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ACCT-1501-LN

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ACCT 1501 - LECTURE NOTES
1: INTRODUCTION TO FINANCIAL ACCOUNTING & KEY FINANCIAL
STATEMENTS
Accounting: process of identifying, measuring, recording and communicating economic
information to assist users to make decisions.
Accounting Systems
Financial Accounting System: Periodic financial statements and related disclosures
 External Decision Makers: Investors, creditors, suppliers, customers, etc.
 Focuses on the provision of information to users external to the enterprise. The focus is
on reporting financial position and financial performance.
Managerial Accounting System: Detailed plans and continuous performance reports
 Internal Decision Makers: Managers throughout the organization
Uses of financial accounting
Bankers
Company Management
ASIC
Shareholders
Suppliers
Australian Tax Office
Trade Unions
The likelihood of the company meeting its
interest payment on time
The profitability of each division of the
company
Financial position and performance of a
company issuing shares to the public for
the first time
Prospects for future dividend payments
Probability that the company will be able
to pay for its purchases on time
Profitability of company based on tax law
Profitability of company since last contract
with employees was signed
Financial accounting presents information through financial statements
1. Balance sheet: Financial position of an enterprise at a particular point in time (static), i.e. set of
financial resources and obligations at a point in time.
 3 main elements assets, liabilities, shareholder’s equity
Assets
= Liabilities + Equity
2. Income statement: Financial performance of an enterprise over a period of time, i.e. business
profitability over a specific time period. It reports net profit based on revenues earned, and any
expenses incurred.
 Sometimes referred to as the Profit and Loss Statement (P&L)
3. Cash flow statement: Statements of cash flows (inflows and outflow) provide details of
movements in an entity’s cash balance over a specific time period.
The cash flows are normally categorised into:
 Operating activities: main revenue producing activities
 Investing activities: acquisition and disposal of non-current assets
 Financing activities: equity capital and borrowing
Appendix: Consolidated financial statement
 Financial statements that factor the holding company (parent company)'s subsidiaries
into its aggregated accounting figure.
A subsidiary is a company controlled by parent company. Control exists when the
parent company has the power, directly or indirectly, to govern the financial and
operating policies of an entity so as to obtain benefits from its activities.
o Intragroup balances, and any unrealised gains and losses or income and expenses
arising from intragroup transactions, are eliminated
It shows how the holding company is doing as a group. The consolidated accounts should
provide a true and fair view of the financial and operating conditions of the group.
o

Accrual vs. Cash Accounting
Accrual accounting: a financial accounting system where income statement reports revenues
and expenses when they are incurred, regardless of whether cash has yet changed hands.
 NB: Economically meaningful event, revenues earned, expense incurred
Cash accounting: cash flow statement reports cash inflows and outflows
Financial statement assumptions
Accounting entity assumption
 Activities of the accounting entity are separate from those of its owners/members
 Includes, but not limited to, legal entities
 Economic entity–a group of entities where the goals of the controlling entity are pursued:
o e.g. companies, partnerships, funds, associations, public sector bodies.
Accounting Period assumption
 Life of business can be divided into discrete, smaller time periods of equal length to
determine financial performance and position.
 Production of regular, comparable financial statements.
Monetary assumption
 Universally accepted medium of exchange.
 Measure economic activity by a common denominator.
o Currencies are used to measure transaction.
Historical cost assumption
 Transactions are initially recorded at their original cost.
 Treats assets in terms of their use rather than for sale.
o Land is exception because can be revaluated over time.
Going concern assumption
 Assumes continued operation of accounting entity into foreseeable future
 There is no intention or need to liquidate
 Produces demand for financial information during life of entity
Materiality assumption
 A piece of information is said to be material if its omission or misstatement could
influence the economic decisions of users made on the basis of the financial statements
 No set rules on determining materiality (auditors use 5% as a guide)
 e.g. Financial statements in $million(see Woolworths example in the Appendix)
2: MEASURING & EVALUATING FINANCIAL POSITION & PERFORMANCE
1. The Balance Sheet
A statement that summarises the financial position of an enterprise at a particular point in time
– What are the resources (Assets) of the enterprise and how were they financed?
o (Debt or Equity)
Provides information about
– Financial structure (mix of debt/equity) – Debt to equity ratio
o (Liability/equity)
– Liquidity – ease of converting assets to cash in normal course of business (short-term
focus) – working capital, current ratio
o Assets are listed by liquidity
– Solvency – ability to pay debts when they fall due (longer-term focus) – Debt to equity
ratio
What is on Balance sheet?
Identifying information:
– Name of the reporting entity
– Type of financial statement: Balance Sheet
o As at  point in time
o For the year ending  period of time
– Date – what point in time it refers to
– Currency used: $m, $AUD
1.1 Assets
A resource that is controlled (not owned) by an entity as a result of past events, and from which
future economic benefits are expected to flow to the entity.
Definition Criteria of assets
1. Future economic benefit: assets are used to provide goods or services with the objective of
generating net cash flows. Consider future economic benefit of cash, receivables,
investments, inventory, prepayments, property plant and equipment. Etc.
2. Control by the entity: relates to the capacity of an entity to benefit from the asset in
pursuing its objectives and to deny or regulate the access of others
3. Occurrence of past transactions or other past events: transaction or other event giving the
entity control over the future economic benefits must have occurred, e.g. paid cash or
credit
Examples
Current (expect to realise the benefits in the next 12 months from balance sheet date)
Non-current (realise benefits over a longer period)
– Cash & cash equivalents C (liquidity)
– Accounts receivable C (generally)
– Inventory C
– Prepayments (< 12 months) C
– Property, plant and equipment
o Machinery, motor vehicles, buildings NC
– Investments
o Trading; Non-trading Shares C (depends on intention)
o Accounted for using equity method
– Intangible assets e.g., Goodwill NC
1.2 Liabilities
A liability is a present obligation of the entity arising from past events, the settlement of which is
expected to result in an outflow from the entity of resources embodying economic benefits.
Essential characteristics
1. A present obligation exists and the obligation involves settlement in the future
2. It has adverse financial consequences for the entity in that the entity is obligated to
sacrifice economic benefits (net cash flows) to one or more other entities
3. Past event
Examples
– Current liabilities: obligation expected to be paid off within one year of the balance sheet
date.
– Non-current liabilities: obligations that will remain liabilities for at least the next year.
o Reason for this distinction (assets and liabilities): To help the financial statement
user assess short-term financial position.
–
–
–
–
–
Trade and other payables
o Accounts payable C
o Dividends payable C
o Wages payable C
Provisions
o Provision for warranty expense NC
Interest-bearing liabilities
o Loans payable C/NC
Tax liabilities
o Taxes payable C
Overdrafts C
NB: Tax payable = trade payable = accounts payable
Market value: value sold for
IMPORTANT: Not all assets and liabilities are on the Balance Sheet!
To be reported on a balance sheet, assets and liabilities must meet definition criteria and
recognition criteria:
1. It is probable that any future economic benefit associated with the item will flow to or
from the entity, and
2. The item has a cost or value that can be measured reliably
If they only meet definition criteria they are disclosed in the F/S notes .
Working capital and Current ratio
Working capital = Current Assets – Current Liabilities
– In general, low or negative working capital is an indication of short-term financial
difficulties.
– Current assets considerably more than liabilities may not be good thing either. Not
investing or utilising cash.
Current ratio = current assets/current liabilities
– Also known as the working capital ration
– Ideally b/t 1.2 and 2.0
1.3 Equity
Equity (owner for private, shareholders for public) is the residual interest in the assets of the
entity after deducting all its liabilities
o Also referred to as Net asset
o book value  original price
Examples
– Share capital
– Retained profits
– Contributed equity/Issued capital
– Reserves
–
Minority interest/Outside equity
Share capital: equity obtained through trading stock to shareholder for cash
Retained profits: net income/profit not distributed as dividends to shareholders (last)
Revenue: income received from normal business activities
Expenses: outflow of cash to another company/person
Dividend: portion of profit paid out to shareholders. Not an expense
2. Connecting income and balance sheet
The Retained Profit Account provides the link between the balance sheet and income statement
– Income statement accounts are temporary accounts.
– Balance sheet accounts are permanent accounts.
– Income statement accounts are ‘closed’ and their balances transferred to the retained
profits account (on the balance sheet) at the end of each accounting period.
General formula for RP
Closing retained profits = Opening retained profits + Net profit for the period (Revenues –
Expenses) – Distributions (Dividends declared)
INSERT Page 40/INSERT PAGE 44 /45
3. Income statement
Shows the results of business operations over a specific time period
– Relates to the accounting period assumption
– Reports revenues earned, less any expenses incurred
– Has the entity used its resources efficiently and effectively?
– Provides a measure of organisational efficiency
– Calculates the profit that may be available to shareholders
o If revenues > expenses, profit
o If revenues < expenses, loss
3.1 Revenue
‘Revenue is gross inflows of economic benefits (wealth) during the period arising in the ordinary
activities of an entity, other than those relating to contributions from equity participants, which
increases equity’
– Is recognized when it is considered to be ‘earned’.
– Requires a ‘trigger point’
– E.g., when goods/services have been provided to customers
– Receipt of cash is not necessary!
When is revenue earned?
– Devising idea
– Making purchases receipt of orders before production
– Commencing production
– Progressing through production
– Completion of production
– Receipt of orders
– Delivery of goods to customers
– Receipt of cash
Examples
– Sales revenue, rent revenue, service revenue, fees earned, interest revenue
3.2 Expenses
Expenses are decreases in economic benefits, during the period that are incurred when generating
revenue, which decreases in the entity’s wealth.
– Incurred when you use resources to generate revenue (matching principle)
NB: Expenses do not include payments or returns to owners (i.e. withdrawals by sole traders or
partners, or, dividends to shareholders). Payments to owners are considered to be ‘distributions’
of net profit to owners.
Wealth decreases because
Operating costs have to be paid
Long term assets wear out
– Referred to as ‘depreciation’ or ‘amortisation’
– Notice this has no direct effect on cash!
–
Valuation v.s. cost allocation (matching principle)
Assets are used up (e.g. prepayments, inventory)
–
Accrual accounting adjustments (Week 5)
– the using up of prepayments and inventory does not lead to a cash outflow!
4. Capitalized v Expense
Capital expenditures are costs that create future benefits through purchase of fixed assets or
adding value to existing assets. When a firm spends money, if the resulting benefit is to be realized
in the
o Current accounting period  expense
o Next or future accounting period  asset, capitalized
SLIDE 61
5. Cash v. Acrual profit
Accrual accounting records:
– Revenues when they are earned, not received.
– Expenses when they are incurred, not paid.
The earning of a revenue is not necessarily accompanied by an inflow of cash.
The incurrence of an expense is not necessarily accompanied by an outflow of cash
Accrual profit is not the same as cash profit
3: DOUBLE ENTRY SYSTEM
Transaction analysis: the analysis of how various transactions affect the accounting equation.
Assets = Liabilities + Equity
Double entry bookkeeping
Every transaction always affects at least two different accounts in order to maintain balance in the
accounting equation.
– Debit (Dr): increase to resources/assets, anything on the LHS of a balance sheet
– Credit (Cr): increase to sources/liabilities or equity, anything on the RHS of a balance
sheet
Way to remember: A = L + RP + R – E - D
 A + E + D = L + RP + R
Debit
credit
Type of account
Assets
Liabilities
Shareholder’s
equity
Revenue
Expense
Normal balance
Debit
Credit
Credit
Increase
Credit
Credit
Credit
Decrease
Credit
Debit
Debit
Credit
Debit
Credit
Debit
Debit
Credit
Account: record of the dollar amounts comprising a particular asset liability, equity revenue or
expense
Ledger: all the accounts collected together
Trial balance: prepared before producing a balance sheet to make sure all the accounts balances
from the ledger balances ie. debits = credits
Journal entries: method of recording transactions in terms of debit and credit
Reclassification: moving items between different accounts
Depreciation: cost of wear and tear
Accumulated Depreciation: the addition of all depreciation to date on assets
Notes payable: involves a written promissory note
Operating revenue from third parties: money earned indirectly through another source e. ads
Prepayments  debit
Revenue received in advance/unearned revenue  credit
Provisions  credit
Reserves: additional funds of money gained by other sources  credit
Dividends received from investments (cash)  debit
QUESTION: wages paid why is it not an expense?????
4: RECORD KEEPING
Accounting cycle: collective process of recording and processing accounting events of a company,
starting from transactions to the preparation of financial statements
Transactions – five characteristics
– exchange, past, external, evidence, dollars
1. Source documents
2. Prepare Journal entries
3. Post of ledgers
Leger accounts: summaries of journal entry transactions
Subsidiary Ledgers: separate ledger accounts for stake holders (e.g. A/R, A/P)
Accounts: store information for similar transactions
Chart of accounts – list of all accounts in the general ledger + numbering system
4. Trial balance
Debits = credits
5. Adjusting journal entries
Adjust revenue and expense accounts to reflect
– Expenses incurred but not yet paid
– Revenues earned but not yet received
– Cash received before the work being done
– Using up of assets, which creates an expense such as depreciation
Examples
– Accrued wages, interest revenue, depreciation expenses
6. Prepare Adjusted trial balance
Any adjusted entries are then posted to the relevant ledger accounts, which require another
trial balance to be prepared to make sure no mechanical error has been made.
7. Prepare Closing journal entries
Transfer the balance of revenue and expense accounts to Profit-loss summary and then to
retained profits.
Profit-loss summary: net earnings or loss
– Temporary accounts
o Accounts closed at end of accounting period i.e. revenue and expense accounts
o Debit all revenue accounts and credit profit-loss summary
o Credit all expense accounts and debit profit-loss summary
o Debit profit loss summary then credit it to retained profits
o Credit balance in profit-loss summary  profit
o Debit balance in profit loss summary  loss
– Permanent accounts
o Accounts NOT closed at end of accounting period i.e. assets, liabilities, equity
o Balances in these accounts are carried forward to the next accounting period
8. Prepare Post closing trial balance
Total debit = total credit
9. Financial statements
5: ACCRUALS ACCOUNTING ADJUSTMENTS (Q5)
LO1: Explain how the timing of revenue and expense recognition differs from cash inflows and
outflows (the accrual concept)
Accrual accounting
Often a timing difference between the significant economic event (earning revenue/incurring
expense) and related cash flow
 Provide a more complete picture of economic performance, particularly in the short term
Does not imply that the payment or receipt of cash are unimportant events
 The life blood of business
Expense and revenue recognition
Revenue recognition
1. Recognition of revenue (resource inflow) at the same time as cash inflow
 E.g. Sale to customer for cash.
 Cash entry:
Dr Cash (+A)
o Cr Sales (+R)
 Accrual entry:
Dr Cash (+A)
o Cr Sales (+R)
 Note: both entries are the same.
2. Recognition of revenue (resource flow) prior to cash inflow
 E.g. Sale to customer on credit
 Cash entry
o Nothing
 Accrual entry
Dr Accounts receivable (+A)
o Cr sales (+R)
 Note: the cash entry understates sales
3. Recognition of revenue (resource inflow) after cash inflow
 E.g. Receipt of subscription fees in advance
 Cash entry:
Dr Cash (+A)
o Cr sales (+R)
 Accrual entry:
Dr Cash (+A)
o Cr unearned revenue (+L)
 Note: the cash entry overstates sales
Expense recognition
1. Recognition of expense (resource outflow) at the same time as cash outflow.
 E.g. payment of wages
 Cash entry:
Dr wages expense (+E)
o Cr cash (-A)
 Accrual entry:
Dr wages expense (+E)
o Cr cash (-A)
 Note: both entries are the same
2. Recognition of expense (resource outflow) prior to cash outflow
 E.g. wages owing at year end
 Cash entry:


Nothing
Accrual entry
Dr wages expense (+E)
o Cr wages payable (+L)
Note: the cash entry understates expenses
3. Recognition of expense (resource outflow) after cash outflow
 E.g. Payment of insurance for the next 24 month period
 Cash entry
Dr insurance expense (+E)
o Cr cash (-A)
 Accrual entry:
Dr prepaid insurance (+A)
o Cr cash (-A)
 Note: the cash entry overstates expenses
Summary
–
The earning of a revenue is not necessarily accompanied by an inflow of cash in the same
period
–
The incurrence of an expense is not necessarily accompanied by an outflow of cash in the
same period
–
Accrual profit is not the same as cash profit
LO2: Prepare journal entries for accrual accounting adjustments (the adjusting entries)
Accrual accounting adjustments
Adjusting entries are entries necessary at the end of the accounting period to measure all
revenues and expenses of that period
Types:
1. Deferrals- related: haven’t provided service
yet
1.1 Revenue adjustment: Unearned revenue
1.2 Expense adjustment: Prepayment
2. Accruals-related
1.1 Revenue adjustment: Accrued revenues
1.2 Expense adjustment: Accrued expenses
2. Valuation-related: Book value adjustments:
contra accounts
1.1 Unearned revenue
–
Cash received in advance of earning revenue
o Liability – goods or services are owing to others
–
E.g. insurance premiums, magazine subscriptions, rent received in advance, Quants,
Telstra
1.2 Prepayments
–
Cash paid in advance of incurring expense
o Assets – future economic benefit
o Current or non-current asset?
–
E.g. Prepaid insurance, prepaid rent, office supplies
2.1 Accrued revenue
–
Revenue has been earned but cash will not be received until following period
o Receivables, assets
–
E.g. commissions earned but not received, interest earned but not received, Telstra,
Sydney water
2.1 Accrued expenses
–
Expense has been incurred but will not be paid until the following period
o Payables, liability
–
E.g. wages earned by employees but not paid after end of financial period, interest payable
on outstanding loan
LO3: Understand contra accounts and the impact on the financial statements
Contra accounts
–
Is paired with and follows its related account
–
Its normal balance (debit or credit) is the opposite of the balance of the related account
–
E.g.
o Accounts receivable  allowance for doubtful debts (ADD)
o Property, plant and equipment  Accumulated depreciation
o Intangibles  accumulated amortisation
o Inventory  provision for obsolescence
–
Allows users to ascertain
o Accounts receivable → Allowance for doubtful debts (ADD)
 Level of doubtful debts (and changes therein), collection policies and
problems
o Property, plant and equipment → Accumulated depreciation
 Likely ages of assets and future cash outflows for purchases of new assets
o Intangibles → Accumulated amortisation
 Likely life of intangibles
o Inventory → Provision for obsolescence.
 Levels of slow-moving, out-of-date stock, efficiency of stock management.
Contra account – depreciation
–
Allocation of the cost of a noncurrent asset to expense over the life of an asset
–
To recognise the consumption of the asset’s economic value
o Accumulated depreciation (A contra asset account B/S) shows all depreciation
charged against an asset to date
o Depreciation expense (I/S) shows only this year’s depreciation allocation
LO4: Understand and perform the closing process
LAST 2 REVISION QS!!!
APPENDIX 5: SUBSIDIARY LEDGERS
8: INTERNAL CONTROL
Internal control systems are a process, affected by an entity’s board of directors, management
and other personnel, designed to provide reasonable assurance in achieving:
–
Effectiveness and efficiency of operation //safeguard assets against fraud, waste and
inefficiency
–
Accurate and reliable financial data
–
Compliance with applicable laws, regulations and management policies
Internal control consists of 5 components (C.R.I.M.E):
All must be present and function effectively to ‘control’ reliability of financial reporting
–
Control activities: policies and procedures that ensure management directives are
carried out and necessary actions are taken to manage risks
–
Risk assessment: assessment of risks to objectives both internally and externally.
–
Information and communication: information must be identified and relayed in the
appropriate timeframe, such as financial reports
–
Monitoring: the control system itself is monitored to assess its quality and any
deficiencies
–
Environment: a control environment that encourages good control activities
Effective Control Activities are:
–
Tone from the top
–
Competent employees
–
Establish clear lines of responsibility
–
Separation of duties
o Authorisation
o Custody
o Record keeping
o Reconciliation
–
Physical protection of assets using locks and safes
–
Independent approval and reviews for transactions to spot irregularities
–
Matching independently generated documents, such as checking sales invoices against
orders
–
Internal auditing
–
Rotation of duties
–
Employees take regular leave
–
Adequate pay and motivation for employees
–
Limitations (reasonable, not absolute, assurance)
o Mistakes
o Manangement override
o Collusion among employees
o Computer fraud
o Cost vs benefit
Internal Control over Cash
Cash is the asset that is most susceptible to theft, misappropriation or fraud, because of its
liquidity (cash can be transferred easily) and anonymity (does not belong to a particular
person).
Cash control activities
1. Separation of duties for
o receiving and paying cash
o recording and handling cash
2. All cash receipts and cheques banked in its entirety daily
3. All payments (except petty cash) made by pre-numbered cheque or EFT (electronic funds
transfer)
4. Authorised supporting documentation for payments
5.
6.
7.
8.
9.
Cheques or EFT countersigned (signed by 2 people) independent of accounting and
invoice approval duties
Payment invoices and cancel documentation stamped so they cannot be fraudulently
reused
Physical safeguards over cash: locked PC box, close cash drawer
Reconcile bank accounts regularly (monthly)
Mail opened by someone not involved in record keeping
Bank reconciliation (Q1)
Bank reconciliation: Process where additional internal control can be achieved by comparing
the bank statements with the cash accounts in general ledger and explain differences.
Bank statements are monthly statements from banks that summarise all financial transactions in
a bank account. However, usually the ending monthly balance of bank statements will not match
the cash at bank account of the company’s records, due to timing differences in recording.
Reason for differences
1. Timing differences: Items in company records but NOT bank statement
o Deposit in transit: deposits in company records but not yet processed by bank
 E.g. cash received from customers
o Unpresented/outstanding cheques: payment cheques written and recorded by
company but not yet presented to the bank or paid from the bank account
 E.g. cheques written to supplies
o Require reconciliation with bank statement
2. Information asymmetry: Items in bank statement but NOT in company records
o Deposits not recorded in company ledger but recorded by bank
 E.g. notes receivable/interest collected by the bank, direct
deposits/credits, EFT in
o Payments not recorded in company ledger but recorded by bank
 E.g. bank service charges, interest charges, direct withdrawals/debits, EFT
out, dishonoured cheques: Non Sufficient Funds
o Require adjustments in accounting system, i.e. journal entries
3. Errors
o Made by company in company ledger
o Made by banks in bank statement
Bank reconciliation process
1. Check our records Cash Payment Journal, Cash Receipt Journal, last bank reconciliation
against bank statement
o Tick items that are the same
2. Items in our records that have not been ticked
o Represent items have not yet been recorded by the bank
3. Items in the bank statements that have not been ticked
o Represent new information not yet recorded by company that affects the cash
balance in our records
o Update CPJ and CRJ to give adjusted cash balance
Bank reconciliation of COMPANY as at DATE
$
Ending balance per bank statement
XXX
Add: Increases recorded on company records but not on bank XXX
statement
Less: Decreases recorded on company records but not on bank XXX
statement
Adjusted cash balance: Bank
XXX
CR
Ending balance per company records
XXX
Add: Increase recorded on bank statement but not in company XXX
records
Less: Decrease recorded on bank statement but not in company XXX
records
Adjusted cash balance: Book
XXX
DR
Dr Postage expense
Dr Office supplies expense
Dr Misc expense
Cr Cash at bank
20
50
15
85
Petty cash
A petty cash fund is established for making small payments
– Created by cashing a cheque from a company’s regular bank account.
– Vouchers: documents providing evidence for disbursements from petty cash account
– Petty cash account is an asset and it is regularly replenished.
– Despite small amounts, increase control is necessary  indicative of their overall internal
controls approach in the company could be lacking
Establishing
Dr Petty cash
Cr Cash at bank
200
200
Disbursement from fund
When a voucher is placed in the petty cash box, i.e. a payment is made; NO journal entries are
recorded at the time. This is to avoid a lot of troublesome bookkeeping for small amounts of cash .
Reimbursing the fund
The petty cash fund needs to be replenished when the fund becomes low due to small expenses. At
that time, the vouchers are used to record the expense entries and CASH is credited. The petty
cash account is NOT affected by the reimbursement journal entry
Accounts receivable
– Current asset
– Arise from sale of COGS on credit
– Also known as debtors, trade debtors, trade receivables
Sale on credit
Benefits
– Earn more revenue if willing to sell to customers who wish to buy on credit
Costs
– Additional record keeping
– Risk of not being paid
– Time value of money – delaying cash inflow, lending to customers interest free
Bad debts
– Part of customer’s debts to the company not collected
– Matching principle: recognising bad debts at the same time as sales revenue
Value of Accounts Receivable
With accounts receivable there is always some uncertainty regarding whether all of it can be
collected due to accrual accounting. So reductions are often necessary to measure its true value.
There are two ways to record uncertainties in the amount collectable:
Direct write off method
Debts are written off when there is direct evidence to suggest that the debt is unlikely to be
repaid, e.g. if a customer company goes into liquidation. To record this, the accounts receivable for
that company is directly credited
Dr Bad debts expense
200
Cr Accounts receivable
200
Allowance method
This method credits a contra asset account called allowances for doubtful debts for payments
that may not be collected, while debiting a bad debts expense account. The allowances for
doubtful debts reflect the percentage of the accounts receivable that might not be received, it
doesn’t actually state which customers will not pay. Accounts receivable does not change.
Estimating bad debts
1. % of sales method (income statement approach)
– Based on a relationship between past experiences with bad debts and net credit sales
o i.e. credit sales x 2% = bad debt expenses (BDE) for the next year
2. Aging of A/R method (balance sheet approach)
– Estimated bad debts depending on how many days outstanding the debt is, the older the
amount owed the greater the probability that the amount will not be collected
– Must consider the present balance of ADD, just add on
Dr Bad debts expense
Cr Allowance for doubtful debts
2m
2m
SPECIAL JOURNAL, SUBSIDIARY & CONTROL ACCOUNTS (Q4)
–
–
–
–
LO1: Understand a ten column worksheet
LO2: Explain the function of the special journals
LO3: Record appropriate transactions in special and general journals and post to
subsidiary ledgers and the general ledger
LO4: Understand trade discount and cash discount
Worksheet
– A “tool” to help prepare financial statements.
– Use of worksheet is optional
– Lists all the accounts vertically down the page
o Current assets/Noncurrent assets
o Current liabilities/Non-current liabilities
o Shareholder’s equity
o Revenue
o Expense
– A multiple-column form
o 10 columns, or 5setsof “2” columns. Each set has a “debit” and a “credit” column
1. Trial Balance
2. Adjustments
3. Adjusted Trial Balance
4. Income Statement (IS)
5. Balance Sheet (BS)
Steps
– The Trial Balance
o From the general ledger get your “pre-adjustment” balance
– Adjustments
o Adjusting journal entries
– Calculate the adjusted trial balance
– Prepare IS
– Closing Entries
– Prepare BS
Preparing financial statements
– After completing the worksheet, transfer the information from the IS and BS columns to
financial statements, in the correct format.
– Important to classify accounts correctly
o Not just at A, L, SE, R, and E
o Also categories of A, L and E
o Expenses need to be classified into:
 Selling expenses
 Administration expenses
 Financing expenses
 Other expenses
General journals
– Used for all other transactions including
o Sales and purchase returns
o Purchase of equipment
o Credit transactions
 Other than those related to inventory
o Adjusting entries
o Closing entries
Special journals
– Record the most common transactions undertaken by a business
– Allow some classification and summarisation to occur in the journal
– Advantages
o Recording efficiency: amounts posted to general ledger as totals rather than an
individual journal entries
– Used in conjunction with subsidiary ledgers
Types
A. Sales journal
– Sales of inventory on credit
B. Purchases journal
– Purchases of inventory on credit
C. Cash receipts journal
– All cash inflows (including cash sales)
– E.g. cash sales, payments received from debtors, the sale of fixed assets
D. Cash payments journal
– All cash outflows (including cash purchases)
– E.g. payments to creditors, cash purchases, payment of wages
Subsidiary ledgers
– Used for detailed records in the accounting system.
– Subsidiary ledger is a set of ledger accounts that collectively represent a detailed
analysis of one general ledger account
– Relevant general ledger account is called a control account.
– Periodic reconciliation of subsidiary ledger to control account is needed.
Examples
– Debtors/accounts receivable
o A separate account for each debtor
– Creditors/accounts payable
o A separate account for each creditor
– Property, plant and equipment
o Separate records of each piece of property, plant and equipment
– Raw materials inventory
o Separate records of each type of raw material held
– Finished goods inventory
o Separate records of each type of finished goods held.
A. Sales journal – credit sales
Procedure
Trade discounts
– Trade discount is given by businesses for customers that are expected to purchase large
volumes.
– This discount is not recorded in the books. The purchases amount is recorded net of the
discount.
Cash or settlement discount
– Offered if payment is made or given within a specified date from the transaction
– These discounts are recorded only when received
o ‘Discount allowed/expense’ (for the seller)
o ‘Discount received/revenue’ (for the buyer)
– part of the company’s cash management policy
REVISION QS
INVENTORY AND NON -CURRENT ASSETS ( Q6&7)
–
–
–
–
–
LO1: Understand the difference between, and prepare journal entries for, periodic and
perpetual inventory systems
LO2: Describe the three cost flow assumptions: FIFO, LIFO and weighted average
LO3: Classify and account for the acquisition of different types of assets
LO4: Explain and apply different methods of asset depreciation and disposal, as well as
their impact on the financial statements
LO5: Describe and evaluate the importance of ‘other’ types of assets
Inventory – cost calculations
– The cost of inventory comprises
– Cost of purchase
– Add: Purchase price + import duties and other taxes + inward transport and handling
costs + any other directly attributable costs of acquisition
– Less: trade discounts, rebates and their similar items
– Costs of conversion
o Raw materials, labour, overhead
Inventory records
Inventory
Additions
Withdrawals
Inventory control systems – recording the sales of inventory and the COGS
1. Perpetual Method
– Perpetual system maintains continuous records on the flow of units of inventory for ALL
transactions (Balances for Inventory and COGS always in the accounting system)
o Beginning inventory cost (often supported by a physical count – internal control)
o Add Inventory acquired during the period (from transaction records)
o Less Cost of inventory sold (COGS records)
o Ending inventory cost (supported by physical count – internal control)
–
If the physical count in the end does not match the closing balance, e.g. $5000 less, then
managers know that there is a shortage of inventory. Then adjusting journal entries are
required:
Dr Inventory shortage expense 5,000
Cr Inventory
5,000
–
Perpetual method is the preferred method that we have been dealing with:
o Purchase involve crediting cash or accounts receivable
o Sales involves revenue and cost of goods sold
o Closing entries closes all revenues and expenses to P&L summary
Advantage
Disadvantage
Provides more accurate control as it Costly, managers must pay someone to
records everything, stock losses easily constantly record, sort and compile data
determined
Conclusion: perpetual method is better for firms that sell expensive goods. E.g. car
dealerships, since cars are a large investment for the dealers so it needs to be better
protected.
2. Periodic Method
–
Periodic system determines inventory by physical count at end of period and COGS is
deduced as opening inventory plus purchases less closing inventory (Balances for
Inventory and COGS in the accounting system at period END)
o No records are maintained for individual inventory items.
Purchases Expense Account
Purchases of inventory are NOT recorded on inventory, but rather a purchase expense account.
Dr Purchase expense
cost price
Cr Cash/Accounts payable
cost price
Sales of inventory only needs to have revenue recorded, NOT changes to inventory and the COGS.
Dr Cash/Accounts receivable
selling price
Cr Sales revenue
selling price
Closing Entries in Periodic Method
In the periodic method, closing entries not only close the temporary sales and purchases accounts,
they also adjust the balance sheet account of inventory
Cost of goods sold
In reality, the cost of each unit of good varies, since goods can become cheaper or more expensive
throughout the year, so often stocks consist of goods purchased at different prices.
Advantage
Disadvantage
Lower costs and faster
Does not reveal shortage of stock
Conclusion: periodic method is better for stock of low unit value with a large number of
sales, such as retail shops
Specific Identification
This method tracks each individual item through inventory flow using barcodes or serial
numbers:
– An accurate approach
– Based on physical flow of goods
– Time consuming and expensive, but improving with technology
– Used for high value items, e.g. cars and house
Cost Flow assumption
For most low value items, it is not worthwhile to keep track of every item. Instead, of calculating
the exact COGS and inventory on hand, we make assumptions on cost flow to get a general idea.
The 3 major types of cost flow assumptions with periodic systems are:
1. First-in First-out (FIFO)
Assumes that items acquired first are the first ones sold, so any remaining inventory on balance
sheet are the most recently acquired. This assumption:
– Results in a higher profit and inventory in times of rising prices
– Suitable for perishable items or those subject to obsolescence
– Closing balance is closer to current cost
2. Weighted Average Assumption (AVGE)
Assumes ending inventory are a mixture of old and new units and COGS is the average of cost of
all units, i.e. total cost divide by total units available. Also called moving average method for
perpetual systems. This assumption is suitable for homogeneous products that tend to mix a lot
3, Last-in Last-out (LILO)
Assumes that items acquired last are the first ones sold, so any remaining inventory on balance
sheet are the oldest units. This assumption:
– Results in higher reported COGS and lower profit level during times of rising prices
– Results in a lower and outdated inventory balance
Non-Current Assets – Property, Plant and Equipment Property
Plant and Equipment (PPE) are tangible assets that are held for use in the production, supply of
goods or services, or administrative purposes, with benefits lasting more than one period.
Cost of Acquisition
PPE should initially be recorded under its historical cost. This cost includes:
– Purchase price including taxes, minus trade discount
– Costs directly attributable to bring the cost to location, e.g. transportation, and to a
condition necessary for usage, e.g. installation cost
– Estimate of costs associated with restoration and extending its life or value
– Estimates of costs associated with removal and dismantle
Depreciation
PPE usually have long but limited useful lives, i.e. its economic benefit are consumed over time.
Depreciation is the systematic allocation of the cost of an asset over its useful life as a deduction
from profit. It is NOT a system of valuation to measure the current value of assets. Depreciation
recognises an expense that matches the revenue generated by using up the asset’s economic
value. To calculate depreciation, 3 factors are considered:
1. Useful Life
The estimated useful life of PPE is the period of time over which an asset is expected to be
available for use OR the number of production expected to be obtained from an asset. Useful life is
different to the physical life of an asset!
2. Residual value
The estimated residual value is the amount that an entity would obtain from the disposal of an
asset at the end of its useful life. It is used to calculate the depreciable amount, i.e. the amount of
depreciation allocated over an asset’s useful life:
Depreciable Amount = Asset Cost – Residual value
3. Assumption on Flow of benefit
Depending on how the asset brings economic benefit, the method of allocation of depreciable
amount is different:
Assumption
Method of Allocation
Spread evenly over asset’s life
Straight line depreciation – constant expense
Falls over the asset’s life
Reducing balance method – increasing expense
Variable over the asset’s life
Units of production – expense depends on volume of production
Straight Line Depreciation
Straight line depreciation is used when the decline in value of an asset is uniform.
𝐶𝑜𝑠𝑡 − 𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑉𝑎𝑙𝑢𝑒
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝐸𝑥𝑝𝑒𝑛𝑠𝑒 =
𝑈𝑠𝑒𝑓𝑢𝑙 𝐿𝑖𝑓𝑒
Reducing Balance Method
Reducing balance method is used if the asset is expected to contribute more benefit in the earlier
years of its useful life. The depreciation expense is different every year and decreases gradually.
This method requires a depreciation rate and the current book value of the asset
The formula for depreciation expense
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝐸𝑥𝑝𝑒𝑛𝑠𝑒 = (𝐶𝑜𝑠𝑡 − 𝐴𝑐𝑐. 𝐷𝑒𝑝. ) 𝑥 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒
𝑛
= 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑥 (1 − √
𝑅𝑒𝑠𝑖𝑑𝑢𝑎𝑙 𝑉𝑎𝑙𝑢𝑒
)
𝐶𝑜𝑠𝑡
where n is no. of years
Exception
If residual value is 0, then this formula cannot be used. In general, the depreciation rate is taken to
be 150% of the straight-line percentage of depreciation.
Unit of Production Depreciation
The unit of production method is an activity-based method of allocating depreciation costs. In this
method, we find the depreciation for ONE unit of use or production first. To do so we need to
estimate the number of units to be used or produced over life of asset
Subsequent Expenditure
Any expenditure made on an asset can either increase the value of the asset or become an
expense. If the expenditure:
– Increase productivity, efficiency, output quality or useful life, then it IMPROVES the asset.
Therefore the expenditure is capitalised and added to the asset account
– MAINTAIN current level, i.e. needed for the asset to continue production, then the
expenditure is expensed
Disposal of Non-Current Assets
When PPE needs to be disposed, i.e. sold or scrapped, the steps to record it are:
1) Record depreciation up to the date of disposal
2) Record proceeds or losses from sale
3) Remove the non-current asset from company’s book
Intangible Assets
An intangible asset is an identifiable non-monetary asset without physical substance. It must also
fit the criteria for an asset in general. Intangible assets include: brand names, trademarks, patents
and copyrights. Intangible assets can also have limited life, in which case the depreciation is called
amortisation.
FINANCIAL REPORTING PRINCIPLES, ACCOUNTING STANDARDS AND
AUDITING (Q2)
Generally Accepted Accounting Principles (GAAP)
GAAP is a set of rules and standards that companies are expected to follow when they prepare
their financial statements. In Australia, the GAAP is a combination of conceptual framework
issued by the Australian Accounting Standards Board (AASB) and generally accepted accounting
rules.
Underlying Assumptions
The two key underlying assumptions to financial reports are:
– Going concern: assumption that the entity will continue in operation for the foreseeable
future. Otherwise, if must give the liquidation value of its asset, which will often be a lot
less than historical book value
– Also accounting entity, period, monetary assumptions
Qualitative Characteristics of Financial
Information Qualitative characteristics are the attributes that make the information provided in
financial reports useful to users.
– Understandability: financial reports should be readily understandable to users with a
reasonable knowledge of accounting. However, complex information should not be
omitted.
– Relevance: all information should assist users to make, confirm, or correct predictions
about the outcomes of past, present or future events. It is affected by nature and
materiality
– Comparability: financial reports should be comparable to other periods and companies.
Also consistency, verifiability timelessness
– Reliability: affected by these subcategories:
o Faithful Representation: information must be a faithful representation of that
which it purports to portray, i.e. information must be complete, neutral, free from
error (true)
o Substance and Form: transactions and events must be presented in accordance
with their substance and economic reality, not merely the legal or technical
requirements
o Neutrality: unbiased information, i.e. the situation and presentation of
information should not be made to achieve a predetermined outcome, e.g.
impressing analysts
o Prudence: degree of caution exercised in making accounting estimates in situation
of uncertainty. Make sure assets are not overstated and liabilities not understated
o Completeness: material information is not omitted
Standard Set of Financial Statements
– Balance sheet  financial position
– Income statement  financial performance
– Statement of changes in equity (reserves)
– Statement of cash flows
– Notes to financial statements, which provide information about accounting policies chosen
and other supplementary information to help interpret data of financial statements
Definition of Elements of Financial Statement
Asset
Essential Characteristics
Recognition Criteria
- Probable future economic benefit with small
- Control by entity
- Future economic benefit
uncertainty allowed
- Result of past transactions
- A value that can be measured reliably
Liabilities
Essential Characteristics
- Present obligation
- Settlement involves loss of future economic
benefit
- Result of past transactions
Recognition Criteria
- Probable that future sacrifices of economic benefit
required
- A value that can be measured reliably
External Auditors Report
– Evaluation of an organisation’s financial statements
– Add credibility to financial statements prepared by the management.
– Do not prepare financial statements
– Render an independent, unbiased and professional perspective
– Render a competent opinion on the fairness of the financial statements
Types of Audit Opinions
– Unqualified opinion: financial statements are free from missing material information and
are represented fairly in accordance with GAAP
– Qualified opinion: auditor is generally satisfied except for a specific departure from
GAAP
– Adverse opinion: financial statements are not presented fairly in accordance with GAAP
–
Disclaimer: auditors are unable to express an opinion because of limitations in their work
Principal-Agent Problem
This problem describes the conflicts of interest and moral hazard issues when a principal hires an
agent to perform specific duties that are in the best interest of the principal, but not in the best
interest of the agent. E.g. it is difficult for shareholders of a company (principal) to monitor the
managers (agents) to perform tasks precisely as they want them to. Since the principal faces
information asymmetry and risk regarding whether the agent has effectively completed a
contract, principals create incentives for the agent to act as the principal wants.
Corporate Governance
Corporate governance is the system by which companies are directed and controlled. It is the
relationships between a company’s management, board of directors and its shareholders
and other stakeholders. Its aim is to mitigate or prevent conflicts of interests of stakeholders
– Adequate disclosures and effective decision making to achieve corporate objectives
– Transparency in business transactions
– Statutory and legal compliances
– Protection of shareholder interests by board of directors
– Commitment to values and ethical conduct of business
Sustainability reporting
– Increasing demands for the environment, social and economic performance
– Triple bottom time reporting
Reasons for sustainability reporting
– External reputation
– Financial incentives
– Improving internal processes
– Differentiating the company to stakeholders
– Benefits vs Costs
– Assurance is voluntary
Global Reporting Initiative
The GRI are the most commonly used guidelines on sustainability reporting practices. Provides
sufficiently detailed non-financial performance indicators under:
– Economic, Environment , Social
Integrated reporting
– Combines information about a firm’s strategy, governance, performance with it’s
commercial, social and environmental practices
– Protecting and being responsible for actions
– How to create and sustain value
Benefits vs costs
–
Relevant, concise information to
stakeholders as well as shareholders
–
See the whole picture
–
Better understanding of operations
–
–
Sensitive information being disclosed
expensive
Energy measurement
– Scope 1: ALL direct emissions which the company has direct control over
– Scope 2: ALL indirect emissions which the company has indirect control over from the
generation of purchased electricity, heat or steam (transferred and consumed)
– Scope 3: ALL indirect emissions which the company has indirect control over other than
from the generation of purchased electricity, heat or steam
FINANCIAL STATEMENT ANALYSIS (Q3) PUT INTO TABLE?
Ratio analysis is a tool used to quantitatively analyse the information on financial statements.
Ratios allow comparison to other year, companies or the industry to evaluate the performance
Performance Ratios
Gives indication of a company’s potential for generating profits in the future. In general,
performance ratio should exceed zero and as high as possible, indicating a positive return
Types of Performance Ratios:
 Return on Assets
ROA indicates the amount of return earned from a company’s assets. EBIT is usually not shown
on financial statements, but can be calculated by adding interest back to net profit before tax.
𝑬𝒂𝒓𝒏𝒊𝒏𝒈 𝑩𝒆𝒇𝒐𝒓𝒆 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 & 𝑻𝒂𝒙 (𝑬𝑩𝑰𝑻)
𝑹𝒆𝒕𝒖𝒓𝒏 𝒐𝒏 𝑨𝒔𝒔𝒆𝒕𝒔 =
𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔
o
Change in ROA  asset turn over and profit margin
 Return on Equity
ROE indicates how much return the company is generating from accumulated shareholder’s
equity. It is useful to owners as it measures the efficiency of their equity at generating profits.
𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑷𝒓𝒐𝒇𝒊𝒕 𝑨𝒇𝒕𝒆𝒓 𝑻𝒂𝒙
𝑹𝒆𝒕𝒖𝒓𝒏 𝒐𝒏 𝑬𝒒𝒖𝒊𝒕𝒚 =
𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓′ 𝒔 𝒆𝒒𝒖𝒊𝒕𝒚
 Profit Margin
Profit margin indicates the percentage of sales revenue that ends up as profit, or the average
profit on each dollar of sales. A low profit margin indicates higher risks that a decline in sales will
erase profits and result in a net loss, or a negative margin. Profit margin also indicates the
company’s pricing strategy and how well it controls costs.
o Low profit margin high volume sales
o Strategies
 product differentiation
 product mix/pricing
𝑷𝒓𝒐𝒇𝒊𝒕 𝒎𝒂𝒓𝒈𝒊𝒏 =
𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑷𝒓𝒐𝒇𝒊𝒕 𝑨𝒇𝒕𝒆𝒓 𝑻𝒂𝒙
𝑺𝒂𝒍𝒆𝒔 𝒓𝒆𝒗𝒆𝒏𝒖𝒆
 Gross margin
Gross margin is similar to profit margin in that it indicates the company’s pricing strategy. An
increase in profit margin is either due to a better gross margin or a fall in expenses.
o sell product with higher gross profit margin (however you will sell less)
𝑮𝒓𝒐𝒔𝒔 𝑷𝒓𝒐𝒇𝒊𝒕
𝑮𝒓𝒐𝒔𝒔 𝒎𝒂𝒓𝒈𝒊𝒏 =
𝑺𝒂𝒍𝒆𝒔 𝒓𝒆𝒗𝒆𝒏𝒖𝒆
 Earning per share
Earnings per share (EPS) is the amount of earnings per each outstanding share of a company’s
stock.
𝑬𝒂𝒓𝒏𝒊𝒏𝒈 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆 =
𝑵𝒆𝒕 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑷𝒓𝒐𝒇𝒊𝒕 − 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅𝒔 𝒐𝒏 𝑷𝒓𝒆𝒇𝒆𝒓𝒓𝒆𝒅 𝑺𝒉𝒂𝒓𝒆𝒔
𝑾𝒆𝒊𝒈𝒉𝒕𝒆𝒅 𝒂𝒗𝒆𝒓𝒂𝒈𝒆 𝒏𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒐𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈 𝒐𝒓𝒅𝒊𝒏𝒂𝒓𝒚 𝒔𝒉𝒂𝒓𝒆𝒔
Activity (Turnover) Ratios
Gives indication of the company’s operations in certain areas.
Types of Activity Ratios:
 Total Asset Turnover
Total asset turnover measures the efficiency of a company’s use of its assets in generating sales
revenue. It is related to profit margin:
o Low profit margin = high turnover, as company’s cut prices to sell more
o High profit margin = low turnover, as company’s raise prices to make more on
each unit sold
𝑺𝒂𝒍𝒆𝒔 𝒓𝒆𝒗𝒆𝒏𝒖𝒆
𝑨𝒔𝒔𝒆𝒕 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒕𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔
 Inventory turnover
Inventory turnover is a measure of the number of times inventory is sold or used in a year,
reflecting the efficiency of inventory management. It relates the level of inventories to the
volume of activity. A company with low inventory turnover is in risk of obsolescence or
deterioration in its inventory
𝑪𝑶𝑮𝑺
𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚
Average days in inventory measure how long it takes to sell inventory items on average:
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒅𝒂𝒚𝒔 𝒊𝒏 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 =
𝟑𝟔𝟓
𝑰𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒚 𝒕𝒖𝒓𝒏 𝒐𝒗𝒆𝒓 𝒓𝒂𝒕𝒊𝒐
 Debtors Turnover
Debtors turnover measures the number of times on average receivables are collected in a year. It
indicates the efficiency of the company to collect the amount due from debtors.
𝑪𝒓𝒆𝒅𝒊𝒕 𝒔𝒂𝒍𝒆𝒔
𝑫𝒆𝒃𝒕𝒐𝒓𝒔 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑻𝒓𝒂𝒅𝒆 𝒅𝒆𝒃𝒕𝒐𝒓𝒔
Days in debtors measure how long it takes to recover debts on average:
𝟑𝟔𝟓
𝑫𝒂𝒚𝒔 𝒊𝒏 𝒅𝒆𝒃𝒕𝒐𝒓𝒔 =
𝑫𝒆𝒃𝒕𝒐𝒓𝒔 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝒓𝒂𝒕𝒊𝒐
o High days in debtor indicate a problem with granting of credit and/or collection
policies
o Low days in debtor indicate the credit granting and/or collection policies are too
strict
Liquidity ratio
Liquidity ratios aim to give financial statement users some indication of the company’s ability to
pay its short term debts as they fall due. A company may be forced into liquidation if it cannot pay
its short term debts, even if it might be profitable in the long run .
Types of Liquidity Ratios
 Current ratio
Gives indication whether a firm can pay its debts in the current period.
𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒂𝒔𝒔𝒆𝒕𝒔
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒓𝒂𝒕𝒊𝒐 =
𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
Low ratio (< 1) indicate a problem in paying short term debts
High ratio (> 2) indicates the company may not be efficiently using its current
assets
 Quick ratio
Quick ratio, or “acid test”, measures the ability of a company to use its cash or quick assets to pay
its short term debts. Quick assets are cash, accounts receivable and short-term investments, i.e.
current assets not including inventory. It indicates whether current liabilities could be paid
without having to sell the inventory, useful for companies that cannot quickly convert its
inventory to cash.
o
o
𝒒𝒖𝒊𝒄𝒌 𝒓𝒂𝒕𝒊𝒐 =
𝑪𝒂𝒔𝒉 + 𝑨𝒄𝒄𝒐𝒖𝒏𝒕𝒔 𝒓𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆 + 𝑺𝒉𝒐𝒓𝒕 𝒕𝒆𝒓𝒎 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒍𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
Financial structure ratio
Gives indication of the company’s ability to continue operations in the long term, i.e. the risks
Types of Financial Structure Ratio:
 Debt-to-Equity Ratio
D/E ratio measures how a company is financed, through debts or shareholder investment.
o Value higher than 1 indicates the assets are mostly financed with debt, which is
risky
o Value less than 1 indicates the assets are mostly financed by owners
𝒅𝒆𝒃𝒕 𝒕𝒐 𝒆𝒒𝒖𝒊𝒕𝒚 =
𝒕𝒐𝒕𝒂𝒍 𝒍𝒊𝒂𝒃𝒊𝒍𝒕𝒊𝒆𝒔
𝒕𝒐𝒕𝒂𝒍 𝒔𝒉𝒂𝒓𝒆 𝒉𝒐𝒍𝒅𝒆𝒓′ 𝒔 𝒆𝒒𝒖𝒊𝒕𝒚
 Debt-to-Asset Ratio
Debt-to-asset ratio (D/A) measures the proportion of assets that are financed via debts. The
higher the value, the greater the risks in firm’s operation
𝒅𝒆𝒃𝒕 𝒕𝒐 𝒂𝒔𝒔𝒆𝒕 =
𝒕𝒐𝒕𝒂𝒍 𝒍𝒊𝒂𝒃𝒊𝒍𝒕𝒊𝒆𝒔
𝒕𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔
 Leverage Ratio
Leverage ratio measures the proportion of assets financed by equity. The higher the ratio, the less
is funded by equity and more by debt
𝑳𝒆𝒗𝒆𝒓𝒂𝒈𝒆 𝒓𝒂𝒕𝒊𝒐 =
𝒕𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔
𝒕𝒐𝒕𝒂𝒍 𝒔𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒆𝒓′ 𝒔 𝒆𝒒𝒖𝒊𝒕𝒚
Du Pont System of Ratio Analysis
The Du Pont system of analysis links the ratios together using the concept of a leverage. Leverage
refers to any technique to multiply gains and losses.
𝒕𝒐𝒕𝒂𝒍 𝒂𝒔𝒔𝒆𝒕𝒔
𝒕𝒐𝒕𝒂𝒍 𝒔𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒆𝒓′ 𝒔 𝒆𝒒𝒖𝒊𝒕𝒚
However, leverage is a double edge sword. E.g. a company can leverage its equity by borrowing
money because the more it borrows the less equity capital it needs. Thus, any profits are shared
among less owners so it is proprotionally larger. However, any losses are also burdened more on
the company and borrowing too much money may lead to bankruptcy in a financial downturn.
𝑳𝒆𝒗𝒆𝒓𝒂𝒈𝒆 =
Du point systems links:
- ROA with profit margin and total asset turnover
- ROE with ROA and leverage
Limitations
of
Financial
Statement
Ratios
 Ratios rely on past information
o Ratios assume past relationships are useful in forecasting future performance
o Numerous factors can prove otherwise o
 Ratios rely on historical cost financial statements
o Failure to adjust for inflation or market values result in current dollar amounts
being
o compared to past dollar amounts. E.g. current dollar profits with historical dollar
assets
 Ratios are based on year end data
o Year-end data may not be reflective of the typical situation of company
o Management may improve ratios, e.g. current ratio, by using cash to pay off debts


Not all required information will be disclosed
o E.g. foreign companies may not disclose COGS so inventory turnover hard to
calculate
The balance sheet and income statement may not provide all information
o Financial statement users should also examine director’s report, auditors report
and etc.
Common Size Financial Statements
Common size financial statements present all balance sheet items as a percentage of total assets
and profit and loss items as a percentage of total sales. This way the financial statements factor
out the size of the company and assist in comparing companies and analysing trends.
Management Accounting: Introduction and Cost Concepts (Q8)
Learning objectives:
1. Describe basic production process used by manufacturing companies
2. Identify the key characteristics and benefits of lean production and JIT manufacturing
3. Distinguish manufacturing costs from non-manufacturing costs and classify manufacturing
costs as direct materials, direct labour or overhead.
4. Diagram the flow of costs in manufacturing, merchandising and service companies and
calculate the cost of manufacturing or selling goods and services.
5. Evaluate the impact of product costs and period costs on a company’s income statement and
balance sheet.
Management accounting is the processes and techniques that focus on the effective use of
organisational resources to support managers in their task of enhancing both customer value
and shareholder value:
– Customer value: the value that a customer places on a particular feature/product
– Shareholder value: the value that shareholders place on a business
Management accounting systems are information systems that produce the information for all
levels of management to manage resources and create value. The key functions of management
are planning, directing, motivating and controlling. Some common management accounting
approaches are:
– Total Quality Management: a comprehensive philosophy for continuously improving the
quality of products. It functions on the premise that the quality of products is the
responsibility of everyone involved in its production or consumption.
– Just-in-Time Systems: a production strategy that strives to improve returns on
investment by reducing in-process inventory and associated carrying costs. It aims for
zero defects and reduced setup time, using a flexible workforce and a small number of
suppliers.
– Customer Relationship Management: a model that seeks to find, attract and win new
clients while retaining existing customers, enticing former clients to return and reducing
the cost of marketing and client services.
Organisational Framework
Classified into 3 categories with each type needing different cost information:
– Manufacturing: produce goods by converting raw materials through use of labour and
capital inputs such as plant and machinery.
– Merchandising: buy goods already made by manufactures and sell them to consumers.
Those that sell directly to consumers are retailers while those that sell to other
merchandising firms are wholesalers
– Servicing: provide a service to customers, dealing with intangible products.
 Service companies: companies that sell products that do not sell a tangible
product as their primary business.
Service providers include such diverse companies and industries as Qantas airlines,
hospitals, brokerage firms, law firms and CPA.
1. Describe basic production process used by manufacturing companies
Manufacturing companies purchase raw materials from other companies and transform them
into a finished product. This requires labour and the incurring of other costs such as utilities, the
depreciation of factory equipment and supplies.
Manufacturing in a traditional environment:
Traditionally, the factory of a manufacturing company was organized with similar machines grouped
together. For example, furniture manufacturer still using traditional process.
It was normal (and perhaps even desirable) to accumulate raw materials inventory and finished-goods
inventory to serve as buffers in case of unexpected from demand for products or unexpected problems
in production.



Raw materials inventory: inventory of materials needed in the production process but not yet
moved to the production area. Usually sitting in a warehouse, awaiting transfer into the factory.
Finished-goods inventory: inventory of finished product waiting for sale and shipment to
customers.
Work in process (WIP) inventory: inventory that is moved out of a warehouse and into a
factory –they are in the process of being transformed (in other words, what is left in the factory
at the end of the period).
Cost Concepts
Cost is the cash or cash equivalent value sacrificed for goods and services that are expected to
bring a current or future benefit to the organisation. As costs expire in the production of revenues,
they become expenses whereas a cost that has not expired is an asset.
– Differential cost: amount by which a cost differs between two alternatives
– Controllable costs: costs heavily influenced by a manager, therefore all costs are
somewhat controllable to some degree, depending on which manager’s point of view
– Non-controllable cost: cost that cannot be influenced by a manager
Manufacturing Costs: Manufacturing costs are the costs associated with the process of
converting raw materials into finished goods. It can be further classified as:
– Direct Manufacturing Costs: costs that can be traced to a cost object, i.e. items/activities
to which costs are assigned, e.g. cost raw materials and cost of labour
o Direct materials: raw materials that can be directly traceable to product
o Direct labour: cost of labour used to covert raw material to a finished product o
– Indirect Manufacturing Costs: other overhead costs that are common to all products, i.e.
ones that cannot be associated with a particular cost object
o Indirect materials: generally material necessary for production that do not
become or become an insignificant part of finished product, e.g. glue
o Indirect labour: generally factory labour other than those that actually transform
raw materials into a finished good, e.g. supervisors, maintenance
Non-Manufacturing Costs : Costs not associated with the direct production of finished goods:
– Selling Costs: cost necessary to market and distribute a product, e.g. shipping, advertising
– Administrative Costs: costs associated with the general administration of the
organisation that cannot be assigned to either marketing or manufacturing, e.g. legal fees,
R&D
Related Cost Concepts
– Period Cost: costs that are expensed in the period in which they are incurred. ALL selling
and administrative costs are period costs
– Product Cost: costs that have potential to produce revenues beyond current period. All
manufacturing costs that that leads to products not sold in the current period are product
costs
– Prime Costs: combination of direct materials and direct labour
– Conversion Costs: combination of direct labour and manufacturing overhead
Financial Statements and the Functional Classification
When calculating profit, there are two major functional categories of expense:
–
–
Cost of goods sold represents ALL manufacturing expenses
Operating expenses represents ALL non-manufacturing expenses Cost of goods sold is
the cost of direct materials, direct labour and overhead attached to the units sold. To
calculate COGS, it is first necessary to determine cost of goods manufactured
Cost of goods manufactured represents the total cost of goods completed during the current
period. It is the sum of all manufacturing costs including direct materials, direct labour and
overhead, then added to the beginning work in progress, and then subtracting ending work in
progress:
COGM = Direct Material + Direct Labour + Overhead Costs + Beginnning WIP - Ending WIP
*Direct material is defined as materials that can be directly and conveniently traced to a particular
product or other cost object and that become an integral part of the finished product.
– Beginning WIP is added because that’s the cost of unfinished goods from last period
– Ending WIP is subtracted because that’s the cost of unfinished goods for next period
Work in progress (WIP) consists of all partially completed units found in production at a given
point in time. A manufacture usually has 3 types of inventory:
– Raw materials
– Work in progress
– Finished goods
Statement of cost of goods manufactured:
Then cost of goods sold is given by:
COGS = Goods available for sale – ending finished goods
= (Beginning finished goods + COGM) – ending finished goods
Management Accounting: Cost-Volume-Profit Analysis (Q8)
Learning objectives:
1.
2.
3.
4.
5.
Describe the nature and behavior of fixed and variable costs
Calculate the break-even point using the contribution margin approach.
Use CVP analysis for profit planning and graph the cost-volume-profit relations
Analyses what-if decisions using CVP analysis
Applying CVP analysis in a multi-product setting.
6. Compute a company’s operating leverage and understand its relationship to cost
structure
7. Applying Excel to CVP analysis.
 Exchange rate and exporting and cost, energy cost and oil cost and importance for ABC
news. (up on multiple choice final)
Cost Behaviour deals with how costs change with respect to changes in activity levels.
Cost drivers are factors that cause activity costs. Knowing how cost behaves in respect to a
relevant cost driver is essential for planning, controlling and decision making. 3 types of cost
behaviours are:
 Fixed Costs
Fixed costs are constant in total within the relevant range as the level of the cost driver varies. The
relevant range is the range over which the assumed fixed cost relationship is valid.
 Variable Costs
Variable costs vary in direct proportion to changes in a cost driver. It has a linear relationship:
means straight line
Total Variable Cost= Variable Cost per unit x Quantity
 Mixed Costs
Mixed costs have both a fixed and a variable component. It also has a linear relationship:
Total Cost = Fixed Cost + Variable Cost per unit x Quantity


Relevant range, the band of volume in which a specific relation between cost and volume.
It has capacity of the usage of power that people getting over the capacity and will reduce
the power.
the business can maximize the profitability through difference procedures to avoid
bearing fixed cost.
Breakeven point (BE)
 BE is 0 profit level
Level of activity where total cost = total revenue
Always round up
Cost-Volume-Profit (CVP) Analysis
Assumptions of CVP Analysis
1.
 Sale mix: is product that we sell.
 We are using contribution margin income statement
If contribution Margin = Fixed expenses = BE
 Regular price – variable cost = Contribution margin per unit
 FC + Target profit
Contribution margin per unit
Profit and Loss Statement – Cost Behaviour
–
–
–
Variable cost of goods sold (product cost):
total variable manufacturing costs attached to units sold,
e.g. direct materials, direct labour and variable overhead such as power.
Contribution margin (period cost): sales revenue – variable costs
Variable-costing profit (period cost): contribution margin – fixed costs
CVP analysis focuses on volume of activity, unit selling prices, variable costs, fixed costs and sales
mix using variable-costing profit and loss statement:
Profit before Tax = Sales Revenue - Variable Expenses - Fixed Expenses
 Unit-Sold Approach
This approach to CVP analysis measures sales activity in terms of the number of units sold.
Contribution margin per unit is the difference between unit revenue and unit variable cost.
 Sales-Revenue Approach
This approach of CVP analysis measures sales activity in terms of the total dollars of revenue.
This approach is useful for when units are difficult to identify, e.g. service industry
–
–
Variable cost ratio (vr): the proportion of each sales dollar used to cover variable cost
Contribution margin ratio (1-vr): the proportion of each sales dollar available to cover
fixed costs and provide a profit
Limitations of CVP Analysis:
– It assumes a linear revenue and cost function
– It assumes that what is produced is sold
– It assumes that fixed and variable costs can be accurately identified
– Selling prices and costs are assumed to be known with certainty, which is often not the
case
4. Analyses what-if decisions using CVP analysis
the needs to consider options to increase net income while maintaining high quality
products. Consideration the following options:
1. Reduce variable product manufacturing costs.
2. Increase sales through improved game features and increased advertising.
Reduce variable product manufacturing costs:
When variable costs are reduced, contribution margin will increase.
 Find a less expensive supplier of raw material
 Reduce the amount of labor used
 Use lower-wage employees (should consider the qualitative factors beyond the
numbers)
Option 2 –Improve features and increase advertising:
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