4T H E DI T I ON
Accounting
I n f o r m at io n f o r B u s in e s s D e ci s io n s
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
4T H E DI T I ON
Accounting
I n f o r m at io n f o r B u s in e s s D e ci s io n s
Billie M Cunningham
Loren A Nikolai
John D Bazley
Marie Kavanagh
Sharelle Simmons
Christina James
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Accounting: Information for business decisions
4th Edition
Billie M Cunningham
Loren A Nikolai
John D Bazley
Marie Kavanagh
Sharelle Simmons
Christina James
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Adaptation of ACP Accounting: Information for business decisions Volumes 1, 2nd
edition, by Cunningham/Nikolai/Bazley [ISBN 9780324833492], published by
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Acknowledgements
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BRIEF CONTENT S
1
Introduction to business accounting and the role of professional skills ...................................... 1
2
Developing a business plan: Cost–volume–profit analysis ...................................................... 44
Appendix: CVP analysis for cups of coffee .......................................................................86
3
Developing a business plan: Applied budgeting..................................................................... 94
4
The accounting system: Concepts and applications............................................................... 132
5
Recording, storing and reporting accounting information ..................................................... 179
6
Internal control: Managing and reporting working capital ................................................... 226
7
The income statement: Components and applications........................................................... 263
Appendix: Calculating the cost and the amount of inventory .............................................299
8
The balance sheet: Components and applications ................................................................ 308
9
The cash flow statement: Components and applications ....................................................... 352
Appendix: Indirect method for reporting cash flows from operating activities ......................390
10
Sustainable and profitable business practices ...................................................................... 398
11
Short-term planning decisions ............................................................................................. 440
12
Capital expenditure decisions.............................................................................................. 473
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v
CONTENT S
Guide to the text ....................................................... x
Guide to the online resources ....................................xiv
Preface ...................................................................xvi
About the authors...................................................xxiii
Acknowledgements ................................................. xxv
Chapter 1
Introduction to business accounting and the role of professional skills...................... 1
1.1 Factors affecting the complexity of a changing business environment ............... 4
1.2 Business enterprise categories..................................................................... 7
1.3 Business structures ..................................................................................... 9
1.4 The accounting system ............................................................................. 15
1.5 Ethics in business and accounting.............................................................. 24
1.6 The accountant in a changing society ........................................................ 26
Study tools ................................................................................................... 36
Chapter 2
Developing a business plan: Cost–volume–profit analysis ...................................... 44
2.1 Planning in a new business....................................................................... 45
2.2 Cost–volume–profit (CVP) planning ............................................................ 54
2.3 Using CVP analysis.................................................................................. 65
2.4 Other planning issues and effects .............................................................. 69
Study tools ................................................................................................... 71
Appendix: CVP analysis for cups of coffee ........................................................ 86
Chapter 3
Developing a business plan: Applied budgeting .................................................... 94
3.1 Why budget? ......................................................................................... 95
3.2 Operating cycles..................................................................................... 97
3.3 The budget as a framework for planning .................................................... 99
3.4 Using the master budget in evaluating the business’s performance ............... 117
Study tools ................................................................................................. 121
Chapter 4
The accounting system: Concepts and applications .............................................. 132
4.1 Financial accounting information and decision making............................... 134
4.2 Basic concepts and terms used in accounting ............................................ 136
4.3 Components of the accounting equation ................................................... 139
4.4 Accounting for transactions to start a business........................................... 143
4.5 Expanding the accounting equation ......................................................... 148
4.6 Recording daily operations..................................................................... 150
4.7 End-of-period adjustments....................................................................... 160
Study tools ................................................................................................. 166
vi
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Contents
Chapter 5
Recording, storing and reporting accounting information .................................... 179
5.1 Accounts .............................................................................................. 180
5.2 Accounting cycle................................................................................... 183
5.3 Recording (journalising) transactions........................................................ 183
5.4 Posting from journals to the accounts ....................................................... 190
5.5 Trial balance ........................................................................................ 196
5.6 Preparing adjusting entries ..................................................................... 197
5.7 Adjusted trial balance............................................................................ 202
5.8 Preparing the financial statements............................................................ 203
5.9 Preparation of closing entries .................................................................. 205
5.10 Modifications for companies................................................................. 209
5.11 Other journal entries............................................................................ 212
Study tools ................................................................................................. 214
Chapter 6
Internal control: Managing and reporting working capital.................................. 226
6.1 Working capital.................................................................................... 228
6.2 Cash ................................................................................................... 230
6.3 Accounts receivable .............................................................................. 241
6.4 Inventory .............................................................................................. 244
6.5 Accounts payable ................................................................................. 248
Study tools ................................................................................................. 251
Chapter 7
The income statement: Components and applications .......................................... 263
7.1 Why the income statement is important .................................................... 265
7.2 Measuring financial performance: The income statement ............................ 267
7.3 Defining and classifying revenues/income ................................................ 269
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vii
Contents
7.4 Defining and classifying expenses ........................................................... 274
7.5 Evaluating the income statement using ratios............................................. 279
7.6 Linking profit to owner’s equity and closing the accounts ............................ 283
Study tools ................................................................................................. 287
Appendix: Calculating the cost and the amount of inventory .............................. 299
Chapter 8
The balance sheet: Components and applications................................................ 308
8.1 Why the balance sheet is important ......................................................... 310
8.2 The accounting equation and the balance sheet ........................................ 312
8.3 Using the balance sheet figures for evaluation........................................... 318
8.4 Evaluating financial flexibility.................................................................. 321
8.5 Limitations of the income statement and the balance sheet .......................... 329
8.6 Business activity statements (BAS) ............................................................ 331
Study tools ................................................................................................. 336
Chapter 9
The cash flow statement: Components and applications....................................... 352
9.1 Understand the importance of the cash flow statements to
organisations and users ............................................................................... 354
9.2 Identify the types of transactions that generate cash inflows and outflows ..... 355
9.3 The organisation of the cash flow statement .............................................. 357
9.4 Construct cash flow statements based on the direct method ......................... 360
9.5 Analysis of the cash flow statement .......................................................... 367
9.6 Calculate the relevant cash flow ratios ..................................................... 370
Study tools ................................................................................................. 374
Appendix: Indirect method for reporting cash flows from operating activities ....... 390
viii
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Contents
Chapter 10
Sustainable and profitable business practices ..................................................... 398
10.1 Corporate social responsibility (CSR) ..................................................... 400
10.2 The triple bottom line ........................................................................... 401
10.3 Triple-bottom-line accounting: Practical measures..................................... 409
10.4 Environmental project appraisal ............................................................ 415
10.5 Social accounting................................................................................ 426
10.6 Sustainability as a business strategy ...................................................... 429
Study tools ................................................................................................. 431
Chapter 11
Short-term planning decisions ............................................................................ 440
11.1 Relevant costs and revenues.................................................................. 442
11.2 Other cost (and revenue) concepts for short-term decisions........................ 445
11.3 Calculating short-term decisions ............................................................ 449
11.4 Non-financial issues in decision making ................................................. 460
Study tools ................................................................................................. 461
Chapter 12
Capital expenditure decisions............................................................................. 473
12.1 Capital expenditure decisions ............................................................... 474
12.2 Making a capital expenditure decision .................................................. 475
12.3 Net present value (NPV) method ........................................................... 483
12.4 Alternative methods for evaluating capital expenditure proposals .............. 491
12.5 Selecting alternative proposals for investment.......................................... 494
Study tools ................................................................................................. 497
Glossary ..............................................................510
Index ...................................................................518
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ix
x
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Guide to the text
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xi
Guide to the text
xii
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Guide to the text
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xiii
xiv
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Guide to the online resources
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xv
PREFACE
For students
There is a saying that ‘knowledge is power’, and in business and our own personal lives this is
true. Those who have knowledge hold a competitive advantage over those who don’t. Those who
understand business information, and know how to interpret and use it, make the best business
decisions. Furthermore, what we know continually evolves as new information and ideas emerge
through media and technology. Change is a very exciting and necessary component of our
business life.
Financial reports, generated by the accounting system of a business, are a major source of
business information for both business and personal use. When reading these reports, you
must evaluate the information they contain by looking for supporting evidence, assumptions
and bias, and by considering other points of view. Furthermore, you must know how to
interpret the information contained in these reports and be able to analyse and project future
change and growth to manage sustainability of your business or your own personal finances.
To do this, you must understand how a business’s accounting system develops these reports,
and what concepts, principles and assumptions underlie the accounting process used to
produce the information in these reports. With this in mind, we designed this book to
address these issues.
After you graduate, you may work in business and use accounting information to make
decisions as an ‘internal user’. Alternatively, you may consider investing in a business or have
some other reason to use its accounting information to make decisions as an ‘external user’.
Your ability to use the material in this book to later help you make effective business
decisions (regardless of your career choice) depends on you making it a part of your own
knowledge base. This means that you should reflect on the issues and ideas as you read about
them, making sure that you understand them before you read further. This will require some
effort on your part. Make sure you read this book critically. Test it in your mind. Does it
make sense to you?
To help you learn this material and think about what you are learning, throughout the book we
have placed questions labelled ‘Stop’ (identified by a hand gesture) that we think are worth your
time and effort to answer. Each time you encounter one of these questions, stop, reflect, think
through the question and answer it honestly. Base your answer on what you have learned in your
life experiences, on your knowledge of accounting, business and the world – and on your own
common sense. By pausing in your reading and answering these questions, you will have time to
process what you are reading and an opportunity to build new knowledge into your existing
knowledge base. This edition also includes ‘Discussion’ questions that are aimed to spur problem
solving, critical thinking and judgement, and to test your development of these skills.
Besides answering these questions as you read the book, think about questions you have, or what
else you would like to know about the subject at hand. Pursuing the answers to these questions in
class or online will help you add to your knowledge base and the quality of your later decisions.
We hope you find this book interesting and easy to read, and that the examples based around
coffee add relevance to your accounting experience! We also hope you find the book useful not
only by increasing your personal capacity to manage financially through an appreciation of the
power of being financially literate, but also by enhancing your ability as a business professional
now and in the future.
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Preface
For educators
Caution – hot contents
This textbook has a number of themes that revolve around coffee, and this preface is no exception. As
well as the brew of all the classic accounting topics that you will need, this book also percolates a blend
of a number of phrases and terms well known to coffee lovers (and we know that includes accountants!).
We hope that this preface serves as an enticing aroma, that once inhaled, draws you to take measured
sips from the chapters beyond, guiding your students to extract knowledge along the way.
Two great ingredients that brew one great text
In the real world, today’s students face an accounting environment where management accounting
and financial accounting issues are integrated and inter-related every day. Modern textbooks need
to emphasise accounting information as a basis for general business decisions, maintain students’
interest through relevant case scenarios, and dispense with the perception that accounting is best
left solely to accountants. In fact, financial literacy skills are life skills that we all need.
This textbook integrates management accounting and financial accounting topics in a way that
is more reflective of the world the students in your first year accounting class will face outside of
the classroom.
Sometimes you feel like a debit, sometimes you don’t
A major focus of this textbook is about understanding and applying information in various business
settings. We wrote this book at a non-technical level for all business and non-business students – not
just those intending to be accounting majors. Because all of the authors are heavily involved in
teaching first, second and third level accounting, we are aware of the needs of your accounting majors.
So we discuss recording, storing and reporting accounting information.
We begin with a non-procedural approach to explain transactions in terms of the accounting
equation (with entries into account columns) to illustrate the effect of these transactions on the
financial statements. In Chapter 5 we discuss the rules for double entry and cover the
accounting cycle, from journal entries (using debits and credits) through the post- closing trial
balance. We designed it so that you may use it in as much depth as you see fit in the process of
teaching from this book. Accounting majors who have used this elementary accounting text are
well prepared to enter second and third level accounting classes. For non-accounting students
they will have a basic understanding of the process behind the financial reports produced by
accounting systems.
The house roast (the approach of this text)
An introduction to business approach
Chapter 1 takes an ‘introduction to business’ approach that orients students to the business
environment, that is, the operations of a business, the different functions of business, managers’
responsibilities, and the types of information, management reports, and financial statements the
business’s accounting system provides for use in internal and external decision making. Unique for
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xvii
Preface
an accounting textbook, this chapter provides students with a basic understanding of business so
they can more effectively envision the context in which accounting information is collected and
used, and the types of decisions users make in this context. This approach allows students to see
the ‘big picture’ more clearly.
Professional skills
Another unique feature of this book is the introduction it gives students to professional skills
such as critical thinking, and demonstrates how they are used in decision making and problem
solving. This book emphasises the type of analytical and critical thinking that successful
accountants and other business people use in a world that is constantly changing and increasing
in complexity.
‘Stop questions’ throughout the textbook ask students to take a break from reading to think
about an issue and/or consider the outcome of a situation. We also ask them why they think
what they think. The end-of-chapter materials include both structured and unstructured
questions and problems that strengthen students’ problem-solving capabilities by emphasing the
use of reflective and critical thinking skills. Therefore, some of the questions and problems do
not have a ‘correct’ answer; rather the focus is on the approach or process that students use to
solve them.
With the increasing complexity of business activities, the inclusion of critical thinking materials
better prepares students to understand the substantive issues involved in new or unusual business
practices, and guides them to understand that today’s accountants need to ‘think outside the box’.
New ‘Sustainability’ icons draw attention to sections that discuss environmental and ethical
issues and how they relate to students’ understanding of triple bottom line accounting.
First things first
The chapters are designed to reflect actual practice in that a business must plan and
understand its activities before it communicates its plans to external users, and it must perform
and evaluate its operations (internal decision making) before it communicates the results of its
operations to external users. Therefore, in keeping with the ‘introduction to business’ theme and
the logical sequencing of business activities, we discuss accounting for planning first, and then
operating and evaluating (controlling) – discussing management accounting and financial
accounting where they logically fit into this framework.
For instance, Chapter 2 covers cost–profit–volume (CVP) analysis for planning purposes. After
students have an understanding of cost and revenue relationships, we introduce them to budgeting in
Chapter 3. The discussion of the master budget includes projected financial statements, which links
the coverage back to the financial statements in Chapter 1. Chapter 4 then introduces accounting for
the operations of a business. Chapters 7 to 9 describe a business’ major financial statements, and
discuss how internal and external users would use these statements to analysis the business.
Chapters 1, 10 and 11 evaluate results and use short and long term financing and investment tools to
plan for sustainable growth of the business.
Factors affecting a business and its reputation such as sustainable practice and business ethics
are highlighted throughout the chapters. This approach reinforces the idea that societal,
environmental and global issues are not topics that can or should be dealt with separately from
the other issues, but rather are an integral and significant part of business in a world where
immediate access to information is available.
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Preface
The simpler things
Earlier we mentioned a ‘non-technical’ approach. Although we explain identifying, measuring,
recording and reporting of economic information, we discuss these activities at a basic level in
Chapter 4 (increases and decreases in account balances) and do not include a discussion of debit
and credit rules and journal entries in the main body of the text.
We use account columns to record transactions, but we explain the increases or decreases
in relation to the accounting equation (Assets = Liabilities + Owners’ equity), rather than as
debits and credits. At the same time, we also emphasise the effects of the transactions on a
business’ financial statements and the impact they have on analysis of the business, for
example its risk, liquidity, financial flexibility, and operating capability. We chose this
approach to better help students gain an understanding of the logic of the accounting system
and its interrelationships, the effects of transactions on a business’s financial statements, and
the use of accounting information in decision making without getting ‘bogged down’ in the
mechanics of the system.
For those wanting to incorporate the mechanics of the system we do provide thorough coverage of
the double entry system, through the use of the accounting equation and its linkage to the income
equation (Income = Revenues – Expenses), as well as the complete accounting cycle in Chapter 5.
Short black or cappuccino with extra foam (a scaffolded approach)
This textbook also uses a building-block approach. It begins with starting and operating a small
retail cafe – a sole proprietorship – and then progresses learning to an understanding of a more
complex business in the form of a company. This allows students to learn basic concepts first, and
then to broaden and reinforce those concepts later in a more complex setting. Several of the same
topics re-emerge, but each time they are refined or enhanced by a different business structure or a
different user perspective. For example, because of its location at the beginning of the semester,
the Chapter 2 discussion of CVP analysis is simple. This topic would be covered again in greater
depth in second and third year courses after students have a better understanding of costs in a
manufacturing setting. Each time we revisit an issue, we discuss the uses of accounting
information for both internal and external decision making, as appropriate.
Likewise, we use a scaffolded approach to arranging the end-of-chapter materials according to
levels of learning. To indicate these levels, we have divided these materials into sections on Testing
your knowledge, Applying your knowledge, and Making evaluations. These categories are arranged so
that the answers to questions require students to use increasingly higher-order thinking skills as
they move from one category of question to the next.
• The Testing your knowledge section includes questions that test students’ knowledge of specifics –
terminology, specific facts, concepts and principles, classifications, and so forth.
• The Applying your knowledge section includes questions, problems, and situations that test
students’ abilities to translate, interpret, extrapolate and apply their knowledge.
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Preface
•
The Making evaluations section includes questions, problems, and cases that not only test
students’ abilities to apply their knowledge but also their abilities to analysis elements,
relationships and principles, to synthesise a variety of information, and to make judgments
based on evidence and accounting criteria.
New and improved flavour
In this new edition, and as a result of our own use of the book and feedback from other users, we
have further developed the key features of the textbook including:
1 The opportunity for students to experience what it is like to start up, run, and grow a small
business as they assist Emily Della to operate and make decisions about her business, Café
Revive. Each chapter scaffolds knowledge about financial records and reports of the business
and the decision-making processes that flow from evaluation of the results. Students assist
Emily to plan, operate and evaluate the business as though it was their own.
2 Issues and real-life examples relating to ethical issues in triple bottom line accounting have
been woven into this new edition. The sustainability theme that runs through the text is
another key feature that differentiates it from other introductory accounting texts.
3 Chapter 10 has been specifically designed to give students a taste of the impact of environmental
and energy issues on business, and how to record and manage them. It also broadens their
perspectives by introducing them to the Global Reporting Initiative (GRI) to make them truly
aware of the knowledge and skills they will need in the global business arena.
4 This edition of the text highlights the importance of developing a range of skills other than
technical skills, such as judgement, critical thinking, ethical and sustainability skills, selfmanagement and teamwork using activities throughout each chapter, the end-of-chapter
materials and case studies.
5 We moved some topics to chapter appendices to keep them available to those who wish to
teach them, including periodic and perpetual inventory.
6 We have revised ‘real’ business examples in the text, and have updated the ‘real’ business
problems in the end-of-chapter materials.
We believe these features enhance the ‘flavour’ of the book and make its topics even more
relevant and understandable to our students.
Real-world/worldwide/total world
Life is not a ‘textbook case’. That’s why we not only integrate management accounting and financial
accounting topics, but also include information about real-world businesses as examples for many of
these topics. We include analyses of the financial information of some of these businesses in the
text and in the end of chapter materials. The list of company URLs at the end of each chapter gives
students the opportunity to connect to some of these businesses.
Students will navigate to various sections of a business’s website such as pages titled: About
Us, Business Information, Investors, Investor Information, Financial Statements, Annual Reports
and other financial information. They will be able to read about real world businesses and their
activities for each financial year.
Navigating to the financial information of an organisation, such as the CPA, can follow a less
logical path and may involve more trial and error.
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Preface
Orientation of the Book
In the rapidly changing business environment, the businessperson must interpret, evaluate,
synthesise and apply new information and technology. With this new information and technology
come new problems, many of which have several reasonable solutions and many of which may not
have obvious solutions, or in fact any solutions at all. In this environment, businesspeople and
accountants are not operating in a ’textbook world’ where there are clearcut, right-and-wrong
answers, and where the relevant facts for making decisions are neatly laid out. Therefore, to help
you prepare for this challenging environment, throughout this book we will illustrate the use of
critical thinking and judgement skills for solving accounting-related problems. Then, in the
’Integrated business and accounting situations’ at the end of each chapter, we will give you the
opportunity to enhance your own thinking and judgement skills.
In addition to solving problems that have specific ’correct’ solutions, we will ask you to make
decisions and to solve problems that may have several reasonable solutions or obscure solutions.
We will also ask you to interpret, evaluate and synthesise information, and to apply new
information to new and different situations.
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Preface
Framework of the Book
Now that you have been introduced to business and accounting, and to the skills required to be a
good business manager or accountant in a global business environment, it is time to begin a more
in-depth study of the use of accounting information in the business environment. Beginning in
Chapter 2, we will discuss in more depth accounting and its use in the management activities of
planning, operating and evaluating, starting with a simple business. In later chapters, we will
progress through more complex businesses. We will also discuss the use of accounting by decision
makers outside the business.
As you read through the book, you will begin to notice that the same topics re-emerge, but
each time a topic recurs, it is refined or enhanced by a different business structure, a different
type of business or a different user perspective. You will also notice that we frequently discuss
ethical and sustainability considerations. That is because these considerations exist in all aspects
of business and accounting. By constantly practising critical thinking, judgement and problem
solving, you will also be developing self-management skills.
You will also notice that international issues appear again and again. Many businesses
operating in Australia and New Zealand have home offices, branches and subsidiaries in other
countries, or simply trade with businesses in foreign countries. Managers must know the
implications of conducting business in foreign countries and with foreign businesses. External
users of accounting information must also know the effects of these business connections.
xxii
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ABOUT THE AUTHORS
Professor Marie Kavanagh, University of Southern Queensland
Marie (DipTeach, BCom, AdvDipFinAcctg, MFinMgmt, PhD, CPA) works in accounting education at
the University of Southern Queensland, and has taught accounting for many years across all levels of
secondary and tertiary education. Marie’s research interests are in the areas of accounting and business
education, particularly online business education. She is well known for her involvement in several
large ALTC/OLT grants, as both a leader and a team member, working in collaboration with other
universities to further knowledge and improve practice in business and accounting education.
Marie is an active member of several NFP Boards and remains a member of the Accounting
Education Special Interest Group for the Accounting and Finance Association of Australia and
New Zealand (AFAANZ) after chairing that group for 10 years. She has been engaged for 18 years
as an academic advisor for Enactus (Entrepreneurship and Action through Us) Australia working
with teams of students from several universities to deliver relevant entrepreneurial projects in
their communities. She was a has won individual and national team awards for Contribution to
Student Learning and Student Support. She is a Fellow of the Business Educators Association of
Queensland and an active member of local Chambers of Commerce, and delivers community
outreach projects that develop financial literacy skills in young people.
Sharelle Simmons, Leaders Institute
Sharelle (BA, BEd, MCom, CPA) is the Program Director at Leaders Institute Pty Ltd and former
Academic Director at Charles Sturt University (CSU) Study Centre Brisbane. She has had extensive
teaching experience, having held positions at Griffith University, University of Queensland,
Newcastle University and Avondale University College. Her primary areas of teaching are Financial
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
xxiii
About the authors
Accounting, Management Accounting, Strategic Management Accounting, Accounting Information
Systems and Business Statistics
Sharelle’s research interests include the adoption of Performance Measurement Systems,
especially in the public sector, and the choice of and functioning of networks within the healthcare
sector. Sharelle has been the recipient of a large ARC Linkage Grant for research into networks in
the healthcare sector. Her PhD research into the adoption of the Balanced Scorecard in the
Australian healthcare sector has been presented at an EIASM conference. She is a co-recipient of an
ALTC teaching award for the Professional Development Program conducted at Griffith University.
Doctor Christina James, University of Southern Queensland Christina (BA(Hons),
GDipEd, MFinMgt , PhD, FCCA) works in accounting and finance education at the University of
Southern Queensland, and has taught accounting at both secondary and tertiary levels, and at a
number of Australian universities. Christina’s research interests are in the areas of corporate
governance, climate change mitigation, accounting for sustainability and Triple Bottom Line (TBL)
reporting.
Prior to working in education, Christina worked as an auditor and company accountant in the
United Kingdom and in Australia. She has also done voluntary work as a Treasurer for a number
of not for profit organisations.
xxiv
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ACKNOWLEDGEMENTS
The authors and Cengage would like to thank the following reviewers for their incisive and helpful
feedback:
• Peter Baxter – University of the Sunshine Coast
• Carol Cheong – Lincoln University
• Kirsty Dunbar – University Southern Queensland
• Pandula Gamage – Australian Catholic University, Melbourne
• Abdel K Halabi – Federation University
• Nicole Ibbett – Western Sydney University
• Dr Amid Khosa – Monash University
• Amy McCormack – Flinders University
• Terri Trireksani – Murdoch University
• Basil Tucker – University of South Australia
Every effort has been made to trace and acknowledge copyright. However, if any infringement has
occurred, the publishers tender their apologies and invite the copyright holders to contact them.
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
xxv
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
1
INTRODUCTION TO BUSINESS
ACCOUNTING AND THE ROLE OF
PROFESSIONAL SKILLS
‘Business is a game, the greatest game in the world if you know how to
play it.’
Thomas J Watson Sra
Learning objectives
After reading this chapter, students should be able to do the following:
1.1
Have an understanding of business, and the skills and knowledge
required for success in a complex business environment.
1.2 Explain the categories of business.
1.3 Know the three common business structures and the regulations
faced by each.
1.4 Outline how accounting systems play a role in providing
information to enable informed business decisions.
1.5 Understand how ethics and sustainability impact business outcomes.
1.6 Discuss the skills required by accountants and those involved in
business to solve problems and make decisions.
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
1
Accounting Information for Business Decisions
Understanding the learning objectives is assisted in the chapter by asking key questions:
Key questions
1
Why is it necessary to have an understanding of business before trying to learn about
accounting?
2
What factors are affecting the complexity of a changing business environment?
3
What are three characteristics that someone might require to become a successful
businessperson in a complex business environment?
4
What are the three main categories of business enterprise?
5
What are the three most common forms of business organisation and their basic
characteristics?
6
What types of regulations do businesses face?
7
What information does the accounting system provide to support management activities?
8
How does accounting provide support and information to people who are external to the
business when they are making decisions?
9
What roles do ethics and sustainability play in the business environment?
10
What skills are required from accountants of the twenty-first century?
11
How can people learn to think critically?
12
How can critical thinking help people to make better business decisions?
13
What are the logical stages in problem solving and decision making?
What are you planning to do when you graduate from university? Maybe become an entrepreneur, own your
own business, work your way up to marketing manager for a multinational business, manage the local corner
store or manage a sporting goods store? Regardless of your career choice, you will be making business
decisions, both in your personal life and at work. We have oriented this book to students like you, who are
interested in business and the role of accounting in business. You will see that, when used properly,
accounting information is a powerful tool for making good business decisions. People inside a business use
accounting information to help them to determine and manage costs, set selling prices and control the
operations of the business. People outside the business use accounting information to help them make
investment and credit decisions about the business. So what kinds of businesses use accounting? All of
them! Let’s take a little time to look at what business means.
Business affects almost every aspect of our lives. Think for a moment about your normal daily
activities. How many businesses do you usually encounter? How many did you directly encounter today?
Suppose you started the day with a quick trip to the local convenience store for milk and eggs. While you
were out, you noticed that your car was low on petrol so you stopped at the local petrol station. On the
way to class, you dropped off some clothes at the dry-cleaners. After your first class, you skipped lunch so
that you could go to the bookshop and buy the calculator you needed; then, after buying a cappuccino
from Café Revive to keep yourself awake in lectures, you headed to your next class. In just half a day, you
have already interacted with five businesses – the convenience store, the petrol station, the drycleaners,
the bookshop and the campus café. You have also managed your own personal financial requirements –
that is, had enough money to pay for these things.
Discussion
Do you view your university as a business? Why or why not?
2
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Chapter 1 Introduction to business accounting and the role of professional skills
Although, in this scenario, you were directly involved with five businesses, you were also probably
affected by hundreds of others. For example, two different businesses manufactured the calculator you
purchased from the bookshop and the coffee you purchased from Café Revive. Suppose DeFlava Coffee
Corporation roasted and ground the coffee beans used in the cappuccino you purchased. As we illustrate
in Case Exhibit 1.1, DeFlava purchased the ingredients from other businesses (suppliers). Each supplier
provided DeFlava with particular goods. Shipping businesses (carriers) moved the goods from the
suppliers’ warehouses to DeFlava’s factory, where the coffee beans were roasted and ground. A different
carrier then moved the coffee from the factory to DeFlava’s outlets, such as Café Revive.
1
Why is it necessary to
have an understanding of
business before trying to
learn about accounting?
Case Exhibit 1.1 Businesses involved in the manufacture and sale of coffee
Suppliers
Carriers
Manufacturer
Carrier
Coffee shop
Coffee
Farmers
Gas on Tap
DeFlava
Coffee
State
Packing
Company
Boxes’n
Bits
Café Revive
The making and shipping of the coffee would follow the same process. You can see that many
businesses are involved in manufacturing, shipping and selling products. Now think about all the other
products that you used during the morning and all the businesses that were involved in the
manufacturing and delivery of each product. Before leaving your home this morning, you could easily
have been affected by hundreds of businesses. All these businesses have a role to play in providing goods
and services to final customers.
Products and services affect almost every minute of our lives, and businesses provide us with these
products and services. As you will soon see, accounting plays a vital role for businesses by keeping track of
a business’s economic resources and activities, and nowadays by measuring the environmental and social
impacts of the business (these will be discussed throughout this text). The financial position of the
business and the results of its activities are then reported to people who are interested in how well it is
doing, similar to the way statistics are gathered and reported for cricket players and other athletes.
Stop & think
What do you think is the role of accounting and accountants in operating a business?
In this chapter, we will introduce you to accounting by first looking at different forms of business
enterprise and the environments within which they operate. Regulatory issues associated with forming,
operating and reporting on the activities of a business, and the role of ethics and sustainability in the
management of a business, are discussed. We will highlight the need to understand the language of
business in order to develop and apply business knowledge and build a range of skills to enable you to
practise professionally in business. The role that accounting information plays in problem solving, making
judgements and decision making within a business will be outlined.
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
3
Accounting Information for Business Decisions
2
What factors are affecting
the complexity of a
changing business
environment?
1.1 Factors affecting the
complexity of a changing
business environment
Why is the business environment changing so rapidly? As Exhibit 1.2 illustrates, a combination of many
interwoven factors in this environment contribute to its complexity and excitement.
Exhibit 1.2 Factors affecting the complexity of the business environment
Information
explosion
Evolving forms
of business
Technological
advances
Business
environment
More complex
business activities
Globalisation
Increased
regulations
One contributor to the rapidly evolving business environment is the information explosion. More
information is being generated than ever before, and this information is available to far more people than
in the past. On the information superhighway, networks such as the internet make available an almost
endless bank of information that includes library listings, books, journal articles, financial reports,
catalogues and directories of businesses, organisations and people with similar interests. Because of the
amount and accessibility of information, and because new information may replace existing information,
business managers must be able to use their skills to evaluate and manage this information to their
advantage. We will discuss this idea more thoroughly later in the chapter.
Consider how technological advances have affected the transmission and sharing of information. Most
businesspeople have adapted their workday habits to include the use of smartphones, text messaging, web
conferences or online meetings using Zoom, and Skype or WhatsApp for conducting business online.
Email, SMS, scanners and online data-drop boxes for sharing documents facilitate information
transmission to and from multiple global sites. Huge databases, such as airline flight schedules and rate
structures, are now stored online and accessed by millions of users around the world every day. The
impact of social media has changed the ways firms communicate and involve their clients and customers
using Facebook and other social media. All these developments have made the world more competitive.
Businesses and individuals who in the past had difficulty travelling or communicating internationally
(perhaps because the infrastructures of their countries could not accommodate their needs) have
enthusiastically ‘thrown their hats in the ring’.
Technological advances have affected not only the products we use and the way business is conducted
but also how products are manufactured. For example, advanced technologies have allowed the
production process in many businesses to become fully automated. In many modern factories, computers
are used to plan, operate and monitor manufacturing processes, and to make adjustments to these as
4
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Chapter 1 Introduction to business accounting and the role of professional skills
This book uses
alphabetic endnotes
to denote reference
material related to
the discussion. Find
the corresponding
references at the end
of the chapter.
Getty Images/Monty Rakusen
needed. Robots are now common workers on many production lines. Apps are now a popular means of
capturing customer or client interest, securing business and delivering goods or services.
The globalisation of business activities and economies is providing more opportunities for businesses and
individuals to conduct business by creating a larger, more diverse marketplace. At the same time, it is
providing new business challenges. For example, when businesses begin to sell or source their products in
other countries, they must translate their product names and advertising slogans into different languages. This
is not as straightforward as it might first appear to be. Consider the dilemma KFC (http://www.kfc.com.au)
faced when it tried to translate its slogan ‘finger-lickin’ good’ into Taiwanese: the literal translation was ‘Eat
your fingers off’.b Globalisation also means that pandemics like
COVID-19 impact businesses all over the world.
Businesspeople must also translate transactions involving
foreign currencies – for example, Japanese yen to Australian
dollars. Furthermore, they must learn to negotiate other
cultures, economies, laws and ways of conducting business.
Another factor adding to the complexity of the business
environment is the increase in the number of regulations that
companies must address. These are discussed later in the chapter.
More complex business activities also contribute to the
changing business environment. For example, business owners and
managers are finding more creative methods to finance their
activities, new outlets for investing their excess cash, a larger
variety of alternatives for compensating their employees and more
Machines at work in an automated factory.
complicated tax laws with which they must comply. In addition, the
way companies conduct business is evolving. Where businesses used to be ‘bricks and mortar’, many now exist
on the internet. It is now common and convenient for firms to conduct business using e-commerce, where
businesses and consumers buy and sell goods and services over the internet. E-commerce takes three forms:
business-to-business, or B2B (e.g. Cisco Systems, Inc – http://www.cisco.com), business-to-consumer, or
B2C (e.g. Amazon – http://www.amazon.com.au), and consumer-to-consumer, or C2C (e.g. eBay – http://
www.ebay.com.au).
Businesses also need to factor in the effect that climate change is having, and monitor the impact of
business activities on greenhouse gas emissions. Businesses need to consider disclosure frameworks so as to
keep their stakeholders informed about physical risks to the business associated with climate change, and
details of any compliance obligations – for example, in Australia those dictated by the National Greenhouse and
Energy Reporting Scheme introduced in 2007, and amended in 2017. In November 2019, the New Zealand
Government passed the Climate Change Response (Zero Carbon) Amendment Bill to establish historic climate
change laws. Similarly, in 2019 the Australian environment and climate change legislation was introduced.
Finally, evolving forms of business are cropping up in the new business environment. For example,
numerous variations of the simple business organisation (i.e. sole proprietorships, partnerships and
companies) now exist. Each of these forms of organisation has legal advantages and disadvantages that
the others do not have, and each addresses a particular aspect of the business environment. A business
owner chooses the form of business that most closely meets the needs of their business.
e-commerce
A method of conducting
business where
companies and
consumers buy and sell
goods and services
online
Ethics and Sustainability
Discussion
Has social media improved the way we conduct business? Give examples.
3
The successful businessperson
The factors discussed above not only contribute to the complexity and excitement of the business
environment, but also challenge the assumptions on which businesses and their employees operate. For
example, the assumption that a university graduate will go out into the world, pursue a lifelong career and
never return to university is no longer valid. Many people now change careers – careers, not just jobs! –
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
What are three
characteristics that
someone might require to
become a successful
businessperson in a
complex business
environment?
5
Accounting Information for Business Decisions
several times before they retire. People live and work longer. Often, in order to make a change, they
return to study between careers to ‘retool’ or expand their education to learn new skills. Even people who
stay in the same career expand their education (through continuing professional education, short courses,
conferences and seminars) in order to improve their knowledge and abilities.
It is easy to see that a person entering or remaining in this dynamic environment must also be
dynamic. In the following sections, we will discuss the characteristics, attitudes and skills that help people
to succeed in the business world. While reading these sections, keep in mind that these are attributes and
abilities that people learn over a period of time and continue to develop throughout their lives (similar to
the way athletes continuously learn and improve their athletic skills).
Adapting to change
Imagine a successful businessperson. Perhaps the person, with sleeves rolled up and hands dirty, is
working hard on some project. Or maybe, dressed in a business suit and with a briefcase in hand, they are
heading for a meeting. You may have a picture of what this businessperson looks like, but what really
determines success is harder to see. This is more a matter of approach than of image.
The successful businessperson thrives on change, seeing it as an opportunity rather than an obstacle.
However, treating change as an opportunity is more than just a matter of attitude – it is not simply seeing
the glass as ‘half full’. It also involves being prepared for the opportunity; the successful businessperson is
both willing and able to change. Therefore, this person is devoted to lifelong learning, realising that
continuous learning is the only way to keep up with, and be prepared for, the fast-paced change we
described earlier. This means that the businessperson must be willing to read industry or professional
journals, network with others by attending conferences and/or take courses to stay up to date.
Stop & think
What qualities can people develop to better prepare themselves for problem solving and
decision making in today’s rapidly changing business environment?
To be able to adapt to change (or ‘go with the flow’), the successful businessperson also needs to
develop certain other qualities. They welcome others’ viewpoints, appreciate differences among people,
take educated and thoughtful risks, anticipate environmental trends – and identify the potential problems
and opportunities associated with these trends – and willingly abandon old plans to pivot their business if
new information, circumstances or technology makes existing methods less workable. This does not mean
that the successful businessperson is a chameleon, changing colour every time the business environment
changes, but it does mean that they are flexible and adaptable. In addition, the successful businessperson
must understand the language of business as discussed in the next section and, more importantly, be able
to develop a business plan to guide the operations and direction of their business.
The language of business
To be successful in business, you must also understand the language of business. For example, what is a
‘transaction’, or what does it mean when a car ‘depreciates’? How do you know if a business is ‘solvent’?
For many people, the concepts and terminology of business are not part of their normal vocabulary.
When you begin to study your first course in business, you will be engaged with many new words and
terms. In some ways, learning the language of business can be compared with learning a foreign language.
Accounting and financial concepts may be alien to you. Still, the ability to understand and communicate
financial information is critical not only to every entrepreneur and those engaged in business but to all of us,
as a personal skill that allows us to survive our own financial journey through life. For example, if we borrow
money to buy textbooks or a bigger asset such as a house, we become aware of the word ‘debt’. Every debt we
have, we will need to pay back. So communication among owners, managers and investors is essential.
Accounting fills the need for a common language of business. It records and processes financial information
into an easily accessible format that can be understood by any person in the business world. Many people’s
6
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Chapter 1 Introduction to business accounting and the role of professional skills
first encounter with accounting might be completing and submitting a tax return. Accounting is what
accountants or certified public accountants (CPAs) do to prepare your taxes. Bookkeeping is what bookkeepers
or business owners do to keep your business running smoothly. Bookkeeping is made up of two things:
(1) payables – that is, paying bills, and paying your employees, contractors and yourself; and (2) receivables –
that is, sending invoices to people who owe you money (debtors or accounts receivable) and making sure your
invoices get paid. You can add to it things like categorising income and/or expenses to see how you’re
spending money and how you’re making money. Underpinning all these activities is the need to manage and
monitor cash flow. Regardless, as you progress through this text, you will encounter and become familiar with
many new terms as your business vocabulary grows.
1.2 Business enterprise categories
Business in Australia, New Zealand and most other countries operates within an economic system based on
private enterprise. In this system, individuals – that is, people like us, rather than public institutions like the
government – own businesses that produce and sell services and/or goods for a profit. These businesses
generally fall into three categories: service businesses, merchandising businesses and manufacturing businesses.
4
What are the three main
categories of business
enterprise?
Service businesses
A service business performs services or activities that benefit individuals or business customers. The drycleaning establishment where you dropped off your clothes this provides the service of cleaning and pressing
your clothes for you. Businesses like Stefan Hair Fashions (http://www.stefan.com.au), LJ Hooker (http://
www.ljhooker.com.au) and Qantas Airlines Limited (http://www.qantas.com.au), and professional practices
such as those in accounting, law, architecture and medicine, are all service businesses.
service business
A business that
performs services or
activities that benefit
individuals or business
customers
Merchandising businesses
Other businesses in the private enterprise system produce or provide goods or tangible/physical products.
These businesses can be either merchandising businesses or manufacturing businesses. A merchandising
business purchases goods (sometimes referred to as merchandise or products) for resale to its customers.
Some merchandising businesses, such as plumbing supply shops, electrical suppliers or beverage distributors,
are wholesalers. Wholesalers primarily sell their goods to retailers or other commercial users, like plumbers or
electricians. Some merchandising businesses, such as the bookshop where you bought your calculator and
chocolate bar, or the convenience store where you bought your milk and eggs, are retailers. Retailers
sell their goods directly to the final customer or consumer. Woolworths Supermarkets (http://
www.woolworths.com.au) and The Good Guys (http://www.thegoodguys.com.au) are retailers. Other
examples of retailers include shoe shops, furniture outlets, online bookshops and car dealerships.
merchandising
business
A business that
purchases goods
(sometimes referred to
as merchandise or
products) for resale to
its customers
Manufacturing businesses
A manufacturing business makes products and then sells these products to their customers. Therefore,
a basic difference between merchandising businesses and manufacturing businesses involves the products
that they sell. Merchandising businesses buy products that are physically ready for sale and then sell these
products to their customers, whereas manufacturing businesses make their products first and then sell the
products to their customers. For example, the university café is a merchandising business that uses the
coffee it purchased from DeFlava, a manufacturing business. The DeFlava factory, though, purchases (from
suppliers) the coffee beans, essences and other ingredients needed to make the coffee, which it then sells to
the university café and other retail stores. Ford Australia (http://www.ford.com.au), Black & Decker
(http://www.blackanddecker.com.au) and BlueScope Steel Ltd (http://www.bluescopesteel.com.au) are
examples of manufacturing businesses.
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
manufacturing
business
A business that makes
its products and then
sells these products to
its customers
7
Accounting Information for Business Decisions
The relationship between types of
private enterprises
Exhibit 1.3 shows the relationship between manufacturing businesses and merchandising businesses and
how these businesses relate to their customers.
Exhibit 1.3 Relationship of manufacturing and merchandising businesses
Suppliers
Manufacturing
business
Merchandising
business
(wholesaler)
Merchandising
business
(retailer)
Merchandising
business
(retailer)
Final
customer
The line of distinction between service, merchandising and manufacturing businesses is sometimes
blurry because a business can be undertaking activities in more than one area. For example, Dell Inc.
(http://www.dell.com.au) manufactures personal computers, directly sells the computers it manufactures
to business customers, government agencies, educational institutions and individuals, and services those
computers through installation, technology transition and management.
Stop & think
What sort of business do you think Café Revive is? Justify your decision.
Whether a business is a service, merchandising or manufacturing business (or all three), for it to
succeed in a private enterprise system, it must be able to obtain cash to begin to operate and then grow.
As we will discuss in the following sections, businesses have several sources of cash.
Entrepreneurship and sources of capital
capital
Funds a business uses
to operate or expand its
operations
8
Owning a business involves a level of risk, along with a continuing need for capital. Although capital has
several meanings, we use the term here to mean the funds a business needs to operate or to expand
operations. In the next two sections, we will discuss the risk involved in owning a business, and possible
sources of capital.
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Chapter 1 Introduction to business accounting and the role of professional skills
Entrepreneurship
Businesses in a private enterprise system produce and sell services and goods for a profit. So profit is the
primary objective of the business. Profit rewards the owner or owners of the business for having a
business idea, and for following through with that idea by investing time, talent and money in the
business. The owner hires employees, purchases land and a building (or signs a lease for space in a
building) and purchases (or leases) any tools, equipment, machinery and furniture necessary to produce or
sell services or goods – expecting, but not knowing for sure, that customers will buy what the business
provides. An individual who is willing to risk this uncertainty in exchange for the reward of earning a
profit (and the personal reward of seeing the business succeed) is called an entrepreneur.
Entrepreneurship, then, is a combination of three factors: the business owner’s idea, the willingness of the
business’s owner to take a risk and the abilities of the owner and employees to use capital to produce and
sell goods or services. But where does the business get its capital?
Sources of capital
One source of capital for a business is the entrepreneur’s (or business owner’s) investment in the business.
An entrepreneur invests money ‘up front’ so that the business can get started. The business uses this
money to acquire the resources it needs to function. Then, as the business operates, the resources of the
business – the capital – will increase or decrease through the profits and losses of the business. It is
important to the sustainability of the business that it generates sufficient funds to allow expansion as
opportunities arise.
When an entrepreneur invests money in a business, they hope to eventually get back the money that
they have contributed to the business (a return on investment). Furthermore, the entrepreneur hopes to
periodically receive additional money above the amount they originally contributed to the business (a
return on the contribution). The entrepreneur would like the return on the contribution to be higher than
the return that could have been earned with that same money on a different investment, such as an
interest-bearing savings account.
Borrowing is another source of capital for a business. To acquire the resources necessary to grow or to
expand the types of products or services it sells, a business may have to borrow money from institutions
like banks (called creditors or lenders). This occurs when the cash from the business’s profits, combined
with the business owner’s contributions to the business, is not large enough to finance its growth. But
borrowing by a business can be risky for the owner or owners. In some cases, if the business is unable to
pay back the debt that it owes, the owner(s) must personally assume this responsibility, or liability (i.e.
something that is owed).
Borrowing in general can also be risky for a business. If the business cannot repay its debts, it will be
unable to borrow more money and will soon find itself unable to continue operating. In addition to
earning a profit, then, another objective of a business is solvency, meaning that the business can pay off
its debts.
Stop & think
entrepreneur
Individual who is willing
to risk the uncertainty
of starting a business
in exchange for the
reward of earning a
profit (and the personal
reward of seeing the
business succeed)
solvency
A business’s long-term
ability to pay off its
debts
Why are accessible and affordable sources of capital important to the sustainability of a
business?
1.3 Business structures
In this text, we emphasise business organisations. These organisations, or businesses, are a significant
aspect of the Australian, New Zealand and world economies. As Exhibit 1.4 shows, a business may be
organised as one of the following general types of business organisations: (1) sole proprietorship; (2)
partnership; or (3) company.
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
9
Accounting Information for Business Decisions
Exhibit 1.4 General characteristics of each form of business organisation
Characteristic
Partnerships
Sole proprietorships
Company/corporations
Number of owner(s)
Single owner
Two or more owners (partners)
Usually many owners (shareholders)
Size of business
Small
Most are small; some professional
partnerships e.g. law firms) have
several hundred partners
Many are very large; some may have
stock traded on an exchange
Examples of
businesses that
typically have this
legal form
Small retail shops; local service or repair
shops; single practitioners such as CPAs,
lawyers,doctors
Law firms; CPA firms; realestate agencies;
family-owned businesses
Manufacturing companies; multinational
companies; retail store chains; fast-food
chains
Who makes business
decisions
Owner
Depends on partnership agreement; small
partnerships will have all partners involved
in business decisions; large partnerships
will have managing partners. Partners are
agents
Decided by board of directors; large
companies/corporations are managed by
business professionals who often own
little or no stock
Liability of owner(s)
Unlimited
Unlimited
Limited
Life of organisation
Limited
Limited
Continuous
Choosing the legal form of a business is an important decision for the owners to make. As a business
owner, this decision determines, for example, how laws and regulations affect your personal responsibility
to pay the business’s debts. When choosing among legal forms, you need to know the characteristics, and
the advantages and disadvantages, of each of them. Once you select a legal form and start operating your
business, laws and regulations specific to your type of organisation will affect some of your business
decisions. In reality, choosing how to operate your business will often be determined by the size of the
operation and the requirements for capital. Most small businesses operate as sole proprietors or
partnerships, while large businesses will become companies/corporations. In the following sections, we will
discuss the three most common forms of business organisations: sole proprietorships, partnerships and
companies or corporations.
Stop & think
What percentage of business is conducted by small businesses in (a) Australia; and (b) New
Zealand?
5
What are the three most
common forms of business
organisation and their
basic characteristics?
sole proprietorship or
sole trader
Business owned by one
individual who is the
sole investor of capital
into the business
10
Sole proprietorship
A sole proprietorship or sole trader is a business owned by one person, who is the sole investor of
capital into the business. Café Revive is a coffee shop (i.e. a retail business) run by Emily Della. It sells
good coffee and coffee products manufactured by DeFlava Coffee Corporation. Because Emily is the only
investor in Café Revive, this business is an example of a sole proprietorship. In general, sole
proprietorships are small businesses that focus on either selling merchandise or performing a service.
Many of the small shops you come across are sole proprietorships.
The owner of a sole proprietorship usually also manages the business. The owner makes the business’s
important decisions, such as when to purchase equipment, how much debt to incur and which customers are
extended credit and allowed to pay later (as mentioned earlier, these customers are known as the business’s
debtors or accounts receivable). In Australia and New Zealand, tax laws and regulations require each owner of
a sole proprietorship to report and pay taxes on their business’s taxable income. The business’s taxable income
is included in the owner’s individual income tax return; there is no separate income tax return for a sole
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Chapter 1 Introduction to business accounting and the role of professional skills
proprietor. So the owner adds the income from the sole proprietorship to their other sources of income, such
as wages earned from other jobs and interest received from bank deposits. In the case of Café Revive, Emily
Della includes with her personal income tax return a schedule that reports Café Revive’s taxable income. She
includes this amount in her total personal taxable income. Emily calculates her personal income tax liability
based on all her sources of income.
Australian and New Zealand laws state that an owner of a sole proprietorship must assume personal
responsibility for the debts incurred by the business. This requirement is referred to as unlimited
liability. Unlimited liability may be a problem for the owner of a sole proprietorship because if the
business cannot pay its debts, the business’s creditors may force the owner to use their personal assets to
pay them. So if the sole proprietorship becomes insolvent, the owner may lose more than the amount of
capital they invested in the business. Unlimited liability thus adds additional financial risk for the owner
of a sole proprietorship.
The life of a sole proprietorship is linked directly to its individual owner. Basically, a sole
proprietorship ceases to exist when the owner decides to stop operating as a sole proprietor. If the owner
of a sole proprietorship decides to sell the business, the owner’s sole proprietorship dissolves and the new
owner(s) must choose the new business’s form of business organisation. Because of these characteristics, a
sole proprietorship is said to have a limited life.
Partnership
By definition, a sole proprietorship is owned by only one person. What if two or three people come up with a
great idea and want to start a business? What if the owner of a sole proprietorship wants someone else to
invest in their business? One option is for the individuals to operate their business as a partnership. A
partnership is a business owned by two or more individuals, who each invest capital into the business.
Discussion
Have you ever shared the purchase and use of an item with someone? Maybe you share a
computer or an apartment. How do you decide how much money each person contributes?
unlimited liability
Indefinite or unlimited
personal liability for the
debts incurred by the
business. For a sole
proprietorship, this
means that the owner’s
personal assets may be
at risk if things go
wrong in the business
limited life
Business that will
cease when the
business is sold or
when a specific project
is completed is said to
have a limited life. For
example, a sole
proprietorship has a
limited life because it
ceases to exist if the
business is sold.
partnership
Business owned by two
or more individuals
who each invest capital,
time and/or talent into
the business and share
in its profits and losses
How do you split the costs of software, rent or insurance?
Individuals must make many decisions before starting a partnership. These decisions include:
the dollar amount each partner will invest
the percentage of the partnership each individual will own
how to allocate and distribute partnership income to each partner
how business decisions will be made
the steps to be taken if a partner withdraws from the partnership or if a new partner is added.
To limit disagreements, partners should always sign a contract, called a partnership agreement,
before their business begins operating. This is a good idea even if the partners are best friends or close
relatives. This agreement specifies the terms of the formation, operation and termination of the
partnership. It defines the nature of the business, the types and number of partners, the capital
contributions required of each partner, the duties of each partner, the conditions for admission or
withdrawal of a partner, the method of allocating income to each partner, and the distribution of assets
when the partnership is terminated.c
•
•
•
•
•
partnership
agreement
Contract signed by
partners of a partnership
before the business
begins operations
Characteristics of partnerships
Partnerships have many characteristics similar to those of sole proprietorships. Each partner is required
by tax laws and regulations to report their share of the partnership income on their individual income tax
return. Laws and regulations regarding unlimited liability also apply to partnerships. In addition, a
partnership has a limited life. It terminates whenever the partners change that is, when a partner leaves
the partnership or when a new partner is added.
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11
Accounting Information for Business Decisions
Stop & think
What concerns would you have about joining a partnership? Why?
joint ownership
The idea that all
partners jointly own all
the assets of a
partnership
agent
A person who has the
authority to act for
another person
There is a basic difference between partnerships and sole proprietorships, in that a partnership
requires two or more owners. Several characteristics of partnerships relate to the co-ownership feature. To
understand these, assume that Emily Della invites you to commence Café Revive as a partnership. If you
are like most other people, the first thing you would think is, ‘What would I be getting myself into?’
Because of a partnership’s legal and business characteristics, you may be getting into more than you
realise. One important characteristic to understand is that all the partners jointly own all the assets
owned by a partnership; this is called joint ownership. Therefore, if you contribute your property to the
partnership, it no longer belongs to you alone.
Before entering a partnership, you should also know that each partner is an agent of the partnership. An
agent is a person who has the authority to act for another. A partner thus has the power to enter into and
bind the partnership – and, therefore, all the partners – to any contract within the scope of the business. For
example, either you or Emily can bind the partnership to contracts for purchasing inventory, hiring employees,
leasing a building, purchasing fixtures or borrowing money. All these activities are within the normal scope of
a coffee shop or café.
The fact that each partner can obligate the partnership to honour contracts affects unlimited liability
requirements. Unlimited liability for a partnership means that each partner is liable for all the debts of the
partnership. A creditor’s claim is on the partnership, but if there are not enough assets to pay the debt,
each partner’s personal assets may be used to pay the debt. The only personal assets that are excluded are
a partner’s assets protected by bankruptcy laws, such as a personal residence. If one of the partners uses
personal assets to pay the debts of the partnership, that partner has a right to claim a share of the
payment from the other partner(s).
Stop & think
Given the partnership characteristics we just discussed, if you were about to form a
partnership, what specific items would you want to include in your partnership agreement?
Partnership equity
equity
Claims by creditors and
owner(s) against the
assets of a business
12
Accounting for the owner’s equity of a partnership differs from accounting for the owner’s equity of
a sole proprietorship (and for a company/corporation). Business transactions that do not affect
owner’s equity are recorded in the same way, regardless of the organisational form. But because a
partnership’s ownership is divided among the partners, its accounting system has a capital account for
each partner in which it records the partner’s investments, withdrawals and share of the partnership’s
net income.
A partnership’s net income is computed in the same way as the net income for a sole
proprietorship. However, because there is more than one owner in a partnership, the net income must
be allocated to each partner. Before their business begins operations, the partners need to decide how
to split the partnership’s net income among themselves and how to list this allocation in the
partnership agreement. Two factors that usually affect the distribution of income among partners are:
(1) the dollar amount of capital contributed by each partner; and (2) the dollar value of the time each
partner spends working for the partnership. These factors are important because the portion of net
income allocated to each partner represents the return on their investment of capital or time. A
partnership includes a schedule at the bottom of its income statement that shows how, and how much,
net income is allocated to each partner.
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Chapter 1 Introduction to business accounting and the role of professional skills
Company/corporation
Recall that DeFlava Coffee Corporation is a company that manufactures coffee products and sells them to
businesses like Café Revive. Although a company is made up of individual owners, the law treats it as a
separate ‘being’. A company/corporation is a separate legal entity that is independent of its owners and
is run by a board of directors. Hence, it has a continuous life beyond that of any particular owner. This has
a number of advantages. Because of the legal separation of the owners and the company, ownership in a
company may be passed easily from one individual to another. Briefly, here’s how it works. In exchange
for contributing capital to the company, the owners of a company receive shares of the company’s share
capital. Hence, they are called shareholders. These shares of stock are the ‘ownership units’ of the
company and are transferable. That is, the current shareholders can transfer or sell their shares to new
owners. The share capital of many companies can be sold on organised stock markets, such as the
ASX Group (http://www.asx.com.au), the New Zealand Stock Exchange NZX (http://www.nzx.com),
the New York Stock Exchange (http://www.nyse.com), the London Stock Exchange (http://
www.londonstockexchange.com) and the NASDAQ Stock Market, Inc. (http://www.nasdaq.com), so that
shareholders of these companies can sell their shares to new owners more easily.
Because a company is a separate legal entity, a shareholder has no personal liability for the company’s
debts. Therefore, each shareholder’s liability is limited to their investment. Companies tend to be larger
than sole proprietorships and partnerships, so to operate they need more capital invested by owners.
Since transferring ownership is easy, and since shareholders have limited liability, companies can usually
attract a large number of diverse investors and the large amounts of capital needed to operate. Companies
can also attract top-quality managers to operate the different departments, so that shareholders are not
involved in the company’s operating decisions.
But companies also have several disadvantages. As a separate legal entity, a company must pay income
taxes on its taxable income. It reports this income on a company income tax return. The maximum income
tax rate for companies in Australia, for example, is currently 30 per cent. If some, or all, of the after-tax
income of the company is distributed to shareholders as dividends, the shareholders may be taxed on this
personal income, but only pay tax on that portion of their income in tax brackets higher than the 30 per
cent corporation tax already paid.
Because the owners (shareholders) of a company have limited liability, a company (particularly a smaller
one) may find it more difficult to borrow money. Since the creditors cannot go to the owners for payment,
they may think there is more risk of not being paid. Companies are also subject to more government
regulation. In Australia, the federal and state/territory governments have laws in place to protect creditors
and owners – for example, the laws of the state or territory in which a company is incorporated usually limit
the payment of dividends by the company. Since creditors cannot go to the owners of a company for
payment of debts, limiting the company’s dividend payments is a way of protecting creditors – the company
may then have more resources with which to pay its debts. In addition, if a company’s share capital is traded
on the share market, the company must file specified reports with the Australian Securities and Investments
Commission (ASIC). However, the advantages of a company usually exceed the disadvantages when a
business grows to a reasonable size.
company/corporation
A business entity that
has been incorporated
and registered by the
Australian Securities
and Investments
Commission (ASIC)
under the Corporations
Act 2001
shareholders
Individuals who own
shares (stock) in a
company
Stop & think
With reference to the three most common forms of business organisation and their basic
characteristics, what sort of business do you think Café Revive is? What sort of business do
you think DeFlava Coffee is? Why?
Several types of organisations use accounting information in their decision-making functions but do
not have profit making as a goal. These organisations are called not-for-profit organisations; they include
many educational institutions, religious institutions, charitable organisations, councils, governments and
some hospitals. Since making a profit is not a goal of these organisations, some aspects of accounting for
these organisations’ activities are unique and beyond the scope of this book.
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13
Accounting Information for Business Decisions
Stop & think
Can you list two not-for-profit organisations?
The regulatory environment of business
6
What types of regulations
do businesses face?
Businesses affect each of us every day, but they also affect each other, the economy and the environment.
Just as individuals must abide by the laws and regulations of the cities, states and countries in which they
live and work, all businesses, regardless of type, size or complexity, must deal with regulatory issues.
Think again about that coffee you had today. When DeFlava Corporation was formed, the business
had to do more than build a factory, purchase equipment and ingredients, hire employees, find retail
outlets to sell the coffee and begin operations. It also had to deal with the regulatory issues involved in
opening and operating even the smallest of businesses. Furthermore, its managers must continue to
address regulatory issues as long as they continue to operate the business.
Stop & think
Suppose a business is about to open a factory down the street from your house. What
concerns do you have? What regulations might help reduce your concerns?
Many different laws and authorities regulate the business environment, covering issues such as
business registration and reporting requirements, consumer protection, environmental protection,
employee safety, employment practices and taxes. Businesses must comply with different sets of
regulations, depending on where their factories and offices are located. These regulations are imposed by
local, state/territory and federal governments.
In Australia, taxation is regulated by the Australian Taxation Office (ATO). Each business must withhold
taxes from its employees’ pay and send them to the ATO. Furthermore, the ATO also collects the 10 per cent
goods and services tax (GST) from business activities through a business activity statement (BAS). Businesses
offset the GST they pay on business inputs, such as inventory, against the GST they collect on the sales of
goods to customers. The ATO also taxes the profits of the businesses themselves. The type of business
determines who actually pays the taxes on profits. Companies must pay their own income taxes to the ATO
because, from a legal standpoint, they are viewed as being separate from their owners. Sole proprietorships
and partnerships, on the other hand, do not pay taxes on their profits. Rather, owners of these types of
businesses include their share of the business profits along with their other taxable income on their personal
income tax returns. This is because tax law does not distinguish the owners of sole proprietorships and
partnerships from the businesses themselves.
Stop & think
Is GST the same as income tax? Do different countries use GST as tax?
Laws and other government agencies
Ethics and Sustainability
14
Similarly, in Australia, a variety of laws and government departments and agencies (in addition to the
ATO) regulate businesses. Federal departments and agencies oversee the administration of laws governing
areas such as competition (the Australian Competition and Consumer Commission, or ACCC, which
administers the Competition and Consumer Act 2010), fair work practices (Fair Work Australia), work health
and safety (Safe Work Australia), workplace discrimination (the Australian Human Rights Commission),
sustainability and control of pollution to air, land and water (environmental protection agencies in each
state/territory), and the like.
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Chapter 1 Introduction to business accounting and the role of professional skills
International regulations
When a business conducts business internationally, it must abide by the laws and regulations of the
countries in which it operates. These address such issues as foreign licensing, export and import
documentation requirements, tax laws, multinational production and marketing regulations, domestic
ownership of business property, and expatriation of cash (i.e. how much of the business’s cash can leave
the country). Of course, these laws and regulations differ from country to country, so a business operating
in several countries must abide by many laws and regulations. Exhibit 1.5 lists some of the more common
regulatory issues facing businesses operating in different jurisdictions.
Ethics and Sustainability
Exhibit 1.5 Common regulatory issues faced by Australian businesses
Local government issues
• Zoning/planning restrictions
• Council rates (taxes)
• Environmental regulations
• Council by-laws
State/territory issues
• Stamp duty
• Payroll tax
• Work health and safety
• Professional or occupational
licences
• Industry-specific regulations
• Workplace discrimination
Federal issues
• Federal taxes, including GST
• Competition
• Work health and safety
• Fair work standards
• Workplace discrimination
• Company name and
registration (including ABNs
and ACNs)
International issues
• Foreign licensing
• Exports and imports
• Taxes/customs duties
• Multinational production and
marketing
• Property ownership
• Cash restrictions
Stop & think
Suppose that, as a manager of a manufacturing business, you have the opportunity to have
many parts of your product manufactured in another country, where the labour is much
cheaper and the environmental regulations less stringent. What are the pros and cons of
taking advantage of this opportunity?
1.4 The accounting system
A business is responsible to many diverse groups of people, both inside and outside the business. For
example, its managers and employees depend on the business for their livelihood. Customers expect a
dependable product or service at a reasonable cost. The community expects the business to be a good citizen
and to be mindful of the impact of the business’s activities on the environment. Owners want returns on
their investments and creditors expect to be paid back. Governmental agencies expect businesses to abide by
their rules.
People in all of these groups use accounting information about a business to help them assess the
ability of the business to carry out its responsibilities and to help them make decisions involving the
business. This information comes from the business’s accounting system. An accounting system is a
means by which accounting information about a business’s activities is identified, measured, recorded and
summarised so it can be communicated in an accounting report. Two branches of accounting, management
accounting and financial accounting, use the information in the accounting system to produce reports for
different groups of people. Management accounting provides vital information about a business to
internal users; financial accounting gives information about a business to external users. These two terms
will be discussed in more detail later in this chapter.
7
What information does
the accounting system
provide to support
management activities?
accounting system
Process used to
identify, measure,
record and retain
information about a
business’s activities so
that the business can
prepare its financial
statements
Stop & think
What are the main functions of an accounting system?
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15
Accounting Information for Business Decisions
Management accounting information
Management accounting information helps managers inside the business to plan, operate and evaluate a
business’s activities. Managers must operate the business in a changing environment. They need information
to help them compete in a global market in which technology and methods of production are changing
constantly. Therefore, managers can request ‘tailor-made’ information in whatever form is useful for their
decision making, such as in dollars, units, hours worked, products manufactured, numbers of defective units
or service agreements signed. Moreover, in a world exploding with new information, managers must manage
this information in a way that will let them use it more efficiently and effectively. The accounting system
provides information about segments of the business, including products, tasks, plants or individual activities,
depending on what information is important for the decisions managers are making.
Financial accounting information
Financial accounting information is organised for the use of interested people outside the business.
External users analyse the business’s financial reports as one source of useful financial information about
the business. For these users to be able to interpret the reports, businesses reporting to outsiders follow
specific guidelines, or rules, known as generally accepted accounting principles (GAAP), discussed in more
detail later. Financial accounting information developed by the accounting system is expressed in dollars
in Australia, New Zealand and the United States, and in different currencies (e.g. the yen, euro and peso)
in other countries.
Stop & think
What is the difference between financial accounting and management accounting?
Management activities
In small businesses, owners are often also the managers. In larger businesses, owners sometimes employ
managers to drive the operations of the business. Regardless, managers play a vital role in the success of a
business – by setting goals, making decisions, committing the resources of the business to achieving these
goals and then achieving them. To help ensure the achievement of these goals and the success of the
business, managers use accounting information as they perform the activities of planning the operations
of the business, operating the business and evaluating the operations of the business for future planning
and operating decisions. Exhibit 1.6 shows these activities.
Exhibit 1.6 Management activities
Planning
Operating
Feedback
Evaluating
(controlling)
16
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Chapter 1 Introduction to business accounting and the role of professional skills
Planning
Management begins with planning. At a strategic level, every business must have a business plan. Planning
establishes the business’s goals and the means of achieving these goals, and is a key requirement for business
sustainability. Managers use the planning process to identify what resources and employees the business
needs, and to set standards, or benchmarks, against which they can later measure the business’s progress
towards its goals. Once written, the business plan becomes a ‘living document’, in that managers will report to
owners in relation to the plan. Because the business environment changes so rapidly, plans must be ongoing
and flexible enough to deal with change before it occurs or as it is happening.
Managers of multinational businesses must also consider such factors as multiple languages, economic
systems, political systems, monetary systems, markets and legal systems. In such businesses, managers
must also plan and encourage online communication between and among branches in different countries.
planning
Management activity
that establishes a
business’s goals and
the means of achieving
these goals
Operating
Operating refers to the set of activities in which a business engages to conduct its business according to its
plan. For DeFlava Coffee, these are the activities that will ensure that coffee products are made and sold.
In operating the business, managers and work teams must make day-to-day decisions about how best
to achieve goals. For example, accounting information gives them valuable data about a product’s
performance. With this information, they can decide which products to continue to sell and when to add
new products or drop old ones. In a manufacturing business, managers and work teams can decide which
products to produce and whether there is a better way to produce them. With accounting information,
managers can also make decisions about how to set product selling prices, whether to advertise and how
much to spend on advertising, and whether to buy new equipment or expand facilities. These decisions
are ongoing, and depend on managers’ evaluations of the progress being made towards the business’s
goals and on changes in the business’s plans and goals.
operating
Management activity
that enables a business
to conduct its business
according to its plan
Evaluating is the management activity that measures the actual
operations and progress of a business against standards or
benchmarks. It provides feedback for managers to use to correct
deviations from those standards or benchmarks, and to plan for
the business’s future operations. Evaluating is a continuous
process that attempts to prevent problems, and to detect and
correct problems as quickly as possible.
The more countries in which a business operates, the more
interesting the evaluating activity becomes. Managers must pay
particular attention to the cultural effects of evaluation methods
and feedback in order to achieve effective control.
Shutterstock.com/Lana K
Evaluating
Businesses engage in planning, operating and evaluating activities.
Stop & think
Which of the three functions of management do you think is the most important, and why?
Discussion
evaluating
Management activity
that measures a
business’s actual
operations and
progress against
standards or
benchmarks
Even coaches of professional sports teams perform the activities of planning, operating and
evaluating. If a team’s goal is to win the grand final, how would the head coach implement
each of these activities?
Planning, operating and evaluating all require information about the business. The business’s
accounting system provides much of the quantitative information used by managers.
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17
Accounting Information for Business Decisions
Accounting support for
management activities
internal users
Managers within a
business who use
information about the
business for decision
making
The accounting system identifies, measures, records, summarises and then communicates economic
information about a business to internal users for management decision making. Internal users include
individual employees, work groups or teams, departmental supervisors, divisional and regional managers,
and ‘top management’. Management accountants then provide information to internal users for planning
the operations of the business, for operating the business and for evaluating the operations of the
business.
Management accounting responsibilities and activities may vary widely from business to business and
continue to evolve as management accountants respond to the need for new information need caused by
the changing business environment.
Stop & think
Are there any guidelines for reporting to business managers?
Basic management accounting reports
Budgets, cost analyses and manufacturing cost reports are examples of the management tools the
accounting system provides. Exhibit 1.7 illustrates the relationships among management activities and
these reports.
Exhibit 1.7 Activities of managers and related accounting reports
Accounting report
Management activities
Budget
Planning
Cost analysis
Operating
Cost reports for products/services
Feedback
Evaluating
(controlling)
Stop & think
Suppose you are the manager of your business’s sales force. What type of information would
you want to help you do your job?
budgeting
Process of quantifying
managers’ plans and
showing the impact of
these plans on a
business’s operating
activities
18
Budgets
Budgeting is the process of quantifying managers’ plans and showing the impact of these plans on the
operating activities and financial position of the business. Managers present this information in a report
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Chapter 1 Introduction to business accounting and the role of professional skills
called a budget (or forecast discussed in more detail in Chapter 3). Once the planned activities have
occurred, managers can evaluate the results of the operating activities against the budget to make sure
that the actual operations of the various parts of the business have achieved the results planned. For
example, DeFlava Coffee might develop a budget showing how many kilograms of coffee beans it plans to
roast and sell during the first three months of next year. Later, after the next year’s actual sales have been
made, managers will compare the results of these sales with the budget to determine whether their
forecasts were ‘on target’ and, if not, to find out why differences occurred.
Cost analysis
Cost analysis, or cost accounting, is the process of determining and evaluating the costs of specific
products or activities within a business. Managers use cost analysis when making decisions about these
products or activities. For example, DeFlava Coffee might use a cost analysis to decide whether to stop or
to continue making the Aroma coffee premix product. The cost analysis report might show that the
premix coffee product is not profitable because it earns less than it costs to make. If this is the case, the
fact that this product does not make a profit will be one factor in the managers’ decision. The managers
will also have to resolve the ethical issue of whether to make the employees who produced the product
redundant or to revitalise through the creation of a new product line.
cost analysis, or cost
accounting
Process of determining
and evaluating the
costs of specific
products or activities of
a business
Stop & think
Suppose you are a manager of a business that makes a pharmaceutical product thought to
create major health problems after long-term use. What factors would you consider when
trying to decide whether the business should drop the product or continue producing it?
Ethics and Sustainability
8
Cost reports for products and services
A cost report might show that total actual costs for a given month were greater than total budgeted costs.
However, it might also show that some actual costs were greater than budgeted costs while others were
less than budgeted costs. The detailed information will be useful for managers as they analyse why these
differences occurred, and then make adjustments to the operations of the business to help it achieve its
plans.
Accounting support for external decision
making
As mentioned earlier, management accounting gives people inside a business vital information about
the business and its performance, but the business must also provide business information about its
performance to people outside the business. Financial accounting involves identifying, measuring,
recording, summarising and then communicating economic information about a business to external users
for use in their various decisions. External users are people and groups outside the business who need
accounting information to decide whether or not to engage in some activity with the business. These
users include individual investors, stockbrokers and financial analysts (who offer investment assistance),
consultants, bankers, suppliers, labour unions, customers and local, state/territory and federal
governments, including governments of countries in which the business conducts operations.
The accounting information that helps external users make a decision – for example, a bank’s loan officer
deciding whether or not to extend a loan to a business – may be different from the information a manager
within the business needs. Thus, accounting information prepared for the external user may differ from that
prepared for the internal user. However, some of the accounting information that internal users need also
helps external users, and vice versa. For example, DeFlava Coffee may decide to continue to produce and sell a
new coffee line or product if it can borrow enough money to do so. In weighing the likelihood of getting a loan
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How does accounting
provide support and
information to people who
are external to the business
when they are making
decisions?
management
accounting
Identification,
measurement,
recording, accumulation
and communication of
economic information
about a business for
internal users in
management decision
making
financial accounting
Identification,
measurement,
recording,
accumulation and
communication of
economic information
about a business for
external users to use in
their various decisions
external users
Individuals outside of a
business who use the
business’s information
for decision making
19
Accounting Information for Business Decisions
from the bank, the business’s managers will probably want to evaluate the same financial accounting
information that the bank evaluates. In deciding whether to loan money to DeFlava Coffee, the bank will
consider the likelihood that DeFlava Coffee will be able to repay the loan. Since this likelihood may depend on
current and future sales of coffee, the bank may also want to evaluate the business’s actual sales, as well as the
sales budget that DeFlava’s managers have developed as part of the planning process.
Stop & think
Suppose you have been offered a job at the DeFlava Coffee roasting factory. What economic
information concerning DeFlava would you want to know to help you decide whether to
accept the job offer?
Guidelines for reporting to people outside the business
generally accepted
accounting principles
(GAAP)
Currently accepted
principles, procedures
and practices that are
used for financial
accounting in many
countries of the world,
including Australia
While accounting is based on logic, it is very important that universal guidelines exist and are followed to
ensure consistency in terms of how items are recorded and reported in a financial sense. Financial reports
prepared using these guidelines enable comparison among firms and provide external users with reassurance
that they can rely on the information to make decisions.
Generally accepted accounting principles (GAAP) are the currently accepted principles, procedures,
practices and standards that businesses use for financial accounting and reporting in Australia, New
Zealand and all over the world. These principles or rules must be followed, as they establish minimum
disclosure requirements for the external reports of businesses that sell shares to the public – and many
other businesses as well. GAAP cover such issues as how to account for inventory, buildings, income taxes
and capital stock; how to measure the results of a business’s operations; and how to account for the
operations of businesses in specialised industries, such as the banking industry, the entertainment industry
and the insurance industry. Without these agreed-upon principles, external users of accounting information
would not be able to understand the meaning of this information. (This is similar to people trying to
communicate with each other without any agreed-upon rules of spelling and grammar.)
Several organisations contribute to GAAP through their publications, called pronouncements or
standards. Accounting standards are important for protecting the interests of investors, managers and the
general public by establishing acceptable accounting procedures and the content of financial reports.
The Australian Accounting Standards Board (AASB) sets standards for Australian companies and
government bodies. However, since 2005 the regulation of financial accounting and reporting has become
globalised. International Financial Reporting Standards (IFRS) generated by the International Accounting
Standards Board (IASB) are used globally in accordance with the objectives of the governing body. Companies
whose shares are traded publicly in Australia report to the Australian Securities and Investments Commission
(ASIC). This agency examines corporate financial reports to ensure they conform and comply with GAAP and
the Corporations Act 2001.
Many GAAP pronouncements are complex and very technical in nature. In this text, we will introduce
only the basic aspects of GAAP that apply to the issues we discuss. It is important to recognise, though,
that these principles do change; they are modified as business practices and decisions change, and as
better accounting techniques are developed. They also underpin the preparation of the financial
statements discussed in the following sections.
Basic financial statements
Profit
Difference between the
total revenues of a
business and the total
costs (expenses) of the
business during a
specific time period
20
Businesses operate to achieve various goals. To reach these goals, a business must first achieve its two
primary objectives: earning a satisfactory profit and remaining solvent.
Profit (commonly referred to as net income) is the difference between the cash and credit sales of a
business (revenues) and its total costs (expenses). Solvency is a business’s long-term ability to pay its debts
as they come due. As you will see, both internal and external users analyse the financial statements of a
business to determine how well the business is achieving its two primary objectives.
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Chapter 1 Introduction to business accounting and the role of professional skills
Financial statements are accounting reports used to summarise and communicate financial
information about a business. A business’s accounting system produces three major financial statements:
the income statement, the balance sheet and the cash flow statement. It also produces a supporting
financial statement, the statement of changes in owner’s equity. Each of these statements summarises
specific information that has been identified, measured and recorded during the accounting process.
Income statement
A business’s income statement (or profit and loss statement) summarises the results of its operating
activities for a specific time period and shows the business’s profit for that period. It shows a business’s
revenues, expenses and net income (or net loss) for that time period, usually one year.
Exhibit 1.8 shows what kind of information appears in a business’s income statement. Revenues
are the amounts earned by charging the business’s customers for the goods or services that the
business has provided to them. Examples of revenue items include sales (for a retail business) and
fees for services performed (for a service firm). Expenses are the costs of providing the goods or
services. These amounts include the costs of the products the business has sold (either the cost of
making these products or the cost of purchasing these products), the costs of conducting business
(called operating expenses) and the costs of income taxes (if any exist). Examples of common expenses
for most businesses include wages, insurance, rent or lease of property, telephone, maintenance and
repairs, costs of goods sold (for a retail business) and costs of materials or products used (for a
service firm). The net income is the excess of revenues over expenses, or the business’s profit; a
net loss arises when expenses are greater than revenues. (We will discuss the income statement
further in Chapter 7 and throughout this text.) For example, the net result – profit or loss – is
transferred to owner’s equity, providing a link between the income statement and the owner’s equity
section in the balance sheet.
financial statements
Accounting reports
used to summarise and
communicate financial
information about a
business
income statement
Accounting report that
summarises the results
of a business’s
operating activities for
a specific time period
net income
Excess of a business’s
revenues over its
expenses from
providing goods or
services to its
customers during a
specific time period
net loss
Excess of a business’s
expenses over its
revenues from
providing goods or
services to its
customers during a
specific time period
Exhibit 1.8 What a business’s income statement shows
This is
where the
business
shows what
it charged
customers
for the goods
or services
provided to
them during
a specific
time period
INCOME STATEMENT OF DEFLAVA
COFFEE CORPORATION
20 000
Revenue – sales
Less: Expenses – cost of goods sold
12 500
Wages
5 000
Rent
1 000
Other operating expenses
Total expenses
Net income or net profit
500
19 000
$ 1 000
This is the
difference
between
revenues
and
expenses
Here’s where
the business
lists the
costs of
providing the
goods and
services
during that
period
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21
Accounting Information for Business Decisions
Statement of changes in owner’s equity
statement of changes
in owner’s equity
A summary of the
changes in the
shareholders’ (owner’s)
equity in a company
that have occurred
during a specific period
of time
A business’s accounting system frequently provides a supporting financial statement, called a statement
of changes in owner’s equity, to explain the amount shown in the owner’s equity section of the
business’s balance sheet. Exhibit 1.9 shows the kind of changes in owner’s equity that appear on this
statement. Net income earned during the period increases the owner’s investment in the business’s assets
(and the assets themselves) as the owner reinvests the profit of the business back into the business.
Similarly, additional contributions of money by the owner to the business during the time period also
increase the owner’s investment in the business’s assets (and the assets themselves). On the other hand, a
net loss, rather than a net income, decreases the owner’s investment in the business (and the business’s
assets), as does the owner’s choice to remove (or withdraw) money from the business (‘disinvesting’ the
profit from the business). We will discuss this further in Chapter 7 and throughout this text.
Exhibit 1.9 What a business’s statement of changes in owner’s equity shows
Term
Explanation
Beginning owner’s equity
Here’s where the business shows the owner’s equity amount at the beginning of
the period (the last day of the previous period). This amount also appears on the
balance sheet on the last day of the previous period.
+ Net income
Here’s where the business adds the net income from the current period’s income
statement (the profit that the business earned during the period).
+ Owner’s contributions
Here’s where the business adds any additional contributions to the business that
the owner of the business made during the period.
– Withdrawals by owner
Here’s where the business subtracts any withdrawals of cash from the business
that the owner of the business made during the period.
Ending owner’s equity
Here’s where the business shows the resulting owner’s equity amount that also
appears on the business’s balance sheet on the last day of the period.
Stop & think
What is the link between the income statement and the balance sheet?
Balance sheet
A business’s balance sheet summarises its financial position on a given date (usually the last day of the time
period covered by the income statement). It is also called a statement of financial position. Exhibit 1.10
shows what kind of information appears on a balance sheet. A balance sheet lists the business’s assets,
liabilities and owner’s equity as at a given date. Assets are economic resources or items that a business
owns and that it expects will provide future benefits to the business. Examples include cash at bank,
Exhibit 1.10 What a business’s balance sheet shows
Term
22
Explanation
Assets
Here’s where the business lists its economic resources, such as cash, money owed to it by clients,
inventories of its products, equipment and buildings it owns.
Liabilities
Here’s where the business lists the obligations it owes to creditors, such as banks and suppliers,
and to employees.
Owner’s equity
Here’s where the business lists the owner’s current investment in the assets of the business.
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Chapter 1 Introduction to business accounting and the role of professional skills
amounts owed to the business by debtors (accounts receivable), stock of goods (or inventory), and land
and buildings. Liabilities are the business’s economic obligations (debts) to its creditors – people outside
the business, such as banks and suppliers – and to its employees. Examples include amounts owed by the
business to creditors (accounts payable), outstanding expenses (expenses payable), loans payable and
mortgage payable. The owner’s equity of a business is the owner’s current investment in the assets of the
business, which includes the owner’s contributions to the business (called capital) and any earnings (net
income or profit; for example, Able Enterprises made $1000 profit) that the owner leaves (or invests) in the
business. Exhibit 1.11 shows what kind of information appears on a balance sheet for Able Enterprises. A
company’s owner’s equity is called shareholders’ equity. We will discuss the balance sheet further in Chapter
8 and throughout this text.
Exhibit 1.11 Balance sheet of DeFlava Coffee Corporation
Assets
Liabilities
Cash
1 200 Accounts payable
Accounts receivable
1 600 Loan from bank
Inventory
2 300
Premises
2 100
10 000
Owner’s equity
42 000 Capital
34 000
Plus net profit
1 000
47 100
35 000
47 100
Cash flow statement
A business’s cash flow statement summarises its cash receipts, cash payments and net change in cash for a
specific time period. Exhibit 1.12 shows what kind of information appears in a cash flow statement. We
will discuss the cash flow statement further in Chapter 9 and throughout this text.
Exhibit 1.12 What a business’s cash flow statement shows
Term
Explanation
Cash flow from operating activities
Here’s where the business lists the cash it received and paid in selling products
or performing services for a specific time period.
Cash flow from investing activities
Here’s where the business lists the cash it received and paid in buying and
selling assets such as equipment and buildings.
Cash flow from financing activities
Here’s where the business lists the cash it received and paid in obtaining and
repaying bank loans, and from contributions and withdrawals of cash made by
the business’s owners.
A business may publish its income statement, balance sheet and cash flow statement (and statement
of changes in owner’s equity), along with other related financial accounting information, in its annual
report. Many businesses (mostly companies) do so.
Stop & think
In business, the phrase ’cash is king’ is often used. What does this mean and why is it so
important to understand your cash flow?
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annual report
Document that includes
a business’s income
statement, balance
sheet and cash flow
statement, along with
other related financial
accounting information
23
Accounting Information for Business Decisions
9
What roles do ethics and
sustainability play in the
business environment?
Ethics and Sustainability
1.5 Ethics in business
and accounting
A business’s financial statements are meant to convey information about the business to internal and
external users in order to help them make decisions about the business. But if the information in the
financial statements does not convey a realistic picture of the results of the business’s operations or its
financial position, the decisions based on this information can have disastrous consequences.
Consider the fallout from Enron Corporation’s 2001 financial statements,d in a case that remains one of
the biggest corporate collapses in history. On 1 October 2001, Enron was the seventh-largest business in the
United States, employing 21 000 people in more than 40 countries. It was also the largest energy-trading
business in the United States. Fortune magazine had ranked Enron 24th in its ‘100 Best Companies to Work
For’ in 2000.e Its stock was trading for around US$83 per share. Two weeks later, after reporting incredible
profits for its first two quarters (January to June) of 2001, Enron reported a third-quarter (July to September)
loss, in part because of adjustments caused by previously misstated profits. But by 1 November, JPMorgan
Chase & Co. (http://www.jpmorganchase.com) and Citigroup’s (http://www.citigroup.com) Salomon Smith
Barney had attempted to rescue Enron by offering the business an opportunity to borrow US$1 billion (above
what Enron already owed them). On 19 November, Enron publicly acknowledged that its financial statements
did not comply with GAAP in at least two areas. This failure resulted in huge misstatements on Enron’s
financial statements: assets and profits were overstated, and liabilities were understated. On 2 December
2001, Enron declared insolvency.
The rapid fall of a corporate powerhouse, and what appeared to be one of the most successful businesses in
the world, was one of the largest corporate collapses in history, creating a wave of economic and human
ramifications around the world. Before Enron reported a third-quarter loss, its stock was selling for around
US$83 per share. After it reported its loss, its stock dropped to US$0.70 per share – a total drop in market
value of almost US$60 billion. Most of those who had purchased shares of Enron stock lost money; many of
them lost hundreds of thousands of dollars. The Enron employees’ pension plan, 62 per cent of which was
Enron stock, lost nearly US$2.1 billion, virtually wiping out the retirement savings of most of Enron’s
employees, many of whom were nearing retirement age. Close to 5600 Enron employees were made redundant.
Enron left behind approximately US$63 billion in debts, with JPMorgan Chase & Co. owed $900 million and
Citigroup up to $800 million. Many banks around the world were also affected by having lent money to Enron.
In addition to these after-effects, the US Justice Department prosecuted the accounting firm Arthur
Andersen, Enron’s auditor. It claimed that Andersen had interfered in a federal investigation of Enron’s
collapse by shredding paperwork related to Andersen’s audit of Enron. Two Andersen executives – a partner
and an in-house attorney – had reminded employees of Andersen’s ‘document destruction’ policy during the
time that the Justice Department was investigating Enron’s failure, resulting in large-scale shredding of the
Enron documents. A jury found Andersen guilty. As a result, Arthur Andersen, a highly respected accounting
firm and once a bastion of integrity, relinquished its accounting licence, preventing it from conducting further
audits. This once-thriving business of 28 000 employees shrivelled to a staff of 200. Ironically, the US
Supreme Court found – too late for the employees who had lost their jobs – that the jurors in this case had
received improper instructions, and it rejected the Justice Department’s claim, vindicating Arthur Andersen.f
Ethical behaviour on the part of all of Enron’s managers would not have guaranteed the success of the
business. However, it could have prevented much of the damage suffered by those inside and outside the
business, including those who depended on Enron’s financial statements to provide them with dependable
information about the business.
Discussion
Do you think JPMorgan Chase & Co. or Citigroup would have loaned Enron as much money if
Enron had not overstated its net income and assets, and understated its liabilities? Why or
why not? What might Enron’s employees have done differently if Enron’s financial statements
had been properly prepared?
24
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Chapter 1 Introduction to business accounting and the role of professional skills
Enron was not the first, nor (unfortunately) will it be the last, business to get into trouble for misleading
financial reporting. While it seems clear that some of what Enron’s managers, and managers of some other
businesses, disclosed on their financial statements was wrong, many business and accounting issues and
events in the business environment cannot be interpreted as absolutely right or wrong. Every decision or
choice has pros and cons, costs and benefits, and people or institutions who will be affected positively or
negatively by the decision. Even in a setting where many issues and events fall between the extremes of right
and wrong, it is very important for accountants and businesspeople to maintain high ethical standards.
The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services
Industry, also known as the Banking Royal Commission and the Hayne Royal Commission, provides
another example of the high standards required of those involved in business. The Commission resulted
in a comprehensive review of the culture, governance and ethics of organisations operating in the
financial services sector. The Royal Commission’s final report, released on 4 February 2019, directly calls
out the boards and senior management of the financial services industry. The report affirms the key role
of regulators such as ASIC in the supervision of culture, governance and remuneration.
Stop & think
The term ‘ethical coffee’ is often used in relation to coffee. What does this mean? Can you
find examples of websites that demonstrate this concept?
Professional organisations’ codes of ethics
The International Federation of Accountants (IFAC) is an independent global organisation. Its stated purpose
is to ‘serve the public interest by the worldwide advancement of education and development for professional
accountants leading to harmonized standards’.g As part of its efforts, it has developed a code of ethics for
accountants in each country to use as the basis for founding their own codes of ethics. Because of the wide
cultural, language, legal and social diversity of the nations of the world, IFAC expects professional accountants
in each country to add their own national ethical standards to the code, or even to delete some items of the
code, to reflect their national differences. The code addresses objectivity, resolution of ethical conflicts,
professional competence, confidentiality, tax practice, cross-border activities and publicity. It also covers
independence, fees and commissions, activities incompatible with the practice of accountancy, clients’ money,
relations with other professional accountants, and advertising and solicitation.
In Australia, members of professional bodies such as CPA Australia, Chartered Accountants Australia and
New Zealand (CAANZ, formerly the Institute of Chartered Accountants in Australia, or ICAA) and the
Institute of Public Accountants (IPA) adopt the Code of Ethics for Professional Accountants developed by the
Accounting Professional and Ethical Standards Board (APESB), which is based on the IFAC Code of Ethics.h
Ethics at the business level
In our society, we expect people to behave within a range of civilised standards. This expectation allows
society to function with minimal confusion and misunderstanding. Similarly, accounting information
developed by businesses in an ethical environment allows our economy to function efficiently and enables
users to direct or allocate resources productively. In both our personal and our business lives, ethics and
integrity are our ‘social glue’.
Sustainability in business
We often hear reports about businesses’ negative impacts on the environment and their disregard for society.
What is clear is that businesses must play a key role if we are to become globally sustainable. Many
businesses, in fact, are working to become more environmentally sustainable and more socially responsible. It
is clear that businesses are doing this because a range of related benefits may result from it – including
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Ethics and Sustainability
25
Accounting Information for Business Decisions
sustainability
The recognition of
intergenerational and
intragenerational
equity, where the
meeting of the needs
and wants of a person
or group now should
not compromise the
ability of a future
person or group to
meet their needs and
wants
10
What skills are required
from accountants of the
twenty-first century?
improving their reputation, reducing costs and strengthening the communities in which they operate – but also
because of improved profitability. The issue for accountants is that environmental and social impacts are often
business costs. However, good environmental management and social responsibility tend to improve long-term
profitability rather than reduce it. Given that investors place a high value on environmental responsibility, and
many people are now willing to pay more for products and services that are environmentally friendly, it is in
the interest of businesses to be ‘green’. Consider two key elements that affect most businesses: the use of water
and energy, and the generation of waste. These are costs to the business, so more efficient management
can lead to considerable cost savings, as well as often facilitating new income streams from recycling or reusing
materials and emissions rather than putting these in landfill or into the atmosphere.
In many contexts, the term ‘sustainable business’ is taken to refer to a ‘green’ business or enterprise
that has no negative impact on the global or local environment, community, society or economy. A
sustainable business is one that ensures that all processes, products and activities, while maintaining a
profit, address current environmental concerns. Business sustainability requires proactive business
management and a strategic approach if the best results for the business are to be achieved. It is an
overarching concept that involves doing everything better and more efficiently, and that makes good
business sense because the benefits feed directly into the bottom line. There are many factors that
contribute to longevity in terms of a business’s survival, growth and improvement. The first is that a
business needs to operate efficiently and productively in order to remain profitable and grow. The second
is that a business must engage responsibly and ethically with the triple bottom line issues it faces. There
will be more discussion of this in Chapter 10.
1.6 The accountant in
a changing society
In this section, we discuss the broad skills needed by businesspeople to do business effectively in a changing
environment. These same skills, as well as others, also apply to accountants, and make accountants more
effective in dealing with their clients. In the past decade, professional bodies, academics and employers have
reframed these broad skills into a set of core competencies that all university graduates entering the
profession of accountancy should possess.
In Australia, the first learning standards for accounting graduates were devised as part of the Learning
and Teaching Academic Standards (LTAS) project. These Standards, which were revised in 2016 in
consultation with the accounting community, are shown in Exhibit 1.13, and have been defined under the
headings ‘Judgement’, ‘Knowledge’, ‘Critical Analysis and Problem Solving’, ‘Communication’, ‘Teamwork’
and ‘Self-management’. We discuss each of these skills in the following sections.i
Judgement, knowledge, and critical
analysis and problem solving
general knowledge
A category of the
businessperson’s
knowledge base that
encompasses
knowledge about
history and cultures, an
ability to interact with
people who have
dissimilar ideas, and
experience in making
value judgements
26
Large accounting firms, and the accounting community in general, recognise that gathering information,
interpreting it and effectively communicating it to others relies on the businessperson’s knowledge base
and ability to integrate theoretical and technical knowledge of accounting and other relevant areas. First,
accountants must have accounting knowledge, including the ability to construct accounting data, as well
as the ability to use this data to make decisions, to exercise judgements, to evaluate risks and to solve
problems in a range of contexts. Knowledge of related areas, such as auditing and assurance, finance,
economics, quantitative methods, information systems and applicable laws, is also necessary. In addition
to knowledge of accounting, accountants must have a knowledge base and skills that support applying
accounting knowledge and technical skills to solve accounting problems. General knowledge
encompasses knowledge about history and cultures; an ability to interact with people who have dissimilar
ideas; a sense of the contrasting economic, political and social forces in the world and of the magnitude of
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Chapter 1 Introduction to business accounting and the role of professional skills
Exhibit 1.13 Learning Standards for accounting
Bachelor graduates in accounting will be able to:
Judgement
Exercise judgement under supervision to provide possible solutions to routine accounting
problems in straightforward contexts using, where appropriate, social, ethical, economic,
regulatory, sustainability, governance and/or global perspectives.
Knowledge
Integrate theoretical and technical accounting knowledge in a business context.
Critical
analysis and
problem
solving
Critically apply theoretical and technical accounting knowledge and skills to provide
possible solutions to routine accounting problems.
Communication
Justify and communicate accounting advice and ideas in straightforward contexts to
influence both specialists and non-specialists.
Teamwork
Contribute accounting expertise to a diverse team, collaboratively providing possible
solutions to a routine business problem in a straightforward context.
Selfmanagement
Reflect on performance feedback to identify and action learning opportunities and
self-improvements.
Source: Source: Adapted from Australian Learning and Teaching Council (2010) Learning and
Teaching Academic Standards Statement for Accounting. Canberra: Australian Government: p10.
global issues and ideas; and experience in making value judgements. Accountants also need to have
organisational and business knowledge, which includes an understanding of the effects of economic,
social, cultural and psychological forces on businesses; an understanding of how businesses work; an
understanding of methods and strategies for managing change; and an understanding of how technology
helps organisations. An accountant must also be able to apply their skills to new situations and, in a
logical manner, use their knowledge and skills to produce answers to accounting problems. The ability to
apply knowledge to solve problems will also require a certain level of proficiency in information and
communication technology (ICT). There are many problems that require judgement, such as the choice of
inventory and depreciation method, decisions about whether to capitalise or expense costs and measures
to be taken following a variance from budget. Auditors must exercise judgement when deciding whether
to issue an unqualified audit that says the financial statements of a firm have been prepared in accordance
with GAAP and accounting standards. Management accountants exercise judgement when making
decisions about whether to outsource products and services or make and deliver them internally. Financial
accountants exercise judgement in choosing accounting methods. ‘Being able to make good judgements is
a cornerstone of being a professional accountant … Professional judgement is a key skill for preparers,
auditors and regulators of financial statements.’j
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organisational and
business knowledge
A category of the
businessperson’s
knowledge base that
includes an
understanding of the
effects of economic,
social, cultural and
psychological forces on
companies; an
understanding of how
companies work; an
understanding of
methods and strategies
for managing change;
and an understanding
of how technology
helps organisations
judgement
involves the evaluation
of evidence to make a
decision, choice or
recommendation. We
exercise judgement
when we use our
critical thinking to
decide between two
alternatives based on
objective facts or data
27
Accounting Information for Business Decisions
Communication skills
An accountant’s job involves both collecting and communicating information. A key part of collecting
information is knowing where to look for it. Although some information may be located in routine places,
such as sales invoices, the accountant must be ready to look beyond the routine. Information may appear
in written form (such as documents, written procedures, reports, journals and reference materials), in
electronic form (such as emails or files) or in verbal form (such as conversations or presentations).
To gather information from written, electronic and verbal sources, an accountant must be a proficient
reader and listener, and must possess an appropriate level of ICT proficiency. In this case, reading and
listening mean more than is initially apparent. To be useful, the information gathered must be relevant to the
decision at hand. The accountant must be able to interpret information, decide whether it is relevant and then
filter out everything else. So the accountant cannot be just a casual reader or listener. Rather, the accountant
must analyse the information they have read or heard, actively trying to understand it by considering both its
context and its source. Context includes such aspects as the perspective or bias of the information source, how
the information was developed and what assumptions were made in developing it. To gain this understanding,
the accountant must use critical thinking skills, which we will discuss later in the chapter.
Accountants also communicate information. They must be able to present their ideas coherently to
people at different levels of the company (all the way up to the chair of the board of directors) as well as
to people outside the company, who will have different interests, backgrounds and levels of accounting
and business understanding. These ideas may be presented formally or informally in written, electronic or
verbal form. Accountants must be able to justify and communicate accounting advice and ideas in routine
collaborative contexts involving both accountants and non-accountants. An accountant must therefore
also be an effective speaker and writer.
Teamwork skills
Although working with numbers may be the most familiar aspect of an accountant’s job (have you ever
heard accountants referred to as ‘number crunchers’ or ‘bean counters’?), working with people is just as
important. Accountants collect information from some people and communicate it to others. They work on
team projects, act as leaders within departments and serve on teams that span the entire company. Since
accountants advise managers and board members, they must possess the same interpersonal skills that a
competent manager or board member possesses. These include the ability to lead and influence others, to
motivate others, to withstand and resolve conflict, and to organise and delegate tasks.
Self-management skills
To be successful in business, it is necessary to understand a range of business contexts. Because the world
of business changes constantly, it is also important that those involved in the business world –
particularly accountants – take responsibility and be accountable for their own continuous learning in
order to keep remain of current issues. An ability to reflect on performance feedback is important in order
to identify and carry out learning opportunities that will lead to self-improvement.
Critical thinking skills are necessary and complementary for successful, efficient problem solving and
decision making. However, these skills do not necessarily come naturally. You might be an extremely creative
thinker, but not a good critical thinker. Similarly, you might be a very capable critical thinker, but not very
good at thinking ‘outside the box’. The accountant needs to be an analytical thinker, and must be innovative
and able to apply critical thinking to problem solving and decision making within the business world.
11
How can people learn to
think critically?
28
Critical thinking
Most of us tend to consider thinking, like breathing, to be a natural function. (’We all do it.’) However,
critical thinking requires practice. Take tennis, for example. Few people expect to be good at tennis the
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Chapter 1 Introduction to business accounting and the role of professional skills
first time they take to the court. At first, bad tennis seems to be the norm. But, with practice aimed at
improving and at learning new forms and specific techniques, better tennis comes more naturally. In the
same way, practising critical thinking, including ‘new forms and specific techniques’, makes it more
natural. Awareness of our current thinking patterns helps us to recognise our strengths and weaknesses,
and this knowledge provides a starting point for modifying and improving our thinking performance.
Critical thinking is the process that evaluates ideas. It determines whether any of the ideas will work,
what types of problems there might be with them, whether ideas can be improved and which ideas are
better than others. To be a successful critical thinker, you need to be in the right frame of mind, to use the
thought processes and actions necessary for thinking critically, and to constantly watch and monitor your
thinking (much as a tennis player watches their game).
critical thinking
Process that evaluates
the ideas generated by
creative thinking
Characteristics of the critical thinker
Above all, the critical thinker values truth rather than just the appearance of truth. For example, in looking
for the truth, critical thinkers must be independent and objective. Being independent means that, in the
process of evaluating ideas, the critical thinker must rely on their own conclusions rather than those of
others. This doesn’t mean that the critical thinker is a know-it-all – just that they don’t accept the beliefs of
others without questioning where those ideas came from, what evidence supports them and what
assumptions were made in developing them.
Objectivity, the quality of being unbiased, is a very difficult characteristic to achieve, but one that critical
thinkers must have if they value truth. All people select, organise and interpret information based on their
own perceptions, beliefs and past experiences. Even when we are trying very hard to understand someone
else’s point of view, we tend to say to ourselves, ‘This is how I would feel if I were in that situation; therefore,
they must feel the same way.’ We tend to unconsciously impose our own perceptions, beliefs and past
experiences on our understanding of information, ideas and other people, which may bias the outcome.
Besides being willing to consider new ideas and information, critical thinkers know they may have biases and
prejudices that keep them from true understanding, and that they must try to eliminate these biases from
their thinking. By realising that their viewpoints are a product of their unique experiences, critical thinkers are
better able to really listen for, and try to understand, other viewpoints.
In order to strive towards independent, objective thinking, critical thinkers develop openness to new
and different ideas, as well as empathy for other points of view. Have you ever encountered a know-it-all?
Do you remember feeling frustrated that this person did not listen to your perspective or your
contributions to the conversation? As you have probably experienced, a know-it-all assumes that there is
no more to learn about a subject. Unfortunately, this assumption blocks the person’s receptivity to new
information and new perspectives about the subject. How much more could the know-it-all learn by
keeping an open mind? Furthermore, could this person make better decisions by acknowledging the limits
of their own knowledge and by making use of all available relevant information?
Critical thinkers also tolerate ambiguity and willingly defer judgement until they can collect more
information and consider and evaluate other solutions. Many problems involve complex issues with
multiple interpretations and numerous good solutions. Critical thinkers must think creatively, and they
do not accept the first solution generated as necessarily being the best solution. Critical thinkers recognise
that ‘good’ ideas are often relative rather than absolute – for example, ‘higher-quality’, ‘more probable’ and
‘more objective’. So, even though many ideas may satisfy the critical thinker’s values and criteria, some
ideas may be better than others.
Finally, critical thinkers have the courage of their own convictions. Have you ever had an idea that you
just knew was right (after analysing and evaluating other ideas and viewpoints), but nobody else agreed
with you? Conviction is what kept you from caving in to the majority opinion and kept you going when
the going got tough. As we said earlier, many problems in business are complex and multifaceted.
Identifying problems, finding solutions and overcoming all the obstacles and frustrations along the way
takes perseverance.
You can develop and improve the critical thinking characteristics we have just discussed.
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independent
In the process of
evaluating ideas,
relying on one’s own
conclusions rather than
relying on the
conclusions of others
objectivity
Quality of being
unbiased in critical
thinking
29
Accounting Information for Business Decisions
Stop & think
Questions for critical thinkers to ask themselves
• If an issue is controversial, do I accept my initial reaction to it, or do I debate the issue in my
head first?
• Do I tend to reject new evidence that contradicts my current opinion on a subject, or do
I evaluate the new evidence and then decide whether to accept or reject it?
• When I am trying to solve a problem, do I usually accept the first solution that ‘works’, or do
I generate multiple solutions, reflect and then choose the best one?
• When others disagree with me, do I usually listen to them with an open mind and critically
evaluate their ideas, or do I try to defend my own ideas?
Strategies of the critical thinker
To make sense of the world, to develop solutions to complex problems, to deal with ambiguous issues and
to make decisions, the critical thinker must apply a variety of thinking and reasoning strategies to the
thought process. First, the critical thinker must be able to define, clearly and precisely, the problem or
issue at hand. Without a clear and precise definition of the problem, it is almost impossible to generate
the best solution. How could you identify the relevant information for solving it?
12
How can critical thinking
help people to make
better business decisions?
creative thinking
Process of actively
generating new ideas to
discover solutions to a
problem
13
What are the logical
stages in problem solving
and decision making?
30
Applying critical thinking to
business decisions
Every day of our lives, we must solve problems and make decisions on issues both minor, like what to
have for breakfast, and major, like which career to choose. Think about your breakfast decision this
morning. To choose what to have for breakfast, you had to gather certain information, such as what types
of food you had available to eat, how much of these foods were available (did you ever pour a bowl of
cereal only to find that there wasn’t enough milk in the refrigerator to go with it?), what type of food you
could tolerate in the morning, when your next meal would be, what activities you had planned for the
day, the nutritional content of the food, which dishes were clean and how much time the food would take
to prepare. After evaluating all the facts, you were able to make a decision.
A simple problem like choosing what to have for breakfast does not require complex analysis
(although you may need a quick shower first, to wake you up). However, many business problems can
involve a jumble of information, opinions, considerations, risks and alternatives.
A systematic method that includes creative and critical thinking is necessary to organise the problemsolving approach and decide on a solution to the problem. Exhibit 1.14 illustrates the four stages in
decision making and the particular impact of creative and critical thinking on each stage. Creative
thinking involves ‘thinking outside the box’ to generate new ideas or raise questions that extend beyond
what is usual or normal. Note that creative thinking might be more important in the earlier stages, while
critical thinking is more important in the later stages. We will discuss these stages of decision making in
the next four sections.
Stage 1: Recognising and defining the problem
The first stage in solving a problem is the recognition and definition of the problem. As we suggested earlier in
the chapter, the chances of arriving at a successful solution to a problem are considerably reduced if the
decision maker does not have a clear understanding of the problem. An incorrectly defined problem will lead
to an unproductive course of action at best, and could actually create new problems or make the current
problem worse. To fully understand the problem, the decision maker needs to clearly state the problem, gather
the facts surrounding the problem and identify the objectives that would be achieved by solving the problem.
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Chapter 1 Introduction to business accounting and the role of professional skills
Exhibit 1.14 Critical thinking and four stages in problem solving and decision making
Critical thinking
Step 1
Recognise problem
Step 2
Identify alternatives
Step 3
Evaluate alternatives
Step 4
Make decision
Step 5
Critical thinking
For example, consider the situation facing Jenny Highflyer, a manager at DeFlava Coffee Corporation.
Jenny’s newly health-conscious boss, Graham Wheatley, has asked whether it is possible to process and sell a
new decaffeinated coffee bean that is high in antioxidants, to be called Decaffi Bean. Jenny doesn’t want to
make a hasty decision, so she uses her critical and creative thinking skills to brainstorm a list of questions she
has about the idea. Jenny’s first list looks like this:
• Why does Wheatley want us to manufacture this new coffee bean?
• When must a decision be made?
• Who inside the business would be affected by a decision to manufacture and sell this new product?
How would they be affected?
• Who outside the business would be affected by a decision to manufacture and sell this new product?
In what ways would they be affected?
• How can I break down this decision into smaller parts?
• What additional information do I need to make a decision?
• Where can I find additional information?
Stop & think
Why do you think it is important to know who will be affected by a business decision and how
they will be affected?
Answers to these questions will no doubt lead Jenny to further, more probing questions, such as the
following:
• Can we manufacture a decaffeinated coffee bean that meets the business’s standards of excellence?
• How long would it take to develop, market and process this new coffee bean?
• Who would buy this new product?
• Will people stop purchasing the popular Pure Gold coffee beans and instead buy the new Decaffi
beans? Or will people who typically avoid buying coffee be tempted by the decaffeinated and
antioxidant qualities of the Decaffi beans, leaving sales of Pure Gold coffee virtually unaffected, and
thereby increasing total customers and total sales?
• What kind of competition would this new product face?
• At what price could the company sell the new range of coffee beans?
• What resources (if any) would the company need to acquire in order to manufacture this product? Are
these resources available?
• What would the additional costs be? Does DeFlava have access to additional financing, if necessary?
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Accounting Information for Business Decisions
•
•
•
•
Would additional people need to be hired? What qualifications and skills would these people need to
have? What is the probability of finding people with these qualifications and skills?
Would production of the new coffee beans force DeFlava Coffee to comply with additional
government regulations?
Would any of the ingredients used in the process pose health risks?
How can we package the product to limit waste or promote recycling?
Stop & think
In trying to decide whether or not it is possible to process a delicious, decaffeinated coffee
bean that meets the company’s standards of excellence, what else might you ask?
Now that Jenny has an initial list of questions, she brainstorms about where she might find
answers to them. In this case, Jenny’s sources of information would include such people as suppliers,
customers and potential customers (through market surveys), as well as the company’s marketing
managers, production managers, chief financial officer and accountants, environmental control
managers, distribution managers and human resources managers. Jenny would need to analyse
information from these sources for faulty logic, unsupported assumptions and emotional appeal, and
would need to determine the credibility of these sources of information and the nature of evidence
supporting the information. Jenny would then need to synthesise the information received from
separate sources into an understandable ‘whole’, or a clear statement of the problem.
In identifying the objectives that would be achieved by manufacturing and selling the new coffee bean,
Jenny would need to determine what it is that her boss would like to achieve by having DeFlava Coffee
manufacture the Decaffi Bean. Jenny surmises that Wheatley wants to:
• satisfy customers who have a desire for coffee, but not the accompanying caffeine
• enhance DeFlava Coffee’s reputation for being an industry leader and an innovator
• increase the company’s market share (i.e. get a greater percentage of all coffee sales, perhaps by
bringing in people who drink decaffeinated coffee but who have not been buying DeFlava products)
• increase profit for the company.
After using critical thinking skills to gather, analyse and synthesise the facts about the problem and the
results that could be achieved by solving the problem (from all perspectives), Jenny should have a better
understanding of the problem. This understanding will allow Jenny to state the problem more clearly and in
more detail than she did in the original problem statement, perhaps even allowing for a division of the problem
into smaller parts. Exhibit 1.15 shows the memo that Jenny wrote to Wheatley outlining the problem.
Exhibit 1.15 Jenny’s memo outlining the problem
24 September
TO: Graham Wheatley
FROM: Jenny Highflyer
SUBJECT: Decaffi Bean
Dear Mr Wheatley,
You asked me if it is possible to process and sell a new coffee bean to be called Decaffi Bean.
I have thought about this for several days and would like to know whether I completely
understand the assignment. I presume that you would like DeFlava Coffee to process and
sell a new coffee bean while at the same time achieving the following objectives:
• satisfying customers who have a desire for good coffee and cannot consume caffeine
• enhancing our reputation as an innovator and industry leader
• increasing our market share
• increasing our profit.
Am I on target? I would appreciate your response in the next day or two.
Thanks,
Jenny Highflyer
32
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Chapter 1 Introduction to business accounting and the role of professional skills
Stage 2: Identifying alternative solutions
After the problem has been clearly defined and stated, the problem-solver identifies alternative solutions.
Generating numerous alternative solutions makes it more likely that at least one of them will be workable.
Discussing the problem and possible solutions with other people can help to identify alternative
solutions. By talking with people who are uninvolved with or unaffected by the problem or its solution,
Jenny is likely to get a more objective assessment of the problem, or perhaps an entirely new perspective
on it. Brainstorming with a group would generate plenty of ideas from which to choose workable
solutions. Jenny decides to call a meeting of several people from all areas of the company to join a
brainstorming team.
After generating a list of ideas, the team must critically evaluate them to identify potentially workable
solutions. To be workable, the solutions must fit within the boundaries or limits of the company. For
instance, the chief financial officer tells the brainstorming team that the company can borrow only $40 000
to launch the new product; the purchasing officer lists for the team all the available suppliers of ingredients;
the production manager reminds the team that Valentine’s Day orders will keep managers so preoccupied
and production employees so swamped that work on the new product could not begin until after 14
February; and the cleaning-crew supervisor informs the team that, because the company uses only pure
mountain spring water to clean the machines every day, the factory must be located in a mountainous area.
Given this new information, the team comes up with several workable alternatives:
1 Don’t manufacture or sell the new Decaffi Bean, and stay with the status quo. (This may be workable,
but it may not achieve Wheatley’s objectives.)
2 Because $40 000 is not enough to expand the factory, use available space in the current factory to
manufacture and sell only a small quantity of Decaffi Bean coffee to test-market the concept before
beginning full-scale production.
3 Drop the Double Shot coffee product line (which many customers stopped purchasing because it kept
them awake at night) and convert this line’s production resources so that they can be used for
manufacturing Decaffi Bean. Manufacture and sell a large amount of Decaffi Bean (without testmarketing the concept).
brainstorming
Process where
members of a group try
to generate as many
solutions as possible to
a particular problem
Stop & think
Can you think of other possible alternatives for solving this problem?
Stage 3: Weighing the advantages and disadvantages
of each solution
After the team identifies potentially workable solutions, Jenny must evaluate each of them. Critical
thinking becomes paramount at this stage.
In this example, accounting information is useful in evaluating each solution because each is likely to
have different economic effects. Accounting information that is relevant to Jenny in weighing the
advantages and disadvantages of each solution includes information about the solution’s effect on the
company’s costs, profits and related income taxes, as well as its effect on the timing of cash receipts and
payments. Furthermore, if the Double Shot product line is dropped (see alternative 3 above), Jenny must
also consider the accompanying change in profits caused by this, as well as the change in profits caused by
the movement of Double Shot customers to other types of coffee.
After gathering accounting and other information for each alternative, Jenny can list the advantages
and disadvantages of each choice. For example, Exhibit 1.16 shows Jenny’s list of advantages and
disadvantages for alternative 2, manufacturing and selling only a small quantity of Decaffi Bean coffee to
test-market the concept before beginning full-scale production. Jenny should evaluate the advantages and
disadvantages of each workable solution in this way in order to fully understand each alternative.
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33
Accounting Information for Business Decisions
Exhibit 1.16 Jenny’s list of advantages and disadvantages of manufacturing and selling only a
small quantity of Decaffi Bean coffee
Advantages
• This alternative will require a smaller initial investment
in factory equipment and personnel than the full-scale
production alternative.
• In this alternative, DeFlava has less to lose if Decaffi
Bean does not sell as predicted than it would if the
fullscale production alternative were implemented and
sales of Decaffi Bean were less than predicted.
• Feedback from the test market can be used to improve
Decaffi Bean coffee before it is marketed nationally.
• A positive market response to Decaffi Bean might open
up new sources of financing for further expansion of
the roasting factory.
Disadvantages
• A market failure could damage the reputation of the
business. The cost of additions to the factory and
personnel could outweigh the money brought
into the company through the sale of Decaffi Bean.
• Company employees assigned to produce Decaffi
Bean would be spending time on this that would
otherwise be spent contributing to the production
and sale of well-established coffee beans.
• While DeFlava is test-marketing the Decaffi Bean
coffee, the company’s competitors could launch
a successful full-scale market blitz with a similar
coffee bean.
• A new group of customers might be tapped into because
of the decaffeinated nature of the Decaffi Bean coffee.
Stop & think
Can you think of advantages and disadvantages of not manufacturing and selling Decaffi
Bean?
Stage 4: Choosing a solution
The first three stages of the problem-solving process break down the problem in a systematic and detailed
manner. In this way, Jenny becomes completely familiar with the problem and its possible solutions.
After these first three stages, Jenny must choose the best solution from the alternative workable
solutions. Jenny makes the product decision based largely on the accounting information gathered in the
previous stage, in which she evaluated the alternatives. However, even after the advantages and
disadvantages of each alternative have been listed and quantified (where possible), the choice of a solution
can be difficult. This is because individual advantages and disadvantages weigh differently in the decision
and are hard to compare. One technique that is useful in ordering the alternatives is to rank them based
on their effectiveness in achieving the desired results, and then also rank them based on their desirability
in relation to the company’s value system. For example, suppose the company values an innovative image
more than one of stability. In this case, alternatives 2 and 3 in the list above would rank higher than
alternative 1. Another technique that is useful in choosing a solution is to combine the best features of
multiple alternative solutions while eliminating some of the disadvantages that each alternative would
have if it alone were selected.
The decision-making process is similar for people who are outside the company and are making
decisions about the company. For example, assume DeFlava Coffee applies for a three-year bank loan of
$40 000. When this request is made, the banker recognises that a decision must be made about granting the
loan. For the banker, there are many alternatives, including refusing the bank loan, granting a loan of a
smaller or greater amount for a shorter or longer period of time, or granting the loan as requested. The
banker must have information concerning the cash in DeFlava’s bank accounts, the cash DeFlava must
spend to pay its bills, the amount DeFlava expects to collect from its customers, the timing of these
payments and collections, and the way in which the bank loan would be used. By gathering the related
accounting information, the banker can evaluate whether DeFlava needs the bank loan, the appropriate
amount and length of time of the loan, and the likelihood that DeFlava will repay the loan. The banker
makes the loan decision, to a great extent, on the basis of accounting information provided by DeFlava.
34
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Chapter 1 Introduction to business accounting and the role of professional skills
Accounting information and
decision making
The role of accounting information in the decision-making process is further illustrated in Exhibit 1.17.
As this exhibit illustrates, the accounting information system and decision making are interactive – that is,
an accountant collects information about a company (i.e. locates, gathers, interprets and organises
relevant information) and communicates this information to both internal and external users to assist
them in making decisions. These decisions have an impact on the company’s activities, which then have
an impact on the company’s resulting accounting information (as is reflected when the accounting process
of information accumulation and communication is repeated again).
You can see, through the bank loan and product decisions, that the decisions made by both the internal
and the external users will affect the accounting information accumulated and communicated about the
company. Before either decision is reached, the information accumulated and communicated will be the
information needed to make the decisions, as discussed earlier. After the decisions are made, regardless of
the alternative chosen (whether or not the bank grants a loan to DeFlava Coffee, and whether or not
DeFlava manufactures and sells the Decaffi Bean coffee), the result of the decision will affect DeFlava’s
future activities and, in turn, result in different accounting information about the company.
Exhibit 1.17 Accounting information and decision making
Effect of decision
Make decision
Business
activities
Collect accounting
information
Accountant
Communicate
accounting
information
Internal
user
External
user
Make decision
Effect of decision
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35
Accounting Information for Business Decisions
STUDY TOOLS
Summary
1.1 Have an understanding of business, and the skills and knowledge required for success in a complex
business environment.
1
Why is it necessary to have an understanding of business before trying to learn about accounting?
Accounting involves identifying, measuring, recording, summarising and communicating economic information about a business for
decision making. It focuses on the resources and activities of businesses. Therefore, it is important to understand businesses and the
business environment in which they exist before trying to learn how to account for their resources and activities.
2
What factors are affecting the complexity of a changing business environment?
The business environment is dynamic and is becoming increasingly complex. More information is being generated than ever
before, and this information is available to more people than ever before. Technology is advancing rapidly, affecting not only the
products we use but also the ways in which products are manufactured and business is conducted. Business activities and
economies are becoming globalised, the number of regulations is escalating, business transactions are becoming more complex and
new forms of business are emerging.
3
What are three characteristics that someone might require to become a successful businessperson in a complex
business environment?
The successful businessperson must be willing and able to adapt to change. Because of the dynamic and complex business
environment, they must be:
u able to take change in their stride
u devoted to lifelong learning
u open to other viewpoints
u tolerant of differences
u willing to take educated and thoughtful risks
u able to anticipate environmental trends, and identify the potential problems and opportunities associated with these trends
u ready to abandon old plans and change course in light of new information.
1.2 Explain the categories of business.
4
What are the three main categories of business enterprise?
Businesses in the private enterprise system produce goods and services for a profit. They can be service, merchandising or
manufacturing businesses. While merchandising and manufacturing businesses deal in goods or products, a service business provides
services to customers to make a profit. Entrepreneurs, or individuals, invest money in businesses so that the businesses can acquire
resources, such as inventory, buildings and equipment. The businesses then use these resources to earn a profit.
1.3 Know the three common business structures and the regulations faced by each.
5
What are the three most common forms of business organisation and their basic characteristics?
The three most common forms of business organisation are: (1) the sole proprietorship, owned by one individual; (2) the
partnership, owned by two or more individuals (partners); and (3) the company (or corporation), incorporated as a separate legal
entity and owned by numerous shareholders who hold shares in the company. The owner of a sole proprietorship and the partners
in a partnership generally have unlimited personal liability for any debts incurred by the business. Sole proprietorships and
partnerships have a limited life because the business will cease to exist if there is a change in partners or owners.
36
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Chapter 1 Introduction to business accounting and the role of professional skills
6
What types of regulations do businesses face?
Businesses must be regulated because the activities of a business affect not only that business but also other businesses, the economy
and the environment. All businesses, regardless of type, size or complexity, must contend with regulatory issues. Numerous laws and
authorities regulate businesses on issues ranging from environmental protection to taxes. Each local government area, state/territory
and nation has its own regulations. Owners of businesses must learn and comply with the regulations issued by the different levels of
government where the businesses are located and in the areas where they conduct business.
1.4 Outline how accounting systems play a role in providing information to enable informed business
decisions.
7
What information does the accounting system provide to support management activities?
Accounting information helps people both inside and outside businesses to make decisions. It supports management activities by
providing managers with quantitative information about their business to aid them in planning, operating and evaluating the
business’s activities. Accounting information supports external decision making by providing people outside the business – such as
investors, creditors, stockbrokers, financial analysts, bankers, suppliers, labour unions, customers and governments – with
financial statements containing economic information about the performance of the business.
Managers strive to make their business successful through setting and achieving the goals of the business, making decisions and
committing the resources of the business to the achievement of these goals. Planning provides the organisation with direction for the
other activities. Operating involves gathering the necessary resources and employees, and implementing the plans. Evaluating measures
actual progress against standards or benchmarks so that problems can be corrected.
8
How does accounting provide support and information to people who are external to the business when they are
making decisions?
So external users can understand the meaning of accounting information, businesses follow agreed-upon principles in their external
reports. These generally accepted accounting principles (GAAP) are the standards, or rules, that businesses must follow. A business
may publish its income statement, balance sheet and cash flow statement (and statement of changes in owner’s equity), along with
other related financial accounting information, in its annual report. This report must present a true and accurate record of the
activities of the business so as to enable informed decisions to be made by interested parties, particularly external parties.
1.5 Understand how ethics and sustainability impact business outcomes.
9
What roles do ethics and sustainability play in the business environment?
Since the world is a complex place, where issues are not always clear, decisions must be made in an ethical context using the best
available information. Accounting information can be relied on only if it is generated in an ethical environment. Many groups have
established codes of ethics. Adopting an ethical approach to business will also increase the business’s chances of sustainability.
Sustainability refers not only to environmentally ‘green’ aspects of the business but also to planning for survival and growth using
an effective business plan.
1.6 Discuss the skills required by accountants and those involved in business to solve problems and make
decisions.
10
What skills are required from accountants of the twenty-first century?
Besides being willing to change, businesspeople can develop skills that will better prepare them for problem solving and decision
making in the current environment. Businesspeople can become broadly proficient in all forms of communication: speaking,
writing, listening, reading and teamwork (working cooperatively with others). Businesspeople can also develop their interpersonal
skills and personal management skills. These include the ability to lead and influence others, to motivate others, to withstand and
resolve conflict, to organise and delegate tasks, and to prioritise and manage their own tasks. Judgement is another type of skill
that businesspeople can develop. Beyond these skills, an ability to think critically and to apply knowledge and skills to problems in
order to make decisions is needed in a rapidly changing business environment.
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Accounting Information for Business Decisions
11
How can people learn to think critically?
People can learn to think critically first by learning new forms and techniques of thinking, and then by practising these techniques
to improve their decision-making skills. An awareness of their current thinking patterns helps people recognise their strengths and
weaknesses; this knowledge provides a starting point for modifying and improving their thinking performance.
12
How can critical thinking help people to make better business decisions?
The ideas generated by innovative thinking provide the raw materials of the decision-making process. Critical thinking helps
decision makers analyse decision alternatives for faulty logic, unsupported assumptions and emotional appeals. Furthermore, it
helps decision makers evaluate the relevance of evidence used to support decision alternatives, the credibility of the sources of
evidence, and the consistency of the evidence with the decision alternatives it supports. Finally, critical thinking helps decision
makers to be sure that all relevant information, all points of view and all workable solutions have been considered.
13
What are the logical stages in problem solving and decision making?
Many business problems are difficult and complicated. A systematic approach is therefore necessary to clarify the problem and to
decide on a solution to it. The four stages in problem solving and decision making are: (1) recognise the problem; (2) identify
alternatives; (3) evaluate the alternatives; and (4) make the decision. The accounting information system plays a big part in the
business’s decision-making process.
Key terms
accounting system
financial accounting
net loss
agent
financial statements
objectivity
annual report
general knowledge
operating
brainstorming
generally accepted accounting
organisational and business knowledge
budgeting
principles (GAAP)
partnership
capital
income statement
partnership agreement
company/corporation
independent
planning
cost analysis, or cost accounting
internal users
profit
creative thinking
joint ownership
service business
critical thinking
judgement
shareholders
e-commerce
limited life
sole proprietorship or sole trader
entrepreneur
management accounting
solvency
equity
manufacturing business
statement of changes in owner’s equity
evaluating
merchandising business
sustainability
external users
net income
unlimited liability
Online research activity
This activity provides an opportunity to gather information online about real-world issues related to the topics in this chapter. For
suggestions on how to navigate various businesses’ websites to find their financial statements and other information, see the related
discussion in the Preface. Put your skills to the test and find answers to the following questions by visiting the listed websites.
u Find out and note what resonates with you in the Code of Ethics for Professional Accountants at the website of the
Accounting Professional and Ethical Standards Board (APESB): http://www.apesb.org.au/page.php?id¼12.
u Discover what the benefits of being a member of CPA Australia (CPAA) and how to become a member of the organisation at
http://www.cpaaustralia.com.au.
u Are there any notable differences between the following three professional bodies: CPAA (see above), Chartered Accountants
Australia and New Zealand (or CAANZ; see https://www.charteredaccountantsanz.com) and the Institute of Public
Accountants (or IPA; see https://www.publicaccountants.org.au)?
38
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Chapter 1 Introduction to business accounting and the role of professional skills
u
In one paragraph, define the role of each of the following organisations:
– Australian Taxation Office (ATO): http://www.ato.gov.au
– Australian Competition and Consumer Commission (ACCC): http://www.accc.gov.au
– Australian Securities and Investments Commission (ASIC): http://www.asic.gov.au.
Integrated business and accounting situations
Answer the following questions in your own words.
Testing your knowledge
1-1
1-2
1-3
1-4
1-5
1-6
1-7
1-8
1-9
1-10
1-11
1-12
1-13
1-14
1-15
1-16
1-17
1-18
1-19
1-20
1-21
1-22
1-23
1-24
1-25
1-26
1-27
1-28
1-29
1-30
What do we mean when we refer to different categories of business?
What distinguishes a service business from a merchandising business?
How is a merchandising business different from a manufacturing business? How are the two types of business the same?
What is entrepreneurship?
Suppose you were an entrepreneur. Where might you go for business capital?
Describe the factors that are affecting the current business environment and the impact of each of these factors.
What impact does changes in interest rates have on the business environment?
What distinguishes a sole proprietorship from a company and a partnership?
What are the types of regulations with which businesses must comply in different jurisdictions?
What is an accounting management system?
How would you describe the similarities and differences between management accounting and financial accounting? Why are
they different and why are they similar?
How do management accounting reports help managers with their activities?
What are generally accepted accounting principles (GAAP)?
Which groups of users require financial accounting reports to make decisions and what type of information do they need?
What does the term ‘ethics’ mean in business?
Why are ethical codes of conduct important for professional groups such as accountants and who monitors these codes of
conduct?
What does ‘sustainability’ mean in regard to business?
What is internal control?
In addition to knowledge of accounting, what other skills and knowledge prepare a university graduate to enter the
profession of accountancy?
What is auditing?
What are three professional organisations of accountants and who are their members?
Think of a recent discovery, technological innovation, world event, regulation or other factor affecting the business
environment (one not mentioned in this chapter). What effect has this factor had on the business environment? What
future effect do you think this factor will have on the business environment?
What are the broad skills, as outlined by the accounting community, that are necessary for practising accounting and for
effectively conducting business?
Explain the characteristics of a critical thinker. How do critical thinking skills improve problem solving?
What is the difference between being independent and being objective?
Why is it important to evaluate the credibility of a source of information?
How do general knowledge and organisational and business knowledge support decision making?
Describe the stages of problem solving. What pitfalls might you encounter at each stage?
Describe how accounting information is used in each of the stages of problem solving.
What is ‘judgement’, and how does it apply in business? Give three examples.
Applying your knowledge
1-31
Give an example of a service business and of a manufacturing business. Explain the similarities and differences between
the two.
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39
Accounting Information for Business Decisions
1-32
1-33
1-34
1-35
1-36
1-37
1-38
1-39
1-40
1-41
1-42
1-43
1-44
40
How might knowledge of a business’s cash receipts and payments affect a bank’s decision about whether to loan the
business money? What financial statement would the loan officer want to look at to begin to understand the business’s
cash receipts and payments?
What factors would you consider in deciding whether to operate your business as a sole proprietorship, a partnership or a
company?
Suppose you are Samuel Cook, CEO of DeFlava Coffee. DeFlava currently operates in south-eastern Australia, and you are
considering opening a factory and sales office in Queensland. What questions do you want answered before you proceed
with this idea?
Refer to question 1-34. Suppose, instead, that you were considering opening a factory and sales office in Bejing, China.
What questions would you want answered before proceeding with this idea? How do you explain the similarities and
differences in your answers to this and the previous question?
What are some examples of business information in which both internal and external users have an interest?
Suppose you are a manager of The Foot Note, a small retail store that sells socks. Give an example of information that
would help you in each of the management activities of planning, operating and evaluating the operations of the store.
How do generally accepted accounting principles (GAAP) affect the accounting reports of businesses in Australia? Why
might the owner(s) of a business be concerned about a proposed new accounting principle?
A friend of yours, Timorous Ghostly (‘Tim’ for short), who has never taken an accounting subject, has been assigned a
short speech in his public-speaking class. In this speech, Tim must describe the financial statements of a business. Tim has
come to you for help (with his teacher’s permission). He says, ‘Please describe what financial statements are, what the
major financial statements are and what each financial statement includes.’ Prepare a written response to Tim’s request.
How do codes of ethics help businesspeople to make decisions?
Consider the following opposing sides of an issue:
a All businesses, even those in other countries, should have to follow generally accepted accounting principles (GAAP).
b All businesses should not have to follow GAAP.
Required:
Identify reasons that support each side of the issue.
Suppose your job is beginning to eat into your personal time. During the last six months, you have noticed that you have
been taking home files to work on after dinner and at the weekend. Even so, you are having trouble keeping up. After
explaining this to your boss, she suggests that you find a way to work more efficiently. Furthermore, she points out that
there are many people who would be glad to take over your job.
Required:
a What are some alternative ways to approach your boss? What reasons, information and evidence might support your
point of view?
b What reasons, information and evidence might support your boss’s point of view? In what ways might these reasons
affect the approach you take in presenting your problem to your boss?
You have just been promoted in your job working for an established Australian fashion label, Aussie Designs, operating
out of Sydney. The business specialises in hats. Your new boss wants your opinion about whether to open a new branch
office in Auckland, New Zealand. You desperately want to make a good impression on your first assignment, and want to
ensure you have a good grasp of the situation before you form your opinion.
Required:
a What questions do you want answered before you offer your opinion to your boss?
b Where might you find the answers to your questions?
Suppose your brother, the owner of Muscle Up, a fitness centre, has asked you for a substantial loan to help him expand
his business.
Required:
What would you like to know about Muscle Up before you make a decision about whether to loan the company money?
How could the answers to each of your questions affect your decision? What accounting information could your brother
provide you that could affect your decision?
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Chapter 1 Introduction to business accounting and the role of professional skills
1-45
1-46
1-47
Refer to question 1.44. At your request, your brother provides you with the following information:
Revenues for previous year
$80 000
Expenses for previous year
$65 000
Profit for previous year
$15 000
Required:
How could this information be presented differently to make it more meaningful for you in reaching your loan decision?
What could be added to this particular information to make it more meaningful for you?
The office photocopier has just stopped working and is beyond repair. The big question now is what to do with it. Your
boss is offering a cash prize for each of the following:
u the longest list of ideas for what to do with the copier
u the most unusual idea
u the widest variety of ideas.
Required:
See whether you can win all the cash by providing a written list of your ideas.
Your new co-worker just came into the office and made the following statement: ‘Every Friday is casual day around here; people
wear casual clothes to work on Fridays. Jan, over there, is wearing jeans and a T-shirt today. It must be Friday. TGIF!’
Required:
What’s wrong with your co-worker’s logic?
Making evaluations
1-48
1-49
1-50
1-51
1-52
Your friend, Vito Guarino (an incredible cook), plans to open a restaurant when he graduates from university. One evening,
while extolling the virtues of linguine to you and some other friends, he glances down at your accounting textbook, which is
open at Exhibit 1.4. ‘What kind of a business is a restaurant?’ Vito asks, ‘How would a restaurant fit into this exhibit?’ Everyone
in the room waits with great anticipation for your answer and the rationale behind it. What will you say?
You and your cousin, Harvey, have decided to form a partnership and open a landscaping business in town. Before you do,
you and Harvey would like to ‘iron out’ a few details about how to handle various aspects of the partnership, then write a
partnership agreement outlining the details. What specific issues would you like to see addressed in the partnership
agreement before you begin your partnership with Harvey?
As an ongoing activity, read a daily newspaper every day over the next week. What evidence do you find that supports the
need for business codes of ethics?
Is a business suit the most appropriate attire to wear to a business meeting?
Required:
Answer the question based on what you believe to be true (answer ‘Yes’, ‘No’ or ‘Not sure’). Explain why you answered the
way you did. Now give reasons and evidence (e.g. authorities, references, facts, personal experience) that you believe support
your answer.
Consider again the plight of Jenny, the manager at DeFlava Coffee Corporation, whose boss wants to manufacture and sell
the new Decaffi Bean coffee product, perhaps using it to replace the Double Shot coffee product.
Suppose the accounting department has projected that profit per kilo will be $2.00 higher for Double Shot coffee than for
Decaffi Bean coffee. The marketing department predicts that DeFlava Coffee can sell 1000 kg of Decaffi Bean coffee in the first
year, and then more each year for the next 10 years, if it drops Double Shot coffee. During that same time period, the marketing
department forecasts that sales of Double Shot coffee will be 800 kg in the first year, with sales decreasing slightly after that if
the company does not produce Decaffi Bean coffee. However, if the company produces both types of coffee, predicted sales for
Decaffi Bean reduce to 700 kg in the first year, with a slow and steady increase in sales over the next 10 years. Predicted sales for
Double Shot coffee will decrease to 650 kg during the first year, and decrease slightly each year for the next 10 years.
The production department has determined that the new Decaffi Bean coffee is possible to manufacture, and that the
factory can be reconfigured to accommodate the new coffee while continuing to produce the old Double Shot coffee. If DeFlava
Coffee drops Double Shot coffee, it can convert the equipment so that this can be used to produce Decaffi Bean coffee. The
human resources department is confident that numerous qualified people are available to work if the company wants to
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41
Accounting Information for Business Decisions
1-53
produce both types of coffee. If the company drops Double Shot coffee, those people currently working on that product can
easily be retrained to work on Decaffi Bean coffee. The chief financial officer has arranged for financing if it is needed.
Required:
a Based on the above information, what are the advantages and disadvantages of: (i) dropping the Double Shot product
line and producing Decaffi Bean; (ii) continuing production of Double Shot and not producing Decaffi Bean;
(iii) producing both Double Shot and Decaffi Bean; and (iv) producing neither coffee bean? How would you decide
which alternative is best?
b What additional information would make your decision in the previous question easier?
c What other alternative solutions can you think of?
The changing business environment provides many challenges for today’s businessperson, but also opportunities.
Required:
What opportunities do you see that result from this environment? How would you prepare yourself to take full advantage
of these opportunities?
Dr Decisive
You’ve just accepted a great job, joining a team of consultants who write an advice column, ‘Dear Dr Decisive’, for the local
newspaper. Yesterday, you received your first letter.
Dear Dr Decisive,
Today is my lucky day. I have just graduated from a course in body art and received $10 000 from my rich
aunt as a graduation present. My long-term goal has been to start up a ‘Body Beautiful’ Salon. I believe it
would be best located in a beachside area and have found premises on the Gold Coast. My boyfriend, who
is an accountant, says he might assist me financially but needs to know that we have done the right
research and have the right skills to embark on this venture. Do you think I have the right skills to go into
this business? And what research should I do? Also, do you have any advice on how i can convince a bank to
lend me enough money to get the business up and running? Very excited, Body Beautiful.
Required:
Meet with your Dr Decisive team and write a response to ‘Body Beautiful’.
Endnotes
a
The Executive’s Book of Quotations (1994) Julia Vitullo-Martin and J. Robert Moskin (eds). Oxford: Oxford University Press, 41.
Language Resources (nd) ‘Translation blunders: Don’t let this happen to you’. http://www.languageresources.com/blunders.html.
Accessed 14 April 2017.
c
See http://www.dynamicbusiness.com.au/entrepreneur-profile/australian-bureau-statistics-count-australian-businesses-2141.html.
d
Hill, A (2011) ‘Ten years on, Enron remains an open sore’. Financial Times, 17 October.
http://www.ft.com/intl/cms/s/0/9d57f8da-f66d-11e0-86dc-00144feab49a.html#axzz2mNOWBza6. Accessed 15 June 2013.
e
Levering, R & Moskowitz, M (2000) ‘With labor in short supply, these companies are pulling out all the stops for employees’.
Fortune, 10 January. http://archive.fortune.com/magazines/fortune/fortune_archive/2000/01/10/271718/index.htm. Accessed
14 April 2017.
f
Lane, C (2005) ‘Justices overturn Andersen conviction’. Washington Post, 1 June.
http://www.washingtonpost.com/wp-dyn/content/article/2005/05/31/AR2005053100491.html. Accessed 22 April 2017.
g
International Federation of Accountants (2002) Recognition of Pre-Certification Education Providers by IFAC Member Bodies. New
York, IFAC, 2.
b
42
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Chapter 1 Introduction to business accounting and the role of professional skills
h
i
j
International Federation of Accountants (2006) Code of Ethics for Professional Accountants. New York: IFAC.
Freeman, M & Ball, C (2010) Learning and Teaching Academic Standards Statement for Accounting. Canberra, Australian
Government, 10.
Institute of Chartered Accountants of Scotland (2012) A Professional Judgement Framework for Financial Reporting: An International
Guide for Preparers, Auditors, Regulators and Standard Setters. Edinburgh: ICAS, 3.
List of company URLs
u
u
u
u
u
u
u
u
u
u
u
u
u
u
u
u
u
u
u
u
Amazon: http://www.amazon.com.au
ASX Group: http://www.asx.com.au
Black & Decker: http://www.blackanddecker.com.au
BlueScope Steel Ltd: http://www.bluescopesteel.com.au
Cisco Systems, Inc: http://www.cisco.com
Citigroup: http://www.citigroup.com
Dell Inc.: http://dell.com.au
eBay: http://www.ebay.com.au
Ford Australia: http://www.ford.com.au
JPMorgan Chase & Co.: http://www.jpmorganchase.com
KFC: http://www.kfc.com.au
LJ Hooker: http://www.ljhooker.com.au
London Stock Exchange: http://www.londonstockexchange.com
NASDAQ Stock Market: Inc. http://www.nasdaq.com
New York Stock Exchange: http://www.nyse.com
New Zealand Stock Exchange: NZX http://www.nzx.com
Qantas Airlines Limited: http://www.qantas.com.au
Stefan Hair Fashions: http://www.stefan.com.au
The Good Guys: http://www.thegoodguys.com.au
Woolworths Supermarkets: http://www.woolworths.com.au
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43
2
DEVELOPING A BUSINESS PLAN:
COST–VOLUME–PROFIT
ANALYSIS
‘He who every morning plans the transaction of the day, and follows out
that plan, carries a thread that will guide him through the maze of the
most busy life. But where no plan is laid, where the disposal of time is
surrendered merely to the chance of incidence, chaos will soon reign.’
Victor Hugo
Learning objectives
After reading this chapter, students should be able to do the following:
2.1 Understand the importance of planning for a new business and
what to include in the plan.
2.2 Understand the concepts of cost–volume–profit analysis (CVP)
and cost behaviour.
2.3 Be able to apply CVP analysis to estimate break-even, target
profits and assess alternatives.
2.4 Consider other planning issues and effects.
44
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Chapter 2 Developing a business plan: Cost–volume–profit analysis
Understanding the learning objectives is assisted in the chapter by asking key questions:
Key questions
1
Since the future is uncertain and circumstances are likely to change, why should a
business bother to plan?
2
What should a business include in its business plan?
3
In Chapter 1, we referred to accounting as the language of business. How does
accounting information contribute to the planning process?
4
What must decision makers be able to predict in order to estimate profit at a given
sales volume?
5
How can decision makers predict the sales volume necessary for estimated revenues to
cover estimated costs?
6
How can decision makers predict the sales volume necessary to achieve a target profit?
7
How can decision makers use accounting information to evaluate alternative plans?
As mentioned in Chapter 1, your friend Emily Della has asked you to help her set up and open her café.
When you finish your course, you plan to join her in the business and form a partnership, but the initial
structure will be a sole trader as Emily is providing the capital. Emily, who earned her degree last year with a
major in marketing, has a congenial personality and always enjoys a chat over a good cup of coffee. She has
always aspired to own a coffee shop. After long and lively discussions with you about the name of the
business, Emily’s decision is to name it Café Revive. You and Emily arrange to obtain retail space, purchase
display fixtures, supplies and coffee products, and hire a barista and a university student on a casual basis to
serve in the café. You also develop a marketing strategy using social media and the campus weekly
newspaper. Now you are ready to open for business. But whoa not so fast … have you thought of
everything? If you and Emily want Café Revive to succeed, you need to consider several other issues before
you open the business. Instead of rushing into business when the idea is fresh, it would be smart to first
develop a detailed business plan that addresses these issues.
2.1 Planning in a new business
Planning is an ongoing process for successful companies. It begins before a business opens for operations
and continues throughout the life of the business. A business plan is an evolving report that describes a
business’s goals and its current plans for achieving those goals. The business plan is used by both internal
and external users. A business plan typically includes the elements shown in Exhibit 2.1. We will discuss
these various elements individually in later sections of this chapter.
In general, a business plan has three main purposes. First, it helps an entrepreneur to visualise and
organise the business and its operations. Remember from Chapter 1 how Jenny tested the strengths and
weaknesses of the proposal to make the Decaffi Bean coffee? Similarly, thinking critically about your
hopes for the business and putting a plan on paper will help you and Emily to imagine how the plan will
work, and to evaluate the plan, develop new ideas and refine the plan. By looking at the plan from
different perspectives, such as those of managers who have responsibility for marketing the business’s
products or purchasing its inventory of products, you can discover and correct flaws before implementing
the plan. Then ‘paper mistakes’ won’t become real mistakes!
Second, a business plan serves as a benchmark, or standard, against which the entrepreneur can later
measure the actual performance of a business. You and Emily will be able to evaluate differences between
the planned performance of Café Revive, as outlined in its business plan, and its actual performance.
Then you will be able to use the results of your evaluation to adjust Café Revive’s future activities. For
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business plan
Describes a business’s
goals and its plans for
achieving those goals
1
Since the future is
uncertain and
circumstances are likely to
change, why should a
business bother to plan?
2
What should a business
include in its business
plan?
45
Accounting Information for Business Decisions
Exhibit 2.1 Business plan elements
risk
Amount of uncertainty
that exists about the
future operations of a
business
return
Money received from
investment and credit
decisions
Step
1
A description of the business
Step
2
A marketing plan
Step
3
An operating plan
Step
4
An environmental management plan
Step
5
A financial plan
instance, suppose that in the first month of business, sales are higher than you and Emily predicted. If
you decide that sales will continue at this level, you can use that information to increase Café Revive’s
future coffee purchases.
Third, a business plan helps an entrepreneur to obtain the financing that new and growing companies
often need. When you and Emily start looking for additional funding for Café Revive, potential investors
and creditors may request a copy of the business plan to help them decide whether or not to invest in
Café Revive or to loan it money. For example, as part of its loan-making decisions, the Commonwealth
Bank (http://www.commbank.com.au) routinely evaluates the business plans of companies that apply for
business loans at the bank.
Investors and creditors, such as the Commonwealth Bank, have two related concerns when they are
making investment and credit decisions. One concern is the level of risk involved in their decisions. Risk
usually refers to how much uncertainty exists about the future operations of the business. The other
concern is the return, or money back, that they will receive from their investment and credit decisions. A
thorough business plan will provide useful information for helping investors and creditors evaluate their
risk and potential return. Now let’s look at the parts of a business plan.
Description of the business
A business plan usually begins with a description of the business and its basic activities. Details of this
description include information about the organisation of the business, its product or service, its current
and potential customers, its objectives, where it is located and where it conducts its business.
Café Revive is a new hospitality business located at a university campus in a high-growth suburb in
the northern part of a major metropolitan area. Initially, Café Revive will sell a typical selection of coffees
for consumption both in-café and takeaway. It will also sell a limited range of pre-packaged coffee gift
packs. You and Emily will expand this product line to include other types of coffee and coffee products as
the business grows. You and Emily are eager to begin marketing and operating the business, but are
waiting to do so after you finish writing the business plan and obtain financing. You realise that writing
the plan is helping you to think through the various aspects of the business, so that you don’t miss
something important in planning your activities. Case Exhibit 2.2 illustrates how you might describe Café
Revive in its business plan.
The organisation of a business and its personnel can have a major influence on the success of the
business. Therefore, the description of the business also includes a listing of the important people within
the business and the major roles they will play. This listing can include the individuals responsible for
starting the business, significant investors who also are providing expertise and direction to the business,
and influential employees and consultants who have a strong impact on the business. Case Exhibit 2.3
gives examples of how you might discuss Café Revive’s organisation in its business plan. Notice how this
part of the plan highlights the combination of your major in business and Emily’s degree in marketing.
46
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Chapter 2 Developing a business plan: Cost–volume–profit analysis
Case Exhibit 2.2 Description of Café Revive
How company
is organised
Type of company
and product
Café Revive is a new retail café organised as a sole
proprietorship (trader)* and owned by Emily Della. It rents space in
the University Hub, a centre located on a university campus in the
north west of Brisbane. In the last 10–20 years, many companies
have begun to locate their corporate headquarters to the west of
Brisbane, so the population in this area has surged. Demographic Location and
surveys indicate that growth should continue steadily for the
where it
foreseeable future. The university campus is also growing.
does business
Objectives
Café Revive has the following objectives:
1
2
3
4
To initially provide the cups of coffee and coffee gift packs from
DeFlava Coffee to students on the university campus in the
north west of Brisbane.
To expand the product line within three years to include other
types of coffee.
To open new stores in 3–5 years in nearby suburbs.
To remain privately owned.
Potential
customers
*Note the definition of sole proprietor in Chapter 1.
Case Exhibit 2.3 Organisation of Café Revive
The team at Café Revive is composed of four people, one of whom is a financial consultant. The members of this team are as
follows:
Emily Della
Owner
[Your name]
Advisor/potential partner
Jackson Downes
Employee
Briana Small
Consultant
List of important
people and the roles
they will play
Each of these individuals brings special skills to Café Revive.
Emily Della graduated last year with a BCom in marketing from
UQ. She has already earned a reputation for her marketing and
business skills. At university, she won the State Finalist Award
from the Australian Marketing Institute and the coveted CPA
Australia’s Student Award. She graduated with first-class
honours. While studying, Emily worked for three retail stores,
two of which were start-up companies. One of the start-up
companies was a boutique specialist food and beverage store.
[Your name] is a business honours student at QUT and will be
graduating this year. [Your first name] has worked 20 hours per
week ‘keeping the books’ at a local restaurant for the past two
years. Prior to that, [your first name] worked during the summer
break and part-time during the academic year doing
miscellaneous jobs at the same restaurant.
Qualifications of
important people
Jackson Downes is a business honours student at UQ. Jackson
has worked in the summer breaks at several restaurants in
Brisbane.
Briana Small is a partner in the management advisory services
area of Cracknell Ltd, a large public accounting firm in
Brisbane. Her firm specialises in consulting with start-up
companies.
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47
Accounting Information for Business Decisions
This part may also contain the business’s policies or strategies for selecting, training and rewarding
employees. These issues are particularly important for the long-term success of the business.
Stop & think
The long-term plan for Café Revive is for the ownership structure to change to a partnership as
you finish your degree and join Emily. Recall what you read about partnerships in Chapter 1.
What steps should you take to set up the partnership?
Marketing plan
The marketing section of a business plan shows how the business will make sales, and how it will
influence and respond to market conditions. This section receives a lot of attention from investors and
creditors because the business’s marketing strategy and its ability to implement that strategy can be very
important for the business’s success.
The marketing section provides evidence of demand for the business’s products or services, including
any market research that has been conducted. It describes current and expected competition in the
market, as well as relevant government regulations. It outlines how the business will promote, price and
distribute its products (the business’s ‘marketing strategy’), as well as the predicted growth, market share
and sales of products (its ‘sales forecast’) by period. This information is helpful to the entrepreneur as a
starting point for thinking about the business’s other activities related to sales, such as timing the
purchase of its inventories. The marketing section of the business plan is also helpful to people outside
the business, such as bank loan officers, because it shows how well the entrepreneur has thought through
the business’s sales potential, and how the business will attract and sell to customers.
Café Revive’s business plan may be centimetres thick! We don’t have room to show every part of its plan,
so in the following sections, we will ask you to think in general terms about what to include in the plan.
Following is a brief description of Café Revive’s market conditions. Initially, Café Revive will have a
temporary marketing advantage as there are not currently any good coffee facilities on campus offering
DeFlava Coffee – in fact, students and staff members actually drive off campus to get a good coffee in
between lectures! After evaluating the available retail space (and plans for building retail space), you and
Emily believe that there will be very little competition during the next five years. However, you expect
competing outlets to eventually open on campus and close to the campus. In the meantime, part of your
marketing plan is to build a reputation for friendly service, quality products and environmentally friendly
packaging. Your advertising will focus on the quality of the coffee that you provide. Your initial
advertising ‘punch’ will also include the fact that Café Revive sells only ‘everyone’s favourite’, DeFlava
Coffee. You believe that selling DeFlava Coffee gives Café Revive a distinct advantage because of the
established good reputation and popularity of the DeFlava Coffee brand.
Stop & think
What information about market conditions facing Café Revive would you include in the
marketing section of your business plan?
Operating plan
Since a business is organised to deliver a product or service to a market, the business plan must address
how the business will develop and enhance its products or services. The business operations section of a
business plan includes a description of the relationships among the business, its suppliers and its
customers, as well as a description of how the business will develop, service, protect and support its
products or services. This section also includes any other influences on the operations of the business.
48
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Chapter 2 Developing a business plan: Cost–volume–profit analysis
The business operations section of the business plan is important because it helps the entrepreneur to
think through the details of making the idea work. It also helps outside users to evaluate the
entrepreneur’s ability to successfully carry out the idea.
Here is a brief description of Café Revive’s operations. Café Revive has a ready supply of coffee
products. DeFlava Coffee has no sales agreements with any other outlets within a 20 kilometre radius of
Café Revive. Furthermore, you know of other potential suppliers (i.e. coffee roasting companies) that have
high production standards, quality ingredients and good reputations in the industry, as well as an
environmentally friendly product. In fact, Emily is now talking with representatives of these companies
and visiting their premises so that, if and when Café Revive is ready to sell other coffee products, she will
have identified and selected other suppliers.
Other influences on the operations of the business might also be described in this section. These might
include the availability of employees, concerns of special-interest groups, regulations (including environmental),
the impact of international trade and the need for patents, trademarks and licensing agreements.
Discussion
If Café Revive’s major supplier of coffee was a company in India, rather than the DeFlava
Coffee Corporation, what additional issues do you think would need to be included in this part
of the business plan? What else do you think managers, owners, creditors and investors would
like to know?
Environmental management plan and
sustainability
Today, there is a growing expectation that businesses will demonstrate corporate social responsibility
(CSR) and report on environmental and social as well as economic aspects of their business (Triple
Bottom Line). Hence Café Revive and businesses such as DeFlava Coffee need to be aware of their
environmental and social impacts, and to account for these costs. According to the Global Reporting
Initiative (GRI) Sustainability Reporting Standards (https://www.globalreporting.org/standards), the
environmental dimension of sustainability concerns an organisation’s impacts on living and non-living
natural systems, including ecosystems, land, air and water. Environmental disclosures cover performance
related to inputs (e.g. material, energy, water) and outputs (e.g. emissions, effluents, waste). In addition,
they cover performance related to biodiversity and environmental compliance, as well as other relevant
information such as environmental expenditure and the impacts of products and services. This is
particularly relevant for DeFlava Coffee in relation to the manufacturing processes it adopts and the
environmental impacts of its waste disposal. The GRI Standards are required for all reports or other
materials published on or after 1 July 2018.
Emily has checked the ‘green’ (environmental) credentials of their supplier DeFlava Coffee and knows
that the coffee used in the gift packs is sourced from coffee farms in northern Australia and ethically
farmed and produced. In 2018 the Australian Government introduced the Modern Slavery Act, requiring
any business operating in Australia with a turnover of more $100 million ($50 million in New South
Wales) to report annually on the risks of modern slavery in their operations and supply chains and
actions taken to address those risks. Forced labour can be an issue in the coffee supply chain. As DeFlava
Coffee is a large company, the Act applies to it.
Discussion
The Modern Slavery Act 2018 does not include penalties for failing to lodge a statement or
have independent oversight of the statements made. There is however a public register. How
then do you think business could be held accountable?
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49
Accounting Information for Business Decisions
Ethics and Sustainability
In accounting for environmental costs, DeFlava Coffee will need to employ an environmental management
accounting system, an approach that provides for the transition of data from both financial accounting and
cost accounting, to increase material efficiency, reduce environmental impact and risk, and reduce costs of
environmental protection. (For more on this topic, refer to Chapter 10.)
Environmental costs and decision making
The main problem of environmental management accounting is the lack of a standard definition of
environmental costs. Depending on various interests, they include a variety of costs – for example, waste
disposal costs or investment costs, and sometimes external costs (i.e. costs incurred outside the company,
mostly to the general public, such as greenhouse gas emissions). Of course, these differences in accounting
methods are also true for the reported profits of corporate environmental activities (i.e. environmental cost
savings). Moreover, environmental costs are often not traced systematically or attributed correctly to the
responsible processes and products, but instead are simply included in general overheads and therefore
‘hidden’.
Because of this inconsistency of definition, caution needs to be taken when using this information to
make decisions. In the manual Environmental Management Accounting Procedures and Principles, published by the
United Nations Division for Sustainable Development, it was noted that the fact that:
environmental costs are not fully recorded often leads to distorted
calculations for improvement options. Environment protection projects
aiming to prevent emissions and waste at the source (avoidance option) by
better utilising raw and auxiliary materials, and requiring less (harmful)
operating materials are not recognised and implemented. The economic and
ecological advantages to be derived from such measures are not used. The
people in charge are often not aware that producing waste and emissions is
usually more expensive than disposing of them.a
Put simply a business cannot seek to improve its environmental performance without the tools to
measure that performance, so a business aiming to achieve sustainable operations needs to develop
management systems capable of measuring financial and non-financial (often physical) information to make
informed decisions. This requires a constant evolution of tools and controls to measure environmental (and
social) impacts, specific to a business.b For Café Revive, this might be developing a method of recording the
number of disposable coffee cups used or the packing wasted, in order to seek to minimise the environmental
impact of these and reduce waste.
Public-sector reporting
Ethics and Sustainability
50
The public sector comprises organisations that are owned and operated by the government, and that
provide services for its citizens. These organisations do not strive to make a profit. The public sector has
in place several rules and regulations requiring organisations within it to report on their environmental
impact and costs. Under section 516A of the Environment Protection and Biodiversity Conservation Act 1999,
Australian Government organisations are required to include in their annual reports information about
their environmental performance and contribution to ecologically sustainable development. Some
Australian Government organisations are also required to report against National Environmental
Protection Measures (NEPMs). NEPMs are designed to ensure consistency of environmental regulations
across jurisdictions. They are also aimed at ensuring Australians, wherever they live, will enjoy the
benefits of equivalent protection from air, water and soil pollution and noise.
A recent tool available for organisations to assist them in complying with these statutory requirements is
an environmental management system (EMS), a structured system or management tool designed to help an
organisation reduce its negative impacts on the environment and improve its environmental performance. It
can provide ‘a methodical approach to planning, implementing and reviewing an organisation’s environmental
management’.c
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Chapter 2 Developing a business plan: Cost–volume–profit analysis
Stop & think
List the sorts of environmental costs that DeFlava Coffee would be likely to incur. Suggest
ways that DeFlava Coffee could measure these costs. How could the business turn waste into
profit? (Refer also to Chapter 10.)
Financial plan
Since Café Revive is a new business, it has no credit history or recent financial statements. Therefore, you
and Emily should also provide a detailed, realistic financial plan in Café Revive’s business plan. The
purpose of the financial plan section is to identify the business’s capital requirements and sources of
capital, as well as to describe the business’s projected financial performance. For a new business, this
section also highlights the business’s beginning financial activities, or start-up costs.
Before we begin the discussion of start-up costs, it is important to note that the Australian economy has
a goods and services tax (GST), which is a tax levied on the supply of goods and services. The tax is charged
at a flat percentage (currently 10%). Each business that meets certain criteria is required to register for GST.
The business collects GST on the goods and services it supplies and pays tax on the goods and services it
buys. The business then deducts the GST paid from the GST collected, and pays (or receives a refund of) the
balance to the Australian Taxation Office (ATO). How this is accounted for will be discussed in Chapters 4
and 5. For our purposes, the figures in this chapter are all GST-inclusive – that is, the expense is calculated
based on its cost plus GST. This is done because the calculations in this chapter will be used to make
decisions, so we need to recognise the full cost, inclusive of the GST component. Note that New Zealand
also has a GST, which at the time of publication was at a rate of 15 per cent.
Emily has worked out the following information about Café Revive’s start-up costs (GST inclusive
where appropriate):
• Emily will invest $22 000 of her own money as capital.
• The monthly rent for shop space is estimated at $1320 per month based on the rent charged for space
in the campus building. Café Revive is required to pay six months’ rent in advance, totalling $7920,
when Emily signs the rental in December 20X1.
• Based on a supplier’s cost quotation, Café Revive can buy equipment to fit out the cafe for $1650. The
supplier will allow a $250 down-payment and Emily will sign a note (a legal document referred to as a
note payable – effectively a loan to be paid at a later date) for the remaining amount, due at the end
of three months (March 20X2).
• Based on the purchases budget (which we will discuss in Chapter 3), Café Revive will purchase 50
coffee gift packs in December 20X1 at a cost of $1430 (50 $28.60 per pack) from DeFlava Coffee.
Although they have different contents, all of these gift packs will be acquired for the same cost price
of $28.60 per pack. DeFlava Coffee has agreed to allow Café Revive to pay for this inventory in
January 20X2.
• Café Revive will also purchase $2255 of coffee supplies in December 20X1, paying DeFlava Coffee for
the supplies at that time.
Stop & think
What information about Café Revive’s start-up costs would you include in the financial
section of its business plan?
Identifying capital requirements
Most businesses eventually need additional funding, or capital. The financial section of a business plan
should include a discussion of the business’s capital requirements, as well as potential sources of that
capital. For new businesses and small businesses, this discussion can be the most important part of the
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51
Accounting Information for Business Decisions
business plan. As you may have noticed while reading the business section of your local newspaper, if a
business does not have enough capital and sources of capital, it will have a difficult time surviving.
An entrepreneur can determine a business’s capital requirements by analysing two major issues: what
the business needs and the amount of capital this will require. The steps are shown in Exhibit 2.4.
Exhibit 2.4 Steps for determining capital requirements
Step 1
Determine the resources needed – for example, buildings,
equipment, furniture
Step 2
Determine the capital needed to acquire the resources (via cost
quotations, appraisals and sales agreements, etc.)
Step 3
Analyse the business’s projected cash receipts and payments
Alamy/Richard Levine
Step 4
Determine available cash and any need for borrowing
Start-up costs for a business can be significant.
Planning capital requirements involves projections, not
guarantees, so the entrepreneur must expect and provide for
reasonable deviations from plans. Suppose, for example, that
cash sales for a month turn out to be less than expected. To
allow for ‘surprises’ like this, the entrepreneur should plan to
have a cash ‘buffer’, which is extra cash on hand above the
projected short-run cash payments of the business. One purpose
of this buffer is to protect the business from differences between
actual cash flows and projected cash flows, as well as from
unanticipated problems, such as having to replace a refrigerated
display case sooner than expected. A cash buffer lets the
business operate normally through downturns without having to
look for financing. It also lets the business take advantage of
unexpected opportunities that require cash.
Stop & think
Can you think of an example of an unexpected opportunity for which an entrepreneur or
manager might find a cash buffer handy?
Sources of capital
short-term capital
Capital that will be
repaid within a year or
less
52
Once the entrepreneur knows the business’s capital requirements, potential sources of capital can be
identified. Government agencies also offer advice to small business, with regular initiatives such as the
Entrepreneurs’ Programme (https://www.business.gov.au/assistance/entrepreneurs-programme) and
grants may be available. The entrepreneur must know both the length of time for which the business
plans to use the capital before paying it back to creditors or returning it to investors, and the availability
of short- and long-term sources of capital. They can determine how long the business will need to use the
capital by analysing the business’s projected cash receipts and payments. We will discuss the tools of this
analysis more thoroughly in Chapter 3.
Short-term capital will be repaid within a year or less. Short-term capital can come from two sources.
First, suppliers provide short-term capital to some of their customers through what is called credit or trade
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Chapter 2 Developing a business plan: Cost–volume–profit analysis
credit. This involves allowing a customer to purchase inventory ‘on credit’ if the customer agrees to pay
soon, usually within 30 days. Emily, for example, has an arrangement with DeFlava Coffee that will allow
Café Revive to buy coffee supplies and gift packs on credit and pay DeFlava Coffee 30 days later.
Discussion
If Café Revive took longer than 30 days on average to sell its inventory of coffee, do you think
its arrangement with DeFlava Coffee would be valuable? What other questions would you like
answered to help you determine the answer to this question?
Second, financial institutions, such as commercial banks, provide loans to companies, many of
which are guaranteed by government agencies such as the AusIndustry Programs (https://
www.business.gov.au/advisory-services/ausindustry-qld-state-office). These institutions require a more
formal agreement with a business than do issuers of credit or trade credit. They also charge interest on
these short-term loans. At some point, Emily may talk with her banker to arrange a small line of credit for
Café Revive. A line of credit allows a business to borrow money ‘as needed’, with a pre-arranged, agreedupon interest rate and a specific payback schedule.
Long-term capital will be repaid to creditors or returned to investors after more than a year. Initially,
as we mentioned in Chapter 1, businesses obtain capital from the owner(s) and from bankers. Café Revive
obtained its initial capital from Emily, who invested money from her savings account. Other sources of
long-term capital can include friends and relatives, commercial banks and lending organisations.
line of credit
Amount of money a
business is allowed to
borrow with a
prearranged, agreedupon interest rate and
a specific payback
schedule
long-term capital
Capital that will be
repaid to creditors or
returned to investors
after more than one
year
Discussion
All institutions require a formal agreement with the business about payment dates and
interest rates. But suppose Café Revive borrows money from Emily’s and your friends
and relatives. Do you think it is necessary to have a formal written agreement between
Café Revive and these friends and relatives? Why or why not?
FINANCIAL STATEMENT EFFECTS
After finding it hard to raise a bank loan, the owner of Cheeta Australia, an Australian company that manufactures
automated self-loading hand trucks, took his company’s business plan and applied for a Commercialising Emerging
Technologies (COMET) grant from the Australian Government. After reviewing the plan, the government granted
$64 000 for a business adviser to help him attract potential investors and source manufacturers.d
Eventually, as a business grows too large to be financed by the owner and these other sources, it may offer
private placements or public offerings. Private placements are securities that are sold directly to private
individuals or groups (called investors). Public offerings involve issuing bonds or shares to the public (investors)
through securities firms or investment bankers.
For the near future, several of Emily’s and your friends and relatives have agreed to lend Café Revive
specific amounts of money, as needed. Emily and these friends and relatives have agreed that the interest
rate on these loans will match the market interest rate at the time of each loan. Café Revive includes this
information in its financial plan.
Projected financial performance
This section of the financial plan projects the business’s financial performance. Suppose Emily has
assigned you the responsibility of preparing this section of Café Revive’s financial plan. Remember that,
although projecting a business’s financial performance involves uncertainty, if you follow some guidelines
the financial performance information will be more dependable.
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Accounting Information for Business Decisions
Case Exhibit 2.5 Steps in projecting financial performance
Step
1
The data you use should be as reliable as possible
Since Café Revive is a new business, you don’t have historical data to use for planning purposes. When you have unclear data
(or no data at all), industry averages found in such sources as Moody’s (http://www.moodys.com.au), Standard and Poor’s
(http://www.standardandpoors.com/home/en/au) and Austrade (https://www.austrade.gov.au) can serve as a guide.
Step
2
Consider several scenarios because predicting a business’s financial performance is uncertain
‘What if’ questions are useful for this type of planning. For example, what if coffee sales fall below expectations by 30 per
cent? What if we sell only 100 coffee gift packs? What if we can sell 300 coffee gift packs? The scenarios should be realistic;
perhaps you should consider the best case, the worst case and the most probable case.
Step
3
Revise your projections as more facts become available
Step
4
Ensure that the financial plan is consistent with the information in the other sections of the business plan
For example, since the marketing section of Café Revive’s business plan refers to the advertising that you plan to do,
the financial plan section must show advertising costs.
Stop & think
If you use Moody’s, Standard & Poor’s or Austrade reports for industry information, you
must be able to identify the industry in which Café Revive is operating. What are some key
words that you could use to identify the industry?
The financial performance section of the financial plan includes projected financial statements,
supported by cost–volume–profit (CVP) analysis and budgets. Budgets include reports on such items as
estimated sales and purchases of inventory and expenses, as well as estimated cash receipts and payments.
In the remainder of this chapter, we will discuss CVP analysis and its relationship to the projected income
statement (the income statement was discussed briefly in Chapter 1, and will be covered in depth in
Chapter 7). In Chapter 3, we will discuss budgets and how they fit into a business’s financial plan.
In summary, you have just learned that the business plan shows the direction a business will be taking
during the next year. You have also learned that the business plan includes a description of the business,
a marketing plan, a description of business operations, an environmental management plan and a
financial plan. Accountants are most involved with the financial plan, which includes an analysis of
predicted costs, sales volumes and profits. We will thus spend the remainder of this chapter discussing
CVP analysis and its use in planning.
3
In Chapter 1, we referred
to accounting as the
language of business.
How does accounting
information contribute to
the planning process?
54
2.2 Cost–volume–profit (CVP)
planning
Determining whether a business will be profitable is difficult before it begins operations. This uncertainty
is part of the risk that the entrepreneur takes in starting a business. (Although it can be scary, it is also
part of the fun.) Uncertain profit does not mean the entrepreneur should disregard any type of analysis
before beginning the operations of a business; however, it is possible to take educated risks based on
estimations of costs, sales volumes and profits. The financial plan should include an analysis of these
three factors. One type of analysis that takes these into account is called cost–volume–profit (CVP) analysis.
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Chapter 2 Developing a business plan: Cost–volume–profit analysis
Cost–volume–profit (CVP) analysis
Cost–volume–profit (CVP) analysis shows how profit will be affected by alternative sales volumes, selling
prices of products and various costs of the business. CVP analysis is sometimes also called break-even
analysis. Entrepreneurs use CVP analysis to help them understand how the plans they make will affect
profits. This understanding can produce better informed decisions during the ongoing planning process.
CVP analysis is based on a simple profit calculation involving revenues and costs. This calculation can
be shown in an equation or in a graph. Although equations provide precise numbers, CVP graphs provide
a convenient visual form for presenting the analysis to decision makers. However, to understand a CVP
equation or graph, decision makers must also understand how costs behave.
cost–volume–profit
(CVP) analysis
Shows how profit is
affected by changes in
sales volume, selling
prices of products and
the various costs of a
business
Cost behaviour
A careful cost analysis considers the activity level of the operation that causes the cost. For example,
DeFlava Coffee, a manufacturing business, might measure its activity by using the number of kilograms of
coffee produced or the number of hours worked in producing so many kilograms of coffee. On the other
hand, Café Revive, a retail business, might measure its activity by using the number of coffees or gift packs
sold. This activity level (i.e. the number of cups of coffee or gift packs sold) is often referred to as volume.
The relationship between an activity’s cost and its volume helps us determine the cost’s behaviour pattern.
To understand what CVP equations and graphs reveal about a business’s potential profitability, let’s
first look at two cost-behaviour patterns that describe how most costs behave. These are called fixed costs
and variable costs.
volume
Activity level in a
business
Fixed costs
Fixed costs are constant in total for a specific time period – that is, they are not affected by differences
in volume during that same time period. Managers’ annual salaries are usually fixed costs, for instance.
For another example, think about the $1320 monthly rent that Café Revive will pay for its retail space.
Café Revive’s activity level is its sales volume – the number of coffees or gift packs sold. The rent cost of
the retail space will not change as a result of a change in the sales volume, assuming you have planned
carefully and have leased enough retail space. Café Revive will pay its monthly rent of $1320 no matter
how much coffee it sells that month. Since the rent cost does not change as volume changes, it is a fixed
cost. Let’s assume that half of the café space is used by the gift packs and half for making the coffees.
Hence, $660 rent cost is allocated to gift pack expenses and $660 is allocated to coffee-making expenses.
We will examine how costs and CVP analysis works using the gift packs sold by Café Revive. A business
would need to do this analysis for its entire business (all products), however, and the analysis for the
coffee supplies/cups of coffee sales is included in the Appendix at the end of this chapter.
The graph in Case Exhibit 2.6 illustrates the relationship between the rent cost and the sales volume.
As you can see, the rent cost for the gift packs will be $660 whether Café Revive sells 50 or 200 gift packs.
Also note in Case Exhibit 2.6 that we show a fixed cost as a horizontal straight line on the graph,
indicating that the cost will be the same (i.e. fixed) over different volume levels. It is important not to be
misled about fixed costs. Saying that a cost is fixed does not mean it cannot change from one time period
to the next. In the next period, Café Revive could rent more retail space if needed, or the landlord could
raise the rent when the lease is renewed, causing the rent cost to be higher. To be fixed, a cost must
remain constant for a time period in relation to the volume attained in that same time period and be
within the relevant range (see below). For example, most companies consider the costs of using their
buildings, factories, office equipment and furniture – called depreciation – to be fixed.1 That is,
depreciation costs within a specific time period will not change even if volume changes within that time
period. Relevant range is the range of activity levels over which the particular (fixed) cost behaviour
1
fixed costs
Costs that are constant
in total and that are not
affected by changes in
volume
relevant range
Range of volumes over
which cost estimates
are needed for a
particular use and over
which observed cost
behaviours are
expected to remain
stable
We will discuss in Chapter 4 how a business determines its depreciation costs. We include a brief discussion here because
most companies have some depreciation costs to consider in evaluating their operations.
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Accounting Information for Business Decisions
Case Exhibit 2.6 Fixed cost behaviour – coffee gift packs
Total monthly rent cost
$1 200
$900
$660
Rent cost
$600
$300
$0
50
100
Sales volume
(in coffee gift packs)
200
pattern remains valid. For example, if we lease the retail space mentioned above and that space is only
large enough to stock between 50 and 200 coffee gift packs, then the rent cost will be fixed at $660. But if
Café Revive needs to stock more than 200 gift packs, then it will need to lease other premises for $1980;
hence, when volume is outside the relevant range, the fixed rent cost will be different.
You have estimated that Café Revive’s monthly fixed costs will include the $1320 rent cost, plus
$2360 for total salaries (wages of $2050 & PAYG2 of $310) for you and Jackson Downes – the employee
Emily hired to work in the shop – $330 consulting costs, $231 advertising costs, $159 depreciation of
fixtures, $143 mobile/wifi and $209 energy costs (gas for heating and electricity).3 Café Revive’s total
fixed costs will be the sum of the individual fixed costs, or $4752. Again, based on equal use of floor space
for the products, assume that these costs are shared equally between coffee gift packs (fixed costs $2376)
and cups of coffee (fixed costs $2376).
Stop & think
What would the graph look like for Café Revive’s $4752 total fixed costs? Why?
Shutterstock.com/Africa Studio
Decision makers sometimes state fixed costs as a dollar
amount per unit, calculated by dividing the total fixed costs by
the volume in units. This can be misleading and should be
avoided. For instance, if we use only coffee gift pack sales, at a
sales volume of 200 gift packs, Café Revive’s fixed cost per gift
pack will be $11.88 ($2376 fixed costs 200 packs). At a sales
volume of 300 gift packs, the fixed cost per pack will be only
$7.92 ($2376 fixed costs 300 packs). Comparing $11.88 with
$7.92, you might think that total fixed costs decrease as sales
volume increases. This is not true! Café Revive’s total fixed costs
for gift packs will still be $2376, regardless of the sales volume.
If this coffee gift pack contained more items, would the business’s total
fixed costs decrease?
variable cost
Cost that is constant
per unit and that
changes in total in
direct proportion to
changes in volume
Variable costs
A variable cost is constant per unit of volume, and changes in total
in a time period in direct proportion to the change in volume. For instance, consider Café Revive’s cost of
purchasing coffee products from DeFlava Coffee to resell to its customers. You have estimated that each coffee
2
Note that PAYG will be explained in Chapter 4.
3
Some telephone and utility costs may have minimum charges, but their total costs are affected by changes in the volume of
usage. Here, for simplicity, we assume they are fixed costs.
56
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Chapter 2 Developing a business plan: Cost–volume–profit analysis
gift pack that Café Revive purchases will cost it $28.60. The total cost of coffee gift packs sold varies in
proportion to the number sold. If Café Revive sells 100 gift packs in January, the total variable cost of these
packs of coffee sold will be $2860 (100 packs $28.60). If the volume doubles to 200 packs, the total variable
cost of packs sold will also double, to $5720 (200 $28.60). It is important to remember that the total
variable cost for a time period increases in proportion to volume in that same time period, based on the variable
cost of each unit.
Case Exhibit 2.7 shows the estimated total variable costs of coffee gift packs sold by Café Revive at
different sales volumes. Note that total variable costs are shown by a straight line sloping upwards from the
origin of the graph. This line shows that the total variable cost increases as volume increases. If no coffee
gift packs are sold, the total variable cost will be $0. If 100 are sold, the total variable cost will be $2860.
The slope of the line is the rate at which the total variable cost will increase each time Café Revive sells
another coffee gift pack. This rate is the variable cost per unit of volume sold – that is, $28.60 per pack.
Case Exhibit 2.7 Variable cost behaviour – coffee gift packs
Total monthly variable cost
$6 000
$5 720
$5 000
$4 862
$4 000
sts
le
iab
co
r
Va
$3 000
$2 860
$2 000
$1 000
$0
50
100
150
Sales volume
(in gift packs of coffee)
170
200
250
Stop & think
How could rent be a variable cost? If it were a variable cost, how do you think it would affect
Café Revive’s variable costs line in Case Exhibit 2.7?
Because graphs are easy to see, we used them to show Café Revive’s fixed and variable costs in Case
Exhibits 2.6 and 2.7. For CVP analysis, however, it is often better to use equations because they show
more precise numbers. For instance, the equation for the total amount of a variable cost is as follows:
Total variable cost ¼ vX
Where:
v ¼ Variable cost per unit sold
X ¼ Sales volume.
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57
Accounting Information for Business Decisions
The equation for the variable cost line in Case Exhibit 2.7 is:
Total variable cost of gift packs of coffee sold ¼ $28.60X
Total costs
total costs
Sum of the fixed costs
and variable costs at a
given volume
Total costs at any volume are the sum of the fixed costs and the variable costs at that volume. For example,
at a sales volume of 100 coffee gift packs, Café Revive’s estimated fixed costs share for coffee packs are $2376
and its estimated variable costs are $2860 (100 $28.60), for an estimated total cost of $5236 at that
volume. At a sales volume of 200 coffee gift packs, estimated fixed costs are still $2376, estimated variable
costs are $5720 (200 $28.60) and the estimated total cost is $8096. Case Exhibit 2.8 illustrates the total
cost in relation to sales volume of gift packs. Notice that if no gift packs are sold, the total cost will be equal to
the fixed costs of $2376. As sales increase, the total cost will increase by $28.60 per pack, the amount of the
variable cost per pack.
Case Exhibit 2.8 Total cost behaviour – coffee gift packs
$8 096
$8 000
$7 238
$7 000
sts
l co
$6 000
$5 720
$5 236
a
Tot
$5 000
$4 950
$4 000
$3 000
Fixed costs
$2 376
$2 000
$1 000
$0
0
20
40
60
80 90 100
120
140
Sales volume – coffee gift packs
160
180
170
200
The equation for the total cost is:
Total cost ¼ f þ vX
where: f ¼ Total fixed costs
v ¼ Variable cost per unit sold, and
X ¼ Sales volume:
The equation for the total cost line in Case Exhibit 2.8 is:
Total cost of coffee gift packs sold ¼ $2376 þ $28.60X
Where X ¼ sales volume.
Now that you understand the relationships of volume, fixed costs and variable costs to the total cost,
we can use CVP analysis to estimate profit.
58
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Chapter 2 Developing a business plan: Cost–volume–profit analysis
Case Exhibit 2.9 Projected income statement for external users – coffee gift packs
Café Revive
Projected income statement – coffee gift packs
For the month ended 31 January 20X2
Revenues:
Sales revenues – coffee gift packs (170 55)
$ 9 350
Expenses:
Cost of gift packs sold (170 28.60)
Rent expense
$4 862.00
660.00*
Salaries expense
1 180.00
Consulting expense
165.00*
Advertising expense
115.50*
Depreciation expense: fixtures
79.50
Mobile and wifi expenses
71.50*
Energy expense
104.50*
Total expenses
(7 238)
Net income
$ 2 112
* These figures are GST-inclusive. Recall also that all fixed expenses are shared equally between the two product lines based on their equal use of space.
Profit calculation
According to its marketing plan, Café Revive expects to sell 170 coffee gift packs at $55 each and 880
cups of coffee at an average price of $5.50 in January. Case Exhibit 2.9 shows Café Revive’s projected
income statement for coffee gift packs and Case Exhibit 2.10 shows a combined income statement for
coffee gift packs and cups of coffee (see Case Exhibit 2.20 in this chapter’s Appendix for a coffee cup
sales income statement). These income statements are in the format that is presented to external users.
This is the same format that we discussed in Chapter 1 and illustrated in Exhibit 1.8 in Chapter 1.
External decision makers find this format easy to understand, and use this form of income statement for
their investment and credit decisions. This income statement results from the following equation:
Net income (Profit) ¼ Revenues – Expenses
In this equation, revenues (the selling prices of all cups of coffee and coffee gift packs sold to customers)
include cash and credit sales, and expenses (the costs of providing coffee and gift packs to customers)
include the cost of cups of coffee and gift packs sold and the expenses of operating the business.
Profit graph
One way of graphing a business’s net income (profit) is to show both its revenues and its costs (expenses)
on the same graph. Recall that the graph of a business’s total costs includes its fixed costs and its variable
costs, as we illustrated for Café Revive in Case Exhibit 2.8. The graph of a business’s revenues is shown
by a straight line sloping upwards from the origin. The slope of the line is the rate (selling price per unit)
at which the total revenues increase each time the business sells another unit.
Given that Café Revive has two different products, it is necessary to calculate the CVP analysis for
each of the products (see this chapter’s Appendix for details of the sales of cups of coffee). Recall that as
half of the café’s space is used by the gift packs and half for making the coffees, the fixed costs have been
divided evenly across the two products. Hence, the fixed cost of coffee gift packs will be $2376.
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59
Accounting Information for Business Decisions
Case Exhibit 2.10 Projected income statement for external users – both products
Café Revive
Projected income statement
For the month ended 31 January 20X2
Revenues:
Sales – coffee gift packs
$ 9 350
Sales – cups of coffee
4 840
Total revenues
$ 14 190
Expenses:
Cost of gift packs sold
$4 860
Cost of coffee supplies used
1 936
Rent expense
1 320*
Salaries expense
2 360
Consulting expense
330*
Advertising expense
231*
Depreciation expense – fixtures
159
Mobile & wifi expenses
143*
Energy expense
209*
Total expenses
Net income
(11 550)
$ 2 640
* These figures are GST-inclusive.
break-even point
Unit sales volume at
which a business earns
zero profit
The graph in Case Exhibit 2.11 shows the estimated total revenue line and the estimated total cost line
for Café Revive’s gift packs. Note that the total revenue line crosses the total cost line at 90 coffee gift packs.
At this point, the total revenues will be $4950 (90 $55), and the total costs will also be $49504 (Fixed costs
$2376 þ Variable costs $2574 [90 $28.60]); refer to the note under the heading ‘Finding the break-even
point’ later in this chapter), so there will be zero profit. The unit sales volume at which a business earns zero
profit is called the break-even point. Above the break-even unit sales volume, the total revenues of the
business are more than its total costs, so there will be a profit. Below the break-even point, the total revenues
are less than the total costs, so there will be a loss.
The profit graph in Case Exhibit 2.11 at a sales volume of 170 coffee gift packs shows that Café
Revive will earn a profit of $2112 (as we computed in the income statement in
Case Exhibit 2.9), the difference between the $9350 estimated total revenue and $7238 estimated total cost
at this volume. Although some decision makers use this type of graph, many others prefer to use a different
graph that shows a business’s contribution margin, as we discuss next.
Contribution margin
To estimate profit at different volume levels, the entrepreneur needs CVP information in a form that relates
the estimated revenues and estimated variable costs to the estimated fixed costs. Case Exhibits 2.12, 2.13
and 2.14 show income statements containing the same information as given in Case Exhibits 2.9, 2.20 (in
Appendix) and 2.10, but in a format that is more useful for internal decision makers in performing CVP
analysis because it shows expenses as variable and fixed. This income statement format is sometimes called
the contribution margin approach. Note that, on the income statement in Case Exhibit 2.12, Café Revive first
calculates its estimated sales revenue for coffee gift packs ($9350) by multiplying the number of gift packs it
expects to sell (170) by the selling price per pack ($55). Café Revive next determines the total estimated
4
60
These figures are GST-inclusive.
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Chapter 2 Developing a business plan: Cost–volume–profit analysis
Case Exhibit 2.11 Profit graph for Café Revive – coffee gift packs
$10 000
$9 350
Profit
$2 112
$8 000
$7 238
Profit
$6 000
$4 950
Break-even point
al
To
tal
re
ve
Tot
ts
cos
nu
es
$4 000
Loss
$2 000
$0
0
20
40
60
80
90 100
120
140
160 170 180
200
Sales volume – coffee gift packs
Case Exhibit 2.12 Projected income statement for internal users – coffee gift packs
(contribution margin approach)
Café Revive
Projected income statement – coffee gift packs
For the month ended 31 January 20X2
Total sales revenues ($55 170 coffee gift packs)
$ 9 350.00*
Less: Total variable costs
Cost of coffee gift packs sold ($28.60 170 packs)
(4 862.00)*
Total contribution margin
$ 4 488.00
Less: Total fixed costs
Rent expense
$ 660.00*
Salaries expense
1 180.00
Consulting expense
165.00*
Advertising expense
115.50*
Depreciation expense: display cases
Mobile and wifi expenses
Energy expense
79.50
71.50*
104.50*
Total fixed costs
Net income
(2 376.00)*
$ 2 112.00
* These figures are GST-inclusive.
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61
Accounting Information for Business Decisions
total contribution
margin
Difference between the
total sales revenue and
the total variable costs
contribution margin
per unit
Difference between the
sales revenue per unit
and the variable costs
per unit
variable costs of selling the 170 gift packs of coffee ($4862) by multiplying the number of packs it expects to
sell (170) by the variable cost per pack of coffee ($28.60). These total variable costs are then subtracted from
total sales revenue. The $4488 ($9350 – $4862) difference is called the total contribution margin.
Case Exhibit 2.20 (in Appendix) calculates net income using this approach for cups of coffee and the
income statement in Case Exhibit 2.13 shows the combined figures for Café Revive.
As you can see, the total contribution margin, at a given sales volume, is the difference between the
estimated total sales revenue and the estimated total variable costs. It is the amount of revenue remaining
after subtracting the total variable costs, which will contribute to covering the estimated fixed costs. To
compute the estimated profit, we subtract the total estimated fixed costs for the month from the total
contribution margin. If the contribution margin is more than the total fixed costs, there will be a profit. If the
contribution margin is less than the total fixed costs, there will be a loss. Case Exhibit 2.9 shows that Café
Revive’s estimated profit for coffee gift packs is $2112 ($4488 total contribution margin – $2376 total fixed
costs). Case Exhibit 2.20 shows that Café Revive’s estimated profit for cups of coffee is $528 ($2904 total
contribution margin – $2376 total fixed costs). Case Exhibit 2.13 shows that Café Revive’s estimated profit is
$2640 ($7392 total contribution margin – $4752 total fixed costs).
The contribution margin may also be shown on a per-unit basis. The contribution margin per unit is
the difference between the estimated sales revenue per unit and the estimated variable costs per unit. For
Café Revive, the contribution margin for gift packs per unit is $26.40 ($55 sales revenue – $28.60
variable costs). This may also be expressed as a percentage: $26.40/$55 ¼ 0.48 or 48% contribution
margin percentage. At 170 units, the total contribution margin will be $4488 (170 $26.40), which is
the same as that shown in Case Exhibit 2.12. Note that the contribution margin percentage remains
unchanged: $4488/$9350 ¼ 48%. This is the percentage of sales remaining to pay for – or contribute
Case Exhibit 2.13 Projected income statement for internal users – combined (contribution
margin approach)
Café Revive
Projected income statement
For the month ended 31 January 20X2
Revenues:
Sales – coffee gift packs ($55 170)
$ 9 350*
Sales – cups of coffee ($5.50 880)
4 840*
$14 190
Less: Total variable costs
Cost of coffee gift packs sold ($28.60 170 boxes)
4 862*
Cost of cups of coffee sold ($2.20 880)
1 936*
(6 798)
Total contribution margin
$ 7 392
Less: Total fixed costs
Rent expense
Salaries expense
$1 320*
2 360
Consulting expense
330*
Advertising expense
231*
Depreciation expense – display cases
159
Mobile and wifi expenses
143*
Energy expense
209*
Total fixed costs
Net income
* These figures are GST-inclusive.
62
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(4 752)
$ 2 640
Chapter 2 Developing a business plan: Cost–volume–profit analysis
towards – the fixed costs. Later, you will see that computing the total contribution margin (by either
method described above) is the key to understanding the relationship between profit and sales volume.
Case Exhibit 2.14 shows what the total contribution margin will be at different unit sales volumes of
coffee gift packs. In this graph, since the contribution margin of one coffee gift pack is $26.40, the total
contribution margin increases at a rate of $26.40 per gift pack sold. For example, at a volume of 100 gift packs,
the contribution margin will be $2640 (100 gift packs $26.40). At a volume of 300 gift packs of coffee, the
contribution margin will be $7920 (300 gift packs $26.40). At a volume of 170 gift packs of
coffee, the contribution margin will be $4488 (170 gift packs $26.40), as calculated in Case Exhibit 2.14.
Case Exhibit 2.14 Relationship between total contribution margin and unit sales volume –
coffee gift packs
Contribution margin
$8 000
$7 920
$7 000
$6 000
n
rgi
o
uti
ib
ntr
$5 000
a
nm
Co
$4 488
$4 000
$3 000
$2 640
$2 376
$2 000
$1 000
$0
0
50
90 100
150 170
200
Sales volume – coffee gift packs
250
300
Stop & think
If variable costs were higher per unit, would you expect the contribution margin line in
Case Exhibit 2.14 to be steeper or flatter than it is? Why or why not?
Discussion
Examine Case Exhibit 2.14 and note the contribution margin for Café Revive level at a sales
level of 90 gift packs. Where have you seen this figure before? Why do you think this level of
contribution from 90 coffee gift pack sales is significant?
Showing CVP relationships
Now that you understand the contribution margin and fixed costs, we can show the estimated profit or
loss at different sales volumes in a graph. Case Exhibit 2.15 shows how sales volume affects the
estimated profit (or loss) for Café Revive for coffee gift packs. Two lines are drawn on these graphs. One
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63
Accounting Information for Business Decisions
Case Exhibit 2.15 Cost–volume–profit relationships for Café Revive – coffee gift packs
$8 000
$7 920
$7 000
in
arg
$3 987.50
$6 000
$3 495.50
m
ion
ut
trib
n
Co
$5 000
$4 448
$4 000
Profit
$5 544
$3 000
$2 376
$1 320
Total fixed costs
$2 000
Loss
$–1 056
Break-even point
$1 000
$0
0
50
100
150 170 200
250
90
Sales volume – coffee gift packs
300
line shows the estimated total contribution margin at different sales volumes. This is the same line as
shown in Case Exhibit 2.14. The other line shows the $2376 total estimated fixed costs. The vertical
distance between these lines is the estimated profit or loss at the different sales volumes for each product.
Remember, estimated profit is the total contribution margin minus the estimated total fixed costs. Note
that Exhibit 2.15 shows that Café Revive will earn $0 profit if it sells 90 gift packs of coffee; this is its
break-even point. Above the break-even unit sales volume (such as at a volume of 300 gift packs), the
total contribution margin ($7920) is more than the total estimated fixed costs ($2376), so there would be
a profit ($7920 – $2376 ¼ $5544). Below the break-even point, such as at a volume of 50 gift packs, the
total contribution margin ($1320) is less than the total estimated fixed costs, so there would be a loss
($1320– $2376 ¼ –$1056).
Stop & think
If fixed costs were greater, would you expect Café Revive to break even at a lower sales
volume or a higher sales volume? Why?
Profit calculation (equation form)
In Case Exhibit 2.15 we graphed the CVP relationship for Café Revive’s coffee gift packs. Graphs are
usually a helpful tool, allowing an entrepreneur (and students!) to see a ‘picture’ of these relationships.
Sometimes, however, an entrepreneur (or student) does not need a picture to understand the
relationships. In this case, using equations may be a better and faster way to understand CVP
relationships. (You may have thought of these equations as you studied Case Exhibit 2.15.) In this
section, we look at how to use equations for CVP analysis to answer the following questions:
1 How much profit will the business earn at a given unit sales volume?
2 How many units must the business sell to break even?
3 How many units must the business sell to earn a given amount of profit? (The given amount is
usually a desired profit that the business uses as a goal.)
In the following discussion, we use Café Revive’s revenue and cost information from the projected income
statement for internal decision makers for coffee gift packs in Case Exhibit 2.12. We determined the total
64
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Chapter 2 Developing a business plan: Cost–volume–profit analysis
sales revenue by multiplying the selling price per unit by the estimated sales volume. We determined the total
estimated variable costs by multiplying the variable cost per unit by the same sales volume. We subtracted the
total estimated variable costs from the estimated revenue to calculate total contribution margin. Finally we
subtracted the fixed costs from the total contribution margin to determine the estimated profit. We can show
this in a profit equation, as follows:
3
2
3 2
Total
Variable
Unit
Profit
Selling
Unit
(for a given ¼ 4 price 3 sales 5 4 cost 3 sales 5 fixed
costs
per unit
volumes
sales volume)
per unit
volumes
The profit equation can be used in CVP analysis. For Café Revive, for instance, if we use X to stand for
a given sales volume of coffee gift packs, and if we include the estimated selling price and variable cost per
unit, the equation is as follows:
Profit ¼ $55X $28:60X $2376
¼ ð$55 $28:60ÞX $2376
¼ $26:40X $2376
These equations can be used to solve various CVP questions for Café Revive.
Note in the last line of the equation that for coffee gift packs, the $26.40 is the contribution margin
per unit. This can come in handy as a ‘shortcut’ when using the profit equation, so that the equation
becomes:
2
3
Total
Profit
Contribution
Unit
(for a given ¼ 4 margin
3 sales 5 fixed
costs
sales volume)
per unit
volume
2.3 Using CVP analysis
CVP analysis is useful in planning because it shows the impact of alternative plans on profit. This analysis
can help the entrepreneur make planning decisions, and can help investors and creditors evaluate the risk
associated with their investment and credit decisions. For instance, suppose Emily has asked you to
answer, for Café Revive, the three questions listed in the previous section. In this section, we describe
how to do so.
4
What must decision
makers be able to predict
in order to estimate profit
at a given sales volume?
Estimating profit at given unit
sales volume
Suppose Emily wants you to estimate Café Revive’s monthly profit for coffee gift packs if it sells 250 gift
packs (i.e. a unit sales volume of 250 gift packs) a month. Remember that Café Revive’s selling price for
gift packs is $55 per unit and its variable cost is $28.60 per unit. You can estimate monthly profit when
250 gift packs of coffee are sold in a month by using the profit equation, as follows:
2
3 2
3
Selling
Unit
Variable
Unit
Total
Profit ¼ 4 price 3 sales 5 4 cost 3 sales 5 fixed
per unit
volume
per unit
volume
costs
¼ ð$55 3 250Þ ð$28:60 3 250Þ $2376
¼ $13 750 $7150 $2376
¼ $4224
Thus, you can tell Emily that Café Revive will make a monthly profit of $4224 if it sells 250 coffee gift
packs a month.
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65
Accounting Information for Business Decisions
Finding the break-even point
Suppose Emily wants you to estimate how many coffee gift packs Café Revive must sell to break even
each month. Recall that the break-even point is the unit sales volume that results in zero profit. This
occurs when total sales revenue equals total costs (total variable costs plus total fixed costs). To find the
break-even point, we start with the profit equation. Remember that the contribution margin per unit is
the difference between the sales revenue per unit and the variable costs per unit. With this in mind, we
can rearrange the profit equation5 into a break-even equation, as follows:
Unit sales volume (to earn zero profit) ¼
Total fixed costs
Contribution margin per unit
So, for Café Revive, you can tell Emily that the break-even point is 90 coffee gift packs, computed
using the break-even equation as follows (letting X stand for the unit sales volume):
Unit sales volume (to earn zero profit) ¼
$2376 Total fixed costs
ð$55 Selling price $28:60 Variable cost per unitÞ
Which can also be remembered as:
Total fixed costs $ 2376
Contribution margin per unit $ 26.40
$ 2376
X¼
$ 26.40
X ¼ 90 coffee gift packs
Break-even unit sales volume ¼
You can verify the break-even sales volume of 90 coffee gift packs with the following schedule:
Total sales revenue (90 gift packs @ $55.00 per pack)
$ 4 950
Less: Total variable costs (90 gift packs @ $28.60 per pack)
(2 574)
Total contribution margin (90 gift packs @ $26.40 per pack)
$ 2 376
Less: Total fixed costs
(2 376)
Profit
5
$
0
For those of you who want ‘proof’ of this break-even equation, since the contribution margin per unit is the selling price per
unit minus the variable cost per unit, we can substitute the total
follows:
2
Contribution
Profit ¼ 4 margin
3
per unit
contribution margin per unit into the profit equation as
3
Unit
Total
sales 5 fixed
volume
costs
Since break-even occurs when profit is zero, we can omit the profit, move the total fixed costs to the other side of the
equation, and rewrite the equation as follows:
2
3
Contribution
Unit
Total fixed costs ¼ 4 margin
3 sales 5
per unit
volume
Finally, we can divide both sides of the equation by the contribution margin per unit to derive the break-even equation:
Total fixed costs
¼ Unit sales volume (to earn zero profit)
Contribution margin per unit
66
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Chapter 2 Developing a business plan: Cost–volume–profit analysis
Finding the unit sales volume to achieve
a target profit
Finding the break-even point gives the entrepreneur useful information. However, most entrepreneurs are
interested in earning a profit that is high enough to satisfy their goals and those of the business. A business
often states its profit goals at amounts that result in a satisfactory return on the average total assets used in
its operations. Since this is an introduction to CVP analysis, we will wait until Chapters 7 and 8 to discuss
what is meant by ‘satisfactory return’ and ‘average total assets’. Here, we will assume an amount of profit that
is satisfactory. Suppose Emily’s goal is that Café Revive earns a profit of $2112 per month for coffee gift packs
and a profit of $528 for cups of coffee. How many gift packs must Café Revive sell per month to earn $2112
profit? How many cups of coffee must Café Revive sell per month to earn $528 for cups of coffee? To answer
these questions, we modify the break-even equation.
The break-even point is the sales volume at which the total contribution margin is equal to, or
‘covers’, the total fixed costs. Therefore, each additional unit sold above the break-even sales volume
increases profit by the contribution margin per unit. Hence, to find the sales volume at which the total
contribution margin covers both total fixed costs and the desired profit, we can modify the break-even
equation simply by adding the desired profit to fixed costs, as follows:
Unit sales volume (to earn desired profit) ¼
5
How can decision makers
predict the sales volume
necessary for estimated
revenues to cover
estimated costs?
6
How can decision makers
predict the sales volume
necessary to achieve a
target profit?
Total fixed costs þ Desired profit
Contribution margin per unit
So, if we let X stand for the unit sales volume, Café Revive needs to sell 170 coffee gift packs to earn a
profit of $2112 a month, calculated as follows:
$2376 þ $2112
ð$55 $28:60Þ
$4488
X¼
$26:40 per coffee gift pack
X ¼ 170 coffee gift packs
Unit sales volume required (X) ¼
You can verify the $2112 profit with the following schedule:
Total sales revenue (170 gift packs @ $55.00 per pack)
$ 9 350
Less: Total variable costs (170 gift packs @ $28.60 per pack)
Total contribution margin (170 gift packs @ $26.40 per pack)
($4 862)
$ 4 488
Less: Total fixed costs
Profit
(2 376)
$ 2 112
Since Emily had included the desired profit of $2112 per month in Café Revive’s business plan, the
income statement for internal decision makers shown in Case Exhibit 2.12 is an expanded version of the
preceding schedule.
The calculations for the target profit from coffee cup sales are shown in the Appendix.
Summary of CVP analysis calculations
Case Exhibit 2.16 summarises the equations that we used in our discussion of CVP analysis. Although it
may be tempting to try to memorise these, you should strive to understand how the equations relate to
one another.
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67
Accounting Information for Business Decisions
Case Exhibit 2.16 Summary of cost–volume–profit calculations
Profit
(for a given ¼
sales volume)
Total fixed
Unit sales
Variable cost
Unit sales
Selling price
costs
volume
per unit
volume
per unit
Total fixed
Unit sales
Contribution margin
costs
volume
per unit
Total fixed costs
Unit sales volume (to earn zero profit) ¼
Contribution margin per unit
¼
Unit sales volume (to earn a profit) ¼
Total fixed costs þ Desired profit
Contribution margin per unit
Using CVP for ‘what if’ scenarios
Providing answers to the previous three questions showed how CVP analysis is useful in planning. There
are many other planning issues for which CVP analysis also provides useful information. CVP is often
used to examine what would happen in changing circumstances, or a range of different circumstances,
sometimes called sensitivity analysis or ‘what if’ scenarios. For instance, suppose you and Emily are
considering alternative plans to raise Café Revive’s monthly profit. These plans include the following:
1 Raise the selling price of the coffee gift packs to $60 per pack. With this alternative, the variable costs
per pack and the total fixed costs do not change.
2 Purchase a premium line of coffee to include in coffee gift packs, rather than the existing line, thus
increasing variable costs to $30 per pack. You and Emily are considering this alternative because an
improvement in the coffee’s quality may cause the sales volume of the gift packs to increase. With this
alternative, neither the selling price per unit nor the total fixed costs change.
3 Increasing the total fixed costs by spending $110 more on advertising. With this alternative, the
selling price per unit and the variable costs per unit do not change, but the additional advertising may
cause an increase in sales volume.
Stop & think
How would you modify the graph in Case Exhibit 2.15 to provide information for Plan 1?
We raise these issues here to get you to think about how to use CVP equations or graphs to provide
helpful information. The CVP analyses for these three alternative plans, however, do not provide all the
information you need to make a decision. CVP is a helpful tool, but is most effective when used in
conjunction with critical thinking. In the ‘what if’ scenarios above, for example, you must also think about
the effects each of the alternatives will have on your customers.
For instance, each of the alternatives is likely to affect the number of coffee gift packs that Café
Revive can sell. A change in selling price would certainly affect your customers’ decisions to purchase
coffee gift packs. A decrease in selling price would bring the gift packs into the spending range of more
people (probably increasing the number of coffee gift packs you could sell), whereas an increase in selling
price (alternative 1) may make the gift packs too expensive for some customers (possibly decreasing the
number of packs you could sell). Selling a higher quality of coffee (alternative 2) may attract a different, or
additional, group of customers, thus affecting sales volume. Increasing advertising (alternative 3) may
make more people aware of, and may attract more customers to, Café Revive. Before you make a decision,
you should consider how it will affect customers’ interest in your product and estimate the probable unit
sales volume for each alternative. Then, for whatever sales volume you expect, the analysis can provide a
more realistic profit estimate.
68
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Chapter 2 Developing a business plan: Cost–volume–profit analysis
2.4 Other planning issues and
effects
What can happen if a business doesn’t
have a business plan
7
How can decision makers
use accounting
information to evaluate
alternative plans?
As the last century ended, many internet companies were in such a rush to join their apparently wildly
successful dot.com peers that they forgot one small detail: a sound business plan. By the end of 2002,
more than 862 dot.com companies had failed in the United States.e Some went bankrupt; others had to
make radical adjustments to the way they conducted business, including through massive layoffs (98 522
employees in 2000). Some, such as Art.com and Wine.com, began again with new owners and business
plans, while yet others simply shut down their websites.f
A look back at this period reveals that many of these companies needed huge revenue growth just to break
even. For example, the revenue of Tickets.com increased by 38.77 per cent during 2000 – but in order to
break even, the business’s revenue would have had to grow by 606.7 per cent! A number of companies faced
even grimmer situations. The worst was E-Loan, whose revenue had increased by 85.24 per cent during
2000 – but whose revenue would have had to grow 5065.2 per cent in order for the business to break even!
Both of these companies had failed by the end of 2000.g The problem with a lot of these companies was that
huge investments in expenses were incurred up front, without the necessary inflows of revenue arriving in a
timely manner to cover these expenses. Information about all of these cases can be found online, including a
notorious Australian example of dot.com failure, One.Tel.h
Stop & think
Read what media articles/journals said about One.Tel. Can you summarise the main problems
leading to the collapse?
Try these suggested links (or search for your own!):
https://www.abc.net.au/news/2009-11-20/28324
https://www.theregister.co.uk/2017/08/01/onetel_liquidation_ending_after_16_years
https://www.academia.edu/25879736/The_OneTel_Collapse_Lessons_from_Corporate_Governance
So what happened? Many business owners, in an effort to compete and attract customers, thought
they could start out selling their products for less than they paid for them then, after increasing their
volume of customers, make up the difference later by raising the selling prices of their products. This
meant that they started out with negative contribution margins, causing them to lose money on every
sale that they made right from the outset. (For some companies, even the low selling prices didn’t attract
enough customers.) Unfortunately, there was no ‘later’ because these companies ran out of capital or
attracted an insufficient number of customers to ‘make a go of it’. Additionally, some owners didn’t
consider the extremely high costs involved in running and advertising a website (particularly marketing
and salary costs), as well as the costs of storing and distributing their companies’ products.
A business plan, along with its CVP analysis, could have helped the owners of these companies to discover
the flaws in their thinking before their companies got into trouble. With CVP analysis, it would have been easy
for them to confirm that the planned initial selling prices of their products would not have been high enough,
at any volume, for the companies to break even. Furthermore, a business plan would have focused the owners’
attention on the high marketing and salary costs, and on the product storage and distribution costs, thereby
helping the owners to determine the selling prices that would most likely help their companies break even and
earn desired profits. A business plan could also have helped the owners to see the possible effects on their
companies’ profits of sales predictions that were too optimistic or too pessimistic.
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Accounting Information for Business Decisions
Business issues and values: Waste not, want not
CVP accounting information is one factor that influences business decisions, but
entrepreneurs also need to consider the non-financial effects of their decisions. For example, if
the managers of a business are thinking about lowering the business’s total costs by omitting the
clean-up of toxic waste around the factory, they must ask questions such as the following:
•
•
What will be the impact on the environment?
What health effects might employees suffer later?
•
What might be the health impact on the business’s neighbours?
• Legally, can we even consider not cleaning up the toxic waste?
Although omitting toxic waste clean-up may reduce total costs dramatically, these managers might
consider that other, more-difficult-to-measure costs involved are simply too high. Therefore, after
Ethics and Sustainability
70
weighing all the factors surrounding the alternatives, the managers may choose a more socially
acceptable alternative that results in a lower profit margin.
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Chapter 2 Developing a business plan: Cost–volume–profit analysis
STUDY TOOLS
Summary
2.1 Understand the importance of planning for a new business and what to include in the plan.
1
Since the future is uncertain and circumstances are likely to change, why should a business bother to plan?
A business plan helps the owners or managers of a business to organise the business, serves as a benchmark against which
owners/managers can evaluate actual business performance and helps the business to obtain financing. The business plan consists
of a description of the business, a marketing plan, a description of the business’s operations and a financial plan. Accounting
information contributes to the planning process by providing information for CVP analysis, and by including in the financial plan
the effects that estimated revenues, variable costs and fixed costs have on the business’s profits.
2
What should a business include in its business plan?
A business plan should include a description of the business, a marketing plan, a description of the operations of the business, an
environmental management plan and a financial plan. The description should include information about the organisation of the
business, its products or services, the business’s current and potential customers, its objectives, where it is located and where it conducts
business. The marketing plan shows how the business will make sales, and how it will influence and respond to market conditions. The
business operations section includes a description of the relationships among the business, its suppliers and its customers, as well as a
description of how the business will develop, service, protect and support its products or services. The financial plan identifies the
business’s capital requirements and sources of capital, and describes its projected financial performance.
2.2 Understand the concepts of cost–volume–profit analysis (CVP) and cost behaviour.
3
In Chapter 1, we referred to accounting as the language of business. How does accounting information contribute to
the planning process?
Accountants determine how revenues, variable costs and fixed costs affect profits, based on their observations of how costs behave
and on their estimates of future revenues and costs. By observing cost-behaviour patterns, accountants are able to classify the
costs as either fixed or variable, and to then use this classification to predict the amounts of the costs at different activity levels.
Accounting information, then, can help decision makers to evaluate alternative plans by using CVP analysis to show the profit
effect of each plan. CVP analysis is a tool that helps managers think critically about the different aspects of each plan.
4
What must decision makers be able to predict in order to estimate profit at a given sales volume?
To estimate profit at a given sales volume, decision makers must be able to predict the product’s selling price, the costs that the
business will incur and the behaviour of those costs (whether they are fixed or variable costs). Fixed costs will not change because
of sales volume, but variable costs will change directly with changes in sales volume.
2.3 Be able to apply CVP analysis to estimate break-even, target profits and assess alternatives.
5
How can decision makers predict the sales volume necessary for estimated revenues to cover estimated costs?
To predict the sales volume necessary for estimated revenues to cover estimated costs, decision makers must rearrange the profit
equation into the break-even equation. Using what they know about the product’s selling price and the behaviour of the business’s
costs, decision makers can determine the contribution margin per unit of the product by subtracting the estimated variable costs
per unit from the product’s estimated selling price. They can then substitute the contribution margin and the estimated fixed costs
into the equation and solve for the necessary sales volume.
6
How can decision makers predict the sales volume necessary to achieve a target profit?
Predicting the sales volume necessary to achieve a target profit is not very different from predicting the sales volume necessary for
estimated revenues to cover estimated costs. The only difference is that decision makers must modify the break-even equation by
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71
Accounting Information for Business Decisions
adding the desired profit to the estimated fixed costs. Then, after substituting the contribution margin and the estimated fixed
costs plus the desired profit into the equation, they can solve for the necessary sales volume.
2.4 Consider other planning issues and effects.
7
How can decision makers use accounting information to evaluate alternative plans?
Decision makers can determine how changes in costs and revenues affect the business’s profit. Based on accounting information
alone, the alternative that leads to the highest profit will be the best solution. However, decision makers should also consider the
non-financial effects that their decisions may have.
Key terms
break-even point
line of credit
short-term capital
business plan
long-term capital
total contribution margin
contribution margin per unit
relevant range
total costs
cost–volume–profit (CVP) analysis
return
variable cost
fixed costs
risk
volume
Online research activity
This activity provides an opportunity to gather information online about real-world issues related to the topics in this chapter. For
suggestions on how to navigate various businesses’ websites to find their financial statements and other information, see the
related discussion in the Preface.
u Go to http://www.business.gov.au. What is the aim of this website? What types of loans or grants are available? How do you
get access to these funds?
u Go to http://www.business.gov.au. Investigate the starting a business guide. What key decisions are suggested? How is it
suggested that you plan for success? How do these compare with what we discussed in this chapter?
u Go to https://www.business.gov.au/assistance/entrepreneurs-programme. What are the four elements of support for
businesses mentioned?
Integrated business and accounting situations
Answer the following questions in your own words.
Testing your knowledge
2-1
2-2
2-3
2-4
2-5
2-6
2-7
2-8
2-9
72
Since the future is uncertain and circumstances are likely to change, why should the managers and owners of a business
bother to plan?
How are ‘risk’ and ‘return’ each defined? Do you think there is a relationship between them?
Describe the three main functions of a business plan.
Describe the components of a business plan. How does each of these components help the following people to make
decisions about a business?
(a) An investor.
(b) A creditor.
(c) A manager or owner.
Why is it important for businesses to have an environment management plan? List 10 possible environmental costs that a
breakfast cereal manufacturing business might incur.
Why is it important for a business to have a cash buffer on hand?
How can an entrepreneur determine a business’s capital requirements?
What is the difference between short-term and long-term capital?
Explain what cost–volume–profit (CVP) analysis is. How does CVP analysis help entrepreneurs to develop their companies’
business plans?
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Chapter 2 Developing a business plan: Cost–volume–profit analysis
2-10
2-11
2-12
2-13
2-14
2-15
2-16
2-17
2-18
2-19
How can you tell whether a cost is a variable cost or a fixed cost?
Define relevant range. Why is it important?
What is a contribution margin?
Explain what it means when a business breaks even.
Indicate the effect (increase, decrease, no change, or not enough information) that each of the following situations has on
break-even unit sales. If you answered, ‘not enough information’, list the information that you need in order to be able to
determine the effect.
a A retail business purchases price tags to use in place of the stickers it has used in the past.
b An athletic equipment store leases more retail space.
c A bakery increases its advertising expenditure.
d A merchandiser plans to increase the selling price of its product. To counteract potential decreases in sales, the
merchandiser also plans to increase the amount of per-product commission earned by the sales staff.
e An accounting firm plans to increase its billing rate per hour.
f A retail business has found a supplier that will provide the same merchandise its old supplier provided, but at a lower
price.
g A private boarding school in Sydney installs air conditioning in its dormitories.
h A retail business reduces advertising expenses and increases the commissions of its sales force.
i Instead of having its office building cleaned by a cleaning service, a business plans to hire its own cleaning crew.
If the total variable cost per unit increases while the selling price per unit and the fixed costs and sales volume remain the
same, how would you expect the change in variable costs to affect (a) profit; and (b) the break-even point?
If total fixed costs increase while the selling price per unit, the variable costs per unit and the sales volume remain the
same, how would you expect the change in fixed costs to affect (a) profit; and (b) the break-even point?
How does the format of the income statement shown in Case Exhibits 2.12, 2.13 and 2.22 help internal decision makers
perform cost–volume–profit (CVP) analysis?
A business is considering two type of containers to package its product, one made of plastic and the other of biodegradable
cardboard with native wild flower seeds embedded in the packaging, designed to germinate after disposal. A cost–volume–
profit (CVP) analysis has been undertaken and the contribution margin per unit is $1 less with the biodegradable packaging.
Should the business make the decision about which to use based on CVP alone, or can you think of other considerations?
Complete the crossword puzzle below:
1
2
3
4
3
6
9
7
8
10
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73
Accounting Information for Business Decisions
Clues
Across
2
Amount of uncertainty that exists about the future operations of a business
4
The ‘V’ in CVP analysis
6
The amount provided by the sale of a product after variable costs have been deducted
9
The S in GST
10 This type of cost changes in total in proportion to changes in volume of the cost driver
Down
1
The point at which revenue equals total costs and neither a profit nor a loss is made
3
This type of cost does not change in total in response to changes in volume
5
The purpose of this plan is to identify the business’s capital requirements, sources of capital, and describe the business’s projected performance
7
A part of the business plan that details how the plan will be actioned
8
Triple bottom line (TBL) refers to reporting on economic, environmental and __________________________
aspects of a business
Applying your knowledge
2-20
2-21
2-22
2-23
2-24
74
Imagine that you are going to start your own business. Think about the concept for a minute.
Required:
What will you call your business? What kind of product or service will you sell? What price will you charge for your
product(s) or service? Why? What variable costs and what fixed costs do you think you will incur?
Suppose you want to start a business that sells sports equipment.
Required:
Go to the reference section of your library or use internet resources. What type of information can you find through
Moody’s or Standard & Poor’s to help you prepare projected financial statements for your business?
TLC Company sells a single product, a food basket (containing fruit, cheese, nuts and other items) that friends and family
can purchase for university students who need ‘a little TLC’. This product, called the Exam-O-Rama, sells for $10 per
basket. The variable cost is $6 per basket, and the total fixed cost is $24 000 per year.
Required:
Draw one graph showing TLC’s (i) total revenues; and (ii) total costs as volume varies.
a Locate the break-even point on the graph.
b What is TLC’s profit equation in terms of units sold?
c What is TLC’s break-even point in units?
ExamChoc Company sells a single product, a chocolate basket that friends and family can purchase for university students
studying for their exams. This product, called the Exam-O-Choc, sells for $20 per basket. The variable cost is $14 per
basket, and the total fixed cost is $48 000 per year.
Required:
Draw one graph showing ExamChoc’s (i) total revenues; and (ii) total costs as volume varies.
a Locate the break-even point on the graph.
b What is ExamChoc’s profit equation in terms of units sold?
c What is ExamChoc’s break-even point in units?
Bathtub Rings is a business that sells shower-curtain rings for $1.60 per box. The variable cost is $1.20 per box, and fixed
costs total $20 000 per year.
Required:
a What is Bathtub Rings’ profit equation in terms of boxes of shower-curtain rings sold?
b Draw a graph of Bathtub Rings’ (i) total contribution margin; and (ii) total fixed costs as volume varies. Locate the
break-even point on this graph.
c What is Bathtub Rings’ break-even point in units?
d What would total profits be if Bathtub Rings sold 500 000 boxes of shower-curtain rings?
e How many boxes of shower-curtain rings would Bathtub Rings have to sell to earn $50 000 of profit?
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Chapter 2 Developing a business plan: Cost–volume–profit analysis
2-25
2-26
2-27
2-28
Tube Rings is a business that sells inner tubes for $50 per box. The variable cost is $30 per tube, and fixed costs total
$400 000 per year.
Required:
a What is Tube Rings’ profit equation in terms of inner tubes sold?
b Draw a graph of Tube Rings’ total contribution margin and total fixed cost as volume varies. Locate the break-even
point on this graph.
c What is Tube Rings’ break-even point in units?
d What would total profits be if Tube Rings sold 500 000 inner tubes?
e How many inner tubes would Tube Rings have to sell to earn $100 000 of profit?
Go Green is a business selling worm farm start-up kits for $12 each. This year, Go Green’s fixed cost totals $110 000. The
variable cost per kit is $7.
Required:
a What is the break-even point in number of kits?
b How many kits does Go Green need to sell to earn a profit of $70 000?
c If the total fixed cost increases to $160 000 next year:
i what will Go Green’s break-even point be in number of kits?
ii what profit (or loss) will Go Green have if it sells 30 000 kits?
iii how many kits will Go Green have to sell to earn a profit of $70 000?
Green Grow is a business selling bags of organic fertiliser for $24 each. This year, Green Grow’s fixed cost totals $110 000.
The variable cost per bag is $14.
Required:
a What is the break-even point in number of bags?
b How many bags does Green Grow need to sell to earn a profit of $70 000?
c If the total fixed cost increases to $160 000 next year:
i what will Green Grow’s break-even point be in number of bags?
ii what profit (or loss) will Green Grow have if it sells 30 000 bags?
iii how many bags will Green Grow have to sell to earn a profit of $70 000?
Silencer Company sells a single product, mufflers for leaf blowers. The business’s profit calculation for last year is shown
here:
Sales revenue (2000 units @ $25)
$ 50 000
Less: Variable costs
(20 000)
Contribution margin
$ 30 000
Less: Fixed costs
Profit
(22 000)
$ 8 000
Silencer has decided to increase the price of its product to $30 per muffler. The business believes that if it increases its
fixed advertising (selling) cost by $3400, sales volume next year will be 1800 mufflers. Variable cost per muffler will be
unchanged.
Required:
a Using the above income statement format, show the calculation of expected profit for Silencer’s operations next year.
b How many mufflers would Silencer have to sell to earn as much profit next year as it did last year?
c Do you agree with Silencer’s decision? Explain why or why not.
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75
Accounting Information for Business Decisions
2-29
Below is an income statement for Rosie’s Flowers, prepared for internal management use.
Rosie’s Flowers
Projected income statement
For the year ended 31 December 20X9
Revenues:
Sales (16 000 units)
$80 000
Less: Total variable costs
2-30
$20 000
Less: Total fixed costs
$ 8 000
Profit for year
$52 000
Required:
Rewrite the income statement so that it is more useful for decision making. (Hint: There is a missing subtotal.)
Below is an income statement for Rosie’s Flowers, prepared for internal management use.
Rosie’s Flowers
Projected income statement
For the year ended 31 December 20X9
Revenues:
Sales (16 000 units)
2-31
$80 000
Less: Total variable costs
$20 000
Less: Total fixed costs
$ 8 000
Profit for year
$52 000
Required:
Rewrite the income statement using a contribution margin approach and a sales level of 20 000 units.
Topsy’s Trailers makes small trailers for towing light loads. The business’s accountant has undertaken CVP analysis on its
main product – the Tipping Trailer – and presented the results to the owner, Topsy, in the following profit graph:
Profit graph – Tipping Trailer
$1 200 000
$1 000 000
$800 000
$600 000
$400 000
$200 000
$–
0
50
100
150
200
250
300
350
400
450
Required:
a Label the lines on the graph
b Use the graph to determine:
i the break-even point in units
ii the fixed costs.
c Use the break-even formula in units to determine the contribution per unit.
76
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Chapter 2 Developing a business plan: Cost–volume–profit analysis
2-32
2-33
2-34
Rapunzel is a small business that currently sells a single product, shampoo, for $4 per bottle. The variable cost per bottle
is $3. Rapunzel’s fixed costs total $6000.
Required:
a Calculate the following amounts for Rapunzel’s business:
i contribution margin per bottle of shampoo
ii break-even point in bottles of shampoo
iii the profit that Rapunzel will earn at a sales volume of 25 000 bottles of shampoo
iv the number of bottles of shampoo that Rapunzel must sell to earn a profit of $16 000.
b Rapunzel is considering increasing its total fixed cost to $8000 and then also increasing the selling price of its product
to $5. The variable cost per bottle of shampoo would remain unchanged. Repeat the calculations from (a) using this
new information. Will this decision be a good one for Rapunzel? Why or why not?
c Draw a graph with six lines to show the following:
i total contribution margin earned when Rapunzel sells from 0 to 10 000 bottles of shampoo at a selling price of $4
per bottle
ii total contribution margin earned when Rapunzel sells from 0 to 10 000 bottles of shampoo at a selling price of $5
per bottle
iii Rapunzel’s fixed cost total of $6000
iv Rapunzel’s fixed cost total of $8000
v Rapunzel’s break-even point in bottles of shampoo before and after the selling price and fixed cost changes.
d Does the graph support your conclusion in (b)? If so, how? If not, what new or different information did you get from
the graph?
Thumper is a small business that currently sells a single product, gluten-free bread, for $6 per loaf. The variable cost per
loaf is $4. Thumper’s fixed costs total $6000.
Required:
a Calculate the following amounts for Thumper’s business:
i contribution margin per loaf
ii break-even point in loaves
iii the profit that Thumper will earn at a sales volume of 25 000 loaves
iv the number of loaves that Thumper must sell to earn a profit of $16 000.
b Thumper is considering increasing its total fixed cost to $8000 and then also increasing the selling price of its product
to $8. The variable cost per loaf would remain unchanged. Repeat the calculations from (a) using this new information.
Will this decision be a good one for Thumper? Why or why not?
c Draw a graph with six lines to show the following:
i total contribution margin earned when Thumper sells from 0 to 10 000 loaves at a selling price of $6 per loaf
ii total contribution margin earned when Thumper sells from 0 to 10 000 loaves at a selling price of $8 per loaf
iii Thumper’s fixed cost total of $6000
iv Thumper’s fixed cost total of $8000
v Thumper’s break-even point in loaves before and after the selling price and fixed cost changes.
d Does the graph support your conclusion in (b) above? If so, how? If not, what new or different information did you get
from the graph?
The Body Shop Equipment Company (BSEC) sells a small, relatively lightweight, multipurpose exercise machine. This
machine sells for $700. A recent cost analysis shows that BSEC’s cost structure for the coming year is as follows:
Variable cost per unit
Total annual fixed costs
$
325
125 000
Required:
a Draw a graph that clearly shows (i) total fixed cost; (ii) total cost; (iii) total sales revenue; and (iv) total contribution
margin as the sales volume of exercise machines increases. Locate the break-even point on the graph.
b Calculate the break-even point in number of machines.
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77
Accounting Information for Business Decisions
2-35
c How many machines must BSEC sell to earn $30 000 of profit per year?
d How much profit would be earned at a sales volume of $420 000?
e Sean McLean, the owner of BSEC, is considering travelling to visit a circuit of gyms and fitness centres around
Australia each year to demonstrate the exercise machine, distribute information and obtain sales contracts. He
estimates that this will cost about $6000 per year. How many additional exercise machines must the business sell per
year to cover the cost of this effort?
The Water Ski Equipment Company (WSEC) sells a small, relatively lightweight kneeboard. This kneeboard sells for $350.
A recent cost analysis shows that WSEC’s cost structure for the coming year is as follows:
Variable cost per unit
Total annual fixed costs
2-36
78
$ 162.50
125 000
Required:
a Draw a graph that clearly shows (i) total fixed cost; (ii) total cost; (iii) total sales revenue; and (iv) total contribution
margin as the sales volume of exercise machines increases. Locate the break-even point on the graph.
b Calculate the break-even point in number of machines.
c How many machines must WSEC sell to earn $30 000 of profit per year?
d How much profit would be earned at a sales volume of $420 000?
e Sally Morgan, the owner of WSEC, is considering visiting a circuit of water-ski schools around Australia each year to
demonstrate the kneeboard, distribute information and obtain sales contracts. She estimates that this will cost about
$6000 per year. How many additional kneeboards must the business sell per year to cover the cost of this effort?
Lady MacBath is a business selling bottles of dry-cleaning solvent (spot remover) for $10 each. The variable cost for each
bottle is $4. Lady MacBath’s total fixed cost for the year is $3600.
Required:
a Answer the following questions about the business’s break-even point:
i How many bottles of spot remover must Lady MacBath sell to break even?
ii How would your answer to (a-i) change if Lady MacBath lowered the selling price per bottle by $2? What if,
instead, it raised the selling price by $2?
iii How would your answer to (a-i) change if Lady MacBath raised the variable cost per bottle by $2? What if, instead,
it lowered the variable cost by $2?
iv How would your answer to (a-i) change if Lady MacBath increased the total fixed cost by $60? What if, instead,
Lady MacBath decreased the total fixed cost by $60?
b Answer the following questions about the business’s profit:
i How many bottles must Lady MacBath sell to earn $4800 profit?
ii How would your answer to (b-i) change if Lady MacBath lowered the selling price per bottle by $2?
iii Suppose that for every $1 the selling price per bottle decreases below its current selling price of $10 per bottle,
Lady MacBath predicts sales volume will increase by 325 bottles. Assume that before lowering the selling price,
Lady MacBath predicts that it can sell exactly 1400 bottles. Can Lady MacBath earn $4800 profit by lowering the
selling price per bottle by $2? Explain why or why not.
iv Suppose that for every $1 the selling price per bottle increases above its current selling price of $10 per bottle,
Lady MacBath predicts sales volume will decrease by 200 bottles. Assume that before raising the selling price,
Lady MacBath predicts that it can sell exactly 1400 bottles. Can Lady MacBath earn $4800 profit by raising the
selling price per bottle by $2? Explain why or why not.
v How would your answer to (b-i) change if Lady MacBath raised the variable cost per bottle by $2? What if,
instead, it lowered the variable cost per bottle by $2?
vi How would your answer to (b-i) change if Lady MacBath raised the total fixed cost by $60? What if, instead, Lady
MacBath lowered the total fixed cost by $60?
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Chapter 2 Developing a business plan: Cost–volume–profit analysis
2-37
2-38
2-39
2-40
2-41
The Brickhouse Company is planning to lease a fuel-efficient, hybrid delivery van for its northern sales territory. It can
choose to lease the van under three alternative plans:
• Plan A: Brickhouse pays $0.34 per kilometre and buys its own fuel.
• Plan B: Brickhouse pays $320 per month plus $0.10 per kilometre and buys its own fuel.
• Plan C: Brickhouse pays $960 per month, and the leasing company pays for all fuel.
The leasing company will pay for all repairs and maintenance, insurance, registration and so on. Fuel should cost $0.06 per
kilometre.
Required:
Using kilometres driven as the units of volume, do the following:
a Write out the cost equation for the cost of operating the delivery van under each of the three plans.
b Graph the three cost equations on the same graph (put cost on the vertical axis and kilometres driven per month on
the horizontal axis).
c Determine at what kilometres per month the cost of Plan A would equal the cost of Plan B.
d Determine at what kilometres per month the cost of Plan B would equal the cost of Plan C.
e Calculate the cost, under each of the three plans, of driving 3 500 kilometres per month.
Mallory Motors sells small electric motors for $2 each. Variable costs are $1.20 per unit, and fixed costs total $60 000 per
year.
Required:
a Write out Mallory’s profit equation in terms of motors sold.
b Draw a graph of Mallory’s total contribution margin and total fixed cost as volume varies. Locate the break-even point
on this graph.
c Calculate Mallory’s break-even point in units.
d What total profit would Mallory expect if it sold 500 000 motors?
e How many motors would Mallory have to sell to earn $40 000 profit?
Simmons Kitchens sells small electric knives for $4 each. Variable costs are $2.40 per unit, and fixed costs total $60 000
per year.
Required:
a Write out Simmons’ profit equation in terms of knives sold.
b Draw a graph of Simmons’ total contribution margin and total fixed cost as volume varies. Locate the break-even point
on this graph.
c Calculate Simmons’ break-even point in units.
d What total profit would Simmons expect if it sold 500 000 knives?
e How many knives would Simmons have to sell to earn $80 000 profit?
Campcraft is a small manufacturer of camping trailers. The business manufactures only one model and sells the units for
$2500 each. The variable costs of manufacturing and selling each trailer are $1900. The total fixed cost amounts to
$180 000 per year.
Required:
a Calculate Campcraft’s contribution margin per trailer.
b Calculate Campcraft’s profit (or loss) at a sales volume of 160 trailers.
c Calculate the number of units that Campcraft must sell for it to break even.
d Calculate the number of units that Campcraft must sell for it to earn a profit of $30 000.
This year, Babco’s fixed costs total $110 000. The business sells recyclable one-litre thermos drink containers for $13 each.
The variable cost per container is $8.
Required:
a Compute the break-even point in number of containers.
b Compute the number of containers that Babco must sell to earn a profit of $70 000.
c If the total fixed cost increases to $150 000 next year:
i what will be Babco’s break-even point in containers?
ii what profit (or loss) will Babco have if it sells 28 000 containers?
iii how many containers will Babco need to sell to earn a profit of $70 000?
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79
Accounting Information for Business Decisions
2-42
2-43
The Cardiff Company sells a single product for $40 per unit. Its total fixed cost amounts to $360 000 per year, and its
variable cost per unit is $34.
Required:
a Compute the following amounts for the Cardiff Company:
i contribution margin per unit
ii break-even point in units
iii the number of units that must be sold to earn a $30 000 profit.
b Repeat all calculations in (a), assuming Cardiff decides to increase its selling price per unit to $44. Assume that the total fixed
cost and the variable cost per unit remain the same.
You have worked out the following facts about three of your business’s products:
A
Expected number of unit sales
B
1 400
C
5 000
6 600
Sales price per unit
$
200
$
50
$
160
Variable cost per unit
$
80
$
10
$
120
Total fixed costs
$96 000
$120 000
$160 000
Target (desired) profit
$78 000
$ 75 000
$100 000
Required:
Calculate:
Contribution margin per unit
Contribution margin ratio (%)
Breakeven point in units
Breakeven point in sales dollars
Unit sales needed to achieve target profit
Profit at expected sales level
Will the product achieve/exceed the target
profit with expected sales?
Note: Try putting the information into a spreadsheet and using the CVP formulas to complete the table.
2-44
An internationally renowned professor specialising in management accounting has agreed to conduct a one-day seminar at a
university for management executives. The head of the Graduate School initially offered the professor the regular compensation
package of a business-class airfare and accommodation ($3000) and a $2000 lecture fee.
The university will charge $260 for each executive attending the one-day seminar. The fixed costs for conducting the
seminar will be as follows:
Advertising in magazines
$ 4 000
Mailing of brochures
$ 3 000
Administrative labour
$ 2 000
Charge for use of lecture auditorium
$ 1 000
$10 000
The variable costs per participant attending the seminar are expected to be:
80
Meals and drinks
$25
Binders and photocopying
$35
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Chapter 2 Developing a business plan: Cost–volume–profit analysis
2-45
2-46
Required:
a Calculate the university’s break-even point in sales dollars if the professor accepts the regular compensation package of
$3000 for expenses and a $2000 lecture fee.
b Suppose the professor views the $2000 lecture fee as limiting his potential earnings, and has requested that he instead
receive 50 per cent of the university’s net operating profit from the one-day seminar, and no other payments
(including airfare and accommodation costs). The head of the Graduate School agrees after confirming that the
professor is willing to pay his own airfare and accommodation (which will cost the professor $3000) and deliver the
seminar irrespective of the number of executives signed up to attend.
Calculate:
i the number of executives who must attend in order for the professor to receive a total payment from the university of $6000
ii the minimum number of executives who must attend in order that the university does not make a loss on running the
seminar (i.e. the professor receives no fee at all).
Bellevue Amateur Dramatics club produces Shakespearian plays in a rural country setting. There are two productions every year
and each production has five performances. The average performance sells 150 tickets. The cast are not paid; however, the
director is paid $500 per year. Stage backdrops are made and painted locally by a TAFE art school which charges $400 for the
two sets. Guests receive a programme and a ticket at a cost of $4 for printing per guest and also a complimentary drink at an
average cost of $2 per guest. Members of the club act as staff for the performance and are paid $30 per show and each show
needs three such students to help. The shows are popular and are always sold out in advance; tickets sell for $30 each.
Required:
a Calculate the annual fixed costs.
b Calculate the variable expenses per show.
c Calculate the contribution margin per ticket sold/patron.
d Calculate the break-even point in terms of number of ticket sales/patrons.
e Calculate the annual profit or loss of the business with the expected number of shows planned for the year.
Doggy Day Care is a proposed new business venture that will look after pet dogs for their owners during the day while the
dogs’ owners are at work. The following costs have been identified by the business owner:
Annual registration of the business with the local council
$ 240
Annual lease costs for the new premises
$3 000
Utilities costs per month
$
30
Daily food costs per dog
$
2
Monthly salary for staff
$ 560
Other sundry daily expenses per dog
$
Monthly cleaning expenses for the business
$ 200
Proposed daily fee charged per dog per day
$
Number of days expected to be open per year
3
15
245
Expected number of dogs cared for per day
10
Required:
a Calculate the annual fixed costs of the proposed business.
b Calculate the variable expenses per dog.
c Calculate the contribution margin per dog.
d Calculate how many dogs would need to be cared for each year for the business to break-even.
e Calculate the annual profit or loss of the business with the expected number of dogs in care currently expected.
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81
Accounting Information for Business Decisions
Making evaluations
2-47
2-48
2-49
2-50
Suppose your wealthy aunt gave you and your cousins $10 000 each. Assume for a moment that you are not associated
with Café Revive, and that you are considering loaning the $10 000 to Café Revive.
Required:
From the information included in Café Revive’s business plan so far, do you think this would be a wise investment on your
part? Why or why not? What else would you like to know before making a decision? (You don’t have to limit your thinking to
Café Revive.)
Refer to Question 2.47. What if your aunt instead gave you $100 000 and you were interested in investing this amount in
Café Revive?
Required:
Would this change your answers to Question 2.47? Why or why not?
The John Williams Company sells a single product – bush hats – for $24 per hat. The total fixed cost is $180 000 per year,
and the variable cost per hat is $15.
Required:
a Compute the following amounts for the John Williams Company:
i contribution margin per hat
ii break-even point in hats
iii the numbers of hats that must be sold to earn $27 000 profit.
b Repeat all calculations in (a) assuming that John Williams decides to increase its selling price per hat to $25. Assume
the total fixed cost and the variable cost per hat remain the same.
c Do you agree with the John Williams Company’s decision to increase its selling price per hat? What other factors
should the managers consider in making this decision?
The Vend-O-Bait Company operates and services fishing-bait vending machines placed in service stations, motels and
restaurants surrounding a large lake. Vend-O-Bait rents 200 machines from the manufacturer. It also rents the space
occupied by the machines at each location where it places them. Arnie Bass, the business’s owner, has two employees who
service the machines. Monthly fixed costs for the business are as follows:
Machine rental:
200 machines $100 per month
$20 000
Space rental:
200 locations $60 per month
12 000
Employee wages:
2 employees $800 per month
Other fixed costs
Total
1 600
2 400
$36 000
Currently, Vend-O-Bait’s only variable cost is the bait, which it purchases for $1.20 per pack. Vend-O-Bait sells this bait for
$1.80 per pack.
Required:
a Answer the following questions:
i What is the monthly break-even point (in packs sold)?
ii Compute Vend-O-Bait’s monthly profit at monthly sales volumes of 52 000, 56 000, 64 000 and 68 000 packs,
respectively.
b Suppose that instead of paying $60 fixed rent per month, Arnie Bass could arrange to pay $0.20 for each pack of bait
sold at each location to rent the space occupied by the machines. Repeat all calculations in (a).
c Would it be desirable for Arnie Bass to try to change his space rental from a fixed cost ($60 per location) to a variable
cost ($0.20 per pack sold)? Why or why not?
82
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Chapter 2 Developing a business plan: Cost–volume–profit analysis
2-51
2-52
2-53
Refer to Question 2-36. Suppose your boss at Lady MacBath is considering some alternative plans and would like your
input on the following three independent alternatives:
i Increase the selling price per bottle by $3.
ii Decrease the variable cost per bottle by $2 by purchasing an equally effective, but less environmentally-friendly
solvent from your supplier.
iii Decrease the total fixed cost by $1260.
Assume again that Lady MacBath currently sells bottles of dry-cleaning solvent for $10 each, that the variable cost for each
bottle is $4 and that the total fixed cost for the year is $3600.
Required:
a How many bottles would Lady MacBath have to sell to break even under each of the three alternatives? Using this
accounting information alone, write your boss a memo in which you recommend an alternative.
b Your boss would like to earn a profit of $4320. How many bottles would Lady MacBath have to sell to earn a profit of
$4320 under each of the alternatives? Which of the three alternatives would you recommend to your boss? Is this
consistent with your recommendation in (a)? Why or why not? What other issues did you consider when making your
recommendation?
Fred Sports manufactures trucks and four-wheel drive vehicles (4WDs). The company has announced that it plans to
eliminate 1000 jobs (25% of its workforce) over the next three years. Fred Sports plans to achieve these job cuts
through normal attrition, a freeze on hiring and an early-retirement program. The business had experienced years of
losses, but predicted it would earn a profit as early as the following year.
Required:
a What effect would you expect this decision to have on (i) Fred Sports’ break-even point; (ii) the number of trucks and
4WDs that Fred Sports would have to sell to earn a desired profit?
b What non-financial issues do you think Fred Sports’ owners had to resolve in order to make this decision?
c What questions do you think the owners had to answer in order to resolve these issues?
Suppose you work for the Miniola Hills Bus Company. The business’s 10 buses made a total of 80 trips per day on 310
days last year, for a total of 350 000 kilometres travelled. Another year like last year will put the business out of business
(and you out of a job!). Your boss has come to you for help. Last year, instead of earning a profit the business lost
$102 000, as shown below.
Revenue from passengers (496 000 @ $0.50)
$ 248 000
Less: Operating costs
Depreciation on buses
$100 000
Garage rent
20 000
Registrations, fees and insurance
40 000
Maintenance
15 000
Drivers’ salaries
65 000
Tyres
20 000
Petrol and oil
90 000
Loss
(350 000)
($102 000)
Your boss is considering the following two plans for improving the business’s profitability:
– Plan A: Change the bus routes and reduce the number of trips to 60 per day in order to reduce the number of kilometres driven.
– Plan B: Sell bulk bus tickets (five for $1.00) and student passes ($2.50 for a week’s use) in order to increase the number
of passengers.
Required:
a Write your boss a memo discussing the effect that each of these plans might have on the costs and revenues of the
company. Identify in your memo any assumptions you have made.
b If you were making this decision, what questions would you like answered before making the decision?
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83
Accounting Information for Business Decisions
2-54
2-55
2-56
Generally speaking, in the context of fixed and variable costs, if my company’s sales volume doubles, should I also expect
my profits to double? Explain why or why not.
Killweed sells weed killers. It is currently considering importing a weed killer for bindii (Soliva sessilis), a weed commonly
found in grass, which produces painful prickly seeds, to replace its existing Australian made brand. The cost per litre of
this imported weed killer is $1 compared with $2.50 for the commonly used weed killer for bindii manufactured in
Australia. The selling price for the Australian made brand is $15 per litre. Import costs are $0.20 per litre for the new
brand. Killweed currently sells 80 000 litres of bindii poison per year. Killweed estimates that it needs to spend $10 000
per annum advertising the new brand to achieve these sales levels and would have to sell the new spray for $1 less per
litre.
Required:
a Calculate the contribution margin per unit for both bindii weed killers.
b From a financial point of view, should Killweed replace their existing brand of weed killer with the new imported
brand? Show calculations.
c Are there any non-economic considerations that you can think of?
d What course of action do you recommend, and why?
Refer to Question 2-45 regarding Bellevue Amateur Dramatics. The drama club is uncertain about some of its estimates
and wants to conduct some sensitivity analysis or ‘what if’ scenario analysis:
Required:
For each of the change in estimates listed below, calculate a new contribution margin per ticket sale (if appropriate),
breakeven point in ticket sales and estimate a revised annual profit/loss.
a The club is uncertain whether the director will continue next year unless he has a significant increase in his annual fee.
They are considering offering him $4700 per year.
b Alternatively the club could pay a different director the original planned amount, but if they do this they estimate that
ticket sales will fall to 100 patrons/ticket sales per show. Which course of action is preferable economically – (a) or (b)?
c A third alternative is to pay a different director the original planned amount but offer guests two complimentary
drinks each instead one just one. If this is done they estimated that ticket sales will be 120 patrons per show. Is this
worthwhile trying compared to options (a) and (b)?
Dr Decisive
Yesterday, you received the following letter for your advice column at the local paper:
Dear Dr Decisive,
What do you think about this situation? My boyfriend refuses to meet me for lunch until I admit I am
wrong about this, which I’m not. The other day, when we went to lunch at the Pizza Place, a restaurant on
campus, he noticed that they had raised the price of Hawaiian pizzas. He got mad because he thinks the
only reason they raised the price was to increase their profit. I told him that, first of all, their profit
might not increase. And second, he was basing his conclusion on some assumptions that might not be true,
and if he would just open up his mind, he might see how those assumptions were affecting his conclusion.
Well, then he got mad at me. I’m really upset because I know I’m right and because now I have to buy my
own lunch. Will you please explain why I’m right? I know he’ll listen to you (he reads your column daily).
Until you answer, I’ll be . . .
‘Starving’
Required:
Meet with your Dr Decisive team and write a response to ‘Starving’.
84
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Chapter 2 Appendix: CVP analysis for cups of coffee
Endnotes
a
United Nations Division for Sustainable Development (2001) Environmental Management Accounting Procedures and Principles. New
York: United Nations, p. 7, https://sustainabledevelopment.un.org/content/documents/proceduresandprinciples.pdf.
b
Gibassier, D & Alcouffe, S (2018) ‘Environmental management accounting: The missing link to sustainability?’, Social and
Environmental Accountability Journal, 38(1), 1–18.
c
Department of the Environment, Water, Heritage and the Arts (2009) Environmental Management System Tool: Guidance Notes.
Canberra: Australian Government, 2.
d
Australia Business Financing Centre (n.d.) ‘$64,000 funding grant helps inventor turn dream into successful small business’,
http://www.australiangovernmentgrants.org/articleview.php?id¼50&t¼64000-funding-grant-helps-inventor-turn-dream-into-successfulsmall-business. Accessed 26 May 2017. http://www.australiangovernmentgrants.org/articleview.php?id¼50&t¼64000-fundinggrant-helps- inventor-turn-dream-into-successful-small-business
e
Krantz, M (2000) ‘What detonated dot-bombs?’ USA Today, 4 December, 2A, 2B; Florian, E (2001) ‘Dead and (mostly) gone’.
Fortune, 24 December, 46, 47; Chait, M (2002) ‘Is the dot com bust coming to an end?’, http://www.clickz.com/clickz/stats/
1701286/is-dot-com-bust-coming-end.
f
Rovenpor, J (2004) ‘Explaining the e-commerce shakeout: Why did so many internet-based businesses fail?’ e-Service Journal,
3(1), 53–76; Cook, T (2001) ‘Collapse of Australia’s fourth largest telco adds to growing list of corporate failures’. World Socialist
Website,http://www.wsws.org/ articles/2001/jun2001/onte-j08.shtml.
g
Razi, MA, Tarn, JT & Siddiqui, FA (2004) ‘Exploring the failure and success of DotComs’. Information Management & Computer
Security, 12(3), 228–44.
h
Cook, T (2001) ‘Collapse of Australia’s fourth largest telco adds to growing list of corporate failures’. World Socialist Website,
http://www.wsws.org/articles/2001/jun2001/onte-j08.shtml.
List of company URLs
u
u
u
u
u
AusIndustry Programs: https://www.rdalc.org.au/wp-content/uploads/2016/01/AusIndustry_Programme_Summary_July_2016_002.pdf
Austrade: https://www.austrade.gov.au
Commonwealth Bank: http://www.commbank.com.au
Moody’s: https://www.moodys.com/Pages/default_au.aspx
Standard & Poor’s: https://www.standardandpoors.com/en_AU/web/guest/home
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85
Accounting Information for Business Decisions
APPENDIX
CVP analysis for cups of
coffee
Fixed costs
Recall from page 55–6 that the fixed cost of rent is divided equally between coffee gift packs and sale of
cups of coffee. As you can see in Case Exhibit 2.17, the rent cost for the coffee-making will be $660
whether Café Revive sells 500 or 1000 cups of coffee.
Case Exhibit 2.17 Fixed cost behaviour – cups of coffee
Total monthly rent cost
$1 200
$900
$660
Rent cost
$600
$300
$0
100
500
Sales volume
(in cups of coffee)
1 000
Just as with the sales of gift packs (see Case Exhibit 2.6), in Case Exhibit 2.17 we show a fixed cost
as a horizontal straight line on the gra
ph, indicating that the cost remains the same over different volume levels.
Variable costs
Case Exhibit 2.18 shows the estimated total variable costs of cups of coffee sold by Café Revive at
different sales volumes. Total variable costs are shown by a straight line sloping upwards from the origin
of the graph. This line shows that the total variable cost increases as volume increases. If no cups of
coffee are sold, the total variable cost will be $0. Given that the variable cost per cup of coffee is
calculated at $2.20, if 500 cups of coffee are sold, the total variable cost will be $1100. The slope of the
line is the rate at which the total variable cost will increase each time Café Revive sells another cup of
coffee. This rate is the variable cost per unit of volume sold – that is, $2.20 per cup of coffee.
The equation for the variable cost line in Case Exhibit 2.18 is:
Total variable cost of cups of coffee sold ¼ $2.20X
Where X ¼ Sales volume.
86
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Chapter 2 Appendix: CVP analysis for cups of coffee
Case Exhibit 2.18 Variable cost behaviour – cups of coffee
Total monthly variable cost
$5 000
$4 500
$4 000
$3 500
$3 000
$2 500
$2 200
$2 000
$1 500
$1 100
osts
ble c
$1 936
Varia
$1 000
$500
$0
100
500
Sales volume
(in cups of coffee)
880
1 000
Total costs
Case Exhibit 2.19 shows the total costs for cups of coffee sales. At a sales volume of 500 cups of coffee,
Café Revive’s share of estimated fixed costs for coffee cups is $2376 and its estimated variable costs are
$1100 (500 $2.20), for an estimated total cost of $3476 at that volume. At a sales volume of 1000
cups of coffee, estimated fixed costs are still $2376 and estimated variable costs are $2200 (1000 Case Exhibit 2.19 Total cost behaviour – cups of coffee
$5 000
$4 576
$4 312
$4 000
$3 960
$3 476
ts
l cos
Tota
$3 000
$2 376
Fixed costs
$2 000
$1 000
$0
0
250
500
750
720
Sales volume – cups of coffee
880
1 000
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87
Accounting Information for Business Decisions
$2.20) and the estimated total cost is $4576. Case Exhibit 2.19 illustrates the total cost in relation to the
sales volume of cups of coffee. Notice that if no cups of coffee are sold, the total cost will be equal to the
fixed costs of $2376. As sales increase, the total cost will increase by $2.20 per cup, the amount of
the variable cost per cup of coffee.
The equation for the total cost line in Case Exhibit 2.19 is:
Total cost of cups of coffee sold ¼ $2376 þ $2.20X
Where X = sales volume.
Profit calculation
The projected income statement is shown in Case Exhibit 2.20.
Case Exhibit 2.20 Projected income statement for external users – cups of coffee
Café Revive
Projected income statement – cups of coffee
For the month ended 31 January 20X2
Revenues:
Sales revenues – cups of coffee (880 $5.50)
$ 4 840
Expenses:
Cost of coffee supplies used (880 $2.20)
Rent expense
Salaries expense
$1 936.00
660.00*
1 180.00
Consulting expense
165.00*
Advertising expense
115.50*
Depreciation expense: fixtures
Mobile and wifi expense
Utilities expense
79.50
71.50*
104.50*
Total expenses
Net income
(4 312)
$ 528
* These figures are GST-inclusive.
Profit graph
The graph in Case Exhibit 2.21 shows the estimated total revenue line and the estimated total cost line
for Café Revive’s cups of coffee. Note that the total revenue line crosses the total cost line at 720 cups of
coffee. At this point, the total revenues will be 720 cups at $5.50 ¼ $3960, and the total costs will be
variable costs of 720 cups at $2.20 ($1584) þ fixed costs of $2376 ¼ $3960. (These figures are GSTinclusive).
At a sales volume of 880 cups of coffee, the graph in Case Exhibit 2.21 shows that Café Revive will earn a
profit of $528 (as we computed in the income statement in Case Exhibit 2.20), the difference between the
$4840 estimated total revenue and $4312 estimated total cost at this volume.
88
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Chapter 2 Appendix: CVP analysis for cups of coffee
Case Exhibit 2.21 Profit graph for Café Revive – cups of coffee
$6 000
$5 500
$5 000
$4 840
$4 500
$4 312
Profit
Profit
$528
$4 000
$3 960
$3 500
Break-even
point
s
cost
Total
$3 000
$2 500
Loss
$2 000
es
nu
ve
re
tal
To
$1 500
$1 000
$500
$0
0
100
200
300
400
500
600
Sales volume – cups of coffee
700
720
800
880
900
1 000
Contribution margin
Recall that a more useful analysis of profit for internal managers of a business uses a contribution margin
approach - relating the estimated revenues and estimated variable costs to the estimated fixed costs. Case
Exhibit 2.22 shows an income statement containing the same information as given in Case Exhibit 2.20,
but in a format that is more useful for internal decision makers in performing CVP analysis because it
shows expenses as variable and fixed – that is, a contribution margin approach.
In the income statement in Case Exhibit 2.22, Café Revive first calculates its estimated sales revenue
for cups of coffee ($4840) by multiplying the number of cups of coffee it expects to sell (880) by the
selling price per cup ($5.50). Café Revive next determines the total estimated variable costs of selling the
880 cups of coffee ($1936) by multiplying the number of cups it expects to sell (880) by the variable cost
per pack of coffee ($2.20). These total variable costs are then subtracted from total sales revenue. The
$2904 ($4840 – $1936) difference is the total contribution margin. Fixed costs are then deducted from
this ($2904 – $2376) to work out net income (or profit) of $528.
The per unit contribution margin for a cup of coffee is $3.30 ($5.50 sales revenue – $2.20 variable
costs). At 880 units, the total contribution margin will be $2904 (880 $3.30), which is the same as that
shown in Case Exhibit 2.22. The contribution margin percentage (contribution/selling price) would
therefore be: $3.30/$5.50 ¼ 60% or $2904/$4840 ¼ 60%.
Case Exhibit 2.23 shows what the total contribution margin will be at different unit sales volumes of cups
of coffee. In this graph, since the contribution margin of one cup of coffee is $3.30, the total contribution
margin increases at a rate of $3.30 per cup of coffee sold. For example, at a volume of 500 cups of coffee, the
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89
Accounting Information for Business Decisions
Case Exhibit 2.22 Projected income statement for internal users – cups of coffee (contribution
margin approach)
Café Revive
Projected income statement – cups of coffee
For the month ended 31 January 20X2
Total sales revenues ($5.50 880) cups of coffee
$ 4 840*
Less: Total variable costs
Cost of cups of coffee sold ($2.20 880)
(1 936)*
Total contribution margin
$ 2 904
Less: Total fixed costs
Rent expense
Salaries expense
$ 660.00
1 180.00
Consulting expense
165.00*
Advertising expense
115.50*
Depreciation expense: display cases
79.50
Mobile and wifi expenses
71.50*
Energy expense
104.50*
Total fixed costs
Net income
(2 376)*
$ 528
* These figures are GST-inclusive.
contribution margin will be $1650 (500 cups $3.30). At a volume of 1000 cups of coffee, the contribution
margin will be $3300 (1000 cups $3.30).
Showing CVP relationships
We can show the estimated profit or loss at different sales volumes in a graph similar to Case Exhibit 2.15 for
the coffee cup sales. Again we estimate total contribution margin at different sales volumes and compare
this to the estimated $2376 fixed costs for the coffee cup sales, the difference being the profit (if the
contribution is greater than the fixed costs) or loss (if contribution is less than the fixed costs). Case
Exhibit 2.24 shows that Café Revive will earn $0 profit if it sells 720 cups of coffee as this is its breakeven point. Above the break-even unit sales volume (e.g. at a volume of 1000 cups of coffee), the total
contribution margin ($3300) is more than the total estimated fixed costs ($2376), so there would be a
profit ($3300 – $2376 ¼ $924). Below the break-even point (e.g. at a volume of 500 cups of coffee), the
total contribution margin ($1650) is less than the total estimated fixed costs, so there would be a loss
($1650 – $2376 ¼ –$726).
Profit calculation (equation form)
In Case Exhibit 2.20 we graphed the CVP relationships for Café Revive’s coffee cup sales, but recall that
we can also use equations to understand CVP relationships. Café Revive’s projected income statement for
coffee cup sales prepared for internal decision makers in Case Exhibit 2.22 used the format sales revenue
(Unit selling x Estimated sales volume) less variable costs (Unit variable cost x That same sales volume) to
90
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Chapter 2 Appendix: CVP analysis for cups of coffee
Case Exhibit 2.23 Relationship between total contribution margin and unit sales volume – cups
of coffee
$4 000
$3 500
$3 300
$3 000
$2 500
$2 000
$1 650
n
argi
on m
uti
ntrib
Co
$1 500
$1 000
$500
$0
100
500
Sales volume – cups of coffee
1 000
Case Exhibit 2.24 Cost–volume–profit relationships for Café Revive – cups of coffee
$3 300
Contribution margin
$3 000
Profit
Total fixed costs
$2 376
$2 000
–$726
$1 650
$1 000
$0
$924
Break-even point
Loss
500
720
Sales volume – cups of coffee
1 000
work out total contribution margin. Then we subtracted the total fixed costs from the contribution margin to
determine the estimated profit. In profit equation form, this is:
3
2
3 2
Total
Variable
Unit
Profit
Selling
Unit
(for a given ¼ 4 price 3 sales 5 4 cost 3 sales 5 fixed
costs
per unit
volumes
sales volume)
per unit
volumes
Using X to stand for the volume of coffee cup sales, the equation is as follows:
Profit ¼ $5:50X $2:20X $2 376
¼ ð$5:50 $2:20ÞX $2 376
¼ $3:30X $2 376
Recall that in the last line of the equation that for cups of coffee, the $3.30 is the contribution margin
per unit. As a ‘shortcut’ when using the profit equation, we can use:
2
3
Total
Profit
Contribution
Unit
(for a given ¼ 4 margin
3 sales 5 fixed
costs
sales volume)
per unit
volume
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91
Accounting Information for Business Decisions
Using CVP analysis
Estimating profit for coffee cup sales
Suppose Emily wants you to estimate Café Revive’s monthly profit for cups of coffee if it sells 1000 cups of
coffee (i.e. a unit sales volume of 1000 cups) a month. Remember that Café Revive’s selling price is $5.50 per
unit and its variable cost is $2.20 per unit. You can estimate monthly profit when 1000 cups of coffee are sold
in a month by using the profit equation, as follows:
2
3 2
3
Selling
Unit
Variable
Unit
Total
Profit ¼ 4 price 3 sales 5 4 cost 3 sales 5 fixed
per unit
volume
per unit
volume
costs
¼ ð$5:50 3 1000Þ ð$2:20 3 1000Þ $2376
¼ $5500 $2200 $2376
¼ $924
Thus, you can tell Emily that Café Revive will make a monthly profit of $924 if it sells 1000 cups of
coffee a month. Or, using the ‘short cut’:
2
3
Profit
Contribution
Unit
Total
(for a given = 4 margin
3
sales 5 fixed
sales volume)
per unit
volume
Profit ¼ $3:30 3 1000 $2376
¼ $924
Finding the break-even point for coffee cup sales
Using the break-even equation, as follows:
Unit sales volume (to earn zero profit) ¼
Total fixed costs
Contribution margin per unit
You can also tell Emily that the break-even point is 720 cups of coffee (letting X stand for the unit
sales volume):
$2376 total fixed costs
($5:50 selling price $2:20 variable) per unit
$2376
X¼
$3:30
X ¼ 720 cups of coffee
Unit sales volume (to earn zero profit) ¼
You can verify the break-even sales volume of 720 cups of coffee with the following schedule:
Total sales revenue (720 cups of coffee @ $5.50 per cup)
$ 3 960
Less: Total variable costs (720 cups of coffee @ $2.20 per cup)
Total contribution margin (720 cups of coffee @ $3.30 per cup)
(1 584)
$ 2 376
Less: Total fixed costs
Profit
92
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(2 376)
$
0
Chapter 2 Appendix: CVP analysis for cups of coffee
Finding the unit sales volume to achieve a target
coffee cup sales profit
Assume that Emily’s goal is for Café Revive to earn a profit of $528 per month for cups of coffee. How
many cups of coffee must Café Revive sell per month to earn $528 for cups of coffee?
Unit sales volume (to earn zero profit) ¼
Total fixed costs þ Desired profit
Contribution margin per unit
So, if we let X stand for the unit sales volume, Café Revive needs to sell 880 cups of coffee to earn a
profit of $528 a month, calculated as follows:
$2376 þ $528
$3:30 per cup of coffee
X ¼ 880 cup of coffee
X¼
You can verify the $528 profit with the following schedule:
Total sales revenue (880 cups of coffee @ $5.50 per cup)
Less: Total variable costs (880 cups of coffee @ $2.20 per cup)
Total contribution margin (880 cups of coffee @ $3.30 per cup)
Less: Total fixed costs
Profit
$ 4 840
(1 936)
$ 2 904
(2 376)
$ 528
Since Emily had included the desired profit of $528 per month in Café Revive’s business plan, the
income statement for internal decision makers shown in Case Exhibit 2.22 is an expanded version of the
preceding schedule.
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93
3
DEVELOPING A BUSINESS PLAN:
APPLIED BUDGETING
‘Adventure is the result of poor planning.’
Colonel John Nicholas Blashford-Snell
Learning objectives
After reading this chapter, students should be able to do the following:
3.1 Understand why budgeting is needed to align business activities
with strategy.
3.2 Understand the difference in operating cycles between retail and
service businesses.
3.3 Understand that the interrelated budgets provide a framework
for planning.
3.4 Know how the master budget is used to evaluate performance.
3.5 Understand that a budget should include all key values of the
business.
94
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Chapter 3 Developing a business plan: Applied budgeting
Understanding the learning objectives is assisted in the chapter by asking key questions:
Key questions
1
How does a budget contribute to helping a business achieve its goals?
2
Do the activities of a business have a logical order that drives the organisation of a budget?
3
What is the structure of the budgeting process, and how does a business begin that process?
4
What are the similarities and differences between the master budget of a retail business
and that of a service business?
5
After a business begins the budgeting process, is there a strategy it can use to complete
the budget?
6
How can a manager use a budget to evaluate the performance of a business and then
use the results of that evaluation to influence the business’s plans?
7
What key values of the business need to be taken into account in a budget
8
What non-economic goals might be included in Café Revive’s budget?
Unless you have been lucky enough to win the lottery, you probably have to budget your money. Think for a
moment about where you get your money. Do you receive money from a job, a scholarship, financial aid, your
parents or some combination of these sources? Now think about where you spend your money. You probably
spend it on day-to-day living expenses such as food, rent, utilities and miscellaneous items, as well as on
university-related costs such as course fees and textbooks. Budgeting helps you estimate when – and how
much – cash will come in, and it also helps you figure out when – and how much – cash you will need to pay
out. With these estimates, you can plan your activities so that you will have enough cash to cover them.
Discussion
Suppose that, in budgeting your future cash payments, you realise that unless something
changes, you will not have enough cash to pay your next car insurance bill. What alternatives
do you have to solve this problem?
Businesses must budget their resources too. For most businesses, budgeting is a formal part of the
ongoing planning process and periodically results in a set of related reports called budgets. A budget is a report
that gives a financial description of one part of a business’s planned activities for the budget period. For
example, a budget might show how many products the business plans to sell during the next year, the dollar
amount of these sales and when the business will collect the cash from these sales. Another budget might
show how much cash a business plans to spend during the same year renting business space, employing
workers and advertising its products, as well as when the business plans to incur these costs.
budget
Report that gives a
financial description of
one part of a business’s
planned activity
3.1 Why budget?
Budgeting is a tool to align the activities of the business with the strategy of the business. It will include both
long- and short-term goals. Any aspect of the business considered key to its success should be included.
Budgeting improves the planning, operating and evaluating processes by helping an entrepreneur to:
• add discipline, or order, to the planning process
• recognise and avoid potential operating problems
• quantify plans
• create a benchmark for evaluating the business’s performance.
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95
Accounting Information for Business Decisions
1
How does a budget
contribute to helping a
business achieve its
goals?
Budgeting adds discipline
Businesses survive or fail because of the financial results of their activities. Therefore, before
implementing planning decisions, effective entrepreneurs think carefully about what is likely to happen as
a result of these decisions. That’s where budgeting comes in: the more complete and detailed the planning
process, the easier it is for an entrepreneur to foresee what might happen. Budgets add discipline because
of their orderliness and detail.
Budgeting highlights potential problems
Using budgeting to describe a business’s plans allows the entrepreneur to uncover potential problems
before they occur, and to spot omissions or inconsistencies in the plans. For example, you and Emily may
plan for Café Revive to sell more gift packs and cups of coffee in February than during other months
because of expected Valentine’s Day sales. Through the budgeting process, you may discover that unless
something changes, Café Revive will not have enough coffee gift packs on hand in February to fill the
expected customer orders. By seeing this problem ahead of time, you and Emily can adjust your purchase
plans, perhaps preventing disappointed customers from having to go elsewhere to buy coffee gift packs.
If you and Emily decide to purchase more gift packs and coffee in January and February because of
expected increases in sales, Café Revive will also have a higher bill from DeFlava Coffee. You and Emily
will need to plan to have enough cash on hand to pay the bill when it is due. This plan will show up in the
part of the budget that shows expected purchases. The budgeting process helps the entrepreneur to see
and evaluate how changes in plans affect different parts of a business’s operations.
Budgeting quantifies plans
As we described in Chapter 2, a business plan includes all the operating activities needed to meet the
business’s goals. A budget quantifies, or expresses in numbers, these operating activities and goals. For
example, most businesses have a goal of earning a specific profit for the budget year. This is stated in their
business plan. Recall from Chapter 2 that Café Revive included in its business plan a goal of earning a profit of
$2112 per month from coffee gift packs and $528 from cups of coffee, or $31 680 (($2112 þ 528) 12)
during the coming year. The CVP analysis included in the business plan in Chapter 2 indicates that to earn
this profit, Café Revive must have monthly sales averaging 170 coffee gift packs and 880 cups of coffee, so
during the year it must sell at least 2040 coffee gift packs (170 12) and 10 560 cups of coffee (880 12).
Café Revive’s budget will indicate how many gift packs and how many cups of coffee it plans to sell each
month of the year to meet its profit goal, and how many gift packs and how much coffee it must purchase
each month to support its projected sales.
Budgeting also quantifies the resources that the business expects to use for its planned sales and
purchasing activities. For example, if Café Revive must purchase 300 coffee gift packs to cover its expected
sales for any given month, the budget will indicate how much (and when) Café Revive expects to pay for
these coffee gift packs. Likewise, with the cups of coffee, if Café Revive plans to sell 1000 cups of coffee in
any given month, you and Emily will need enough coffee supplies (coffee granules, sugar, cups, spoons, etc.)
to meet those expected sales. You will also need to establish that the business has enough funds to cover
the cost when it falls due.
Budgeting creates benchmarks
Since budgets help to quantify plans, an entrepreneur also uses budgets as benchmarks. The entrepreneur
periodically compares the results of the business’s actual operating activities with the related budget amounts.
These comparisons measure the business’s progress towards achieving its goals and help the entrepreneur to
evaluate how efficiently the business is using its resources. The comparisons also help the entrepreneur to focus
96
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Chapter 3 Developing a business plan: Applied budgeting
on what changes, if any, should be made to bring the business’s operating activities more in line with its goals. To
save time and effort, the entrepreneur uses a management principle known as management by exception.
Under this principle, the entrepreneur focuses on improving the activities that show significant differences (or
exceptions) between budgeted and actual results. These activities have the greatest potential to positively
influence the operations of the business. Entrepreneurs should focus on both the favourable and unfavourable
differences so they can capitalise on opportunities as well as locate problem areas.
3.2 Operating cycles
Earlier, we referred to the operating activities of a business. The operating activities of a business depend
on whether it is a retail, service or manufacturing business because each business type has a different
operating cycle. In budgeting, a business quantifies its planned activities in relation to its operating cycle.
This process is similar to when you prepare your personal budget for the semester. Before we get into the
details of budgeting, we will briefly discuss the operating cycles of retail and service businesses.
management by
exception
Management principle
where an entrepreneur
or manager focuses on
improving the activities
that show significant
differences between
budgeted and actual
results
2
Do the activities of a
business have a logical
order that drives the
organisation of a budget?
A retail business’s operating cycle
The operating cycle of a retail business is the average time it takes the business to use cash to buy goods
for sale (called inventory), to sell these goods to customers and to collect cash from customers. Café Revive’s
operating cycle is the time it takes to pay cash to purchase coffee gift packs from DeFlava Coffee, to sell these
gift packs to customers and to collect the cash from customers. DeFlava Coffee allows Café Revive to ‘charge’
its purchases of coffee gift packs. These purchases are made on ‘charge accounts’ set up directly between Café
Revive and DeFlava Coffee; they are not made on credit cards. From Café Revive’s perspective, these are called
credit purchases, and they result in accounts payable. Similarly, although most of Café Revive’s sales are cash
sales, it also allows some of its customers to ‘charge’ their purchases of coffee gift packs and allows the
university’s lecturers to run an account for their cups of coffee. From Café Revive’s perspective, sales to these
customers are called credit sales, and they also result in accounts receivable.
operating cycle of a
retail business
The average time it
takes a retail business
to use cash to buy
goods for sale (called
inventory), to sell these
goods to customers
and to collect cash
from its customers
Stop & think
What do you think Café Revive’s credit sales to customers are called from the customers’
perspective?
Café Revive will pay cash for its accounts payable to DeFlava Coffee within 30 days of the purchases.
Similarly, Café Revive will collect cash from customers’ accounts receivable within 10 days after their
purchases of coffee gift packs or cups of coffee. We will talk more about how a business decides to extend
credit to customers later in this chapter and in Chapter 6.
Case Exhibit 3.1 shows Café Revive’s operating cycle. As you will see later, Café Revive’s budgeting
process quantifies its operating cycle and its other activities.
A service business’s operating cycle
Service businesses have a budgeting process that is very similar to that of retail businesses. One major
difference between these two types of businesses, however, involves their operating cycles. The operating
cycle of a service business is the average time it takes the business to use cash to acquire supplies and
services, to sell the services to customers and to collect cash from customers.
Case Exhibit 3.2 shows the operating cycle of Express Transfer Company, a shipping company hired
by DeFlava Coffee to ship its coffee to Café Revive and other retail businesses around the country. This
operating cycle may be shorter than that of a retail business because there is no inventory to purchase.
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operating cycle of a
service business
The average time it
takes a service
business to use cash to
acquire supplies and
services, to sell the
services to customers
and to collect cash
from its customers
97
Accounting Information for Business Decisions
Case Exhibit 3.1 Café Revive’s operating cycle
Cash sources
Cash
Collection
of cash
Accounts
receivable
Cash purchases of
Credit purchases of
coffee gift packs or coffee gift packs
and coffee supplies and coffee supplies
Credit sales of
Cash sales of
coffee gift packs or coffee gift packs
and coffee supplies and coffee supplies
Accounts
payable
Coffee gift packs
and coffee supplies
Payment
of cash
Case Exhibit 3.2 Express Transfer Company’s operating cycle
Cash sources
Cash
Collection
of cash
Deliveries
for cash
Deliveries on
credit
Accounts
receivable
Advertising campaigns for Weet-Bix have been around for decades. Do
you think the agency’s operating cycle is that long?
98
The operating cycle for some service businesses can be
much longer than the cycle for most retail businesses because,
for certain service businesses, one service or job can take
months or years. For example, think about the longevity of
some of the advertising campaigns you have observed recently
– for example, Weet-Bix (cereal) and the Energizer Bunny
(batteries) have been around for decades, and is still being
used, although the 1989 Energizer Bunny may be introducing
Dancing Bots on YouTube in 2019! Many service companies
with lengthy jobs try to shorten their operating cycles by
periodically collecting payments from their customers for
completed segments of the work. Express Transfer’s operating
cycle, on the other hand, might average only two or three days,
since it delivers perishable coffee to businesses in the same city
in which DeFlava Coffee’s factory is located, as well as to
businesses around the country. The length of Express
Transfer’s operating cycle depends on Express’s collection
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Chapter 3 Developing a business plan: Applied budgeting
policies and when it expects to be paid by its customers. Like Café Revive, Express Transfer quantifies
its operating cycle and other activities in a budget.
Stop & think
How long do you think a university’s operating cycle is? What are the components of its
operating cycle?
3.3 The budget as a framework
for planning
Budgeting is most useful in decision making when it is organised to show different aspects of
operations. The master budget is the overall structure a business uses to organise its budgeting
process. It is a set of interrelated reports (or budgets) showing the relationships among a business
(Exhibit 3.3). A business includes the master budget with the CVP analysis in the financial plan section
of its business plan (refer to Chapter 2).
Exhibit 3.3 Elements of the master budget
1
Goals to be met
2
Activities to be performed in its operating cycle
3
Resources to be used
4
Expected financial results
3
What is the structure of the
budgeting process, and
how does a business
begin that process?
master budget
Set of interrelated
reports showing the
relationships among a
business’s goals to be
met, activities to be
performed, resources
to be used and
expected financial
results
The individual budgets in the master budget may be different from business to business. These
differences are due to the number of different products each business sells, the varying sizes and
complexities of the businesses and their operations, and whether it is a retail, service or manufacturing
business. Regardless of the differences, each master budget describes the relationships among a business’s
goals, activities, resources and results.
A master budget for a retail business usually includes the following budgets and projected financial
statements:
1 sales budget
2 purchases budget
3 selling expenses budget
4 general and administrative expenses budget
5 cash budget (projected cash flow statement)
6 projected income statement
7 projected balance sheet.
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99
Accounting Information for Business Decisions
4
What are the similarities
and differences between
the master budget of a
retail business and that of
a service business?
projected balance
sheet
Statement summarising
a business’s expected
financial position
(assets, liabilities and
owner’s equity) at the
end of a budget period
A service business’s master budget does not include a purchases budget, and usually combines the
expenses budgets. A manufacturing business’s master budget includes additional budgets related to its
manufacturing activities – for example, direct material purchases, direct labour and cost of goods sold.
A business prepares its annual master budget for a year or more into the future. It breaks down the
master budget by each budget period – generally by quarter (three-month period). Within each quarter, it
shows the budget information on a monthly basis. Some businesses develop budgets for each department,
which they then combine to form a master budget. For example, Kmart (http://www.kmart.com.au)
might develop budgets for women’s apparel, homewares, bed and bath accessories, and stationery.
Exhibit 3.4 shows the important relationships among the reports in the master budget of a retail
business like Café Revive. Notice that the last budgets prepared in a business’s budgeting process are the
projected financial statements for the budget period: the cash budget (also called a projected cash flow
statement) and the projected financial statements (projected income statement and projected balance
sheet). The projected financial statements give managers a ‘preview’ of what the business’s actual
financial statements should look like at the end of the budget period if everything goes according to plan.
The information for these projected financial statements comes from the other budgets.
Exhibit 3.4 Interrelationships among budget schedules in the master budget – retail
Purchases
budget
Cash budget
(projected cash
flow statement)
Selling expenses
budget
Projected income
statement
General and
administrative
expenses budget
Projected balance
sheet
Sales
budget
We will discuss the nature and the relationships among Café Revive’s budgets to illustrate how a retail
business plans and describes its operating activities. Since Café Revive is a small business, the illustrations
will be simple. The larger a business is, the more complex and detailed its budget reports must be in order to
be useful. Often, though, managers of large businesses prepare summaries similar to the simpler budgets that
we use in this chapter. Large manufacturing businesses, like Sanitarium (https://www.sanitarium.com.au),
the manufacturer of Weet-Bix, would have more budgets, as is shown in Exhibit 3.5.
When you look at the budgets for Café Revive, try to understand the logic of their development and
how they interrelate. As you study the budgets, remember the following ‘start-up’ information from
Chapter 2. Note that the monetary figures used in this chapter are GST-inclusive (refer to Chapter 2).
During December 20X1, Emily plans to:
• invest $20 000 in Café Revive
• rent shop space for $1320 per month, paying $7920 in advance for six months’ rent
• buy $1650 of shop equipment by making a $250 down-payment and signing a note payable (a loan)
for the remaining amount
• order 50 coffee gift packs from DeFlava Coffee for $1430, to be paid for in January 20X2
• purchase and pay for $2255 of coffee supplies.
In discussing each of Café Revive’s budgets in the following sections, we will also briefly discuss the
corresponding budget for Express Transfer, a service business.
100
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Chapter 3 Developing a business plan: Applied budgeting
Exhibit 3.5 Interrelationships among budget schedules in the master budget – manufacturing
Selling expenses
budget
Capital
expenditures
budget
General and
administrative
expenses budget
Sales
budget
Production
budget
Direct
materials
purchases
budget
Cash budget
(projected
cash flow
statement)
Direct labour
budget
Projected
income
statement
Factory
overhead
budget
Projected
balance
sheet
The sales budget
The budgeting process begins with the sales budget because product sales/service contracts affect all
the other operating activities of a business. (Without sales of coffee, why would Café Revive be in
business? Without arrangements with DeFlava Coffee and other businesses to ship coffee and other
goods, why would Express Transfer exist?) A retail business without sales would not need employees,
inventory, retail space, shop equipment, supplies, advertising or utilities. As you will soon see, the same
is true for a service business. For this reason, the sales budget affects all the other budgets. It is the
cornerstone of the budgeting process.
5
After a business begins
the budgeting process, is
there a strategy it can use
to complete the budget?
The retail business’s sales budget
For a retail business, the sales budget shows the number of units of inventory that the business expects
to sell each month, the related monthly sales revenue and the months in which the business expects to
collect cash from these sales. To estimate the number of units of inventory it will sell in each month, a
business gathers various types of information, such as past sales data, industry trends and economic
forecasts. If Café Revive were an older business, you and Emily might analyse its past sales trends to get
an idea about what sales level to expect for the future.
You and Emily should consider the current economic conditions or circumstances that are affecting
the coffee industry. For example, if the economy has worsened and people are struggling to put food on
the table, customers may view the purchase of coffee as a luxury, and sales may drop regardless of the
level of past sales. On the other hand, if the economy is improving, people may have extra income to
spend (disposable income) and sales of coffee may increase. New findings and breakthroughs can also
affect sales. For example, in 2011 Di Bella Coffee (http://dibellacoffee.com) began to manufacture TORQ
Natural Instant Coffee, a liquid coffee concentrate designed for use wherever a specialty coffee option is
needed – for instance, while camping, at conferences and in other corporate hospitality contexts. To add
to its range of coffee solutions, the company also introduced a range of Nespresso¤-compatible specialty
coffee capsules.a Do you think that after Di Bella Coffee marketed its coffee concentrates, sales of these
products would have affected sales of other coffees the company already had on the market? Marketing
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sales budget
Budget showing the
number of units of
inventory that a
business expects to sell
each month, the related
monthly sales revenue,
and the months in
which the business
expects to collect cash
from these sales
101
Accounting Information for Business Decisions
should not be static, but part of the plan – and budget – for the future. In 2018, Di Bella merged four
businesses to expand in the United States and New Zealand, and now sells related products such as teas,
hot chocolate and sugar. Businesses need adaptable plans to be able to respond to changing
circumstances, such as the increase in Di Bella’s online sales in response to the Covid-19 restrictions
imposed in 2020.
Stop & think
How do you think a well-publicised discovery that sugar was actually good for people would
affect your prediction of coffee sales for the next year?
Market analysts or consultants are another source of information about the estimated number of
products to be sold. Although Emily has a marketing degree, she is busy getting the business up and
running, and you are only able to work at the business part time, given your university commitments.
Therefore, she has hired Briana Small (see Case Exhibit 2.3 in Chapter 2), a consultant, to study the
market for gift-packed coffee in the area north of the university campus and to provide an analysis of it,
including a report on the effect that different prices would have on potential sales of the coffee. Briana’s
research should help Emily to predict sales during Café Revive’s first year of operations. Large businesses
have additional sources of market information, including their sales teams, and marketing and advertising
specialists.
After a business has estimated the amount of inventory it expects to sell, it determines its estimated
sales revenue by multiplying the number of units of inventory it expects to sell by the unit selling price.
After calculating its monthly estimated sales revenue, the business determines how much cash it expects
to collect each month from sales. If all sales are cash sales, the cash to be collected each month is equal to
the sales revenue of that month. For most businesses, however, a portion (sometimes substantial) of their
sales consists of credit sales. If a business allows credit sales, its cash collections of accounts receivable will
lag behind its sales revenues.
Stop & think
What do you think is the difference between cash sales and sales revenue? Are they the same
thing?
The credit-granting policy of a business can have a major impact on the amount of time between the
sale of its product and the collection of cash from that sale. You and Emily would certainly not grant
credit to a customer with a poor credit history because there would be a good chance that the customer
would either pay you a long time after the sale, pay you only part of the bill or not pay you at all. Many
businesses spend a lot of time and effort studying the paying habits of their customers and deciding on
an appropriate credit-granting policy. The goals are to shorten the amount of time between sales and
collections of cash, and to reduce the risk of not being able to collect from customers. At the same time,
businesses don’t want an overly restrictive credit policy that discourages customers from buying on credit.
Stop & think
What information about a customer do you think would be helpful in Café Revive’s decision
about whether or not to grant the customer credit?
You and Emily have decided to grant credit for sales of coffee gift packs to a few nearby businesses in
the hope that they will make numerous purchases. In the future, you aim to extend credit for sales of
cups of coffee to trusted customers, but at this early stage cups of coffee will be purchased as cash sales
only. To start, you estimate that the coffee gift pack credit sales will be about 6 per cent of total sales. You
have also decided to give these credit customers terms of n/10 (net 10), which means that they will pay
102
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Chapter 3 Developing a business plan: Applied budgeting
Café Revive within 10 days of when they make credit purchases. You selected n/10 because Café Revive is
a new business and Emily does not think the business should wait more than 10 days to receive cash
from its credit customers. Because of this policy, Café Revive will collect roughly two-thirds of each
month’s coffee gift pack credit sales in the month of the sales, and the remaining one-third of the credit
sales in the following month.
Case Exhibit 3.6 shows the relationship between Café Revive’s January coffee gift pack credit sales
and its cash collections from these sales. It shows that the sales revenue is earned at the time of the credit
sale. However, the cash collection from the credit sale occurs 10 days after the sale takes place. As you can
see in the exhibit, cash collections from January credit sales occur partly in January and partly in
February. For instance, the cash collections from the 1 January credit sales occur on about 11 January,
and the cash collections from the credit sales on 31 January occur on about 10 February.
Case Exhibit 3.7 shows the sales budget of Café Revive for the first quarter of 20X2 for coffee gift
packs. Case Exhibit 3.8 shows the sales budget of Café Revive for the first quarter of 20X2 for cups of
coffee. The sales amounts are based on Briana Small’s market analysis. Notice that the exhibit shows
budgeted sales for each month in both units (coffee gift packs, cups of coffee) and dollars of sales
revenue, and that the monthly sales amounts are added across to show the quarter totals (620 units and
$34 100 sales revenue for coffee gift packs, and 2900 units and $15 950 sales revenue for cups of coffee).
Also notice that the sales budget for coffee gift packs divides total sales each month between cash sales
and credit sales.
Case Exhibit 3.6 Relationship between credit sales and cash collections
Date of:
January
February
Sales revenues 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31
Cash collections
11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 1 2 3 4 5 6 7 8 9 10
Stop & think
How do you think dividing total monthly sales between cash sales and credit sales helps in the
creation of the rest of the sales budget?
The service business’s sales budget
The sales budget of a service business is very similar to the sales budget of a retail business, except that the
former is selling services rather than products. When Express Transfer budgets its sales, it is budgeting sales of
delivery services. Expected cash collections from customers depend on Express’s collection policies. For
example, Express may expect to be paid by its customers when it picks up merchandise that customers want
to ship. On the other hand, Express may expect to be paid by its customers only after it delivers the
customers’ merchandise. Also, Express may grant credit to some of its customers – a policy that will also affect
the timing of its cash receipts.
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Accounting Information for Business Decisions
Case Exhibit 3.7 Sales budget – coffee gift packs
CAFÉ REVIVE
Sales budget – coffee gift packs
First quarter 20X2
January
Budgeted total unit sales – coffee gift packs
February
170
March
250
55
$
55
Quarter
200
Budgeted selling price per gift pack
$
Budgeted total sales revenue
$9 350
$13 750
$11 000
$34 100
Budgeted cash sales (94% of total sales revenue)
$8 789
$12 925
$10 340
$32 054
825
$
55
620
$
$
55
Budgeted credit sales (6% of total sales revenue)
$ 561
$
660
$ 2 046
Budgeted total sales revenue
$9 350
$13 750
$11 000
$34 100
From cash sales
$8 789
$12 925
$10 340
$32 054
From January credit sales (2/3; 1/3)
$ 374*
Expected cash collections:
$ 187*
From February credit sales
$ 550*
From March credit sales
Total cash collections
$9 163
$13 662
$
561
$ 275*
$
825
$ 440*
$
440
$11 055
$33 880
* Café Revive estimates that it will collect two-thirds of each month’s credit sales during the month of sale. It will collect the remaining one-third in
the month following the sale. All figures rounded to the nearest dollar.
Case Exhibit 3.8 Sales budget – cups of coffee
CAFÉ REVIVE
Sales budget – cups of coffee
First quarter 20X2
January
Budgeted total unit sales – cups of coffee
February
March
Quarter
880
1 320
700
2 900
Budgeted selling price per cup
$ 5.50
$ 5.50
$ 5.50
$ 5.50
Budgeted total sales revenue
$ 4 840
$ 7 260
$3 850
$15 950
Total cash collections
$4 840
$7 260
$3 850
$15 950*
* Café Revive does not intend at this stage to allow customers to buy cups of coffee on credit therefore the sales figure for the month should be the same as the
cash collected, as they are all cash sales. This may change in the future if it allows credit terms for regular customers.
Discussion
In the mid-2000s, Jetstar began flying from Brisbane, Queensland, to Newcastle, New South
Wales. Suppose the fare for the trip at that time was $49 plus taxes. How do you think Jetstar
would have budgeted its cash receipts?
Seasonal sales
Some businesses’ sales occur evenly throughout the year, while other businesses experience seasonal sales
– that is, these businesses’ customers purchase the inventory or services more often in some months than
in others. The sale of water-ski apparel is an example of seasonal sales. Although water-ski shops sell
inventory throughout the year, most of their sales occur immediately before and during summer.
104
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Chapter 3 Developing a business plan: Applied budgeting
A business offering water-skiing lessons (a service) may not even be open during the winter. The sale of
coffee is not as extreme, but it does have some seasonality. For Café Revive, monthly sales differences
during its first quarter reflect an expected increase in sales as Valentine’s Day approaches.
Stop & think
What other seasonal effects would you expect for Café Revive? Will sales be influenced by
the location?
The retail business’s purchases budget
Once a business has estimated (budgeted) its unit sales for each month of the quarter, it can determine
the best approach to purchasing the needed inventory. Café Revive expects to sell 620 coffee gift packs
and 2900 cups of coffee this quarter (from the sales budgets in Case Exhibits 3.7 and 3.8. You may now
be wondering how many of those gift packs Café Revive should be ordering. In making this purchase
decision, you should consider several factors.
First, there are the costs of keeping the business’s money invested in inventory (rather than investing
it somewhere else), storing and handling inventory, and paying for insurance and taxes on inventory.
Higher inventory levels also increase the risk of theft, damage and obsolescence. If Café Revive holds too
many coffee gift packs, you and Emily risk either selling coffee that is not fresh, and thereby losing future
customers, or having to throw away old coffee. (Or, with more coffee around, you may be more tempted
to drink the inventory!) There is also a physical limit to the number of gift packs you can stock in the
café. For these reasons, some businesses use just-in-time (JIT) inventory systems, in which they purchase
inventory only when an order has been placed and they need it immediately.
On the other hand, it can also be very expensive not to carry enough inventory (which is called
stockout). For example, if Café Revive starts running low on coffee, it may have to pay Express Transfer
higher shipping costs for rush orders or pay DeFlava Coffee higher costs per gift pack for smaller, lastminute orders. You may also risk alienating customers if you run out of inventory. Every business must
plan its own inventory levels while considering the costs of both carrying and not carrying inventory, and
trying to keep the combined total at the lowest possible amount. Even though the purchases budget does
not address all the above factors, it will help you and Emily make the best purchase decision.
The purchases budget shows the purchases (in units) required in each month to make the expected
sales (from the sales budget) in that month and to keep inventory at desired levels. It also shows the costs
of these purchases and the expected timing and amount of the cash payments for these purchases.
Frequently, businesses set desired end-of-month inventory levels at either a constant percentage of
the following month’s budgeted unit sales or at large enough levels to meet future sales for a specified
time. Since many businesses base their purchase orders on sales estimates, they want to have extra
inventory available to sell in case they have underestimated their sales, or in case their next shipment of
inventory arrives later than expected.
You and Emily plan to order coffee from DeFlava Coffee once every month. Emily has also decided that,
during any month, Café Revive should have enough coffee on hand to cover that month’s coffee sales, and also
to have an ending inventory large enough to cover one-fifth (20%) of the next month’s sales of gift packs and
half (50%) of the next month’s sales of coffee cups. For example, projected sales for the first quarter of 20X2
(from the sales budgets in Case Exhibits 3.7 and 3.8) and for April (from projections for the second quarter)
are as follows:
Budgeted total unit sales – coffee gift packs
Budgeted total unit sales – cups of coffee
January
February
March
April
170
250
200
225
January
February
March
April
880
1320
700
1200
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purchases budget
Budget showing the
purchases (in units)
required in each month
to make the expected
sales in that month
(from the sales budget)
and to keep inventory at
desired levels
105
Accounting Information for Business Decisions
Based on Emily’s purchasing policy, Café Revive must have enough inventory during January to equal
budgeted sales for January plus one-fifth (20%) of budgeted gift pack sales for February, or 220 coffee gift
packs (170 packs þ (20% 250)). The ending inventory estimate would be rounded up to a whole
number as necessary because Café Revive cannot buy part of a gift pack. (Then if Café Revive sells 170
gift packs during January, it will have inventory at the end of January equal to one-fifth or 20% of
February’s budgeted sales in units.) Since Café Revive will start business in January with the 50 coffee gift
packs purchased in December, January purchases must be 170 gift packs (220 total packs needed – 50
packs already on hand). Café Revive uses the same calculations to determine each month’s purchases of
coffee gift packs. Case Exhibit 3.9 illustrates how budgeted purchases and budgeted sales for coffee gift
packs are linked together for the first quarter of the year. A similar schedule would be developed for the
purchase of coffee supplies (see Case Exhibit 3.10).
Case Exhibit 3.9 The link between budgeted purchases and budgeted sales – coffee gift packs
First quarter 20X2
December
Budgeted
sales*
January
February
March
April
170
gift packs
250
gift packs
200
gift packs
225
gift packs
× ¹⁄5
34
Budgeted
purchases
× 4⁄5
136
× ¹⁄5
+ 50
× 4⁄5
200
× ¹⁄5
+ 40
× 4⁄5
160
50
gift packs#
186
gift packs#
240
gift packs
205
gift packs
December
January
February
March
× ¹⁄5
+ 45
April
First quarter 20X2
*From Case Exhibit 3.7, except April, which was estimated as part of second-quarter projections.
#Ordered 50 instead of 34 because of the difficulty of estimating sales for the first month of a start-up business and because
Café Revive did not want to run out of stock. Café Revive would only need to purchase 170 gift packs in January
(186 – the extra 16 from December (50 – 34)) if they keep to the budget.
Case Exhibit 3.10 The link between budgeted purchases and budgeted sales – cups of coffee
First quarter 20X2
December
Budgeted
sales*
January
February
March
April
880
cups of coffee
1 320
cups of coffee
700
cups of coffee
1 200
cups of coffee
×½
440#
Budgeted
purchases
×½
×½
440# + 660
×½
660
×½
+ 350
×½
350
1 025
cups of coffee
1 100
cups of coffee#
1 010
cups of coffee
950
cups of coffee
December
January
February
March
×½
+ 600
April
First quarter 20X2
*From Case Exhibit 3.8, except April, which was estimated as part of second-quarter projections. Figures are rounded for simplicity.
# Ordered 1 025 instead of 440 (585 extra) because Café Revive did not want a stockout situation.
The excess (1 025 – 440 = 585) reduces those required in January to 515 (1 100 – 585).
106
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Chapter 3 Developing a business plan: Applied budgeting
Stop & think
What do you think are the advantages of Emily’s plans to order coffee once per month rather
than more often?
Normally, Café Revive will make purchases during the first week of each month and receive delivery of
the purchases at the beginning of the second week of the month. However, since Café Revive will open for
business in January, Emily has chosen to purchase 50 coffee gift packs in mid-December so that these will
be available to sell on the first day of business in January. (Note that the 50 is more than the required onefifth or 20%, of January [34] as Emily was concerned that the sales estimate for January might not be
accurate, as it is hard to predict for a start-up business, and she wanted to avoid any possible stock
shortages. No sales of coffee will occur in December, so the amount of coffee that Café Revive purchases in
December will still be in Café Revive’s inventory at the end of December (and at the beginning of January).
Case Exhibit 3.11 shows the purchases budget of Café Revive for the first quarter of 20X2 for coffee gift
packs. Remember that Café Revive wants to purchase enough gift packs each month to meet budgeted sales
during the month, and to have enough gift packs left at the end of the month to cover one-fifth or 20 per
cent of the next month’s sales. These gift packs must come from the inventory on hand at the beginning of
the month and from any purchases that the business makes during the month. By subtracting the budgeted
beginning inventory from the total inventory required for any given month, you can determine how many
purchases (in gift packs) to budget for that month. Since purchases are a variable cost, the cost of coffee gift
packs purchased is determined by multiplying the number of gift packs by $28.60 per unit. Since Café Revive
has an agreement with DeFlava Coffee to pay for its purchases within 30 days of the purchases, the payment
for each month’s purchase is budgeted for the following month. For instance, the budgeted January purchase
of 170 coffee gift packs costing $28.60 per pack amounts to a total purchase cost of $4862, which is
budgeted to be paid in February. A similar budget would be prepared for the supplies for the cups of coffee,
but with one half of the next month’s sales as the desired level of ending inventory (see Case Exhibit 3.12).
Case Exhibit 3.11 Purchases budget – coffee gift packs
CAFÉ REVIVE
Purchases budget
First quarter 20X2
January
Budgeted total unit sales (coffee gift
packs)
Add: Desired ending inventory of
coffee gift packs*
Total gift packs required
Less: Beginning inventory of coffee
gift packs§
Budgeted purchases of coffee
gift packs
February
March
Quarter
170
250
200
50
40
45
220
290
245
620
45à
655
(50)*
(50)
(40)
(50)**
170
240
205
615
Purchase price per coffee gift packs
$28.60
$28.60
$28.60
$ 28.60
Cost of purchases
$4 862
$6 864
$5 863
$17 589
Cash payments for purchases
$1 430{
$4 862
$6 864
$13 156
* The desired ending inventory is 1/5 or 20% of next month’s budgeted sales.
† April’s budgeted sales are 225 coffee gift packs, therefore March-ending inventory equals (225 1/5).
‡ The desired ending inventory at the end of the quarter is the same as the desired ending inventory at the end of
March (which is the end of the quarter).
§ The beginning inventory is the same as the previous month’s ending inventory.
{ 50 coffee gift packs, at a total purchase price of $1430, ordered in December 20X1 to prepare for the start of business.
**The quarter’s beginning inventory is the same as December’s ending inventory (January’s beginning inventory).
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107
Accounting Information for Business Decisions
Case Exhibit 3.12 Purchases budget – cups of coffee
CAFÉ REVIVE
Purchases budget
First quarter 20X2
January
February
March
Quarter
Budgeted total unit sales (cups of
coffee)
880
1 320
700
Add: Desired ending inventory of
coffee supplies*
660
350
600
Total coffee supplies required
1 540
1 670
1 300
Less: Beginning inventory of coffee
supplies§
(1 025){
(660)
(350)
Budgeted purchases of coffee supplies
2 900
600à
3 500
(1 025)**
515
1 010
950
2 475
Purchase price per cup of coffee
$ 2.20
$ 2.20
$ 2.20
$ 2.20
Cost of purchases
$ 1 133
$2 222
$2 090
$ 5 445
Cash payments for purchases
$
$1 133
$2 222
$ 3 335
0{
* The desired ending inventory is 1/2 (50%) of next month’s budgeted sales.
† April’s budgeted sales are 1200 cups of coffee.
‡ The desired ending inventory at the end of the quarter is the same as the desired ending inventory at the end of
March (which is the end of the quarter).
§ The beginning inventory is the same as the previous month’s ending inventory.
{ Supplies for approximately 1025 cups of coffee, at a total purchase price of $2255, ordered in December 20X1 to prepare
for the start of business were paid for with cash in December, so nothing is due in January. As with the gift packs, DeFlava
Coffee from then on is allowing Café Revive to pay for purchases the following month.
**The quarter’s beginning inventory is the same as December’s ending inventory (January’s beginning inventory).
Stop & think
Suppose that January sales turn out to be 210 coffee gift packs. Should Café Revive change
its plans for February and March? What questions should you ask before deciding whether
the plans should change, which part of the plans should change, and by how much?
Businesses that purchase their inventories from suppliers in other countries sometimes pay for those
purchases in the currency of the other country (e.g. in yen or euros rather than dollars). However, these
businesses should budget their purchases in dollars. Suppose, for example, that Café Revive purchased coffee
gift packs from a Belgian business instead of from DeFlava Coffee. Since Belgium is a member of the
European Union (EU), which uses a currency called the euro, Café Revive would have to convert euros to
dollars when preparing its purchases budget.
Remember that budgets represent a business’s plans, and that they are based on estimates. As new
information becomes available, the business sometimes changes its plans.
selling expenses
budget
Budget showing the
expenses and related
cash payments
associated with
planned selling
activities
108
The retail business’s selling expenses
budget
To sell its inventory, a retail business must engage in selling activities. The selling expenses budget
shows the expenses and related cash payments associated with planned selling activities. Examples of
selling expenses include salespeople’s salaries and commissions, shop rent and advertising. Each of these
expenses relates directly to sales.
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Chapter 3 Developing a business plan: Applied budgeting
A selling expenses budget is developed by reviewing past selling expenses (if they are available) and
then adjusting them for current plans. It is important for the entrepreneur to understand prior costbehaviour patterns when creating a selling expenses budget because some selling expenses are variable and
change directly with the amount of inventory sold, whereas some remain fixed regardless of the sales
volume. By applying these behaviour patterns, the entrepreneur can predict what each selling expense will
be at a given estimated sales volume. Sales commissions are an example of variable selling expenses, since
total sales commissions increase in direct proportion to increases in sales. Shop rent and advertising, on
the other hand, are in many cases fixed selling expenses because total rent and advertising expenses stay
the same while sales increase during the period. In developing a selling expenses budget, the entrepreneur
should also be able to distinguish selling expenses from general and administrative expenses. Sometimes
fixed expenses must be allocated on a reasonable basis between the two types of expenses.
Case Exhibit 3.13 shows the selling expenses budget for Café Revive for the first quarter of 20X2. The
January expenses are the same items listed in Case Exhibit 2.13 in Chapter 2. These expenses are all
fixed expenses, so Café Revive expects them to be the same in all three months. (Remember, though, that
selling expenses can also be variable expenses.) Not all the amounts from Case Exhibit 2.13 are related to
selling activities, however. You and Emily have estimated that three-quarters of each of the following
expenses is tied directly to selling activities. The other one-quarter of each expense is tied to the
administrative activities of Café Revive and will be included in the general and administrative expenses
budget. These expenses are allocated to the selling expenses budget as follows:
Rent
$1320 3/4 ¼ $990.00
Salaries
$2360 3/4 ¼ $1770.00
Consulting
$ 330 3/4 ¼ $247.50
Mobile & wifi
$ 143 3/4 ¼ $107.25
Energy
$ 209 3/4 ¼ $156.75
Case Exhibit 3.13 Selling expenses budget
CAFÉ REVIVE
Selling expenses budget
First quarter 20X2
January
February
March
Quarter
$ 990.00
$ 2 970.00
Budgeted selling expenses:*
Rent expense
$ 990.00
Salaries expense
$1 770.00
$1 770.00
$1 770.00
$ 5 310.00
Consulting expense
$ 247.50
$ 247.50
$ 247.50
$
742.50
$ 231.00
$ 231.00
$ 231.00
$
693.00
Advertising expense
#
$ 990.00
Depreciation expense: fixtures
$ 159.00
$ 159.00
$ 159.00
$
477.00
Mobile and wifi expense
$ 107.25
$ 107.25
$ 107.25
$
321.75
Energy expense
470.25
$ 156.75
$ 156.75
$ 156.75
$
Total budgeted selling expenses
$3 661.50
$3 661.50
$3 661.50
$10 984.50
Budgeted cash payments for selling expenses
$2 512.50
$2 512.50
$2 512.50
$ 7 537.50
* Case Exhibit 2.13 (Chapter 2) shows Café Revive’s projected expenses for the month of January. Since these are fixed
expenses, they are expected to be the same for February and March.
# Advertising expenses are only in the selling expenses not in the general and administration expenses as they relate only
to the selling of the coffee, as does the depreciation expenses.
† The $1149 ($3661.50 – $2512.50) difference between the total budgeted selling expenses and budgeted cash payments
for selling expenses each month occurs because the expenses for rent and depreciation ($990 þ $159) relate to Café
Revive’s planned December expenditures for rent, and equipment. They are not counted again as cash payments. Note:
Depreciation is a non-cash item (refer to Chapter 4).
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109
Accounting Information for Business Decisions
Like the purchases budget, the selling expenses budget includes a schedule of budgeted cash payments
for each month in the budget period. The business’s payment policies and how they apply to the
individual expenses determine the budgeted cash payments.
For now, Café Revive’s payment policy is to pay for all of its expenses (except rent, supplies and
depreciation) in the month in which they occur. However, if its policy were to make payments in the month
following the expenses, the cash payment schedule of the selling expenses budget would resemble the cash
collection schedule illustrated in the sales budget in Case Exhibit 3.7. Notice that there is an $1149
($3661.50 – $2512.50) difference between the budgeted total selling expenses each month and the
budgeted monthly cash payments for these expenses. This is because Café Revive expects to pay cash in
advance for six months’ rent, to purchase supplies with cash and to make a cash down payment to buy shop
equipment in December 20X1 to get ready to open for business. The $1149 ($990 rent expense þ $159
depreciation expense) monthly expenses related to these planned December cash expenditures, and so are
not counted again as planned cash payments in January, February or March. Note that depreciation is not
included in the cash payments because it is a non-cash item.
The retail business’s general and
administrative expenses budget
general and
administrative
expenses budget
Budget showing the
expenses and related
cash payments
associated with
expected activities
other than selling
For a retail business, the general and administrative expenses budget shows the expenses and related
cash payments associated with expected activities other than selling.
Examples of general and administrative expenses include administrative staff salaries, consulting
charges and the cost of renting office space. To prepare the general and administrative expenses
budget, the entrepreneur reviews past expenses (if they are available), identifies them as fixed or
variable, and adjusts them for current plans.
Case Exhibit 3.14 shows the general and administrative expenses budget for Café Revive for the
first quarter of 20X2. These expenses are all fixed, although general and administrative expenses can
Case Exhibit 3.14 General and administrative expenses budget
CAFÉ REVIVE
General and administrative expenses budget
First quarter 20X2
January
February
March
Quarter
Budgeted general and administrative
expenses:*
Rent expense
$ 330.00
$ 330.00
$ 330.00
$ 990.00
Salaries expense
$ 590.00
$ 590.00
$ 590.00
$1 770.00
Consulting expense
$
82.50
$
82.50
$
82.50
$ 247.50
Mobile and wifi expense
$
35.75
$
35.75
$
35.75
$ 107.25
Energy expense
$
52.25
$
52.25
$
52.25
$ 156.75
Total budgeted general and
administrative expenses
$1 090.50
$1 090.50
$1 090.50
$3 271.50
Budgeted cash payments for general
and administrative expenses
$ 760.50
$ 760.50
$ 760.50
$2 281.50
* Case Exhibit 2.13 (Chapter 2) shows Café Revive’s projected expenses for the month of January. Since these are fixed
expenses, Café Revive expects them to be the same for February and March.
† The $330.00 ($1090.50 – $760.50) difference between the total budgeted general and administrative expenses and the
budgeted cash payments for these expenses each month occurs because the monthly expenses ($330) related to the
planned December cash expenditures for rent are not counted again as cash payments.
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Chapter 3 Developing a business plan: Applied budgeting
also be variable expenses. As we discussed earlier, Café Revive allocates the total of certain monthly
expenses between selling activities and general and administrative activities. Recall that you and
Emily estimated that one-quarter of each of the expenses is tied directly to administrative activities.
The other three-quarters of each is tied to sales activities, and appears on the selling expenses
budget. These expenses are allocated to the general and administrative expenses budget as follows:
Rent
$1320 1/4 ¼ $330.00
Salaries
$2360 1/4 ¼ $590.00
Consulting
$ 330 1/4 ¼ $ 82.50
Mobile and wifi
$ 143 1/4 ¼ $ 35.75
Energy
$ 209 1/4 ¼ $ 52.25
Like the selling expenses budget, the general and administrative expenses budget includes a schedule
of budgeted cash payments for each month in the budget period. These cash payments are determined
according to the business’s payment policies. Café Revive plans to pay for all the expenses listed on the
general and administrative expenses budget in the month they occur, except for rent, which it paid for in
December.
The service business’s expenses budget
Service businesses do not have a purchases budget for inventory, since they are selling a service rather
than a product. Nor do they usually divide their budgeted expenses into two different budgets, one for
selling expenses and one for general and administrative expenses. Instead, in budgeting expenses, service
businesses simply prepare an operating expenses budget. Budgeting is a management accounting exercise
designed for internal control of the business by internal users of the information, so each business will
design a system of budgeting (and formats) that suits their particular business needs. Be prepared to be
flexible!
Remember that our discussion of cost behaviours in Chapter 2 noted that variable costs vary in total in
direct proportion to volume. Volume can refer to a variety of activities. One measure of volume used by retail
businesses is number of unit sales. Because they are selling a service, though, service businesses are very
labour-intensive. Salaries are a major expense for these businesses, and many of their other expenses vary with
the number of hours that employees work. Therefore, many service businesses use the number of hours that
employees work as a measure of volume. Regardless, service businesses have many of the same fixed expenses
as retail businesses, such as rent and advertising. Today, businesses are also increasingly aware that their
customers and the government expect them to be sustainable organisations, so they are devising methods of
accounting for such costs and ways to promote their views of sustainability to their customers.
Some businesses are trying to make potential clients or customers aware of their environmental policies
and commitment to sustainability by giving customers an option to offset their carbon imprints. For example,
Virgin Australia (http://www.virginaustralia.com/au/en) and Europcar (http://www.europcar.com.au) give
their customers a chance to opt to include, on top of their travel costs, a small charge that will be used by
these companies to offset carbon emissions.
Ethics and Sustainability
Cash management and the cash budget
The way in which a business manages its cash can be the difference between the business’s success and
failure. Cash management involves keeping an eye on the business’s cash balance to make sure that:
1 there is enough cash on hand to pay for planned operations during the current period
2 there is a cash buffer on hand
3 there is not too much cash on hand.
An insufficient cash balance can cause problems for a business. Without enough cash, a business will
have trouble operating at a normal level and paying its bills. In the most extreme case, an entrepreneur
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Accounting Information for Business Decisions
will no longer be able to operate the business at all because it will have failed. Therefore, a good
entrepreneur is always looking for long- and short-term financing sources – such as lines of credit at a
bank – that allow the business to borrow money as needed and loan guarantees from government
agencies such as the AusIndustry Programs https://www.business.gov.au and Support for Small
Business (http://www.innovation.gov.au/audience/business). A good entrepreneur also watches the
business’s cash balance to determine when to pay back the finance.
As we introduced in Chapter 2, a cash buffer means having some extra cash on hand (or available
through a line of credit) to cover normal, but unexpected, events. For example, an unexpected surge in
coffee sales would cause Café Revive to have to purchase more inventory than planned. A cash buffer
would help to cover this purchase. A business’s insurance policy would usually cover abnormal and
unexpected events, such as natural disasters or fires.
Too much cash on hand may seem like an odd problem to have because almost everyone would like to
have more cash. An excessive cash balance is a problem for a business, though, because this cash balance
is not productive. That is, cash earns nothing for the business unless the business invests it internally in
profitable projects, or externally in an interest-bearing account or in government or business securities
that earn dividends or interest. Therefore, a successful entrepreneur continually watches for good
investment opportunities – even short-run opportunities.
The retail business’s cash budget (projected cash flow
statement)
cash budget
Budget showing a
business’s expected
cash receipts and
payments and how they
affect the business’s
cash balance
operating activities
section
Section of a business’s
cash flow statement (or
cash budget) that
summarises the cash
receipts and payments
from its actual (or
planned) operating
activities
investing activities
section
Section of a business’s
cash flow statement (or
cash budget) that
shows the cash
receipts and payments
from its actual (or
planned) investing
activities
112
The cash budget shows the business’s expected cash receipts and payments, and how these affect the
business’s cash balance. The cash budget is very important in cash management. It helps the entrepreneur to
anticipate cash shortages, thus avoiding the problems of having too little cash on hand to operate the business
and to pay its bills. This budget also helps the business to avoid having excess cash that could be better used
for profitable projects or investments.
Besides helping the entrepreneur to anticipate cash shortages and excesses, the cash budget can also
help external users. For example, a potential lender (e.g. a bank) may want to evaluate the business’s cash
budget to see how the business plans to use the borrowed cash, and to anticipate whether and when the
business will have enough cash to repay the loan.
A business’s cash budget is similar in many respects to the cash flow statement we discussed in
Chapter 1. However, the cash budget shows the cash receipts (inflows) and cash payments (outflows) that
the business expects as a result of its plans (which is why it sometimes is called a projected cash flow
statement). On the other hand, a business’s cash flow statement reports its actual cash receipts and
payments. Like the cash flow statement (see Exhibit 1.12 in Chapter 1, and Chapter 9), a cash budget can
have three sections: it always has an operating activities section, and if the business plans for investing or
financing activities, the cash budget will have separate investing activities and financing activities sections.
The operating activities section of the cash budget summarises the cash receipts and payments the
business expects as a result of its planned operations. These expected cash flows come from the sales,
purchases and expenses budgets we discussed earlier. This section also shows the net cash inflows (excess
of cash receipts over cash payments) or the net cash outflows (excess of cash payments over cash receipts)
expected from operations. Adding the net cash inflows to the beginning cash balance (or subtracting the
net cash outflows) results in the expected cash balance from operations at the end of the budget period.
The investing activities section of the cash budget – if needed – shows the cash payments and
receipts the business expects from planned investing activities. A business’s investing activities include,
for instance, purchases or sales of land, buildings and equipment, or investments in the stocks and bonds
of governments or other businesses. Recall that Café Revive purchased $1650 worth of equipment in
December 20X1 and paid a cash deposit of $250. The deposit would have been an investing activity in
December’s budget. The remaining $1400 is still owed and is recorded as an investing activity in the cash
budget when the cash is paid. As it was a three-month loan, this amount is due to be paid in March 20X2
and is included in the cash budget for March.
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Chapter 3 Developing a business plan: Applied budgeting
Stop & think
Why do you think cash receipts from the sale of land, buildings and equipment, as well as
from dividends received on investments, are included in the investing activities section of the
cash budget?
Although investing activities can occur at any time, businesses usually have policies about investing
cash balances on hand in excess of a predetermined amount. For instance, based on planned operating
activities, you and Emily have decided that Café Revive should invest any cash on hand in excess of
$35 000 in any month.
The financing activities section of the cash budget – if needed – shows the cash receipts and
payments that the business expects from planned financing activities. A business’s financing activities
include borrowings and repayments of loans and investments and withdrawals by owners. The cash
budget helps a manager to decide when financing activities will be necessary. For example, in considering
the need for a cash buffer, you and Emily have decided that Café Revive will begin financing activities
when its cash balance drops below $7000.
Case Exhibit 3.15 shows Café Revive’s cash budget for the first quarter of 20X2. Notice that the cash
budget summarises the receipts and payments you saw in the budgets we discussed earlier. The cash
financing activities
section
Section of a business’s
cash flow statement (or
cash budget) that
shows the cash
receipts and payments
from its actual (or
planned) financing
activities
Case Exhibit 3.15 Cash budget projected cash flow statement
CAFÉ REVIVE
Cash budget
First quarter 20X2
January
February
March
Quarter
Cash receipts from sales of coffee gift
packs*
$ 9 163.00
$13 662.00
$11 055.00
$33 880.00
Cash receipts from sales of cups of
coffee
$ 4 840.00
$ 7 260.00
$ 3 850.00
$15 950.00
$14 003.00
$20 922.00
$14 905.00
$49 830.00
Cash flow from operating activities:
Cash payments for:
Purchases of gift packs
$ 1 430.00
$ 4 862.00
$ 6 864.00
$13 156.00
Supplies: cups of coffee
$
–
$ 1 133.00
$ 2 222.00
$ 3 355.00
Selling expensesà
$ 2 512.50
$ 2 512.50
$ 2 512.50
$ 7 537.50
General and administrative
expenses§
$
$
$
760.50
$ 2 281.50
Total payments
760.50
760.50
$ 4 703.00
$ 9 268.00
$12 359.00
$26 330.00
Net cash inflow (outflow) from operations
$ 9 300.00
$11 654.00
$ 2 546.00
$23 500.00
Cash (outflow) from investing activities
Purchase of equipment
$
$
–
$ (1 400.00)
$ (1 400.00)
Net increase (decrease) in cash
$ 9 300.00
$11 654.00
$ 1 146.00
$22 100.00
Add: Beginning cash balance{
$11 575.00
$20 875.00
$32 529.00
$11 575.00
Ending cash balance from operations
$20 875.00
$32 529.00
$33 675.00
$33 675.00
–
* From sales budget (Case Exhibits 3.7 and 3.8)
† From purchases budget (Case Exhibits 3.11 and 3.12)
‡ From selling expenses budget (Case Exhibit 3.13)
§ From general and administrative expenses budget (Case Exhibit 3.14)
{ The cash balance at the beginning of January is the result of cash receipts and payments in December: $22 000 capital –
rent $7920 – deposit for equipment $250 – coffee supplies $2255 ¼ $11 575.
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Accounting Information for Business Decisions
receipts amounts come from the sales budget, and the cash payments amounts come from the purchases
budget, the selling expenses budget, and the general and administrative expenses budget. The $11 575
beginning cash balance for January (and the quarter) is Café Revive’s cash balance at the end of
December, assuming preparations for the start of business go according to plan. The ending cash balance
for each month is also the beginning cash balance for the next month.
Café Revive has no investment activities planned for this quarter, since the expected cash balances in
the first three months of 20X2 are not more than $35 000. Also, none of the monthly cash balances
during the quarter are less than $7000, so no financing activities are planned during this quarter. Thus,
Café Revive’s cash budget does not include a financing activities section. We will discuss planned cash
flows from both investing and financing activities in Chapter 9.
The service business’s cash budget (projected cash
flow statement)
The cash budget of a service business is similar to that of a retail business, except that the service
business reports cash flow information that is obtained from fewer budgets.
In Café Revive’s cash budget, information came from the sales, purchases, selling expenses, and
general and administrative expenses budgets. A service business’s cash budget information, on the other
hand, would be obtained from its sales budget and its operating expenses budget. Information from these
budgets would be used in the same way that a retail business uses its information to prepare the projected
financial statements, as we discuss in the next sections.
The projected income statement
projected income
statement
Statement summarising
a business’s expected
revenues and expenses
for the budget period
A projected income statement summarises a business’s expected revenues and expenses for the budget
period, assuming the business follows its plans. Note that the projected income statement is not the same
as the cash budget. In Case Exhibit 3.7, we showed the relationship between sales revenues from credit
sales and cash collections from sales. If a business has credit sales, cash receipts occur later than the
related sales. The same thing can happen with expenses. Often, the cash payment for an expense occurs
later than the activity that causes the expense. For example, employees usually work before being paid. If
the work occurs late in March, the business may not pay the employees until early in April. The projected
salaries expense will appear on the projected income statement for the quarter that ends in March (since
the work occurred in March), but the projected cash payment will appear on April’s cash budget. In other
words, timing differences between the operating activities and the related cash receipts and payments
cause the differences between the projected income statement and the cash budget. The projected income
statement reports on the business’s planned operating activities, whereas the cash budget reports on the
expected cash receipts and payments related to those activities.
The projected income statement is important because it shows what the business’s profit will be if the
business follows its plans. At this point in the budgeting process, if the expected profit for the budget
period is not satisfactory, the entrepreneur may revise the business’s plans to try to increase the profit. In
Chapter 2, we discussed how a business uses CVP analysis to estimate how some changes in plans will
affect its profit. If, as a result of this analysis, the entrepreneur changes the business’s plans, then the
budgets are changed according to these revised plans.
Stop & think
What changes do you think an entrepreneur might make in a business’s plans to increase its
expected profit?
Case Exhibit 3.16 shows Café Revive’s projected income statement for the first quarter of 20X2. Café
Revive includes this income statement in its business plan. There are three differences between this
114
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Chapter 3 Developing a business plan: Applied budgeting
Case Exhibit 3.16 Projected income statement
CAFÉ REVIVE
Projected income statement#
For the quarter ended 31 March 20X2
Total sales revenue ($34 100 þ $15 950)
$ 50 050*
Less: Total variable costs
Cost of coffee gift packs sold
$
Cost of cups of coffee sold
$
(17 732)
(6 380)^
Total contribution margin
$(24 112)
$ 25 938
Less: Total fixed costs
Selling expenses
$10 984.50à
General and administrative expenses
$ 3 2 71.50§
Total fixed costs
Profit
$ (14 256)
$ 11 682
# This exhibit is shown in contribution margin format.
* From the sales budget (Case Exhibits 3.7 and 3.8).
† The 620 budgeted total sales in number of gift packs (Case Exhibit 3.6) times the $28.60 cost per gift pack (Case Exhibit 3.9).
^ The 2900 budgeted total sales in number of cups of coffee (Case Exhibit 3.7) times the $2.20 cost per cup of coffee
(Case Exhibit 3.12).
‡ From the selling expenses budget (Case Exhibit 3.13).
§ From the general and administrative expenses budget (Case Exhibit 3.14).
Note: For some businesses, selling expenses and general and administration expenses can be made up of both variable
and fixed costs, in which case the appropriate amount would be included in both the variable and the fixed sections of the
income statement. In Case Exhibit 2.13, we listed each expense separately and did not attempt to categorise them. Finally,
we do not list all the separate expenses here because they are shown in the selling expenses and general and
administrative expenses budgets.
statement and the income statement1 for internal decision makers that we showed in Case Exhibit 2.13
in Chapter 2. First, the income statement in Exhibit 3.16 is for the first quarter of 20X2. To keep the
discussion simple, we showed only the income statement for January in Exhibit 2.13. (If Café Revive had
chosen to show an income statement for each month of the first quarter in Exhibit 3.16, the January
profits of Exhibits 2.13 and 3.16 would be identical.) Second, in Exhibit 3.16 we group the fixed costs
into two categories: selling expenses and general and administrative expenses.
Notice that the amounts of most of the revenues and expenses in the projected income statement in
Case Exhibit 3.16 come from the budgets we discussed earlier. The format used in this income statement is
a contribution margin approach (splitting costs between fixed and variable – see Chapter 2), as it is an
income statement for management purposes and based on the budgets. External reports typically use
a different format (as discussed in Chapter 7). The variable cost of coffee gift packs sold, however, is
calculated by multiplying the budgeted number of gift packs sold during the quarter (620, from the
sales budget in Case Exhibit 3.7) by Café Revive’s cost per gift pack ($28.60, from the purchases budget in
Case Exhibit 3.11). So the cost of coffee gift packs sold that Café Revive listed on its projected income
statement is different from the cost of coffee gift packs purchased that Café Revive listed on its purchase
budget. This is because the number of gift packs sold is different from the number of gift packs purchased.
The variable cost of cups of coffee sold is calculated by multiplying the budgeted number of cups sold during
the quarter (2900, from the sales budget in Case Exhibit 3.8) by Café Revive’s cost per cup ($2.20, from the
purchases budget in Case Exhibit 3.12). So the cost of cups of coffee sold that Café Revive listed on
its projected income statement is different from the cost of cups of coffee purchased that Café Revive
1
We could rearrange this income statement so that it would look similar to the income statement for external users that we show
in Case Exhibit 2.13 in Chapter 2. To save space, we do not include the rearranged income statement in Case Exhibit 3.16.
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115
Accounting Information for Business Decisions
listed on its purchase budget. This is because the number of cups sold is different from the number of cups
purchased.
Many businesses preparing a projected Income statement will also produce a projected balance
sheet, which shows the assets (resources owned or controlled by the business), liabilities (amounts
owed by the business to external entities) and equity (the amount of owner investment in capital and
past profits) of the business, at a particular date (recall Exhibit 1.11). The balance sheet date will match
the end of the budget period, to match the end of the projected income statement. For Café Revive,
that would be the end of the first quarter, which is 31 March 20X2. Case Exhibit 3.17 shows Café
Revive’s projected balance sheet at that date. The assets include the cash according to the cash budget,
money still owed on the gift pack sales by customers (accounts receivable), the value of the ending
inventory (gift packs and coffee supplies), the three out of the original six months’ rent still paid in
advance, and the value of the equipment purchased less the estimated decline in the equipment value
(depreciation) for the period. The liability owed by the business is the amount owed for purchases. The
owner’s equity is the capital amount invested by the owner, Emily Della, plus the profit for the first
quarter, which belongs to the owner.
Case Exhibit 3.17 Projected balance sheet
CAFÉ REVIVE
Projected balance sheet
As at 31 March 20X2
Assets
Liabilities
Cash
$33 675 Accounts payable
Accounts receivable
$
Inventory
$ 2 607
Prepaid rent
$ 7 953
220
$ 3 960
Equipment
$1 650
Less: Accumulated depreciation
$ 477
Owner’s equity
$ 1 173 Capital – E.Delta
$22 000
Profit for quarter
$11 682
$41 635
$33 682
$41 635
Remember that a business should include in its budgeting any aspect of the business that is important
to its strategy. Increasingly stakeholders expect businesses to be concerned about their social and
environmental impacts, in addition to their economic results. This means that businesses need to plan for
these aspects of their business (and their related costs and benefits) as well. In global reporting therefore,
there is a recognition that, organisationally, businesses need to be more focused and accountable socially
and environmentally. Hence there is a move towards global reporting and guidelines regarding the
reporting for such costs. In 2006, the Global Reporting InitiativeTM (GRI) issued a paper called
Sustainability Reporting Guidelines, which outlined suggestions for content, disclosures and format of
sustainability reports. The Guidelines were replaced by GRI Standards in 2016, which came into effect on
1 July 2018. As it is something that Emily Della identified as being important to the business, Café
Revive needs to consider what sort of environmental and social expenses it might be incurring. Some
sample expenses of this type have been included in Exhibit 3.18. Note that some organisations will have
separate budgets for environmental and social expenses. To keep our budgets simple, we have not
included any figures for environmental and social expenses in this chapter. Ways in which businesses can
build sustainability into their corporate budgeting are considered in the section ‘Budgets: Business issues
and values’.
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Chapter 3 Developing a business plan: Applied budgeting
Exhibit 3.18 Environmental and social expenses budget
Recycling research
Maternity leave
Carbon emissions reduction project
Childcare centre expenses
Efficiency improvement
Product compliance
Site clean-up
Employee training
3.4 Using the master budget
in evaluating the business’s
performance
6
Managers of all types of businesses use budgets as planning tools. Budgeting is also a valuable tool for
evaluating how a business, division, department or team actually performed.b There has been considerable
research on the use of budgeting as a motivational tool, with most suggesting that staff participation in
the budgeting process and a sense of ‘ownership’ contribute to success.c Done well, it should be a tool for
communicating the aims of the business and aligning these with staff expectations and aspirations. A
good budget should promote a sense of teamwork, but this can be difficult to achieve. By analysing
differences between a business’s budgeted results and its actual results, a manager can determine where
plans went wrong and where to take corrective action next time. In this way, the budget becomes an
important tool for controlling the business. Done well, the budgeting exercise should motivate all those
involved in the business to achieve the aims of the business.
How can a manager use
a budget to evaluate the
performance of a business
and then use the results
of that evaluation to
influence the business’s
plans?
Finding differences between actual
and budgeted amounts
Comparing budgeted amounts to actual results is an important part of the budgeting process. By using the
budgets discussed in this chapter as benchmarks, a manager can evaluate the differences between the actual
performance of the business and its planned performance. By understanding why the differences occurred, a
manager can decide what actions to take for future time periods. For example, Case Exhibit 3.19 shows a
Case Exhibit 3.19 Comparison of actual versus budgeted amounts
CAFÉ REVIVE
Cost report
For the quarter ended 31 March 20X2
Budgeted
Rent expense
Difference:
Favourable/
(unfavourable)
Actual
$ 3 960
$ 3 960
–
7 080
7 080
–
Consulting expense
990
990
–
Advertising expense
693
693
–
Depreciation expense
477
477
–
Mobile and wifi
429
429
–
Energy
627
580
$47
$14 256
$14 209
$47
Salaries expense
Total
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Accounting Information for Business Decisions
cost report
Report showing a
comparison between a
business’s budgeted
and actual expenses for
an accounting period
comparison (called a cost report) between Café Revive’s budgeted and actual expenses for the first quarter of
20X2. A large business would usually divide its cost report into selling expenses, and general and
administrative expenses, and would also divide it by division, department, manager, product or some other
identifiable unit. This breakdown is not necessary for Café Revive’s cost report because it has only a few items.
With a quick glance at this cost report, you can see that Café Revive’s actual expenses were $47 less
than budgeted expenses in the first quarter of 20X2. You can even see that the difference between total
planned and actual expenses occurs because the energy expense was less than expected. However,
knowing that there are differences is not enough information for a manager to use in explaining the
differences and planning the next time period’s activities. It is at this point in the evaluation process that
a manager must use creative and critical thinking skills. A manager can learn about the causes of the
differences by asking questions and investigating further. As we discussed in Chapter 1, the answers to
these questions will generally lead to additional questions. The cost report gives the manager a starting
point from which to begin an investigation.
Learning why differences occur
While analysing the difference between the budgeted and the actual telephone and utility expenses, you and
Emily might ask yourselves questions such as those shown in Case Exhibit 3.20.
Case Exhibit 3.20 Reasons for differences between budgeted and actual expenses
Which of the monthly energy bills
was higher or lower than expected?
What other explanations are there
for the differences?
Why were these bills different from
what was expected?
Was there a difference because
Cafe´ Revive has just begun operations and
you had no previous experience to use in
estimating what the expenses would be?
Did the difference occur because of
selling activities or general and
administrative activities (or both)?
After formulating the questions you want answered, you and Emily can devise a strategy to find the
answers. Looking for them will require your creative thinking skills. Suppose Emily decides to start her
investigation by first looking at the monthly energy bills. If she finds minor differences between planned
and actual expenses for all the bills except the energy bill, then these can be attributed to her use of
estimates. Minor differences from estimates are to be expected, so there would be no need to plan any
correcting activities for the future. Suppose, however, that, in looking at the energy bill, Emily discovers
that the energy supplier has introduced a 10 per cent discount for business customers since the budget
was created. Before planning for the next quarter, you and Emily must ask another question: Will the
same discount be in effect next quarter? If so, you will use this information in your future planning and
budgeting activities, and the next master budget will include the 10 per cent decrease in Café Revive’s
planned energy expenses.
Stop & think
What questions do you think you and Emily should ask about the differences between
planned and actual supplies expenses?
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A manager can use information from the master budget to help identify the causes of differences
between budgeted and actual expenses, and then to decide what to change in the future. As you just saw,
an analysis of the causes of these differences may lead an owner or manager to make changes in future
budgets. On the other hand, the same analysis may lead the owner or manager to change future activities
rather than future budgets. For example, suppose packaging workers at DeFlava Coffee are working
overtime repackaging coffee gift packs because of a sudden decrease in the quality of purchased packaging
materials. Because of this unplanned problem, the actual salary expense for DeFlava Coffee will be higher
than its budgeted salary expense. An analysis of the cause of this salary difference may lead the packaging
manager to look for a new supplier of packaging materials.
Differences between planned and actual expenses can also be
positive. For example, Café Revive’s energy expense was less than
the budgeted expense. Suppose you and Emily based Café
Revive’s budgeted energy expense on a well-publicised planned
increase in electricity rates. If Trade and Investment Queensland
later turns down the rate increase, this would explain why Café
Revive’s actual expense was less than its budgeted expense. You
and Emily will use this rate information, which you noticed
because of your analysis of the difference between the planned
and the actual expenses, for future planning activities. Unless
circumstances change between this budget period and the next
budget period, you and Emily will use the old rate to budget Café
Revive’s energy expense.
At other times, differences between planned and actual
Do you think Hungry Jack’s estimate of Whopper sales would have
results can have both positive and negative consequences. affected its estimated sales of French fries?
Hungry Jack’s (http://www.hungryjacks.com.au) introduced its
‘Whopper’ burger as competition against McDonald’s Australia’s
(http://www.mcdonalds.com.au) ‘Big Mac’ burger. Let us assume that Hungry Jack’s estimated that it
would sell one million Whoppers per day. Let us also assume that the burger was so popular at that time
that Hungry Jack’s could have sold nearly 1.8 million per day – about 80 per cent more than it had
expected! Since Hungry Jack’s would have budgeted – and hence purchased materials – based on
anticipated sales, what impact would the extra sales have on Hungry Jack’s, both immediately and in the
future?
Business issues and values: Budgets
The accounting information included in budgets affects, and is affected by, business
decisions. In using this information for decision making, entrepreneurs must also consider other,
non-financial issues. For example, suppose a small new airline has entered a market dominated by a
large, well-established airline. To effectively compete, the new business determines that it must cut
7
What non-economic goals
might be included in Café
Revive’s budget?
costs. A look at the budget shows that one of the largest costs, and an easy one to reduce, is
maintenance costs on the fleet. When making the decision about whether to reduce maintenance
costs, the entrepreneur would need to consider whether reducing these costs now would drive up
Ethichs and Sustainability
future maintenance costs. More importantly, the entrepreneur would need to consider the safety of
the passengers and crew. In this case, the safety concern may outweigh the financial gain resulting
from reducing the maintenance costs.
As already discussed, a business should include in the budget all issues relevant to its business
strategy. The budget should reflect any non-economic aims of the organisation, although these may
also have an economic effect on the business. The issue of business sustainability is of increasing
concern to businesses and their stakeholders. Businesses can build sustainability into their
corporate budgeting and planning by following the five basic steps shown in Exhibit 3.21.
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119
Newspix/James Croucher
Chapter 3 Developing a business plan: Applied budgeting
Accounting Information for Business Decisions
Case Exhibit 3.21 Five basic steps to sustainability
120
1
Understand what is really meant by sustainability.
2
Define ‘sustainability’ for your organisation and determine the factors that are to be
included and excluded during planning and budgeting.
3
Determine your time horizon for achieving profitability.
4
Ensure that upper management’s definition of sustainability is understood widely
throughout the organisation and that it is embedded into corporate strategy and objectives.
5
Ensure that the performance management system reports and rewards initiatives related to
sustainability.c
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Chapter 3 Developing a business plan: Applied budgeting
STUDY TOOLS
Summary
3.1 Understand why budgeting is needed to align business activities with strategy.
1
How does a budget contribute to helping a business achieve its goals?
A budget helps a business by providing a financial description of the activities planned by the business to help it achieve its goals.
It also helps by adding order to the planning process, by providing an opportunity to recognise and avoid potential operating
problems, by quantifying plans and by creating a benchmark for evaluating the business’s performance.
3.2 Understand the difference in operating cycles between retail and service businesses.
2
Do the activities of a business have a logical order that drives the organisation of a budget?
The operating activities of a business make up what is called the business’s operating cycle, which is the average time it takes the
business to use cash to buy goods and services, to sell these goods to or perform services for customers, and to collect cash from
these customers. The order of activities, and the cash receipts and payments associated with these activities, influence how a
business organises its budget.
3.3 Understand that the interrelated budgets provide a framework for planning.
3
What is the structure of the budgeting process, and how does a business begin that process?
The master budget is the overall structure used for the financial description of a business’s plans. It consists of a set of budgets
describing planned business activities, the cash receipts or payments that should result from these activities and the business’s projected
financial statements (what the financial statements should look like if the planned activities occur). The budgeting process begins with
the sales budget because product or service sales affect all other business activities. By gathering various types of information, such as
past sales data, knowledge about customer needs, industry trends, economic forecasts and new technological developments, a business
estimates the amount of inventory (or employee time) to be sold (used) in each budget period. Cash collections from sales are planned
by examining the business’s credit-granting policies. Cash payments for expenses are planned by examining the business’s payment
policies.
4
What are the similarities and differences between the master budget of a retail business and that of a service
business?
For a retail business, the master budget usually includes a sales budget, a purchases budget, a selling expenses budget, a general
and administrative expenses budget, a cash budget and a projected income statement (some businesses may also include a
projected balance sheet). A service business does not have a purchases budget, and it usually has one operating expenses budget.
5
After a business begins the budgeting process, is there a strategy it can use to complete the budget?
A retail business follows a strategy similar to the following. After budgeting sales, the business plans the amount and timing of
inventory purchases. To budget purchases, the business examines the costs associated with inventory purchases and storage, as
well as the costs of not carrying enough inventory. It also considers its policy on required inventory levels. After budgeting
purchases, the business plans the cash payments for inventory purchases by reviewing its payment agreements with suppliers. To
budget expenses, the business must first determine the behaviours of these expenses. It budgets fixed expenses by evaluating
previous fixed expenses and then adjusting them (if necessary) according to the plans for the coming time period. It budgets
variable expenses by first observing what activity causes these expenses to vary and then calculating the total expenses by
multiplying the cost per unit of activity by the budgeted activity level. For a retail business, the activity level is usually sales. The
business budgets the cash payments for these expenses by reviewing the business’s policy on the payment of expenses. The
information for developing the cash budget comes from the other previously prepared budgets, as does the information for
creating the projected income statement.
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121
Accounting Information for Business Decisions
3.4 Know how the master budgeting is used to evaluate performance.
6
How can a manager use a budget to evaluate a business’s performance and then use the results of that
evaluation to influence the business’s plans?
A manager uses a master budget to evaluate a business’s performance by comparing the information in the various budgets with the
results that occur after the planned activities are implemented. The manager identifies the differences between budgeted and actual
results, and learns about the causes of these differences by asking questions and investigating further. Based on these investigations, a
manager may adjust the business’s activities and plans, as well as its future budgets.
3.5 Understand that a budget should include all key values of the business.
7
What key values of the business need to be taken into account in a budget
The budget needs to include staff welfare costs and the business needs to measure how effective these are. This may be done via
surveys or interviews. Quality products depend on quality suppliers, and this requires developing good relationships with suppliers
and working with them to provide the quality expected by customers. Identifying what adds value to the product through the eyes
of customers is also important, and again may require research and customer surveys, which should be included in the budget. The
results of such research should also inform future planning. A budget should seek to provide information on, and targets for, all
aspects of the business that are considered important for its success.
Environmentally friendly packaging requires designing products to minimise packaging, sourcing packaging that that is
appropriate (e.g. biodegradable) and investigating recycling, again working with suppliers and identifying customer concerns. This
may involve tracking non-economic information that is not captured by a traditional accounting system – for example, physical
weight of packing used.
8
What non-economic goals might be included in Café Revive’s budget?
Recall that Café Revive’s objectives included building a reputation for friendly service, quality products and environmentally
friendly packaging. In order for staff to maintain a positive attitude, they should feel involved in the budgeting process, so staff
training, welfare and retention are all important.
The budget needs to include staff welfare costs and the business needs to measure how effective these are. This may be done
via surveys or interviews.
Quality products depend on quality suppliers and this requires developing good relationships with suppliers, and working with
suppliers to provide the quality customers expect. Identifying what adds value to the product through the eyes of the customers is
also important, and again may require research and customer surveys, which should be included in the budget. The results of such
research should also inform future planning.
Environmentally friendly packaging also requires designing products to minimise packaging, sourcing packaging that is
appropriate (e.g. biodegradable) and investigating recycling, again working with suppliers and identifying customer concerns. This
may involve tracking non-economic information not captured by a traditional accounting system, for example physical weight of
packing used.
A budget should seek to provide information on, and targets for, all aspects of the business that are considered important for
its success.
Key terms
budget
management by exception
projected income statement
cash budget
master budget
purchases budget
cost report
operating activities section
sales budget
financing activities section
operating cycle of a retail business
selling expenses budget
general and administrative expenses budget
operating cycle of a service business
investing activities section
projected balance sheet
122
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Chapter 3 Developing a business plan: Applied budgeting
Online research activity
Here is an opportunity to gather information online about real-world issues related to the topics in this chapter. For suggestions
on how to navigate various businesses’ websites to find their financial statements and other information, see the related
discussion in the Preface.
u Go to http://www.business.gov.au and click on the ‘Business plans’ link to view the Business Plan Guide and Business Plan
Template. What is a cash flow forecast, and how does it compare with the cash budget that we discussed in this chapter? What
are the steps involved in preparing a cash flow forecast? How would preparing the budgets discussed in this chapter help an
entrepreneur in preparing a cash flow forecast?
u Go to http://www.business.gov.au and click on the ‘Business plans’ link then in the Business Planning section
look up the information on environmental, water and energy management. What are the benefits of
environmental management? What tips are there for saving energy?
Ethichs and
Sustainability
u Go to http://www.business.gov.au. How often should a business update its business plan? What are the
benefits to a business of keeping its business plan current?
u Go to https://www.nbs.net/articles/5-steps-for-building-sustainability-into-corporate-budgeting-and-planning. Looking at the
example from Africa, what do you think about HIV medication and its drain on long-term profits?
Integrated business and accounting situations
Answer the following questions in your own words.
Testing your knowledge
3-1
3-2
3-3
3-4
3-5
3-6
3-7
3-8
3-9
3-10
3-11
3-12
3-13
3-14
3-15
3-16
3-17
3-18
3-19
What is it about budgeting that adds discipline to the planning process?
If a problem comes to light during the budgeting process, what is the manager likely to do?
‘Budgeting serves as a benchmark for evaluation.’ Explain what this statement means.
Describe a master budget. Why might a master budget be different from one business to another?
How are the master budgets of a retail business and a service business similar to each other? How are they different from
each other?
Describe the operating cycle of a retail business. How are the operating cycles of a retail business and a service business
similar to and different from each other?
What are the considerations for an appropriate credit-granting policy?
Why must the sales budget be developed before any of the other budgets? Where does information for sales forecasts
come from?
If you have just finished budgeting sales for next year, what information will you need to be able to budget cash
collections from sales?
How does knowing forecasted sales help a manager develop a purchases budget? What else besides forecasted sales would
a manager have to know to complete the purchases budget?
When developing a selling expenses budget and a general and administrative expenses budget, why do you have to know
how expenses behave?
Why must you complete all the other budgets before you can develop the cash budget?
Why is it important to know about anticipated cash shortages ahead of time?
What is a cash buffer, and what is an example of a circumstance where a business could use one?
Why is having too much cash on hand a problem?
On the cash budget, why is the beginning cash balance for July the same as the beginning cash balance for the first
quarter of the year? Why is the September ending cash balance the same as the first quarter’s ending cash balance? How
do you determine the first quarter’s cash receipts from sales?
How is the cash budget similar to a cash flow statement? How are they different from each other?
Why is the cash budget not the same as the projected income statement? What items included on the projected income
statement are not included on the cash budget?
Why do you think budgeting is described as a cycle? How is that related to the control of the business?
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123
Accounting Information for Business Decisions
3-20
3-21
3-22
In evaluating a business’s performance, why do managers or owners need to learn the causes of differences between actual
and budgeted amounts?
Can you think of some circumstances where the budget or the budget-setting process might demotivate
rather than motivate employees?
Ethichs and
Why should a business consider sustainability in its budget?
Sustainability
Applying your knowledge
3-23
3-24
3-25
3-26
3-27
Wivenhoe Wines is based in the Brisbane Valley and makes boutique wines sold online to customers on credit (70% of sales)
and to customers visiting the vineyard and purchasing bottles of wine at the cellar door for cash (30% of sales). Wivenhoe
Wines is preparing a sales budget for the October–December quarter. Sales are estimated at 100 bottles in October, 200 bottles
in November and 350 bottles in December. The average selling price per bottle is $30. Credit customers pay 95 per cent in the
month after sale. The remaining credit sales are bad debts. September sales were 220 bottles.
Required:
a Prepare the Sales Budget and a schedule of cash collections for the October–December quarter (each month and quarter
total).
b Explain why bad debts are not included in the cash collections. Would these appear in any other financial report?
Jaime’s Hat Shop sells hats with school logos on them for $22 each. This year, Jaime’s expects to sell 350 hats in August,
300 in September, 400 in October, 800 in November, 1040 in December and 750 in January. On average, 25 per cent of
customers purchase on credit. Jaime’s allows those customers to pay for their purchases the month after they have made
their purchases.
Required:
Prepare a sales budget for Jaime’s Hat Shop for the second quarter of this financial year. Include the expected cash
collection schedule for the second quarter of this financial year.
Refer to 3-24. Jaime’s business policy is to plan to end each month with an ending inventory equal to 20 per cent of the
next month’s projected sales. Jaime’s pays $8 for each hat that it purchases. Jaime’s and its supplier have an arrangement
that allows Jaime’s to pay for each purchase 60 days after the purchase.
Required:
Prepare a purchases budget for the second quarter of this financial year for Jaime’s Hat Shop.
Refer to Question 3-24. Assume Jaime’s ended the first quarter of this financial year with 60 hats on hand.
Required:
a Notice that Jaime’s ended the first quarter with less than 20 per cent of projected sales for October. What do you
think accounts for the difference?
b How many hats should Jaime’s purchase in October?
Refer to Question 3-24. Jaime’s Hat Shop expects to incur the following expenses for each month of the second quarter of
this financial year:
Rent (30% general and administrative, 70% selling)
$1 200
Utilities (30% general and administrative, 70% selling)
600
Advertising
400
Salaries (50% general and administrative, 50% selling)
Commissions (for each hat sold)
3-28
124
5 000
2
In April, Jaime’s had prepaid the rent for the whole year. Jaime’s plans to pay for all the other expenses in the month
they occur.
Required:
a Prepare a selling expenses budget for the second quarter of this financial year.
b Prepare a general and administrative expenses budget for the second quarter of this financial year.
Refer to Questions 3-24 to 3-27. Jaime’s Hat Shop ended September with a cash balance of $10 343.
Required:
Prepare a cash budget for the second quarter of this financial year.
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Chapter 3 Developing a business plan: Applied budgeting
3-29
3-30
3-31
Refer to Questions 3-24 to 3-27.
Required:
Prepare a projected income statement for the second quarter of this financial year.
Robert and Gwen are partners in a new superannuation search business called Super Lost and Found, which will begin
operations in December. The business finds lost accounts from superannuation companies where the super fund no longer
knows the current contact details of the holder(s) of the superannuation policy. Robert estimates that the employees of
Super Lost and Found will spend 500 hours in December, 700 hours in January, 800 hours in February and 725 hours in
March working on finding current contact information for Super Lost and Found’s clients. Super Lost and Found will bill
each of its clients at the end of the month, charging $400 per hour spent working for that client during the month. On
average, 60 per cent of the billings for any month will be collected during the following month, 25 per cent during the
second month following the billing, and 15 per cent during the third month following the billing.
Required:
Prepare a sales budget and expected cash collection schedule for Super Lost and Found for the quarter (January through
March).
Maid Company sells a single product for $12 per unit. Sales estimates (in units) for the last four months of the year are as
follows:
Units
3-32
September
50 000
October
55 000
November
45 000
December
50 000
Ninety per cent of Maid’s sales are credit sales, and it expects to collect each account receivable 15 days after the
related sale. Assume that all months have 30 days.
Required:
Prepare a sales budget for the last three months of the year, including estimated collections of accounts receivable.
Helena’s Chocolates is preparing a sales budget for the quarter (3 months) April–June 202X for their gift chocolate box
product and a schedule of cash collections. The majority of their sales are cash via their retail shop (80%), but they also supply
chocolate boxes to hotels (20% of their sales) on credit. Credit customers (accounts receivable) may claim a 5% discount if
they pay within the month of sale.
Accounts receivable at 31st March were $64 000. In the past, 10 per cent of credit customers have been able to claim the
discount, with the remainder paying in the month following sale.
Sales in units for April-July 202X are estimated as 60 000, 70 000, 80 000 and 80 000 chocolate boxes. The selling
price per box is $6.
Boxes of chocolates are purchased for $2.50 and Helena’s has a policy of keeping sufficient ending inventory for 60 per
cent of the following month’s sales in units. Purchases are paid for in the month following purchase. Accounts payable for
chocolate boxes were $170 000 on 31st March.
Required:
a Prepare the sales budget for the boxes of chocolate, including estimated cash receipts for April–June 202X. Show each
month separately and a total for the quarter. (Hint: split the sales between cash and credit; then for the credit sales spit
the sales between those able to claim the settlement discount, and those who receive no discount).
b Prepare a purchases budget for the boxes of chocolate (in units and then dollars), and a schedule of cash payments for
purchases.
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125
Accounting Information for Business Decisions
3-33
The sales budget for Merita Medallion Company shows budgeted sales (in medallions) for December and the first four
months of next year:
Medallions
December
January
40 000
February
90 000
March
April
3-34
100 000
150 000
50 000
Required:
Prepare a budget for the number of medallions Merita needs to purchase in the first three months of next year for each of
the following two independent situations:
a The business’s policy is to have inventory on hand at the end of each month equal to 15 per cent of the following
month’s sales requirement.
b The business’s policy is to keep each month’s ending inventory to a minimum without letting it fall below 5000
medallions. Assume that the 1 December inventory has 5000 medallions and that the business’s only supplier is
willing to sell a maximum of 125 000 medallions to the business per month.
The sales budget for Astra Trophy Company shows budgeted sales (in awards) for December and the first four months of
next year:
Trophies
December
January
40 000
February
90 000
March
April
3-35
100 000
150 000
50 000
Required:
Prepare a budget for the number of trophies Astra needs to purchase in the first three months of next year for each of the
following two independent situations:
a The business’s policy is to have inventory on hand at the end of each month equal to 20 per cent of the following
month’s sales requirement.
b The business’s policy is to keep each month’s ending inventory to a minimum without letting it fall below 10 000
trophies. Assume that the 1 December inventory has 10 000 trophies and that the business’ only supplier is willing to
sell a maximum of 130 000 trophies to the business per month.
Total Pet Shop sells pet food in 20-kilogram bags for $20 per bag, which it buys from its supplier for $12 per bag. Total
estimates that its sales of bags of pet food for the second quarter of the year will be as follows:
Bags
April
2 400
May
2 800
June
3 000
Total’s policy is to have bags of pet food on hand at the end of each month equal to 15 per cent of the next month’s
budgeted sales (bags). It expects to have 240 bags of pet food on hand at the end of March and to sell 3300 bags in July.
Total expects its cost of purchases to be $26 340 in March; it pays for its purchases in the following month.
Required:
a Prepare Total’s purchases budget for bags of pet food for the second quarter of this year.
b How many bags of pet food did Total expect to sell in March?
126
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Chapter 3 Developing a business plan: Applied budgeting
3-36
3-37
Fred’s Electronics Machines estimates its monthly selling expenses as follows:
Advertising
$22 000 per month
Sales salaries
$18 000 per month
Sales calls on customers
$70 per machine
Commissions paid to sales personnel
$100 per machine
Delivery
$40 per machine
Assume that Fred pays selling expenses in the month after they are incurred. Based on the current plans of Fred’s sales
department, monthly sales estimates are as follows: March: 80 units; April: 90 units; May: 100 units; June: 120 units.
Required:
Prepare a selling expenses budget for the June quarter for Fred’s Electronics Machines.
Well Feed Company sells pet food in 10-kilogram bags for $12.40 per bag. Sales estimates for the first three months of the
year are as follows:
Bags
3-38
3-39
January
20 000
February
17 000
March
15 000
December sales were 16 000 bags of pet food. Well Feed’s desired ending inventory of pet food each month is 25 per
cent of the next month’s sales estimate (in bags). All sales are cash sales. Well Feed purchases bags of pet food at $9.40
per bag and pays for them the month after the purchase. General and administrative expenses total $18 000 per month
(including $10 000 depreciation), and Well Feed pays for these expenses (except for depreciation) in the same month they
are incurred. January’s current liabilities (all to be paid in January) total $35 500. The business’s cash balance on
1 January is $38 000.
Required:
Prepare a cash budget for each of the first two months of the year.
Refer to 3-37.
Required:
Prepare a projected income statement for Well Feed for February. How do you explain the differences between the income
statement and the cash budget?
Taylor Pty Ltd is based in Brisbane and sells ’glamping’ yurt tents imported from China at a cost of $150 each plus import
duties and other costs of $60. These purchase and import costs are paid cash in the month that they incur and are not
expected to change in the next six months. Taylor Pty Ltd sold 1500 yurts per month from July to September, but intends
spending $1500 per month on advertising from October to December inclusive in the lead-up to the Australian summer.
As a result, the company expects that sales will increase to 3000 yurts in October and then by 200 units per month until
May the following year when they are expected to decrease to 2000 yurts. Currently yurts sell for $480 but the price will
be increased in the lead-up to Christmas with the selling price increasing to $500 in November and December and then
reverting to $480 in January. Yurts are packaged and sent to customers by courier at a cost of $30 each (for which the
customers pay in addition to the price of the tent, so it is added to their invoice). Taylor Pty Ltd has an account with the
courier company and pays the delivery costs the month following delivery. Other fixed costs are expected to be $3000 per
month for the next six months, paid in the month of expenditure. Sales are 60 per cent cash and 40 per cent credit. Credit
sales customers pay 80 per cent in the month following sale and 20 per cent in the month after that. To prevent loss of
sales due to stock outs, Taylor Pty Ltd has a target ending inventory level of 20 per cent of the next month’s sales in
units. Taylor Pty Ltd’s bank balance at 1 October is $100 000.
Required:
Prepare the following budgets for the October–December quarter (each month and quarter total):
a sales budget and a schedule of cash collections
b purchases budget
c cash budget.
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127
Accounting Information for Business Decisions
Making evaluations
3-40
Suppose you are a banker, and the controller of a small business asks you for a short-term $10 000 loan due in 120 days.
Interest on the loan would be 12 per cent, due when the loan is paid back. To support his request, he gives you the
following information from his business’s cash budget for the next quarter:
January
February
March
Quarter
Cash flow from operations:
Cash receipts from sales
$20 000
$14 400
$13 600
$48 000
$15 000
$10 800
$10 200
$36 000
Selling expenses
3 300
3 300
3 300
9 900
General and administrative expenses
1 650
650
650
2 950
Total payments
$19 950
$14 750
$14 150
$48 850
Net cash inflow (outflow) from operations
$
$ (350)
$ (550)
$ (850)
Cash payments for:
Purchases
50
Cash flow from investments: Cash receipt
from sale of equipment
Net cash inflow (outflow) from operations and
investments
Add: Beginning cash balance
Ending cash balance from operations and
investments
3-41
128
3 000
$
3 000
50
$ 2 650
$ (550)
$ 2 150
4 880
4 930
7 580
4 880
$ 4 930
$ 7 580
$ 7 030
$ 7 030
Required:
a What is your first reaction?
b Before making your decision, what else would you like to know about this business? Could any of what you would like
to know be found in any of the business’s other budgets or financial statements? What other budgets or statements
would you like the owner to provide for you? What information would you hope to get from each of these budgets or
statements?
c What other information would help you make your decision?
d Can you think of any circumstances in which it would be a good idea to loan this business $10 000?
e Depending on the information you are able to get, what alternatives are there to loaning or not loaning this business
$10 000?
Jimmy, Matt and Andy are business partners who own Jimmy/Matt/Andy’s Beach Wear. Jimmy/Matt/Andy’s
arrangement with all of its clothing suppliers allows it to pay for its merchandise purchases one month after the purchases
have been made. About 15 per cent of the business’s customers make purchases on credit. These customers pay for their
purchases one month after they have made their purchases. All the partners agree that a bank loan would allow Jimmy/
Matt/Andy’s to revamp the shopfront (perhaps causing more customers to want to come inside and shop). The partners
are having a disagreement, however, about the cash budget that they plan to include in their loan application package.
Jimmy and Andy believe that the budget should be revised to present the bank with the most positive projected cash
flows. To accomplish this revision, they are suggesting that on the cash budget, payments for purchases be shown two
months after the purchases have been made, instead of one month after they have been made, as agreed to by Jimmy/
Matt/Andy’s suppliers. Jimmy and Andy are also suggesting that cash receipts from credit customers be budgeted in the
same month as the related sales rather than one month later, even though they expect these customers to wait a month
before paying for their purchases. Matt thinks the budget should reflect the partners’ actual expectations. The partners
have come to you for advice.
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Chapter 3 Developing a business plan: Applied budgeting
3-42
3-43
3-44
Required:
a What ethical issues are involved in this decision?
b If the partners make the revisions, what effect will the revisions have on (i) the sales budget; (ii) the purchases budget;
(iii) the cash budget?
c Who stands to gain and who stands to lose by this budget revision? Is the gain or loss temporary or permanent, short
term or long term?
d How might the bank be hurt by the changed budget? How might the business be hurt by the changed budget?
e Since the budget represents a plan of action, how might the changed budget affect the activities of the business during
the budget period?
f Are there other alternatives to choose from apart from changing the budget or not changing the budget?
g What do you recommend that the partners do?
Assume that a business collects two-thirds of its sales revenue in the month of sale and the remaining one-third in the
following month.
Required:
a How much revenue has the business actually earned in the month of sale?
b Should the business record revenue on the income statement in the month when it collects the cash or when the work
to earn the revenue was done?
c What are your reasons for choosing one alternative over the other? What are your reasons for not choosing the other
alternative?
The airline industry is very competitive – management is under constant pressure to improve business profits. Ideas that
could improve profits include the following:
a increasing the price of tickets
b reducing the number of flight attendants
c reducing the number of flights on which meals are served
d serving smaller meals or serving snacks instead of meals
e limiting the size of – or eliminating – salary increases
f reducing the number of baggage handlers.
Required:
For each of these ideas, describe the effect the idea would have on each of the budgets and on the projected financial
statements. What other issues should management consider in deciding whether to implement any of these ideas?
Bill Morgan is the manager of the sales department of Rise & Shine Company, which sells deluxe bread makers. At the
beginning of each month, Bill estimates the total cost of operating the department for the month. At the end of the
month, he compares the total estimated costs to the total actual costs to determine the difference. If the difference is
‘small’, he doesn’t investigate any further because he prefers to spend his time on ‘more important’ issues.
At the beginning of April, Bill estimated that the total operating costs of the sales department would be $60 500. For
April, actual operating costs were $60 400. At the end of April, Bill says, ‘The sales department is doing pretty well. We
came in $100 under budget for the month.’
Alice Hoch, the CEO of the business, has come to you for help. She says, ‘I am concerned that we are not doing enough
analysis of our costs, and I need your assistance. Start with the sales department and prepare a cost report for me to help
me review costs for April. You can have whatever information you need.’
Upon investigation, you find the sales department was expected to sell 500 units (bread makers) in April. Based on
these projected sales, its budgeted fixed costs were as follows:
Advertising: $18 000
Salaries: $25 000
Budgeted variable costs were $25 commission per unit sold and $10 delivery cost per unit sold.
You determine that, during April, 500 units were sold and the sales department spent $19 300 on advertising and
$22 600 on salaries. It also paid the $25 commission per unit sold and paid $6000 for delivering the 500 units.
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Accounting Information for Business Decisions
3-45
3-46
3-47
Required:
Write a report for the CEO that:
a includes a cost report for the sales department that compares budgeted costs to actual costs for April
b identifies the questions you think the CEO should ask to analyse any differences you find
c suggests some potential answers to the questions raised.
Joe Collagen is the CEO of a small retail business that sells a skin-smoothing lotion. The business has been operating for
several years. Joe keeps meticulous records of his actual operating activities, including monthly sales, purchases and
operating expenses, as well as the related cash receipts and payments. However, Joe has never prepared a master budget
for the business. He comes to you for help, saying, ‘My profits have been slowly decreasing, and I don’t know why. Also,
sometimes, when I least expect it, the business runs short of cash and I have to invest more into it. I’ve heard that
preparing a master budget is a good thing to do, but I don’t know what is involved or where to begin.’
Required:
Prepare a report for the CEO that:
a explains what budgets and projected financial statements are included in a master budget
b clearly specifies how he would use the information from his previous actual operating activities to develop each of
these budgets and the projected income statement.
Steve and Tammy are thinking of opening a fitness centre with facilities for aerobics, weight training, jogging and lap
swimming, as well as dietary and injury consultation. They plan to buy land and build their facility near a new shopping
centre. They want to employ a director, an assistant director, experts to supervise members in each fitness area, and
numerous consulting dietitians and sports medicine professionals. They hope to have the entire facility, including an
outdoor all-weather track and an indoor swimming pool, completed by the end of the year. They believe that it will be
important to have the facility fully equipped and staffed before they begin taking memberships. Although their estimates
indicate that the fitness centre can be profitable if they can establish a growing membership over the first five or six years,
many small businesses in town have failed because of cash flow problems (excess of cash payments over cash receipts).
Before committing themselves to this venture, Steve and Tammy have come to you for advice and for help in preparing a
cash budget.
Required:
Write Steve and Tammy a memo explaining why they might have cash flow problems during their early periods of
operations. Show them how they can identify these cash flow problems through careful cash budgeting. Make a few
suggestions that might help them reduce such problems if they do decide to open the fitness centre.
The owner of the small business Wivenhoe Wines has completed a report analysing the results of the business for the
quarter ended 31st December. He has compared the actual results with the original budget for the quarter. As budgets are
only estimates, the business has a policy of not investigating differences between the actual and budgeted figures
(variances) of less than $1,000. None of the variances is greater than $1,000, so the owner believes the results are
reasonable, even though profit is $850 less than planned.
Wivenhoe Wines
Income statement Analysis
For the quarter ended 31st December
Oct-Dec Actual
Sales
Variable costs
Oct-Dec Budget
Variance
19 600
19 500
100
5 950
5 200
750
13 650
14 300
650
Fixed costs
4 000
3 800
200
Profit
9 650
10 500
850
Contribution margin
You have discovered that the original budget expected sales of 650 bottles of wine for the quarter, but in fact 700 bottles
were sold. You are concerned that, given 700 bottles were sold, the profit should have been greater than budgeted, not
less. Can you think of a way of presenting the report that would improve the analysis?
130
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Chapter 3 Developing a business plan: Applied budgeting
Dr Decisive
Yesterday, you received the following letter for your advice column in the local paper:
Dear Dr Decisive,
Please help me persuade my mother to budget! She says that life is short and that she probably won’t live
long enough to enjoy her savings. The trouble is that she is only 45, and even though I have pointed out
that the average life expectancy in Australia is over 80, she can’t see the point in budgeting when ’the
future is too unpredictable’. ’How can you plan for the unexpected?’ she says. ’Bills can vary too much.
How could I know when the car is going to need repairs and how much that will be?’So she uses her credit
card to pay for unexpected items and then can’t afford to pay it off and the interest and repayments
are getting higher. She won’t listen to me, but she reads your column and would take your advice seriously.
‘Dwindling Inheritance’
Required:
Meet with your Dr Decisive team and write a response to ‘Dwindling Inheritance’.
Endnotes
a
Di Bella Coffee online shop. http://dibellacoffee.com/shop. Accessed 15 May 2017.
Shields, JF & Shields, MD (1998) ‘Antecedents of participative budgeting’. Accounting, Organizations and Society, 23(1), 49–76;
Searfoss, DG & Monczka, RM (2017) ‘Perceived participation in the budget process and motivation to achieve the budget’,
Academy of Management Journal, 16(4), 541–54.
c
Based on Network for Business Sustainability (2012) ‘5 steps for building sustainability into corporate budgeting and planning’.
http://nbs.net/knowledge/5-steps-for-building-sustainability-into-corporate-budgeting-and-planning. Accessed 14 April 2017.
b
List of company URLs
u
u
u
u
u
u
u
u
u
AusIndustry Programs: https://www.business.gov.au
Di Bella Coffee: http://dibellacoffee.com
Europcar: http://www.europcar.com.au
Hungry Jack’s: http://www.hungryjacks.com.au
Kmart: http://www.kmart.com.au
McDonald’s Australia: http://www.mcdonalds.com.au
Sanitarium: https://www.sanitarium.com.au
Support for Small Business: https://www.industry.gov.au/strategies-for-the-future/boosting-innovation-and-science
Virgin Australia: http://www.virginaustralia.com/au/en
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131
4
THE ACCOUNTING SYSTEM:
CONCEPTS AND APPLICATIONS
‘Profits are the mechanism by which society
decides what it wants to see produced.’
Henry C Wallicha
Learning objectives
After reading this chapter, students should be able to do the following:
4.1 Understand how to interpret and evaluate financial accounting
information in order to make informed decisions.
4.2 Understand the basic concepts and terms that help identify and
record the activities of a business.
4.3 Describe the basic components of the accounting equation:
assets, liabilities and owner’s equity.
4.4 Understand the impact that individual transactions have on the
accounting equation.
4.5 Define revenue and expenses and expand the accounting
equation to include the impact of revenue and expenses on
net income.
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Chapter 4 The accounting system: Concepts and applications
4.6 Identify types of adjusting entries and why they are necessary
at the end of the financial period.
4.7 Compile basic financial reports from the running totals in the
accounting equation.
Understanding the learning objectives is assisted in the chapter by asking key questions:
Key questions
1
Why do managers, investors, creditors and others need information about the operations
of a business?
2
What are the basic concepts and terms that help identify the activities recorded by the
accounting records of a business?
3
What do users need to know about the accounting equation for a business?
4
Why are at least two effects of each transaction recorded in a business’s accounting system?
5
What are revenues and expenses, and how is the accounting equation expanded to
record these items?
6
What are the accounting principles and concepts related to net income?
7
Why are adjustment entries necessary at the end of a financial period?
8
Is it possible to prepare basic financial reports for a business from the running totals of the
accounting equation?
Do you have a system for keeping track of your financial activities? Do you plan your monthly cash receipts
and payments by using a budget, as described in the previous chapter? When you get your wage or salary, do
you always review it to ensure you have been paid correctly for the hours that you worked? Do you record
every bill you pay, and keep a running total of the amount you have in your bank account? At the end of each
month, do you check all entries on your bank statement? When you charge something on your credit card, do
you always check the amount on the receipt before you sign it? Do you keep your credit-card receipts and
compare them with the charges on your monthly credit card statement before you pay your bill? When you pay
your landlord, do you always pay your rent at the beginning of the month? Do you have your bank
automatically deduct your car payments from your savings account? Do you pay for your car insurance soon
after you get the bill? At the end of each month, do you compare your actual receipts and payments with what
you budgeted to see how you stand? If you answered yes to the majority of these questions, then you are
already managing the financial aspects of your life quite well.
After you graduate, you may want to become a manager or owner of a business. As we discussed in
Chapters 2 and 3, accounting methods, such as cost–volume–profit (CVP) analysis and budgeting, help
managers to carry out the planning, operating and evaluating activities of a business. However, managers
must also keep track of the business’s operations in order to evaluate its performance, as well as their
own performance as managers. To do this, managers develop and use an accounting system. For example,
an accounting system shows managers the total value of products sold in a certain period of time, what
cash payments have been made, whether the business is staying within its budgets and, more particularly,
whether the business is generating sufficient cash flow.
Managers are not the only people interested in the operations of a business. External users need
information about the business’s operations to help them make decisions, such as whether they want to
invest in or lend money to the business. In this chapter, we will discuss the role of financial accounting in
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Accounting Information for Business Decisions
decision making, explain the basics of the financial accounting process and illustrate how the figures
provided by the financial accounting process support the day-to-day decisions that managers or business
owners must make.
4.1 Financial accounting
information and decision making
The main function of recording and accounting for business activities is to provide financial information
that is useful in making decisions. Let’s return to our discussion of DeFlava Coffee Corporation, the coffee
manufacturer, to see why external users need accounting information. As you can imagine, it takes lots of
coffee beans to make good coffee. Suppose for a moment that you are the CEO of Green Trees Coffee
Farm, and that DeFlava Coffee is considering a purchase of coffee-bean supplies from your business.
DeFlava wants to make bulk purchases on credit and pay for them 30 days later when it has collected
money from its customers for coffee products that have been supplied.
Stop & think
As CEO of Green Trees Coffee Farm, how would you initially react to this request? Why?
What facts may change your mind?
1
Why do managers,
investors, creditors and
others need information
about the operations of a
business?
Although your immediate response may be to sell the coffee beans to DeFlava Coffee, you should
think carefully before agreeing to the credit (buy now and pay later) arrangement. Certainly, businesses
like to make sales. However, increasing sales by allowing credit is a good decision only if you are
reasonably sure that credit customers will pay their bills. If DeFlava doesn’t pay its bills, Green Trees
Coffee Farm will have given up some of its resources and have nothing to show for it.
The four-step problem-solving process we discussed in Chapter 1 provides an excellent framework for
making decisions of a financial nature, and for analysing the credit decision being considered here. You’ve
already taken the first step – recognising that the problem is to decide whether to sell coffee beans to
DeFlava Coffee on credit. You now can move on to the second step: identifying your business’s alternatives.
You might decide not to extend credit to DeFlava, to extend credit under stricter or more lenient terms or
to agree to the original request.
The third step, evaluating each alternative by weighing its advantages and disadvantages, helps you to
decide which alternative best helps your business meet its goals of remaining solvent and earning a
satisfactory profit. The alternative you choose will depend partly on your business’s ability to extend credit
and on its existing credit policies. When you perform this step, financial accounting information about
DeFlava Coffee will play a big role in helping you to determine how good a customer DeFlava will be.
Case Exhibit 4.1 shows a simplified income statement and a simplified balance sheet for DeFlava
Coffee Corporation for the first quarter of 20X1.1 When you analyse these financial statements, you learn
from the income statement that during the most recent quarter DeFlava earned $18.1 million of revenue
from selling coffee and made $720 000 net income. From the balance sheet, you learn that on 31 March
20X1, DeFlava had $1.2 million cash in the bank, inventory (stock of coffee) of $1.3 million and other
assets (trucks, factory, etc.) totalling $16.8 million, and that it owed $3 million to suppliers and $2
million to the bank. Each of these items should affect the specific credit terms, if any, that you are willing
to offer. After evaluating the alternatives, you are ready to make a decision about DeFlava’s credit request.
This is just one example of how financial accounting information can help external decision makers
choose whether or not to do business with another business. Another is when a banker studies a
business’s financial statements to decide the conditions for granting a loan. Businesspeople routinely
1
For simplicity, we assume here that DeFlava Coffee sells only one type of coffee. We will relax this assumption in later
chapters. Additionally, DeFlava Coffee’s actual financial statements have many more items, which we don’t show here because
you have not yet studied them. We will show more complete financial statements in later chapters.
134
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Chapter 4 The accounting system: Concepts and applications
Case Exhibit 4.1 Income statement and balance sheet
DEFLAVA COFFEE CORPORATION
Income statement
For quarter ended 31 March 20X1
(in thousands of dollars)
Revenues:
Sales revenue
$ 18 100
Expenses:
Cost of sales
$11 500
Selling expenses
3 460
General and administrative expenses
1 940
Total expenses
(16 900)
Income before income taxes
$ 1 200
Income tax expense
(480)
Net income
$
720
DEFLAVA COFFEE CORPORATION
Balance sheet
31 March 20X1
(in thousands of dollars)
Assets
Cash
Liabilities
$ 1 200 Accounts payable (suppliers)
Inventories
$ 3 000
1 300 Loan payable (bank)
Other assets
2 000
16 800 Total liabilities
$ 5 000
Shareholders’ equity
Total shareholders’ equity
Total assets
$19 300 Total liabilities and shareholders’ equity
$14 300
$19 300
make decisions like these. In each case, financial statements provide information that is important for
solving business problems.
Making good decisions based on information in financial statements assumes that there is agreement about
what is included in those statements and about how the amounts are measured. Without agreement on what
accounting information the balance sheet, income statement and cash flow statement should contain, the
statements would essentially be useless. If every business defined and measured financial statement items such
as assets, liabilities, revenues and expenses differently, there would be no way to compare the information of
one business with that of another.
Discussion
What difficulties do you think would be caused if each Australian state and territory defined
traffic laws differently (for example, laws stipulating which side of the road to drive on) and
used different traffic signs?
The generally accepted accounting principles (GAAP) that we introduced in Chapter 1 were developed to
overcome this problem by setting rules for businesses to follow when they prepare financial statements. Thus, if
you know that a business’s financial statements are prepared according to GAAP, and you know what rules are
included in GAAP, you can confidently use the information in the business’s financial statements for your
decision making. The rest of this chapter will provide you with a basic understanding of the financial accounting
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135
Accounting Information for Business Decisions
process. This process provides the information a business needs to prepare financial statements according to
GAAP. Once you have learned some fundamental concepts, we will discuss how the accounting process
accumulates and reports information about a business’s activities. In addition, accounting standards prescribe
rules for the measurement and disclosure of items reported in the financial statements. Accounting standards
are issued by bodies such as the Australian Accounting Standards Board (AASB); more recently, many countries
have adopted the International Financial Reporting Standards (IFRS).
4.2 Basic concepts and terms
used in accounting
Several basic concepts and terms help us to identify the activities that a business’s accounting process
records:
1 entity concept
2 transactions
3 source documents
4 monetary unit concept
5 historical cost concept.
Each of these items is important for understanding the process of accumulating and reporting
information about a business’s activities.
Entity concept
entity
Separation of
accounting records
of a business from
the records of the
business’s owner
or owners
As you saw in Chapter 1, there are three broad forms of business structure: sole proprietorships,
partnerships and companies/corporations. Regardless of the form of a business, its accounting records
must remain separate from those of its owner(s). Even though Emily Della is the sole proprietor of Café
Revive, she doesn’t consider her personal assets to belong to Café Revive, nor does she consider Café
Revive’s assets to be hers. If you or Emily owned all or part of several businesses, you would keep separate
records for each of them. This separation is the basis of the entity concept. An entity is considered to be
separate from its owner(s) and from any other business. Thus, each business is an entity and has its own
accounting system and accounting records. An owner’s personal financial activities are not included in the
accounting records of the business unless the activity has a direct effect on the business. For instance, if
Emily bought a car for personal use only, the purchase would not affect Café Revive’s accounting records.
On the other hand, if Emily used personal funds to buy a delivery van to be used by the business, the
purchase would affect the records of the business.
Stop & think
2
What are the basic
concepts and terms that
help identify the activities
recorded by the
accounting records of a
business?
Why do you think it is important to treat each entity separately?
Combining business-related items and personal items would make it hard to tell which items are intended for
business purposes and which are for personal use. External users interested in the activities of a business would
gain little information if you gave them financial statements that included both sets of items. With a separate
accounting system for a business, it is much easier to identify, measure and record activities, and to prepare
financial statements. Therefore, financial statements provide useful information to managers and external users
for evaluating the effectiveness of the business’s operations, allowing these users to make better decisions.
Transactions
Recall from Chapter 1 that accounting involves identifying, measuring, recording, summarising and
communicating economic information about the activities of a business for use in decision making. The
136
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Chapter 4 The accounting system: Concepts and applications
accounting process usually begins with a business transaction, which is an exchange of property or service
with another entity. For example, when DeFlava Coffee purchases gas for the roaster, it exchanges cash (or
the promise to pay cash) for the products needed to roast the coffee. Businesses engage in numerous
transactions every day. Each of them must be recorded based on information from source documents.
transaction
Exchange of property
or service by a business
with another entity
Source documents
A source document is a business record that is used as evidence that a transaction has occurred. A source
document may be a sales receipt, a printout from an electronic funds transfer (EFT) machine, an electronically
generated acknowledgment of an order and/or receipt for payment of an order, an invoice or a bill from a
supplier, an invoice or bill sent to a customer, an electronic payroll timesheet printout or a log of the kilometres
driven in the business’s delivery truck. Although the accounting process begins when a transaction occurs, the
identification, measurement and recording of information are based on an analysis of the related source
documents. For instance, if DeFlava Coffee pays for a bulk purchase of coffee beans by electronic funds transfer,
details such as the date of the transaction, the dollar amount, the name of the person or business to whom the
payment was made (called the payee) and the reason for the payment are all noted in the funds transfer
notification. Additionally, all transfers made by DeFlava Coffee electronically are recorded automatically and
included in a printout of the bank statement. Several source documents may be used as evidence of a single
transaction. For example, DeFlava Coffee’s purchase of coffee beans will include the sales invoice from the
supplier and a report from the loading dock stating that the coffee arrived at DeFlava Coffee’s factory.
source document
Business record
used as evidence
that a transaction
has occurred
Monetary unit concept
The source documents for a transaction show the value of the exchange in terms of money. This is known
as the monetary unit concept. In Australia and New Zealand, the monetary unit is the dollar, so
businesses will show their financial statements in dollars. The monetary unit used depends on the
national currency of the country in which the business operates. For example, Sony (http://
www.sony.com.au) uses the Japanese yen, while Audi (https://www.audi.de/de/brand/de.html) and
Benetton (http://www.benetton.com) use the euro.
Stop & think
If an organisation, such as Aldi (http://www.aldi.com.au), does business in a number of
countries, what currency do you think it uses to prepare its financial statements? Why?
monetary unit concept
Concept that
transactions are to be
recorded in terms of
money or currency
historical cost concept
Concept that a business
records its transactions
based on the dollars
exchanged at the time
the transaction occurred
As we all know, the value of every country’s currency changes.
Also, the values of particular goods and services change in the
marketplace as supply and demand change. So a business has to
decide whether to adjust the recorded amounts to include these
types of changes, and, if buying from overseas, whether to factor
in foreign currency translation rates. Under GAAP, businesses
generally do not record the change in the value of either the
currency or the individual goods and services. Instead, they use
the historical cost concept, or simply the cost concept. The
historical cost concept states that a business records its
transactions based on the dollars exchanged (the cost) at the
time the transaction occurred. The related source documents
show this cost, and the business’s accounting records continue to
show the cost involved in each transaction, regardless of whether
AAP Images/Audi Images
Historical cost concept
If DeFlava Coffee purchased an Audi from a dealership in Germany,
do you think this purchase should be recorded in dollars or
euros? Why?
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137
Accounting Information for Business Decisions
the value of the property or service owned increases (or decreases) and whether the value of the currency
changes over time. For instance, suppose that a business acquires land for $100 000, and that one year
later, the value of the land has increased to $130 000. Under the historical cost concept, the business
continues to show the land in its accounting records at $100 000, the acquisition cost. However,
businesses may adjust some assets for changes in their values in certain circumstances.
Stop & think
In this example, why do you think most accountants wouldn’t want to change the recorded
value for the land from $100 000 to $130 000? Why might some want to change?
In Case Exhibit 4.2, we combine the entity concept, the monetary unit concept and the historical cost
concept to develop DeFlava Coffee’s balance sheet that we showed in Case Exhibit 4.1. In this balance
sheet, we (a) separate business items from personal items according to the entity concept; and (b) use the
monetary unit concept and the historical cost concept to show dollar values for each item of the business.
Case Exhibit 4.2 DeFlava Coffee Corporation’s assets and liabilities and balance sheet
Business items
Personal items
Cash
House
Cash
Factory
Mortgage
Note
Trucks
Car
Inventory
$ Paid or Owed
DeFlava Coffee Corporation
Balance sheet
31 March 20X1
(in thousands of dollars)
Assets
Cash
Inventories
Other assets
Liabilities
$ 1 200
1 300
16 800
Accounts payable
Notes payable
Total liabilities
$ 3 000
2 000
$ 5 000
Shareholders’ equity
Total assets
138
$19 300
Total shareholders’ equity
Total liabilities and
Shareholders’ equity
$14 300
$19 300
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Chapter 4 The accounting system: Concepts and applications
These three concepts are the foundation of what the accounting process shows. With this in mind,
you can see how that process functions. The accountant, or the owner, uses the entity concept to separate
the activities of a business from the owner’s activities, which are not related to the business. The
business’s transactions are identified by analysing source documents. The accountant or owner then enters
the transactions into the business’s accounting records using monetary units (dollars) based on the costs
involved in its activities. Every time a business activity occurs, the accountant or owner uses these
concepts to help decide the proper way to record that activity. After the financial information about a
business’s activities is recorded and accumulated, the ultimate goal of the accounting process is to
communicate this information in the business’s balance sheet, income statement and cash flow
statement, each prepared according to GAAP.
4.3 Components of the
accounting equation
We can now begin to discuss how the accounting system works. Using financial information to make
decisions usually involves the following processes to identify and measure, record, report, analyse and
interpret, and retain information about the activities of a business so that owners and managers can make
effective decisions. Most decisions are made on the basis of information provided in the financial
statements, which summarise the results of the financial activities of a business for a period, culminating
in the balance sheet. Every time a business records the exchange of property or services with another
party, the transaction affects at least one of the sections of the balance sheet. As discussed in previous
chapters, a balance sheet has three sections: assets, liabilities and owner’s equity. So, before moving on,
let’s consider the following expanded definitions of these terms.
Assets
Assets are a business’s economic resources that will provide future benefits to the business. A business
may own many assets, some of which are physical in nature – such as land, buildings, supplies to be used
and inventory that the business expects to sell to its customers. Other assets do not have physical
characteristics but are economic resources because of the legal rights (benefits) they convey to the
business. These assets include amounts owed by customers to the business (accounts receivable), the right
to insurance protection (prepaid insurance) and investments made in other businesses and items, such
as trademarks or copyrights. We will discuss assets further in Chapter 8.
prepaid insurance
Cost paid for the right
to insurance protection
Stop & think
Can you think of more examples of assets? How does each of these examples meet the
definition of assets?
Liabilities
Liabilities are the economic obligations (debts) of a business. The external parties to whom a business owes
the debts are referred to as the creditors of the business. Liabilities include amounts owed to suppliers for
credit purchases (accounts payable), amounts owed to employees for work they have done (wages and
salaries payable) and amounts owing to financial institutions for money lent to the business (loans
payable). Legal documents are often evidence of liabilities. These documents establish a claim by the
creditors against the assets of a company. We will discuss liabilities in more detail in Chapter 8.
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creditors
External parties to
whom a business
owes debts
wages and salaries
payable
Amounts owed to
employees for work
they have done
loans payable
Amounts owing to
financial institutions
for money lent to the
business
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Accounting Information for Business Decisions
Stop & think
Can you think of more examples of liabilities? How does each of these examples meet the
definition of liabilities?
Owner’s equity
partners’ equity
The partners’ current
investment in the
assets of the business
residual equity
Term used to refer to
owner’s equity because
creditors have first
legal claim to a
business’s assets
The owner’s equity of a business is the owner’s current investment in the assets of the business. (A
partnership’s balance sheet would refer to partners’ equity, and a company’s balance sheet would call
this shareholders’ equity, as you saw in Case Exhibits 4.1 and 4.2 and as we will discuss in Chapter 5.) The
capital invested in the business by the owner, the business’s earnings from operations and the owner’s
withdrawals of capital (drawings or dividends) from the business all affect owner’s equity. For a sole
proprietorship, the balance sheet shows the owner’s equity by listing the owner’s name, the word ‘capital’
and the amount of the owner’s current investment in the business. As you will see later, partners’ equity
and shareholders’ equity appear slightly differently. Owner’s equity is sometimes referred to as residual
equity because creditors have first legal claim to the assets of a business. Once the creditors’ claims have
been satisfied, the owner is entitled to the remainder (i.e. residual) of the assets. We will discuss owner’s
equity in greater detail in Chapter 8.
Using the accounting equation
3
What do users need
to know about the
accounting equation
for a business?
accounting equation
Assets ¼ Liabilities þ
Owner’s equity
balance
The amount in an
account column at the
beginning of the period
plus the increases and
minus the decreases
recorded in the column
during the period
In summary, accountants use the term assets to refer to a business’s economic resources, and the terms
liabilities and owner’s equity to describe claims on those resources. All of a business’s economic resources
are claimed by either creditors or owners. Therefore, the financial accounting system is built on a simple
equation:
Economic resources ¼ Claims on economic resources
Using the accounting terms you have learned, we can restate the equation:
Assets ¼ Liabilities þ Owner’s equity
This mathematical expression is known as the basic accounting equation. Both sides of the equation
must always be equal; that is, the total of the assets must equal the total of the liabilities plus owner’s
equity. This is the reason a business’s statement of financial position is called a balance sheet: the
monetary total for the economic resources (assets) of the business must always be in balance (or equal)
with the monetary total for the claims (Liabilities þ Owner’s equity) on the economic resources. Like the
components of any other equation, the components of this equation may be transposed. Another way of
showing the equation is:
Owner’s equity ¼ Assets Liabilities
In this form of the equation, the right-hand side (i.e. Assets – Liabilities) is referred to as net assets.
This form of the equation also stresses that owner’s equity may be thought of as a residual amount. In a
similar fashion, we can calculate liabilities from the equation:
Liabilities ¼ Assets Owner’s equity
Regardless of what form the equation takes, both sides must always balance (or be equal). Because a
transaction normally begins the accounting process, a business must record each transaction in a way that
maintains this equality. Keeping this equality in mind will help you to understand other aspects of the
accounting process.
140
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Chapter 4 The accounting system: Concepts and applications
The dual effect of transactions
To keep the accounting equation in balance, a business must make at least two changes in its assets,
liabilities or owner’s equity when it records each transaction. This is called the dual effect of
transactions. For instance, when an owner invests $20 000 in a business, assets (cash) are increased by
$20 000 and owner’s equity (owner’s capital) is increased by $20 000. This transaction causes two
changes: one change in the asset section of the business’s balance sheet, and one change in the owner’s
equity section of its balance sheet. Because the left side and the right side both increase by the same
amount, the accounting equation (Assets ¼ Liabilities þ Owner’s equity) stays in balance.
The fact that transactions always have a dual effect does not mean that every transaction will affect
both sides of the equation – or even two components of the equation. A transaction may affect only one
side, by increasing one asset and decreasing another asset by the same amount. For example, assume a
business buys office equipment by paying $400 cash. In this case, the asset ‘Office equipment’ increases
by $400 and the asset ‘Cash’ decreases by $400. The accounting equation still balances after the business
records this transaction because the transaction does not affect the right side of the equation, since the
total for the asset (left) side of the equation is not changed.
To understand how the accounting equation and the dual effect of transactions provide structure to a
business’s accounting system, think about these concepts as the scales of a business’s transactions.
Exhibit 4.3 shows a set of transaction ‘scales’. Instead of measuring the weight of various objects using
grams or kilograms as measuring units, these scales measure transactions using dollars (historical cost
monetary units). Suppose a business currently has assets of $100 000, liabilities of $25 000 and owner’s
equity of $75 000. Assume that the business’s accountant or owner ‘places’ the business’s current
economic resources (assets of $100 000) on the left side of the scales and the current claims on those
resources (Liabilities of $25 000 þ Owner’s equity of $75 000) on the right side of the scales. Remember
that after each transaction, the scales must balance. The dual effect of transactions provides a way to keep
the scales in balance as business activities are placed (recorded) on the scales. Note that in Exhibit 4.3 the
left side of the scales holds $100 000 in total assets, and the right side holds $25 000 in liabilities and
$75 000 in owner’s equity. The scales balance according to the accounting equation:
dual effect of
transactions
A business must make
at least two changes in
its assets, liabilities or
owner’s equity when it
records each transaction
4
Why are at least two
effects of each transaction
recorded in a business’s
accounting system?
Assets ¼ Liabilities þ Owner’s equity
$100 000 ¼ $25 000 þ
$75 000
Exhibit 4.3 The dual effect of transactions – transaction ‘scales’
$25 000
$100 000
Liabilities ⴙ Owner’s
equity
Assets
Assets
$100 000
$75 000
ⴝ
ⴝ
Liabilities ⴙ Owner’s equity
$25 000 ⴙ $75 000
As we stated earlier, regardless of the type of transaction that occurs, the accounting equation – like
our set of transaction scales – must always balance. Exhibits 4.4 and 4.5 use the scales to illustrate two
more transactions. In Exhibit 4.4, you can see what happens when the owner deposits $5000 from
personal funds into the business’s bank account. The first frame shows the accounting equation in
balance before the owner’s deposit. The second frame shows the equation out of balance because only one
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141
Accounting Information for Business Decisions
Exhibit 4.4 Transaction ‘scales’ – increase in assets and owner’s equity
The transaction ‘scales’ balance in
this frame because the business’s
assets ($100 000) equal the
business’s liabilities ($25 000)
plus owner’s equity ($75 000).
$25 000
$100 000
Liabilities ⴙ Owner’s
equity
Assets
In this frame, the transaction
‘scales’ are out of balance. This
happens because the $5 000 increase
in assets has been added to the asset
side of the scales, but the $5 000
increase in owner’s equity has not
yet been added to the liabilities
and owner’s equity side
$5 000
of the scales.
$75 000
$25 000
$75 000
Liabilities ⴙ Owner’s
equity
$100 000
Assets
The transaction ‘scales’ are in
balance again once the $5 000
increase in owner’s equity has
been added to the liabilities and
owner’s equity side of the scales.
$5 000
$100 000
$25 000 $5 000
Assets
$75 000
Liabilities ⴙ Owner’s
equity
change, the $5000 increase in business assets on the left side of the equation, has been recorded. In the
last frame, the scales again balance, showing that the $5000 owner’s equity increase on the right side of
the equation has been recorded. After this transaction, the accounting equation is as follows:
Assets ¼ Liabilities þ Owner’s equity
$105 000 ¼ $25 000 þ $80 000
Exhibit 4.5 shows what happens when the business pays $20 000 off a bank loan. The accounting
equation stays in balance because assets and liabilities decrease by the same amount:
Assets ¼ Liabilities þ Owner’s equity
$85 000 ¼ $5 000
þ
$80 000
Stop & think
Do you think that businesses in other countries use this same structure? Why or why not?
In Chapters 2 and 3, you saw how managers use accounting information to develop a business plan to
show potential investors or lenders. Managers also use accounting information for internal decision
142
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Chapter 4 The accounting system: Concepts and applications
Exhibit 4.5 Transaction ‘scales’ – decrease in assets and liabilities
The transaction ‘scales’ balance in
this frame because the business’s
assets ($105 000) equal the
business’s liabilities ($25 000)
plus owner’s equity ($80 000).
$105 000
$80 000
Liabilities ⴙ Owner’s
equity
Assets
The transaction ‘scales’ do not
balance in this frame because,
although the $20 000 decrease in
assets has been taken off the scales,
the liabilities have not yet been changed.
$25 000
$85 000
Assets
$25 000
$80 000
Liabilities ⴙ Owner’s
equity
The transaction ‘scales’ are in
balance again once the $20 000
decrease in liabilities is removed
from the liabilities and owner’s
equity side of the scales.
$85 000
Assets
$5 000
$80 000
Liabilities ⴙ Owner’s
equity
making. CVP analysis and budgeting provide accounting information that helps managers answer
questions such as:
• How much money does the business need to have on hand to start operations?
• How much inventory should the business have available?
• How much money can the business spend to advertise a grand opening?
These initial considerations are undertaken for one purpose: so that managers can pursue the goal of
earning a satisfactory income (profit) for the owners. The profit goal is met by selling products or services
to customers at prices that are higher than the costs of providing the products or services.
4.4 Accounting for transactions
to start a business
Once a business starts operating, it uses financial statements to report to external users about its
operations. To prepare these financial statements, the business’s accountant or owner identifies
transactions and records them in the business’s accounting system. This analysis uses the accounting
equation and recognises the dual effect of transactions.
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143
Accounting Information for Business Decisions
Stop & think
If you loaned money to a business, how often would you want the company to report on its
operations? Why?
The transactions recorded in the accounting system are the basis for the internal and external reports
that the business issues. Therefore, it is very important that the transactions are entered correctly, since
they ‘live on’ in the system for many years.
With the accounting equation (and the dual effect of transactions) in mind, watch your friend Emily
Della as she analyses and records the December 20X1 transactions involved in starting her business, Café
Revive. Note how Emily uses accounting concepts, the accounting equation and the dual effect of
transactions to build an effective accounting system.
Investing cash (transaction 1)
Emily Della starts her business on 1 December 20X1 by transferring $22 000 to a bank account she opened
for Café Revive. Emily wants to open the coffee shop to customers as soon as possible so that she can build
some customer traffic as people start Christmas shopping. The business’s bank account is separate, of course,
from her personal account because of the entity concept.
Emily decides to establish on a spreadsheet a basic accounting system for Café Revive, by listing
assets, liabilities and owner’s equity as headings of separate columns. Each column is called an account –
that is, a place a business uses to record and retain information about the effect of its transactions on a
specific asset, liability or owner’s equity item. Emily records each transaction by entering the amounts in
the appropriate account columns. She uses the receipt issued by Café Revive for the $22 000 and the bank
printout of the business’s bank account as evidence for the first transaction. Case Exhibit 4.6 shows how
she records this first transaction.
Case Exhibit 4.6 Emily invests cash in Café Revive
Assets
Trans
Date
(1)
1/12/X1
Balances
¼
Cash
Liabilities
þ
Owner’s equity
E Della, capital
þ$22 000
$22 000
þ$22 000
¼
$22 000
Stop & think
Why does Emily’s personal transfer of funds need to be recorded for Café Revive?
Note that Emily makes two $22 000 entries to record the dual effect of the transaction – one to an
asset account, ‘Cash’ (or ‘Cash at bank’) and one to an owner’s equity account, ‘E Della, capital’ – and that
the accounting equation balances because she increases both sides of the equation by the same amount.
At the end of each day, Emily calculates the balance of each account – that is, the amount in the account
at the beginning of the day plus the increases and minus the decreases recorded in the column that day.
In this case, since Emily has recorded only one transaction, Café Revive now has a balance of ‘$22 000’ in
the ‘Cash’ account and a balance of $22 000 in the ‘E Della, Capital’, as we indicate by the double lines
under these amounts.
144
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Chapter 4 The accounting system: Concepts and applications
Prepaying rent (transaction 2)
To open Café Revive at the University Hub, Emily signed, in the company’s name, a rental agreement
with the centre’s manager on 1 December 20X1. The monthly rent is $1320 – $1200 plus goods and
services tax (GST) of $120 – and the agreement requires that rent for six months be paid in advance.
Since the space is empty, the centre manager agrees to let Emily begin setting up her business
immediately but not start charging her rent until 1 January 20X2. This arrangement works well for Emily
because now she can begin purchasing shop equipment, supplies and inventory.
When Emily signs the rental contract on 1 December, she pays $7920 ($1320 6 months) to the
University Hub. Café Revive receives an electronic receipt, and this and the signed rental agreement are
the source documents for the transaction. Case Exhibit 4.7 shows how Emily records this second
transaction.
Case Exhibit 4.7 Café Revive prepays rent
¼
Assets
Trans.
Date
Cash
(1)
1/12/X1
þ$22 000
(2)
1/12/X1
$ 7 920
Balances
$14 080
þ
Prepaid rent
þ
Liabilities
GST paid
þ
Owner’s equity
E Della, capital
þ$22 000
þ$7 200
þ
$7 200
þ$720
þ
$720
¼
$22 000
The benefit of using the University Hub space to conduct business for six months represents an
economic resource or asset to Café Revive. As a result, Emily records $7200 as an increase in a new asset
account, ‘Prepaid rent’. She also records $720 in the ‘GST paid’ account. This account will attract a rebate
from the taxation office, and so is treated in the same manner as an account receivable. Because cash is
paid out, Emily decreases the asset ‘Cash’ by the total amount paid, $7920. At the end of the day, she
subtracts this amount from the previous amount of cash to show a new balance of $14 080. She then
checks the accounting equation to see that it remains in balance. She does this by adding the assets
($14 080 þ $7200 þ $720) and comparing this $22 000 amount with the total of the liabilities ($0) plus
owner’s equity ($22 000). As you can see, the equation still balances.
Stop & think
How many changes did Emily make in the accounting equation to record this transaction?
Why?
Purchasing supplies with cash
(transaction 3)
On 7 December 20X1, Café Revive purchases $2255 of coffee supplies from City Supply Company by
transferring $2255 in cash. Emily receives an invoice that lists the items purchased, the cost of each item
and the total cost. She uses the invoice as the source document to record this third transaction, as we
show in Case Exhibit 4.8. Because the supplies will be used to conduct business, Emily records them as
an asset, or ‘Supplies’, of $2050. She also records $205 in the ‘GST paid’ account. Because the purchase is
made with cash, she reduces the asset ‘Cash’ by $2255. Note that the changes in these two assets offset
each other on the left side of the accounting equation, and so it remains in balance.
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145
Accounting Information for Business Decisions
Case Exhibit 4.8 Café Revive purchases supplies with cash
¼
Assets
þ Prepaid rent þ
Trans
Date
Cash
(1)
1/12/X1
þ$22 000
(2)
1/12/X1
$ 7 920
(3)
7/12/X1
$ 2 255
þ
Owner’s equity
E Della,
capital
Trans
Date
þ$22 000
þ$7 200
þ$720
þ$2 050
$11 825 þ
Balances
þ GST paid
Supplies
Liabilities
$7 200 þ
þ$205
$2 050 þ
$925 ¼
$22 000
Purchasing inventory on credit
(transaction 4)
On 12 December 20X1, Café Revive purchases $1430 of coffee gift packs (50 gift packs for $28.60 each;
that is, $26 plus GST of $2.60) on credit from DeFlava Coffee Corporation. Café Revive agrees to pay for
the gift packs within 30 days of purchase. An invoice from DeFlava Coffee is the source document for the
transaction. Case Exhibit 4.9 shows how Emily records this fourth transaction. Café Revive needs a way
to keep track of the cost of the coffee gift packs that it buys from manufacturers and has on hand to sell
to its retail customers.
Case Exhibit 4.9 Café Revive purchases inventory on credit
Assets
Trans
Date
Cash
(1)
1/12/X1
þ$22 000
(2)
1/12/X1
$ 7 920
(3)
7/12/X1
$ 2 255
(4)
12/12/X1
Balances
þ
Prepaid
rent
þ
Supplies
þ
Inventory
þ
Liabilities
þ
Owner’s
equity
¼
Accounts
payable
þ
E Della,
capital
þ$22 000
þ$7 200
þ$ 720
þ$2 050
þ$ 205
þ$1 300
$11 825
GST paid
¼
þ
$7 200
þ
$2 050
þ
$1 300
þ$ 130
þ
$1 025
þ$1 430
¼
$1 430
þ
$22 000
Emily thus adds an account column to assets to record inventory. She increases ‘Inventory’ by the cost
of the gift packs, $1300, and ‘GST paid’ by $130, but does not reduce ‘Cash’ because none was paid out.
Since Café Revive agrees to pay for the inventory later, it incurs a debt, or liability. Emily calls the liability
an account payable because it is an amount to be paid by the business, and she increases ‘Accounts
payable’ by $1430. Note that DeFlava Coffee, not Emily, finances this increase in Café Revive’s assets
(economic resources). DeFlava Coffee Corporation is now Café Revive’s creditor (liability) because it has a
claim of $1430 of the café’s assets. The $1430 increase in economic resources matches the $1430
increase in the claims on those resources. So the left side of the accounting equation and the liability
component of the right side both increase by $1430. The accounting equation balances after the
transaction is recorded.
146
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Chapter 4 The accounting system: Concepts and applications
Purchasing shop equipment with cash
and credit (transaction 5)
On 20 December 20X1, Café Revive purchases shop equipment from Restaurant Equipment at a cost of $1650.
It pays $250 immediately and takes a small loan payable agreeing to pay the remaining $1400 (plus interest of
$33) at the end of three months. Emily records this fifth transaction, as we show in Case Exhibit 4.10. Because
the shop equipment is an economic resource to be used in the business, Emily increases the asset ‘Shop
equipment’ by the total cost of $1500. She also records $150 in the ‘GST paid’ account. She decreases the asset
‘Cash’ by the amount paid, $250. Since Café Revive incurs a $1400 liability by taking a small loan, Emily
increases the liability ‘Loan payable’ by this amount. She does not record any interest now because interest
accumulates as time passes, and will be accumulated at the end of each of the three months. This transaction
affects three asset accounts and a liability account, but the accounting equation remains in balance.
Case Exhibit 4.10 Café Revive purchases shop equipment with cash and credit
¼
Assets
Trans
Date
Cash
(1)
1/12/X1
þ$22 000
(2)
1/12/X1
$ 7 920
(3)
7/12/X1
$ 2 255
(4)
12/12/X1
(5)
20/12/X1 $
þ Prepaid þ Supplies þ Inventory þ
Shop
þ
rent
equipment
þ$ 720
þ$2 050
þ$ 205
þ$ 130
þ$1 500
250
$11 575 þ
¼ Accounts þ Loan þ E Della,
payable
payable
capital
GST
paid
þ$22 000
þ$7 200
þ$1 300
Balances
þ Owner’s
equity
Liabilities
$7 200 þ
$2 050 þ
$1 300 þ
þ$1 430
þ$ 150
$1 500 þ
þ$1400
$1 205 ¼
$1 430 þ
$1 400 þ
$22 000
Selling extra shop equipment on credit
(transaction 6)
Café Revive obtained a special price on its shop equipment by buying a ‘package’ that included an extra
computer desk the company did not need. So, on 22 December 20X1, Café Revive sells the desk for $440
to Beau Flowers Store, another shop in the University Hub. The manager of Beau Flowers agrees to pay
for the desk on 7 January. Case Exhibit 4.11 shows how Emily records this sixth transaction.
Case Exhibit 4.11 Café Revive sells extra shop equipment on credit
¼
Assets
(1)
1/12/X1
þ$22 000
(2)
1/12/X1
$ 7 920
$ 2 255
7/12/X1
12/12/X1
(5)
20/12/X1
(6)
22/12/X1
Balances
þ$22 000
þ$7 200
þ$ 720
þ$2 050
þ$ 205
þ$1 300
$
þ$ 130
þ$1 500
250
$ 400
$11 575 þ
$7 200 þ
$2 050 þ
$1 300 þ
8
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<
(3)
(4)
þ Prepaid þ Supplies þ Inventory þ
Shop þ Accounts þ GST paid ¼ Accounts þ
Loan þ
GST
þ E Della,
rent
equipment
receivable
payable
payable
collected
capital
$1 100 þ
þ$1 430
þ$ 150
þ$1 400
þ$440
$440 þ
þ$40
$1 205 ¼
$1 430 þ
$1 400 þ
$24 870
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
$40 þ
$22 000
>
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:
Cash
8
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<
Date
>
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:
Trans
þ Owner’s
equity
Liabilities
$24 870
147
Accounting Information for Business Decisions
Because Café Revive sells one of its economic resources, Emily decreases the asset ‘Shop equipment’ by
$400, the cost of the desk. She also records $40 in the ‘GST collected’ account. This account records amounts
payable to the taxation office, and so is treated in the same manner as an account payable. Because the
amount to be received from Beau Flowers in January is an economic resource for Café Revive, Emily also
records an increase of $440 in the asset ‘Accounts receivable’. Again, note the equality of the accounting
equation. Note that after six transactions the end result as shown in Exhibit 4.11 is that the accounting
equation still balances with Assets total $24 870 ¼ Liabilities ($2 870) þ Owner’s equity ($22 000).
5
What are revenues and
expenses, and how is
the accounting equation
expanded to record
these items?
4.5 Expanding the accounting
equation
Until now, we have focused on how a business records transactions that occur when it is preparing to
open for business. You have learned how the accounting equation changes as the business uses its
accounting system to record an owner’s investment, the purchases of assets with cash and on credit, and
the sale of equipment. After the business opens and begins trading, internal and external users of
financial statements need income information to evaluate how well the business has been operating. By
recording the transactions of its day-to-day operations, a business develops this income information. As
you continue reading, keep in mind the accounting equation and the dual effect of transactions.
Emily had no problem using the basic accounting equation to record the start-up transactions in the
balance sheet columns. However, she needs to modify the accounting system to record revenues (the
inflows or income-producing transactions, such as sales to customers) and expenses (the outflows or
costs, such as wages paid); these transactions do not fit easily into the equation as it is currently stated.
Discussion
If you were Emily, how would you expand Café Revive’s accounting system so that you could
record revenue and expense transactions? What column headings would you add to the
accounting system?
To modify the accounting system, Emily separates the owner’s equity part of the equation into two
sections. The first, the ‘Owner’s capital’ account, lets her record transactions relating to her investments
and withdrawals of capital from the company. The second section lets her record net income (revenues
and expenses). For recording both types of transactions, the equality of the accounting equation is
maintained because of the dual effects of transactions. The expanded accounting equation is as follows:
8
>
>
>
>
>
>
>
>
>
>
<
>
>
>
>
>
>
>
>
>
>
:
Owner’s equity
Assets ¼ Liabilities þ Owner’s capital þ
Net income
Revenues Expenses
revenues
Prices charged to a
business’s customers
for the goods or
services the business
provides to them
expenses
Costs a business
incurs to provide goods
or services to its
customers during an
accounting period
148
Recall from Chapter 1 that the profit of a business is commonly referred to as net income. Net income
is the excess of revenues over expenses for a specific time period; it is sometimes called net profit, net
earnings or simply earnings. Revenues are the amounts earned by charging customers for goods or
services the business provided during a specific time period. Expenses are the costs of providing the
goods or services to customers during the time period.
Emily records revenue and expense transactions by expanding the columns in the simple accounting
system she uses. To find out how much net income Café Revive earned over a specific time period, such
as the month of January, she subtracts the total in the expense column from the total in the revenue
column.
We will demonstrate how to use the expanded accounting equation later in the chapter. But first we
will discuss various principles and concepts related to net income, since the expanded equation deals with
revenues and expenses – the two items that affect net income.
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Chapter 4 The accounting system: Concepts and applications
Accounting principles and concepts
related to net income
6
What are the accounting
principles and concepts
related to net income?
Earlier in the chapter, we explained several basic concepts and terms used in accounting. Before you learn
how a business records its daily transactions to determine net income, it is helpful to know several
additional accounting principles and concepts that are part of GAAP.
Accounting period
A business typically operates for many years. The business’s owner (internal user) needs information about
its net income on a regular basis to make operating decisions. External users of financial statement
information also need to know about the business’s net income on a regular basis to make timely business
decisions. Suppliers need this information for granting credit, creditors need it for renewing bank loans and
investors need it for providing additional capital.
Given that both internal and external users benefit when a business routinely reports its net income, the
question is: How often should a business do so? Earlier, we said that net income is the excess of revenues
over expenses for a specific time period. An accounting period is the time span for which a business
reports its revenues and expenses. Most businesses base their financial statements on a 12-month
accounting period called a financial year. The financial year may be the same as the calendar year; however,
most businesses regard the financial year as being from 1 July to 30 June because this corresponds to the
financial year for tax purposes. Many businesses also calculate and report their net income on a quarterly
basis. These and other accounting periods shorter than a year are referred to as interim periods. In this book,
we often present simplified examples that use one month as the accounting period.
Earning and recording revenues
Revenues result from operating activities of a business that contribute to the business’s earning process.
Broadly speaking, every activity of a business contributes to its earning process. More specifically, a
business’s earning process includes purchasing (or producing) inventory, selling the inventory (or
services), delivering the inventory (or services), and collecting and paying cash. Although a business earns
revenues continuously during this process, it generally records revenues near or at the end of the earning
process.2 This is because (1) the earning process is complete (the business has made the sale and delivered
the product or performed the service); and (2) the prices charged to customers are collectable (accounts
receivable) or collected. So we can say that a business is recording revenues during the accounting
period in which they are earned and are collectable (or collected).
Matching principle
Expenses are subtracted from revenues to calculate net income. Another way of saying this is that the
costs used up are matched against the prices charged to customers to determine net income. The
matching principle states that to determine its net income for an accounting period, a business
calculates the expenses involved in earning the revenues of the period and deducts the total expenses
from the total revenues earned in that period. By matching expenses against revenues, a business has a
good idea of how much better off it is at the end of an accounting period as a result of its operations
during that period.
accounting period
Timespan for which a
business reports its
revenues and expenses
earning process
Purchasing (or
producing) inventory,
selling the inventory
(or services), delivering
the inventory (or
services), and collecting
and paying cash
recording revenues
A business does this
during the accounting
period in which the
revenues are earned
and are collectable
(or collected)
matching principle
To determine its net
income for an
accounting period, a
business computes and
deducts the total
expenses from the total
revenues earned during
the period
2
Construction companies sometimes take several years to complete a project such as an office building. To more fairly report
their yearly net income, these businesses record a portion of their total revenues each year based on the amount earned
during the year.
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149
Accounting Information for Business Decisions
Going concern
going concern
An assumption that an
entity is able to continue
as a viable entity for the
foreseeable future
This principle assumes that the entity is able to continue as a viable entity for the foreseeable future.
Financial statements that are not prepared using this assumption are usually prepared for liquidation
purposes. AASB 101 Presentation of Financial Statements (paragraphs 25 and 26) requires an entity to
assess its ability to operate as a going concern and prepare its financial statements accordingly, and to
disclose if this is not the case. Ensuring an entity is a going concern is a fundamental financial reporting
issue that requires regular and careful assessment, especially when economic conditions are challenging.
Accrual accounting
accrual accounting
Recording revenues
and related expense
transactions in the
same accounting
period that goods or
services are provided,
regardless of when
cash is received or paid
Accrual accounting is related to both the recording of revenue and the matching principle. When a
business uses accrual accounting, it records its revenue and related expense transactions in the same
accounting period that it provides goods or services (i.e. in the period in which it earns the revenue),
regardless of whether it receives or pays cash in that period. To accrue means to accumulate. Accrual
accounting makes accounting information helpful to external users because it does not let cash receipts
and cash payments distort a business’s net income. Otherwise, the amount of revenues the business
earned during an accounting period could be distorted because the business may have received cash
earlier or later than it sold goods or provided services. The amount of expenses could also be distorted
because the business may have paid cash earlier or later than it incurred (or used up) the related costs.
Discussion
Do you think that by requiring accrual accounting to be used in the preparation of a business’s
income statement, GAAP implies that the company’s cash receipts and payments are not
important? Why or why not?
Under accrual accounting, a business must be certain that it has recorded in each accounting period all
revenues that it earned during that period, even if it received no cash during the period. Similarly, at the
end of each accounting period, the business must be certain that it has matched all expenses it incurred
during the period against the revenues it earned in that same period, even if it paid no cash during the
period.
You may be wondering how these concepts relate to a business’s accounting system. In summary, a
company sets up and uses its accounting system based on the accounting equation and the dual effect of
transactions. A business, which is a separate entity from its owners, analyses source documents to record its
transactions. It records the transactions in the accounting system in monetary units based on the historical
costs involved in the company activity. In keeping with accrual accounting, a business records its revenue
transactions when the revenues are earned and collectable, and records expenses when it incurs the costs. The
matching principle ensures that all expenses are matched with the revenues they helped earn so that the
business can calculate its net income for each accounting period.
4.6 Recording daily operations
The following sections describe how Emily uses the expanded accounting equation to record the January
20X2 day-to-day operations of Café Revive.
Cash sale (transaction 1)
Café Revive is fully operational by 2 January 20X2, and on that day sells a total of 30 coffee gift packs at $55
a box (for cash). For each sale, the cash-register tape lists the date, type and number of gift packs sold, and the
total dollar amount of the sale. Emily uses the cash register tape as the source document for the 30 cash sales,
which total $1650. At the end of the day, Emily increases the ‘Revenues’ column of ‘Owner’s equity’ by $1500.
150
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Chapter 4 The accounting system: Concepts and applications
She also records $150 in the ‘GST collected’ account. She increases ‘Cash’ by an amount of $1650. Of course,
Café Revive had to give customers 30 gift packs in order to make the $1500 in sales. By checking the
purchasing records, Emily knows that the gift packs originally cost Café Revive $780 plus $78 GST paid, or
$858 ($28.60 30 boxes), when purchased from DeFlava Coffee. Because Café Revive no longer owns the
gift boxes, Emily decreases ‘Inventory’ by $780. In addition, because the cost of the gift packs is a cost of
providing goods that were sold to customers, she increases ‘Expenses’ by $780.
Case Exhibit 4.12 shows Café Revive’s accounting equation at the close of its first business day,
assuming no other transactions occur. The first line shows the balances in each of Café Revive’s assets,
liabilities and owner’s equity accounts at the start of its first business day. These balances came from
the transactions that Emily recorded in December as she prepared for business (see the balances in
Case Exhibit 4.11). The next line shows how Emily records the cash sale on 2 January. Note that on
this line, Emily shows that the increase in expenses causes a decrease in net income (and therefore in
owner’s equity) by putting a minus sign in the column before the increased amount [i.e. |–| þ $780] in
the ‘Expense’ column. Note also how the accounting equation remains in balance because of the dual
effect of the cash sales transaction. Cash sales will take place every day that Café Revive is open.
Although Emily would record these cash sales transactions every day as they occur, to keep things
simple in Case Exhibit 4.20 (later in the chapter), we include a transaction (no. 13) to represent all the
cash sales (200 boxes) that took place from 3 January 20X2 to 31 January 20X2.
Stop & think
Do you think it is typical to have customers purchase 30 gift packs from a small retail shop
during its first day of business? How could you verify your opinion?
Payment for credit purchase of inventory
made in December (transaction 2)
Recall that Café Revive purchased its beginning inventory on credit from DeFlava Coffee on 12 December
20X1. Emily recorded this transaction as a $1300 increase in ‘Inventory’, a $130 increase in ‘GST paid’ and an
$1430 increase in ‘Accounts payable’. On 3 January 20X2, Emily pays DeFlava Coffee Corporation for the 12
December 20X1 purchase. An invoice from DeFlava Coffee is the source document for the transaction. To
show the results of this transaction, Emily decreases the asset ‘Cash’ by $1430. Because the business no longer
owes DeFlava Coffee for its purchase, she also decreases the liability ‘Accounts payable’ by $1430.
Purchase of Inventory of Gift Packs
(transaction 3)
On 4 January 20X2, Café Revive purchases 190 gift packs (at $28.60 per pack) on credit from DeFlava
Coffee for $5434. As a result of this purchase, Emily increases ‘Inventory’ by $4940. She also records
$494 in the ‘GST paid’ account and, because the purchase is made on credit, increases ‘Accounts payable’
by $5434. Case Exhibit 4.13 shows the changes in the accounting equation resulting from these two
transactions.
Stop & think
Does this purchase correspond to the expected purchase noted in Café Revive’s purchases
budget for January, as we discussed in Chapter 3?
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151
152
1/1/X2
2/1/X2
Balances
(1)
¼
Liabilities
(2)
$7 200 þ
$7 200
$2 050 þ
$2 050
$1 300
$ 520 þ
$ 780
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
1/1/X2
2/1/X2
3/1/X2
4/1/X2
6/1/X2
Balances
(1)
(2)
(3)
(4)
Balances
Date
Trans
$1 100 þ
$1 100
$440 þ
$440 þ
$1 205 ¼
$1 205 ¼
$1 430 þ
$1 430
$1 400 þ
$ 1400
¼
Liabilities
$ 40
$22 000
$1 500 þ$1 500 þ Owner’s þ
capital
$780
þ$780
Net income
Owner’s equity
$190 þ $22 000 þ
þ$150
$7 200 þ
$7 200
$2 050 þ
$2 050
$1 300
$5 460 þ
þ$4 940
$ 780
Assets
$1 100 þ
$1 100
$440 þ
$440 þ
¼
$1 699 ¼
þ$ 494
$1 205
$5 434 þ
þ$5 434
$1 430
$1 430
Liabilities
$ 1400
$1 400
$ 40
$22 000
$1 500 þ$1 500 $780
þ$780
Net income
Owner’s equity
þ Owner’s þ
capital
$190 þ $22 000 þ
þ$150
$7 200 þ
$7 200
$2 050 þ
$2 050
$5 260 þ
$ 260
þ$4 940
$ 780
$1 360
$1 100 þ
$1 100
$990 þ
þ$550
$440 þ
$1 699 ¼
þ$ 494
$1 205
$5 434 þ
þ$5 434
$1 430
$1 430
$1 400 þ
$1 400
$22 000
$240 þ $22 000 þ
þ$ 50
þ$150
$ 40
$2 000 þ$ 500 þ$1 500 $1 040
þ$ 260
þ$ 780
þ Prepaid þ Supplies þ Inventory þ
Shop
þ Accounts þ GST paid ¼ Accounts þ Loan þ
GST
þ E Della, þ Revenues Expenses
rent
equipment
receivable
payable
payable
collected
capital
$11 795 þ
$ 1 430
þ$ 1 650
$11 575
Cash
Net income
þ Prepaid þ Supplies þ Inventory þ
Shop
þ Accounts þ GST paid ¼ Accounts þ Loan þ
GST
þ E Della, þ Revenues Expenses
rent
equipment
receivable
payable
payable
collected
capital
$11 795 þ
$ 1 430
þ$ 1 650
$11 575
Cash
Assets
Case Exhibit 4.14 Café Revive sells coffee gift packs on credit
Balances
4/1/X2
3/1/X2
(1)
(3)
1/1/X2
2/1/X2
Balances
Date
Trans
þ Owner’s þ
capital
Owner’s equity
þ Prepaid þ Supplies þ Inventory þ
Shop
þ Accounts þ GST paid ¼ Accounts þ Loan þ
GST
þ E Della, þ Revenues Expenses
rent
equipment
receivable
payable
payable
collected
capital
$13 225 þ
þ$ 1 650
$11 575
Cash
Assets
Case Exhibit 4.13 Café Revive pays for credit purchases and makes additional credit purchases of inventory
Balances
Date
Trans
Case Exhibit 4.12 Café Revive makes cash sales
Accounting Information for Business Decisions
Chapter 4 The accounting system: Concepts and applications
Credit sale (transaction 4)
On 6 January 20X2, Café Revive sells 10 gift packs for $550 (including GST) on credit to Bud Salcedo,
owner of Beau Flowers Shop, next door to Café Revive. The sales invoice lists the date, the type of gift
pack sold, the flower shop’s name and account number, and the total dollar amount of the sale. Emily
assigns each of Café Revive’s credit customers a unique account number to help her identify transactions
the company has with each of these customers. (This will be particularly useful as the number of credit
customers grows.) Having the account number on the sales invoice lets Café Revive keep track of the
money each customer owes.
Emily increases the ‘Revenues’ column of ‘Owner’s equity’ by $500. She also records $50 in the ‘GST
collected’ account. Because Café Revive sold the gift packs on credit instead of receiving cash, Emily increases
the asset ‘Accounts receivable’ by $550. Remember, Café Revive has to dip into its inventory of coffee gift
boxes to make the sale. By checking the purchasing records, Emily knows that the boxes originally cost $260.
Because the business no longer owns the gift packs, Emily decreases ‘Inventory’ by $260. In addition, because
the cost of the gift packs is a cost of providing the goods sold, she increases ‘Expenses’ by $260. Case Exhibit
4.14 shows the four changes in the accounting equation from this transaction. The accounting equation
remains in balance.
Receipt of payment for credit sale of
extra shop equipment (transaction 5)
Café Revive receives a funds transfer for $440 from Beau Flowers on 7 January 20X2. This is to pay for
the shop equipment that Café Revive sold on credit to Beau Flowers on 22 December 20X1. As you can
see in Case Exhibit 4.15, Emily reduces the asset ‘Accounts receivable’ by $440 because Beau Flowers has
settled its account and no longer owes Café Revive the money for the equipment. She increases the asset
‘Cash’ by $440 to show the receipt of the money.
Withdrawal of cash by owner
(transaction 6)
On 20 January 20X2, Emily Della withdraws $250 cash from the business for personal use, transferring
$250 to her personal bank account from the Café Revive bank account. The EFT notification and receipt
is the source document for the transaction. A withdrawal is a payment from the business to the owner,
known as drawings. It is a removal of assets by the owner from the business. As we show in Case Exhibit
4.16, Emily records a decrease in ‘Cash’ and a decrease in ‘E Della, capital’ by the amount of the
withdrawal ($250). Note there is no GST recorded on this withdrawal.
withdrawal
A payment from the
business to the owner
Stop & think
What do you think Emily would record if she took 10 gift packs instead of cash?
Stop & think
Can you think of any possible ethical issues involved in withdrawals?
We will discuss withdrawals again in Chapter 7.
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153
154
6/1/X2
7/1/X2
(4)
(5)
440
(5)
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Balances
Liabilities
$7 200 þ
$7 200
$2 050 þ
$2 050
$1 300
$5 200 þ
$ 260
þ$4 940
$ 780
Assets
$1 100 þ
$1 100
$550 þ
$440
þ$550
$440 þ
¼
$1 699 ¼
þ$ 494
$1 205
$5 434 þ
þ$5 434
$1 430
$1 430
Liabilities
$1 400
$1 400
$ 40
$7 200 þ
$7 200
$2 050 þ
$2 050
$1 300
$5 200 þ
$ 260
þ$4 940
$ 780
$1 100 þ
$1 100
$550 þ
$440
þ$550
$440 þ
$1 699 ¼
þ$ 494
$1 205
$5 434 þ
þ$5 434
$1 430
$1 430
$1 400
$1 400
$ 40
$240 þ
þ$ 50
þ$150
$2 000 þ$ 500 þ$1 500 $1 040
þ$ 260
þ$ 780
250
$21 750 þ
$
$22 000
$2 000 þ$ 500 þ$1 500 $800
þ$260
þ$780
E Della, þ Revenues Expenses
capital
Net income
Owner’s equity
$22 000 þ
$22 000
þ Owner’s þ
capital
$240 þ
þ$ 50
þ$150
E Della, þ Revenues Expenses
capital
Net income
Owner’s equity
þ Owner’s þ
capital
þ Prepaid þ Supplies þ Inventory þ
Shop
þ Accounts þ GST paid ¼ Accounts þ Loan þ
GST
þ
rent
equipment
receivable
payable
payable
collected
$11 985 þ
250
7/1/X2
(4)
$ 1 430
20/1/X2 $
6/1/X2
(3)
(6)
4/1/X2
(2)
$11 575
þ$ 1 650
440
3/1/X2
(1)
Cash
þ$
1/1/X2
2/1/X2
Balances
Date
Trans
¼
þ Prepaid þ Supplies þ Inventory þ
Shop
þ Accounts þ GST paid ¼ Accounts þ Loan þ
GST
þ
rent
equipment
receivable
payable
payable
collected
$12 235 þ
þ$
$ 1 430
þ$ 1 650
$11 575
Cash
Case Exhibit 4.16 Emily withdraws cash from Café Revive
Balances
4/1/X2
(3)
(1)
3/1/X2
1/1/X2
2/1/X2
Balances
(2)
Date
Trans
Assets
Case Exhibit 4.15 Café Revive receives payment from credit sale of extra shop equipment
Accounting Information for Business Decisions
Payments for consulting
and advertising
(transactions 7 and 8)
To prepare for the start of the university year and its
orientation-week grand opening sale, Café Revive hires the Dana
Media Group as consultants to build a website for the business.
The design group charges $363 and presents the website on 25
January 20X2. Café Revive pays for the full amount that day. The
receipt received from Dana Media is the source document. As a result
of this transaction, Emily increases ‘Expenses’ by $330, records $33
Do you think Café Revive’s location next to the flower shop Beau Flowers
in the ‘GST paid’ account and decreases ‘Cash’ by $363.
Also on 25 January 20X2, Café Revive pays for a small will improve its sales of Valentine’s Day gift packs? Why or why not?
advertisement to be published in University Hub’s end-of-January promotional flyer. The quarter-page
advertisement cost $121. The bill from University Hub’s management office is the source document for
the transaction. As we show in Case Exhibit 4.17, to record this transaction, Emily increases ‘Expenses’
by $110, increases ‘GST paid’ by $11 and decreases ‘Cash’ by $121. Note that the accounting equation
remains in balance after these transactions are recorded.
Stop & think
If ‘Cash’ was mistakenly decreased by only $100 when the last transaction was recorded, how
would you find out that an error had been made?
Purchase of extra supplies (transaction 9)
On 29 January 20X2, because sales are anticipated to increase as the university year commences, Café
Revive purchases more supplies of coffee and flavour additives. Café Revive transfers $275 in cash for
these supplies. As you can see in Case Exhibit 4.18, Emily increases ‘Supplies’ by $250, increases ‘GST
paid’ by $25 and decreases ‘Cash’ by $275.
Payment of salaries (transaction 10)
Café Revive employs two people (you and Jackson Downes) to help make and sell coffee. On 31 January
20X2, you both receive payment totalling $2050 for your services during January. Your timesheets, wagerate schedules and payslips are the source documents for the transactions. As you can see in Case Exhibit
4.19, Emily decreases the asset ‘Cash’ by $2050. Wages of salaries of employees attract PAYG tax, in this
case $310. Because paying an employee’s salary is a cost of providing goods and services to customers, she
increases ‘Expenses’ (salaries) by $2360 and records an amount of $310 as ‘PAYG (pay as you go) tax
payable’. Under the Australian tax system, all businesses must deduct PAYG tax from employee wages and
pay the PAYG tax to the government. This is recorded as a liability because the amount will have to be
submitted to the taxation office.
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155
Shutterstock.com/Alessandro Cristiano
Chapter 4 The accounting system: Concepts and applications
156
2/1/X2
(1)
$2 050 þ
$2 050
$1 360
$5 200 þ
$ 260
þ$4 940
$ 780
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
11
33
$5 434 þ
þ$5 434
$1 430
$1 430
Liabilities
$1 400
$1 400
$ 40
$240 þ
þ$ 50
þ$150
250
$7 200 þ
$7 200
$2 300 þ
þ$ 250
$2 050
$5 200 þ
$ 260
þ$4 940
$ 780
$1 360
Assets
$1 100 þ
$1 100
$550 þ
$440
þ$550
$440 þ
25
11
33
$1 768 ¼
þ$
þ$
þ$
þ$ 494
$1 205
$5 434 þ
þ$5 434
$1 430
$1 430
$1 400
$1 400
$ 40
$240 þ
þ$ 50
þ$150
250
$2 000 þ$ 500 þ$1 500 $1 480
þ$ 110
þ$ 330
þ$ 260
þ$ 780
$2 000 þ$ 500 þ$1 500 $1 480
þ$ 110
þ$ 330
þ$ 260
þ$ 780
þ Revenues Expenses
Net income
Owner’s equity
þ
$21 750 þ
$
$22 000
Net income
þ Revenues Expenses
þ
Owner’s equity
$21 750 þ
$
$22 000
E Della,
capital
¼
$1 743 ¼
þ$
þ$
þ$ 494
$1 205
þ Prepaid þ Supplies þ Inventory þ
Shop
þ Accounts þ GST paid ¼ Accounts þ Loan þ
GST
þ
rent
equipment
receivable
payable
payable
collected
$11 226 þ
121
275
25/1/X2 $
29/1/X2 $
(8)
(9)
Balances
250
363
20/1/X2 $
25/1/X2 $
(6)
(7)
440
þ$
7/1/X2
(5)
$ 1 430
4/1/X2
3/1/X2
(2)
$11 575
þ$ 1 650
6/1/X2
2/1/X2
(1)
(3)
1/1/X2
Balances
Cash
(4)
Date
Trans
$550 þ
$440
þ$550
$440 þ
Owner’s
capital
$1 100 þ
$1 100
þ
Case Exhibit 4.18 Café Revive purchases more supplies
$7 200 þ
$7 200
E Della,
capital
Liabilities
þ Prepaid þ Supplies þ Inventory þ
Shop
þ Accounts þ GST paid ¼ Accounts þ Loan þ
GST
þ
rent
equipment
receivable
payable
payable
collected
$11 501 þ
121
25/1/X2 $
(8)
Balances
250
363
20/1/X2 $
25/1/X2 $
(6)
7/1/X2
(5)
(7)
440
þ$
4/1/X2
6/1/X2
(3)
$ 1 430
þ$ 1 650
$11 575
Cash
(4)
3/1/X2
1/1/X2
Balances
(2)
Date
Trans
¼
Owner’s
capital
Assets
þ
Case Exhibit 4.17 Café Revive pays for consulting and advertising
Accounting Information for Business Decisions
1/1/X2
2/1/X2
3/1/X2
4/1/X2
6/1/X2
7/1/X2
20/1/X2
25/1/X2
25/1/X2
29/1/X2
31/1/X2
Balances
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
Balances
Date
Trans
Assets
¼
$7 200
$2 300 þ
þ$ 250
$2 050
$5 200 þ
þ$4 940
$ 260
$1 300
$ 780
$3 800 þ
$1 100
$550 þ
þ$550
$440
$440 þ
33
11
25
$1 768 ¼
þ$
þ$
þ$
þ$ 494
$1 205
$1 400
$5 434 þ $1 400
$1 430
þ$5 434
$1 430
þ
$310
þ$310
$240 þ
þ$ 50
$ 40
þ$150
PAYG þ
GST
þ
tax
collected
payable
Liabilities
þ Prepaid þ Supplies þ Inventory þ
Shop
þ Accounts þ GST paid ¼ Accounts þ Loan
rent
equipment
receivable
payable
payable
$ 9 176 þ $7 200 þ
þ$ 440
$ 250
$ 363
$ 121
$ 275
$ 2 050
$11 575
þ$ 1 650
$ 1 430
Cash
Case Exhibit 4.19 Café Revive pays salaries
250
$2 000 $ 500 þ$1 500 $3 840
þ$2 360
þ$ 330
þ$ 110
þ$ 260
þ$ 780
Expenses
Net income
þ Revenues þ
$21 750 þ
$
$22 000
E Della,
capital
Owner’s
capital
Owner’s equity
Chapter 4 The accounting system: Concepts and applications
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157
Accounting Information for Business Decisions
Payment of mobile and wifi and energy
bills (transactions 11 and 12)
On 31 January 20X2, Café Revive pays its mobile and wifi and energy bills for January for $143 and
$209, respectively. Emily records each transaction separately, using the invoices as the source documents.
As you can see in Case Exhibit 4.20, for mobile and wifi, she decreases ‘Cash’ by $143, and increases
‘Expenses’ by $130 and ‘GST paid’ by $13. For energy, she decreases ‘Cash’ by $209, and increases
‘Expenses’ by $190 and ‘GST paid’ by $19.
Summary cash sales
(transactions 13 and 14)
Case Exhibit 4.20 also shows the summary transaction for the sale of 200 coffee gift packs, which we
discussed earlier in transaction 1 (noting that all of the cash sales from 3 January to 31 January would
be recorded in one transaction – that is, transaction 13). These sales of gift packs total $11 000 ($55 200 boxes), so Emily increases ‘Revenues’ by $10 000 and ‘GST collected’ by $1000. Cash will increase
by $11 000. She also decreases ‘Inventory’ by $5200 (200 boxes $26 ($28.60 less $2.60 GST paid))
and increases expenses by $5200. Emily also needs to record in transaction 14 that during January, 976
cups of coffee were sold at an average price of $5.50 each. Emily records in ‘Revenue’ an increase in
cups of coffee sold of $4880 and in ‘GST collected’ of $488. Because all sales of coffee beverages are for
cash, she records an increase in ‘Cash’ of $5368. As with all previous transactions, the accounting
equation still balances.
Stop & think
How many additional coffee gift packs did Café Revive sell for cash from 3 January to
31 January? Why were expenses increased by $5200?
Managing inventory level (transaction 15)
On 31 January, after a request from a customer, Emily realises she is very low on inventory of coffee gift
packs. She takes the order from the customer and then immediately places an emergency order with DeFlava
Coffee for 50 boxes of gift packs, in order to have stock on hand for the next few days of trading. The boxes are
delivered on the same day, but the price has increased to $29.70 ($27.00 plus GST of $2.70). Emily increases
‘Inventory on hand’ by $1350 and ‘GST paid’ by $135. DeFlava Coffee allows Emily 30 days’ credit, so
‘Accounts payable’ also increases by $1485.
Stop & think
What are the consequences for a business of having a ‘stock-out’ situation? How could Emily
have avoided this situation?
158
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Balances
1/1/X2
2/1/X2
3/1/X2
4/1/X2
6/1/X2
7/1/X2
20/1/X2
25/1/X2
25/1/X2
29/1/X2
31/1/X2
31/1/X2
Balances
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
(10)
(11)
(12)
(13)
(14)
(15)
31/1/X2
Date
Trans
¼
$7 200
$2 300 þ
þ$ 250
$2 050
$1 350 þ
þ$1 350
$5 200
þ$4 940
$ 260
$1 300
$ 780
$1 100 þ
$1 100
$550 þ
þ$550
$440
$440
13
19
þ$
þ$
$1 935 ¼
þ$ 135
33
11
25
þ$
þ$
þ$
þ$ 494
$1 205
$1 400
$6 919 þ $1 400
þ$1 485
$1 430
þ$5 434
$1 430
þ
$310 þ
þ$310
50
$1 728 þ
þ$1 000
þ$ 488
þ$
$ 40
þ$ 150
PAYG þ
GST
þ
tax
Collected
payable
Liabilities
þ Prepaid þ Supplies þ Inventory þ
Shop
þ Accounts þ GST paid ¼ Accounts þ Loan
rent
equipment
receivable
payable
payable
$25 192 þ $7 200 þ
þ$ 440
$ 250
$ 363
$ 121
$ 275
$ 2 050
$ 143
$ 209
þ$11 000
$ 5 368
$11 575
þ$ 1 650
$ 1 430
Cash
Assets
Case Exhibit 4.20 Café Revive pays mobile and wifi and energy bills and records sales for 3 January to 31 January
250
Net income
500 $16 880 þ$10 000
þ$ 4 880 þ$
þ$ 1 500 $9 360
þ$2 360
þ$ 60
þ$ 190
þ$5 200
þ$ 330
þ$ 110
þ$ 260
þ$ 780
þ Revenues Expenses
þ
$21 750 þ
$
$22 000
E Della,
capital
Owner’s
capital
Owner’s equity
Chapter 4 The accounting system: Concepts and applications
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159
Accounting Information for Business Decisions
7
Why are adjustment
entries necessary at the
end of a financial period?
4.7 End-of-period adjustments
Remember, revenues are the amount earned by charging a business’s customers for goods or services that
the business provided during the accounting period, and expenses are the costs of providing those goods
or services during the period. Net income is the excess of revenues over expenses for the period. To
calculate net income for a month, for example, a business counts the dollar totals for all the revenue and
expense transactions of that specific month, and subtracts the expense total from the revenue total – that
is, it matches the expenses against the revenues for the month.
To calculate a business’s net income under accrual accounting, the business must make sure that all its
revenues and expenses for the accounting period are included in the totals. For Café Revive, Emily can
easily verify that the revenue total is correct because every sale is listed on a source document (a sales
invoice or a cash-register tape) that she uses to record each sales transaction. Emily can verify that most of
Café Revive’s expenses are correct because she also has source documents (invoices, utility bills and
timesheets) relating to these.
Stop & think
Do you think it may sometimes be difficult to identify when a sale has occurred? Why?
end-of-period
adjustments
Increases or decreases
to account balances
at the end of the period
to reflect the costs
of providing goods
or services that are
not supported by
source documents
It is more difficult for a business to make sure that all of the expenses it incurred during the month
are included in the net income calculation because some of the costs of providing goods or services occur
without a source document. Since these expense transactions don’t have source documents, there is no
‘automatic trigger’ to record the transactions. Before calculating its net income, a business must analyse
its unique expenses (and a few unique revenues, which we will briefly discuss later) to see if it needs to
adjust (increase) the total expenses (or revenues) to include those without source documents. These
adjustments are called end-of-period adjustments.
Stop & think
What types of expenses can you think of that occur without source documents?
In general, end-of-period adjustments involve assets that a business had at the beginning of the
accounting period, but that it used during the period to earn revenues. Because assets are used during the
period to provide benefits or earn revenues, they are changed to expenses. Emily must analyse Café Revive’s
assets to see what additional expenses to record. As you will see, the end-of-period adjustments may also
include liabilities that a company owes because of expenses that have not been paid or recorded. Let’s take a
look at the four end-of-period adjustments that Emily makes before calculating Café Revive’s net income for
January 20X2, its first month of operations.
Supplies used (transaction 16)
Recall that on 7 December 20X1, Café Revive purchased $2255 of supplies (coffee, essences, paper cups,
sweeteners, etc.), including GST, from City Supply Company. At this time, Emily increased the asset
‘Supplies’ by $2050 to show the cost of this new asset. Similarly, Emily purchased extra supplies on 29
January for $275. This further increased the amount of the asset supplies on hand by $250 after GST
paid of $25 was recorded.
Because Café Revive operated during January, it used some of these supplies. Thus, at 31 January
20X2, the $2300 amount in ‘Supplies’ is not correct. Emily must adjust the amount to show that, since
some of the supplies were used, they now are an expense, and only part of the $2300 of supplies is still
an asset. Emily determines that office supplies used during January amount to $1955. She makes an endof-period adjustment to increase ‘Expenses’ by $1955 and decrease the asset ‘Supplies’ by $1955, as we
160
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Chapter 4 The accounting system: Concepts and applications
show in Case Exhibit 4.21. When she subtracts the $1955 from the original $2300 amount, the $345
ending balance is the cost of supplies the company still owns at the end of January. Notice how this
adjustment (and each of the following adjustments) maintains the equality of Café Revive’s accounting
equation and has a dual effect on the equation.
Stop & think
How do you think Emily determined the amount of supplies used?
Expired rent (transaction 17)
Recall that Café Revive paid $7920 to University Hub on 1 December 20X1 to pay in advance for six
months’ rent, starting from 1 January 20X2. At that time, Emily recorded a $7200 asset, ‘Prepaid rent’, to
show that Café Revive had purchased the right to use space in the University Hub for six months
(January to June) at a price of $1200 per month. At the end of January, Café Revive has used up one
month of prepaid rent – for January – because the business occupied the rented space for that entire
month. Therefore, Emily must include the cost of the rented space as an expense in the calculation of
Café Revive’s net income.
Since Café Revive made the $7200 payment on 1 December 20X1, no other source documents relating to
the rental of the space exist. Although Café Revive has used up one of its six months of rent, the amount listed
for prepaid rent is still $7200. Emily must adjust the prepaid rent amount to show that only five months of
prepaid rent remain. To do so, she increases ‘Expenses’ for January by $1200 and reduces ‘Prepaid rent’ by the
same amount, as we show in Case Exhibit 4.21. Now ‘Prepaid rent’ shows the correct balance of $6000 ($1200
5) for the remaining five months.
Stop & think
What adjustment do you think Emily would make at the end of January if Café Revive
occupied the rented space for January but did not pay for any rent until February?
Depreciation of shop equipment
(transaction 18)
At the beginning of January, the amount for the asset ‘Shop equipment’ was listed at the cost of $1100.
Café Revive purchased the shop equipment because it would help earn revenue. The equipment includes,
for instance, display cases, a cash register and a moving trolley. Although Café Revive doesn’t expect any
equipment to wear out completely after one month, or even after one year, it does not expect it all to last
indefinitely. At some point in the future, the display cases will become outdated, the cash register will
stop working and the moving trolley will fall apart. At that time, Emily will decide to sell or dispose of the
equipment.
The shop equipment provides benefits to the business for every period in which it is used. Because
Café Revive used the shop equipment in January to help earn revenue, and because the shop equipment
has a finite life, a portion of the cost of the equipment is included as an expense in the January net
income calculation. Depreciation is the part of the cost of a physical asset allocated as an expense to each
time period in which the asset is used.
The simplest way to calculate depreciation is to divide the cost by the estimated life of the asset. For
now, assume that depreciation for the shop equipment is $19 a month. Emily makes an end-of-period
adjustment for January’s depreciation by increasing ‘Expenses’ by $19 and decreasing the asset ‘Shop
equipment’ by $19, as we show in Case Exhibit 4.21. Now shop equipment shows the $1081 remaining
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depreciation
The systematic periodic
transfer of the cost
of a fixed asset to an
expense account during
its expected useful life
161
162
31/1/X2
31/1/X2
31/1/X2
31/1/X2
31/1/X2
31/1/X2
Balances
(16)
(17)
(18)
(19)
Balances
Date
Trans
þ
$25 192 þ
$25 192
Cash
$6 000 þ
$1 200
$7 200
$ 345 þ
$1 955
$2 300
$1 350 þ
$1 350
19
$1 081 þ
$
$1 100
$1 935
GST
paid
$6 919 þ
$6 919
$1 411
þ$ 11
$1 400
þ
$310 þ
$310
$1 728 þ
$1 728
PAYG þ
GST
þ
tax
collected
payable
Liabilities
¼ Accounts þ
Loan
payable
payable
¼
$550 þ $1 935 ¼
$550
Prepaid þ Supplies þ Inventory þ
Shop
þ Accounts þ
rent
equipment
receivable
Assets
Case Exhibit 4.21 Café Revive makes end-of-period adjustments
$ 9 360
$16 880 19
11
$12 545
þ$
þ$
þ$ 1 200
þ$ 1 955
$16 880 þ Revenues Expenses
Net income
Owner’s equity
þ
$21 750 þ
$21 750
E Della,
capital
Owner’s
capital
Accounting Information for Business Decisions
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Chapter 4 The accounting system: Concepts and applications
cost (called its book value). As Café Revive uses the shop equipment in each future month, the equipment
will record an additional $19 depreciation, which will reduce the book value of the equipment. Therefore, at
any point in time the difference between the original cost and the book value is the accumulated depreciation
to date.
Accrual of interest (transaction 19)
Towards the end of December 20X1, Café Revive purchased shop equipment by establishing a $1400 loan
payable, to be paid at the end of three months. Generally, all loans payable also involve the payment of
interest for the amount borrowed. This interest is an expense of doing business during the time between the
signing of the note and the payment of the note. Café Revive agreed to pay $33 total interest for the note, so
that at the end of the three months Café Revive will pay $1433 ($1400 þ $33). Interest accumulates
(accrues) over time until it is paid. Since Café Revive owed the loan during all of January, Emily must record
one month of interest on the loan as an expense of doing business during January. Because Café Revive will
not pay the interest until it pays the loan, it records the January interest as an increase in liability. For now,
assume that the interest is $11 per month ($33 3). Emily makes an end-of-period adjustment for the
January interest by increasing ‘Expenses’ by $11 and increasing the liability ‘Loans payable’ by $11, as we
show in Case Exhibit 4.21. We will discuss how to calculate interest later in the book.
End-of-period revenue adjustments
There are a few end-of-period adjustments that a business may need to make to ensure that its revenues
are correct for the accounting period. Here, we briefly discuss two. First Emily stocked and sold a product
(fig jam) on behalf of another small business. She receives commission on the sales when all the products
are sold. At the end of the accounting period, the business must record any commission that has
accumulated (accrued) by increasing ‘Revenues’ and increasing the asset ‘Accrued Revenue/Accounts
Receivable’. Second, a business might collect cash in advance from a customer for sales of products that it
will deliver to the customer, or for services that it will perform for the customer later in the current
accounting period or in the next accounting period. In this case, the business has not earned the revenue
at the time of the cash collection. Therefore, it records the receipt by increasing ‘Cash’ and increasing a
liability that is called unearned revenue. At the end of the current accounting period, the business must
decrease ‘Unearned revenue’ and increase ‘Revenue’ for the amount of revenue it has earned during the
period. We will discuss end-of-period revenue adjustments more completely in later chapters.
Stop & think
How would the interest of $11 be recorded by the lender making the loan to Café Revive?
Net income and its effect on the
balance sheet
After recording the results of all the transactions and end-of-period adjustments (shown in Case Exhibit
8
Is it possible to prepare
basic financial reports for
a business from the
running totals of the
accounting equation?
4.21), Emily calculates Café Revive’s net income for January:
Net Income ¼ Revenues Expenses
$4335 ¼ $16 880 $12 545
A business will normally prepare an income statement that lists the various types of revenues and
expenses included in net income. For simplicity, in this chapter we use a simple accounting system, which
does not help in the preparation of a detailed income statement. In Chapter 7, we will expand the
accounting system and show you how to prepare an income statement. Emily can, however, compare the
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163
Accounting Information for Business Decisions
actual net income amount for January with the projected net income that she calculated when she
planned Café Revive. Since Emily is the owner, the net income (Revenues – Expenses) will be transferred
to her capital for operations. In Chapter 3, she calculated a projected net income or profit $7524 for the
first quarter (or three months) of 20X2. Emily should be very pleased; by achieving an actual net income
of $4335 for the first month of the quarter, Café Revive has done better than she expected. Later in this
text, we will discuss how internal and external users analyse the financial statements of a business to
understand how well it did for a specific time period.
To prepare the 31 January 20X2 balance sheet for Café Revive, Emily uses the end-of-the- month
balances for each asset, liability and owner’s equity account listed in Case Exhibit 4.21. Case Exhibit 4.22
shows Café Revive’s balance sheet at 31 January 20X2.
You should be able to trace the asset and liability amounts directly to the ending balances listed in
Case Exhibit 4.21. The assets on the balance sheet are rearranged, however, to show them in the order of
their liquidity, or how quickly the assets can be converted to cash or used up. (We will discuss liquidity
more in later chapters.) Also notice that Emily must calculate the balance sheet amount for owner’s equity
(‘E Della, Capital’) at the end of January. It is the sum of all of the owner’s equity items included in Case
Exhibit 4.21. Expressed another way, it is the sum of ‘E Della, Capital’ and ‘Net income’; in this case, a
profit of $4335 ($16 880 – $12 545) ($21 750 þ $4335 ¼ $26 085). We will explain how to update the
balance of the owner’s capital account for net income in Chapter 7.
Case Exhibit 4.22 Café Revive’s balance sheet at 31 January 20X2
CAFÉ REVIVE
Balance sheet
31 January 20X2
Assets
Liabilities
Cash
$25 192
Accounts payable
$ 6 919
Accounts receivable
$
550
Loan payable
$ 1 411
GST paid
$
207** PAYG tax
Inventory
$ 1 350
Supplies
$
Prepaid rent
$ 6 000
Shop equipment
$ 1 081
Total assets
$
Total liabilities
310
$ 8 640
345
$34 725
Owner’s equity
E Della, capital
$26 085*
Total owner’s equity
$26 085
Total liabilities and owner’s equity
$34 725
* $21 750 þ $16 880 – $12 545 from Exhibit 4.21.
**$1 935 GST Paid $1 728 GST Collected.
E Della, capital
$ 21 750*
þ16 880
Revenues
12 545
Expenses
Owner’s Equity
$ 26 085
* $21 750 is the original $22 000 invested in the business less Emily’s withdrawal of $250 on 20 January.
Since Emily is the owner, the net income (Revenues – Expenses) is included in her capital amount on the
31 January 20X2 balance sheet. Using the total amounts for the assets, liabilities and owner’s equity sections
of Café Revive’s balance sheet, we can state the accounting equation on 31 January 20X2 as follows:
Assets ¼ Liabilities þ Owner’s equity
$34 725 ¼ $8 640
164
þ $26 085
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Chapter 4 The accounting system: Concepts and applications
Because Emily properly recorded Café Revive’s transactions, the company’s accounting equation is in
balance at 31 January 20X2.
Just as we expanded the accounting equation to record revenue and expense transactions, we will
discuss other changes in the accounting system throughout this book. These changes make it easier to
keep track of the activities of the business, and increase the usefulness of the accounting system. We will
also introduce additional accounting concepts to help you understand why businesses make changes to
the accounting system. In the following chapters, we will take a detailed look at the recording process for a
business, and at three very important outputs of the accounting process: the income statement, the balance
sheet and the cash flow statement. We will continue to answer questions concerning what accounting is,
how accounting works, why accounting is performed and how accounting information is used for problem
solving and decision making. We will also discuss how to minimise errors that, among other things, can
cause major embarrassments, as we illustrate below.
Business issues and values: A billion here, a billion there
In one year, US fund manager Fidelity Investments (http://www.fidelity.com.au) estimated
that it would make a year-end distribution of $4.32 per share to shareholders in its Magellan Fund.
But the company then admitted to an error. Included in a letter sent to shareholders was the
following statement: ‘the error occurred when the accountant omitted the minus sign on a net
capital loss of $1.3 billion and incorrectly treated it as a net capital gain on [a] separate spreadsheet.
Ethics and sustainability
b
This meant that the dividend estimate spreadsheet was off by $2.6 billion’. The error had no effect
on the fund’s results or on the shareholders’ taxes, but was clearly an embarrassment to the
company’s management!
Stop & think
Do you know of any recent cases where a business may have made errors of a similar nature?
What were the circumstances and what was the impact for owners? For investors?
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165
Accounting Information for Business Decisions
STUDY TOOLS
Summary
4.1 Understand how to interpret and evaluate financial accounting information in order to make informed
decisions.
1
Why do managers, investors, creditors and others need information about the operations of a business?
Internal and external users need information about a business’s operations to evaluate alternatives. For instance, a manager needs
this information to decide which alternative best helps the business meet its goals of remaining solvent and earning a satisfactory
profit. A banker also needs this information to decide the conditions for granting a loan.
4.2 Understand the basic concepts and terms that help identify and record the activities of a business.
2
What are the basic concepts and terms that help identify the activities recorded by the accounting records of a
business?
The basic concepts and terms that help identify the activities that a business’s accounting system records are the entity concept
(each business is separate from its owners); transactions (exchanges between a business and another entity); source documents
(business records as evidence of transactions); the monetary unit concept (transactions are recorded in monetary terms); and the
historical cost concept (transactions are recorded based on dollars exchanged).
4.3 Describe the basic components of the accounting equation: assets, liabilities and owner’s equity.
3
What do users need to know about the accounting equation for a business?
Users need to understand the accounting equation: Assets ¼ Liabilities þ Owner’s equity. They need to know that assets are a business’s
economic resources, liabilities are a business’s debts and owner’s equity is the owner’s current investment in the assets of the company.
4.4 Understand the impact that individual transactions have on the accounting equation.
4
Why are at least two effects of each transaction recorded in a business’s accounting system?
A business’s accounting system is designed so that two effects of each transaction are recorded in order to maintain the equality of
the accounting equation. Under the dual effect of transactions, recording a transaction involves at least two changes in the assets,
liabilities and owner’s equity of a business.
4.5 Define revenue and expenses and expand the accounting equation to include the impact of revenue
and expenses on net income.
5
What are revenues and expenses, and how is the accounting equation expanded to record these items?
Revenues are the amounts earned by a business charging customers for goods or services provided during an accounting period.
Expenses are the costs of providing the goods or services during the period. Net income is the excess of revenues over expenses
for the period. The accounting equation is expanded as follows to record revenues and expenses: Assets ¼ Liabilities þ [Owner’s
capital þ (Revenues – Expenses)].
6
What are the accounting principles and concepts related to net income?
The accounting principles and concepts related to net income are the accounting period, earning and recording revenues, the
matching principle, and accrual accounting. The accounting period is the timespan used by a business to report its net income. A
business records revenues during the accounting period in which they are earned and collectable. The matching principle states
that a business matches the total expenses of an accounting period against the total revenues of the period to determine its net
income. Accrual accounting means that a business records its revenues and expenses in the accounting period in which it provides
goods or services, regardless of whether it receives or pays cash.
166
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Chapter 4 The accounting system: Concepts and applications
4.6 Identify types of adjusting entries and why they are necessary at the end of the financial period.
7
Why are adjustment entries necessary at the end of a financial period?
End-of-period adjustments are necessary to record any expenses that a business has incurred (or any revenue that the business has
earned) during the accounting period but that it has not yet recorded. Adjustments ensure that these expenses (and revenue) are
included in the business’s net income calculation.
4.7 Compile basic financial reports from the running totals in the accounting equation.
8
Is it possible to prepare basic financial reports for a business from the running totals of the accounting equation?
We use the total totals for revenue and expenses in the owner’s equity section of the equation to calculate net income. We use the
totals in the assets section to find total assets and relate this to total liabilities plus owner’s equity total after adding or subtracting
the net income (profit) or loss.
Key terms
accounting equation
entity
recording revenues
accounting period
expenses
residual equity
accrual accounting
going concern
revenues
balance
historical cost concept
source document
creditors
loans payable
transaction
depreciation
matching principle
wages and salaries payable
dual effect of transactions
monetary unit concept
withdrawal
earning process
partners’ equity
end-of-period adjustments
prepaid insurance
Online research activity
This activity provides an opportunity to gather information online about real-world issues related to the topics in this chapter. For
suggestions on how to navigate various businesses’ websites to find their financial statements and other information, see the
related discussion in the Preface.
Examine the websites for Fortescue Metals Group (http://www.fmgl.com.au) and Origin Energy (http://
www.originenergy.com.au).
1
2
3
4
List the differences between the activities of the two companies.
What are the similarities?
Which company recorded the highest profit?
Which company paid the better dividend?
Integrated business and accounting situations
Answer the following questions in your own words.
Testing your knowledge
4-1
4-2
4-3
4-4
4-5
List external users who need financial accounting information about a business? List five external users and discuss the
type of information that each might require.
What does GAAP mean? Why is this important when financial statements are being prepared for a business?
What is the difference between an accounting entity and a legal entity?
What is the entity concept? How does it affect the accounting for a specific business?
What is a ‘going concern’, and why is it important in accounting?
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167
Accounting Information for Business Decisions
4-6
4-7
4-8
4-9
4-10
4-11
4-12
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What is a source document? Why does a business need to prepare source documents?
What are the monetary unit and historical cost concepts? How do they affect the recording of transactions?
Define assets. Give four examples.
Define liabilities. Give two examples.
Define owner’s equity. What items affect owner’s equity positively? What items affect owner’s equity negatively?
Why is a business’s statement of financial position called a balance sheet?
What are a business’s net assets? How do they relate to owner’s equity?
What is meant by the dual effect of transactions? How does it relate to the accounting equation?
What is an ‘accounting system’? Why is it important that a business has an effective accounting system?
What is an account? What is an account balance?
Define revenues, expenses and net income. How is the accounting equation expanded to record income-related transactions?
Name and briefly define four principles or concepts relating to net income.
What is an accounting period? What is the usual length of an accounting period?
For a service business, what is the business’s earning process, and when does the business record revenues?
What is the matching principle and what types of accounts are matched according to this principle. What is the outcome
for a business?
What is accrual accounting, and why is it important?
Why are adjustment entries needed at the end of a period? Give four examples of adjustments that might be necessary.
How does an understanding of the accounting equation facilitate the preparation of financial reports?
Applying your knowledge
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4-25
Arrange the following items from the books of Lucy Breen, Beautician, under the correct column headings: Assets,
Liabilities, Owner’s Equity, Revenue or Expense:
a Equipment
b Malcolm Black (a client to whom the business provided services)
c Ava Pty Ltd who provide supplies to the business
d Cash at Bank
e Service fees
f Energy costs
g Mortgage on Building
h Drawings – Lucy Breen
i Salon furniture
j Loan from Bank
k Commission received on sale of products
l Wages of staff.
Each of the following cases is independent of the others.
Case
1
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168
Assets
Liabilities
A
Owner’s equity
$30 000
$62 000
2
$ 95 000
B
$54 000
3
$102 000
$44 000
C
Required:
Determine the amounts for A, B and C.
At the beginning of the year, Thomas Lighting had total assets of $78 000 and total liabilities of $22 000. During the year,
the total assets increased by $16 000. At the end of the year, owner’s equity totalled $64 000.
Required:
Determine:
a owner’s equity at the beginning of the year
b total liabilities at the end of the year.
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Chapter 4 The accounting system: Concepts and applications
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At the end of the year, a business’s total assets are $43 000 and its total owner’s equity is $22 000. During the year, the
business’s liabilities decreased by $8000, while assets increased by $4000.
Required:
Determine the business’s:
a ending total liabilities
b beginning total assets
c beginning owner’s equity.
The following transactions are taken from the records of Phantom Security Company:
Assets ¼ Liabilities þ Owner’s equity
4-29
a Rex Simpson, the owner, invested $12 000 cash in the business.
b Phantom paid $6000 cash to acquire security equipment.
c Phantom received a $7000 cash loan from Story Regional Bank.
Required:
Determine the overall effect of each transaction on the assets, liabilities and owner’s equity of Phantom Security Company.
Use I to indicate an increase, D a decrease and N no change. Also show the related dollar amounts.
Jamieson Enterprises was established recently. The balance of each item in its accounting equation is shown below for 6
March and for each of the following business days.
Date
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Cash at
bank
Accounts
receivable Supplies
Inventory
Land
Accounts
payable
Loan
payable
Owner’s
equity
06 Mar.
$4 000
$6 000
$200
$ 800
$11 000
$4 000
$18 000
11 Mar.
3 500
6 000
700
800
11 000
4 000
18 000
13 Mar.
3 500
6 000
700
800
16 000
4 000
5 000
18 000
17 Mar.
3 500
6 000
700
1 600
16 000
4 800
5 000
18 000
19 Mar.
3 250
6 000
700
1 600
16 000
4 800
5 000
17 750
20 Mar.
5 250
4 000
700
1 600
16 000
4 800
5 000
17 750
21 Mar.
5 000
4 000
700
2 150
16 000
5 100
5 000
17 750
23 Mar.
7 000
4 000
700
2 150
16 000
5 100
5 000
19 750
25 Mar.
7 000
5 500
700
2 150
16 000
5 100
5 000
21 250
31 Mar.
7 000
5 500
200
2 150
16 000
5 100
5 000
20 750
Required:
Assuming a single transaction took place on each day, describe briefly the most likely transaction to have occurred,
beginning with 11 March. Indicate which accounts were affected and by what amount.
On 31 August 20X2, Hernandez Engineering Company’s accounting records contained the following items (listed in
alphabetical order):
Accounts payable
$3 700
Accounts receivable
4 000
Cash
5 200
GST collected
L Hernandez, capital
500
?
Loans payable
6 000
Office equipment
8 900
Office supplies
600
Prepaid insurance
800
Required:
Prepare a balance sheet for Hernandez at 31 August 20X2. Insert the correct amount for ‘L Hernandez, capital’.
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
169
Accounting Information for Business Decisions
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Determine the missing elements in the accounting equation. Treat each case separately.
A ¼ L þ OE R E P/L
Case
Total
Assets
A
96 000
B
90 000
Total
Liabilities
C
D
E
4-32
46 000
$ 38 000
50 000
40 000
Cash
Supplies
Accounts payable
Building
A Ridge, capital
170
38 000
83 000
64 000
54 000
57 000
18 000
50 000
95 000
$35 000
56 000
60 000
20 000
32 000
Listed below, in random order, are all the items included in Ridge Rental Company’s balance sheet at 31 December 20X1:
Accounts receivable
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Total
Total
Net Profit OE at beg.
Revenues Expenses or (Loss) of period
21 000
Land
4-33
Owner’s
Equity
$ 2 200
3 500
?
900
4 600
19 000
?
Rental equipment
6 800
Loans payable
5 700
Total assets on 31 December 20X1 are $33 800.
Required:
Prepare a balance sheet for Ridge Rental on 31 December 20X1. Insert the correct amounts for ‘Cash’ and for ‘A Ridge,
capital’.
In the chapter, we stated that a business transaction is an exchange of property or service with another entity. We also
explained that in the recording of a transaction, at least two changes must be made in the assets, liabilities or owner’s
equity of a business.
Required:
In each case, describe a transaction that will result in the following changes in the contents of a business’s balance sheet:
a increase in an asset and increase in a liability
b decrease in an asset and decrease in a liability
c increase in an asset and decrease in another asset
d increase in an asset and increase in owner’s equity
e increase in an asset and increase in revenues
f increase in expenses and decrease in an asset.
In the chapter, we defined a source document as a business record used as evidence that a transaction has occurred.
Required:
Name the source documents that you think a business would use as evidence for each of the transactions listed below:
a receipt of cash from the owner for additional investment in the business
b payment by EFT to purchase office equipment
c purchase of office supplies on credit
d sale of office equipment at its original purchase price to a local accountant
e purchase of fire and injury insurance protection
f sale of inventory on credit.
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Chapter 4 The accounting system: Concepts and applications
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During October, the Wilson Company incurred the following costs:
a At the beginning of the month, the company paid $1200 to an insurance agency for a two-year comprehensive
insurance policy on the company’s building.
b The company purchased office supplies costing $970 on credit from Bailey’s Office Supplies.
c The company paid the telephone company $110 for telephone service during October.
d The owner withdrew $1200 for personal use.
e The company found that, of the $970 of office supplies purchased in (c), only $890 remained at 31 October.
Required:
Identify whether each of the above items would be recorded by the Wilson Company as an asset or an expense for
October. List the dollar amount and explain your reasoning.
Gertz Rent-A-Car is in the business of providing customers with quality rental cars at low rates. The business engaged in
the following transactions during March:
a The owner, Jim Gertz, deposited an additional $1900 of his personal cash into the cash account.
b The business collected $1500 in car rental fees for March.
c The business borrowed $7000 from the Nation Bank, to be repaid in one year.
d The business completed arrangements to provide fleet service to a local company for one year, starting in April and
collected $18 000 in advance.
Required:
For each of the above transactions, identify which revenues, liabilities or owner’s equity would be recorded as revenues by
Gertz Rent-A-Car for March. List the dollar amounts and explain your reasoning.
The Slidell Auto Supply Company entered into the following transactions during the month of July:
Date
Transaction
1 July
Joan Slidell, the owner, deposited $12 000 in the cash account.
11
Slidell Auto Supply purchased $800 of office supplies from Jips Paper Company, agreeing to pay for half of the supplies on 31 July
and the rest on 15 August.
16
Slidell Auto Supply purchased a three-year fire insurance policy on a building owned by the company, paying $600 cash.
31
Slidell Auto Supply paid Jips Paper Company half the amount owed for the supplies purchased on 11 July.
Required:
Using the basic accounting equation that we introduced in this chapter, record the above transactions. Use headings for
the specific kinds of assets, liabilities and owner’s equity. Set up your answer in the following form:
Date
4-38
¼
Assets
þ
Liabilities
Owner’s equity
The financial balances for Steve’s Car Rentals on 31st May, 2019 are provided below in a table in accounting equation
format. You are required to:
a draw up the table and list the balances for May
b record the effects of each of the transactions listed. Show the total of each column after each transaction to ensure the
accounting equation balances.
c calculate the profit or loss made by comparing revenues with expenses.
d prepare a balance sheet at 31st May.
Asset ¼ Liabilities þ Equity
Transaction
Balances
Cash at
Bank
12 000
Accounts
Office
Receivable Equipment
13 800
1 800
Motor
Vehicle
93 700
Supplies
Accounts
Payable
200
3 000
Loan
Payable
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
13 500
Equity
105 000
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Accounting Information for Business Decisions
Transactions for the month of May:
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172
i
Collected $2800 of accounts receivable.
ii
Billed customers for services performed on credit $13 700.
iii
Paid $1200 of accounts payable.
iv
Purchased supplies worth $700 on credit.
v
Purchased another motor vehicle for $21 000. Paid $1000 in cash and borrowed the rest as a loan.
vi
Steve withdrew $650 in cash.
vii Received $3900 cash for services performed.
viii Paid wages $1500 and advertising $200 in cash.
ix
Recorded supplies used of $600.
x
Recorded interest on loan $235.
Amy Dixon opened the Dixon Travel Agency in January, and the company entered into the following transactions during
January:
i
On 2 January, Amy deposited $23 000 in the cash account.
ii
To conduct its operations, the company purchased land for $3300 (including GST of $300) and a small office building
for $16 500 (including GST $1500) on 3 January, paying $19 800 cash.
iii
On 5 January, the company purchased $770 (including GST $70) of office supplies from City Supply Company,
agreeing to pay for half of the supplies on 15 January and the remainder on 15 February.
iv
On 12 January, the company purchased office equipment from Ace Equipment Company at a cost of $3300 (including
GST $300). It paid $1300 down and signed a note agreeing to pay the remaining $2000 at the end of one year.
v
On 15 January, the company paid City Supply Company half the amount owed for the supplies purchased on 5
January.
vi
On 28 January, Amy decided that the company did not need a desk it had purchased on 12 January for $440. The
desk was sold for $440 cash to Chris Watson, an insurance agent, for use in his office.
vii On 30 January, the company collected $990 (including GST $90) of commissions for travel arrangements made for
customers during January.
viii On 31 January, the company paid Frank Jones $550 (including GST $50) for repair work done during January.
ix
On 31 January, the company received its telephone bill totalling $132 (including GST $12) for January. It will pay
for this bill in early February.
x
On 31 January, Amy withdrew $600 from the company for her personal use.
Required:
a Using the accounting system we developed in the chapter, record the preceding transactions.
b Prove the equality of the accounting equation at the end of January.
c List the source documents that you would normally use in recording each of the transactions.
Parsons Fashion Designers was started on 1 June. The following transactions of the business occurred during June:
i
E Parsons started the business by investing $18 000 cash.
ii
Land and an office building were acquired at a cost of $5500 (including GST $500) and $19 800 (including GST
$1800), respectively. The company paid $6300 immediately and established a short-term loan for the remaining
balance of $19 000. The payment is due in two years.
iii
Design equipment was purchased. The cash price of $2860 (including GST $260) was paid by cheque to the supplier.
iv
Office supplies totalling $275 (including GST $25) were purchased on credit. The amount is due in 30 days.
v
A one-year fire insurance policy was purchased for $880 (including GST $80).
vi
Fashion design commissions (fees) of $1320 (including GST $120) were collected from clients for June.
vii An assistant’s wage of $660 was paid for June. PAYG tax included in this amount was $160.
viii E Parsons withdrew $500 from the business for personal use.
ix
Utility bills totalling $165 (including $15 GST) for June were received and will be paid in early July.
Required:
a Using the accounting system shown in the chapter, record the above transactions.
b Prove the equality of the accounting equation at the end of June.
c List the source documents that you would normally use in recording each of the transactions.
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Chapter 4 The accounting system: Concepts and applications
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4-42
L Snider, a young accountant, started Snider Accounting Services on 1 September. During September, the following
transactions of the business took place. (Note: where appropriate, GST is included in the amount.)
i
On 1 September, Snider invested $7000 to start the business.
ii
On 1 September, the business paid $3300 for one year’s rent of office space in advance.
iii
On 2 September, office equipment was purchased at a cost of $5500. A down-payment of $1500 was made and a
$4000, one-year note was signed for the balance owed.
iv
On 5 September, office supplies were purchased for $660 cash.
v
On 18 September, $1100 (including $100 GST) was collected from clients for accounting services performed.
vi
On 28 September, $500 wages were paid to an accounting assistant; $100 PAYG tax was included.
vii On 29 September, Snider withdrew $800 for personal use.
viii On 30 September, the business billed clients $1320 (including $120 GST) for accounting services performed during
the second half of September.
ix
On 30 September, the September electricity bill of $110 (including $10 GST) was received; it will be paid in early
October.
x
On 30 September, Snider recorded the following adjustments:
– Rent expense of $250
– Depreciation of $60 on office equipment
– Interest expense of $40 on loan payable
– Office supplies used of $50.
Required:
a Using the accounting system shown in this chapter, record the above items.
b Prove the equality of the accounting equation at the end of September.
c Calculate the net income of the company for September.
d Prepare a balance sheet for the company on 30 September.
The Johnson Drafting Company, which draws blueprints for building contractors, was started on 1 March. The following
transactions of the company occurred during March:
Date
Transactions
1 Mar.
M Johnson, the owner, started the business by investing $14 000 cash
2
Land and a small office building were purchased at a cost of $4400 and $22 000, respectively including GST. A down payment of $8000
was made, and a loan for $18 400 was signed. The loan is due in one year
3
Cash of $4840 (including GST) was paid to purchase computer drafting equipment
8
Drafting supplies totalling $880 (including GST) were purchased on credit. The amount is due in early April
15
The company collected $1500 (excluding GST) from contractors for drafting services performed
28
M Johnson withdrew $1000 for personal use
29
The company received a $110 (including GST) utility bill for March, to be paid in April
30
The company paid $7600 in salary to a drafting employee. PAYG tax payable included in this amount was $420
30
The company billed contractors $2200 (including GST) for drafting services performed during the last half of March
31
The company recorded the following adjustments:
i Depreciation of $80 on the office building
ii Depreciation of $100 on computer drafting equipment
iii Interest of $160 on loan payable
iv Drafting supplies used of $150
Required:
a Using the accounting system shown in the chapter, record the preceding transactions.
b Prove the equality of the accounting equation at the end of March.
c Calculate the net income of the company for March.
d Prepare a balance sheet for the company on 31 March.
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Accounting Information for Business Decisions
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The five transactions that occurred during June, the first month of operations for Brown’s Gym, were recorded as follows
(excluding GST implications):
¼
Assets
þ
Trans
Date
Cash
a
01/6
þ$24 000
b
05/6
8 000
c
07/6
270
d
17/6
4 000
e
26/6
Balances
30/6
Gym
þ
supplies
Land
þ Building þ
Gym
þ
equipment
þ Owner’s equity
þ
þ Tom Brown,
capital
Loans
payable
þ$24 000
þ$5 000
þ$23 000
þ$20 000
þ$270
þ$10 000
þ6 000
þ480
$11 730 þ
$750 þ
þ$480
$5 000 þ
$23 000 þ
$10 000 ¼
þ$480 þ
$26 000 þ
$24 000
Required:
a Describe the five transactions that took place during June.
b Prepare a balance sheet on 30 June.
The following transactions were recorded by the Sutton Systems Design Company for May, its first month of operations
(excluding GST implications):
4-44
¼
Assets
þ
Trans
Date
Cash
a
01/5
þ$55 000
b
02/5
8 000
c
08/5
3 500
d
10/5
e
22/5
Balances
31/5
4-45
Liabilities
Accts
payable
Office þ
supplies
Land
þ Building þ
Office
þ
equipment
þ Owner’s equity
þ
þ Steve Sutton,
capital
Loans
payable
þ$55 000
þ$6 000
þ$18 000
þ$16 000
þ$7 500
þ$1 100
þ4 000
þ$1 100
þ300
$43 800 þ
Liabilities
Accts
payable
300
$1 100 þ
$6 000 þ
$18 000 þ
$7 200 ¼
$1 100 þ
$20 000 þ
$55 000
Required:
a Describe the five transactions that took place during May.
b Prepare a balance sheet at 31 May.
At the beginning of July, Patti Dwyer established PD Company, investing $20 000 cash in the business. On 5 July, the
company purchased land and a building, making a $6000 down payment (which was 10 per cent of the purchase price)
and signing a 10-year mortgage for the balance owed. The land was 20 per cent of the cost and the building was 80 per
cent of the cost. On 17 July, the company purchased $3800 of office equipment on credit, agreeing to pay half the
amount owed in 10 days and the remainder in 30 days. On 27 July, the company paid the amount due on the office
equipment. On 31 July, the company sold $900 of the office equipment that it did not need to another company for
$900. That company signed a note requiring payment of the $900 at the end of one year.
Required:
Based on the above information, prepare a balance sheet for PD Company on 31 July. Show supporting calculations.
Ignore GST in this question.
Making evaluations
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174
Your friend Maxine plans to supplement her job salary by running her own company at night and on weekends. When the
company earns enough money for her to pay for a holiday house in Fiji, she plans to pay the company’s bills, sell its
remaining assets, withdraw all its cash and shut it down. Since Maxine will be extremely busy with her regular job and
with running her new company, she plans to wait until she is ready to shut down the company to prepare a balance sheet,
income statement and cash flow statement. You think this is a bad idea.
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Chapter 4 The accounting system: Concepts and applications
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4-48
Required:
Do your best to convince Maxine that she should prepare financial statements more often, giving her examples of how
doing this can help her and her company.
Chris Schandling is a loan officer at the Nation Bank in Brisbane, Australia. One day, Nathan Wooten, who owns KidzLand
(an indoor playground for young children), comes to the bank to see Chris about getting a $50 000 loan.
Required:
a What types of questions do you think Chris will ask Mr Wooten? Come up with at least three types of questions.
b What types of financial information do you think Chris will ask Mr Wooten to provide?
c If Mr Wooten asks Chris why this financial information is needed, how should Chris respond?
Is it important that KidzLand’s financial statements follow GAAP? Why or why not?
Andrew Poist works for a public accounting firm in Melbourne, Australia. On 4 October 20X1, Sydney Langston, who
started selling decorative carved wooden ducks out of a booth at Cypress Court Shopping Centre during the first week in
September, comes to see Andrew for some accounting help.
Mr Langston walks into Andrew’s office carrying a small cardboard box. He tells Andrew the following: ‘After I retired,
I decided I needed something to help keep me busy. I started this little business, The Woodshed, a month ago. It is open
only on Fridays, when the shopping centre has its Craft Market. I leased the booth for one year. So every Friday until 1
September 20X2, I will display my ducks in the booth and sell them. I know I should have come to see you before I got
started, but I kept putting it off. So here’s what I did. During September, I tossed everything to do with The Woodshed’s
finances into this box. It has all kinds of documents in it. I have all of my bank deposits for the month, cheques I wrote
that were paid by my bank, the receipts for the woodworking supplies I bought the day I started, and so on. I sorted out
some items, like payments I made to the grocery shop and the electricity company. Anyway, it’s the first part of October,
and I can’t figure out how well The Woodshed did in September. Can you?’
‘Of course I can’, replies Andrew. ‘I’ll have something for you in a couple of days.’
Mr Langston leaves, and Andrew opens the small box. Inside is a small pile of documents:
i Five deposit slips from Mr Langston’s bank account. They total $2300. Andrew notices that on four of the deposit slips,
Mr Langston has written ‘Craft Sales’. Each of the deposit dates corresponds to each of the four Fridays in September. On
the other deposit slip, which is for $1300, Mr Langston has written ‘Centrelink payment’.
ii There are six cheques honoured by Mr Langston’s bank account, totalling $3350; four cheques written to Miranda’s
Woodworking Supplies, total $600; one cheque for $350 written to Circuit City; and one cheque for $2400 written to
Cypress Court Shopping Centre management.
iii A handwritten schedule reads as follows:
Mallard
$ 60
Sold
Grey Goose
$100
Sold
Baby Duck
$ 40
Sold
Swan
$200
Donald Duck
$ 70
Sold
Large Mallard
$130
Sold
Required:
a Using the information Mr Langston supplied to Andrew, calculate your best estimate of the revenues, expenses and
net income for The Woodshed for September 20X1.
b How could your calculations of revenues, expenses and net income be misstated? When Andrew meets with Mr
Langston to discuss The Woodshed’s operating results for September, what questions should he ask concerning the
information Mr Langston supplied?
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
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Accounting Information for Business Decisions
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In this assignment, we are going to chronicle the changes in value and ownership of one asset – a one-hectare plot of land
on the corner of Cedar Springs Road and McKinney Avenue in Tamborine Mountain, Gold Coast – from January 20X1 to
December 20X2. Here are the significant events that happened to that plot of land during this time period:
4 January 20X1
The land is purchased for $450 000 by Dalton Realty
25 April 20X1
Dalton Realty receives an assessment notice stating that the council now values the land at $510 000 for local rate purposes
12 December 20X1
The land is sold by Dalton Realty to Park Cities Development for $515 000. Park Cities pays in cash
22 May 20X2
Using the land as collateral (meaning that if Park Cities fails to repay its loan, the bank may get ownership of the land),
Park Cities borrows $550 000 from the bank
14 June 20X2
Park Cities rents the land to Crescent Court Construction for six months. Crescent Court will store construction equipment
on the land while making renovations to a nearby housing estate
31 December 20X2
Park Cities sells the land to Crescent Court Constructions for $590 000
Required:
When business closes for each day listed below, state:
a which company shows this land in its accounting records as an asset
b at what dollar amount the land is shown in that company’s accounting records.
Date
Company showing
the land as its asset
Dollar amount
shown
04/01/20X1
25/04/20X1
12/12/20X1
22/05/20X2
14/06/20X2
31/12/20X2
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176
Five years ago, Linda Monroe became the sole owner of LM Electronics, which sells home entertainment centres, car audio
equipment and computers. LM advertises that it sells only the best brands, purchasing its inventory from well-known
manufacturers in Japan, Germany, Norway and the United States. Before opening this company, Linda was the accountant
for The Music Warehouse. She understands accounting extremely well, and maintains LM Electronics’ accounting records
according to GAAP.
On the morning of Friday 12 September, one of Linda’s best customers, Sandy Wheeler, purchased a German-made CD
player for $600. Linda was excited about making the sale because LM had only recently started carrying this particular
brand. Linda filled out the sales invoice, collected the money and helped Sandy carry the CD player to her car.
Later that day, Linda’s friend Chris Rucker came into the shop, also wanting to purchase a CD player. After browsing
for a while, Chris went to leave the shop. Linda stopped him and asked, ‘Chris, didn’t you find a CD player that you’d like
to own?’ Chris replied, ‘Well, Linda, I saw several items I’d love to own, but I hadn’t realised how expensive the equipment
was. I guess I really can’t afford to buy a new CD player.’
Except for the deposit of the day’s cash sales in the bank, no other activity took place at LM Electronics that day. After the
shop closed, Linda began thinking about Chris’s comment. Early that evening, she telephoned Chris and said, ‘Chris, I
know you were wanting a new CD player, but if you’re interested in saving money, I’d like to sell you the CD player I use
at home. It’s about two years old and in great shape. I would sell it to you for $100.’
Chris was excited about Linda’s offer. He drove over to her house that night, gave her $100 in cash and took the CD
player home. Linda immediately deposited the $100 in the bank night depository.
Required:
Given the facts presented above and the information you learned in the chapter, (a) indicate whether you agree or disagree
with the following statements, and (b) explain each answer (this is the most important part, so think through the
following statements carefully).
i Linda Monroe sold two CD players on 12 September.
ii LM Electronics sold two CD players on 12 September.
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Chapter 4 The accounting system: Concepts and applications
4-51
4-52
4-53
iii LM Electronics should record CD player sales of $700 on 12 September.
iv Linda Monroe should deposit $700 in the bank on 12 September.
Paul Jenkins is the sole owner of Friendly Exchange Shop, which buys and sells jewellery, musical instruments, televisions,
telephones and small kitchen appliances. Paul has owned the shop for almost one year, and the shop has developed a
reputation as an honest, reliable place for families to buy or sell their used items.
Until now, Friendly Exchange has bought and sold goods only from retail customers. Paul believes that Friendly Exchange is
overstocked with jewellery, and he thinks the shop does not have enough musical instruments to meet the demand that will
occur after the new school year starts. Paul believes the shop needs to sell some of its jewellery, which cost about $1500. He
anticipates that he could sell the jewellery for $4000 and replace this with several trumpets, trombones and flutes.
Friendly Exchange Shop advertises in the newspaper when it wants to buy particular types of used items. This way Paul has
the opportunity to inspect the goods before they are purchased, and to discuss the history of each item with its current owner.
In the present situation, however, Paul is considering making a merchandise trade with a wholesale exchange broker.
Although Paul is almost convinced that the trade will be the best way for his business to obtain the musical instruments, he
has two major concerns. First, Paul is concerned about maintaining the shop’s reputation for reliable merchandise. He knows
almost all of his customers and he has earned their trust. Because Paul does not know where the wholesaler’s musical
instruments were purchased, he worries that he will be trading good jewellery for inferior quality musical instruments. He
would not find out that the instruments are inferior until the customers told him of their dissatisfaction. Second, Paul does not
know how to record the trade in Friendly Exchange Shop’s accounting records. As mentioned earlier, he knows that the
jewellery he plans to trade cost $1500, and that he was going to try to sell the jewellery for $4000. Paul does not know how
much the wholesaler paid for the musical instruments or what price to charge his customers for each item.
Required:
a Using the four-step approach you learned in this chapter and earlier in this book, discuss how you think Paul should
solve this business problem.
b Assuming Friendly Exchange Shop trades the jewellery for the musical instruments owned by the wholesaler, discuss
how you think this transaction should be recorded in the accounting records. Be sure to include references to the
accounting concepts introduced in this chapter.
Your friend Jane Thomson is about to prepare the 31 January balance sheet for her new business, Tasty Bites cupcake
shop. This is Tasty Bites’ first month of operation, and Jane is also going to calculate the first month’s net income. She
needs to prepare the balance sheet and calculate net income so she can pass the information along to her parents. They
loaned her $5000 so that she could start Tasty Bites.
Although Jane thinks that business is booming, she has a big problem. She does not know enough about accounting to
prepare the balance sheet or calculate January’s net income. As a matter of fact, Jane had never heard the words ‘balance
sheet’ and ‘net income’ until her parents asked her to promise to give them these statements every month before they
would agree to loan Jane the $5000.
Luckily, Jane saves every piece of paper associated with Tasty Bites. She kept copies of all of the business agreements
she signed. She deposited all of the money Tasty Bites earned in the company’s bank account and she retained copies of
every deposit slip. Jane also paid every company bill with a cheque and saved all of the related documents.
Required:
Assume Jane wants to prepare Tasty Bites’ 31 January balance sheet and January’s income statement according to GAAP.
Describe to Jane, in your own words, how she should organise the information about Tasty Bites’ January transactions so
that she can prepare a balance sheet and an income statement and keep her promise to her parents.
Samson Construction Company is a small business that constructs buildings. Usually, the amount of time it takes Samson to
complete the construction of a building is about six months. At the beginning of this year, Samson signed a contract to build a
three-storey office building at a selling price of $2 million. Samson will collect this amount when it completes construction of
the building. Because this is a larger building than it usually builds, Samson expected that it would take two years to complete
the construction, at a total cost of $1.4 million. This is the only building on which Samson worked during the year. By the end
of the year, construction was on schedule: the office building was half-complete and Samson had paid $700 000 costs. At this
time, Samson’s bookkeeper came to Bill Samson, the owner, and said, ‘Samson Construction Company didn’t do very well this
year; it had a net loss of $700 000 because its revenue was zero and its expenses were $700 000.’
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177
Accounting Information for Business Decisions
Bill comes to you for advice. He says, ‘Usually, my company records the revenue and related expenses for constructing a
building when it is completed. However, this three-storey building will take much longer than usual. My construction crews
have already been working on the building for one year, and will continue to work on it for another year. My company has paid
for one year’s worth of salaries, materials and other costs, and will continue to pay for all of these costs incurred next year, so a
lot of money will be tied up in the contract and won’t be recovered until my company collects the selling price when the
building is completed. How and when should my company record the revenue and expenses on this building? Do I really have a
$700 000 net loss for the current year?’
Required:
Prepare a written answer to Bill Samson’s questions.
Dr Decisive
Yesterday, you received the following letter for your advice column at the local paper:
Dear Dr Decisive,
My girlfriend and I have just started out on our studies of accounting and are thinking of starting up a
fitness business together. We recently had a bit of an argument about the terms ‘asset’ and ‘liability’. I
feel that because I am tall, fit, dark and handsome, those qualities will be an asset to the business and
should be recorded. It will help to bring in customers and ultimately make profit. She says I have the
concept completely wrong but if we are going to do that insists, that we should also focus on my
liabilities, which are my ego and tardiness in getting work done, which will cost the business money. She
insists that we should only record tangible things that are of value to the business as assets and things
that are negative as liabilities. Can you give me examples of what she means? And what is tangible? Also,
can you explain to me why my business ‘qualities’ should not be recorded as assets of the business?
Yours sincerely,
‘Dark and Handsome’
Required
Meet with your Dr Decisive team and write a response to ‘Dark and Handsome’.
Endnotes
a
b
Quoted in Metcalf, M (2014) The Biteback Book of Humorous Business Quotations. London: Biteback Publishing, np.
Godfrey, K (1995) ‘Computing error at Fidelity’s Magellan fund’. The Risks Digest, 16(72). http://catless.ncl.ac.uk/risks/16.72.html.
List of company URLs
u
u
u
u
u
u
u
Aldi: http://www.aldi.com.au
Benetton: http://www.benetton.com
Fidelity Investments: http://www.fidelity.com.au
Fortescue Metals Group: http://www.fmgl.com.au
Origin Energy: http://www.originenergy.com.au
Sony: http://www.sony.com.au
Audi: http://www.audi.de/de/brand/de.html
178
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5
RECORDING, STORING AND
REPORTING ACCOUNTING
INFORMATION
‘The system of bookkeeping by double entry is perhaps the most beautiful
one in the wide domain of literature and science.’
Edwin T. Freedley, 1852a
Learning objectives
After reading this chapter, students should be able to do the following:
5.1
Understand the rules for recording transactions in a business’s
accounting system records.
5.2 Identify and complete the major steps in a business’s accounting
cycle.
5.3 Journalise and post to accounts the transactions of a business
and prepare a trial balance.
5.4 Complete adjusting and closing entries.
5.5 Prepare financial reports – income statement and balance sheet.
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179
Accounting Information for Business Decisions
Understanding the learning objectives is assisted in the chapter by asking key questions:
Key questions
1
What is a debit entry, and what is a credit entry?
2
What are the rules for recording increases and decreases in asset and liability accounts?
3
What are the rules for recording increases and decreases in owner’s equity accounts?
4
What are the major steps in a business’s accounting cycle?
5
What is the difference between journalising and posting?
6
What are adjusting entries, and what are the three types of adjusting entries?
7
What are closing entries, and how do they relate to the income summary account?
8
How are accounting procedures modified for companies?
9
What circumstances might cause directors to act unethically when making dividend
distribution decisions for owners?
In Chapter 4, we explained transactions and source documents, as well as the entity, monetary unit and
historical cost concepts as they apply to a business’s accounting process. We explained that the accounting
process accumulates information and reports the results of the business’s activities. We introduced a basic
accounting system in terms of the accounting equation: Assets ¼ Liabilities þ Owner’s equity. We noted that
the accounting system included columns for recording and retaining information from transactions related to
the business’s assets, liabilities and owner’s equity accounts, so that the business can report the information
on its balance sheet. We also explained the dual effect of recording transactions. We discussed several
accounting principles and concepts related to net income, including the concepts of an accounting period, the
earning process, the matching principle and accrual accounting.
In Chapter 7, we will expand the accounting system to include columns for recording and
retaining information from transactions relating to each of the business’s revenue and expense
accounts, so that the business can report the information on its income statement. We will use the
accounting equation to explain the impact of transactions on a business’s accounting system. We will
also explain the effect of each transaction on the financial statements.
The accounting-equation approach to a business’s accounting system works well to explain the accounting
process without getting ‘bogged down’ in specific accounting procedures. This approach enables you to focus
more on understanding how to use the information generated by this process. However, the column method for
a business’s accounting system is unmanageable when the business has many transactions involving numerous
accounts (sometimes hundreds!) for which it needs to keep detailed records. In this case, the business uses a
more complex accounting system. Many of you will need to have a basic understanding of the specific
accounting procedures used by a business to operate a more complex accounting system. Others may also be
interested in understanding these procedures that will enable you to better evaluate financial statements as a
manager or as an investor. The purpose of this chapter is to explain rules for double entry (i.e. debit and credit
rules), the accounting cycle and how businesses record transactions in journals, post and retain transaction
information, record adjusting and closing entries, and prepare financial statements. To help explain some of
these procedures, we will review what we discussed in earlier chapters. For simplicity, our discussion will initially
focus on a sole proprietorship, but we will explain the differences for companies later in the chapter.
5.1 Accounts
Ethics and Sustainability
180
Recall that an accounting system is a means by which a business identifies, measures, records and retains
accounting information about its activities so that it can report this information in its financial
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Chapter 5 Recording, storing and reporting accounting information
statements. Most businesses will use an electronic accounting system. For small to medium businesses
this will most likely be a package like MYOB or XERO. Business transactions are entered into the system,
processed electronically in order to produce the reports required by the owners or managers to make
decisions. Understanding the process that takes place in an electronic accounting system such as MYOB
or XERO helps shed light on the information or output produced by the system. In an accounting system,
a business uses accounts to record and retain the monetary information from its transactions. It uses a
separate account for each asset, liability and owner’s equity item, as well as for each revenue and expense
item. The number of accounts, as well as the types and names of the accounts, will depend on the
particular business’s operations, and on whether it is a sole proprietorship, partnership or company. A
general ledger is the entire set of accounts that a business uses. For this reason, accounts are
sometimes referred to as general ledger accounts.
accounts
Documents used to
record and retain the
monetary information
from a business’s
transactions
general ledger
Entire set of accounts
for a business
Stop & think
Why is it necessary to have a separate account for each item that the business must record?
Stop & think
How does keeping records of the financial transactions of a business help to make a business
more sustainable?
1
An account can take several physical forms. Today, most accounting is done using software packages, and
records are stored on computer hard drives and in back-up files. Very few businesses now use a manual
system to record daily operations, and the general ledger is usually a computer file. Regardless of their physical
form, a business uses each account for recording and accumulating accounting information about a financial
statement item.
Stop & think
How do we decide what name to call an account?
Debits and credits
In a manual system, accounts may have several different forms. For convenience, in this chapter we will use the
T-account form. The title of the account is written across the top of each T-account, and each T-account has a
left side and a right side. The left side is called the debit (DR) side, and the right side is called the credit (CR) side.
The left (debit) and the right (credit) sides of each account are used for recording and accumulating the
monetary information from transactions. A debit entry is a monetary amount recorded (debited) on the left
side of an account. A credit entry is a monetary amount recorded (credited) on the right side of an account.
Title of account
Left (debit) side
Right (credit) side
Recording rules
Each account accumulates information about how much it has increased or decreased as a result of
various transactions. Whether a business records increases or decreases on the left or the right side of an
account depends on the type of account (i.e. on where the account ‘fits’ within the accounting equation),
and is based on the debit and credit rules. For assets, liabilities and owner’s equity accounts, these rules
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
What is a debit entry, and
what is a credit entry?
T-account
Accounts used to
record transactions for
individual types of
assets, liabilities and
owner’s equity, as well
as revenues and
expenses
debit entry
Monetary amount
recorded (debited) on
the left side of an
account
credit entry
Monetary amount
recorded (credited) on
the right side of an
account
2
What are the rules for
recording increases and
decreases in asset and
liability accounts?
3
What are the rules for
recording increases and
decreases in owner’s
equity accounts?
181
Accounting Information for Business Decisions
double entry rule
In the recording of a
transaction, the total
amount of the debit
entries must be equal
to the total amount of
the credit entries for
the transaction
relate to the side of the accounting equation on which the account is located.1 For withdrawal,2 revenue
and expense accounts, these rules relate to whether the transactions increase or decrease owner’s equity.
That is, when an owner withdraws money from the business, the effect of the withdrawal is that the
owner’s equity in the business decreases. When the business earns revenue, the ultimate effect of the
revenue increase is to increase the owner’s equity. When the business incurs expenses, the ultimate effect
of the expense increase is to decrease the owner’s equity.
The debit and credit rules are as follows:
1 Asset accounts (accounts on the left side of the accounting equation) are increased by debit (DR) entries
(amounts recorded on the left side of a T-account) and decreased by credit (CR) entries.
2 Liability accounts (accounts on the right side of the equation) are increased by credit (CR) entries
(amounts recorded on the right side of a T-account) and decreased by debit (DR) entries.
3 Permanent owner’s equity, or capital, accounts (accounts on the right side of the equation) are
increased by credit (CR) entries and decreased by debit (DR) entries. Temporary owner’s equity
accounts have the following rules:
a Withdrawal accounts are increased by debit (DR) entries and decreased by credit (CR) entries.
b Revenue accounts are increased by credit (CR) entries and decreased by debit (DR) entries.
c Expense accounts are increased by debit (DR) entries and decreased by credit (CR) entries.
Exhibit 5.1 illustrates the debit and credit rules as they relate to the accounting equation.3
As we introduced in the previous chapter, a business uses the double entry rule for recording its
accounting information. The double entry rule states that in the recording of a transaction, the total
Exhibit 5.1 The accounting equation and debit–credit rules
Assets
Asset accounts
(debit)
increase
ⴙ
(credit)
decrease
ⴚ
ⴝ
Permanent accounts
Liabilities
Liability accounts
(debit)
decrease
ⴚ
(credit)
increase
ⴙ
ⴙ
Temporary accounts
Owner’s equity
Owner’s
Equity (capital) accounts
Withdrawals accounts
(debit)
decrease
ⴚ
(debit)
increase
ⴙ
(credit)
increase
ⴙ
(credit)
decrease
ⴚ
Revenue accounts
(debit)
decrease
ⴚ
(credit)
increase
ⴙ
Expense accounts
(debit)
increase
ⴙ
1
(credit)
decrease
ⴚ
Owner’s equity accounts may be permanent or temporary. Permanent owner’s equity accounts are those that a business
reports on its balance sheet. Temporary owner’s equity accounts are used only to calculate a business’s net income or
withdrawals for the accounting period.
2
In earlier chapters, we recorded withdrawals as reductions in the owner’s capital account column. Many businesses keep track
of withdrawals separately, and use a withdrawals or drawings account to do so.
3
The debit and credit rules for increasing and decreasing a contra-account are the opposite of the account to which it relates.
We discuss contra-accounts later in this chapter.
182
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Chapter 5 Recording, storing and reporting accounting information
amount of the debit entries must equal the total amount of the credit entries for the transaction. The use
of both the double entry rule and the debit and credit rules in recording transactions ensures that the
accounting equation remains in balance.
At any given time, an account may have a number of debit and credit entries. The balance of an
account is the difference between the total increases and the total decreases recorded in the account.
Typically, total increases exceed total decreases. Therefore, each asset account normally has a debit balance
because the total increases (debits) exceed the total decreases (credits) in the account. Similarly, each
liability and permanent owner’s equity (capital) account normally has a credit balance because the total
increases (credits) exceed the total decreases (debits) in each account. For the temporary owner’s equity
items, revenue accounts normally have credit balances, whereas expense and withdrawal accounts normally
have debit balances. The following list summarises the normal balances in the various accounts.
Account
Normal balance
Assets
Debit
Liabilities
Credit
Owner’s capital
Credit
Owner’s withdrawals
Debit
Revenues
Credit
Expenses
Debit
5.2 Accounting cycle
Now that you are familiar with the rules for recording and accumulating information in the various
accounts, we will discuss the steps that a business completes during each accounting period to record,
retain and report the monetary information from its transactions. These steps are called the accounting
cycle. The major steps include:
1 recording (journalising) the transactions in the general journal
2 posting the journal entries to the accounts in the general ledger
3 recording (and posting) adjusting entries
4 preparing the financial statements
5 recording (and posting) closing entries.
We will discuss and illustrate each of these steps, along with several sub-steps, in the following sections.
balance of an account
Difference between the
total increases and the
total decreases
recorded in the account
4
What are the major steps
in a business’s accounting
cycle?
accounting cycle
Steps that a business
completes during each
accounting period to
record, retain and
report the monetary
information from its
transactions
5.3 Recording (journalising)
transactions
Recall that a source document (an invoice, a receipt or a printout from an EFT machine) is the record
from which a business obtains the information for each transaction. The business uses this information
to record each transaction in a journal, after which it transfers the information to its accounts. A general
journal includes the following information about each transaction:
• the date of the transaction
• the accounts to be debited and credited
• the amounts of the debit and credit entries
• an explanation of each transaction.
In a manual system, the general journal is a book of columnar pages.
A business can use a general journal to record all types of transactions. The general journal is the
kind of journal we will discuss in this chapter; however, some businesses may have a number of
special journals, each of which is used to record a particular type of transaction. The common special
journals are the sales (for recording credit sales), purchases (for credit purchases of inventory), cash
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
general journal
Includes the following
information about each
transaction: the date of
the transaction, the
accounts to be debited
and credited, the
amounts of the debit
and credit entries and
an explanation of each
transaction
183
Accounting Information for Business Decisions
journalising
Process of recording a
transaction in a
business’s general
journal
journal entry
Recorded information
for each transaction
receipts (for cash inflows) and cash payments (for cash outflows) journals. We do not discuss these
special journals in this chapter.
A general journal consists of a date column, a column to list the accounts affected by each transaction
(and an explanation of the transaction), a column to list the account numbers of the affected accounts,
and debit and credit columns to list the amounts to be recorded in each account. Journalising is the
process of recording a transaction in a business’s general journal. A journal entry is the recorded
information for each transaction. We show an example of transactions and how they are recorded in a
general journal in Case Exhibits 5.2 and 5.3 later in this chapter.
Stop & think
Why is it so important to ensure that the journal entry is correct when entering it into
the system?
A business gains several advantages by using a general journal for initially recording its transactions.
First, this process helps prevent errors. Since the business initially records the accounts and the debit and
credit amounts for each transaction on a single journal page, rather than directly in the many accounts,
this method makes it easier to prove that the debits and the credits are equal, thus keeping the
accounting equation in balance. Second, all the information about each transaction (including the
explanation) is recorded in one place, thereby providing a complete ‘picture’ of the transaction. This is
useful in the auditing process or if an error is discovered because it will be easy to review all of the
transaction information. Third, the business records the transactions chronologically (i.e. day to day), so
that the journal provides a ‘history’ of its financial transactions.
Key procedures in journalising
narration
A description of the
transaction that has
been entered into the
general journal
184
The following list outlines the journalising procedures for each column of the general journal. Study it
carefully, referring to the completed general journal in Case Exhibit 5.3.
1 Enter the day, month and year of the first transaction in the ‘Date’ column. It is not necessary to
repeat the month and year of later transactions until the beginning of a new journal page, a new
month or a new year.
2 Enter the title of the account to be debited at the far left of the column titled ‘Account titles and
explanations’. Enter the amount of the debit to this account in the ‘Debit’ column on the same line as
the account title. Dollar signs are typically not used in the debit (or credit) columns.
3 Enter the title of the account to be credited on the next line below the title of the debited account.
Indent the title of the credit account slightly to the right, so that a reader looking at the journal
page can easily identify which account titles are debited and which are credited. Enter the amount of
the credit to this account on the same line in the ‘Credit’ column.
4 Some transactions involve two or more debits, two or more credits, or both. (Remember that for each
transaction, the total amount of the debit entries must equal the total amount of the credit entries.) In
this case, the type of journal entry a business uses is called a compound entry. When recording a
compound entry, first list all the accounts and amounts to be debited (list each account on a separate
line), followed by all the accounts to be credited (indent and list each account on a separate line).
Because of GST, most of the entries in Case Exhibit 5.3 are examples of a compound journal entry.
5 Enter a brief explanation of the transaction on the line below the last credit entry of the transaction. Write
the explanation at the far left of the column entitled ‘Account titles and explanations’. Leave a blank line
before beginning another journal entry, to set off each entry. The explanation is called a narration.
6 During the process of journalising, do not record a number in the column entitled ‘Acct no.’ (‘Account
number’). You will enter a number in this column during the ‘posting’ process, which we will discuss
later. (When you are referring to Case Exhibit 5.3, note that this is what the general journal page
looks like after the posting process is complete.)
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Chapter 5 Recording, storing and reporting accounting information
Case Exhibit 5.2 Café Revive’s December 20X1 transactions and analysis
Date
Transaction
Analysis
1/12
E Della makes initial investment in Café Revive
of $22 000.
Asset account ‘Cash’ is increased (debited) by $22 000;
owner’s equity account ‘E Della, capital’ is increased
(credited) by $22 000
1/12
Café Revive pays $7920 (including GST) to
University Hub for six months’ rent in advance.
Asset account ‘Prepaid rent’ is increased (debited) by $7200;
asset account ‘GST paid’ is increased (debited) by $720;
asset account ‘Cash’ is decreased (credited) by $7920
7/12
Café Revive pays $2255 (including GST) for
the purchase of coffee supplies from City
Supply Company.
Asset account ‘Supplies’ is increased (debited) by $2050;
asset account ‘GST paid’ is increased (debited) by $205;
asset account ‘Cash’ is decreased (credited) by $2255
12/12
Café Revive purchases coffee gift packs
inventory of $1430 (including GST) on credit
from DeFlava Coffee Corporation.
Asset account ‘Inventory’ is increased (debited) by $1300;
asset account ‘GST paid’ is increased (debited) by $130;
liability account ‘Accounts payable’ is increased (credited)
by $1430
20/12
Café Revive purchases shop equipment from
Restaurant Equipment for $1650 (including
GST), paying $250 cash and taking a loan of
$1400.
Asset account ‘Shop equipment’ is increased (debited) by
$1500; asset account ‘GST paid’ is increased (debited) by
$150; asset account ‘Cash’ is decreased (credited) by
$250; liability account ‘Loan payable’ is increased
(credited) by $1400
22/12
Café Revive sells $440 (including GST) of
unneeded shop equipment on account to Beau
Flowers Store.
Asset account ‘Accounts receivable’ is increased (debited)
by $440; asset account ‘Shop equipment’ is decreased
(credited) by $400; liability account ‘GST collected’ is
increased (credited) by $40
After journalising the debit and credit entries of a transaction, journalise the next transaction for the
day and continue the process until all the transactions have been recorded. By strictly following these
journalising procedures, you will minimise the chance of error.
Illustration of journal entries
Recall from Chapter 4 that Emily Della started Café Revive, a retail coffee shop, by investing $22 000 on 1
December 20X1. During the remainder of December, the shop engaged in several transactions to get
ready to open for customers.
Also recall that Café Revive is a retail coffee shop that uses a perpetual inventory system4 and leases
shop space in the University Hub.
We have prepared Case Exhibit 5.2 to help you remember the December transactions of Café Revive. This
exhibit summarises the six transactions and analyses the debit and credit entries for each transaction.
To illustrate the general journal and the journalising process, Case Exhibit 5.3 shows the journal entries
for these six transactions. In studying Case Exhibit 5.3, you should do the following:
1 Review each transaction listed in Case Exhibit 5.2.
2 Think of the source documents for the transaction.
3 Understand the impact of the transactions on the accounting equation.
4 Determine the debit and credit entries.
5 Think of the journalising procedures.
6 Compare these procedures with the journal entries that we made in Case Exhibit 5.2.
4
Alternatively, a business could use a periodic inventory system, as we will discuss in Chapter 6. Under this system, the
business does not keep a continuous record of the inventory on hand and sold. Instead it determines its inventory by taking a
physical inventory at the end of the period. The business derives its cost of goods sold by adding its purchases to the
beginning inventory and then subtracting the ending inventory.
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185
Accounting Information for Business Decisions
Case Exhibit 5.3 Café Revive’s general journal entries – December 20X1
Date
Account titles and explanations
Acct no.
Debit
Credit
20X1
1 Dec.
Cash
E Della, capital
101
22 000
301
22 000
Made initial investment in Café Revive
1
Prepaid rent
107
7 200
GST paid
109
720
Cash
101
7 920
Paid 6 months’ rent in advance to University Hub
7
Supplies
106
2 050
GST paid
109
205
Cash
101
2 255
Purchased coffee supplies from City Supply Company
12
Inventory
105
1 300
GST paid
109
130
Accounts payable
201
1 430
Purchased inventory on credit from DeFlava Coffee
Corporation
20
Shop equipment
123
1 500
GST paid
109
150
Cash
101
250
Loan payable
204
1 400
Purchased shop equipment from Restaurant Equipment,
making cash down payment and taking a loan
22
Accounts receivable
103
GST collected
203
440
40
Shop equipment
123
400
Sold unneeded shop equipment (desk) on credit to Beau
Flowers Store
Ethics and Sustainability
To understand the journalising process, look at the 12 December 20X1 transaction, in which Café
Revive purchased $1430 (including GST) of inventory on credit from DeFlava Coffee Corporation. The
source document for the transaction is the invoice that Café Revive received from DeFlava Coffee. The
effect of this purchase on the accounting equation is that asset ‘Inventory’ is increased by $1300, asset
‘GST paid’ is increased by $130, and liability (‘Accounts payable’) is increased by $1430. To record the
transaction in the general journal, Café Revive skipped a line after the previous transaction. It then
entered the date, and the account title (‘Inventory’) and amount ($1300) of the account to be debited, and
moved to the next line, entering the account title (‘GST paid;) and the amount ($130). It indented the
next line and entered the account title (‘Accounts payable’) and amount ($1430) to be credited. On the
next line, it wrote a brief explanation of the journal entry. After following this process for each
transaction, Café Revive stored all the source documents in its files.
Discussion
From a business sustainability perspective, why is it important to ensure that the amount of
inventory on hand is always recorded correctly?
186
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Chapter 5 Recording, storing and reporting accounting information
Discussion
Currently, Café Revive sells its merchandise pre-packed. If the business is concerned about
environmental matters, what changes might it consider?
After a business records the journal entries, it transfers (or posts) the amounts to the related accounts
in the ledger. It records the number (which we discuss later) of each of these accounts in the ‘Acct no.’
column of the general journal. To save space, we do not show this posting process for Case Exhibit 5.3,
but continue our example of journalising in Case Exhibits 5.4 and 5.5. Case Exhibit 5.4 summarises and
analyses the transactions of Café Revive for January 20X2, including revenue and expense transactions,
along with other transactions.5
Case Exhibit 5.4 Café Revive’s January 20X2 transactions and analysis
Date
5
Transaction
Analysis
02/1
Café Revive sells inventory (coffee gift packs) at
total cash selling price of $1650 (including
GST).
Asset account ‘Cash’ is increased (debited)
by $1650; liability account ‘GST collected’
is increased (credited) by $150; revenue
account ‘Sales revenue’ is increased (credited)
by $1500
02/1
Café Revive records cost of goods sold of $780
on cash sale.
Expense account ‘Cost of goods sold’ is increased
(debited) by $780; asset account ‘Inventory’ is
decreased (credited) by $780
03/1
Café Revive pays $1430 to DeFlava Coffee
Corporation for inventory purchased on
12/12/X1.
Liability account ‘Accounts payable’ is decreased
(debited) by $1430; asset account ‘Cash’ is
decreased (credited) by $1430
04/1
Café Revive purchases $5434 (including GST)
of inventory (coffee gift packs) on credit from
DeFlava Coffee Corporation.
Asset account ‘Inventory’ is increased (debited)
by $4940; asset account ‘GST paid’ is
increased (debited) by $494; liability account
‘Accounts payable’ is increased (credited)
by $5434
06/1
Café Revive makes credit sale of $550
(including GST).
Asset account ‘Accounts receivable’ is increased
(debited) by $550; liability account ‘GST
collected’ is increased (credited) by $50;
revenue account ‘Sales revenue’ is increased
(credited) by $500
06/1
Café Revive records cost of goods sold of $260
on credit sale.
Expense account ‘Cost of goods sold’ is increased
(debited) by $260; asset account ‘Inventory’ is
decreased (credited) by $260
07/1
Café Revive collects $440 of accounts
receivable from Beau Flowers Store.
Asset account ‘Cash’ is increased (debited) by
$440; asset account ‘Accounts receivable’ is
decreased (credited) by $440
20/1
E Della withdraws $250 for personal use.
Owner’s equity account ‘E Della, withdrawals’ is
increased (debited) by $250; asset account ‘Cash’
is decreased (credited) by $250
25/1
Café Revive pays $363 (including GST) to a
consultant for promotion coordination.
Expense account ‘Consulting expense’ is
increased (debited) by $330; ‘GST paid’ is
increased (debited) by $33; asset account ‘Cash’
is decreased (credited) by $363
For simplicity, on 31 January we recorded the sum of Café Revive’s cash sales. Normally, a business records its cash sales
each day.
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187
Accounting Information for Business Decisions
Date
Transaction
Analysis
25/1
Café Revive pays $121 (including GST) for
advertising in promotional flyer.
Expense account ‘Advertising expense’ is
increased (debited) by $110; ‘GST paid’ is
increased (debited) by $11; asset account ‘Cash’
is decreased (credited) by $121
29/1
Café Revive purchases more supplies of coffee
$275 (including GST).
Asset account ‘Supplies’ is increased (debited) by
$250; ‘GST paid’ is increased (debited) by $25; asset
account ‘Cash’ is decreased (credited) by $275
31/1
Café Revive records salaries totalling $2360.
This amount includes $310 in PAYG tax
payable to employees.
Expense account ‘Salaries expense’ is increased
(debited) by $2360; ‘PAYG tax payable’ liability
account is increased (credited) by $310; asset
account ‘Cash’ is decreased (credited) by $2050
31/1
Café Revive pays mobile and wifi bill of $143
(including GST).
Expense account ‘Mobile and Wifi’ is increased
(debited) by $130; ‘GST paid’ is increased
(debited) by $13; asset account ‘Cash’ is
decreased (credited) by $143
31/1
Café Revive pays an energy bill of $209
(including GST).
Expense account ‘Energy expense’ is increased
(debited) by $190; ‘GST paid’ is increased
(debited) by $19; asset account ‘Cash’ is
decreased (credited) by $209
31/1
Café Revive records $11 000 (including GST) of
cash sales for 3/1/X2 to 31/1/X2.
Asset account ‘Cash’ is increased (debited) by
$11 000; liability account ‘GST collected’ is
increased (credited) by $1000; revenue account
‘Sales revenue’ is increased (credited) by $10 000
31/1
Café Revive records cost of goods sold of
$5200 on cash sales.
Expense account ‘Cost of goods sold’ is increased
(debited) by $5200; asset account ‘Inventory’ is
decreased (credited) by $5200
31/1
Café Revive records sales of cups of coffee
$5368 (including GST).
Asset account ‘Cash’ is increased (debited) by
$5368; liability account ‘GST collected’ is
increased (credited) by $488; revenue account
‘Sales of coffee’ is increased (credited) by $4880
31/1
Café Revive purchases inventory of 50 coffee
gift packs on credit for $1485 (including GST).
Asset account ‘Inventory’ is increased (debited) by
$1350; asset account ‘GST paid’ is increased
(debited) by $135; liability account ‘Accounts
payable’ is increased (credited) by $1485
Case Exhibit 5.5 illustrates the journal entries that Café Revive made to record the January
transactions. In studying this exhibit, you should review Case Exhibit 5.4 and think through the steps of
the journalising process. Once again, note that Café Revive did not enter the account numbers at the time
it recorded the journal entries; it entered them during the posting process, which we will discuss next.
Case Exhibit 5.5 Café Revive’s general journal entries for January 20X2
Date
Account titles and explanations
Acct no.
Debit
101
1 650
Credit
20X2
2 Jan.
Cash
GST collected
203
150
Sales revenue
401
1 500
Made cash sales
188
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Chapter 5 Recording, storing and reporting accounting information
Date
2
Account titles and explanations
Cost of goods sold
Inventory
Acct no.
Debit
501
780
105
Credit
780
To record cost of goods sold on cash sales
3
Accounts payable
Cash
201
1 430
101
1 430
Paid DeFlava Coffee Corporation for inventory purchased on 20/12/X1
4
Inventory
105
4 940
GST paid
109
494
Accounts payable
201
5 434
Purchased inventory on credit from DeFlava Coffee Corporation
6
Accounts receivable
103
550
GST collected
203
50
Sales revenue
401
500
Made credit sale
6
Cost of goods sold
Inventory
501
260
105
260
To record cost of goods sold on credit sale
7
Cash
101
Accounts receivable
440
103
440
Collected amount owed from Beau Flowers for shop equipment sold on
22/12/X1
20
E Della, withdrawals
Cash
304
250
101
250
Withdrew cash for personal use
25
Consulting expense
502
330
GST paid
109
33
Cash
101
363
Paid consultant for promotion coordination
25
Advertising expense
503
110
GST paid
109
11
Cash
101
121
Paid for advertising in promotional flyer
29
Supplies
106
250
GST paid
109
25
Cash
101
275
Purchased shop equipment
31
Salaries expense
504
2 360
PAYG tax payable
209
310
Cash
101
2 050
Paid employees’ salaries
31
Mobile and wifi expense
505
130
GST paid
109
13
Cash
101
143
Paid Mobile and wifi bill
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189
Accounting Information for Business Decisions
Date
31
Account titles and explanations
Acct no.
Debit
Energy expense
506
190
GST paid
109
19
Cash
101
Credit
209
Paid energy bill
31
Cash
101 11 000
GST collected
203
1 000
Sales revenue
401
10 000
To record cash sales for 3/1/X2 to 31/1/X2
31
Cost of goods sold
Inventory
501
5 200
105
5 200
To record cost of goods sold on cash sales
31
Cash
101
5 368
GST collected
203
488
Sales of cups of coffee
402
4 880
To record sales of coffee cups
Inventory
105
1 350
GST paid
109
135
Accounts Payable
201
1 485
Purchased inventory on credit from DeFlava Coffee Corporation
5.4 Posting from journals to the
accounts
posting
Process of transferring
the debit and credit
information for each
journal entry to the
accounts in a business’s
general ledger
In the journalising process, a business records each transaction in its general journal. However, at this
point it has not yet recorded the accounting information from each transaction in the accounts, the
‘storage units’ for the business’s accounting information. To do so, the business must post (transfer) the
amounts from the general journal to the related accounts. Posting is the process of transferring the debit
and credit information for each journal entry to the accounts in a business’s general ledger. The ledger is a
list of all accounts being used by the business. The ledger is useful because it summarises the information
for each account in the one place and provides a quick way to determine the balance of any particular
account at any time, as opposed to sorting through a large number of journal entries. In other words, the
focus of the ledger is the account rather than the transaction. Because of this focus, the ledger
summarises the basic transaction data in accounts to provide more useful information to the managers of
the business. When posting occurs, the accounting cycle becomes:
Transaction fi Source document fi Journal fi Ledger
Note that an account is simply the mechanism used to record changes in individual items. Accounts
are most commonly drawn up in T-account form or running balance (three-column) account form.
190
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Chapter 5 Recording, storing and reporting accounting information
When the T-account form is used, accounts are drawn up in a ledger ruled as follows.
Ledger of a business
Cash at bank A/c
DR
Date
Particulars
Folio
Amount
CR
Date
Particulars
Folio
Amount
1 Jan
Balance
5 000 31 Jan
Payments
5 500
31
Receipts
4 500
Balance c/d
4 000
9 500
Feb
Balance b/d
9 500
4 000
When the three-column account form is used, accounts are drawn up in a ledger ruled as below. Note
that in most electronic accounting systems such as MYOB and Xero the format for accounts is always the
three column format.
Ledger of a business
Cash at bank A/c
Date
Particulars
1 Jan
Balance
31
Receipts
31
Payments
Debit
Credit
Balance
Dr 5 000
4 500
9 500
5 500
4 000
Stop & think
In your everyday life, which method of drawing up accounts (e.g. your bank account) have
you encountered?
Stop & think
Which method do you think is most practical, and why?
Account numbers and chart of accounts
To help in the accounting process, a business assigns a number to each of its accounts and lists that
number to the right of the account title on a T-account. The business obtains the account number from
its chart of accounts. A chart of accounts is a numbering system designed to organise a business’s
accounts efficiently, and to reduce errors in the recording and accumulating process. A business usually
sets up its chart of accounts so that the cash account is assigned the lowest number, followed (in order)
by all the other asset accounts, all the liability accounts, the permanent owner’s equity (capital) account,
the withdrawals account, the income summary account (discussed later), the revenue accounts and the
expense accounts. The business then includes the accounts in its general ledger in the order in which they
are listed in the chart of accounts. As you will see shortly, ordering the accounts in the general ledger in
this way helps in preparing the financial statements.
Case Exhibit 5.6 lists Café Revive’s chart of accounts. Notice that the asset account numbers begin at
101, the liabilities at 201, the owner’s equity at 301, the revenues at 401 and the expenses at 501.
A business uses a numbering system such as this to help to identify and classify its accounts. (Some large
corporations use numbers of as many as six digits for classifying their accounts, and even use decimals to further
sub-classify their accounts.) Note also that the accounts are not numbered consecutively. Café Revive follows this
procedure so it can insert any new accounts into its chart of accounts (and general ledger) later and still assign
account numbers in their proper order.
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5
What is the difference
between journalising and
posting?
chart of accounts
Numbering system
designed to organise a
business’s accounts
efficiently and to
reduce errors in the
recording and
accumulating process
191
Accounting Information for Business Decisions
Case Exhibit 5.6 Café Revive’s chart of accounts
Account title
Account number
Cash
101
Accounts receivable
103
Inventory
105
Supplies
106
Prepaid rent
107
GST paid
109
Shop equipment
123
Accumulated depreciation
124
Accounts payable
201
GST collected
203
Loan payable
204
Interest payable
205
PAYG tax payable
209
E Della, capital
301
E Della, withdrawals
304
Income summary
306
Sales revenue – coffee gift packs
401
Sales revenue – cups of coffee
402
Interest revenue
405
Cost of goods sold
501
Consulting expense
502
Advertising expense
503
Salaries expense
504
Mobile and wifi expense
505
Energy expense
506
Supplies expense
507
Rent expense
508
Interest expense
509
Depreciation expense
510
Bank charges
515
Key procedures in posting
A business with a manual accounting system usually posts at the end of each day. In an automated
system, accounts are updated automatically. As with the journalising process, the business follows a set of
procedures for posting to the individual accounts. The following list outlines these procedures:
1 In the general ledger, locate the first account of the first transaction to be posted from the general journal.
2 Enter the day, month and year of the transaction and the debit amount (as listed in the general
journal) in the debit (left) side of the account.
3 Go back to the general journal and, on the same line as the account title, enter in the ‘Acct no.’ column
the number of the account in which the debit amount was posted. A number in this column indicates that
the posting process has been completed for that line of the general journal. It also indicates to which
account that amount was posted. This is the last step before continuing with the posting of the next line.
(Caution: Remember that the business completes this procedure after it posts the amount in the account.)
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Chapter 5 Recording, storing and reporting accounting information
4 For the next line of the transaction in the general journal (usually the credit entry, unless a compound
entry is involved), repeat steps 2 and 3, except that the date and amount are posted to the credit
(right) side of the appropriate account.
After posting the debit and credit entries for the first transaction to the related accounts, post the next
journal entry for the day and continue the process until the daily postings are completed. By strictly following
these posting procedures, you will minimise the chance of error.
Stop & think
Why is it important that accounts have both a number and a title?
Illustration of posting process
Case Exhibit 5.7 illustrates the posting process for the 2 January 20X2 sales transactions of Café Revive. The
arrows from the general journal to the general ledger indicate the debit and credit postings. Note that Café
Revive transferred the date of the transaction from the general journal to each ledger account. It posted the
amount ($1650) in the debit column of the ‘Cash’ account, an amount ($150) in the credit column of ‘GST
collected’, and the amount ($1500) in the credit column of the ‘Sales revenue’ account in the general ledger. It
then listed the account numbers (101, 203 and 401) on the respective lines in the ‘Acct no.’ column of the
general journal, as we indicate by the arrows from the general ledger to the general journal.
Note, in Case Exhibit 5.7, that the cash account has a beginning (1/1/X2) balance of $11 575. This
was the ending balance from December 20X1, after Café Revive posted the December transactions listed
in Case Exhibit 5.3. Note also that the sales revenue account did not have a beginning balance. Later in
this chapter, we will discuss the calculation of account balances and why some accounts have beginning
balances and some accounts do not have beginning balances.
Case Exhibit 5.7 Illustration of posting
General journal
Date
20X2
2 Jan.
Account titles and explanations
Acct
No
101
203
401
Cash
GST collected
Sales revenue
Made cash sales.
Debit
Credit
1 320
120
1 200
General ledger
1/01/X2 Bal
2/01/X2
Cash
8 825
1 320
GST collected
2/01/X2
No. 101
Sales revenue
2/01/X2
No. 401
1 200
No. 203
120
Café Revive completes the posting process at the end of each day in January. Case Exhibit 5.8 shows all
of the general ledger accounts of Café Revive at the end of January (before it makes its adjusting and closing
entries). They are listed according to the chart of accounts shown in Case Exhibit 5.6. You should study the
postings to the accounts, referring to the journal entries listed in Case Exhibit 5.5. Again, note that in Case
Exhibit 5.5, the ‘Acct no.’ column had not been completed when the journal entry was made, but was
completed during the posting process. You should think of the account numbers that would be listed in this
column based on the chart of accounts in Case Exhibit 5.6.
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193
Accounting Information for Business Decisions
Ledgers – general and subsidiary
accounts payable
subsidiary ledger
The subsidiary ledger
containing each of the
individual accounts for
suppliers (creditors)
accounts receivable
subsidiary ledger
The subsidiary ledger
containing each of the
individual accounts for
customers (debtors)
In the discussion so far, we have assumed the existence of a single ledger that contains all the accounts of the
business. This ledger is known as the general ledger. It is the most important ledger, in that balances of
accounts contained in this ledger will be used to draw up the trial balance, and subsequently the financial
reports. Most businesses will also maintain subsidiary ledgers or files for accounts receivable and accounts
payable. The reason for this is that the general ledger contains one account for accounts receivable (control
account) and one account for accounts payable (control account). But the business will usually have multiple
people who owe money to the business, and multiple suppliers to whom the business owes money.
While the balance in the accounts payable control account tells us how much the business owes in
total to suppliers or creditors for accounts payable, it does not tell us how much we owe each individual
supplier. This would make paying the right amount to the right person very difficult unless an accounts
payable subsidiary ledger or file was kept. The balance in the accounts payable control account must
always equal the total of all the accounts in the accounts payable subsidiary ledger or file.
Similarly, the balance in the accounts receivable account tells us how much is owed in total by debtors
(accounts receivable), but it does not tell us which debtors owe which amounts. Establishing an accounts
receivable subsidiary ledger allows details of what is owed by individual debtors to be maintained in accounts
for each debtor. In principle, the accounts receivable account in the general ledger becomes a control account,
which records in total details of what is owed to the business. This is supported by an accounts receivable
subsidiary ledger, which records specific details for each customer of what they owe to the business. At any
time, the balance of the accounts receivable control account in the general ledger will equal the sum of the
balances of all the individual debtors accounts in the accounts receivable subsidiary ledger or file. The same
principle applies to accounts payable.
Subsidiary ledgers are kept outside of the general ledger. Unnecessary detail, such as the names of all
debtors or creditors, is then omitted from the general ledger, making preparation of the trial balance
much quicker. See the following example.
General ledger extract
Accounts receivable subsidiary ledger
Cash at bank A/c
31/1 Accs rec.
M More
380
1/1 Balance
300 20/1 Cash at bank
15/1 Sales rev.
500
140
Accounts receivable control A/c
1/1 Balance
31/1 Sales rev.
Balance
540 31/1 Cash at bank
380
920
1 080
O Over
1/1 Balance
240 20/1 Cash at bank
15/1 Sales rev.
420
240
Sales revenue
31/1 Accs rec.
920
As you can see, entries made in total in the general ledger accounts receivable control account are made in
detail in each account in the subsidiary ledger accounts for individual debtors; for example, sales total $920
DR in the control account was split up as $500 worth of sales to M More and $420 worth of sales to O Over.
It is also important to understand that it is only in the general ledger that the rule for double entry
accounting has to be applied. The subsidiary ledger is kept separate from the general ledger. Individual
debtors’ accounts refine in detail what is included in total in the accounts receivable control account.
At the end of the period, the total of the balances of the individual debtors’ accounts for M More and
O Over should equal the balance of the accounts receivable account in the general ledger. As such, using
subsidiary ledgers provides a means of control, or an ability to check for errors in individual accounts
when a discrepancy occurs; for example:
Schedule of accounts receivable balances – as at 31 January
M More
660
O Over
420
Total
194
1 080
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Chapter 5 Recording, storing and reporting accounting information
The total of $1080 reconciles with the balance of the accounts receivable control account in the
general ledger.
Stop & think
If subsidiary ledgers for accounts receivable are not kept, how would the business determine
who owes them what amount?
Stop & think
In the case of Café Revive, do you know how much each individual debtor owes the business?
Case Exhibit 5.8 Café Revive’s general ledger – January 20X2
Cash
01/1/X2
Bal
No. 101
GST paid
11 575 03/1/X2
1 430
01/1/X2
1 650 20/1/X2
250
04/1/X2
494
06/1/X2
440 25/1/X2
121
25/1/X2
33
31/1/X2
11 000 25/1/X2
363
25/1/X2
11
31/1/X2
5 368 29/1/X2
275
29/1/X2
25
31/1/X2
2 050
31/1/X2
13
31/1/X2
143
31/1/X2
19
31/1/X2
209
31/1/X2
02/1/X2
31/1/X2
Bal
25 192
Accounts receivable
01/1/X2
Bal
440 07/1/X2
31/1/X2
Bal
550
01/1/X2
Bal
06/1/X2
440
04/1/X2
31/1/X2
1 205
135
Bal
1 935
01/1/X2
Bal
1 100
31/1/X2
Bal
No. 103
550
Inventory
Bal
Shop equipment
1 100
Accumulated depreciation
No. 124
780
4 940 06/1/X2
260
1 350 31/1/X2
5 200
03/1/X2
Accounts payable
No. 201
1 430 01/1/X2
5 434
1 485
1 350
01/1/X2
Bal
2 050
GST collected
250
01/1/X2
Bal
2 300
02/1/X2
Prepaid rent
01/1/X2
Bal
7 200
No. 107
1 430
31/1/X2
Bal
No. 106
Bal
04/1/X2
31/1/X2
25/1/X2
No. 123
No. 105
1 360 02/1/X2
Supplies
No. 109
31/1/X2
Bal
6 919
No. 203
Bal
40
150
06/1/X2
50
31/1/X2
1 000
31/1/X2
488
Bal
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1 728
195
Accounting Information for Business Decisions
Loan payable
01/1/X2
No. 204
Bal
1 400
Interest payable
No. 205
PAYG tax payable
No. 209
Consulting expense
25/1/X2
Advertising expense
25/1/X2
31/1/X2
310
E Della, capital
No. 301
01/1/X2
Bal
E Della, Withdrawals
20/1/X2
31/1/X2
250
130
Energy expense
31/1/X2
No. 505
No. 506
190
Income summary
No. 306
Supplies expense
No. 507
Sales revenue – coffee gift packs
No. 401
Rent expense
No. 508
Interest expense
No. 509
Depreciation expense
No. 510
02/1/X2
1 500
06/1/X2
500
31/1/X2
10 000
31/1/X2
Bal
12 000
Sales revenue – cups of coffee
No. 402
31/1/X2
4 880
Bal
Cost of goods sold
02/1/X2
780
06/1/X2
260
31/1/X2
31/1/X2
22 000
No. 504
2 360
Mobile and wifi expense
No. 304
No. 503
110
Salaries expense
31/1/X2
No. 502
330
4 880
No. 501
5 200
Bal
6 240
5.5 Trial balance
trial balance
Schedule that lists the
titles of all accounts in
a business’s general
ledger, the debit or
credit balance of each
account, and the totals
of the debit and credit
balances
196
In discussing the journalising and posting process, we set up procedures ensuring that the double entry
rule is followed. That is, the total amount of the debit entries equals the total amount of the credit entries
in both the general journal and the general ledger accounts. By following these procedures, the accounting
equation remains in balance and errors are minimised.
However, mistakes may still occur. Therefore, it is important to set up a procedure that will help to
detect a journalising or posting error. This procedure involves proving the equality of the debit and credit
balances in the accounts by preparing a trial balance.
A trial balance is a schedule that lists the titles of all the accounts in a business’s general ledger, the
debit or credit balance of each account, and the totals of the debit and credit columns, to ensure that the
ledger balances. Normally, a business prepares a trial balance at the end of the accounting period, before
proceeding with the adjusting entries (which we discuss next). To prepare a trial balance, first calculate the
balance of each account and list it (along with the date on which it is calculated) on the appropriate side
of the account. Next, list the account titles and debit or credit balances on the trial balance in the order in
which the accounts are listed in the general ledger. Finally, total the debit and credit columns to
determine their equality. To save space, we do not show the trial balance of Café Revive here because we
will show an adjusted trial balance (which is similar to, but more extensive than, a trial balance) later in
Case Exhibit 5.11.
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Chapter 5 Recording, storing and reporting accounting information
Stop & think
If a trial balance is only an internal document, why is it so necessary to complete one?
5.6 Preparing adjusting entries
A business prepares financial statements to report the results of its operations (the income statement), its
cash receipts and payments for operating, investing and financing activities (the cash flow statement), and
its financial position (the balance sheet) at the end of the accounting period. The business prepares these
financial statements from the balances in its general ledger accounts. To make sure its financial
statements are accurate, the business must be certain that its account balances are up to date. This is
important because most businesses use the accrual basis of accounting, where they record revenues in the
accounting period when they sell products to, or perform services for, customers and not necessarily when
they collect cash. Then they match all the related expenses against these revenues, regardless of whether
they have paid cash. In many cases, not all of a business’s revenue and expense account balances are up to
date at the end of the accounting period. In these cases, the business must adjust certain amounts so that
it can report the correct net income on its income statement and the correct ending financial position on
its balance sheet. The business makes these adjustments by preparing adjusting entries.
Adjusting entries are journal entries that a business makes at the end of its accounting period to
bring the business’s revenue and expense account balances up to date, and to show the correct ending
balances in its asset and liability accounts. An adjusting entry usually affects both a permanent (balance
sheet) account and a temporary (income statement) account. Adjusting entries may be grouped into three
types:
1 apportionment of prepaid items and unearned revenues
2 recording of accrued items
3 recording or apportionment of estimated items.
We will discuss the adjusting entries for each type in the following sections.
6
What are adjusting
entries, and what are the
three types of adjusting
entries?
adjusting entries
Journal entries that a
business makes at the
end of its accounting
period to bring the
business’s revenue and
expense account
balances up to date and
to show the correct
ending balances in its
asset and liability
accounts
Apportionment of prepaid items and
unearned revenues
This category of adjusting entries includes adjustments of prepaid items and unearned revenues. A
prepaid item (sometimes called a prepaid expense) is an economic resource for which a business has paid
cash, and which the business expects to use in its operating activities in the near future. When a business
purchases goods or services involving a prepaid item, it records the cost as an asset. By the end of the
accounting period, the business has used a part of the goods or services to earn revenues. Therefore, it
must record the ‘expired’ part of the cost as an expense to be matched against the revenues on its income
statement, while retaining the unexpired part of the cost as an asset on its ending balance sheet.
Examples of prepaid items include supplies, prepaid rent and prepaid insurance.
A business records the apportionment (allocation) of the cost of each prepaid item between an
expense and an asset in an adjusting entry in its general journal. The adjusting entry involves a debit
(increase) to an appropriately titled expense account (e.g. ‘Rent expense, obtained from the business’s
chart of accounts’) and a credit (decrease) to the asset account (e.g. ‘Prepaid rent’). The calculation of the
amount of the adjusting entry depends on the type of prepaid item. For instance, in the case of supplies,
the business takes a physical count of the supplies on hand (and related costs) at the end of the
accounting period. In the case of prepaid rent or insurance, the business apportions the total cost evenly
over the number of months of the rent agreement or insurance coverage.
For example, recall that Café Revive purchased $2050 of coffee supplies on 7 December 20X1, and
recorded an asset – ‘Supplies’ – for that amount. On 25 January, a further $250 worth of supplies was
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prepaid item
Current asset
(economic resource)
that a business records
when it pays for goods
or services before
using them
197
Accounting Information for Business Decisions
purchased. The amount of supplies that was available for operations during January 20X2 was $2300. At
the end of January, by counting the supplies, the business determined that it had $345 of supplies on
hand. Based on this information, the business must have used $1955 ($2300 – $345) of supplies during
January. To record this expense, on 31 January 20X2, Café Revive debits (increases) ‘Supplies expense’ for
$1955, and credits (decreases) the asset ‘Supplies’ for $1955 in the general journal, as we show in Case
Exhibit 5.9. Note in Case Exhibit 5.10 that after Café Revive posts this adjusting journal entry to its
general ledger accounts (as indicated by an ‘Adj’ in the account), the ‘Supplies expense’ account has a debit
balance of $1955. Also note that the ‘Supplies’ account has a debit balance of $345.
Case Exhibit 5.9 Café Revive’s adjusting entries – 31 January 20X2
Date
Account titles and explanations
Acct no.
Debit
Credit
Adjusting entries
20X2
31 Jan.
Supplies expense
507
Supplies
106
1 955
1 955
Supplies used during January
31
Rent expense
Prepaid rent
508
1 200
107
1 200
Expiration of one month’s rent paid in advance on 01/12/X1
31
Depreciation expense
Accumulated depreciation
510
19
124
19
Depreciation on shop equipment for January
31
Interest expense
Interest payable
509
205
11
11
Interest accrued on loan payable
unearned revenue
Obligation of a business
to provide goods or
services in the future,
resulting from an
advance receipt of cash
198
Café Revive records its rent expense in a similar manner. Recall that Café Revive paid $7200 for six
months’ rent in advance on 1 December 20X1, and recorded this amount as an asset, prepaid rent. The
rental agreement stated that rent would not be charged for the last half of December. Therefore, at the
end of January 20X2, one month’s rent has expired, and the business has incurred rent expense of $1200
($7200 6). To record this expense, on 31 January the business debits (increases) ‘Rent expense’ for
$1200 and credits (decreases) ‘Prepaid rent’ for $1200, as we show in Case Exhibit 5.9.
After posting, the ‘Rent expense’ account has a debit balance of $1200 and the ‘Prepaid rent’ account
has a debit balance of $6000, as we show in Case Exhibit 5.10.
In some cases, customers may make an advance payment to a business for goods or services that the
business will provide in the future. At the time of the advance receipt, even though the business’s asset ‘Cash’
has increased, the business has not earned revenue because it has not yet provided the goods or services.
Instead, the business has incurred a liability because it has an obligation to provide the future goods or services.
An unearned revenue is an obligation of a business to provide goods or services in the future, and results
from an advance receipt of cash. A business records an unearned revenue as a liability when it receives the
cash. At the end of the accounting period, the business examines all such liabilities and related source
documents to determine whether it has provided the goods or services. If it has, the business makes an
adjusting entry to reduce the liability and increase its revenues of the period. The adjusting entry involves a
debit (decrease) to the liability account and a credit (increase) to a related revenue account.
Café Revive does not have any unearned revenues at the end of January, so we will use a different
example. Recall that University Hub collected $7200 from Café Revive on 1 December 20X1 for six
months’ rent in advance. At that time, University Hub debited (increased) an asset – ‘Cash’ – for $7920,
credited ‘GST collected’ for $720 and credited (increased) a liability – ‘Unearned rent’ – for $7200. On 31
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Chapter 5 Recording, storing and reporting accounting information
Case Exhibit 5.10 Café Revive’s general ledger after adjusting entries – 31 January 20X2
Cash
01/1/X2
Bal
No. 101
Accounts payable
No. 201
11 575 03/1/X2
1 430
1 650 20/1/X2
250
04/1/X2
5 434
06/1/X2
440 25/1/X2
121
31/1/X2
1 485
31/1/X2
11 000 25/1/X2
363
31/1/X2
5 368 29/1/X2
275
30/1/X2
2 050
01/1/X2
31/1/X2
143
02/1/X2
31/1/X2
143
06/1/X2
50
31/1/X2
1 000
31/1/X2
488
02/1/X2
31/1/X2
Bal
01/1/X2
Bal
31/1/X2
No. 103
440 07/1/X2
440
Bal
04/1/X2
31/1/X2
31/1/X2
Bal
Bal
25/1/X2
31/1/X2
01/11/X2
No. 105
1 360 02/1/X2
780
31/11/X2
260
PAYG tax payable
1 350 31/1/X2
5 200
2 050 31/1/X2
Adj
01/11/X2
1 955
345
Bal
7 200 31/1/X2
31/1/X2
Bal
6 000
6 919
40
150
Bal
1 728
No. 204
Bal
1 400
No. 205
Adj
11
No. 209
Bal
310
No. 301
Bal
E Della, withdrawals
20/1/X2
01/1/X2
22 000
No. 304
250
Income summary
No. 306
Sales revenue – coffee gift packs
No. 401
No. 107
Adj
GST paid
Bal
Bal
E Della, capital
No. 106
250
Bal
31/1/X2
1 350
1 430
No. 203
Interest payable
4 940 06/1/X2
Prepaid rent
01/1/X2
31/1/X2
550
Supplies
01/1/X2
Bal
Loan payable
Inventory
01/1/X2
31/1/X2
Bal
GST collected
550
Bal
1 430 01/1/X2
25 192
Accounts receivable
06/1/X2
03/1/X2
1 200
No. 109
02/11/X2
1 500
06/11/X2
500
1 205
31/11/X2
10 000
04/1/X2
494
31/11/X2
12 000
25/1/X2
33
25/1/X2
11
29/1/X2
25
31/1/X2
13
31/1/X2
19
02/1/X2
31/1/X2
135
06/1/X2
260
31/1/X2
1 935
31/1/X2
5 200
31/1/X2
6 240
Sales revenue – cups of coffee
31/1/X2
Shop equipment
01/1/X2
Bal
1 100
31/1/X2
Bal
1 100
4 880
Bal
Cost of goods sold
No. 123
Accumulated depreciation
31/1/X2
Adj
No. 124
19
No. 501
No. 502
330
Advertising expense
25/1/X2
4 880
780
Consulting expense
25/1/X2
No. 402
No. 503
110
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199
Accounting Information for Business Decisions
Salaries expense
31/1/X2
No. 504
Mobile and wifi expense
31/1/X2
31/1/X2
Adj
31/1/X2
Adj
No. 508
1 200
Interest expense
No. 506
No. 509
11
Depreciation expense
190
31/1/X2
Supplies expense
Adj
31/1/X2
No. 505
130
Energy expense
31/1/X2
Rent expense
2 360
Adj
No. 510
19
No. 507
1 955
January 20X2, since University Hub earned one month of rent by providing shop space to Café Revive
during January, University Hub makes an adjusting entry to reduce the liability and increase its revenue.
The journal entry is a debit (decrease) to ‘Unearned rent’ and a credit (increase) to ‘Rent revenue’ for
$1200, as shown in the following; note that for simplicity, we do not show the ‘Acct No.’ column in the
general journal).
Date
31 Jan.
Account titles and explanations
Unearned rent
Debit
Credit
1 200
Rent revenue
1 200
To record rent earned from Café Revive
The remaining $5000 ($6000 – $1000) balance in University Hub’s ‘Unearned rent’ account
represents the obligation to provide shop space to Café Revive for five more months.
Accrued items
accrued expense
Incurred by a business
during the accounting
period but not paid or
recorded
accrued revenue
Earned by a business
during the accounting
period but neither
collected nor recorded
200
The accrued items category of adjusting entries includes adjustments for accrued expenses and accrued
revenues. A business records most of its expenses when it pays for them. At the end of an accounting
period, however, it has not paid some expenses. An accrued expense is an expense that a business has
incurred during the accounting period but that it has not paid or recorded. A common type of accrued
expense is unpaid employees’ salaries. Other common accrued expenses include unpaid interest, taxes and
utility bills. To match all expenses against revenues, and to report all the liabilities at the end of the
period, a business makes an adjusting entry to record each accrued expense. The journal entry involves
a debit (increase) to an appropriately titled expense account and a credit (increase) to the related
liability account.
Recall that on 12 December 20X1, Café Revive signed a $1400, three-month loan payable. It agreed to
pay $33 total interest, so that at the end of three months it will repay $1433 ($1400 þ $33). Since Café
Revive owed the loan during all of January, one month of interest, or $11 ($33 3 months), has accrued
and is an expense of doing business during January. To record this expense, on 31 January 20X2 Café
Revive debits (increases) ‘Interest expense’ and credits (increases) the liability account ‘Interest payable’
for $11, as we show in Case Exhibit 5.9. It would record other accrued expenses in a similar way.
A business records most revenues at the time it provides goods or services to a customer. At the end
of an accounting period, however, it may not have recorded a few revenues. An accrued revenue is a
revenue that a business has earned during the accounting period but that it has neither collected nor
recorded. To report all the revenues of the period and all the assets at the end of the period, a business
makes an adjusting entry for each accrued revenue. The journal entry is a debit (increase) to an asset
account and a credit (increase) to a related revenue account.
There are not many types of accrued revenues, and Café Revive has none. However, one common
accrued revenue is the interest that has accumulated on a loan given by a business. Recall that the $1400, a
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Chapter 5 Recording, storing and reporting accounting information
three-month loan was made available by Restaurant Equipment Company. On 31 January 20X2, Restaurant
Equipment Company would record accrued interest revenue of $11. The journal entry would be a debit
(increase) to the asset account ‘Interest receivable’ and a credit (increase) to the revenue account ‘Interest
revenue’ for $11, as follows:
Date
31 Jan.
Account titles and explanations
Interest receivable
Debit
Credit
11
Interest revenue
11
To record accrued interest revenue on note earned from Café Revive
A business would record other accrued revenues similarly.
Estimated items
A few other adjusting entries involve estimated amounts because they are based partly on expected future
events. Adjusting entries involving estimated amounts include the recording of (1) depreciation on
buildings and equipment; (2) amortisation of intangible assets; and (3) recognition of uncollectable
accounts receivable.
The adjusting entry for depreciation is a debit (increase) to the expense account ‘Depreciation expense’
and a credit (increase) to the contra-asset account ‘Accumulated depreciation’. Note that a business uses a
contra-account to record an amount that is subtracted from the balance in a related account. Thus, the rule
for increasing a contra-account is the opposite of the rule for increasing the related account. ‘Accumulated
depreciation’ is a contra-asset account, which is why it is increased by a credit entry. Also, recall that an
increase of $19 in the ‘Accumulated depreciation’ account decreases the book value of the related
depreciable asset account equipment to $1081 because the amount of accumulated depreciation to date is
subtracted from the cost of the depreciable asset. Similarly, the adjusting entry for amortisation is a debit
(increase) to the expense account ‘Amortisation expense’, and a credit to the related intangible asset
contra-account ‘Accumulated amortisation’.
When making credit sales, a business records the value of these sales as an asset accounts receivable
and a sales revenue. Sometimes accounts receivable amounts are not paid; that is, they become
uncollectable and result in the business losing money as a result of a bad debt. The adjusting entry for
uncollectable accounts receivable is a debit (increase) to the expense account ‘Bad debts expense’ and a
credit (increase) to the contra-asset account ‘Allowance for bad debts’. The balance of the ‘Allowance for
bad debts’ account is subtracted from the balance of the ‘Accounts receivable’ account to determine the
net realisable value of the accounts receivable.
To understand the adjustment process for an estimated item, recall that at the end of December, Café
Revive had an asset shop equipment recorded at $1100, and then used this in its operations during
January.6
Café Revive estimates that the simplest way to calculate depreciation is to divide the cost by the
estimated life of the asset. For now, assume that the depreciation for the shop equipment is $19 a month.
On 31 January 20X2, Café Revive records a debit entry to depreciation expense of $19 and a credit entry
to accumulated depreciation, as we show in Case Exhibit 5.9.
Discussion
Why do we need to make adjusting entries? What are they? What are the three types of
adjusting entries?
6
Café Revive purchased $200 of shop equipment at the end of January. Since it did not use this shop equipment in January,
it did not depreciate the equipment for that month. Café Revive will include the depreciation on this shop equipment as an
expense in later months when it uses the equipment.
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201
Accounting Information for Business Decisions
Posting adjusting entries
After a business prepares its adjusting entries, the business posts these entries from its general journal to
the accounts in its general ledger. Café Revive posts the adjusting entries that it recorded in Exhibit 5.9 to
its general ledger, as we show in Case Exhibit 5.10. Note that Case Exhibit 5.10 is similar to Case
Exhibit 5.8, except that the adjusting entries (as indicated by ‘Adj’) are included. This completes the
adjusting entry process for Café Revive.
5.7 Adjusted trial balance
adjusted trial balance
Schedule prepared to
prove the equality of
the debit and credit
balances in a
business’s general
ledger accounts after it
has made the adjusting
entries
transposition
Occurs when two digits
in a number are
mistakenly reversed
slide
Occurs when the digits
are listed in the correct
order but are
mistakenly moved one
decimal place to the
left or right
After a business journalises and posts its adjusting entries, it balances its accounts, and all the account
balances are then up to date for the accounting period. But before preparing the business’s financial
statements, it is useful to prepare an adjusted trial balance, which is a schedule prepared to prove the
equality of the debit and credit balances in a business’s general ledger accounts after it has made the
adjusting entries. An adjusted trial balance is similar to a trial balance, except that it also includes all the
revenue and expense accounts. An adjusted trial balance is an accountant’s working paper and is not a
financial statement. It is used to (1) help prevent the business from including debit and credit errors in its
financial statements; and (2) make preparing the financial statements easier, as you will see.
Case Exhibit 5.11 shows the adjusted trial balance of Café Revive on 31 January 20X2. The account
balances listed were taken from the general ledger in Case Exhibit 5.10. Note that the $49 267 total of
the debits is equal to the total of the credits.
If an adjusted trial balance (or a trial balance) does not balance – that is, the total debits do not
equal the total credits – the business has made an error. To find the error, the business should re-add
the debit and credit columns of the adjusted trial balance. If the column totals still do not agree, the
business should check the amounts in the debit and credit columns to be sure that it did not
mistakenly list a debit or credit account balance in the wrong column.
If it still does not find the error, the business should calculate the difference in the column totals and
divide it by 9. When the difference is evenly divisible by 9, there is a good chance that a transposition or a
slide has occurred. A transposition occurs when two digits in a number are mistakenly reversed. For
instance, if the $25 192 cash balance in Case Exhibit 5.11 had been listed as $25 912, the debit column
would have totalled $49 987 instead of $49 267. The difference between the debit column and the correct
credit column total, $720, is evenly divisible by 9. A slide occurs when the digits are listed in the correct
order but are mistakenly moved one decimal place to the left or right. For instance, if the $1400 loan
payable balance in Case Exhibit 5.11 had been listed as $140, the credit column would have totalled
$48 007 instead of $49 267. The $1260 difference between this and the correct debit column total is
evenly divisible by 9.
A transposition or slide may have occurred when the business transferred the account balances from
the accounts to the adjusted trial balance or when it initially calculated the account balances. Thus, the
business should compare the account balances listed on the adjusted trial balance with the account
balances listed in the general ledger. If it properly transferred the balances, it should re-calculate the
ledger account balances; if it finds no error, it should double-check the postings. Finally, if the business
still does not find the error, it should review the journal entries for accuracy. As you can imagine,
detecting where an error has been made is time-consuming and frustrating. That is why it is very
important to follow the set procedures in the journalising and posting process.
Stop & think
When the trial balance balances, does that mean that all transactions have been recorded
correctly in the books of the business? Give examples.
202
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Chapter 5 Recording, storing and reporting accounting information
Case Exhibit 5.11 Adjusted trial balance
Café Revive
Adjusted trial balance
31 January 20X2
Account titles
Cash
Debits
Credits
$25 192
Accounts receivable
Inventory
550
1 350
Supplies
345
Prepaid rent
6 000
GST paid
1 935
Shop equipment
1 100
Accumulated depreciation
19
Accounts payable
6 919
GST collected
$ 1 728
Loan payable
1 400
Interest payable
11
PAYG Tax payable
310
E Della, capital
E Della, withdrawals
22 000
250
Sales revenue – Coffee gift packs
12 000
Sales revenue – Cups of coffee
Cost of goods sold
4 880
6 240
Consulting expense
330
Advertising expense
110
Salaries expense
Telephone expense
Utilities expense
2 360
130
190
Supplies expense
1 955
Rent expense
1 200
Interest expense
11
Depreciation expense
19
Totals
$49 267
$49 267
5.8 Preparing the financial
statements
A business prepares its financial statements for the accounting period after it completes the adjusted trial
balance. It prepares the income statement first because the amount of net income (or net loss) affects the
owner’s capital account on the balance sheet. A sole proprietorship prepares the statement of changes in
owner’s equity (a supporting schedule for the balance sheet) next. Then it prepares the balance sheet and,
finally, the business completes its cash flow statement.7
7
For simplicity, we do not prepare a cash flow statement in this chapter. Refer to Chapter 9 for an in-depth discussion of the
cash flow statement.
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203
Accounting Information for Business Decisions
Income statement
An income statement is the financial statement that summarises the results of a business’s earnings
activities – that is, revenues, expenses and net income – for its accounting period. Case Exhibit 5.12
shows Café Revive’s income statement for January 20X2. Café Revive prepared its income statement from
the accounts listed on the lower part of the adjusted trial balance in Case Exhibit 5.11. Because the
revenue and expense accounts are listed at the end of each business’s chart of accounts (and, therefore, its
general ledger), these accounts are always listed in the lower portion of each business’s adjusted trial
balance. This procedure simplifies preparation of the income statement.
Case Exhibit 5.12 Income statement
Café Revive
Income statement
For month ended 31 January 20X2
Sales revenue – Coffee gift packs
$12 000
Sales revenue – Cups of coffee
$ 4 880
16 880
Cost of goods sold – Coffee gift packs
(6 240)
Gross profit
$10 640
Operating expenses:
Consulting expense
Advertising expense
Salaries expense
$
330
110
2 360
Telephone expense
130
Utilities expense
190
Supplies expense
1 955
Rent expense
1 200
Depreciation expense
19
Total expenses
Operating income
(6 294)
$ 4 346
Other item:
Interest expense
Net Income
(11)
$ 4 335
Statement of changes in owner’s equity
A statement of changes in owner’s equity is a schedule that shows the impact on owner’s equity of any
additional investments by the owner in the business, the business’s net income, and owner withdrawals
during the accounting period. A business presents this statement as a supporting schedule to the owner’s
capital account balance listed on the balance sheet. Case Exhibit 5.13 shows Café Revive’s statement of
owner’s equity for January 20X2. Emily made no additional investments during January. Café Revive
obtained the beginning balance of the ‘E Della, capital’ account and the amount of the withdrawals from
the middle portion of the adjusted trial balance in Case Exhibit 5.11. It obtained the net income from the
income statement in Case Exhibit 5.12.
Balance sheet
A balance sheet is the financial statement that reports the financial position – that is, assets, liabilities
and owner’s equity – of a business on a particular date. Case Exhibit 5.14 shows Café Revive’s balance
204
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Chapter 5 Recording, storing and reporting accounting information
Case Exhibit 5.13 Statement of changes in owner’s equity
Café Revive
Statement of changes in owner’s equity
For month ending 31 January 20X2
E Della, capital, 1 January 20X2
Add: Net income for January
$22 000
4 335
$26 335
Less: Withdrawals for January
E Della, capital, 31 January 20X2
(250)
$26 085
sheet on 31 January 20X2. The business prepared the balance sheet from the accounts listed on the upper
portion of the adjusted trial balance in Case Exhibit 5.11. Use of the adjusted trial balance makes the
preparation of the balance sheet very easy. The assets, liabilities and owner’s capital accounts are the first
accounts in a business’s chart of accounts and its general ledger. Therefore, these accounts are always
listed in the upper portion of a business’s adjusted trial balance. Note, however, that the amount listed as
the owner’s capital on the adjusted trial balance is not the amount the business lists on the ending balance
sheet because the amount has not been updated for the net income or withdrawals for the period.
Instead, the business obtains the ending owner’s capital account balance from the statement of changes in
owner’s equity. Café Revive obtained the owner’s capital account balance in Case Exhibit 5.14 from the
statement in Case Exhibit 5.13.
5.9 Preparation of closing entries
Earlier, we made two points that are relevant to our discussion of closing entries. The first was that the
revenue, expense and withdrawals accounts are temporary accounts. A business uses these accounts to
determine the changes in its owner’s equity in the current accounting period resulting from its net
income (or net loss) and from owner’s withdrawals. Second, a business does not use the owner’s capital
account listed on the adjusted trial balance in preparing its balance sheet because this account balance is
not up to date for the net income and withdrawals of the period.
To begin the next accounting period, the business needs to (1) update the balance in the owner’s
capital account; and (2) show zero balances in the revenue, expense and withdrawals accounts. The
owner’s capital account balance should be up to date, so as to show the owner’s current investment in the
assets of the business. The business will use the revenue, expense and withdrawals accounts in the next
accounting period to accumulate the business’s net income and any of the owner’s withdrawals for that
period. Therefore, it is important to start with a zero balance in each of these accounts at the beginning of
the period, so that, at the end of the period, the balances in the accounts will show the revenue, expense
and withdrawal amounts for only that period.
Closing entries are journal entries that a business makes at the end of its accounting period to create
a zero balance in each revenue, expense and withdrawal account and to transfer these account balances to
the owner’s permanent capital account. It makes closing entries after preparing the financial statements.
Like other journal entries, a business records closing entries in the general journal and then posts them to
the respective accounts. It does not close the revenue and expense accounts directly to the owner’s capital
account. Instead, it first transfers these account balances to an account entitled ‘Income summary’.
The income summary account is a temporary account a business uses to facilitate the closing process
and to accumulate the amount of the business’s net income (or net loss) before it transfers this amount
to the owner’s capital account.
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7
What are closing entries,
and how do they relate to
the income summary
account?
closing entries
Entries made by a
business at the end of
an accounting period to
create a zero balance
in each revenue,
expense and
withdrawals
T-account, and to
update the owner’s
equity by transferring
the balances in the
revenue, expense, and
withdrawals
T-accounts to the
T-account for owner’s
capital
income summary
Temporary account
used in the closing
process to accumulate
the amount of net
income (or net loss)
before transferring it to
the T-account for
owner’s capital
205
Accounting Information for Business Decisions
Case Exhibit 5.14 Balance sheet
Café Revive
Balance sheet
31 January 20X2
Assets
Current assets:
Cash
$25 192
Accounts receivable
550
Inventory
1 350
Supplies
345
Prepaid rent
6 000
GST paid
1 935
Total current assets
$35 372
Property and equipment:
Shop equipment
$1 100
Less: Accumulated depreciation
(19)
Total assets
1 081
$36 453
Liabilities
Current liabilities:
Accounts payable
$ 6 919
Loan payable
1 400
Interest payable
11
GST collected
1 728
PAYG tax payable
310
Total current liabilities
$10 368
Owner’s equity
E Della, capital
Total liabilities and owner’s equity
$26 085
$36 453
Closing the revenue accounts
Recall that each revenue account has a credit balance (prior to closing). To reduce this credit balance to
zero, the business makes a debit entry in the revenue account for an amount equal to that of the credit
balance. At the same time, it transfers the revenue amount to the income summary account by a credit
entry to that account. It first records these debit and credit entries in the general journal, and then posts
them to the related accounts in the general ledger. We show Café Revive’s closing entries in Case Exhibit
5.15. The $16 880 journal entry of Café Revive to close its revenue accounts is the first closing entry in
Case Exhibit 5.15. Café Revive obtained the amount of the sales revenue from the adjusted trial balance
in Case Exhibit 5.11. It obtained the account number of the income summary account from the chart of
accounts shown in Case Exhibit 5.6. In this example, Café Revive has two sales revenue accounts. When a
business has more than one revenue account, it makes a compound entry in which it first debits each
revenue account for the amount of the balance in the account, then credits the total of the revenues to
the income summary account.
206
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Chapter 5 Recording, storing and reporting accounting information
Closing the expense accounts
Each expense account has a debit balance (prior to closing). To reduce each debit balance to zero, the
business makes a credit entry in each expense account for an amount equal to that of the debit balance. It
transfers this expense amount to the income summary account by a debit entry to that account. A
business typically has many expense accounts, so it usually closes all the expense accounts by making a
compound entry in the general journal in which it credits each expense account for the amount of the
balance in the account and debits the income summary account for the total amount of the expenses.
(Remember, however, that it always lists the debit entry first in the general journal.) The $12 545 journal
entry of Café Revive to close its expense accounts is the second closing entry at the end of Case Exhibit
5.15. Café Revive obtained the amounts of the various expenses from the adjusted trial balance shown in
Case Exhibit 5.11. (Remember that ‘Cost of goods sold’ is an expense account.)
Case Exhibit 5.15 Café Revive’s closing entries – 31 January 20X2
Date
Account titles and explanations
Acct No.
Debit $
Credit $
Closing entries
20X2
31 Jan.
Sales revenue – Coffee gift packs
401
12 000
Sales revenue – Cups of coffee
402
4 880
Income summary
306
16 880
To close revenue account
31
Income summary
306
12 545
Cost of goods sold
501
6 240
Consulting expense
502
330
Advertising expense
503
110
Salaries expense
504
2 360
Telephone expense
505
130
Utilities expense
506
190
Supplies expense
507
1 955
Rent expense
508
1 200
Interest expense
509
11
Depreciation expense
510
19
To close expense accounts
31
Income summary
E Della, capital
306
4 335
301
4 335
To close net income to owner’s capital account
31
E Della, capital
E Della, withdrawals
301
304
250
250
To close withdrawals to owner’s capital account
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207
Accounting Information for Business Decisions
Closing the income summary account
After a business closes the revenue and expense accounts to the income summary account, the balance in
the account is the amount of the net income (or net loss). A credit balance indicates that the business
earned a net income for the period because revenues exceeded expenses. A debit balance indicates a net
loss because expenses exceeded revenues. A business transfers the amount of its net income (or net loss)
to the owner’s permanent capital account in the third closing entry. In the case of net income, the closing
entry in the general journal is a debit to the income summary account for an amount equal to its balance
and a credit to the owner’s capital account for the same amount. The credit to the owner’s capital account
increases that account by the amount of the net income. (The business would handle a net loss in the
opposite way, with a debit to the owner’s capital account and a credit to the income summary account.)
The $4 335 journal entry of Café Revive to close the income summary account to the ‘E Della, capital’
account is the third closing entry at the end of Case Exhibit 5.15.
Closing the withdrawals account
A business closes the debit balance of the withdrawals account directly to the owner’s permanent capital account,
since withdrawals are disinvestments by the owner. The closing entry in the general journal is a debit to the
owner’s permanent capital account and a credit to the withdrawals account for the amount of the total
withdrawals of the period. The debit entry brings the owner’s capital account balance up-to-date at the end of the
period. The credit entry to the withdrawals account reduces the account balance to zero so that it can accumulate
the withdrawals of the next period. A business never closes the withdrawals account to the income summary
account because withdrawals are not part of net income. The $250 journal entry to close the ‘E Della, withdrawals’
account balance to the ‘E Della, capital’ account is the last closing entry at the end of Case Exhibit 5.15. Café
Revive obtained the amount of the withdrawals from the adjusted trial balance in Case Exhibit 5.11.
Posting the closing entries
After a business records its closing entries, the business posts these entries from its general journal to the
accounts in its general ledger. Café Revive posts the closing entries that it prepared in Case Exhibit 5.15
to the appropriate accounts in its general ledger, as we show in Case exhibit 5.16. Note that Case Exhibit
5.16 is similar to the right side of Case Exhibit 5.10, except that the closing entries (as indicated by a ‘Cl’)
are included. Also note that after the closing entries are posted, all the revenue, expense and withdrawals
accounts have zero balances. The ‘E Della, capital’ account has a balance of $26 085, the amount Café
Revive listed as the owner’s equity on its 31 January 20X2 balance sheet in Case Exhibit 5.14. This
completes the closing entry process for Café Revive.
Post-closing trial balance
post-closing trial
balance
Schedule a business
prepares after making
its closing entries to
prove the equality of
the debit and credit
balances in its asset,
liability and owner’s
equity accounts
208
After a business journalises and posts its closing entries, the only accounts with non-zero balances should be
the permanent accounts – that is, the assets, liabilities and owner’s capital accounts. As a check to make sure
that no debit or credit errors were made during the closing entries, a business prepares a post-closing trial
balance. A post-closing trial balance is a schedule a business prepares after making the closing entries to
prove the equality of the debit and credit balances in its assets, liabilities and owner’s capital accounts. The
post-closing trial balance includes only these permanent accounts because all the temporary accounts have
zero balances after the closing process. After the business prepares the post-closing trial balance, the
accounting cycle for the current period is complete. The business then begins the accounting cycle for its next
accounting period. To save space, we do not show the post-closing trial balance of Café Revive here.
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Chapter 5 Recording, storing and reporting accounting information
Case Exhibit 5.16 Café Revive’s postings of closing entries – 31 January 20X2
E Della, capital
31/1/X2
Cl
22 000
25/1/X2
31/1/X2
Cl
4 335
31/1/X2
31/1/X2
Bal
E Della, withdrawals
20/1/X2
31/1/X2
250 31/1/X2
Bal
Cl
Cl
31/1/X2
Cl
12 545 31/1/X2
Cl
Bal
12 000 31/1/X2
31/1/X2
Bal
31/1/X2
Bal
Bal
6 240 31/1/X2
Cl
31/1/X2
330 31/1/X2
Bal
No. 306
31/1/X2
16 880
31/1/X2
0
31/1/X2
No. 401
31/1/X2
No. 504
Cl
Bal
No. 505
Cl
31/1/X2
Adj
31/1/X2
Bal
0
31/1/X2
Adj
No. 501
31/1/X2
Bal
Cl
31/1/X2
Adj
31/1/X2
Bal
190
1 955 31/1/X2
No. 507
Cl
1 955
0
1 200 31/1/X2
No. 508
Cl
1 200
0
Interest expense
11
31/1/X2
No. 509
Cl
11
0
Depreciation expense
330
0
Cl
0
Rent expense
6 240
No. 502
No. 506
Supplies expense
0
130
0
190 31/1/X2
Bal
2 360
0
130 31/1/X2
No. 402
0
Consulting expense
25/1/X2
Bal
4 880
Cost of goods sold
Bal
31/1/X2
12 000
4 880 31/12/X2
31/1/X2
31/1/X2
250
2 360 31/1/X2
Energy expense
Sales revenue – coffee
31/12/X2 Cl
30/1/X2
110
0
Salaries expense
26 085
No. 304
4 335
31/1/X2
Cl
Bal
No. 503
Cl
Mobile and wifi expense
Sales revenue – coffee gift packs
31/1/X2
110 31/1/X2
0
Income summary
31/1/X2
Advertising expense
No. 301
Bal
250 01/1/X2
31/1/X2
Adj
19
31/1/X2
Bal
0
31/1/X2
5.10 Modifications for companies
For simplicity, earlier we discussed and illustrated the procedures in the accounting cycle of a sole
proprietorship (Café Revive). However, many businesses are companies or corporations, and you should
also be familiar with the accounting procedures for these. Fortunately, the procedures we discussed for
sole proprietorships need to be modified only slightly for companies. The modifications involve
differences in how a business records and reports investments by owners, distributions to owners, and
some income statement and balance sheet items. To illustrate, we will modify the Café Revive example by
assuming the business is a company instead of a sole proprietorship.
No. 510
Cl
19
8
How are accounting
procedures modified for
companies?
Investments by owners
One difference between the accounting for companies and that for sole proprietorships involves
investments in the business by owners (shareholders). Assume that on 15 December 20X1, Café Revive
was incorporated and issued 1000 ordinary shares of $10 par value to Emily Della for $10 per share. Café
Revive would make the following journal entry to record this transaction:
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209
Accounting Information for Business Decisions
Date
Account titles and explanations
Debit
Credit
20X1
15 Dec.
Cash
10 000
Paid-up capital
10 000
Issued 1000 ordinary shares for $10 per share
In addition to a paid-up capital account, a company has a retained earnings account, which lists its total
lifetime earnings (net income or net loss) that have not been distributed to shareholders as dividends.
Distributions to owners
Ethics and Sustainability
The decision to pay dividends to owners is made by a company’s board of directors. In order to be ethical,
company directors are required to make this decision with the best interest of owners in mind. The payment
of dividends to shareholders by a corporation is recorded differently from the owner’s withdrawals from a sole
proprietorship. Since the retained earnings account includes total earnings not distributed to shareholders as
dividends, a business records any dividend payments directly as a reduction in retained earnings by a debit
(decrease) to ‘Retained earnings’ and a credit (decrease) to ‘Cash’. For example, assume that on 20 January
20X2, Café Revive Company Ltd declared and paid a dividend of $0.05 per share. Café Revive makes the
following journal entry to record the dividend of $50 (1000 shares $0.05).
Date
Account titles and explanations
Debit
Credit
20X2
20 Jan.
Retained earnings
50
Cash
50
Declared and paid dividends
Café Revive reports the dividends as a reduction of retained earnings in the statement of retained
earnings.
9
What circumstances might
cause directors to act
unethically when making
dividend distribution
decisions for owners?
Income statement items
Another difference between a company and a sole proprietorship is that a company must pay income
taxes on its earnings. These income taxes are considered an expense of doing business. Normally a
company pays its income taxes at the end of the financial year. Goods and services tax (GST), though, is
dealt with quarterly. Since income taxes are an expense, they should be matched against the income in
the period in which the income is earned. Thus, in addition to the adjusting entries described earlier, a
company also makes an adjusting entry for accrued income taxes at the end of each period.
Because Café Revive, in this example, is a company, it must pay income taxes based on a return
submitted at the end of the financial year. During January 20X2, Café Revive earned $4335 of income
before income taxes. If we assume a 30 per cent tax rate, then it records the $1300.50 ($4335 0.30,
rounded) income taxes in the following adjusting entry.
Date
Account titles and explanations
Debit
Credit
20X2
31 Jan.
Income tax expense
Income taxes payable
1 300.50
1 300.50
To record income taxes for January
Café Revive reports the income tax expense on its income statement for January, and reports the
income taxes payable as a current liability on its 31 January 20X2 balance sheet.
210
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Chapter 5 Recording, storing and reporting accounting information
A company’s income statement is similar to that of a sole proprietorship, with two exceptions. First,
the income tax expense is deducted from net income before income taxes to determine net income after
tax. Second, earnings per share is shown directly below net income. The income statement of Café Revive
for January 20X2 would look exactly like Case Exhibit 5.12, except for the lower portion, which would
appear as follows.
Income before income taxes
$ 4 335.00
Income tax expense
(1 300.50)
Net income after tax
$ 3 034.50
Earnings per share (1000 shares)
$
3.03
Balance sheet items
The balance sheet of a company is similar to that of a sole proprietorship, with two exceptions. In
addition to including income taxes payable as a current liability, a company’s balance sheet also has a
modified owner’s equity section. The owner’s equity of a company is called shareholders’ equity, and
consists of two parts: contributed capital and retained earnings. Contributed capital includes both the paidup capital account balances from the adjusted trial balance. The business obtains the retained earnings
amount from the statement of retained earnings. This statement is very similar to the statement of
changes in owner’s equity, which we discussed earlier. The balance sheet of Café Revive on 31 January
20X2 would look like Case Exhibit 5.14, except that the liabilities and the shareholders’ equity sections
would appear as follows:
shareholders’ equity
The shareholders’
interest in the
business, which is the
difference between
total assets and total
liabilities – that is, the
amount that the
business owes to the
owner (shareholders)
Liabilities
Current liabilities:
Accounts payable
$ 6 919.00
Loan payable
1 400.00
Interest payable
11.00
GST collected
1 728.00
PAYG tax payable
310.00
Income taxes payable
Total liabilities
1 300.50
$11 668.50
Shareholders’ equity
Contributed capital:
Paid-up capital, 1000 shares $10 par
Total contributed capital
Retained earnings
$10 000.00
$10 000.00
$ 2 984.50
Total shareholders’ equity
$12 984.50
Total liabilities and shareholders’ equity
$24 673.00
Café Revive would have obtained the income taxes payable, paid-up capital amounts from its adjusted
trial balance. It would have obtained the $2984.50 retained earnings amount ($0 beginning retained
earnings þ $3034.50 net income – $50 dividends) from its statement of retained earnings.
There is also a slight difference in the closing entries of a company compared with those of a sole
proprietorship. A company closes the balance of the income summary account to the retained earnings
account. Also, since it recorded any dividends during the period directly as a reduction of retained
earnings, there is no closing entry at the end of the period for dividends.
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211
Accounting Information for Business Decisions
5.11 Other journal entries
Earlier in the chapter, we discussed the journal entries made by Café Revive. Other businesses may record
journal entries for transactions such as sales discounts, purchases discounts, sales returns and allowances, and
purchases returns and allowances. The way a business records these transactions depends on the business’s
accounting system and on whether it uses a perpetual or a periodic inventory system. Exhibit 5.17 shows a
general framework for recording these types of transactions, although we show only a few of them. However,
by using your knowledge of the accounting equation, debit and credit rules, contra-accounts, revenues and
expenses, and assets, liabilities, and owner’s equity, you can develop the correct journal entries for recording
other transactions. These types of entries will be discussed in more detail in Chapter 7 Appendix.
Exhibit 5.17 Illustrations of additional journal entries
Sales discounts
Purchases discounts
Cash (net)
X
Sales discounts taken
X
Accounts receivable (gross)
Accounts payable (gross)
X
Sales returns and allowances
Sales returns and allowances
X
Cash (net)
X
Purchases returns and allowances
X
Accounts receivable (or cash)
X
Accounts payable (or cash)
Inventory (or purchases returns and
allowances*)
Inventory (at cost)
Cost of goods sold
X
Inventory (or purchases discounts taken*)
X
X
X
X
* Accounts used under periodic inventory system
Business issues and values: Accounting information
In this chapter and Chapter 4, we explained how businesses need to record and report
transactions that occur as part of daily operations using generally accepted accounting principles
(GAAP). We also explained the importance of recording transactions correctly and how managers,
investors and creditors use financial statements to assess a business’s financial position. Because
investors and creditors make business decisions that are based on their assessment of the
business’s financial statements, and often a manager’s bonus payments are based on these results,
a manager may be tempted to make the business appear more financially flexible than it really is, or
to not report on pending matters, such as environmental issues, likely to have an impact on
profitability and even sustainability.
For example, a business may opt to record credit sales very aggressively, stretching its
interpretation of GAAP. By recording credit sales before the revenue is earned, a business may
overstate its accounts receivable and net income for the accounting period. Alternatively, a business
Ethics and Sustainability
might understate or not mention at all the impact of legislation on ‘green’ businesses in terms of
how products are packaged – for example, the abolition of plastic packaging. In a similar fashion, a
business may intentionally under-estimate warranty liabilities by using a lower estimate of warranty
claims outstanding at year-end. In this case, a business may indicate that a loss contingency is only
remotely possible even though it knows that the probability is much higher. When revenues are
overstated or costs and expenses understated or not recorded, a business may appear to have more
financial flexibility than is actually the case, and wrong decisions will occur.
212
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Chapter 5 Recording, storing and reporting accounting information
By relying on this incorrect information, external users may make wrong business decisions – for
example, make a loan to a business that is riskier than they thought, or pay more than they should
for shares in a business. If managers intentionally misstate financial statements, they have broken
the law, breached professional regulations and failed to conduct themselves ethically. They have
committed what is called management fraud, and can be arrested and prosecuted for their actions.
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213
Accounting Information for Business Decisions
STUDY TOOLS
Summary
5.1 Understand the rules for recording transactions in a business’s accounting system records.
1
What is a debit entry, and what is a credit entry?
A debit entry is a monetary amount recorded (debited) on the left side of an account. A credit entry is a monetary amount
recorded (credited) on the right side of an account.
2
What are the rules for recording increases and decreases in asset and liability accounts?
Asset accounts (accounts on the left side of the accounting equation) are increased by debit entries (amounts recorded on the left
side) and decreased by credit entries. Liability accounts (accounts on the right side of the equation) are increased by credit entries
(amounts recorded on the right side) and decreased by debit entries.
3
What are the rules for recording increases and decreases in owner’s equity accounts?
Permanent owner’s equity, or capital, accounts (accounts on the right side of the equation) are increased by credit entries and
decreased by debit entries. Temporary owner’s equity accounts have the following rules: (a) withdrawal accounts are increased by
debit entries and decreased by credit entries; (b) revenue accounts are increased by credit entries and decreased by debit entries;
and (c) expense accounts are increased by debit entries and decreased by credit entries.
5.2 Identify and complete the major steps in a business’s accounting cycle.
4
What are the major steps in a business’s accounting cycle?
The major steps in a business’s accounting cycle are: (1) recording (journalising) the transactions in the general journal; (2) posting
the journal entries to the accounts in the general ledger; (3) recording (and posting) adjusting entries; (4) preparing the financial
statements; and (5) recording (and posting) closing entries.
5.3 Journalise and post to accounts the transactions of a business and prepare a trial balance.
5
What is the difference between journalising and posting?
Journalising is the process of recording a transaction in a business’s general journal. A journal entry is the recorded information
for each transaction. Posting is the process of transferring the debit and credit information for each journal entry to the accounts
in a business’s general ledger.
5.4 Complete adjusting and closing entries.
6
What are adjusting entries, and what are the three types of adjusting entries?
Adjusting entries are journal entries that a business makes at the end of its accounting period to bring the business’s revenue and
expense account balances up to date, and to show the correct ending balances in its asset and liability accounts. Adjusting entries
may be grouped into three types: (1) apportionment of prepaid and unearned items; (2) recording of accrued items; and (3)
recording or apportionment of estimated items.
7
What are closing entries, and how do they relate to the income summary account?
Closing entries are journal entries that a business makes at the end of its accounting period to create a zero balance in each revenue,
expense and withdrawals account, and to transfer these account balances to the owner’s permanent capital account. The income
summary account is a temporary account used in the closing process to accumulate the amount of the business’s net income (or net
loss) before transferring this amount to the owner’s capital account.
214
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Chapter 5 Recording, storing and reporting accounting information
5.5 Prepare financial reports – income statement and balance sheet.
8
How are accounting procedures modified for companies?
Accounting procedures are modified for companies or corporations as follows: (1) investments by owners (shareholders) are
recorded in paid-up capital accounts; (2) distributions (dividends) to shareholders are recorded as a decrease in the retained
earnings account; (3) the income statement includes income tax expense and earnings per share; and (4) the balance sheet includes
income taxes payable in the current liabilities section, and contributed capital and retained earnings in the shareholders’ equity
section.
9
What circumstances might cause directors to act unethically when making dividend distribution decisions for
owners?
Directors may find themselves in an ethical dilemma when they also own shares in the company. All directors on boards are
required to declare conflicts of interest. When a conflict of interest arises, the director should declare it and most appropriately
extract themselves from the decision-making process.
Key terms
accounting cycle
closing entries
post-closing trial balance
accounts
credit entry
posting
accounts payable subsidiary ledger
debit entry
prepaid item
accounts receivable subsidiary ledger
double entry rule
shareholders’ equity
accrued expense
general journal
slide
accrued revenue
general ledger
T-account
adjusted trial balance
income summary
transposition
adjusting entries
journal entry
trial balance
balance of an account
journalising
unearned revenue
chart of accounts
narration
Online research activity
This activity provides an opportunity to gather information online about real-world issues related to the topics in this chapter. For
suggestions on how to navigate various businesses’ websites to find their financial statements and other information, see the related
discussion in the Preface.
Explore the website of Qantas (http://www.qantas.com.au).
1 How does Qantas ensure its fleet of aircraft is up to date? Does it lease or buy its planes?
2 What measures is Qantas taking to reduce the business’s carbon footprint?
Integrated business and accounting situations
Answer the following questions in your own words.
Testing your knowledge
5-1
5-2
5-3
5-4
5-5
Define an account. Which format is better: T-account or three column?
What is a debit entry? What is a credit entry?
What are the debit and credit rules? How do these rules relate to each of the account types in the accounting equation?
Explain the double entry rule. How (if at all) does this rule change in the case of an entry where more than two accounts
are involved?
What is a general journal? List the advantages of initially recording a business’s transactions in a general journal.
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
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Accounting Information for Business Decisions
5-6
5-7
5-8
5-9
5-10
5-11
5-12
5-13
What does journalising of transactions refer to? Briefly describe the steps in the process.
What is posting? Briefly describe the posting process. Where are entries posted to?
What are adjusting entries? Why are they necessary?
What is an adjusted trial balance? Why is it used?
What are closing entries? Describe how (a) revenue accounts; (b) expense accounts; and (c) the withdrawals account are closed.
How does the lower portion of the income statement for a company differ from that of a sole proprietorship? Why it is
different?
How does a company report its income taxes payable on its financial statements?
How is the owner’s equity of a company shown on its balance sheet?
Applying your knowledge
Note: For the exercises below, GST is included unless otherwise stated.
5-14 During the month of July, Sands Insurance entered into the following transactions:
5-15
5-16
Date
Transaction
1 July
Nancy Sands deposited $30 000 in the business’s cash at bank account
10
Purchased land and an office building at a cost of $110 000 and $220 000, respectively, paying $80 000 down and signing a loan
payable for the remaining $250 000
20
Sold insurance policies worth $33 000 to clients
25
Purchased office supplies costing $880 on credit
Required:
a Prepare journal entries to record the preceding transactions.
b List the source documents that might normally be used in recording each of these transactions.
Albert Mitchell started Worldwide Travel Service on 1 April of the current year, and the business engaged in the following
transactions during April:
Date
Transaction
1 Apr.
Albert Mitchell opened the business by depositing $30 000 in the new business’s bank account
3
Purchased land and a small office building for $2750 and $30 800, respectively, paying $10 850 down and signing a loan payable
for $22 700
15
Sold travel services to clients worth $5500. The clients paid 20 per cent deposit with balance to be paid later
20
Purchased office equipment at a cost of $7700. Half of the cost was paid in cash, and the remainder is due at the end of May
Required:
a Prepare journal entries to record the preceding transactions. Include GST entries.
b List the source documents normally used in recording each of these transactions.
Bothwell Plumbing entered into the following transactions during the month of May. GST applies.
Date
Transaction
4 May
Installed plumbing in new house under construction; contractor agreed to pay contract price of $1980 in 30 days
15
Made plumbing repairs for customer and collected $88 for services performed
28
Paid $77 for May telephone bill
31
Paid $9000 to employees for May salaries, including PAYG tax payable of $900
31
Received $110 electricity bill, to be paid in early June
Required:
a Prepare journal entries to record the preceding transactions.
b List the source documents normally used to record these transactions.
216
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Chapter 5 Recording, storing and reporting accounting information
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5-18
5-19
Aline Taxi Service entered into the following transactions during September. Where applicable, GST applies.
Date
Transaction
1 Sept.
Paid $550 rent on garage for the month of September
15
Cash receipts for taxi fares for the first half of the month totalled $1760
23
Paid $990 for September fuel bill from Wildcat Garage
29
PL Aline withdrew $400 for personal use
30
Paid salaries amounting to $1200 to employees, including PAYG tax payable of $160
30
Cash receipts for taxi fares for the second half of the month totalled $1540
Required:
a Prepare journal entries to record the preceding transactions.
b List the source documents normally used to record these transactions.
In August, Healthcheck Sales, a medical supplies wholesaler, entered into the following transactions (the business uses the
perpetual inventory system):
Date
Transaction
1 Aug.
Purchased $5500 of medical supplies on credit from Nead Company
3
Returned $220 of defective medical supplies purchased on 1 August from Nead Company for credit
5
Sold $2200 of medical supplies on credit to P & H Drugs. The cost of the inventory sold was $1200
8
Granted $330 credit to P & H Drugs for return of medical supplies purchased on 5 August. The cost of the inventory returned was $180
9
Purchased $1100 of medical supplies for cash
10
Paid balance due to Nead Company for purchase of 1 August
15
Received balance due from P & H Drugs for medical supplies purchased on 5 August
30
Sold $880 of merchandise to customers for cash. The cost of the inventory sold was $500
Required:
Prepare journal entries to record the preceding transactions.
Taylor Art Supplies Company sells various art supplies to local artists. The business uses a perpetual inventory system, and
the cost of its inventory of art supplies at the beginning of August was $2500. Its cash balance was $800 at the beginning
of August, and it entered into the following transactions during August:
Date
Transaction
1 Aug.
Purchased $440 of art supplies for cash
4
Made a $990 sale of art supplies on credit to P Marks, with terms of n/15. The cost of the inventory sold was $550
6
Purchased $770 of art supplies on credit from Tott Company, with terms of n/20
10
Returned, for credit to its account, $110 of defective art supplies purchased on 6 August from Tott Company
12
Made cash sales of $275 to customers. The cost of the inventory sold was $160
13
Refunded a $22 allowance to a customer for damaged inventory sold on 12 August
15
Received payment from P Marks of the amount due for inventory sold on credit on 4 August
25
Paid balance due to Tott Company for purchase on 6 August
Required:
a Prepare journal entries to record the preceding transactions.
b Set up appropriate T-accounts, post the journal entries to the accounts (for simplicity, it is not necessary to assign
numbers to the accounts) and determine the ending account balances.
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
217
Accounting Information for Business Decisions
5-20
5-21
5-22
Ralph Antonio operates an architectural design business. The following transactions were recorded for the month of March.
Date
Transaction
2 Mar.
Antonio invested a further $10 000 into the business
3
Invoiced clients for work completed $4400
7
Purchased a new 3D equipment for $5500. Paid $500 with the balance payable in 30 days
10
Paid wages $2370 including payroll tax of $370
11
Paid rent on premises for 6 months $2200
15
Invoiced clients for work performed $6600
20
Paid telephone and internet connection bill $330 for the month
22
Antonio withdrew $150 from the business
25
Received $1750 as a deposit for work to be performed for a client in April
26
Received a water bill to be paid in two months $421
31
Paid bank fees incurred on the business bank account $37
Required:
a Prepare journal entries for the above transactions.
b Post to appropriate accounts in the ledger (use three-column format).
c Prepare a trial balance to ensure posting has been completed correctly.
At the end of the current year, Rulem Hair Styling provides you with the following information (ignore GST):
i Depreciation expense on styling equipment totals $1360 for the current year.
ii Accrued interest on a note payable issued on 1 October amounts to $850 at year-end.
iii Unearned rent in the amount of $1000 has been earned (the business records all receipts in advance in an unearned
rent account).
iv Hair styling supplies used during the year total $210 (the business records all purchases of supplies in an asset account).
Required:
Prepare adjusting entries at the end of the current year based on the above information.
On 30 June of the current year, Washington Background Music Company showed the following trial balance:
Account titles
Cash
Debits
Credits
$10 150
Office supplies
368
Sound system
6 500
Accounts payable
$
295
DL Washington, capital
15 000
Music system revenues
3 198
Salary expense
1 000
Rent expense
300
General expenses
175
Totals
$18 493
$18 493
The following adjustments are needed (ignore GST):
i Office supplies used during the month of June totalled $62.
ii Depreciation expense on the sound system for the month of June totalled $75.
June was the first month of operations for Washington Background Music Company.
Required:
a Prepare adjusting entries to record the preceding adjustments.
b Prepare the 30 June adjusted trial balance for Washington Background Music Company.
218
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Chapter 5 Recording, storing and reporting accounting information
5-23
5-24
5-25
On 1 October of the current year, Bourdon Company paid $396 for a two-year comprehensive insurance policy on the
business’s building.
Required:
a Prepare the journal entry to record each of the following:
i the purchase of this insurance policy
ii the adjusting entry at the end of the year (31 December).
b If the adjusting entry had not been made in (a-ii), discuss what effect this error would have on the accounts and totals
listed on the income statement and balance sheet.
On 1 October of the current year, Sagir Appraisal Company received $1980 in advance from the Land-Ho Real Estate
Agency for six months’ rent of office space.
Required:
a Prepare the Sagir Appraisal Company journal entries to record the following:
i the receipt of the payment
ii the adjustment for rent revenue at the end of the current year.
b If the adjusting entry had not been made in (a-ii), discuss what effect this error would have on the accounts and totals
listed on the income statement and balance sheet.
The Cobbler Company shows the following revenue, expense and withdrawals account balances on 31 December of the
current year, before closing:
Account titles
AB Cobbler, withdrawals
Debits
Credits
$2 100
Shoe service revenues
$14 230
Salaries expense
3 700
Utilities expense
350
Supplies expense
197
Rent expense
880
Depreciation expense
125
Commission Received
5-26
Required:
a Prepare closing entries.
b Prepare an income statement.
The following are various accounts related to the income statement and owner’s equity of Lynn Company (a sole
proprietorship) for the current year.
P Lynn, withdrawals
$ 30 000
Salaries expense
31 400
Delivery expense
9 300
Utilities expense
14 700
Sales
Depreciation expense
Cost of goods sold
5-27
1 050
189 500
5 600
73 800
Required:
From the information given, prepare the 31 December closing entries.
For the year ended 30 June 20X1, Newhard Corporation had sales revenues of $120 000, operating expenses of $68 000
and other revenue of $2800. The company is subject to a 30 per cent income tax rate and currently has 10 000 shares held
the entire year by shareholders.
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
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Accounting Information for Business Decisions
5-28
Required:
a Prepare the journal entry on 30 June 20X1 to record Newhard Corporation’s 20X0 income taxes.
b Prepare a 20X0 income statement for Newhard Corporation.
On 1 January 20X1, ACE Corporation showed the following account balances:
Paid-up capital ($10 par)
Retained earnings
$100 000
69 700
During 20X1, the following events occurred:
i The corporation issued 1000 shares of additional stock for $30 000.
ii Net income for the year was $39 000.
iii Dividends in the amount of $12 000 were declared and paid to shareholders.
Required:
Prepare the shareholders’ equity section of ACE Corporation’s balance sheet on 31 December 20X1.
Making evaluations
5-29
5-30
220
The Cameron Copy-Quick Company was recently set up by Joseph Cameron. The business’s transactions during October,
the first month of operations, are given below:
Date
Transaction
3 Oct.
Joseph Cameron deposited $28 000 in the business’s bank account
4
Acquired land and a building for $33 000 and $44 000, respectively, paying $5000 cash and signing a five-year mortgage for the
remaining balance
15
Copy equipment costing $8800 was purchased on credit from Tailor Equipment Company
20
Office supplies costing $1760 were purchased for cash
24
Purchased office furniture costing $2530 from Freddy’s Furniture, paying $300 cash. The balance of $2230 is due in 30 days
28
Purchased a three-year insurance policy for $9900 cash
31
Paid balance due to Tailor Equipment Company for copy equipment purchased on 15 October
Required:
a Set up the following general ledger T-accounts (and account numbers): ‘Cash’ (101), ‘GST paid’ (108), ‘Office supplies’
(105), ‘Prepaid insurance’ (106), ‘Land’ (110), ‘Building’ (112), ‘Copy equipment’ (114), ‘Office furniture’ (118),
‘Accounts payable’ (201), ‘Mortgage payable’ (220) and ‘J Cameron, capital’ (301).
b Record the preceding transactions in a general journal.
c Post the journal entries to the general ledger accounts and determine the ending account balances.
d Prepare a trial balance.
The Foster Tax Services Company was established on 2 January of the current year to help clients with tax planning and
preparation of their tax returns. The business engaged in the following transactions during January:
Date
Transaction
2 Jan.
R Foster set up the business by investing $33 000 cash in the business’s bank account
3
Acquired land and a building at a cost of $99 000 and $231 000, respectively. A $60 000 down-payment was made, and a
mortgage was signed for the remaining balance
4
Purchased office equipment costing $7700 by signing a loan due in one year
10
Office supplies costing $880 were purchased for cash
21
Performed tax planning services for customer and collected $3300
31
Paid $1595 for employee’s salary, $325 of this for PAYG tax
31
Paid utilities bill of $88 for January
31
R Foster withdrew $850 cash for personal use
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Chapter 5 Recording, storing and reporting accounting information
5-31
5-32
Required:
a Set up the following T-accounts (and account numbers): ‘Cash’ (101), ‘Office supplies’ (105), ‘GST paid’ (108), ‘Land’
(110), ‘Building’ (112), ‘Office equipment’ (115), ‘Notes payable’ (220), ‘PAYG tax payable’ (231), ‘GST collected’ (232),
‘Mortgage payable’ (221), ‘R Foster, capital’ (301), ‘R Foster, drawings’ (302), ‘Tax service revenues’ (401), ‘Salary
expense’ (501), ‘Utilities expense’ (502) and ‘Supplies expense’ (503).
b Prepare journal entries to record the preceding transactions.
c Post the journal entries to the accounts.
d Prepare a trial balance at 31 January.
Ryan Landscaping Service had the following account balances at the start of March: cash $2310; accounts receivable $440;
GST paid $330; supplies of landscaping materials $3200; land $40 000; buildings $82 000; accounts payable $123; GST
collected $380; and mortgage payable $60 000.
Ryan Landscaping Service entered into the following transactions during March.
Date
Transaction
1 Mar.
Provided landscaping service for customer, collecting $572 cash
2
Paid three months’ rent in advance at $297 per month on storage and office building
4
Paid accounts payable owing from previous month
5
Purchased $55 of repair parts on credit from JR’s, a small-engine service business; the parts are to be used immediately in
repairing several of the business’s mowers
6
Received accounts receivable from previous month
6–10
Provided landscaping service for a customer; customer agreed to pay the contract price of $2695 in 15 days
12
Owner withdrew supplies $100
15
Paid amount due to JR’s for repair parts purchased on 5 March
25
Collected amount owing from customer for service provided on 6–10 March
31
Paid $44 for March utilities bill
31
Paid $1980, including PAYG tax of $280, to employees for March salaries
31
Received $88 March telephone bill, to be paid in early April
31
A stocktake of supplies indicated $1350 worth of supplies on hand
Required:
a Calculate Ryan’s capital account balance at 1 March.
b Prepare journal entries to record the preceding transactions.
c Set up the following T-accounts (and account numbers): ‘Cash’ (101), ‘Accounts receivable’ (103) ‘GST paid’ (104), ‘Supplies’
(108), ‘Land’ (110), ‘Building’ (112), ‘Accounts payable’ (215), ‘GST payable’ (220), ‘PAYG tax payable’ (231), ‘Mortgage
payable’ (221), ‘R Foster, capital’ (301), ‘R Foster, drawings’ (302), ‘Landscaping services revenue’ (401), ‘Repairs expense’
(501), ‘Supplies expense’ (503), ‘Utilities expense’ (502), ‘Telephone expense’ (505) and ‘Salaries expense’ (507).
d Prepare a trial balance at 31 March.
Watson Heater Company sells portable heaters and related equipment. The business uses a perpetual inventory system,
and the cost of its inventory at the beginning of November was $2600. Its cash balance was $1500 at the beginning of
November, and it entered into the following transactions during November.
Date
Transaction
1 Nov.
Made $550 cash sales to customers; the cost of the inventory sold was $300
3
Purchased $1870 of heaters for cash from Tyler Supply Company
5
Received $275 cash allowance from Tyler Supply Company for defective inventory purchased on 3 November
6
Paid $231 for parts and repaired defective heaters purchased from Tyler Supply Company on 3 November
8
Made $1650 sale of heaters on credit to Nate Nursing Home, with terms of 2/10, n/20. The cost of the inventory sold was $850
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221
Accounting Information for Business Decisions
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5-34
Date
Transaction
15
Purchased $1100 of heaters on credit from Miller Supplies, with terms of n/15
18
Received amount owed by Nate Nursing Home for heaters purchased on 8 November, less the cash discount
30
Paid for the inventory purchased from Miller Supplies on 15 November
Required:
Prepare journal entries to record the preceding transactions.
Morg Building Supplies sells building supplies and small tools to retail customers. It entered into the following
transactions (the business uses the perpetual inventory system) during September.
Date
Transaction
1 Sept.
Purchased $2090 of building supplies on credit from Doe Company, with terms 2/10, n/30
2
Returned $165 of defective building supplies purchased on 1 September from Doe Company for credit
5
Sold $990 of small tools (which cost $660) to customers for cash
6
Purchased $385 of small tools for cash
6
Granted $77 cash allowance to customer for minor defects found in small tools sold on 5 September
10
Paid balance due to Doe Company for purchase of 1 September
21
Sold $1650 of building supplies (which cost $1100) on credit to R Bailey, with terms 1/10, n/30
30
Received balance due from R Bailey for building supplies purchased on 21 September
Required:
a Prepare journal entries to record these transactions.
b What were net sales for the month?
The trial balance of Halsey Architectural Consultants on 30 June of the current year (the end of its annual accounting period)
included the following account balances before adjustments.
Accounts receivable
Prepaid insurance
$ 16 000 debit
1 560 debit
Building
92 000 debit
Drafting equipment
12 000 debit
Unearned rent
6 240 credit
Note payable
10 000 credit
Supplies
Capital
1 500 debit
106 820 credit
In reviewing the business’s recorded transactions and accounting records for the current year, you find the following
information pertaining to the 30 June adjustments:
i
On 1 January, the business had accepted a $16 500, one-year, 10 per cent note receivable from a customer. The interest is
to be collected when the note is collected.
ii
On 1 April, the business had paid $1760 for a three-year insurance policy.
iii The building was acquired several years ago and is being depreciated using the straight-line method over a 20-year
life with no residual value.
iv The drafting equipment was purchased on 1 June. It is to be depreciated using the straight-line method over an
eight-year life with no residual value.
v
On 1 January, the business had received $6644 for two years’ rent in advance for a portion of its building rented to
Shields Company.
vi On 1 May, the business had issued a $10 000, three-month, 9 per cent note payable to a supplier. The $225 total
interest is to be paid when the note is paid.
222
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Chapter 5 Recording, storing and reporting accounting information
vii
5-35
5-36
On 1 July, the business had $200 of supplies on hand. During the year, the business purchased $1300 of supplies. A
count on 30 June determined that $90 worth of supplies were still on hand.
viii On 1 June an entry to record prepaid rates of $6600 for 12 months had not been recorded. Record the entry and make the
adjustment required at 30 June to report rates expenses.
Required:
Prepare the adjusting entries that are necessary to bring Halsey’s accounts up to date on 30 June. Each journal-entry
explanation should summarise your calculations.
VirusFree Janitorial Services engaged in the following transactions during the current year and properly recorded them in
its balance sheet accounts.
Date
Transaction
1 Jan.
Purchased cleaning equipment for $14 300, paying $3000 down and taking out a two-year, 12 per cent loan payable for the
balance. The equipment has an estimated life of 10 years and no residual value; straight-line depreciation is appropriate. The
interest on the note will be paid on the maturity date
24 May
Purchased $330 of office supplies. The office supplies on hand at the beginning of the year totalled $145
1 June
Purchased a two-year comprehensive insurance policy for $990
1 Jan.
Received six months’ rent in advance at $550 per month and recorded the $3300 receipt as unearned rent
1 Jan.
Accepted a $3000, six-month, 10-per-cent note receivable from a customer. The $150 total interest is to be collected when the
note is collected
Additional information:
a On 31 December, office supplies on hand totalled $58.
b All employees work Monday to Friday. The weekly payroll of Paribus amounts to $6000. All employees are paid at the close
of business each Friday for the previous five working days (including Friday). This year, 31 December falls on a Thursday.
Required:
On the basis of the preceding information, prepare journal entries to record whatever adjustments are necessary on 31
December. Each journal-entry explanation should show any related calculations.
The adjusted trial balance for Swish Interior Decorating Company on 30 November 20X1 (the end of its monthly
accounting period) is as follows:
Account titles
Cash
Debits
Credits
$ 7 042
Accounts receivable
4 394
Office supplies
1 074
Prepaid insurance
1 240
GST control
Land
Building
300
6 000
29 400
Accumulated depreciation: building
Office equipment
$
130
2 880
Accumulated depreciation: office equipment
40
Accounts payable
1 580
Mortgage payable
10 000
A Swire, capital
A Swire, drawings
40 000
800
Interior decorating revenues
3 105
Salaries expense
850
Insurance expense
140
Telephone expense
177
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
223
Accounting Information for Business Decisions
Account titles
Debits
276
Office supplies expense
112
Depreciation expense: building
130
Depreciation expense: office equipment
Totals
5-37
Credits
Utilities expense
40
$54 855
$54 855
Required:
a Prepare a November income statement, a statement of changes in owner’s equity and a 30 November 20X1 balance
sheet for Swire Interior Decorating Company.
b Prepare the closing entries on 30 November 20X1.
c Prepare a post-closing trial balance.
On 31 May 20X1, the bookkeeper of Marina Boat Storage prepared the following closing entries for the month of May:
(a) Storage revenues
4 060
Income summary
4 060
(b) Income summary
2 724
Depreciation expense: building
140
Depreciation expense: equipment
110
Supplies expense
233
Salaries expense
1 650
Telephone expense
92
Utilities expense
264
Insurance expense
235
(c) Income summary
1 336
L Marina, capital
1336
(d) L. Marina, capital
830
L Marina, withdrawals
830
In addition, the following post-closing trial balance was prepared:
Account titles
Cash
Debits
Credits
$ 6 120
Accounts receivable
4 989
Supplies
1 117
Land
16 000
Building
25 200
Accumulated depreciation: building
Equipment
140
10 560
Accumulated depreciation: equipment
Accounts payable
GST clearing
110
2 150
200
Notes payable (due 1/5/X3)
7 000
Mortgage payable
20 000
L Marina, capital
Totals
224
34 386
$63 986
$63 986
Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202
Chapter 5 Recording, storing and reporting accounting information
5-38
Required:
a Prepare an income statement for the month ended 31 May 20X1.
b Prepare a statement of changes in owner’s equity for the month ended 31 May 20X1.
c Prepare a 31 May 20X1 balance sheet (in report form).
Finestein Corporation showed the following balances on 1 January 20X1.
Paid-up capital (14 500 shares, $10 par)
Retained earnings
$145 000
64 000
On 4 January 20X1, the company issued 1000 shares for $40 000. For the year ended 31 December 20X1, the company
had sales revenues of $102 000, cost of goods sold of $48 000, operating expenses of $17 000 and other revenues of
$3000. In addition, the company declared and paid dividends of $6000 on 31 December. Finestein Corporation is subject
to a 30 per cent income tax rate and uses a perpetual inventory system.
Required:
a Prepare journal entries to record the issue of common shares on 4 January 20X1, and the declaration and payment of
the cash dividends on 31 December 20X1. (Assume that the company appropriately recorded the journal entries for
the other transactions during the year.)
b Prepare the journal entry on 31 December 20X1 to record the 20X1 income taxes of Finestein Corporation.
c Prepare an income statement for the year ended 31 December 20X1.
d Prepare the shareholders’ equity section of the 31 December 20X1 balance sheet.
e Prepare the 31 December 20X1 closing entries.
Dr Decisive
Yesterday, you received the following letter for your advice column in the local paper:
Dear Dr Decisive
My brother and I are having a fight over bad debt expenses, and have bet one another on the outcome. I think he
owes me $100; he disagrees. He is a civil engineer, and you know how they like their numbers and measurements to
be precise. The other day I showed him a newspaper report in which a bank’s CEO was saying that the bank had
some tenuous first-homeowner property loans, and so would be recording estimated amounts for large bad-debt
expenses this year and for the next couple of years in anticipation that borrowers would not be able to pay back
their loans as interest rates rose. My brother said that the CEO’s statement was crazy, and that the bank should
wait until the loans are written off before recording them as an expense. I tried to tell him that the bank should
record all the loans as expenses now. Whoever is right, we both disagree with the bank’s CEO about interest-rate
rises. I do need the $100, though, and would appreciate your help.
Call me . . .
‘Confused Again’
Required
Meet with your Dr Decisive team and write a response to ‘Confused Again’.
Endnote
a
Quoted in RJ Chambers (ed.) (1995), An Accounting Thesaurus: 500 Years of Accounting. New York: Permagon, 7.
Company URL
u
Qantas: http://www.qantas.com.au
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225
6
INTERNAL CONTROL: MANAGING
AND REPORTING WORKING
CAPITAL
‘Most people have wrong-minded ideas about why companies fail.
They think it’s because of a lack of money.
In most cases, it has very little to do with that.’
Michael E. Gerber
Learning objectives
After reading this chapter, students should be able to do the following:
6.1
Define the concept of ‘working capital’ and reasons for exercising
control over working capital items.
6.2 Discuss why managing the asset cash in terms of cash receipts
and cash payments is so important.
6.3 Understand how to properly monitor and control accounts
receivable.
6.4 Identify control procedures and methods for inventory.
6.5 Explain the need to manage accounts payable.
226
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Chapter 6 Internal control: Managing and reporting working capital
Understanding the learning objectives is assisted in the chapter by asking key questions:
Key questions
1
What is working capital, and why is its management important?
2
How can managers control cash receipts in a business?
3
How can managers control cash payments in a business?
4
What is bank reconciliation, and what are the causes of the difference between a
business’s cash balance in its accounting records and its cash balance on its bank
statement?
5
How can managers control accounts receivable in a business?
6
How can managers control inventory in a business?
7
How can managers control accounts payable in a business?
How do you protect your cash? Do you organise your money in your wallet so that five-dollar notes are in
front and larger denominations behind? Do you keep a jar of change to pay for small items? Do you store
your wallet in a secret place? Do you have a credit card or a savings account? Do you earn interest on
the balance you keep in the account? Do you split your pay into savings and other accounts each week?
Do you record each payment that you make automatically? Do you reconcile your record of cash
transactions each time you get a bank statement? Have any of your friends asked you to lend them
money? Did you consider the likelihood that they would pay you back before you decided whether to lend
them the money? If you loaned them money, did you make them sign an agreement to pay you back?
When you pay for several items at a shop by using your credit card, do you examine the receipt to make
sure the shop has not overcharged you?
These are all ways by which individuals might keep ‘control’ over their cash, amounts owed to them
and amounts they owe. To be successful, businesses also require sound controls over their cash, accounts
receivable and accounts payable.
According to Michael E Gerber, accounting issues are the basis for three of the top 10 reasons why
small businesses, in particular, fail. They are:
1 a lack of management systems, such as financial controls
2 a lack of financial planning and review
3 an inadequate level of financial resources.a
The third reason can be interpreted to mean ‘a lack of money’. The first two reasons, however, focus
on the management of a business’s financial resources.
Often, it is difficult for a new business to keep an adequate amount of financial resources. Because so
many businesses start with very little cash, they operate under very tight financial constraints. Some very
successful businesses – for example, Dell Inc. (http://www.dell.com.au) and Woolworths Supermarkets
(http://www.woolworths.com.au) – started business with very limited resources, but were able to manage
their resources effectively and grow into big companies.
In this chapter, we will build on the knowledge you gained in previous chapters. We will take a closer
look at how businesses manage and report four important balance sheet items: cash, accounts receivable,
inventory and accounts payable. How a business manages these items affects its cash flows, financial
performance and financial reporting. More specifically, we will define working capital, discuss its
importance, examine its major components and explain how managers and external users evaluate it. We
believe that through proper short-term financial management, many small businesses can increase their
likelihood of success.
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227
Accounting Information for Business Decisions
.
1
What is working capital,
and why is its
management important?
working capital
A business’s current
assets minus its
current liabilities
6.1 Working capital
A business’s working capital is the excess of its current assets over its current liabilities. That is, working
capital is current assets minus current liabilities.
Discussion
Why do you think this amount is called ‘working’ capital? Why do you think a business is
concerned with its working capital?
Recall that the current assets section of a business’s balance sheet includes assets that the business
expects to convert into cash, to sell or to use up within one year. The current liabilities section includes
liabilities that it expects to pay within one year by using current assets. The term working capital
represents the net resources that managers have to work with (manage) in the business’s day-to-day
operations. To demonstrate working capital, we will assume – even though we have only just started to
record transactions up to January 20X2 – that Café Revive has operated for two full years and has
recorded all its transactions correctly. Case Exhibit 6.1 shows Café Revive’s balance sheets for 31
Case Exhibit 6.1 Café Revive’s balance sheets
CAFÉ REVIVE
Comparative balance sheets
31 December 20X2 and 20X3
Assets
31 December 20X2
31 December 20X3
Current assets
Cash ($5783 þ petty cash $35)
$ 5 818
$ 5 014
Accounts receivable (net)
7 340
8 808
Inventory
1 570
Total current assets
1 300
$14 728
$15 122
Property and equipment:
Store equipment (net)
$13 500
Total property and equipment
Total assets
$10 420
13 500
10 420
$28 228
$25 542
Liabilities
Current liabilities:
Accounts payable
GST clearing
$ 6 200
$ 7 500
1 340
231
Total current liabilities
$ 7 540
$ 7 731
Non-current liabilities:
Notes payable
Total non-current liabilities
$ 5 000
$ 5 000
5 000
5 000
$12 540
$12 731
E Della, capital
$15 688
$12 811
Total liabilities and owner’s equity
$28 228
$25 542
Total liabilities
Owner’s equity
Working capital ¼ Current assets – Current liabilities
31/12/20X2: Working capital ¼ $14 728 – $7540 ¼ $7188
31/12/20X3: Working capital ¼ $15 122 – $7731 ¼ $7391
228
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Chapter 6 Internal control: Managing and reporting working capital
December 20X2 and 31 December 20X3. We highlight the current sections of the balance sheet and
calculate Café Revive’s working capital at the bottom of Case Exhibit 6.1. Note that the amount of the
current liabilities (accounts payable) is subtracted from the total amount for the current assets (cash,
accounts receivable and inventory) to calculate working capital. Changes in any of these four items affect
Café Revive’s working capital. The decisions managers make regarding any of these items are considered
part of working capital management. Other terms for working capital management are operating capital
management and short-term financial management.
Stop & think
Businesses manage working capital because they want to keep an appropriate amount of it on hand.
But what is an appropriate amount of working capital for a business? An appropriate amount is enough
working capital to finance the business’s day-to-day operating activities plus an extra amount in case
something unexpected happens. For instance, the extra amount may enable the business to buy inventory
when it is offered at a reduced price, or to cover the lost cash when a customer doesn’t pay their account.
If a business has too little working capital, it risks not having enough liquidity. If it has too much working
capital, the business risks not putting its resources to their best use. In summary, businesses manage
working capital to keep an appropriate balance between (1) having enough working capital to operate and
to handle unexpected needs for cash, inventory or short-term credit; and (2) having so much excess cash,
inventory or available credit that profitability is reduced.
Keeping the right amount of working capital requires careful planning and monitoring. For instance,
the timing of inventory purchases usually does not coincide with the timing of sales. So a business may
find itself, at any given time, with either too little or too much inventory. Cash receipts usually do not
coincide with the business’s need to use its cash. Thus, a business may have excess cash sitting idly in its
bank account, or it may need additional short-term financing.
The fact that customers have some control over when they make their payments
affects a business’s management of cash collections from its accounts receivable. The
longer customers take to pay, the longer the business must wait between the time when it
purchased inventory and the time when it receives cash from the sale. The business can
manage this aspect of working capital by setting policies that encourage early payment of
accounts receivable.
On the other hand, the business must also manage the payments of its obligations. It
should make these payments on time, as well as take advantage of purchases discounts
available from its suppliers.
Managing working capital affects all aspects of a business’s operating activities. Case
Exhibit 6.2 shows a timeline of Café Revive’s operating activities. The top half of the
exhibit shows Café Revive’s (CR) transactions with its supplier, DeFlava Coffee
Corporation (DFC). These consist of Café Revive purchasing coffees (increasing inventory)
on credit (increasing accounts payable), paying invoices as they come due (decreasing cash
and accounts payable) and monitoring inventory to determine when to restock (not How can a business encourage its customers
shown).
to pay their bills more quickly?
Stop & think
Why do you think Café Revive waits almost until the invoice’s due date to process its cash
payment to DeFlava Coffee?
The bottom half of Case Exhibit 6.2 shows Café Revive’s transactions with its customers. These
consist of Café Revive making coffee sales (decreasing inventory) on credit (increasing accounts
receivable) or for cash (not shown), and of credit customers posting payments based on the credit terms
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229
Getty Images/Photodisc
How much working capital do you need in your personal life? Why?
Accounting Information for Business Decisions
Case Exhibit 6.2 Working capital flows
DeFlava Coffee (DFC)
Purchasing and
cash payments
1 CR purchases coffee products
from DFC on credit.
2 CR waits until almost the
invoice due date to process
cash payment.
4
3
Coffee
products
Deposit
CR’s
cheque/EFT CR’s cheque/EFT
1
Banking
system
2
8
3 CR sends cheque or electronic
payment.
Deposit
customer’s cheque/EFT
4 DFC processes receipt
from CR; CR’s bank deducts payment
Café Revive (CR)
payment from CR’s bank
Cash
account.
Accounts receivable
Accounts payable
Inventory
5
7
Coffee
products
Customer’s
cheque/EFT
Sales and
cash receipts
5 CR sells coffee products
to a customer on credit.
6 Customer waits until
almost the due date to
process cash payment.
7 Customer transfers funds
electronically for payment to CR.
8 CR processes receipt and checks
the deposit with other daily receipts
in its bank account.
6
Customer
internal control
structure
Set of policies and
procedures that directs
how employees should
perform a business’s
activities
cash
Money on hand,
deposits in bank
accounts, and cheque
and credit card invoices
that a business has
received from its
customers but not yet
deposited
230
of the sales (decreasing accounts receivable). When Café Revive receives customers’ payments, it deposits
them in the bank (increasing cash). These deposits are then available to make cash payments.
Managers control each aspect of the operating cycle to ensure that operating activities are performed
in accordance with business objectives. As you will see, they do this by establishing an internal control
structure, which is a set of policies and procedures that directs how employees should perform a
business’s activities.
The reporting by a business of the amount of each current asset and current liability on its balance
sheet provides external users with information about the ability of the business to keep an appropriate
level and mix of working capital. In turn, this reporting helps managers and users evaluate the business’s
liquidity.
To put it another way, working capital is to a business what water is to a plant. If the plant does not
have enough water, it will not grow, and eventually it will wither and die. If the plant receives too much
water, it will drown. Just as plants need the right amount of water in order to grow, businesses need the
right amount of working capital to achieve desired levels of profitability and liquidity. In the following
sections, we will discuss how a business manages and reports its working capital items – cash, accounts
receivable, inventory and accounts payable.
6.2 Cash
A business’s cash includes money on hand, deposits in bank accounts and other documents that are
convertible to cash, such as cheques that it has received from customers but not yet deposited. A simple rule
is that cash includes anything that a bank will accept as a deposit.
In addition to being an integral part of a business, cash is also the most likely asset for employees and
others to steal or for the business to misplace. For example, cash received from customers in a retail shop
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Chapter 6 Internal control: Managing and reporting working capital
has no identification marks that have been recorded by the shop. So when cash goes ‘missing’, it is very
difficult to prove the cash was stolen or who stole it. Also, cash that is illegally transferred from a business
bank account involves no physical possession of the cash by the thief, and if the thief can conceal or
destroy the records, the theft of the money may not be traceable. Although internal control procedures
are necessary for all phases of a business’s operations, they are usually most important for cash.
Simple cash controls
For businesses of all sizes, the best way to prevent both intentional and unintentional losses is to hire
competent and trustworthy personnel, and to establish cash controls. We will discuss two categories of
simple cash controls. These are internal controls over (1) cash receipts and (2) cash payments. These
controls apply to all cash transactions except those dealing with a business’s petty cash fund, which we
will discuss later in the chapter.
Controls over cash receipts
A business uses internal control procedures for cash receipts to ensure that it properly records the
amounts of all cash receipts in the accounting system, and to protect these from being lost or stolen. Cash
receipts from a business’s operating activities result from cash sales and from collections of accounts
receivable from its customers.
2
How can managers
control cash receipts
in a business?
Stop & think
How might an employee steal from their employer when working at the business’s cash
register?
For cash sales, a business should use three control procedures. The most important is the proper use
of a cash register. Managers should make sure that a pre-numbered sales receipt is completed for every
sale, and that the salespeople ring up each sale on the register. In most businesses, the cash register
produces the receipt as well as a tape containing a chronological list of all sales transactions rung up on
the register. This step is important because it is the first place sales are entered into the accounting
system. The fact that customers expect to receive a copy of the receipt helps to ensure that each sale is
entered. As a customer, you may have been part of a business’s cash controls without even knowing it.
For example, a pizza shop could have a sign near the cash register that reads:
Dear Customer: If we fail to give
you a receipt for your pizza purchase,
let us know and your next meal is free!
This added control increases the likelihood that salespeople will enter all sales into the cash register,
and it signals to employees the importance of this activity.
Stop & think
Could an employee still steal money from a business even though receipts are issued for every
transaction? If so, how?
Second, if a cheque or voucher is accepted for payment, the salesperson should make sure that the
customer has proper identification in order to minimise the likelihood that the bank might not accept it.
Even this procedure is not always adequate.
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231
Accounting Information for Business Decisions
Third, at the end of each salesperson’s work shift, the employee should match the total of the
amounts collected (cash plus credit card sales) against the total of the cash register tape and report any
difference between the two totals to a supervisor.
Some companies, such as Coles (http://www.coles.com.au), use a fourth control procedure for cash
sales. These companies remove the ‘big notes’ from cash registers during a single employee’s shift. For
example, if more than five 50-dollar notes are in the register, the employee inserts the excess notes into a
slot that leads to a locked safe kept behind the counter; only the shop manager knows the combination to
the safe.
A business should use three control procedures to safeguard collections of cash from accounts
receivable (Exhibit 6.3):
Exhibit 6.3 Control procedures to safeguard cash from accounts receivable
1
Separation of duties. Either the owner–manager or an employee who does not handle
accounting records should open the mail. Separating duties that involve handling accounting
records from activities that involve receiving cash, such as opening the mail or taking cash at
point of sale, prevents an employee from stealing undeposited amounts of cash and covering up
the theft by making a fictitious entry in the accounting records.
2 List details. Immediately after opening the mail or receiving cash, the employee should list or
input all of the details of the money received. Later, if a customer claims to have previously
paid a bill, the business can review documentation. You may be wondering what happens if the
customer did pay the bill but the money is not deposited because the employee stole the
undeposited money. Review of documentation may help the business discover that its employee
is stealing money.
3 Endorsement. Employees should ensure each incoming amount is registered at the cash register. At
Café Revive, this is done by ensuring that all cash received is placed in the cash register till and the
amount entered into the system. Café Revive accepts only cash or card, cheques are a thing of the
past.
3
How can managers
control cash payments
in a business?
Stop & think
Why do you think an owner might be interested in not recording all cash receipts?
Getty Images/Ryan McVay
Finally, a business should adopt one additional procedure to help it safeguard the cash
collected from both its cash sales and its accounts receivable: it should deposit all cash
receipts intact daily. This means that at the end of each day, the business should take all of
its cash (i.e. everything included in our definition of cash), fill out a deposit slip and make a
bank deposit. These daily bank deposits help in two ways. First, keeping a substantial amount
of cash at the business overnight is taking an unnecessary risk of theft. By depositing all cash
receipts on a daily basis, the business does not leave cash unattended overnight. Second, the
bank’s deposit records show the business’s cash receipts for each day. When the business
receives its monthly bank statement, it can check the daily bank deposits listed in the bank
statement against its ‘Cash’ account to determine that it deposited all its recorded cash
receipts in the bank and that it properly recorded all bank deposits in its ‘Cash’ account.
Controls over cash payments
How can this customer help the supermarket
keep control of the cash in this register?
232
The basic rule for good internal control over cash payments is to have all payments
authorised before they are made. A very small business operated by the owner may have
little need for any additional internal control procedures – the owner purchases items and
pays employees, either electronically or by cheque. As the business grows, though, two
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Chapter 6 Internal control: Managing and reporting working capital
more controls over cash payments can provide added security over cash. First, the business should pay
only for approved purchases that are supported by proper documents. These documents generally include
an approved copy of the business’s purchase order providing evidence that the business actually ordered
the items (which we will discuss in detail later in the chapter), a freight receipt showing evidence that the
business received the items it ordered, and the supplier’s invoice. This procedure reduces the chance that
the business will pay for either items that it did not want to purchase or items that it has not received.
Second, immediately after payment, the owner should stamp ‘Paid’ on the supporting documents, along
with the date paid and the receipt number. Cancelling the documents in this way prevents the business
from paying for items more than once.
Discussion
Why do you think an employee might want to deceive a business about its cash payments?
Why do you think an owner might be interested in not recording all cash payments?
Bank reconciliation
Despite all of the procedures used to control the receipts and payments of cash, errors can still occur in a
business’s records. Since the bank also keeps a record of the business’s cash balance, the business can use
both sets of records to determine what its correct cash balance should be. However, the time when the
business records its receipts and payments differs from the time when the bank records them, so a
business uses a bank reconciliation to determine the accuracy of the balance in its cash account. In this
section, we discuss what a bank reconciliation is, why it is necessary and how it is performed.
4
What is bank
reconciliation, and what
are the causes of the
difference between a
business’s cash balance in
its accounting records and
its cash balance on its
bank statement?
Stop & think
Do you reconcile your bank statement every month? What risks do you take if you don’t
reconcile your records of cash transactions with the bank statement?
A business’s bank independently keeps track of the business’s cash balance. Each month, the bank
produces a bank statement for the business that summarises the business’s banking activities (e.g.
deposits and payments) during the month. A business uses its bank statement, along with its own cash
records, to prepare a bank reconciliation.
When a business uses the internal control procedures of depositing daily receipts and ensuring all
payments are approved and documented, the ending balance in its cash account should be the same as the
bank’s ending cash balance for the business’s bank account, except for a few items. (We will discuss the
various causes of the difference between the two balances later.) A business prepares a bank reconciliation
to analyse the difference between the ending cash balance in its accounting records and the ending cash
balance reported by the bank in the bank statement. Through this process, the business learns what changes,
if any, it needs to make in its ‘Cash’ account balance. This enables the business to report the correct cash
balance on its balance sheet.
Exhibit 6.4 summarises the causes of the difference between the ending cash balance listed on the
bank statement and the ending cash balance listed in the business’s records. The causes include: (1)
deposits in transit; (2) outstanding payments/cheques; (3) deposits made directly by the bank; (4) charges
made directly by the bank; and (5) errors.
bank statement
Statement that
summarises a
business’s banking
activities during the
month
bank reconciliation
Schedule used to
analyse the difference
between the ending
cash balance in a
business’s accounting
records and the ending
cash balance reported
by the bank on the
business’s bank
statement
Stop & think
Which of the five listed items are most important when you reconcile your bank account?
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233
Accounting Information for Business Decisions
Exhibit 6.4 Causes of difference in cash balances
deposit in transit
A cash receipt that a
business has added to
its cash account but
that the bank has not
deducted from the cash
balance reported on the
bank statement
because the cheque
has not yet ‘cleared’
the bank
NSF (not sufficient
funds)
A customer’s cheque
that has ‘bounced’ (the
business’s bank is
unable to collect
because the customer’s
bank account has
insufficient funds to
cover the cheque)
234
1
Deposits in transit. A deposit in transit is a cash receipt that the business has added to its ‘Cash’
account but that the bank has not included in the cash balance reported on the bank
statement. When a business receives a transfer of money or other receipt, it records an
increase to its ‘Cash’ account. As illustrated in Case Exhibit 6.2, a short period of time may
pass before the business deposits the money and the bank records it. At the end of each
month, the business may have deposits in transit (either cash, cheques or pending electronic
funds transfers) that cause the deposits recorded in the business’s cash account to be greater
than deposits reported on the bank statement. For businesses using electronic transfer of funds
(EFT), there is usually less delay between when a receipt is made and when it is recorded into
the business’s bank account; however, delays may still occur.
2 Outstanding or pending payments. For example, an outstanding payment might be an amount that
the business has paid and deducted from its cash account but that the bank has not deducted
from the cash balance reported on the bank statement because the payment has not yet
‘cleared’ the system. As illustrated in Case Exhibit 6.2, a period of time is necessary for a
cheque to be received by the payee (the business to whom the cheque is written), deposited in
the payee’s bank and forwarded to the business’s bank (physically or electronically) for
subtraction from the business’s bank balance. So at the end of each month, a business usually
has some outstanding or pending payments that cause the cash payments recorded in its ‘Cash’
account to be more than the honoured payments itemised on the bank statement.
3 Deposits made directly by the bank. Many bank accounts earn interest on the balance in the
account. For these accounts, the bank increases the business’s cash balance in the bank’s
records by the amount of interest the business earned on its account; the bank lists this
amount on the bank statement. This causes deposits listed on the bank statement to be greater
than the deposits listed in the business’s cash account. The business is informed of the amount
of interest when it receives the bank statement.
4 Charges made directly by the bank. A bank frequently imposes a service charge for managing a
depositor’s account, and deducts this charge directly from the bank account. Banks also charge
for the cost of maintaining the account and other services delivered. The business is informed
of the amount of the charge when it receives the bank statement showing the amount of the
deduction.
When the business receives a customer’s cheque, it adds the amount to its cash account and
deposits the cheque in its bank account for collection. The business’s bank is occasionally unable
to collect the amount of the customer’s cheque. That is, the customer’s cheque has ‘bounced’. A
customer’s cheque that has ‘bounced’ is referred to as NSF (not sufficient funds). Because the
bank did not receive money for the customer’s cheque, it lists the cheque as an NSF cheque on
the bank statement. Although the bank usually informs the business immediately of each NSF
cheque, there may be some NSF cheques that are included in the bank statement and that the
business has not recorded.
At the end of the month, the bank lists any service charges and NSF cheques as deductions
on the bank statement – deductions not yet listed in the business’s ‘Cash’ account.
5 Errors. Despite the internal control procedures established by the bank and the business, errors
may arise in either the bank’s records or the business’s records. The business may not discover
these errors until it prepares the bank reconciliation. For example, a bank may include a deposit
in the wrong depositor’s account, or may make an error in recording an amount. Or a business
may record a deposit for an incorrect amount, or may forget to record a cash transaction.
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Chapter 6 Internal control: Managing and reporting working capital
The structure of bank reconciliation
Exhibit 6.5 shows a common way to structure bank reconciliation. Notice that the reconciliation has two
sections: an upper section starting with the bank’s record of the business’s ending cash balance, and a
lower section starting with the business’s record of its cash balance. It is logical to set up these two
sections because the purpose of the bank reconciliation is to determine the business’s correct ending cash
balance. By adjusting the cash balance in each section for the amounts that either are missing or are made
in error, the business is able to determine its reconciled (correct) ending cash balance.
Exhibit 6.5 Structure of a bank reconciliation
Business name
Bank reconciliation
Date for cash balance being reconciled
Ending cash balance from the bank statement
þ
Deposits in transit
–
Outstanding cheques
þ/–
¼
Errors made by the bank
Ending reconciled cash balance
Ending cash balance from business cash account
þ
Deposits made directly by the bank
–
Charges made directly by the bank
þ/–
¼
Must be the
same
Errors made by the business
Ending reconciled cash balance
For example, in the upper section, a deposit in transit is added to the ending cash balance from the
bank statement because this deposit represents a cash increase that the bank has not yet added to the
business’s bank account. In the lower section, a service charge made by the bank is subtracted from
the ending balance in the business’s ‘Cash’ account because this charge represents a cash decrease that the
business has not yet recorded.
The bank reconciliation is complete when the ending reconciled cash balances calculated in these two
sections are the same. This ending-reconciled cash balance is the correct cash balance that the business
includes in its ending balance sheet. This form of bank reconciliation acts as another type of internal control
over cash because it enables a business to identify errors in its cash-recording process and to know its
correct cash balance at the end of each month.
Preparing a bank reconciliation
When you prepare a bank reconciliation, keep in mind that you are doing it to determine the correct ending
cash balance to be shown on the business’s balance sheet. The cash balance at the end of the month is correct if
it includes all of the business’s transactions and events that affected cash. As you work through the upper
section of the reconciliation, ask yourself, ‘What cash transactions (e.g. payments and deposits made) have
taken place that the bank doesn’t know about?’ In the lower section, ask yourself, ‘What is not included in
calculating the business’s ending cash balance but should be (e.g., bank service charges and interest earned)?’
Keep these questions in mind as you work through the reconciliation until the reconciled balances are the same.
To prepare a bank reconciliation, you need two sets of items: (1) the bank statement for the month
being reconciled, along with all of the items returned with the statement; and (2) the business’s cash
records. With these items, you can work through a reconciliation in a step-by-step manner. Exhibit 6.6
summarises the eight steps to follow in preparing a bank reconciliation.
In the following section, we illustrate the reconciliation process by preparing Café Revive’s 31 January
20X2 bank reconciliation.
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Accounting Information for Business Decisions
Exhibit 6.6 Steps in preparing a bank reconciliation
1
2
3
4
5
Set up the proper form for the bank reconciliation. Fill in the information you already know
(e.g. ending unadjusted cash balances from the bank statement and the ‘Cash’ account).
Look for deposits in transit. Compare the increases in cash listed in the business’s ‘Cash’
account with the deposits shown on the bank statement. Check to see whether any increase in
the business’s ‘Cash’ account is not listed as a deposit on the bank statement. For any deposit
in transit, add the amount to the ending cash balance from the bank statement listed on the
reconciliation. At the same time, check for differences or discrepancies that may be as a result
of errors.
Look for outstanding, transfers payments or cheques. Compare the decreases in cash listed on
the business’s ‘Cash’ account with the payments shown on the bank statement. Identify any
decrease that is shown in the business’s ‘Cash’ account during the month but that is not
matched with a corresponding bank deduction on the bank statement. Starting from the
business’s records, trace each decrease to its cheque listing on the bank statement. Subtract
the amounts of the outstanding cheques, or payments from the ending cash balance, from the
bank statement listed on the bank reconciliation. At the same time, check for differences or
discrepancies that may be as a result of errors.
Identify any deposits that were made directly by the bank but that are not included as increases
in the business’s ‘Cash’ account. Look through the bank statement for bank deposits that the
business has not recorded as increases in its ‘Cash’ account. Usually, these deposits are for
interest earned on the business’s bank account balance. Add these deposits to the balance of
the business’s ‘Cash’ account listed on the bank reconciliation.
Identify any charges that were made directly by the bank but that are not included as decreases
in cash on the business’s records. Look through the bank statement for bank charges that the
business has not recorded as decreases in its ‘Cash’ account. Usually, these charges result from
bank services such as printing cheques or handling the business’s own NSF cheques. Deduct
these charges from the balance of the business’s ‘Cash’ account listed on the bank
reconciliation.
6 Determine the effect of any errors. While completing steps 1 to 5, you may discover that the
bank or the business (or both) made an error during the processing of the cash transactions. If
you find a bank error, contact the bank to get the error corrected in the business’s bank
account, and ensure you have already corrected the amount of the error in the upper section of
the bank reconciliation. If the business made an error, correct the amount of the error by
adjusting the ending balance on the bank statement accordingly in the reconciliation statement.
7 Complete the bank reconciliation. After you have finished steps 1 to 6, the reconciled (correct)
cash balances in the ‘Cash at bank’ account and the bank reconciliation should be the same. If not,
trace back through the process carefully to locate any mistakes (e.g. outstanding cheques or
transfers that you failed to include and errors in maths).
8 Journalise and post entries for amounts adjusted in the books of the business – that is, those
items recorded on the bank statement but not recorded in the ‘Cash at bank’ account before
reconciliation.
236
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Chapter 6 Internal control: Managing and reporting working capital
Café Revive’s bank reconciliation
Case Exhibit 6.7 shows the following documents:
•
Café Revive’s ‘Cash’ account for January (for illustrative purposes, it is set up in three-column form,
showing increases in the left – or debit – column and decreases in the right – or credit – column, with
the running balance after each transaction in the balance column)
• the January bank statement the business received from City Bank
• the completed bank reconciliation statement.
Case Exhibit 6.7 also summarises steps 1 to 7 from Exhibit 6.6, which Emily Della followed to
prepare the reconciliation. We use an arrow and a number to trace each step on the documents.
In step 8, Emily entered the reconciling items listed in the lower section of Café Revive’s bank
reconciliation (interest earned, bank service charge and correction of error) into the business’s accounting
records on 31 January 20X2. The effect of these changes on the accounting equation is as follows:
Owner’s equity
¼
Assets
Liabilities
þ
Net income
Revenues
Cash
Accounts payable
Interest revenue
þ$25.00
Expenses
Banking expense
þ $25.00
$35.00
þ$35.00
$10.00
þ$25.00
þ$35.00
Case Exhibit 6.7 also shows that, after Emily recorded the reconciling items, Café Revive’s ‘Cash’
account balance is the correct amount: $25 182. Emily will add this amount to the total amount in the
petty cash fund (discussed later), and will show the combined total as ‘Cash’ on Café Revive’s 31 January
20X2 balance sheet.
Similar to the end of period adjustment entries (number 16, 17, 18 and 19) recorded in chapters 4
and 5, the adjustments to cash at bank in the reconciliation process shown in Case Exhibit 6.7 are
reflected in the following adjustment journal entries (number 20 and 21), as per step 8:
Trans
Date
(20)
31/01/X2
Cash
Interest revenue
CR
(21)
31/01/X2
Bank charges/expenses
DR
Cash
DR
CR
25
25
35
35
Note that the adjustment for the error made in recording the deposit of $8800 (incorrectly recorded
by the bank as $8880) was done by notifying the bank of its error and adjusting the balance taken from
the bank statement to commence the bank reconciliation statement, as per the following adjustment of
the bank balance for the error.
Balance in bank taken from bank statement
Less: Correction of error (deposit recorded as $8880 instead of $8800)
Adjusted balance
21 324
(80)
21 244
Additional controls over cash
There are two other steps in preparing a bank reconciliation that help a business keep control over its
cash. First, the business should ensure that any deposit in transit listed on the bank reconciliation for the
previous month is listed as a deposit on the current bank statement. If it is not listed, the business should
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Accounting Information for Business Decisions
Case Exhibit 6.7 Café Revive’s bank reconciliation
Steps to complete bank reconciliation
1
Step 1. Emily transferred the $25 324 cash balance from the bank statement to the reconciliation and noted the $25 192 balance from
Café Revive’s Cash account.
2
Step 2. Emily compared the increases in the Cash account with the bank deposits. She found that an amount for cash sales of
$11 000 had been incorrectly recorded in the bank statement by the bank as $11 080. In Step 6 she will adjust for this. She also found
the January 31 increase of $5368 was not listed on the bank statement. She entered $5368 on the reconciliation as a deposit in transit.
3
Step 3. Emily compared the bank statement’s listing of withdrawals and Café Revive’s record of decreases in its Cash account and
found that all but one of the decreases (cheque no. 939 for $1430) were deducted on the current month’s bank statement. She
subtracted this outstanding cheque from the balance in the bank statement in the reconciliation.
4
Step 4. Emily began completing the lower section of Café Revive’s reconciliation. Emily reviewed the deposits listed in the bank
statement and found that Café Revive had not recorded a $25 bank deposit for interest earned as an increase in its Cash account. She
added the $25 deposit to the Cash at Bank account.
5
Step 5. Emily reviewed the charges on the bank statement and found that Café Revive had not recorded a $35.00 bank service charge
as a decrease in its Cash account. She subtracted the $35 charge from the company’s Cash at Bank account.
6
Step 6. Emily adjusted for the error discovered in Step 2. Because the amount that the bank should have recorded is $80 more than
the amount that it did record ($11 080 $11 000), Emily subtracted $80 from the ending balance from the bank statement.
7
Step 7. After completing the bank reconciliation, Emily calculated the reconciled ending cash balance to be $25 182. Emily also
observed that the reconciled balance shown in the bank reconciliation statement is the same. This indicates that she completed the bank
reconciliation properly.
8
238
Step 8. In accordance with Exhibit 6.6, Emily completed end of period adjustment entries.
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Chapter 6 Internal control: Managing and reporting working capital
Cash
+ (DR)
– (CR)
Beginning balance 1/1/20X2
(1)
2/1/20X2
(2)
3/1/20X2
Balance
11 575
1 650
Chq no 939
13 225
1 430
11 795
(5)
7/1/20X2
(6)
20/1/20X2
EFT
250
11 985
(7)
25/1/20X2
EFT
363
11 622
(8)
25/1/20X2
EFT
121
11 501
(9)
25/1/20X2
EFT
275
11 226
(10)
31/1/20X2
EFT
2 050
9 176
(11)
31/1/20X2
EFT
143
9 033
(12)
31/1/20X2
EFT
(13)
31/1/20X2
(14)
31/1/20X2
440
31/1/20X2
Interest earned
31/1/20X2
Bank charges
12 235
209
8 824
11 000
19 824
5 368
25 192
25
25 217
35
$ 25 182
Café Revive
PO Box 45
Westaway, Brisbane
City Bank
Westaway Centre, Brisbane
Account no 137-187-8
Bank statement
January 20X2
+ (DR)
(CR)
Beginning balance 1/1/20X2
Balance
11 575
4/1/20X2
Deposit
1 650
13 225
8/1/20X2
Deposit
440
13 665
21/1/20X2
250
13 415
26/1/20X2
363
13 052
27/1/20X2
121
12 931
27/1/20X2
275
12 656
31/1/20X2
25
Interest earned
2 050
10 631
31/1/20X2
143
10 488
31/1/20X2
209
31/1/20X2
35
3
4
5
6
7
10 279
11 080
Bank charges
2
12 681
31/1/20X2
31/1/20X2
1
21 359
21 324
Bank reconciliation statement
as at 31 January 20X2
Balance from bank statement
Adjusted for bank error (Dep on 31/1 $8880 instead of $8800)
21 324
(80)
21 244
Add: Deposit in transit
5 368
26 612
Less: Outstanding payments Chq 939
(1 430)
$ 25 182
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239
Accounting Information for Business Decisions
investigate to determine what happened to the deposit. It may be that the deposit was misplaced or even
stolen. Second, the business should investigate any outstanding cheque from the previous month that is
still outstanding for the current month. It may be that the cheque was misplaced or perhaps lost in the
mail. Café Revive has neither of these situations.
Petty cash fund
petty cash fund
Specified amount of
money that is under the
control of one
employee and that is
used for making small
cash payments for a
business
Although paying for all items electronically is an excellent internal control, there may be instances when
cash is required, particularly for small amounts. (e.g. some businesses will not allow the use of EFT for
amounts under $5.) To make it easier for employees to make small but necessary purchases, a business
may set up a petty cash fund. A petty cash fund is a specified amount of money under the control of one
employee that is used for making small cash payments for the business. A business uses a petty cash fund
because some payments can be made only with ‘currency’, or because use of a card to pay electronically is
restricted to amounts over a certain value or writing a cheque would be cumbersome. There is less control
over these expenditures, but the amounts involved are so small that an employee probably will not be
tempted to steal.
Discussion
What items do you always pay for with cash?
To start a petty cash fund, a business gives an employee called the petty cashier, who is in charge of
petty cash, an amount of money – say, $50 – to be kept at the business. Usually, the petty cashier keeps
the money in a locked box or drawer. Each time a payment is made from the fund, the employee makes a
record of the payment (e.g. ‘Postage $22’, or ‘Stationery $16’) and keeps a written receipt. No payments
are reimbursed out of petty cash without a receipt or invoice to substantiate the payment. At any time,
the total of the receipts plus the remaining cash should equal the amount (in this case, $50) that was
originally given to the employee. When the fund gets low, or on the date of its balance sheet, the business
replenishes the fund to the original amount and uses the receipts to record the various cash transactions
in its accounting system. For each receipt, the business records an increase in the related expense (or
asset) account (e.g. postage expense or office supplies) and a decrease in its cash account (e.g. ‘Postage DR
22’, ‘Stationery DR 16’ or ‘Cash CR 38’). This ensures that all of the petty cash payments are included in
the amounts reported in the business’s financial statements.
Café Revive keeps a petty cash fund totalling $55. As we will discuss in the following section, Emily
adds this amount to Café Revive’s ending reconciled cash balance for its bank account so that Café Revive
shows the total cash on its balance sheet.
Reporting the cash balance
on the balance sheet
Cash is usually the first asset listed on the balance sheet because it is the most liquid current asset. Recall
that cash includes money on hand, deposits in bank and savings accounts, and cheques and credit card
receipts that a business has received but not yet deposited. As we discussed in previous sections, a
business’s accounting system keeps track of these items separately. When reporting cash on its balance
sheet, a business must combine the balances of each of these items.
Café Revive’s total cash balance at 31 January 20X2 consists of two items:
1 The 31 January reconciled cash balance in its bank account
$25 182.00
2 The amount in its petty cash fund
Total cash balance on 31 January 20X2
240
55.00
$25 239.00
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Chapter 6 Internal control: Managing and reporting working capital
Notice that Café Revive shows this amount as Cash on its 31 January 20X2 balance sheet.
A business that sells on credit cannot manage its cash without managing its accounts receivable. We
will discuss the management of accounts receivable next.
Stop & think
Have you ever applied for credit? What steps did you have to go through? Why do you think
you had to go through that process in order to get credit?
6.3 Accounts receivable
Accounts receivable are the amounts owed to a business by customers from previous credit sales. The
business intends to collect these amounts in cash. Businesses make sales on credit for three basic reasons.
The first is that selling on credit may be more convenient than selling for cash. For example, when a
business is selling goods that must be shipped, it is common for the purchaser to pay for the goods after
receiving them. Between the time that the purchaser receives the goods and the time that the seller
collects the payment, the seller has extended credit to the purchaser. The second reason why a business
makes credit sales is that managers believe offering credit will encourage customers to buy items they
might not otherwise purchase. This is common in retail sales, when the customer may not have enough
cash to make the purchase. The third reason why a business makes credit sales is to signal product
quality. By allowing customers to pay after receiving, seeing and using the goods, a business shows that it
is confident about the level of its quality.
accounts receivable
Amounts owed by
customers to the
business
Stop & think
Do credit card sales result in accounts receivable?
Credit sales using accounts receivable are not the same as ‘credit card sales’. If you use a credit card to
pay for goods that are sold to you, it is the credit card company – for example, Visa (http://
www.visa.com.au), MasterCard (http://www.mastercard.com.au) or Virgin Money (http://
www.virginmoney.com.au) – that is extending credit to you, not the business that sold you the goods. A
retail shop deposits its credit card receipts into its bank account, just as it does its cash receipts. Because of
this, credit card sales receipts are sometimes referred to as instant cash.
If accounts receivable increase the sales of a business, why not
automatically decide to grant all customers credit? The decision is
not automatic because accounts receivable also have two
disadvantages. One disadvantage of credit sales is that having
accounts receivable requires significant management effort.
Managers must make credit investigations, prepare and send bills,
and encourage payments from customers. All these activities
involve a cost to the business in money and in employee time.
The second disadvantage is that when a business makes credit
sales, there is always the chance that the purchaser will not pay.
However, just because a business has some uncollectable accounts
(bad debts), it does not mean that the business should not make
credit sales. If, given the additional revenues and costs of
managing accounts receivable, the business’s profits are increased
AAP Images/AP/Julia Malakie
The decision to extend credit
Who is extending credit in this transaction?
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Accounting Information for Business Decisions
by extending credit, then credit sales help the business to achieve its goals. A business uses a form of Cost–
volume–profit (CVP) analysis for this evaluation (see Chapter 2).
Stop & think
Has anyone ever asked to borrow money from you? If they did, what factors affected your
decision? Will you deal with the next situation in the same way? Why or why not?
5
How can managers
control accounts
receivable in a business?
Simple controls over accounts receivable
Accounts receivable provide a greater increase in profit if credit sales are monitored properly. Internal
controls over accounts receivable focus on procedures that help maximise the increase in profit from
granting credit. For a small business, such as Café Revive, three control procedures should be used with
accounts receivable.
First, before extending credit, a business should determine that a customer is likely to pay. The risk of
not collecting customers’ accounts is greatly reduced if a business extends credit only to customers who
have a history of being financially responsible. But how does a business decide whether a customer is
creditworthy? And how much credit should a business extend?
Discussion
Some businesses grant credit ‘on the spot’ with no credit checks. Why would a business do
this? What problems could these businesses encounter later?
To answer these questions, a business asks each potential credit customer to complete a credit
application (similar to one you would fill out for a car loan). Normally, a credit application requests that
the applicant provide the following information:
1 the name of the applicant’s employer and the applicant’s income
2 the name of the applicant’s bank, her/his bank account numbers, and the balances in his/her accounts
3 a list of assets
4 credit card account numbers and amounts owed
5 a list of other debts.
The business will contact the applicant’s employer, bank and credit card businesses to verify the
application information and to ask questions about the applicant’s credit history. If the applicant has been
financially responsible – that is, has earned a minimum level of income, has not issued many NSF (not
sufficient funds) cheques, and has made bank and credit card payments in a timely manner – the business
approves the application. The amount of credit that it approves depends on the applicant’s income, amounts
of other debt and the specific results of the business’s investigation. Credit sales should be made only to
customers whose credit it has approved.
Second, a business should monitor the accounts receivable balances of its customers. Credit customers
agree to accept certain payment terms – a concept we have already raised, and which we will discuss in
detail in Chapter 7. Common credit terms include ‘2/10, net/30’, where the customer agrees that a 2 per
cent cash discount will be granted if they make payment within 10 days, and that, if they do not make
payment, then the full amount is due in 30 days. To monitor customer credit effectively, a business needs
to have an accounting system that is capable of keeping track of each customer’s credit activity. The
business also needs to have an organised collection effort. It should post monthly statements to
customers, and should consider payments not received in 30 days (in this case) to be past due. It should
send personalised letters to customers whose accounts become past due, and should deny these customers
additional credit until it collects the past-due amounts. If accounts become very overdue – say, 90 days or
more – the business can use telephone calls to encourage payments. At some point, it may consider an
overdue account to be uncollectable and decide not to make any further effort to collect the account, or to
turn it over to a collection agency.
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Chapter 6 Internal control: Managing and reporting working capital
Third, a business should monitor its total accounts receivable balance. If the balance increases, the
business should investigate the reasons for the increase. If the increase resulted from an increase in credit
sales from creditworthy customers, the business will continue with its standard collection efforts. However, if
the increase resulted from a slowdown in cash collections, the business should re-examine its credit and
collection policies to try to solve the problem.
Regardless of the collection effort made by a business, it can expect that some of its accounts
receivable will not be uncollectable. The point of the collection effort is to improve the percentage of
accounts receivable that are collected. Most financial statement users know that some of a business’s
accounts receivable are not collectable. In the next section, we will discuss how a business includes this
information when reporting the amount of its accounts receivable on its balance sheet.
Stop & think
Would you rather know the amount you are owed or the amount you expect to receive?
Why?
Accounts receivable balance
The amount of accounts receivable that a business reports on its balance sheet is the amount of cash it
expects to receive from customers as payments for previous credit sales. The words ‘expects to receive’
reflect the fact that the business may not collect all of its accounts receivable, so the amount a business
shows on its balance sheet as accounts receivable is the total owed by customers (the ‘gross’ amount) less
an amount that it expects to be uncollectable. Generally accepted accounting principles (GAAP) refer to
this amount as the net realisable value of accounts receivable.
A business shows its accounts receivable at their net realisable value because, as part of an analysis of
its liquidity, financial statement users are concerned with the business’s ability to turn accounts receivable
into cash. As you will see in Chapter 9, predicting a business’s cash flows helps external users to make
business decisions.
The gross amount of the total accounts receivable at year-end is calculated by adding all individual
customers’ balances. However, the dollar amount of accounts receivable that are uncollectable requires an
estimate. This is because the business doesn’t know which customers won’t pay. (If, at the time of the
credit sale, the business thought a particular customer would not pay for the goods, it would not have
granted the credit!)
Given the uncertainties of collecting accounts receivable, how does a business estimate the amount
that it expects will be uncollectable? In general, a business bases this estimate on its past experience with
collections. Using the business’s history as a guide, it either calculates the estimate as a percentage of
credit sales (e.g. 1 per cent of credit sales) or bases the estimate on an ageing analysis of the accounts
receivable (i.e. the older a receivable is, the more likely it is to be uncollectable).
To inform financial statement users that a business is showing its accounts receivable at the net
realisable value, the business places the word ‘net’ after accounts receivable on the balance sheet – that is,
‘Accounts receivable (net)’.
For illustrative purposes, in Case Exhibit 6.1, Café Revive shows its accounts receivable on its 31
December 20X2 balance sheet as follows:
Accounts receivable (net)
$7 340
To determine this net amount, Café Revive calculated its dollar estimate of uncollectable accounts
receivable based on the age of outstanding accounts and subtracted it from the total amount of accounts
receivable listed in the accounting records. Assuming Café Revive’s gross accounts receivable are $7874
(the business’s accounting system keeps track of this amount), we can determine that its estimated
uncollectable accounts receivable at 31 December 20X2 are $534 ($7874 – $7340).
Many businesses’ accounts receivable result from selling inventory on credit. We will discuss
inventory management in the next section.
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Accounting Information for Business Decisions
6.4 Inventory
inventory
Merchandise a retail
business is holding for
resale
A business’s inventory is the merchandise being held for resale. In Chapter 7, we will discuss how a
business uses either a perpetual inventory system or a periodic inventory system to keep track of its
merchandise. The discussion focuses on the calculation of a business’s cost of goods sold. The cost of
goods sold is the cost a business has incurred for the merchandise (goods) it has sold to customers during
the accounting period. The business includes the cost of goods sold as an expense on its income
statement. In this section, we focus on the calculation of a business’s ending inventory.
Accounting for, controlling and reporting inventory are important for several reasons. First, selling
inventory is the primary way a retail or manufacturing business gets cash from operating activities (and
earns a profit). If the amount of inventory is too low, the business could have future difficulties providing
the cash it will need for operations. Second, a business usually expects to turn over its inventory (i.e.
purchase it, sell it and replace it with newly purchased inventory) several times during the year. If
inventory sales slow down, investors and creditors may become concerned about the business’s ability to
continue to sell the inventory at a satisfactory profit. Third, storing inventory is expensive, due to storage
space, utilities and insurance costs. Finally, inventory can be stolen and/or become obsolete. For these
reasons, a business must effectively account for, control and report on its inventory.
Discussion
Why do businesses sometimes sell their goods for 50 per cent off the retail price? Why do they
advertise that they are having a ‘stocktake sale’? Should this affect the way they account for
their inventory?
6
How can managers
control inventory in
a business?
purchase order
Document authorising
a supplier to ship the
items listed on the
document at a specific
price
Simple inventory controls
A business should establish several simple internal controls that will help safeguard its inventory and improve
record-keeping. First, it should control the ordering and acceptance of inventory deliveries. In a small business,
the owner is usually the only person who places orders for inventory. But even in a small business, the owner
should place orders using a purchase order. A purchase order is a document authorising a supplier to ship
the items listed on the document at a specific price. It is signed by an authorised person in the business. Use of
purchase orders helps ensure that purchasing activities are efficient and that no unauthorised person can
purchase inventory.
A business should keep a list of the purchase orders (or copies of the purchase orders) where
employees have access to it. Employees receiving inventory need to know what has been ordered because
they should accept only approved orders. In addition, employees should check the quantity and condition
of every order received. If, on further inspection, an employee finds that the order was not filled properly
(e.g. boxes of the wrong coffee are received) or that the goods are damaged (e.g. bags of coffee were ripped
or coffee gift packs were broken), the supplier should be notified immediately.
Second, a business should establish physical controls over inventory while the inventory is being held
for sale. One physical control involves restricting access to inventory. You have probably seen signs on
certain business doors that state:
FOR EMPLOYEES ONLY
Businesses post the signs to help to keep customers out of storage areas. Other controls include
locked display cases, magnetic security devices and camera surveillance systems.
Finally, to make sure that inventory records are accurate, a business should periodically take a physical
count of its inventory. Whether a business uses a perpetual or a periodic inventory system (discussed in
Chapter 7), by physically counting inventory, it can determine the accuracy of its inventory records and
estimate losses from theft, breakage or spoilage. Almost all businesses count inventory at least once a
year. Many businesses count inventory after closing on the date of their year-end balance sheet. By
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Chapter 6 Internal control: Managing and reporting working capital
counting inventory at the end of the financial year, a business can use the inventory count to help
determine the dollar amount of inventory that it will show on its balance sheet and the cost of goods sold
that it will show on its income statement.
Stop & think
Think about the last time you went shopping. What physical controls over inventory did you
notice?
Recall that Café Revive uses a perpetual inventory system, so it keeps a running balance of its
inventory and cost of goods sold in its accounting records. To verify the accuracy of these balances, Emily
Della and Jackson Downes spent two hours counting bags/supplies of coffee and gift packs on hand in
Café Revive’s inventory after it closed on 31 January 20X2. When they were finished the stocktake, Emily
calculated that Café Revive owned 50 coffee gift packs and that supplies of coffee remaining on hand were
worth $345 at month-end.
Determining the cost of ending inventory
A business shows its inventory on its ending balance sheet as a dollar amount. So, after the business has
counted the number of units in its ending inventory, it must determine the appropriate unit cost for each
item. How does a business figure out the cost of each inventory item? To answer that question, we need
to explain two things: (1) the relationship among cost of goods available for sale, cost of goods sold and
year-end inventory; and (2) the concept of cost flows.
Cost of goods for sale, sold and held in inventory
At the start of any month, a business has a certain number of inventory items available for sale – its
beginning-of-the-month inventory. For example, say Café Revive starts the month of January 20X2 with
50 coffee gift packs. During the month, a business like Café Revive sells some of its inventory and makes
purchases to restock for additional sales. Ideally, at the end of the month, one of two things has happened
to all the items that were available for sale during the month: either the goods were sold, or the goods
remain in inventory. If Café Revive purchases an additional 240 gift packs during January and sells 240,
50 gift packs remain in inventory on 31 January. These calculations for the month of January can be
summarised as:
Beginning inventory for January
50 packs
þ
January purchases
240 packs
¼
Goods available for sale during January
290 packs
Goods sold during January
¼
Goods in inventory on 31 January 20X2
(240) packs
50 packs
As discussed in earlier chapters, when Café Revive prepares its financial statements for the month, it
includes the cost of the goods sold during the month in the monthly income statement and the cost of the
ending inventory in the month-end balance sheet, based on its perpetual inventory records. For
December, Café Revive’s ‘Cost of goods sold’ account shows a balance of $6240, and its ‘Inventory’
account shows an ending balance of $1350. To arrive at these amounts, Café Revive converted the
number of coffee gift packs purchased, sold and on hand to dollar amounts. Café Revive recorded these
dollar amounts in its ‘Inventory’ and ‘Cost of goods sold’ accounts, as we will illustrate in Chapter 7.
Case Exhibit 6.8 shows the December inventory information for Café Revive. Notice that Café
Revive’s beginning inventory cost $28.60 per pack ($26 plus GST $2.60). The purchases it made on 31
January increased so the last 50 gift packs cost $29.70 ($27 plus GST $2.70). When goods cost different
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Accounting Information for Business Decisions
Case Exhibit 6.8 Café Revive’s inventory information
50 packs
50 @ $26 per pack ¼ $1 300
Jan. purchases
240 packs
190 @ $26 per pack ¼ 4 940
Cost of goods available for sale
290 packs
Beg. inventory, 1 Dec.
50 @ $27 per pack ¼ 1 350
Dec. sales
End. inventory, 31 Dec.
7 590
(240) packs
50 packs
50 packs @ $27 1 350
unit prices, Café Revive would have to decide which cost to assign to the packs it sold and which cost to
assign to the gift packs left in inventory. Or should it use both costs and, if so, to which packs should it
assign $27 and to which ones $26? Or should it use the average of both costs?
A business must have a method for deciding how to calculate the dollar amounts for inventory and
cost of goods sold. It may use one of several methods to do so: specific identification; first in, first out
(FIFO); last in, first out (LIFO), which is not used in Australia; or weighted average. (The latter three methods
are discussed briefly later in this chapter and again, in more detail, in Chapter 7.) The business should use its
chosen method consistently from year to year, unless a different method would better reflect the business’s
operations, so that users of its financial statements can compare its performance from year to year. We will
discuss the specific identification method in the next section.
Specific identification method
specific identification
method
Allocates costs to cost
of goods sold and to
ending inventory by
assigning to each unit
sold and to each unit in
ending inventory the
cost to the business of
purchasing that
particular unit
The specific identification method allocates costs to cost of goods sold and ending inventory by assigning
to each unit sold and each unit in ending inventory the cost to the business of purchasing that particular
unit. Under this method, a business keeps track of the cost of each inventory item separately. Usually, it
does this tracking through a computer system or an inventory coding system. For example, every coffee gift
pack that Café Revive receives from DeFlava Coffee is stamped with the date that the coffee was made.
Because DeFlava Coffee sends out its coffee freshly made, Café Revive can use this date to tell which
shipment a gift pack came from and the exact cost of the pack. (We will use the specific identification
method in our inventory discussion in Chapter 7.) Many businesses have point of sale cash register systems
that scan inventory codes to keep track of the costs of inventory sold and inventory on hand.
FINANCIAL STATEMENT EFFECTS
1
1
Increases current assets and total assets on balance sheet
Increases revenues, which increases net income on income statement (and therefore increases owner’s equity on balance
sheet). Increases cash flows from operating activities on cash flow statement
2
FINANCIAL STATEMENT EFFECTS
2
Decreases current assets and total assets on balance sheet
Increases expenses (cost of goods sold), which decreases net income on income statement (and therefore decreases
owner’s equity on balance sheet)
3
FINANCIAL STATEMENT EFFECTS
3
Decreases current assets and total assets on balance sheet
Increases expenses (cost of goods sold), which decreases net income on income statement (and therefore decreases
owner’s equity on balance sheet)
The inventory amount that Café Revive shows on its 31 January 20X2 balance sheet is calculated from
the results of the physical inventory count. (This amount should be the same as the amount that it shows in
its accounting records.) Recall that 50 gift packs remained in inventory on 31 January. Under the specific
identification method, in addition to counting the inventory, Emily and her employee must keep track of the
246
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Chapter 6 Internal control: Managing and reporting working capital
gift packs according to the stamped dates. Case Exhibit 6.9 shows Emily’s inventory count instructions, the
results of the count, and the year-end inventory and cost of goods sold calculations.
Case Exhibit 6.9 Café Revive’s year-end inventory calculation
The inventory count
After Café Revive closes on the evening of 31 January 20X2, Emily and one employee, Jackson, spend two hours counting the
business’s inventory. Emily tells Jackson how the count will work: ‘You and I will count all of the items independently. I will follow along
behind you. We will count one section of the shop at a time. Both of us will mark our findings on inventory count sheets, noting
separately the number of gift packs. After we finish each section of the shop, we will compare our results to see that we agree on the
count. If the numbers don’t match, we will recount the section. After we count all of the inventory, we will compute a total for the
number of gift packs and the supplies of coffee on hand.’
Results of the inventory count
Café Revive’s inventory count ran smoothly. After compiling all the inventory count sheets, Emily concluded that the year-end inventory
consisted of the following: 50 gift packs purchased on 31 January at a cost of $27.00. These calculations are shown in the following.
31 January 20X2 inventory calculation
50 packs @ $27
1 350.00
Ending inventory
$1 350.00
January cost of goods sold calculation
Cost of goods available for sale (see Case Exhibit 6.7)
$ 7 590.00
– Ending inventory
(1 350.00)
Cost of goods sold
$ 6 240.00
Using the information contained in Case Exhibit 6.9, can you see what the calculations for each other inventory method would be?
This is outlined below in the following. (Note that there is more discussion of each of these methods in Chapter 7, where their
implications for net income are discussed.)
FIFO
Ending inventory
Cost of goods sold
LIFO
50 @ 27
1 350
50 @ 26
1 300
240 @ 26
6 240
190 @ 26
4 940
50 @ 27
7 590
Weighted average
*50 @ 26.17
1 309
1 350 240 @ 26.17
6 281
7 590
7 590
* Weighted average cost (6 240þ1 350) / 290 ¼ $26.17
Discussion
As a manager, would you choose the specific identification method for a coffee business?
Why?
Because Café Revive’s physical inventory count of 50 gift packs is the same as the calculation of its
ending inventory from its perpetual inventory records of beginning inventory, purchases and sales shown
earlier, the $1350 cost of the ending inventory calculated in Case Exhibit 6.9 is the same as the amount in
its Inventory account. Also, the $6240 cost of goods sold calculated in Case Exhibit 6.9 is the same as the
amount in its ‘Cost of goods sold’ account. So by taking a physical count, Café Revive has verified that the
amounts in its accounting records are correct.
Now suppose that Emily and her employee counted 45 gift packs. In this case, five gift packs are
missing, and the cost of the ending inventory is $1215 (45 $27). Emily should try to find out why these
gift packs are missing. For instance, they may have been given away as ‘free samples’, stolen (or consumed by
the employees) or thrown away because they were presumed stale. Whatever the reason, she should adjust the
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Accounting Information for Business Decisions
accounting records by increasing the ‘Cost of goods sold’ account and decreasing the Inventory account by $135
(5 $27) for the missing gift packs.
Stop & think
Suppose that the year-end count of inventory is less than the accounting records show as
ending inventory because Emily threw away some boxes of stale coffee. How might this
information affect Emily’s future decisions?
Other methods to determine inventory at end and cost
of goods sold
As mentioned earlier in the chapter, there are several methods for determining dollar amounts for
inventory at year-end and cost of goods sold. Café Revive has chosen the specific identification method,
but how would the figures have appeared had the FIFO LIFO or weighted average methods been used?
The adoption of different methods leads to different value for cost of goods sold and ending inventory. A
brief description of each of these methods follows.
The FIFO method means that when valuing inventory that is sold and on hand at the end, goods or
stock that is purchased first is sold first. This means that the cost of inventory on hand at the end is
valued at the last price paid as inventory that was purchased at earlier prices would have been sold and
recorded as part of cost of goods sold.
The LIFO method means that goods purchased last (or most recently) are sold first. This method may
result in unsold stock becoming out of date, but means that the cost of valuing inventory on hand at the end
is usually at the earlier price, while costs of goods sold throughout the period are valued at most recent prices.
The weighted average method requires the unit price of inventory to be calculated and updated after
each transaction. The value is determined by recalculating the average price. For example, if, at 1
February, there are 50 units at $26.17 worth $1309, and the purchases another 20 units at $27 worth
$540, then the value of each unit would be calculated as:
1 309 þ 540 ¼ 1 849
50 þ 20 ¼ 70
Unit Value ¼ 1 849=70 ¼ $26:41 per unit
Inventory will be discussed further in Chapter 7.
Stop & think
As a manager, which method would you use to calculate cost of goods sold and ending
inventory? Why?
6.5 Accounts payable
accounts payable
Amounts owed to
suppliers for credit
purchases
248
As we explained earlier in the chapter, businesses often sell to customers on credit. These credit sales result in
accounts receivable. Similarly, businesses often make purchases on credit, which result in the liability accounts
payable. Accounts payable are the amounts that a business owes to its suppliers for previous credit purchases
of inventory and supplies. The reasons for purchasing on credit are similar to the reasons for selling on credit.
The first reason is that it is often more convenient than purchasing with cash. The second reason for purchasing
on credit is to delay paying for purchases and, by doing so, to obtain a short-term ‘loan’ from the supplier. Many
businesses – particularly small businesses – are often short of cash and find it difficult to pay for their purchases
immediately. Managers of these businesses therefore try to delay payment until their businesses receive the cash
from the eventual sale of their products; they then use this cash to pay the amounts their businesses owe. This
delay is the reason many suppliers offer their customers cash discounts for prompt payment.
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Chapter 6 Internal control: Managing and reporting working capital
Simple controls over accounts payable
A business’s accounts payable represent promises to pay the amounts due to other businesses. As is the
case with accounts receivable, a business needs controls over accounts payable. Controls over accounts
payable should focus on three primary concerns. The first concern involves the ability of employees to
make the business responsible for an account payable. Giving too many employees the authority to place
orders for business purchases makes it more difficult for managers to coordinate and monitor credit
purchases, and makes it easier for untrustworthy employees to make the business responsible for personal
expenditures. In response to this concern, a business should limit the number of employees who have the
authority to make business purchases. In a small business, this authority may be given only to the owner.
Larger businesses usually have a purchasing department that controls all purchases.
Second, once a business incurs an account payable, the business is concerned that it makes each
payment at the appropriate time and that the supplier records each payment properly. A business
monitors the timeliness of its payments by having an employee keep track of the credit terms of each
account payable. If cash discounts are available, the business should take advantage of the cash savings by
making the payment within the cash discount period. A business makes sure that the supplier records its
payments properly by checking the supplier’s monthly statements. If the payment is not recorded
properly, an employee should investigate the discrepancy and perhaps contact the supplier.
Finally, managers, investors and creditors are concerned about a business’s total dollar amount of
accounts payable because, in the very near future, the business will need to use its cash to pay these
liabilities. If the accounts payable are large, relative to the business’s current assets, the business may
experience liquidity problems.
Managers will investigate relatively large increases in accounts payable. If the increase is a result of
planned increases in inventory, they assume that increased sales will provide the cash needed to pay the
liabilities. If the increase is a result of cash flow problems, managers may postpone purchases of inventory
and/or property and equipment, or may contact suppliers to try to arrange an extension of the credit terms.
7
How can managers
control accounts payable
in a business?
Accounts payable balance
The amount of accounts payable that a business owes on the balance sheet date is listed in the current
liabilities section of the ending balance sheet. A business calculates this amount by summing the accounts
payable owed to individual suppliers. As Case Exhibit 6.1 shows, on 31 December 20X2, after one year of
operations Café Revive’s total accounts payable is $6200.
Discussion
Has anyone ever forgotten to repay you for money that they borrowed? Has it ever been
difficult for you to pay off a debt? How should a business handle these situations? What
factors should it consider when developing policies concerning late payments by its
customers or to its suppliers?
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Accounting Information for Business Decisions
Business issues and values: Working capital
We began this chapter by stating that managing working capital effectively is an important
part of financial management. This is especially true for new businesses that have a relatively small
amount of capital, and that may be prone to liquidity problems. But how aggressive should a
business be in managing its working capital? When trying to collect accounts receivable payments,
some businesses repeatedly telephone customers at their offices and homes. On the other hand,
when trying to hold off paying their own debts, some businesses continue to tell suppliers that ‘the
cheque is in the mail’ when it really is not. The ethics of aggressive working capital management
have been questioned by some business leaders and critics. Instead of being seen as conscientious,
a business that uses aggressive collection efforts can be viewed as intimidating and harassing. A
business that signs a purchase agreement, even though it knows that it will make suppliers wait an
additional 30 or 60 days before paying for the goods, can be viewed as untrustworthy, not as a
shrewd financial planner.
In addition, managing working capital is critical for both the present liquidity and the longer-term
sustainability of the business. Effective working capital management will enable the business to
Ehnics and Sustainability
250
have sufficient funds on hand not only for its usual operations but also to take advantage of growth
opportunities for the business.
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Chapter 6 Internal control: Managing and reporting working capital
STUDY TOOLS
Summary
6.1 Define the concept of ‘working capital’ and reasons for exercising control over working capital items.
1
What is working capital and why is its management important?
Working capital is current assets minus current liabilities. A business needs to manage its working capital so that it will keep an
appropriate balance between having enough to conduct its operations and to handle unexpected needs, and having too much so
that profitability is reduced.
6.2 Discuss why managing the asset cash in terms of cash receipts and cash payments is so important.
2
How can managers control cash receipts in a business?
Managers can control cash receipts by requiring the proper use of a cash register, separating the duties of receiving and processing
collections of accounts receivable, and depositing receipts every day.
3
How can managers control cash payments in a business?
Managers can control cash payments by paying all bills by cheque, paying only for approved purchases supported by source
documents, and immediately stamping ‘Paid’ on the supporting documents after payment.
4
What is a bank reconciliation, and what are the causes of the difference between a business’s cash balance in
its accounting records and its cash balance on its bank statement?
A bank reconciliation is an analysis that a business uses to resolve the difference between the cash balance in its accounting
records and the cash balance reported by the bank on its bank statement. The causes of the difference are deposits in transit,
outstanding payments/cheques, deposits made directly by the bank, charges made directly by the bank and errors.
6.3 Understand how to properly monitor and control accounts receivable.
5
How can managers control accounts receivable in a business?
Managers can control accounts receivable by evaluating a customer’s ability to pay before extending credit, monitoring the
accounts receivable balance of each customer, and monitoring the total accounts receivable balance.
6.4 Identify control procedures and methods for inventory.
6
How can managers control inventory in a business?
Managers can control inventory by establishing policies for ordering and accepting inventory, establishing physical controls over
inventory being held for sale and taking a periodic physical count of the inventory.
6.5 Explain the need to manage accounts payable.
7
How can managers control accounts payable in a business?
Managers can control accounts payable by coordinating and monitoring credit purchases, making payments at the appropriate time
and monitoring the total accounts payable balance.
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Accounting Information for Business Decisions
Key terms
accounts payable
deposit in transit
purchase order
accounts receivable
internal control structure
specific identification method
bank reconciliation
inventory
working capital
bank statement
NSF (not sufficient funds)
cash
petty cash fund
Online research activity
This activity provides an opportunity to gather information online about real-world issues related to the topics in this chapter. For
suggestions on how to navigate various businesses’ websites to find their financial statements and other information, see the
related discussion in the Preface.
Go to the websites of Woolworths Supermarkets (http://www.woolworths.com.au) and Coles (http://www.coles.com.au).
1 What credit control policies does each company exercise?
2 Which inventory methods does each company use?
3 What controls over inventory are exercised by each company?
Integrated business and accounting situations
Answer the following questions in your own words.
Testing your knowledge
6-1
6-2
6-3
6-4
6-5
6-6
6-7
6-8
6-9
6-10
6-11
6-12
6-13
6-14
6-15
6-16
6-17
6-18
6-19
6-20
6-21
6-22
6-23
6-24
6-25
252
What is a business’s working capital, and what do its two components comprise?
Why does a business need to manage its working capital?
What is included in ‘cash’ for a business?
Why is it so important that cash and cash flow be managed in a business?
Briefly discuss the controls over cash sales.
Briefly discuss the controls that should be put in place to manage over collections of cash from accounts receivable.
Briefly discuss the controls that should be put in place to ensure cash payments are authorised and made in a timely manner.
What is a bank reconciliation?
Identify the causes of the difference between the ending cash balance in a business’s records and the ending cash balance
reported on its bank statement.
Briefly explain what is meant by the terms ‘deposits in transit’ and ‘outstanding cheques’?
What does ‘insufficient funds’ mean in relation to a transaction on a bank statement?
Briefly explain what are included in deposits made directly by the bank and charges made directly by the bank.
Prepare an outline of a bank reconciliation for a business.
Briefly explain what a petty cash fund is and how it works.
Why do businesses make sales on credit?
Briefly discuss the controls over accounts receivable.
Briefly explain how a business reports its accounts receivable on its ending balance sheet.
Why is accounting for, controlling and reporting of inventory important?
Briefly discuss the controls over inventory.
What does a ‘stock out’ mean? What are the implications of this? How can it be prevented?
Briefly explain how the specific identification method works for determining inventory costs.
To what does FIFO refer?
How is the LIFO method of costing different from the FIFO method in terms of the effect on net profit for a period?
Evaluate this statement: ‘My business uses a perpetual inventory system, so it doesn’t need to take a periodic physical
inventory.’
Briefly discuss the controls over accounts payable.
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Chapter 6 Internal control: Managing and reporting working capital
6-26
6-27
Why is it important that a business pays accounts payable in a timely manner?
‘If all employees behave ethically, there is no need for expensive control systems to manage working capital.’ Do you agree
or disagree with this statement? Why?
Applying your knowledge
6-28
6-29
6-30
6-31
Following are several internal control weaknesses of a small retail business in regard to its cash receipts and accounts
receivable:
i Sales invoices are not pre-numbered.
ii Receipts from daily sales are deposited every Tuesday and Thursday evening.
iii One employee is responsible for depositing customer cheques from collections of accounts receivable and for recording
their receipt in the accounts.
iv For credit sales on terms of 2/10, net/30, customers are allowed, for convenience, a discount if payment is received
within 20 days.
v A money box is used instead of a cash register to store both the sales invoices and cash from sales.
vi Credit sales of a large dollar amount can be approved by any sales employee.
vii When customers write cheques for payment, only the identification of customers who ‘look untrustworthy’ is verified.
Required:
a For each internal control weakness, explain how the weakness might result in a loss of assets.
b For each internal control weakness, explain what action should be taken to correct the weakness.
The following are several internal control weaknesses of a retail business in regard to its cash payments, accounts payable
and inventory:
i The inventory of gold jewellery for sale is kept in unlocked display cases.
ii One employee is responsible for ordering inventory and writing cheques.
iii Some purchases are made by phone, and no purchase order is written up.
iv The business takes a physical inventory every two years.
v Employees are allowed to bring coats, bags and handbags into working areas.
vi Inventory received at the loading dock is rushed immediately to the sales floor before it is counted.
vii When inventory is low, any sales employee can prepare a purchase order and post it to the supplier.
viii For efficiency, the business pays invoices on credit purchases once a month, even if it has to forgo any cash discounts
for prompt payment.
Required:
a For each internal control weakness, explain how the weakness might result in a loss of the assets of the business.
b For each internal control weakness, explain what action should be taken to correct the weakness.
A Robetto & Co. is preparing its bank reconciliation, and discovers the following items:
i outstanding cheques
ii deposits in transit
iii deposits made directly by the bank into business account with the bank
iv charges made directly by the bank to the business account with the bank
v the bank’s erroneous under-recording of a deposit
vi the business’s erroneous under-recording of a cheque it wrote.
Required:
Indicate how each of these items would be used to adjust:
a the business’s cash balance
b the bank balance to calculate the reconciled cash balance.
At the end of March, the Elbert Company records showed a cash balance of $7027. When comparing the 31 March bank
statement with the business’s ‘Cash’ account, the business discovered that deposits in transit were $725, outstanding
cheques totalled $862, bank service charges were $28 and NSF cheques totalled $175.
Required:
a Calculate the 31 March reconciled cash balance of the Elbert Company.
b Calculate the cash balance listed on the 31 March bank statement.
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253
Accounting Information for Business Decisions
6-32
6-33
At the end of September, the Cyclops Bicycle Company’s records showed a cash balance of $3513. When comparing the
business’s 30 September bank statement, which showed a cash balance of $1860, with its ‘Cash’ account, the business
discovered that outstanding cheques were $462, bank service charges were $23 and NSF cheques totalled $89.
Required:
a Calculate the 30 September reconciled cash balance of the Cyclops Bicycle Company.
b Calculate the September deposits in transit.
The following five situations (columns 1–5) are independent.
Ending balance in the business’s bank account
254
3
4
5
(a)
$2 000
$4 000
$12 000
$3 000
(b)
500
450
200
Deposits in transit
700
800
(c)
500
900
Outstanding cheques
450
1 200
600
(d)
1 000
6 000
3 000
4 100
12 000
(e)
Ending cash balance from bank statement
6-35
2
$200
Deposits made directly by the bank
6-34
1
Required:
Calculate each of the unknown amounts, items (a) to (e).
An examination of the accounting records and the bank statement of the Evans Company at 31 March provides the
following information:
i The ‘Cash’ account has a balance of $6351.98.
ii The bank statement shows a bank balance of $3941.83.
iii The 31 March cash receipts of $3260.95 were deposited in the bank at the end of that day, but were not recorded by
the bank until 1 April.
iv Cheques issued and mailed in March but not included among the cheques listed as paid on the bank statement were:
Cheque no. 706
$869.38
Cheque no. 717
212.00
v A bank service charge of $30 for March was deducted on the bank statement.
vi A cheque received from a customer for $185 in payment of his account and deposited by the Evans Company was
returned marked ‘NSF’ with the bank statement.
vii Interest of $20.42 earned on the business’s bank account was added on the bank statement.
viii The Evans Company discovered that cheque no. 701, which was correctly written as $562 for the March rent, was
recorded as $526 in the business’s accounts.
Required:
a Prepare a bank reconciliation on 31 March.
b Record the appropriate adjustments in the business’s accounts. Calculate the ending balance in the ‘Cash’ account.
You have been asked to help the Rancher Company prepare its bank reconciliation. You examine the business’s accounting
records and its bank statement at 31 May, and find the following information:
i The ‘Cash’ account has a balance of $7753.24.
ii The bank statement shows a bank balance of $3783.04.
iii The 31 May cash receipts of $4926.18 were deposited in the bank at the end of that day, but were not recorded by the
bank until 1 June.
iv Cheques issued and mailed in May but not included among the cheques listed as paid on the bank statement were:
Cheque no. 949
$518.65
Cheque no. 957
699.95
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Chapter 6 Internal control: Managing and reporting working capital
6-36
v A bank service charge of $27 for May was deducted on the bank statement.
vi A cheque received from a customer for $241 in payment of her account and deposited by the Rancher Company was
returned marked ‘NSF’ with the bank statement.
Interest of $25.18 earned on the business’s bank account was added on the bank statement.
vii The Rancher Company discovered that cheque no. 941, which was correctly written as $647.21 for the May electricity
bill, was recorded as $627.41 in the business’s accounts.
Required:
a Prepare a bank reconciliation on 31 May.
b Record the appropriate adjustments in the business’s accounts. Calculate the ending balance in the ‘Cash’ account.
Munro Pty Ltd presented you with the following information relating to the June bank reconciliation process. You are
required to reconcile the records of the business with the bank statement and:
a adjust the ‘Cash at bank’ account
b prepare a bank reconciliation statement as at 30 June
c journalise the entries required in Munro’s books.
Note: Assume any errors in amounts have been made by the bank.
Bank reconciliation statement at 31 May 20X1
Balance as per bank statement
12 367.90
Add: Deposits in transit
1 980.50
14 348.40
Less: Outstanding cheques and payments
No. 2470
(1 530.20)
No. 2471
(844.50)
No. 2472
(1 426.80)
(3 801.50)
Adjusted cash balance
$10 546.90
The June bank statement shows the following withdrawals and deposits:
Date
Details
1 June
Balance
2470
Debit
Credit
Balance
12 367.90
1 530.20
Deposit
10 837.70
1 980.50
844.50
12 818.20
2
2471
11 973.70
4
Deposit
5
2475
1 640.70
12 543.70
2 850.00
9 693.70
55.00
9 638.70
2 210.70
8
2476
10
Bank fees
13
Deposit
15
2478
1 750.00
18
Dishonoured cheque – insufficient funds
2 120.00
21
Deposit
25
Dividend
2 575.00
14 184.40
12 213.70
10 463.70
8 343.70
2 945.00
11 288.70
500.00
11 788.70
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Accounting Information for Business Decisions
The records for the cashbooks are as follows:
Cash at bank balance 1 June
$10 546.90
Cash receipts
Date
6-37
Cash payments
Amount
2475
1 640.70
12 June
2 575.00 12 June
2476
2 830.00
20 June
2 945.00 24 June
2477
678.00
27 June
2 855.00 28 June
2478
1 750.00
30 June
2479
1 230.00
The Huron Company keeps a petty cash fund of $80. On 30 June, the fund contained cash of $36.87 and these petty cash
receipts:
Miscellaneous
6-40
Amount
2 210.70 1 June
Postage
6-39
Cheque no.
3 June
Office supplies
6-38
Date
$10.00
27.48
5.65
Required:
a If the business’s fiscal year ends on 30 June, should the petty cash fund be replenished on 30 June? Why?
b How much cash is needed to replenish the petty cash fund?
c Prepare entries in the business’s accounts to record the petty cash payments.
On 31 December, the Big Hole Property Management Company had a balance of $70 in its petty cash fund, a reconciled
balance of $1283 in its bank account and a $4627 balance in its savings account.
Required:
Show how the business would report its cash on its 31 December balance sheet.
On 1 January, the balance in the accounts receivable account for James Pty Ltd was $4125. During the next six months, credit
sales amounted to $13 075 and clients paid $14 560 to settle their accounts after allowances for goods returned by clients of
$240. At 30 June, James Pty Ltd has decided to write off accounts receivable of $450 as a bad debt.
Required:
a Calculate the ending balance of ‘Accounts receivable’ at 30 June.
b What steps might the business take to reduce the possibility of incurring bad debts in future?
Johnson and Bates run a small business and are worried about their accounts receivable spiralling out of control.
a Advise them of the steps they can take to manage credit and recover outstanding accounts.
They are thinking about which method to calculate an amount for debts that might become bad. They are
considering two methods:
i percentage of credit sales @ 1% of credit sales annually
ii ageing of debtors.
Suppose their credit sales average $235 000 for a six-month period, and they have accounts receivable of
$93 000 at present, with days outstanding and expected uncollectable rates being as follows:
0 to 30 days
$51 000 1% uncontrollable
31 to 60 days
$24 000 1.5% uncontrollable
61 to 90 days
$12 000 5% uncontrollable
Over 90 days
$ 6 000 50% uncontrollable
b What method would you recommend they choose to calculate uncollectable debts and why?
c What would be the difference between the amount recorded in the balance sheet for accounts receivable for each
method?
256
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Chapter 6 Internal control: Managing and reporting working capital
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6-42
The Heat Be Gone business sells one type of air conditioner, and uses the perpetual inventory system. At the beginning of
January, the business had a balance in its cash account of $2100 and an inventory of eight units (air conditioners) costing
$100 each. During January, it made the following purchases and sales of inventory:
5 Jan.
Purchases
4 units @ $102 per unit
12
Sales
11 units @ $150 per unit
18
Purchases
12 units @ $104 per unit
25
Purchases
6 units @ $103 per unit
29
Sales
13 units @ $150 per unit
All purchases and sales were for cash. The business uses barcodes to verify each sale (i.e. specific identification). Of sales
on 12 January, eight were units from the beginning inventory and three were units purchased on 5 January. Of the sales on
29 January, nine were units purchased on 18 January and four were units purchased on 25 January.
Required:
a Record the beginning balances in the ‘Cash’ and ‘Inventory’ accounts. Using account columns, record the purchases and
sales transactions during January, and calculate the ending balances of all the accounts you used.
b Assume that the business counted its inventory at the end of January and determined that it had six air conditioners
on hand. Prove that the ending balance in the inventory account that you calculated in (a) is correct.
c Calculate the business’s gross profit.
The Short Cut Lawnmower Store sells one type of lawnmower at a price of $200 per unit. On 1 June, it had an $800
accounts receivable balance and a $600 accounts payable balance, as well as an inventory of 10 mowers costing $120 each.
During June, its purchases and sales of mowers were:
Purchases
8 June
7 mowers @ $125 each
15
11 mowers
21
6 mowers @ $121 each
26
4 mowers @ $124 each
30
Sales
8 mowers
All purchases and sales were on credit. No payments or collections were made during June. The business has a
perpetual inventory system and uses barcodes to verify each sale, which allows the specific identification method of
inventory valuation to be used. Of the 15 June sales, eight were mowers from the beginning inventory and three were
mowers purchased on 8 June. Of the 30 June sales, two were mowers from the beginning inventory, five were mowers
purchased on 21 June and one was a mower purchased on 26 June.
Required:
a Assume that the business uses the specific identification method and that it counted its inventory at the close of
business on 30 June to determine that it had eight mowers in stock. Calculate the ending balance in the inventory
account and the cost of goods sold.
b Following on from (a) above, record the beginning balances in the accounts receivable, inventory and accounts payable
accounts. Using account columns, record the purchases and sales transactions during June, and calculate the ending
balances of all the accounts you used.
c Assume that the business uses the first-in, first-out (FIFO) method, and that it counted its inventory at the close of
business on 30 June and determined that it had eight mowers in stock. Calculate the ending balance in the inventory
account and the cost of goods sold.
d Use the same information as for (c) above, but assume that the business uses the last-in, first-out (LIFO) method to
calculate the ending balance in the inventory account and the cost of goods sold.
e Use the same information as (c) above, but assume that the business uses the weighted average method to calculate
the ending balance in the inventory account and the cost of goods sold.
f Calculate the business’s gross profit percentage for June using the specific identification method. How does this
compare with its gross profit percentage of 40.8 per cent for May? What might account for the difference?
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Accounting Information for Business Decisions
6-43
Bugs-Be-Gone sells two types of screen doors: Model A, which sells for $30, is the basic screen door, and Model B, which sells
for $50, is the deluxe screen door. At the beginning of July, the business had a balance in its cash account of $1600 and an
inventory consisting of 12 units of Model A, costing $20 each, and 15 units of Model B, costing $35 each. During July, it made
the following purchases and sales of inventory:
Model A
6 July
Sales
13
Purchases
20
Sales
24
29
8 units @ $30 each
Model B
10 units @ $50 each
9 units @ $19 each
10 units @ $36 each
10 units @ $30 each
12 units @ $50 each
Purchases
7 units @ $21 each
6 units @ $37 each
Sales
7 units @ $30 each
3 units @ $50 each
All purchases and sales were for cash. The business has a perpetual inventory system that uses barcodes to verify each
sale. For the 20 July sales, three units of Model A were from the beginning inventory and seven were units purchased on
13 July; five units of Model B were from the beginning inventory and seven were units purchased on 13 July. For the 29
July sales, one unit of Model A was purchased on 13 July and six were units purchased on 24 July; one unit of Model B
was purchased on 13 July and two were units purchased on 24 July.
On 31 July, the business counted its inventory and determined that it had three units of Model A and six units of
Model B on hand. However, one of the three units of Model A was run over by a customer’s truck and had to be thrown
away. This unit had been in the beginning inventory.
Required:
a Record the beginning balances in the ‘Cash’ and ‘Inventory’ accounts. Using account columns (use one account column
for inventory), record the purchases and sales transactions during July, and calculate the ending balances of all the
accounts you used.
b Record the disposal of the damaged unit and prove the accuracy of the ending balance in the inventory account.
c Calculate the gross profit percentage. How was this affected by the damaged inventory?
d Do you think your work would have been easier if you had used two inventory accounts in (a)? How do you think a
business with many items of inventory keeps track of these items under a perpetual inventory system?
Making evaluations
6-44
6-45
6-46
258
Your friend, an avid sports fan, recently purchased a cricket bat from a catalogue. While he was filling out the order form, he
noticed the warning, ‘Don’t send cash!’ He asked you, ‘Does it seem odd to you that a business wouldn’t appreciate receiving
cash? You’re taking accounting. Don’t they teach you that businesses need cash? Why would they say such a thing?’
Required:
Tell your friend why you think the business puts this warning in its catalogues and give him some examples of what might
happen if customers paid for their purchases with cash. Explain how EFT and credit cards might prevent this from
happening.
Sam Lewis has been operating a ‘full-service’ service station for several years. Although he has occasionally employed
students part time, he has collected the cash and cheques for petrol and repair work himself. He now has decided to open
a second ‘full-service’ service station and to put himself more in the role of manager. He will hire employees to run the
service stations, to pump petrol and to do repair work.
Required:
How should Sam Lewis implement internal control procedures over cash receipts for the service stations? Who should be
in charge of making payments on behalf of the second service station?
Your father’s friend Frank has a business, Frank’s Franks, which is involved in the street-corner vending of sausages, pies
and soft drinks. It’s a small business with an office and four vending carts located in different areas of the city. When you
asked Frank what kind of internal controls his business has in place, Frank said, ‘We don’t have a formal system of
internal controls – don’t need them. My employees are family members and friends, and I trust them completely! When
the business grows and I have to hire strangers, then I’ll think about those controls. But for now, the business is
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Chapter 6 Internal control: Managing and reporting working capital
6-47
6-48
6-49
6-50
profitable, and I’m happy.’ After Frank left, you talked to your father about what you had learned in accounting and asked
whether he thought Frank would appreciate hearing about it. He assured you that Frank would be open to your
suggestions.
Required:
Write a letter to Frank questioning whether ‘trust’ is enough. Explain how you think his business would benefit from a
system of internal controls, even though he trusts his employees. Also describe specific controls that Frank could use in
his business.
Your sister, Ella, works at a bar in an upmarket hotel located above a shopping centre that includes a bank. She often works
the late shift and doesn’t leave work until 1 or 1.30 a.m. One day, when you were having lunch with her, she began
complaining about an aspect of her job: ‘My boss is a real stickler for procedures. Even though it’s really late when the last
customer leaves, and even though we’re exhausted, we still have to follow procedure. Before the boss and I can leave, we have
to count the money in the register and match it against the register tape and match both amounts against the dollar total of
the bills the customers paid. And, as if that’s not enough, we have to make sure that every bill number is accounted for.
Every night, the manager writes down the numbers of the bills each staff member has been given to use that night for taking
customer orders. At the end of the night, the bar staff gives the cashier all the bills that weren’t used. If any money is
missing, guess who takes the blame and has to make up the difference? After we count the money, we have to put it and the
tape in a deposit bag, walk it across the parking area to the bank and deposit it in the bank’s night-deposit box, even though
there is a safe right under the cash register! Like we’re not sitting ducks for anybody who wants to rob us. I don’t understand
why she would risk our lives like that. Also, she unlocks the part of the register that contains a copy of the tape we took to
the bank, and uses that tape to enter the day’s cash receipts amount into the accounting system. Like, she trusts me so much
that she has to keep the tape copy under lock and key. What a jerk!’
Now that you are studying accounting, you have a little better insight into why the boss is so interested in these
procedures.
Required:
Explain to Ella what’s going on before she does something rash, like quit her job.
The Anibonita Company is a retail shop with three sales departments. It also has a small accounting department, a purchasing
department and a receiving department. All inventory is kept in the sales departments. When the inventory for a specific item
is low, the manager of the sales department that sells the item notifies the purchasing department, which then orders the
merchandise. All purchases are on credit. Anibonita pays the freight charges on all its purchases after being notified of the cost
by the freight business. When the inventory is delivered, it is inspected and checked in by the receiving department, then sent
to the sales department, where it is placed on the sales shelves. After notification that the ordered inventory has been received,
the accounting department records the purchase. Upon receipt of the supplier’s invoice or the freight bill, the accounting
department verifies the invoice (or freight bill) against the purchase order and the receiving report before making payment.
Required:
Briefly explain the internal controls that the Anibonita Company uses for its purchasing process. Include in your
discussion what source documents it probably uses.
The JeBean Company makes sales only on credit. All of JeBean’s customers order online and receive stock via a freight
company. The business has a small accounting department, a credit department, an inventory department and a despatch
department. After approval of an order by the credit department, the merchandise is assembled in the inventory
department and then sent to the despatch department. Despatch packs the merchandise in cardboard boxes; it is then
picked up by the freight company to be sent to the customer. The JeBean Company pays for freight charges on all items
sent to customers after being notified of the cost by the freight company. After verification of despatch, the accounting
department posts an invoice to the customer and records the sale. On receipt of the customer’s bank details, the
accounting department records the collection.
Required:
Briefly explain the internal controls that the JeBean Company uses for its sales process. Include in your discussion what
source documents it probably uses.
Oliver Bauer, owner of Bauer’s Retail Store, has been very careful to establish good internal control over inventory
purchases for his shop. The shop has several employees and, since Oliver cannot devote as much time as he would like to
running the shop, he has entrusted a long-term employee with the task of purchasing inventory. This employee has
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Accounting Information for Business Decisions
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6-52
6-53
260
worked for Oliver for 15 years and knows all the shop’s suppliers. Whenever inventory must be purchased, the employee
prepares a purchase order and posts it to the supplier. When a rush order is needed, the employee occasionally calls in the
order and does not prepare a purchase order. This procedure is acceptable to the suppliers because they know the
employee. When the merchandise is received from the supplier, this employee carefully checks in each item to verify the
correct quantity and quality. This job is usually done at night, after the shop is closed, thus allowing the employee to help
with sales to customers during normal working hours. After checking in the items, the employee initials the copy of the
supplier invoice received with the merchandise, staples the copy to the purchase order (if there is one), records the
purchase in the business’s accounts and prepares a cheque for payment. At this point, Oliver Bauer examines the source
documents (purchase order and initialled invoice) and signs the cheque, and the employee records the payment.
Oliver has become concerned about the shop’s gross profit, which has been steadily decreasing even though he has heard
customers complaining that the shop’s selling prices are too high. He has a discussion with the employee, who says, ‘I’m doing
my best to hold down costs. I will continue to do my purchasing job as efficiently as possible – even though I’m overworked.
However, I think you should hire another salesperson and spend more on advertising. This will increase your sales and, in turn,
your gross profit.’
Required:
Why do you think the gross profit of the shop has gone down? Prepare a report for Oliver Bauer that summarises any
internal control weaknesses existing in the inventory purchasing procedure, and explain what the result might be. Make
suggestions for improving any weaknesses you uncover.
In the chapter, we mentioned that if Café Revive came up short four coffee gift packs, it should increase its cost of goods
sold account and decrease its inventory account by the cost of those gift packs. Suppose Emily wanted to keep a record of
coffee shortages in the accounting system.
Required:
Design a way that Café Revive’s accounting system could be changed to accommodate Emily’s request.
Suppose that one of your business’s largest customers has written an NSF cheque for $9734, and your boss has just found
out about it. He comes flying into your office demanding to know how this NSF cheque will affect specific accounts in the
business’s financial statements. You examine the bank statement that came in the morning’s post, and notice that not
only has the customer written an NSF cheque but the bank has charged you a fee of $75 for processing this cheque.
Required:
List the accounts that will be affected by this turn of events, and indicate how much they will be affected. What do you
think should happen next?
You are a consultant for several businesses. The following are independent situations you have discovered, each of which
may or may not have one or more internal control weaknesses. (The names of the businesses have been changed to
protect the innocent.)
i In Business A, one employee is responsible for counting and recording all the receipts (remittances) received in the
post from customers paying their accounts. Customers usually pay by cheque, but occasionally they mail cash. Every
day, after the mail is delivered, this employee opens the envelopes containing payments by customers. She carefully
counts all remittances and places the cheques and cash in a bag. She then lists the amount of each cheque or cash
received and the customer’s name on a sheet of paper. After totalling the cash and cheques received, she records the
receipts in the business’s accounts, endorses the cheques in the business’s name, and deposits the cheques and cash in
the bank.
ii Business B has purchased several calculators for use by office and sales employees. So that these calculators will be
available to any employee who needs one, they are kept in an unlocked storage cabinet in the office. Anyone who takes
and uses a calculator ‘signs out’ the calculator by writing their name on a sheet of paper posted near the cabinet. When
the calculator is returned, the employee crosses out their name on the sheet.
iii Business C owns a van for deliveries of sales to customers. No mileage is kept of the deliveries, although all petrol and
oil receipts are carefully checked before being paid. To advertise the shop, Business C has two signs with the shop’s
name hung on either side of the van. These signs are easily removable so that the van can be cleaned periodically
without damaging the signs. The business allows employees to borrow the van at night or on the weekends if they
need it for personal use. No record is kept of personal use, but the employee who borrows the van must fill the petrol
tank before returning it.
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Chapter 6 Internal control: Managing and reporting working capital
iv Employee Y is in charge of employee records for Business D. Whenever a new employee starts, the new employee’s
name, address, salary and other relevant information are properly recorded. On payday, all employees are paid by
cheque. At this time, Employee Y makes out each employee’s cheque, signs it and gives it to each employee. After
distributing the pay cheques, Employee Y makes an entry in the business’s accounts, increasing ‘Salaries expense’ and
decreasing ‘Cash’ for the total amount of the salary cheques.
v To reduce paperwork, Business E places orders for purchases of inventory from suppliers by phone. No purchase order
is prepared. When the goods arrive at the business, they are immediately brought to the sales floor. An employee then
authorises payment based on the supplier’s invoice, writes and signs a payment authorisation and makes payment to
the supplier. Another employee uses the paid invoice to record the purchase and payment in the business’s accounts.
vi All sales made by Business F, whether they are for cash or on account, are ‘rung up’ on a single cash register. Employee
X is responsible for collecting the cash receipts from sales and the customer charge slips at the end of each day. The
employee carefully counts the cash, preparing a ‘cash receipts’ slip for the total. Employee X sums the amount on the
cash receipts slip and the customer charge slips, and compares this total with the total sales on the cash register tape
to verify the total sales for the day. The cash register tape is then discarded and the cash is deposited in the bank. The
cash receipts slip and the customer charge slips are turned over to a different employee, who records the cash and
credit sales in the business’s accounts.
Required:
a List the internal control weakness or weaknesses you find in each of the above independent situations. If no weakness
can be found, explain why the internal control is good.
b In each situation in which there is an internal control weakness, describe how you would remedy the situation to
improve the internal control.
Dr Decisive
Yesterday, you received the following letter for your advice column in the local paper:
Dear Dr Decisive
Well, this takes the cake! I thought my boss was a little on the shady side, and now I’m pretty convinced but some of my friends think I’m wrong. What do you think? Here’s some background. The business for
which I work uses the specific identification method to assign costs to inventory and cost of goods sold.
This year, our inventory consisted of two batches of goods. We paid $6.00 per unit for each inventory item
in the old batch, and $6.75 for each item in the batch we purchased this year. As it turned out, most of
the inventory items we sold this year came out of the new batch (the $6.75 ones). The effect was that our
cost of goods sold for the year is higher than it would have been if we had sold the old batch of items
before we sold items from the new batch. My attitude was, ‘Well, que sera sera’. But that’s not my boss’s
attitude. This morning, he came into my office and actually asked me to ‘re-cost’ the inventory and cost
of goods sold assuming that we had sold the items in the old batch first, and then sold items from the
new batch. But we didn’t! Of course, his method would make the cost of goods sold that we report in our
income statement lower and our net income higher, so the business would look better. But something
about this really galls me. My friends say: ‘So what? What difference does it make?’
Help! You can call me . . .
‘Ethical Ethyl’ (or not)
Ethics and
Sustainability
Required:
Meet with your Dr Decisive team and write a response to ‘Ethical Ethyl’.
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Accounting Information for Business Decisions
Endnote
a
Shao, M (1994). Interview with Michael E Gerber. Des Moines Register, 14 February, 15–B.
List of company URLs
u
u
u
u
u
u
Coles: http://www.coles.com.au
Dell Inc: http://www.dell.com.au
MasterCard: http://www.mastercard.com.au
Virgin Money: http://www.virginmoney.com.au
Visa: http://www.visa.com.au
Woolworths Supermarkets: http://www.woolworths.com.au
262
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7
THE INCOME STATEMENT:
COMPONENTS AND
APPLICATIONS
‘Business without profit is not business any more than a pickle is candy.’
Charles F. Abbotta
Learning objectives
After reading this chapter, students should be able to do the following:
7.1 Explain the purpose of the income statement.
7.2 Understand the importance of measuring financial performance.
7.3 Discuss the definition and classification of revenue/income.
7.4 Discuss the definition and classification of expenses.
7.5 Evaluate the performance of business using ratios.
7.6 Link outcomes from the income statement to owner’s equity and
close the accounts.
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Accounting Information for Business Decisions
Understanding the learning objectives is assisted in the chapter by asking key questions:
Key questions
1
Why is a business’s income statement important?
2
How are changes in a business’s income statement accounts recorded in its accounting
system?
3
What are the parts of a retail business’s classified income statement, and what do they
contain?
4
What are inventory and cost of goods sold, and what inventory systems may be used by
a business?
5
What are the main concerns of external decision makers when they use a business’s
income statement to evaluate its performance?
6
What type of analysis is used by external decision makers to evaluate a business’s
profitability?
7
Why does a business close off its revenue and expense accounts at the end of each
period?
How much did you earn last year working during the holidays or the school year? How did you keep track
of your earnings? Did you make enough to cover all of your expenses? Or did your parents have to help
you out? If so, what percentage of your expenses did your earnings cover?
Businesses, like individuals, keep track of their earnings. For instance, for the year ended 30 June 2018,
Woolworths Group Ltd reported $56 965 million in revenue in its income statement. It also reported
$40 256 million as the cost of goods sold, and a gross profit of $16 709 million.b Woolworths obtained these
numbers from its accounting system. Did Woolworths charge enough for the products it sold to customers,
given that its net profit after tax was $1795 million for the year? Did Woolworths make enough net profit as
a percentage of its revenues?
In Chapter 4, we looked at the fundamentals of the financial accounting process. You saw how basic
accounting concepts, such as the entity concept, the accounting equation and accrual accounting, provide the
framework for the accounting system that a business uses to record its day-to-day activities. The system
provides internal users with valuable information that helps managers in their planning, operating and
evaluating activities. The revenue and expense transactions are also the basis of a business’s income
statement, which shows external users the business’s profit (income) for the accounting period.
Stop & think
Overall, do the numbers show that Woolworths had a ‘good’ or a ‘bad’ year? What other
information would you like to have to answer this question?
In this chapter, we will discuss the importance of the income statement, expand Chapter 4’s
discussion of the accounting system, describe and present a classified income statement, show how the
income statement helps managers and external users make business decisions, and introduce the
statement of comprehensive income.
264
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Chapter 7 The income statement: Components and applications
7.1 Why the income statement
is important
1
Why is a business’s
income statement
important?
A business’s income statement plays a key role in the decision making of users of financial information by
communicating the business’s revenues, expenses and net income (or net loss) for a specific time period.
A business earns income by selling inventory (goods) or by providing services to customers during an
accounting period. Recall that revenues are amounts earned by a business in charging its customers for
goods or services. Expenses are the costs of providing the goods or services during the period. An income
statement is based on the equation we showed in Chapter 4:
Net income ¼ Revenues Expenses
You may also hear the income statement referred to as a profit and loss (or P&L) statement, but in this
book, we refer to it as the income statement. Later, we will introduce the statement of comprehensive
income, which is effectively the income statement plus all other comprehensive income.
Recall from Chapter 3 that a business prepares a projected income statement for internal use as part
of its master budget. Exhibit 7.1 shows how internal users (managers) use a business’s projected income
statement and actual income statement in their decision making, as well as how external users use a
business’s actual income statement to make economic decisions. We now explain the impact of the
income statement on users’ decisions.
Exhibit 7.1 Uses of a business’s income statement
Management
activities
Business
Business environment
Internal users
External users
Reports and analyses
Planning
decisions
Projected income statement
Operating
decisions
Actual income statement
Evaluating
decisions
Comparisons of projected
and actual income statements
Company’s income statement
Comparisons
Over several
years
With other
companies’
income statements
Evaluating
decisions
The income statement summarises the results of a business’s operating activities for a specific
accounting period. These stem from the planning and operating decisions that managers made during the
period. A business’s income statement shows the relationship between managers’ decisions and the
results of those decisions. This information helps both internal and external users to evaluate how well
the business’s managers have ‘managed’ during the period. By comparing a business’s income statement
information from period to period, users can also evaluate managers’ ability over the longer term.
Let’s look first at how managers use the income statement to make comparisons. Remember from
Chapter 4 that a business keeps track of its activities by using an accounting system based on the
accounting equation and the dual effect of transactions. The accounting system provides the information
that managers need to compare actual results with expected (budgeted) results, and to prepare external
financial statements. At the end of an accounting period (e.g. one year), a business’s income statement
will show how well many of its managers’ business decisions worked out.
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Accounting Information for Business Decisions
For example, the revenue and expense information shows the results of managers’ cost–volume–profit
(CVP) analysis and budgeting decisions. In Chapter 2, we saw how you and Emily Della used CVP analysis to
develop your business plan. CVP analysis showed you and Emily how Café Revive could break even and how
it could earn a satisfactory profit. You calculated that Café Revive needed to sell 90 coffee gift packs at $55
per pack for the business to break even. In addition to helping managers predict a business’s breakeven
point, CVP analysis improves managers’ operating decisions, such as estimating how much inventory to
purchase, what sales price to charge and what effect on profit to expect from price changes. We determined
that if Café Revive could sell 170 gift packs at $55 per pack, it would earn a profit of $2112.
Consider the decisions that managers must make about what sales price to charge. If you and Emily set
prices too high, Café Revive would risk not selling enough cups of coffee or coffee gift packs to break even. If
you set prices too low, Café Revive might sell many cups of coffee and gift packs, but may not earn high
enough revenues to cover the costs of operating the business. Later, when the accounting system keeps track
of every sale, it records those sales at the prices that the customers actually paid. (Remember that every sale
generates a sales invoice to document the transaction and the amount of the sale.) If you and Emily do a good
job of assessing the market and establishing appropriate prices, Café Revive will make sales, earn revenues
high enough to cover its expenses and make a profit, which it will report on its income statement.
In Chapter 3, we discussed how budgets help managers make plans, control business expenses and
evaluate business performance. If you were the manager of Café Revive, budgeting would allow you to
compare your expectations for revenue and expense amounts (reported in the projected income statement)
with the actual amounts (reported in the actual income statement). If sales were higher or expenses lower
than expected, you could find out what you did right and keep doing it. If, on the other hand, sales were lower
or expenses higher than expected, you could analyse your mistakes and try to improve.
Stop & think
How do you think a business’s decision to decrease the price of its product will affect the
revenues that it reports on its income statement? How will this decision affect its expenses?
As valuable as CVP analysis and budgets are for internal decision making, businesses do not report
much of the information they provide to external decision makers. For one thing, businesses don’t want
to reveal specific cost or budget information to their competitors. For another, many businesses prepare
internal accounting reports daily, so external users may be more confused than helped by the sheer
volume of information.
External users need accounting information that lets them compare a business’s actual operating
performance over several years, or compare this with the operating performance of other businesses. For
instance, if the business is a public company, potential investors and current shareholders use its income
statement information to help them decide whether to buy or hold shares in the business. By comparing
the business’s current operating performance with that of prior years, they can get a sense of the
business’s future operating performance. By comparing the business’s current operating performance with
that of other businesses, they can get a sense of whether the business is doing ‘better’ or ‘worse’ than
these businesses. Banks and other financial institutions also use a business’s income statement in a
similar way to evaluate whether or not to give the business a loan. Finally, suppliers also use a business’s
income statement information. Suppliers do not have the resources to grant credit to all customers. A
supplier can compare its customers’ income statements to determine which customers might represent the
best credit risks. Generally accepted accounting principles (GAAP) (see Chapter 4) ensure that all businesses
calculate and publish financial statement information in a similar, and thus comparable, manner. So
understanding GAAP is important – to the accountant who prepares financial statements and to the
external decision maker who uses these statements to make business decisions.
In Chapter 4, we introduced a simple accounting system, as well as several concepts and terms that
form the foundation of GAAP. In this chapter, we will expand that accounting system, extend our
discussion of GAAP as it relates to the income statement and begin to explain how external users evaluate
income statement information for decision making.
266
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Chapter 7 The income statement: Components and applications
7.2 Measuring financial
performance: The income
statement
In Chapter 4, we kept track of Café Revive’s transactions using the accounting equation to set up columns
for recording amounts for assets, liabilities and/or owner’s equity. We then expanded the accounting
equation to include revenue and expense transactions. Adding revenue and expense columns lets us keep
track of these transactions separately from owner investments and withdrawals. However, a business
needs to know more than its total revenues and total expenses. A business must know the total of each of
its revenues and the total of each of its expenses for the accounting period, so it can report these items in
a useful manner on its income statement for that period. In this chapter, we will continue to use columns
for each asset and liability account. However, we will create a separate column under ‘Owner’s equity’ for
each revenue account and each expense account, while still retaining an owner’s capital account column. A
business uses these revenue and expense accounts for only one accounting period to record the effects of its
transactions on its net income, and so they are called temporary accounts. The asset, liability and owner’s
capital accounts are called permanent accounts because they are used for the life of the business to record
the effects of its transactions on its balance sheet.
By using this expanded accounting system, we show how a business keeps track of the changes in (and
balances of) each asset, liability, owner’s capital, revenue and expense account. After showing how a
business records a transaction in this accounting system, we include a marginal note to help you
understand the effect of the transaction on the business’s financial statements. (There’s an example in the
next section.) We use this columnar accounting system because it allows us to see easily the effects of a
business’s transactions on its various accounts, accounting equation and financial statements. You should
realise, however, that a real business has many (sometimes hundreds) different types of assets, liabilities,
revenues and expenses. Imagine how wide the paper would need to be to record transactions involving
hundreds of account columns! So a real business uses either a computerised accounting system, or a more
complex manual accounting system, that involving journals, ledgers, debits and credits, and different
forms of accounts.
As we discussed earlier, the income statement is an important part of the decision-making process for
both internal and external users. It is an expansion of the income equation introduced in Chapter 4:
2
How are changes in a
business’s income
statement accounts
recorded in its accounting
system?
permanent accounts
Accounts used for the
life of a business to
record the effects of its
transactions on its
balance sheet (assets,
liabilities and owner’s
capital accounts)
Net income ¼ Revenues Expenses
Revenues may be thought of as the ‘accomplishments’ of a business during an accounting period. They are
the amounts earned, and result in increases in assets (cash or accounts receivable) or decreases in liabilities
(unearned revenues). Expenses may be thought of as the ‘efforts’ or ‘sacrifices’ made by a business during an
accounting period to earn revenue. They are the costs of providing goods and services, and result in decreases
in assets or increases in liabilities.
Keep these definitions in mind while we discuss how a business matches revenue and expenses in its
‘classified’ income statement in order to provide information to external users about the profit or loss the
business is making as a result of activiities for a certain period of time. Let’s now return to Café Revive to
see how Emily records and reports the results of its first month of operations. To reinforce your
understanding of the columnar accounting system, we will show how to record a few revenue and expense
transactions. We will also show Café Revive’s classified income statement. As you look at it, focus on
understanding the income statement sections, but also think about how Emily recorded the individual
revenue and expense transactions.
The classified income statement of a retail business like Café Revive has two parts: an operating income
section and an other items section. Operating income includes all the revenues earned and expenses
incurred in the primary operating activities of the business. The operating income section has three
subsections: (1) revenues; (2) cost of goods sold; and (3) operating expenses. Other items include any
revenues and expenses that are not directly related to the primary operations of the business – items such
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3
What are the parts of a
retail business’s classified
income statement, and
what do they contain?
operating income
All the revenues earned
less the expenses
incurred in the primary
operating activities of
a business
other items
Revenues and expenses
that are not directly
related to the primary
operations of a
business
267
Accounting Information for Business Decisions
as interest revenue and interest expense. Case Exhibit 7.2 shows Café Revive’s classified income
statement for January 20X2.
In the next sections, we will discuss various issues related to recording and reporting revenues and
expenses, referring to Case Exhibit 7.2 to show how Café Revive reports certain items.
Operating income, other items and net
income
On a business’s income statement, the total operating expenses are deducted from gross income to determine
net income. We have already completed the Income Statement in Exhibit 5.12. However this version did not
include the adjustments made for the bank reconciliation in Chapter 6. So in Case Exhibit 7.2, Emily also
includes in operating income the $25 interest, making a total of $10 665.00. Emily adds the total selling
expenses to the total general and administrative expenses and financial expenses to determine the $6340 total
operating expenses. Note that this is different to the total in Case Exhibit 5.12 because Emily now needs to
include the expenses from the bank (i.e. bank charges $35). She deducts the total operating expenses from the
gross profit and other revenue of $10 665 to determine Café Revive’s operating income of $4325.
Case Exhibit 7.2 Café Revive’s classified income statement
CAFÉ REVIVE
Income statement
For the month ended 31 January 20X2
Sales revenues – coffee gift packs (net)
$12 000.00
Cost of goods sold
(6 240.00)
Gross profit
$ 5 760.00
Sales revenues – cups of coffee (net)
4 880.00
Interest revenue
25.00
19 665.00
Operating expenses:*
Selling expenses
$5 241.50
General and administrative expenses
Financial expenses
^
1 052.50
46.00
Total operating expenses
Net income
(6 340.00)
$ 4 325.00
*See Case Exhibit 7.4.
^
(Interest expense $11 plus Bank Charges $35)
The ‘Other items’ (sometimes called the non-operating income) section of a business’s income
statement includes items that are not related to the primary operations of the business. This section
reports revenues and expenses related to investing activities or to financing the business’s operations (e.g.
interest revenue and interest expense), revenues and expenses (called gains and losses) related to selling
property and equipment assets, and incidental revenues and expenses (e.g. miscellaneous rent revenue
and losses due to theft or fire). We will discuss these items more fully later in the book. The total amount
of the other items (non-operating income) section is added to (or subtracted from) the operating income
to determine a business’s net income. The net income of Café Revive (shown in Case Exhibit 7.2) for the
month ended 31 January 20X2 is $4325.
268
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Chapter 7 The income statement: Components and applications
7.3 Defining and classifying
revenues/income
Revenue is income that arises during the course of the ordinary activities of a business. Most commonly,
revenue is recognised at the point of sale or delivery of a service. For example, a retail business sells goods to
customers either for cash or on credit. As such, sales revenue is the major source of revenue for a retail
business and is recognised at the time the sale takes place. When goods are sold on credit, some retail
businesses offer an incentive for prompt payment. Whether the sales are for cash or on credit, customers
sometimes return the goods they purchased. Let’s see how businesses record these aspects of sales.
Sales revenue
Whether a customer buys goods for cash or on credit, retail businesses use a ‘Sales revenue’ (or ‘Sales’)
account to record the transaction. Recall from Chapter 4 that the source document for a sale is a sales
invoice (or invoice). Some businesses that sell only a few products or have a computerised accounting system
may use a cash-register tape or credit-card receipt as the source document. Case Exhibit 7.3 shows a sales
invoice that Café Revive used for one of its sales. It shows that on 6 January 20X2, Café Revive sold 10
coffee gift packs for $55 per pack (including GST), bringing the total amount to $550. Notice that the invoice
also tells you that the invoice number is 0006, that the gift packs had an inventory identification number (ID
no.) of 0122, that it was a credit sale, and that the credit sale was made to Beau Flower Shop. It is important
that the invoice includes all of the sales information needed to record this transaction.
Case Exhibit 7.3 Café Revive’s sales invoice
Sales invoice
Café Revive
INVOICE: 0006
Cash
Sold to: Beau Flower Shop
Credit
Acct: 0103
Date
06/01/20X2
Description
Coffee gift packs
ID
Number of units
0122
10
Unit price
Amount
$50.00
$500.00
GST (10%)
50.00
Total
$550.00
Thank you for your business.
Emily records the 6 January credit sale by first increasing ‘Accounts receivable’ by $550 to show that
Beau Flower Shop owes Café Revive that amount. Notice that the beginning balance of accounts receivable
was $440; this is the amount Beau Flower Shop already owes to Café Revive for the shop equipment it
purchased from Emily (see Case Exhibit 4.11 in Chapter 4). So ‘Accounts receivable’ now has a balance of
$990. Emily also increases the ‘Sales revenue’ account column under the ‘Net income’ heading of ‘Owner’s
equity’ by $500, to show that Café Revive earned that amount from the sale, and increases the ‘GST collected’
account column by $50, to show the 10 per cent GST on the sale. Notice that the previous balance of sales
revenue was $1500, due to a sale on 2 January, so that ‘Sales revenue’ now has a balance of $2000.
FINANCIAL STATEMENT EFFECTS
Increases assets on balance sheet
Increases revenues, which increases net income on income statement (and therefore increases owner’s equity on balance
sheet)
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269
Accounting Information for Business Decisions
¼
Assets
Accounts receivable
Liabilities
þ
Owner’s equity
GST collected
Net income
Sales revenue
Bal.
440
190
1 500
6/1/20X2
550
50
500
Bal.
990
240
2 000
Expenses
To illustrate how an account balance changes, we showed above the beginning and ending balances of
the ‘Accounts receivable’, ‘GST collected’ and ‘Sales revenue’ accounts. For simplicity, later in this chapter
and in future chapters we will include the balance of an account only when it is critical to the discussion. At
first glance in the previous example, it does not appear that Café Revive’s accounting equation is in balance.
Remember, though, that Café Revive has many accounts in its accounting system, and that we are showing
only three of its accounts in this example. Café Revive’s accounting equation was in balance before Emily
recorded this transaction, as we showed in Case Exhibit 4.13 in Chapter 4. What is important to notice is
that in the above example, assets (‘Accounts receivable’) increased by $550, liabilities (‘GST collected’)
increased by $50 and owner’s equity (‘Sales revenue’) increased by $500. So Café Revive’s accounting
equation remained in balance after Emily recorded the transaction, as we showed in Case Exhibit 4.14.
Remember that Café Revive had to dip into its inventory of coffee gift packs to make the sale. Emily
uses the identification numbers on the gift packs that Café Revive sold to determine the $260 cost of
the packs (10 gift packs at $26 per pack; note that the cost price is $26, not $28.60, because it includes
GST). So Emily records the cost of the sale by first decreasing ‘Inventory’ by $260, as we show below.
Note that the balance of ‘Inventory’ prior to the sale was $5460 (see Case Exhibit 4.13), and the balance
is $5200 after the sale. Emily also increases ‘Cost of goods sold’ (an expense) under the ‘Net income’
heading of ‘Owner’s equity’ by $260, to show the cost of the gift packs that Café Revive sold on 6
January. Remember that as cost of goods sold (an expense) increases, both net income and owner’s
equity decrease. That is why we include a minus (–) sign in the column to the left of the ‘Cost of goods
sold’ column. Notice that the previous balance of ‘Cost of goods sold’ was $780 due to the sale on 2
January, so that ‘Cost of goods sold now has a balance of $1040.
¼
Assets
Liabilities
þ
Owner’s equity
Net income
Revenue
Inventory
Bal.
Bal.
Cost of goods sold
$ 5 460
1/6/X2
Expenses
$
780
260
þ 260
$ 5 200
$ 1 040
FINANCIAL STATEMENT EFFECTS
Decreases assets on balance sheet
Increases cost of goods sold, which decreases net income on income statement (and therefore decreases owner’s equity
on balance sheet)
Although we do not show all the account balances in Café Revive’s accounting system, notice that
the accounting equation continues to remain in balance after Emily records these two transactions
because the $240 total increase in assets ($550 increase in ‘Accounts receivable’, less $50 GST collected
and $260 decrease in ‘Inventory’) is equal to the $240 total increase in owner’s equity ($500 increase in
‘Sales revenue’, a revenue, less $260 increase in ‘Cost of goods sold’, an expense). Emily records each
sales transaction for January in the same way (except she records cash sales in the ‘Cash’ account
column rather than the ‘Accounts receivable’ column). At the end of the accounting period, she
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Chapter 7 The income statement: Components and applications
calculates the $16 880 balance in ‘Sales revenue’ (sales of coffee gift packs $12 000, sales of cups of coffee
$4880), and Café Revive reports it as revenue on its income statement for January, as we showed in Case
Exhibit 7.2. Emily calculates the $6240 balance in the ‘Cost of goods sold’ account column, and Café Revive
reports this as an expense on its income statement.
How sales policies affect income
statement reporting
Businesses may have several policies related to the sales of their goods or services. There are three types
of policies: discount policies, sales return policies and sales allowance policies. Businesses want to
encourage customers to buy their merchandise or services, and sales policies help them to do this. A retail
business’s specific policies will also have an impact on its net sales – the net dollar amount of sales
reported on its income statement – because its revenues for an accounting period should include only the
prices actually charged to customers for goods or services sold during the period. In the following sections,
we will discuss each of these sales-related policies.
Discounts
Have you ever taken advantage of a two-for-one special, paid a lower price because you bought a larger
quantity of the same item or used a coupon to get three dollars off the price of your pizza? If so, the
business you bought from offered you a discount. A quantity (or trade) discount is a reduction in the sales
price of goods or a service because of the number of items purchased or because of a sales promotion.
Businesses use discounts to attract customers and increase sales. Suppose that in early February, Café
Revive puts in its front window a sign that reads, ‘Valentine’s Day special: Buy four or more coffee gift
packs and receive a 10 per cent discount’. By using this sales promotion, Café Revive hopes that people
walking by will notice the sign, come into the shop and buy coffee gift packs. In addition, the business
hopes that customers who had planned to buy only one or two gift packs will instead buy four, so that
they can get the discount. Emily also hopes the policy will encourage repeat customers.
Before deciding to start a specific quantity discount policy, Café Revive uses CVP analysis to determine
the discount that is most likely to improve the business’s profits. Once a quantity discount policy is set,
the business keeps track of the impact the policy has on sales, costs and profits. However, the business
does not record quantity discounts in its accounting system.
A business also may decide to offer a discount for early payment on credit sales. A sales discount is a
percentage reduction of the invoice price if the customer pays the invoice within a specified period. A
sales discount is frequently called a cash discount because when taken by a customer, the discount
reduces the cash received. The sales invoice shows the terms of payment. These terms vary from business
to business, although most competing businesses have similar credit terms.
Sales (cash) discount terms might read, for example, ‘5/7, n/31’ (i.e. ‘five seven, net 31’). The first
number is the percentage discount (5%), and the second number (7) is the number of days in the
discount period. The discount period is the time, starting from the date of the invoice, within which the
customer must pay the invoice to get the sales discount. The term n/31 means that the total invoice price
is due within 31 days of the invoice date. Thus, ‘5/7, n/31’ is read as, ‘A 5 per cent discount is allowed if
the invoice is paid within seven days; otherwise, the total amount of the invoice is due within 31 days’. If
Café Revive makes a $66 (including $6 GST collected) sale on credit with the terms 5/7, n/31 and the
customer pays the invoice within seven days, the customer would pay $62.70 ($66 – [0.05 $66]), and
$3.30 would be the sales discount taken. GST collected would now become $62.70 – ($62.70/1.1), and
$5.70 would be the GST collected and the sales revenue $57 ([$57 þ $5.70 ¼ $62.70). Sometimes
businesses offer cash discounts by charging a lower price for cash sales (rather than credit sales). For
example, The Good Guys’ (http://www.thegoodguys.com.au) catchphrase is ‘Pay less, pay cash’. A
business’s accounting system keeps track of sales (cash) discounts by reducing sales revenue by the
amount of sales discounts taken when customers pay for their credit purchases.
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quantity discount
Reduction in the sales
price of a good or
service because of the
number of items
purchased or because
of a sales promotion
sales discount
Percentage reduction
of the invoice price if
the customer pays the
invoice within a
specified period
cash discount
Percentage reduction
of the invoice price if
the customer pays the
invoice within a
specified period
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Accounting Information for Business Decisions
Stop & think
How do you think that a sales discount taken by a credit customer when paying the account
receivable is recorded in the customer’s accounting system?
Sales returns and allowances
sales return
When a customer
returns previously
purchased
merchandise and
receives a refund
When a customer buys merchandise, both the business and the customer assume that it is not damaged
and will be acceptable to the customer. Occasionally, on checking the merchandise after the purchase, a
customer may find that it is damaged, of inferior quality or simply the wrong size or colour. Most retail
businesses have a policy allowing customers to return merchandise. For example, David Jones (http://
www.davidjones.com.au) has a very liberal return policy. A sales return occurs when a customer returns
previously purchased merchandise. The effect of a sales return is to cancel the sale (and the related cost of
goods sold).
Discussion
Have you ever returned merchandise to a shop? Did the customer service representative ask
to see your sales receipt? Did you or the customer service representative fill out additional
source documents? Why?
DAVID JONES RETURN POLICY
‘We appreciate that you want to shop with the confidence of knowing that if you are not completely satisfied with your
purchase, you can simply return it to any David Jones department store and we will provide you with an exchange,
refund or repair.’c
sales allowance
When a customer
agrees to keep
damaged merchandise
and the business
refunds a portion of the
original sales price
If a customer discovers that merchandise is damaged, a business may offer the customer a sales
allowance, which occurs when a customer agrees to keep the merchandise, and the business refunds a
portion of the original sales price.
Although this transaction is not part of our ongoing analysis of Café Revive, assume that one of its
customers, Jake McAdams, pays cash for four coffee gift packs at $55 per box ($200 sales þ $20 GST
collected). Remember that each gift pack has a base cost price of $26. Emily would record this transaction by
increasing Café Revive’s ‘Cash’ account by $220 (4 $55) and ‘Sales revenue’ by $200 (4 $50), and by
increasing ‘GST collected’ by $20 ($4 5), decreasing ‘Inventory’ by $104 (4 $26) and increasing ‘Cost of
goods sold’ (an expense) by $104.
What would happen if, when Jake opens the gift packs later that day, he notices that one of them is
damaged? If he returns to the shop, Emily might ask him whether he wants to exchange the gift pack for
a new gift pack, return the gift pack for a refund or accept a $55 sales allowance and keep the gift pack. If
the gift pack is still usable, Jake might decide to accept the sales allowance.
Because Jake paid for his purchase with cash, Café Revive would grant the sales allowance by
refunding him $55 cash. Emily would record this sales allowance transaction in Café Revive’s accounts as
follows:
Assets
¼
Cash
Liabilities
þ
Owner’s equity
GST collected
Net income
Sales revenue
55
5
Expenses
50
FINANCIAL STATEMENT EFFECTS
Decreases assets on balance sheet
Decreases revenues, which decreases net income on income statement (and therefore decreases owner’s equity on
balance sheet)
272
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Chapter 7 The income statement: Components and applications
If Jake originally purchased the goods on credit, Café Revive would grant the sales allowance by
decreasing Jake’s ‘Account receivable’ balance, instead of the ‘Cash’ balance, by $55.
Stop & think
If Jake returned the coffee for a refund, how would you record the transaction?
Whether a business grants a sales return or a sales allowance, it prepares a source document called a
credit memo. (Remember that a source document serves as evidence that a transaction has occurred.) A
credit memo is a business document that lists information about a sales return or allowance. It includes
the customer’s name and address, how the original sale was made (cash or credit), the reason for the sales
return or allowance, the item(s) returned or on which the allowance was given, and the amount of the
return or allowance. The credit memo is the source document used to record the return or allowance. It is
also the document used to keep track of and measure external-failure costs – those stemming from
customer dissatisfaction. The effect of recording sales discounts, sales returns and sales allowances is to
reduce sales revenue, as we will discuss in the next section.
credit memo
Business document
that lists the
information for a sales
return or allowance
Discussion
How can a business’s sales return policy help increase profits? Do you think a sales return
policy can ever hurt more than it helps? How?
Net sales
At the end of the accounting period, the balance of a business’s ‘Sales revenue’ account includes the initial
sales revenue, less the sales returns and allowances and the sales (cash) discounts taken. The balance of
the ‘Sales revenue’ account is called sales revenue (net) or net sales, and is reported on the business’s
income statement.
In January 20X2, Café Revive did not allow any cash discounts and did not have any customers return
their purchases or ask for an allowance. The business thus reports total sales revenue of $16 880 on its
income statement, as we showed in Case Exhibit 7.2. It seems that Café Revive’s customers were satisfied
with the quality of the coffee and gift packs they bought. In general, the amounts that a business records
as sales returns and allowances (and sales discounts) provide useful information about the quality of the
business’s products (and the effect of its cash discount policy).
Stop & think
Do you think a business should report to its managers a single net sales amount, or both the
total sales and the sales returns, allowances and discounts? Should this amount be reported
to external users? Why or why not?
Revenue from other sources
As well as revenue from the main operations of the business (i.e. sales or service fees), a business may receive
revenue from other sources, such as commission, interest on investments and gains on the sale of assets.
These revenues are recorded as part of the accounting process, and should be included in the income
statement when calculating the business’s profit. Following the bank reconciliation process (outlined in
Chapter 6), Emily now knows that she received interest of $25 on her account with the bank. The amount of
$25 will be included in the income statement as ‘Other revenue’. This will result in ‘Revenues’ increasing from
$10 640, in Case Exhibit 5.12, to $10 665 in Case Exhibit 7.2.
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273
Accounting Information for Business Decisions
4
What are inventory
and cost of goods sold,
and what inventory
systems may be used
by a business?
7.4 Defining and classifying
expenses
An old business aphorism states, ‘You have to spend money to make money’. Managers of businesses
should understand that planning and controlling expenses is an important part of running a business.
Expenses are outflows that arise as a result of the ordinary activities of a business. They are recognised
when the cost incurred can be measured reliably. Most expenses result from the production or delivery of
goods and/or services during the accounting period. In the previous section, you saw how Café Revive, a
retail business, recorded and reported its revenues. In this section, we focus on expenses.
Cost of goods sold
cost of goods sold
Major expense of a
retail business
consisting of the cost of
the goods
(merchandise) that it
sells during the
accounting period
One of the major expenses of a retail business is the cost of the goods (merchandise) that it sells during
the accounting period. A classified income statement shows this expense as the cost of goods sold.
Although all retail businesses report their costs of goods sold, how a retail business calculates the
amount depends on the type of inventory system it uses. Remember that inventory is the merchandise a
retail business is holding for resale. A business uses an inventory system to keep track of the inventory it
purchases and sells during an accounting period, and thus of the inventory it still owns at the end of the
period. Businesses use either a perpetual inventory system or a periodic inventory system. Because the type of
inventory system used by a business affects its managers’ decisions, as well as income statement
calculations, we will briefly discuss the cost of goods sold in each type of system.
Perpetual inventory system
perpetual inventory
system
System that keeps a
continuous record of
the cost of inventory on
hand and the cost of
inventory sold
A perpetual inventory system keeps a continuous record of the cost of inventory on hand and the cost
of inventory sold. Under this system, when a business purchases an item of inventory, it increases the
asset ‘Inventory’ by the invoiced cost of the merchandise, plus any freight charges (sometimes called
transportation-in) it paid to have the inventory delivered. When the business sells merchandise, it records
the sale in the usual way. It also reduces ‘Inventory’ and increases ‘Cost of goods sold’ by the cost of the
inventory that it sold. (We illustrated this earlier for one of Café Revive’s sales.) In this way, the business
will have inventory and cost of goods sold accounts that are always up to date, and it will always know the
physical quantity of inventory that it should have on hand.
Stop & think
Do you think perpetual inventory records could be wrong? What could cause the records to
show either too much or too little inventory?
Because of the widespread use of computer technology, many retail shops use a perpetual inventory
system. When you buy something in a shop, if the salesperson uses a scanner to record your purchase,
the business is using a perpetual inventory system. Computers help shops to record sales transactions
and to keep their perpetual inventory records. For instance, a supermarket uses an optical scanner to
read a barcode and record the price of the item into the cash register. The shop’s computer
simultaneously increases the assets ‘Cash’ (or ‘Accounts receivable’) and ‘Sales revenue’ for the item’s
sales price, reduces ‘Inventory’ and increases ‘Cost of goods sold’ by the amount of that item’s cost and
updates the count of the quantity of inventory on hand. Most department stores use a perpetual
inventory system, as do most retail stores that sell a relatively small number of very expensive items,
such as cars and jewellery.
Whether a business sells expensive jewellery or generic grocery items, the business’s perpetual inventory
system keeps up-to-date amounts for both inventory and cost of goods sold. This information helps
274
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Chapter 7 The income statement: Components and applications
managers with decisions about day-to-day operations. By monitoring the daily changes in inventory
amounts, managers can decide when to make inventory purchases, thus ensuring that inventory items are
always in stock. Because the cost of goods sold information is current, managers can also compare the
revenues and costs of recent sales, and estimate the business’s profitability. However, before deciding to use
a perpetual inventory system, managers should evaluate the costs of various systems and technology,
employee training and the other support needed to operate it. In some cases, the benefits may not justify
the added costs of keeping perpetual records. But, as computer technology becomes more affordable and
competition increases, businesses are typically finding that perpetual systems, and the added control over
inventory they offer, are worth the costs.
At the end of an accounting period, a business includes the balance of its inventory account on its
balance sheet. It includes the balance of its cost of goods sold account on its income statement. As we
illustrated earlier, Café Revive uses a perpetual inventory system. Café Revive also uses the specific
identification method, which we discussed in Chapter 6 (refer also to the Appendix at the end of this
chapter), to determine its cost of goods sold because it identifies the cost of each coffee gift pack sold
based on the gift pack’s identification number. At the end of January 20X2, its ‘Inventory’ account has a
balance of $1000, and its ‘Cost of goods sold’ account has a balance of $4800 from the purchases and
sales transactions recorded in that month. We show these account columns below (the amounts are the
same as those listed in Case Exhibit 4.20 in Chapter 4).
Inventory
Cost of goods sold
Bal 1/1
$
2/1
–$
1 360
2/1
+$ 780
780
6/1
+$ 260
4/1
+$ 4 940
3/1–31/1
+$5 200
Bal 1/31
6/1
–$
3/1–31/1
–$5 200
260
Bal 31/1
$1 350
$6 240
Cost of inventory purchased
Cost of inventory sold
The $6240 cost of goods sold is reported on the income statement, as we showed in Case Exhibit 7.2.
The $1350 ending inventory of gift packs is reported on the balance sheet shown in Case Exhibit 4.22 in
Chapter 4.
periodic inventory
system
System that does not
keep a continuous
record of the inventory
on hand and sold, but
determines the
inventory at the end of
each accounting period
by physically counting it
A periodic inventory system does not keep a continuous record
of the inventory on hand and sold, but instead determines the
inventory at the end of each accounting period by physically
counting it. Because a periodic inventory system does not reduce
the ‘Inventory’ account each time a sale occurs, the only time the
business knows the cost of its inventory on hand is when it
counts the inventory.
Why would a business choose not to keep perpetual
inventory records? There are two common reasons. First, many
businesses that use a periodic inventory system are small enough
to manage their inventory without perpetual records. Second,
many businesses sell a high volume of similar, inexpensive
Assuming this person is ‘taking inventory’, what information do you
goods. If these items are not expensive, perpetual records may
suppose he is recording?
not be as important for keeping day-to-day physical control over
the inventory. For these reasons, a business may decide that the costs of a perpetual system – that is,
record-keeping costs, and computer hardware and software costs – are not worth the benefits.
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275
Alamy Stock Photo/Bill Lyons
Periodic inventory system
Accounting Information for Business Decisions
Because a business using a periodic system does not keep perpetual records, it must physically count
its inventory at year-end. Physically counting the inventory is the only way for the business to determine
an accurate inventory amount to be reported in the business’s ending balance sheet. Therefore, a business
usually counts its inventory (in a process generally referred to as stocktaking) immediately after the last
working day of its financial or fiscal year.1 This is a difficult and time-consuming task. Thus, most
businesses end their financial year when inventory levels are likely to be low and business is slow. In
Australia and New Zealand, a fiscal year can be based on either a calendar year (1 January to 31
December) or a financial year (1 July to 30 June), depending on which of these best suits an individual
business’s ongoing activities.
Perhaps you have noticed a business’s advertisement saying something like this:
STOCKTAKE
CLEARANCE SALE!!!
WE’D RATHER SELL IT
THAN COUNT IT!
This business is reducing its prices in order to sell more goods so that it will not have to spend as
much time counting inventory. Near the end of the financial year, it is not unusual for a business to close
temporarily so that it can count its inventory. If you peeked in the window of a business displaying a sign
like the one shown, you would likely see people moving from one aisle to the next and counting the
merchandise on each shelf.
How does a business using a periodic system know its cost of goods sold? Since the business does not
record the cost of the goods sold when each sales transaction takes place, it must calculate its cost of
goods sold for an accounting period as follows:
Cost of goods
Cost of goods
not sold
available for sale
zfflfflfflfflfflffl}|fflfflfflfflfflffl{
zfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl}|fflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl{
Cost of
Cost of
Cost of
ending
Cost of goods sold ¼ beginning þ
net
inventory
inventory
purchases
net purchases
Amount of
merchandise
purchases adjusted for
purchase returns,
allowances and
discounts
cost of ending
inventory
Dollar amount of
merchandise on hand,
based on a physical
count, at the end of the
accounting period
gross profit
Net sales minus cost of
goods sold
A business knows the cost of its beginning inventory because the beginning inventory for a new
accounting period is the same as the ending inventory for the previous accounting period. A business’s
cost of net purchases is the dollar amount it recorded during an accounting period for the merchandise
it bought for resale. The term net purchases is used because the amount of merchandise purchases
(invoice cost and transportation-in) is adjusted (reduced) for purchases returns, allowances and
discounts. (These adjustments are similar to the net sales adjustments we discussed earlier.) A
business’s cost of ending inventory is the dollar amount of merchandise on hand, based on a physical
count at the end of the accounting period.
Cost of goods sold and gross profit
Because cost of goods sold is usually a retail business’s largest expense, many businesses subtract cost of
goods sold from net sales to determine gross profit (refer to this chapter’s Appendix). Gross profit is the
amount of revenue that a business has ‘left over’ (after recovering the cost of the products it sold) to
cover its operating expenses. Café Revive subtracts its $6240 cost of goods sold for coffee gift packs
from its $12 000 sales revenue (net) for coffee gift packs to get its $5760 gross profit, as we showed in
Case Exhibit 7.2.
1
A business using a perpetual inventory system also physically counts its inventory at year-end. Even though its accounting
records show what should be in the inventory, the business takes a physical count to determine its actual inventory so it can
test the accuracy of its accounting records and estimate the amount of lost or stolen inventory.
276
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Chapter 7 The income statement: Components and applications
Stop & think
Do you think Emily is pleased with Café Revive’s gross profit on gift packs? Why or why not?
FINANCIAL STATEMENT EFFECTS
Decreases assets on balance sheet
Increases operating expenses, which decreases net income on income statement (and therefore decreases owner’s equity
on balance sheet)
Operating expenses
Of course, the cost of goods sold is not the only expense that a retail business incurs. Activities such as
having a sales staff, occupying building space or running advertisements in the newspaper also cost
money. These types of expenses are called operating expenses. Operating expenses are the expenses
(other than cost of goods sold) that a business incurs in its day-to-day operations.
¼
Assets
Liabilities
þ
Owner’s equity
operating expenses
Expenses (other than
cost of goods sold) that
a business incurs in its
day-to-day operations
Net income
Revenue
Cash
Expenses
Advertising
expense
$121 (GST paid þ11)
þ $110
A business records its operating expenses in account columns, as we discussed earlier. For instance,
when Café Revive paid $121 for advertising on 25 January 20X2, Emily recorded the transaction as
shown.
Notice, again, that an increase in an expense causes a decrease in owner’s equity, as indicated by the
minus (–) sign in the column in front of the $110 advertising expense.
Likewise, on 31 January 20X2, when Emily prepared the end-of-period adjustment of $19 for
depreciation, she recorded the expense as follows:
Assets
¼
Liabilities
þ
Owner’s equity
Net income
Revenue
–
Shop depreciation
Bal.
Depreciation
expense
$1 100
$
Bal.
Expenses
19
þ$19
$1 081
$19
As we noted in Chapter 5, businesses refer to the recording of end-of-period adjustments as making
adjusting entries.
A business may divide the operating expenses section of its income statement into three parts: one
for selling expenses, one for general and administrative expenses and one for financial expenses. Selling
expenses are operating expenses related to the sales activities of a business. Sales activities are activities
involved in the actual sale and delivery of merchandise to customers. Selling expenses include such items
as sales salaries expense, advertising expense and delivery expense (sometimes called transportation-out)
for merchandise sold. General and administrative expenses are the operating expenses related to the
general management of a business. They include such items as office salaries expense, insurance expense
and office supplies expense. Financial expenses relate to the financing of the business and its operations
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selling expenses
Operating expenses
related to the sales
activities of a business
general and
administrative
expenses
Operating expenses
related to the general
management of a
business
financial expenses
Expenses related to
financing of the
business and its
operations, and to debt
collection
277
Accounting Information for Business Decisions
and debt collection. They include bank charges, interest expense, discounts allowed to customers, bad
debts and debt collectors’ fees.
Stop & think
Why do you think that businesses may report selling expenses separately from general and
administrative expenses?
Some operating expenses involve both sales activities and the general management of a business.
Consider utilities, for example. Suppose a business keeps telephones at sales desks and office desks, and
both sales areas and office spaces are provided with electricity. In these cases, the business allocates part
of the total expense to selling expenses and the remainder to general and administrative expenses, based
on an estimate of how much is used for each activity, as we discussed in Chapter 4.
Case Exhibit 7.4 shows a detailed schedule of Café Revive’s operating expenses for January 20X2.
Emily developed this schedule from the balances in Café Revive’s expense accounts at the end of January.
These balances are based on all the expense transactions Emily recorded in the accounts in January.
Although we do not show these expense accounts here, the amounts she recorded are the same as those
in the ‘Expenses’ column in Case Exhibits 4.20 and 4.21 in Chapter 4. For clarity, we have identified the
number of the 20X2 transaction listed in Chapter 4 that caused each expense. Most of Café Revive’s
Case Exhibit 7.4 Café Revive’s operating expenses
CAFÉ REVIVE
Schedule 1: Operating expenses
For month ended 31 January 20X2
Chapter 4
transaction no.
Amount
Selling expenses:
Consulting expense
$ 247.50
(7)
Advertising expense
110.00
(8)
Sales salaries expense
1 770.00
(10)
97.50
(11)
142.50
(12)
1 955.00
(16)
Sales mobile and wifi expense
Sales energy expense
Sales supplies expense
Rent expense
Depreciation expense
Total selling expenses
900.00
(17)
19.00
(18)
$5 241.50
General and administrative expenses:
Consulting expense
$
Office salaries expense
Office mobile and wifi expense
Office energy expense
Rent expense
Total general and administrative expenses
82.50
(7)
590.00
(10)
32.50
(11)
47.50
(12)
300.00
(17)
$1 052.50
Financial expenses:
Bank charges
Interest
Total financial expenses
278
$
35.00
(21)
11.00
(21)
46.00
(21)
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Chapter 7 The income statement: Components and applications
operating expenses are selling expenses. However, Emily estimates that one-quarter of each total for
consulting ($330), salaries ($2360), mobile and wifi ($130), energy expenses ($190) and rent ($1200)
expenses are general and administrative expenses.2 Café Revive includes the $5241.50 total selling
expenses and the $1052.50 total general and administrative expenses on its income statement in
Case Exhibit 7.2. The detailed schedule of expenses is included with its income statement so that users
interested in specific types of expenses can get the information they need.
Stop & think
Are you wondering about the $11 interest expense on the loan payable? Should we include it
as an expense even though we have not yet paid it?
Many business expenses are related to waste. Initiatives to reduce waste, such as improving water use
efficiency, installing energy-efficient light globes and increasing the use of recycling, can reduce costs, and
thus increase profitability, while at the same time improving a business’s environmental credentials.
7.5 Evaluating the income
statement using ratios
To help you understand how internal and external decision makers use income statements, we will first
briefly review why businesses prepare financial statements and what the statements show. Recall that
accounting information helps managers plan, operate and evaluate business activities. Managers use
accounting information on a day-to-day basis to help them make decisions (e.g. about what type of sales
return policy to use, or how much inventory to order) that will achieve their objective of earning a profit,
and thereby increase the business’s value. At the end of a specific time period, managers prepare financial
statements to report the cumulative results of their day-to-day decisions to external users. By analysing a
business’s financial statements, external users can evaluate how well managers’ decisions have worked and
decide whether to work with the business.
If you are a creditor, a business’s financial statements help you decide whether to loan money to the
business and, if so, under what loan arrangements (e.g. the interest rate to charge, the amount of time to
allow before the loan must be repaid and the restrictions to place on the business’s ability to borrow
additional money). If you are an investor, a business’s financial statements help you estimate the return
you may expect on your investment and to decide whether you want to become or continue to be an
owner.
Ethics and Sustainability
5
What are the main
concerns of external
decision makers when
they use a business’s
income statement to
evaluate its performance?
Stop & think
Who else do you think is interested in a business’s financial statements? Why?
Investors use the income statement to help judge their return on investment and creditors use it to help
make loan decisions. On what do these users base their evaluations? To make their business decisions,
financial statement users evaluate a business’s risk, operating capability and financial flexibility. Although these
may sound like complicated terms, once we have explained them, you will see that they describe the main
concerns of most investors and creditors.
When investors or creditors use the income statement to evaluate a business’s risk, they are estimating
the chances that the business will not earn a satisfactory profit, or that it will earn a higher-than-expected
profit, in the future. As we introduced in Chapter 2, risk refers to this uncertainty about the future earnings
potential of a business. The greater the chance that a business will earn a satisfactory or higher-than-
2
For simplicity, the salaries, supplies and utilities expense allocations are rounded to the nearest dollar.
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279
Accounting Information for Business Decisions
expected profit, the less risk there is in investing in that business. As the likelihood that a business will
earn a satisfactory profit decreases, or the likelihood that it will earn a lower-than-expected profit increases,
the risk of investing in that business increases. A business’s ‘risk factor’ affects the expected investment
return that is needed to attract investors, as well as the interest rate that creditors charge on that
business’s loans. The greater the risk, the higher the required rate of return and the interest rate will be.
External users evaluate a business’s operating capability and financial flexibility because these factors
help to determine a business’s level of risk. Operating capability refers to a business’s ability to continue a
given level of operations in the future. For example, by comparing a business’s current set of financial
statements with those of previous years, external users can learn about the business’s ability to earn a
stable stream of operating income. If the statements show that the business can do this, the chances are
good that the business will be able to maintain its current level of operations in the future.
Financial flexibility refers to a business’s ability to adapt to change in the future. External users want to
see evidence of financial flexibility because this means that a business will be able to take advantage of
business opportunities, such as introducing a new product or building a new warehouse. As you would
expect, investors want the business to grow, so they prefer businesses that have financial flexibility. We
will discuss these concepts further in Chapter 8.
Discussion
Do you think your level of personal financial flexibility is high or low? Why?
Ratios
ratio analysis
Calculations made in
financial analysis in
which an item on a
business’s financial
statements is divided
by another related item
To evaluate a business’s operating performance, managers and external users may perform ratio analysis.
Ratio analysis consists of calculations in which an item on the business’s financial statements is
divided by another related item. Although individual users may calculate ratios themselves, groups that
specialise in financial analysis calculate and publish ratios for many businesses and industries. The ratios
are benchmarks that are used to compare a business’s performance with that of previous periods and
with that of other businesses. There are many commonly calculated ratios, which we will discuss in later
chapters. As an introduction, we will discuss two that relate to profitability – the profit margin and gross
profit percentage – since profitability affects risk, operating capability and financial flexibility.
Profit margin
profit margin
Net income divided by
net sales
6
What type of analysis is
used by external decision
makers to evaluate a
business’s profitability?
One ratio is the profit margin (sometimes called the return on sales), which is usually expressed as a
percentage. A business’s profit margin is calculated as follows:
Profit margin =
Net income
Net sales
If a business’s profit margin is higher than that of previous years, or higher than that of other
businesses, it usually means that the business is doing a better job of controlling its expenses in relation
to its sales.
The profit margin of Café Revive for January 20X2 is calculated as follows, based on the information
in Case Exhibit 7.2:
4 325
¼ 25:62%
16 880
This means that, on average, 2.56 cents of every sales dollar is profit (net income) for Café Revive.
Since this is Café Revive’s first month of operation, we cannot compare the 25.62 per cent profit margin
for January with the profit margins of previous months. However, this profit margin during initial
operations is a positive sign.
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Chapter 7 The income statement: Components and applications
Gross profit percentage
A second ratio is the gross profit percentage (sometimes called the gross profit margin), which relates a
business’s gross profit to its net sales. A business’s gross profit percentage is calculated as follows:
Gross profit percentage ¼
Gross profit
Net sales
gross profit
percentage
Gross profit divided by
net sales
A retail business’s gross profit generally ranges from 20 per cent to 60 per cent of net sales, depending
on the types of products it sells or its pricing strategy. For example, some businesses use a pricing
strategy of offering lower selling prices to increase their sales volume, thereby increasing their total gross
profit. We can calculate the gross profit percentage of Café Revive for coffee gift packs for January
20X2 as:
5760
¼ 48%
12000
This means that, on average, 48 cents of every sales dollar (after the cost of goods sold is subtracted)
is left to cover operating expenses and other expenses and to increase Café Revive’s net income. Again, we
cannot make comparisons with previous months, but this 48 per cent gross profit margin for January for
coffee gift packs is within the range of a retail business’s usual gross profit. This is another positive sign of
Café Revive’s successful initial operating capability. The managers of a retail business keep a close watch
on the business’s gross profit because changes in gross profit typically result in large changes in net
income.
Profitability ratios of actual businesses
To illustrate ratio analysis, we will use information from the financial statements of two retail businesses,
Super Retail Group Limited (which includes Supercheap Auto, BCF, Amart Allsports, Ray’s Outdoors,
Rebel Sports and Goldcross Cycles; see http://www.superretailgroup.com.au) and Woolworths Group
Limited (which includes Big W and BWS and see https://www.woolworthsgroup.com.au). These two
companies’ profit margin percentages3 for the year ended 30 June 2018 were as follows:
Super Retail Group
Profit margin percentage
4.94%
Woolworths
d
3.15%
When we compare these two ratios, Super Retail Group was more successful at generating net income
from its revenues than Woolworths.
Stop & think
Would you expect Super Retail Group’s gross profit percentage also to be higher than
Woolworths’? Why or why not?
Now let’s compare the gross profit percentages4 for the two businesses.
Super Retail Group
Gross profit percentage
45.22%
Woolworths
29.33%
3
We use well-known corporations such as Super Retail Group and Woolworths in this illustration because the financial
statements of most small entrepreneurial businesses are not publicly available. For simplicity, we do not show the calculations
of the ratios, although the numbers were taken from each business’s financial statements. For instance, we calculated profit
margin percentage by dividing net income by sales.
4
Gross profit percentage is calculated as ([Revenue – Cost of goods sold]/Revenue).
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281
Accounting Information for Business Decisions
Notice that Super Retail Group had a higher gross profit percentage and a higher profit margin
percentage than Woolworths. Based on a comparison of these ratios, we can say that Super Retail Group
was more efficient than Woolworths in controlling both the costs of merchandise and the costs of
operating expenses.
Stop & think
How else might you explain the differences in the ratios of the two businesses?
We will expand the discussion of operating capability and financial flexibility in Chapter 8, adding new
ratios for analysis and continuing our comparison of Super Retail Group and Woolworths.
Statement of comprehensive income
In addition to the income statement, the Australian Accounting Standards Board AASB 101 Presentation
of Financial Statements requires that entities present a statement of comprehensive income, which is
effectively the income statement plus all other comprehensive income. According to paragraph 7 of AASB
101, other comprehensive income ‘comprises items of income and expense (including reclassification
adjustments) that are not recognised in profit or loss as required or permitted by other Australian
Accounting Standards’.e
AASB 101 requires disclosures of comprehensive income that allow users of the financial statements
to analyse changes in an entity’s equity resulting from transactions with owners in their capacity as
owners (e.g. dividends and share repurchases), separately from ‘non-owner’ changes (e.g. transactions with
third parties). Owners have been defined as holders of instruments classified as equity.
Other comprehensive income includes non-owner changes in equity, such as asset revaluations, fairvalue movements on available-for-sale financial assets, and the tax implications arising from non-owner
changes in equity.
Examples of other comprehensive income from AASB 101, paragraph 7 are:
• changes in revaluation surplus (see AASB 116 Property, Plant and Equipment and AASB 138
Intangible Assets)
• actuarial gains and losses on defined benefit plans recognised in accordance with paragraph 93A of
AASB 119 Employee Benefits
• gains and losses arising from translating the financial statements of a foreign operation (see AASB
121 The Effects of Changes in Foreign Exchange Rates)
• gains and losses on remeasuring available-for-sale financial assets (see AASB 139 Financial
Instruments: Recognition and Measurement)
• the effective portion of gains and losses on hedging instruments in a cash flow hedge (see AASB 139
Financial Instruments: Recognition and Measurement).
Therefore, ‘profit or loss’ represents the change in equity during a period resulting from transactions
and other events, while ‘other comprehensive income’ represents changes in equity resulting from
transactions with owners in their capacity as owners.
In presenting the statement of profit or loss and other comprehensive income, entities can choose to
present either:
• a single income statement and statement of other comprehensive income
• two statements: the income statement immediately followed by the statement presenting other
comprehensive income.
282
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Chapter 7 The income statement: Components and applications
Example 1 Income statement and statement of comprehensive income in one statement
Statement of comprehensive income
Revenue from continuing operations
20X1 ($000s)
2 100
Other income
420
Raw materials and consumables used
(735)
Employee benefits expense
(525)
Depreciation and amortisation expense
(210)
Impairment of goodwill
(42)
Other expenses
(252)
Finance costs
(105)
Profit before income tax
651
Income tax expense
(189)
Profit from continuing operations
462
Profit for the year
462
Other comprehensive income:
Gain on revaluation of land and buildings
210
Fair value movements on financial assets available for sale
(126)
Income tax relating to components of other comprehensive income
(42)
Other comprehensive income for the year, after tax
42
Total comprehensive income for the year
504
Note: Figures used are for illustration only.
7.6 Linking profit to owner’s
equity and closing the accounts
A business owner’s equity is affected by the owner’s investments and withdrawals, as well as by the
business’s revenue and expense transactions. Although an income statement and its supporting schedules
help external users to understand the results of revenue and expense activities, the statement and
schedules do not include all the activities that affect owner’s equity. A business prepares a supplementary
schedule, called a statement of changes in owner’s equity, for this purpose. This summarises the transactions
that affected owner’s equity during the accounting period. A business presents this statement to ‘bridge the
gap’ between its income statement and the amount of owner’s capital it reports on its balance sheet.
The schedule begins with the balance in the owner’s capital account at the beginning of the accounting
period. Then the total amount of the owner’s investments for the accounting period is added, because this
amount increases the owner’s claim on the business’s assets. Next, the amount of the business’s net
income is added, because this amount also increases the owner’s claim on the business’s assets as a result
of its operating activities for the accounting period. Finally, the amount of withdrawals that the owner
made during the accounting period is subtracted.
Note that the owner’s withdrawals are recorded directly in the owner’s capital account, as we illustrated
in Chapter 4 for Emily’s $250 withdrawal in transaction 6 and in Case Exhibit 4.16. It is important to
understand that withdrawals are not expenses because they are not costs of providing goods or services to
customers. Withdrawals are recorded as reductions of the owner’s capital account because they are
disinvestments of assets by the owner. The final amount on a business’s statement of changes in owner’s
equity is the owner’s capital balance at the end of the accounting period. The business reports this amount
on its ending balance sheet.
By summarising all the transactions affecting the owner’s equity of a business, the statement of
changes in owner’s equity helps to complete the picture of the business’s financial activities for the
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Accounting Information for Business Decisions
Example 2 Income statement and statement of comprehensive income in separate statements
When this option is selected, the statement of comprehensive income is to be presented immediately after the income
statement, as follows:
Income statement
20X1 ($000s)
Revenue from continuing operations
2 100
Other income
420
Raw materials and consumables used
(735)
Employee benefits expense
(525)
Depreciation and amortisation expense
(210)
Impairment of goodwill
(42)
Other expenses
(252)
Finance costs
(105)
Profit before income tax
651
Income tax expense
(189)
Profit from continuing operations
462
Profit for the year
462
Statement of comprehensive income
20X1 ($000s)
Profit for the year
462
Other comprehensive income:
Fair value movements on financial assets available-for-sale
Income tax relating to components of other comprehensive income
Other comprehensive income for the year, after tax
Total comprehensive income for the year
(126)
(42)
42
504
Note: Figures used are for illustration only.
accounting period. External users find this information helpful in evaluating the changes in the claims on
the business’s assets, and changes that have an impact on its risk, operating capability and financial
flexibility.
Stop & think
If you saw a large amount of withdrawals reported in a business’s statement of changes in
owner’s equity, how would this affect your evaluation of its risk? Why?
Case Exhibit 7.5 shows Café Revive’s statement of changes in owner’s equity for the month ended
31 January 20X2. The $22 000 beginning amount of owner’s capital comes from the ‘E Della, capital’
account (shown in Case Exhibit 4.6 in Chapter 4). Emily made no additional investments during the
accounting period, so the next item is net income. The $4325 net income comes from the income
statement in Case Exhibit 7.2. The $250 of withdrawals comes from the ‘E Della, capital’ account in
Café Revive’s accounting records, as we just discussed. The $26 075 ending amount for ‘E Della, capital’
is the amount to be reported as owner’s equity in Café Revive’s 31 January 20X2 balance sheet as
illustrated in Case Exhibit 7.5.
Managers and external users know that a business’s income statement and statement of changes in
owner’s equity do not provide all the financial information needed for business decisions. Information
that is not reported on the business’s income statement can have a big impact on its ability to earn profits
in the future. In the next chapter, we will discuss how managers, investors and creditors use the balance
sheet in conjunction with the income statement to make business decisions.
284
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Chapter 7 The income statement: Components and applications
Case Exhibit 7.5 Café Revive’s statement of changes in owner’s equity
CAFÉ REVIVE
Statement of changes in owner’s equity
For month ended 31 January 20X2
E Della, capital, 1 January 20X2
$22 000
Add: Net income
4 325
$26 325
Less: Withdrawals
(250)
E Della, capital, 31 January 20X2
$26 075
Closing the temporary accounts
Earlier in the chapter, we explained that revenue and expense accounts are temporary accounts used to
accumulate a business’s net income amounts for the accounting period. After a business prepares its
income statement, statement of changes in owner’s equity, balance sheet and cash flow statement for the
accounting period, it prepares closing entries. As we discussed in Chapter 5, closing entries are entries
made by a business to transfer the ending balances from its temporary revenue and expense accounts into
its permanent account for owner’s capital. A business uses closing entries so that when a new accounting
period starts:
1 the revenue and expense accounts (temporary accounts) have zero balances, and no longer contain the
amounts of any transactions from previous periods
2 the accounting system keeps the revenue and expense transactions of the current period separate
from the revenue and expense transactions of other periods
3 the permanent (balance sheet) accounts are up-to-date (i.e. net income has been added to the previous
balance of the owner’s capital account).
We do not illustrate the closing entries for each revenue and expense account because it is too timeconsuming and not necessary for your understanding of how a business’s accounting system works. To
provide an idea of closing entries, however, we will show you a ‘summary closing entry’ for Café Revive.
Recall from Case Exhibit 4.21 that the amounts of the ‘E Della, capital’, ‘Revenues’ and ‘Expenses’
columns at the end of January 20X2 (prior to closing) were ‘E Della, capital’ $21 750 Revenues $16 880
minus Expenses $12 545, which resulted in a net income or profit of $4335. After adjusting for journal
entries for Bank Reconciliation Case Exhibit 6.6 Step 4, Revenues equal $16 905 ($16 880 þ $25) and
Step 5 Expenses $12 580 ($12 545 þ $35) as illustrated in the following table:
7
Why does a business
close off its revenue and
expense accounts at the
end of each period?
temporary accounts
Accounts used for one
accounting period to
record the effects of a
business’s transactions
on its net income
(revenues and
expenses)
Owner’s equity
Owner’s capital
E Della, capital
Balances prior to closing
Summary closing entry
Balances after closing
þ
Net income
Revenues
Expenses
$21 750
$16 905
$12 580
þ$ 4 325
$16 905
$12 580
$26 075
$
0
$
0
Emily prepares the summary closing entry as follows. To decrease the ‘Revenues’ account column to
zero, she subtracts $16 905 from it. Similarly, to decrease ‘Expenses’ to zero, she subtracts $12 580 from
this column. Emily then adds the $4325 difference (which is the net income shown in Case Exhibit 7.2)
to the ‘E Della, capital’ account column. After this summary closing entry, the ‘Revenues’ and ‘Expenses’
columns both have zero balances and are ready to accumulate the revenue and expense information for
February 20X2. Similarly, the Withdrawals (drawings) account is also closed by subtracting the $250 and
transferring this to E Della, capital account (to reduce the capital). After these closing entries the ‘E Della,
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285
Accounting Information for Business Decisions
capital account’ has a balance of $26 075, which is the amount shown in Case Exhibit 7.5. We
emphasise that this is a summary closing entry because in an actual closing entry, a business would close
each revenue account and each expense account to the owner’s capital account. Further, a business’s
accounting period is usually one year, so it would normally prepare its closing entries at the end of the
year rather than at the end of each month.
Stop & think
Which accounts in Café Revive’s accounting system have non-zero balances at 1 February
20X2?
Business Issues and Values: Corporate social responsibility
What is corporate social responsibility (CSR)? Have you ever had a casual job? If so, then
you know that many businesses depend on casual employees in their operations. For some
businesses, casual employees make up a large percentage of their staff. By using casual
employees, these businesses may significantly enhance their financial flexibility because they can
hire and lay off employees quickly. They also avoid having to pay for items such as holiday pay and
sick leave, which businesses normally only pay for full-time or part-time employees. Other
businesses, while using some casual employees to help improve their financial flexibility, have a
different view regarding their commitment to their employees, and believe that it is part of their
social responsibility to hire, train and retain full-time employees. Although these businesses may
have less financial flexibility than those that depend more on casual employees, some investors and
creditors feel that a commitment to full-time employees offsets this limitation.
Environmental disasters can result in costs that have significant impacts on business
profitability. Consider the impact of the BP Gulf of Mexico oil spill in 2010, when an estimated four
million barrels of oil spilt into the ocean over a three-month period. A compensation fund of over
Ethics and Sustainabiity
286
A$20 billion was set up by BP in 2010 to address the social and environmental issues resulting from
the oil spill.f The reputational and financial damage to BP is ongoing.
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Chapter 7 The income statement: Components and applications
STUDY TOOLS
Summary
7.1 Explain the purpose of the income statement.
1
Why is a business’s income statement important?
A business’s income statement is important because it summarises the results (revenues, expenses and net income) of the
business’s operating activities for an accounting period. This information is useful in the decision making of both internal and
external users because it helps to show how well the business’s management has performed during the period and how it is
performing from period to period.
7.2 Understand the importance of measuring financial performance.
2
How are changes in a business’s income statement accounts recorded in its accounting system?
Changes in a business’s balance sheet accounts are recorded in its accounting system by creating a separate column for each asset,
liability and owner’s capital account. These accounts are called permanent accounts because they are used for the life of the
business to record its balance sheet transactions. Changes in a business’s income statement accounts are recorded in its accounting
system by creating a separate column under ‘Owner’s equity’ for each revenue account and each expense account, while still
retaining the ‘Owner’s capital’ account column. A business uses these revenue and expense accounts to record its net income
transactions for only one accounting period, so they are called temporary accounts.
7.3 Discuss the definition and classification of revenue/income.
3
What are the parts of a retail business’s classified income statement, and what do they contain?
The classified income statement of a retail business includes two parts: an ‘Operating income’ section and an ‘Other items’ section.
The operating income section includes revenues, cost of goods sold and operating expenses subsections related to a business’s
primary operating activities. The other items section includes any revenues or expenses that are not directly related to the
business’s primary operations.
7.4 Discuss the definition and classification of expenses.
4
What are inventory and cost of goods sold, and what inventory systems may be used by a business?
Inventory is the merchandise a retail business is holding for resale. Cost of goods sold is the cost to the business of the
merchandise that it sells during the accounting period. A business may use either a perpetual inventory system or a periodic
inventory system. A perpetual inventory system keeps a continuous record of the cost of inventory on hand, the cost of inventory
sold and the cost of goods sold. A periodic inventory system does not keep a continuous record of the inventory on hand and sold,
but uses a physical count to determine the inventory on hand at the end of the accounting period and the cost of goods sold.
7.5 Evaluate the performance of business using ratios.
5
What are the main concerns of external decision makers when they use a business’s income statement to
evaluate its performance?
When external decision makers use a business’s income statement to evaluate its performance, they are concerned with the
business’s risk, operating capability and financial flexibility. Risk is uncertainty about the future earnings potential of the business.
Operating capability refers to the business’s ability to continue a given level of operations. Financial flexibility refers to the
business’s ability to adapt to change.
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287
Accounting Information for Business Decisions
6
What type of analysis is used by external decision makers to evaluate a business’s profitability?
Ratio analysis is used by external users to evaluate a business’s profitability. It involves calculations in which an item on the
business’s financial statements is divided by another related item. The ratios are compared with the business’s ratios in previous
periods, or with other businesses’ ratios. The ratios used to evaluate a business’s profitability include the profit margin (net
income/net sales) and the gross profit percentage (gross profit/net sales).
7.6 Link outcomes from the income statement to owner’s equity and close the accounts.
7
Why does a business close off its revenue and expense accounts at the end of each period?
The income statement summarises the results of the business by matching revenues and expenses to determine profit or loss. This
result should flow onto the owners of the business. The statement of changes in owner’s equity helps to complete the picture in terms
of the accounting cycle and the financial outcome (profit or loss) of the business which flows to the owners.
Revenue and expense accounts are viewed as temporary accounts used to accumulate information about the total revenues and
expenses for a period. At the end of the period, balances are transferred to a profit and loss summary to enable calculation of the
profit or loss for the period and close the accounts to zero balance.
Key terms
cash discount
gross profit percentage
profit margin
cost of ending inventory
in transit
quantity discount
cost of goods sold
net purchases
ratio analysis
credit memo
operating expenses
sales allowance
financial expenses
operating income
sales discount
FOB destination point
other items
sales return
FOB shipping point
periodic inventory system
selling expenses
general and administrative expenses
permanent accounts
temporary accounts
gross profit
perpetual inventory system
Online research activity
This activity provides an opportunity to gather information online about real-world issues related to the topics in this chapter. For
suggestions on how to navigate various businesses’ websites to find their financial statements and other information, see the related
discussion in the Preface. Put your skills to the test and find answers to the following questions by visiting the listed websites:
u Go to Super Retail Group’s website (http://www.superretailgroup.com.au). Find the business’s income statements. Calculate
the profit margin and the gross profit percentage for the most current year. How do these results compare with the year-ended
30 June 2016 ratios we discussed in this chapter?
u Go to Woolworths’ website (https://www.woolworthsgroup.com.au). Find the business’s income statements. Calculate the
profit margin and the gross profit percentage for the most current year. How do these results compare with the year ended 30
June 2016 ratios we discussed in this chapter?
Integrated business and accounting situations
Answer the following questions in your own words.
Testing your knowledge
7-1
7-2
7-3
7-4
7-5
288
In terms of the accounting equation, where are changes in revenue and expense accounts recorded?
Explain how managers use a business’s income statement for decision making.
What are the main types of accounts included in the Income statement to determine profit or loss? Define each.
What is the difference between temporary and permanent accounts?
What is the matching principle?
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Chapter 7 The income statement: Components and applications
7-6
7-7
7-8
7-9
7-10
7-11
7-12
7-13
7-14
7-15
7-16
7-17
7-18
7-19
7-20
7-21
7-22
7-23
7-24
7-25
7-26
Identify the parts and subsections of a retail business’s classified income statement. What is included in each part?
When do businesses normally recognise and record (a) revenues and (b) expenses?
Explain the difference between a quantity discount and a sales (cash) discount.
Explain the difference between a sales return and a sales allowance.
What is a perpetual inventory system? How is a business’s cost of goods sold determined under this system?
What is a periodic inventory system? How is a business’s cost of goods sold determined under this system?
What is the difference between operating expenses and non-operating expenses. Give examples of each.
Explain the difference between selling, general and administrative, and financial expenses.
What is the link between the income statement and the statement of owner’s equity?
Explain the meaning of the terms ‘risk’, ‘operating capability’ and ‘financial flexibility’.
What is ratio analysis and what is it used for?
Explain how to calculate a business’s profit margin. What is this ratio used for?
Explain how to calculate a business’s gross profit percentage. What is this ratio used for?
Explain what is included in a business’s statement of changes in owner’s equity and how the statement is used.
What are closing entries and why are they used?
What is ‘other comprehensive income’?
Explain the importance of trends in analysing business performance. What methods and indicators would you use to
analyse performance trends?
What are the limitations of using ratio analysis to make decisions about the performance of a business?
Short-term profits may come at the expense of long-term profits if consideration is not given to the environmental and
social implications of a decision.
a How could a decision that is profitable now have an impact on the social aspects of a business’s operations and reduce
long-term profitability?
b How could environmental risks from a decision that increases profits now reduce long-term profitability?
State whether you think a business would recognise the following as revenue. When would it be recognised?
a Cash sale by business $20 000
b Sale of excess equipment by a restaurant $350
c Hairdressing services for which clients paid cash $120
d Sale of goods on credit by a retailer $180
e A printer received deposit on an order to print stationery for a client $200
f A real estate business receives commission on advance of a sale of a house $3000.
State whether you think a business would recognise the following as an expense. When would it be recognised?
a Depreciation $350
b Wages to be paid in the next month $1200
c Electricity bill due to be paid next month $430
d Purchase of goods for resale $500
e Insurance amount paid at the start of the year in January (now June) $1400
Applying your knowledge
7-27
7-28
On 1 October, Cooper’s Appliance purchased $8800 of goods including GST for resale. On 11 October, it sold $4500 of
these goods that cost $4400 including GST to customers at a selling price of $6600 (including GST). The business uses a
perpetual inventory system, and all transactions were for cash.
Required:
Prepare the following accounts to record this information: Cash at bank, Inventory, Costs of goods sold and Sales.
On 9 February, Simmons Toy Shop made a $198 cash sale (including GST) of merchandise to a customer. The business uses a
perpetual inventory system. The merchandise had cost Simmons Toy Shop $110. On 12 February, the customer was given a
sales allowance of $55 cash (including GST) for a defective item that the customer chose to keep.
Required:
a Prepare account column entries to record this information.
b What source documents would be used to record each transaction?
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289
Accounting Information for Business Decisions
7-29
7-30
290
The Swanlake Tax Services business was established on 1 March of the current year to help clients with their tax planning.
During January, the business entered into the following transactions:
Date
Transactions
2 Mar.
Mr Swan set up the business by investing $15 000 in the business’s bank account
3
The business paid $6600 (including GST) in advance for one year’s rent of office space
4
Office equipment was purchased at a cost of $12 100 (including GST). A down payment of $2000 was made, and a loan payable
was signed for the balance owed. The note is due in one year
7
Office supplies were purchased for $1870 cash (including GST)
16
Fees of $5500 (including GST) were collected from clients for tax services provided during the first half of March
29
A salary of $2300, which included $300 PAYG tax, was paid to the office secretary
30
Mr Swan withdrew $2500 for personal use
31
The March electricity bill of $264 (including GST) was received; it will be paid in early April
31
Clients were billed $6600 including GST for tax services performed during the second half of March
31
Swan recorded the following adjustments:
a Rent expense for the month
b Depreciation of $90 on office equipment
c Interest expense of $110 on the loan payable
d Office supplies used (the office supplies on hand at the end of the month were $1440).
Required:
a Using the following column headings or account titles, prepare a worksheet to record the above transactions: date,
cash, prepaid rent, office equipment, office supplies, accounts receivable, GST paid, notes payable, electricity payable,
GST collected, PAYG payable, capital, tax service revenue, salary expense, electricity expense, rent expense,
depreciation, interest expense, office supplies expense.
b Prepare a trial balance.
c Prepare a classified income statement for the business for March.
d Prepare a balance sheet for the business on 31 March.
e Briefly comment on how well the business did during March.
The Speedy Answering Service business was started on 1 July of the current year to answer the phones of doctors, lawyers
and accountants when they are away from their offices. The following transactions of the business occurred and
adjustments were made in July:
Date
Transactions
1 Jul.
M Salmon started the business by investing $7500 cash
2
The business paid cash of $2475 (including GST) in advance for six months’ rent of office space
3
The business purchased telephone equipment costing $13 750 (including GST), paying $3750 down and signing a $10 000 note
payable for the balance owed
6
Office supplies totalling $1237.50 (including GST) were purchased on credit. The amount is due in early August
15
The business collected $2200 (including GST) from clients for answering services performed during the first half of July
28
M Salmon withdrew $1500 for personal use
29
The April $275 (including GST) utility bill was received; it is to be paid in August
30
The business paid $875 salary to a part-time employee. This includes $125 PAYG tax
30
Clients were billed $1925 (including GST) for answering services performed during the last half of July
30
M Salmon recorded the following adjustments:
a Rent expense for July
b Depreciation of $105 on telephone equipment
c Interest of $100 on the note payable
d Office supplies used of $145.
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Chapter 7 The income statement: Components and applications
7-31
7-32
Required:
a As for question 7-29a, record the above transactions in appropriate accounts.
b Prepare a simple income statement for the business for July.
c Prepare a balance sheet for the business on 31 July.
d Briefly comment on how well the business did in July.
The Jung Art Supplies business sells various art supplies to local artists. The business uses a perpetual inventory system. The
balance of its inventory of art supplies at the beginning of October was $3000. Its cash balance was $960 and the ‘Jung, capital’
balance was $3960 at the beginning of October. Ms Jung entered into the following transactions in October:
Date
Transactions
1 Oct.
Ms Jung invested another $1200 cash into the business
2
Purchased $528 (including GST) of art supplies for cash
4
Made an $1188 (including GST) sale of art supplies on credit to P Tarrant, with terms of n/15; the cost of the inventory sold was
$660
6
Purchased $924 (including GST) of art supplies on credit from Ray’s Paints, with terms of n/20
10
Returned, for credit to its account, $120 of defective art supplies purchased on 6 October from Ray’s Paints
12
Made cash sales of $396 (including GST) to customers; the cost of the inventory sold was $240
13
Granted a $30 allowance to a customer for damaged inventory sold on 12 October
15
Received payment from P Tarrant of the amount due for inventory sold on credit on 4 October
25
Paid balance due to Ray’s Paints for purchase on 6 October
Required:
a Record the above transactions in appropriate accounts.
b Determine the balances in all the accounts at the end of October.
c Calculate the gross profit and the gross profit percentage for October.
The Khan Heater business sells portable heaters and related equipment. The business uses a perpetual inventory system, and
its inventory balance at the beginning of September was $3900. Its cash balance was $2250, and the ‘I Khan, capital’ balance
was $6150 at the beginning of September. Khan entered into the following transactions during September:
Date
Transactions
1 Sep.
I Khan invested another $1350 cash into the business
2
Made $825 (including GST) cash sales to customers; the cost of the inventory sold was $420
3
Purchased $2805 (including GST) of heaters for cash from Djokovic Supply
5
Received $412.50 (including GST) cash allowance from Djokovic Supply for defective inventory purchased on 3 September
6
Paid $330 (including GST) for parts and repaired defective heaters purchased from Djokovic Supply on 3 September
8
Made a $2475 (including GST) sale of heaters on credit to Botham Nursing Home, with terms of
2/10, n/20; the cost of the inventory sold was $1275
15
Purchased $1815 (including GST) of heaters on credit from Donaldson Supplies, with terms of n/15
18
Received amount owed by Botham Nursing Home for heaters purchased on 8 September, less the cash discount
30
Paid for the inventory purchased from Donaldson Supplies on 15 September
Required:
a Record the above transactions in appropriate accounts.
b Determine the balances in all the accounts at the end of September.
c Calculate the gross profit and the gross profit percentage for September.
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291
Accounting Information for Business Decisions
7-33
The following information is available for the Miller & Keen business for the year:
Beginning inventory
$135 000
Ending inventory
150 000
Purchases
306 000
Purchases returns and allowances
7-34
12 000
Required:
Prepare a schedule that calculates the cost of goods sold for the year.
The income statement information of Walten Furniture business for 20X2 and 20X3 is as follows.
20X2
Cost of goods sold
(a)
$95 360
Interest expense
960
00
Selling expenses
(b)
17 280
Operating income
34 880
(d)
153 600
(e)
12 640
(f)
Net income
(c)
34 560
Interest revenue
0
960
62 400
64 320
Sales (net)
General expenses
Gross profit
7-35
Required:
Fill in (a)–(f). All the necessary information is given. (Hint: It is not necessary to find the answers in alphabetical order.)
The following information is taken from the accounts of Harrison’s Moto Shop for the month of January of the current
year:
Cost of goods sold
$ 97 200
Sales revenue (net)
158 400
Selling expenses
9 000
Interest expense
1 800
General and administrative expenses
7-36
21 600
Required:
a Prepare a classified income statement for Harrison’s Moto Shop.
b Calculate Harrison’s profit margin.
The following information is taken from the accounts of Xeno’s Music Store for the current year ended 31 December:
Depreciation expense: office equipment
Interest revenue
$ 1 920
870
Sales salaries expense
9 840
Rent expense
2 160
Depreciation expense: shop equipment
2 880
Sales revenue (net)
Office salaries expense
113 040
4 800
Interest expense
300
Office supplies expense
720
Cost of goods sold
Advertising expense
292
$
20X3
71 280
432
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Chapter 7 The income statement: Components and applications
7-37
Of the rent expense, five-sixths is applicable to the shop and one-sixth is applicable to the office.
Required:
a Prepare a classified income statement for Xeno’s Music Store for the current year.
b Calculate the profit margin.
c Calculate the gross profit percentage. Does this percentage fall near the high or the low end of the range of typical
retail businesses’ gross profit percentages?
The 31 December 20X3 income statement accounts and other information of Lyon’s Fashion are shown below.
Advertising expense
$ 6 450
Depreciation expense: shop equipment
2 400
Depreciation expense: building (shop)
5 550
Depreciation expense: office equipment
3 450
Depreciation expense: building (office)
1 650
Interest revenue
2 550
Interest expense
1 350
Cost of goods sold
95 850
Insurance expense
525
Sales (net)
7-38
153 000
Office supplies expense
720
Shop supplies expense
1 200
Sales salaries expense
5% of net sales
Office salaries expense
3 900
Utilities expense (shop)
2 250
Utilities expense (office)
600
Required:
a Prepare a classified 20X3 income statement for Lyon’s Fashion.
b Calculate the profit margin for 20X3. If the profit margin for 20X2 was 12.5 per cent, what can be said about the 20X3
results?
Four independent cases related to the owner’s equity account of the Schmidt business are as follows:
Schmidt, capital
Net income
Withdrawals
Schmidt, capital
1 May
for May
in May
31 May
(a)
$5 400
Case
1
7-39
$
2
74 000
3
54 400
1 800
(b)
4
68 000
7 640
$2 000
$51 400
3 440
80 500
(c)
3 000
49 600
(d)
Required:
Determine the amounts of (a)–(d).
The beginning balance in the ‘S Carton, capital’ account on 1 March of the current year was $36 800. For March, the
Carton business reported total revenues of $12 800 and total expenses of $6800. In addition, S Carton withdrew $2240
for her personal use on 25 March.
Required:
Prepare a statement of changes in owner’s equity for March for the Carton business.
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293
Accounting Information for Business Decisions
7-40
The Maximo business shows the following amounts in its owner’s equity accounts at the end of December:
R Maximo, capital: $45 080
u Revenues: $80 220
u Expenses: $59 920.
Required:
Set up the account balances in account columns and prepare summary closing entries at the end of December.
A business engages in many types of activities.
Required:
For each of the following sets of changes in a business’s accounts, give an example of an activity that the business could
engage in that would cause these changes, and explain why you think the activity would cause these particular changes:
a Increase in an asset and decrease in another asset
b Increase in an asset and increase in a liability
c Increase in an asset and increase in owner’s equity
d Increase in an asset and increase in a revenue
e Decrease in an asset and increase in an expense
f Decrease in an asset and decrease in a liability.
During the current accounting period, the bookkeeper for Foley made the following errors in the year-end adjustments:
u
7-41
7-42
Effect of error on:
Error
Example: Failed to record $240 of salaries owed at the
end of the period
Net
income
Revenues
Expenses
N
U
O
$240
$240
Assets
Liabilities
Owner’s
equity
N
U
O
$240
$240
1 Failed to adjust prepaid insurance for $480 of expired
insurance
2 Failed to record $600 of interest expense that had
accrued during the period
3 Inadvertently recorded $360 of annual depreciation
twice for the same equipment
4 Failed to record $120 of interest revenue that had
accrued during the period
5 Failed to reduce unearned revenues for $720 of
revenues that were earned during the period
7-43
7-44
294
Required:
Assuming that the errors are not discovered, indicate the effect of each error on revenues, expenses, net income, assets,
liabilities and owner’s equity at the end of the accounting period. Use the following code: O ¼ Overstated, U ¼ Understated
and N ¼ No effect. Include dollar amounts. Be prepared to explain your answers.
The statement of profit and loss for JT Andrews for the financial year ended 30 June 2019 reports that the business had
increased its gross profit from $123 000 in 2018 to $147 000 in 2019. Its net profit for 2019 was $59 000 compared with
$49 000 in 2018.
Suggest reasons why
Required:
a the gross profit may have risen
b the net profit changed.
Suppose you own a retail business and are considering whether to allow your customers to have quantity discounts, sales
discounts and sales allowances.
Required:
How do you think quantity discounts, sales discounts and sales allowances would affect the results of a business’s CVP analysis
and its budgets? Explain what the effects would be. If a business gives quantity discounts, sales discounts and sales allowances,
what information would it need to conduct CVP analysis and develop budgets? (What questions would you have to ask?)
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Chapter 7 The income statement: Components and applications
7-45
7-46
7-47
7-48
Your friend Georgia is planning to open an automobile parts shop and has come to you for advice about whether to use a
perpetual or a periodic inventory system.
Required:
Before you advise Georgia, list the questions you would like to ask her. How would the answer to each question help you
advise her? Explain to her the advantages and disadvantages of each system.
Yvonne Martin owns a hairdressing shop, In-style Now. It is September 20X3 and Yvonne thinks she might need a bank
loan. Her bank has asked Yvonne to prepare a projected income statement and to calculate the projected profit margin for
next year. Although she has never developed this information before, she understands that to do so, she must make a
‘best guess’ of her revenues and expenses for 20X4, based on past activities and future estimates. She asks for your help,
and provides you with the following information:
a Styling revenues for 20X3 were $98 000. Yvonne expects these to increase by 10 per cent in 20X4.
b In-style Now employees are paid a total ‘base’ salary of $42 000 plus 20 per cent of all styling revenues.
c Hairdressing supplies used have generally averaged 15 per cent of styling revenues; Yvonne expects this relationship to
be the same in 20X4.
d In-style Now recently signed a two-year rental agreement on its shop, requiring payments of $560 per month, payable
in advance.
e The cost of utilities (electricity, water, phone) is expected to be 25 per cent of the yearly rent.
f In-style Now owns styling equipment that cost $16 800. Depreciation expense for 20X4 is estimated to be one-sixth of
the cost of this equipment.
Required:
Prepare a projected income statement for In-style Now for 20X4 and calculate its projected profit margin. Show your calculations.
The Hewitt Newsagency had a fire and lost some of the accounting records it needed to prepare its 20X3 income
statement. Dave Hewitt, the owner, has been able to determine that his capital in the business was $38 400 at the
beginning of 20X3 and was $39 600 at the end of 20X3. During 20X3, he withdrew $16 800 from the business. Dave has
also been able to remember or determine the following information for 20X3:
a Cash service revenues were three times the amount of net income; credit service revenues were 40 per cent of cash
service revenues.
b Rent expense was $600 per month.
c The business has one employee, who was paid a salary of $24 000 plus 20 per cent of service revenues.
d The supplies expense was 15 per cent of the total expenses.
e The utilities expense was $120 per month for the first nine months of the year and $240 per month during the
remaining months of the year, due to the cold winter.
Dave also knows that the business owns some office equipment, but he cannot remember the cost or the amount of
depreciation expense.
Required:
Using the above information, prepare Hewitt Newsagency’s 20X3 income statement and calculate its profit margin. Show
supporting calculations.
Your boss has given you two businesses’ income statements from last year and asked you to recommend the one in which
your business should invest. The income statements include the following information (in thousands):
Consolidated Confectionery
Net sales
Groovy Foods
$2 720 000
$4 000 000
1 768 000
2 720 000
Selling expenses
410 588
624 000
General and administrative expenses
229 082
220 000
Net income
312 330
436 000
Cost of goods sold
Required:
a Based on this information alone, which business would be the better investment choice? Explain your answer.
b What other information would you like to have in order to make a more informed decision? How would this
information help you recommend the business in which you think you should invest?
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295
Accounting Information for Business Decisions
7-49
7-50
A paragraph in the recent financial statements of Winfred Discount Stores begins as follows: ‘Advertising, selling,
administrative and general expenses increased as a percentage of sales in 20X1 compared to 20X0. This occurred because
of the slower growth rate of sales during the year as compared to prior years.’
Required:
How does the second sentence explain the first? Explain in more detail how this could happen.
On 3 January 20X2, Drew Kent agreed to buy Sharp Repair and Services from Nadine Joyner. They agreed that the
purchase price would be five times the 20X3 net income of the business. To determine the price, Nadine prepared the
following condensed income statement for 20X3:
Revenues
$ 144 000
Expenses
(108 000)
Net income
7-51
$ 36 000
Nadine said to Drew, ‘Based on this net income, the purchase price of the business should be $180 000 ($36 000 5). Of
course, you may look at whatever accounting records you would like.’ Drew examined the business’s accounting records
and found them to be correct, except for several balance sheet accounts. These accounts and their 31 December 20X3
balances are:
u two asset accounts – ‘Prepaid rent’: $10 800; and ‘Equipment’: $14 400
u one liability account – ‘Unearned repair service revenues: $0.
Drew gathered the following business information related to these accounts. The business was started on 2 January 20X0.
At that time, the business rented space in a building for its operations and purchased $19 200 of equipment. At that time,
the equipment had an estimated life of eight years, after which it would be worthless. On 1 July 20X3, the business paid
one year of rent in advance at $900 per month. On 1 September 20X3, customers paid $1800 in advance for cleaning
services to be performed by the business for the next 12 months.
Drew asks for your help. He says, ‘I don’t know how these items affect net income, if at all. I want to pay a fair price
for the business.’
Required:
a Discuss how the 20X3 net income of Sharp Repair and Services was affected, if at all, by each of the items listed.
b Prepare a corrected condensed 20X3 income statement.
c Calculate a fair purchase price for the business.
Neil Russell, the owner and bookkeeper for Jiffy Couriers, was confused when he prepared the following financial
statements:
Jiffy Couriers profit and expense statement
31 December 20X3
Expenses:
Salaries expense
$ 31 500
Utilities expense
5 100
Accounts receivable
2 400
N Russell, withdrawals
30 000
Office supplies
2 250
Total expenses
$(71 250)
Revenues:
Service revenues
$ 70 500
Accounts payable
1 650
Accumulated depreciation: office equipment
2 700
Total revenues
Net revenues
296
$ 74 850
$ 3 600
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Chapter 7 The income statement: Components and applications
Jiffy Couriers balancing statement
For year ended 31 December 20X3
Liabilities
Mortgage payable
Accumulated depreciation: building
Total liabilities
Assets
$40 500 Building
9 600 Depreciation expense: building
$50 100 Office equipment
Depreciation expense: office equipment
N Russell, capital*
Total liabilities and owner’s equity
$66 000
2 400
14 550
1 350
40 500
$90 600 Cash
Total assets
6 300
$90 600
* $36 900 beginning capital þ $3600 net revenues.
Neil asks for your help. He says, ‘Something is not right! My business had a fantastic year in 20X3; I’m sure it made more than
$3600. I don’t remember much about accounting, but I do recall that ‘‘accumulated depreciation’’ should be subtracted from the
cost of an asset to determine its book value.’ You agree, based on your understanding of the depreciation discussion in Chapter
4. After examining the business’s financial statements and related accounting records, you find that, with the exception of office
supplies, the amount of each item is correct, even though the item might be incorrectly listed in the financial statements. You
determine that the office supplies used during the year amount to $1200, and that the office supplies on hand at the end of the
year amount to $1050.
Required:
a Review each financial statement and indicate any errors you find.
b Prepare a corrected 20X3 income statement, statement of changes in owner’s equity and ending balance sheet.
c Calculate the profit margin for 20X3 to verify or refute Mr Russell’s claim that his business had ‘a fantastic year’.
Dr Decisive
Yesterday, two letters arrived for your advice column in the local paper, as follows:
Dr Decisive,
I can’t believe I am writing to you. In the past, I have always tried to solve my own problems but now I have
one I can’t solve on my own. My housemate and I are studying accounting together. Late one night - or maybe
I should say early one morning - we were debating where insurance goes on an income statement. I think it
should go in the ‘Other items’ section, but my housemate thinks it should go in ‘Operating expenses’under
financial expenses. We could argue about this forever, since neither of us is willing to give in. My housemate
agrees that we will accept your answer. If I win, I don’t have to pay my housemate interest on the money I
owe her.
‘Interested’
Required
Meet with your Dr Decisive team and write a response to ‘Interested’.
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297
Accounting Information for Business Decisions
Dear Dr Decisive,
I think I must be losing my mind! I have just been looking over some annual reports with my girlfriend. I
was trying to impress her with my knowledge. But then I started to explain to her about inventory, cost of
goods sold, and measures of performance like gross profit and inventory turnover. I got lost trying to
explain why some companies use one method, other similar companies use a different method and others
use three different methods. Is all this just to help keep accountants in jobs? My girlfriend made sense
when she said, ‘When I go into a clothing store, I just pick the one that is on top of the pile, but when I
buy food, I always look for the package with the latest expiry date. Is there an accountant watching me
through the security camera to check which I buy?’
Call me . . .
‘Inventor-ially Impaired’
Required:
Meet with your Dr Decisive team and write a response to ‘Inventor-ially Impaired’.
Endnote
a
Quoted in Miller, RL (2015) Business Law Today, Comprehensive: Text and Cases: Diverse, Ethical, Online, and Global Environment
(10th ed.). Stamford, CT: Cengage Learning, 755.
b
All Woolworths Group figures sourced from the company’s 2016 annual report, available at https://wow2016ar.qreports.com.au/.
c
David Jones Limited, https://www2.davidjones.com.au/services/returns_policy.jsp.
d
All Super Retail Group figures sourced from the company’s 2016 annual report, available at http://media.supercheapauto.com.au/
corp/files/documents/SRG_AnnualReport20.pdf.
e
AASB Standard (AASB101) Presentation of Financial Statements July 2015 ª Australian Accounting Standards Board.
f
United States Environmental Protection Agency (2017) ‘Deepwater Horizon – BP Gulf of Mexico oil spill’. https://www.epa.gov/
enforcement/deepwater-horizon-bp-gulf-mexico-oil-spill.
List of company URLs
u
u
u
u
David Jones: http://www.davidjones.com.au
Super Retail Group: http://www.superretailgroup.com.au
The Good Guys: http://www.thegoodguys.com.au
Woolworths Group Limited: http://www.woolworthslimited.com.au
298
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Chapter 7 Appendix: Calculating the cost and the amount of inventory
APPENDIX
Calculating the cost and the
amount of inventory
Why is inventory management one of the key functions for managing the profitability of a business?
Under AASB 102 Inventories, the cost of each unit of inventory includes all the costs incurred to bring
the item to its existing condition and location. Thus, the cost of inventory includes the purchase price
(less any purchases discounts), GST, applicable transportation costs, insurance, customs duties and similar
costs. When a cost, such as the cost of ordering the inventory, is difficult to associate with a particular
inventory item, many companies record it as a general and administrative expense. A business determines
the cost of each unit of inventory by reviewing the source documents (e.g. invoices) that it uses to record
the purchase of the inventory.
AASB 102 also states that ‘inventories shall be measured at the lower of cost and net realisable value’.
This means that if the net realisable value of inventory falls below its cost, it must be revalued so that its
value is not overstated and reflects net realisable value. Net realisable value is equal to the selling price of
the inventory goods less the selling costs.
A business needs to continuously examine the value of inventory to see if its recorded cost should be
reduced due to factors such as obsolescence, damage or spoilage, which result in reduced demand from
customers.
For example, suppose that DeFlava Coffee Corporation has 100 coffee gift packs for which it paid $55
per box (including GST). Only the cost excluding GST is recorded as the cost of inventory; the $5 is
recorded as GST paid. Therefore, if the replacement cost of the gift packs declines to $40 per box
(excluding GST), the business will revalue the inventory on its balance sheet at $40 per box because $50
is an overstatement of the value of the asset – inventory – that the company will use to generate future
revenues. The business will report the total of the $10 per unit loss on each coffee gift pack on its income
statement.
Revaluing the cost of inventory avoids carrying forward any losses for recognition in a future period.
Thus, the use of lower of cost or net realisable value is a way to ensure the conservative measurement of
the value of inventory.
Calculating the amount of inventory
When a business takes a physical inventory (stocktake), it counts the units of inventory in its stores and
warehouses (and factories). The company may also own additional units of inventory that are in transit. In
transit means that a freight company is in the process of delivering the inventory from the selling
company to the buying company. The company (the buyer or the seller) that has economic control over
the items in transit includes them in its inventory. Typically, economic control transfers at the same time
legal ownership transfers.
A company may buy or sell inventory under terms of free on board (FOB) shipping point or FOB
destination. FOB shipping point means that the selling company transfers ownership to the buyer at the
place of sale (shipping point) – that is, before the inventory is in transit. The selling company excludes these
items in transit from its inventory; the buying company includes them in its inventory. The buying
company is responsible for any transportation costs incurred to deliver the items, and includes those costs
as a cost of its inventory (rather than immediately recording them as an expense). The free on board
(FOB) destination point refers to the selling company transferring ownership to the buyer at the place of
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in transit
When a freight
company is in the
process of delivering
the inventory from the
selling company to the
buying company. The
company (the buyer or
the seller) that has
economic control over
the items in transit
includes them in its
inventory. Typically,
economic control
transfers at the same
time legal ownership
transfers
free on board (FOB)
shipping point
The selling company
transfers ownership to
the buyer at the place of
sale (shipping point) –
that is, before the
inventory is in transit.
The selling company
excludes these items in
transit from its
inventory; the buying
company includes them
in its inventory. The
buying company is
responsible for any
transportation costs
incurred to deliver the
items, and includes
those costs as a cost of
its inventory (rather
than immediately
recording them as an
expense)
free on board (FOB)
destination point
The selling company
transfers ownership to
the buyer at the place
of delivery (after transit
is completed). The
selling company
includes these items in
transit in its inventory
until delivery takes
place; the buyer
excludes them. In this
case, the selling
company is responsible
for any transportation
costs incurred to
deliver the items and
includes those costs in
its selling expenses
299
Accounting Information for Business Decisions
delivery (after transit is completed). The selling company includes these items in transit in its inventory until
delivery takes place; the buyer excludes them. In this case, the selling company is responsible for any
transportation costs incurred to deliver the items, and includes those costs in its selling expenses.
Using alternative inventory cost flow
assumptions
During the course of business operations, inventory will be purchased at different times and at different
prices. So, in determining cost of goods sold, which of the varying cost prices should be used?
Businesses that use perpetual inventory systems cross-check the actual number of units in their
perpetual inventory records by performing a physical stocktake. In contrast, businesses that use periodic
inventory systems perform a physical stocktake to establish the cost of goods sold at the end of a specific
accounting period. However, the physical flow of inventory is not necessarily the same as the cost flow
assumptions.
Once a business has determined the number of units in its ending inventory and the cost of the units
it purchased during the period, it must determine how to allocate the total cost of these units (the cost of
goods available for sale) between the ending inventory (balance sheet) and the cost of goods sold (income
statement). The following diagram shows this relationship:
Cost of beginning
inventory
Cost of purchases
(or goods manufactured)
Cost of
goods
available
for
sale
Cost of ending
inventory
Cost of
goods sold
Balance
sheet
Income
statement
If the cost of each unit of inventory is the same during the period, the business simply allocates these
costs to ending inventory and cost of goods sold according to how many units it has left and how many it
has sold. It is more difficult to determine which costs a business includes in the ending inventory and
which costs it includes in the cost of goods sold when the costs it incurred to acquire the units changed
during the period. Such changes are common, and under Australian Accounting Standard AASB 102
Inventories, a business can choose one of three alternative cost flow assumptions to allocate its cost of
goods available for sale between ending inventory and cost of goods sold:
1 specific identification
2 first-in, first-out (FIFO)
3 weighted average cost.
As mentioned in Chapter 6, there is also a fourth method that is often used in the US: last-in, first-out
(LIFO). While the use of LIFO is not permitted under the Australian Accounting Standard AASB 102
Inventories, it is still important to understand the LIFO method from a conceptual perspective because it
provides a contrast to FIFO.
A business must disclose in its annual reports the method it uses, and it must use that method
consistently every year. Since we discussed the specific identification method in Chapter 6, in this Appendix,
we will focus on the FIFO, weighted average cost and LIFO methods of inventory cost flow assumptions. To
illustrate, we will discuss each of these methods for the fictional business Echidna Supplies Ltd using the
information in Exhibit 7.6. (For simplicity, we use a month rather than the more common quarterly or annual
accounting period used by actual companies.)
The business has a beginning inventory of $10 500 (1500 units) and makes two purchases (of 750
and 1350 units) during January for a total cost of $17 115 ($5775 þ $11 340). During the month, it sold
1950 units (600, 1050 and 300). Therefore, it must divide its cost of goods available for sale (for its 3600
300
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Chapter 7 Appendix: Calculating the cost and the amount of inventory
Exhibit 7.6 Echidna Supplies – inventory information
Beginning inventory, 1 January
1 500 units @ $7.00 per unit
7 January sale
(600) units
12 January purchase
750 units @ $7.70 per unit
20 January sale
(1 050) units
24 January purchase
1 350 units @ $8.40 per unit
26 January sale
$10 500
5 775
11 340
(300) units
Cost of goods available for sale
Ending inventory, 31 January
$27 615
1 650 units
Notes:
1. The units are sold for $13 per unit.
2. Echidna Supplies Ltd uses the perpetual inventory system.
3. 3600 units are available for sale during January (1500 þ 750 þ 1350).
units available) of $27 615 ($10 500 þ $17 115) among the 1950 units it sold (the cost of goods sold)
and its ending inventory of 1650 units. For our purposes, we assume that Echidna Supplies Ltd uses the
perpetual inventory system. We also assume the company makes only three sales during the month.
When the costs to acquire the inventory have changed during the period, each of the inventory cost
flow assumptions produces different amounts for the cost of goods sold and the ending inventory
balance. It is important to understand that these cost flow assumptions may not be related to the actual
physical flow of the goods in inventory. Typically, a business will use a FIFO physical flow of its inventory
to reduce the risk of obsolescence, but it may still use any of the three allowable cost flow assumptions to
allocate its cost of goods available for sale between ending inventory and cost of goods sold.
First-in, first-out (FIFO)
When a business uses the first-in, first-out (FIFO) cost flow assumption, it includes the earliest (first) costs
it incurred in the cost of goods sold as it sells its products, leaving the latest costs in ending inventory. (In
other words, the business assumes that it sells the inventory in the same order as it purchased it – even if
it may not actually sell the inventory in the same order.) Under the FIFO cost flow assumption, Echidna
Supplies Ltd calculates the cost of goods sold to be $13 965 and the ending inventory to be $13 650, as
we show in Exhibit 7.7. The exhibit has two parts: the upper part shows a diagram of the ‘flow’ of costs,
and the lower part shows schedules calculating the cost of goods sold and the ending inventory.
The business sold 1950 units. Using the FIFO cost flow assumption, the business moves the first
costs it incurred into cost of goods sold first. The most recent costs it incurred remain in inventory.
Therefore, the 600 units sold on 7 January have a cost of $7 per unit from the beginning inventory. After
the sale, the cost of 900 units from the beginning inventory remains in inventory. On 12 January, the
business purchased 750 units at $7.70 per unit. For the 20 January sale of 1050 units, 900 units have a
cost of $7 per unit from the beginning inventory and 150 units have a cost of $7.70 from the 12 January
purchase. After this sale, the cost of 600 units from the 12 January purchase remains in the ‘Inventory’
account. On 24 January, the business purchased 1350 units at $8.40 per unit. For the 26 January sale,
the 300 units have a cost of $7.70 from the 12 January purchase. This leaves the cost of the other 300
units from the 12 January purchase in the Inventory account. The cost of the ending inventory includes
the cost of these 300 units remaining from the 12 January purchase ($2310), as well as the cost of the
1350 units the company purchased on 24 January ($11 340). So the total cost of the 1650 units in
ending inventory is $13 650.
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301
Accounting Information for Business Decisions
Exhibit 7.7 Echidna Supplies Ltd – FIFO cost flow assumption
Diagram
Inventory
Units in
inventory
1/1 Beg. inv.
7/1 Sale
Cost of goods sold
Cost per unit
Total cost of
units in
inventory
8 1 500
< 600
7.00
¼10 500
7.00
(4 200)
: 900
7.00
¼ 6 300
750
7.70
¼ 5 775
12/1 Purchase
1 650
20/1 Sale
Units sold
Cost per unit
Total cost of
units sold
600
7.00
¼4 200
12 075
900
7.00
(6 300)
900
7.00
¼6 300
150
7.70
(1 155)
150
7.70
¼1 155
7.70
¼2 310
600
7.70
4 620
24/1 Purchase
1 350
8.40
¼11 340
26/1 Sale
300
1 950
1 650
15 960
(
300
1350
7.70
(2 310)
300
7.70
13 650
1 950
13 965
8.40
Schedules
Cost of goods sold (1950 units):
7 January
600 units @ $7.00 per unit (from beginning inventory)
$ 4 200
20 January
1 050 units: 900 units @ $7.00 (from beginning inventory)
$ 6 300
26 January
300 units @ $7.70 per unit (from 12 January purchase)
150 units @ $7.70 (from 12 January purchase)
1 950
$ 1 155
$ 2 310
$13 965
Ending inventory (1650 units):
Ending inventory ¼ Beginning inventory þ Purchases Cost of goods sold
$13 650
¼
$10 500
þ $17 115 $13 965
or
Ending inventory ¼ 300 units @ $7.70 (from 12 January purchase)
þ 1350 units @ $8.40 (from 24 January purchase)
$ 2 310
$11 340
$13 650
Weighted average cost
When a business uses the weighted average cost flow assumption under the periodic inventory system, it
allocates the average cost per unit for the period to both the ending inventory and the cost of goods sold.
That is, it combines the costs of all the units available for sale, calculates the average cost, and assigns the
resulting average cost to the units in both the ending inventory and the cost of goods sold.
As we show in Exhibit 7.8, Echidna Supplies Ltd calculates its average cost per unit of $7.67
(rounded) by dividing the total cost of goods available for sale ($27 615) by the number of units available
for sale during the period (3600, which includes the 1500 units in the beginning inventory plus the 2100
units purchased).
302
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Chapter 7 Appendix: Calculating the cost and the amount of inventory
The business calculates the cost of the ending inventory balance to be $12 656.88 for the 1650 units
remaining on hand at the average cost of $7.67 per unit, and calculates the cost of goods sold to be
$14 957, which includes the 1950 units sold at the average cost of $7.67 per unit (adjusted for a $2
rounding error).
When a business uses the weighted average cost flow assumption under the perpetual inventory
system, it must calculate an average cost per unit after each purchase and then assign this new average
cost to items sold until the next purchase (when it calculates another new average cost). This method is
called the moving average cost flow assumption; because it involves tedious calculations, it is not discussed
further in this book.
Exhibit 7.8 Weighted average cost
1 500 units
$7.00 per unit
$10 500
12 January purchase
Beginning inventory, 1 January
750 units
7.70 per unit
5 775
24 January purchase
1 350 units
8.40 per unit
11 340
3600 units
7.67 per unit
27 615
Notes:
1. Weighted average cost: $27 615/3600 ¼ $7.67 per unit.
2. Cost of goods sold: 1950 7.67 ¼ 14 957 (rounded to whole figures).
3. Ending inventory: 1650 7.67¼ 12 656 (rounded to whole figures).
Last-in, first-out (LIFO)
As stated earlier, the use of last in, first out (LIFO) is not permitted under the Australian Accounting
Standard AASB 102 Inventories. This is because at the end of an accounting period, ending inventory
does not reflect the current cost of inventory, so it is not an accurate method of valuation.
When a business uses the last-in, first-out (LIFO) cost flow assumption, it includes the latest (last)
costs it incurred before a sale in its cost of goods sold and the earliest costs (part or all of which are costs
it incurred in previous periods) in ending inventory. (In other words, it assumes that the order in which it
sells the inventory items is the reverse of the order in which it purchased them. Remember, however, that
these cost assumptions are not necessarily the same as the actual physical flows of the inventory.) Under
the LIFO cost flow assumption, Echidna Supplies Ltd calculates the cost of goods sold to be $14 595 and
the ending inventory to be $13 020, as we show in Exhibit 7.9. Again, this exhibit has two parts: the
upper part shows a diagram of the ‘flow’ of costs, and the lower part shows schedules calculating the cost
of goods sold and the ending inventory.
The business sold 1950 units. Using the LIFO cost flow assumption, the business moves the most
recent costs it incurred to purchase inventory into cost of goods sold first. The earliest costs it incurred
remain in the ‘Inventory’ account. The 600 units sold on 7 January have a cost of $7 per unit from the
beginning inventory. On 12 January, the business purchased 750 units at $7.70 per unit. For the 20
January sale of 1050 units, the first 750 of these units have a cost of $7.70 per unit from the 12 January
purchase, and the remaining 300 units have a cost of $7 from the beginning inventory. (Remember we are
assuming that the most recent units purchased are sold first, even though that may not be the case.) On
24 January, the business purchased 1350 units at $8.40 per unit. For the 26 January sale, the 300 units
sold have a cost of $8.40 per unit from the 24 January purchase. The cost of the ending inventory includes
the cost of the remaining 1050 units from the 24 January purchase and the cost of 600 units from
January’s beginning inventory. So the total cost of the 1650 units in ending inventory ($13 020) includes
the cost of 600 units remaining from the beginning inventory ($4200) plus the cost of 1050 units
remaining from the purchase on 24 January ($8820).
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303
Accounting Information for Business Decisions
Exhibit 7.9 Echidna Supplies Ltd – LIFO cost flow assumption
Diagram
Inventory
Units in
inventory
1/1 Beg. inv.
7/1 Sale
Cost of goods sold
Cost per unit
Total cost of
units in
inventory
@$7.00
@$7.00
¼$ 6 300
750
@$7.70
$ 5 775
(4 200)
Total cost of
units sold
600
@$7.00
$ 4 200
¼$12 075
1650
20/1 Sale
Cost per unit
¼10 500
8 1500
<600
: 900
12/1 Purchase
Units sold
750
@7.70
(5 775)
750
$7.70
$ 5 775
300
@7.00
(2 100)
300
$7.00
$ 2 100
300
$8.40
$ 2 520
600
@$7.00
$ 4 200
24/1 Purchase
1350
@$8.40
$11 340
26/1 Sale
300
1950
1650
$15 540
@8.40
(2 520)
600
@$7.00
$13 020
1050
@$8.40
(
$14 595
Schedules
Cost of goods sold (1950 units)
7 January
600 units @ $7.00 per unit (from beginning inventory)
20 January
1050 units: 750 units @ $7.70 (from 12 January purchase)
26 January
300 units @ $8.40 per unit (from 24 January purchase)
300 units @ $7.00 (from beginning inventory)
$ 4 200
$ 5 775
$ 2 100
$ 2 520
$14 595
Ending inventory (1650 units)
Ending inventory ¼ Beginning inventory þ Purchases Cost of goods sold
$13 020
¼
$10 500
þ $17 115 $14 595
or
Ending inventory ¼ 1050 units @ $8.40 (from 24 January purchase)
$ 8 820
þ 600 units @ $7.00 (from beginning inventory)
$ 4 200
$13 020
Testing your knowledge of this chapter’s Appendix
A7-1
A7-2
A7-3
304
Company X purchases inventory under terms FOB destination from Company Y, and the goods
are still in transit. Which company includes the goods in its inventory? Why? How would your
answers change if the purchase had been made under terms FOB shipping point?
Explain which costs are included in cost of goods sold and ending inventory under: (a) FIFO; (b)
weighted average cost; and (c) LIFO cost flow assumptions.
Explain the impact of FIFO and LIFO on a company’s income statement and balance sheet if
costs are rising.
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Chapter 7 Appendix: Calculating the cost and the amount of inventory
A7-4
A7-5
A7-6
Is GST included in the cost of inventory? Why or why not?
What is the formula for calculating cost of goods sold under the periodic inventory system?
Explain what is meant by the lower-of-cost or net realisable value method.
Applying your knowledge of this chapter’s Appendix
A7-7
A7-8
Schulte Tape has a beginning inventory for May of $2500 (250 tapes at $10 each) and makes the
following purchases and sales of tapes during May:
5 May
Purchases
150 tapes @ $11 ¼ $1 650
12
Sales
160 tapes
22
Purchases
150 tapes @ $12 ¼ $1 800
25
Sales
90 tapes
Required:
Calculate the cost of goods sold and the ending inventory for May if the company uses the
following:
a the perpetual inventory system and the FIFO cost flow assumption
b the perpetual inventory system and the LIFO cost flow assumption.
Gomez Folding Chair Company has 400 chairs (at $15 each) in its beginning inventory for July. It
makes the following purchases and sales of chairs during July:
6 Jul.
200 chairs @ $16 each
14
21
220 chairs @ $30 each
140 chairs @ $17 each
29
A7-9
100 chairs @ $30 each
Required:
Calculate the cost of goods sold and the ending inventory for July if the company uses the
following:
a the perpetual inventory system and the FIFO cost flow assumption
b the perpetual inventory system and the LIFO cost flow assumption.
The Russell DVD business had 200 DVDs in its 1 April inventory. It uses the perpetual inventory
system, and it made the following purchases and sales of DVDs during April and May:
9 Apr.
Purchases
20 DVDs for $5 each
17
Sales
30 DVDs
24
Purchases
50 DVDs for $16 each
26
Sales
20 DVDs
8 May
Sales
30 DVDs
15
Purchases
70 DVDs for $17 each
22
Sales
50 DVDs
The FIFO and the LIFO costs of the DVDs in the 1 April inventory were $12 and $8, respectively.
Required:
a Calculate the cost of goods sold and the ending inventory for each month if the company uses
the following:
i the FIFO cost flow assumption
ii the LIFO cost flow assumption.
b Which cost flow assumption provides the more realistic balance sheet amount for ending
inventory? Why? Which provides the more realistic measure of income? Why?
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305
Accounting Information for Business Decisions
A7-10 The Brabham Kite business had the following FIFO costs and replacement costs of kites for its
ending inventory:
Item #
804
Number of units
Unit cost
Unit replacement cost
100
$10
$11
603
150
12
10
331
320
8
6
928
70
20
22
Required:
a Calculate the value of the ending inventory under the lower-of-cost or net realisable value
method.
b How are the company’s financial statements affected by the application of the lower-of-cost or
net realisable value method?
c Show how the ending inventory would be reported on the company’s balance sheet.
A7-11 Slick Suction’s ending inventory of vacuum cleaner parts included the following items:
Item #
Number of units
Unit cost (FIFO)
Unit replacement cost
A12B
50
$100
90
L15C
150
76
82
P27X
200
60
55
W08S
400
10
9
Required:
a Calculate the value of the ending inventory under the lower-of-cost or net realisable value
method.
b Show how the ending inventory would be reported on the company’s balance sheet.
A7-12 Ginther Power Tools Ltd had 100 air compressors in its 1 January inventory. It uses the
perpetual inventory system and the FIFO inventory cost flow assumption. Ginther made the
following purchases of air compressors during January and February:
10 Jan.
50 air compressors for $100 each
20
40 air compressors for $102 each
5 Feb.
20 air compressors for $104 each
18
70 air compressors for $108 each
The costs of the 100 air compressors in the 1 January inventory were 20 units @ $95 and 80
units @ $98. Sales during January and February were 80 air compressors and 100 air
compressors, respectively.
Required:
Calculate the ending inventory and the cost of goods sold for each month.
A7-13 Johnson Watches Ltd had 300 watches in its 1 July inventory. The company uses the perpetual
inventory system and made the following purchases of watches during July and August:
8 Jul.
840 watches for $20 each
27
100 watches for $21 each
18 Aug.
1850 watches for $22 each
24
60 watches for $23 each
The costs of the 300 watches in the 1 July inventory were 100 units @ $18 and 200 units @ $19.
Sales during July and August were 500 watches and 650 watches, respectively.
Required:
Calculate the ending inventory and the cost of goods sold for each month.
306
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Chapter 7 Appendix: Calculating the cost and the amount of inventory
A7-14 Red Centre uses the FIFO inventory cost flow assumption. It includes the following amounts in
the company’s financial statements:
Inventory, 1 January
$100 000
Purchases
300 000
Cost of goods sold
250 000
Inventory, 31 December
150 000
The company sells only one product, and purchases and sales are made evenly throughout the year.
The replacement cost of the inventory at 1 January and 31 December is $125 000 and $187 500,
respectively. The cost of the company’s purchases was 25 per cent higher at the end of the year than
at the beginning.
Required:
The owner of Red Centre asks you to analyse the preceding information and tell her the following:
a How much would the cost of goods sold be if it was calculated on the basis of the moving
average for the period?
b What is the amount of the holding gain (inventory profit) included in the income calculated
on a FIFO basis?
c Did the number of units in inventory increase or decrease during the year?
A7-15 When Janet Chiu arrived at her shop on the morning of 15 June 20X3, she found that thieves
had broken in overnight and stolen much of her merchandise. The agent of Alright Insurance
Company agreed to visit in the afternoon, and promised that the insurance company would cover
the cost of the goods stolen, but said that Janet first had to verify the amount of the loss. Janet
took a physical inventory of the merchandise not stolen and determined that the cost was $2000.
Janet needs to make an estimate of the loss so that she can collect the insurance money and buy
new merchandise. She asks for your help, and you agree to look at her accounting records. She
tells you that the store has been in business since 1 January 19X7, and that she does not use the
retail method of accounting for inventory. You obtain the following information:
Inventory, 1 January, 20X2
$ 7 000
Purchases, 20X2
49 000
Purchases, 20X3
33 000
Sales (net), 20X2
80 000
Sales (net), 20X3
50 000
Purchases returns, 20X2
4 000
Purchases returns, 20X3
2 500
Inventory, 1 January, 20X3
Physical inventory after theft, 15 June 20X3
16 000
2 000
Required:
Make a recommendation to Janet on the amount she should settle for with the insurance
company. What is the major assumption underlying your answer?
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307
8
THE BALANCE SHEET:
COMPONENTS AND
APPLICATIONS
‘There are but two ways of paying a debt – increase of industry
in raising income, increase of thrift in laying out.’
Thomas Carlylea
Learning objectives
After reading this chapter, students should be able to do the following:
8.1 Explain the purpose of the balance sheet and the link to the
income statement.
8.2 Understand the relationship between the accounting equation and
the balance sheet.
8.3 Understand how to use balance sheet figures to evaluate the
operating capability, financial flexibility and profitability of a business.
8.4 Know how to evaluate financial flexibility.
8.5 Understand the limitations of the income statement and the
balance sheet.
8.6 Discuss the purpose of a business activity statement (BAS).
308
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Chapter 8 The balance sheet: Components and applications
Understanding the learning objectives is assisted in the chapter by asking key questions:
Key questions
1
What information does a balance sheet convey to users of accounting information?
2
Why is it important to classify assets and liabilities into groups when preparing a
balance sheet?
3
What is a business’s liquidity, and how do users evaluate it?
4
What is a business’s financial flexibility, and how do users evaluate it?
5
Why and how do users evaluate a business’s profitability?
6
What is a business’s operating capability, and how do users evaluate it?
7
What is a business activity statement (BAS)?
What assets do you own? How do you keep track of them? How much is in your savings account? How
much do you owe on your credit card? Do you currently have some bills that you need to pay before next
month? Do you own a car? A computer? A house? What did these assets cost? Did you take out a loan to pay
for any of them? Do you still owe money on this loan? If so, what percentage of your total assets is the
amount that you owe? Do your assets exceed your debts?
Businesses also keep track of their assets and debts. For instance, on its 30 June 2018 balance sheet,
Super Retail Group Limited (http://www.superretailgroup.com.au) reported $591.3 million of current
assets and $1171.3 million of non-current assets; that is, $1762.6 million in total assets. Super Retail
Group Ltd also reported $427.4 million in current liabilities, $536 million of non-current liabilities and
owner’s equity of $799.2 million.b
Super Retail Group obtained these numbers from its accounting system. Does Super Retail Group
have enough ‘current’ assets on hand to pay its ‘current’ liabilities? Given Super Retail Group has financed
its assets with a combination of owner’s equity and liabilities, are Super Retail Group’s total liabilities
too high?
Stop & think
Overall, do these numbers show that Super Retail Group was in a ‘good’ or ‘bad’ financial
position on this date? What other information would you like to have to answer this question?
In Chapter 7, you saw how a business’s income statement provides managers and external users with
important information about its activities. By describing the revenues, expenses and net income (or net loss)
for an accounting period, the income statement helps show whether a business is earning a satisfactory
profit. A business’s net income (or net loss) for an accounting period is the increase (or decrease) in owner’s
equity that resulted from the operating activities of that period. An income statement prepared according to
generally accepted accounting principles (GAAP) also enables users to compare financial results from period
to period or across businesses.
Although the income statement provides useful information for business decision making, managers
and external users don’t use it alone; they also study the balance sheet. In this chapter, we will discuss
the importance of the balance sheet. First, we will look at the principles, concepts and accounting
methods related to the balance sheet. Second, we will describe and present a classified balance sheet.
Finally, we will explore how managers and external users use a balance sheet to help them make
business decisions.
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309
Accounting Information for Business Decisions
1
What information does a
balance sheet convey to
users of accounting
information?
8.1 Why the balance sheet
is important
A balance sheet provides information that helps internal and external users to evaluate a business’s ability
to achieve its primary goals of earning a satisfactory profit and remaining solvent. You may recall from
Chapter 8 that the information on the income statement is used for similar purposes. The income
statement and the balance sheet provide different, yet related, types of information.
An income statement presents a summary of a business’s operating activities for an accounting period:
revenues earned, expenses incurred and the net income that resulted. So the income statement reports on a
business’s actions over a period of time, representing the ‘flow’ of a business’s operating activities. The income
statement answers questions such as, ‘How much sales revenue did the business earn last year?’ and, ‘What
was the cost of advertising for the year?’
In contrast, a balance sheet presents a business’s financial position on a specific date, allowing users to
‘take stock’ of a business’s assets, liabilities and owner’s equity on that date. Managers and external users
need this financial-position information in order to make business decisions. By examining the balance
sheet, users can answer questions such as, ‘What types of resources does the business have available for
its operations?’ and, ‘What are the business’s obligations?’ They can find out how much money customers
owe the business (accounts receivable), see the total dollar amount of the inventory on hand at year-end
and discover how much money the business owes its creditors (accounts payable).
Stop & think
Some people refer to the balance sheet as a ‘snapshot’ of a business’s assets, liabilities and
owner’s equity on a given date. What do they mean by this? Do you agree? Why or why not?
Why users need both the balance sheet
and the income statement
drawing analogies
Making connections
among facts, ideas or
experiences that are
normally considered
separately
310
Remember the critical thinking strategies we discussed in Chapter 1? Let’s try using a couple of analogies
to understand why internal and external users need both the income statement and the balance sheet.
You will get the most out of these analogies if you read them actively. In other words, every time you see
a question, don’t just read ahead, but instead try to come up with your own answers first. Drawing
analogies will help you understand accounting.
Let’s say that you want to predict whether your friend Tim can bake a loaf of bread. What do you
need to know to increase your chances of making an accurate prediction? We think you need to know
three related items. First, before baking delicious bread, Tim must have on hand all the cooking
equipment and ingredients for the bread: flour, butter, yeast, salt, sugar, bread pans, an oven, and so on.
So your first question would be, ‘Does Tim have everything he needs to bake the bread?’ However, even if
Tim has all the necessary equipment and ingredients, does that mean he can bake bread? Certainly not!
So the second question you would ask is, ‘Has Tim baked bread before?’ If the answers to both these
questions were yes, then it would be likely that Tim could bake a loaf of bread. If the answer to either of
these questions were no, then you would be much less sure about his ability to bake. Do you agree? The
third question (and probably the most important, if you plan on eating the bread) is not as easy to
answer. That question is, ‘Does Tim still know how to bake bread?’ You won’t know the answer to this
question until you taste the next loaf out of his oven.
You would follow a similar strategy if you were trying to determine whether a business could earn a
satisfactory profit. You would want to know whether the business had the assets, liabilities and owner’s
equity (the ‘ingredients’) needed to earn a satisfactory profit (to bake a delicious loaf of bread). You would
also need to know whether the business had been able to use its resources in the past to earn such a
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