SLIDES Day 02

ACCOUNTING FOR DECISION MAKING AND CONTROL
FINANCIAL ACCOUNTING
© Haydn Pound 2011-21. These materials are subject to copyright of Haydn Pound and may not be reproduced, distributed
or used in any manner, in whole or in part, except in connection with the course Accounting for Decision Making and Control
at the Nanyang Business School, August 2021. The moral right of the creator, Haydn Pound, has been asserted
3
Over half of financial fraud cases relate to revenue recognition
² Recording fictitious revenue

² Recognising inappropriate amounts of
revenue
² Recognising revenue from sales that have
been billed, but products/services have not
been shipped/provided
² Recognising revenues where contingencies Over 50% of all financial fraud
exist
² Recognising revenue where
products/services have not been delivered in
full or where the customer has not accepted
the delivery
² Inadequate provisions for returns or
cancellations
Source: Anthony, Hawkins & Merchant/SEC

2108 Nanyang NF - Accounting © Haydn Pound 2011-21 85
Four common-sense tests to determine if revenue has been 3
earned… and therefore can be recognised
Clear evidence of Delivery has

Collection of the
an order / occurred or The price is fixed
sale proceeds is
purchase by services have been and clear
reasonably likely
customer rendered
Revenue earned
and can be recognised
3
Consider revenue recognition of an airfare
² A customer pays $750 for a airfare. The airfare is 50% refundable up to 30 days before the flight.
Within 30 days of departure, the airfare is entirely non-refundable. This airfare has a peculiar
feature, however. If the customer takes the flight, she must pay an additional $250 not later
than 30 days after the flight. If the customer does not take the flight, there is no more to pay
² When should revenue be recognised, and how much?
Customer Customer pays 30 days before 30 days after Customer pays

Flight
makes booking $750 flight flight $250
time
Customer takes flight

… Customer does not take flight
… Customer cancels more than 30 days before flight
… Customer cancels within 30 days of flight

3
Consider revenue recognition of an airfare
² When should revenue be recognised, and how much?

Customer Customer pays 30 days before 30 days after Customer pays
Flight
makes booking $750 flight flight $250
time
Customer takes flight:
Customer does not take flight:
Customer cancels more than 30 days before flight
Customer cancels within 30 days of flight
3
Syndicate exercise: Case 5-3 Joan Holtz (A)
² Prepare answers to the ten scenarios in your syndicate group
² Take 40 minutes, and be ready to share your answers

3
Consider a few other situations
² (1) Bank interest on a 12 month, fixed period cash deposit that is paid by the bank at the end of
the 12 months
² (2) Discount of 2% offered if customers pay their account within 30 days
² (3) A bed debt that has arisen due to a customer going bankrupt
² (4) A three year project where works are 40% complete end of year 1, 75% year 2, and 100% year
3 while the customer pays one-third of the contract amount in each year
REFERENCE ONLY
Reference only
4
Consider the flow of inventory and its impact on financials
Receives
Business orders Inventory is Pays for Inventory is cash from
inventory received inventory sold
customer
Dr Inventory/Stock Dr A/c payable Dr A/c receivable Dr Cash at bank
Nothing to record
Cr A/c payable Cr Cash at bank Cr Revenue Cr A/c receivable
Dr Cost of Goods Sold

Cr Inventory/Stock
Revenue
Balance sheet impact Income statement impact
less CoGS
Assets Revenue
equals Gross profit
Liabilities Expenses
Equity
Reference only
4
Two main inventory systems: Perpetual and Periodic
² Perpetual inventory system

• Keeps a running record of inventory and cost of goods sold
– Every purchase increases inventory
– Every sale decreases inventory and increases cost of goods sold
• Provides a good level of control
– The inventory (A) account indicates the amount of stock on hand
– The CoGS (E) up to date all the time (perpetually)
² Periodic inventory system

• Inventory is only updated periodically (usually at the end of each period) to
determine quantities on hand
• Cost of Goods sold calculated and posted at the end of a period
• System only appropriate for relatively inexpensive goods

Reference only
4
Three ways of thinking about inventory movements
² Last In, First Out Inventory

• Inventory items are interchangeable
• The most recently received stock will be the next stock to be sold
• LIFO not typically used and not allowed under IFRS
² First In, First Out Inventory

• Inventory items are interchangeable
• The oldest stock will be the next to be sold
² Specific unit cost

• Cost of goods sold are calculated with respect to specific
units of inventory
• Appropriate where inventory differs from unit to
unit (eg. vehicles, jewels, real estate)
Reference only
4
Let’s explore inventory costing using the following example
² Canberra Sportswear
Will vary depending

on costing method

Reference only
4
Nov 1: Start with the opening inventory – 1 unit @ $40
FIFO
The journal Not required. Stock is “on hand” from previous period.
entry Purchase of stock would have been recorded in the previous period
Reference only
4
Nov 5: Record the purchase of 6 units at $45 each
FIFO
Stock on hand
comprises 1 unit with
cost $40 and 6 units with
cost $45
Nov 5 Inventory (A) 270

The journal
Accounts payable (L) 270
entry
Record purchase of inventory (6 units @ $45)

Reference only
4
Nov 15: Record the sale of 4 units for $80 each
FIFO
For costing purposes,

the oldest unit (cost $40)
is sold first. After the
sale, only 3 units with
cost $45 remain
FIFO
First item into
stock (oldest), is
the first item out
of stock
Nov 15 Accounts receivable (A) 320

Sales revenue (R) 320
The journal Sale on credit (4 units @ $80 each)
entry Nov 15 Cost of Goods Sold (E) 175
Inventory (A) 175
Record the cost of goods sold (1@$40, 3@$45)
Reference only
4
FIFO
Inventory on hand
comprises 3 units
purchased on 5 Nov and
7 purchased 26 Nov for
$50 each

The journal
entry

Reference only
4
FIFO
Sell the oldest first!

3 @ cost $45 and the
remaining 5 @ cost $50

Inventory (A) 560
Record the cost of goods sold (1@$40, 6@$45, 5@$50)
Reference only
4
Note the closing inventory and CoGS under FIFO
FIFO
Using FIFO, Using FIFO,

CoGS = $560 Closing inventory = $100

Reference only
Nov 1 & 5: Start with the opening inventory and 4
record the purchase of 6 units for $45 each
LIFO
Opening inventory.
Given!
Purchase transactions
are recorded in the same
way as for FIFO

The journal
entry
Reference only
4
LIFO
For costing purposes,

the newest unit (cost
$45) is sold first. After
the sale, only 1 unit
with cost $40, and 2
units with cost $45
remain
LIFO
Last item into
stock (newest), is
the first item out
of stock

Inventory (A) 180
Record the cost of goods sold (4@$45)
Reference only
4
LIFO
Inventory on hand
comprises 1 unit from
the last period, 2 units
purchased on 5 Nov,
and 7 units purchased
26 Nov

The journal
entry
Reference only
4
LIFO
Sell the newest first!

The oldest remain
in stock!

Inventory (A) 395
Record the cost of goods sold (7@$50, 1@$45)
Reference only
4
Note the closing inventory and CoGS under LIFO
LIFO
Using LIFO, Using LIFO,

CoGS = $575 Closing inventory = $85
Reference only
IAS2 prescribes specific unit cost, FIFO or weighted average cost
If inventory is not
interchangeable,
must used specific cost
Otherwise,
must use FIFO or
weighted average cost

Reference only
4
Consider where cost of stock is changing
² If the cost of stock is increasing (costs more to buy an item now than it did a month ago):
• Using LIFO will result in HIGHER CoGS and LOWER profit
• Using FIFO will result in LOWER CoGS and HIGHER profit
² If the cost of stock is decreasing (costs less to buy an item now than it did a month ago):
• Using LIFO will result in LOWER CoGS and HIGHER profit
• Using FIFO will result in HIHGER CoGS and LOWER profit
² Which method do you think is more appropriate?

² Hint: Consider the nature of stock… do you want to be selling old stock first, or new stock?
Reference only
4
Accounting principles (I)
² The accounting principles introduced in Seminar 1 have special relevance to inventories,

especially conservatism
• Relevance
– This implies disclosing the methods used in valuing inventory to enable
outsiders to make knowledgeable decisions about the business
• Comparability
– Comparability requires the business to consistently use the same accounting
methods and procedures each period, disclosing any changes to these
methods and effects on net profit
• Materiality
– A loss in inventory may be material depending on the size of the business,
and should be reported separately in the case that it is material

Reference only
4
Accounting principles (II)
• Conservatism
– Calls for accountants to report items in the financial statements that lead to
the gloomiest immediate financial results
– When dealing with inventory, conservatism underpins the lowest of cost and
net realisable value rule
– This rule requires us to value at whatever is lower:
- the cost of the inventory
- the net realisable value
– Where the sale value of inventory falls below cost, we are required to write-
down the amount of inventory recorded on the balance sheet
- Dr Inventory write-down
Cr Inventory
Reference only
4
Effects of inventory errors
² Businesses count inventory at the end of each period (called a stocktake)
² Should an error occur in this count, it will impact the profit and asset balances
² But as the ending inventory of one period becomes the beginning inventory of the next
period, any error (in one period) will automatically net out (in the next)
• The cumulative profit for both periods will be correct

Reference only
Inventory errors will net out as one period’s ending inventory 4
is the next period’s beginning inventory
But in the next period, beginning

inventory is overstated, so:
Ending inventory is overstated by
• CoGS is overstated
$5,000, so:
• Profit is understated
• CoGS is understated;
• Assets at end are correct
• Profit is overstated
• Assets at end are overstated
Reference only
For you to try...
² A business starts the accounting period with 10 items of stock, 2 of which cost $45 each (acquired 2
weeks ago), and 8 of which cost $50 each (acquired 3 weeks ago) and
² The following transactions occurred
• Sold 3 units for $75 each
• Purchased 10 units for $52
• Sold 1 unit for $77
• Sold 8 units for $80
• Purchased 5 units for $55
• Sold 5 units for $80
² A stocktake revealed 2 units in stock at the end of the period
² Calculate:
• The amount of closing inventory
• The revenue, cost of goods sold, gross profit and gross margin on each of the three sale
transactions
• Gross profit for the period, gross margin for the period

5
Accounting for non-current assets
² Most organisations require some form of property, plant and equipment (PPE) to carry out
business operations
² PPE assets are long-lived tangible assets used to operate a business and are not held for resale
• Their physical form provides their usefulness
² However, most assets (with the exception of land) deteriorate over time
• Wear out, become obsolete or their usefulness is “used up”
• The accounting treatment of this deterioration is referred to as depreciation

5
Measuring the cost of PPE
² The cost of an asset = The sum of all the costs incurred to bring the asset to
the location and condition necessary for its intended use
² What to include? Some examples…

Land & Land improvements Buildings Machinery & equipment
Purchase price Architectural fees Purchase price
Agent’s commission Building permits Transportation charges
Stamp duty Contractors’ charges Insurance while in transit
Survey & legal fees Material, labour, overhead Customs duty
Other costs (eg. Clearing) Installation & testing costs
5
Capital expenditure is included in PPE
² When a business spends money on an asset, it must decide whether to debit an asset
account or expense account
• Asset – Capital expenditure – DR to asset account
• Expense – Normal expenditure – DR to Repairs and maintenance account
² Expenditure that increases an asset’s capacity or efficiency or extends its useful life is
referred to as capital expenditure
Expenditure: Qantas… Treatment?

… performs a major (once every 7 years) maintenance overhaul on an aircraft Capex / Expense
… repairs an engine damaged by a bird strike Capex / Expense
… converts a passenger jet into a freighter at a cost of $5m Capex / Expense
… pays an annual aircraft registration fee to the Federal Govt Capex / Expense
… installs “electronic flight bag” technology into its fleet of 747-400 aircraft Capex / Expense
… performs a routine weekly maintenance check on an aircraft Capex / Expense

5
Tangibles and intangibles
Tangible assets Intangible assets

Most organisations require some form of Intangible assets do not have physical form
property, plant and equipment (PPE) to carry •They can’t been seen or touched
out business operations
Intangibles are useful only through the special
PPE assets are long-lived tangible assets used rights they carry or benefits they confer
to operate a business and are not held for •Examples: Patents, copyrights, trademarks,
resale goodwill
•Their physical form provides their
usefulness The accounting treatment of intangibles is
•They can be seen and touched! referred to as amortisation
However, most PPE (with the exception of

land) deteriorate over time
•Wear out, become obsolete or their
usefulness is “used up” We will deal first with the tangibles (property,
plant and equipment) and then turn to the
The accounting treatment of this accounting for intangibles
deterioration is referred to as depreciation
5
Depreciation allocates the cost of an asset over its useful life
² Consider a Boeing 777-200LR – the world’s longest range commercial airliner!
² Depending on fit-out and configuration, a 777-200LR has a list price of around

USD $230 million
• Around AUD $300 million
² Properly maintained, the aircraft will have a productive life of at least 20 years
² Depreciation allocates the cost of the 777-200LR over its useful life
• Record as an asset on acquisition
• Gradually expense the asset as the plane’s usefulness declines

5
Depreciation gradually converts assets to expenses
² Property, plant and equipment are tangible assets used in the operation of the business
that are not intended for sale to customers
² These assets are recorded according to the cost principle

• Cost includes all the charges and expenses incurred in getting the asset to a state
ready for use
– including cash purchase price, legal fees, commissions, freight charges,
installation and setup costs
² Depreciation allocates the cost of an asset over its useful life

• A cost allocation process, not a method of valuation
• Only applies to depreciable assets
– those that will decline in value over time with use
– land is not a depreciable asset
5
There are three methods of depreciation
² Straight line (SL)

• Annual depreciation rate (applied to cost) and annual depreciation amount are the
same for each year of the asset’s useful life
• Depreciation rate is applied to depreciable value
– Depreciable value = Cost – Residual value
² Units of production (UoP)

• Annual depreciation varies depending on the level of use made of the fixed asset
during each year of its useful life
² Reducing balance (RB)

• Annual depreciation rate is the same for each year of the asset’s useful life…
… but annual depreciation amount decreases each year
• Depreciation rate is applied to carrying amount at beginning of each year (also
known as the written down value)
– Carrying amount = Cost – accumulated depreciation

Straight line method 5
1
Annual depreciation rate =
Useful life
Annual depreciation amount = (Cost - Residual value ) • Annual depreciation rate
² Asset to depreciate: Truck

Straight line depreciation
² Acquired 1/7/X4
² Cost $41,000
35,000
² Estimated residual value: $1,000
² Estimated useful life: 5 years 30,000
² Units of production: 100,000 km 25,000
20,000
² Annual depreciation rate (straight line)
= 1/5 = 20% 15,000
10,000
² Annual depreciation amount
5,000
= (41,000 – 1,000)*20% = $8,000
-
30/6/X5 30/6/X6 30/6/X7 30/6/X8 30/6/X9
Carrying amount Depreciation
Units-of-production method 5
Cost - Residual value

UoP depreciation per unit of output =
Useful life, in units of production
Annual depreciation amount = Units of production • UoP depn per unit of output

Units of production depreciation
² Acquired 1/7/X4
² Cost: $41,000
35,000
² Units of production: 100,000 km 25,000
20,000
² UoP depreciation per unit of output
= (41,000 – 1000) / 100,000 15,000
= $0.40 10,000
5,000
² Annual depreciation amount based on distance
• 30/6/X5: 20,000km 20,000*0.40 = $8,000 -
• 30/6/X6: 30,000km 30,000*0.40 = $12,000 30/6/X5 30/6/X6 30/6/X7 30/6/X8 30/6/X9
• 30/6/X7: 25,000km 25,000*0.40 = $10,000
• 30/6/X8: 15,000km 15,000*0.40 = $6,000
• 30/6/X9: 10,000km 10,000*0.40 = $4,000

Reducing balance method 5
1
Approximate as
Residual value æ Residual value ö n
Annual depreciation rate = 1 - n = 1- ç ÷ 1.5 x PC rate
Cost è Cost ø
Annual depreciation amount = Carrying value • Annual depreciation rate

Reducing balance depreciation
² Acquired 1/7/X4
² Cost $41,000
25,000
² Units of production: 100,000 km
15,000
² Annual depreciation rate (reducing balance)
= 1 – (1,000/41,000)(1/5) 10,000
= 1 – 0.4758 = 52.4%
5,000
² Annual depreciation amount
• 30/6/X5, 41,000 * 52.4% = $21,484 (CA = $19,516) -
• 30/6/X6, 19,516 * 52.4% = $10,226 (CA = $9,290) 30/6/X5 30/6/X6 30/6/X7 30/6/X8 30/6/X9
• 30/6/X7, 9,290 * 52.4% = $4,868 (CA = $4,422)
• 30/6/X8, 4,422 * 52.4% = $2,317 (CA = $2,105)
• 30/6/X9, 2,105 – 1,000 = $1,105 (CA = $1,000)
Final year depreciation is the amount
needed to bring the asset to residual
value. Often a “plug” figure
For you to try...
² A manager buys an asset for $100,000. The useful life is 7 years and the scrap value at the end of
that period is $15,000
² Excluding depreciation, annual profits from the machine are expected to be around $30,000
² Determine net profit and return on assets in each year assuming:

• Prime cost depreciation
• Diminishing balance depreciation
² Which method do you think provides better information? Why?

5
Other issues with depreciation
² Depreciation and income tax

• Depending on location, taxation laws may allow a choice of depreciation type
• Typically straight line or diminishing value
• Choice of depreciation type can impact taxable income and tax payable
² Depreciation for partial years

• Depreciation of an asset should begin when the asset is available for use
• Where an asset is acquired part way through the financial year, most businesses
apportion depreciation based on days or months
² Changing the useful life

• Estimating useful life can be problematic, as assets may last for shorter or longer
periods than originally thought
• A manager looking to increase profits may select a longer useful life
– Is this possibility concerning?
5
Depreciation journal entry
² The standard journal entry to record acquisition of an asset is (1):

Dr Asset account XXX
Cr Cash at bank/Liability XXX
² Depreciation allocates the cost of the asset over its useful life as an expense. The journal
entry is straight forward (2):
Dr Depreciation expense (E) YYY
Cr Accumulated depreciation (-A) YYY Depreciation expense (E)
(2) YYY
The accumulated depreciation account is a contra-asset

account
Cash at Bank (A) Plant & equipment (A) Accumulated depreciation (-A)
(1) XXX (1) XXX (2) YYY

Written down value is the cost of the asset less accumulated 5
depreciation
Plant & equipment (A)
(1) XXX
Plant and equipment

At cost XXX
Less accumulated depreciation YYY
Accumulated depreciation (-A)
Written down value ZZZ
(2) YYY
5
Accounting for intangibles
² Intangible assets have no physical form
² Some intangibles can, however, be individually and specifically identified

• Patent, copyright, trademarks
² Other intangibles cannot be separately identified

• Goodwill
² Intangibles can account for a huge amount of value

• How much is the Coca-Cola brand worth?
• What about the right to use the chemical formula of a wonder drug?

5
Specific intangibles (I)
² There are a variety of specific intangibles

• Patents – the exclusive right to use a particular process or technology
• Copyrights – the exclusive right to reproduce and sell intellectual property
• Trademarks and brand names – assets in the form or a symbol or name
• Franchises and licences – the right to operate under specified conditions (ie. McDonalds
operates a franchise model)
² Specific intangibles are recorded as an asset on acquisition
² Similar to depreciation, the value of a specific intangible is amortised (written-off) over its useful
life
5
Specific intangibles (II)
² Example
² Sunbeam Appliances pays $200,000 to acquire a patent on 1 January 20X7. Sunbeam
believes the patent’s useful life is 5 years
² Annual amortisation expense will be $40,000 ($200,000 / 5)
² On acquisition
1 Jan X7 Dr Patent 200,000
Cr Cash at bank 200,000
To acquire a patent
² At year end
31 Dec X7 Dr Amortisation expense 40,000
Cr Accumulated amortisation 40,000
To amortise the cost of a patent

5
Accounting for goodwill
² Often a business will be worth more than the sum of its parts
• We refer to this as goodwill
² Internally generated goodwill is built up by a business over its life

• Embodied in reputation, capabilities or even position!
• Not possible to identify the specific events or transactions that gave rise to the
goodwill
• Impossible to value
• Internally generated goodwill shall not be recognised as an asset
² Purchased goodwill arises when a business is purchased

• Excess of cost to acquire the business over the fair (market) value of the acquired
business’s identifiable net assets
• Purchased goodwill is recorded as an asset!
5
Purchased goodwill (I)
² Example
² Assume Woolworths decides to expand into Tasmania and acquires Tasman Stores at a cost
of $10 million
² At time of acquisition, Tasman Stores’s balance sheet appears as follows:
• Assets $9,000,000
• Liabilities ($1,000,000)
• Fair (market) value $8,000,000
² Why did Woolworths pay $10 million when the fair value is only $8 million?
² Woolworths must have believed they were obtaining something else! Goodwill!
² The excess of purchase price over fair (market) value is goodwill

5
Purchased goodwill (II)
² Example (continued)
² The transaction records the cash paid to acquire the business, the assets and liabilities
acquired, and the goodwill component
Dr Assets (receivables, inventory, stores) 9,000,000
Dr Goodwill 2,000,000
Cr Liabilities (creditors, long term loans) 1,000,000
Cr Cash at bank 10,000,000
Record purchase of business
² One interesting attribute of goodwill is that it is not amortised (unlike specific intangibles)
² Instead, the value of the goodwill is re-evaluated every year

• If goodwill has increased, there is nothing to record
• If goodwill has decreased, the business records a loss and writes-down goodwill
5
Other issues with non-current assets
² Imagine you purchased a block of land 20 years ago for $100,000

• Under the historical cost principle, this asset would be recorded on the balance sheet at
$100,000
² The block of land is today worth $500,000

• We can revalue the land from $100,000 to $500,000
• Broadly, we debit the asset with $400k and credit an asset revaluation reserve for $400k
² What if the land was now only worth $60,000 (we discovered toxic chemicals in the soil)?
• We can revalue the land from $100,000 to $60,000
• Broadly, we debit Asset write down expense with $40k and credit the asset with $40k

5
Lease liabilities
² A lease is an agreement under which the lessee obtains the use of an asset by making payments
to the asset owner (lessor)
• Most property rental agreements are lease agreements
² Leasing avoids having to make a large initial cash-outlay to obtain the use of an asset
² Leases are classified as either operating leases or finance leases

• Operating lease – allows the lessee to use the asset, but the lessor keeps all the usual
rewards and risks of ownership
– Example: Renting a car when you go on vacation
• Finance lease – a form of borrowing where the lessee obtains use of the asset and takes
on the rewards and risks of ownership
– Entering into a hire-purchase arrangement for a new company car
5
Distinguishing an operating lease from a finance lease
² A finance lease transfers to the lessee substantially all the risks and rewards incidental to
ownership of the leased asset. Under an operating lease, these rewards and risks remain with
the lessor – the lessee merely rents the property, but is otherwise not responsible for it
² Consider some situations that would normally give rise to a finance lease, including:
• The lease transfers ownership of the asset to the lessee by the end of the lease period
• The lessee has a bargain purchase option, allowing purchase of the asset at a price
sufficiently below the asset’s expected fair value such that it is reasonably certain the
option will be exercised
• The lease term is for the major part of the economic life of the asset
• The present value of the lease payments amounts to substantially all of the fair value of
the leased asset
• The leased asset is of such a specialised nature that only the lessee can use it without
substantial modifications
² Recent changes to the accounting for leases has pulled more leases onto the balance sheet.
• Rule of thumb: Lease greater than 12 months? Could well be a finance lease!

5
Accounting for leases
Operating lease Finance lease
Easy! More complex!
Lease payments are expensed A finance lease involves a series of payments

when incurred • Say $10,000 per year for 10 years
• Present value of these payments = $81,000 (at 5%)
Example: We enter into a 12
month lease for $120. Of the In this case, we record a leased asset at $81,000 and a lease
12 months, four months liability of $81,000
occur in the current financial • This leased asset is amortised over the life of the lease
year and 8 months in the next (very similar to depreciation)
financial year
As each payment of $10,000 is made, part is allocated
This year’s income statement: (debited) to reducing the lease liability, and part is allocated
• Lease exp $400 (debited) to interest expense
Balance sheet (end of this yr)
• Pre-paid lease $800 Why treat finance leases this way instead of going for the
simple operating lease treatment?
6
² How little you know

about the age you live in
if you think that honey is sweeter
than cash in hand
» Ovid
43BC – 17AD
6
Cash is the life-blood of business
² Businesses need cash to operate

• An unprofitable business can survive if it has plenty of cash
• But a profitable business will
not last long with poor
cashflows
² The cash flow statement reports

on where cash came from and
how the company spent it
² In conjunction with the income

statement, it lets us reconcile
the balance sheets of
successive accounting periods

6
Purposes of the cash flow statement
² Predict future cash flows

• Past cash receipts and payments are good predictors of future cash flows
² Evaluate management decisions

• Cash flow statement reports on cash flows from operations and also the investments the
company is making
• Investors and creditors use cash flow information to evaluate management’s decisions
² Predict ability to make debt payments to lenders and pay dividends to shareholders
• Lenders want to collect interest and principal on their loans. Shareholders want
dividends on their investments
• Cash flow statement will help predict whether the business is able to make these
payments
6
The three types of cash flows…
Operating activities
are related to the
transactions that
make up net profit
Investing activities
relate to the long
term asset accounts
Financing activities
relate to the long-
term liability
accounts and the
owners’ equity
accounts

6
… are represented on the cash flow statement
The individual cash flows

for this cash flow
statement are shown in
the upcoming
“Example: Direct method”
Reconciles to the
Balance Sheet
6
Cash flows from operating activities
² Listed first on the cash flow statement due to their importance as a source of cash for most
businesses
• The failure of operations to generate the bulk of cash inflows for an extended period will
signal trouble for the business
² Some cash flows from operating activities

• Cash collections from customers (note: this is different to sales)
• Receipts of interest and dividends
Interest received, dividends
• Payments to suppliers received and interest paid are
• Payments to employees included in operating activities
as they appear on the income
• Payments of interest expense and income tax statement. Dividends paid are
excluded from operating
activities as they do not
• Note: Depreciation does not appear on the appear on the income
statement.
cash flow statement – it’s a non cash expense

6
Cash flows from investing activities
² Investing activities are important as they determine a company’s future

• Investment signals expansion and renewal and is generally a good sign
• Low levels of investment may indicate the business is not replenishing its assets (or is
diminishing its capital stock)
• Excessive investment, however, may also be a problem
² Some cash flows from investing activities

• Cash payments for non-current assets, investments and loans to other entities
• Proceeds from the sale of non-current assets, investments and collection of loans
6
Cash flows from financing activities
² Financing activities relate to obtaining money from lenders and owners, and paying them back
² Some cash flows from financing activities

• Proceeds from the issue of shares and bills payable
• Payment of bills payable and share buy-backs
• Money received from taking out a loan, and payments when the loan is repaid
• Payment of cash dividends

6
Two methods for preparing the cash flow statement
² Direct method
• Examines individual cash flows and categorises them as operating, investing or financing
² Indirect method
• Shows the link between net profit, cash flows and the balance sheet
• Statement starts with profit for the period, then makes adjustments to arrive at cash net
cash inflow/outflow for the period
6
Three steps to the direct method
• Identify the activities that increased or decreased cash
• Classify each cash increase or decrease as an operating, investing or financing activity
• Identify the cash effect for each transaction

– By examining the specific cash payment or receipt
– By using the T-account approach

6
Example: Direct method (Anchor Limited)
6
The direct method and the T-account approach
² Sometimes it is not possible to generate the cash flow statement from a nice, neat list of cash
receipts and payments!
² In such a case, we need the T-account approach

• Very handy technique to learn – enables you to measure the cash effects using the
income statement and the balance sheet
• Based on reconstructing accounts with only limited information
² Example Accounts receivable

• Sales revenue for the period = $284 Opening 80
• Opening A/c receivable = $80 Sales 284 Collections 271
• Closing A/c receivable = $93 Closing 93
• By reconstruction, we know receipts

from customers must have been $271
• Opening A/c receivable + Sales – Collections = Closing A/c receivable

• Collections = Opening A/c receivable + Sales – Closing A/c receivable

The direct method uses changes in balance sheet accounts 6
from one period to the next…
Changes in current assets – Operating
Changes in non-current assets – Investing
Changes in current liabilities – Operating
Changes in long term liabilities – Financing

Changes in capital – Financing
Changes due to profit – Operating

Changes due to dividends – Financing
6
... and income statement amounts matching to those changes
The number we need to make

the account balance!
Accounts receivable
Opening 80
Sales 284 Collections 271
Closing 93

6
Cash flow statement and the indirect method
² The indirect method is also known as the reconciliation method as it reconciles net profit (per
the income statement) to operating cash flows
• The main shortfall of the indirect method is that it doesn’t show operating cash flows –
how the business receives cash from customers and pays out cash in expenses
² The indirect method cash flow statement begins with net profit, and then lists additions and
subtractions where an item affects profit and cash flows differently
² There broad categories for these items

• Depreciation and amortisation expense
• Gains and losses on sales of assets
• Changes in the current asset and current liability accounts
6
Cash flow statement and the indirect method
² Investing and financing activities are presented the same way under the indirect method as they
are under the direct method
² The difference applies for presentation of operating activities
² Three steps to preparing the cash flows from operating activities under the indirect method
• Add-back non-cash expenses
– Depreciation and amortisation expense
• Subtract (add back) gains (losses) on sales of non-current assets
– Changes in the non-current asset accounts
• Adjust for changes in non-cash current assets and current liabilities

6
Indirect method: Add back non-cash expenses
² Review the income statement for non-cash expenses…

• Typically, depreciation and amortisation
² … and add back to profit on the cash flow statement
Indirect method: Subtract (add back) gains (losses) on sales of 6

non-current assets
² Changes in non-current assets are a result of investing activities

• Need to reverse the effect of the sale to arrive at operating cash flows
• Subtract any gain on sale of non-current assets
• Add back any loss on sale of non-current assets

Indirect method: Adjust for changes in non-cash current assets 6
and current liabilities
² Increases in current assets suggest cash not received – subtract the increase
• Decreases suggest cash inflows – add back the decrease
² Decreases in current liabilities suggest cash payments – subtract the decrease
• Increases suggest cash not paid (for an expense) – add back the increase
Indirect method: Summary of adjustments for operating 6

activities
² Three steps to preparing the cash flows from operating activities under the indirect method
•1 Add-back non-cash expenses (Depn & amort)
•2 Subtract (add back) gains (losses) on sales of non-current assets
•3 Adjust for changes in non-cash current assets and current liabilities
Net profit
+ Depreciation and amortisation 1

+ Loss on disposal of a long-term asset (or early extinguishment of bill payable)
2
– Gain on disposal of a long-term asset (or early extinguishment of a bill payable)
– Increase in current asset other than cash
+ Decrease in current asset other than cash

3
– Decrease in current liability
+ Increase in current liability

Net cash inflow (outflow) from operating activities
* Short term bills payable for general borrowing, and current portion of long-term bills payable, are related to financing activities, not to operating activities
REFERENCE ONLY
7
Financial statement analysis enables business insight
² Financial statement analysis helps managers, creditors and investors monitor business
operations and make decisions
² A key element of financial statement analysis is the use of standard measures

• Enables comparison of companies of different size and companies that operate in
different industries
² Various uses of financial statement analysis

• Predict the amount of expected future returns
• Assess the risk associated with those returns
• Assess an organisation’s ability to meet payments as they come due and generate
enough cash to pay long-term debts as they mature
² Three techniques
• Ratio analysis
• Horizontal analysis
Considered earlier
• Vertical analysis

7
Five categories of ratios
² Ratios are an important tool for business analysis

• Expresses the relationship between two numbers
² We calculate a ratio by dividing one number by another

• Assume current assets of $100,000 and current liabilities of $25,000
• The ratio of current assets to current liabilities is $100k to $25k
• We can simplify this to 4:1 or 4/1 or even just 4
² Five categories
• Ratios that measure the company’s ability to pay current liabilities
• Ratios that measure the company’s ability to sell inventory and collect receivables
• Ratios that measure the company’s ability to pay long-term debt
• Ratios that measure the company’s profitability
• Ratios used to analyse the company’s shares as an investment
7
Measuring ability to pay current liabilities (I)
Ratio Current ratio
Formula Current assets ÷ Current liabilities
•Measures the organisation’s ability to pay current liabilities from current assets
•The higher the current ratio, the stronger the financial position of the business
Purpose
•A high current ratio suggests the business has sufficient current assets to maintain
normal business operations
Example
Company A’s current ratio is 2:1 (or simply 2)
Company B’s current ratio is 1.333:1 (or

simply 1.333)
Company A has $2 of current assets for every

$1 in current liabilities (compared to 1.333 for
company B)

7
Measuring ability to pay current liabilities (II)
Ratio Acid-test (or quick) ratio
(Cash + short-term investments + net current receivables)

Formula
Current liabilities
•Measure of liquidity using a narrower asset base than the current ratio
•Indicates whether the business could pay all its current liabilities if they became due
Purpose immediately
•Inventory and pre-paid expenses are excluded as they are the least liquid current
assets – difficult to convert them quickly into cash
Current ratio and acid-test ratio compared
The acid-test ratio should always be LOWER than the current ratio as we exclude some current assets (inventory and pre-paid expenses)
when calculating the acid-test ratio
Company Current ratio Acid-test ratio

Boral 1.33 0.88
Qantas 0.67 0.60
Woolworths 0.86 0.29
What do you think explains the ratio differences for these companies?
7
Measuring ability to sell inventory and collect receivables (III)
Ratio Inventory turnover
Cost of Goods Sold

Formula
Average inventory
• A measure of the number of times a company sells its average level of inventory during a year -
indicates how quickly inventory “moves”
Purpose • Turn too low indicates it is taking longer than it should to sell stock (maybe too much inventory).
Turn too high indicates quick sale but maybe insufficient inventory on hand
• Ideal inventory turn varies by industry, but higher turn is generally better
Example
Opening inventory = $95,000 and ending inventory of $105,000
Cost of Goods Sold = $500,000
Average inventory is $100k. With CoGS of $500k, inventory turn = 5.0
To work out how long inventory is held (on average) before it is sold, divide 365 by the turn. In our example, 365/5 = 73, indicating it
takes 73 days (on average) to sell inventory. This is also referred to as days’ sales in inventory – the business currently holds enough
stock for 73 days worth of sales
Inventory turnover comparisons are useful over time (eg. is inventory management improving pr getting worse?) and for benchmarking
against industry averages and competitors

7
Measuring ability to sell inventory and collect receivables (II)
Ratio Accounts receivable turnover
Net credit sales

Formula
Average net accounts receivable
•Ratio indicates how many times per year the average level of receivables was turned
into cash
Purpose •Measures a company’s ability to collect cash from credit customers
•The higher the ratio the better (although if it is too high, it may indicate a restrictive
credit sales policy causing loss of sales)
Example
Opening net accounts receivable $20,000
Ending net accounts receivable $30,000
Net credit sales $200,000
Average net accounts receivable is $25k, and with net credit sales of $200k, A/C receivable turn = 8.0
Days’ sale in receivables indicates how long it takes to collect cash from the average credit sale. It is also the number of days worth of
credit sales oustanding at any point in time
• Calculated by dividing 365 by the accounts receivable turnover
• In our example: 365 ÷ 8 = 45.6
7
Measuring ability to pay long-term debt (I)
Ratio Debt ratio
Total liabilities
Formula
Total assets
•Measures the proportion of a company’s assets financed with debt

•The higher the ratio, the greater the strain on paying interest
Purpose
•All else being equal, a creditor would prefer to loan money to a business with a
lower debt ratio than a higher debt ratio
Example
Total liabilities $431,000
Total assets $787,000
Debt ratio 0.55
Generally this ratio is between 0.4 and 0.5 (40% to 50%). Some entrepreneurial businesses will have much high debt ratios, however.
A related ratio is Debt to Equity = Total liabilities ÷ Total equity. Measures how the business is financed – by contributions from owners
or through borrowings

7
Measuring ability to pay long-term debt (II)
Ratio Times interest earned ratio (Interest cover)
Profit before tax + Interest expense

Formula
Interest expense
•Measures the number of times profit can cover the interest expense
Purpose •High ratio suggests ease in paying interest expense, a lower ratio indicates the
business may have some difficulty generating enough profit to adequately cover
interest
Example
Profit $80,000
Interest expense $20,000
Times interest earned ratio 5
As the measure indicates the number of times profit can cover interest, we use profit before interest and taxes – this is why interest is
added back to the numerator
Debt ratio and the interest cover ratio are useful metrics for lenders to determine how well a business can meet its long term liability
obligations
7
Measuring profitability (I)
Ratio Rate of return on net sales (profit margin)
Net profit
Formula
Net sales
•Measures the proportion of each dollar of sales that generates a profit (the balance
being consumed by expenses)
Purpose
•Rate of return on net sales can be increased by increasing prices or by decreasing
costs
Example
Profit $48,000
Net sales $858,000
Profit margin 0.056 = 5.6%
You will also generate the rate of return on net sales number when performing vertical analysis. Where?

7
Measuring profitability (II)
Ratio Rate of return on total assets (Return on assets)
Profit before income tax and interest expense

Formula
Average total assets
•Measures how well a company has used its assets to generate a profit
•As assets are funded by debt and equity, we measure the rate of return using profit
Purpose before tax and interest (EBIT) – the return to the two groups, lenders (interest) and
owners (profit), who have financed the company’s operations
•RoA can also be determined after tax
Example
Profit $80,000
Interest expense & tax $20,000
Total assets $600,000
Return on assets 0.167 or 16.7%
This metric is also known as Return on Invested Capital (ROIC) and can be calculated after tax but before interest
7
Measuring profitability (III)
Ratio Earnings per share
Net profit – Preference dividends

Formula
Number of ordinary shares issued
•The amount of net profit per ordinary share

Purpose •Preference dividends are subtracted as preference shareholders have a prior claim
on dividends
Example
Profit $80,000
Preference dividends $10,000
Number of shares 500,000
Earnings per share $0.14 per share
A useful measure when considering the purchase of a share on the open market
All else being equal, a share with a higher EPS is better

7
Analysing shares as an investment (I)
Ratio Price/earnings ratio (PE)
Market price per ordinary share

Formula
Earnings per share
•Ratio of the market price of an ordinary share to the company’s earnings per share
Purpose •A higher PE may indicate earnings growth prospects for the company. A lower PE
may indicate limited growth
Example
Share price $1.40
EPS $0.14
PE ratio 10
This means the company’s shares are selling at 10 times earnings
Why is a higher PE potentially indicative of good future prospects for the company? When the future looks rosy, the market bids up the
share price as an increase in EPS is anticipated in the future. However, EPS is a backward looking measure (which doesn’t factor in future
prospects). So the increasing market price, with EPS constant, results in a higher PE
7
Analysing shares as an investment (II)
Ratio Dividend yield
Dividend per ordinary share

Formula
Market price per share
•Ratio of dividends per share to the market price per share

Purpose •Measures the percentage of a share’s value that is returned annually as dividends to
shareholders
Example
Share price $1.40
Dividend per ordinary share $0.07
Dividend yield 5%

Questions to ask when performing 7
financial statement analysis (I)
² Earnings problems
• What trend is profit showing? Increasing or decreasing?
• Is profitability improving or getting worse?
² Decreased cash flows

• Is cash flow from operations consistently lower than profit? Why?
• How does the business generate its cash? From operations, or from selling assets,
borrowing money, or contributions from owners?
² Too much debt

• How does the debt ratio compare to competitors and the industry?
• Is the company comfortably able to service and repay its debts?
Questions to ask when performing 7

financial statement analysis (II)
² Inability to collect receivables
• Is accounts receivable turnover slowing down?
• How does days’ sale in accounts receivable compare to the industry and
competitors?
² Buildup of inventories
• Is inventory turnover slowing down?
• Is the company ordering and holding too much stock? Or is it selling less? Or
both?
• Recall that overstated ending inventory will result in overstated profit. Slowing
inventory turnover may be indicative of overstated inventory and, therefore,
overstated profit
² Movement of sales, inventory and receivables

• Sales, inventory and receivables generally move together. An increase in one
should be matched with an increase in the others. Inconsistent movements may
suggest a problem

Introducing IPSAS
² IPSAS - International Public Sector Accounting Standards (developed by the IPSAS Board)
• Purpose: To improve public sector financial reporting worldwide through the development
of IPSAS®, international accrual-based accounting standards, for use by governments and
other public sector entities around the world
² IPSAS (public sector entities) and IFRS (profit oriented entities) are broadly similar, but differences
do exist, for example:
• IAS12 (Income tax) – Public sector entities generally don’t pay income tax
• IAS33 (Earnings per share) – Public sector entities don’t issue equity
• IPSAS24 (Budget information) – Reporting of budgets not required under IFRS
² In Singapore, the Statutory Board Financial Reporting Standards (SB-FRS) apply

• Generally consistent with IPSAS and IFRS
² Specific standards within IFRS, IPSAS, SB-FRS are beyond the scope of this course

What do you understand when you hear “ESG”
² Environmental – Sustainability – Governance
² Take 15 minutes in your groups

• What does ESG mean to you?
• Why is it important?
² Be ready to report back
ESG reporting has increased significantly
National Rates of ESP Reporting

(% of 100 largest public companies)
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
n
e
a
en
ly
s
Ge ia
Po o
an
ile
Au a
a
dS s
S in n d
dia
k
y
ce
il
Sw l
ut ce
De i n
ga
te
an
ar
re
ric
Ne nad
pa
az
ali
So por
ic
Ita
ss
a
ee
Un rlan
Ch
n
iw
ed
ala
rt u
ex
Sp
In
ta
nm
Ko
Br
str
rm
Ru
Af
a
Ja
ga
Gr
Fr
Ca
Ta
M
Ze
e
h
h
th
ut
ite
w
So
Ne
2011 2017
Source: ESG metrics – Reshaping capitalism? (April 2019, Harvard 9-116-037)
More companies consider maintaining ESG commitments to be
a higher priority than protecting margins
Longer term? Shorter term?
Paying attention to ESG concerns delivers value

McKinsey identified five sources of ESG value
² Top line growth

• Helps companies expand existing markets and tap new ones because governing
authorities tend to trust companies with superior ESG execution
² Cost reduction
• A focus on ESG helps with the responsible use of resources and the minimization of
waste
² Reduced regulatory and legal interventions
• A commitment to ESG helps to reduce a company’s risk of adverse government action
and can even result in enhanced government support
² Employee productivity uplift
• A strong ESG proposition can help companies attract and retain quality people, enhance
employee engagement by instilling a sense of purpose, and increase productivity overall
² Investment and asset optimization
• ESG facilitates capital allocation to more promising and sustainable opportunities
Source: Five ways that ESG creates value (McKinsey, Nov 2019)
Business planning should include ESG objectives
Example: Xella’s(1) 2030 ESG Targets
(1) One of the world’s leading manufacturers and suppliers of building and insulation materials
Source: Crafting Xella Group’s ESG Strategy for the 2020s (BCG, February 2021)
BCG have identified even actions to develop ESG strategies
1. Fully integrate ESG considerations into the broader business strategy
2. Determine those ESG topics across the value chain that are most likely to have the greatest
financial materiality now and in the future
3. Develop a deep understanding of investor priorities and practices for ESG investing
4. Take a proactive approach to engaging and educating current, as well as potential, investors
on ESG issues and priorities
5. Maintain clear, effective, and consistent communication on ESG topics with all stakeholders
6. Build time or space for ESG topics in planning sessions, meetings, and dashboards (across
business units and functions)
7. Implement clear processes to ensure the reliable measurement and internal reporting of ESG
data.
SASB Standards connect business and investors on the financial

impacts of sustainability
² “A wide range of constituencies—including investors, companies, policy makers, regulators, NGOs,

and civil society—use corporate sustainability reporting to inform a wide range of decisions.
“A dynamic ecosystem of organizations has evolved to meet these various information needs.
“Disclosure standards and frameworks, including SASB’s, are the foundation of this ecosystem.
They facilitate the disclosure of comparable, consistent, and reliable ESG information.”
• Frameworks provide principles-based guidance on how information is structured, how it is

prepared, and what broad topics are covered
• Standards provide specific, detailed, and replicable requirements for what should be
reported for each topic, including metrics. Standards make frameworks actionable,
ensuring comparable, consistent, and reliable disclosure
² SASB Standards are organized by industry and present specific guidelines on topics to be reported
• Visit www.sasb.org, click on Standards | Download standards and select your industry
Source: sasb.org
Example: BHP Billiton’s Sustainability Performance 2020 (I)
Source: www.bhp.com/sustainability/
Example: BHP Billiton’s Sustainability Performance 2020 (II)
Example: BHP Billiton’s Sustainability Performance 2020 (III)
We will revisit this topic in session 12 when we talk about

measuring business performance in non-financial ways

SLIDES Day 02

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

SLIDES Day 02

Uploaded by

Copyright:

Available Formats

ACCOUNTING FOR DECISION MAKING AND CONTROL

² Recording fictitious revenue

Source: Anthony, Hawkins & Merchant/SEC

Clear evidence of Delivery has

2108 Nanyang NF - Accounting © Haydn Pound 2011-21 86

² When should revenue be recognised, and how much?

Customer Customer pays 30 days before 30 days after Customer pays

Customer takes flight

2108 Nanyang NF - Accounting © Haydn Pound 2011-21 87

² When should revenue be recognised, and how much?

Customer does not take flight:

Customer cancels more than 30 days before flight

Customer cancels within 30 days of flight

2108 Nanyang NF - Accounting © Haydn Pound 2011-21 88

² Prepare answers to the ten scenarios in your syndicate group

² Take 40 minutes, and be ready to share your answers

2108 Nanyang NF - Accounting © Haydn Pound 2011-21 89

² (2) Discount of 2% offered if customers pay their account within 30 days

2108 Nanyang NF - Accounting © Haydn Pound 2011-21 90

ACCOUNTING FOR DECISION MAKING AND CONTROL

Dr Cost of Goods Sold

2108 Nanyang NF - Accounting © Haydn Pound 2011-21 92

² Perpetual inventory system

² Periodic inventory system

2108 Nanyang NF - Accounting © Haydn Pound 2011-21 93

² Last In, First Out Inventory

² First In, First Out Inventory

² Specific unit cost

2108 Nanyang NF - Accounting © Haydn Pound 2011-21 94

Will vary depending

2108 Nanyang NF - Accounting © Haydn Pound 2011-21 95

2108 Nanyang NF - Accounting © Haydn Pound 2011-21 96

Nov 5 Inventory (A) 270

2108 Nanyang NF - Accounting © Haydn Pound 2011-21 97

For costing purposes,

Nov 15 Accounts receivable (A) 320

Nov 26 Inventory (A) 350

2108 Nanyang NF - Accounting © Haydn Pound 2011-21 99

Sell the oldest first!

Nov 30 Accounts receivable (A) 640

Using FIFO, Using FIFO,

2108 Nanyang NF - Accounting © Haydn Pound 2011-21 101

Nov 5 Inventory (A) 270

2108 Nanyang NF - Accounting © Haydn Pound 2011-21 102

For costing purposes,

Nov 15 Accounts receivable (A) 320

Nov 26 Inventory (A) 350

2108 Nanyang NF - Accounting © Haydn Pound 2011-21 104

Sell the newest first!

Nov 30 Accounts receivable (A) 640

Using LIFO, Using LIFO,

2108 Nanyang NF - Accounting © Haydn Pound 2011-21 106

IAS2 prescribes specific unit cost, FIFO or weighted average cost

2108 Nanyang NF - Accounting © Haydn Pound 2011-21 107

² Which method do you think is more appropriate?

2108 Nanyang NF - Accounting © Haydn Pound 2011-21 108

² The accounting principles introduced in Seminar 1 have special relevance to inventories,

2108 Nanyang NF - Accounting © Haydn Pound 2011-21 109

2108 Nanyang NF - Accounting © Haydn Pound 2011-21 110

² Businesses count inventory at the end of each period (called a stocktake)

2108 Nanyang NF - Accounting © Haydn Pound 2011-21 111

But in the next period, beginning

2108 Nanyang NF - Accounting © Haydn Pound 2011-21 112

For you to try...