Module 4 LCP - workplacement.nsw.edu.au 4 LCP.pdf · confirm or revise your answers find the answers you did not know. When you have completed the module you should revise the quiz

001

Introduction

An important part of your role on the management committee is to monitor and control the financial dealings of the organisation. To do this you need to read, understand, analyse and query the information provided to the committee in a number of different financial reports. The three key financial reports prepared under the accounting process are the Income and Expenditure Statement, the Balance Sheet and the Cash Flow Statement. Each of these reports show a different aspect of the financial status of the organisation. In this module we explore Balance Sheets from two organisations, Sunnyway Training Services Inc and ARC Adult Education. We will consider what you should look for in a Balance Sheet and questions you should ask about the information it contains.

Before you begin

If you already have some knowledge of using and interpreting Balance Sheets, you might choose to begin with the Quick quiz on page 16 and then

the Review tasks on page 17. When you have answered as many of the quiz and review questions as you can, come back to the beginning of this module and begin to work through it, to:

confirm or revise your answers

find the answers you did not know.

When you have completed the module you should revise the quiz and the review tasks. If you have little or no knowledge of using and interpreting Balance Sheets, read on.

Key learning outcomes

The learning outcomes for this module are divided into two categories — learning which involves improving your knowledge or understanding, and learning which develops skills and strategies. After successfully completing all the exercises in this module you will:

4 understand the need for monitoring and controlling finances

4 be able to analyse and question the data in Balance Sheets

4 be able to monitor financial reporting procedures in the organisation in relation to Balance Sheets.

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Accounting Practices: Balance Sheets

The Balance Sheet

What is a Balance Sheet?

A Balance Sheet is a 'snapshot' of the financial position of the business at a specific point in time, usually the end of an accounting period. This report lists assets and liabilities as either current or non-current, as well as the organisation's equity.

How is a Balance Sheet prepared?

At the end of an accounting period, the assets and liabilities of an organisation are grouped together from the most fluid (changeable) to the most permanent. The assets will be set up showing their cost or nett realisable value. The liabilities are the amounts owing to third parties. The difference between the totals of the assets and the totals of the liabilities is known as the nett worth or equity (funds plus profits) of the organisation.

TOTAL ASSETS — TOTAL LIABILITIES = EQUITY

When should Balance Sheets be presented?

The Balance Sheet should be presented at the end of an accounting period following the balancing of accounts on 'Balance Day'.

See Module 8 for more information on Balance Day Because the Balance Sheet presents an organisation’s financial state at a point in time, it is prudent that it be reviewed with the same frequency as the review of the Income and Expenditure Statement.

Neither the Income and Expenditure Statement nor the Balance Sheet can, on their own, provide a complete picture of the financial status of an organisation.

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Current and non-current assets and liabilities

Assets and liabilities can be classified as current or non-current. Assets

Current Non-current

These assets represent the value an organisation expects to receive (or benefit from) in the short-term, usually within one year. For example, cash at bank is a current asset because it can be accessed and utilised at any time.

These assets are expected to have value to the organisation over an extended period of time — beyond one year. Buildings and items of equipment used by the organisation are non-current assets.

Liabilities

Current Non-current

These liabilities need (or possibly will need) to be satisfied in the short-term — usually within one year. For example, the accounts for Trade Creditors (ie accounts for suppliers who provide goods or services on credit) are considered current liabilities.

Typically the period allowed for payment of these accounts ranges from seven days (from date of supply) to the month-end following the date of supply.

Another current liability is provision for employee entitlements (annual leave, long service leave) which will, or may, have to be paid within the next twelve months.

These liabilities are not required to be paid out within the next year. A 10-year loan from a bank would be a non-current liability.

Employee entitlements to long service leave in future years would be non-current liabilities.

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Exercise 4.1: Classifying accounts

Classify each of the accounts in the table below as one of the following:

Current asset

Non-current asset

Current liability

Non-current liability

Equity

Income

Expense

Account Classification

Short term loan from bank

Fees income

Fees income received in advance

Petty cash

12 year loan

Accounts receivable

Wages

Wages accrued

Depreciation

Accounts payable

Land and buildings

Q

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Answers Exercise 4.1

You were asked to classify the accounts

Account Classification

Short term loan from bank Current liability

Fees income Income

Fees income received in advance Current liability

Petty cash Current asset

12 year bank loan Non-current liability

Accounts receivable Current asset

Wages Expense

Wages accrued Current liability

Depreciation Expense

Accounts payable Current liability

Land and buildings Non-current asset

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What does a Balance Sheet look like?

The following is an example: Sunnyway Balance Sheet as at 31 December 2005

$ $

Current assets

Cash at bank 8,400

Accounts receivable 5,200

Prepaid expenses 1,600

Non-current assets

Investments 1,200

Land and buildings 85,000

Furniture and fittings 29,300

Less: Accumulated depreciation (8,100) 21,200

Total assets 122,600

Current liabilities

Creditors and accrued expenses 7,300

Provisions for staff entitlements 1,200

Non-current liabilities

Provisions for staff entitlements 23,000

Total liabilities 31,500

Nett assets Note a 91,100

Equity represented by:

Accumulated funds 1 January 60,400

Surplus for period Note b 30,700

Closing balance 91,100

Note a. The ending balance of equity is equal to nett assets (assets minus liabilities).

$91,100 = $122,600 — $31,500. Note b. The period surplus from income and expenditure, $30,700, added to the

accumulated funds (equity) at the beginning of the year, $60,400, gives the new equity balance of $91,100 at the year end. The accumulated funds is the sum of all profits (ie surplus achieved) since the organisation’s inception.

See Glossary, Appendix 2, for Key Accounting Terms ð&

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Exercise 4.2: Assets and liabilities

Consider the following items which will be included in the ARC Balance Sheet on 31 December, 2005. What is each worth? Are they assets or liabilities? Write your answers in the spaces below.

Item Worth Asset Liability

Insurance for a year was paid on 1 July. The amount paid was $2,400 ($200 per month).

The quarterly electricity bill received on 31 December is unpaid. The amount is $150.

Fees amounting to $750 have been received in advance for next term.

Wages are paid fortnightly. The amount due and unpaid on 31 December is $1,100.

The bill from Telstra received on 31 December amounted to $410 (not paid yet). This includes three months’ phone calls amounting to $320 and rental in advance (January to March) of $90.

Course fees due for this term that have not yet been received amount to $1,100.

The rent for January ($400) was paid on 20 December.

Q

008



You were asked to identify the items and their worth as either assets or liabilities for inclusion in the Balance Sheet on 31 December.

1 Prepaid Insurance Worth = $1,200 Asset

2 Accrued Electricity expense Worth = $150 Liability

3 Received Fees income advance Worth = $750 Liability

4 Accrued Wages Worth = $1,100 Liability

5 Accrued Telstra expense Worth = $320 Liability

6 Accrued Course fees income Worth = $1,100 Asset

7 Prepaid Rent Worth = $400 Asset

What should you look for in the Balance Sheet?

When reviewing the figures in a Balance Sheet you should consider the following questions: Do current assets exceed current liabilities?

Current assets are assets which are in the form of cash or can be readily converted to cash in the short term. Current liabilities are liabilities which the organisation will have to satisfy in the short term. If current liabilities exceed current assets, the organisation is at risk of running out of cash and not being able to pay its debts. Does the organisation have nett assets − in other words, do its total assets exceed its total liabilities?

If total liabilities exceed total assets, then committee members should be looking at the financial viability of the organisation. An organisation will be considered insolvent if it is unable to pay its debts when they fall due. An excess of liabilities over assets is not, of itself, an indication of insolvency (conversely, an excess of assets over liabilities does not guarantee an organisation’s solvency). It should, however, be taken as a warning sign that the organisation is at financial risk. Are there significant changes between balances in the current Balance Sheet and balances in the last period’s Balance Sheet?

Significant changes in the Balance Sheet are pointers to significant transactions or changes in circumstances in the organisation. A marked increase in the value of fixed assets is an indicator of significant expenditure on items of equipment, furniture, etc. The committee needs to consider whether this expenditure was budgeted for and approved. An increase in provision for staff entitlements can indicate that staff are not taking leave due to them or that staff numbers are increasing.

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Is the financial position of the organisation (presented in the current Balance Sheet) consistent with its position at the end of the last accounting period (shown in the last period’s Balance Sheet)? [The assessment should be made after taking into consideration the financial performance since the end of the last accounting period (shown in this period’s Income and Expenditure Statement)].

Balance Sheets can vary greatly from period to period. The Balance Sheet should show how the organisation has operated and performed. Looking at the ‘opening’ Balance Sheet and the current performance together is the key. If you look at performance since the ‘opening’ Balance Sheet was prepared, you should get a feel for what to expect in the next Balance Sheet. Example: An increase in accounts receivable may reflect an increase in student enrolments and fees. (This would, in turn, be reflected as increased fee revenues in the Income and Expenditure Statement.) This is a positive outcome indicating good performance. However, if fees have not increased, then it may reflect inadequate or ineffective efforts to collect overdue fees or, even worse, the misappropriation of fees collected from students.

Tip for committee action

You are required to report any suspected fraud or misappropriation to your principal, coordinator or manager, and to ask for the figures to be explained. Such action on your part must, however, be carried out with great caution and discretion, and with complete confidentiality. If you are dissatisfied with the explanations you receive, you (and/or the committee) may decide to refer the matter to the relevant funding bodies. The committee might also decide to pay for legal advice on the matter.

Analysing financial information

When financial information is prepared under an accrual accounting system, the Balance Sheet is analysed using current and liquid ratios to indicate financial stability. Financial stability

Financial stability or the ability to meet financial commitments, particularly in the short term, is what allows the business to keep operating. The ratio is usually expressed in the form of X : 1. The following two ratios are useful measures of financial stability: 1 Current ratio (working capital ratio)

This ratio can also be calculated under a cash accounting system. It shows the amount by which our readily available assets exceed soon -to-be-paid liabilities, or it can be interpreted as the amount of cash available in the short term for each dollar of short term liabilities.

Calculated as: Current assets

Current liabilities

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This ratio:

4 indicates the ability of the organisation to pay its current debts as they fall due

4 should be greater than 1 : 1. If not the organisation has less than one dollar available in the short term to cover each dollar that is due for payment in the short term. In this case the organisation is probably facing liquidity difficulties and requires very careful cash management.

2 Liquid ratio (quick or acid test ratio)

Calculated as: Current Assets – Stock – Prepayments

Current Liabilities – Bank Overdraft This ratio gives a better picture of the short term liquidity of the organisation because it excludes:

4 those assets that are not easily converted to cash (even though they are considered current)

4 any bank overdraft because this usually does not have to be repaid quickly.

Below is an extract from a Sunnyway Balance Sheet as at 31 December 2005. Under this table you can see the calculations used to arrive at the current ratio and the liquid ratio. The right hand column shows which components of the Balance Sheet are used to calculate the current and liquid ratios.

Extract of Balance Sheet of Sunnyway as at 31 December 2005

Liquid Current

Current Assets

Cash at Bank $8,400 8,400 8,400 Accounts receivable $5,200 5,200 5,200 Prepaid insurance $1,600 1,600 − $15,200 $13,600

Current Liabilities

Creditors and accrued expenses $7,300 7,300 7,300 Provisions for staff entitlements $1,200 1,200 1,200 $8,500 $8,500

The ratios are:

Current Ratio = 15,200 = 1.79 : 1

8,500

Liquid Ratio = 13,600 = 1.60 : 1

8,500

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Exercise 4.3: Financial stability

Take a moment to consider, and if possible discuss, these questions: What does a current ratio of 1.79:1 mean for Sunnyway and its ability to pay its current debts? What does a liquid ratio of 1.60:1 mean for Sunnyway in terms of its short term liquidity? Check answers below.


You were asked about the significance of the current and liquid ratios. A current ratio of 1.79:1 means that for each $1 of the organisation’s liabilities which will fall due in the short term, the organisation has $1.79 in either cash or assets which can be converted to cash. These include accounts receivable which the organisation can expect to receive as cash in the short term and prepaid insurance which could, in the event of cessation of operations, be realised as cash through refund of the unexpired portion. The liquid ratio of 1.60:1 can be interpreted in similar fashion except that the prepaid insurance, which would not normally be expected to be converted to cash, is excluded. The organisation’s physical cash plus the cash it expects to receive from accounts receivable together provide $1.60 for each $1 of liabilities which will fall due in the short term.

Q

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Exercise 4.4: Balance Sheet — Calculating current and liquid ratio

Balance Sheets from ARC Adult Education have been combined below to show trends over a three year period. Study the statement line by line. For each year from 2003 calculate the:

current ratio

liquid ratio

Write your answers in the table on page 14.

Q

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ARC Adult Education Inc – Three-year Balance Sheet

2005 2004 2003

Current assets $’000 $’000 $’000

Cash 5 8 16

Debtors 4 6 18

Prepaid expenses 7 2 10

Sub-total 16 16 44

Non-current assets

Land and buildings 448 301 67

Furniture and equipment 66 43 52

Investments 5 10 15

Sub-total 519 354 134

TOTAL ASSETS 535 370 178

Current liabilities

Creditors 8 16 6

Prepaid funding allocation 2 4 2

Provision for staff entitlements 3 1 2

Sub-total 13 21 10

Non-current liabilities

Provisions for staff entitlements 3 3 2

Long-term loans 356 180

Sub-total 359 183 2

TOTAL LIABILITIES

372 204 12

NETT ASSETS 163 166 166

Represented as:

Accumulated funds at 1 January

166 166 156

Surplus/(Deficit) this period (3) 0 10

Accumulated funds at 31 Dec 163 166 166

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For each year calculate the current ratio and the liquid ratio. Fill in your answers. Current ratio (working capital ratio)

2005 2004 2003

Calculated as: Current Assets

Current Liabilities

Liquid ratio (quick or acid test ratio)

2005 2004 2003

Calculated as:

Current assets — stock — pre-payments

Current liabilities — bank overdraft

015


You were asked to calculate current ratio and liquid ratio for each year from 2003 Current ratio (working capital ratio)

2005 2004 2003

Calculated as: Current Assets 16 16 44

Current Liabilities 13 21 10

1.23:1 0.76:1 4.40:1

Liquid ratio (quick or acid test ratio)

2005 2004 2003

Calculated as:

Current assets — stock — pre-payments 9 14 34

Current liabilities — bank overdraft

13 21 10

0.69:1 0.67:1 3.40:1

A

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Exercise 4.5: Balance Sheet — Identifying trends and changes

Study again the three-year Balance Sheet from ARC Adult Education, on page 12. Consider the statement line by line. Look at student fees. What trends can you identify in th e results over the three years? What other significant trends or changes do you notice in current and liquid ratios? Look for trends in the Income and Expenditure Statement. Consider ARC’s income and its interest expense and rent expense accounts.


You were asked to:

consider student fees, current and liquid ratios, and identify any trends in the results over the three years

identify any other significant changes in ARC’s Balance Sheet and the implications of these changes.

ARC’s current ratio has decreased from a very comfortable 4.40:1 in 2003 to 0.76:1 in 2004. In 2005 it is back above 1:1. The liquid ratio has also deteriorated, dropping from 3.40:1 in 2003 to 0.67:1 in 2004 and 0.69:1 in 2005. It can also be seen from ARC’s Balance Sheet that it has entered into a program of borrowing and property investment in the last two years. The value of land and buildings has increased by $67,000 from $381,000 in 2003 to $448,000 in 2005. Long-term loans have increased from nil to $356,000. ARC ‘s debt level has increased. The organisation has invested heavily in buildings and taken out loans to do this. At the same time the business has declined, ie there has been a decline in student fees. The committee should ask why business is declining. The committee should also question the wisdom of borrowing money at this time. Financial reports to the committee should summarise and comment on trends reflected in the Balance Sheet, in a kind of ‘executive summary’.

Q

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Exercise 4.6: Balance Sheet — Analysing financial results

What are the implications of changes in the current and liquid ratios? What do these results mean for the financial position of ARC? What are the implications of any other changes in the Balance Sheet?


You were asked to consider the implications of the results of the current and liquid ratio analyses for the financial position of ARC. The changes in current and liquid ratios, and especially the liquid ratio, indicate that ARC faces the prospect of not being able to meet its short-term financial obligations as and when they fall due. ARC may, in fact, be technically insolvent and, as such, its financial position and viability should be the subject of urgent and objective critical review. On the basis of these ratios alone, it would be appropriate to seek professional financial advice at this point. From our review of ARC’s Income and Expenditure Statement earlier, we can see that this is happening at a time when student fees are declining. (Remember the first hint we had of ARC’s borrowing program was the increase in interest costs evident on the Income and Expenditure Statement (see Module Three). From the Balance Sheet it is apparent that these borrowings have been used to invest in land and buildings.) The merits of this sort of investment for ARC are questionable on two grounds:

it is taking place when operations are in decline

ARC’s accommodation (rent) costs had, in each of the last three years, amounted to not more than $2,780 (from the income and expenditure statement).

If the purpose of ARC’s $381,000 investment was simply to save a $2,780 rental cost, then the organisation would be looking at a return on investment of a little over 0.7% per annum ($2,780/$381,000). ARC would need to generate significantly greater income from its investment, by way of student fees and possibly rental income, to remain viable with this level of borrowing and investment. As it is, ARC has not even shown a saving in its existing rent expense.

Q

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Quick quiz

Use the questions below to check your understanding of the material covered in this module. If you are unable to complete the quiz, review the appropriate sections of the module.

Write short answers in the spaces provided, eg Question 2. In other questions, eg Question 1, you are given more than one possible answer. In this case tick the box or boxes that you think are correct.

q on its own 1 The Balance Sheet should be considered q together with other financial reports

1

2

2 List three things the committee should look for when reviewing the Balance Sheet 3

q profitability ratio

q current and liquid ratios

3 The Balance Sheet is analysed using ...

q liquid ratio

q current

q non-current

q equity

4 The Balance Sheet lists assets and liabilities as

q expenses

q at a specific point in time

q over a period of time

5 The Balance Sheet shows the financial position of the organisation ...

q at the end of an accounting period

q profit and loss

q financial stability

6 Current and liquid ratios indicate

q nett worth

1 7 Give an example of a current asset and a non -current asset

2

1 8 Give an example of a current liability and a non-current liability.

2

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Review tasks

Task 1 Responsibilities of management committee members

The committee should review the Balance Sheet …

Task 2 Reviewing financial reports

When reviewing the Balance Sheet the committee should ask questions about …

Documents

Module 4 LCP - workplacement.nsw.edu.au 4 LCP.pdf · confirm or revise your answers find the answers you did not know. When you have completed the module you should revise the quiz