Brian Lam
08/11/2016
ACCT1511: ACCOUNTING & FINANCIAL MANAGEMENT 1B
1
1.1
ASSETS
Introduction: Financial Accounting
The Australian Securities and Investments Commission (ASIC) administers the Corporation Act and
oversees compliance, ensuring:
o
financial statements provide true and fair view of financial position and performance;
o
financial reports comply with accounting standards.
Accounting standards:
o
Generally Acceptable Accounting Principles (GAAP): common set of standards and procedures;
o
International Accounting Standards Board (IASB) develops international financial reporting
standards (IFRSs).
o
AASB develops accounting standards for Australian companies. Recently adopted most of IFRSs –
harmonisation.
Financial reports provide financial information about the reporting entity useful in making decisions.
o
Balance sheet: financial position;
o
Income statement: financial performance;
o
Cash flow statement: cash inflows and outflows.
Financial information should possess these characteristics:
o
Fundamental characteristics: relevance and faithful representation;
o
Enhancing characteristics: comparability, verifiability, timeliness and understandability.
Recall the accounting assumptions:
1.2
o
Accrual basis and the matching principle (matching expenses to same period as revenue recognition);
o
Going concern;
o
Economic entity;
o
Accounting period;
o
Monetary unit;
o
Historical cost.
Definition of an Asset
An asset is a resource controlled by the entity as a result of past events and from which future economic
benefits are expected to flow to the entity.
o
Future Economic Benefits: the potential to contribute (both directly and indirectly) to the flow of
cash/cash equivalents to the entity.
E.g. part of operating activities; sell the item; help save cost.
o
Control: the entity controls the benefits expected to flow to the entity. This does NOT mean that the
entity has legal control/ownership of the item.
o
Past event/transaction. Expected future events do NOT count!
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An asset is recognised on the balance sheet if they also satisfy the recognition criteria:
o
It is probable that it will bring future economic benefits: greater than 50% chance.
o
The asset has a cost or value that can be measured with reliability. Reasonable estimates do not
undermine their reliability.
If an item does not meet the essential characteristics or recognition criteria, they might appear only in the
annual report or notes (respectively).
1.3
Cost vs Assets vs Expenses
Cost/expenditure: amount of cash/equivalents paid or fair value of consideration given. We either:
o
Capitalise the cost and record it as an asset;
o
Not capitalise the cost and record it as an expense.
If an item does not meet the essential characteristics or recognition criteria of an asset, then it is an expense.
Capitalising the cost (recording as assets) defers the recognition of expenses to later periods for the matching
principle – matching expenses to the period where the revenue is recognised.
E.g. depreciation:
o
Capitalising the cost:
Dr Asset & Cr Cash;
o
Asset → Expense:
Dr Depreciation Expense & Cr Accumulated Depreciation;
o
Derecognising the asset at the end of useful life: Dr Accumulated Depreciation & Cr Asset.
E.g. inventory:
1.4
o
Capitalising the cost:
Dr Inventory
&
Cr Cash;
o
When revenue is earned:
Dr COGS
&
Cr Inventory (and revenue entries).
Current vs Non-current Assets
An asset is classified as current if it satisfies any of the following:
o
it is expected to be realised in, or is intended for sale or consumption in, the entity’s normal
operating cycle;
o
it is held primarily for the purposes of being traded;
o
it is expected to be realised within twelve months after the reporting date; or
o
it is cash or cash equivalent (unless it is restricted from being exchanged or is being used to settle a
liability for at least twelve months).
All other assets shall be classified as non-current.
In other words:
o
Cash → current asset;
o
Inventory → current asset;
o
If the asset is expected to be “used” up within the next 12 months → current asset;
o
If the asset is expected to be “used” up within the entity’s normal operating cycle → current asset.
Operating cycle: the time between the acquisition of assets for processing and their
realisation in cash or cash equivalents. Or 12 months.
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1.4.1
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THE VALUE OF NON-CURRENT ASSETS
Five ways to record value of non-current assets:
o
Historical cost – initial cost;
o
Current/Market value (value in exchange) – price to sell/buy?;
o
Value in use (present value) – asset worth to the company;
o
Liquidation value – what would we get if we have to sell it really fast?;
o
Price-adjusted historical cost – historical cost adjusted for inflation.
The first three are common and are referred to throughout the accounting standards.
o
Liquidation Value is generally never used unless the company is not expected to be able continue as a
going concern.
o
Price Adjusted Historical Cost is generally never used unless the company is reporting their financial
statements in a currency from an economy that is experiencing hyperinflation.
Note: “Fair value” generally means the same as Current or Market Value.
1.5
1.5.1
Property, Plant and Equipment (PPE)
MEASUREMENT AT RECOGNITION
An item of property, plant and equipment shall be measured at its cost, which includes:
o
Purchase price (including duties, non-refundable purchases taxes, less trade discounts and rebates);
o
Costs directly attributable to bringing the asset to the location and condition necessary to operate in
the manner intended by management;
o
The initial estimate of the cost of dismantling and removing the item and restoring the site on
which it is located.
Depreciation begins when the asset is capable of operating in a manner intended by management.
1.5.2
MEASUREMENT AFTER RECOGNITION
Cost model: After recognition as an asset, an item of PPE shall be carried (carrying amount/book value) at its
costs less accumulated depreciation and accumulated impairment.
o
Depreciation is the systematic allocation (not valuation!) of the depreciable amount (asset cost less
residual value) of an asset over its useful life.
o
Depreciation method depends on useful life, residual value (sale or scrap), pattern of flow of benefits
over the useful life – reassessed annually.
Useful life: the period of time over which an asset is expected to be available for use by an
entity; or the number of production or similar units expected to be obtained from the asset by
the entity. Relates to expected utility.
Residual value: estimated amount that an entity would currently obtain from disposal of the
asset, after deducting the estimated costs of disposal, if the asset were already of the age and
in the condition expected at the end of its useful life.
o
Depreciation methods: straight-line; reducing balance; units of production.
o
Recall recording gain/loss on sale based on discrepancies between book value and market value.
o
Improvements to assets are capitalised (where repairs/maintenance are expensed).
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1.5.2.1 THE REVALUATION MODEL
Revaluation model: After recognition as an asset, an item of property plant and equipment whose fair value
can be measured reliably shall be carried at a revalued amount – that is, its fair value at the date of
revaluation less any subsequent accumulated depreciation and accumulated impairment losses.
o
I.e. estimate fair value (current/market value), then depreciate the asset based on the fair value until
the next revaluation.
Revaluations shall be made with sufficient regularity. This ensures that the carrying amount does not differ
materially from the fair value at the reporting date.
o
Practically, this is usually every three to five years – and must be regular.
A revaluation may either be an increment or a decrement – based on the carrying amount.
The company must revalue a whole class of assets.
A model is chosen as its accounting policy and shall be applied to an entire class of PPE. The company must
revalue a whole class of assets.
For assets without depreciations, the first time we revalue:
o
Increments:
Dr Asset
Cr Revaluation Reserve;
o
Decrements:
Dr Loss on Revaluation
Cr Asset.
o
Revaluation reserve is an equity account – it does not increase period profit.
o
Loss on revaluation is an expense (i.e. on income statement and decreases profits).
For subsequent revaluations:
o
Increments that reverses previous decrements:
Dr Asset
AND/OR
o
Cr Gain on Revaluation (until all prior losses are reversed)
Cr Revaluation Reserve
Decrements that reverses previous increments: Dr Revaluation Reserve (if any) AND/OR
Dr Loss on Revaluation
Cr Asset
For depreciable assets, we must first write down the asset to its carrying amount before we record the
increment/decrement:
1. Update the depreciation to the date of revaluation:
Dr Depreciation Expense
Cr Accumulated Depreciation;
2. Write down the asset to its carrying amount:
Dr Accumulated Depreciation Cr Buildings
3. Record the increment/decrement:
Dr Building
Cr Revaluation Reserve/Gain on Revaluation; OR
Dr Loss on Revaluation/Revaluation Reserve
Cr Building
4. Recalculate depreciation:
Depreciable amount has increased/decreased. Yearly depreciation expense is thus changed.
When disposing an asset, any amount that is left in revaluation reserve can be taken to retained earnings –
these increments “belong” to previous periods.
Previous decrements are recorded as losses in previous periods – they are already included in retained earnings.
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1.6
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Intangible Assets
An intangible asset is an identifiable non-monetary asset without physical substance.
It must meet the essential characteristic of an asset: i.e. control, future economic benefits, past
event/transaction, as well as the identifiable criterion:
o
It is separable, that is, is capable of being separated/divided from the entity and sold, transferred,
licensed, rented or exchanged, either individually or together with a related contract/asset/liability; or
o
Arises from a contractual or other legal right, regardless of whether those rights are transferable or
separable from the entity or from other rights or obligations.
E.g. patents, licences, copyrights, franchises, trademarks, etc.
The definition excludes monetary items (i.e. financial instruments). E.g. shares are not intangible assets.
An intangible asset shall be measured initially at cost. Elements of costs include:
o
Purchase price (including import duties and non-refundable purchase taxes after deducting trade
discounts and rebates);
o
Any directly attributable costs of preparing the asset for its intended use;
o
For internally generated intangibles, the cost is the sum of expenditure incurred from the date
when the intangible asset first meet the recognition criteria (i.e. from the development phase).
For most intangible assets, only the cost model for can be used. An active market, which rarely exists due to
the uniqueness of intangible assets, is needed to determine its fair value for the revaluation model.
1.6.1
ACQUISITION VS INTERNALLY GENERATED
Separate acquisition: The intangible asset is purchased from outside the company.
o
It will always satisfy the probability recognition criterion. It is thus an asset on the balance sheet.
Internally generated: The intangible asset is developed by the company.
o
To assess whether an internally generated asset meets the criteria for recognition, an entity classifies
the generation of the asset into:
Research phase: the original and planned investigation undertaken with the prospect of
gaining new scientific or technical knowledge and understanding.
Development phase: the application of research findings or other knowledge to a plan or
design for the production of new or substantially improved materials, devices, products,
processes, systems or services before the start of commercial production or use.
o
All costs during the research phase are expensed – because an entity cannot demonstrate that an
intangible asset that will generate probably future economic benefits exists.
o
An intangible asset arising from the development phase shall be recognised if and only if an entity
can demonstrate all of the following:
the technical feasibility of completing the asset so that it will be available for use or sale;
its intention to complete the intangible asset and use or sell it;
its ability to use or sell the intangible asset;
how the intangible asset will generate probable future economic benefits;
the availability of adequate technical, financial or other resources to complete the
development and to use or sell the intangible asset;
its ability to measure reliably the expenditure attributable to the intangible asset during its
development.
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1.6.2
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GOODWILL
Goodwill is a non-current intangible asset, which it is not identifiable.
Goodwill is an accounting concept meaning the value of an entity in addition to the value of its separate
identifiable assets less liabilities.
o
because of synergies, reputation, loyalty of clients, staff knowledge etc.
Goodwill is the value of all the things that are hard to measure, and not separately listed on the balance sheet.
o
Measured as the consideration transferred LESS the fair value of net identifiable assets and
liabilities (the estimated market value of the net assets obtained).
Goodwill appears in a company’s books after its acquisition of another company.
1.7
Impairment
Checking for impairment = check for indications of overstatement of asset values.
If there are indications of overstatement, then we must test for impairment.
Note: intangible assets with indefinite useful life and goodwill MUST be tested for impairment at least
annually.
1.7.1
INDICATORS OF IMPAIRMENT
External sources:
o
significant declination in an asset’s market value;
o
negative changes in the technological, market, economic or legal environment;
Internal sources:
1.7.2
o
obsolescence or physical damage of an asset;
o
changes making an asset idle, plans to discontinue or restructure operations to which asset belong;
o
plans to dispose an asset before the previously expected date;
o
internal reporting indicating the economic performance of an asset is worse than expected.
TEST FOR IMPAIRMENT
We test for impairment by comparing the carrying value with the recoverable amount:
o
Recoverable amount is the highest value of either selling or using the asset. I.e. either the fair value
less cost to sell or the value in use.
If the carrying amount is higher than the recoverable amount, then the asset is impaired – need to write down.
o
COST Method:
Dr Loss on Impairment
Cr Accumulated Impairment;
o
REVALUATION:
Dr Loss on Revaluation/Reserve
Cr Asset
Reversing an Impairment Loss: Dr Accumulated Impairment
o
Cr Gain on Reversal of Impairment.
Revaluation reserve or gain on revaluation for revaluation method.
Impairment recognised for Goodwill can NOT be reversed.
The increased carrying amount due to the reversal cannot be greater than the carrying amount had no
impairment loss been recognised.
Even if revaluation method is used, companies CANNOT ignore indications of impairment. The company
must test for impairment before its next revaluation.
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1.8
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Inventory
Inventories are assets:
o
held for sale in the ordinary course of business;
o
in the process of production for such sale, or;
o
in the form of materials/supplies to be consumed in the production process or in rendering of services.
Inventory types: raw materials; work in progress; finished goods inventory; merchandise inventory.
Cost of inventory includes costs of purchase, costs of conversion, and other costs incurred in bringing the
inventories to their present location and condition.
Recall the cost flows:
o
Merchandise inventory → cost of goods sold;
o
Raw material + Labour + Overhead → Work in Progress → Finished goods → COGS.
o
Opening inventory + Purchases = Goods available for sale.
o
Goods available for sale – ending inventory = Cost of goods sold.
In periods of rising prices:
o
FIFO leads to highest ending inventory, highest gross profit, highest net profit and lowest COGS;
o
LIFO leads to lowest ending inventory, lowest gross profit, lowest net profit and highest COGS.
o
Weighted average results fall between FIFO and LIFO.
Recall overstatement of ending inventory will lead to:
o
Understatement of current period’s COGS;
o
Overstatement of current period’s profit.
Ending inventory should be measured at the lower of cost and net realisable value.
1.9
o
Net realisable value is the estimated selling price in the ordinary course of business less the
estimated costs of completion and the estimated costs necessary to make the sale.
o
Net realisable value might be lower because obsolescence, damage, demand etc.
o
Loss from this rule is recorded as an expense (inventory loss).
Accounts Receivable & Doubtful Debts
Estimating doubtful debts for the period: Dr Bad Debts Expense & Cr Allowance for Doubtful Debts.
Writing off uncollectable bad debts:
Dr Allowance for Doubtful Debts & Cr Accounts Receivable.
1.10 Relevance, Reliability and Prudence/Conservatism
Reliability vs Relevance: historical cost vs market value.
Prudence/Conservatism: careful not to overstate assets and income and careful not to understate liabilities
and expenses.
o
Revaluation model – decrements are on income statement but not increments.
o
Testing for impairment: we concern about whether the asset is overvalued.
o
Lower of cost and net realisable value rule: inventory can never be recorded at a value higher than
cost – not overstating them.
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LIABILITIES
A liability is a:
o
present obligation (duty/responsibility) of the entity arising from past events,
either legally enforceable obligations or constructive obligations – practice to maintain good
business relations or act in an equitable manner.
an agreement is irrevocable if the entity has little/no discretion to avoid an outflow or
resources if the obligation is not honoured.
o
the settlement of which is expected to result in an outflow of resources embodying economic
benefits from the entity (outflow of economic benefits).
Recognition criteria:
o
It is probable that any future economic benefit associated with the item will flow from the entity;
For obligations for one item with small probability, we consider the class of obligations as a
whole instead – then it is probable that there will be some outflow of resources.
o
The item has a cost or value that can be measured with reliability.
In practice, obligations under contracts that are equally proportionately underperformed are generally not
recognised as liabilities in the financial statements.
2.1
Current Liabilities
A liability is current if either:
o
it is expected to be settled in the entity’s normal operating cycle;
o
it is due to be settled within twelve months after the reporting date.
Accruals: for goods/services received\ but have not been paid. E.g. accounts payable, unearned revenue.
Interest bearing liabilities (obligations with interest): e.g. note payables, bank loans, etc.
Current tax liabilities
Dividends payable.
2.2
Non-Current Liabilities
Non-current liabilities typically arise from:
2.2.1
o
specific financing situations, e.g. borrowings and bonds/debentures;
o
ordinary business operations. E.g. superannuation, deferred income tax, long service leave etc.
BONDS
A bond is a promise to pay interest, usually a fixed amount at set intervals, and a specified amount on a
specified date in the future.
o
The buyer of a bond is the lender; the seller of the bond is a borrower.
o
Terminology: face value, maturity date, coupon rate.
o
Note: coupon rate (compared with market interest rate) will determine whether a bond is being sold at
par, discount, or premium.
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For bonds:
o
Face value: recognise in bond payable;
o
Difference between cash and face value (discount/premium): a contra-liability account, either bond
discount (with debit balance – reduce carrying amount!) or bond premium (with credit balance).
The discount or premium is amortised over the accounting periods until the bonds are due on maturity.
Amortisation of Bond Discounts:
o
The total interest expense from it was issued to its maturity is the sum of coupon interest payments
and the difference between the proceeds received on issue and the principal repaid (the face value) –
i.e. the bond discount.
o
The annual interest expense is measured by multiplying the effective interest rate by the carrying
amount of the liability at the beginning of each period.
I.e. annual interest expense = opening balance of the carrying amount
effective interest rate.
Change in Bond Discount = annual interest expense – annual coupon payment.
So Dr Interest Expense
Cr Bond Discount & Cash
o
Any excess of interest costs over the amount of interest paid in cash (i.e. coupon interest payment) is
accounted for as an increase in the carrying amount of the liability.
o
By maturity date, the carrying amount of the bond liability will be increased to an amount equal to
the principal, as the discount reduces to zero.
Amortisation of Bond Premiums are similar but opposite (and MINUS bond premium for interest!):
o
2.3
2.3.1
So Dr Interest Expense & Bond Premium
Cr Cash
Provisions and Contingent Liabilities
PROVISIONS
Provisions are liabilities that are either uncertain in timing or amount. Reliable estimates are made.
o
May be current or non-current.
o
May arise from either a legal or constructive obligation.
E.g. warranties (uncertainty in amount and timing) and employee benefits (e.g. annual leave, sick leave).
There is only provision if there is a present obligation.
Creating a provision:
Dr (some) expense
Settling a provision:
Dr Provision for (something) Cr Cash
o
Cr Provision for (something)
If the provision is not enough, then directly debit expense and credit cash/inventory.
For annual leaves:
o
o
In periods where employee works and earn the annual leave:
Dr Wages Expense
Cr Cash and;
Dr Annual Leave Expense
Cr Provision for Annual Leave
In periods where employee takes annual leave:
Dr Provision for Annual Leave
Cr Cash
Net effect when people take annual leave, compared to people not taking annual leave, is a reduction in
liabilities and reduction in expenses.
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2.3.2
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CONTINGENT LIABILITIES
Contingent liabilities are either:
o
a possible obligation arising from past events but whose existence depends on future events, e.g.
lawsuit;
o
liabilities that do not meet the recognition criteria.
Contingent liabilities are NOT recognised on the balance sheet – disclosed in the notes instead.
An entity determines whether a present obligation exists at the reporting date by taking into account all
available evidence, including that of experts:
o
where it is more likely than not that a present obligation exists at the end of the reporting period,
the entity recognises a provision (if the recognition criteria are met); and
o
where it is more likely that no present obligation exists at the end of the reporting period, the entity
discloses a contingent liability, unless the possibility of an outflow of resources embodying economic
benefits is remote (very unlikely).
If a liability exists, but fails the recognition criteria, a contingent liability is disclosed in the notes to the
financial statements.
2.4
Funding Assets: Liabilities or Equity
Both liabilities and equity details how our assets have been funded. That is: Assets = Liabilities + Equity.
o
Liabilities that come out of legal or constructive obligations (e.g. borrowings, bonds, unsecured notes,
leases); or
o
Equity capital (e.g. ordinary shares, preferred shares).
With debt, the issuer is obliged to deliver either cash or another financial asset to the holder.
o
E.g. repay principal or interest or dividends in the terms of the agreement.
Equity is any contract that evidences a residual interest in the entity’s assets after deducting all of its
liabilities.
o
E.g. ordinary shares, where all the payments are at the discretion of the issuer.
The critical feature that distinguishes a liability from an equity instrument is the fact that the issuer does not
have an unconditional right to avoid delivering cash or another financial asset to settle a contractual
obligation.
But hybrid instruments: Financing forms that exhibit both debt and equity characteristics (e.g. convertible
notes, and convertible preference shares).
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FINANCIAL STATEMENTS: EQUITY, INCOME AND EXPENSES
3.1
Shareholder’s Equity
Recall that Assets = Liabilities + Shareholder’s Equity.
Shareholder’s Equity consists of share capital, retained profits and reserves.
o
Change in Retained profit =
Profits – dividends paid (interim paid and final dividend declared) + in/out from reserves.
o
Reserves are direct adjustments to equity, instead of changing revenue/profit.
Issuing equity is a way to raise funds and for takeover defence.
3.1.1
SHARE CAPITAL (CONTRIBUTED EQUITY)
We have different types of shares: ordinary, preference, founder and deferred.
When we issue shares, there are usually a few steps: offer, application, allotment of shares.
In its simplest form, we would just debit cash and credit share capital.
Issuing to an institutional investor or Private placement – here we would simply debit cash and credit
share capital.
Issuing publicly (Initial Public Offering/IPO) – payable in full on application:
1. Receiving applications at A:
Dr Cash Trust
Cr Application
Money does not belong to the company (yet)!
2. Allotment at B:
Dr Cash
Cr Cash Trust
Dr Application
Cr Share Capital
(company’s money!)
Dr Cash Trust
(reverse)
3. In case of excess applications: Dr Application
Issuing publicly (Initial Public Offering/IPO) – payable by instalment:
o
We have steps: application, allotment, allotment payment (due later), and call for final payment.
1. Receiving applications at A:
Dr Cash Trust
Cr Application
2. Allotment at B:
Dr Cash
Cr Cash Trust
Dr Application
Cr Share Capital
3. Call at allotment at B:
Dr Allotment
Cr Share Capital
4. Allotment money at C:
Dr Cash
Cr Allotment
5. Call for payment at D:
Dr Call
Cr Share Capital
6. Receiving call money at E:
Dr Cash
Cr Call
(company’s money!)
A company may get more applications (over-subscription) or less applications (under-subscription).
o
An underwriter is an agreement with a stockbroker/financial institution, who guarantees to purchase
shares that were not sold in the issue period.
o
In the case of undersubscription, if the minimum subscription condition is not met, then share issue
may be abandoned.
o
In the case of oversubscription, directors decide who and how much applicants to receive.
When an applicant is allotted fewer shares than applied, then the money may be applied to
allotment/future calls, OR returned.
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3.1.1.1 FURTHER SHARE ISSUES/ACTIONS
Rights issues: shares are offered in a ratio to a member’s existing holding, usually below market price.
o
Members can sell this right of purchase: renounceable rights issue.
Share options: giving the holder the right to purchase an agreed number of shares at a later date, and at a
fixed exercise price.
Bonus issues: existing shareholders get additional shares. Usually from Reserves to share capital.
o
Shares are given away in proportion to existing holdings.
o
E.g. 1:4 – 1 new share for 4 currently held.
o
Dr Revaluation/other reserve Cr Share Capital
o
This capitalises long-term reserves, signals good future profitability, for “dividend” expectations
without spending cash.
o
However, share price will fall.
Share splits: increase the number of shares. E.g. 2:1 means each share will become 2. No journal entries.
Share buybacks: repurchase of issued shares. This will reduce share capital.
3.1.2
o
This signals the company is undervalued.
o
This is a management of surplus funds other than paying dividends or reinvesting.
o
If buyback price equals issue price:
o
If buyback price IS MORE THAN issue price: Dr Share capital & Retained Profits
Dr Share capital
Cr Cash
Cr Cash
EQUITY: DIVIDENDS
Dividends are distributions of profits to shareholders; it will reduce owners’ equity (retained profits).
Dividends are can be interim or final.
3.1.3
Declaring dividends:
Dr Retained Profits
Cr Dividends Payable.
Paying dividends:
Dr Dividends Payable
Cr Cash.
EQUITY: RESERVES
Reserves reflect where certain gains/losses have originated.
o
E.g. revaluation reserve, foreign currency translation reserve, general reserve etc.
Recall that when a non-current asset is revalued upwards, revaluation reserve is credited.
General reserve is a reserve created to reduce retained profits. This might mean:
o
reducing amount available for distribution;
o
a signal to re-investment and thus future growth;
o
rainy day contingencies, etc.
General reserve transfers and their natures must be disclosed.
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3.2
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Capital Structure
Considerations when deciding on financing mix (debt/equity):
o
Voting rights;
o
Temporary versus permanent needs;
o
Contractual implications;
o
Interest versus dividend;
o
Tax considerations;
o
Expected cash flows.
Capital structure of a company can be used in a takeover defence.
Issuing bonus shares:
o
increases market value of the target – due to increase expected future cash flows – higher price.
o
increases the number of shares – raider needs to withdraw/modify offer to include the new shares.
Share splits: new offer to include the new shares.
Share buybacks: return cash to shareholders. Company less attractive since less asset. HOWEVER, since
there will be less shares the acquirement might be easier.
Issue through Private Placement: change the balance of voting rights. However, restriction on amount.
Inter-corporate investments: investing in debt and equity securities of other companies. Enter new markets,
diversify, obtain competitive advantages etc.
3.3
Consolidation Process
Parent and Subsidiary have separate financial statements.
We then combine, eliminate (parent’s investment in each subsidiary, and parent’s portion of equity in
subsidiary) and intragroup transactions (transactions between entities within the group).
We then obtain a group, consolidated financial statement.
3.4
Income Recognition
Periodic profits are timely and decision relevant, but there is a level of uncertainty and judgement required.
Revenue is generally recognised at the point of delivery of the goods/services.
Income:
o
are increases in economic benefits;
o
results in increase in equity (i.e. A – L), and are NOT contributions from owners.
o
Income includes both revenue and gains.
Income are recognised when:
o
increase in future economic benefits (either increase in asset or decrease in liability);
o
can be measured with reliability.
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Revenue is recognised at an event where:
o
significant risks and rewards of ownership have been transferred to the buyer;
o
amount of revenue can be reasonably measured in dollar terms;
o
probable that economic benefits related to the transaction will flow to the seller;
o
most costs to generate the revenue have been incurred, and the remaining can be measured reasonably.
E.g.: point of sale/delivery, percentage of production (periodic profit is the proportion that is completed in
that period multiplied by total profit), completion of production, cash receipt, after cash receipt, etc.
3.5
Expense Recognition
Expense:
o
are decreases in economic benefits;
o
NOT contributions from owners.
Income are recognised when:
o
decrease in future economic benefits (either decrease in asset or increase in liability);
o
can be measured with reliability.
Revenue is recognised at an event where:
o
significant risks and rewards of ownership have been transferred to the buyer;
o
amount of revenue can be reasonably measured in dollar terms;
o
probable that economic benefits related to the transaction will flow to the seller;
o
most costs to generate the revenue have been incurred, and the remaining can be measured reasonably.
E.g.: point of sale/delivery, percentage of production (periodic profit is the proportion that is completed in
that period multiplied by total profit), completion of production, cash receipt, after cash receipt, etc.
3.6
Income Statement
Recall asset: expectation of economic benefit, control, past event or transaction; probably and measurement.
Matching principle: expenses are matched with the revenues produced during a period.
Income statement includes: revenues, expenses, financing costs expense, shares of net profits/losses of
associates and joint ventures accounted for using the equity method, income tax expense, P/L from ordinary
activities after related income tax expense, net P/L, net P/L attributable to outside equity interest, net P/L
attributable to members of the parent entity.
Significant items are revenues/expenses from ordinary activities is of such size, nature or incidence that its
disclosure is relevant in explaining the financial performance of a company, its nature and amount must be
disclosed separately in the notes in the financial report.
o
E.g. write-down of inventories/non-current assets, litigation settlements, disposal of investments/PPE.
Expenses can be classified by either nature of expense method or function of expense method.
Statement of Changes in Owners’ Equity: summarises transactions affecting owners’ equity.
o
“Bridge the gap” between balance sheet and income statement.
o
E.g. due to additional investment, net income, withdrawals by owner, dividends, etc.
What-if analyses? Impact on net profit, balance sheet numbers, ratios?
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4
4.1
08/11/2016
CASH FLOW STATEMENT AND ANALYSIS
The Cash Flow Statement
The cash flow statement shows changes in a company’s cash balance during the accounting period as a result
of operating activities, investing activities and financing activities.
It gives information about a company’s ability to remain solvent/financial stability and grow.
Ending cash balance = Beginning cash balance + cash inflows – cash outflows.
The cash flow statement has structure:
1. Cash from operating activities: cash inflows and outflows;
2. Cash from investing activities: cash inflows and outflows;
3. Cash from financing activities: cash inflows and outflows;
4. Net cash flow;
5. Cash both opening and closing balance.
Operating activities:
o
E.g. receipts from sale of G&S, receiving interest and dividend;
o
E.g. purchasing inventories, paying tax, paying utilities and interests etc.
Investing activities: buying and selling of non-current assets.
Financing activities: capital structure – owner investment or withdrawal, borrowings and their repayments.
4.2
o
E.g. issuing shares, borrowing from banks;
o
E.g. paying long-term debts, paying dividends.
The Direct Method
We use the balance sheet and income statement to construct the cash flow statement.
We start with operating activities, then investing activities, and finally financing activities.
Begin with the income statement: use relevant journal entries and T-accounts to find balancing cash item!
o
Accounts receivable: sales, writing off bad debts;
o
Accounts payable: inventory purchases, repayments.
o
Depreciation expense: non-cash!
If there are no sales/purchases of asset, depreciation expense is the increase in accumulated
depreciation.
Otherwise, depreciation expense needs to be determined from T-accounts.
o
Receipts from… and payments to/for…
Then investing activities: non-current assets!
o
Disposal or acquisition.
Lastly financing activities: liabilities and equity!
o
Changes to retained earnings: profit/loss, dividends, transfers from/to reserves.
o
Dividend paid: opening balance for final dividend payable – paid in the year!
o
Interim dividends: look at retained earnings – paid as cash during the year.
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4.3
08/11/2016
The Indirect Method
Note: All sales are on credit – accounts receivable; all inventory purchases are on credit – accounts payable;
other expenses – accrued expenses; buying and selling of non-current assets are for cash.
The indirect method discloses a note showing the reconciliation of net profit and cash from operations (CFO)
to reconcile why net profit and CFO are different. Take net profit after tax, then:
o
Adjust for permanent differences: differences that will not reverse over time. E.g. disposal.
Add depreciation.
Decrease gain from sale.
o
Adjust for timing differences: differences that will reverse over time. I.e. accrual basis vs cash basis.
Subtract increases in current assets – except cash.
Add increases in current liabilities – except dividends payable and short-term borrowings.
Write “changes in asset and liabilities.”
4.4
Decision Usefulness of Cash Flow
Cash flow information allow assessment of a firm’s ability to:
4.5
o
Generate future cash flows;
o
Continue meeting its financial obligations;
o
Pay future dividends.
Analysing the Cash Flow Statements
Relate the cash flow statement to the balance sheet and income statement;
o
E.g. inventory and accounts receivable should be low, sales revenue close to cash received from
customers, COGS close to cash paid to suppliers.
Examining CFO and total cash flows;
o
Positive CFO – and how well is cash managed? Paying off debts? Paying dividends? Etc.
Examine the relationship between cash flows from operating, investing and financing activities.
o
Life cycles of firms:
Start-up/Growth
Maturity/Stability
Decline
Operating CF
Negative
High
Low
Investing CF
Negative
None
Positive
Financing CF
High
None/negative
Negative
Calculate cash flow ratios.
o
Free cash flow = CFO – capital expenditure.
o
Financial flexibility is when there are free cash flows to invest in growth projects/capital expenditure.
o
Solvency & Liquidity Ratios:
Operating cash flow:
o
CFO
CFO cash dividends
; Cash current debt coverage:
Current liabilities
Current liabilities
Viability as a going concern:
Capital expenditure:
CFO
CFO
; Cash flow to total debt:
.
Total debt
Capital expenditures
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5
5.1
08/11/2016
FINANCIAL STATEMENT ANALYSIS AND ACCOUNTING POLICY CHOICE
Comparative Analysis
Should we invest in some company?
We find the closest among comparable companies.
o
A comparable firm could be: similar industry? similar products?
o
Why is a choice not so appropriate: product range does not match? franchise? bulk-buying?
Business model
5.2
o
What is the unfair advantage?
o
Where does the cash come from? Fruit or tree.
o
Competitive threats.
o
Special situations/context that affect analysis?
Ratio Analysis
Profitability ratios
o
Shows return, compares return on capital and return on assets against cost of capital.
Activity Turnover: Asset/inventory turnover/Days in inventory
o
A low inventory turnover may indicate obsolete products, high storage costs.
Liquidity ratio: current ratio
o
Related to short-term cash flow issues.
o
Traditionally, a current ratio that is > 1 is better (since positive working capital and enough current
assets to cover current liabilities).
o
Nowadays we consider a current ratio of < 1 is better – using other suppliers (accounts payable) and
customers’ (unearned revenue) to run the business – not your own!
Solvency ratios: debt/equity and interest coverage (below 1?). Leverage = 2.
5.3
o
Related to risk of bankruptcy.
o
Some industries may be able to sustain higher leverage – if more tangible assets? If cash flows are
more predictable?
Valuation Analysis
We use both comparative and valuation/pricing analysis.
Use a comparable firm and measure the expected growth.
Price-to-earnings (PE) ratio is Price / EPS.
o
A low PE means the company is undervalued;
o
A high PE means the company is overvalued.
PE ratio – historical, forward (current year), forecast (future, 3 or 5 years out)
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Price target: what you think the share is worth. We use a similar company to compare.
o
What is the share price if company A has the same PE ratio as B?
o
I.e. Price target A
o
If the price target is greater than its price, then BUY.
o
I.e. if PE is lower, then buy because it is undervalued.
o
Note: if there is a loss (i.e. negative EPS and PE ratio) then the analysis is meaningless.
o
Other ratios e.g. price to sales (income statement), price to book/equity (balance sheet).
Price A
PE A
PE B .
A high price might indicate an expected future growth in earnings.
Price Earning Growth (PEG) Ratio is PE / expected growth in earnings (%)
5.4
o
PEG > 1 then share is overvalued, so SELL.
o
PEG < 1 then share undervalued, so BUY.
o
PEG = 1 fairly priced.
Accounting Policy Choice
Accounting policy choices must be under GAAP/accounting standards, and is commonly related to
depreciation, inventories, revenue recognition, amortisation and expenditure on assets.
Management incentives: higher profit? lower liabilities? expectations? tax?
Accounting policy choices must be disclosed in the notes, including its nature, reasons and financial effects.
E.g. changes in depreciation will affect:
o
Depreciation expense, income tax expense;
o
Accumulated depreciation, income tax payable.
Consider journal entries, and see what is affected.
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6
6.1
08/11/2016
MANAGEMENT ACCOUNTING
Revision: Cost of Goods Manufactured and Cost of Goods Sold
Cost of goods manufactured represents the total cost of goods completed during the period.
Recall that prior to completion, the costs is debited into Work-in-progress. After completion, this cost is
debited into finished goods.
So the COGM for a period is the amount that is debited into WIP + the existing WIP credited out of WIP.
Thus, COGM = opening WIP + total manufacturing costs – closing WIP.
o
where total manufacturing costs include direct materials, direct labour and overhead applied.
COGS = Beginning FG + Cost of Goods Manufactured (= goods available for sale) – Ending FG
Raw materials used
or, COGS
Begin FG (Begin WIP begin DM
purchases end DM
DL OH
end WIP ) end FG
product cost / total manufacturing cost
COGM
Recall that we can classify costs into manufacturing and non-manufacturing.
o
6.2
Manufacturing: direct materials, direct labour, overhead – these are included in COGS and COGM.
Cost Measurement: Applied Overhead
With direct costs (i.e. materials and labour), it is easy to calculate/measure how much is allocated. I.e. we
know the actual costs.
o
Journal entry:
Dr WIP
Cr Raw materials/Wages Payable (not expense!)
However, with indirect costs (e.g. depreciation), it is difficult to allocate.
o
Usually we have a pre-determined rate (e.g. based on machine hours).
For overhead, we have a temporary account called Overhead control.
o
The debit side is the actual overhead. The credit side is the applied (estimated) overhead.
o
First, we apply the pre-determined/applied overhead:
Dr WIP
o
Cr Overhead Control
Then, once we have actual amounts:
Dr Overhead Control Cr Related accounts
Note: related accounts e.g. accumulated depreciation, wages, electricity, rent payable, etc.
The overhead control account needs to be zero at the end:
o
Overapplied: if applied > actual (credit > debit) – this means we have debited too much WIP.
o
Underapplied: if applied < actual (debit > credit) – this means we have debited not enough WIP.
If the OH difference is immaterial: Adjust through COGS.
o
Overapplied:
Dr Overhead control
o
Underapplied: Dr COGS
I.e.:
Cr COGS
Dr Overhead control
If the OH difference is material:
o
Adjust all three WIP, FG and COGS in a pro rata basis – based on ending balances.
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6.3
08/11/2016
Limitations of Product Costing
Traditionally overhead cost allocation based on volume measures. E.g. Direct labour hours.
o
Choice of volume measure is important.
Variety of methods now in use:
6.4
o
Multiple allocation rates. E.g. direct machine hours for machine, labour hours for labour
o
Activity-based costing (ABC).
o
Target costing.
COGM and COGS Statements
Cost of Goods Manufactured:
o
Title
+
Direct materials: [beginning + purchases = materials available] – ending = direct materials used
+
Direct labour
+
Overhead applied – list each overhead
Plus: over‐applied OH (or less under-applied OH)
Total manufacturing costs added
o
Add Beginning WIP = (total costs of WIP)
o
Less Ending WIP = COGM.
Note: total manufacturing costs uses pre-determined OH.
Cost of Goods Sold:
o
Beginning finished goods inventory + Cost of Goods Manufactured
goods available for sale
o
Less Ending finished goods inventory
Cost of goods sold (unadjusted)
+
Less: over‐applied OH (or plus: under-applied OH)
Adjusted COGS
Note: COGS uses actual OH.
Income Statement
Title (name of company, “income statement”, time period)
o
Sales (note: unadjusted COGS is used for markups)
o
Less (adjusted) COGS
Gross profit
o
Less operating expenses (list each period cost, selling, general, administrative)
Net profit
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6.5
08/11/2016
Budgeting
Budgets are formal documents that quantity an organisation’s plan for achieving its goals. Budgets allow:
o
Planning: setting targets or goals;
o
Communication and coordination: a tangible means for communication and coordination;
o
Control: evaluate performance based on a benchmark.
Master budget: a comprehensive financial plan consisting of interrelated budgets.
6.5.1
o
Operating: sales budget, purchases and expenses budget;
o
Cash: cash receipts and cash payments budget;
o
Financial statements: budgeted financial statements.
OPERATING BUDGET
We construct budgets in the order: sales → production & selling and admin → direct materials, labour &
overhead → ending inventory → COGS.
We first construct a Sales budget.
o
We have rows: number of units, selling price and total sales revenue.
Then we construct a Production budget. Production amount = desired ending inventory + sales – opening.
o
We have rows:
number of sales units, desired ending inventory,
Sum to get number of units needed,
Less beginning inventory,
To get number of units to produce.
Then we consider the costs of production. Direct materials, Direct Labour and Overhead budgets.
o
For direct materials, we have rows:
Units to produce, cost of direct materials per unit,
Multiply to get cost of production needs, in dollar terms,
Plus desired ending inventory of raw materials (in dollar terms),
To get total cost of direct materials needed,
Less beginning inventory of raw materials,
To get direct material (required to) purchased.
o
For direct labour, we have rows:
Units to produce, direct labour per unit,
Multiply to get total hours needed,
Multiply by wage/hour,
To get total direct labour cost budgeted
o
For overhead, we have rows:
Units to produce, variable OH rate per unit,
Multiply to get budgeted variable OH costs,
Plus budgeted fixed OH costs,
To get total OH costs budgeted.
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Then we have the Selling and Admin budget (includes commission!).
o
We have rows:
Planned number of sales, variable S&A cost per unit,
Multiply to get total variable costs,
Plus fixed S&A costs,
To get total S&A costs budgeted.
Then we have the Ending inventory budget – which is required for COGS budget.
o
Ending inventory (for the whole period!) is calculated by unit cost × number of units.
o
We have rows:
Each cost: direct materials, direct labour, OH (variable/fixed) which sum to total unit cost.
Note: with fixed OH, we allocate per unit costs by splitting up the period fixed OH
costs (e.g. based on direct labour hours).
Then for each inventory account, we consider the number of units and unit costs, which
multiplied to get the total ending inventory.
Note: for raw materials/WIP there might not be number of units. Ending finished
goods inventory depends on desired ending inventory for the last month.
Sum to get total inventory.
Lastly, we construct the COGS budget.
o
6.6
Here, we also include the COGM. Refer to 6.4.
Behavioural Aspects of Budgeting
When preparing budgets, we should consider: participation of staff? Are goals achievable?
There should be clearly-defined responsibilities and accountability; controllability and flexibility.
Managerial myopia: tendency for public listed firm managers (other individuals or employees) to favour
short-term profits over long-term gains.
Slack creation: where a manager deliberately underestimates budgeted revenue or overestimates budgeted
expenses, such that budget targets can be achieved more easily.
o
Potentially leading to bonuses, appraisals etc.
Goal congruence: aligning goals to achieve an overarching mission.
o
A lack of goal congruence occurs when a manager is induced by a control system to do something
that is not in best interests of the company.
o
The incentive is to obtain their bonus. Their actions could be inconsistent with the company’s goals.
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