acct1501 study notes

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Chapter 1 – Introduction to Financial Accounting

The basic purpose of financial accounting is to produce useful info which is used

in many and varied ways.

People use the info generated by financial accounting to improve their

decision-making in allocating scarce resources.

1.2 Financial Accounting

Accounting is a process of identifying, measuring and communicating

economic information to allow informed decisions by the users of that

information.

Financial Accounting – periodic financial statements to external decision makers

(investors, creditors)

Financial accounting measures performance and position

Management accounting – information for planning and performance reports

(internal decision makers)

Financial performance – generating new resources from day-to-day operations

over a period of time

Financial position – the enterprise‟s set of financial resources and obligations at a

point in time

Financial Statements – reports describing financial performance and position

Notes – part of the statements, adding explanations to numbers

1.3 The Social Setting of Financial Accounting

Financial accounting:

o Helps stock market investors – buy/sell/hold

o Helps banks and lenders – lend?

o Helps mangers run enterprises (in addition to help from management acct)

o Provides basic financial records for day-to-day mgmt, control, insurance and

fraud prevention

o Used by govt in monitoring actions of enterprises and in taxes, e.g. GST

Accounting is not a passive force within the social setting – it tells us what is

going on, and in doing so, affects decision making

1.4 The People Involved in Financial Accounting

Main Participants: Information users, information preparers, auditors


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Users

User is someone who makes decisions on his own behalf, or on behalf of an org

User‟s main demand is for the credible periodic reporting of an enterprise‟s

financial position and performance

Main groups of users: Owners, Potential Owners, Creditors and potential creditors,

Managers, Employees, Regulators/govt, Financial and market analysts,

Competitors, Accounting researchers, customers, miscellaneous third parties

Preparers (Decision Facilitators)

Main groups: Managers, Bookkeepers and clerks, Accountants

Auditors (Credibility Enhancers)

Auditors report on the credibility of the enterprise‟s financial statements, on

behalf of owners and others.

Assists users by verifying financial statements have been prepared fairly

Internal and external auditors

Role is to scrutinise the preparation process

External auditors are appointed by the owners – not allowed to be owner or

manager, ensuring that auditor is independent from company‟s – objectivity

Accounting firms offer external auditing, advice on income tax, accounting,

comp systems and many other financial and business topics

1.5 Accrual Accounting

Accrual accounting system, impact of transactions is recognised in the time

period the transactions and expenses occur, rather than when the cash is

received or paid

Revenue – sales of goods or services

Expenses – the costs of services or resources in the process of generating

revenues

Accrual Accounting versus Cash Accounting

Cash accounting records revenues and expenses when the cash is received or

paid.

Problem: timing of cash flow is in a different accounting period to the substance

of transaction – affected by interest rates, exchange rates, depreciation

Using Accrual Accounting to prepare financial statements

Include all the cash receipts and payments that have already happened; for

example, cash sale, cash payment for wages

Incorporate future cash receipts and payments that should be expected, based

on existing transactions


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Measure the value of incomplete transactions (amount of remaining loans can

be recorded as an expense)

Estimate figures when exact amounts are unknown (interest on loans)

Make an economically meaningful overall assessment of awkward problems

1.6 The Key Financial Statements

Balance Sheet – shows an organisation‟s resources and claims on resources at a

particular point in time.

Income Statement – measures financial performance over a defined period

Cash Flow Statement – shows the sources and uses of cash during the period

Retained Profits Note

Balance Sheet

Assets – future economic benefits as a result of past transactions or other past

events – needs to be measured in monetary terms

Assets – cash, accounts receivable, inventory, property

Liabilities – future sacrifices of economic benefits that an organisation is

presently obliged to make to other organisations as a result of past events

Liabilities – goods on credit, bank loans, mortgages, long service leave, warranty

Liabilities – accounts payable, wages payable, provision for employee

entitlements, long term loans

Shareholder’s Equity – excess of assets over liabilities – share capital and retained

profits

Shared capital – amount that owners have directly invested into the company

Retained profits – total cumulative amounts of profits that the company has

retained in the business rather than distributed as dividends

Assets = Liabilities + Owners‟ Equity

Income Statement

Provides info on an organisation‟s profitability for a period of time

Previously called the profit and loss statement

Gross profit = Sales revenue – cost of goods

Income statement – Sales revenue, Costs of goods sold, Gross profit, Operating

expense, profit before tax, profit after tax

Statement of cash flows

Shows the changes of cash during the period in one balance sheet accounting

Shows receipts and payments of cash

Revenues reported usually do not equal cash collected and expenses do not

equal cash paid, net profit is different from the change in cash for the period

Individual transactions split into:

o operating activities (G&S),


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o investing activities (NCA/capital),

o financing activities (equity and certain borrowings)

1.7 Relationships between the financial statements

The cash flow statement explains the change in cash in the balance sheet.

Net profit appears in income statement, also reflected in retained profits note.

1.8 Information use scenarios

Evaluation of CEO‟s performance by member of board of directors

Preparation of buy/sell/hold shares recommendations by financial analyst

Review of company‟s borrow status by bank lending officer

Development of supply contract with the company by a stationery supplier‟s

sales manager.

Demands on the quality of financial accounting information

Relevance – useful, valuable, and timely manner

Reliability – objective, undue error, not deliberately misleading

Materiality – assessing whether omissions, misstatement of disclosure of info can

affect decisions. Judged by size of error compared to net profit, total assets.

Time.

GAAP (general accepted accounting principles) – to assure accepted methods

are followed, auditor‟s opinion is that the statement have been prepared in

accordance with the GAAP, and that the resulting figures are appropriate to its

circumstances.

Prudence – controversial criterion that A, R, P should not be overstated and L, E,

Losses, should not be understated if there is uncertainty. Cautiousness

Disclosure – make clear to reader which acct methods was followed, provide

supplementary info on debts, share capital, commitments and other necessities

in understanding statements

Understandability – reports should be prepared to regard to interests of users,

and making sure they have the ability to comprehend and contempt.

Accounting practices

Comparability – financial statements should be prepared in a comparable way

so companies can determine their performance, as absolute sense is ambiguous

Consistency – Keeping same accounting methods – Following GAAP, changes

in method will be recorded, or record significant events that might have

affected the trend.


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AASB (Australian Accounting Standards Board) – Framework

Understandability

Relevance

- Materiality

Reliability

- Faithful representation (represents what really existed/happened)

- Substance over form (substance and economic reality)

- Neutrality (objectivity, freedom from bias)

- Prudence (caution in estimates)

- Completeness (material info not omitted, not misleading)

Comparability

Tradeoffs among accounting principles

Prudence is a bias, interfering with neutrality and reliability

New AASB to conform with GAAP will mean lack of comparability with other

companies that didn‟t previously use this standard

For the sake of comparability, if other companies change acct methods, a

comp has to decide whether to change or not

↑reliability or ↑costs, ↑time, ↓relevance

1.9 Financial Statement Assumptions

Accrual basis – accrual accounting

Going concern – organisation will continue operations as a going concern in the

foreseeable future

Accounting equity – separate and distinguishable from owner‟s personal equity

Accounting period – discrete equal periods – annual or half yearly or quarterly

Monetary – Measured in common denominator – AUD

Historical Cost


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Chapter 2 – Measuring and Evaluating Financial Position and

Performance

2.1 Introduction to the Balance Sheet

Contains 2 lists that have the same dollar total

Describe enterprise‟s financial position at a particular date

List 1: resources/assets

List 2: Liabilities (existing obligations to be paid in future), Shareholder‟s equity

(amounts received from owners, involve permanent financing but do not have

to be repaid, and any past accrual profits)

Assets = Liabilities + Owner’s Equity

Must have Company Name and “Balance Sheet as at DATE

2 styles – side by side: vertical:

Assets:

Useful Financial

Resources

Liabilities:

Obligations to be

paid

Equity:

Owner‟s Investment

Assets:

Useful Financial Resources

Liabilities:

Obligations to be paid

Equity:

Owner‟s Investment

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

Assets

Assets are resources controlled by the entity as a result of past events and from

which future economic benefits are expected to flow to the entity.

Three essential characteristics – future economic benefits, control by the entity,

occurrence of past transactions of past events

Future economic benefits – as assets are used to provide G&S for exchange,

aiming to generate net cash flows

Control by entity – relates to whether an entity can benefit from asset, and to

deny or regulate access of others – public good


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Occurrence of past transactions or other past events means that the transaction

giving the entity control over benefits must have occurred

Other assets may include happy employees or safe working environment

However they do not count into balance sheet

- Cannot verify dollar cost

- Difficult to measure reliability – how much more productive?

- Enterprise does not own employees – don‟t have economic control

Expenditure on market research not an asset – impossible to calculate future

benefits at date of expenditure.

Current assets – sold / used / collected within 1 year.

Liabilities

Liabilities are present obligations of the entity arising from past events, the

settlements of which are expected to result in an outflow from the entity of

resources embodying economic benefits.

Two essential characteristics

A present obligation exists and involves settlement in the future via the sacrifice

of future economic benefits.

- Legally enforceable – contracts – money borrowed, credit

- Imposed on entity – e.g. tax payable, or damages awarded by courts

- Normal business transactions to maintain a good – e.g. warranty

Adverse financial consequences for the entity, in that the entity is obliged to

sacrifice economic benefits to one or more entries

Requirement of obligation means that liability occurs if enterprise has already

received a benefit, e.g. received cash from bank

Equity

Equity is the owner‟s interest in the enterprise.

Can be direct contributions from shareholders/owners

Can be derived from profit that are not collected – e.g. dividends that have not

been distributed

Assets represent pool of resources provided by all sources – regardless of

whether it is provided by owners or not.

Book value of enterprise = residual or net concept of equity

Book value is arithmetically valid idea, but does not tell very much. Impractical

when companies go out of business, because equity (money returned to owners)

will not simply be calculated by the difference between A and L.

Shareholder‟s equity is generally based on historical transactions, and does not,

except by coincidence, equal the current market value of business.

Retained profits or retained earnings represent past accrual profit not yet given

to owners.


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

source of assets

2.3 Some preliminary analysis of the sound and light balance sheet

Soundly financed?

- Assets come from liabilities – look at where assets come from

- Debt to equity ratio – L/E

Pay bills on time?

- Able to turn current assets to cash

- Look at current liabilities and cash

- Current assets – current liabilities = ___ in working capital

- Working capital / current ratio – CA/CL

Company‟s ability to sell inventory to pay for bills

- Quick ratio/ Acid test ratio – Cash + AR / CL

- If less than 1, then that means company has to sell inventory to get pay L

All ratios are only indicators

Should owners declare for dividend?

- By taking out dividend, decreasing retained profits, they decrease cash.

- This can create cash strain

- Most retained earnings are reinvested in land, equipment, inventories, so less

cash

Equipment / Depreciation:

- In calculating profit, accumulated depreciation counts as an expense

- Net book value of equipment = cost of equipment – accumulated

depreciation

- Accumulated depreciation is a negative asset

2.4 A closer look at the balance sheet

Comparative balance sheets:

- Contains figures for 2 periods, to help users recognise changes.

- Recent on the left, closer to words

Remember to look for notes when studying financial statements

Buildings (net) – means the accumulated depreciation has been deducted

Prepayments are prepaid expenses that have been paid for, for which the

benefits have not been received.

Intangible assets – noncurrent assets that have no physical substance –

copyrights, patents, trademarks, brand names and good will.

Accrued expenses relate to expenses that have been incurred during the year,

but not yet paid – wages, electricity bills

Employee entitlements can be current or non-current


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Where do the figures come from?

Accounting is generally a historical measurement system

Assets are generally valued at what they cost when they were acquired

Liabilities are generally valued at what was promised when the obligation arose

Other terms/notes

Usually, accrued expenses and accounts payable is joint into payables account,

but will be separated in the notes

Sometimes use different terms – payables liabilities (no interest) and interest-

bearing liabilities (such as loans, which incur interest)

Current tax liabilities – estimate of the amount of income tax to be paid in next

financial year

Deferred tax liabilities –

- current profit > profit reported on tax return, liability for income tax is implied

for later

- current profit < profit reported on tax return, deferred tax asset – govt has to

pay tax paid back

Derivative financial instruments used to reduce exposure to foreign exchange

and interest rate risks

2.5 Maintaining the accounting equation

Assets = Liabilities + Owner‟s Equity

Double entry system – where accounting equation is always in balance

2.6 Managers and the Balance Sheet

Balance sheets are important, because outsiders read it.

Balance sheet reports what the organisation‟s position is at a point in time.

Shows assets that management has chosen to acquire

Provides useful picture of the state of organisation

Balance sheet does not state how management has performed in using assets

to earn profit

2.7 The Income Statement

Might measure company‟s fin performance by closing it down, selling it, paying

off liabilities and see whether money left was more than money owners put in


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But this is too drastic just to find out performances.

Income statement uses accrual accounting to measure financial performance

over a period of time, usually a year, 6 months, 3 months.

Net profit for the period = Revenues – Expenses

Revenues

Increase in company‟s wealth arising from the provision of G/S

Wealth increases due to increase in cash, promise for cash or pay with other

forms of wealth, such as providing other assets, or forgiving debts

Interests and dividends

Test for revenue – whether the good or services have been rendered (provided)

Expenses

Expenses are the opposite of revenues

Decreases in company‟s wealth incurred in order to earn revenue

Wealth decreases due to costs of G/S, giving assets to customers, and wear and

tear of long term assets

2 cases when goods are sold – enterprise is better off because of revenue

gained and enterprise is worse off because of cost of goods and services

customer takes away

Start with asset account of inventory of unsold goods, transferred to expense

account of cost of goods sold

Whether the firm makes profit depends on whether R > E.

Separate account of Expenses with Revenue

Profit

Net profit = net inflow of wealth to the company during the period

If net profit is negative = net outflow of wealth = loss

Expenses include costs of earning revenue – taxes (not including dividends),

depreciation...

The relationship of profit for the period to retained profits

Retained profits is the sum of past net profits since the firm began, minus

dividends declared (even if not yet paid)

Through retained profits, balance sheet can be said to reflect everything that

happened from the beginning – a historical information system

Transactions with owners are taken out of RP, not an expense

Owners can be creditors too, if they are owed dividends, or if they lent the

company money in addition to shares they bought


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2.8 Connecting Balance Sheets and Income Statements

CA + NCA = CL + NCL + SC + Op. RP + R – E – D

2.9 A close look at the income statement

Income statement covers period in time not point in time

Subsidiary is considered a controlled entity when parent company has the

capacity to dominate decision-making

Consolidation basically involves totalling revenues and expenses of parent entity

and all the subsidiaries after eliminating any transactions between these entities

When calculating retained profits, use profit AFTER tax.

2.10 Capital Markets, Managers and Performance Evaluation

Importance placed on “bottom line” – profit figure and components

The Australian or the Australian Financial Review show announcements of

company‟s annual or half yearly profits.

Emphasis on profit – never any data on non-financial performance, LT issues, or

managerial efforts

Announcement show sales, profits before and after tax (net), earnings per share

(EPS), interim and financial dividends per share data (ff, p), present share price

Per share data used by investors – e.g. own n shares, so earn 0.355n $

Share market prices and profit announcements tend to end up moving in the

same direction, so they are correlated

Managers should be conversant about how his or her performance is measured

in the income statement

2.11 Capital Markets, Managers and Performance Evaluation

Public sector organisations are required to provide balance sheets that discloses

the A,L, E of the govt department

Also an income statement (before June 2001, was called operating statement)

Accumulated surplus or deficit = retained profits for private companies

Reserves

Income Statement

Emphasis on cost of services

Operating revenue is separate and deducted from operating expenses

After net cost of services are included, other revenues are included

Liabilities such as super is included in employee entitlements in addition to

salaries


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When govt takes over liability, providing an appropriation, therefore recorded as

revenue

The income statement enables users to identify:

- cost of services provided by the department during the year

- extent to which costs were covered by revenue

- source of revenue

- changes in resources controlled during the period as a result of operations

Chapter 2 Appendix – Background: Sole Traders, Partnerships,

Companies and Financing

A2.1 Four Kinds of Business Organisation

Two general kinds of equity:

- Directly contributed equity – owners provide money or other assets to

enterprise

- Indirectly contributed equity – owners allowed profits to remain, to help earn

more profits in the future...

Types of owners depends on what type of business organisation

Sole Trader

One owner (the proprietor)

Unincorporated – does not legally exist separately from owner

Cannot distinguish between the owner‟s direct contributions to the business and

the indirect contributions by retained profits – both lumped together as owner‟s

capital

Balance sheet:

Owner’s equity

Owner‟s capital $XXXX

Partnership

More than one owners

Unincorporated

Not separate legal entities, and all partners are all personally responsible for

debts of partnership

Since owner‟s personal assets can be claimed by business creditors, there is

somewhat arbitrary distinction between business and personal affairs

Similar to sole trader, lumped together as owner‟s capital


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As with sole traders, partnerships are not legal entities, but are considered

separate entity from partners

Balance sheet:

Owner’s equity

Partner‟s capital:

Partner A $XXXX

Partner B $XXXX

Partner C $XXXX

Total Capital $XXXX

Company

Legal entities under corporations law

Capital is divided into shares – owners = shareholders

Separate legal entities – can buy, sell, own assets, enter contracts and sue and

be sued

Limited liability in the event of failure – shareholders are not liable for debts once

shares have been paid for in full

Ease of transfer of ownership and increased borrowing powers

Shares can be sold freely, and transfer of ownership does not affect continuity of

operations

Companies may issue debentures or unsecured notes.

Debenture – document that evidences an undertaking by comp to repay

particular amount at or before an agreed date, and to pay interest at an

agreed rate a specific intervals

Debt may be secured over floating charge or all assets, or specific charge over

certain assets

Public company can invite public to subscribe to their share capital by

prospectus (listed ones are on ASX)

Private companies (Pty Ltd) cannot invite public and has a limit on number of

shareholders (50) and other restrictions and transferability of shares.

Company: Forms of Share Capital

When shares are first issued, money received comes in as shared capital

Second time sold, money is not received by company but shareholder

Therefore, the millions of transactions on ASX that occur do not affect

company‟s financial statement

Several classes of shares:

Ordinary shares – owners votes – basically residual owners, deciding who will be

on the board of directors and managers

Preference shares or otherwise special shares – owners usually do not vote, but in

return they have rights, such as receiving fixed dividend, or preference in asset

distribution if company liquidates

Class A, Class B and other categorisations – vague terms, because complexity of

rights often prevents simple categorisation such as ordinary or preference


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Face of balance sheet or notes will list all kinds of shares, and specify rights

Cash received is property of company – owners have no right to get money

back, except in specific circumstances

Company: Retained profits

Profits can be paid to owners in the form of dividend or retained within company.

Balance sheet:

Shareholder’s equity $

Share capital:

Class A Shares XXXX

Class B Shares XXXX

Total issued capita XXXX

Retained Profits XXXX

Total Shareholder‟s equity XXXX

Corporate Group

Groups of many companies

E.g. Woolworths, BHP Billiton, Commonwealth Bank

Balance sheet represent what group looks like as a consolidated economic

entity, although there is no such legal entity

Looks like that of single company, with shareholder‟s equity section representing

equity of primary, parent, company in grouo

A2.2 Business Financing

Non - Current Liabilities (debts due more than a year in the future)

Mortgages and other debts extending several years

Special loans from owners, LT tax estimates, estimated liabilities to be paid to

employees in the future

Owner‟s equity

Sole trader and Partnership – owner‟s capital

Company – shared capital received for each kind of share + retained profits (+

other items if legal or accounting complexities require them)


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Chapter 3 – The Double Entry System

3.1 Transaction Analysis + 3.2 Transaction Analysis Extended

A = L + SE

CA + NCA = CL + NCL + SC + RP

CA + NCA = CL + NCL + SC + Op. RP + Profit - Dividend


Set out:

- Assets – Cash, AR, Inventory, Land and Building, Equipment

- Liabilities – AP, Notes Payable, Wages Payable, LT Loans

- Equity – SC, R, E, Dividend

3.3 Recording Transactions: Double-entry Bookkeeping

System of debits and credits

Balancing Equation : A = L + SE


A + E + D = L + SC + Op. RP + R

↑D, ↓C ↑C, ↓D

Resources = Assets

Sources = Liabilities / Equity

Therefore sum of credits must = sum of debits

Transactions measured in terms of country‟s currency (AUD)

Recording transactions = entry

Records of transactions = journals / journal entries

Entries are transferred and summarised in accounts, which lie behind all amounts

and descriptions shown on balance sheet

All accounts collected together = ledger accounts

Accountants makes a list of account balances from ledger to make sure Dr = Cr.

(this list is called the trial balance)

All accounts put together = balance sheet

Each double entry record names one (or more) account that is debited, and

one (or more) that is credited

Double entry records = journal entries – each journal entry, sum Dr = sum Cr


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3.4 More about Accounts

An account is a record of the dollar amounts comprising a particular A, L, E, R or

Exp.

Net effect of these amounts is debit or credit, and is called the accounts

balance

3.5 How Debits and Credits Work

Negative asset = contra asset – has credit balance, e.g. accumulated

depreciation

3.6 Debits and Credits, Revenues and Expenses

Accounting accumulates information about activities

Financial statements are prepared from the accounts that are produced as the

information is accumulated

Double entry recording system creates a set of accounts which is in balance (Dr

= Cr)

From these accounts are produced:

- The income statement

- A note to the accounts showing a statement of retained profits, the bottom

line (ending retained profits), which transfers to

- The balance sheet, which summarises all accounts

3.7 Arranging accounts on the balance sheet

Placement of CA, NCA, CL, NCL, E allows for calculation of meaningful ratios

and other analysis

Thus balance sheet is “classified” – because it is classified into meaningful

categories

Moving items around within Balance sheet is called reclassification

Reclassification done by accountants whenever it is thought to improve

informativeness of financial statement

Three examples of account classification

Current and Non-current portions of noncurrent liabilities

- Liabilities e.g. mortgages, bonds, debentures

- Thus accountants need to reclassify the amount to be paid on principal

within the next year (to Current) and the residual to non current

- Interest owing but not paid is a separate liability


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Bank overdrafts

- E.g. bank overdraft of $500

- This means bank allowed company to remove $500 more cash from

account than there was in it, in effect, lending comp $500

Two ways of representing this:

- Other assets of $12400 minus bank overdraft of $500 = L & E of $11900

- Other assets of $12400 = L&E of $11900 + bank overdraft of $500

Negative amounts left as deductions

- Some negative amounts are left as deductions unlike the bank overdraft

- E.g. accumulated depreciation – left as a negative deduction for asset

Three ways of representing this:

- Shown on RHS of balance sheet (before it was, and in some countries still is)

- Separate disclosure as a deduction on LHS of balance sheet, but since

many types of assets and depreciation amounts –can make sheet clustered

- Could be deducted from assets cost, so net book value of assets could be

disclosed on balance sheet, but not the accumulated depreciation

This method is becoming more popular, accompanied by note to fin

statements, listing cost and accumulated depreciation amounts separately

3.9 Cash versus accrual accounting revisited

Accrual accounting

Cash sale would increase by revenue and cash in that period

Credit sale will ↑AR and R in that period

When the cash is paid,

AR ↓, Cash ↑

Way accrual financial accounting info is assembled:

- Cash

- Credit transactions

- ST/LT adjustments are needed to prepare financial statements, unless the

comp‟s accounting system is sophisticated enough to have already built

them in

- Extensive narrative and supplementary disclosures (e.g. notes to financial

statements)


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3.10 Example: Simone’s Jewellery Business

Difficulties of accrual accounting:

Accrual profit requires extra calculation – more complex – cause confusion as it

leaves more room for error than the simpler calculation

Accrual profit differ from cash profit, differ from change in amount in bank

Accrual accounting can be a lot more complicated – tax, rent, time...

3.11 Public Sector Issues

During 1990s, all govt moved from cash based acct system to accrual based

acct system


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Chapter 4 – Record Keeping

4.1 The Importance of Good Records

Complete and accurate records provide observations and history of enterprise

This is used by investors, managers to plan for future

Records cost money

Records provide:

The basis for extrapolations into the future

Info for evaluating and rewarding performance

Basis of internal control over existence and quality of enterprise‟s assets

4.2 Financial Accounting’s Transactional Filter

Accounting is an info system to filter and summarise data.

Economically efficient to have 1 system organise data into information on behalf

of the various users

E.g. of summarising and organising – daily newspaper

Like newspaper, info system e.g. financial acct is limited.

Only report what sensors pick up as it seeks out data or filters data

Data bank: ledgers, journals (the books) and supporting records

Recording – Classifying... = Bookkeeping

Information = accounting or reporting

Accounting reports are limited by the collected data

Transaction – recorded

Not transaction – routine accounting system ignores event

Two general kinds of transactions – cash transactions or credit transactions

Non transactions – natural disasters/ incidents, future delivery, land value ↑/↓


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Financial accounting transaction – fundamental eco or legal characteristics:

- Exchange – must involve exchange of G/S, $, legal promises, items of eco

value

- Past – exchange must have happened

- External – exchange must be between entity and another party

Supplementary characteristics needed for accounting‟s record-keeping:

- Evidence – must be some documentation – paper/electronic

- Dollars – must be measured in the currency relevant in country where

transaction happens (AUD)

Following transaction characteristics define nature and value of fin acct info:

1. Transactions linked to legal and economic concept of exchange (bounded

by legal contract – including $ transactions)

2. Constitute large part of underlying rationale for historical cost basis of

accounting, founded on accounting (history – has to have happened)

3. Characteristics of transaction provide basis on which records can be verified

(audited) later as part of the process of ensuring info is credible

5 key points – exchange, past exchange, external party, evidence, dollars

Adjustments/ adjusting journal entries in data bank – when accountant is not

satisfied with set of data and wishes to alter some event which is important

RHS – information – deciding on adjustments, deciding on reporting format,

making supplementary notes...

4.3 Accounting’s ‘Books’ and Records

Accounting cycle

1. Source documents

2. Prepare journal entries

3. Post to ledgers

4. Prepare trial balance (collection of ledger accounts – Dr = Cr)

5. Prepare adjusting journal entries

6. Prepare adjusted trial balance

7. Prepare closing journal entries (close revenue, expenses and dividends to RP)

8. Prepare post-closing trial balance

9. Prepare financial statements

Source Documents and transactional style

Source documents show that transactions have occurred

Documents are kept so that the accounting records can be checked and

verified to correct errors; permit auditing; used for disputes; support income tax

claims and other legal action.


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Discounts after ordering: cheque will be less than amount owed

Debit AP, Cr Cash discounts received (other revenue account)

Journal Entries

Record accounting transactions

When business event is first recorded by acct system

Basic transactional records are often called books of original entry

A journal entry can list as many accounts as are needed to record transaction,

but each journal entry must be recorded, so sum of debits equals sum of credits

Dr left, Cr right

Omit $

Traditional to write short explanation called narration below each entry as a

memorandum of what the recorded transaction was about (not compulsory)

Every journal entry must be dated and is usually numbered

Posting reference is given to indicate the ledger account to which each journal

entry is posted. Number obtained from company‟s chart of accounts.

Enterprises with many transactions to record do not create separate entry for

each transaction, but instead use special records for each routine kind of

transaction... e.g. sales journal, cash receipt journal, cash payment journal and

purchases journal

Posting to ledgers

Ledgers are books or computer records that have a separate page or account

code for each individual account referred in the books of original entry

Where T accounts come in – to illustrate simpler version of ledger accounts

General ledgers – collection of all the A, L, E, R, Exp, summarising the entire

operations of business

Subsidiary ledgers – AR, AP – balance isn‟t based on Dr, Cr, but sum equal

amount in primary account in general ledger

Trial Balance

Balanced journal entries > general ledger accounts > balanced balance sheet

There is always a little uncertainty on whether standard bookkeeping procedure

ensures that ledger adds up all Dr and Cr and makes sure they equal

Therefore calculation is called trial balance

What to do when trial balance doesn‟t balance?

Re-add trial balance

Check posted journal entries to correct side of ledger accounts

Check that each ledger account is balanced correctly


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Check that each journal entry balances (Dr = Cr)

Determine difference between Dr and Cr and look for account with that

amount – maybe left out ledger balance

Difference / 2 and look for that amount – means posted to wrong side of ledger

account

If difference is divisible by 9, maybe transposition error – 21 instead of 12, 72

instead of 27

Sometimes trial balance cannot pick up error

Adjusting Entries

At end of each acct period, it is necessary to adjust Rev and Exp accounts

Splitting between accounting periods – e.g. prepayments for insurance

Closing entries

Needed to facilitate preparation of financial statements

Needed to prepare accounting records to begin next period

Closing entries formally transfer the balances of the revenue and expense

accounts to a profit and loss summary, then to retained profits

Closing entries also reset the rev and exp account balances to zero to being

records for the next accounting period

P&L summary account to decreases everything to 0

Debit sales account to zero, credit expenses account

Debit profit and loss summary account

Then, to balance P&L account, clear it by debiting P&L

Credit retained profits

Post closing trial balance

Put together ledger accounts to see if Dr = Cr

Financial Statements

P&L summary account > Income statement

Post-closing trial balance > Balance sheet


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4.4 An Example: Northern Star Theatre Company

Source documents

General Journal

General Ledger

General Ledger trial balance

General Journal (with adjustments)

General Ledger

General Ledger trial balance

Closing entries – returning everything to 0, dr revenue, cr P&L

Financial statements – Retained profits, income statement, balance sheet

4.6 Electronic Commerce

Electronic commerce (e-commerce) is a challenge to financial accounting and

internal control, because of the absence of “paper trail” that has traditionally

supported accounting records.

E.g. moving away from cash and cheque, but using lots of credit cards or

EFTPOS.

Employees are being paid by deposits in personal bank accounts

Implications of e-commerce

- Needs to be compatibility between computing systems for proper

recognition of accounting systems on both sides of transactions

Trust in electronic media to make system work

- Tendency for records and payments to be speedier and separate from

movements of product, means in-transit items can be a challenge to control

and reconcile

- Not only financial statements must be right, but also the underlying records –

for business partners‟ enquiries to be answered reliably

Paradox: e-commerce works without paper but demands a good trail of

evidence

4.7 Managers, Bookkeeping and Control (Importance of bookkeeping to managers)

Bookkeeping and its associated record keeping:

- Provide underlying data on which accounting info is built

Decisions and evaluations may be constrained on nature of underlying data

- Provide data and systems used in meeting management‟s important

responsibilities to safeguard assets and generally keep the business under

control


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The process of accounting also applies to public sector organisations

Accumulated funs = Public sector equity

Recurrent appropriation = govt revenue

User charges = revenue

Grants and subsidies = expense


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Chapter 5 – Revenue and Expense Recognition in Accrual

Accounting

5.1 Conceptual Foundation of Accrual Accounting

Revenues are inflows of economic resources from customers earned through

providing goods or services.

Expenses are outflows of economic resources to employees, suppliers, taxation

authorities and others, resulting from business activities, to generate revenue and

serve customers.

Incurring expenses are the cost of earning revenues.

Net profit is the difference between revenues and expenses over time.

Net profit is the measure of success in generating more revenue and it costs to

do so.

Features

Revenue and expenses refer to inflows and outflows of economic resources.

Involve phenomena that arise before or after cash changes hands, as well as

the point of cash flows

Net profit is dependent on how revenues and expenses are measured.

A conceptual system for accrual profit measurement

Need system that recognises revenue and expense before, at the same time

and after cash flows.

Accrual method includes cash accounting

Summary

Revenue before cash collection – form asset account (e.g. Accounts receivable)

Expense before cash payment – form liability account (e.g. Accounts payable)

Unearned revenue – liability

Expense after cash payment – asset

Before cash After cash

Rev Asset Liability

Exp Liability Asset


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5.2 Accrual Accounting Adjustments

Adjustments involved implementation of routine accruals, such as those

mentioned above

Sophisticated accounting systems go beyond transactional records and

routinely include many adjustments

Simpler systems make adjustments at year end in a special set of journals

Many small companies don‟t bother until financial statements are needed

Follow double entry format:

- After each adjustments, A=L+E still balances

- Sum of credit = sum of debit

Adjusting journal entries – purpose: augment transaction based figures, add story

told by transactional records.

Objective of accrual accounting – improve measurement of financial

performance and position

Accrual > cash – provides more complete record, more representative of

economic performance

Four main types of routine adjustments:

- Expiration of assets (after prepayments)

- Unearned revenues

- Accrual of unrecorded expenses

- Accrual of unrecorded revenues

Expiration of assets

Prepayments – assets that arise because an expenditure has been made, but

there is still value extending into the future

Usually current assets

Arise whenever payment schedule for an expense does not match the

company‟s financial period – e.g. insurance premiums where policy date

doesn‟t match financial year

Prepaid expenses do not have market value, but they have economic value

because future resources will not have to be used

E.g. insurance, advertisements

Prepayment DR Prepayment Expense DR

Cash CR OR Cash CR

Prepayment Expense DR Prepayment DR

Prepayment CR Prepayment Expense CR


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Unearned Revenues

Unearned Revenue – future revenue where the cash has been received before

earning revenue (deposits)

E.g. newspaper or magazine subscription companies, or airline, phone,

membership

Cash DR

Unearned Revenue CR

Unearned Revenue DR

Sales Revenue CR

Accrual of unrecorded expenses

Involves determining which expenses have been incurred by the organisation

(but not paid in cash) during a particular time period

Involves checking which invoices have been received from suppliers,

incorporating that info into accounting systems (e.g. AP), and making estimates

for expenses for which invoices have not yet been received

Accrued expenses

E.g. wage expense – end of pay period and end of financial period occur on

different days

Wages Expense DR

Accrued expense CR

Accrued expense DR

Cash CR

Accrual of unrecorded revenues

Accrued revenue

Occurs when a service has been provided but cash will not be received until the

following period

Interest revenue, unbilled revenues, commissions earned

Accrued Revenue DR

Revenue CR

Cash DR

Accrued Revenue CR


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Multicolumn Worksheets

Useful device to help prepare financial statements

Pre adjusted

Trial Balance

Adjusting

Entries

Adjusted Trial

Balance

Income

statement

numbers

Balance sheet

numbers

5.3 The Financial Period

As businesses run continuously, financial statements are prepared at specific

points or periods in time

2009 net profit is a measure of economic value added by the project during that

year

IF there are 2 cash inflows – 2008 and 2009:

- If 08 cash > 08 revenue, then unearned revenue will be set up

- If 08 cash < 08 revenue, then account received set up

Companies have initial choices about when the financial year begin and end.

Once they made their choice, reasons relating to habit, legal and tax rules force

them to stay with the choice

Australia – 30 June is most common

US, Canada, Singapore – 31 December

UK, NZ, Japan – 31 March

Possible in Australia to use substituted accounting period for taxation purposes

5.4 Introduction to Accounting for Inventory

Several different methods for controlling inventory

Most popular – perpetual inventory control method (compared to periodic)

Under perpetual method, inventory is an asset

- Inventory bought – debit inventory account

- Inventory sold – debit cost of goods sold, credit inventory

- 2 entries are required for sales – (revenue and cost of goods expense)

- Return of sales also require 2 entries

5.5 Contra Accounts

Just about every balance sheet account can be considered a control account

Amounts in accounts should be supported by detailed lists or subsidiary ledgers

Sometimes want to change account, and at the same time reluctant to.


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Worried that company might not be able to collect all money back from

customers. Want to recognise bad debts. However that means crediting

accounts receivable. But at the same, since we have not given up on collecting

debts, we should not do that.

Property and plan are being used up economically. Want to record

depreciation expense. But do not want to change asset cost account, because

costs are not changing, but rather economic value is being used.

Contra account set up to allow recognition of expense and related value

changes without changing control account

Contra accounts have balances that are in opposite direction to those of the

control account in which they are associated

Contra accounts only have meaning in conjunction with the control accounts to

which they match.

Most common: accumulated depreciation (amortisation), doubtful debts

receivable

Accumulated Depreciation (Amortisation)

Accumulate depreciation on fixed assets (e.g. buildings and equipments)

DR Depreciation Expense

CR Accumulated Depreciation

Accumulated Depreciation relates to asset account of buildings

Showing both allows users to make rough guess on age of asset

Depreciation expense shows how much depreciated during that period

Accumulated depreciation shows total amount the buildings have depreciated

by

Net book value = cost – accumulated depreciation

Contra account is only meaningful in comparison to the cost. When the asset is

gone/sold, neither account is needed anymore.

E.g. Truck bought at 50,000. Depreciates at 8,000 each year. Sold at end of 2nd

year for 37,000

Net book value of truck = 50,000 – 16,000 = 34,000

Journal Entry for selling truck:

Cash 37,000

Truck asset 50,000

Accumulated Depreciation 34,000

Revenue on sale of truck 3,000

When non-physical assets, e.g. goodwill, patents and trademarks are amortised,

the accumulated amortisation account is used instead of accumulated

depreciation


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5.6 Accounts Receivable and Contra Accounts

Accounts receivable – when revenue is recognised but uncollected

DR accounts receivable, CR sales revenue

Such receivables are often called trade receivables

Valuation of accounts receivable

Receivables are valued on BS at lower of cost (original transaction value +

interest charges) or net realisable value (amount expected to be collected)

If collectable amount < expected amount, receivable must be reduced to an

estimated collectable amount.

This is done by subtracting an allowance for doubtful accounts from the

accounts receivable balance

Estimated amount collectable = Trade receivables – allowance for doubtful

debts

Therefore allowance adjusts net value down to the lower of cost and current

estimated collectable amount

Other receivables

2 other main types of receivables. If they are large, they are shown separately.

If they are not large, together, they‟re called “other debtors”

Notes receivable –

- Supported by signed contract specifying payment schedule, interest rate

and often other legal details.

- Used for large or long term receivables, e.g. motor cars, house, appliances

and loans by banks and finance comps

Other receivables:

- Loans to employees, officers and shareholders, associated companies, tax

Refunds Company is waiting for and other receivables not arising from

revenue transactions.

- Accounted for and valued same as AR and notes receivable.

- Usually arise from peculiar circumstances, where company disclose reasons.

Allowance for doubtful debts

There is always a risk where customers will fail to pay

Therefore portion of debts will be doubtful and portion should be deducted from

revenue in determining profit for the period

To recognise expense:

DR Bad Debts Expense

CR Allowance for doubtful debts


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Reason for not deducting directly – to keep balance between accounts

receivable and list of individual accounts.

Company may still try to collect on the accounts

After pursuing non-paying customer for months, company may decide to write

off account.

Then:

DR Allowance for doubtful debts

CR Accounts Receivable

Allowance can be seen as a temporary holding account for amounts the

company believes will not be collected, based on past experience and an

assessment of outstanding accounts.

Another way of writing: Direct write off method

DR Bad Debts Expense

CR Accounts Receivable

Used when company has few accounts receivable or when large account not

included in allowance suddenly goes bad

Purposes of contra accounts are to provide useful information to the readers of

financial statements or to assist in accounting‟s internal control functions

5.8 Managers and Accrual Accounting Assumptions

Accrual accounting‟s purpose: to move beyond cash flows towards a broader

economic concept of profit and financial position.

Implications from a managers point of view:

- Fair evaluation of managerial performance

- Limitation accrual accounting, basing on history reflects on the past rather

than looking into the future, as managers are inclined to do

- Only look at the resulted actions, not the reason why mangers initiated

action

- Evidenced based accounting procedures for recognition of profit and

expenses may not relate very well to economic concepts of earnings, or

manager‟s struggles to increase the value of their companies

- To managers seeking even handed evaluation of their performance,

accounting may seem downwardly biased in its measures

- Criteria for revenue and expenses recognition is subjective –some managers

manipulate, some managers find it too loose and flexible

- The shorter the time period, the more mismatch the figures are between

cash flow and accrual profit

Accrual accounting has many advantages and is very widely used, but

managers should not accept it uncritically


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5.9 Accrual Accounting in the public sector

Since 1995, local governments in Australia have been required to produce

financial statements using accrual accounting

Since 1994 – NSW govt. 1999 – all govt

Key differences with accrual accounting:

Non-cash assets and depreciation

Value of receivables and payables

Liabilities (employee entitlements)

Changing value of financial assets and liabilities (exchange rate)

Cost and revenue of government activities

Cost of consuming assets – expense (e.g. depreciation)

Value of goods and services received for free from other bodies (revenue)


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Chapter 5 Appendix – Special Journals, Subsidiary Ledgers and

Control Accounts

Business with small set of transactions – initially recorded in general journal, then

posted to general ledger

Complex business – rather than info captured in 1 journal and posted to 1 ledger,

system of special journals, subsidiary ledgers used

Special journals – allow easy recording of the most common transactions

undertaken by a business

Subsidiary ledgers present detailed analysis of info that is eventually transferred

to general ledger account

Sales invoice >>> Journal Entries + Subsidiary ledger AR >>> General Ledger, Trial

Balance

General ledger account called debtors or Accounts receivable

A5.1 Prime Entry Records: Special Journals

Special Journal : Transaction Recorded:

Sales Credit sales of inventory

Purchases Credit purchases of inventory

Cash receipts All cash inflows (including cash sales)

Cash payments All cash outflows (including cash purchases)

Each entry represents a transaction that belongs to the same class as others in

the same journal

Transactions not in special journal are recorded in general journal

Advantages of Special Journals:

- Recording efficiency

- Amounts posted from special journals to general ledger as totals, rather than

individual journal entries

- More than one user can update accounting system, because it consists a

number of related subsystems

- Nature of transaction eliminates need for narrations

- Info such as receipt or invoice number may be recorded for narrations

- Additional info can be added for convenience as it is available from source

documents, e.g. discounts

A5.2 Subsidiary Ledgers and Control Accounts

Most common way of accommodating need for detailed records in the

accounting system, without grossly expanding number of separate general

ledger accounts


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Subsidiary ledger – a set of ledger accounts that collectively represents a

detailed analysis of one general ledger account classification

Relevant account in general ledger is called the control account

Accounts in subsidiary ledger can be periodically checked against total data

and balance in control account

Examples of general ledger accounts that have subsidiary ledgers:

- Debtors/Accounts Receivable – separate account for each debtor

- Creditors/Accounts payable – separate account for each creditor

- Property, plant and equipment – Asset Register – separate for each piece

- Raw materials Inventory – Separate records of each type of raw material

- Finished goods inventory – Separate record of each type of finished good

Advantages for subsidiary accounts

Check on accuracy (as subsidiary account and general account balances

should =)

Enable any desired amount of detail to be maintained to explain composition of

selected general ledger account, without overloading general ledger

A5.3 Trade discount and Cash discount

Both Trade discount and cash discounts represents a reduction in the amount

that a customer ultimately pays a vendor for gods and services supplied

Differ in the way they are recorded

Trade Discount

Trade discounts are a means of adjusting the actual price charged to a

customer from a standard list price.

Usually determined by category of customer or normal volume of businesses

Manufacturer may sell at list price to general public, 40% off for retainers and 55%

off to wholesalers

Most enterprises record only net amount of transaction

Effect of trade discount is merely to set an actual price for transaction

Cash Discount

Cash discounts are conditional adjustment after determining the actual selling

price at which the transaction takes place

NOT a change in price of original sales transaction – generally recorded as an

additional transaction

Credit terms 2.5/10, n/30 – 2.5% deducted if money was paid within first 10 days,

the net amount must be paid within the next 30 days

Discounts recorded as “Discounts allowed” (EXPENSE), or “Discounts Received”

(REVENUE)


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A5.4 Operation of Special Journals and Subsidiary Ledgers

Sales

Purpose of special journals is to eliminate need for such detailed recording in a

general journal and the general ledger

Totals of special journals posted to control account, because CA only record

aggregates

Sales journal updated everyday

Sales journal – posted to AR, Sales revenue, COGS, Inventory

Subsidiary ledger may be established for each customer who buys on credit

Posting reference S1 indicates info comes from page S1 of sales journal

Tick in posting reference indicates that the amount has been posted to the

subsidiary ledger

End of period – total of subsidiary ledgers can be checked against balance of

AR control account.

I.e. sum of balance in each debtor should = balance of AR control account

Purchases

Purchases only used for recording the acquisition of goods, on credit, intended

for resale

Source document – purchase invoice from supplier, matched against delivery

docket and copy of official purchase order

Even with discounts, the full amount owing is recorded

If discounts are received, then this is recorded in CPJ – discount revenue, when

items are paid for

Purchases journal updated every day for each creditor of each item of

inventory

Credit transactions involving acquisition of fixed assets or items to be charged to

expense accounts, such as repairs, maintenance, printing and stationery, are

often recorded in general journal.

Cash Receipts

Source document: evidence of cash receipt, list of cheques received or direct

deposit recorded on bank account statement

Cash receipts journals are designed to meet specific needs of an enterprise

Most businesses – include payments from debtors, possibly cash sales

Also sundry or miscellaneous column for cash receipts not otherwise identified by

specific column that represents a particular general ledger account

E.g. proceeds from sale of fixed assets, refunds by creditors, new capital or

mortgage funding

Discount expense column – not sundry


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Cash Payments

Source documents: duplicate of cheque or cheque butt, statement and

invoices from creditors, receipt issued by recipient or payroll analysis certified as

correct by responsible staff member

Bank statement – evidence of interest charged on any overdraft, together with

info about other bank charges and fees

Minimise postings and provide analysis of payments, separate columns may be

provided to record entries affecting those ledger accounts frequently involved

Sundry or miscellaneous column might be needed.

DO NOT POST total of sundry column

Desirable in all books of prime entry (journals) to provide reference to source

document for each entry

Done by recording cheque number

In addition to postings to general ledger made at end of period, each individual

item in the creditors column will be posted as a debit to the creditors account

A5.5 Role of General Journal and General Ledger

General journal used to record a number of important transactions:

Sales and purchase returns

Credit transactions other than those related to inventory, such as the purchase

of equipment

Adjusting entries

Closing entries

Each entry in general journal is individually posted to appropriate account in

general ledger

At the end of a period, all financial information will be posted to general ledger,

either as an individual entry sourced from general journal (including sundry from

special journal), or in aggregate from columns of various special journals


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Chapter 6 – Financial Reporting Principles, Accounting Standards

and Auditing

6.2 Accounting Principles and the use of Accounting Information

Doing accounting takes expert knowledge, considerable experience and

continuous attention to new problems and solutions.

Concepts and principles are important, as they form logical structure that

practising accountants use every day to consider problems to make

recommendations

GAAP (Generally Accepted Accounting Principles) applied differently for

different entities

Rules, standards and usual practices that companies are expected to follow

when preparing financial statements

Stock market crash of 1929 brought GAAP

AASB (Aust Accounting Standards Board)

IASB (International Accounting Standards Board)

AASB uses IASB as foundation, but includes more details applicable to Aust

environment

SACS – Statement of Accounting concepts

SAVS established for general concepts and principles to be used in preparing

financial statements

SAC 1 – Definition of a Reporting Entity

SAC 2 – Objective of General Purpose Financial Reporting

SAC 3 – Qualitative Characteristics of Financial Information

SAC 4 – Definition and Recognition of the Elements of Financial Statements

Now, SAC 3 and SAC 4 is replaced with “Framework for Preparation and

Presentation of Financial Statements”

FYI: Difficulties that face accounting and managers by GAAP

Difference in company structures – e.g. ABC = not for profit, publicly owned.

Should ABC use same methods as other profit seeking organisations?

Qantas / UNSW – employees are not assets. But for sports team, such as Sydney

Swans – millions are paid to have certain players on the team. Are they assets or

expenses? Should they be amortised?

Comparing movies‟ net profits – hard to measure profitability of certain movies –

e.g. star wars attracted many viewers when it was first released. However, due

to its popularity, it continues to generate revenue, through video, dvd, toys,

books…


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6.3 Framework for the Preparation and Presentation of Financial Statements

Framework includes the coverage of:

- objectives of financial reports

- assumptions underlying financial reports

- qualitative characteristics that determine the usefulness of financial reports –

assets and liabilities

- definition of the elements from which financial reports are constructed:

assets, liabilities, equity, income and expenses

- recognition and measurement of the elements of financial statements

Framework makes distinction between general purpose financial report (for most

users who rely on this as main source of info) and special purpose financial

report (list for issues of shares – outside scope of Framework).

Users of financial reports

Investors – info on risk and return, including shareholders – buy, hold or sell?

Employees – including unions – stability and profitability and whether company

can afford employee benefits

Lenders – whether interest and loans will be able to be paid off

Suppliers and other trade creditors – whether amounts owing can be paid

Customers – continuance of entity, e.g. with warranties

Governments and their agencies – allocation of resources & tax

Public – substantial contribution to public – e.g. employment

Framework regards investors as the majority of users, so satisfy most the needs of

investors

The objective of financial reports

Objective: provide information about financial position, financial performance

and cash flows that is useful to users in making economic decisions

Users need evaluations of cash generation – due to its liquidity to buy inventory,

pay wages, distribute shares etc

Users need info on financial position, financial performance and cash flows to

evaluate this

Financial position – balance sheet – economic resources (NCA), financial

structure (who finances assets), information on liquidity and solvency (L & ratios)

Financial performance – income statement – profitability, employment of

resources, potential chances in assets controlled by the entity

Movement in cash – cash flow statement – operating, investing and financing

decisions


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Underlying Assumptions

Accrual basis of accounting

Going Concern

- entity will continue to operate in the foreseeable future

- book value = cost – accumulated depreciation

- liquidation value can be a lot less than book value

- this is because when companies close down, they may not be able to sell

off its assets at the book value

Other authors also regard accounting entity, accounting period and monetary

assumptions as key underlying assumptions.

Key Qualitative Attributes

Understandability – concern on complexity of financial statements that could

not be understood by experts. Pozen committee examined US financial

reporting system and made recommendations on the usefulness of reports

Relevance – Pozen committee suggests that the increased complexity has led to

less relevant info to users – evolution of business strategies and businesses do not

want investors to know about their liabilities

- materiality

Reliability – Pozen Committee suggests detailed rules in standards permit

structuring of transactions to achieve particular accounting results, even if results

are inconsistent with transactions

- Faithful representation – real existence

- Substance over form – inaccordance with substance and economic reality

- Neutrality – freedom from bias

- Prudence – degree of caution in exercise of judgements

- Completeness – material info is not omitted

Comparability – Pozen Committee notes that GAAP contain many detailed rules

with several industry exceptions and alternative accounting policies for same

transactions

Elements of Financial Statements

Assets – resources controlled by the entity as a result of past events, and from

which future economic benefits are expected to flow from the entity

Asset recognition

- It is probable that any future economic benefits associated with the item will

flow to the entity


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Liabilities – present obligation of the entity arising from past events, the

settlement of which is expected to result in an outflow from the entity of

resources embodying economic benefits

Liability Recognition

- probable that any future sacrifice of economic benefits associated with the

item will flow to or from the entity

- the item has a cost or value that can be measured reliably

Equity – residual interest in the assets of the entity after the deduction of its

liabilities SE = A – L

Equity ranks after liabilities as a claim to the assets of an entity

Income – increases in economic benefits during the accounting period in the

form of inflows or enhancements of assets or decreases in liabilities that result in

increase in equity

Issues of shares are not included

2 main components – revenue and assets/liabilities

Expenses – decreases in economic benefits during the accounting period in the

form of outflows of assets, depletion of assets or incurrences of liabilities that

result in decreases in equity

mainly COGS, wages and depreciation

Measurement of the elements of financial statements

Measurement – determining the monetary amounts that the elements of the

financial statements are to be recognised at and included in the balance sheet

and the income statement

Historical cost – assets are recorded at the time of acquisition

Current cost – assets are carried at the amount that would have to be paid if it

was bought currently

Realisable (settlement) value – assets are carried at the amount that could

currently be obtained by selling the asset in an orderly disposal

Present value – assets carried at present discounted value of future net cash

inflows that the item is expected to general in the normal course of business


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6.4 Assets and Liabilities: Valuation and Measurement

Five basic methods to measure or value assets and liabilities

- Historical cost

- Price-level-adjusted historical cost

- Current or market value

- Value in use (or present value)

- Liquidation value

Asset: Whether market values are better than historical cost?

Liability: Whether present value or estimation of future cash flows?

Historical cost

Acquisition cost – values assets at the amount paid or promised to acquire the

assets, and values liabilities at the amount of any associate promises

Ability to document cost of asset through receipts, invoices or contracts

An asset valued at historical costs is valued at its expected lowest or most

conservative value of future benefits at the date of acquisition

At the point of acquisition, historical cost = market value = value in use (present

value), in most cases.

“writing down” of unproductive assets

“lower of cost or market” rule

Price level adjusted historical cost

Adjusts for changes in the value of the dollar, rather than the changes of the

values of the assets

Lack of popularity – because if historical cost is unsatisfactory compared to

current values, adjusting the cost for inflation still makes it unsatisfactory, only

now less understandable

Current Price or Market Value (value in exchange)

Records assets and liabilities at their current particular market value

focuses on the individual values of the assets and liability items

assumes that value is market-determined and that profit should be measured

using changes over time in market values.

Input market value – entry value – refers to the amount it would cost to bring the

asset into the company if it were not currently in it.

Output market value – exit value – amount an asset is worth if it were sold now

(net realisable value)

Fair value – alternative asset valuation method – amount of the consideration

that would be agreed upon in an arm‟s length transaction between

knowledgeable, willing parties who are under no compulsion to act.


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Value in use (present value)

Considers that value flow from the generation of cash flows from the asset

Estimated by calculating the net present value of future cash inflows – cash

flows minus lost interest – expected to be generated by the asset

Present value – future cash flow – future interest implied by waiting for the cash

Present value = future cash payment / (1+r)

Liquidation Value

“going out of business, sell it for what you can business”

presumes the entity is not a going concern

6.5 Accounting Regulation in Australia

CLERP Act 1999 – Corporate Law Economic Reform Program Act modified

institutional arrangements for the setting of accounting standards in Australia,

recognising that financial reporting requirements can play an important role in

Australia companies‟ ability to compete effectively and efficiently in a global

environment

FRC – Financial Reporting Council

6.6 International Accounting Standards

IASB (International Accounting Standards Board) have issued more than 40

individual standards.

Aim: develop common standards that could be used by companies operating

in several countries, and eventually that all countries could use within their

borders

CONVERGENCE

Horror stories of 1 company with huge profits in one country also with huge losses

according to another country‟s acct standards are an embarrassment to the

accounting profession and awkward for regulators such as SEC (security

exchange commission) to deal with

Challenge to IAS is the attempt to make even the Canadian, US and Mexican

accounting systems similar, given that the 3 countries have signed the NAFTA.

VERY different in accounting standards, as govts have passed laws that set strict

requirements for financial accounting in accordance with national priorities and

culture


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6.7 The Annual Report and Financial Statements

The standard set of financial statements has five components:

- balance sheet

- income statement

- statement of changes in equity

- statement of cash flows

- notes to the financial statements

Statement of changes in equity – reports the profit or loss in equity

Notes to the financial statements provide additional detail on the items in the

financial statements – note 1 is accounting policies – inventory method,

depreciation method

Public companies and other organisations include their set of financial

statements in a much larger annual report. This report usually contains:

1. Summary data on company‟s performance for the year, comparisons going

back 5 or more years

2. Letter to the company‟s shareholders from the chairperson of the BOD or the

managing director, including highlights of the performance and future plans

3. Extensive CEO‟s report – description of the eco, financial and other factors

4. For listed companies – a corporate govt statement, required under ASX reg

5. Set of financial statements

6. Directors‟ statement – required by Corporations Act 2001 – signed by CEO

and CFO that the fins records are prepared in accordance with the

Corporations Act 2001. Debt opinions of directors

7. Independent audit report

8. Directors‟ report – names of directors, principle activities, operating results…

9. For listed companies, info on substantial shareholders, distribution of

ownership

10. Other voluntary information – graphs, details on products, pollution…

Full versus concise financial reports

Corporations Act 2001 now requires the publication of both FULL general

purpose financial reports (GPFR) and concise financial reports

GPFR contains the 5 financial statements in addition to the auditor‟s report and

director‟s declaration

Concise financial statements are sent to all shareholders, with a statement that

the report is concise and GPFR if a shareholder requests

Concise financial statements include the 5 financial statement components

minus notes. Additionally there must be a discussion and analysis of financial

statements to assist the user‟s understanding.


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6.8 The External Auditor’s Report

Auditor‟s report – a routine statement by the auditors that provides an opinion

on whether financial statements are fairly presented

Adverse opinion – when auditors deny the fairness of the statements

External auditing refers to the evaluation of an organisation‟s financial

statements by an auditor who should be unconnected with, and therefore

independent of, the management of the organisation

Role of external auditor:

- to have an independent, unbiased and professional perspective

- to render a competent opinion on the fairness of the financial statements

Fundamental objective of professional associations such as CA or CPA is to

protect society by ensuring the professionalism and independence of the

external auditors who belong to them

Independence is maintained because the auditor is appointed by, and reports

to the shareholders, not management

However, in practice, auditor has close working relationship with management

and managers has a strong position to recommend change of auditor

Recent legislative changes have strengthened the independence of audit firms:

- rotation of audit partners every 5 years

- banning the provision of many non-audit services by the firm carrying out

the audit

Audits are opinions, not guarantees.

Audits do not state whether a company is performing good or bad. It simply

states whether the performance and position have been measured and

presented in a generally accepted and unbiased way


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Content and form of auditor‟s report changes every few years, as auditors

rethink how it is best to communicate with the users.

Addressed to owners, titled “Independent Audit Report”

Standard version of the auditor‟s report includes the following:

1. Identifies company, set of statements and their date and states that the

statements are the responsibility of mgmt and that the auditor‟s responsibility,

having conducted an independent audit of the financial report, is to express

an opinion to them.

2. A section of the report contains the following statements:

a. audit conducted in accordance with AAS to provide reasonable

assurance on whether financial report is free of material misstatement

b. auditor‟s procedures included the examination, on a test basis, of

evidence supporting the amounts in the financial report, and the

evaluation of accounting policies and significant accounting estimates

c. procedures have been undertaken to form an opinion to form an

opinion on whether, in all material respects, the financial report is

presented fairly in accordance with AAS

d. statement that audit opinion expressed in the report has been formed

on the above basis

3. Normally, the third paragraph provides the auditor‟s opinion that the

financial statements give a true and fair view that they are in accordance

with the provisions of the Corporations Act 2001, applicable accounting

standards and other professional mandatory reporting requirements.

Redraft: include paragraph of respective roles of mgmt and auditors and

inclusion of separate section related to the independence of auditors

There are 3 main exceptions to unqualified opinion:

- qualified opinion – generally satisfied, but disagree with mgmt

- adverse opinion – financial statement not presented in accordance to AAS

- disclaimer – unable to express an opinion either way because of a limitation

in the works the auditors were able to do

Even if unqualified opinion is expressed, auditor will still alert reader to the facts in

the financial statements, but not of such nature that it affects the audit opinion

6.9 The Nature of a Profession and Professional Ethics

Professionals are recognised by post-secondary education

3 main professional accounting bodies – ICAA (Institute of Chartered

Accountants in Australia), CPA Australia and the NIA (National Institute of

Accountants)

If a professional accounting has not lived up to the standards of conduct held

by the profession, he or she can be reprimanded or expelled by the profession

and/or sued in court


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Professional codes of ethics involve not only behaving in professional manner,

but also maintaining the level of expertise required in order to perform skilfully

APES 110 Code of Ethics for Professional Accountants

Five fundamental principles:

- Integrity

- Objectivity

- Professional competence and due care

- Confidentiality

- Professional behaviour

Compliance with the fundamental principles may be threatened by various

threats, including the following:

- Self interest threats – undue dependence on total fees

- Self review threats – auditing systems on reports you designed

- Advocacy threats – promoting shares in a listed company you are auditing

- Familiarity threats – familial relationship with director or officer

- Intimidation threats – threatened with dismissal etc


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Chapter 7 – Internal Control and Cash

7.1 Internal Control

Internal control is a process, affected by an entity‟s board of directors,

management and other personnel, designed to provide reasonable assurance

regarding the achievement of objectives in the following categories:

- Effectiveness and efficiency of operations [also reduce risk of asset loss]

- Reliability of financial reporting

- Compliance with applicable laws and regulations

Internal control is not one event or circumstance but a process integrated with

other basic management processes, such as planning and monitoring

CEO is ultimately responsible for internal control

Internal control affects working life of most personnel

Internal control can only provide reasonable assurance rather than absolute

assurance to management and the board of directors regarding the

achievement of an entity‟s objectives

Limitations of Internal Control:

- Problems of human judgement – not follow instructions

- Managers may override prescribed policies or procedures – increasing

revenue

- Collusion between individuals can result in control failures

- Internal controls cost money – should apply cost benefit principle

Internal control can be considered to be effective for each of the 3 categories if

management and the board of directors have reasonable assurance that:

- They understand the extent to which operation objectives are being

achieved

- Financial statements are being prepared reliably

- Compliance with relevance laws and regulations

5 interrelated components of internal control:

- Control environment – integrity, ethical values and competence of entity‟s

people

- Risk assessment – associated with change and establishing objectives

- Control activities – ensure necessary action for risk assessment

- Information and communication – internal and external

- Monitoring – assess quality of system‟s performance over time – ongoing

monitoring and separate evaluations


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Control Activities

Examples of control activities:

- Top level reviews – compared to budgets and forecasts to assess which

targets are being achieved

- Information processing – controls check accuracy, authorisation and

completeness of transactions

- Separate record keeping from handling assets – segregation of duties –

where person who physically handles assets is different to person who keeps

records

- Physically protect sensitive assets

Examples of Internal control

Matching independently generated documents – matching sales invoices and

shipping documents

Prenumbering and sequencing checking of documents – to prevent

unauthorised use

Comparison with independent third party info – bank reconciliations of ledger

accounts with bank statements

Cancellation of documentation – deal with cheques immediately

Segregation of duties

Demanding timeliness of operations – prompt deposit of cash receipts and

depositing cash intact

7.2 Internal Control of Cash

Cash is the asset that is most susceptible to theft because of its liquid and

generally anonymous nature

Common control is locked in sales registered or carefully controlled records

Another way is to have multi copied, pre numbered sales invoices – check cash

sales, cash received, credit sales, accounts receivable, inventory

Prevent stealing cash / cheques – there should be more than one person

opening, disable function to turn into cash, list of cheques received, should be

posted to register, general ledger, accounts receivable of subsidiary records

Payments of cash: properly authorised documents/invoices and cheques should

be signed by 2 staff members who are independent of invoice approval and

accounting duties, original invoice should be stamped “paid”

7.3 Bank Reconciliations

Because of high frequency of transactions and potential for error, accuracy of

cash balance in general ledger should be examined periodically

Process is called bank reconciliation – based on bank statement


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Bank Reconciliation versus cash accounts

Bank statements summarise the activity in a cheque account and report the

ending monthly balance.

Cash account of depositor = asset, for bank = liability

This is because when cash is deposited in the bank, the bank now owes the

depositor money

End of month – bank statement cash balance normally won‟t agree with

company‟s cash records

Items on company‟s record but not on bank statement:

- Deposits in transits – receipts entered in a firm but not yet processed by the

bank (debit for company > credit for bank)

- Outstanding (un-presented) cheques – cheques written by business but not

yet presented to the bank – company issued cheque, but external person

hasn‟t cashed it yet (credit for comp > debit for bank)

Items reported on the bank statement but not yet entered in the company‟s

record

- NSF cheques (non sufficient funds/ dishonoured cheque) – customer

cheques deposited but refunded due to lack of funds (debit on bank

statement)

- Bank service charges for accounting processing

- Notes receivable and interest collected by the bank – collection of interest

or note is reported with a credit memo notation because of depositors

increase in account balance

- Interest earned on the account

In addition to timing differences, errors may cause a discrepancy between the

bank statement balance and company accounting records

The reconciliation process


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If balances do not agree and the reconciling items are deemed correct, there is

a chance that a record keeping error has been made.

Reconciliation not only highlights timing differences but also identify errors made

by either the bank or the depositor

Bank reconciliations contain adjustments to both ending cash balance for bank

and company records

After reconciliation is completed, general journal entries must be prepared for

adjustments made to company records

Adjustments necessary to update cash account in relation to correction of

company errors and info processed by the bank

No journal entries are needed for adjustments made to the ending bank

statement balance

These adjustments reflect items that have already been recorded in a

company‟s accounts – thus no further updating is necessary

7.4 Performing a Bank Reconciliation from information in cash journals

1. Go through last month‟s bank reconciliation statement, ticking off any amounts

that were outstanding last month

Go through bank statement and tick off items appearing in both CJ‟s and bank

Errors: if bank has mistake, inform bank of error.

If business has made a mistake – correct relevant cash journal

2. Go through bank statement to see what amounts remained unticked

Enter such amounts into CRJ or CPJ

Go through CRJ and CPJ and see if there are any unticked amounts – these are

outstanding deposits and unpresented cheques

CRJ – deposit in transit

CPJ – unpresented cheques

3. Total CJ‟s and post to bank ledger account

4. Prepare bank reconciliation

7.5 Petty Cash

Under the petty cash system, a fund is established in making small payments,

especially those that are impractical or uneconomical to make by cheque.

E.g. taxi fares or miscellaneous office needs

To establish petty cash funds:

Petty Cash DR

Cash CR

As payments are made from the fund, the custodian completes a form known

as petty cash voucher


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Each voucher indicates amount paid, purpose of expenditure, date and

individual who received money

Petty cash vouchers and invoices and receipts are evidences of disbursements

Cash remaining in fund + Petty cash vouchers + Invoices = Original amount

Replenishing the fund

To replenish fund

Postage expense $$$

Office supplies expense $$$

... $$$

Cash $$$

Note credit is to cash account

Fund is restocked by writing cheque on the company‟s cheque account

Replenished when funds are low, or at the end of each accounting period

Process is necessary because no formal journal entries have been recorded

Errors in petty cash fund

Occasionally petty cash vouchers and cash will not equal original fund balance

Adopt cash short and over account

Shortage – miscellaneous expense

Overage – miscellaneous revenue item

7.6 Disclosure of Internal Control in Annual Reports

Australian companies listed with ASX are now required to include section in their

annual reports on corporate governance.

A number of companies include a description of internal controls in this section

Common aspects of these descriptions:

- Board of directors has responsibility for internal control system

- Role of audit committee is noted

- Operating budgets used to monitor performance

- Internal audits are important part

- Controls are important in certain key area including treasury

- These are clearly defined guidelines for capital investment


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7.7 Managers and Internal Control

Internal control is the responsibility of management

Internal control should minimize errors and irregularities

Errors – unintentional mistakes, irregularities – intentional

Irregularities should be detected except when there is collusion or management

override

No system of internal control can eliminate all errors and uncertainties, but can

decrease the possibility of them occurring and increase chances of detecting

them

Important question – how much internal control is necessary

Cost money to implement an extra internal control

Must apply cost benefit analysis

Difficult because benefits of having controls are often difficult to quantify

Based on judgement


Internal control is an integral part of the environment of all public sector entities

June 1995 – NSW Treasury issued a “statement of best practice – internal control

and internal audit”

Guidance for govt agencies on such topics as responsibility for internal control,

relationship between management processes and internal control; analysing

risks and establishing controls and effective collection of information,

communication and monitoring

4 critical elements in an effective system of internal control for public sector

entities

Appropriate “tone at the top”

Well designed control system aimed at mitigating (explaining) risks

Effective collection of info and communication thru agency

Effectively monitoring of system of internal control


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Chapter 8 – Inventory

8.1 Inventory Control

Inventory control is an important issue for management because a high

percentage of working capital may be tied up in inventory.

May be consumable or outdated, high potential for theft

Choice of inventory is a record keeping choice as opposed to a reporting

choice

The perpetual inventory control method

When an order of inventory items is received, the quantity received is added to

the quantity recorded as being already on hand.

When they are sold, they are deducted from the recorded quantity

Therefore, the perpetual method shows how many items are supposed to be on

hand at any time

Inventory on hand = quantity on hand at beginning of period + quantity

purchased – quantity sold

Perpetual – continuously updated figure

Physical count of inventory fails to show that quantity, therefore error or lost or

stolen inventory

Beginning inventory cost (support with physical count if desired) +

Cost of purchases of inventory (records) – Cost of inventory sold (records) =

Ending inventory cost

Debit expense, credit inventory

Overage = negative expense where there is more inventory than expected

Overage/shortage expense account would probably be included with COGS in

the income statement

The periodic count method

If complete records of inventory changes are not kept, the enterprise does not

have records to indicate what should be on hand

The only way to tell is to count

This is done periodically when inventory figure is needed for financial statements

or insurance purposes – this is called the periodic inventory method.

Periodic count method lacks the parallel record keeping that gives the

perpetual method its value.

There is no way to reconcile counts to records in order to discover errors, but

simple and cheap, as no continuing records are kept

Beginning inventory (count) + purchases (records) – ending inventory (count) =

Inventory sold (deduced); that is cost of goods sold


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Because what is sold has been inferred, under the periodic method, cost of

goods sold expense includes all other possibilities (lost, stolen...)

Other forms of control need to exist to indicate theft or so on

E.g. unexpected changes in the ratio of cost of goods sold to sales should be

investigated

Inventory: Cost and benefits of controls

Perpetual method can be costly in terms of record keeping

Car dealership needs perpetual system

Cars are expensive, so large investment must be made if a good supply is to be

on hand for customers to choose from.

Need to keep track of registration, insurance, serial numbers, other types of

identification

Because of small quantity of cars sold by dealerships, record keeping costs are

not high.

Similarly, companies selling more expensive items, e.g. TV, fridge, jewellery, use

perpetual method

Companies with large amount of sales, particularly items with low value, use

periodic inventory method because of lower costs.

However, most organisations now use perpetual because of computer based

inventory systems

Retail companies have optical scanners scanning barcode

Assist with inventory control and helps with planning for ordering additional

inventory

8.2 Accounting Entries for Perpetual and Periodic Inventory

Perpetual – includes costs of goods sold and inventory shortage expense

Sales XXX

Less cost of goods sold XXX

Less inventory shortage XXX XXX

Gross profit XXX

Periodic – excludes costs of goods sold and inventory shortage expense

Sales XXX

Cost of goods sold:

Opening Inventory XXX

Purchases XXX

Cost of goods available for sale

Less ending inventory XXX

Costs of goods sold XXX

Gross profit XXX


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8.3 Inventory Valuation and Cost of Goods Sold

Inventory accounting uses a modified version of the standard historical cost

valuation basis: lower of cost or market value

Application of accounting conservatism: anticipate no gains but allow for losses

Inventory accounting affects both the balance sheet (inventory valuation) and

the income statement via the COGS

Inventory cost flow assumptions

Cost of inventory varies

Actual cost is usually tracked only for high value items (houses, motor vehicles)

that can be identified by serial numbers and other methods

Method – “specific identification”

As the cost of keeping records decreases, because of computerisation, more

items will be able to be tracked this way.

Impossible to keep track of individual items in inventory, so ASSUME flows of costs

By using periodic method: first calculate COG available for sale

Problem: how to allocate COG available for sale between COGS and ending

inventory asset

Three common inventory cost flow assumptions:

- FIFO – First in first out – sell the oldest items first

(BS – recent cost, COGS – old costs)

- AVGE – weighted average assumption – assume mixture of old and new

items (average unit cost = total cost / total units)

- LIFO – Last in first out – sell newest items first

(BS – old costs, COGS – new costs)

8.4 More about Inventory Cost Flow Assumptions

Assumption Periodic Control Perpetual Control

FIFO FIFO FIFO

AVGE Weighted Average Moving weighted average

LIFO Periodic LIFO Perpetual LIFO

FIFO is not affected by inventory control method because it just assigns the most

recent costs to whatever is on hand.

Others depends on control method, as it depends on what happened to

inventory levels during the period

Thus there is 5 methods

There is a six – specific identification and 2 others


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In Australia, LIFO is not allowed to be used for either financial reporting or tax

purposes

Because each assumption allocates the available inventory cost between the

inventory asset and the costs of goods sold expense differently, the choice of

assumption has an effect on both the income statement and the balance sheet

If there is little change in purchase costs, the various methods will show very

similar results

FIFO

Used because it‟s convenient where inventory asset are close to current costs

Convenient because only need to keep invoices

Doesn‟t matter which control, because all info needed is the quantity on hand,

whether by count or by perpetual records

Most popular cost flow assumption for inventories for larger Aust companies

Considered appropriate for current asset because it is the most reasonable

method of physically moving inventory, especially inventory that is perishable or

subject to changes in style

AVGE

When prices are rising, average cost shows a higher cost of goods sold (lower

profit) and lower inventory balance sheet figures than the FIFO method

LIFO

In US, cost flow assumption used for accounting purposes does not have to

match physical flow of items

Allowable method for income tax purposes.

E.g. rising inflation increases purchases costs, produces higher COGS, lower profit

and lower inventory asset value – used for tax purposes

Matches revenues and expenses more adequately.

E.g. if company changes prices in response to purchase cost changes, its

revenues reflect recent prices changes

Problem: LIFO produces inventory asset values that are based on older purchase

costs, and this can substantially underestimate the asset value

LIFO is affected by whether its amounts are determined using the periodic or

perpetual control methods,

8.5 An Example: MEEIX LTD

Beginning inventory + purchases = cost of goods sold expense + ending

inventory

MUST refer back to pg 398 when studying.

In a period of rising purchase prices

Inventory asset value: FIFO > AVGE > LIFO

Cost of goods expense: LIFO > AVGE > FIFO


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

8.6 Lower of Cost or Market Rule

The lower of cost or market rule states that the value of inventory should be

written down from the cost price to the market price in situations where market is

below costs

To calculate the lower of cost or market value, we just take the cost of the items

and match those costs against the net realisable value and use the lower as the

balance sheet inventory value.

If inventory costs 1000 had a net realisable value at year end of 800:

DR Inventory Write down expense 200

CR Inventory 200

8.7 Retain Inventory and standard costs

Retail inventory method is most application to retailers‟ inventories

Combines purchase costs and selling prices into a single calculation/estimate

Department is charged with total selling value (sale price x time)

Revenue from sale is deducted from total value as items are sold

Ties inventory control to cash control

AT any given point in time, inventory + cash + receipts for credit cards = total

retail value

Retail price of all goods – department sales = inventory on hand priced at retail

If physical count doesn‟t match then use shortage or overage

Retail method is complicated in practice because of the need to keep track of

markdowns, returned goods, special sale prices and other price adjustments if

the method is to work accurately

Another popular method: standard costs

Applicable to inventories manufactured by a company and uses estimated

costs based on standard production costs and volumes

balances, purchases and sales

8.8 Disclosure of Inventories Policies

Accounting standards require the financial reports disclose the value of

inventory split between CA and NCA and further split into the following classes:

- Raw materials and stores

- Work in progress

- Finished goods

- Land held for resale

In addition requires disclosure of general basis of inventory valuation and

methods used to assign costs to inventory quantities


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Within one organisation, more than one method can be used and it may vary

between the type of product or the class of inventories

8.9 Managers and the valuation of inventory

Managers have to choose control method

Perpetual – better control, higher costs

Important to managers as both profit figures and balance sheet figures affect

managers‟ performance reports

Therefore managers need to understand the effect, across time, of different cost

flow assumptions on financial statements

Managers must make important judgements

Which cost flow assumption must closely represent the actual physical flow?

What inventory items have a net realisable value which is lower than cost?

8.10 Inventory in the public sector

Inventory is not normally a material item for most public sector organisations.

But there may be exceptions – hospital bandages, medicine

When inventory does exist, the same accounting standards apply as in the

private sector.


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Chapter 9 – Noncurrent Assets

9.1 The Cost of an Asset: Basic Components

The basic premise of historic cost valuation is to use the cost of an asset, at

acquisition to value that asset on the balance sheet

When machines are bought, there are certain conditions that must exist for the

machine to operate, e.g. temperature, raised floor for wiring, fire protection

system

Therefore a section of the factory must be renovated to meet specifications of

the machine

These costs are known as installation costs

Overall, the cost of an asset includes all those costs required to install it ready for

use

Should the interest on monies borrowed to finance the project be included?

Most the time, no

Enterprises often have policies for how to determine whether expenditures, such

as interest are included in assets‟ costs

Decision between whether to include costs as 1 year‟s expense or included in

assets

Expense – profits and income taxes for the year will be lower

Assets – total assets will be higher, and this year‟s profit and tax expenses will also

be higher

Capitalising versus expensing choice

When deciding where in BS maintenance goes, think about whether there is

improvement or extension of useful life of asset. If yes – asset, if no –

maintenance expense

Common components of asset cost:

- Land – purchase price, costs of clear title (legal fees), clearing unwanted

items, draining

- Building (purchased) – purchase prise, renovation, decoration

- Building (self-constructed) – labour, material, insurance

- Purchased Equipment – installation, transport, testing

9.2 Depreciation of Assets and Depreciation Expense

Depreciation – an allocation of cost as a deduction from profit over the useful

life of the asset

Depreciation expense – annual deduction from revenue

Depletion – wasting assets are involved

Amortisation – intangible assets or leases are involved


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Why Allocate the Cost?

Assets are returns on investments

In accrual accounting, some method is needed to allocate the cost of long

lived assets over their useful lives

If whole asset cost was deducted in the year of acquisition, that year‟s profits will

be very low and subsequent years‟ profits very high

It would also mean that an asset has further benefits that is not recognised

Allocation of cost in order to measure profit

NOT a system to tract value changes in assets or to measure the current value of

those assets in the balance sheet

Balance sheet shows the net of assets original cost minus Acc Dep: it does not

mean the asset‟s current value is that net amount

Why not depreciate land?

Land‟s economic value is not considered to decline through use

Land is not normally susceptible to physical or economic decline

Equipment can be depreciated via physical causes (wear and tear) and non-

physical causes (obsolete with the advent of newer and faster machine)

Land is considered immune from all this, and is therefore not depreciated

When does cost allocation (depreciation expense) begin?

When the asset is put to use and the benefit begins to be realised, depreciation

of the expense should begin.

Once asset has been put into service, further costs involved in painting,

maintenance, repair and so on are now considered to be expenses

If a cost that is incurred significantly changes the asset‟s economic value in

earning revenue, e.g. betterment of asset, then cost may be capitalised as part

of asset‟s cost, then depreciated along with the rest of the asset.

Other questions

Depreciation is recognised by the following journal entry:

DR Depreciation Expense

CR Accumulated Depreciation

Accumulated depreciation is a contra asset

Depreciation is a prediction – it is never exact

Choice of accounting purposes does not affect the tax paid

Why is depreciation any good, if it‟s not exact, it has no cash effect and it does

not match market value changes in assets?

It is used to spread the cost out over the useful life of the asset, which matches

the presumed consumption of that cost with the benefits gained from that use


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9.3 Depreciation Bases and Methods

Assumption Kind of Cost Allocation

Spread evenly over the asset‟s life –

benefits is equal throughout useful life

Straight line –

expense is the same each year

Falls over the asset‟s life –

benefits decrease as asset gets older

Reducing balance method –

expense is larger in earlier years

Variable over the asset‟s life –

benefits varies according to how much

production is achieved each year

Units of production –

expense depends on each year‟s

volume of production

Straight line depreciation

Simplest and most widely used

Need 3 pieces of info:

- Cost of the asset: total cost to be depreciated over time

- Estimated useful life: number of periods for which the asset is expected to

benefit the enterprise

- Estimated „salvage value‟: amount expected to be recovered via the sale

of the asset at the end of its useful life

Depreciation for one period = Cost minus estimated salvage value

Estimated useful life (no. of periods)

A common practice for many firms is to assume the salvage value of the asset to

be zero, which then enables depreciation to be expressed in terms of

percentages instead of years

Reducing Balance method

Next most common depreciation method

Assets contribute more of their benefit to the enterprise in early parts of their lives



- Accumulated depreciation: total depreciation recorded since acquisition

- Depreciation rate: % of book value of the asset that is to be depreciated in

the period

Depreciation for one period = (cost – accumulated depreciation) x rate

Reducing balance depreciation does not normally take into account salvage

value


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Reducing balance percentage: r = 1 - n 𝑠

𝑐

r = required depreciation rate

n = estimated life in years

s = estimated residual value

c = original cost

Units of Production Depreciation and Depletion

Also used to compute depletion of natural resources



- Estimated „salvage value‟: amount expected to be recovered via the sale

of the asset at the end of its useful life

- Estimated number of units to be produced during the life of the asset

Depreciation for one unit = Cost minus estimated salvage value

estimated no. of units of production during life

To determine the depreciation for one year, the charge per unit is multiplied by

the number of actual units produced or used

Whichever method is adopted, the company can always adjust its calculations

later if the expectations about length of useful life or salvage value begin to look

seriously inaccurate

For now, note that it is usual to allocate the remaining book value over the

remaining useful life

9.5 Gains and Losses on Noncurrent Asset Disposals

Selling off assets are kept separate from ordinary revenues via the following kind

of journal entry:

E.g. Truck bought at 50,000. Depreciates at 8,000 each year. Sold at end of 2nd

year for 37,000

Net book value of truck = 50,000 – 16,000 = 34,000

Journal Entry for selling truck:

Cash 37,000

Accumulated Depreciation 34,000

Truck asset 50,000

Revenue on sale of truck 3,000

If there is a loss, it will be debit revenue

Think of gains and losses as depreciation corrections


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9.6 Assets Revaluations

Carry amount – book value

Fair value – amount for which an asset could be exchanged between

knowledgeable willing parties in an arm‟s length transaction

In Australia, directors need to ensure that the carrying value of an asset exceeds

the recoverable amount.

If not, the carrying value must be reduced to its recoverable amount –

impairment loss

Recoverable amount – asset‟s fair value – costs to sell it, or an asset‟s value in

use – whichever is higher

Value in use is the present value of future cash flows that are expected to be

derived from an asset

Accounting standards state that each class of noncurrent assets must be

measured using either the cost model or the revaluation model

Cost model – after recognition of an asset, the asset is carried at cost less

accumulated depreciation and any accumulated impairment losses

Revaluation model – after recognition of an asset, the asset whose fair value

can be measured reliably is carried at a revalue amount, which is the fair value

at the date of revaluation less any subsequent accumulated depreciation and

subsequent accumulated impairment losses

Revaluing upwards – revaluation increment – increase in asset account and

shareholder‟s equity (asset revaluation reserve)

Revaluing downwards – revaluation decrement – decrease in asset account

and increase in expense account

Increments in asset valuations do not generally affect profit directly, but

decrements do reduce the profit for the year

Changes in asset valuation (except for land) result in different depreciation

expenses in subsequent years

When an asset is revalued, all assets within the same class of assets should also

be valued at the same time on a consistent basis.

Exception: downwards valuation

Land – Revaluation increment:

DR Land

CR Revaluation Reserve

Land – Revaluation decrement:

DR Loss on devaluation of land

CR Land

Equipment – Revaluation increment

DR Accumulated Depreciation

CR Equipment

DR Equipment

CR Revaluation Reserve


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9.6 Intangible Assets

Intangible assets are identifiable, non-monetary assets that do not have a visible

physical existence, unlike land, buildings or equipment

Intangible Assets include:

- patents, copyrights, trademarks and other such legal property

- brand names, which can be registered to maintain exclusive use

- franchises, distributorships and other rights to sell someone else‟s products in

a certain geographical area

- deferred charges – such as incorporation costs, financing costs and other

items that are really long term prepaid expenses

- development costs (including product development costs and mineral

exploration costs), which are capitalised and later expensed at the time

they earn revenue in the future – strict criteria applies

AASB require organisations to charge all research costs to an expense account

when they are incurred.

Organisations prohibited from capitalising any expenditure associated with

internally generated brands, publishing titles, customer lists and similar items

What are intangible assets worth?

Existence and value of intangible assets may be doubtful

generally the more clearly identifiable and documented, the less difficulty they

pose

Assets such as brand names, trademarks and franchises have considerable

doubt about their economic value

Development expenditures – question on whether they belong on the balance

sheet at all. is it for sure that the product will sell and that it will bring future

economic value? will the revenue be larger than the costs?

Amortisation or impairment of intangibles

Legal useful life is different from economic useful life

If useful life is finite – intangible is amortised

If useful life is indefinite – intangible would be tested annually for impairment, by

comparing carrying amount with recoverable amount

If carrying amount > recoverable amount, then impairment loss

9.8 Goodwill

Goodwill arises when more is paid for a group of assets, such as a whole business,

than the assets seem to be worth individually


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The rationale for paying the additional amount may be based on such factors

as how the business is organised or the number of customers it has

Goodwill occurs to keep the books in balance

Purchased goodwill is measured as the excess of the cost of acquisition of

another entity over the fair value of the identifiable net asset and contingent

liabilities

Externally generated goodwill is recognised by the accounting system. It is a

transaction, supported by documentation, that shows how much was paid

Internally generated goodwill – not recognised by accounting system – e.g.

better management and improving friendliness of staff

Internally developed goodwill is never capitalised – cannot put an economic

value on it yet – e.g. expenditure on office parties to keep employees happy is

an expense

Following the acquisition of goodwill, rather than amortising it over a deemed

useful life – an entity will test it for impairment on an annual basis

Or more frequently, if events or changes in circumstances indicate that the

goodwill‟s carrying value has decreased below its recoverable amount

9.9 Financial Leases

Leases are rental agreements in which one individual (lessee) pays, to the owner

of a property (lessor), a certain amount in return for the right to use that property

over a predetermined period

Concern: some companies use leases to avoid putting assets on balance sheet

As a result, AASB established 2 types of leases: finance leases and operating

leases

Finance leases – when all the risks and benefits incidental to ownership are

substantially transferred to the lease

Cost – present value of the future lease payments using an appropriate interest

rate usually deducted from the lease agreement

At the same time – present value of those payments is recorded as a liability

DR Finance lease asset

CR Finance lease obligations liability

After that:

1. Leased asset is amortised

2. Liability is reduced as payments are made on the lease. Each payment

includes interest, but only principle deducted. This maintains the liability at

the present value of the remaining lease payments

3. Expenses for using the leased asset are amortisation and interest

4. Various particulars of significant capital leases are usually disclosed in the

notes to the financial statements so that the readers of the statements may

judge the effects of such capitalisation

Result: leased asset is treated essentially as if it were owned


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Accrual accounting recognises the economic value of the asset and disregards

the legalities of who owns it

If the lease does not result in the economic equivalence of ownership – if it is

really a rental situation where the owner is responsible for repairs, the lease is an

operating lease

9.10 Reporting of Non Current Assets and Associated Depreciation/Amortisation

The Corporations Act 2001 and AASB require certain disclosures concerning

noncurrent assets and their related depreciation/amortisation. These include:

- Depreciation and amortisation expense

- Cost and accumulated by major classes of assets

- Description of policies with regards to D/A

- Details concerning revaluation

- If items are measured at fair value – include carrying costs and other costs

- Statement that assets have not been valued above their recoverable

amount

- What the recoverable amount is – fair value – cost to sell/value in use

9.11 Managers and Noncurrent Assets

Managers need to make many judgements related to noncurrent assets.

What should be included in the cost of an asset?

What period/method should it be depreciated?

Value on brand names?

When should assets be revalued and who should do the revaluing?

All of the above judgements (except upward revaluation) will affect the

enterprise‟s profit figure, which is a key indicator of management performance


Infrastructure system assets include items such as roads, water supply, bridges

and transmission lines

Generally valued by govt departments at cost or written-down replacement

value (estimated replacement value – accumulated depreciation)

Difficulty in obtaining these figures

Heritage assets cannot be replaced

Valuation of $1 highlights to readers that an asset exists, but at this point in time it

is not clear how to value it.

E.g. Library collection held by State Library

In general, a number of factors have a bearing on the difficulty of reliably

measuring the assets of public sector entities.

E.g. completeness of asset registers, type of asset, extent of asset‟s similarity to

other assets used in other govt departments

Such assets e.g. historic buildings, gardens, monuments


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Chapter 13 – The Statement of Cash Flows

13.1 The purpose of Cash Flow analysis

Cash is the most important asset to any entity

Many firms have had positive profit figures, but have still run out of cash and

gone bankrupt

Important for present and potential investors and creditors to have info about a

firm‟s cash inflows and outflows and its resulting cash position

Solvency – the ability of a firm to meet all its debts and obligations as they are

due

Liquidity – enough cash and short term assets now to recover its immediate

debts and obligations

Too much cash – large supply of cash idle does not yield great returns for

investors

Cash should be put to work by making investments and attract new customers

Statement of cash flow – provides info on a firm‟s generation and use of cash

and highly liquid short-term assets, hence assist in evaluating the firm‟s financial

viability

Cash profit is not a complete measure of what has happened to the cash

Certain inflows or outflows of cash are not part of the process to generate

revenue and incurring expenses, so they would not be covered even by a cash

profit measure

Purpose of cash flow analysis:

- produce measure of performance that is based on day-to-day cash flow:

cash generated by ordinary business activities, instead of accrual

accounting – different perspective on performance and therefore

enhances the info for users

- incorporate other non-operating cash inflows and outflows, such as from

investing in new assets, selling old ones, borrowing or repaying debts. By

including these non-operating cash flows, the statement of cash flows can

provide a complete description of how the firm‟s cash was managed during

the period.

With all this info, the user can evaluate management‟s strategy for managing

cash and make a better judgement of the company‟s liquidity, solvency, risk

and opportunities than could be made just from the balance sheet and income

statement


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13.2 Overview of the Statement of Cashflows

Classification of Cash Flow Transactions

Operating activities – relate to provision of goods and services

Investing activities – relate to the acquisition and disposal of noncurrent assets,

including property, plant, equipment and other productive assets, and

investments such as securities, that do not fall within the definition of cash

Financing activities – relate to changing the size and composition of the

financial structure of the entity, including equity, and borrowings not falling

within the definition of cash


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Some important features of this format:

1. Same period as income statement

2. Include some equivalents: very liquid near cash assets

3. Cash may include temporary negative bank balances (overdrafts)

4. Uncertainty explained in the notes to financial statements

5. Focus must stay on cash

6. Transactions without cash are not included

7. Any numbers can be positive or negative

8. Deriving cash flow – Aust = direct method (start from cash receipts to cash

payments). Some other countries = indirect method (start with accrual net

profit, then remove effects on profit of non-cash expenses and revenues)


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Chapter 14 – Financial Statement Analysis

14.1 Investment and Relative Return

Relative return (return on investment / ROI) = Return

Investment

Main points about ratios:

- Purpose: produce a scale free (because it‟s dependent on same units and

size of company), relative measure of a company that can be used to

compare with other companies, or other years for the company

- Ratio may be unreliable and misleading, if numerator/denominator is

inappropriate. Return can imply EBIT, net profit or cash flow

14.2 Introduction to Financial Statement Analysis

Purpose of financial statement analysis: use statements to evaluate an

enterprise‟s financial performance and financial position

Value of the analysis depends on the value of the financial statements

Financial Evaluation is not just a calculation

Not just a calculation – it is a judgement based on the calculations that make

sense for that company and based on substantial knowledge of the company

The more info knew about business, mgmt and acct, the more useful and

credible the analysis

Affected by its own quality – whether the statements have been carefully

prepared and are comparable with other companies

Affected by availability of other sources of info that may contain all or part of

what is in the financial statements

Financial acct info is a part of a network of info, not a stand-alone item.

Preparation for intelligent analysis

Requires aim and substantial knowledge of the enterprise

Scale free ratios means that it allows comparisons over certain periods of time,

among companies of different sizes and with other indicators such as interest

rates or share prices

In order to do an intelligent and useful financial statement analysis:

4. Learn about the enterprise, its circumstances and its plans – look at

descriptive sections of annual reports and footnotes to financial statements

5. Obtain a clear understanding of the decision or evaluation to which the

analysis will contribute, who the decision maker (investor, lender, creditor,

management) is and what assistance is required

6. Calculate the ratios, trends and other figures that apply to the problem

7. Find whatever comparative info you can to provide a frame of reference for

your analysis – industry data, reports by other analysts, etc.


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8. Focus on the analytical results that are most significant to the decision

maker‟s circumstances, and integrate and organise the analysis so that it will

be of most help to the decision maker.

The preparer of financial statements can choose between a number of

accounting policies on which to base the financial information

May want to review such policies, e.g. deducing goodwill from assets, before

computing ratios

Validity of financial analysis based on accounting rations has been challenged

HISTORICAL DATA

Stock markets and other capital markets adjust prices of companies‟ securities

as info comes out, ratios based on publicly available info cannot tell people

anything the markets have not already incorporated into security prices.

14.3 Common Size Statements

Whilst focus on chapter is ratio analysis, another method to analyse financial

statements is common size statements

By calculating all balance sheet figures as a percentage of total assets and all

income statement figures as a percentage of total sales revenue

Sizes of companies is factored out

This procedure assists in comparing companies of different sizes and in spotting

trends over time for a single company

14.5 Financial Statement Ratio Analysis

Ratios are usually done to 2 decimals

They could be done to more decimals, but that would be false accuracy

This is because ratios depend on all sorts of judgements and estimates made in

assembling the financial statements

There should not be thought of as precise quantities but rather as indicators

Profitability Ratios

Return on equity (ROE) = Operating profit after tax

shareholder’s equity

Indicates how much return the company is generating on the historically

accumulated shareholder‟s investment

There are different versions of ratio – e.g. instead of closing year-end equity,

Woolworths uses average equity


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Return on assets (ROA) = Operating profit after tax

total assets

Determines the after tax return the managers are earning on the assets under

their control

Alternative ROA = EBIT

total assets

Determines the return on assets under management‟s control

Total assets can be year-end figure, or the average over the year

Denominator can also be gross assets (Assets before depreciation) and net

assets

Increase in ROA means that company has a better return on assets under their

control

Du Pont Formula: ROE = ROA x Leverage

Leverage = Total Assets

Total Shareholder‟s Equity

Indicates how much of the company‟s assets are financed by equity

The higher the ratio, the smaller the shareholder‟s funding of assets, the greater

the proportion of total assets that must have been funded by debt

Return on assets indicates the company‟s ability to generate a return on its

assets before considering the cost of financing those assets

Helps judging whether borrowing is worthwhile

Profit Margin = Operating profit after tax

Sales

Measures performance of managers in converting sales to net profit

Average profit on each dollar of sales

Useful indication of pricing strategy or competition intensity

Alternative Profit Margin = EBIT

Sales

Measures the ability of mangers to generate profit from sales

Gross Margin = Sales – COGS

Sales

Indicates whether sales are profitable

Also known as gross profit ratio

Further indication of company‟s product pricing and product mix

If Gross Margin = 33%, then revenue = 150% of cost, so mark up of 50%

Increase in profit margin either due to increase in gross margin or decrease in

expenses as a percentage of total sales


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Cash flow to total Assets = Cash flow from operations

Total Assets

Determines the company‟s ability to generate cash resources relative to

company‟s size

Approximately factors out size

Alternative measure of ROA, focusing on cash returns rather than accrual profit

Earnings per share (EPS)= Operating profit after tax – preference dividends

Weighted no. of ordinary shares outstanding

Relates earnings attributable to ordinary shares to the number of shares issued

Profit figure is after deducting outside equity in the operating profit

Weighted no. of ordinary shares outstanding should be provided – should not be

calculated by outsiders

If company has commitment to issue more shares, potential effect of the

exercise of such commitments is calculated by showing both basic EPS and

diluted EPS

Dilution refers to the potential of lowering returns to current shareholders as a

result of other people‟s exercising rights

Price to earnings ratio (P/E) = Current market price per share

EPS

Relates to the accounting earnings to the market price per share to reflect

present company performance with market expectations

Since relationship between such earnings and market price of shares is not

straightforward, interpretation is controversial

Idea is that because market price should reflect the market‟s expectation of

future performance, P/E compares the present info with those performances

High P/E means that company will do better in the future – e.g. popular

companies with good share prices

P/E is highly subject to general increases and decreases in market prices, so it is

difficult to interpret overtime and is more useful to compare similar companies

listed in the same stock market at the same time

Dividend Payout Ratio = Annual dividends declared per share

EPS

Measures the portion of earnings paid to shareholders

Stable ratio – company has a policy of paying dividends based on profits

Variable ratio – factors other than profits are important in the director‟s decisions

to declare dividents


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Activity (Turnover Ratios)

Total Asset Turnover = Sales

Total Assets

Determines the amount of sales volume associated with each dollar of assets

Similar turnover ratios relate the company‟s sales volume to its size

Turnover and profit/margin ratios are used together, because they tend to move

in opposite directions

High Turnover = Low margins and vice versa

Pricing low and trying for high volume versus pricing high and high profit

This is because competitive pressures are likely to force down selling prices and

therefore profit margins if a high turnover is desired

Represent contrary marketing strategies or competitive pressures

How much revenue is the company getting out of each dollar of assets?

ROA = profit margin x Asset Turnover

Inventory Turnover = COGS

Average Inventory

Relates the level of inventory to the volume of sales activity

A company with low turnover may be risking deteriorating level of inventories

and or may be incurring excessive storage and insurance costs

Inventory turnover can be converted to measure how long inventory in days,

inventory is held on average

Days in inventory = 365

Inventory turnover

Measures how long on average, inventory is held in stock

Debtor’s Turnover = Credit Sales

Trade Debtors

Relates the level of debtors to the volume of credit sales activity

Also called accounts receivable turnover

Credit sales may be hard to find – as sales is one section

Trade debtors refers to gross trade debtors (before deducting allowance for

doubtful debts)

Days in debtors = 365

Debtor‟s turnover

Measures how long it takes on average, to collect outstanding debtors


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Liquidity Ratios

Current Ratio = Current Assets

Current Liabilities

Indicates whether the company has enough short term assets to cover short

term debts

>1 working capital +ve, <1 working capital –ve

Working capital = current assets – current liabilities

Usually, high CR = financial stability

But if CR is too high, it implies that the firm is not reinvesting in LT assets to

maintain future productivity

Also indicate problems if inventories are getting larger than they should or

collections of receivables are slowing down

Static ratio – measuring financial position at a point in time and not considering

any future cash flows the company may be able to generate to pay its debts

Most useful for companies that have relatively smooth cash flows

Hardest to interpret for those who have unusual assets or liabilities, or depend on

future cash flows to pay current debts

Low current ratio is common for large companies – quick cash flow cycle

In general, can buy inventory, sell it and get cash before they have to pay their

accounts payable

Quick Ratio = Cash +AR + Short Term Investments

Current Liabilities

Indicates whether current liabilities can be paid immediately

Also called the acid test

Includes all assets except inventory

Ratio is particularly useful for companies that cannot sell inventory quickly

Interest Coverage Ratio = EBIT

Interest Expense

Indicates the ability of the company to pay interest on borrowings from profit

This and similar coverage ratios based on cash flow figures indicate the degree

to which financial commitments are covered by the company‟s ability to

generate profit or cash flow

Low coverage level (especially less than 1) means that company is not

operating at a sufficiently profitable level to cover the interest obligation

comfortably, and may also be a warning of solvency problems


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Financial Structure Ratios

Debt to Equity Ratio = Total Liabilities

Total Shareholder’s Equity

Measures the proportion of borrowings to the investment by owners

Includes retained profits

Ratio greater than 1 means that liabilities are mostly financed with debt

Ratio less than 1 indicates that liabilities are mostly financed with equity

High ratio = warning about risk: company is heavily in debt relative to its equity

and may be vulnerable to interest rate increases

Debt to Assets Ratio = Total Assets

Total Liabilities

Indicates the proportion of assets financed by liabilities

Ratio highly correlated with debt to equity ratio

Leverage = Total Assets

Total Shareholder’s Equity

Indicates how much of the company‟s assets are financed by equity

The higher the ratio, the smaller the proportion of total assets funded by

shareholder‟s equity, and therefore, the more funded by debt

Summary

Ratios are a quick method of breaking info in the financial statement into a form

that allows comparability with similar companies and with the financial

performance of the company over a number of years

Advantage: different ratios consider different parts of a company‟s

performance

User do NOT only rely on ratios – also on notes to the financial statements,

auditor‟s report, etc

Notes to the financial statements provide further explanations of some key areas

in the statements, e.g. accounting policies, detailed calculation of some

account values, etc