Accounting for Management Decisions

1
Accounting for Management Decisions

• (DBA10AMD)
• WEEK 4
• Measuring and reporting Balance Sheet (financial
  position) and Income Statement (financial
  performance)
• READING TEXT Chs 3 4

2
Learning Objectives contd

• Demonstrate an understanding of assets,
  liabilities and owners equity in terms of
  classification
• Contrast the alternative balance sheet formats
• Prepare a simple balance sheet
• Analyse balance sheets of reporting entities
• State the purpose of the income statement (profit
  and loss)
• Explain the relationship between the income
  statement and the balance sheet

3
Learning Objectives

• Present the profit and loss equation and identify
  alternative formats for the income statement
• Demonstrate an understanding of income in
  relation to definition, recognition,
  classification and measurement
• Demonstrate an understanding of expenses in
  relation to definition, recognition,
  classification and measurement
• Distinguish between accrual and cash-based
  transaction recognition
• Prepare an income statement from relevant
  financial information
• Review and interpret income statements
• Explain the limitations of financial statements

4
The Classification of Assets

• Assets are normally categorised as either
• or
• Current assets
• Are held on a
  basis
• cash and other assets expected to
  be consumed or converted into cash within the
• - normally
• Also inventory, trade debtors
  and pre-payments

5
Classification of Assets contd

• Presentation of Financial
  Statements requires a current asset to be
  according to the following
  criteria
• to be realised or
  intended for sale or consumption in the entitys
  operating cycle (usually 1 year)
• Held for the purpose of being
  
• to be realised within 1
  year after the
• or
• The asset is or a
  unless it is restricted from being exchanged
  or used to settle a liability for at least 1 year
  after the reporting date

6
Classification of Assets contd

• assets
• Held for the purpose of generating
  (ie longer term) rather than for
• May be seen as the of the
  business
• Normally held on a
  basis for a minimum period of 1 year
• Includes purchased -
  see p. 90
• AASB 101 Presentation of Financial Statements
  requires assets to be classified as non-current
  if they do satisfy any of the
  criteria for being
  (previous slide)

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Classification of Liabilities

• are normally
  categorised as either current or non-current
• liabilities
• Amounts due for to outside
  parties within of the
  statement of financial position date

8
Classification of Liabilities contd

• AASB 101 Presentation of Financial Statements
  requires a liability to be classified as
  when it satisfies the following
  criteria
• The liability is expected to be settled in the
  entitys normal operating cycle
• The liability is held primarily for the purpose
  of being
• The liability is due to be
  within 1 year after the reporting date or
• The entity does have an unconditional
  right to defer settlement of the liability for at
  least 1 year after the reporting date

9
Classification of Liabilities contd

• Non-Current liabilities
• Those amounts due to other parties which are not
  liable for repayment within the next
• Only the of time for which the
  liability is outstanding matters - the
  for which it is held
• AASB 101 Presentation of Financial Statements
  requires liabilities to be classified as
  non-current if they do satisfy any of
  the criteria for being classified as current
  (previous slide)

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Classification of Liabilities contd

• AASB 101 Presentation of Financial Statements
  also requires that liabilities be
  according to their nature
• 
  basis, or
• The order of (payment)
• This alternative
  classification may be used for
  if it provides more relevant and reliable
  information

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Classification of Owners Equity

• Owners equity is normally classified in
  separate categories
• contributed
• profit
• It is common to combine categories 2 and 3 into
  reserves with sub-categories
  (a) retained profits and (b) other reserves

12
Formats for Balance Sheets

• Learning Objective Contrast the alternative
  balance sheet formats

Fig 3.2 Horizontal layout aka T account
format The equation for Horizontal form of layout
Figure 3.3 The Vertical layout and proprietary
approach The equation for the vertical form
layout is
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for Balance Sheet

• (T account)

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Formats for Balance Sheet contd

• format
• ASSETS XXX
• - XX
• NET ASSETS XX
• REPRESENTED BY XX

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Financial Position at a Point in Time

• Learning Objective Analyse balance sheets of
  reporting entities
• The balance sheet is a statement of the financial
  position of the business at a specified
• in time
• Therefore it is important to
  when reading a balance sheet the it
  was drawn up, hence it is important to
  the date prominently in the heading

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Interpreting the Balance Sheet

• Learning Objective Analyse balance sheets of
  businesses
• The balance sheet provides useful insights into
  the financing and investment activities of a
  business. In particular, the following aspects
  can be examined
• The of the business
  the ability of the business to meet its
  obligations
• The of assets held by the
  business the relationship between
  and assets held is
  important as it is not easy to convert non
  current assets into cash
• The financial of the
  business the relative proportion of total
  finance contributed by the
  and can be calculated to
  see whether the business depends too heavily on
  outside financing.

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The Income Statement

• Learning Objective State the purpose of the
  income statement (profit and loss)
• The purpose of the income statement is to measure
  and report how much (wealth) the
  business has generated over a period
• Profit (or loss) is the
  between Income and Expenses
• Income is made up of
  (from operating activities) and
  (usually from non-operating activities)
• Expenses are of resources
  to generate income

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The Income Statement

• Examples of revenues sales of goods, fees for
  services, subscriptions, interest
• Examples of expenses cogs, salaries/wages, rent,
  rates, insurance, heating and lighting,
  telephone, interest etc.

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Relationship Between Income Statement and Balance
Sheet

• Learning Objective Explain the relationship
  between the income statement and the balance
  sheet
• They are CLOSELY related, but are NOT substitutes
  for each other in any way
• The income statement can be viewed as LINKING the
  balance sheet at the START of a period with that
  at the END of the period
• This link can ALSO be represented in the
  Statement of Changes in Owners Equity
• The accounting equation can thus be
  as
• Assets Liab OEbeg Profit/- Loss /- Other
  OE adj
• or further extended to
• Assets Liab OEbeg (Inc - Exp) /- Other OE
  adj

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Relationship Between Income Statement and Balance
Sheet contd
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Format of the Income Statement contd

• In practice, there are at least forms of
  income statement
• Simple listings of accounts (small businesses)
• Classified reports (larger organisations)
• Regulatory presentations (companies)
• Simple reports
• For organisations, may be just a
  listing of income and expenses in alphabetical or
  financial magnitude order

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Format of the Income Statement contd

• reports
• Relate to organisations and often
  called the classified financial report. Income
  and expenses are not simply listed, but grouped
  into categories
• Income would normally be broken down into sales,
  and other revenues
• can be broken down into
  categories
• Cost of sales ( )
• Selling and distribution
• Administration and general
• Financial

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Format of the Income Statement

• The format of the classified income statement
  will depending on whether the business
  is a business or a
  business.
• A retail business income statement will have a
• section. This section calculates
• by deducting COS sold from sales.
  All
• expenses are then deducted from
  the Gross Profit to get the Profit.
• We will be concentrating on the classified income
  statement for a retail business.

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Format of the Income Statement contd

• Regulatory reports
• Required to be produced by cos in accordance
  with accounting standards
• AASB 101 Presentation of Financial Statements
  requires that the income statement should
  classify expenses according to their nature or
  function
• See p.149 for a list of AASB 101 requirements
• For reporting, the reporting
  cycle is normally 1 year
• For functions, it is common
  for profit figures to be prepared on a monthly
  basis

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Example

• The following information was obtained from the
  records of Apple Ltd

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Example contd

• Required
• Prepare an income statement, statement of changes
  in owners equity and a balance sheet.

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Example

• Apple Ltd
• Income Statement for the
  31/12/09
• Sales 150,000
• Less cost of sales 90,000
• Less
• Selling general and Admin exp 14,000
• Operating profit 46,000
• Less interest expense 6,000
• Net profit before tax 40,000
• Less tax expense 14,000
• Net profit

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Example

• Apple Ltd
• Statement of changes in OE for
  31/12/09
• Share Capital 35,000
• Retained Profits
• Beginning balance 21,500
• profit 26,000
• - dividends (6,500) 41,000
• Total owners equity

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Example

• (horizontal format)
• Apple Ltd Balance sheet 31/12/09

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Profit Measurement and Recognition of Income

• Learning Objective Demonstrate an understanding
  of income in relation to definition, recognition,
  classification and measurement
• Income should only be recognised in the accounts
  when it has been
• Realisation is considered to have occurred when
• Activities necessary to generate the revenue are
  
• complete
• The amount of the revenue can be
  determined
• There is
  that amounts owing will be received
• Any other outstanding items can be determined
  with reasonable certainty

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Profit Measurement and Recognition of Income
vs

• Learning Objective Distinguish between accrual
  and cash-based transaction recognition for income
• based accounting recognises
  income when it is
• based accounting recognises
  income when it has been irrespective
  of whether the cash receipt is in arrears or in
  advance
• eg An based transaction
  recognition might be used in a long-term civil
  works project where multiple revenue recognition
  points occur within the project cycle prior to
  completion

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Profit Measurement and Recognition of Expenses

• Learning Objective Demonstrate an understanding
  of expenses in relation to definition,
  recognition, classification and measurement
• Expenses measure the of assets (eg
  cash) or the increase in liabilities that result
  from generating
• The Matching principle says that expenses
  should be to the income they
  to generate. That is, expenses have to
  be taken into account in the
  in which the associated income is recognised
• More recently, there have been moves away from
  matching in favour of a common basis for
  recognition of income and expenses
• Common basis is that if an item satisfies
  recognition criteria, it will be recognised if
  its occurrence is probable, and it can be
  reliably measured

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Profit Measurement Recognition of Expenses
contd

• If cash payments expenses incurred then no
  problem as cash expense accrual expense.
• If expenses incurred cash paid then we
  have
• expenses expenses
  which are
• at the end of the
  accounting period.
• eg Rent paid in the period to which it
  relates. The rent has been so
  it is reported in the Income Statement as an
  expense, but it is not paid so it is reported as
  a (Accrued/ overdue rent) in the
  Balance Sheet.

34
Profit Measurement Recognition of Expenses
contd

• 3. If cash payments expense incurred
  then we have a expense
• eg Rent payments paid in . The
  prepaid expense will appear as a current
  in the balance sheet. In the
  period, the prepayment will
  to be an asset and will become an
  in the income statement.

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Profit and Cash

• It is important to note that profit and cash
  (liquidity) are the same.
• Profit is a measure of
  , or productive
• rather than a measure of
  generated.
• Income does necessarily represent cash
  received, expenses do necessarily
  represent cash paid out
• Prepaid/deferred expenses relate to expenses paid
  in
• of being incurred and are an
  
• Prepaid/deferred revenue relates to where the
  cash has been received in advance of it being
  and are a .
• Accrued expenses are where the expense has been
  incurred but payment has been made
  and are a
• , while accrued revenue
  relates to revenue earned but
  received and are an

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Interpreting the Income Statement

• Learning Objective Review and interpret income
  statements
• To evaluate the financial performance of the
  business effectively you must determine
  the final net profit figure was derived. This
  can be found by
• analysing the amount - against
  history planned sales for the current/future
  periods
• examining the nature and amount of
  incurred
• against history and
  future
• is an indicator of efficiency of business
  operations
• investigating profit levels in
  relation to sales in similar businesses
• helpful in assessing and
  
• analysing net profit levels, for example, against
  previous periods and also in relation to sales

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Limitations of Financial Statements

• Financial statements report only
  data.
• They do reflect non-quantitative data
  such as the value of the management team or the
  employee
• The balance sheet reports assets at their
• cost and does
  generally report market values or the replacement
  costs of the assets
• Many are used, such as
  warranty costs, depreciation and bad debts
  expense.

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Limitations of Financial Statements contd

• Financial statements are adjusted to
  show the impact of inflation (stable monetary
  assumption).
• Financial statements do reflect
  cost
• ie income foregone when an income earning
  opportunity is foregone (losing a contract is
  reported)