ACCT1501 Notes

Chapter 1 Introduction to Financial

Accounting

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x
x

The basic purpose of financial accounting is to produce useful info which

is used in many and varied ways.
People use the info generated by financial accounting to improve
their decision-making in allocating scarce resources.

1.2 Financial Accounting

x

x
x
x

x
x
x
x

Accounting is a process of identifying, measuring and

communicating economic information to allow informed
decisions by the users of that information.
Financial Accounting periodic financial statements to external decision
makers (investors, creditors)
Financial accounting measures performance and position
Management accounting information for planning and performance
reports (internal decision makers)
Financial performance generating new resources from day-to-day
operations over a period of time
Financial position the enterprises set of financial resources and
obligations at a point in time
Financial Statements reports describing financial performance and
position
Notes part of the statements, adding explanations to numbers

1.3 The Social Setting of Financial Accounting

Financial accounting:
o Helps stock market investors buy/sell/hold
o Helps banks and lenders lend?
o Helps mangers run enterprises (in addition to help from management
acct)
o Provides basic financial records for day-to-day mgmt, control,
insurance and fraud prevention
o Used by govt in monitoring actions of enterprises and in taxes,
e.g. GST x Accounting is not a passive force within the social setting it
tells us what is
going on, and in doing so, affects decision making
x

1.4 The People Involved in Financial Accounting

Main Participants: Information users, information preparers, auditors

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Users
x
x
x

User is someone who makes decisions on his own behalf, or on behalf

of an org
Users main demand is for the credible periodic reporting of an
enterprises financial position and performance
Main groups of users: Owners, Potential Owners, Creditors and potential
creditors, Managers, Employees, Regulators/govt, Financial and market
analysts, Competitors, Accounting researchers, customers, miscellaneous
third parties

Preparers (Decision Facilitators)

x

Main

groups:

Managers,

Bookkeepers

and

clerks,

Accountants Auditors (Credibility Enhancers)

x
x
x
x
x

Auditors report on the credibility of the enterprises financial

statements, on behalf of owners and others.
Assists users by verifying financial statements have been prepared fairly
Internal and external auditors
Role is to scrutinise the preparation process
External auditors are appointed by the owners not allowed to be
owner or manager, ensuring that auditor is independent from
companys objectivity
Accounting firms offer external auditing, advice on income tax,
accounting, comp systems and many other financial and business
topics

1.5 Accrual Accounting

x

x
x

Accrual accounting system, impact of transactions is recognised in

the time period the transactions and expenses occur, rather than
when the cash is received or paid
Revenue sales of goods or services
Expenses the costs of services or resources in the process of
generating revenues

Accrual Accounting versus Cash Accounting

x
x

Cash accounting records revenues and expenses when the cash is

received or paid.
Problem: timing of cash flow is in a different accounting period to the
substance of transaction affected by interest rates, exchange rates,
depreciation

Using Accrual Accounting to prepare financial statements

x
x

Include all the cash receipts and payments that have already
happened; for example, cash sale, cash payment for wages
Incorporate future cash receipts and payments that should be expected,
based on existing transactions

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x
x
x

Measure the value of incomplete transactions (amount of remaining

loans can be recorded as an expense)
Estimate figures when exact amounts are unknown (interest on loans)
Make an economically meaningful overall assessment of awkward
problems

1.6 The Key Financial Statements

x
x
x
x

Balance Sheet shows an organizations resources and claims on

resources at a particular point in time.
Income Statement measures financial performance over a defined
period
Cash Flow Statement shows the sources and uses of cash during the
period
Retained Profits Note

Balance Sheet
x
x
x

x
x
x
x
x

Assets future economic benefits as a result of past transactions or

other past events needs to be measured in monetary terms
Assets cash, accounts receivable, inventory, property
Liabilities future sacrifices of economic benefits that an
organization is presently obliged to make to other organizations as
a result of past events
Liabilities goods on credit, bank loans, mortgages, long service leave,
warranty
Liabilities accounts payable, wages payable, provision for
employee entitlements, long term loans
Shareholders Equity excess of assets over liabilities share capital
and retained profits
Shared capital amount that owners have directly invested into the
company
Retained profits total cumulative amounts of profits that the
company has retained in the business rather than distributed as
dividends
Assets = Liabilities + Owners Equity

Income Statement
x
x
x
x

Provides info on an organizations profitability for a period of time

Previously called the profit and loss statement
Gross profit = Sales revenue cost of goods
Income statement Sales revenue, Costs of goods sold, Gross profit,
Operating expense, profit before tax, profit after tax

Statement of cash flows

x
x
x

Shows the changes of cash during the period in one balance sheet
accounting
Shows receipts and payments of cash
Revenues reported usually do not equal cash collected and expenses
do not equal cash paid, net profit is different from the change in cash
for the period
Individual transactions split into:

operating activities (G&S),

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o investing activities (NCA/capital),

o financing activities (equity and certain borrowings)

1.7 Relationships between the financial statements

x The cash flow statement explains the change in cash in the balance
sheet.
x Net profit appears in income statement, also reflected in retained profits
note.

1.8 Information use scenarios

x
x
x
x

Evaluation of CEOs performance by member of board of directors

Preparation of buy/sell/hold shares recommendations by financial analyst
Review of companys borrow status by bank lending officer
Development of supply contract with the company by a stationery
suppliers sales manager.

Demands on the quality of financial accounting information

x
x
x

Relevance useful, valuable, and timely manner

Reliability objective, undue error, not deliberately misleading
Materiality assessing whether omissions, misstatement of disclosure
of info can affect decisions. Judged by size of error compared to net
profit, total assets. Time.
GAAP (general accepted accounting principles) to assure accepted
methods are followed, auditors opinion is that the statement have been
prepared in accordance with the GAAP, and that the resulting figures are
appropriate to its circumstances.
Prudence controversial criterion that A, R, P should not be overstated
and L, E, Losses, should not be understated if there is uncertainty.
Cautiousness
Disclosure make clear to reader which acct methods was followed,
provide supplementary info on debts, share capital, commitments and
other necessities in understanding statements
Understandability reports should be prepared to regard to
interests of users, and making sure they have the ability to
comprehend and contempt. Accounting practices
Comparability financial statements should be prepared in a comparable
way so companies can determine their performance, as absolute sense is
ambiguous

Consistency Keeping same accounting methods Following GAAP,

changes in method will be recorded, or record significant events that
might have affected the trend.

ACCT1501 Notes
AASB (Australian Accounting Standards Board) Framework
x
x
x

Understandability
Relevance
- Materiality
Reliability
- Faithful representation (represents what really existed/happened)
- Substance over form (substance and economic reality)
- Neutrality (objectivity, freedom from bias)
- Prudence (caution in estimates)
- Completeness (material info not omitted, not misleading)
Comparability

Tradeoffs among accounting principles

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x
x

x
x

Prudence is a bias, interfering with neutrality and reliability

New AASB to conform with GAAP will mean lack of
comparability with other companies that didnt previously use
this standard
For the sake of comparability, if other companies change acct
methods, a comp has to decide whether to change or not
reliability or costs, time, relevance

1.9 Financial Statement Assumptions

x
x
x
x
x
x

Accrual basis accrual accounting

Going concern organisation will continue operations as a going concern in
the foreseeable future
Accounting equity separate and distinguishable from owners personal
equity
Accounting period discrete equal periods annual or half yearly or
quarterly
Monetary Measured in common denominator AUD
Historical Cost

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Chapter 2 Measuring and Evaluating Financial

Position and
Performance

2.1 Introduction to the Balance Sheet

x
x
x
x

Contains 2 lists that have the same dollar total

Describe enterprises financial position at a particular date
List 1: resources/assets
List 2: Liabilities (existing obligations to be paid in future),
Shareholders equity (amounts received from owners, involve
permanent financing but do not have to be repaid, and any past
accrual profits)
Assets = Liabilities + Owners Equity

Must have Company Name and Balance Sheet as at DATE

x 2 styles side by side:

Assets:
Useful Financial
Resources

Liabilities:
Obligations to be
paid
Equity:
Owners Investment

vertical:
Assets:
Useful Financial Resources
Liabilities:
Obligations to be paid
Equity:
Owners Investment

2.2 Explanations of the three Balance Sheet Categories: Assets,

Liabilities and Equity

Assets

x
x
x

Assets are resources controlled by the entity as a result of past

events and from which future economic benefits are expected to
flow to the entity.
Three essential characteristics future economic benefits, control
by the entity, occurrence of past transactions of past events
Future economic benefits as assets are used to provide G&S
for exchange, aiming to generate net cash flows
Control by entity relates to whether an entity can benefit from
asset, and to deny or regulate access of others public good

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Earning profit means more assets (e.g. cash) or fewer liabilities, so

profit is a source of assets

2.3 Some preliminary analysis of the sound and light balance sheet
x

x
x

Soundly financed?
- Assets come from liabilities look at where assets come from
- Debt to equity ratio L/E
Pay bills on time?
- Able to turn current assets to cash
- Look at current liabilities and cash
- Current assets current liabilities = ___ in working capital
- Working capital / current ratio CA/CL
Companys ability to sell inventory to pay for bills
- Quick ratio/ Acid test ratio Cash + AR / CL
- If less than 1, then that means company has to sell inventory to get
pay L
All ratios are only indicators
Should owners declare for dividend?
- By taking out dividend, decreasing retained profits, they decrease
cash.
- This can create cash strain
- Most retained earnings are reinvested in land, equipment, inventories,
so less cash
Equipment / Depreciation:
- In calculating profit, accumulated depreciation counts as an expense
- Net book value of equipment = cost of equipment
accumulated depreciation
- Accumulated depreciation is a negative asset

2.4 A closer look at the balance sheet

x

x
x
x
x

Comparative balance sheets:

- Contains figures for 2 periods, to help users recognise changes.
- Recent on the left, closer to words
Remember to look for notes when studying financial statements
Buildings (net) means the accumulated depreciation has been deducted
Prepayments are prepaid expenses that have been paid for, for
which the benefits have not been received.
Intangible assets noncurrent assets that have no physical
substance copyrights, patents, trademarks, brand names and
good will.

x
x

Accrued expenses relate to expenses that have been incurred during the
year, but not yet paid wages, electricity bills
Employee entitlements can be current or non-current

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Where do the figures come from?

x
x
x

Accounting is generally a historical measurement system

Assets are generally valued at what they cost when they were acquired
Liabilities are generally valued at what was promised when the obligation
arose

Other terms/notes
x
x
x
x

Usually, accrued expenses and accounts payable is joint into payables

account, but will be separated in the notes
Sometimes use different terms payables liabilities (no interest) and
interest-bearing liabilities (such as loans, which incur interest)
Current tax liabilities estimate of the amount of income tax to be paid
in next financial year
Deferred tax liabilities
- current profit > profit reported on tax return, liability for income tax
is implied for later
- current profit < profit reported on tax return, deferred tax asset
govt has to pay tax paid back
Derivative financial instruments used to reduce exposure to foreign
exchange and interest rate risks

2.5 Maintaining the accounting equation

x Assets = Liabilities + Owners Equity
x Double entry system where accounting equation is always in balance

2.6 Managers and the Balance Sheet

x
x
x
x
x

Balance sheets are important, because outsiders read it.

Balance sheet reports what the organisations position is at a point in
time.
Shows assets that management has chosen to acquire
Provides useful picture of the state of organisation
Balance sheet does not state how management has performed in using
assets to earn profit

2.7 The Income Statement

x

Might measure companys fin performance by closing it down, selling it,

paying off liabilities and see whether money left was more than money
owners put in

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x
x
x

But this is too drastic just to find out performances.

Income statement uses accrual accounting to measure financial
performance over a period of time, usually a year, 6 months, 3 months.
Net profit for the period = Revenues Expenses

Revenues
x
x

x
x

Increase in companys wealth arising from the provision of G/S

Wealth increases due to increase in cash, promise for cash or pay
with other forms of wealth, such as providing other assets, or
forgiving debts
Interests and dividends
Test for revenue whether the good or services have been rendered
(provided)

Expenses
x
x
x
x

x
x
x

Expenses are the opposite of revenues

Decreases in companys wealth incurred in order to earn revenue
Wealth decreases due to costs of G/S, giving assets to customers, and
wear and tear of long term assets
2 cases when goods are sold enterprise is better off because of
revenue gained and enterprise is worse off because of cost of
goods and services customer takes away
Start with asset account of inventory of unsold goods, transferred to
expense account of cost of goods sold
Whether the firm makes profit depends on whether R > E.
Separate account of Expenses with Revenue

Profit
x
x
x

Net profit = net inflow of wealth to the company during the period
If net profit is negative = net outflow of wealth = loss
Expenses include costs of earning revenue taxes (not including
dividends), depreciation...

The relationship of profit for the period to retained profits

x

Retained profits is the sum of past net profits since the firm
began, minus dividends declared (even if not yet paid)

x
x

Through retained profits, balance sheet can be said to reflect

everything that happened from the beginning a historical information
system
Transactions with owners are taken out of RP, not an expense
Owners can be creditors too, if they are owed dividends, or if they
lent the company money in addition to shares they bought

ACCT1501 Notes
2.8 Connecting Balance Sheets and Income Statements
x CA + NCA
2.9 A close look at the income statement
x
x

Income statement covers period in time not point in time

Subsidiary is considered a controlled entity when
parent company has the capacity to dominate
decision-making
Consolidation basically involves totalling revenues and
expenses of parent entity and all the subsidiaries after
eliminating any transactions between these entities
When calculating retained profits, use profit AFTER tax.

2.10 Capital Markets, Managers and Performance Evaluation

x
x

x
x

x
x

Importance placed on bottom line profit figure and components

The Australian or the Australian Financial Review show
announcements of companys annual or half yearly
profits.
Emphasis on profit never any data on non-financial
performance, LT issues, or managerial efforts
Announcement show sales, profits before and after tax (net),
earnings per share (EPS), interim and financial dividends per
share data (ff, p), present share price
Per share data used by investors e.g. own n shares, so earn 0.355n $
Share market prices and profit announcements tend to
end up moving in the same direction, so they are
correlated
Managers should be conversant about how his or her
performance is measured in the income statement

2.11 Capital Markets, Managers and Performance Evaluation

x

Public sector organisations are required to provide balance

sheets that discloses the A,L, E of the govt department

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= CL +
NCL

x
x
x

Also an income statement (before June 2001, was called operating

statement)
Accumulated surplus or deficit = retained profits for private companies
Reserves

Income Statement
x
x
x
x

Emphasis on cost of services

Operating revenue is separate and deducted from operating expenses
After net cost of services are included, other revenues are included
Liabilities such as super is included in employee
entitlements in addition to salaries

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When govt takes over liability, providing an appropriation, therefore

recorded as revenue

The income statement enables users to identify:

- cost of services provided by the department during the year
- extent to which costs were covered by revenue
- source of revenue
- changes in resources controlled during the period as a result of
operations

Chapter 2 Appendix Background: Sole Traders,

Partnerships, Companies and Financing

A2.1 Four Kinds of Business Organisation

x

Two general kinds of equity:

- Directly contributed equity owners provide money or other
assets to enterprise
- Indirectly contributed equity owners allowed profits to remain, to
help earn more profits in the future...
Types of owners depends on what type of business organisation

Sole Trader
x
x
x

One owner (the proprietor)

Unincorporated does not legally exist separately from owner
Cannot distinguish between the owners direct contributions to the
business and the indirect contributions by retained profits both lumped
together as owners capital

Balance sheet:
Owners equity
Owners capital

$XXXX

Partnership
x
x
x

More than one owners

Unincorporated
Not separate legal entities, and all partners are all personally
responsible for debts of partnership

Since owners personal assets can be claimed by business creditors,

there is somewhat arbitrary distinction between business and
personal affairs
Similar to sole trader, lumped together as owners capital

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x
x

As with sole traders, partnerships are not legal entities, but are
considered separate entity from partners
Balance sheet:
Owners equity
Partners capital:
Partner A
$XXXX
Partner B
$XXXX
Partner C
$XXXX
Total Capital
$XXXX

Company
x
x
x
x
x
x
x
x

x
x
x

Legal entities under corporations law

Capital is divided into shares owners = shareholders
Separate legal entities can buy, sell, own assets, enter contracts and
sue and be sued
Limited liability in the event of failure shareholders are not liable for
debts once shares have been paid for in full
Ease of transfer of ownership and increased borrowing powers
Shares can be sold freely, and transfer of ownership does not affect
continuity of operations
Companies may issue debentures or unsecured notes.
Debenture document that evidences an undertaking by comp to
repay particular amount at or before an agreed date, and to pay
interest at an agreed rate a specific intervals
Debt may be secured over floating charge or all assets, or specific
charge over certain assets
Public company can invite public to subscribe to their share
capital by prospectus (listed ones are on ASX)
Private companies (Pty Ltd) cannot invite public and has a limit on
number of shareholders (50) and other restrictions and transferability
of shares.

Company: Forms of Share Capital

x
x
x
x
x
x

When shares are first issued, money received comes in as shared capital
Second time sold, money is not received by company but shareholder
Therefore, the millions of transactions on ASX that occur do
not affect companys financial statement
Several classes of shares:
Ordinary shares owners votes basically residual owners, deciding
who will be on the board of directors and managers
Preference shares or otherwise special shares owners usually do not
vote, but in return they have rights, such as receiving fixed dividend, or
preference in asset distribution if company liquidates

Class A, Class B and other categorisations vague terms, because

complexity of rights often prevents simple categorisation such as
ordinary or preference

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x
x

Face of balance sheet or notes will list all kinds of shares, and specify
rights
Cash received is property of company owners have no right to get
money back, except in specific circumstances

Company: Retained profits

x

Profits can be paid to owners in the form of dividend or retained within

company.
Balance sheet:
Shareholders equity
$
Share capital:
Class A Shares
XXXX
Class B Shares
XXXX
Total issued capita
XXXX
Retained Profits
XXXX
Total Shareholders equity
XXXX

Corporate Group
x
x
x
x

Groups of many companies

E.g. Woolworths, BHP Billiton, Commonwealth Bank
Balance sheet represent what group looks like as a consolidated
economic entity, although there is no such legal entity
Looks like that of single company, with shareholders equity section
representing equity of primary, parent, company in grouo

A2.2 Business Financing

Non - Current Liabilities (debts due more than a year in the future)
x
x

Mortgages and other debts extending several years

Special loans from owners, LT tax estimates, estimated liabilities to
be paid to employees in the future

Owners equity
x
x

Sole trader and Partnership owners capital

Company shared capital received for each kind of share + retained
profits (+ other items if legal or accounting complexities require them)

ACCT1501 Notes
Chapter 3 The Double Entry System

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3.1 Transaction Analysis + 3.2 Transaction Analysis Extended

A

L
CL +
= NCL
CL +
= NCL
CL +
= NCL

CA + NCA
CA + NCA
CA + NCA
x

Set out:
- Assets Cash, AR, Inventory, Land and Building, Equipment
- Liabilities AP, Notes Payable, Wages Payable, LT Loans
- Equity SC, R, E, Dividend

3.3 Recording Transactions: Double-entry Bookkeeping

x
x

System of debits and credits

Balancing Equation : A = L + SE
CA + NCA

A+E+D

CL + NCL

D, C
x
x

Resources = Assets
Sources = Liabilities / Equity

x
x
x
x
x

Therefore sum of credits must = sum of debits

Transactions measured in terms of countrys currency (AUD)
Recording transactions = entry
Records of transactions = journals / journal entries
Entries are transferred and summarised in accounts, which
lie behind all amounts and descriptions shown on balance
sheet
All accounts collected together = ledger accounts
Accountants makes a list of account balances from ledger to
make sure Dr = Cr. (this list is called the trial balance)
All accounts put together = balance sheet

x
x
x

SC +
+ Op.
L +
C,
D

S
C

x
x

Each double entry record names one (or more) account

that is debited, and one (or more) that is credited
Double entry records = journal entries each journal entry, sum Dr =
sum Cr

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3.4 More about Accounts
x
x

An account is a record of the dollar amounts comprising a

particular A, L, E, R or Exp.
Net effect of these amounts is debit or credit, and is called
the accounts balance

3.5 How Debits and Credits Work

x Negative asset = contra asset has credit balance, e.g.
accumulated depreciation

3.6 Debits and Credits, Revenues and Expenses

x
x
x

Accounting accumulates information about activities

Financial statements are prepared from the accounts that are
produced as the information is accumulated
Double entry recording system creates a set of accounts which is in
balance (Dr
= Cr)
From these accounts are produced:
- The income statement
- A note to the accounts showing a statement of retained profits,
the bottom line (ending retained profits), which transfers to
- The balance sheet, which summarises all accounts

3.7 Arranging accounts on the balance sheet

x
x
x
x

Placement of CA, NCA, CL, NCL, E allows for calculation of

meaningful ratios and other analysis
Thus balance sheet is classified because it is classified
into meaningful categories
Moving items around within Balance sheet is called reclassification
Reclassification done by accountants whenever it is thought
to improve informativeness of financial statement

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Three examples of account classification

x

Current and Non-current portions of noncurrent liabilities

- Liabilities e.g. mortgages, bonds, debentures
- Thus accountants need to reclassify the amount to be paid on
principal within the next year (to Current) and the residual to
non current
- Interest owing but not paid is a separate liability

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Bank overdrafts
- E.g. bank overdraft of $500
- This means bank allowed company to remove $500 more cash
from account than there was in it, in effect, lending comp
$500
Two ways of representing this:
- Other assets of $12400 minus bank overdraft of $500 = L & E of
$11900
- Other assets of $12400 = L&E of $11900 + bank overdraft of $500
Negative amounts left as deductions
- Some negative amounts are left as deductions unlike the bank
overdraft
- E.g. accumulated depreciation left as a negative deduction for asset
Three ways of representing this:
- Shown on RHS of balance sheet (before it was, and in some countries
still is)
- Separate disclosure as a deduction on LHS of balance sheet, but since
many types of assets and depreciation amounts can make sheet
clustered
- Could be deducted from assets cost, so net book value of assets
could be disclosed on balance sheet, but not the accumulated
depreciation
This method is becoming more popular, accompanied by note to fin
statements, listing cost and accumulated depreciation amounts
separately

3.9 Cash versus accrual accounting revisited

x
x
x

Accrual accounting
Cash sale would increase by revenue and cash in that period
Credit sale will AR and R in that
period When the cash is paid,
AR , Cash

Way accrual financial accounting info is assembled:

- Cash
- Credit transactions
- ST/LT adjustments are needed to prepare financial statements,
unless the comps accounting system is sophisticated enough to
have already built them in
- Extensive narrative and supplementary disclosures (e.g. notes to
financial statements)

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3.10 Example: Simones Jewellery Business

x
x
x
x

Difficulties of accrual accounting:

Accrual profit requires extra calculation more complex cause confusion
as it leaves more room for error than the simpler calculation
Accrual profit differ from cash profit, differ from change in amount in bank
Accrual accounting can be a lot more complicated tax, rent, time...

3.11 Public Sector Issues

x

During 1990s, all govt moved from cash based acct system to accrual
based acct system

ACCT1501 Notes
Chapter 4 Record Keeping

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4.1 The Importance of Good Records

x
x
x
x
x
x
x

Complete and accurate records provide observations and history of

enterprise
This is used by investors, managers to plan for future
Records cost money
Records provide:
The basis for extrapolations into the future
Info for evaluating and rewarding performance
Basis of internal control over existence and quality of enterprises assets

4.2 Financial Accountings Transactional Filter

x
x
x
x
x
x
x
x

x
x
x
x

Accounting is an info system to filter and summarise data.

Economically efficient to have 1 system organise data into information on
behalf of the various users
E.g. of summarising and organising daily newspaper
Like newspaper, info system e.g. financial acct is limited.
Only report what sensors pick up as it seeks out data or filters data
Data bank: ledgers, journals (the books) and supporting records
Recording Classifying... = Bookkeeping
Information = accounting or reporting

Accounting reports are limited by the collected data

Transaction recorded
Not transaction routine accounting system ignores event
Two general kinds of transactions cash transactions
transactions

or credit

Non transactions natural disasters/ incidents, future delivery, land value

/

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Financial accounting transaction fundamental eco or legal

characteristics:
- Exchange must involve exchange of G/S, $, legal promises, items
of eco value
- Past exchange must have happened
- External exchange must be between entity and another party
Supplementary characteristics needed for accountings record-keeping:
- Evidence must be some documentation paper/electronic
- Dollars must be measured in the currency relevant in country
where transaction happens (AUD)

Following transaction characteristics define nature and value of fin acct

info:
1. Transactions linked to legal and economic concept of exchange
(bounded by legal contract including $ transactions)
2. Constitute large part of underlying rationale for historical cost
basis of accounting, founded on accounting (history has to
have happened)
3. Characteristics of transaction provide basis on which records can be
verified (audited) later as part of the process of ensuring info is
credible

5 key points exchange, past exchange, external party, evidence, dollars

Adjustments/ adjusting journal entries in data bank when accountant is

not satisfied with set of data and wishes to alter some event which is
important
RHS information deciding on adjustments, deciding on reporting

format, making supplementary notes...

4.3 Accountings Books and Records

Accounting cycle
1.
2.
3.
4.
5.
6.
7.

Source documents
Prepare journal entries
Post to ledgers
Prepare trial balance (collection of ledger accounts Dr = Cr)
Prepare adjusting journal entries
Prepare adjusted trial balance
Prepare closing journal entries close revenue, expenses and dividends
to RP)
8. Prepare post-closing trial balance

9. Prepare financial statements

Source Documents and transactional style
x
x

Source documents show that transactions have occurred

Documents are kept so that the accounting records can be checked and
verified to correct errors; permit auditing; used for disputes; support
income tax claims and other legal action.

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Discounts after ordering: cheque will be less than amount

owed Debit AP, Cr Cash discounts received (other revenue
account)

Journal Entries
x
x
x
x

x
x
x

x
x

Record accounting transactions

When business event is first recorded by acct system
Basic transactional records are often called books of original entry
A journal entry can list as many accounts as are needed to record
transaction, but each journal entry must be recorded, so sum of debits
equals sum of credits
Dr left, Cr right
Omit $
Traditional to write short explanation called narration below each entry as
a memorandum of what the recorded transaction was about (not
compulsory)
Every journal entry must be dated and is usually numbered
Posting reference is given to indicate the ledger account to which each
journal entry is posted. Number obtained from companys chart of
accounts.
Enterprises with many transactions to record do not create separate
entry for each transaction, but instead use special records for each
routine kind of transaction... e.g. sales journal, cash receipt journal, cash
payment journal and purchases journal

Posting to ledgers
x

x
x
x

Ledgers are books or computer records that have a separate page or

account code for each individual account referred in the books of original
entry
Where T accounts come in to illustrate simpler version of ledger
accounts
General ledgers collection of all the A, L, E, R, Exp, summarising
the entire operations of business
Subsidiary ledgers AR, AP balance isnt based on Dr, Cr, but sum
equal amount in primary account in general ledger

Trial Balance

x
x

x
x
x
x
x

Balanced journal entries > general ledger accounts > balanced balance
sheet
There is always a little uncertainty on whether standard bookkeeping
procedure ensures that ledger adds up all Dr and Cr and makes sure they
equal
Therefore calculation is called trial balance
What to do when trial balance doesnt balance?
Re-add trial balance
Check posted journal entries to correct side of ledger accounts
Check that each ledger account is balanced correctly

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x
x
x
x
x

Check that each journal entry balances (Dr = Cr)

Determine difference between Dr and Cr and look for account with
that amount maybe left out ledger balance
Difference / 2 and look for that amount means posted to wrong side of
ledger account
If difference is divisible by 9, maybe transposition error 21 instead
of 12, 72 instead of 27
Sometimes trial balance cannot pick up error

Adjusting Entries
x
x

At end of each acct period, it is necessary to adjust Rev and Exp accounts
Splitting between accounting periods e.g. prepayments for insurance

Closing entries
x
x
x

x
x
x
x
x
x

Needed to facilitate preparation of financial statements

Needed to prepare accounting records to begin next period
Closing entries formally transfer the balances of the revenue and
expense accounts to a profit and loss summary, then to retained
profits
Closing entries also reset the rev and exp account balances to zero to
being records for the next accounting period
P&L summary account to decreases everything to 0
Debit sales account to zero, credit expenses account
Debit profit and loss summary account
Then, to balance P&L account, clear it by debiting P&L
Credit retained profits

Post closing trial balance

x

Put together ledger accounts to see if Dr = Cr

Financial Statements
x
x

P&L summary account > Income statement

Post-closing trial balance > Balance sheet

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4.4 An Example: Northern Star Theatre Company

x
x
x
x
x
x
x
x

Source documents
General Journal
General Ledger
General Ledger trial balance
General
Journal
(with
adjustments) General Ledger
General Ledger trial balance
Closing entries returning everything to 0, dr revenue, cr P&L
Financial statements Retained profits, income statement, balance sheet

4.6 Electronic Commerce

x

x
x
x

Electronic commerce (e-commerce) is a challenge to financial accounting

and internal control, because of the absence of paper trail that has
traditionally supported accounting records.
E.g. moving away from cash and cheque, but using lots of credit cards or
EFTPOS.
Employees are being paid by deposits in personal bank accounts
Implications of e-commerce
- Needs to be compatibility between computing systems for
proper recognition of accounting systems on both sides of
transactions Trust in electronic media to make system work
- Tendency for records and payments to be speedier and separate from
movements of product, means in-transit items can be a challenge to
control and reconcile
- Not only financial statements must be right, but also the underlying
records for business partners enquiries to be answered reliably
Paradox: e-commerce works without paper but demands a good
trail of evidence

4.7 Managers, Bookkeeping and Control (Importance of bookkeeping

to managers)
x

Bookkeeping and its associated record keeping:

- Provide underlying data on which accounting info is built
Decisions and evaluations may be constrained on nature of underlying
data

Provide data and systems used in meeting managements

important responsibilities to safeguard assets and generally keep
the business under control

ACCT1501 Notes
4.8 Public Sector Issues
x
x
x
x
x

The process of accounting also applies to public sector organisations

Accumulated funs = Public sector equity
Recurrent appropriation = govt revenue
User charges = revenue
Grants and subsidies = expense

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ACCT1501 Notes
Chapter 5 Revenue and Expense Recognition in
Accrual
Accounting

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5.1 Conceptual Foundation of Accrual Accounting

x
x

x
x
x
x
x

Revenues are inflows of economic resources from customers earned

through providing goods or services.
Expenses are outflows of economic resources to employees, suppliers,
taxation authorities and others, resulting from business activities, to
generate revenue and serve customers.
Incurring expenses are the cost of earning revenues.
Net profit is the difference between revenues and expenses over time.
Net profit is the measure of success in generating more revenue and it
costs to do so.
Features
Revenue and expenses refer to inflows and outflows of economic
resources. Involve phenomena that arise before or after cash changes
hands, as well as the point of cash flows
Net profit is dependent on how revenues and expenses are measured.

A conceptual system for accrual profit measurement

x
x

Need system that recognises revenue and expense before, at the

same time and after cash flows.
Accrual method includes cash accounting

Summary
x
x
x
x

Revenue before cash collection form asset account (e.g. Accounts

receivable)
Expense before cash payment form liability account (e.g. Accounts
payable)
Unearned revenue liability
Expense after cash payment asset
Before cash

After cash

Rev

Asset

Liability

Exp

Liability

Asset

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5.2 Accrual Accounting Adjustments

x
x

x
x

x
x
x
x

Adjustments involved implementation of routine accruals, such

as those mentioned above
Sophisticated accounting systems go beyond transactional
records and routinely include many adjustments
Simpler systems make adjustments at year end in a special set of journals
Many small companies dont bother until financial statements are needed
Follow double entry format:
- After each adjustments, A=L+E still balances
- Sum of credit = sum of debit
Adjusting journal entries purpose: augment transaction based figures,
add story told by transactional records.
Objective of accrual accounting improve measurement of
financial performance and position
Accrual > cash provides more complete record, more
representative of economic performance
Four main types of routine adjustments:
- Expiration of assets (after prepayments)
- Unearned revenues
- Accrual of unrecorded expenses
- Accrual of unrecorded revenues

Expiration of assets
x
x
x

x
x

Prepayments assets that arise because an expenditure has been

made, but there is still value extending into the future
Usually current assets
Arise whenever payment schedule for an expense does not match
the companys financial period e.g. insurance premiums where
policy date doesnt match financial year
Prepaid expenses do not have market value, but they have economic
value because future resources will not have to be used
E.g. insurance, advertisements

x Prepayment
Cash
Prepayment Expense
Prepayment

DR
CR
DR
CR

OR

Prepayment Expense
Cash

D
R
CR

Prepayment
Prepayment Expense

D
R
CR

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Unearned Revenues
x
x

Unearned Revenue future revenue where the cash has been received
before earning revenue (deposits)
E.g. newspaper or magazine subscription companies, or airline,
phone, membership

x Cash
Unearned Revenue

DR
CR

Unearned Revenue
Sales Revenue

DR
CR

Accrual of unrecorded expenses

x
x

x
x

Involves determining which expenses have been incurred by the

organisation (but not paid in cash) during a particular time period
Involves checking which invoices have been received from suppliers,
incorporating that info into accounting systems (e.g. AP), and making
estimates for expenses for which invoices have not yet been received
Accrued expenses
E.g. wage expense end of pay period and end of financial period
occur on different days

x Wages Expense
Accrued expense

DR
CR

Accrued expense
Cash

DR
CR

Accrual of unrecorded revenues

x
x
x

Accrued revenue
Occurs when a service has been provided but cash will not be received
until the following period
Interest revenue, unbilled revenues, commissions earned

x Accrued Revenue
Revenue
Cash
Accrued Revenue

DR
CR
DR
CR

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Multicolumn Worksheets
x

Useful device to help prepare financial statements

Pre adjusted
Trial Balance

Adjusting
Entries

Adjusted Trial
Balance

Income
statement
numbers

Balance sheet
numbers

5.3 The Financial Period

x
x
x

x
x
x
x
x
x

As businesses run continuously, financial statements are prepared at

specific points or periods in time
2009 net profit is a measure of economic value added by the project
during that year
IF there are 2 cash inflows 2008 and 2009:
- If 08 cash > 08 revenue, then unearned revenue will be set up
- If 08 cash < 08 revenue, then account received set up
Companies have initial choices about when the financial year begin and
end.
Once they made their choice, reasons relating to habit, legal and tax
rules force them to stay with the choice
Australia 30 June is most common
US, Canada, Singapore 31 December
UK, NZ, Japan 31 March
Possible in Australia to use substituted accounting period for taxation
purposes

5.4 Introduction to Accounting for Inventory

x
x
x

Several different methods for controlling inventory

Most popular perpetual inventory control method (compared to periodic)
Under perpetual method, inventory is an asset
- Inventory bought debit inventory account
- Inventory sold debit cost of goods sold, credit inventory
- 2 entries are required for sales (revenue and cost of goods expense)
- Return of sales also require 2 entries

5.5 Contra Accounts

x
x
x

Just about every balance sheet account can be considered a control

account
Amounts in accounts should be supported by detailed lists or subsidiary
ledgers
Sometimes want to change account, and at the same time reluctant to.

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x
x
x
x

Worried that company might not be able to collect all money back from
customers. Want to recognise bad debts. However that means crediting
accounts receivable. But at the same, since we have not given up on
collecting debts, we should not do that.
Property and plan are being used up economically. Want to record
depreciation expense. But do not want to change asset cost account,
because costs are not changing, but rather economic value is being used.
Contra account set up to allow recognition of expense and related
value changes without changing control account
Contra accounts have balances that are in opposite direction to those
of the control account in which they are associated
Contra accounts only have meaning in conjunction with the
control accounts to which they match.
Most common: accumulated depreciation (amortisation), doubtful
debts receivable

Accumulated Depreciation (Amortisation)

x
x
x
x
x
x
x
x
x
x
x

Accumulate depreciation on fixed assets (e.g. buildings and equipments)

DR Depreciation Expense
CR Accumulated Depreciation
Accumulated Depreciation relates to asset account of buildings
Showing both allows users to make rough guess on age of asset
Depreciation expense shows how much depreciated during that period
Accumulated depreciation shows total amount the buildings have
depreciated by
Net book value = cost accumulated depreciation
Contra account is only meaningful in comparison to the cost. When the
asset is gone/sold, neither account is needed anymore.
E.g. Truck bought at 50,000. Depreciates at 8,000 each year. Sold at end
of 2nd year for 37,000
Net book value of truck = 50,000 16,000 = 34,000
Journal Entry for selling truck:
37,00
Cash
0
50,00
Truck asset
0
Accumulated Depreciation
Revenue on sale of truck

34,00
0
3,000

When non-physical assets, e.g. goodwill, patents and trademarks are

amortised, the accumulated amortisation account is used instead of
accumulated depreciation

ACCT1501 Notes
5.6 Accounts Receivable and Contra Accounts
x
x
x

Accounts receivable when revenue is recognised but uncollected

DR accounts receivable, CR sales revenue
Such receivables are often called trade receivables

Valuation of accounts receivable

x

x
x
x
x

Receivables are valued on BS at lower of cost (original

transaction value + interest charges) or net realisable value
(amount expected to be collected)
If collectable amount < expected amount, receivable must be
reduced to an estimated collectable amount.
This is done by subtracting an allowance for doubtful
accounts from the accounts receivable balance
Estimated amount collectable = Trade receivables allowance
for doubtful debts
Therefore allowance adjusts net value down to the lower of cost
and current estimated collectable amount

Other receivables
x
x
x

2 other main types of receivables. If they are large, they are shown
separately.
If they are not large, together, theyre called other debtors
Notes receivable
- Supported by signed contract specifying payment schedule,
interest rate and often other legal details.
- Used for large or long term receivables, e.g. motor cars,
house, appliances and loans by banks and finance comps
Other receivables:
- Loans to employees, officers and shareholders, associated
companies, tax Refunds Company is waiting for and other
receivables not arising from revenue transactions.
- Accounted for and valued same as AR and notes receivable.
- Usually arise from peculiar circumstances, where company disclose
reasons.

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Allowance for doubtful debts

x
x
x

There is always a risk where customers will fail to pay

Therefore portion of debts will be doubtful and portion should be
deducted from revenue in determining profit for the period
To recognise
expense: DR
Bad
Debts
Expense
CR Allowance for doubtful debts

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x
x
x
x

x
x

Reason for not deducting directly to keep balance between

accounts receivable and list of individual accounts.
Company may still try to collect on the accounts
After pursuing non-paying customer for months, company may decide to
write off account.
Then:
DR Allowance for doubtful
debts
CR
Accounts
Receivable
Allowance can be seen as a temporary holding account for amounts
the company believes will not be collected, based on past
experience and an assessment of outstanding accounts.
Another way of writing: Direct write off
method DR Bad Debts Expense
CR Accounts Receivable
Used when company has few accounts receivable or when large account
not included in allowance suddenly goes bad
Purposes of contra accounts are to provide useful information to the
readers of financial statements or to assist in accountings internal
control functions

5.8 Managers and Accrual Accounting Assumptions

x
x

Accrual accountings purpose: to move beyond cash flows towards a

broader economic concept of profit and financial position.
Implications from a managers point of view:
- Fair evaluation of managerial performance
- Limitation accrual accounting, basing on history reflects on the past
rather than looking into the future, as managers are inclined to do
- Only look at the resulted actions, not the reason why mangers
initiated action
- Evidenced based accounting procedures for recognition of profit
and expenses may not relate very well to economic concepts of
earnings, or managers struggles to increase the value of their
companies
- To managers seeking even handed evaluation of their
performance, accounting may seem downwardly biased in its
measures
- Criteria for revenue and expenses recognition is subjective some
managers manipulate, some managers find it too loose and flexible
- The shorter the time period, the more mismatch the figures are
between cash flow and accrual profit

Accrual accounting has many advantages and is very widely

used, but managers should not accept it uncritically

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5.9 Accrual Accounting in the public sector

x
x
x
x
x
x
x
x
x
x

Since 1995, local governments in Australia have been required to produce

financial statements using accrual accounting
Since 1994 NSW govt. 1999 all govt
Key differences with accrual accounting:
Non-cash assets and depreciation
Value of receivables and payables
Liabilities (employee entitlements)
Changing value of financial assets and liabilities (exchange rate)
Cost and revenue of government activities
Cost of consuming assets expense (e.g. depreciation)
Value of goods and services received for free from other bodies (revenue)

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Chapter 5 Appendix Special Journals, Subsidiary

Ledgers and Control Accounts
x
x
x
x
x
x

Business with small set of transactions initially recorded in general

journal, then posted to general ledger
Complex business rather than info captured in 1 journal and posted to 1
ledger, system of special journals, subsidiary ledgers used
Special journals allow easy recording of the most common
transactions undertaken by a business
Subsidiary ledgers present detailed analysis of info that is eventually
transferred to general ledger account
Sales invoice >>> Journal Entries + Subsidiary ledger AR >>> General
Ledger, Trial Balance
General ledger account called debtors or Accounts receivable

A5.1 Prime Entry Records: Special Journals

x Special Journal :
Sales
Purchases
Cash receipts
Cash payments
x
x
x

Transaction Recorded:
Credit sales of inventory
Credit purchases of inventory
All cash inflows (including cash sales)
All cash outflows (including cash purchases)

Each entry represents a transaction that belongs to the same class as

others in the same journal
Transactions not in special journal are recorded in general journal
Advantages of Special Journals:
- Recording efficiency
- Amounts posted from special journals to general ledger as totals,
rather than individual journal entries
- More than one user can update accounting system, because it
consists a number of related subsystems
- Nature of transaction eliminates need for narrations
- Info such as receipt or invoice number may be recorded for narrations
- Additional info can be added for convenience as it is available from
source documents, e.g. discounts

A5.2 Subsidiary Ledgers and Control Accounts

Most common way of accommodating need for detailed records in

the accounting system, without grossly expanding number of
separate general ledger accounts

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x
x
x

x
x
x

Subsidiary ledger a set of ledger accounts that collectively

represents a detailed analysis of one general ledger account
classification
Relevant account in general ledger is called the control account
Accounts in subsidiary ledger can be periodically checked against
total data and balance in control account
Examples of general ledger accounts that have subsidiary ledgers:
- Debtors/Accounts Receivable separate account for each debtor
- Creditors/Accounts payable separate account for each creditor
- Property, plant and equipment Asset Register separate for each
piece
- Raw materials Inventory Separate records of each type of raw
material
- Finished goods inventory Separate record of each type of finished
good
Advantages for subsidiary accounts
Check on accuracy (as subsidiary account and general account
balances should =)
Enable any desired amount of detail to be maintained to explain
composition of selected general ledger account, without overloading
general ledger

A5.3 Trade discount and Cash discount

x

Both Trade discount and cash discounts represents a reduction in the

amount that a customer ultimately pays a vendor for gods and
services supplied
Differ in the way they are recorded

Trade Discount
x
x
x
x
x

Trade discounts are a means of adjusting the actual price

charged to a customer from a standard list price.
Usually determined by category of customer or normal volume of
businesses
Manufacturer may sell at list price to general public, 40% off for retainers
and 55% off to wholesalers
Most enterprises record only net amount of transaction
Effect of trade discount is merely to set an actual price for
transaction

Cash Discount

x
x
x
x

Cash discounts are conditional adjustment after determining the

actual selling price at which the transaction takes place
NOT a change in price of original sales transaction generally
recorded as an additional transaction
Credit terms 2.5/10, n/30 2.5% deducted if money was paid within
first 10 days, the net amount must be paid within the next 30 days
Discounts recorded as Discounts allowed (EXPENSE), or Discounts
Received
(REVENUE)

ACCT1501 Notes
A5.4 Operation of Special Journals and Subsidiary Ledgers
Sales
x
x
x
x
x
x
x
x
x

Purpose of special journals is to eliminate need for such detailed

recording in a general journal and the general ledger
Totals of special journals posted to control account, because CA
only record aggregates
Sales journal updated everyday
Sales journal posted to AR, Sales revenue, COGS, Inventory
Subsidiary ledger may be established for each customer who buys on
credit
Posting reference S1 indicates info comes from page S1 of sales journal
Tick in posting reference indicates that the amount has been
posted to the subsidiary ledger
End of period total of subsidiary ledgers can be checked against
balance of AR control account.
I.e. sum of balance in each debtor should = balance of AR control account

Purchases
x
x
x
x
x
x

Purchases only used for recording the acquisition of goods, on

credit, intended for resale
Source document purchase invoice from supplier, matched
against delivery docket and copy of official purchase order
Even with discounts, the full amount owing is recorded
If discounts are received, then this is recorded in CPJ discount
revenue, when items are paid for
Purchases journal updated every day for each creditor of
each item of inventory
Credit transactions involving acquisition of fixed assets or items to
be charged to expense accounts, such as repairs, maintenance,
printing and stationery, are often recorded in general journal.

Cash Receipts
x
x

Source document: evidence of cash receipt, list of cheques

received or direct deposit recorded on bank account statement
Cash receipts journals are designed to meet specific needs of an
enterprise

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x
x

x
x

Most businesses include payments from debtors, possibly cash sales

Also sundry or miscellaneous column for cash receipts not otherwise
identified by specific column that represents a particular general
ledger account
E.g. proceeds from sale of fixed assets, refunds by creditors,
new capital or mortgage funding
Discount expense column not sundry

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Cash Payments
x

x
x

x
x
x
x
x

Source documents: duplicate of cheque or cheque butt, statement and

invoices from creditors, receipt issued by recipient or payroll analysis
certified as correct by responsible staff member
Bank statement evidence of interest charged on any overdraft,
together with info about other bank charges and fees
Minimise postings and provide analysis of payments, separate columns may
be provided to record entries affecting those ledger accounts frequently
involved
Sundry or miscellaneous column might be needed.
DO NOT POST total of sundry column
Desirable in all books of prime entry (journals) to provide reference to
source document for each entry
Done by recording cheque number
In addition to postings to general ledger made at end of period, each
individual item in the creditors column will be posted as a debit to the
creditors account

A5.5 Role of General Journal and General Ledger

x
x
x
x
x
x
x

General journal used to record a number of important transactions:

Sales and purchase returns
Credit transactions other than those related to inventory, such as the
purchase of equipment
Adjusting entries
Closing entries
Each entry in general journal is individually posted to appropriate
account in general ledger
At the end of a period, all financial information will be posted to general
ledger, either as an individual entry sourced from general journal
(including sundry from special journal), or in aggregate from columns of
various special journals

ACCT1501 Notes

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Chapter 6 Financial Reporting Principles, Accounting

Standards
and Auditing

6.2 Accounting Principles and the use of Accounting Information

x

x
x
x
x
x
x
x
x
x
x
x
x
x

Doing accounting takes expert knowledge, considerable

experience and continuous attention to new problems and
solutions.
Concepts and principles are important, as they form logical
structure that practising accountants use every day to
consider problems to make recommendations
GAAP (Generally Accepted Accounting Principles) applied
differently for different entities
Rules, standards and usual practices that companies are
expected to follow when preparing financial statements
Stock market crash of 1929 brought GAAP
AASB (Aust Accounting Standards Board)
IASB (International Accounting Standards Board)
AASB uses IASB as foundation, but includes more details
applicable to Aust environment
SACS Statement of Accounting concepts
SAVS established for general concepts and principles to be used
in preparing financial statements
SAC 1 Definition of a Reporting Entity
SAC 2 Objective of General Purpose Financial Reporting
SAC 3 Qualitative Characteristics of Financial Information
SAC 4 Definition and Recognition of the Elements of Financial
Statements
Now, SAC 3 and SAC 4 is replaced with Framework for
Preparation and Presentation of Financial Statements

FYI: Difficulties that face accounting and managers by GAAP

Difference in company structures e.g. ABC = not for profit,

publicly owned. Should ABC use same methods as other profit
seeking organisations?
Qantas / UNSW employees are not assets. But for sports team,
such as Sydney Swans millions are paid to have certain players
on the team. Are they assets or expenses? Should they be
amortised?
Comparing movies net profits hard to measure profitability of
certain movies e.g. star wars attracted many viewers when it was
first released. However, due to its popularity, it continues to
generate revenue, through video, dvd, toys, books

ACCT1501 Notes

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6.3 Framework for the Preparation and Presentation of Financial

Statements
x

Framework includes the coverage of:

- objectives of financial reports
- assumptions underlying financial reports
- qualitative characteristics that determine the usefulness of financial
reports assets and liabilities
- definition of the elements from which financial reports are
constructed: assets, liabilities, equity, income and expenses
- recognition and measurement of the elements of financial statements

Framework makes distinction between general purpose financial report

(for most users who rely on this as main source of info) and special
purpose financial report (list for issues of shares outside scope of
Framework).

Users of financial reports

x
x
x
x
x
x
x
x

Investors info on risk and return, including shareholders buy, hold or

sell?
Employees including unions stability and profitability and whether
company can afford employee benefits
Lenders whether interest and loans will be able to be paid off
Suppliers and other trade creditors whether amounts owing can be
paid
Customers continuance of entity, e.g. with warranties
Governments and their agencies allocation of resources & tax
Public substantial contribution to public e.g. employment
Framework regards investors as the majority of users, so satisfy most the
needs of investors

The objective of financial reports

x

x
x
x

Objective: provide information about financial position, financial

performance and cash flows that is useful to users in making economic
decisions
Users need evaluations of cash generation due to its liquidity to buy
inventory, pay wages, distribute shares etc
Users need info on financial position, financial performance and cash
flows to evaluate this
Financial position balance sheet economic resources (NCA), financial
structure (who finances assets), information on liquidity and solvency (L
& ratios)

Financial performance income statement profitability,

employment of resources, potential chances in assets controlled
by the entity
Movement in cash cash flow statement operating, investing and
financing decisions

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Underlying Assumptions
x
x

Accrual basis of accounting

Going Concern
- entity will continue to operate in the foreseeable future
- book value = cost accumulated depreciation
- liquidation value can be a lot less than book value
- this is because when companies close down, they may not be able
to sell off its assets at the book value
Other authors also regard accounting entity, accounting period and
monetary assumptions as key underlying assumptions.

Key Qualitative Attributes

x

Understandability concern on complexity of financial statements

that could not be understood by experts. Pozen committee examined
US financial reporting system and made recommendations on the
usefulness of reports

Relevance Pozen committee suggests that the increased complexity

has led to less relevant info to users evolution of business strategies
and businesses do not want investors to know about their liabilities
- materiality

Reliability Pozen Committee suggests detailed rules in standards

permit structuring of transactions to achieve particular accounting
results, even if results are inconsistent with transactions
- Faithful representation real existence
- Substance over form inaccordance with substance and economic
reality
- Neutrality freedom from bias
- Prudence degree of caution in exercise of judgements
- Completeness material info is not omitted

Comparability Pozen Committee notes that GAAP contain many

detailed rules with several industry exceptions and alternative accounting
policies for same transactions

Elements of Financial Statements

x

Assets resources controlled by the entity as a result of past events,

and from which future economic benefits are expected to flow from
the entity
Asset recognition

It is probable that any future economic benefits associated with the

item will flow to the entity

ACCT1501 Notes

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x
x
x

x
x
x

Liabilities present obligation of the entity arising from past

events, the settlement of which is expected to result in an
outflow from the entity of resources embodying economic
benefits
Liability Recognition
- probable that any future sacrifice of economic benefits associated
with the item will flow to or from the entity
- the item has a cost or value that can be measured reliably
Equity residual interest in the assets of the entity after the
deduction of its liabilities SE = A L
Equity ranks after liabilities as a claim to the assets of an entity
Income increases in economic benefits during the accounting period
in the form of inflows or enhancements of assets or decreases in
liabilities that result in increase in equity
Issues of shares are not included
2 main components revenue and assets/liabilities
Expenses decreases in economic benefits during the accounting period
in the form of outflows of assets, depletion of assets or incurrences of
liabilities that result in decreases in equity
mainly COGS, wages and depreciation

Measurement of the elements of financial statements

x

x
x
x

Measurement determining the monetary amounts that the elements of

the financial statements are to be recognised at and included in the
balance sheet and the income statement
Historical cost assets are recorded at the time of acquisition
Current cost assets are carried at the amount that would have to be
paid if it was bought currently
Realisable (settlement) value assets are carried at the amount that
could currently be obtained by selling the asset in an orderly
disposal
Present value assets carried at present discounted value of future
net cash inflows that the item is expected to general in the normal
course of business

ACCT1501 Notes
6.4 Assets and Liabilities: Valuation and Measurement
x

x
x

Five basic methods to measure or value assets and liabilities

- Historical cost
- Price-level-adjusted historical cost
- Current or market value
- Value in use (or present value)
- Liquidation value
Asset: Whether market values are better than historical cost?
Liability: Whether present value or estimation of future cash flows?

Historical cost
x

x
x

x
x
x

Acquisition cost values assets at the amount paid or promised to

acquire the assets, and values liabilities at the amount of any
associate promises
Ability to document cost of asset through receipts, invoices or contracts
An asset valued at historical costs is valued at its expected
lowest or most conservative value of future benefits at the
date of acquisition
At the point of acquisition, historical cost = market value = value
in use (present value), in most cases.
writing down of unproductive assets
lower of cost or market rule

Price level adjusted historical cost

x
x

Adjusts for changes in the value of the dollar, rather than the
changes of the values of the assets
Lack of popularity because if historical cost is unsatisfactory
compared to current values, adjusting the cost for inflation still
makes it unsatisfactory, only now less understandable

Current Price or Market Value (value in exchange)

x
x

Records assets and liabilities at their current particular market value

focuses on the individual values of the assets and liability items

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x

x
x

assumes that value is market-determined and that profit should

be measured using changes over time in market values.
Input market value entry value refers to the amount it would
cost to bring the asset into the company if it were not currently in
it.
Output market value exit value amount an asset is worth if it
were sold now (net realisable value)
Fair value alternative asset valuation method amount of the
consideration that would be agreed upon in an arms length
transaction between knowledgeable, willing parties who are
under no compulsion to act.

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Value in use (present value)

x
x

x
x

Considers that value flow from the generation of cash flows from the
asset
Estimated by calculating the net present value of future cash inflows
cash flows minus lost interest expected to be generated by the
asset
Present value future cash flow future interest implied by waiting for
the cash
Present value = future cash payment / (1+r)

Liquidation Value
x
x

going out of business, sell it for what you can business

presumes the entity is not a going concern

6.5 Accounting Regulation in Australia

x

CLERP Act 1999 Corporate Law Economic Reform Program Act modified
institutional arrangements for the setting of accounting standards in
Australia, recognising that financial reporting requirements can play an
important role in
Australia companies ability to compete effectively and efficiently in a
global environment
FRC Financial Reporting Council

6.6 International Accounting Standards

x
x

x
x

IASB (International Accounting Standards Board) have issued more

than 40 individual standards.
Aim: develop common standards that could be used by companies
operating in several countries, and eventually that all countries could
use within their borders
CONVERGENCE
Horror stories of 1 company with huge profits in one country also with
huge losses according to another countrys acct standards are an
embarrassment to the accounting profession and awkward for regulators
such as SEC (security exchange commission) to deal with
Challenge to IAS is the attempt to make even the Canadian, US and
Mexican accounting systems similar, given that the 3 countries have
signed the NAFTA.

VERY different in accounting standards, as govts have passed laws that

set strict requirements for financial accounting in accordance with
national priorities and culture

ACCT1501 Notes
6.7 The Annual Report and Financial Statements
x

x
x

The standard set of financial statements has five components:

- balance sheet
- income statement
- statement of changes in equity
- statement of cash flows
- notes to the financial statements
Statement of changes in equity reports the profit or loss in equity
Notes to the financial statements provide additional detail on the
items in the financial statements note 1 is accounting policies
inventory method, depreciation method
Public companies and other organisations include their set
of financial statements in a much larger annual report.
This report usually contains:
1. Summary data on companys performance for the year,
comparisons going back 5 or more years
2. Letter to the companys shareholders from the chairperson of
the BOD or the managing director, including highlights of the
performance and future plans
3. Extensive CEOs report description of the eco, financial and other
factors
4. For listed companies a corporate govt statement, required under ASX
reg
5. Set of financial statements
6. Directors statement required by Corporations Act 2001
signed by CEO and CFO that the fins records are prepared in
accordance with the Corporations Act 2001. Debt opinions of
directors
7. Independent audit report
8. Directors report names of directors, principle activities, operating
results
9. For listed companies, info on substantial shareholders,
distribution of ownership
10.Other voluntary information graphs, details on products, pollution

Full versus concise financial reports

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x
x

Corporations Act 2001 now requires the publication of both

FULL general purpose financial reports (GPFR) and concise
financial reports
GPFR contains the 5 financial statements in addition to the
auditors report and directors declaration
Concise financial statements are sent to all shareholders, with a
statement that the report is concise and GPFR if a shareholder
requests
Concise financial statements include the 5 financial statement
components minus notes. Additionally there must be a
discussion and analysis of financial statements to assist the
users understanding.

ACCT1501 Notes

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6.8 The External Auditors Report

x
x
x

x
x

Auditors report a routine statement by the auditors that provides an

opinion on whether financial statements are fairly presented
Adverse opinion when auditors deny the fairness of the statements
External auditing refers to the evaluation of an organisations
financial statements by an auditor who should be unconnected with,
and therefore independent of, the management of the organisation
Role of external auditor:
- to have an independent, unbiased and professional perspective
- to render a competent opinion on the fairness of the financial
statements
Fundamental objective of professional associations such as CA or
CPA is to protect society by ensuring the professionalism and
independence of the external auditors who belong to them
Independence is maintained because the auditor is appointed by, and
reports to the shareholders, not management
However, in practice, auditor has close working relationship with
management and managers has a strong position to recommend
change of auditor
Recent legislative changes have strengthened the independence of audit
firms:
- rotation of audit partners every 5 years
- banning the provision of many non-audit services by the firm
carrying out the audit
Audits are opinions, not guarantees.

Audits do not state whether a company is performing good or bad. It

simply states whether the performance and position have been
measured and presented in a generally accepted and unbiased way

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x
x

Content and form of auditors report changes every few years, as

auditors rethink how it is best to communicate with the users.
Addressed to owners, titled Independent Audit Report

Standard version of the auditors report includes the following:

1. Identifies company, set of statements and their date and states that
the statements are the responsibility of mgmt and that the auditors
responsibility, having conducted an independent audit of the financial
report, is to express an opinion to them.
2. A section of the report contains the following statements:
a. audit conducted in accordance with AAS to provide reasonable
assurance on whether financial report is free of material
misstatement
b. auditors procedures included the examination, on a test basis, of
evidence supporting the amounts in the financial report, and the
evaluation of accounting policies and significant accounting
estimates
c. procedures have been undertaken to form an opinion to
form an opinion on whether, in all material respects, the
financial report is presented fairly in accordance with AAS
d. statement that audit opinion expressed in the report has been
formed on the above basis
3. Normally, the third paragraph provides the auditors opinion that
the financial statements give a true and fair view that they are in
accordance with the provisions of the Corporations Act 2001,
applicable accounting standards and other professional mandatory
reporting requirements.

Redraft: include paragraph of respective roles of mgmt and

auditors and inclusion of separate section related to the
independence of auditors
There are 3 main exceptions to unqualified opinion:
- qualified opinion generally satisfied, but disagree with mgmt
- adverse opinion financial statement not presented in accordance to
AAS
- disclaimer unable to express an opinion either way because of a
limitation in the works the auditors were able to do
Even if unqualified opinion is expressed, auditor will still alert reader to
the facts in the financial statements, but not of such nature that it affects
the audit opinion

6.9 The Nature of a Profession and Professional Ethics

x
x

Professionals are recognised by post-secondary education

3 main professional accounting bodies ICAA (Institute of
Chartered Accountants in Australia), CPA Australia and the NIA
(National Institute of Accountants)
If a professional accounting has not lived up to the standards of
conduct held by the profession, he or she can be reprimanded or
expelled by the profession and/or sued in court

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Professional codes of ethics involve not only behaving in professional

manner, but also maintaining the level of expertise required in order to
perform skilfully
APES 110 Code of Ethics for Professional Accountants

Five fundamental principles:

- Integrity
- Objectivity
- Professional competence and due care
- Confidentiality
- Professional behaviour

Compliance with the fundamental principles may be threatened by

various threats, including the following:
- Self interest threats undue dependence on total fees
- Self review threats auditing systems on reports you designed
- Advocacy threats promoting shares in a listed company you are auditing
- Familiarity threats familial relationship with director or officer
- Intimidation threats threatened with dismissal etc

ACCT1501 Notes
Chapter 7 Internal Control and Cash

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7.1 Internal Control

x

Internal control is a process, affected by an entitys board of directors,

management and other personnel, designed to provide reasonable
assurance regarding the achievement of objectives in the following
categories:
- Effectiveness and efficiency of operations [also reduce risk of
asset loss]
- Reliability of financial reporting
- Compliance with applicable laws and regulations

Internal control is not one event or circumstance but a process

integrated with other basic management processes, such as planning
and monitoring
CEO is ultimately responsible for internal control
Internal control affects working life of most personnel
Internal control can only provide reasonable assurance rather than
absolute assurance to management and the board of directors
regarding the achievement of an entitys objectives
Limitations of Internal Control:
- Problems of human judgement not follow instructions
- Managers may override prescribed policies or procedures
increasing revenue
- Collusion between individuals can result in control failures
- Internal controls cost money should apply cost benefit principle

x
x
x

Internal control can be considered to be effective for each of the 3

categories if management and the board of directors have reasonable
assurance that:
- They understand the extent to which operation objectives are
being achieved
- Financial statements are being prepared reliably
- Compliance with relevance laws and regulations
5 interrelated components of internal control:
- Control environment integrity, ethical values and competence of
entitys people
- Risk assessment associated with change and establishing objectives
- Control activities ensure necessary action for risk assessment
- Information and communication internal and external
- Monitoring assess quality of systems performance over time
ongoing monitoring and separate evaluations

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Control Activities
x

Examples of control activities:

- Top level reviews compared to budgets and forecasts to assess
which targets are being achieved
- Information processing controls check accuracy, authorisation
and completeness of transactions
- Separate record keeping from handling assets segregation of duties
where person who physically handles assets is different to person
who keeps records
- Physically protect sensitive assets

x
x

Examples of Internal control

Matching independently generated documents matching sales invoices
and shipping documents
Prenumbering and sequencing checking of documents to
prevent unauthorised use
Comparison with independent third party info bank reconciliations of
ledger accounts with bank statements
Cancellation of documentation deal with cheques immediately
Segregation of duties
Demanding timeliness of operations prompt deposit of cash
receipts and depositing cash intact

x
x
x
x
x

7.2 Internal Control of Cash

x
x
x

Cash is the asset that is most susceptible to theft because of its

liquid and generally anonymous nature
Common control is locked in sales registered or carefully controlled
records
Another way is to have multi copied, pre numbered sales invoices
check cash sales, cash received, credit sales, accounts receivable,
inventory
Prevent stealing cash / cheques there should be more than one person
opening, disable function to turn into cash, list of cheques received,
should be posted to register, general ledger, accounts receivable of
subsidiary records
Payments of cash: properly authorised documents/invoices and cheques
should be signed by 2 staff members who are independent of invoice
approval and accounting duties, original invoice should be stamped
paid

7.3 Bank Reconciliations

x

Because of high frequency of transactions and potential for error,

accuracy of cash balance in general ledger should be examined
periodically
Process is called bank reconciliation based on bank statement

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Bank Reconciliation versus cash accounts

x
x
x
x
x

Bank statements summarise the activity in a cheque account and

report the ending monthly balance.
Cash account of depositor = asset, for bank = liability
This is because when cash is deposited in the bank, the bank now
owes the depositor money
End of month bank statement cash balance normally wont agree
with companys cash records
Items on companys record but not on bank statement:
- Deposits in transits receipts entered in a firm but not yet
processed by the bank (debit for company > credit for bank)
- Outstanding (un-presented) cheques cheques written by
business but not yet presented to the bank company issued cheque,
but external person hasnt cashed it yet (credit for comp > debit for
bank)
Items reported on the bank statement but not yet entered in the
companys record
NSF cheques (non sufficient funds/ dishonoured cheque)
customer cheques deposited but refunded due to lack of funds
(debit on bank statement)
- Bank service charges for accounting processing
- Notes receivable and interest collected by the bank
collection of interest or note is reported with a credit memo notation
because of depositors increase in account balance
- Interest earned on the account
In addition to timing differences, errors may cause a discrepancy
between the bank statement balance and company accounting records
-

The reconciliation process

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x
x
x
x
x
x
x

If balances do not agree and the reconciling items are deemed correct,
there is a chance that a record keeping error has been made.
Reconciliation not only highlights timing differences but also identify
errors made by either the bank or the depositor
Bank reconciliations contain adjustments to both ending cash balance for
bank and company records
After reconciliation is completed, general journal entries must be
prepared for adjustments made to company records
Adjustments necessary to update cash account in relation to
correction of company errors and info processed by the bank
No journal entries are needed for adjustments made to the ending
bank statement balance
These adjustments reflect items that have already been
recorded in a companys accounts thus no further updating is
necessary

7.4 Performing a Bank Reconciliation from information in cash

journals
1. Go through last months bank reconciliation statement, ticking off any
amounts that were outstanding last month
Go through bank statement and tick off items appearing in both CJs and
bank
Errors: if bank has mistake, inform bank of error.
If business has made a mistake correct relevant cash journal
2. Go through bank statement to see what amounts remained
unticked Enter such amounts into CRJ or CPJ
Go through CRJ and CPJ and see if there are any unticked amounts
these are outstanding deposits and unpresented cheques
CRJ deposit in transit
CPJ unpresented cheques
3. Total CJs and post to bank ledger account
4. Prepare bank reconciliation

7.5 Petty Cash

x

x
x

Under the petty cash system, a fund is established in making small

payments, especially those that are impractical or uneconomical to make
by cheque.
E.g. taxi fares or miscellaneous office needs
To establish petty cash funds:

Petty Cash
DR
Cash
CR
As payments are made from the fund, the custodian completes a form
known as petty cash voucher

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x
x
x

Each voucher indicates amount paid, purpose of expenditure, date

and individual who received money
Petty cash vouchers and invoices and receipts are evidences of
disbursements
Cash remaining in fund + Petty cash vouchers + Invoices = Original
amount

Replenishing the fund

x To replenish fund
Postage expense
$$$
Office supplies expense
$$$
...
$$$
Cash
$$$
x Note credit is to cash account
x Fund is restocked by writing cheque on the companys cheque account
x Replenished when funds are low, or at the end of each accounting period
x Process is necessary because no formal journal entries have been
recorded

Errors in petty cash fund

x
x
x
x

Occasionally petty cash vouchers and cash will not equal original fund
balance
Adopt cash short and over account
Shortage miscellaneous expense
Overage miscellaneous revenue item

7.6 Disclosure of Internal Control in Annual Reports

x
x
x

Australian companies listed with ASX are now required to include section
in their annual reports on corporate governance.
A number of companies include a description of internal controls in this
section
Common aspects of these descriptions:
- Board of directors has responsibility for internal control system
- Role of audit committee is noted
- Operating budgets used to monitor performance
- Internal audits are important part
- Controls are important in certain key area including treasury
- These are clearly defined guidelines for capital investment

ACCT1501 Notes
7.7 Managers and Internal Control
x
x
x
x
x

x
x
x
x
x

Internal control is the responsibility of management

Internal control should minimize errors and irregularities
Errors unintentional mistakes, irregularities intentional
Irregularities should be detected except when there is collusion or
management override
No system of internal control can eliminate all errors and
uncertainties, but can decrease the possibility of them occurring
and increase chances of detecting them
Important question how much internal control is necessary
Cost money to implement an extra internal control
Must apply cost benefit analysis
Difficult because benefits of having controls are often difficult to quantify
Based on judgement

7.8 Public Sector Issues

x
x
x

x
x
x
x
x

Internal control is an integral part of the environment of all public sector

entities
June 1995 NSW Treasury issued a statement of best practice
internal control and internal audit
Guidance for govt agencies on such topics as responsibility for
internal control, relationship between management processes and
internal control; analysing risks and establishing controls and
effective collection of information, communication and monitoring
4 critical elements in an effective system of internal control for
public sector entities
Appropriate tone at the top
Well designed control system aimed at mitigating (explaining) risks
Effective collection of info and communication thru agency
Effectively monitoring of system of internal control

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ACCT1501 Notes
Chapter 8 Inventory

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8.1 Inventory Control

x
x
x

Inventory control is an important issue for management because

a high percentage of working capital may be tied up in inventory.
May be consumable or outdated, high potential for theft
Choice of inventory is a record keeping choice as opposed to a
reporting choice

The perpetual inventory control method

x
x
x
x
x
x
x

x
x
x

When an order of inventory items is received, the quantity received is

added to the quantity recorded as being already on hand.
When they are sold, they are deducted from the recorded quantity
Therefore, the perpetual method shows how many items are supposed to
be on hand at any time
Inventory on hand = quantity on hand at beginning of period +
quantity purchased quantity sold
Perpetual continuously updated figure
Physical count of inventory fails to show that quantity, therefore error
or lost or stolen inventory
Beginning inventory cost (support with physical count if desired) +
Cost of purchases of inventory (records) Cost of inventory sold
(records) = Ending inventory cost
Debit expense, credit inventory
Overage = negative expense where there is more inventory than
expected
Overage/shortage expense account would probably be included with
COGS in the income statement

The periodic count method

x
x
x

x
x
x

If complete records of inventory changes are not kept, the enterprise

does not have records to indicate what should be on hand
The only way to tell is to count
This is done periodically when inventory figure is needed for financial
statements or insurance purposes this is called the periodic inventory
method.
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, but simple and cheap, as no continuing records are kept
Beginning inventory (count) + purchases (records) ending inventory
(count) = Inventory sold (deduced); that is cost of goods sold

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x
x

Because what is sold has been inferred, under the periodic method,
cost of goods sold expense includes all other possibilities (lost,
stolen...)
Other forms of control need to exist to indicate theft or so on
E.g. unexpected changes in the ratio of cost of goods sold to sales
should be investigated

Inventory: Cost and benefits of controls

x
x
x
x
x
x
x
x
x
x

Perpetual method can be costly in terms of record keeping

Car dealership needs perpetual system
Cars are expensive, so large investment must be made if a good supply is
to be on hand for customers to choose from.
Need to keep track of registration, insurance, serial numbers, other
types of identification
Because of small quantity of cars sold by dealerships, record keeping
costs are not high.
Similarly, companies selling more expensive items, e.g. TV, fridge,
jewellery, use perpetual method
Companies with large amount of sales, particularly items with low
value, use periodic inventory method because of lower costs.
However, most organisations now use perpetual because of computer
based inventory systems
Retail companies have optical scanners scanning barcode
Assist with inventory control and helps with planning for ordering
additional inventory

8.2 Accounting Entries for Perpetual and Periodic Inventory

Perpetual includes costs of goods sold and inventory shortage expense
XX
x Sales
X
Less cost of goods sold
XXX
XX
Less inventory shortage
XXX
X
XX
Gross profit
X
x Periodic excludes costs of goods sold and inventory shortage expense
x Sales
XXX
Cost of goods sold:
Opening Inventory
XXX
Purchases
XXX
Cost of goods available for sale
x

Less ending inventory

Costs of goods sold
Gross profit

XXX
XXX
XXX

ACCT1501 Notes
8.3 Inventory Valuation and Cost of Goods Sold
x
x
x

Inventory accounting uses a modified version of the standard

historical cost valuation basis: lower of cost or market value
Application of accounting conservatism: anticipate no gains but allow for
losses
Inventory accounting affects both the balance sheet (inventory
valuation) and the income statement via the COGS

Inventory cost flow assumptions

x
x

x
x
x
x
x
x

Cost of inventory varies

Actual cost is usually tracked only for high value items (houses,
motor vehicles) that can be identified by serial numbers and
other methods
Method specific identification
As the cost of keeping records decreases, because of
computerisation, more items will be able to be tracked this way.
Impossible to keep track of individual items in inventory, so ASSUME flows
of costs
By using periodic method: first calculate COG available for sale
Problem: how to allocate COG available for sale between COGS
and ending inventory asset
Three common inventory cost flow assumptions:
- FIFO First in first out sell the
oldest items first (BS recent
cost, COGS old costs)
- AVGE weighted average assumption assume mixture of
old and new items (average unit cost = total cost / total
units)
- LIFO Last in first out sell
newest items first (BS old
costs, COGS new costs)

8.4 More about Inventory Cost Flow Assumptions

Assumption Periodic Control

Perpetual Control

FIFO

FIFO

FIFO

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x
x
x

AVGE

Weighted Average

Moving weighted average

LIFO

Periodic LIFO

Perpetual LIFO

FIFO is not affected by inventory control method because it just

assigns the most recent costs to whatever is on hand.
Others depends on control method, as it depends on what
happened to inventory levels during the period
Thus there is 5 methods
There is a six specific identification and 2 others

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x
x

x
x
x
x
x
x

In Australia, LIFO is not allowed to be used for either financial

reporting or tax purposes
Because each assumption allocates the available inventory cost between
the inventory asset and the costs of goods sold expense differently, the
choice of assumption has an effect on both the income statement and the
balance sheet
If there is little change in purchase costs, the various methods will
show very similar results
FIFO
Used because its convenient where inventory asset are close to current
costs
Convenient because only need to keep invoices
Doesnt matter which control, because all info needed is the quantity on
hand, whether by count or by perpetual records
Most popular cost flow assumption for inventories for larger Aust
companies
Considered appropriate for current asset because it is the most
reasonable method of physically moving inventory, especially inventory
that is perishable or subject to changes in style

x
x

AVGE
When prices are rising, average cost shows a higher cost of goods sold
(lower profit) and lower inventory balance sheet figures than the FIFO
method

x
x

LIFO
In US, cost flow assumption used for accounting purposes does not
have to match physical flow of items
Allowable method for income tax purposes.
E.g. rising inflation increases purchases costs, produces higher COGS,
lower profit and lower inventory asset value used for tax purposes
Matches revenues and expenses more adequately.
E.g. if company changes prices in response to purchase cost
changes, its revenues reflect recent prices changes
Problem: LIFO produces inventory asset values that are based on older
purchase costs, and this can substantially underestimate the asset value
LIFO is affected by whether its amounts are determined using the
periodic or perpetual control methods,

x
x
x
x
x
x

8.5 An Example: MEEIX LTD

x
x
x

Beginning inventory + purchases = cost of goods sold expense +

ending inventory
MUST refer back to pg 398 when studying.
In a period of rising purchase prices
Inventory asset value: FIFO > AVGE >
LIFO Cost of goods expense: LIFO >
AVGE > FIFO

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Larger differences in price, larger differences in end results of method

8.6 Lower of Cost or Market Rule

x

The lower of cost or market 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 costs
To calculate the lower of cost or market value, we just take the cost of the
items and match those costs against the net realisable value and use the
lower as the balance sheet inventory value.
If inventory costs 1000 had a net realisable value at year end of 800:
DR Inventory Write down expense
CR Inventory

200
200

8.7 Retain Inventory and standard costs

x
x
x
x
x
x
x
x
x

x
x
x

Retail inventory method is most application to retailers inventories

Combines purchase costs and selling prices into a single
calculation/estimate
Department is charged with total selling value (sale price x time)
Revenue from sale is deducted from total value as items are sold
Ties inventory control to cash control
AT any given point in time, inventory + cash + receipts for credit
cards = total retail value
Retail price of all goods department sales = inventory on hand priced at
retail
If physical count doesnt match then use shortage or overage
Retail method is complicated in practice because of the need to keep
track of markdowns, returned goods, special sale prices and other price
adjustments if the method is to work accurately
Another popular method: standard costs
Applicable to inventories manufactured by a company and uses
estimated costs based on standard production costs and volumes
balances, purchases and sales

8.8 Disclosure of Inventories Policies

x

Accounting standards require the financial reports disclose the value of

inventory split between CA and NCA and further split into the following
classes:
- Raw materials and stores
- Work in progress
- Finished goods

- Land held for resale

In addition requires disclosure of general basis of inventory
valuation and methods used to assign costs to inventory
quantities

ACCT1501 Notes

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Within one organisation, more than one method can be used and it
may vary between the type of product or the class of inventories

8.9 Managers and the valuation of inventory

x
x
x
x
x
x
x

Managers have to choose control method

Perpetual better control, higher costs
Important to managers as both profit figures and balance sheet figures
affect managers performance reports
Therefore managers need to understand the effect, across time, of
different cost flow assumptions on financial statements
Managers must make important judgements
Which cost flow assumption must closely represent the actual physical
flow?
What inventory items have a net realisable value which is lower than
cost?

8.10 Inventory in the public sector

x
x
x

Inventory is not normally a material item for most public sector

organisations.
But there may be exceptions hospital bandages, medicine
When inventory does exist, the same accounting standards apply as
in the private sector.

ACCT1501 Notes
Chapter 9 Noncurrent Assets

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9.1 The Cost of an Asset: Basic Components

x
x

x
x
x
x
x
x
x
x
x
x

The basic premise of historic cost valuation is to use the cost of an

asset, at acquisition to value that asset on the balance sheet
When machines are bought, there are certain conditions that must exist
for the machine to operate, e.g. temperature, raised floor for wiring, fire
protection system
Therefore a section of the factory must be renovated to meet
specifications of the machine
These costs are known as installation costs
Overall, the cost of an asset includes all those costs required to install it
ready for use
Should the interest on monies borrowed to finance the project be
included? Most the time, no
Enterprises often have policies for how to determine whether
expenditures, such as interest are included in assets costs
Decision between whether to include costs as 1 years expense or
included in assets
Expense profits and income taxes for the year will be lower
Assets total assets will be higher, and this years profit and tax
expenses will also be higher
Capitalising versus expensing choice
When deciding where in BS maintenance goes, think about whether
there is improvement or extension of useful life of asset. If yes
asset, if no maintenance expense
Common components of asset cost:
- Land purchase price, costs of clear title (legal fees), clearing
unwanted items, draining
- Building (purchased) purchase prise, renovation, decoration
- Building (self-constructed) labour, material, insurance
- Purchased Equipment installation, transport, testing

9.2 Depreciation of Assets and Depreciation Expense

x
x
x
x

Depreciation an allocation of cost as a deduction from profit over the

useful life of the asset
Depreciation expense annual deduction from revenue
Depletion wasting assets are involved
Amortisation intangible assets or leases are involved

ACCT1501 Notes

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Why Allocate the Cost?

x
x
x
x
x
x
x

Assets are returns on investments

In accrual accounting, some method is needed to allocate the cost of
long lived assets over their useful lives
If whole asset cost was deducted in the year of acquisition, that years
profits will be very low and subsequent years profits very high
It would also mean that an asset has further benefits that is not
recognised
Allocation of cost in order to measure profit
NOT a system to tract value changes in assets or to measure the current
value of those assets in the balance sheet
Balance sheet shows the net of assets original cost minus Acc Dep: it
does not mean the assets current value is that net amount

Why not depreciate land?

x
x
x

Lands economic value is not considered to decline through use

Land is not normally susceptible to physical or economic decline
Equipment can be depreciated via physical causes (wear and tear) and
non-physical causes (obsolete with the advent of newer and faster
machine)
Land is considered immune from all this, and is therefore not depreciated

When does cost allocation (depreciation expense) begin?

x
x

When the asset is put to use and the benefit begins to be realised,
depreciation of the expense should begin.
Once asset has been put into service, further costs involved in
painting, maintenance, repair and so on are now considered to
be expenses
If a cost that is incurred significantly changes the assets economic value
in earning revenue, e.g. betterment of asset, then cost may be
capitalised as part of assets cost, then depreciated along with the rest
of the asset.

Other questions
x

x
x
x

Depreciation is recognised by the following journal entry:

DR Depreciation Expense
CR
Accumulated Depreciation
Accumulated depreciation is a contra asset
Depreciation is a prediction it is never exact
Choice of accounting purposes does not affect the tax paid

x
x

Why is depreciation any good, if its not exact, it has no cash effect and
it does not match market value changes in assets?
It is used to spread the cost out over the useful life of the asset, which
matches the presumed consumption of that cost with the benefits
gained from that use

ACCT1501 Notes

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9.3 Depreciation Bases and Methods

Assumption

Kind of Cost Allocation

Spread evenly over the assets life

Straight line

benefits is equal throughout useful life

expense is the same each year

Falls over the assets life

Reducing balance method

benefits decrease as asset gets older

expense is larger in earlier years

Variable over the assets life

Units of production

benefits varies according to how much

production is achieved each year

expense depends on each years

volume of production

Straight line depreciation

x
x

x
x

Simplest and most widely used

Need 3 pieces of info:
- Cost of the asset: total cost to be depreciated over time
- Estimated useful life: number of periods for which the asset is
expected to benefit the enterprise
- Estimated salvage value: amount expected to be recovered via
the sale of the asset at the end of its useful life
Depreciation for one period = Cost minus estimated salvage value
Estimated useful life (no. of periods)
A common practice for many firms is to assume the salvage value of
the asset to be zero, which then enables depreciation to be expressed
in terms of percentages instead of years

Reducing Balance method

x
x
x

Next most common depreciation method

Assets contribute more of their benefit to the enterprise in early parts of
their lives
Need 3 pieces of info:
- Cost of the asset: total cost to be depreciated over time
- Accumulated depreciation: total depreciation recorded since
acquisition
- Depreciation rate: % of book value of the asset that is to be
depreciated in the period
Depreciation for one period = (cost accumulated depreciation) x rate

Reducing balance depreciation does not normally take into account

salvage value

ACCT1501 Notes
x Reducing balance percentage: r = 1 - n
r = required depreciation rate n = estimated life in years
s = estimated residual value c = original cost
Units of Production Depreciation and Depletion

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Also used to compute depletion of natural resources

Need 3 pieces of info:
- Cost of the asset: total cost to be depreciated over time
- Estimated salvage value: amount expected to be recovered via the
sale of the asset at the end of its useful life
- Estimated number of units to be produced during the life of the asset
x Depreciation for one unit =
Cost minus estimated salvage value
estimated no. of units of production
during life
x To determine the depreciation for one year, the charge per unit is
multiplied by the number of actual units produced or used
x
x

Whichever method is adopted, the company can always adjust its

calculations later if the expectations about length of useful life or salvage
value begin to look seriously inaccurate
For now, note that it is usual to allocate the remaining book value
over the remaining useful life

9.5 Gains and Losses on Noncurrent Asset Disposals

x
x
x
x

x
x

Selling off assets are kept separate from ordinary revenues via the
following kind of journal entry:
E.g. Truck bought at 50,000. Depreciates at 8,000 each year. Sold at end
of 2nd year for 37,000
Net book value of truck = 50,000 16,000 = 34,000
Journal Entry for selling truck:
37,00
Cash
0
34,00
Accumulated Depreciation
0
50,00
Truck asset
0
Revenue on sale of truck
3,000
If there is a loss, it will be debit revenue
Think of gains and losses as depreciation corrections

ACCT1501 Notes
9.6 Assets Revaluations
x
x

x
x
x
x
x

x
x
x
x
x

x
x

Carry amount book value

Fair value amount for which an asset could be
exchanged between knowledgeable willing parties in an
arms length transaction
In Australia, directors need to ensure that the carrying value of an
asset exceeds the recoverable amount.
If not, the carrying value must be reduced to its
recoverable amount impairment loss
Recoverable amount assets fair value costs to sell it, or an
assets value in use whichever is higher
Value in use is the present value of future cash flows that are
expected to be derived from an asset
Accounting standards state that each class of noncurrent
assets must be measured using either the cost model or the
revaluation model
Cost model after recognition of an asset, the asset is
carried at cost less accumulated depreciation and any
accumulated impairment losses
Revaluation model after recognition of an asset, the asset whose
fair value can be measured reliably is carried at a revalue amount,
which is the fair value at the date of revaluation less any
subsequent accumulated depreciation and subsequent
accumulated impairment losses
Revaluing upwards revaluation increment increase in asset
account and shareholders equity (asset revaluation reserve)
Revaluing downwards revaluation decrement decrease in
asset account and increase in expense account
Increments in asset valuations do not generally affect profit
directly, but decrements do reduce the profit for the year
Changes in asset valuation (except for land) result in different
depreciation expenses in subsequent years
When an asset is revalued, all assets within the same class of
assets should also be valued at the same time on a consistent
basis.
Exception: downwards valuation
Land Revaluation
increment: DR Land

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CR
Revaluation Reserve
Land Revaluation decrement:
DR
Loss on devaluation of land
CR
Land
Equipment Revaluation increment
DR
Accumulated Depreciation
CR
Equipment
DR
Equipment
CR
Revaluation Reserve

ACCT1501 Notes
9.6 Intangible Assets
x

x
x

Intangible assets are identifiable, non-monetary assets that do not

have a visible physical existence, unlike land, buildings or
equipment
Intangible Assets include:
- patents, copyrights, trademarks and other such legal property
- brand names, which can be registered to maintain exclusive use
- franchises, distributorships and other rights to sell someone
elses products in a certain geographical area
- deferred charges such as incorporation costs, financing
costs and other items that are really long term prepaid
expenses
- development costs (including product development costs
and mineral exploration costs), which are capitalised and
later expensed at the time they earn revenue in the future
strict criteria applies
AASB require organisations to charge all research costs to an
expense account when they are incurred.
Organisations prohibited from capitalising any expenditure
associated with internally generated brands, publishing titles,
customer lists and similar items

What are intangible assets worth?

x
x
x
x

Existence and value of intangible assets may be doubtful

generally the more clearly identifiable and documented, the less
difficulty they pose
Assets such as brand names, trademarks and franchises have
considerable doubt about their economic value
Development expenditures question on whether they belong on
the balance sheet at all. is it for sure that the product will sell and
that it will bring future economic value? will the revenue be larger
than the costs?

Amortisation or impairment of intangibles

x

Legal useful life is different from economic useful life

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x
x

If useful life is finite intangible is amortised

If useful life is indefinite intangible would be tested annually for
impairment, by comparing carrying amount with recoverable
amount
If carrying amount > recoverable amount, then impairment loss

9.8 Goodwill
x

Goodwill arises when more is paid for a group of assets, such as a

whole business, than the assets seem to be worth individually

ACCT1501 Notes

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x
x

x
x

The rationale for paying the additional amount may be based on such
factors as how the business is organised or the number of customers it
has
Goodwill occurs to keep the books in balance
Purchased goodwill is measured as the excess of the cost of
acquisition of another entity over the fair value of the identifiable net
asset and contingent liabilities
Externally generated goodwill is recognised by the accounting
system. It is a transaction, supported by documentation, that shows
how much was paid
Internally generated goodwill not recognised by accounting system
e.g. better management and improving friendliness of staff
Internally developed goodwill is never capitalised cannot put an
economic value on it yet e.g. expenditure on office parties to keep
employees happy is an expense
Following the acquisition of goodwill, rather than amortising it over a
deemed useful life an entity will test it for impairment on an annual
basis
Or more frequently, if events or changes in circumstances indicate
that the goodwills carrying value has decreased below its
recoverable amount

9.9 Financial Leases

x

x
x
x
x
x

Leases are rental agreements in which one individual (lessee) pays, to the
owner of a property (lessor), a certain amount in return for the right to
use that property over a predetermined period
Concern: some companies use leases to avoid putting assets on balance
sheet
As a result, AASB established 2 types of leases: finance leases and
operating leases
Finance leases when all the risks and benefits incidental to
ownership are substantially transferred to the lease
Cost present value of the future lease payments using an appropriate
interest rate usually deducted from the lease agreement
At the same time present value of those payments is recorded as a
liability

x DR
x

Finance lease asset

Finance lease obligations
CR
liability
After that:
1. Leased asset is amortised
2. Liability is reduced as payments are made on the lease. Each
payment includes interest, but only principle deducted. This

maintains the liability at the present value of the remaining lease

payments
3. Expenses for using the leased asset are amortisation and interest
4. Various particulars of significant capital leases are usually disclosed
in the notes to the financial statements so that the readers of the
statements may judge the effects of such capitalisation
Result: leased asset is treated essentially as if it were owned

ACCT1501 Notes

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x
x

Accrual accounting recognises the economic value of the asset and

disregards the legalities of who owns it
If the lease does not result in the economic equivalence of ownership if
it is really a rental situation where the owner is responsible for repairs,
the lease is an operating lease

9.10 Reporting of Non Current Assets and Associated

Depreciation/Amortisation
x

The Corporations Act 2001 and AASB require certain disclosures

concerning noncurrent assets and their related depreciation/amortisation.
These include:
- Depreciation and amortisation expense
- Cost and accumulated by major classes of assets
- Description of policies with regards to D/A
- Details concerning revaluation
- If items are measured at fair value include carrying costs and other
costs
- Statement that assets have not been valued above their
recoverable amount
- What the recoverable amount is fair value cost to sell/value in use

9.11 Managers and Noncurrent Assets

x
x
x
x
x
x

Managers need to make many judgements related to noncurrent assets.

What should be included in the cost of an asset?
What period/method should it be depreciated?
Value on brand names?
When should assets be revalued and who should do the revaluing?
All of the above judgements (except upward revaluation) will affect the
enterprises profit figure, which is a key indicator of management
performance

9.12 Public Sector Issues

x
x

x
x
x

Infrastructure system assets include items such as roads, water

supply, bridges and transmission lines
Generally valued by govt departments at cost or written-down
replacement value (estimated replacement value accumulated
depreciation)
Difficulty in obtaining these figures
Heritage assets cannot be replaced
Valuation of $1 highlights to readers that an asset exists, but at this point
in time it is not clear how to value it.

x
x
x
x

E.g. Library collection held by State Library

In general, a number of factors have a bearing on the difficulty of
reliably measuring the assets of public sector entities.
E.g. completeness of asset registers, type of asset, extent of assets
similarity to other assets used in other govt departments
Such assets e.g. historic buildings, gardens, monuments

ACCT1501 Notes
Chapter 13 The Statement of Cash Flows

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13.1 The purpose of Cash Flow analysis

x
x
x
x
x
x
x
x

x
x

Cash is the most important asset to any entity

Many firms have had positive profit figures, but have still run out of
cash and gone bankrupt
Important for present and potential investors and creditors to have info
about a firms cash inflows and outflows and its resulting cash position
Solvency the ability of a firm to meet all its debts and obligations as
they are due
Liquidity enough cash and short term assets now to recover its
immediate debts and obligations
Too much cash large supply of cash idle does not yield great
returns for investors
Cash should be put to work by making investments and attract new
customers
Statement of cash flow provides info on a firms generation and use of
cash and highly liquid short-term assets, hence assist in evaluating the
firms financial viability
Cash profit is not a complete measure of what has happened to the cash
Certain inflows or outflows of cash are not part of the process to
generate revenue and incurring expenses, so they would not be covered
even by a cash profit measure
Purpose of cash flow analysis:
- produce measure of performance that is based on day-to-day cash
flow: cash generated by ordinary business activities, instead of
accrual accounting different perspective on performance and
therefore enhances the info for users
- incorporate other non-operating cash inflows and outflows, such as
from investing in new assets, selling old ones, borrowing or repaying
debts. By including these non-operating cash flows, the statement of
cash flows can provide a complete description of how the firms cash
was managed during the period.
With all this info, the user can evaluate managements strategy for
managing cash and make a better judgement of the companys liquidity,
solvency, risk and opportunities than could be made just from the
balance sheet and income statement

ACCT1501 Notes
13.2 Overview of the Statement of Cashflows

Classification of Cash Flow Transactions

x
x

Operating activities relate to provision of goods and services

Investing activities relate to the acquisition and disposal of
noncurrent assets, including property, plant, equipment and other
productive assets, and investments such as securities, that do not
fall within the definition of cash
Financing activities relate to changing the size and
composition of the financial structure of the entity, including
equity, and borrowings not falling within the definition of cash

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ACCT1501 Notes

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Some important features of this format:

1. Same period as income statement
2. Include some equivalents: very liquid near cash assets
3. Cash may include temporary negative bank balances (overdrafts)
4. Uncertainty explained in the notes to financial statements
5. Focus must stay on cash
6. Transactions without cash are not included
7. Any numbers can be positive or negative
8. Deriving cash flow Aust = direct method (start from cash receipts to
cash payments). Some other countries = indirect method (start with
accrual net profit, then remove effects on profit of non-cash expenses
and revenues)

ACCT1501 Notes

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Chapter 14 Financial Statement Analysis

14.1 Investment and Relative Return
x Relative return (return on investment / ROI) = Return
Investmen
t
x Main points about ratios:
- Purpose: produce a scale free (because its dependent on same
units and size of company), relative measure of a company that can
be used to compare with other companies, or other years for the
company
- Ratio
may
be
unreliable
and
misleading,
if
numerator/denominator is inappropriate. Return can imply
EBIT, net profit or cash flow
14.2 Introduction to Financial Statement Analysis
x

Purpose of financial statement analysis: use statements to

evaluate an enterprises financial performance and financial
position
Value of the analysis depends on the value of the financial statements

Financial Evaluation is not just a calculation

x

x
x
x
x

Not just a calculation it is a judgement based on the calculations that

make sense for that company and based on substantial knowledge of
the company
The more info knew about business, mgmt and acct, the more
useful and credible the analysis
Affected by its own quality whether the statements have been
carefully prepared and are comparable with other companies
Affected by availability of other sources of info that may contain all or
part of what is in the financial statements
Financial acct info is a part of a network of info, not a stand-alone item.

Preparation for intelligent analysis

x
x

Requires aim and substantial knowledge of the enterprise

Scale free ratios means that it allows comparisons over certain periods
of time, among companies of different sizes and with other indicators
such as interest rates or share prices
In order to do an intelligent and useful financial statement analysis:

4. Learn about the enterprise, its circumstances and its plans look at
descriptive sections of annual reports and footnotes to financial
statements
5. Obtain a clear understanding of the decision or evaluation to which
the analysis will contribute, who the decision maker (investor,
lender, creditor, management) is and what assistance is required
6. Calculate the ratios, trends and other figures that apply to the problem
7. Find whatever comparative info you can to provide a frame of
reference for your analysis industry data, reports by other analysts,
etc.

ACCT1501 Notes

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x
x
x
x

8. Focus on the analytical results that are most significant to the decision
makers circumstances, and integrate and organise the analysis so
that it will be of most help to the decision maker.
The preparer of financial statements can choose between a
number of accounting policies on which to base the financial
information
May want to review such policies, e.g. deducing goodwill from assets,
before computing ratios
Validity of financial analysis based on accounting rations has been
challenged
HISTORICAL DATA
Stock markets and other capital markets adjust prices of companies
securities as info comes out, ratios based on publicly available info
cannot tell people anything the markets have not already incorporated
into security prices.

14.3 Common Size Statements

x
x
x
x

Whilst focus on chapter is ratio analysis, another method to analyse

financial statements is common size statements
By calculating all balance sheet figures as a percentage of total assets
and all income statement figures as a percentage of total sales revenue
Sizes of companies is factored out
This procedure assists in comparing companies of different sizes and in
spotting trends over time for a single company

14.5 Financial Statement Ratio Analysis

x
x
x
x

Ratios are usually done to 2 decimals

They could be done to more decimals, but that would be false accuracy
This is because ratios depend on all sorts of judgements and estimates
made in assembling the financial statements
There should not be thought of as precise quantities but rather as
indicators

Profitability Ratios
x Return on equity (ROE) =
x

Operating profit after

tax

shareholders equity
Indicates how much return the company is generating on the
historically accumulated shareholders investment

There are different versions of ratio e.g. instead of closing year-end

equity, Woolworths uses average equity

ACCT1501 Notes

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Return on assets (ROA) =

Operating profit after

tax

total assets
Determines the after tax return the managers are earning on the assets
under
their control
x

Alternative ROA =

EBIT

total assets
Determines the return on assets under managements control
x
x
x
x
x

x
x
x

Total assets can be year-end figure, or the average over the year
Denominator can also be gross assets (Assets before depreciation) and
net assets
Increase in ROA means that company has a better return on assets under
their control
Du Pont Formula: ROE = ROA x Leverage
Leverage =
Total Assets
Total Shareholders
Equity
Indicates how much of the companys assets are financed by equity
The higher the ratio, the smaller the shareholders funding of assets, the
greater the proportion of total assets that must have been funded by debt
Return on assets indicates the companys ability to generate a return
on its assets before considering the cost of financing those assets
Helps judging whether borrowing is worthwhile

x Profit Margin =

Operating profit after

tax

x
x

Sales
Measures performance of managers in converting sales to net profit
Average profit on each dollar of sales
Useful indication of pricing strategy or competition intensity

Alternative Profit Margin =

EBIT

Sales
Measures the ability of mangers to generate profit from
sales
x

Gross Margin =

Sales COGS
Sales

Indicates whether sales are profitable

Also known as gross profit ratio

x
x
x

Further indication of companys product pricing and product mix

If Gross Margin = 33%, then revenue = 150% of cost, so mark up of 50%
Increase in profit margin either due to increase in gross margin or
decrease in expenses as a percentage of total sales

ACCT1501
Notes

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x Cash flow to total Assets =

x
x

Total Assets
Determines the companys ability to generate cash
resources relative to companys size
Approximately factors out size
Alternative measure of ROA, focusing on cash returns rather than accrual
profit

x Earnings per share (EPS)=

preference dividends

x
x
x

x
x

Operating profit after tax

Weighted no. of ordinary shares

outstanding
Relates earnings attributable to ordinary shares to the number of shares
issued
Profit figure is after deducting outside equity in the operating profit
Weighted no. of ordinary shares outstanding should be provided
should not be calculated by outsiders
If company has commitment to issue more shares, potential
effect of the exercise of such commitments is calculated by
showing both basic EPS and diluted EPS
Dilution refers to the potential of lowering returns to current
shareholders as a result of other peoples exercising rights

x Price to earnings ratio (P/E) =

Cash flow from operations

Current market price per

share

EPS
Relates to the accounting earnings to the market price per
share to reflect present company performance with market
expectations
Since relationship between such earnings and market price of
shares is not straightforward, interpretation is controversial
Idea is that because market price should reflect the markets
expectation of future performance, P/E compares the present
info with those performances
High P/E means that company will do better in the future
e.g. popular companies with good share prices
P/E is highly subject to general increases and decreases in market
prices, so it is difficult to interpret overtime and is more useful to

compare similar companies listed in the same stock market at the

same time
x

x
x

Dividend Payout Ratio =Annual dividends declared per share

EPS
Measures the portion of earnings paid to shareholders
Stable ratio company has a policy of paying dividends based on profits
Variable ratio factors other than profits are important in the
directors decisions to declare dividents

ACCT1501
Notes

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Activity (Turnover Ratios)

x Total Asset Turnover =

x
x
x
x
x

x
x
x

Sales
Total Assets
Determines the amount of sales volume associated with each dollar of
assets
Similar turnover ratios relate the companys sales volume to its size
Turnover and profit/margin ratios are used together, because they
tend to move in opposite directions
High Turnover = Low margins and vice versa
Pricing low and trying for high volume versus pricing high and high profit
This is because competitive pressures are likely to force down
selling prices and therefore profit margins if a high turnover is
desired
Represent contrary marketing strategies or competitive pressures
How much revenue is the company getting out of each dollar of assets?
ROA = profit margin x Asset Turnover

x Inventory Turnover =

COGS
Average Inventory
Relates the level of inventory to the volume of sales activity
x A company with low turnover may be risking deteriorating level
of inventories and or may be incurring excessive storage and
insurance costs
x Inventory turnover can be converted to measure how long inventory in
days,
inventory is held on average
x Days in inventory = 365 Inventory
turnove
r
Measures how long on average, inventory is held in stock

x Debtors Turnover =

Credit Sales

Trade Debtors
Relates the level of debtors to the volume of credit sales activity

Also called accounts receivable turnover

Credit sales may be hard to find as sales is one section
Trade debtors refers to gross trade debtors (before deducting allowance
for
doubtful debts)
x Days in debtors =
365
Debtors turnover
x
x
x

Measures how long it takes on average, to collect outstanding debtors

ACCT1501
Notes

Cheryl
Mew

Liquidity Ratios
x Current Ratio =

x
x
x
x
x
x

x
x
x
x

Current Assets

Current Liabilities
Indicates whether the company has enough short term assets
to cover short term debts
>1 working capital +ve, <1 working capital ve
Working capital = current assets current liabilities
Usually, high CR = financial stability
But if CR is too high, it implies that the firm is not
reinvesting in LT assets to maintain future productivity
Also indicate problems if inventories are getting larger than
they should or collections of receivables are slowing down
Static ratio measuring financial position at a point in time and not
considering any future cash flows the company may be able to
generate to pay its debts
Most useful for companies that have relatively smooth cash flows
Hardest to interpret for those who have unusual assets or liabilities,
or depend on future cash flows to pay current debts
Low current ratio is common for large companies quick cash flow cycle
In general, can buy inventory, sell it and get cash before they have
to pay their accounts payable

x Quick Ratio =

x
x
x

Cash +AR + Short Term Investments

Current Liabilities
Indicates whether current liabilities can be paid immediately
Also called the acid test
Includes all assets except inventory
Ratio is particularly useful for companies that cannot sell inventory
quickly

x Interest Coverage Ratio =

EBIT
Interest
Expense
Indicates the ability of the company to pay interest on borrowings from
profit
This and similar coverage ratios based on cash flow figures
indicate the degree to which financial commitments are covered
by the companys ability to generate profit or cash flow

Low coverage level (especially less than 1) means that

company is not operating at a sufficiently profitable level to
cover the interest obligation comfortably, and may also be a
warning of solvency problems

ACCT1501
Notes

Cheryl
Mew

Financial Structure Ratios

x Debt to Equity Ratio =

x
x
x
x

Total Liabilities

Total Shareholders Equity

Measures the proportion of borrowings to the investment by owners
Includes retained profits
Ratio greater than 1 means that liabilities are mostly financed with debt
Ratio less than 1 indicates that liabilities are mostly financed with equity
High ratio = warning about risk: company is heavily in debt
relative to its equity and may be vulnerable to interest rate
increases

x Debt to Assets Ratio =

Total Assets
Total Liabilities
Indicates the proportion of assets financed by liabilities
Ratio highly correlated with debt to equity ratio

x Leverage =

Total Assets
Total Shareholders
Equity
Indicates how much of the companys assets are financed by equity
The higher the ratio, the smaller the proportion of total
assets funded by shareholders equity, and therefore, the
more funded by debt

Summary
x

x
x

Ratios are a quick method of breaking info in the financial

statement into a form that allows comparability with similar
companies and with the financial performance of the company over
a number of years
Advantage: different ratios consider different parts of a
companys performance
User do NOT only rely on ratios also on notes to the
financial statements, auditors report, etc

Notes to the financial statements provide further explanations of

some key areas in the statements, e.g. accounting policies, detailed
calculation of some account values, etc