e_financial accounting 09

8/7/2019 E_Financial Accounting 09

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Financial Reporting


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Lecture Outline

Financial Accounting Defined

Characteristics

Preparing FinancialStatements

Income Statement

Balance Sheet

Interpreting FinancialStatements


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Financial Accounting

Communication of financial information to externalusers. Specifically; Financial Performance Income Statement

Is the business making a profit

Financial Position Balance Sheet What how strong is the business financially

Without financial accounting, the economy could notoperate effectively. no-one would know whether it was safe to invest or lend

money to an entity. If no one invested or lent money, organisations could not

grow.

The annual report, and in particular the financial statements, are the primarysource of information for investors, lenders and suppliers. Investors andlenders are afraid of losing their money so they look to the financial statementsto assess the financial strength and performance of a company before makingan investment decision. Financial statements are supposed to provide a trueand fair view of an organisations financial position and performance. If the

information within the financial statements is reliable then it enablesinvestors/lenders to make sound investment decisions and hence lowers therisk associated with investment and lending.

However, if the information contained within the financial statements isunreliable (false or misleading) it increases the risk to investors and lenders ofmaking poor decisions (i.e. investing in an organisation on the brink ofcollapse). If investors and lenders lose faith in the reliability of financialstatements then they may withdraw from the market completely. If this occursit becomes very difficult, and expensive, for organisations to obtain finance tosupport their growth.

As was seen in the US following events with Enron and Worldcom in the earlypart of this decade, a loss of investor confidence in financial reporting can haveserious, adverse consequences for the economy, growth and the ability ofgraduates to obtain jobs.


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The Enron share price fell dramatically in a very short period of time. Thefinancial statements did not warn investors of the perilous position of thecompany and consequently many investors lost a very significant amount ofmoney. This, and other similar scandals around the same time, causedinvestors to lose confidence in financial statements and withdraw from the

market. The government responded with stringent regulations and toughcriminal penalties to minimise the risk of these scandals reoccurring and to

inturn increase investor confidence in financial reporting.


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Financial Reporting

Reporting entities must prepare financialstatements at the end of the financial year.

1. public companies,2. large partnerships,3. large private companies

Non Reporting entities (sole traders, smallpartnerships) may need to prepare financialstatements in order to: obtain loans attract investors (i.e. additional partners) sell the business

The reporting entity rule is a very logical one. If an organisation is likely tohave external users who are interested in the organisations performance then itis considered to be a reporting entity and is required to prepare financialstatements. Examples of reporting entities are shown in this slide.

If there are unlikely to be external users then an organisation is not a reporting

entity and does not have to prepare financial statements (i.e. if it is unlikelyanyone will ever read the financial statements then why should a non reportingentity be compelled to prepare them). Preparing financial statements requires asignificant amount of time and money so the advantage of being a nonreporting entity is the saving in time and cost.


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Financial Reporting

Financial Year (Australia)

Financial Year Begins: 1 July

Financial Year Ends: 30 June

Current Financial Year

1 July 2008 30 June 2009


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Financial Accounts

All components of an organisations financialactivity is recorded within specific accounts.

Each account records just one thing. Cash: The amount of cash available to the business

Accounts Receivable: Amount owed by customers

Inventory: Value of inventory held by the business

Accounts Payable: Amount owed to suppliers

Loan Payable: Amount owed to lenders

Capital: Value of assets contributed to the business by the owner

Retained Profits: Owners share of profits

To be able to do any of the remaining topics you must know what each accountused in this unit records and how it is classified. Students experiencingdifficulties with later topics can generally trace their problems back to thistopic and a failure to be able to explain what each account records and how itis classified.


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Financial AccountingElements

Each financial account can be classified into one offive elements (A.L.O.R.E). The elements, and thestatement in which they appear, is shown below:

1. Assets Balance

2. Liabilities Sheet

3. Owners Equity

4. Revenues Income

5. Expenses Statement

One of the most common mistakes in the final exam is students placingbalance sheet items in the income statement and vice versa. If you canunderstand that Assets, Liabilities and Equity items never appear in the incomestatement and revenues and expenses never appear in the balance sheet thenyou are well on the track to doing well.


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Income Statement

Statement showing the performance (profit)of a business over a given period (i.e. 12months, 6 months, 3 months, 1 month).

Profit = Revenue - Expenses


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Income StatementRevenue

Revenue is the total income earned in a period. Recorded in the period EARNED even if payment

has not been received

Can also include a saving in outflow (i.e. discountreceived)

Under the accrual system, an organisation would recognise (record) incomeonly when the income has been earned (when the work has been done or theservice provided). If a service was provided in September but the customer didnot pay for this service until October then the business would recognise theincome in September (i.e. when the service is provided).

Expenses are recognised when incurred (used). If an employee works for abusiness in September, but is not paid until December then the business wouldrecognise the expense in September (this is when the employee was used).

Saving in outflow refers to situations where you save money. If you owe$1,000 and someone pays the debt for you then you have saved $1,000. Thissaving is treated as revenue. The most common form of saving in outflow iswhen you receive a discount. If you owe $1,000 but receive a 10% discountthen you only have to pay $900. The $100 saving is treated as revenue.


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Income StatementRevenue Accounts

1.

Sales Revenue Income earned by selling goods to customers.

2. Fees Revenue Income earned by providing services to customers.

3. Interest Revenue Interest earned on investments

4. Discount Received Savings in outflow

These are four accounts you must be aware of.

A retail entity (a business that sells goods to customers) records its revenue ina Sales Revenue account.

A service entity(a business that provides services to customers) records its

revenue in a Service Revenue account.


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Income StatementExpenses

Loss or consumption of economic benefits. Discount Allowed: Value of discount given to customers

Wages Expense: Value of labour used in a period

Electricity Expense: Value of electricity used in a period

Rent Expense: Value of rental premises used in a period

Expenses are recorded in the period INCURRED. When, for example, the electricity, water and telephone is

actually used, even if the expenses have not been paid.


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Accrual Accounting

On the 28th of June you pay $1,000 rent for themonth of July.

30/6/08 Period A 30/6/09 Period B 30/6/10

Paid Incurred

The Rent is an expense of period B

Slides 12-15 are used to practice the recognition principals of accrualaccounting. Many students will understandably find it difficult to ignore cash(i.e. the timing of payments and receipts) as our lives are based on when do Ineed to pay and when do I get the money.

In this example, even though the $1,000 is paid in Period A (financial year

ended 30/6/09) the rent is actually an expense of the next period, Period B(financial year ended 30/6/10) as that is when the premises will actually beused.


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Accrual Accounting

An employee worked for the business but at theend of June has not received the $500 owed.

30/6/07 Period A 30/6/08 Period B 30/6/09

Incurred Paid

The wages is an expense of period A

The employee was used (worked for the business) in Period A, but was notpaid until Period B. Under accrual accounting, cash is ignored and the onlything that matters is when the employee was used, hence the wages expense isrecognised (recorded) in Period A.


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Accrual Accounting

On the 29th June a customer pays you $20 tomow his lawn in July.

30/6/07 Period A 30/6/08 Period B 30/6/09

Received Earned

The $20 is revenue for the period B.

Under accrual accounting, the only thing that matters, in relation to recognitionof revenue, is when the work was done. In this example the cash was receivedin Period A but the work was not done until Period B.

Regardless of the fact the business already has the cash, the revenue would not

be recognised until Period B.


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Accrual Accounting

You mow a customers lawn on 26th June for$20, but do not receive payment until 2 July.

30/6/08 Period A 30/6/09 Period B 30/6/10

Earned Received

The $20 is revenue in period A.

This is the opposite of the previous example. In this case the work wasperformed in Period A, but the money was not received until Period B. Eventhough the customer has not yet paid the revenue would be recorded in PeriodA because this is when the work was done.


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Accrual AccountingEdwards Painting Business

Month 1 Edward completes $19,000 worth of work on credit

(customers have not yet paid). An employeeworked with Edward, but his wages for the monthhave not been paid.

Month 2 Didnt Work. Received $19,000 from customers.

Month 3 Didnt work. Paid $4,000 wages to employee.


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Accrual Profit

1 2 3Revenue 19,000 0 0

Expenses 4,000 0 0

Profit 15,000 0 0

The accrual method provides an accurate indication of how the business hasperformed over the three month period (i.e. all the work was done in Month 1,no work done in months 2 and 3). It does so because the profit for a particularmonth includes only the revenues earned and expenses incurred in that month.

In contrast, profit calculated using the cash method would have shown a profit

of zero in month 1, $19,000 in month 2 and a loss of $4,000 in month 3. Thecash method would therefore suggest month 2 was the most productive for thebusiness and yet no work was done in this month. The cash method wouldalso suggest nothing happened in month 1 and yet this is when all the workwas done.


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Lecture Illustration I

Refer to Lecture Illustration I


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Assets

First Test Is an item an asset? Must possess future economic benefit

Must help an organisation make money (private sector)or provide a service (public sector).

Control Organisation must have the ability to deny or regulate

access.

Result of a past transaction or event

An item has future economic benefit if it helps an organisation achieve itsobjective. The objective of private sector businesses is to make moneytherefore anything that helps to achieve this objective satisfies the first criteria(i.e. machinery, buildings, computers, delivery vehicles). The objective ofpublic sector organisations is to provide a service so anything which helps the

public sector to do this therefore satisfies the criteria (i.e. libraries, hospitals,street lights, footpaths, roads).

It is worthwhile noting that ownership is not one of the essential criteria.Without going into detail, as it is beyond the scope of this unit, in somecircumstances it is possible to control an item but not own it.


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Assets

Second Test Can the asset be recognised Can the assets value be reliably measured?

Historical cost: Original price paid for the asset

Fair Value: Market value of asset today.

Present value: Present value of cash flows assetwill generate.

Is it probable economic benefits will occur?

It is possible that an asset may not be included on the balance sheet because itfails the second test. An oil discovery for example, satisfies the first testhowever if it is unclear how much oil has been discovered then it cannot bemeasured reliably and hence fails the second text.

To improve the relevance of information to users of financial statements

(primarily investors), without compromising too greatly on reliability,accounting standards require organisations to record asset values in differentways. Where possible, assets are recorded at present value or fair value. Ifthis cannot be done reliably then historical cost is used.


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Assets

Current Assets

Assets the business estimates it will hold for lessthan 12 months from the reporting date.

Cash

Accounts Receivable

Inventory

Non Current Assets

Assets the business estimates it will hold for morethan 12 months from the reporting date

Motor Vehicles

Machinery


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Liabilities

First Test Does a liability exist? Present obligation to sacrifice economic benefit.

Result of a past transaction or event

Second Test Can we recognise the liability?

Reliable Measurement

It must be probable that sacrifice of economic benefits willoccur.

Present obligation is the important phrase in this definition. If an organisationwas being sued for $1 million in damages it would not record this amount as aliability because until the courts decision is made there is no presentobligation on the business to pay $1 million.

Similarly, if a lawnmower man cuts the lawn of a business every month and

charges $50 each time the business would not record next months, or latermonths, amounts as a liability because there is no present obligation to pay thelawnmower man $50 (i.e. there is no obligation to pay until the lawnmowerman actually cuts the grass).


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Liabilities

Current Liabilities Liabilities that are payable within 12 months of the

reporting date. Accounts payable

Short term loan

Non Current Liabilities

Liabilities which are not due within 12 months of thereporting date.

Long term loans

There are many types of Non Current Liabilities but the only one dealt with inAccounting 100 is long term loans.


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Equity

Residual interest in the assets after liabilities havebeen deducted.

Capital A [Amount invested by Partner A]

Capital B [Amount invested by Partner B]

Retained Profits A [Partner As share of profit]

Retained Profits B [Partner Bs share of profit]

Each partners share of profit is allocated to them via their Retained Profitaccount.

In Lecture illustration 1 for example, the profit is $1,200 and the profit wasallocated as follows:

Belita 800Tiana 400

Given the business had only been operating one month the retained profitaccounts for both partners was previously zero therefore the retained profitaccounts for both partners as at 30 June 2009 would appear in the balancesheet as follows:

Retained Profit Belita 800

Retained Profit Tiana 400


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Lecture Illustration II

Refer to Lecture Illustration II


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Accounting Entity Principle

The personal assets and liabilities of theowner(s) must be kept separate from those ofthe business.

Owner

Assets Liab.

Business

Assets Liab.

The owner must not include, for example, his/her personal assets (home, caretc) or liabilities (loans) on the balance sheet of their business.


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Interpreting Financial StatementsRatio Analysis

Profitability Ratios

Designed to help investors evaluate a firms ability to controlexpenses and earn an adequate return.

Liquidity Ratios

Enables the user to evaluate the ability of an entity to repayits short term liabilities as they fall due.

Leverage Ratios

Measures the extent to which an entity relies on debtfinancing.

The remainder of this topic will address the meaning of information containedwithin the financial statements and how this information can be used fordecision making.

Reading pages and pages of financial statements can create informationoverload and it can be very difficult to interpret how an organisation is

performing. One method of simplifying the interpretation of financialstatements is ratio analysis. Each ratio measures one aspect of anorganisations operations. Collectively, a series of ratios can summarise theperformance of an organisation as shown on slide 45.

Ratios measure different areas of an organisations operations. Rather thanexamining pages and pages of financial statements users can therefore targetthe areas that are of primary interest to them. The net profit margin measuresthe profitability of an organisation which is important to investors. The currentratio measures liquidity which is particularly important to suppliers. The debtto equity and interest coverage ratios measure the level of financial risk an

organisation has which is of special interest to lenders.


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Profitability Ratios

Profit Margin = O.P.A.T x 100Net Sales

O.P.A.T = Operating profit after tax

Expressed as a percentage (i.e. 10%)

Shows the amount of operating profit earned for every $1 ofsales.

If profit margin is 10% then for every $100 of sales theorganisation makes an operating profit of $10.

Net Sales = Sales less Sales Returns

The profit margin or net profit margin shows how much net profit anorganisation is making for each dollar of sales. Accounting 100 dealsprimarily with partnerships and consequently the income statements in this unitwill not show the following:

Operating Profit before Tax 100,000Income Tax Expense 30,000Operating Profit after Tax 70,000

This is how the income statement for a company may look. As partnershipsare not separate legal entities they are not taxed and consequently the incomestatement for a partnership does not include income tax expense. The profitsfor the business are instead distributed to the partners and the partners aretaxed as individuals. In calculating the profit margin for a partnership, simplyuse the operating profit figure.


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Profit MarginIndustry Averages (Australia)

4.6%

(2007 = 5.2%)

Transportation (Qantas)

25.6%

(2007 = 34.2%)

Materials (BHP)

3.4%

(2007 = 3.0%)

Food & Staples Retailing(Woolworths)

Profit MarginIndustry (Aust.)

Industry information is not provided for this ratio therefore I have shown individualcompanys within each industry. BHP is one of the worlds largest mining companies,Qantas is Australias only international airline and Woolworths is one of the largestgrocery stores in Australia.


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Profit Margin: Increasing

Greater control of costs (i.e. operating expensesand/or cost of goods sold have declined relative toselling price).

Increase in selling price with a less than proportionalincrease in cost of goods sold and operating costs.

Selling price increases by 6% but costs increase by only3%


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Profit Margin: Decreasing

Operating costs or cost of goods sold inincreasing but selling price remains thesame.

Operating costs and/or cost of goods sold areincreasing at a greater rate than selling price.

Selling price is falling while operating costsand cost of goods sold remain unchanged.


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Liquidity Ratio

Current Ratio = Current AssetsCurrent Liabilities

Average on the ASX (2009): 1.64:1

For every $1 in current liabilities, a business has$1.56 in current assets.

If ratio lower than 1, business cant meet itsobligations to creditors.

ASX = Australian Stock Exchange


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Current RatioWhat does it measure?

If the short term creditors (current liabilities)of a business were to demand immediatepayment, can the business pay these debtsby:

Using cash at bank

Collecting money owed by customers

Selling off all inventory

Converting short term investments to cash

Collecting prepayments


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Current RatioShould it be maximised?

A high current ratio may indicate the businesshas excessive:

Money that has gonePrepayments

Excessive inventory earns no income(increases costs of holding inventory).

Inventory

Money that has not been collected.AccountsReceivable

Earning very little interest in a bankaccount.

Cash

This slide demonstrates that the Current Assets section is not a productive areaand therefore a business would wish to minimise the resources held in thisarea. Excessive cash earning little interest could be more productivelyinvested in long term investments which produce significantly higher returns.

A large accounts receivable balance is also not productive - it is generating no

return for the business. A business would want to collect the outstandingamounts as soon as possible so the cash can be invested in longer term, highreturn projects. A high accounts receivable figure could also indicate poorcredit collection procedures which may in turn suggest a higher rate of baddebts (the longer people take to pay the more likely they will never pay).

Similarly, a high inventory balance is not efficient. A clothing store whichsells only $1,000 worth of inventory per week does not need to hold $50,000worth of inventory. The business would be better to hold around $5,000 worthof inventory and use the $45,000 to invest in projects earning a return ratherthan buying a further $45,000 worth of inventory that will just sit in the store.

Aside from the opportunity cost, holding too much inventory can also createadditional costs such as higher rent (the more inventory held, the more spacerequired and hence the higher the rent) and higher insurance costs (the moreinventory held, the greater the insurance cost). There is a potential opportunitycost in terms of lost sales but if managed effectively this cost is generallyoutweighed by the additional costs of holding too much inventory.


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Current RatioIndustry Averages (Australia)

1.25

(2007 = 1.23)

Transportation

7.67

(2007 = 7.29)

Materials (Mining)

1.27

(2007 = 1.24)

Food Retailing

Current RatioIndustry


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Current RatioTrends

If the current ratio is increasing: Stronger liquidity or inefficient use of assets?

If the current ratio is decreasing:

Decline in liquidity or more efficient use of assets?

Organisations prefer to have most of their available resources in the noncurrent asset section. It is this section which generates the most returns for abusiness.


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Leverage Ratio

Debt to Equity Ratio = Total LiabilitiesTotal Equity

Shows the financial structure of the firm.

Average on ASX (2009): 36.9%

The Debt to Equity ratio measures the financial risk associated with a business.(i.e. the risk of defaulting on an interest payment). The higher the ratio, themore debt the business has and therefore the more interest payments it has tomake and therefore the higher the risk of defaulting on one of these payments.


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Debt To Equity Ratio

Industry Averages (Australia)

55%

(2007 = 54.2%)

Transportation

41.8%

189%

Materials - BHP

Rio Tinto

50.8%

(2007 = 61.4%)

Food & Staples Retailing

Debt to EquityIndustry

No information for Materials sector so individual companies given. Rio Tinto isanother major mining company. Rio Tinto, BHP and some Brazilian companiessupply China with a very high percentage of its Iron-Ore. The very high debt to equityratio for Rio Tinto is the result of investments in infrastructure projects to enable themto ship more iron-ore to China and take advantage of the record prices for iron-orewhich existed less than 12 months ago. It should be compared to the Interest coverage

ratio for Rio Tinto which suggests it can easily manage this debt level.


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Debt to Equity: Increasing

Increased borrowing may fund expansionleading to growth and higher profits.

or

More of the firms operations are financed bydebt leading to:

Increased interest payments

Increased risk of failure


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Debt to Equity: Decreasing

Less of the firms operations are financed bydebt leading to: Reduced interest payments

Lower risk of failure

Insufficient borrowing may impede growth.


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Interest Coverage Ratioor Times Interest Earned

OPBT + Interest ExpenseInterest Expense

Measures the extent to which an organisation canmeet interest payments using current profits.

A ratio of 4:1

An organisation is making $4 in operating profit for every$1 of interest expense (i.e. profit can cover interestexpense four times).

OPBT = Operating Profit Before Tax

As discussed earlier, a partnership is not a separate legal entity andconsequently is not taxed. When calculating this ratio for a partnership simplyuse the operating profit.

The rule of thumb for this ratio is that a ratio of at least 4:1 should bemaintained


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Interest Coverage RatioIndustry Averages (Australia)

4.75

(2007 = 5.71)

Transport

(2007 = 20.00)

Materials (Mining)

1.97

(2007 = 4.68)

Food & Staples Retailing

Interest CoverageIndustry

Again, the mining sector is an aberration in comparison to other sectors. The averagefor the mining sector is still 20. For the ASX it is 5.38.


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Interest Coverage RatioTrend

Declining Ratio Capacity to meet interest payments has declined.

Greater risk of defaulting on a payment.

Increasing Ratio

Capacity to meet interest payments hasincreased.


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Interest Coverage RatioTrend

High debt to equity ratio is ok if: interest coverage ratio is also high (i.e. the

business has the capacity to cover the higherinterest expenses).


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Ratio AnalysisBenefits

6.77.47.7Interest Coverage

1058265Debt to Equity (%)

1.191.151.1Quick

1.821.751.6Current

6.45.74.3Profit Margin (%)200920082007Ratio

Ratio analysis can summarise 3 years worth of financial statements down to half apage. This allows trends and/or areas of concern to be quickly identified.

Ratios are also very useful for users who do not understand accrual accounting (i.e.investors who have not studied an accounting degree can quickly learn the meaning ofratios and how to interpret them).


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