Accounting is the process of identifying, measuring and communicating entity’s activities, Income must be inflows or enhancements of economic activities,
onomic activities, Net cash flows from financing activities, Total net cash flow, Ending
economic information about an entity to a variety of users for decision making
purposes. Financial accounting is the preparation and presentation of
financial statements to allow users to make economic decisions about the
entity. Financial Statements are a set of statements directed towards the
common information needs of a wide range of users (both internal and
external). Management accounting is about preparing internal reports and is
not regulated by rules like financial accounting. Management accounting
reports are prepared to suit the needs of management, and so can provide
any level of
detail required.
Management
accounting also
considers the
various parts of
the entity rather
than just the
overall entity as
in financial accounting. Asset: A resource controlled by the entity as a result of
past events and from which future economic benefits are expected to flow to
the entity. Liability: A present obligation of the entity arising from past events,
the settlement of which is expected to result in an outflow from the entity of
resources embodying economic benefits. Equity: The residual interest in the
assets of the entity after all its liabilities have been deducted. Income: Inflows
or other enhancements of assets, or decreases in liabilities that result in an
increase in equity other than those relating to contributions by equity
participants. Expenses: Decreases in economic benefits in the from of
outflows or depletions of assets or incurrence of liabilities that result in a
decrease in equity other than those relating to distributions from equity
participants. Balance sheet is a financial statement that details the entity’s
assets, liabilities and equity as at a particular point in time-the end of the
reporting period. Control(A): legal ownership, capacity to benefit from asset &
to deny or regulate access of others to the benefit. Past event(A): existence of
a past event resulting in entity controlling asset eg exchange transaction,
transfer. Future economic benefits(A): refers to service potential.
Probable(A): more than likely that the future economic benefits will flow from
the asset to the business controlling it. Reliably Measured(A): the value of the
asset can be measured reliably, involves the use of estimates. Present
obligation(L): legal contractual obligation, set of facts create expectation to
other parties entity will satisfy obligation. Past event(L): event resulting on
future sacrifice of economic benefits must have occurred. Outflow of
resources(L): future sacrifices of economic benefits with adverse financial
consequences for entity. Probable(L): It is more than likely that the future
economic benefits will flow from the business to another entity. Reliably
Measured(L): The value of the liability can be measured reliably, involves the
use of estimates. Current (up to 1 year): If the economic benefits (of asset) or
outflow of resources (for liability) are expected to be realised in the next
reporting period. Non-current (more than 1 year): If economic benefits (of
asset) or outflow of resources (of liability) are expected beyond next the
reporting period. Share capital: Paid-up share capital, contributed capital.
Retained earnings: Cumulative profits that have not been distributed.
Reserves: A component of equity that takes many forms. Carrying amounts
or book values: The dollar value assigned to assets and liabilities. Fair value
is defined as the price that would be received to sell an asset or paid to transfer
a liability in an orderly transaction between market participants at the
measurement date. Allowance for doubtful debits: the amount owing must
be reduced by the amount expected to be uncollectable using an account.
Depreciation is the allocation of the depreciable amount of the life of the asset.
Goodwill is an intangible asset associated with the purchase of one company
by another, specifically, goodwill is recorded in a situation in which the
purchase price is higher than the sum of the fair value of all identifiable tangible
and intangible assets purchased in the acquisition and the liabilities assumed in
the process. Intangible assets are those that are non-physical, but identifiable,
things that one can touch, exactly, but it is possible to estimate their value to
the enterprise. Intangible assets can be bought and sold independently of the
business itself. Financial instruments are assets that can be traded, or they
can also be seen as packages of capital that may be traded. Income
statement: A statement that reports on the income and expenses of an entity
for a period, and the resulting profit or loss, reflects the accounting return for an
entity over a specified time period. Revenue is a subset of Income, arising in
the ordinary course of activities. Reporting period (accounting period):
Period of time to which the financial statements relate, based on the accounting
assumption that the economic life of an entity can be divided into discrete
periods of time for reporting purposes. Accrual accounting is a system in
which transactions and events are recorded in the periods they occur, rather
than in the periods the cash is received or paid. Cash accounting: system
would determine profit or loss as the difference between the cash received in
relation to income items and the cash paid for expenses. Accrued income:
Amounts not yet received for goods or services that have been provided.
Income received in advance: Amounts received from customers and
recognised as liabilities until the services are performed or the goods are
provided. Accrued expenses: Amounts not yet paid for economic benefits
used or consumed. Prepaid expenses (prepayments): Amounts paid in cash
and recorded as assets until the economic benefits are used or consumed.
Accounting policies: The rules and practices, having substantial authoritative
backing, that are recognised as a general guide for financial reporting. Income:
Recall that income comprises both revenue and gains, with revenue arising in
the ordinary course of an entity’s activities, gains also represent increases in
economic benefits, but they may or may not arise in the ordinary course of an
Average total assets). Days inventory: Measure of asset efficiency calculated
benefits that increase assets or reduce liabilities. Expense: Decreases in
economic benefits
during the
accounting period
in the form of
outflows or
depletions of assets
or incurrence of
liabilities that result
in decreases in
equity, other than those relating to distributions to equity participants. Cost of
sales expense is the main expense incurred by an entity-in order to sell goods
and generate income, the entity must purchase goods for resale, the total cost
of inventory sold during the period. In a periodic inventory system, it is
determined by opening inventory plus purchases less ending inventory.
Depreciation (amortisation) is the systematic allocation of the cost of a
tangible (intangible) asset over its useful life, it does NOT represent the loss in
the asset’s value during the reporting period, it does NOT involve cash flows.
Depreciation: The allocation of the depreciable amount of a depreciable asset
over its estimated useful life. Amortisation: The allocation of the cost of an
intangible asset over its estimated useful life. Other comprehensive income:
refers to all changes in equity during the reporting period other than those
resulting from transactions with owners as owners (such as dividends and
capital contributions) i.e. income and expenses taken directly to equity instead
of recognised as a profit or loss. Examples of Other comprehensive income:
non-current asset revaluations directly taken to a revaluation reserve; net
exchange differences associated with translating foreign currency
denominated; accounts of a subsidiary into the reporting currency of the
group adjustments to equity allowed pursuant to the operation of a new
accounting standard. Gross profit: The excess of net sales revenue over the
cost of sales. Earnings before interest and taxation (EBIT): The profit before
net interest and taxation expense. Net finance costs: Interest income less
interest expense (including finance lease charges). Which basis of
accounting you think is more useful for decision making: The accrual
basis of accounting is more useful for decision making since it recognises
income and expenses when they occur, rather than when cash has been paid
or received. Cash accounting is not satisfactory for measuring performance
during a reporting period as the cash received (paid) may not correspond to the
income earned (expenses incurred). Reviewing both the performance as
reflected in the income statement and an entity’s cash flows from operating
activities will provide the most useful information for users. Earnings before
interest, tax, depreciation and amortisation (EBITDA): The profit before
interest, taxation and depreciation/amortisation expense. Pro forma earnings:
Earnings that are not in accordance with GAAP earning, unusual items
(particularly expense items) tend to be excluded in the calculation of pro forma
earnings. Cash flow statement is a financial statement that provides
aggregate data regarding all cash inflows a company receives from its ongoing
operations and external investment sources. It also includes all cash outflows
that pay for business activities and investments during a given period. Working
Capital=difference between current assets and current liabilities. The income
statement and statement of comprehensive income-which show the results
of an entity’s performance for the reporting period. The balance sheet-which
shows the entity’s financial position at a particular point in time. The statement
of changes in equity-which shows the change in an entity’s equity between
two reporting periods. The statement of cash flows-which shows the entity’s
cash inflows, outflows and net cash flow for the reporting period. Note: The
income statement summarised the entity’s income and expense transactions
but did not identify the flow of funds relating to those transactions; and a
comparison of successive balance sheets would show the change in cash
position from one point in time to another, but would not expose the cash flows
associated with that change. Together the income statement and balance
sheet (based on accrual accounting) and the cash flow statement provide users
with information on an entity’s: Profitability, Liquidity, Solvency. Operating
activities-day to day activities including receipts and payments, included:
Receipts from customers, Payments to suppliers and employees, Other cash
payments expenses and receipts for income (Dividend received, Interest and
bill discounts received, Income taxes paid). Use sales and comparative
accounts receivable account balances: Cash from customers = Opening
accounts receivable + Sales - Closing accounts receivable. Payment to
suppliers for inventory: Cash paid to suppliers = Opening accounts payable
+ Purchases - Closing accounts payable. Payment to other suppliers: Cash
paid to other suppliers = Other expenses +/- Increase(decrease) in
prepayments +/- Increase(decrease) in accruals. Investing activities-activities
which relate to the acquisition and/or disposal of non-current assets, and
investments, (e.g. securities), that do not fall within the definition of cash,
included: Proceeds from repayment of related party loans, Payments for plant
and equipment, Proceeds from sale of plant and equipment, Payments for
businesses. Financing activities-activities which relate to changing the size
and/or composition of the financial structure of the entity (e.g. equity, and
borrowings that do not fall within the definition of cash), included: Proceeds
from issue of shares, Proceeds from borrowing, Repayment of borrowings,
Dividends paid. Direct method: discloses major classes of: gross cash
receipts, gross cash payments. Indirect method: adjusts profit and loss for:
effects of transactions of non-cash nature, deferrals or accruals of operating
revenue and expenses. The statement of cash flows can be prepared by:
analysing cash receipts and payments or evaluating income statement and
balance sheet. Presentation of the statement of cash flows: Beginning cash
balance, Net cash flows from operating activities, Net cash flows from investing
cash balance. Evaluating the income statement and the balance sheet:
Direct cash flow investment the same indirect cash flow investment, Direct cash
flow financing the same indirect cash flow financing, Direct cash flow operating
not the same indirect cash flow operating. First step is to determine the cash
flows from operating activities: Calculate receipts from customers, Calculate
payments to suppliers and employees, Calculate other payments for expenses
and receipts from income. Second step is to determine the cash flows from
investing activities: Proceeds from repayment of related party loans,
Payments for plant and equipment, Proceeds from sale of plant and equipment,
Payments for businesses. Third step is to determine cash flows from
financing activities: Proceeds from issue of shares, Proceeds from borrowing,
Repayment of borrowings, Dividends paid. Last step is to Calculate net cash
flows and ending cash balance for the year (direct method) or Reconcile
cash from operating activities with operating profit (indirect method).
Profit or loss after tax = Non-cash expenses +/- Changes in non-current
assets and liabilities. Cash adequacy ratio: Shows entity’s ability to
reinvest in operations and make distributions to owners (A ratio > 1 over
several years suggests good performance); Cash adequacy ratio = (Cash
from operating activities) / (Capital expenditure + Dividends paid). Cash flow
ratio: Compares cash flow from operating activities with current liabilities to
assess liquidity (provides the link to short-term liabilities); Cash flow ratio =
(Cash from operating activities) / (Current liabilities). Debt coverage ratio:
Measures a firm’s ability to survive in the longer term and remain solvent (links
cash flows from operating activities with long-term debt); Debt coverage ratio
= (Non-current liabilities) / (Cash from operating activities). Cash flow to sales
ratio: Measures the relative amount of cash flow generated by sales and helps
to assess profitability; Cash flow to sales ratio = (Cash from operating
activities) / (Net sales). Free cash flow: Represents the free cash an entity has
available to repay debt, pay dividends and expand operations; Free cash flow
= (Cash from operating activities) - (Capital investments for PPE to maintain
existing operations). Horizontal analysis: Compares reported numbers in
different reporting periods to highlight magnitude and significance of changes.
Dollar change = (Accounting number in current reporting period) – (Accounting
number in previous reporting period). Percentage change = ((Accounting
number in current reporting period – Accounting number in previous reporting
period) / Accounting number previous reporting period) x 100 (cannot be
calculated if the equivalent reported figure for the previous year was zero).
Trend analysis: A method of examining changes, movements and patterns in
data over a number of time periods, identifying trends is useful in formulating
predictions as to the future prospects of the entity (Devide with the base year).
Vertical analysis: of the financial statements identifies the importance of an
item relative to the anchor item, involves comparing the items in a financial
statement to an anchor item in the same financial statement. Ratio analysis:
An examination of the relationship between two quantitative amounts with the
objective of expressing the relationship in ratio or percentage form, An
expression of one item in the financial statements as another item in the
financial statements – one item is divided by another to create the ratio. Flow
item: An item reported in the financial statements that is generated over a
period of time. Stock item: An item reported in the financial statements as at a
point in time. Ratio analysis is a 3-step process: Calculate a meaningful ratio
by expressing $ amt of an item by $ amount of another item, Compare the ratio
with a benchmark, Interpret the ratio and seek to explain why it differs (from
previous years, from comparative entities or from industry averages).
Profitability ratios: Measure of the profit relative to the resources available to
generate the profit. Efficiency ratios: The sales generated per dollar invested
in assets. Liquidity ratios: Measure of the short-term ability of the entity to pay
its maturing obligations and to meet unexpected needs for cash. Market
performance ratios (market test ratios): Ratios that generally relate the
entity’s financial numbers to the entity’s share price. Benchmarks: the entity’s
ratios over time (identify trends), the entity’s ratios with those of other entities in
same industry (intra-industry analysis), the entity’s ratios with industry
averages, the entity’s ratios with those of entities operating in different
industries (inter-industry analysis), the entity’s ratios with arbitrary standards
e.g. targets. Return on equity (ROE): Measure of profit earned for each dollar
invested by the owners, calculated as profit available to ordinary shareholders
divided by average ordinary shareholders’ equity. ROE = (Net profit / Average
owners’ equity) x 100. Return on assets (ROA): Measure of profitability,
calculated as profit divided by average total assets (to convert sales revenue
into profit, to generate income from its asset investments). ROA = (EBIT /
Average assets) x 100. Gross profit margin: Measure of profitability
calculated as gross profit divided by sales revenue, ratios that relate profit to
sales revenue generated by the entity include the gross profit margin and the
profit margin (Entities with high (low) turnover tend to have smaller (larger)
gross margins). Gross profit margin = (Gross profit / Sales revenue) x 100.
Profit margin: Measure of profitability calculated as profit divided by sales
revenue. Expense ratio: A measure of profitability calculated as expenses
divided by sales revenue. Profit margin = (EBIT / Sales revenue) x 100.
Cash flow to sales ratio: Measure of profitability calculated as cash from
operating activities divided by sales revenue, this ratio measures the relative
amount of cash flow generated by each sales revenue dollar. Cash flow to
sales ratio = (Net cash flow from operating activities / Sales revenue) x 100.
Asset efficiency ratios: Measures of the efficiency with which an entity
manages its current and non-current investments, and converts its investment
decisions into sales dollars. Asset turnover ratio Measure of asset efficiency
calculated as sales revenue divided by average total assets, Shows an
entity’s overall efficiency in generating income per dollar of investments in
assets, Value will depend on the efficiency with which it manages its current
and non-current investments. Asset turnover ratio = (Sales revenue /
as the average inventory balance divided by cost of sales and multiplied by 365
days, indicates the average period of time it takes to sell inventory. Days
inventory = (Average inventory / Cost of sales) x 365. Days debtors: Measure
of asset efficiency calculated by dividing the average trade debtors balance by
sales revenue and multiplying by 365 days, indicates average period of time it
takes to collect the money from its trade related. Days debtors = (Average
accounts receivable / Sales revenue) x 365. Times inventory turnover = Cost
of sales / Average inventory. Times debtors turnover = Sales revenue /
Average accounts receivable. Activity cycle (operating cycle): The length of
time it takes for an entity to acquire goods, sell them to customers and collect
the cash from the sale. Cash cycle: The period of time that elapses between
paying for the inventory, selling the inventory and receiving cash for the
inventory. Cash cycle = Days inventory + Days debtors – Days creditors.
Liquidity: is the
ability of an entity to
meet its short-term
financial
commitments
(obligations that are
expected to become
due within the next year or operating cycle). Working capital: Difference
between current assets and current liabilities. Current ratio (working capital
ratio): Measure of liquidity calculated by dividing current assets by current
liabilities, indicates $ of current assets per $ of current liabilities. Current ratio
= Current assets / Current liabilities. Quick asset ratio (or acid test ratio):
measures $ of current assets available (excluding inventory) to service each $
of current liabilities. Quick asset ratio = (Current assets – inventory) / Current
liabilities. Difference between the current and quick asset ratios will be
significant for manufacturing and retail entities with large inventory holdings,
but insignificant for entities that are in service-related industries. Debt ratio
(Solvency): indicates how many dollars of liabilities exist per dollar of assets. If
ratio >50% then the entity finances its investments in assets by relying more on
debt relative to equity. If the debt ratio is <50% then the entity finances more of
its assets with equity than with debt. Debt ratio (solvency) = (Total liabilities /
Total assets) x 100. Debt to equity ratio (Solvency): indicates how many
dollars of debt exist per dollar of equity financing. If ratio >100% then the entity
is more reliant on debt funding than equity funding. Debt to equity ratio
(solvency) = (Total liabilities / Total equity) x 100. Equity ratio; suggests the
dollars of equity per dollar of assets. If ratio <50%, then the entity is more
reliant on debt funding than equity funding. Equity ratio = (Total equity / Total
assets) x 100. Interest coverage ratio (times interest earned): Capital
structure measure calculated as EBIT divided by net finance costs, This ratio
measures the number of times an entity’s existing EBIT covers the entity’s net
finance costs, It indicates the level of comfort that an entity has in meeting
interest commitments from earnings. Interest coverage ratio = EBIT / Net
finance costs (Interest expense – interest income = net finance costs). Debt
coverage ratio: Capital structure measure calculated as non-current liabilities
divided by cash from operating activities, It is also a measure of an entity’s
ability to survive in the longer term and remain solvent, as it indicates how long
it will take to repay the existing long-term debt commitments at the current
operating level. Debt coverage ratio = Non-current liabilities / Net cash flows
provided by operating activities. Net tangible asset backing (NTAB) per
share Market performance ratio measured as tangible assets divided by the
number of issued shares, Provides an indication of the book value of the
entity’s tangible assets (as reported in the balance sheet) per ordinary share on
issue, Intangible assets, such as goodwill, are excluded from calculation due to
their lack of identifiability. Net tangible asset backing per share = (Ordinary
shareholders’ equity – Intangible assets) / No. of ordinary shares on issue at
year-end. Earnings per share (EPS) is the entity’s profit expressed relative to
the no. of ordinary shares on issue. Companies seek to achieve growth in
earnings per share, as this signals to the mkt the company’s earning ability.
Companies are required to disclose their EPS at the bottom of their Income
Statement. Earnings per share (EPS) (very common) = Net profit / Weighted
no. of ordinary shares on issue. Operating cash flow per share (CFPS): can
be calculated. This reflects net cash flows from operating activities that are
available to pay dividends to shareholders and fund future investments. The
difference in the EPS and CFPS highlights differences that arise from preparing
accounts on an accrual rather than a cash basis. Operating cash flow per
share (CFPS) = (Net cash flows from operating activities – Preference
dividends) / Weighted no. of ordinary shares on issue. Dividend per share
(DPS): is the former measure of return, and indicates the distribution of the
company’s profits in the reporting period via dividends expressed relative to the
number of ordinary shares on issue. Dividend per share (DPS) = Dividends
paid to ordinary shareholders in current period / Weighted no. of ordinary
shares on issue. Share capital = ordinary shares + preference shares. Price
earnings ratio
(PER): A
market value
indicator that
reflects the
number of
years of
earnings that
investors are
prepared to
pay to acquire
a share at its
current market
price (PE ratios fluctuate as share prices change). Price earnings ratio =
Current market price / Earnings per share. Across Time: A ratio from two
years. The method – DES: Describe the change: In the previous year the ratio
was... This year the ratio is...; Explain the change: The numerator moved at
greater rate than the denominator (or vice-versa). Limitations of ratio
analysis: Limitations of the analytical process need to be considered when
interpreting and relying on the ratios to form an opinion as to a firm’s financial
health, both past and present, Limitations relate to the nature of the financial
statements and the data disclosed (or not disclosed), while others are inherent
in the nature of the financial ratios themselves, Ratio analysis is only one
financial analysis tool, Comprehensive and effective financial analysis
considers information beyond financial reported numbers, Non-financial
considerations, such as environmental performance, are also taken into
consideration by users when assessing an entity’s performance.
The Conceptual Framework defines a liability as ‘a present obligation of the entity
arising from past events, the settlement of which is expected to result in an outflow
from the entity of resources embodying economic benefits’. In order to be
classified as a liability, the frequent flyer program must satisfy the definition criteria of a
liability being:
 present obligation
As Velocity members accumulate frequent flyers points, there is a present
obligation for Virgin to provide free (or cheaper) flights or other rewards to
members when frequent flyer points are redeemed.
 past events
The present obligation of providing rewards to frequent flyer members arises
as a result of past events, being the airline flights or other associated products
or services acquired/used by Velocity members. For mileage of travel with
partner airlines or dollars spent on associated products/services, members will
receive frequent flyer points which then can be exchanged or redeemed for
rewards.
 outflows of future economic benefits
Upon redemption of frequent flyer points, sacrifices of future economic benefits
are expected to occur to Virgin in the form of provision of flights or other
products and services to the Velocity members.
Since the frequent flyer program satisfies the definition of liability, it is then
classified as a liability for Virgin. However, in order for the frequent flyer
program to be recorded in Virgin’s balance sheet, it must also satisfy the
recognition criteria:
 probable occurrence
It is probable (more likely than less likely) that the outflows of economic
benefits will occur, since Velocity members have accumulated frequent flyer
points from airline ticket purchase and it is expected that they will redeem the
points sometimes in the future.
 reliable measurement
The value for frequent flyer points can be calculated with reliability based on to the items in the income statement. What is meant by the term ‘cash’: According to
management’s estimate of the fair value of the expected awards for which the AASB 107 Statement of cash flows, the definition of cash includes cash on hand and
points will be redeemed. Historical data on frequent flyer redemptions are used cash equivalents. Cash on hand is all the notes and coins held, and deposits at
to determine the liability to record on the balance sheet. financial institutions. Cash Equivalents are highly liquid investments and borrowings
In conclusion, Virgin Australia has a liability to record in relation to its frequent flyer that are part of cash management and not subject to a term facility. Highly liquid
program as it satisfies both definition and recognition criteria in the Conceptual investments means those that have short terms to maturity, are readily converted to
Framework. Discuss the difference between profit or loss and comprehensive cash at the investors’ option, and have a low risk of changing in value. Outline some
income: Profit is a measure of accounting return and is determined as income less cash-flow warning signals: Some cash flow warning signals are: cash received less
expenses. The profit figure is not a measure of the change in entity value from the than cash paid, operating ‘outflow’, cash receipts from customers being less than cash
beginning to the end of the reporting period because not all value changes result in payments to suppliers and employees, cash from operating activities being lower then
income or expenses that are recognised in the income statement. For example, if the operating profit after tax, proceeds of share capital being used to finance operating
entity is fair valuing property, plant and equipment, any increment in value bypasses activities, consistent inflows from investing activities, proceeds from borrowings
the income statement and is directly credited to a revaluation reserve account. Other continually much greater than the repayment of borrowings. Explain the difference
comprehensive income, on the other hand, refers to items that result in changes in between cash accounting and accrual accounting for determining profit for a
equity and are required or permitted by accounting standards to be taken directly t reporting period. Provide an example of a transaction that would appear as a
equity rather than recognised in the income statement as part of profit or loss. revenue for a reporting period under accrual accounting that would not appear
Examples of such items are: revaluation of non-current assets; net exchange under cash accounting: The difference between cash and accrual accounting in
differences associated with translating foreign currency denominated accounts of a determining profit is that accrual accounting captures the income earned and expenses
subsidiary into the reporting currency of the group; and adjustments to equity allowed incurred for a period. Cash accounting captures the cash received and cash paid for
pursuant to the operation of a new accounting standard. Explain the three methods income and expense related items respectively; Students need to provide an example
of depreciation: Depreciation is the allocation of the cost of an asset over its useful life of a revenue under accrual accounting that is not a revenue under cash accounting.
and represents the future economic benefits of the depreciable assets that have Students are most likely to refer to revenue that has been earned but for which
contributed to earning income in the period. Depreciation reduces the value of the payment has not occurred. For example, selling goods on credit with payment due in
asset in the balance sheet and consequently decreases the equity during the reporting 30 days. Under accrual accounting, this will be recorded as revenue earned for the
period. The three methods of depreciation commonly used are: straight-line period, since revenue has been earned through the provision of goods or services to
depreciation. Annual depreciation: charge is calculated as cost less residual value customers. However, such transaction will not be recorded as revenue earned under
divided by the useful life of the asset. Hence, the annual depreciation charge for the cash accounting, until the payment is received. Explain if the following statements
asset is the same every year using this method of depreciation. Diminishing balance true or false for an entity using the accrual method of accounting: a. Income
depreciation: The diminishing balance depreciation method is based on the statements are used only by users external to the entity: False. Internal users such
assumption that the economic benefits of using the asset will decrease over its useful as management also need the income statement to assess the profitability of their
life. The depreciation charge under this method is calculated by applying a constant investment decisions and the appropriateness of their financing decisions. b. Revenue
percentage to the asset’s carrying amount at the start of each period. Consequently, from sales is included in the income statement when it is received, not when it is
the depreciation charge is higher in the asset’s earlier years relative to later years. earned: False. Since financial statements are prepared on the basis of accrual
Units of production depreciation: Using the units of production depreciation method, accounting rather than cash accounting, it is not necessary for cash to have been
the depreciation charge is calculated based on the activity or output in the reporting received for an item to be recognised as sales revenue. Under accrual accounting,
period relative to the asset’s total expected activity or output. That is, the depreciation revenue from sales is recognised when it is earned. c. At the end of the reporting
charge each year is a function of the total units produced by the asset each year period, accrued expenses need to be included in the profit or loss determination:
relative to the units to be produced during its useful life. Hence, the annual depreciation True. Based on the accrual basis of accounting, all expenses incurred in the reporting
charge will vary depending on the amount of units produced in a particular year. period are recognised in the income statement. Expenses incurred but unpaid at
Explain the difference between income and revenue: The definition of income balance date are included as an expense with a liability recognised in the balance
includes both revenue arising in the ordinary course of activities (e.g. sales, fees, sheet. d. At the end of the reporting period, revenue received for services not yet
dividends) and gains (e.g. gains on disposal of non-current assets). Therefore, revenue provided needs to be excluded from the profit or loss determination: True. Under
is a subset of income. Explain the difference between profit or loss, gross profit the accrual accounting, revenue should be recognised when the earning process is
and EBIT: The term ‘profit or loss’ refers to the residual (net) income remaining complete. If the services have not been rendered or provided, irrespective of the cash
after deducting all expenses incurred by an entity for the reporting period, being received, the earnings process is incomplete and the revenue should not be
including finance costs (i.e. interest expense) and income tax. Gross profit, on recognised in the current period.
the other hand, is the remaining revenue after deducting cost of sales.
Subsequently, gross profit is calculated as sales revenue less cost of sales.
Afterwards, all other expenses (such as wages, sales and administration,
interest, etc.) are deducted from gross profit to arrive at the entity’s profit or loss
for the period. EBIT (i.e. ‘Earnings Before Interest and Taxation’) refers to profit
before net interest and income tax expense. It is the relevant figure to analyse
returns associated with investment decisions only. To calculate EBIT, income
tax for the period is added to the entity’s profit to give profit before tax figure. If
the entity has net finance income (costs), then the net finance income (costs) is
deducted (added) from (to) profit before tax to give EBIT. Discuss the difference
between the statement of cash flows and the income statement: The income
statement and the statement of cash flows are both ‘flow’ accounts. The income
statement presents the accounting information based on accrual accounting (the
underlying transactions) while the statement of cash flows presents the accounting
information based on the actual inflows and outflows of cash. Outline the difference
between the direct method and the indirect method of reporting cash
flows. Why is it necessary to present the cash flows using both methods:
The direct method requires the statement of cash flows to show the separate
cash inflows and outflows from operating activities. The indirect method is a
reconciliation between cash flows from operating activities and operating profit
showing adjustments in non-cash transactions and in current assets and
liabilities. In Australia, the relevant accounting standard prescribes the direct method
to be used in the statement of cash flows, and the indirect method to be presented in a
note to the statement to ensure that users of financial statements have full information
regarding cash flow activities. Outline the difference between cash and accrual
bases of accounting: The recording of transactions to determine a profit or loss for a
period is based on accrual accounting. That is a matching of revenues and expenses.
Cash flow is concerned with when receipts are received and payments are made and
not the underlying transaction. Discuss three limitations of ratio analysis as a
fundamental analysis tool: Ratio analysis relies on financial numbers in financial
statements. Accordingly, the quality of the ratios calculated is dependent on the quality
of the entity’s financial statements. The quality may be affected by inadequate
disclosures and lack of details in financial statements and/or a firm’s accounting policy
choices and estimations; Many of the ratios that are calculated rely on the asset,
liability or equity numbers reported in the balance sheet. This statement reflects the
financial position of an ongoing entity at a particular date and may not be
representative of the financial position at other times of the year; Financial statements
are historical statements reflecting past transactions. Often, the past is a good guide to
the future; however, the use of information outside the financial statements also needs
to be considered when forming predictions as to an entity’s future financial health.
EBIT, rather than profit, is sometimes used as the numerator in the ROA. Discuss
the rationale for using EBIT rather than Profit: EBIT (Earnings Before Interest and
Taxes) measures an entity’s operating earnings before interest expense and income
taxes are paid. EBIT is sometimes used rather than profit as the numerator in the ROA
as EBIT focuses on the earnings from an entity’s operations relative to the investment
in assets used to generate those earnings, before taking into account interest and tax
expense. This gives a more comparable ROA ratio across entities, as EBIT ignores the
level of debts and tax rates which usually vary between entities. Profit, on the other
hand, incorporates the effect of interest and tax on operating earnings. Using profit as
numerator in the ROA might create bias in comparison as it results in lower ROA for
entities with higher borrowings and higher tax rates. It is asserted that using EBIT
better reflects the firm's return associated with investing decisions. Using profit reflects
the accounting return associated with financing and investing decisions. Assess how
each section in the statement of cash flows relate to the balance sheet: The cash
flows of investment activities relate to the non-current assets in the balance sheet. The
cash flows of financing activities relate to the non-current liabilities and the equity in the
balance sheet. The cash flows of operating activities relate to the current assets and
current liabilities in the balance sheet. The cash flows of operating activities also relate