1. Financial Accounting - Learning Outcomes
Accounting concepts
Having completed this module you will be able:
 Explain the relationship between accounting concepts and principles
 Calculate the key ratios used in accounting
 Match common accounting issues and their cause
 Record the correct daily journal transactions
 Discuss the use of budgeting in relation to debtors and creditors
 Describe the commons functions within debtors and creditors
 Explain the role of key statements, such as historical cash flow and
profit & loss
 Identify areas of risk for small businesses
2.
General accounting concepts
Relevance Accounting information must be based on
information directly related to the business
being reported on.
Reliability The accounting reports should represent an
effective and faithful representation of
financial events relating to the business.
Materiality This concept requires that all significant
events be included in financial reports. An
event is regarded as material if it is likely to
effect financial decisions.
Comparability If accounting reports are to be compared from
one reporting period to the next then the
methods of accounting used must be
consistent from one period to the next.
Understandability It is of no value to present accounting reports
which users are simply unable to understand
Constraint of Acts as a constraint to achieving the above
timeliness qualities in reporting. Timeliness indicates
that reports are only of value if available
within a reasonable time period.
Accounting Principles – recap
1 Matching Sets out the point of time at which revenue may
be recognised.
Breach: A contract is signed for
advertising in your magazine. Although
you will not include any advertising in
this period's work you still include the
revenue paid in advance.
2 Disclosure The owner is obligated to disclose any
transactions of a significant financial nature in
their reports.
Breach: The owner determines not to
include the recent sale of property in
the financial reports as this may deter
potential buyers of the business.
3 Consistency Accounting reports from one period to the next
should be prepared on the same basis.
Breach: The owner uses one method of
depreciation for a particular asset in one
period and an alternative method in the
second period.
4 Diversity Allows for the fact that no two firms are the
 same and therefore may use different owner.
accounting methods. Breach: The owner includes in the
Breach: The owner decides that because business balance sheet personal assets
the business down the road uses the such as his or her golf clubs.
straight line method of depreciation his
or her business should do the same. 12 Historical All items are recorded at the original cost, i.e.
5 Dependability Data used in accounting should be subject to Cost the cost at which they were acquired.
stringent internal control. Breach: Property owned by the business
Breach: Price calculations are based on is shown at the higher market value
outdated information. rather than for the amount at which it
6 Materiality Is concerned with which data should be was originally acquired.
disclosed in financial reports. All transactions 13 Conservatism May also be known as prudence. Losses should
regardless of size should be recorded. be recognized as soon as the business is aware
Breach: The owner does not bother to of their likely event, whilst profits should not
record minor withdrawals of stock from be recognized until they actually occur.
the business. Breach: The net realizable value of stock
7 Accounting The life of the business is broken up into has fallen below cost yet the owner
Period arbitrary periods for the purpose of measuring refuses to adjust cost of goods sold
profit. calculations.
Breach: The owner decides to wait until The relationship between concepts and principles
the project is completed before Relevance
preparing the financial reports.
8 Monetary Only events whose impact can be measured in  comparability
money terms can be treated as a financial  disclosure
transaction and thus entered in the books of  accounting entity
the business.  conservatism
All transactions should be recorded in  going concern
money terms.
Breach: Stock is shown in financial Reliability
reports in quantity amounts.
9 Verifiability All transactions recorded in the books of the  Verifiability
business are supported by documentary  Historical cost
evidence.  Objectivity
Breach: Payments are made and  accounting period
recorded without supporting evidence,
such as invoices or cheque butts. Materiality
10 Going Assumes that the life of the business is  materiality
Concern ongoing, indefinite and continuous. Also known
as the continuity principle. Comparability
Breach: The owner does not wish to
prepare a balance sheet but rather  consistency
reports non-current assets as costs in  disclosure
the period they were acquired.  accounting period
11 Entity Recognizes that the business, from an  conservatism
accounting viewpoint, is separate from the
 3. Accounting information Return on Net profit/average This ratio reflects the return
assets (ROA) total asset NP/TA on the total assets used in the
Understanding and using accounting information business. The average of total
assets at the beginning of the
An understanding of the accounting system is an important first step period and at the end is used
in this topic. in case there is a significant
change in assets.
2. Return on
sales
Gross profit Gross profit/sales Reflects the difference between
ratio the selling price of the stock
and the cost price. This may be
described as the mark up on
stock.
Basically this topic is about Output. The data (input) has been
Net profit Net profit/sales Measures net profit against
collected and sorted into records from which reports have been
ratio sales. It reflects total revenue
prepared (process) and now it is up to you to use that information to
against all costs and expenses
make decisions (output).
incurred by the business. When
used in conjunction with the
There are several steps in using output:
Gross profit ratio a business is
able to discern whether the
Analysis and interpretation - directing attention to the
new situation is due to change
significance of various figures and relationships.
in trading or operating.
For instance this could involve comparing this year's sales
*3. Expense An example is These ratios are particularly
revenue with the previous year's.
ratios 'selling expenses to useful when engaged in trend
Evaluation - to assess the worth or value of what is shown by
sales'. The business analysis. The responsiveness of
step 1.
may seek to an expense category such as
Decision Making - to make decisions based on conclusions
measure other selling expenses to sales
reached on the value of that information.
major indicates the effectiveness in
classifications of the use of those expenses to
Key ratios – profitability expenses against generate revenue for the
The key ratios used in the previous course are repeated here. Several sales. business.
ratios have been added and are indicated by an asterisk. 4. Asset Sales/average Displays the revenue generated
Profitability is the measure of profit against sales, assets, capital or turnover assets by assets. It shows how well
other figures. the business is using its assets.
Ratio Formula Explanation The carrying of excess stock,
Profitability debtors or bank will be
1. Return on reflected by a decline in the
assets ratio.
*Return on Net profit/average This ratio shows the return to
owner's owners equity the owner on funds invested in Key ratios – liquidity
investment the business. Allowing for the Liquidity is the ability of the firm to meet its short term debts.
(ROI) extent of funds borrowed this Ratio Formula Explanation
ratio may differ from return on Liquidity
assets. 1. Current The working capital ratio attempts
Working assets/current to measure the ability of the if the business is taking advantage
capital liabilities business to meet short term of discounts.
ratio obligations. Working capital is
current assets minus current Key ratios - stability
liabilities. It is difficult to define Stability is the long term prospects of the business surviving.
what is an adequate working Ratio Formula Explanation
capital. Too high a working capital Stability
indicates ineffective use of funds *Interest Net cash inflow from This ratio reflects the ability
whilst insufficient working capital coverage operations + of a firm to meet the
means difficulty meeting ratio interest/interest interest requirements on
obligations. expense borrowed funds. Some texts
2. Quick Current assets less This ratio is a more urgent define this ratio as Net
asset stock and prepaid measure of liquidity. It does not profit + interest/interest
ratio expenses/current include items that are not so expense.
liabilities less bank quickly converted to cash. The Gearing - Total liabilities/total Measures the percentage of
overdraft bank overdraft has been regarded Debt ratio assets borrowed funds against
as an obligation not immediately total assets.
called for. Some definitions,
however, no longer regard this as
always being true so do not deduct The cash cycle
from current liabilities. It is
probably a better measure of The cash cycle measures the time it takes to buy and sell stock,
liquidity than working capital. collect money from debtors and return that money to the business.
To complete the measurement the time allowed by creditors to pay is
deducted.
Key ratios - efficiency
Efficiency it the ability of the firm to maximize their stock For instance, if stock turnover is 65 days and debtors turnover is 40
Ratio Formula Explanation days this adds to 105 days. If creditors turnover is 30 days then the
Efficiency cash cycle is said to be 75 days.
1. Debtors Credit This ratio may be measured in 'times
turnover sales/average per annum' or in days. It shows how Trend analysis
debtors quickly the money is returned to the
business when goods are sold on
credit. To evaluate the effectiveness It is important to recognise trends or patterns relating to particular
of this ratio it has to be compared to businesses. These trends may relate to sales, margins, expenses or
the credit terms offered to debtors. profit. All of these items may be measured in amount or as a
percentage of some other relevant figure. When measured over more
2. Stock Cost of Measures how quickly stock
than one period it may show trends or movements in these figures.
turnover sales/average (inventory) is sold on average. Like
Business may then act by making decisions relating to those
inventory debtors turnover it may be
statistics.
measured in 'times per annum' or in
days
3. Credit This measures the average time
Creditors purchases/avera taken to pay creditors. When Benchmarks
turnover ge creditors compared to the credit terms
offered by creditors it may indicate
 This may be a target internally determined by a business or an o loss of traditional customers
industry benchmark gained by the collection of data from a number o increase in expenses without a commensurate increase in sales
of similar firms. There are numerous other possible reasons, however, they must 'fit
the scenario'.
Benchmarks are also known as yardsticks. They may be based on
comparisons and so may include comparisons with: Example of Losses
For example, let us select the profit to sales ratio. In a hypothetical
o previous reports example, net profit to sales may fall in the budgeted year.
o budgeted reports
o industry averages This may be due to a fall in profit or a rise in sales and reasons may
o reports of similar firms include:
o opportunity cost - the value of the next best alternative o an increase in the unit cost of items sold
o reduced prices; for example, discounting
o increased operating expenses
Presentation o an increase in competition

It is recommended that you use graphs to improve presentation and The Profit and Loss statement may be broken up to show both a
understanding of information. This presentation may be assisted by vertical and horizontal analysis. For instance, the revenue section
computer programs. They may be interspersed between paragraphs may be presented as follows:
as they become relevant to the particular accounting task. There is
no doubt graphs add to the report and help the explanation. I would
further recommend the use of graphs when carrying out trend
analysis. The plotting of a series of graphs over several years for
each of the profitability measures may more clearly show changes in
profitability.
The problem with using graphs is that you will often rely on the
graph alone. While this does identify the change which has taken
place it does not necessarily show the amount involved. To fully
satisfy the particular criteria you may have to explain why the change
has taken place.
The use of horizontal and vertical variance analysis is encouraged. Figure 18
Like graphs they tend to focus your response, however, they share
the common problem with graphs, of identifying but not explaining. This process may be repeated for the entire Profit and Loss
It is very important that you support graphs with an explanation. statement.
You are invariably required to give 'reasons for the change'. It is also
important to note that 'the reasons must be relevant to the
hypothetical business'. Reasons will be found in the data and in the
preamble provided by the task. A preamble is preliminary
information.

Decline in profit
The reasons for a decline in profit may include:

o excessive stock loss

o increased competition Figure 19
 o show how it was calculated
Legend ✴NP/OE = Net profit to owner's equity ROI ✴ GP/sales = o explain the changes to the numerator and denominator that caused
Gross profit to sales ✴ NP/sales = Net profit to sales the ratio to change
It is important to note that the percentage change is not arrived at by
direct deduction alone. For NP/owner's equity the percentage in 2000 Looking at key items in the ratios in the figures 18 & 19.
is 80.2% and in 2001,40.9%. Many students then deduct 40.9% from
80.2% and say that this ratio has decreased by 39.3%. However, the Net profit
39.3% must then be divided by 80.2% to find the actual percent May be increased by (for decreases reverse the
change. increase/decrease below)
an increase in sales
Having completed the table above, you should then show this data in a decrease in price, which may stimulate extra demand
a line graph for each profitability measure an improved location
Suppose the issue is liquidity. Once again Table 1 would be repeated, increased spending on advertising and sales wages
this time selecting ratios relevant to liquidity.
These figures can then be converted into line graphs. Remember to Advertising
correctly label all graphs. better qualitymore appropriate
The ratios to select include: increased spending
o working capital
o quick asset ratio Product
o creditors turnover quality
o debtors turnover type
o stock turnover range
o bank balance
Relevant reasons have to be given for changes to liquidity. Customer focus
after sales services
Reasons for deterioration of liquidity include: pre sales service
o deterioration in cash cycle such as slow paying debtors, slow moving extra services such as training
stock items
o buying of non-current assets for cash Cost of Goods sold
o excessive cash drawings buying in bulk - a decrease in buying costs, an increase in
o loan repayments carrying costs
o specific costs such as unexpected legal expenses cheaper items, risk of sacrificing quality
o new and increased expenses without commensurate selling price more expensive items may have greater appeal leading to
increases increased sales
the margin between the cost price and the selling price is an
How changes to numerators and denominators impact on the ratio important factor in the success of a business

Each of the ratios stated previously has a numerator and a Expenses

denominator. For example: Net profit/(average) Total assets. The net
profit is the numerator and the total assets the denominator. The
ratio will be improved by increasing net profit at a faster rate than
total assets or decreasing net profit at a slower rate.
When considering a change in a ratio you should:
o measure the ratio
increased efficiency should be sought in use of expenses
all expenses should be linked to the contribution they make
to profit
Ratios
Liquidity ratios: Working capital (current assets/current liabilities)

There is an optimum amount for working capital and it may be too
high or too low. A working capital (WC) that is too high means an
inefficient use of funds, reflected by excessive stock, debtors or cash.
It may also indicate an inability to obtain stock on credit.
A WC that is too low means the inability to take advantage of credit
terms offered with the loss of discount. Businesses are engaged in
'hand to mouth' buying and may be forced to rely on bank overdrafts
and other credit, which is expensive.
This ratio is easily manipulated. For instance, borrowing long term to
repay short term debts will improve the ratio without being of
benefit to the business.
Quick asset ratio: (current assets less stock and prepaid
expenses/current liabilities less bank overdraft).
There is not the same certainty these days that the bank overdraft
will not be immediately called in, some businesses do not deduct
bank overdraft from current liabilities when calculating this ratio.
This ratio should always be at least 100%.
Efficiency ratios
Debtors turnover: (credit sales/average debtors)
 credit sales
 extension of credit terms offered to potential
credit customers
 offering of credit to a greater range of
potential customers
 debtors
The reduction of average debtors will also improve this ratio:
 discount offered to debtors
 reduction in credit offered
 incentives to buy for cash
 charging of interest (must be a term of the
contract)
 more careful selection of credit customers
 refusal of further credit until payment
 factoring of debtors
 more frequent invoicing

Stock turnover: (cost of goods sold/average inventory)
The cost of sales will improve with greater sales. This is favourable
to the business. On the other hand a business may face an increase in
cost of sales, with increased unit costs and be unable to increase
selling price accordingly. This would be unfavourable to the
business.
Stock
o carrying of less stock - this is supported by strategies
such as 'just in time'. Stock is bought to meet
immediate needs and minimal stock is carried by the
business
o immediate sale/disposal of obsolete or slow moving
lines
o monitoring of stock levels and the turnover of
individual lines
Creditors turnover: (Credit purchases/average creditors)
The terms offered by creditors must be noted when measuring the
success of a business in dealing with this ratio. If creditors offer 30
days and the ratio is below 30 days this would indicate that the
business is taking advantage of discounts and maintaining a happy
relationship with creditors.
By taking longer to pay than the terms offered means that the
business is:
o jeopardising future supplies
o influencing the quality of service, such as being
informed about new products and so on
o reducing discounts received
Discussing long term stability
Selection of the key ratios is again important. It is easy to use a
multitude of 'gearing' ratios, however, only one is necessary. Most
people favour liabilities to total assets as a measure of gearing.
The references are not consistent in their definition of ratio items.
For instance, some define the rate of return ratio using "owner's
equity" whilst others use 'average owner's equity'. Either is acceptable
providing you are consistent in the application of these measures.
Where relevant you should use an 'average' figure.
Two other possible ratios to use are:
debt ratio = Interest bearing debt/total assets
interest coverage ratio = Net cash flow from operations +
interest/interest expense
 It is important that you graph the ratios stated above along with
liabilities: total assets. The movement of these ratios must be
explained and, if provided, compared with a benchmark.
By referring to the financial reports you should attempt to explain
why changes have occurred.
Before condemning a business in respect of it's long term stability
check the nature of the non-current assets. If these assets have been
acquired some time ago and are shown at historical cost then it may
be possible that they are considerably understated in value, which
means the gearing situation is not as bad as it appears.
On the other hand a business, which has a reasonable gearing, may
still fail if it loses a major account or suffers the failure of a major
customer/debtor.
An area you may wish to pursue in your report concerns items which
are certainly not measurable but vital in performance evaluation. One
such example is the quality of the management of the business you
are evaluating.
This may be done in three stages:
o select appropriate ratios and other criteria to identify significant
change over the two historical years and that expected for the
budgeted year
o fully explain the identified changes
o give reasons for the changes. You must indicate the direction,
magnitude and effect of changes where appropriate. The reasons
must be relevant to the scenario chosen
Unfortunately many students fail to go past ratios when selecting
criteria for assessing a business.
When assessing a business - three other areas also are important:
o comparative data (C)
o actual data (A)
o economic data (E)
Owner's equity

The advice you provide to management may be non-financial such as Owner's equity Is relevant as the denominator of ROI. (return on
providing better staff training, improved customer relations and use owner's investment) OE (owner's equity) is the residual value of
of the internet. You may also suggest that the business widen or assets minus liabilities. If excess assets are carried by the business
contract operations. then OE is excessive and the return on investment is diminished. To
reduce OE the owner may dispose of excess assets and take the
Limitations in the use of accounting information excess funds out of the business and invest elsewhere. Alternatively
new, more productive assets may be acquired.
Problems in using historical information: By diminishing the number of unnecessary assets the sales/assets
o the nature of the business may have changed ratio will also be improved.
o the historical information may have been obtained from unreliable
data
o the business may be in an industry which is changing
o the data may not reflect the state of the economy, either specific to
this industry or in general
o the quality of leadership may not be shown
o not all information may be available; for example, the intention to
introduce new technology
The qualities of good information include:
o comparability
o relevance
o reliability
o materiality
o understandability

Strategies for evaluating accounting information

 4. Accounting Issues
Accounting issues apply to:
o depreciation
o revenue/expense recognition (point of sale or point of cash transfer)
o stock valuation (lower of cost and net realisable value)
o historical cost and non-current asset valuation
These accounting issues take effect in terms of valuation, recording
and reporting. The issues may be considered in terms of criteria such
as control, planning, time, cost and simplicity.
This has certain ramifications. Depreciation also has to be adjusted
to allow for changes in current values. This brings into question the
purpose of depreciation itself. Is it intended to allocate the cost of
the asset over the life of the asset? This is the definition currently
used. If the depreciation is based on current or replacement values
then this suggests the purpose is to provide for the replacement of
the asset. This is a purpose not currently met. What happens if you
do not intend to replace the asset or if you do, with a more expensive
asset? There are no ready answers for these questions.

Assessment of performance becomes more difficult if the base

Historical cost and non-current asset valuation
against which profit is measured constantly changes. Is the
improvement in performance due to increased profit or decreased
In preparing reports, we are currently guided by the historical cost asset valuation? The use of ratios, as a measure of performance,
principle. This principle states that non-current assets should be loses its value with these changes and a careful examination of actual
valued at the cost at which the asset was acquired. This cost includes reports becomes important.
costs involved in getting the asset ready for use. For instance, if you
were to buy a combustion stove for your restaurant at a cost of Finally who carries out these valuations and is the expense for a sole
$1500 it may also cost you a further $400 to have the stove installed. trader justified?
The depreciable cost of the stove becomes $1900.
Example: A business upwardly values premises by $20 000
The advantage of using historical cost is that it is based on objective
evidence rather than subjective opinion. However, the problem with
some non-current assets such as property is that they usually
increase in value over a number of years.

This creates problems when assessing the performance of a business.

Supposing a business has a net profit of $30 000 and total assets of
$300 000. The ROA (return on assets) is 10% and in the absence of Depreciation
other information may be regarded as satisfactory. However, the
$300 000 in assets may include premises valued (historical cost) at Two methods of depreciation are:
$200 000. The assets may have been bought in 1979 and may be Straight line method Diminishing balance method
'worth' seven times that amount today, $1 400 000. If that
information was reported in the balance sheet total assets would be
$1 500 000. The ROA would be 2% and much less likely to be
regarded as satisfactory.

This information may substantially affect decision making in the

business. The business may now consider selling the premises and
ending the business, renting elsewhere or seeking a more profitable
activity.
The decision to reflect more current values for non-current assets is
an aspect of current cost accounting. Using this approach the
business attempts to show the non-current asset at current or
replacement values.
The methods differ in valuation and in the impact valuation has on
the profit reported and subsequent effect on the balance sheet.
The results of the application of the different methods apply in the
following ways:
Disposal Value The straight line method deducts the disposal
value of the asset prior to calculation, whereas
the diminishing balance method does not
Matching costs The straight line method assumes a consistent
with revenue return to revenue over the life of the assets
Diminishing balance assumes the asset earns
greater revenue in the earlier years of the asset's
life
Obsolescence Only the diminishing balance method allows for
possible obsolescence by attempting to write off
the bulk of the asset cost as depreciation in the
earlier years of the asset's life
Calculation of The straight line method is most simple to
depreciation calculate, providing the same amount each year
Diminishing balance is based on the written
down value of the asset and requires deduction
of previous accumulated depreciation prior to
calculation of depreciation for this accounting
period
Merits/disadvantages
Straight line method Diminishing balance method
Simple to operate/calculate Allows for obsolescence
Does not allow for obsolescence Enables the recovery of cost of
or the premature end of the the asset at the earliest
economic life of the asset opportunity
Helps long term planning as you Tendency to overstate
know what is going to be the depreciation (and therefore
amount allocated in future understate profit) in the early
periods to depreciation years of the asset life
Revenue and expense recognition
Cash and accrual accounting
These alternative accounting systems should be treated in two
separate stages:
Recognising and recording transactions
A transaction is defined as "an external event involving the transfer
of something of value between two or more entities". The accounting
system records the effects of the transactions. It follows that the
point(s) at which a firm records depends upon the type(s) of
transactions it recognises. There are two methods for recognising
and hence recording transactions.
a. The cash method; which recognises and records only the
receipt and payment of cash.
b. The accrual method; which recognises and records
transactions both when they are entered into (earned or incurred)
and when cash is received and/or paid. This method recognises and
records both credit and cash transactions.View the video on small
businesses.
Revenue realisation
The realisation assumption sets out the point of time at which
revenue is to be recognised. Generally, firms will recognise revenue
at the point of sale or for the provision of a service. For example, a
car is sold by a car dealer on 23 December and payment is on 15
January. The accounting periods are for one calendar month. If
revenue is recognised at the point of sale then this revenue would be
reported in the month of December. At the point of cash the revenue
would be reported in January.
In fact, there are four points at which revenue may be recognised.
Point of Sale Usually applied where merchandise is considered sold
when the price is agreed upon, and a contract
enforceable by both parties is made. Revenue is
recognised at this point, the ownership of the goods
passing to the owner.
Receipt of It is possible to delay the realisation of revenue until
payment cash has been received. This assumption is often used
by people providing a service. Using this point in the
operating cycle as the revenue realisation point avoids
complications caused by clients not paying.
Point of In some cases the scale of the product is assured at
production the known price before any final contract of sale is
made. This happens in some primary industries, such
as where a firm has a government contract.
Degree of Where a firm is engaged in large scale construction
contract projects that may take years to complete, for instance,
completion a large office block, payment may be on a progressive
basis. The revenue will be matched to each accounting
period extending over the life of the project. The main
problem with this method is the subjectivity involved
in arriving at an estimate of the degree of contract
completion.
Essential elements of revenue recognition
1. There must be verifiable evidence of the money amount 2. Craig
involved.
 The process involved in earning that revenue must be
substantially complete.
3. Melanie
Case studies on Revenue recognition points
Scenario
1. Michelle Michelle grows persimmons, a type of fruit, in her
orchard. This activity includes a number of tasks: she
has to prune in winter, water in summer, and pick,
polish and pack in May. The bulk of the fruit is sold in
June.
Last year she averaged $5 per carton on the 300
cartons she sent to market. However, this year has
been a good year for growing and with a glut of fruit
the price may fall.
Consider the appropriate realisation point for Michelle,
assuming accounting periods of one month - see below
cor recommended revenue recognition point.
Craig has a contract to build 40 prefabricated huts for
the army at $30 000 per hut. His accounting period is
for three months. On 1 June, the first day of the new
period, he has partly completed (50%) three huts.
During June, July and August he commences building
work on ten huts, in addition to completing the three
in progress at the beginning of June. Of the 10 huts he
commenced building in this period, two remain
uncompleted (50%) on 31 August.
Consider the appropriate realisation point for Michelle,
assuming accounting periods of one month - see below
cor recommended revenue recognition point.
Melanie contracts to make woollen jumpers. She
charges $100 per jumper. Her accounting period
extends from January to June. She presents you with
the table below and asks you to determine her revenue
using each of the different realisation points.
Contract Jumpers $ received Delivered
signed knitted for
2 1 - - (Jan)
3 3 2 1 (Feb)
1 1 2 3 (Mar)
5 3 2 2 (Apr)
4 3 6 4 (May)
2 4 3 3 (June)