ACCT1501 Notes

Introduction to Accounting
Financial Accounting

 Periodic financial statements that record financial position (BS) and performance (IS)
 Provision of info to ext decision markers (investors, creditors and customers)

Users of Financial Info

Users Purpose/type of info

Bankers To assess liquidity/solvency- likelihood of company meeting
interest/principal payment on time
Suppliers To determine whether the company can pay for purchases on time
Shareholders To decide whether to buy, sell or hold shares
Managers Decision making- planning, controlling and organising
Board of directors To evaluate the CEO’s performance
ATO To monitor the correct payment of taxes
Employees/unions To assess job security by determining the ability of the company to
pay wage/maintain employment and negotiate wages.

Accrual vs Cash Accounting

 Cash acc- records rev/exp when cash is received or paid

 Accrual acc- records rev/exp when the transaction occurs

Key Financial Statements

Balance sheet (statement of fin position)

 Records financial position at a point in time

 Financial position- financial resources and obligations at a point in time
 Structure:
o Heading provides company name, title and date (“as at…”)
o Split up into assets, liabilities and shareholders’ equity

Income statement (profit and loss statement)

 Records financial performance over a certain period of time

 Financial performance- generation of new resources from day to day operations

Cash Flow Statement

 Cash flow statement explains the change in cash in the balance sheet
 Necessary because in an accrual system, revenues do not equal cash gained and
expenses do not equal cash paid
 Structure:
 o Operating activities: provision of g&s between customers, suppliers etc.
o Investing activities: acquisition or disposal of noncurrent assets, e.g. properties
o Financing activities: change in size and composition of the financial structure

Quality of financial information

 Relevance- information should help stakeholders make, confirm or correct

predictions about the outcomes of past, present or future events
 Reliability (faithful representation)- numbers should measure the events neutrally,
neither overstating nor understating their impact
 Materiality- assessing whether omission, misstatement or non-disclosure of a piece of
info would affect the decisions of users of the accounting reports
 Generally accepted accounting principles (GAAP)- standard against which an
accounting method or number can be judged
 Disclosure- financial statements should include notes and account descriptions to
clarify which accounting methods have been followed
 Understandability- reports should be prepared for those with technical knowledge
 Comparability
 Verifiability- the numbers in the fin statements can be verified directly by looking at
documentation or through direct observation (e.g. counting cash/inventory)
 Timeliness: providing information in time for the user to incorporate the information
in their decisions.

Financial statement assumptions

 Accrual basis- accrual accounting used to record transactions

 Acc entity assumption- acc entity is separate and distinguishable from owners
 Acc period assumption- life of business divided into discrete time periods of equal
length
 Monetary- transactions measured in common exchange which is constant (ignores
inflation)
 Historical cost- assets are recorded at their original cost at purchase
 Going concern- assumes entity continues into foreseeable future (no intention to
liquidate)

Measuring & Evaluating Financial Position & Financial Performance

Key Financial Statements

Balance Sheet (B/S)

 Assets (resources)
o Provide future economic benefits (1)
o Controlled by an entity- can deny or regulate access of others (1)
 o Occurs as a result of past transactions/events (1)
o E.g. Accounts receivable (AR), inventory, cash, equipment etc.
 Liabilities (sources)
o Future sacrifices of economic benefits
o Present obligation as a result of past transactions/events
o E.g. Accounts payable, wages payable, loans etc.
 To be reported, assets and liabilities must meet the definition (1) and recognition (2)
criteria:
o It is probable that any future economic benefit associated with the item will
flow to or from the entity (2)
o The item has a cost or value that can be measured (monetary) reliably (2)
o Note: only meets 1 = disclosed in notes
 Shareholders’ Equity (sources)
o Net assets
o Share capital- amount that owners have directly contributed
o Retained profits- profits remaining after distributing dividends
 Both sides must balance- forms accounting eqn (Assets = Liabilities + SE)
 Provides info about:
o Financial structure (mix of debt/equity)- debt to equity ratio
o Liquidity- ease of converting assets to cash (short term)- working capital (CA-
CL), current ratio (CA/CL)
o Solvency- ability to pay debts when they fall due (long term)- debt to equity ratio
 Relies on the accounting entity assumption

Income statement

 Structure:
o Revenues- inflows of econ benefit (increase in wealth) arising from the ordinary
activities of a company (provisions of services or sales of goods)
o Expenses- use/loss of economic benefits to earn revenue that dec wealth (SE)
 Gross Profit = Sales – COGS
 Net Profit = Gross profit/revenue – Expenses
 Profit can be paid out in dividends to shareholders or retained in the business- link
between B/S and I/S (i.e. RP at end of period = RP at beg of period + NP – dividend)
 Relies on accounting period assumption

Capitalising vs Expense

 Capital expenditures are costs that create future benefits through purchase of fixed
assets or adding value to existing assets. When a firm spends money, if the resulting
benefit is to be realised in the:
o Current accounting period, then it is an expense
o Next or future accounting period, then it is an asset
 The Double Entry System

Transaction analysis

 Involves examining individual transactions to understand their effects on the acc eqn
 For each transaction, the acc eqn must balance
 Expanded acc eqn: At = Lt + SCt + (RP(t-1) + R - E – D)
 Expanded acc eqn: CA + NCA = CL + NCL + SC + RP(t-1) + R – E – D
 Example of trans analysis (closing balance recorded on BS + RP recorded on IS):

Double entry accounting

 Every transaction must involve at least 2 accounts for the acc eqn to balance
 We can classify increases/decreases to accounts as debits and credits
 Therefore, for the acc eqn to balance credits must equal debits

 Journal entries are a shorthand version of transaction analysis, prepared using debits
and credits
 Record Keeping
Transaction

 Characteristics of ext transactions:

o exchange of items of economic value
o involves a party external to business
o evidence (documentation) exists
o measurable in monetary units
 Int transactions reflect econ events that are not exchanges (e.g. use of assets- dep)

Accounting Cycle

1. Source documents
 Enable the control of accounts- records can be checked and verified to correct errors
 Permits auditing
 Can be used as evidence against legal actions (e.g. income tax claims)
 Examples: invoices for purchases and sale, cheques, bank statements and receipts

2. Journal entries
 Provide a chronological record of all the transactions recorded by an organisation
 Every journal entry should be dated and numbered
 Usually includes a narration below each entry (not necessary in exam)
  A posting reference from the chart of accounts (list of all ledger accounts) is given
to indicate the ledger account to which each journal entry is posted

3. Post to ledgers
 General ledger- contains a summary of all transactions relating to one account
 Used to determine the changes to an account after all the journal entries in a
period
 Running balance format:

 A simplified version of ledgers is the T-account which only lists debits and credits
without calculating balance after every entry:

N/B:

o Debits = LHS & credits = RHS

o Opening bal is determined by the accounts normal bal
o Each debit/credit should have a brief description (i.e. why has cash decreased? AP,
exp etc.)

4. Trial balance
 Initial check to see if any mechanical errors have occurred
 List of all ledger balances shown as either Dr or Cr.
 Used to check accuracy by showing whether total debits equal total credits
 Some errors can occur even if a trial balance balances:
o If a journal entry was not posted
o If a journal entry debited/credit the wrong account
o If the amount debited and credit is equal but both wrong
5. Adjusting journal entries
 At the end of each acc period, it is necessary to adjust accounts to reflect:
o Expenses incurred but not yet paid
o Revenues earned but not yet received
o Cash received from customer in advance for work
o Using up of assets, which creates an expense such as depreciation
 Involves splitting an expense or revenue item across two different accounting periods

6. Adjusted trial balance- Any adjusted entries are posted to the relevant ledger accounts,
which require another trial balance to be prepare

7. Closing entries
 Rev/exp are temporary accounts- must be closed at the end of acc period (NOTE:
A/L/SE are permanent accounts- balances are carried forward to next acc period)
 Transfers the balances of the rev/exp accounts to a profit and loss (P & L)
summary, then to retained profits
 Steps:
o DEBIT all revenue accounts and CREDIT P&L summary (Reset rev bal to zero).
o CREDIT all expense accounts and DEBIT P&L summary (Reset exp bal to zero).
o CLOSE P&L summary to retained profits (Reset P&L summary bal to zero).
8. Post-closing trial balance- another trial balance is prepared after closing entries are
made to ensure Dr=Cr (NOTE: no R/E accounts- reflected in RP)

9. Prepare financial statements- P & L sum used as a basis for preparing the IS + post-
closing trial balance used to prepare BS

Accrual Accounting Adjustments

 There are four main types of routine adjustments that need to be accounted for:
o expiration of assets
o unearned revenues
o accrued expenses
o accrued revenues

Expiration of assets

 Prepayments (prepaid expenses) are assets that arise because an expenditure has been
made, but there is still value extending into the future
 May be classified as current or non-current asset depending on whether benefit
extends beyond next reporting period
 Requires 2 entries: first entry- recording purchase of asset + second entry- recording
expense and the use up of the asset
 Examples include prepaid insurance, prepaid rent and office supplies

Example: 1 May 2012, paid $1200 insurance premium covering 12 months from 1 May
Journal entry on date of payment:
Dr Prepaid insurance (+A) $1200
Cr Cash (-A) $1200

Adjustment on 30 June:
Dr Insurance expense (+E) $200
Cr Prepaid insurance (-A) $200

- The prepayment balance of $1200 would be shows in the BS at 30 June 2012 as a

CA
- The insurance expense account would appear on the June income statement.
- The transfer from the asset acc (prepayments) to the exp acc (insurance exp) will
continue each month for the next 10 months, by which time the asset will have a zero
balance

Unearned revenue

 Cash received in advance of earning revenue

 Classified as a liability- becomes revenue when goods or services owing are provided
 Examples: insurance premiums, magazine subscriptions and rent received in advance
 Note: not a temporary account  no need to close

Example: Received deposit of $100 000, for service to be provided in the next
accounting period

Journal entry when deposit is received:

Dr Cash $100 000 (+A)
Cr Unearned Revenue (+L) $100 000*

Journal entry when service is provided

Dr Unearned Revenue (-L) $100 000*
Cr Service Revenue (+R) $100 000

Accrued expenses

 Expenses are incurred, but cash is not paid until the following period- payable
account
 Examples: wages earned by employees but not paid after end of financial period and
interest payable on outstanding loan

Example: A firm pays weekly wages of $10 000 each Friday. Balance date is 30 June
(Wednesday)

 In the week that June 30 falls:

 o Three days’ wages will relate to June ($6000)
o Two days’ wages will relate to July ($4000)

Journal entry on June 30:

Dr Wages expense 6000
Cr Wages payable 6000

Accrued revenues

 Revenue has been earned, but cash has not been received until the following
period- receivable account
 Examples: commissions earned but not received and interest earned but not received

Example: On 1st March 2016, the company deposits $100 000 with a bank at 12% p.a
and interest is received on 31 August 2016. The Financial year-end date is 30 June 2016.

Journal entry for 30 June

Dr Accrued interest (+A) $4000
Cr Interest revenue (+R) $4000

Journal entry for 31 August

Dr Cash (+A) $6000
Cr Accrued interest (-A) $4000
Cr Interest revenue (+R) $2000  2 months after June

Contra Accounts

 Most accounts are control accounts, i.e. their value is supported by data and can be
physically measured
 Contra accounts allow changes to control accounts without changing the
underlying records and data
 A contra accounts is paired with and follows its related account- its normal balance
(dr/cr) is the opposite of the balance of the related account
 Examples:
o Accounts receivable  Allowance for doubtful debts (A.D.D)
o Property, plant and equipment  Accumulated depreciation
o Intangibles  Accumulated amortisation
o Inventory  Allowance for obsolescence
Accumulated Dep (amortisation)

 Allocation of the cost of a noncurrent asset to expense over the life of an asset
 Purpose is to recognise the consumption of the asset’s economic value
 Accumulated depreciation (B/S) shows all depreciation charged against an asset to
date (has a normal credit balance in general ledger b/d)
 Depreciation expense (I/S) shows only this year’s depreciation allocation

Example: Asset costs $100 000 with a life of 5 years and no estimated salvage value.

Journal entry for depreciation each year:

Dr Depreciation expense $20 000
Cr Accumulated depreciation $20 000

After 3 years, book value is:

Asset $100 000
Accumulated depreciation ($60 000)
Book value (net assets) $40 000

Internal Control and Cash

Internal Control

 Internal control is a process effected by an entity’s board of directors, management

and other personnel, designed to provide reasonable assurance regarding the
achievement of objectives in the following categories:
o Effectiveness and efficiency of operations including safeguarding assets against
loss
o Reliability of internal and external financial and nonfinancial reporting
o Compliance with applicable laws and regulations

Components (CRIME)

1. Control environment: policies and procedures, unwritten practices

2. Risk assessment: identify and analyse sources of risk
3. Control activities: preventive/detective activities
4. Information and communication: personnel must understand their role in the int control
sys, effective lines of comm required in org and with ext parties
5. Monitoring: assessing quality of the system’s performance  achieved through ongoing
monitoring and/or separate evaluations
Control Activities

 Top level reviews- managers carry out reviews of actual performance compared to
budgets, forecasts and prior period results
 Info processing- edit checks, matching to approved control files and credit limit,
comparing and reconciling file totals with control accounts
 Segregation of duties- separate record-keeping from handling assets
 Physically protect sensitive assets- locks, safes, adequate insurance, adequate pay and
motivation for employees and regular leave

Limitations

 Human judgement mistakes (e.g. misunderstanding instructions)

 Management override (e.g. overstating/understating profits)
 Collusion among employees
 Computer fraud
 Cost versus benefit

Internal Control for Cash

Most liquid asset + cannot be identified as belonging to a particular person- susceptible to

theft, misappropriation or fraud

Internal control procedures

 Separation of duties for recording and handling cash and receiving and paying cash
 All cash receipts banked in entirety daily
 All payments (except petty cash) made by pre-numbered cheque or EFT (Electronic
Funds Transfer)
 Authorised supporting documentation for payments
 Cheques or EFT countersigned – 2 signatures
 Payment invoices stamped so they cannot be fraudulently reused
 Physical safeguards over cash: locked petty cash box, close cash drawer
 Reconcile bank accounts regularly – monthly

Petty Cash Fund

 A petty cash fund is established to handle small cash payments

 Created by cashing a cheque from company’s regular bank account
 Disbursement from the fund: Vouchers provide evidence for amounts spent
 Petty cash fund is replenished on a regular basis
  Errors in the petty cash fund  recorded as debit if shortage or credit if overage at the
time the fund is replenished (shortage- miscellaneous expense + overage-
miscellaneous revenue)

Establishing Petty Cash Fund of $200:

Dr Petty Cash $200
Cr Cash at bank $200
Replenishment:
Dr Postage Expense $20
Dr Office supplies Expense $50
Dr Miscellaneous Expense $15
Cr Cash at bank $85

Bank Reconciliation

 Compares the cash balance in the bank statement with the cash account in the
general ledger (or cheque book)
 Aims to reconcile any difference between the two sources of info

Reasons for differences

 Recorded in ledger before recorded by bank:
o Deposits in transit- deposits recorded by the company’s ledger but not yet
received by the bank (e.g. cash received from customers not yet banked)
o Outstanding/unpresented cheques- recorded in company ledger but paid out from
the bank account (e.g. cheques written to suppliers)
 Recorded by bank before recorded in ledger:
o Non-sufficient funds (NSF) cheques- customer cheques deposited but returned due
to a lack of funds (dishonoured cheques)
o Direct deposits (EFT from customer)
o Bank charges
o Interest earned on the account
 Errors made by the company in the general ledger (e.g. transposition error- ‘198’
instead of ‘918’) or the bank in the bank statement (e.g. bank fees overcharged)

Reconciliation process
Check company records (cash balances, last bank reconciliation) against current bank
statement and tick the items that are the same on both records
- Items in company records that have not been ticked (timing differences)
- Items in the bank statement that have not been ticked (needs to be adjusted!)
EXAMPLE: Bank Reconciliation Statement

Accounts receivable and further record-keeping

Accounts Receivable

 Always some risk that the customer will fail to pay  company can’t collect debts
 Bad debt expense- part of customers’ debts to the company not collected
 Two methods to account for Bad Debts Expense are the direct-write- off (company is
certain) and allowance method (company is uncertain)

Direct write- off method

 Directly reducing the value of AR  company is certain

 Journal entry:
Dr Bad Debts Exp (+E) XXX
Cr Accounts Receivable (-A) XXX
 General ledger:
Allowance for Doubtful Debts

 Allowance for doubtful debts is a contra account- can recognise change in value of
accounts receivable without changing original account
 Even after the collection time has passed, the company may still try to collect the
accounts and, therefore, doesn't want to alter the accounts receivable amount
 The Allowance for doubtful debts account functions to adjust the net value of
accounts receivable down to the lower of cost and current estimated collectable
amount (net realisable value  AR - A.D.D).
 Example: company determines - by past experience or current evidence of customers'
troubles - that about $400 of sales on account are not likely to be paid:
o Journal entry to recognise expense is:
Dr Bad Debts Expense $400
Cr Allowance for doubtful debts $400
o General ledger:

 We can write- off bad debts using the allowance method when the debt is
determined uncollectable (e.g. bankruptcy) using the following journal entry:
- Dr Allowance for Doubtful Debts XXX  company has already recorded it before,
but they were uncertain (reducing uncertainty – i.e. doubtful debts)
- Cr Accounts receivable XXX
- Note: Use this method if A.D.D is greater than write-off value or question says
“write- off $X of previously recorded debts”
 Two estimation approaches: I/S (% of sales) and B/S (ageing of accounts)

Income Statement Approach

EXAMPLE: Bragg Ltd made sales of $100m on credit during the year but, in the past,
it has failed to collect 5% of its credit sales

 Bad debt exp for the year = $100m x 0.05 = $5m

 Journal entry:
- Dr Bad D Exp $5m
- Cr Allowance for DD $5m
 Ledger accounts:
NOTE: this method can be more complicated- look at P8.10

Balance Sheet Approach

 The older the account, the greater the probability that it will not be collected
 Allowance is adjusted based on an ageing analysis- based on prior experience of
customers and the age of defaulting accounts

EXAMPLE

If the opening allowance was $5m and the ageing analysis calculates an ending balance of
$6.25m, the company hasn’t accounted for enough bad debts  must increase BD Exp:

Dr Bad Debts Exp $1.25 m  difference between opening and closing balance
Cr Allowance for DD $1.25 m

NOTE: If opening balance > closing balance, the company has overstated bad debts,
hence the correct journal entry is:
Dr Allowance for DD XXX  difference between opening and closing balance
Cr Bad Debt Revenue XXX
Trade Discount

 Discount given by businesses for customers purchase large volumes

 We record only the net amount of the transaction
 Example: On November 13, Glomobile made a cash sale of 17 Magic Magenta Glow
Mobile Phone Covers for a list price of $20 each. A trade discount of 10% applies.
- Journal entry:
Dr Cash $306  17 x $20 x 0.10
Cr Sales Revenue $306

Cash/Settlement Discount

 Conditional adjustment- offered if payment is made or given within a specified date

from the transaction
 Incentive for prompt settlement of debts
 Recorded as an additional transaction
 Common arrangement is to extend credit terms. E.g. 2.5/10, n/30  discount of
2.5% if payed in 10 days, otherwise, the net amount (n- no early payment discount
but after adjusting for trade discount) is payable within 30 days.
 Recorded as a discount allowed expense for the seller and as a discount received
revenue by the purchaser
 If discount is received, the gross selling price is recorded by both parties

Example: ABC Ltd made a sale of $1 000 to a customer, DD Ltd, on terms of 2/10, n/30
on 1 July. The account was paid on 6 July.

Journal entry when the sale was made (1st July):

Dr Accounts Receivable $1000
Cr Sales Revenue $1000

Journal entries when the account was paid (6th July)

Dr Discount Expense $20
Cr Accounts Receivable $20

Dr Cash $980
Cr Accounts Receivable $980

Special Journals and Subsidiary Ledgers

Special Journals

 Allows the easy recording of the most common transactions undertaken by a business
 Periodically, info from the business's special journals is transferred to the general
ledger
  Promotes recording efficiency- amounts posted to general ledger as summarised
totals rather than as individual journal entries
 Used in conjunction with subsidiary ledgers
 Special journal types:

Subsidiary Ledgers

 Set of ledger accounts that collectively represent a detailed analysis of one general
ledger account (control account)
 Periodic reconciliation of subsidiary ledger to control account is needed
 Examples:
o Debtors/accounts receivable: a separate account for each debtor
o Creditors/accounts payable: a separate account for each creditor
o Property, plant and equipment: separate records of each piece of property, plant
and equipment - it is often called an asset register
o Raw materials inventory: separate records of each type of raw material held
o Finished goods inventory: separate records of each type of finished good held
  Example of a general ledger and relevant subsidiary ledgers for AR:

Debtors and Creditors Control Account

 Used to ensure there are no errors or mistakes in records relating to debtors and
creditors
 Reconciliation performed on a regular basis between the control accounts (general
ledger) and the total of the debtors or creditors ledger
 Reconciliation- use the opening balance in the control account and analyse a
summary of transactions that take place during the year  balance at the end of the
periods should match if transactions are posted correctly
 Transactions included:
o Credit purchases or sales (NOT cash sales)
o Payments to supplies / payments from debtors
o Other transactions related to the sales / purchase of goods on credit

Introduction to Inventory and Non- Current Assets

Inventory Control Systems

 Perpetual system:
o Maintains continuous records of inv for all transactions
o Beginning inv (often supported by physical count- int control) + Inv purchased
(from records) – COGS = Ending inv cost (supported by count)
o Bal for inv and COGS are always in the acc sys
o Two journal entries for the sale of inventory (keeps track of all costs)
o Journal entry for inventory shortage (adjustment):
- Dr inv shortage exp xx
- Cr inv (-A) xx
o Superior method of internal control + shortages easily determined
 o If a physical count of the inventory fails to show that quantity, the business knows
that some have been lost or stolen, or that there has been an error in the records.
o Costly + not suitable for goods that are difficult to count (e.g. coal)
o Used by orgs with high value products such as a motor vehicle dealership.
 Periodic system
o Inv determined by physical count at the end of the period
o Aggregate value for COGS determined at the end of the period (COGS =
Opening Stock + Purchases – Closing Stock)
o Bal for inv and COGS in the acc sys at end of period
o Shortage of inv ignored
o Sale of inv requires one entry (Dr cash/receivables and Cr sales rev)
o Simple and cheap to operate, but no way to reconcile physical inventory counts
to the accounting records to detect irregularities such as errors or theft
o Used by orgs where there is insufficient cost-benefit to keep detailed records for
each item inventory, for example, buttons and needles.

Inventory Measurement

 When the net realizable value (NRV) of a company's inventory is less than its cost,
the company's b/s should report the NRV (selling price – costs)
 The NRV is how much the company expects to receive from the sale of inv
 Cost comprises:
- Cost of purchase
- ADD: Purchase price + Import duties and other taxes + Inward transport and
handling costs + Any other directly attributable costs of acquisition
- LESS: trade discounts, rebates and other similar items
- Conversion Costs (wk 11/12)–if inventories are manufactured (includes cost of
production)
 NOT included in the cost of inventory: Administration costs, selling costs & storage
costs

Cost Flow Assumption

Assumptions made about the order in which units of inventory flow through the business
NOTE: dates are extremely important in questions (esp. perpetual since the record for
inventory is continuously updated- not as important for periodic)

FIFO
 First units purchased = first units sold
 Ending inventory = most recently acquired units  closing inv closer to current cost
 Higher profit level in times of rising prices (record the sale of cheapest inv first =
lower COGS)
 Suitable for perishable items, electronics, etc.
LIFO
 Last units = first units sold
 Ending inv = units purchased earliest (closing bal. not as relevant)
 Lower profit in times of rising prices (record the sale of exp inv first = higher
COGS = tax)
 Banned under Aus accounting standards but permitted in the US

Weighted Avg

 Referred to as ‘moving avg’ when under perpetual method- avg is continually updated
to reflect the units we have on hand  (avg = units on hand x $p/units on hand)
 Value for COGS/G Profit is in between LIFO and FIFO during times of rising
prices
 Appropriate for similar products and ’non-expiry’ items
 Total cost is the same under all methods- diff costs for diff periods
Specific Identification Method- another form of cost-based inventory valuation that
involves the identification of each item sold with its original purchase price (used for high
value inventory items such as boats)

NOTE: Accountants must depart from a cost-based valuation for inventories when the net
realisable value (selling price) is less than costs (selling costs)  must write down
inventory (A + NP)

Non-Current Assets (PPE)

Initial Cost of PPE

 Cost includes:
o Purchase price
o Installation costs- bringing the asset to the location and ensuring the correct
conditions
o Costs associated with dismantling/removing the item
 Examples:
o Invoice price of machinery
o Purchase (and other) taxes
o Freight (delivery costs)
o Installation costs
o Setup costs
o Architects fees
 Associated costs (expenses) are usually capitalised- including the expenditure with
the assets as opposed to deducting it as an expense in the current year:
- Dr Equipment $xxx
- Cr Cash at Bank $xxx

Depreciation of Asset

 PPE has a limited useful life due to the reduction in usefulness in generating revenue,
hence, the value at cost ‘depreciates’ overtime
 Accumulated depreciation (B/S) shows all dep charged against an asset to date.
 Depreciation expense (I/S) shows a specific year’s allocation
 EXAMPLE:
Additional Expenditure

 If definition/recog criteria are met, additional exp is added to the cost of the asset
(otherwise treated as an exp)
 Betterment- increase in expected econ benefits, e.g. productivity, efficiency, output
quality (capitalised exp)
 Maintenance / Repair relates to maintaining expected economic benefits (exp)

Depreciation Methods

 Straight line: Dep exp = Cost- Residual value ($ obtained from disposal)/Useful life
 Reducing balance:
o Uses a depreciation rate expressed as a %
o Dep exp = Carrying amount x Dep rate
o Example:
  If asked to calculate the rate:

 Unit of production:
o Dep per unit = (Cost- Residual value)/ Estimated total # of units of production
over life
o Dep exp = Units x Avg dep per unit

Disposal of PPE

 Step 1: Record depreciation up until the date of disposal (bring down to current book
value- adjusting entry)
 Step 2: Record gain or loss from the sale of the asset
 Step 3: Remove the non-current asset from the company’s book
Common type of q: given balances of acc at beginning and end of period and a series of
transactions, and you must use t-acc to find the missing value to prepare the journal entry for
the sale of equipment

Financial Reporting Principles, Accounting Standards and Auditing

Generally Accepted Accounting Principles (GAAP)

 Rules, standards and usual practices that companies are expected to follow when
preparing their financial statements
 Consists of:
o Accounting standards- Australian Accounting Standards Board (AASB)
o Framework for the preparation and presentation of FS (AASB)
o Accounting Guidance Releases (AAG)
o Urgent Issues Group statements (UIG)
o Corporations Law
o ASX listing requirements

Framework for the preparation and presentation of FS

 Objectives of financial reports

 Provide information about financial position (B/S), financial performance (I/S) and
cash flows that is useful to users in making economic decisions.

 Assumptions underlying financial reports

 Accrual basis of accounting
o Recognising economic events regardless of when cash transactions happen
 o Revenues & exp are reflected in the accounts in the period to which they relate
 Going concern:
o Assumption that entity will continue in operation for the foreseeable future.
o If not – financial reports need to be prepared on a basis other than historical cost.
i.e. liquidation value (lower than historical book val)
 Other assumptions include accounting entity, period, monetary assumptions

 Qualitative characteristics of financial information

 Fundamental char:
o Relevance- info should enable prediction and confirmation of
past/present/future outcomes
o Faithful rep- info should be complete, neutral (without bias- info shouldn’t be
selected to achieve a predetermined outcome) and free from error
 Enhancing char
o Comparability- other entities, different periods of time
o Verifiability- related to faithful rep, can be direct (physical count) or indirect
(checking inputs into a formula)
o Timeliness- info available in time for decision-making
o Understandability- Classifying, characterising and presenting info clearly and
concisely + technical info should not be excluded
 Conflicts between certain characteristics such as faithful rep and
relevance/timeliness- certain estimates become more accurate over time (e.g.
doubtful debts)

 Definition of elements of financial statements

 Balance sheet (framework sets the criteria for the definition of components)
 Income statement
 Statement of changes in equity
 Statement of cash flows
 Notes to the financial statements

 Recognition and measurement of those elements

 The framework sets out a number of different measurement bases that are
employed to different degrees and in various combinations in financial reports
 Historical cost: assets are recorded at the amount of cash paid or the fair value of the
consideration at time of acquisition
 Current cost: assets are carried at the amount of cash that would have to be paid if the
same asset was acquired currently (if buying asset currently)
 Realisable value: assets are carried at the amount of cost that could currently be
obtained by selling the asset (if selling asset currently)
  Present value: assets are carried at the present discounted value of the future cash
inflows that the item could generate

Accounting Regulation in Australia

 Two statutory bodies under the Federal Govt:

o Aus Securities and Investment Commission (ASIC)
- Administers and enforces Corporations Act 2001
- Regulates Aus companies, fin markets and fin services orgs and professionals
- Responsibilities inc oversight of the audit function (registration of auditors,
enforcing auditor independence)
o The Financial Reporting Council (FRC)- oversees the accounting and auditing
standard-setting process in the private and public sector AASB & AUASB

Ensuring Financial Reporting Quality

Corporate governance
 The framework of rules, relationships, systems and processes within and by which
authority is exercised and controlled in corporations (ASX, 2010)
 Rules require a company to state whether it has an audit committee, and explain why
if not
 In annual reports, companies are required to state the main corporate governance
practices they had in place during the reporting period
 ASX-listed entities must benchmark their corporate governance practices against
the Council's recommendations and disclose any non-conformity including reasons
 Covers the preparation, approval and assurance of financial statements
Hierarchy of a Corporation
 Agency theory:
o Agent: the person who is to do something and be compensated (managers)
o Principal: the person who wants it done (shareholders)
o Conflict of interest is viewed as the natural state of affairs (unlikely to have the
same interests)- if the agent is to provide effort on behalf of the principal:
- Agent: wants to work less hard than the principal wishes
- Principal: wants the agent to maximise his/her effort
o From this point of view, acc info is a part of the contract, and should serve the
monitoring and other needs of the contracting parties.
o The collapse of Enron in 2001 highlights the agency problem- collusion between
mgmt and auditors to depict a false stock price and overvalue the company

Financial Reporting Process

 Acc standards require a complete set of financial statements, with five components:
o A statement of financial position at the end of the period (b/s)
o A statement of profit or loss (i/s)
o A statement of changes in equity for the period
o A statement of cash flows for the period
o Notes to the financial statements
 Public companies include their set of f/s’s in a much larger annual report
1. Summary performance data for the year and comparisons for past few years
2. Chairperson’s report.
3. CEO report - review of operations.
4. Corporate governance statement (listed companies).
5. Set of financial statements above
6. Directors’ statement (Corporations Act 2001 requirement)
7. Independent audit report
8. Directors’ report
9. Info about substantial shareholders (listed companies)
10. Sustainability reporting
11. Other voluntary information
  Mgmt- prepares financial statements- involves making judgements on
measurements of assets, liabilities, revenues and expenses
 Board of Directors- approves f/s by signing off statements, legally responsible for f/s
 Due to conflicts in interest, shareholders can’t verify f/s (agency theory), which
creates a need for auditors

External Auditors
 Independent examination of the financial statements prepared by the organisation
 Purpose- verify that the annual accounts provide a true and fair picture of the orgs
finances, and mgmt have correctly applied accounting standards (e.g. GAAP)
 Auditors role- provide an independent, unbiased and professional perspective
(separate statements in financial reports that contains the auditor’s opinion)
 Maintaining independence is difficult, as auditors must have a close working
relationship with mgmt to obtain the necessary info to carry out the audit
 Opinion when auditor agrees = unmodified/unqualified opinion- the f/s meet all the
relevant criteria  true and fair view in accordance with Corporations Act 2001,
acc standards and other mandatory reporting requirements (most common)
 Opinions when auditor disagrees:
o Qualified opinion-specific part of the f/s contains a material misstatement or
adequate evidence cannot be obtained in a specific area, and the rest of the f/s
present a true and fair view, in accordance with acc standards. E.g. auditors have a
different view on the estimation of debts applied by mgmt in the f/s.
o Adverse opinion- opposite of unmodified opinion (complete disagreement)
o Disclaimer- unable to express an opinion due to limitations in work- e.g. auditors
can’t obtain adequate evidence due to a lack of access to info

Professional Ethics

 For members of the professional accounting bodies there are ethical standards that
must be followed (e.g. APES 110 Code of Ethics for Professional Accountants)
  These rules maintain independence between the auditor and the client- intended to
ensure that the auditor has no personal/financial interest in the org
 APES 110 sets out five fundamental principles (POPIC):
o Integrity- straightforward and honest in professional and business relationships
(fair dealing and truthfulness)
o Objectivity- not to compromise professional or business judgement because of
bias, conflict of interest or the undue influence of others
o Professional competence and due care:
- Maintain professional knowledge and skill
- Act in accordance with applicable technical and professional standards
o Confidentiality- refrain from:
- Disclosing confidential info without consent from the client/employer
- Exploiting confidential info from professional relationships to benefit
o Professional behaviour- comply with relevant laws and avoid actions that may
discredit the accounting profession
 Threats to auditor’s independence (APES 110)- SASIF
o Self-interest threat- Financial or other interest inappropriately influencing the
judgment or behaviour of auditors (e.g. dependence on fees/loan from client)
o Self-review threats- auditor audits work that they or others in their audit firm have
previously done for the client
o Advocacy threats- extensively promoting a client’s position such that objectivity
is compromised (e.g. promoting shares in a org that the auditor has a stake in)
o Familiarity threats- due to a long and close rel with their client, auditors may
become too sympathetic to the client’s interest or too accepting of their work
o Intimidation threats- actual or perceived pressures from the client that deters an
auditor from acting objectively (e.g. dismissal threats)

Financial Statement Analysis (FSA)

Purpose of FSA

 Using F/S to evaluate an entity’s financial performance and position

 FSA can be used to compare:
o A firm’s performance over a period of time (usually 4-5 years)
o A firm’s performance relative to industry performance
o A firm’s performance relative to targets/benchmarks
 FSA is utilised by:
o Creditors/shareholders
o Managers- performance evaluation (linked with bonus)
o Regulators- compliance with standards (e.g. govt recently introduced bank tax
based off increased profitability of banks)
o Customers
o Suppliers
Common Size Statements

 B/S items as a % of Total Assets

 I/S items as a % of Sales Revenue
 Removes the effect of company size
 Used to identify large changes in accounts

Ratio Analysis

Profitability Ratios

 Return on Assets (ROA)

o Used to assess the effectiveness of asset utilisation
o ROA= Operating Profit After Tax (i.e. NP)/Total Assets
o Should be positive/high + acceptable range of 5%
o Useful in judging the risk of borrowing- if it costs x% to borrow money, the
company should expect to earn x% on the assets acquired with the money.
 Return on Equity (ROE)
o Return the company is generating on the shareholders’ accumulated investment
o ROE= OPAT/SE
o Should be positive/high + acceptable range of 15-20%
 Profit margin (PM)
o Proportion of sales revenue that ends up as profit (profit earned for every dollar
of sales)
o PM= OPAT/Sales Revenue
o Important for mgmt to determine effective pricing strategy
o Gives indication of competition intensity in the industry
o Should be positive, however there is no clear acceptable range. E.g. Discount
retailer = low & exclusive jeweller = high
 o Gross Margin = Gross Profit/Sales Revenue – profitability in buying and selling
goods before other expenses are covered (provides further info on pricing)
 Earnings per Share (EPS)
o EPS= OPAT- Dividends on pref shares/Weighted avg no. of ordinary shares
outstanding
o Preference shares- must pay dividend vs ordinary shares- dividend is optional

Activity (Turnover) Ratios

 Asset turnover
o Proportion of sales associated with a dollar of assets
o Measures operating efficiency
o AT= Sales/Total Assets
o High ratio indicates assets are efficient at generating sales
o Decrease in ratio could suggest assets are inefficient (i.e. assets  from year to
year and sales remain the same)
 Inventory turnover
o Number of times inventory is sold during the year
o IT = COGS/Closing Inv (want denominator to be minimised, hence, a high figure
= more efficient inv policy)
o How long inventory is held on average (in days) = 365/turnover
 Debtors turnover
o Efficiency of the company to collect the amount due from debtors
o DT= Credit Sales/AR (high figure = more efficient debt collection policy)
o Avg no. of days to collect AR = 365/turnover

Relationship Between Ratios- Du Pont System of Ratio Analysis

 Change in ROA can be the result of a change in the PM and/or a change in AT

 Useful in evaluating a company’s pricing and marketing strategy

 Leverage provides the link between ROA and ROE.

 Useful in evaluating a company’s strategy regarding financial risk

Liquidity Ratios

 Liquidity- ability to pay short term debt when due

 Working capital (short-term funds) = CA-CL
  Current Ratio:
o CR= CA/CL
o Acceptable range = 2 (enough assets to fund twice the liabilities)
o CR < 2 indicates liquidity problems
o High CR = greater financial stability lower risk for creditors and owners
o CR too high = inefficient use of assets (e.g. too much inventory in storage)
o Static ratio- measures financial position, not considering any future cash flows
the company may be able to generate to pay its debts (difficult to interpret)
 Quick Ratio (Acid Test):
o CA- Inventory/CL
o Indicates whether CL could be paid without having to sell the inventory
o Useful for companies that cannot convert inventory into cash quickly if necessary
o Ratio of 1 or >1 is acceptable

Financial Structure Ratios

 Measure of solvency- ability to meet long term debts (>12 months)

 All ratios communicate the same result (depends on preference)
 There are some advantages to having debt, such as tax incentives, however,
unsustainable debt is an indication of high risk
 Debt-to-Equity Ratio:
o Total Liabilities/Total SE
o Measures the proportion of borrowing to owners' investment
o Indicates the company's policy regarding financing of its assets
o DE > 1 = assets are financed mostly with debt & DE < 1 indicates that the assets
are financed mostly with equity (ratio of 0.5 is acceptable)
o The higher the ratio, the more risk involved with the company
 Debt- to-Assets Ratio:
o D: A = Total Liabilities/Total Assets
o The proportion of assets financed by liabilities.
o Ratio of 0.5 is acceptable (closer to 1= more risk)
 Leverage Ratio
o LR= Total Assets/Total SE
o Measure of how much of assets is financed by equity
o The higher the ratio, the smaller the proportion of total assets funded by SE, and,
therefore, the more that is funded by debt
o Ratio of closer to 1 is good (above 2 = more debt than equity)

Limitations of Ratio Analysis

 Financial ratio analysis is useless without business context regarding:

o Industry averages
o Past records
o Business strategy
o General market conditions
 o ‘Abnormal’ situations
 Based on accounting numbers in Financial Statements:
o Different companies use different measurements
o Not all information recognised on the B/S and I/S
o Accounting numbers may be incorrect
 Ensuring financial reporting quality as part of Corporate Governance is important

Impact of Transactions on Financial Ratios

1. Record the relevant transaction using a journal entry

2. Make up an amount and calculate ratios (assume in same units-e.g. millions)
3. Determine impact on ratio (increase, decrease, no effect)
 NOTE: If both numerator and denominator inc/dec by the same amount, there is still
a CHANGE in the ratio

Introduction to Management Accounting

 Procedures, practices and methods that are employed by an organisation's
management to ensure the effective use of its resources
 Resource allocation decisions can be generically categorised as one of planning,
directing, motivating and/or controlling
 Internal- not disclosed because an efficient system can provide competitors with an
adv by providing info on costs
 Many different systems- focus is on cost management system  allows mgmt to
determine whether to manufacture or outsource

Different Between Financial and Management Accounting

Management Account System (MAS) Today

 Impacted by globalisation – development in technology (IT and info systems)

 Complexity and scale of industrial operations
 Lower prices & costs, (easier to obtain products from overseas)
 Customers demanding higher quality products & services
 Total Quality Management (TQM)- 1920s
o Focused on control aspects- minimise defective products
o Criticism led to the dev of continuous improvement- streamlining production
systems to improve efficiency
 Just in Time (JIT)- 1950s
o Lean manufacturing approach used by Toyota – aims for no defects
o Requires a flexible workforce and reliable suppliers
o Reduced inventory costs and rework costs
o Higher quality products and greater customer satisfaction
 Customer Relationship Management (CRM)- 1990s
o System that gathers info on c-sat during various stages of the product life-cycle
o Aims to determine why customers are buying products
 Balanced Scorecard- 1990s
o Performance is assessed across 4 dimensions to control company strategy
(financial, customer, business process, learning and growth)
o Measures are both quantitative and qualitative
o Measures are both backward and forward looking

Costing and Organisational Frameworks

Basic Cost Concepts

 Cost: value sacrificed for g/s that are expected to bring a current or future benefit
(e.g., revenue) to the organisation
 As costs are used up in the production, they expire
o Expired costs = expenses
o Unexpired costs = assets
 A differential cost is the amount by which a cost differs between two or more
alternatives that achieve the same outcome
 Sunk cost- has been paid and irretrievable and cannot be changed
 Controllable costs- heavily influenced by a manager
 Non-controllable costs- manager has no significant influence
 A cost object is any item or activity to which costs are assigned (e.g. products,
departments, projects)
 Direct costs- can be traced to a cost object, in a convenient and cost-effective way
 Indirect costs - common to several cost objects (note: traceability depends on the
point of reference)
Functional Classification of Cost

 Manufacturing org- costs subdivided into two major functional categories:

manufacturing and non-manufacturing.
 Manufacturing costs- incurred in the process of converting raw material into
finished goods (associated with plant or factory)

Direct Manufacturing Costs

 Direct materials- raw materials that become part of the product, can be easily
traced to a finished product in a convenient and cost-effective manner
 Direct labour- physically transform raw materials into finished goods + cost can be
traced to a finished product (e.g. production line workers)
 Example: DM= 1.5 m of metal sheeting, DL= 1 hour of labour

Indirect Manufacturing Costs: Overhead

 Indirect factory-related costs that are incurred when a product is manufactured

 Can’t be economically & conveniently associated with a particular cost object/product
 Aggregated and allocated to each unit produced
 Indirect materials:
 o Necessary for production but do not become part of finished product (e.g.,
lubricating oil for machine)
o Also includes raw materials that form insignificant part of the final product
(e.g., glue used in furniture or toys)
 Indirect labour:
o All factory labour other than those workers who physically transform raw
materials into a finished goods.
o E.g., production-line supervisors, maintenance workers etc.
 Other overhead costs- factory rates, factory insurance, depreciation on plant and
equipment, factory electrical expenses, factory security etc.
 Example: Pink paint and electricity for toaster above

Related cost concepts

 Period costs- costs that are expensed in the period in which they are incurred,
associated with specific time period (e.g. selling, general and admin costs)
 Product costs- manufacturing costs (DM, DL, OH) that are first inventoried and later
expensed as the goods are sold (Product cost = COGS + Inventory)
 Prime cost= DM +DL (direct costs)
 Conversion costs= DL + OH

Non-Manufacturing Costs

 Associated with the functions of selling and administration (SG&A)

 Associated with a specific time period rather than a product
 Deducted from revenues in the period in which they are incurred (usually classified as
operating expenses)
 Examples: sales commission, advertising, legal fees, depreciation of OFFICE equip

Financial Statements and the Functional Classification

Cost of Goods Manufactured (COGM)

  Total cost of goods completed during the current period
 WIP inventory- partially completed units found in production at a given point in time
 WIP- beg = costs carried on from the previous period, end = cost carried over to the
next period beg WIP – end WIP gives us the goods completed during the period
 Additional manufacturing costs must be incurred to complete the units in work
in progress
 Represents the cost of goods that are flowing out of WIP (decreasing WIP) and
into FG inventory
 NOTE: COGM is not an account- journal entry would be Dr FG Inv, CR WIP

Cost flows in a manufacturing organisation

 NOTE: manufacturing org has three types of inventory (raw materials, work-in-
progress and finished goods)

 Total MC flow into WIP (increase WIP)

  NOTE: MC is not an account- must enter amounts from DM, DL and OH separately
to increase WIP

Cost flows in a merchandising organisation

Cost of Goods Sold

 Retailer: COGS= Beg. Inv + Purchases – Ending Inv

 Manufacturer: COGS = Beg. FG Inv + COGM – Ending FG Inv

Statement of COGM

Statement of Cost of Goods Manufactured

$ $

Direct materials:

Add: Purchases

Materials available

Less: Ending inventory

Direct materials used

Direct labour

Manufacturing overhead:

Total manufacturing costs added

Add: Beginning WIP

Total manufacturing costs

Less: Ending WIP

Cost of goods manufactured

Statement of COGS

Statement of Cost of Goods Sold

$ $
 Beginning finished goods inventory

Add: Cost of goods manufactured

Good available for sale
Less: Ending finished goods inventory

Cost of goods sold

Cost- Volume Profit Analysis (WK 12)

Cost-behaviour

 Classifies costs on the basis of how it changes with activity levels (production)-
fixed, variable and mixed
 Important for managers in terms of planning, controlling and decision-making:
o Costing- what are our fixed/variables costs?
o Pricing- unit price to break-even/make x profit after tax
o Product mix- how much of each product must we produce to break-even?
o Make/buy- is it appropriate to manufacture or purchase products?
o Performance eval.
o Financial planning
 Cost driver- a factor that causes activity costs. e.g. work on prod. line (activity) 
direct labour costs (cost caused by activity)  direct labour hours (cost driver)

Fixed cost

 TOTAL cost remains constant within the relevant range (0-max capacity) as the
level of cost driver varies
 PER UNIT cost varies (usually decreases) as the level of the cost driver changes
 EXAMPLE: rent per month, insurance per year

Variable cost
  TOTAL cost varies proportionally with changes to the cost driver
 PER UNIT cost remains the same
 EXAMPLE: direct materials and labour (e.g. hourly wage rate, metres of fabric)

Mixed costs

 Semi-fixed cost- fixed over a moderate range of activity and, then, rise or fall to
new levels beyond that range. E.g. a factory may have to hire additional supervisors
(who have a fixed salary) when production exceeds a certain level
 Cost function:

 Semi-variable cost- has a base cost (fixed) + cost changes for every proportional
increase beyond that point (variable). E.g. ISP- $19.95/month up to 30GB, $5 per
extra 1GB download
 Cost function  y=a +bx, where y represents total cost level, a is the fixed cost
component, b is the unit variable cost and x is output volume
Income Statement: Classification by Cost behaviour

 The COGS (V/F) is deducted from sales to obtain the gross margin
 Selling and administration costs (V/F) are then deducted from the gross margin to
obtain profit before tax

 Alternatively, can create an I/S which classifies cost by behaviour

 Contribution margin (CM) = Rev – VC  contributes to meeting fixed costs
 CM per unit= Unit selling price- Unit VC
 Provides info that facilitates planning, control, and decision-making. E.g. a manager
can assess the contribution each product line is making to cover fixed costs, and
decide whether to keep the product line.
Cost- Volume Profit Analysis

 Examines the effect of changes in costs and volumes on a firm’s profits

 Provides information on volume/activity level, unit selling price, variable cost per
unit, total fixed cost and sales mix
 Assumptions/limitations:
o Behaviour of cost and revenues remains linear over the relevant range
o All units produced are sold
o Cost can only be classified as fixed/variable
o Only changes in activity affect costs
o The firm knows selling prices and costs with certainty
o Sales mix remains constant in multi-product firms
 First step in CVP analysis is to express the variable-costing I/S as a narrative
equation: Profit before tax = Sales revenues – Variable expenses – Fixed expenses
 Break-even analysis- determination of level of activity at which total revenues equal
total costs- fixed + variable  break-even point (BEP)
 BEP can be calculated using the graphical method or the equation method (units-
sold approach and sales revenue approach)
 Graphical method of BEP:

Units-Sold Approach

 Narrative eqn must be converted to an analytical eqn:

1. Profit before tax= Revenue – Total costs
2. Pb = SX – VX -F
3. Pb = X (S – V) – F
4. X (S – V) = F + Pb
5. X = F + Pb / (S – V)
 At BEP, let Pb = 0 and solve for X to determine units needed to break-even
  Note: S – V is the contribution margin per unit  can re-express eqn as X= F + Pb/
Unit CM
 Profit targets- to determine the number of units to produce a certain profit after tax
(Pa), Pa must be converted into Pb before subbing into formula:
1. Pa = Pb – (Pb x t), where t= tax rate
2. Hence, Pb = Pa / (1 – t)
 For multi-product firms, impact of product mix is taken into account by determining
the appropriate weighted average contribution margin (WACM):

1. WACM is ($10 x 0.4) + ($4 x 0.6) = $6.40

2. Use this WACM to calculate the breakeven units
3. Of those units, 40% are expected to be Product A and 60% are expected to be
Product B.

Sales Revenue approach

 Useful when individual units are not easily identifiable or when an organisation has a
very large number of different products or services
 Sales activity is defined as sales revenues instead of units sold and variable costs are
defined as a % of sales rather than as an amount per unit sold
 Pb = R – F – (vr) R

 CM ratio is calculated differently: CM ratio = (S – V)/S

 Sales dollars = F + Pb/ CM ratio
 Typical layout of question: