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 cont’d • 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 cont’d ‘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 entity’s operating cycle (usually 1 year); • Heldfor 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 cont’d 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)

7. 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 cont’d 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 entity’s 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 cont’d 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)

10. Classification of Liabilities cont’d 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

11. 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. Current Assets Non-Current Assets Current Liabilities Non-Current Liabilities Owners’ Equity Current Assets Non-Current Assets Current Liabilities Non-Current Liabilities Capital 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 3.3The Vertical layout and proprietary approach The equation for the vertical form layout is

13. for Balance Sheet (T account)

14. Formats for Balance Sheet cont’d format ASSETS $XXX - XX = NET ASSETS $ XX REPRESENTED BY $ XX

15. 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

16. 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.

17. 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

18. 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.

19. 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 NOTsubstitutes 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

20. Balance sheet at the beginning of Period 1 Balance sheet at the end of Period 1 Balance sheet at the end of Period 2 Income statement Income statement Statement of changes in owners equity Statement of changes in owners equity OpeningPeriod 1Closing/Period 2Closing/ OpeningOpening Relationship Between Income Statement and Balance Sheet cont’d

21. Format of the Income Statement cont’d 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

22. Format of the Income Statement cont’d 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

23. 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.

24. Format of the Income Statement cont’d Regulatory reports: • Required to be produced by co’s in accordance with accounting standards • AASB 101 Presentation of Financial Statementsrequires 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

25. Example The following information was obtained from the records of Apple Ltd:

26. Example cont’d Required: Prepare an income statement, statement of changes in owners’ equity and a balance sheet.

27. 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 $

28. 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 $

29. Example (horizontal format) Apple Ltd: Balance sheet 31/12/09

30. 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

31. 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

32. 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

33. Profit Measurement & Recognition of Expensescont’d • 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 Expensescont’d 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.

35. 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

36. 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

37. 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.

38. Limitations of Financial Statements cont’d • 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)