ACCT1501 Notes

Topic 1: Introduction to financial accounting

Accounting: process of identifying, measuring and communicating economic information to allow informed decisions by the users of that information.

Management accounting: focuses on provision of info to users within the enterprise.

Financial performance – generating new resources from day-to-day operations over a period of time

Financial position – the enterprise’s set of financial resources and obligations at a point in time

Financial statements – the reports describing financial performance and position

– The two main things financial accounting measures are f performance and f position.

User Type of informationBankers Likelihood of company meeting its interest payment on time

Managers Profitability of each division of companyASIC Financial position and performance → issuing shares to public for 1st time

Shareholders

Prospects for future dividend payments

Suppliers Probability that company will be able to pay for its purchases on timeATO Profitability of company based on taxation laws

Trade unions Profitability of company since last contract with employees was signed

3 main groups responsible for information in financial statements: managers, bookkeepers and clerks and accountants.

The simplest method of accounting is to record cash when it is received or paid; termed cash accounting. Alternatively, under an accrual accounting system, revenues and expenses are recorded when they occur, not when the cash is received or paid.

E.g. In June, a company makes cash sales of $10,000 and credit sales of $20,000 (all to be collected in July). It pays wages of $6000 and owes $1000 for June expenses (to be paid in July).

1. What is profit using cash accounting? $10k - $6k = $4k

2. What is profit using accrual accounting? $10k + $20k - $6k - $1k = $23k

Using accrual accounting to prepare financial statements

Include all cash receipts and payments that have already happened Include future cash receipts and payments Measure the value of incomplete transactions e.g. a likely amount of accounts receivable

that won’t be collected – treat the amount as an expense of this year Estimate figures when exact amounts unknown e.g. the amount of interest due from the

bank at year-end – this amount is interest revenue Make an assessment of awkward problems e.g. a customer suing you $1m for a faulty

product, you agree to pay $200k in settlement now but they take the matter to court with the case to be held next year. You need to determine if there is an expense this year.

Balance sheet: shows the financial position at a point in time

- 3 main components: assets, liabilities and shareholder’s equity (if org. is a sole trader; proprietor’s equity OR partnership; partner’s equity).Assets: future economic benefits that are controlled by an organization as a result of past transaction or other past events.

The cash at bank account records deposits and withdrawals from the bank Accounts receivable is shown net, which indicates the amount that management

expects to collect from customers after allowances have been made for unlikely collectable circumstances

Inventory generally represents the cost of stock on hand; unsold products Property, plant and equipment i.e. land, equipment, furniture

Assets = Liabilities + Shareholder’s equityLiabilities: future sacrifices of economic benefits that an organization of presently obliged to make to other organizations/individuals as a result of past transactions or events.

I.e. accounts payable, wages payable, provision for employee entitlements, or long term loans (loans that aren’t repayable within a year.

Shareholder’s equity: excess of assets over liabilities. 1. Share capital – the amount that owners have directly invested in the company2. Retained profits – the total cumulative amounts of profits that the company has

retained in the business rather than distributed as dividends

1. What would be a likely explanation for the increase in accounts receivable? Most likely credit sales (increases acc. receivable) are relatively greater than cash received from customers

2. What does the no change in share capital mean? Normally that there have been no shares issued during the year.

- If the balances of total assets are $100 000 and shareholder’s equity is $40 000, what is the balance of total liabilities? 500 000 = 200 000 + 300 000

- Given the following balances – assets $300 000; liabilities $200 000; share capital $60 000 – what is the balance of retained profits? 300 000 = 200 000 + 60 000 (40 000)

Income statement: measures financial performance over a defined period by deducting expenses from revenues during the period to obtain profit for the period

- The difference between sales revenue and COGS = gross profit… deducting operating expenses from gross profit = operating profit before tax… tax is then deducted to give operating profit after tax

- The profit of 6000 000 can be paid out in dividends to shareholders or retained in the business… Companies provide a separate note to the accounts showing the change in retained profit for the year. Opening retained profits for the year = 24M:

Statement of cash flows: shows the sources and uses of cash during the period. Transactions are normally split into 3 categories:

1. operating activities: related to the provision of goods and services2. investing activities: related to the acquisition and disposal of noncurrent assets, including

property, plant and equipment3. financing activities: related to changing the size and composition of the financial structure of

the entity inc. equity and certain borrowings.

*Note that the figures are not the same as the income statement because cash only.

The company received 17M from customers; paid 7.7M to suppliers; paid 2.3M to employees; and paid 4.5M in other operating costs.

There was only one investing item 2.3M on a machine.

The company receive 4M from an issue of shares; paid back a 3.6M bank loan the net effect on cash was an increase of 600 000. When added to the opening balance of 1.4M, the closing balance is 2M.

Relationships between the financial statements:

The cash flow statement explains the change in cash in the balance sheet from $1400 to $2000. Net profits (6000) is shown in the income statement, this amount increases retained profits (24 000 27 000) due to net profit for the year minus dividends.

Demands on the quality of financial accounting information:

[1] Relevance: Financial statements need to contain info that is useful to those who are making decisions. + Timeliness: the need to provide the relevant info in enough time for the decision to be made [2] Reliability: should not be deliberately misleading, should be free from bias. [3] Materiality: concerned with assessing whether the omission, misstatement or non-disclosure of a piece of information would affect the decisions of the accounting reports. [4] GAAP (generally accepted accounting principles): standard against which an accounting method or number can be judged. [5] Prudence: if there is uncertainty (i.e. value of unsold inventory), assets, revenues and profit should not be overstated and liabilities, expenses and losses should not be understated. [6] Disclosure: disclosure beyond accounting figures i.e. notes or account descriptions to make it clear which accounting methods have been followed and to provide supplementary information on debts, law suits… [7] Understandability: reports should be prepared having regard to the interests of users [8] Comparability: allows to compare performance with other companies [9] Consistency: keeping the same accounting methods over time.

The Framework (put out by the Aust. Accounting Standards Board – AASB) says that these 4 qualitative characteristics are the attributes that make info in financial statements useful to users:

Understandability Relevance

– Materiality Reliability

– Faithful representation, substance over form (economic reality, not legal/technical), neutrality (free from bias), prudence (estimates in uncertain situations) and completeness (no omission of info).

Comparability

Financial statement assumptions:

1. Accounting entity assumption (e.g. private transactions of owners not accounted) Activities of the entity are separate from those of its members

2. Accounting period assumption Life of business is divided into discrete time periods of equal length to determine financial performance and position

3. Monetary assumption Money is the universally accepted medium of exchange4. Historical cost assumption transactions are initially recorded at their original cost e.g.

land purchased at 1995 at $50 000 and still owned will be reported on the balance sheet at its historical cost (50 000) even though market value may be $500 000.

5. Going concern assumption assumes continued operation of accounting entity into foreseeable future. There’s no intention/need to liquidate. It produces demand for financial information during life of entity.

Chapter 1: Practice problems

1. Asset – cash at bank, inventory; liability – accounts payable; revenue – sales; expense – wages, COGS; equity – share capital.

2. Income statementFor the year ending 30 June 2012 $Sales 210 000Cost of goods sold (70 000) Gross profit 140 000 Wages (40 000) Net profit 100 0003. Balance sheet As at 30 June 2012 Assets Liabilities and Shareholder’s Equity $ $Cash at bank 210 000 Accounts payable 30 000Inventory 60 000 Wages 40 000 270 000 Cost of goods sold 70 000 x wrong Share capital 140 000

280 000

1. Total sales – total expenses: 750k + 260k – 580k – 240k = 190k2. COGS: 3000 x 5 = (15 000) x 2000 x 5 (10 000) (cost of goods SOLD!!!) Sales revenue: 2000 x 8 = 16 000

A = L + OE // Assets – Liabilities = OEAssets (1.5m + 400k + 100k + 500k = 2.5m) - Liabilities (250k + 90k = 340k) = 2.16mPreparation questions:

1. Produce information to improve decision-making in allocating scarce resources.

2. Financial performance: generating new resources from day-to-day operations over a period of time. Financial position: the org.’s set of financial resources and obligations at a point in time.3. Managerial accounting is a branch of accounting that aims to help managers and others inside the enterprise. Financial accounting has a more external focus, and is often used by parties external to the enterprise i.e. shareholders, investors, bankers, legislators and employers etc.7. No. They’re all different people with differing objectives, preferences and capabilities.

[1] Profit for the period (revenue – expenses) and financial position; a strong balance sheet makes it easier for the CEO to carry out strategic initiatives e.g. new training facilities[2] Cash flow; as players depend on it. The higher the profit, the likelier to argue for pay increases.[3] Long term viability of the club from the balance sheet.[4] How many people are attending the game – likely to correlate with sales revenue.

1. A 2. L 3. E x 4. E 5. E 6. A

7. SE 8. L 9. A 10. A 11. E 12. R

3) Provision = Liability

Case 1A – Balance Sheet:

1. Trade and other receivables, trade and other payables, provisions, depreciation, amortization, prepayments, accruals, unearned revenue and not 1.2. Total assets at 26 June 2011 = 21,094.5 m3. Total liabilities at 26 June 2011 = 13,248.7m4. Shareholder’s equity at 26 June 2011 = 7,845.8 m5. Accounting equation in dollar figures at 26 June 2011 A = L + OE21,094.5m = 13,248.7m + 7,845.8 m6. Net profit before tax = 3,014.9 m (from income statement)7. Net profit after tax = 2,149 m (from income statement)8. Largest cash inflow relating to operating activities = 58,886.6 m (from cash flow statement)

Largest cash outflow relating to operating activities = 54,797 m (from cash flow statement)9. 2 reasons why the cash flow from operations is a different figure from operating profit after tax: - Operating profit after tax is calculated on an accrual basis. - Cash flow from operations includes revenues and expenses relating to prior/subsequent periods.10. Total assets increased over the last year (balance sheet)11. Inventory at 26 June 2011 = 3,736.5 m12. Their most recent reporting year ends on 26 June 201113. A) 2 years B) 2 years C) 2 years14. Yes, they are. There is an auditor’s declaration from Deloitte (p. 787)

Tutorial questions:

12. Accrual accounting includes impact of transactions on the financial statements in the time periods where revenues and expenses occur rather than when the cash is received or paid. Cash accounting only accounts for revenues/expenses when cash is paid or received by the enterprise.16. [A] The accounting entity is separate and distinguishable from its owners – personal financial affairs of the owners can be separated from the finances of the business the performance of the business can be evaluated [B] The life of a business needs to be divided into discrete periods to evaluate performance for that period. [C] Accounting transactions need to be measured in a common denominator i.e. the AUD for Australia. [D] Assets are initially recorded at cost [E] Financial statements are prepared on the premise that the organisation will continue operations in the foreseeable future. If this is not the case then it’s necessary to report the liquidation values of an organisation’s assets. [F] All transactions are recorded, but items that have a small dollar value are expensed rather than included as an asset on the Balance sheet e.g. a box of pens that costs $13 and has a useful life of 2 years would be treated as a stationery expense rather than an asset.

Accrual profit = total sales – total expenses, 640k + 490k – 590k – 380k = 160k

Bush Traders Income statement for the year ended 30 June 2012 $Sales 48 000Cost of goods sold (21 000) Gross profit 27 000Less operating expenses - Wages (8 000) - Electricity (4 000) - Travel (2 000) - Advertising (1 000) 15 000 Net profit 12 000

1. Loan – L; cash – A; accounts payable – L; accounts receivable – A; equipment – A2. A – L = OE: A = 90k + 170k + 200K, L = 180k + 110k, SE = 460k – 290k = 170k

Topic 2: Measuring and Evaluating Financial performance

Assets include the enterprise’s cash, accounts receivable, inventory, land, building…

Sources (L) include existing obligations that will have to be paid in the future i.e. loans from the bank, wages payable, accounts payable, mortgages… (OE) includes amounts received from owners which normally don’t have to be repaid, plus any past accrual profits that haven’t been paid out to the owners.

E.g.

- The 495k of assets has been financed by 190k (103k + 87k) of liabilities and 305k of owner’s investment.

Is the enterprise soundly financed? It’s debt to equity ratio is 190k/305k = 62.3% = 0.62:1 so Sound and Light is not much in debt proportionally. Can the enterprise pay its bills on time? The company has 245k in current assets that it should be able to turn into cash to pay the 103k of current liabilities. It has 245k – 103 k = 142k in working capital – and its working capital ratio aka current ratio is 245k/103k = 2.38. The number is positive with more than twice current assets over current liabilities so they appear fine.Concerned about the company’s ability to sell inventory to pay its bills – calculate the quick ratio (like the working capital ratio BUT cash, sell-able short-term investments and accounts

receivables). (50k + 75k/103k) = 1.21… the company could pay current L without having to sell inventory.Should owners declare themselves a dividend? If so, how large should it be? Legally, the board of directors are able to declare a dividend to shareholders of 175k (retained earnings) but there isn’t nearly enough cash for that. A dividend of more than 25k would cause Sound and Light some cash strain.

Assets – are a mixture of resources the company needs to do business. They need to have 3 characteristics:

Future economic benefits Control by the entity – relates to the capacity of an entity to benefit from the asset in

pursuing its objectives and to deny or regulate the access of others Occurrence of past transactions or other past events – the transaction or other event

giving the entity control over the future economic benefits must have occurred.

Assets are separated into CURRENT – expect to be used/sold/collected within the next year and NONCURRENT – expected to have benefits for more than a year into the future

Liabilities – are present obligations of the entity arising from past events. 2 characteristics:

A present obligation exists - tis obligation involves settlement in the future via the sacrifice of future economic benefits

It has adverse financial consequences for the entity

Liabilities include amounts owed to creditors, or amounts estimated to be due later i.e. long service leave payments, future income taxes or interest building up on a bank loan. Not all liabilities are expected to be paid in cash; some are paid by providing goods or services i.e. a deposit received from a customer for goods or services to be shipped later.

! An expectation to pay later is NOT a liability if the transaction bringing the benefit has not happened e.g. agreement to borrow cash before the cash has been received isn’t a liability.

Liabilities are separated into CURRENT those that are due within the next year and NONCURRENT – due more than a year into the future… some are partly paid each year so the balance sheet would show BOTH a current and a noncurrent portion for them.

Equity – is the owner’s interest in the enterprise. It can be derived from direct contributions the owners have made, or the accumulation of profits that the owners have chosen not to withdraw.

Because OE = A – L, the concept is often referred to as the book value of the whole enterprise

Working capital = current assets/current liabilities = 3300/2100 = 1.57 so it is not as strong currently as Sound and Light is. Liabilities of 2100 are 39.6% of total sources with a debt to equity ratio of 65.6% (2100/3200) so the company’s financing is similar to Sound and Light’s though all of its liabilities are current which is unusual. With $500 cash, it doesn’t have enough cash to pay all of its $2200 retained profits to shareholders as dividends if it wanted to.

Land isn’t depreciated but buildings, equipment and furniture and fittings are shown in net accumulated depreciation has been deducted

Prepaid expenses e.g. paying for a 12 month insurance premium on April 2012; at May 2013 we will have a prepayment equal to 10/12ths of the amount paid. Prepayments = assets because they represent future economic benefits

Non-current assets that have no physical substance i.e. copyrights, patents, trademarks, brand names and goodwill.

Working capital = current assets/current liabilities = 80 281/27 795 current ratio = 2.89:1 Chez is in a strong position; CA is almost 3 times CL.

Total Assets = 1270 (640 + 210 + [890 – 470] Total Liabilities = 610 (250 + 360)Net Assets = 660 (1270 – 610)Owner’s equity = 660 (stated)

Two types of tax can be- Current tax liabilities: an estimate amount of income tax to be paid next financial yr- Deferred tax liabilities: which result because of some different rules in calculating

accounting profit and taxation profit (as per the company’s tax return). When current reported accounting profit is more than the profit reported on the tax return, a liability is implied for income tax is implied for later. Conversely, if accounting profit is less than reported on the income tax return, an asset is credited (deferred tax asset),

Maintaining the accounting equation (A = L + OE)- The accounting equation is always kept in balance. If an asset goes up, a liability or

equity must go up too (or another asset must go down).

1. No effect: equipment increases but cash decreases2. Increases by 30k (inventory)3. Increases by 50k (cash)4. No effect: cash increases but accounts receivable decreases (both are assets)5. increases by 30k (cash)

The income statement: Net profit for the period = Revenues – Expenses for the period

- Revenues are increases in the company’s wealth arising from the provision of services or the sale of goods to customers.

- Expenses are decreases in the company’s wealth that are incurred in order to earn revenue. When the enterprise buys goods for sale, they begin on the asset account ‘inventory of unsold goods. When they are sold; cost is transferred from the asset account expense account ‘ COGS’

- Profit as the difference between revenues and expenses, represents the net inflow of wealth to the company during the period.Expenses include all costs of earning revenue but do not include payments to owners. Payments or promises of payment, or returns to owners are considered to be distributions of net profit to owners – undistributed remainder is kept in the company as retained profits.

Revenue 200k + 300k; Expenses 30k + 6k +1.5k

Retained profits: is the sum of net past profits, measured since the company began, minus dividends declared to owners since the beginning. Retained profits for the end of preceding period are therefore increased by profits for the period and reduced by any dividends.

- Transactions with owners are taken out of retained profits… they aren’t an expense therefore not deducted in calculating profit for the period.

1. Revenue (1 141 900 + 4000 = 1 145 000) *others accounting figures are assets etc.2. Expenses (700 000 + 218 000 + 2900 = 921 100)3. 1 145 000 – 921 100 = 223 900

Profit is part of the change in retained profits for the period, therefore:

Bratwurst Ltd had this balance sheet at the end of 2011 (beginning of 2012); assets 5000; liabilities 3000; equity 2000.- The beginning equity figure was made up of shareholder’s invested capital of 500 + retained profit accumulated to the end of 2011 (1500; the sum of all net profits the company ever had up to the end of 2011 minus all dividends ever declared to owners)- During 2012 they had revenues of 11 000 and expenses of 10 000 and declared dividends to owners of 300.- At the end of 2012, they had assets of 5900, liabilities of 3200 and equity of 2700 (500 + 2200).

2. Revenue – expenses: 14 200 – 12 900 = 1300 Previous period retained profits + dividends – dividends paid: 2200 + 1300 – 600 = 2900

Here ^ the right hand column refers to the parent company (Tabcorp) and the left-hand columns are consolidated figures that refer to Tabcorp AND its subsidiaries. Consolidation involves aggregating revenues and expenses of the parent entity and subsidiaries after eliminating any transactions between these entities.

- Expenses (inc. employment costs of 583.9m) are then deducted to get operating profit before income tax. For Tabcorp it amounts up to 742.1m (profit income before tax exp.)

- Income tax is levied on a company before it is legally separate from its owners such tax is usually a percentage of profit before income tax. Income tax expense of 220.4, is deducted to get ‘operating profit after income tax’ of 521.7m.

- Note that govt. taxes and levies (1 13600 000) aren’t income tax. There are separate taxes related to the gaming industry.

- In 2008 there’s mention of impairment – where companies need to reduce the value of some assets below cost

850k + 120k – 70k = 900k

Capital markets, Managers and Performance Evaluation:

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