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Accounting Unit 1 Notes

UNIT 1: CHAPTER 1
Accounting is the collection, recording and reporting of financial information to assist business
owners in decision-making.

Accounting Characteristics
Accountants also are also guided by standards as to how Financial Reports are prepared and
presented. These are known as the Qualitative Characteristics.
There are four Accounting Characteristics:
1. Understandability
2. Comparability
3. Relevance
4. Reliability
Understandability
It is essential that information contained in the Reports is understandable by the users. Reports
should be presented so it easy for the user to understand.

Relevance
Reports should include all information that is useful for decision-making. For example, the Income
Statement should only include revenues and expenses from the current Reporting Period. The
personal assets of the owner are not relevant for the decision-making of the business.

Reliability
Reports should contain information that is free from bias. We should not use estimates (unless for
Depreciation). Reliability is assisted by the Historical Cost Principle as figures will be able to be verified
by a source document.

Comparability
Users must be able to compare the Financial Reports of an entity (business) over time in order to
identify trends in its financial position and performance.
Users must also be able to compare the Financial Reports of different entities (firms).
If Accounting procedures are changed, it should be clearly stated.

Accounting Principles
Seven Accounting Principles have been established to:
 Prevent uncertainty as to how accounting information is recorded
 Provide a guide to the recording process

1. Entity
The business is a separate entity from its owner and from other businesses (entities). The business
will have separate records from the owner. Any personal transactions involving the owner must be
recorded to reflect that the business and owner are separate entities.

2. Going concern
It is assumed that the life of the business will be ongoing, i.e. the business will have an indefinite life,
and its records are kept on that basis.

3. Reporting Period
The life of a business must be broken into regular intervals of time to allow reports to be prepared,
and the accounting records should reflect the Reporting period in which a transaction occurs.

4. Monetary Unit
All items must be recorded and reported in the currency of the country of location. This ensures a
common unit of measurement. For example, Australian businesses use Australian dollars.
Accounting Unit 1 Notes
5. Historical Cost
All transactions should be recorded at their original cost or value, as this can be verified by a source
document.

6. Conservatism
It is acknowledged losses should be recorded as soon as they are likely to occur while gains should
not be recognised until earned. This ensures liabilities and expenses are not understated and that
assets and revenues are not overstated.

7. Consistency
The accounting methods used by the business should be applied consistently from one Reporting
Period to another so we can compare reports from periods.

Role of Accounting
Accounting is the collection, recording and reporting of financial information to assist business
owners in decision-making.

1. Collecting (Input Stage)


This is where the business collects source documents
Source documents: are pieces of paper that provide evidence and details of a transaction.
Examples:
 Receipts
 Cheque butts
 Invoices (are source documents that verify Credit Sales and Credit Purchases)
 Memos ( are internal documents)
 Bank Statements

2. Recording (Processing Stage)


Is the sorting, classifying and summarizing of the information contained in the source documents
so that it can be used to produce Accounting Reports.
Examples of Accounting records are:
 Journals
 Ledgers
 Stock cards

3. Reporting (Preparation Stage)


Is the preparation of Financial Reports that communicate financial information to the owner.
There are 3 Reports that all businesses should prepare. The:
 Income Statement (Profit and Loss Statement)
 Balance Sheet
 Cash Flow Statement

 Advising (Output Stage)


The owner (or potential owner’s) are now in a better position to make informed decisions.

UNIT 1: CHAPTER 2

The Accounting Elements


Assets - are future economic benefits controlled by the business (entity) as a result of past
transactions.
Liabilities – a present obligation controlled by the entity is as a result of past transactions from which
will result in future sacrifices of economic benefits.
Accounting Unit 1 Notes
Owner’s Equity - is the net worth of the business – it is the residual interest in the Assets of the entity
after deduction of its Liabilities.
Revenues are inflows of economic benefits (or savings of outflows) in the form of increases in assets
or decreases in liabilities that result in an increase in Owner’s Equity (except for Capital contributions
by the owner).
Expenses are outflows or consumptions of economic benefits (or reductions of inflows) in the form
of decreases in assets or increases in liabilities that result in a decrease in Owner’s Equity (except for
Drawings by the owner).

The Balance Sheet


Is an Accounting Report prepared at the end of every Reporting Period and provides us with the
financial position of a business at that particular point in time.

The Balance Sheet should always balance and it provides us with the Accounting equation where:
ASSETS = LIABITILITIES + OWNER’S EQUITY
OWNER’S EQUITY = ASSETS – LIABILITIES
BUSINESS NAME: Blake’s Hairdressing Salon
ACCOUNTING REPORT: Balance Sheet as at DATE: 30 September 2014
Liquidity is the ability of a business to meet its short-term debts as they fall due.

Working Capital Ratio


The Working Capital Ratio (WCR) measures liquidity by comparing Current Assets over Current
Liabilities.
Current Assets
Working Capital Ratio = Current Liabilities = Ratio (CA:CL)
Liquidity is the ability of a business to meet its short-term debts as they fall due.
The business has insufficient CA to cover its CL, and may not be able to meet its debts as they fall due.
If a business can not pay its debts it may be forced into liquidation, with its Assets sold to raise funds
to pay off its debts.

Debt Ratio
Is the percentage of a firm’s Assets financed by Liabilities
TOTAL LIABILITIES
------------------------- X 100
TOTAL ASSETS

% of the firms assets are financed externally, that is from outsiders, a higher Debt Ratio run a greater
risk of liquidity problems.

UNIT 1: CHAPTER 3

What is a Business?
An individual or organisation that produces or provides goods or services to consumers, with a view
to making a profit.
Businesses are often referred to as:
 Firms
 Organisations
 Entities
 Corporations
Organisation is two or more people who come together to achieve a common goal.
Increase Profit 1. Increase Revenue
 Increase and maximise Sales (if a trading business)
 If a service business the objective will be to increase clients and
maximise fees
2. Reduce expenses
Accounting Unit 1 Notes

Nature of Business Operations


A business can be classified according to the nature of operations of a business
They can be classified as either:
1. Retail or Trading
2. Service
3. Manufacturing
4. Mixed business

Main types of Business Ownership Structures


1. Sole Trader (Proprietorship)- Is a business owned by a single individual, operating their
business under their own name or under a registered business name.
ADVANTAGES:
 1.Simpler and cheaper to establish
 2.Owner has total control
 3.Owner receives all the profits
 4.Easier to wind up or sell

DISADVANTAGES:
 Unlimited Liability – Owner is personally liable for all debts of the business
 Limited access to Capital (finance) It will be limited to the owner’s savings
or the amount they can borrow (loan)
 Limited skills
 Long hours
2. Partnership- Consists of 2 to 20 owners (there are exceptions to this for some types of
businesses)
ADVANTAGES:
 Greater access to finance and skill resources
 Can share work load
DISADVANTAGES:
 Decision making more complicated, with potential for disputes
 Partner’s have unlimited liability
3. Private Company- Consists of up to 50 owners, greater access to finance, more formal
management structure.
ADVANTAGES:
 Owner’s have Limited Liability
 Greater access to Capital
 Tax
DISADVANTAGES:
 Greater set up costs
 Greater regulation – ATO, ASIC
 Decision-making is slower
4. Public Company- Are usually owned by thousands of public shareholders. If you purchase
shares in a company you are a shareholder – you are a part owner of the company.

Starting vs Buying
When a person decides they want to own their own small business they have 3 options:
1. Start a new business
2. Buy an existing business
3. Buy a franchise
Franchise is an agreement under which one party (the franchisor) grants any party (the franchisee)
the right to use the business name and practices.
Accounting Unit 1 Notes

UNIT 1: CHAPTER 4

Sources of Finance
 Money is needed to start a business and we may need additional money to finance certain
business activities
Money may come from 2 sources:

1. Internal Finance (Owner’s Equity)- Are funds generated by and within the firm
Examples:
Capital Contributions- Is the owner’s personal cash or Assets contributed to the business
Advantage:
 No interest or repayment date
Disadvantage:
 Limited to the owner’s wealth
Retained Earnings (Profits)- Are Profits earned by the business which are not taken out as Drawings
Advantage:
 No interest or repayment date
Disadvantage:
 Must make a Profit

2. External Finance (Liabilities – Loans)-

1.Trade Credit- Is purchasing goods or services from suppliers with a promise to pay
back the amount at a later date
ADVANTAGES:
 No interest charges (unless you do not pay with the agreed terms
 Helps cash flow – Hopefully a business can generate Sales of Stock before payment is
required
 Often receive a discount for early payment
Example:
 Terms 2/7, n/30

DISADVANTAGES:
 Can only be used for purchases from suppliers willing to provide credit terms

2.Bank Overdraft- Is provided by the bank which allows the account holder to
withdraw more than what is in their account – up to an agreed limit.
ADVANTAGES:
 Flexible, immediate access
DISADVANTAGES:
 High Interest rate

3.Loans- Is another form of external finance provided by banks and other lending
institutions which must be repaid over time, with interest charges.
DISADVANTAGES:
 Interest charges

4.Mortgage- Is a loan that is secured against a property and interest rate will be
lower for secured loans.

5.Leasing- Is a form of rental and the lessee has the right to use an asset from the
lessor for a period of time in return for periodic payments to the lessor.
ADVANTAGES:
Accounting Unit 1 Notes
 Is a form of rental
 Lessee has the right to use an asset from the lessor for a period of time in return for periodic
payments to the lessor
DISADVANTAGES:
 No ownership of the Asset – although you may have the option to purchase the Asset at the
end of the contract

Interest

Interest Charges -The interest payable is an expense and will appear in the Income
Statement
-The amount outstanding on the Loan referred to as the Principal will be
reported in the Balance Sheet as a Liability
-p.a. – stands for per annum
-Interest can be an expense and also a revenue item

CALCULATING INTEREST for Simple (Flat) interest


 Total interest charge = P x I x T
 P = Principal ( the original amount borrowed)
 I = Interest rate
 T = Time (in years)
Simple Interest Example
1. You obtain a loan of $ 20 000 and the interest is 6% p.a over 2 years
2. $ 20 000 x 0.06 = $ 1 200 (interest p.a.)
3. $ 1 200 x 2 years = $ 2400 is the total interest
REDUCING BALANCE INTEREST
-Interest is calculated as the percentage of the current balance owing on the loan
-It is a cheaper form of borrowing than Simple Interest (given the same interest rate and
time) as the interest rate is not constantly calculated on the original amount borrowed, but
a smaller amount as it is calculated on the principal owing at that particular date
Principal Installments
As you know the Principal is the original amount borrowed:
Loan (amount borrowed)
----------------------------
Number of times reducing per year X years of the loan

Return Owner’s Investment


 Measures how effectively the business has used the Owner’s Equity to earn profit
 Higher the percentage the better
 Percentage indicates the amount the owner earns as profit for every dollar invested
It is possible for Net Profit to decrease but ROI increase
How?
If the Average Owner’s Investment has decreased by more than the decrease in the Net Profit

Likewise it is possible for Net Profit to increase but have a decrease in the ROI
How?
If the Average Owner’s Investment has increased by more than the increase in Net Profit

ROI and Debt Ratio Relationship


 As you know Debt Ratio is the percentage of a firm’s Assets financed by Liabilities
TOTAL LIABILITIES
------------------------- X 100
TOTAL ASSETS
 ___ % means of the firms assets are financed externally, that is from outsiders
Accounting Unit 1 Notes
 A higher debt ratio will improve ROI (as the Owner’s Equity figure will be lower) but it is
riskier as the loan and interest will have to be repaid A = L + Oe
While higher debt ratio means higher risk it gives the owner the opportunity to earn a greater ROI as
the business is using external funds instead of the owner’s.
 A higher Debt Ratio will improve ROI (due to the Accounting equation)
 However, it is riskier as it means a greater reliance on borrowed funds and the firm may have
trouble repaying its debts and the interest payments

UNIT 1: CHAPTER 5

Source documents are pieces of paper that provide both the evidence that a transaction has
occurred, and the details of the transaction.
Examples of source documents:
1. Cash Receipts -Is a source document used to verify cash received
-For example a Cash register receipt
2. Cheque Butts/Cash Payments -Usually this should be a cheque butt
-Cheques provide security but are becoming outdated as
many transactions are done electronically today
3. Invoices -Are source documents which verify Credit transactions.
-When goods or services are sold on credit it will result in a Sales Invoice.
-When a firm purchases goods or services on credit it will result in a
Purchase Invoice
4. Bank Statements -Payments or Receipts done electronically will appear on
the Bank Statement to verify the transaction

5. Memos -Memo’s are source documents which verify internal transactions.


-They do not involve cash
Examples of Memos:
-Stock Losses or Stock Gain
-Non-cash transactions involving the owner such as Drawings of Stock or
contributions of a Non-Current Asset
-Correcting entries (this will not be looked at until Unit 3)

Source documents ensure Reliability in Accounting Reports as they provide evidence that the
transaction has occurred and ensure that the Reports are free from bias.
Cash Sales -When cash is received, a business must give a cash receipt to the customer, as well
as keeping a copy of the receipt for its own records.
-If cash is deposited directly into the business’s bank account, the source document
will be a Bank Statement.
Cash Payments -In most cases cash payments should be made by cheque as it will provide security
and the cheque can be traced and verified.
Credit transactions -Will be verified by an Invoice.
-An Invoice is a source document that verifies credit transactions.
-There are two types of invoices: Sales invoices and Purchase Invoices.
Credit Sales -When a firm sells goods on credit the source document will be a Sales Invoice
Credit Purchases -When goods are purchased on credit, the supplier will issue a Purchase
Invoice.
When there is a Credit Sale or Credit Purchase the GST is recognised and reported at the time of the
Sale or Purchase.
Drawer – is the person writing the cheque.
Drawee – the bank or financial institution of the drawer.
Payee – the entity that is receiving the cheque
Accounting Unit 1 Notes
Goods and Service Tax
What is GST?
GST is a tax (10%) levied by the federal government on most purchases of goods and services
(excluding fresh food)

The GST Clearing account can be either an Asset or a Liability

GST collected by a business on its Sales or Fees for services performed is money that belongs to the
ATO. This amount is a Liability as the business owes the money to the ATO.

When a business purchases goods or pays expenses which are subject to GST the GST component
paid reduces the GST owed to the ATO so the GST Liability is reduced.

All transactions that involve GST are recorded in the appropriate Journals and then posted to the GST
Clearing Ledger account.

Key Points

1. There is no GST to record when cash is received from a Debtor as GST is only
reported at the time when the Sale is made or when the work has been performed.

2. There is no GST to record when the payment is made to the Creditor as GST is only
reported at the time when the credit purchase is made.

3. Never include GST in your Sales, Fees, Stock, Non-Current Asset or expense figures.
The GST is recorded separately.

4. There are a number of inflows of cash and payments that will never include GST.
Inflows that will never include GST:
 Interest Revenue
 Capital contributions
 Loans
 Receipts from Debtors*
Payments that will never include GST:
 Interest expense
 Wages
 Loan repayments
 Drawings
 Payments to Creditors *
 The GST is recorded at the time of the Credit Sale or Credit Purchase
Why the GST Clearing Account will usually be a Liability for a Trading Business?
Because a Trading firm buys Stock and usually always sells the Stock it at a higher price, the GST
incurred (Liability) will be greater than the GST purchase amount.
Reasons why a firm may have the GST Clearing Account as an Asset?
If the business has either:
1. Made large purchases of Stock.
2. Purchased an expensive Non-Current Asset.
3. Is a new business just starting and has not had many customers but has incurred a lot of
expenses or purchases.
Accounting Unit 1 Notes

UNIT 1: CHAPTER 6
Cash Journal
In accounting we record entries in Journals.
In all there are 5 different journals.
Journals are an Accounting record which classifies and summarises transactions during each month
(in Units 1 – 4)

 Frequent transactions have their own headings in the Journals


 Infrequent transactions will be recorded in the Sundries column
 The Bank column will always include GST in the figure unless there is no GST involved in the
transaction

In this Chapter we are going to look at the Cash Journals


There are two Cash Journals:
1. Cash Payments Journal and
2. Cash Receipts Journals

Will always have the following format:


Name of the business
Statement of Receipts and Payments for ….
Cash Receipts
Less Cash Payments
Cash Surplus (Deficit)
Add Opening Bank Balance
Closing Bank Balance

The Cash Payments Journal


Is an accounting record that summarises all cash paid during a Reporting Period.

 All cash paid is recorded in the Payments Journal which results in money going out
of the Bank.
 Date: Transactions are recorded in the Journal on the date paid
 Details: is a description of what has occurred.
 Cheque Number: ensures reliability
 The Bank column total cash paid.
 Where GST is involved, the amount recorded in the Bank column includes the GST
amount.
 Classification columns. Frequent cash transactions are given there own column
while infrequent transactions are recorded in the Sundries column. The amount
each transaction is recorded twice – always in the Bank column and then in the
Classification or Sundries column to record what the cash was paid for.
Classification headings will vary between businesses.
 GST column. Where transactions incur GST, this column will be 10% of the purchase
price or the expense.
 Total of all the other columns should and must equal the Bank column total. This is
known as the double – checking mechanism.
 A GST Settlement must be identified separately in the Sundries column.

The Cash Receipts Journal


Is an accounting record that summarises all cash received during a Reporting Period.
Accounting Unit 1 Notes
 All cash received is recorded in the Cash Receipts Journal which results an increase
in the Bank account.
 The Bank column will include the total amount cash received.
 Where GST is involved, the amount recorded in the Bank column includes the GST
amount.
 Classification columns. As with the Cash Payments Journal, the amount of each
transaction must be recorded twice – always in the Bank column and then in the
Classification or Sundries column to record the source of the cash. Once again,
frequent transactions such as, Sales and Debtors will have their own classification
columns while infrequent transactions are recorded in the Sundries column.
 GST. For Cash Sales or Fees collected, the GST figure will be 10% of the Sales or Fees
Revenue column.
 A GST Refund is received from the ATO and must be recorded separately in the
Sundries column.

UNIT 1: CHAPTER 8

Net Profit
Main objective of a business is to earn a Profit.

Revenue less Expenses = Net Profit


If Expenses exceed Revenue for the Reporting Period we have Net Loss

Cash and Profit are different:


1. Not all cash collected is revenue
2. Not all cash payments are expenses and
3. Some items effect Profit and Cash by different amounts (You will learn about these ones
later in Unit 2)

Revenues: are inflows of economic benefits (or savings of outflows) in the form of increases in assets
(or decreases in liabilities) that result in an increase in owner’s equity (except for capital contributions
by the owner).

Examples include:
Cash Sales, Credit Sales, Service fees, Interest Revenue, Commission Revenue, Discount Revenue.

Expenses are outflows or consumptions of economic benefits (or reductions of inflows), in the form of
decreases in assets or increases in liabilities that result in a decrease in owner’s equity (except for
drawings by the owner).

Examples of Expenses:
Wages, Advertising, Interest Expense, Cost of Sales, Freight In, Customs Duty, Rates, Telephone bill,
Electricity, Rent, Advertising, Insurance, Interest.

How often do we calculate Net Profit?


 It will depend on the owner, but it must be done at least once a year – 30 June.
 More often the better as it will help decision-making and planning.
When confronted about questions regarding Net Profit and Accounting Characteristics think
relevance.
We only want relevant items to determine the Net Profit for the Reporting Period.
For example:
 Never include Drawings – it is not an expense but a negative Owner’s Equity item.
 Do not include revenue and expenses that don’t belong in the current Reporting Period.
Accounting Unit 1 Notes
Only revenue and expense items relating to the current Reporting Period are to be recorded in the
Income Statement.

Format of the Income Statement


The Income Statement is an Accounting Report.
You must always put the name of the business first (Who) and on the next line write the words
“Income Statement”(What) followed by “for”(the month, quarter or year) ended (When).

For example:
Top Gear Car Detailing
Income Statement for month ended April 2015
$ $
Revenue
Washing Fees 17 000
Detailing Fees 15 000 32 000
less Expenses
Wages 8 000
Electricity 200
Rent 3 400
Insurance 400 12 000
Net Profit 20 000

Cash and Net Profit are Different


Not all cash collected is revenue and not all cash payments are expenses.
 A business can make a Profit yet have a reduction in its Bank balance (a cash deficit for the
period) - likewise
 A business can incur a Loss yet have an increase in its bank balance (a cash surplus).
Items that effect will decrease Cash but have no effect on Profit (as they are not expenses):
1. Cash Drawings
2. Loan repayments
3. Cash purchases of Non-Current Assets
4. A GST Settlement to the ATO
5. Any GST paid for items
Items that will increase Cash but has no effect on Profit (as they are not revenues):
1. Loans received
2. Capital contributions of cash
3. A GST Refund from the ATO
4. The GST component received from customers

Reporting a Net Profit or Loss in the Balance Sheet


If revenues are greater than expenses it will result in a Net Profit and the figure must be added to the
Capital in the Owner’s Equity section of the Balance Sheet.

For example:
Owner’s Equity
Capital – T. Cruz 80 000
Add Net Profit 20 000
100 000

If expenses are greater than revenues a Net Loss has occurred for the Reporting Period and the loss
must be deducted from the Capital figure in the Owner’s Equity section of the Balance Sheet.

For example:
Owner’s Equity
Accounting Unit 1 Notes
Capital – T. Cruz 80 000
Less Net Loss 20 000
60 000
Drawings and Benefits
Drawings are a negative Owner’s Equity item.
Drawings are NOT an expense although they reduce the owner’s equity in the business, as do
expenses.

The Drawings figure will be shown in the Balance Sheet under the Owner’s Equity section as follows:
Owner’s Equity
Capital – T. Cruz 80 000
Add Net Profit 20 000
100 000
Less Drawings 27 000 73 000
Total Assets 203 000 Total Equities 203 000

1. Aids decision-making
The performance of the business can be measured. By detailing the revenues and expenses
(and thereby providing a profit figure) the owner can make changes if necessary and
possible.
2. Make comparisons
Is the figure acceptable to what we wanted?
We can compare the figures to previous figures, budgeted forecasts, other businesses and
other investment options.
3. Assists in planning for the future
Can prepare budgets for future periods
4. Can assess performance of management
We can analyse revenue and expenses figures to determine if the people responsible for
generating revenue and controlling expenses are doing a good job.

UNIT 1: CHAPTER 9

The Budgeting Process


Budgeted Reports are prepared – predicting what is likely to occur.
Actual Reports are prepared – shows what has happened in the reporting period.
Variance Reports are prepared to highlight differences.
Decisions are made to improve the business for the future.

Budgeted Sales or Budgeted Fees predictions are very important as:


 Sales are the main source of revenue for a trading firm.
 Fees are the main source of revenue for a service firm.
The level of Sales will have a significant impact on estimating expenses that vary with the number of
units sold or clients (such as Cost of Sales and Wages)
Sales will determine how much Stock will need to be purchased .

Variance Reports
 Are an Accounting Report which compares the actual and budgeted figures, highlighting
variances, so problems can be identified and corrective action taken.
 They are prepared before the next budget
 There are two variance reports:
1. Cash Variance Report
2. Profit Variance Report (Not looked at this year)
Cash Variance Reports
 Compares actual and budgeted cash flows
Accounting Unit 1 Notes
 It shows the variances (differences) so problems can be identified
 Format will be the same as the normal Cash Budget but you will add the following columns:
Actual, Variance and F/U (Favourable or Unfavourable)

 If the actual cash inflows are greater than the budgeted figure the variance is favourable
 If the actual cash inflows are less than the budgeted figure the variance is unfavourable
 If the actual cash outflows are greater than the budgeted figure the variance is unfavourable
 If the actual cash outflows are less than the budgeted figure the variance is favourable
Uses of the Cash Variance Report
1. Helps in accuracy of next budget
2. If estimates are not from poor estimates, unfavourable variances can be investigated.

The Cash Budget


•Cash Budgeting is the process of predicting (estimating) financial consequences of future events
•Is an Accounting Report which attempts to predict all future cash inflows and cash outflows, to give
estimated cash balance at the end of the budgeted period.
•It allows the owner to prepare for an expected cash surplus or deficit.
•If a cash deficit the owner may defer certain cash payments

Receipts from Debtors or Payments to Creditors, there will be no separate GST amount as the GST is
recorded when the Credit transaction occurred.