Accounting and

Financial
Management

Final Exam Study

Notes

ACCT1501
Semester 1 2017

z5160731
 Accounting and Financial Management

WEEK ONE:
1. INTRODUCTION TO FINANCIAL ACCOUNTING
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1.1 Use and preparation of accounting:
Use:
Financial accounting has value because the information it produces is used in a variety of
ways e.g. used by managers, investors, bankers.

Preparation:
Accounting information is produced by a large set of people, activities and computers. How
accounting information is prepared shapes its use e.g. in financial analysis and managerial
decisions.

1.2 Financial accounting:

Accounting is the process of identifying, measuring, recording and communicating economic
information to assist users to make decisions.

Accounting systems are often described as either:

- Financial accounting systems  where financial statements are provided to external
decision-makers e.g. investors, creditors
- Management accounting systems  where financial statements and information for
planning are provided to managers within the organization e.g. internal decision
makers

Financial accounting measures an enterprise’s performance over time and its position at a
point in time. Financial performance is the generation of new resources from day-to-day
operations over a period of time. Financial position is the enterprise’s set of financial
resources and obligations at a point in time. Financial statements are the reports describing
financial performance and position.

Accounting is critical during economic consequences in the equity markets. Here, the
decision maker in the situation is the investor/owner and their decisions are based on what
value they are willing to either buy/sell shares in the market.

Examples of economic consequences:

- Accounting scandals e.g. Dick Smith 2015
- Misleading reporting
- Collapse of company

1.3 Who uses financial accounting information?

Accounting is used by:
- Management in making business decisions
- Shareholders for decision making i.e. dividends and capital gain
- Bankers/creditors in lending decisions i.e. likelihood of the company meeting its
interest payments on time
 - Management and unions in wage negotiations
- Government bodies e.g. ATO, ASIC
Annual report  a glossy magazine that contains a lot of descriptive information about the
company and the general purpose financial statements (obtained from company websites
or the ASX)

1.4 The people involved in financial accounting:

1. Information users (decision-makers)
This is someone who makes decisions on the basis of the financial statements, on behalf of
themselves or on behalf of a company, bank or other organization. A user’s main demand is
for the credible periodic reporting of an enterprises financial position and performance.

2. Information preparers (decision facilitators)

These are people who put together the information in financial statements to facilitate the
user’s decision making e.g. managers (to run the enterprise) and accountants (to shape the
financial statements by applying principles of accounting).

3. Auditors (credibility enhancers)

Auditors assist users by enhancing the credibility of the information, providing a
professional opinion about the fairness and appropriateness of the information. They
ensure that financial statements are consistent with accepted accounting principles.

1.5 Accrual accounting:

When preparing financial statements, some transactions may have yet to be completed or
are in dispute, thus having an unclear status. Therefore, many businesses use accrual
accounting to cope with these complexities  the impact of transactions on the financial
statements are recognized in the time periods where revenues and expenses occur, rather
than when the cash is received or paid (income statement)

However, cash accounting involves recording revenues and expenses at the time when the
cash is paid or received (cash flow statement).

1.6 Key financial statements:

1. Balance sheet:
It is the financial position of an enterprise’s set of financial resources and obligations at a
particular point in time i.e. Statement of Financial Position  it is used to assess financial
structure and ability to pay debts on time.

The 3 main elements are:

- Assets  economic benefits that are controlled by the company within the year
(current) or in future years (non-current) e.g. cash, inventory, equipment
- Liabilities  what the company owes e.g. accounts payable
- Owners equity (residual)  the residual claim of the shareholders on the assets of
the organization e.g. share capital, retained profits
The accounting equation  Assets = liabilities + equity. The balance sheet shows resources
(assets) and claims on those resources (liabilities and equity). Liabilities + owners equity =
sources of funds, assets = use of funds.

2. Income statement:
It is the financial performance of an enterprise generating new resources from operations
over a period of time i.e. Profit and Loss Statement  it shows revenue earned, expenses
incurred with the resulting net profit or loss.

Revenues are inflows of economic benefits that increase owner’s equity e.g. sales revenue
and expenses are the loss of economic benefits that decrease owner’s equity e.g. electricity,
rent. Revenues and expenses are recognized when an economically meaningful event has
occurred  ACCRUAL ACCOUNTING.

3. Cash flow statement:

These are the cash inflows and cash outflows of an enterprise over a period of time.

Cash flows are normally categorized into:

- Operating activities  provision of goods and services
- Investing activities  related to the acquisition and disposal of non-current assets
- Financing activities  relating to changing the size of the financial structure of an
entity e.g. equity capital and borrowing

4. Notes to the financial statements:

Additional financial information left out of the 3 main financial statements.

NB: A consolidated financial statement are financial statements that factor the holding
company’s (parent company) subsidiaries into the aggregated accounting figure. A
subsidiary is a company controlled by a parent company which has the power, directly or
indirectly, to govern the financial and operating policies of an entity to obtain benefits from
its activities. Therefore, it shows how the holding company is doing as a group, providing a
true and fair view of the financial and operating conditions of the group.

1.7 Financial statement assumptions:

1. Accrual basis assumption:
Financial reports are prepared on the accrual basis of accounting, that is, the effects of
transactions are recognized as they occur, regardless of whether cash is received or paid
yet.

2. Accounting entity assumption:

Under this concept, the accounting entity is separate from its owners are separate from
those of its owners/members. For example, the accounting entity of a sole trader is
differentiated from the financial affairs of the owner  accounting entities do not
necessarily correspond to legal entities.

3. Accounting period assumption:

The life of business needs to be divided into discrete time periods of equal length to
determine financial performance and position for that period  it involves the production
of regular, comparable financial statements to determine profit and loss for that period
(accounting period concept).

4. Monetary assumption:
This is the universally accepted medium of exchange that measures accounting transactions
by a common denominator i.e. Australian dollar. This concept also assumes that the value of
the monetary unit is constant, disregarding inflation.

5. Historical cost assumption:

This is where assets are initially recorded at their original costs  therefore it treats assets
in terms of their use rather than for resale (no depreciation or appreciation).

6. Going concern assumption:

Financial statements are prepared on the premise that the organization will continue
operations as a going concern in the foreseeable future  if this is not the case, it is
necessary to report the liquidation values of an organization’s assets.
 Accounting and Financial Management

WEEK TWO:
2. MEASURING AND EVALUATING FINANCIAL POSITION AND
PERFORMANCE
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2.1 Introduction to the balance sheet:
A statement that summarizes the financial position of an enterprise at a particular point in
time. It provides financial information about:
- Financial structure (mix of debt/equity)  debt to equity ratio
- Liquidity  how quickly the firm can sell their assets to acquire cash (short term
focus) e.g. current ratio, working capital ratio
- Solvency  ability to pay debts as they fall due in the longer term e.g. debt to equity
ratio

A balance sheet will always have the following identifying information:

1. Name - of the reporting entity
2. Type of financial statement - balance Sheet
3. Date – what point in time it refers to
4. Currency - $m, $AUD

The 3 main elements of the balance sheet:

1. Assets  they will benefit the company this year (current) or in future years (non-
current) e.g. equipment, buildings, inventories
2. Liabilities  what the company owes e.g. accounts payable, bank loan
3. Equity  What belongs to the owners, the residual i.e. what is left after liabilities are
taken care of e.g. share capital, retained profits
Not all assets and liabilities are listed on the balance sheet. To be reported, assets and
liabilities must:
- Meet definition criteria  future economic benefit (potential to generate cash),
controlled by the entity and arises from past events
- Meet recognition criteria  probable and reliable (it is probable that the future
economic benefit associated with the item will flow into the entity AND the item has
a value that can be measured reliably)
If they meet definition but not recognition criteria, they are disclosed in the notes to the
financial statements.

2.2 Explanation of the 3 balance sheet categories – assets, liabilities and equity:
1) Assets:
A resource that is controlled (not necessarily owned) by an entity as a result of past events,
and from which future economic benefits are expected to flow to the entity. They have 3
essential characteristics derived from the definition:
1. Future economic benefit  assets are used to provide goods or services with the
objective of generating net cash flows
2. Control by an entity  relates to the capacity of an entity to benefit from the asset
in pursuing its objectives and to deny/regulate the access of others
3. Occurrence of past transactions or other past events  means that the transaction
or other event giving the entity control over the future economic benefits must have
occurred e.g. paid cash or credit

Assets are either:

- Current  expect to realize the benefits in the next 12 months from the balance
sheet date
- Non-current  realize benefits over a longer period

2) Liabilities:
A liability is a present obligation of the entity arising from past events, resulting in a future
economic outflow embodying economic benefits. They have 2 essential characteristics:
1. A present obligation exists and the obligation involves settlement in the future
2. It has adverse financial consequences for the entity in that the entity is obligated to
sacrifice economic benefits to one or more other entities

Liabilities are either:

- Current  those that will be paid off within one year of the balance sheet date
- Non-current  will remain liabilities for at least the next year.

The reason for this distinction, for both assets and liabilities, is to help the financial user to
assess short term financial position.

Working capital and current ratio:

Working capital = CA – CL (generally, low or negative working capital is an indication of
short- term financial difficulties)
Current ratio = CA/CL
3) Equity:
The residual interest in the assets of the entity after deducting all its liabilities, also referred
to as net assets. Common components include share capital and retained profits. The 3
components – retained earnings, share capital and reserves.

2.5 Maintaining the accounting equation

2.7 The income statement:

Shows the results of business operations over a specific time period. It relates to the
accounting period assumption and reports revenue earned and expenses incurred with the
resulting profit or loss. Provides a measure of organizational efficiency.

Revenue:
Revenue is gross inflows of economic benefits during the period arising in the ordinary
activities of an entity when those inflows result in increases in equity other than those
relating to contributions from equity participants. Revenue represents an increase in the
wealth of the business (receipt of cash is not necessary for revenue to be earned) e.g.
sales revenue, interest revenue.

Expenses:
Expenses represent decreases in the entity’s wealth and are incurred in order to earn
revenue. Expenses do not include payments or returns to owners e.g. dividends or
withdrawals, as these are considered to be ‘distributions’ of net profit to owners. Expenses
represent a decrease in the wealth
of the business because operating
costs have to be paid, long term
assets wear out (depreciation) and
assets are used up e.g. inventory.

When we classify an expense as an

asset, we say we capitalize it
(BIGGER/BETTER/LONGER). However, if a cost is not capitalized, then it is expensed. This
decision can be affected by the amount and/or for how long it would last/definition of an
asset.

2.8 Connecting balance sheets and income statements:

Equity is the link between the balance sheet and income statement via retained profits.
Transactions that affect owner’s equity:

Retained profits:
When a company earns a profit, that profit can be distributed to shareholders as dividends
or kept in the business to grow the business. Thus, retained profits are the sum of net
profits earned over the life of a company less dividends declared to shareholders. The
retained profit account is the link between the balance sheet and income statement.

Opening retained profits + Net profit – distributions (dividends declared) = closing retained
profits. NB: DIVIDENDS ARE NOT AN EXPENSE.

Income statement accounts are temporary accounts, whilst balance sheet accounts are
permanent accounts. Income statement accounts are ‘closed’ and their balances transferred
to the retained profits account (on the balance sheet) at the end of each accounting period.

Cash v accrual profit:

Accrual accounting records  revenues when they are earned (not received) and expenses
when they are incurred (not paid). The earning of revenue is not necessarily accompanied
by the inflow of cash and the incurrence of expenses is not necessarily accompanied by the
outflow of cash.

Accounting and Financial Management

WEEK THREE:
3. DOUBLE ENTRY SYSTEM
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Transactions:
Transactions are events that affect the operations or finances of an organization (accounting
systems record transactions).

Transaction analysis:
Transaction analysis involves an examination of each business transaction with the aim of
understanding its effect on the accounting equation (A=L+SE) e.g. borrowing $10,000 from
the bank will increase assets (cash) and increase liabilities (loan). After each transaction, the
total assets must always equal the total liabilities and shareholders’ equity.

Expanding the accounting equation  CA + NCA = CL + NCL + SC + Op. RP + R – E – D

The link between the balance sheet and income statement is the closing retained profits.

Double entry accounting:

The Golden Rule  the accounting equation must always balance, it means that debits =
credits. In accounting, we use debit (Dr) and credit (Cr) to describe changes in accounts.

Every transaction will have 2 (or more) effects. One requires a debit entry and the other
requires a credit entry  it provides an additional control on accuracy, in that the sum of
debits must equal the sum of credits.

Debit-credit convention:
We define increases in Assets to be debits (DR) and therefore decreases in Assets must be
credits (CR). DR = CR, therefore increases in Liabilities (and Equity) must be credits,
decreases must be debits.

Assets = resources, liabilities and shareholders’ equity = sources of funds.

Type Normal Increase Decrease

1. Assets Debit Debit Credit
2. Liabilities Credit Credit Debit
3. Owners’ Credit Credit Debit
equity
4. Revenues Credit Credit Debit
5. Expenses Debit Debit Credit
A = L + (R-E) + OE
A + E = L + R + OE

Journal entries:
Journal entries are, essentially, a shorthand version on transaction analysis and are
prepared using the rules of debit and credit. Debits must always equal credits.

Examples:
Machinery bought  Dr Machinery 10,000 / Cr Cash 10,000
Cash sales  Dr Cash / Cr Sales Revenue
Sale of inventory  Dr Cash or Accounts receivable / Cr Sales Revenue

A journal entry can list as many accounts as needed to record the transaction, but for each
journal entry, the sum of debits must equal the sum of credits.

Appendix – Dividends:
The dividends recommended by directors are authorized by shareholders at an annual
meeting. Declaration:
- Dr Retained profits 20,000 (-SE)
- Cr Dividends payable 20,000 (+L)

When the final dividends are paid:

- Dr Dividends payable 20,000 (-L)
- Cr Cash 20,000 (-A)

Depreciation:
Allocation of the cost of a noncurrent asset to expense over the life of an asset to recognize
the consumption of the asset’s economic value:
- Dr Depreciation expense xxx (+E)
- Cr Accumulated depreciation xxx (-A)

Accumulated depreciation (balance sheet)  shows all the depreciation charged against an
asset to date
Depreciation expense (income statement)  shows only this year’s depreciation allocation

For example, an asset costs $10 000 with a life of 4 years and no estimated salvage value.
Straight line depreciation each year:
- Dr Depreciation expense $2 500
- Cr Accumulated depreciation $2 500

After 3 years, book value is:

- Asset $10 000
- Accumulated depreciation $7 500
- Book value $2 500
NB: Relationship between transaction analysis and journal entries is that the negative values
in the transaction analysis mean the abnormal side in journal entries.

Accounts payable (AP)  the dollar amounts owed to others for goods, supplies, and
services purchased on open account.

Notes payable (NP)  evidenced by a promissory note or bill of exchange e.g. credit
purchase of equipment. The interest-bearing characteristic and the written documentation
distinguishes NP from AP.

Tutorial Notes:
- PREPAYMENT IS AN ASSET
- If company has not provided service but received revenue = unearned revenue
(RECOGNIZE AS A LIABILITY UNTIL SERVICE IS COMPLETED) Dr unearned revenue Cr
Service Revenue when service is performed.
- Dividends received from investments is revenue Cr Dividend receivable Dr Cash
- Decrease in value of non-current asset is a depreciation expense  if you issue
shares, or purchase equipment, these are not expenses or revenues, but the
depreciation expense is recognized over the financial period.
- If interest is not payable until end of loan, it is still interest expense for that financial
period accordingly
- Dr Accounts Receivable, CR Sales Revenue
- If an asset depreciates  DR DEPRECIATION EXPENSE, CR ACCUMULATED
DEPRECIATION (THIS IS A NON CURRENT ASSET)
- If made credit sales of X amount, but COGS was Y amount (Dr accounts receivable Cr
sales revenue AND Dr COGS Cr Inventory)
 Accounting and Financial Management

WEEK FOUR:
4. RECORD-KEEPING (ACCOUNTING CYCLE)
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The importance of good records
Complete and accurate records are important as they provide the observations and the
history of the enterprise. Records provide the basis for extrapolations in the future, the
information for evaluating and rewarding performance, and a basis for internal control
over the existence and quality of an enterprise’s assets.

Transactions:
Judgement required to determine:
- Relevant events to record
- When and how events enter the accounting system

Generally, if an event is a transaction, it is recorded in financial accounting’s database; if it is

not, the routine accounting system ignores the event.

Characteristics of a financial accounting transaction:

1. Exchange  event must involve an exchange of items (goods, money) at their
economic value
2. Past  the exchange must of actually occurred
3. External  the exchange must have been between the entity and someone else e.g.
customer, owner, a banker
4. Evidence  documentation of what has occurred
5. Dollars  measureable in dollars

For example, borrowing money from a bank.

However, also note that accrual accounting is

designed to go beyond external transactions
and add a further layer of information related
to internal transactions  adjustments made
to records that introduce new data or alter
existing data; intended to enhance
information and reflect economic effects that
are not exchanges e.g. depreciation and
prepayments.
Step 1 – Source documents:
Accounting record keeping depends upon a set of documents to show that transactions
have occurred. Such documents are kept so that accounting records can be checked and
verified to correct errors. They also permit auditing, and can be used if there is a dispute or
to support tax income claims and other legal actions.

For example:
- Invoices for purchases
- Cheques
- Bank statements
- Receipts

Step 2 – Journal entries:

Based on source documents, accounting transactions are recorded by preparing journal
entries. Because this is when the business event is first recorded by the accounting system,
these basic transactional records are often called books of original entry. Journal entries
provide, in chronological order, a record of all the transactions recorded by an
organization.

- Customary to omit the dollar signs in writing the entry

- Debits should be listed first and then the credit (from left to right)

For example, journal entry for the sale of goods on credit for $80,000 that cost $50,000:
- Dr Accounts receivable 80,000
- Cr Sales Revenue 80,000
- Dr COGS 50,000
- Cr Inventory 50,000

Step 3 – Posting to ledgers (T accounts):

Ledgers are books that have a separate page or account code for each individual account
referred to in the books of original entry  it accumulates journal entries related to each
account, providing a summary of all transactions in a tabular format allowing us to see
how transactions impact a particular account. Represented by run-balance format on T-
accounts (only use on permanent accounts; assets, liabilities and shareholders’ equity).
When posting to the ledger in T format, must write the opposite transaction that the ledger
account relates to (cross-referencing). OPENING BALANCE AND CLOSING BALANCE ON
OPPOSITE SIDE TO BALANCE T ACCOUNT.

Accounts  used to classify transactions and store information for similar transactions e.g.
information about cash inflows and outflows is stored in an account called cash.

Chart of account represents listing of all accounts in the general ledger:

- Identified by specific number
- Usually contained in accounting manual

There are 5 basic types of accounts:

- Assets, liabilities and owner’s equity
- Revenue and expenses
Posting to ledger accounts:
- Involves transferring data from the general journal to the ledger
- Very mechanical; follow the instructions from the general ledger e.g. Dr Cash $100,
place $100 on the debit side for cash
- Posting all other journal entries will provide a set of lodger accounts

Step 4 - Trial balance (do our debits = credits?)

A trial balance is an initial check to see is any mechanical errors have occurred by showing
whether the total debits equal to total credits  because the general ledger contains all
the accounts, all of which came from balanced journal entries, the sum of debts must
equal the sum of credits (balance).

It is a list of all CLOSING LEGER BALANCES shown as either Dr or Cr.

Step 5 – Adjusting journal entries:
At the end of each accounting period, it is necessary to adjust the revenue and expense
accounts (and the related asset and liability accounts) to reflect expenses incurred but not
yet paid, revenues earned but not yet received, cash received from customers before the
work completed, and the using up of assets that creates an expense  these adjusting
entries would be posted to the relevant ledger accounts, then another trial balance can be
prepared.

Step 6 – Adjusted trial balance:

The trial balance after being adjusted for those adjusting entries in step 5.

Step 7 – Closing entries:

To facilitate the preparation of the financial statements and to prepare the accounting
records to begin the next period, a company may prepare closing entries  closing entries
formally transfer the balances of the revenue and expense accounts to a profit and loss
(P+L) summary, then to retained profits. Closing entries also reset the revenue and expense
account balances to 0 to begin recording these items for the next accounting period.

REVENUE AND EXPENSES are TEMPORARY ACCOUNTS; these are accounts that are closed
at the end of the accounting period:
- Revenue  revenue accounts have credit balances and are closed (reduced to 0)
with debits to the revenue accounts and a credit to the P+L summary account (DEBIT
revenue, CREDIT P+L)
- Expense  expense accounts have debit balances and are closed (reduced to 0) with
credits to the expense accounts and debits to the P+L summary account (CREDIT
expense, DEBIT P+L)
- P+L Summary  this account, which is simply a holding account, s then closed off to
retained profits. If the P+L summary has a credit balance (profit made), the entry is
debit P+L summary and credit retained profits. If the P+L summary has a debit
balance (loss made), the entry is credit P+L summary and debit retained profits.

ASSETS, LAIBILITIES AND SHAREHOLDERS EQUITY are PERMANENT ACCOUNTS; these are
accounts that are never closed as their balance is carried over to the next accounting period.
Step 8 – Post-closing trial balance:
Trial balance after adjusting the journal entries in step
7.

Step 9 – Financial statements:

The items in the P+L summary can be used as a basis for preparing the income statement,
and the items in the post-closing trial balance can be used to prepare the balance sheet.
 Accounting and Financial Management

WEEK FIVE:
5. ACCRUAL ACCOUNTING ADJUSTMENTS
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Accrual accounting’s purpose is to extend the measurement of financial performance and
financial position by recognizing phenomena before and after cash flows, as well as at the
point of cash flows. Therefore, a system is needed to cover the following types of events:
1) Recognition of revenue or expense at the same time as cash inflow or outflow
2) Recognition of revenue or expense before cash inflow or outflow
3) Recognition of revenue or expense after cash inflow or outflow

Why do we need adjusting journal entries?

- Revenues and expense may arise before/after cash flow or at the same point in time
- In order to record the accounting transaction to the appropriate time period

Adjusting entries are internal transactions that may be required to make sure that assets
and liabilities are correctly recognized at the end of the accounting period.

There are 4 main types of accrual accounting adjustments:

1) Prepayments (expiration of assets)
2) Unearned revenues
3) Accrual of unrecorded expenses
4) Accrual of unrecorded revenues

1) Prepayments (expiration of assets):

Prepayments (prepaid expenses) are assets that arise because an expenditure has been
made, but there is still value extending into the future. They are usually classified as current
assets because the future value usually continues only in to the next year. Prepayments do
not necessarily have any market value, but they have an economic value because future
resources will not have to be expended. Examples include prepaid insurance, prepaid rent
and office supplies.

As the assets are consumed in the process of earning revenue, a portion of the cost is
written off in each period as an expense. For example, in the case of prepayments e.g.
prepaid insurance, 1/12 of the premium would be used each month, resulting in Cr
Prepayments and Dr Insurance expenses.

EXAMPLE: 1 May 2012, paid $1200 insurance premium covering 12 months from 1 May.

Journal entry on date of payment:

Dr Prepaid insurance (A) $1,200
Cr Cash $1,200

Journal entry adjustment on 30th June:

Dr Insurance expense $200
Cr Prepaid insurance $200
THIS IS BECAUSE IT IS ONLY 2 MONTHS.

2) Unearned revenue:
Unearned revenue is future revenue where the cash has been received in advance of
earning revenue  they relate to collections from customers for goods or services not yet
provided. We defer the recognition of revenue, by recognizing unearned revenue as a
liability account, and as each service is provided the liability is reduced and earned revenue
can be recognized.

Examples include insurance premiums, magazine subscriptions and rent received in

advance.

EXAMPLE: Received deposit of $100 000, for service to be provided in the next accounting
period.

Journal entry when deposit received:

Dr Cash $100,000
Cr Unearned revenue $100,000

Journal entry when service is provided:

Dr Unearned revenue (-L) $100,000
Cr Revenue (R) $100,000

Note  unearned revenue is included in the liability section because the good/service has
not been provided yet and is recognized when the good or service is finally provided.

3) Accrual of unrecorded revenues:

The accrual of unrecorded revenues occurs when a service has been provided but cash will
not be received until the following period (think of it as a receivable account). Examples
include interest receivable on loans, commissions earned and unbilled revenues.

EXAMPLE: A company deposited $500,000 with a bank for one year at 4% on 1 January 2016
(interest payable at the end of the period). At 30 June 2016, it would have earned $10,000
interest, although the total interest of $20,000 would not be received until 31 December
2016.

Journal entry on the 30th June:

Dr Accrued interest (+A) $10,000
Cr Interest revenue $10,000

ACCRUED INTEREST = INTEREST RECEIVABLE

4) Accrual of unrecorded expenses:

This adjustment involves determining which expenses have been incurred by the
organization (but not paid in cash) during a particular period of time. Accrued expenses are
expenses that have been incurred during the current period but will not be paid until the
following period (think of it as a payable account).

A common example is wages, because the end of the pay period and the end of the financial
period occur on different days, it is necessary to include an accrual for wages payable from
the date of the last payment to the day on which the accounting period finishes. Wages
expense is increased because it is an expense of the period, and accrued wages (wages
payable) also increased because there is a liability at the end of the period.

EXAMPLE: A firm pays weekly wages (on Thursday) to cover the previous 5 working days
before the Thursday. If 30 th June falls on a Friday, 2 day’s wages will be owing at 30 June. If
the weekly wages bill is $500,000, then $200,000 (Thursday/Friday) will be owing:
- Dr Wages expense $200,000 Cr Accrued wages $200,000

Contra accounts:
Just about every balance sheet account can be considered to be a control account e.g. cash
is a record of the cash that should be there if it were counted. A contra account allows us to
recognizes expenses and related value changes to assets without changing the control
account. It is useful for both profit measurement and to preserve the international control
aspects of the accounts.

Contra accounts have balances that are in the opposite direction to those of the control
account with which they are associated (debit switches with credit). For example, contra
asset accounts have credit balances that are ‘contra’ the assets’ debit balances.

Contra accounts are useful as they allow users to ascertain:

- Accounts receivable  allowance for doubtful debts (ADD)
Level of doubtful debts (and changes therein), collection policies and problems
- Property, plant and equipment  accumulated depreciation
 Likely ages of assets and future cash outflows for purchases of new assets
- Intangibles  accumulated amortization
Likely life of intangibles
- Inventory  provision for obsolescence
Levels of slow moving, out-of-date stock, efficiency of stock management

Accumulated depreciation (amortization):

Contra accounts are used to accumulate depreciation on fixed assets, such as buildings and
equipment. Accumulated depreciation is the allocation of the cost of a non-current asset to
expense over the life of an asset.

To recognize the consumption of the asset’s economic value:

- Accumulated depreciation (a contra asset account, B/S) shows all depreciation
charged against an asset to date (Cr)
- Depreciation expense (Income statement) shows only this year’s depreciation
allocation (Dr)

EXAMPLE: Asset costs $100 000 with a life of 5 years and no estimated salvage value.
Straight line depreciation each year:
Dr Depreciation expense $20 000
Cr Accumulated depreciation $20 000
After 3 years, book value is:
Asset $100 000
Accumulated depreciation ($60 000)
Book value (net assets) $40,000

- Book value/carrying amount (current value of assets on the balance sheet) = Cost –
accumulated depreciation
- Depreciation is a reduction in the value of an asset over time, due in particular to
wear and tear.
 Accounting and Financial Management

WEEK SIX:
6. INTERNAL CONTROL AND CASH
ACCT1501 z5160731
Worksheet:
- A “tool” to help you prepare your financial statements.
- Use of worksheet is optional

Lists all the accounts vertically down the page:

- Current assets/Non-current assets
- Current liabilities/Non-current liabilities
- Shareholder’s equity
- Revenue
- Expense

From the worksheet columns, transfer the information to financial statements in the
correct format

Internal control system:

Internal control is a process effected by an entity’s board of directors, management and
other personnel, designed to provide reasonable assurance regarding the achievement of
objectives in the following categories:
1. Effectiveness and efficiency of operations including safeguarding assets against loss
2. Reliability of internal and external financial and non- financial reporting
3. Compliance with applicable laws and regulations

Objectives:
- Safeguard assets against waste, fraud, and inefficiency - locks, keys, insurance,
patents, passwords
- Promote the reliability of internal and external accounting data - Separation of
accounting function, separation of duties
 - Encourage compliance with laws - occupational health and safety, complaints

Internal control consists of the following 5 interrelated components:

1. Control environment  incorporates all the written policies and procedures of the
organization as well as the unwritten practices of those within the organization
2. Risk assessment  the identification and analysis of relevant risks that may
adversely impact the achievement of the organization’s objectives, determining the
basis for how the risks should be managed
3. Control activities  the policies and procedures that help to ensure that
management directives are carried out and ensure that necessary actions are taken
to address risks to achieve objectives (authorization, reconciliation and separation of
duties)
4. Information and communication  pertinent information must be identified,
captured and communicated in a form and a timeframe that enable people to carry
out their responsibilities
5. Monitoring  a process that assesses the quality of the system’s performance over
time, accomplished through ongoing monitoring activities and evaluations.

For each objective, all 5 components must be present and function effectively to
demonstrate that internal control over the reliability of financial reporting is effective.

Limitations:
- Judgment mistakes such as misunderstanding instructions
- Managers may overrise effective internal control systems, that is, overrise prescribed
policies or procedures such as increasing revenue to cover up falls in profit
- Collusion among 2 or more employees that may result in control failure
- Cost versus benefit discussions in implementing and checking on controls e.g. you
would not spend $1 million a year protecting inventory that was worth $10,000

Features/examples of control activities:

1. Top level reviews
Managers carry out reviews of actual performance compared to budgets, forecasts and
prior period results; assessing which targets are being achieved.

2. Information processing
Controls are used to check accuracy, completeness and correct authorization of transactions
e.g. data entered is subject to edit checks, such as no payroll amount above $x.

3. Physical protection of sensitive assets

Sensitive assets such as cash, inventories and computer equipment, should be behind lock
and key, kept in particular storage areas, or otherwise protected from unauthorized or
casual access.

4. Separate record keeping from handling assets

An effective way of providing security over assets like cash, accounts receivable and
inventories is to have records showing how much of each asset is supposed to be on hand at
any time.
Some specific examples of internal control procedures include:
- Independent approval and review
- Matching independently generated documents
- Comparison with independent third-party information

Internal control of cash:

Cash is the asset that is usually most susceptible to theft because of its liquid, and generally
anonymous, nature. Internal controls are needed to prevent payment for goods or services
that have not yet been received or payment of an invoice more than once. Some internal
controls include:
- Payments should only be made if documentation has been properly authorized
- The cheques should be signed by 2 staff members who are independent of invoice
approval and accounting duties
- The original invoice should be stamped ‘paid’ to ensure that it is not subsequently
represented for payment.
- Separation of duties for recording/handling cash AND receiving/paying cash
- All cash receipts banked in entirely daily

Petty cash fund:

Under the petty cash system, a fund is established for use in making small payments,
especially those that are impractical or uneconomical to make by cheque e.g. taxi fares and
miscellaneous office needs. Created by cashing a cheque down on the company’s regular
cheque account. The proceeds from the cheque, which are sufficient to cover small cash
payments for a short period of time, are then placed in a petty cash box that is controlled by
an individual known as the fund custodian. PETTY CASH IS AN ASSET.

1) Establishing the petty cash fund:

Dr Petty Cash $200
Cr Cash $200

2) Making disbursements from the petty cash fund:

As payments are made from the fund, the custodian completes a form known as a petty
cash voucher. Each voucher indicates the amount paid, the purpose of the
expenditure, the date of the expenditure and the individual receiving the money
(used as evidence of disbursement)

Preparing a journal entry for every disbursement would give rise to considerable
bookkeeping work and posting for small amounts. Thus, although a payment has
been made, no journal entry is recorded at this time.

Cash remaining in the fund XXX

Plus: Petty cash vouchers XXX
Original amount of the find $200

3) Replenishment:
The petty cash fund is replenished when the amount of cash in the fund becomes low.
Dr Postage Expense $20
Dr Office Supplies Expense $50
Dr Miscellaneous Expense $15
Cr Cash $85 (to replenish petty cash fund)

Notice that the credit is to the cash account and not petty cash, because although
disbursements have been made from the petty cash box, the fund is restocked by
writing a cheque for $85 on the company’s regular cheque account (thus payment is
really from cash)

Bank reconciliations:
Bank reconciliations compare the cash balance in the bank statement with the cash account
in the general lodger (or your cheque book), and is a major internal control for cash due to
the high frequency of transactions and the potential for error. Reconciliation means explain
the difference between 2 sources of information about cash.

Bank statements summarize the activity in a bank account and report the ending monthly
balance. It is important to understand that although the cash account of a depositor is an
asset, the depositor’s account is carried on the bank’s records as a liability. Consequently,
debits and other debits by the bank reduce the bank account, whilst deposits and other
credits increase the account.

At the end of a month, the bank statement cash balance and the company’s cash records
will normally not agree. The 3 reasons for differences:
1. Recorded in ledger before recorded by bank (timing)
- Deposits in transit – receipts entered into the firm’s accounts but not yet
processed by the bank e.g. cash received from customers not yet ‘banked’
- Outstanding cheques – cheques written by a business but not yet presented
to the bank e.g. cheques written to suppliers
2. Recorded by bank before recorded in ledger (timing)
- Non-sufficient funds (NSF) cheques – customer cheques deposited but
returned because of lack of funds
- Bank charges
- Electronic funds transfer transactions – in particular receipts from customers
may not have been recorded in the company’s records
3. Errors
- Made by the company in the general lodger e.g. transposition error ‘198’
recorded as ‘918’
 - Made by the bank in the bank statement e.g. bank fees overcharged

Bank reconciliation process:

One commonly encountered process involves determining the amount of cash a company
has control over and the reports on its end-of-period balance sheet. The purpose of
reconciliation is to isolate specific items that cause a difference between the depositor’s
records and the bank statement balance  the accountant considers these items and
adjusts one cash balance or the other to bring both balances into agreement.

If the balances do not agree and the reconciling items are deemed correct, there is a high
chance that a record-keeping error has been made. Errors must be identified, then added or
subtracted on the reconciliation to arrive at the corrected cash balance.

For example, if a cheque written by a firm for $94.50 was incorrectly entered into the
accounting records as $49.50, the accounting records would be overstated by $45. This
amount ($45) should therefore be deducted from the ending cash balance per company
records, since the company’s books are in error. The bank will deduct the correct amount of
the transaction ($94.50) when the cheque is received for payment. The reconciliation then
does not only highlight timing differences but also identifies errors made by either the
bank or the depositor.

Performing a bank reconciliation from information to cash journals:

The following steps should be undertaken to complete the bank reconciliation statement:
Step 1:
- Go through last month’s bank reconciliation statement, ticking off any amounts that
were outstanding last month e.g. unpresented cheques and appear on this month’s
bank statement
- Go through the bank statement and tick off items appearing both these and in the
cash journals (tick them off in both places)

Errors  if you see any cheques or deposits that are recorded incorrectly by the business of
the bank e.g. transposition error, deal with as follows:
 - If the bank has made a mistake, inform the bank and list it in the bank reconciliation
- If the business has made a mistake, correct the relevant cash journal (CPJ or CRJ)

Step 2:
- Go through the bank statements and see what amounts remain unticked (these
unticked amounts may be dishonored cheques, interest or cash transactions made
directly through the bank and not yet recorded in the books). These should be
entered into the appropriate CRJ or CPJ. After entering them, tick them in the
journals and the bank statements.
- Go through the cash journals to see if there are any unticked amounts in the CRJ and
CPJ. These will represent outstanding deposits and outstanding (unpresented)
cheques respectively.

Step 3:
- If the CRJ and CPJ have not yet been totaled and posted to the bank ledger account,
this should be done
Step 4:
- Prepare a bank reconciliation statement.
Purpose of internal control  mainly manage operational risk
- Safeguard the assets against waste, fraud and inefficiency
- Promote reliability of accounting data
- Encourage compliance with management policies

If bank made the error, then bank fix the error and vise versa.
Adjusting journal entries can only be done for the company’s books, not bank
If NSF, Cr Cash and Dr Accounts Receivable
 Accounting and Financial Management

WEEK SEVEN:
7. ACCOUNTS RECEIVABLE AND FURTHER RECORD-KEEPING
ACCT1501 z5160731
Receivables
Receivables are an asset that occurs when a service has been provided but cash will not be
received until the following period e.g. accounts receivable, interest receivable on loans.
Accounts receivable are a current asset on the balance sheet, arising from the sale of
goods/services on credit e.g. Dr Accounts Receivable $100 Cr Sales Revenue $100. When
payment is made Dr Cash $100 Cr Accounts Receivable $100. Accounts receivable is also
known as debtors, trade debtors and trade receivables.

Control accounts and contra accounts

Control accounts are the items which make up the balance sheet e.g. cash is a record of the
cash that should be there if it were counted. Contra accounts allow us to recognize expense
and related value changes to assets without changing the control account. They have
balances that are in the opposite direction to those of the traditional asset accounts with
which they are associated. Contra accounts have credit balances that are ‘contra the
assets’ debit balances.

Used mainly with:

- Accounts receivable  Allowance for doubtful debts (current assets
- Property, plant and equipment (PPE)  Accumulated depreciation (non-current
asset)
- Intangibles  Accumulated amortization
- Inventory  Provision for obsolescence

Accounts receivable and contra accounts

Valuation of accounts receivable
Receivables are valued on the balance sheet at the lower of cost (original value) or net
realizable value (the amount expected to be collected). If the collection amount is now
expected to be lower than originally anticipated, the receivable must be reduced to an
estimated collectable account  the estimated collectable amount is gross accounts
receivable – the allowance for doubtful debts.
For example:
- We have an accounts receivable balance of $85,000
- One customer ($1,500) has gone bankrupt
- We also estimate that 5% of our other customers will not pay
- Then, our net realizable value of accounts receivable is (85,000 – 1,500 – 4,175) =
$79,325

Allowance for doubtful debts

Benefits of sales on credit:
- Earn more revenue if willing to sell to customers who wish to buy on credit

Costs of sales on credit:

- Additional record keeping
- Risk of not being paid
- Time value of money – delaying cash inflows and lending to customers ‘interest free’

When a company sells to a customer on account, there is always some risk that the
customer will fail to pay. Therefore, a portion of the sales on account will be doubtful, and
that portion should be deducted from revenue in determining profit for the period  this is
known as bad debts expense.

NB: Allowance for doubtful debts is a contra assets account, which means when we increase
allowance we are reducing total assets.

For example, a company determines that about $500 of sales on credit are likely to not be
paid. The journal entry to recognize the expense is:
- Dr Bad debts expense $500
- Cr Allowance for doubtful debts $500

The reason for not deducting the amount directly from the accounts receivable asset is that
even after the usual collection has passed, the company may still try to collect on the
accounts, and therefore, doesn’t want to alter the accounts receivable amount.

Eventually, after pursuing a non-paying customer for months, a company may decide to
write the account off. Suppose the account in question = $100, then the transaction effect
would be to reduce the allowance for doubtful debts and reduce accounts receivable both
by $100  Dr Allowance for doubtful debts $100, Cr Accounts Receivable $100.

There are 2 methods for accounting for bad debts expense:

1. Direct write off method
- Directly ‘writing’ off accounts receivable
- Chances of collecting cash for all accounts is very high
- Small number of credit sales, few customers
- E.g. Dr Bad debts expense $1500, Cr Accounts Receivable $1500

2. Allowance method
- Debts may NOT be collected
- Recognizing a potential risk – part of internal control
- Large number of credit sales, many customers
- E.g. Dr Bad debts expense $1500, Cr Allowance for doubtful debts $1500. Dr
Allowance for doubtful debts $1500, Cr Accounts Receivable $1500.

Step 1  create allowance for doubtful debtors to reflect the amount the company expects
or estimates not to be collected
Step 2  write of actual debts that are uncollectable

Bad debts expense because we need to cancel the revenue in order to not overstate profits
(matching principle)

Closing balance of ADD = opening balance + bad debts expense – write off

Using an allowance account is usually preferable to a direct write-off, not only because of
the internal control advantages the contra account provides, but also because the
allowance provides a way to have an expense before the company gives up on collection.

Ageing of accounts receivable

When determining an estimate for uncollectable accounts, companies can use 2
approaches:
1. The income statement approach
- Focuses on the income statement and calculates the balance of the Bad debts
expense account
- Relies on the historical relationship between credit sales and the amount of
those sales unlikely to be collected e.g. past experience may suggest that bad
debts are about 2% of net credit sales each year
- This percentage is then multiplied by credit sales to determine bad debts
expense

For example, CFO of Anna Limited tells you that from past experience, 2% of credit sales
became uncollectable. Credit sales for this year was $640,000. Using the income statement
approach, Anna must record  Dr Bad debts expense $12,800, Cr Allowance for doubtful
debts $12,800.
However, the income statement approach may easily overstate or understate the level of
bad debts being recognized due to economic/market change e.g. economic downturn may
mean that historic percentages are understated.

2. The balance sheet approach

- Focuses on the balance sheet and calculates the balance of the allowance for
doubtful debts account
- Based on the belief that the older the accounts receivable, the greater the
probability that the amount will not be collected

For example, the CFO of Elsa Limited has prepared a schedule based on past experience
indicating percentages of accounts receivable that have been written off as bad.
Age category Percentage
Not yet due 1
1-30 days overdue 3
31-60 days overdue 9
61-90 days overdue 16
Over 90 days overdue 25

The present balance for allowance for doubtful debts is $1200 CR. As at 30 th June, the ageing
of accounts receivable indicates:

Age category Amount Percentage Estimated

uncollectable
Not yet due $73,000 1 $730
1-30 days overdue $12,000 3 $360
31-60 days overdue $5,000 9 $450
61-90 days overdue $3,000 16 $480
Over 90 days $1,300 25 $325
overdue
Total $94,300 $2,345

Since the opening balance for Allowance for doubtful debts is $1200 CR, an additional $1145
will need to be added to this account (as total is $2345)  Dr Bad debts expense $1145, Cr
Allowance for doubtful debts $1145.

Trade discount and cash discount

Each represents a reduction in the amount that a customer ultimately pays a vendor for
goods and services supplied.

Trade discount
It is a means of adjusting the actual price charged to a customer from a standard ‘list price’
 trade discount is given by businesses for customers that are expected to purchase large
volumes. This discount is NOT recorded in the books, most enterprises record only the net
amount of the transaction. This is because the effect of a trade discount is merely to set an
actual price for the transaction.
For example, on November 13, Glomobile made a cash sale of 17 Magic Magenta Glow
Mobile Phone Covers for a list price of $20 each. A trade discount of 10% applies:
- Dr Cash (17 * $18) $306
- Cr Sales Revenue $306

Cash discount
This is a conditional adjustment after determining the actual selling price at which the
transaction takes place  offered if the payment is made within a specified date from the
transaction, thus providing an incentive for prompt settlement of debts. It is therefore
NOT a change in the price of the original sales transaction, and is generally recorded as an
additional transaction.

A common arrangement is to extend credit terms such as 2/10, n/30. This means that a
discount of 2% may be deducted from the amount due if payment is made within 10 days,
otherwise the net amount is payable within 30 days.

For example, if sales totaling $400 were made to a particular customer during April in the
above terms, $8 could be deducted from the payment is settlement was made within 10
days (the discount period).

Detailed recording using special journals, subsidiary ledgers and control accounts
Recall the accounting cycle. Previously, we have assumed that the economic events
captured in the accounting system are initially recorded in the general journal, then
summarized through posting to the general ledger  this system is best suited towards
businesses with a small set of transactions.

NB: Special systems can be put in place to allow a more efficient recording process for
common transactions (such as cash collections and payments).

Rather than all the accounting information being captured in one journal and posted to one
ledger, a system of special journals and subsidiary legers can be used to streamline the
recording, storage and categorization of data. Special journals are designed to allow the
easy recording of the most common transactions undertaken by a business, whilst
subsidiary legers represent a detailed analysis of the information that is eventually
transferred to a general leger account.

Price entry records – special journals

The most common transactions undertaken by a business can be recorded in special
journals  they allow some classification and summarization to occur in the journal. In a
special journal, each entry represents a transaction that belongs to the same class as others
in the same journal (these journals are used in additional to a general journal). Transactions
not recorded in special journals are recorded in a general journal e.g. depreciation,
adjustments for prepayments.

Apart from improving efficiency, other advantages of special journals include:

- Amounts can be posted from special journals to general journals as totals rather
than individual journal entries
- More than one use can update the accounting system e.g. inventory subsidiary
ledger and the debtor’s subsidiary ledger
- Common nature of transactions eliminates need for narrations

Special journals are used in conjunction with subsidiary ledgers. For example, more detailed
record showing how much each debtor owes the company and when he or she is expected
to pay.

Subsidiary ledgers and control accounts

These are used for detailed records in the accounting system. A subsidiary ledger is a set of
leger accounts that collectively represents a detailed analysis of one general ledger account
classification. The relevant ledger account in the general ledger is known as a control
account. The accuracy of the detailed accounts in the subsidiary ledger can be periodically
checked against the aggregate data and balance contained in the control account.

Subsidiary ledgers do not form part of the general ledger  they are separate ledgers that
show more detail about a general ledger account (such as debtors). Examples of general
ledger accounts that have subsidiary ledgers are:
- Debtors/accounts receivable  a separate account for each debtor
- Creditors/accounts payable  a separate account for each creditor
- Property, plant and equipment  separate records of each property, plant and
equipment (often called asset register)
- Raw materials inventory  separate records of each type of raw material held
- Finished goods inventory  separate records of each type of finished good held
When all required entries have been made in both records, the total of the balance
appearing in the accounts in the subsidiary leger should equal the balance appearing in the
control account in the general ledger. Apart from providing a check on accuracy, subsidiary
ledgers enable any desired amount of detail to be maintained to explain the composition
of a selected general ledger account.

Debtors and creditors control accounts

The reason they are called control accounts is because one uses them to ensure there are
no errors or mistakes in our records relating to debtors and creditors. Traditionally,
bookkeepers perform a reconciliation on a regular basis between the control accounts
(general ledger) and the total of the debtors or creditors ledger.

To perform a reconciliation, we take the opening balance in the control account and analyze
a summary of transactions that take place during the year. The balance at the end of the
periods should match if transactions are posted correctly.

What transactions are included:

- Credit purchases or sales (NOT cash sales)
- Payments to supplies / payments from debtors
- Other transactions related to the sales / purchase of goods on credit

Debtors control account  relates to accounts receivable INCREASE | DECREASE

Creditors control account  relates to accounts payable DECREASE | INCREASE
 Accounting and Financial Management

WEEK EIGHT:
8. INTRODUCTION TO INVENTORY AND NON-CURRENT ASSETS
ACCT1501 z5160731
Inventory control is an important issue for management because a high percentage of
working capital may be tied up in inventory. Inventory may be perishable or become
obsolete if held too long, and there is a potential for theft.

Inventory control systems

1. Perpetual system
- Shows how many items are supposed to be on hand at any point in time
- Has a continuously updated figure for the amount that should be on hand  if a
physical count of the inventory fails to show that quantity, the company knows
that some items have been lost or stolen, or an error has occurred
- If understated inventory cost, the inventory asset account would be adjusted to
match the account by an adjusting entry to reduce inventory and increase an
expense.

Example:

Dr Inventory shortage expense $5,000

Cr Inventory $5,000

Pros:
- Provides better internal control
- Stock losses/shortage of inventory are easily determined
Cons:
- However, it is costly in terms of record keeping and not suitable for all types of
goods e.g. coal

Example: A company bought inventory for $100 cash, then sold it for $500 cash.

Purchases  Dr Inventory $100, Cr Cash/accounts payable $100

All sales of inventory require 2 entries  Dr Cash/receivable $500, Cr Sales $500. Dr COGS
$100, Cr Inventory $100

2. Periodic system
- Determines inventory by physical count at the end of the period when an inventory
figure is needed for financial statements
- However, the periodic count method lacks the parallel record-keeping that gives the
perpetual method its value  there is no way to reconcile counts to records in
order to discover errors (shortage of inventory ignored)

Sale of inventory requires only ONE entry  Dr Cash/Receivable $500, Cr Sales $500

Perpetual or periodic:
- Record-keeping choice, not a reporting choice
- Depends on nature of inventory
 - Cost-benefit
Inventory valuation and COGS
The lower of cost and net realizable value rule states that the value of inventory should be
written down from the cost price to the market price in situations where market is below
cost  in Australia, market is defined as net realizable value, the estimated selling press
less costs to sell the items.

Under accounting standards, the cost of inventory comprises of:

- Cost of purchases
- ADD purchase price, import duties and other taxes, import transport and handling
costs, any other directly attributable cost of acquisition
- LESS trade discounts, rebates and other similar items

Not included in cost of inventory  administration costs, selling costs and storage costs/

To calculate the lower of cost and net realizable value, we just take the cost of the items and
math those costs against the net realizable value and use the lower as the balance sheet
inventory value. For example, if inventory that costs $1,000 had a net realizable value at
year end of $800  Dr Inventory write-down expense $200, Cr Inventory $200.

Cost flow assumptions:

The 3 major types of cost flow assumptions:
1. First in, first out method (FIFO)
2. Last in, first out method (LIFO)
3. Weighted average method (or moving average)

1. First in, first out (FIFO):

Assumes the first units purchased are the first units sold and therefore that any ending
inventory on hand consists of the most recently acquired units (recent costs on the balance
sheet, older costs in COGS expense)  suitable for perishable items e.g. milk and bread.

FIFO results in:

- Higher profit level in times of rising prices (relative to LIFO and weighted average)
- Closing inventory balance closer to current cost (relative to LIFO and weighted
average)

2. Last in, first out (LIFO):

Assumes the opposite of FIFO, saying that any inventory on hand consists of the oldest units
(older costs on the balance sheet, recent costs in COGS expense).
LIFO results in:
- In times of rising prices, results lower value of ending inventory (higher COGS 
lower profit)
- Often does not match physical flow
- Closing inventory balance may not be relevant
- NOT permitted under Australian accounting standards but permitted in US

3. Weighted average:
The AVGE method assigns the available cost equally to the inventory asset and to the COGS
expense. Note that when prices are rising, average cost shows a higher COGS (lower profit)
and lower inventory balance sheet figures than the FIFO method  appropriate for similar
products and ’non-expiry’ items.

A weighted average is first calculated ($15x3) + ($20x3) = $105 -$105/6 = $17.5 per unit.

- When using a perpetual inventory control system, it is referred to as the moving

average method
- It is simple to apply and less subject to profit manipulation

FIFO vs LIFO vs Weighted Average:

- When prices are changing, each method will provide a different ending inventory
and COGS value
- But note that the sum of these 2 items will always be the same, no matter what the
method!

At the end of the period  Total cost = Inventory on hand + COGS

Non-current assets
These are held by company for more than 12 months and are used to generate revenue e.g.
property, plant and equipment (PPE), intangible assets and long term investments

PPE are tangible items that:

- Are held for use in the production or supply of goods or services, for rental to others
or for administrative purposes AND
- Are expected to be used during more than one period

PPE – Main points of interest:

1. Initial cost of PPE
2. Depreciation of assets
3. Additional expenditure on assets after acquisition
4. Recording the disposal of assets

1) Initial cost of PPE:

Cost at acquisition:
- Recorded in the balance sheet ‘at cost’
Cost includes:
- Purchase price
- Any costs directly attributable to bringing the asset to the location and condition
necessary for it to be used in the manner intended by management
- Estimate of costs associated with dismantling and removing the item and/or
restoration costs

E.g. invoice price of machinery, purchase taxes, delivery/freight costs, installation costs and
architects fee. Cost is “capitalised” – i.e. recorded on balance sheet NOT income statement.

2) Depreciation of assets:
PPE usually has a limited useful life due to a reduction in ‘usefulness’ of generating revenue
and the value at cost “depreciating” over time.

Depreciation = systematic allocation of the “usefulness” of an asset over its life (Dr
Depreciation expense, Cr Accumulated depreciation)

The carrying value or book value of an asset = initial cost – accumulated depreciation.

Depreciation should be based upon the asset’s:

- Useful life  period of time over which an asset is expected to be available for use
(may differ from physical life because of technical obsolescence e.g. computer)
- Residual value (sale or scrap)  the estimated amount that an entity would obtain
from disposal of the asset at the end of its useful life (depreciable amount = asset
cost – residual value)
- Pattern of flow of benefits over the useful life  3 methods of depreciation based
on when benefits occur:
1. Straight line - consistent use/benefit over useful life e.g. warehouse
2. Reducing balance – more use/benefit now than later e.g. computer
3. Units of production – more use/benefit later than now or inconsistent
pattern

1. Straight-line depreciation:
Here, the decline in value is expected to be uniform across the life of the asset. It assumes
benefits flow in equal amounts over the useful life of the asset i.e. same depreciation
expense each year.

2. Reducing-balance depreciation:
Assumes that benefits are used more in earlier years and uses a depreciation rate 
expense is not the same every year. Depreciation expense = Carrying amount x
Depreciation rate.
For example, initial cost of PPE = $40,000 and depreciation rate = 25%.

3. Units of production depreciation:

This is the most common activity-based method of apportioning costs.

For example, cost of motor vehicle = $40,000, residual value = $5,000, estimated number of
kilometers to be driven = 200,000. Depreciation per km = (40,000-5,000)/200,000 = $0.175.

If in year 1, Motor Vehicle travels 20,000km  depreciation expense = 20,000 x $0.175 =

$3,500.

3) Additional expenditure on assets after acquisition:

Additional expenditure should be added to the cost of the asset if the definition and
recognition criteria for assets are met (otherwise treat as an expense).

Betterment verses maintenance of PPE:

- Betterment  relates to increase in expected economic benefits e.g. productivity,
efficiency, output quality
- Maintenance (repair)  relates to maintaining expected economic benefits

4) Recording the disposal of assets:

PPE may be:
- Scrapped  the asset is worthless and has no resale/residual value
- Sold
- Traded-in  exchanged for another asset

What do we need to record?

- Step 1  record depreciation up until the date of disposal
- Step 2  record gain or loss from the sale of the asset
- Step 3  remove the non-current asset from the company’s books

Sales price > net book value  profit

Sales price < net book value  loss
Disposal of a machine example:
As of 30 June 2015  original cost = $50,000, accumulated depreciation = $24,000, book
value = $26,000, straight line depreciation = $12,000 per year. Sold on 1 August 2015 for
$21,000 cash.

On 1 August, book value of machine = $25,000

Received cash in exchange for $21,000.

To remove the non-current asset from the company’s books  Dr Cash $21,000, Dr
Accumulated depreciation $25,000, Dr Loss on Sale $4,000, Cr Machine (Cost) $50,000.

Tutorial
Perpetual method (record inventory continuously):
Beginning inventory cost + inventory acquired – COGS = ending inventory cost

If there is inventory shortage:

- Dr Inventory shortage expense
- Cr Inventory

Pros: Better internal control  record simultaneously so easy to spot any stolen inventory
Cons: costly and time consuming  continuous recording

Journal entry:
Purchase: Dr Inventory, Cr Cash/Payable
Sale: Dr Cash/Receivable, Cr Sales (record the amount of sales, Dr COGS/Cr Inventory
(record the cost)

Periodic method (record inventory periodically, year-end):

COGS = beginning inventory + purchases – ending inventory
Journal entry:
Purchase: Dr Purchase expense, Cr Cash/Payable (inventory is calculated at the end)
Sale: Dr Cash/Receivable, Cr Sales revenue

Cash Flow Assumptions: Valuing Inventory

First in, First out (FIFO): first units purchased = first units sold
- Higher profit in terms of rising prices
- Closing inventory balance closer to current cost
- Suitable for perishable items e.g. food

Last in, Last out (LIFO): last units purchases = first units sold
- Lower profit in terms of rising prices (higher COGS)
- Closing inventory balance far from current cost
- Not permitted under AASB

Weighted average (for periodic)/Moving average (perpetual):

- Easy to apply and less subject to profit manipulation
- Suitable for similar products and ‘non-expiry’ items

Calculating LIFO/FIFO  Date|Purchases|Sales|Balance

Inventory must be recorded at the lower of cost (FIFO, LIFO, Average) or net realizable value
(similar to market value)  whichever is lower amount.

E.g. net realizable value = $650

FIFO $1,010
(too high)
Write down $360

LIFO $690
(Still too high)
Write down $40

Dr Inventory write-down (expense) $40 (if LIFO)

Cr Inventory $40

Dr Inventory write-down (expense) $360 (if FIFO)

Cr Inventory $360

ONLY DO THIS IS LOWER OF COST IS GREATER THAN NET REALISABLE VALUE.

Non-current assets: PPE

Definition:
- Tangible asset
- Held for use in the production/supply of goods or services/rent/admin purposes
- Expected to use > 1 year (non-current asset)
Initial cost of PPE = purchase price + any directly attributed costs
- Examples of directly attributed costs = installation, delivery, set-up, dismantling sites

Deprecation:
Method 1: Straight line depreciation
- Depreciation expense = (cost-residual value)/useful life
- Depreciation expense will be the same every year
- Cost = purchase price + initial directly attributed costs
- Residual value  the estimated amount that the company will get from the disposal
of the asset at the end of its useful life
- Useful  periods where the company expects to obtain benefits from the asset

Method 2: Reducing balance

- Depreciation expense is calculated based on a predetermined rate. Expense will not
be the same every year. Under this method, in early years, the asset will be heavily
depreciated but in later years, the depreciation expense will be less and less
- Depreciation expense = carrying amount x depreciation rate

Method 3: Units of production

- Depreciation expense = (cost-residual value)/expected # of units of production
- Depreciation of expense depends on the usage of the assets

Disposal of non-current assets:

Journal entry:
- Dr Cash
- Dr Accumulated depreciation
- Cr/Dr Gains or Loss on sale
- Cr Asset
 Accounting and Financial Management

WEEK NINE:
9. FINANCIAL REPORTING PRINCIPLES, ACCOUNTING STANDARDS AND
AUDITING
ACCT1501 z5160731
Generally Accepted Accounting Principles (GAAP):
GAAP determines what goes into financial statements  they are the rules, standards and
usual practices that companies are expected to follow when preparing financial
statements.

Components of GAAP:
- Accounting standards e.g. Australian Accounting Standards Board (AASB)
- Framework for the Preparation and Presentation of Financial Statements (the
Framework)
- Accounting Guidance Releases
- Corporations Law
- ASX Listing requirements

Framework for the preparation and presentation of financial statements:

The framework issued by AASB sets out the concepts that underlie the preparation of
financial reports for external users. The Framework includes coverage of:
1. Objectives of financial reports
2. Assumptions underlying financial reports
3. Qualitative characteristics that determine the usefulness of financial reports
4. Definition of elements of financial statements
5. Recognition and measurement of those elements of financial statements

1. Objectives of financial reports

To provide information about:
- Financial position (in balance sheet)
- Financial performance (in income statement)
- Cash flows (in cash flow statement)

This information is useful to users in making economic decisions.

2. Assumptions underlying financial reports

Two key assumptions in the preparation of financial statements:
1. Accrual basis of accounting  recognizing economic events (revenues/expenses)
when they occur regardless of when cash transactions happen
2. Going concern  assumption that entity will continue to operate in the foreseeable
future. If not, financial reports need to be prepared on a basis other than historical
cost e.g. liquidation value (liquidation value normally lower than historical book
value due to limited market for the assets)

3. Qualitative characteristics of financial information

Two fundamental qualitative characteristics:
 1. Relevance
- Information should assist users to make, confirm or correct predictions about
the outcomes of past, present or future events.
- Making and evaluating decisions about the allocation of scarce resources:
Prediction  can be used by users in making their own prediction
Confirmation  provides feedback about previous evaluations
2. Faithful representation
- Faithful representation of that which it purports to portray.
- Information needs to be:
Complete  includes all information necessary for a user to understand the
phenomenon being depicted
Neutral  without bias i.e. selection and presentation of information should
not be made to achieve a predetermined result or outcome, such as
impressing financial analysts or avoiding regulatory scrutiny.
Free from error  no errors or omissions in the description of the
phenomenon

Four enhancing qualitative characteristics:

1. Comparability  compared with similar information about other entities and with
similar information about the same entity for another period or another date.
2. Verifiability  relates to the faithful representation of economic phenomena and
may be direct e.g. counting inventory/cash or indirect such as checking inputs to a
formula or model e.g. calculation of depreciation
3. Timeliness  having information available when users need to make their decisions
4. Understandability  classifying, characterizing and presenting information clearly
and concisely that makes it understandable

Both relevance & faithful representation are fundamental qualitative characteristics that
must exist to make financial information useful for decision making. As a result, these
fundamental characteristics often conflict with one another

Relevance:
- Information in the financial reports must be relevant to the users
- Decision makers need timely information relevant to their decision  they cannot
wait for needed information must utilize whatever information available.

Faithful representation:
- The more faithfully representative the accounting information is, the better
- Information is more faithfully representative if:
1. Care is taken in its preparation
2. Such preparation is delayed until major uncertainties are resolved so that we
do not have to estimate them

However, decision-makers need timely information relevant to their decisions. As time

passes, reliability rises and timely relevance falls. Hence, difficult to achieve both need to
find some mid-point.
4. Elements of financial statements
The 5 components:
- Balance sheet
- Income statement
- Statement of changes in equity
- Statement of cash flows
- Notes to the financial statement

Key elements:
- Financial position (balance sheet)  assets, liabilities, shareholder’s equity
- Financial performance (income statement)  revenue, expenses

5. Recognition and measurement of the elements of financial statements

The framework sets out a number of different measurement bases that are employed to
different degrees and in various combinations in financial reports:
- Historical cost  assets are recorded at the amount of cash paid or the fair value of
the consideration given to acquire them at their time of acquisition
- Current cost  assets are carried at the amount of cash that would have to be paid
if the same asset was acquired currently
- Realizable (settlement) value  assets are carried at the amount of cost that could
currently be obtained by selling the asset
- Present value  assets are carried at the present discounted value of the future net
cash inflows that the item is expected to generate in the normal business course

Accounting regulation in Australia

Federal government established 2 statutory bodies:

 - Australian Securities and Investments Commission (ASIC)  administration and
enforcement of the Corporations Act 2001 whose role is to regulate and enforce
laws that promote honesty and fairness in financial markets.
- Financial Reporting Council (FRC)  overseeing the accounting and auditing
standard-setting process in the private and public sectors. It is an advisory council
that sets the general strategic decision for the development of accounting standards
(oversees the Australian Accounting Standards Board – AASB)

Both play an important role in the operation and oversight of financial reporting in Australia.

Ensuring financial reporting quality:

1. Corporate governance
The framework of rules, relationships, systems and processes within and by which authority
is exercised and controlled in corporations.

From the financial reporting perspective:

- Preparation of financial statements
- Approval of financial statements
- Assurance of financial statements

2. Hierarchy of a corporation
Agency theory:
- Principal and agent relationship
- Agent  the person who is to do something and be compensated
- Principal  the person who wants it done
- The people are unlikely to have the same interests
- For example, if the agent is to provide effort on behalf of the principal; the agent
wants to work less hard than the principal wishes and the principal wants the agent
to maximize his/her effort

3. Financial reporting process (management, board of directors, external auditors)

Management:
- Prepares financial statements
- Making judgements about measurement of assets and liabilities, revenues and
expenses
- What is recognized on the B/S and I/S
- Impact on ratios
- Public companies include their set of financial statement in a much larger annual
report

Board of directors:
- Approves financial statements by ‘signing’ off the financial statements
- Legally responsible for financial statements
- Board structure  generally, the Board is structured in a manner whereby there is a
main Board, comprising all directors, and a range of committees, comprising selected
directors e.g. remuneration committee and audit committee
External auditors:
- External auditing  an evaluation of an organization’s financial statements by an
auditor who should be unconnected with, and therefore independent of, the
management of the organizations. The purpose of the audit is to verify that the
annual accounts provide a true and fair picture of the organizations finances and
that the preparers of the organizations financial statements have correctly applied
accounting standards
- External auditor’s role  to render an independent, unbiased and professional
perspective and to render a competent opinion on whether the financial statements
present a true and fair view.
- External auditors  EVALUATE the financial statements (do not prepare them) and
are appointed by the shareholders. They must have a close working relationship with
the management to obtain the necessary information to carry out the audit and
must be independent of the management.

External auditors should provide an independent, unbiased and professional opinion on

whether the financial statements:
- Provide a true and fair view
- In accordance with Corporation Act 2001
- Complies with  Generally accepted accounting principles (GAAP) and other
professional mandatory reporting requirements

Types of audit opinions:

1. Unmodified opinion (unqualified opinion)
- Issued when the auditors believe that the financial statements give a true
and fair view, that they are in accordance with the provisions of the
Corporation Act 2001, applicable accounting standards (GAAP) and other
professional mandatory reporting requirements.
2. Qualified opinion
- Issued when a specific part of the financial statements contains a material
misstatement or adequate evidence cannot be obtained in a specific,
material area, and the rest of the financial statements are found to present a
true and fair view, in accordance with accounting standards
- Auditors are generally satisfied except for a specified problem in doing their
work or a specified departure from GAAP in the statements
- E.g. auditors have a different view on the valuation of asset from that applied
by management in the financial statements – the rest of the financial
statements are free from material misstatement
3. Adverse opinion
- Issued when auditors believe that misstatements are so pervasive that the
financial statements do not present a true and fair view and that they are
no presented in accordance with GAAP/accounting standards
- E.g. auditors believe that management has applied an inappropriate financial
reporting framework in preparing the financial statement
4. Disclaimer of opinion
 - Issued when the auditors unable to express an opinion because of limitation
in the work the auditors were able to do i.e. auditors cannot obtain
adequate evidence to form an opinion on the financial statement
- E.g. the company’s financial reporting information system is damaged and
the key data is lost
Professional ethics
The rights that a profession enjoys come in return for promises made concerning the quality
and ethics of its members’ work. Professional codes of ethics involve not only behaving in
a professional manner, but also maintaining the level of expertise required in order to
perform skilfully.

Professional accounting bodies in Australia:

- Chartered Accountants Australia and New Zealand (CA)
- CPA Australia (CPA)
- The Institute of Public Accountants (IPA)

For members of the professional accounting bodies there are ethical standards, including
APES 110 Code of Ethics for Professional Accountants  this Code notes that essential to
the accounting profession is its acceptance of the responsibility to act in the public
interest.

APES 110 sets out 5 fundamental principles:

1. Integrity  obligation to be straightforward and honest in professional and business
relationships, including fair dealing and truthfulness
2. Objectivity  obligation to not compromise their professional or business
judgement because of bias, conflict of interest or the undue influence of others
3. Professional competence and due care  obligation to maintain professional
knowledge and skills AND to act diligently in accordance with applicable
technical/professional standards
4. Confidentiality  obligation to refrain from disclosing confidential information
acquired through business relationships without proper authority AND using
confidential information acquired to their advantage
5. Professional behaviour  obligation to comply with relevant laws and avoid actions
that may discredit the accounting profession

Compliance with these fundamental principles may be affected by various threats, including:
1. Self-interest threats
- The threat that a financial or other interest will inappropriately influence the
judgement or behavior of auditors
- For example, a financial interest in the client, undue dependence on the total
fees of a client or a loan from a client
2. Self-review threats
- The threat that an auditor will not appropriately evaluate the results of a
previous work performed by the auditor (or by another individual within the
audit firm) on which the auditor will rely when performing a current service
i.e. the auditor audits work that they have previously done for the client
 - For example, the auditing systems on reports that you have been involved in
the design and development of
3. Advocacy threats
- The threat that an auditor will promote a client’s position or interest to the
point that auditor’s objectivity is compromised
- For example, promoting shared in a listed company when you are also the
auditory of that company
4. Familiarity threats
- The threat that due to a long or close relationship with a client, an auditor
will be too sympathetic to the client’s interests or too accepting of the
client’s work
- For example, having a close or immediate family relationship with a director
or officer of a client or a long association with senior personnel of an audit
client
5. Intimidation threats
- The threat that an auditor will be deterred from acting objectively because of
actual or perceived pressures from the client
- This includes attempts to exercise undue influence over the auditor
- For example, being threatened with dismissal and being pressured to reduce
the extent of the work performed in order to reduce fees
 Accounting and Financial Management

WEEK TEN:
10. FINANCIAL STATEMENT ANALYSIS
ACCT1501 z5160731
Investment and relative return
An investment is made to earn a return. The return is usually thought of in relation to the
amount of the investment required to earn it. One way to relate the two components is via
return on investment:

Relative return (return on investment) = Return/Investment.

Purpose of ratios:
- To produce a scale-free, relative measure of a company that can be used to compare
with other companies, or other years for the same company

Ratios
Ratios are a quick method of breaking the information in the financial statements into a
form that allows for comparability with similar companies and with the financial
performance of the company over a number of years. Ultimately, these ratios help users
get a well-rounded picture of the company.

Introduction to financial statement analysis

The purpose of financial statement analysis is to use the financial statements to evaluate an
enterprise’s financial performance and financial position  quality of analysis depends on
the quality of the underlying statements.

Financial evaluation requires a judgement based on calculations that make sense for that
company to develop a substantial body of knowledge about the company.

In order to perform a useful financial statement analysis, one should do the following:
- Learn about the enterprise, its circumstances and its plans
- Obtain a clear understanding of the decision or evaluation to which the analysis will
contribute, who the decision-maker is and what assistance they require
- Calculate the ratio, trends and other figures that apply to your specific problem
- Find whatever comparative information you can to provide a frame of reference for
your analysis
- Focus on the analytical results you can provide a frame of reference for your analysis
Common size statements
Another useful method to analysis financial results is the common size financial statement.
By calculating the balance sheet figures as a % of total assets and all income statement
figures as a % of total revenue, the size of the company can be approximately factored out
 this procedure assists in comparing companies of different sizes and in spotting trends
over time for a single company.

Financial statement ratio analysis

Profitability ratios (how well the company performed and is likely to perform in the future)

These ratios should exceed 0 (a positive return) You would prefer their values to be as high
as possible. Values of these ratios generally range between 5%-20%.

1. Return on equity:
(Operating profit after tax)/(total shareholder’s equity)
- Operating profit after tax generally excludes any extraordinary items or one-off items
- Users of financial information (e.g. bankers and share analysts) can choose how they
calculate these ratios depending on the purpose of their assessment
- ROE indicates how much return the company is generating on the historically
accumulated shareholder’s investment
- For a growing company, you’d expect a slightly larger ROE figure for the latter.

2. Return on assets:
(Operating profit after tax)/(total assets)

- An alternative ROA is often calculated using earnings before interest and tax (EBIT)
 EBIT is a measure of profit based on the operating profit before interest and
taxes are deducted
- EBIT can be calculated by adding interest back to net profit before tax

The leverage ratio provides the link between ROA and ROE.
Leverage = (Total assets)/(Shareholder’s equity)  the ratio measures the proportion of
equity funding on the asset base, with the higher the ratio indicting a smaller
shareholder’s funding of assets and greater proportion of total assets funded by debt.

3. Profit margin:
(Operating profit after tax)/(sales)

- Profit margin indicates the percentage of sales revenue that ends up as profit, so it is
the average profit on each dollar of sales e.g. $0.10 profit margin would mean that
$0.10 in net profit (after income tax and other expenses) is generated from each
dollar of sales
- It is a useful measure of performance, and gives some indication of pricing strategy
or competition intensity e.g. discount retailer in a competitive market low profit
margin whilst upmarket jeweler high profit margin
- An alternative version of profit margin can be calculated by dividing EBIT by sales
revenue
4. Gross margin (gross profit ratio):
(Gross profit)/(sales)

- Provides a further indication of the company’s product pricing and product mix
- If profit margin increases, this will either be due to an increase in gross margin or a
fall in expenses

5. Cash flow to total assets

(Cash generated by operations)/(total assets)

- Cash generated by operations is found in the cash flow statement

- This ratio relates to the company’s ability to generate cash resources to its size,
which approximately factors out size
- It provides an alternative return measure to ROA, focusing on cash return rather
than accrual profit return as used in ROA

6. Earnings per share

(Operating profit after tax – dividends on preferred shares)/(weighted average number of
ordinary shares outstanding)

- Earnings per share (EPS) relates earning attributable to ordinary shared to the
number of ordinary shares issued
- Accounting standards require basic earnings per share to be disclosed in every set of
accounts
- The weighted average number of ordinary shares is provided in the annual report, as
it cannot be calculated by outsiders

7. Price-to-earnings ratio
(Current market price per share)/(earnings per share)

- Because market price should reflect the market’s expectation of future performance,
PE compares the present performance with those expectations
- A company with a high PE is expected to show greater future performance than its
present level, while one with a low PE is not expected to do much better in the
future
- PE is highly subject to general increases and decreases in market prices, so it is
difficult to interpret over time  it is more useful when comparing similar
companies listed in the same stock market at the same time

8. Dividend payout ratio

(Annual dividends per share)/(earnings per share)

- For example, if the dividend payout ratio is 0.40, 40% of the profit was distributed to
shareholders and the remaining 60% was retained profits to finance assets or reduce
debts
 - A stable ratio would suggest that the company has a policy of paying dividends based
on profits, and a variable ratio would suggest that factors other than profits are
important in the board of directors’ decisions to declare dividends

Activity (turnover) ratios

1. Total assets turnover
(Sales)/(total assets)

- Relate to the company’s dollar sales volume to its size

- Turnover and profit/margin ratios are often used together, because they tend to
move in opposite direction  companies with high turnover tend to have low
margins, and those with low turnover tend to have high margins

WANT HIGH

2. Inventory turnover
(COGS expense)/(divided by average inventory assets)

- This ratio indicates the level of inventories to the volume of activity

- A company with low turnover may be risking obsolesce or deterioration in its
inventory and/or may be incurring excessive storage and insurance costs
- Many companies have attempted to reduce inventories to the minimum, the JIT
method  keeping just enough stock on hand to meet consumer demand to
minimize inventories
- Inventory turnover an be converted to measure how long, in days, inventory is held
on average. This can be achieved by dividing 365 by the inventory turnover rate.

WANT HIGH

3. Debtor’s turnover (accounts receivable turnover)

(Credit sales)/(accounts receivable)

- The trade debtors’ figure in the ratio refers to gross trade debtors (i.e. before
deducting allowance for doubtful debts)
- This ratio can be converted into a time period often called days in debtors or days
sales in receivables  this ratio indicated how many days it takes, on average, to
collect a day’s sales revenue
- While days in debtors is critical for many companies that sell everything on credit, it
is not so important for those companies with large cash sales

WANT HIGH.

Liquidity ratios
Current ratio:
(Current assets)/(current liabilities)
 - Indicates whether the company has enough short-term assets to cover its short-term
debts
- A ratio above 1 indicates that working capital is positive and a ratio below 1 indicates
that working capital is negative
- Generally, the higher the ratio, the greater the financial stability and the lower the
risk for both creditors and owners  however, the ratio should not be too high,
because that may indicate that the company is not reinvesting in long-term assets
to maintain future productivity.
- A rough rule says that the current ratio should be around 2 (twice as much in current
assets as current liabilities)
- The ratio is most useful for companies that have cash flows that are relatively
smooth during the year, and hardest to interpret for those that have unusual assets
or liabilities or depend on future cash flows to pay current debts

WANT HIGH (not too high, otherwise inefficient)

Quick ratio:
(Cash + accounts receivable + short term investments)/(current liabilities)

- Also known as the acid test

- This is a more demanding version of the current ratio, and indicates whether current
liabilities could be paid without having to sell the inventory (same as current ratio
except remove inventory from numerator)
- The ratio is useful for companies that cannot convert inventory into cash quickly if
necessary

WANT HIGH.

Interest coverage ratio:

(Earnings before interest and tax)/(net interest expense)

- EBIT = earnings before interest and tax

- Indicates the degree to which(interest on debts are covered by the company’s ability
to generate profit or cash flow
- A low coverage ratio (< 3) indicates that the company is not operating at a
sufficiently profitable level to cover the interest obligation comfortably, and may be
a warning of solvency problems

Financial structure ratios

Debt-to-equity ratio:
(Total liabilities)/(total shareholder’s equity)

- This ratio measures the proportion of borrowing to owner’s investment (including

retained profits)  it indicates the company’s policy regarding financing of its
assets
- A ratio greater than 1 indicates that the assets are financed mostly with debt, while a
ratio less than 1 indicates that the assets are financed mostly with equity
 - A high ratio is warning about risk  the company is heavily in debt relative to its
equity and may be vulnerable to interest rate increases or a general tightening of
credit

TOO HIGH = RISKY.

Debt-to-assets ratio:
(Total liabilities)/(total assets)

- It indicates the proportion of assets financed by liabilities

- An increase in the ratio indicates a greater reliance on liabilities to finance assets

HIGH = MORE RISK.

Leverage ratio:
(Total assets)/(shareholder’s equity)

- This ratio considers how much of assets are financed by equity

- The higher the ratio, the smaller the proportion of total assets funded by
shareholder’s equity, and, therefore, the more that is funded by debt

Limitations of ratio analysis

Ratios need to be considered in the context of:
- Industry averages
- Past records
- Business strategy
- General market conditions
- ‘Abnormal’ situations

Ratios are based on accounting numbers in financial statements, however:

- Different companies use different measurements
- Not all information is recognized on the balance sheet and income statement
- Accounting numbers may be incorrect

Another limitation arises in ensuring financial reporting quality (as part of Corporate
Governance).
 Accounting and Financial Management

WEEK ELEVEN:
11. INTRODUCTION TO MANAGEMENT ACCOUNTING
ACCT1501 z5160731
What is management accounting?
Management accounting is concerned with the provision of information to all levels of
management  assisting management to carry out its functions of planning, directing,
motivating and controlling where and how resources can best be utilized by the
organization to increase stakeholder value.

How does management accounting differ from financial accounting?

The primary distinction is the targeted user. The management accounting system produces
information for internal users, whereas the financial accounting system produces it for
external users.

Management accounting systems and organizational strategies

For management to successfully add value to all of its stakeholders, it needs to have a well-
defined strategy in place showing how they plan to achieve this. Many organizations outline
their strategies in a set of formal documents, including a mission statement that defines
the organization and the purpose for existing.
Two basic strategic models:
1. Cost leadership  when an organization competes in the market based on having a
lower product/service cost than competitors (often underpinned by high economics
of scale)
2. Product differentiation  relies on the organization’s product or service exhibiting
characteristics that make it desirable to consumers other than its low price
(highlighting uniqueness e.g. brand image)

The primary consideration in determining the strategic approach to be utilized is the

business’s competitive advantage (advantage over its competitors).

Management accounting, strategy and costing

One important function of an organization’s management accounting system is to
determine the cost of an organization’s products or services. To succeed in simultaneously
adding value to both its customers and shareholders, the organization must price its product
as inexpensively as possible. Given that the cost leadership approach is usually associated
with products of a relatively homogenous nature, management knows that even a slight
price advantage over its competitors will maximize its market share. As a result,
organizations will adopt a target costing approach.

In applying this approach, management uses competitive market data to determine what
the optimum price of a product should be. They then subtract a desired profit margin from
that price, which then provides them with a ‘target’ cost for the product. The success of a
cost leadership strategy is based on consistently achieving that targeted cost.

Costing and organizational frameworks

A common element shared by all effective management accounting systems is the collection
and reporting of product or service cost data. To understand and effectively use product or
service cost data, managers need to contextualize it within the type of organization they are
operating. Organizations can be classified into 3 categories:
1. Manufacturing
2. Merchandising
3. Service

Manufacturing
Produce goods by converting raw materials into a physical product through the use of labor,
materials and capital inputs e.g. land, factories and machinery. To support the production
process, it must hold three different types of inventory  raw materials, work in progress
and finished goods inventories.

Merchandising
Buy goods already made (by manufacturers) and then sell them on to consumers or to other
merchandising organizations. Merchandising organizations selling directly to consumers are
sometimes referred to as retailers. Merchandising organizations selling to other
merchandising organizations are widely referred to as wholesalers. Do not have supplies of
raw materials or work in progress, only supplies or merchandising inventory ready for
sale.

Service
Differ from both manufacturing and merchandising organizations in 2 ways:
1. Deal with intangible products rather than tangible ones (no inventory)
2. Many service organizations are not profit-making

Nevertheless, they incur administrative and selling/marketing costs.

Basic cost concepts

Costs are incurred to produce future benefits. These future benefits will add value to an
organization’s stakeholders. In a profit-making organization, future benefits usually mean
revenues. As costs are used up in the production of revenues, they are said to expire.
Expired costs are called expenses.

Opportunity cost  the opportunity cost of a given action is the value of the next best
alternative to that particular action.

Differential cost  the cost associated with the different ways an organization may achieve
the same outcome. A differential cost is the amount by which a cost differs between the two
or more alternatives.

For example, deciding whether to drive or fly to Noosa over the mid-session break. Upon
investigation, you find that the cost of a return-trip plane ticket is $350. The cost of driving,
including petrol, is $200.

Flying option $350

Driving option $200
Differential cost $150

Sunk cost  a cost that once paid, cannot be retrieved.

For example, depreciation is a sunk cost as it represents the assignment of a portion of a

past cash outlay to a particular time period.

Controllable cost  are those costs heavily influenced by a manager – in effect, costs a
manager is authorized to incur. For example, a maintenance manager has the ability to
authorize the use of supplies in repair work. The cost of these supplies is, therefore, a
controllable cost for the maintenance manager.

Non-controllable cost  a cost over which the manager has no significant influence.
Although the maintenance manager may not have control over the rent, someone does. The
factory manager may be the person who has the control.
Cost object  is any item or activity, such as products, departments, projects, to which
costs are assigned. Cost objects may be a product, a department, a process or a customer. In
most of the examples used in this chapter, the cost object will be the product.

Direct costs  cost that can be traced to a cost object, in a convenient and cost-effective
way.

Indirect costs  costs that are common to several cost objects and are not directly
traceable to any one particular cost object.

Assume, for example, that the cost object is an assembly department. The salary of the
supervisor of this department is directly traceable to the department and, therefore, is a
direct cost of the department. The salary of the gatekeeper, however, is common to all
departments in the plant. It is an indirect cost of the assembly department.

Functional classification of costs

In a manufacturing organization, costs are subdivided into 2 categories:
1. Manufacturing  costs associated with the production function in the plant or
factory
2. Non-manufacturing  costs associated with the functions of selling and
administration.

Manufacturing costs can further be divided into direct and indirect manufacturing costs.

Direct manufacturing costs

Those manufacturing costs that are directly traceable to the product being converted from
raw materials into a finished good. In a single- product organization, all manufacturing costs
are traceable to the product. In a traditional, multiple-product organization, there are two
types of direct manufacturing costs  the cost of raw materials (direct materials) and the
cost of the direct labor needed to convert the raw materials into a finished product

Indirect manufacturing costs

Indirect manufacturing costs cannot be traced to any one product; the costs are common to
all products. Indirect costs are lumped into one category called manufacturing overhead.
Manufacturing overhead is also known as factory burden or indirect product costs e.g.
depreciation on plant and equipment, maintenance, supplies (indirect materials) and
supervision.

Non-manufacturing costs
There are 2 categories of non-manufacturing costs  selling costs and administrative costs.
Selling costs are those costs necessary to market and distribute a product or service e.g.
advertising, warehousing and salaries. Administrative costs are those concerned with the
general administration of the organization to achieve the overall mission of the organization
e.g. legal fees, internal audit and general accounting.

Period costs  costs that are expensed in the period in which they are incurred e.g.
electricity, depreciation.
Product costs  manufacturing costs that are first inventoried and later expensed as the
goods are sold (related to inventory). The unit product cost is simply the cost of producing
one unit of a product. For external financial reporting, product costs are defined as direct
the direct materials + direct labor + overhead cost assigned to a single unit of production.

Prime costs  combination of direct materials and direct labor.

Conversion costs  combined labor and overhead costs that are incurred in the
transformation of direct material into a finished product (DL + OH)

Financial statements and the functional classification

The functional classification is the cost classification required for external reporting. Profit
computed by following a functional classification is frequently referred to as an absorption-
costing profit or full-costing profit because all manufacturing costs are fully assigned to the
product  under the absorption-costing approach, expenses are segregated according to
function and then deducted from revenues to arrive at profit before taxes.

To compute the cost of goods sold, it is first necessary to determine the cost of goods
manufactured.

Cost of goods manufactured

The cost of goods manufactured represents the total cost of goods completed during the
current period. The only costs assigned to goods completed are the manufacturing costs of
direct materials, direct labor, and overhead.
Cost flows in a manufacturing organization
Costs are accounted for from the point they are incurred to their recognition as expenses on
the income statement  this process is referred to as cost flows.

For a manufacturing organization, the selling and administrative costs are expensed
immediately. However, the flow of product costs is more involved. In order to produce, the
organization must purchase raw materials, acquire services of direct laborers, and incur
overhead costs. As raw materials are purchased, the costs are initially assigned to an
inventory account (i.e. raw materials inventory). When materials are placed in production,
costs flow from the raw materials inventory account to the work in progress inventory
account.

The cost of direct labor is assigned to the work in progress account as it is incurred.
Overhead costs are accumulated in a separate account and assigned periodically to the work
in progress account. When the goods being worked on are completed, the costs associated
with these goods are transferred from the work in progress account to the finished goods
inventory account. Finally, when the goods are sold, the cost of the finished goods is
transferred from finished goods inventory to the cost of goods sold expense account.
Comparison to merchandising organizations:
For a merchandising organization, the two major functional cost classifications still exist but
correspond to product costs and non-product costs. The concept of cost of goods sold also
differs. In a merchandising organization, cost of goods sold represents the acquisition cost of
the goods, rather than the manufacturing cost. This acquisition cost is simply the amount
paid for the goods being sold.

A merchandising organization will show only a merchandise inventory account in the asset
section, whereas a manufacturing organization will show three inventory accounts: raw
materials, work in progress, and finished goods.
Comparison to service organizations:
For a service organization, the functional classifications correspond to service and non-
service categories. The cost of services sold is computed differently from the cost of goods
sold in a manufacturing organization. For example, for a dentist, the cost of services would
include raw materials (e.g. amalgam for fillings), overhead (e.g. depreciation on dental
equipment, electricity, and rent), and direct labor (e.g. salary of a dental assistant). But
unlike a manufacturing organization, the service organization has no finished goods
inventories  thus, product costs for a service organization expire in the period incurred.

Tutorial:
Management accounting  has an internal focus by producing information of budgeting
and strategies to management.

NB: Cycle to determine COGS:

1. Direct materials USED = opening balance of raw materials + purchases – closing
balance of raw materials
2. Direct materials used + direct labor + manufacturing overhead = manufacturing cost
(product cost)
3. Manufacturing cost + Opening work in progress – ending work in progress = cost of
goods manufactured
 4. Cost of goods manufactured + opening finished goods – ending finished goods = cost
of goods sold

Direct labor and direct materials used = prime costs.

Cost of goods manufactured + opening finished goods = goods available for sale.

Accounting and Financial Management

WEEK TWELVE:
12. COST VOLUME PROFIT ANALYSIS
ACCT1501 z5160731
Understanding Cost Behavior
Classification by cost behavior
Cost behavior deals with how costs change with respect to changes in activity levels. It is
important to know cost behavior as it is essential for planning, control and decision making.

The costs associated with an activity are those that are caused by the activity. In choosing a
measure of activity-level changes, a measure must be chosen that is a causal factor for the
activity’s costs. A factor that causes activity costs is called a cost driver.

For example:
- Work on the production line (activity)
- Direct labor costs (costs caused by the activity)
- Cost driver (direct labor hours)

There are 4 major categories of behavioral costs to support decision making:

1. Fixed (used for CVP)
2. Variable (used for CVP)
3. Semi-fixed (step-variable)
4. Mixed (semi variable)
Assume that the cost driver is defined as the number of units produced (for a service
organisation this may be the number of hours of service provided). Because of the difficulty
in estimating the cost function, accountants usually approximate the underlying cost
behavior by assuming that total costs change at a constant rate.

Fixed costs:
Fixed costs  costs that, in total, remain constant within the relevant range as the level of
the cost driver varies.

- The relevant range is the range over which the assumed fixed cost relationship is
valid for the normal operations of an organization.
- Fixed costs per unit vary inversely with activity unit cost changes as the level of cost
driver changes e.g. Insurance per month

Example:
Fixed costs = $1,000
If production = 10 units, fixed costs per unit = $100
If production = 100 units, fixed costs per unit = $10, BUT TOTAL FIXED COSTS = $1,000.

Fixed cost function  y = a, where y represents the total cost level and a is a constant.

Variable costs:
Variable costs  in total, vary proportionally with changes in activity level (remain the same
on a per unit basis) e.g. $5 per hour wage rate (increases as activity level increases)

Example:
Variable costs = $10 per unit
If units = 10, total fixed costs = $100
If units = 100, total fixed costs = $1,000
Variable cost function  y = bx where y represents total cost level, b is the unit variable
cost and x is output volume

Fixed and variable costs assumptions:

- Cost behavior is defined with respect to a single, specific cost object/driver
- It is linear
- Specified time span
- Changes in output volume are moderate

Semi-fixed cost:
Semi fixed cost  fixed over a moderate range of activity and then either rise or fall to new
levels beyond that range.

Semi fixed cost function  y=a1 (0<x<x1), y=a2 (x1<x<x2) where y represents the total
cost level and a1 and a2 are constants.

Mixed (semi- variable) cost:

Mixed costs  although they are directly proportional to activity, they have a fixed
component e.g. electricity bill (service fee + usage)

Cost function  y = a + bx where y represents total cost level, a is the fixed cost
component, b is the unit variable cost and x is output volume.

Cost Volume Profit Analysis

CVP analysis examines the effect of changes in costs and volumes on a firm’s profits. Factors
considered:
 - Volume or activity level
- Unit selling price
- Variable cost per unit
- Total mixed cost
- Sales mix

CVP assumptions:
- Behavior of costs and revenues is linear over the relevant range
- All units produced are sold
- Costs can be classified as either fixed or variable
- Only changes in activity affect costs
- Selling prices and costs are assumed to be known with certainty Sales mix remains
constant in multi-product firms

Contribution margin:
Contribution margin per unit  unit selling price (revenue) – unit variable cost  (S – V)
Contribution margin ratio  (CM per unit)/(unit selling price)

Break-even Analysis
Determination of level of activity at which total revenues equal total costs (fixed + variable)
 known as the break-even point (BEP). Can be calculated via a graphical method or an
equation method (units-sold approach or sales revenue approach).

Graphical method:
Equation method – units sold approach:

ProfitBT = target profit. Unit contribution margin = unit sales variable – unit variable cost .

Sales Mix
For multi-product firms, impact of product mix is taken into account by determining the
appropriate weighted average contribution margin (WACM).

Target Profit
Effect of taxation:
- You may want to determine volume necessary to achieve a certain level of profit
after tax
- The after-tax profit target must be first converted to a before-tax profit target

Let τ be the tax rate:

ProfitAT: = ProfitBT – ProfitBT.τ
ProfitBT(1 – τ)= ProfitAT/(1 – τ)

Equation method – sales revenue approach:

This method is useful when individual units are not easily identifiable and when a company
has a very large number of different products.

To obtain break-even point in sales dollar  Sales dollars = (F + ProfitBT)/CM Ratio

F = Total fixed cost
ProfitBT = Profit before tax
CM Ratio = Contribution margin ratio (CM per unit x units/Unit selling price x units)

NB: However, for sales revenue approach, to get the CM Ratio, we divide total contribution
margin with total sales revenue.

Recall  At break even, ProfitBT (i.e., Profit before tax) = 0.