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[ACCT1511] Comprehensive Notes

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TABLE OF CONTENTS

Table of Contents ………………….……………………….………………….…………………………………….……….. 2

1. Assets .…………………………………………………….…………….…..…………………………….……………….…… 3

2. Liabilities ………………………………………………………………………………………………………….…….…… 10

3. Financial Statements ..…………………………………..……………………………..………….…………….…… 16

4. Cash Flow Statement and Analysis …..……….….………………………………………………………..…… 29

5. Revisiting Financial Statement Analysis & Accounting Policy Choice ..………………………… 35

6. Management Accounting …….………………………………………………………………………………….….. 41

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1. ASSETS 1.1 ASSET DEFINITION

Three essential characteristics:

1. Future economic benefit 2. Controlled by the entity 3. Result of past events

Two recognition criteria:

1. It is probable that any future economic benefit associated with the item will flow to the entity; and 2. The item has a cost or value that can be measured with reliability

1.2 CAPITALIZE VS. EXPENSE

We can account for the costs in two different ways:

1. Capitalize the cost and record it as an asset 2. Not capitalize the cost and record it as an expense

The first scenario is beneficial due to the matching principle which matches expenses used to generate revenue to the same period when that revenue is recognized

Notes: - Cost of an asset includes all of the costs involved in implementing the asset for use - Repairs/maintenance are expensed - Improvements are capitalized

1.3 CURRENT VS. NON-CURRENT ASSETS

An asset is considered current when they satisfy any of the following:

- It is expected to be realized, or is intended for sale or consumption in the entity’s normal operating cycle

- It is held primarily for the purpose of being traded à Inventory - It is expected to be realized within twelve months after the reporting date; or - It is cash or cash equivalent

All other assets are classified as non-current

Asset: An asset is a resource controlled by the entity as a result of a past event from which future economic benefits are expected to flow to the entity

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THE VALUE OF NON-CIRRENT ASSETS

1. Historical cost: what did we pay for the asset or how much did it cost to develop the asset 2. Current or Market Value (value in exchange) what could we get for the asset if we sold it how much

we would have to pay for the asset today) 3. Value in use (present value): what is the asset worth to the company 4. Liquidation value: what could we get for the asset if we have to sell it really fast 5. Pre-adjusted Historical Cost: the historical cost of the asset adjusted for inflation

1.4 PPE: COST MODEL VS. REVLUATION MODEL

COST MODEL

Three methods of depreciation:

1. Straight-line 2. Reducing balance 3. Units of production

REVALUATION MODEL

A revaluation can either be:

1. An increment: increasing the value at which the asset is recorded 2. An Decrement: decreasing the value at which the asset is recorded

Note: whole classes of assets must be revalued, not individual ones e.g. if Building A was to be revalued, building B, C D… must also be revalued

Initial Increment Increment reversing previous decrement Dr Asset Dr Asset CR Revaluation Reserve Dr Gain on Revaluation Cr Revaluation Reserve

Cost Model: after recognition as an asset, an item of property, plant and equipment (PPE) shall be carried at its costs less accumulated depreciation and accumulated impairment

Revaluation Model: after recognition as an asset, an item pf property plant and equipment whose fair value can be measured reliably shall be carried at a revalued amount, being its fair value at the date of

revaluation less any subsequent accumulated depreciation and accumulated impairment

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Initial Increment Decrement reversing previous increment DR Loss on Revaluation DR Revaluation Reserve CR Asset DR Loss on Revaluation CR Asset

1.5 INTANGIBLE ASSETS

Must meet the essential characteristics of an asset and in addition, must be identifiable. The identifiable criterion:

1. It is separable that is, capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, asset or liability

2. Arises from a contractual or other legal right, regardless of whether those rights are transferable or separable form the entity or from other rights or obligations

Typical intangible assets include:

- Patents - Licenses - Copyrights - Franchises - Trademarks

Elements of costs

- It’s purchase price, including import duties and non-refundable purchases taxes after deducting trade discounts and rebates

- Any directly attributable costs of preparing the asset for intended use - For internally generated intangibles the cost is the sum of expenditure incurred from the date when

the asset first meets the recognition criterial

ACQUISITON VS. INTERNALLY GENERATED

Accounting for intangible assets when there is a separate acquisition is simple:

Dr Intangible Asset CR Cash/Accounts Payable

Accounting for internally generated intangibles/R&D is harder because it is difficult to assess whether an internally generated intangible asset qualifies for recognition because of two problems:

1. Determining whether there is an identifiable asset that will generate expected future benefits 2. Determining the cost of the asset reliably

To assess whether an internally generated asset meets the criteria for recognition, an entity classifies the generation of the asset into:

Intangible Assets: is an identifiable non-monetary asset without physical substance

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a) A research phase à expenditure is expensed DR Research Expense CR Cash

b) A development phase à expenditure is capitalized DR Asset CR Cash

Note: in considering the cost or revaluation method, as the ‘fair value’ of the intangible asset is difficult to determine, the cost method is often used instead.

In order for the development phase to be recognized, the following must all be shown:

- The technical feasibility of completing the intangible asset so that it will be available for use/sale - The intention to complete the asset and use or sell it - Its ability to use or sell the intangible asset - How the intangible asset will generate probable future economic benefits - The availability of adequate technical, financial or other resources to complete the development

and to use or sell the intangible asset - Its ability to measure reliably the expenditure attributable to the intangible asset during its

development

1.6 GOODWILL – A SPECIAL CASE OF INTANGIBLE ASSET

Goodwill is an accounting concept meaning the value of an entity over and above the value of its separate identifiable assets less liabilities:

- Because of synergies, reputation, loyalty of clients, staff knowledge etc. - So goodwill is the value of all things that is hard to measure, and not separately listed on the balance

sheet such as buildings, inventory and so on

Goodwill as of the acquisition date is measured as:

1. The consideration transferred (price paid) 2. Less the fair value of the net identifiable assets acquired and the liabilities assumed

When acquiring a company (X): DR Identifiable Assets DR Goodwill CR Liabilities CR Cash

Goodwill: is a non-current intangible asset, but it is not identifiable

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1.7 IMPAIRMENT

If there is an indication of impairment, we must test for impairment.

THE SOURCES OF IMPAIRMENT

External sources of impairment:

1. An asset market value has declined significantly 2. Changes with adverse effect in the technological, market, economic or legal environment

Internal sources of impairment

1. Obsolescence or physical damage of an asset 2. Changes making an asset idle, plans to discontinue or restructure operations to which asset belong,

plans to dispose of assets before previously expected date 3. Internal reporting indicates the economic performance of an asset will be worse than expected

THE TEST FOR IMPAIRMENT

In order to test for impairment, the following steps must be followed

1. Obtain the carrying value of the asset 2. Find the recoverable amount, which is the higher of:

§ Fair value less cost to sell § Value in use

3. Compare the asset’s carrying amount to the asset’s recoverable amount § Carrying amount < Recoverable amount asset is not impairment § Carrying amount > Recoverable amount asset is impairmed

ACCOUNTING FOR IMPAIRMENT

Impairment Under the cost method: Reversal of an Impairment under the cost method: DR Loss on impairment DR Accumulated Impairment CR Accumulated impairment CR Gain on Reversal of Impairment

Or

Impairment Under the revaluation method Reversal of impairment under the revaluation method: (Impairment is treated as a decrement) DR Loss on revaluation DR Asset CR Revaluation Reserve CR Asset CR Revaluation Reserve

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1.8 INVENTORY

Inventory are assets:

- Held for sale in the ordinary course of business - In the process of production for such sale, or - In the form of materials or supplies to be consumed in the production process or in rendering of

services

Inventory types:

- Raw materials - Work in progress - Finished goods inventory - Merchandise inventory

Costs of inventory:

- Cost of purchase - Cost of conversion - Cost of manufacture - Other costs in bringing the inventory to their present location and condition

COST OF GOODS SOLD (COGS)

Opening Inventory Purchases/Cost of Goods manufactured (Ending Inventory) Cost of goods Sold

Methods of calculating inventory/cogs:

- FIFO - LIFO - Weighted average

Note: inventory must be measured at the lower of cost or net realizable value method

1.9 ACCOUNTS RECIEVABLE & DOUBTFUL DEBTS

Allowance for doubtful debts is usually estimated based on past experience, e.g. xx% of all credit sales

Estimating bad debts DR Bad debt expense CR Allowance for doubtful debt

Writing off: DR Allowance for doubtful Debt CR Accounts Receivable

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1.10 FURTHER THEORY ON ASSETS

RELEVANCE VS RELIABILITY

Market/current value à relevant Historical cost à reliable

PRUDENCE/CONSERVATISM

Conservatism à we are careful not to overstate assets and income, and careful not to understate liabilities and expenses

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2. LIABILITIES 2.1 LIABILITY DEFINITION

ESSENTIAL CHARACTERISTICS

The two essential characteristics of a liability are:

1. The existence of a present obligation arising from a past event 2. Potential to result in an outflow of economic benefits

An obligation is a duty or responsibility to act or perform in a certain way. An obligation can arise in two ways:

1. Legally enforceable obligation: as a consequence of a binding contract or statutory requirement 2. Constructive obligation: arising from normal business practice, custom and a desire to maintain good

business relations or act in an equitable manner

It is also important to distinguish present and future obligations as the mere intention of entering a contract does not result in a liability.

RECOGNITION CRITERIA

The two recognition criteria of a liability are:

1. It is probable that any future economic benefit associated with the item will flow from the entity 2. The item has a cost or value that can be accurately measured

2.2 CURRENT VS. NONCURRENT ASSETS

A liability shall be classified as current when it satisfies any of the following:

- It is expected to be settled in the entity’s normal operating cycle - It is due to be settled within twelve months after the reporting date

CURRENT LIABILITIES

1. Accruals: for goods/services received or supplied but have not yet been paid - Accounts payable - Accrued expenses - Unearned revenue

2. Interest bearing liabilities: Notes payable, bank loans and credit facilities

Liability: a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits

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- Supported by formal debt instrument to pay specified amounts at specified time 3. Current tax liabilities 4. Dividends payable

- Goods are usually purchased on credit - Payment is made within short period of time - Accounts Payable = Payables

Inventory purchased on credit Credit account paid DR Inventory DR Accounts Payable CR Accounts Payable CR Cash

Accruing wages DR Wages expense CR Wages payable

Motor vehicle bought using interest bearing note Note paid DR Motor Vehicles DR Notes Payable CR Notes Payable DR Interest expense CR Cash

NON-CURRENT LIABILITIES

1. Specific financing situations: - Borrowings such as direct borrowing from banks - Bonds(debentures) such as selling debt on the open market

2. Ordinary business operations - Superannuation obligations - Deferred income tax obligations - Long service leave

Accounting for borrowings:

Accounts payables: are the amounts owed to suppliers of goods and services to the company, such as inventory, electricity, phone services etc.

Accruals: are obligations to pay for goods and services that have been received or supplied but have not been invoiced or formally agreed on, such as wages, interest and cash deposits from customers

Interest bearing loans: are obligations to pay an amount in the future but have an interest-bearing characteristic. This interest bearing characteristic distinguishes these obligations from accounts payable

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Initial borrowing: Yr. 1 Interest accrual DR Cash DR Interest expense CR Borrowings CR Interest Payable

Yr. 2 Interest accrual + payment of borrowing + payment of accrued interest DR Interest expense CR Interest payable DR Borrowings CR Cash DR Interest Payable CR Cash

2.3 ACCOUNTING FOR BONDS

A bond is a promise to pay fixed amounts in the future in exchange for receiving something today

Promises – that is, bonds – can be bought and sold.

- The buyer of a bond is a lender; and - The seller of the bond is the borrower

Why issue bonds?

- Direct borrowing from a bank can be more restrictive and expensive than selling debt on the open market through a bond issue

- Access to more lenders than just banks - Access to more risk friendly lenders - Possibly less collateral needed to be put up in comparison to bank loans

Terminology:

- Face value: the amount to be repaid by the seller at the maturity date Note: face value is NOT necessarily the amount the bond is issued for (see below)

- Maturity date: the date where the borrower must pay the face value of the bond - Coupon rate: the percentage applied to the instrument’s face value to determine periodic payment

of interest

Bonds are issued at either:

- Face value - Below face value (discount) - Above face value (premium)

Bonds: are issued by companies and is a promise to pay interest, usually a fixed amount at set intervals, and to pay the bondholder a specified amount on a specified date in the future

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The purpose of issuing at a discount or premium is to adjust for the difference between the coupon rate and the market rate

BONDS ISSUED AT FACE VALUE

Company issues 1,000 bonds, $100 bonds with the principal to be repaid at maturity in 2 years. The coupon rate is 7$ per annum and paid annually

On issue date: Recognizing the issuance of the bond DR Cash 100,000 CR Bonds Payable 100,000

End of first year: Recognizing the coupon payment DR Interest Expense 7,000 CR Cash 7,000

End of second year: Repayment of principal and the coupon payment: DR Interest Expense 7,000 DR Borrowings 100,000 CR Cash 107,000

BONDS ISSUED AT DISCOUNTS & PREMIUMS

Bonds payable are listed on the balance sheet (under liabilities) at its face value, and the difference between the cash received and the face value of the bond is recognized in a contra-liability account.

Bond issued at a discount:

DR Cash 96,500 DR Bond Discount 3,500 CR Bonds Payable 100,000

Bonds issued at a premium:

DR Cash 103,800 CR Bond Premium 3,800 CR Bonds Payable 100,000

- Bonds Discount will have a debit balance and therefore reduce the carrying amount of the bond payable

- Bonds Premium will have a credit balance therefore increasing the carrying amount of the bond payable

AMORTISATION OF BOND DISCOUNTS

Bond premiums happens when the effective interest rate is lower than the coupon rate

a) It makes interest expense lower than coupon payments i) Yearly interest = o/b of the carrying amount * market interest rate

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ii) Yearly coupon payment = face value of bond * coupon rate iii) Difference is the yearly amortization of the bond premium

b) Over the life of the bond: total interest expense is the total coupon payments less bond premium

Bond discounts happens when the effective interest rate is higher than the coupon rate

c) It makes interest expense lower than coupon payments iv) Yearly interest = o/b of the carrying amount * market interest rate v) Yearly coupon payment = face value of bond * coupon rate vi) Difference is the yearly amortization of the bond premium

d) Over the life of the bond: total interest expense is the total coupon payments less bond premium

2.4 PROVISIONS & CONTINGENT LIABILITIES

PROVISIONS

Provisions are estimates due to uncertainty in:

§ Timing and/or § Amount

Examples:

- Warranties - Employee benefits (e.g. annual leave, long service leave, sick leave, rostered days, retirement

benefits etc.)

Notes on provisions:

- They can be current or non-current, - May arise from either a legal or constructive obligation. - Are reported separately from payables and accruals on the balance sheet

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Accounting for provisions:

Creating a provision Settlement of a provision DR […] Expense DR Provision for […] CR Provision for […] CR Cash

CONTINGENT LIABILITIES

Two types of contingent liabilities:

1. Possible obligation: that arises from a past event whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity; or

2. A present obligation: that arises from past events but is not recognized because a. It is not probable that an outflow of resources embodying economic benefits will be required to

settle the obligation; or b. The amount of the obligation cannot be measured with sufficient reliability

2.5 FURTHER THEORY ON LIABILITIES

FINANCING OPTIONS

Both liabilities and equity details how our assets have been funded

Assets = Liabilities + Equity

- Liabilities: that come out of legal or constructive obligation (e.g. borrowings, bonds, unsecured notes, leases); or

- Equity: e.g. ordinary shares, preference shares etc. - Hybrid instruments: financing forms that exhibit both debt and equity characteristics e.g. convertible

notes and convertible preference shares

CLASSIFICATION

- The key feature of debt is that the issuer is obliged to deliver either cash or another financial asset to the holder. The contractual obligation may arise from a requirement to repay principal or interest or dividends. Such a contractual obligation may be established explicitly or indirectly but through the terms of the agreement. For example, a bond that requires the issuer to make interest payments and redeem the bond for cash is classified as debt.

- Equity is any contract that evidences a residual interest in the entity’s assets after deducting all of its liabilities. For instance, ordinary shares, where all the payments are at the discretion of the issuer, are classified as equity of the issuer.

- The critical feature that distinguishes a liability from an equity instrument is the fact that the issuer does not have an unconditional right to avoid delivering cash or another financial asset to settle a contractual obligation. But there are other considerations as well.