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Topic

1 - Introduction to accounting & Business structures


(Chapters 1 & 3)
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Purpose of accounting
Accounting provides users with financial information to guide them in making decisions concerning how to
allocate money among different and competing projects.
(Birt et al. 2012, p. 3)
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Accounting is a process
Accounting is the process of identifying, measuring and communicating economic information about an
entity to a variety of users for decision making purposes
Identifying
Transactions that must be able to be reliably measured and recorded
Measuring
Analysis, recording and classifying transactions
Communicating
Via income statements, balance sheets and statements of cash flows
Decision making
Used for a range of decisions by external and internal users
Identifying transactions
Business transactions
External exchange of something of value between two or more entities
Affect assets, liabilities and equity
Must be able to be reliably measured and recorded
Relevant information
Information that makes a difference in decision making
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Accounting information and its role in decision making
Accounting information is designed to meet the needs of both:
internal users (management)
external users (stakeholders)
External users include:
Investors both current and prospective
Suppliers and banks
Employees

Government authorities (e.g., ATO, ASIC)
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Financial Accounting & Management Accounting
Financial accounting
is the preparation and presentation of financial statements to allow a range of users to make economic
decisions about the entity general purpose financial statements

Financial statements consist of


Income statement
Balance sheet
Statement of changes in equity
Statement of cash flows
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A simple income statement - GG Coffee Income statement for the period ended 31 Dec. 2010














A simple balance sheet - GG Coffee G.Green Balance sheet for the period ended 31 Dec. 2010


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Financial Accounting & Management Accounting (cont.)
Management accounting
provides economic information for internal users

Core activities include


Formulating plans and budgets
Providing information to be used in monitoring and control within the entity
Management accounting provides economic information for internal users that is then reflected in financial
accounting statements for external users
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Financial Accounting & Management Accounting (cont)

Financial accounting

Management accounting

Regulations

Bound by GAAP, Corp Act, ASX, etc

Less formal and without prescribed rules

Timeliness

Historical picture of past operations

Can be both a historical record and a


projection

Level of
detail

Quantitative in nature, concerns the


whole entity

Both quantitative and qualitative, more


detailed

Main users

External: ATO, investors, suppliers,


consumers, banks, employees, interested
groups

Internal: managers in the entity

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Sources of Regulation
The Corporations Act
stipulates that all disclosing entities must apply Australian Accounting Standards in preparing their
financial reports
Is a company watchdog that enforces company and financial services laws to protect consumers, investors
and creditors
Enforced by the Australian Securities and Investments Commission (ASIC)
v Disclosing entity an entity that issues securities that are quoted on a stock
market or made available to the public via a prospectus

Australian Securities Exchange (ASX )
The ASX is the main Australian market place for trading equities, government bonds and other fixed interest
securities
ASX Listing Rules help ensure that companies are:
providing adequate disclosures to various stakeholders
behaving appropriately
Standard Setting Framework - Australian and International Standards
Since 1 Jan 2005, Australian entities have complied with International Financial Reporting Standards
(IFRSs)

Australian Accounting Standards Board (AASB) is responsible for


Issuing Australian versions of international accounting standards
Significantly influencing development of IFRSs


The role of professional bodies
3 professional bodies in Australia:
CPA Australia
The Institute of Chartered Accountants in Australia (ICAA)
Institute of Public Accountants (IPA)

Play an important role in regulating Australian companies through:


v stringent regulation of their members
v their input into the standard setting process
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The Conceptual Framework
The IASBs Conceptual Framework applies to entities that are required to prepare general purpose financial
statements (GPFS):
The objective of financial reporting
Qualitative characteristics of financial reports
Definition & recognition criteria of the elements of financial statements
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Components of the Conceptual Framework
Objective of financial reports: to provide financial information useful to existing and potential investors,
lenders and other creditors in making decisions about providing resources to the entity

Qualitative characteristics of financial statements:
Relevance Faithful Representation Comparability Verifiability Timeliness Understandability

Definition and recognition of elements of financial statements

Assets: future economic benefits

Liabilities: future outflows of economic benefits

Equity: net assets = assets less liabilities

Income: increases in equity (excl. contributions from owners)

Expenses: decreases in equity (excl. distributions to owners)


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Limitations of Accounting Information

Time lag in the distribution of information to users, therefore affecting its accuracy

Historical information based on past data and is often out-dated

Subjectivity of information refers to choice involved in inclusion of items to be reported, choice of


accounting policies to adopt, need for estimates
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Costs of Providing Accounting Information
Information costs

Costs involved in gathering, summarising and producing info contained in financial report
Release of competitive information

Info in financial report may contain proprietary information that could be used by competitors to
strengthen their market position
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Careers in accounting
Traditional areas
Public accounting

Private sector

Government and not-for-profit sector
New opportunities
Forensic accounting
E-commerce
Environmental accounting International accounting
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Business structures
The basic forms of business structure are:
Sole trader
Partnership
Company
Trust (not covered in this course)

They differ in terms of owner liability, equity structure, funding opportunities, decision making
responsibilities and taxation

All businesses are separate accounting entities, but may not be separate legal entities accounting
entity concept
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Sole Traders - Definitions and Features

A sole trader is an individual who controls and manages a business

The business is not a separate legal entity

The individual owner is fully liable for all debts

Owner pays personal income tax on business profits

The general registration requirements involve applying for an ABN

Often use accounting software such as MYOB to prepare financial reports

Common examples are plumbers, electricians, hairdressers and carpenters



Sole Trader Advantages

Quick, inexpensive and easy to establish; inexpensive to wind down

Not subject to company regulation

Owner has total autonomy over business decisions

Owner claims all the profits of the business and all the after-tax gains if the business is sold

Disadvantages

Unlmtd liability = owner bears full respons. for bus, debts & legal actions such as negligence

Limited by skill, time and investment of owner

Restrictive structure due to non-legal status of the entity

Business will cease to exist if owner leaves, retires or dies


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Partnerships - Definitions and Features
An association between two or more persons who
carry on a business as partners
share parofits or losses according to partnership agreement

Enables sharing of ideas, skills and resources

Easy and cheap to establish

Not a separate legal entity

No separate taxation payable but does lodge income tax return with Australian Taxation Office
(ATO)

The Partnership Agreement
Includes details of the partnership:
Name of partnership


Partner contributions of cash and other assets
Profit and loss sharing ratios

Entry and exit information

Partnership - Advantages

Relatively easy and simple to set up

Informal business structure not bound by accounting standards

Ability to share capital, skills, talents, knowledge and workload between two or more people

Disadvantages

Unlimited liability for business debts and obligations by all partners

Limited life if one partner dies or withdraws from the business then the partnership must
dissolve

Mutual agency each partner is seen as being an agent for the business and so is bound by any
partnership contract
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Companies - Definition and Features

Owners of a company are known as shareholders

Independent legal entity (i.e. separate from the people who own, control and manage it; can enter
into contracts, sue and be sued in own right)

Shareholders have limited liability only liable for the full purchase price of their shares (not
company debts)

A company has unlimited life not dissolved when owners die or change

Companies - Types

Public and Proprietary (Private) Companies


Public

Proprietary (Private)

Company name includes

Ltd

Pty Ltd

Public sale of shares

Yes

No

Typical size

Large

Smaller

Extent of regulation

Extensive

Moderate

Raise monies from public

Yes

Some restrictions

Subject to reporting requirements

Yes

Depends on size


Company Advantages

Limited liability for shareholders

Taxation rate (30%) lower than top personal tax rate

Business expansion networks made easier due to legal structure

Can raise additional equity (capital) through public share offerings, floating the company

Disadvantages of a company

More time consuming and costly to set up

Must comply with complex company rules and other legal requirements even more so when
issuing shares to the public for the first time
Corporations Act
ASIC
ASX
accounting standards

Taxed from the first dollar of profit

Limited liability aspect may causes problems

Banks often prefer to have directors personal guarantees instead

Separation of ownership and control

E.g. Profit distributions (dividends) are at directors discretion


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Comparison of Business Reports

The main point to note at the moment is the use of the accounting entity concept

A business entity funds are not available for personal use


if business funds are used to pay personal expenses, must be recorded as a decrease in
cash and a decrease in owners equity (drawings)

Comparison of Reports: Sole Trader Income Statement
v Income statement shows income less expenses
v No taxation is shown
SOLE TRADER INCOME STATEMENT - Amelias Cafe A. Wong 31/13/13


Income




Sales

$24 000


Cost of sales


10 000
v Income

Gross profit

statement shows
income less
expenses

14 000

Operating expenses
Administration expenses $1 200
Rent

4 000

Finance expenses

400

No taxation is
shown

Depreciation of store equipment 2 000


Wages and salaries

Profit

$ 400

6 000 13 600

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SOLE TRADER BALANCE SHEET - Amelias Cafe A. Wong 31/12/13




Current assets

Cash on hand
$ 4 000

Cash in bank
6 800
$10 800

Non-current assets
Store equipment

28 000

Less Acc depn

10 000

Accounts payable

8 000

Non-current liabilities
Bank loan

10 000

Total liabilities

18 000

Net assets

$10 800

Owners equity
Profit (loss)

Profit (or loss)


added (or
subtracted) to
capital
account in
balance sheet

28 800

Current liabilities

Total equity

Balance sheet
has only one
capital
account

18 000

Total assets

Capital A. Wong

10 400
400
$ 10 800

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PARTNERSHIP INCOME STATEMENTS - Tom, Felix and Charlie Accountants 31/12/13


Profit
$ 31 200

v Profit and loss
Distributions to partners

is split
Salary Tom
8 000

according to

Felix
4 000
original capital

contributions
Charlie
6 000
18 000

as specified in

Distribution of remaining profit to current accounts
the

partnership
Tom (100 000/560 000 13 200)
2 358

agreement
Felix (400 000/560 000 13 200)
9 428


Charlie (60 000/560 000 13 200)
1 414
13 200
v No taxation is

shown
$ 31 200



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PARTNERSHIP BALANCE SHEET - Tom, Felix and Charlie Accountants 31/12/13

1. Balance

Net assets
$573 200
sheet has a

Partners equity
capital

account
Capital

(and often a

Tom
100 000
current

Felix
400 000
account) for

each

Charlie
60 000
560 000
partner

Current

Tom
2 358


Felix
9 428

Charlie
1 414
13 200

$ 573 200

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PRIVATE COMPANY - INCOME STATEMENT - Simply Scarves Pty Ltd - for period end. 31/12/13


Income

v Income tax

deducted
Sales
$300 000

directly from
Cost of sales
70 000

company profit

Gross profit
230 000

Operating expenses
80 600

(details as per sole trader)


Profit before tax
$ 150 000

Taxation expense
42 900

Profit after tax

$ 107 100

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PRIVATE COMPANY - BALANCE SHEET (EXTRACT) - Simply Scarves Pty Ltd - As at 31/12/13


v Share capital as
Net assets
$290 210

opposed to owners
Shareholders equity

or partners capital

account
Share Capital
200 000

Retained Earnings
90 210
v Retained earnings
Total Shareholders equity
$ 290 210
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PUBLIC COMPANY - INCOME STATEMENT - Power Point Ltd for the period ended 31/12/13


Income
Notes

v The income
Sales
3
$300 000

statement is

Cost of sales
4
70 000
prepared in

accordance
Gross profit
230 000

with

Operating expenses
80 600
pronounceme

nts of the
(details as per sole trader)

Australian

Profit before tax
$ 150 000
Accounting

Standards
Taxation expense
7
42 900

Board (AASBs)

Profit for the year
$ 107 100
Earnings Per Share
Basic Shares

$82.45
31

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T2 Chapter 4 - Business transactions


Business Transactions

Business transactions are occurrences that affect the assets, liabilities and equity items in an entity

A business transaction is recorded when it can be reliably measured in monetary terms

Under the accounting entity concept, every entity must keep records of its business transactions
separate from any personal transactions of the owners

Examples of business transactions
contribution of capital by owners



payment of salaries


receipt of bank interest




receipt of GST refund


purchase of laptop on credit



payment of accounts payable depreciating
office equipment


purchase of accounting software

charging interest on overdue accounts receivable

cash sales

payment of advertising withdrawal of capital
cash purchases
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Personal Transactions and Business Events

Personal transactions are transactions of the owners, partners or shareholders that are unrelated
to the operation of the business

Business events are occurrences that will probably affect the entity in some way, but are not
recorded as business transactions until an exchange of goods occurs between the entity and an
outside entity
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Business transactions and the Accounting Equation

Business transactions affect the elements of the Accounting Equation:


ASSETS = LIABILITIES + EQUITY

A = L + E

Transactions are recorded in a way that keeps this equation balanced

This balance is reflected in the balance sheet, which is based on the accounting equation:
ASSETS - LIABILITIES = EQUITY

A L = E
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Accounting Equation
ASSETS = LIABILITIES + EQUITY

A = L + E

Expresses the relationship between assets (A) of an entity and how those assets are financed

Assets are resources (future economic benefits) controlled by an entity

They can be financed in two ways:


By external fund providers: liabilities (L)
By owners funds: equity (E)

Liabilities and equity represent the claims against the entitys assets
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The concept of duality

Every business transaction has a dual effect

Business transactions are analysed by examining


the dual effect of each business transaction
the impact on the accounting equation
Example:
A firm borrows money from a bank to purchase a truck
A = L
+ E
TRUCK LOAN
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Analysis of business transactions
1. Capital contribution

Owner contributes $50,000 in cash to start a business

This shows as increase in cash (asset) and increase in capital (equity)


ASSETS
=
LIABILITIES
+
EQUITY
CASH $50,000 =
0

+
CAPITAL $50,000

1a. Capital contribution

Stevens Seagulls needs $350,000 of assets to do business. Steven only has $200,000 to contribute
as equity; his business needs to borrow additional funds of $150,000 from a bank which will
become a liability of the business.
A


=
L


+
E
CASH $350,000
=
LOAN $150,000
+
CAPITAL $200,000
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2. Asset purchase

Firm purchases new laptop computer for $3,500 and pays by cash

This will show as a decrease in cash (asset) and an increase in office equipment (asset)
by the same amounT
ASSETS

= LIABILITIES
+
EQUITY
CASH $3,500
OFFICE EQUIPMENT $3,500
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EXPANDED ACCOUNTING EQUATION
Recall Chapter 1
Income produces an increase in equity
Expenses result in decreases in equity
Therefore:
Profit (loss) is added to (subtracted from) opening equity on the balance sheet
ASSETS = LIABILITIES
+
OPENING EQUITY
+
INCOME EXPENSES
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Further analysis of business transactions


3. Income earned

Firm sends invoice for $3,000 for services provided

This will show as an increase in debtors or accounts receivable (asset) and an increase in
fees (income) by the same amount
v Note income increases equity while expenses decrease equity
ASSETS = LIABILITIES + EQUITY + INCOME EXPENSES
DEBTORS



FEES
$3,000



$3,000
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The Accounting Worksheet

Summarises the duality associated with each business transaction

All business transactions of the entity can be entered into the worksheet

Then the individual columns of the worksheet can be totalled and used as the basis for preparing
financial statements
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Capturing Accounting Information: Journal and Ledger Accounts

Analysing each transaction by using the accounting equation is not appropriate for a large number
of transactions

Instead, we can use the journal or ledger to effectively and efficiently capture accounting
information

Pages 123-127 of your textbook describe journal entries, ledger accounts, debit & credit rules, and
the trial balance; however, we do not cover this material in this course.
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Topic 3 Chapter 5 Balance Sheet


Nature and Purpose of the Balance Sheet

The balance sheet is a financial statement that details the entitys assets, liabilities and equity as at
a particular point in time the end of the reporting period

The balance sheet shows:


what the entity owns or controls as at a particular date = the assets
the external claims on the entitys assets (what it owes) = the liabilities
the internal claim on the entitys assets = the owners equity

Reflects
the assets in which the entity has invested (its investing decisions), and
how the entity has financed the assets (its financing decisions)
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Format and presentation of the balance sheet

Two main formats:


T-format

Assets on left hand side and liabilities on right hand side

Often used for smaller entities


Narrative format

Assets, liabilities and equity presented down the page

Comparative information allows users to see how firms financial position has changed between
the previous and current periods
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The definition and recognition of assets

An asset is formally defined in the Conceptual Framework (para. 49(a)) as 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.
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Asset definition -
Control
An entity must control the item for that item to be consid. as an asset and recognised on the balance sheet
The concept of control refers to the capacity of the entity to benefit from the asset in the pursuit of its
objectives, and to deny or regulate the access of others to the benefit
Past event
Every asset must have arisen from a transaction that has already happened
A company cannot include an asset it will be getting in the future
Future Economic Benefit
Items must provide benefits to the entity that uses them in order to be regarded as assets
Benefit can be cash or control of resources
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Recognition
Recognition means recording items in the financial statements with a monetary value assigned to them
Satisfying the definition criteria is only part of the process in recording an item on the balance sheet
recognition criteria must also be satisfied
To be recognised as an asset on the balance sheet, the future economic benefits expected to flow from the
asset must:
be probable, and be capable of being measured reliably

Recognition of an Asset

Probable
It is more than likely that the future economic benefits will flow from the asset to the business controlling it

Reliably Measured
The value of the asset can be measured reliably
May require the use of estimates
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Summarising: Criteria to be satisfied to recognise an asset
v The essential characteristics for an asset are:
1. the resource must be controlled by the entity
2. the resource must be as a result of a past event
3. future economic benefits are expected to flow to the entity from the resource.
v Furthermore, to be recognised as an asset on the balance sheet, the future economic benefits must
be probable and capable of being measured reliably.
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TOPIC 4 CHAPTER 6
INCOME STATEMENT AND STATEMENT OF CHANGES IN EQUITY
Purpose and importance of measuring financial performance

The income statement reflects the accounting return for an entity over a specified time period
PROFIT = INCOME - EXPENSES

But not all value changes result in income or expenses that are recognised in the income statement
(profit & loss account)
E.g. unrealised gains from revaluing assets are taken directly to equity, bypassing the
income statement)
v Income encompasses both:

revenue arising in the ordinary course of activities (e.g. sales, fees, dividends)

gains (e.g. gains on disposal of non-current assets, and unrealised gains on revaluing
assets)
only realised gains are included in the income statement --- unrealised gains
are taken directly to equity (and reported on the statement of comprehensive
income)
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The reporting period

The financial statements assume that an entity is a going concern, but the life of the entity is
divided into arbitrary reporting periods, also known as accounting periods

For external reports, the convention is that the arbitrary reporting period is yearly, and so the
entity prepares financial statements at the end of each 12 months (not necessarily a calendar year)
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Accrual accounting vs Cash Accounting

Accounting standards require financial statements to be prepared on the basis of accrual


accounting

Accrual accounting is a system in which transactions and events are recorded in the periods they
occur, rather than in the periods the entity receives or pays the related cash

A 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
Under accrual accounting, the following may occur:
Income is recognised without receipt of cash (accrued income)
Cash is received but income is not recognised (unearned income)
Expense is recognised without payment of cash (accrued expense)
Expense is paid but not recognised as an expense (prepaid expense)
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Accrued income

Income has been earned in the current accounting period but has not yet been received
in cash

Examples include accrued interest revenue (interest earned on a term deposit) or


accrued rent revenue (tenant is behind in the rent)

Must be recorded as both income (e.g. accrued interest income, accrued rent income) and
an asset (e.g. interest receivable, rent receivable)

When the cash is received next period, do not record as income simply record the
receipt of cash and reduce/eliminate the receivable
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Unearned (deferred) income

Cash has been received in the current accounting period, but the income has not yet been
earned is

Examples include purchases paid for in advance of delivery, magazine subscriptions, etc.

At the time cash is received, income is not recorded instead, a liability is recognised
(unearned income or revenues received in advance)

At the end of the period, must determine how much of the unearned income has now
been earned (goods delivered or services provided) and record this amount as income,
while reducing the liability by the same amount
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Accrued expenses

Expenses have been incurred in the current accounting period (resources consumed) but
cash has not yet been paid

Examples include accrued wages, accrued electricity, etc.

Must be recorded as both an expense (e.g. accrued wages, accrued electricity) and a
liability (e.g. wages payable, electricity payable)

When the cash is paid next period, do not record as an expense simply record the
decrease in cash and reduce/eliminate the liability
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Prepaid (deferred) expenses

Expenses have been paid in the current accounting period but resources not yet
consumed

At the time cash is paid, the expense is not recorded instead, an asset is recognised (e.g.
prepaid rent, prepaid insurance, etc.)

At the end of the period must determine how much of the prepaid expense has expired or
been consumed, and record this amount as an expense while reducing the pre-payment
(asset) by the same amount
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Topic 5

What is a statement of cash flows?


Reports information regarding cash inflows and cash outflows for a particular period of time
The accrual system focuses on when a transaction takes place
In contrast, the statement of cash flows is concerned with cash receipts and payments, and not the
timing of the underlying transactions
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Difference between cash and accrual accounting (cont)

Difference between cash and accrual accounting profit


Cash accounting system

Cash sales

Credit sales

Cash collected from accounts receivable

Cash received in advance of sale

Expenses paid in cash

Expenses incurred, not yet paid

Payments to accounts payable

Expenses paid in advance



Accrual accounting system

Cash sales

Credit sales

Cash collected from accounts receivable

Cash received in advance of sale

Expenses paid in cash

Expenses incurred, not yet paid

Payments to accounts payable

Expenses paid in advance


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Cash flow statement
Receipts from sales



Payments for inventory
Payments for rent, wages


Result is net operating cash flow

Income statement
Sales income


Cost of sales

Rent expense, wages expense
Depreciation expense

Result is net profit
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Why is accrual accounting better than cash accounting?
Accrual accounting recognises income when it has been earned
Accrual acc. system recognises all resources consumed in earning that income
Accrual accounting system permits the recognition of assets (resources available for future
consumption)
Accrual accounting gives a more realistic interpretation of an entitys overall financial
performance
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Why is a statement of cash flow needed?
To provide information about:

cash receipts

cash payments

net change in cash resulting from operating, investing and financing activities
To ensure that an entity has enough cash on hand to meet its financial commitments in a timely fashion
avoid insolvency
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Relationship of the statement of cash flows to other financial statements

Income statement & balance sheet only show part of the activities of the bus.

Cash flow statement gives additional information to assist decision makers in assessing an entitys
ability to:
generate cash flows
meet financial commitments as they fall due
fund changes in scope and/or nature of activities
obtain external finance
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Classified into three main sections reflecting the major cash flow activities

Operating activities (Income statement revenue and expenses; Current assets and liabilities in the
balance sheet)

Investing activities (Non-current assets in the balance sheet)

Financing activities (Non-current liabilities and equity in the balance sheet)


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Definition of cash
Cash:
Notes and coins held
Deposit call accounts at financial institutions

Cash equivalents:
Short term, highly liquid investments, easily converted to known amounts of cash with little risk of
a change in value
Investments with maturity 3 months
Bank overdrafts
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Format of the statement of cash flows (cont)
Operating activities

Activities relating to provision of goods and services and other activities that are neither investing
nor financing activities

Act. reported in the income statement are adjusted from accrual to cash basis
Cash from operating activities shows ability to:
generate cash

meet short term obligations
continue as a going concern expand

Investing activities
Consist of those activities that relate to the acquisition &/or disposal of:

non-current assets (including property, plant and equipment, and other productive assets), and

investments (such as securities) not falling within the definition of cash


These items allow users to analyse future directions of the entity by studying major asset acquisitions and
disposals

Financing activities
Consist of:

Activities that change the size and/or composition of the financial structure of the entity

(including equity), and borrowings not falling within definition of cash


Usually associated with changes in non-current liabilities and equity

Reconciling cash from operations with operating profit

Profit must be reconciled to net cash provided/used by operations

Reconc. must be disclosed in finan. statements as a note to the accounts

Allows users to see the changes in operating accounts brought about by use of accrual
versus cash basis of accounting


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The usefulness of the statement of cash flows
For investment community

Recognition that management of earnings can lead to some accounting manipulations in


the income statement; this has led to increased reliance on statement of cash flows for
extra information about earnings potential.
v For lending community

Statement of cash flows can be used to assess organisations management and whether it
has or can generate sufficient cash.
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Analysing the statement of cash flows
v The statement of cash flow can provide warning signals:
Cash received less than cash paid
Net operating cash outflow
Cash from operations less than after tax profit
Proceeds from share capital, investments and borrowings used to compensate for
negative operating cash
Loss of cash on a continual basis

Managing net working capital


Working capital: funds invested in current assets

Current assets: assets the entity expects to convert to cash within the next 12 month
e.g. cash, debtors
Net working capital: current assets minus current liabilities

Current liabilities: debts to be paid within next 12 months



e.g. creditors
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Effective management of net working capital involves:

maintaining liquidity (i.e. ease of converting an asset into cash)

the need to earn the required rate of return on assets for investors (working capital that is too
high reduces return on equity)

the cost and risk of short-term funding (current liabilities)


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Deciding the appropriate level of net working capital

To achieve an appropriate level of net working capital many firms use the hedging principle

This means matching the maturity of the source of funding with its use or cash flows

To make the hedging principle more useful, it is useful to think in terms of different 3 different
sources of funding
Permanent sources
funding with maturities > I year

e.g. long term debt, leases, shares
Temporary sources
short term finance

e.g. bank loans, commercial bills
Spontaneous sources
unplanned or unstructured funding e.g. trade creditors, accrued expenses
Principles for using the various sources of financing are:

Permanent assets should be financed with permanent & spontaneous sources of funding

Temporary assets should be financed with temporary sources of funding


____________________________________________________________________________________________________________________________
Managing cash
Entities manage cash in relation to the following issues:
the need to have sufficient cash (avoids insolvency)
the timing of cash flows (cash budget useful here)
the cost of cash (opportunity costs and physical security)
the cost of not having enough cash (ultimately, the loss of the business)

The need for sufficient cash

Managers face a trade-off between risk/return when contemplating how much cash to hold

Cost may be minimised by holding as little cash as possible, but risk is increased

The timing of cash flows

The timing of most cash flows is normally variable, the only exceptions probably being the
payment by the entity of wages and taxes

Entities can plan the timing of the purchase and sale of assets, and the requirements for capital
injections, to suit their needs

Similarly, in contracting for loans or placing funds in the short-term money market, an entity can
negotiate timing that best suits its own needs

The cost of cash
Two types of cost associated with holding cash:
Opp. cost of holding currency or cash deposits, rather than short-term securities
cost of ensuring physical security of currency
Electronic alternatives
have reduced the amounts of currency handled by entities
but has increased costs elsewhere

The cost of not having enough cash

Not having enough cash at the required time may result in the loss of the bus.

A deficit in cash has the potential to become a permanent condition - insolvency

Temporary cash shortages may be overcome by arranging emergency loans

However, as a general rule, the more desperate the need, the higher the cost of emergency funds
____________________________________________________________________________________________________________________________

Managing debtors Benefits and costs of granting credit


Benefits

Increasing sales:
new customers from cash-only suppliers
customers may bring planned purchases forward
impulsive purchases
customers who would not otherwise have purchased
Costs

Opportunity cost of funds being tied up

Cost of slow payers, bad debts, specialist collection services

Cost of administering the system


____________________________________________________________________________________________________________________________
Managing inventories

Inventories or stock are normally a component of current assets for most entities involved in
manufacturing or the sale of goods

Types of inventories
Raw materials


Work in progress (WIP)


Finished goods

Benefits and costs of holding inventories
Benefits

Sales are made and profits gained

Cross-sales are made and profits gained


e.g. lotto and card sales in a newsagency

Goodwill built up

No-stock costs are avoided



Costs

Ordering costs
compounded if a large number of small orders

Holding costs
Storage and display costs

Insurance costs
Deterioration and obsolescence
Wholesale price changes

Theft


Financing costs

Inventory management techniques
1. Maintaining a minimum level of stock

Either explicit or implicit level


2. Average inventory turnover period (ITP)

Manager can decide on a number of days of inventory to be held as optimum for the firm

Inventory turnover = Average inventory x 365 = x days


Cost of sales

Economic order quantity (EOQ):

Recognises that total cost includes holding and ordering costs

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

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

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

EOQ Model

EOQ =

2DC
H

where:
D is the annual demand for the item of stock
C is the cost of placing an order
H is the cost of holding one unit of stock for one year
Some limiting assumptions apply to the model:

Demand for product can be predicted accurately

Demand is even

No buffer inventory required

No discounts for bulk purchasing



EXAMPLE
v ADM Ltd sells 2,000 units of product X each year. It has been estimated that the cost of holding one
unit of the product for a year is $4. The cost of placing an order for stock is estimated at $25. What
is the EOQ for this product?
v EOQ = (2DC / H) = (2 x 2,000 x $25 / $4) = 158
v This will mean that the business will have to order product X about 13 times each year in order to
meet sales demand (2,000 / 158 = 12.7)
____________________________________________________________________________________________________________________________
Sources of short-term finance

The most common sources of short-term finance for entities are:


accrued wages and taxes
trade credit
bank overdrafts
commercial bills and promissory notes
factoring or debtor/invoice/trade finance
stock/inventory loans or floor-plan finance

Trade credit particularly important because arises through normal business activities, and doesnt
require formal agreements or additional accounting practices.

Sources of long-term debt finance

Long-term debt finance is supplied to borrowers through financial institutions


acting as intermediaries (e.g. loans, leases), or
directly by the debt markets (e.g. bonds, debentures)
____________________________________________________________________________________________________________________________
Equity finance

Equity finance is usually obtained through selling:


Ordinary shares (most common)
Preference shares

Other forms of equity financing:


Rights issue issue of new shares to existing shareholders
Options confer the right to subscribe to shares in the future at a price and time which
are pre-determined
____________________________________________________________________________________________________________________________

TOPIC 6

Business Sustainability
Sustainable development is development that meets the needs of the present without compromising the
ability of future generations to meet their own needs.
____________________________________________________________________________________________________________________________
Business Sustainability Key Drivers
Competition for Resources

Climate Change
Economic Globalisation



Connectivity and Communication

Business Sustainability Principles
Ethics


Governance


Transparency
Business relationships





Financial return
Comm. involvement/economic dev.
Value of products/services
Employment practices



Protection of the environment
____________________________________________________________________________________________________________________________
Theories of Business Sustainability
Corporate Social Responsibility
Refers to the responsibility an entity has to all stakeholders, including society in general and the physical
environment in which it operates.
Profitable to do so
Reduce interference from government and lobby groups
Desire to do the right thing

Shareholder Value
A corporation has many stakeholders

Stakeholders represent all parties that have a vested interest and can either influence the entitys
management and operations or are affected by them
Shareholder returns are usually the primary focus of an org.
Managers act on behalf of shareholders
____________________________________________________________________________________________________________________________

Stakeholder theory holds that the purpose of the entity is to work for the good of all stakeholder groups,
not just to maximise shareholder wealth.
____________________________________________________________________________________________________________________________
Stewardship theory
Directors act in the interest of a group(s) of stakeholders not just shareholder value
____________________________________________________________________________________________________________________________
Reporting and Disclosure

Organisations are voluntarily reporting on their sustainability practices.

One approach to sust. reporting is the GRI reporting framework comprised of:

Sustainability Reporting Guidelines, Technical Protocol, Sector Supplement


____________________________________________________________________________________________________________________________
Standard disclosures include:
Strategy and profile

Overview of risks & opportunities facing the organisation


Management approach

How to manage sustain. topics associated with risks & opp.


Performance indicators

Economic, environmental, social

Sustainable business practices means that decisions may be made that are not necessarily profit
maximising, but are beneficial for the environ./ community.
____________________________________________________________________________________________________________________________
Triple Bottom Line Reporting
Triple Bottom Line refers to reporting on the 3 Pillars of Sustainability:
1. Economic performance
2. Environmental performance
3. Social performance
____________________________________________________________________________________________________________________________
Corporate Governance

Corporate governance refers to the direction, control and management of an entity. This includes
the rules, procedures and structure upon which the organisation seeks to meet its objectives.

Corporate governance responsibilities generally rest with board of directors.


____________________________________________________________________________________________________________________________
Legal Duties

Specifically, directors owe the following legal duties to their company:


to act in good faith, in the best interests of the company
to act with care and diligence
to avoid improper use of information or position
to avoid conflicts b/w their role as a director & any of their personal interests.
____________________________________________________________________________________________________________________________
Ethics
The key to gov. for sust. may be determined by the extent of ethical consciousness.

Morality vs Prudence
Prudence - Acting in ones self-interest
Morality - Acting as one ought to by taking into account the interests of other people
____________________________________________________________________________________________________________________________
Ethical Theories

Teleological theories are concerned with consequences of decisions

If actions result in good consequences, behaviour is said to be ethical


____________________________________________________________________________________________________________________________
Teleological theories
Most notable teleological theory is ethical utilitarianism
- All ind. maximising their utility (happiness) will lead to societys utility being maximised also
- Greatest happiness princ.: common good (maximisation of human happiness) is most important
Who gets the most utility? Individual or Society?

John Stuart Mill proposed that behaviour should be based on what provides the greatest good to
the greatest number

If all businesses focus on profitability, max. prod. will be achieved from societys limited resources

Provides justification for profit maximisation


____________________________________________________________________________________________________________________________
Ethical Egoism

Individual decision maker decides what is best for himself or herself

Hobbes: if everyone acted in their own self-interest, anarchy would rein therefore people will
want regulation for security and protection

But Smith believed regulation impedes prosperity competitive self-interests are necessary in the
commercial world to achieve overall public benefit

Teleological Conclusion
Friedman mooted limited government intervention and self-interest as long as in accordance with the rules
of the game laissez-faire economy
____________________________________________________________________________________________________________________________
Deontological theories

Deontological theories are concerned with duties

Kant proposed that an action is morally right if it is motivated by a good will that stems from a
sense of duty

So a business motivated by profits, despite doing respectful things, is acting in a prudent rather
than a moral way
____________________________________________________________________________________________________________________________
Ethical behaviour and professional code of ethics

Many companies and professional bodies have developed their own codes of ethics

CPA Australia and ICAA have joint code of ethics for professional accountants

Five fundamental principles
Integrity (honest, sincere)

Objectivity (no bias or conflict of interest)
Professional competence and due care

Confidentiality
Profession. behaviour (uphold rep. of job) Overarching principle act in the public interest.
____________________________________________________________________________________________________________________________
Key ethical issues facing entities today include:
Carbon emissions
Ethical investments
Whistleblowing
Insider trading
Bribery
Fraud
____________________________________________________________________________________________________________________________
Ethics, regulation, sustainability and politics

Ethical decision making in business is complex with only principles, values and approaches to
guide the individual or group

According to Carroll, business entities have 4 key responsibilities:


Economic provide goods & services at a fair price, repay creditors, provide a reasonable
return to shareholders
Legal uphold laws & regulations
Ethical act in socially acceptable manner
Discretionary carried out voluntarily

Why consider the role of ethics?


The free market vs. the community
Nordbergs Framework
____________________________________________________________________________________________________________________________
Special Purpose Entities (SPEs)
established by Enron to provide hedging insurance against potential losses through risky
investments (e.g. speculative dot.com shares)
SPEs were legal entities separate from Enron, and were in compliance with accounting rules, but
were designed to shift losses off Enrons balance sheet
____________________________________________________________________________________________________________________________

TOPIC 7 CHAPTER 9 BUDGETING

Budgeting and strategic planning


If you are failing to plan, you are planning to fail.
____________________________________________________________________________________________________________________________
Management functions:

Planning looking ahead to establish objectives

Directing and motivating coordinating activities and human resources to produce a smooth-running
organisation

Controlling keeping activities on track to achieve objectives


____________________________________________________________________________________________________________________________
Strategic planning concerns longer-term planning (typically, 3-5 years)

Usually carried out by senior management

Commonly relates to broader issues such as business takeovers, expansion plans, deletion of business
segments, and radical product/service development
____________________________________________________________________________________________________________________________
Budgeting is a process that focuses on the short-term

Budgets operationalise strategic plans and allow operational areas to understand how their area
contributes to the entitys strategic objectives


Budgets
Part of the formal planning process relates to an entitys operational plans, including short term goals and
targets:
Performance management:

involves setting targets in other than just financial terms, e.g. improving customer service, corporate
governance, management techniques, and human resource management

a budget is the quantitative expression of an entitys plans


____________________________________________________________________________________________________________________________
Budgeting can assist in decision-making by:

putting into operation longer-term plans

setting targets for managers

identifying resource constraints in budget period

identifying periods of expected cash shortages and excess cash holdings

assisting with short-term planning decisions, such as capacity utilisation

providing profit forecasts and other financial data to the capital markets

forecasting data such as sales or fees, which commonly set the level of activity for the budget period

helping determine required inventory levels and purchasing requirements for raw materials

planning labour and other inputs

determining the ability of the entity to meet financing commitments


____________________________________________________________________________________________________________________________
Types of budgets

Sales (or fees) budget

Operating (expenses) budget

Production and inventory budgets

Purchases budget

Budgeted income statement

Cash budget

Budgeted balance sheet

Capital budgets

Manufacturing overhead budget

Program budget
____________________________________________________________________________________________________________________________
Master budget

A master budget is a set of interrelated budgets for a future period which provides a framework
for viewing relevant budgets of an entity

Because budgets are based on forecasts about the future, complete accuracy is impossible and
variances will inevitably arise
Both favourable and unfavourable variances must be analysed to understand their causes
Corrective action may be taken, or the budget revised

The budgeting process


1. Consideration of past performance
2. Assessment of expected trading and operating conditions
3. Preparation of initial budget estimates
4. Adjustment to estimates based on com. with, and feedback from, managers
5. Preparation of budgeted reports and sub-budgets
6. Monitoring of actual performance against the budget over the budget period
7. Making any necessary adjustments to the budget during the budget period
____________________________________________________________________________________________________________________________
Master budget (cont)
Typical stages in the preparation of a master budget for a manufacturing entity:
Developing the sales budget

managements best estimate of sales revenue for the budget period derived from the sales forecast
Developing the production budget

to meet budgeted sales and desired ending inventory of finished goods


Developing the materials budget

for production needs and desired ending inventory of raw materials


Developing the labour budget

based on labour hours required to meet production budget and wage rates
Developing the operating expenses budget
other production and support department costs
____________________________________________________________________________________________________________________________
The cash budget
The cash budget is a statement of expected future cash receipts and payments
It assists decision making by:

documenting timing of all cash receipts and payments

helping to identify periods of expected cash shortages and surpluses

identifying suitable times for purchase of non-current assets

assisting with planning and use of borrowed funds

providing a framework for what if analysis

For an entity that provides goods or services on credit, one of the main tasks in the preparation of
a cash budget is calculating the cash receipts from the credit sales or fees generated

This is commonly shown in a schedule of receipts from debtors/accounts receivable


____________________________________________________________________________________________________________________________
Example for Akers Transport Pty Ltd (pp. 394 - 395

Past experience suggests debtors settle accounts according to the following pattern:

50% in the month following sale

40% in the 2nd month following sale

10% in the 3rd month following sale


v Sales in last 3 months of 2013 were:

$210,000 in October

$282,000 in November

$303,000 in December
____________________________________________________________________________________________________________________________
v

Step 3 - Prepare a schedule of receipts

Other relevant information:

$2,300 of March vehicle expenses to be paid in April

$4,200 of amount paid in March for marketing expenses relates to April

Loan interest expense will not be paid until April


____________________________________________________________________________________________________________________________
Step 4 - Prepare the cash budget
v


____________________________________________________________________________________________________________________________
Budgets: planning and control

The preparation of the cash budget is an important part of the planning process

It can then be used for monitoring cash performance, also known as the control process

A cash budget prepared on a month-by-month basis is much more useful for this purpose than one
prepared on a quarterly or yearly basis

As each month passes, actual cash numbers can be compared to the budget numbers, with the
difference between the two known as a variance
____________________________________________________________________________________________________________________________
Step 5: Compare actual performance against budget


Step 6: Make any necessary adjustments to budget


____________________________________________________________________________________________________________________________
Improving cash flow
Cash inflow may be increased by:

improving the collections of cash from debtors

seeking ways to improve sales or fees

reducing unnecessary stock levels

arranging external finance

providing an extra capital contribution from the owners, or considering a change in ownership
structure

selling excess non-current assets


____________________________________________________________________________________________________________________________
Cash outflow may be reduced by:

cutting expenses by identifying areas of waste, duplication or inefficiency

making use of creditors terms

keeping inventory levels to only what is required, as excess inventory ties up cash and often adds
to storage and handling costs

deferring capital expenditures


____________________________________________________________________________________________________________________________
Behavioural aspects of budgeting

Like all decision-making processes, budgeting is affected by human behaviour, attitudes and
assumptions

These are seen in the management styles adopted in the budget process

In an authoritarian (top down) style of budgeting


senior management simply sets the targets and the budget for unit managers
unit managers have little say in the targets that are set

In a participative (bottom up) style of budgeting


targets and budgets are arrived at by a process of discussion and negotiation between senior management
and unit managers
unit managers are seen to have had a say in the setting of targets and the budget

The behavioural aspects of budgeting are also seen in the attempts by some line managers to:

overstate planned expenditure or understate planned revenue or receipts

include some margin for error in case targets are not met

manipulate information so that their performance is presented in the best possible light
____________________________________________________________________________________________________________________________


TOPIC 8 CHAPTER 10 - COST-VOLUME-PROFIT ANALYSIS

CVP analysis is concerned with the change in profits in response to changes in sales volumes, costs and
prices
Helps answer the following questions:-
How many units need to be sold, or services performed, to break even (that is, earn zero
profit)?
What is the impact on profit of a change in the mix between fixed and variable costs?
How many units need to be sold, or services performed, to achieve a particular level of
profit?
What is the impact on profit of a 15 per cent increase in costs? A 10% decrease in sales
volume? Etc.
____________________________________________________________________________________________________________________________
Cost behaviour
CVP analysis is an important part of the managerial planning process
Begins with a consideration of cost behaviour

Examining cost behaviour enables us to consider:


the way in which costs change, and
the main factors that influence those changes

Costs can be classified as fixed, variable or mixed


The nature of fixed and variable costs relates
to whether such costs are likely to alter in total
with changes in activity

Fixed, variable and mixed costs
Fixed costs are those costs that remain the same in total (within
a given range of activity and timeframe) irrespective of the level
of activity

e.g. lease costs; depreciation charges

When we consider levels of activity in terms of units of


output:
total fixed costs remain the same, but
fixed costs per unit will decrease as the
number of units produced increases

Variable costs change in total as the level of activity changes
e.g. cost of bricks to build a house; aviation fuel for Qantas

Variable costs can be considered on either a total or unit


basis:
total variable costs increase as the number of
units produced increases, but
variable costs per unit will remain the same

The relevant range is the range of activity over which the cost behaviour is assumed to be valid

If the activity level goes outside the relevant range, then the expected behaviour of costs changes,
e.g. fixed costs can no longer be assumed to be fixed

Mixed costs occur because some costs have both fixed and variable components


____________________________________________________________________________________________________________________________

Break-even analysis
v Break-even analysis relates to the calculation of the necessary levels of activity required in order
to break even in a given period

Break-even occurs when total revenue and total costs are equal, resulting in zero profit
i.e. when
Revenue = FC + VC
Break-even analysis involves the contribution margin concept
Contribution margin is calculated by deducting total variable costs from total revenue
Contribution margin per unit can be calculated by deducting variable cost per unit from revenue per unit
Contribution margin = Revenue VC
____________________________________________________________________________________________________________________________
Break-even analysis for a single product or service
Example 1
Selling price




$25
Purchase price



$14
Fixed exhibition and trade show costs


$28,000 p.a.
Fixed transport costs



$10,600 p.a.
Variable demonstration costs



$1 per unit
Administration fixed costs


$6,400 p.a.

Break-even (in units) =



FC $ = x break-even (units)

CM per unit $
____________________________________________________________________________________________________________________________

EXAMPLE
SP per unit




$25
VC per unit




Purchase price


$14

Demonstration costs


1
15
CM per unit



$10
____________________________________________________________________________________________________________________________
Break-even
=
FC

CM per unit


= $(28,000 + 10,600 + 6,400)



$10


= $45,000


$10


= 4,500 units
____________________________________________________________________________________________________________________________
Units to earn a desired profit =
FC + Expected profit = x sales units

CM per unit
____________________________________________________________________________________________________________________________
Example 1
Expected profit (before tax)

$50,000
FC + Expected profit
=
$(45,000 + 50,000)

CM per unit

$10



=
9,500 units
____________________________________________________________________________________________________________________________
Example 1
VC increased to $17 per unit
FC reduced to $32,000
CM

= $25 $17
= $8
Break-even
= $32,000
= 4,000 units




$8
____________________________________________________________________________________________________________________________
Can also be expressed in an equation format:
s(x) = vc(x) + fc
(for break-even)
s(x) = vc(x) + fc + p
(for meeting desired profit)


____________________________________________________________________________________________________________________________




Graphical representation of CVP


____________________________________________________________________________________________________________________________
Using break-even data

Identifying the number of products or services required to be sold to meet break-even or profit
targets

Planning products and allocating resources by focusing on those products that contribute more to
profitability

Determining the impact on profit of changes in the mix of fixed and variable costs

Pricing products
____________________________________________________________________________________________________________________________
CVP assumptions

The behaviour of costs can be classified as fixed or variable

Cost behaviour is linear

Fixed costs remain fixed over the time period and/or a given range of activity (often referred to
as the relevant range)

Unit price and cost data remain constant over the time period and relevant range

For multi-product entities, the sales mix between the products is constant
____________________________________________________________________________________________________________________________
Margin of safety and operating leverage
The margin of safety provides an indication of how much revenue (or sales in units) can decrease before
reaching the break-even point:
Margin of safety in units =
actual or estimated units of activity - units at break-
even point
Margin of safety revenues
=
actual or estimated reven revenue at
break-even point
Provides a measure of how much risk is involved in the activity
____________________________________________________________________________________________________________________________
Operating leverage is the mix between FC and VC in the cost structure of an entity

It provides an understanding of the impact of changes in revenue on profit


Greater proportion of FC in a firm:

more highly leveraged


more risky
because fluctuations in sales

higher fluctuations in profit
____________________________________________________________________________________________________________________________
Margin of safety and operating leverage (example)

Modclean uses casual labour to demonstrate their product


Variable cost $1 per unit

Human resource manager proposes to hire a part-time permanent employee


Fixed cost $10,000

If this proposal goes ahead


Variable costs drop by $1.00 per unit
Fixed costs increase by $10,000
Is it worthwhile?
Determine level of sales at which profit would be the same...

$10,000/$1 = 10,000 units


At this point we are indifferent because profit is same
____________________________________________________________________________________________________________________________
Contribution margin under permanent employee
$25 14 = $11
Contribution Margin under casual employee
$25 15 = $10
____________________________________________________________________________________________________________________________
Therefore if sales fall below 10,000 units they should use casual labour because profit reduces at a slower
rate and if sales rise above 10,000 units they should use permanent labour because profit increases at a
faster rate

Permanent employee

Casual employee

Sales (10,000 units x $25)

$250,000

Sales (10,000 units x $25)

$250,000

Less variable costs

140,000

Less variable costs

150,000

(10,000 units x $14)

(10,000 units x $15)

Contrib. margin ($11 per unit)

110,000

Contrib. margin ($10 per unit)

100,000

Less fixed costs

55,000

Less fixed costs

45,000

Profit

55,000

Profit

55,000


Permanent employee

Casual employee

Sales (8,000 units x $25)

$200,000

Sales (8,000 units x $25)

$200,000

Less variable costs

112,000

Less variable costs

120,000

(8,000 units x $14)

(8,000 units x $15)

Contrib. margin ($11 per unit)

88,000

Contrib. margin ($10 per unit)

80,000

Less fixed costs

55,000

Less fixed costs

45,000

Profit

33,000

Profit

35,000

____________________________________________________________________________________________________________________________
Contribution margin per limiting factor
Contribution margin per limiting factor is the contribution margin per unit of limited resource
Example 2



Products




B101
C101
D101 .
Budgeted sales next year

60,000 40,000
100,000
SP per unit



$25 $40
$20
VC per unit



$15 $22
$15
CM per unit


$10 $18
$5
Labour time per unit



1 hr 4 hrs
1.5 hrs
Total labour hrs required

60,000 hrs 160,000 hrs 150,000 hrs

By summing the required hours, we find that the firm needs a total of 370,000 hours

BUT only 250,000 hours are available for production

Firm wants to know which product it should promote

This means we need to determine the most profitable product

To do this need to find CM per hour because time is the limiting factor




B101
C101
D101
CM per unit

$10
$18
$5
Labour time per unit

1 hr 4 hrs
1.5 hrs
Total labour hrs required
60,000 hrs 160,000 hrs 150,000 hrs
CM per hour


$10 per hr. $4.50 per hr. $3.33 per hr.

This analysis shows that:
C101 is most profitable per unit
But B101 will maximise profit by providing more CM per hour
May and buy (outsourcing) and special order decision

To make sure decisions are based on the right information, the following must be identified where
relevant:
Relevant costs and relevant income
Incremental costs and incremental income
Opportunity cost
Avoidable costs and unavoidable costs
____________________________________________________________________________________________________________________________

A make or buy (outsourcing) decision requires an entity to choose whether:
To make or provide a product or service, or
To outsource the production of that product or service
Such a decision will involve:
quantitative factors (comparison of relevant costs, opportunity costs between both options) and
qualitative factors (product quality, reliability of supply, on-time delivery, staffing considerations, etc.)
___________________________________________________________________________________________________________________________
A special order is a one-off request from a customer that is diff. from the orders usually received by
the entity
Will incremental revenue exceed incremental costs?
Incremental costs = additional VC, but may also be incremental FC
Must also consider whether the entity is operating at full capacity, or has idle capacity
(or available capacity)
Insufficient idle capacity => opportunity cost
____________________________________________________________________________________________________________________________

TOPIC 9 CHAPTER 8
ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS
Users and decision making
The users of financial reports can broadly be categorised as:
resource providers
e.g. creditors, lenders, shareholders, employees
recipients of goods and services
i.e. customers, debtors
parties performing an overview or regulatory function
e.g. tax office, corporate regulator, statistical bureaus
internal management
to assist in their decision making duties
____________________________________________________________________________________________________________________________
The need for financial analysis
The financial analyst attempts to explain to the players and the umpires the meaning of the accounting
scores:

Involves expressing the reported numbers in relative terms rather than relying on the absolute numbers

This can highlight the strengths and weaknesses of firms

By evaluating an entitys financial past, users are in a better position to form an opinion as to the entitys
future financial health

Try to understand past results to predict future performance


____________________________________________________________________________________________________________________________
Analytical methods
It is essential in financial analysis to compare figures with:

the equivalent figures from previous years (rather than in one years absolute terms)

other figures in the financial statements

benchmarks
Analytical methods include:

Horizontal analysis

Trend analysis

Vertical analysis

Ratio analysis
____________________________________________________________________________________________________________________________
Horizontal analysis
Compares reported numbers in different reporting periods to highlight magnitude and significance of
changes
Dollar change is calculated by:
Accounting number in current reporting period Accounting number in previous reporting period
Percentage change is calculated by
Accounting number in current reporting period Accounting number in previous reporting period x 100
/ Accounting number previous reporting period



2013
2012 Difference
Sales
$858,000
$803,000
$55,000
COGS
513,000
509,000
4,000
Gross profit 345,000 294,000 51,000


____________________________________________________________________________________________________________________________
Trend analysis

Tries to predict the future direction of various items on the basis of the direction of the items in
the past

To calculate a trend, it is necessary to have at least three years of data

Trend analysis of a particular item involves expressing the item in subsequent years, relative to a
selected base year (which is usually given a value of 100)
____________________________________________________________________________________________________________________________
Example : Converting Sales Revenue for a trend analysis
Absolute figures $m

2013

2012

2011

2010

2009

2008

Sales revenue

$2959.3

$2731.3

$2327.3

$1828.6

$1281.8

$945.8

Trend numbers

313

289

246

193

135

100

Working

Etc.

Etc.

Etc.

$1828.6 / $945.8 x 100

$1281.8 / $945.8 x 100


1. Set 2008 as base year and assign it index value of 100
2. Divide 2009 revenue by 2008 revenue and multiply by 100
3. Divide 2010 revenue by 2008 revenue and multiply by 100
4. Divide each subsequent years revenue by 2008 revenue and multiply by 100
____________________________________________________________________________________________________________________________
Vertical analysis
Involves comparing the items in a financial statement to an anchor item in the same financial statement:
Revenue and expense items are expressed as a percentage of sales or revenue
A, L and Equity items are expressed as a percentage of total assets

Demonstrates the internal structure of financial statements

Particularly useful for inter-company comparisons and different size comparisons (common size
financial statements)

JB Hi-Fi Ltd



Ratio analysis

An expression of one item in the financial statements as a fraction of another item in the financial
statements one item is divided by another to create the ratio

The ratio comparison can be between two different statements


But income statement and statement of cash flows involve flow items while balance sheet
reports stock items need to use averages for stock items

Ratios provide clues or symptoms of underlying conditions


Point to areas requiring further investigation

Ratio analysis is a 3-step process
Calculate a meaningful ratio by dividing $ 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



Ratios in various categories help users in their decision making
profitability ratios
efficiency ratios
liquidity ratios
capital structure ratios
market performance ratios (relevant to companies listed on an organised stock
exchange)
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Benchmarks
v Ratios are of limited usefulness unless compared to relevant benchmarks
v Comparisons may be made of:

the entitys ratios over time (identify trends)

the entitys ratios with those of other entities in same industry (intra-industry analysis)

the entitys ratios with industry averages

the entitys ratios with those of entities operating in different industries (inter-industry
analysis)

the entitys ratios with arbitrary standards


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Profitability analysis

v Return on equity (ROE)

ROE measures the rate of return achieved by the companys managers on the capital
invested by shareholders

ROE will be greater than ROA when a firm is earning a return on borrowed funds that is
greater than the cost of those funds
Captures profitability, efficiency and capital structure

Upward trend is advantageous for entity


But, a sustained high ROE attracts new competitors to industry and eventually
erodes excess ROE
Return on equity (ROE)


Profit available to owner s x 100 = x%


Average owners equity


Return on assets (ROA)

Compares a firms profits to the assets that are available to generate the profits
measures the return earned by management through operations

Reflects the results of entitys ability:


to convert sales revenue into profit
to generate income from its asset investments
Return on assets (ROA)


EBIT
x 100 = x%


Average assets
EBIT is used to eliminate impact of how assets are financed and to exclude effects of taxation policy
This ratio will be influenced by asset valuation policy

Profitability analysis
Profit margin ratios

Ratios that relate profit to sales revenue generated by the entity include the gross profit
margin and the profit margin
Gross profit margin reflects the proportion of sales dollars that ends up as gross
profit

Gross profit margin


Gross profit
x 100 = x%


Sales revenue

Profit Margin
EBIT

x 100 = x%
sales revenue

Net profit margin
Net profit margin indicates what percentage of sales dollars remains as distributable profits


Net profit after tax
x 100 = x%


Sales revenue

Cash flor to sales ratio
Measures the amount of operating cash flow generated by each sales dollar
Cash flor from operating activities x 100 = x%

Sales revenue


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Asset efficiency analysis
Asset turnover ratio

Shows an entitys 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
Like ROA, this ratio is influenced by asset valuation policy
Ave. total assets = (open. assets + clos. assets)/2

Asset turnover ratio




Sales revenue = x times


Average total assets

Days inventory ratio

Indicates the average period of time it takes to sell inventory


Often referred to as shelf life

Days inventory


Average inventory x 365 = x days


Cost of sales
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Days debtors ratio
Indicates average period of time it takes to collect the money from its trade related accounts receivable
Days debtors

Average accounts receivable x 365 = x days


Sales revenue

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Asset efficiency analysis
v It is common to calculate the number of times per annum that inventory and trade
debtors are turned over, rather than the number of days it takes for this to occur:
Times inventory turnover


Cost of sales = x times


Average inventory
Times debtors turnover

Sales revenue
= x times

Average accounts receivable


Days inventory and days debtors turnovers can be considered together to reflect the entitys activity
cycle (also referred to as the operating cycle)
The cash cycle represents the period of time that elapses between an entity paying for the inventory,
selling the inventory, and receiving cash for the inventory => deduct days creditors from activity cycle

Liquidity analysis

The survival of the entity depends on its ability to pay its debts when they fall due (its liquidity)
An entity must have sufficient working capital to satisfy its short-term requirements and
obligations

But excess working capital is undesirable because the funds could be invested in other assets that
would generate higher returns

Current ratio and quick ratio

Current ratio (or working capital ratio) indicates $ of current assets per $ of current
liabilities

Measures a firms liquidity = the ability of the firm to meet its short-term
obligations)

An arbitrary ratio of 1.5:1 is considered a minimum


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Current ratio


Current assets = x times


Current liabilities


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Capital structure analysis
An entitys capital structure is the proportion of debt financing relative to equity financing (= gearing or
leverage)

reflects the entitys financing decision

investments in assets are funded externally by liabilities, or internally by owners equity


as shown in accounting equation:
ASSETS = LIABILITIES + EQUITY
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Financial Gearing (Leverage)
Financial Gearing: The existence of fixed payment- bearing securities (e.g. loans) in the capital structure of a
company
The level of gearing (or the extent to which a business is financed by outside parties) is an important
factor in assessing financial risk
Debt carries contractual obligations that must be met regardless of how well the business is performing
inability to meet these obligations can result in bankruptcy
Gearing may be used both to adequately finance the business, and to increase the returns to owners
provided that the returns generated from the borrowed funds exceed the interest cost of borrowing
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Capital structure (gearing) ratios
Only 1 of the 3 capital structure (gearing) ratios needs to be calculated, as all indicate use of debt relative to
equity to finance investments in assets:
Debt to equity ratio


Total liabilities
x 100 = x%


Total equity


Debt ratio


Total liabilities
x 100 = x%


Total assets


Equity ratio


Total equity

x 100 = x%


Total assets

Debt ratio + Equity ratio = 100%

Debt ratio / Equity ratio = Debt to Equity ratio


Debt to equity ratio


Total liabilities
x 100 = 150%


Total equity


Debt ratio


Total liabilities
x 100 = 60%


Total assets


Equity ratio


Total equity

x 100 = 40%


Total assets


v An effect of gearing is that the returns to equity become more sensitive to changes in profits
v When highly geared, an increase or decrease

in profits will lead to a proportionately greater

change in returns to equity

Gearing demonstrated

X Ltd

Y Ltd

Paid-up ord. share capital

100,000

200,000

10% loan

200,000

100,000

300,000

300,000


EBIT


50,000


50,000

Interest expense

(20,000)

(10,000)

Profit before tax

30,000

40,000

Tax (at 30%)

(9,000)

(12,000)

Profit avail. to ord. shareholders

21,000

28,000


ROE


21%


14%

X Ltd

Y Ltd

Paid-up ord. share capital

100,000

200,000

10% loan

200,000

100,000

300,000

300,000


EBIT


25,000


25,000

Interest expense

(20,000)

(10,000)

Profit before tax

5,000

15,000

Tax (at 30%)

(1,500)

(4,500)

Profit avail. to ord. shareholders

3,500

10,500


ROE


3.5%


5.25%

Capital structure ratios (cont)



Interest servicing ratios
The financial risk of the entity can also be assessed through the interest coverage ratio (also referred to as
times interest earned)
Interest coverage ratio


EBIT

= x times


Net finance costs
As a rule of thumb, a value above 3.0 is usually considered adequate
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Debt coverage ratio

Debt needs to be serviced from cash flow, so it is useful to relate the entitys cash generating capacity to
its long-term debt

This ratio links cash flows from operating activities with long-term debt
Debt coverage ratio
Non-current liabilities

= x times
Net cash flows provided by operating activities


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Market performance analysis
Net tangible asset backing per share (NTAB)

Provides an indication of the book value of the entitys 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
(goodwill) or marketability (most other intangible assets)
Net tangible asset backing per share
Ordinary shareholders equity Intangible assets =

x cents/share
No. of ordinary shares on issue at year-end

Earnings, cash flow and dividend per share
Earnings per share

Profit available to ordinary shareholders = x cents/share

Weighted no. of ordinary shares on issue

Operating cash flow per share
Net cash flows from operating activities Preference dividends = x cents/share

Weighted no. of ordinary shares on issue

Dividend per share
Dividends paid to ordinary shareholders in current period = x cents/share
Weighted no. of ordinary shares on issue
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Dividend payout ratio

The proportion of current years profits that are distributed to shareholders as dividends

Profits not distributed are retained by the entity for reinvestment


Dividend payout ratio


Dividends per share x 100%


Earnings per share

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Price earnings ratio (PE ratio)

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


Highlights the markets assessment of the future performance of a firm
Price earnings ratio


Current market price = x times


Earnings per share


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Ratio interrelationships

In presenting profitability, asset efficiency, liquidity, capital structure and market performance
ratios, we attempt to link ratios to describe the financial health of the firm

Ratio analysis is valuable because it helps to interpret and explain why ratios may be different
from those of:
previous years
competitors
industry averages
entities in unrelated industries??
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Performing a ratio analysis
Across Time
A ratio from two years
The method DES (Describe, Explain, Suggest)
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)
Suggest a cause

What would make the denominator/numerator move up or down?

For example: if the numerator was current assets, then what accounts had the
greatest impact on current assets?

Cash?

Inventory?

Sales?

Why?

Trends may be identified by plotting key ratios on a graph, giving a visual representation of
changes happening over time

Intra-company trends may be compared against industry trends


Key financial ratios are often published in companies annual reports as a way of helping users
identify important trends.

Ratios and Prediction Models


Ratios are often used to help predict the future however the choice of ratios and interpretation
of results depend on the skill and judgment of the analyst
Researchers have developed ratio-based models which claim to predict future financial distress as
well as vulnerability to takeover
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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 firms 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

Comparability may be impeded by accounting policy and estimation choices


The quality of the underlying financial statements determines the usefulness of the ratios
derived from them
Beware of aggressive accounting and earnings management

Most analysis is for the purpose of forecasting future performance, but historical relationships
may not continue
Historical cost data fail to account for the effects of inflation
Can ROA be meaningful when current $ profits are divided by historical $ assets?

Any ratios based upon balance sheet figures will not be representative of the whole period
because the balance sheet is a snapshot of a moment in time

No two businesses are identical and the greater their differences, the greater the limitations of
ratio analysis as a basis for comparison:
size
accounting methods employed
diversification of product lines

Lack of disclosure or inconsistent application of accounting policies may necessitate adjustments


or estimations

Remember, 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 entitys performance
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SUMMARY

Summarising: Criteria to be satisfied to recognise an asset


v The essential characteristics for an asset are:
1. the resource must be controlled by the entity
2. the resource must be as a result of a past event
3. future economic benefits are expected to flow to the entity from the resource.
v Furthermore, to be recognised as an asset on the balance sheet, the future economic benefits must
be probable and capable of being measured reliably.


Summary CH 1,2,3

Process of accounting concerns identifying, measuring and communicating economic information


for decision making

Users of accounting information may be external or internal

Management accounting concerns needs of internal users, while financial accounting focuses on
reports for external users

The main sources of company regulation are the Corporations Act, the ASX listing rules and the
influence of the accounting profession

IASBs Framework is applicable to all Australian reporting entities

Limitations of accounting relate to the time lag, historical nature of information and costs
associated with releasing accounting information.

A good decision is based on knowledge and not on numbers Plato.


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Summary Characteristics

Sole Trader

Partnership

Companies

No. Of Owners

2 50

As many as per articles of association

Liability

Unlimited

Unlimited

Limited

Profit

Belongs to owner

Distributed to partners as per


agreement

Distributed to shareholders in form of


dividends, at discretion of board.

Tax

Owner taxed as individual


tax payer (profit treated as
income of owner)

Partners taxed as separate


individuals

Company taxed on profits. Shareholders


taxed on dividends less tax credit for tax
paid by company


Financial Statements

Sole Trader

Partnership

Companies

Income
Statement

No tax shown
Prepared to meet
needs of owner

No tax shown
Profit distribution to individual
partners shown

Tax shown as expense


Earnings per share shown but
not dividends

Equity on
Balance
Sheet

Profit increases capital


directly

Individual partner equity shown

Capital = issued shares


Retained earnings = all profits
not distributed to shareholders.

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CH 4 SUMMARY

Business transactions are occurrences that affect the assets, liabilities and equity items in an entity

Business transactions are an exchange of goods that occurs between the entity and an outside
entity

The accounting equation:


Assets = Liabilities + Equity
Assets Liabilities = Equity

A transaction has a dual effect on the equation

After each and every transaction, the accounting equation must remain balanced

An accounting worksheet is a summary of business transactions

Good for smaller businesses

Larger businesses will have Journals and Ledgers

Journals and Ledgers use debits and credits (not covered in this course)

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TOPIC 5 SUMMARY

A statement of cash flows enables decision makers to evaluate the entitys ability to generate
positive cash flows in the future, pay dividends and finance growth
v It provides a summary of cash and types of cash flows in and out of an equity
v The format is governed by accounting standards
v Interpretation requires a general evaluation as well as the use of trend and ratio analysis
v Working capital consists of funds invested in (net) current assets
v Entities must manage their cash, debtors and inventory as these are their most liquid assets
v Firms have a large number of short term finance options
v Long-term debt may be borrowed through financial institutions as intermediaries or directly by
the debt market
v Equity finance instruments consist of ordinary & preference shares, rights & options
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TOPIC 6 SUMMARY

Sustainable development is development that meets the needs of the present without
compromising the ability of future generations to meet their own needs.
Four key responsibilities of business
1. Economic
2. Legal
3. Ethical
4. Discretionary
Corporate social responsibility (CSR) refers to the responsibility an entity has to all stakeholders,
including society in general and the physical environment in which it operates.
An corporation has many stakeholders
Stakeholder theory holds that the purpose of the entity is to work for the good of all stakeholder
groups, not just to maximise shareholder wealth.
Corporate governance refers to the direction, control and management of an entity. This includes
the rules, procedures and structure upon which the organisation seeks to meet its objectives.
The key to governance for sustainability may be determined by the extent of ethical consciousness
Teleological theories

Consequences of decisions and actions


Deontological theories

Examine the decision and/or action in terms of morality

Is this the right thing to do?

TOPIC 7 SUMMARY

Strategic planning influences shorter term aspects of the budgetary planning process
A master budget may be viewed as a set of interrelated budgets for a future period
A master budget is commonly classified into a set of operating budgets and financial budgets
The behavioural aspects of budgeting relate to the human involvement in decision making


TOPIC 8 SUMMARY

CVP analysis is an important part of the planning process and serves as a useful decision-making
tool
An understanding of fixed, variable and mixed costs is necessary to execute break-even analysis
Break-even analysis can be conducted for single-product/service entities and multi-
product/service entities
we consider only single-product scenario
The concepts of margin of safety and operating leverage provide businesses with useful
extensions to the basic CVP analysis and break-even calculations
Special attention needs to be given to limited resources
Entities use relevant income/costs (not full cost) to analyse make or buy and special order
decisions.


TOPIC 9 SUMMARY

Analysis of financial statements assists users in their decision making


Financial analysis refers to assessment of an entitys financial position and profitability
Examples of analytical methods are horizontal, trend, vertical and ratio analysis
Ratio categories include profitability, asset efficiency, liquidity, capital structure and market
performance
Ratio analysis provides valuable insights but is only a tool.