AEACF — U2

Formula: Current ratio

Current assets / Current liabilities

Formula: Quick asset ratio

(Current Assets – Inventory – Prepayments) / (Current Liabilities – Overdraft)

Formula: Gross profit ratio

Gross profit / Net sales (or fees)

Formula: Profit ratio

Profit / Net sales (or fees)

Formula: Expense ratio

Operating expenses / Net sales (or fees)

Formula: Return on assets

Profit / Average assets (across current and previous year)

Formula: Debt to equity ratio

Total liabilities / Equity

Define: Current ratio

When high, there is high level of assurance that the business will be able to pay current liabilities with the use of current assets.

Define: Quick asset ratio

When high, there is high level of assurance that the business will be able to pay current liabilities with the use of current assets in the short term, and are not relying heavily on inventory turnover to make debt repayments.

Define: Gross profit ratio

When high, business can easily cover all selling, administrative, and financial expenses. They have the capacity to earn acceptable operating profit and adequate return on investment.

Define: Profit ratio

When high, operating income is high and operating expenses are low.

Define: Expense ratio

When low, the business has tight control over expenses relative to sales.

Define: Return on assets

When high, assets are being effectively used to generate profit and are performing well.

Define: Debt to equity ratio

When low (referred to as the business being ‘lowly geared’), they have minimal external borrowings and can therefore easily repay their debts.

Scenario: A company is evaluating whether it has enough assets to cover its short-term debts due within the next year.

Current ratio (measures ability to pay off short-term liabilities with current assets)

Scenario: Management wants to assess how easily the company can meet its short-term obligations without relying on selling its inventory.

Quick asset ratio (excludes inventory from current assets, providing a more conservative measure of liquidity)

Scenario: A business owner wants to know how efficiently the company is producing and selling its products relative to its production costs.

Gross profit ratio (evaluates the percentage of revenue that exceeds the cost of goods sold, indicating production efficiency)

Scenario: A company is trying to determine how much of its revenue is being converted into profit after all expenses have been deducted.

Profit ratio (measures the overall profitability of the company after all expenses)

Scenario: The CFO is interested in understanding how much of the company's revenue is being consumed by operating expenses.

Expense ratio (shows the percentage of revenue that is spent on operating expenses, helping to assess cost management)

Scenario: A company is looking to evaluate how effectively it is utilizing its assets to generate profit.

Return on assets (measures how efficiently a company is using its assets to generate profit, indicating asset productivity)

Scenario: The board of directors wants to assess the company’s financial leverage and risk by comparing its debt to shareholders' equity.

Debt to equity ratio (provides insight into the company’s financial leverage and the proportion of debt used to finance assets compared to equity)

Scenario: A company is assessing its ability to quickly cover short-term liabilities in case of an emergency without having to sell its inventory.

Quick asset ratio (measures liquidity by excluding inventory, focusing on the most liquid assets to cover short-term liabilities)

Scenario: An investor is comparing the profitability of two companies to determine which one is better at converting sales into actual profit.

Profit ratio (provides a clear comparison of profitability between companies by showing what percentage of revenue is converted into profit)

Scenario: A company is analysing its cost structure to identify if operating expenses are too high relative to its total revenue.

Expense ratio (helps to evaluate if operating costs are within a reasonable range, impacting overall profitability)

Scenario: A company is considering taking on additional debt and wants to understand its current leverage to ensure it doesn’t become over-leveraged.

Debt to equity ratio (helps the company assess its financial leverage by comparing the amount of debt to the shareholders' equity)

Scenario: A small business wants to ensure it has enough liquidity to cover unexpected short-term expenses without having to liquidate long-term assets.

Current ratio (measures the company's ability to cover its short-term liabilities with its short-term assets, providing insight into its liquidity position)

Scenario: A retail company wants to compare its profitability against industry benchmarks to see if its cost of goods sold is under control.

Gross profit ratio (shows how much profit is made after deducting the cost of goods sold, which is crucial for assessing profitability relative to industry standards)

Scenario: The CEO wants to evaluate how effectively the company is using its assets compared to its competitors to generate earnings.

Return on assets (used to compare how efficiently a company utilizes its assets in generating profits, providing a basis for comparing operational effectiveness with competitors)

Scenario: A potential investor is analysing a company's financial stability and wants to determine how much risk is associated with its capital structure.

Debt to equity ratio (The Debt to Equity Ratio provides insight into the company's capital structure, indicating the level of financial risk associated with its reliance on debt compared to equity)

Integrity

Be straightforward and honest in all professional and business relationships.

Objectivity

Do not allow bias, conflict of interest, or undue influence of others override personal or business judgements.

Professional competence and due care

Maintain the level of professional knowledge and skill required to provide competent professional services.

Confidentiality

Respect the confidentiality of information acquired as a result of personal and business relationships. Do not disclose information without proper and specific authority.

Professional behaviour

Comply with relevant laws and regulations and avoid any actions that discredit the profession.

Explain the process: Enter bad debts and set new allowance for doubtful debts.

(1) Debit bad debts for value, credit accounts receivable. (Bd expense for year)
(2) Credit bad debts for value, debit allowance for doubtful debts. (Transfer bd to afdd)
(3) Debit doubtful debts for amount needed to make equal to new allowance, credit allowance for doubtful debts. (New allowance for doubtful debts created)

Define: Accrued income

Income earned, but yet to be received.

Define: Unearned income

Income received, but yet to be earned.

Define: Prepaid expense

Expenses paid, but yet to be used.

Define: Accrued expenses

Expenses used, but yet to be paid.

Define: Depreciation

The deterioration of an asset that decreases in value with use.

Explain the process: Sale of a depreciable asset.

(1) Calculate accumulated depreciation at time of sale.
(2) Debit cash for value paid, credit sale of asset.
(3) Debit acc depreciation, credit sale of asset.
(4) Debit sale of asset, credit purchase value of asset.
(5) Debit profit/loss on sale of asset for value to balance sale of asset ledger, credit sale of asset.

Define: Supplies expense

Consumed inventory of supplies.

Straight-line depreciation

Assets that depreciate at a constant rate. Rate of depreciation = (Historical cost - estimated residual value) / Estimated useful life

Reducing balance depreciation

Assets with a pattern of use that decreases over time. Compounded.

Define: Accumulated depreciation

Total depreciation of an asset over its lifespan.

E-commerce

Business activities transacted through electronic devices such as computers, internet, and other data transmission systems.

E-business

A term that refers to all business activities that use electronic devices to conduct any part of business operations. This may or may not involve the internet.

EFTPOS

Electronic Funds Transfer Point of Sale. Allows the user to purchase items with a debit card and withdraw cash in agreement with the retailer. + Generates more sales, reduces cash on premises. - A fee is charged, cards can be skimmed.

Bill payments

Electronic payment for websites. Allows the user to purchase items with a range of cards to pay for online purchases. + Generates more sales, allows prompt receiving of payment, less chance of fraudulent purchases. - A fee is charged.

Credit cards

Allows the user to purchase items on credit up to a set limit. A business has to have a credit card facility to allow this type of transaction. + Generates more sales, reduces cash on premises. - A fee is charged, cards can be skimmed.

Direct debits

Allows the user to directly place money into a retailers bank account to pay for goods and services. + Generates more sales, reduces payment processing time. - A fee is charged, a dishonour fee may be charged for insufficient funds.

Online banking

Allows the user to conduct their banking online without having to go into the bank to do their business. + Banking is available 24/7, bills can be paid online. - A fee is charged, accounts can be hacked.

Card skimming

When a card's details are stolen during payment.

Cash accounting

Recognise, record and report transactions on the basis of when the money is received or paid. The period in which earned/incurred is not taken into account. Most suitable for small sole trader businesses which conduct most transactions on cash. No need to do balance day adjustments. Allows business keep a much closer control on its cash position, focused on cash inflows and cash outflows.

Accrual accounting

Transactions are recognised when they occur. Income is recorded when earned (point of sale) and expenses when incurred (when used or consumed). Recorded in accounting records and reported in financial reports of the periods to which they relate. Therefore, financial reports inform users of both past transactions and future obligations the business must pay/receive. Provide the most useful information in terms of making economic decisions.

Recognition

The process of incorporating an item that meets the definition of an element and satisfies the criteria for recognition into the balance sheet or income statement. Recorded in words and by a monetary amount. Materiality must be considered.

Materiality

The size/significance of an item.

An element that meets a definition is recorded if...

It is probable that associated future economic benefit will flow to/from the entity, and the item has a cost or value that can be reliably measured.

Probability of future economic benefit

Considers how an entity operates and is based on the evidence available at the time. Ex: A receivable for which there is no evidence suggesting non-payment should be recognised as an asset, but some degree of non-payment should be considered, so the expected reduction in economic benefits is recognised as an expense of allowance for doubtful debts.

Reliability of measurement

Costs and values can be reliably measured following the historical cost principle, otherwise may need to be estimated.

Historical cost

Assets are recorded at the amount paid or fair value given to acquire it, and liabilities are recorded at the amount of proceeds received in exchange for an obligation or the amount paid to satisfy it.

Current value

The amount of cash or equivalent that would have to be paid to acquire an asset/settle a liability now.

Realisable/settlement value

In the normal course of business, the amount of cash or equivalent that could be obtained by selling the asset in or, in the case of a liability, that amount that would be paid to satisfy the obligation.

Assets

A resource controlled by the entity that is the result of past event and holds future economic benefits.

An asset is recognised in the balance sheet when...

It is probable that the future economic benefits will flow to the entity and the asset has a cost or value that can be measured reliably.

An asset is not recognised in the balance sheet when...

Expenditure has been incurred for which it is improbable that economic benefits will flow to the entity beyond the current accounting period. This instead results in an expense.

Liabilities

A present obligation that is the result of past event and holds future sacrifice of economic benefits or outflow of resources.

A liability is recognised in the balance sheet when...

It is probable that an outflow of resources embodying economic benefits will result from the settlement of a present obligation and the amount at which the settlement will take place can be measured reliably.

Income

An increase in economic benefits (+assets/-liabilities) that results in increased equity unrelated to equity participants.

Income is recognised in the income statement when...

An increase in future economic benefits related to an increase has arisen that can be measured reliably. Occurs at the same time as recognition of increases in assets or decreases in liabilities. Normally recognised when earned.

Expenses

A decrease in economic benefits (-assets/+liabilities) that results in increased equity unrelated to equity participants.

Expenses are recognised in the income statement when...

A decrease in future economic benefits related to an increase has arisen that can be measured reliably. Occurs at the same time as recognition of decreases in assets or increases in liabilities. Recognised with the matching concept. If expected to arise over several accounting periods, recognised with systematic and rational allocation procedures. If produces no future economic benefits, recognised immediately.

FIFO inventory costing method

Uses the cost of inventory in order of purchase. Recommended for inventory with limited shelf life.

Weighted average inventory costing method

Cost of inventory is calculated by totalling the value spent on inventory, and then dividing it by the quantity. Recommended where there's many inventory types and quantities.

Inventory price changes under FIFO

Inventory value, total current assets, and gross profit follow the direction of the price change. Cost of sales does the opposite.

Depreciation

When the future economic benefits of an asset decrease over time through wear & tear or obsolescence. Calculated on human made non-current assets that have a limited useful life.

Types of depreciation

Wear & tear (over time, use causes maintenance costs to exceed benefits), technical obsolescence (no longer used due to its outdated technology), and commercial obsolescence (redundant due to decreased demand). There are sometimes legal limits on useful life.

Cost of asset

Price, freight cost, long term modifications, installation cost, and things such as un-included 12 month insurance contracts (not on asset itself, but associated goods/services) and repairs in the first year.

Cost of a depreciable asset

Cost of asset and initial estimates of the cost to dismantle and remove it and restore its site after lifespan.

Straight line method

For assets that earn income in a constant matter, whose pattern of use is constant and benefits are consumed or lost in an even way. (Historical Cost - Estimated Residual Value) / Estimated Useful Life

Reducing balance

For assets that earn more income early in its lifespan, whose pattern of use decreases as it ages and benefits are lessened over time. (Value at beginning of accounting period - Estimated Residual Value) / Estimated Useful Life

Carrying amount

The total original cost of an asset minus accumulated appreciation (Also known as the book value or the written down value).

Over-depreciation

Carrying amount < proceeds on disposal → Gain

Under-depreciation

Carrying amount > proceeds on disposal → Loss

objective of general-purpose financial reporting

provide information about the entity useful to current and future investors and creditors in making decisions as capital providers

fundamental qualitative characteristics

relevance, faithful representation

enhancing qualitative characteristics

comparability, verifiability, timeliness, understandability

relevance

information is relevant if it makes a difference to decision makers in their role as capital providers. information is relevant when it has predictive value, confirmatory value, or both.

faithful representation

information is representationally faithful when it is complete, neutral, and free from material error.

comparability

the quality of information that enables users to identify similarities and differences between sets of information. consistency in application of recognition and measurement methods over time enhances comparability.

verifiability

information is verifiable if different knowledgeable and independent observers could reach similar conclusions based on the information.

timeliness

information is timely if it is received in time to make a difference to the decision maker. timeliness can also enhance the faithful representation of information.

understandability

information is understandable if the user comprehends it within the decision context at hand. users are assumed to have reasonable understanding of business and accounting and are willing to study the information with reasonable diligence.