ACCT1501 Lecture 2

Session 1, 2012

THE UNIVERSITY OF NEW SOUTH WALES

Australian School of Business School of Accounting

ACCT 1501: Accounting and Financial Management

1A

Week 2

Measuring & Evaluating Financial Position & Performance

Student Handout

Lecturer:

Dr. Youngdeok Lim School of Accounting

UNSW

QUAD 3069 [email protected]

Blackboard: http://telt.unsw.edu.au

Session 1, 2012

WEEK 2: Measuring & Evaluating Financial Position & Performance

1. Introduction Every commercial entity engages in transactions with other parties. Woolworths buys

products from suppliers, employs shop assistants, builds new stores, sells groceries and

each individual transaction is recorded and reported in the Balance Sheet. Individual

retail stores would report their profitability and the costs of running each store

categorising their expenses so management are fully informed of the cost involved in

running each service or retail store. They will even have information about the individual

products they sell through internal reporting and cost profit sales analysis. In this lecture

we will examine the communication of financial information in the Income Statement

through to the Balance Sheet.

Learning objectives At the end of this topic, you should be able to:

Understand the terms, format and function of the Balance Sheet & the Income Statement

Identify the components of financial statements Prepare your own simple Balance Sheet & Income Statement Describe the relationship between the balance sheet and the income statement Understand the implications of the decision to record expenditure as an asset or as

an expense Understand the differences between cash profit and accrual profit

Required Reading Trotman & Gibbons Chapter 2: except section 2.3 pages 55 - 61 Appendix 2: pp92- 97 AASB Framework for the Preparation and Presentation of

Financial Statements (downloadable from http://www.aasb.com.au)

Session 1, 2012

2. Tutorial Questions Week 3 Preparation Questions

DQ 2.1, P2.17, C2A

Tutorial Questions

DQ 2.6, 2.10, P2.7, P2.22, P2.27

Accounting and Financial Management 1A

Week 2, Session 1, 2012

Measuring & Evaluating FinancialMeasuring & Evaluating Financial Position & Performance.

Dr Youngdeok Lim

Building the foundations of accounting over the next few weeks

Week 2: The Balance Sheet and IncomeWeek 2: The Balance Sheet and Income Statement (Ch. 2)

Week 3: The Double Entry System (Ch. 3)

Week 4: Record Keeping (Ch. 4)

Week 5: Accrual Accounting Adjustments (ChWeek 5: Accrual Accounting Adjustments (Ch. 5)

Week 6: Special Journal, Subsidiary & Control Accounts (Ch. 5 Appendix)

Week 2 The Balance Sheet & Income Statement.

This weeks lecture objectives are:

1. To understand the terms, format, function and content of the Balance Sheet & Income Statement

2. Be able to define assets, liabilities and shareholders equity &

3. indentify the difference between revenue & expenses.

4. Be able to prepare your own simple Balance Sheet & Income Statement

5. Describe the relationship between the balance sheet and the income statement

HOT (higher order thinking) concepts: 6. Understand the implications of the decision to record

expenditure as an asset or as an expense

7. Understand the differences between cash & accrual profit

Dont forget to use the Glossary!!! (T&G p. 749)

In the course of your study you will be introduced to many key Accounting terms, it is like learning a new foreign language.

To assist you acquire a quick grasp of this new language, I recommend that you refer to the glossary often until you get to know all the new terms.

I guarantee there will always be new terms introduced each week. You will need to build on your knowledge and y gunderstanding. Tag this section in the book so you can refer to it easily & often.

Practice using the glossary - look up the new terms each week and try to explain them in your terms or think of an example to explain it. (Tip: Define, explain, example!)

Recap: Financial Statements...

Balance Sheet Income Statement

are the final

Income StatementCash Flows Statement

are the finalproduct of the

accounting process. tell how the

business is performingand where it stands.

1. Balance Sheet

Historically, the most important financial statement showing an organisations resources & claims on resources at a particular point in timeReflects the accountability of managers to owners (shareholders) a statement at one point in time which shows all the resources controlled by

balanceResources Claims/Sources

...a statement, at one point in time, which shows all the resources controlled by the enterprise and all the obligations due by the enterprise.

Assets LiabilitiesEquities

snapshotas at

Recap - The balance sheet equation:A=L+SE

Resources = Sources

What we have = What we owe + What we contributed

Assets = Liabilities + Shareholders Equity

A = L + SE

Basis of accounting entity assumption

Resources = Sources

Click to edit Master title style

Click to edit Master text styles

- Second level

Third level

Fourth level

Fifth level

What is on the Balance Sheet Examine closely the Balance Sheet in the appendix p.711 T&G

Name of the reporting entity Name of the reporting entity

Woolworths Limited Consolidated

Date at which the statement is drawn

as at Eg. Woolworths as at 24 June 2007g represents a point in time

Currency used

$m, $AUD

AASB 101 Presentation of Financial Statements requires at a minimum that these items be shown on the face of the BS

What is on the Balance Sheet cont...

Assets

Cash and cash equivalents Trade and other receivables Inventories Biological assets Investments accounted for using the

Liabilities

Trade and other payables Interest-bearing liabilities Tax liabilities Provisions

Shareholders EquityInvestments accounted for using the equity method Other financial assets Tax assets Property, plant and equipment Investment property Intangible assets

Shareholder s Equity

Contributed equity/Issued capital Reserves Retained profits Minority interest/Outside equity

Purpose of Balance Sheet

Information on financial position

level of debt/equity - how the assets are financed and solvency and liquidity

Solvency

ability to pay debts when they fall d (l t )due (long-term)

Liquidity

the ease with which assets can be converted to cash in the normal course of business (in the short-term)

Which of the following statements about a balance sheet is true?

1. a balance sheet presents the financial performance of a company for a period of time

2. a balance sheet presents the financial position at a point in time

3 a balance sheet shows which source of

1 2 3 4

0% 0%0%0%

3. a balance sheet shows which source of finance produced each asset

4. a balance sheet includes all the resources of a company

The Beach ShackBalance Sheet

as at December 31,Assets Liabilities & Owners' Equity

A simple example of a Balance Sheet

Current Assets Curent LiabilitiesCash 22,500$ Liabilities:Notes receivable 10,000 Notes payable 41,000$ Accounts receivable 60,500 Accounts payable 36,000 Supplies 2,000 Salaries payable 3,000 Non Current AssetsNon Current AssetsLand 100,000 Total liabilities 80,000$ Building 90,000 Shareholder's EquityOffice equipment 15,000 Contribued capital 150,000

Retained earnings 70,000 Total 300,000$ Total 300,000$


Assets

Balance Sheetas at December 31,

Current AssetsCash 22,500$ Notes receivable 10,000 Accounts receivable 60,500 Supplies 2,000 N C t A t

A resource controlled by the entity as a result of

past events from which future economic Non Current Assets

Land 100,000 Building 90,000 Office equipment 15,000

benefits are expected to flow to the entity

Assets - Recognition

Definition:

Future economic benefits (FEB)useful for business now and in future Legal ownership and control

Most assets typically owned BUT ownership is not a precondition Past transaction or other events

purchase made of asset, contract signed

A t iti it i Asset recognition criteria:

An asset should be recognised when and only when:a. it is probable that the future economic benefits associated with the item

will flow to the entity, and

b. the item has a cost or value that can be measured with reliability.

Current assets

These are: cash and cash equivalents; or assets expected to be realised in,

or held for sale or consumption in, the normal course of the entitys operating cycle; orassets held primarily for trading assets held primarily for trading and expected to be realised within 12 months after the end of the last financial period.

Non-current assets

Non current assets (NCA) Non-current assets (NCA) are all assets other than current assets

Examples:

property, plant and equipment

long term investments

Do they meet the definition requirements? future economic benefit? control? Past event?

Are these assets ?

economic benefit? control? Past event?

Cash in the bank? Land and Buildings?

WHAT IF?

WHAT IF?What if you had a bank overdraft would that also be an

asset?

What if the land or buildings changed in value does this effect the balance sheet?

Is it a cost or value???

What are the possible ways in which an asset could be measured?

How much did it cost to purchase? - Historical cost

How much could you sell it for? - Realizable value

How much money could you make by using it in your business? Present valuebusiness? - Present value

What would it cost to purchase or replace today? Current cost

Historic Cost Rule: All assets are initially recorded at their historical cost /original cost (what it cost to acquire)


t D b 31

Liabilities

as at December 31,Liabilities & Owners' Equity

Liabilities: Notes payable 41,000$ Accounts payable 36,000 Salaries payable 3,000

T t l li biliti 80 000$

A present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the

Total liabilities 80,000$ Owners' Equity: Contributed capital 150,000 Retained earnings 70,000 Total 300,000$

entity of resources embodying economic benefits

Liabilities Recognition

Definition:

Future sacrifice of economic benefits Present obligation

currently owed by business Past transaction or other events

purchase of asset on credit, contract signed Liability recognition criteria:

A liability should be recognised when and only when:

a it is probable that the future sacrifice of economic benefits will be required, and

b the amount of the liability can be measured reliably.

Current liabilities

These are expected to These are expected to be settled in the normal course of the entitys operating cycle; or

Due to be settled within Due to be settled within 12 months of the end of the accounting period.

Non-current liabilities

Non current liabilities Non-current liabilities are all liabilities other than current liabilities

Examples:

debentures payablemortgage loan


Shareholders Equity

Balance Sheetas at December 31,

Liabilities & Owners' Equity Liabilities:

Notes payable 41,000$ Accounts payable 36,000 Salaries payable 3,000

T t l li biliti 80 000$

Shareholders Equity is The residual interest in the assets of the entity after deducting all its liabilities

Total liabilities 80,000$ Shareholders' Equity: Contributed capital 150,000 Retained earnings 70,000 Total 300,000$

Equity

Equity is the residual interest in the assets of theinterest in the assets of the entity after deduction of its liabilities (SE A - L)

Common components:

Share capitalShare capitalRetained profits

Expanding the Accounting equation

Rearranging the equation


can be expressed as:

Assets - Liabilities = Shareholders Equity

Net Assets = Shareholder (Owners) Equity

Now we will begin to explore the measurement of changes in shareholder wealth (or changes in Net Assets).

The Accounting Equation


$300 000 = $80 000 + $220 000

Assets Liabilities & Owners' EquityCash 22,500$ Liabilities:Notes receivable 10,000 Notes payable 41,000$ Accounts receivable 60,500 Accounts payable 36,000 Supplies 2,000 Salaries payable 3,000 L d 100 000 T t l li biliti 80 000$

$300,000 = $80,000 + $220,000

Land 100,000 Total liabilities 80,000$ Building 90,000 Owners' EquityOffice equipment 15,000 Share capital 150,000

Retained earnings 70,000 Total 300,000$ Total 300,000$

Example (continued)

You purchase one bed room unit at $500,000 on 1/7/2011 and rent itand rent it.

Financing source: Your own money $100,000, Borrowing from bank $400,000

Rent revenue (cash) $400/week, Interest expense (cash) $200/week, Tax expense (cash) $1000/year

Assume 52 weeks per year

Prepare B/S as of 1/7/2011, 30/6/2012 and 30/6/2013

Prepare I/S for the year ended on 30/6/2012 and 30/6/2013

AA == LL ++ SSEEThe Accounting Equation

AA = = LL + + SSEEThe basic accounting equation can be expanded to include revenues

and expensesand expenses.

AA = = LL + + SESE

The Accounting Equation

Share capital Retained profits

Retained Net profit -Dividendprofits

beginning of period

=Revenue expenses

Traditional view - A company exists for the benefit of its shareholders.

There are alternative views i e other Stakeholders: Society?

Shareholders equity

There are alternative views i.e. other Stakeholders: Society? Community? Economy ? Environment?

In this course we will concentrate (owners) shareholders wealth

An increase in a companys wealth means an increase in owners equity

A L = SE

A closer look at shareholders equity

Shareholders (Owners) Equity

Contributions by owners (Share capital)

Profit Revenues Expenses

Distribution to owners (Dividend)

Increasing shareholders equity

Owners:

Contributions by owners, Share Capital All other transactions & events:

Net profit

Increasing shareholders equity

Owners:

Contributions by owners Issued Shares for $300,000 cash

A L SEShare

CapitalCash

A = L + SE

Increasing Shareholders equityAll other transactions & events:

$ Company receives $3,000 interest on bank deposit.

RevenueCash

A = L + SE

Decreasing Shareholders equity

Owners:

Distributions to owners, Dividends All other transactions & events:

Net loss

Decreasing Shareholders equity

All other transactions & events:

$ Company pays $3,000 interest on a bank loan.

A = L + SEC h InterestCash Interest

Expense

When a company earns a profit, that profit can be distributed to shareholders as dividends or kept in the

Retained profit

pbusiness to grow the business.

Profit (Revenues Expenses)less Distributions (Dividends)

= Retained Profit

Remember: Dividends are NOT AN EXPENSE!

AA = = LL + + SSEE

The Accounting Equation expanded!!!

AA = = LL + + SC +RP + R SC +RP + R E E -- DD

Where:

CC = share capitalRE t i d fit b i iRE = retained profits beginningR = revenueE = expensesD = dividend (declared)

Your own Balance Sheet!

Prepare your own Personal Balance Sheet. Use the correct format, write a title, and date, i.e. Student Xs

Balance Sheet as at 29 February 2012.

Please take a black sheet of paper or use your laptop!

Lets start with listing your assets: what do you own!

You may like to use categories i.e. clothing; books; CD collection; phone; ipod; camera; computer; cash etcEstimate a value based on historical cost for each item.Estimate a value based on historical cost for each item.

Record the amount beside the items you listed. For this exercise you dont need to use your real actual

items if you do not wish to you can make this up. Classify the assets into: Current - items you will keep/use within 12 months; Non-Current - items which you will have for longer than 12 mths

Your Balance Sheet may look something like this

Student Xs Balance Sheet

As at 30 June 2011

Assets

CURRENT $ $

320

NON CURRENTNON CURRENT

3,800

Total Assets 4,120

Your own personal Balance Sheet!Continued

Now list your liabilities what you owe!

This may include money you need to repay i.e. a loan, rent, phone bill, any bill you have received but not yet paid.

Make a heading on you Balance Sheet and list the items with values, split into Current & Non Current as demonstrated in our simple example.

The difference between your assets & your liabilities is your residue, basically it is your Owners Equity (capital).

We will look at your Income Statement a little later in this session to demonstrate the difference between the BS & IS.

The company has bought a new machine

Balance Sheet elements?How do these events impact the BS?

The company has sold some inventory

A major competitor has gone broke

The company has hired a new manager

There was a fire in the main factory

Given only the following information, what is the balance of shareholders equity?

Cash 10 000Cash 10 000Inventory 30 000Equipment 200 000Accounts payable 50 000Taxes payable 40 000Loans to the company 100 000

1. $40 0002. $50 0003. $100 0004. none of the above

Watch ICAA clip which provides an overview of the financial statements

Income Statement

The Income Statement shows the profit or loss for theThe Income Statement shows the profit or loss for the period of time under consideration.

It is sometimes called: Statement of financial performance

Statement of earningsg Profit and loss statement Statement of operations

profit = revenues expenses

Income Statement

Main Street Store, Inc.Income Statement

For the Year Ended 30 June 2009

Net Sales 1,200,000$ Cost of goods sold 850,000 Gross profit 350,000$ Selling, general, and admin. expenses 311,000 Profit from operations 39,000$ Interest expense 9,000 Profit before taxes 30,000$

Revenues result from the entitys operating activities

Income taxes 12,000 Net profit 18,000$

Net profit per ordinary share 1.80$

y p g(e.g. selling inventory,

sometimes referred to as Sales/Revenue/Income).

Revenue

Revenue is gross inflows of economic benefits during the period arising in the ordinary activities of an entity

when those inflows result in increases in equity other than those relating to

48

contributions from equity participants.

(AASB 118, para 7)

The Revenue Recognition Principle

Recognise revenue whenit is earned.

GAAP recommends the accrual basis of accountingaccrual basis of accounting.

Devising an idea Making Receipt

of cash

So, when is REVENUE earned?

purchasesof cash

Delivery of goods to

customers

Receipt of orders before

production

50

Completion of production

Receipt of orders

Progressing through

production

Commencingproduction

What is total revenue for the period?(a) Credit sales of $10 000

(b) Cash sales of $8000(c) $7000 cash received from a customer as a deposit

for work done in the next period

1. $17 0002 $18 000

1 2 3 4

0% 0%0%0%

2. $18 0003. $25 0004. none of the above

Income Statement

Main Street Store, Inc.Income Statement

For the Year Ended 30 June 2009

Net Sales 1,200,000$ Cost of goods sold 850,000 Gross profit 350,000$ Selling, general, and admin. expenses 311,000 Profit from operations 39,000$ Interest expense 9,000 Profit before taxes 30,000$ Income taxes 12,000 Net profit 18 000$

Costs and expenses are incurred in

ti Net profit 18,000$

Net profit per ordinary share 1.80$

generating revenues and operating the

entity.

Expenses

Definition opposite to revenue

Recognition probable outflows & reliability of measurement

Consider:

Realised versus unrealised lossesMatching problems

Prepaid and accrued expensesAllocation of costs

Expenses

Expenses are decreases in economic benefits during the accounting period in

the form of outflows or depletions of assets or incurrence of liabilities that

result in decreases in equity other than

54

those relating to distributions to equity participants.

(IASB Framework, para 70b)

Income Statement

N t l A t f l f h di t t

Explanation of income statement accounts:

Net sales Amount of sales of merchandise to customers, less the amount of customer returns of merchandise

Cost of goods sold Represents the total cost of merchandise removed from inventory and delivered to customers as a result of sales

Gross profit Difference between net sales and cost of goods sold; Represents the seller's maximum amount of "cushion" from which all other expenses of the business must be met before it is possible to have net profit

Income Statement

Account ExplanationSelling general and Represent the operating expenses of the entity

Explanation of income statement accounts:

Selling, general, and administrative expenses

Represent the operating expenses of the entity

Profit from operations Represents one of the most important measures of the firm's activities

Interest expense Represents the cost of using borrowed fundsIncome taxes Shown after all of the other income statement

items have been reported because income taxes are a function of the firm's income before taxes

Net profit per share of ordinary share in issue

A significant item in evaluating the market value of an ordinary share; Often referred to as "earnings per share" or EPS

Appendix: Income, revenue and gains Income = revenue + gains

R i fl f di ti iti Revenue = inflows from ordinary activities

Gains = all other inflows.

57

Income

Revenue

Arises in the course of the ordinary activities of an entity Include sales, fees, interest recd, dividends

recd, royalties, rent Gains

N diff t i t fNo different in nature from revenuesMay or may not arise in the ordinary activitiesEg. Gain from sale of non-current assetsUsually displayed separately useful in decision

making

Your personal Income Statement

Let us prepare your personal Income Statement a summary of your income and expenses.

Often you prepare something like this for your tax return, or applying for a bank loan or other form of credit.

Companies prepare these annually & they prepare monthly ones for operational reasons.

Prepare the IS in the correct format i e title & date Prepare the IS in the correct format, i.e. title & date.

List you income sources first,

Then list your expenses. Lets prepare for the month so you get the idea of what you are doing and how it is different from the Balance Sheet.

Your Income Statement may look something like this:

Income Statement for Student X

for the month ending 29 February 2012

Revenue $Revenue $

Wages

Interest recd

Scholarship 410

Less Expenses

RentRent

Food

Electricity & utilities

Phone 340

Profit 70 (this figure is added to RE)

Income Statement

Did not become formal report until 1830s with beginning of annual reports of railroads. However, income account used for internal management control since 1300sfor internal management control since 1300s

It is a Summary of organisations revenues and expenses over a period of time it measures financial performance over that period of time. Basically, the change in financial position.

Accrual accounting principle!!!! (remember our principles from last week!!! effects both revenue & expenses )from last week!!! effects both revenue & expenses )

Presents the difference between revenues and expenses

Profit = Revenues - Expenses

5. The link between the BS & the IS

Balance Sheet

CA + NCA = CL + NCL + SC + Opening RP + R - E - D

CA + NCA = CL + NCL + SE

Income Statement

The connecting link between the balance sheet and the income statement is:

1. dividends paid to shareholders

2. the opening balance of retained profits

1 2 3 4

0% 0%0%0%

retained profits3. total shareholders

equity4. net profit after tax

6. Capitalise v. expenseA couple of interesting issues

Has the business bought an asset in the following situations?

Spend $50,000 cash for new plant equipment? Borrow $50,000 to buy new plant equipment? Spend $12,000 on 12 months rent in advance? Spend $3,000,000 on research to develop a drug to cure

hangovers?

Spend $500 on 3 months of photocopy ink? Pay $4,000 for telephone calls this month?

Capitalize v. expense why is this important???

It can make a large It can make a large difference!!

Spend $3,000,000 on research to develop a drug to cure hangovers? Do they Capitalize or expense? Which option would a company prefer?

An example

A = L + SE

cash asset

v.s.

CAPITALISE

expensecashEXPENSE

Has a cost been incurred?

Unlikely to be an accounting event

No

Classifying assets and expenses

Is there a benefitto the business?

Yes

Yes

No

Relates to the owner orsomeone else and shouldbe charged appropriately

No

68

Has the benefit beenused in this period?

Charge as an expense

Yes

Show the future benefit as an assetNo

7. Cash v accrual profit

The earning of a revenue is not necessarily accompanied by an inflow of cashaccompanied by an inflow of cash.

The incurrence of an expense is not necessarily accompanied by an outflow of cash

Accrual profit is not the same as cash profit.

A Key objective for this session: begin to understand the Accrual concept***

Cash sales $100

$ Credit sales $100

Total sales =

Total cash inflow at the time of sales =

A Key objective for this session: begin to understand the Accrual concept***

Threshold Concept think about the difference between a business operating on a cash accounting bases & one p g gusing accrual accounting!

What do we mean by this ???? What impact would this have on the figures in the Balance

Sheet and Income Statement????

Use the information given below to answer the following 2 questions.

During 2009, a company makes credit sales of $500 000, f hi h $375 000 i ll t d t d It $200

The threshold concept:Cash v Accrual Profit

of which $375 000 is collected at year-end. It pays $200 000 in expenses and owes $25 000 for electricity used

during 2009.Accrual profit is:

Accrual profit is:1. $300 000

1 2 3 4

0% 0%0%0%

2. $275 0003. $175 0004. $150 000

What would the profit be if cash accounting rather than accrual accounting was used?

The threshold concept:Cash v Accrual Profit

1. $300 0002. $275 0003. $175 0004 $150 000

1 2 3 4

0% 0%0%0%

4. $150 000

Dont forget the practice Quiz!!!Next Lecture

You will study the Double Entry System (chapter 3) You will study the Double Entry System (chapter 3) and work through practice questions.

Documents

ACCT1501 Lecture 2