Financial Decision Making Module 8

Module Objectives and Overview

The primary objectives of Module 8, "Understanding the Conceptual Framework," are as follows: - To understand the differences between cash vs accrual accounting. - To describe the specific characteristics of business transactions. - To differentiate between a business transaction, a personal transaction, and a business event. - To understand, analyse, and apply the definition and recognition criteria provided by the conceptual framework for the five elements: assets, liabilities, equity, income, and expenses. - To explain the accounting equation process within the double-entry system of recording. - To describe the rules for Debits and Credits.
Related Reference Data from Slide 1: - Financial Decision Making, Module 8: A.L.O.R.E, Chapter 08. - Prepared by Wahseem Soobratty. - Faculty of Business and Law, Curtin University. - CRICOS Provider Code: $00301J$ . - Site Average: $75.87$ \%. - Key Dates: $2007-08-01$ , $2007-10-01$ , $2007-12$ .

The Conceptual Framework (CF 2019)

Purpose and Scope: - The purpose is to provide a coherent set of principles issued by the Australian Accounting Standards Board (AASB). - It assists with standard consistency. - It assists preparers in dealing with issues not addressed by a specific standard. - It assists auditors in forming an opinion on compliance. - It assists users in interpreting financial statements. - The Conceptual Framework addresses concepts underlying the preparation and presentation of financial statements.
Relationship with Standards: - Nothing in the Conceptual Framework overrides any specific accounting standard.
Issues Addressed by the CF: 1. The objective of financial reporting. 2. The qualitative characteristics of useful financial information. 3. The elements of financial statements and their definitions. 4. The recognition of the elements of financial statements. 5. The measurement of the elements of financial statements. 6. Concepts of capital and capital maintenance.

Objective of Financial Reporting

General Objective: To provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity.
The Communication Process: - Company's activities $\rightarrow$ Financial Reporting $\rightarrow$ User perception.
IAS 1 Specifics: Further specifies information regarding: - Financial position. - Financial performance. - Cash flows.

Underlying Accounting Assumptions

Accrual Basis (CF 2019, para 1.17): - Effects of transactions are recognised in accounting records when they occur, not when cash is received or paid.
Going Concern Principle (CF 2019, para 3.9): - It is assumed that the entity will continue to operate into the future, unless there is evidence to the contrary.

Methods of Accounting: Cash vs. Accrual

1. Cash Accounting: - A system concerned only with cash inflows and outflows. - Recognises revenue when it is RECEIVED. - Recognises expenses when they are PAID.
2. Accrual Accounting: - A method which matches revenues for a given period with the expenses incurred in earning those revenues. - Recognises revenues when they are EARNT. - Recognises expenses when they are INCURRED. - Enables the preparation of the Balance Sheet (Statement of Financial Position) and the Income Statement. - Predominantly used by businesses worldwide, with the exception of some sole trader businesses.

Qualitative Characteristics and Fair Presentation

True and Fair View / Fair Presentation: - The Conceptual Framework does not directly deal with the concept of a "true and fair view" or "presenting fairly." - However, the application of qualitative characteristics and appropriate accounting standards normally results in financial statements that give a true and fair view of the entity's financial position, performance, and cash flows.

Classifications of Transactions and Events

Business Transactions: - Occurrences that affect assets, liabilities, and equity items. - Recording criteria: Must be reliably measured in monetary terms and must occur at arm's length. - Entity Concept: Every entity must keep records of its business transactions separate from personal transactions of owners.
Personal Transactions: - Transactions of owners, partners, or shareholders that are unrelated to the operations of the business.
Business Events: - Occurrences that will probably affect the entity but are not recorded as transactions until an exchange of goods occurs between the entity and an outside entity.

Defining the Elements of Financial Statements

Assets (CF 2019, para 4.3): - Verbatim: "A present economic resource controlled by the entity as a result of past events." - Economic Resource defined: "A right that has the potential to produce economic benefits." - Three essential characteristics: 1. A right that has the potential to produce economic benefits. 2. Entity must have control over the economic resource. 3. There must be a past event.
Liabilities (CF 2019, para 4.26): - Verbatim: "A present obligation of the entity to transfer an economic resource as a result of past events." - Three essential characteristics: 1. A present obligation. 2. Results in the transfer of an economic resource. 3. Must have resulted from a past transaction or event.
Equity (CF 2019, para 4.63): - Verbatim: "The residual interest in the assets of the entity after deducting all its liabilities." - Equation: $Equity = Assets - Liabilities$ . - Increases as a result of profitable operations; influenced by measurement systems and capital maintenance concepts.
Income (CF 2019, para 4.68): - Verbatim: "Increases in assets, or decreases in liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims." - Revenue: Income arising from ordinary activities of the entity. - Gains: Income arising from non-ordinary activities. - Characteristics: Increase in assets/decrease in liabilities; results in increase in equity; not from owner contributions.
Expenses (CF 2019, para 4.69): - Verbatim: "Decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims." - Characteristics: Increase in liabilities/decrease in assets; results in decrease in equity; not from distributions to owners.

Detailed Asset Accounts

Cash: Amount available in bank accounts, shop till, or safe. Includes cheques (cash equivalents).
Accounts Receivable: Amounts owed by customers after credit sales.
Inventory: Goods/stock held by a retail store for sale at a profit.
Land: Land controlled by the entity; not subject to depreciation.
Vehicles: Motor vehicles controlled by the entity; recorded in separate or collective accounts.
GST Outlays: GST paid by the entity on purchases; represents a refund due from the tax office (future benefit).
Prepaid Expenses: Expenses paid in advance (e.g., paying July's rent in May). Service use triggers expense recognition.
Accumulated Depreciation: A contra-asset account representing the total depreciation recorded against a non-current asset. It reduces the asset's carrying amount.

Detailed Liability Accounts

Accounts Payable: Amount owed to suppliers for credit purchases.
Loan Payable: Amount owed to a bank (principal); distinct from interest payable.
Rent Payable: Amount owed to a landlord for premises use.
Utilities Payable: Amounts owed for Water, Power, Gas, etc., for services already provided.
Wages Payable: Unpaid wages still owed to employees.
GST Collections: GST collected from sales; represents an obligation to be paid to the tax office.
Unearned Revenue: Money received from customers for goods/services not yet provided. Revenue is only recognised upon provision.

Detailed Owner's Equity Accounts

Note: In partnerships, each partner has individual capital, retained profits, and drawings accounts.
Capital: Value of assets (money or otherwise) contributed to the entity by the owner.
Retained Profits: Profits not yet withdrawn that the owner is entitled to.
Drawings: A contra-equity account representing the value of assets removed from the entity by the owner.

Detailed Revenue and Expense Accounts

Revenue Accounts: - Sales Revenue: Money earned through provision of goods. - Sales Returns and Allowances: A contra-revenue account representing refunds or debt reductions (credit notes) for returned items, exclusive of GST. - Fees Revenue: Money earned through services. - Discount Received: Discounts from suppliers for paying accounts. Value = total discount $\times \frac{10}{11}$ . - Rent Revenue: Money earned from renting out properties owned by the business.
Expense Accounts: - Cost of Sales: Cost of inventory sold; deducted in the revenue section of the Income Statement. - Depreciation Expense: Amount of a non-current asset's finite productive capacity used during the period. - Discount Allowed: Discounts granted to customers for payment. Value = total discount $\times \frac{10}{11}$ . - Wages Expense: Cost of employee wages incurred during the period. - Advertising Expense: Cost of posters, radio ads, TV ads, etc. - Rent Expense: Cost incurred for renting premises. - Telephone Expense: Cost of telephone usage incurred.

Recognition Criteria (CF 2019, para 5.7)

Definition: Recognition means incorporating an item in the financial statements through a journal entry.
Two Core Criteria: 1. Recognition provides users with relevant information. 2. Recognition provides users with a faithful representation.
Relevance: Capability to make a difference in decisions. Recognition may be skipped if asset/liability existence is uncertain or inflow/outflow probability is low.
Faithful Representation: Must be complete, neutral, and free from error. Recognition may be skipped if the level of uncertainty in measurement is excessively high.
Simultaneous Recognition: - Income recognition occurs with initial asset recognition or liability derecognition. - Expense recognition occurs with initial liability recognition or asset derecognition.

The Accounting Equation and Cycle

The Basic Model: $A = L + OE$ - Assets ( $A$ ) = Liabilities ( $L$ ) + Owners Equity ( $OE$ ). - Must remain in balance at all times.
Profit Formula: $Profit = Revenue - Expenses$
Owner's Equity Dynamics: - Increased by income, profit, and capital contributions. - Decreased by expenses, losses, and withdrawals (drawings).
The Accounting Cycle Steps: 1. General Journal 2. General Ledger 3. Adjusting Entries 4. Financial Statements 5. Closing Entries

Debit and Credit Rules (A.L.O.R.E.)

The nature of the account determines how to record increases and decreases:
Debit Nature Accounts (Assets and Expenses): - To Increase: Debit (Dr) the item. - To Decrease: Credit (Cr) the item.
Credit Nature Accounts (Liabilities, Owner's Equity, and Revenue): - To Increase: Credit (Cr) the item. - To Decrease: Debit (Dr) the item.