ACCT1501 ACCOUNTING & FINANCIAL MANAGEMENT 1A SEMESTER 1 2008 COURSE NOTES Last Revised: 13th August 2008. kaheiyeh. web. officelive. com Contents Page 3: The Nature of Accounting Page 5: The Balance Sheet & Transaction Analysis Page 8: The Income Statement & Transaction Analysis Page 13: Financial Reporting Principles Page 18: Adjustment to Accounting Entries Page 23: Completing the Accounting Cycle Page 26: Accounting for Cash Holdings & Receivables Page 30: Accounting for Inventory Page 37: Accounting for Non-Current Assets I Page 42: Accounting for Non-Current Assets II Page 45: Accounting for Liabilities 2~ Week 1 – The Nature of Accounting What is Accounting? Accounting is the main way in which organisations present the financial performance and financial position of that organisation. Essentially, it is a “language”. It is also used to convey economic information to the decision-makers (users). The Rise of Economic Consequences Economic consequences have a very acute relationship with accounting. Take, for example, the collapse of Enron in 2001. This was due to: ? Misleading accounting ?
Accounting scandals Accounting along took the business down and also the auditing firm and demonstrates this relationship. There is a focus on economic consequence in equity markets. This means that the decision maker is usually the investor/owner and they decide the value and the amount of shares they are willing the buy or sell. Users of Accounting Some users of accounting include: Management: To Monitor and Control Creditors: To decide lending amounts and terms Customers: To buy the product or not? This generally applies to large buyers, not the end consumer) Tax Office: To see the assessable income Regulators: To check for compliance with legislation and laws Analysts: To provide recommendations to potential and current shareholders Competitors: To gain insight into the business’s strategies Managers: To decide on performance incentives (Pay rises, bonuses etc. ) Employees: To check their work, pay and conditions Accounting is a dynamic field. It can adapt and is responsive to current events. Double Entry Book-Keeping Double Entry Book-Keeping states that for every transaction, there is a source and a resource.
That is: RESOURCES = SOURCES Which turns into: ASSETS = LIABILITIES + OWNER’S EQUITY This is known as the Accounting Equation and always balances. ? ? ? ? ? ? ? ? ? ~3~ Assumptions in Accounting There are a few assumptions in accounting: ? Reporting Entity The enterprise which is being reported should be the same entity (Either the legal entity or the economic entity or both) The Legal Entity is the enterprise itself, such as Woolworths Ltd. The Economic Entity is the consolidated business, such as Woolworths Ltd and all it’s subsidiaries. Monetary Assumption The universally accepted medium of exchange, such as cash, and in common denominators, such as the Australian Dollar, is assumed. ? Going Concern The report is prepared under the presumption that the business will continue to trade for the indefinite future. ? Period Assumption This assumes that reports are generated at set intervals (per month, year etc. ) ? Historical Cost This assumes that transactions are initially recorded at the price they were bought for. Cash Accounting and Accrual Accounting Cash Accounting is when the transaction is recorded when the actual cash is received.
Accrual Accounting records a transaction when it happens, not when the cash is received. ~4~ Week 2 – The Balance Sheet & Transaction Analysis The Statement of Financial Position The Statement of Financial Position (aka. The Balance Sheet), shows an organisation’s resources and claims on those resources at a particular point in time. The sheet shows an enterprises’ assets, liabilities and owner’s equity. Owner’s Equity can be described in different ways: ? A Company: Shareholder’s equity ? A Sole Trader: Proprietor’s equity ? A Partnership: Partners’ equity Most importantly, the
Balance Sheet shows the accounting equation: ASSETS = LIABILITIES + OWNER’S EQUITY The balance sheet is usually laid out in the following: ASSETS LIABILITIES OWNER’S EQUITY This emphasises the equality between Assets, Liabilities and Owner’s Equity. Or ASSETS LIABILITIES OWNER’S EQUITY Important elements on the Balance Sheet include: ? The entity ? The date at which the statement was prepared ? The currency and amount ? Assets, Liabilities and Owner’s Equity Australian Accounting Standards Board (AASB) Requirements The AASB101 requires that the following must be shown on the Balance Sheet: Assets ? ? ? ? ? Cash and cash equivalents Trade and other receivables Inventories Biological assets Investments Other financial assets ~5~ ? ? ? ? Tax assets Property, plant and equipment Investment property Intangible assets Liabilities ? ? ? ? Trade and other payables Interest-bearing liabilities Tax liabilities Provisions Owner’s Equity ? Contributed equity/Issued capital ? Reserves ? Retained profit ? Minority interest/Outside equity Assets An asset is defined by the AASB Framework as: “A resource controlled by the entity as a result of past events from which economic benefits are expected to flow to the entity. – AASB Framework Control of an asset is not necessarily limited to legal ownership of the asset. A past event is usually a transaction such as the purchase of an item or through production. Future economic benefit is the potential for the asset to generate profits/cash flows in the future. The asset does not actually need to generate a future economic benefit itself. As long as it helps in generating future economic benefit (such as buildings), it can be classed as an asset. An item must meet all three requirements to be classed as an asset.
It must also be noted that persons cannot be considered assets; as you do not control them. An asset should be recognised on the balance sheet if it is probable (more likely than not likely)that any future economic benefit associated with it will flow into the entity and that the asset has a cost or value that can be measured with reliability. The value of an asset can be measured through historical cost, it’s realisable value (current or market value) (how much you can sell it for now), its present value (value in use) (the amount it can generate), or the current cost (the amount you have to pay to replace it today).
Liabilities A liability is defined by the AASB Framework as: “A 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. ” – AASB Framework ~6~ A present obligation may be due in the near future (A present obligation is not a future commitment. Such as the planning of purchasing an asset in two years is NOT considered a liability) and the giving up of resources embodying future economic benefits is the payment of cash or the provision of services as obliged.
A liability should be recognised on the balance sheet with the same requirements as that of an asset, except with an outflow of cash and not an inflow. Equity Equity is defined as: “The residual interest in the assets of the entity after deducting all liabilities” That is: OWNER’S EQUITY = ASSETS – LIABILITIES Current vs. Non-Current An asset is considered current if it is: ? Expected to be realised within 12 months of the date ? Unrestricted cash or cash equivalent ? Held primarily to be traded ? Expected to be settled in normal business processes If it does not meet these criteria, it is considered a Non-Current Asset.
A liability is considered current if it is: ? Due to be settled in 12 months of the date ? No right to extend the settlement date past 12 months ? Held primarily to be traded If it does not meet these criteria, it is considered a Non-Current Liability. Transactions A Transaction is an impact on the company’s assets, liabilities and owner’s equity. The criteria for a transaction are: ? Exchange of economic value ? External to the entity ? Evidence of the exchange ? In dollars for quantification purposes Balance is always maintained in transactions.
There are always two or more things moving, hence, “Double entry accounting”. More on transactions is revealed in Week 3. ~7~ Week 3 – The Income Statement & Transaction Analysis Relating Performance and Wealth A company’s net assets (ie. Their Owner’s Equity) increases in wealth as the company’s wealth increases. The company is there to benefit shareholders but, does it benefit society? The community? The economy? The environment? Some do, some don’t. For us, we will focus on looking at the company’s benefit to its shareholders.
The Statement of Changes in Equity Changes to owner’s equity can be calculated in this way: Start of Year Balance Add Contributions (new share issues) Add Profit/Loss (Revenue – Expenses) Add Increases in Reserves Less Distributions (dividends) —————————————————-= End of Year Balance Owner’s equity can be increased by contributions by owners, share capital and profitable transactions and events. Owner’s equity can be decreased by distributions to owners, dividends and unprofitable transactions and events. Retained Profit is when a company earns profit.
That profit can be distributed amongst shareholders as dividends. NET PROFIT – DISTRIBUTIONS = RETAINED PROFITS It must be stressed that DIVIDENDS ARE NOT AN EXPENSE! The Statement of Financial Performance The Statement of Financial Performance (aka. The Income Statement) uses the accrual accounting principle and measures the financial performance of an enterprise over a period of time. Basically, it records the change in financial position of a business. Principally; it presents the difference between revenues and expenses. That is: PROFIT = REVENUES – EXPENSES Differences with the Balance Sheet: ?
The income statement covers a period of time and not a point in time. ~8~ ? ? Both can have extensive explanatory notes which are referred to throughout the statement. Different types of data are displayed such as detailed revenue, expenses, gross profit, net profit and net profit before tax. The Statement of Financial Performance must include: ? Revenue ? Finance costs ? Share of the profit or loss of associates and joint ventures accounted for using the equity method ? A single amount that combines the post tax profit (loss) of discontinued operations and the post tax gain (loss) on the disposal of the related assets ?
Tax expense ? Profit or loss The following may be shown on either the statement or the notes for it: ? Income or expenses items that are material ? Analysis of expenses ? Depreciation ? Amortisation ? Employee benefits ? Dividends to equity holders Elements of the Statement of Financial Performance Income Income increases with economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases in liabilities that result in increases in equity, other than those relating to contributions from equity participants (ie. Those from Owner’s Equity). Income can be further split into two categories: ?
Revenue Revenue arises in the course of ordinary activity of an entity. They include sales, fees, interest, dividends, royalties, rents etc. Revenue should be recognised if the good or service has been rendered (ie. The good or service has been delivered) It should be noted that revenue is any sort of inflow of economic benefits. Even if the activity produces a net loss of equity, the inflow of money is still labelled as revenue. ? Gains Gains are no different in nature from revenue, however, they may or may not arise in ordinary activities and are usually displayed separately in decision making.
Expenses Expenses are the opposite of revenues. They are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or liabilities that result in decreases in equity, other than those relating to distributions to equity participants. ~9~ Capitalising vs. Expensing Capitalising is when the transaction is seen as a deduction in cash but an increase in asset which evens it out with no net change. Expensing is when the transactions is seen as a deduction from cash and also a deduction in Owner’s Equity.
This can create issues if there are large amounts of money involved but not very much with small amounts. If a business continually classes the acquiring of an asset as capitalising (so that Owner’s Equity is not affected), the business may get into serious problems later on. Recall the definition of an asset from last week. If it does not meet those requirements, consider it under expensing. Cash vs. Accrual Profit An enterprise may post an accrual profit but not a cash profit if the cash has not been received after the day the statement was made.
This can cause discrepancies when analysing statements and transactions. In short, the accrual profit is not the same as the cash profit. The incurrence of an expense is not necessarily accompanied by an outflow of cash nor is the earning of revenue necessarily accompanied by an inflow of cash. When should something be recognised? Recognition should occur for revenue when a service has been performed and expenses when you expect to have incurred it. They should be given asymmetric treatment. Under accrual accounting, cash flows are not necessary to recognise revenue and expenses.
You do not need to know when cash will arrive, only when cash has been transacted. Expanding the Accounting Equation Consider the Accounting Equation ASSETS = LIABILITIES + OWNER’S EQUITY We know what comprises of assets and liabilities: CA + NCA = CL + NCL + OE But what comprises Owner’s Equity? Owner’s equity is comprised of: ? Contributions by owners ? Retained Earnings ? Profit (revenue and expenses) ? Distributions ~ 10 ~ Hence, Owner’s Equity can be described as: Capital Contributions (CC) + Retained Earnings (RE) + Opening Retained Earnings (Op. RE) + Revenue (R) – Expenses (E) – Distributions (D) = CC + Op.
RE + RE + R – E – D Therefore, the final equation is: CA + NCA = CL + NCL + CC + Op. RE + RE + R – E – D We see the Revenue and Expenses are part of the Income Statement and the whole equation is part of the Balance Sheet. This provides us with the link between the Balance Sheet and the Income Statement. Double Entry Accounting: Transactions This is an extension of transactions we briefly introduced in Week 2. We already know of one example of double entry accounting; that being: ASSETS = LIABILITIES + OWNER’S EQUITY However, there is another example: DEBITS = CREDITS ? Debits are abbreviated to “Dr” Credits are abbreviated to “Cr” To consider what credits and debits do to each part of the accounting equation, consult this table: Type of Account Assets Liabilities Share Capital Retained Profits Revenues Expenses Normal Debit Credit Credit Credit Credit Debit Increases result in Debit Credit Credit Credit Credit Debit Decreases result in Credit Debit Debit Debit Debit Credit *Note: The sections in italics are all part of Owner’s Equity, however different parts of Owner’s Equity have different effects on where to debit and credit.
The general rule of thumb is that Normal or Increases result in a Credit and a decrease results in a Debit; this is only different for Expenses. ~ 11 ~ Remember that in a transaction, there must always be two or more effects. One must be a credit activity and one must be a debit activity. They must also keep the accounting equation balanced. Journal Entries Journal Entries are small entries that document transactions with credits and debits. Remember that in every transactions, there has to be at least two effects; one credit, one debit.
An example of a Journal Entry is as follows: ________________________________________________________ Date Debit Account Credit Account Short Statement of transaction PR PR $xxx $xxx ________________________________________________________ *Where PR = Posting Reference. This is usually provided for you in the example, such as “A1” or “E3”. Also take note of the indents, this helps to differentiate debits from credits and show that they balance more easily than if they were accounted for in a straight column. ~ 12 ~ Week 4 – Financial Reporting Principles Note: The entire first section of this week (everything before the accounting cycle) is explained in the document, “Framework for the Preparation and Presentation of Financial Statements” (Published July 2004 by the AASB) and is available at this link: http://www. aasb. com. au/pronouncements/aasb_standards_2005. htm What is Financial Reporting? Financial reporting is used to provide information about a firm’s financial position, performance and cash flows to help the users of that information make good economic decisions. The full set of reports (as required by the AASB) includes: ?
The Balance Sheet ? The Income Statement ? The Cash Flow Statement (This uses cash accounting) ? The Statement of Changes in Equity (This is not discussed in ACCT1501. ) ? Notes to these accounts and also other relevant material. The notes to the accounts and reports are not required in a There is a demand for this information which stems from the need to make appropriate and reliable economic decisions for the firm. The people demanding this information want to know about the: ? Performance of the firm ? Financial position of the firm ? Financing and investing with the firm ?
Firm’s compliance with laws Framework Within the AASB’s framework, we will need to look at four areas: ? Underlying Assumptions ? Qualitative Characteristics ? The elements of the financial report ? Recognition Principles Underlying Assumptions The underlying assumptions are basically the same as those discussed in Week 1. For more details, look at the Week 1 notes. Listed here briefly are the assumptions: ? Accrual Basis This simply means that financial statements should be produced under accrual accounting methods (to record transactions when they occur, not when the cash is received) so that they can meet their objectives. Going Concern Financial reports should be prepared under the assumption that the business that it is reporting on will continue to operate and function for the foreseeable future. ~ 13 ~ This is so that the business has no assumed intention of liquidation or to scale back its operations. Qualitative Characteristics The accounting statements must fulfil a wide range of qualitative characteristics so that it can be understood by all. These are: ? Understandability The statements must be able to be understood by a wide variety of people including professional accountants to high school graduates.
The way in which the information is displayed is vital to this (i. e. Logical sequence). Relevant information that is complex should still be presented in statements, but less professional users should be advised to seek professional advice. ? Relevance (Materiality) The information presented on the statements must be relevant to the time period that it is describing. It must be based on current information so that proper predictions can be made. The relevance of information is usually classed by its materiality. Information may be relevant and reliable but it may be immaterial.
Including this on statements may do nothing but impair its understandability. If the item will not affect the user’s decisions (i. e. Transactions of small amounts), then it need not be included. Reliability There should be a faithful representation of transactions and events (i. e. No material bias or error. It should be objective). Prudence must be exercised in that assets or revenue or gains are not overstated and liabilities or expenses are not understated. There, however, may be a small level of bias allowed with small immaterial amounts such as those described above.
The information in financial reports must also be complete within the bounds of materiality and cost. An omission can cause information to be false or misleading and thus unreliable and deficient in terms of its relevance. “If information is to represent faithfully the transactions and other events that it purports to represent, it is necessary that they are accounted for and presented in accordance with their substance and economic reality and not merely their legal form. The substance of transactions or other events is not always consistent with that which is apparent from their legal or contrived form.
For example, an entity may dispose of an asset to another party in such a way that the documentation purports to pass legal ownership to that party; nevertheless, agreements may exist that ensure that the entity continues to enjoy the future economic benefits embodied in the asset. In such circumstances, the reporting of a sale would not represent faithfully the transaction entered into (if indeed there was a transaction). ” @ ? ~ 14 ~ ? Comparability The information that is generated by the firm must be able to be compared with those generated from other firms and to its own statements from earlier periods as well.
This means that the information should be presented in the standards as set by the AASB. The firm should state which policy that it has used, any changes to that policy and the effects of those changes. Reliability vs. Relevancy Information that may be relevant can also be unreliable in nature, or representing it would be useless and/or potentially misleading to the users. Such as a lawsuit against a company would be relevant to the users, but its cost cannot be measured reliably. Thus, these should be mentioned on the notes of the statements. Another issue with this is usually with historical cost of assets.
The asset is always relevant to the accounting statements but its measurement is not always reliable. The timeliness of the information also matters as the information will lose its relevance if there is a delay in reporting it. Information should always be relevant to when the statements were prepared and not for a period before. Cost vs. Benefits of Information The cost of providing the information to the user should never outweigh the benefits that can be derived from the information that is produced. There are some problems with this as evaluation of the information is largely by judgement.
Also, the costs are not necessarily borne by those who will reap the benefits of that information. In the end, there must always be a trade-off between the qualitative characteristics and this is often inevitable. Appropriate balance must be maintained among these characteristics so that it can meet the objective of financial reports. Financial reports should provide a fair and true view of the financial information of an entity. The appropriate application of and the balance of qualitative characteristics will usually lead to this result.
The Accounting Cycle The accounting cycle is a never-ending cycle of gathering economic information and presenting that to the users. The cycle is: 1. 2. 3. 4. 5. Transactions Identifying and measuring (Source Documents) Recording (Journal Entries) Classifying and summarising (Ledgers and Trial Balances) Reporting (The Financial Statements) ~ 15 ~ 1. Transactions First, recall the definition of a transaction: “A transaction is an economic event that affects a business and needs to be reflected in its financial statements” Characteristics of an external transaction include: ? Exchange of items of economic value ?
Past Event ? Involves a party that is external to the business ? Evidence ? Measureable in monetary units Internal transactions are adjustments made to records that introduce new data or alter that existing data. It is normally intended to enhance information. This includes things such as the use of office supplies and the depreciation of an asset. Transactions are a vital first step to the accounting cycle and so must not be left out. 2. Source Documents Source documents are those that provide evidence that a transaction has taken place. These include items such as cheque butts, invoices, bank statements etc. . Journal Entries From source documents, the transactions are transformed into more classified and ordered information that is presented in journal entries. However, the problem with journal entries is that they only show the balance at any one point in time. We need ledger accounts to show a change in balance over time (This is similar to how a balance sheet is to the income statement). Journal entries were discussed in Week 3; please see Week 3’s notes for more details. 4. Ledger Entries & Trial Entries A general ledger is a collection of all individual accounts for a business.
It shows a list of all accounts in assets, liabilities and owner’s equity for a firm but the basic ones are assets, liabilities, owner’s equity, revenue and expenses. These can be represented in Taccounts. As always, debits are placed on the left while credits are placed on the right. Accounts are used to classify transactions and store information for similar transactions. A chart of accounts is basically, a listing of all accounts in the general ledger. They are usually identified by a single number and are listed in the accounting manual. These are different for each firm and it does not matter how they list them.
Writing to a ledger can be in the same way as that of journal entries. Debts and Credits to each of the accounts still follow the same rules as those for journal entries (See Week 3 notes). Writing to the ledger is a very simple process of just transferring the information from journal entries directly to the ledger entry. ~ 16 ~ There are other accounting formats used which includes the narrative format. This method is used more widespread than the T-account because it also includes a column at the right to show the net balance of the account after each debit or credit. Otherwise, it is exactly the same as T-accounts.
Trial entries are listings of all accounts with their related balances at certain point in time. They are used to check the accuracy of ledgers and journals by seeing if the total debits equal the total credits. Although, even if all the debits equal the credits, it does not necessarily mean that it is correct. All it means is that there are no obvious errors in the documentation of journals and ledgers. Ways to recheck if the trial balance is not in the balance: ? Re-add the trial balance ? Check that the correct amounts are posted in the journal entries ? Check that each ledger is balanced correctly ?
Check that everything balances in the journal entries 5. Reporting Finally, this information is reported in the different forms such as the Balance Sheet, Income Statement etc. References @ Page 18-19, Framework for the Preparation and Presentation of Financial Statements – Published July 2004 – Australian Accounting Standards Board. ~ 17 ~ Week 5 – Adjustment to Accounting Entries During the course of accounting, a business encounters inaccuracies due to the lack of time that is available to make this accurate. A business with very accurate information would do more accounting than actually doing what the business is supposed to be doing!
However, once at the end of the financial period, this is where accuracy matters. Adjusting the accounting entries is what makes this correct in the end. As always, remember that the accrual accounting system is used, period assumption and going concern are also assumed. Revenue Recognition Revenue should only be recognised in the current period if it fits all four criteria: All or most of the good/service has been provided to the customer. Costs to generate the revenue have been incurred and measured. Revenue can be measured accurately. Cash or a promise to pay has been received. ? ? ? ?
To recognise a revenue means to include it on the Income Statement for that period. First, we must find out how much should be written down as revenue and when. Revenue is earned only when the goods and services related to the inflows of economic benefits or service potential have been provided. For example: If a magazine company receives money for yearly subscriptions, it cannot be classed as revenue until the magazines have physically been sent out to the customers. This can be divided up as staggered revenue for each individual magazine or as one entire subscription at the end of the year.
Expense Recognition Expenses should be recognised in the same period as when the revenue associated with it is recognised (i. e. The matching principal). By matching revenues to expenses, a better picture of the business is created. Recognising in this case is the same as revenue; it means it is included on the Income Statement for that period. Expenses are incurred for that period when there has been consumption or loss of economic benefit or service potential. Buying an asset is NOT considered an expense until it has been used up. i. e.
Whiteboard markers are not an expense until they have run out of ink or are lost. The same thing is done with things that are expensed over time, such as pre-paid insurance. The company should show that the item’s value is being used up each month instead of reporting on bigger loss at the end of the year. This shows a company’s financial position and performance much more accurately. ~ 18 ~ Adjusting The Entries The adjusting of entries is done at the end of the accounting period, which is assumed to be equal under the period assumption. There are four types of accounts that must be adjusted at the end of the period.
Accruals Revenues Expenses Accrued revenues (an asset) Accrued expenses (a liability) Deferrals Unearned revenues (a liability) Prepayments (an asset) Unearned revenue is cash received but the good or service has not been provisioned yet to the customer. It is also known as: ? Revenue received in advance ? Advances from customers ? Customer Deposits An example would be a customer buying a plane ticket for next month from your firm. This would be unearned revenue for you because you have yet to provision the plane journey for the customer. Prepayments are the like unearned revenues but from the payer’s perspective.
This is considered an asset because you have already paid for goods but they have not been received yet. It may be classified as a current or non-current asset depending on how long the benefits are perceived to last for. Continuing on from the last example, this would be from the customer’s view. He has paid for the service he wants but he is yet to receive that service from the firm. Note that these can be done in the reverse as well. Sometimes, prepayments are seen as an expense at first until the goods and services arrive, at which then they are not considered expenses anymore.
They can also split this into two parts: part prepayment and part expenses. Accrued Revenue is when the good or service has been provided but the cash will not be received until the next accounting period. Accrued Expenses are when expenses are incurred in one period but the outflow of cash associated with it is not paid until the following accounting period. (For example: The wages earned by an employee at the end of the last period. ) The accrual process here certainly does not imply that the receipt of cash and transactions are unimportant.
Cash is the life of a business and that is why it should never be regarded as insignificant. Often, transactions recorded under the accrual process are removed from the physical reality of cash flows. This means we are forced to make estimates and assumptions, however, it does make the accrual a weaker system. It is intended to yield us a better picture of the performance of the business, particularly in the short run. ~ 19 ~ Temporary Accounts These are temporary accounts and at the end of the accounting period, they must be set back to zero in preparation for the next accounting period.
After adjusting the entries and then closing them, we can then prepare the balance sheet and the income statement for that period. Temporary accounts are only related to the current period they are in and they include: Revenue, Expenses and Dividends. To set these accounts to zero, the credits must equal the debits. We make these equal by crediting or debiting the remaining about to the Profit & Loss Account. In this way, we can calculate the retained profit for that period. This has the nice effect of allowing us to both reset the temporary accounts and also provide us with the retained profit or the loss for that accounting period.
It must be emphasised that the remaining amount in the Profit & Loss account should always equal the balance in the Income Statement. Accounts should not be closed individually to the Profit & Loss account because it would consume too much time and resources. All revenue should be grouped together and similarly, all expenses should be grouped together, and only then, should these two accounts be closed. Post-Closing Now because revenues, expenses and dividends have been closed, all that remain should be the Balance Sheet items. If this is not true, then a mistake has been made in closing the temporary accounts.
This is a good way to check that the closing process has been completed correctly. Contra Accounts Contra accounts are accounts which are used to keep accruals from being mixed with the control accounts. They have the opposite balance of their respective control accounts that they are linked to (For example: DR$1000 in the control account and CR$1000 in the contra account). These accounts only have meaning when they are used in conjunction with the control account for which they are matched with. The two most common contra accounts are: ? Accumulated Depreciation (Control Account: Plant, Property & Equipment) ?
Allowance for Doubtful Debts (Control Account: Accounts Receivable) Summary In short, closing entries is the completion of the following: ? Closing the temporary accounts (Revenue, Expense & Dividends/Drawings) ? Completing the journal entries ? Posting to the ledger ? Preparing a post-closing trial balance. In the next period, all revenue and expense accounts should start with a zero balance. ~ 20 ~ 1. Recognising an expense or revenue at the same time as the cash flow Example Revenue: Dr Cash Cr Sales Revenue Although the expense to match this is usually put together, it is usually considered a recognition of expense after cash flow.
Example Expense: Dr Office Supplies Expense Cr Cash By recognising both the revenue and expense at the same time as the cash flows, these journal entries MUST include a movement in Cash. 2. Recognising an expense or revenue before cash flows These are usually purchases on credit. Example Revenue: Dr Accounts Receivable Cr Revenue This just shows that revenue has been recognised, probably due to a transaction, and that the cash for that transaction will be received at a later date. This is only done if the inflow of cash is guaranteed (not always as the owing party may go bankrupt; but a reasonably high probability cash will be received).
Example Expense: Dr Expense Cr Accounts Payable This is basically the same as the above, except from the other point of view. The firm now has a liability to pay this, probably because of a past transaction, and it has no right to not pay the amount owed from the transaction. Other examples of such expenses include: Tax Payable, Warranty Expense etc. 3. Collecting cash from previously recognised revenues and expenses Example Revenue: Dr Cash Cr Accounts Receivable Example Expense: Dr Accounts Payable Cr Cash Basically, these two are just the “cashing” of the payable/receivable accounts that occurred in Part 2 journals. 21 ~ 4. Cash flow before a recognition of a revenue or expense Example Revenue: Dr Cash Cr Unearned Revenue (Liability) Unearned revenue can also be identified as: “Revenue received in advance”. This usually occurs when a firm is paid by the consumer the amount for a certain good/service but that certain good/service has not yet been provisioned. Example Expense: Dr Prepayment (Asset) Cr Cash This is the same as the revenue example except from the consumer’s point of view. If the firm pays for something but does not actually receive it, then this applies.
The recognition of depreciation (with assets) is deferred until that period so that these expenses can be matched with the revenue that generated them. 5. Recognition of a revenue or expense after cash flow Example Revenue: Dr Accrued Revenue (Asset) Cr Revenue Example Expense: Dr Depreciation Expense Cr Accumulated Depreciation (Contra) Dr Insurance Expense Cr Prepaid Insurance These two are the recognition of an expense as explained for the recognition of an expense with a cash flow before.
As mentioned before, another example of an expense recognised after cash flow is: Dr COGS Cr Inventory Which is the expense that matches the revenue gained in: Dr Cash Cr Sales Revenue ~ 22 ~ Week 6 – Completing the Accounting Cycle The Worksheet The worksheet lists all the accounts vertically down the page starting with the: ? Current assets ? Non current assets ? Current liabilities ? Non-current liabilities ? Owner’s equity ? Revenue ? Expenses The worksheet is an optional, is a six-step process and is NOT a permanent accounting record (ie.
It is temporary; much like revenues and expenses are for that certain accounting period. ) Each worksheet has 10 columns (or 5 sets of 2 columns each). Each set must have a debit and a credit column: 1. 2. 3. 4. 5. Trial Balance Adjustments Adjusted Trial Balance Income Statement Balance Sheet After worksheet, all there is left to do is to transfer all information from the IS and Bs columns to their respective financial statements, in the correct format. The worksheet greatly simplifies the process of preparing financial statements.
Adjusting the Entries Adjusting entries are needed for: ? Recognising revenue You need to adjust your unearned revenue (a liability) and recording your accrued revenue (revenue that has been earned but not yet in the books that is an asset). ? Matching expenses Adjusting for prepayments (asset) for expenses and recording accrued expense (liability). Steps in creating the worksheet Step 1 – The Trial Balance From the general ledger, you get your “pre-adjustment” end of June balance. Step 2 – Adjustments Calculate your adjustments and input it into the worksheet.
Step 3 – Calculating your adjusted trial balance Step 4 – Closing Entries Step 5 – Putting your IS accounts in the worksheet. Step 6 – Putting your BS accounts in the worksheet. ~ 23 ~ Preparing the Financial Statements It is very important to classify your accounts properly such as “Cash at Bank”, not just “Asset”. Expenses can be classified into: ? Selling expenses ? Administration expense ? Financing expenses ? Other expenses Types of systems to create a worksheet are: ? Manual (Mostly for small businesses) ? Mechanical (For larger businesses as these are machine prepared ledgers/journals/worksheets etc. ) ?
Computerized Special Journals and General Journals Special Journals Group the most commonly used transactions into special journals such as: ? Sales journal For sales of items on credit ? Purchase journal For purchases on credit ? Cash receipts journal ? Cash payments journal The advantage of special journals is that the amounts are posted to the general ledger as totals rather than thousands on small individual journal entries. Therefore, more than one user can update accounting system and there is no need for narrations (ie. The small written component of a journal which states what has happened in the transaction).
These are used in conjunction with subsidiary ledgers. Had each person had their own account on the general ledger, it would be very long. Special ledgers are used to minimise the amount of things listed on the general ledger. Subsidiary Ledgers These are detail information about certain general ledger accounts and are recorded outside of the general ledger. General ledger accounts are supported by subsidiary ledgers: which are a set of ledger accounts that collectively represent a detailed analysis of one general ledger account. e. g. Debtors.
Relevant general ledger accounts are called as Control Accounts. The total of subsidiary ledger should equal the balance of relevant general ledger accounts (control account) after posting. Subsidiary ledger are used for a number of general ledger accounts: ~ 24 ~ ? ? ? ? ? Debtors/accounts receivable: separate account for each debtor. Creditors/accounts payable: separate account for each creditor. Property/plant/equipment: for each piece of property. Raw materials inventory: separate for each type of material Finished goods inventory: separate records of each type of finished goods held.
The Types of Special Ledgers Sales Journal This records the credit sales of inventory. The procedure is to: Enter date of sale, invoice number, customer name and amount from sale (These are usually from the source documents ie. Sales invoice). At the end of each day, post information to the related customer’s account (ie. For some company in the subsidiary ledger). At the end of each month, post the totals for the period to the general ledger. Check total of subsidiary ledger against the accounts receivable control account. Purchase Journal This records purchases of inventory on credit.
The procedure is to: Enter invoice date, supplier’s name, credit terms and amount of purchase (Usually from source documents), At the end of each day, information should be posted to the related supplier’s account in the subsidiary ledger. At the end of the month, post the totals to the general ledger. Check total of subsidiary ledger again the accounts payable control account. Cash Receipts Journal This records all cash inflows, including cash sales. It includes debit and credit columns. The procedure is to: Post amounts in accounts receivable column daily to the subsidiary ledger.
Post column totals to the general ledger at the end of the month. Cash Payments Journal This records all cash outflows, including cash purchase and disbursements. It includes debit and credit columns. The procedure is to: Post amounts in accounts payable column daily to the subsidiary ledger. Post column totals to the general ledger at the end of the month. General Journals are used for all other transactions including: ? Sales returns and purchase returns ? Credit transactions including other than those related to inventory such as the purchase or sale of equipment on credit ?
Adjusting and reversing entries ? Closing entries ? ? ? ? ? ? ? ? ? ? ? ? ~ 25 ~ Week 7 – Accounting Cash Holdings & Receivables Internal Control Key elements include: ? Efficiency in the environment ? An information system for cross checking records ? Policies and procedures for this ? Competent employees (That can easily pick up errors and problems) ? Clear responsibilities ? Division and rotation of duties Companies can go bankrupt and out of business all because of one employee. This is usually a result where there is no division and rotation of duties in keeping the accounting records.
This results in frauds that people will not pick up except for the employee who does the records. Remember that no internal control system is without its imperfections. Such as: collusion among employees, computer fraud and mistakes. Disclosure in Annual Reports ASX listed companies have a requirement to include a section on corporate governance. These often include a description of the internal control system. Petty Cash Fund A petty cash fund is set up to handle small cash expenditures, such as for miniscule amounts of $100. It is not feasible to write a cheque for such a small amount.
The fund is created by cashing a cheque from the company’s regular bank account. It contains a limited amount of funds (float) to cover payments for a short period of time. The company will always try to maintain the fund at a specified amount. Vouchers usually provide evidence for the amounts spent. Control of Cash Cash is one of the firm’s most vital asset and it also has the highest inherent risk. It is both liquid and anonymous. Physical controls and the separation of duties is usually very important. Different employees should be used to handle and record cash, and also to receive and pay cash.
This ensures that no one employee can directly commit, himself, fraud that can take down the business. Usually, two or more authorized people must sign a cheque for it to be able to be cashed at the bank. Always stamp documents so they are not paid twice. Cash should also be physically stored safely such as in safes. ~ 26 ~ Reconciliation The internal accounting records should be compared with external evidence. Ask the question: Do they agree with each other? Internal are cash journals, ledgers etc. External are statements from banks, suppliers, creditors, debtors etc. Reasons for the difference Information asymmetry ?
Events in the bank statement are usually not in our records. They would not show in our books (such as bank fees, DDs) Timing Issues ? Events in the CPJ and the CRJ are recorded, but not usually in the bank statement. ? Unpresented cheques and outstanding deposits. Errors made by the bank or yourself in the books. Bank Reconciliation Steps: 1. Check off the same items in your CPJ/CRJ and the bank account. 2. Items in the bank statement that have no been ticked represent new information that potentially affects the cash balance in our records (Information asymmetry). 3. Update the CPJ/CRJ to reflect this adjusted cash balance. . Items ticked in our records but not the bank are those that have timing issues. They represent differences between the adjusted cash balance and the balance as per the bank statement. Receivables These are also known as Accounts Receivables, debtors, trade debtors and trade receivables. These are made when an entity makes a sale on credit. We sell on credit because we can earn more revenue by selling to customers who wish to buy on credit. Ie. Satisfying a larger market. This benefit comes with costs such as: additional record keeping, the time value of money (PV/FV; Refer to QMA. ) and the risk of not being paid.
For each credit customer, the business can get (from the credit company), the customer’s name, address, credit status, credit limit, payment history and outstanding amount. There is always an expectation that some people will not pay; thus, the company is taking a credit risk. Such cases are where the customer goes bankrupt or refuses to pay. There must be the creation of an “allowance for doubtful debts”. This then becomes a matter of adjusting the journal entries to account for these bad debts. Two possible approaches to this are the direct write-off method and the allowance method. 27 ~ Direct Write-Off Method Debt is written off as bad when management has direct evidence to suggest that the debt in question is highly unlikely to be repaid or is significantly impaired. Debit the bad debts expense and credit the accounts receivable for the company in question to write off this bad debt. This method is rarely used because it doesn’t give a full picture of what accounts receivable are worth. It does not relate expense to revenue that has been earned (ie. The Matching Principle). We want the balance sheet to show net realisable value of accounts receivable.
This is not represented with the direct write-off method. It’s use may be justified if the amounts are not material (ie. Miniscule) and will not adversely affect decision makers. Allowance Method This method is to estimate the year’s bad debt expense. The problem here is that we are always unsure of what exact amount of debts are bad. Thus, we create an “allowance for bad debts”, which is done in a two stage process; by determining the allowance and writing off the bad debts against the allowance. Two methods to estimate the allowance for doubtful debts are: ?
Net credit sales method (IS Approach) This assumes a certain level of credit sales will cause a given level of bad debts. For example: from past experience, we can deduce that 2% of all credit sales will be bad. We can then use this information to set the allowance for doubtful debts. ? Ageing method (BS Approach) This assumes that the longer a debt has not been collected, the more likely it is that it will not be paid off. The longer the particular debt, the more allowance factor is given to that certain debt. Allowance factor is a percentage here, not a physical amount of cash.
In short, the longer the time the debt has not been paid, the higher the allowance factor for the debts. The aging method determines the desired balance for the Allowance of doubtful debts account. Contra Accounts Both these methods use contra accounts which is reported as a deduction from a related account. Ie. Allowance for doubtful debts is a contra account for accounts receivable. Similarly, Accumulated depreciation is a contra account for Property, Plant and Equipment. These accounts are generally found in the asset part of the BS with a credit/negative balance.
Collection of Bad Debts If a bad debt can suddenly be collected, then we must reinstate the receivable and record the collection of cash. We do this by debiting the accounts receivable, crediting the allowance for DD; then debit the cash and credit the accounts receivable. ~ 28 ~ Financial Ratios ? Accounts Receivable Turnover Ratio (Debtors Turnover) Credit Sales ——————-Trade Debtors ? Days in Debtors (Average Collection Period/Days sales in receivables) 365 ———————-Debtors Turnover ~ 29 ~ Week 8 – Accounting for Inventory
Inventories are assets that are held for sale in the normal course of the business. Types of Inventory Types of inventory include: ? Raw materials ? WIP ? Finished goods inventory ? Merchandise inventory (These are inventory that umnare purchased for the sole purpose of reselling. Such as what a retailer does. ) Usually one of the largest resources for retail and manufacturing firms. What is defined as inventory depends on what the business type is. Such as a car would be a long-term asset for most firms but would be inventory for a car retailer.
Measurement and disclosure of inventory Either the cost or NRV or the item; depending on which is less (Prudence principle). Disclosure of this is required under accounting policies. The total carrying amount of inventory is the price and the expense of it is found in COGS. The cost of inventory The cost of the purchase can be defined with: ? Purchase price ? Import duties and other taxes ? Inward transport and handling costs ONLY (Outward transport is defined as an expense) ? Any other costs associated with acquiring the item(s). Minus from this, any discounts and the likes. The cost of conversion can be defined with: ?
Cost of raw materials, labour and overhead The COGS for each unit of inventory may not be the same as the costs of raw materials, labour and overhead can change at anytime during the course of the business. Inventory Controls These include: ? Physical safeguards ? Inventory level ? Record-keeping as opposed to reporting. ~ 30 ~ Perpetual inventory system The inventory account is updated the same time as the transactions are made. These are: ? Purchases ? Sales ? Purchase returns ? Sales returns It provides better control but is much more costly than the periodic method as it requires entries each time inventory is updated.
It, however, makes it easier to account for losses. It determines exactly how many items that SHOULD be on hand at any time. In relation to ledgers, there is a Total inventory control account in the general ledger and subsidiary accounts for individual inventory items. There is always a COGS expense account. Periodic inventory system Inventory is only updated at the end of the financial period and is determined by an inventory count (ie. Stocktake). COGS has to be derived here instead of being calculated automatically in the perpetual system.
It lacks the parallel record keeping that is found in the perpetual system and what COGS is must be deduced. However, this is a much cheaper method to maintain inventory than by using the perpetual method. The choice of inventory system The choice of which inventory system to adopt depends on many factors. These include: ? The type of inventory ? The sophistication of the information system used to keep such records of inventory. ? Management objectives ? Cost Purchase returns and allowances are not a separate account under the perpetual system as it affects the inventory account.
However, contra purchases account under periodic system. In such a case: Perpetual Dr Accounts Payable Cr Inventory Periodic Dr Accounts Payable Cr Purchase returns and allowances (Contra) To pay Accounts Payable: ~ 31 ~ Under both perpetual and periodic systems Dr Accounts Payable Cr Cash Cr Discount Received For sales on credit: Perpetual Dr Accounts Receivable Cr Sales Dr COGS Cr Inventory Periodic (As this system does not account for COGS) Dr Accounts Receivable Cr Sales Sales returns and allowances This is when the customer returns goods because they are either incorrect or faulty.
The customer would receive a reduction in price of the good or a refund. The journal entry to record this would be: Perpetual Dr Sales returns and allowances (Contra) Cr Accounts Receivable Dr Inventory Cr COGS Periodic Dr Sales returns and allowances (Contra) Cr Accounts Receivable Presenting in the Income Statement In the perpetual system: Sales revenue Less: Sales returns and allowances Net sales revenue Less: COGS Gross profit The COGS account must be closed to the profit and loss summary account. In the periodic system: Opening inventory + Purchases + (Freight costs) – (Returns) = Cost of goods available for sale – Closing inventory 32 ~ Some complications with the periodic system of generating COGS include: ? Costs involved with inward freight charges. ? Purchases that are returned are not available for sale. So for the periodic system: Sales revenue Less: sales returns and allowances Net sales revenue COGS: Cost of Opening inventory Add: Cost of purchases Less: Purchase return Cost of goods available for sale Less: Cost of ending inventory COGS Gross Profit Closing entries for COGS under the periodic system are: Dr P&L Summary Cr Inventory Dr P&L Summary Cr Purchases $opening balance purchases for the period Dr Inventory $count(closing balance) Cr P&L Summary Cost flow assumptions We assume, often, that inventory purchases are made at various times during the year where the price of these items may vary. So when inventory is stored for later use or sale, items with different costs can be mixed together. This creates complications in accounting for the closing inventory balance and COGS associated with it. Physical Flow Method You would have probably sold the most recent inventory as those were the last to be put into storage.
Cost Flow Method Some assumptions: ? First-in, first-out (FIFO) ? Last-in, first-out (LIFO) ? Weighted average (periodic system) ? Moving weighted average (perpetual system) ? Specific identification ~ 33 ~ FIFO Here, we assume that the first goods purchased are the first goods to be sold. Therefore, the ending inventory is assumed to consist of the latest inventory units. This results in a higher profit level during times of inflation. It is a suitable assumption for perishable items or items that are subject to becoming obsolete.
LIFO This assumes that the last goods purchased are the first goods to be sold. Therefore, the ending inventory is assumed to be the earliest acquired units. This results in a lower profit during times of inflation. It results in a higher reported COGS and lower inventory balance than other methods in times in inflation. This does not necessarily match the physical flow of inventory. This also results in an outdated inventory balance. This is NOT permitted under the AASB, however, it is popular in the US where it can help to minimize loss of cash to tax.
Weighted average and moving average The weighted average (Periodic) Total cost of goods available for sale for a period Unit cost = ———————————————————————Total number of units available for sale for a period The moving weighted average (Perpetual) Recalculate the average cost after every purchase of inventory. This is simple to apply and less subject to profit manipulation that FIFO or LIFO. *Note: Remember that FIFO and LIFO are cost flow assumptions that do not necessarily represent the true physical flow of inventory through the firm.
Comparison of the two methods In periods of inflation: ? ? ? FIFO results in the highest ending inventory, highest gross profit, highest net profit and the lowest COGS. LIFO results in the lowest ending inventory, lowest gross profit, lowest net profit and the highest COGS. Weighted average results fall between FIFO and LIFO. Inventory Measurement as required by AASB102 ? ? The lower of cost or net realisable value (It should be written down as in accordance with the prudence principle). Cost of purchase for the retailer as mentioned above. 34 ~ Why would NRV Coupon Rate; Discount ? Market Rate < Coupon Rate; Premium ? Market Rate = Coupon Rate; Par To account for debentures, we need to consider many factors. Debentures issued at Par The journal entry to record the issue of debentures is: Dr Cash Cr Debentures To record semi-annual interest expense: Dr Interest Expense Cr Interest Payable Debentures issued at Discount The journal entry to record the issue of a debenture is: Dr Cash Dr Discount on Debenture (Contra) Cr Debenture ~ 47 ~
The journal entry required at the end of the year is: Dr Interest Expense Cr Interest Payable Cr Discount on Debenture (Contra) To record coupon payments: Dr Interest Payable Cr Cash Debentures issued at Premium The journal entry to record the issue of a debenture is: Dr Cash Cr Debenture Premium (Contra) Cr Debenture The journal entry required at the end of the year is: Dr Interest Expense Dr Debenture Premium Cr Interest Payable (Contra) To record coupon payments: Dr Interest Payable Cr Cash *Interest Payable can be replaced with Coupon Payable.
Financial Statement Analysis Liquidity Ratios These ratios measure the ability of the entity to meet its current obligations. ? Working Capital Working Capital = Current Assets – Current Liabilities ? Current Ratio Current Ratio = Current Assets/Current Liabilities Quick Ratio Quick Ratio = (Cash + Market Securities + Net Accounts Receivable)/Current Liabilities ? ~ 48 ~ Financial Structure and Solvency Ratios These measure the ability of the entity to meet its obligations in the long term. ? Debt to Equity Ratio Total Liabilities / Total Owner’s Equity Debt to Total Assets Ratio Total Liabilities / Total Assets ? ~ 49 ~