Accounting Fundamentals

Financial Accounting

Information is prepared for external users, but is used by internal users as well.

Management Accounting

Information is prepared for internal users only. (more detailed)

Financial Accounting v Management Accounting

- the primary users (external v internal)

- frequency of information (6/12 monthly v ad hoc, when necessary and needed)

- time period focus (past v present-future)

- content (financial v all types of information)

- format (standard v no prescribed format)

The Conceptual Framework

Relates to financial accounting. A document underlying accounting that outlines the 'who', 'what' and 'why' of financial reporting.

Recognition Criteria

- Relevance: if it influences users' economic decisions through feedback or confirmatory value, and comparability (decision-related)

- Faithful representation: complete, neutral and free from error

Enhancing characteristics

- Comparability: must be able to compare financial statements over time and between entities (over time and between entities)

- Verifiability: different knowledgeable and independent observers can reach a consensus

- Timeliness: whether the information is available to users before it ceases to be relevant

- Understandability: readily understandable by users, assumed to have a reasonable business knowledge

The Five Elements of Accounting

- Assets

- Liabilities

- Owner's Equity

- Income

- Expenses

Assets

A present economic resource controlled by the entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits.

Assets Characteristics

- Present economic resource

- Controlled by the entity

- As a result of past events

Liabilities

A present obligation of the entity to transfer an economic resource as a result of past events.

Liabilities Characteristics

- Present obligation

- Transfer of economic resources

- Past events

Owner's Equity

(Assets - Liabilities = Equity), The residual interest in the assets of the entity after deducting all its liabilities.

Income

Increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims.

Income Characteristics

- Increase in assets or decrease in liabilities

- Result in increases in equity

- Exclude the owner's contribution to equity

Expenses

Decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims.'

Expenses Characteristics

- Decreases in assets or increases in liabilities
- Result in decreases in equity
- Exclude distributions to owners

Accounting Entity Concept

No matter what business structure is chosen, the records of the business must be kept separate from the financial and personal affairs of the owner(s).

Sole Traders

An individual operating as the sole person legally responsible for all aspects of the business. Like other structures, as a sole trader you can employ people to help you run your business

Sole Traders Characteristics

- A sole trader is the simplest business structure and consists of an individual trading on their own.
- That person controls and manages the entire business.

Sole Traders Advantages

- Easy, cheap, and simple to set up.

- The owner makes all the decisions and has full control.

- Not highly regulated — just need an ABN, Tax File Number, and GST registration if earning over $75,000.

- The owner pays tax on business income as personal income, and any losses can reduce tax from other income sources.

Sole Traders Disadvantages

- Tax is charged at marginal rates (on a scale up to 45%), and there is a lack of ability to split income.

- Unlimited liability of the owner, which means that all the assets of the sole trader (including personal assets) are at risk.

- Limited business life - the business ends when the sole trader ceases working (on retirement or death)

- Sole owners generally have limited skills, time and investment.

Partnership

An association of people or entities running a business together, but not as a company.

Partnership Characteristics

- Very similar to a sole trader to set up, but with more than one owner to pool skills, knowledge and resources.

- They conduct business together with a view to making a profit.

- The role of a 'partnership agreement' is very important.

Partnership Advantages

- Similar to sole traders, tax is calculated on an individual basis, however income may be more easily 'split' between the partners in the partnership.

- The partners own and operate the business so this means they can make all the decisions.

- Partnership agreement may allow flexibility for varying profits/losses between the partners on an annual basis.

- Partnerships are relatively simple and easy to establish and run and are not highly regulated

Partnership Disadvantages

- Joint liability of the owners - if any of the partners do not have enough money or assets to pay their share of the debt, the other partners may be personally liable.

- Mutual agency and unlimited liability - the partners' personal assets may need to be used to repay the business' debts and individual members of the partnership may be personally liable.

- Limited life - if there is a change in the membership of partners this will usually alter the partnership agreement and affect the continuity of the business.

- Tax is charged at marginal rates which can be high.

Companies

A company is a separate legal entity with its own tax and superannuation obligations, run by its directors and owned by its shareholders.

Companies Advantages

- Limited liability - companies offer the advantages of limited liability for the shareholders.

- Company tax rates apply. The higher company tax rate, 30%, is much lower than the highest marginal tax rate for individuals, which is 45% plus Medicare.

- It is easier for public companies to raise capital.

- Business operations continue when ownership is transferred, with an indefinite life.

Companies Disadvantages

- More expensive and time consuming to establish (especially a public company).

- May be harder to attract finance initially with limited liability of shareholders.

- There is separation of ownership and control (agency).

- Companies are subject to high amounts of regulation.

Cash Accounting

A very simplistic approach to accounting, which recognises income when it is received in cash, and expenses when they are paid in cash.

Accrual Income

Under this approach, income is recognised (and recorded) when it has been earned (regardless of whether the cash has been received or not). Earned now, paid later

Accrual Expenses

Similarly, expenses are recognised (and recorded) when they have been incurred (regardless of whether cash has been paid or not). Incurred now, paid later.

Transactions

- A cash transaction involves an exchange of money immediately.

- A credit transaction means something has occurred that needs recording, but it does

Business Events

Will potentially affect the business, but CANNOT be recorded until a transaction actually takes place. For example, meeting the Bank Manager to negotiate a loan, which has not been finalised or approved.

Prepaid Income

Cash was received in advance but products or services have not been delivered. Paid now, earned later

Prepaid Expenses

Cash was paid in advance but products or services have not been received. Paid now, incurred later

EXAMPLE: On 1 January 2024, Tao paid RACV $4,000 for one-year car insurance that will commence on 15 January 2024 and end on 14 January 2025.

On 1 January 2024, RACV needs to record $4,000 of income received in advance (prepaid income) as their LIABILITY. On the same day, Tao has her car insurance paid in advance (prepaid expense) which she needs to recognise $4,000 as her ASSET at the time of payment.

Double Entry Accounting

- A system that records the DUAL EFFECT of each transaction in appropriate accounts

- Double entry accounting means that whenever something is recorded, it affects at least two items (or two accounts) in the business records.

Transaction Analysis

Three questions to ask:

- Which elements (and which accounts within those elements) are AFFECTED?

- What HAPPENS to these accounts? i.e. increase or decrease?

- After answering the first 2 questions, does the accounting equation remain BALANCED?

What is the purpose of general purpose financial statements?

To provide useful financial information to users for decision-making.

What are the four main reports included in general purpose financial statements?

Income Statement, Statement of Changes in Equity, Balance Sheet, Statement of Cash Flows.

What does the Income Statement measure?

The financial performance of the entity for a specific period.

What is the formula for calculating profit or loss in an Income Statement?

Income - Expenses = Profit (Loss) (or Net Income).

What accounting method is used to prepare the Income Statement?

Accrual accounting.

How does the complexity of an Income Statement vary?

It varies based on the size of the entity; smaller entities have simpler statements.

What is the difference between revenue and gains?

Revenue is money earned from normal business activities, while gains are extra income not from regular activities.

What does Cost of Goods Sold (COGS) represent?

An expense incurred to buy or make a product for resale, recognized only when goods are sold.

What is gross profit?

Gross profit = Sales revenue - Cost of Goods Sold.

What are operating expenses?

Expenses incurred in operating a business, including selling, administrative, and financial expenses.

What is the formula for calculating profit?

Profit = Total income - Total expenses.

What does the Income Tax Expense represent?

The amount of tax the entity needs to pay based on its profit level.

What is the Statement of Changes in Equity?

A financial statement that outlines how the owner's wealth has changed during the accounting period.

What factors can change equity?

Profit/loss, drawings/dividends, additional capital, and asset revaluations.

What is depreciation?

The recognition of the consumption of an economic benefit of non-current assets over time.

Which assets are subject to depreciation?

Non-current assets like land improvements, buildings, and plant and equipment (excluding land).

What are the three main methods of calculating depreciation?

Straight line, reducing balance, and units of production.

What is the straight-line depreciation method?

It recognizes the same amount of depreciation each period over the asset's useful life.

What is the reducing balance depreciation method?

It recognizes more depreciation in the early years of an asset's life and less later on.

What is the units of production depreciation method?

It recognizes depreciation based on actual usage of the asset compared to its productive capacity.

What should be considered when interpreting an income statement?

The time period, factors affecting performance, and potential impact of policy choices.

What is earnings management?

The manipulation of an entity's reported profit for the period through accounting policy choices.

What does the term 'accrual accounting' refer to?

An accounting method where income and expenses are recorded when they are earned or incurred, not when cash is exchanged.

What is the significance of line-items in an income statement?

They help identify significant items affecting the overall financial result (profit or loss).

How does the format of the Statement of Changes in Equity vary?

It varies from simple for small businesses to complex for larger companies.

What is the general purpose of financial statements?

To assist external users in decision-making by providing financial accounting information.

What are the four main reports included in general purpose financial statements?

Income Statement, Statement of Changes in Equity, Balance Sheet, Statement of Cash Flows.

What does the Balance Sheet provide an overview of?

The wealth of the entity (assets), level of debt (liabilities), and owner's share of the business (owner's equity).

What is the accounting equation?

Assets - Liabilities = Owner's Equity + Income - Expenses.

How can the balance sheet equation be presented?

Assets = Liabilities + Owner's Equity (T format) or Assets - Liabilities = Owner's Equity (Narrative format).

What classification is commonly used for assets and liabilities in a balance sheet?

Current and Non-Current classifications.

What is the definition of current assets?

Assets expected to be used within 12 months.

What is the definition of current liabilities?

Liabilities expected to be paid back within 12 months.

What is the purpose of the Statement of Changes in Equity?

To show the profit (loss) from the Income Statement and how it affects the equity of the business.

What are some common items listed under equity in a balance sheet?

Share capital, retained earnings, and reserves.

What are the three methods of depreciation?

Straight-line, reducing balance, and units of production.

What is the impact of bad debts on accounts receivable?

It reduces the reported value of accounts receivable due to uncollectible amounts.

What limitation does the balance sheet have regarding timing?

It is prepared as of a specific date and may not represent the position at other times during the period.

Why might the balance sheet not reflect an entity's true value?

Some items may not appear on the report, and others are recorded at historical cost.

What is a significant consideration when interpreting a balance sheet?

Identifying the date(s) the report relates to and ensuring consistency when comparing entities or time periods.

What should you look for when analyzing the overall position of a balance sheet?

The relationship between liabilities and assets.

What does the term 'liquidity' refer to in the context of a balance sheet?

The order in which assets and liabilities are listed based on how quickly they can be converted to cash.

What is the significance of line-items in a balance sheet?

Identifying any significant changes or unusual items that stand out.

What does the balance sheet represent in terms of financial position?

A historical representation of the financial position of an entity.

What factors can affect the amounts included in a balance sheet?

Choices, assumptions, and estimates made during preparation.

What is the relationship between the Income Statement and the Statement of Changes in Equity?

Profit or loss from the Income Statement is transferred to the Statement of Changes in Equity.

Why is a statement of cash flows necessary?

It supplements information from the income statement and balance sheet, revealing cash flow differences from profit and how cash changes occurred.

What does the income statement reveal?

It reveals information about profitability.

What is a major risk of relying solely on profitability?

Strong profit does not necessarily mean good liquidity; businesses can face bankruptcy due to cash shortages despite being profitable.

What does the statement of cash flows identify?

It identifies sources of cash inflows and shows where cash was used during a specific period.

What are the three main sections of the statement of cash flows?

Operating, Investing, and Financing.

What is net cash flow?

The difference between total receipts and total payments, which can be positive (surplus) or negative (deficit).

What are operating cash flows?

Cash flows related to day-to-day activities, such as providing goods or services and paying expenses.

Give an example of cash receipts in operating cash flows.

Cash from customers or clients (cash sales and collections from debtors).

What do investing cash flows relate to?

The acquisition and disposal of non-current assets.

Provide an example of cash payments in investing cash flows.

Cash paid for the purchase of computers or vehicles.

What do financing cash flows relate to?

Changes in liabilities and equity.

Give an example of cash receipts in financing cash flows.

Cash from the issue of shares to the public.

What is the importance of cash flow to business survival?

Adequate cash flow is critical; many businesses fail due to cash shortages.

What should you check when interpreting a statement of cash flows?

Identify the reporting period, overall net cash flow, category subtotals, significant line-items, and any background information.

What are short-term strategies to improve cash flow?

Reduce current assets, delay payments, and increase current liabilities.

What are longer-term strategies to improve cash flow?

Increase equity financing and reduce spending on non-current assets.