Unit 3 AOS 1
Purpose of accounting
Includes both financial information (information that can be sourced from financial reports) and non-financial information (information that cannot be sourced from financial reports)
Must also consult ethical considerations being the social and environmental impacts of financial decisions
Accounting assumptions and qualitative characteristics
Assumptions
Characteristics
Accounting entity - states that the financial records of the business are to kept seperate from that of the owner and other entities
Going concern - states that the business is assumed to continue operations into the future and thus its reports should be kept on that basis
Accrual basis - states that revenues are recognised when earned and expenses when incurred to allow for accurate profit calculations for the period
Period - reports are to be prepared for a particular period of time in order to be able to compare results between periods and allow for the calculation of profit
Relevance - all financial information capable of influencing business decision making should be included in reports
Faithful representation - financial information should accurately reflect the real world economic event it represents free of bias and error
Verifiability - all financial information should be supported by evidence, such as source documents, to ensure accuracy of reports
Comparability - financial information should be able to be easily compared to that of other reporting periods of the business or other entities
Timeliness - financial information should be available to decision makers while it is still capable of influencing their decisions
Understandability - financial information should be understandable to users with reasonable knowledge of business activities
Accounting elements
Assets
A present economic resource controlled by an entity, as a result of past events, that has potential to produce future economic benefit
Current - reasonably expected to the be converted to cash, sold or consumed by the entity within the next 12 months
Non-current - are expected to be used by the entity for a period exceeding 12 months
Liabilities
A present obligation of an entity, as a result of past events, to transfer an economic resource
Current - reasonably expected to be settled within the next 12 months
Non-current - not required to be styled within the next 12 months
Owners equity
The residual value of the assets of an entity after deducting all its liabilities
Revenues
Transactions that increase assets, or decrease liabilities, that result in an increase in owners equity other than those relation to contributions by the owner
Expenses
Transactions that decrease assets, or increase liabilities, that result in a decrease in owner's equity, other than those relating to distributions to the owner
Ledger accounts
An accounting record showing all the transactions that affect a particular item in the balance sheet
Increase on the debit - assets and expenses
Increase on the credit - liabilities, owner's equity, revenues
Specific transactions: drawings - negative OE account (increases on the credit)
Specific transactions: GST - asset or liability depending on balance
Footing ledger accounts - informal process of calculating the balance of an account and can be done at any time in the period
- Add up totals of both sides
- larger side - smaller side
- Pencil on the larger side and circle
Trial balance - list of all accounts in the general ledger and their balances to determine if debits = credits
Errors it will reveal = two entries on the same side, only one side has been recorded, differing amounts on both sides
Errors it won't reveal = transaction has been omitted, debit and credits are reversed, incorrect amount on both sides
Balancing - ruling off an A,L or OE account to determine its balance at the end of the current reporting period, transferring that balance to the next period
- Total both sides
- Write the larger total at the bottom of both sides
- Larger - smaller side
- Write this balance at the bottom of the smaller side and as the balance at the beginning of the next period on the larger side
Cash transactions
Cash sales can be evidenced by an EFT receipt, credit card receipt, bank statement
Cash payments can be evidenced by cheque butts, EFT receipts, ATM documents, bank statement
All cash sales must also be verified by a tax invoice which must have the following characteristics - 'tax invoice' stated clearly, name and ABN of the seller, date, description of the g/s, price and GST
GST
GST liability
GST collected is owed to the ATO
Creates a GST liability as selling prices are higher than cost prices meaning GST on sales is larger than that of purchases
Will be settled in a GST settlement
Balances on the credit side
GST asset
GST paid to suppliers reduces the GST liability
Technically being paid directly to ATO through supplier
Could be due to a larger order of inventory not yet sold to purchase of an expensive NCA
Balances on the debit side
General journal
Records each transaction before it is recorded in the general ledger
Allows for the identification of source documents and details of the transaction
Narrations include a brief description of the transactions and a reference to the source document (upholds verifiability)
Accounts payable
AAs and QCs links
Going concern - when a business records a credit purchase, this amount still needs to be recorded as a liability as we assume the life of the business is continuous and thus it will still be operating when it is due
Accrual basis - credit transactions are recorded when goods are exchanged not when cash is received or paid for the goods
Relevance - by recognising credit purchases at the time of the goods being exchanged ensures all information and profit is accurate for decision making
Ethical considerations
Striking a balance between quality and price
Businesses have a legal/ethical obligation to provide goods that are safe and socially responsible
Must be transparent about goods being sold
Payments to accounts payable
Verified by cheque butts and EFTs
No GST to account for when the payment is made as it was already recognised at the point of the goods being exchanged
Purchase returns
A return to a supplier for inventory purchases on credit
Reasons for returns - faulty, wrong size, too many were purchased
Evidenced by a credit note which is issued by the account payable when the goods are returned
Discount revenue
Revenue in the form of a decrease in liabilities and an increase in owner's equity earned when an account payable is paid within discount terms
Includes GST
Discount revenue = discount rate x amount owing
Advantages - less cash is paid to accounts payable and thus more is retained to make other payments, net profit is increased
Disadvantages - cash is paid faster and this there is less time to generate cash from selling inventory, cash is unavailable in the short term to make other payments
Returning inventory that was delivered in a good condition and only damaged by the business could jeopardise relationships with suppliers
Consistently paying suppliers late could jeopardise relationships
APTO
Average AP/net credit purchases including GST x 365 = average number of days taken to pay APs
Strategies to manage - paying within credit terms or paying early to earn discount revenue, checking each statement of account against the accounts payable ledger for errors, developing a strong relationship with suppliers
Statement of account - a summary of the transactions a business has had with a particular account payable, can be compared to the account payable ledger for errors
Accounts receivable
Ethical considerations
Must consider the nature of the goods (safety, quality, environmentally friendly, socially responsible)
Consider the customer's capacity to pay debt
Receipts from accounts receivable
Verified by a bank statement, EFT, ATM statement, receipt
No GST to account for when cash is collected as it was already recognised at the point of sales
Sales returns
When inventory is returned by a customer
Verified by a credit note which is issued by the business
Reasons - faulty, wrong size/colour, change of mind, too many were purchased
Discount expense
Expense in the form of a decrease in assets and owners equity incurred in return for an early payment by accounts receivable
Includes GST
Discount expense = discount rate x amount owing
ARTO
Advantages - cash is received faster from accounts receivable making this cash available for other uses, sales may increase as customers may be more willing to buy from a business that offers discounts
Disadvantages - less cash is received from accounts receivable, net profit is decreased
Average AR/net credit sales including GST x 365 = average days taken to collect cash from ARs
Strategies to manage - offer discounts for early settlements, send reminder notes, conduct credit checks
Other transactions
Memos
Verifies transactions which do not relate to the sale, purchase or return of inventory of the movement of cash
Evidences non-cash contributions and drawings, establishment of a double entry system, correction of errors, use of inventory for advertising purposes, losses and gains, write downs, BDAs
Non-cash contributions
Must be valued at fair value (price that would be received if the asset was sold at the time it was acquired by the business)
AAs and QCs of fair value
May oppose faithful representation and verifiability as fair value is an estimate however owner would have likely referenced current market valuations to ensure accuracy of valuation
Recording asset at original purchase price would undermine relevance by overstating its value, it would also overstate the benefit of the asset as it has already been partly consumed by the owner
Establishing a double-entry system
A commencing entry is a general journal entry to establish double entry records by entering existing asset, liability and owner's equity balances in the general ledger accounts
Narration - commencement of double entry system
Correcting entries
A general journal entry to correct an error in the way a transaction is recorded in the general ledger/journal
Narration - correcting entry as... was incorrectly recorded as...
Other source documents
Order form - document issued by a business requesting the supply of goods
Order confirmation - document issued by the supplier confirming the receipt of the order
Shipping confirmation - document issued by the supplier confirming that inventory has been dispatched and is being shipped
Delivery docket - document issued by the supplier to accompany a delivery listing the type and quantity of all items delivered
Recording inventory
Inventory cards
Records each individual transaction involving the movement of a particular line of inventory in and out of the business
Show cost prices excluding inventory
Valuing methods - FIFO and identified cost, regardless of which is chosen comparability requires that the method is consistent from one period to another
Identified cost method
A method of valuing inventory by physically marking each item in some way so that its individual cost price can be identified at the point of sale
Benefits - accurate and neutral providing faithful representation of the value of inventory
Costs - it is not always possible or practical to mark every individual item of inventory as this can be costly and time wasting
First in First out method
A method of valuing inventory that assumes that the first items purchased are the first sold and therefore inventory sold is valued using the earliest cost price on hand
Sales returns - last items sold are the first to be returned
Inventory gains - valued by the most recent in transactions as the most recent cost prices reflect what the business would be charged if it was to purchase those items at the time of the count and thus are a faithful representation
Benefits - no time, effort or staff are wasted by labelling inventory, can be applied to all types of inventory
Costs - there is no way of knowing whether the cost price allocated at the point of sale is the same as that at the time of purchase
IC vs FIFO
Both methods result in the same number of units sold and left on hand
FIFO means that when cost prices are rising the older and thus cheaper items are assumed to be sold first, reducing costs of sales and increasing net profit in comparison to IC
FIFO assumes that newer, more expensive units remain on hand leading to a higher valuation of inventory on hand and assets in comparison to IC
Inventory cost
AAs and QCs
Should be valued by its original purchase price as this is verifiable and provides a faithful representation of its value
Under going concern the business is not intending to liquidate all its inventory so it does not need to be valued at what it would realise if sold today
Costs of inventory
Product costs
A cost incurred in order to bring inventory into a condition and location ready for sale that can be allocated to individual units of inventory on a logical basis
Recorded as an increase in the unit cost of inventory in the cards and in the entry for inventory purchase
Directly traceable to a line of inventory
Upholds faithful representation as it provides a more accurate reflection of the value of inventory
Period costs
A cost incurred in order to bring inventory into a condition and location ready for sale that cannot be allocated to individual units of inventory on a logical basis
Affect more than one line of inventory
Treated as a cost incurred in the whole period and is recorded in its own ledger account
Recognised as being incurred only in the period in which inventory is sold, when sold it is a costs of sales and when unsold it remains as a current asset
Recognised as being incurred in the period in which inventory is purchased under costs of goods sold
Period vs product costing
Period recognises the entire cost as an expense in the period when inventory is purchased whereas product costs are only incurred in the period is which the inventory is sold
Unless all inventory is sold, period costing wl lead to a higher COGS and thus a lower net profit and owners equity and assets balance
Cost vs NRV
NRV is the estimated selling price of inventory less an costs involved in its selling, marketing and distribution
Cost < NRV = inventory is expected to be sold for a profit, cost price is still a faithful representation of the value of inventory, cost price is used
Cost > NRV = inventory is not expected to be sold for a profit, cost priced no longer provides a faithful representation of the value of inventory, NRV is used
NRV = estimated selling price - directing selling expenses (NO GST included on either)
Inventory write-down - if the NRV is the lower value then inventory must be written down, cost - NRV, narration - write down of... to NRV due to ..., reported under adjusted gross profit
ITO
Average inventory/COGS x 365 = average days taken to convert inventory into sales
Fast turnover - more cash on hand to meet short term debts and increased sales however selling price is possibly too low or business may be holding too little inventory
Slow turnover - consider nature of goods but is a negative impact on cash flow and profitability and liquidity and makes inventory susceptible to write downs and losses which reduces net profit
Managing ITO - promote sale of complementary goods, rotate inventory, appoint inventory manager, consider inventory mix