ACCT1501 Notes Chapter 1 Introduction to Financial Accounting Cheryl Mew The basic purpose of financial accounting is to produce useful

l info which is use d in many and varied ways. People use the info generated by financial accounting to improve their decision-making in allocating scarce resources. 1.2 Financial Accounting Accounting is a process of identifying, measuring and c ommunicating economic information to allow informed decisions by the users of th at information. Financial Accounting periodic financial statements to external d ecision makers (investors, creditors) Financial accounting measures performance and position Management accounting information for planning and performance repo rts (internal decision makers) Financial performance generating new resources fr om day-to-day operations over a period of time Financial position the enterprises set of financial resources and obligations at a point in time Financial Stateme nts reports describing financial performance and position Notes part of the stat ements, adding explanations to numbers

1.3 The Social Setting of Financial Accounting Financial accounting: o Helps sto ck market investors buy/sell/hold o Helps banks and lenders lend? o Helps manger s run enterprises (in addition to help from management acct) o Provides basic fi nancial records for day-to-day mgmt, control, insurance and fraud prevention o U sed by govt in monitoring actions of enterprises and in taxes, e.g. GST Accounti ng is not a passive force within the social setting it tells us what is going on , and in doing so, affects decision making

1.4 The People Involved in Financial Accounting sers, information preparers, auditors

Main Participants: Information u

ACCT1501 Notes Users Cheryl Mew User is someone who makes decisions on his own behalf, or on behalf of an org Us ers main demand is for the credible periodic reporting of an enterprises financial position and performance Main groups of users: Owners, Potential Owners, Credit ors and potential creditors, Managers, Employees, Regulators/govt, Financial and market analysts, Competitors, Accounting researchers, customers, miscellaneous third parties Preparers (Decision Facilitators) Accountants Main groups: Managers, Bookkeepers and clerks,

Auditors (Credibility Enhancers) Auditors report on the credibility of the enter prises financial statements, on behalf of owners and others. Assists users by ver ifying financial statements have been prepared fairly Internal and external audi tors Role is to scrutinise the preparation process External auditors are appoint ed by the owners not allowed to be owner or manager, ensuring that auditor is in dependent from companys objectivity Accounting firms offer external auditing, adv ice on income tax, accounting, comp systems and many other financial and busines s topics 1.5 Accrual Accounting Accrual accounting system, impact of transactions is reco gnised in the time period the transactions and expenses occur, rather than when the cash is received or paid Revenue sales of goods or services Expenses the cos ts of services or resources in the process of generating revenues

Accrual Accounting versus Cash Accounting Cash accounting records revenues and e xpenses when the cash is received or paid. Problem: timing of cash flow is in a different accounting period to the substance of transaction affected by interest rates, exchange rates, depreciation Using Accrual Accounting to prepare financial statements Include all the cash re ceipts and payments that have already happened; for example, cash sale, cash pay ment for wages Incorporate future cash receipts and payments that should be expe cted, based on existing transactions

ACCT1501 Notes Measure the value of incomplete transactions (amount of remaining loans can be r ecorded as an expense) Estimate figures when exact amounts are unknown (interest on loans) Make an economically meaningful overall assessment of awkward problem s Cheryl Mew 1.6 The Key Financial Statements Balance Sheet shows an organisations resources a nd claims on resources at a particular point in time. Income Statement measures financial performance over a defined period Cash Flow Statement shows the source s and uses of cash during the period Retained Profits Note

Balance Sheet Assets future economic benefits as a result of past transac r other past events needs to be measured in monetary terms Assets cash, accounts receivable, inventory, property Liabilities future sacrifices of economic benef its that an organisation is presently obliged to make to other organisations as a result of past events Liabilities goods on credit, bank loans, mortgages, long service leave, warranty Liabilities accounts payable, wages payable, provision for employee entitlements, long term loans Shareholders Equity excess of assets o ver liabilities share capital and retained profits Shared capital amount that ow ners have directly invested into the company Retained profits total cumulative a mounts of profits that the company has retained in the business rather than dist ributed as dividends Assets = Liabilities + Owners Equity Income Statement Provides info on an organisations profitability for a period of time Previously called the profit and loss statement Gross profit = Sales revenu e cost of goods Income statement Sales revenue, Costs of goods sold, Gross profi t, Operating expense, profit before tax, profit after tax Statement of cash flows Shows the changes of cash during the period in one balan ce sheet accounting Shows receipts and payments of cash Revenues reported usuall y do not equal cash collected and expenses do not equal cash paid, net profit is different from the change in cash for the period Individual transactions split into: o operating activities (G&S),

ACCT1501 Notes o o investing activities (NCA/capital), financing activities (equity and certain borrowings) Cheryl Mew 1.7 Relationships between the financial statements The cash flow statement expla ins the change in cash in the balance sheet. Net profit appears in income statem ent, also reflected in retained profits note. 1.8 Information use scenarios Evaluation of CEOs performance by member of board o f directors Preparation of buy/sell/hold shares recommendations by financial ana lyst Review of companys borrow status by bank lending officer Development of supp ly contract with the company by a stationery suppliers sales manager. Demands on the quality of financial accounting information Relevance useful, val uable, and timely manner Reliability objective, undue error, not deliberately mi sleading Materiality assessing whether omissions, misstatement of disclosure of info can affect decisions. Judged by size of error compared to net profit, total assets. Time. GAAP (general accepted accounting principles) to assure accepted methods are followed, auditors opinion is that the statement have been prepared i n accordance with the GAAP, and that the resulting figures are appropriate to it s circumstances. Prudence controversial criterion that A, R, P should not be ove rstated and L, E, Losses, should not be understated if there is uncertainty. Cau tiousness Disclosure make clear to reader which acct methods was followed, provi de supplementary info on debts, share capital, commitments and other necessities in understanding statements Understandability reports should be prepared to reg ard to interests of users, and making sure they have the ability to comprehend a nd contempt. Accounting practices Comparability financial statements should be p repared in a comparable way so companies can determine their performance, as abs olute sense is ambiguous Consistency Keeping same accounting methods Following G AAP, changes in method will be recorded, or record significant events that might have affected the trend.

ACCT1501 Notes AASB (Australian Accounting Standards Board) Framework Understandability Relevan ce - Materiality Reliability - Faithful representation (represents what really e xisted/happened) - Substance over form (substance and economic reality) - Neutra lity (objectivity, freedom from bias) - Prudence (caution in estimates) - Comple teness (material info not omitted, not misleading) Comparability Cheryl Mew

Tradeoffs among accounting principles Prudence is a bias, interfering with neutr ality and reliability New AASB to conform with GAAP will mean lack of comparabil ity with other companies that didnt previously use this standard For the sake of comparability, if other companies change acct methods, a comp has to decide whet her to change or not reliability or costs, time, relevance

1.9 Financial Statement Assumptions Accrual basis accrual accounting Going conc rn organisation will continue operations as a going concern in the foreseeable f uture Accounting equity separate and distinguishable from owners personal equity Accounting period discrete equal periods annual or half yearly or quarterly Mone tary Measured in common denominator AUD Historical Cost

ACCT1501 Notes Chapter 2 Measuring and Evaluating Financial Position and Performance Cheryl Mew 2.1 Introduction to the Balance Sheet Contains 2 lists that have the same dollar total Describe enterprises financial position at a particular date List 1: resou rces/assets List 2: Liabilities (existing obligations to be paid in future), Sha reholders equity (amounts received from owners, involve permanent financing but d o not have to be repaid, and any past accrual profits) Assets = Liabilities + Ow ners Equity Must have Company Name and Balance Sheet as at DATE 2 styles side by s ide: vertical: Assets: Useful Financial Resources Liabilities: Obligations to be paid Equity: O wners Investment Assets: Useful Financial Resources Liabilities: Obligations to be paid Equity: Owners Investment 2.2 Explanations of the three Balance Sheet Categories: Assets, Liabilities and Equity Assets Assets are resources controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. Thre e essential characteristics future economic benefits, control by the entity, occ urrence of past transactions of past events Future economic benefits as assets a re used to provide G&S for exchange, aiming to generate net cash flows Control b y entity relates to whether an entity can benefit from asset, and to deny or reg ulate access of others public good

Cheryl Mew Occurrence of past transactions or other past events means that the t ransaction giving the entity control over benefits must have occurred Other asse ts may include happy employees or safe working environment However they do not c ount into balance sheet - Cannot verify dollar cost - Difficult to measure relia bility how much more productive? - Enterprise does not own employees dont have ec onomic control Expenditure on market research not an asset impossible to calcula te future benefits at date of expenditure. Current assets sold / used / collecte d within 1 year. ACCT1501 Notes Liabilities Liabilities are present obligations of the entity arising from past events, the settlements of which are expected to result in an outflow from the e ntity of resources embodying economic benefits. Two essential characteristics A present obligation exists and involves settlement in the future via the sacrific e of future economic benefits. - Legally enforceable contracts money borrowed, c redit - Imposed on entity e.g. tax payable, or damages awarded by courts - Norma l business transactions to maintain a good e.g. warranty Adverse financial conse quences for the entity, in that the entity is obliged to sacrifice economic bene fits to one or more entries Requirement of obligation means that liability occur s if enterprise has already received a benefit, e.g. received cash from bank

Equity Equity is the owners interest in the enterprise. Can be direct contributi ns from shareholders/owners Can be derived from profit that are not collected e. g. dividends that have not been distributed Assets represent pool of resources p rovided by all sources regardless of whether it is provided by owners or not. Bo ok value of enterprise = residual or net concept of equity Book value is arithme tically valid idea, but does not tell very much. Impractical when companies go o ut of business, because equity (money returned to owners) will not simply be cal culated by the difference between A and L. Shareholders equity is generally based on historical transactions, and does not, except by coincidence, equal the curr ent market value of business. Retained profits or retained earnings represent pa st accrual profit not yet given to owners.

ACCT1501 Notes Earning profit means more assets (e.g. cash) or fewer liabilities, so profit is a source of assets Cheryl Mew 2.3 Some preliminary analysis of the sound and light balance sheet Soundly finan ced? - Assets come from liabilities look at where assets come from - Debt to equ ity ratio L/E Pay bills on time? - Able to turn current assets to cash - Look at current liabilities and cash - Current assets current liabilities = ___ in work ing capital - Working capital / current ratio CA/CL Companys ability to sell inve ntory to pay for bills - Quick ratio/ Acid test ratio Cash + AR / CL - If less t han 1, then that means company has to sell inventory to get pay L All ratios are only indicators Should owners declare for dividend? - By taking out dividend, d ecreasing retained profits, they decrease cash. - This can create cash strain Most retained earnings are reinvested in land, equipment, inventories, so less c ash Equipment / Depreciation: - In calculating profit, accumulated depreciation counts as an expense - Net book value of equipment = cost of equipment accumulat ed depreciation - Accumulated depreciation is a negative asset

2.4 A closer look at the balance sheet Comparative balance sheets: - Contains fi gures for 2 periods, to help users recognise changes. - Recent on the left, clos er to words Remember to look for notes when studying financial statements Buildi ngs (net) means the accumulated depreciation has been deducted Prepayments are p repaid expenses that have been paid for, for which the benefits have not been re ceived. Intangible assets noncurrent assets that have no physical substance copy rights, patents, trademarks, brand names and good will. Accrued expenses relate to expenses that have been incurred during the year, but not yet paid wages, ele ctricity bills Employee entitlements can be current or non-current

ACCT1501 Notes Where do the figures come from? Accounting is generally a historical measurement system Assets are generally valued at what they cost when they were acquired Li abilities are generally valued at what was promised when the obligation arose Cheryl Mew Other terms/notes Usually, accrued expenses and accounts payable is joint into p ayables account, but will be separated in the notes Sometimes use different term s payables liabilities (no interest) and interestbearing liabilities (such as lo ans, which incur interest) Current tax liabilities estimate of the amount of inc ome tax to be paid in next financial year Deferred tax liabilities - current pro fit > profit reported on tax return, liability for income tax is implied for lat er - current profit < profit reported on tax return, deferred tax asset govt has to pay tax paid back Derivative financial instruments used to reduce exposure t o foreign exchange and interest rate risks

2.5 Maintaining the accounting equation Assets = Liabilities + Owners Equity Doub le entry system where accounting equation is always in balance 2.6 Managers and the Balance Sheet Balance sheets are important, because outside rs read it. Balance sheet reports what the organisations position is at a point i n time. Shows assets that management has chosen to acquire Provides useful pictu re of the state of organisation Balance sheet does not state how management has performed in using assets to earn profit 2.7 The Income Statement Might measure companys fin performance by closing it dow n, selling it, paying off liabilities and see whether money left was more than m oney owners put in

ACCT1501 Notes But this is too drastic just to find out performances. Income statement uses acc rual accounting to measure financial performance over a period of time, usually a year, 6 months, 3 months. Net profit for the period = Revenues Expenses Cheryl Mew Revenues Increase in companys wealth arising from the provision of G/S Wealth inc reases due to increase in cash, promise for cash or pay with other forms of weal th, such as providing other assets, or forgiving debts Interests and dividends T est for revenue whether the good or services have been rendered (provided) Expenses Expenses are the opposite of revenues Decreases in companys wealth incur red in order to earn revenue Wealth decreases due to costs of G/S, giving assets to customers, and wear and tear of long term assets 2 cases when goods are sold enterprise is better off because of revenue gained and enterprise is worse off because of cost of goods and services customer takes away Start with asset accou nt of inventory of unsold goods, transferred to expense account of cost of goods sold Whether the firm makes profit depends on whether R > E. Separate account o f Expenses with Revenue

Profit Net profit = net inflow of wealth to the company during the period If net profit is negative = net outflow of wealth = loss Expenses include costs of ear ning revenue taxes (not including dividends), depreciation... The relationship of profit for the period to retained profits Retained profits i s the sum of past net profits since the firm began, minus dividends declared (ev en if not yet paid) Through retained profits, balance sheet can be said to refle ct everything that happened from the beginning a historical information system T ransactions with owners are taken out of RP, not an expense Owners can be credit ors too, if they are owed dividends, or if they lent the company money in additi on to shares they bought

ACCT1501 Notes 2.8 Connecting Balance Sheets and Income Statements Cheryl Mew = CL + NCL

CA + NCA

2.9 A close look at the income statement Income statement covers period in time not point in time Subsidiary is considered a controlled entity when parent compa ny has the capacity to dominate decision-making Consolidation basically involves totalling revenues and expenses of parent entity and all the subsidiaries after eliminating any transactions between these entities When calculating retained p rofits, use profit AFTER tax. 2.10 Capital Markets, Managers and Performance Evaluation Importance placed on ttom line profit figure and components The Australian or the Australian Financial Review show announcements of companys annual or half yearly profits. Emphasis on profit never any data on non-financial performance, LT issues, or managerial ef forts Announcement show sales, profits before and after tax (net), earnings per share (EPS), interim and financial dividends per share data (ff, p), present sha re price Per share data used by investors e.g. own n shares, so earn 0.355n $ Sh are market prices and profit announcements tend to end up moving in the same dir ection, so they are correlated Managers should be conversant about how his or he r performance is measured in the income statement 2.11 Capital Markets, tions are required to vt department Also an tatement) Accumulated s Reserves Managers and Performance Evaluation Public sector organisa provide balance sheets that discloses the A,L, E of the go income statement (before June 2001, was called operating s surplus or deficit = retained profits for private companie

Income Statement Emphasis on cost of services Operating revenue is separate and deducted from operating expenses After net cost of services are included, other revenues are included Liabilities such as super is included in employee entitlem ents in addition to salaries

Cheryl Mew When govt takes over liability, providing an appropriation, therefore recorded as revenue The income statement enables users to identify: - cost of s ervices provided by the department during the year - extent to which costs were covered by revenue - source of revenue - changes in resources controlled during the period as a result of operations ACCT1501 Notes

Chapter 2 Appendix Background: Sole Traders, Partnerships, Companies and Financi ng A2.1 Four Kinds of Business Organisation Two general kinds of equity: - Directly contributed equity owners provide money or other assets to enterprise - Indirec tly contributed equity owners allowed profits to remain, to help earn more profi ts in the future... Types of owners depends on what type of business organisatio n

Sole Trader One owner (the proprietor) Unincorporated does not legally exist sep arately from owner Cannot distinguish between the owners direct contributions to the business and the indirect contributions by retained profits both lumped toge ther as owners capital Balance sheet: Owners equity Owners capital $XXXX

Partnership More than one owners Unincorporated Not separate legal entities, and all partners are all personally responsible for debts of partnership Since owne rs personal assets can be claimed by business creditors, there is somewhat arbitr ary distinction between business and personal affairs Similar to sole trader, lu mped together as owners capital

ACCT1501 Notes As with sole traders, partnerships are not legal entities, but are considered se parate entity from partners Balance sheet: Owners equity Partners capital: Partner A $XXXX Partner B $XXXX Partner C $XXXX Total Capital $XXXX Cheryl Mew Company Legal entities under corporations law Capital is divided into shares ers = shareholders Separate legal entities can buy, sell, own assets, enter cont racts and sue and be sued Limited liability in the event of failure shareholders are not liable for debts once shares have been paid for in full Ease of transfe r of ownership and increased borrowing powers Shares can be sold freely, and tra nsfer of ownership does not affect continuity of operations Companies may issue debentures or unsecured notes. Debenture document that evidences an undertaking by comp to repay particular amount at or before an agreed date, and to pay inter est at an agreed rate a specific intervals Debt may be secured over floating cha rge or all assets, or specific charge over certain assets Public company can inv ite public to subscribe to their share capital by prospectus (listed ones are on ASX) Private companies (Pty Ltd) cannot invite public and has a limit on number of shareholders (50) and other restrictions and transferability of shares.

Company: Forms of Share Capital When shares are first issued, money received com es in as shared capital Second time sold, money is not received by company but s hareholder Therefore, the millions of transactions on ASX that occur do not affe ct companys financial statement Several classes of shares: Ordinary shares owners votes basically residual owners, deciding who will be on the board of directors and managers Preference shares or otherwise special shares owners usually do no t vote, but in return they have rights, such as receiving fixed dividend, or pre ference in asset distribution if company liquidates Class A, Class B and other c ategorisations vague terms, because complexity of rights often prevents simple c ategorisation such as ordinary or preference

ACCT1501 Notes Face of balance sheet or notes will list all kinds of shares, and specify rights Cash received is property of company owners have no right to get money back, ex cept in specific circumstances Cheryl Mew Company: Retained profits Profits can be paid to owners in the form of dividend or retained within company. Balance sheet: Shareholders equity $ Share capital: C lass A Shares XXXX Class B Shares XXXX Total issued capita XXXX Retained Profits XXXX Total Shareholders equity XXXX Corporate Group Groups of many companies E.g. Woolworths, BHP Billiton, Commonwe alth Bank Balance sheet represent what group looks like as a consolidated econom ic entity, although there is no such legal entity Looks like that of single comp any, with shareholders equity section representing equity of primary, parent, com pany in grouo A2.2 Business Financing Non - Current Liabilities (debts due more than a year in the future) Mortgages and other debts extending several years Special loans fro m owners, LT tax estimates, estimated liabilities to be paid to employees in the future Owners equity Sole trader and Partnership owners capital Company shared capital re ceived for each kind of share + retained profits (+ other items if legal or acco unting complexities require them)

ACCT1501 Notes Chapter 3 The Double Entry System Cheryl Mew 3.1 Transaction Analysis + 3.2 Transaction Analysis Extended A CA + NCA CA + NCA CA + NCA Set out: - Assets Cash, AR, Inventory, Land and Building, Equipment Liabilities AP, Notes Payable, Wages Payable, LT Loans - Equity SC, R, E, Divide nd = = = = L CL + NCL CL + NCL CL + NCL 3.3 Recording Transactions: Double-entry Bookkeeping System of debits and credit s Balancing Equation : A = L + SE CA + NCA A+E+D D, C = = CL + NCL SC + Op. R + SC + C, D Resources = Assets Sources = Liabilities / Equity Therefore sum of credits must = sum of debits Transactions measured in terms of countrys currency (AUD) Recordi ng transactions = entry Records of transactions = journals / journal entries Ent ries are transferred and summarised in accounts, which lie behind all amounts an d descriptions shown on balance sheet All accounts collected together = ledger a ccounts Accountants makes a list of account balances from ledger to make sure Dr = Cr. (this list is called the trial balance) All accounts put together = balan ce sheet Each double entry record names one (or more) account that is debited, a nd one (or more) that is credited Double entry records = journal entries each jo urnal entry, sum Dr = sum Cr

ACCT1501 Notes 3.4 More about Accounts Cheryl Mew An account is a record of the dollar amounts comprising a particular A, L, E, R or Exp. Net effect of these amounts is debit or credit, and is called the accoun ts balance 3.5 How Debits and Credits Work , e.g. accumulated depreciation Negative asset = contra asset has credit balance

3.6 Debits and Credits, Revenues and Expenses Accounting accumulates information about activities Financial statements are prepared from the accounts that are p roduced as the information is accumulated Double entry recording system creates a set of accounts which is in balance (Dr = Cr) From these accounts are produced : - The income statement - A note to the accounts showing a statement of retaine d profits, the bottom line (ending retained profits), which transfers to - The b alance sheet, which summarises all accounts 3.7 Arranging accounts on the balance sheet Placement of CA, NCA, CL, NCL, E all ows for calculation of meaningful ratios and other analysis Thus balance sheet i s classified because it is classified into meaningful categories Moving items arou nd within Balance sheet is called reclassification Reclassification done by acco untants whenever it is thought to improve informativeness of financial statement Three examples of account classification Current and Non-current portions of non current liabilities - Liabilities e.g. mortgages, bonds, debentures - Thus accou ntants need to reclassify the amount to be paid on principal within the next yea r (to Current) and the residual to non current - Interest owing but not paid is a separate liability

ACCT1501 Notes Bank overdrafts - E.g. bank overdraft of $500 - This means bank allowed company to remove $500 more cash from account than there was in it, in effect, lending c omp $500 Two ways of representing this: - Other assets of $12400 minus bank over draft of $500 = L & E of $11900 - Other assets of $12400 = L&E of $11900 + bank overdraft of $500 Negative amounts left as deductions - Some negative amounts ar e left as deductions unlike the bank overdraft - E.g. accumulated depreciation l eft as a negative deduction for asset Three ways of representing this: - Shown o n RHS of balance sheet (before it was, and in some countries still is) - Separat e disclosure as a deduction on LHS of balance sheet, but since many types of ass ets and depreciation amounts can make sheet clustered - Could be deducted from as sets cost, so net book value of assets could be disclosed on balance sheet, but not the accumulated depreciation This method is becoming more popular, accompani ed by note to fin statements, listing cost and accumulated depreciation amounts separately Cheryl Mew

3.9 Cash versus accrual accounting revisited Accrual accounting Cash sale would increase by revenue and cash in that period Credit sale will AR and R in that per iod When the cash is paid, AR , Cash

Way accrual financial accounting info is assembled: - Cash - Credit transactions - ST/LT adjustments are needed to prepare financial statements, unless the comps accounting system is sophisticated enough to have already built them in - Exten sive narrative and supplementary disclosures (e.g. notes to financial statements )

ACCT1501 Notes Cheryl Mew 3.10 Example: Simones Jewellery Business Difficulties of accrual accounting: Accr ual profit requires extra calculation more complex cause confusion as it leaves more room for error than the simpler calculation Accrual profit differ from cash profit, differ from change in amount in bank Accrual accounting can be a lot mo re complicated tax, rent, time... 3.11 Public Sector Issues During 1990s, all govt moved from cash based acct syst em to accrual based acct system

ACCT1501 Notes Chapter 4 Record Keeping Cheryl Mew

4.1 The Importance of Good Records Complete and accurate records provide observ tions and history of enterprise This is used by investors, managers to plan for future Records cost money Records provide: The basis for extrapolations into the future Info for evaluating and rewarding performance Basis of internal control over existence and quality of enterprises assets 4.2 Financial Accountings Transactional Filter Accounting is an info system lter and summarise data. Economically efficient to have 1 system organise data i nto information on behalf of the various users E.g. of summarising and organisin g daily newspaper Like newspaper, info system e.g. financial acct is limited. On ly report what sensors pick up as it seeks out data or filters data Data bank: l edgers, journals (the books) and supporting records Recording Classifying... = B ookkeeping Information = accounting or reporting

Accounting reports are limited by the collected data Transaction recorded Not tr ansaction routine accounting system ignores event Two general kinds of transacti ons cash transactions or credit transactions Non transactions natural disasters/ incidents, future delivery, land value /

ACCT1501 Notes Financial accounting transaction fundamental eco or legal characteristics: - Exc hange must involve exchange of G/S, $, legal promises, items of eco value - Past exchange must have happened - External exchange must be between entity and anot her party Supplementary characteristics needed for accountings record-keeping: Evidence must be some documentation paper/electronic - Dollars must be measured in the currency relevant in country where transaction happens (AUD) Following tr ansaction characteristics define nature and value of fin acct info: 1. Transacti ons linked to legal and economic concept of exchange (bounded by legal contract including $ transactions) 2. Constitute large part of underlying rationale for h istorical cost basis of accounting, founded on accounting (history has to have h appened) 3. Characteristics of transaction provide basis on which records can be verified (audited) later as part of the process of ensuring info is credible 5 key points exchange, past exchange, external party, evidence, dollars Adjustment s/ adjusting journal entries in data bank when accountant is not satisfied with set of data and wishes to alter some event which is important RHS information de ciding on adjustments, deciding on reporting format, making supplementary notes. .. Cheryl Mew

4.3 Accountings Books and Records Accounting cycle 1. 2. 3. 4. 5. 6. 7. 8. 9. Sourc e documents Prepare journal entries Post to ledgers Prepare trial balance (colle ction of ledger accounts Dr = Cr) Prepare adjusting journal entries Prepare adju sted trial balance Prepare closing journal entries (close revenue, expenses and dividends to RP) Prepare post-closing trial balance Prepare financial statements Source Documents and transactional style Source documents show that transactions have occurred Documents are kept so that the accounting records can be checked and verified to correct errors; permit auditing; used for disputes; support inco me tax claims and other legal action.

ACCT1501 Notes Discounts after ordering: cheque will be less than amount owed Debit AP, Cr Cash discounts received (other revenue account) Cheryl Mew

Journal Entries Record accounting transactions When business event is fir rded by acct system Basic transactional records are often called books of origin al entry A journal entry can list as many accounts as are needed to record trans action, but each journal entry must be recorded, so sum of debits equals sum of credits Dr left, Cr right Omit $ Traditional to write short explanation called n arration below each entry as a memorandum of what the recorded transaction was a bout (not compulsory) Every journal entry must be dated and is usually numbered Posting reference is given to indicate the ledger account to which each journal entry is posted. Number obtained from companys chart of accounts. Enterprises wit h many transactions to record do not create separate entry for each transaction, but instead use special records for each routine kind of transaction... e.g. sa les journal, cash receipt journal, cash payment journal and purchases journal Posting to ledgers Ledgers are books or computer records that have a separate pa ge or account code for each individual account referred in the books of original entry Where T accounts come in to illustrate simpler version of ledger accounts General ledgers collection of all the A, L, E, R, Exp, summarising the entire o perations of business Subsidiary ledgers AR, AP balance isnt based on Dr, Cr, but sum equal amount in primary account in general ledger

Trial Balance Balanced journal entries > general ledger accounts > balanced bal nce sheet There is always a little uncertainty on whether standard bookkeeping p rocedure ensures that ledger adds up all Dr and Cr and makes sure they equal The refore calculation is called trial balance What to do when trial balance doesnt b alance? Re-add trial balance Check posted journal entries to correct side of led ger accounts Check that each ledger account is balanced correctly

ACCT1501 Notes Check that each journal entry balances (Dr = Cr) Determine difference between Dr and Cr and look for account with that amount maybe left out ledger balance Diff erence / 2 and look for that amount means posted to wrong side of ledger account If difference is divisible by 9, maybe transposition error 21 instead of 12, 72 instead of 27 Sometimes trial balance cannot pick up error Cheryl Mew Adjusting Entries At end of each acct period, it is necessary to adjust Rev and Exp accounts Splitting between accounting periods e.g. prepayments for insurance

Closing entries Needed to facilitate preparation of financial statements Ne to prepare accounting records to begin next period Closing entries formally tran sfer the balances of the revenue and expense accounts to a profit and loss summa ry, then to retained profits Closing entries also reset the rev and exp account balances to zero to being records for the next accounting period P&L summary acc ount to decreases everything to 0 Debit sales account to zero, credit expenses a ccount Debit profit and loss summary account Then, to balance P&L account, clear it by debiting P&L Credit retained profits Post closing trial balance Financial Statements alance > Balance sheet Put together ledger accounts to see if Dr = Cr

P&L summary account > Income statement Post-closing trial b

ACCT1501 Notes 4.4 An Example: Northern Star Theatre Company Source documents General Journa eneral Ledger General Ledger trial balance General Journal (with adjustments) Ge neral Ledger General Ledger trial balance Closing entries returning everything t o 0, dr revenue, cr P&L Financial statements Retained profits, income statement, balance sheet Cheryl Mew 4.6 Electronic Commerce Electronic commerce (e-commerce) is a challenge to finan cial accounting and internal control, because of the absence of paper trail that h as traditionally supported accounting records. E.g. moving away from cash and ch eque, but using lots of credit cards or EFTPOS. Employees are being paid by depo sits in personal bank accounts Implications of e-commerce - Needs to be compatib ility between computing systems for proper recognition of accounting systems on both sides of transactions Trust in electronic media to make system work - Tende ncy for records and payments to be speedier and separate from movements of produ ct, means in-transit items can be a challenge to control and reconcile - Not onl y financial statements must be right, but also the underlying records for busine ss partners enquiries to be answered reliably Paradox: e-commerce works without p aper but demands a good trail of evidence

4.7 Managers, Bookkeeping and Control (Importance of bookkeeping to managers) Bo okkeeping and its associated record keeping: - Provide underlying data on which accounting info is built Decisions and evaluations may be constrained on nature of underlying data - Provide data and systems used in meeting managements importa nt responsibilities to safeguard assets and generally keep the business under co ntrol

ACCT1501 Notes 4.8 Public Sector Issues The process of accounting also applies to public sector organisations Accumulated funs = Public sector equity Recurrent appropriation = govt revenue User charges = revenue Grants and subsidies = expense Cheryl Mew

ACCT1501 Notes Chapter 5 Revenue and Expense Recognition in Accrual Accounting Cheryl Mew 5.1 Conceptual Foundation of Accrual Accounting Revenues are inflows of economic resources from customers earned through providing goods or services. Expenses a re outflows of economic resources to employees, suppliers, taxation authorities and others, resulting from business activities, to generate revenue and serve cu stomers. Incurring expenses are the cost of earning revenues. Net profit is the difference between revenues and expenses over time. Net profit is the measure of success in generating more revenue and it costs to do so. Features Revenue and expenses refer to inflows and outflows of economic resources. Involve phenomena that arise before or after cash changes hands, as well as the point of cash flow s Net profit is dependent on how revenues and expenses are measured.

A conceptual system for accrual profit measurement Need system that recognises r evenue and expense before, at the same time and after cash flows. Accrual method includes cash accounting Summary Revenue before cash collection form asset account (e.g. Accounts receiva ble) Expense before cash payment form liability account (e.g. Accounts payable) Unearned revenue liability Expense after cash payment asset Before cash Rev Exp Asset Liability After cash Liability Asset

ACCT1501 Notes 5.2 Accrual Accounting Adjustments Cheryl Mew

Adjustments involved implementation of routine accruals, such as those mentioned above Sophisticated accounting systems go beyond transactional records and rout inely include many adjustments Simpler systems make adjustments at year end in a special set of journals Many small companies dont bother until financial stateme nts are needed Follow double entry format: - After each adjustments, A=L+E still balances - Sum of credit = sum of debit Adjusting journal entries purpose: augm ent transaction based figures, add story told by transactional records. Objectiv e of accrual accounting improve measurement of financial performance and positio n Accrual > cash provides more complete record, more representative of economic performance Four main types of routine adjustments: - Expiration of assets (afte r prepayments) - Unearned revenues - Accrual of unrecorded expenses - Accrual of unrecorded revenues Expiration of assets Prepayments assets that arise because an expenditure has be en made, but there is still value extending into the future Usually current asse ts Arise whenever payment schedule for an expense does not match the companys fin ancial period e.g. insurance premiums where policy date doesnt match financial ye ar Prepaid expenses do not have market value, but they have economic value becau se future resources will not have to be used E.g. insurance, advertisements Prep ayment Cash Prepayment Expense Prepayment DR CR DR CR Prepayment Expense Cash Pr epayment Prepayment Expense DR CR DR CR

OR

ACCT1501 Notes Unearned Revenues Unearned Revenue future revenue where the cash has been receiv ed before earning revenue (deposits) E.g. newspaper or magazine subscription com panies, or airline, phone, membership Cash Unearned Revenue Unearned Revenue Sal es Revenue DR CR DR CR Cheryl Mew

Accrual of unrecorded expenses Involves determining which expenses have been inc urred by the organisation (but not paid in cash) during a particular time period Involves checking which invoices have been received from suppliers, incorporati ng that info into accounting systems (e.g. AP), and making estimates for expense s for which invoices have not yet been received Accrued expenses E.g. wage expen se end of pay period and end of financial period occur on different days Wages E xpense Accrued expense Accrued expense Cash DR CR DR CR

Accrual of ovided but , unbilled enue DR CR

unrecorded revenues Accrued revenue Occurs when a service has been pr cash will not be received until the following period Interest revenue revenues, commissions earned Accrued Revenue Revenue Cash Accrued Rev DR CR

ACCT1501 Notes Multicolumn Worksheets Useful device to help prepare financial statements Pre ad justed Trial Balance Adjusting Entries Adjusted Trial Balance Income statement n umbers Cheryl Mew Balance sheet numbers 5.3 The Financial Period As businesses run continuously, financial statements ar e prepared at specific points or periods in time 2009 net profit is a measure of economic value added by the project during that year IF there are 2 cash inflow s 2008 and 2009: - If 08 cash > 08 revenue, then unearned revenue will be set up - If 08 cash < 08 revenue, then account received set up Companies have initial choices about when the financial year begin and end. Once they made their choice , reasons relating to habit, legal and tax rules force them to stay with the cho ice Australia 30 June is most common US, Canada, Singapore 31 December UK, NZ, J apan 31 March Possible in Australia to use substituted accounting period for tax ation purposes

5.4 Introduction to Accounting for Inventory Several different methods for contr olling inventory Most popular perpetual inventory control method (compared to pe riodic) Under perpetual method, inventory is an asset - Inventory bought debit i nventory account - Inventory sold debit cost of goods sold, credit inventory - 2 entries are required for sales (revenue and cost of goods expense) - Return of sales also require 2 entries 5.5 Contra Accounts Just about every balance sheet account can be considered a c ontrol account Amounts in accounts should be supported by detailed lists or subs idiary ledgers Sometimes want to change account, and at the same time reluctant to.

ACCT1501 Notes Cheryl Mew

Worried that company might not be able to collect all money back from customers. Want to recognise bad debts. However that means crediting accounts receivable. But at the same, since we have not given up on collecting debts, we should not d o that. Property and plan are being used up economically. Want to record depreci ation expense. But do not want to change asset cost account, because costs are n ot changing, but rather economic value is being used. Contra account set up to a llow recognition of expense and related value changes without changing control a ccount Contra accounts have balances that are in opposite direction to those of the control account in which they are associated Contra accounts only have meani ng in conjunction with the control accounts to which they match. Most common: ac cumulated depreciation (amortisation), doubtful debts receivable

Accumulated Depreciation (Amortisation) Accumulate depreciation on fixe (e.g. buildings and equipments) DR Depreciation Expense CR Accumulated Depreciat ion Accumulated Depreciation relates to asset account of buildings Showing both allows users to make rough guess on age of asset Depreciation expense shows how much depreciated during that period Accumulated depreciation shows total amount the buildings have depreciated by Net book value = cost accumulated depreciation Contra account is only meaningful in comparison to the cost. When the asset is gone/sold, neither account is needed anymore. E.g. Truck bought at 50,000. Depre ciates at 8,000 each year. Sold at end of 2nd year for 37,000 Net book value of truck = 50,000 16,000 = 34,000 Journal Entry for selling truck: Cash 37,000 Truc k asset 50,000 Accumulated Depreciation Revenue on sale of truck 34,000 3,000 When non-physical assets, e.g. goodwill, patents and trademarks are amortised, t he accumulated amortisation account is used instead of accumulated depreciation

ACCT1501 Notes 5.6 Accounts Receivable and Contra Accounts Accounts receivable when revenue is recognised but uncollected DR accounts receivable, CR sales revenue Such receiva bles are often called trade receivables Cheryl Mew Valuation of accounts receivable Receivables are valued on BS at lower of cost ( original transaction value + interest charges) or net realisable value (amount e xpected to be collected) If collectable amount < expected amount, receivable mus t be reduced to an estimated collectable amount. This is done by subtracting an allowance for doubtful accounts from the accounts receivable balance Estimated a mount collectable = Trade receivables allowance for doubtful debts Therefore all owance adjusts net value down to the lower of cost and current estimated collect able amount Other receivables 2 other main types of receivables. If they are large, they are shown separately. If they are not large, together, theyre called other debtors Not es receivable - Supported by signed contract specifying payment schedule, intere st rate and often other legal details. - Used for large or long term receivables , e.g. motor cars, house, appliances and loans by banks and finance comps Other receivables: - Loans to employees, officers and shareholders, associated compani es, tax Refunds Company is waiting for and other receivables not arising from re venue transactions. - Accounted for and valued same as AR and notes receivable. - Usually arise from peculiar circumstances, where company disclose reasons.

Allowance for doubtful debts There is always a risk where customers will fail to pay Therefore portion of debts will be doubtful and portion should be deducted from revenue in determining profit for the period To recognise expense: DR Bad D ebts Expense CR Allowance for doubtful debts

ACCT1501 Notes Reason for not deducting directly to keep balance between accounts receivable an d list of individual accounts. Company may still try to collect on the accounts After pursuing non-paying customer for months, company may decide to write off a ccount. Then: DR Allowance for doubtful debts CR Accounts Receivable Allowance c an be seen as a temporary holding account for amounts the company believes will not be collected, based on past experience and an assessment of outstanding acco unts. Another way of writing: Direct write off method DR Bad Debts Expense CR Ac counts Receivable Used when company has few accounts receivable or when large ac count not included in allowance suddenly goes bad Purposes of contra accounts ar e to provide useful information to the readers of financial statements or to ass ist in accountings internal control functions Cheryl Mew

5.8 Managers and Accrual Accounting Assumptions Accrual accountings purpose: to m ove beyond cash flows towards a broader economic concept of profit and financial position. Implications from a managers point of view: - Fair evaluation of mana gerial performance - Limitation accrual accounting, basing on history reflects o n the past rather than looking into the future, as managers are inclined to do Only look at the resulted actions, not the reason why mangers initiated action - Evidenced based accounting procedures for recognition of profit and expenses m ay not relate very well to economic concepts of earnings, or managers struggles t o increase the value of their companies - To managers seeking even handed evalua tion of their performance, accounting may seem downwardly biased in its measures - Criteria for revenue and expenses recognition is subjective some managers mani pulate, some managers find it too loose and flexible - The shorter the time peri od, the more mismatch the figures are between cash flow and accrual profit Accru al accounting has many advantages and is very widely used, but managers should n ot accept it uncritically

ACCT1501 Notes 5.9 Accrual Accounting in the public sector Since 1995, local governments tralia have been required to produce financial statements using accrual accounti ng Since 1994 NSW govt. 1999 all govt Key differences with accrual accounting: N on-cash assets and depreciation Value of receivables and payables Liabilities (e mployee entitlements) Changing value of financial assets and liabilities (exchan ge rate) Cost and revenue of government activities Cost of consuming assets expe nse (e.g. depreciation) Value of goods and services received for free from other bodies (revenue) Cheryl Mew

ACCT1501 Notes Chapter 5 Appendix Special Journals, Subsidiary Ledgers and Control Accounts Cheryl Mew Business with small set of transactions initially recorded in general journal, t hen posted to general ledger Complex business rather than info captured in 1 jou rnal and posted to 1 ledger, system of special journals, subsidiary ledgers used Special journals allow easy recording of the most common transactions undertake n by a business Subsidiary ledgers present detailed analysis of info that is eve ntually transferred to general ledger account Sales invoice >>> Journal Entries + Subsidiary ledger AR >>> General Ledger, Trial Balance General ledger account called debtors or Accounts receivable A5.1 Prime Entry Records: Special Journals Special Journal : Sales Purchases Cas h receipts Cash payments Transaction Recorded: Credit sales of inventory Credit purchases of inventory All cash inflows (including cash sales) All cash outflows (including cash purchases)

Each entry represents a transaction that belongs to the same class as others in the same journal Transactions not in special journal are recorded in general jou rnal Advantages of Special Journals: - Recording efficiency - Amounts posted fro m special journals to general ledger as totals, rather than individual journal e ntries - More than one user can update accounting system, because it consists a number of related subsystems - Nature of transaction eliminates need for narrati ons - Info such as receipt or invoice number may be recorded for narrations - Ad ditional info can be added for convenience as it is available from source docume nts, e.g. discounts A5.2 Subsidiary Ledgers and Control Accounts Most common way of accommodating ne ed for detailed records in the accounting system, without grossly expanding numb er of separate general ledger accounts

ACCT1501 Notes Cheryl Mew

Subsidiary ledger a set of ledger accounts that collectively represents a detail ed analysis of one general ledger account classification Relevant account in gen eral ledger is called the control account Accounts in subsidiary ledger can be p eriodically checked against total data and balance in control account Examples o f general ledger accounts that have subsidiary ledgers: - Debtors/Accounts Recei vable separate account for each debtor - Creditors/Accounts payable separate acc ount for each creditor - Property, plant and equipment Asset Register separate f or each piece - Raw materials Inventory Separate records of each type of raw mat erial - Finished goods inventory Separate record of each type of finished good A dvantages for subsidiary accounts Check on accuracy (as subsidiary account and g eneral account balances should =) Enable any desired amount of detail to be main tained to explain composition of selected general ledger account, without overlo ading general ledger A5.3 Trade discount and Cash discount Both Trade discount and cash discounts rep resents a reduction in the amount that a customer ultimately pays a vendor for g ods and services supplied Differ in the way they are recorded Trade Discount Trade discounts are a means of adjusting the actual price charged to a customer from a standard list price. Usually determined by category of cus tomer or normal volume of businesses Manufacturer may sell at list price to gene ral public, 40% off for retainers and 55% off to wholesalers Most enterprises re cord only net amount of transaction Effect of trade discount is merely to set an actual price for transaction Cash Discount Cash discounts are conditional adjustment after determining the ac tual selling price at which the transaction takes place NOT a change in price of original sales transaction generally recorded as an additional transaction Cred it terms 2.5/10, n/30 2.5% deducted if money was paid within first 10 days, the net amount must be paid within the next 30 days Discounts recorded as Discounts a llowed (EXPENSE), or Discounts Received (REVENUE)

ACCT1501 Notes A5.4 Operation of Special Journals and Subsidiary Ledgers Sales Purpose of al journals is to eliminate need for such detailed recording in a general journa l and the general ledger Totals of special journals posted to control account, b ecause CA only record aggregates Sales journal updated everyday Sales journal po sted to AR, Sales revenue, COGS, Inventory Subsidiary ledger may be established for each customer who buys on credit Posting reference S1 indicates info comes f rom page S1 of sales journal Tick in posting reference indicates that the amount has been posted to the subsidiary ledger End of period total of subsidiary ledg ers can be checked against balance of AR control account. I.e. sum of balance in each debtor should = balance of AR control account Cheryl Mew Purchases Purchases only used for recording the acquisition of goods, on credit, intended for resale Source document purchase invoice from supplier, matched aga inst delivery docket and copy of official purchase order Even with discounts, th e full amount owing is recorded If discounts are received, then this is recorded in CPJ discount revenue, when items are paid for Purchases journal updated ever y day for each creditor of each item of inventory Credit transactions involving acquisition of fixed assets or items to be charged to expense accounts, such as repairs, maintenance, printing and stationery, are often recorded in general jou rnal. Cash Receipts Source document: evidence of cash receipt, list of cheques receive d or direct deposit recorded on bank account statement Cash receipts journals ar e designed to meet specific needs of an enterprise Most businesses include payme nts from debtors, possibly cash sales Also sundry or miscellaneous column for ca sh receipts not otherwise identified by specific column that represents a partic ular general ledger account E.g. proceeds from sale of fixed assets, refunds by creditors, new capital or mortgage funding Discount expense column not sundry

ACCT1501 Notes Cash Payments Cheryl Mew

Source documents: duplicate of cheque or cheque butt, statement and invoices fro m creditors, receipt issued by recipient or payroll analysis certified as correc t by responsible staff member Bank statement evidence of interest charged on any overdraft, together with info about other bank charges and fees Minimise postin gs and provide analysis of payments, separate columns may be provided to record entries affecting those ledger accounts frequently involved Sundry or miscellane ous column might be needed. DO NOT POST total of sundry column Desirable in all books of prime entry (journals) to provide reference to source document for each entry Done by recording cheque number In addition to postings to general ledger made at end of period, each individual item in the creditors column will be pos ted as a debit to the creditors account A5.5 Role of General Journal and General Ledger General journal used to record number of important transactions: Sales and purchase returns Credit transaction s other than those related to inventory, such as the purchase of equipment Adjus ting entries Closing entries Each entry in general journal is individually poste d to appropriate account in general ledger At the end of a period, all financial information will be posted to general ledger, either as an individual entry sou rced from general journal (including sundry from special journal), or in aggrega te from columns of various special journals

ACCT1501 Notes Chapter 6 Financial Reporting Principles, Accounting Standards and Auditing Cheryl Mew 6.2 Accounting Principles and the use of Accounting Information Doing accounting takes expert knowledge, considerable experience and continuous attention to new problems and solutions. Concepts and principles are important, as they form log ical structure that practising accountants use every day to consider problems to make recommendations GAAP (Generally Accepted Accounting Principles) applied di fferently for different entities Rules, standards and usual practices that compa nies are expected to follow when preparing financial statements Stock market cra sh of 1929 brought GAAP AASB (Aust Accounting Standards Board) IASB (Internation al Accounting Standards Board) AASB uses IASB as foundation, but includes more d etails applicable to Aust environment SACS Statement of Accounting concepts SAVS established for general concepts and principles to be used in preparing financi al statements SAC 1 Definition of a Reporting Entity SAC 2 Objective of General Purpose Financial Reporting SAC 3 Qualitative Characteristics of Financial Infor mation SAC 4 Definition and Recognition of the Elements of Financial Statements Now, SAC 3 and SAC 4 is replaced with Framework for Preparation and Presentation of Financial Statements

FYI: Difficulties that face accounting and managers by GAAP Difference in compan y structures e.g. ABC = not for profit, publicly owned. Should ABC use same meth ods as other profit seeking organisations? Qantas / UNSW employees are not asset s. But for sports team, such as Sydney Swans millions are paid to have certain p layers on the team. Are they assets or expenses? Should they be amortised? Compa ring movies net profits hard to measure profitability of certain movies e.g. star wars attracted many viewers when it was first released. However, due to its pop ularity, it continues to generate revenue, through video, dvd, toys, books

ACCT1501 Notes 6.3 Framework for the Preparation and Presentation of Financial Statements Cheryl Mew Framework includes the coverage of: - objectives of financial reports - assumpti ons underlying financial reports - qualitative characteristics that determine th e usefulness of financial reports assets and liabilities - definition of the ele ments from which financial reports are constructed: assets, liabilities, equity, income and expenses - recognition and measurement of the elements of financial statements Framework makes distinction between general purpose financial report (for most users who rely on this as main source of info) and special purpose fin ancial report (list for issues of shares outside scope of Framework).

Users of financial reports Investors info on risk and return, including sha ders buy, hold or sell? Employees including unions stability and profitability a nd whether company can afford employee benefits Lenders whether interest and loa ns will be able to be paid off Suppliers and other trade creditors whether amoun ts owing can be paid Customers continuance of entity, e.g. with warranties Gover nments and their agencies allocation of resources & tax Public substantial contr ibution to public e.g. employment Framework regards investors as the majority of users, so satisfy most the needs of investors The objective of financial reports Objective: provide information about financia l position, financial performance and cash flows that is useful to users in maki ng economic decisions Users need evaluations of cash generation due to its liqui dity to buy inventory, pay wages, distribute shares etc Users need info on finan cial position, financial performance and cash flows to evaluate this Financial p osition balance sheet economic resources (NCA), financial structure (who finance s assets), information on liquidity and solvency (L & ratios) Financial performa nce income statement profitability, employment of resources, potential chances i n assets controlled by the entity Movement in cash cash flow statement operating , investing and financing decisions

ACCT1501 Notes Underlying Assumptions Accrual basis of accounting Going Concern - entity will c ontinue to operate in the foreseeable future - book value = cost accumulated dep reciation - liquidation value can be a lot less than book value - this is becaus e when companies close down, they may not be able to sell off its assets at the book value Other authors also regard accounting entity, accounting period and mo netary assumptions as key underlying assumptions. Cheryl Mew

Key Qualitative Attributes Understandability concern on complexity of financial statements that could not be understood by experts. Pozen committee examined US financial reporting system and made recommendations on the usefulness of reports Relevance Pozen committee suggests that the increased complexity has led to les s relevant info to users evolution of business strategies and businesses do not want investors to know about their liabilities - materiality Reliability Pozen C ommittee suggests detailed rules in standards permit structuring of transactions to achieve particular accounting results, even if results are inconsistent with transactions - Faithful representation real existence - Substance over form ina ccordance with substance and economic reality - Neutrality freedom from bias - P rudence degree of caution in exercise of judgements - Completeness material info is not omitted Comparability Pozen Committee notes that GAAP contain many detai led rules with several industry exceptions and alternative accounting policies f or same transactions

Elements of Financial Statements Assets resources controlled by the entity as a result of past events, and from which future economic benefits are expected to f low from the entity Asset recognition - It is probable that any future economic benefits associated with the item will flow to the entity

ACCT1501 Notes Liabilities present obligation of the entity arising from past events, the settl ement of which is expected to result in an outflow from the entity of resources embodying economic benefits Liability Recognition - probable that any future sac rifice of economic benefits associated with the item will flow to or from the en tity - the item has a cost or value that can be measured reliably Equity residua l interest in the assets of the entity after the deduction of its liabilities SE = A L Equity ranks after liabilities as a claim to the assets of an entity Inco me increases in economic benefits during the accounting period in the form of in flows or enhancements of assets or decreases in liabilities that result in incre ase in equity Issues of shares are not included 2 main components revenue and as sets/liabilities Expenses decreases in economic benefits during the accounting p eriod in the form of outflows of assets, depletion of assets or incurrences of l iabilities that result in decreases in equity mainly COGS, wages and depreciatio n Cheryl Mew

Measurement of the elements of financial statements Measurement determining the monetary amounts that the elements of the financial statements are to be recogni sed at and included in the balance sheet and the income statement Historical cos t assets are recorded at the time of acquisition Current cost assets are carried at the amount that would have to be paid if it was bought currently Realisable (settlement) value assets are carried at the amount that could currently be obta ined by selling the asset in an orderly disposal Present value assets carried at present discounted value of future net cash inflows that the item is expected t o general in the normal course of business

ACCT1501 Notes 6.4 Assets and Liabilities: Valuation and Measurement Five basic methods to meas ure or value assets and liabilities - Historical cost - Price-level-adjusted his torical cost - Current or market value - Value in use (or present value) - Liqui dation value Asset: Whether market values are better than historical cost? Liabi lity: Whether present value or estimation of future cash flows? Cheryl Mew

Historical cost Acquisition cost values assets at the amount paid or promised t acquire the assets, and values liabilities at the amount of any associate promi ses Ability to document cost of asset through receipts, invoices or contracts An asset valued at historical costs is valued at its expected lowest or most conse rvative value of future benefits at the date of acquisition At the point of acqu isition, historical cost = market value = value in use (present value), in most cases. writing down of unproductive assets lower of cost or market rule Price level adjusted historical cost Adjusts for changes in the value of the dol lar, rather than the changes of the values of the assets Lack of popularity beca use if historical cost is unsatisfactory compared to current values, adjusting t he cost for inflation still makes it unsatisfactory, only now less understandabl e Current Price or Market Value (value in exchange) Records assets and liabilities at their current particular market value focuses on the individual values of th e assets and liability items assumes that value is market-determined and that pr ofit should be measured using changes over time in market values. Input market v alue entry value refers to the amount it would cost to bring the asset into the company if it were not currently in it. Output market value exit value amount an asset is worth if it were sold now (net realisable value) Fair value alternativ e asset valuation method amount of the consideration that would be agreed upon i n an arms length transaction between knowledgeable, willing parties who are under no compulsion to act.

ACCT1501 Notes Value in use (present value) Considers that value flow from the generation of ca sh flows from the asset Estimated by calculating the net present value of future cash inflows cash flows minus lost interest expected to be generated by the ass et Present value future cash flow future interest implied by waiting for the cas h Present value = future cash payment / (1+r) Cheryl Mew Liquidation Value going out of business, sell it for what you can business presume s the entity is not a going concern 6.5 Accounting Regulation in Australia CLERP Act 1999 Corporate Law Economic Ref orm Program Act modified institutional arrangements for the setting of accountin g standards in Australia, recognising that financial reporting requirements can play an important role in Australia companies ability to compete effectively and efficiently in a global environment FRC Financial Reporting Council

6.6 International Accounting Standards IASB (International Accounting Standards Board) have issued more than 40 individual standards. Aim: develop common standa rds that could be used by companies operating in several countries, and eventual ly that all countries could use within their borders CONVERGENCE Horror stories of 1 company with huge profits in one country also with huge losses according to another countrys acct standards are an embarrassment to the accounting professio n and awkward for regulators such as SEC (security exchange commission) to deal with Challenge to IAS is the attempt to make even the Canadian, US and Mexican a ccounting systems similar, given that the 3 countries have signed the NAFTA. VER Y different in accounting standards, as govts have passed laws that set strict r equirements for financial accounting in accordance with national priorities and culture

ACCT1501 Notes 6.7 The Annual Report and Financial Statements Cheryl Mew

The standard set of financial statements has five components: - balance sheet income statement - statement of changes in equity - statement of cash flows - no tes to the financial statements Statement of changes in equity reports the profi t or loss in equity Notes to the financial statements provide additional detail on the items in the financial statements note 1 is accounting policies inventory method, depreciation method Public companies and other organisations include th eir set of financial statements in a much larger annual report. This report usua lly contains: 1. Summary data on companys performance for the year, comparisons g oing back 5 or more years 2. Letter to the companys shareholders from the chairpe rson of the BOD or the managing director, including highlights of the performanc e and future plans 3. Extensive CEOs report description of the eco, financial and other factors 4. For listed companies a corporate govt statement, required unde r ASX reg 5. Set of financial statements 6. Directors statement required by Corpo rations Act 2001 signed by CEO and CFO that the fins records are prepared in acc ordance with the Corporations Act 2001. Debt opinions of directors 7. Independen t audit report 8. Directors report names of directors, principle activities, oper ating results 9. For listed companies, info on substantial shareholders, distribu tion of ownership 10. Other voluntary information graphs, details on products, p ollution Full versus concise financial reports Corporations Act 2001 now requires the pub lication of both FULL general purpose financial reports (GPFR) and concise finan cial reports GPFR contains the 5 financial statements in addition to the auditors report and directors declaration Concise financial statements are sent to all sh areholders, with a statement that the report is concise and GPFR if a shareholde r requests Concise financial statements include the 5 financial statement compon ents minus notes. Additionally there must be a discussion and analysis of financ ial statements to assist the users understanding.

ACCT1501 Notes Cheryl Mew 6.8 The External Auditors Report Auditors report a routine statement by the audito rs that provides an opinion on whether financial statements are fairly presented Adverse opinion when auditors deny the fairness of the statements External audi ting refers to the evaluation of an organisations financial statements by an audi tor who should be unconnected with, and therefore independent of, the management of the organisation Role of external auditor: - to have an independent, unbiase d and professional perspective - to render a competent opinion on the fairness o f the financial statements Fundamental objective of professional associations su ch as CA or CPA is to protect society by ensuring the professionalism and indepe ndence of the external auditors who belong to them Independence is maintained be cause the auditor is appointed by, and reports to the shareholders, not manageme nt However, in practice, auditor has close working relationship with management and managers has a strong position to recommend change of auditor Recent legisla tive changes have strengthened the independence of audit firms: - rotation of au dit partners every 5 years - banning the provision of many non-audit services by the firm carrying out the audit Audits are opinions, not guarantees. Audits do not state whether a company is performing good or bad. It simply states whether the performance and position have been measured and presented in a generally acc epted and unbiased way

ACCT1501 Notes Content and form of auditors report changes every few years, as auditors rethink how it is best to communicate with the users. Addressed to owners, titled Indepen dent Audit Report Cheryl Mew Standard version of the auditors report includes the following: 1. Identifies com pany, set of statements and their date and states that the statements are the re sponsibility of mgmt and that the auditors responsibility, having conducted an in dependent audit of the financial report, is to express an opinion to them. 2. A section of the report contains the following statements: a. audit conducted in a ccordance with AAS to provide reasonable assurance on whether financial report i s free of material misstatement b. auditors procedures included the examination, on a test basis, of evidence supporting the amounts in the financial report, and the evaluation of accounting policies and significant accounting estimates c. p rocedures have been undertaken to form an opinion to form an opinion on whether, in all material respects, the financial report is presented fairly in accordanc e with AAS d. statement that audit opinion expressed in the report has been form ed on the above basis 3. Normally, the third paragraph provides the auditors opin ion that the financial statements give a true and fair view that they are in acc ordance with the provisions of the Corporations Act 2001, applicable accounting standards and other professional mandatory reporting requirements. Redraft: incl ude paragraph of respective roles of mgmt and auditors and inclusion of separate section related to the independence of auditors There are 3 main exceptions to unqualified opinion: - qualified opinion generally satisfied, but disagree with mgmt - adverse opinion financial statement not presented in accordance to AAS disclaimer unable to express an opinion either way because of a limitation in th e works the auditors were able to do Even if unqualified opinion is expressed, a uditor will still alert reader to the facts in the financial statements, but not of such nature that it affects the audit opinion

6.9 The Nature of a Profession and Professional Ethics Professionals are recogni sed by post-secondary education 3 main professional accounting bodies ICAA (Inst itute of Chartered Accountants in Australia), CPA Australia and the NIA (Nationa l Institute of Accountants) If a professional accounting has not lived up to the standards of conduct held by the profession, he or she can be reprimanded or ex pelled by the profession and/or sued in court

ACCT1501 Notes Professional codes of ethics involve not only behaving in professional manner, b ut also maintaining the level of expertise required in order to perform skilfull y APES 110 Code of Ethics for Professional Accountants Five fundamental principl es: - Integrity - Objectivity - Professional competence and due care - Confident iality - Professional behaviour Compliance with the fundamental principles may b e threatened by various threats, including the following: - Self interest threat s undue dependence on total fees - Self review threats auditing systems on repor ts you designed - Advocacy threats promoting shares in a listed company you are auditing - Familiarity threats familial relationship with director or officer Intimidation threats threatened with dismissal etc Cheryl Mew

ACCT1501 Notes Chapter 7 Internal Control and Cash Cheryl Mew 7.1 Internal Control Internal control is a process, affected by an entitys board of directors, management and other personnel, designed to provide reasonable ass urance regarding the achievement of objectives in the following categories: - Ef fectiveness and efficiency of operations [also reduce risk of asset loss] - Reli ability of financial reporting - Compliance with applicable laws and regulations Internal control is not one event or circumstance but a process integrated with other basic management processes, such as planning and monitoring CEO is ultima tely responsible for internal control Internal control affects working life of m ost personnel Internal control can only provide reasonable assurance rather than absolute assurance to management and the board of directors regarding the achie vement of an entitys objectives Limitations of Internal Control: - Problems of hu man judgement not follow instructions - Managers may override prescribed policie s or procedures increasing revenue - Collusion between individuals can result in control failures - Internal controls cost money should apply cost benefit princ iple Internal control can be considered to be effective for each of the 3 catego ries if management and the board of directors have reasonable assurance that: They understand the extent to which operation objectives are being achieved - Fi nancial statements are being prepared reliably - Compliance with relevance laws and regulations 5 interrelated components of internal control: - Control environ ment integrity, ethical values and competence of entitys people - Risk assessment associated with change and establishing objectives - Control activities ensure necessary action for risk assessment - Information and communication internal an d external - Monitoring assess quality of systems performance over time ongoing m onitoring and separate evaluations

ACCT1501 Notes Control Activities Examples of control activities: - Top level reviews compared to budgets and forecasts to assess which targets are being achieved - Informatio n processing controls check accuracy, authorisation and completeness of transact ions - Separate record keeping from handling assets segregation of duties where person who physically handles assets is different to person who keeps records Physically protect sensitive assets Examples of Internal control Matching indepe ndently generated documents matching sales invoices and shipping documents Prenu mbering and sequencing checking of documents to prevent unauthorised use Compari son with independent third party info bank reconciliations of ledger accounts wi th bank statements Cancellation of documentation deal with cheques immediately S egregation of duties Demanding timeliness of operations prompt deposit of cash r eceipts and depositing cash intact Cheryl Mew

7.2 Internal Control of Cash Cash is the asset that is most susceptible to theft because of its liquid and generally anonymous nature Common control is locked i n sales registered or carefully controlled records Another way is to have multi copied, pre numbered sales invoices check cash sales, cash received, credit sale s, accounts receivable, inventory Prevent stealing cash / cheques there should b e more than one person opening, disable function to turn into cash, list of cheq ues received, should be posted to register, general ledger, accounts receivable of subsidiary records Payments of cash: properly authorised documents/invoices a nd cheques should be signed by 2 staff members who are independent of invoice ap proval and accounting duties, original invoice should be stamped paid

7.3 Bank Reconciliations Because of high frequency of transactions and potential for error, accuracy of cash balance in general ledger should be examined period ically Process is called bank reconciliation based on bank statement

ACCT1501 Notes Bank Reconciliation versus cash accounts Bank statements summarise the activity in a cheque account and report the ending monthly balance. Cash account of depos itor = asset, for bank = liability This is because when cash is deposited in the bank, the bank now owes the depositor money End of month bank statement cash ba lance normally wont agree with companys cash records Items on companys record but n ot on bank statement: - Deposits in transits receipts entered in a firm but not yet processed by the bank (debit for company > credit for bank) - Outstanding (u n-presented) cheques cheques written by business but not yet presented to the ba nk company issued cheque, but external person hasnt cashed it yet (credit for com p > debit for bank) Items reported on the bank statement but not yet entered in the companys record - NSF cheques (non sufficient funds/ dishonoured cheque) cust omer cheques deposited but refunded due to lack of funds (debit on bank statemen t) - Bank service charges for accounting processing - Notes receivable and inter est collected by the bank collection of interest or note is reported with a cred it memo notation because of depositors increase in account balance - Interest ea rned on the account In addition to timing differences, errors may cause a discre pancy between the bank statement balance and company accounting records Cheryl Mew

The reconciliation process

ACCT1501 Notes Cheryl Mew If balances do not agree and the reconciling items are deemed correct, there is a chance that a record keeping error has been made. Reconciliation not only high lights timing differences but also identify errors made by either the bank or th e depositor Bank reconciliations contain adjustments to both ending cash balance for bank and company records After reconciliation is completed, general journal entries must be prepared for adjustments made to company records Adjustments ne cessary to update cash account in relation to correction of company errors and i nfo processed by the bank No journal entries are needed for adjustments made to the ending bank statement balance These adjustments reflect items that have alre ady been recorded in a companys accounts thus no further updating is necessary 7.4 Performing a Bank Reconciliation from information in cash journals 1. Go thr ough last months bank reconciliation statement, ticking off any amounts that were outstanding last month Go through bank statement and tick off items appearing i n both CJs and bank Errors: if bank has mistake, inform bank of error. If busines s has made a mistake correct relevant cash journal Go through bank statement to see what amounts remained unticked Enter such amounts into CRJ or CPJ Go through CRJ and CPJ and see if there are any unticked amounts these are outstanding dep osits and unpresented cheques CRJ deposit in transit CPJ unpresented cheques Tot al CJs and post to bank ledger account Prepare bank reconciliation 2. 3. 4. 7.5 Petty Cash Under the petty cash system, a fund is established in making smal l payments, especially those that are impractical or uneconomical to make by che que. E.g. taxi fares or miscellaneous office needs To establish petty cash funds : Petty Cash DR Cash CR As payments are made from the fund, the custodian comple tes a form known as petty cash voucher

ACCT1501 Notes Each voucher indicates amount paid, purpose of expenditure, date and individual who received money Petty cash vouchers and invoices and receipts are evidences o f disbursements Cash remaining in fund + Petty cash vouchers + Invoices = Origin al amount Cheryl Mew Replenishing the fund To replenish fund Postage expense $$$ Office supplies expe nse $$$ ... $$$ Cash $$$ Note credit is to cash account Fund is restocked by wri ting cheque on the companys cheque account Replenished when funds are low, or at the end of each accounting period Process is necessary because no formal journal entries have been recorded

Errors in petty cash fund Occasionally petty cash vouchers and cash will not equ al original fund balance Adopt cash short and over account Shortage miscellaneou s expense Overage miscellaneous revenue item 7.6 Disclosure of Internal Control in Annual Reports Australian companies listed with ASX are now required to include section in their annual reports on corpora te governance. A number of companies include a description of internal controls in this section Common aspects of these descriptions: - Board of directors has r esponsibility for internal control system - Role of audit committee is noted - O perating budgets used to monitor performance - Internal audits are important par t - Controls are important in certain key area including treasury - These are cl early defined guidelines for capital investment

ACCT1501 Notes 7.7 Managers and Internal Control Cheryl Mew

Internal control is the responsibility of management Internal control should min imize errors and irregularities Errors unintentional mistakes, irregularities in tentional Irregularities should be detected except when there is collusion or ma nagement override No system of internal control can eliminate all errors and unc ertainties, but can decrease the possibility of them occurring and increase chan ces of detecting them Important question how much internal control is necessary Cost money to implement an extra internal control Must apply cost benefit analys is Difficult because benefits of having controls are often difficult to quantify Based on judgement 7.8 Public Sector Issues Internal control is an integral part of the environment of all public sector entities June 1995 NSW Treasury issued a statement of best practice internal control and internal audit Guidance for govt agencies on such t opics as responsibility for internal control, relationship between management pr ocesses and internal control; analysing risks and establishing controls and effe ctive collection of information, communication and monitoring 4 critical element s in an effective system of internal control for public sector entities Appropri ate tone at the top Well designed control system aimed at mitigating (explaining) risks Effective collection of info and communication thru agency Effectively mon itoring of system of internal control

ACCT1501 Notes Chapter 8 Inventory Cheryl Mew 8.1 Inventory Control Inventory control is an important issue for management bec ause a high percentage of working capital may be tied up in inventory. May be co nsumable or outdated, high potential for theft Choice of inventory is a record k eeping choice as opposed to a reporting choice

The perpetual inventory control method When an order of inventory items is rece ved, the quantity received is added to the quantity recorded as being already on hand. When they are sold, they are deducted from the recorded quantity Therefor e, the perpetual method shows how many items are supposed to be on hand at any t ime Inventory on hand = quantity on hand at beginning of period + quantity purch ased quantity sold Perpetual continuously updated figure Physical count of inven tory fails to show that quantity, therefore error or lost or stolen inventory Be ginning inventory cost (support with physical count if desired) + Cost of purcha ses of inventory (records) Cost of inventory sold (records) = Ending inventory c ost Debit expense, credit inventory Overage = negative expense where there is mo re inventory than expected Overage/shortage expense account would probably be in cluded with COGS in the income statement

The periodic count method If complete records of inventory changes are not kept, the enterprise does not have records to indicate what should be on hand The onl y way to tell is to count This is done periodically when inventory figure is nee ded for financial statements or insurance purposes this is called the periodic i nventory method. Periodic count method lacks the parallel record keeping that gi ves the perpetual method its value. There is no way to reconcile counts to recor ds in order to discover errors, but simple and cheap, as no continuing records a re kept Beginning inventory (count) + purchases (records) ending inventory (coun t) = Inventory sold (deduced); that is cost of goods sold

ACCT1501 Notes Because what is sold has been inferred, under the periodic method, cost of goods sold expense includes all other possibilities (lost, stolen...) Other forms of control need to exist to indicate theft or so on E.g. unexpected changes in the ratio of cost of goods sold to sales should be investigated Cheryl Mew

Inventory: Cost and benefits of controls Perpetual method can be costly i of record keeping Car dealership needs perpetual system Cars are expensive, so large investment must be made if a good supply is to be on hand for customers to choose from. Need to keep track of registration, insurance, serial numbers, oth er types of identification Because of small quantity of cars sold by dealerships , record keeping costs are not high. Similarly, companies selling more expensive items, e.g. TV, fridge, jewellery, use perpetual method Companies with large am ount of sales, particularly items with low value, use periodic inventory method because of lower costs. However, most organisations now use perpetual because of computer based inventory systems Retail companies have optical scanners scannin g barcode Assist with inventory control and helps with planning for ordering add itional inventory 8.2 Accounting Entries for Perpetual and Periodic Inventory Perpetual includes c osts of goods sold and inventory shortage expense Sales XXX Less cost of goods s old XXX Less inventory shortage XXX XXX Gross profit XXX Periodic excludes costs of goods sold and inventory shortage expense Sales XXX Cost of goods sold: Open ing Inventory XXX Purchases XXX Cost of goods available for sale Less ending inv entory XXX Costs of goods sold XXX Gross profit XXX

ACCT1501 Notes 8.3 Inventory Valuation and Cost of Goods Sold Inventory accounting uses a modif ied version of the standard historical cost valuation basis: lower of cost or ma rket value Application of accounting conservatism: anticipate no gains but allow for losses Inventory accounting affects both the balance sheet (inventory valua tion) and the income statement via the COGS Cheryl Mew

Inventory cost flow assumptions Cost of inventory varies Actual cost is usual tracked only for high value items (houses, motor vehicles) that can be identifie d by serial numbers and other methods Method specific identification As the cost o f keeping records decreases, because of computerisation, more items will be able to be tracked this way. Impossible to keep track of individual items in invento ry, so ASSUME flows of costs By using periodic method: first calculate COG avail able for sale Problem: how to allocate COG available for sale between COGS and e nding inventory asset Three common inventory cost flow assumptions: - FIFO First in first out sell the oldest items first (BS recent cost, COGS old costs) - AVG E weighted average assumption assume mixture of old and new items (average unit cost = total cost / total units) - LIFO Last in first out sell newest items firs t (BS old costs, COGS new costs) 8.4 More about Inventory Cost Flow Assumptions Assumption FIFO AVGE LIFO Periodic Control FIFO Weighted Average Periodic LIFO Perpetual Control FIFO Moving weighted average Perpetual LIFO

FIFO is not affected by inventory control method because it just assigns the mos t recent costs to whatever is on hand. Others depends on control method, as it d epends on what happened to inventory levels during the period Thus there is 5 me thods There is a six specific identification and 2 others

ACCT1501 Notes Cheryl Mew

In Australia, LIFO is not allowed to be used for either financial reporting or t ax purposes Because each assumption allocates the available inventory cost betwe en the inventory asset and the costs of goods sold expense differently, the choi ce of assumption has an effect on both the income statement and the balance shee t If there is little change in purchase costs, the various methods will show ver y similar results FIFO Used because its convenient where inventory asset are clos e to current costs Convenient because only need to keep invoices Doesnt matter wh ich control, because all info needed is the quantity on hand, whether by count o r by perpetual records Most popular cost flow assumption for inventories for lar ger Aust companies Considered appropriate for current asset because it is the mo st reasonable method of physically moving inventory, especially inventory that i s perishable or subject to changes in style AVGE When prices are rising, average cost shows a higher cost of goods sold (lower profit) and lower inventory balan ce sheet figures than the FIFO method LIFO In US, cost flow assumption used for accounting purposes does not have to match physical flow of items Allowable meth od for income tax purposes. E.g. rising inflation increases purchases costs, pro duces higher COGS, lower profit and lower inventory asset value used for tax pur poses Matches revenues and expenses more adequately. E.g. if company changes pri ces in response to purchase cost changes, its revenues reflect recent prices cha nges Problem: LIFO produces inventory asset values that are based on older purch ase costs, and this can substantially underestimate the asset value LIFO is affe cted by whether its amounts are determined using the periodic or perpetual contr ol methods,

8.5 An Example: MEEIX LTD Beginning inventory + purchases = cost of goods sold e xpense + ending inventory MUST refer back to pg 398 when studying. In a period o f rising purchase prices Inventory asset value: FIFO > AVGE > LIFO Cost of goods expense: LIFO > AVGE > FIFO

ACCT1501 Notes Larger differences in price, larger differences in end results of method Cheryl Mew 8.6 Lower of Cost or Market Rule The lower of cost or market rule states that th e value of inventory should be written down from the cost price to the market pr ice in situations where market is below costs To calculate the lower of cost or market value, we just take the cost of the items and match those costs against t he net realisable value and use the lower as the balance sheet inventory value. If inventory costs 1000 had a net realisable value at year end of 800: DR Invent ory Write down expense 200 CR Inventory 200

8.7 Retain Inventory and standard costs Retail inventory method is most app ion to retailers inventories Combines purchase costs and selling prices into a si ngle calculation/estimate Department is charged with total selling value (sale p rice x time) Revenue from sale is deducted from total value as items are sold Ti es inventory control to cash control AT any given point in time, inventory + cas h + receipts for credit cards = total retail value Retail price of all goods dep artment sales = inventory on hand priced at retail If physical count doesnt match then use shortage or overage Retail method is complicated in practice because o f the need to keep track of markdowns, returned goods, special sale prices and o ther price adjustments if the method is to work accurately Another popular metho d: standard costs Applicable to inventories manufactured by a company and uses e stimated costs based on standard production costs and volumes balances, purchase s and sales

8.8 Disclosure of Inventories Policies Accounting standards require the financia l reports disclose the value of inventory split between CA and NCA and further s plit into the following classes: - Raw materials and stores - Work in progress Finished goods - Land held for resale In addition requires disclosure of genera l basis of inventory valuation and methods used to assign costs to inventory qua ntities

ACCT1501 Notes Within one organisation, more than one method can be used and it may vary betwee n the type of product or the class of inventories Cheryl Mew

8.9 Managers and the valuation of inventory Managers have to choose control met od Perpetual better control, higher costs Important to managers as both profit f igures and balance sheet figures affect managers performance reports Therefore ma nagers need to understand the effect, across time, of different cost flow assump tions on financial statements Managers must make important judgements Which cost flow assumption must closely represent the actual physical flow? What inventory items have a net realisable value which is lower than cost? 8.10 Inventory in the public sector Inventory is not normally a material item fo r most public sector organisations. But there may be exceptions hospital bandage s, medicine When inventory does exist, the same accounting standards apply as in the private sector.

ACCT1501 Notes Chapter 9 Noncurrent Assets Cheryl Mew 9.1 The Cost of an Asset: Basic Components The basic premise of historic cost va luation is to use the cost of an asset, at acquisition to value that asset on th e balance sheet When machines are bought, there are certain conditions that must exist for the machine to operate, e.g. temperature, raised floor for wiring, fi re protection system Therefore a section of the factory must be renovated to mee t specifications of the machine These costs are known as installation costs Over all, the cost of an asset includes all those costs required to install it ready for use Should the interest on monies borrowed to finance the project be include d? Most the time, no Enterprises often have policies for how to determine whethe r expenditures, such as interest are included in assets costs Decision between wh ether to include costs as 1 years expense or included in assets Expense profits a nd income taxes for the year will be lower Assets total assets will be higher, a nd this years profit and tax expenses will also be higher Capitalising versus exp ensing choice When deciding where in BS maintenance goes, think about whether th ere is improvement or extension of useful life of asset. If yes asset, if no mai ntenance expense Common components of asset cost: - Land purchase price, costs o f clear title (legal fees), clearing unwanted items, draining - Building (purcha sed) purchase prise, renovation, decoration - Building (self-constructed) labour , material, insurance - Purchased Equipment installation, transport, testing

9.2 Depreciation of Assets and Depreciation Expense Depreciation an allocation o f cost as a deduction from profit over the useful life of the asset Depreciation expense annual deduction from revenue Depletion wasting assets are involved Amo rtisation intangible assets or leases are involved

ACCT1501 Notes Why Allocate the Cost? Cheryl Mew Assets are returns on investments In accrual accounting, some method is needed t o allocate the cost of long lived assets over their useful lives If whole asset cost was deducted in the year of acquisition, that years profits will be very low and subsequent years profits very high It would also mean that an asset has furt her benefits that is not recognised Allocation of cost in order to measure profi t NOT a system to tract value changes in assets or to measure the current value of those assets in the balance sheet Balance sheet shows the net of assets origi nal cost minus Acc Dep: it does not mean the assets current value is that net amo unt Why not depreciate land? Lands economic value is not considered to decline throug h use Land is not normally susceptible to physical or economic decline Equipment can be depreciated via physical causes (wear and tear) and nonphysical causes ( obsolete with the advent of newer and faster machine) Land is considered immune from all this, and is therefore not depreciated When does cost allocation (depreciation expense) begin? When the asset is put to use and the benefit begins to be realised, depreciation of the expense should b egin. Once asset has been put into service, further costs involved in painting, maintenance, repair and so on are now considered to be expenses If a cost that i s incurred significantly changes the assets economic value in earning revenue, e. g. betterment of asset, then cost may be capitalised as part of assets cost, then depreciated along with the rest of the asset. Other questions Depreciation is recognised by the following journal entry: DR De preciation Expense CR Accumulated Depreciation Accumulated depreciation is a con tra asset Depreciation is a prediction it is never exact Choice of accounting pu rposes does not affect the tax paid Why is depreciation any good, if its not exac t, it has no cash effect and it does not match market value changes in assets? I t is used to spread the cost out over the useful life of the asset, which matche s the presumed consumption of that cost with the benefits gained from that use

ACCT1501 Notes 9.3 Depreciation Bases and Methods Assumption Spread evenly over the assets life benefits is equal throughout useful life Falls over the assets life benefits decr ease as asset gets older Variable over the assets life benefits varies according to how much production is achieved each year Kind of Cost Allocation Straight li ne expense is the same each year Reducing balance method expense is larger in ea rlier years Units of production expense depends on each years volume of productio n Cheryl Mew Straight line depreciation Simplest and most widely used Need 3 pieces of info: - Cost of the asset: total cost to be depreciated over time - Estimated useful l ife: number of periods for which the asset is expected to benefit the enterprise - Estimated salvage value: amount expected to be recovered via the sale of the as set at the end of its useful life Depreciation for one period = Cost minus estim ated salvage value Estimated useful life (no. of periods) A common practice for many firms is to assume the salvage value of the asset to be zero, which then en ables depreciation to be expressed in terms of percentages instead of years

Reducing Balance method Next most common depreciation method Assets contribute m ore of their benefit to the enterprise in early parts of their lives Need 3 piec es of info: - Cost of the asset: total cost to be depreciated over time - Accumu lated depreciation: total depreciation recorded since acquisition - Depreciation rate: % of book value of the asset that is to be depreciated in the period Depr eciation for one period = (cost accumulated depreciation) x rate Reducing balanc e depreciation does not normally take into account salvage value

ACCT1501 Notes Reducing balance percentage: r = 1 - n r = required depreciation rate n = estima ted life in years s = estimated residual value c = original cost Cheryl Mew Units of Production Depreciation and Depletion Also used to compute depletion of natural resources Need 3 pieces of info: - Cost of the asset: total cost to be depreciated over time - Estimated salvage value: amount expected to be recovered v ia the sale of the asset at the end of its useful life - Estimated number of uni ts to be produced during the life of the asset Depreciation for one unit = Cost minus estimated salvage value estimated no. of units of production during life T o determine the depreciation for one year, the charge per unit is multiplied by the number of actual units produced or used Whichever method is adopted, the com pany can always adjust its calculations later if the expectations about length o f useful life or salvage value begin to look seriously inaccurate For now, note that it is usual to allocate the remaining book value over the remaining useful life

9.5 Gains and Losses on Noncurrent Asset Disposals Selling off assets are kept s eparate from ordinary revenues via the following kind of journal entry: E.g. Tru ck bought at 50,000. Depreciates at 8,000 each year. Sold at end of 2nd year for 37,000 Net book value of truck = 50,000 16,000 = 34,000 Journal Entry for selli ng truck: Cash 37,000 Accumulated Depreciation 34,000 Truck asset 50,000 Revenue on sale of truck 3,000 If there is a loss, it will be debit revenue Think of ga ins and losses as depreciation corrections

ACCT1501 Notes 9.6 Assets Revaluations Cheryl Mew

Carry amount book value Fair value amount for which an asset could be exchanged between knowledgeable willing parties in an arms length transaction In Australia, directors need to ensure that the carrying value of an asset exceeds the recove rable amount. If not, the carrying value must be reduced to its recoverable amou nt impairment loss Recoverable amount assets fair value costs to sell it, or an a ssets value in use whichever is higher Value in use is the present value of futur e cash flows that are expected to be derived from an asset Accounting standards state that each class of noncurrent assets must be measured using either the cos t model or the revaluation model Cost model after recognition of an asset, the a sset is carried at cost less accumulated depreciation and any accumulated impair ment losses Revaluation model after recognition of an asset, the asset whose fai r value can be measured reliably is carried at a revalue amount, which is the fa ir value at the date of revaluation less any subsequent accumulated depreciation and subsequent accumulated impairment losses Revaluing upwards revaluation incr ement increase in asset account and shareholders equity (asset revaluation reserv e) Revaluing downwards revaluation decrement decrease in asset account and incre ase in expense account Increments in asset valuations do not generally affect pr ofit directly, but decrements do reduce the profit for the year Changes in asset valuation (except for land) result in different depreciation expenses in subseq uent years When an asset is revalued, all assets within the same class of assets should also be valued at the same time on a consistent basis. Exception: downwa rds valuation Land Revaluation increment: DR Land CR Revaluation Reserve Land Re valuation decrement: DR Loss on devaluation of land CR Land Equipment Revaluatio n increment DR Accumulated Depreciation CR Equipment DR Equipment CR Revaluation Reserve

ACCT1501 Notes 9.6 Intangible Assets Cheryl Mew

Intangible assets are identifiable, non-monetary assets that do not have a visib le physical existence, unlike land, buildings or equipment Intangible Assets inc lude: - patents, copyrights, trademarks and other such legal property - brand na mes, which can be registered to maintain exclusive use - franchises, distributor ships and other rights to sell someone elses products in a certain geographical a rea - deferred charges such as incorporation costs, financing costs and other it ems that are really long term prepaid expenses - development costs (including pr oduct development costs and mineral exploration costs), which are capitalised an d later expensed at the time they earn revenue in the future strict criteria app lies AASB require organisations to charge all research costs to an expense accou nt when they are incurred. Organisations prohibited from capitalising any expend iture associated with internally generated brands, publishing titles, customer l ists and similar items What are intangible assets worth? Existence and value of intangible assets may b e doubtful generally the more clearly identifiable and documented, the less diff iculty they pose Assets such as brand names, trademarks and franchises have cons iderable doubt about their economic value Development expenditures question on w hether they belong on the balance sheet at all. is it for sure that the product will sell and that it will bring future economic value? will the revenue be larg er than the costs? Amortisation or impairment of intangibles Legal useful life is different from ec onomic useful life If useful life is finite intangible is amortised If useful li fe is indefinite intangible would be tested annually for impairment, by comparin g carrying amount with recoverable amount If carrying amount > recoverable amoun t, then impairment loss 9.8 Goodwill Goodwill arises when more is paid for a group of assets, such as a whole business, than the assets seem to be worth individually

ACCT1501 Notes The rationale for paying the additional amount may be based on such factors as h ow the business is organised or the number of customers it has Goodwill occurs t o keep the books in balance Purchased goodwill is measured as the excess of the cost of acquisition of another entity over the fair value of the identifiable ne t asset and contingent liabilities Externally generated goodwill is recognised b y the accounting system. It is a transaction, supported by documentation, that s hows how much was paid Internally generated goodwill not recognised by accountin g system e.g. better management and improving friendliness of staff Internally d eveloped goodwill is never capitalised cannot put an economic value on it yet e. g. expenditure on office parties to keep employees happy is an expense Following the acquisition of goodwill, rather than amortising it over a deemed useful lif e an entity will test it for impairment on an annual basis Or more frequently, i f events or changes in circumstances indicate that the goodwills carrying value h as decreased below its recoverable amount Cheryl Mew

9.9 Financial Leases Leases are rental agreements in which one individual (lesse e) pays, to the owner of a property (lessor), a certain amount in return for the right to use that property over a predetermined period Concern: some companies use leases to avoid putting assets on balance sheet As a result, AASB establishe d 2 types of leases: finance leases and operating leases Finance leases when all the risks and benefits incidental to ownership are substantially transferred to the lease Cost present value of the future lease payments using an appropriate interest rate usually deducted from the lease agreement At the same time present value of those payments is recorded as a liability DR Finance lease asset CR Fi nance lease obligations liability After that: 1. Leased asset is amortised 2. Li ability is reduced as payments are made on the lease. Each payment includes inte rest, but only principle deducted. This maintains the liability at the present v alue of the remaining lease payments 3. Expenses for using the leased asset are amortisation and interest 4. Various particulars of significant capital leases a re usually disclosed in the notes to the financial statements so that the reader s of the statements may judge the effects of such capitalisation Result: leased asset is treated essentially as if it were owned

ACCT1501 Notes Accrual accounting recognises the economic value of the asset and disregards the legalities of who owns it If the lease does not result in the economic equivale nce of ownership if it is really a rental situation where the owner is responsib le for repairs, the lease is an operating lease Cheryl Mew 9.10 Reporting of Non Current Assets and Associated Depreciation/Amortisation Th e Corporations Act 2001 and AASB require certain disclosures concerning noncurre nt assets and their related depreciation/amortisation. These include: - Deprecia tion and amortisation expense - Cost and accumulated by major classes of assets - Description of policies with regards to D/A - Details concerning revaluation If items are measured at fair value include carrying costs and other costs - St atement that assets have not been valued above their recoverable amount - What t he recoverable amount is fair value cost to sell/value in use 9.11 Managers and Noncurrent Assets Managers need to make many judgements relate d to noncurrent assets. What should be included in the cost of an asset? What pe riod/method should it be depreciated? Value on brand names? When should assets b e revalued and who should do the revaluing? All of the above judgements (except upward revaluation) will affect the enterprises profit figure, which is a key ind icator of management performance

9.12 Public Sector Issues Infrastructure system assets include items such a ds, water supply, bridges and transmission lines Generally valued by govt depart ments at cost or written-down replacement value (estimated replacement value acc umulated depreciation) Difficulty in obtaining these figures Heritage assets can not be replaced Valuation of $1 highlights to readers that an asset exists, but at this point in time it is not clear how to value it. E.g. Library collection h eld by State Library In general, a number of factors have a bearing on the diffi culty of reliably measuring the assets of public sector entities. E.g. completen ess of asset registers, type of asset, extent of assets similarity to other asset s used in other govt departments Such assets e.g. historic buildings, gardens, m onuments

ACCT1501 Notes Chapter 13 The Statement of Cash Flows Cheryl Mew

13.1 The purpose of Cash Flow analysis Cash is the most important asset to an ntity Many firms have had positive profit figures, but have still run out of cas h and gone bankrupt Important for present and potential investors and creditors to have info about a firms cash inflows and outflows and its resulting cash posit ion Solvency the ability of a firm to meet all its debts and obligations as they are due Liquidity enough cash and short term assets now to recover its immediat e debts and obligations Too much cash large supply of cash idle does not yield g reat returns for investors Cash should be put to work by making investments and attract new customers Statement of cash flow provides info on a firms generation and use of cash and highly liquid short-term assets, hence assist in evaluating the firms financial viability Cash profit is not a complete measure of what has h appened to the cash Certain inflows or outflows of cash are not part of the proc ess to generate revenue and incurring expenses, so they would not be covered eve n by a cash profit measure Purpose of cash flow analysis: - produce measure of p erformance that is based on day-to-day cash flow: cash generated by ordinary bus iness activities, instead of accrual accounting different perspective on perform ance and therefore enhances the info for users - incorporate other non-operating cash inflows and outflows, such as from investing in new assets, selling old on es, borrowing or repaying debts. By including these non-operating cash flows, th e statement of cash flows can provide a complete description of how the firms cas h was managed during the period. With all this info, the user can evaluate manag ements strategy for managing cash and make a better judgement of the companys liqu idity, solvency, risk and opportunities than could be made just from the balance sheet and income statement

ACCT1501 Notes 13.2 Overview of the Statement of Cashflows Cheryl Mew Classification of Cash Flow Transactions Operating activities relate to provisio n of goods and services Investing activities relate to the acquisition and dispo sal of noncurrent assets, including property, plant, equipment and other product ive assets, and investments such as securities, that do not fall within the defi nition of cash Financing activities relate to changing the size and composition of the financial structure of the entity, including equity, and borrowings not f alling within the definition of cash

ACCT1501 Notes Some important features of this format: 1. Same period as income statement 2. In clude some equivalents: very liquid near cash assets 3. Cash may include tempora ry negative bank balances (overdrafts) 4. Uncertainty explained in the notes to financial statements 5. Focus must stay on cash 6. Transactions without cash are not included 7. Any numbers can be positive or negative 8. Deriving cash flow A ust = direct method (start from cash receipts to cash payments). Some other coun tries = indirect method (start with accrual net profit, then remove effects on p rofit of non-cash expenses and revenues) Cheryl Mew

ACCT1501 Notes Chapter 14 Financial Statement Analysis 14.1 Investment and Relative Return Relative return (return on investment / ROI) = Return Investment Cheryl Mew Main points about ratios: - Purpose: produce a scale free (because its dependent on same units and size of company), relative measure of a company that can be us ed to compare with other companies, or other years for the company - Ratio may b e unreliable and misleading, if numerator/denominator is inappropriate. Return c an imply EBIT, net profit or cash flow 14.2 Introduction to Financial Statement Analysis Purpose of financial statement analysis: use statements to evaluate an enterprises financial performance and fi nancial position Value of the analysis depends on the value of the financial sta tements Financial Evaluation is not just a calculation Not just a calculation it is a ju dgement based on the calculations that make sense for that company and based on substantial knowledge of the company The more info knew about business, mgmt and acct, the more useful and credible the analysis Affected by its own quality whe ther the statements have been carefully prepared and are comparable with other c ompanies Affected by availability of other sources of info that may contain all or part of what is in the financial statements Financial acct info is a part of a network of info, not a stand-alone item. Preparation for intelligent analysis Requires aim and substantial knowledge of t he enterprise Scale free ratios means that it allows comparisons over certain pe riods of time, among companies of different sizes and with other indicators such as interest rates or share prices In order to do an intelligent and useful fina ncial statement analysis: 4. Learn about the enterprise, its circumstances and i ts plans look at descriptive sections of annual reports and footnotes to financi al statements 5. Obtain a clear understanding of the decision or evaluation to w hich the analysis will contribute, who the decision maker (investor, lender, cre ditor, management) is and what assistance is required 6. Calculate the ratios, t rends and other figures that apply to the problem 7. Find whatever comparative i nfo you can to provide a frame of reference for your analysis industry data, rep orts by other analysts, etc.

ACCT1501 Notes 8. Focus on the analytical results that are most significant to the decision mak ers circumstances, and integrate and organise the analysis so that it will be of most help to the decision maker. The preparer of financial statements can choose between a number of accounting policies on which to base the financial informat ion May want to review such policies, e.g. deducing goodwill from assets, before computing ratios Validity of financial analysis based on accounting rations has been challenged HISTORICAL DATA Stock markets and other capital markets adjust prices of companies securities as info comes out, ratios based on publicly availa ble info cannot tell people anything the markets have not already incorporated i nto security prices. Cheryl Mew

14.3 Common Size Statements Whilst focus on chapter is ratio analysis, another m ethod to analyse financial statements is common size statements By calculating a ll balance sheet figures as a percentage of total assets and all income statemen t figures as a percentage of total sales revenue Sizes of companies is factored out This procedure assists in comparing companies of different sizes and in spot ting trends over time for a single company 14.5 Financial Statement Ratio Analysis Ratios are usually done to 2 decimals Th ey could be done to more decimals, but that would be false accuracy This is beca use ratios depend on all sorts of judgements and estimates made in assembling th e financial statements There should not be thought of as precise quantities but rather as indicators Profitability Ratios Return on equity (ROE) = Operating profit after tax shareho lders equity Indicates how much return the company is generating on the historica lly accumulated shareholders investment There are different versions of ratio e.g . instead of closing year-end equity, Woolworths uses average equity

ACCT1501 Notes Return on assets (ROA) = Operating profit after tax total assets Determines the after tax return the managers are earning on the assets under their control Alte rnative ROA = EBIT total assets Determines the return on assets under managements control Total assets can be year-end figure, or the average over the year Denom inator can also be gross assets (Assets before depreciation) and net assets Incr ease in ROA means that company has a better return on assets under their control Du Pont Formula: ROE = ROA x Leverage Leverage = Total Assets Total Shareholders Equity Indicates how much of the companys assets are financed by equity The high er the ratio, the smaller the shareholders funding of assets, the greater the pro portion of total assets that must have been funded by debt Return on assets indi cates the companys ability to generate a return on its assets before considering the cost of financing those assets Helps judging whether borrowing is worthwhile Cheryl Mew

Profit Margin =

Operating profit after tax Sales Measures performance of managers in converting sales to net profit Average profit on each dollar of sales Useful indication of pricing strategy or competition intensity Alternative Profit Margin = EBIT Sales Measures the ability of mangers to generate profit from sales Gross Margin = Sa les COGS Sales Indicates whether sales are profitable Also known as gross profit ratio Further indication of companys product pricing and product mix If Gross Ma rgin = 33%, then revenue = 150% of cost, so mark up of 50% Increase in profit ma rgin either due to increase in gross margin or decrease in expenses as a percent age of total sales

ACCT1501 Notes Cash flow to total Assets = Cash flow from operations Total Assets Determines th e companys ability to generate cash resources relative to companys size Approximat ely factors out size Alternative measure of ROA, focusing on cash returns rather than accrual profit Earnings per share (EPS)= Cheryl Mew

Operating profit after tax preference dividends Weighted no. of ordinary shares outstanding Relates earnings attributable to ordinary shares to the number of sh ares issued Profit figure is after deducting outside equity in the operating pro fit Weighted no. of ordinary shares outstanding should be provided should not be calculated by outsiders If company has commitment to issue more shares, potenti al effect of the exercise of such commitments is calculated by showing both basi c EPS and diluted EPS Dilution refers to the potential of lowering returns to cu rrent shareholders as a result of other peoples exercising rights Price to earnin gs ratio (P/E) = Current market price per share EPS Relates to the accounting ea rnings to the market price per share to reflect present company performance with market expectations Since relationship between such earnings and market price o f shares is not straightforward, interpretation is controversial Idea is that be cause market price should reflect the markets expectation of future performance, P/E compares the present info with those performances High P/E means that compan y will do better in the future e.g. popular companies with good share prices P/E is highly subject to general increases and decreases in market prices, so it is difficult to interpret overtime and is more useful to compare similar companies listed in the same stock market at the same time Dividend Payout Ratio = Annual dividends declared per share EPS Measures the portion of earnings paid to share holders Stable ratio company has a policy of paying dividends based on profits V ariable ratio factors other than profits are important in the directors decisions to declare dividents

ACCT1501 Notes Activity (Turnover Ratios) Cheryl Mew

Total Asset Turnover =

Sales Total Assets Determines the amount of sales volume associated with each do llar of assets Similar turnover ratios relate the companys sales volume to its si ze Turnover and profit/margin ratios are used together, because they tend to mov e in opposite directions High Turnover = Low margins and vice versa Pricing low and trying for high volume versus pricing high and high profit This is because c ompetitive pressures are likely to force down selling prices and therefore profi t margins if a high turnover is desired Represent contrary marketing strategies or competitive pressures How much revenue is the company getting out of each dol lar of assets? ROA = profit margin x Asset Turnover

Inventory Turnover =

COGS Average Inventory Relates the level of inventory to the volume of sales act ivity A company with low turnover may be risking deteriorating level of inventor ies and or may be incurring excessive storage and insurance costs Inventory turn over can be converted to measure how long inventory in days, inventory is held o n average Days in inventory = 365 Inventory turnover Measures how long on averag e, inventory is held in stock Debtors Turnover = Credit Sales Trade Debtors Relat es the level of debtors to the volume of credit sales activity Also called accou nts receivable turnover Credit sales may be hard to find as sales is one section Trade debtors refers to gross trade debtors (before deducting allowance for dou btful debts) Days in debtors = 365 Debtors turnover Measures how long it takes on average, to collect outstanding debtors

ACCT1501 Notes Liquidity Ratios Cheryl Mew

Current Ratio =

Current Assets Current Liabilities Indicates whether the company has enough shor t term assets to cover short term debts >1 working capital +ve, <1 working capit al ve Working capital = current assets current liabilities Usually, high CR = fin ancial stability But if CR is too high, it implies that the firm is not reinvest ing in LT assets to maintain future productivity Also indicate problems if inven tories are getting larger than they should or collections of receivables are slo wing down Static ratio measuring financial position at a point in time and not c onsidering any future cash flows the company may be able to generate to pay its debts Most useful for companies that have relatively smooth cash flows Hardest t o interpret for those who have unusual assets or liabilities, or depend on futur e cash flows to pay current debts Low current ratio is common for large companie s quick cash flow cycle In general, can buy inventory, sell it and get cash befo re they have to pay their accounts payable Quick Ratio = Cash +AR + Short Term I nvestments Current Liabilities Indicates whether current liabilities can be paid immediately Also called the acid test Includes all assets except inventory Rati o is particularly useful for companies that cannot sell inventory quickly Intere st Coverage Ratio = EBIT Interest Expense Indicates the ability of the company t o pay interest on borrowings from profit This and similar coverage ratios based on cash flow figures indicate the degree to which financial commitments are cove red by the companys ability to generate profit or cash flow Low coverage level (e specially less than 1) means that company is not operating at a sufficiently pro fitable level to cover the interest obligation comfortably, and may also be a wa rning of solvency problems

ACCT1501 Notes Financial Structure Ratios Debt to Equity Ratio = Total Liabilities Total Shareh olders Equity Measures the proportion of borrowings to the investment by owners I ncludes retained profits Ratio greater than 1 means that liabilities are mostly financed with debt Ratio less than 1 indicates that liabilities are mostly finan ced with equity High ratio = warning about risk: company is heavily in debt rela tive to its equity and may be vulnerable to interest rate increases Cheryl Mew

Debt to Assets Ratio =

Total Assets Total Liabilities Indicates the proportion of assets financed by li abilities Ratio highly correlated with debt to equity ratio

Leverage =

Total Assets Total Shareholders Equity Indicates how much of the companys assets a re financed by equity The higher the ratio, the smaller the proportion of total assets funded by shareholders equity, and therefore, the more funded by debt Summary Ratios are a quick method of breaking info in the financial statement in to a form that allows comparability with similar companies and with the financia l performance of the company over a number of years Advantage: different ratios consider different parts of a companys performance User do NOT only rely on ratio s also on notes to the financial statements, auditors report, etc Notes to the fi nancial statements provide further explanations of some key areas in the stateme nts, e.g. accounting policies, detailed calculation of some account values, etc