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.
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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).
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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.
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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.
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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.
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