Background (double-entry system)

The expanded accounting equation:

Assets = Liabilities + share capital + opening retained profits + revenue expenses dividends
OR
Assets + expenses + dividends = liabilities + share capital + opening RP + revenue
The highlighted section; increases are debited and decreases are credited
The underlined section; increases are credited and decreases are debited
For example; machinery is purchase for $10000 cash (an asset increases, another asset decreases)
DR Machinery 10000
CR Cash 10000

Topic 6: Inventory
This topic examines the inventory asset
What is inventory?
Inventory refers to assets which are held for sale in the ordinary course of business or assets in the
process of production for such sales.
Types of inventory includes raw materials, works in progress, finished goods and merchandise
Costs of inventory include the costs of purchase, the costs of conversion (converting raw materials)
and other costs incurred in bringing inventory to its current location and condition

Control of inventory
There are two methods of keeping records of inventory transactions; the perpetual method and the
periodic method

Perpetual method

Periodic method

Beginning inventory + purchases COGS = ending

inventory
Involves continuously updating inventory; all inflows
and outflows of inventory are recorded as they occur
The cost of goods sold account continuously records
the costs of sales or outflows

Beginning inventory + purchases ending inventory

= COGS
Doesnt maintain a running balance of inventory

This method is costly; costly to track every single

inventory
The balance of inventory account in the general
ledger gives a value of inventory at any time

This method is cheap

The balance of inventory account in the general

ledger reflects the stocktake quantity and valuation
at the close of the last period
Requires a stock take to update inventory
COGS is calculated at the end of the period

Journal entries of inventory

Purchasing inventory
Sale of goods

Collections of accounts
receivable
Year-end entry
Period-end stock take

Perpetual
Dr Inventory
Cr Cash/Accounts Payable
Dr Cash
Cr Sales Revenue
Dr COGS
Cr Inventory
Dr Cash
Cr Accounts Receivable

Periodic
Dr Purchases
Cr Cash/Accounts Payable
Dr Cash
Cr Sales Revenue

Dr Cash
Cr Accounts Receivable
Dr COGS
Cr Inventory
Dr Inventory
Cr COGS

Valuation of inventory
Inventory is classified as a current asset in the balance sheet because it is expected that it will be
sold within one year it is valued using a modified historical cost valuation basis termed the lower
of cost or market value
The lower of cost or market rule states that the value of inventory should be written down from the
cost to market price IF/WHEN the market values it below cost
o In other words, we work out the net realisable value of the inventory and compare that to the
cost of the inventory item per our ledger the value which is recorded in the balance sheet
is the lower value of the two
Journal entry for inventory write-down
DR Inventory write-down
CR Inventory

The cost of inventory, tracking and reporting this cost

Cost of inventory; sum of all costs for all individual inventory items
The cost-flow assumptions of inventory...
1. Specific identification
Each inventory item is individually identified using serial numbers and other methods
Used for low-volume, high-value merchandise
2. First in, first out (FIFO)
Assumed that first items purchased are first items sold (the oldest inventory is sold first)
Inventory on hand is therefore always the newest inventory
In times of rising prices (inflation) this method results in the highest inventory asset value
and the lowest COGS and gives the highest gross profit
3. Weighted Average
This method assumes that the cost of inventory is averaged and the cost will combine old
and new inventory
If a perpetual system is used; the average cost will change each time there is a
purchase of inventory or a moving cost
If a periodic system is used; inventory items will be valued at an annual weighted
average
4. Last in, last out (LIFO)
Assumed that last items purchased are last items sold (the newest inventory is sold first)
Inventory on hand is therefore always the oldest inventory
Results in lower income tax and lower profit with inflation; if you have inflation higher COGS
and lower asset value

Topic 7: Non-current assets

This topic examines the way noncurrent assets are valued and treated for
accounting purposes throughout their life in a business.
Background Definitions

Assets refer to future economic benefits which are controlled by an enterprise as a result of past
transactions
Current assets are assets which are consumed within the normal operating cycle of an enterprise
(usually one year). Examples include inventory, receivables and current prepayments.
Non-current assets are assets which are expected to bring financial benefits for more than one year,
intended for long-term use. Examples include fixed assets such as buildings and furniture.
Cost of an asset refer to all costs required for an assets use
Historical cost refers to a principle of financial accounting in which an asset will be valued and
recorded on the balance sheet as its cost at the time of its acquisition
Tangible assets are assets which are physical in nature (such as cash, inventory, property,
equipment) as opposed to intangible assets which are not physical in form (such as brand name,
trademarks)
Depreciation is the decrease in the value of the asset due to use or obsolescing (becoming out of
date).
Accumulated depreciation is the total depreciation from an assets life to the current date
Carrying amount refers to the remaining net book value of an asset, after the accumulated
depreciation is subtracted from the original cost
Accrual account refers to the accounting system which measures the performance and position by
recording revenues and expenses of an enterprise at the time they occur, not when cash is received
or paid
Amortisation refers to the depreciation of intangible assets
Betterment refers to charges incurred to improve an assets value to a business (commonly
betterment will improve the functionality and/or the useful life of an asset). Betterment is added to
the value of an asset, not expensed; after being capitalised (added to the value of an asset and not
expensed) it is depreciated along with the rest of the assets cost

The cost of an asset

The cost of an asset includes all costs that are required to make it suitable for the purpose intended.
For example, a machine may cost $50000 but it may require extras such as a fire protection system.
The cost of the asset will include the initial cost of the machine and the extras required.
The cost of acquisition refers to the purchase price of an asset including all costs required to make it
suitable for the purpose intended
Examples of costs of assets

Asset

Costs of acquisition/Costs of asset

Land

Purchase price, costs in obtaining title (legal fees

etc), costs of removing unwanted waste
Purchase price, delivery cost, insurance in transit,
testing of computer, installation and configuration

Computer system

Depreciation of assets
Depreciation is the process of allocating the cost of an asset over the years of benefit it provides.
o Why would one allocate the cost of an asset?
- Because an objective of accrual accounting is to match expenses with the revenue
earned
- The asset produces benefits and earns revenue for an organisation over many
different periods not just when it is purchased. Therefore, through depreciation we
are able to allocate the cost of the asset over all these periods which share the
consumption of the assets value.

There are three ways methods of depreciation

The straight-line method

Refers to the simplest method of depreciation which assumes that the asset is used up evenly over
its life. In calculating depreciation using the straight-line method, three pieces of information are
required.
o The cost of the asset (the total cost of the asset which will be depreciated over time)
o The estimated salvage value or residual value (the estimated value of the assets worth at
the end of its life)
o The estimated useful life of an asset (the number of periods the asset is expected to benefit
the enterprise)
Formula
Example; a truck costs $5000, has an estimated life of 6 years and its salvage value after 6 years
will be $800. Calculate the depreciation expense over one period
(5000 800) / 6
Depreciation for one period = $700
The appropriate journal entry for depreciation (FOR ALL DEPRECIATION METHODS) would be;
DR Depreciation Expense 700
CR Accumulated Depreciation 700
-

Accumulated depreciation is a contra-asset account, which shows the total

depreciation expense over the life of an asset to date

The reducing balance method (also known as the accelerated depreciation meth0d)
Some assets contribute more benefit to an enterprise in the early parts of their lives.
o For example, when first purchased a computer may benefit the company greatly but due to
technological advances the computer may be relegated to less important tasks as better
computers are acquired.
The reducing balance method charges more depreciation early in the assets life based on the
assumption that an asset contributes more benefit when it is new.
Information required to calculate depreciation with this method;
o Cost of the asset
o Accumulated depreciation (total amount that the asset has already depreciated)
o Depreciation rate (percentage of book-value of the asset to be depreciated to date)
- Book value::::: current value of an asset, after depreciation (the cost of the asset
minus depreciation to date)
Formula: (cost accumulated depreciation) x depreciation rate
Example; a truck costs $5000, has an estimated life of 6 years, an accumulated depreciation of $0
as it is brand new. The depreciation rate is 25%
1st year of depreciation = (5000 0) x 25%
DEPRECIATION FOR YEAR 2 = $1250 // remaining book value = $3750
2nd year of depreciation = (5000 1250) x 0.25
DEPRECIATION FOR YEAR 2 = $937.50 // remaining book value = 3750 937.50 = 2812.50
Calculating the depreciation rate if it is not given.
To do so, use the formula below. R = depreciation rate, n = estimated life in years, s = estimated
residual value, c = original cost
Example. An asset has an original cost of $30000, is expected to last for 5
s
n
years and has an estimated salvage value of $5000
r 1
c

r 1 5

Units-of-production method

5000
30000

In some businesses, the economic consumption of assets is more a function of use rather than time.
For example, it makes sense to say a truck is expected to last for X kilometres, rather than X years.
This method is used when we expect an asset to last for a measure of use.
The unit of production method requires the following information;
o Cost of the asset
o Estimated salvage value
o Estimated number of units to be produced during the life of the asset

Formula for calculating depreciation;

o (cost minus estimated residual value) divided by number of units of use
o Using this formula, we can determine the yearly depreciation by multiplying the cost per unit
by the number of units used up or produced
Example; a truck costs $5000, has an estimated salvage value of $800. When it reaches the
residual stage (in which its value is $800) the estimated number of kilometres driven will be
210000 km
Depreciation per km= (5000 800) / 210000
= 4200 / 210000
= 0.02 depreciation per km
To calculate the depreciation expense for distances, multiply 0.02 by the kilometres driven

Sum-of-years digits method

This method calculates depreciation with the formula; (cost salvage value) x fraction
o The numerator (top number) of the fraction is the number of years of life remaining for an
asset
o The denominator (bottom number) is the sum of all the years of the assets life
For example, if the number of years in the life of an asset is 15, the numerator will be
1+2+3+4+5 = 15. The denominator will be 15
Example; a truck costs $30000, has an estimated salvage value of $5000 at the end of 5 years
Depreciation after 1 year = (30000 5000) x 5/15
= 8333

Depreciation and the balance sheet

The balance sheet shows the value of noncurrent assets at their carrying amount.
Carrying amount refers to the book value of an asset, or the value of an asset AFTER subtracting
the accumulated depreciation is subtracted from the original asset cost.
EXAMPLE: If a motor vehicle was purchased for $40000 and depreciated $4000 by year-end, it
would be presented on the balance sheet under assets as follows

Why is land not depreciated?

Because its economic value doesnt decline through use
As machines are used in production they wear out and decrease in value. Land doesnt decrease in
value through USE therefore it isnt depreciated.
Land can decrease in value though this is an impairment rather than depreciation

Betterment
Companies often spend money on assets. This expenditure by the firm is classified as a betterment
if it;
o Increases the useful life of an asset (makes it last longer)
o increases the residual value of an asset (makes it worth more)
o increases the production capacity of an asset (makes it greater in production)
Difference between repairs and maintenance and betterment is that repairs and maintenance is an
expense account because its purpose is to keep the asset working as expected, whilst a betterment
makes an asset more useful that in was previously
Journal entry for betterment VS journal entry for repairs and maintenance

Updating depreciation // gain-loss of noncurrent asset

An asset value may be removed from accounts if
o It is sold
o It is disposed of
o It had no future economic benefits
The three steps in the sale of an asset
o Update depreciation
o Calculate the gain/loss on sale
o Record the sale
Depreciation is updated to the date of the sale by calculating and entering in journal
entry
To see if we made a gain or a loss on the sale of the noncurrent asset we compare the proceeds from the sale with
the carrying amount of the asset sold
o If the proceeds of the sale are greater than the carrying amount, we made a gain
o If the proceeds of the sale are less than the carrying amount, we make a loss

Disposal of noncurrent assets

Refers to when the asset is disposed of and there are no proceeds
When recording a disposal, we must (1) update depreciation and (2) record disposal
RECORDING DISPOSAL... (handwrite)

Asset revaluation
Refers to when companies revalue their assets.
o A revaluation is an increment if the value of the asset increases (in which case it is a part of
the shareholders equity account in the balance sheet)
o A revaluation is a decrement if the value of the asset decreases (in which case it is a part of
an expense account in the income statement)
The purpose of revaluation is to ensure users of accounting information have relevant and reliable
information for evaluating the financial position and performance of an organisation.
The carrying value must exceed the recoverable amount of an asset
o The recoverable amount refers to the amount that is expected to be recovered after
continued use and subsequent disposal

Impairment
Impairment of a fixed asset refers to a decrease in its value due to damage or other reason
As per accounting standards, assets must not be shown on the balance sheet at an amount greater
than their recoverable amount

Intangible assets
Refers to an identifiable non-monetary asset, which is non-physical in nature.
Examples; brand name, trademarks, research and development cost, franchises
o The difficulty with intangible assets is in valuation
o Intangible assets are amortised over their useful lives on a straight-line basis

Goodwill
Goodwill is an intangible asset; shown as a non-current asset. It refers to when more is paid for a
group of assets (a whole business) than the assets are worth individually
o The reason for paying extra for a group of assets is that the business may be organised and
already established reason for the extra $
EXAMPLE:
- McDonalds purchases KFC for $800000. Individually, the assets of KFC are worth
660000 (accounts receivable 60000, inventory 100000, building 260000, equipment
130000.
- Balance sheet of McDonalds
DR KFC 660000
DR Goodwill 140000
CR Cash 800000

Topic 8: Liabilities
Defined
Liabilities refer to present obligations of an enterprise arising from past events, the settlement of
which will result in a sacrifice of future economic benefits
Liabilities can be monetary (eg accounts payable, loans) and non-monetary (eg provisions)

Essential criteria/characteristics of liabilities

The existence of a present obligation
The obligation will involve a future settlement and sacrifice of future economic benefits

Recognition criteria of liabilities a liability should ONLY BE RECOGNISED WHEN

The amount of the liability can be reliably measured
It is probable that a future sacrifice of economic benefits will be required

Current liabilities
Refer to liabilities which are expected to be settled within 12 months of the reporting date.
Examples include;
o Accounts payable
Money owed to creditors
o Unearned revenue
When cash is paid but goods/services not given to customers
o Taxes payable
o Portions of long term debt
o Provisions
A liability of uncertain timing and uncertain amount, reported separately from
payables and accruals. For example, employee benefits (long service leave)
Only if present obligation exists
o Accruals
for goods/services received or supplied but not yet paid for
o Dividends payable
only recognised as a liability when dividends have been declared undeclared
dividends do not involve a present obligation

Third party collections

Companies may collect money on behalf of 3rd parties
o Goods and services tax (on behalf of government)
o Union fees
o PAYG withholding tax (system of withholding amounts from payments to employees so they
can meet their end-of-year tax liabilities)
EXAMPLE:
Dr Wages Expense 1000
Cr Cash 701
Cr PAYG withholding 230
Cr Superannuation 60
Cr Union fees 9

Contingent liabilities
Liabilities which may or may not be incurred, dependant on the outcome of a future event
o A possible obligation, the recognition of which depends on future events
Contingent liabilities are not recognised as they do not meet one or both of the criteria for
recognition
o The amount of the contingent liability cannot be reliably measured
o It is not certain that a future sacrifice of economic benefits will be required
Example includes: liability arising out of litigation process (awaiting the results of a trial before
liability is recognised)
contingent liabilities are disclosed in the notes of financial statements (only required if the amount of
the contingent liability is material/quantifiable)

IN COMPARISON TO PROVISIONS
o contingent liabilities depend on uncertain future events OR do not meet the recognition
criteria
o provisions are uncertain in timing or amount
Provision or contingent liability? Example 1
the manufacturer gives warranties at time of sale
PRESENT OBLIGATION?
of its product
Assume yes because past experience shows it is
the manufacturer will make good of any defects
so
within 3 years of sale date
Likelihood of outflow of economic resources?
based on past experience it is probable that there
Yes probably due to past claims
will be some claims under warranty
OVERALL: This example is a provision
assume the obligation of the manufacturer can be
reliably measured
IS THIS A PROVISION OR A CONTINGENT
LIABLITY?
Provision or contingent liability? Example 2
Ten people die at wedding of food poisoning from
PRESENT OBLIGATION?
products sold by firm
No it is based on uncertain future events
Legal proceedings have started; firm disputes
Likelihood of outflow of economic resources?
liability
No lawyers believe firm wont be found liable
Firms lawyers advise it is probably the firm will
therefore there is an UNLIKELY outflow of
not be found liable
economic resources
If found liable, however, assume obligation can
OVERALL: This example is a contingent liablity
be reliably measured
IS THIS A PROVISION OR A CONTINGENT
LIABLITY?

Financial statement presentation

Liabilities are presented on financial statements as either current (see above) or non-current.

Non-current liabilities
refers to all liabilities other than current liabilities; generally those liabilities under which settlement will
occur after 12 months
Includes; the non-current portions of accounts payable, accruals, provisions and tax liablities. ALSO
INCLUDES INTEREST-BEARING LIABILITIES such as term-loans, mortgage payments, debentures or
bonds

Following the classification of liabilities as current, or non-current, they are

further classified by their nature
Payables
o The most common type of payables are accounts payable and accruals (which are made up
of money the enterprise collects on behalf of others; such as income tax, superannuation
deductions and union dues.
Interest-bearing liabilities
o can be both short-term and long-term
Short-term interest bearing liabilities include bank overdrafts (when money is
withdrawn from a bank and the available balance falls below zero), notes payable,
private loans
Long-term interest bearing liabilities include debentures and hybrid security
# Debentures (bonds): simple loan contract between company and holder of the
contract, which acknowledges the receipt of funds in exchange for payments
at a fixed rate over the term of the debenture. Debentures are more complex
than bank borrowings as time value is considered in detail
# Bank borrowings: the terms of the loan incorporate time value principles
# Mortgage payments
# Term loans

 Tax liabilities
Provisions
o Liabilities for which the amount or timing of sacrifices of future economic benefits is uncertain

Provisions example
Long-term employee entitlements (long-service leave)
The journal entry to recognise the accrual of long-service leave entitlements;
DR Long-service leave expense [expense goes up]
CR Provision for long-service leave [liability goes down as it is fulfilled]

Notes payable review

Notes payable is an interest-bearing liability which can be either current or non-current
o Assume, for example that a business issues a 90-day notes payable, interest rate 15% - as it
is 90 days it is a current liability
The journal entry to recognise notes payable (BOTH WHEN THE NOTE IS ISSUED AND REPAID)
o When the note is issued;
DR Cash [as cash increases from the loan]
CR Notes payable [as liability increases due to borrowing]
o When the note is repaid;
Dr Notes payable [as the liability decreases when it is repaid]
Dr Interest expense [As the interest expense decreases when it is repaid]
Cr Cash [as cash decreases when repaid]

Debentures/Bond - review
Refer to a form of interest-bearing notes issued by corporations and governments usually long-term
o Face-value: the amount to be repaid by borrowers
o Coupon rate: a percentage applied to the face-value which determines how much interest is
periodically paid
THE PRICE OF DEBENTURES:
o Assume, for example that a business issues a 90-day notes payable, interest rate 15% - as it
is 90 days it is a current liability
DR Cash
CR Debenture payable

Topic 9: Completing the balance sheet

This topic firstly examines the shareholders equity section of the balance sheet
and secondly provides an introductory discussion of investments
Intercompany investment
Companies frequently invest in other companies achieved by one company buying shares in
another company.

Short-term investments
Short-term investments are when management intend to hold shares for less than one year
The primary purpose of these investments is to put extra cash to work. Management has no interest
in trying to influence the operations of the organization which issues the shares
Journal at cost of acquisition of investment
DR Marketable Securities
CR Cash
Because there is no intention to hold these investments for long, these investments are included in
current liabilities under the heading of marketable securities
JOURNAL ENTRY EXAMPLE
o An organisation has short-term investments costing $520000. If the investments market value
slipped to $480000 the difference ($40000) would be included as an expense and profit would go
down by 40000. THE JOURNAL ENTRY WOULD BE:
DR Loss of Marketable Securities 40000
CR Marketable securities 40000
If there was a gain of 40000 on the investment, the debit and credit of the above journal entry would
reverse (DR marketable securities, CR Gain on marketable securities)

Long-term investments
Refers to when management does not intend to convert investments to cash within one year. Some
of the ways these investments can be accounted for include...
5. The cost method
Used for short-term investments. The investment is recorded as a noncurrent asset in the
balance sheet at the cost of acquisition. Dividends received are recorded as revenue and
investments can be revalued periodically as with all noncurrent assets
As mentioned, under the cost method investments are recorded at the cost of acquisition.
JOURNAL ENTRY EXAMPLE OF RECEIVING $20000 IN DIVIDENDS
DR Cash 20000
CR Dividend revenue 20000
6. The equity method
When an investing company has significant influence (but not control) of an investee
company the investee company is an associated company of the investor
Significant influence is assumed when an investor holds over 20% of issued shares
In this case the investor, within its financial statements, accounts for the associated
company using the EQUITY METHOD OF ACCOUNTING ^^^
Under this, the investing company includes its share of earnings (from the investee company)
in its income statement and balance sheet BECAUSE it is in a position to significantly
influence that companys performance

THE EQUITY BASIS EXPLAINED USING EXAMPLE

Assume Company X buyers a 30% of Company Ys shares for $1million. One year later Company Y reports an aftertax profit of $240000 from which it pays a dividend of $90000
The investment asset is still valued initially at its cost of acquisition. JOURNAL ENTRY=
DR INVESTMENTS 1000000
CR CASH 1000000
As the investee company earns profit, the asset increases in value by the investing companys percentage share of
that profit. That share is included in the investing companys revenue. JOURNAL ENTRY SHOWING ASSET
INCREASING BY 30% SHARE OF AFTER-TAX PROFIT
DR INVESTMENTS 72000
CR SHARE OF COMPANY YS PROFITS 72000
When the associated company pays a dividend, the investing company deducts their percentage share of the
dividend from the investment value. JOURNAL ENTRY SHOWING INVESTING COMPANIES SHARE OF 30% OF
DIVIDENDS
DR CASH 27000
CR INVESTMENTS 27000

Differences in Cost method and Equity method

Refers to when management does not intend to convert investments to cash within one year. Some of the
ways these investments

Initial carrying value of the

investors intercorporate
investment asset
Investors share of profit
earned by investee
Investors share of dividend
paid by investee

COST METHOD
Original cost

EQUITY METHOD
Original cost

Nothing done

Share of profit is added to

investment asset and to other
revenue
Dividend is added to cash and
deducted from investment
asset
Original cost plus accrued
profit share minus share of
dividends received by investor

Add to cash and to other

revenue

Original cost
Resulting balance sheet value
of the investors intercorporate
investment asset

7. Consolidation method
This method is used when over 50% of shares are owned by a company which gives it
control over a subsidiary entity.
Control is defined as the power to govern the financial and operating policies of an
entity so as to obtain benefits from its activities
Although having greater than 50% of shares means control is gained, an investor
with less than 50% of shares may be the only shareholder with a large parcel of
shares and therefore can exert control
This group of companies (the parent entity and the subsidiary entity) when combined, are
called the economic entity
When control exists, we use the consolidation method to present the accounts of economic entity
The aim is to present the group of companies as if it were a single entity. Therefore, to consolidate basically
means to add up all the individual statements into one merged statement
o putting the balance sheets, income statements and other statements of the companies side-by-side
and adding them up

ISSUES IN CONSOLIDATION:
o Outside equity interests (or minority interests)
- Often the parent company owns less than 100% of the subsidiarys voting shares, the other
interest refer are minority interests which are the interests of shareholders who have shares
that are not owned by the parent entity. A consolidation is prepared and the outside equity
interest is shown separately in the shareholders equity section of the balance sheet
o Asset and liability values
- The asset and liability values of the parent and subsidiary companies are added together in
consolidation for example the parents accounts receivable are added to the subsidiarys
accounts receivable.
- Some changes are made to the parents and subsidiarys balance sheet before the adding is
done together one such change is offsetting any intercompany balances against each other.
For example, if a subsidiary company owned the parent company $40000 (the
parent company has a $40000 accounts receivable and the subsidiary has a $40000
accounts payable) THIS FIGURE WILL BE ELIMINATED AND LEFT OUT OF
CONSOLIDATED FIGURES
o Goodwill on consolidation
- Goodwill on consolidation arises when the parent company pays more than fair value for the
subsidiarys net assets the extra may be for good managers, faithful customers, etc
- The goodwill is shown as a noncurrent asset on the consolidated balance sheet and is
amortised over time against the consolidation net profit
Amortisation is the process of decreasing or accounting for an amount over a period
o Consolidated income statements
- Consolidated income statements are prepared by combining revenues and expenses of a
parent company and a subsidiary company
Inter-company transactions are eliminated

Shareholders Equity
Shareholders equity section of the balance sheet has three main components
o Reserves
o Share capital/issues capital
o Retained profits
Accounting standards require that these components are kept separately from one another to
maintain capital maintenance
o Capital maintenance is a concept under which profit is only earned after the capital of the
company has been maintained
- Dividends can only be paid when there are retained profits and revenue reserves to
cover them; they cannot be paid out of issued capital
What does shareholders equity represent? Recall the accounting equation (assets = liabilities + SE)
o Shareholders equity is shown to represent the difference between assets and liabilities (in
other words it shows net assets)

Share capital / issued shares / issued capital

The majority of shares issued are termed ordinary shares which confer to special rights or
privileges and only earn a dividend when sufficient profits are earned
Preference shares do grant special rights on their holders, such as a prescribed rate of dividend and
preferential return of capital in the event of liquidation
o Liquidation is the process by which a company is brought to an end and the assets and
property of the company are redistributed
Journal at cost of acquisition of investment
JOURNAL ENTRY FOR ISSUE OF SHARES
DR Cash
CR Share Capital

Public companies can issue shares directly into the public based on a prospectus
o For example, XYX issued 200000 shares for $1.50 each payable on application
JOURNAL ENTRY FOR APPLICATION OF SHARES
DR Cash Trust 375000
CR Application for shares 375000
Once the minimum subscription is received and the directors allot the shares to the applicants, the
amount of money paid by successful applicants would be transferred from the cash trust account to
the cash at bank account
DR Cash at bank 375000
CR cash trust 375000
If there were excess application funds, they would be refunded with the following entry
DR application
CR cash trust
Finally, transfer the balance from applications account to share capital account as shareholders
have now been issued with shares
DR application 375000
CR share capital 375000

Reserves
Examples include asset revaluation reserve and general reserve
Equity may be transferred from retained profits to the general reserve
(DR retained profits CR general reserve)

Retained profits
Refers to the accumulated profits of a company, not appropriated through dividends to shareholders
or transferred to reserves
o Accounting standards require a note to the financial statements which detail the movements
in retained profits balances
o Such movements may include; profit/loss for the year, dividends provided for that are paid,
transfers to and from reserves
THE FOUR MAIN WAYS IN WHICH THE BALANCE OF RETAINED PROFITS CHANGE
o A profit or loss for the year
o Changes in accounting policies
o Dividends paid or provided for
o Transfer to or from a reserve
DIVIDENDS
o Represent a distribution of profits from the company to shareholders
o For this reason, shareholders equity is reduced when a dividend is paid
Interim dividends: authorised by the board of directors during the year, based on an expectation of
adequate profits
When dividends are declared
When dividends are paid
DR Retained profits 5000
DR Dividends Payable 5000
CR Dividends Payable 5000
CR Cash 5000
Final dividends are recommended by directors and authorised by shareholders at the annual
general meeting; dividends are provided for in the period in which they are declared
When dividends are declared
When dividends are paid
DR Retained profits 5000
DR Dividends Payable 5000
CR Dividends Payable 5000
CR Cash 5000

Dividends may also be paid as share dividends or bonus issues.

o A bonus issue is the giving away of shares to existing shareholders; shareholders equity is
unchanged by a bonus issue
When bonus issues are declared
When issued
DR Bonus issues declared
DR Bonus issue Payable
CR Bonus issues payable
CR Share capital
DR asset revaluation (or general reserve)
CR Bonus issues declared
Bonus issues do not affect the shareholders equity; merely the allocation within shareholders equity.
For example, bonus issue from the asset revaluation reduces the reserve and increases share
capital by the share amount
The point? Increasing the number of shares issued without changing the value of the firm results in
a proportional fall in share price there are no changes in total assets, liabilities and equity
A share split increases the number of shares available
o If a company has a $200,000 share capital comprising of 100,000 shares and there was a
2:1 share-split there would now be 200,000 shares
o The share-split doesnt change the value of any of the shareholders equity accounts (the
share capital is 200,000 before and after the share split)
The purpose of a share-split is to reduce the value of each individual share
WHY ALTER SHAREHOLDERS EQUITY ACCOUNTS IF THERE IS NO OVERALL EFFECT?
- Makes shares seem more affordable. On a per-share basis they are cheaper (but
there are also more on issue)

Topic 10: Statement of cash-flow analysis

This topic examines statement of cash-flows
Cash-flow statement defined
Cash-flow statements report the inflows and outflows of cash under the headings of Operating,
Investing and Financing Activities over a period of time

Cash-flow VS the balance sheet

Although the balance sheet shows cash, it only reveals the opening and closing balances of cash
The cash-flow statement provides information about what caused the movement in the cash
balance

How information in cash-flow statements are used

Using information in cash-flow statements, users can measure business solvency. Business
solvency is best described as the ability of an entity to meet its long-term fixed expenses and to
accomplish long-term expansion and growth. A business cannot survive without sufficient cash and
under accrual accounting it is difficult to evaluate cash performance
Information from cash-flow statements can also be used to value a business. Cash is central to
valuation of a business BECAUSE dividends can only be paid if there is sufficient cash

The three sections of a cash-flow statement

A cash-flow statement is divided into three sections; operating activities, financing activities and
investing activities
o Operating activities refer to the principal revenue-producing activities with an entity which
relate to the provision of goods/services. Examples of operating activities include;
- interest paid
- income tax paid
- interest and dividends received
- payments to suppliers and employees
- receipts from customers
o

Investing activities refer to activities which relate to the acquisition and disposal of
noncurrent assets (long-term assets). Examples include;
- investments in other companies
- collection of/making loans to other companies

Financial activities refer to activities which relate to the changing of the size and composition
of financial structure of the entity, such as equity and loans
- Dividends paid
- Borrowing/repaying debt
- Issuing shares/buy back of shares
- collection of/making loans to other companies

The format of a standard cash-flow statement

Operating activities
+ investing activities
+ financing activities
= change in cash for the period
+ cash at the beginning of the period
= cash at the end of the period

Exclusions of cash-flow statements

The statement of cash-flows excludes non-cash investing and financing activities such as;
o Conversions of liabilities to equity
o Acquiring equipment through a lease
o Purchasing investments, property through a long-term loan (by incurring long-term debt)
o Acquiring investments or property by exchanging other investments or property
TRANSACTIONS WHICH DO NOT AFFECT CASH ARE NOT REPORTED WITHIN THE BODY OF THE CASH FLOW
STATEMENT, HOWEVER, THESE ITEMS ARE REPORTED IN A SEPERATE SCHEDULE AT THE BOTTOM OF THE
STATEMENT OF CASH FLOWS

THE TWO DIFFERENT METHODS

Cash-flow from operations can be prepared using either the direct or indirect method.
o Australian accounting standards require that the direct method of presentation be used for
cash-flow operations because it provides information which is not otherwise available on the
income statement or balance sheet
o The indirect method is used in a note to provide reconciliation between operating profit and
cash flow from operations

Both methods provide the same total for cash flow from operations

The direct method

Under the direct method, cash inflows and outflows from operating activities (such as receipts from
customers, payments to suppliers) are listed directly in the operating cash flow section of the
statement
The categories of operating, investing and financing are prepared as follows;
o Cash flow from operating activities determined through calculations involving operating
activities
o Cash flow from investing activities determined by examining any changes in noncurrent
asset section of the balance sheet
o Cash flow from financing activities determined by examining any changes in the non-current
liability and shareholders equity section of the balance sheet

The indirect method

Under the indirect method of reporting, the operating cash-flow section
o Begins with the accrual net profit figure from the income statement
o Following this, lists a series of adjustments (including non-cash expenses and changes in
current assets and liability accounts other than cash)
o Concludes with net cash flows from operating activities
The indirect method only applies to cash-flow from operations.
The indirect method calculates operating cash flows by adjusting accrual accounting profit
Operating profit after tax
+ non-cash expenses (depreciation, loss on sale)
- non-cash revenues (gain on sale of assets)
+ decrease in current assets (accounts receivable, inventory, prepayments)
+ increase in current liabilities (accounts payable, accrued expenses)
- decrease in current liabilities (accounts payable, accrued expenses)
- increase in current assets (accounts receivable, inventory, prepayments)
= cash flows from operating activities

Interpretation of cash-flow statements

Cash-flow statements are useful in identifying liquidity problems, using the following warning signs;
o Significant declines in operating cash flows
- Is the company having difficulty selling inventory?
o Significant declines in the quality of earnings ratio (operating cash flow/net profit) relative to
the prior period
o Significant declines in cash-balance
- Is the company having difficult replenishing the cash it consumes?
o Significant increase in payables
- Is the company not paying short-term obligations on a timely basis?

Significant increase in cash provided from sales of investments or property

- Is the company selling off non-current assets to avoid a liquidity problem?
Additionally, when making assertions about from cash-flow statements, we should consider it with the balance sheet
and the income statement.
o
o
o

The balance sheet shows increasing accounts receivable and the income statement shows
steady sales revenue
- Check the cash-flow statement to see what is happening to cash from customers
The balance sheet shows decreasing inventory and the income statement shows increasing
accounts payable
- Check the cash-flow statement to see if the company is struggling to pay suppliers?
The balance sheet shows increasing accounts receivable and the income statement shows
increasing sales and steady bad debts
- Check the cash-flow statement to see if they are received cash from customers OR
should they make more allowances for bad debts?

Steps in preparing cash-flow statements

Determine the net increase (or decrease) in cash
Determine cash provided (or used) by operations
Determine cash provided (or used) by investing
Determine cash provided (or used) by financing
Determine any significant non-cash transactions that should be disclosed

Finding total cash-flow from balance sheet, income statement and other sources
Determine cash received from customers using T-account of accounts receivable
o credit sales + opening balance of accounts receivable closing balance of accounts
receivable
Determine salaries paid using T-account of salaries payable (determining any payable account)
o Cash paid = expense + opening balance closing balance

Topic 11: Financial statement analysis

This topic examines tools for evaluating financial statements
Ratio analysis
Ratio analysis is used to scrutinise a companys performance by examining categories of ratios.
The results of ratios can be used for comparison with other years for the same company and for
comparison with other companies
Users of analysed financial information include;
o Managers for decision making
o Creditors to make lending decisions
o Suppliers to assess opportunities
o Investors to make investing decisions

Sources of information about a company

Financial statement analysis must include an analysis of all available sources of information (not
only financial statements), include...
o Financial newsletters
o Press releases
o Internet
o Economy-wide factors
o Information regarding other companies
When analysing a companys profits, factors which may be of assistance include;
o Profit from last year
o Profit of companies within the same industry
o Levels of assets required to generate profit

Relationship between users of different financial statements

Each user of financial information will have different requirements;
o Some may be interested in a companys profitability
o Some may be interested in the companys ability to pay short-term debt
o Some may be interested in the companys ability to repay long-term borrowings
ALL OF THESE ARE RELATED: e.g. a companys ability to pay a long-term debt is related to
whether it is able to pay short-term debts and generate sufficient profit (if it cant generate profit,
how will it pay any debts. If it cant pay short-term debts, how will it pay long-term debts)

Common size statements

A complementary method of explaining financial results
Involves the presentation of all balance sheet items as a percentage of total assets, and the
presentation of all profit/loss items as a percentage of total sales this factors our size and is
therefore a useful tool for comparing companies of different sizes and for establishing trends over
time

Ratio analysis
The calculation of a ratio simply involves dividing the dollar amount of one item with the dollar
amount of another item
The key attributed analysed using ratio analysis include;
o Financial performance: to do with the companys effectiveness in earning profits and
providing a return on shareholders investment
o Liquidity and solvency: to do with the companys ability to meet its financial obligations on a
timely basis gives the user of financial information some indication of the companys ability
to pay its short term debts as they fall due
o Financial performance: to do with the companys balance of debt and equity as sources of
the companys financing the percentage that each major class of financing bears of the
firms total financing
o Activity turnover: to do with the efficiency under which the company utilises its resources to
generate revenue and profit

Financial performance ratios (profitability ratios)

These ratios provide information regarding a companys record of generating profit and indicate its
potential for generating profit in the future

Profitability ratio

Formula

What it tells you

Return on assets (ROA)

Operating profit after tax / total

assets

Return on equity (ROE)

Operating profit after tax /

shareholders equity

Profit margin

Operating profit after tax / sales

Gross margin

(sales COGS) / sales

Cash flow to assets

Cash flow from operations / total

assets

Earnings per share

(Operating profit after tax

preference dividends)
/
weighted number of ordinary shares
outstanding
Current market price per share /
earnings per share

Determines the after-tax

returns the managers are
earning on the assets under
their control how efficient
management is at using its
assets to generate earnings
Reveals how much profit a
company generates with the
money shareholders have
invested.
If this is greater than return on
assets, the company is using
leverage to the benefit of the
shareholders
Measures performance of
managers in converting sales
to net profit
Indicates whether or not sales
are profitable
Determines the companys
ability to generate cash
resources relative to the
companys size
Relates earnings attributable
to ordinary shares to the
number of shares outstanding

Price-earnings ratio (P/E)

Dividend payout

Dividends declared per share /

earnings per share

Relates the accounting

earnings to the market price
per share, in order to reflect
present company performance
with market expectations
Measures the portion of
earnings paid to shareholders

Activity ratios

Activity ratio

Formula

What it tells you

Asset turnover

Sales revenue / total assets

Inventory turnover

COGS / Average Inventory

Days in inventory

365 / Inventory turnover

Debtors turnover

Credit sales / trade debtors

Days in debtors (receivables)

365 / receivables

Determines the amount of

sales volumes associated with
each dollar of assets
Relates the level of inventor to
the vole of sales activity
Measures how long inventory
is held in stock
Relates the level of debtors to
the volume of credit sales
activity
Indicates how many days it
takes to collect outstanding
receivables

Liquidity ratios

Liquidity ratio

Formula

What it tells you

Current ratio

Current assets / current liabilities

Indicates whether the

company has enough shortterm assets to cover shortterm debts
Low ratio = problems paying
short-term debt

Quick ratio

(current assets inventories) /

current liabilities

Interest coverage ratio

Earnings before interest and tax /

interest expense

High ratio = excessive

investment in non-productive
current assets
Indicates whether or not
current liabilities can be paid
immediately
Indicates the ability of the
company to pay interest on
borrowings, from profit

Financial structure ratio

Liquidity ratio

Formula

What it tells you

Debt-to-equity ratio

Total liabilities / total shareholders

equity

Debt-to-assets ratio

Total liabilities / total assets

Leverage

Total assets / total shareholders

equity

Measures the proportion of

borrowings to the investment
by owners
Indicates the proportion of
assets financed by liabilities
Indicates how much of the
companys assets are
financed by equity

Relationship between ratios

Many ratios are related and analysis will be beneficial from understanding these relationships
o Activity (turnover) ratios are related to liquidity and solvency warning ratios
o Performance ratios are related to financing ratios AND to activity (turnover) ratios

Overall, what do ratios do

They summarise large amounts of financial statement information
They add meaning to information in financial statements
They are useful in assisting various kinds of decision-making

Limitations in ratio analysis

Ratio comparisons across companies can be misleading if the companies use different accounting
methods
The quality of ratios are sensitive to any lack of consistency in the accounting methods used by a
company over time
Ratio comparisons across companies can be misleading if the companies operate in different
industries or are substantially different in other ways
Ratios fail to adjust for external factors such as inflation and market values of the dollar (the current
dollar may be worth different amount to what it was in past yet the two are still compared)