the items in the financial statements note 1 is accounting policies inventory method, depreciation method Public companies and other organisations include their set of financial statements in a much larger annual report. This report usually contains: 1. Summary data on companys performance for the year, comparisons going back 5 or more years 2. Letter to the companys shareholders from the chairperson of the BOD or the managing director, including highlights of the performance and future plans 3. Extensive CEOs report description of the eco, financial and other factors 4. For listed companies a corporate govt statement, required under ASX reg 5. Set of financial statements 6. Directors statement required by Corporations Act 2001 signed by CEO and CFO that the fins records are prepared in accordance with the Corporations Act 2001. Debt opinions of directors 7. Independent audit report 8. Directors report names of directors, principle activities, operating results 9. For listed companies, info on substantial shareholders, distribution of ownership 10. Other voluntary information graphs, details on products, pollution

Full versus concise financial reports Corporations Act 2001 now requires the publication of both FULL general purpose financial reports (GPFR) and concise financial reports GPFR contains the 5 financial statements in addition to the auditors report and directors declaration Concise financial statements are sent to all shareholders, with a statement that the report is concise and GPFR if a shareholder requests Concise financial statements include the 5 financial statement components minus notes. Additionally there must be a discussion and analysis of financial statements to assist the users understanding.

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6.8 The External Auditors Report Auditors report a routine statement by the auditors that provides an opinion on whether financial statements are fairly presented Adverse opinion when auditors deny the fairness of the statements External auditing refers to the evaluation of an organisations financial statements by an auditor who should be unconnected with, and therefore independent of, the management of the organisation Role of external auditor: - to have an independent, unbiased and professional perspective - to render a competent opinion on the fairness of the financial statements Fundamental objective of professional associations such as CA or CPA is to protect society by ensuring the professionalism and independence of the external auditors who belong to them Independence is maintained because the auditor is appointed by, and reports to the shareholders, not management However, in practice, auditor has close working relationship with management and managers has a strong position to recommend change of auditor Recent legislative changes have strengthened the independence of audit firms: - rotation of audit partners every 5 years - banning the provision of many non-audit services by the firm carrying out the audit Audits are opinions, not guarantees. Audits do not state whether a company is performing good or bad. It simply states whether the performance and position have been measured and presented in a generally accepted and unbiased way

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Content and form of auditors report changes every few years, as auditors rethink how it is best to communicate with the users. Addressed to owners, titled Independent Audit Report

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Standard version of the auditors report includes the following: 1. Identifies company, set of statements and their date and states that the statements are the responsibility of mgmt and that the auditors responsibility, having conducted an independent audit of the financial report, is to express an opinion to them. 2. A section of the report contains the following statements: a. audit conducted in accordance with AAS to provide reasonable assurance on whether financial report is free of material misstatement b. auditors procedures included the examination, on a test basis, of evidence supporting the amounts in the financial report, and the evaluation of accounting policies and significant accounting estimates c. procedures have been undertaken to form an opinion to form an opinion on whether, in all material respects, the financial report is presented fairly in accordance with AAS d. statement that audit opinion expressed in the report has been formed on the above basis 3. Normally, the third paragraph provides the auditors opinion that the financial statements give a true and fair view that they are in accordance with the provisions of the Corporations Act 2001, applicable accounting standards and other professional mandatory reporting requirements. Redraft: include paragraph of respective roles of mgmt and auditors and inclusion of separate section related to the independence of auditors There are 3 main exceptions to unqualified opinion: - qualified opinion generally satisfied, but disagree with mgmt - adverse opinion financial statement not presented in accordance to AAS - disclaimer unable to express an opinion either way because of a limitation in the works the auditors were able to do Even if unqualified opinion is expressed, auditor will still alert reader to the facts in the financial statements, but not of such nature that it affects the audit opinion

6.9 The Nature of a Profession and Professional Ethics Professionals are recognised by post-secondary education 3 main professional accounting bodies ICAA (Institute of Chartered Accountants in Australia), CPA Australia and the NIA (National Institute of Accountants) If a professional accounting has not lived up to the standards of conduct held by the profession, he or she can be reprimanded or expelled by the profession and/or sued in court

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Professional codes of ethics involve not only behaving in professional manner, but also maintaining the level of expertise required in order to perform skilfully APES 110 Code of Ethics for Professional Accountants Five fundamental principles: - Integrity - Objectivity - Professional competence and due care - Confidentiality - Professional behaviour Compliance with the fundamental principles may be threatened by various threats, including the following: - Self interest threats undue dependence on total fees - Self review threats auditing systems on reports you designed - Advocacy threats promoting shares in a listed company you are auditing - Familiarity threats familial relationship with director or officer - Intimidation threats threatened with dismissal etc

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Chapter 7 Internal Control and Cash

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7.1 Internal Control Internal control is a process, affected by an entitys board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following categories: - Effectiveness and efficiency of operations [also reduce risk of asset loss] - Reliability of financial reporting - Compliance with applicable laws and regulations Internal control is not one event or circumstance but a process integrated with other basic management processes, such as planning and monitoring CEO is ultimately responsible for internal control Internal control affects working life of most personnel Internal control can only provide reasonable assurance rather than absolute assurance to management and the board of directors regarding the achievement of an entitys objectives Limitations of Internal Control: - Problems of human judgement not follow instructions - Managers may override prescribed policies or procedures increasing revenue - Collusion between individuals can result in control failures - Internal controls cost money should apply cost benefit principle Internal control can be considered to be effective for each of the 3 categories if management and the board of directors have reasonable assurance that: - They understand the extent to which operation objectives are being achieved - Financial statements are being prepared reliably - Compliance with relevance laws and regulations 5 interrelated components of internal control: - Control environment integrity, ethical values and competence of entitys people - Risk assessment associated with change and establishing objectives - Control activities ensure necessary action for risk assessment - Information and communication internal and external - Monitoring assess quality of systems performance over time ongoing monitoring and separate evaluations

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Control Activities Examples of control activities: - Top level reviews compared to budgets and forecasts to assess which targets are being achieved - Information processing controls check accuracy, authorisation and completeness of transactions - Separate record keeping from handling assets segregation of duties where person who physically handles assets is different to person who keeps records - Physically protect sensitive assets Examples of Internal control Matching independently generated documents matching sales invoices and shipping documents Prenumbering and sequencing checking of documents to prevent unauthorised use Comparison with independent third party info bank reconciliations of ledger accounts with bank statements Cancellation of documentation deal with cheques immediately Segregation of duties Demanding timeliness of operations prompt deposit of cash receipts and depositing cash intact

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7.2 Internal Control of Cash Cash is the asset that is most susceptible to theft because of its liquid and generally anonymous nature Common control is locked in sales registered or carefully controlled records Another way is to have multi copied, pre numbered sales invoices check cash sales, cash received, credit sales, accounts receivable, inventory Prevent stealing cash / cheques there should be more than one person opening, disable function to turn into cash, list of cheques received, should be posted to register, general ledger, accounts receivable of subsidiary records Payments of cash: properly authorised documents/invoices and cheques should be signed by 2 staff members who are independent of invoice approval and accounting duties, original invoice should be stamped paid

7.3 Bank Reconciliations Because of high frequency of transactions and potential for error, accuracy of cash balance in general ledger should be examined periodically Process is called bank reconciliation based on bank statement

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Bank Reconciliation versus cash accounts Bank statements summarise the activity in a cheque account and report the ending monthly balance. Cash account of depositor = asset, for bank = liability This is because when cash is deposited in the bank, the bank now owes the depositor money End of month bank statement cash balance normally wont agree with companys cash records Items on companys record but not on bank statement: - Deposits in transits receipts entered in a firm but not yet processed by the bank (debit for company > credit for bank) - Outstanding (un-presented) cheques cheques written by business but not yet presented to the bank company issued cheque, but external person hasnt cashed it yet (credit for comp > debit for bank) Items reported on the bank statement but not yet entered in the companys record - NSF cheques (non sufficient funds/ dishonoured cheque) customer cheques deposited but refunded due to lack of funds (debit on bank statement) - Bank service charges for accounting processing - Notes receivable and interest collected by the bank collection of interest or note is reported with a credit memo notation because of depositors increase in account balance - Interest earned on the account In addition to timing differences, errors may cause a discrepancy between the bank statement balance and company accounting records

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The reconciliation process

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If balances do not agree and the reconciling items are deemed correct, there is a chance that a record keeping error has been made. Reconciliation not only highlights timing differences but also identify errors made by either the bank or the depositor Bank reconciliations contain adjustments to both ending cash balance for bank and company records After reconciliation is completed, general journal entries must be prepared for adjustments made to company records Adjustments necessary to update cash account in relation to correction of company errors and info processed by the bank No journal entries are needed for adjustments made to the ending bank statement balance These adjustments reflect items that have already been recorded in a companys accounts thus no further updating is necessary

7.4 Performing a Bank Reconciliation from information in cash journals 1. Go through last months bank reconciliation statement, ticking off any amounts that were outstanding last month Go through bank statement and tick off items appearing in both CJs and bank Errors: if bank has mistake, inform bank of error. If business has made a mistake correct relevant cash journal Go through bank statement to see what amounts remained unticked Enter such amounts into CRJ or CPJ Go through CRJ and CPJ and see if there are any unticked amounts these are outstanding deposits and unpresented cheques CRJ deposit in transit CPJ unpresented cheques Total CJs and post to bank ledger account Prepare bank reconciliation

2.

3. 4.

7.5 Petty Cash Under the petty cash system, a fund is established in making small payments, especially those that are impractical or uneconomical to make by cheque. E.g. taxi fares or miscellaneous office needs To establish petty cash funds: Petty Cash DR Cash CR As payments are made from the fund, the custodian completes a form known as petty cash voucher

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Each voucher indicates amount paid, purpose of expenditure, date and individual who received money Petty cash vouchers and invoices and receipts are evidences of disbursements Cash remaining in fund + Petty cash vouchers + Invoices = Original amount

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Replenishing the fund To replenish fund Postage expense $$$ Office supplies expense $$$ ... $$$ Cash $$$ Note credit is to cash account Fund is restocked by writing cheque on the companys cheque account Replenished when funds are low, or at the end of each accounting period Process is necessary because no formal journal entries have been recorded

Errors in petty cash fund Occasionally petty cash vouchers and cash will not equal original fund balance Adopt cash short and over account Shortage miscellaneous expense Overage miscellaneous revenue item

7.6 Disclosure of Internal Control in Annual Reports Australian companies listed with ASX are now required to include section in their annual reports on corporate governance. A number of companies include a description of internal controls in this section Common aspects of these descriptions: - Board of directors has responsibility for internal control system - Role of audit committee is noted - Operating budgets used to monitor performance - Internal audits are important part - Controls are important in certain key area including treasury - These are clearly defined guidelines for capital investment

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7.7 Managers and Internal Control

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Internal control is the responsibility of management Internal control should minimize errors and irregularities Errors unintentional mistakes, irregularities intentional Irregularities should be detected except when there is collusion or management override No system of internal control can eliminate all errors and uncertainties, but can decrease the possibility of them occurring and increase chances of detecting them Important question how much internal control is necessary Cost money to implement an extra internal control Must apply cost benefit analysis Difficult because benefits of having controls are often difficult to quantify Based on judgement

7.8 Public Sector Issues Internal control is an integral part of the environment of all public sector entities June 1995 NSW Treasury issued a statement of best practice internal control and internal audit Guidance for govt agencies on such topics as responsibility for internal control, relationship between management processes and internal control; analysing risks and establishing controls and effective collection of information, communication and monitoring 4 critical elements in an effective system of internal control for public sector entities Appropriate tone at the top Well designed control system aimed at mitigating (explaining) risks Effective collection of info and communication thru agency Effectively monitoring of system of internal control

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Chapter 8 Inventory

Cheryl Mew

8.1 Inventory Control Inventory control is an important issue for management because a high percentage of working capital may be tied up in inventory. May be consumable or outdated, high potential for theft Choice of inventory is a record keeping choice as opposed to a reporting choice

The perpetual inventory control method When an order of inventory items is received, the quantity received is added to the quantity recorded as being already on hand. When they are sold, they are deducted from the recorded quantity Therefore, the perpetual method shows how many items are supposed to be on hand at any time Inventory on hand = quantity on hand at beginning of period + quantity purchased quantity sold Perpetual continuously updated figure Physical count of inventory fails to show that quantity, therefore error or lost or stolen inventory Beginning inventory cost (support with physical count if desired) + Cost of purchases of inventory (records) Cost of inventory sold (records) = Ending inventory cost Debit expense, credit inventory Overage = negative expense where there is more inventory than expected Overage/shortage expense account would probably be included with COGS in the income statement

The periodic count method If complete records of inventory changes are not kept, the enterprise does not have records to indicate what should be on hand The only way to tell is to count This is done periodically when inventory figure is needed for financial statements or insurance purposes this is called the periodic inventory method. Periodic count method lacks the parallel record keeping that gives the perpetual method its value. There is no way to reconcile counts to records in order to discover errors, but simple and cheap, as no continuing records are kept Beginning inventory (count) + purchases (records) ending inventory (count) = Inventory sold (deduced); that is cost of goods sold

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Because what is sold has been inferred, under the periodic method, cost of goods sold expense includes all other possibilities (lost, stolen...) Other forms of control need to exist to indicate theft or so on E.g. unexpected changes in the ratio of cost of goods sold to sales should be investigated

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Inventory: Cost and benefits of controls Perpetual method can be costly in terms of record keeping Car dealership needs perpetual system Cars are expensive, so large investment must be made if a good supply is to be on hand for customers to choose from. Need to keep track of registration, insurance, serial numbers, other types of identification Because of small quantity of cars sold by dealerships, record keeping costs are not high. Similarly, companies selling more expensive items, e.g. TV, fridge, jewellery, use perpetual method Companies with large amount of sales, particularly items with low value, use periodic inventory method because of lower costs. However, most organisations now use perpetual because of computer based inventory systems Retail companies have optical scanners scanning barcode Assist with inventory control and helps with planning for ordering additional inventory

8.2 Accounting Entries for Perpetual and Periodic Inventory Perpetual includes costs of goods sold and inventory shortage expense Sales XXX Less cost of goods sold XXX Less inventory shortage XXX XXX Gross profit XXX Periodic excludes costs of goods sold and inventory shortage expense Sales XXX Cost of goods sold: Opening Inventory XXX Purchases XXX Cost of goods available for sale Less ending inventory XXX Costs of goods sold XXX Gross profit XXX

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8.3 Inventory Valuation and Cost of Goods Sold Inventory accounting uses a modified version of the standard historical cost valuation basis: lower of cost or market value Application of accounting conservatism: anticipate no gains but allow for losses Inventory accounting affects both the balance sheet (inventory valuation) and the income statement via the COGS

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Inventory cost flow assumptions Cost of inventory varies Actual cost is usually tracked only for high value items (houses, motor vehicles) that can be identified by serial numbers and other methods Method specific identification As the cost of keeping records decreases, because of computerisation, more items will be able to be tracked this way. Impossible to keep track of individual items in inventory, so ASSUME flows of costs By using periodic method: first calculate COG available for sale Problem: how to allocate COG available for sale between COGS and ending inventory asset Three common inventory cost flow assumptions: - FIFO First in first out sell the oldest items first (BS recent cost, COGS old costs) - AVGE weighted average assumption assume mixture of old and new items (average unit cost = total cost / total units) - LIFO Last in first out sell newest items first (BS old costs, COGS new costs)

8.4 More about Inventory Cost Flow Assumptions

Assumption FIFO AVGE LIFO

Periodic Control FIFO Weighted Average Periodic LIFO

Perpetual Control FIFO Moving weighted average Perpetual LIFO

FIFO is not affected by inventory control method because it just assigns the most recent costs to whatever is on hand. Others depends on control method, as it depends on what happened to inventory levels during the period Thus there is 5 methods There is a six specific identification and 2 others

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Cheryl Mew

In Australia, LIFO is not allowed to be used for either financial reporting or tax purposes Because each assumption allocates the available inventory cost between the inventory asset and the costs of goods sold expense differently, the choice of assumption has an effect on both the income statement and the balance sheet If there is little change in purchase costs, the various methods will show very similar results FIFO Used because its convenient where inventory asset are close to current costs Convenient because only need to keep invoices Doesnt matter which control, because all info needed is the quantity on hand, whether by count or by perpetual records Most popular cost flow assumption for inventories for larger Aust companies Considered appropriate for current asset because it is the most reasonable method of physically moving inventory, especially inventory that is perishable or subject to changes in style AVGE When prices are rising, average cost shows a higher cost of goods sold (lower profit) and lower inventory balance sheet figures than the FIFO method LIFO In US, cost flow assumption used for accounting purposes does not have to match physical flow of items Allowable method for income tax purposes. E.g. rising inflation increases purchases costs, produces higher COGS, lower profit and lower inventory asset value used for tax purposes Matches revenues and expenses more adequately. E.g. if company changes prices in response to purchase cost changes, its revenues reflect recent prices changes Problem: LIFO produces inventory asset values that are based on older purchase costs, and this can substantially underestimate the asset value LIFO is affected by whether its amounts are determined using the periodic or perpetual control methods,

8.5 An Example: MEEIX LTD Beginning inventory + purchases = cost of goods sold expense + ending inventory MUST refer back to pg 398 when studying. In a period of rising purchase prices Inventory asset value: FIFO > AVGE > LIFO Cost of goods expense: LIFO > AVGE > FIFO

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Larger differences in price, larger differences in end results of method

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8.6 Lower of Cost or Market Rule The lower of cost or market rule states that the value of inventory should be written down from the cost price to the market price in situations where market is below costs To calculate the lower of cost or market value, we just take the cost of the items and match those costs against the net realisable value and use the lower as the balance sheet inventory value. If inventory costs 1000 had a net realisable value at year end of 800: DR Inventory Write down expense 200 CR Inventory 200

8.7 Retain Inventory and standard costs Retail inventory method is most application to retailers inventories Combines purchase costs and selling prices into a single calculation/estimate Department is charged with total selling value (sale price x time) Revenue from sale is deducted from total value as items are sold Ties inventory control to cash control AT any given point in time, inventory + cash + receipts for credit cards = total retail value Retail price of all goods department sales = inventory on hand priced at retail If physical count doesnt match then use shortage or overage Retail method is complicated in practice because of the need to keep track of markdowns, returned goods, special sale prices and other price adjustments if the method is to work accurately Another popular method: standard costs Applicable to inventories manufactured by a company and uses estimated costs based on standard production costs and volumes balances, purchases and sales

8.8 Disclosure of Inventories Policies Accounting standards require the financial reports disclose the value of inventory split between CA and NCA and further split into the following classes: - Raw materials and stores - Work in progress - Finished goods - Land held for resale In addition requires disclosure of general basis of inventory valuation and methods used to assign costs to inventory quantities

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Within one organisation, more than one method can be used and it may vary between the type of product or the class of inventories

Cheryl Mew

8.9 Managers and the valuation of inventory Managers have to choose control method Perpetual better control, higher costs Important to managers as both profit figures and balance sheet figures affect managers performance reports Therefore managers need to understand the effect, across time, of different cost flow assumptions on financial statements Managers must make important judgements Which cost flow assumption must closely represent the actual physical flow? What inventory items have a net realisable value which is lower than cost?

8.10 Inventory in the public sector Inventory is not normally a material item for most public sector organisations. But there may be exceptions hospital bandages, medicine When inventory does exist, the same accounting standards apply as in the private sector.

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Chapter 9 Noncurrent Assets

Cheryl Mew

9.1 The Cost of an Asset: Basic Components The basic premise of historic cost valuation is to use the cost of an asset, at acquisition to value that asset on the balance sheet When machines are bought, there are certain conditions that must exist for the machine to operate, e.g. temperature, raised floor for wiring, fire protection system Therefore a section of the factory must be renovated to meet specifications of the machine These costs are known as installation costs Overall, the cost of an asset includes all those costs required to install it ready for use Should the interest on monies borrowed to finance the project be included? Most the time, no Enterprises often have policies for how to determine whether expenditures, such as interest are included in assets costs Decision between whether to include costs as 1 years expense or included in assets Expense profits and income taxes for the year will be lower Assets total assets will be higher, and this years profit and tax expenses will also be higher Capitalising versus expensing choice When deciding where in BS maintenance goes, think about whether there is improvement or extension of useful life of asset. If yes asset, if no maintenance expense Common components of asset cost: - Land purchase price, costs of clear title (legal fees), clearing unwanted items, draining - Building (purchased) purchase prise, renovation, decoration - Building (self-constructed) labour, material, insurance - Purchased Equipment installation, transport, testing

9.2 Depreciation of Assets and Depreciation Expense Depreciation an allocation of cost as a deduction from profit over the useful life of the asset Depreciation expense annual deduction from revenue Depletion wasting assets are involved Amortisation intangible assets or leases are involved

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Why Allocate the Cost?

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Assets are returns on investments In accrual accounting, some method is needed to allocate the cost of long lived assets over their useful lives If whole asset cost was deducted in the year of acquisition, that years profits will be very low and subsequent years profits very high It would also mean that an asset has further benefits that is not recognised Allocation of cost in order to measure profit NOT a system to tract value changes in assets or to measure the current value of those assets in the balance sheet Balance sheet shows the net of assets original cost minus Acc Dep: it does not mean the assets current value is that net amount

Why not depreciate land? Lands economic value is not considered to decline through use Land is not normally susceptible to physical or economic decline Equipment can be depreciated via physical causes (wear and tear) and nonphysical causes (obsolete with the advent of newer and faster machine) Land is considered immune from all this, and is therefore not depreciated

When does cost allocation (depreciation expense) begin? When the asset is put to use and the benefit begins to be realised, depreciation of the expense should begin. Once asset has been put into service, further costs involved in painting, maintenance, repair and so on are now considered to be expenses If a cost that is incurred significantly changes the assets economic value in earning revenue, e.g. betterment of asset, then cost may be capitalised as part of assets cost, then depreciated along with the rest of the asset.

Other questions Depreciation is recognised by the following journal entry: DR Depreciation Expense CR Accumulated Depreciation Accumulated depreciation is a contra asset Depreciation is a prediction it is never exact Choice of accounting purposes does not affect the tax paid Why is depreciation any good, if its not exact, it has no cash effect and it does not match market value changes in assets? It is used to spread the cost out over the useful life of the asset, which matches the presumed consumption of that cost with the benefits gained from that use

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9.3 Depreciation Bases and Methods Assumption Spread evenly over the assets life benefits is equal throughout useful life Falls over the assets life benefits decrease as asset gets older Variable over the assets life benefits varies according to how much production is achieved each year Kind of Cost Allocation Straight line expense is the same each year Reducing balance method expense is larger in earlier years Units of production expense depends on each years volume of production

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Straight line depreciation Simplest and most widely used Need 3 pieces of info: - Cost of the asset: total cost to be depreciated over time - Estimated useful life: number of periods for which the asset is expected to benefit the enterprise - Estimated salvage value: amount expected to be recovered via the sale of the asset at the end of its useful life Depreciation for one period = Cost minus estimated salvage value Estimated useful life (no. of periods) A common practice for many firms is to assume the salvage value of the asset to be zero, which then enables depreciation to be expressed in terms of percentages instead of years

Reducing Balance method Next most common depreciation method Assets contribute more of their benefit to the enterprise in early parts of their lives Need 3 pieces of info: - Cost of the asset: total cost to be depreciated over time - Accumulated depreciation: total depreciation recorded since acquisition - Depreciation rate: % of book value of the asset that is to be depreciated in the period Depreciation for one period = (cost accumulated depreciation) x rate Reducing balance depreciation does not normally take into account salvage value

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Reducing balance percentage: r = 1 - n r = required depreciation rate n = estimated life in years s = estimated residual value c = original cost

Cheryl Mew

Units of Production Depreciation and Depletion Also used to compute depletion of natural resources Need 3 pieces of info: - Cost of the asset: total cost to be depreciated over time - Estimated salvage value: amount expected to be recovered via the sale of the asset at the end of its useful life - Estimated number of units to be produced during the life of the asset Depreciation for one unit = Cost minus estimated salvage value estimated no. of units of production during life To determine the depreciation for one year, the charge per unit is multiplied by the number of actual units produced or used Whichever method is adopted, the company can always adjust its calculations later if the expectations about length of useful life or salvage value begin to look seriously inaccurate For now, note that it is usual to allocate the remaining book value over the remaining useful life

9.5 Gains and Losses on Noncurrent Asset Disposals Selling off assets are kept separate from ordinary revenues via the following kind of journal entry: E.g. Truck bought at 50,000. Depreciates at 8,000 each year. Sold at end of 2nd year for 37,000 Net book value of truck = 50,000 16,000 = 34,000 Journal Entry for selling truck: Cash 37,000 Accumulated Depreciation 34,000 Truck asset 50,000 Revenue on sale of truck 3,000 If there is a loss, it will be debit revenue Think of gains and losses as depreciation corrections

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9.6 Assets Revaluations

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Carry amount book value Fair value amount for which an asset could be exchanged between knowledgeable willing parties in an arms length transaction In Australia, directors need to ensure that the carrying value of an asset exceeds the recoverable amount. If not, the carrying value must be reduced to its recoverable amount impairment loss Recoverable amount assets fair value costs to sell it, or an assets value in use whichever is higher Value in use is the present value of future cash flows that are expected to be derived from an asset Accounting standards state that each class of noncurrent assets must be measured using either the cost model or the revaluation model Cost model after recognition of an asset, the asset is carried at cost less accumulated depreciation and any accumulated impairment losses Revaluation model after recognition of an asset, the asset whose fair value can be measured reliably is carried at a revalue amount, which is the fair value at the date of revaluation less any subsequent accumulated depreciation and subsequent accumulated impairment losses Revaluing upwards revaluation increment increase in asset account and shareholders equity (asset revaluation reserve) Revaluing downwards revaluation decrement decrease in asset account and increase in expense account Increments in asset valuations do not generally affect profit directly, but decrements do reduce the profit for the year Changes in asset valuation (except for land) result in different depreciation expenses in subsequent years When an asset is revalued, all assets within the same class of assets should also be valued at the same time on a consistent basis. Exception: downwards valuation Land Revaluation increment: DR Land CR Revaluation Reserve Land Revaluation decrement: DR Loss on devaluation of land CR Land Equipment Revaluation increment DR Accumulated Depreciation CR Equipment DR Equipment CR Revaluation Reserve

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9.6 Intangible Assets

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Intangible assets are identifiable, non-monetary assets that do not have a visible physical existence, unlike land, buildings or equipment Intangible Assets include: - patents, copyrights, trademarks and other such legal property - brand names, which can be registered to maintain exclusive use - franchises, distributorships and other rights to sell someone elses products in a certain geographical area - deferred charges such as incorporation costs, financing costs and other items that are really long term prepaid expenses - development costs (including product development costs and mineral exploration costs), which are capitalised and later expensed at the time they earn revenue in the future strict criteria applies AASB require organisations to charge all research costs to an expense account when they are incurred. Organisations prohibited from capitalising any expenditure associated with internally generated brands, publishing titles, customer lists and similar items

What are intangible assets worth? Existence and value of intangible assets may be doubtful generally the more clearly identifiable and documented, the less difficulty they pose Assets such as brand names, trademarks and franchises have considerable doubt about their economic value Development expenditures question on whether they belong on the balance sheet at all. is it for sure that the product will sell and that it will bring future economic value? will the revenue be larger than the costs?

Amortisation or impairment of intangibles Legal useful life is different from economic useful life If useful life is finite intangible is amortised If useful life is indefinite intangible would be tested annually for impairment, by comparing carrying amount with recoverable amount If carrying amount > recoverable amount, then impairment loss

9.8 Goodwill Goodwill arises when more is paid for a group of assets, such as a whole business, than the assets seem to be worth individually

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The rationale for paying the additional amount may be based on such factors as how the business is organised or the number of customers it has Goodwill occurs to keep the books in balance Purchased goodwill is measured as the excess of the cost of acquisition of another entity over the fair value of the identifiable net asset and contingent liabilities Externally generated goodwill is recognised by the accounting system. It is a transaction, supported by documentation, that shows how much was paid Internally generated goodwill not recognised by accounting system e.g. better management and improving friendliness of staff Internally developed goodwill is never capitalised cannot put an economic value on it yet e.g. expenditure on office parties to keep employees happy is an expense Following the acquisition of goodwill, rather than amortising it over a deemed useful life an entity will test it for impairment on an annual basis Or more frequently, if events or changes in circumstances indicate that the goodwills carrying value has decreased below its recoverable amount

Cheryl Mew

9.9 Financial Leases Leases are rental agreements in which one individual (lessee) pays, to the owner of a property (lessor), a certain amount in return for the right to use that property over a predetermined period Concern: some companies use leases to avoid putting assets on balance sheet As a result, AASB established 2 types of leases: finance leases and operating leases Finance leases when all the risks and benefits incidental to ownership are substantially transferred to the lease Cost present value of the future lease payments using an appropriate interest rate usually deducted from the lease agreement At the same time present value of those payments is recorded as a liability DR Finance lease asset CR Finance lease obligations liability After that: 1. Leased asset is amortised 2. Liability is reduced as payments are made on the lease. Each payment includes interest, but only principle deducted. This maintains the liability at the present value of the remaining lease payments 3. Expenses for using the leased asset are amortisation and interest 4. Various particulars of significant capital leases are usually disclosed in the notes to the financial statements so that the readers of the statements may judge the effects of such capitalisation Result: leased asset is treated essentially as if it were owned

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Accrual accounting recognises the economic value of the asset and disregards the legalities of who owns it If the lease does not result in the economic equivalence of ownership if it is really a rental situation where the owner is responsible for repairs, the lease is an operating lease

Cheryl Mew

9.10 Reporting of Non Current Assets and Associated Depreciation/Amortisation The Corporations Act 2001 and AASB require certain disclosures concerning noncurrent assets and their related depreciation/amortisation. These include: - Depreciation and amortisation expense - Cost and accumulated by major classes of assets - Description of policies with regards to D/A - Details concerning revaluation - If items are measured at fair value include carrying costs and other costs - Statement that assets have not been valued above their recoverable amount - What the recoverable amount is fair value cost to sell/value in use

9.11 Managers and Noncurrent Assets Managers need to make many judgements related to noncurrent assets. What should be included in the cost of an asset? What period/method should it be depreciated? Value on brand names? When should assets be revalued and who should do the revaluing? All of the above judgements (except upward revaluation) will affect the enterprises profit figure, which is a key indicator of management performance

9.12 Public Sector Issues Infrastructure system assets include items such as roads, water supply, bridges and transmission lines Generally valued by govt departments at cost or written-down replacement value (estimated replacement value accumulated depreciation) Difficulty in obtaining these figures Heritage assets cannot be replaced Valuation of $1 highlights to readers that an asset exists, but at this point in time it is not clear how to value it. E.g. Library collection held by State Library In general, a number of factors have a bearing on the difficulty of reliably measuring the assets of public sector entities. E.g. completeness of asset registers, type of asset, extent of assets similarity to other assets used in other govt departments Such assets e.g. historic buildings, gardens, monuments

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Chapter 13 The Statement of Cash Flows

Cheryl Mew

13.1 The purpose of Cash Flow analysis Cash is the most important asset to any entity Many firms have had positive profit figures, but have still run out of cash and gone bankrupt Important for present and potential investors and creditors to have info about a firms cash inflows and outflows and its resulting cash position Solvency the ability of a firm to meet all its debts and obligations as they are due Liquidity enough cash and short term assets now to recover its immediate debts and obligations Too much cash large supply of cash idle does not yield great returns for investors Cash should be put to work by making investments and attract new customers Statement of cash flow provides info on a firms generation and use of cash and highly liquid short-term assets, hence assist in evaluating the firms financial viability Cash profit is not a complete measure of what has happened to the cash Certain inflows or outflows of cash are not part of the process to generate revenue and incurring expenses, so they would not be covered even by a cash profit measure Purpose of cash flow analysis: - produce measure of performance that is based on day-to-day cash flow: cash generated by ordinary business activities, instead of accrual accounting different perspective on performance and therefore enhances the info for users - incorporate other non-operating cash inflows and outflows, such as from investing in new assets, selling old ones, borrowing or repaying debts. By including these non-operating cash flows, the statement of cash flows can provide a complete description of how the firms cash was managed during the period. With all this info, the user can evaluate managements strategy for managing cash and make a better judgement of the companys liquidity, solvency, risk and opportunities than could be made just from the balance sheet and income statement

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13.2 Overview of the Statement of Cashflows

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Classification of Cash Flow Transactions Operating activities relate to provision of goods and services Investing activities relate to the acquisition and disposal of noncurrent assets, including property, plant, equipment and other productive assets, and investments such as securities, that do not fall within the definition of cash Financing activities relate to changing the size and composition of the financial structure of the entity, including equity, and borrowings not falling within the definition of cash

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Some important features of this format: 1. Same period as income statement 2. Include some equivalents: very liquid near cash assets 3. Cash may include temporary negative bank balances (overdrafts) 4. Uncertainty explained in the notes to financial statements 5. Focus must stay on cash 6. Transactions without cash are not included 7. Any numbers can be positive or negative 8. Deriving cash flow Aust = direct method (start from cash receipts to cash payments). Some other countries = indirect method (start with accrual net profit, then remove effects on profit of non-cash expenses and revenues)

Cheryl Mew

ACCT1501 Notes
Chapter 14 Financial Statement Analysis
14.1 Investment and Relative Return Relative return (return on investment / ROI) = Return Investment

Cheryl Mew

Main points about ratios: - Purpose: produce a scale free (because its dependent on same units and size of company), relative measure of a company that can be used to compare with other companies, or other years for the company - Ratio may be unreliable and misleading, if numerator/denominator is inappropriate. Return can imply EBIT, net profit or cash flow

14.2 Introduction to Financial Statement Analysis Purpose of financial statement analysis: use statements to evaluate an enterprises financial performance and financial position Value of the analysis depends on the value of the financial statements

Financial Evaluation is not just a calculation Not just a calculation it is a judgement based on the calculations that make sense for that company and based on substantial knowledge of the company The more info knew about business, mgmt and acct, the more useful and credible the analysis Affected by its own quality whether the statements have been carefully prepared and are comparable with other companies Affected by availability of other sources of info that may contain all or part of what is in the financial statements Financial acct info is a part of a network of info, not a stand-alone item.

Preparation for intelligent analysis Requires aim and substantial knowledge of the enterprise Scale free ratios means that it allows comparisons over certain periods of time, among companies of different sizes and with other indicators such as interest rates or share prices In order to do an intelligent and useful financial statement analysis: 4. Learn about the enterprise, its circumstances and its plans look at descriptive sections of annual reports and footnotes to financial statements 5. Obtain a clear understanding of the decision or evaluation to which the analysis will contribute, who the decision maker (investor, lender, creditor, management) is and what assistance is required 6. Calculate the ratios, trends and other figures that apply to the problem 7. Find whatever comparative info you can to provide a frame of reference for your analysis industry data, reports by other analysts, etc.

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8. Focus on the analytical results that are most significant to the decision makers circumstances, and integrate and organise the analysis so that it will be of most help to the decision maker. The preparer of financial statements can choose between a number of accounting policies on which to base the financial information May want to review such policies, e.g. deducing goodwill from assets, before computing ratios Validity of financial analysis based on accounting rations has been challenged HISTORICAL DATA Stock markets and other capital markets adjust prices of companies securities as info comes out, ratios based on publicly available info cannot tell people anything the markets have not already incorporated into security prices.

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14.3 Common Size Statements Whilst focus on chapter is ratio analysis, another method to analyse financial statements is common size statements By calculating all balance sheet figures as a percentage of total assets and all income statement figures as a percentage of total sales revenue Sizes of companies is factored out This procedure assists in comparing companies of different sizes and in spotting trends over time for a single company

14.5 Financial Statement Ratio Analysis Ratios are usually done to 2 decimals They could be done to more decimals, but that would be false accuracy This is because ratios depend on all sorts of judgements and estimates made in assembling the financial statements There should not be thought of as precise quantities but rather as indicators

Profitability Ratios Return on equity (ROE) = Operating profit after tax shareholders equity Indicates how much return the company is generating on the historically accumulated shareholders investment There are different versions of ratio e.g. instead of closing year-end equity, Woolworths uses average equity

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Return on assets (ROA) = Operating profit after tax total assets Determines the after tax return the managers are earning on the assets under their control Alternative ROA = EBIT total assets Determines the return on assets under managements control Total assets can be year-end figure, or the average over the year Denominator can also be gross assets (Assets before depreciation) and net assets Increase in ROA means that company has a better return on assets under their control Du Pont Formula: ROE = ROA x Leverage Leverage = Total Assets Total Shareholders Equity Indicates how much of the companys assets are financed by equity The higher the ratio, the smaller the shareholders funding of assets, the greater the proportion of total assets that must have been funded by debt Return on assets indicates the companys ability to generate a return on its assets before considering the cost of financing those assets Helps judging whether borrowing is worthwhile

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Profit Margin =

Operating profit after tax Sales Measures performance of managers in converting sales to net profit Average profit on each dollar of sales Useful indication of pricing strategy or competition intensity Alternative Profit Margin = EBIT Sales Measures the ability of mangers to generate profit from sales Gross Margin = Sales COGS Sales Indicates whether sales are profitable Also known as gross profit ratio Further indication of companys product pricing and product mix If Gross Margin = 33%, then revenue = 150% of cost, so mark up of 50% Increase in profit margin either due to increase in gross margin or decrease in expenses as a percentage of total sales

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Cash flow to total Assets = Cash flow from operations Total Assets Determines the companys ability to generate cash resources relative to companys size Approximately factors out size Alternative measure of ROA, focusing on cash returns rather than accrual profit Earnings per share (EPS)=

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Operating profit after tax preference dividends Weighted no. of ordinary shares outstanding Relates earnings attributable to ordinary shares to the number of shares issued Profit figure is after deducting outside equity in the operating profit Weighted no. of ordinary shares outstanding should be provided should not be calculated by outsiders If company has commitment to issue more shares, potential effect of the exercise of such commitments is calculated by showing both basic EPS and diluted EPS Dilution refers to the potential of lowering returns to current shareholders as a result of other peoples exercising rights Price to earnings ratio (P/E) = Current market price per share EPS Relates to the accounting earnings to the market price per share to reflect present company performance with market expectations Since relationship between such earnings and market price of shares is not straightforward, interpretation is controversial Idea is that because market price should reflect the markets expectation of future performance, P/E compares the present info with those performances High P/E means that company will do better in the future e.g. popular companies with good share prices P/E is highly subject to general increases and decreases in market prices, so it is difficult to interpret overtime and is more useful to compare similar companies listed in the same stock market at the same time Dividend Payout Ratio = Annual dividends declared per share EPS Measures the portion of earnings paid to shareholders Stable ratio company has a policy of paying dividends based on profits Variable ratio factors other than profits are important in the directors decisions to declare dividents

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Activity (Turnover Ratios) Total Asset Turnover =

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Sales Total Assets Determines the amount of sales volume associated with each dollar of assets Similar turnover ratios relate the companys sales volume to its size Turnover and profit/margin ratios are used together, because they tend to move in opposite directions High Turnover = Low margins and vice versa Pricing low and trying for high volume versus pricing high and high profit This is because competitive pressures are likely to force down selling prices and therefore profit margins if a high turnover is desired Represent contrary marketing strategies or competitive pressures How much revenue is the company getting out of each dollar of assets? ROA = profit margin x Asset Turnover

Inventory Turnover =

COGS Average Inventory Relates the level of inventory to the volume of sales activity A company with low turnover may be risking deteriorating level of inventories and or may be incurring excessive storage and insurance costs Inventory turnover can be converted to measure how long inventory in days, inventory is held on average Days in inventory = 365 Inventory turnover Measures how long on average, inventory is held in stock Debtors Turnover = Credit Sales Trade Debtors Relates the level of debtors to the volume of credit sales activity Also called accounts receivable turnover Credit sales may be hard to find as sales is one section Trade debtors refers to gross trade debtors (before deducting allowance for doubtful debts) Days in debtors = 365 Debtors turnover Measures how long it takes on average, to collect outstanding debtors

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Liquidity Ratios Current Ratio =

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Current Assets Current Liabilities Indicates whether the company has enough short term assets to cover short term debts >1 working capital +ve, <1 working capital ve Working capital = current assets current liabilities Usually, high CR = financial stability But if CR is too high, it implies that the firm is not reinvesting in LT assets to maintain future productivity Also indicate problems if inventories are getting larger than they should or collections of receivables are slowing down Static ratio measuring financial position at a point in time and not considering any future cash flows the company may be able to generate to pay its debts Most useful for companies that have relatively smooth cash flows Hardest to interpret for those who have unusual assets or liabilities, or depend on future cash flows to pay current debts Low current ratio is common for large companies quick cash flow cycle In general, can buy inventory, sell it and get cash before they have to pay their accounts payable Quick Ratio = Cash +AR + Short Term Investments Current Liabilities Indicates whether current liabilities can be paid immediately Also called the acid test Includes all assets except inventory Ratio is particularly useful for companies that cannot sell inventory quickly Interest Coverage Ratio = EBIT Interest Expense Indicates the ability of the company to pay interest on borrowings from profit This and similar coverage ratios based on cash flow figures indicate the degree to which financial commitments are covered by the companys ability to generate profit or cash flow Low coverage level (especially less than 1) means that company is not operating at a sufficiently profitable level to cover the interest obligation comfortably, and may also be a warning of solvency problems

ACCT1501 Notes
Financial Structure Ratios Debt to Equity Ratio = Total Liabilities Total Shareholders Equity Measures the proportion of borrowings to the investment by owners Includes retained profits Ratio greater than 1 means that liabilities are mostly financed with debt Ratio less than 1 indicates that liabilities are mostly financed with equity High ratio = warning about risk: company is heavily in debt relative to its equity and may be vulnerable to interest rate increases

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Debt to Assets Ratio =

Total Assets Total Liabilities Indicates the proportion of assets financed by liabilities Ratio highly correlated with debt to equity ratio

Leverage =

Total Assets Total Shareholders Equity Indicates how much of the companys assets are financed by equity The higher the ratio, the smaller the proportion of total assets funded by shareholders equity, and therefore, the more funded by debt

Summary Ratios are a quick method of breaking info in the financial statement into a form that allows comparability with similar companies and with the financial performance of the company over a number of years Advantage: different ratios consider different parts of a companys performance User do NOT only rely on ratios also on notes to the financial statements, auditors report, etc Notes to the financial statements provide further explanations of some key areas in the statements, e.g. accounting policies, detailed calculation of some account values, etc