Chapter 13

Purchase return: the return of stock by our firm to a trade creditor.

Sales return: the return of stock to our firm by a trade debtor.

Reasons for return of stock

● Wrong product(size, colour, shape, model)
● Faulty/damaged stock
● Oversupply
● Change of mind(just don’t like the product)

Purchase or sales return?

● Purchase return is when our firm is in middle of credit note
● Sales return is when our firm is on top of the credit note

Purchase return and the accounting equation

● Assets decrease(stock control)
● Liabilities decrease(GST clearing increase, creditors decrease)

Sales return and the accounting equation

● Assets decrease(debtors control decrease, stock control increase)
● Liabilities decrease(GST clearing)
● Owner’s equity decrease(Sales return increase, Cost of Sales decrease)

General Ledger
Sales return:
Debit Credit

Sales return Debtors Control

GST clearing Debtor-(name)

Stock control Cost of Sales

X items returned by customer: (reason)-Credit Note ___

Purchase Return
Debit Credit

Creditors Control Stock control

Creditor-(name) GST clearing

X items returned to supplier: (reason)-Credit Note___

Income Statement
Revenue
Sales
Less sales returns
=Net sales

Chapter 14
Cost of Stock: all costs incurred in order to bring stock into a location and condition ready for sale.

Cost of stock = product costs + period costs

Principles & Characteristics and the Valuation of Stock

Stock should be valued at it’s Historical Cost as that is the most Reliable value.
However when selling price is lower than cost price, it should be valued at its NRV to uphold Conservatism as
stock is valued at its lower value so that assets are not overstated, disregarding Reliability but upholding
Relevance, as the NRV is the value that is more useful in decision making than the Historical Cost.

Product Cost: a cost incurred in order to bring stock into a condition and location ready for sale that can be
logically allocated to individual units of stock.
● Stock is valued on a stock card at its product cost.
● Product costs are accounted for in the Income statement as part of Cost of Sales

Period Cost: a cost incurred in order to bring stock into a condition and location ready for sale that cannot be
logically allocated to individual
● Period costs are included in the income statement as part of Cost of Goods Sold(e.g freight in)
● If product costs are classified as period costs then:
○ Assets(stock value) are understated
○ Owner’s equity is understated(as COGS is overstated, and profit understated)

Net Realisable Value(NRV) rule: Stock must be valued at the lower of ‘cost’ and ‘Net Realisable Value’

NRV: estimated selling price - direct selling expenses(any costs involved in its selling, marketing or
distribution)
● Therefore stock should be valued at NRV when it is lower than cost price.

Stock Write-down: the expense incurred when the NRV of an item falls below its original purchase price.
● Stock write-down = HC - NRV

Reasons for Stock Write-down

● Physical deterioration
● Marketing ploy
● Decrease in demand
● Obsolescence/out of date

Stock write down is reported in the Income Statement under Gross Profit, hence changing Adjusted Gross
Profit.

Stock write-down and the accounting equation

● Assets decrease(stock control)
 ● Owners’ equity decrease(expenses increase, Net profit decrease)

Chapter 15
Credit purchase of non-current asset
General Journal
 ● Debit: NCA
● Debit: GST clearing
● Credit: Sundry Creditor - ____(name)
● Narration: credit purchase of __(name of NCA, eg. fittings)

Sundry creditor vs creditors control

● Creditors control only relates to credit purchase of stock, sundry is related to all other credit purchases

Cash flow statement

● Investing outflow

Cost of a non-current asset: all costs involved in getting a NCA into a condition and location ready for use
that will provide a benefit for the life of the asset. (e.g installation, modification, delivery costs)
Depreciation: the allocation of the cost of a NCA over its useful life.

Accumulated depreciation: the value of the NCA that is that has been consumed over its life so far.

Carrying Value: the value of the NCA that is yet to be consumed/allocated as an expense + any RV.

Purpose of Depreciation
● Ensure that accurate profit is calculated, by comparing revenue earned against expenses incurred in
the current Reporting Period
● Depreciation recognises only the part of the asset that has been consumed within the Reporting
Period as an expense, ensuring the Income Statement upholds Relevance by including all information
useful in decision making.

Methods of Depreciation
Reducing Balance Method:
Depreciation expense($) = Carrying Value x Depreciation Rate
● Used when assets contribute to more revenue at the start of its life than its end.
● Usually has movable parts.
● Depreciation expense is greater as start of assets life, and less later on.
● Ensures that revenue earned by the NCA is matched with the expenses incurred so that a more
accurate profit can be calculated in each Reporting Period.

Straight line method:

Depreciation expense($) = HC - RV/ Life OR
HC x Depreciation Rate
● Used when assets contribute to revenue evenly over its useful life

Similarities and Differences

● Both affect the same accounts/ledgers; i.e.
○ Depreciation- NCA(E) → Decrease in net profit, decrease in OE
○ Accum Depn(-A)
● Both end with the same RV at the end of the asset’s useful life
 ● Affects accounts by varying amounts
○ Straight line method depreciation expense will be the same every year.
○ Reducing balance method depreciation expense is higher at start and decreases as NCA ages.
■ Therefore Net Profit would be lower at start and higher at end of assets life, than if
straight line method was used.
■ Carrying value decreases faster than using straight line method

Disposal of NCA
Three steps:
1. Transfer the Carrying Value
2. Record proceeds from the sale(selling price of asset)
3. Transfer profit or loss on disposal of asset

Cash Sale of NCA

On 31 January 2015, Duke Industries sold some equipment for $1 100 cash (Rec. 17). The equipment had
originally been valued at $12 000, but accumulated depreciation amounted to $10 000 when it was sold.
General Ledger Subsidiary Ledger

Date Details Debit Credit Debit Credit

Jan 31 Disposal of Equipment 12000

Equipment 12000

Accum Depn - Equipment 10000

Disposal of Equipment 10000

Loss on Disposal of Equipment 900

Disposal of Equipment 900

Disposal of Equipment at a loss (rec 31)

Cash receipts Journal

● $2000 in sundries column of CRJ

Trade-in of NCA
● Same General Journal entries with additional general journal entry instead of CRJ entry.
● Normal credits purchase of NCA entries added
General Ledger Subsidiary Ledger
Date Details Debit Credit Debit Credit

Jan 31 Sundry Creditor - IQ Motors 2000

Disposal of Equipment 2000

Profit/Loss on Disposals of NCA

● Profits go under Other Revenue in Income Statement
● Losses go under Other Expenses in Income Statement

Under-depreciation(reason for loss on disposal): occurs when insufficient depreciation has been allocated
over the life of the asset, so that the carrying value of the asset is overstated
● Because RV or Useful Life was overstated
Possible reasons:
● Damage
● Outdated(superseded by newer model)

Over-depreciation(reason for profit on disposal): occurs when excess depreciation has been allocated over
the life of the asset, so that the carrying value of the asset is understated
● Because RV or Useful Life was understated
Possible Reasons:
● Good condition/better than expected → longer useful life
● High demand(rare)

Chapter 16

Profit = Revenue earned - Expenses incurred

● Balance day adjustments are made so that all revenue earned and expenses incurred in the Reporting
Period are reported in the income statement of the Reporting Period.
● This ensures Relevance as Balance day adjustments include information that is useful in decision
making in the the reports and records.

Prepaid Revenue: revenue that is received and yet to be earned

 ● When goods/service are provided to customer, prepaid revenue is debited, and revenue is credited
● Prepaid Revenue is a CL

Account Equation and Earning of Prepaid Revenue

● Liabilities(prepaid revenue) decrease
● Owners equity(revenue increases Net Profit) increase

Accrued Revenue: revenue that is earned but not yet received

Accrued Revenue vs Debtors

● Verified by memo instead of invoice
● R
elates
to
reven
ue
other
than
sales
Accounting Equation and Accrued Revenue
● Increase in assets(accrued revenue)
● Increase in owners equity(increase in revenue, increase in Net Profit)

Chapter 17
Budgeting: the process of predicting/estimating the financial consequences of future events

Budgeted vs Actual Reports

● Budgeted reports future events vs historical events
● Consequently, budgeted reports are an estimate rather than actual, verifiable data.

Purpose of Budgeting
● Assist planning by predicting what is likely to occur in the future.
○ Allows owner to prepare for possible problems and take on possible opportunities
● Aid decision making by providing a standard or benchmark which actual performance can be
measured
○ Allow owner to identify areas where performance is unsatisfactory, so corrective action can be
taken

Budgeting Process
Budgeted Cash Flow Statement
● Ideally the budgeted Net Cash Flows from Operations will be positive.
● This means that the business is able to generate sufficient cash from Operations to meet its ongoing
obligations
● If operations are expected to be negative the owner can
○ Increase inflows by..
■ Increasing sales(by discounting goods, increases advertising)
■ Increasing receipts from debtors(by contacting slow payers or discounting early
payment)
○ Decrease outflows by..
■ Deferring payments to creditors.. Or paying early to get a discount
■ Cut back on cash paid for expenses(however, owner must be mindful as decreasing
outflows may also consequently decrease inflows by decreasing sales)
● Investing Net Cash Flows are expected to be negative, as the sale of a NCA is pretty rare.
● Whether Net Cash Flows are positive or negative for Financing Activities depends on whether
business is expanding or simply continuing operations
● There is a relationship between Financing and Investing Activities; negative Investing cash flows
could be financed by a positive Financing cash flows(i.e loan or capital contribution).

Consecutive Budgets
+ Allows owner to identify monthly and seasonal trends
+ Allows owner to identify problems earlier and take corrective action earlier, minimizing losses and
maximising gains
+ Greater accuracy of reports(more useful comparison) so gains will not be overstated and losses not
understated
- Time consuming(mostly computerized however some parts of budgeting may still require more time for
the owner, which they could be spending to earn more revenue/improve the business)

Budgeted receipts from debtors and payments to creditors

● Not all credit sales are excluded from the Budgeted Cash Flow Statement.
● Schedule of collections is a table used by businesses (that sell stock on credit to help predict cash
inflows from debtors by identifying how much percentage pay in the first month, second, and so on.
● Similarly, schedule of payments is a table used by businesses (that purchase stock on credit) to help
predict cash outflows to creditors.
 ● In both tables, you must deduct discounts from amounts.

Uses of Budgeted Reports

Cash Flow Statement
● Assists in planning by allowing owner to prepare for a cash surplus or deficit
● Aids decision making by setting a benchmark for cash performance
Income statement
● Aids planning because it indicates the future requirements of the firm relating to issues such as staffing,
stock levels or advertising campaigns.
Balance sheet
● Aids planning for replacement of NCA(based on carrying value), repayment of loans, and to set
drawings
● Assists decision making my setting benchmark for liquidity & stability indicators(e.g WCR & DR)
Cash Vs Profit
Cash Both by Varying Amounts Profit

Operating Operating ● Stock loss/gain

● GST ● Credit Sales(Profit) & ● Depreciation
Receipts from ● Bad debts
Investing Debtors(Cash) ● Stock write down
● Purchase of NCA ● Cost of sales(profit) &
● Cash payments for NCA payments of stock (cash)
● Accrued/prepaid items
Financing
● Loan Investing
● Capital contribution ● Loss/gain on
● Drawings disposal(profit) & Sale of
NCA(cash)

Account Reconstruction

1. Identify the entries we would expect to see in a particular ledger account(use template)
2. Match these entries with known figures
3. Complete the ledger account to calculate the figures that are not known.

Variance Reports
● Favourable(F) means that cash(for cash budget variance) or profit(for income statement variance) is
higher than expected
● Unfavourable(U) means that cash or profit is lower than expected.

Uses of Variance Reports

● Aids planning for next budgeted report so it’s more accurate
● Assists in decision making by identifying the unfavourable variances so corrective action can be taken.
Chapter 18
Profitability: the ability of the business to earn profit, as compared against a base, such as sales, assets of
owner’s equity.

Profit vs Profitability
● Profit is simply Revenue less Expenses.
● However, sales, assets and owner’s equity all contribute to determining the firm’s profitability(ability to
earn profit)

Analysing: examining the financial reports in detail to identify changes or differences in performance.
Interpreting: examining the relationships between the items in the financial reports in order to explain the
cause and effect of changes or differences in performance.

Trend: the pattern formed by changes in an item over a number of periods.

Variance: highlights if trend is favourable to unfavourable.
Benchmark: an acceptable standard against which the firm’s actual performance can be assessed.
● Performance in previous periods
● Budgeted performance for the current year
● Performance of other similar firms

Profitability Indicators
● ROI
● ROA
● ATO
● NPM
● GPM

Return on Owner’s Investment (ROI)

● Measures how effectively a business has used its capital or earn profit.

● ROI =
● ROI should be measured with Debt Ratio
● Debt Ratio: a stability indicator that measures the percentage of the firm’s assets that are financed by
liabilities.
 ● Debt ratio =
● Higher debt ratio → higher ROI
● Lower debt ratio → lower ROI
● The owner must judge carefully that the Debt Ratio is high enough to maximise the Return on Owner’s
Investment, but not too high that it will create difficulties for the business in relation to its debt burden.

Return on Assets (ROA)

● Measures how effectively a business has used its assets to earn profit

● ROA =
● ROI will always be higher than ROA, because OE will always be lower than total assets, due its
liabilities
● Assuming assets do not change, an improvement in the ROA may be the result of an improved ability
to earn revenue or expense control.

Asset Turnover (ATO)

● Measures how productively a business has used its assets to earn revenue

● ATO =
● ATO and ROA are similar as they both assess the firm’s ability to use its assets
● Difference is ROA relates to profit, ATO only relates to revenue.
● Where the ATO and ROA move in different directions, or differing degrees, it indicates a change in
expense control.

Expense control: the firm’s ability to manage its expenses to that they either decrease or, in the case of
variable expenses, increase no faster than sales revenue.
● Variable expenses: Cost of Sales, Wages, Advertising
● If expense control improves, profitability should also improve.
● The ‘margins’ help evaluate expense control

Net Profit Margin

● Measures expense control by calculating the percentage of sales revenue that is retained as net profit.

● NPM=
● ROA depends on both the ATO and NPM
● ATO * NPM = ROA

Gross Profit Margin (GPM)

● Measures the average mark-up by calculating the percentage of sales revenue that is retained as
Gross Profit.

● GPM =
● Increasing selling price will increase the average mark-up, but it carries the risk of lowering demand,
and thus reducing the volume of sales.
● However finding a cheaper supplier may reduce the quality of the stock, causing a decrease in sales, or
an increase in sales returns or stock losses(through damage).
Vertical analysis: a report that expresses every item as a percentage of a base figure; in this case, Sales
Rev.

Non financial information: any information that cannot be found in the financial statements, and is not
expressed in dollars and cents, or reliant on dollars and cents for its calculation
● Number of repeat sales
● Number of sales & purchase returns
● Number of customer complains
● Staff turnover/average length of employment
● Number of days lost due to sick leave
● Interest rates
● Number of competitors

Strategies to Improve Profitability

● Should be strategies aimed to earn more revenue and control its expenses

Earning Revenue
● Change in selling price
● Increase Advertising, or target more accurately at prospective customers
● Stock mix: remove slow lines of stock, replace with faster moving lines
● NCAs: increased/updated to enable an increase in Sales
● Customer service: staff training, extra services, internal procedures made more customer friendly

Controlling Expenses
● Management of stock: security cameras to prevent theft, purchase better quality stock/train staff to
prevent damage, cheaper stock to decrease cost of sales.
● Management of staff: make sure firm is not under/over staffed, train staff to improve productivity
● Management of NCAs: unused, inefficient, unreliable NCAs should be replaced/removed.

Chapter 19
Liquidity: the ability of the firm to meet its short term debts as they fall due.

Assessing liquidity
● Trends: from budgeted cash flow statement, and cash flow statement.
● Liquidity indicators
○ Level of Liquidity
■ Working Capital Ratio
■ Quick Asset Ratio
■ Cash Flow Cover
○ Speed of Liquidity
■ Stock Turnover
■ Debtors Turnover
■ Creditors Turnover

Working Capital Ratio (WCR)

● Measures the ratio of current assets to current liabilities, the assess the firm’s ability to meet its short
term debts.
 ● WCR =
● Satisfactory ratio is 1:1, as the firm has at least $1 of current assets for every $1 of current liabilities

If WCR is less than 1:1

● Firm is likely to face liquidity problems
● To avoid such difficulties the firm may need to
○ Make a (cash) capital contribution
○ Enter/extend an overdraft facility
○ Take out a loan
■ However, this also places the firm into a larger debt, as they require more cash to repay
both principal and interest. Good for the short term, bad for the long term.

If WCR is much greater than 1:1

● Indicates the firm may have excess current assets that are idle, and not being employed effectively
○ E.g debtors not paying, stock not selling, cash in bank not being used(interest rate is low so not
using it is not very beneficial.
● The owner may:
○ Contact debtors for amounts outstanding
○ Allow stock levels to run low before reordering
○ Use excess cash to repay debts, purchase NCAs or taking extra drawings

Quick Asset Ratio (QAR)

● Measures the ratio of quick assets to quick liabilities, to assess the firm’s ability to meet its immediate
debts
● QAR=
● Stocks are excluded as there is no guarantee that all stock can be sold immediately, as the firm is
already selling stock as fast as it can.
● Prepaid expenses cannot normally be converted back into cash.
● It is unlikely that Bank Overdraft will be called in(for repayment) as long as it remains under the limit

Cash Flow Cover (CFC)

● Measures the number of times Net Cash Flows from operations is able to cover average current
liabilities

● CFC =
● If the business cannot re-generate sufficient cash from its day-to-day operating activities, it will require
regular contributions from the owner or external financiers in order to meet its loan repayments and
provide cash for the owner’s drawings.
● There is no set benchmark for CFC but it can be compared to previous and budgeted cash flow
statements as well as the CFC of similar businesses.
○ More times = better

The Speed of Liquidity

● Businesses are not static entities(as they are constantly generating sales, which will then be turned into
cash, which will then turn into purchases of more stock, to generate more sales, etc), so the level of
liquidity on its own is an inadequate measure of firm’s ability to meet its debts.
 ● A business can survive with an unsatisfactory level of liquidity, as long as the speed of its trading cycle
is fast enough
● Turnovers are efficiency indicators, but have a significant impact on liquidity.

Stock turnover (STO)

● Measures the average number of days for a business to convert its stock into sales

● STO =
Assessing STO
If STO is too slow
● Firm will be less able to generate sales, and therefore less able to generate cash inflows in time to
meet debts as they fall due
● The business may need to:
○ Employ strategies to increase sales(e.g increase advertising, decrease selling price, change
stock mix by adding more fast moving lines and removing slow moving lines of stock)
○ Decrease level of stock on hand(e.g ordering less stock more frequently, or replacing slow
moving lines of stock)
If STO is too fast
● Means that firm is selling stock for too low a selling price(missing out on extra revenue)
● Or is not holding enough stock(missing out on discounts for bulk purchases, or extra delivery costs due
to constant deliveries)
● Owner should also analyse at stock cards to identify slow and fast moving lines

Stock management
Ways to manage stock wisely to maximise the potential for sales
● Review Sales to maintain appropriate stock mix
○ Fast lines expanded, slow lines reduced/removed
● Promote the sale of complementary goods
○ E.g customers buying shoes will often want socks, so socks should be offered to increase sales
● Ensure stock is up to date
○ older/out-of-date versions should be discounted for quick sale
● Rotate stock
○ Older stock(i.e food) placed in front of newer stock
○ Most up to date/popular items at the front of the shop to attract more customers
● Determine an appropriate level of stock on hand
● Strong marketing

Debtor’s Turnover (DTO)

● Measures the average number of days it takes for a business to collect cash from its debtors

● DTO =

Assessing DTO
● Compared to credit terms given to customers and budgeted DTO to be determined as
satisfactory/unsatisfactory
● Can be compared to previous periods DTO
 ● Owner should also analyse Debtors Schedule so each individual debtor can be managed as DTO is
only an average

Debtor management
If DTO is too slow
● Offer a discount for early payment
● Give invoice at point of sale rather than later(because debtor would not even think of paying before
invoice)
● Extensive credit checks(so only reliable customers will be provided credit)
● Reminder notices
● Threats of legal action
● Debt collection agency
● Threats of not providing credit in the future

Creditors Turnover (CTO)

● Measures the average number it takes for a business to pay its creditors.

● CTO =
● Credit purchases of stock allow the firm some time to sell the stock and collect the cash before the
creditor must be paid

STO, DTO and CTO

● The firm’s ability to pay its creditors is heavily reliant on its ability to generate cash from its stock.
● This means that CTO is reliant on STO, and if the business deals mainly on credit, DTO.
● Faster STO → faster DTO → faster CTO

Assessing CTO
● Should be compared against credit terms or budgeted CTO
● Paying early may be beneficial due to discounts
● If there is no discount, it should be paid as close to credit terms as possible(without going over), so the
firm has cash for longer and can use it to repay other debts that are due
● Penalties of not paying on time
○ Interest charge on late accounts
○ Removal of credit facilities
○ Reduction in credit rating