Extensive Theory Package.docx

Kal Godellewatte MHS

ACCOUNTING UNITS 3&4 THEORY RESOURCE PACKAGE Kal Godellewatte – Melbourne High School

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Kal Godellewatte MHS

Table of Contents

1. Unit 3 Basic Notes (3-22) 2. Unit 4 Basic Notes (23-57) 3. Exam Discuss Revision (58-61) 4. ATARNotes Discuss Answers (62-66)

5. Things to watch out for (67-68)

6. Salient points (69-70)

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Kal Godellewatte MHS

UNIT 3 BASIC NOTES Chapter 1 – The Role of Accounting Accounting – The collection and recording of financial data, and the reporting, analysis and interpretation of financial information Purpose of Accounting – To provide financial information to assist decision-making Financial Data – Raw facts and figures upon which financial information is based Financial Information – Financial data that has been sorted, classified and summarised into a more useable and understandable form Accounting Process: Source documents -> Records -> Reports -> Provides advice Input -> Recording -> Output -> Advice Source Documents – Documents that provide both the evidence that a transaction has occurred and the details of the transaction itself Recording – Sorting, classifying and summarising the data contained in source documents so that it is more usable Reporting – The preparation of financial statements that communicate financial information to the owner Advice – The provision to the owner of a range of options appropriate to their aims/objectives, together with recommendations as to the suitability of those aims/objectives Accounting principles – The generally accepted rules that govern the way accounting information is generated Entity – The business is assumed to be separate from the owner and other businesses, and its records should be kept on this basis Going Concern – The life of the business is assumed to be continuous, and its records are kept on this basis Reporting Period – The life of the business must be divided into periods of time to allow reports to be prepared, these reports should reflect the reporting period in which transactions occurred Historical Cost – The recording of a transaction at its original cost, as this value is verifiable by reference to a source document

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Conservatism – Losses should be recorded hen probable but gains should only be recorded when certain, so that liabilities and expenses aren’t understated and assets and revenues aren’t overstated Consistency – Accounting methods should be applied in a consistent manner to ensure reports are comparable between periods Monetary Unit – All items must be recorded and reported in a common unit of measurement, of the country in which reports are being prepared Relevance – Accounting reports should include all information that is useful for decision-making, and omit any information that is immaterial and will not be useful for decision-making purposes Reliability – Accounting reports should contain information that is accurate, and free from bias and error Comparability – Accounting reports should be able to be compared over time Understandability – Accounting reports should be presented in a manner that makes it easy for them to be understood by the user, even if they have no or limited accounting background Accrual Accounting – Calculating profit by comparing revenues earned against expenses incurred in a particular reporting period Agreed Value – The accepted value of a non-cash asset at the time of its contribution by the owner Asset – A resource controlled by the entity as a result of past events, from which future economic benefits are expected to flow to the entity Liability – A present obligation of the entity arising from past events, the settlement of which will result in an outflow of economic benefits Owner’s Equity – The residual interest in the assets of the business once liabilities have been deducted Revenue – An inflow of economic benefits (or savings in outflows) in the form of an increase in assets (or decrease in liabilities), that increases owner’s equity, expect for capital contribution by the owner Expense – An outflow or consumption of economic benefits (or reduction in inflows) in the form of a decrease in assets (or increase in liabilities) that reduces owner’s equity, except for drawings by the owner

Chapter 2 – The Accounting Equation: Equities: -

Claims to the assets of the business, comprising of both liabilities and owners’ equity

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Double Entry Accounting: -

A system that records two effects on the accounting equation as a result of each transaction

Rules of Double Entry Accounting: 1. Every transaction will affect at least two items in the accounting equation: a double entry 2. After recording these changes, the accounting equation must still balance Classification: -

Grouping together items that have some common characteristics

Balance Sheet: -

An accounting report that details the business’s assets, liabilities and owner’s equity at a particular point in time.

Chapter 3 – The General Ledger Ledger Accounts: -

Accounting records showing all the transactions that affect a particular item

General Ledger: -

A collective name for the main group of ledger accounts

Double Entry Rules: 1. Every transaction must be recorded in at least two ledger accounts 2. Every transaction must be recorded on the debit side of one ledger account and the credit side of another Cross Reference: -

The name of the other account affected by a transaction, so that both accounts affected by a particular transaction can be identified. This improves the traceability of these transactions.

Why are receipts from debtors not considered as a revenue? While receipts from debtors represents an inflow of economic benefits in the form of an increase in assets (Bank), it does not increase owner’s equity as a revenue must, but rather leads to a decrease in another asset (Debtors Control). The revenue from the credit sale was already recorded when it was earned at the point of sale, when the goods were provided to the customer. Trial Balance: -

A list of all the accounts in the General Ledger and their balances, to determine if total debits equals total credits

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Kal Godellewatte MHS

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Facilitates the preparation of reports as totals can be directly taken from the trial balance and reported

Trial Balance Errors Revealed: 1. Two entries have been recorded on the same side of the general ledger (For example two debits or two credits instead of one debit and one credit) 2. Only one entry has been recorded (For example a debit entry without a corresponding credit entry) 3. Different amounts have been recorded on each side (For example $450 on the debit side and $4500 on the credit side)

Trial Balance Errors Not Revealed: 1. A transaction has been omitted altogether 2. The debit and credit entries have been reversed (For example a payment to creditor instead of being recorded as a debit to creditors control and a credit to bank, being incorrectly recorded as a debit to bank and credit to creditors control) 3. The transaction has been recorded in the wrong ledger account (For example instead of recording a payment of wages as a debit to the wages account, the transaction is incorrectly debited to rent) 4. An incorrect amount is recorded on both sides of the ledger (For example if there was a payment to creditor of $500, both the debit and credit entries being recorded as $5000) Balancing: -

Ruling off an asset, liability or owners’ equity account to determine its balance at the end of the reporting period, and transferring that balance to the next reporting period

Footing: -

An informal process of determining the balance of a ledger account

Chapter 4 – The Goods and Services Tax Source Documents: Printed or electronic documents that provide evidence that a transaction has occurred, and provide the details of the transaction itself Benefits of Paying by Cheque 1. Security – Paying by cheque avoids the risk of carrying large sums of cash, and the danger of theft this entails 2. Traceability – Cheques must be deposited into a bank account, meaning it is possible to trace the eventual recipients of the funds

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3. Verifiability – All payments made by cheque are recorded on the cheque butt, providing a source document to verify the transaction

Statement of Account: -

A summary of the transactions a firm has had with a particular debtor/creditor over a certain period of time As it is a list of transactions that have already occurred – and should have already been recorded – this is not a source document that must be recorded

Order Forms: -

A document requesting the supply of stock of other goods It is only when the goods are received that the invoice will be sent, and it is the invoice, not the order form that must be recorded There is no exchange of goods/services, hence there is no transaction to record The order form does not specify an amount, as the business ordering the stock is not able to set the selling price, hence there is no amount to record

Chapter 5 - Special Journals 1: Credit Journals Explain how the use of subsidiary records improves the presentation of the financial reports of the business The use of subsidiary records removes excessive detail from the general ledger and hence the financial reports of a business. This is because instead of listing each individual debtor or creditor account, they can be represented under one total in the form of a control account balance. Hence, individual information is still stored in subsidiary records however only relevant information is reported, improving the presentation of reports as there are less unnecessary accounts and less bulky details. Benefits of Special Journals: -

An accounting record that summarises similar transactions, so that totals can be posted to the general ledger at the end of the reporting period. In the process, it reduces the number of repetitive ledger entries that need to be recorded, hence improving the efficiency of the accounting system by removing excessive detail

Why might a business choose not to use Special Journals? -

If stock if purchased infrequently, the business may not require a purchases journal If stock is not sold on credit, there is no need for the sales journal

Control Account: -

An account in the general ledger summarising the transactions recorded in the subsidiary ledger accounts

Subsidiary Ledger: 7|Page

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An additional set of ledger accounts kept outside the General Ledger, recording individual transactions for each individual debtor/creditor

Schedule: -

A list of the name and balance of each individual account in the debtors/creditors ledger, added together to enable checking against the balance of the debtors control/creditors control account

GST Settlement: -

A cash payment made to the ATO to settle the liability that occurs when GST on sales is greater than GST on purchases in the previous reporting period

GST Refund: -

A cash receipt from the ATO to refund the excess that occurs when GST on sales is less than GST on purchases in the previous reporting period

Why is GST collected not considered revenue GST collected as a result of cash sales is an inflow of economic benefits in the form of an increase in assets (bank) that increases liabilities (GST Clearing), however has no effect on owner’s equity, hence has it is not a revenue. GST is collected on behalf of the ATO, hence the amount collected is owed to the ATO. It is a current liability as it is a present obligation of the entity as a result of past transactions that will result in an outflow of economic benefits in in the form of a payment to the ATO within the next reporting period and 12 months. Why do credit sales increase the GST Liability of the business? This is because the GST charged to debtors is collected on behalf of the ATO, and must be passed onto the ATO, thus represents a GST liability. It is a present obligation of the entity, arising from past events, the settlement of which is expected to result in an outflow of economic benefits within the next 12 months when the GST is passed onto the ATO. Explain, using an example how a business could receive a GST Refund -

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The business had a debit balance in the GST Clearing account at the end of the reporting period This would be due to GST collected on cash sales and GST charged on credit sales being less than GST paid on cash purchases and GST incurred on credit purchases of stock This may have occurred a result of a purchase of stock in bulk that remained unsold at the end of the reporting period, or the purchase of an expensive non-current asset

GST is a Current Liability (GST Settlement) when?

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Kal Godellewatte MHS

GST charged on credit sales and GST collected on cash sales is greater than GST paid on payments and GST incurred on credit purchases of stock. This would result in there being a credit balance for GST Clearing at the end of the reporting period, hence a GST settlement would need to be paid in the subsequent reporting period to clear the amount owing to the ATO GST is a Current Asset (GST Refund) when? GST charged on credit sales and GST collected on cash sales is less than GST paid on payments and GST incurred on credit purchases of stock. This would lead to there being a debit balance for GST Clearing at the end of a reporting period, hence in the subsequent reporting period a GST Refund would need to be made by the ATO.

Benefits of Using Control Accounts and Subsidiary Ledgers 1. Double checking mechanism that allows detection of recording errors - The preparation of a debtors or creditors schedule allows the balance of the control account to be checked against the sum of the subsidiary ledger accounts - This allows for recording errors to be detected and corrected, improving the reliability of the balances reported in the balance sheet

2. Ease of Reporting The single balance for all debtors or creditors means that the balance sheet only needs to report the balance of the control account, rather than list every individual debtor or creditor, and their individual balances. - Omitting these details gives greater relevance, as these details would not be useful for decision-making -

3. Allocation of responsibility - Separating the subsidiary ledger accounts from the general ledger means the management of the subsidiary ledger can be allocated to a particular employee. - Greater accountability would hopefully improve effectiveness, and would also leave the senior book-keeper free to manage the general ledger - By sharing the accountability of records between different staff members, if reduces the likelihood of fraud as it isn’t only one person responsible for the entire recording system

Chapter 6 – Special Journals 2: Cash Journals Sundries Column: -

Records infrequent transactions that do not occur more than once a reporting period, hence do not warrant their own singular column It is made up of a collection of transactions that must be individually posted to ledger accounts at the end of the reporting period

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Settlement Discount: -

A reduction in the amount repayable by a credit customer in return for early repayment

Discount Benefits: 1. Cash is received faster from debtors  This allows the business to pay its debts on time, take advantage of any discounts offered by creditors or make other payments such as wages or other expenses 2. The possibility of bad debts is reduced  The longer a debt goes unpaid, the more likely it is that the debtor will not actually pay at all 3. Greater sales may be encouraged  Customers may be more willing to buy from a firm that offers discounts than one that does not, knowing that the amount they end up paying will be less Discount Costs: 1. Less cash is received from debtors  Because a discount reduces the amount the debtor has to pay, less cash is received 2. Net profit is reduced  The amount of the discount is an expense, and thus reduces net profit Discount Revenue: A savings in outflows of economic benefits (less cash is paid to creditors) in the form of a decrease in liabilities (creditors control) that increases owner’s equity (discount revenue increases net profit) Discount Expense: A reduction in the inflows of economic benefits (less cash is received from debtors) in the form of a decrease in assets (debtors control) that decreases owner’s equity (discount expense decrease net profit)

Chapter 7 – General Journal General Journal: An accounting record used to record infrequent, non-cash transactions which cannot be recorded in the special journals Narration:

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A brief description of a transaction recorded in the General Journal, including a reference to the relevant source document Commencing Entry: A General Journal entry to establish double-entry records by entering existing asset, liability and owner’s equity balances in the ledger account Bad Debt: An expense incurred when a debt is written off because it is deemed to be irrecoverable, after all avenues have been taken to retrieve the debt (For example if the debtor has declared bankruptcy) What is a narration and why is it used? A brief description of a transaction recorded in the General Journal, including a reference to the relevant source document. It is used as the General Journal records a wide variety of transactions. What is the purpose of a correcting entry? To rectify any errors that have been made in the recording process. This ensures that information contained in accounting records are accurate.

Chapter 8 – Stock Cards Stock Control Account: Summarises all transactions involving the movement of stock in and out of the business in the General Ledger Stock Card Account: Records all individual transactions relating to each individual line of stock, and is a subsidiary record Cost of Goods Sales: All costs incurred in order to bring stock into a condition and location ready for sale Reasons why a small business might choose to value its stock using the FIFO assumption In situations where it is impossible, impractical or a waste of the businesses resources to individually label each unit of stock with its stock price, hence it is a convenient cost assignment method Physical Stocktake: A physical count of the number of units of stock on hand Role of the Stocktake:

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To verify the accuracy of the stock cards, and in the process, detect any stock losses and stock gains that have occurred Stock Loss: An expense as it is an outflow of economic benefits (Stock leaves the business) in the form of a decrease in assets (Stock Control) that decreases owner’s equity (As stock loss reduces net profit) Reasons for Stock Loss: -

Theft Damages/Breakages Undersupply from a supplier unaccounted for Oversupply to customers unaccounted for

Stock Gain: A revenue as it is an inflow of economic benefits (Stock enters the business) in the form of an increase in assets (Stock Control) that increases owner’s equity (As stock gain increases net profit) Reasons why stock may be used for advertising purposes: -

To use for display purposes To donate stock to local community organisations

Stock used for advertising: An expense as it is an outflow of economic benefits (stock leaves the business) in the form of a decrease in assets (Stock Control) that decreases owner’s equity (As advertising reduces net profit) Reasons why Cost of Goods Sold may be greater than Cost of Sales -

Customs Duty/ Import Duties Freight In/Delivery from suppliers Modifications Packaging Buying expenses

Identifying Gross Profit: Allows the owner to assess the adequacy of the firm’s mark-up, because Gross Profit expresses the relationship between selling prices and cost prices Identifying Adjusted Gross Profit: Allows the owner to isolate stock losses or gain and bring it to the attention to the owner, so that strategies may be developed to address any problems that are identified Perpetual System of Stock Recording:

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Involves recording individual stock transactions in the stock cards as they occur, then conducting a physical stocktake at the end of the reporting period to verify the balances of those stock cards. In the process, any stock losses or gains will be detected. Benefits of the Perpetual System of Stock Recording: -

Reordering of stock is assisted by maintaining a continuous record of the number of units of stock on hand, enabling the business to avoid loss sales Stock losses and gains can be detected by comparing the balance of the stock cards against the results of the physical stocktake Fast and slow moving lines of stock can be identified so that stock can be rotated within the store or the stock mix adjusted

Explain how the FIFO method of stock valuation can overstate the value of stock on hand in times of rising prices FIFO assumes that older stock is sold first, and that newer stock is still on hand. In times of rising prices, this newer stock becomes more expensive. Therefore, stock on hand will be overstated as it is possible that some of the stock on hand consists of the older and less expensive stock, whereas by using FIFO we are assuming that it consists entirely of the newer and more expensive stock. Explain how the FIFO method of stock valuation can understate the value of stock on hand in times of falling prices FIFO assumes that older stock is sold first, and that newer stock is still on hand. In times of falling prices, this newer stock becomes cheaper. Therefore, stock on hand will be understated as it is possible that the stock on hand consists of the older and more expensive stock, whereas by using FIFO we are assuming it consists entirely of the newer and cheaper stock. Explain the impact of FIFO on cost of sales and net profit in times of rising prices FIFO assumes that older stock is sold first, and that newer stock is still on hand. In times of rising prices, this older stock is cheaper. Therefore, Cost of Sales is understated and Net Profit is overstated as some of the stock sold may consist of the newer and more expensive stock, whereas by using FIFO we are assuming it consists entirely of the older and cheaper stock. Explain the impact of FIFO on cost of sales and net profit in times of falling prices FIFO assumes that older stock is sold first, and that newer stock is still on hand. In times of falling prices, this older stock is more expensive. Therefore, Cost of Sales is overstated and Net Profit is understated as some of the stock sold may have been the newer and cheaper stock, whereas by using FIFO we are assuming it consists entirely of the older and more expensive stock. Explain why businesses adopt the FIFO cost assignment method FIFO may be used when a business is physically unable to identify individual stock items with different cost prices. Management may elect to use the FIFO assumption 13 | P a g e

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rather than label each unit of stock with its cost price, as this may be impossible, impractical or a waste of the businesses resources. Thus, FIFO is a convenient method of cost assignment, allocating a cost to each sale allowing cost of sales to be calculated for the period. From this, it enables for the calculation of profit. What are some disadvantages of the perpetual inventory system -

It requires considerable amounts of recording due to the often large number of different lines of stock in a business It is expensive to maintain as staff must be paid to look after it, and the accounting software and computers itself are expensive It is time-consuming to maintain as a lot of care and attention must go into recording the many transactions that need to be recorded

Why is the total of the out column of a stock card not the cost of goods sold figure in the income statement As it may include drawings and stock used for advertising purposes that are verifiable by a memo, and not included as part of cost of sales and cost of goods sold as they do not involve a sale of stock. It only represents one line of stock, and a business may have multiple lines of stock. As cost of goods sold consists of all costs incurred to bring stock into a condition and location ready for sale, and this may include cost of sales as well as expenses such as freight in and customs duty What is the relationship between the stock control account and stock cards The stock control account provides a summary of all transactions involving the movement of stock, while specific and detailed information relating to each line of stock are recorded in subsidiary records known as stock cards. Explain the impact of GST on the recording of transactions in the stock cards GST has no effect on the recording of transactions in stock cards as stock is recorded at its cost price. The GST portion paid of collected represents an amount that the ATO either owes to the form or the amount of the firm owes the ATO. Explain the role of stock cards in an accounting system Stock cards are a subsidiary accounting record that are used to maintain a perpetual record of all stock movements in and out of the business of a particular line of stock

Chapter 9 – Determining Profit or Loss Closing the Ledger: Transferring balances from revenue and expense ledger accounts to the profit and loss summary so that profit can be calculated Reasons for closing the ledger: -

Transfer revenue and expenses to the profit and loss summary account in order to calculate profit for the current reporting period

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Reset revenue and expense accounts to zero in preparation for the next reporting period

Income Statement: An accounting report that details the revenues earned and expenses incurred during the current reporting period Uses of the Income Statement: -

To aid decision making about the firm’s trading operations o Allows the owner to assess the firm’s ability to earn revenue so that decisions can be made about the types of stock that are held for sale, the level of advertising or the level of selling prices o The adequacy of the firm’s mark-up can be assessed so that decisions can be made about adjusting selling prices or controlling cost prices o The firm’s ability to control its expenses can be assessed so that decisions can be made about managing staff wages, protecting stock from stock loss or operating more efficiently to control operating costs

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To assess the firm’s performance in meeting its sales and expense targets o The income statement can be compared against budgeted performance as shown in the budgeted income statement, with the comparison highlighting where performance was better or worse than expected, allowing corrective action to be taken

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To assist in planning for future trading activities o Provides a basis for the next budget, hence the income statement will aid in the setting of targets for the future. This may include stock levels, staffing requirements or advertising expenditure

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To facilitate the calculation of financial indicators for analysis and interpretation o These indicators can be used to uncover what happened and help explain why

Explain, with reference to an accounting principle why it is necessary to close revenue and expense accounts Reporting period state that the life of the business should be divided into periods of time so that reports can be prepared, that these reports should reflect the reporting period in which transactions occur. Revenue and expense accounts must be closed to the profit and loss summary at the end of each reporting period to allow for an accurate profit figure to be determined. In addition, the revenue and expense accounts are reset to zero in preparation for the subsequent reporting period. Profit and Loss Summary Account: A temporary general ledger account used to summarise all revenues and expenses for a reporting period, with the difference being the profit or loss over that time 15 | P a g e

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How is a checking mechanism formed? The profit and loss calculated by the profit and loss summary ledger account can be checked against the net profit figure in the income statement to detect any errors, so they can be corrected Why aren’t drawings included in the calculation of profit? Drawings are excluded from the calculation of profit as they are not a transaction that relates to the trading activities of the business, but rather a personal transaction between the owner and the business. Including drawings in the calculation of profit would be a breach of relevance as these details are not useful for the type of decisionmaking that is made off the income statement. In addition, transactions with the owner are expressly excluded from the definitions of revenues and expenses and thus a profit is a comparison of revenues earned and expenses incurred, drawings must not be included

Chapter 10 – Balance Day Adjustments (Expenses) Accrual accounting: Calculating profit by comparing revenues earned against expenses incurred in a particular reporting period Balance day adjustment: A change made to a revenue or expense on balance day so that revenue accounts show revenue earned and expense accounts show expenses incurred in a particular reporting period Prepaid Expense: An expense paid in advance but yet to be consumed. It is a current asset as it represents a resource controlled by the entity, as a result of past events, from which future economic benefits are expected to flow to the entity (When the expense is incurred) Accrued Expense: An expense that has been incurred but not yet paid. It is a current liability as it is a present obligation of the entity, arising from past events, the settlement of which will result in an outflow of economic benefits (When the expense is paid) Pre-adjustment Trial Balance: A list of all General Ledger accounts and their balances before balance day adjustments have been made Post-adjustment Trial Balance: A list of all General Ledger accounts and their balances after balance day adjustments have been made Purpose of Balance Day Adjustments: 16 | P a g e

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To ensure only revenues earned and expense incurred in the current reporting period are used to accurately calculate profit as this is the only information that is useful for decision-making How do balance day adjustments satisfy reporting period principle? Balance day adjustments ensure reports include information that reflects the reporting period in which the transactions occurred. This ensures profit is accurately calculated by comparing revenues earned against expenses incurred in the current reporting period. Identify and explain the accounting principle that best supports the reason for preparing balance day adjustments Reporting Period. Under accrual accounting, revenues earned should be compared against expenses incurred in order to determine an accurate profit figure. Balance day adjustments recognise that not all revenues are received and not all expenses are paid in the same reporting period as they are earned or incurred. Hence, by having balance day adjustments it allows reports to include information that reflects the reporting period in which the transactions occurred.

Chapter 11 – Depreciation of Non-Current Assets Depreciation: The allocation of the cost of a non-current asset over its estimated useful life Depreciation Expense: The part of the cost of the non-current asset that has been consumed in the current reporting period Historical Cost: The original purchase price of the non-current asset Residual Value: The estimated value of the non-current asset at the end of its useful life Useful Life: The estimated period of time for which the non-current asset will be used by the current entity to earn revenue Depreciable Value: The total value of the asset that will be consumed by the current entity, and so must be allocated over its estimated useful life Accumulated Depreciation: The value of a non-current asset that has been consumed/incurred over its estimated useful life thus far 17 | P a g e

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Carrying Value: The value of a non-current asset that is yet to be consumed/allocated as an expense, plus any residual value. Historical cost less accumulated depreciation. Cost of a Non-Current Asset: All costs incurred in order to bring the asset into a condition and location ready for use/revenue earning, which will provide a benefit for the life of the asset Explain why non-current assets are depreciated Non-current assets are prone to wear and tear and hence they are consumed over the course of their estimated useful life. The depreciable cost of the non-current asset will become an expense. This expense must be allocated over the estimated useful life of the asset as it is used to earn revenue for the business. Depreciation is an expense incurred and should be recognised in order to determine an accurate profit figure for the reporting period. Link to Relevance -

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The depreciable cost of the non-current asset will become an expense to be allocated over the assets estimated useful life It is necessary to depreciate non-current assets to ensure the value of the noncurrent asset consumed is reported as an expense against where the asset earns revenue, as this is more useful for decision-making This ensures an accurate profit figure can be calculated for the current reporting period by comparing revenues earned with expenses incurred (which includes the recognition of depreciation)

Link to Reporting Period -

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The depreciable cost of the non-current asset will become an expense to be allocated over the assets estimated useful life It is necessary to depreciate non-current assets to ensure the value of the noncurrent asset consumed is reported as an expense against where the asset earns revenue This ensures an accurate profit figure can be calculated by comparing revenues earned with expenses incurred for the current reporting period, and also ensures that reports include information that reflect the reporting period in which transactions occur

Relevance vs Reliability -

In order to calculate depreciation we must estimate the non-current assets residual value and useful life As they are estimates, they are not verifiable by reference to a source document and hence may be inaccurate and not free from error or bias, undermining the reliability of reports

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However, relevance states that reports should contain information that is useful for decision-making, and thus depreciation should be calculated The allocation of depreciation provides a more accurate comparison of revenues earned with expenses incurred to more accurately calculate profit for the current reporting period Depreciation ensures the income statement includes information that is useful for decision-making about profit (by including the expense of the consumption of a non-current asset) in the current reporting period It also ensures the balance sheet includes information that is useful for decisionmaking by showing depreciable assets at their carrying value, which is a more up to date valuation and enables decisions to be made about the replacement of the asset It would be more incorrect not accounting for depreciation than accounting for depreciation using estimates Hence, relevance overrides reliability

Chapter 12 – Cash Flow Statement Statement of Receipts and Payments: An accounting report that details cash received and cash paid during a reporting period, and the change in the firm’s bank balance over that period Cash Surplus: An excess of cash receipts over cash payments, leading to an increase in the bank balance Cash Deficit: An excess of cash payments over cash receipts, leading to a decrease in the bank balance Cash Flow Statement: An accounting report that details all cash inflows and outflows from Operating, Investing and Financing activities, and the overall change in the firms cash balance Explain a benefit of preparing a Cash Flow Statement rather than a Statement of Receipts and Payments: It aids decision-making by classifying the sources and uses of funds, allowing the owner to identify whether the net cash flows from operations is sufficient to cover other cash requirements. It also allows the owner to make decisions, such as the amount of drawings for the next period Operating Activities: Cash flows related to the day to day trading activities, examples include sales, receipts from debtors, GST received, expenses, payments to creditors, cash purchases of stock, GST paid, prepaid and accrued expenses Investing Activities:

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Cash flows related to the purchase or sale of a non-current asset, for example the purchase of equipment of the sale of a vehicle Financing Activities: Cash flows related to changes in the financial structure of the firm, for example capital contributions, cash drawings and repaying the principle of a loan

Explain the importance of Net Cash Flows from Operations: To assess whether the firms net cash flow from its day to day trading activities is able to repay debts and cover its investing and financing activities. If there is a negative net cash flow from Operations, the firm will be unable to meet its payments without capital contributions by the owner or external finance such as a loan. It is important that net cash flow from the day to day trading activities of the business is positive for the long term growth and future of the business Explain with an example how the business reported a net profit for the reporting period but reported a negative bank balance for the same reporting period Under accrual accounting, there is a difference between revenues earned and received, and expenses incurred and paid. Profit relates to revenues earned less expenses incurred, whereas cash at bank relates to cash receipts less cash payments. Thus, cash and profit are different resources. Some items affect either profit or cash only, or both by differing amounts. For example, drawings reduces cash at bank but has no bearing on net profit hence may be a reason as to the situation of this firm The owner believes that Net Cash from Operating Activities indicates whether the business has made a profit or loss. Explain, giving one example, why the owner is incorrect. Only cash inflows and cash outflows relating to the day to day trading activities of the business are include in the calculation of net cash from operating activities, whereas profit is the result of comparing revenues earned with expenses incurred. Therefore, net cash from operating activities and net profit measure different information. For example, the figure for receipts from debtors may be greater than credit sales, leading to a greater increase to net cash from operating activities than profit Explain the meaning of Net Cash Flows from Financing Activities Identifies the net result of cash inflows and outflows relating to changes in the financial structure of the firm. Therefore, it involves cash flows relating to capital contributions, drawings, loans received and loan repayments Discussion of a negative cash flow from Investing Activities If net cash flows from investing activities is negative, it reduces the firm’s bank balance. However, a negative investing cash flow may be expected if the business is purchasing new non-current assets, and positive financing cash flows may be required to finance these assets. More of better non-current assets may generate more sales in the long20 | P a g e

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term, and thus more cash, meaning the owner should not be concerned about the negative cash flow from investing activities as these non-current assets may provide economic benefits in the near future

Explain why the GST received and GST refund must be reported separately in the Cash Flow Statement As GST received is the amount of GST collected from customers as a result of cash sales in the current reporting period, and is collected on half of the ATO to eventually be passed onto them. On the other hand, the GST refund is received directly from the ATO as a result of GST on sales being less than GST on purchases in the previous reporting period. In addition, they are recorded in separate columns in the cash receipts journal, with GST received going in the GST column as it is a frequent transaction, while GST refund goes in the sundries column as it is an infrequent transaction. Explain why GST paid on non-current assets is not reported as an Investing Activity Investing activities are cash flows relating to the purchase and sale of a non-current asset. GST paid is not part of the actual cost of the non-current asset as it is not a necessary cost incurred to bring the asset into a condition and location ready for use, and will provide a benefit for the life of the asset, but rather represents the amount forwarded to the ATO that reduces the GST liability owing to the ATO. Hence, all GST cash flows are reported under Operating Activities as they eventually lead to a GST settlement or Refund which come about due to day to day trading activities. Uses of the Cash Flow Statement -

Aids decision making about the firm’s cash activities by detailing the sources and uses of funds in a period o In particular, the owner would assess if the business is generating enough cash from its Operating activities to cover its Investing and Financing activities o If not, it will be unable to meet some of its payments without contributions from the owner or external finance

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Used to assess the firms performance in meeting its cash targets o It can be compared against budgeted performance (as shown in the budgeted cash flow statement) to show where performance was better or worse than expected, so corrective action can be taken

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Used to assist in planning for future cash activities o Provides a basis for the next budget and thus aids in the setting of targets for the future. Includes estimations for cash receipts from sales/debtors, payments for stock or expenses, drawings

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Facilitates the calculation of financial indicators for analysis and interpretation

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o These indicators can be used to uncover what has happened and help explain why

Graphical Representation of Cash Flows It improves the understandability of the cash flow statement as by presenting it in a graphical format it makes it easier for users to understand and comprehend the meaning of the report Credit Sales vs Receipts from Debtors: Selling goods on credit will increase profit immediately, but may not involve a cash flow until much later. Conversely, when the cash is received from the bank it will increase bank but is not a revenue, and if a discount is involved, the cash received from the debtor will be less than the revenue earned when the sale was made. Thus, the different amounts reported as credit sales and receipts from debtors could explain why profit and cash are not the same. If credit sales are greater than receipts from debtors, the benefit in terms of profit will be greater than the benefit in terms of cash. If credit sales is less than receipts from debtors the firm may very well have less profit than cash Cost of Sales vs Payments to Creditors/Cash Purchases of Stock The way stock is paid for can also mean that cash and profit are not the same. Cost of sales represents the value of stock sold, but this may not be the same as the amount that has been paid for that stock (In the form of cash purchases of stock or payments to creditors). Cost of sales represents a stock flow and not a cash flow. If cost of sales is greater than payments to creditors and cash purchases of stock, it will reduce profit more than it reduces bank. Whereas if cost of sales is less than payments to creditors and cash purchases of stock, it will reduce bank more than it reduces profit Expenses: The amount paid vs amount incurred Due to balance day adjustments, the amount paid for expenses is frequently different from the amount incurred. When expenses are paid in advance for the next reporting period, the amount paid will be greater than the amount incurred, meaning bank decreases more than profit. Conversely, if expenses are accrued at the end of the reporting period, the amount incurred will be greater than the amount paid, leading to a greater reduction in profit compared to cash At the conclusion of the reporting period a business is likely to prepare a preadjustment trial balance. Explain whether it would be appropriate to use the information contained in the pre-adjustment trial balance to prepare the Income Statement and the Cash Flow Statement It is not appropriate to prepare an income statement from a pre-adjustment trial balance as the net profit would not be accurate. Some revenues and expense accounts 22 | P a g e

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may be available as they may not have to be adjusted. However, under accrual accounting, revenues earned and expenses incurred are both required in order to get an accurate profit. This means that balance day adjustments for items such as prepaid expenses, accrued expenses, stock losses and depreciation must all be done before profit is determined. Hence, a pre-adjusted trial balance does not provide all the required information. In regards to Cash Flow Statements, the required information is included in cash journals, not a trial balance. The pre-adjusted trial balance does not reveal items such as: cash received from debtors, cash paid to creditors, cash drawings, capital contributions and loan repayments. Some outflows, such as payments of expenses may be listed in a trial balance. However, may cash flows would be hidden in account balances, and therefore it is inappropriate to try to prepare a cash flow statement from any trial balance

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UNIT 4 BASIC NOTES Chapter 13 – Returns of Stock 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 Credit Note – A source document that verifies the return of stock either to a trade creditor or by a trade debtor Why should a business report sales returns separately? Relevance, as it provides information in reports that is useful for decision-making, such as making decisions about changing lines of stock or changing suppliers. It provides information of customer satisfaction with stock sold, and indicates the suitability and quality of the stock. It is so the owner can identify whether sales returns are a problem that need to be addressed. Use of FIFO in returns: Purchase returns – FIFO is not applied, the credit note identifies the cost price of stock being returned to the supplier Sales returns – FIFO is applied, as the sales invoice will not identify the cost price of stock that has been sold. A sales return should value stock at the cost price used in the most recent transaction in the OUT column, a technique known as the reversal of FIFO that maintains the FIFO assumption

Chapter 14 – Stock Valuation Cost of stock – All costs incurred in order to bring stock into a condition and location ready for sale Cost of stock AP and QC links: Relevance -

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An accurate calculation of the cost price of stock is useful for decision-making as the owner usually decides the stock’s selling price based on a mark-up applied to the cost price. This decision is important as selling prices must be high enough to cover costs and provide for a profit. If a business calculates the cost price of stock incorrectly, then it may set its selling prices too high, leading to a loss of potential saves revenue and profit, or set it too low, leading to an insufficient mark-up and not enough sales revenue to cover its expenses. Also, an accurate valuation of stock in the Balance Sheet is useful for making decisions relating to stock.

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Historical Cost – Stock should be valued at its original purchase price as this is verifiable by reference to a source document Reliability – Recording stock at its original purchase price ensures Reliability as the valuation is accurate and free from error or bias, because there is source document evidence to verify that the transaction occurred Conservatism – Stock is not recorded at selling price as there is no guarantee that it can be sold for this amount. By doing so it would overstate assets (Stock control) and revenue (sales) before the gain was certain Unit cost – The cost price of each individual item/unit of stock Product cost: -

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A cost incurred in order to bring stock into a condition and location ready for sale, which can be allocated to individual units of stock on a logical basis, and is a significant amount that will impact decision-making. Recognised as being incurred and their benefit consumed in the reporting period when stock is sold.

Period cost: -

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A cost incurred in order to bring stock into a condition and location ready for sale, which cannot be allocated to individual units of stock because there is no logical basis to do so. This may occur if a cost ‘per item’ cannot be easily calculated, or if the cost is traceable to more than one line of stock. Recognised as being incurred in the period when the stock is purchased, regardless of whether or not the stock is sold. Unless all stock is sold, it will overstate Cost of Goods Sold and thus understate owner’s equity (net profit), and understate assets (stock control)

Explain why the monthly payment (Eg. Insurance of stock) must be treated as a period cost. Although it was incurred to get stock ready for sale, there’s no logical basis to allocate the payment of insurance to each individual unit of stock on a ‘per item’ basis, as the insurance is incurred ‘per month.’ However, it will be treated as a period cost and not as an other expense as it a cost incurred to get the stock into a condition and location ready for sale. Explain your treatment of rebadging costs and GST when determining the unit cost of the scooters Rebadging is included in the cost of stock as it is a cost incurred to get the item into a condition and location ready for sale, which can be allocated logically to each individual scooter. It is also a significant amount that will affect decision-making, and hence must be included in the cost of stock. GST is excluded from the cost of stock as it is not an 25 | P a g e

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expense of the business, but rather the GST paid on stock purchases will simply reduce the amount of GST liability owing to the ATO. Explain the effect on net profit if period costing had been used instead of product costing Under product costing, the cost becomes part of the cost of stock and is only expensed as the stock is sold, whereas under period costing, the entire cost is written off as an expense in the period the stock is purchased, regardless of how much of the stock is sold. Therefore, it period costing was used instead of product costing, cost of goods sold would be overstated, resulting in owner’s equity being understated (Net profit) and assets (Stock Control), however only if not all stock is sold. Explain, with reference to the difference between product and period costs, how the $140 cost price was calculated The packaging and labelling was added to the suppliers price of $120 as it could be allocated to the individual units of stock on a logical basis. Therefore, it was treated as a product cost of $20 per unit, making a total unit cost of $140. The delivery charge covers many different lines of stock and cannot be directly linked to the Golden Strap bag. Therefore, it cannot be logically allocated on a ‘per unit’ basis, and it should be treated as a period cost and written off as an expense for the current reporting period. Net Realisable Value – The estimated selling price of stock less any direct selling expenses (Eg. Marketing and distribution) expressed per unit Lower of cost and NRV AP’s and QC’s links: Conservatism – The rule must be followed as it satisfies the demands of conservatism, where losses are recognised as soon as they are anticipated, to ensure that assets (Stock Control) are not overstated in the balance sheet and owner’s equity is not overstated (Stock Writedown leads to decreased Net Profit) Relevance – By following this rule, a more realistic and up to date valuation of stock will be derived and relevance will be upheld as the information reports will be more useful for decision-making purposes With reference to an accounting principle, explain why lower of cost and NRV rule should be applied. As the stock has been for example damaged and can no longer be sold above its cost price. To satisfy the demands of Conservatism, this loss must be recognised as soon as its anticipated to ensure assets (Stock control) aren’t overstated and expenses (stock write-down) aren’t understated, so owner’s equity (net profit) isn’t overstated. Referring to one AP, explain why it would be incorrect to value stock at their normal selling price Historical Cost – The selling price is not the original purchase price, and hence cannot be verified by reference to a source document, and thus may not be accurate or free from bias 26 | P a g e

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Conservatism – There is no guarantee that the stock will be sold at selling price, so using the selling price would be recognising a gain before it is certain, thus overstating the value of assets (Stock Control) and breaching the demands of conservatism Referring to one QC, explain why the stock should no longer be valued at its historical cost when its NRV is lower. When the net realisable value is lower than the stock’s historical cost, the historical cost is out of date and no longer useful for decision-making. By valuing the stock at net realisable value, a more realistic valuation of stock will be derived and relevance will be upheld as the information in reports will be more useful for decision-making. Reasons why NRV may fall below cost price: 1. Physical deterioration o The stock is damaged or shop soiled, meaning it can no longer be sold at a profit 2. Purposeful decrease in selling price o As a deliberate marketing ploy to attract new customers of force a competitor out of the market 3. A decrease in demand o As the item is no longer in fashion, or is out of season. Consequently, customers will not be as willing to pay high prices 4. Obsolescence o As the item is technically obsolete, or superseded by a new model, or for food items out of date. Stock Write-Down: -

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When the net realisable value of a stock item falls below its cost price, an expense will be incurred in the form of a loss on that sale of stock. The asset stock must be ‘written down’ to reflect this loss in value The expense incurred when the net realisable value of an item of stock falls below its original purchase price Relates to stock and affects the overall margin the business will earn from the sale of stock. In this way, it has the same effect as a stock loss/gain and thus is reported as a deduction from gross profit to determine adjusted gross profit. It’s not classified under cost of goods sold as it’s not a cost incurred to get stock into a condition and location ready for sale.

Discuss whether the damaged stock should be recorded in a separate stock card. It is purchased as an item from the same line of stock and should thus be recorded in the same stock card as the other items. However, because it is damaged, it is identifiably different from the other items of the same line of stock and thus should be recorded in a separate stock card as if it were a separate line of stock. 27 | P a g e

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Chapter 15 – Sale of a NCA Accrual Accounting – A method of determining profit where revenues earned are matched against expenses incurred for a particular reporting period Cost of a NCA – Includes all costs incurred in getting a non-current asset into a condition and location ready for use/revenue earning, that will provide an economic benefit for the life of the asset Why is GST not included in the cost of a NCA? GST is excluded as it does not provide an economic benefit for the life of the asset, but rather represents a reduction in the GST liability owing to the ATO Explain your treatment of the yearly registration when calculating the cost of the van. It was not treated as part of the costs of the non-current asset as it’s not a cost incurred to bring the van into a condition and location ready for use. It’s a yearly payment so will be consumed within a year and will not provide an economic benefit for the life of the van. Hence, it will be recorded separately as a current asset (Prepaid Registration) and will be expensed as the registration is used up Depreciation – The allocation of the cost of a non-current asset over its estimated useful life Depreciation Expense – The part of a non-current asset that has been consumed in the current reporting period Accumulated Depreciation – The value of a non-current asset that has been consumed over its life thus far Carrying Value – The value of a non-current asset that is yet to be consumed/allocated as an expense, plus any residual value Depreciable Value – The value of the non-current asset that will be consumed by the current entity, and so must be allocated over its estimated useful life Explain what the carrying value in the Balance Sheet represents. The carrying value represents the value of the non-current asset that is yet to be allocated as depreciation expense, plus any residual value expected to be realised at the end of the asset’s useful life. Depreciation Links to AP and QC’s Relevance – The depreciable cost of a non-current asset will become an expense to be allocated over the assets estimated useful life. The value of the non-current asset consumed is reported as depreciation expense against where the asset earns revenue in a particular reporting period, to ensure that an accurate profit figure is calculated. This means that the income statement will contain information that is useful for decision making as there will be the inclusion of depreciation expense, and decision-making in 28 | P a g e

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the balance sheet will be improved as there will be a more up to date and realistic valuation of the non-current asset. Reporting Period – The depreciable cost of a non-current asset will become an expense to be allocated over the assets estimated useful life. The value of the non-current asset consume is reported as depreciation expense against where the asset earns revenue in a particular reporting period, to ensure that an accurate profit figure can be calculated by comparing revenues earned against expenses incurred. Hence, the reports will contain information that reflects the transactions that occurred in the current reporting period. Straight-Line Method of Depreciation -

Assumes that the NCA contributes evenly to revenue, and that the value of the NCA is consumed evenly over its life. The value of the NCA is consumed over time, and not according to use, with the depreciation expense being the same every year

Explain why the straight-line method should be used to depreciate the noncurrent asset. The straight-line method best reflects the revenue earning pattern of the non-current asset, as it will contribute evenly to revenue over its useful life, and this method allocates depreciation expense evenly over the asset’s life. Hence, the revenue the asset earns is matched against its depreciation expense each period to accurately calculate profit. Reducing Balance Method of Depreciation -

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The NCA contributes more to revenue when it is new, efficient and productive, hence is consumed more at the start of its useful life, while it contributes less to revenue when it is old, hence it is consumed less at the end of its useful life, and the depreciation expense must reflect this revenue earning pattern The depreciation expense and the revenue the asset earns are matched in each reporting period Typically used for assets with moving parts, as they are likely to be more efficient and productive when new

Explain why the reducing balance method should be used to depreciate noncurrent assets. The reducing balance method best reflects the revenue earning pattern of the NCA, as it will contribute more to revenue earning when it is new, efficient and productive, and contribute less when it is old and unproductive. Hence, this method allocates more depreciation expense at the start of the asset’s life and less as it ages. The revenue the asset earns is matched against its depreciation expense each period to accurately calculate profit.

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Straight Line Method Contribution to revenue

The NCA contributes evenly to revenue over its estimated useful life

Cost consumed

The value of the NCA is consumed evenly over its estimated useful life

Depreciation expense

Depreciation expense is the same each year

Reducing Balance Method The NCA contributes more to revenue when it is new, efficient and productive at the start of its estimated useful life, and contributes less as it ages and becomes old, inefficient and unproductive The value of the NCA is consumed more at the start of its useful life and less as it ages Depreciation expense is higher at the start of the assets useful life and lower as it ages

Selecting a Depreciation Method -

If the asset contributes evenly to revenue and the cost is consumed evenly over its life, the straight line method should be used If the asset contributes more to revenue at the start of its life when it is new, efficient and productive, and less as it ages, the reducing balance should be used It depends on the revenue earning pattern of the NCA that determines which method of depreciation is appropriate

Explain how the accountant should determine the appropriate method of depreciation for the equipment. Refer to alternate methods of depreciation in your answer. The method of deprecation chosen should allocate the depreciable cost of the asset according to the expected revenue-earning pattern of the NCA. If the asset is expected to generate the same amount of revenue each reporting period, the straight line method should be adopted as it allocates the same amount of depreciation expense each reporting period. However, if the asset is expected to contribute more to revenue in its earlier years as it is more productive and efficient when new, and contribute less as it ages, the reducing balance method should be adopted as it allocates more cost in the earlier years and less in the asset’s later years, when it is less productive. Links to Changing Depreciation Methods AP’s and QC’s Consistency – Once a method is chosen it should be used from one period to the next to allow reports to be compared between periods and satisfy consistency. Changing depreciation methods means reports are unable to be compared between periods, and it will be unclear whether changes in depreciation expense are the result of changes in financial performance of changes in depreciation methods 30 | P a g e

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Comparability – Once a method is chosen it should be used from one period to the next to allow reports to be compared over time and thus satisfy comparability. Changing depreciation methods means reports are unable to be compared between periods and it will be unclear if changes in depreciation expense are as a result of changes in financial performance or changes in depreciation methods -

Changing depreciation methods is possible, but the change must be clearly disclosed in the reports

A business currently uses the reducing balance method to depreciate its photocopier. The accountant recommends the owner uses the straight line method from now on as it will provide a more appropriate depreciation expense each year for the photocopier. With reference to appropriate AP’s and QC’s, discuss the factors the accountant would have considered when making this recommendation. -

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Depreciation is allocated so the value of the NCA consumed is reported as an expense against where the asset earns revenue in a particular reporting period to ensure that an accurate profit figure is calculated The depreciation method selected should consider the expected revenue earning pattern of the photocopier. If it contributes evenly to revenue, the straight line method should be used as it consumes the value of the NCA evenly over its life as depreciation expense, whereas if the asset contributes more to revenue at the start of its life when it is productive and less as it ages and becomes unproductive, the reducing balance method should be used as this method consumed the value of the asset more at the start of its life and less as it ages Selecting the most appropriate depreciation method ensures the most relevant amount of expense is written off each period, meaning the reports will contain information that is useful for decision-making. However, since the reducing balance method has already been used, the consistency principle demands that the same method be used in future periods, as it allows for the comparison of reports between periods, thus also satisfying Comparability. This is because otherwise it will not be known whether changes in depreciation expense is as a result of changes in financial performance or changes in depreciation method. However, Relevance overrides Comparability in this case Conservatism principle supports the reducing balance method as it writes off more of the assets cost in its earlier years, thus reducing the likelihood of overstating the value of the asset.

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Discuss whether the owner should change the method used to calculate the depreciation of the photocopiers. The straight-line method is currently being used. The consistency principle requires that the same depreciation method be used from one reporting period to the next so that reports are comparable between periods. However, changing to the reducing balance method, which allocates more depreciation expense at the start of the asset’s useful life than at its end, would most likely more closely match the revenue earning pattern of the photocopier, as it is likely to earn more revenue when it is new and productive and less as it ages. Hence, as changing depreciation methods would lead to more useful information for decision-making purposes off the Balance Sheet and the Income Statement, relevance trumps consistency. Explain the effect on the carrying value of the NCA at the end of its useful life if the owner had used the other depreciation method. There would be no effect, as both the straight-line and reducing balance methods allocate the same total depreciation expense over the life of the asset, the allocation is just divided differently between depreciation methods. Explain why the residual value of an asset is not taken into account when calculating the depreciation amount. The residual value is not part of the cost of the asset that will be allocated as an expense during the life of the asset. The residual value is expected to be recovered when the asset is sold so it is not a cost which needs to be allocated over the life of the asset. Explain the need to depreciate the machinery over its useful life Depreciation is the allocation of the cost of the asset over its estimated useful life. It is necessary to match the depreciation expense against the revenue the asset earns each reporting period, in order to calculate an accurate profit figure by comparing revenues earned against expenses incurred as per the accrual accounting method. Loss on Disposal of Asset – When the proceeds from the disposal of an asset is less than its carrying value Profit on Disposal of Asset – When the proceeds from the disposal of an asset is greater than its carrying value Trade-In – When the firm uses the proceeds from the sale of a non-current asset to reduce the amount payable for the purchase of a new non-current asset Explain how the value of the trade-in is reported in the Income Statement. A trade-in is not reported in the income statement. Only the overall profit or loss on the disposal of a non-current asset is reported in the income statement under either other revenues or other expenses

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Reasons for a loss on the disposal of a NCA -

Under-depreciation o Occurs when insufficient depreciation has been allocated over the life of the asset, so that the carrying value of the asset is overstated o This may be because estimated residual value or estimated useful life were overstated o The original estimates did not anticipate that the asset would be damaged, as this would automatically reduce the residual value and possibly reduce its estimated useful life o The original estimates did not anticipate that the asset would be outdated or superseded by a newer, technologically superior model. This reduces its residual value o Overstating the estimated residual value or estimated useful life means not enough depreciation has been allocated over the life of the asset. As a result, the proceeds from the disposal of the asset will be less than its carrying value.

Reasons for a profit on the disposal of a NCA -

Over-depreciation o Occurs when excess depreciation has been allocated over the life of the asset, so the carrying value of the asset is understated o This may be because the estimated residual value was understated or the estimated useful life was understated o The original estimates did not anticipate that the asset would be in good condition. This would increase its residual value and perhaps increase its useful life. o The original estimates did not anticipate that the asset would be in high demand. May be because it is rare, and this would increase its residual value o Understating the estimated residual value or estimated useful life means too much depreciation has been allocated over the life of the asset. As a result, the proceeds from the disposal of the asset will be more than its carrying value.

Suggest two reasons for the profit on the disposal of a NCA 1. Over-depreciation occurring over the life of the asset as a result of either an understated estimated residual value or an understated estimated useful life 2. Asset was in high demand (maybe due to rarity) or better condition than expected which increases its resale value The accountant stated, ‘A profit or loss on disposal of a non-current asset is really just a depreciation adjustment.’ Do you agree? Explain. I agree. A loss on disposal of a NCA occurs due to under-depreciating the asset over its life which happens because the estimated residual value or estimated useful life is overstated. A profit on disposal of a NCA occurs due to over-depreciating the asset over 33 | P a g e

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its life which happens because the estimated residual value or estimated useful life is understated. Thus, a profit or loss on disposal of an asset can be said to be a depreciation adjustment as it occurs as a result of a miscalculation of depreciation, so it rectifies this error. ‘The reporting of a profit or loss on disposal of a NCA proves that while depreciation expense may be relevant it is not reliable.’ A lot of the information used to calculate depreciation is based on estimates and is not verified by reference to a source document, such as an assets useful life or residual value, so depreciation expense may not be accurate and hence subject to bias and error, and thus not be reliable. However, by allocating depreciation we can determine a more accurate profit figure as depreciation expense is matched against revenues earned by the asset in a particular reporting period, meaning the reports contain more information that is useful for decision-making purposes, thus proving that depreciation is relevant. Relevance vs Reliability -

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In order to calculate depreciation we must estimate the non-current assets residual value and useful life As they are estimates, they are not verifiable by reference to a source document and hence may be inaccurate and not free from error or bias, undermining the reliability of reports However, relevance states that reports should contain information that is useful for decision-making, and thus depreciation should be calculated The allocation of depreciation provides a more accurate comparison of revenues earned with expenses incurred to more accurately calculate profit for the current reporting period Depreciation ensures the income statement includes information that is useful for decision-making about profit (by including the expense of the consumption of a non-current asset) in the current reporting period It also ensures the balance sheet includes information that is useful for decisionmaking by showing depreciable assets at their carrying value, which is a more up to date valuation and enables decisions to be made about the replacement of the asset It would be more incorrect not accounting for depreciation than accounting for depreciation using estimates Hence, relevance overrides reliability

Chapter 16 – BDA Revenues Purpose of balance day adjustments -

Balance day adjustments match revenues earned against expenses incurred in a particular reporting period to ensure an accurate profit figure is calculated Upholds relevance as it ensures reports will contain information that is useful for decision-making Upholds reporting period as it ensures that reports include information that reflect the current reporting period

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Prepaid Revenue -

A revenue that has been received in advance but yet to be earned Examples include magazine subscriptions, renting out extra space in a warehouse, offering layby facilities or accepting cash as a deposit to secure a sale Represents a current liability as it is a present obligation of the entity arising from past events, the settlement of which will result in an outflow of economic benefits (When the goods/service is provided within 12 months and the obligation is fulfilled)

Referring to one AP, explain why only part of the rent received should be recognised as revenue for the year ended June 30 2015. Reporting period states that accounting reports should reflect the reporting period in which transactions occur. Only 4 months’ worth of rent revenue (March-June) have been earned in the reporting period ending 30 June and this is the amount that should be matched against expenses incurred in the current reporting period to accurately calculate profit. The remaining 2 months of rent remain a current liability as we still owe the tenant the space rented for 2 months. Prepaid sales revenue for sales of stock involving a deposit -

Sales revenue is a particular type of prepaid revenue because it includes the provision of stock Deposits do not recognise GST or cost of sales, and the full amount of both is recorded with the final payment at the point of sale when the goods are provided to the customer

Explain why the deposit should be recorded as Prepaid Revenue. The deposit should be recorded as prepaid revenue as it creates an obligation that will not be met until the goods are supplied, so the revenue is not earned until the goods have been supplied Referring to one AP, explain why the deposit is not recognised as revenue for December 2014 Reporting period. As at 31 December 2014, the goods had not been provided to the customer, and hence the revenue had not been earned in the current reporting period. The revenue will be earned the following reporting period once the goods have been provided to the customer. Explain why deposits are not reported as revenue. Although there is an inflow of economic benefits (cash) and assets (Bank) increase, the stock has not been provided and hence liabilities (Prepaid Sales Revenue) increases by the same amount as assets. Thus, there’s no increase in owner’s equity and it doesn’t meet the definition of a revenue. Accrued revenue -

A revenue that has been earned but not yet received

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Examples include interest on a term deposit, royalties and commissions Represents a current asset as it is a resource controlled by the entity as a result of past events, from which future economic benefits are expected to flow to the entity within the next 12 months (When the revenue is received in the form of cash)

Explain why a balance day adjustment of accrued interest revenue was required on 31 December. State an accounting principle to support your answer. Reporting period. Reports should reflect the reporting period in which a transaction occurs. The interest revenue was earned in the current reporting period and thus should be recognised in the current reporting period. This interest revenue earned can be matched against expenses incurred in the current reporting period to accurately calculate profit so that reports contain information that reflects the current period. Accrued Revenue vs Debtors -

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Accrued revenue and debtors are similar in that they are both current assets, with the revenue being earned before the cash is received, so they represent a resource controlled by the entity (the debt owed to the business), which will bring a future economic benefit in the next 12 months (When the cash is received). If the customer has the goods and the invoice, then a credit sale has occurred, and a debtor should be recognised If the revenue relates to a transaction other than sales, and the customer has not been sent the invoice, then an accrued revenue has been earned which is verified by a memo

How are sales returns reported? Balance Sheet: -

Decrease in assets by $1100 (Debtors Control), decrease in liabilities by $100 (GST Clearing) and decrease in owner’s equity by $1000 (As negative revenue in the form of sales returns reduces net profit)

Cash Flow Statement: -

No effect as there is no impact on bank

Income Statement: -

As a negative revenue titled ‘less sales returns’ below the sales revenue, as it is a reduction in the inflow of economic benefits in the form of a decrease in assets (Debtors Control) that will decrease owner’s equity (As the negative revenue sales revenue reduces net profit)

Chapter 17 – Budgets

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Budgeting – The process of predicting/estimating the financial consequences of future events Budget – An accounting report that predicts/estimates the financial consequences of financial reports Advantages of more frequent budgets -

More accurate, and thus be more useful as a benchmark for comparison against actual performance Allow for earlier detection of problems, so that corrective action can be taken in a more timely fashion to stop small problems from becoming large

Purpose of Budgeting -

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Assists planning by predicting what is likely to occur in the future o Allows the owner to prepare to manage possible problems and to take up possible opportunities (Eg. Buying a NCA in a certain period) Aids decision-making o Provides a benchmark from which actual performance can be measured against. This allows the owner to identify areas where performance was unsatisfactory, so that remedial action can be taken.

Importance of Budgeted Sales -

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Sales is the main revenue in the budgeted income statement and generates significant cash inflows (Cash Sales and Receipts from Debtors) in the budgeted cash flow statement Level of sales will be crucial in estimating variable expenses that vary with the number of units sold (Eg. Wages, Cost of Sales) and their corresponding cash outflows Level of sales affects how much stock is purchased, which affects payments to creditors Budgeted Sales must be an accurate estimate as the balance sheet uses figures derived from the cash flow statement and income statement

Budgeting Process -

Going Concern states that businesses are assumed to be continuous, so a business’s budgeting process should be continuous as well

1. 2. 3. 4.

Budgeted reports are prepared, predicting what is likely to occur Actual reports are prepared to detail what happened in the current period Variance reports are prepared to highlight differences/problem areas Decisions are made to improve business performance for the next period

Budgeted Cash Flow Statement -

An accounting report that attempts to predict all future cash inflows and cash outflows, and thus the estimated bank balance at the end of the budget period

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Consecutive budgets allows the owner to identify monthly and seasonal trends and can be used for identifying when to undertake a particular cash activity, such as the purchase of a non-current asset or repayment of a loan

How to increase expected inflows -

Increase sales (via promotions, greater advertising or discounting prices) Increase receipts from debtors (via offering discounts, contacting slow payers or sending reminder notices)

How to decrease expected outflows -

Defer payments to creditors Cut back on cash paid for expenses (Be wary as expenses are vital in the earning of sales, thus this may make cash situation worse rather than better)

Importance of Net Cash Flow from Operations -

So the firm’s day-to-day trading activities is able to repay debts, and cover any investing or financing activities. Hence the firm isn’t reliant on capital or external finance to meet payments Important that cash from day to day trading activities is business for the long term future of the business

Relationship between Investing and Financing -

Negative investing cash flows (Eg. Purchase of NCA) could be financed by positive financing cash flows (Eg. Capital or Loan)

Uses of Budgeted Cash Flow Statement Planning -

Aids planning by allowing the owner to prepare in advance for an expected cash surplus or deficit

If decrease in cash position is expected -

Defer purchase of NCA or use credit facilities/loan to purchase Reduce/defer loan repayments or payments to creditors Take less cash out as drawings Inject capital Organise or extend an overdraft facility

If increase in cash position is expected -

Purchase more/newer NCA Increase loan repayments or payments to creditors Increase cash drawings Expand trading activities by increasing advertising or employing more staff Do nothing (When bank overdraft is there)

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Aids decision-making as it sets a benchmark for the assessment of the firm’s actual cash performance. The owner can compare budgeted and actual cash flows, identify problem areas, and then take corrective action

Owner could assess: -

Effectiveness of advertising in generating cash sales Debtor collection procedures Creditor payment policies Level of cash payments for expenses Level of cash drawings Adequacy of finance for the purchase of NCA

Schedule of Receipts from Debtors – A table used to calculate how much cash will be received from debtors in the budgeted period as a consequence of credit sales in the current and previous periods Schedule of Payments to Creditors – A table used to calculate how much cash will be paid to creditors in the budget period as a consequence of credit purchases of stock in the current and previous periods Budgeted Income Statement – An accounting report that shows expected future revenues and expenses Aims met by preparing this – The owner should plan ahead to achieve the main objective of a trading firm, to earn profit, and this allows for a benchmark against which actual performance can be assessed Uses of the Budgeted Income Statement Planning -

Aids planning because it indicates if the business is expected a profit or loss, and indicates future requirements of the firm such as staffing (May require firing or hiring), stock levels or advertising campaigns

Decision-Making -

Aids decision-making by providing a standard against which trading performance can be measured, allowing problems to be identified and corrective action to be taken. Can also act as a target to motivate staff and management

You can assess -

Level of sales and effectiveness of advertising Mark-up achieved Level of stock loss to assess stock management procedures Expense control Staff performance

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Allows the owner to assess the adequacy of the firms mark-up, so that preparations can be made to purchase from a cheaper supplier, change selling prices or purchase in bulk to reduce costs

Budgeted Balance Sheet Planning -

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Can be used as a planning document by detailing the expected carrying value of NCA’s at some time in the future, and helps the owner prepare for their replacement When used in conjunction with the budgeted cash flow statement, it can be used to plan for the repayment of loans and set the drawings amount for the next period

Decision-making -

Can be used to aid decision-making by setting a benchmark for indicators that assess liquidity and stability. It allows for the calculation of budgeted WCR and DR

Variance Report – An accounting report that compares actual and budgeted figures, highlighting variances, so that problems can be identified and corrective action taken Explain the importance of variance analysis in the budgeting process -

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It is a means of checking the performance of the business and the accuracy of budgets, by comparing actual and budgeted performance, before decisions are made and budgets are prepared for the next period Significant differences and problems can be identified so the owner can make decisions to improve the firm’s performance next period

Cash Budget Variance Report – An accounting report that compares actual and budgeted cash flows, highlighting variances Uses of the Cash Budget Variance Report Planning Document – It assists with planning the next budget as budgeted figures can now be estimated more accurately, especially if poor budgeting mistakes were made beforehand Aids decision-making – The unfavourable variances should be investigated and their cause identified. The owner can then take corrective action and make decisions to improve the firm’s performance. Loan received was budgeted to be $7500, but the actual amount was $10000. Explain whether variance of $2500 was F or U/F The loan variance is favourable as it increase net cash flows by $2500 more than expected, however it could be argued to be unfavourable as it increases the firm’s liabilities by $2500 more than expected, meaning there’s a higher loan to be repaid and interest expenses may be higher, and thus more cash will leave the firm in the long term 40 | P a g e

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Income Statement Variance Report – An accounting report that compares actual and budgeted revenues and expenses, and highlights variances Uses of the Income Statement Variance Report Planning document – Assists with planning the next budget as budgeted figures can now be estimated more accurately, especially if poor budgeting mistakes were made beforehand Aids decision-making – The unfavourable variances should be investigated and their cause identified. The owner can then take corrective action to improve the firm’s performance (Eg. Unfavourable variance in stock loss is problematic, as it may be caused due to poor stock management procedures) Cost of Sales was budgeted to be $70000, but the actual amount was $55000. It had a variance of $15000. Explain whether the cost of sales variance is favourable or unfavourable. -

Cost of Sales is favourable as it decreased net profit by $15000 less than expected, however, it can be argued to be unfavourable as it means the firm didn’t sell as much stock as expected and thus sales will be lower than expected

Explain why the owner should be concerned about the firm’s profit performance when compared to the budget -

Without the higher than expected profit on disposal of the vehicle, the profit variance should have been unfavourable, and such a profit is unlikely to happen every period. There are several key items that are unfavourable such as Sales, which was lower than expected

The Income Statement Variance Report shows sales is U/F, cost of sales is U/F and gross profit is U/F. Explain the implications of the variance in G/P. Even though actual sales is lower than budgeted, actual cost of sales is higher than budgeted so perhaps more expensive stock and higher selling prices have lead to a lack of demand from customers and thus less sales. Explain how variance reports can be used by the owner to assist decision-making -

The variance report highlights the difference between budgeted business performance and actual business performance. This can be used by the owner to aid decision-making as it allows problem areas to be identified and corrective action to be taken (Eg. The owner could assess the debtor collection procedures to see if it has improved)

Explain how budgets can be used to facilitate control during the budget period -

Budgeted amounts can be compared against actual amounts during a budgeted period so the owner can identify problem areas and corrective action can be taken to improve performance. By setting targets, control may be achieved over expenses, thus improving performance

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Chapter 18 – Profitability Analysing – Examining the financial reports in detail to identify changes or differences in performance Interpreting – Examining the relationships between items in the financial reports in order to explain the cause and effect of changes or differences in performance N: Once the causes and effects of changes or differences in performance are understood, a course of action can be recommended to the owner to assist decisionmaking Profitability – The ability of the business to earn profit, as compared against a bases such as Sales, Assets or Owner’s Equity Liquidity – The ability of the business to meet its short term debts as they fall due Efficiency – The ability of the business to manage its assets and liabilities Stability – The ability of the business to meet its debts and continue its operations in the long term Assessing profitability: -

A firms ability to earn profit is dependent on its ability to earn revenues and control expenses Profitability is about assessing the firms capacity or ability to earn profit, assuming all other factors were equal Expressing profit relative to another measure allows for comparisons between different firms and different periods. In this sense profit is a relative measure

Trends -

The pattern formed by changes in an item over a number of periods Favourable trend makes net profit higher Unfavourable trend makes net profit lower

Link to Understandability -

In order to aid the Understandability of information, trends may be presented as bar or line graphs. This makes it easier for users of reports who have little or no financial knowledge or background in accounting to comprehend the meaning of what is presented in reports

Explain what ‘trends in liquidity’ means -

Changes over time, such as over consecutive reporting periods, in the firm’s ability to meet its short term debts as they fall due

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Variances -

The difference between an actual figure and a budgeted figure, expressed as ‘favourable’ or ‘unfavourable’ Allows problem areas to be identified and addressed Draws attention to areas where performance has been below expectation

Benchmarks -

An acceptable standard against which the firms actual performance can be assessed o Performance in previous periods  Allows for preparation of horizontal analysis and the identification of trends, and enables an assessment of whether profitability as improved or worsened from one period to the next o Budgeted Performance  Allows for the preparation of a variance report, and enables an assessment of whether profitability was satisfactory or unsatisfactory in terms of meeting the firm’s goals/expectations o Performance of other similar firms  Sometimes expressed as the ‘industry average,’ allows for the firms performance to be compared against other firms operating under similar conditions. This is sometimes known as ‘inter-firm’ comparison

Identify one benchmark for a business that has just started up -

Cannot be compared against performance in previous period as it is only just starting up, and it would not be appropriate for a starting business to compare its performance against an already established business. Thus, in this scenario, the only benchmark possible would be budgeted performance

Identify one benchmark for a business that is one of its kind -

Either past performance or budgeted performance, as ‘inter-firm’ comparison is not possible

Profitability Indicators – Measures that express an element of profit in relation to some other aspect of business performance Return on Owner’s Investment (ROI) -

A profitability indicator that measures how effectively the business has used the owner’s capital to earn profit Most important indicator for investors No set level for satisfactory ROI Can be compared against ROI from previous periods, budgeted ROI, ROI of similar businesses and alternative investments

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Alternative investments is most important as ROI is assessing profitability from an investors point of view, and the owner has not invested elsewhere where return could be earned on similar businesses, property, shares or financial products For these reasons ROI must be comparable with the interest rate on a bank account and returns that could have been yielded from shares or property The owner may want a higher ROI because of their hard work and hours put in, or be okay with a lower ROI because of the satisfactory they get from running their own business ROI can increase even though profit has decreased in the instance where average capital decreases by a greater proportion ROI = Net Profit/Average Capital x 100 Measured in the form “For evert $1 the owner has invested, he/she earns 25c in profit”

Explain the effect of the increase in the Debt Ratio on the profitability of the business -

The increase in the debt ratio has led to an increase in the ROI and an increase in profitability from an investor’s perspective as the business is using more borrowed funds to finance its operations, but the owner is still receiving all the profits

Explain why the ROI is higher for business 1 than business 2. Both businesses have earned the same amount of profit this period. As business 1 has a lower average capital than business 2, so the owner is earning the same profit on a smaller investment, because more of the funds to finance the firm’s operations are being provided by liabilities compared to business 2 which is more reliant on the owner’s capital. Debt Ratio -

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A stability indicator that measures the percentage of the firm’s assets that are financed by liabilities An analysis of ROI must include an analysis of debt ratio, because ROI is not just reliant on profit, but also the financial structure of the business, as to whether it is reliant on the owner’s capital or borrowed funds to purchase the assets that earn its profit A higher debt ratio indicates a greater reliance on borrowed funds (Liabilities) to purchase assets, and consequently, a lower reliance on the owner’s capital It is a measure of the firm’s long term stability, as a high debt ratio increases the level of risk for the business of being unable to meet its debts, and increases the possibility of financial collapse Can be compared with previous reporting periods, budgeted debt ratio and similar firms, which are the most useful as they operate in the same industry with similar assets and selling similar products Can’t be assessed in isolation, should be done in conjunction with ROI Measured by “% of the assets of the business are funded from liabilities, with the remaining % being funded by the owner’s capital”

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Why is high debt ratio concerning -

Higher levels of debt generally equates to a higher level of risk. There’s a higher risk that the business will be unable to pay debts (Eg. Creditors), and meet loan repayments and interest payments, especially if interest rates rise. Hence it leads to an increased risk of total financial collapse

Why is high debt ratio good -

The business is using someone else’s funds to buy the assets to earn profit, but the owner still receives all the profit. It can allow the firm to expand its trading activities (By purchasing more NCA’s, increase advertising and have a better location), and it increases ROI without actually increasing profit

Why is low debt ratio concerning -

Most of the finance used to purchase assets have been contributed by the owner, and this results in a lower ROI. This is not good from an investors point of view as they have to have a large investment

Why is a low debt ratio good -

Firm is not very reliant on borrowed funds and thus is at a lower risk of being unable to repay its debts

N: The debt ratio should be high enough to maximise ROI, but not too high that it creates difficulties for the business to meet its debts Explain the effect of the increase in debt ratio on the long-term stability of the business -

The increase in debt ratio means a decrease in the firm’s long-term stability because there is a greater reliance on borrowed funds, and thus a greater risk that the business will be unable to repay both its debts but any interest charges incurred, especially in times of rising interest rates. Hence, there is a greater risk of total financial collapse.

Return on Assets (ROA) -

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A profitability indicator that measures how effectively and productively a business has used its assets to earn profit Assesses profitability from a mangers point of view To assess can be compared against ROA from previous periods, budgeted ROA and ROA of similar businesses The owner needs to look at both the ROI and ROA when assessing profitability. ROI will always be higher than ROA because OE will always be less than total assets due to the presence of liabilities. Only a firm that has no liabilities will ROA and ROI be the same Net profit is reliant on earning revenues and controlling expenses. A higher ROA may be due to a better ability to earn revenue and control expenses Measured by “The business earns 20c in profit for every $1 in assets it controls

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Net Profit/Average Total Assets x 100

How to improve ROA -

Decrease assets by renting instead of buying a new building/equipment, as this will increase ROA as you are earning the same net profit on a lower asset base Increase sales through more targeted advertising that will increase net profit Improve expense control through (Eg. less wages, leasing a cheaper building), as this will improve net profit

Asset Turnover (ATO) -

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An efficiency indicator that measures how productively a business has used its assets to earn revenue Measures the number of times in a period the value of assets is earned as sales revenue When a business expansion is planned, budgeted ATO may be the best benchmark to use for assessment as it reflects the firm’s goal for increase in sales revenue on a greater asset base The higher the ATO, the more capable the firm is at using its assets to earn revenue While technically it is an efficiency indicator (As it indicates how efficiently the firm has used its assets to generate revenue), as revenue earning is key to earning profit, ATO has a direct and significant effect on profitability Sales/Average Total Assets Measured by “The business earned ___ times the value of its assets as revenue”

How to improve ATO -

Increase sales Decrease NCA’s by selling idle and unproductive assets or leasing instead of buying

Relationship between ATO and ROA -

They both assess the firm’s ability to use its assets, but ROA relates to profit while ATO relates only to revenue. Theoretically, an increase in ATO (Increased ability to earn sales revenue) should lead to an increase in ROA (Ability to earn profit), but this is not always the case because of worsened expense control

State the reason for the decrease in the firm’s ATO As average total assets increased by proportionately more than the increase in sales, or sales has decreased proportionately more than the decrease in assets. Explain why ATO has changed from 2014 to 2015. Sales revenue increased proportionately more (By xxx – almost xx%) than the increase in average total assets (Which increased by xxx, or xx%), indicating an improved ability to use assets to earn sales revenue Expense Control

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The firm’s ability to manage its expenses so that they either decrease or, in the case of variable expenses (Eg. Cost of sales, advertising, wages), increase no faster than sales revenue The firm’s ability to control its expenses is a key factor in its ability to earn profit Expenses assist in the earning of revenue so should not be perceived as ‘bad’ As sales volume increases, some expenses such as cost of sales, wages and advertising may increase too. As long as they don’t increase more than sales proportionately, its satisfactory expense control. If they increase by less than sales, it is improved expense control NPM and GPM calculates the % of each dollar of sales is retained as profit, so it can be used to evaluate expense control

Explain why an improvement in expense control could still see a total expense increase Some expenses, such as Cost of Sales, advertising and wages are variable, and hence increase in line with sales volume. If these expenses increase in proportion to or less than sales revenue, it indicates satisfactory expense control Net Profit Margin (NPM) -

A profitability indicator that measures expense control by calculating the percentage of sales revenue that is retained as net profit Measures how much of each dollar of sales revenue remains as net profit after expenses are deducted Net Profit Margin decreasing is due to GPM (Average mark-up) decreasing, and/or having worsened expense control Net Profit/Sales Revenue x 100 Measured by “20c of every dollar of sales revenue was retained as net profit”

Relationship between NPM, ATO and ROA ATO is an indicator that measures the ability of the firm to use its assets to earn revenue, while NPM is an indicator that measures the ability of the firm to control its expenses. Thus, ROA which is an indicator for how effectively the firm has used its assets to earn profit depends on both ATO and NPM, and this is represented mathematically as by multiplying the two it gives you the formula for ROA. Explain how increasing advertising could lead to an improvement in the NPM or a worsening in the NPM. Higher advertising will increase expenses, but should also mean more sales revenue (As more potential customers are aware of the business and its products). If sales revenue is proportionately more than the increase in advertising expense, the net profit margin will increase, but if not it will decrease. Gross Profit Margin (GPM) -

A profitability indicator that measures the average mark-up by calculating the percentage of sales revenue retained as gross profit

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Measures the percentage of sales that is retained as gross profit Used to assess the adequacy of the firm’s mark-up, the difference between the selling price and cost price of stock Higher GPM indicates higher average mark-up, and a bigger gap between selling and cost prices Gross Profit/Sales Revenue x100 Measured as “53c of each $1 of sales revenue was retained as gross profit, and 47c was consumed as cost of goods sold”

How could a higher GPM occur? -

Selling prices increased and cost prices remained constant (Increased mark-up) Cost prices decreased and selling prices remained constant (Purchasing stock from a cheaper supplier and hence increasing mark-up) Both cost and selling prices increasing, but selling prices by a greater proportion Both cost and selling prices decreased, but cost price decreased by proportionately more

Strategies to increase GPM/Average Mark-Up -

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Increase selling prices, which comes with the risk of lowering demand and sales volume, which may end up reducing total sales. However if total sales increases, then GPM will increase Buy from a cheaper supplier, comes with the risk of having worse stock quality. This may lead to a reduction in sales as customers are less willing to purchase products, or an increase in sales returns, stock write-downs and stock losses

Explain how increasing selling prices could lead to an increase in GPM but a decrease in gross profit. A higher selling price will increase the average mark-up and the gross profit margin. However, customers may be unwilling to pay the higher prices, leading to a decrease in the volume of sales, and hence there will be a decrease in gross profit. Explain why the increasing advertising will not lead to an improvement in the GPM Increasing advertising will not change the average mark-up as it will not affect selling prices or cost prices. It may generate greater sales volume, and thus greater sales revenue, but will not affect the gross profit per dollar of sales revenue State one limitation of relying on Gross Profit Margin to assess the firm’s profitability -

Only reflects the average mark-up Relies on historical data Doesn’t assess revenue earning ability Doesn’t assess control of other expenses

Vertical Analysis of the Income Statement

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A report that expresses every item as a percentage of a base figure (Such as sales revenue) Comparing a vertical analysis between reporting periods shows changes in expenses as percentage of sales, hence showing a comparison between revenues and expenses between periods in the instance that sales remained constant

Link to Understandability -

Not all owners are accountants, so presenting a vertical analysis as a pie-chart satisfies Understandability as it ensures that users without an accounting background can comprehend the meaning of the report

Non-Financial Information – Any information that cannot be found in financial statements, and is not expressed in dollars and cents, or reliant on dollars and cents for its calculation The firm’s relationship with its customers -

It’s important small businesses retain customers they already have as its difficult to attract customers Thus, it’s essential to have feedback from current customers as to their level of satisfaction with current products and services Customer satisfaction surveys Number of repeat sales Number of sales returns Number of customer complaints Number of sales enquiries/catalogue requests Degree of brand recognition (Based on market research) Number of hits on the website of the business

Suitability of stock -

Business must assess the suitability of stock to ensure they are meeting their customers’ demands Level of sales reports how much was sold but provides no feedback as to whether customers were satisfied Number of sales returns Number of purchase returns Number of customer complaints

The firm’s relationship with its employees -

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The performance of employees has a direct and significant impact on generating profit, as staff are responsible for important tasks like generating sales and managing stock Performance appraisals (Evaluating staff performance) Number of days lost due to sick leave/industrial action (Employee satisfaction and workplace harmony) Staff turnover/average length of employment (Employee satisfaction and workplace harmony)

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State of the Economy -

A factor in evaluating profitability as all businesses struggle to survive in a shrinking economy Interest rates (Affects firm’s ability to generate sales) Unemployment rate (Affects firm’s ability to generate sales) Number of competitors (Affects firm’s ability to generate sales) Level of inflation (Relevant when assessing firm’s ability to control expenses)

Limitations of Financial Indicators -

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Reports use historical data o Do not guarantee what will happen in the future and can’t make certain predictions Many indicators rely on averages o This may conceal details about individual items that are doing extremely well or bad Firms use different accounting methods o This can undermine the comparability of reports and profitability indicators when comparing between business Reports contain limited information o There are many items of information not reported in the income statement

Strategies to improve profitability -

Earning revenue o Selling price  Could be decreased to generate more sales volume or increased to generate greater revenue per sale o Advertising  Could be increased or targeted more accurately at prospective customers o Stock Mix  Stock for sale could be changed so only products in demand are kept on hand and slow moving lines are removed and replaced with lines that sell o Non-Current Assets  Could be increased with idle/inefficient assets replaced by more productive versions that enable the business to increase sales or lower operating and maintenance expenses o Customer Service  Internal procedures such as paperwork could be made more customer friendly, better staff training to improve service or product knowledge, extra services such as delivery, wrapping, internet access and product advice could be offered to increase sales

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Controlling expenses o Management of stock  Purchase from an alternative supplier that provides cheaper and/or better quality stock, different ordering procedures that reduce storage costs and stock loss or generate price discounts o Management of staff  Different rostering systems, appropriate incentives and extra training may improve staff productivity and performance o Management of NCA’s  Inefficient, under-utilised, unreliable or idle assets are expensive and should be replaced or removed. They increase expenses due to depreciation and maintenance expense

Chapter 19 – Liquidity Liquidity – The ability of a business to meet its short term debts as they fall due N: An assessment of liquidity should analyse the level of liquid funds (Bank and cash that can be generated from stock and debtors) available to meet short term obligations and the speed at which these resources become available to assess whether the cash will be available in time to meet the firm’s short-term obligations Tools for assessing liquidity -

Trends Benchmarks Variances Liquidity Indicators

N: The cash flow statement and budgeted cash flow statement are the primary sources of information, detailing the actual and expected inflows and outflows of cash for trends and variances. The budgeted cash flow statement is essential to analysing liquidity as it details all expected cash inflows and cash outflows and states categorically if the firm will meet its cash obligation for the coming reporting period Benchmarks for assessing liquidity -

Liquidity in previous periods Budgeted liquidity Liquidity of similar businesses/industry averages

Working Capital Ratio (WCR) -

A liquidity indicator that measures the ratio of current assets to current liabilities, to assess the firm’s ability to meet its short term debts Measures how many dollars of current assets are available to meet each dollar of current liabilities

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Indicates whether the firm is able to meet its short-tern debts using cash generated from its current assets Measured by “the business has $1.50 in current assets for every $1 of current liabilities”

Assessing WCR -

Satisfactory liquidity exists if the WCR is at least 1:1, as this would indicate there’s at least $1 of current assets available to meet every $1 of current liabilities A WCR of exactly 1:1 would leave no room for error, if any current asset could not be converted into cash, the firm would have insufficient cash to meet its short term debts, and would face liquidity problems

WCR less than 1:1 -

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Indicates unsatisfactory liquidity, as the business is unable to meet its short term debts as they fall due as it has insufficient current assets to meet its current liabilities. If not addressed and creditors and banks are unable to be paid, the business may be forced into liquidation, and have to sell its assets to raise funds to pay off its debt. In order to avoid these difficulties, the owner may make a capital contribution, seek additional finance by entering into an overdraft facility or take out a long-term loan to pay for short-term debts In the long term borrowing may worsen cash situation due to repayment of principle and interest In the short term the survival of the business depends on the extra finance

WCR much greater than 1:1 -

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This is good, but the owner should be wary of having a WCR too high as this may indicate the business has excess current assets that are idle and not being used effectively This may be apparent in: o Bank  Small amounts of interest so little to gain from keeping more cash in the bank than necessary to meet obligations. Better off using excess cash to retire debts, expand operations or make other investments where it can earn a greater return o Stock Control  Large amounts of stock could incur additional storage costs, or increase the possibility of stock loss or damage and technical obsolescence which would lead to stock write-down o Debtors Control  Large debtors figure indicates increasing group of “ageing” debtors. The older a debt is it becomes less likely that it will be received and a greater possibility of bad debts arises

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When it is too high the owner may use excess cash to repay debts, purchase noncurrent assets, allow stock levels to run down before reordering or take extra drawings

Quick Asset Ratio (QAR) -

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A liquidity indicator that measures the ratio of quick assets to quick liabilities, to assess the firm’s ability to meet its immediate debts While WCR assumes all current assets can be liquidated immediately, there is no guarantee that stock will suddenly all be sold and usually prepaid expenses can’t be converted into cash. A bank overdraft is unlikely to be called in for repayment as long as it remains under the limit QAR = CA (Excluding stock and prepaid expenses)/CL (Excluding bank overdraft) Measured as “The business has $0.75 in quick assets for every $1 of quick liabilities

Assessing the QAR -

Should be at least 1:1 If WCR is satisfactory but QAR is unsatisfactory, it is because the business has a large investment in stock and prepaid expenses, and may have a bank overdraft If this happens, the business needs to improve its level of quick assets by improving debtors or trying to maintain a positive bank balance. Can also reduce level of quick liabilities by reducing level of creditors and accrued expenses.

Limitations of WCR and QAR -

They both rely on static information (Items that only look at one point in time), when liquidity is better assessed using actual cash flows

Cash Flow Cover (CFC) -

A liquidity indicator that measures the number of times Net Cash Flow from Operations is able to cover average current liabilities Measures the number of times average current liabilities can be met using net cash flows from operations Assesses liquidity by identifying the actual cash that the business earns from its day-to-day trading activities to meet its financial obligations Net Cash Flows from Operations/Average Current Liabilities Measured as “Net Cash Flow from Operations was able to pay average current liabilities ____ times”

How to improve CFC -

Increase cash sales or receipts from debtors Decrease current liabilities by using capital injections instead of bank overdraft to pay debts and find a cheaper supplier to reduce average creditors

Assessing CFC -

No set benchmark to be considered satisfactory

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Can be compared against CFC from previous periods, budgeted CFC or CFC of similar businesses If a business can’t generate sufficient cash from its operations, regular contributions from the owner or external financers are needed to meet its loan repayments

Indicators that assess the speed of liquidity -

A business can survive, even if it has an unsatisfactory level of liquidity, if it can sell its stock and collect cash from customers before that cash is needed to pay debts These indicators assess efficiency, the ability of the firm to manage its assets and liabilities

Stock Turnover (STO) -

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The average number of days it takes for a business to convert its stock into sales Assesses how effectively the firm has managed its stock holdings Only measures the average time taken to sell stock – decisions should also consider the details found in stock cards, as they provided detailed information of how specific lines of stock are selling Average Stock/Cost of Goods Sold x 365 Measured by “In _____ reporting period, it took an average of _____ days to sell stock”

Assessing STO -

Can be compared to the budgeted STO or STO of similar businesses to assess whether the STO is satisfactory Assessment must consider the nature of the goods sold. Goods that are perishable or susceptible to technological obsolescence should have a fast stock turnover and cheap items should be sold faster than expensive items

STO too slow -

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If STO is too slow the firm is less able to generate sales and hence less able to generate cash inflows from Cash Sales and Receipts from Debtors to meet debts as they fall due Could be caused by a decrease in the level of sales (Due to general economic conditions, seasonal factors, stock quality of competition), or an increase in the level of stock on hand (Due to ordering more stock than required) Strategies should be employed to increase sales, through advertising, changing selling prices to either increase sales volume or the revenue earned per sale or changing stock mix Level of stock on hand should be decreased, by ordering less, ordering smaller amounts more frequently (Just In Time Ordering) or replacing slow moving lines of stock

STO too fast -

Business is generating high sales However, this may mean the selling price is too low leading to a loss in potential revenue and profit

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This may be because the firm is holding too little stock, costs of delivery are higher as they are more frequent, and there is a loss in the possibility of earning discounts when buying stock in bulk, and the business may run out of stock if it doesn’t have enough stock on hand Perhaps less stock so less stock variety, leading to customers not being able to find what they want, hence a loss of potential sales

Stock Management Strategies to Maximise Sales -

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Maintain appropriate stock mix o The owner must pay close attention to which stock is selling so it’s appropriate for the season and current tastes and preferences. Stock lines selling well should be expanded while those that are not should be reduced, discounted or discontinued Promote the sale of complementary goods o Complementary goods are add on sales that are generated to support the original item sold. The owner should consider what ‘extra sales’ it can generate from stock that is related Ensure stock is up to date o Sales of some stock is heavily affected by changes in fashion or technology. Stock of these items must be the most current available and older and out of date versions should be discounted for quick sale Rotate stock o Positioning of stock in a store can have a significant impact on whether it sells. For perishable items, older products should be moved to the front so they are taken first, minimising stock loss and stock write-down. Can move an entire stock line to another location or shelf within the store, perhaps boosting sales Determining an appropriate level of stock on hand o Stock levels should be sufficient to meet demand, but not so high that there’s additional storage costs or stock write-down issues through damage or technical obsolescence. Setting a target assists in identifying when to reorder. Strong marketing o Strategies like advertising may lead to increase in sales and faster STO. Can attract customers and entice them to buy goods

Debtors Turnover (DTO) -

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The average number of days it takes for a business to collect cash from its debtors Assesses how effectively the firm has managed its debtors by calculating the average number of days it takes to collect cash from its debtors Businesses that allow credit sales must first sell its stock and then wait until cash is received from debtors, influencing the firm’s ability to generate cash to meet shortterm debts as they fall due The cash cycle or turning stock into cash is STO + DTO Average Debtors/Credit Sales x 365

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Measured by “In _____ reporting period, it took an average of _______ days to collect cash from debtors”

Implications of longer DTO -

Positive for profitability as less discount expense is given to customers Negative for profitability as perhaps more bad debt expense Negative for liquidity as the business is receiving cash more slowly

Assessing DTO -

The credit terms offered to customers is used to determine whether DTO is satisfactory Can be assessed against a previous period to identify increases/decreases and perhaps the budgeted DTO Owner needs to analyse the debtor’s ledger in conjunction with the DTO so each individual debtor can be managed appropriately. Business could prepare a debtors ageing analysis (A list of the amount and proportion of debtors according to the length of time they are owing)

Debtor Management Strategies -

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Extensive credit checks o Only offering credit to customers who have a proven record will increase the chances of cash being received on time Discounts for quick settlement o Offering settlement discounts can encourage debtors to pay well within the credit terms. However, this is a negative for profitability as discount expense reduces net profit Prompt invoicing o Invoices should be sent with the goods so the customer is immediately aware of the amount owing and the repayment date so starts thinking about it Threats of not providing credit in the future o Debtors who have not paid their current overdue debts should be refused further credit facilities until the amount outstanding is received. However, this leads to less sales Reminder notices o Notices should be immediately sent to remind debtors their payment is overdue (Ranging from friendly reminders to threatening legal action). Reminders could be a copy of the invoice or statement of account. However, this is a negative for profitability as it increases administrative expenses and wages Debt collection agency o Debt collection agency can annoy a late payer by persistent telephone contact to embarrassing them at their place of work Threats of legal action

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o Threat of court action may prompt payment, but the negatives are that legal action is a long and costly process, which may end the relationship with the debtor, leading to less or no sales from this debtor

Creditors Turnover (CTO) -

The average number of days it takes for a business to pay its creditors Indicates the effectiveness of the firm in managing its creditors Average Creditors/Credit Purchases x 365 Measured by “In _____ reporting period, it took an average of ______ days to pay creditors, (____ days before the credit terms expired)

High CTO Implications -

Positive for liquidity as you retain cash for longer to meet other debts as they fall due Negative for profitability as there is a loss of potential discount revenue

Assessing CTO -

The credit terms offered by suppliers are used to determine whether CTO is satisfactory Can be assessed against a previous period to identify increases/decreases and perhaps the budgeted CTO If discounts are offered and the cash is available, then paying early is beneficial If there are no discounts, there is no incentive to pay early so CTO should be as close as possible to the credit terms, so the firm retains cash for longer and can use it to meet other payments as they fall due

Penalties for exceeding credit terms offered by suppliers -

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Removal of credit facilities o With credit facilities withdrawn, the firm would have to pay cash for its stock (may not have a large amount of cash to pay in one instalment), or may not be able to purchase stock at all Reduction in credit rating o This makes it difficult to establish lines of credit in the future if the business has a poor history of repaying its debts

STO, DTO and CTO Relationship -

A firm’s ability to pay its creditors will rely heavily on its ability to generate cash from its stock CTO is reliant on STO and DTO (if the business deals mainly on credit) A firm ill want its cash inflow (From STO and DTO) to be as fast as possible, whereas it will want to pay its creditors as slowly as possible (Higher number of days possible without exceeding credit terms)

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EXAM DISCUSS REVISION 1. Accrual accounting system o A system where revenues earned irrespective of received are compared against expenses incurred irrespective of paid in order to determine an accurate profit figure for the reporting period. o This is achieved through balance day adjustments which ensure that revenue accounts show revenues earned and expense accounts show expenses incurred at the end of balance day o This allows for a more accurate balance sheet at the end of the reporting period as future economic benefits and obligations will be recognised (Eg. Accrued or prepaid expenses) o Satisfies reporting period and relevance

2. Agreed value o Historical cost states that transactions should be recorded at their original purchase price as this value is verifiable by reference to a source document o This ensures reliability as reports will be more accurate and hence more free from bias and error o However given that the owner has consumed part of the value of the asset through personal use, the historical cost is outdated and hence irrelevant and not useful for decision-making purposes o The agreed value which is the accepted value of the non-current asset at the time of its contribution by the owner should be used as it has been estimated by a neutral third-party, hence it is a more up to date valuation and will be more useful for decision-making purposes o Entity supports this as it states that the firm and the owner are separate entities and their records should be kept on this basis. Hence as the vehicle was purchased using personal funds, it should not be recorded into business records at that cost, as it was not a business transaction o Conservatism also supports using agreed value as it is lower than the historical cost and thus ensures that assets and owner’s equity are not overstated

3. Control accounts o Control accounts summarise transactions involving debtors, creditors and stock, while subsidiary accounts provide detailed information showing individual transactions for each individual debtors, creditors and lines of stock on the day they occur o A benefit is that it creates an in-built double checking mechanism via a schedule whereby the balance of the control account can be checked 58 | P a g e

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o

o

o

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against the sum of the balances of the subsidiary accounts. This allows for recording errors to be detected and corrected, improving the Reliability of reports as they will be more accurate and free from bias and error A second benefit is that it allows for ease of reporting, as instead of listing every individual debtor or creditor and their individual balance in the balance sheet, a single balance for the control account can be included. This prevents excessive detail in reports and ensures that the information is more useful for decision-making purposes, giving greater relevance A third benefit is that it allows for allocation of duties that leads to greater internal control and reduces the likelihood of fraud. This is because certain employees can be allocated to work on the general ledger and others the subsidiary ledger, improving accountability which will hopefully prompt greater effectiveness A disadvantage is that by having both control and subsidiary accounts it will require considerably more recording and be more time consuming, and perhaps will require a greater amount of staff which could lead to an increase in administration expense. A second disadvantage is that it may not be appropriate for all firms, as a firm that only has one creditor will find little benefit in having creditor subsidiary accounts, as all it would create is unnecessary duplicate accounts, that would be a waste of the firm’s resources

4. Perpetual inventory system o A system whereby a continuous record of stock movements in and out of the business is kept, with individual stock transactions being recorded on the day they occur in stock cards, and then a physical stocktake conducted at the end of the reporting period to verify the accuracy of the stock cards o This acts as an in-built double checking mechanism as the value of what should be stock on hand in the stock control account can be checked against the results of the physical stocktake, so that any stock losses or gains can be detected o A benefit is that by maintaining a continual record of the number of units of stock on hand, reordering of stock is assisted allowing the business to avoid loss sales o A second benefit is that it allows for the identification of fast and slow moving lines of stock so the stock mix can be adjusted or stock rotated within the store accordingly o A third benefit is that stock losses and stock gains can be detected by comparing the stock cards against the results of the physical stocktake o Disadvantages are that it requires considerable recording due to the often large number of lines of stock a firm has, it expensive to maintain as staff must be paid to look after it as well as the cost of computer software and the maintenance expenses that come with it, and it is time-consuming and a lot of effort and care must be taken 59 | P a g e

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5. Double entry accounting o A system whereby every transaction has at least two effects on the accounting equation and ledger accounts, and after recording these transactions the equation still balances. Every transaction involves a debit and a corresponding credit, and total debits must equal total credits o A trial balance is a list of all the account balances in the general ledger, used to determine if total debits equals total credits. Thus this creates an in-built checking mechanism that allows for recording errors to be detected, thus improving the Reliability of reports as they will be more accurate and free from bias and error o However, it is not a perfect mechanism as in some instances the trial balance will still equal with recording errors present, such as omitting a transaction altogether o In addition, it requires considerably more recording and a higher level of skill required to operate in comparison to a single-entry system 6. Special Journals o Summarises similar transactions so that totals can be posted to the general ledger at the end of the reporting period o This reduces the number of repetitive ledger entries required, thus improving the efficiency of the accounting system, by reducing the amount of excessive detail in the general ledger o Satisfies relevance o However, it may not be appropriate for all businesses, for example a firm that does not sell stock on credit would not need a sales journal 7. Depreciation o Depreciation is the allocation of the cost of a non-current asset over its estimate useful life o It breaches reliability as the useful life and residual value which are used in the calculation of depreciation are estimates and hence they are not verifiable by reference to a source document, and could be inaccurate and prone to bias and error o It satisfies relevance as it ensures that the value of the non-current asset consumed is matched against the revenue the asset earns in a period, allowing for a more accurate calculation of profit for the period in the income statement, improving decision-making and satisfying reporting period in the process. It improves decision-making in the balance sheet as it allows depreciable assets to be shown at their carrying value, which is useful for decisions regarding the replacement of the asset o Straight-line method is for assets with a revenue earning pattern that is even, and cost is allocated appropriately with the same amount of depreciation expense each period o Reducing balance method is for assets with a revenue earning pattern whereby it contributes more to revenue when it is new and productive, and less as it ages and becomes unproductive. Thus, cost is allocated 60 | P a g e

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accordingly with more depreciation allocated near the start of its useful life and less as it approaches its end. o Using the correct depreciation method that matches a non-current assets revenue earning pattern ensures both reporting period and relevance as it ensures that the depreciation expense incurred for the period is matched against where the asset earns revenue in a period more appropriately, allowing for a more accurate profit figure for the period o However, consistency and comparability state that consistent accounting procedures should be used to ensure that reports are comparable between periods, and thus a firm should be reluctant to change depreciation method, as otherwise it will not be known whether changes in depreciation expense are as a result of changes in financial performance or changes in depreciation method 8. Period vs Product o Product costing is for costs incurred in order to bring stock into a condition and location ready for sale that can be logically allocated to individual units of stock on a per ‘unit’ basis. The expense is incurred in the reporting period in which stock is sold under cost of sales o Period costing on the other hand is for costs incurred in order to bring stock into a condition and location ready for sale that cannot be logically allocated to individual units of stock as there is no logical basis to do so, as perhaps it is traceable to more than one line of stock or it is too difficult to calculate a ‘per unit’ amount. It can also be used in cases where it can be logically allocated, however the amount is too immaterial to impact decision-making and thus it is simply written off as a period cost for convenience. The expense is incurred in the reporting period in which stock is purchased under cost of goods sold. o Using product costing where applicable satisfies Going Concern as it recognises that the stock will be sold in future reporting periods and thus the expense will be incurred accordingly, thus acknowledging that the life of the firm is indefinite. o Product costing also satisfies relevance as often there is a fixed mark-up on cost price, and thus by getting a more accurate cost price, it allows for a more appropriate selling price, thus it provides information that is useful for decision-making o Product costing satisfies reporting period as it matches revenue (sales) against the cost incurred for that sale to occur (cost of sales) more appropriately, allowing for a more accurate profit figure to be determined for the period 9. Cost assignment method o Used in cases where it is not possible to physically identify between units of stock with different cost prices, when it is impossible, impractical or a waste of the firm’s resources to label each individual unit of stock with its cost price. 61 | P a g e

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o Thus, it is convenient as it allocates a cost to each sale, allowing net profit to be calculated for the period o An example of this is FIFO which is an assumption whereby the first stock in is the first to leave the firm 10. Lower of cost and NRV o When the estimated selling price of stock less any direct selling expenses falls below cost price, stock must be written down as a loss has become anticipated. This ensures that assets (Stock Control) and owner’s equity (Net profit) are not overstated, because a stock write-down will take place 11. Budgeting o Budgeted performance can be compared against actual performance so that variances can be determined, and problem areas can be highlighted where performance was worse than expected so that corrective action can be taken to improve performance in the next period, as such it improves control o Improves planning by predicting what is likely to occur in the future, so that the owner can prepare to manage possible problems or take up possible opportunities. It can also act as a goal to motivate staff and management o It is beneficial to prepare budgets more frequently as it allows for more frequent comparison against actual performance, so that problem areas can be highlighted more often and remedial action can be taken in a more timely fashion. In addition, it will allow for more accurate estimations in budgets as it is more accurate to predict in the short-term as opposed to the long-term 12. Internal Control (In study design but outside of textbook) o Defined as protecting assets from theft, damage and misuse o Physical safeguards (Eg. Fences and locks) o Preventative safeguards (Eg. Cameras and alarms) o Separation of duties (Cross checking mechanism) o Rotation of duties (Allows for scrutiny) o Careful hiring practices (Eg. Police checks and criminal record checks) o Effective employee training

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MY ATARNOTES DISCUSS ANSWERS 1. Discuss the different methods of depreciation and why it is not recommended that the method be changed regularly. Refer to 1 AP and 1 QC in your answer. Depreciation is the allocation of a cost of a non-current asset over its estimated useful life. The straight-line method is applied for non-current assets that contribute evenly to revenue, with cost being allocated accordingly so depreciation expense being the same each period. This can be contrasted to the reducing line method, which is applied for non-current assets that contribute more to revenue when they are new and productive and less as they age and become unproductive. Thus, cost is allocated accordingly with more depreciation expense at the start of its useful life and less towards its end. Therefore, by using the depreciation method that most appropriately matches an assets revenue earning pattern, it allows for depreciation expense to be more appropriately compared against the revenue the asset earns in the period in order to calculate an accurate profit figure, thus satisfying reporting period and relevance as now the income statement is more useful for decision-making. However, consistency and comparability state that consistent accounting procedures be used so that reports can remain comparable between periods. Therefore, by changing methods it will not be known whether changes in depreciation expense are as a result of changes in financial performance or changes in depreciation method, thereby breaching both.

2. Discuss the effect the movement of the debt ratio has on the profitability and liquidity of the business The debt ratio is a stability indicator that measures the percentage of the firm’s assets that are funded by liabilities, and thus can be used to assess the firm’s ability to manage its debts and continue its operations in the long-term. An increase in debt ratio means an increased reliance on external funds to finance its assets, and this will lead to greater amounts of debt, which will lead to more repayments as well as greater cash outflows required for interest, therefore having an unfavourable effect on liquidity as the firm will be less able to meet its short-term debts as they fall due, while a decrease in debt ratio would have the opposite effect. The greater amount of interest expense will have a negative effect on profitability as it will reduce net profit, with a decrease in debt ratio leading to less interest expense hence a positive on profitability. However in the longterm, the firm may see a favourable improvement in profitability as the firm will be able to purchase assets using borrowed funds it otherwise would not have been able to, and these can tap into new revenue streams and generate net profit in the long-term, improving profitability. This may ultimately lead to greater cash inflows from cash sales as well, improving liquidity in the long-term. This expansion wouldn’t occur with a lower debt ratio and hence both profitability and liquidity would suffer. Lastly, a greater reliance on borrowed funds means the firm is less reliant on the owner’s capital, and thus return on owner’s investment should increase and the firm is earning a greater return on a lower capital base, thereby improving profitability from the owner’s 63 | P a g e

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perspective. A lesser reliance on borrowed funds on the other hand means the firm is more reliant on the owner’s capital, and so they would be receiving a lower return for the amount they have invested, decreasing profitability from the owner’s perspective.

3. Discuss how stock cards follow accounting principles (Refer to 2) Stock cards are a subsidiary record for stock and as per the perpetual inventory system record individual stock transactions relating to individual lines of stock on the day they occur. They satisfy historical cost in most instances as stock is recorded at cost price, as this figure is verifiable by reference to a source document and hence is accurate and free from bias and error. They satisfy conservatism as stock is not recorded as selling price as this would be recognising a gain before it is certain, thus overstating assets (Stock Control) and owner’s equity (Net Profit). Also in instances where net realisable value falls below cost price, it again satisfies conservatism as stock is written down to reflect that a loss is probable. A negative are that it requires considerable recording and are time consuming to maintain.

4. Determine the limitations of using financial indicators to determine performance Financial indicators measure aspects of business performance that can be calculated using cents and dollars. They are limited in that they are reliant on historical data, and this does not necessarily reflect what is going to occur in the future. For example a previously favourable cash flow cover doesn’t necessarily mean it will favourable in the future. Many indicators use averages and thus may conceal details about specific items, for example a fast stock turnover may conceal a particular line of stock that is selling badly. Lastly, there are some aspects of business performance that cannot be measured through the use of cents and dollars, and require the use of non-financial indicators, for example numbers of days taken off by staff due to sickness or industrial action, as this could measure workplace harmony and staff satisfaction, which cannot be achieved using financial indicators. Another example is number of sales returns measuring the quality and suitability of stock sold. However while they are limited, they can still provide insight into the firm’s business performance such as how debtors turnover measures how quickly cash can be collected from customers.

5. Discuss the benefits of preparing budgets for business performance Budgets predict what is likely to occur in the future. Hence, they assist in planning as they allow the owner to take pre-emptive action in order to prepare to manage possible problems or take up possible opportunities that have been forecasted, therefore improving decision-making. For example, if a cash deficit is budgeted then the owner could plan to inject capital or take out a loan to relieve liquidity. They also allow for a comparison to be made between budgeted performance as a benchmark and actual performance through the use of variance reports, which can highlight where 64 | P a g e

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performance was better or worse than expected, so that problem areas can be identified and corrective action taken to improve performance for the next period, improving control. Lastly, they can act as a tool to motivate staff and management to reach a certain target such as sales. A disadvantage of preparing budgets are that they are time consuming and require staff members to work on it, possibly increasing book-keeping or accountancy fees. Also they are merely estimates, and are based off historical data, hence are not reflective of what will actually happen in the future.

6. Discuss the reasons for sales returns and the benefits of offering them to customers Sales returns are the allowance for stock to be returned from trade debtors to the entity, and a benefit derived by offering them is that is encourages greater sales, as customers would be more willing to purchase from a firm knowing they can return the stock over a firm that doesn’t offer sales returns. Hence it improves relationships with the firm’s trade debtors. There’s a plethora of reasons for offering sales returns such as due to stock being damaged, the incorrect size, the wrong stock being delivered, the wrong colour or even if the customer no longer wants the stock item anymore. A disadvantage of providing them is that is reduces net profit as pre-existing sales are now being cancelled out, leading to net sales being lower. It is also an inconvenience to the entity as there will be administration expenses involved in the return process.

7. Discuss strategies that a business could employ to improve liquidity As the firms major cash inflows come from cash sales and receipts from debtors, the first step towards improving liquidity is improving the speed of both of these. This can be achieved through improving debtors turnover, with strategies implemented involving actions such as more prompt invoicing, more reminder notices and improved credit screening. This will lead to receipts form debtors coming in at a quicker rate, improving the firm’s ability to meet short-term debts as they fall due as they will have greater cash reserves to do so. Improving stock turnover will lead to cash sales occurring at a faster rate and this can be achieved through stronger advertising campaigns, and slow moving lines of stock being displaced with lines that sell faster. Another strategy is reconfiguring the layout of the shop and rotating stock so that fast moving lines of stock are located in prime positions for customer viewing. By doing so the firm will be more able to meet its short-term debts as they fall due as it will have greater cash reserves. Disadvantages of these strategies involve more administration expenses due to greater staff attention and considerable time investments.

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Discuss business’s decision to improve stock turnover -

Improves speed of liquidity because stock is converted into sales at a faster rate, hence cash inflows from cash sales and receipts from debtors will be quicker

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If gross profit margin stays the same then it will lead to greater gross profit in dollar terms

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If increase in STO is due to reducing selling prices and keeping cost price constant (Decreasing GPM), then it could lead to improved gross profit in dollar terms if the increase in customer demand and sales volume outweighs the reduction in gross profit per sale

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If increase in STO is due to a more expensive supplier that provides better quality stock (Reducing GPM) but increasing customer demand and sales volume (Due to customers wanting to buy better quality stock), then it may lead to an increase in gross profit in dollar terms if the increase in customer demand outweighs the decrease in gross profit per sale

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It may lead to loss sales if the firm runs out of stock, thus reducing customer demand

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THINGS TO WATCH OUT FOR Practical -

Depreciation entry before the disposal of a non-current asset Drawings or advertising of stock not being recorded has NO EFFECT on owner’s equity (As stock loss will compensate accordingly) Reporting period wrong Depreciating for wrong amount of months BDA for wrong amount of months In I/S don’t forget to add accrued/prepaid amount to cash paid to find the expense Don’t forget GST refund/settlement Don’t forget cost of sales in CRJ and SJ When calculating cost of sales in I/S consider sales returns and prepaid sales A business commencing entry does not have bank in GJ, only case when that happens is when converting from single to double entry Don’t get a purchase and sales return mixed up Check the entity and who you are recording/reporting for Bank statement DR means you are in overdraft ‘Invoice from _____’ means they are your creditor, while ‘invoice to _______’ means they are your debtor as you are issuing the invoice Interest and discount revenue are often forgotten!! Get variance report the right way when determining F or U/F Statement of account check if they are your creditor or debtor Read and highlight dates!!!!!! Watch for GST Make narration specific, refer to exact line of stock and quantity and reason A cash deposit on purchase of NCA is a payment to sundry creditor When asking for effect on balance sheet and addressing OE, say capital not net profit Don’t forget sales/purchase returns in ledgers Capital account in trial balance is BEFORE profit and drawings have been considered

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Theory -

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In cash vs profit, line that should be used is ‘revenues earned irrespective of received and expenses incurred irrespective of paid’ Discuss must acknowledge the other sides (Positives vs negatives) If there is a deterioration in liquidity suggest that ‘the owner may need to inject capital or borrow if this is to continue’ Never say improve debtor management procedures without giving an example (Prompt invoicing) Creditors turnover increasing may be negative as it means the firm has insufficient cash on hand to meet creditor payments, may be positive as the firm retains its cash for longer Increase in debt ratio will lead to idle assets being replaced with more efficient ones due to borrowing, and this may generate more revenue and net profit and hence increase in OE Four aspects are control, accrual, double entry and perpetual, should be able to explain each of these Increase in capital may be in response to negative net cash flow from operating activities In discuss questions be creative, think of hypothetical situations, it is globally marked so go wild!! If it asks for how something effects business performance and gives you information about liquidity, say you may need to look into profitability as well to get a better gauge off overall business performance

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SALIENT POINTS What constitutes a direct selling expense? A cost incurred in order to have that particular unit of stock sold. This might include delivery out paid for by the customer, advertising, labelling, wages, coffee beans but they must be ‘special’ in that they only apply to sell that particular stock item and it must be expressed ‘per unit’ When is a complimentary product treated as a selling expense, a product cost or a different line of stock? Coffee beans are example of selling expense, because the firm wouldn’t sell these by themselves as they are a ‘whitegood supplier’. A gas cylinder being sold with a barbeque would be treated as a separate line of stock and have its own stock card. A sticker or label put on an item is a product cost. Can insurance ever be COGS? Yes, if it’s a cost required to bring it into a conditional and location ready for sale, in most cases this is called ‘transit insurance’, and should be differentiated with general insurance which is an other expense Can you argue keeping stock cards satisfies Going Concern. No that is pushing it. Stock cards satisfy reporting period because they allow for cost of sales to be calculated and hence net profit, as well as historical cost as its recorded at cost, and conservatism as the lower of cost and net realisable value is used and stock isn’t valued at selling price. What qualitative characteristic supports monetary unit Comparability is number one as per the textbook, as without a common unit of measurement it would be impossible to aggregate totals or ake comparisons between periods or business. Secondly it would be Understandability as using a common unit of measurement that the users of information are familiar with makes it easier to comprehend. Thirdly, relevance as its useful for decision making, but this is less powerful because everything ultimately improves relevance. It is only the key QC when it is to do with something being included or excluded from reports. What qualitative characteristic supports classification? First and foremost is Understandability, as it makes the information easier to comprehend, with relevance being a minor second point. Do balance day adjustment’s satisfy reliability because memos are prepared? No don’t be a spastic. Relevance, reporting period and going concern are always for BDA Is there a cross checking mechanism between special journals and ledgers?

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Even though information is transposed from special journals to ledgers, it improves traceability and so satisfies reliability as the information is more accurate and free from error and bias Does product costing breach conservatism? You can argue either way. Yes because it overstates stock control and net profit in the initial reporting period stock is purchased, no because it is justified due to relevance, and also no because at the end of the day all of the expense is going to be incurred. This satisfies going concern because you’re recognising that the cost will be incurred in future reporting periods, thus acknowledging the firm will continue to exist into the future.

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