Chapter 1 – The Nature and Role of Accounting in Small Business – solutions to exercises Exercise 1.1 The accounting process Order Accounting process b Collecting source documents like receipts and cheque butts a Recording transactions in journals and stock cards d Preparing financial reports c Providing advice to the owner of the business Exercise 1.2 The accounting process Action Accounting process Stage Preparing an Income Statement Reporting Output Filing sales invoices Collecting source documents Input Entering transactions in a cash journal Recording Processing Presenting the owner with alternative sources of finance Advice Advice Exercise 1.3 Accounting Principles a Principle Entity Explanation The owner and the business are separate accounting entities. Therefore, the business’s assets (bank account) should not be used for personal purposes. This payment should be recorded as drawings by the business as the owner has taken business funds for personal use. b Principle Reporting Period Explanation The business is deemed to be a going concern. Michael cannot wait until the end of the business’s life to calculate profit as that may never come. Therefore, the life of the business must be broken up into periods so that performance can be determined. Also the tax office would require the business’s financial statements at the end of the financial year. Simmons, Hardy 1 © Cambridge University Press 2012 Chapter 1 – The Nature and Role of Accounting in Small Business – solutions to exercises c Principle Historical Cost Explanation The musical instruments must be valued at their original purchase price as this value is verified by source document evidence. Valuing the instruments at their perceived market value ‘estimates’ their worth, which may be swayed by the owner’s opinion of their value and thus make the valuation biased and unreliable. d Principle Monetary Unit Explanation This principle states that all items must be recorded and reported in the currency of the country of location where the reports are to be repaired. Michael recording the tour’s earnings in yen would make it impossible to use with the existing financial information. The tour’s earnings should be converted from yen to Australian dollars and then incorporated in the financial reports. e Principle Consistency Explanation This principle states that accounting methods used by the business should be consistent to allow the comparison of reports from one period to the next. If Michael was to change accounting methods every year he would not know whether the business improved due to changes in business performance or the changes in accounting methods. f Principle Going Concern Explanation The business is deemed to have a continuous life and its records should be kept on that basis. Michael cannot list a three-year loan as current because that implies that this liability and all others will have to be paid within 12 months. This is not the case as the business should be able to distinguish between those liabilities that are current (to be paid within 12 months) and those that are non-current (do not have to be paid for a period greater than 12 months). Simmons, Hardy 2 © Cambridge University Press 2012 Chapter 1 – The Nature and Role of Accounting in Small Business – solutions to exercises Exercise 1.4 Qualitative Characteristics a Qualitative Characteristic Relevance Explanation Pat does not need to list all 35 individual debtors as this information would not be seen as material; that is, it would not aid or improve decision-making. In fact, it would probably have the opposite effect because it would make the Balance Sheet more difficult to read. The same information could be shown with one ‘debtors’ figure and have the same impact on decisions. b Qualitative Characteristic Comparability Explanation The accounting methods used by the business should be consistent from one period to the next to allow the comparison of reports. If Pat was to change accounting methods every year he would not know whether the business improved due to changes in business performance or the change in accounting method. The change in accounting method should be disclosed in the financial reports of the business. c Qualitative Characteristic Reliability Explanation Pat has recorded the electricity as an estimate. Hence this information is unreliable as there is no source document evidence to verify the amount and thus the information contained in the reports will not be free from bias. d Qualitative Characteristic Relevance Explanation Pat has paid for business expenses using his personal cheque book, which means that the reports of the business will not include all information that will be useful for decision-making. He will need to record these transactions as a capital contribution as he is a separate accounting entity to the business. Simmons, Hardy 3 © Cambridge University Press 2012 Chapter 1 – The Nature and Role of Accounting in Small Business – solutions to exercises e Qualitative Characteristic Reliability Explanation The plumbing equipment must be valued at its original purchase price as this value is verified by source document evidence. Valuing the instruments at their perceived market value ‘estimates’ their worth, which may be swayed by the owner’s opinion of their value and thus make the valuation biased and unreliable. f Qualitative Characteristic Relevance Explanation Pat should only include information that relates to the current reporting period that will help us to determine the business’s performance and provide information useful for decision-making. The amount received has yet to be earned and thus does not relate to this reporting period but should be reported in the next reporting period. Exercise 1.5 Accounting Principles and Qualitative Characteristics a Principle Historical Cost Explanation Betty must keep all the firm’s source documents as these provide evidence of the asset’s original purchase price. This is the only value that can be verified and ensures that the figures in the Balance Sheet are accurate and free from bias. b Qualitative Characteristic Reliability Explanation Betty must keep the source documents as they provide verifiable evidence of transactions and this ensures that all information contained in the financial reports are free from bias. Simmons, Hardy 4 © Cambridge University Press 2012 Chapter 1 – The Nature and Role of Accounting in Small Business – solutions to exercises Exercise 1.6 Accounting Principles and Qualitative Characteristics a Qualitative Characteristic Relevance Explanation The owner should only include information that relates to the current reporting period that will help to determine the business’s performance and provide information useful for decision-making. The receipt is two years old and may have already been recorded. This transaction does not relate to the current reporting period and if included would alter the final result and may mislead decision-makers. b Principle Reporting Period Explanation The business should have recorded and reported the cash receipt two years ago in the reporting period in which the transaction occurred. Then the financial reports would have included all significant information for decision-making. Exercise 1.7 Accounting Principles and Qualitative Characteristics a Principle Entity Explanation The owner and the business are separate accounting entities. Therefore, the business’s assets (bank account) should not be used for personal purposes. Beria’s payment should be recorded as drawings by the business as the owner has taken business funds for personal use. b Qualitative Characteristic Relevance Explanation If this transaction is not recorded or reported then the reports of the business will not include all information that will be useful for decisionmaking. Beria has withdrawn business assets for personal use but this must be recorded from the business’s perspective because the business and Beria are separate accounting entities. By making drawings she has reduced her claim on the assets of the business. Simmons, Hardy 5 © Cambridge University Press 2012