Buss1030 Notes

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BUSS1030 Notes
Accounting,Business and Society (University of Sydney)
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WEEK 1: INTRODUCTION TO ACCOUNTING
FINANCIAL AND MANAGEMENT ACCOUNTING
 Accounting: Information system that measures business activities, processes information and communicates
financial information; accounting is the language of business
- Used as a tool for planning, making informed choices about the allocation of scarce resources:
o Decisions to develop or terminate new products or services
o Decisions to change the price or quantity of existing products
o Decisions to borrow money to help finance the business
o Decisions to change the methods of purchasing, production or distribution
Financial accounting
 Preparing general-purpose external reports that are looked at by share/stakeholders

 Reports usually prepared annually; larger companies may have half-yearly or quarterly reports
 Includes a broad overview of the position, performance and cash flows of the business for a period
- Reports will usually reflect past performance of the business (can then be used for forecasting)
- Statement of financial performance/comprehensive income (the “income statement”)
o Statement which reports show much wealth (profit) has been generated in a period
- Statement of financial position (the “balance sheet”)
o Statement that shows the assets of a business and the claim on those assets
- Statement of cash flows (“cash flow statement”)
o Statement that shows the sources and uses of cash for a period
 Need to adhere to set standards  Generally Accepted Accounting Principles (GAAP)
 AASB (Australian Accounting Standards Board) is responsible for technical accounting standards – they set the
standards that govern measurement rules and the level of disclosure
Income statement Statement of financial position Statement of cash flows

Nature Flow report (for the period) Static report (at the end of the Flow report (for the
period) period)
Basis of Accrual Accrual Cash
transaction
recognition
Related elements Income and expenses Assets, liabilities, owner’s All elements
(account types) equity
Focus The increment in owner’s The financial position or wealth The change in cash or cash
equity for the period from at a point in time equivalents for the period
non-ownership transactions

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 Cash accounting: Recognises revenue and expenses only when money changes hands
- Simple to determine when a transaction has occurred
- No need to track receivables or payables
- Easy to look at your bank balance and understand the exact resources at your disposal
- Business’ income isn’t taxed until it’s in the bank
 Accrual accounting: Recognises revenue when it’s earned and expenses when they’re billed (not paid)
- More realistic idea of income and expenses during a period of time; provides a long-term picture of the
business that cash accounting cannot provide
- Doesn’t provide any awareness of cash flow – can appear profitable whilst actually empty accounts
- There is a timing difference between the provision of goods and payment in the bank
Management accounting
 Preparing specific-purpose reports, designed with a particular decision in mind

 Provides economic information (in considerable detail) for internal users, which will be used in monitoring and
control within the entity
- Reports will be produced as frequently as required by the manager
- Eg. Managers provided with a weekly or monthly report to allow them to check progress on a regular
basis. Special-purpose reports may also need to be prepared when required
 Provides information for planning and budgets, costs and pricing
- Reports provide information on future and past performance
 No standards due to its internal use only
QUALITIES OF ACCOUNTING
Fundamental qualities of accounting
 Relevance: Accounting information needs to be able to influence decisions of users

- That is, relevant to the prediction of future events (eg. estimating next year’s profits) or confirmation
of past events (eg. establishing last year’s profit)
- To be relevant, information needs to cross a threshold of materiality
o Will omission or misrepresentation alter the decisions that users make? If no, the information is
not material and should be included separately (otherwise, clutters reports)
 Faithful representation: Needs to be complete, neutral (without bias) and free from error (no errors in how the
estimates haves been prepared and described)
- Financial information may not always be entirely from error
- However, no errors or omissions should affect the description of the economical phenomena
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Enhancing qualitative characteristics
 Comparability: Users can identify similarities and differences between different periods within a set of financial
statements and across different reporting entities
- Evaluate performance of the business in relation to similar businesses
 Verifiability: Assurance that the information represents what it’s supposed to
- Independent experts need to reach a consensus
- Tends to be supported by evidence
 Timeliness: Produced in time for users to make informed decisions
- The older the information, the less useful that information
 Understandability: Set out clearly and concisely so that it’s understood by whom the information is aimed at
TYPES OF BUSINESS ORGANISATIONS
Sole proprietorship
 Individual is the sole owner of the business

 Legal perspective: No separate legal identity – no distinction between the owner and business
 Accounting perspective: Distinguish clearly between the two – recognise transactions between the owner and
business (eg. capital funds contributed by the owner and profits distributed to the owner)
- Business will cease on the death of the owner
 Advantages:
- Easy and inexpensive to set-up; minimal financial reporting regulation
- Financial rewards flow directly to the owner
 Limitations:
- Unlimited liability: Personal assets may have to be used to satisfy business debts and obligations
- Limitation on size, based on fundraising power
Partnership
 Relationship between two or more individuals that share the aim of generating a financial profit
- Partners agree whatever arrangements suits them concerning the financial and management aspects
 Legal perspective: No separate legal entity – no distinction between the owner and business
- Hence, contracts with third parties need to be entered into the name of the individual partners
 Accounting perspective: Distinguish clearly between owners and business
 Advantages:
- Pooling in different resources of the partners = more brain power
- Simple to form
 Limitations: Unlimited personal liability for general partners
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Limited companies
 Businesses owned by multiple investors, each of which owns a share of the company (shareholders)
- Application must be made to the Australian Securities and Investments Commission (ASIC)
- Requirement for the annual financial reports to be subject to an audit
 Advantages:
- Separate legal existence and hence limited liability of shareholders
- Transferability of ownership is relatively easy
 Limitations:
- Separation of ownership and control
- Extensive governmental regulation
OTHER NOTES
 Entity concept: Business activities and the personal affairs of the owner are separate
 Cost principle: Assets and services acquired should be recorded at their historical cost (reliable and objective)
- Eg. If the garage purchases petrol pumps for $25 000, it would record these at the same amount
 Matching principle: Revenues are reconciled with the appropriate expense
 Accounting information should be produced if the cost of providing it is less than the benefits/value derived
from its use (Constraint: Cost of preparation vs. benefits)
 CF is a set of concepts defining the nature, purpose and content of general-purpose financial reporting
 Financial reporting: To provide information useful for making investment and lending decisions
 Stakeholder theory: Argues that organisations have a variety of interested parties and these interests need to
be considered and incorporated in a harmonised manner
Changing face of business and accounting
 Customers are increasingly sophisticated and demanding due to changing technology

 National frontiers are less important in a global economy
 Domestic markets are becoming more de-regulated
 Shareholders are increasing pressure for competitive returns
 Financial markets are more volatile
 Increasing awareness of the need to recognise the implications of the actions of business on the environment
and society at large (ie. sustainability – environmental and social)
 Business ethics

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WEEK 2: KEY ACCOUNTING CONCEPTS
THE ACCOUNTING EQUATION: ASSETS AND CLAIMS
Definitions
 Account: Name that describes the classifications

- Eg. Wages expense, wages receivable and cash at bank
 Journals: Record business transactions
 T-account/ledger: Detailed information for a particular account name
- Running balance and T-account are different formats of a ledger
E c o n o m ic
R e so u r c e s
C la im s to
E c o n o m ic R e so u r c e s
 Assets: Something that a company owns which has future economic value (ie. has monetary value)
- Business has an exclusive right to control the benefit of the asset, which has arisen from a past
transaction or event
- Can be tangible or intangible (eg. trademarks and patents)
- Eg. Land, building, equipment, goodwill, accounts and bills receivable, inventories, prepaid expenses
- Current assets: Assets that will be used up within 12 months (eg. cash, pre-payments such as insurance
– the item still has a future economic value); assets expected to be consumed or converted into cash
within the operating cycle
o Operating cycle: Time between the acquisition of the assets and their ultimate realisation in cash
or cash equivalents
- Non-current assets: Assets that will still be in your account after a year (eg. land and building)
o Typically held for generating wealth rather than resale (“tools” of the business)
- Classification of an asset may vary between current and non-current, according to the nature of the
business being carried out
o Eg. Motor vehicle manufacturer – holds its motor vehicles for resale – inventory

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o Eg. Business that uses motor vehicles for transport would classify them as non-current assets
 Liability: Something that a company owes - Obligations of an entity that you need to settle at a later date
- Eg. Money, service (legal retainers), accounts and bills payable (payment to suppliers), accrued liabilities
(for expenses incurred but not paid), long-term liabilities (mortgages and debentures)
- Current liabilities: Liabilities that will be settled within 12 months
- Non-current liabilities: Liabilities that are not settled within 12 months
Current Non-current
 Accounts payable  Mortgage loan
 Bank overdraft  Long-term loans
 Bank loan
 Revenue received in advance (eg. subscriptions)
- Only the period for which the liability is outstanding is important

o That is, a long-term liability will turn into a current liability when the settle date comes within the
operating cycle of the statement of financial position date
- Classification between current and non-current liabilities helps to highlight financial obligations that
need to be met first; also helps to indicate how long-term finance is raised
o Eg. If rely on long-term borrowings to finance the business, financial risks associated will increase
 Owner’s equity: What is left of the assets after liabilities have been deducted (ie. net assets)
- Along with liabilities, owner’s equity is a source of the company’s assets  Represents the capital that
is theoretically available for distribution (eg. to shareholders)
- Owners’ equity accounts: Capital (owner’s interest in the business), drawings, revenues, expenses and
dividends
- Any funds where the owner contributes to help finance the business (sole proprietorship) will be
regarded as a claim against the business in its statement of financial position
 Revenues: Amounts received or to be received from customers for sales of products of services
- Sales, performance of services, rent and interest received
- Once you have finished doing your part (eg. finish delivering the service), then you can record revenue
o That is, you have used up your resources in producing the revenue
- Accounts receivable: What money your customers owe you
 Expenses: Amounts paid or will be paid later for costs that have been incurred to earn revenue
- Salaries and wages; electricity and gas; supplies used; advertising
- Accounts payable: Money owed (at a later date) because you’ve incurred that cost – it is a liability
o What you owe your suppliers
o For other salaries and wages, electricity etc., create separate payable accounts
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o When you use an asset, you incur an expense
DOUBLE-ENTRY BOOKKEEPING
 Double-entry bookkeeping means to record the dual effects of each business transaction
- Business transaction: That transaction relates to the business and it has a monetary value
o If you just agree/discuss something, there is no monetary value involved and hence it is not a
business transaction
- Dual effects: Every business transaction will affect at least two accounts – after processing that
transaction, the accounting equation needs to be in balance
- Each transaction is recorded with at least one debit and one credit
- The total debits must equal total credits
 Assets (debit) = Liabilities + Owner’s Equity (credit)

- The following is a T-account (ledger account)
A c c o u n t T i tl e
D e b it C r e d it
L E F T S ID E R IG H T S ID E
 EXAMPLE: Buy a computer for $1000 cash  Two assets are affected
- Decrease in cash asset; new asset of computer equipment
The trial balance
 Trial balance: Listing of all accounts in a ledger as a check to see whether they balance
- If the totals of each column agree, then this provides some indication that no errors have been made
Closing off the accounts
 Transferring the revenues and expenses to a profit and loss account; then transfer the balance of this account
to the capital account (owner’s equity)
Rules of debit and credit

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EXAMPLE:
D a te D e s c r i p ti o n
Sep 1 D o u g C o w r a i n v e s t e d $ 3 7 0 ,0 0 0 p e r s o n a l c a s h i n t h e b u s i n e s s b y d e p o s i t i n g t h a t
a m o u n t in a b a n k
Sep 2 P a i d $ 3 6 0 ,0 0 0 c a s h t o p u r c h a s e a t h e a t r e b u i l d i n g
Sep 5 B o r r o w e d $ 2 6 0 ,0 0 0 f r o m t h e b a n k
Sep 10 P u r c h a s e d t h e a t r e s u p p l i e s o n c r e d i t $ 1 ,4 0 0
Sep 15 P a i d $ 1 ,2 0 0 o n a c c o u n t
Sep 16 A g r e e d t o h i r e a s e c r e t a r y w i t h a n n u a l w a g e s o f $ 5 5 ,0 0 0
Sep 17 P a i d e m p l o y e e s a l a r i e s o f 2 ,5 0 0 f o r t h e w e e k
Sep 28 A c c e p te d d e liv e r y o f th e a tr e su p p lie s
The recording process
 System of ledger accounts uses a system of pluses and minuses

to record transactions
- Every type of asset, liability, equity, revenue or expenses
that is needed in the financial statements has an
individual account
- Each account has two sides: A debit and credit side
 The basic steps in the recording process can be summarised as:
1. Identify the effect of a business transaction on the
accounts.
2. Record it in the journal.
3. Transfer the journal entry to the appropriate account in the
ledger.

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 The recording process has become more complex due to a range of factors:
- Greater volumes and complexity of transactions
- Different ways of cheating the system have been found – hence, systems need to be constantly received
- For developing systems, attention needs to be given to safety, security and efficiency
- Requirement for a well-documented audit trail
- As new types of businesses develop, new problems and opportunities will arise
WEEK 3 AND 4: BUSINESS TRANSACTIONS
5 IMPORTANT PRINCIPLES OF MODERN ACCOUNTING
1. The Revenue Principle

 Revenue for the business is earned and recorded at the point of sale
- That is, revenue occurs at the time at which the buyer takes legal possession of the item or when the
service is performed
2. The Expense Principle

 Expense occurs at the time at which the business accepts goods or services from another entity
- That is, expenses occur when the goods are received, or the service is performed, regardless of when
the business is billed or pays for the transaction
3. The Matching Principle

 Match each item of revenue with an item of expense
- Eg. If you are selling tacos, you would match the expense of the shells, meat and toppings at the time at
which a customer buys the taco
o Match expense with revenue earned from sale of the taco
4. The Cost Principle

 Use the historical cost of an item when recording its value (not the current market value or resell cost)
5. The Objectivity Principle

 Only use factual, verifiable data in the books, not a subjective measurement of values
 This is to ensure that financial statements are not affected by opinions and biases of the company
BUSINESS TRANSACTIONS

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Business transactions and source documents
 Has a transaction occurred?

- Check source documents, including cash receipts, invoices, credit card receipts, cash register tapes,
cancelled checks, customer invoices, supplier invoices, purchase orders, deposit slips, banks statements,
notes for loans, payment stubs
- They provide documentary evidence that a transaction has occurred and allows internal control over
the firm’s resources
 Is the transaction a business transaction?
- Either classified as an external, internal or non-business transaction
 How does the transaction affect the accounting equation?
 What specific accounts are affected by the transaction?
Journals
 A journal is a list, in chronological order, of all the transactions for a business

- The effect of business transactions on assets, liabilities, equities, revenues and expenses are first
recorded in a journal (called journal entries)
- The journal entries will show the “debit” or “credit” entries to be made to the accounts
 To record in a journal:
1. Identify transaction from source documents
2. Undertake transaction analysis
3. Specify accounts affected
4. Apply debit/credit rules
5. Record transaction (with description)
 Each general journal entry must contain the following information:
- The date that the business transaction occurred
- Details of the accounts to be debited (name, account number and amount)
- Details of the accounts to be credited
- A narration or description of the transaction
Notes regarding recording journal entries:
 Reserve accounts payable for payment to suppliers. Therefore, will need to be specific for the other payable
accounts (eg. rent payable, interest payable etc.)
 Reserve accounts receivable for money owed to us by customers
 Normal balance: What the normal balance of the account is supposed to be
- Liabilities, equity and revenue  Debit - Expenses  Credit

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 All debits and credits for revenue and expenses will go to their individual accounts (not to owners’ equity)
Asset Liability Owners’ equity

 Cash at bank  Bank loan  Capital (owner’s investment)
 Buildings  Accounts payable  Drawings
 Inventories  Salary payable  Service revenue
 Bills receivable  Rent expense
 Prepaid rent
EXAMPLE:
 Note: Cost of goods sold is treated as an expense and hence is always debited. But, on the income statement,
it will be found directly under revenue since the cost of goods sold will always be directly related to a revenue.
- When you sell inventory/goods, there will be an initial cost for that good (from initial purchase)
- To record a change in inventory, it requires two separate journal entries
1. Determine revenue first (eg. debit accounts receivable and credit sales revenue)
2. Debit the cost of goods sold to show the decrease in inventory (ie. credit inventory)
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Posting
 Posting is the procedure where information is transferred from the general journal entries to the general ledger
accounts
- Two formats of ledgers: T-format and running balance format
 Steps in the posting process:
1. Find the account to be debited
2. Enter the transaction date in the account
3. Enter name of account that will be credited
4. Enter amount of the debit
5. Go back to the journal and enter the account number to show that part of the entry has been posted and
place a tick next to the line in the journal
6. Repeat steps 1 – 5 for the account to be credited
Running balance (4 column ledger)
 For every account name, require a separate ledger for each, which shows every single debit and credit
 Explanation: Where the other half of the journal entry is found
 Balance: Running balance
 Post Ref: Referencing which journal you got the transaction from
A c c o u n t : S te w a r t, C a p i ta l A c c o u n t N o .:
D a te E x p la n a tio n P o st R e f D e b it C r e d it B a la n c e
Sep 1 C a sh G J1 4 2 ,0 0 0 4 2 ,0 0 0 C R
EXPLAIN THE IMPORTANCE OF A TRIAL BALANCE
Expanding the accounting equation
 a
- Capital contributions and revenue increase owners’ equity
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- Drawings and expenses decrease owners’ equity

- Revenue and expenses: Not found on the balance sheet – found as “retained earnings” after calculating
profit or loss
- Normally balances on each of the accounts:
o Debit: Assets, drawings and expenses
o Credit: Liabilities, capital and revenue
Trial balance
 After posting journals to the ledger, a trial balance is prepared to check that the general ledger “balances”
- That is, debits = credits
 It is an internal document and working paper to check on accuracy by showing whether total debits equal total
credits (ie. helps to identify some types of posting errors)
- Must show totals to prove total DR = total CR
- Computerised accounting programs usually prohibit out-of-balance entries
 It is a listing of all the accounts with their closing balances at that point in time
- It is the closing number from the general ledger
Locating trial balance errors
1. Are the additions correct?

2. Are all accounts listed?
3. Are the balances listed correctly?
4. Review accounts for “reasonableness”
5. Check that you have not omitted the balance of an account by mistake
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- Dr balance – Cr balance = Missing value

6. Check that you have not recorded an amount on the wrong side (eg. recorded a debit instead of a credit)
- (Dr balance – Cr balance)/2 = Amount on wrong side
7. Check that you have not made a transposition error (eg. recording 210 as 120)
- (Dr balance – Cr balance)/9 = A whole number
8. If these steps do not identify the error, you may have made more than one error
ADJUSTING ENTRIES
 At the end of the period (eg. week, month, quarter), the accountant prepares the financial statements
 The unadjusted trial balance lists the revenues and expenses of an entity. However, these amounts omit
various transactions
 Accrual accounting requires adjusting entries at the end of the period
What are adjusting entries?
 Adjusting entries assign revenues to the period when they are earned and expenses to the period when they
are incurred  Adjusts for the timing differences
 Adjusting entry has the same format as a journal entry
 Adjusting entries also update the asset and liability account
- Eg. Wages incurred but not paid (accruals)
- Eg. Supplies purchased but not used (prepayments)
- Eg. Rent paid but not used (prepayments)
Types of adjusting entries
 Prepayments occur when an expense account includes an amount that related to a later accounting period
- Expense account should be reduced (credited) and a prepaid (asset) account is set up and debited
- Eg. Prepaid insurance or prepaid rent
- Eg. Prepaid rent on 1st Jan for $24 000
o At the end of June, 6 months of the rent has not been used
o Prepaid rent (asset) debit $12 000
o Rent expense credit $12 000
 Accruals occur when some of the expense remains unpaid at the end of the period
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- Expense account should be increased (debited) and a liability account (accrued expenses) set up and
credited
 Revenues due and prepaid:

- Cash and revenue do not always run in tandem  Timing difference
o Eg. If revenue has been prepaid, at the end of the accounting period, it is necessary to adjust the
accounts so that the amount of revenue that has been earned is recorded
- Unearned revenue/Customer deposits/Revenue received in advance  Liability because you have not
performed the service to earn the revenue
o Once the service has been performed; unearned revenue is debited
o Credit the relevant revenue account
 Depreciation is an expense
- Accumulated depreciation (or depreciation provision) is what is known as a contra account
o A contra account is used to offset another account (eg. a non-current asset)
o Hence, it sits directly under the asset it is related to
- Dr Depreciation Expense  Income statement account
- Cr Accumulated Depreciation
o Eg. Property plants and equipment
o Less accumulated depreciation  Amount is a negative number
WORKSHEETS
What is a worksheet?
 A worksheet is a tool which is used to help assemble all the information required to adjust the accounts and
prepare interim financial statements
 It is not a substitute for journals and ledgers
 It does not form part of the financial statements
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FINANCIAL STATEMENTS
Preparing financial statements
1. Prepare the worksheet

2. Adjust entries
3. Calculate the adjusted general ledger balances
4. Identify the items to show on each financial statement  Income statement and balance sheet
5. Calculate profits
Steps completed each month Steps completed at end of each financial period/half yearly
Identify (new) transactions Prepare end-of-year adjustments
Record transactions in journal(s) Prepare an adjusted trial balance
Post to the general ledger Prepare financial statements
Prepare a trial balance
Prepare internal management reports if needed –
after doing the necessary adjustments
Closing off the accounts
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 Involves transferring the revenues and expenses to a profit and loss account
 Transfer the balance of the profit and loss account, and the drawings account, to the capital (equity) account
The Accounting Cycle
 Business Transactions  Journal  Ledger  Trial Balance  Financial Statements
DESCRIBE A CHART OF ACCOUNTS AND ITS IMPORTANCE
The chart of accounts
 List of all the accounts within an organisation’s accounting system

 It is organised so that the accounts link the balance sheet and income statement
- Must include all accounts necessary to complete the final account
 Chart of account will vary depending on the size and scope of the organisation
- Needs to be consistent for comparability
- Needs to be reviewed periodically for redundancy
 Separated by assets, liabilities, equity, revenues and expenses
WEEK 5: CASH MANAGEMENT AND INTERNAL CONTROL
IDENTIFY THE MAIN ELEMENTS OF INTERNAL CONTROL
Internal controls
 Definition: Process, effected by an entity’s management and other personnel, designed to provide reasonable
assurance regarding the achievement of objectives relating to operations, reporting and compliance
- Hence, it involves the safeguarding of the assets of the company (eg. intellectual property, physical
property) and to prevent fraudulent behaviour from occurring
 Internal control has five integrated components, relating to the following:

- Control environment: Set of standards and structures that provide the basis for carrying out control
- Risk assessment: Establishment of objectives, linked at different levels of the entity
o Need to consider the impact of possible changes in the external environment that may render
internal control ineffective
- Control activities: Actions established through policies and procedures that help ensure that
management’s directives to mitigate risks are carried out throughout all levels of the entity
o Encompass a range of manual and automated activities (eg. authorisation and approvals;
verifications; reconciliations and business performance reviews
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- Information and communication: Information is disseminated throughout the organisation

o Personnel receive clear message from senior management
- Monitoring activities: Ongoing evaluations to ascertain if the five components of internal control are
present and functioning
 Internal controls can be either preventive or detective:

- Preventive: Policies and procedures designed to prevent errors, inaccuracy or fraud before it occurs
- Detective: Identify problems that already exist by examining information (eg. performance reviews,
actual figures vs. budgets, forecasts and benchmarks, internal and external audits)
Internal control in practice
Relevant to all areas:
 Segregation of duties: Reduces risk of mistakes, makes fraud and embezzlement more difficult
- No individual should be able to perform all the activities related to a particular asset
- Eg. Payroll preparation, distribution and cheque writing are done by different people
 Good record maintenance: Ensures proper documentation exists and backs up transactions
 Safeguards: Prevents loss of valuable business assets (eg. CCTV, passwords and safes)
 Approval authority: Requires specific managers to authorise certain types of transactions before they occur
Specifically relevant to accounting
 Physical audits: Can reveal discrepancies in the system

- Records of what is owned (asset registers) are required for these checks to occur
- Eg. Stock take  Comparing what you count the physical stock to be and comparing what is entered in
the system  Will need to explain any discrepancies
 Standardised documents: Range of documents required for careful linkage and standard approaches
- Standardisation makes it easier to check for consistency
 Trial balances: Identifies some discrepancies and hence enable them to be investigated quickly
 Reconciliations: Matching your accounts and records
- Ensures that the balance on the control (total) account agrees (reconciles) with the sum of all the
individual accounts
- Eg. Comparing bank statements to what you have recorded in the ledger
Key elements of internal control
 Honest and capable staff

 Clear system of responsibility, authority, delegation and separation of duties
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 Proper procedures for processing transactions

 Production of suitable documents (source documentation) and records to create an audit trail
- Eg. Invoices and bank statements
 Appropriate control over assets
 Independent verification of performance
 Processes for checking the IT system
Some ways of implementing internal control
 Develop an organisation chart and clear job descriptions; rotate key jobs
 Prepare and use a procedures manual
 Use an appropriate authorisation process (eg. Does a manager need to sign off on stock before it leaves?)
 Prepare a budget of expected results and use comparative financial statements
 Complete relevant reconciliations
 Number appropriate documents
 Hire good people with good references and appropriately train staff; utilise a staff feedback process
 Assign appropriate responsibility for compliance
 Separate record-keeping from custodianship of assets
 Require two signatures on payments above a specified amount
 Separate purchasing from receiving
 Run spot checks and process customer complaints
 Keep detailed records of assets (make sure they all really exist) and limit access to the records
 Have clear guidelines about personal use of assets
 Verify that records of assets reflect assets in your possession
 Have safeguards to protect documents and computer files (eg. regularly changing passwords & firewalls)
 Conduct an annual audit
 Deposit receipts intact
 Reconcile bank statements independently
 Require annual vacations to be taken
 Have and enforce a conflict of interest policy (eg. no associations between staff – leads to collusion)
Internal control and e-commerce
 E-commerce presents new challenges in internal control

1. Electronic transactions do not have a paper trail
2. Internal controls need to be inter-organisational
3. New elements of risk
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4. Internet is a public, rather than private, network

5. Lack of technical expertise
6. Legal and technical issues
 Special considerations for e-commerce and internal control

1. Ensure proper knowledge and skills of staff regarding effect of e-commerce
2. Use fraud prevention tools to reduce risk
3. Comply with Payment Card Industry Data Security Standards
4. Ensure accessibility to records for audit purposes
5. Align e-commerce with overall strategy
6. Be aware of implications of outsourcing (eg. lose control over the things you outsource)
7. Extend and expand policies to cover e-commerce
8. Ensure legal and regulatory issues are understood
9. Ensure use to firewalls and virus protection
10. Use encryption to protect messages
 Any internal control system must also consider cybersecurity:

- Many issues are international, making consensus difficult
- Threats happening more quickly than regulations
- Eg. Stolen credit card numbers, computer viruses and trojan horses, impersonation of companies
 Encryption: Plain-text messages are rearranged by some mathematical process

- Primary method of achieving confidentiality in e-commerce
- The encrypted message cannot be read by anyone who does not know the process
 Firewalls: Limits access to a local network to keep out intruders

- Enable members of the local network to access the internet while keeping non-members out
- Usually several firewalls built into a local network
 Limitations of internal control

- Cost vs. benefit  Cost of establishing procedure should not exceed expected benefits
- Human element  Collusion (two or more employees work together to defraud the firm) or an
individual may act dishonestly and perpetrate fraud
- Size of the business
- Unexpected transactions – transactions not covered by the procedure manual
- Judgement errors – incorrect information can lead to incorrect decisions
- Management override – management staff see the systems are getting in the way/are inefficient
- Weak internal controls
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EXPLAIN THE IMPORTANCE OF CONTROL ACCOUNTS AND RECONCILIATIONS
Control accounts
 Summarises all the transactions that have been recorded in a particular ledger; used for trial balance purposes
- Balance on the control account for a particular ledger should agree with the sum of the individual
balances of the individual accounts in the ledger
 The bank account as a control device: Documents used to control a bank account
- Deposit slip
- Cheque (multiple people are required to sign); treated as cash
- Bank statement
- Bank reconciliation
o Contributes significantly to good internal control over cash by:
 Minimising the amount of cash that must be kept on hand
 Helping a company safeguard its cash by using a bank as a depository and clearinghouse
for cheques received and written
 Providing a double record of all bank transactions (by the business and bank)
 Overall, the advantages are:

- Provides an effective check on the accuracy of the postings from the subsidiary records and on the
addition of those records
- Control account has limited postings, so it is possible to extract balances very quickly
- Control account can be easily kept by someone other than the person making the detailed posting –
makes fraud more difficult
Reconciliations
 Aim of reconciliation statements is confirmation of the actual cash balance at a particular date
 Lack of agreement between the firm’s books and bank statement can result for two main reasons:
1. Time lags
- Time between when the cheque is written and dated, and the date it is paid by the bank
- Time between when receipts are recorded and when recorded by the bank
2. Errors
- Errors by either party in recording transactions
 Two records of a business’ cash:
1. Cash account in the business’ own general ledger
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2. Bank statement which tells the actual amount of cash the business has in the bank
 The bank reconciliation includes:

- Items recorded by the company, not on the bank statement
o Eg. Deposits in transit or outstanding cheques
- Items on a bank statement, and not recorded by the business
o Eg. Bank collections, electronic funds transfers, service charges, interest earned or paid on
account, NSF cheques (bounced)
 Reconciliation procedure
- Reconcile balance per books and balance per bank to their adjusted or correct balances
- Reconciliation should be prepared by an employee who has no other responsibilities pertaining to cash
1. Start with two figures, the balance shown on the bank statement (balance per bank) and the balance in the
firm’s cash at bank account (balance per books)
2. Add to, or subtract from the bank balance, the items that appear on the books but not on the bank
statement (the bank side of the reconciliation)
a) Add deposits in transit to the bank balance
b) Subtract outstanding cheques from the bank balance
c) Calculate the adjusted bank balance
3. After checking their correctness, journalise those items that appear on the bank statement but not books
a) Debit to cash at bank (1) bank collections, (2) EFT cash receipts and (3) interest revenue earned on
money in the bank
b) Credit to cash at bank (1) EFT cash payments, (2) service charges, (3) cost of printed cheques and (4)
other bank charges (eg. charges for dishonoured cheques or stale-date cheques)
4. Compare the adjusted bank balance and the adjusted book balance: these should be equal
5. Notify the bank of any errors it has made
EXAMPLE
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EXPLAIN THE MAJOR ELEMENTS OF COMPUTERISED ACCOUNTING SYSTEMS
Computerised accounting systems
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 Systems come in all sizes and degrees of complexity

 System chosen should be used appropriately and add value to the organisation
 Computerised systems use the same principles as manual systems
 Internal control principles also apply to computerised systems
 Main elements of a computerised accounting system:
- An interface comprised of a number of sub-systems (eg. debtors, creditors, payroll, banking, inventory
etc.), which each are sub-divided to provide a set of individual records as required
- A sound coding system
- A variety of input methods
- Automatic updates of accounting system records
- Ability to produce a range of reports
- Most computerised systems are menu-driven
- Most information only needs to be entered once and then posting and updating occurs automatically
- Usually faster and more error free than manual systems
 Cloud computing: Ability to use and store a data file on an online server instead of a physical computer
- Requires internet access
- Provides real-time data, which is automatically back-upped
- Allows links to external parties (banks, customers and suppliers)
- Concerns about cloud computing include internet reliability, system provider reliability, privacy and
legal issues
WEEK 6: STATEMENT OF FINANCIAL POSITION
EXPLAIN THE NATURE AND PURPOSE OF THE STATEMENT OF FINANCIAL POSITION (BALANCE SHEET)
AND ITS COMPONENT PARTS
 Purpose: Set out the financial position of a business at a particular point in time
 Contains a snapshot of the assets, liabilities and equity position of the entity at a particular point in time
- Must include retained profits/losses as a part of the equity to ensure the accounting equation balances
- Can use these details to determine solvency ratios and hence liquidity etc.
 Sets out the assets of the business on the one hand, and the claims against it on the other
 AASB Framework is the accounting standards that we follow
CLASSIFY ASSETS AND CLAIMS
Assets
 May be either tangible (eg. machinery and equipment) or intangible (patents, goodwill and trademarks)
 The main identifying characteristics of an asset are (must have all four conditions):
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- Expected future economic benefit

- Business has an exclusive right to control the benefit
- Benefit must arise from some past transaction or event
- Asset must be capable of reliable measurement in monetary terms
 Current assets: Expected to be consumed or converted into cash within the next 12 months
- Held primarily for the purpose of trading
- Includes inventory, trade debtors and pre-payments
 Non-current assets: Seen as the tools of the business; held for more than one year
- Held for the purpose of generating wealth, rather than for resale
- Can be either tangible or intangible
- Includes “goodwill purchased” and accumulated depreciation (contra-asset)
 Note: For exam, assets need to be classified as either current or non-current assets
For questions regarding balance sheets, in the asset section, need to remember that accumulated depreciation will
accrue to non-current assets. To record them on the balance sheet:
 Motor vehicle 100,000

 Less: Accumulated depreciation (5,000)
 Written-down value 95,00
Claims
 A claim is an obligation on the part of the business to provide cash or some other benefit to an outside party
- External claims (liabilities)or internal claims (owners’ equity)
- Will need to settle the obligation by either sacrificing a resource or through an outflow of cash
 The other side of the statement of financial position includes claims against the assets of an entity, or simply
the different interests in those assets
Liabilities:
 Present obligation of the entity arising from past events, the settlement of which is expected to result in an
outflow from the entity of resources embodying economic benefits
 Classification of liabilities between current and non-current helps to highlight the financial obligations that
must be met first and it also informs you of the liquidity of the business
- Hence, can analyse the health and wealth of the business
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 Eg. Accounts payable, staff entitlements, loans/other credit facilities, warranty provisions and other social or
moral obligations, provision for employee bonuses or owners’ distribution
 There is also a twofold recognition criteria for liabilities – must satisfy both:
1. Probability of occurrence: More likely than not, that a future sacrifice of economic benefits will occur
2. Reliability of measurement: Amount of the claim that can be determined with acceptable precision or
accuracy
 Current liabilities: Due for repayment to outside parties within 12 months

- Liability is held primarily for the purpose of being traded
- Entity does not have an unconditional right to deter settlement of the liability for at least 12 months
 Non-current liabilities: Those that are not liable for repayment within the next 12 months
 Other classification of current liabilities:

- Provisions: Estimate of how much of a particular liability will be used – there is uncertainty regarding
the amount of timing of the liability
o Income tax, long-service leave and warranties
- Contingent liability: Potential liability that might arise in the event of a particular event occurring
o Will become a liability, contingent on that event happening
o If the event is highly likely to occur (and you know the amount – eg. settlement), then you would
show the contingent liability on the financial statement
o If unsure if the event will occur (ie. fails the measurement test), then it is not a liability. You would
usually disclose it in the notes section, or you can leave it out altogether
Owners’ equity:
 Residual interest in the assets of the entity after deducting all its liabilities
 On the statement of financial position, there are two additional accounts to the owners’ equity contributed
account:
1. Owners’ equity retained: Represents profits left in the business by the owners
2. Reserves: Represents “special purpose” owners’ equity accounts (eg. Capital profits reserve)
- Represents ownership interests in the assets, not the assets themselves
- Reserves are not separate deposits of cash available for other purposes
 Normally classified in three separate categories:
- Owners’ equity contributed (capital)
- Reserves
- Retained profit Common to combine categories 2 and 3 into “reserves” with subcategories
a) Retained profits and b) Other reserves
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EXPLAIN THE ACCOUNTING EQUATION AND USE IT TO BUILD UP A STATEMENT OF FINANCIAL

POSITION AT THE END OF A PERIOD
 Trading introduces additional transactions to the statement of financial position

 To cover the effect of trading, the statement of financial position equation is extended:
Assets = Owners’ equity at the beginning
+ Profit (or – Loss)
± Other Owners’ Equity Changes
+ Liabilities
APPLY THE DIFFERENT POSSIBLE FORMATS FOR THE STATEMENT OF FINANCIAL POSITION
VERTICAL METHOD ONLY
 Entity approach
 Proprietary approach (PREFERRED)
IDENTIFY THE MAIN FACTORS THAT INFLUENCE THE CONTENT AND VALUES IN A STATEMENT OF
FINANCIAL POSITION
Accounting conventions
 Accounting is based on a number of conventions

- Rules that have been devised over time in order to deal with practical problems experienced by
preparers and users of financial reports
- Known as GAAP (generally accepted accounting principles)
 Business entity convention: For accounting purposes, the business and its owner(s) are treated and separate
and distinct entities
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 Historic cost convention: Assets should be recorded at their historic (acquisition) cost
 Prudence convention: Financial reports should err on the side of caution

- Profits should only be recognised when they actually arise
- Expected loss from future sales should be recognised immediately rather than when the goods are
actually sold
- Designed to prevent an overstatement of financial position and performance
 Going concern (or continuity) convention: Financial statements should be prepared on the assumption that a
business will continue operations for the foreseeable future (usually 12 months)
- No intention or need to liquidate the business
- Supports the historic costs convention under normal circumstances
 Dual aspect convention: Each financial transaction has two aspects and each aspect must be recorded in the
financial statements (double-entry bookkeeping)
 Money measurement convention: Accounting should only deal with items that are capable of being expressed
in monetary terms
- Eg. Goodwill and brands, and human resource are intangible assets that cannot be reliably measured in
monetary terms
 Stable monetary unit convention: Money, which is the unit of measurement in accounting, will not change in
value over time
Valuing assets
 Non-current assets have lives that are either finite or indefinite

- Finite lives: Provide benefits for a limited period of time
o Used up over time and their cost is recognised as an expense in each period (depreciation or
amortisation for intangible non-current assets)
o Total depreciation that has accumulated over the period since the asset was acquired is deducted
from its cost – net figure is called the carrying amount
o Eg. Equipment, vehicles and patents
- Indefinite lives: Provide benefits without a foreseeable time limit

o May, or may not, be used up over time; not subjected to routine annual depreciation over time
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o Eg. Land and goodwill
 Fair values: Current market values  Alternative method for recording non-current assets, provided these
values can be measured reliably (eg. by expert advice)
- Revaluations can be used only where there is an active market, thereby permitting fair values to be
properly determined
- Intangible assets are seldom revalued to fair values because active markets for them do not exist
 Impairment: Amount of loss that must be written-off for an asset

- All types of assets (current and non-current) are at risk of suffering a significant fall in value
- Only occurs where the carrying amount of the asset exceeds its recoverable amount
o Occurs when a non-current asset suffers a significant fall in value
o Fall could be caused by changes in market conditions, technological obsolescence etc.
Conceptual framework
 Represents a logical theoretical structure to support and direct accounting practice

 Major implications:
- Definition of the reporting entity
- Objective of general purpose financial reporting
- Qualitative characteristics of financial information
- Definition and recognition of the elements of financial statements
 Conceptual Framework for Financial Reporting (2010) lists the fundamental and enhancing qualitative
characteristics of useful financial information:
- Fundamental: Relevance and faithful representation
- Enhancing: Comparability, verifiability, timeliness and understandability
EXPLAIN THE MAIN WAYS IN WHICH THE STATEMENT OF FINANCIAL POSITION CAN BE USEFUL FOR
USERS OF ACCOUNTING INFORMATION
 Provides insights about how the business is financed and how its funds are deployed
- Shows how much finance is contributed by the owners and by outside lenders  Relative proportion
will help determine if the business depends heavily on outside financing or not
- Shows different kinds of assets and how much is invested in each kind
 Provides insights into the liquidity of the business
- Liquidity: Ability of the business to meet its short-term obligations (current liabilities)
 Can provide a basis for assessing the value of the business
- Ultimately, the value of a business is based on its ability to generate wealth in the future
 Provides a means of assessing relationships between assets and claims
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- Relationship between wealth invested in assets and how much is owed in the short term
 Provides insights into the “mix” of assets held by the business
- Relationship between current and non-current assets is important
- Too much funds in non-current assets = Vulnerable to financial failure as they are uneasy to turn into
cash to meet short-term obligations
 Can help users in assessing performance
- Relationship between profit earned during a period and the value of the net assets invested
 Provides insight into the financial structure (solvency) of the business
- Solvency ratio measures the company’s ability to meet its long-term debts
- Looks at the specific mixture of long-term debt and equity used to finance its operations
IDENTIFY THE MAIN DEFICIENCIES OR LIMITATIONS IN THE STATEMENT OF FINANCIAL POSITION
 Potential conflicts within GAAP (generally accepted accounting principles)

- Eg. Monetary unit is not always stable and GAAP does not take fluctuations in exchange rates or
inflation into account
- Eg. Relevant information (useful in decision-making) is not always entire reliable (faithfully
representative) and vice versa
 Doesn’t show the true value of the business because it only records at historical cost
- That is, doesn’t cater for fair value and revaluations
 Use of judgement and the requirement to make estimates or guesses about future events
- Eg. Uncollectable accounts, sales returns and useful lives of assets
 Wide range of methods which are equally acceptable under GAAP, but which result in different financial
statement figures  Harder to compare businesses
- Eg. Inventory costing (eg. FIFO or AVCO) and asset depreciation methods
 Lack of non-financial information included in the financial position
- Ignores things that may be happening in the industry or geographic location that the company is in
WEEK 7: STATEMENT OF FINANCIAL PERFORMANCE
EXPLAIN THE NATURE AND PURPOSE OF THE FINANCIAL PERFORMANCE AND ITS RELATIONSHIP
WITH THE STATEMENT OF FINANCIAL POSITION
Nature and purpose
 Purpose of the income statement is to measure and report how much profit (financial progress or wealth) the
business has generated over a period
 Profit (or loss) is the difference between the increases in owners’ equity (income) and the decreases in owners’
equity (expenses)
 Income: Made up of revenue (from operating activities) and other gains (usually from non-operating activities)
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 Expense: Outflow of assets (or increase in liabilities) incurred as a result of generating revenues
Relationship to statement of financial position
 Both are closely related, but they are NOT substitutes for each other in any way
 Statement of financial performance can be viewed as linking the statement of financial position (balance sheet)
at the start of a period with that at the end of the period
UNDERSTAND THE LAYOUT OF A TYPICAL STATEMENT OF FINANCIAL PERFORMANCE, AND DESCRIBE

ITS COMPONENT PARTS
Definitions of key terms
 Gross profit: Difference between the revenues from sales and the cost of those sales
 Operating profit: Increase in wealth for a period that is generated from normal operations
- Operating expenses (eg. salaries, rent and rates) are deducted from the gross profit
 Profit for the period: Profit for the year after a reasonable estimate of tax likely for the year
- Add non-operating income (eg. interest receivables) and deduct non-operating expenses (eg. interest
payable on borrowings made by the business)
- This is the figure that will be added to the equity figure in the statement of financial position
 Cost of sales: Cost attributable to the sales revenues
Forms of income statement
 Simple reports: Small organisations

- May be just a listing of income and expenses in alphabetical or financial magnitude order
 Classified reports (AKA classified financial report): Larger organisations that often has departments
- Income and expenses are grouped into categories  Helps managers to manage the funds of each
department separately
- Income is normally broken down into sales and “other revenues”
- Expenses are often broken down into four categories:
1. Cost of sales
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2. Selling and distribution

3. Administration and general
4. Financial
 Regulatory presentations: Companies  Use the AASB 101 framework

- Required to be produced by companies and other entities in accordance with statutory standards
- Required that the income statement should classify expenses according to their nature or function
- List of requirements include revenue, finance costs, share of profits/losses of associates/joint ventures,
tax and discontinued operations
The reporting period: Usually one year – 1 July to 30 June (for financial reporting)
 For internal functions, it is common for profit figures to be prepared on a monthly basis to show how things are
progressing so that they have a rough idea of where they stand
DEMONSTRATE AN UNDERSTANDING OF INCOME AND EXPENSES IN RELATION TO DEFINITION,

RECOGNITION, CLASSIFICATION AND MEASUREMENT
Profit measurement and the recognition of expenses
 Expenses measure the outflow of assets (eg. cash) or the increase in liabilities that result from trading and
generating revenues
 The “matching” principle dictated that expenses should be “matched” to the income they helped to generate
- Hence, this gives rise to three possibilities when recognising expenses in a specific period
1. Cash payments are the same as the expenses incurred (eg. benefits used up or consumed)
2. Cash payments are less than the expenses incurred (eg. split payments)
3. Cash payments exceed the expenses incurred (eg. prepayments)
 Recall that manual adjustments are sometimes required for:
- Accrued expenses - Prepayments - Depreciation
Profit measurement and recognition of income
Recognition of revenues
 A key issue in the measurement of profit concerns the point at which income (revenue) is recognised
 It is possible to recognise income at different points in the production/selling cycle
 The point chosen can have a significant effect on the total income reported and profit recognised for the period
Criteria for recognising revenue
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 The main criteria for recognising revenue are that:

- Amount of revenue can be measured reliably
- It is probable that the economic benefits will be received
 Revenue on a customer sale (eg. motor car dealer) could be recognised at three different points in time:
- At the time that the order is placed by the customer
- At the time that the car is collected by the customer
- At the time that the customer pays the dealer
 Criterion where the revenue comes from the sale of goods, which is that:
- Ownership and control of the items should pass to the buyer
 Some contracts, both for goods and services, can last for more than one reporting period
- These may be broken down into stages to facilitate revenue recognition throughout the contract,
provided that the outcome of the contract as a whole can be estimated reliably
- If such a breakdown is not possible, then revenue will not usually be recognised until the service is fully
completed
- Application of the revenue recognition criteria means that revenue is often recognised before the
related cash is received
- Alternatively, cash may be received in advance of revenue being recognised (eg. cash deposit)
 Revenue is recognised on the basis that it has been earned irrespective of whether the cash receipt is in arrears
(money that was previously owed) or advance
- Revenue is deemed to be earned when it is realised
- Realisation being closely linked to probability of occurrence and reliability of measurement
 Cash accounting means recognising transactions at the time when cash flows take place
- Recall that manual adjustment are sometimes required for
o Accrued revenues
o Unearned revenues (Note: Should not appear on income statement; only on balance sheet)
EXPLAIN THE CONCEPT OF DEPRECIATION AND ITS IMPACT ON THE FINANCIAL STATEMENTS
Depreciation
 A measure of that portion of the cost (less residual value) of a fixed asset which has been consumed during an
accounting period
 The depreciation method has to reflect the use of the asset
- Eg. If there is steady depreciation for the asset over time, you would use the straight-line method
 Note: Depreciation refers to long-term, limited-life, tangible assets  Under non-current assets
- Amortisation is the equivalent concept for intangible assets
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1. Cost (or fair value) of the asset

 Includes all costs incurred by the business to bring the asset to its required location and make it ready for use
- Eg. Delivery, installation, legal title, alterations, improvements etc.
2. Useful life of the asset

 The economic life of the asset determines its expected useful life for the purpose of calculating depreciation
 The economic life of an asset ends when the cost of operating or holding it exceeds the benefit derived
 Economic life may be shorter than physical life (eg. computer)
3. Estimated residual value (disposal value)

 Defined as the likely amount to be received on disposal of the asset
- Ie. Amount that the asset is worth at the end of its useful life
 Estimated residual value can be difficult to predict
4. Depreciation method
 Once the “depreciable amount” has been estimated, it must be allocated over the useful life of the item,
property, plant or equipment there are three common methods of deriving a depreciation expense
1. Straight-line method of depreciation
- Allocates the amount to be depreciated equally over each year of the useful life of the asset
- (Cost – residual value)/years of useful life
2. Accelerated depreciation
- Applies a fixed percentage rate of depreciation to the written-down value of an asset each year
- Higher annual depreciation is charged in earlier years
3. Units of production-based depreciation
- Depreciation based on productive capacity of the asset and its use over time
o Eg. Kilometres travelled, units produced hours of operation
Selecting the depreciation method
 Methods should be selected to be appropriate to the particular assets and to their use in the business
(ie. match the depreciation expense to the income it helped to generate)
- Accounting standard “Property, plant and equipment” reinforces this view
- If benefits are likely to remain fairly constant over time – straight-line method
- If assets lose their efficiency over time and benefits also decline – reducing-balance method
- If depreciation relates more to use than time – units of production method
 Depreciation does not provide funds for asset replacement, it is used to calculate net profit
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 Depreciation is an example of an accounting process that requires judgement
USE A FIRST-PRINCIPLES APPROACH TO BUILD UP A SIMPLE SET OF FINAL ACCOUNTS

(IE. STATEMENT OF FINANCIAL POSITION AND INCOME STATEMENT)
 Main area of difficulty relates to period-end adjustments

 Amount included as an expense for a particular period generally includes the following:
- Any amounts that were paid in earlier periods, but which related to the period in question
- That part of the amount paid in the period that related to the period
- Plus any amounts due for the period that are unpaid
 Cost of sales = Opening inventory + purchases – closing inventory
CASH VERSUS ACCRUAL ACCOUNTING
 It is important to note that “profit” and “cash” (liquidity) are not the same
- Profit is a measure of achievement, or productive effort rather than of cash generated
Accrual accounting
 Prepaid expenses relate to expenses paid in advance of being incurred

 Unearned revenues refer to cash received in advance of being earned
 Accrued revenue relates to revenue earned but not received
 Accrued expenses are where the expense has been incurred but payment has not been made
Cash accounting
 Cash receipt or payment triggers income or expense recognition

 Hence, balances from cash accounting will be different to that of accrual accounting
REVIEW AND INTERPRET THE INCOME STATEMENT
Looking at revenues and expenses
 Did the company make a profit or loss for the year?

- Earnings before income and tax
- Net profit
 How does the profit or loss compare to last year’s performance?
 Were total revenues/expenses higher or lower than last year? Why?
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 What are the reported earnings per share and how does this compare to prior years?
Insights: Used for both internal and external evaluation
 How much income has been generated?

 What are the main sources of income?
 How efficient is the firm?  Are we able to settle our expenses and liabilities when they are due or are we
living day-to-day?
 What is the cost structure of the firm?
 What is the operating performance?
- Earnings before interest and tax = Revenues minus operating expenses (excluding interest and tax)
 What is the overall performance?
- Net profit = All revenues – All expenses
Example of an income statement
 If tax rate or amount is provided, then calculate net profit AFTER tax
 Recall that the income statement is for that period as these are temporary accounts that do not transfer over
to the next financial year
WEEK 8: STATEMENT OF CASH FLOWS
EXPLAIN WHY CASH IS IMPORTANT TO THE REPORTING ENTITY
 Organisations and people will not normally accept any other form of settlement of claim
 Businesses fail as a result of their inability to find sufficient cash to settle their responsibilities
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 These factors make cash the critical business asset and therefore, the one that analysts and others watch
carefully in assessing survivability of the business
 Statement of cash flows is required to be produced because the below two reports do not concentrate
sufficiently on liquidity (cash flow)
- Statements of financial position and performance show movements in wealth and the net increase or
decrease in wealth for the period concerned
 The accrual nature of the above two reports are thought to obscure the question of how and where a company
is generating the cash it needs to continue operating
DEFINE CASH AND CASH EQUIVALENTS
 Cash: “Cash on hand” and “demand deposits”

 Cash equivalents: Short-term, highly liquid investments that can be readily converted to a fixed amount of cash
(eg. short-term money market deposits and bank bills)
COMPARE AND CONTRAST THE ROLES OF THE FOUR EXTERNAL FINANCIAL REPORTS
Statement of financial position (balance sheet)
 Static report made at a given point in time

 Based on balances in assets, liabilities and owners’ equity  Normally based on accrual transactions
Statement of financial performance (income statement)
 Measures the financial performance over a period of time (normally for one year)
 Related to revenues earned less expenses incurred
Statement of changes in equity (Not examinable for BUSS1030)
 Provide a reconciliation of all the changes in the equity account

 Identifies all changes in equity for the period related both to comprehensive income, owners’ contributions
and withdrawals, and all other changes in equity not in the income statement
Statement of cash flows
 Identifies all cash receipts and cash payments for the period
 All account types are included and is based on cash, not accrual transactions
 Reconciles the opening and closing balance of cash and cash equivalent accounts
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 It reports the inflows and outflows of cash (and cash equivalents) in three activity areas:
- Operating, investing and financing activities
DISCUSS THE THREE COMPONENTS OF THE STATEMENT OF CASH FLOWS
Cash flow statements
 It is an analysis of the business’ cash movements over the period concerned

 All payments of a particular type are added together to give just one figure, which appears in the statement
 The net total of the statement is the net increase or decrease in cash of the business over the period
 Since cash flows do not include non-cash expenses (eg. depreciation), the cash flow from operations will
normally be higher than the profit recorded
Format of cash flow statement Cash flows fromOperating activities

Received fromcustomers 1,200
Paid to suppliers (500)
Paid for wages or other expenses (300)
Paid for interest (170)
Paid for tax (160)
Net cash provided fromoperating activities 70
Cash flows fromInvesting activities
Proceeds fromsale of machinery 605
Paid for purchase of motor vehicles (805)
Net cash used in investing activities (205)
Cash flows fromFinancing activities
Proceeds fromshare issue 2,000
Paid to redeemdebentures (1,600)
Paid for dividends (270)
Net cash provided by financing activities 130
Net increase in cash (5)
Cash balance at beginning of period 20
Cash balance at end of period 15
 Need to provide proper details for where payments are going to etc.
 Do not refer to revenues and expenses on the cash flow statement  Only include payments or receipts
 Cash will either be “provided from” or “used in” activities  Will not use both
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 If you have the purchase and sale of a single item (eg. machinery), show both items as it provides more info
Three components of the cash flow statement
 Operating activities: Activities that are typical (regularly occurring transaction) of the company
- Represents net inflows from operations (ie. items recognised in the income statement)
- Only cash received and paid (not expenses and revenue) are featured
- Cash receipts from:
o Customers from cash sales or receivables
o Interests or dividends received
- Cash payments for:
o Inventory/services from suppliers o Taxes to governments

o Wages and expenses o Interest to lenders
 Investing activities
- Concerned with cash payments to acquire additional non-current asset, and cash receipts for disposal
of such assets (eg. plant and machinery, investments etc.)
o That is, changes in non-current assets on the balance sheet
o Proceeds from sale of property, plant and equipment, or investments
o Loan repayments from others
o Purchase/acquisition of property, plant and equipment, or business
o Shares/debentures for investment purposes
 Financing activities: Deals with long-term liabilities and equity

- Deals with financing the business, excluding short-term credit (eg. debt and equity sources)
o Cash flows that change the size or composition of the financial structure
o Proceeds of issue of shares
o Cash from borrowing
o Repayment of borrowings o Dividends paid

o Share buybacks
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EXPLAIN HOW THE STATEMENT OF CASH FLOWS CAN BE USEFUL FOR IDENTIFYING CASH FLOW
MANAGEMENT STRENGTHS, WEAKNESSES AND OPPORTUNITIES
What does the statement of cash flows tell us?
 The statement of cash flows tells us how the business has generated cash during the period (preferably from
operating activities) and where that cash has gone
 Tracks the sources and uses of cash over time, which is indicative of trends and useful for predicting future
opportunities and patterns of cash flow
 Provides an insight to working capital management
 Is a good indicator of debt management practices
 Identifies non-operational cash flows
Benefits of cash flow statement
 Explains what caused the movement in cash balance and other items impacted by the cash flows
 Helps to measure cash sufficiency and business solvency
- That is, the ability to meet obligations and/or pay dividends
 Helps users to evaluate:
- Investing and financing transactions during the period (not just operating activities)
- The entity’s ability to generate future cash flows
- Differences between net profit and net cash provided from/used by operating activities
IDENTIFY NON-CASH TRANSACTIONS
 Transactions that do not directly involve cash

 Most of these transactions relate to the “operating activity” section and are also linked to the difference
between cash-based and accrual-based transactions
- Eg. Depreciation, revaluations, doubtful debts, accruals (receivables, inventory, prepayments, payables,
gains or losses on disposal of non-current assets) etc.
 Others may relate to the “investing and financing activity” section
- Eg. Direct exchanges such as shares for assets, non-current assets for reduction in debt, bonus issues
from reserves etc.
RECOGNISE THE ALTERNATIVE APPROACHES TO PREPARING A STATEMENT OF CASH FLOWS
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 There are two methods of calculating and reporting the cash flows from the operating section of the cash flow
statement (there is no difference in the investing and financing section)
 Direct method: Required for BUSS1030
- Analyse the cash records to identify cash payments and receipts by type
- Cash inflows/outflows from the operating section are calculated directly and individually listed
- Hence, can derive net cash flow from operating activities
 Indirect method: Not required for BUSS1030

- Uses accounting information from the income statement and the statement of financial position to
convert the profit figure to a cash figure
o Need to adjust net profit to derive the net cash flow from operating activities
o Recognises that sales revenue will give rise to cash inflows and expenses will give rise to outflows
- Net cash inflow/outflow from the operating total is calculated indirectly
- Doesn’t show direct individual inflows/outflows
- Eliminates non-cash and accrual items from net profit
PREPARE A SIMPLE STATEMENT OF CASH FLOWS
 Reconstruction of the statement of comprehensive income is the most often used. Three alternative
approaches can be used:
1. Schedules using additions and subtractions
2. Ledger reconstructions
3. Worksheets
Deducing cash flows from operating activities
1. Calculate the cash receipts from customers:

- Opening balance of accounts receivable
o Plus sales for the period
o Less closing balance of accounts receivable
o Equals cash received from customers
2. Calculate payments relating to accounts payable for inventory purchases

- Opening balance of accounts payable
o Plus purchases of inventory for the period
o Less closing balance of accounts payable
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o Equals the cash paid to accounts payable

Note: For current situations, increasing liabilities is good as it reduces cash outflow
(In the long-term, it will be bad because you have to pay it out later)
3. Calculation of interest paid relating to interest payable (may also be used for any other expense item)
- Opening balance of interest payable
o Plus interest expense for the period
o Less closing balance of interest payable
o Equals interest paid
- If the liability stays the same at the start and end of the period, then cash outflow = expense
4. Complete “cash flows from operating activities”

- Cash receipts from customers
- Less cash paid to suppliers and employees
- Less interest paid
- Less income taxes paid (start of the year liability)
- Equals net cash provided by operating activities
Deducing cash flows from investing activities
 Need to compare opening and closing statements for our non-current assets
- Accumulated depreciation is linked to the adjusting entry of the depreciation expense. Hence, it will not
be accounted for in the cash flow statement.
 Net cash used in investing activities is equal to:
- Purchase of property, plant and equipment (cash outflow = negative number)
- Plus proceeds from sale of property, plant and equipment
o Note: If this is not applicable, and has a value of 0, do not include it on the statement.
Deducing cash flows from financing activities
 Need to compare the opening and closing statements for long-term liabilities and equity
- Note: If liabilities and equity are going up, this is a cash inflow
 Net cash provided by financing activities is equal to:
- Proceeds from issuance of share capital
- Plus proceeds of long-term borrowings
- Less repayment of long-term borrowings
- Less dividends paid
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 Note: If there are any calculations required for the cash flow statement, don’t write it in the statement itself.
Instead, draw a star and make a note at the bottom of the page.
EXAMPLE:
Statement of financial performance for the year ended 31 December 2017
Statement of financial position as at 31 December
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WEEK 9: ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS
FINANCIAL RATIOS
 Provides a quick and simple means of examining the financial health of a business
 Simply expresses the relationship between one figure appearing in the financial statements and some other
figure appearing in the financial statements
- Eg. Profit in relation to capital employed or profit per employee
 Are simple to calculate, and a good picture of the financial position and performance of the business can be
built up with just a few ratios
 Ratios can be difficult to interpret
- Eg. The change in profit per employee of a business may be due to several possible reasons:
o Change in number of employees without a corresponding change in output or vice versa
o Change in the mix of goods and services being offered, which changes the level of profit
 Can be expressed in various forms depending on the need, use for the information, tradition and user
preferences (eg. Percentages, fractions or proportions)
Classification of financial ratios
 Profitability: Measure of success in wealth creation

- Express profits made in relation to other figures or some business resource
 Efficiency: Effectiveness of utilisation of resources
- Referred to as “activity ratios” or “turnover ratios”
 Liquidity: The ability to meet short-term obligations
 Financial gearing/Solvency: Measure of the degree of risk to do with the amount of leverage (long-term
borrowing) used to finance the business (ie. meeting long-term obligations)
 Investment: Measure of the returns and performance of shared held by a business
Financial ratios: The need for comparison
 Calculating a ratio by itself will not tell you much about the position or performance of a business
 Ratios need to be compared with some form of “benchmark” so that it can be interpreted and evaluated
- Past periods: Detect if there has been an improvement or deterioration in performance; identify trends
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- Similar businesses: Survival in an industry may depend upon a firm’s ability to achieve comparable
levels of performance (eg. what’s the average in the industry?)
- Planned performance: Ratios may be compared with the targets that management developed before
the start of the period to reveal level of achievement attained
o However, planned performance must be based on realistic assumptions
- Best practice: Top performers
Key steps to financial ratio analysis
1. Identify users and their information needs

- Thus, will determine which ratios will be useful
- Eg. Managers: Interested in all ratios as they are responsible for overall performance of the business
- Eg. Shareholders: Interested in profitability, investment and gearing ratios
2. Calculate appropriate ratios

- When a ratio involves a comparison between two statements of financial position, we use year-end
figures
- If the ratio involves both the statement of financial position and the statement of financial
performance, we would use the average of the two figures from the statement of financial position,
rather than the year-end figure
3. Interpret and evaluate the results

- Interpretation involves examining the ratios in conjunction with an appropriate basis for comparison
and any other relevant information
- Hence, the significance of the ratios calculated can be established
PROFITABILITY RATIOS
Return on ordinary shareholders’ funds/return on equity
 Compares the amount of profit for the period available to the ordinary shareholders with the ordinary
shareholders’ average stake (ie. ordinary share capital) in the business during that same period
- Denominator: Total investment that the shareholders have put into the business
Return on capital employed
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 Fundamental measure of business performance; primary measure of profitability

 Expresses the relationship between the operating profit generated during a period and the average long-term
capital invested in the business during that period
Operating profit margin
Gross profit margin
 Represents the profitability in buying (or producing) and selling goods, before any other expenses are taken
into account  A change in this ratio can significantly affect the “bottom line” (ie. profit)
- That is, how much profit do you earn for every dollar of revenue?
 Gross profit = Difference between sales and cost of sales
EFFICIENCY RATIOS
Average inventories turnover period
 Measures the average period for which inventory is being held
- Average inventory is the average of opening and closing inventory for the period
 Typically expressed in months or weeks, rather than days
Average settlement period for accounts receivable
 Calculates how long, on average, credit customers take to pay the amounts they owe
 Prefer a shorter average settlement period so that the funds can be used for more profitable purposes
 However, the average can be badly distorted by a few large customers who are very slow payers
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Average settlement period for accounts payable
 Calculates how long, on average, the business takes to pay its accounts payable
 Whilst companies may attempt to increase their average settlement period, taking it too far will result in a loss
of suppliers’ goodwill
Sales revenue to capital employed (asset turnover ratio)
 Examines how effectively the assets of the business are being employed in generating sales revenue
 Higher ratio is preferred as it suggests that assets are being used more productively in the generation of
revenue. However, a very high ratio may suggest “overtrading”
Sales revenue per employee
 Provides a measure of the productivity of the workforce
 Prefer a high value for this ratio as it implies that staff are being used efficiently
LIQUIDITY
Current ratio
 A liquidity ratio that relates the current assets of the business to the current liabilities
 Higher ratio = More liquid the business is considered to be
- However, may indicate that too much funds are being tied up in cash or other liquid assets  Not being
used productively
 Need to consider the type of business to determine the most relevant current ratio
- Eg. Manufacturing business: Relatively high current ratios as it needs to hold stocks of finished goods,
raw materials and work-in-progress
- Eg. Supermarket chain: Relatively low current ratio as it will only hold fast-moving stocks
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Acid test/liquid/quick ratio
 A liquidity ratio that relates the liquid assets (usually defined as current assets less inventories and
prepayments) to the current liabilities
Cash flows from operations ratio
 AKA “Cash generated from operations to mature obligations ratio”

 Compares operating cash flows with the current liabilities of the business
- Indication of how well a business can meet its maturing obligations
 Higher the ratio = Better liquidity of the business
FINANCIAL GEARING RATIOS (LEVERAGE)
 Financial gearing occurs when a business is financed, at least in part, by outside parties, typically borrowings
 The level of gearing, or the extent to which a business is financed by outside parties, is an important factor in
assessing risk
- Business that borrows heavily is committed to pay interest charges and make capital repayments
 Gearing may be used both to adequately finance the business, and to increase the returns to owners – as long
as the returns generated from the borrowed funds exceed the interest cost of paying interest
 Change in profits can lead to a proportionally greater change in the returns to equity
Gearing ratio
 A ratio that relates the long-term, fixed-return, finance contributed (eg. borrowings) to the total long-term
finance of the business
 Other variations of the gearing ratio include:

- Total liabilities to total assets
- Total liabilities to total owner’s equity
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- Long-term liabilities to total owners’ equity
Interest cover ratio (times interested earned)
 Measures the amount of profit available to cover interest expense

 Divides the operating profit (ie. profit before interest and taxation) by the interest expense for a period
 The lower the level of operating profit coverage, the greater the risk to lenders that interest payments will not
be met
INVESTMENT RATIOS
Dividends per share ratio
 Relates the dividends paid for a period to the number of shares in issue
 Indicates the cash return an investor receives from holding shares in a company
Dividend payout ratio
 % of the company’s profits being paid out as dividends
Dividend yield ratio
 An investment ratio that relates the cash return from a share to its current market value
 Helps investors to assess the cash return on their investment in the company
 t represents the company tax rate

- “Imputation credit” system used to avoid double taxation
Earnings per share

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 An investment ratio that relates the earnings generated by the business during a period, and available to
shareholders, to the number of shares in issue
 Governed by accounting standards
 Regarded by many analysts as a fundamental measure of share performance and is used to help assess the
investment potential of a company’s shares
Operating cash flow per share
 Operating cash flows provide a better guide to the ability of a company to pay dividends and to make planned
expenditures than the earnings figure
Price/earnings (P/E) ratio
 Relates the market value of a share to the earnings per share
 It is a measure of market confidence in the future of a company

- The higher the P/E ratio, the greater the confidence in the company’s future earning power
- Consequently, the more investors are prepared to pay
ISSUES RELATING TO FINANCIAL ANALYSIS
Overtrading
 Overtrading: Situation in which a business is trying to operate at a capacity which is beyond that capable of
being achieved with its current level of funding
- Often occurs due to poor financial control, such as:
o Misjudge the level of expected sales demand
o Owners are unable to inject further funds into the business themselves and/or cannot persuade
others to invest in the business
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 Results in liquidity problems such as exceeding borrowing limits, or slow repayment or borrowings and trade
payables, and may ultimately lead to business failure
 For survival, a business must ensure that the finance available is consistent with the level of operations
Trend analysis
 A form of analysis that uses trends, usually graphically or by percentage analysis

 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 a companies’ annual reports as a way to help users to identify
important trends
Index or percentage analysis
 A simple technique that can be used to highlight potential strengths and weaknesses in financial performance,
financial position and liquidity over time
 Makes it easy to see trends emerging over time, or differences between different entities
 Techniques include:
- Common size reports (vertical analysis)  Set the key magnitude at 100 and everything else as a %
- Trend percentage
- Percentage change (horizontal analysis)
Ratios and prediction models
 Ratios are often used to help “predict the future” and assess future prospects
- However, the choice of ratios and interpretation of the results depend on the judgement of the analyst
 Researchers have developed ratio-based models which claim to predict future financial distress as well as
vulnerability to takeover
 The future is likely to see further ratio-based prediction models developed to predict other aspects of financial
performance
LIMITATIONS OF RATIO ANALYSIS
 Help to highlight the financial strengths and weaknesses of a business, but cannot explain why they exist or
why certain changes have occurred
 Quality of financial statements: Determines the usefulness of the ratios derived from them
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- Ratios will inherit the limitations of the financial statements they are based on
- Limitation of financial statements themselves is their failure to include all resources controlled by the
business (eg. goodwill and brands excluded)
 Inflation: Financial results of businesses can be distorted as a result of inflation
- Reported value of non-current assets will be understated in current terms during a period of inflation
- Hence, it distorts the measurement of profit
 Over-reliance on ratios: Ratios only offer a restricted view of “relative” performance and position
 Basis for comparison: No two businesses are identical and the greater their differences, the greater the
limitations of ratio analysis as a basis for comparison
- Eg. Differences in scale or the use of different accounting policies
 Financial position ratios: 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 (eg. seasonality effects)
WEEK 10: COST BEHAVIOUR AND COST VOLUME PROFIT ANALYSIS
FINANCIAL AND MANAGEMENT ACCOUNTING

Financial accounting Management accounting
Focus Mainly external Internal only
Nature of reports General purpose Specific purpose
Level of detail Broad overview Quite detailed – may be detailed down to the
employee basis
Restrictions Accounting standards and other regulations No restrictions
Reporting interval Mainly semi-annual or annual Whenever required
Time horizon Mainly historical Both past and future
Range of information Quantifiable in money terms Can contain non-financial information
Focuses on objective and verifiable data (eg. customer satisfaction)
Less focus on objectivity and verifiability
VARIABLE VS. FIXED COST
Fixed costs
 Costs that do not change in total when volume of activity (eg. units sold) changes
- Are likely to change as a result of inflation or general price increases, but not as a result of change in
volume of activity
 Are almost always “time-based” (ie. vary with the length of time concerned)
 Theoretically stay the same regardless of the level of output
- However, often must increase to allow higher levels of output (stepped fixed costs)
- Eg. At a particular point, volume of activity cannot increase further without additional space being
rented. Additional rent causes a “step” in the rent cost
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Variable costs
 Costs that do change in total when volume of activity (eg. units sold) changes
 Linear line: Same cost per unit of production, irrespective of the number of units produced
 Non-linear line: Higher volumes of activity may introduce economies of scale, thus changing the variable costs
line as production increases
Semi-fixed (semi variable) costs
 These costs exhibit aspects of both fixed and variable costs

- Part of such costs are fixed and will not change with level of activity, while some parts are variable and
vary accordingly with changes in level of activity
 Eg. Electricity costs for heating, lighting and powering machinery
- Cost for heating and lighting would remain largely fixed irrespective of production activity
- For powering of machinery, it would increase with production level
BREAK-EVEN ANALYSIS
Break-even analysis
 Break-even point: Total revenues = Total costs

- Note: Increases in activity do not have any bearing on total fixed costs.
- Total variable costs will increase as activity increases.
 Provides the activity level to cover all costs associated
 The break-even point must be expressed with respect to a period of time
 Assess sales level required to achieve profit targets

 Assess margin of safety – difference between break-even volume and actual sales volume (output)
- Provides an indication of risk  How much can your sales go down before you start losing money?
- Want this to be as large as possible (ie. further above the break-even point)
 Operating gearing: Relationship between the total fixed and the total variable costs for some activity
- High operating gearing: An activity with relatively high fixed costs compared with its variable costs
o Although riskier if demand is low, it has the ability to make more profit than activities with low
operating gearing
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Contribution and contribution margin
 Contribution per unit: Difference between the revenue per unit (sales price) and the variable cost per unit
- How much does each sale contribute to paying off our fixed costs?
- This is effectively a contribution to fixed costs and profit
o Useful figure to know for decision-making contexts  Once the fixed costs are covered, then the
money will contribute to profit
 Contribution margin ratio: Contribution per unit/Sales revenue * 100%
 Marginal cost: Variable cost per unit
- Addition to total cost which will be incurred by making/providing one more unit of output
 Subsequently, the break-even point is calculated as = Fixed costs/Contribution margin
EXAMPLE:
 Here are the planned sales and costs of a business for a period.
Sales 10 000 units @ $6 each $60 000

Variable costs 10 000 units @ $3.50 each $35 000
Fixed costs - $15 000
 The break-even point can be calculated as follows:
Sales price per unit $6

Variable costs per unit $3.50
Contribution per unit $2.50
 Break-even point = Fixed costs/Contribution margin

= 15 000/2.50 = 6 000 units
 Hence, the margin of safety is 4 000 units
 To make a profit of $5 000:
- (Fixed costs + profit)/Contribution margin = Level of sales needed to achieve desired profit
- (15 000 + 5 000)/2.50 = 8 000 units
Profit volume charts
 Obtained by plotting profit or loss against volume of activity

 The slope of the graph is equal to the contribution
per unit
 As the level of activity increases, the amount of the
loss gradually decreases until the break-even point
is reached
 Beyond the break-even point, profits increase as
activity increases
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Weaknesses of break-even analysis
 Non-linear relationships:
- Relationships between sales revenue, variable costs and volume are unlikely to be linear ones due to:
o Economies of scale
o Diseconomies of scale (when a business expands so much that cost per unit increases – eg. labour)
o Need for price reduction to achieve volumes of sales
- Dropping the linear assumption can lead to more effective, although more complex, analysis
 Stepped fixed costs: Most activities will likely include fixed costs of various types with varying step points
 Multi-product businesses:
- Multiple products make break-even analysis difficult as fixed costs tend to relate to more than one
activity, making division of fixed costs across products arbitrary
o Eg. Rent often relates to more than one activity
COSTS, OUTLAY (HISTORIC) COSTS AND OPPORTUNITY COSTS
 Cost: Represents the amount of resources sacrificed to achieve a particular objective

 Sunk cost: Cost that has already been incurred, and as such, is not relevant for future decisions
 Outlay cost: Total costs (expenditure or transfer of assets) incurred in acquiring an asset, achieving an objective
or executing a decision
 Opportunity cost: Cost of the best alternative strategy  This is a relevant cost
- It is the value of an opportunity foregone in order to pursue another course of action
- Do not involve any out-of-pocket expenditure and are rarely taken into account in financial accounting
 Relevant costs: Cost which is relevant to any particular decision – need to exclude those costs that are not
relevant to the decision; used for measuring costs for decision-making purposes
- Historical cost behaviour is often the starting point by which the relevant future cost may be estimated
- To be relevant, a cost must satisfy all of the following criteria:
o Relate to the objectives of the business
o Be a future cost
o Vary with the decision
 Eg. In the decision to buy a new truck, the model of the truck is relevant but the decision
to employ a new driver is irrelevant
Marginal analysis/relevant costing
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 In decisions involving limited periods of time or small variations from usual practice, fixed costs tend to be
irrelevant. Such decisions include:
- Accepting/rejecting special contracts
- Making the most efficient use of scarce resources
- Deciding whether to make or buy
o Eg. Outsourcing specific components of production  However, leads to loss of control of quality
and potential unreliability of supply
- Closing or continuing a section/department
o Assess the relative effectiveness or probability of each section
WEEK 11: COSTING
FULL COSTING
Why calculate costs?
 Cost accounting: Involves measuring, recording and reporting costs of any cost object (eg. product, service
department, customer, employee etc.)
 Why calculate costs?
- To value inventory (balance sheet)
- To determine cost of goods sold (income statement)
- For contractual purposes
- For management decision making (eg. product pricing)
- To motivate employees
Nature of full costing
 Full costing: Deducing the total direct and indirect (overhead) costs of pursuing some objective of activity of
the business
- Not only concerned with variable costs but with all costs involved in achieving an objective
- Used to determine the minimum price of a product or service that will cover all costs
 Full cost: Total amount of resources, usually measured in monetary terms, sacrificed to achieve a particular
objective
- To derive the full cost figure, need to accumulate the costs incurred and then assign them to the
particular product or service
 Cost object: Thing that you’re trying to come up with the costs for
Areas where full costing may prove to be useful
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 Pricing and output decisions: Can help make decisions on the price to be charged and volume of output
 Exercising control: Helps in re-engineering the production process, finding new sources of supply
 Assessing relative efficiency: Can help managers compare the cost of carrying out an activity in a particular
way, or particular place, with its cost if carried out in a different way, or place
 Assessing performance: Allows sales revenue to be compared with the costs consumed in generating that
revenue, and helps in assessing past decisions and guiding future decisions
DERIVING FULL COSTS
Single-product operation
 Assume each unit of product is identical; mass production

 Add all of the costs of production and divide by the number of units produced
- In practice, historic costs are often used to deduce full costs
 Process costing: Derive the full cost per unit of output when the overlap of production runs occurs across
periods (eg. “work-in-progress” products that are yet to be completed at the end of the period)
- Done if the units of output are exactly the same or very similar, or it is reasonable to treat them as
being similar
Multi-product operation
 Assuming the units of output are not identical, costs are separated into two categories:
- Direct costs: Costs that can be identified with specific cost units
o Effect of cost can be measured easily in respect of each particular unit of output
o Eg. Direct materials and direct labour
- Indirect costs (overheads): All costs except direct costs
o Cannot be directly measured in respect of each particular unit of output
o AKA common costs as they are common to all aspects of production
o Eg. Rent of premises and other infrastructure costs
 Job costing: Technique for identifying the full cost per unit of output, when the units of output differ
- Usually used for service companies, where they’ll provide unique goods for each customer
- Process ascribes all possible direct costs to the job (requires extensive record keeping)
- Then charge each unit of output with a “fair share” of indirect costs
 Absorption costing: Indirect costs are “absorbed” so full costing is also known as “absorption costing”
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Full absorption costing and the behaviour of costs
 Total cost = Sum of variable and fixed costs of pursuing some activity
 It is not correct to assume that variable costs and indirect costs are the same or that fixed costs and overheads
are the same
- Notion of fixed and variable costs is concerned with the behaviour of costs in the face of changing
volume of output
 Overhead absorption (recovery) rate: Rate at which overheads are charged to cost units
- Eg. Sharing the overhead costs equally between each cost unit produced in the period  Can only be
done if the cost units are almost identical in how they benefit from the overhead
 If overheads are not shared equally between each cost unit produced in the period, it is common practice to
use time, measured by direct labour hours, as the basis of allocation
- Direct labour hours: Number of hours of direct labour spent on a job or jobs
- Most overheads are related to time (eg. rent, light and depreciation)  Hence, will usually benefit from
the “service” rendered by the overheads
 No “correct” way to apportion (share) overheads to jobs, therefore the most acceptable method of
apportionment must be found and applied
Overhead application rate
 Predetermined overhead application rate: Based on relationship between estimated annual costs and
expected annual operating activity
- Established at beginning of year
- Single figure used to apply overhead costs to jobs
- Enables estimated costs of overheads to be determined at any given time
 EXAMPLE: Johnson Ltd has overheads of $60 000 each month. Each month 2,500 direct labour hours are
worked and charged to units of output. A particular job uses direct materials costing $238. Direct labour
worked on the job is 15 hours and the wage rate is $25 an hour. Overheads are charged to jobs on a direct
labour hour basis. What is the full cost of the job?
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How is full cost derived?
 Judgement is involved in selecting the appropriate basis for charging overheads

 Often based on what those affected feel is “fair” (ie. process vs. job costing)
 This can result in irrational approaches and outcomes
- Eg. Selecting a basis because it apportions either a higher or lower cost to a particular job will result in
higher or lower costs being allocated to other jobs
 Summary of how full costs are derived:

- Determine costs of direct labour and materials required
- Ascertain total overheads for the period
- Derive a suitable overhead absorption rate for the business as a whole
- Apply the overhead absorption rate (based on the specifics of the job (eg. direct labour hours)
SEGMENTING OVERHEADS
Segmenting the overheads
 The concept of segmenting overheads is to charge one part of the overheads on one basis and another part on
another basis
- Charging overheads to cost units on a department-by-department basis allows a fairer and more
accurate means of charging overheads
 Commonly done in practice by dividing a business into separate “areas” or “departments” for costing
purposes and charging overheads differently between areas (ie. shipping, storage, production)
 EXAMPLE: A business expects to incur overheads totally $20 000 next month. The total direct labour time
worked is expected to be 1,600 hours, and machines are expected to operate for a total of 1,000 hours. During
the month, the business expects to do just two large jobs, outlined as follows:
Job 1 Job 2
Direct labour hours 800 800
Machine hours 700 300
Determine how much overhead will be charged to each job if overheads are to be charged on a direct hour or
machine hour basis.
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Upon closer analysis, of the $20 000 overheads, $8 000 relate to machines and the rest is to more general
overheads. Calculate the overheads that can be charged to the jobs now.
- Rather than using only direct labour or machine hours to calculate the full cost for the job, we can
segment the overhead costs according to the different departments (ie. direct labour or machine)
Overheads charged on cost centre basis
 Cost centre: Each department is called a cost centre when the costs are dealt with departmentally
- Charging direct costs to jobs is simply a matter of keeping a record of:
o Number of hours of direct labour worked on the particular job
o Cost of direct materials
o Any other direct costs (eg. subcontracted work) involved with the job
 Businesses are divided into departments for the following

reasons:
- Size and complexity: It is more practical to run large
and complex businesses as a series of relatively
independent units
- Expertise: Each department normally has its own
specific activity and is managed by a specialist
- Accountability: Each department can have its own
accounting records to assess its performance and
encourage staff motivation
 Sum of the departmental overheads = Overheads for the entire business

 For purposes of cost assignment, need to distinguish between:
- Product cost centres: Jobs are worked on by direct workers and/or direct materials are added
- Service cost centres: No direct costs are involved (ie. renders a service to other cost centres)
 The process of dividing overheads between cost centres:
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- Cost allocation: Allocate indirect cost elements that are specific to particular cost centres
o Eg. Salaries of indirect workers whose activities are wholly within the cost centre
(eg. cost centre manager)
o Eg. Electricity, where it is separately metered for each cost centre
- Cost apportionment: Apportion the more general overheads to various cost centres
o Overheads may relate to more than one cost centre
o Apportion the total cost of service cost centres to product cost centres
o Costs will be apportioned based on the extent to which each cost centre benefits from the
overheads concerned
o Eg. Salaries of cleaning staff who work in a variety of cost centres
o Eg. Electricity, where it is not separately metered
Batch costing
 Batch costing: Technique for identifying full cost when the production of goods and services (particularly
goods) involves the production of “batches” or identical units of output
- However, each batch is distinctly different from other batches
 Done by taking into account direct and indirect costs associated with each batch
- Then divide the total by the number of production units produced in each batch
Forward-looking nature of full costing
 Full costs are often done in advance of production and hence have to be predicted
 Necessary to predict full costs in advance for:
- Output (product) pricing
- Assessing the viability of commencing production
- Quoting on potential work orders
- Comparison with actual production costs
ACTIVITY-BASED COSTING
Costing and pricing
 Traditional characteristics of industrial production:

- Direct labour-intensive and direct labour-paced production
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o Labour is at the heart of production and speed of production was dependent on labour
- A low level of overheads relative to direct costs
o Little effort to control cost of overheads because costs of controlling exceed benefits
- A relatively uncompetitive market  Customers accepted what supply was offered
 Changed characteristics of industrial production:

- Capital-intensive and machine-paced production
o Most labour supports the efforts of machines
- A high level of overheads relative to direct costs
o More efficient production methods tend to make overhead costs more dominant
- A highly competitive international market
o Production and service provision is carried out worldwide
ABC contrasted with the traditional approach
 Activity-based costing: A technique for more accurately relating overheads to specific production or provision
of a service. Based on the fact that overheads do not just occur.
- Traditional method: Regards overheads as rending a service to cost units
o Overheads are apportioned to product cost centres
- ABC: Overheads are caused by cost units which must be charged with the costs they incur
o Overheads are analysed into cost pools (ie. cost pools are linked to a particular activity)
 Cost drivers: Activities which cause costs (ie. overheads) to occur
- Eg. Holding products in stock
Attributing overheads using ABC
 An overhead cost pool is established for each activity

- There will be one cost pool for each separate cost driver
 All costs associated with the activity are placed in the relevant pool
- The total cost in the pool is charged to output by dividing the amount in the pool by the estimated
usage of the pool’s cost driver, to get the cost per unit of the cost driver
- Then, multiply the cost per unit of the cost driver used by a particular product
- Gives the amount of overhead costs to be attached to (or absorbed by) the activity
Benefits of ABC
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 More accurate cost for each unit of product or service

 Helps managers in assessing product profitability and in making decisions concerning pricing and the
appropriate product mix
 Helps managers gain a better understanding of the business, thus controlling overheads and improving
efficiency
 Helps managers in forward planning (eg. assess the likely effect of processes on activities and costs)
Criticisms of ABC
 More time-consuming and costly to identify cost drivers

 Benefits of ABC are unlikely to outweigh the costs in the short-term
 The actual data generated, like full costing, is historical and is not very relevant for decision-making
 ABC is possibly more relevant to service industries because overheads are likely to be a significant proportion
of total costs
USERS OF FULL COST INFORMATION
Uses of full (absorption) cost information
 Pricing and output decisions: Used for the basis of pricing

- Where full cost is deduced and a percentage is added on for profit
- AKA cost-plus pricing
 Exercising control: Basis of budgeting and comparing actual outcomes with budgets
- Enables action to be taken to exercise control
 Assessing relative efficiency: Basis of comparing relative efficiency in terms of the comparative cost of doing
similar things
- However, including all aspects of cost (as full costing does) can lead to incorrect decisions
- That is, need to identify relevant costs to a decision
 Assessing performance: Valid means of measuring a business’s income requires matching expenses with the
revenues realised in the same accounting period
- If inventory is partially made in one period but sold in the next, the full cost needs to be carried from
one accounting period to the next
Full cost (cost-plus) pricing
 Cost-plus pricing: Full cost is deduced and a percentage is added on for profit
 Prices at which businesses can sell their output will determine quantity made available to the market
- When a business charges the full cost of its output as a selling price, it breaks even
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- Charging something above full cost yields a profit

 In a competitive market for the product or service, it is often not possible to set prices on a cost-plus basis
- Businesses will usually have to accept the price that the market is prepared to pay
 Cost-plus pricing may be appropriate for price makers, but it has less relevance for price takers
- Cost-plus pricing implies that the seller sets the price that is then accepted by the customer
- However, for price takers, cost-plus pricing can be useful in evaluating whether or not it’s profitable to
enter a certain market
Criticisms of full costing
 Historical in nature and restricts consideration of future costs to outlay costs

 Can be argued that decisions can only be made about the future, not the past
 Overhead allocation is arbitrary (random) in nature
 Full costing can be misleading in that actual costs rarely, if ever, behave in line with calculated overhead
recovery rates used
WEEK 12: BUDGETING
PLANNING AND CONTROL
Corporate objectives
 Identify the broader goals of the business: Eg. Wealth enhancement

 Mission statement: A statement of broad intent
 Position statement: Where the business is currently placed relative to where it wants to be
 Vision statement: A vision of the future in broad terms
Exercising control
 Control is defined as compelling events to conform to plan

 Variances between actual expenditure and budgets should be highlighted by accounting information
- This can be followed by steps to get the business back on track towards achieving the budget
ROLE OF PROJECTED FINANCIAL STATEMENTS
Role of projected financial statements
 What are projected financial statements?

- Are valuable for developing long-term strategic plans
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- Help managers make informed decisions about the future of a business

- Indicate and assess future financial outcomes
- Identify future financial needs
 Projected financial statements may be prepared on the basis of:
- An optimistic or pessimistic view of likely future events
o Changing one entry/data cell in spreadsheet can quickly change between each of these outcomes
- A “most likely” view of future events
Information required for forecast statements
 Assumptions and estimated relating to the income statement:

- Sales: Estimates covering the whole range of products or services supplied will need to be made
o Sales forecast affects everything – how much labour and materials are required etc.
o If you get the sales forecasts (very) wrong, all budgets will be affected
 Hence, need to make allowances for getting the budget wrong
- Cost of sales and associated expenses: Care will need to be taken to differentiate fixed and variable
expenses
- Depreciation and related costs
- Appropriations of profit, including tax rates, dividends and transfers to reserves
 Assumptions and estimates relating to statement of financial position include:

- Non-current assets: Future acquisition and disposal of assets and depreciation policies
- Working capital: Accounts receivable and accounts payable
- Loans: Raised or repaid
- Capital: New capital raised (infrequently) and the amount of proportion of profits retained
 Assumptions and estimated relating to the statement of cash flows include:
- Profit - Taxation
- Acquisitions of non-current assets - Dividends
- Levels of working capital - Capital raise or redeemed
- Loans raised or repaid
- Depreciation adjustments and asset disposals
DEFINE A BUDGET
Long-term plans and budgets

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 Long-term (strategic) plan: Defines the general direction of the business over next five or so years
 Budget: Essentially a financial plan for the short term, usually 12 months (but different for every organisation)
- Expressed in financial terms
- Converts the long-term plan into an actionable blueprint for the future
- Budgets may also be done on a “rolling” monthly basis (ie. continually updated)
o Whilst rolling budgets give you better information, it’s very costly in terms of time
 Appropriate time horizon depends on business and industry (eg. five years in an IT business would be too long
due to rate of change)
Benefits of budgets
 Promote forward thinking and identification of short-term problems

 Motivate managers to improve performance
 Provide a basis for a system of control – ensures events conform to plans
 Provide a system of authorisation
 Help coordinate the various sections of the business
Limiting factors
 Aspects stopping a business from achieving its objectives to the maximum always exist
- Eg. Amount and specialisation of labour, materials or plant and equipment
- Eg. Projected sales are incorrect
 Limiting factors need to be identified early in the budgeting process when preparing the budget
Interrelationship of various budgets
 In a business, there are normally several budgets, each relating to a specific aspect of the business
 Ideally, there should be a separate budget for each person in a managerial position
 The contents of all individual budgets are summarised in a master budget
- Master budget typically consists of a statement of financial performance and position
o The statement of cash flows is usually considered to be a third master budget
- Bottom line of one budget (eg. sales forecast) is the starting point of the next budget
o Expected level of sales defined the overall level of activity for the business
o Other budgets will be drawn up in accordance with this
Budget-setting process
1. Establish who will take responsibility for the budget-setting process

2. Communicate budget guidelines to relevant managers
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3. Identify the key or limiting factor

4. Prepare the budget for the area of the limiting factor
5. Prepare draft budgets for all other areas
6. Review and coordinate the budgets
7. Prepare the master budgets
8. Communicate the budgets to all interested parties
9. Monitor performance relative to the budgets
 Budget committee: A group of managers formed to supervise and take responsibility for budget-setting
 Budget officer: An individual, often an accountant, appointed to carry out, or take immediate responsibility for
having carried out, the tasks of the budget committee
 Top-down: Senior management of each budget area originates the budget targets, perhaps discussing them
with lower levels of management
 Bottom-up: Great weight is given to the views of relatively junior staff, who often have good experiences and
detailed knowledge of what is going on in the business and its markets
- Budgets are driven by the views of staff such as sales representatives
- Increases motivation within the company – more likely to achieve objectives as you’ve set them
Incremental and zero-based budgeting
 Incremental budgeting: Uses what happened in the last year as the starting point for negotiating the budget
for the next year
- Referred to as discretionary budgets
- Budget holder is allocated a sum of money to be spent in the area of the activity concerned
- Typically used for activities where there is no clear relationship between inputs (resources required)
and outputs (benefits)
 Zero-based budgeting: Starts with the assumption that everything must be justified (ie. start from scratch)
- No reliance on needs from earlier periods
- Encourages managers to adopt a more questioning approach to their areas of responsibility
- Managers are forced to think carefully about particular activities and the ways in which they are
undertaken
- Tends to be “bottom-up” and is time-consuming
Non-financial measures in budgeting
 Non-financial performance indicators have a vital role in assessing performance

- Eg. Customer/supplier delivery times, set-up times, defect levels, customer satisfaction
 Can be used as a basis for targets
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 Can be incorporated into the budgeting process and reported alongside financial targets
IMPORTANCE OF CASH BUDGETING
 Cash budget is a key budget as all aspects of the business are eventually reflected in cash
 Cash budget reflects the whole business more than any other single budget
 Cash budget features:

- Budget period broken down into sub-periods, usually months
- In columnar form, one month per column
- Cash receipts and payments are identified under headings and a total for each month is shown
- The surplus or deficit of cash is identified for each month
- Running balance of cash is identified
 Other budgets are mostly prepared in the same format as the cash budget, such as:
- Accounts receivable and payable budgets
- Inventory budgets
USING BUDGETS FOR CONTROL
introduction
 Control is usually seen as making events conform to a plan

 Budgets represent the plan and provide the basis for exercising control over the business
 The planning and control process usually follows a sequence
 The most important budget target is to meet the profit target
 Draw a comparison between actual costs incurred and budgets costs for the level of production achieved
- Budget is prepared in sufficient detail to be able to both plan and control activities
- Figures for actual performance are compared with those budgeted, and differences (variances) are
examined and rectified
Necessary conditions for effective budgets
 A serious attitude to the system – from all levels of management

 Clear demarcation between areas of management responsibility
 Reasonable budget targets – rigorous yet achievable
 Established data collection, analysis and dissemination routines
 Reports aimed at individual managers (ie. not general-purpose)
 Fairly short reporting periods (eg. monthly)
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 Timely variance reports made available to managers

 Action is taken to get operations back under control if they are out of control
LIMITATIONS OF THE TRADITIONAL APPROACH TO CONTROL THROUGH BUDGETS AND STANDARDS
General limitations concerning budgeting systems
 Many areas of business and commercial activities do not have a direct link between inputs and outputs
 Standards can quickly become out of date due to technological and price changes
 Factors outside of a manager’s control can affect a variance for which he or she is accountable
 Defining a manager’s areas of responsibility may prove difficult in practice
Behavioural aspects of budgetary control
 Research indicates that:

- Existence of budgets tends to improve performance
- Demanding but achievable targets seem to motivate more than easy targets
- Unrealistic targets adversely affect performance
- Allowing managers to set their own targets improves motivation, commitment and performance
Beyond budgeting
 Modern research has suggested that budgets:

- Rarely focus on strategy and are often contradictory
- Are time-consuming and costly to put together
- Constrain responsiveness and flexibility
- Often deter change
- Add little value, especially given the time taken to prepare them
- Focus on cost reduction rather than value creation
- Strengthen vertical command and control
Replacing traditional budgeting
 Common principles for developing tools and techniques to replace traditional budgeting include:
- A governance framework based on clear priorities and boundaries
- A high performance climate based on visible and relative success at all levels
- Front-line teams with the freedom to take decisions in line with the company’s governance principles
and strategic coals
- Teams with responsibility for value-creating systems
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- Teams focused on customer outcomes

- Provision of open and ethical information
Overall review
 Budgeting is critical to the success of most businesses

 It has its limitations and its critics, so any budgetary control system must be set up carefully to ensure that:
- The environment in which the business operates is fully understood
- The business develops an appropriate culture
- The role of the budget in terms of the fit with the strategic plan is clearly understood
- A culture of value-adding is developed
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lOMoARcPSD|28458024

Accounting,Business and Society (University of Sydney)

Studocu is not sponsored or endorsed by any college or university

WEEK 1: INTRODUCTION TO ACCOUNTING

FINANCIAL AND MANAGEMENT ACCOUNTING

 Preparing general-purpose external reports that are looked at by share/stakeholders

Income statement Statement of financial position Statement of cash flows

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 Preparing specific-purpose reports, designed with a particular decision in mind

Fundamental qualities of accounting

 Relevance: Accounting information needs to be able to influence decisions of users

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Enhancing qualitative characteristics

TYPES OF BUSINESS ORGANISATIONS

 Individual is the sole owner of the business

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Changing face of business and accounting

 Customers are increasingly sophisticated and demanding due to changing technology

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WEEK 2: KEY ACCOUNTING CONCEPTS

THE ACCOUNTING EQUATION: ASSETS AND CLAIMS

 Account: Name that describes the classifications

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- Only the period for which the liability is outstanding is important

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o When you use an asset, you incur an expense

 Assets (debit) = Liabilities + Owner’s Equity (credit)

The trial balance

Closing off the accounts

Rules of debit and credit

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The recording process

 System of ledger accounts uses a system of pluses and minuses

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WEEK 3 AND 4: BUSINESS TRANSACTIONS

5 IMPORTANT PRINCIPLES OF MODERN ACCOUNTING

1. The Revenue Principle

2. The Expense Principle

3. The Matching Principle

4. The Cost Principle

5. The Objectivity Principle

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Business transactions and source documents

 Has a transaction occurred?

 A journal is a list, in chronological order, of all the transactions for a business

Notes regarding recording journal entries:

- Liabilities, equity and revenue  Debit - Expenses  Credit

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Asset Liability Owners’ equity

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Running balance (4 column ledger)

EXPLAIN THE IMPORTANCE OF A TRIAL BALANCE

Expanding the accounting equation

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- Drawings and expenses decrease owners’ equity

Locating trial balance errors

1. Are the additions correct?

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- Dr balance – Cr balance = Missing value

What are adjusting entries?

Types of adjusting entries

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 Revenues due and prepaid: