Professional Documents
Culture Documents
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Lecture Outline
Preparing Financial
Statements
Income Statement
Balance Sheet
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Financial Accounting
The annual report, and in particular the financial statements, are the primary
source of information for investors, lenders and suppliers. Investors and
lenders are afraid of losing their money so they look to the financial statements
to assess the financial strength and performance of a company before making
an investment decision. Financial statements are supposed to provide a true
and fair view of an organisations financial position and performance. If the
information within the financial statements is reliable then it enables
investors/lenders to make sound investment decisions and hence lowers the
risk associated with investment and lending.
As was seen in the US following events with Enron and Worldcom in the early
part of this decade, a loss of investor confidence in financial reporting can have
serious, adverse consequences for the economy, growth and the ability of
graduates to obtain jobs.
The Enron share price fell dramatically in a very short period of time. The
financial statements did not warn investors of the perilous position of the
company and consequently many investors lost a very significant amount of
money. This, and other similar scandals around the same time, caused
investors to lose confidence in financial statements and withdraw from the
market. The government responded with stringent regulations and tough
criminal penalties to minimise the risk of these scandals reoccurring and to
inturn increase investor confidence in financial reporting.
Financial Reporting
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Financial Accounts
To be able to do any of the remaining topics you must know what each account
used in this unit records and how it is classified. Students experiencing
difficulties with later topics can generally trace their problems back to this
topic and a failure to be able to explain what each account records and how it
is classified.
Financial Accounting
Elements
Each financial account can be classified into one of
five elements (A.L.O.R.E). The elements, and the
statement 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 student’s placing
balance sheet items in the income statement and vice versa. If you can
understand that Assets, Liabilities and Equity items never appear in the income
statement and revenues and expenses never appear in the balance sheet then
you are well on the track to doing well.
Income Statement
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Income Statement
Revenue
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. discount
received)
“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. This
saving is treated as revenue. The most common form of saving in outflow is
when you receive a discount. If you owe $1,000 but receive a 10% discount
then you only have to pay $900. The $100 saving is treated as revenue.
Income Statement
Revenue 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
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A retail entity (a business that sells goods to customers) records its revenue in
a ‘Sales Revenue’ account.
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Accrual Accounting
Paid Incurred
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 be
used.
Accrual Accounting
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The employee was used (worked for the business) in Period A, but was not
paid until Period B. Under accrual accounting, cash is ignored and the only
thing that matters is when the employee was used, hence the wages expense is
recognised (recorded) in Period A.
Accrual Accounting
Received Earned
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Under accrual accounting, the only thing that matters, in relation to recognition
of revenue, is when the work was done. In this example the cash was received
in 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.
Accrual Accounting
Earned Received
This is the opposite of the previous example. In this case the work was
performed in Period A, but the money was not received until Period B. Even
though the customer has not yet paid the revenue would be recorded in Period
A because this is when the work was done.
Accrual Accounting
Edwards Painting Business
Month 1
Edward completes $19,000 worth of work on credit
(customers have not yet paid). An employee
worked with Edward, but his wages for the month
have not been paid.
Month 2
Didn’t Work. Received $19,000 from customers.
Month 3
Didn’t work. Paid $4,000 wages to employee.
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Accrual Profit
1 2 3
Revenue 19,000 0 0
Expenses 4,000 0 0
Profit 15,000 0 0
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The accrual method provides an accurate indication of how the business has
performed 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 particular
month 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. The
cash method would therefore suggest month 2 was the most productive for the
business and yet no work was done in this month. The cash method would
also suggest nothing happened in month 1 and yet this is when all the work
was done.
Lecture Illustration I
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Assets
Control
Organisation must have the ability to deny or regulate
access.
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It is possible that an asset may not be included on the balance sheet because it
fails the second test. An oil discovery for example, satisfies the first test
however if it is unclear how much oil has been discovered then it cannot be
measured reliably and hence fails the second text.
Current Assets
Assets the business estimates it will hold for less
than 12 months from the reporting date.
Cash
Accounts Receivable
Inventory
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Liabilities
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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 later
months, amounts as a liability because there is no present obligation to pay the
lawnmower man $50 (i.e. there is no obligation to pay until the lawnmower
man actually cuts the grass).
Liabilities
Current Liabilities
Liabilities that are payable within 12 months of the
reporting date.
Accounts payable
Short term loan
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There are many types of Non Current Liabilities but the only one dealt with in
Accounting 100 is long term loans.
Equity
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Each partners share of profit is allocated to them via their Retained Profit
account.
In Lecture illustration 1 for example, the profit is $1,200 and the profit was
allocated as follows:
Belita 800
Tiana 400
Given the business had only been operating one month the retained profit
accounts for both partners was previously zero therefore the retained profit
accounts for both partners as at 30 June 2009 would appear in the balance
sheet as follows:
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Accounting Entity Principle
Owner Business
Assets Liab. Assets Liab.
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The owner must not include, for example, his/her personal assets (home, car
etc) or liabilities (loans) on the balance sheet of their business.
Interpreting Financial Statements
Ratio Analysis
Profitability Ratios
Designed to help investors evaluate a firms ability to control
Liquidity Ratios
Enables the user to evaluate the ability of an entity to repay
Leverage Ratios
Measures the extent to which an entity relies on debt
financing.
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The remainder of this topic will address the meaning of information contained
within the financial statements and how this information can be used for
decision making.
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The profit margin or net profit margin shows how much net profit an
organisation is making for each dollar of sales. Accounting 100 deals
primarily with partnerships and consequently the income statements in this unit
will not show the following:
This is how the income statement for a company may look. As partnerships
are not separate legal entities they are not taxed and consequently the income
statement for a partnership does not include income tax expense. The profits
for the business are instead distributed to the partners and the partners are
taxed as individuals. In calculating the profit margin for a partnership, simply
use the operating profit figure.
Profit Margin
Industry Averages (Australia)
Industry (Aust.) Profit Margin
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Industry information is not provided for this ratio therefore I have shown individual
company’s within each industry. BHP is one of the world’s largest mining companies,
Qantas is Australia’s only international airline and Woolworths is one of the largest
grocery stores in Australia.
Profit Margin: Increasing
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Profit Margin: Decreasing
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Liquidity Ratio
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Current Ratio
Should it be maximised?
A high current ratio may indicate the business
has excessive:
Cash Earning very little interest in a bank
account.
Accounts Money that has not been collected.
Receivable
Inventory Excessive inventory earns no income
(increases costs of holding inventory).
Prepayments Money that has gone
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This slide demonstrates that the Current Assets section is not a productive area
and therefore a business would wish to minimise the resources held in this
area. Excessive cash earning little interest could be more productively
invested in long term investments which produce significantly higher returns.
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Current Ratio
Trends
If the current ratio is increasing:
Stronger liquidity or inefficient use of assets?
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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, the
more debt the business has and therefore the more interest payments it has to
make and therefore the higher the risk of defaulting on one of these payments.
Debt To Equity Ratio
Industry Averages (Australia)
Industry Debt to Equity
Transportation 55%
(2007 = 54.2%)
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Debt to Equity: Decreasing
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Interest Coverage Ratio
or Times Interest Earned
OPBT + Interest Expense
Interest Expense
A ratio of 4:1
An organisation is making $4 in operating profit for every
$1 of interest expense (i.e. profit can cover interest
expense four times).
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The rule of thumb for this ratio is that a ratio of at least 4:1 should be
maintained
Interest Coverage Ratio
Industry Averages (Australia)
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Again, the mining sector is an aberration in comparison to other sectors. The average
for the mining sector is still 20. For the ASX it is 5.38.
Interest Coverage Ratio
Trend
Declining Ratio
Capacity to meet interest payments has declined.
Greater risk of defaulting on a payment.
Increasing Ratio
Capacity to meet interest payments has
increased.
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Interest Coverage Ratio
Trend
High debt to equity ratio is ok if:
interest coverage ratio is also high (i.e. the
business has the capacity to cover the higher
interest expenses).
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Ratio Analysis
Benefits
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Ratio analysis can summarise 3 years worth of financial statements down to half a
page. 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 of
ratios and how to interpret them).
Ratio Analysis
Limitations
1. Ratios mean nothing on their own. To be useful a
ratio must be compared with:
Previous periods
A competitor
An industry average or benchmark.
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A profit margin of 10% on its own means nothing. However if it is known that
the margin last year was 8% and the year before that 5% then we can start to
draw some meaningful conclusions. Similarly, if we know the industry
average (the average profit margin for all competitors) is 16% then more
information can be drawn from the ratios.