VCE Accounting, Units 3&4

Study Design 2013-2016

Notes by Yakir Havin

Class of 2014
Contents

(control + click to jump to chapter)

Chapter 1 The nature of accounting....................................................................5

Chapter 2 Balance sheets................................................................................... 7
Chapter 3 Analysing and designing accounting systems....................................9
Chapter 4 The double entry recording process.................................................12
Chapter 5 Special journals: cash transactions...................................................14
Chapter 6 credit sales and credit purchases journals........................................15
Chapter 7 The general journal...........................................................................17
Chapter 9 The perpetual inventory system.......................................................18
Chapter 10 Closing the general ledger..............................................................20
Chapter 11 Income statements.........................................................................21
Chapter 12 Cash flow statements.....................................................................22
Chapter 13 Depreciation of non-current assets.................................................23
Chapter 14 Profit determination and balance day adjustments........................24
Chapter 15 Sales returns and purchases returns..............................................25
Chapter 16 The reducing balance methods of depreciation..............................27
Chapter 17 Buying and selling non-current assets............................................28
Chapter 18 Inventory valuation.........................................................................29
Chapter 19 Balance day adjustments: repaid revenue and accrued revenue...30
Chapter 20 Managing and controlling debtors, creditors and stock..................31
Chapter 21 Budgeting: planning for the future.................................................34
Chapter 22 Analysis and interpretation of accounting reports..........................36

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Chapter 1 The nature of accounting

The uses of financial information
Main users of accounting information and their areas of interest:
Owner/manager: profit, liquidity, stability, sales, growth, budgets, stock
management, debtors, creditors, rates of return.
Prospective owners: budgets, future earnings, predicted returns,
stability, prospects of growth.
Banks/ledgers: liquidity, stability, budgets.
Suppliers of good or materials: credit rating, reliability, stability.
Government departments: e.g. Taxation Department, Bureau of
Statistics, Small Business Victoria (needs are specific according to their
own specialist areas).
Employees/unions: stability of employment, profits, likelihood of wage
increases.
Customers: pricing, credit facilities, future trading opportunities.

Statements of accounting concepts

SAC1: Definition of the reporting entity
SAC2: Objective of general purpose financial reporting

SAC2: Objective of general purpose financial reporting

Qualitative characteristics
Relevance: all information that may influence the users of a report must
be disclosed so that decision-makers are fully informed.
- Materiality is the test of whether something is worth reporting or not. If
the item has no or little effect on decision-making, it is not considered
an asset, and its purchase is rather written off as an expense.
Reliability: the need to be able to check and verify accounting
information against business documents to improve accuracy and prevent
bias.
Comparability: financial reports are prepared in a consistent manner so
that they may be compared from one reporting period to the next.
Understandability: accounting information is presented in a simplified,
understandable fashion so that those without accounting training may be
able to understand reports.
Assets are resources controlled by the entity as a result of past events and from
which future economic benefits are expected to flow to the entity.

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Liabilities are present obligations of the entity arising from past events, the
settlement of which is expected to result in an outflow from the entity of
resources embodying economic benefits.
Owners equity is the residual interest in the assets of the entity after
deduction of its liabilities.
Revenues are increases in economic benefits during the reporting period in the
form of inflows or enhancements of assets or decreases in liabilities that result in
increases in equity, other than those relating to contributions from the owner.
Expenses are decreases in economic benefits during the reporting period in the
form of outflows or depletions of assets or incurrences of liabilities that result in
decreases in equity, other than those relating to distributions to equity
participants.

Accounting principles

Consistency: accounting methods used must be applied consistently

from one reporting period to another.
Historical cost: transactions are recorded at their original cost price, as
verified by source documents.
Entity: the personal transactions of the owner(s) should be kept separate
from those of the business, to ensure easy evaluation of business
performance.
Reporting period: the continuous life of the business is divided into
equal periods of time for the purpose of the preparation of reports in order
to show the performance of the business (e.g. profit and loss).
Monetary unit: the unit of currency used in all accounting reports must
be that of the country in which the report is being prepared.
Conservatism: a tendency to be cautious when preparing reports. Losses
should be recorded when probable and profits when they are earned.
Going concern: deems that a business will continue as a going concern
for an indefinite period.

Relevance is supported by the Entity and Reporting Period principles.

Comparability is supported by the Consistency principle.

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Chapter 2 Balance sheets

Balance sheet
Assets are the resources controlled by an entity that have future economic
benefits as a result of past transactions.
Liabilities are present obligations of an entity that will result in an outflow of
resources in the future.
Owners equity is the residual interest in the assets of the entity after
deduction of its liabilities. Also referred to as the net worth of the business.

Assets = Liabilities + Owners equity

Owners equity = Assets Liabilities

Equities describe anyone who has a legal claim on assets of the business.
Liabilities include all external equities, as these are obligations to outsiders of the
business. The internal equity is the owners claim on the firm. This is the net
worth of the business of the proprietor.
There are two formats of a Balance Sheet:
T-form presentation
Narrative presentation

Classification in the balance sheet

Current assets are economic resources controlled by the entity, which are
normally expected or intended to be turned into cash or used up in the next 12
months. E.g. cash on hand, cash at bank, short-term investments, the goods held
for re-sale, stocks of supplies and amounts owing by credit customers.
Non-current assets are usually acquired with the intention of controlling them
for a period of time greater than 12 months for the purpose of generating income
for business. E.g. computers, vehicles, machinery, furniture, equipment, property
and long-term investments.
Current liabilities include obligations of economic sacrifices due for payment
within the next 12 months. E.g. bank overdrafts, short-term loans and amount
owing to suppliers who have extended credit to the business.
Non-current liabilities are debts for which payment has been deferred over a
period greater than 12 months. E.g. long-term loans.
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Classification of loans
Interest-only loans do not require the principal of the loan to be repaid until
the loan period has expired. That is, only the interest due is paid to the lender
each year until the loan period has expired.
Characteristics:
Gives owner time to accumulate the amount borrowed before having to
make the single repayment of the principal.
Requires excellent planning skills, as the total amount borrowed has to be
available on the day the loan period expires.
Classification is non-current liability as they do not involve an obligation
for payment within the next 12 months.
Instalment loans require the borrower to make scheduled repayments
throughout the life of the loan. These amounts are usually stated as a dollar
amount per month or per quarter.
Characteristics:
Allows a business owner to avoid having to make one lump sum payment.
Must be repaid constantly throughout the loan period and may therefore
put a business under steady pressure for several reporting periods.
Classification is current liability for the instalment amounts owing within
the next 12 months and non-current liability for the remainder that is due
at a time after 12 months.

Financial transactions and balance sheets

Revenues are the increases in economic benefit in the form of inflows of assets
or reductions in liabilities that result in an increase in equity, other than
contribution of capital by the owner.
Expenses are the decreases in economic benefits in the form of reduction in
assets or increases in liabilities that result in a decrease in equity, other than
distributions of equity (drawings).
Under the accrual accounting method of determining profit, revenue
earned less expenses incurred equals the net profit for a period.
GST liability is an obligation owing of a business to the taxation office because
the business has collected (charged) more GST than it has paid to its suppliers.

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GST refund is an amount owing to a business from the taxation office because
the business has paid (been charged) more GST than it has collected from its
customers.

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Chapter 3 Analysing and designing accounting

systems
The basic accounting process
Collection of raw
data

Recording of raw
data in financial
records

Reporting of
results

It is common practice to produce copies of business documents, the documents

that are the starting point of the accounting process.
For example:
The original document may be issues to the customer.
A white copy may go to the general accounting department within the firm.
A blue copy may be used by the credit department to update credit accounts.
Where stock is involved, a green copy may be used for inventory purposes.

The GST and business documents

Tax invoices are issues to customers when goods or services are provided. They
must contain:
The name of the business providing the goods or services
The ABN of this business
The words Tax invoice (top of document)
A pre-printed document number (reference)
The date of the transaction (top right-hand side)
Description of the goods or services provided
Purchasers name, together with their address or ABN (for transaction of
$1000 or more)
GST-exclusive price, GST amount and GST-inclusive price for each items,
together with totals (bottom, vertically on the right-hand side)
For cash sales or transactions, the words Cash receipt can be printed next to
Tax invoice, and the credit terms are removed. The inclusion of the words Tax
invoice do not guarantee that the transaction was of a credit nature.

General business documents: cash transactions

For cash inflows, a cash receipt is used to evidence the transaction. A receipt
should be issued to the customer and a copy kept by the firm.

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It is common practice to make all cash payments by cheque. The details of the
cheque should be copied on to the cheque butt, which acts as a copy of the
original cheque.

Business documents: credit transactions

When goods are purchased on credit an invoice is used to communicate the cost
of the good supplied. Therefore invoices can be both received and issued by
firms dealing on credit. The business/customer making the purchase always
receives the original document while the supplier keeps a copy.

Memorandums for internal transactions

Internal transactions are transactions that only affect the business and its
owner, not involving another business entity or individual. E.g. capital and
drawings (receipt and cashed cheque).
However, for withdrawals of stock (as donations for advertising purposes),
memorandums, or memos are used. Memos must also suit the needs of the
reliability characteristic.

Statements of account
A statement of account is used to summarise the transactions involving a
credit customer over a given period. Common practice is to issue these monthly.
A statement of account includes a running balance after each transaction, as
well as other basic transactional details (i.e. date, description etc.).

Other business documents

Order forms for requests from suppliers (not a financial transaction yet)
Cash registers rolls
Delivery dockets
Employee pay slips
Bank statements

Information flows: an overview of the accounting system

1) Source documents are the original documents of accounting data.
2) Journals are used on a daily basis to record the details of the data in the
source documents.
3) Ledgers are used to record the details of a particular item/account (this is
where double entry occurs).
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4) Trial balance is a summary of the closed/footed ledgers listed in debit
and credit total columns. The purpose is to check that the double entry
procedure has been carried out correctly.
5) Balance day adjustments adjust revenue and expense accounts so that
they equal revenue earned and expenses incurred (under the accrual
accounting method).
6) Accounting reports provide the owner/s with the results of the periods
activities.
7) Evaluations of reports include profitability, liquidity, efficiency and
financial stability.
8) Planning for the future involves decision-making in response to the
current periods results. This may include cash budgets and budgeted
income statements.

source
documents

journals

ledgers

trial balance

balance day
adjustments

accounting
reports

evaluation of
reports

planning for
the future

Manual versus computerised accounting systems

The accounting process (computerised system)
Collection of
raw data

Data input

Processing of
data by
computer
package

Output of
information
(reports)

Advantages:

Computer systems can process data at more rapid rates.

Information is free from human error (input and calculation).

Disadvantages:

Computer systems cost money and their purchase must be calculated

before being undertaken.
Employees are required to have specific skills before using computer
systems.

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Chapter 4 The double entry recording process

Double entry accounting: an introduction
A ledger account is a financial record that relates to a particular item within the
business. There are three parts to an entry in a ledger account: the date, a crossreference, and an amount.
Assets appear on the left side of the ledger and are debit in nature. Liabilities
and owners equity are on the right side of the ledger and are credit in nature.
Therefore, assets are decreased with credits, while liabilities and owners equity
are decreased with debits.

Double entry for revenue and expenses

As revenue increases owners equity, a revenue ledger account will be the same
in nature as owners equity (credit in nature). Expenses have the opposite effect
on owners equity and are therefore debit in their nature.

The role of the trial balance

A trial balance is a summary of the closed/footed ledgers listed in debit and
credit total columns. The purpose is to check that the double entry procedure
has been carried out correctly and accurately, and to detect input errors made in
the ledgers.
Undetectable errors:
Entering an incorrect amount for both the debit and credit
Entering a debit or credit in the wrong account
The debit and credit entries are reversed
Omitting a transaction completely
Compensating errors
None of the above errors will be detected in the trial balance as the debit and
credit figures will balance, albeit with the wrong amounts.

Detecting errors through a trial balance

Detectable errors:
Debit or credit omitted
Duplication of a debit or credit
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Transposing errors

Accounting for drawings

Drawings occur when the proprietor of the business withdraws assets for
personal use. Classification is owners equity but is the opposite of capital. As
capital is credit in its nature, drawings, is debit in nature.

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Chapter 5 Special journals: cash transactions

Source
documents

Journals

Ledger
accounts

The role of special journals

Journals provide the first form of classification in a double entry accounting
system. Special journals are used to group transactions of a similar nature to
make posting to ledger accounts easier.

Recording in the cash receipts journal

Advantage of multi-column cash receipts journal:

A cross check may be made of the entries in a CRJ to ensure that recording
errors have not been made. Excluding Cost of Sales, the columns are
totalled and checked that they equal the total Bank figure. If Discount
expense applies, this is deducted. This is usually done before posting to a
ledger account.

Recording cash discounts for debtors and creditors

Credit terms 2/7: n/30 indicate that a 2% discount is available as a cash
discount if the invoice is settled within 7 days. If the customer does not take
advantage of this cash discount period, the net amount is due for payment
within 30 days.
Credit customers are offered a cash discount as an incentive for early payment
because:
If debtors pay early the likelihood of bad debts is reduced.
The early receipt of cash allows a business to pay for inventory purchases
at an earlier time, thus taking advantage of any cash discounts available
from suppliers.
It helps a business reduce time taken by debtors to settle their accounts,
thus improving the firms liquidity.
Cash received earlier may be used to reduce other debts of the business.

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Chapter 6 credit sales and credit purchases journals

Credit transactions
Characteristics:
Applies to supplierbusiness and businesscustomer.
Used to attract more customers and increase revenue.
May be necessary when dealing with other businesses.
Stock can be bought on credit and then sold while the business hasnt paid
the supplier.

The need for control accounts

Control accounts are used to summarise all the debtors and creditors subsidiary
accounts (as well as transactions of stock). The control account saves time as
one does not need to add all the subsidiary accounts when finding the total. Also,
the control account acts as a checking mechanism, to ensure that it equals all
the subsidiary accounts. Control accounts reduce the bulky detail contained in
subsidiary ledgers and help reduce the threat of fraud (when recording duties are
separated). Control accounts help maintain accuracy of debtors and creditors
transactions. Control accounts are not relevant for all businesses as it depends
on the firms needs. If a business does not trade on a credit basis, debtor and
creditor control accounts are deemed unnecessary, as are subsidiary accounts,
as the business will possess no debtors or creditors. Also, control accounts may
need additional staff and new computer systems, thus their use needs to be
weighed up.

Debtors schedules
A debtors schedule is a listing of the balances of individual debtors account in
the subsidiary ledger. The total of this listing is then checked against the balance
of the debtors control account in the general ledger. The purpose of this is to
identify recording errors in one or both ledgers.

Creditors schedules
To reconcile the creditors subsidiary ledgers, a creditors schedule is made,
listing all creditors with the amount owing to them at a particular date.

Advantages and disadvantages of control accounts

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Advantages:
Bulky details is removed from the general ledger.
Trial balance figures provide a summary of total figures, rather than
individual accounts.
In larger businesses, accounting departments can be set up to cater for
specific areas.
Control accounts provide a checking mechanism to detect recording
errors.
Control accounts assist in enforcing internal control procedures over staff
and may therefore reduce the likelihood of fraud.
Disadvantages:
Control accounts are not suited to all business and can create unnecessary
work in terms of accounting records.
Additional staff may have to be hired.
A computerised system may be introduced.

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Chapter 7 The general journal

The need for a general journal
Contributions and drawings of stock or non-current assets by the owner are not
covered by the special journals and are instead entered into the general journal.
The general journal is also used for error corrections. An additional entry is made
instead of removing the erroneous entry to reduce the chance of fraud.

Recording the contribution or withdrawal of assets by an owner

Whenever an owner puts an asset into a business, the particular asset must be
debited and capital credited. For a withdrawal, the opposite occurs.

Using agreed value for assets

When an owner contributes a non-current asset to the business, an estimate of
the assets worth based on current market value is made as the asset has
depreciated since its original purchase and this figure becomes the agreed
value henceforth. The original amount that the owner paid has no relevance to
the business. This system does not satisfy the demands of reliability (no source
document). However, relevance takes precedence here for the estimation of the
assets worth to the business at the time of contribution, as this is the amount
that affects decision making. Historical cost of the asset is not used here and
conservatism is applied as to the worth of the contributed asset.

Donations of stock and business advertising

When a business donates stock for advertising purposes, this transaction is not
recorded as drawings but rather as an advertising expense. However, there is no
cash flow involved. Rather, the business has suffered a loss of economic
resources, leading to a decrease in equity.

Accounting for bad debts

When a debtor cannot complete a payment, the outstanding debt is written off
as a bad debt, resulting in a credit to debtor control and a debit to a new
account, bad debts. Debtors may sometimes may be forced to pay [xx] cents in
the dollar instead of the full amount.

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Chapter 9 The perpetual inventory system

What is inventory?
Inventory is defined as stock or merchandise that has been purchased for the
purpose of resale to generate a profit. This does not include non-current assets.

What is perpetual inventory?

Control and monitoring of stock is vital towards business success. The perpetual
inventory system helps to accurately record the inflows and outflows of stock. It
record the stock item, quantity, cost price and balance of a type of stock.

Advantages:

Greater control over stock is possible as up-to-date information is available

throughout the reporting period.
Slow-moving and fast-moving lines of inventory can be identified.
Reordering of inventory is more efficient.
Interim profit reports can be prepared without doing a stocktake.
The level of stock losses or gains is measured.

Disadvantages:

Additional record keeping is involved because inventory balances must be

continuously updated.
Additional costs may be incurred due to the additional record keeping.
The need for a physical stocktake at the end of a reporting period is not
eliminated.

Fixed mark-up systems

Cost price =

selling price 100

100 + mark up

First in, first out stock valuation

FIFO is the assumption that the oldest cost price of inventory on hand is the cost
price for inventory sold at any given time. This assumption also applies to stock
losses. FIFO is used as it can be impossible to identify the cost price of each
stock item, and to satisfy the demands of perpetual inventory, it is more a more
efficient method of cost allocation than identified cost.

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The role of stock cards

Stock

cards include:
Name (or description) of an item
Product code number (if applicable)
Name of the supplier
Location of the item
Minimum or maximum to be in stock (for reordering purposes)
Valuation method used (e.g. FIFO)
All purchases and sales in relation to the particular product

Stock cards and the general ledger

The stock control ledger account and the stock cards can be checked against
each other at the end of a reporting period as a control mechanism.

Stock losses and stock gains

Stock

losses are caused by:

Undersupply by suppliers.
Oversupply to customers.
Theft.
Recording errors in stock cards.
Duplicate invoices issued by a supplier.
Stocktaking errors.

Stock

gains are caused by:

Oversupply by suppliers.
Undersupply to customers.
Recording errors in stock cards.
Stocktaking errors.

Adjusting for a stock gain

When an adjustment is made in a stock card to account for a stock gain, the
lowest cost price of inventory on hand is used to comply with conservatism.

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Chapter 10 Closing the general ledger

The closing of the general ledger
Revenue, expense and drawings accounts are closed off at the end of reporting
periods:
To determine profit earned in the period.
To prepare the ledger accounts for the new period (zero balances).

The profit and loss (P&L) summary account

The P&L summary account is a temporary ledger account used to find the net
profit or loss of a firm during a reporting period and to close off revenue and
expense accounts. The differential is posted to the capital account as a net profit
or loss.

The general journal and closing entries

Before closing off accounts in the general ledger, the particulars should be
recorded in the general journal for:
Closing entries (for revenue and expenses separately).
Transfer of net profit.
Transfer of owners drawings.

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Chapter 11 Income statements

The income statement
The income statement reports the revenues and expenses of a firm during a
reporting period to determine a net profit or loss figure. This report is produced
to satisfy the needs of understandability as many would not be familiar with
the workings of a double entry system (i.e. seeing the net profit/loss figure in the
general journal).

Evaluating a net profit figure

Comparing the profit earned in the current period with that earned in
previous periods.
Checking that the profit earned in the current period meets with budgeted
expectations.
Comparing the profit earned in the current period against industry
averages.
Evaluating using analytical ratios (gross profit ratio, net profit ratio, etc.).

Cost of goods sold and gross profit

Cost of goods sold includes any expenses incurred in the purchasing of stock and
preparing it for sale. This may include, but are not limited to:
Cost of sales
Cartage inwards
Buying expenses
Customs duty
Import expenses
Packaging expenses

Reporting discounts
Discount revenue, interest revenue, commission revenue and other forms of nonsales revenue fall under the category of other revenues in the Income
Statement. Discount expenses and the like fall under other expenses.

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Chapter 12 Cash flow statements

The role of the cash flow statement
The Cash Flow Statement (CFS) completes a set of the important accounting
reports along with the Income Statement and Balance Sheet. It provides
streamlined information relating to cash flows in and out of the business during a
given reporting period.

Classification of cash flows

Operating activities: cash sales, collections from debtors, GST

paid/collected, etc.
Investing activities: purchase or sale of non-current assets (for cash).
Financing activities: capital contribution, loans, loan repayments and
drawings.

Cash flows and decision-making

Cash Flow Statements provide management with information that demonstrates
the effects of its decision-making on the cash resources of the firm. Therefore,
statements for consecutive reporting periods are often prepared within the one
report to highlight changes that have occurred.

Cash versus profit

Cash and profit are not necessarily the same thing. Cash movements are
reported in the cash flow statement in order to determine the firms net cash
position, while revenues and expenses are reported in the income statement to
determine an accurate profit figure. While some revenues and expenses may be
earned or incurred in the form of cash movements, this is not always true. For
example, while credit sales may be a contributing factor to a net profit, there is
no cash inflow involved which may leave the cash flow statement in a net cash
decrease. Conversely, capital contributions improve the firms cash position but
have no effect on the net profit. Thus it is evident that a firm can have a net cash
decrease/increase while also having a net profit/loss.

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Chapter 13 Depreciation of non-current assets

The meaning of depreciation
Depreciation is the allocation of the cost of a non-current asset over its effective
working life (when it makes revenue for the firm). The revenue earned by an
asset should be considered in the same period as depreciation expense is
recognised to satisfy accrual accountings method of profit determination.

The meaning of cost

The historical cost of the asset

All other once-of costs incurred to get the asset into a revenue-earning
capacity

Straight-line method of depreciation

Depreciationexpense=

Cost of assetScrap value

Usefullife( years)

The adjusting entry for depreciation

Debit: Depreciation of [asset] account
Credit: Accumulated depreciation of [asset]
Narration: Adjusting entry for depreciation of [asset] at [rate/amount] per annum

Depreciation and the balance sheet

Accumulated depreciation is reported as a negative asset and detracts from the
assets value to create a book value or carrying value. This is the worth of the
asset to the firm after depreciation has been allocated and accumulated (or not
yet depreciated), and is not a market value estimate.

Depreciation: relevance and reliability

Depreciation must be recorded as it is relevant to decision making as it
decreases an assets worth, and increases the accumulated depreciation
negative asset. However, depreciation value is based on estimates and therefore
does not satisfy reliability. Relevance takes precedence here.

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Chapter 14 Profit determination and balance day

adjustments
Profit determination: underlying assumptions
The going concern principle assumes that the business will continue to
operate as a going concern for an indefinite period into the future. This allows for
reporting of non-current elements that are expected to have a future effect on
the business.
The reporting period principle divides the indefinite life of the business into
arbitrary periods of time for the preparation of reports, determination of profit
and evaluation of the business.
The relevance characteristic demands that accounting information relevant to
decision making be included in business reports in order to calculate an accurate
profit or loss figure. Based on accrual accounting, profit is determined by
deducting expenses incurred from revenues earned in a given reporting period,
not taking into account when payments are actually made.

Accrual accounting and balance day adjustments

Balance day adjustments have the function of adjusting the balances of
revenue and expense accounts to match revenue earned and expenses incurred
in the reporting period. Adjusting entries make revenue and expense accounts
equal respective earned and incurred amounts. Closing entries close off the
adjusted revenue and expense accounts to the P&L summary account.

Prepaid expenses
Prepaid expenses are expenses that are paid for in a period prior to the benefit
thereof being consumed. Prepaid expenses are current assets and are adjusted
to become expenses when the benefit is consumed by the business.

Accrued expenses
Accrued expenses are expenses whose benefit has been consumed before
payment has been made. Accrued expenses are current liabilities and the
(consumed) expense components are adjusted to respective expense accounts
on balance day.

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Chapter 15 Sales returns and purchases returns

Credit notes for returns
A firm that purchases and sells stock on credit may have good retuned to the
supplier or the customer because:
Goods and damaged or faulty
Wrong size, type, brand or colour
Late delivery and no longer required
When good are returned, a credit note may be issued as acknowledgement of a
return. Credit notes are considered a form of source document. They typically
include:
The firm that issued the credit note
The firm that received the credit note
Description, quantity, total and GST
Date and credit note number

Purchases returns
When a firm returns goods that were bought on credit to its supplier, this is a
purchases return. When a purchases return occurs, four accounts in the books of
the firm are affected:
Creditors control (debit)
Subsidiary creditor (debit)
Stock control (credit)
GST clearing (credit)
This transaction is recorded in the general journal and it does not fit into any of
the special journals.

Sales returns
When a customer returns goods that were bought on credit to a firm, this is a
sales returns from the perspective of the firm. The following six accounts are
affected:
Sales returns (debit)
GST clearing (debit)
Debtor control (credit)
Subsidiary debtor (credit)
Stock control (debit)
Cost of sales (credit)
Sales returns totals at the end of the period are deducted from sales in the
income statement. Sales returns have their own account so that management
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can analyse trends in goods that have been returned which may indicate poor
stock quality. A firm may choose a new supplier for this line of stock or remove it
altogether.

Recording purchases returns in stock cards

Purchases returns have nothing to do with the FIFO assumption. This is
because the supplier will always determine what credit will be allowed for the
returned goods. Therefore, the actual value of any value of credit allowed will be
identified by the supplier and evidenced by the credit note issued.

Recording sales returns in stock cards

The value of a sales return is the value of the sale that was originally made.
However, the cost of sales for the return may not always be easily identified.
Here, the cost price of the most recent sale of that item is considered the cost
price of the goods being returned. This is, in effect, a reverse of the FIFO
assumption.

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Chapter 16 The reducing balance methods of

depreciation
The need for an alternative method of depreciation
Depreciation is the allocation of a cost of a non-current asset over its useful
working life. This is an expense charged against the revenue earning capacity
of the asset, so as to satisfy the demands of relevance and the reporting
period principle. This is because matching all revenues earned with all
expenses incurred will result in an accurate profit figure.
As some assets are not expected to earn a fixed amount of revenue throughout
their working lives, depreciation must be allocated accordingly. This is where the
reducing balance method (RBM) comes in.

The reducing balance method of depreciation

Assets that typically earn more revenue in the earlier years of their working lives
than in the later years. This may be because certain assets require maintenance
after a time or because they get superseded by newer models. Reducing balance
depreciation allocates increasingly less depreciation throughout the assets life.
The depreciation is calculated from the carrying value, as opposed to its
historical cost, and as the carrying value decreases with each depreciation, so
too does each depreciation amount.

Depreciation methods: which one to use?

To satisfy relevance and reporting period, depreciation allocated must match
the assets revenue earning capacity. In this way, the assets carrying value
decreases at a similar rate as the revenue that it is expected to earn, and accrual
accounting is thus followed. Under the stipulations of relevance, depreciation
should always be allocated as it will affect decision making.
While there are no clear cut rules to selecting a depreciation method, assets that
typically earn a fixed revenue (furniture, shop fittings, etc.) should be
depreciated using the straight-line method (SLM). Conversely, assets that
generally earn more revenue earlier on should be depreciated using the reducing
balance method.
Whichever method is chosen, it is important that the method remains the same
in order that consistency be followed, and to maintain comparability between
reports.
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Chapter 17 Buying and selling non-current assets

Recording credit purchases on non-current assets
These purchases are recorded in the general journal, as the credit purchases
journal is designated for stock. If an asset is bought for cash, this should be
recorded in the cash payments journal. Credit purchases, however, do not affect
creditors control or creditors subsidiary ledgers whatsoever, as no stock
purchase is involved. Rather, a sundry creditor account is made for the supplier
of the asset.

Disposal of non-current assets

The four necessary steps to records to disposal of an asset for cash:
1. Transfer the historical cost to the disposal of asset account.
2. Transfer the accumulated depreciation to the disposal of asset account.
3. Record the proceeds from the sale in the disposal of asset account.
4. Close off disposal of asset account by recording profit/loss on the sale of
the asset.
If a profit was made on the disposal of an asset, this means that the depreciation
was too high, over-depreciation. If there was a loss made, this means that the
depreciation was too low, under-depreciation. Other factors may include
incorrect residual value or useful life, the asset is no longer popular or in
demand, the asset has become technologically obsolete, or it may be damaged.
These mistakes are expected as depreciation is based on estimates and does not
satisfy reliability.
Profit on disposal of an asset is reported under other revenue as it is not earned
in the normal course of business trading, while a loss is simply reported under
other expenses.

Trading in non-current assets

Instead of being disposed of for cash, assets can be traded in on newer models.
This reduces the amount owing to the sundry creditor for the new asset being
purchased. Recording this is the same as disposing of an asset, except that
instead of making a cash receipts entry, the trade-in allowance for the old asset
is deducted from the sundry creditor account, and this is first recorded in the
general journal.

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Chapter 18 Inventory valuation

Product costs versus period costs
The cost of inventory refers to the purchase price plus other costs involved in
getting the inventory into a selling position. If costs related to the stock can be
divided equally/directly related per stock item, then we check if the amount per
item is considered material of enough value to affect decision making and
therefore warrant reporting (part of relevance). If the amount is indeed
material, then this cost is a product cost and is added to the cost of the stock
itself.
However, if the cost cannot be directly attributed to each stock item, or does not
divide equally (e.g. $100 delivery cost for 10 chairs, 20 tables, 25 stools) and/or
is not material, then this cost is written off as a period cost and is reported in
that periods income statement under other expenses.

Lower of cost and net realisable value

While inventory is generally recorded at cost price, there is an exception when
the expected selling price of an item is less than its cost price. Net realisable
value (NRV) is defined as the selling price less any costs incurred in the
marketing, selling, and distribution of the item. The lower option of cost price or
NRV is selected and recorded as the value of the inventory. This is due to
conservatism, which calls on accountants to be prudent in recognising losses
when they are expected, and gains only when realised, and as the stock sale will
incur a loss, this is recorded in the stock write-down.
Possible reasons that an NRV will be lower than cost prices:
Item has been superseder by a newer model
Item has become obsolete, possibly through technological advancements
Out of season or fashion
Damaged
Shop-soiled
Being deliberately sold below cost to attract customers
If the value of stock is written down due to recording at NRV, a stock writedown must be recorded in the general journal and stock card, before being
transferred to the general ledger and so on. The disclosure of stock write-downs
are necessary under relevance, as lowering the value of stock will affect
decision making.

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Chapter 19 Balance day adjustments: repaid revenue

and accrued revenue
What is revenue earned for a period?
Under accrual accounting, revenues earned and expenses incurred are matched
per period to determine profit. Besides for prepaid and accrued expenses, there
are times when a firm will be paid for a service/goods it has not yet provided
(prepaid revenue), or earns revenue before being paid (accrued revenue). These
also fall under the category of balance day adjustments, and accrual accounting
demands that these be reported for the period in which they were earned.

Prepaid revenue (the liability approach)

If a firm is paid and has not yet earned the revenue, this should be recorded as a
prepaid revenue which is classified as a current liability as it is a resource
controlled by the business as a result of past transaction (the receipt of cash)
and is expected to result in an outflow of economic resources (the service/goods)
within the next 12 months. In this way, the revenue will only be reported during
the period in which the expenses relating to earning the revenue are incurred,
thus making the match as stipulated by accrual accounting.

Accrued revenue (revenue owing)

If the revenue earning process has been completed, this revenue must be
recorded during the period as it has been earned, even if it has not necessarily
been paid for. Accrued revenue is classified as a current liability as it is a
resource controlled by the business as a result of a past transaction (provision of
service/goods) that is expected to result in an inflow of economic resources
(cash) within the next 12 months. Sometimes when a firm is owed cash for a
provision of service or goods, it will be paid a larger amount including payment
for new service or goods in the new period. Here, the cash receipt should be split
up as payment for the accrued revenue and as new revenue.

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Chapter 20 Managing and controlling debtors,

creditors and stock
Controlling inventory
Buying and selling of stock is the lifeblood of the firm. Questions management
may face daily are:
What goods should be buy?
How many and which size should we purchase?
What brand and colour should be stocked?
Steps to take to ensure enhanced control of stock:
1. Setting minimum and maximum levels of inventory
In a perfect situation, the minimum quantity should be just enough to
satisfy sales until the new order is delivered. This is called just in time
ordering.
2. Physically rotating stock by hand to avoid damages and shopsoiling
3. Identifying and removing slow-moving lines
The definition of slow-moving is on a per item basis, and typically depends
on the amount of revenue being brought in per item and nature of the
business.
4. Monitoring seasonal products to avoid dead stock
5. Monitoring products subject to technological obsolescence
6. Introducing complementary products
7. Changing with the times
8. Monitoring selling prices
9. Ensuring that adequate stock security is in place
- Security guards
- Undercover security personnel
- Video surveillance
- Security tags on products
- Random checks on staff
- Check deliveries against invoices
- Document files in an organised fashion to avoid double invoicing by
suppliers
- Place cash from cash sales securely in registers

Evaluating stock turnover

Stock turnover ratio measures how long it takes to turn stock into sales. This
can be determined in times per year or days.

Stock turnover ratio ( ) =

Cost of goods sold

Averagelevel of stock
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Stock turnover ratio ( days )=

Stock

Average stock 365

Cost of goods sold

turnover should be evaluated against:

Turnover rates in previous reporting periods
Comparisons with expectations of management
Consideration of the type of inventory sold

Action that can be taken if a problem is detected with a slow stock turnover:
Reducing the selling price of slow-moving items
Relocating stock within the store to highlight particular goods
Running special promotions of targeted stock lines
Item combinations for promotion

Controlling debtors
Before granting credit to a customer, a credit check should be performed and
may include:
Banking history
Loans and/or credit card history
References from other businesses
References from financial institutions
Cash forecasts and/or budgets
Income statements and balance sheets
If receipt for a credit sale is overdue, management may undertake the following
action:
Offering discounts for prompt payment
Charging interest on overdue accounts (if detailed in original contract)
Sending reminders via email
Reminding debtors via telephone (for personal contact)
Sending monthly statements including coloured stickers
Threatening not to provide credit in future
Threatening clients with legal action
An age analysis of debtors provides a snapshot look at debtors due payments
and apportions them according to days since sale has occurred.

Evaluating debtors turnover

Debtors turnover ratio measure how long it takes to turn debtors into cash.

Debtors turnover ratio()=

Credit sales
Average debtors
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Debtors turnover ratio(days )=

Average debtors 365

Credit sales

Evaluating the cash cycle

Cash cycle measures how long it takes to turn stock into cash. This is
determined by the sum of the stock turnover and debtors turnover ratios in days.
It is possible for changes in either stock or debtors turnover ratio to occur
without cash cycle changing, as these may offset one another.

Evaluating creditors turnover

Creditors turnover ratio measures how long it takes for the firm to pay off its
creditors.

Creditorsturnover ratio()=

Credit purchases
Average creditors

Creditorsturnover ratio( days)=

Average creditors 365

Credit purchases

Unlike the stock and debtors turnover ratios, it is not always favourable to have a
low creditors turnover. If the firm is repaying its creditors too quickly, issues of
liquidity will arise where the firm may not have sufficient funds to pay off other
debts. Conversely, creditors turnover should also not be too slow as this may
force legal action from creditors or they may decide to cut off all supply.

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Chapter 21 Budgeting: planning for the future

The need for budgeting
Budgeting is a means of planning and controlling the future financial transactions
of a business. All business have a need for budgeting because all managers
should have a basic financial plan. This is preferred to not having a plan at all,
whereby the business would be allowed to run haphazardly without control or
interference.
It is crucial that the budgeting process remains flexible, as they are simply a tool
for planning future events. Budgets should be reviewed and updated as required.

The sales budget

Perhaps considered the cornerstone of budgeting, the sales budget is crucial to
overall budgeting. A sales budget predicts the future sales revenue expected to
be earned by the business. A sales budget usually includes quantities expected
to be sold and the anticipated selling prices.
Cash sales link to inflows of cash (cash flow statement). Credit sales link to
debtor balances (balance sheet). Sales is revenue (income statement). Sales
estimates leads to predictions such as stock requirements, estimated purchases
and staffing needs.

Cash budgeting
A budgeted cash flow statement looks at future cash inflows and outflows of a
business.
When

making predictions, take into account the follow possible factors:

Is the business likely to continue trading as successfully as before?
Will the business sell the same products?
Are there new competitors?
Has the demand for products changed?
Will technology affect the business?

Decisions that may be made as a result of cash budgeting include:

Additional capital contributions
Cut backs on personal cash drawings
Reductions or postponement of payments of expenses
Borrowing required cash
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Leasing assets rather than owning

Budgeted income statements

A budgeted income statement is used to examine the predicted revenues and
expenses of a business over a given period of time.
If the budgeted income statement predicts managements overall objectives, the
budget should be adopted and put into action. If not, the budget should be
reviewed and changes introduced until management is happy with the budgets
goals.

The budgeted balance sheet

The budgeted balance sheet predicts the firms financial position at a particular
date in the future.
This can be used for:
Reporting on the future situation of a firms non-current assets
Examining the future liquidity
Evaluating the gearing
Showing future details of owners equity

Budget variance reports

Variance reports are where management analyses the differences between
budgeted and actual results. If the variances are favourable, these should be
maximised to further aid the firms performance in these respective areas. If not,
management should examine the areas of unfavourable variance and attempt to
take corrective action to rectify them. This is part of the perpetual budgeting
system whereby budgets are continually reviewed and used to make decisions.

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Chapter 22 Analysis and interpretation of accounting

reports
The role of analysis and interpretation
Analysis and interpretation should be seen as a tool that can assist management
to make better decisions.

Distinguishing between analysis and interpretation

Analysis is the process of breaking down something complex into simpler,
smaller portions.
Interpretation is the process of explaining the meaning of the completed
analysis.
When dollar figures on a report are converted to percentages, this is known as
vertical analysis because the information is analysed in a vertical fashion. On
an income statement, this allows management to interpret in terms of
percentages of sales consumed by each expense, and how much remained for
gross/net profit.
Horizontal analysis is reports that have been converted to percentages
(common size statements) are analysed across different periods to detect trends.
Trend analysis involves measuring changes in an item from period to period.

Analytical ratios
An analytical ratio is simply the comparison of two items that have a particular
relationship to each other.

Ratio benchmarks

Previous reporting periods (trend analysis)

Industry averages, or comparison with other similar businesses
Budget estimates, or predicted results
Alternative investments in the money market

Ratios should always be compared to at least one benchmark to give the ratio
some sort of meaning.

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Types of analytical ratios

1. Profitability ratios: comparing profit with investment
2. Operating efficiency ratios: how efficiently assets have been used by
management
3. Liquidity ratios: the businesss ability to meet its short term debts as
they fall due
4. Stability ratios: the financial stability of the business and financial risk
undertaken

Profitability ratios
Profit is simply a dollar figure of revenue earned less expenses incurred for a
period. Profitability measures the comparison between the profit earned and the
investment made.

1.

Gross profit ratio=

Gross profit
Sales

Increases due to:

Cost prices decreased, sales
remained
Cost prices remained, selling
prices increased
Cost price and selling price
decreased, but cost price
decreased at a greater rate

2.

Net profit ratio=

Decreases due to:

Cost prices increased, sales
remained
Cost prices remained, selling
prices decreased
Cost price and selling price
increased, but cost price
increased at a greater rate

Net profit
Sales

This will deviate from the gross profit ratio according to the firms operating
expenses.
3.

Expense ratio=

[ Expense item]
Sales

Informs management about the percentage of sales consumed by each expense.

4.

Return on assets=

Net profit
Average total assets
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Compares net profit with the amount invested in the firms assets. The assets
value is averaged across the period to preclude fluctuations at the beginning or
end of the period from offsetting this ratio.
5.

Returnon owne r ' s investment =

Net profit
Average capital

This may diverge significantly from ROA as many firms fund their assets through
liabilities instead of capital.

Operating efficiency ratios

A trading business purchases assets for the purpose of generating revenue. If
these assets are used to maximum operating efficiency, the result should be
maximum profit. Operating efficiency ratios are related to profitability ratios in
the sense that they measure how well the assets generate revenue, which
ultimately determines the level of profit earned.
1.

Asset turnover ratio=

Sales
Average totalassets

Compares sales revenue with the average investment in the firms total assets.
2.

Stock turnover rate=

Average stock 365

Cost of goods sold

Measures the number of days it takes for a business to turn stock into sales.

Type of stock being sold

3.

Consider
Previous periods results

Debtors turnover rate=

Budget objectives

Average debtors 365

Credit sales

Examines the performance of management in collecting debts from debtors. The

days figure shows the average time it takes for debtors to settle their accounts.

Credit terms

4.

Debtors age
analysis

Consider
Previous results

Budget objectives

Debtors age analysis

Provides management with a breakdown of debtors accounts in relation to the

age of their debts.
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Consider
Previous results

Credit terms
5.

Budget objectives

Cash cycle=Stock turnover + Debtors turnover

Evaluates the time taken to turn stock into sales, and then sales into cash.

Individual turnover
rates

6.

Consider
Previous results
Budget objectives

Creditorsturnover rate=

Creditors turnover
rate

Averagecreditors 365
Credit purchases

Measures the time taken to repay creditors. It is important to balance the time to
complete the cash cycle and the time taken to settle creditors account.

Cash cycle results

Credit terms from

suppliers

Consider
Previous results

Budget objectives

Efficiency ratios and profitability

The way management uses its asset has a direct impact on profitability.

Return on assets=

Net profit
Sales
Net profit
=

Average assets Average assets

Sales

The return on assets reports on two aspects of a firms performance. First, how
efficiently the assets have been used to generate revenue. Second, the return on
assets is affected by the percentage of sales revenue consumed by the firms
expenses, which determines net profit.

Liquidity analysis
Liquidity is the ability of a business to meet its short term debts as they fall due,
which usually refers to debts within the next 12 months. For a firm to survive, it
needs cash to meet needs such as expenses, creditors, loan repayments, and
drawings.
1.

Working capital ratio=

Current assets
Current liabilities

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Gives a percentage or dollar figure of current assets that the firm possesses
relative to each dollar of its liabilities. Businesses may be able to survive on a
low working capital if they have fast cash cycles. If WCR is too high, this may
mean the firm has invested too much in current assets, meaning there is too
much cash tied up in bank, inventory or debtors.
2.

Quick asset ratio=

Current assetsstock prepaid expenses

Current liabilitiesbank overdraft

Measures liquidity of a much more immediate form than WCR, as only quick
assets are being compared to urgent debts. In essence, the comparison becomes
bank and debtors compared to creditors. Again, a quick cash cycle may allow a
firm to operate on a low quick asset ratio, but this this not be encouraged, and
may signal liquidity problems in the immediate future.

Liquidity analysis and cash flows

There is a logical connection between the cash flow statement and liquidity as
this statement reports all inflows and outflows of cash, thus providing a summary
of what has happened to cash resources over time. A cash flow statement should
be read in conjunction with analytical ratios. A profitable business may cease
trading if it cannot control cash, as bills and wages must be promptly paid.

3.

Net cash flows

Cash flows ratio= operating activities

Average current liabilities

Shows the amount of times net cash flows from operations is equal to currently
owing liabilities. If this is high, the business is unlikely to experience difficulty in
meeting short term debts.

Previous results

Consider
Budget objectives

Gearing and financial stability

Financial stability looks at the long term structure of a business entity. Gearing
is the dependence of a firm on outside funds (as opposed to capital). A highly
geared business is one that is funded majorly by external funds i.e. liabilities.
This creates higher financial risk as there is pressure to meet repayments of
debts. Consequences may include legal action threatened, or cut-off of supply by
creditors.

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Debt ratio=

Total liabilities
Total assets

Determines the percentage of assets funded by borrowed finances.

Gearing and the rate of return on owners investment

Reasons an owner might borrow money:
Necessity: the firm does not have sufficient wealth to finance business
operations
Optional: funds are borrowed and used to increase personal return
High gearing also affects business in the form of interest expense which will
reduce net profit. A highly geared firm may achieve high ROIs, as the level of
capital is very low, and simultaneously may achieve low ROAs, as the level of
assets (funded by liabilities) is very high. Certain owners may choose a high risk high return strategy of funding their business, while others may opt for a more
conservative approach.

Other analysis tools

Non-financial key performance indicators give management information about
the businesss performance in non-financial forms, such as:

Customer satisfaction surveys

Sales returns ratio=

Salesreturns
Total sales

Quality assurance

Purchases returns ratio=

Quality of management
- Communication skills
- Management skills (controlling stock, debtors, creditors)
- Adapting to change
- Developing new products
- Flexibility in response to customers
- Recognising ones weaknesses
Profit compared to hours worked

Profit earned =

Purchases returns
Total purchases

Net profit
Hours worked

Economic climate
- Consumer confidence
- Market competitions
- Wage demands by unions
- Market trends
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Technological change

Limitations of ratio analysis

1. Ratios are based on historical data and there is no guarantee these will
correspond to future results
2. Historical cost accounting (changes due to inflation)
3. Changes in accounting methods
4. Inter-firm comparisons
5. Frequency of reporting
6. Limited information

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