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Study organiser

Study Organiser

Topic
(weeks)

Topic Title and Topic Outline

Learning Activities and Assessment



Discussion questions Additional exercises Review questions Summarizing Vocabulary activity

Introduction to accounting and finance

1
(1)

Nature and role of accounting Accounting information user groups Accounting as an information system Accounting as a service function Characteristics of accounting information Decision-making, planning and control Overview of the planning and control process Business objectives Financial and management accounting The main financial reports and relationships

Different accounting entities

2
(2,3)

Nature of sole proprietorships Nature of partnerships Nature of companies Corporate governance and the role of directors Types of companies Analyse the capital of companies Role of the alternative regulatory bodies

Discussion questions Additional exercises Review questions Summarizing Vocabulary activity

Measuring and reporting financial position

3
(3,4,5)

Purpose of the balance sheet Assets definition, recognition, measurement and classification Liabilities in terms of definition, recognition, measurement and classification Nature and classification of owners equity Basic accounting equation Balance sheet formats Factors that influence in a balance sheet Simple balance sheet Analyse balance sheets of reporting entities Limitations of the balance

Discussion questions Additional exercises Review questions Critical thinking Paraphrasing Summarizing Listening & note taking

Measuring and reporting financial performance

4
(6,7)

Measuring and reporting financial performance Income statement (profit and loss) Income statement and the balance sheet Profit and loss equation Income statement format Income definition, recognition, classification and measurement Relation definition, recognition, classification and measurement Accrual and cash-based transaction recognition Expense recognition for noncurrent tangible assets Expense recognition for inventory Expense recognition for accounts receivable Income statement

Discussion questions Additional exercises Review questions Summarizing Listening & note taking Critical thinking and analysis skills

Measuring and reporting cash flows

5
(9,10)

Importance of cash Define cash and cash equivalents Accrual and cash-based transaction recognition Three external financial reports Cash flow statement Non-cash transactions Recognise the alternative Cash flow statement Reconciliation of net profit Useful of cash flow statement

Discussion questions Additional exercises Review questions Summarizing Critical thinking and analysis skills Report writing Vocabulary activity

Analysis and interpretation of financial statements

6
(11,12)

Define ratio Financial performance and financial position Terms profitability, efficiency, liquidity, gearing and investment Comparison for ratio analysis Ratio formulae Analyse and interpret ratios Limitations of ratios Index or percentage analysis

Discussion questions Additional exercises Review questions Report writing

Managing working capital

7
(13)

Working capital Working capital cycle The importance of inventory Controlling asset Controlling and managing holding cash Creditor management

Discussion questions Additional exercises Review questions

These notes have been adapted from power point slides from Atrill, McLaney, Harvey & Jenner, Accounting: An Introduction, 4th edition, Pearson Education Australia

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Cost volume profit

8
(14)
Budgeting

Cost behaviour Fixed costs and variable costs Break-even point Concept of contribution Concept of a margin of safety Weaknesses of break-even analysis

Discussion questions Additional exercises Stress management

9
(15,16)

Define a budget Relation between budgets, corporate objectives and longterm plans Main components of the budgetsetting process Interlinking of the various budgets Main uses of budgeting Construct budgets from relevant data Use a budget Implication of controlling budgets traditionally

Discussion questions Additional exercises Review questions

(8)
_

Review and test 1 (Class2)

(12)

Test 2 (Class 2)

Print version of study organiser Introductory Accounting - study organiser (39.561 Kb)

Topic Notes

ACCT 1046 Introductory Accounting


These notes have been adapted from power point slides from Atrill, McLaney, Harvey & Jenner, Accounting: An Introduction, 4th edition, Pearson Education Australia Page 3 of 73

Semester 2, 2009
Course Title: Introductory Accounting
Part A: Course Overview
Course Title: Introductory Accounting Credit Points: 12

Course CodeCampus
ACCT2189

Career

School

Learning ModeTeaching Period(s)


Sem 2 2009

City Campus Undergraduate 650T TAFE Business Face-to-Face

Course Coordinator: Sonia Magdziarz Course Coordinator Phone: +61 3 9925 5737 Course Coordinator Email:sonia.magdziarz @rmit.edu.au

Pre-requisite Courses and Assumed Knowledge and Capabilities None

Course Description Introductory Accounting introduces you to the role of accounting information in business and is taught with the assumption that you have not previously studied accounting concepts and techniques. Introductory Accounting is a compulsory core unit in the Bachelor of Business (Accountancy) degree and is required for membership of CPA Australia and the ICAA for all Faculty of Business students seeking this form of professional recognition.

Objectives/Learning Outcomes/Capability Development Successful completion of Introductory Accounting means that you should be able to identify and understand the most significant critical factors that influence the success or failure of a business. In addition, the course provides an opportunity for you to develop generic capabilities. These include the
These notes have been adapted from power point slides from Atrill, McLaney, Harvey & Jenner, Accounting: An Introduction, 4th edition, Pearson Education Australia Page 4 of 73

ability to: - Analyse, reason logically and conceptualise issues - Identify, understand and interpret basic concepts.

Overview of Learning Activities As an introductory course, learning activities are based on the assumption that set tutorial work will be completed by you prior to attending tutorials. This ensures that valuable discussion, extension of concepts and issues requiring clarification can be attended to in the tutorial.

Overview of Learning Resources You will be advised of the prescribed text for this course and other reading materials upon enrolment. Extra material may be provided or recommended by the teaching team of this course. This material may be supplied in hard copy, and/or via the RMIT internet site called the Learning Hub.

Overview of Assessment Assessment in Introductory Accounting may take the form of an assignment, and/or an in-semester test, and/or an end-of-semester examination.The in-semester assessment is designed to test your comprehension and understanding of the course material. The end-of-semester exam will again test the students ability to identify and understand basic accounting concepts and further, their ability to analyse and interpret basic accounting information. To pass this course you must:

obtain a mark of at least 50% on the final exam.

These notes have been adapted from power point slides from Atrill, McLaney, Harvey & Jenner, Accounting: An Introduction, 4th edition, Pearson Education Australia

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Topic 1 Business Decision Making and Accounting


Learning Objectives Define accounting Discuss the role of accounting information List the main accounting information user groups for a business entity Summarise the uses of accounting information Explain the procedures within the accounting information system State the key characteristics of accounting information Relate the steps in the planning process Discuss the nature of control in the decision-making process List some alternative business objectives Compare and contrast financial and management accounting Provide an overview of the main financial reports The Nature and Role of Accounting What is accounting? Accounting is concerned with the collection, analysis and communication of economic information. Accounting information is useful to those who need to make decisions and plans about businesses, and for those who control those businesses. The role of accounting information: Stewardship The more traditional role of providing accountability reports of transactions for a given period Decision usefulness Is about assisting users with making informed choices about issues e.g. resource allocation Accounting information user groups

Figure 1.1 Accounting as an Information System


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Different procedures involved in the accounting information system: Identify and capture relevant economic information Record the information collected in a systematic manner Analyse and interpret the information collected Report the information in a manner suitable to the needs of users

Figure 1.2 Accounting as a Service Function The key characteristics of accounting information: Relevance (ability to be used to influence decisions) Reliability (free from material error or bias) Comparability (consistency of measurement and presentation of items) Understandability (clarity and readability of presentation) Cost of information (is the benefit worth the cost) Characteristics of accounting information

Figure 1.3

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Decision-Making, Planning and Control The steps in the planning process: Planning is usually broken down into three stages: 1. Setting the objectives or mission of the business (Detailing what the business is basically trying to achieve) 2. Setting long-term plans (Describing how the business will set out to achieve its long-term objectives) 3. Setting detailed short-term plans or budgets (Typically financial plans for one year ahead) The nature of control in the decision-making process: Control is the process of making planned events actually occur terms Accounting is useful in control to compare planned outcomes with actual outcomes in commonly specified

Managers can take steps to get the business back on track if variances are highlighted between planned and actual outcomes Overview of the planning and control process:

Step 1 Step 2 Step 3 Step 4 Step 5 Step 6 Step 7

Identify business objectives

Consider options

Prepare a long-term plan based on the most appropriate option(s)

Prepare short-term plans (budgets)

Perform and collect information on actual performance Respond to divergences between plans and actuals, and exercise control Revise plans and budgets if necessary
Figure 1.4
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96668135.doc

Business Objectives Some alternative business objectives: The popular suggested business objectives include: Maximisation of sales revenue (this does not consider the need to cover business costs) Maximisation of profit (this takes in to account sales revenues as well as expenses, but is limited as it does not include other factors such as risk.). Maximisation of return on capital employed (accounts for level of profit as well as the level of investment) Survival (This is the aim of most businesses, however it is rarely a primary objective) Long-term stability (Like survival, most businesses aim for it, but it is rarely a primary objective) Growth (Encompasses survival and long-term stability and aims to strike a balance between short and long-term benefits, however it is probably not a specific enough target) Satisficing (Attempting to grant a satisfactory return to all stakeholders - not just the owners. Difficult to define as a practical benchmark for business decisions.) Achieving sustainable development (Achieving economic growth while minimising or eliminating environmental impact and meeting societys expectations of good corporate citizenship.) Enhancement / maximisation of business wealth Means the business takes decisions intended to make it worth more. Encompasses all the valuable features of the previous suggested objectives. Likely to be the main financial objective for many businesses ) Financial and Management Accounting Management accounting is concerned with providing managers with information required for day-to-day running of the business Financial accounting is concerned with providing the other users with useful information

Financial Accounting Focus Nature of reports Level of detail Restrictions Reporting interval Time horizon Range of information Mainly external General purpose Broad overview

Management Accounting Internal only Specific purpose Quite detailed

Accounting standards and other regulationsNo restrictions Mainly semi-annual or annual Mainly historical Whenever required Both past and future

Quantifiable in money terms; focus onCan contain non-financial information; less objective and verifiable data focus on objectivity and verifiability

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An Overview of the Main Financial Reports There are four main financial reports: The Statement of Cash Flows (shows the sources and uses of cash for a period) The Income Statement (traditionally known as Profit and Loss; measures and reports how much profit has been generated in a period) The Statement of Financial Position (otherwise known as the Balance Sheet; shows overall net financial position) The Statement of Changes in Owners Equity (shows all changes in owners interest in net assets from transactions during the period)

A Simple Example: Paul starts an office stationery retail business with $100 On the first day, he uses the $100 to purchase office stationery (inventory) On the same day he sells 75% of that inventory for $110 in total What cash movements took place in the first day of trading? Opening balance $100 - $100 stock purchase + $110 sales = $110 What is the closing cash balance at the end of day 1? Closing cash balance for day 1 is $110 How much did wealth increase as a result of the first days trading? The increase or decrease in wealth is measured as the difference between sales made and the cost of goods sold Sales were $110 less cost of goods sold $75 = profit of $35 Note: that only the cost of the office stationery SOLD is measured against the sales to find profit, not the total cost of the office supplies purchased. What is the financial position at the end of the first day? At the end of the first day, a balance sheet is drawn up, showing the resources held by the business: Cash (closing balance) = $110 Inventory (stock available for resale) = $25 Total business wealth at end of day = $135 Note: that the profit of $35 has led to an increase in wealth of $35 that the increase in cash of $10 is not the same as the increase in wealth because wealth does not exist only in the form of cash (see inventory) Summary: Cash Opening balance $100 purchase inventory $100 + sales $110 = Closing cash balance of $100 Wealth (of the owner) Owner invested $100 + Profit $35 = Owners wealth of $135 Wealth (of the total business) Consists of Cash $110 + Inventory $25 = $135

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Some important concepts arise from this example: assets (inventory, cash) revenue expenses profit (matching revenue with expenses) wealth of the owner/owners investment in the business transactions taking place in a business purchase of the wrapping paper sale of the wrapping paper cash being different to profit recognising the relationship between the business and the owner (what happens when the owner undertakes a personal transaction? Is this transaction recorded in the accounting information system?)

Now revisit the financial reports:


Statement of cash flows cash inflows and cash outflows of the business Statement of financial performance performance of the business (calculation of profit or loss by matching revenues and expenses) Statement of financial position the position of the business at a point in time (what assets does the business have? What is the owners investment in the business? Does the business have any liabilities? What if the wrapping paper (inventory) purchased was bought on credit and not with cash?) Statement of changes in equity how has the investment of the owner changed between the start of the period and the end of the period (in the above example, this was a change between one day and the next) Financial Report Relationships

Balance sheet at the beginning of Period 1 Income statement

Balance sheet at the end of Period 1

Balance sheet at the end of Period 2

Income statement

Cash flow statement Statement of changes in owners equity

Cash flow statement Statement of changes in owners equity

Period 1 Time

Period 2
Figure 1.6

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Topic 2 Different Accounting Entities


Learning Objectives
Discuss the nature of sole proprietorships Discuss the nature of partnerships Discuss the nature of companies Discuss corporate governance and the role of directors Distinguish between different types of companies Analyse the capital of companies Identify and discuss the role of the alternative regulatory bodies in company operations and financial reporting

Types of business entities


Sole proprietorship Partnership Company

Sole Proprietorships
The nature of sole proprietorships: No separate legal entity (as distinct from a separate accounting entity) Limited life (restricted to the period the owner continues to operate the business in) Unlimited liability (the owner is fully responsible for the debts and obligations of the business) Minimum reporting regulations (minimal compared with other entity structures) Limited access to funds (restricted to the personal resources of a single owner) Low establishment costs (comparatively much lower compared to other entity structures) Some advantages of sole proprietorships include: Simple and inexpensive to establish and operate Minimal financial reporting regulations Ownership and management are normally combined Financial rewards flow directly to the owner Timely decision-making is possible

Partnerships
The nature of partnerships: A partnership may be described as the relationship that exists between two or more persons carrying on a business with a view to profit. The relationship may be established by a formal partnership agreement or an informal arrangement
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between the parties, or it may be inferred by the actions of two or more individuals. The partnership maintains individual records of each partners transactions according to: Resource contributions (capital) Resource withdrawals (drawings) Share of undistributed profits (either current or retained earnings)

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The characteristics of partnerships: No separate legal entity Limited life Unlimited liability Mutual agency (each partner is responsible for the actions of the other partners) Co-ownership of assets (the partnership assets are owned by the partners in aggregate, not individually) Co-ownership of profits (equally or in agreed proportions) Limited membership (a restriction on the number of partners allowed. Normally twenty is the limit. Some exemptions exist e.g. accounting practices) Increased regulation (most states have Partnership Acts for direction of activities and rights and responsibilities of partners) Partnership Agreements: Important to have a detailed and formal agreement so that most potential problems can be avoided Issues not covered by the partnership agreement will be governed by law Some examples of default legal rules that an agreement may cover include: No entitlement of partners to a salary or wage Partners not entitled to interest on capital contributed Equal shares of profits and losses

Companies
The nature of companies: There are a number of company types, the most common being the company limited by shares, or limited company A limited company may be defined as: An artificial legal person who has an identity separate from that of those who own and manage it. Ownership interest is broken down into shares hence the term shareholders to describe the owners, who have invested in the business. Characteristics of companies: Separate legal entity (a limited company has the legal capacity of a person and is separate from those who own the entity i.e. can sue and be sued, buy, borrow, lend and employ in its own right as a legal person) Unlimited (perpetual) life (the life of the company is indefinite and not related to the life of the owners) Limited liability (the entity is responsible for its own debts and obligations because it is a legal person. Shareholders obligations cease upon full payment of the agreed price of their shares.) Company ownership of assets (assets owned by the company in its own right as a legal person) Company profits belong to the shareholders (profits are either distributed or retained for the benefit of shareholders) Extensive membership (some forms of companies may be limited, but public companies e.g. Westpac, Telstra often exceed 250,000 initial shareholders) Separation of ownership and management (usually a separate specialist management team exists outside the ownership interest, although increasingly managers are also shareholders)
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Extensive regulation (much stricter requirements due to limited liability benefit granted to owners. Corporations Act, ASIC, ASX, accounting standards all govern reporting to shareholders and markets) Advantages of companies: Separation of ownership and management Perpetual existence Separate legal entity Owners have limited liability Greater access to ownership funding Potentially greater access to debt funding Potential taxation advantages Potential increases in share values when listed on the ASX (Australian Stock Exchange) Disadvantages of companies: Extensive regulation Higher establishment costs Subject to more public scrutiny Owners not able to watch everything Pressure for short-term performance Loss or dilution of original ownership control Income tax is paid on every dollar of profit earned (no tax-free threshold)

Corporate Governance and the Role of Directors


Corporate governance: The system by which corporations are directed and controlled Directors: Individuals elected to act as the most senior level of management in a company The Board of Directors is the most senior level of management in a company A limited company must have at least one director Directors are elected by the shareholders Shareholder interests should be the guiding principle for a directors governance decisions Directors are also subject to a framework of rules based on the principles of Disclosure, Accountability and Fairness

Disclosure, Accountability and Fairness:


Disclosure (lies at the heart of good corporate governance, is all about adequate and timely information being available to investors) Accountability (involves defining the roles and duties of directors and establishing an adequate monitoring process which may include external auditing) Fairness (is about directors not benefiting from inside information. The law and ASX have imposed regulations that restrict directors ability to buy and sell shares of the business)

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Public and Proprietary (Private) Companies Different types of companies:


Public Proprietary Company name includes Ltd Pty Ltd Public sale of shares Yes No Typical size Large Smaller Extent of regulation Extensive Moderate Raise monies from public Yes Some restrictions Subject to reporting requirements Yes Depends on size Public companies and large proprietary companies must prepare annual financial reports including financial statements and directors reports Small proprietary companies do not have these requirements unless requested by ASIC or by at least 5% of members To be small, they must satisfy at least 2 of: Consolidated gross operating revenue < $10 million Consolidated gross assets at end of year < $5 million Must employ < 50 employees at end of year

Capital of Limited Companies


The basic division - an example (refer example 2.1 on page 45): Several people decide to start a new company They estimate they will need $50,000 to obtain assets to run the business Between them, they raise the cash to buy shares in the company, which issues 50,000 shares at $1 each. The statement of financial position at this point would be: Net Assets (all in cash) $50,000 Shareholders equity Share capital - 50,000 shares $50,000 The company buys the necessary assets and inventory and starts to trade During the first year it makes a profit of $10,000 and the shareholders (owners) make no drawings At the end of the first year the summarised statement of financial position is: Net assets (various assets less liabilities) $60,000 Shareholders equity Share capital - 50,000 shares $50,000 Reserves (retained profits) $10,000 $60,000

Owners' Claim (Shareholders' Equity)


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Shares (Investment by owners)


Reserves (Profits and gains subsequently made)

Different types of shares Different types of Reserves


The profit is shown in a reserve known as retained profits and is kept separate from share capital Retained profits are not added to share capital due to Corporations Act restrictions on the maximum drawings of capital (or dividends) the owners can make

Share Capital
Shares are the basic units of ownership of the business All companies issue ordinary shares which are the main risk-bearing shares of the company. Ordinary shareholders returns come from distributions of profit (dividends) or from increases in the value of the shares Normally, retaining profits will increase the value of ordinary shares Dividends - transfers of assets made by a company to its shareholders Partly-paid shares - shares on which the full issue price has not been paid, but the balance is to be paid in a series of installments or calls Fully paid shares - shares on which the shareholders have paid the full issue price Preference shares - shares which have a fixed rate of dividend that must be paid before any ordinary share dividends can be paid. These have higher priority in the event of the company going in to liquidation Companies may issue shares of various classes with equally various conditions, but ordinary and preference shares are the most common Within each class, all shares must be treated equally Voting rights are normally only ascribed to holders of ordinary shares. One ordinary share normally equals one vote New shares can be issued at any time and they are priced at, or close to, market price. This is to ensure no disadvantage to existing shareholders since all have the same rights

Reserves
Reserves - profits and gains made by the company that have not been distributed to Shareholders. The most common type of reserve is retained profits - profits earned by the company that are held back for use within the company Other reserves may be created in certain circumstances - a reserve is created (asset revaluation reserve) when assets are re-valued at greater than their book value

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Bonus Shares
Bonus shares - reserves which are converted into shares and given free to shareholders - A bonus issue of shares simply takes one form of shareholders equity (reserves) and transforms it into another form (share capital) - Bonus share issues have no impact on the net assets (total assets less total liabilities) of a company Rights Issues To generate additional share capital for expansion, a company may make a rights issue - These are issues of shares for cash, offered first to current shareholders (who may sell the right to others) in proportion to their existing holdings Such shares are normally offered at a price below the prevailing market price to encourage takeup of the offer - Rights issues differ from bonus issues in that rights issues result in an asset (cash) being transferred from shareholders to the company

Transfer of Share Ownership


Stock exchange - a formal marketplace where shares may be bought and sold, and where new capital can be raised Prices are determined according to the law of supply and demand, which in turn is determined by investors perceptions of future economic prospects for the companies concerned Transfer of ownership of shares has no direct impact on the companys business or on shareholders not involved in the transfer

Restrictions on the rights of shareholders to make capital drawings:


Limited companies are required by law to distinguish between capital that may be withdrawn by shareholders and that which may not The balance sheet must clearly identify the amount of non-distributable capital It is illegal for shareholders to withdraw that part of their claim represented by capital The legal provisions are in place to prevent unscrupulous activity which may disadvantage other shareholders as well as creditors and lenders

The Nature of Regulatory Bodies


The role of alternative regulatory bodies in company operations and financial reporting:

Directors duty to account:


To be accountable for their actions and to demonstrate good stewardship To provide financial reports that are true and fair and that comply with all relevant laws as well as
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accounting standards Financial reports must include the balance sheet, the income statement, the cash flow statement, the statement of changes in owners equity and related notes, also the directors declaration and directors report Compliance with Corporations Act disclosure requirements Publish the auditors report (if applicable)

The role of accounting standards:


For most of the 20th century GAAP was the guiding set of principles in Australia Since 2005, Australia has adopted International Accounting Standards Accounting standards narrow managements range of methods for recording and reporting transactions, bringing about greater consistency There are two types of accounting standard AASB applies to companies and now sets all standards AAS applies to other entities

The role of the ASX in company accounting:


Companies listed on the ASX (public companies) are subjected to further rules specified by the ASX in relation to more frequent reporting other matters e.g. corporate mergers/takeovers Shareholders are responsible for appointing qualified and independent auditors to audit the companys financial statements audits are not mandatory for small proprietary companies

Topic 3 Measuring and Reporting Financial Position


Learning Objectives
Explain the nature and purpose of the statement of financial position/balance sheet Demonstrate an understanding of assets in terms of definition, recognition, measurement and classification Demonstrate an understanding of liabilities in terms of definition, recognition, measurement and classification Discuss the nature and classification of owners equity Explain the basic accounting equation Contrast the alternative statement of financial position/balance sheet formats Discuss the main factors that influence the content and values in a statement of financial position/ balance sheet
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Prepare a simple statement of financial position/balance sheet Analyse statements of financial position/balance sheets of reporting entities State the potential limitations of the statement of financial position/balance sheet in portraying an entitys financial position. Note: the term Statement of Financial Position and Balance Sheet refer to the same report. The names will be used interchangeably in this course.

Nature and Purpose of a Statement of Financial Position/Balance Sheet


The purpose of the balance sheet is to set out the financial position of a business at a particular point in time It contains a snap shot of the assets, liabilities and equity position of the entity at a particular point in time As from January 2009 an accounting standard recommendation is that the balance sheet should be referred to as a statement of financial position

Assets
Definition: An asset, according to the AASB Framework is a resource controlled by the entity as a result of past events, and from which economic benefits are expected to flow to the entity The main identifying characteristics of an asset are: Expected future economic benefit The business has exclusive right to control the benefit The benefit must arise from some past transaction or event The asset must be capable of reliable measurement in monetary terms Note that these conditions limit the kind of items that may be referred to as assets in financial reports Some examples of items that appear as assets in a business balance sheet include: Freehold premises Machinery and equipment Fixtures and fittings Patents and trademarks Debtors Investments Assets may be either tangible (items with a physical substance) or intangible (no physical substance e.g. patents)

Claims against the Assets:


There are essentially two types of claims against the assets of an entity: External claims - known as liabilities Internal claims - labelled owners equity, equity, or capital

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Liabilities
Definition: A liability according to the AASB Framework is a 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 In addition to meeting the definition on the previous slide, there is a twofold recognition criterion: Probability of occurrence (in the case of liabilities, it is more likely than not that a future sacrifice of economic benefits will occur) Reliability of measurement (in the case of liabilities the amount of the claim can be determined with acceptable precision or accuracy) Some examples of items that appear as liabilities in a business balance sheet include: Creditors Staff entitlements Loans and other credit facilities Warranty provisions and other social or moral obligations Provision for employee bonuses

Owners equity

- The claim of the owner(s) on the assets of the business

The Accounting Equation The basic accounting equation:


The basic accounting equation is expressed as: Assets = Liabilities + Owners Equity OR A = L + OE This equation will always hold true, as total claims (against the assets) are always the same as total assets, ensuring that the balance sheet always balances.

Effect of trading operations on the balance sheet:


Every transaction has at least 2 effects on the accounting equation. You will notice in the following example that we not only look at how assets, liabilities and/or owners equity is affected but we also state which asset (cash at bank, motor vehicle, etc), which liability (creditor, loan, etc) or which part of owners equity (capital, drawings) is actually affected. This is necessary as the financial reports such as the balance sheet displays details of the business assets, liabilities and equity items and NOT JUST total assets, total liabilities and total owners equity. Similarly, the income statement shows details of income and expense items and NOT JUST total income and total expenses. Both totals and detailed information is provided in both reports. For example: A business purchases a motor vehicle for $40,000 cash
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Assets (cash at bank) by $40,000 Assets (motor vehicle) by $40,000 Overall, there is no change to the accounting equation as the total value of assets remains the same. One asset has simply been exchanged for another. Trading operations (i.e. the sale of goods or services) introduces additional transactions that impact on the balance sheet. To take into account the effect of trading, the balance sheet equation previously described is extended as follows to take into account the impact of income and expenses and changes in owners equity. Recall that this is the basic accounting equation:

BASIC ACCOUNTING EQUATION:


Assets (A) = Liabilities (L) + Owners Equity (OE) Or A = L + OE This is the expanded accounting equation shown in your textbook: Assets = Owners equity beginning + Profit (or -Loss) +/- Other Owners Equity Changes + Liabilities While the expanded accounting equation may look daunting, it is really just expanding on the Owners Equity part of the equation as shown below: Assets = Owners equity beginning + Profit (or -Loss) +/- Other Owners Equity Changes + Liabilities Owners Equity You may also notice that the equation above shows that A = OE + L. This has the same effect as A = L + OE. You will also see that Income and Expenses have been indirectly included in the accounting equation now as the result of Income minus Expenses will provide you with profit/loss. You may recall that the result of trading (profit or loss) is added to/subtracted from the owners investment in the business (capital) which is therefore part of owners equity. Any additional contributions by the owner are added to capital and any assets taken from the business by the owner for personal use are subtracted from the owners investment and are usually known as drawings for a sole trader. These components of owners equity are illustrated below in the expanded accounting equation. The five major accounting elements that result from these equations are: Assets (A) Liabilities (L) Owners Equity (OE) Income (I) Expenses (E) While additional capital contributions and drawings have been shown separately in the expanded accounting equation, they are not an accounting element in their own right. They are both part of owners equity. Income and expenses are separate accounting elements. However it is the end result of trading (profit/loss) that is
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then added to owners equity (capital). In summary, three of these accounting elements (assets, liabilities and owners equity) are shown in the Balance Sheet (Statement of Financial Position) while the remaining two accounting elements (income and expenses) are shown in the Income Statement.

The Balance Sheet / Statement of Financial Position


The Classification of Assets
Assets are normally categorised as either current, or non-current. Current assets: Are not held on a continuing basis Include cash and other assets expected to be consumed or converted into cash within the operating cycle Also include inventory, trade debtors and pre-payments

AASB 101 Presentation of Financial Statements requires a current asset to be classified according to the following criteria: a) The asset is expected to be realised in, or is intended for sale or consumption in, the entitys normal operating cycle; b) The asset is held primarily for the purpose of being traded; c) The asset is expected to be realised within twelve months after the reporting date; or d) The asset is cash or a cash equivalent unless it is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting date Non-Current assets: Held for the purpose of generating wealth, rather than for resale May be seen as the tools of the business Normally held on a continuing basis for a minimum period of one year Includes goodwill purchased - see page 90

AASB 101 Presentation of Financial Statements requires assets to be classified as non-current if they do not satisfy any of the criteria for being classified as current (previous slide)

The Classification of Liabilities


Liabilities are normally categorised as either current or non-current Current liabilities: Amounts due for repayment to outside parties within 12 months of the statement of financial position date AASB 101 Presentation of Financial Statements requires a liability to be classified as current when it satisfies the following criteria: a) The liability is expected to be settled in the entitys normal operating cycle; b) The liability is held primarily for the purpose of being traded; c) The liability is due to be settled within twelve months after the reporting date; or
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d) The entity does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting date AASB 101 Presentation of Financial Statements also requires that liabilities be classified according to their nature. This classification can be on: Current / Non-Current basis, or The order of liquidity (payment)

The alternative liquidity classification may be used for liabilities if it provides more relevant and reliable information

Owners Equity (OE, or Equity)


Definition:

The claim of the owner(s) against the business

AASB Framework defines equity as the residual interest in the assets of the entity after deducting all its liabilities. Classification of owners equity: Owners equity is normally classified as follows for a sole trader/sole proprietorship: 1) Capital 2) Drawings Owners equity is normally classified as follows for a partnership: 1) Capital account for each partner 2) Current account for each partner (optional) Owners equity is normally classified in three separate categories for a company: 1) Owners equity contributed (share capital) - represents profits left in the business by the owners 2) Reserves 3) Retained profit It is common to combine categories 2 and 3 into other reserves and then have them listed as sub-categories of other reserves such as (a) retained profits and (b) other reserves. Note: Reserves represent ownership interests in the assets, not the assets themselves. Reserves are not separate deposits of cash available for other purposes.

Formats for Balance Sheets

Curren t Assets

NonCurrent Assets

Curren t Liabiliti es

NonCurrent Liabilitie s

Owner s Equity

Figure 3.2 The Horizontal layout and entity approach The equation for the horizontal form of balance sheet layout Example: page 93 of textbook for Brie Manufacturing (reproduced in lecture notes)
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$ Current assets Cash at bank Trade debtors Inventory Non current assets Motor vehicle Plant and machinery Freehold premises Total assets 12,000 18,000 23,000

Brie Manufacturing Balance Sheet as at 31 December 2008 $ Current liabilities Trade creditors 53,000 Non current liabilities Loan Owners equity Opening balance Add profit 94,000 147,000 Less drawings Ending balance Total liabilities and owners equity

$ 37,000 50,000

87,000 19,000 30,000 45,000 50,000 14,000 64,000 4,000 60,000 147,000

Source: Accounting-An Introduction, 4th edition, Atrill, McLaney, Harvey & Jenner, Pearson Education Australia 2009

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Formats for Balance Sheets (continued) Curren t Assets

NonCurrent Assets

Curren t Liabiliti es

NonCurrent Liabilitie s

= Capital

Figure 3.3 The Vertical layout and proprietary approach The equation for the vertical form of balance sheet layout Example: page 94 of textbook for Brie Manufacturing (reproduced in lecture notes) Brie Manufacturing Balance Sheet as at 31 December 2008 $ Current assets Cash at bank 12,000 Trade debtors 18,000 Inventory 23,000 Non current assets Motor vehicle Plant and machinery Freehold premises Total assets minus Current liabilities Trade creditors Non current liabilities Loan Total liabilities Net assets equals Owners equity Opening balance Add profit Less drawings Ending balance 50,000 14,000 64,000 4,000 60,000 37,000 50,000 87,000 60,000 19,000 30,000 45,000 94,000 147,000

53,000

Source: Accounting-An Introduction, 4th edition, Atrill, McLaney, Harvey & Jenner, Pearson Education Australia 2009

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Analysis of balance sheets of reporting entities


The balance sheet is a statement of the financial position of the business at a specified point in time It is important to establish when reading a balance sheet the date it was drawn up hence it is important to display the date prominently in the heading.

Factors Influencing the Form and Content of the Balance Sheet


There are three main influences on the accounts included in the balance sheet: 1. Traditional accounting conventions and doctrines 2. More recent theoretical developments in conceptual framework projects 3. Professional and statutory accounting standards

Conventional Accounting Practice:


Made up of doctrines, principles, assumptions and accepted ideas on which accounting rules, records and reports were or are based These have collectively been known as GAAP (Generally Accepted Accounting Principles / Practices)

Business Entity Convention: Holds that for accounting purposes, the business and its owner(s) are treated as separate and distinct Money Measurement Convention: Holds that accounting should only deal with those items which are capable of being expressed in monetary terms Historic Cost Convention: Holds that assets should be recorded at their historic (acquisition) cost Going Concern (Continuity) Convention: Holds that the business will continue operations for the foreseeable future i.e. no intention or need to liquidate the business Dual Aspect Convention: Holds that each transaction has two aspects and that each aspect must be recorded in the financial statements Conservatism / Prudence Convention: Holds that financial reports should err on the side of caution vis--vis, anticipating losses but only recognising realised profits Other conventions include: Stable monetary unit convention, Objectivity / reliability convention, Accounting period convention, Realisation convention and Matching convention. Further details are on pp 101 - 103

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The Conceptual Framework:


Four Statements of Accounting Concepts (SACs) were current up until 2004, known as SACs 1 - 4 SAC 3 and SAC 4 have now been replaced by the adoption of the AASB Framework, SAC 1 and SAC 2 continue in their previous form While the framework and statements are not mandatory, they have significant influence on new and revised standards being issued

Accounting Standards:
The history and significance of accounting standard setting in Australia is covered in detail in chapter 2 Regarding the balance sheet, there are numerous standards that directly affect recording and reporting assets, liabilities and owners equity The implications of the applicable Australian Accounting Standards will continue to be considered

Basis of Valuation of Assets on the Balance Sheet


While the historical cost convention underlies the conventional accounting system, other conventions have led to departures from it. Examples include: Prudence convention Accounting Period / Going Concern conventions Full Disclosure / Relevant Financial Information convention

Basis of Valuation of Liabilities on the Balance Sheet


While liabilities in general do not have the same range of alternative measures as assets, there are still several alternative bases for measurement, both in practice and in the accounting standards. These include: The Contracted Amount Estimate of Expected Future Sacrifice Present Value of the future known or expected cash outflows

Interpreting the Balance Sheet


The balance sheet provides useful insights into the financing and investment activities of a business. In particular, the following aspects can be examined: The liquidity of the business The mix of assets held by the business The financial structure of the business

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Balance Sheet Deficiencies


Limitations of the balance sheet in portraying financial position are largely related to: Limitations related to the element definitions Limitations related to transaction recognition The range of alternative asset and liability financial measures

Topic 4 Measuring and Reporting Financial Performance


Learning Objectives State the purpose of the income statement (profit and loss) Explain the relationship between the income statement and the balance sheet Present the profit and loss equation and identify alternative formats for the income statement Demonstrate an understanding of income in relation to definition, recognition, classification and measurement Demonstrate an understanding of expenses in relation to definition, recognition, classification and measurement Distinguish between accrual and cash-based transaction recognition Analyse expense recognition for non-current tangible assets Analyse expense recognition for inventory Analyse expense recognition for accounts receivable Prepare an income statement from relevant financial information Review and interpret income statements

The Income Statement


The purpose of the income statement is to measure and report how much profit (wealth) the business has generated over a period. Profit (or loss) is the difference between Income and Expenses Income is made up of Revenue (from operating activities) and Gains (usually from non-operating activities) Expenses are outflows of resources to generate income

Relationship between the Income Statement and the Balance Sheet:


The two are closely related, but NOT substitutes for each other in any way The income statement can be viewed as linking the balance sheet at the start of a period with the balance sheet at the end of the period The accounting equation can thus be extended as:

Assets = OEbeg + Profit (or - Loss) +/- Other OE adj + Liabilities

or further extended to:


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Assets = OEbeg + (Income - Expenses) +/- Other OE adj + Liabilities

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Remember: this is an extension of the basic accounting equation of A = OE + L As a result of the relationship between the income statement and two consecutive balance sheets, profit and loss can be calculated for a period based on the stock approach The stock approach computes profit and loss by adjusting the change in net assets for the period by other changes in owners equity in the period The equation for the stock approach is:

Profit (or Loss) = (Aend - Abeg) - (Lend - Lbeg) - New contributions + Owners distributions +/- Other changes in owners equity The stock approach can be used to check the accuracy of the transaction approach where income less expenses is used to calculate profit. It can also be used where there are incomplete records and may be used by insurance assessors or the Australian Taxation Office.

NOTE: you will not be required to calculate profit using the stock approach. You will need to be aware of the theoretical aspects of the stock approach.

Format of the Income Statement


In practice, there are at least three forms of income statement: Simple listings of accounts (small organisations) Classified reports (larger organisations) Regulatory presentations (companies)

Simple reports:
For smaller organisations, may be just a listing of income and expenses in alphabetical or financial magnitude order Example: page 145 of textbook for Newlands Soccer Club and reproduced in lecture notes.

Newlands Soccer Club


Income statement for the year ended 31 October 2008 $ $ Income Ticket sales 9,200 Fundraising 5,700 Members fees 3,500 Government grant 2,700 Interest 600 21,700 Expenses Players payments 8,300 Ground fees 2,900 Insurance 2,100 Travel costs 1,900 Uniforms 1,500 Repairs and maintenance 900 Telephone and postage 600 Sundries 400 18,600 Period profit (surplus) 3,100

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Classified reports:
Relate to larger organisations and often called the classified financial report. Income and expenses are not simply listed, but grouped into categories Income would normally be broken down into sales, and other revenues

Expenses are often broken down into four categories: 1. Cost of sales 2. Selling and distribution 3. Administration and general 4. Financial Example: page 147 of textbook for Hi-Price Stores

Hi-Price Stores
Income Statement for the year ended 31 October 2008 $ Sales Less Cost of sales Gross profit Other revenue Interest from investments Rent from properties Less Expenses Selling and distribution Advertising Commissions Delivery Display Salary and wages Administration and general Salary and wages Rates Heat and light Telephone and postage Insurance Repairs and maintenance Motor vehicle running expenses Depreciation plant and equipment Depreciation motor vehicles Depreciation buildings Financial Interest Bad debts Total expenses Net profit $ 432,000 254,000 178,000 7,000 185,000

2,000 5,000

5,000 4,000 3,000 2,000 37,000 41,000 2,000 3,000 2,000 1,000 5,000 4,000 1,000 2,000 3,000 3,000 7,000

51,000

64,000 10,000 125,000 60,000

Regulatory reports:
Required to be produced by companies and other entities in accordance with statutory standards AASB 101 Presentation of Financial Statements requires that the income statement should classify expenses according to their nature or function Refer to page 149 for a list of AASB 101 requirements For external reporting, the reporting cycle is normally one year
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For internal functions, it is common for profit figures to be prepared on a monthly basis Example: page 150/151 of textbook

Cash versus Accrual Transaction Recognition

Distinguish between accrual and cash-based transaction recognition:


Cash-based accounting recognises income when it is received and expenses when they are paid Accrual-based accounting recognises income on the basis that it has been earned irrespective of whether the cash receipt is in arrears or in advance and expenses are recognized on the basis that the expense has been used up/incurred/consumed by the business

Profit Measurement and Recognition of Income


Income should only be recognised in the accounts when it has been realised Realisation is considered to have occurred when: Activities necessary to generate the revenue are substantially complete The amount of the revenue can be objectively determined Reasonable certainty that amounts owing will be received Any other outstanding items can be determined with reasonable certainty

The Accrual Basis for Recognising Revenue


It is common for adjustments to be made to accounting information prior to it being published in the financial reports. These adjustments are known as balance day adjustments. The adjustments are required to ensure that revenue earned is reflected in the Income Statement for the period rather than revenue received when using the cash basis for revenue recognition. The need for such adjustments arises where: Revenue earned for the period is greater than the cash received for the revenue The amount received for the revenue is greater than the revenue earned for the period

Revenue earned for the period is greater than the cash received for the revenue (accrued revenue)
For example, a business earns rental income from renting out part of their premises but there is an amount of rental income that relates to the current financial period but has not been received. Hence, the revenue has been earned but has not been received so it should be recognised as revenue in the current financial period. In this case, the revenue account is increased and a temporary asset is created for the amount that is owed to the business and appears in the balance sheet as effectively it is an asset at the date of the balance sheet

The amount received for the revenue is greater than the revenue earned for the period (prepaid / unearned revenue)
For example, a business earns rental income from renting out part of their premises and the tenant has paid the rent in advance of which part of this amount relates to the next financial period. In this case, the revenue account is decreased and a temporary liability is created for the unused amount and appears in the balance sheet as effectively it is an amount that has been received but not earned at the date of the balance sheet
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In the next period, the prepayment will cease to be an liability and become revenue in the income statement in the period it relates to

Profit Measurement and Recognition of Expenses


Expenses measure the outflow of assets (such as cash) or the increase in liabilities that result from trading and generating revenues

The Matching Principle and Common Basis for Recognition


The Matching principle dictated that expenses should be matched to the income they helped to generate. More recently, there have been moves away from matching in favour of a common basis for recognition of income and expenses. The common basis is that if an item satisfies recognition criteria, it will be recognised if its occurrence is probable, and it can be reliably measured

The Accrual Basis for Recognising Expenses

It is common for adjustments to be made to accounting information prior to it being published in the financial reports. These adjustments are known as balance day adjustments. The adjustments are required to ensure that expenses incurred are reflected in the Income Statement for the period rather than expenses paid when using the cash basis for revenue recognition. The need for such adjustments arises where: An expense incurred for the period is greater than the cash paid for the expense The amount paid for an expense is greater than the expense incurred for the period

An expense incurred for the period is greater than the cash paid for the expense (accrued expense)
For example, the wages account may show the total wage expense however the next pay period occurs in the new financial year. However, we are unaware that a portion of the wages to be paid next financial year have actually been used up in the current financial year and therefore should appear as wages expense in the current year. In this case, the wages account is increased and a temporary liability is created for the unpaid amount and appears in the balance sheet as effectively it is an unpaid expense at the date of the balance sheet

The amount paid for an expense is greater than the expense incurred for the period (prepaid expense)
For example, some expenses may be paid in advance (such as insurance, advertising) but not all of the amount paid may have been used up/consumed by the end of the financial year. In this case, the expense account is decreased and a temporary asset is created for the unused amount and appears in the balance sheet as effectively it is an amount that has been paid but not used up at the date of the balance sheet In the next period, the prepayment will cease to be an asset and become an expense in the income statement in the period it relates to

Profit and Cash:


It is important to note that profit and cash (liquidity) are not the same Profit is a measure of achievement, or productive effort rather than of cash generated Deferred/prepaid expenses relate to expenses paid in advance of being incurred while accrued revenue relates to revenue earned but not received Accrued expenses are where the expense has been incurred but payment has not been made

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Profit measurement
We will now look at three common assets and how they impact on expense recognition: Non-current tangible assets (depreciation expense) Inventory (cost of goods sold) Accounts receivable (bad and doubtful debts)

Profit Measurement and the Calculation of Depreciation on Non-Current Tangible Assets


Depreciation is a measure of that portion of the cost (less residual value) of a fixed asset which has been consumed during an accounting period Four factors are considered: The cost (or other value) of the asset The useful life of the asset The estimated residual value of the asset The depreciation method The cost of the asset - includes all costs incurred by the business to bring the asset to its required location and make it ready for use e.g. delivery, installation, legal title, alterations, improvements etc The useful life of the asset - the economic life of the asset determines the expected useful life of the asset for the purpose of calculating depreciation. The economic life of an asset ends when the cost of operating or holding the asset exceeds the benefit derived from it. Economic life may be shorter than physical life in many cases. Estimated residual value (disposal value): defined as the likely amount to be received on disposal of the asset. Like useful life, estimated residual value can be difficult to predict Depreciation method: Once the depreciable amount has been estimated, it must be allocated over the useful life of the item, property, plant or equipment. The three common methods of deriving a depreciation expense are detailed on the next slide Straight line method of depreciation: See Example 4.1 on page 163 See Figure 4.7 on page 164 See Activity 4.15 on page 164 Accelerated depreciation formula:

P = (1 n

R ) x 100% C

where P = the depreciation percentage, n = the useful life (in years), R = the residual value, and C = the cost of the asset

NOTE: you will not need to use the accelerated depreciation formula to calculate the depreciation percentage in the exam. If you are asked to use the accelerated depreciation method, the depreciation percentage (P) will be provided to you.
Units of production based depreciation: Depreciation based on productive capacity of the asset and its use over time

Depreciation:

Depreciation methods should be selected to be appropriate to the particular assets and to their use in the business. Accounting standard AASB 116 - Property, Plant and Equipment reinforces this view Depreciation does not provide funds for asset replacement, it is used to calculate net profit Depreciation is an example of an accounting process that requires a lot of judgement
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Profit Measurement and the Valuation of Inventory


Inventory - Finished goods, raw materials, stores or supplies and work-in-progress Cost of Inventory - All costs directly related to bringing the inventory into a saleable state. See AASB 102, paragraph 10

What is the basis for transferring the inventory cost to cost of sales/cost of goods sold?

Where inventory movements are difficult to trace, assumptions can be made about the physical flow of inventory through the business. These assumptions are: First in First out (FIFO) - the earlier inventory held is the first to be sold Last in First out (LIFO) - the latest inventory held is the first to be sold (not permitted in Australia) Average Cost - a weighted average cost is determined, to derive cost of sales and cost of remaining inventory held

Systems to Record Inventory


Perpetual inventory system - maintains continuous records of all inventory movements, records both cost and selling price, and volume. The cost allocation methods that can be used are: Physical / Periodic inventory system - much simpler than perpetual, does not maintain records of cost of inventory sold, the inventory (asset) account remains unchanged during the year and is updated at end of period following a stock count, does not work with LIFO method.

Net realisable value (NRV)


Any unsold inventory is recorded as a current asset in the balance sheet. The prudence/conservatism assumption requires that closing inventory be valued at the lower of cost and net realisable value. Net realisable value (NRV) is defined as: the estimated selling price less any further costs necessary to complete the goods and any costs involved in selling and distributing the goods

AASB 102 Inventories requires valuing inventory on the basis of the lower of cost and net realisable value on an item-byitem basis. Inventory valuation and depreciation are good examples of where the consistency convention should be applied. Consistency convention: holds that when a particular method of accounting is selected to deal with a transaction, this method should be applied consistently over time

Note: from a practical perspective, you are only expected to undertake practical examples regarding use of the FIFO and average cost assumptions as part of the inventory section just covered.

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Profit Measurement and the Problem of Bad and Doubtful Debts


Bad and doubtful debts are associated with income derived from selling goods on credit The risk of credit sales is that the customer will not pay the amount due, thus bad debts are created and doubtful debts if the matter is uncertain Bad debts must be written off which increases expenses and reduces accounts receivable Doubtful debts can be accounted for (estimated) using either the percentage of credit sales or the aged debtors listing There are three alternative approaches to recording bad and doubtful debts observed in practice: Recognise only on basis of realised uncollectable amount (customer is bankrupt, deceased etc) Recognise Bad and Doubtful Debt expenses separately - the bad debt expense is always written off against accounts receivable Recognise a single combined bad and doubtful debts expense based on either percentage of credit sales or aged debtors listing approach An overall impairment test under AASB 132 may mean changes to the terminology within the reporting for bad and doubtful debt expenses

Interpreting the Income Statement How the final net profit figure was derived can be found by: analysing sales levels - against history and planned sales for the current/future periods examining the nature and amount of expenses incurred comparison against history and future indicator of efficiency of business operations investigating gross profit levels in relation to sales in similar businesses helpful in assessing profitability and margins analysing net profit levels, for example against previous periods and also in relation to sales

Topic 5 - Measuring and Reporting Cash Flows


Learning Objectives Explain why cash is important to the reporting entity Define cash and cash equivalents Distinguish between accrual and cash-based transaction recognition Compare and contrast the roles of the three external financial reports (income statement, balance sheet, cash flow statement) Discuss the three components of the cash flow statement (operating activities, investing activities, financing activities) Identify non-cash transactions Recognise the alternative approaches to preparing a cash flow statement Prepare a simple cash flow statement Describe the purpose of a reconciliation of net profit to cash flow from operations Explain how the cash flow statement can be useful for identifying cash flow management strengths, weaknesses and opportunities The Importance of Cash and Cash Flow Cash is important because organisations and people will not normally accept any other form of settlement of claim against the business Businesses fail as a result of inability to find sufficient cash to settle their responsibilities These factors make cash the pre-eminent business asset, and therefore the one analysts and others watch carefully in assessing survivability of the business and other factors
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Balance sheet and profit and loss reports show movements in wealth and the net increase or decrease in wealth for the period concerned The cash flow statement is required to be produced because the above two reports do not concentrate sufficiently on liquidity (cash flow) The accrual nature of the above two reports are thought to obscure the question of how and where a company is generating the cash it needs to continue operating Cash and Cash Equivalents Cash represents cash on hand and demand deposits Cash equivalents represent short-term, highly liquid investments that can readily be converted to a fixed amount of cash Examples include: - Cash at Bank - Bank Overdraft - Short-term Money Market Deposits - Bank Bills

Cash vs Accrual Transaction Recognition Cash-based - Revenue is recognised when cash is received and expenses are recognised when cash is paid Accrual-based - Revenue is recognised when it is earned and expenses are recognised when they are incurred Accrual-based accounting removes the distortion of the entitys performance from the cash-based system and reflects the economic reality of what has been earned Differences between the Three External Financial Reports Balance Sheet static report made at a given point in time and based on balances in assets, liabilities and owners equity, normally based on accrual transactions Income Statement (Profit & Loss) measures the financial performance over a period of time - normally one year, related to revenues earned less expenses incurred Cash flow statement identifies all cash receipts and cash payments for the period. All account types are included and is based on cash, not accrual transactions

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Balance sheet at the start of Owners the claim accounting period


Cash

Income statement

Cash flow statement

Balance sheet at the end of Owners the claim accounting period


Cash

Figure 5.1 - The relationship between the balance sheet, the income statement and the cash flow statement

The Cash Flow Statement The cash flow statement is basically an analysis of the business cash movements over the period concerned All payments of a particular type are added together to give just one figure, which appears in the statement The net total of the statement is the net increase or decrease in cash of the business over the period

The three components of the cash flow statement are: Operating activities - represents net inflows from operations. Only cash received and paid, not expenses earned and revenue incurred, are featured (that is, cash flows associated with the operating activities of the business) Investing activities - concerned with cash payments to acquire additional non-current assets, and cash receipts from the disposal/sale of such assets e.g. plant and machinery, shares etc (that is, cash flows from changes in Non Current Assets and Investments) Financing activities - deals with financing the business excluding short-term credit e.g. debt and equity sources, share issues, repayment of debt etc (that is, cash flows from changes in Non Current Liabilities and Equity)

Items which may appear under more than one section of the cash flow statement: Interest Paid, Interest Received and Dividends Received Interest paid may be shown under Operating Activities (because it is used to help determine profit or loss) or under Financing Activities (because it is a cost of obtaining financial resources). Interest received and dividends received can be shown under operating activities (because they help determine profit or loss) or under investing activities (because they are returns on investment).

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Net cash flows from operating activities


plus or minus

Net cash flow from investing activities


plus or minus

Net cash flow from financing activities

Net increase or decrease in cash and cash equivalents over the period
Non-cash Transactions

Figure 5.2 - Standard layout of the cash flow statement

Non-cash transactions are transactions that do not directly involve cash Most relate to the operating activity section of the cash flow statement and are linked to the difference between cashbased and accrual-based transactions Examples - depreciation, revaluations, doubtful debts, accruals (receivables, inventory, prepayments, payables, gains or losses on disposal of non-current assets) etc Some relate to the investing and financing activity section e.g. direct exchanges such as shares for assets, non-current assets for reduction in debt, bonus issues from reserves etc

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Preparation of the Cash Flow Statement - an Overview Can be produced in two ways: 1. Independently viewing the cash receipts and cash payments for the period and allocating transactions to the different activities and categories 2. Reconstructing the income statement by tracking the changes in the balance sheet for the period and eliminating accrual transactions so that only cash transactions remain, forming the basis for preparing the cash flow statement. The information can be reconstructed in the following ways: Schedule approach using additions and subtractions Ledger reconstructions Worksheets You will only be expected to use the first approach to prepare a Cash Flow Statement. You will not be expected to use method 2 to prepare a cash flow statement. Preparation of the Cash Flow Statement - a Simple Example Refer to Example 5.1 on page 231 for detailed information on how reconstructions are used to prepare a cash flow statement. You will not be expected to use these reconstructions in this course. However you may be interested in these calculations as a matter of interest. Cash flow statement for the year ended 30 June 2009 $m Cash flows from operating activities Cash receipts from customers Cash payments to suppliers and employees Interest paid Income taxes paid Net cash provided by operating activities Cash flows from investing activities Purchase of property, plant and equipment Net cash used in investing activities Cash flows from financing activities Proceeds from issue of share capital Proceeds from long-term borrowings Dividends paid Net cash provided by financing activities Net decrease in cash and cash equivalents held Cash and cash equivalents at the beginning of the financial year Cash and cash equivalents at the end of the financial year Reconciling Cash from Operations with Operating Profit Purpose of reconciliation is to reconcile the net operating profit or loss after tax with the cash flows from operating activities The starting point is the operating profit after tax We then effectively add back the depreciation charged in arriving at that profit and adjust this total by movements in non-cash current asset and current liability accounts to arrive at cash flow from operations 95 (80) (3) (4) 8 (20) (20) 15 5 (15) 5 (7) 12 5 $m

Refer Example 5.1 on page 231 for data. Reconciliation would be as follows: Operating profit after tax $m 10
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Depreciation Increase in inventory Increase in accounts receivable Increase in accounts payable Increase in tax payable Net cash flow provided by operating activities

5 (8) (5) 5 1 8

You will not be expected to prepare this reconciliation but you will need to be aware of it. What Does the Cash Flow Statement Tell Us? The cash flow statement tells us how the business has generated cash during the period and where that cash has gone Tracks the sources and uses of cash over time, which is indicative of trends and useful for predicting future opportunities and patterns of cash flow Provides an insight to working capital management Is a good indictor of debt management practices Identifies non-operational cash flows

Required activities For this topic, you are expected to have completed, as a minimum, Discussion Questions 5.5, 5.6, 5.8, 5.9, 5.15, 5.18. Application Exercises 5.1 These questions are on pages 256 to 258 of the text book Accounting, an introduction 4th Edition by Atrill, McLaney, Harvey and Jenner. The answers to these questions are available on the Learning Hub.

Topic 6 - Analysis and Interpretation of Financial Statements


Learning Objectives Define what a ratio is Identify the key aspects of financial performance and financial position that are evaluated by the use of ratios Explain the terms profitability, efficiency, liquidity, gearing and investment Summarise the alternative bases of comparison for ratio analysis Present the ratio formulae for the basic ratios Calculate ratios to analyse the profitability, efficiency, liquidity, gearing and investment of a given entitys financial statements over several periods Interpret basic ratios for profitability, efficiency, liquidity, gearing and investment Discuss the limitations of ratios as a tool of financial analysis Understand index or percentage analysis as an alternative to ratios Financial Ratios What is a ratio? Ratios provide a quick and simple means of examining the financial health of a business A ratio simply expresses the relationship between one figure appearing in the financial statements with another e.g. net profit in relation to capital employed Ratios are simple enough to calculate, and a good picture can be built up with just a few, however ratios can be difficult to interpret Can be expressed in various forms e.g. percentages, fractions, proportions depending on the need and use for the information
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The key aspects of financial performance / position evaluated by the use of ratios are: Profitability Efficiency Liquidity Gearing Investment

Financial Ratio Classification Profitability - Measure of success in wealth creation Efficiency - Effectiveness of utilisation of resources Liquidity - The ability to meet short-term obligations Gearing - Measure of degree of risk to do with the amount of leverage used to finance the business Investment - Measure of the returns and performance of shares held by a business The alternative bases of comparison for ratio analysis Bases (benchmarks) that may be used as a basis of comparison for ratio analysis include: Intertemporal - Based on past performance Budget - Based on planned performance Intra-industry - Based on comparison of performance with other firms in the same industry A calculated ratio on its own does not say much about a business - it is only when it is compared with some form of benchmark that the information can be interpreted and evaluated The Key Steps in Financial Ratio Analysis Step 1: Identify which key indicators and relationships require examination Identify who needs the information and why they need it Step 2: Choose the most relevant set of ratios that will accomplish the desired purposes Calculate and record the results using the selected ratios Step 3: Interpret and evaluate the results

Common ratios that we will consider now follow that illustrate the name of the ratio, a description of the ratio, the ratio formula and the terms in which the ratio is often expressed, for example, %, times, etc. Note that we will not be focusing on the Investment Ratios in any great detail.

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Calculation of Ratios - Profitability Ratios


Ratio Return on shareholders funds (ROSF) Description Compares the amount of profit for the period available to the owners with the owners stake in the business Compares the net profit generated by the business with the assets owned by the business Relates the net profit for the period to the sales during that period Relates the gross profit of the business to the sales generated during the same period Gross profit represents the difference between sales and cost of sales Formula
ROSF = Net profit after taxation and preference dividend (if any) x 100 Average ordinary share capital plus reserves

Normally expressed as a percentage

Return on (ROA):

total

assets

ROA = Net profit before interest and taxation x 100 Average total assets

Normally expressed as a percentage x 100 Normally expressed as a percentage Normally expressed as a percentage

Net profit margin:

Net profit margin = Net profit before interest and taxation Sales

Gross profit margin:

Gross profit margin = Gross profit x 100 Sales

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Calculation of Ratios - Efficiency Ratios


Ratio Average period: inventory turnover Description Measures the average period inventory was held Formula Inventory turnover periods = Average inventory held x 365 Cost of sales Average settlement period = Average trade debtors x 365 Credit sales Normally expressed in terms of days Normally expressed in terms of days Normally expressed in terms of days Normally expressed in terms of days

Average settlement period for accounts receivable (debtors):

Calculates how long, on average credit customers take to pay amounts owed

Average settlement period for accounts payable (creditors):

Calculates how long, on average the business takes to pay its creditors Examines how effectively the assets of the business are being employed in generating sales revenue

Average settlement period = Average trade creditors x 365 Credit purchases

Asset turnover period:

Average asset turnover period = Average total assets employed x 365 Sales

The Relationship Between Profitability and Efficiency The overall return on funds employed in the business will be determined both by the profitability of sales, and by efficiency in the use of assets

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Calculation of Ratios Liquidity Ratios


Ratio Current ratio: Description Compares the businesss liquid assets with shortterm liabilities (current liabilities) Formula Current ratio = Current assets Current liabilities Expressed in terms of the number of times the current assets will cover the current liabilities

Acid test (also known as the quick or liquid) ratio: Cash flows from operations ratio:

Represents a more stringent test of liquidity than the current ratio Compares the operating cash flows with the current liabilities of the business

Acid test ratio = Current assets (excluding inventory & prepayments) Current liabilities

Expressed in terms of the number of times the liquid current assets will cover the current liabilities Expressed in terms of the number of times the operating cash flows will cover the current liabilities

Cash flows from operations ratio =

Operating cash flows Current liabilities

Calculation of Ratios Financial Gearing (Leverage)


Financial Gearing: The existence of fixed payment bearing securities (e.g. loans) in the capital structure of a company The level of gearing, or the extent to which a business is financed by outside parties is an important factor in assessing risk Gearing may be used both to adequately finance the business, and to increase the returns to owners - provided that the returns generated from the borrowed funds exceed the interest cost of borrowing

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Ratio Gearing ratio:

Description Measures the contribution of long-term lenders to the long-term capital structure of the business Measures the amount of profit available to cover interest expense of the business

Formula Gearing ratio = Long term liabilities x 100 Share capital + Reserves + Long-term liabilities Expressed in terms of a percentage

Interest cover ratio (times interest earned):

Interest cover ratio = Profit before interest and taxation Interest expense

x 100

Usually expressed in terms of the number of times

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Trend Analysis Trends may be identified by plotting key ratios on a graph, giving a visual representation of changes happening over time Intra-company trends may be compared against industry trends Key financial ratios are often published in companies annual reports as a way to help users to identify important trends

Ratios and Prediction Models Ratios are often used to help predict the future however the choice of ratios and interpretation of results depend on the judgment of the analyst Researchers have developed ratio-based models which claim to predict future financial distress as well as vulnerability to takeover The future is likely to see further ratio-based prediction models developed to predict other aspects of financial performance

Limitations of Ratio Analysis The quality of the underlying financial statements determines the usefulness of the ratios derived from them Ratios only offer a restricted view of relative performance and position - not the full picture No two businesses are identical and the greater their differences, the greater the limitations of ratio analysis as a basis for comparison Any ratios based upon balance sheet figures will not be representative of the whole period because the balance sheet is a snapshot of a moment in time Index or Percentage Analysis Index or Percentage analysis simply allows monetary figures to be replaced with an index or a percentage as an alternative to ratio analysis There are three alternative index or percentage methods: 1. The common size reports (also known as vertical analysis) 2. Trend percentage 3. Percentage change (also known as horizontal analysis)

Topic 7 - Managing Working Capital


Learning Objectives List the items making up working capital Discuss the nature and importance of working capital
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Illustrate the working capital cycle Demonstrate the importance of inventory and the techniques available to manage this asset efficiently Discuss the provision of credit to customers and use various management tools to monitor and control this asset Explain the reasons for holding cash, and the basis of management and control Summarise the key aspects of creditor management

The Nature and Purpose of Working Capital


Usually defined as current assets less current liabilities The main elements of current assets are: - Inventory - Accounts receivable (trade debtors) - Cash (in hand and at bank) The main elements of current liabilities are: - Accounts payable (trade creditors) - Bank overdrafts Represents a net investment in short-term assets

Cash sales Finished Goods Trade Receivabl es Raw Material s Inventor ies

Cash / Bank Overdraf t

Work in Progress

Trade Creditor s

Figure 13.1 - The working capital cycle of a manufacturing business

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The management of working capital is an essential part of the short-term planning process There are costs incurred by holding too much and too little of each element Costs include opportunity cost of using these elements elsewhere Needs are likely to change over time Change may be externally driven or result from changes to the internal environment

The Management of Inventories


Inventories are held mainly to meet the immediate requirements of customers and production Manufacturing businesses tend to hold a high proportion of their assets as inventory: - Raw materials - Work-in-progress - Finished goods Seasonality may vary inventory holdings over a year Retail businesses would try and minimise their inventories because of costs e.g. storage, financing, opportunity cost etc.

Forecasts of future demand: Accurate forecasts are key Can use statistical approaches or judgment of staff / managers Financial ratios:

Inventory turnover period =

Average inventory held x 365 Cost of sales

Recording and re-ordering systems: Efficiency is key, should be monitored regularly Decision authority should be confined to a few senior staff Lead-times and likely demand should be determined Buffer levels to deal with uncertainty should be determined

Levels of control: ABC system - a method of applying selective levels of control to different categories of inventory High levels of control and recording would apply to high-value, low-volume A items Lower levels of recording would apply to lesser-value, higher-volume B items Lowest levels of control and recording would apply to low-value, high-volume Category C items
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Stock / inventory management models: Economic order quantity (EOQ): Recognises that total cost includes holding and ordering costs Calculates the optimum size of the order, taking these two components into account Decreasing inventory held means an increase in order costs as the number of orders rises in the period EOQ seeks to identify the size of the order that will minimise the total costs

Figure 13.4 - Inventories holding and order costs The EOQ model:

EOQ =

2DC H

where: D is the annual demand for the item of stock C is the cost of placing an order H is the cost of holding one unit of stock for one year Some limiting assumptions apply to the model: That demand for the product can be predicted with accuracy Demand is even over the period with no fluctuations
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No buffer inventory is required There are no discounts for bulk purchasing

Materials requirements planning (MRP) systems: Begins with forecasting sales demand Technology schedules delivery of bought-in parts to coincide with production requirements By ordering those items of inventory necessary for production, inventory holding costs may be reduced Recognises that ordering decisions cannot be made independent of production decisions Newer systems also take account of other resources such as labour and machine capacity

Just-in-time (JIT) stock / inventory management: Aims to have materials delivered to production just in time for their required use Limits holding time and investment in raw materials Suppliers are informed of production requirements in advance Some disadvantages: May mean inventory is more expensive Risk of non-supply

The Management of Debtors


Selling goods or services on credit incurs costs Costs include administration, bad debts and opportunity costs When a business offers to sell on credit, it must have clear policy concerning: Which customers should receive credit How much credit should be offered What length of credit it is prepared to offer Whether discounts will be offered for prompt payment What collection policies should be adopted How the risk of non-payment can be reduced

Which customers should receive credit? The five Cs of credit: 1. Capital - must appear to be financially sound (liquidity risk) before credit is offered 2. Capacity - must seem able to pay amounts owing (examine payment record / history) 3. Collateral - can the customer offer satisfactory security if required 4. Conditions - how the industry and general economic environment the customer operates in affects their ability to pay amounts owing

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5. Character - a subjective assessment made by the business of factors such as honesty, integrity etc. Length of credit period: The length of credit offered varies and may be influenced by factors such as: The typical credit terms operating in the industry The degree of competition in the industry The bargaining power of particular customers The risk of non-payment The capacity of the business to offer credit The marketing strategy of the business An alternative approach is to view the credit decision as a capital investment decision, using the NPV investment appraisal method Cash discounts (early settlement): The cost must be weighed against the benefits Danger that customers will be slow to pay and still take the discount offered The benefit represents a reduction in the cost of financing debtors and bad debts Collection policies: Steps to ensure amounts owing are paid promptly may include: Develop customer relationships Publicise credit terms Issue invoices promptly Monitor outstanding debts Produce a schedule of aged debtors (refer example below) Answer queries quickly Deal with slow payers Identify the monthly pattern of receipts from credit sales Example of Schedule of Aged Debtors Ageing schedule of debtors at 31 December Days outstanding 1-30 days 31-60 days 61-90 days $ $ $ 20,000 10,000 24,000 12,000 13,000 14,000 32,000 47,000 14,000

Customer A Ltd B Ltd C Ltd Total

>91 days $ 18,000 18,000

Source: Accounting An Introduction 4th edition, Atrill et al, Pearson Education Australia, page 656.

The Management of Cash

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Why hold cash? Most businesses hold cash but the amount held varies considerably There are three reasons for holding cash: Transactionary Precautionary Speculative How much cash should be held? No set formula - different businesses will have different views Amount held can be reduced if funds can be raised quickly or assets held that can be converted to cash such as shares or bonds Controlling the cash balance Use of upper and lower control limits: Assumes business can access cash as needed The model proposes the use of two upper and two lower limits If an outer limit is exceeded, managers must decide if the balance is likely to return over the next few days to within the inner limits, if not, cash must be bought or sold to restore the cash balance to within limits Model relies heavily on management judgement to determine where the control limits are set and what time limits for breaches are acceptable

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Figure 13.5 - Controlling the cash balance Cash flow statements and management of cash: It is useful for a business to a prepare cash flow statements and / or a cash budget Comparison of budgeted cash flows to cash flow statements will identify variances for action Expected cash surpluses and deficits can have a course of action decided upon by management prior to them occurring Operating cash cycle: Definition: The time period between the outlay of cash to purchase supplies and the ultimate receipt of cash from the sale of goods To effectively manage cash, there must be awareness of the operating cash cycle Management seeks to shorten the time and reduce cash required in the cycle Cash transmission: Benefit is received immediately when payment is made in cash Cheques normally incur a delay of up to ten working days to clear through the banking system Opportunity cost of this delay can be significant
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Alternatives to minimise delays can include: - Insist on payment in cash (not always practical) - Utilise direct debit facilities and card payments Are simply a type of bank loan Can be useful for managing cash flow requirements

Bank overdrafts:

The Management of Trade Creditors


Trade credit is an important source of finance for many businesses Tends to increase in line with the increase in sales Widely regarded as free however, there can be costs associated with taking credit: - Cost of goods may rise as credit needs to be paid for - May be given lower priority in terms of delivery dates - Administration costs associated with dealing with invoices and confirming receipt of goods / service

Controlling trade creditors: Using the average settlement period method:

Average settlement period =

Average trade creditors x 365 Credit purchases

Alternative approaches: Ageing schedule Pattern of credit payments

The Operating Cash Cycle - Illustrated


The time period between the outlay of cash to purchase supplies and the ultimate receipt of cash from the sale of goods Retail/Wholesale Business Purchase of goods on credit

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Pay for goods

Sell goods on credit

OPERATING CASH CYCLE

Receive cash from debtors

The operating cash cycle can be calculated using ratios as follows:

Average inventory turnover period (days)

= Average inventory held x 365 Cost of sales

+
Average settlement period for debtors (days)
= Average trade debtors x 365 Credit sales

Average settlement period for creditors (days)


= Average trade creditors x 365 Credit purchases

Topic 8 - Cost-Volume-Profit Analysis


Learning Objectives
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Explain the importance of a detailed understanding of cost behaviour Distinguish between fixed costs and variable costs Use knowledge of this distinction to deduce the break-even point for some activity Explain why knowledge of the break-even point is useful Explain and apply the concept of contribution Explain the concept of a margin of safety Identify the weaknesses of break-even analysis Explain and apply the idea of relevant costing Make decisions using knowledge of the relationship between fixed and variable costs.

The behaviour of costs


Costs can be broadly classified as:

Fixed (those that stay the same when the volume of activity changes) Variable (those that vary in accordance with the volume of activity)

Both types of costs are often associated with an activity, hence the importance to the decisionmaking process of understanding the quantity and impact of both.

Fixed Costs
As the volume of activity increases, the fixed costs stay

Fixed Cost Behaviour

Figure 7.1

Fixed costs: likely to change as a result of inflation or general price increases but not as a result of change in volume of activity are almost always time-based i.e. they vary with the length of time concerned do not stay unchanged irrespective of level of output. They often must increase to allow higher output levels

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Graph of rent cost (R) against volume of activity


This concept is visually demonstrated as follows:

Figure 7.2

Variable Costs

Figure 7.3 The graph above suggests that costs are linear, i.e. normally the same per unit of production irrespective of the number of units produced. In some cases the line is not straight as higher volumes of activity may introduce economies of scale, thus changing the variable costs line as production increases

Semi-fixed (semi-variable) Costs


These costs exhibit aspects of both fixed and variable costs. Part of such costs are fixed and will not change with level of activity while some parts are variable and vary accordingly with changes in level of activity. E.g. electricity costs for heating, lighting and powering machinery. The cost for heating and lighting would remain largely fixed irrespective of production activity, but for powering of machinery, it would increase with production level

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The slope of this line gives the variable cost per unit of activity

Electricit y cost ($) Fixed cost element 0 Volume of activity


Figure 7.4

Break-even analysis
We have established that with fixed costs, increase in activity does not have any bearing on total cost. We also know that variable costs will increase on a per unit basis as activity increases. Break-even point occurs where total revenues equal total costs.

Break-even point can be calculated as follows: Fixed Costs (Sales Revenue per Unit Variable Cost per Unit)

Figure 7.6 Example 7.1 (refer page 358) Fixed Costs = $1,500
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Variable Costs = $6 + $18 = $24 Sales revenue per unit sold = $30 = 150 ($30-$24) 250 units per month

Note: Break-even point must be expressed with respect to a period of time

The Use of Break-even Analysis


Break-even analysis can be used to: Determine the activity level required to cover all costs associated with the business Assess activity level required to achieve profit targets Assess margin of safety - difference between break-even activity and output, provides indication of risks involved

Contribution
Contribution per unit - Sales revenue per unit less variable costs per unit (bottom part of the break-even formula) Marginal cost - The addition to total cost which will be incurred by producing one more unit of output Break-even point can be calculated as:

Break-even point = Fixed costs Contribution per unit

Profit-Volume Charts
Obtained by plotting profit or loss against volume of activity The slope of the graph is equal to the contribution per unit As level of activity increases, the amount of the loss gradually decreases until the break-even point is reached Beyond the break-even point, profits increase as activity increases

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Profit ($)

Break-even point

Volume of activity

Fixed cost

0
Figure 7.8

Note: you will not be expected to draw a profit-volume chart in the exam
Margin of Safety and Operating Gearing
Margin of safety is the difference between output activity and the break-even activity level. Operating gearing is the relationship between contribution and fixed costs. An activity with relatively high fixed costs compared with its variable costs is said to have high operating gearing

Weakness of Break-Even Analysis


Non-linear relationships - relationships between sales revenues, variable costs and volume are unlikely to be straight-line (linear) Stepped fixed costs - most activities will likely include fixed costs of various types with varying step points Multi-product businesses - multiple products make break-even analysis difficult as fixed costs tend to relate to more than one activity, making division of fixed costs across products arbitrary, and consequently the break-even analysis becomes questionable

Marginal Analysis / Relevant Costing


Analysis done to support decision-making where fixed costs are not relevant to the decision. Some examples where relevant costing may be used are: Accepting or rejecting special contracts
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Making the most efficient use of scarce resources Deciding whether to make or buy Deciding whether to close or continue a section

Accepting / Rejecting Special Contracts


In undertaking this analysis, broader issues such as the following may be considered: Is there another customer who would pay more for spare capacity rather than selling it off cheaply Potential loss of customer goodwill as a result of selling the same product at different prices It may be better to reduce total capacity and thereby reduce fixed costs, if inability to sell full production capacity is an ongoing problem Accessing overseas markets may be a means of selling product / excess capacity at a different pricing structure

The Most Efficient Use of Scarce Resources


Sometimes it is a limit on production capacity resulting from factors such as a shortage of labour, raw materials, space or machinery that limits sales potential Limiting factor - Some aspect of the business (e.g. lack of sales demand) which will stop it from achieving its objectives to the maximum extent The most profitable combination of products occurs when the contribution per unit of the limiting factor is maximised

Make or Buy Decisions


Example 7.6 (page 377) Jones Ltd needs a component for one of its products. It can have the component made by a subcontractor who will charge $20 each, or the business can produce the components internally for total variable costs of $15 per component. Jones Ltd has spare capacity. Should it subcontract, or produce the component in-house? Answer: Jones Ltd should produce the component itself since the variable cost of subcontracting is greater by $5 than the variable cost of internal manufacture

Closing or Continuance of a Section or Department

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It is common for businesses to account separately for each department or section in order to assess the relative effectiveness of each one Example 7.7 (page 378) Looking solely at trading results it would seem that the general clothes department is running at a loss to the overall business Further analysis shows that the department makes a positive contribution If the general clothes department is closed, Goodsports Ltd would be worse off to the value of the contribution made

Required activities

For this topic, you are expected to have completed, as a minimum,

Discussion Questions 7.1, 7.2, 7.7, 7.8


Application exercises 7.2, 7.3, 7.4, 7.5, 7.6, 7.7, 7.8, 7.9.

These questions are on pages 381 to 388 of the text book Accounting, an introduction 4th Edition by Atrill, McLaney, Harvey and Jenner. The answers to these questions are available on the Learning Hub.

Topic 9 - Budgeting
Learning Objectives Define a budget Explain how budgets, corporate objectives and long-term plans are related Set out the main components of the budget-setting process Explain the interlinking of the various budgets in the business Identify the main uses of budgeting Construct budgets from relevant data Use a budget to provide a means of exercising control over the business Identify the limitations and the behavioural implications of the traditional approach to control through budgets and standards

Relevant parts of Chapter 9 are: Pages 437 449 Pages 453 457 Pages 464 471
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Note that we will be focusing on the Cash Budget. In terms of exercising control over the business, we will look theoretically at flexible budgets, variances and standards but you will not be expected to prepare a flexible budget or calculate the variances mentioned in your textbook. This is done in further detail in ACCT1060 Management Accounting and Business.

Budgets, Long-term Plans and Corporate Objectives


Corporate objectives - identify the broader goals of the business Long-term plan - defines the general direction of the business over next (e.g.) five years, covers
matters like: Market(s) the business aims to serve Production / service methods Levels of profit sought Financial / financing requirements and methods Personnel and other requirements

Budget - essentially a financial plan for a future time


Expressed in financial terms Converts the long-term plan into an actionable blueprint for the future

The Planning Process

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Identify business objectives

Consider options

Evaluate options and make a selection

Prepare long-term plans (long-term budgets)

Prepare budgets (short-term)

Figure 9.1

Time Horizons of Plans and Budgets


Long-term plans are typically 5 years and budgets typically set for 12 months Not set in concrete - management has discretion Depends on industry e.g. 5 years in an I.T. business would be too long due to rate of change Budgets may also be done on a rolling monthly basis Limiting factors - aspects of a business that stop it from achieving objectives and which must be factored in to the budget

Budgets and Forecasts


Budgets and forecasts are distinctly different: A budget is a plan for a future time, expressed mainly in financial terms Forecasts tend to be predictions of the future state of the environment Forecasts are useful to the planner / budget setter

The Interrelationship of Various Budgets

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In a business, there is not one budget, but several - each relating to a specific aspect of the business Ideally, there should be a separate budget for each person in a managerial position

Trade receivables budget

Cash budget

Trade payables budget

Sales budget

Overheads budget

Capital expenditur e budget

Direct labour budget

Raw materials purchases budget

Finished inventories budget

Production budget

Raw materials inventories budget


Figure 9.2

This may seem a little confusing so looking at a Master Budget for a Manufacturer (next diagram) might help to make more sense of this interrelationship between the budgets.

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The Master Budget


Sales Budget

Production Budget

Direct materials usage and purchases budgets Direct labour budget Manufacturing overhead budget

Operating Expenses Budget

Capital budget

Budgeted Income Statement Budgeted Balance Sheet Cash Budget

Adapted from Jackling, Raar, Williams & Wines, 2007, Accounting a Framework for Decision Making, McGraw-Hill p.718

The Budget Setting Process

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1.
Establish who will take responsibility for the budget-setting

6.
Review and co-ordinate the budgets

7.
Prepare the master budgets

process

2.
Communicate budget guidelines to relevant managers

5.
Prepare draft budgets for all other areas

8.
Review and co-ordinate the budgets

3.
Identify the key or limiting factor

4.
Prepare the budget for the area of the limiting factor

9.
Monitor performance relative to the budgets

Budget committee - a group of managers formed to supervise and take responsibility for the budgetsetting process Budget officer - an individual, often an accountant, appointed to carry out or take responsibility for having carried out the tasks of the budget committee Top-down - an approach to budgeting where senior management originates the budget targets Bottom-up - most of the budget input comes from lower level staff such as sales representatives

The Uses of Budgets


There are five main uses of budgets:
1. 2. 3. 4. 5. Promote forward thinking and the possible identification of short-term problems; Help co-ordinate various sections of the business; Motivate managers to achieve better performance; Provide a basis for a system of control; Provide a system of authorisation for managers to spend up to a limit

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Promote forward thinking and identification of short-term problems

Budgets

Help coordinate the various sections of the business

Motivate managers to achieve better performance

Provide a basis for a system of control

Provide a system of authorisation


Figure 9.3

Preparing the Cash Budget


The cash budget is a key budget - all aspects of a business are eventually reflected in cash The cash budget reflects the whole business more than any other single budget

Most cash budgets feature the following:


Broken down into sub-periods, usually months In columnar form, one month per column Cash receipts and payments identified under headings and a total for each month is shown The surplus or deficit of cash is identified for each month The running cash balance is identified

Preparing Other Budgets


Other budgets are mostly prepared in the same format as the cash budget and may include: - The debtors budget
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The creditors budget The inventories budget

Using Budgets for Control Control is usually seen as making events conform to a plan Budgets represent the plan and therefore provide the basis for exercising control over the business The planning and control process usually follows a sequence which is illustrated on the following slide

The Planning and Control Process

Identify objectives

Consider options

Evaluate options and make a selection

Perform and collect information on actual performance

Prepare budgets (short term)

Prepare long-term plans (long-term budgets)

Identify and analyse differences between plans and actuals (variances)

Respond to variances and exercise control

Revise plans (and budgets) if necessary

(This is figure 9.4 in your textbook it just looks a little different but contains the same steps).

Comparing actual performance with the budget


There are a number of ways in which control can be exercised: The budget is constructed using standards as a base. Standards are planned quantities and costs (or revenues) for individual units of input or output. For example, the standard
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selling price is $100 for every unit of output. (Atrill et al., p. 464). They are developed from experience and require frequent reviews and possibly revisions and they need to be as realistic as possible. A flexible budget can be prepared (i.e. Can flex the budget) o Revise the budget to reflect actual volume of output using the same standards as when the original budget was prepared o Then the flexed budget is compared with actual figures to determine variances between items in the budget Specific variances can be calculated and analysed to assist in decision making. These variances include: o Sales volume variance o Sales price variance o Materials variance o Labour variances o Fixed overhead variances Variances can be adverse (unfavourable) or favourable and significant or insignificant o Small variances (favourable or unfavourable) are not unexpected o Significant adverse variances should be investigated but organization needs to decide what significant means to them o Significant favourable variances should also be investigated as they may indicate that target is too low o Insignificant favourable or unfavourable variances should be monitored o Policy needed to determine which variances to investigate as there is a cost/benefit issue with investigating minor variances o Variances do not solve an issue; investigation of variances can only highlight issues o Adverse variances may occur because standards used to construct the budget are not realistic but it should not be assumed that this is the cause investigation is required to determine the cause of adverse variances.

Behavioural Aspects of Budgetary Control


Research indicates that: Existence of budgets tends to improve performance Demanding but achievable targets seem to motivate more than easy targets Unrealistic targets adversely affect performance Allowing managers to set their own targets improves motivation, commitment and performance

Criticisms of Budgetary Control


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Time consuming and costly to put together Budgets are rarely strategically focused Budgets are out of touch with the needs of modern business

Different budgets needed for planning, control and motivation

Behavioural aspects are often misunderstood, leading to perverse behaviour

Budgets dealing with Increases in technology may lead to more centralisation at the cost of greater involvement

Budgets can be seen as a bureaucratic exercise in costcutting

Budgets may make people feel under-valued A system of accountability may create a counterproductive atmosphere of blame and mistrust When managers are in a position to influence budget figures, the danger of bias exists

Budgets can stifle projects because resources are already allocated

Often associated with an overly inward focus

Budgets may lead to department centredness

Review
Any budgetary control system set up must ensure that: The environment the business operates in is fully understood; The business develops an appropriate culture; The role of the budget in terms of its fit with the strategic plan is clearly understood; A culture of value-adding is developed

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