Week 2 Chapter 1, LO 5 - 8

REVIEW FROM WEEK 1 USERS & USES OF FINANCIAL INFORMATION

Internal Users
Managers who plan, organise and run the business
e.g. production supervisors, marketing managers, and directors

An introduction to Accounting (continued)

External Users
Resource providers
e.g. shareholders, potential investors, lenders, creditors, employees

Recipients of goods and services

e.g. customers, beneficiaries

Parties performing a review or oversight function

PowerPoint presentation adapted by Anne Abraham University of Wollongong 2009 John Wiley & Sons Australia, Ltd

e.g. auditors, tax, government

REVIEW FROM WEEK 1 USERS & USES OF FINANCIAL INFORMATION Users want information about the entitys
Financing Activities Investing activities Operating activities

Week 2 An Introduction to Accounting Part 2

Text: Chapter 1, Learning Objectives 5 8 Demonstration Questions: PSA1.3; PSA1.4; PSA1.5 Self-Study Questions: Q4, Q7, BE1.7, E1.10, PSA1.6, PSA1.7, PSA1.8, BBS1.1, PSA1.10*, E1.6* * optional Outline: A) Financial Statements B) Financial Accounting Environment C) Introduction to Accounting Principles and assumptions D) Introduction to financial analysis
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Common information is provided in general purpose financial reports on the entitys

Financial performance over the period Financial position at a particular point in time Cash flows (sources/uses of cash) over the period
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A) FINANCIAL STATEMENTS
This information is provided in the following statements: Income Statement Reports financial performance by reporting income less expenses for a particular period Statement of Changes in Equity Reports profit and other changes in equity for a period Statement of financial position (prior 1 January 2009 Balance Sheet) Reports assets and claims to those assets at a particular point in time Statement of Cash Flows Reports cash receipts and payments for a period dissected into operating, investing & financing activities
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Income statement
Purpose is to report success or failure of the entitys operations for a period of time It is the entitys income earned less expenses incurred, over the period of time. The difference (profit) adds to the equity (or wealth) of the business

Income Expenses = Profit

Managers are interested in the bottom line (i.e. profit figure) because they allocate resources based on their beliefs about an entitys future performance
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Income statement
Presentation WONG PTY LTD Income Statement for the month ended 31 October 2010 Service revenues $10 600 Expenses Salaries expense $3 200 Supplies expense 1 500 Rent expense 900 Insurance expense 50 Interest expense 50 5 740 Depreciation expense 40 Profit before tax 4 860 Tax expense 2 000 Profit $ 2 860

Statement of changes in equity

Reports amount of profit for period and other changes in equity such as adjustments to retained earnings for
Changes in accounting standards Changes in accounting policies Correction of errors Gains recognised directly in equity

Retained earnings refers to accumulated profit which has not been distributed to shareholders
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I E = Profit

Statement of changes in equity

Presentation WONG PTY LTD Statement of Changes in Equity (extract) as at 31 October 2010 Profit Retained earnings 1/10/10 Dividends Retained earnings 31/10/10 $ 2 860 0 (500) $ 2 360

Statement of financial position

Reports assets and claims to those assets at a specific point in time Based on the basic accounting equation

A
Resources

Eq
EQUITY

ASSETS =

LIABILITIES +

Owned/controlled owed to other entities that belongs to owners (creditors & lenders) (capital+profit-drawing) OR: by the entity

Obligations/debt

Residual remaining

Assets = Sources to finance them

(external +
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internal sources)
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The equation is always equal, by definition

The classified statement of financial position continued

Assets provide future economic benefits are owned or controlled by an entity are from past transactions or events a) Current assets Assets that are cash, held for the purpose of being traded, or expected to be converted to cash or used in the business within one year Non-current assets Assets that are not expected to be sold or consumed within one year Liabilities (external claims) Present obligations /debt Owed to other external entities Arise from past transactions or events a) Current liabilities Obligations that are to be paid within the coming year or the entitys operating cycle b) Non-current liabilities Obligations that are not classified as current Owners Equity Claim of owners of the business: a residual claim after deducting liabilities from assets
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Statement of financial position

WONG PTY LTD Statement of Financial Position as at 31 October 2010 Assets Cash Accounts receivable Advertising supplies Prepaid insurance Office equipment Total assets Liabilities and equity Liabilities Accounts payable $ 2 500 Interest payable 50 Revenue received in advance 800 Salaries payable 1 200 Bank loan 5 000 Total liabilities Equity Share capital 10 000 Retained earnings 31/10/08 2 360 Total equity

contd

$15 200 200 1 000 550 4 960 $21 910

b)

$ 9 550

12 360 $21 910

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A = L + Eq

statement of financial position

Minimum disclosures:
Assets Cash assets Trade and other receivables Other financial assets Inventories Investments in property Property, plant and equipment Tax assets Intangible assets

contd

Statement of Cash Flows

Main purpose is to provide financial information about cash receipts and cash payments of an entity for a specific time period Users are interested in the statement of cash flows in order to find out what is happening to entitys most important resource Cash is important because it is needed to:
finance operations, invest and repay debt and dividends pay debts when they are due (liquidity and solvency)

Liabilities Trade and other payables Financial liabilities Tax liabilities Provisions

Equity Capital and reserves Retained earnings or accumulated losses

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A lack of cash from operations has to be financed from financing and disinvesting activities
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Statement of Cash Flows

continued
WONG PTY LTD Statement of Cash Flows for the month ended 31 October 2010 Cash flows from operating activities Cash receipts from operating activities $11 200 Cash payments for operating activities (5 500) Net cash provided by operating activities $ 5 700 Cash flows from investing activities Purchased office equipment (5 000) Net cash used in investing activities (5 000) Cash flows from financing activities Issue of shares 10 000 Proceeds from bank loan 5 000 Payment of dividend (500) Net cash provided by financing activities 14 500 Net increase in cash 15 200 Cash at beginning of period -15 Cash at end of period $15 200

Interrelationships between the statements

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PSA1.5

PSA1.4

B) THE FINANCIAL REPORTING ENVIRONMENT

C) Introduction to Accounting Principles and Assumptions Monetary principle

only economic (financial) transactions that can be measured in money are recorded

Accounting entity concept

activities of the owner(s) are kept separate from the economic entity. The report is about the accounting entity

Accounting period concept

economic life of an entity are divided into discrete periods of time, to help measure profit (and other flows) for the period and financial position at end of the period

Going concern principle

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www.aasb.gov.au

assumes the business will continue to operate for at least 18 the next accounting period.

Introduction to Accounting Principles and Assumptions Conservation Principle (prudence)

periodical preparation of financial statements require estimates. Prudence suggests that when a good argument can be made for competing estimates, the one that results in lower profit, a lower asset value, or a higher liability value should be chosen

Qualitative characteristics

Relevance
materiality information needs to be disclosed if its omission or misstatement could influence decision making

Reliability
free from material error and bias faithful representation

Cost principle
all assets are initially recorded at their cost not what you think they are worth. Existence of asset not recognised without cost

Comparability
between entities and for one entity over time

Full disclosure principle

circumstances and events that make a difference to financial statement users should be disclosed
PSA1.3
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Understandability
to the users of the financial information
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Constraints in accounting (to be expanded) Timeliness

time of communication of financial information vs time decision has to be made

ANALYSING FINANCIAL STATEMENTS Ratio analysis

Expresses relationship among items of financial statement data Expresses mathematical relationship between two different quantities Expressed in terms of percentages, rates or proportions
The major ratios are listed in the back of your textbook.
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Cost versus benefits

preparation costs for financial statement should not exceed benefits to users

Profitability
Measures operating success of an entity for a given time period

Profitability continued
2. Profit margin
Measures percentage each sales dollar that results in profit Profit Net Sales Example:
($ in thousands) 2008 $18 616 $305 591 $6 596 $78 840 = 6.1% 2007 $16 390 $273 405 $8 664 $77 202 = 6.0% Fantastic Holdings

1. Return on assets
Indicates amount of net profit generated by each dollar invested in assets Net Profit Average Total Assets
.

Example:

($ in thousands) Fantastic Holdings

2008 $18 616 = 19.3% ($103 960 + $89 323)/2 $6 596 = 22.8% ($28 326 + $29 618)/2

2007 $16 390 = 20.0% ($89 323 + $74 842)/2 $8 664 = 32.1% ($29 618 + $24 432)/2
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Nick Scali

= 8.4%

= 11.2%

Nick Scali

Higher value suggests efficient use of assets

Higher value suggests favourable return on each dollar of sales

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Liquidity
Measures short-term ability of entity to pay its maturing obligations and to meet unexpected needs for cash

Liquidity continued
2. Current Ratio
Measures short ability to meet current obligations Current assets Current liabilities
.

1. Working Capital
Current Assets Current Liabilities
Example:

Fantastic Holdings (year ending 30 June 2008) Working Capital = $70 812 000 $29 401 000 = $41 411 000

Example:
($ in thousands) Fantastic Holdings 2008 $70 812 = 2.41:1 $29 401 1.74:1 2007 $58 978 = 2.29:1 $25 797 1.76:1

Nick Scali

Good position to pay short-term debts as they fall due

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Higher ratio indicates more favourable liquidity

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Liquidity

continued

Solvency
Measures ability of an entity to survive over a long period of time

using the Statement of Cash Flows

3. Current cash debt coverage

Indicates the entitys ability to generate sufficient cash to meet short term needs

1. Debt to total assets ratio

Measures percentage of assets financed by creditors rather than shareholders

Net cash provided by operating activities Average current liabilities

Example:
($ in thousands) Fantastic Holdings 2008 2007

Total liabilities Total assets

Example:
($ in thousands) Fantastic Holdings 2008 $42 225 = 41% $103 960 44% 2007 $37 531 = 42% $89 323 44%

$17 072 = 0.62 times $13 675 = 0.55 times ($29 401 + $25 797)/2 ($25 797+ $23 952)/2 0.52 times 0.80 times

Nick Scali

Nick Scali

A higher value indicates more favourable liquidity.

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A higher ratio indicates solvency risk because the entity has fewer assets available for creditors.

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Solvency continued
2. Cash debt coverage
Indicates entitys ability to generate sufficient cash to meet long term needs

Preparation for week 3

Net cash provided by operating activities Average total liabilities

Example:
($ in thousands) Fantastic Holdings 2008 2007

$17 072 = 0.43 times $13 675 = 0.41 times ($42 225 + $37 531)/2 ($37 531 + $29 888)/2 0.52 times 0.79 times

Nick Scali

Do Week 2 self-study questions Check solutions on Blackboard after doing the questions yourself Complete reflective, self-evaluation and learning strategies exercise Skim read Chapter 2, Start with Summary of Learning Objectives, pp.114 Obtain a copy of Week 3 lecture material from Blackboard to bring to class Think about what groups you want to form to work on the group assignment.
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A higher ratio indicates better solvency as the entity is generating cash to meet is long-term needs.

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