Study organiser

Study Organiser

Topic(weeks)

Topic Title and Topic Outline Learning Activities and

Assessment

Introduction to accounting and finance

1(1)

Nature and role of accounting Accounting information user groups Accounting as an information system Accounting as a service function Characteristics of accounting information Decision-making, planning and control Overview of the planning and control process Business objectives Financial and management accounting

The main financial reports and relationships

Discussion questions Additional exercises Review questions Summarizing

Vocabulary activity

Different accounting entities

2(2,3)

Nature of sole proprietorships Nature of partnerships Nature of companies Corporate governance and the role of directors Types of companies Analyse the capital of companies

Role of the alternative regulatory bodies

Discussion questions Additional exercises Review questions Summarizing

Vocabulary activity

Measuring and reporting financial position

3(3,4,5

)

Purpose of the balance sheet Assets definition, recognition, measurement and classification Liabilities in terms of definition, recognition, measurement and classification Nature and classification of owner’s equity Basic accounting equation Balance sheet formats Factors that influence in a balance sheet Simple balance sheet Analyse balance sheets of reporting entities

Limitations of the balance

Discussion questions Additional exercises Review questions Critical thinking Paraphrasing Summarizing Listening  & note taking

Measuring and reporting financial performance

4 Measuring and reporting financial performance

Discussion questions Additional exercises

(6,7)

Income statement (profit and loss) Income statement and the balance sheet Profit and loss equation Income statement format Income definition, recognition, classification and measurement Relation definition, recognition, classification and measurement Accrual and cash-based transaction recognition Expense recognition for non-current tangible assets Expense recognition for inventory Expense recognition for accounts receivable

Income statement

Review questions Summarizing Listening & note taking Critical thinking and analysis skills

Measuring and reporting cash flows

5(9,10)

Importance of cash Define cash and cash equivalents Accrual and cash-based transaction recognition Three external financial reports Cash flow statement Non-cash transactions Recognise the alternative Cash flow statement Reconciliation of net profit

Useful of cash flow statement

Discussion questions Additional exercises Review questions Summarizing Critical thinking and analysis skills Report writing

Vocabulary activity

Analysis and interpretation of financial statements

6(11,12

)

Define ratio Financial performance and financial position Terms profitability, efficiency, liquidity, gearing and investment Comparison for ratio analysis Ratio formulae Analyse and interpret  ratios Limitations of ratios

Index or percentage analysis

Discussion questions Additional exercises Review questions

Report writing

Managing working capital

7(13)

Working capital Working capital cycle The importance of inventory Controlling asset Controlling and managing holding cash

Creditor management

Discussion questions Additional exercises

Review questions

These notes have been adapted from power point slides from Atrill, McLaney, Harvey & Jenner, ‘Accounting: An Introduction’, 4th edition, Pearson Education Australia Page 2 of 70

Cost volume profit

8(14)

Cost behaviour Fixed costs and variable costs Break-even point Concept of contribution Concept of a margin of safety

Weaknesses of break-even analysis

Discussion questions Additional exercises

Stress management

Budgeting

9(15,16

)

Define a budget Relation between budgets, corporate objectives and long-term plans Main components of the budget-setting process Interlinking of the various budgets Main uses of budgeting Construct budgets from relevant data Use a budget

Implication of controlling budgets traditionally

Discussion questions Additional exercises

Review questions

_

(8)    Review and test 1 (Class2)

_

(12)    Test 2 (Class 2)

Print version of study organiserIntroductory Accounting - study organiser (39.561 Kb)

Topic Notes

ACCT 1046Introductory Accounting

These notes have been adapted from power point slides from Atrill, McLaney, Harvey & Jenner, ‘Accounting: An Introduction’, 4th edition, Pearson Education Australia Page 3 of 70

Semester 2, 2009 Course Title: Introductory Accounting

Part A: Course Overview

Course Title: Introductory Accounting

Credit Points: 12

Course CodeCampus Career School Learning ModeTeaching Period(s)

ACCT2189 City CampusUndergraduate650T TAFE BusinessFace-to-Face

Sem 2 2009

Course Coordinator: Sonia Magdziarz

Course Coordinator Phone: +61 3 9925 5737

Course Coordinator Email:sonia.magdziarz @rmit.edu.au

Pre-requisite Courses and Assumed Knowledge and Capabilities

None

Course Description

Introductory Accounting introduces you to the role of accounting information in business and is taught with the assumption that you have not previously studied accounting concepts and techniques.

Introductory Accounting is a compulsory core unit in the Bachelor of Business (Accountancy) degree and is required for membership of CPA Australia and the ICAA for all Faculty of Business students seeking this form of professional recognition.

Objectives/Learning Outcomes/Capability Development

Successful completion of Introductory Accounting means that you should be able to identify and understand the most significant critical factors that influence the success or failure of a business.

These notes have been adapted from power point slides from Atrill, McLaney, Harvey & Jenner, ‘Accounting: An Introduction’, 4th edition, Pearson Education Australia Page 4 of 70

In addition, the course provides an opportunity for you to develop generic capabilities. These include the ability to: - Analyse, reason logically and conceptualise issues - Identify, understand and interpret basic concepts.

Overview of Learning Activities

As an introductory course, learning activities are based on the assumption that set tutorial work will be completed by you prior to attending tutorials. This ensures that valuable discussion, extension of concepts and issues requiring clarification can be attended to in the tutorial.

Overview of Learning Resources

You will be advised of the prescribed text for this course and other reading materials upon enrolment.

Extra material may be provided or recommended by the teaching team of this course. This material may be supplied in hard copy, and/or via the RMIT internet site called the Learning Hub.

Overview of Assessment

Assessment in Introductory Accounting may take the form of an assignment, and/or an in-semester test, and/or an end-of-semester examination.The in-semester assessment is designed to test your comprehension and understanding of the course material. The end-of-semester exam will again test the student’s ability to identify and understand basic accounting concepts and further, their ability to analyse and interpret basic accounting information.

To pass this course you must:

obtain a mark of at least 50% on the final exam.

These notes have been adapted from power point slides from Atrill, McLaney, Harvey & Jenner, ‘Accounting: An Introduction’, 4th edition, Pearson Education Australia Page 5 of 70

Topic 1 – Business Decision Making and Accounting

Learning Objectives• Define accounting• Discuss the role of accounting information• List the main accounting information user groups for a business entity• Summarise the uses of accounting information• Explain the procedures within the accounting information system• State the key characteristics of accounting information• Relate the steps in the planning process• Discuss the nature of control in the decision-making process• List some alternative business objectives• Compare and contrast financial and management accounting• Provide an overview of the main financial reports

The Nature and Role of Accounting

What is accounting?

Accounting is concerned with the collection, analysis and communication of economic information.

Accounting information is useful to those who need to make decisions and plans about businesses, and for those who control those businesses.

The role of accounting information:

Stewardship The more traditional role of providing accountability reports of transactions for a given period

Decision usefulness Is about assisting users with making informed choices about issues e.g. resource allocation

Accounting information user groups

Figure 1.1

Accounting as an Information System

Different procedures involved in the accounting information system:• Identify and capture relevant economic information

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• Record the information collected in a systematic manner• Analyse and interpret the information collected• Report the information in a manner suitable to the needs of users

Figure 1.2Accounting as a Service Function

The key characteristics of accounting information:• Relevance (ability to be used to influence decisions)• Reliability (free from material error or bias)• Comparability (consistency of measurement and presentation of items)• Understandability (clarity and readability of presentation)• Cost of information (is the benefit worth the cost)

Characteristics of accounting information

Figure 1.3

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Decision-Making, Planning and Control

The steps in the planning process:

Planning is usually broken down into three stages:

1. Setting the objectives or mission of the business(Detailing what the business is basically trying to achieve)

2. Setting long-term plans(Describing how the business will set out to achieve its long-term objectives)

3. Setting detailed short-term plans or budgets(Typically financial plans for one year ahead)

The nature of control in the decision-making process:• Control is the process of making planned events actually occur

• Accounting is useful in control to compare planned outcomes with actual outcomes in commonly specified terms

• Managers can take steps to get the business back on track if variances are highlighted between planned and actual outcomes

Overview of the planning and control process:

Figure 1.4

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Step 1

Step 2

Step 3

Step 4

Step 5

Step 6

Step 7

Identify business objectives

Consider options

Prepare a long-term plan based on the most appropriate option(s)

Perform and collect information on actual performance

Prepare short-term plans (budgets)

Respond to divergences between plans and actuals,and exercise control

Revise plans and budgets if necessary

Business Objectives

Some alternative business objectives:

The popular suggested business objectives include:• Maximisation of sales revenue (this does not consider the need to cover business costs)• Maximisation of profit (this takes in to account sales revenues as well as expenses, but is limited as it does not

include other factors such as risk.).• Maximisation of return on capital employed (accounts for level of profit as well as the level of investment)• Survival (This is the aim of most businesses, however it is rarely a primary objective)• Long-term stability (Like survival, most businesses aim for it, but it is rarely a primary objective)• Growth (Encompasses survival and long-term stability and aims to strike a balance between short and long-term

benefits, however it is probably not a specific enough target)• Satisficing (Attempting to grant a satisfactory return to all stakeholders - not just the owners. Difficult to define as a

practical benchmark for business decisions.)• Achieving sustainable development (Achieving economic growth while minimising or eliminating environmental

impact and meeting society’s expectations of good corporate citizenship.)• Enhancement / maximisation of business wealth

• Means the business takes decisions intended to make it worth more. • Encompasses all the valuable features of the previous suggested objectives. • Likely to be the main financial objective for many businesses )

Financial and Management Accounting

• Management accounting is concerned with providing managers with information required for day-to-day running of the business

• Financial accounting is concerned with providing the other users with useful information

  Financial Accounting Management Accounting

Focus Mainly external Internal only

Nature of reports General purpose Specific purpose

Level of detail Broad overview Quite detailed

Restrictions Accounting standards and other regulations

No restrictions

Reporting interval Mainly semi-annual or annual Whenever required

Time horizon Mainly historical Both past and future

Range of information Quantifiable in money terms; focus on objective and verifiable data

Can contain non-financial information; less focus on objectivity and verifiability

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An Overview of the Main Financial Reports

There are four main financial reports:

• The Statement of Cash Flows (shows the sources and uses of cash for a period)• The Income Statement (traditionally known as Profit and Loss; measures and reports how much profit has been

generated in a period)• The Statement of Financial Position (otherwise known as the Balance Sheet; shows overall net financial position)• The Statement of Changes in Owner’s Equity (shows all changes in owner’s interest in net assets from transactions

during the period)

A Simple Example:

Paul starts an office stationery retail business with $100On the first day, he uses the $100 to purchase office stationery (“inventory”)On the same day he sells 75% of that inventory for $110 in total

What cash movements took place in the first day of trading?Opening balance $100 - $100 stock purchase + $110 sales = $110

What is the closing cash balance at the end of day 1?Closing cash balance for day 1 is $110

How much did wealth increase as a result of the first day’s trading?•The increase or decrease in wealth is measured as the difference between sales made and the cost of goods

sold•Sales were $110 less cost of goods sold $75 = profit of $35

Note: that only the cost of the office stationery SOLD is measured against the sales to find profit, not the total cost of the office supplies purchased.

What is the financial position at the end of the first day?At the end of the first day, a balance sheet is drawn up, showing the resources held by the business:

• Cash (closing balance) = $110• Inventory (stock available for resale) = $25• Total business wealth at end of day = $135

Note: that the profit of $35 has led to an increase in wealth of $35 that the increase in cash of $10 is not the same as the increase in wealth because wealth does not exist only

in the form of cash (see inventory)

Summary:CashOpening balance $100 – purchase inventory $100 + sales $110 = Closing cash balance of $100Wealth (of the owner)Owner invested $100 + Profit $35 = Owners wealth of $135Wealth (of the total business)Consists of Cash $110 + Inventory $25 = $135

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Some important concepts arise from this example: assets (inventory, cash) revenue expenses profit (matching revenue with expenses) wealth of the owner/owners investment in the business transactions taking place in a business

purchase of the wrapping paper sale of the wrapping paper

cash being different to profit recognising the relationship between the business and the owner (what happens when the owner undertakes a

personal transaction? Is this transaction recorded in the accounting information system?)

Now revisit the financial reports:

Statement of cash flows – cash inflows and cash outflows of the business

Statement of financial performance – performance of the business (calculation of profit or loss by matching revenues and expenses)

Statement of financial position – the position of the business at a point in time (what assets does the business have? What is the owner’s investment in the business? Does the business have any liabilities? What if the wrapping paper (inventory) purchased was bought on credit and not with cash?)

Statement of changes in equity – how has the investment of the owner changed between the start of the period and the end of the period (in the above example, this was a change between one day and the next)

Financial Report Relationships

Figure 1.6

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Balance sheet at the beginning of Period 1

Balance sheet at the end of Period 2

Balance sheet at the end of Period 1

Period 1 Period 2 Time

Income statement Income statement

Cash flow statement

Statement of changesin owner’s equity

Cash flow statement

Statement of changesin owner’s equity

Topic 2 – Different Accounting EntitiesLearning Objectives

• Discuss the nature of sole proprietorships• Discuss the nature of partnerships• Discuss the nature of companies• Discuss corporate governance and the role of directors• Distinguish between different types of companies• Analyse the capital of companies• Identify and discuss the role of the alternative regulatory bodies in company operations and financialreporting

Types of business entities

Sole proprietorship Partnership Company

Sole Proprietorships

The nature of sole proprietorships:• No separate legal entity (as distinct from a separate accounting entity)• Limited life (restricted to the period the owner continues to operate the business in)• Unlimited liability (the owner is fully responsible for the debts and obligations of the business)• Minimum reporting regulations (minimal compared with other entity structures)• Limited access to funds (restricted to the personal resources of a single owner)• Low establishment costs (comparatively much lower compared to other entity structures)Some advantages of sole proprietorships include:• Simple and inexpensive to establish and operate• Minimal financial reporting regulations• Ownership and management are normally combined• Financial rewards flow directly to the owner• Timely decision-making is possible

Partnerships

The nature of partnerships:A partnership may be described as the relationship that exists between two or more persons carrying on a business with a view to profit.The relationship may be established by a formal partnership agreement or an informal arrangement between the parties, or it may be inferred by the actions of two or more individuals.The partnership maintains individual records of each partner’s transactions according to:• Resource contributions (capital)• Resource withdrawals (drawings)• Share of undistributed profits (either current or retained earnings)

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The characteristics of partnerships:• No separate legal entity• Limited life• Unlimited liability• Mutual agency (each partner is responsible for the actions of the other partners)• Co-ownership of assets (the partnership assets are owned by the partners in aggregate, not individually)• Co-ownership of profits (equally or in agreed proportions)• Limited membership (a restriction on the number of partners allowed. Normally twenty is the limit.Some exemptions exist e.g. accounting practices)• Increased regulation (most states have Partnership Acts for direction of activities and rights and responsibilities of partners)

Partnership Agreements:• Important to have a detailed and formal agreement so that most potential problems can be avoided• Issues not covered by the partnership agreement will be governed by lawSome examples of ‘default’ legal rules that an agreement may cover include:• No entitlement of partners to a salary or wage• Partners not entitled to interest on capital contributed• Equal shares of profits and losses

Companies

The nature of companies:There are a number of company types, the most common being the company limited by shares, or ‘limited company’A limited company may be defined as: An artificial legal person who has an identity separate from that of those who own and manage it. Ownership interest is broken down into ‘shares’ hence the term ‘shareholders’ to describe the owners, who have invested in the business.

Characteristics of companies:• Separate legal entity (a limited company has the legal capacity of a person and is separate from those who own the entity i.e. can sue and be sued, buy, borrow, lend and employ in its own right as a legal person)• Unlimited (perpetual) life (the life of the company is indefinite and not related to the life of the owners)• Limited liability (the entity is responsible for its own debts and obligations because it is a legal person. Shareholder’s obligations cease upon full payment of the agreed price of their shares.)• Company ownership of assets (assets owned by the company in its own right as a legal person) • Company profits belong to the shareholders (profits are either distributed or retained for the benefit of shareholders)• Extensive membership (some forms of companies may be limited, but public companies e.g. Westpac, Telstra often exceed 250,000 initial shareholders)• Separation of ownership and management (usually a separate specialist management team exists outside the ownership interest, although increasingly managers are also shareholders)• Extensive regulation (much stricter requirements due to ‘limited liability’ benefit granted to owners. Corporations Act, ASIC, ASX, accounting standards all govern reporting to shareholders and markets)

Advantages of companies:• Separation of ownership and management• Perpetual existence• Separate legal entity• Owners have limited liability• Greater access to ownership funding• Potentially greater access to debt funding• Potential taxation advantages

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• Potential increases in share values when listed on the ASX (Australian Stock Exchange)

Disadvantages of companies:• Extensive regulation• Higher establishment costs• Subject to more public scrutiny• Owners not able to watch everything• Pressure for short-term performance• Loss or dilution of original ownership control• Income tax is paid on every dollar of profit earned (no tax-free threshold)

Corporate Governance and the Role of Directors

Corporate governance: The system by which corporations are directed and controlledDirectors: Individuals elected to act as the most senior level of management in a company• The Board of Directors is the most senior level of management in a company• A limited company must have at least one director• Directors are elected by the shareholders• Shareholder interests should be the guiding principle for a director’s governance decisions• Directors are also subject to a framework of rules based on the principles of Disclosure,Accountability and Fairness

Disclosure, Accountability and Fairness:

• Disclosure (lies at the heart of good corporate governance, is all about adequate and timely information being available to investors)• Accountability (involves defining the roles and duties of directors and establishing an adequate monitoring process which may include external auditing)• Fairness (is about directors not benefiting from ‘inside information’. The law and ASX have imposed regulations that restrict directors’ ability to buy and sell shares of the business)

Public and Proprietary (Private) Companies

Different types of companies:

Public ProprietaryCompany name includes ‘Ltd’ ‘Pty Ltd’Public sale of shares Yes NoTypical size Large SmallerExtent of regulation Extensive ModerateRaise monies from public Yes Some restrictionsSubject to reporting requirements Yes Depends on size• Public companies and ‘large’ proprietary companies must prepare annual financial reports – including financial statements and directors’ reports• ‘Small’ proprietary companies do not have these requirements unless requested by ASIC or by at least 5% of members• To be ‘small’, they must satisfy at least 2 of:• Consolidated gross operating revenue < $10 million• Consolidated gross assets at end of year < $5 million

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• Must employ < 50 employees at end of year

Capital of Limited Companies

The basic division - an example (refer example 2.1 on page 45): Several people decide to start a new company They estimate they will need $50,000 to obtain assets to run the business Between them, they raise the cash to buy shares in the company, which issues 50,000 shares at

$1 each.

The statement of financial position at this point would be:Net Assets (all in cash) $50,000Shareholder’s equityShare capital - 50,000 shares $50,000

The company buys the necessary assets and inventory and starts to trade During the first year it makes a profit of $10,000 and the shareholders (owners) make no

drawingsAt the end of the first year the summarised statement of financial position is:

Net assets (various assets less liabilities) $60,000Shareholder’s equityShare capital - 50,000 shares $50,000Reserves (retained profits) $10,000

$60,000Owners' Claim(Shareholders' Equity)Shares(Investment by ‘owners’)Reserves(Profits and gains subsequently made)

Different types of shares Different types of Reserves

• The profit is shown in a ‘reserve’ known as ‘retained profits’ and is kept separate from share capital• Retained profits are not added to share capital due to Corporations Act restrictions on the maximum drawings of capital (or dividends) the owners can make

Share Capital

Shares are the basic units of ownership of the business• All companies issue ‘ordinary shares’ which are the main risk-bearing shares of the company.• Ordinary shareholders’ returns come from distributions of profit (dividends) or from increases in the value of the shares• Normally, retaining profits will increase the value of ordinary shares• Dividends - transfers of assets made by a company to its shareholders• Partly-paid shares - shares on which the full issue price has not been paid, but the balance is to be paid in a series of installments or ‘calls’• Fully paid shares - shares on which the shareholders have paid the full issue price• Preference shares - shares which have a fixed rate of dividend that must be paid before any ordinary share dividends can be paid. These have higher priority in the event of the company going in to liquidation

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• Companies may issue shares of various classes with equally various conditions, but ordinary and preference shares are the most common• Within each class, all shares must be treated equally• ‘Voting rights’ are normally only ascribed to holders of ordinary shares. One ordinary share normally equals one vote• New shares can be issued at any time and they are priced at, or close to, market price. This is to ensure no disadvantage to existing shareholders since all have the same rights

Reserves

Reserves - profits and gains made by the company that have not been distributed toShareholders.The most common type of reserve is ‘retained profits’ - profits earned by the company that are held back for use within the companyOther reserves may be created in certain circumstances - a reserve is created (asset revaluation reserve) when assets are re-valued at greater than their book value

Bonus Shares

Bonus shares - reserves which are converted into shares and given ‘free’ to shareholders- A bonus issue of shares simply takes one form of shareholders’ equity (reserves) and transforms it into another form (share capital)- Bonus share issues have no impact on the net assets (total assets less total liabilities) of a companyRights IssuesTo generate additional share capital for expansion, a company may make a ‘rights issue’- These are issues of shares for cash, offered first to current shareholders (who may sell the right to others) in proportion to their existing holdingsSuch shares are normally offered at a price below the prevailing market price to encourage takeup of the offer- Rights issues differ from bonus issues in that rights issues result in an asset (cash) being transferred from shareholders to the company

Transfer of Share Ownership

Stock exchange - a formal marketplace where shares may be bought and sold, and where new capital can be raisedPrices are determined according to the law of supply and demand, which in turn is determined by investor’s perceptions of future economic prospects for the companies concernedTransfer of ownership of shares has no direct impact on the company’s business or on shareholders not involved in the transfer

Restrictions on the rights of shareholders to make capital drawings:

– Limited companies are required by law to distinguish between capital that may be withdrawn by shareholders and that which may not– The balance sheet must clearly identify the amount of non-distributable capital– It is illegal for shareholders to withdraw that part of their claim represented by capital– The legal provisions are in place to prevent unscrupulous activity which may disadvantage other shareholders as well as creditors and lenders

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The Nature of Regulatory Bodies

The role of alternative regulatory bodies in company operations and financial reporting:

Director’s duty to account:

• To be accountable for their actions and to demonstrate good stewardship• To provide financial reports that are ‘true and fair’ and that comply with all relevant laws as well as accounting standards• Financial reports must include the balance sheet, the income statement, the cash flow statement, the statement of changes in owner’s equity and related notes, also the director’s declaration and director’s report• Compliance with Corporations Act disclosure requirements• Publish the auditors report (if applicable)

The role of accounting standards:

– For most of the 20th century GAAP was the guiding set of principles in Australia– Since 2005, Australia has adopted International Accounting Standards– Accounting standards narrow management’s range of methods for recording and reporting transactions, bringing about greater consistencyThere are two types of accounting standard• AASB – applies to companies and now sets all standards• AAS – applies to other entities

The role of the ASX in company accounting:

Companies listed on the ASX (public companies) are subjected to further rules specified by the ASX in relation to• more frequent reporting• other matters e.g. corporate mergers/takeoversShareholders are responsible for appointing qualified and independent auditors to audit the company’s financial statements• audits are not mandatory for small proprietary companies

Topic 3 – Measuring and Reporting Financial PositionLearning Objectives

• Explain the nature and purpose of the statement of financial position/balance sheet• Demonstrate an understanding of assets in terms of definition, recognition, measurement and classification• Demonstrate an understanding of liabilities in terms of definition, recognition, measurement and classification

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• Discuss the nature and classification of owner’s equity• Explain the basic accounting equation• Contrast the alternative statement of financial position/balance sheet formats• Discuss the main factors that influence the content and values in a statement of financial position/ balance sheet• Prepare a simple statement of financial position/balance sheet• Analyse statements of financial position/balance sheets of reporting entities• State the potential limitations of the statement of financial position/balance sheet in portraying an entity’s financial position.

Note: the term ‘Statement of Financial Position’ and ‘Balance Sheet’ refer to the same report. The names will be used interchangeably in this course.

Nature and Purpose of a Statement of Financial Position/Balance

Sheet

The purpose of the balance sheet is to set out the financial position of a business at a particular point in time• It contains a snap shot of the assets, liabilities and equity position of the entity at a particular point in time• As from January 2009 an accounting standard recommendation is that the balance sheet should be referred to as a ‘statement of financial position’

Assets

Definition: An asset, according to the AASB Framework is “a resource controlled by the entity as a result of past events, and from which economic benefits are expected to flow to the entity”The main identifying characteristics of an asset are:• Expected future economic benefit• The business has exclusive right to control the benefit• The benefit must arise from some past transaction or event• The asset must be capable of reliable measurement in monetary termsNote that these conditions limit the kind of items that may be referred to as ‘assets’ in financial reportsSome examples of items that appear as assets in a business balance sheet include:• Freehold premises• Machinery and equipment• Fixtures and fittings• Patents and trademarks• Debtors• InvestmentsAssets may be either tangible (items with a physical substance) or intangible (no physical substance e.g. patents)

Claims against the Assets:

There are essentially two types of claims against the assets of an entity:• External claims - known as liabilities• Internal claims - labelled owners’ equity, equity, or capital

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Liabilities

Definition: A liability according to the AASB Framework is “a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits”In addition to meeting the definition on the previous slide, there is a twofold recognition criterion:• Probability of occurrence (in the case of liabilities, it is more likely than not that a future sacrifice of economic benefits will occur)• Reliability of measurement (in the case of liabilities the amount of the claim can be determined with acceptable precision or accuracy)Some examples of items that appear as liabilities in a business balance sheet include:• Creditors• Staff entitlements• Loans and other credit facilities• Warranty provisions and other social or moral obligations• Provision for employee bonuses

Owners’ equity - The claim of the owner(s) on the assets of the business

The Accounting Equation

The basic accounting equation:

The basic accounting equation is expressed as:

Assets = Liabilities + Owners’ Equity OR A = L + OE

This equation will always hold true, as total claims (against the assets) are always the same as total assets, ensuring that the balance sheet always ‘balances’.

Effect of trading operations on the balance sheet:

Every transaction has at least 2 effects on the accounting equation. You will notice in the following example that we not only look at how assets, liabilities and/or owners’ equity is affected but we also state which asset (cash at bank, motor vehicle, etc), which liability (creditor, loan, etc) or which part of owners’ equity (capital, drawings) is actually affected. This is necessary as the financial reports such as the balance sheet displays details of the business’ assets, liabilities and equity items and NOT JUST total assets, total liabilities and total owners’ equity. Similarly, the income statement shows details of income and expense items and NOT JUST total income and total expenses. Both totals and detailed information is provided in both reports.

For example:– A business purchases a motor vehicle for $40,000 cash– Assets (cash at bank) ↓ by $40,000– Assets (motor vehicle) ↑ by $40,000– Overall, there is no change to the accounting equation as the total value of assets remains the same. One asset has simply been exchanged for another. Trading operations (i.e. the sale of goods or services) introduces additional transactions that impact on the balance sheet.To take into account the effect of trading, the balance sheet equation previously described is extended as follows to take into account the impact of income and expenses and changes in owners’ equity.Recall that this is the basic accounting equation:

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BASIC ACCOUNTING EQUATION:

Assets (A) = Liabilities (L) + Owners’ Equity (OE)OrA = L + OE

This is the expanded accounting equation shown in your textbook:Assets = Owners’ equity beginning + Profit (or -Loss) +/- Other Owners’ Equity Changes + Liabilities

While the expanded accounting equation may look daunting, it is really just expanding on the Owners’ Equity part of the equation as shown below:Assets = Owners’ equity beginning + Profit (or -Loss) +/- Other Owners’ Equity Changes + Liabilities

Owners’ EquityYou may also notice that the equation above shows that A = OE + L.This has the same effect as A = L + OE.You will also see that Income and Expenses have been indirectly included in the accounting equation now as the result of Income minus Expenses will provide you with profit/loss. You may recall that the result of trading (profit or loss) is added to/subtracted from the owners’ investment in the business (capital) which is therefore part of owners’ equity.Any additional contributions by the owner are added to capital and any assets taken from the business by the owner for personal use are subtracted from the owners’ investment and are usually known as drawings for a sole trader. These components of owners’ equity are illustrated below in the expanded accounting equation.

The five major accounting elements that result from these equations are: Assets (A) Liabilities (L) Owners’ Equity (OE) Income (I) Expenses (E)

While additional capital contributions and drawings have been shown separately in the expanded accounting equation, they are not an accounting element in their own right. They are both part of owners’ equity. Income and expenses are separate accounting elements. However it is the end result of trading (profit/loss) that is then added to owners’ equity (capital).In summary, three of these accounting elements (assets, liabilities and owners’ equity) are shown in the Balance Sheet (Statement of Financial Position) while the remaining two accounting elements (income and expenses) are shown in the Income Statement.

The Balance Sheet / Statement of Financial PositionThe Classification of Assets

Assets are normally categorised as either current, or non-current.

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• Include cash and other assets expected to be consumed or converted into cash within the operating cycle• Also include inventory, trade debtors and pre-payments

AASB 101 ‘Presentation of Financial Statements’ requires a ‘current asset’ to be classified according to the following criteria:

a) The asset is expected to be realised in, or is intended for sale or consumption in, the entity’s normal operating cycle;

b) The asset is held primarily for the purpose of being traded;c) The asset is expected to be realised within twelve months after the reporting date; ord) The asset is cash or a cash equivalent unless it is restricted from being exchanged or used to settle a

liability for at least twelve months after the reporting date

Non-Current assets:

• Held for the purpose of generating wealth, rather than for resale• May be seen as the tools of the business• Normally held on a continuing basis for a minimum period of one year• Includes ‘goodwill purchased’ - see page 90

AASB 101 ‘Presentation of Financial Statements’ requires assets to be classified as non-current if they do not satisfy any of the criteria for being classified as current (previous slide)

The Classification of Liabilities

Liabilities are normally categorised as either current or non-current

Current liabilities:• Amounts due for repayment to outside parties within 12 months of the statement of financial position date

AASB 101 ‘Presentation of Financial Statements’ requires a liability to be classified as current when it satisfies the following criteria:

a) The liability is expected to be settled in the entity’s normal operating cycle;b) The liability is held primarily for the purpose of being traded;c) The liability is due to be settled within twelve months after the reporting date; ord) The entity does not have an unconditional right to defer settlement of the liability for at least twelve

months after the reporting date

AASB 101 ‘Presentation of Financial Statements’ also requires that liabilities be classified according to their nature. This classification can be on:

• Current / Non-Current basis, or• The order of liquidity (payment)

The alternative liquidity classification may be used for liabilities if it provides more relevant and reliable information

Owners’ Equity (OE, or ‘Equity)

Definition:• The claim of the owner(s) against the business

• AASB Framework defines equity as the “residual interest in the assets of the entity after deducting all its liabilities.”

Classification of owners’ equity:

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Owners’ equity is normally classified as follows for a sole trader/sole proprietorship:1) Capital2) Drawings

Owners’ equity is normally classified as follows for a partnership:1) Capital account for each partner2) Current account for each partner (optional)

Owners’ equity is normally classified in three separate categories for a company:1) Owners’ equity contributed (share capital) - represents profits left in the business by the owners2) Reserves 3) Retained profit

It is common to combine categories 2 and 3 into ‘other reserves’ and then have them listed as sub-categories of ‘other reserves’ such as (a) retained profits and (b) other reserves.

Note: Reserves represent ownership interests in the assets, not the assets themselves. Reserves are not separate deposits of cash available for other purposes.

Formats for Balance Sheets

Figure 3.2 The Horizontal layout and entity approachThe equation for the horizontal form of balance sheet layout

Example: page 93 of textbook for Brie Manufacturing (reproduced in lecture notes)

Brie ManufacturingBalance Sheet as at 31 December 2008

$ $ $ $Current assets Current liabilitiesCash at bank 12,000 Trade creditors 37,000Trade debtors 18,000Inventory 23,000 Non current liabilities

53,000 Loan 50,00087,000

Non current assets Owners’ equityMotor vehicle 19,000 Opening balance 50,000Plant and machinery 30,000 Add profit 14,000Freehold premises 45,000 64,000

94,000 Less drawings 4,000Ending balance 60,000

Total assets 147,000 Total liabilities and owners’ equity 147,000

Source: Accounting-An Introduction, 4th edition, Atrill, McLaney, Harvey & Jenner, Pearson Education Australia 2009

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CurrentAssets

Non-CurrentAssets

CurrentLiabilities

Non-Current

Liabilities

Owners’Equity=+ + +

Formats for Balance Sheets (continued)

Figure 3.3 The Vertical layout and proprietary approachThe equation for the vertical form of balance sheet layout

Example: page 94 of textbook for Brie Manufacturing (reproduced in lecture notes)

Brie ManufacturingBalance Sheet as at 31 December 2008

$ $Current assetsCash at bank 12,000Trade debtors 18,000Inventory 23,000

53,000Non current assetsMotor vehicle 19,000Plant and machinery 30,000Freehold premises 45,000

94,000Total assets 147,000

minus

Current liabilitiesTrade creditors 37,000

Non current liabilitiesLoan 50,000Total liabilities 87,000Net assets equals 60,000

Owners’ equityOpening balance 50,000Add profit 14,000

64,000Less drawings 4,000Ending balance 60,000

Source: Accounting-An Introduction, 4th edition, Atrill, McLaney, Harvey & Jenner, Pearson Education Australia 2009

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CurrentAssets

Non-CurrentAssets

CurrentLiabilities

Non-Current

LiabilitiesCapital-+ - =

Analysis of balance sheets of reporting entities

The balance sheet is a statement of the financial position of the business at a specified point in time

It is important to establish when reading a balance sheet the date it was drawn up hence it is important to display the date prominently in the heading.

Factors Influencing the Form and Content of the Balance Sheet

There are three main influences on the accounts included in the balance sheet:

1. Traditional accounting conventions and doctrines2. More recent theoretical developments in conceptual framework projects3. Professional and statutory accounting standards

Conventional Accounting Practice:

• Made up of doctrines, principles, assumptions and accepted ideas on which accounting rules, records and reports were or are based

• These have collectively been known as GAAP (Generally Accepted Accounting Principles / Practices)

Business Entity Convention:• Holds that for accounting purposes, the business and its owner(s) are treated as separate and distinct

Money Measurement Convention:• Holds that accounting should only deal with those items which are capable of being expressed in monetary terms

Historic Cost Convention:• Holds that assets should be recorded at their historic (acquisition) cost

Going Concern (Continuity) Convention:• Holds that the business will continue operations for the foreseeable future i.e. no intention or need to liquidate the

business

Dual Aspect Convention:• Holds that each transaction has two aspects and that each aspect must be recorded in the financial statements

Conservatism / Prudence Convention:• Holds that financial reports should err on the side of caution vis-à-vis, anticipating losses but only recognising

realised profits

Other conventions include: Stable monetary unit convention, Objectivity / reliability convention, Accounting period convention, Realisation convention and Matching convention. Further details are on pp 101 - 103

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The Conceptual Framework:

• Four Statements of Accounting Concepts (SACs) were current up until 2004, known as SACs 1 - 4• SAC 3 and SAC 4 have now been replaced by the adoption of the AASB Framework, SAC 1 and SAC 2 continue in

their previous form• While the framework and statements are not mandatory, they have significant influence on new and revised

standards being issued

Accounting Standards:

• The history and significance of accounting standard setting in Australia is covered in detail in chapter 2• Regarding the balance sheet, there are numerous standards that directly affect recording and reporting assets,

liabilities and owners’ equity• The implications of the applicable Australian Accounting Standards will continue to be considered

Basis of Valuation of Assets on the Balance Sheet

While the ‘historical cost’ convention underlies the conventional accounting system, other conventions have led to departures from it. Examples include:

Prudence convention Accounting Period / Going Concern conventions Full Disclosure / Relevant Financial Information convention

Basis of Valuation of Liabilities on the Balance Sheet

While liabilities in general do not have the same range of alternative measures as assets, there are still several alternative bases for measurement, both in practice and in the accounting standards. These include:

The Contracted Amount Estimate of Expected Future Sacrifice Present Value of the future known or expected cash outflows

Interpreting the Balance Sheet

The balance sheet provides useful insights into the financing and investment activities of a business. In particular, the following aspects can be examined:

• The liquidity of the business• The mix of assets held by the business• The financial structure of the business

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Balance Sheet Deficiencies

Limitations of the balance sheet in portraying financial position are largely related to:

• Limitations related to the element definitions• Limitations related to transaction recognition• The range of alternative asset and liability financial measures

Topic 4 – Measuring and Reporting Financial Performance

Learning Objectives• State the purpose of the income statement (profit and loss)• Explain the relationship between the income statement and the balance sheet• Present the profit and loss equation and identify alternative formats for the income statement• Demonstrate an understanding of income in relation to definition, recognition, classification and measurement• Demonstrate an understanding of expenses in relation to definition, recognition, classification and measurement• Distinguish between accrual and cash-based transaction recognition• Analyse expense recognition for non-current tangible assets• Analyse expense recognition for inventory• Analyse expense recognition for accounts receivable• Prepare an income statement from relevant financial information• Review and interpret income statements

The Income Statement

The purpose of the income statement is to measure and report how much profit (wealth) the business has generated over a period.

• Profit (or loss) is the difference between Income and Expenses • Income is made up of Revenue (from operating activities) and Gains (usually from non-operating activities)• Expenses are outflows of resources to generate income

Relationship between the Income Statement and the Balance Sheet:

• The two are closely related, but NOT substitutes for each other in any way• The income statement can be viewed as linking the balance sheet at the start of a period with the balance sheet at the

end of the period• The accounting equation can thus be extended as:

Assets = OEbeg + Profit (or - Loss) +/- Other OE adj + Liabilities

or further extended to:

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Assets = OEbeg + (Income - Expenses) +/- Other OE adj + Liabilities

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• Remember: this is an extension of the basic accounting equation of A = OE + L• As a result of the relationship between the income statement and two consecutive balance sheets, profit and loss can

be calculated for a period based on the ‘stock approach’• The stock approach computes profit and loss by adjusting the change in net assets for the period by other changes in

owners’ equity in the period• The equation for the stock approach is:

Profit (or Loss) = (Aend - Abeg) - (Lend - Lbeg) - New contributions + Owners’ distributions +/- Other changes in owners’ equity

The stock approach can be used to check the accuracy of the transaction approach where income less expenses is used to calculate profit. It can also be used where there are incomplete records and may be used by insurance assessors or the Australian Taxation Office.

NOTE: you will not be required to calculate profit using the stock approach. You will need to be aware of the theoretical aspects of the stock approach.

Format of the Income Statement

In practice, there are at least three forms of income statement:• Simple listings of accounts (small organisations)• Classified reports (larger organisations)• Regulatory presentations (companies)

Simple reports:

For smaller organisations, may be just a listing of income and expenses in alphabetical or financial magnitude order

Example: page 145 of textbook for Newlands Soccer Club and reproduced in lecture notes.

Newlands Soccer ClubIncome statement for the year ended 31 October 2008

$ $IncomeTicket sales 9,200Fundraising 5,700Members’ fees 3,500Government grant 2,700Interest 600 21,700ExpensesPlayers’ payments 8,300Ground fees 2,900Insurance 2,100Travel costs 1,900Uniforms 1,500Repairs and maintenance 900Telephone and postage 600Sundries 400 18,600Period profit (surplus) 3,100

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Classified reports:

• Relate to larger organisations and often called the classified financial report. Income and expenses are not simply listed, but grouped into categories

• Income would normally be broken down into sales, and ‘other revenues’

Expenses are often broken down into four categories: 1. Cost of sales2. Selling and distribution3. Administration and general4. Financial

Example: page 147 of textbook for Hi-Price Stores

Hi-Price StoresIncome Statement for the year ended 31 October 2008

$ $Sales 432,000Less Cost of sales 254,000Gross profit 178,000Other revenue

Interest from investments 2,000Rent from properties 5,000 7,000

185,000Less ExpensesSelling and distribution

Advertising 5,000Commissions 4,000Delivery 3,000Display 2,000Salary and wages 37,000 51,000

Administration and generalSalary and wages 41,000Rates 2,000Heat and light 3,000Telephone and postage 2,000Insurance 1,000Repairs and maintenance 5,000Motor vehicle running expenses 4,000Depreciation plant and equipment 1,000Depreciation motor vehicles 2,000Depreciation buildings 3,000 64,000

FinancialInterest 3,000Bad debts 7,000 10,000

Total expenses 125,000Net profit 60,000

Regulatory reports:

• Required to be produced by companies and other entities in accordance with statutory standards• AASB 101 ‘Presentation of Financial Statements’ requires that the income statement should classify expenses

according to their nature or function• Refer to page 149 for a list of AASB 101 requirements• For external reporting, the reporting cycle is normally one year

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• For internal functions, it is common for profit figures to be prepared on a monthly basis • Example: page 150/151 of textbook

Cash versus Accrual Transaction Recognition

Distinguish between accrual and cash-based transaction recognition:

• Cash-based accounting recognises income when it is received and expenses when they are paid• Accrual-based accounting recognises income on the basis that it has been earned irrespective of whether the cash

receipt is in arrears or in advance and expenses are recognized on the basis that the expense has been used up/incurred/consumed by the business

Profit Measurement and Recognition of Income

Income should only be recognised in the accounts when it has been ‘realised’ Realisation is considered to have occurred when:

• Activities necessary to generate the revenue are substantially complete• The amount of the revenue can be objectively determined• Reasonable certainty that amounts owing will be received• Any other outstanding items can be determined with reasonable certainty

The Accrual Basis for Recognising Revenue

It is common for adjustments to be made to accounting information prior to it being published in the financial reports. These adjustments are known as balance day adjustments. The adjustments are required to ensure that revenue earned is reflected in the Income Statement for the period rather than revenue received when using the cash basis for revenue recognition. The need for such adjustments arises where:

Revenue earned for the period is greater than the cash received for the revenue The amount received for the revenue is greater than the revenue earned for the period

Revenue earned for the period is greater than the cash received for the revenue (accrued revenue)

For example, a business earns rental income from renting out part of their premises but there is an amount of rental income that relates to the current financial period but has not been received. Hence, the revenue has been earned but has not been received so it should be recognised as revenue in the current financial period.

In this case, the revenue account is increased and a temporary asset is created for the amount that is owed to the business and appears in the balance sheet as effectively it is an asset at the date of the balance sheet

The amount received for the revenue is greater than the revenue earned for the period (prepaid / unearned revenue)

For example, a business earns rental income from renting out part of their premises and the tenant has paid the rent in advance of which part of this amount relates to the next financial period. In this case, the revenue account is decreased and a temporary liability is created for the unused amount and appears in the balance sheet as effectively it is an amount that has been received but not earned at the date of the balance sheet

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In the next period, the prepayment will cease to be an liability and become revenue in the income statement in the period it relates to

Profit Measurement and Recognition of Expenses

Expenses measure the outflow of assets (such as cash) or the increase in liabilities that result from trading and generating revenues

The Matching Principle and Common Basis for Recognition

The ‘Matching’ principle dictated that expenses should be ‘matched’ to the income they helped to generate. More recently, there have been moves away from ‘matching’ in favour of a common basis for recognition of income and expenses. The ‘common basis’ is that if an item satisfies recognition criteria, it will be recognised if its occurrence is probable, and it can be reliably measured

The Accrual Basis for Recognising ExpensesIt is common for adjustments to be made to accounting information prior to it being published in the financial reports. These adjustments are known as balance day adjustments. The adjustments are required to ensure that expenses incurred are reflected in the Income Statement for the period rather than expenses paid when using the cash basis for revenue recognition. The need for such adjustments arises where:

An expense incurred for the period is greater than the cash paid for the expense The amount paid for an expense is greater than the expense incurred for the period

An expense incurred for the period is greater than the cash paid for the expense(accrued expense)

For example, the wages account may show the total wage expense however the next pay period occurs in the new financial year. However, we are unaware that a portion of the wages to be paid next financial year have actually been used up in the current financial year and therefore should appear as wages expense in the current year.

In this case, the wages account is increased and a temporary liability is created for the unpaid amount and appears in the balance sheet as effectively it is an unpaid expense at the date of the balance sheet

The amount paid for an expense is greater than the expense incurred for the period (prepaid expense)

For example, some expenses may be paid in advance (such as insurance, advertising) but not all of the amount paid may have been used up/consumed by the end of the financial year.

In this case, the expense account is decreased and a temporary asset is created for the unused amount and appears in the balance sheet as effectively it is an amount that has been paid but not used up at the date of the balance sheet

In the next period, the prepayment will cease to be an asset and become an expense in the income statement in the period it relates to

Profit and Cash:

• It is important to note that ‘profit’ and ‘cash’ (liquidity) are not the same• Profit is a measure of achievement, or productive effort rather than of cash generated• Deferred/prepaid expenses relate to expenses paid in advance of being incurred while accrued revenue relates to

revenue earned but not received• Accrued expenses are where the expense has been incurred but payment has not been made

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Profit measurement

We will now look at three common assets and how they impact on expense recognition: Non-current tangible assets (depreciation expense) Inventory (cost of goods sold) Accounts receivable (bad and doubtful debts)

Profit Measurement and the Calculation of Depreciation on Non-Current Tangible Assets

Depreciation is a measure of that portion of the cost (less residual value) of a fixed asset which has been consumed during an accounting period

Four factors are considered:• The cost (or other value) of the asset• The useful life of the asset• The estimated residual value of the asset• The depreciation method

The cost of the asset - includes all costs incurred by the business to bring the asset to its required location and make it ready for use e.g. delivery, installation, legal title, alterations, improvements etc

The useful life of the asset - the economic life of the asset determines the expected useful life of the asset for the purpose of calculating depreciation. The economic life of an asset ends when the cost of operating or holding the asset exceeds the benefit derived from it. Economic life may be shorter than physical life in many cases.

Estimated residual value (disposal value): defined as the likely amount to be received on disposal of the asset. Like useful life, estimated residual value can be difficult to predict

Depreciation method: Once the ‘depreciable amount’ has been estimated, it must be allocated over the useful life of the item, property, plant or equipment. The three common methods of deriving a depreciation expense are detailed on the next slide

• Straight line method of depreciation:• See Example 4.1 on page 163• See Figure 4.7 on page 164• See Activity 4.15 on page 164

• Accelerated depreciation formula:

where P = the depreciation percentage, n = the useful life (in years), R = the residual value, and C = the cost of the asset

NOTE: you will not need to use the accelerated depreciation formula to calculate the depreciation percentage in the exam. If you are asked to use the accelerated depreciation method, the depreciation percentage (P) will be provided to you.

• Units of production based depreciation: Depreciation based on productive capacity of the asset and its use over time

Depreciation:• Depreciation methods should be selected to be appropriate to the particular assets and to their use in the business.

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• Accounting standard AASB 116 - ‘Property, Plant and Equipment’ reinforces this view• Depreciation does not provide funds for asset replacement, it is used to calculate net profit• Depreciation is an example of an accounting process that requires a lot of judgement

Profit Measurement and the Valuation of Inventory

Inventory - Finished goods, raw materials, stores or supplies and work-in-progress

Cost of Inventory - All costs directly related to bringing the inventory into a saleable state. See AASB 102, paragraph 10

What is the basis for transferring the inventory cost to cost of sales/cost of goods sold?Where inventory movements are difficult to trace, assumptions can be made about the physical flow of inventory through the business. These assumptions are:

• First in First out (FIFO) - the earlier inventory held is the first to be sold• Last in First out (LIFO) - the latest inventory held is the first to be sold (not permitted in Australia)• Average Cost - a weighted average cost is determined, to derive cost of sales and cost of remaining inventory held

Systems to Record Inventory

• Perpetual inventory system - maintains continuous records of all inventory movements, records both cost and selling price, and volume. The cost allocation methods that can be used are:

• Physical / Periodic inventory system - much simpler than perpetual, does not maintain records of cost of inventory sold, the inventory (asset) account remains unchanged during the year and is updated at end of period following a stock count, does not work with LIFO method.

Net realisable value (NRV)Any unsold inventory is recorded as a current asset in the balance sheet. The prudence/conservatism assumption requires that closing inventory be valued at the lower of cost and net realisable value. Net realisable value (NRV) is defined as:

- the estimated selling price less any further costs necessary to complete the goods and any costs involved in selling and distributing the goods

AASB 102 ‘Inventories’ requires valuing inventory on the basis of the lower of cost and net realisable value on an item-by-item basis. Inventory valuation and depreciation are good examples of where the ‘consistency convention’ should be applied.

Consistency convention: holds that when a particular method of accounting is selected to deal with a transaction, this method should be applied consistently over time

Note: from a practical perspective, you are only expected to undertake practical examples regarding use of the FIFO and average cost assumptions as part of the inventory section just covered.

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Profit Measurement and the Problem of Bad and Doubtful Debts

• Bad and doubtful debts are associated with income derived from selling goods on credit• The risk of credit sales is that the customer will not pay the amount due, thus ‘bad debts’ are created and ‘doubtful

debts’ if the matter is uncertain• Bad debts must be ‘written off’ which increases expenses and reduces accounts receivable• Doubtful debts can be accounted for (estimated) using either the percentage of credit sales or the aged debtors listing• There are three alternative approaches to recording bad and doubtful debts observed in practice:

• Recognise only on basis of realised uncollectable amount (customer is bankrupt, deceased etc)• Recognise Bad and Doubtful Debt expenses separately - the bad debt expense is always written off against

accounts receivable• Recognise a single combined ‘bad and doubtful debts expense’ based on either percentage of credit sales or

aged debtors listing approach• An overall impairment test under AASB 132 may mean changes to the terminology within the reporting for bad

and doubtful debt expenses

Interpreting the Income Statement

How the final net profit figure was derived can be found by:• analysing sales levels - against history and planned sales for the current/future periods• examining the nature and amount of expenses incurred

• comparison against history and future• indicator of efficiency of business operations

• investigating gross profit levels in relation to sales in similar businesses• helpful in assessing profitability and margins

• analysing net profit levels, for example against previous periods and also in relation to sales

Topic 5 - Measuring and Reporting Cash Flows

Learning Objectives• Explain why cash is important to the reporting entity• Define cash and cash equivalents• Distinguish between accrual and cash-based transaction recognition• Compare and contrast the roles of the three external financial reports (income statement, balance sheet, cash flow

statement)• Discuss the three components of the cash flow statement (operating activities, investing activities, financing

activities)• Identify non-cash transactions• Recognise the alternative approaches to preparing a cash flow statement• Prepare a simple cash flow statement• Describe the purpose of a reconciliation of net profit to cash flow from operations• Explain how the cash flow statement can be useful for identifying cash flow management strengths, weaknesses and

opportunities

The Importance of Cash and Cash Flow

• Cash is important because organisations and people will not normally accept any other form of settlement of claim against the business

• Businesses fail as a result of inability to find sufficient cash to settle their responsibilities• These factors make cash the pre-eminent business asset, and therefore the one analysts and others watch carefully in

assessing survivability of the business and other factors

• Balance sheet and profit and loss reports show movements in wealth and the net increase or decrease in wealth for the period concerned

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• The cash flow statement is required to be produced because the above two reports do not concentrate sufficiently on liquidity (cash flow)

• The accrual nature of the above two reports are thought to obscure the question of how and where a company is generating the cash it needs to continue operating

Cash and Cash Equivalents

• Cash represents ‘cash on hand’ and ‘demand deposits’

• Cash equivalents represent short-term, highly liquid investments that can readily be converted to a fixed amount of cash

• Examples include: - Cash at Bank - Bank Overdraft - Short-term Money Market Deposits - Bank Bills

Cash vs Accrual Transaction Recognition• Cash-based - Revenue is recognised when cash is received and expenses are recognised when cash is paid• Accrual-based - Revenue is recognised when it is earned and expenses are recognised when they are incurred • Accrual-based accounting removes the ‘distortion’ of the entity’s performance from the cash-based system and

reflects the ‘economic reality’ of what has been earned

Differences between the Three External Financial Reports

• Balance Sheet – static report made at a given point in time and based on balances in assets, liabilities and owners’ equity, normally based on accrual transactions

• Income Statement (Profit & Loss) – measures the financial performance over a period of time - normally one year, related to revenues earned less expenses incurred

• Cash flow statement – identifies all cash receipts and cash payments for the period. All account types are included and is based on cash, not accrual transactions

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Balance sheetat the start ofthe accounting

periodOwners’

claim

Cash

Balance sheetat the end of

the accountingperiod

Owners’claim

Cash

Income statement

Cash flow statement

Figure 5.1 - The relationship between the balance sheet, the income statement and the cash flow statement

• The cash flow statement is basically an analysis of the business’ cash movements over the period concerned• All payments of a particular type are added together to give just one figure, which appears in the statement• The net total of the statement is the net increase or decrease in cash of the business over the period

The three components of the cash flow statement are:

• Operating activities - represents net inflows from operations. Only cash received and paid, not expenses earned and revenue incurred, are featured (that is, cash flows associated with the operating activities of the business)

• Investing activities - concerned with cash payments to acquire additional non-current assets, and cash receipts from the disposal/sale of such assets e.g. plant and machinery, shares etc (that is, cash flows from changes in Non Current Assets and Investments)

• Financing activities - deals with financing the business excluding short-term credit e.g. debt and equity sources, share issues, repayment of debt etc (that is, cash flows from changes in Non Current Liabilities and Equity)

Items which may appear under more than one section of the cash flow statement:Interest Paid, Interest Received and Dividends Received

Interest paid may be shown under Operating Activities (because it is used to help determine profit or loss) or under Financing Activities (because it is a cost of obtaining financial resources).

Interest received and dividends received can be shown under operating activities (because they help determine profit or loss) or under investing activities (because they are returns on investment).

Figure 5.2 - Standard layout of the cash flow statement

Non-cash Transactions

• Non-cash transactions are transactions that do not directly involve cash

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Net cash flows fromoperating activities

Net cash flow frominvesting activities

Net cash flow fromfinancing activities

Net increase or decrease incash and cash equivalents

over the period

plus orminus

plus orminus

• Most relate to the ‘operating activity’ section of the cash flow statement and are linked to the difference between cash-based and accrual-based transactions

• Examples - depreciation, revaluations, doubtful debts, accruals (receivables, inventory, prepayments, payables, gains or losses on disposal of non-current assets) etc

• Some relate to the ‘investing and financing activity’ section e.g. direct exchanges such as shares for assets, non-current assets for reduction in debt, bonus issues from reserves etc

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Preparation of the Cash Flow Statement - an Overview

Can be produced in two ways:1. Independently viewing the cash receipts and cash payments for the period and allocating transactions to the

different activities and categories2. Reconstructing the income statement by tracking the changes in the balance sheet for the period and eliminating

accrual transactions so that only cash transactions remain, forming the basis for preparing the cash flow statement. The information can be reconstructed in the following ways: Schedule approach using additions and subtractions Ledger reconstructions Worksheets

You will only be expected to use the first approach to prepare a Cash Flow Statement. You will not be expected to use method 2 to prepare a cash flow statement.

Preparation of the Cash Flow Statement - a Simple Example

Refer to Example 5.1 on page 231 for detailed information on how reconstructions are used to prepare a cash flow statement. You will not be expected to use these reconstructions in this course. However you may be interested in these calculations as a matter of interest.

Cash flow statement for the year ended 30 June 2009  $m $mCash flows from operating activities Cash receipts from customers 95 Cash payments to suppliers and employees (80) Interest paid (3) Income taxes paid (4) Net cash provided by operating activities 8Cash flows from investing activities Purchase of property, plant and equipment (20) Net cash used in investing activities (20)Cash flows from financing activities Proceeds from issue of share capital 15 Proceeds from long-term borrowings 5 Dividends paid (15) Net cash provided by financing activities 5Net decrease in cash and cash equivalents held (7)Cash and cash equivalents at the beginning of the financial year 12Cash and cash equivalents at the end of the financial year 5

Reconciling Cash from Operations with Operating Profit

• Purpose of reconciliation is to reconcile the net operating profit or loss after tax with the cash flows from operating activities

• The starting point is the operating profit after tax• We then effectively add back the depreciation charged in arriving at that profit and adjust this total by

movements in non-cash current asset and current liability accounts to arrive at cash flow from operations

Refer Example 5.1 on page 231 for data.

Reconciliation would be as follows: $m

Operating profit after tax 10Depreciation 5

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Increase in inventory (8)Increase in accounts receivable (5)Increase in accounts payable 5Increase in tax payable 1Net cash flow provided by operating activities 8

You will not be expected to prepare this reconciliation but you will need to be aware of it.

What Does the Cash Flow Statement Tell Us?

• The cash flow statement tells us how the business has generated cash during the period and where that cash has gone• Tracks the sources and uses of cash over time, which is indicative of trends and useful for predicting future

opportunities and patterns of cash flow• Provides an insight to working capital management• Is a good indictor of debt management practices• Identifies non-operational cash flowsRequired activities

For this topic, you are expected to have completed, as a minimum,

             Discussion Questions 5.5, 5.6, 5.8, 5.9, 5.15, 5.18.

             Application Exercises 5.1

These questions are on pages 256 to 258 of the text book Accounting, an introduction 4th Edition by Atrill, McLaney, Harvey and Jenner.

The answers to these questions are available on the Learning Hub.

Topic 6 - Analysis and Interpretation of Financial Statements

Learning Objectives• Define what a ratio is• Identify the key aspects of financial performance and financial position that are evaluated by the use of ratios• Explain the terms profitability, efficiency, liquidity, gearing and investment• Summarise the alternative bases of comparison for ratio analysis• Present the ratio formulae for the basic ratios• Calculate ratios to analyse the profitability, efficiency, liquidity, gearing and investment of a given entity’s financial

statements over several periods• Interpret basic ratios for profitability, efficiency, liquidity, gearing and investment• Discuss the limitations of ratios as a tool of financial analysis• Understand index or percentage analysis as an alternative to ratios

Financial Ratios

What is a ratio?

• Ratios provide a quick and simple means of examining the financial health of a business• A ratio simply expresses the relationship between one figure appearing in the financial statements with another e.g.

net profit in relation to capital employed• Ratios are simple enough to calculate, and a good picture can be built up with just a few, however ratios can be

difficult to interpret• Can be expressed in various forms e.g. percentages, fractions, proportions depending on the need and use for the

information

The key aspects of financial performance / position evaluated by the use of ratios are:

• Profitability

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• Efficiency• Liquidity• Gearing• Investment

Financial Ratio Classification•• Profitability - Measure of success in wealth creation• Efficiency - Effectiveness of utilisation of resources• Liquidity - The ability to meet short-term obligations• Gearing - Measure of degree of risk to do with the amount of leverage used to finance the business• Investment - Measure of the returns and performance of shares held by a business

The alternative bases of comparison for ratio analysis

Bases (benchmarks) that may be used as a basis of comparison for ratio analysis include:• ‘Intertemporal’ - Based on past performance• Budget - Based on planned performance• Intra-industry - Based on comparison of performance with other firms in the same industry

A calculated ratio on its own does not say much about a business - it is only when it is compared with some form of ‘benchmark’ that the information can be interpreted and evaluatedThe Key Steps in Financial Ratio Analysis

Step 1:• Identify which key indicators and relationships require examination• Identify who needs the information and why they need it

Step 2:• Choose the most relevant set of ratios that will accomplish the desired purposes• Calculate and record the results using the selected ratios

Step 3:• Interpret and evaluate the results

Common ratios that we will consider now follow that illustrate the name of the ratio, a description of the ratio, the ratio formula and the terms in which the ratio is often expressed, for example, %, times, etc.

Note that we will not be focusing on the Investment Ratios in any great detail.

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Calculation of Ratios - Profitability Ratios

Ratio Description FormulaReturn on shareholders funds (ROSF)

Compares the amount of profit for the period available to the owners with the owners’ stake in the business

ROSF = Net profit after taxation and preference dividend (if any) x 100Average ordinary share capital plus reserves

Normally expressed as a percentage

Return on total assets (ROA):

Compares the net profit generated by the business with the assets owned by the business

ROA = Net profit before interest and taxation x 100 Average total assets

Normally expressed as a percentage

Net profit margin: Relates the net profit for the period to the sales during that period

Net profit margin = Net profit before interest and taxation x 100Sales

Normally expressed as a percentage

Gross profit margin:

Relates the gross profit of the business to the sales generated during the same periodGross profit represents the difference between sales and cost of sales

Gross profit margin = Gross profit x 100Sales

Normally expressed as a percentage

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Calculation of Ratios - Efficiency Ratios

Ratio Description FormulaAverage inventory turnover period:

Measures the average period inventory was held Inventory turnover periods = Average inventory held x 365

Cost of sales

Normally expressed in terms of days

Average settlement period for accounts receivable (debtors):

Calculates how long, on average credit customers take to pay amounts owed

Average settlement period = Average trade debtors x 365 Credit sales

Normally expressed in terms of days

Average settlement period for accounts payable (creditors):

Calculates how long, on average the business takes to pay its creditors

Average settlement period = Average trade creditors x 365 Credit purchases

Normally expressed in terms of days

Asset turnover period:

Examines how effectively the assets of the business are being employed in generating sales revenue

Average asset turnover period = Average total assets employed x 365 Sales

Normally expressed in terms of days

The Relationship Between Profitability and EfficiencyThe overall return on funds employed in the business will be determined both by the profitability of sales, and by efficiency in the use of assets

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Calculation of Ratios – Liquidity Ratios

Ratio Description FormulaCurrent ratio: Compares the

business’s liquid assets with short-term liabilities (current liabilities)

Current ratio = Current assets Current liabilities

Expressed in terms of the number of times the current assets will cover the current liabilities

Acid test (also known as the quick or liquid) ratio:

Represents a more stringent test of liquidity than the current ratio

Acid test ratio = Current assets (excluding inventory & prepayments) Current liabilities

Expressed in terms of the number of times the ‘liquid’ current assets will cover the current liabilities

Cash flows from operations ratio:

Compares the operating cash flows with the current liabilities of the business

Cash flows from operations ratio = Operating cash flows Current liabilities

Expressed in terms of the number of times the operating cash flows will cover the current liabilities

Calculation of Ratios – Financial Gearing (Leverage)

Financial Gearing: The existence of fixed payment bearing securities (e.g. loans) in the capital structure of a company

• The level of gearing, or the extent to which a business is financed by outside parties is an important factor in assessing risk

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• Gearing may be used both to adequately finance the business, and to increase the returns to owners - provided that the returns generated from the borrowed funds exceed the interest cost of borrowing

Ratio Description FormulaGearing ratio: Measures the

contribution of long-term lenders to the long-term capital structure of the business

Gearing ratio = Long term liabilities x 100 Share capital + Reserves + Long-term liabilities

Expressed in terms of a percentage

Interest cover ratio (times interest earned):

Measures the amount of profit available to cover interest expense of the business

Interest cover ratio = Profit before interest and taxation x 100Interest expense

Usually expressed in terms of the number of times

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Trend Analysis

• Trends may be identified by plotting key ratios on a graph, giving a visual representation of

changes happening over time

• Intra-company trends may be compared against industry trends

• Key financial ratios are often published in companies annual reports as a way to help users to

identify important trends

Ratios and Prediction Models

• Ratios are often used to help ‘predict the future’ however the choice of ratios and

interpretation of results depend on the judgment of the analyst

• Researchers have developed ratio-based models which claim to predict future financial

distress as well as vulnerability to takeover

• The future is likely to see further ratio-based prediction models developed to predict other

aspects of financial performance

Limitations of Ratio Analysis

• The quality of the underlying financial statements determines the usefulness of the ratios

derived from them

• Ratios only offer a restricted view of ‘relative’ performance and position - not the full picture

• No two businesses are identical and the greater their differences, the greater the limitations of

ratio analysis as a basis for comparison

• Any ratios based upon balance sheet figures will not be representative of the whole period

because the balance sheet is a snapshot of a moment in time

Index or Percentage Analysis

• Index or Percentage analysis simply allows monetary figures to be replaced with an index or a

percentage as an alternative to ratio analysis

• There are three alternative index or percentage methods:

1. The common size reports (also known as vertical analysis)

2. Trend percentage

3. Percentage change (also known as horizontal analysis)

Topic 7 - Managing Working Capital

Learning Objectives

• List the items making up working capital

• Discuss the nature and importance of working capital

• Illustrate the working capital cycle

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• Demonstrate the importance of inventory and the techniques available to manage this

asset efficiently

• Discuss the provision of credit to customers and use various management tools to monitor

and control this asset

• Explain the reasons for holding cash, and the basis of management and control

• Summarise the key aspects of creditor management

The Nature and Purpose of Working Capital• Usually defined as current assets less current liabilities

• The main elements of current assets are:

- Inventory

- Accounts receivable (trade debtors)

- Cash (in hand and at bank)

• The main elements of current liabilities are:

- Accounts payable (trade creditors)

- Bank overdrafts

• Represents a net investment in short-term assets

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FinishedGoods

FinishedGoods

Work inProgressWork in

Progress

Cash salesCash sales

TradeReceivables

TradeReceivables

Cash /Bank

Overdraft

Cash /Bank

Overdraft

RawMaterials

Inventories

RawMaterials

InventoriesTrade

CreditorsTrade

Creditors

Figure 13.1 - The working capital cycle of a manufacturing business

• The management of working capital is an essential part of the short-term planning process

• There are costs incurred by holding too much and too little of each element

• Costs include opportunity cost of using these elements elsewhere

• Needs are likely to change over time

• Change may be externally driven or result from changes to the internal environment

The Management of Inventories• Inventories are held mainly to meet the immediate requirements of customers and production

• Manufacturing businesses tend to hold a high proportion of their assets as inventory:

- Raw materials

- Work-in-progress

- Finished goods

• Seasonality may vary inventory holdings over a year

• Retail businesses would try and minimise their inventories because of costs e.g. storage,

financing, opportunity cost etc.

Forecasts of future demand:

• Accurate forecasts are key

• Can use statistical approaches or judgment of staff / managers

Financial ratios:

Recording and re-ordering systems:

• Efficiency is key, should be monitored regularly

• Decision authority should be confined to a few senior staff

• Lead-times and likely demand should be determined

• Buffer levels to deal with uncertainty should be determined

Levels of control:

• ‘ABC’ system - a method of applying selective levels of control to different categories of

inventory

• High levels of control and recording would apply to high-value, low-volume ‘A’ items

• Lower levels of recording would apply to lesser-value, higher-volume ‘B’ items

• Lowest levels of control and recording would apply to low-value, high-volume Category ‘C’

items

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Stock / inventory management models:

Economic order quantity (EOQ):

• Recognises that total cost includes holding and ordering costs

• Calculates the optimum size of the order, taking these two components into account

• Decreasing inventory held means an increase in order costs as the number of orders rises in

the period

• EOQ seeks to identify the size of the order that will minimise the total costs

Figure 13.4 - Inventories holding and order costs

The EOQ model:

where:

D is the annual demand for the item of stock

C is the cost of placing an order

H is the cost of holding one unit of stock for one year

Some limiting assumptions apply to the model:

• That demand for the product can be predicted with accuracy

• Demand is even over the period with no fluctuations

• No ‘buffer’ inventory is required

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• There are no discounts for bulk purchasing

Materials requirements planning (MRP) systems:

• Begins with forecasting sales demand

• Technology schedules delivery of bought-in parts to coincide with production

requirements

• By ordering those items of inventory necessary for production, inventory holding

costs may be reduced

• Recognises that ordering decisions cannot be made independent of production

decisions

• Newer systems also take account of other resources such as labour and machine

capacity

Just-in-time (JIT) stock / inventory management:

• Aims to have materials delivered to production ‘just in time’ for their required

use

• Limits holding time and investment in raw materials

• Suppliers are informed of production requirements in advance

Some disadvantages:

• May mean inventory is more expensive

• Risk of non-supply

The Management of Debtors• Selling goods or services on credit incurs costs

• Costs include administration, bad debts and opportunity costs

• When a business offers to sell on credit, it must have clear policy concerning:

• Which customers should receive credit

• How much credit should be offered

• What length of credit it is prepared to offer

• Whether discounts will be offered for prompt payment

• What collection policies should be adopted

• How the risk of non-payment can be reduced

Which customers should receive credit?

The ‘five Cs’ of credit:

1. Capital - must appear to be financially sound (liquidity risk) before credit is offered

2. Capacity - must seem able to pay amounts owing (examine payment record / history)

3. Collateral - can the customer offer satisfactory security if required

4. Conditions - how the industry and general economic environment the customer operates in

affects their ability to pay amounts owing

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5. Character - a subjective assessment made by the business of factors such as honesty, integrity

etc.

Length of credit period:

The length of credit offered varies and may be influenced by factors such as:

• The typical credit terms operating in the industry

• The degree of competition in the industry

• The bargaining power of particular customers

• The risk of non-payment

• The capacity of the business to offer credit

• The marketing strategy of the business

• An alternative approach is to view the credit decision as a capital investment

decision, using the NPV investment appraisal method

Cash discounts (early settlement):

• The cost must be weighed against the benefits

• Danger that customers will be slow to pay and still take the discount offered

• The benefit represents a reduction in the cost of financing debtors and bad debts

Collection policies:

Steps to ensure amounts owing are paid promptly may include:

• Develop customer relationships

• Publicise credit terms

• Issue invoices promptly

• Monitor outstanding debts

• Produce a schedule of aged debtors (refer example below)

• Answer queries quickly

• Deal with slow payers

• Identify the monthly pattern of receipts from credit sales

Example of Schedule of Aged Debtors

Ageing schedule of debtors at 31 December

Days outstanding

Customer 1-30 days 31-60 days 61-90 days >91 days

$ $ $ $

A Ltd 20,000 10,000 -

B Ltd - 24,000 -

C Ltd 12,000 13,000 14,000 18,000

Total 32,000 47,000 14,000 18,000

Source: Accounting – An Introduction 4th edition, Atrill et al, Pearson Education Australia, page 656.

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The Management of Cash

Why hold cash?

• Most businesses hold cash but the amount held varies considerably

• There are three reasons for holding cash:

• Transactionary

• Precautionary

• Speculative

How much cash should be held?

• No set formula - different businesses will have different views

• Amount held can be reduced if funds can be raised quickly or assets held that can be

converted to cash such as shares or bonds

Controlling the cash balance

Use of upper and lower control limits:

• Assumes business can access cash as needed

• The model proposes the use of two upper and two lower limits

• If an outer limit is exceeded, managers must decide if the balance is likely to return over the

next few days to within the inner limits, if not, cash must be bought or sold to restore the cash

balance to within limits

• Model relies heavily on management judgement to determine where the control limits are set

and what time limits for breaches are acceptable

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Figure 13.5 - Controlling the cash balance

Cash flow statements and management of cash:

• It is useful for a business to a prepare cash flow statements and / or a cash budget

• Comparison of budgeted cash flows to cash flow statements will identify

variances for action

• Expected cash surpluses and deficits can have a course of action decided upon by

management prior to them occurring

Operating cash cycle:

• Definition: The time period between the outlay of cash to purchase supplies and the

ultimate receipt of cash from the sale of goods

• To effectively manage cash, there must be awareness of the operating cash cycle

• Management seeks to shorten the time and reduce cash required in the cycle

Cash transmission:

• Benefit is received immediately when payment is made in cash

• Cheques normally incur a delay of up to ten working days to clear through the

banking system

• Opportunity cost of this delay can be significant

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• Alternatives to minimise delays can include:

- Insist on payment in cash (not always practical)

- Utilise direct debit facilities and card payments

Bank overdrafts:

• Are simply a type of bank loan

• Can be useful for managing cash flow requirements

The Management of Trade Creditors• Trade credit is an important source of finance for many businesses

• Tends to increase in line with the increase in sales

• Widely regarded as ‘free’ however, there can be costs associated with taking credit:

- Cost of goods may rise as credit needs to be paid for

- May be given lower priority in terms of delivery dates

- Administration costs associated with dealing with invoices and confirming receipt of

goods / service

Controlling trade creditors:

Using the average settlement period method:

Alternative approaches:

- Ageing schedule

- Pattern of credit payments

The Operating Cash Cycle - Illustrated

The time period between the outlay of cash to purchase supplies and the ultimate receipt of cash

from the sale of goods

Retail/Wholesale Business

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Purchase of goods on credit

Pay for goods

Sell goods on creditReceive cash from debtors

OPERATINGCASH

CYCLE

The operating cash cycle can be calculated using ratios as follows:

+

-

Topic 8 - Cost-Volume-Profit Analysis

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Average inventory turnover period (days)

Average settlement period for debtors (days)

Average settlement period for creditors (days)

= Average inventory held x 365Cost of sales

= Average trade debtors x 365 Credit sales

= Average trade creditors x 365Credit purchases

Learning Objectives

• Explain the importance of a detailed understanding of cost behaviour

• Distinguish between fixed costs and variable costs

• Use knowledge of this distinction to deduce the break-even point for some activity

• Explain why knowledge of the break-even point is useful

• Explain and apply the concept of contribution

• Explain the concept of a margin of safety

• Identify the weaknesses of break-even analysis

• Explain and apply the idea of relevant costing

• Make decisions using knowledge of the relationship between fixed and variable costs.

The behaviour of costs

Costs can be broadly classified as:

• Fixed (those that stay the same when the volume of activity changes)

• Variable (those that vary in accordance with the volume of activity)

Both types of costs are often associated with an activity, hence the importance to the decision-

making process of understanding the quantity and impact of both.

Fixed Costs

Figure 7.1

Fixed costs:

likely to change as a result of inflation or general price increases – but not as a result of

change in volume of activity

are almost always ‘time-based’ i.e. they vary with the length of time concerned

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As the volume of activity

increases, thefixed costs stay

the same Fixed Cost Behaviour

do not stay unchanged irrespective of level of output. They often must increase to allow

higher output levels

This concept is visually demonstrated as follows:

Figure 7.2

Variable Costs

Figure 7.3

The graph above suggests that costs are linear, i.e. normally the same per unit of production

irrespective of the number of units produced.

In some cases the line is not straight as higher volumes of activity may introduce economies of

scale, thus changing the variable costs line as production increases

Semi-fixed (semi-variable) Costs

These costs exhibit aspects of both fixed and variable costs.

Part of such costs are fixed and will not change with level of activity while some parts are variable

and vary accordingly with changes in level of activity.

E.g. electricity costs – for heating, lighting and powering machinery. The cost for heating and

lighting would remain largely fixed irrespective of production activity, but for powering of

machinery, it would increase with production level

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Graph of rent cost (R) against volume of activity

Break-even analysis

We have established that with fixed costs, increase in activity does not have any bearing on total

cost.

We also know that variable costs will increase on a per unit basis as activity increases.

Break-even point occurs where total revenues equal total costs.

Break-even point can be calculated as follows:

Fixed Costs

(Sales Revenue per Unit – Variable Cost per Unit)

Figure 7.6

Example 7.1 (refer page 358)

Fixed Costs = $1,500

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Fixedcost

element

Electricitycost($)

Volume of activity0

The slope of this line gives thevariable cost per unit

of activity

Figure 7.4

Variable Costs = $6 + $18 = $24

Sales revenue per unit sold = $30

= 150

($30-$24)

= 250 units per month

Note: Break-even point must be expressed with respect to a period of time

The Use of Break-even Analysis

Break-even analysis can be used to:

Determine the activity level required to cover all costs associated with the business

Assess activity level required to achieve profit targets

Assess margin of safety - difference between break-even activity and output, provides

indication of risks involved

Contribution

• Contribution per unit - Sales revenue per unit less variable costs per unit (bottom part of the

break-even formula)

• Marginal cost - The addition to total cost which will be incurred by producing one more unit

of output

• Break-even point can be calculated as:

Break-even point = Fixed costs

Contribution per unit

Profit-Volume Charts• Obtained by plotting profit or loss against volume of activity

• The slope of the graph is equal to the contribution per unit

• As level of activity increases, the amount of the loss gradually decreases until the break-even

point is reached

• Beyond the break-even point, profits increase as activity increases

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Note: you will not be expected to draw a profit-volume chart in

the exam

Margin of Safety and Operating Gearing

Margin of safety is the difference between output activity and the break-even activity level.

Operating gearing is the relationship between contribution and fixed costs.

An activity with relatively high fixed costs compared with its variable costs is said to have high

operating gearing

Weakness of Break-Even Analysis

• Non-linear relationships - relationships between sales revenues, variable costs and volume

are unlikely to be straight-line (linear)

• Stepped fixed costs - most activities will likely include fixed costs of various types with

varying step points

• Multi-product businesses - multiple products make break-even analysis difficult as fixed

costs tend to relate to more than one activity, making division of fixed costs across products

arbitrary, and consequently the break-even analysis becomes questionable

Marginal Analysis / Relevant Costing

Analysis done to support decision-making where fixed costs are not relevant to the decision.

Some examples where relevant costing may be used are:

Accepting or rejecting special contracts

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Fixedcost

0

Volume of activity

Profit($)

Break-evenpoint

Figure 7.8

Making the most efficient use of scarce resources

Deciding whether to make or buy

Deciding whether to close or continue a section

Accepting / Rejecting Special Contracts

In undertaking this analysis, broader issues such as the following may be considered:

• Is there another customer who would pay more for spare capacity rather than ‘selling it off’

cheaply

• Potential loss of customer goodwill as a result of selling the same product at different prices

• It may be better to reduce total capacity and thereby reduce fixed costs, if inability to sell full

production capacity is an ongoing problem

• Accessing overseas markets may be a means of selling product / excess capacity at a different

pricing structure

The Most Efficient Use of Scarce Resources• Sometimes it is a limit on production capacity resulting from factors such as a shortage of

labour, raw materials, space or machinery that limits sales potential

• Limiting factor - Some aspect of the business (e.g. lack of sales demand) which will stop it

from achieving its objectives to the maximum extent

• The most profitable combination of products occurs when the contribution per unit of the

limiting factor is maximised

Make or Buy Decisions

Example 7.6 (page 377)

Jones Ltd needs a component for one of its products. It can have the component made by a

subcontractor who will charge $20 each, or the business can produce the components internally for

total variable costs of $15 per component. Jones Ltd has spare capacity. Should it subcontract, or

produce the component in-house?

Answer:

Jones Ltd should produce the component itself since the variable cost of subcontracting is greater

by $5 than the variable cost of internal manufacture

Closing or Continuance of a Section or Department

It is common for businesses to account separately for each department or section in order to assess

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the relative effectiveness of each one

Example 7.7 (page 378)

Looking solely at trading results it would seem that the general clothes department is

running at a loss to the overall business

Further analysis shows that the department makes a positive contribution

If the general clothes department is closed, Goodsports Ltd would be worse off to the

value of the contribution made

Required activities

For this topic, you are expected to have completed, as a minimum,    

Discussion Questions  7.1, 7.2, 7.7, 7.8

Application exercises 7.2, 7.3, 7.4, 7.5, 7.6, 7.7, 7.8, 7.9.

    

These questions are on pages 381 to 388 of the text book Accounting, an introduction 4th

Edition by Atrill, McLaney, Harvey and Jenner.

The answers to these questions are available on the Learning Hub.

Topic 9 - Budgeting

Learning Objectives

• Define a budget

• Explain how budgets, corporate objectives and long-term plans are related

• Set out the main components of the budget-setting process

• Explain the interlinking of the various budgets in the business

• Identify the main uses of budgeting

• Construct budgets from relevant data

• Use a budget to provide a means of exercising control over the business

• Identify the limitations and the behavioural implications of the traditional approach to control

through budgets and standards

Relevant parts of Chapter 9 are:Pages 437 – 449Pages 453 – 457Pages 464 – 471

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Note that we will be focusing on the Cash Budget. In terms of exercising control over the business, we will look theoretically at flexible budgets, variances and standards but you will not be expected to prepare a flexible budget or calculate the variances mentioned in your textbook. This is done in further detail in ACCT1060 Management Accounting and Business.Budgets, Long-term Plans and Corporate Objectives Corporate objectives - identify the broader goals of the business

Long-term plan - defines the general direction of the business over next (e.g.) five years, covers

matters like:

• Market(s) the business aims to serve

• Production / service methods

• Levels of profit sought

• Financial / financing requirements and methods

• Personnel and other requirements

Budget - essentially a financial plan for a future time

• Expressed in financial terms

• Converts the long-term plan into an actionable blueprint for the future

The Planning Process

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Figure 9.1

Time Horizons of Plans and Budgets• Long-term plans are typically 5 years and budgets typically set for 12 months

• Not set in concrete - management has discretion

• Depends on industry e.g. 5 years in an I.T. business would be too long due to rate of change

• Budgets may also be done on a ‘rolling’ monthly basis

• Limiting factors - aspects of a business that stop it from achieving objectives and which must

be factored in to the budget

Budgets and Forecasts• Budgets and forecasts are distinctly different:

• A budget is a plan for a future time, expressed mainly in financial terms

• Forecasts tend to be predictions of the future state of the environment

• Forecasts are useful to the planner / budget setter

The Interrelationship of Various Budgets

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Identify business objectives

Consider options

Evaluate options and make a selection

Prepare long-term plans (long-term budgets)

Prepare budgets (short-term)

• In a business, there is not one budget, but several - each relating to a specific aspect of the

business

• Ideally, there should be a separate budget for each person in a managerial position

Figure 9.2

This may seem a little confusing so looking at a Master Budget for a Manufacturer (next diagram)

might help to make more sense of this interrelationship between the budgets.

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Productionbudget

Directlabourbudget

Tradereceivables

budget

Cashbudget

Tradepayablesbudget

Finishedinventories

budget

Raw materialsinventories

budget

Salesbudget

Overheadsbudget

Capitalexpenditure

budget

Rawmaterials

purchasesbudget

Adapted from Jackling, Raar, Williams & Wines, 2007, Accounting a Framework for Decision Making,

McGraw-Hill p.718

The Budget Setting Process

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Sales Budget

Production Budget

Operating Expenses Budget

Direct materials usage and purchases budgets

Direct labour budget

Manufacturing overhead budget

Capital budget

Budgeted Income Statement

Budgeted Balance Sheet

Cash Budget

The Master Budget

Budget committee - a group of managers formed to supervise and take responsibility for the

budget-setting process

Budget officer - an individual, often an accountant, appointed to carry out or take responsibility

for having carried out the tasks of the budget committee

Top-down - an approach to budgeting where senior management originates the budget targets

Bottom-up - most of the budget input comes from lower level staff such as sales representatives

The Uses of Budgets

There are five main uses of budgets:

1. Promote forward thinking and the possible identification of short-term problems;

2. Help co-ordinate various sections of the business;

3. Motivate managers to achieve better performance;

4. Provide a basis for a system of control;

5. Provide a system of authorisation for managers to spend up to a limit

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1.Establish who will takeresponsibility for the

budget-settingprocess

2.Communicate budgetguidelines to relevant

managers

3.Identify the key or

limiting factor

7.Prepare the

master budgets

5.Prepare draft budgets

for all other areas

4.Prepare the budget for

the area of thelimiting factor

6.Review and co-ordinate

the budgets

8.Review and co-

ordinatethe budgets

9.Monitor performance

relative to thebudgets

Preparing the Cash Budget

• The cash budget is a key budget - all aspects of a business are eventually reflected in cash

• The cash budget reflects the whole business more than any other single budget

Most cash budgets feature the following:- Broken down into sub-periods, usually months

- In columnar form, one month per column

- Cash receipts and payments identified under headings and a total for each month is shown

- The surplus or deficit of cash is identified for each month

- The running cash balance is identified

Preparing Other Budgets

Other budgets are mostly prepared in the same format as the cash budget and may include:

- The debtors budget

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Promote forwardthinking and

identification ofshort-term problems

BudgetsHelp co-ordinate

the various sectionsof the business

Motivate managersto achieve better

performance

Provide a basisfor a system

of control

Provide a systemof authorisation

Figure 9.3

- The creditors budget

- The inventories budget

Using Budgets for Control

• Control is usually seen as making events conform to a plan

• Budgets represent the plan and therefore provide the basis for exercising control over the

business

• The planning and control process usually follows a sequence which is illustrated on the

following slide

The Planning and Control Process

(This is figure 9.4 in your textbook – it just looks a little different but contains the same steps).

Comparing actual performance with the budget

There are a number of ways in which control can be exercised:

The budget is constructed using standards as a base. Standards are ‘planned quantities

and costs (or revenues) for individual units of input or output’. For example, the standard

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Identify objectives Consider optionsEvaluate options

and make a selection

Prepare long-termplans (long-term

budgets)

Prepare budgets(short term)

Perform and collectinformation on

actual performance

Identify and analysedifferences betweenplans and actuals

(variances)

Respond to variances and

exercise control

Revise plans (and budgets)if necessary

selling price is $100 for every unit of output. (Atrill et al., p. 464). They are developed

from experience and require frequent reviews and possibly revisions and they need to be

as realistic as possible.

A flexible budget can be prepared (i.e. Can flex the budget)

o Revise the budget to reflect actual volume of output using the same standards as

when the original budget was prepared

o Then the flexed budget is compared with actual figures to determine variances

between items in the budget

Specific variances can be calculated and analysed to assist in decision making. These

variances include:

o Sales volume variance

o Sales price variance

o Materials variance

o Labour variances

o Fixed overhead variances

Variances can be adverse (unfavourable) or favourable and significant or

insignificant

o Small variances (favourable or unfavourable) are not unexpected

o Significant adverse variances should be investigated but organization needs to

decide what ‘significant’ means to them

o Significant favourable variances should also be investigated as they may indicate

that target is too low

o Insignificant favourable or unfavourable variances should be monitored

o Policy needed to determine which variances to investigate as there is a

cost/benefit issue with investigating minor variances

o Variances do not solve an issue; investigation of variances can only highlight

issues

o Adverse variances may occur because standards used to construct the budget are

not realistic but it should not be assumed that this is the cause – investigation is

required to determine the cause of adverse variances.

Behavioural Aspects of Budgetary Control

Research indicates that:

• Existence of budgets tends to improve performance

• Demanding but achievable targets seem to motivate more than easy targets

• Unrealistic targets adversely affect performance

• Allowing managers to set their own targets improves motivation, commitment

and performance

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Criticisms of Budgetary Control

ReviewAny budgetary control system set up must ensure that:

• The environment the business operates in is fully understood;

• The business develops an appropriate culture;

• The role of the budget in terms of its fit with the strategic plan is clearly

understood;

• A culture of value-adding is developed

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Time consuming andcostly to put togetherTime consuming andcostly to put together

Budgets are rarelystrategically focusedBudgets are rarely

strategically focused

Budgets dealing with Increases in technology

may lead to more centralisation at the cost

of greater involvement

Budgets dealing with Increases in technology

may lead to more centralisation at the cost

of greater involvement

Often associated withan overly inward focusOften associated with

an overly inward focus

Behavioural aspects areoften misunderstood, leading to perverse

behaviour

Behavioural aspects areoften misunderstood, leading to perverse

behaviour

A system of accountabilitymay create a counter-

productive atmosphereof blame and mistrust

A system of accountabilitymay create a counter-

productive atmosphereof blame and mistrust

Budgets can be seenas a bureaucratic exercise in cost-

cutting

Budgets can be seenas a bureaucratic exercise in cost-

cutting

Budgets may lead todepartment centredness

Budgets may lead todepartment centredness

Budgets are out of touchwith the needs ofmodern business

Budgets are out of touchwith the needs ofmodern business

Budgets may make peoplefeel under-valued

Budgets may make peoplefeel under-valued

Budgets can stifle projectsbecause resources are

already allocated

Budgets can stifle projectsbecause resources are

already allocated

When managers are in aposition to influence budget

figures, the danger ofbias exists

When managers are in aposition to influence budget

figures, the danger ofbias exists

Different budgets neededfor planning, control

and motivation

Different budgets neededfor planning, control

and motivation