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CERTIFICATE IV IN RESIDENTIAL CONSTRUCTION

Course No. 19734

BSBSMB406AManage Small Business FinancesTAFE NSW Riverina Institute, Wagga Wagga Campus

Prepared by

Peter Klimpsch

Produced by

Resource Centre, TAFE NSW Riverina Institute, Wagga Wagga Campus.

© TAFE NSW Riverina Institute 2007. Information contained in this training manual remains the property of TAFE NSW Riverina Institute and cannot be reproduced or used for other purposes without prior written permission.

TABLE OF CONTENTS

Record Keeping .....................................................................................1

Plant & Equipment................................................................................43

Taxation................................................................................................59

Wages & Employment..........................................................................93

Business Finance................................................................................111

Business Planning..............................................................................147

Cash Flow...........................................................................................175

Insurances..........................................................................................199

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RECORD

KEEPING

1

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RECORD KEEPING

A business needs instruments to control it, just as a driver of a motor car needs instruments. When driving around the city the minimum instrumentation would be a Speedo, fuel gauge and warning lights for oil, water and alternating current. Other instruments are available, but one can do without them. This is the same with a business, where the essential instruments are bookkeeping or accounting records.

Take the same car off the city roads and place it on a race track. The professional racing driver will need a tachometer and additional gauges for oil pressure, water and oil temperature for engine and gearbox, along with gauges containing current and charge details.

As a business grows, it will need more sophisticated records and you will move away from the practical hands-on approach into an office situation. As the nature and size of your business changes, so will the need for information upon which to base decisions. The records of a sub-contractor in the building industry will be different to those of a major building contractor. If you are a sub-contractor the very nature of your trade will determine the records you need to keep. Some trades, like plumbers and electricians, supply materials to every job, while others supply the materials that fix or attach to other construction work. Builders supplying materials will need to keep track of the items supplied, so that all expenditures can be recovered from the client.

This topic deals primarily with the recording and classifying of business transactions. We will see how ‘journals’ and ‘ledger’ accounts are used for this purpose.

Objectives

On completion of this unit you should be able to :

define basic bookkeeping terminology; list the documents used and describe the clerical functions applicable to a business in the

building industry; define the purpose and layout of the cash receipts journal; define the purpose and layout of the cash payments journal; define the purpose and layout of the sales journal; identify credit versus debit entries and record them accurately in the journals; transfer journal entries to ledger accounts; Prepare bank reconciliation.

The accounting framework

Keeping records (or bookkeeping) is the first step in accounting for the performance and financial position of any business. For our purposes, accounting may be defined as the process of recording, classifying and reporting, in monetary terms, the transactions of a business.

Let's take a closer look at what this definition means:

Recording : documenting and systematically recording transactions into journals, where information is grouped by transaction type (i.e. bookkeeping);

Classifying : posting the totals from the journals into the ledger, where information relating to individual ‘accounts’ is stored;


Laws, Adrian, 07/08/14,

Summary of the accounts such as purchases, wages,

Reporting : using the balances of ledger accounts to provide end-of-year financial statements (i.e. profit-and-loss statement and balance sheet)

This topic deals with the recording and classifying of transactions.

An accounting system may be described as an information system, since we input data about transactions during a period, and after some processing, the system produces summary information about the performance and financial position of the business.

Purpose of bookkeeping

It is important to recognise that bookkeeping forms the basis of any accounting system. Bookkeeping/accounting systems generally have two main purposes:

To keep complete and easily accessible records of all transactions and events, and

To provide timely accurate and relevant information about :

The financial position and the amount of the owner's capital at any point in time. the nature and amount of its assets and liabilities at any point in time; eg .amounts

owed by debtors and mounts owing to creditors the amount of income and expenditure (gains and losses) during any stated period,

and how these have arisen;

The financial reports produced by a bookkeeping/accounting system may be of interest to

owners, managers, investors, creditors, clients, the ATO (Australian Taxation Office) and other government authorities,

Australian tax legislation (S.262A ITAA) makes record keeping compulsory.

“... every person carrying on a business shall keep sufficient records, in the English language, of his/her income and expenditure to enable his/her assessable income and allowable deductions to be readily ascertained, and shall retain such records for a period of at least seven years after the completion of the transactions, acts or operations to which they relate ...”

Also, the N.S.W Companies Code imposes similar requirements upon limited liability companies, as well as the need for financial reports and audits.

While there may be several different users of accounting information, the main users should be the owners/managers of the business. Accounting information can assist managers in their tasks of:

Decision making (eg. decisions based on accurate information about the business)

Planning (eg. preparing budgets using historical information as a guide)

Co-ordination (eg. allocating resources to most profitable areas of business)

Control (eg. monitoring costs, debtors, cash flows etc.)


The Bookkeeping Flow

The bookkeeping process may be divided into several stages as indicated in

During the course of business, transactions (and events) occur, which must be documented and recorded so that their effect on the performance and position of the business can be analysed. For each transaction there will be a source document, which will act as evidence of the transaction. The document may have been produced by the business (eg. a copy of an invoice sent to a client) or by the other party to the transaction (eg. an invoice received from a supplier).

At the end of each day, week, or month, the various source documents are grouped and sorted in chronological order. They are then used as the basis for recording each transaction in an appropriate journal (book). A number of different journals are used, each one recording a different type of transaction. For example, all receipts of cash are entered into the cash receipts journal and all payments of cash are entered into the cash payments journal. This grouping of transactions (by transaction type) in the journal makes it easy to transfer or ‘post’ the information to the ledger at the end of each month. The ledger is usually in the form of a bound book or a collection of loose sheets in a binder, with each page or sheet used for a separate ‘account’. Each ledger account (a/c) contains information relating to a particular aspect of the business. For example, the Cash at Bank account is used to keep track of all transactions affecting the bank account of the business;The Sales account is used to keep track of all sales (cash and credit) made by the business; The Debtor’s Control account is used to keep track of all amounts owed to the business as a result of credit sales.

The ledger system allows financial reports to be prepared at any time, although the common reporting period for most businesses is monthly. At the end of each month the ledger accounts are ‘balanced’ (to determine the state of each account). All ledger accounts and their balances are listed in a trial balance. Revenue and expense accounts are then used to draw up a Profit and Loss Statement, while asset, liability and proprietorship accounts are used to produce a Balance Sheet.

The Bookkeeping flow

TRANSACTIONTransaction recorded on a voucher or document.

SOURCE DOCUMENTSInvoice, credit note, receipt, cheque, cash sales docket, petty cash voucher, purchase order.

JOURNALSSales, purchases, cash receipts, cash payments and general journal.

LEDGERSGeneral, accounts receivable, accounts payable, stock records, asset register, cost ledger.

TRIAL BALANCE AND RECONCILIATIONSWith a view to checking the accuracy of the ledgers. (Note that certain errors may not be located).


FINANCIAL REPORTS

Comprising the following: job cost reports, revenue (or profit and loss) statement, and balance sheet.

Ledger accounts

A ledger is a book of second, or classified, record. It is made up of entries posted from the journals, and thus it is the place where entries which originated in the various journals are summarised. Ledger accounts are at the heart of the accounting system since they contain the information about each aspect of the business. The listing of accounts which follows gives the more commonly used account names. Not all of them will be relevant for a business, and some others may be required. Also be aware that account names can differ between accounting systems. The general ledger is sectionalised into five basic account groupings:

A = assetsL = liabilitiesP =proprietorship = (owners equity)R =revenueE= expense

A for Assets

The assets of a business are the things the business owns. Assets can be classified as:

Current assets - these are assets that are acquired for the purpose of using them quickly and turning them into cash within twelve months.

Non-current assets - these are assets which have been bought for use in providing income and not for conversion into cash. Be careful not to include leased or hired assets as they are the property of the supplying firm.

Assets that a typical building business could have are:

Current assets

cash at bank, work in progress, cash on hand, loose tools, accounts receivable (debtors) shares, inventories of stock/materials, investments and accounts prepaid

Non-current assets

land and buildings, improvements, fixtures and fittings, plant and equipment office equipment and furniture, telecommunication equipment, computer equipment Goodwill and motor vehicle.

L for Liabilities

This is the grouping for money owed to outsiders (creditors). Liabilities are usually classified into:

Current liabilities - money due to be repaid within twelve months.

Non-current liabilities - money not due to be repaid within the next twelve months.


It is necessary to reclassify money owing when a debt moves from payable after twelve months to repayable within twelve months. For example, you take out a loan on the 1st July 2005 for $100,000 repayable on 30th April 2007, The loan would be classified as a non-current liability in the balance sheet as at 30 June 2006, and as a current liability in the balance sheet as at 30 June 2007, since the loan falls due within the next twelve months.

Current liabilities

accounts payable (creditors), expenses accrued (payable/deferred), bank overdraft group (PAYE) tax payable, payroll tax payable, sales tax payable Health fund contribution payable, provision for holiday and sick pay and provision for

income tax.

Non-current liabilities

mortgage, long-term loan, hire-purchase

P for Proprietorship (owners equity)

The owner’s claims on the assets of a business (or what a business owes its owner/s) are referred to as proprietorship. Proprietorship consists of the original investment, additional funds invested, plus profits, less losses and money withdrawn. Proprietorship accounts will vary depending on the type of business ownership:

Sole trader

capital; owner, profit and loss account, drawings (of cash or stock)

Partnership

Capital (one account for each partner) eg. Capital; Jim, Capital; Bob current year's profit or loss (one account for each partner), drawings (one account for each

partner) profit-and-loss appropriation (optional)

Companies

authorised capital, called-up capital, issued and paid-up capital, retained earnings Profit-and-loss appropriation and reserves.

R for Revenue

Revenue or income is where the business derives inflows either from normal trading or as a result of investment. The main source of trading income is from contracting, sales of manufactured goods, or fees from trade or professional services offered. If business is to make a profit and survive, the income must be sufficient to cover direct and indirect expenses. The income charged to clients by way of sales or contract fees must take into consideration the volume of work available, running expense recovery and competition.

Typical income accounts of builders are:

building contracts receipts, sundry income, contracting fees, bad debts recovered sub-contracting fees, gain on disposal of non-current assets, commission income discount received, sales of manufactured goods, dividend income, rent income interest received


E for Expenses

Expenses are of two types:

direct expenses - those expenses that can be assigned or identified as relating to a particular job;

Indirect expenses - those expenses that cannot be assigned or identified as relating to a particular job. Indirect expenses are fixed costs and are also known as builder's overhead. They include the operating costs of running a business from a head office and they continue for as long as you are open for business. These indirect expenses (builder's overhead) are usually expressed as a percentage of annual turnover. When tendering for building works this percentage is applied to the estimated cost of the project and added to it. Following is a list of typical direct and indirect expenses.

Direct expenses

purchases of stock/materials, equipment operating costs, freight inwards costs Security costs of the site, direct labour wages. consultants' fees, sub-contractors'

payments delivery expenses, stores supplied to the site, electricity to site, equipment hire cost inventory losses, holiday pay, plus loading, minor tools replacement, meal allowance superannuation for workers, protective clothing, sick leave costs, workers 'compensation

insurance, unrecoverable warranty cost

Indirect expenses / Overheads

accounting fees, advertising, bad debts, bank charges, commission expenses, water ratescomputer expenses, council rates, debt collection expenses, depreciation of plant and equipment general expenses for the office, industry association fees, insurance on builders' office, interest paid, leasing costs for company vehicles, legal expenses, licences and registration fees, light and power to the office, local government charges, and long service leave for staff, loss on disposal of non-current assets, motor vehicle expenses, office manager's salary, office supplies and sundry expenses, payroll tax, printing and stationery, recruitment and training, rent, repair and maintenance of vehicles, stamp duty, subscriptions and memberships, travel by staff.

All of the accounts listed above can be found in the general ledger. The general ledger could be contained in a bound book, on secured loose leaves, loose cards or on a computer. Whichever system is used, the same principles are applied.

The ledger system is based upon the use of T-accounts. A small business might have as few as twenty accounts, compared to a large corporation which could have thousands of accounts. An example of a ledger account (in columnar format) is shown below.


Ledger account in columnar format.

Account name A/c No__________

DATE DETAILS DEBIT CREDIT BALANCE

The details column contains the name of the other accounts which are affected by the relevant transactions.

The debit and credit columns (which for the “T” in the account) are used to record increases and decreases in the account’s balance. The rules for using these columns will be covered in the next section.

The balance column is used to keep a running balance of the account, which may be updated after each entry.

Alternatively, ledger accounts may be in the following format, in which the ‘T’ in the account is more obvious.

Ledger account in T - account format

Account Name A/c No _________

Date Details

$

Debit entry

Date Details

$

Credit entry

When using T-accounts, the balance can be found by adding each column and taking the smaller away from the larger.

Principles of double-entry bookkeeping

Double-entry is the term applied to the underlying principles of all present-day accounting systems. Its origin lies in the simple fact that every business transaction will affect (at least) two accounts in the general ledger.

Recall that there are five types or classes of accounts; Asset (A)Liability (L)Proprietorship(P)Revenue (R)Expense (E)

We treat the accounts on either side of the equation in exactly the opposite way. In this way the equality of the accounting equation is maintained.

Asset accounts normally have a debit balance. Expense accounts normally have a debit balance. Liability accounts normally have a credit balance. Proprietorship accounts normally have a credit balance. Income accounts normally have a credit balance.

Classify each of the following ledger accounts by indicating their account type, and give the normal balance of each account.


LEDGER ACCOUNT ACCOUNT TYPE

(A,L,P,R,E)

NORMAL BALANCE (DR/CR)

Sales R Cr

Rent E Dr

Cleaning E Dr

Telephone/Fax equipment E Dr

Electricity E Dr

Insurance E Dr

Motor vehicles A Dr

Motor vehicle expenses E Dr

Accounting cost E Dr

Bank costs E Dr

Creditors L Cr

Long-term loan L Cr

Advertising E Dr

Printing E Dr

Car lease L Cr

Plant and machinery A Dr

Travel E Dr

Wages E Dr

Inventory A Dr

E Dr

To account for increases and decreases in the balance of individual accounts we use the following system.


Diagram 3.4 Debit/Credit rules

ACCOUNTTYPE

NORMAL BALANCE

TO INCREASE BALANCE

TO DECREASE BALANCE

ASSET DR DR CREXPENSE DR DR CRLIABILITY CR CR DRPROPRIETORSHIP CR CR DRREVENUE CR CR DR

Lease is an expense. Hire purchase is a Liability. Proprietorship is always in credit (LIABILITY) on the company’s books because the company owes the money to the stakeholders.



The ones builders work with mostly


The ones builders work with mostly

To determine the effect of a transaction on the ledger you need to:

decide which two accounts are affected

decide whether each account is an A, L, P, R or E

know if the account is being increased or decreased

decide which account to debit and which account to credit(Use the above table for this)

Each transaction will affect two accounts (sometimes more) and the total of the debits will be equal to the total of the credits for any transaction. By consistently applying these rules of debit and credit, the equality of the accounting equation should always be maintained.

Recall that the terms ‘debit’ (DR) and ‘credit’ (CR) simply refer to the left and right hand sides of an account.

To debit an account means to place an amount on the left-hand side of the account.To credit an account means to place an amount on the right-hand side of the account.

For example, the Cash at Bank account is an asset account and therefore (based on the above rules):

the normal balance of the account is a debit balance, to record increases in the account, the amount involved is recorded in the DR column, that

is the left hand side to record decreases in the account, the amount involved is recorded in the CR column.

That is the right hand side

To illustrate the use of debits and credits, the following example shows how increases (eg. from cash sales) and decreases (eg. due to cash purchases) are recorded in the Cash at Bank ledger account.

Cash at Bank (A) A/c No _________

DATE DETAILS DEBIT CREDIT BALANCE

1 July 95 Opening Balance 5 000 DR2 Sales 2 000 7 000 DR3 Purchases 1 000 6 000 DR

The other two ledger accounts affected by the two transactions are shown below.

Sales (R) A/c No ________

2 July 05 Cash at Bank 2 000 2 000 CR

Purchases (E) A/c No ________

3 July 05 Cash at Bank 1 000 1 000 DR


The ledger accounts in the above example show that:

The Cash at Bank account has an opening balance of $5,000.

$2,000 came into the business’ bank account from cash sales (on July 2).

The amount of $2,000 is entered into both of the accounts affected;

As a DR in the Cash at bank account (A) (an asset account increasing)As a CR in the Sales account (R) (a revenue account increasing)

$1,000 was spent from the business’ bank account on purchases (on July 3).

Note again that the transaction affects two accounts.

A DR to the Purchases account (E) (an expense account increasing)A CR to the Cash at Bank account (A) (an asset account decreasing)

Note that the double entry principle is adhered to. Since for each transaction, every debit entry must have an equal and corresponding credit entry, it follows that the totals of the debit entries will equal the total of the credit entries. This is sometimes referred to as 'the golden rule' of accounting.

In our example : DEBIT CREDITTOTAL 3 000 3 000

Note: The above transactions would normally find their way into the ledger only after having first been entered into journals. Hence, the ledger is often known as the book of second entry. It is possible to enter all transactions directly into the ledger; however, the volume of transactions in most businesses usually makes this impractical.

To clarify some points of potential confusion regarding debits and credits:

The rules we use for debit and credit are simply the standard convention. There is no special reason for the way debits and credits are used. For example, the rules for debit and credit could be reversed and the whole process would still work; we would just end up with the numbers on the opposite side of the accounts.

If you have a positive balance in your bank account, your monthly bank statement will say that you have a credit balance. But this is a credit balance only from the banks point of view. You have effectively lent the bank money. The bank owes the money to you, which means that your account is a liability of the bank (and liabilities normally have a credit balance). However, from your point of view the account is obviously an asset which has a debit balance.

If a supplier says to you “we'll credit your account”, they refer to the debtor account with your name on it in their ledger. When they are paid by you, they must decrease the balance of this asset account, and so must credit the account. At the same time, the suppliers account in your ledger would be debited to reflect a decreasing liability.

As an alternative to the method outlined above, the following rules can be applied to determine which account to debit and which to credit for each transaction:


When dealing with real accounts (eg property, assets and cash):

- debit the receiving account- credit the giving account

When dealing with persons or firms:

- debit the receiver- credit the giver

When dealing with expenses and gains:

- Debit losses and expenses- Credit income and gains

When deciding which two accounts are affected by the transaction, you must consider the implications of each transaction in terms of how it will affect the business. For example, you should realise that:

All transactions involving cash will affect the cash at bank account. All transactions involving debtors will affect the debtors control account.

Revision

Using the table provided, for each of the following transactions;

name the ledger accounts affected, and for each account; state the type of account (A,L,P,R or E) state whether the account increases or decreases as a result of the transaction enter the appropriate amounts in the debit (DR) and credit (CR) columns

(a) You buy some plant and equipment from ABC Ltd. for $1400 on credit with payment within 30 days.

GENERAL LEDGERTRANS- ACTION

ACCOUNTS AFFECTED

A/C TYPE

(A,L,P,R,E)

OR DR CR

a) Plant and equipment

A 1 400

Creditors; ABC Ltd.

L 1 400

The general ledger

The general ledger will contain all the ledger accounts which are used to find the profitability and stability of the business at month’s or year’s end (by organising them into financial reports; i.e. Profit & Loss Statement and Balance Sheet). The general ledger also contains control accounts (eg. debtors control and creditor’s control) the individual components of which are contained in the subsidiary ledgers.


At the end of each accounting period, all amounts are ‘posted’ from the various journals into the ledger accounts. Many of the postings involve totals, since the journal makes use of columns to total the debits and credits made to some columns. For example, the cash at bank column in the cash payments journal is used to total all of the individual credits to the Cash at Bank account. The posting of totals and other amounts from the journals to the ledger are explained in the section on journals. Note that the debit and credit rules are used to make these postings.

The general ledger is usually structured to group accounts so that financial reports may be produced quickly. This structuring is achieved by a chart of accounts.

The following chart of accounts, with added accounts as necessary, is suitable for most computerised bookkeeping programs. Notice the groupings and how the prefix system is used to identify the accounts within the groups.

Chart of accounts

Proprietorship 0000Capital 0010Current year's profit/loss 0020Drawings 0030

Current assets 1000Bank 1010

Accounts receivable 1020Inventory 1030

Current liabilities 2000Bank overdraft 2010

Accounts payable 2020

Non-current assets 3000Land 3010

Plant and equipment 3020Accumulated depreciation - plant and equipment 3025Office equipment 3030Accumulated depreciation - office equipment 3035

Non-current liabilities 4000Mortgage 4010

Income 5000 Job income 5010

Sub-contract income 5020Discount received 5510Interest income 5520

Direct material expenses 6000Opening inventory - materials 6010Work in progress at beginning - materials 6020Materials purchases 6030Closing inventory - materials 6040Work in progress at end - materials 6050


Direct labour expenses 7000Work in progress at beginning - labour 7120Wages 7130Work in progress at end - labour 7150

Indirect expenses 8000Indirect materials purchases 8030Bank fees 8210Accounting fees 8220Office wages 8230Bad debts 8240Printing, stationery and postage 8250Interest 8260Discount allowed 8270

Non-operating income 9000Gain on disposal on non-current asset 9010Bad debts recovered 9020

Non-operating expenses 9500Loss on disposal on non-current asset 9510

Subsidiary ledgers

A subsidiary ledger is where we keep the individual accounts relating to a control account in the general ledger. You look at the general ledger control account to find the balance of that account, but to see the balance of individual accounts; you need to look at the subsidiary ledger accounts. These individual accounts could be housed in the general ledger book, but we keep them in a separate subsidiary ledger, in order to reduce the amount of information in the general ledger. They also provide a means of control over amounts owed by/to debtors/creditors. The chart of accounts on the previous page highlights some common control accounts.


CONTROL ACCOUNT IN GENERAL LEDGER

SUBSIDIARY LEDGER

Accounts receivable control Accounts receivable - containing individual debtors' accounts

Accounts payable control Accounts payable - containing individual creditors' accounts

Plant and equipment Asset register - containing details of individual items of plant and equipment

Job Control Job Cost Cards - containing details of progress payments and costs relating to each job.

The subsidiary ledger's individual ledger balances must add up to and equal the balance of the control account. Each control account should be reconciled with the associated accounts in the subsidiary ledger. This procedure should be undertaken as often as a trial balance is taken out, which should normally be monthly.

The following example shows the relationship between a control account and its subsidiary accounts. The example shows the Debtors (Accounts Receivable) control account in the general ledger and the individual accounts of all of the associated accounts for individual debtors in the subsidiary ledger. In this case there are only four individual debtors. You should focus on the balance of each debtor’s account and note that these figures are included in the schedule of accounts receivable. Also note that the sum of all balances owed by individual debtors is reflected in the balance of the control account.

This is in fact a debtor’s reconciliation, prepared so that the total of all amounts owed to you by debtors can be checked against the total of all the individual debtors’ accounts.

EXTRACT - GENERAL LEDGER Refer to diagram 3.4 P/10 Accounts Receivable Control (A) A/c No

________

31/5/05 Balance 18 000 DR30/6/05 Sales (from Sales

journal)14 000 32 000 DR

30/6/05 Cash at bank(from cash receipts journal)

12 000 20 000 DR


EXTRACT - ACCOUNTS RECEIVABLE SUBSIDIARY LEDGER

R. Jones (A) A/c No ________

31/05 Balance 6 000 DR5/6/05 Sales 3 000 9 000 DR14/6/05 Sales 1 000 10 000 DR24/6/05 Cash at bank 2 500 7 500 DR

A. Smith (A) A/c No ________

31/5/05 Balance 2 000 DR3/6/05 Sales 4 000 6 000 DR27/6/05 Cash at bank 2 500 3 500 DR

C. Brown (A) A/c No ________

31/5/05 Balance 4 000 DR15/6/05 Sales 4 000 8 000 DR27/6/05 Cash at bank 7 000 1 000 DR

B. Good (A) A/c No ________

31/5/05 Balance 6 000 DR3/6/05 Sales 2 000 8 000 DR

SCHEDULE OF ACCOUNTS RECEIVABLE (as at 30/6/95)

R. Jones 7 500A. Smith 3 500C. Brown 1 000B. Good 8 000

Total $20 000 as per balance of Debtors Control account in the general ledger.

Source Documents

Documents or vouchers are the paperwork that record a particular transaction or event. This is the beginning of the record-keeping process. All information originates from these basic documents. Without them, you cannot compile your records or substantiate your tax deductions. All documents should state what they are and be numbered for reference. They are available from stationery outlets or you can have them designed and printed for your own business. Wherever possible, you should design forms that are similar to those used by others in the industry. All documentation must be kept for taxation and corporate legislation purposes for at least seven years.


Purchase order

The purchase order has a number of functions: to offer in writing to buy from a supplier the specified goods or services; to put into writing delivery and payment instructions for the goods or services ordered; to keep a record of orders placed and unfulfilled; to keep a record of the quantity and price of goods that you have offered to buy; to give a record of contingent liabilities - amounts that you will be called upon to pay in the

near future; to support payments to suppliers for goods or services received.

Note: Purchase orders are not entered into any journal because at that stage, only a contingent liability has been incurred. The purchase will be recorded upon receipt of the suppliers invoice.

The components of a purchase order include:

a statement that it is a purchase order;a purchase order number and date of issue;your business name, business address, postal address, telephone and facsimile number;payment terms - when the supplier will receive the money;quantity, description and unit price of goods or services to be delivered;a reference to the job number.

The number of copies required may vary but often include:

an original that is sent to supplier (with inexpensive items, a copy may be given when goods are delivered);

a copy for the job file, if you feel this is necessary;a copy showing goods and services yet to be supplied (i.e. outstanding);a copy to be attached to the payment request - indicating that payment is outstanding (the

last two could be the same copy by moving from one file to another upon receipt of goods).

Invoice

You will come into contact with two types of invoices:

the invoices you raise and forward in numerical order to your clients indicating the amount they owe for the work specified and when payment is to be made to you. Invoices that you write out are written into your sales journal. Where the nature of your business means a low volume of credit sales transactions, the invoices could be entered into the general journal.

the invoices you received from suppliers of goods and services on credit as a result of your purchase order. Invoices you receive are entered into your purchases journal.


Details to be found on an invoice include:

a clear statement that the document is an invoice; a consecutive number; the issuing business's name, business address, postal address, telephone numbers (office and mobile) and facsimile numbers should be printed or stamped on form; the name and postal address of the receiver of the goods or services who owes the money; delivery instructions that should include locations, day and time (if important);a reference to client's purchase order and job number if known; the date of issue; a reference to delivery docket (if it is not same number); quantity ordered and delivered, part number, part description, unit price, extension (10 @ $5.60 = $56.00), sales tax (if applicable) and total; terms of settlement of account - generally 30 days, which means 30 days from the end of the month in which the account was raised.

The number of copies again depends on your needs:

the original that goes with the goods or upon completion of the service, or which is forwarded shortly afterwards;

an office copy that is used for bookkeeping and possible legal evidence in disputes;a copy that forms the delivery docket, but does not include the price;a copy that is used for receipt of delivery or, if a carrier has been hired, their reference

numbers so that confirmation of delivery may be made if necessary.

Credit note (= Moneys that are inside brackets which means the reverse action. E.g.,($100) in Debit on a product return will cancel out the original purchase.) You could issue or receive a credit note which has the opposite effect to an invoice. Credit notes are raised as a result of returning goods to the supplier, or following a request for a reduction in price resulting from mathematical error or damage to goods supplied.

The credit note has similar details to the invoice with the addition of a reference to the original invoice numbers. The original invoices should be noted with the details of the goods returned so that you will not be called upon to give credit for more than you originally sold.

The credit note should be signed before issue by the owner or managing director. If you are sending goods back, you should raise a request for a credit note, which could be a form or a letter. The duplicate of this request should be held in an outstanding file until it is satisfied by a credit note from your supplier.

The credit note would have at least two copies, with one going to your client while the other is used for your bookkeeping. The monetary value of the credit note would be taken off your sales if you issue it, or off your purchases if your supplier issues it.

Cheque butts

A cheque is a written instruction by the drawer on the drawer's bank to pay another party a certain sum of money. The drawer is responsible to meet the payment as defined by the Cheques and Payment Orders Act. You should cross the cheque with parallel lines with the words 'not negotiable' to reduce your liability should be cheque be lost or stolen.A cheque is a single piece of paper with the following information:

drawer - the bank and branch where the document must be met on demand unless crossed;

payee - made out to pay a person or business, or cash;drawer - the person or business whose account is being drawn against (for your own

business, two people should sign each cheque);


amount in words and figures;date - this is not essential but it cannot be more than fifteen months old or post-dated; that

is, a date in the future. Cheques can be dated any day that the cheque is written out, including Sundays and holidays.

Your record is the cheque butt rather than the cheque itself. In a large organisation it is common to use cheque requisition forms. Details that is included:

cheque number; date cheque raised; payee of the cheque; reasons for raising the cheque, including allocation to job(s) or expense account(s); the amount and the signatories.

When payment is made, a payment (or remittance) advice detailing the payment is forwarded with the cheque. Do not assume that the receiver will know what the remittance is about. Unless you include the details of the payment, the receiver may allocate it to any account of yours, which is usually to the earliest sum owing.

Note that it is the Cheque butts or requisitions which are entered into the cash payments journal.

Receipt

A receipt is issued when money is received from clients. Details that are included on a receipt include:

name and address of the business issuing the receipt, date of receipt, the name of the payee, amount received, and cash discount allowed (if applicable).

A similar document for cash sales is the cash sales docket.Receipts, cash sales dockets and remittances received are entered into the cash receipts journal.You may also write up receipts yourself to document the receipt of cheques and/or cash.

Statement

This document details the transactions you have had with a client. The statements you receive detail the transactions you have had with your supplier or bank. Statements are usually issued monthly as they remind clients to make their payment at the end of the month. It is necessary to compare your own records with the statement received from your creditor or from your bank. This comparison is called a reconciliation (eg. bank reconciliation) which is covered later in this unit.Journals

A journal is a book of first record where the day-to-day transactions are recorded. There are a number of journals but all are based on the same double entry principle. In each journal and for each transaction, the sum of the debits must equal the sum of the credits. Each journal entry must be supported by a source document.

Invoices you raise indicate a request for payment from your clients due to goods/services supplied on credit and are entered into the credit sales journal (SJ).

Invoices you receive indicate that you have purchased on credit - they are demands from your suppliers. They are entered into your credit purchases journal (PJ).

Credit notes you raise will be entered into the sales journal (in brackets, which indicate they are the opposite of the invoices).


Receipts issued, your cash sales dockets and/or cash register rolls document the receiving of money, are entered into the cash receipts journal (CRJ) or the receipt side of the cash book if one is being used.

Cheque butts or cheque requisitions (evidence of cheques written) are used to write up your cash payments journal (CPJ) or the payments side of your cash book.

Petty cash vouchers record details of purchases from petty cash, which are recorded in the petty cash journal and ultimately in the cash payments journal.

Source documents and Journals

SOURCE DOCUMENT TRANSACTIONS INVOLVING

JOURNAL USED

ReceiptsCash sale docketsCash register tapes

Money received by the business

CASHIN

CRJ

Cheque buttsPetty cash vouchers

Money paid out by the business

CASHOUT

CPJ

Suppliers invoicesSuppliers credit notesSuppliers monthly statement

Credit purchases CREDIT PURCHASES

PJ

Customer invoicesCustomer credit notesCustomer monthly statements

Credit sales CREDIT SALES

SJ

Other documents Other / special OTHER GJ(see over)

General Journal

The general journal is designed to handle any type of transaction. However, other specific journals, such as the sales journal or the purchases journal, may be used for more efficient handling of the transactions they are designed for. For this reason the general journal is usually used only for transactions which do not fit into the other journals or are special transactions. As with all business stationery, your business name must be included in the heading. Also included is the folio reference, which in other words is the page number; an example would be 'GJ 1', the digits indicating the particular page.

The general journal may break from the rule of having documentation to support the entry because the narration (or explanation) to the entry may itself explain the transaction. The general journal is also used for adjusting and closing ledger accounts at the end of the period. The following columns are used in the general journal :

date; which show the year (at least at the top of each page) along with month (which is generally abbreviated to three letters). All journals record transactions in chronological order, i.e. by date.


particulars or details; where the name of the accounts that will be affected are entered (the practice is to write the debit entries first, then the credit entry which is indented at least four letters or characters);

folio; which is the reference to the general ledger account where the entry is posted (this folio is entered when posting to the ledger is completed);

left-hand money column; where the debit amounts are entered;

right-hand money column; where the credit amounts are placed.

Example 1 Owner invests personal funds into business

A simple example of the use of the general journal would be the cash contribution of the owner to set up the business. The names of the two accounts affected are in the particulars column.

General Journal GJ1

DATE FOLIO PARTICULARS DEBIT CREDIT$ $

1/7/95 Cash at bank 10 000 Capital; Bill 10 000(Capital introduced to establish business)

To make entries in the general journal you need to apply the rules of debit and credit discussed earlier. Those rules have been applied in the above example as follows. We debit the Cash at Bank ledger account, as it is an asset account that is increasing (A DR) from nil to a balance of $10,000. At the same time we credit the capital account of the owner (Capital; Bill) since it is a proprietorship account which is increasing (P CR). The details in brackets after the entry, ‘Capital introduced to establish the businesses, are known as the narration. Refer to page 10 diagram 3:4 Example 2 Purchase of fixed asset on credit.

General Journal GJ1

20/7/5 Plant and Equipment (A) = 5 000 Loan; A. Financier (L) = 5 000(Purchase of fixed asset on credit)

In this example the asset account; Plant and Equipment account is to be increased by $5,000, hence the debit entry (A DR). At the same time the liability account (Loan; A. Financier) is to be increased/credited by the same amount (L CR).

Example 3 Write off a debtors account (when you no longer expect to receive payment from the debtor).

Moneys not paid= expense (DR) will reduce your assets (CR))

General Journal GJ1

29/7/5 Bad Debts (E) 1 000 Accounts Receivable; A. Debtor. 1 000


(A)(To write off bad debt of A. Debtor)

In this example the Bad Debts expense account is to be increased by $1,000, hence the debit entry in that account. At the same time the asset Accounts Receivable is to be decreased (i.e. credited) with the same amount. Also, the account of A. Debtor in the accounts receivable subsidiary ledger account is also to be reduced by a credit. In this transaction, the narration may be the only documentation for the entry.

Most of the entries into the general journal will be written by your accountant or bookkeeper. If you write up any general journals, ensure the debits equal the credits before posting to the ledgers.

Purchases journal

The credit purchases journal is used for transactions involving the purchase of goods or services on credit. As we know these transactions are supported by invoices sent from suppliers. The purchases journal has the normal headings as to ownership and identification of what it is, along with a folio reference, eg. 'PJ1'.

The first three columns contain the following information:

date of invoice.

invoice number; which identifies the document sent by the supplier (renumbering of suppliers' invoices, although advocated by some, is a waste of time).

particulars; where the supplier's name is entered.

'purchases / Job expense control' has sub-headings for job identification, which is generally made by a job number and the amount to be allocated.

the 'sundries' column is used where new acquisitions will be recorded, therefore you need to have sub-headings to identify the account and the amount.

the 'accounts payable' column is where the total amount is posted (usually at month end) to the general ledger accounts payable control account and the individual amounts are posted (usually daily) to the individual's accounts in the accounts payable subsidiary ledgers.


DateInvNo.

Particulars/Creditor

Purchases / Job expense

controlSundries

Accountspayable

No. AmountAccounts

Amount

2005Sep2

3479

10* 13

14

190394177440377

184396(27)

R EllissV PatchP EckfordM ScatonBoard Cars

C ThomsonP EckfordV Patch

101M103M100M 99M

101M102M103M

$750

1,000 550

1,050

900 300

(400)

Motorvehicles

$

21,000

$750

1,000 550

1,050

21,000 900 300

(400)

4,150 21,000 25,150

DR DR CR

Note, *13 = (400) = Goods returned.

The postings from the above purchases journal to the general ledger are as follows :Debit Purchases $ 4 150

Motor vehicles $21 000Credit Accounts payable control ___ $25 150

$25,150 $25,150 Notes:

The direct expense ‘purchases’ is an expense control account with the expense having been increased, hence the debit. The individual jobs will be charged their respective amounts.

The motor vehicle asset account is debited because this entry reflects the acquisition of a vehicle (ie the increasing of an asset).

Accounts payable control account is a liability account, therefore as it is increasing, the credit entry is made.

The 'opposite' to a purchase invoice is a credit note, which comes about as a result of goods having been returned to the supplier. Credit notes are entered in this journal in brackets, which indicate a negative figure when adding. For the subsidiary ledgers, the brackets will indicate the opposite sign for posting to the ledger.

It is important that you check that the sum of the debits equal the sum of the credits before posting to the ledgers.

Subsidiary ledgers are affected as follows:


Job Expense Ledger (debit entries) Accounts payable (credit entries) $

Jobs-Materials 99 1,050100 550101 750101 900102 300103 1,000103 (400)

4,150

$

R Elliss 750 V Patch 1,000 P Eckford 550 P Eckford 300 M Scaton 1,050 Board Cars 21,000 C Thomson 900 V Patch (400)

25,150

Note that the total of the subsidiary ledger entries equal the control account entry.

Sales Journal

The credit sales journal has similar design to the purchases journal and should include the following:

the name of the journal; the firm's name; a folio number for the journal (eg. 'SJ1');a date for reference to the year, month and day; an invoice number, which should be in

numerical order as an internal control procedure to ensure that all invoices are accounted for; the client's name for charging in the subsidiary ledger and recognising who owes you the money, a folio column for subsidiary ledger posting reference; and a sales / job income control column for the ultimate allocation of receipts relating to particular jobs.

DateInvNo.

Particulars / Debtor

Sales / Job income control

SundriesAccountsreceivable

No. Amount Accounts Amount

2006

Oct2

714

21

24

184

185186

187

(29)

J & M PoulosJ WongMacintoshComputersMud Brick- laying Services J Wong (returns)

3133

29

33

$

5,000 10,500

6,000

(500)

Plant & equipment (Sale of plant and equipment)

$

290

$

5,000 10,500

6,000

290

(500)

21,000 290 21,290

CR CR DR


The postings to the ledger from this journal are: $ $

Debit Accounts receivable control 21,290 21,290Credit Job income control / Sales

Plant and equipment 290====== =======21,290 21,290

Notes

The accounts receivable control account is debited because it is an asset account that is increasing, as more money is owed to you as a result of these transactions.

The job income control account is an income account, hence the credit entry. The charging of the client means you will be entitled to receive the income.

The credit to the plant and equipment account indicates that you have sold an asset, thus the credit entry to reduce the asset.

Subsidiary ledgers are affected as follows:

Accounts receivable (debit entries) Job income (credit entries)

$ $

J & M Poulos 5 000 J Wong 10,500 J Wong (500) Macintosh Computer Inc 6 000 Mud Bricklaying 290

21,290

$Jobs 29 6,000

31 5,00033 10,50033 (500) ( Note; = Negative )

21,000

Note : The sales journal may be of limited use for a small or medium-sized business in the building industry since it is more suitable for the retail or wholesale outlet. The general journal may be more suitable for recording credit sales where there is a low volume of such transactions.

A business with a low volume of sales or fees charged would normally keep copies of outstanding invoices (duplicates) in the invoice book unfolded. Upon receipt of payment, the appropriate invoice copy is noted with the details of the payment and then folded into the centre. This means only the right-hand sides of the outstanding invoices are seen. The result is that outstanding invoices can be identified quickly for follow-up action. It is important to follow up as soon as the transaction becomes outstanding, and then regularly, until you receive payment.

Should your client dispute the account, check the problem and if necessary, rectify it. Problems arising at the time you contact a business because of their late payment are usually due to delaying tactics. To reduce problems when you tender or quote for a job, obtain credit references and check them out. However, be careful of the referees offered, because they may be the people who are paid promptly so that they will give a good credit reference.


Cash receipts journal

The cash receipts journal is used for all money received, whether it is by cash or cheque. The total of the day's receipts must equal the amount deposited into your bank account. This journal must show the total banking for the day. The number of transactions for the day will dictate the best method of recording. For a small volume the suggested method is to enter the amounts into each column, except for 'amount banked'. The total in the bank column (which should equal the bank deposit) is entered at the end of the day's transactions.

The cash receipts journal usually has more columns than the previously discussed journals, the width of the page being the limitation. It will contain:

the heading, naming the journal and identifying the business;

the folio (say 'CR1');

the date on which the transaction took place;

the receipt number (if issued) or the cash sales docket number;

particulars, where the name of the debtor paying you is entered;

the folio column, where a subsidiary ledger reference is inserted when the transaction is posted to the ledger;

the discount allowed column, which is only used where an accounts receivable client pays his or her debt within the prescribed discount time;

the accounts receivable column, for the amount actually received (note that the entries here for both cash received and discount allowed are credits when posted to the subsidiary ledger accounts, as the debtors have paid and therefore no longer owe you the money);

the sundries column for other money received, with sub-headings enabling you to identify the account involved and the amount - the items here could be a mixture, but will generally show a credit for the following reasons:

asset decreasing as a result of sale or disposal (as the asset is decreasing, a credit entry is needed);

liability increasing as a result of a loan being received (as the liability is increasing, a credit entry is made);

expense decreasing as an overpayment is refunded (as the expense is reduced, a credit entry is required);

income that is received, such as interest or dividends as a result of investment (your income is increasing, therefore the credit entry is required);

the amount banked column shows the total money banked. This is where this journal differs from all the others, in that the daily banking total must be shown. The bank account for this purpose is an asset and as it is increasing, the entry needed is a debit.

if you also receive cash from cash sales, an extra column can be added to record the totals which can be compiled in a separate cash sales journal if necessary..

to analyse sales by job type, labour/material costs, geographic area, salesperson, etc. simply add extra columns and split sales into these columns as appropriate.


Date ReceiptNo. Particulars

/ Debtor

Discount allowed

Accountsreceivable

Sundries Amount Banked

Accounts Amount

19X7

Nov2

5

12

15

23

14

15

16

17

18

19

J & M PoulosMacintosh ComputersWater BoardTelecom Aust.Sit-on furnitureNRMA Finance

210

$

4,790

6,000Interest incomeTele- phoneOfficefurniture

Loan

$

300

60

200

5,000

$

4,790

6,300

60

200

5,000

210 10,790 5,560 16,350

DR CR CR DR

General ledger postings from the above are :$ $

Debit Discount allowed 210Bank 16,350

Credit Accounts receivable control 10,790Accounts receivable control 210

Interest income 300Telephone (refund) 60

Office furniture 200Loan 5,000

===== =====16,560 16,560

Notes

'Discount allowed' is an expense that is increasing, therefore the debit entry is needed.

Bank' is an asset that is increasing, hence the debit entry (note that bank is the only account that changes 'hats', wearing an asset 'hat' when the bank owes you money or a liability 'hat' when you owe them money).

'Accounts receivable' is an asset reducing as a result of the debtors paying the money. Note that the payee (J & M Poulos) will be credited with the amount received ($4790) and the discount allowed ($210).

'Interest income' is an income account which is increasing, hence the credit entry. The entry means that you have an investment in Water Board debentures and they have sent you their cheque for the current period.

'Telephone' is an expenses account reducing as result of a refund. In this transaction, assume that Telecom charged you for an additional handpiece and after discussions they agreed to refund the amount. As the expense is reducing, a credit is the most appropriate entry.


'Office furniture' has been sold - the asset account is reduced, hence a credit entry.

'Loan' is an amount obtained from NRMA Finance to be used to assist in the acquisition of a replacement vehicle. This means that the liabilities are increasing, therefore the credit entry.

The accounts receivable subsidiary ledger is affected as follows:

Credit J & M Poulos 4,790J & M Poulos 210

Macintosh Computers 6,000$11,000

Note the subsidiary ledger total transactions will equal the accounts receivable control account in the general ledger, ($10790 Cash plus $210 Discount Allowed = $11,000.)Associated document - Bank deposit slip

The bank deposit slip is used to deposit money into your business bank account. It contains the following information :

the date of the deposit; the name of the account to be credited; the account number so that the bank's computer can speedily record the transaction;

breakdown of the deposit into notes, coins and cheques; details of each cheque included in the deposit the drawer's name (most likely this will be the person who owed you the money); the amount of each cheque (check for any discrepancies with words and figures); the bank's name - because there is only a small space to write this, you have to use an abbreviation of the bank's name

Cash payments journal

All money paid out by your business will go through the cash payments journal. Details are obtained from the cheque butt/stub or cheque requisition.

Date Cheque Particulars/ Discount Accounts Sundries Bank2006 No Payee Received Payable Accounts Amount

Dec 7 176 Wages Wages 490 490177 P Eckford 20 820 820178 Wages Wages 490178 Drawings Drawings 600 1090

15 179 Board cars 16000 1600017 180 M Seaton 50 1000 100019 181 Petty Cash

RecoupmentFares 25

Postage 43Courier 16M/V Expenses

36 120

21 182 Wages Wages 500 50025 183 V Patch 20 580 580

$90.00 $18,400.00 $2,200.00 $20,600.00CR DR DR CR


The previous journal would be suitable where there are relatively few expenses paid by the business. However, when the number of cash payments for expenses becomes large, it is useful to use a journal with a separate column for certain expenses so that they can be easily totalled at the end of the month. This makes the end of month process much simpler and reduces the chance of errors by using the sundries column for fewer transactions...

Cash Book

An alternative format to the cash receipts and cash payments journals is known as the cash book. The cash book is a marriage of the cash receipts journal, cash payments journal and the general ledger account bank all into the one record. This arrangement is suitable for smaller organisations that have very few cash transactions. The more transactions there are, the greater is the need for separate columnar journals for cash receipts and payments.

The cash book uses only two columns to record all cash transactions. It may be set out as a columnar ledger account, or the two columns may be on either side of the page. The left-hand column is for cash receipts and the right-hand side is for cash payments. This is due to the fact that we debit the bank account in cash receipts transactions. Similarly, we credit the cash at bank account in cash payments transactions. The balance of the cash book - that is, the difference between the two sides - is the amount of cash at bank (or overdraft).

The format of a typical cashbook is shown below.

DATE ITEM / ACCOUNT

CHEQUE #

RECEIPTS PAYMENTS BANK BALANCE

Petty Cash

Petty Cash is a float of money put aside to cover small outlays or payments of money. The amount put aside should not exceed one month's miscellaneous payments or $250, whichever is the lower figure. Wherever possible keep the receipts or other documentation as evidence to fulfil audit requirements and the substantiation of expenses as allowable deductions in your tax return(s).

Expenses that could be paid out of petty cash should be minor items like:

bridge and tollway charges postage equipment repairs minor tools purchases stationery bus fares courier and freight charges morning tea public telephone calls minor materials purchased newspapers taxi fares train fares tea money

Imprest petty cash system

The imprest petty cash system is the normal system of controlling petty cash. Characteristics of the imprest petty cash system are:


It sets aside a sum of money known as the float. The float is fixed but will always be made up of petty cash in hand or vouchers paid. It will be stored in a secure place.

A petty cash voucher is used to record money claimed and subsequently paid out.

Vouchers are entered into the petty cash book.

At least once a month the float is balanced and reimbursed; that is, the vouchers are totalled and a cheque drawn for their total value, which is then entered into the cash payments journal.

Petty Cash Voucher Number...........

Date For Expense accountto be charged

Amount

Approved by.......................................... Received by...................................

Establishment of petty cash float

The float amount will depend on the value and frequency of petty cash payments made. It should be enough to last the business at least a week, but must be reimbursed at the end of each month. The entry in the cash payment books would be:

Debit Petty cash (an asset account established)Credit Cash at Bank (an asset account reduced)

Petty cash book

The petty cash vouchers are entered into a type of journal called the petty cash book (or petty cash register). This book enables you to group like expenditures together. The grouping is done by having numerous columns where we dissect the total paid out as per the voucher. The headings f columns in your petty cash book depends upon the type of petty cash payments made. This enables you to allocate the total expense to the various ledger accounts. To facilitate the transfer of this information into the cash payments journal, you should have the same columns set up in your cash payments journal.

Trial Balance

At the end of a reporting period, usually on the last day of each month, details from the journals must be posted to the ledger, so that the state or balance of each account can be determined. When we looked at journals, we outlined the rules for posting to the ledger from each of the journals. These rules were based on the system of debits and credits. Before postings are made, you need to ensure that each journal balances; that is, the sum of the debits equals the sum of the credits. Once the postings from all journals (including the general journal) are complete, each ledger account should be balanced and incorporated into a trial balance.


The trial balance is a listing of the balances of all accounts in the general ledger. It provides a guide to the accuracy of the postings from the journals to the ledger. The trial balance does not reveal all errors but it does tend to prove the arithmetical accuracy of postings to the general ledger. If postings have been performed correctly, the trial balance will balance; i.e. the totals of the debit and credit columns will be equal.

In the example which follows, note that all asset and expense accounts have a debit balance, while all liability, proprietorship and revenue accounts have a credit balance. Importantly, the total of the debit balances equals the total of the credit balances.

Euell CementTrial balance

As at 31 March, 19X3

ACCOUNT Folio DR CR

CapitalDrawingsAccounts receivable controlBankInventoryAccounts payable controlLand Plant and equipmentAccumulated depreciation - plant and equipmentMortgage

10 3010201010103020203010302030254010

2,0003,0001,0004,000

23,00015,000

30,000

1,800

5,00011,200

TOTALS 48,000 48,000

The balance of the Cash at Bank account should have been verified and updated before inclusion in the trial balance. Also, any control accounts should have been checked against the subsidiary ledger to ensure accuracy.

Exercise No1Given the following information prepare: Trial balance Trading accountProfit & Loss AccountBalance Sheet

Capital in Company 6000Motor Vehicle 7000Plant & Equipment 1000Office Furniture 1000Bank Overdraft 200Petty Cash 100


Trade Debitors 2500 (continued over page)

Trade Creditors 5000Job Costs 4700Job Income 6000Electricity 50Insurances 100Telephone 150Licenses 100

Motor Vehicle Expenses 210

Goods & Service Tax 150

Payroll Tax 120Postage 20

Exercise No1

TRIAL BALANCE Debit CreditCapital in Company 6000 6000Motor Vehicle 7000 7000 Plant & Equipment 1000 1000 Office Furniture 1000 1000 Bank Overdraft 200 200Petty Cash 100 100 Trade Debitors 2500 2500 Trade Creditors 5000 5000Job Costs 4700 4700 Job Income 6000 6000Electricity 50 50 Insurances 100 100 Telephone 150 150 Licenses 100 100 Motor Vehicle Expenses 210 210 Goods & Service Tax 150 150 Payroll Tax 120 120 Postage 20 20

Total $17,200.00 $17,200.00

Trading Account


Job Costs 4700Job Income 6000

Carried Forward to Profit & Loss Account 1300

Profit & Loss Account

Expenses Income

Electricity 50From Trading cc

1300

Insurances 100

Telephone 150

Licenses 100



Payroll Tax 120

Postage 20

Total 900 1300

Profit for month 400

Balance Sheet Method 1

Capital 6000 Motor Vehicle 7000

Plus profit for month 400 Plant & Equipment 1000

Bank Overdraft 200 Office Furniture 1000

Trade Creditors 5000 Petty Cash 100

Trade Debitors 2500

Total 11600 Total 11600

Balance Sheet Method 2

Capital 6000

Plus profit for Month 400

Owners Funds 6400

These are represented by Current assests and current LiabilitiesMotor Vehicle 7000

Plant & Equipment 1000

Office Furniture 1000

Petty Cash 100

Trade Debitors 2500

Total Assets 11600

Less Liabilities

Bank Overdraft 200

Trade Creditors 5000 5200

6400


Given the following information prepare, Trial balance, Trading Account, Profit & Loss Account, Balance Sheet method 1 & 2

Capital in Company 6400Motor Vehicle 7500Plant & Equipment 2300Office Furniture 1000Bank Overdraft 2100Petty Cash 50Trade Debitors 3000Trade Creditors 5000Job Costs 3500Job Income 6170Electricity 100Insurances 50Telephone 250Licenses 50



Payroll Tax 250Postage 20

Bank Reconciliation procedures

Reconciliation is the procedure you undertake to check your records with a third party. The major check is when your records are compared with that of the banks, as most of your transactions affect the bank. By checking with the bank the accuracy of your general ledger bank account, and updating your journals as part of this process, you can calculate the correct figure for cash at bank to be included in the trial balance.

Bank reconciliation

Our receipts and payments are written up into the cash receipts and cash payments journals (or the cash book). However, by the nature of the operation of bank accounts, some transactions may be known to the bank, but not known to us until the reconciliation is effected. These are adjusted as you complete the bank reconciliation procedure. At the same time, the reconciliation may pick up other errors in your records or those of the banks; banks do sometimes make mistakes with customer’s accounts.


Purpose: To provide control over the cash in a business by doing the following;

verify and update your own records (journals) verify the records of the bank (bank statement) check that the records of the business agree with those of the bank find the ‘true’ balance of Cash at bank to be included in the balance sheet

Frequency: The bank reconciliation should be completed monthly, when you receive your bank statement.

Data: You will need the following data:

prior bank reconciliation (if available) cash receipts journal (or the receipts section of the cash book) since the last

reconciliation; Cash payments journal (or the payment section of the cash book) since the last

reconciliation. Bank statements since the last reconciliation.

Procedure:

1. Identify items common to both records

You match items on the prior bank reconciliation, the cash receipts journal and the cash payments journal with items on the bank statement. A match is signalled by placing a tick on the right-hand side of the particular amount in both records. With deposits there is no second reference to ensure that the amounts ticked are the same transaction, but with payments you have the cheque number and amount to identify them.

2. Update your journals

Those items remaining unticked on the bank statement do not appear in your records and (provided they relate to your business) they should be entered into your cash receipts journal or cash payments journal as appropriate. The items that may not be included in your records would be third-party mail remittances, bank charges, government fees, and any dishonoured cheques. Dishonoured cheques (cheques you have received from debtors and which have now been dishonoured) are ‘written back’ by making an entry in the cash payments journal re-charging the debtor.

3. Balance your Cash at Bank ledger account

Total and post your cash journals to the general ledger Cash at Bank account. Upon completing the posting you will find the balance of your general ledger bank account. A common practice is to notionally complete by entering on a piece of paper the opening balance, cash receipt and cash payments in the form of the 'T' account as will be done when posting to the actual ledger. When your general ledger is properly posted, check that the rough or notional workings equal the actual general ledger bank account. The balance of your Cash at Bank account in the ledger will be used as the check in the bank reconciliation.


4. Prepare the Bank Reconciliation

You are now in a position to complete the bank reconciliation. What you are basically doing is updating the bank statement. The action you take will be the same as the bank will take when they receive the outstanding transaction, for example, any unpresented cheques. You start with the bank statement balance and adjust it to show what will happen when the transactions are received by the bank. The items to be included are the unticked items in the cash receipts and cash payments journals.

The bank reconciliation will show:

Balance as per bank statement: the closing balance as per the most recent bank statement.

Outstanding deposits: i.e. the items that remains unticked in your cash receipts journal.

Unpresented cheques: i.e. the items that remains unticked in the prior bank reconciliation and cash payments journal.

Adjusted bank statement balance: this gives the balance the bank would obtain when the items included in this reconciliation are received or (if applicable) adjusted. This balance should be equal to the balance of the Cash at Bank ledger account. If this is the case, you have successfully reconciled your records with those of the bank and now have an accurate balance in your cash at bank account.

Example bank reconciliation problem

Data to start with:

Prior bank reconciliation

Bank reconciliation U Blewitt

As at 31 December 2005

Balance as per bank statement (CR)Add Outstanding deposit (30 Dec)

Less Unpresented cheques 3401 3743406 1903408 440

= Dr Balance of general ledger bank account

$

6,5412,590 9,131

1,004

8,127


Cash receipts journal since the last reconciliationCash receipt journal

U Blewitt CR 1

Bank

2005Jan 4 1234 Joan Citizen

$2,590

$ 2,590

7 12351236

Steelers IndustryP Blundell

1,1252,350 3,475

13 12371238

Slick Industrial ClothingSaints Hardware

1,16350 1,213

21 1239 Gwen Ho 4,350 4,350

23 12401241

Ross Van TungWong Industries

450590 1,040

29 124212431244

John SmithJoan CitizenDame Bulldog Pty Ltd

36063050 1,040

Cash payments journal since the last reconciliation

Cash payments journalU Blewitt CP 1

Bank statement since the last reconciliation

Statement of accountTurimetta Banking Corporation

Turimetta SA 2102

The SecretaryU Blewitt Building Services Pty Ltd123 Your StreetYOURTOWN SA 2250

Account number 143962 Folio 127 Name of account U Blewitt Building Service Pty Ltd

Date Particulars Debit Credit Balance2 Jan 1

2 Jan 15 Jan 15 Jan 1

8 Jan 10 Jan 11 Jan 14 Jan 14 Jan 15 Jan 16 Jan

Balance brought forward

DepositDeposit3411Deposit34083413Deposit341534063416

500

440438

374190734

2,5902,590

3,475

1,213

6,541 CR

9,131 CR11,721 CR11,221 CR14,696 CR14,256 CR13,818 CR15,031 CR14,657 CR14,467 CR13,733 CR


17 Jan 23 Jan 23 Jan 23 Jan 25 Jan 28 Jan 29 Jan 30 Jan

3414Deposit34183419Deposit34223421Fee

184

1,6901,250

4,2003,980

25

4,350

1,040

13, 549 CR17,899 CR16,209 CR14,959 CR15,999 CR11,799 CR7,819 CR7,794 CR

Step 1. Tick the entries common to your records and those of the banks.

Hint: Tick from the bank statement to the journals, starting with the DR column.

Bank reconciliationU Blewitt

As at 31 December 19X0

Balance as per bank statement (CR)Add Outstanding deposit (30 Dec)

Less Unpresented cheques3401 374 6 190 8 440

= Dr Balance of general ledger bank account

$

6,541 2,590

9,131

1,004

8,127

Cash receipts journalU Blewitt CR 1

Bank

2005

Jan 4 1234 Joan Citizen

$

2,590

$

2,590

7 12351236

Steelers IndustryP Blundell

1,1252,350 3,475

13 12371238

Slick Industrial ClothingSaints Hardware

1,16350 1,213

21 1239 Gwen Ho 4,350 4,350

23 12401241

Ross Van TungWong Industries

450590 1,040

29 124212431244

John SmithJoan CitizenDame Bulldog Pty Ltd

36063050 1,040

13,708


Cash payments journalU Blewitt CP1

Bank2005

Jan 2468

11

1518

2325

2830

3411341234133414341534163417341834193420342134223423* BS

Hardware & General Pty LtdKWB & CoMHB Industry Pty LtdMHB ServicesMac StationeryRUB BathroomsAMB Woodwork Pty LtdSlave Tiles CompanyTaxation CommissionerSharks ProductsGreen's Timber Pty LtdPanther Bricks LtdJones & WrightBank fee (from bank statement)

$500550438184374734184

1,6901,2509,6903,9804,2003,500

25

$ 500

550 438 184 374 734

184 1,690

1,250

9,690 3,980

4,200

3,500

25

27,299


Step 2. Update the cash journals (* above) and total the bank columns in these journals.

Statement of accountTurimetta Banking Corporation

Turimetta SA 2102

The SecretaryU Blewitt Building Services Pty Ltd123 Your StreetYOURTOWN SA 2250

Account number 143962 Folio 127 Name of account U Blewitt Building Service Pty Ltd

Date Particulars Debit Credit Balance

2 Jan 2 Jan 5 Jan 5 Jan 8 Jan

10 Jan 11 Jan 14 Jan 14 Jan 15 Jan 16 Jan 17 Jan 23 Jan 23 Jan 23 Jan 25 Jan 28 Jan 29 Jan 30 Jan

Balance brought forwardDepositDeposit3411Deposit34083413Deposit3415340634163414Deposit34183419Deposit34223421Fee

500

440 438

374 190 734 184

1,690 1,250

4,200 3,980

25

2,590 2,590

3,475

1,213

4,350

1,040

6,541 CR9,131 CR

11,721 CR11,221 CR 14,696 CR14,256 CR13,818 CR15,031 CR14,657 CR14,467 CR13,733 CR13,549 CR17,899 CR16,209 CR14,959 CR15,999 CR11,799 CR7,819 CR7,794 CR

Step 3. Prepare the Cash at Bank account in the general ledger

The balancing of the cash at bank ledger account represents the following calculation:

OPENING BALANCE + CASH RECEIPTS - CASH PAYMENTS = CLOSING BALANCE

in this case : $8,127 + $13,708 - $27,299 = ($5,464)

The bank account in the general ledger will appear as follows when the postings from the journals have been completed, and the account has been balanced.


Cash at Bank - General Ledger

Balance b/d (start) 8,127Cash receipts 13,708Balance c/d 5,464

27,299

Cash payments 27,299

27,299

Balance b/d (end) 5,464

Step 4. Prepare the Bank Reconciliation

Bank reconciliationU Blewitt

As at 31 December 19X0

Balance as per bank statement (CR)Add Outstanding deposit (29 Jan)

Less Unpresented cheques 3401 3743412 5503417 1843420 9,6903423 3,500

= Cr Balance of general ledger bank account (overdraft)

$

7,794 1,040 8,834

14,298

(5,464)

Note that the balance obtained in the Bank Reconciliation ($5,464) is equal to the balance found in the general ledger account. This verified balance can now be used in the trial balance and the balance sheet.

In this example, the balance of the cash at bank account has moved from an asset (debit balance) at the start of the month to a liability (credit balance) at the end of the month. In other words, the bank no longer owes you money; you now owe money to the bank (i.e. you are in overdraft).

Accounts reconciliation

Subsidiary listings

The subsidiary ledgers can have mistakes, particularly when it has a high volume of transactions. To check that these records are accurate, the individual accounts in the subsidiary ledger are listed along with their current balances. Then the balances are totalled and this total is compared with the general ledger control account, for example, with the accounts receivable control account, or the accounts payable control account.


Accounts receivable

Statements of account will be produced by (or extracted from) your accounts receivable subsidiary ledger system. Each statement will detail all transactions between you and the relevant debtor. Statements should be forwarded to your debtors as quickly as possible after the end of each month so that payment will be made to you as early as possible. Before the statements are dispatched you should see that they are accurate by comparing the subsidiary ledger (debtors' ledger) balances with the accounts receivable control account in the general ledger.

Accounts payable

The subsidiary ledger balances (in the creditors' ledger) should be reconciled at the end of each month with the accounts payable control account in the general ledger.

You will receive statements from your suppliers, which you will need to reconcile with suppliers invoices before payment is made. Do not pay amounts simply because they appear on your creditor's statements. You should verify these amounts on the relevant invoices and ensure they are not already stamped ‘paid’. If you are in dispute, contact the supplier and discuss the problem.

References

AGPS (Australian Government Publishing Service);

Trimpac Three - Bookkeeping for Small BusinessPart 1: 'Basic Bookkeeping for Small Business'Part 2: 'The Bookkeeping Cycle'.

Other Publications

Elaine Pitwood; Small Business Bookkeeping, Small Business Training Centre, Adelaide College of TAFE.

Ian Pascoe and Peter Carr; Accounting to trial balance, Thomas Nelson Australia

Antcliffe, Ron W; Principles and Practice of Accounting, Heinemannn Educational Australia.

Gaffney T. G.; First Steps in Small Business, Butterworths(271-3 Lane Cove Road, North Ryde, NSW 2113).

Hoggett J. and Edwards L; Financial Accounting in Australia, John Wiley & Sons.


PLANT

and

EQUIPMENT


PLANT and EQUIPMENT

To the casual observer, building contractors seem to surround themselves with lots of machines, items of plant, equipment, tools, instruments and gadgets in an endeavour to make their sites as noisy and polluted as possible. The next-door neighbours may see these energy gluttons, belching carbon monoxide, as expensive builders' toys whose sole purpose is to cause them irritation and deafness. However, in the building industry, we know that in fact this is not so. Builders' plant is certainly expensive and noisy to the extent that ear protection for workers is necessary. One could wager confidently that some contractor on a fixed price is losing money. Consider also that the losing contractor could be you.

Plant and equipment to the builder are as important a building construction commodity as labour, material and finance. The builder will somehow seek out and acquire pieces of plant and equipment that will allow the construction tasks to be done in the quickest time. The emphasis is on speed to achieve maximum productivity. How the building contractor acquires these valuable pieces of equipment is determined by the company's chief executive (you). The decision is mainly based on the financial commitment best suited to fit the short-term and long-term objectives of the company. The amount of working capital invested in the operation will be an important factor in the decision.

Most machines, plant and equipment used by building contractors on the site and in the office can be hired, bought outright or leased. The decision to hire, buy or lease is important, because of the length of the commitment and the size of the financial obligation placed on your company. You should prepare ‘cost comparisons’ to see the effect of the acquisition on your cashflows. Advice from the sales technician, your accountant and bank manager should also be considered before you commit yourself.

Objectives

At the completion of this unit you should be able to:

1. Describe the nature and effect of depreciation expense.

2. Calculate straight line and reducing balance depreciation.

3. List and explain the characteristics of hiring, leasing and buying.

4. List and explain the reasons that influence the decision to hire buy or lease equipment.

5. Prepare castings for hire, buy and lease arrangements, including tax implications.

Depreciation

If your business owns assets that are used for earning income, you can claim an annual tax deduction for the ‘depreciation’ of those assets. Consider the following definitions

1. Allocating/distributing/writing off the cost of a fixed asset over the effective life of that asset.

2. The annual recording of an expense (with an associated tax deduction) to reflect the reduced value of an asset due to use in operations.

3. The method of spreading capital expenditure over a number of accounting periods; by recording a depreciation expense in each period.


Depreciation is applied only to fixed assets which cost over $300 and have an effective life of over 3 years. Assets which cost less than $300 (such as loose tools) can be written off (i.e. expensed) immediately.

The cost of an asset for the purpose of depreciation is deemed to include all expenses necessary to get the machine operational including delivery, installation etc. Any ‘improvements’ to the asset are also included in the asset’s cost for depreciation purposes. The costs of repairs and maintenance to assets on the other hand are expensed as they occur.

The two methods used to calculate the yearly depreciation expense are:

The prime cost method, and

The diminishing value method.

The total depreciation expense you can claim on an asset is limited to the cost of the asset and the asset continues to be written off until its depreciated value reaches zero, or it is lost, sold or destroyed.

Prime cost method

This method of calculating the annual depreciation expense is also referred to as straight line depreciation.

The allowable deduction is found by multiplying the asset's ‘depreciable value’ (i.e. original cost) with the prime cost rate.

DEPRECIATION EXPENSE = COST x PRIME COST RATE

For a truck costing $10,000 to be depreciated at 20% Depreciation expense = $10,000 x 20% = $2000 per year

This method results in the same amount depreciation expense each year, and the asset

will be fully written off after five years. In this example one fifth (i.e. 20%) of the original

(prime) cost of the asset will be written off each year for five years. Reducing balance methodThis method of calculating depreciation is also referred to as accelerated depreciation or the diminishing value method.

DIMINISHING VALUE RATE = 1. 5 X PRIME COST RATE

Diminishing value rate = 1.5 x 20% = 30%The diminishing value rate is applied to the reducing book value, rather than to the original cost of the asset (as is the case with prime cost depreciation).


DEPRECIATION EXPENSE = BOOK VALUE x DIMINISHING VALUE RATE

(AT START OF YEAR)

Year 1Dep’ n exp. = $10,000 x 30% = $ 3,000Year 2 = $10000 - $3000 = $7000 x 30% = $ 2,100

Year 3 = $7000 - $2100 = $4900** x 30% = $ 1,470

These annual depreciation charges can be incorporated into a depreciation schedule.

DEPRECIATION SCHEDULE - DIMINISHING VALUE METHOD

YEARSTARTING

BOOK VALUE$

DEPRECIATION EXPENSE

$

ACCUMULATED DEPRECIATION

$

ENDING BOOK VALUE

$

2002 10 000 3 000 3 000 7 0002003 7 000 2 100 5 100 4 9002004 4 900 1 470 6 570 3 4302005 3 430 1 029 7 599 2 4012006 2 401 720 8 319 1 681TOTAL DEPRECIATION 8 319

After five years this asset has a written down value of $1,681, since depreciation deductions to that point totals $8,319.

Recall that under any method of depreciation, you can only depreciate the asset until it’s written down book value reaches zero. Using the prime cost method (at 20%), the asset was fully written off in the fifth year.

Note that in the case of reducing balance depreciation, the asset was not completely written off after five years, (and in fact, never would be completely written off under this method). The asset would simply continue to be written down in value each year until it is sold, lost or scrapped, at which time an adjustment would have to be made for any difference between the sale price and the ‘written down’ book value.

Importantly, the diminishing value method provides larger tax deductions in earlier years than does the prime cost method. For example, compare the first year’s depreciation expense/deduction of $3,000 with the $1,500 allowed under the prime cost method.

The Commissioner of Taxation automatically assumes that the diminishing value method will be used in all cases; however a business may exercise a written option to use the prime cost method. The option must also include which assets (i.e. new assets only or all assets) the option relates to. This option is irrevocable; once exercised, it cannot be reversed.

It is possible to “pool” assets which are being depreciated at the same rate in order to reduce the number of depreciation charges to be calculated. The ATO (Australian Taxation Office) has provided six broadband rates for depreciating assets, based on the effective life of the asset.


BROADBAND DEPRECIATION RATES (for assets acquired after 26/2/92)

EFFECTIVE LIFE IN YEARS

PRIME COST RATE

DIMINISHING VALUE RATE

3 to less than 5 40 % 60 %5 to less than 62/3 27 % 40 %62/3 to less than 10 20 % 30 %10 to less than 13 17 % 25 %13 to less than 30 13 % 20 %30 or more 7 % 10 %

The above rates can be applied to all assets except the following:

Passenger motor vehicles designed to carry less than one tonne and/or less than nine passengers (these are depreciated at reduced rates, as set out in a separate schedule; eg. a car with an estimated effective life of 7 years is depreciated at 15% and 22.5%).Employee amenities, (which are depreciable at rates of 33% and 50%). Buildings (depreciated at 2.5 %).

The ATO also provides suggested estimates of effective lives and associated rates of depreciation for various classes/types of assets. Examples of these rates are shown below (for assets acquired after 26/2/92). A more complete list is provided in the booklet ‘Depreciation Guide 1992’ available on request from the ATO.

ASSET CLASS EFFECTIVE LIFE

(YEARS)

PRIME COST RATE

%

DIMINISHING VALUE RATE

%

Cars* 7 15 22.5Computers 5 27 40Concrete pump 10 17 25Curtains and drapes

7 20 30

Earth moving plant

7 20 30

Electric hand tools

5 27 40

Furniture 15 13 20 Trailers 10 17 25Trucks ( 1 tonne) 7 20 30

Alternatively you may make your own estimate of an asset’s effective life. If you choose this option, you must be able to demonstrate to the ATO that you “took all relevant information into account”, such as:

1. Potential physical life2. Expected circumstances of use3. Predictable obsolescence4. Whether the asset was acquired to fulfil a particular project


Upon disposal or loss of an asset, an adjustment for depreciation is recorded which represents the difference between the salvage value and the reduced book value/written down value. If the ‘consideration’ (sale price) received for the asset was more than the reduced book value, the excess will be treated as assessable income (i.e. a gain on disposal). If the consideration received is less than the reduced book value, then the difference will be an allowable deduction (i.e. a loss on disposal). For example, if an asset had a written down book value of $4,900 and you sold it for $5,000, you would have to record a ($100) gain on disposal, which would be assessed as income for tax purposes. The ATO only allows a tax deduction for depreciation to the extent to which an asset is used for income producing purposes. Where a business asset is used for non-business purposes, the amount of the tax deduction for depreciation is reduced by the percentage of private use, using the following formula.

DEP’N EXPENSE = FULL YEARS DEP’N x NO DAYS ASSET USED/INSTALLED 365

Accounting for depreciation

On the last day of each accounting period, the following general journal entry is made (usually by the accountant).

Eg. DR Depreciation Expense (E) 2 000CR Accumulated Depreciation (-A) 2 000 (Motor Vehicles)

The depreciation expense appears in the Profit & Loss Statement as an overhead expense.

The Balance Sheet contains the reduced value of the asset, also called the written down value or the book value.

EXTRACT FROM BALANCE SHEET

Motor Vehicle 10 000 Less Accumulated Depreciation 2 000 8 000 (i.e. book value) (Motor Vehicles)

In summary, the two effects of depreciation on the accounts of a business are:The book value of the asset is reducedSince depreciation expense is an allowable tax deduction;

Overhead expenses are increased,net profit is reduced,Tax is reduced.

Revision

1 Calculate depreciation schedules for the following asset using the rate suggested by the ATO.

ASSET: Earthmoving equipment COST: $5,000 (Acquired July 1 1994)

DEPRECIATION RATES: Prime cost rate: 20%


Diminishing value rate: 30%

PRIME COST METHOD

YEAR STARTING BOOK VALUE



ENDING BOOK VALUE

2002

2003

2004

2005

2006

TOTAL DEP’N EXPENSE

DIMINISHING VALUE METHOD




ENDING BOOK VALUE

2002

2003

2004

2005

2006

TOTAL DEP’N

Acquiring plant and equipment

Building contractors may choose to hire, buy or lease assets (eg. plant and equipment). The fundamental differences are summarised below.

Hire

A hire agreement is a clear arrangement of paying for the temporary use of an item of plant or equipment. The hirer does not take on temporary ownership of the equipment on hire, and there is no cost to the hirer for maintaining the equipment in working order, except for fuel and consumable parts.Buy


To buy an item of equipment is to purchase outright and take ownership the asset for use in your business operation. The equipment is owned by the company and appears in the balance sheet, whether it is purchased with borrowed money or financed from the company's accumulated funds. If excess funds are available, purchasing an asset with internal funding is usually the least costly option.

Lease

Leasing commits the lessee (you) to an agreement to pay for the possession and use of the equipment for the term of the lease (although the financier retains ownership of the equipment during this time). Lease periods vary and can be as short as twelve months, while plant and equipment leasing is commonly for a term of four years.

Under a ‘financial lease’ (the most common), the lessee is responsible for maintaining the equipment in working order and incurs all costs. At the end of the lease term, the lessee may re-lease the equipment, purchase it for its residual value or simply hand it back. Like other forms of finance, the monthly instalments may be structured to suit the needs of the lessee. We will also examine another option similar to leasing, that of hire-purchase, which has some characteristics in common with both leasing and borrowing.

Note that financial institutions often choose other names for their asset financing products, such as ‘asset purchase’, ‘lease purchase’ etc. These are often simply generic names for the same products outlined in this section. When enquiring about such products, you should ask if this is the case.


Hire, Buy or LeaseThe decision as to how to acquire equipment is dominated by finance. The funds available and the allocation of these funds are determined on information available to you at the time. No standard criteria for a decision to hire, buy or lease can be established for universal application by the building contractor. All building companies are different and all factors must be considered.

Cost Factors

1. Purchase price, hire fees, lease payments2. Available capital3. Current/expected interest rates4. Current/expected tax rates5. Expected residual value of asset6. Expected maintenance/repair costs

Other factors

1. Expected pattern of use of the asset2. Expected useful life of the asset for the business3. Expected need to update asset (obsolescence)4. Need for flexibility eg. periodically update/replace assets


Hiring

1. No large capital outlay is involved when an item is hired, freeing working capital for use in contracting works or for investment. It can remove the need to borrow money and burden your company with loan repayments.

2. Hire costs are classified by the Australian Taxation Office as business costs incurred in gaining or producing assessable income. They are therefore a tax deduction and appear in the profit-and-loss account.

3. Repairs and maintenance on hired equipment are paid by the hire company. Losses of construction time on site due to breakdown of equipment are minimised because the hire company provides a replacement unit.

4. Hire companies usually have the current model of equipment for hire. The time of actual usage of hired equipment is the extent of the cost incurred by the building contractor. You incur no costs for downtime or storage elsewhere.

5. Hire equipment can come with an operator trained to use the equipment to its maximum productivity. The building contractor incurs no expense for providing training and paid downtime for a company employee as an operator.

6. Short-term use for an item of equipment needs only a matching short-term financial commitment.

7. The providers of hire equipment offer a wide range from which the hirer can choose. Otherwise, the building contractor is limited to what he or she can afford to buy or lease.

8. The hirer needs no facility, truck or float to move equipment to or from building sites. Hire companies deliver and collect from the site.

9. Cost of on-site delays through bad weather or industrial disruption need not extend to the equipment. Hired equipment can be returned and the hire costs stopped for the duration of the delay.

10. City-based building contractors who undertake country projects can usually hire equipment locally, rather than transport equipment that they own or lease.

Buying

Purchasing plant and equipment consumes capital, but increases the company's assets.

The source of funds may be:

1. Use of company's paid up capital;2. Directors' loans;3. Use of accumulated profit not paid in dividends;4. Borrowing on a term loan;5. Hire purchase from a finance company.

Purchases made with borrowed money can double what would have been the original purchase price. Therefore if funds are available, purchasing the asset with these funds is usually the most cost effective option. In some cases, company funds used on the unnecessary purchase of equipment could be used elsewhere and for a better return, especially where assets are idle for long periods.

Interest on loans for purchases of equipment is tax deductible and appears in the profit-and-loss account as a financial overhead expense.


The value of the equipment can be depreciated annually at the rate determined by the Australian Taxation Office. This produces a ‘book value' of the equipment which is an asset of the company. Employees sometimes buy the equipment (eg. a car) from the company for its book (depreciated) value.

Any term loans taken out by a company may need to be secured by a director's security (perhaps a dwelling) or a personal guarantee.

Repair and maintenance costs are tax deductible.

The longer you keep the equipment the more obsolete (out of date) it becomes.

Special items of plant need a licensed plant operator. A wages employee needs to be trained and, once trained, needs to have continuous employment with the plant.Large building projects could provide sufficient work for a particular item of plant or equipment to justify the purchase of a machine especially for that single project. The cost of purchase, use and disposal at the end of the job would be allowed for in the tender for the job.

You may be able to rent out the asset when you are not using it. Advertising your company name and business operation on your own plant on site can provide an advertisement opportunity, creating an impression of long-term stability.

Company-owned plant needs a secure area or premises at which to carry out repairs or where it can be stored when not on site.

Leasing

No large capital outlay is involved, freeing working capital for use in operations.

Lease arrangements for vehicles and some plant items provide for the lessee to purchase the vehicle or plant item for its residual value at the end of the lease term. Usually the residual value is less than the market value of the vehicle or plant.You avoid the burden and risk involved with borrowing money, although penalties will apply if you decide to vary or terminate a lease agreement early.

Lease payments are calculated according to a number of factors. Firstly, a residual value is established, which is the amount the asset is deemed to be worth at the expiration of the lease. The remainder of the purchase price is amortised over the period of the lease, interest is added, and equal monthly instalments calculated.

Lease payments can be structured. For example, a high residual value with a low monthly rental may be attractive to a recently established business. Alternatively a low residual value and high monthly rentals may suit a business seeking tax relief.

Lease payments are classified by the Australian Taxation Office as costs incurred in the business process. The payments are therefore a tax deduction and appear in the profit-and-loss account.

Regular and consistent cash-flow patterns assist financial planning.

All insurances, repairs, maintenance and running costs of the equipment are the responsibility of the lessee.


The lessee incurs the cost of downtime until the equipment is returned to operation.

A lease commitment for four years would need to coincide with a four-year forecast of turnover for the company.Lease companies favourably view lessees who renew lease contracts with the purpose of updating.

Manufacturers may offer lease arrangements that provide use of equipment on a lifetime deal through a regular series of renewals. These contracts are term contracts and include maintenance, replacement and update facilities. All the lessee does is use the equipment and pay the agreed lease payments. For example:

1. On building sites: lifts, escalators and boilers;2. In the office: office equipment, such as computers, photocopiers and3. Telephones.

When comparing the option of leasing with other methods of financing, you should request from the lessor, a schedule of the repayments. These should show the interest and principal payments of the proposed lease.

Hire-purchase

Special note should be made of the availability of acquisition by hire-purchase arrangement. This is simply another way of borrowing money from a lender over an agreed term under agreed conditions.

Hire purchase is usually reserved for motor vehicle acquisition and is mainly made available by finance companies. Banks prefer the alternative which is a term loan. You, the borrower, have a choice between these two similar loan facilities. Either could suit your particular situation and you are the ultimate decision-maker for the commitment. The fundamental differences are these:

Term loanIt is available from a bank.The loan will be ‘secured' by an asset or guarantor.The term of the loan is usually four to 15 years.There is usually a fee.Interest rates as at June 2006 - variable 13.5%, - fixed 15.5%.You can gain approval in two days.

Hire purchaseIt is available from a finance company.The item itself will be the securityThe term of the hire purchase agreement is five years.Interest rates as at June 2006: variable 15.5% fixed 16.5%.You can gain approval in three days.Deposit can be 10% of the purchase price or nil in some cases.

Note that with hire-purchase agreements, the interest expense and depreciation expense are tax deductible. The conditions, interest and fees will change every month due to Government policy and lenders' policy. However, when preparing castings, you should always assess the potential impact of interest rate and other changes.


Costing your acquisition

The decision to hire buy or lease is influenced by the cost comparison and a group of other influences depending on the type of operation the building contractor conducts. Newly-licensed building contractors, in the course of establishing the business, will obtain work and acquire plant and equipment. A work vehicle is usually the first acquisition and may involve funds of around $30,000. The decision to allocate funds to acquire this item should be made objectively. Builders sometimes lose sight of tangible (and sensible) influences, such as those involving real cash, among dozens of intangible influences, such as:

Prestige,

Showing-off,

Need for stability,

Convenience

Predicting future trends

Gut-feeling

Feeling of commitment

Conservatism in decision-making

Sheer incompetence.

Unfortunately, we often succumb to the weakness of making decisions ‘against our better judgement’, but nothing can be done about that after the event. However, a properly prepared hire-buy-lease cost comparison will present a clear picture of the total after tax cost of each method.

The cost comparison could be prepared by yourself or any of a number of professional people, for example:

1. Your accountant

2. Your bank manager

3. Your taxation consultant

4. Your bookkeeper.

You should always consult your accountant regarding major asset purchases and have them check over your cost comparisons, and ask for feedback on any unforseen implications of your decision.

The conditions may not apply to your organisation or individual situation, but the method of calculation will be standard for any situation.

Hire-buy-lease cost comparison

Equipment sought : Toyota Hilux truck Purchase Price, $27,683 Term of comparison : Four years


Buying (with borrowed funds)

COST YEAR 1$

YEAR 2$

YEAR 3$

YEAR 4$

TOTALS$

Total outflowTax deduction on interestTax deduction on depreciation

11,766 (1,599

(2,741)

10,554 (1,199

(1,918)

9,343 (799)

(1,343

8,131(399)(940)

39,794(3,996

(6,942)

Adjusted outflow totalsSales proceeds

7,426 7,437 7,201 6,792 28,856(11,000)

Cost of the vehicle 17,856

Leasing

COST YEAR 1$

YEAR 2$

YEAR 3$

YEAR 4$

TOTALS$

Lease payments quoted 8,628 8,628 8,628 8,628 34,512

Tax deduction at 33% (2)8,628

(2,847)8,628

(2,847)8,628

(2,847)8,628

(2,847)34,512

(11,389)

Total outflow

Residual value 30% of purchase value (5)

5,263 5,263 5,263 5,263 23,123

8,305

Sales proceeds (4)31,428

(11,000)

Cost of the vehicle 20,428

Hiring

COST YEAR 1$

YEAR 2$

YEAR 3$

YEAR 4$

TOTALS$

Hire payments quoted 18,250 18,250 18,250 18,250 73,000

Total outflow

Tax deduction 33% (3)

18,250

(6,023)

18,250

(6,032)

18,250

(6,032)

18,250

(6,032)

73,000

(24,128)

Cost of the vehicle over four years

48,872


Notes to the tables

1. This interest expense has been calculated on the yearly opening balance only. In practice, it would probably be calculated on monthly opening or average balances and becomes a more complicated procedure

2. We have assumed the business is a company. (Company tax rate = 33% as at 30/06/95). For individual taxpayers subject to progressive rates of tax, use an estimated effective rate.

3. Depreciation schedule - diminishing value method - 30%


$


$


$

ENDING BOOK VALUE

$

1 27,683 8,305 8,305 19,378

2 19,378 5,813 14,118 13,565

3 13,565 4,070 18,188 9,496

4 9,496 2,849 21,037 6,647

TOTAL DEPRECIATION EXPENSE 21,037

To calculate tax savings due to deductions for depreciation, multiply the depreciation expense (highlighted) by the tax rate.

4. The actual sales proceeds need to be estimated (assumed to be $11,000 in this case).

5. The residual value payable to acquire the asset at the end of a lease is calculated as a percentage of the cost, in this case 30%. This cost comparison shows that the option of borrowing to purchase the asset results in the lowest net after-tax cost to the business, in this case. Note that this simple analysis has ignored other potential cost differences, such as savings achieved on motor vehicle expenses when hiring.


Revision

Assume your company is considering the acquisition of the following asset.

Equipment sought : Power tools

Purchase Price : $10,000

Expected use for asset: Four years

Expected salvage value: $1,000

Find the net after tax cost of buying this asset. Use the loan repayments already given and a reducing balance depreciation rate of 40%. The calculations have already been made for year one in the cost schedule and depreciation schedule.

Buying (with borrowed funds) (Refer to page 75)

COST YEAR 1$

YEAR 2$

YEAR 3$

YEAR 4$

TOTALS$

Purchase on credit

Interest at 12% on opening yearly balance

2,500

1,200

2,500

900

2,500

600

2,500

300

Total outflowTax deduction on interest at 33%Tax deduction on depreciation - 40% of diminishing value x 33%

3,700 (396)

(1,320)

Adjusted outflow totals

Sales proceeds (4)

1,984

(1,000)

Cost of the vehicle over

Depreciation schedule - diminishing value method - 40%


$


$


$

ENDING BOOK VALUE

$

1 10,000 4,000 4,000 6,000234

TOTAL DEPRECIATION EXPENSE


TAXATION


TAXATION

In this unit, ‘Taxation’, we have provided a broad outline of Australia’s income tax system. We discuss how income tax is imposed, what constitutes assessable income and how business/work-related expenses may be claimed as allowable deductions.

We will also mention the self-assessment scheme of processing tax returns, the need for substantiation of business/work-related expenses, and desk audits conducted by the Australian Taxation Office (referred to in these notes as ATO).

In this topic we will also briefly cover a number of taxation areas, including:

Goods and Services Tax (GST) Pay-As-You-Go system (PAYG) Personal Services Income Tax Fringe Benefits Tax (FBT) Capital Gains Tax (CGT) Payroll tax Land tax

It is not possible in this one unit to cover all aspects of these topics. Consequently, it is important that you recognise the need for you to obtain additional information from the ATO on the matters that affect you as an individual taxpayer.

For example, you may be an employee, concerned mainly with assessable income and work-related expenses; or you may be an employer, concerned with pay-as-you-go tax and the business activity statement, the goods and services tax, and /or fringe benefits tax.

The ATO has a wide range of information sheets and brochures on all of these topics. You should obtain the brochures that have a direct relationship to your own employment or business situation, or visit their web site at www.ato.gov.au or www.taxreform.ato.gov.au.

Information sheets, schedules and/or brochures on taxation matters can be obtained from Taxation Offices or Government Bookshops in all capital cities. In smaller towns your local accountant or tax agent will be able to advise you on taxation matters and tell you where you can obtain relevant taxation information sheets and brochures.

Finally, the Tax Pack, issued each year by the ATO, contains a wealth of information on taxation matters. If you are going into business for the first time, don’t hesitate to seek professional advice from a chartered accountant, a certified practising accountant or a well-qualified tax agent about the most appropriate form of business organisation - sole trader, partnership or company. Many business people see companies as a status symbol but as we saw in topic 2: Business Finance, the decision to incorporate should be taken only after investigation into tax implications and other costs.

The ATO also offers a free advisory service to businesses to help them convert to the New Tax System.


http://www.ato.gov.au/

The New Tax System

As you would know, a New Tax System was introduced on 1 July 2000. The most significant elements of this system were the introduction of a broad-based goods and services tax (GST), the abolition of a range of existing taxes and substantial reductions in personal income tax rates.

The GST is a general tax of 10% on the supply of most goods and services consumed in Australia. The implications of this to business was an increase in the cost of raw materials and other inputs to the business and a requirement to charge 10% GST on all their supplies of goods and services (with some exclusions). In effect, businesses collect a 10% GST from their customers to be paid to the Australian Tax Office (ATO). The GST they pay to conduct their business can be claimed back as a refund or Input Tax Credit from the ATO.

The final consumer cannot claim an input tax credit and therefore is the ultimate payer of this tax. A reduction in personal income tax was applied to offset the increased cost of goods and services.

A new form called a Business Activity Statement (BAS) is used to report most tax entitlements and obligations for business. All businesses also need to register for an Australian Business Number (ABN) to identify themselves for all dealings with the ATO. A new system called Pay As You Go (PAYG) is used for reporting and paying instalments of a business’s tax liability. A somewhat controversial new tax has been introduced applying to income earned from providing personal services. This new tax affects mainly consultants and contractors, and therefore is particularly relevant to the building industry. A range of other measures has been announced including a Simplified Tax System (STS) for small business. The three main components of this system are cash accounting (instead of accrual accounting), a simplified depreciation system and simplified trading stock rules.

Glossary

ABN Australian Business Number. Identification required for all businesses for any dealings with government departments.

Allowable deduction A deduction allowed under the Act.

Assessable income All the amounts which, under the provisions of the Act, are included in the assessable income.

ATO Australian Taxation Office (also referred to in these notes as Taxation Office or Tax Office).

BAS Business Activity Statement; a form on which business income and taxes is reported to the ATO.

Capital Gains Tax Tax on the gain resulting from the disposal of an asset.

Commissioner The Commissioner of Taxation.

Fringe Benefits Tax Tax payable on a non-salary benefit provided to an employee.


GST Goods and Services Tax; a 10% broad-based tax on the supply of most goods and services consumed within Australia.

IAS Instalment Activity Statement; a form on which business income and taxes is reported to the ATO for businesses that are not required to register for GST.

Medicare Levy A 1.5 % levy on your taxable income, with an additional 1% for high income earners without private health insurance.

Pay As You Go A system whereby business tax liabilities are paid by Instalments to the ATO

Pay As You Go An instalment system where an employer deducts tax from Withholding the gross salary and wages of employees and forwards this tax to the Tax Office.

Personal Services Income Income derived from providing personal services that is through your personal skills or effort; usually affects consultants and other contractors.

Provisional Tax A tax payable on all non wage/salary income that was abolished with the introduction of the New Tax System, but is now incorporated into the PAYG system.

Rebate/ Offset A rebate or reduction of tax payable (eg a confessional rebate allowed for a dependent).

Sales Tax A tax on goods imported or manufactured in Australia; this tax was abolished with the introduction of the GST.

Superannuation Guarantee A charge applied to businesses that do not make sufficient superannuation provisions for their employees.

Tax Pack The current Tax Pack issued by the Australian Tax Office.

Taxable income Assessable income less allowable deductions.

The Act The Income Tax Assessment Act.

The Rates Act The Income Tax Rates Act.


Objectives

When you have finished this unit, you should be able to:

1. Explain the meaning of various terms used in the preparation and submission of income tax return forms;

2. State the method of substantiation of information submitted to the Australian Taxation Office;

3. Define the terms assessable income, allowable deductions and taxable income, instalment rate, effective life of an asset;

4. List the essential records for the Australian Taxation Office which must be maintained by a building contractor;

5. Name the areas of tax which affect contractors in the building industry;

6. Describe how the goods and services tax affects individuals and companies;

7. Detail the system of Pay-As-You-Go (PAYG) withholding tax and tax instalments;

8. Detail the records needed for the completion of a Business Activity Statement (BAS);

9. Outline the new laws applying to personal services income;

10. Detail how Fringe Benefits Tax (FBT) is calculated and to which benefits it applies;

11. Nominate when Capital Gains Tax (CGT) is payable and how it is calculated;

12. Nominate when Payroll tax is applicable and how it is collected;

13. Nominate when Land tax is applicable and how it is assessed and collected.

How income tax is imposed

The Commonwealth is the sole income taxing authority in Australia, with the Commonwealth Parliament deriving its power to impose income tax from various sections in the Constitution.

The Australian taxing laws (other than those relating to customs and excise) are administered by the Commissioner of Taxation, whose office is in Canberra. The day-to-day work of administering the legislation is carried on by the local taxation offices situated in each state. Each of these offices is headed by a Deputy Commissioner. This structure is represented in the following diagram.

The Commonwealth parliament legislates on income tax mattersThe Parliament delegates its power to the Commissioner of taxation (in Canberra) who inturns delegates power to Deputy Commissioner in each state


Who pays tax?

Income tax is levied on individuals, companies, superannuation funds and certain other entities, but not on partnerships. So far as partnerships are concerned, the profits (or losses) are shared by the partners according to their agreed profit-sharing ratios; the partners are then assessed as individuals for income tax purposes.

Section 17 of the Income Tax Assessment Act outlines the scheme of the Act. It provides basically that:

“income tax at the rates declared by the Parliament is levied and shall be paid for each financial year, upon the taxable income derived during the year of income by any person, whether a resident or a non-resident.”

(Note: The word ‘person’ includes companies)

Components of taxable income

The plan or pattern of an income tax assessment emerges from the definitions taxable income and its relevant components - assessable income and allowable deductions. Allowable deductions are now also called specific or general deductions.

The resulting calculation is:

ASSESSABLE INCOME LESS ALLOWABLE DEDUCTIONS = TAXABLE INCOME

Following are some definitions and examples of assessable income and allowable deductions:

Assessable income

This includes all amounts that the provisions of the Act characterise as assessable income. Virtually all income becomes assessable income. Some examples of exempt income are also shown.

Examples (for an individual) could be: wages and salaries, director’s fees, bonuses received, interest on investments or deposits, dividends received and rents received


INCOME TAX is a tax

imposed on

INDIVIDUALS deriving income

COMPANIES deriving income

TRUSTEES on income

derived from trusts

Exempt income

Examples of income deemed to be exempt by the commissioner include: gifts and bequests, gambling and lottery wins, some social security benefits, and child support payments

Allowable deductions

These are deductions or amounts that are allowable as deductions under the Act. Examples (for an individual) include : union fees, costs of trade or technical journals, cost of replacing or repairing tools of trade, protective clothing, other expenses necessarily incurred in earning income

Taxable income

This is the amount remaining after deducting from the assessable income all allowable deductions. For an individual, income tax is levied on the taxable income calculated.

Calculation of tax payable

The amount of tax payable on the taxable income is determined by applying the relevant rates set out in the Income Tax Rates Act to that taxable income, and then deducting any rebates of tax (eg for dependants) and any other credits allowed.

Note: The Income Tax Rates Act provides a tax ‘ceiling’ or ‘tax free threshold’ (for an individual taxpayer) under which no tax is payable. This tax-free ceiling is reviewed each year. At the time of writing, the tax ceiling is $6,000 (i.e. the first $6,000 of taxable income is tax-free). This is reflected in the following table which shows the current marginal tax rates.Tax rates 2010–11Taxable income Tax on this income0 – $6,000 Nil

$6,001 – $37,000 15c for each $1 over $6,000

$37,001 – $80,000 $4,650 plus 30c for each $1 over $37,000

$80,001 – $180,000 $17,550 plus 37c for each $1 over $80,000

$180,001 and over $54,550 plus 45c for each $1 over $180,000

The following example shows how table 1.2 is used to calculate income tax payable for a sole trader with an assessable income of $100,000 and allowable deductions of $60,000.

Example 1 Assessable income $100,000less Allowable deductions $ 60,000

Taxable income = $ 40,000Income tax bracket = $37,001 to $80,000

Tax on $37,001 = $4,650 Tax on remaining $2,999 x 0.3 = $899.70

Income Tax Payable = $5,549.70The individual in this example is paying tax at a marginal tax rate of 30%.

Note also that $5,549.70 tax on a $40,000 income represents an effective tax rate of 13.874% (i.e. $5,549.70 $40,000).


Medicare levy

The Medicare Levy Act 1986 allows the Commonwealth Government to impose a levy for Medicare on individual taxpayers each year. Currently (at July 2001) the rate is 1.5%f of taxable income. The levy is added to the income tax payable in calculating total tax payable. High income earners (individuals earning more than $50,000) without private patient hospital cover pay an extra 1% levy.

A taxpayer may be entitled to claim a Medicare reduction or exemption, as described in the Tax Pack (eg if your taxable income is less that around $13,000).

The Medicare levy is not included in the personal tax scales; it must be calculated separately and is shown separately on your assessment notice. Employees have the levy taken out with income tax from their pay packet each week, as per the tax instalment schedules issued by the ATO.

Example 2

A resident taxpayer received wages totalling $35,000 during the current year ended 30 June 2006. There were no allowable deductions, but the taxpayer had an entitlement to a rebate of tax totalling $1,080 for contributing to the maintenance of a dependant during the whole year.

Assuming that the gross tax payable on assessable income was $6,880, calculate the tax payable, including Medicare levy.

Gross tax on assessable income $6,880.00Less: Rebate of tax $1,080.00

Net tax payable $5,800.00

Add: Medicare levy(1.5% x taxable income $35,000) $525.00

Total tax payable $6,325.00

Commissioner’s assessment

To make an assessment on the tax payable by each individual, the Commissioner requires each taxpayer, soon after the close of each financial year, to lodge an income tax return showing the assessable income and allowable deductions relating to the year of income. The Commissioner issues a number of forms (including the annual Tax Pack) for the income tax returns. (You should obtain samples of these forms which are relevant to your business from the nearest ATO).

Having made an assessment, the Commissioner will issue a notice of assessment for the year ended 30 June (or substituted accounting period). This assessment will show:

1. Your taxable income for the year2. Tax on taxable income 3. Medicare levy4. A credit for any provisional tax previously paid 5. Rebates and other credits6. Balance of assessment (payable/refundable)7. Due date of payment.


Complementary to the issue of a notice of assessment, are sections in the Act which provide the Commissioner with the machinery for the collection of taxes.

Under the Freedom of Information Act, a taxpayer can see his or her return and other documents used by the ATO to assess the return or to make decisions about that tax payable. The ATO may make a charge to cover the time and expense involved in finding the information that the taxpayer wants.

A taxpayer dissatisfied with an assessment may lodge an objection within 60 days after issue of the assessment. The Commissioner determines the objection and then notifies the taxpayer of the decision.

A taxpayer dissatisfied with the Commissioner’s decision on the objections may, within 60 days of service of the decision, take one of these two steps:

request a reference to the Administrative Appeals Tribunal;

request the Commissioner to refer the decision on the objection to the Federal Court.

Now attempt the following question,

John Boag is a third year apprentice carpenter employed by Ace Builders Pty Ltd. His wages for the year ended 30 June, 2001 totalled $20,190. His only other income was interest received on a savings account of $242.

Allowable deductions were $35 (union fees) and $85 (replacement of essential tools of trade). He is married and is entitled to a spouse rebate of $1,188.For this question, use the personal tax rates and Medicare levy provided in this topic.

Required

(a) Calculate John Boag’s taxable income.

(b) Calculate the net tax payable on that taxable income.

(c) Calculate the total tax payable, including Medicare levy.

Tax audits

With the increasing reliance by the Taxation Office on the self-assessment system, there has been a corresponding increase in the incidence of income tax audits.

Under the self-assessment system the Taxation Office initially accepts the information given in a tax return to be true and correct. An individual taxpayer’s return is not generally examined before the Tax Office assesses how much tax is to be paid, or what the refund will be. But after the notice of assessment is sent out, the Tax Office continues to check by way of a desk audit for incorrect or missing information. During a desk audit, the auditor will check claims for work expenses as well as taxable income items.

The Act also allows the Commissioner to conduct a much more formal examination and audit of a taxpayer’s affairs.


Section 263(1) of the Act entitles ‘the Commissioner or his representative to full and free access to all buildings, places, books, documents and other papers for any purpose of the Act ....’

Section 263(3) places an obligation on the taxpayer to ‘provide the officer with reasonable facilities and assistance as well as advising of the location of relevant documents’.

Points commonly examined

For individuals

cash income, understatement of income, purpose of expenditures, fringe benefitsbusiness and personal records, bank credit, and loan accounts of taxpayer and family.

For sole traders, partnerships and companies

Stock

valuation and stock-taking procedures.

Assets

usage and rates of depreciationuse of motor vehicles including mileage claims etc.

Profit and loss

Receipt and treatment of income, cash receipts and accruals, bad debts, superannuation, deductions, subscriptions, travel expenses, payments to sub-contractors, management fees and royalties.

PAYG Withholding tax system

Sighting of exemption and deduction certificates, dates of certificates, whether payments have been made by the due dates and forms filled in correctly.

Fringe benefits tax

examination of employment contracts, provision of fringe benefits to shareholders, beneficiaries or contractors, examination of records kept and the calculation of taxable value of the benefits, number of motor vehicles, log books and odometer readingsexistence of loans to employees, directors and associates, reimbursement of employee expenses, provision of accommodation.


Audit procedures

There are three steps in a formal tax audit:

1 A preliminary conference at which the officer will seek to understand the operations and the financial dealings of the taxpayer and obtain information regarding the nature and structure of the business;

2 The investigation carried out by the officer;

3 A concluding conference to determine the extent of any adjustments to be made to the taxpayer’s return, and the imposition of penalties (if appropriate).

Summary

The ATO says that every taxpayer will, at some point of time, be subjected to a desk audit or possibly a more formal tax audit. This again reinforces the need for every taxpayer to keep proper records.

Records relating to car and travel expenses should be kept for seven years. Records relating to the income and expenditure of a business and all records relating to any expenses incurred in producing that income should be kept for five years.

If you are advised by the ATO that your tax affairs are to be audited, it would be sensible to have your accountant or tax agent present at both the preliminary and concluding conferences.

Assessable income and allowable deductions

Assessable income

The relevant section of the Income Tax Assessment Act states:

“In calculating the taxable income of a taxpayer, the total assessable Income derived .during the year of income shall be taken as a basis and from it there shall be deducted all allowable deductions.”

Thus the first step in calculating the taxable income of a taxpayer is to determine the total assessable income derived in the year of income.

What constitutes assessable income?

The Act defines assessable income as:

“all the amounts which under the provisions of the Act are included in assessable income”

This definition is not particularly helpful and we need to go to other sections of the Act for further amplification. Section 25 lays down the general principles for determining what shall be classified as assessable income. It speaks of the gross income derived by:

persons who are resident - from all sourcespersons who are non-resident - from sources in Australia only,


Gross income

The Act does not define income - however the term has been interpreted by the courts as that which, in general parlance, everyone understands to be income: for example, wages or salaries, commissions, directors’ fees, bonuses allowable, dividends, interest and rents received.

The income of a building contractor would include revenue received from building contracts; sales of houses or buildings; income from renovations, alterations and/or repairs.

Since the Act refers to ‘income derived ... during the year of income ...’ it is important to consider the word derived. In the context of Section 25 of the Act, ‘derived’ means ‘obtained’. Wages and salaries are normally derived when received. Where, however, they are credited to an employee in the employer’s books, and the money is available when the employee requires it, it is deemed to be ‘derived’ at the time it is credited.

Classes of income

In summary, assessable income may be classified as:

income from personal exertion (all business income and personal earnings); income from dividends; other income - for example, rents, royalties, interest (all of which are, under the definition, deemed to be income from property).

General or specific (allowable) deductions

Section 51 of the Act sets out the general principles for the allowance of deductions. This section says:

“All losses and outgoings to the extent to which they are incurred in gaining or producing the assessable income, or are necessarily incurred in carrying on a business for the purpose of gaining or producing such income, shall be allowable deductions except to the extent to which they are losses or outgoings of capital, or of a capital, private or domestic nature, or are incurred in relation to gaining of exempt income.”

For an individual taxpayer the following could be allowable deductions (but only if they were necessarily incurred in gaining assessable income):

subscriptions paid to unions, business or professional associations;tools of trade; uniforms and protective clothing; home laundry work-related expenses;technical journals; self-education expenses (if directly related to employment); sickness or accident insurance; superannuation contributions; certain car expenses.

Note: Special conditions apply to the allowable deductions for superannuation contributions and for car expenses - refer to the Tax Pack for further information.

Business deductions

In a business, there will be a wide range of expenses necessarily incurred in earning assessable income for a building contractor. Some of these would be:


Manufacturing and workshop expenses

Purchases - raw materials, purchases -indirect materials, freight inwards, wages, rent, power, light and fuel, repairs and maintenance, sub-contracting - labour and materials.

Marketing and selling expenses

Advertising, commissions paid, freight outward, travel and allowances.

General administrative expenses

office salaries, printing, stationery and supplies, postage and telephone, motor vehicle expenses, depreciation, insurance, computer servicing and supplies, uniforms and protective clothing, accounting and audit fees, interest and bank charges.

Because of the wide range of expenses involved in a business, it is particularly important that adequate accounting records be maintained. This of course applies to income as well as to expenditure items.

Accounting records and all vouchers (for example, invoices, wages records, receipts and expenditure vouchers) should be kept for a period of five years. These records and vouchers are necessary to substantiate the income and expenditure should the Taxation Office conduct a desk audit of your income tax return(s).

Non-allowable deductions

The Act contains provisions that have the effect of denying a deduction for certain expenditures. These are:losses or outgoings of capital (i.e. capital expenditures);outgoings of a capital, private or domestic nature (eg normal travel from home to work and return, living expenses, household insurance, motor vehicles insurance and related expenses - except to the extent to which the vehicle is used for income-producing purposes); outgoings incurred in relation to the gaining of exempt income.

Capital expenditure

So, losses or outgoings of capital, or of a capital, private or domestic nature, are not allowable deductions. In most cases there is no difficulty in distinguishing between capital and revenue expenditure, for example, the cost of purchasing a building is clearly capital expenditure. On the other hand, amounts paid for rent of premises is revenue expenditure. The cost of alterations or additions which increase the useful life of assets is a capital expenditure, while the cost of repairs is revenue expenditure. However, there are many instances where the dividing line between capital and revenue expenditure is often difficult to distinguish.

The Act does not define capital or outgoings of a capital nature, and it has often been left to the courts to determine what expenditure of a capital nature is. An accepted meaning of capital expenditure is ‘the acquisition, establishment, addition to, alteration or improvement to the income-producing structure. The following diagram provides a summary of the relevant section of the Act concerning allowable deductions.


Now attempt the following question,

State whether or not the following expenditures are allowable deductions and give reasons for your conclusions:

(a) cost of purchasing trading stock;

(b) costs of purchasing new plant;

(c) expenses of travelling overseas to purchase new plant;

(d) salary of a housekeeper employed by a person who conducts a business which demands his or her attention in the city during the day;

(e) cost of moving trading stock from old premises to new premises;

(f) legal expenses incurred in connection with the collection of book debts;

(g) amounts paid to a builder for major alterations to the taxpayer’s business premises.


Expenditure incurred in deriving assessable

income

Expenditure necessarily incurred in carrying on business to

produce assessable income

Expenditure of a capital nature

Private or domestic expenditure

Expenditure incurred in deriving exempt in-

come

Allowable deductions

Non-allowable deductions

Expenses incurred

Substantiation of expenses

We should mention here that as part of the taxation process the Act contains rules for the substantiation of employment-related expenses of employees, and car and travel expense claims by employees and self-employed persons.

Substantiation means that a taxpayer must prove his or her claim for a deduction to the satisfaction of the Commission - usually a receipt or some other documentary evidence showing the nature and amount will be required.Your Tax Pack gives specific details of the substantiation records to support travel expenses and car expenses. A taxpayer must also be able to substantiate work-related expenses such as expenditure on uniforms, protective clothing, tools of trade, technical and trade journals, and tertiary studies.

Note that the ‘onus of proof’ lies with the taxpayer and failure to substantiate (prove) an expense may result in that expense being disallowed by the Commissioner as an allowable deduction. This again reinforces the point that proper accounting and other records must be kept.

Records relating to car and travel expenses should be kept for seven years. Records relating to the income and expenditure of a business and all other records relating to an expense for producing income should be kept for five years.

There are some exceptions to the rules on substantiation. They do not generally apply if a taxpayer’s total work expenses for the year, including car and travel expense, add up to $300 or less (subject to certain conditions).

Finally on the topic of substantiation, while the rules on proving claims are clearly aimed at work-related expenses, records supported by adequate documentation applies equally to income transactions.

Revision Questions

Q1 List five particular expenses which might be included under the heading ‘Travel expenses’ and state the substantiation requirements of the ATO.

Q2. You are in business as a furniture manufacturer and you use your private car in the business. The method that you have chosen to work out your claim for car expenses is the ‘set rate per kilometre’ method., What records do you need to keep to substantiate your claim? Are there any conditions or limitations on the use of this method?

Depreciation

It has been mentioned earlier in these notes (under the heading of ‘Non-allowable deductions’) that expenditure on certain items, such as the purchase of plant and equipment, motor vehicles, furniture and so on, is expenditure of a capital nature, and is thus not allowable as a deduction. The Act does however allow a deduction for depreciation on such assets if, during the year of income, the plant or articles were used to produce assessable income or were installed ready for the use for that purpose.

There is no statutory definition of plant or articles but the terms clearly apply to non-current (fixed) assets whose function is to produce assessable income. Examples are equipment, machinery, motor vehicles, furniture and fittings.


The term does not include buildings (except in the case of primary producers who are entitled to depreciation on certain structural improvements).

Computer software is also a depreciable expense if it was purchased on or after 11 May 1998. From 21 September 1999, expenditure on acquiring the right to use an international communications submarine cable system is also depreciable. There are variations to the normal provisions for depreciation for these items. You should contact the ATO if you need more information on either of these items for depreciation expenses.


Methods of calculating depreciation

There are two methods of calculating depreciation, as seen in topic 6; they are:

the prime cost method

the diminishing value method.

Prime cost depreciation method

A builder owns a motor vehicle which is used exclusively for business purposes. The vehicle cost $16,000 on 1 July, and its effective life is estimated to be 8 years. The rate of depreciation allowed under the Act for a vehicle with an effective life of between 6 2/3 to less than 10 years is 15% pa. and the builder has made an election to depreciate under the prime cost method. Show the depreciation calculations for the first three years.

Solution

Prime Cost DepreciationCost $16,000.00Year Depreciation Amount Value2003 15% $2,400.00 $13,600.002004 15% $2,400.00 $11,200.002005 15% $2,400.00 $8,800.002006 15% $2,400.00 $6,400.00

Note: If the vehicle was purchased on 1 January of year one, the depreciation expense for the first year would be:

Example 4 Diminishing value depreciation method = (1.5xPrime cost depreciation)

Using the same data as in the previous example, but this time the builder has made no election as to depreciation, hence the diminishing value method will apply.

Diminishing Value methodCost $16,000 ValueYear2003 22.50% $3,600.00 $12,400.002004 22.50% $2,790.00 $9,610.002005 22.50% $2,162.25 $7,447.752006 22.50% $1,675.74 $5,772.01


What the Commissioner will allow

Before a taxpayer (or the taxpayer’s accountant) decides on the rates of depreciation for various assets for accounting purposes, they should give consideration to the rates that the Commissioner will allow.

Depreciation rates provided by the Commissioner are determined with reference to the effective life of the asset. The effective life is an estimate of the length of time that an asset can be expected to be productive given that it is maintained and kept in good condition. If an asset was purchased second-hand before 21 September 1999, the effective life is estimated assuming that it was new. The longer the effective life of an item, the lower its depreciation rate. For assets acquired after 21 September 1999, the prime cost percentage is 100 divided by effective life and the diminishing value percentage is 150 divided by effective life. For example, an asset with an estimated effective life of 20 years has a basic rate of depreciation of 5%. The diminishing value rate would be 7.5%. If the effective life was 10 years, the basic rate of depreciation is 10%. The diminishing value rate would be 15%.

For simplicity, most small businesses tend to adopt, for accounting purposes, the same rates of depreciation as the Commissioner will allow, however you can adopt your own rates, so long as you can justify the rate you have chosen. Note that certain small business taxpayers are able to apply an accelerated depreciation, and will retain this method under the Simplified Tax System.

Note that taxpayers, in adopting the Commissioner’s rates, still have the choice of deciding on the diminishing value method or, if they elect to do so, on the prime cost method.

Summary

The depreciation provisions of the Act are quite complex. There are many matters such as accelerated depreciation for plant acquired before 26 February 1992 (for small business only), acquisition of depreciated property, profit or loss on disposal of depreciated assets and other matters, which are beyond the scope of this unit.

Taxpayers setting up in business for the first time would be well advised to seek professional advice from their accountant or tax agent on the question of depreciation and taxation.

You should also obtain from the Taxation Office (or Government Bookshop) the latest publication on depreciation rates, plus any other publication on this topic.

Calculate the deduction for depreciation in respect of each of the following transactions affected in the income year ended 30 June 2005:

new equipment purchased 1 October for $15,000, with an effective life of 10 years

second-hand equipment purchased 1 December for $5,000. The equipment if new would be deemed to have an effective life of 20 years

in each case the plant was used to produce assessable income from the date of purchase

The taxpayer has not elected to use any particular method of depreciation.

How would your calculations vary if the taxpayer had elected to use the prime cost method?


Taxes and payments

In this part of the unit we will look at a number of taxation areas and summarise the main provisions of the Act concerning the assessment and recovery of tax for each of them.

The topics we will look at are:

Goods and Services Tax Pay-As-You-Go instalments (PAYG) Pay-As-You-Go withholding tax (PAYG) Personal Services Income Tax Fringe Benefits Tax (FBT) Capital Gains Tax indirect taxes; Payroll tax Land tax.

The following pages contain information about who is affected by these taxes, which is responsible for remittance (payment) of the tax, and the basis upon which the tax is calculated. More detailed information about any of these taxes can be obtained from the ATO.

Goods and Services Tax (GST)This tax was introduced on 1 July 2000 as part of the New Tax System and applies to the supply of most goods and services consumed in Australia. The major exceptions are: basic food items, educational services, health services, exports, and the sale of a business as a going concern, water, sewerage and drainage

At the same time, Wholesale Sales Tax and some other indirect taxes were abolished.A business is not obliged to register for GST unless its annual turnover is $75, 000 or more. If a business does not register, then it can not charge GST to its customers and it can also not claim back the GST it pays on any of its own business costs. Other registered businesses may choose not to purchase goods and services from unregistered businesses since they cannot claim GST credits on these goods. It might depend on whether the price is cheaper than competitor’s prices minus GST.

However, businesses with an annual turnover of $75, 000 or more must register. All businesses must also register for an Australian Business Number (ABN). This number will not replace the tax file number but it will eventually replace the Australian Company Number or Australian Registered Body Number. The ABN is an identification number for dealings with the ATO and other government departments.

How the GST works

As stated earlier, it is the ultimate consumer of goods or services who incurs the cost of GST. However, the liability to pay the GST rests with the supplier. In other words, the supplier adds the value of the GST (10% of the cost price) to the final cost that the customer pays. The supplier is then obliged to pay this amount to the ATO. Note that businesses also consume goods and services and will pay GST on these. If these goods and services are acquired for business purposes, then the GST paid on them can be claimed back from the ATO (or offset against the GST obtained from goods and services supplied). Let’s demonstrate this with an example.


Example

XYZ Building Supplies sells building materials to Bob the builder for $16,500. Note that $1,500 of this price is GST.Bob charges Debbie the developer $15,000 for the materials and $6,000 for labour plus $2,100 GST, a total invoice cost of $23,100.Debbie sells the finished house to Howard the homemaker for $143,000 (this price includes GST of $13,000).The table below outlines the path of all these goods, services and the GST.

XYZ Building Supplies pays the $1,500 GST to the ATO.

Bob must pay $2,100 to the ATO, but is able to claim back $1 500 in GST that he paid on goods that he bought for his business.

Debbie must pay $13 000 in GST to the tax office for the sale of the house. However, she is also able to claim back $2 100 of GST that she paid on goods and services that she acquired to build the house. Her net GST liability is $13 000 - $2 100 = $10 900.

Howard, the final consumer, has paid $13 000 in GST. He cannot claim any of this back. Bob, Debbie and XYZ Building Supplies are each responsible for paying a part of this to the ATO.

Note that although Howard paid the GST on the final product, the other parties were responsible for submitting this money to the tax office. Also, notice that to calculate the amount of GST in the price of an item, we must divide by 11.Therefore .The cost of the house was $143 000, the GST included in this is $143,000 is

1/11 which is $13,000

There are some new terms associated with the GST that it would be useful to introduce now:

Acquisitions – these are inputs or goods and services required to carry on a business

Supplies – are business outputs, including sales

Input tax credit – the amount a business can claim from the ATO for any GST included in the price of its acquisitions

Supplies can be taxable, input taxed or GST-free. Taxable supplies are those on which GST is payable by the consumer. GST-free supplies include all those items listed as exempt from GST. Input tax credits can still be claimed on business costs incurred in supplying the GST-free goods. If a transaction is input taxed, it means that GST cannot be added to the supply. However, neither can input tax credits be claimed for costs incurred in providing this supply.


To summarise –

GST taxable GST free GST input taxed

GST paid on supplies no GST payable on supplies

no GST payable on supplies

claim input tax crediton acquisitions made

to provide supply

claim input tax crediton acquisitions made

to provide supply

no claim for input tax credits

allowable

eg. most goods and services

eg. exported goods eg. provision of residential rental property,

most financial supplies

A claim for an input tax credit must be backed up with a tax invoice. The tax invoice must include the following information1. The ABN of the supplier

2. The GST-inclusive price of the supply

3. The words ‘Tax Invoice’

4. The date of issue

5. The name of the supplier

6. A brief description of the items supplied

7. When the GST payable is exactly 1/11th of the total price, either a statement along the lines of ‘the total price includes GST’ or the actual GST amount.

GST liability is reported on the Business Activity Statement. For a business with an annual turnover of up to $20 million, there is an obligation to submit the BAS, with the GST reported and paid, quarterly. However, a business may elect to lodge monthly. Businesses turning over more than $20 million annually must report their GST monthly. There are changes currently being considered to allow yearly reporting for businesses with a turnover of less than $2 million.

A business supplies goods and services to a total value of $21 893 for the previous month. Of this, $5 231 is made up of GST-free and input taxed supplies and sales.

The business acquisitions for the same month totalled $9 074, $244 of this being acquisitions with no GST in the price.


You are required to calculate the amount of GST to be paid for the month

Total value of supplies $21,893.00Supplies with no GST $5,231.00Total supplies with GST included $16,662.00

Total cost of acquisitions $9,074.00Acquisitions for which no GST paid $244.00Total cost of acquisitions with GST $8,830.00

GST supplied on goods and service$16662/11 $1,514.73GST paid on acquisitions $ 8830/11 $802.73

GST payable to ATO $712.00

Pay-as-you-go taxation (PAYG)

PAYG is a system for reporting and paying1. tax on business and investment income (called PAYG instalments), and2. amounts withheld from employee and other payments (PAYG withholding)

PAYG instalments replace the company and superannuation fund instalment system and the provisional tax systems. A business will pay its expected tax liability on all its income for the current year by PAYG instalments. The figure will be calculated using an instalment rate that has been calculated by the ATO for individual businesses, based on previous income.

PAYG instalments will generally be calculated using this formula:

instalment income x instalment rate = PAYG instalment

Instalment income includes:all sales (with no deductions for expenses), plus, interest received, plus, gross rent earned, plus, dividends received, plus, partnership income, income from trusts, and royalties.

PAYG withholding refers to the tax that a company withholds on behalf of its employees. This includes taxes payable on salary and wages, payments such as retirement and termination payments, annuities, compensation and other benefits, and, payments to company directors and office holders.

Pay-as-you-go instalments

Unlike the previous systems of paying tax instalments, PAYG instalments are paid on the income actually earned during each quarter, not on income projections. There is still an annual income tax return, and PAYG instalments made during the year are credited to the annual assessment.


The ATO will calculate an instalment rate based on the latest income tax assessment received. The rate is calculated as a percentage based on the tax payable on that income tax assessment in relation to the ordinary assessable income in that tax return. The rate is calculated to 2 decimal places.

Example

A sole trader had ordinary assessable income before deductions of $230,000 for the tax year 2005/2006. After deductions, and allowing for the new lower tax rates under the New Tax System, his notional tax for that year was $8,700.

The initial instalment rate as advised by the ATO would be

8,700 x 100 = 3.78% 230,000 1

It is possible to use a different rate from that advised by the ATO. Application can be made with reasons for the adjustment. However, if the varied rate results in payment of tax that is less than 85% of the actual liability, a General Interest Charge may be applied.

The General Interest Charge (GIC) is payable on the debit balance at the rate of the Treasury Note yield plus 8%, calculated daily. This rate changes quarterly. It was 13.86% for the October-December 2000 quarter. The GIC is also charged for late payment of taxes.

PAYG instalments are payable quarterly and are included on the Business Activity Statement or Instalment Activity Statement.

Business Activity Statement and Instalment Activity Statement

At the end of each tax period, which may be monthly or quarterly, every business must lodge an activity statement to the ATO. All businesses that should be registered for GST will use a Business Activity Statement, or BAS, to report GST and other tax entitlements and obligations. Those businesses that are not required to register for GST will report tax entitlements and obligations on an Instalment Activity Statement, or IAS.

A BAS is a 2-page form. It has sections for filling in amounts relating to:

1. GST owing and GST input tax credits,2. Other taxes including fringe benefits tax (FBT), wine equalisation tax and luxury car

tax,3. PAYG instalments,4. PAYG withholding,5. Deferred company and fund instalments for 1999-2000, and6. Any wholesale sales tax paid on stock on hand at 30 June 2000.

Note that an annual income tax return must still be lodged. The IAS is also a 2-page form but it has fewer sections to be completed.

When the New Tax System was introduced, the frequency of lodgement of Activity Statements was determined on the size and nature of the business as follows:

Monthly: On GST payments if the annual business turnover was $20 million or more; and, on PAYG withholding, if the annual business withholding obligations were $25,001 to $1 million.


Quarterly: On GST, if the annual business turnover was less than $20 million; on PAYG withholding where the annual business withholding obligations were up to $25,000; on PAYG instalments for all businesses (some businesses may be eligible for annual payments); for FBT instalments

Weekly: On PAYG withholding where the annual withholding obligations were more than $1million.

The monthly reports were due on the 21st of the month following the reported month, and the quarterly reports were due on November 11th, February 4th, April 28th and July 21st.

In March, 2001, the Government introduced further changes, intended to simplify the reporting procedures for GST and PAYG for small business. These changes applied to businesses that pay their GST and PAYG quarterly, as follows: for GST reporting,

Option 1: Keep reporting as previously, or

Option 2 All businesses with an annual turnover of less than $20 million need only report GST collected on sales, GST paid on purchases and total sales in their quarterly reports with the other GST information reported annually, or

Option 3: If annual turnover is less than $2 million, and two quarterly BAS forms have already been submitted for this tax year, then an instalment can be worked out by the Tax Office.

Businesses paying GST quarterly also now have more time to prepare and lodge their forms and to make payments to the Tax Office. The due dates for quarterly reports are now October 28th, February 28th, April 28th and July 28th.

For PAYG reporting,

Option 1: Continue as previously, or

Option 2: Let the Tax Office work out a PAYG instalment for you.


Pay-as-you-go withholding tax

The PAYG (withholding tax) system is the method by which wage and salary earners pay income tax and the Medicare levy. This system requires that the employer deduct tax from the gross pay of employees at prescribed rates and periodically forward these taxes to the Tax Office. All employers are required to deduct from the employees’ salaries or wages the amount prescribed by the rates Act. The term ‘salary or wages’ also includes bonuses, allowances, commission, unemployment or sickness benefits, eligible termination payments, overtime and penalty payments, holiday and long service leave payments.


PAYG withholding tax is reported on the BAS and remitted to the ATO at regular intervals, depending on the withholding tax amount. For small withholders with annual withholdings of up to $25,000, PAYG withholding tax will be reported on the BAS (or IAS) quarterly. Medium withholders, with annual withholdings of more than $25,000 but less than $1m, must remit their withholding tax every month. If these businesses pay their GST liabilities quarterly, then they will receive a monthly activity statement, but they will only need to complete the PAYG withholding sections, until the quarterly statement, on which GST will also be reported. For withholding amounts of over $1m, PAYG withholding will need to be reported and remitted up to 9 times a month.

When an employee lodges a tax return at the end of the financial year, the ATO makes an adjustment between the tax payable on the income shown in that return and the tax deductions already made by the employer.

Instalment deduction schedules

PAYG schedules with explanatory notes, setting out the appropriate tax instalment deductions to be made from salaries or wages for the current income year are available from the Taxation Office and most newsagents. An electronic version is also available from the ATO website www.ato.gov.au

These schedules show weekly, fortnightly or monthly rates of instalments. Each schedule incorporates the effect of the Medicare levy. They show the tax instalment deductions applicable where the employee has not provided a tax file number and where one has been provided, deductions based on whether or not the employee is claiming the general exemption.

Tax File Number Declaration

Employees who wish to claim the general exemption from tax for the first $6,000 of taxable income must indicate this on the Tax File Number declaration form to be lodged with their employer. This form also makes provision for the employee to quote his or her tax file number. An employee can take advantage of the tax free threshold with only one employer.

Withholding Declaration

An employee may wish to apply for a reduced rate of tax based on their eligibility for a family tax benefit or personal rebate. They must indicate the value of the rebates they are entitled to on this form.

Duties of an employer

An employer must;

1. Obtain from each employee, a Tax File Number Declaration and if applicable, a Withholding Declaration,

2. Deduct the correct amount of tax based on the information provided on these forms and PAYG schedules,

3. Keep records of wages, other payments, fringe benefits for all employees,


http://www.ato.gov.au/

4. Complete the relevant section on the BAS (or IAS) and remit the appropriate amount to the ATO,

5. Issue a Payment Summary to every employee. At the end of the financial year, two copies of a PAYG Payment Summary must be issued to each employee. PAYG summaries have replaced the group certificates that were used before but contain similar information. The Payment Summary must be issued by 14 July each year.

6. Complete an annual report. This report is similar to the previous annual group tax reconciliation. It includes details of recipients of withholding payments, the total of withholding payments made, amounts withheld, amounts paid in respect of non-cash payments, and reportable fringe benefits paid during the financial year.

Summary

You can also obtain information brochures on the PAYG system from your nearest Taxation Office. Phone enquiries may be made on the national enquiry number: 13 28 66 (local call cost).

Revision

Q1. How does the employer know how much to deduct each week from the gross salary of an employee?

Q2. What are the employer’s responsibilities in relation to the issue of payment summaries to employees?

Q3. What are the employer’s responsibilities to the Taxation Office when reconciling deductions made from employees?

Q4. How does a sole trader know how much tax to pay as PAYG instalment tax?

Q5. How often does the BAS need to be completed for a small business with an annual turnover of $13m and a PAYG withholding tax amount of $26,000 per year?

Personal Services Income Tax

Another new tax measure was introduced on 1 July 2000. Its aim was to ensure that persons earning money through personal services, paid tax at a rate that is consistent with the rate paid by other income earners.

What is personal services income?

If your income is earned on the personal skills or services that you offer, then it is personal services income. Income that is derived mainly from the supply of goods or the supply of an income-producing asset is not personal services income. You would earn personal services income if you are a consultant, such as a consulting engineer, or a contractor, or if you provided labour or other skills under a contract.

However, if a contractor or consultant is a personal services business, then the personal services income legislation should not affect them. The criteria needed to qualify as a personal services business are determined by the following tests:


the employment test; do you employ others to do 20% of the work that you obtain, or do you employ an apprentice for half of the year?

the business premises test; do you have a completely separate premises in which you conduct your income-producing activities?

the unrelated clients test; do you have 2 or more clients that you obtained through offering your services to the public?

If you earned less than 80% of your personal services income from the one client (and associates of that client), and you fulfilled one of the tests for a personal services business, then the ATO would allow you to self-assess.

There is a Personal Services Income Self-Assessment Guide put out by the ATO.

However, if you earned 80% or more from the one client and associates of that client, then you are considered NOT to fulfil the requirements for a personal services business, and this new legislation applies to you! (Note that you can apply to have a determination of your situation by the Commissioner for taxation.)

What are the tax implications of earning personal services income?

Personal services income is taxed at the same rate as income earned by an employee, even if a company, partnership or trust (personal services entity) obtains the income. The deductions that are claimable by the entity are limited. That is, the allowable deductions are those that apply for personal earnings rather than for business earnings, unless the entity qualifies as a personal services business.

This tax has been in force since 1 July 2000. However, the new tax will not apply if you had a payee declaration under the old Prescribed Payment System (PPS), and it was lodged with the Tax Office prior to 13 April, 2000.

The personal services income tax legislation is currently under review following a significant registration of concern from various self-employed individuals to whom the new legislation would apply. There is the expectation of amendments and/or reviews of the current legislation in the near future. You should keep informed of any developments.

Fringe benefits tax (FBT)

The Fringe Benefits Tax Assessment Act 1986 provides for the assessment and collection of fringe benefits tax payable by employers. This tax is imposed on all employers who provide fringe benefits at a set rate by the Fringe Benefits Tax Act. The essence of the system is to impose a separate tax (FBT) on the employer, based on the value of fringe benefits received from employment.

Fringe benefits tax aims to impose a tax on all benefits other than salary and wages provided to employees. The crucial issue for consideration whenever a person receives a benefit is whether that benefit has been provided by the employer in respect of the employment of the recipient. Note that FBT does not apply to:

Payment of salary or wage

Employer contributions to complying superannuation funds

Eligible termination payments

Approved employee share acquisition schemes


The provisions of the Fringe Benefits Tax Assessment Act in general terms

1. Lays down specific rules for valuing the following main types of fringe benefits provided by employers to employees:

private use of a motor vehicle payment or reimbursement of private expenses free or subsidised residential accommodation living away from home payments remote area housing and travel car parking benefits concession fares for airline transport some other types of benefits (see the Tax Pack for details);

2. Specifies that the fringe benefits tax is an annual tax payable in respect of benefits provided in each year ended 31 March (that is, the fringe benefits tax year is 1 April to 31 March);

3. Requires employers to pay fringe benefits tax in four quarterly instalments;

4. Imposes an obligation on employers to calculate their annual liability for fringe benefits tax and remit the amount calculated (less the three instalments paid) to the Taxation Office with an annual fringe benefits tax return by 28 April each year;

5. Contains measures for assessment, collection and recovery of tax and afford the usual rights of objection and appeal.

Employers are required to keep records that identify and explain all transactions and acts that are relevant to establishing their liability to FBT.

Liability for fringe benefits tax

The liability to fringe benefits tax is put into a dollar amount by Section 5 of the Fringe Benefits Tax Act which imposes the tax.

The rate of tax for the year ended 31 March 2001 was 48.5 per cent.

If you are the director of your company, you are an employee of the company. Any fringe benefits you receive (such as the weekend use of the company vehicle) will also be subject to FBT. Once you start providing fringe benefits you must register with the ATO. FBT is a widely criticised tax (especially by employers) for its complexity as well as its perceived unfair treatment of employers.

Employers who are likely to be involved in the payment of this tax should obtain the following publications from the Australian Tax Office:

‘Fringe benefits tax - Does it apply to you?’‘Fringe Benefits Tax - A Guide for Employers’.Who is liable for this tax - the employer or the employee?

Capital Gains Tax (CGT)

Capital Gains Tax is charged on gains made on the sale of assets you acquired on or after 20 September 1985. A capital gain occurs when the price received upon sale of an asset is greater than the original cost of that asset. The cost may include incidental expenses of acquisition and disposal as well as capital improvement. Prior to 21 September 1999, if you owned the asset for more than 12 months you only payed tax on the ‘real’ (adjusted for


inflation) capital gain. Since this date, the legislation has changed the assessment of capital gains tax.

Assets include:

real estate (including land); some motor vehicles; the goodwill of a business; leases; shares in companies; units in unit trusts; some plant and equipment and Forfeited deposits you receive when a contract is not finalised may also be subject to CGT.

Assets usually exempt include:

your home motor vehicles (except those designed to carry more than 1 tonne); personal belongings (unless they cost more than $10,000); most superannuation policies; part of the capital gain on the goodwill of some business.

It is possible to make a capital loss on the sale of an asset

Calculating your capital gain

On 21 September 1999, the legislation regarding CGT (Capital Gains Tax) was amended and this changed how capital gains are calculated. This means that different rules apply to CGT assets owned before and after this date... There are two methods of calculating capital gains for assets owned prior to 21 September 1999. They are:

Frozen indexation of tax base, and CGT discount.

For assets acquired after 21 September 1999, only the CGT discount method may be used. Note that for CGT assets held for less than 12 months, neither of these can be used.

Frozen indexation of cost base

Before 21 September 1999, a taxpayer could index the cost of an asset held for more than 12 months to account for inflation. However, the capital gain on the disposal of an asset after this date can only be indexed up until 30 September 1999.

Example 8

Joe bought a unit as an investment in December 1995 for $150,000 and sold it in February 2001 for $250,000.

This represents a capital gain of $100,000. However, not this entire amount is taxable. The cost base that is the $150,000 initial cost can be indexed to take account of inflation.

The CPI average for the duration of the investment was 1.05 % so therefore $150,000 x 1.05% equals $157,500. The capital gain is $250,000 minus $157,500 leaves $92,500. So tax is payable on $92,500 not $100,000.

Note that other costs associated with the asset may be included in the original cost base to reduce the taxable gain. These may include:

costs incurred in acquiring the asset, such as stamp duty, legal fees, agent’s commission, etc.,


non-capital costs incurred in owning the asset eg. maintenance, loan interest, repairs, insurances, etc.,

cost of capital improvements, provided that the amount does not exceed a value specified by the ATO ($91,972 in 1999/2000), in which case this would be treated as a separate asset.

All of these additional costs, if they are allowed to be indexed, must be calculated separately, using the dates at which they are incurred. Only costs that are not allowable deductions elsewhere can be included in the cost base.

The net capital gain would be added to your other taxable income and the normal tax rates applied.

CGT Discount

A capital gain can now be discounted for tax purposes. If the asset was owned for more than 12 months by an individual (not a company), then only 50% of the capital gain is taxable. But no indexation of the cost base is applied.

To take our previous example:

Sale price - original cost = $250,000 - $150,000

= $100,000

after 50% discount, taxable gain = $50,000

In some cases, capital gains tax liability can be deferred, eg. when assets are transferred between spouses after a marriage breakdown and when beneficiaries dispose of assets that were acquired by the previous owner before 20 September 1985.

Small business provisions

There are some concessions to the CGT provisions that apply to small businesses that comply with the following:

the asset in question is owned by the business, there would have been a capital gains tax liability without the concessions, the business and connected entities own not more than $5 million in assets, the asset is used in carrying on the business (it is an active asset).

Four concessions are available to small businesses that satisfy the above requirements. They are:

An exemption from CGT if the asset was owned for 15 years or more, and disposed of after 21 September, 1999,

A 50% reduction in the taxable capital gain of an active asset disposed of after 21 September 1999. This can be applied in addition to the CGT discount (so that only 25% of the original capital gain is taxable),


A small business retirement exemption. If the capital gain from the sale of a business or share of a business is used as an eligible termination payment to an owner or part owner who is retiring, then the capital gain can be tax exempt to an individual lifetime limit of $500,000.

Small business rollover. When an active asset is replaced and a capital gain is made on the sale of the old asset, the amount of the reduced gain (using the CGT discount and 50% reduction rule) can be ‘rolled over’ to the extent that it does not exceed the total costs of the replacement asset.

Record keeping requirements

You should keep any document which shows the dates you acquire and dispose of an asset, and which shows the date and amount of any expenditure which forms part of the cost of the asset. These documents would include:

Copies of contracts of purchase and sale; market valuations (where applicable);bills and receipts for service rendered; advice slips relating to amounts paid by you to companies in which you own shares or be unit trusts in which you own units.

Only certain types of expenses can form part of the cost of an asset. The most common types include:

purchase price of the asset; legal fees (for purchase and sale); agent’s commission and broker’s fees; stamp duty; costs of improvements (such as paving or extending a rental property).

The following worksheet is supplied by the ATO to assist in the keeping of records for Capital Gains Tax.

Payroll tax

Before 1971 payroll tax was imposed by the Commonwealth. In that year the Commonwealth handed over payroll tax to the States in order to compensate them for losses of other revenues. There are presently considerable differences between the States and Territories in a number of aspects of payroll tax.

Calculation of payroll tax

Payroll tax is payable by an employer whose total wages exceed a specified exemption threshold. Tables are available from the Taxation Office which shows how payroll tax is calculated and the rates to be applied. The rates tend to change each year and are generally announced in the State’s annual budget.

From 1 July 1999, the rate of payroll tax applied to employers in NSW was 6.4%. As at 1 January 2011, the rate is 5.45% of the total payroll where the monthly payroll exceeds $50,000. Employers with a monthly payroll smaller than this amount do not need to register.


Taxable wages

Payroll tax is levied on the taxable wages paid during the year ended 30 June.

The following are taxable wages in NSW:

ordinary wages, salary, commissions, certain allowances, some payments under contractsfringe benefits, termination payments, wages paid under an employment agencywages paid outside NSW for services performed wholly in NSW, and a proportion of apprentice wages.

Tax is payable on the above taxable wages if paid in cash or kind and includes any non-cash component of a remuneration package.

Main exclusions from taxable wages

The following payments are not liable to payroll tax:

workers’ compensation payments; lump-sum payments made on termination of employment relating to unused leave

accrued before 1 January 1990; reimbursement of the exact amount of an employee’s receipted or documented

expenses; wages paid by charities, religious or public benevolent institutions; redundancy payments; wages to an employee under a group apprenticeship or traineeship scheme approved

by the NSW Department of Education and Training.

Responsibility of employers

An employer is obliged to register with the Office of State Revenue (OSR) promptly following the close of the month during which the liability first arose. Employers who are liable to payroll tax are required to calculate the total value of taxable wages, apply the appropriate rate of tax and remit the tax applicable in instalments.The OSR will inform the employer if the tax is to be paid monthly or annually. Monthly returns must be lodged within seven days of the close of each month and within 21 days of the end of June (annual return).

Employers affected must keep records (for at least five years) written in the English language which shows:

The name and address of each person to who wages are paid;

The wages paid or payable to that person by the employer.

These records must be kept for at least five years. The records used for FBT are also acceptable for payroll tax.

Non-compliance

Failure to lodge payments and returns on time will attract penalties according to the Taxation Administration Act 1996. The interest rate for the period 1 July 1999 to 30 June 2000 is 12.72% and for 1 July 2000 to 30 June 2001, it is 13.95%. The interest is calculated from the due date. In cases where late payment is judged to be due to circumstances beyond the taxpayers control, the market rate of the stated rate less 8% is payable.


The penalty tax rates are a percentage of the tax payable and are dependent upon whether there has been intentional disregard for the law and if the taxpayer has sought to conceal information in relation to tax payable. A table of the rates is available from the OSR.

The Commissioner has a general discretionary power for payroll tax to reduce or remit penalties; alternatively, the Commissioner may choose to prosecute a person who attempts to avoid tax, in which case penalties may be imposed by the court.

Revision

Q1. Who is liable to pay payroll tax and to whom is it paid?

Q2. What types of payment attract payroll tax?

Land tax

Land tax is a tax on the ownership of land in NSW to the value of $205,000 or more, assessed as at 31 December 2000. Your principal place of residence is exempt, unless the land value is more than $1.319 million (as at 31 December 2000), in which case, you would be liable to pay a Premium property tax. Land used for primary production is also exempt from land tax. This tax is administered by the Office of State Revenue (OSR).

The land tax rate for 2001 is 1.7%. An allowance or deduction in land value, and therefore tax liability, may be applicable where expenses for land improvements have been incurred.

All land in NSW is valued on 1 July proceeding each year for land tax purposes for the Chief Commissioner of State Revenue. This valuation is not to be confused with that provided to local governments for rates assessments.

Any taxpayer who may be liable for land tax should contact the OSR to lodge an initial return. The OSR can then assess any liability before it becomes due. There are penalties for the avoidance or late payment of land taxes similar to those for payroll tax. They are detailed in the Taxation Administration Act 1996.

Land tax payable is calculated as shown in the following table:

Taxable value as assessed Land tax payable

< $205,000 Nil

= $205,000 $100

$205,000 $100 plus 1.7c for each $1 in excess of $205,000


WAGES

and

EMPLOYMENT


WAGES and EMPLOYMENT

In this topic we will look at the calculation, processing, and payment of wages to employees. This knowledge is essential if you are to employ others in your business, or if you pay a wage to yourself as the director of your own company. The main focus is on wage and salary earners and we will look at areas such as:

1. Office facilities required for the processing of the payroll2. Setting up a payroll system3. Processing the weekly payroll4. Accounting for wages expense

If you are or have been employed yourself, you will be familiar with some of the records and documents, which are necessary in a payroll system.

As we shall see, wage records need to be kept for various reasons, eg:

1. for proof of payment2. for taxation returns3. for various authorities to check or audit4. To provide management with information about and control over wages.

We will use a basic wages system to process a week’s payroll in order to satisfy all of the above requirements. This involves the use of timesheets to calculate ordinary and overtime hours worked, which provides the basis for the gross pay calculation. Deductions are made from the gross wage such as tax, superannuation, union fees etc. to calculate the net wage. Some calculations involve looking to relevant awards and schedules, such as the schedule of weekly tax instalments issued by the ATO. All of the information is recorded and processed through the relevant journals to account for the transactions involved.

Note: It is essential to remember to keep records any part-time or casual workers as well as full-time employees.

Objectives

At the end of this unit you should be able to:

1. Describe what you need in an office to be able to process wages;

2. set up a commonly-used wage system suitable for use in the building ndustry;

3. Nominate the statutory authorities that control wage records;

4. Differentiate between normal hourly rates and penalty rates and methods of recording details;

5. List appropriate wages tax records required;

6. Define the layout and use of:

Time sheetsWages journals

7. List the options for methods of wage payment.


Methods of engagement

As a building contractor you may choose to limit the size of your operation to a one- person activity. As you expand you may contemplate taking on extra workers, but you should consider all of the implications of this move. You can operate under three basic concepts:

1. You work on your own and never engage anybody else.2. You engage wages personnel.3. You engage personnel on a sub-contract arrangement.

Let’s consider these options in turn.

Working on your own (sole trader)

If you ever intend engaging any help, the road ahead is probably going to be very difficult at times. The risk is that you may suddenly need assistance and employ help without initiating the necessary insurance and pay procedures. It is advisable to have in place, a basic minimum workers’ compensation policy. It should cover casual or part-time help (labourers or trades people).

It is also advisable to have a kit ready with time sheets, tax forms and pay-slips in case you need to pay someone occasionally.

While you are self-employed, you need to consider having yourself suitably covered by disability insurance. This will give you an income if injury or sickness prevents you from working.

Wages personnel

Many people question the advantages of employing extra staff, especially when so much paperwork is required. However, the extra costs and paperwork can be worthwhile if you can find the ‘right person’ to employ.

In the building industry it is worth considering the services of an apprentice. This can be done direct or through the Vocational Training Registry. You could employ a new apprentice or one looking for a change of employer.

Sub-contracting

Firstly, it is important to realise that a sub-contractor should run a business in the same way as all contractors. This means that the sub-contractor works for the main contractor on a sub-contract basis.

You have limited direction or control over a sub-contractor, whether they are a carpenter or a plumber. The sub-contractor should give a quote for the work, either on an hourly or lump-sum basis. Within the quote should be an estimated date of completion.

A sub-contractor should also have a licence, a trade certificate and have his or her own cover for disability insurance. If you treat the sub-contractor like an employee by directing and controlling him or her, you could end up with the same responsibilities as you have for an employee.


The worst situation would be in the case of an accident on site where the court rules that the worker is deemed to be an employee and therefore has a claim on your workers’ compensation. If you have no workers’ compensation cover, you would have to pay for all medical costs plus lost wages. This could amount to thousands of dollars.

Another ruling to do with the length of continuous service the sub-contractor works for the contractor on a labour-only basis. After three months working for the one contractor on a labour-only basis, you would have to either put the sub-contractor on wages or terminate the contract.

Engaging a sub-contractor has its limitations. You have no real direction or control over the times a sub-contractor works and how long the job takes. The positive side of engaging sub-contractors is:

1. Minimum paperwork - only tax and occasionally superannuation;2. Negotiated price for the work - usually on a quote or agreement.

Also, using license sub-contractors gives the main contractor protection against faulty workmanship. The Licensing Authority can call on the sub-contractor to make good any faulty work done.

Statutory Controls

The main authorities who affect the record keeping requirements of all employers are

1. Australian Taxation Office (ATO)2. Department of Industrial Relations (DIR)3. Department of Employment, Education and Training (DEET)

Each state will also have its own government bodies set up to oversee workers compensation schemes, superannuation schemes, training funds etc.

1. Workers compensation authority (Workcover)2. Construction Industry Training Fund (CITF)3. Building Industry Redundancy Scheme Trust (BIRST)4. Construction Industry Long Service Leave Board

You should contact the industry body in your state to find out which authorities will affect your business, and request information about how they will affect you.

Australian Taxation Office (ATO)

It is often necessary to have a tax accountant who will help you with your obligations to this office. Tax audits are likely every few years, so it is important to comply with the regulations and have the records up to date, especially the wage book or an equivalent journal. Tax audits are carried out on your premises by tax inspectors, usually at short notice.

Department of Employment & Workplace Relations (DE&WR))

This department controls award conditions including rates of pay and safety. If an employee complains about pay or conditions you may be approached so your employment records can be checked.


Department of Employment, Education and Training (DEET)

If you have an apprentice employed you will need to register him or her with the Registry. This body monitors the time spent serving the apprenticeship. Your employment records are important to establish when the apprentice should progress to the second, third and if applicable the fourth year. This is now also competency based.

Workcover

Workcover controls workers’ compensation insurance. This insurance is related to wages, so proper accurate records of earnings will help. All employers pay a levy (min. $50) which can vary depending on industry, claim history etc. and with taxation, regular and random audits occur to check that wages are declared accurately.

Construction Industry Long Service Leave Fund

For building projects with an ‘estimated value’ of over $5,000, project owners must pay a levy of 0.25% of the estimated value to the Construction Industry Superannuation Fund. This levy must be paid before approval for a building project is granted. This is usually paid at the local council as part of the Development Application Fee. Where the levy is paid, there will be no obligation under the Training Guarantee Levy, which affects most other industries.This corporation controls long service in the building and construction industry. Employers and employees must be registered, so that the levy can be distributed to registered workers after specified periods of service in the industry. Some employers and sub-contactors may be eligible for benefits if they fill in a ‘claim for service’ form.

Office facilities

Your office facilities requirements will depend on the size of your business and the actual number of employees you have. Because of the importance of keeping up with the paperwork involved in wage records, it is often necessary to have a person employed to do the work. If you do employ someone for this task, he or she would need to be reasonably good with figures and be able to work alone for the majority of the time. The following summary outlines the basic requirements of a manual payroll system...

Basic office requirements

1. an office2. a filing cabinet3. a phone and possibly a fax machine4. a copy of the relevant awards5. stationery including time sheets, journals, wage book, pay-slips or special packages

for your particular system6. bank forms7. group employers payment book (available from the ATO)8. employment declaration and termination forms9. taxation deduction schedules10. long service leave forms11. Workers’ compensation forms, etc.

As this unit is only covering wage records, the facilities listed above do not include other obvious office requirements, such as other office furniture and everyday items like writing and typing equipment. We shall, however, examine the requirements listed above in more detail.


An office

This does not need to be anything fancy but it should be more than just the corner of the bedroom. If you are planning to do the office work yourself, the type of office you have can be less presentable than if you are employing someone. Often a section of the garage or workshop makes a good ‘out of the way’ area for an office - somewhere comfortable so you can concentrate on your work with minimum distraction.

Before you decide to rent or lease an office or purchase or lease a factory unit with an office, you will need to consider the cost. Work out what you can afford to pay weekly or monthly, and then check what is available in your price bracket. Beware of hidden costs such as insurance, maintenance, parking or security.

Office equipment

Filing cabinet

Use a filing cabinet to keep files on each employee. You can also store the various awards and special forms you will need from time to time.Quick an easy reference to information can mean the difference between getting it right or making costly mistakes.

Phone and fax

The phone is essential for communication between the office and the site especially on pay day. Incorrect interpretations regarding time sheets can cause problems and therefore should be sorted out as soon as possible. Fax machines are popular as a form of communication and are handy for transmitting plans or diagrams.

Calculator

A calculator with a printer will take the risk out of calculating wages. It’s a good idea to staple the printed calculations onto the time sheet to show how the wage was calculated.

Computer

Rather than manually processing the payroll, you may choose to use a computer. This should help to reduce time spent processing the weekly payroll. Ideally, the payroll software will be just one part of your computerised accounting system. The ATO now has facilities to allow you to down-load information from the computer in your office to theirs, saving much time in paperwork.

Stationery

For wage and employment records you will need various forms such as time sheets, pay-slips, pay envelopes and either a wage book or payroll journal. If you are using a computerised or one-write payroll system, all the necessary material should be supplied in the package.


Awards and special forms

Awards

These are necessary to refer to the rates and entitlements to be paid. Current awards are available from the Department of Industrial Relations, Employment, Training and Further Education for a small fee. Rates of pay can change often, so keep an eye on the date of the issue you are using (it should not be more than one year old), or the latest award amendment. The Department of Labour publishes a ‘State Award Information’ series of brochures containing basic information on awards and conditions. They also provide a mailing list service to update employers about variations to award rates.

Banking forms

If wages are to be deposited directly into the employee’s account, special forms from the bank must be completed to direct the deposits into the correct accounts. Cash analysis sheets may also be available for cash payments to employees.

Group employer’s payment book

All employers are now regarded as group employers, and expected to deduct tax from the employee’s weekly gross pay, forward this to the tax office periodically, and prepare an annual reconciliation statement. When you register as a group employer, you will receive this ‘kit’ which includes all of the various forms needed to comply with tax requirements, as well as information on how to calculate tax deductions.

Taxation forms

A good supply of forms from the Taxation Office should be on hand. Remember, penalties apply if tax is not in on time. Prescribed payment forms and tax instalment schedules are available from post offices. Other reconciliation forms are available from the Taxation Office.

Long service leave

Obtain forms from the Long Service Leave Board or Authority in your state to report workers’ periods of employment, so employees will be allocated correct credits.

Superannuation

On some sites the employer is required to make contributions towards the employee’s superannuation fund. If this is the case, the correct forms must be sent with the contributions.

Workers’ compensation

If an employee is off work and is entitled to work cover, the correct forms must be completed and sent to the Work Cover Authority. A record of the time off should be entered into the wage book or equivalent journal, as well as the employee’s history card.

Sick leave

Any sick leave taken must be entered into the wage book, so you can see the number of days taken against the employee’s entitlement. File away any medical certificates for future reference, and record the information on the employee’s history card.


Employment and Termination

On employment of an individual, you should supply the ATO with an employment declaration. Among other things, the information contained on the form will help you to establish the weekly tax instalment. If one is not supplied within 28 days, you will need to deduct tax at the top marginal rate (47%). It is your responsibility to notify all of the appropriate authorities regarding a new employee. For example a builder employing people may need to notify or register with the ATO, Workcover, CITF, Long Service Leave Board, BIRST, etc; these organisations usually supply forms for registration and change of details.

You are required by law to notify the Department of Industrial Relations, Employment, Training and Further Education when an employee’s services are terminated or his or her employment is severed. This is just one of the many forms which have to be completed when employment is severed. You would need to notify the Long Service Leave Board, the Superannuation fund manager and the Taxation Office at the end of the financial year. Special consideration will have to be given to the payment and taxing of ‘eligible termination payments’ (ETPs). You will need to obtain from the ATO the booklet “Employers Guide to Termination and other Lump Sum Payments”.

Choosing a payroll system

Do you need a special system? How much is it going to cost? Does it require lots of training to be able to use it? These are some of the questions you may ask before you make a decision to purchase a payroll system.

Manual systems

For most small businesses (eg. with less than 10 employees), a simple manual payroll system can be the most appropriate way to record and process the weekly payroll. As the number of employees grows, you may decide to change to either a one-write system or a computerised system. The records presented in the section ‘Processing the payroll’ (later in this topic) would constitute a manual system capable of maintaining all of the required records.

One-write systems

The Kalamazoo system uses pre-carbonated forms which are punched to line up with pins on a special board. It is possible to do three entries at once, which are:

The wages journalThe individual’s employee earnings recordThe pay-slip.

This method not only saves time but also prevents transcription errors. The Kalamazoo system is a manual system and needs little training, if any. It is worth having a good look at this type of system for your business.

Computerised payroll systems

Computers are very useful in payroll preparation and can be used with:

1. An existing payroll program2. A computerised accounting package that has a payroll module included3. Customised payroll software designed specifically for your own business

Eg. Using a spreadsheet).


A computerised payroll system removes the need for manual calculations and paperwork. For example, each payday you would feed data (eg. hours worked) into the system, which would automatically calculate gross pay, deductions (including tax) and net pay. The system would print out pay-slips to be given to the employee and update the general ledger as necessary, and prepare a brief to the bank to transfer the appropriate amounts to the relevant employees’ accounts

Payroll items

Gross pay

Earnings

Employees may be paid using several methods of remuneration, including:

Hourly wage Hourly wage with overtime entitlement Yearly salary Piece-rate Commission Bonuses

Sometimes a combination of these will be used. All these amounts represent gross earnings. As an example, consider the calculation of gross wage for an hourly wage earner entitled to overtime rates.

Normal wages: NORMAL HOURS WORKED X NORMAL HOURLY RATEOvertime: OVERTIME HOURS WORKED X OVERTIME RATE

The overtime rate is commonly 1½, or 2 times the normal hourly rate, and more than one rate may apply. Eg. An employee may be paid ‘time and a half’ for the first three hours overtime, then double time for all additional hours.

Entitlements

The gross wage can also include the following entitlements:

Sick leave Annual leaveStudy leave Maternity leave

The obligation of the employer to pay these entitlements would be contained in an industrial award or in an employment contract.

Allowances

Other amounts may be included in the pay-packet which is designed to compensate the employee for personal work related expenditures. These may include:

car allowances travel allowancesmeal allowances tool allowancessite allowances height allowances


Deductions from gross pay

NET PAY = GROSS PAY less DEDUCTIONS

Tax

Every employer is required to register as a group employer and deduct tax from the wages of employees, which will be forwarded to the ATO (quarterly if total years PAYE tax deducted will be less than $10,000, otherwise, monthly). The ATO provides weekly and fortnightly tax instalment schedules, which allow you to look up the amount of tax to be deducted from each employee’s pay packet. The amount of tax to be deducted will depend upon:

the gross wage of the employee for that week whether a tax file number (TFN) has been quoted to the employer (if no TFN has been

supplied, tax is deducted at 48.4%; whether the tax free threshold has been claimed by the employee

These schedules also come with a ready reckoner for dependant and zone rebates which may be claimed by employees on their employment declaration form. Other schedules are available from the ATO to help calculate adjustments made for Medicare exemption and repayment of HECS debts via the employer.

Other Deductions

Besides income tax, other deductions will have to be made from the gross pay, usually at the employee’s request. These other deductions could be a flat amount each pay or may be a percentage of the gross pay. Examples include:

Medical benefits payments Union feesSuperannuation Loan repaymentsSavings plan Social club fundChild Support Payments

Processing the payroll

Records required

For each employee you will need a record of:

name of employee - surname, and Christian names, address of employee - street, suburb and postcode, telephone number - area code and phone number, next of kin - contact person in case of sickness or death, date of birth, date of employment - to work out holiday and long service leave entitlement, provisions for holiday pay, sick pay, long service leave, record of leave taken - holiday, sick and long service leave, taxation file number, taxation rebate, dependent’s allowance claim or otherwise, dependent spouse and number of dependent children, Medicare levy, method of pay - cash, cheque or direct deposit, direct deposit details - bank, branch, account name, account number, position held or classification, award pay, remuneration - and rates of pay, frequency of payment - weekly,, fortnightly, monthly, attendance records

The wages journal should give you an efficient method to calculate and record what has been paid as well as what has been retained to be given to others either to comply with legislation or at an employee’s written request. They may need to be produced to the court, to the employee, to the Australian Taxation Office, Industrial Commission, the Companies


and Securities Commission and/or the appropriate Union. Each week for each employee, you need a record of:

hours worked (normal and overtime) gross wages (normal and overtime) Allowances - motor vehicle, shift, tools, danger money, uniform, protective clothing,

commission etc. Entitlements - for sick leave, annual leave, etc. Deductions - tax, superannuation, union fees, medical and hospital benefits, credit

union contribution, insurance contributions etc. net wage paid to employee

Employee history card

This can be used to store all information about the employee, such as personal details, starting date, pay level, allowances, banking as well as all leave details.

Time sheets

Time sheets or Bundy cards if properly used reflect the employee’s time on site, workshop, TAFE, sick leave, compensation or holidays. The time sheet can be either filled in by the employee and checked by the employer, or simply completed daily by the employer. If possible, choose time sheets that cover a week at a time and provide a carbon copy in case the original gets lost.

Processing time sheets

Information from the time sheets must be entered into the wage book or journal after calculations for overtime, any allowance, tax and any deductions are made. Be sure to refer to the relevant awards for current rates of pay and entitlements.

The wages journal

The wages journal is where the details of each individual pay packet are recorded. For each employee, you will have a record of hours worked, ordinary pay, overtime pay, total gross pay, tax and other deductions and finally, net pay. As with all journals, the total amounts are posted to the general ledger (as well as being used to double-check your addition).Note that the net pay column is entered into the cash payments journal via the cheque book or bank statement, depending on method of payment.

Wages Journal - Week ending 14/7/95

Gross earningsNormal earnings $440.00 40 Normal hours x $11.00 (normal hourly rate)Overtime earnings $ 66.00 4 Overtime hours x $16.50 (overtime hourly rate)Allowances $ 15.00 tool allowance

Total Gross Wage $521.00

Fewer DeductionsTax $111.00 (assume TFN supplied & tax free

threshold claimed)Super $ 22.00 as per awards, legislation and/or

employee requestUnion $ 3.00 as per employee request

Total Deductions $136.00 Net pay $385.00 ($521 - $136)


Much of the information which has gone into these calculations needs to be looked up from the employee’s history card, such as normal and hourly overtime rates for the employee. The information necessary to look up the appropriate tax instalment should also be contained on the employee’s history card.

Pay-slips

A pay-slip (also called a pay advice) is prepared for the employee, using essentially the same information.All employees should receive a pay-slip each time they are paid, regardless of the method of payment. Many awards stipulate when the employee should receive the pay-slip; usually at the same time as or before the net wage is paid to them. A standard pay-slip shows the gross pay, the deductions and the net pay. The overtime hours and gross pay for overtime must be shown on the pay-slip. Some also include year-to-date totals, and other notices to employees.

Employee earnings record

Individual weekly payroll records are also posted to the individual employee’s earnings record, which is simply an up to date schedule of dates and wages paid to a particular employee.At the end of each month, the tax deducted from each employees gross pay during that month sent to the ATO, along with the reconciliation of tax instalments deducted. The ATO provides wages record sheets

Group certificates

Group certificates are used to inform the employee and the ATO of the total yearly gross earnings and tax paid by that employee. They must be issued by the employer by 14th July, unless the employee has terminated his/her employment during the year, in which case the group certificate is to be issued within seven days. Two copies are sent to the employee, one to the ATO and one is retained by the employer.

Details included on the group certificate.

1-3 Employees’ personal details

4 Period of employment

5 Total union fees paid

6-7 Employer details

8 Gross earnings

9 Lump sum payments: eg. Unused leave, eligible termination payments

10-11 Allowances: eg. Motor vehicle allowance, tool allowance

12-13 Tax instalments deducted

14 Signature of employer or authorised person


Methods of wage payments

Wages can be paid to employees in various ways, namely:

Cash, cheque, direct deposit.

Cash

When paying wages in cash, it is important to have the employee sign a form or slip on receiving his or her pay. You need these signatures as proof of payment and receipt.If you are paying with cash, you will need to consider the security aspect of having large sums of cash on the premises. Check that your insurance covers cash on the premises and in transit. Consider installing a safe if you have a large payroll.

Cheque

Paying by cheque is satisfactory if the employee can cash the cheque easily on pay day. Make sure the cheques will be honoured when presented.

Direct deposits

This method is a good alternative, because Automatic Teller Machines provide easy access to wages. Be prepared for problems now and then as the system can break down. The employee should receive a pay-slip on or before the day the pay is deposited into his or her account. All employees need to have an account at the bank where you decide to deposit the pay.

Accounting for Payroll

Recording expense and payment of net wages

The recording of cash payments related to the payroll is made by entries in the cash payments journal at the time of actual payment. A weekly payroll would involve the recording of payment of net wages to employees once a week.

Cash payments Journal (extract)

DATE PAID TO CHEQUE #

WAGES EXPENSE

CASH AT BANK

14/7/95 Wages : J Bradley 9999 385.00 385.00

DR CR

Recording expense of payroll deductions

The total wage expense to the employee is not only the net wage of the employee, but rather, the entire gross wage before deductions. We have already recorded the payment of net wages and now we must also record the deductions as wages expenses by making an entry in the general journal to record:

An increase to wages expense for the week andAn increase in the amounts payable to the various recipients of deductions.


The deductions made from the gross wages of employees effectively become temporary liabilities of the employer, since the employer is simply holding these funds (usually until the end of the month) for payment to the appropriate organisation.

General Journal

DATE ACCOUNTS DEBIT CREDIT

$ $14/7/5 Wages expense 136.00

PAYE tax payable suspense a/c

111.00

Union fees payable suspense a/c

3.00

Superannuation payable suspense a/c

22.00

(payroll deductions for w/e 14/7/2005

Note that the total amount which has now been debited to the wages expense account ($385 + $136) is the total gross wage for the week ($521).

Recording payment of payroll deductions

There would also need to be entries in the cash payments book to record the payment by cheque of other temporary payroll related liabilities at the end of each month, as shown below.

Cash payments Journal (extract)

DATE PAID TO CHEQUE # SUNDRIES ACCOUNT AMOUNT

CASH AT BANK

31/7/06 ATO 9991 PAYE tax payable suspense a/c

111.00 111.00

Union 9992 Union fees payable suspense a/c

3.00 3.00

Super fund 9993 Superannuation payable suspense a/c

22.00 22.00

136.00 136.00

DR CR

The above entry reflects the reduction of the temporary liability accounts, and the reduction in the Cash at Bank account.

These amounts would generally be totals for the entire payroll; however, for simplicity we have processed the payments on behalf of just one employee in this case.

Note that there is an alternative method of accounting for payroll to the one shown here. This involves the recording of the net wages expense in the general journal along with all of the other components of the total wages expense, i.e. it also is treated as a temporary liability. When payment is made through the Cash Payments Journal, you debit the wages payable account rather than the wages expense account.


The following people were employed by your firm during last week:

Name Trade

Fred Burton CarpenterBilly Good CarpenterTommy Smith LabourerDean Jones Apprentice carpenter year 1Plillip Measday Apprentice carpenter year 2Mike Foster Apprentice carpenter year 3William Linden CarpenterFred Bear CarpenterJason Border Foreman carpenterWilly Makit Carpenter

During the week they worked the following hours:

Name Hourly rate Monday Tuesday Wednesday Thursday FridayFred Burton 12.5 8 8.5 7.5 7.5 7.5Billy Good 12.5 8 7.5 8 7.5 7.5Tommy Smith 10 8.5 7.5 8 7.5 7.5Dean Jones 5 9 7.5 8 7.5 7.5Plillip Measday 6 8 7.5 8 8 7.5Mike Foster 7 8.5 7.5 8 7.5 7.5William Linden 12.5 9 7.5 9 8 7.5Fred Bear 12.5 8 7.5 9 8 7.5Jason Border 14 8.5 7.5 9 9 7.5Willy Makit 12.5 9 7.5 8 9 8.5

They all pay into a Superannuation fund of $20 a week except the apprentices who only pay $10 each per week

The tax was paid as follows:

Name Tax

Fred Burton $126.6Billy Good $126.6Tommy Smith $101.75Dean Jones $42.60Plillip Measday $51.10Mike Foster $59.25William Linden $135.97Fred Bear $131.28Jason Border $154.63Willy Makit $140.66


They all received travelling and tool allowance as listed below:

Fred Burton $9.50Billy Good $9.50Tommy Smith $9.50Dean Jones $15.00Plillip Measday $17.00Mike Foster $18.00William Linden $9.50Fred Bear $9.50Jason Border $9.50Willy Makit $9.50

Please complete the weekly time sheet as supplied


BUSINESS

FINANCE


BUSINESS FINANCE

In order to survive and grow, a business must have funds with which to finance both its infrastructure and its operations. That is, a business needs fixed assets (permanent assets used to help generate an income) as well as current assets (working capital to finance the day to day operations of the business). The money used to finance these assets can come from three sources.

1. It can be invested into the business by its owner/s (equity)2. Borrowed from third parties (debt), or3. Generated internally by the business (retained profits).

In this topic we begin by comparing the different methods of ownership for a business. This will enable you to have an elementary knowledge when speaking to your accountant about setting up or changing ownership structure. We will look at the main characteristics and advantages of each form of ownership and focus on issues such as the personal liability of owners and the overall tax liability of the business.

We will then look at the choice between debt and equity capital. Is debt good or bad? How much debt is too much? It seems impossibility for any business to continuously trade without at some time or another having to borrow money. Debt should be managed carefully so that it is used to the advantage of the business. This requires an understanding of the various terms of debt contracts. In particular we will consider security requirements, interest rates and repayments. We then proceed to compare different types of debt, and take a look at sources of debt appropriate for builders.

Finally, we will look at how to go about obtaining finance from lending institutions such as banks. Even where good security is provided, the lender will need to be convinced that the business is viable and that the debt will be repaid. Among other things, the applicant must present evidence on the liquidity, profitability and financial position of the business.

Objectives

At the end of this unit you should be able to:

Discuss the main characteristics of each of the different forms of business ownership. Calculate income tax liability for individuals, partnerships and companies. Compare and contrast the use of debt and equity capital. Name and describe various types and sources of debt. Identify appropriate types and sources of finance for various purposes. Calculate repayments on ‘interest only’ and ‘reducing balance’ loans. Present a case to a financial institution for a loan.

Forms of business ownership

There are basically three forms of business ownership

sole trader partnership company

Many businesses start off as sole traders and change their method of ownership as the business grows, by forming a partnership and later, a company. This allows the business


owners to take advantage of the different characteristics of each of these ownership methods.

We will focus at the main factors which influence the selection of ownership structure, including: tax treatment, owner’s liability, costs and regulations, availability of finance, management control

Sole trader

A sole trader is “a single person carrying on a business with a view to making a profit.” While the owner and the business are considered to be one and the same, separate accounting records are still maintained for the business. A sole trader pays tax on the profits of the business, calculated using personal tax rates.

Advantages of sole trader

The owner or proprietor has total control of the business, and will usually manage the business personally, although it is possible for him or her to employ someone else to perform the task.

Formation is simple. Besides the possible registration of a business name, there are no formalities or specific regulation related to this ownership structure. Anyone who can enter into contracts can be a sole trader. Note that industry or trade specific licences may apply.

The owner has independence, sole decision making power and is answerable only to them.

The owner gets to keep all profits (after paying tax at individual rates).

Disadvantages of sole trader

As well as getting all the profits, the sole trader must also bear any losses by themselves.

Since there is no legal distinction between a sole trader and their business, the owner has unlimited liability, and is therefore liable for the debts of the business, to the full extent of they personal estate. This means that if the business fails, and has outstanding debts, the creditors will have access to the personal assets of the owner.

Sole traders often experience a lack of capital, since all the capital must come from the owners own savings. Additional finance may also be difficult to obtain.

There may be restrictions on the owner’s lifestyle, in terms of taking holidays etc. Hired help may be available, but it is often risky to trust others with your profits and assets.

Partnership

A partnership is "the relationship which exists between persons carrying on a business in common with a view to profit".

Partnerships must have a minimum of 2 and a maximum of 20 persons (maximum 400 for some professions; eg. accountants, lawyers). With the exception of undischarged bankrupts and the mentally ill, anyone may be a partner. The term 'persons' also includes corporations, which means that a company may also be a member of a partnership.


Mutual Agency is the ability of each partner to act as an 'agent' for the partnership and all other partners. This results in joint liability for all partners. For example, one partner can bind all other partners to a contract which they sign (if it is within the apparent scope of the business), and all partners will be equally liable for any resulting loss. Thus, mutual agency can be both an advantage and a disadvantage to members of a partnership. It allows other partners to negotiate on your behalf, when you cannot be there, but may ruin you if your partner incurs a loss on behalf of the partnership. The ability of each partner to bind other partners may be restricted in the partnership agreement, but, for them to be effective, they must also be communicated to those with whom the partnership normally deals.

A Partnership may exist as a result of:

Written agreement Eg. Partnership agreement.

Oral agreement Some or all of the terms; risky.Implied by action Deemed to exist by law where individuals 'behave' as partners.

Obviously, written agreements are preferred to verbal agreements, to eliminate any possible misunderstandings. A Partnership Agreement should address all areas of potential conflict, including:

Each partner's rights and responsibilities Duration of the partnership Capital contributed Management responsibilities Profit sharing arrangements, i.e. one or any combination of the following;

Interest on capital (optional) Salaries (optional) Share of remaining Net Profit or Loss

Arrangements for drawings of profit/capital Limitations on authority of partner/s to act as agent Dispute Settling Procedures/ Arbitration clause Provisions for death/bankruptcy of a partner.

It is recommended that all partnerships (even family partnerships) should use a written partnership agreement. Legal and accounting advice should also be sought before agreements are entered into. If no partnership document is drawn up (i.e. verbal contract), or if any particular issue is not addressed in it, then the Partnership Act will automatically apply. For example, if no profit sharing ratio was agreed upon, this act deems that profits (and losses) be shared evenly amongst partners (eg. 50-50 for a partnership of two).

A partnership may be deemed to exist (implied by action) by a court if it finds that two people act in such a way as to imply that they are partners. The court will pay particular attention to the intention of the parties, any sharing of profits and any state of agency between the parties. If the court does find that a partnership exists, then the parties will be subject to all the provisions of the Partnership Act, eg. Mutual agency and joint liability. An example of this is where an unpaid supplier is seeking to collect trade debts from you, because he alleges that you held yourself out to be a partner of his bankrupt client, despite you denying this. To avoid potential problems (especially if you do joint projects), it may be necessary to ensure that your clients know who (if anyone) you are in partnership with.

The partnership itself does not pay tax. Once the profits have been distributed to partners (according to the profit sharing agreement), each partner pays individual tax on their share of


profits, regardless of when (if at all), the profits are 'drawn' from the business. That is, partners are taxed on profits 'earned', not on drawings of profit. Hence, as with sole traders, the decision to draw profits from the business has no tax implications.

Advantages of partnerships

It is relatively easy to form and administer a partnership. Unless the partners intend using a trade name, no registration procedures need to be complied with. The only real cost will be the legal advice regarding the terms of the partnership agreement.

The pooling of resources can provide numerous benefits. Each partner contributes assets/resources to the partnership, including, skills, capital (equipment &/or funds), customers (goodwill), time.

The formation of a partnership (or the admission of a new partner) may enable the business to take on larger contracts, service customers better, use premises and plant and equipment more efficiently and increase flexibility of working hours.

Tax advantages may exist for a partnership. Family partnerships allow a household to pay less tax on the same household income. For example, many sole traders go into partnership with their spouse, so as to decrease total tax payable (for a constant income). Income splitting provides this advantage due the progressive tax rates for individuals the greater the number of partners; the more the total tax bill is reduced (for a constant income). The Australian Taxation Office may not accept an equal-sharing spouse unless the proprietor can show that the spouse is working in the business. The Taxation Office will accept bookkeeping and other clerical duties from the spouse as working in the business. Where family members (or minors) are being admitted to a partnership, professional advice should be sought, to ensure compliance with the tax act. For two sole traders going into partnership, there is no real tax saving, unless total income falls, since each partner will still pay tax at individual rates. Partnerships can have a tax advantage over companies when income levels are relatively low

Disadvantages of partnerships

In a general partnership all partners have unlimited liability so that each partner is equally personally liable for the debts of the business. This means that if the business fails, each partner is liable to the full extent of their personal assets. Some States (not S.A.) allow limited partnerships where one or more partners has their liability limited to their capital investment, however, at least one general partner is still required.

The combination of mutual agency and unlimited liability mean that a partner could lose their entire estate as a result of a negligent, dishonest or incompetent decision made by their partner/s. Note also that the partner at fault may have few or no personal assets to be seized, causing the personal loss to be greater for other partners. Consequently, a partnership should only be entered into after having fully considered the associated risks and potential losses. Also, a partner should not enter into or continue in a partnership, unless they have absolute faith in their partner/s.

Partnerships are said to have a 'limited life'. Ownership is not always easily transferable, and may require the dissolution of the existing partnership and the formation of a new one, often resulting in disruptions to the running of the business. The partnership act deems that a partnership is automatically dissolved upon the death, insanity, bankruptcy, withdrawal or admittance of a partner. However, provisions in the partnership agreement may give remaining partners the option to 'buy out' the outgoing partner, and thereby avoid dissolution.


To ensure funds are available for the purchase of a deceased partners share, partnership insurance should be taken out.

Companies

A company (or corporation) is “an artificial body created by law”; generally under the Corporations Act 1989. This means that a separate legal entity (an artificial person) is born. As such, a company has all the rights and obligations of an ordinary person, including the right to sue and be sued, borrow and lend money, operate a bank account and own assets in it's own name. All companies are regulated by the ASC (Australian Securities Commission).

The owners are called members or shareholders under one of the following ownership methods:

limited by shares : general ownership by way of share capital of trading, service, construction and/or manufacturing businesses;

limited by guarantee : general ownership of entertainment and sporting clubs;

limited by both shares and guarantee : an amount is paid by way of share capital but a guarantee is also given (used by very large companies);

unlimited : used by professional people where their profession will not allow any limitation on their members' liability;

No liability: restricted to mining companies.

Companies limited by shares

This is the type of company relevant for most businesses. They are easily identified by the abbreviation 'Ltd.' appearing with the company name, signifying that the owners have limited liability for the debts of the company. Ownership is via shares in the company and after tax profits can be distributed to owners/shareholders as a dividend per share, so that each shareholder gets a share of profits relative to his/her share of equity. Dividends are usually tax free in the hands of the shareholder (via dividend imputation), since dividends are taken from after tax profits.

Companies are taxed at a flat rate (30% as at 2010) on their taxable income. This means that, unlike progressive tax rates for individuals, every dollar of taxable income earned by a company is taxed at the same rate in the hands of the company. Also, in contrast to sole traders and partnerships, the owners of a company can pay themselves a wage or salary, resulting in a tax deduction (and reduced taxable income) for the company. The income which is drawn as a wage will be taxed in the hands of the individual owner at progressive rates of tax. The task of management in a company is performed by directors, who are selected by shareholders. Directors, (who may also be shareholders), act as agents of a company, and must comply with the Corporations Act and the Articles of Association (see below). Each company must also have a 'company secretary' who acts as a general administrative officer, ensures compliance with the Companies Code, takes minutes at all meetings, files annual returns and performs other duties delegated by directors.

All companies must be registered with the ASC (Australian Securities Commission) which will issue the company with a unique ACN (Australian Company Number). This must be included along with the company name on virtually all documents issued or signed by the company.

Eg. U-Beaut Constructions Pty. ACN 123 456 789


A corporation may use a trading name different to its registered company name, if that trading name is registered with the Corporate Affairs Commission under the Business Names Act. Note that a business name containing the word "Company" or "Co." does not imply that the business is a registered company. Eg. "The U-Beaut Construction Company" is not a company since it does not have "Ltd." affixed to its name.

Incorporation: The act of setting up a new company

Reserve a trade name (up to 2 months before starting) with the CAC (Corporate Affairs Commission).

Draw up a Memorandum & Articles of Association. After forwarding these and other relevant documents (with fees) to the ASC, a certificate of incorporation is issued. This represents the 'birth' of the new company which can then begin trading.

Memorandum of Association (Charter/Constitution):

Company name Liability clause (eg. limited by shares) Amount of share capital Objects (intended activities) of the company etc.

Articles of Association (Internal management rules)

Powers & duties of directors Voting rights of shareholders Issue and transfer of shares Declaration of dividends etc.

The Memorandum of Association and Articles of Association are comparable to a partnership agreement and set out the operations and management of the company. Unlike a partnership, a company must have this documentation to be registered. (Lodgement of these documents is no longer compulsory for proprietary companies, but they must be supplied upon request).

A company may use 'model' articles contained in the Corporations Act, but it is still necessary to engage an accountant or lawyer to tailor the articles/memorandum of association to suit the individual needs of a business, and to clarify the legal obligations of the company and its directors.

The cheapest and fastest way to form a company is to purchase a pre-existing company in the form of a "shelf company". These are already registered with pre-prepared documents which allow a business to begin trading as a company almost immediately (eg. within 48 hours). The cost is around $900, which includes legal fees required to tailor some articles such as the names of directors, and the amount of share capital to be issued.

Advantages of limited liability companies

Raising Capital: Companies may raise capital by issuing 'shares' of the company to existing or new members/shareholders, making them part-owners of the company. These shares may be either voting (preference) shares or non-voting (ordinary) shares, so that the issue of new shares need not reduce the original owners' control of the company. After tax profits may be retained in the business (an important source of finance) rather than distributed to shareholders. As well as borrowing from financial institutions (eg. the bank), companies can also issue debt (in the form of debentures) to shareholders or other individuals.


Limited Liability: Companies are favoured by many because of the protection provided for owners/shareholders by limited liability. By forming a company, the owners can ensure that their personal assets will not be at risk if the business fails. "Limited by shares" means that the liability (or responsibility) of shareholders for losses incurred by the company will be limited to the amount unpaid (if any) on shares issued to them.

When a company issues shares they are either fully paid or partly paid. Fully paid shares means that the shareholder has paid the full face value of the shares issued to them, so there is no further liability for the shareholder if the company is wound up. With partly paid shares, the company can demand that shareholders pay the balance, known as 'uncalled capital'. This money may be demanded at any time, in one sum or in several amounts, but the total amount payable by the shareholder is always limited to the amount (if any) of uncalled capital.

Should the company become insolvent (i.e. cannot pay its debts) and go into liquidation, uncalled capital will be called up by the liquidator. If you are holding partly paid shares at the time the company makes a call, you would be legally obliged to pay the amount called. For example, if you had originally invested $8,000 and received 10,000 $1 shares paid up to 80 cents each, you would still be liable for the unpaid balance of $2,000 (10,000 x 20 cents). The company or liquidator could take legal action to ensure payment of the call. Usually however, shares are fully paid and therefore shareholders have no further liability.

Shareholders who are also directors should be aware that their liability may not be limited at all if they breach certain laws governing company directors (such as trading when they know the company is insolvent). Basically, to avoid liability, directors must always act within their powers, be neither fraudulent nor dishonest, and exercise the proper judgement as directors. Also, for many small proprietary companies, the owner/directors may have used personal assets as security for business debt or provided a director's guarantee (which places personal responsibility of the debt with the director/s). In these cases, the shareholders' assets are in fact at risk, thus reducing the benefits of limited liability.

As well as considering the potential advantages of limited liability for your own business, it is also important that you are aware of the limited liability of others that you do business with.

Organisation: Running a business as a company can force the owners to become more organised, to formalise their decision-making processes and their operations, in order for them to comply with the law. The benefit of this is that better organisation usually leads to better performance.

Taxation for companies: Companies may have a tax advantage over partnerships, when taxable income is large; over $120,000 this occurs because of the flat rate of tax which is 30%applies to all company income, regardless of the level of income (recall that an individual pays around 25cents tax for every dollar of income over $100,000.)

There may be further tax savings available if the owners of the company pay some wages/salaries to themselves and are on a low marginal rate of tax. Wages paid by a company (including those paid to the owner) will be taxed at progressive rates in the hands of the individual (rather than in the hands of the company). Thus the owner/directors of a company can reduce the overall tax liability on the business’ income. In general, the owners of a company will benefit by drawing wages up to the point where their marginal tax rate is equal to the company tax rate.


The transfer of ownership: is simple for a company, since the existence of the company is not dependant on the identity of the shareholders. For example, a company is not affected by the death of a shareholder, because ownership of the shares is automatically transferred to another person as per the will of the deceased shareholder. Note, however that in a proprietary company, all existing shareholders must agree to the admission of any particular individual as a shareholder.

Disadvantages of limited liability companies

Complicated regulations and extra costs apply to companies, For example:

High formation costs (minimum $800), ASC document lodgement fees., Certain statutory books and registers must be kept, Professional (accounting and/or legal) advice to ensure compliance with the Corporations Act, The appointment of an auditor and the lodgement of an annual return with the ASC, Companies must have a registered office within the state of incorporation, and a sign out front displaying this, Lack of privacy may be a problem, since the ASC keeps a file on each company, which is made available for perusal by any interested party (for a small fee), Tax liability may be greater for a company than for a partnership if taxable income is low.

Types of limited liability companies

There are three types of limited liability companies

1 Public companies2 Proprietary companies3. Exempt-proprietary

Public Companies

This type of incorporation is used by large entities that require greater access to capital. Public companies can have their shares 'listed' on the stock exchange, allowing the general public to become shareholders. For this reason, there are much tighter controls for public companies than for proprietary companies. The main characteristics of public companies include:

the word Ltd. appears in the company name (abbreviation for limited liability)

minimum of five shareholders

minimum three directors

no restrictions on raising funds from the public

May be listed or unlisted (on the Australian Stock Exchange)

Proprietary companies

Proprietary (meaning private) companies are suitable for a wide range of businesses, including small businesses in the building industry. Proprietary companies are subject to the following regulations:

the company name must be followed by Pty. Ltd. (short for Proprietary Limited)

minimum of one, maximum of fifty shareholders


minimum of two directors

Public invitation to subscribe for shares or debentures is prohibited; it cannot be listed on the Stock Exchange.

Existing shareholders must consent to the admission of any new shareholder, thus allowing the original owners to retain control of the company (unlike public companies).

There is no need to lodge Articles/Memorandum of association with ASC, but they must be available when requested.

Exempt proprietary companies

These are a special type of proprietary company in which none of the shares can be owned by a public company (thus excluding subsidiaries of public companies from this type of company structure). Generally, exempt-proprietary companies face the same requirements as apply to proprietary companies, however certain privileges are provided, including:

exemption from the need to audit the accounting records (if all shareholders agree)

they can make loans to directors

general meetings not necessarily required to pass some resolutions (if all shareholders agree)

any liquidator appointed need not be registered

Many small family companies exist in this form, for example, with the husband and wife as the directors and one of them also acting as company secretary. Being an exempt-proprietary company enables the business to avoid some regulations and costs associated with proprietary companies, but still provides owners with the protection of limited liability and tax advantages normally associated with companies.

TRUSTS

A trust fund is a device where a 'trustee' holds property (eg. an investment or an income producing company) for the benefit of others.

Trusts have traditionally been formed for tax purposes (via income splitting) since they allow flexibility in the distribution of profits among 'beneficiaries'. The trust will enable the distribution of profits to individuals (eg. family members), in such a way as to minimise total tax payable. Trusts themselves do not pay tax unless they fail to distribute the income.

The laws associated with trusts are complicated. Legal assistance is always required to set up such a structure to ensure the legality of the arrangement. Recent legislation states that a trust cannot be formed solely for the purposes of avoiding tax.

Tax Tables

Table 1.1 shows the amount of income tax payable under different forms of business ownership, for various levels of taxable income. It highlights the points where, for tax purposes, it may pay to move from one form of ownership to another. The highlighted columns show total tax payable for various levels of taxable income.


This comparison includes results for a partnership of two people. The first column under ‘partnership’ shows the tax payable on each partner’s share of income (net profit is assumed to be split 50: 50 and each partner pays individual tax on their share). The second column shows the combined tax payable for the partnership. Comparing the tax paid for sole traders and partnerships shows that splitting the business income with a spouse by forming a partnership can result in tax savings. Comparing the tax payable for partnerships and companies reveals a tax advantage for companies with large taxable incomes, over about $140,000

Results in above table should be used as a guide only, since individual circumstances will affect tax payable, eg. Non-business income, wages drawn by shareholder/director, rebate entitlements. Also, taxation rates can change from time to time and therefore you should check with the Australian Taxation Office for a current schedule of rates.


Revision

1. Name the three forms of business ownership most suitable for small businesses in the building industry.

2. What is the minimum and maximum number of persons for a partnership in the building industry?

3. Given that a partnership can be 'implied by action', and that 'mutual agency' and 'unlimited liability' usually apply to partnerships, what does this mean for individual contractors who 'get together to share jobs.'?

4. Name three types of ownership that you could use in creating a company. Which one is more appealing for small business and why?

5. A) what is “unlimited liability”?A) Which form/s of business ownership offer limited liability for owners?

7. Complete the following table.

FORM OF BUSINESS OWNERSHIPSOLE TRADER PARTNERSHIP PROPRIETARY

COMPANY

Number of owners(Min. and max.)Liability of ownersTaxationarrangements

Tax deductible wage for owner?Formal ownership document/s

Sources of Finance

Debt versus Equity

Debt Capital

Equity Capital Funds/assets invested by ownersRetained Profits

We have already looked at the different ways of having equity in a business. Equity capital represents the value of assets (funds and other assets) invested in the business by the sole trader, partners, or shareholders. Owners can increase their equity in the business by investing more of their personal funds and/or assets into the business. Owner’s equity is also increased when profits are greater than drawings for a period. Leaving some 'retained profits' in the business provides a very important source of funds for growth.


The business may also obtain funds externally by borrowing from financial institutions (eg. banks or finance companies). Debt capital is seen by some as a last resort, to be avoided if at all possible, since debt is accompanied by extra risk and reduced financial stability. However, if debt is managed properly, it can be used to the advantage of the business and provide a better return to existing owners.

Consider the following comparison between debt and equity capital.

DEBT • Lenders' claims on the assets of the business.• Contractual claims (usually secured).• Return to lender is by way of interest.• Tax deduction on interest.

EQUITY Owners' claims on the assets of the business.• Residual claims (after honouring contractual claims).• Return to owners is by way of distributed profits.• No tax deduction on distributed profits.

Once it has been identified that business finance is required, the owners should analyse the feasibility and effects of both debt and equity. The choice between debt and equity will depend on the circumstances of the business and its owners. Usually, if the existing owners have personal funds available, they may make a further investment into the business, increasing owner’s equity. If existing owners are unwilling or unable to supply the funds, then either the funds must be borrowed (debt) or a new investor/part-owner must be found (new equity).

It is important to understand debt and equity in terms of their effects on the existing owner's claims to profits and on the financial stability of a business. Debt involves fixed contractual claims (i.e. a financial expense which reduces future profits), whereas rising (new) equity results in new residual claims on the profits of the business (which dissolve the claims of existing owners to future profits). As a result, the choice between debt and equity will involve a trade off between the desire to maintain financial stability (by using new equity) and the desire to maximise the return to existing owners (by using debt).

Depending on the amount of funds required, a mix of debt and equity may be appropriate. Note that it is a simplified illustration. In preparing such an analysis for your own business, you may need to take other factors into account.

Example: Comparing financing options

Bill and Ted own a company (each having one $100,000 share). The 'current' column in Table 1.3 shows the existing financial position and profitability of the company. Bill and Ted wish to expand their operations, by acquiring additional plant and equipment, worth $100,000. They have conservatively estimated that the new assets will generate an extra $60,000 Gross Profit. Since they have no personal funds available to finance the expansion, they decide to compare the option of raising debt (column 2) with that of raising new equity by issuing a third share in the company (column 3).

The debt would involve interest only payments at 10% p.a. (i.e. $10,000 interest expense per annum) and the depreciation rate is 20% p.a. (i.e. $20,000 depreciation expense per annum). Assume that there would be no other effects on overhead costs.


Currently Debit EquityAsset (A) 300,000.00 400,000.00 400,000.00Debit (L) 100,000.00 200,000.00 100,000.00Equity (P) 200,000.00 200,000.00 300,000.00Proprietary Percent 0.67 0.50 0.75Gross Profit 100,000.00 160,000.00 160,000.00Overheads 40,000.00 70,000.00 60,000.00Net profit 60,000.00 90,000.00 100,000.00Tax Payable 20,000.00 30,000.00 33,000.00After tax profit 40,000.00 60,000.00 67,000.00No Of Owners 2 2 3Earning per Share $20,000.00 $30,000.00 $22,333.33

You can see that net profit is higher using equity funding, but the return to each owner (earnings per share) is reduced. This implies that raising debt may be preferable to admitting new owners, in some circumstances, in order to maximise the returns to existing owners. The table also highlights the increased financial risk which is associated with extra debt as shown by the much lower proprietary ratio.

Debt Contracts

There are many different conditions in a finance contract of which you should be aware. The main areas to be concerned with are:

Security: Assets of the business/individual to which the financier will have legal claims, should the borrower fail to satisfy the debt?

Interest rate: Is the interest rate variable or fixed, and if fixed, for how long?

Calculation of interest: Is the interest calculated on the full amount of the loan or on the reducing balance?

Payments: When do payments fall due and what is the amount to be repaid?

Deposit: What amount of deposit is to be paid and when?

Term: What is the length of the loan and can it be further extended?

Withdrawal: What are the terms and conditions upon which early withdrawal from the contract (i.e. repayment of the debt in full) may be made?

Default: What are the conditions concerning default in payment and under what situation can an asset is repossessed?

Charges: What other charges or fees are involved in borrowing the funds other than interest payments?

Ownership: Who owns the asset being financed and when does ownership pass to the borrower?


Residual: What, if any residual payment must be made at the end of the contract?

Insurance: Is the borrower expected to take out any insurances connected with the loan, eg. Mortgage insurance, asset insurance, disability or unemployment insurance?

Review: Is the loan facility subject to review. Will this incur additional costs?These questions should be asked of the lender before signing any debt contract. Note that conditions available on debt contracts may differ between lenders and change over time.

Security: Assets owned by the borrower over which the lender has specific legal claims. If the borrower fails to satisfy debt obligations, the financier may take possession of and sell the asset to recover monies owed.

Many financial institutions require some form of security against which they will lend. If you fail to meet your debt repayments and cannot renegotiate the loan with the financier, then the asset/s provided as security may be seized and liquidated (sold) by them. They will recover the debt owed including any unpaid interest, plus any expense reasonably incurred in liquidating the asset. Any money remaining will be returned to you. There are several other ways of enforcing payment of debt under contract; the provision of security simply ensures that certain asset/s will be available if the borrower defaults.

Financiers generally require more security than you may think is necessary, however they cannot liquidate (sell) more than is required to satisfy your outstanding debt, including interest to date. Hopefully, the financier will negotiate with you on what to liquidate, in order to cause you the least problem. Some financiers give you the opportunity to sell privately so that a liquidation sale is not advertised. If they allow you to sell, you may obtain a better figure and might not have to sell as many assets. The financier’s valuation of assets is most likely less to what you would expect. Financiers traditionally value assets conservatively, basing their valuation on the worst possible sale price. They usually lend amounts up to a predetermined percentage of the valuation (note that the percentage of valuation figures quoted here may differ between institutions and change over time). Some assets are preferred over others by financiers, based on their permanence and retention of value. The various assets that you can offer for security are explained below.

Land and buildings

This is the type of security preferred by most financiers. A mortgage is placed on the land. The buildings form part of the security on the understanding that the borrower will properly maintain the property he fire insurance policy is usually assigned to the financier. The generally allowed percentage base comes within the following figures:

Banks without mortgage insurance will allow around 60 percent of the bank's valuation (which is usually about 10 to 20 per cent below the market value).

With mortgage insurance and for domestic owner-occupied finance, the banks will lend to a maximum of 95 per cent of their valuation.

Other financiers will generally allow up to a maximum of 80 per cent of the market value for their standard loans.A second or subsequent mortgage occurs when you have more than one financier using the same asset as security. The first financier to register is considered to have first right to the funds should the asset be liquidated (sold). The amount provided under a second mortgage will depend largely on the extent to which the first mortgage which has been satisfied.


Bill of Sale

These are over property other than land and buildings and allow the bank to seize and sell the assets. For example, Plant and machinery is often accepted as secondary security when property is not sufficient. Banks will lend you approximately 30 per cent of their valuation. Finance companies may lend up to 75 per cent of the market value for loans and for lease valuation this may be up to 90 per cent.

Motor vehicles are another common asset used as security. Banks usually lend around 25 per cent of their valuation, which will most likely be the market value. Except for personal loans, banks will only accept motor vehicles as secondary security, requiring some other security with it. With personal loans, the bank may go to 80 per cent of the purchase price. Finance companies give similar loans for the purchase of motor vehicles, but as security for other loans will generally go to about 50 per cent of the market value of the vehicle.

Shares, accounts receivable, inventories, insurance policies, etc.

You will need to have the bank manager on your side for him/her to accept these assets for security. The reason that banks dislike them as security is that they may be worth little when the banks wish to exercise their right when a loan is overdue. For this reason the bank's valuation is down considerably on their book value; they only lend around 25 to 35 per cent of that valuation. Finance companies look very favourable in comparison, sometimes lending up to 75 per cent for debtors factoring. With shares you are looking at about 50 per cent of the lowest price in the last twelve months for valuation.

Guarantee

If you are unable to provide conventional assets as security, the financier may require that you have a guarantor; a third party who becomes bound by the contract. The borrower is primarily responsible for the repayment of the loan. Should the borrower default, the guarantor is called upon to repay the loan. The lender will generally try to come to some arrangement with the guarantor to pay the loan off. If the guarantor is not in a position to repay the loan, any security supporting the guarantee will be used to repay the loan. Loans to companies often require a ‘director’s guarantee’ to provide the bank with extra security.

If you find yourself being asked to act as a guarantor for somebody else’s debt, think carefully about the likelihood of default. Even when the borrower is a friend or family member, you should carefully consider the risks involved. Can you afford to repay the debt if the borrower defaults? How would this affect your own business?Banks usually have tighter security requirements than other financial institutions. The two main types of bank security are:

Equitable mortgage : Claims on specific assets.

Mortgage debenture: Claims on assets of the business generally. The business itself is used as security, 'lock, stock and barrel'.

Upon applying for a loan from a bank, they may suggest the use of a mortgage debenture. A mortgage debenture often is unattractive to business people because they dislike the idea of loosing control of the business if a receiver is appointed. On the other hand, this may be a better option than using specific assets, since the receiver may be able to return the business to profitability.


If a business becomes insolvent, this may lead to bankruptcy, liquidation or receivership.

Insolvency : Being unable to service debt commitments.

Bankruptcy: For insolvent sole proprietors & partnerships; declared by owners or forced upon them by lenders

Liquidation: Winding up procedure for a company, initiated by owners or creditors. Involves the orderly realisation (turning into cash) of assets to distribute proceeds to creditors & shareholders.

Receivership: The debt contract may specify that upon default, the lender may act to recover funds by appointing a 'receiver'. The receiver may attempt to realise assets and/or manage the business back to profitability, by assuming the powers of managers/directors.

The usual order of claims over the assets of a business (in the event of bankruptcy or liquidation) is as follows:

Receiver/liquidator (receive payment for services)Employees (receive any wages owing)A.T.O. (Receive outstanding tax obligations)Secured creditors (eg. banks and other financial institutions)Unsecured creditors (eg. accounts payable)Owners (receive remaining funds/assets if any are available)

Note that business owners are the last to be repaid, confirming that equity holders have residual claims on the assets of the business.

Interest Rates

The interest rate charged to an individual borrower will be depend mainly on the current market level of interest rates, which is affected by the general level of economic activity, and government policy. The market interest rate is reflected in the base or index rate used by a lending institution. The lender then adds a risk premium to compensate the lender for the risk of default.

INTEREST RATE = BASE RATE + RISK PREMIUM

For example, on a business term loan with no security.

7.8 % + 3 % = 10.8 %

If the lender perceives the loan to be a risky one, there will usually be a risk premium of somewhere between one and three percent added to the base rate. The greater the risk, the larger the risk premium will be and vice versa.

The 'perceived risk' of default in the eyes of the financier can be reduced via:

evidence of good liquidity, profitability and financial stability

the provision of good security.

the presentation of a good business plan

the consistent business-like behaviour of the loan applicant./tt/file_convert/5a9ffa0e7f8b9a71178d6da3/document.doc 133

The interest rate may be fixed or variable (floating). A variable rate means a degree of uncertainty as to the size of future interest repayments, since variable rates may change without notice, depending on the supply and demand for funds and on government policies (which are often unpredictable). In general, interest rates move in relation to economic cycles. For example, when the economy is growing quickly, interest rates are typically high, since demand for funds is greater. Also, the government may act to increase interest rates (via monetary policy) to slow down the economy when necessary.

If you borrow on variable rates, it's prudent to work out what the repayments would be for various interest rates. You can then measure the effect of interest rate rises on your liquidity and profitability. (See the "what if" analysis in topic 1 page 5). In this way you can be prepared for a worst case scenario. You may be able to eliminate the uncertainty associated with interest rate changes by seeking a fixed interest rate for up to seven years.

If you are comparing interest rates on loans with different terms, be sure to ask for the effective rate of interest. The effective rate of interest is derived from the nominal (quoted) rate by adjusting it for the effect of interest compounding. It is the rate of interest which would be paid if there was only one interest charge each year, rather than regular interest charges throughout the year, eg. Weekly, fortnightly or monthly. This rate is calculated specifically for the purpose of comparing interest rates of loans with different repayment schedules.

Repayments

Usually, the financier will have a facility (eg. a computer spreadsheet) which allows you to quickly compare repayments for various terms and rates. The repayments may consist of ‘interest only’ or ‘interest and principal’.

Interest only: In this case, the principal is repaid at the end of the loan term, so interest calculations are based on the entire principal.

I = P x R x T Interest = Principal x Interest Rate x Time

Example: An interest only loan is taken out for $15,000, with the principal to be repaid in 1 year’s time, at a fixed interest rate of 12% per annum.

Interest expense = Principal x Rate x Time

= $15,000 x 0.12 x 1

= $1,800

Monthly Interest Payments = Total interest expense # months

= $1,800 12

= $150 per month.


Interest and principal:

This is the most common type of loan arrangement. Principal repayments are spread over the life of the loan and repaid with interest which is usually calculated on the reducing balance of the principal owed.

To calculate repayments for this type of loan, you can draw up a schedule of interest payments. You will need to apply the same formula (I = P x R x T, where R = annual interest rate # of repayments per year and T always = 1) to calculate each individual interest repayment.

Example: A reducing balance loan for $15,000 at 12% pa. Is taken out, with interest charged monthly (calculated on the monthly opening balance).

MONTH OPENINGBALANCE

(P)

PRINCIPALREPAYMENT($15,000 12)

CLOSING BALANCE

INTERESTEXPENSE

(P x .12 12)(P x .01)

1 $ 15,000 $ 1,250 $ 13,750 $ 150.002 $ 13,750 $ 1,250 $ 12,500 $ 137.503 $ 12,500 $ 1,250 $ 11,250 $ 125.004 $ 11,250 $ 1,250 $ 10,000 $ 112.505 $ 10,000 $ 1,250 $ 8,750 $ 100.006 $ 8,750 $ 1,250 $ 7,500 $ 87.507 $ 7,500 $ 1,250 $ 6,250 $ 75.008 $ 6,250 $ 1,250 $ 5,000 $ 62.509 $ 5,000 $ 1,250 $ 3,750 $ 50.0010 $ 3,750 $ 1,250 $ 2,500 $ 37.5011 $ 2,500 $ 1,250 $ 1,250 $ 25.0012 $ 1,250 $ 1,250 $ 0 $ 12.50

TOTAL $15,000 $ 975.00

Note that the monthly interest payment is reduced each month, since the interest is calculated on the reducing balance of principal owed. You should compare these monthly interest charges with those of the interest only loan shown previously ($150.00 per month). Also compare the total interest charged under each method. Even though the same rate of interest was charged, the reducing balance loan attracted a smaller interest charge in total, since the interest was calculated for each month on a reducing principal balance.


Revision

Q1. Why would the owners of a business seeking funds for expansion prefer to admit a new owner into the business rather than use debt?

Q2 Why would the owners of a business seeking funds for expansion prefer to use debt rather than admit a new owner into the business?

Q3. List the common types of security which are used to support business loans

Q4. What assets do most financiers prefer for security?

Q5. Your parents at your request sign a guarantee for a business loan and put their house and land up as security for the debt. Could they lose their house if you went into bankruptcy?

Q6 Calculate the monthly and total interest payments due on the following two loans.

LOAN DETAILS OPTION 1 OPTION 2

Type of loan Interest Only Reducing BalanceAmount $60,000 $60,000Term 1 year 1 yearRepayments Monthly MonthlyInterest rate 11% pa. fixed 11% pa. fixed

Total interest paid

Short-term debt

Short-term debt can range from overnight to 3 years. The main types of short term debt relevant to business are: Overdraft, Bridging loan, Personal loan, Wholesale finance, Trade Credit/Accounts Payable, Debtor factoring, and Commercial bills

Overdraft

Overdrafts are only available from your bank. They are usually the cheapest form of business debt and are designed to cover the seasonal or cyclic needs of your business. It is common for most small businesses to have an overdraft facility. The unique feature with this type of debt is that you are allowed to overdraw your account to a pre-arranged limit. The amount overdrawn will increase as cheques drawn from your account are paid, and will decrease as deposits are made. Banks prefer to see your account fluctuating and will generally review the facility at least yearly.

As the bank cannot lend unused limits to other customers, they may have some form of minor fee or penalty for the unused limit. Interest is calculated on the daily balance, so early repayment will favourably affect interest charged. To ensure the continued availability of the overdraft facility, you should ensure that you will use this facility only for it’s originally agreed purpose, that of providing funds to honour cheques drawn in the course of normal business.


Bridging loan

This form of loan is designed to provide temporary finance for one of two purposes:

Loan accommodation when the sale of an asset is in progress but not yet finalised. Loan accommodation while more permanent financing arrangements are being

finalised.

Because of the short term (twelve months maximum) of the loan, high interest rates are charged. Often only one payment is required, although with certain institutions you may make payments to cover interest and therefore reduce the final payout. This form of loan is available from banks, building societies, credit unions, selected solicitors, merchant banks and finance companies.

Personal loan

These are not designed for business or for large sums, because the maximum amount is around $50,000, with a maximum term of seven years. They are primarily designed for non-business needs and have fixed monthly repayments; however, a sole trader or partnership business may borrow under this system. The lender may not require security; hence interest rates are generally higher than the other forms of loans. If security is offered to support the debt, then interest rates may be reduced.

Personal loans are available from banks, building societies, credit unions and finance companies. There is usually no advantage obtained for early repayment of principal on this type of loan, unless total repayment is made, in which case your refund will consist of a proportion of the interest overpaid as a result of total repayment before the agreed date.

Wholesale finance

You may use this type of finance to buy supplies or minor equipment for jobs. Bankcard, MasterCard, Visa and Diners Club are one form of finance under this heading. Some firms have the support of a finance company; when you buy from the firm, it arranges finance for you with a finance company. Custom Credit and Esanda are finance companies that offer retailers this form of finance when the firm is not strong enough to provide its own finance. David Jones, Grace Bros and BBC Hardware fund their own finance for credit sales.

Trade Credit/Accounts Payable

Most industries, including the building industry, trade in 30 day periods. This means that the payment for goods or services supplied to you is not usually due until the end of the month following delivery. You should always take advantage of any such credit arrangements. Trade credit provides a valuable source of finance for any business, since it reduces your need for working capital. It is also a cheap form of finance in that no interest is charged. Some suppliers may want to check your credit record and/or trade with you on a cash basis for some time, before providing you with a credit facility. If your supplier offers you a discount for prompt payment (usually 2.5 per cent, for payment within seven days of invoicing) and you have adequate working capital, it usually pays to take advantage of the discount. If discount is not offered, or you are short of working capital, then you should delay your payment until necessary. If necessary, you may try asking suppliers to extend your credit terms to 60 or even 90 days.


In terms of accounts receivable (which result from credit you have extended to your clients), you should aim to collect your money from them as quickly as possible. You may specify that payment is required within 30 days of delivery, rather than the end of the month following delivery. If your business is short of working capital, you could also try offering a discount, to encourage your clients to pay early.

Debtor Factoring

This involves ‘factoring’ some or all of the book debts (accounts receivable) of a business. The financier (usually a finance company) lends you money against the security of your accounts receivable. They will often lend up to 75 per cent of their value. Alternatively, the financier may actually buy some or all of the book debts from you at a discount. In which case, you will be required to satisfy the debt in full should your clients fail to do so at the end of the normal trading term. The financier will assess the credit rating of the debtors in order to establish the creditworthiness of the debtors. The rate of interest/discount will depend on the quality of debtors as well as the proportion of sales factored. Debtor factoring is usually available only for amounts over $100,000. The financier may also provide other services, such as maintaining debtor’s ledgers and advice on credit control. Debtor factoring is an excellent source of funds for expanding businesses, but may be relatively expensive, and therefore is often used only as a last resort.

Commercial bills

A commercial bill can be thought of as a post-dated cheque. Essentially, you write a promissory note or bill of exchange (a promise to pay a set amount to the holder in the future) and effectively sell it to the holder at a discount (equivalent to the interest component). You are, in effect, given money today in exchange for an IOU which you promise to honour at a set date in the future.

The normal periods are 30, 60, 90, 120 and 180 days, but the bill can often be rolled over. Rolling over is the term given in the finance industry for new arrangements at the end of the maturity of the original document. A new document or settlement is needed every time the maturity date is reached. The rate of discount is fixed for the term of the bill, which provides certainty as to the cost of the debt. If the document is settled earlier, you may gain some advantage with a refund of the discount proportioned.

Endorsement may be provided by a bank, development bank or merchant bank. The endorsement guarantees that the person funding the bill will be repaid. Should the borrower not repay the commitment, the endorser will? The endorser would then if necessary take the legal action, or cash in the security.

The area of bill finance is a complex one. There are different types of bills such as bank bills, trade bills or finance bills. Professional assistance is usually required when seeking this type of finance, since legal documents must be drawn up.

Long-term debt

We will define long term debt as including terms of over three years. We will look at the most common types of long term debt include:

Housing loan Speculative loan Term loan Lease


Hire Purchase Sale/lease-back Interest only mortgage loans (solicitor’s loans)

Housing loans

As a builder, you will most likely be involved in this form of finance as the third party when your client negotiates with the bank, building society or credit union. You will have to sign the contract document, which is either the bank's or master builder's standard contract.

Be careful if you change anything on the standard contract; the financier may not accept the modification. All your hard work may be lost if the financier directs your client to another builder. If you are not happy about a particular clause, approach the financier and see if you can change the clause.

Generally these loans have fixed stages of completion before money is paid. The financier may inspect your work before money is paid. Usually financiers ask for three progress payments, plus ten per cent retention money. You will need to finance the project to these stages before reimbursement. The funds required will include wages, sub-contractors' payments, tax and materials. (Do not forget the bricklayers require their money each week.)

Speculative Building Loan

A speculative building loan is a common source of finance the building industry, specifically, for the owner-builder who intends to sell upon completion.

This form of debt is usually relatively cheap, and more importantly, tailored to the needs of builders. Loans tailored for these purposes are provided by most banks.

Term loans (fully drawn loans)

These consist of a fixed amount of money lent for a set period of time for a specific business purpose, generally up to ten years, although longer terms may be negotiated with the financier. The disadvantage is that, if your operating bank provides the funds, credit in your bank account may attract no interest and is not offset against the debit balance in your loan account. Depending on security, this form of loan has similar interest rates to that charged on bank overdrafts. Repayment is usually monthly or quarterly for the life of the loan and consists of interest and principal. Most financial institutions provide this form of finance.

Leasing

Leasing is a distinctive method of financing fixed assets. The security in this form of finance is the asset which has been leased. The leasing company (the lessor) buys an asset chosen by the business and leases it to the business (the lessee) at an agreed ‘rental’. While the lessee enjoys the use of the asset, ownership remains with the lessor during the term of the lease. Lease periods can vary and can be as short as twelve months, although the most common term is four years for items such as plant and equipment. Repayments consist of interest (at a relatively high rate) and an allowance for depreciation. Importantly, the lease payments are tax deductible for the lessee. At the end of the lease term, the business may offer to purchase the asset for a pre-determined residual value or may re-lease the asset at a reduced rental. Should neither of these options be appropriate, the asset will have to be returned to the lessor? Leasing is mainly


available from finance companies and banks. Assets also may be leased directly from traders if the trader has the backing of a finance company.

The area of leasing is covered in greater depth in topic 6; Plant and Equipment, where we compare various methods of financing fixed assets, including buying, leasing, and hire purchase.

Commercial hire purchase.

A bill of sale is taken over the goods (usually a vehicle) by the financier and ownership remains with the lender (finance company) until the last instalment is paid.

This form of finance may be more suitable for your business needs if, after doing your calculations, you see it as the best way of funding the purchase of assets. This form of financing is similar to leasing in that ownership of the asset remains with the financier. The main difference is that the business has automatic ownership upon fulfilment of the contract.

Sale/lease-back

This type of finance enables you to sell assets to a finance company or similar financier, and then lease them back. This is an important potential source of funds for a business, since it allows you to free up funds currently in the form of fixed assets, in order to free up funds for working capital.

Interest only mortgage loans (solicitors' loans)

These have not been popular in recent years. They are generally loans generated with a solicitor who has a client or clients with funds wishing to receive a return greater than the bank but with little risk. The loan is generally negotiated for a term of three or five years. At maturity, the loan is rolled over for a similar term. Interest is usually paid monthly, which is often used by the lender as income to live on. Security is generally by way of a first mortgage over real estate property.

Relative cost of various types and sources of debt.

The following is a list of the most commonly used types of business debt. The list reflects the usual order in which loans may be ranked, from the cheapest through to the dearest. Also included are the relevant financiers, in order from cheapest to dearest.

OWNER-OCCUPIER HOUSING LOANS : saving banks, building societies and trading banks;

OVERDRAFTS : trading banks;

PROJECT OR SPECULATIVE LOANS for domestic homes : saving banks and building society;

TERM LOANS : banks and insurance companies;

MORTGAGE LOANS : insurance companies, solicitors and finance companies;

SHORT-TERM LOANS : money market;


BILLS OF EXCHANGE : trading banks, merchant banks, finance houses;

LEASE : trading banks, Commonwealth Development Bank and finance companies;

INVESTMENT PROPERTY LOANS : building societies, savings banks, trading banks and finance companies;

PERSONAL LOANS : credit unions, building societies, trading banks, and finance companies;

BRIDGING LOANS: building societies, credit unions, trading banks and finance companies.

Since the deregulation of the Australian financial markets, there has been some shifting in the mix of debt products offered by the various financial institutions, for example building societies and credit unions have recently gained market share in the area of housing finance. In the next section we will take a closer look at look at the various sources of debt, in terms of the services and products offered by them.

Revision

Q1. a) Name six types of short term debt.

b) Name six types of long term debt.

c) Identify six areas commonly covered in a debt contract.

Q2. How often is interest calculated on an overdraft?

Q3. Personal loans are generally limited to amounts of $...............

Q4. Debtor factoring is usually provided for amounts over $..............

Debt sources

Banking finance

Trading Banks, Savings Banks, Commonwealth Development Bank, Merchant Banks

Other financial institutions

Finance Companies, Building Societies and Credit Unions, Insurance Companies

Other sources

Creditors/Suppliers, Vendor Finance, Private finance, Confirming Houses Venture Capital Companies, Finance Brokers, Land Brokers, Stock Brokers Accountants and Solicitors

Banking finance

Despite extensive deregulation of the Australian financial markets, the ‘big 4’ trading banks (Westpac, Commonwealth, National, and ANZ) still control most of the business in the banking sector. Most businesses can find all of the financial services they require at a


trading bank, and the most important facility for many businesses, the cheque account, can be provided only by trading banks. As a result most businesses will already have contacts with a particular bank.

All bank debt is callable upon demand, meaning that the bank may demand full repayment of a debt or cancel a loan facility at any time. Even if approval given for a longer period, bank debt is always subject to call. This is a condition placed on all bank loans by the Reserve Bank of Australia. The ability to call in debt is generally only exercised by a bank after default has occurred and the bank believes it's 'investment' is at risk. The purpose of the arrangement is to provide extra security for depositors (whose money the bank lends out as personal or business loans).

Trading Banks

Trading banks are the largest lenders to small business in Australia. The debt products they offer are competitively priced and usually cheaper than similar products from other sources. The greatest drawback with them for a builder is that they usually insist on adequate security. Trading banks provide the following types of debt.

Overdraft, term loans (fully drawn loans), personal loans, bridging loans, commercial bills discounting and endorsement, leasing, housing loans (except for investment property applications, which are usually approved by savings bank subsidiaries).

Saving Banks

Savings banks are designed to serve individuals, clubs and societies, but may also offer the following loan facilities to their customers at relatively low interest:

Project home-builder exhibition house loans; Speculative house loans to builders, where the builder is building a house to sell upon

completion; Investment property loans: mainly given when surplus loan funds are available, and

then at penalty interest rates. (Established savings banks will give loans through their trading banks whereas some new savings banks will fund direct.

The Commonwealth Development Bank

The Commonwealth Development Bank of Australia (CDB) is part of the Commonwealth Bank. One of its main roles is to assist the development of Australian small businesses by providing loans to applicants to whom funds are not otherwise available on 'reasonable terms and conditions'. Generally, it provides only medium to long term finance and prefers the applicant's normal trading bank to have rejected a similar application. If your bank rejects a loan application (eg. due to lack of security), you should ask to be referred to the CDB. For plant and equipment finance, you can approach them directly. The CDB may lend to a business with no security, if it believes that the long term prospects of the business are good.

Types of loans available from the Development Bank include term loans, mortgage loans, hire purchase and commercial bills (discounting and endorsement).The CDB may sometimes even be willing to take up an equity position in the applicants business. Besides providing funds for businesses, the bank may also provide advisory services.


Merchant banks

Merchant banks (their official name is money market corporations) are primarily concerned with wholesale finance to large enterprises and are an unlikely source of finance to small businesses, unless large projects are involved. They are usually subsidiaries of other financial institutions such as sharebroker and banks, both local and overseas. The exact services offered by various merchant banks vary significantly, however they usually provide one or more of three main functions:

investment department (portfolio managers of funds); corporate finance department (financial advice services); Money market department (depository for temporarily idle cash).

They may also be active in foreign exchange markets, commercial bill markets, the underwriting of debt or equity or providing direct finance.

Other Financial Institutions

Finance Companies

After trading banks and savings banks, finance companies are the third largest institutional group in the Australian financial system. Many finance companies are subsidiaries of trading banks, and an unsuccessful applicant at the bank will often be referred to their finance company. The advantage of finance companies is that less security is required than with the other institutions. In some cases, they will lend without any security. However, to compensate themselves for the extra risk involved, higher interest rates will be charged. Ensure that you are fully aware of interest arrangements, since interest may sometimes be charged at a flat rate on the principal of the loan rather than on the reducing balance. Today, finance companies are mainly engaged in providing individuals and businesses with personal loans, Commercial term loans and leasing.

Building Societies and Credit Unions

These two types of financial institutions are grouped together since they are both co- operative organisations, sometimes run on a non-profit basis. These were originally dedicated to lending money to members for owner-occupier housing and personal loans. In recent years they have also allowed borrowing for investment purposes at a higher interest rate than owner-occupied loans. They may be a source for bridging finance and loans similar to those of the savings banks, depending on supply and demand of funds. Often they will lend a larger amount of funds for the security offered and will /may lend to new members if there are surplus funds available. Provided you are a member at the time of the loan application, they will assess the application.

Be aware that building societies and credit unions are continually branching out into non-traditional areas of finance and in the process, competing with the banks for customers. A recent major change has been in the area of cheques. Previously, cheques could only be drawn on banks, but building societies and credit unions are now able to issue a form of cheque called a ‘payment order’. A payment order is used in a similar way to a cheque, and provides the same type of protection afforded to cheques.


Insurance Companies and Pension Funds

The liabilities of these institutions (i.e. insurance pay-outs) may take several years before they are required to be paid. This is a result of the nature of the liabilities and/or the legal system determining the insurance payment. Therefore they accumulate funds, which are made available by way of loans. Most of these institutions prefer to lend to policy holders in the following forms:

Term loans, mortgage loans (interest-only loans), bridging finance, and loans to terminating building societies.

If you are a policy holder, (especially with superannuation or life insurance), you will usually have a good chance of borrowing from the fund. Since the insurer has accumulated your premiums over time, these funds can be used as security, so that you can borrow an amount up to your current policy value, with no need for other security.

Other Sources of Finance

Creditors/Suppliers; since they stand to gain from the success of your business, suppliers may be willing to help finance the establishment or expansion of your business.

Vendor Finance; if you are buying a business or property, the seller (vendor) may be willing to provide finance for some or all of the amount required, since this will help them secure the sale.

Private finance; where business associates, friends or family are willing to invest or lend funds for a business venture. The borrower should ensure that the arrangements are formalised in writing, to avoid any problems which may result from potential misunderstandings.

Confirming Houses; finance companies set up especially to assist importers and exporters. They endorse bills of exchange so that traders can get funds from overseas, provide finance to exporters awaiting payment from overseas purchasers and provide importers with funds to pay overseas manufacturers. Such borrowings are generally expensive. If you are advised to go off-shore to obtain funds, be careful. The debt will be in a foreign currency, which means that principal and interest payments will be subject to fluctuations in foreign exchange rates. It is possible to ‘hedge’ against this risk, at extra cost to you.

Money Market Corporations; the official money market is made up of ten authorised dealers with minimum transactions of $500,000. Your surplus money may be deposited for terms as short as overnight. The money is invested mainly in approved government securities. In the unofficial money market, some two hundred operators in take deposits and lend money for short terms. Minimum amounts are usually in the order of $100,000, but availability of funds and interest rates are subject to supply and demand on any given day.


If the above sources are unavailable to you, there are a number of other potential sources to consider. You may need to approach a finance broker, whose job it is to find the cheapest and most appropriate source of finance via a network of contacts in the finance industry including :

Venture Capital Companies, Land Brokers, Stock Brokers, Accountants

Solicitors

These ‘intermediaries’ often have clients (individuals of businesses) who are looking to invest their spare funds in other businesses. Usually the investor will expect a reasonably high rate of return and there may be a fee payable to the finance broker.

Obtaining Finance

Sources of funds for various purposes

The most common reasons for seeking funds are:

additional funds to purchase an existing business, additional funds to start your own business, additional funds to expand your business, acquisition of additional plant and equipment, replacement of plant and equipment and funds to increase working capital

Following is a summary of the sources which will usually be appropriate for each of the above financing purposes. It can be used as a guide when deciding where to go for your financing needs.

TO ACQUIRE THE ASSETS OF AN EXISTING BUSINESS

Vendor Finance Private financeTrading Banks SuppliersFinance Company Leasing Company Commonwealth Development Bank

TO ESTABLISH A NEW BUSINESS

Trading Banks Commonwealth Development BankFinance Company CreditorsLeasing Company Private Finance

TO ACQUIRE LAND AND BUILDINGS

Trading Bank Term loan or mortgage

Building Society mortgage

Insurance Company mortgage Vendor of propertyFinance Company 1st or 2nd mortgage

Solicitors and Accountants

Commonwealth Development Bank term loan or mortgage


TO ACQUIRE/REPLACE FIXED ASSETS

Supplier of machinery Trading BanksLeasing Company Commercial BillsBuilding Society/Credit Union Finance Company

TO OBTAIN WORKING CAPITAL

Bank Overdraft Credit from SuppliersFinance Companies Sale/Lease-backCommonwealth Development Bank Personal LoanPrivate Finance Debtor FactoringCommercial bills

If the money required is for expansion of your operations, do not forget to provide for new running expenses and increased working capital needs.

Before you go to apply for finance, you should consider any alternatives methods of raising the funds.

Could the funds be provided by existing owners? Could the funds be provided by admitting new owners? Could money be raised by cashing in your under-utilised assets? Could you decrease your need for working capital by getting your clients to pay more

quickly, or delay payment to creditors? Could money be saved by reducing waste, damage or misuse of materials, instead of

borrowing? Would it be more appropriate to hire the asset/s as required? Will there be sufficient profit generated to make debt financing viable? Will the expected cash flows be adequate to cover the repayments?

Presenting a case for finance

Loan application checklist

Type of finance and amount funds required

Details of how funds are to be used (include any supporting documents such as brochures on the asset and any quotes which have been supplied to you)

Information about owner/s (experience and background)

Information about business (brief history as well as current activities and expectations for the immediate and long term future.)

Profit and Loss Statements (for the current year to date and if possible, the last three years results)

Tax returns and assessment notices for the last three years.

Profit and Loss budget for the current year and for the life of the loan.


Balance sheet (current position and if possible reports from the last three years)

Dissection of debtors and creditors by amount outstanding, age and credit limits

Breakdown of any inventories held and method of valuation.

Description of major assets and methods of valuation

Copies of documents relating to title or proof of ownership

Current cash flow budget or forecast

Cash flow budgets or forecasts for the life of the loan (including estimated repayments under the proposed arrangement)

Most financiers will have a standard loan application form which you will need to complete. It is usually necessary for you to attach other information to support the loan application. The loan application checklist provides a summary of the type of information required. Ask your accountant to help you plan the submission if necessary.

The financier will assess your loan application on the basis of the ‘five C’s’

Character of Management Capacity to repay Collateral/security Capital worth (owners interest in business) Conditions in the economy/industry/business.

You should keep these essentials in mind when preparing your loan application.

You could also include in your presentation, the results of key ratios for your business. For example, the working capital and proprietary ratios are important indicators affecting your chances of securing finance.

What would your bank manager consider is an acceptable working capital ratio?A low working capital ratio (< 1:1) means that you may not be able to pay all of your current liabilities as they fall due, indicating some risk of bankruptcy.

What would your bank manager consider is an acceptable debt equity ratio?A high debt equity ratio indicates greater financial leverage and higher debt servicing costs, indicating long term insolvency Therefore, the lower the result, the better.

The bank will also pay close attention to the ‘times interest earned’ (TIE) ratio. It indicates the number of times that the current interest expense could be paid for out of current or expected profits. The higher the result, the better.

TIMES INTEREST EARNED = _ NET PROFIT _ __ INTEREST EXPENSE


For larger loans the financier may also look at external information such as market trends (eg. estimates of expected housing activity) and the business cycle (i.e. the forecast levels of general economic activity). These factors will be particularly relevant for large general purpose/expansion loans. An outline of the major influences on profit and competition covering the years presented in the reports and the expected outcome over the period of the loan would be helpful.

If successful in your loan application, you get a Letter of Offer which specifies the details of the loan contract. If you are unsure of any of the terms, seek clarification before signing. Once you sign, you are generally locked into the contract.

You and your bank manager

If you do not currently have an established relationship with a bank, try to find a bank/manager with industry knowledge, so that they will understand your business and its needs. You should then try to build on that relationship. A good relationship involves plenty of information sharing, confidence and trust between you and the bank manager. As a result you will have better chances of loan approvals, loan extensions, etc.

Remember that, besides finance, bank managers provide advice and support to their clients (borrowers). They are keen to see your business succeed and may be able to offer advice in regard to many aspects of business management.

To develop a mutual trust, you should always be honest with your bank manager and you should consider keep him updated regularly about your business. For example :

Send periodic reports & forecasts. Inform them of any changes (good and bad) that will affect your business. Provide as much warning as possible about future cash flow problems.

Remember that if you are experiencing difficulty in meeting your repayments, or if you know you will not be able to for a period, there is usually room for negotiation with the financier (especially in the case of banks). Payments may be deferred or spread over future months, to give you more time to make repayments.

Debt Management Principles

It is important to match the term of the debt to life of the investment. Expenses involved in any project/investment (eg. interest exp, depreciation exp.) should be matched to the revenue produced by that project/investment. This means that the loan repayments should be spread over the period in which the assets will contribute to income.

Eg. A four year term loan for the purchase of fixed assets which are expected to produce income for four years.

Eg. Short term debt for temporary or short term financial requirements (eg. an overdraft for working capital fluctuations)

When interest rates are low, and expected to rise, use long term fixed debt to lock in the low interest rate. Besides giving predictability to cash flows, this may allow the business to enjoy lower rates than would apply if a variable rate applied and interest rates were forced up. In a similar sense, some say that when interest rates are high and expected to fall, you should use short term variable debt and re-finance the debt/s when interest rates go down. However, bear in mind that the banks set their fixed interest rates based by


factoring in their expectations for future interest rates. If expectations for interest rates are correct, there will be little, if any advantage in choosing fixed rates over variable rates or vice versa.

There is, however, a distinct advantage in using fixed interest rate debt. Fixed rate debt provides predictability for the business or individual, since the amount of each repayment will be known with certainty for the life of the loan. This provides a basis for good budgeting and planning, especially in regard to cash flows and profitability. For this reason a prudent business may prefer to lock in to a fixed rate, rather than ‘gamble’ on the future movements of interest rates.

If you find that you are paying higher interest rates than are available elsewhere, you should consider re-financing your debt/s. Specifically you can ‘retire’ (pay out) existing high interest rate debt by taking out a new loan at a lower interest rate.

If you have several different debt contracts, it may be advantageous to ‘consolidate’ these debts by taking out one new loan to retire some or all of the existing debt contracts. This may allow you to reduce your total interest payments and would make planning for cash flows easier. In both of these cases, you should be careful to examine any penalties which may apply if you pay out a debt contract earlier than the originally agreed term. These costs may be greater than the benefit of any interest rate savings.

If you feel that your business risk has reduced over time, ask the financier for a reduction of your risk premium. You may be able to renegotiate the loan in your favour. A one percent reduction on your interest rate could save you hundreds of dollars annually.

Revision

Q1. Which group of financiers is usually the most competitive in terms of interest rates?

Q2. Which is the only group of financial institutions able to provide cheque account facilities?


References

AGPS (Australian Government Publishing Service) Small Business Booklets.

No. 1 : Checklist for starting a businessNo. 2 : Sources of finance for small businessNo. 11: Planning for management successionNo. 12: Building tradesNo. 22: Presenting a case for financeNo. 33: Small business and the law

Trimpex One: Starting a Small Business. ISBN 0 642 06497 0

Other publications

Gaffney T First Steps in Small Business, Butterworths, 271:3 Lane Cove Road, and North Ryde 2113. ISBN 0 409 30185 X

Meredith, G. G., Small Business Management in Australia. McGraw-Hill. Chapters 8 and 16.

Meredith, G. G., Financial Management of the Small Enterprise, McGraw-Hill. Chapters 15,16,17,18 and 19.

Perry, C. & Pendleton, W., Successful Small Business Management, Pitman Chapter 4.

Ratnatunga, J. & Dixon, J. Australian Small Business Manual, CCH. Chapter 4.

The Law Society of South Australia, a Legal Guide for Small Business in South Australia. Chapter 3.

Brochures from the ASC (Australian Securities Commission) Business Centre;

Checklist for Newly Incorporated Companies and their Officers.Statutory Obligations.The Company Director’s Survival Kit.ASC Fees

Australian Taxation Office, Business Structures ‘A quick guide to the tax implications of different business structures’.


BUSINESS

PLANNING


BUSINESS PLANNING

Many of the necessary skills are based on good common sense, and may be supplemented by experience as a manager. However, you could well become a statistic if you rely only on your common sense while gaining experience. To give yourself and your business a head start on the competition, there are some key areas in which you need to be competent. These are :

Accounts/Financial Management, Staff Management, , Contracts Management (including marketing), and Planning

You should note that as taxation rates and interest rates change over time, those used in this text are examples only and not necessarily the current rates.

Objectives

On completion of this topic you should be able to :

Identify internal and external factors in the business environment.

Understand the requirements for preparing a feasibility study, long range plan and a full-written business plan.

Understand the purpose and components of a cash flow forecast.

Analyse the profit expected for a given level of sales.

Calculate sales required to break even or achieve a desired level of profit.

Understand the use of a cost benefit analysis.

Prepare a simple “what if” analysis.

Understand and interpret a balance sheet.

Measure the financial stability and liquidity of a business.

Definitions

The following definitions will be useful as you work through this module. It is important that you understand each of the definitions which follow, since these terms will be used often throughout the course.

Debt : Money owed by the business (short and long term).

Equity: Claims on the assets of a business by owners and others.Assets are contributed via internal (owners) and external equity (debt). A=L+P Equity sometimes refers to owner’s equity only.

Asset: Item of monetary value owned by the business.

Liability: What a business owes to non-owners. Usually debt (external equity).


Proprietorship: What a business owes to its owners. Owner’s equity (internal equity).

The owner’s investment in the business.

Revenue: Income/money earned by a business, usually from sales of goods or services.

Expense: Costs incurred in the course of producing revenue. Expenses can be classified in two ways.

Direct expenses: Cost of Goods Sold. Traceable to a particular job/product.

Indirect expenses: Overheads; contributing to many jobs.

Variable Costs: Costs which vary directly with sales.

Fixed Costs: Costs which are constant, regardless of the level of sales.

Gross Profit: Revenue - Direct Expenses

Net Profit: Revenues - All Expenses. (Gross Profit - Indirect Expenses).

Net Profit after tax: Net Profit less Tax expense.Earnings after tax.

Finance: Funding for/of a business or project. Monetary resources.

Capital: Usually refers to owner’s equity.

Capital Structure: The mix of debt and equity in a business. How the assets of the business are financed.

Financial Leverage: Financial gearing. The extent to which debt is used in the capital structure of the business.

Financial Stability: Ability to meet financial commitments as they fall due.

Liquidity : Short term financial stability.Availability of cash to meet debts/expenses as they fall due.

Working Capital: Current Assets - Current LiabilitiesFunds available for day to day operations of the business.

Working Capital Ratio: Current Assets Current Liabilities

Solvency: Long term financial stability of the business.

Proprietary Ratio: Proprietorship Total Assets

Current: Short term (within 1 year)


Current Assets: Assets expected to be turned into cash within 1 year.

Current Liabilities: Debts to be paid within 1 year.

Non Current Assets: Fixed assets; not expected to be converted into cash in the current period.

Non Current Liabilities: Fixed/deferred liabilities; not expected to be repaid within the current period.

Security: Assets over which a financier has effective control until the debt is repaid.

The business environment

Managing a business involves direct interaction with a number of parties who can have a significant influence on the success or failure of a business. The most obvious examples of these include :

Suppliers/Creditors, Customers/Debtors, Employees, Sub-contractors

Financial institutions eg. Bank/Finance Company and Insurance companies

The relationship with each of these parties should be mutually beneficial and typically based upon negotiation. Where possible, managers should have clear policies/strategies in place to deal with each of these parties. For example, a particular business may have the following policies :

Choose a few reliable suppliers, rather than continually pursuing the cheapest suppliers. This may involve developing close relationships with a select number of suppliers, chosen carefully to meet the requirements of your business.

Maintain a good working relationship with your bank manager. Among other things, this may involve making available to them a copy of your monthly reports and budgets, and communication all information relevant to the financier.

External factors

External factors which influence a business often present the most difficult problems for managers to deal with. There are many forces at play in the business world that the average business has little or no control over. No business operates in a vacuum; a local, state, national or even international event can affect it. For example, a rise in interest rates overseas can cause interest rates here to increase, resulting in reduced demand for new housing. Reduced housing demand would have direct effects on building contractors, sub-contractors, interior decorators and others involved in the housing industry. While none of these businesses could possibly have any control over international interest rates, they may be indirectly affected by them.

The only remedy in this type of situation is to be informed, prepared and knows when to take appropriate action. Maintaining flexibility in your business operations to allow for changes in external factors is imperative.


Some external factors which you should keep your eye on include:

The Economy, consumer demand, interest rates, inflation, unemployment,

government economic policy (including tax)

The Industry Competition, government regulations, (state and commonwealth) industry

controlling bodies, wages and employment conditions, unions, consumer

tastes and trends, the property market (as an investment relative to financial

markets)

One way to keep a track of these areas is to keep files into which you can place all of the relevant information you come across. For example, newspaper clippings, articles from industry magazines, newsletters from industry organisations, banks and others should all be kept for future reference.

Business survival and success

FACT : About 50% of small businesses go broke within their first 3 years of operations and 70 % fail within 5 years.

Of course, these figures will differ between industries. Periodically the building industry experiences a slump because of low housing demand. As a result, some businesses invariably fail due to lack of work. However, when a business fails, it is usually at least partly the result of poor management.

The large number of such business failures gives rise to the need to study business management. The aim is to improve your chances of business success/survival through the use of sound management practices and techniques. Many studies over the years have identified certain factors which are necessary to increase your chances of success.

CRITICAL SUCCESS FACTORS

Good Planning, Adequate cashflows, Adequate capital resources, Adaptability of business, Marketing strategy (product, price, placement, promotion), Appropriate debtors/creditors management, Good inventory control, Wise use of capital, allocation of resources, Use of sound bookkeeping and Accounting practices, maintaining/improving productivity , Up to date skills & knowledge (management, trade, legal etc.)

Functions of management

The task of managing a business can be broken down into four main functions or activities. These are:

DECISION MAKING

PLANNING

CO-ORDINATING

CONTROLLING


Each and every day, managers perform these functions countless times. Rather than being four quite separate activities, they are interrelated and continuous. This means that there is not always a clear distinction between each activity and that each activity is closely related to the other three activities. It is helpful to recognise that these functions exist, since it should prompt you to stand back and take an objective look at how you are running their business.

To illustrate, we will apply the four functions to two common business decisions.

a) Starting up in business.

b) Tendering for a particular contract.

The examples provided suggest the use of a variety of management tools, which will be presented in this topic, and in more detail throughout the course.

MAKE DECISIONS

a) Do a cost/benefit analysis, feasibility study, cash flow forecast, what if analysis. Consider economic/market conditions, competition, experience, finances, motivation.

b) Consider the availability of capacity, finance and expertise.

PLAN

a) Draw up a Budget reflecting the planned sales target for this year..Draw up a cashflow budget. Set purchasing strategy (eg. service before price).Set pricing strategy (eg. 7% profit on job costs).

b) Allocate resources to project.Develop timetable (Gannt chart) for project.

COORDINATE (direct, organise)

a) Set up an accounting system.Acquire finance and assets.Comply with govt. regulations.

b) Hire employees & sub-contractors.Purchase materials.Oversee site construction.

CONTROL (checks and correct)

a) Compare actual cashflows to cashflow budget.Compare actual costs to budgeted costs.Prepare periodic accounting reports.Use ratio analysis on accounting reports.

b) Daily inspection of progress reports.Regular quality checks.Compare actual costs with budgeted costs.


What is business planning?

Planning is the process of looking ahead and anticipating events. It leads to a set of pre-determined actions that will be put into effect to achieve a desired objective.

While planning is a skill in itself, business planning requires management skills in each of the areas mentioned above. Planning helps you to work smarter rather than harder. It keeps you future-orientated and motivates you to achieve the results you want. Perhaps most importantly, the process of planning enables you to determine what commitment you are prepared to make to a business venture or project. Planning significantly increases your chances of success by forcing you to

Be realistic: by quantifying your plans, and addressing different scenarios, your expectations will be based on solid reasoning and facts rather than hopes or feelings.

Recognise change : Running a business involves many variables. Where some of these are hard to predict, you will at least have identified these variables and considered all likely outcomes.

Plan for growth: Many businesses fail because they grow too quickly. The capital resources of the business may be stretched if there is a lack of planning for funding requirements.

Focus on results : Once you have drawn up a plan, you will want to compare your actual results with the planned results and identify any differences.

Seek outside assistance where necessary: You should recognise that some problems will require advice or information from outside the business.

Benefits of Business Planning

It reduces firefighting. Many small business owners spend so much time ‘putting out the fires’ that they never have a chance to take a long term view of their operations. By planning, you can anticipate problems that are likely to occur and decide how they should be handled.

It forces you to justify your plans and actions. Often one decides to do something because it ‘sounds’ or feels ‘right’. You may do something because that is the way you have always done it. Planning forces you to prove the validity of your actions or at least explain you’re reasoning for them. It enables you to test your ideas on paper. It is much better to produce a plan and find that a project is likely to be unprofitable, than to find out after you have invested time and money into it.

It is an indication of your ability and commitment. A well prepared business plan is an impressive document. It shows outsiders, such as lenders and suppliers, that you understand the business. The fact that you have spent the time to prepare a plan shows that you have a commitment to the business.

Planning can generally used for three main purposes :

The Feasibility Study : to investigate and evaluate a new project or business opportunity.

The Long-Range Plan : to provide a long term management tool so that decisions can be made which best fit with the aims or goals of the business.


The full Business Plan : to present a clear picture of the business and it’s potential. Often used to support an application for finance.

We will now taker a closer look at each of these.

The feasibility study

The purpose of the feasibility study is to evaluate the proposed course of action, by considering whether the project is feasible in terms of profitability, cashflows and financing requirements. At the same time you need to highlight other critical factors such as legal or financial constraints which may affect your proposal. The feasibility study is an initial form of planning which may lead to a more detailed business plan, if the feasibility study supports the idea. To illustrate the areas typically covered in the process of preparing such a study, we will look at the examples of establishing a business and buying an existing business.

Establishing a new business

To establish the feasibility of starting up a new business venture, you must gather information that will prove the idea is financially viable and that there is a profit to be made. You will need an understanding of marketing issues and a working knowledge of financial matters. The kind of questions you must answer will include :

What special experience or technical expertise will be required?

What is the market demand for this product of service?

What is the level of competition?

Is the market growing, declining or static?

What is the anticipated selling price of goods or rates to be charged for services?

What are the costs involved in operating and marketing the business?

Will the business generate sufficient cashflows to fund continuing operations?

What could the business yield in terms of profit and is that sufficient reward for the risks involved?

How much finance is required and will it be possible to acquire it?

What legal requirements will apply?

If possible and where appropriate, you should discuss your plan with other people who may be able to offer advice or constructive criticism. If the answers to the above questions support the idea or proposal, you can then undertake more detailed planning. On the other hand, many an idea has been rejected at this stage, saving those involved a lot of money, time and heartache.

Buying an established business

This type of feasibility analysis will attempt to ensure that you are obtaining value for money and that the current business owners have given you a true picture of the current


and potential profitability and financial stability of the business. It should help to uncover any omissions or misleading facts, made either knowingly or unknowingly by the current owners. The following types of questions are appropriate :

Why do the existing owners wish to sell? Try to determine the real reason.

Have you had experienced friends in business look over the business?

Have you looked at other similar businesses? How does this one compare?

Have you assessed the competition?

Is the business in an appropriate location?

Will the site, building and lease be suitable for your future plans?

Have you discussed the proposal with your solicitor?

Have you investigated all the laws relevant to this type of business?

Have you been given a form 6 (SA only) or trading figures for the past three years (supported by documentary evidence).

Have you checked out the business with suppliers, customers and staff?

Have you checked the ownership and condition of plant and equipment included in the sale?

Is the figure asked for goodwill reasonable?

Are you expected to assume any liabilities previously incurred? Will you need any additional equipment/fittings/renovations?

The long-range plan

This type of planning is designed to give a business direction and purpose over the long term. It attempts to look beyond the current range of business activities and ask questions such as :

What are the business objectives?

Are we in the right business?

What is happening to our market in the long term?

What is the outlook for our present product/service?

Long range planning involves the business as a total entity. It considers the future direction and sets the objectives of the business owners. These objectives are then broken down into measurable targets that you hope to achieve.

Once this is done, you can put into effect your operational planning which will assist you on a day-to-day basis to achieve these targets and thus over time, the long term objectives of the business. Operational planning involves the consideration of events over the short term (usually twelve months) and deals with the more immediate aspects of the business.


A successful business plan requires both long-term and operational planning. There is no point in setting long-term objectives if you fail to translate them into day-to-day activities. On the other hand, operational plans are ineffective without a clear direction.

The steps used in formulating a long range plan are shown below.

1. Decide on the objectives of the business.

What is its purpose? What is it there for? Why was it created? What do you want it to do for you and/or the other owners? This essentially tries to establish why the business exists and why it should continue to exist?

2. Establish a suitable time-frame for the plan.

How far ahead can you see? Is it a two year plan, a five year plan or a ten year plan?

3. Conduct a SWOT analysis.Forces you to identify important fundamental characteristics of your business in terms of it’s:

Strengths (often referred to as critical success factors)WeaknessesOpportunitiesThreats

The strengths and weaknesses relate to the internal aspects of your business and will involve areas you have some control over. Opportunities and threats are features outside the business, in the external environment, over which you may have little or no control.

This will require an extensive examination of your business and the industry trends affecting it. The specific areas which you should concentrate on are listed in the summary which follows this discussion. You may require market research material to help to identify future trends in the industry.

4. Identify potential strategies.

Once the SWOT analysis has been conducted and important characteristics of the business have been identified, business managers can identify strategic plans which will help to; fully utilise strengths, overcome weaknesses, take advantage of opportunities,, and deal with threats appropriately.

A list of these, and any other alternative strategies should be compiled.

5. Select appropriate strategies

You should select the most suitable course of action that best suits your objectives. This should be done only after careful evaluation of all the potential strategies which you have developed.


6. Develop an operational plan that :

a) Sets definite targets that you want to achieve in a certain time-frame, eg. To increase sales by 10% in the coming twelve month period.

b) Outlines the resources and means by which you will achieve your targets, eg. The extra resources staff or advertising you will require to achieve the 10% increase as well as the method of financing you will use to obtain them.

c) Has methods of control and feedback so that you can evaluate and maintain your operational plan, eg. Sales records, cash flow budgets, and marketing plan. These and other management tools will indicate you whether you are on track to fulfilling your plans.

This type of planning should never be regarded as inflexible or cast in iron. In today’s ever changing business environment, the need for constant re-assessment and flexibility is of paramount importance. Therefore when approaching your long-range planning, you should always be prepared to change direction if it is required.

Also, remember that planning is an ongoing process and you must continue to plan for your future. For example, you do not wait for the end of the two year time-frame to commence the next planning period. Rather, you must try to look two years ahead at all times and keep adjusting your outlook and plans on that basis.

It has been said that the real benefit of long-range planning is that it allows a business to keep its ‘eyes open and forward looking’.

There are many books written on this type of business planning. For further reference, you should consult the recommended readings presented as references at the end of this topic.

The full written business plan

If an initial feasibility study shows promise, then a full written business plan can be prepared to assist you in the implementation of your business idea.

If the plan is for your own use only, the long range plan discussed earlier may be sufficient. However, if you have to ‘sell’ your idea, perhaps in seeking support or finance, a detailed business plan, well prepared and presented, will be invaluable. A financial institution will judge your idea based on the information you present to them.

There are many questions to be answered in a detailed business plan, many of which also apply to feasibility studies and long range plans. However, this type of plan usually also includes information of interest to third parties such as lending institutions or potential business partners. The areas covered and questions that need to be answered are presented below.

Description of the business

What type of business are you planning (retail, wholesale, service)?

What products or services will you sell?

What type of opportunity is it (new, part-time, full-time, seasonal, and year-round?)


Why does it promise to be successful?

What are the growth opportunities?

Marketing Plan

Who are your potential customers?

How will you attract and hold your share of the market?

Who are your competitors? How are their businesses performing?

How will you promote sales?

Who will be your main suppliers?

Where will the business be located? What features will this location have?

How will your premises contribute to your marketing strategy?

What will your building layout feature?

Organisation Plan

Who will manage the business?

What qualifications will you look for in a manager?

How many employees will you need? What will they do?

What are your plans for employee hiring, salaries and wages, benefits, training and supervision?

Will the business subcontract work to others outside the business? How will these sub-contractors be found?

What consultants and specialists do you need? Why will you need them?

How will you manage your finances?

How will you manage your record keeping?Which form of legal ownership will you choose for your business? Why?

What licences and permits will you need?

What regulations will affect your business?

Financial Plan

What is your estimated monthly and total business income for the first year?

What will it cost you to start up the business and sustain it for eighteen months?

What will be your monthly cashflows during the first year?


What income do you expect to remove from the business for personal use?

What sales volume will you need in order to make a profit for the first year?

What will be the break-even point?

What will be your projected assets, liabilities and net worth is upon commencement of the business?

What will the capital value of your equipment be?

What will your total financial needs be?

What will your potential funding sources be?

How will you use the money contributed by lenders or investors?

How will the debts be secured?

When you have the answers to these questions, you can formulate your planA full business plan includes information on long-term planning, operational planning feasibility studies and much more. The preparation of such a detailed business plan may seem quite daunting. It may well be beyond your skills at this point in time, and you may find it difficult to understand the importance or relevance of some of the above points When preparing any business plan, you may need to seek information and advice from various sources.

Management planning tools

A Statement shows actual historical data.A Forecast shows estimated future data.A Budget shows planned future data.

Control is achieved by comparing actual results to budgeted results.

The terms 'forecast' and 'budget' are often used interchangeably (both involve future data), but technically they are different.

A forecast is what you expect to happen, whereas, budget is what you want to make happen. For example, you may decide to draw up a forecast of expected future cashflows; it may indicate that cash shortages will occur in the future, giving you an early warning and a chance to do something about the situation. On the other hand, the preparation of budgets implies a pro-active role in planning and control.

For example, a cashflow budget will be seen as a plan for future operations. After preparing one, you will have a plan which outlines goals or targets which you can work towards and be guided by. For control purposes, you will later compare the cashflow statement with the cashflow budget in order to observe any major variances.


Figures used in forecasts/budgets can be based on :

1. Historical analysis of previous results2. A % change on previous year3. Managements perceptions

Statements, Forecasts and Budgets (which usually all have the same format) can be prepared for all types of reports including :

CashflowsProfit & LossBalance Sheet Cashflows and profits.

Cashflow analysis

Cashflow planning is essential for effective management of the cash resources of any business. A cashflow forecast is commonly used to estimate the changing cash position of a business in the future. By including all estimated cashflows for a period, it allows us to calculate the net cashflow for each period as well as the cash balance at the end of each period. This type of report is absolutely essential when planning for financing requirements, asset purchases, investment decisions, owner's drawings etc. The basic calculation performed in a cashflow forecast is as follows :

OPENING CASH BALANCE + NET CASHFLOWS = CLOSING CASH BALANCE

The following example shows the typical format of a basic cashflow forecast.

Cashflow Forecast of ABC Pty. Ltd.For the six months ending June 30 2006

Jan Feb March April May June TotalProgress payments 8000 12000 12000 4000 10000 16000 62000Other Income 2000 2000 2000 2000 2000 2000 12000TOTAL CASH IN 10000 14000 14000 6000 12000 18000 74000 Materials Purchased 4000 5000 2000 4000 5000 2000 22000Wages Paid 1000 2000 3000 1000 2000 3000 12000Other Expenses 1000 1000 2000 1000 1000 1000 7000Asset Purchase 4000 2000 6000Drawings 1000 1000 1000 2000 1000 1000 7000TOTAL CASH OUT 7000 9000 12000 8000 11000 7000 54000 NETT CASH FLOW 3000 5000 2000 -2000 1000 11000 20000OPENING Bank Balance 5000 8000 13000 15000 13000 14000 5000CLOSING Bank Balance 8000 13000 15000 13000 14000 25000 25000


This example shows that the business is starting with a bank balance of $5,000 at the beginning of January and due to an estimated net cashflow of $20,000 ($74,000 - $54,000) during the six month period, expects to end up with a bank balance of $25,000 at the end of June. These results can be read directly from the ‘total’ column and a similar analysis can be applied to each month.

Profit analysis

To examine the profitability of a business we need to construct a profit and loss statement (revenue statement), which shows all of the revenues and expenses for a period. A profit budget should be prepared by those in business as well as those intending to start in business. The profit budget can be used to investigate :

The amount of profit (before tax) which will flow from a given level of sales.The level of sales required to produce a given level of profit (before tax).

Also the profit budget should be used as a control mechanism, by checking actual results against the budget which was prepared.

The following steps are required to prepare a profit and loss budget.

Steps 1 Forecast sales for the period.

Step 2 Calculate variable cost/cost of goods sold (COGS) using a set ratio established from either :

Past experience (i.e. based on previous profit reports), orIndustry average ratios

Step 3 Calculate fixed cost/overheads

Step 4 Calculate net profits.

Example : Use the following information to calculate the budgeted net profit for January and February.

Forecast sales : Jan $30,000 Feb $40,000

Cost of Goods Sold Ratio : 70% of sales (established from past results)

Fixed costs : Office wages $ 2,000 per monthRent $ 1,300 per monthMotor Vehicle expenses $ 200 per monthLease expense $ 500 per month


Profit budget

Jan Feb Sales 30 000 40 000

Less COGS (70% of sales) 21 000 28 000 70% = Gross Profit 9 000 12 000 30%

Less Other expenses Office wages 2 000 2 000 Rent 1 300 1 300 Motor Vehicle exp 200 200 Lease expense 500 500

Total expenses 4 000 4 000

= Net Profit (before tax) 5 000 8 000

Break-even analysis

The break-even point is the level of sales for which there will be zero profit.

It is important to know what your break-even point is since this will be the level of sales below which the business will make a loss, and above which the business will make a profit. The break-even point is calculated as follows.

Break-even point = Total Fixed Costs Gross Profit %

The gross profit percentage is simple to calculate since it is simply 100 % - COGS %.

Using the data from the previous example, calculate the break-even point for the business.

Break-even point = $ 4 000 = $ 4 000 = $13,333 30% 0.3

We now know that the business must achieve monthly sales of at least $13,333 to break even. If the business has lower sales in any month, a loss will be incurred for that month. If the business has sales over $13,333 for any month, the business should make a profit for that month.

Target profit levels

You can also calculate the level of sales required to achieve a target profit level (before tax), by using the following formula.

Sales required = Total Fixed Costs + Target Net Profit (before tax) Gross Profit %

What sales would be required to generate a net profit (before tax) of $10 000 in one month.

Sales required = $ 4 000 + $10 000 = $14 000 = $46,667 30 % 0.3


So, to earn a profit (before tax) of $10,000 in any month, the business must achieve sales of $46,667 for the month.

Cost/benefit analysis

To prepare a cost/benefit analysis you need to draw up a detailed list comparing all the expected costs and benefits of a particular course of action.

A cost/benefit analysis allows you to organise your thoughts more clearly, by preparing a list of all the costs and benefits associated with a proposal. This planning tool is commonly applied by managers to help them make a variety of business decisions. Your are currently in a partnership and considering the option of forming a company. To help you make the decision, you draw up the following cost/benefit analysis.

COSTS BENEFITSOne off costs Annual tax advantage ($10,000) Accountants Fees ($500) Limited liability Lawyers fees ($200) Better business image Set up costs ($1,000) Business name registration ($90) Changes to stationary ($200) New signs for premises/site ($500)Extra Periodic costs Part-time company secretary ($200 pw.) ASC Document lodgement fees ($50 pa.) Lost privacy

This example shows a simple analysis, which in reality would be done in as much detail as possible. Notice that the analysis contains costs and benefits which can be measured in monetary terms, as well as those that cannot. For example, it is impossible to place a value on the advantage of limited liability which is available to owners of a company. This means that there cannot usually be any firm conclusions drawn from the analysis, although the decision making process does becomes more objective, since all of the relevant factors will be taken into consideration.

Some figures used in any cost benefit analysis would most likely be estimations, and you should bear this in mind when assessing the net benefit of undertaking the proposal. The figures included above are examples only and would differ between businesses, depending on the size and nature of the business. The amount of the tax advantage would be largely dependant on the size of profits and the personal financial situations of the owners.

"What if" analysis

This management tool allows you to predict how a change in the business environment would affect your business. We can use it to trace the effect of a given event or set of circumstances on the business.

Usually, this tool is applied to predict how liquidity, performance or financial position will be affected under different scenarios. The example below shows a “what if” report that investigates the effect of increasing interest rates on profits.


Eg. How will Net Profit after Tax be affected by increases in interest rates?(Assume debt = $100,000 and current interest rate = 10%.)

To answer the question we can prepare a Profit & Loss Forecast for several different interest rate levels.

Eg. What if interest rates rise to 15%?What if interest rates rise to 20%?

Interest rate 10% 15% 20% (now)

Sales 250 000 250 000 250 000-Direct exp 200 000 200 000 200 000 Gross Profit 50 000 50 000 50 000

-Admin exp 10 000 10 000 10 000-Financial exp 10 000 15 000 20 000 Net Profit before tax 30 000 25 000 20 000

- Tax (company @33%) 9 900 8 250 6 600

Net Profit after tax 20 100 16 750 13 400

Note : The fall in After Tax Profit is less than the increase in interest expenses because of the tax deduction, which effectively reduces the extra interest expense.

A Cashflow Forecast should also be prepared to predict liquidity changes.Other common examples of applications for “what if” analysis:

Eg. What will happen to my business if Sales fall by 10%?

Eg. What will happen to my business if COGS as a % of sales increases to 75%?

Eg. What would happen to my tax bill if I enter into a partnership with my spouse?

Computerised spreadsheets make this type of analysis easier, since they allow fast automatic re-calculation.

The Balance Sheet

Consider the following summary of the sources and uses of funds for a business.

Sources of Funds

DEBT Funds contributed to the business by non-owners.Short or long term liabilities.

EQUITY Funds contributed to the business by owner/s;

OWNER'S CAPITAL Funds invested into the business by owner/s.

RETAINED PROFITS Profits not withdrawn from the business by owner/s.= Net Profit less drawings/dividends.(Added to owners capital each year)


Uses of Funds

FIXED ASSETS Permanent assets owned or controlled by the business, used to provide income generating capacity (i.e. infrastructure).

CURRENT ASSETS Working capital, used to fund day to day activities, eg. To buy materials or stock, pay for expenses, satisfy creditors, finance debtors, etc.

All of the above information is contained in the Balance Sheet, an example of which is shown below.

Balance Sheet - T FormU-beaut Builders

As at 30 June 1995

ASSETS $40,000 LIABILITIES $10,000(Debt)

PROPRIETORSHIP $30,000(Equity)

====== ======$40,000 $40,000

The balance sheet : an accounting report which summarises information about what a business owns and what it owes to owners and non-owners, at a given date.

Alternatively, we could say that the balance sheet contains information about :

What assets a business owns and who has claims to those assets, at a given date.

The assets, liabilities and proprietorship of a business, at a given date.

The financial position and capital structure of a business, at a given date.

Assets : What a business owns; items of monetary value.

Liabilities : What a business owes to non-owners/creditors (generally debt).Contractual claims on business assets.Also referred to as external equity.

Proprietorship : What a business owes to its owner/s.The owner's (proprietor’s) financial interest in the business.Residual claims on business assets.Also referred to as : owner's capitalOwner’s equity, equity capital, equity (internal) or net worth of the business.

Note that we describe the balance sheet as showing what the business (not the owner) owns and owes. That is, the balance sheet (and all accounting reports) is prepared on the basis that the business is a separate entity (from its owners). For example, money invested by the owner appears as an asset of the business, but also as an internal liability (proprietorship), showing that the money invested is 'owed' to the owner. This 'accounting entity convention' is discussed more fully in topic 2 - Bookkeeping.


The balance sheet presents us with a 'snapshot' of the assets, liabilities and proprietorship in a business. That is, it shows the financial position of the business 'at a particular point in time'. The balance sheet is usually prepared on the last day of the accounting period, eg. on the last day of the month or year.

The balance sheet in diagram 1.1 shows us that (on 30/6/95) the business has $40,000 worth of assets, owes $10,000 to creditors, and owes $30,000 to its owner/s. Note that A = L + P, ($40,000 = $10,000 + $30,000). We know this must be the case since any assets (A) the business has must have been financed by either debt (L) or equity (P). The balance sheet should always 'balance', according to the A = L + P equation.The balance sheet presented in T-format (Diagram 1.1) shows us what assets a business has and how they have been financed, (or put another way, which has claims on those assets). We can rearrange the format of the balance sheet to present the same information in a different way

Balance Sheet - Narrative formU-beaut Builders

As at 30 June 199X

PROPRIETORSHIP $30,000Represented by :

ASSETS $40,000 less

LIABILITIES $10,000

Net Assets $30,000

Note that P = A - L. Presented in this form, it tells us is that the owners interest/investment in the business is equal to the net assets (or net worth) of the business. If the business ceased operations on this date, the assets (A) could be liquidated (turned into cash) to pay outstanding liabilities (L), with the remainder (A - L) belonging to the proprietors/owners (P).

Recall that the owners have 'residual claims' on the assets of the business. Conversely, debt finance involves contractual claims on the business' assets (with effective control over assets which are used as security for the debt). This means that if the business ceases trading, all creditors must be repaid first, before the owners are entitled to any remaining or 'residual' funds.

Assets and liabilities can be further classified as either current or non-current (fixed). The word 'current' refers to the short term, as you will see from the following definitions and examples of common ‘accounts’.

Assets

Current Assets: Assets that a business intends to convert to cash (or consume) in the short term (i.e. in the next period).

Eg. Cash at Bank, Petty Cash (cash on hand), Loose tools, Trade Debtors (accounts receivable), Inventory of materials or stock work in Progress (WIP inventory; partially completed jobs), Prepayments (money paid in advance for a services yet to be used) eg. Prepaid insurance premiums or prepaid rent under lease agreement.


Fixed assets: Assets of a relatively permanent nature.Used to help produce income; not to be converted to cash.

Eg. Motor Vehicles, Machinery, Plant & Equipment, Land & Buildings, Other Investments eg. term deposits, shares, bonds, Intangible Assets eg. goodwill, patents, trademarks

Current Liabilities: Debts that the business must repay in the short term.

Eg. Trade Creditors (accounts payable)Accrued expenses (money owing on expenses already incurred), eg. unpaid telephone expense

Deferred liabilities: Debts of a long term nature (non-current liabilities)

Eg. Term Loan, Mortgage

Proprietorship : The proprietor’s (owner’s) financial claims on the assets of the business. The accounts in this section of a balance sheet will depend upon the type of ownership method used. Sole traders use the following two accounts.

Owner’s Capital: A separate account for each owner showing their investment in the business.

Drawings: Funds (or other assets) removed from the business by its owner/s.

Balance Sheet - Narrative FormU-Beaut Builders

As at 30 June 199X

PROPRIETORSHIP

Owners Capital (start) $28 000 + Net Profit $20 000 - Drawings $(18 000) Owners Capital (30/6/2005) $30 000

Represented by

ASSETS

Current Assets Cash at Bank $5 000 Debtors $3 000 Materials $7 000 $15 000

Fixed Assets Motor Vehicles $15 000Plant & Equipment $10 000 $25 000

Total Assets $40 000


LIABILITIES

Current Liabilities Creditors $5 000Accrued wages $1 000 $6 000

Non-Current LiabilitiesTerm Loan $4 000

Total Liabilities $10 000

NET ASSETS $30 000

Note that the Proprietorship section of the balance sheet shows how the new figure for Owner's Capital was arrived at; by adjusting the opening capital balance (at the start of the 12 month period) for profits/losses and drawings taken out during the period. The net profit figure would have been calculated in the Revenue Statement which contains details of revenues and expenses for the period. The Revenue Statement, also called the Profit and Loss Statement, is covered in detail in topic 4; Using Financial Reports.

Financial Stability and Capital Structure

Financial Stability: The ability to satisfy long term commitments and to continue operating in the future.

We can assess the financial stability of a business by looking at its capital structure (the mix of debt and equity in the business). One way of doing this is to calculate the proprietary ratio which compares the amount of proprietorship to the value of assets in the business.

Proprietary Ratio = Proprietorship Total Assets

Eg. (For U-Beaut Builders) = $ 30,000 = .75: 1 $ 40,000

The higher the ratio, the better the long term stability/viability of the business. The financial stability of ‘U-Beaut Builders’ looks to be in reasonable shape, since the owners have claims to 75% of the business’ assets. Since A = L + P we know that creditors must have the other 25% of ownership in the business.

Financial stability can be undermined if a business has high levels of debt, relative to owner’s equity. The more reliant it is on debt capital, the more it is affected by higher interest rates and credit squeezes. If times get tough, the business may be at risk of becoming insolvent, (i.e. unable to satisfy creditors), which may lead to the bankruptcy of the owner/s. On the other hand, a business financed mostly by its owners is insulated from these potential problems. A business with relatively low levels of debt may also benefit by having some 'spare borrowing capacity', which may allow it to take advantage of new investment opportunities.

Although the level of debt must be controlled, this does not imply that debt is bad. In fact, debt can be good for a business, since it allows the owners to make use of funds not otherwise available. Debt may be favoured over equity when the owners wish to maintain


control over management and profits. If the borrowed funds can be invested to yield a return greater than the cost of the debt, then this will increase profitability. The use of debt in this way is referred to as 'financial leverage' or 'gearing'. Thus, so long as the business is not 'over leveraged', debt may be used to the advantage of the business. Note also that the cost of business debt (interest expense) is tax deductible, whereas the cost of equity (a share of profits), is not.

As we have seen, the balance sheet allows us to asses the long term financial stability of the business. Next, we look at the short term financial stability (liquidity) of a business

Liquidity and Working Capital

Liquidity: The ability to satisfy short term commitments as they fall due.

We can assess the liquidity of a business by looking at the availability of working capital (the funds available to finance the day to day activities of the business). This involves looking at the current items in the balance sheet.

(Net) Working capital = Current Assets - Current Liabilities.

Eg. (for U-Beaut Builders) = ($15,000 - $6,000) = $9,000

Working Capital Ratio = Current Assets Current Liabilities

Eg. (For U-Beaut Builders) = $15,000 = 2.5: 1

$ 6,000

'Net working capital' is often referred to simply as 'working capital'. Working capital requirements for different business will vary, depending on the nature and size of the operation. The Operating Cycle (or cash cycle) of a business is the length of time it takes from when cash is first converted into raw materials or goods or services, to when payment for them is received. It is this cycle, this delay in time, which creates a need for working capital. Consider the time it takes from when cash is first used to secure a contract and buy materials and labour to when payment is finally received for work done.

For a builder, working capital requirements will depend largely on the size of contracts and also the frequency of progress payments. Large projects may involve several weeks or even months in which the builder is required to finance the work to completion or pre-determined stages of completion. Large sums of money may be 'tied up' as WIP - work in process inventory (eg. unfinished building work which has consumed labour and materials costs, but is yet to be paid for by the client). The builder must finance the project until this current asset is turned into cash by way of progress payments or account settlement.

A builder must ensure that there is adequate working capital to cover any retention monies, plant hire, materials, wages, sub-contract expenses, other operating costs and overhead costs. If sales are made on a credit basis (eg. 30 day terms), then the business will also need to finance this 'credit facility' for its clients. That is, the cash cycle is extended further, since it takes longer to receive the revenue earned. Conversely, if trade credit is received from suppliers, then this reduces the cash cycle and the need for working capital, since the cash would not need to be outlaid until after materials were used up in projects. The following diagram shows the timing of cashflows associated with a simple building project.


Cashflow Timeline.

| 1 month | 1 month | | | |

START PROJECT COMPLETE PROJECT RECEIVES PAYMENT BUY MATERIALS INVOICE CLIENT HIRE LABOUR

CASH OUT CASH IN

Note that the cash outflows occur now, whereas the resultant income is not received until two months later. This means that the business must finance the cost of the project for two months. Also, the business must meet its overhead expenses during this time, further increasing the need for working capital. The example in diagram 1.4 assumes that no trade credit is received (i.e. all materials purchases are on a cash basis) and the client is given 30 days to pay.

The availability of adequate levels of working capital is essential to the success of any business. Working capital requirements can be reduced by purchasing on credit and/or reducing the time allowed for clients to pay. Also, prompt invoicing and strict debt collection procedures are vital for keeping the cash cycle and working capital needs to a minimum.

Seeking help & advice

Numerous sources of information and advice are available (at varying costs).

SOURCE INFORMATION / ADVICEAccountant Accounts/tax preparation, advice

Bank Manager Advice regarding business finance

Lawyer Advice in legal matters

The Business Centre Advice and services in all areas of business management.

Business consultant as above, specialist services

The Tax Office Information & advice on most tax matters

Trade Associations Industry information, news etc.

Employers Federations List of trade associations and training courses

Chamber of Commerce List of trade exhibitions/fairs& Industry

Office of fair Trading Regarding Fair Trading Act

Law Society Litigation fund, $15 for 1st 1/2 hr

Dept of Labour Award & trading hrs. Information


ABS (Aust. Bureau of Economic, business, population statistics.Statistics)

Local Govt Councils Information on other local businesses; start up/closures

TAFE seminars/courses bookkeeping, accounting, tax, etc.

Industry magazines Current issues, new technology, materials etc.

Books (Libraries) Information on all areas of business management

Other business owners/ Experience and information with the industry, theManagers/representatives. competition, suppliers, debtors

Friends, family etc.


Revision

Q1. Briefly define each of the following terms.a) Assetb) Capital structurec) Liabilityd) Financial stabilitye) Proprietorshipf) Liquidity

Q2. Fill in the missing figures for each of the following businesses (a, b & c).

ASSETS LIABILITIES PROPRIETORSHIP

a) $ $40,000 $40,000

b) $30,000 $10,000 $

c) $60,000 $ $20,000

Q3. Which business (a, b or c) has the greatest net worth?

Q4. Complete the following table.

ACCOUNTNAME

ACCOUNTTYPE

Cash at Bank Current assetsDebtorsCreditors Plant & EquipmentBank OverdraftOwner's CapitalWages PayableTerm LoanWork in ProgressPrepaid insuranceDrawingsMotor Vehicles


Q5. Construct a balance sheet (as at 30/6/2006) including all the following items

ACCOUNT NAME $

Owners Capital (1/7/2006) 90,000Net Profit (2005/2006) 43,000Drawings 25,000Cash at Bank 11,000Debtors 14,000 Work in Progress 6,000Materials Inventory 4,000Motor Vehicles 28,000

Plant & Equipment 15,000Land & Buildings 80,000

Creditors 15,000Bank Loan 35,000

References

AGPS (Australian Government Printing Service) publications

No. 8 Avoiding Management pitfallsNo. 31 Help your business survive and growNo. 24 Management for the self-employed

Business planning for small manufacturers Preparing a business plan

Other publications

Alison, R., Mind your own business, Pittman 1986.

Meredith,G. G.; Small business management in Australia, McGraw-Hill

Meredith,G. G.; Small business success stories, McGraw-Hill

Morkel, Andre; Business planning. Do it yourself, published by the Company Directors Association of Australia.

Ratnatunga, J & Dixon, J. Australian Small Business Manual; CCHChapters 1, 4 and 22

Vogelaar, D.M.. How to write a business plan. Australian Business Library, 1990.


CASH

FLOW


CASH FLOW

The profit for a period is calculated by subtracting expenses from revenues. On the other hand, your cash flow refers to the amount of cash coming in and cash going out of your business for a period. The balance of cash in and cash out (the net cashflow) during a period, will determine the effect on your cash position.

A cash flow analysis is a summary of the cash in and out of a business, showing a positive or negative cashflow (i.e. the net cashflow) for a given period. This allows you to calculate the bank balance at the end of each period by adding the net cashflow to the opening bank balance.

A term used in financial reports to describe cash flow is liquidity. A business must remain liquid to survive. Your cashflow is the lifeblood of your business and personal survival so be careful and plan your cash flow, carefully and regularly.

This unit will provide you with an understanding of the preparation and use of cash flow forecasts.

Objectives

On completion of this unit, you should be able to:

1. Define the following terms: cash flow, liquidity, profitability, net profit ratio

2. Complete a cash flow forecast;

3. Calculate monthly net cash flows and cash balances;

4. Interpret a cashflow forecast and report on the results;

5. forecast your administration/overhead expenses;

6. forecast your other cash outlays;

7. Design an S graph.

Cash flow basics

Profitability and net income

We will first revise some basic concepts of profit and then see how profits and cashflows are usually closely linked, but differ in several important ways.The object of your business is survival, coupled with a good return (i.e. profit). To ensure survival, a business must be liquid so that cash is available to pay for expenses and meet debts as they fall due. Notice that the three objectives are related:

PROFITABILITY POSITIVE CASH FLOW SURVIVAL

What is profitability? You may also hear it referred to as net profit or net income. It is the total of your income (revenue) earned in a period, less any expenses incurred in that period.


Example

J Smith, a builder, generated income for the year ended 30 June 2005 of $60,000 and his expenses during that period of time were $28,000. What is his profit?

Progress payments $60,000Less expenses $28,000

$32,000

Net profit ratio

How then can you compare the operating results of your business from one job to the next, or one period to the next? A simple way of doing this is to apply a profitability (net profit) ratio (or as it’s sometimes called an efficiency ratio).

This is a simple ratio which will help you to assess the profitability of each job as well as each period. You can use this net profit ratio to compare your business with past performance or another business to indicate how efficient your business is.

The ratio is simple if we ignore income tax for the moment.

NET PROFIT RATIO = NET PROFIT X 100 SALES 1

For the example of J. Smith: 32,000 x 100 = 53.33%

60,000 1What does this mean?

For every dollar of income in the form of progress payments that Smith earns, he is keeping 53.33 cents in the dollar - again it appears a good return.You should calculate the profit ratio on a monthly basis and also on a job basis by using your individual job cards.Calculate the net profit and net profit ratios for the following businesses and comment on the result.

1 J Brown received progress payments for the year of $126,550 and her expenses totalled $96,480.

2 D White received progress payments of $78,000 for the year and his expenses totalled $82,000.

Liquidity

Refer back to our example of J. Smith. We found that he made a net profit of $32,000 for the year, and we calculated a net profit ratio of 53.3%.

Does this mean that J Smith is doing well?

His profitability seems quite good. However, it is impossible to completely tell from this small amount of information. An important question we need to answer

Is the business liquid?


Even though a business is a profitable one, it may not be liquid. It is possible for profitable businesses to run out of cash and go broke. In fact, a common symptom of all expanding businesses is that they are usually short of ready cash. It is not uncommon for major building companies to go into liquidation because their cash flow has dried up, even when there are many thousands of dollars of orders on its books for new building work.

The opposite position is also possible, but rare. A business can also be liquid but not necessarily profitable. Over time, this lack of profitability will obviously work to reduce the liquidity of the business as well.

Both of these situations are undesirable. However, in the short-term liquidity and cashflows are more important than profitability, since cash is needed just to keep the business operational so that it can make a profit. In the long term, a healthy business should be both profitable and liquid.

A lack of liquidity can pose many problems. The day to day running of the business requires an adequate cash position to meet expenses & debts as they fall due. It is also important to be in a position to finance contracts to various stages of completion. You have to have money to make money. When a business is not liquid, the business becomes financially unstable. This is a trap that many businesses (and individuals) fall into. Often however, the liquidity problem can be identified and corrected ahead of time through the use of cash flow forecasts. If you can see that a "cash crisis" is looming you can act now to avoid it. Once cash flow shortages have been identified there are usually several options available including?

1. Convert liquid investments or other assets into cash

2. Focus on individual cashflows and try to improve them (eg. reducing expenses)

3. Delay payments to creditors (note you may loose goodwill or discounts as a result)

4. Negotiating better trading terms with debtors/creditors.

5. Arrange short term finance. Usually overdraft.

6. Use Sale/Lease Back Finance to free up working capital.

7. Delay expenditure on fixed assets.

8. Sell (idle) assets.

On the other hand, if forecasts indicate that you will have a cash surplus in the future, then plans can be made to use spare funds to reduce debt or to invest them at higher rates of return. Above all, the aim is to avoid a cashflow crisis by ‘forecasting’ cash shortages before they occur. The more warning you have about cashflow problems, the more time you have to correct the situation. Some general tips for contractors on managing cashflows are included later in this topic.

At this stage, you need to realise that you should keep a close eye on liquidity, by keeping up to date on your current and expected cash position. This will involve:

1. Keeping an up to date balance of your cash at bank account, by using your chequebook, cashbook or cash journals checking your cash position by performing regular bank reconciliations


2. Preparing cashflow forecasts regularly.

3. Using appropriate ratios to keep track of liquidity

A common measure of liquidity which we have seen in earlier topics is the current ratio (Current Assets Current Liabilities) which also takes into account other liquid (current) assets and liabilities, besides cash at bank. This ratio should also be calculated on a regular basis.

We will now examine the reasons why profits and cashflows for a period may be different.

Cashflows versus profits

The following summary shows the clear distinction between “accrual accounting” (i.e. accounting for profit) and “cash accounting” (i.e. accounting for cash).

CASH ACCOUNTING vs. ACCRUAL ACCOUNTINGMEASURES LIQUIDITY PROFITABILITY

Cash Flows Revenues and Expenses(In and out) (Earned and incurred)

REPORT TYPE Cash Flow Forecast Profit & Loss statement

BOTTOM LINE CASH POSITION NET PROFIT

The cash position of a business (i.e. the cash at bank balance) should be forecast regularly, to provide a good basis for planning.The following table provides a summary of all the potential cash inflows and outflows for a period, all of which affect the bank balance.

SOURCE OF CASHFLOW

CASHFLOWS

IN OUTCASH TRANSACTIONS Cash sales Cash Purchases

Other cash income Eg. rent/interest received

Other expenses (refer to P&L statement)

CREDIT TRANSACTIONS

Receipts from debtors Payments to creditors

CAPITAL TRANSACTIONS

Sell assets Buy assets

Borrow funds Repay fundsOwner injects funds Owner draws funds

While profits and cash flows are related, recall that they are not equal. Examples of transactions that cause this difference include:

Materials are purchased on credit. An expense is recorded now but the cash flows out in the next period.Credit sales these increase revenues in this period but the cash inflow occurs next period.

A telephone bill is paid which relates to the expense incurred in the previous period. The cash flows are affected in this period even though the expense occurred in the last period.


Tax is incurred in this period and paid in the next. The expense is included in this period but the cashflow occurs in the next period.

A job may be done in this period, but some income from that job will not be received until the next period. You record the revenue now, but the cashflow occurs next period.

You make a capital expenditure on new equipment. This is a capital expenditure and is not included with other expenses in the profit calculation, but a cash outflow occurs.

Depreciation is charged against an asset. An expense is recorded but no cash leaves the business.

The owner withdraws some of his capital from the business. A cash outflow occurs but no expense is recorded.

The business borrows funds from the bank. A cash inflow occurs but no revenue is recorded.

These examples highlight the differences between profits and cash flows.In summary the two types of transactions which cause the difference are:

Credit transactions where the revenue/expense is gained/incurred in a different period than the associated cashflow.

Capital transactions (those transactions which do not involve revenues or expenses) generally affect cashflows but not profits in the current period.

While we can use accrual accounting to determine profit for a period, we need to examine the actual cash flows of a period to determine the ending cash position.

RevisionQ1. What is a cash flow?

Q2. What term is used to describe the availability of funds in a business?

Q3. Comment on this statement: “Profitability and cash flow can be the same amount for a period.”

There are three different types of cashflow reports.Cashflow Forecasts Help to identify problems ahead of time.

Cashflow Budgets Used for planning and control purposes.

Cashflow Statement Summary of past cashflows.

Often, a cash flow forecast is used to predict future cash flows and cash positions, and the results are then used to help formulate a budget which is used for cash planning and control purposes.


The steps involved in constructing a cash flow forecast are as follows:

1 Identify and estimate/forecast all cash inflows and outflows for each period 2 Determine the net cashflow (i.e. a cashflow surplus/deficit) for each period.3 Add the net cashflow to the opening bank balance to determine the ending balance

for each period.4 Transfer that closing bank balance of each period to the opening balance for the

next period.5 Use a ‘totals’ column to double check your calculations.

Example 2 month cashflow forecast

A contractor asks you to prepare a cash flow forecast for the two months of March and April, stating that progress payments are estimated to be $60,000 and $40,000; cash outflows, $20,000 and $50,000, with an opening bank balance of $5,000.

Cash flow forecast for 2 monthsEnding 30 April 1996

March$

April$

Total

$

A

B

Cash in Progress paymentsCash out Cash expenses

60,000 20,000

40,000

50,000

100,000

70,000

C

D

Net cashflow

Opening bank balance

40,000

5,000

(10,000)

45,000

30,000

5,000

E Closing bank balance 45,000 35,000 35,000

Although the cash flow forecast above looks simple, it is important to note the following:

C = (A - B) and E = (C + D) for each month and for the total column.

The opening bank balance (in this case $5,000) is always entered twice, once in the beginning month (in this case March) and also in the ‘total’ column. This is because the opening balance for the first month must also be the opening balance for the total period. The closing balance for the first month of $45,000 is transferred to the opening balance for the following month.

As a check on your calculations, the closing bank balance of your final month (in this case $35,000 at the end of April) must always agree with the closing bank balance in your total column.

The first section of your cash flow that the bank manager will look at is the ‘bottom line’ which shows the closing bank balances for each month. This contractor has a final bank balance on 30 April showing funds of $35,000.

From the ‘total’ column we can see that there was a positive net cashflow for the period of $30,000; a very healthy sign.


Example 6 month cashflow forecast.

M Howard, a contractor, provides the following information for the six months to 30 June 2005, and requires a cash flow forecast for this period.

Estimated cash inflows Estimated cash outflows

Progress payments Other income

$

2005Jan

Feb

March

April

May

June

$

6,000

18,000

26,000

5,000

28,000

17000

$

4,000

4,000

12,000

8,000

19,000

16,000

12000

He informs you that in April he will spend $17,000 on new machinery.

His opening bank balance on 1 January is an overdraft of $13,000.

Cash Flow Forecast Jan Feb Mar Apr May June TotalProgress Payments 6,000 18,000 26,000 5,000 28,000 17,000 100,000 Other Income 4,000 4,000 Total Cash In 6,000 18,000 26,000 5,000 32,000 17,000 104,000 Expenses 4,000 12,000 8,000 19,000 16,000 12,000 71,000 Asset Purchase 17,000 17,000 Total Cash Out 4,000 12,000 8,000 36,000 16,000 12,000 88,000 Net Cash Flow 2,000 6,000 18,000 -31,000 16,000 5,000 16,000 Opening Balance -13,000 -11,000 -5,000 13,000 -18,000 -2,000 -13,000 Closing Balance -11,000 -5,000 13,000 -18,000 -2,000 3,000 3,000

Analysing and interpreting a cash flow forecast

C = (A - B) and E = (C + D) for each month as well as for the total column.

The surplus or deficit refers to the net cashflow. This is reflected in line D. Note that in this context, the surplus/deficit refers to cashflows only and should not to be confused with profitability.

A negative value for a bank balance represents an overdraft. Eg. The opening bank balance is shown as -13,000.


The opening bank balance -$13,000 has been included in the total column as well as for January.

The closing bank balance in the last month of $3,000 agrees with the final bank balance in the total column.

Notice the closing balance for each month becomes the opening bank balance for the next month, except in the total column.

Your report

The business starts with a bank overdraft of $13,000 at the beginning of January and due to an estimated net cashflow (a cashflow surplus) of $16,000 ($104,000 - $88,000) during the six month period, can expect to end up with a bank balance of $3,000 at the end of June. This summary of the cashflow forecast can be read directly from the ‘total’ column and a similar analysis can be applied to each month.

The forecast shows that in April, the closing bank balance is expected to be an overdraft of $18,000. This appears to be largely the result of the asset purchase. The owner may need to renegotiate the existing overdraft arrangement with the bank, to ensure that the bank will allow the account to be overdrawn by this amount (otherwise a separate loan may have to be taken). Alternatively, he may be able to defer some of the cash outflows until May and/or bring forward some of the cash inflows from May.

This analysis has assumed that cash inflows and outflows will occur at the same time during each month. It may be necessary to look more closely at the timing of cashflows during some months. As an example, consider what would happen to the bank balance during the month of April if all of the cash outflows for the month occurred before any cash flowed in. Potentially, the overdraft required during this month could be as large as $23,000 ($13,000 - $36,000), depending on the actual timing of the cashflows.

Revision

You should be able to answer the following questions by referring directly to the cashflow forecast.

a) Which period of time do the cashflows relate to?

b) What is the opening cash balance for January?

c) What is the expected net cashflow for January?

d) What is the expected closing cash/bank balance for January?

e) What is the expected opening bank balance for February?

f) What is the expected net cashflow for the entire six month period?

g) What is the expected closing bank balance at the end of the six month period?

h) What profit is expected for the six month period?

Complete the cash flow forecast of A. Green for the six months to June 30 1996.

Individual cash inflows and outflows have already been estimated and entered into the cashflow forecast. Also, the first month’s calculations have been completed and the closing balance for January has been copied to the opening balance for February.The bank balance at 1 Jan 1996 is $5,000.


A GreenCashflow Forecast

For the six months ending June 30 1996

Jan Feb Mar Apr May June TOTAL$ $ $ $ $ $ $

Progress payments 10 000 12 000 16 000 14 000 14 000 10 000 76 000Other income 1 000 2 000 1 000 - 2 000 2 000 8 000

TOTAL CASH IN 11 000 84 000

Expenses 5 000 6 000 8 000 5 000 6 000 4 000Other outflows 1 000 - 4 000 - - 5 000

TOTAL CASH OUT 6 000

NET CASHFLOW 5 000OPENING bank balance

5000 10 000 5 000

CLOSING bank balance

10 000 =

You should use your ‘total’ column to check the accuracy of your calculations, at each stage of the equation. For example, ‘total cash in’ for the six months ($84 000) is shown in the total column as the sum of all progress payments ($76,000) plus all other income ($8,000). This total of $84,000 can be confirmed by adding up the all the monthly total cash inflows, which should produce the same answer. If a different answer is found, you will need to re-check your calculations. This checking process should also be used to check total cash outflows, and total net cashflow.

However, the same method does not apply to the bottom two rows which show opening and closing bank balances. As indicated previously, the opening balance for the ‘total’ period will be the opening balance at the start of the first month, and the closing balance for the ‘total’ period should be the same as the closing balance for the last month.

Using the following estimates (for the business of B. Black), complete a cash flow forecast for the six months to June 30 2006

OPERATING PROGRESS EXPENSES PAYMENTS Jan 96 8 000 10 000Feb 6 000 8 000Mar 8 000 10 000Apr 10 000 14 000May 10 000 16 000June 6 000 12 000

Operating expenses are payable as they occur.Other job income is estimated at $2,000 per month.During March the business will borrow $10,000 cash from the bank.


Administration overheads are expected to be $3,000 per month and are payable as they occur.

$6,000 tax will be paid in February and $4,000 will be spent on a computer in June.The bank balance at 1 Jan 2006 is $10,000

Using the following estimates (for the business of A. White), complete a cash flow forecast for the six months to June 30 1996.

OPERATING PROGRESS EXPENSES PAYMENTS Jan 96 6 000 14 000Feb 4 000 10 000Mar 4 000 18 000Apr 9 000 13 000May 11 000 18 000June 8 000 15 000

Operating expenses are payable as they occur.

Other job income is estimated at $2,000 per month.

During March, the owner will inject $5,000 cash into the business.

Administration overheads are expected to be $1,000 per month and are payable as they occur.

In April, $45,000 will be used to purchase a new truck.

The bank balance at 1 Jan 2006 is $2,000

Prepare a cash flow forecast for A Contractors Pty Ltd for 6 months to 30 June 2006 and using your results, report on the forecast cashflow situation of A Contractors.

Their opening bank balance is an overdraft of $17,000 and the current overdraft facility allows for a maximum overdraft of $30,000.

Progress Payments for Jan 12,000 Feb 46000, March 84000, April 68000, May 15000 and June 48000

Expenses for Jan 10000, Feb 60000, March 65000, April 28000, May 40000 and June 30000

Tax payable in Jan of 10000, and April of 8000


Estimating overhead expenses

Overhead expenses may also be referred to as indirect expenses, administration overhead expenses, or simply administration expenses. These relate to any expense that you incur which either cannot be specifically traced or related to a particular job, or is of such a small amount that it is not commercially practical to trace this cost to a particular job (eg cleaning lubricants).

For simplicity’s sake, we will refer to all administration expenses as overheads (meaning administration overheads). These costs usually are expenses of a time nature such as rent payable, council rates, water rates, telephone. The important aspect to note is that even though you may not use their facilities, you still have to pay for them. For example, water rates are payable even if you never turn a tap on. It is this characteristic which makes them a hidden expense to your business.

Example allowing for overheads in a cash flow forecast

There are several steps which are reflected in the table on the following page:

1 List all your administration overheads (column 2).

2 Column 1 shows in what month the actual expenditure is made. Note that stationery is purchased monthly and therefore is a total of $1,320 forecast for next year, or $110 per month ($1,320 / 12). When an expense is paid every three months, such as electricity, the actual month is shown when that payment is made.

3 Column 3 shows the total amount paid last year. These items of expenditure should be listed on your income tax return schedules prepared by your accountant.

4 Column 4 shows how you arrived at this year’s figure with the inflation factor shown next to the expense. For example, advertising last year was $800 so $800 + 11% ($88) = $888.

5 Column 5 shows your forecast of the amount next year (eg advertising, $888).

6 Another table is drawn up to summarise the forecast monthly overheads.


Schedule of forecast administration expenses

Monthly payable Expense item

Amount 2005

Inflation factor

Forecast 2006

FebOctNovSeptDecMarchJuneAprilJulyOctJanMaySeptDecMarchJune

AdvertisingAudit feeAccountancy feeTelephoneTelephoneTelephoneTelephoneCouncil ratesWater ratesElectricityElectricityElectricityInterest expenseInterest expenseInterest expenseInterest expense

$ 800

1,000 1,500

450 950 750 650 680 350 400 450 650

1,500 1,200 1,025 1,125

% 11

10.4 10.4

15

13 10 11 10 10

$ 888

1,104 1,656

518 960 756 660 768 385 444 495 715 696 600 504 396

13,480 11,545

MonthlyMonthlyMonthlyMonthly

Stationery PostageOffice wagesMotor vehicle expenses

1,200804

1,0005,000

10 15 10 10

1,320925

1,1005,500

8,004 8,845

Total 21,484 20,389


Month Calculation$

Forecast overheads$

JanFebMarch

AprilMayJune

JulyAugustSept

Oct

NovDec

737 + 495 =737 + 888 =737 + 756 + 504

=737 + 768 =737 + 715 =737 + 660 + 396

=737 + 385 =737 =737 + 518 + 696

=737 + 1104 + 444

=737 + 1656 =737 + 960 + 600

=

1,233 1,625

1,997 1,505 1,452

1,793 1,122

737

1,951

2,285 2,393

2,297

20,389

Other cash outlays

As you examine your cash payments book or other similar records, you will see that there are a number of other cash expenditures which we have not yet included in the cash flow forecast.

It is vital for you to learn what these items of expense are; often they are overlooked because they are not quite so noticeable (due to the fact that they may occur only once in a year). They can be divided into two categories:

Those outlays which occurred last year and which will occur again next year (ongoing expenses);

Those outlays which did not occur last year, but will be incurred next year (new expenses).

Ongoing outlays

These are items such as: payments of income tax or provisional tax; repayment of any borrowings (principal) from the bank or finance company; purchase of new machinery and plant; other capital payments, such as owner’s drawings.

New outlays

These are items such as:

Expenses you incur in attending a conference somewhere; purchase of some special future superannuation benefit (eg purchase of a deferred annuity or insurance bonds);Investments by purchasing debentures, or money put into an interest-bearing deposit with the bank.


These lists are not exhaustive - you will find other items to be included in your cash flow forecast. You should use a schedule of ‘other cash outlays’

Example estimating other cash outlays

J White, a contractor shows in his schedule for the year ended 30 June 2006, the following information about his ‘other cash outlays’.

J WhiteSchedule of forecast ‘other cash outlays’

Year ended 30 June 2006

Year ended 30 June 2006 Year ended 30 June 2006

When paid previously Item

Amount last year

DetailsAmount

next year

1 Last year’s items Monthly

Oct 90 March 91

Loan repaymentWestpacNew machineryMixerScaffoldingProvisional tax

12,000

3,0002,000

-

-April 92Changed

12,000

-4,000

-

The following two tables have been provided to help you forecast your business cashflows.

Schedule of forecast administration expensesFor year ended.............

Month payableItem

Amount last year

Inflation factor

Amount next year

Schedule of forecast ‘other cash outlays’Year ended.................

Previous year ended Year ended 30 June 1992

When paid previously Item

Amountlast year Details

Amountnext year

1 Last year’s items

2 Additional items


Cash inflows

Even though you invoice a client on a particular date, it does not necessarily mean that you will get paid promptly - you may observe in your business a time lag in receiving payment. To allow for this, it is necessary to estimate the extent of this period of time and reflect this in your cash flow forecast.

Example allowing for credit transactions

Your client payment records show that on average your clients pay 50% on completion of the job and 50% within one month of completion.

S Wilson estimates his sales for the four month period to 30 June 1996 as follow:March $22,000, April 8,000, May 15,000 and June 19,000

He insists on terms of 50% paid on completion and the balance within one month. He asks you to complete his cash flow budget for four months to 30 June 1996. Assume there were no sales in February.

S WilsonCash inflow analysis

Four months ending June 30 1996

March$

April$

May$

June$

Total$

Sales 22,000 8,000 15,000 19,000 64,000

Cash inflows

from this months sales from last months sales (i.e. receipts from debtors)

11,000 4,000

11,000

7,500

4,000

9,500

7,500

32,000

22,500

TOTAL CASH INFLOWS

11,000 15,000 11,500 17,000 54,500


Revision

Q1. Using the following estimates, prepare a cash flow forecast for the six months to June 30 2006. for I am Good

OPERATING SALES EXPENSE Dec 05 5 000 8 000Jan 06 6 000 14 000Feb 4 000 10 000Mar 4 000 18 000Apr 11 000 13 000May 10 000 18 000June 8 000 15 000

All Sales are also made on credit terms of 30 days.Other job income is estimated at $1,000 per month.The owner will withdraw $500 cash from the business each week.Administration overheads are expected to be $3,000 per month for the first three months and $4,000 for the last three months (payable as they occur)The business makes loan repayments of $1,000 each Month.$15,000 Cash will be used to purchase a truck in April.The bank balance at 1 Jan 2006 is $10,000

Q2. D Bates is a sub-contractor who wants to prepare a cash flow budget for the year ending 31 December 2006 He estimates his sales for the period as follows:Dec 2005 15000, Jan 2006 8000 Feb 12000 March 18000, April 22000, May 20000, June 32000, July 20000, August, nil, September, 8000, October, 20000, November 18000,and December, 6000. Other informationAll sales are made on the following basis: 60% payable on invoice date

40% payable one month later.He earns other minor income of $400 per month.From past experience, he estimates that operating expenses will total 60% of all monthly sales, payable one month after the month’s sales.He has an income tax assessment to pay in July of $16,000.His motor vehicle repayments are $1,100 per month.He has decided to take one month’s holiday in August (i.e. no sales or other minor income earned during August).His administration overheads average $1,500 per month, except September when they are expected to be $2,200.

His existing bank overdraft on January 1 2006 is $18,000.

Draw up a cashflow forecast for the twelve month period

Maintaining liquidity

Maintaining liquidity is one of the main problems facing the contractor today in the building industry -just ask any bank manager. Planning for an adequate cash flow requires you to have involvement in every aspect of your business, especially record keeping.

Establish the credit rating and financial stability of any prospective clients before deciding whether to tender for any work.


Establish deficit arrangements with the client and the architect for the submission and processing of progress claims, as well as any rise and fall claims. These conditions should be written into the contract before you sign.

Maintain a good credit rating in the industry so that you can negotiate the best possible terms from your own suppliers and sub-contractors. (Some sub-contractors offer a bank guarantee or some other form of financial guarantee as an alternative to retention amounts.)

Keep full records of all site instructions, meetings, delays etc so that final accounts can be prepared, provided and agreed upon as quickly as possible.

Keep a close control of all costs, including labour, because information from past jobs is a good guide for future quotes on similar jobs.

You must have prompt and efficient follow-up and collection procedures. Small amounts, especially, should not be allowed to go beyond the agreed time. You should submit invoices immediately upon completion of the work and insist on adherence to the agreed terms of payment.

Conclusion - Importance of a cash flow forecastIf there is any budget you should prepare, it is a cash flow budget. So do it. People often ask the question, ‘How much cash does a business actually need?’ There is no answer to this, as it depends on a number of factors including your management ability.

However, it is vital for your success to calculate and predict on paper the amount of money your business will need in order to meet its obligations, as and when they fall due for payment over a fixed period of time.

All successful businesses, from sole traders to multinational companies prepare cash flow budgets based on the same calculations we have used in this topic.

Remember: Desperate last minute appeals for cash and credit are seldom successful. The result is neither additional funds nor the solution of the basic problems causing the cash shortage.

Turning up at a bank to request additional funds for an unexpected shortage of cash is not guaranteed to gain your bank manager much confidence in your managerial ability.

The S graph

It is wise to pre-plan any project you undertake. To plan for materials, labour and other requirements, critical path method (CPM) diagrams provide a useful tool. These allow you to schedule your resources efficiently using a diagrammatic plan for activities. CPM diagrams are often then used to create a Gannt chart which shows the optimal timing of activities in the form of a graph or bar chart. We can use also a Gannt chart to help with cashflow planning. Your estimated costs can be plotted directly onto your bar chart, along with your estimated progress payments received.The cost curve drawn on your bar chart, showing cumulative expenses outlaid on the job, is often called an S graph.

Many contractors have a ‘market profile’ of their standard type of customer. If your work is of a repetitive nature within a limited scope, it is usually possible to develop a standard cost structure or a ‘cost profile’ which can be applied to most jobs. For example, some contractors


may specialise only in installing windows. Over a period of time they get to know exactly their cost estimates for at least 80% of all jobs on which they quote.

Construction of an S graph

This system requires a money value to be assigned to each activity on the Gannt chart/bar chart. An activity is defined as any task on the job that consumes time and/or resources.

At regular intervals of time, at least weekly but not less than monthly, the money values of all the different trade activities within this period of time are added up and shown on the bar chart, together with the total cumulative cost outlays to date.

These figures are then used to estimate the amounts that you should be invoicing your customers. Some contractors even use it to show the amounts paid by their customers to them and the date they received the cheque.

When the points are plotted on the bar chart, a line is drawn between them and this shows a ‘cost curve’ which sometimes has a remote resemblance to the letter S.

Step 1

The first step is to construct a bar chart. We include the following basic information, as shown in the following table.

TasksTotalcost

A

Time plannedB

Cost perdayA/B

ABCDEF

PreliminariesSet outFootingsDrainsBrickworkFloor frame

1,500 2,400 1,500 3,600

14,000 1,000

15 2 3 4 7 2

100 1,200

500 900

2,000 500

$24,000

1 2 3 4 5

Notes

1 This column shows a reference code for referring back to basic documentation, such as plans etc.

2 This column lists the tasks to be completed.

3 This column shows the total cost for the job, broken down by each task (such as footings $1,500), and the total job cost is shown at the very bottom ($24,000).

4 This column shows the number of working days each task will take. Notice no total of days is shown, because some of the tasks overlap.

5 The column shows the cost per working day for each task. ‘Preliminaries’ cover 15 working days for a total cost of $1,500 which means:

TOTAL COST = $1,500 = $100 cost per working day for preliminaries.

WORKING DAYS 15 days


This step assumes that the cost of each activity will be spread evenly over the days that the activity is being undertaken. Note that this will usually give approximate results, since cash outlays associated with many activities occur at specific times during, before of after the activity. Your cost schedules should be formulated with this in mind.

Step 2

Put in two axes:

The horizontal axis shows the time in working days (here 0-15 working days).

The vertical axis shows the cost in dollars (here $0-$24,000, from the bottom).Show also the calendar period, excluding weekends (along the top). Here, the job lasts from 1-19 July.

You can now plot the times taken for each task, as on a normal bar graph.

Step 3

This step shows two very important facts: The daily cost incurred for each of the individual working days;The total cumulative cost to date;The percentage cumulative cost.

The ‘daily cost’ line shows the actual estimated costs for each working day.

The ‘cumulative cost’ line shows the cumulative or progressive total cost for each work day - Sometimes an extra row can be put in underneath ‘cumulative costs’, showing the percentage completed for each working day of this job.

Now the final step is to put these three steps together and plot the S curve on the bar chart, using both axes.

Step 4

Complete the bar chart and plot the S curve.Larger projectsBar charts may also be used for much larger projects. The vertical axis, the money axis (cash outflow), is now $2,400,000.The horizontal axis, the time axis, is for 15 weeks.

When we prepare our cash flow forecast we can read the following information on this job which starts 1 July 2006

Monthly cash outflows$

Progressive cash outflows

$

JulyAugSeptOct

4 weeks5 weeks4 weeks2 weeks

380,000 860,000 840,000 320,000

380,0001,240,0002,080,0002,400,000

15 weeks 2,400,000 2,400,000


The period of 15 weeks can be broken up into months by the number of Fridays in those months.

The monthly totals must add up to $2,400,000.

The progressive totals must also add up to $2,400,000.

Cash inflow schedule

Now that the cash outflows are clearly shown on the bar chart the estimated cash inflows from progress payments can, if you so wish be graphed onto it as well. Because the same principles apply, all retention moneys will be ignored.

The progress payments depend on many factors. Some important influences are:

Is an architect involved in the job? If so, they must approve all claims for progress payments first.

What conditions have you agreed to for the funding of progress payments in the contract?When possible, always try and receive your progress payments as close as possible to the time when you have to make payments for materials, wages etc.It is advisable that you have some standard routine for making progress payments. A simple method is based on time:

Time elapsedProgress payments

(% of contract price)

0%

25%

50%

75%

100%

0%

25%

50%

75%

100%

That is a very basic method - you should develop your own. Most importantly, stick to your schedule. Often contactors are too busy to invoice their clients and often only do so when the bank manager contacts them because their bank account is overdrawn over the agreed credit limits. This is committing commercial suicide.

Disadvantages

Although bar charts have many advantages they have one major disadvantage in that they take time to complete, and often you have to change them during a job, because of changed circumstances. It is important that they are kept up to date in order to use the information from them properly.


Revision

Q1. A contractor estimates that a job will take 12 working days and costs $42,000. His work schedule was as follows:

Days Estimated cost ($)

Starts on day

Preliminaries

Set out

Footings

Drains

Brickworks

1 - 12

1 - 3

2 - 5

4 - 10

10 - 12

2,400

3,600

16,000

14,000

6,000

1

1

2

4

10

Complete a bar chart showing all relevant information, including an S curve, daily and cumulative costs.

Q2. A builder received the following monthly amounts one month after he paid them out. $20000, $15000, $25750, $16875, $28950, $27850 and paid out $22500, $16750, $26750, $29250, $18255, and $12675He also put aside $60000 for the projectHow much profit did he make and what is the minimum amount needed to finance the project

Money in Bank 60000 Month Claim Money Received Money Paid out Outstanding

No No Month Total Month Total AmountBank

Account1 22500 22500 -22500 $37,500.002 1 20000 20000 16750 39250 -19250 $40,750.003 2 15000 35000 26750 66000 -31000 $29,000.004 3 25750 60750 29250 95250 -34500 $25,500.005 4 16875 77625 18255 113505 -35880 $24,120.006 5 28950 106575 12675 126180 -19605 $40,395.00

7 6 27850 134425 0 126180 8245 $68,245.00

Profit = 134,425.00 126180 8,245.00Profit = 68,245.00 60000 8,245.00

Minimum Needed -35880


INSURANCES


INSURANCES

An important area in the subject of business management is insurance. Insurance is based on the principle of ‘risk sharing’ in which a large number of people make a small contribution to a fund which will be used to compensate those who do suffer a loss. Insurance allows you to protect your assets (and your profits), by having strategies to manage the risks that may affect your business.

Some forms of insurance are compulsory, so if you neglect to insure or to renew, your business is at risk of being fined and in some cases licences may be cancelled. You may also be forced into bankruptcy, if you suffer a loss without insurance cover. Sadly this is what happens to many businesses.

Insurance cover is often used to ‘indemnify’ the insured against losses. This means that the insured can be restored to their original position before the occurrence of the insured event. The level of cover and premium costs will normally be the main considerations when seeking insurance; however, there are numerous other questions you should ask. If you insure for a high amount, or if you have complicated insurance needs, it may be advisable to use the services of an insurance broker to advise you and give you quotes.

Some of the insurances covered in this unit will only be applicable to builders, not sub-contractors;

Objectives

1. By the end of the unit you should be able to:

2. Define basic insurance terminology;

3. Discuss basic principles in regard to risk management and purchasing insurance;

4. List and describe the insurances required by a contractor in the building industry:i. Under law,ii. Under contract,iii. Other

5. List and describe insurances required by businesses in general;

Glossary of terms

The terms listed here are some of the most common which may need some explanation. The list is not exhaustive. Your insurance company or broker can give further help if it is needed.

Actuary a specialist in the theory and practice of statistics.

Alterations changes in the policy approved by both the insurance company and the policy holder.

Assignment transfer of policy ownership from one person to another.

Assurance the same as insurance, but generally applied to life insurance.

Average sees co-insurance.


Claim calling on the insurance company to make good a loss; (generally on a form supplied by the insurance company).

Co-insurance (also called average) a condition of some policies which obliges people who are under-insured to bear a proportion of every loss.

Cover to insure or protect; also means the amount of protection provided.

Cover notes a temporary cover pending acceptance of the risk and the issue of a formal policy document.

Declaration a statement signed by the person insured, certifying that the information supplied to the company is accurate.

Endorsement and addition to a policy defining an alteration to the terms of the policy.

Excess the first part of a loss paid for by the person insured before a claim is met under the policy (sometimes you can pay extra to have the excess removed).

Ex gratia payment a payment made by the insurer when there is no strict liability to pay.

Risk Management

Loss prevention strategies

Insurance will never fully compensate you for a loss. Even if you are fully insured, there will always be side effects not covered by the insurance pay-out. For example, if there is a fire on your premises, you may not be covered for the loss of profits or removal of debris. Yet, even if you are insured for these things, you will still lose out in terms of the time and effort that will need to be spent getting the business back on its feet, and the possible loss of goodwill from customers affected by the disruptions.

It is important therefore, that a loss prevention programme be prepared for your business. Besides helping you avoid risk, it may also assist you in lowering your insurance premiums as the insurer may judge you as not to big a risk. Following is a checklist for implementing a loss prevention strategy. Not all suggestions are applicable to all businesses.

STAFFTrain staff on all emergency and safety procedures.

STOCKInstitute adequate stock control procedures.Develop safe-materials handling techniques.

PREMISESMaintain adequate indoor and outdoor lighting.


PLANTEnsure emergency equipment and first aid kits are in good order and easily accessible.Ensure that layout is neat and orderly.Install good locks and change keys periodically.

OFFICEKeep money and valuables safely guarded.Bank regularly and avoid having large amounts of cash at any one time.Develop good procedures to properly identify and keep track of assets.Purchase fire-proof cabinets for valuables, books of accounts, etc.

GENERALInstitute liaison with local fire brigade, police, etc. and ensure they are informed of all risks and consulted and/or advised on safety procedures.Use the services of a security firm.

Self-insurance

Many small business owners feel that buying commercial insurance is a waste of money and that their interests are better served through ‘self-insurance’ that is, acting as their own insurer. Let’s look more closely at this idea.

Insurance companies operate so that each separate company combines under one management the risks of a large number of people-its customers. On the assumption that the chances of a building being destroyed are one in a thousand, then for every thousand fire policies issued, the insurer could estimate that there will be a claim under one of these policies. In effect, one thousand people are paying premiums towards covering a possible loss which you would have to bear yourself if you self-insure.

Self-insurance may be appropriate in some cases, depending on several factors.

The potential loss. Where the potential for loss is limited, eg. to a few hundred dollars, there would be little point in taking out insurance. Where a large excess applies to any claim, this should be taken into account also. For example, to fully insure a $1,000 asset for an annual premium of $200 with a $400 excess may not be economical, since it would take only 3 years worth of premium payments to provide the same level of protection through self-insurance.

Financial resources. If the business has sufficient financial resources to absorb some or all of a potential loss, owners may decide to self-insure. A business may decide to take out insurance to cover only the losses which could not be covered by available finances.

The size of the risk. If you believe that a certain risk you face is much smaller than the risk faced by others who have the insurance, then you may find that the premiums are unreasonably high in your situation.

A decision to self-insure may be appropriate if some or all of these factors apply in your situation. Most importantly, if you do decide to self-insure, make sure that you know what will happen to your business should the risk eventuate, as well as how you will deal with the loss and disruption.


Purchasing insurance

The main part of this topic deals with purchased insurance. As mentioned, this part of your risk management strategy is very important, even though it should only be one part of your strategy. First of all, it is important to decide if the risk is great enough to require full insurance, or if average insurance or self-insurance will suffice. If the worst happened, how much would it cost to replace the assets, or the person insured?

Many small businesses risk financial disaster through under-insurance. Although some firms knowingly under-insure, others often misunderstand the terms of their contract and do not realise just how small pay-outs from those policies would be, or else do not know the real replacement value of their assets.

Misunderstandings about insurance contracts frequently concern the terms of the insurance contract, such as replacement policies and co-insurance clauses. A replacement policy aims to replace or restore property as new; it may be called a ‘new for old’ policy. Replacement policies often include an upper limit on the amount payable and, unless you are aware of this, you may not be as well insured as you think.

A co-insurance clause means that if the sum insured in your property falls substantially below the full value of the property, you are entitled to be compensated for only a proportion of the loss. The most common co-insurance clause is 90 per cent. The following example shows how this proportion is calculated:

Value of your property $50,000Sum insured $30,000Loss suffered $ 5,000

Policy pays:

30,000 x 5,000 = $3,33390% x 50,000 1

In this case, the difference between your loss and what the policy pays is $1,667.

Co-insurance may not apply in some cases and it is therefore important that you have your insurer explain fully all aspects of your co-insurance clause.

Over-insurance is almost as bad as under-insurance. When you insure for a larger sum than is necessary or when you cover the same risk twice under different policies, you waste money. In the event of a claim, you will not recover more than you have lost.

Insurances required by lawHome Warranty InsuranceWorkers’ Compensation insurance

Insurances required by contractConstruction riskPublic liability


Other insurances (Chosen at the discretion of the builder)

Plant and machineryMotor vehiclePartnership insuranceKeyman insuranceMoney insuranceFidelity guaranteeDebtors insurance

Insurances required by law

Home Warranty Insurance

This insurance provides cover for home owners and purchasers. It covers situations where the builder goes broke, dies or disappears, and indemnifies the owner against:

1. Cost of repairing faulty contract work2. The loss of a deposit where work has not commenced3. Additional cost to complete unfinished building work.

A home owner or purchaser can claim for rectification of faulty workmanship for up to seven years after completion.

This insurance is required for building work which:

1. Costs over $20,0002. Requires council approval3. Is performed on a normal domestic block of land.

You are obliged to insure the project within 30 days of the date of the contract being signed; the usual procedure to initiate this insurance is to submit your plans to council as normally required. The council will not approve the plans until the insurance is paid. The cost of the insurance is often passed on to the home owner in the contract amount.The minimum coverage of the policy is $50,000. A successful claim by the householder will result in the insurer either arranging a builder to do the work, or paying you the amount of the claim so that you can engage another builder.

There is a legal obligation on the builder to obtain the insurance, and two copies of the certificate of insurance must be given to the home owner. Subcontractors engaged in domestic construction do not need this insurance unless the principal builder is unlicensed.

Workers’ compensation insurance

Each state has its own authority to ensure workers are covered for the risk of workplace injuries. This scheme is designed to provide compensation and rehabilitation to ‘workers’ who are injured in the course of performing their duties and require medical attention and/or time off work. The cover includes personal injury to workers on site.(Not travelling to and from work.) ‘Workers’ include those employed full-time, part-time, casual, apprenticeships and working directors. Main contractors should ensure that all sub-contractors working for them are registered.


Rates or premiums for Work Cover are set for various industries and are reviewed annually. Workerscompensation can only be taken out with approved insurance companies through workcover. The rate charged for each employer may also be affected by the number of claims made by that employer. Every employee must be registered with Work Cover within 14 days of commencing work. Employers who do not register employees face significant penalties.

Once registered, you will be advised of:

1. Your employer number2. Location number(s)3. Industry Classification4. Levy Rate(s)5. Payment frequency

The minimum levy of $50 per financial year applies if the calculated levy is less than $50. If the entire annual levy is under $1,000, you can pay yearly; otherwise you will need to pay monthly.

An employer is required to pay the first weeks’ wages of an injured worker. By paying an additional 8% of your calculated levy, Work Cover will take over this obligation for you. The standard annual levy rate for the housing and construction industry was 3.8% of the total remuneration for each employee.

Insurances required by contract

Construction risk (contract works)

These days it is possible to purchase a combined policy which covers both construction risk and public liability. Builders may prefer the combined cover to negotiating two different policies, perhaps with two different insurance companies. It is usual for the contract conditions to oblige the contractor to insure the works in the names of the principal, the contractor, and any sub-contractors.

The construction risk section of the policy typically indemnifies the insured during the construction period and the maintenance period against any loss or damage not excluded by the policy to the works, contents and materials, not just on the site but often at other locations and in transit.

Policies generally exclude such risks as defective design, material or workmanship, wear and tear and gradual deterioration, and damage to registered vehicles, boats and aircraft. Among the extensions available are clauses to cover removal of debris following loss or damage, architects, legal and other professional fees, and allowance for profit margins and overheads.

The contractor’s constructional plant, including tools, equipment, temporary buildings and their contents can also be included.

Public liability and construction risk insurance are often required to be in force for the purposes of signing building contracts or agreements. The cover insures the contract work in progress, be it a new building or work on an existing structure.


Public liability (public risk)

This insurance will cover your legal liability for compensation if someone who is not an employee, or a family member, suffers injury, damage to property or death as a result of your business operations. In these cases, the injured person has to show that you were negligent in some way. Even if you have not been negligent, you may, if the case goes to court, have to pay costs, which can run into several thousand dollars. It is advisable to be protected against expenses and costs.

The insurance company will indemnify you against all sums you may become liable to pay upon accidental bodily injury, loss, or damage to property on the contract site during the period of insurance. You may also be able to claim legal expenses and costs.

Some exceptions (things you are not covered for) are:

1. Employed persons or members of the insured’s family;2. Damage or injury caused by a vehicle except when being used as a tool of trade on

the contract site;3. Damage or injury caused by a water-borne vessel or craft or aircraft;4. Damage or injury caused by vibration or removal of weakening supports.

Typical claims

One example of a typical liability claim might be a person walking on the footpath outside a building site trips and falls due to timber lying across the pathway. Because of the injury sustained this person has a claim against the contractor. If you are not insured against this risk it could put you out of business.

Another typical construction risk claim in the building industry is water or storm damage during construction, usually to an existing building. Damage to ceiling, wall, carpets and furniture is not uncommon. Who is liable? Which party has covered this risk? Was anyone negligent or was it an Act of God? The home owner or purchaser will expect the contractor to claim on his or her insurance, but the contractors could say they took reasonable precautions to prevent the damage.

The contractor’s insurance company warns the insured party not to admit to any liability. At this point it is important to refer to the building agreement or contract to see what insurance was included and who was responsible for covering storm damage during construction. The owner would expect the insurance to have cover for storm during construction. This may not necessarily be to the whole building but only to the part or parts of the building where the work is being carried out.

Construction risk cover could only be claimed if the contractor was negligent or failed to take reasonable precautions to prevent the damage. Reasonable precautions would entail the use of good quality tarpaulins which are secured well to prevent normal gusts of wind lifting the edges. If there is no claim against the contractor’s insurance due to negligence, the home owners would have to claim on their Household and Contents insurance.

Contractors should make sure they check that the owners have in force a Household and Contents policy and that the insurer is notified in writing or on a standard form about any substantial renovations or additions about to take place. It may be necessary for the owner or for you to take out additional cover during the construction period, especially if the location of the work is in a high wind area or during the wet season. Remember there are never any real winners when there is a dispute over insurance claims.


Examples

1 At 3.30 pm the bricklayers finish a brick wall 5 metres long by 2.4 metres high. They go home leaving it unsupported. If it blows over before it sets, the construction risk insurance will cover the cost of cleaning the bricks and re-building the wall. Negligence could be raised against the contractor; however, considering the type of work, it would be quite impractical for the contractor to secure everything on a building site. Therefore, the insurance company usually will favourable view claims by the contractor.

2. During excavation and clearing a site a contractor disturbs the roots of a large tree. The tree later blows down in a storm and cracks part of the foundations. The claim would include costs to repair the foundations and the removal of the tree from the site.

3. If a sub-contractor causes the damage or injury the responsibility could be transferred to the builder or owner as long as they acted according to the plans and specifications. In other words there only needs to be one construction risk policy in force on each contract. Sub-contractors usually need to have in force only a public liability.

4. A roof conversion is being added to a cottage and the builder has completed the frames and roof trusses. The windows are installed but no roof or cladding is in place. Overnight a wind gust blows out five of the window frames, breaking the glass and damaging some aluminium frames. No damage is caused to any other property. This is straightforward storm and tempest claim and the owner’s household insurance would not be claimed on.

Neglect

An example of a claim where the builder is negligent would be as follows:

A roof conversion is commenced and the tiles are removed for preparation of the new floor area. The builder left it to the last minute to hire a suitable tarpaulin which he had arranged to be delivered. Needless to say it didn’t arrive in time to beat the rain storm which flooded the ceilings and caused extensive water damage to walls, carpets and furniture below.

This is a clear case of neglect by the builder and therefore his insurance, even if in order, would not cover the loss. If his insurance was not current or was inadequate the owner could claim directly from the builder.

So, be warned. Adhere to proper building construction technique and avoid being refused insurance payment.

Paying premiums

When paying the premiums for construction risk insurance, companies have different arrangements. Some require all contracts over a minimum amount to be declared and a premium paid, within a set time of commencement. Others require you to pay a premium on an estimate of the total contract work for one year in advance.


Other insurances

Plant and machinery (including tools of trade)

These assets are essential for your business, so if their replacement value is high they should be insured in some way. If they are under hire purchase, or lease, it may be necessary to have comprehensive cover in force. Some financiers will be able to arrange finance for you; however, you should compare these policies with others that are available.

Do you want cover only on site? What are the definitions of ‘site’? Does plant have to be chained?Is hired equipment covered by your policy or is it covered by the hire company?Does the policy cover electric motors, accidental damage, or damage in transit?Does the excess sky-rocket for ‘under 25’ drivers?

A typical claim

Your vehicle is stolen with all your tools and the compressor locked and bolted on the tray. The vehicle is found stripped. This is when you need a good memory or, better, you will be able to refer to a list of tools and plant you own so you can work out the contents of the toolbox and the cabin at the time it was stolen. Check with your insurance company or broker to see when you can purchase replacements.

Motor vehicle insurance

Comprehensive motor vehicle insurance covers damage to your motor vehicle and damage to other people’s property including vehicles, legal costs, towing cost and theft. It may also give additional cover for liability for death or bodily injury not covered by third party motor vehicle insurance.

Under the terms of most policies, the policy holder has to pay the first part of a loss, often a fixed sum called an excess. This excess can often be removed by paying an extra premium. Many insurance companies give a discount if no claims have been made during the previous year. This is usually called a no-claim bonus. You can also pay less and arrange a restricted cover (eg damage to other people’s property only) but this is not advisable unless your vehicle is of very low value.

Third party motor vehicle death and injury cover is compulsory and is arranged each year when you register your motor vehicle.

Partnership insurance

This is a common form of life insurance, which provides funds from which surviving partners can buy a deceased partner’s share. An insurance policy is taken out on each partner’s life, with the other partners as beneficiaries.

An example would be where each partner insures the other’s life for $20,000. On the death of either partner the survivor is paid the amount plus any bonus accrued. This insurance may be advisable if you would unable to finance the acquisition of your partner’s shares.


Keyman insurance

This is similar to partnership insurance, and covers the financial loss to a business resulting from the death of a key person (such as a director or an employee with management responsibilities or special knowledge and skills).

Money insurance

Money insurance provides cover for cash kept on the premises, and in transit to or from the business. Businesses who make cash sales would have a definite need for this type insurance. However, many builders pay employees in cash, so the transportation and storage of the weekly pay packets represents a risk for the business which could be covered with this insurance.

Fidelity Guarantee

This type of insurance covers you against losses as a result of fraudulent activity or embezzlement by employees. This may be particularly important if you have employees who have control over finances or records, or access to bank accounts. A good business will also have procedures in place to control cash transactions and provide regular checks on the finances of the business.

Trade debtor insurance

This insurance covers the non-payment of trade debts by debtors. You can insure against bad debts relating to specific accounts, or you can have a policy covering the whole of your turnover. The cost of the cover can be as low a 1% of insured debts. Every business with trade debtors should consider this insurance.

Superannuation

As a self-employed person with no employer to look after you, you must make your own financial arrangements for your retirement. When you subscribe to a superannuation fund, the fund trustees invest your contribution and, on your retirement, you receive either a lump sum benefit or a pension.

Superannuation is now compulsory for all employers and is currently nine (9) percent of gross wages. This contribution should be paid to the Building Union Superannuation often referred to as the BUS scheme.

Long Service Leave

Don’t confuse superannuation with Long Service Leave The long service leave levy is paid for when submitting plans to council. All employers must register their employees. It is free to register as the premiums have been paid for when the building plans were submitted

Disability insurance (sickness and accident)

If you are self-employed it is particularly important for you to provide yourself with funds to compensate for loss of income because of illness or accident. If you become ill and your business has to close for some time, you will lose income and possibly some of your goodwill. This policy provides you with an income while you are unable to run your business, so you can pay incoming bills and possibly employ someone to keep the business going.


There is sometimes confusion between disability insurance and workers’ compensation insurance, which we have already dealt with. Listed below are some of the main differences.

Workers’ compensation is compulsory insurance if you employ anybody. The cover is only for workers while they work on site or in a workshop or place of work. Disability insurance is not compulsory and the cover is for 24 hours a day at work or at home and in some cases world wide.

Workers ’ compensation premiums are based on wages paid and are paid by the employer. Disability premiums are based on the age and trade of the contractor and are paid by the insured.

Workers’ compensation insurance gives immediate cover and does not depend on the state of health of the worker to be covered. Generally if they are fit for work they are covered, but it is wise to inform the insurance company if you are in doubt about a worker’s state of health considering the work to be performed.

Disability insurance has a waiting period, usually 14 or 30 days. Payment of benefits starts on the 15th or 31st day.

Obtaining insurance cover

Evaluating Policies

To secure cover you may seek quotations on insurance proposals from different insurance companies. Most insurance companies specialise in or limit their activities to a particular area of insurance. For example, you may not be able to get motor insurance and workers’ compensation from the same insurance company.

In general, when choosing an insurance policy, you should consider

1. The value of the item insured2. The risks they are subject to3. The effect of a loss without insurance

Choose the type and amount of insurance carefully. Specifically, beware of under/over insurance. Shop around; seek quotes from different insurance companies.

Possibly use an insurance broker (to save time / money)

Brokers usually get a commission from the insurance company. Some brokers offer free service. Usually they get the best price/cover for you.

Instant cover can be arranged over the phone by obtaining a cover note number.To help you compare the value of different policies to your business, you should consider the following

Which policy covers the most risks?Which policy does not exclude specific risks I want covered?Which policy offers the extensions to the normal cover hat I need?Which policy has the best pay-outs?Which policy has the lowest premiums?Which policy has the least fees and charges?Which policy offers payment by instalments?


Which policy gives the best refund if the cover is cancelled?Which policy offers immediate cover?Which policy has the lowest excess?Which policy has the least restrictions on how I run my business?Which policy does not have a co-insurance clause?Which policy offers replacement cover?Which policy has the easiest/fastest claims procedures?

Choosing an insurer

There are numerous insurance companies offering a wide range of insurance products, many of which can be tailored to the circumstances of the business. Some business owners may choose to deal largely or exclusively with one insurance company. Others may decide to secure the services of an insurance agent or broker who may do the shopping around for individual policies.

Insurance brokers

You may choose to deal with an insurance broker. The business of the broker is to secure the best deal with a chosen insurance company on your behalf. Usually the broker will be commissioned to handle all of your insurance needs. Insurance companies generally pay the broker a commission. It is unusual for you to pay for the broker’s services. It is now compulsory for all agents to declare to clients any commissions they will receive from the sale of policies.

You should ask yourself the following questions when choosing an insurance company or insurance broker:

Can the insurer offer me a full range of insurance products?

Can the insurer give me advice on how to assess the risks in my business?

Does the insurer or agent have expert knowledge in this area of insurance?

Can the insurer tailor the policy to my business?

Has the insurer fully explained the policy and what it covers?

Will the insurer give me a copy of the policy to look through?

Is the insurance company or broker registered?

Does the insurer have a reputation for quick pay-outs on claims?

Can the insurer offer immediate insurance by issuing a cover note?

Are the premiums competitive with those of other companies?

Proposal and claim forms

You should now know what insurances are available to you and your business. You may also have decided which insurances are appropriate for your contracting and employment activities. Insurance cover should be secured without delay. It can be very expensive if an incident occurs before you have taken out your insurance cover.


Proposals

You can get instant cover for insurance over the telephone by obtaining a numbered cover note. A written proposal form is used formally to apply for a particular policy. Once the proposal is accepted by the insurance company and you pay the premium, you are insured. Your policy usually follows in the mail, and you file it, hoping that you never have to refer to it again.

Claims

Every insurance company has a claims department or person and their own claim form.

If you need to make a claim on insurance you simply telephone the company and arrange for a claim to be sent to you. Fill it in and return it to the company

Summary

You probably realise by now why you are not an insurance salesperson and also why most insurance companies make good profits. Despite this, insurance is a necessity in the building business. The things that go on day by day that you have limited or no control over make your insurance portfolio a crucial part of your business. If you had full control you would not need any insurance cover.

You need to have a good overall knowledge of insurance if you are going to get adequate cover and best value for your insurance dollar. Often people do not understand enough about claims and ‘claims in relation to excesses’. The fact is that each particular event, be it either an explosion, a fall, an impact or a storm, is treated as a separate claim even though the one insurance policy is covering all the risks. The trap is the excess, which is an amount deducted from the payout on a successful claim. The situation could occur where three $500 excesses are deducted from what you thought was going to be a single claim and only one excess. You may be able to avoid this by insuring against the excess, but a higher premium will be charged.

Have on hand if possible all the different claim forms applicable to each policy you carry. Study the forms to find out what information the insurance company will need to process the claim (eg the names of police officers notified and when). Hopefully you won’t have many claims, but if you do it is important to know the correct procedures.

Uberrima fidei

Before you enter into any contract of insurance you have a duty to disclose every matter that you know or could reasonably be expected to know, that is relevant to the insurer’s decision whether to accept the risk and on what terms. This is known in insurance law as the duty of uberrima fidei (utmost good faith). You have the same duty to disclose those matters before you renew, extend, vary or reinstate the contract of insurance.


Glossary of terms

Indemnity a payment which makes good a loss.

Insurable interest a person who has an insurable interest will suffer monetary loss if some particular event takes place.

Insurance a system where the many who are at risk contribute to a fund from which the subsequent losses of the few are compensated.

Policy the document setting out the contract between the insurer and the insured.

Proposal a form filled out by the person seeking insurance which shows details of the information needed to affect the cover.

Premium the price of the policy.

Reinstatement replacement of goods or building damaged, with similar goods or building.

Salvage property which is saved from a disaster; also payment due for saving property from loss.

Standing charges overheads.

Statutory required by law.

Subject matter something that can be lost, damaged or destroyed and which consequently can be insured.

Tort words or actions which damage someone else; a civil wrong.

Underwriter an insurer; also a life insurance sales person.

Utmost good faith a basic requirement for insurance contract, which means that the person seeking the insurance must not lie to, or withhold information from, the insurance company. The same idea is sometimes expressed by the Latin phrase ‘uberrima fidei’.
