Accounting: Information for Business Decisions Accounting: Information for Business Decisions [4 ed.] 0170446247, 9780170446242

Table of contents :
Cover
Half title page
Title page
Imprint page
Brief contents
Contents
Guide to the text
Guide to the online resources
Preface
About the authors
Acknowledgements
Chapter 1: Introduction to business accounting and the role of professional skills
1.1 Factors affecting the complexity of a changing business environment
1.2 Business enterprise categories
1.3 Business structures
1.4 The accounting system
1.5 Ethics in business and accounting
1.6 The accountant in a changing society
Study tools
Chapter 2: Developing a business plan: Cost–volume–profit analysis
2.1 Planning in a new business
2.2 Cost–volume–profit (CVP) planning
2.3 Using CVP analysis
2.4 Other planning issues and effects
Study tools
Appendix: CVP analysis for cups of coffee
Chapter 3:
Developing a business plan: Applied budgeting
3.1 Why budget?
3.2 Operating cycles
3.3 The budget as a framework for planning
3.4 Using the master budget in evaluating the business’s performance
Study tools
Chapter 4: The accounting system: Concepts and applications
4.1 Financial accounting information and decision making
4.2 Basic concepts and terms used in accounting
4.3 Components of the accounting equation
4.4 Accounting for transactions to start a business
4.5 Expanding the accounting equation
4.6 Recording daily operations
4.7 End-of-period adjustments
Study tools
Chapter 5: Recording, storing and reporting accounting information
5.1 Accounts
5.2 Accounting cycle
5.3 Recording (journalising) transactions
5.4 Posting from journals to the accounts
5.5 Trial balance
5.6 Preparing adjusting entries
5.7 Adjusted trial balance
5.8 Preparing the financial statements
5.9 Preparation of closing entries
5.10 Modifications for companies
5.11 Other journal entries
Study tools
Chapter 6: Internal control: Managing and reporting working capital
6.1 Working capital
6.2 Cash
6.3 Accounts receivable
6.4 Inventory
6.5 Accounts payable
Study tools
Chapter 7: The income statement: Components and applications
7.1 Why the income statement is important
7.2 Measuring financial performance: The income statement
7.3 Defining and classifying revenues/income
7.4 Defining and classifying expenses
7.5 Evaluating the income statement using ratios
7.6 Linking profit to owner’s equity and closing the accounts
Study tools
Appendix: Calculating the cost and the amount of inventory
Chapter 8: The balance sheet: Components and applications
8.1 Why the balance sheet is important
8.2 The accounting equation and the balance sheet
8.3 Using the balance sheet figures for evaluation
8.4 Evaluating financial flexibility
8.5 Limitations of the income statement and the balance sheet
8.6 Business activity statements (BAS)
Study tools
Chapter 9: The cash flow statement: Components and applications
9.1 Understand the importance of the cash flow statements to
organisations and users
9.2 Identify the types of transactions that generate cash inflows and outflows
9.3 The organisation of the cash flow statement
9.4 Construct cash flow statements based on the direct method
9.5 Analysis of the cash flow statement
9.6 Calculate the relevant cash flow ratios
Study tools
Appendix: Indirect method for reporting cash flows from operating activities
Chapter 10: Sustainable and profitable business practices
10.1 Corporate social responsibility (CSR)
10.2 The triple bottom line
10.3 Triple-bottom-line accounting: Practical measures
10.4 Environmental project appraisal
10.5 Social accounting
10.6 Sustainability as a business strategy
Study tools
Chapter 11: Short-term planning decisions
11.1 Relevant costs and revenues
11.2 Other cost (and revenue) concepts for short-term decisions
11.3 Calculating short-term decisions
11.4 Non-financial issues in decision making
Study tools
Chapter 1
2: Capital expenditure decisions
12.1 Capital expenditure decisions
12.2 Making a capital expenditure decision
12.3 Net present value (NPV) method
12.4 Alternative methods for evaluating capital expenditure proposals
12.5 Selecting alternative proposals for investment
Study tools
Glossary
Index

Citation preview

4T H E DI T I ON

Accounting I n f o r m at io n f o r B u s in e s s D e ci s io n s

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

4T H E DI T I ON

Accounting I n f o r m at io n f o r B u s in e s s D e ci s io n s

Billie M Cunningham Loren A Nikolai John D Bazley Marie Kavanagh Sharelle Simmons Christina James Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Accounting: Information for business decisions 4th Edition Billie M Cunningham Loren A Nikolai John D Bazley Marie Kavanagh Sharelle Simmons Christina James

Head of content management: Dorothy Chiu Content manager: Geoff Howard Content developer: Rhiannon Bowen/Stephanie Davis Project editor: Raymond Williams Cover designer: Claire Atteia Text designer: James Steer Editor: Susan Jarvis Permissions/Photo researcher: Liz McShane Proofreader: Jade Jakovcic Indexer: Max McMaster Cover: iStockphoto/shapecharge Typeset by Cenveo Publisher Services Any URLs contained in this publication were checked for currency during the production process. Note, however, that the publisher cannot vouch for the ongoing currency of URLs.

© 2021 Cengage Learning Australia Pty Limited Copyright Notice This Work is copyright. No part of this Work may be reproduced, stored in a retrieval system, or transmitted in any form or by any means without prior written permission of the Publisher. Except as permitted under the Copyright Act 1968, for example any fair dealing for the purposes of private study, research, criticism or review, subject to certain limitations. These limitations include: Restricting the copying to a maximum of one chapter or 10% of this book, whichever is greater; providing an appropriate notice and warning with the copies of the Work disseminated; taking all reasonable steps to limit access to these copies to people authorised to receive these copies; ensuring you hold the appropriate Licences issued by the Copyright Agency Limited (“CAL”), supply a remuneration notice to CAL and pay any required fees. For details of CAL licences and remuneration notices please contact CAL at Level 11, 66 Goulburn Street, Sydney NSW 2000, Tel: (02) 9394 7600, Fax: (02) 9394 7601 Email: [email protected] Website: www.copyright.com.au For product information and technology assistance, in Australia call 1300 790 853; in New Zealand call 0800 449 725 For permission to use material from this text or product, please email [email protected]

Third edition published 2019

National Library of Australia Cataloguing-in-Publication Data ISBN: 9780170446242 A catalogue record for this book is available from the National Library of Australia

Adaptation of ACP Accounting: Information for business decisions Volumes 1, 2nd edition, by Cunningham/Nikolai/Bazley [ISBN 9780324833492], published by Cengage © 2008

Cengage Learning Australia Level 7, 80 Dorcas Street South Melbourne, Victoria Australia 3205

Acknowledgements Prelim images: iStock.com/Eva-Katalin; iStock.com/Cecilie_Arcurs; iStock. com/Weedezign; iStock.com/RichLegg; iStock.com/monzenmachi; iStock. com/PeopleImages; iStock.com/Dan Rentea; iStock.com/andresr; iStock. com/Dziggyfoto

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Chapter opener images: iStock.com/andresr; iStock.com/joci03; iStock.com/pixelfit; iStock.com/monkeybusinessimages; iStock.com/Cecilie_Arcurs; iStock. com/TommasoT; iStock.com/Weedezign; iStock.com/RichLegg; iStock. com/fotostorm; iStock.com/monzenmachi; iStock.com/PeopleImages; iStock.com/Dan Rentea

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BRIEF CONTENT S 1

Introduction to business accounting and the role of professional skills ...................................... 1

2

Developing a business plan: Cost–volume–profit analysis ...................................................... 44 Appendix: CVP analysis for cups of coffee .......................................................................86

3

Developing a business plan: Applied budgeting..................................................................... 94

4

The accounting system: Concepts and applications............................................................... 132

5

Recording, storing and reporting accounting information ..................................................... 179

6

Internal control: Managing and reporting working capital ................................................... 226

7

The income statement: Components and applications........................................................... 263 Appendix: Calculating the cost and the amount of inventory .............................................299

8

The balance sheet: Components and applications ................................................................ 308

9

The cash flow statement: Components and applications ....................................................... 352 Appendix: Indirect method for reporting cash flows from operating activities ......................390

10

Sustainable and profitable business practices ...................................................................... 398

11

Short-term planning decisions ............................................................................................. 440

12

Capital expenditure decisions.............................................................................................. 473

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v

CONTENT S Guide to the text ....................................................... x Guide to the online resources ....................................xiv Preface ...................................................................xvi About the authors...................................................xxiii Acknowledgements ................................................. xxv Chapter 1

Introduction to business accounting and the role of professional skills...................... 1 1.1 Factors affecting the complexity of a changing business environment ............... 4 1.2 Business enterprise categories..................................................................... 7 1.3 Business structures ..................................................................................... 9 1.4 The accounting system ............................................................................. 15 1.5 Ethics in business and accounting.............................................................. 24 1.6 The accountant in a changing society ........................................................ 26 Study tools ................................................................................................... 36

Chapter 2

Developing a business plan: Cost–volume–profit analysis ...................................... 44 2.1 Planning in a new business....................................................................... 45 2.2 Cost–volume–profit (CVP) planning ............................................................ 54 2.3 Using CVP analysis.................................................................................. 65 2.4 Other planning issues and effects .............................................................. 69 Study tools ................................................................................................... 71 Appendix: CVP analysis for cups of coffee ........................................................ 86

Chapter 3

Developing a business plan: Applied budgeting .................................................... 94 3.1 Why budget? ......................................................................................... 95 3.2 Operating cycles..................................................................................... 97 3.3 The budget as a framework for planning .................................................... 99 3.4 Using the master budget in evaluating the business’s performance ............... 117 Study tools ................................................................................................. 121

Chapter 4

The accounting system: Concepts and applications .............................................. 132 4.1 Financial accounting information and decision making............................... 134 4.2 Basic concepts and terms used in accounting ............................................ 136 4.3 Components of the accounting equation ................................................... 139 4.4 Accounting for transactions to start a business........................................... 143 4.5 Expanding the accounting equation ......................................................... 148 4.6 Recording daily operations..................................................................... 150 4.7 End-of-period adjustments....................................................................... 160 Study tools ................................................................................................. 166

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Contents

Chapter 5

Recording, storing and reporting accounting information .................................... 179 5.1 Accounts .............................................................................................. 180 5.2 Accounting cycle................................................................................... 183 5.3 Recording (journalising) transactions........................................................ 183 5.4 Posting from journals to the accounts ....................................................... 190 5.5 Trial balance ........................................................................................ 196 5.6 Preparing adjusting entries ..................................................................... 197 5.7 Adjusted trial balance............................................................................ 202 5.8 Preparing the financial statements............................................................ 203 5.9 Preparation of closing entries .................................................................. 205 5.10 Modifications for companies................................................................. 209 5.11 Other journal entries............................................................................ 212 Study tools ................................................................................................. 214

Chapter 6

Internal control: Managing and reporting working capital.................................. 226 6.1 Working capital.................................................................................... 228 6.2 Cash ................................................................................................... 230 6.3 Accounts receivable .............................................................................. 241 6.4 Inventory .............................................................................................. 244 6.5 Accounts payable ................................................................................. 248 Study tools ................................................................................................. 251

Chapter 7

The income statement: Components and applications .......................................... 263 7.1 Why the income statement is important .................................................... 265 7.2 Measuring financial performance: The income statement ............................ 267 7.3 Defining and classifying revenues/income ................................................ 269 Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

vii

Contents

7.4 Defining and classifying expenses ........................................................... 274 7.5 Evaluating the income statement using ratios............................................. 279 7.6 Linking profit to owner’s equity and closing the accounts ............................ 283 Study tools ................................................................................................. 287 Appendix: Calculating the cost and the amount of inventory .............................. 299 Chapter 8

The balance sheet: Components and applications................................................ 308 8.1 Why the balance sheet is important ......................................................... 310 8.2 The accounting equation and the balance sheet ........................................ 312 8.3 Using the balance sheet figures for evaluation........................................... 318 8.4 Evaluating financial flexibility.................................................................. 321 8.5 Limitations of the income statement and the balance sheet .......................... 329 8.6 Business activity statements (BAS) ............................................................ 331 Study tools ................................................................................................. 336

Chapter 9

The cash flow statement: Components and applications....................................... 352 9.1 Understand the importance of the cash flow statements to organisations and users ............................................................................... 354 9.2 Identify the types of transactions that generate cash inflows and outflows ..... 355 9.3 The organisation of the cash flow statement .............................................. 357 9.4 Construct cash flow statements based on the direct method ......................... 360 9.5 Analysis of the cash flow statement .......................................................... 367 9.6 Calculate the relevant cash flow ratios ..................................................... 370 Study tools ................................................................................................. 374 Appendix: Indirect method for reporting cash flows from operating activities ....... 390

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Contents

Chapter 10

Sustainable and profitable business practices ..................................................... 398 10.1 Corporate social responsibility (CSR) ..................................................... 400 10.2 The triple bottom line ........................................................................... 401 10.3 Triple-bottom-line accounting: Practical measures..................................... 409 10.4 Environmental project appraisal ............................................................ 415 10.5 Social accounting................................................................................ 426 10.6 Sustainability as a business strategy ...................................................... 429 Study tools ................................................................................................. 431

Chapter 11

Short-term planning decisions ............................................................................ 440 11.1 Relevant costs and revenues.................................................................. 442 11.2 Other cost (and revenue) concepts for short-term decisions........................ 445 11.3 Calculating short-term decisions ............................................................ 449 11.4 Non-financial issues in decision making ................................................. 460 Study tools ................................................................................................. 461

Chapter 12

Capital expenditure decisions............................................................................. 473 12.1 Capital expenditure decisions ............................................................... 474 12.2 Making a capital expenditure decision .................................................. 475 12.3 Net present value (NPV) method ........................................................... 483 12.4 Alternative methods for evaluating capital expenditure proposals .............. 491 12.5 Selecting alternative proposals for investment.......................................... 494 Study tools ................................................................................................. 497

Glossary ..............................................................510 Index ...................................................................518 Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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x

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Guide to the text

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Guide to the text

xii

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Guide to the text

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xiv

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Guide to the online resources

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PREFACE For students There is a saying that ‘knowledge is power’, and in business and our own personal lives this is true. Those who have knowledge hold a competitive advantage over those who don’t. Those who understand business information, and know how to interpret and use it, make the best business decisions. Furthermore, what we know continually evolves as new information and ideas emerge through media and technology. Change is a very exciting and necessary component of our business life. Financial reports, generated by the accounting system of a business, are a major source of business information for both business and personal use. When reading these reports, you must evaluate the information they contain by looking for supporting evidence, assumptions and bias, and by considering other points of view. Furthermore, you must know how to interpret the information contained in these reports and be able to analyse and project future change and growth to manage sustainability of your business or your own personal finances. To do this, you must understand how a business’s accounting system develops these reports, and what concepts, principles and assumptions underlie the accounting process used to produce the information in these reports. With this in mind, we designed this book to address these issues. After you graduate, you may work in business and use accounting information to make decisions as an ‘internal user’. Alternatively, you may consider investing in a business or have some other reason to use its accounting information to make decisions as an ‘external user’. Your ability to use the material in this book to later help you make effective business decisions (regardless of your career choice) depends on you making it a part of your own knowledge base. This means that you should reflect on the issues and ideas as you read about them, making sure that you understand them before you read further. This will require some effort on your part. Make sure you read this book critically. Test it in your mind. Does it make sense to you? To help you learn this material and think about what you are learning, throughout the book we have placed questions labelled ‘Stop’ (identified by a hand gesture) that we think are worth your time and effort to answer. Each time you encounter one of these questions, stop, reflect, think through the question and answer it honestly. Base your answer on what you have learned in your life experiences, on your knowledge of accounting, business and the world – and on your own common sense. By pausing in your reading and answering these questions, you will have time to process what you are reading and an opportunity to build new knowledge into your existing knowledge base. This edition also includes ‘Discussion’ questions that are aimed to spur problem solving, critical thinking and judgement, and to test your development of these skills. Besides answering these questions as you read the book, think about questions you have, or what else you would like to know about the subject at hand. Pursuing the answers to these questions in class or online will help you add to your knowledge base and the quality of your later decisions. We hope you find this book interesting and easy to read, and that the examples based around coffee add relevance to your accounting experience! We also hope you find the book useful not only by increasing your personal capacity to manage financially through an appreciation of the power of being financially literate, but also by enhancing your ability as a business professional now and in the future.

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Preface

For educators Caution – hot contents This textbook has a number of themes that revolve around coffee, and this preface is no exception. As well as the brew of all the classic accounting topics that you will need, this book also percolates a blend of a number of phrases and terms well known to coffee lovers (and we know that includes accountants!). We hope that this preface serves as an enticing aroma, that once inhaled, draws you to take measured sips from the chapters beyond, guiding your students to extract knowledge along the way.

Two great ingredients that brew one great text In the real world, today’s students face an accounting environment where management accounting and financial accounting issues are integrated and inter-related every day. Modern textbooks need to emphasise accounting information as a basis for general business decisions, maintain students’ interest through relevant case scenarios, and dispense with the perception that accounting is best left solely to accountants. In fact, financial literacy skills are life skills that we all need. This textbook integrates management accounting and financial accounting topics in a way that is more reflective of the world the students in your first year accounting class will face outside of the classroom.

Sometimes you feel like a debit, sometimes you don’t A major focus of this textbook is about understanding and applying information in various business settings. We wrote this book at a non-technical level for all business and non-business students – not just those intending to be accounting majors. Because all of the authors are heavily involved in teaching first, second and third level accounting, we are aware of the needs of your accounting majors. So we discuss recording, storing and reporting accounting information. We begin with a non-procedural approach to explain transactions in terms of the accounting equation (with entries into account columns) to illustrate the effect of these transactions on the financial statements. In Chapter 5 we discuss the rules for double entry and cover the accounting cycle, from journal entries (using debits and credits) through the post- closing trial balance. We designed it so that you may use it in as much depth as you see fit in the process of teaching from this book. Accounting majors who have used this elementary accounting text are well prepared to enter second and third level accounting classes. For non-accounting students they will have a basic understanding of the process behind the financial reports produced by accounting systems.

The house roast (the approach of this text) An introduction to business approach Chapter 1 takes an ‘introduction to business’ approach that orients students to the business environment, that is, the operations of a business, the different functions of business, managers’ responsibilities, and the types of information, management reports, and financial statements the business’s accounting system provides for use in internal and external decision making. Unique for

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Preface

an accounting textbook, this chapter provides students with a basic understanding of business so they can more effectively envision the context in which accounting information is collected and used, and the types of decisions users make in this context. This approach allows students to see the ‘big picture’ more clearly. Professional skills Another unique feature of this book is the introduction it gives students to professional skills such as critical thinking, and demonstrates how they are used in decision making and problem solving. This book emphasises the type of analytical and critical thinking that successful accountants and other business people use in a world that is constantly changing and increasing in complexity. ‘Stop questions’ throughout the textbook ask students to take a break from reading to think about an issue and/or consider the outcome of a situation. We also ask them why they think what they think. The end-of-chapter materials include both structured and unstructured questions and problems that strengthen students’ problem-solving capabilities by emphasing the use of reflective and critical thinking skills. Therefore, some of the questions and problems do not have a ‘correct’ answer; rather the focus is on the approach or process that students use to solve them. With the increasing complexity of business activities, the inclusion of critical thinking materials better prepares students to understand the substantive issues involved in new or unusual business practices, and guides them to understand that today’s accountants need to ‘think outside the box’. New ‘Sustainability’ icons draw attention to sections that discuss environmental and ethical issues and how they relate to students’ understanding of triple bottom line accounting. First things first The chapters are designed to reflect actual practice in that a business must plan and understand its activities before it communicates its plans to external users, and it must perform and evaluate its operations (internal decision making) before it communicates the results of its operations to external users. Therefore, in keeping with the ‘introduction to business’ theme and the logical sequencing of business activities, we discuss accounting for planning first, and then operating and evaluating (controlling) – discussing management accounting and financial accounting where they logically fit into this framework. For instance, Chapter 2 covers cost–profit–volume (CVP) analysis for planning purposes. After students have an understanding of cost and revenue relationships, we introduce them to budgeting in Chapter 3. The discussion of the master budget includes projected financial statements, which links the coverage back to the financial statements in Chapter 1. Chapter 4 then introduces accounting for the operations of a business. Chapters 7 to 9 describe a business’ major financial statements, and discuss how internal and external users would use these statements to analysis the business. Chapters 1, 10 and 11 evaluate results and use short and long term financing and investment tools to plan for sustainable growth of the business. Factors affecting a business and its reputation such as sustainable practice and business ethics are highlighted throughout the chapters. This approach reinforces the idea that societal, environmental and global issues are not topics that can or should be dealt with separately from the other issues, but rather are an integral and significant part of business in a world where immediate access to information is available.

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Preface

The simpler things Earlier we mentioned a ‘non-technical’ approach. Although we explain identifying, measuring, recording and reporting of economic information, we discuss these activities at a basic level in Chapter 4 (increases and decreases in account balances) and do not include a discussion of debit and credit rules and journal entries in the main body of the text. We use account columns to record transactions, but we explain the increases or decreases in relation to the accounting equation (Assets = Liabilities + Owners’ equity), rather than as debits and credits. At the same time, we also emphasise the effects of the transactions on a business’ financial statements and the impact they have on analysis of the business, for example its risk, liquidity, financial flexibility, and operating capability. We chose this approach to better help students gain an understanding of the logic of the accounting system and its interrelationships, the effects of transactions on a business’s financial statements, and the use of accounting information in decision making without getting ‘bogged down’ in the mechanics of the system. For those wanting to incorporate the mechanics of the system we do provide thorough coverage of the double entry system, through the use of the accounting equation and its linkage to the income equation (Income = Revenues – Expenses), as well as the complete accounting cycle in Chapter 5. Short black or cappuccino with extra foam (a scaffolded approach) This textbook also uses a building-block approach. It begins with starting and operating a small retail cafe – a sole proprietorship – and then progresses learning to an understanding of a more complex business in the form of a company. This allows students to learn basic concepts first, and then to broaden and reinforce those concepts later in a more complex setting. Several of the same topics re-emerge, but each time they are refined or enhanced by a different business structure or a different user perspective. For example, because of its location at the beginning of the semester, the Chapter 2 discussion of CVP analysis is simple. This topic would be covered again in greater depth in second and third year courses after students have a better understanding of costs in a manufacturing setting. Each time we revisit an issue, we discuss the uses of accounting information for both internal and external decision making, as appropriate. Likewise, we use a scaffolded approach to arranging the end-of-chapter materials according to levels of learning. To indicate these levels, we have divided these materials into sections on Testing your knowledge, Applying your knowledge, and Making evaluations. These categories are arranged so that the answers to questions require students to use increasingly higher-order thinking skills as they move from one category of question to the next. • The Testing your knowledge section includes questions that test students’ knowledge of specifics – terminology, specific facts, concepts and principles, classifications, and so forth. • The Applying your knowledge section includes questions, problems, and situations that test students’ abilities to translate, interpret, extrapolate and apply their knowledge.

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•

The Making evaluations section includes questions, problems, and cases that not only test students’ abilities to apply their knowledge but also their abilities to analysis elements, relationships and principles, to synthesise a variety of information, and to make judgments based on evidence and accounting criteria.

New and improved flavour In this new edition, and as a result of our own use of the book and feedback from other users, we have further developed the key features of the textbook including: 1 The opportunity for students to experience what it is like to start up, run, and grow a small business as they assist Emily Della to operate and make decisions about her business, Cafe´ Revive. Each chapter scaffolds knowledge about financial records and reports of the business and the decision-making processes that flow from evaluation of the results. Students assist Emily to plan, operate and evaluate the business as though it was their own. 2 Issues and real-life examples relating to ethical issues in triple bottom line accounting have been woven into this new edition. The sustainability theme that runs through the text is another key feature that differentiates it from other introductory accounting texts. 3 Chapter 10 has been specifically designed to give students a taste of the impact of environmental and energy issues on business, and how to record and manage them. It also broadens their perspectives by introducing them to the Global Reporting Initiative (GRI) to make them truly aware of the knowledge and skills they will need in the global business arena. 4 This edition of the text highlights the importance of developing a range of skills other than technical skills, such as judgement, critical thinking, ethical and sustainability skills, selfmanagement and teamwork using activities throughout each chapter, the end-of-chapter materials and case studies. 5 We moved some topics to chapter appendices to keep them available to those who wish to teach them, including periodic and perpetual inventory. 6 We have revised ‘real’ business examples in the text, and have updated the ‘real’ business problems in the end-of-chapter materials. We believe these features enhance the ‘flavour’ of the book and make its topics even more relevant and understandable to our students.

Real-world/worldwide/total world Life is not a ‘textbook case’. That’s why we not only integrate management accounting and financial accounting topics, but also include information about real-world businesses as examples for many of these topics. We include analyses of the financial information of some of these businesses in the text and in the end of chapter materials. The list of company URLs at the end of each chapter gives students the opportunity to connect to some of these businesses. Students will navigate to various sections of a business’s website such as pages titled: About Us, Business Information, Investors, Investor Information, Financial Statements, Annual Reports and other financial information. They will be able to read about real world businesses and their activities for each financial year. Navigating to the financial information of an organisation, such as the CPA, can follow a less logical path and may involve more trial and error.

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Preface

Orientation of the Book In the rapidly changing business environment, the businessperson must interpret, evaluate, synthesise and apply new information and technology. With this new information and technology come new problems, many of which have several reasonable solutions and many of which may not have obvious solutions, or in fact any solutions at all. In this environment, businesspeople and accountants are not operating in a ’textbook world’ where there are clearcut, right-and-wrong answers, and where the relevant facts for making decisions are neatly laid out. Therefore, to help you prepare for this challenging environment, throughout this book we will illustrate the use of critical thinking and judgement skills for solving accounting-related problems. Then, in the ’Integrated business and accounting situations’ at the end of each chapter, we will give you the opportunity to enhance your own thinking and judgement skills. In addition to solving problems that have specific ’correct’ solutions, we will ask you to make decisions and to solve problems that may have several reasonable solutions or obscure solutions. We will also ask you to interpret, evaluate and synthesise information, and to apply new information to new and different situations.

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Preface

Framework of the Book Now that you have been introduced to business and accounting, and to the skills required to be a good business manager or accountant in a global business environment, it is time to begin a more in-depth study of the use of accounting information in the business environment. Beginning in Chapter 2, we will discuss in more depth accounting and its use in the management activities of planning, operating and evaluating, starting with a simple business. In later chapters, we will progress through more complex businesses. We will also discuss the use of accounting by decision makers outside the business. As you read through the book, you will begin to notice that the same topics re-emerge, but each time a topic recurs, it is refined or enhanced by a different business structure, a different type of business or a different user perspective. You will also notice that we frequently discuss ethical and sustainability considerations. That is because these considerations exist in all aspects of business and accounting. By constantly practising critical thinking, judgement and problem solving, you will also be developing self-management skills. You will also notice that international issues appear again and again. Many businesses operating in Australia and New Zealand have home offices, branches and subsidiaries in other countries, or simply trade with businesses in foreign countries. Managers must know the implications of conducting business in foreign countries and with foreign businesses. External users of accounting information must also know the effects of these business connections.

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ABOUT THE AUTHORS Professor Marie Kavanagh, University of Southern Queensland Marie (DipTeach, BCom, AdvDipFinAcctg, MFinMgmt, PhD, CPA) works in accounting education at the University of Southern Queensland, and has taught accounting for many years across all levels of secondary and tertiary education. Marie’s research interests are in the areas of accounting and business education, particularly online business education. She is well known for her involvement in several large ALTC/OLT grants, as both a leader and a team member, working in collaboration with other universities to further knowledge and improve practice in business and accounting education. Marie is an active member of several NFP Boards and remains a member of the Accounting Education Special Interest Group for the Accounting and Finance Association of Australia and New Zealand (AFAANZ) after chairing that group for 10 years. She has been engaged for 18 years as an academic advisor for Enactus (Entrepreneurship and Action through Us) Australia working with teams of students from several universities to deliver relevant entrepreneurial projects in their communities. She was a has won individual and national team awards for Contribution to Student Learning and Student Support. She is a Fellow of the Business Educators Association of Queensland and an active member of local Chambers of Commerce, and delivers community outreach projects that develop financial literacy skills in young people. Sharelle Simmons, Leaders Institute Sharelle (BA, BEd, MCom, CPA) is the Program Director at Leaders Institute Pty Ltd and former Academic Director at Charles Sturt University (CSU) Study Centre Brisbane. She has had extensive teaching experience, having held positions at Griffith University, University of Queensland, Newcastle University and Avondale University College. Her primary areas of teaching are Financial

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About the authors

Accounting, Management Accounting, Strategic Management Accounting, Accounting Information Systems and Business Statistics Sharelle’s research interests include the adoption of Performance Measurement Systems, especially in the public sector, and the choice of and functioning of networks within the healthcare sector. Sharelle has been the recipient of a large ARC Linkage Grant for research into networks in the healthcare sector. Her PhD research into the adoption of the Balanced Scorecard in the Australian healthcare sector has been presented at an EIASM conference. She is a co-recipient of an ALTC teaching award for the Professional Development Program conducted at Griffith University. Doctor Christina James, University of Southern Queensland Christina (BA(Hons), GDipEd, MFinMgt , PhD, FCCA) works in accounting and finance education at the University of Southern Queensland, and has taught accounting at both secondary and tertiary levels, and at a number of Australian universities. Christina’s research interests are in the areas of corporate governance, climate change mitigation, accounting for sustainability and Triple Bottom Line (TBL) reporting. Prior to working in education, Christina worked as an auditor and company accountant in the United Kingdom and in Australia. She has also done voluntary work as a Treasurer for a number of not for profit organisations.

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ACKNOWLEDGEMENTS The authors and Cengage would like to thank the following reviewers for their incisive and helpful feedback: • Peter Baxter – University of the Sunshine Coast • Carol Cheong – Lincoln University • Kirsty Dunbar – University Southern Queensland • Pandula Gamage – Australian Catholic University, Melbourne • Abdel K Halabi – Federation University • Nicole Ibbett – Western Sydney University • Dr Amid Khosa – Monash University • Amy McCormack – Flinders University • Terri Trireksani – Murdoch University • Basil Tucker – University of South Australia Every effort has been made to trace and acknowledge copyright. However, if any infringement has occurred, the publishers tender their apologies and invite the copyright holders to contact them.

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1 INTRODUCTION TO BUSINESS ACCOUNTING AND THE ROLE OF PROFESSIONAL SKILLS ‘Business is a game, the greatest game in the world if you know how to play it.’ Thomas J Watson Sra

Learning objectives After reading this chapter, students should be able to do the following: 1.1

Have an understanding of business, and the skills and knowledge required for success in a complex business environment.

1.2 Explain the categories of business. 1.3 Know the three common business structures and the regulations faced by each. 1.4 Outline how accounting systems play a role in providing information to enable informed business decisions. 1.5 Understand how ethics and sustainability impact business outcomes. 1.6 Discuss the skills required by accountants and those involved in business to solve problems and make decisions. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

1

Accounting Information for Business Decisions

Understanding the learning objectives is assisted in the chapter by asking key questions:

Key questions 1

Why is it necessary to have an understanding of business before trying to learn about accounting?

2

What factors are affecting the complexity of a changing business environment?

3

What are three characteristics that someone might require to become a successful businessperson in a complex business environment?

4

What are the three main categories of business enterprise?

5

What are the three most common forms of business organisation and their basic characteristics?

6

What types of regulations do businesses face?

7

What information does the accounting system provide to support management activities?

8

How does accounting provide support and information to people who are external to the business when they are making decisions?

9

What roles do ethics and sustainability play in the business environment?

10

What skills are required from accountants of the twenty-first century?

11

How can people learn to think critically?

12

How can critical thinking help people to make better business decisions?

13

What are the logical stages in problem solving and decision making?

What are you planning to do when you graduate from university? Maybe become an entrepreneur, own your own business, work your way up to marketing manager for a multinational business, manage the local corner store or manage a sporting goods store? Regardless of your career choice, you will be making business decisions, both in your personal life and at work. We have oriented this book to students like you, who are interested in business and the role of accounting in business. You will see that, when used properly, accounting information is a powerful tool for making good business decisions. People inside a business use accounting information to help them to determine and manage costs, set selling prices and control the operations of the business. People outside the business use accounting information to help them make investment and credit decisions about the business. So what kinds of businesses use accounting? All of them! Let’s take a little time to look at what business means. Business affects almost every aspect of our lives. Think for a moment about your normal daily activities. How many businesses do you usually encounter? How many did you directly encounter today? Suppose you started the day with a quick trip to the local convenience store for milk and eggs. While you were out, you noticed that your car was low on petrol so you stopped at the local petrol station. On the way to class, you dropped off some clothes at the dry-cleaners. After your first class, you skipped lunch so that you could go to the bookshop and buy the calculator you needed; then, after buying a cappuccino from Cafe´ Revive to keep yourself awake in lectures, you headed to your next class. In just half a day, you have already interacted with five businesses – the convenience store, the petrol station, the drycleaners, the bookshop and the campus cafe´. You have also managed your own personal financial requirements – that is, had enough money to pay for these things.

Discussion Do you view your university as a business? Why or why not?

2

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Chapter 1 Introduction to business accounting and the role of professional skills Although, in this scenario, you were directly involved with five businesses, you were also probably affected by hundreds of others. For example, two different businesses manufactured the calculator you purchased from the bookshop and the coffee you purchased from Cafe´ Revive. Suppose DeFlava Coffee Corporation roasted and ground the coffee beans used in the cappuccino you purchased. As we illustrate in Case Exhibit 1.1, DeFlava purchased the ingredients from other businesses (suppliers). Each supplier provided DeFlava with particular goods. Shipping businesses (carriers) moved the goods from the suppliers’ warehouses to DeFlava’s factory, where the coffee beans were roasted and ground. A different carrier then moved the coffee from the factory to DeFlava’s outlets, such as Cafe´ Revive.

1

Why is it necessary to have an understanding of business before trying to learn about accounting?

Case Exhibit 1.1 Businesses involved in the manufacture and sale of coffee Suppliers

Carriers

Manufacturer

Carrier

Coffee shop

Coffee Farmers

Gas on Tap

DeFlava Coffee

State Packing Company

Boxes’n Bits

Café Revive

The making and shipping of the coffee would follow the same process. You can see that many businesses are involved in manufacturing, shipping and selling products. Now think about all the other products that you used during the morning and all the businesses that were involved in the manufacturing and delivery of each product. Before leaving your home this morning, you could easily have been affected by hundreds of businesses. All these businesses have a role to play in providing goods and services to final customers. Products and services affect almost every minute of our lives, and businesses provide us with these products and services. As you will soon see, accounting plays a vital role for businesses by keeping track of a business’s economic resources and activities, and nowadays by measuring the environmental and social impacts of the business (these will be discussed throughout this text). The financial position of the business and the results of its activities are then reported to people who are interested in how well it is doing, similar to the way statistics are gathered and reported for cricket players and other athletes.

Stop & think What do you think is the role of accounting and accountants in operating a business? In this chapter, we will introduce you to accounting by first looking at different forms of business enterprise and the environments within which they operate. Regulatory issues associated with forming, operating and reporting on the activities of a business, and the role of ethics and sustainability in the management of a business, are discussed. We will highlight the need to understand the language of business in order to develop and apply business knowledge and build a range of skills to enable you to practise professionally in business. The role that accounting information plays in problem solving, making judgements and decision making within a business will be outlined. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions 2

What factors are affecting the complexity of a changing business environment?

1.1 Factors affecting the complexity of a changing business environment Why is the business environment changing so rapidly? As Exhibit 1.2 illustrates, a combination of many interwoven factors in this environment contribute to its complexity and excitement. Exhibit 1.2 Factors affecting the complexity of the business environment

Information explosion Evolving forms of business

Technological advances Business environment

More complex business activities

Globalisation

Increased regulations

One contributor to the rapidly evolving business environment is the information explosion. More information is being generated than ever before, and this information is available to far more people than in the past. On the information superhighway, networks such as the internet make available an almost endless bank of information that includes library listings, books, journal articles, financial reports, catalogues and directories of businesses, organisations and people with similar interests. Because of the amount and accessibility of information, and because new information may replace existing information, business managers must be able to use their skills to evaluate and manage this information to their advantage. We will discuss this idea more thoroughly later in the chapter. Consider how technological advances have affected the transmission and sharing of information. Most businesspeople have adapted their workday habits to include the use of smartphones, text messaging, web conferences or online meetings using Zoom, and Skype or WhatsApp for conducting business online. Email, SMS, scanners and online data-drop boxes for sharing documents facilitate information transmission to and from multiple global sites. Huge databases, such as airline flight schedules and rate structures, are now stored online and accessed by millions of users around the world every day. The impact of social media has changed the ways firms communicate and involve their clients and customers using Facebook and other social media. All these developments have made the world more competitive. Businesses and individuals who in the past had difficulty travelling or communicating internationally (perhaps because the infrastructures of their countries could not accommodate their needs) have enthusiastically ‘thrown their hats in the ring’. Technological advances have affected not only the products we use and the way business is conducted but also how products are manufactured. For example, advanced technologies have allowed the production process in many businesses to become fully automated. In many modern factories, computers are used to plan, operate and monitor manufacturing processes, and to make adjustments to these as 4

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Chapter 1 Introduction to business accounting and the role of professional skills

This book uses alphabetic endnotes to denote reference material related to the discussion. Find the corresponding references at the end of the chapter.

Getty Images/Monty Rakusen

needed. Robots are now common workers on many production lines. Apps are now a popular means of capturing customer or client interest, securing business and delivering goods or services. The globalisation of business activities and economies is providing more opportunities for businesses and individuals to conduct business by creating a larger, more diverse marketplace. At the same time, it is providing new business challenges. For example, when businesses begin to sell or source their products in other countries, they must translate their product names and advertising slogans into different languages. This is not as straightforward as it might first appear to be. Consider the dilemma KFC (http://www.kfc.com.au) faced when it tried to translate its slogan ‘finger-lickin’ good’ into Taiwanese: the literal translation was ‘Eat your fingers off’.b Globalisation also means that pandemics like COVID-19 impact businesses all over the world. Businesspeople must also translate transactions involving foreign currencies – for example, Japanese yen to Australian dollars. Furthermore, they must learn to negotiate other cultures, economies, laws and ways of conducting business. Another factor adding to the complexity of the business environment is the increase in the number of regulations that companies must address. These are discussed later in the chapter. More complex business activities also contribute to the changing business environment. For example, business owners and managers are finding more creative methods to finance their activities, new outlets for investing their excess cash, a larger variety of alternatives for compensating their employees and more Machines at work in an automated factory. complicated tax laws with which they must comply. In addition, the way companies conduct business is evolving. Where businesses used to be ‘bricks and mortar’, many now exist on the internet. It is now common and convenient for firms to conduct business using e-commerce, where businesses and consumers buy and sell goods and services over the internet. E-commerce takes three forms: business-to-business, or B2B (e.g. Cisco Systems, Inc – http://www.cisco.com), business-to-consumer, or B2C (e.g. Amazon – http://www.amazon.com.au), and consumer-to-consumer, or C2C (e.g. eBay – http:// www.ebay.com.au). Businesses also need to factor in the effect that climate change is having, and monitor the impact of business activities on greenhouse gas emissions. Businesses need to consider disclosure frameworks so as to keep their stakeholders informed about physical risks to the business associated with climate change, and details of any compliance obligations – for example, in Australia those dictated by the National Greenhouse and Energy Reporting Scheme introduced in 2007, and amended in 2017. In November 2019, the New Zealand Government passed the Climate Change Response (Zero Carbon) Amendment Bill to establish historic climate change laws. Similarly, in 2019 the Australian environment and climate change legislation was introduced. Finally, evolving forms of business are cropping up in the new business environment. For example, numerous variations of the simple business organisation (i.e. sole proprietorships, partnerships and companies) now exist. Each of these forms of organisation has legal advantages and disadvantages that the others do not have, and each addresses a particular aspect of the business environment. A business owner chooses the form of business that most closely meets the needs of their business.

e-commerce A method of conducting business where companies and consumers buy and sell goods and services online

Ethics and Sustainability

Discussion Has social media improved the way we conduct business? Give examples. 3

The successful businessperson The factors discussed above not only contribute to the complexity and excitement of the business environment, but also challenge the assumptions on which businesses and their employees operate. For example, the assumption that a university graduate will go out into the world, pursue a lifelong career and never return to university is no longer valid. Many people now change careers – careers, not just jobs! – Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

What are three characteristics that someone might require to become a successful businessperson in a complex business environment?

5

Accounting Information for Business Decisions several times before they retire. People live and work longer. Often, in order to make a change, they return to study between careers to ‘retool’ or expand their education to learn new skills. Even people who stay in the same career expand their education (through continuing professional education, short courses, conferences and seminars) in order to improve their knowledge and abilities. It is easy to see that a person entering or remaining in this dynamic environment must also be dynamic. In the following sections, we will discuss the characteristics, attitudes and skills that help people to succeed in the business world. While reading these sections, keep in mind that these are attributes and abilities that people learn over a period of time and continue to develop throughout their lives (similar to the way athletes continuously learn and improve their athletic skills).

Adapting to change Imagine a successful businessperson. Perhaps the person, with sleeves rolled up and hands dirty, is working hard on some project. Or maybe, dressed in a business suit and with a briefcase in hand, they are heading for a meeting. You may have a picture of what this businessperson looks like, but what really determines success is harder to see. This is more a matter of approach than of image. The successful businessperson thrives on change, seeing it as an opportunity rather than an obstacle. However, treating change as an opportunity is more than just a matter of attitude – it is not simply seeing the glass as ‘half full’. It also involves being prepared for the opportunity; the successful businessperson is both willing and able to change. Therefore, this person is devoted to lifelong learning, realising that continuous learning is the only way to keep up with, and be prepared for, the fast-paced change we described earlier. This means that the businessperson must be willing to read industry or professional journals, network with others by attending conferences and/or take courses to stay up to date.

Stop & think What qualities can people develop to better prepare themselves for problem solving and decision making in today’s rapidly changing business environment? To be able to adapt to change (or ‘go with the flow’), the successful businessperson also needs to develop certain other qualities. They welcome others’ viewpoints, appreciate differences among people, take educated and thoughtful risks, anticipate environmental trends – and identify the potential problems and opportunities associated with these trends – and willingly abandon old plans to pivot their business if new information, circumstances or technology makes existing methods less workable. This does not mean that the successful businessperson is a chameleon, changing colour every time the business environment changes, but it does mean that they are flexible and adaptable. In addition, the successful businessperson must understand the language of business as discussed in the next section and, more importantly, be able to develop a business plan to guide the operations and direction of their business.

The language of business To be successful in business, you must also understand the language of business. For example, what is a ‘transaction’, or what does it mean when a car ‘depreciates’? How do you know if a business is ‘solvent’? For many people, the concepts and terminology of business are not part of their normal vocabulary. When you begin to study your first course in business, you will be engaged with many new words and terms. In some ways, learning the language of business can be compared with learning a foreign language. Accounting and financial concepts may be alien to you. Still, the ability to understand and communicate financial information is critical not only to every entrepreneur and those engaged in business but to all of us, as a personal skill that allows us to survive our own financial journey through life. For example, if we borrow money to buy textbooks or a bigger asset such as a house, we become aware of the word ‘debt’. Every debt we have, we will need to pay back. So communication among owners, managers and investors is essential. Accounting fills the need for a common language of business. It records and processes financial information into an easily accessible format that can be understood by any person in the business world. Many people’s 6

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Chapter 1 Introduction to business accounting and the role of professional skills first encounter with accounting might be completing and submitting a tax return. Accounting is what accountants or certified public accountants (CPAs) do to prepare your taxes. Bookkeeping is what bookkeepers or business owners do to keep your business running smoothly. Bookkeeping is made up of two things: (1) payables – that is, paying bills, and paying your employees, contractors and yourself; and (2) receivables – that is, sending invoices to people who owe you money (debtors or accounts receivable) and making sure your invoices get paid. You can add to it things like categorising income and/or expenses to see how you’re spending money and how you’re making money. Underpinning all these activities is the need to manage and monitor cash flow. Regardless, as you progress through this text, you will encounter and become familiar with many new terms as your business vocabulary grows.

1.2 Business enterprise categories Business in Australia, New Zealand and most other countries operates within an economic system based on private enterprise. In this system, individuals – that is, people like us, rather than public institutions like the government – own businesses that produce and sell services and/or goods for a profit. These businesses generally fall into three categories: service businesses, merchandising businesses and manufacturing businesses.

4

What are the three main categories of business enterprise?

Service businesses A service business performs services or activities that benefit individuals or business customers. The drycleaning establishment where you dropped off your clothes this provides the service of cleaning and pressing your clothes for you. Businesses like Stefan Hair Fashions (http://www.stefan.com.au), LJ Hooker (http:// www.ljhooker.com.au) and Qantas Airlines Limited (http://www.qantas.com.au), and professional practices such as those in accounting, law, architecture and medicine, are all service businesses.

service business A business that performs services or activities that benefit individuals or business customers

Merchandising businesses Other businesses in the private enterprise system produce or provide goods or tangible/physical products. These businesses can be either merchandising businesses or manufacturing businesses. A merchandising business purchases goods (sometimes referred to as merchandise or products) for resale to its customers. Some merchandising businesses, such as plumbing supply shops, electrical suppliers or beverage distributors, are wholesalers. Wholesalers primarily sell their goods to retailers or other commercial users, like plumbers or electricians. Some merchandising businesses, such as the bookshop where you bought your calculator and chocolate bar, or the convenience store where you bought your milk and eggs, are retailers. Retailers sell their goods directly to the final customer or consumer. Woolworths Supermarkets (http:// www.woolworths.com.au) and The Good Guys (http://www.thegoodguys.com.au) are retailers. Other examples of retailers include shoe shops, furniture outlets, online bookshops and car dealerships.

merchandising business A business that purchases goods (sometimes referred to as merchandise or products) for resale to its customers

Manufacturing businesses A manufacturing business makes products and then sells these products to their customers. Therefore, a basic difference between merchandising businesses and manufacturing businesses involves the products that they sell. Merchandising businesses buy products that are physically ready for sale and then sell these products to their customers, whereas manufacturing businesses make their products first and then sell the products to their customers. For example, the university cafe´ is a merchandising business that uses the coffee it purchased from DeFlava, a manufacturing business. The DeFlava factory, though, purchases (from suppliers) the coffee beans, essences and other ingredients needed to make the coffee, which it then sells to the university cafe´ and other retail stores. Ford Australia (http://www.ford.com.au), Black & Decker (http://www.blackanddecker.com.au) and BlueScope Steel Ltd (http://www.bluescopesteel.com.au) are examples of manufacturing businesses. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

manufacturing business A business that makes its products and then sells these products to its customers

7

Accounting Information for Business Decisions

The relationship between types of private enterprises Exhibit 1.3 shows the relationship between manufacturing businesses and merchandising businesses and

how these businesses relate to their customers. Exhibit 1.3 Relationship of manufacturing and merchandising businesses

Suppliers

Manufacturing business

Merchandising business (wholesaler)

Merchandising business (retailer)

Merchandising business (retailer)

Final customer

The line of distinction between service, merchandising and manufacturing businesses is sometimes blurry because a business can be undertaking activities in more than one area. For example, Dell Inc. (http://www.dell.com.au) manufactures personal computers, directly sells the computers it manufactures to business customers, government agencies, educational institutions and individuals, and services those computers through installation, technology transition and management.

Stop & think What sort of business do you think Cafe´ Revive is? Justify your decision. Whether a business is a service, merchandising or manufacturing business (or all three), for it to succeed in a private enterprise system, it must be able to obtain cash to begin to operate and then grow. As we will discuss in the following sections, businesses have several sources of cash.

Entrepreneurship and sources of capital capital Funds a business uses to operate or expand its operations

8

Owning a business involves a level of risk, along with a continuing need for capital. Although capital has several meanings, we use the term here to mean the funds a business needs to operate or to expand operations. In the next two sections, we will discuss the risk involved in owning a business, and possible sources of capital.

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Chapter 1 Introduction to business accounting and the role of professional skills

Entrepreneurship Businesses in a private enterprise system produce and sell services and goods for a profit. So profit is the primary objective of the business. Profit rewards the owner or owners of the business for having a business idea, and for following through with that idea by investing time, talent and money in the business. The owner hires employees, purchases land and a building (or signs a lease for space in a building) and purchases (or leases) any tools, equipment, machinery and furniture necessary to produce or sell services or goods – expecting, but not knowing for sure, that customers will buy what the business provides. An individual who is willing to risk this uncertainty in exchange for the reward of earning a profit (and the personal reward of seeing the business succeed) is called an entrepreneur. Entrepreneurship, then, is a combination of three factors: the business owner’s idea, the willingness of the business’s owner to take a risk and the abilities of the owner and employees to use capital to produce and sell goods or services. But where does the business get its capital?

Sources of capital One source of capital for a business is the entrepreneur’s (or business owner’s) investment in the business. An entrepreneur invests money ‘up front’ so that the business can get started. The business uses this money to acquire the resources it needs to function. Then, as the business operates, the resources of the business – the capital – will increase or decrease through the profits and losses of the business. It is important to the sustainability of the business that it generates sufficient funds to allow expansion as opportunities arise. When an entrepreneur invests money in a business, they hope to eventually get back the money that they have contributed to the business (a return on investment). Furthermore, the entrepreneur hopes to periodically receive additional money above the amount they originally contributed to the business (a return on the contribution). The entrepreneur would like the return on the contribution to be higher than the return that could have been earned with that same money on a different investment, such as an interest-bearing savings account. Borrowing is another source of capital for a business. To acquire the resources necessary to grow or to expand the types of products or services it sells, a business may have to borrow money from institutions like banks (called creditors or lenders). This occurs when the cash from the business’s profits, combined with the business owner’s contributions to the business, is not large enough to finance its growth. But borrowing by a business can be risky for the owner or owners. In some cases, if the business is unable to pay back the debt that it owes, the owner(s) must personally assume this responsibility, or liability (i.e. something that is owed). Borrowing in general can also be risky for a business. If the business cannot repay its debts, it will be unable to borrow more money and will soon find itself unable to continue operating. In addition to earning a profit, then, another objective of a business is solvency, meaning that the business can pay off its debts.

Stop & think

entrepreneur Individual who is willing to risk the uncertainty of starting a business in exchange for the reward of earning a profit (and the personal reward of seeing the business succeed)

solvency A business’s long-term ability to pay off its debts

Why are accessible and affordable sources of capital important to the sustainability of a business?

1.3 Business structures In this text, we emphasise business organisations. These organisations, or businesses, are a significant aspect of the Australian, New Zealand and world economies. As Exhibit 1.4 shows, a business may be organised as one of the following general types of business organisations: (1) sole proprietorship; (2) partnership; or (3) company. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

9

Accounting Information for Business Decisions Exhibit 1.4 General characteristics of each form of business organisation

Characteristic

Partnerships

Sole proprietorships

Company/corporations

Number of owner(s)

Single owner

Two or more owners (partners)

Usually many owners (shareholders)

Size of business

Small

Most are small; some professional partnerships e.g. law firms) have several hundred partners

Many are very large; some may have stock traded on an exchange

Examples of businesses that typically have this legal form

Small retail shops; local service or repair shops; single practitioners such as CPAs, lawyers,doctors

Law firms; CPA firms; realestate agencies; family-owned businesses

Manufacturing companies; multinational companies; retail store chains; fast-food chains

Who makes business decisions

Owner

Depends on partnership agreement; small partnerships will have all partners involved in business decisions; large partnerships will have managing partners. Partners are agents

Decided by board of directors; large companies/corporations are managed by business professionals who often own little or no stock

Liability of owner(s)

Unlimited

Unlimited

Limited

Life of organisation

Limited

Limited

Continuous

Choosing the legal form of a business is an important decision for the owners to make. As a business owner, this decision determines, for example, how laws and regulations affect your personal responsibility to pay the business’s debts. When choosing among legal forms, you need to know the characteristics, and the advantages and disadvantages, of each of them. Once you select a legal form and start operating your business, laws and regulations specific to your type of organisation will affect some of your business decisions. In reality, choosing how to operate your business will often be determined by the size of the operation and the requirements for capital. Most small businesses operate as sole proprietors or partnerships, while large businesses will become companies/corporations. In the following sections, we will discuss the three most common forms of business organisations: sole proprietorships, partnerships and companies or corporations.

Stop & think What percentage of business is conducted by small businesses in (a) Australia; and (b) New Zealand?

5

What are the three most common forms of business organisation and their basic characteristics? sole proprietorship or sole trader Business owned by one individual who is the sole investor of capital into the business

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Sole proprietorship A sole proprietorship or sole trader is a business owned by one person, who is the sole investor of capital into the business. Cafe´ Revive is a coffee shop (i.e. a retail business) run by Emily Della. It sells good coffee and coffee products manufactured by DeFlava Coffee Corporation. Because Emily is the only investor in Cafe´ Revive, this business is an example of a sole proprietorship. In general, sole proprietorships are small businesses that focus on either selling merchandise or performing a service. Many of the small shops you come across are sole proprietorships. The owner of a sole proprietorship usually also manages the business. The owner makes the business’s important decisions, such as when to purchase equipment, how much debt to incur and which customers are extended credit and allowed to pay later (as mentioned earlier, these customers are known as the business’s debtors or accounts receivable). In Australia and New Zealand, tax laws and regulations require each owner of a sole proprietorship to report and pay taxes on their business’s taxable income. The business’s taxable income is included in the owner’s individual income tax return; there is no separate income tax return for a sole Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 1 Introduction to business accounting and the role of professional skills proprietor. So the owner adds the income from the sole proprietorship to their other sources of income, such as wages earned from other jobs and interest received from bank deposits. In the case of Cafe´ Revive, Emily Della includes with her personal income tax return a schedule that reports Cafe´ Revive’s taxable income. She includes this amount in her total personal taxable income. Emily calculates her personal income tax liability based on all her sources of income. Australian and New Zealand laws state that an owner of a sole proprietorship must assume personal responsibility for the debts incurred by the business. This requirement is referred to as unlimited liability. Unlimited liability may be a problem for the owner of a sole proprietorship because if the business cannot pay its debts, the business’s creditors may force the owner to use their personal assets to pay them. So if the sole proprietorship becomes insolvent, the owner may lose more than the amount of capital they invested in the business. Unlimited liability thus adds additional financial risk for the owner of a sole proprietorship. The life of a sole proprietorship is linked directly to its individual owner. Basically, a sole proprietorship ceases to exist when the owner decides to stop operating as a sole proprietor. If the owner of a sole proprietorship decides to sell the business, the owner’s sole proprietorship dissolves and the new owner(s) must choose the new business’s form of business organisation. Because of these characteristics, a sole proprietorship is said to have a limited life.

Partnership By definition, a sole proprietorship is owned by only one person. What if two or three people come up with a great idea and want to start a business? What if the owner of a sole proprietorship wants someone else to invest in their business? One option is for the individuals to operate their business as a partnership. A partnership is a business owned by two or more individuals, who each invest capital into the business.

Discussion Have you ever shared the purchase and use of an item with someone? Maybe you share a computer or an apartment. How do you decide how much money each person contributes?

unlimited liability Indefinite or unlimited personal liability for the debts incurred by the business. For a sole proprietorship, this means that the owner’s personal assets may be at risk if things go wrong in the business limited life Business that will cease when the business is sold or when a specific project is completed is said to have a limited life. For example, a sole proprietorship has a limited life because it ceases to exist if the business is sold.

partnership Business owned by two or more individuals who each invest capital, time and/or talent into the business and share in its profits and losses

How do you split the costs of software, rent or insurance?

Individuals must make many decisions before starting a partnership. These decisions include: the dollar amount each partner will invest the percentage of the partnership each individual will own how to allocate and distribute partnership income to each partner how business decisions will be made the steps to be taken if a partner withdraws from the partnership or if a new partner is added. To limit disagreements, partners should always sign a contract, called a partnership agreement, before their business begins operating. This is a good idea even if the partners are best friends or close relatives. This agreement specifies the terms of the formation, operation and termination of the partnership. It defines the nature of the business, the types and number of partners, the capital contributions required of each partner, the duties of each partner, the conditions for admission or withdrawal of a partner, the method of allocating income to each partner, and the distribution of assets when the partnership is terminated.c • • • • •

partnership agreement Contract signed by partners of a partnership before the business begins operations

Characteristics of partnerships Partnerships have many characteristics similar to those of sole proprietorships. Each partner is required by tax laws and regulations to report their share of the partnership income on their individual income tax return. Laws and regulations regarding unlimited liability also apply to partnerships. In addition, a partnership has a limited life. It terminates whenever the partners change that is, when a partner leaves the partnership or when a new partner is added. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions

Stop & think What concerns would you have about joining a partnership? Why?

joint ownership The idea that all partners jointly own all the assets of a partnership agent A person who has the authority to act for another person

There is a basic difference between partnerships and sole proprietorships, in that a partnership requires two or more owners. Several characteristics of partnerships relate to the co-ownership feature. To understand these, assume that Emily Della invites you to commence Cafe´ Revive as a partnership. If you are like most other people, the first thing you would think is, ‘What would I be getting myself into?’ Because of a partnership’s legal and business characteristics, you may be getting into more than you realise. One important characteristic to understand is that all the partners jointly own all the assets owned by a partnership; this is called joint ownership. Therefore, if you contribute your property to the partnership, it no longer belongs to you alone. Before entering a partnership, you should also know that each partner is an agent of the partnership. An agent is a person who has the authority to act for another. A partner thus has the power to enter into and bind the partnership – and, therefore, all the partners – to any contract within the scope of the business. For example, either you or Emily can bind the partnership to contracts for purchasing inventory, hiring employees, leasing a building, purchasing fixtures or borrowing money. All these activities are within the normal scope of a coffee shop or cafe´. The fact that each partner can obligate the partnership to honour contracts affects unlimited liability requirements. Unlimited liability for a partnership means that each partner is liable for all the debts of the partnership. A creditor’s claim is on the partnership, but if there are not enough assets to pay the debt, each partner’s personal assets may be used to pay the debt. The only personal assets that are excluded are a partner’s assets protected by bankruptcy laws, such as a personal residence. If one of the partners uses personal assets to pay the debts of the partnership, that partner has a right to claim a share of the payment from the other partner(s).

Stop & think Given the partnership characteristics we just discussed, if you were about to form a partnership, what specific items would you want to include in your partnership agreement?

Partnership equity equity Claims by creditors and owner(s) against the assets of a business

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Accounting for the owner’s equity of a partnership differs from accounting for the owner’s equity of a sole proprietorship (and for a company/corporation). Business transactions that do not affect owner’s equity are recorded in the same way, regardless of the organisational form. But because a partnership’s ownership is divided among the partners, its accounting system has a capital account for each partner in which it records the partner’s investments, withdrawals and share of the partnership’s net income. A partnership’s net income is computed in the same way as the net income for a sole proprietorship. However, because there is more than one owner in a partnership, the net income must be allocated to each partner. Before their business begins operations, the partners need to decide how to split the partnership’s net income among themselves and how to list this allocation in the partnership agreement. Two factors that usually affect the distribution of income among partners are: (1) the dollar amount of capital contributed by each partner; and (2) the dollar value of the time each partner spends working for the partnership. These factors are important because the portion of net income allocated to each partner represents the return on their investment of capital or time. A partnership includes a schedule at the bottom of its income statement that shows how, and how much, net income is allocated to each partner.

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 1 Introduction to business accounting and the role of professional skills

Company/corporation Recall that DeFlava Coffee Corporation is a company that manufactures coffee products and sells them to businesses like Cafe´ Revive. Although a company is made up of individual owners, the law treats it as a separate ‘being’. A company/corporation is a separate legal entity that is independent of its owners and is run by a board of directors. Hence, it has a continuous life beyond that of any particular owner. This has a number of advantages. Because of the legal separation of the owners and the company, ownership in a company may be passed easily from one individual to another. Briefly, here’s how it works. In exchange for contributing capital to the company, the owners of a company receive shares of the company’s share capital. Hence, they are called shareholders. These shares of stock are the ‘ownership units’ of the company and are transferable. That is, the current shareholders can transfer or sell their shares to new owners. The share capital of many companies can be sold on organised stock markets, such as the ASX Group (http://www.asx.com.au), the New Zealand Stock Exchange NZX (http://www.nzx.com), the New York Stock Exchange (http://www.nyse.com), the London Stock Exchange (http:// www.londonstockexchange.com) and the NASDAQ Stock Market, Inc. (http://www.nasdaq.com), so that shareholders of these companies can sell their shares to new owners more easily. Because a company is a separate legal entity, a shareholder has no personal liability for the company’s debts. Therefore, each shareholder’s liability is limited to their investment. Companies tend to be larger than sole proprietorships and partnerships, so to operate they need more capital invested by owners. Since transferring ownership is easy, and since shareholders have limited liability, companies can usually attract a large number of diverse investors and the large amounts of capital needed to operate. Companies can also attract top-quality managers to operate the different departments, so that shareholders are not involved in the company’s operating decisions. But companies also have several disadvantages. As a separate legal entity, a company must pay income taxes on its taxable income. It reports this income on a company income tax return. The maximum income tax rate for companies in Australia, for example, is currently 30 per cent. If some, or all, of the after-tax income of the company is distributed to shareholders as dividends, the shareholders may be taxed on this personal income, but only pay tax on that portion of their income in tax brackets higher than the 30 per cent corporation tax already paid. Because the owners (shareholders) of a company have limited liability, a company (particularly a smaller one) may find it more difficult to borrow money. Since the creditors cannot go to the owners for payment, they may think there is more risk of not being paid. Companies are also subject to more government regulation. In Australia, the federal and state/territory governments have laws in place to protect creditors and owners – for example, the laws of the state or territory in which a company is incorporated usually limit the payment of dividends by the company. Since creditors cannot go to the owners of a company for payment of debts, limiting the company’s dividend payments is a way of protecting creditors – the company may then have more resources with which to pay its debts. In addition, if a company’s share capital is traded on the share market, the company must file specified reports with the Australian Securities and Investments Commission (ASIC). However, the advantages of a company usually exceed the disadvantages when a business grows to a reasonable size.

company/corporation A business entity that has been incorporated and registered by the Australian Securities and Investments Commission (ASIC) under the Corporations Act 2001 shareholders Individuals who own shares (stock) in a company

Stop & think With reference to the three most common forms of business organisation and their basic characteristics, what sort of business do you think Cafe´ Revive is? What sort of business do you think DeFlava Coffee is? Why? Several types of organisations use accounting information in their decision-making functions but do not have profit making as a goal. These organisations are called not-for-profit organisations; they include many educational institutions, religious institutions, charitable organisations, councils, governments and some hospitals. Since making a profit is not a goal of these organisations, some aspects of accounting for these organisations’ activities are unique and beyond the scope of this book. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions

Stop & think Can you list two not-for-profit organisations?

The regulatory environment of business

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What types of regulations do businesses face?

Businesses affect each of us every day, but they also affect each other, the economy and the environment. Just as individuals must abide by the laws and regulations of the cities, states and countries in which they live and work, all businesses, regardless of type, size or complexity, must deal with regulatory issues. Think again about that coffee you had today. When DeFlava Corporation was formed, the business had to do more than build a factory, purchase equipment and ingredients, hire employees, find retail outlets to sell the coffee and begin operations. It also had to deal with the regulatory issues involved in opening and operating even the smallest of businesses. Furthermore, its managers must continue to address regulatory issues as long as they continue to operate the business.

Stop & think Suppose a business is about to open a factory down the street from your house. What concerns do you have? What regulations might help reduce your concerns? Many different laws and authorities regulate the business environment, covering issues such as business registration and reporting requirements, consumer protection, environmental protection, employee safety, employment practices and taxes. Businesses must comply with different sets of regulations, depending on where their factories and offices are located. These regulations are imposed by local, state/territory and federal governments. In Australia, taxation is regulated by the Australian Taxation Office (ATO). Each business must withhold taxes from its employees’ pay and send them to the ATO. Furthermore, the ATO also collects the 10 per cent goods and services tax (GST) from business activities through a business activity statement (BAS). Businesses offset the GST they pay on business inputs, such as inventory, against the GST they collect on the sales of goods to customers. The ATO also taxes the profits of the businesses themselves. The type of business determines who actually pays the taxes on profits. Companies must pay their own income taxes to the ATO because, from a legal standpoint, they are viewed as being separate from their owners. Sole proprietorships and partnerships, on the other hand, do not pay taxes on their profits. Rather, owners of these types of businesses include their share of the business profits along with their other taxable income on their personal income tax returns. This is because tax law does not distinguish the owners of sole proprietorships and partnerships from the businesses themselves.

Stop & think Is GST the same as income tax? Do different countries use GST as tax?

Laws and other government agencies

Ethics and Sustainability

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Similarly, in Australia, a variety of laws and government departments and agencies (in addition to the ATO) regulate businesses. Federal departments and agencies oversee the administration of laws governing areas such as competition (the Australian Competition and Consumer Commission, or ACCC, which administers the Competition and Consumer Act 2010), fair work practices (Fair Work Australia), work health and safety (Safe Work Australia), workplace discrimination (the Australian Human Rights Commission), sustainability and control of pollution to air, land and water (environmental protection agencies in each state/territory), and the like. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 1 Introduction to business accounting and the role of professional skills

International regulations When a business conducts business internationally, it must abide by the laws and regulations of the countries in which it operates. These address such issues as foreign licensing, export and import documentation requirements, tax laws, multinational production and marketing regulations, domestic ownership of business property, and expatriation of cash (i.e. how much of the business’s cash can leave the country). Of course, these laws and regulations differ from country to country, so a business operating in several countries must abide by many laws and regulations. Exhibit 1.5 lists some of the more common regulatory issues facing businesses operating in different jurisdictions.

Ethics and Sustainability

Exhibit 1.5 Common regulatory issues faced by Australian businesses Local government issues • Zoning/planning restrictions • Council rates (taxes) • Environmental regulations • Council by-laws

State/territory issues • Stamp duty • Payroll tax • Work health and safety • Professional or occupational licences • Industry-specific regulations • Workplace discrimination

Federal issues • Federal taxes, including GST • Competition • Work health and safety • Fair work standards • Workplace discrimination • Company name and registration (including ABNs and ACNs)

International issues • Foreign licensing • Exports and imports • Taxes/customs duties • Multinational production and marketing • Property ownership • Cash restrictions

Stop & think Suppose that, as a manager of a manufacturing business, you have the opportunity to have many parts of your product manufactured in another country, where the labour is much cheaper and the environmental regulations less stringent. What are the pros and cons of taking advantage of this opportunity?

1.4 The accounting system A business is responsible to many diverse groups of people, both inside and outside the business. For example, its managers and employees depend on the business for their livelihood. Customers expect a dependable product or service at a reasonable cost. The community expects the business to be a good citizen and to be mindful of the impact of the business’s activities on the environment. Owners want returns on their investments and creditors expect to be paid back. Governmental agencies expect businesses to abide by their rules. People in all of these groups use accounting information about a business to help them assess the ability of the business to carry out its responsibilities and to help them make decisions involving the business. This information comes from the business’s accounting system. An accounting system is a means by which accounting information about a business’s activities is identified, measured, recorded and summarised so it can be communicated in an accounting report. Two branches of accounting, management accounting and financial accounting, use the information in the accounting system to produce reports for different groups of people. Management accounting provides vital information about a business to internal users; financial accounting gives information about a business to external users. These two terms will be discussed in more detail later in this chapter.

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What information does the accounting system provide to support management activities?

accounting system Process used to identify, measure, record and retain information about a business’s activities so that the business can prepare its financial statements

Stop & think What are the main functions of an accounting system? Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions

Management accounting information Management accounting information helps managers inside the business to plan, operate and evaluate a business’s activities. Managers must operate the business in a changing environment. They need information to help them compete in a global market in which technology and methods of production are changing constantly. Therefore, managers can request ‘tailor-made’ information in whatever form is useful for their decision making, such as in dollars, units, hours worked, products manufactured, numbers of defective units or service agreements signed. Moreover, in a world exploding with new information, managers must manage this information in a way that will let them use it more efficiently and effectively. The accounting system provides information about segments of the business, including products, tasks, plants or individual activities, depending on what information is important for the decisions managers are making.

Financial accounting information Financial accounting information is organised for the use of interested people outside the business. External users analyse the business’s financial reports as one source of useful financial information about the business. For these users to be able to interpret the reports, businesses reporting to outsiders follow specific guidelines, or rules, known as generally accepted accounting principles (GAAP), discussed in more detail later. Financial accounting information developed by the accounting system is expressed in dollars in Australia, New Zealand and the United States, and in different currencies (e.g. the yen, euro and peso) in other countries.

Stop & think What is the difference between financial accounting and management accounting?

Management activities In small businesses, owners are often also the managers. In larger businesses, owners sometimes employ managers to drive the operations of the business. Regardless, managers play a vital role in the success of a business – by setting goals, making decisions, committing the resources of the business to achieving these goals and then achieving them. To help ensure the achievement of these goals and the success of the business, managers use accounting information as they perform the activities of planning the operations of the business, operating the business and evaluating the operations of the business for future planning and operating decisions. Exhibit 1.6 shows these activities. Exhibit 1.6 Management activities

Planning

Operating

Feedback

Evaluating (controlling)

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Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 1 Introduction to business accounting and the role of professional skills

Planning Management begins with planning. At a strategic level, every business must have a business plan. Planning establishes the business’s goals and the means of achieving these goals, and is a key requirement for business sustainability. Managers use the planning process to identify what resources and employees the business needs, and to set standards, or benchmarks, against which they can later measure the business’s progress towards its goals. Once written, the business plan becomes a ‘living document’, in that managers will report to owners in relation to the plan. Because the business environment changes so rapidly, plans must be ongoing and flexible enough to deal with change before it occurs or as it is happening. Managers of multinational businesses must also consider such factors as multiple languages, economic systems, political systems, monetary systems, markets and legal systems. In such businesses, managers must also plan and encourage online communication between and among branches in different countries.

planning Management activity that establishes a business’s goals and the means of achieving these goals

Operating Operating refers to the set of activities in which a business engages to conduct its business according to its

plan. For DeFlava Coffee, these are the activities that will ensure that coffee products are made and sold. In operating the business, managers and work teams must make day-to-day decisions about how best to achieve goals. For example, accounting information gives them valuable data about a product’s performance. With this information, they can decide which products to continue to sell and when to add new products or drop old ones. In a manufacturing business, managers and work teams can decide which products to produce and whether there is a better way to produce them. With accounting information, managers can also make decisions about how to set product selling prices, whether to advertise and how much to spend on advertising, and whether to buy new equipment or expand facilities. These decisions are ongoing, and depend on managers’ evaluations of the progress being made towards the business’s goals and on changes in the business’s plans and goals.

operating Management activity that enables a business to conduct its business according to its plan

Evaluating is the management activity that measures the actual operations and progress of a business against standards or benchmarks. It provides feedback for managers to use to correct deviations from those standards or benchmarks, and to plan for the business’s future operations. Evaluating is a continuous process that attempts to prevent problems, and to detect and correct problems as quickly as possible. The more countries in which a business operates, the more interesting the evaluating activity becomes. Managers must pay particular attention to the cultural effects of evaluation methods and feedback in order to achieve effective control.

Shutterstock.com/Lana K

Evaluating

Businesses engage in planning, operating and evaluating activities.

Stop & think Which of the three functions of management do you think is the most important, and why?

Discussion

evaluating Management activity that measures a business’s actual operations and progress against standards or benchmarks

Even coaches of professional sports teams perform the activities of planning, operating and evaluating. If a team’s goal is to win the grand final, how would the head coach implement each of these activities?

Planning, operating and evaluating all require information about the business. The business’s accounting system provides much of the quantitative information used by managers. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions

Accounting support for management activities internal users Managers within a business who use information about the business for decision making

The accounting system identifies, measures, records, summarises and then communicates economic information about a business to internal users for management decision making. Internal users include individual employees, work groups or teams, departmental supervisors, divisional and regional managers, and ‘top management’. Management accountants then provide information to internal users for planning the operations of the business, for operating the business and for evaluating the operations of the business. Management accounting responsibilities and activities may vary widely from business to business and continue to evolve as management accountants respond to the need for new information need caused by the changing business environment.

Stop & think Are there any guidelines for reporting to business managers?

Basic management accounting reports Budgets, cost analyses and manufacturing cost reports are examples of the management tools the accounting system provides. Exhibit 1.7 illustrates the relationships among management activities and these reports. Exhibit 1.7 Activities of managers and related accounting reports Accounting report

Management activities

Budget

Planning

Cost analysis

Operating

Cost reports for products/services

Feedback

Evaluating (controlling)

Stop & think Suppose you are the manager of your business’s sales force. What type of information would you want to help you do your job? budgeting Process of quantifying managers’ plans and showing the impact of these plans on a business’s operating activities

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Budgets Budgeting is the process of quantifying managers’ plans and showing the impact of these plans on the

operating activities and financial position of the business. Managers present this information in a report

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 1 Introduction to business accounting and the role of professional skills called a budget (or forecast discussed in more detail in Chapter 3). Once the planned activities have occurred, managers can evaluate the results of the operating activities against the budget to make sure that the actual operations of the various parts of the business have achieved the results planned. For example, DeFlava Coffee might develop a budget showing how many kilograms of coffee beans it plans to roast and sell during the first three months of next year. Later, after the next year’s actual sales have been made, managers will compare the results of these sales with the budget to determine whether their forecasts were ‘on target’ and, if not, to find out why differences occurred.

Cost analysis Cost analysis, or cost accounting, is the process of determining and evaluating the costs of specific products or activities within a business. Managers use cost analysis when making decisions about these products or activities. For example, DeFlava Coffee might use a cost analysis to decide whether to stop or to continue making the Aroma coffee premix product. The cost analysis report might show that the premix coffee product is not profitable because it earns less than it costs to make. If this is the case, the fact that this product does not make a profit will be one factor in the managers’ decision. The managers will also have to resolve the ethical issue of whether to make the employees who produced the product redundant or to revitalise through the creation of a new product line.

cost analysis, or cost accounting Process of determining and evaluating the costs of specific products or activities of a business

Stop & think Suppose you are a manager of a business that makes a pharmaceutical product thought to create major health problems after long-term use. What factors would you consider when trying to decide whether the business should drop the product or continue producing it?

Ethics and Sustainability

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Cost reports for products and services A cost report might show that total actual costs for a given month were greater than total budgeted costs. However, it might also show that some actual costs were greater than budgeted costs while others were less than budgeted costs. The detailed information will be useful for managers as they analyse why these differences occurred, and then make adjustments to the operations of the business to help it achieve its plans.

Accounting support for external decision making As mentioned earlier, management accounting gives people inside a business vital information about the business and its performance, but the business must also provide business information about its performance to people outside the business. Financial accounting involves identifying, measuring, recording, summarising and then communicating economic information about a business to external users for use in their various decisions. External users are people and groups outside the business who need accounting information to decide whether or not to engage in some activity with the business. These users include individual investors, stockbrokers and financial analysts (who offer investment assistance), consultants, bankers, suppliers, labour unions, customers and local, state/territory and federal governments, including governments of countries in which the business conducts operations. The accounting information that helps external users make a decision – for example, a bank’s loan officer deciding whether or not to extend a loan to a business – may be different from the information a manager within the business needs. Thus, accounting information prepared for the external user may differ from that prepared for the internal user. However, some of the accounting information that internal users need also helps external users, and vice versa. For example, DeFlava Coffee may decide to continue to produce and sell a new coffee line or product if it can borrow enough money to do so. In weighing the likelihood of getting a loan Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

How does accounting provide support and information to people who are external to the business when they are making decisions? management accounting Identification, measurement, recording, accumulation and communication of economic information about a business for internal users in management decision making financial accounting Identification, measurement, recording, accumulation and communication of economic information about a business for external users to use in their various decisions external users Individuals outside of a business who use the business’s information for decision making

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Accounting Information for Business Decisions from the bank, the business’s managers will probably want to evaluate the same financial accounting information that the bank evaluates. In deciding whether to loan money to DeFlava Coffee, the bank will consider the likelihood that DeFlava Coffee will be able to repay the loan. Since this likelihood may depend on current and future sales of coffee, the bank may also want to evaluate the business’s actual sales, as well as the sales budget that DeFlava’s managers have developed as part of the planning process.

Stop & think Suppose you have been offered a job at the DeFlava Coffee roasting factory. What economic information concerning DeFlava would you want to know to help you decide whether to accept the job offer?

Guidelines for reporting to people outside the business

generally accepted accounting principles (GAAP) Currently accepted principles, procedures and practices that are used for financial accounting in many countries of the world, including Australia

While accounting is based on logic, it is very important that universal guidelines exist and are followed to ensure consistency in terms of how items are recorded and reported in a financial sense. Financial reports prepared using these guidelines enable comparison among firms and provide external users with reassurance that they can rely on the information to make decisions. Generally accepted accounting principles (GAAP) are the currently accepted principles, procedures, practices and standards that businesses use for financial accounting and reporting in Australia, New Zealand and all over the world. These principles or rules must be followed, as they establish minimum disclosure requirements for the external reports of businesses that sell shares to the public – and many other businesses as well. GAAP cover such issues as how to account for inventory, buildings, income taxes and capital stock; how to measure the results of a business’s operations; and how to account for the operations of businesses in specialised industries, such as the banking industry, the entertainment industry and the insurance industry. Without these agreed-upon principles, external users of accounting information would not be able to understand the meaning of this information. (This is similar to people trying to communicate with each other without any agreed-upon rules of spelling and grammar.) Several organisations contribute to GAAP through their publications, called pronouncements or standards. Accounting standards are important for protecting the interests of investors, managers and the general public by establishing acceptable accounting procedures and the content of financial reports. The Australian Accounting Standards Board (AASB) sets standards for Australian companies and government bodies. However, since 2005 the regulation of financial accounting and reporting has become globalised. International Financial Reporting Standards (IFRS) generated by the International Accounting Standards Board (IASB) are used globally in accordance with the objectives of the governing body. Companies whose shares are traded publicly in Australia report to the Australian Securities and Investments Commission (ASIC). This agency examines corporate financial reports to ensure they conform and comply with GAAP and the Corporations Act 2001. Many GAAP pronouncements are complex and very technical in nature. In this text, we will introduce only the basic aspects of GAAP that apply to the issues we discuss. It is important to recognise, though, that these principles do change; they are modified as business practices and decisions change, and as better accounting techniques are developed. They also underpin the preparation of the financial statements discussed in the following sections.

Basic financial statements Profit Difference between the total revenues of a business and the total costs (expenses) of the business during a specific time period

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Businesses operate to achieve various goals. To reach these goals, a business must first achieve its two primary objectives: earning a satisfactory profit and remaining solvent. Profit (commonly referred to as net income) is the difference between the cash and credit sales of a business (revenues) and its total costs (expenses). Solvency is a business’s long-term ability to pay its debts as they come due. As you will see, both internal and external users analyse the financial statements of a business to determine how well the business is achieving its two primary objectives. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 1 Introduction to business accounting and the role of professional skills Financial statements are accounting reports used to summarise and communicate financial information about a business. A business’s accounting system produces three major financial statements: the income statement, the balance sheet and the cash flow statement. It also produces a supporting financial statement, the statement of changes in owner’s equity. Each of these statements summarises specific information that has been identified, measured and recorded during the accounting process.

Income statement A business’s income statement (or profit and loss statement) summarises the results of its operating activities for a specific time period and shows the business’s profit for that period. It shows a business’s revenues, expenses and net income (or net loss) for that time period, usually one year. Exhibit 1.8 shows what kind of information appears in a business’s income statement. Revenues are the amounts earned by charging the business’s customers for the goods or services that the business has provided to them. Examples of revenue items include sales (for a retail business) and fees for services performed (for a service firm). Expenses are the costs of providing the goods or services. These amounts include the costs of the products the business has sold (either the cost of making these products or the cost of purchasing these products), the costs of conducting business (called operating expenses) and the costs of income taxes (if any exist). Examples of common expenses for most businesses include wages, insurance, rent or lease of property, telephone, maintenance and repairs, costs of goods sold (for a retail business) and costs of materials or products used (for a service firm). The net income is the excess of revenues over expenses, or the business’s profit; a net loss arises when expenses are greater than revenues. (We will discuss the income statement further in Chapter 7 and throughout this text.) For example, the net result – profit or loss – is transferred to owner’s equity, providing a link between the income statement and the owner’s equity section in the balance sheet.

financial statements Accounting reports used to summarise and communicate financial information about a business income statement Accounting report that summarises the results of a business’s operating activities for a specific time period net income Excess of a business’s revenues over its expenses from providing goods or services to its customers during a specific time period net loss Excess of a business’s expenses over its revenues from providing goods or services to its customers during a specific time period

Exhibit 1.8 What a business’s income statement shows

This is where the business shows what it charged customers for the goods or services provided to them during a specific time period

INCOME STATEMENT OF DEFLAVA COFFEE CORPORATION 20 000

Revenue – sales Less: Expenses – cost of goods sold

12 500

Wages

5 000

Rent

1 000

Other operating expenses Total expenses Net income or net profit

500 19 000 $ 1 000

This is the difference between revenues and expenses

Here’s where the business lists the costs of providing the goods and services during that period

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Accounting Information for Business Decisions

Statement of changes in owner’s equity statement of changes in owner’s equity A summary of the changes in the shareholders’ (owner’s) equity in a company that have occurred during a specific period of time

A business’s accounting system frequently provides a supporting financial statement, called a statement of changes in owner’s equity, to explain the amount shown in the owner’s equity section of the business’s balance sheet. Exhibit 1.9 shows the kind of changes in owner’s equity that appear on this statement. Net income earned during the period increases the owner’s investment in the business’s assets (and the assets themselves) as the owner reinvests the profit of the business back into the business. Similarly, additional contributions of money by the owner to the business during the time period also increase the owner’s investment in the business’s assets (and the assets themselves). On the other hand, a net loss, rather than a net income, decreases the owner’s investment in the business (and the business’s assets), as does the owner’s choice to remove (or withdraw) money from the business (‘disinvesting’ the profit from the business). We will discuss this further in Chapter 7 and throughout this text. Exhibit 1.9 What a business’s statement of changes in owner’s equity shows Term

Explanation

Beginning owner’s equity

Here’s where the business shows the owner’s equity amount at the beginning of the period (the last day of the previous period). This amount also appears on the balance sheet on the last day of the previous period.

+ Net income

Here’s where the business adds the net income from the current period’s income statement (the profit that the business earned during the period).

+ Owner’s contributions

Here’s where the business adds any additional contributions to the business that the owner of the business made during the period.

– Withdrawals by owner

Here’s where the business subtracts any withdrawals of cash from the business that the owner of the business made during the period.

Ending owner’s equity

Here’s where the business shows the resulting owner’s equity amount that also appears on the business’s balance sheet on the last day of the period.

Stop & think What is the link between the income statement and the balance sheet?

Balance sheet A business’s balance sheet summarises its financial position on a given date (usually the last day of the time period covered by the income statement). It is also called a statement of financial position. Exhibit 1.10 shows what kind of information appears on a balance sheet. A balance sheet lists the business’s assets, liabilities and owner’s equity as at a given date. Assets are economic resources or items that a business owns and that it expects will provide future benefits to the business. Examples include cash at bank, Exhibit 1.10 What a business’s balance sheet shows Term

22

Explanation

Assets

Here’s where the business lists its economic resources, such as cash, money owed to it by clients, inventories of its products, equipment and buildings it owns.

Liabilities

Here’s where the business lists the obligations it owes to creditors, such as banks and suppliers, and to employees.

Owner’s equity

Here’s where the business lists the owner’s current investment in the assets of the business.

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Chapter 1 Introduction to business accounting and the role of professional skills amounts owed to the business by debtors (accounts receivable), stock of goods (or inventory), and land and buildings. Liabilities are the business’s economic obligations (debts) to its creditors – people outside the business, such as banks and suppliers – and to its employees. Examples include amounts owed by the business to creditors (accounts payable), outstanding expenses (expenses payable), loans payable and mortgage payable. The owner’s equity of a business is the owner’s current investment in the assets of the business, which includes the owner’s contributions to the business (called capital) and any earnings (net income or profit; for example, Able Enterprises made $1000 profit) that the owner leaves (or invests) in the business. Exhibit 1.11 shows what kind of information appears on a balance sheet for Able Enterprises. A company’s owner’s equity is called shareholders’ equity. We will discuss the balance sheet further in Chapter 8 and throughout this text. Exhibit 1.11 Balance sheet of DeFlava Coffee Corporation Assets

Liabilities

Cash

1 200 Accounts payable

Accounts receivable

1 600 Loan from bank

Inventory

2 300

Premises

2 100 10 000 Owner’s equity

42 000 Capital

34 000

Plus net profit

1 000

47 100

35 000 47 100

Cash flow statement A business’s cash flow statement summarises its cash receipts, cash payments and net change in cash for a specific time period. Exhibit 1.12 shows what kind of information appears in a cash flow statement. We will discuss the cash flow statement further in Chapter 9 and throughout this text. Exhibit 1.12 What a business’s cash flow statement shows Term

Explanation

Cash flow from operating activities

Here’s where the business lists the cash it received and paid in selling products or performing services for a specific time period.

Cash flow from investing activities

Here’s where the business lists the cash it received and paid in buying and selling assets such as equipment and buildings.

Cash flow from financing activities

Here’s where the business lists the cash it received and paid in obtaining and repaying bank loans, and from contributions and withdrawals of cash made by the business’s owners.

A business may publish its income statement, balance sheet and cash flow statement (and statement of changes in owner’s equity), along with other related financial accounting information, in its annual report. Many businesses (mostly companies) do so.

Stop & think In business, the phrase ’cash is king’ is often used. What does this mean and why is it so important to understand your cash flow?

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annual report Document that includes a business’s income statement, balance sheet and cash flow statement, along with other related financial accounting information

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Accounting Information for Business Decisions 9

What roles do ethics and sustainability play in the business environment?

Ethics and Sustainability

1.5 Ethics in business and accounting A business’s financial statements are meant to convey information about the business to internal and external users in order to help them make decisions about the business. But if the information in the financial statements does not convey a realistic picture of the results of the business’s operations or its financial position, the decisions based on this information can have disastrous consequences. Consider the fallout from Enron Corporation’s 2001 financial statements,d in a case that remains one of the biggest corporate collapses in history. On 1 October 2001, Enron was the seventh-largest business in the United States, employing 21 000 people in more than 40 countries. It was also the largest energy-trading business in the United States. Fortune magazine had ranked Enron 24th in its ‘100 Best Companies to Work For’ in 2000.e Its stock was trading for around US$83 per share. Two weeks later, after reporting incredible profits for its first two quarters (January to June) of 2001, Enron reported a third-quarter (July to September) loss, in part because of adjustments caused by previously misstated profits. But by 1 November, JPMorgan Chase & Co. (http://www.jpmorganchase.com) and Citigroup’s (http://www.citigroup.com) Salomon Smith Barney had attempted to rescue Enron by offering the business an opportunity to borrow US$1 billion (above what Enron already owed them). On 19 November, Enron publicly acknowledged that its financial statements did not comply with GAAP in at least two areas. This failure resulted in huge misstatements on Enron’s financial statements: assets and profits were overstated, and liabilities were understated. On 2 December 2001, Enron declared insolvency. The rapid fall of a corporate powerhouse, and what appeared to be one of the most successful businesses in the world, was one of the largest corporate collapses in history, creating a wave of economic and human ramifications around the world. Before Enron reported a third-quarter loss, its stock was selling for around US$83 per share. After it reported its loss, its stock dropped to US$0.70 per share – a total drop in market value of almost US$60 billion. Most of those who had purchased shares of Enron stock lost money; many of them lost hundreds of thousands of dollars. The Enron employees’ pension plan, 62 per cent of which was Enron stock, lost nearly US$2.1 billion, virtually wiping out the retirement savings of most of Enron’s employees, many of whom were nearing retirement age. Close to 5600 Enron employees were made redundant. Enron left behind approximately US$63 billion in debts, with JPMorgan Chase & Co. owed $900 million and Citigroup up to $800 million. Many banks around the world were also affected by having lent money to Enron. In addition to these after-effects, the US Justice Department prosecuted the accounting firm Arthur Andersen, Enron’s auditor. It claimed that Andersen had interfered in a federal investigation of Enron’s collapse by shredding paperwork related to Andersen’s audit of Enron. Two Andersen executives – a partner and an in-house attorney – had reminded employees of Andersen’s ‘document destruction’ policy during the time that the Justice Department was investigating Enron’s failure, resulting in large-scale shredding of the Enron documents. A jury found Andersen guilty. As a result, Arthur Andersen, a highly respected accounting firm and once a bastion of integrity, relinquished its accounting licence, preventing it from conducting further audits. This once-thriving business of 28 000 employees shrivelled to a staff of 200. Ironically, the US Supreme Court found – too late for the employees who had lost their jobs – that the jurors in this case had received improper instructions, and it rejected the Justice Department’s claim, vindicating Arthur Andersen.f Ethical behaviour on the part of all of Enron’s managers would not have guaranteed the success of the business. However, it could have prevented much of the damage suffered by those inside and outside the business, including those who depended on Enron’s financial statements to provide them with dependable information about the business.

Discussion Do you think JPMorgan Chase & Co. or Citigroup would have loaned Enron as much money if Enron had not overstated its net income and assets, and understated its liabilities? Why or why not? What might Enron’s employees have done differently if Enron’s financial statements had been properly prepared?

24

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Chapter 1 Introduction to business accounting and the role of professional skills Enron was not the first, nor (unfortunately) will it be the last, business to get into trouble for misleading financial reporting. While it seems clear that some of what Enron’s managers, and managers of some other businesses, disclosed on their financial statements was wrong, many business and accounting issues and events in the business environment cannot be interpreted as absolutely right or wrong. Every decision or choice has pros and cons, costs and benefits, and people or institutions who will be affected positively or negatively by the decision. Even in a setting where many issues and events fall between the extremes of right and wrong, it is very important for accountants and businesspeople to maintain high ethical standards. The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, also known as the Banking Royal Commission and the Hayne Royal Commission, provides another example of the high standards required of those involved in business. The Commission resulted in a comprehensive review of the culture, governance and ethics of organisations operating in the financial services sector. The Royal Commission’s final report, released on 4 February 2019, directly calls out the boards and senior management of the financial services industry. The report affirms the key role of regulators such as ASIC in the supervision of culture, governance and remuneration.

Stop & think The term ‘ethical coffee’ is often used in relation to coffee. What does this mean? Can you find examples of websites that demonstrate this concept?

Professional organisations’ codes of ethics The International Federation of Accountants (IFAC) is an independent global organisation. Its stated purpose is to ‘serve the public interest by the worldwide advancement of education and development for professional accountants leading to harmonized standards’.g As part of its efforts, it has developed a code of ethics for accountants in each country to use as the basis for founding their own codes of ethics. Because of the wide cultural, language, legal and social diversity of the nations of the world, IFAC expects professional accountants in each country to add their own national ethical standards to the code, or even to delete some items of the code, to reflect their national differences. The code addresses objectivity, resolution of ethical conflicts, professional competence, confidentiality, tax practice, cross-border activities and publicity. It also covers independence, fees and commissions, activities incompatible with the practice of accountancy, clients’ money, relations with other professional accountants, and advertising and solicitation. In Australia, members of professional bodies such as CPA Australia, Chartered Accountants Australia and New Zealand (CAANZ, formerly the Institute of Chartered Accountants in Australia, or ICAA) and the Institute of Public Accountants (IPA) adopt the Code of Ethics for Professional Accountants developed by the Accounting Professional and Ethical Standards Board (APESB), which is based on the IFAC Code of Ethics.h

Ethics at the business level In our society, we expect people to behave within a range of civilised standards. This expectation allows society to function with minimal confusion and misunderstanding. Similarly, accounting information developed by businesses in an ethical environment allows our economy to function efficiently and enables users to direct or allocate resources productively. In both our personal and our business lives, ethics and integrity are our ‘social glue’.

Sustainability in business We often hear reports about businesses’ negative impacts on the environment and their disregard for society. What is clear is that businesses must play a key role if we are to become globally sustainable. Many businesses, in fact, are working to become more environmentally sustainable and more socially responsible. It is clear that businesses are doing this because a range of related benefits may result from it – including Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Ethics and Sustainability

25

Accounting Information for Business Decisions

sustainability The recognition of intergenerational and intragenerational equity, where the meeting of the needs and wants of a person or group now should not compromise the ability of a future person or group to meet their needs and wants

10

What skills are required from accountants of the twenty-first century?

improving their reputation, reducing costs and strengthening the communities in which they operate – but also because of improved profitability. The issue for accountants is that environmental and social impacts are often business costs. However, good environmental management and social responsibility tend to improve long-term profitability rather than reduce it. Given that investors place a high value on environmental responsibility, and many people are now willing to pay more for products and services that are environmentally friendly, it is in the interest of businesses to be ‘green’. Consider two key elements that affect most businesses: the use of water and energy, and the generation of waste. These are costs to the business, so more efficient management can lead to considerable cost savings, as well as often facilitating new income streams from recycling or reusing materials and emissions rather than putting these in landfill or into the atmosphere. In many contexts, the term ‘sustainable business’ is taken to refer to a ‘green’ business or enterprise that has no negative impact on the global or local environment, community, society or economy. A sustainable business is one that ensures that all processes, products and activities, while maintaining a profit, address current environmental concerns. Business sustainability requires proactive business management and a strategic approach if the best results for the business are to be achieved. It is an overarching concept that involves doing everything better and more efficiently, and that makes good business sense because the benefits feed directly into the bottom line. There are many factors that contribute to longevity in terms of a business’s survival, growth and improvement. The first is that a business needs to operate efficiently and productively in order to remain profitable and grow. The second is that a business must engage responsibly and ethically with the triple bottom line issues it faces. There will be more discussion of this in Chapter 10.

1.6 The accountant in a changing society In this section, we discuss the broad skills needed by businesspeople to do business effectively in a changing environment. These same skills, as well as others, also apply to accountants, and make accountants more effective in dealing with their clients. In the past decade, professional bodies, academics and employers have reframed these broad skills into a set of core competencies that all university graduates entering the profession of accountancy should possess. In Australia, the first learning standards for accounting graduates were devised as part of the Learning and Teaching Academic Standards (LTAS) project. These Standards, which were revised in 2016 in consultation with the accounting community, are shown in Exhibit 1.13, and have been defined under the headings ‘Judgement’, ‘Knowledge’, ‘Critical Analysis and Problem Solving’, ‘Communication’, ‘Teamwork’ and ‘Self-management’. We discuss each of these skills in the following sections.i

Judgement, knowledge, and critical analysis and problem solving general knowledge A category of the businessperson’s knowledge base that encompasses knowledge about history and cultures, an ability to interact with people who have dissimilar ideas, and experience in making value judgements

26

Large accounting firms, and the accounting community in general, recognise that gathering information, interpreting it and effectively communicating it to others relies on the businessperson’s knowledge base and ability to integrate theoretical and technical knowledge of accounting and other relevant areas. First, accountants must have accounting knowledge, including the ability to construct accounting data, as well as the ability to use this data to make decisions, to exercise judgements, to evaluate risks and to solve problems in a range of contexts. Knowledge of related areas, such as auditing and assurance, finance, economics, quantitative methods, information systems and applicable laws, is also necessary. In addition to knowledge of accounting, accountants must have a knowledge base and skills that support applying accounting knowledge and technical skills to solve accounting problems. General knowledge encompasses knowledge about history and cultures; an ability to interact with people who have dissimilar ideas; a sense of the contrasting economic, political and social forces in the world and of the magnitude of Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 1 Introduction to business accounting and the role of professional skills Exhibit 1.13 Learning Standards for accounting Bachelor graduates in accounting will be able to:

Judgement

Exercise judgement under supervision to provide possible solutions to routine accounting problems in straightforward contexts using, where appropriate, social, ethical, economic, regulatory, sustainability, governance and/or global perspectives.

Knowledge

Integrate theoretical and technical accounting knowledge in a business context.

Critical analysis and problem solving

Critically apply theoretical and technical accounting knowledge and skills to provide possible solutions to routine accounting problems.

Communication

Justify and communicate accounting advice and ideas in straightforward contexts to influence both specialists and non-specialists.

Teamwork

Contribute accounting expertise to a diverse team, collaboratively providing possible solutions to a routine business problem in a straightforward context.

Selfmanagement

Reflect on performance feedback to identify and action learning opportunities and self-improvements.

Source: Source: Adapted from Australian Learning and Teaching Council (2010) Learning and Teaching Academic Standards Statement for Accounting. Canberra: Australian Government: p10.

global issues and ideas; and experience in making value judgements. Accountants also need to have organisational and business knowledge, which includes an understanding of the effects of economic, social, cultural and psychological forces on businesses; an understanding of how businesses work; an understanding of methods and strategies for managing change; and an understanding of how technology helps organisations. An accountant must also be able to apply their skills to new situations and, in a logical manner, use their knowledge and skills to produce answers to accounting problems. The ability to apply knowledge to solve problems will also require a certain level of proficiency in information and communication technology (ICT). There are many problems that require judgement, such as the choice of inventory and depreciation method, decisions about whether to capitalise or expense costs and measures to be taken following a variance from budget. Auditors must exercise judgement when deciding whether to issue an unqualified audit that says the financial statements of a firm have been prepared in accordance with GAAP and accounting standards. Management accountants exercise judgement when making decisions about whether to outsource products and services or make and deliver them internally. Financial accountants exercise judgement in choosing accounting methods. ‘Being able to make good judgements is a cornerstone of being a professional accountant … Professional judgement is a key skill for preparers, auditors and regulators of financial statements.’j

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organisational and business knowledge A category of the businessperson’s knowledge base that includes an understanding of the effects of economic, social, cultural and psychological forces on companies; an understanding of how companies work; an understanding of methods and strategies for managing change; and an understanding of how technology helps organisations

judgement involves the evaluation of evidence to make a decision, choice or recommendation. We exercise judgement when we use our critical thinking to decide between two alternatives based on objective facts or data

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Accounting Information for Business Decisions

Communication skills An accountant’s job involves both collecting and communicating information. A key part of collecting information is knowing where to look for it. Although some information may be located in routine places, such as sales invoices, the accountant must be ready to look beyond the routine. Information may appear in written form (such as documents, written procedures, reports, journals and reference materials), in electronic form (such as emails or files) or in verbal form (such as conversations or presentations). To gather information from written, electronic and verbal sources, an accountant must be a proficient reader and listener, and must possess an appropriate level of ICT proficiency. In this case, reading and listening mean more than is initially apparent. To be useful, the information gathered must be relevant to the decision at hand. The accountant must be able to interpret information, decide whether it is relevant and then filter out everything else. So the accountant cannot be just a casual reader or listener. Rather, the accountant must analyse the information they have read or heard, actively trying to understand it by considering both its context and its source. Context includes such aspects as the perspective or bias of the information source, how the information was developed and what assumptions were made in developing it. To gain this understanding, the accountant must use critical thinking skills, which we will discuss later in the chapter. Accountants also communicate information. They must be able to present their ideas coherently to people at different levels of the company (all the way up to the chair of the board of directors) as well as to people outside the company, who will have different interests, backgrounds and levels of accounting and business understanding. These ideas may be presented formally or informally in written, electronic or verbal form. Accountants must be able to justify and communicate accounting advice and ideas in routine collaborative contexts involving both accountants and non-accountants. An accountant must therefore also be an effective speaker and writer.

Teamwork skills Although working with numbers may be the most familiar aspect of an accountant’s job (have you ever heard accountants referred to as ‘number crunchers’ or ‘bean counters’?), working with people is just as important. Accountants collect information from some people and communicate it to others. They work on team projects, act as leaders within departments and serve on teams that span the entire company. Since accountants advise managers and board members, they must possess the same interpersonal skills that a competent manager or board member possesses. These include the ability to lead and influence others, to motivate others, to withstand and resolve conflict, and to organise and delegate tasks.

Self-management skills To be successful in business, it is necessary to understand a range of business contexts. Because the world of business changes constantly, it is also important that those involved in the business world – particularly accountants – take responsibility and be accountable for their own continuous learning in order to keep remain of current issues. An ability to reflect on performance feedback is important in order to identify and carry out learning opportunities that will lead to self-improvement. Critical thinking skills are necessary and complementary for successful, efficient problem solving and decision making. However, these skills do not necessarily come naturally. You might be an extremely creative thinker, but not a good critical thinker. Similarly, you might be a very capable critical thinker, but not very good at thinking ‘outside the box’. The accountant needs to be an analytical thinker, and must be innovative and able to apply critical thinking to problem solving and decision making within the business world.

11

How can people learn to think critically?

28

Critical thinking Most of us tend to consider thinking, like breathing, to be a natural function. (’We all do it.’) However, critical thinking requires practice. Take tennis, for example. Few people expect to be good at tennis the Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 1 Introduction to business accounting and the role of professional skills first time they take to the court. At first, bad tennis seems to be the norm. But, with practice aimed at improving and at learning new forms and specific techniques, better tennis comes more naturally. In the same way, practising critical thinking, including ‘new forms and specific techniques’, makes it more natural. Awareness of our current thinking patterns helps us to recognise our strengths and weaknesses, and this knowledge provides a starting point for modifying and improving our thinking performance. Critical thinking is the process that evaluates ideas. It determines whether any of the ideas will work, what types of problems there might be with them, whether ideas can be improved and which ideas are better than others. To be a successful critical thinker, you need to be in the right frame of mind, to use the thought processes and actions necessary for thinking critically, and to constantly watch and monitor your thinking (much as a tennis player watches their game).

critical thinking Process that evaluates the ideas generated by creative thinking

Characteristics of the critical thinker Above all, the critical thinker values truth rather than just the appearance of truth. For example, in looking for the truth, critical thinkers must be independent and objective. Being independent means that, in the process of evaluating ideas, the critical thinker must rely on their own conclusions rather than those of others. This doesn’t mean that the critical thinker is a know-it-all – just that they don’t accept the beliefs of others without questioning where those ideas came from, what evidence supports them and what assumptions were made in developing them. Objectivity, the quality of being unbiased, is a very difficult characteristic to achieve, but one that critical thinkers must have if they value truth. All people select, organise and interpret information based on their own perceptions, beliefs and past experiences. Even when we are trying very hard to understand someone else’s point of view, we tend to say to ourselves, ‘This is how I would feel if I were in that situation; therefore, they must feel the same way.’ We tend to unconsciously impose our own perceptions, beliefs and past experiences on our understanding of information, ideas and other people, which may bias the outcome. Besides being willing to consider new ideas and information, critical thinkers know they may have biases and prejudices that keep them from true understanding, and that they must try to eliminate these biases from their thinking. By realising that their viewpoints are a product of their unique experiences, critical thinkers are better able to really listen for, and try to understand, other viewpoints. In order to strive towards independent, objective thinking, critical thinkers develop openness to new and different ideas, as well as empathy for other points of view. Have you ever encountered a know-it-all? Do you remember feeling frustrated that this person did not listen to your perspective or your contributions to the conversation? As you have probably experienced, a know-it-all assumes that there is no more to learn about a subject. Unfortunately, this assumption blocks the person’s receptivity to new information and new perspectives about the subject. How much more could the know-it-all learn by keeping an open mind? Furthermore, could this person make better decisions by acknowledging the limits of their own knowledge and by making use of all available relevant information? Critical thinkers also tolerate ambiguity and willingly defer judgement until they can collect more information and consider and evaluate other solutions. Many problems involve complex issues with multiple interpretations and numerous good solutions. Critical thinkers must think creatively, and they do not accept the first solution generated as necessarily being the best solution. Critical thinkers recognise that ‘good’ ideas are often relative rather than absolute – for example, ‘higher-quality’, ‘more probable’ and ‘more objective’. So, even though many ideas may satisfy the critical thinker’s values and criteria, some ideas may be better than others. Finally, critical thinkers have the courage of their own convictions. Have you ever had an idea that you just knew was right (after analysing and evaluating other ideas and viewpoints), but nobody else agreed with you? Conviction is what kept you from caving in to the majority opinion and kept you going when the going got tough. As we said earlier, many problems in business are complex and multifaceted. Identifying problems, finding solutions and overcoming all the obstacles and frustrations along the way takes perseverance. You can develop and improve the critical thinking characteristics we have just discussed.

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independent In the process of evaluating ideas, relying on one’s own conclusions rather than relying on the conclusions of others objectivity Quality of being unbiased in critical thinking

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Accounting Information for Business Decisions

Stop & think Questions for critical thinkers to ask themselves • If an issue is controversial, do I accept my initial reaction to it, or do I debate the issue in my head first? • Do I tend to reject new evidence that contradicts my current opinion on a subject, or do I evaluate the new evidence and then decide whether to accept or reject it? • When I am trying to solve a problem, do I usually accept the first solution that ‘works’, or do I generate multiple solutions, reflect and then choose the best one? • When others disagree with me, do I usually listen to them with an open mind and critically evaluate their ideas, or do I try to defend my own ideas?

Strategies of the critical thinker To make sense of the world, to develop solutions to complex problems, to deal with ambiguous issues and to make decisions, the critical thinker must apply a variety of thinking and reasoning strategies to the thought process. First, the critical thinker must be able to define, clearly and precisely, the problem or issue at hand. Without a clear and precise definition of the problem, it is almost impossible to generate the best solution. How could you identify the relevant information for solving it?

12

How can critical thinking help people to make better business decisions?

creative thinking Process of actively generating new ideas to discover solutions to a problem

13

What are the logical stages in problem solving and decision making?

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Applying critical thinking to business decisions Every day of our lives, we must solve problems and make decisions on issues both minor, like what to have for breakfast, and major, like which career to choose. Think about your breakfast decision this morning. To choose what to have for breakfast, you had to gather certain information, such as what types of food you had available to eat, how much of these foods were available (did you ever pour a bowl of cereal only to find that there wasn’t enough milk in the refrigerator to go with it?), what type of food you could tolerate in the morning, when your next meal would be, what activities you had planned for the day, the nutritional content of the food, which dishes were clean and how much time the food would take to prepare. After evaluating all the facts, you were able to make a decision. A simple problem like choosing what to have for breakfast does not require complex analysis (although you may need a quick shower first, to wake you up). However, many business problems can involve a jumble of information, opinions, considerations, risks and alternatives. A systematic method that includes creative and critical thinking is necessary to organise the problemsolving approach and decide on a solution to the problem. Exhibit 1.14 illustrates the four stages in decision making and the particular impact of creative and critical thinking on each stage. Creative thinking involves ‘thinking outside the box’ to generate new ideas or raise questions that extend beyond what is usual or normal. Note that creative thinking might be more important in the earlier stages, while critical thinking is more important in the later stages. We will discuss these stages of decision making in the next four sections.

Stage 1: Recognising and defining the problem The first stage in solving a problem is the recognition and definition of the problem. As we suggested earlier in the chapter, the chances of arriving at a successful solution to a problem are considerably reduced if the decision maker does not have a clear understanding of the problem. An incorrectly defined problem will lead to an unproductive course of action at best, and could actually create new problems or make the current problem worse. To fully understand the problem, the decision maker needs to clearly state the problem, gather the facts surrounding the problem and identify the objectives that would be achieved by solving the problem. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 1 Introduction to business accounting and the role of professional skills Exhibit 1.14 Critical thinking and four stages in problem solving and decision making

Critical thinking

Step 1

Recognise problem

Step 2

Identify alternatives

Step 3

Evaluate alternatives

Step 4

Make decision

Step 5

Critical thinking

For example, consider the situation facing Jenny Highflyer, a manager at DeFlava Coffee Corporation. Jenny’s newly health-conscious boss, Graham Wheatley, has asked whether it is possible to process and sell a new decaffeinated coffee bean that is high in antioxidants, to be called Decaffi Bean. Jenny doesn’t want to make a hasty decision, so she uses her critical and creative thinking skills to brainstorm a list of questions she has about the idea. Jenny’s first list looks like this: • Why does Wheatley want us to manufacture this new coffee bean? • When must a decision be made? • Who inside the business would be affected by a decision to manufacture and sell this new product? How would they be affected? • Who outside the business would be affected by a decision to manufacture and sell this new product? In what ways would they be affected? • How can I break down this decision into smaller parts? • What additional information do I need to make a decision? • Where can I find additional information?

Stop & think Why do you think it is important to know who will be affected by a business decision and how they will be affected? Answers to these questions will no doubt lead Jenny to further, more probing questions, such as the following: • Can we manufacture a decaffeinated coffee bean that meets the business’s standards of excellence? • How long would it take to develop, market and process this new coffee bean? • Who would buy this new product? • Will people stop purchasing the popular Pure Gold coffee beans and instead buy the new Decaffi beans? Or will people who typically avoid buying coffee be tempted by the decaffeinated and antioxidant qualities of the Decaffi beans, leaving sales of Pure Gold coffee virtually unaffected, and thereby increasing total customers and total sales? • What kind of competition would this new product face? • At what price could the company sell the new range of coffee beans? • What resources (if any) would the company need to acquire in order to manufacture this product? Are these resources available? • What would the additional costs be? Does DeFlava have access to additional financing, if necessary?

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Accounting Information for Business Decisions • • • •

Would additional people need to be hired? What qualifications and skills would these people need to have? What is the probability of finding people with these qualifications and skills? Would production of the new coffee beans force DeFlava Coffee to comply with additional government regulations? Would any of the ingredients used in the process pose health risks? How can we package the product to limit waste or promote recycling?

Stop & think In trying to decide whether or not it is possible to process a delicious, decaffeinated coffee bean that meets the company’s standards of excellence, what else might you ask? Now that Jenny has an initial list of questions, she brainstorms about where she might find answers to them. In this case, Jenny’s sources of information would include such people as suppliers, customers and potential customers (through market surveys), as well as the company’s marketing managers, production managers, chief financial officer and accountants, environmental control managers, distribution managers and human resources managers. Jenny would need to analyse information from these sources for faulty logic, unsupported assumptions and emotional appeal, and would need to determine the credibility of these sources of information and the nature of evidence supporting the information. Jenny would then need to synthesise the information received from separate sources into an understandable ‘whole’, or a clear statement of the problem. In identifying the objectives that would be achieved by manufacturing and selling the new coffee bean, Jenny would need to determine what it is that her boss would like to achieve by having DeFlava Coffee manufacture the Decaffi Bean. Jenny surmises that Wheatley wants to: • satisfy customers who have a desire for coffee, but not the accompanying caffeine • enhance DeFlava Coffee’s reputation for being an industry leader and an innovator • increase the company’s market share (i.e. get a greater percentage of all coffee sales, perhaps by bringing in people who drink decaffeinated coffee but who have not been buying DeFlava products) • increase profit for the company. After using critical thinking skills to gather, analyse and synthesise the facts about the problem and the results that could be achieved by solving the problem (from all perspectives), Jenny should have a better understanding of the problem. This understanding will allow Jenny to state the problem more clearly and in more detail than she did in the original problem statement, perhaps even allowing for a division of the problem into smaller parts. Exhibit 1.15 shows the memo that Jenny wrote to Wheatley outlining the problem. Exhibit 1.15 Jenny’s memo outlining the problem 24 September TO: Graham Wheatley FROM: Jenny Highflyer SUBJECT: Decaffi Bean Dear Mr Wheatley, You asked me if it is possible to process and sell a new coffee bean to be called Decaffi Bean. I have thought about this for several days and would like to know whether I completely understand the assignment. I presume that you would like DeFlava Coffee to process and sell a new coffee bean while at the same time achieving the following objectives: • satisfying customers who have a desire for good coffee and cannot consume caffeine • enhancing our reputation as an innovator and industry leader • increasing our market share • increasing our profit. Am I on target? I would appreciate your response in the next day or two. Thanks, Jenny Highflyer

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Chapter 1 Introduction to business accounting and the role of professional skills

Stage 2: Identifying alternative solutions After the problem has been clearly defined and stated, the problem-solver identifies alternative solutions. Generating numerous alternative solutions makes it more likely that at least one of them will be workable. Discussing the problem and possible solutions with other people can help to identify alternative solutions. By talking with people who are uninvolved with or unaffected by the problem or its solution, Jenny is likely to get a more objective assessment of the problem, or perhaps an entirely new perspective on it. Brainstorming with a group would generate plenty of ideas from which to choose workable solutions. Jenny decides to call a meeting of several people from all areas of the company to join a brainstorming team. After generating a list of ideas, the team must critically evaluate them to identify potentially workable solutions. To be workable, the solutions must fit within the boundaries or limits of the company. For instance, the chief financial officer tells the brainstorming team that the company can borrow only $40 000 to launch the new product; the purchasing officer lists for the team all the available suppliers of ingredients; the production manager reminds the team that Valentine’s Day orders will keep managers so preoccupied and production employees so swamped that work on the new product could not begin until after 14 February; and the cleaning-crew supervisor informs the team that, because the company uses only pure mountain spring water to clean the machines every day, the factory must be located in a mountainous area. Given this new information, the team comes up with several workable alternatives: 1 Don’t manufacture or sell the new Decaffi Bean, and stay with the status quo. (This may be workable, but it may not achieve Wheatley’s objectives.) 2 Because $40 000 is not enough to expand the factory, use available space in the current factory to manufacture and sell only a small quantity of Decaffi Bean coffee to test-market the concept before beginning full-scale production. 3 Drop the Double Shot coffee product line (which many customers stopped purchasing because it kept them awake at night) and convert this line’s production resources so that they can be used for manufacturing Decaffi Bean. Manufacture and sell a large amount of Decaffi Bean (without testmarketing the concept).

brainstorming Process where members of a group try to generate as many solutions as possible to a particular problem

Stop & think Can you think of other possible alternatives for solving this problem?

Stage 3: Weighing the advantages and disadvantages of each solution After the team identifies potentially workable solutions, Jenny must evaluate each of them. Critical thinking becomes paramount at this stage. In this example, accounting information is useful in evaluating each solution because each is likely to have different economic effects. Accounting information that is relevant to Jenny in weighing the advantages and disadvantages of each solution includes information about the solution’s effect on the company’s costs, profits and related income taxes, as well as its effect on the timing of cash receipts and payments. Furthermore, if the Double Shot product line is dropped (see alternative 3 above), Jenny must also consider the accompanying change in profits caused by this, as well as the change in profits caused by the movement of Double Shot customers to other types of coffee. After gathering accounting and other information for each alternative, Jenny can list the advantages and disadvantages of each choice. For example, Exhibit 1.16 shows Jenny’s list of advantages and disadvantages for alternative 2, manufacturing and selling only a small quantity of Decaffi Bean coffee to test-market the concept before beginning full-scale production. Jenny should evaluate the advantages and disadvantages of each workable solution in this way in order to fully understand each alternative.

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Accounting Information for Business Decisions Exhibit 1.16 Jenny’s list of advantages and disadvantages of manufacturing and selling only a small quantity of Decaffi Bean coffee Advantages • This alternative will require a smaller initial investment in factory equipment and personnel than the full-scale production alternative. • In this alternative, DeFlava has less to lose if Decaffi Bean does not sell as predicted than it would if the fullscale production alternative were implemented and sales of Decaffi Bean were less than predicted. • Feedback from the test market can be used to improve Decaffi Bean coffee before it is marketed nationally. • A positive market response to Decaffi Bean might open up new sources of financing for further expansion of the roasting factory.

Disadvantages • A market failure could damage the reputation of the business. The cost of additions to the factory and personnel could outweigh the money brought into the company through the sale of Decaffi Bean. • Company employees assigned to produce Decaffi Bean would be spending time on this that would otherwise be spent contributing to the production and sale of well-established coffee beans. • While DeFlava is test-marketing the Decaffi Bean coffee, the company’s competitors could launch a successful full-scale market blitz with a similar coffee bean.

• A new group of customers might be tapped into because of the decaffeinated nature of the Decaffi Bean coffee.

Stop & think Can you think of advantages and disadvantages of not manufacturing and selling Decaffi Bean?

Stage 4: Choosing a solution The first three stages of the problem-solving process break down the problem in a systematic and detailed manner. In this way, Jenny becomes completely familiar with the problem and its possible solutions. After these first three stages, Jenny must choose the best solution from the alternative workable solutions. Jenny makes the product decision based largely on the accounting information gathered in the previous stage, in which she evaluated the alternatives. However, even after the advantages and disadvantages of each alternative have been listed and quantified (where possible), the choice of a solution can be difficult. This is because individual advantages and disadvantages weigh differently in the decision and are hard to compare. One technique that is useful in ordering the alternatives is to rank them based on their effectiveness in achieving the desired results, and then also rank them based on their desirability in relation to the company’s value system. For example, suppose the company values an innovative image more than one of stability. In this case, alternatives 2 and 3 in the list above would rank higher than alternative 1. Another technique that is useful in choosing a solution is to combine the best features of multiple alternative solutions while eliminating some of the disadvantages that each alternative would have if it alone were selected. The decision-making process is similar for people who are outside the company and are making decisions about the company. For example, assume DeFlava Coffee applies for a three-year bank loan of $40 000. When this request is made, the banker recognises that a decision must be made about granting the loan. For the banker, there are many alternatives, including refusing the bank loan, granting a loan of a smaller or greater amount for a shorter or longer period of time, or granting the loan as requested. The banker must have information concerning the cash in DeFlava’s bank accounts, the cash DeFlava must spend to pay its bills, the amount DeFlava expects to collect from its customers, the timing of these payments and collections, and the way in which the bank loan would be used. By gathering the related accounting information, the banker can evaluate whether DeFlava needs the bank loan, the appropriate amount and length of time of the loan, and the likelihood that DeFlava will repay the loan. The banker makes the loan decision, to a great extent, on the basis of accounting information provided by DeFlava.

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Chapter 1 Introduction to business accounting and the role of professional skills

Accounting information and decision making The role of accounting information in the decision-making process is further illustrated in Exhibit 1.17. As this exhibit illustrates, the accounting information system and decision making are interactive – that is, an accountant collects information about a company (i.e. locates, gathers, interprets and organises relevant information) and communicates this information to both internal and external users to assist them in making decisions. These decisions have an impact on the company’s activities, which then have an impact on the company’s resulting accounting information (as is reflected when the accounting process of information accumulation and communication is repeated again). You can see, through the bank loan and product decisions, that the decisions made by both the internal and the external users will affect the accounting information accumulated and communicated about the company. Before either decision is reached, the information accumulated and communicated will be the information needed to make the decisions, as discussed earlier. After the decisions are made, regardless of the alternative chosen (whether or not the bank grants a loan to DeFlava Coffee, and whether or not DeFlava manufactures and sells the Decaffi Bean coffee), the result of the decision will affect DeFlava’s future activities and, in turn, result in different accounting information about the company. Exhibit 1.17 Accounting information and decision making Effect of decision Make decision

Business activities

Collect accounting information

Accountant

Communicate accounting information

Internal user

External user Make decision

Effect of decision

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Accounting Information for Business Decisions

STUDY TOOLS Summary 1.1 Have an understanding of business, and the skills and knowledge required for success in a complex business environment. 1

Why is it necessary to have an understanding of business before trying to learn about accounting?

Accounting involves identifying, measuring, recording, summarising and communicating economic information about a business for decision making. It focuses on the resources and activities of businesses. Therefore, it is important to understand businesses and the business environment in which they exist before trying to learn how to account for their resources and activities. 2

What factors are affecting the complexity of a changing business environment?

The business environment is dynamic and is becoming increasingly complex. More information is being generated than ever before, and this information is available to more people than ever before. Technology is advancing rapidly, affecting not only the products we use but also the ways in which products are manufactured and business is conducted. Business activities and economies are becoming globalised, the number of regulations is escalating, business transactions are becoming more complex and new forms of business are emerging. 3

What are three characteristics that someone might require to become a successful businessperson in a complex business environment?

The successful businessperson must be willing and able to adapt to change. Because of the dynamic and complex business environment, they must be: u able to take change in their stride u devoted to lifelong learning u open to other viewpoints u tolerant of differences u willing to take educated and thoughtful risks u able to anticipate environmental trends, and identify the potential problems and opportunities associated with these trends u ready to abandon old plans and change course in light of new information.

1.2 Explain the categories of business. 4

What are the three main categories of business enterprise?

Businesses in the private enterprise system produce goods and services for a profit. They can be service, merchandising or manufacturing businesses. While merchandising and manufacturing businesses deal in goods or products, a service business provides services to customers to make a profit. Entrepreneurs, or individuals, invest money in businesses so that the businesses can acquire resources, such as inventory, buildings and equipment. The businesses then use these resources to earn a profit.

1.3 Know the three common business structures and the regulations faced by each. 5

What are the three most common forms of business organisation and their basic characteristics?

The three most common forms of business organisation are: (1) the sole proprietorship, owned by one individual; (2) the partnership, owned by two or more individuals (partners); and (3) the company (or corporation), incorporated as a separate legal entity and owned by numerous shareholders who hold shares in the company. The owner of a sole proprietorship and the partners in a partnership generally have unlimited personal liability for any debts incurred by the business. Sole proprietorships and partnerships have a limited life because the business will cease to exist if there is a change in partners or owners.

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Chapter 1 Introduction to business accounting and the role of professional skills

6

What types of regulations do businesses face?

Businesses must be regulated because the activities of a business affect not only that business but also other businesses, the economy and the environment. All businesses, regardless of type, size or complexity, must contend with regulatory issues. Numerous laws and authorities regulate businesses on issues ranging from environmental protection to taxes. Each local government area, state/territory and nation has its own regulations. Owners of businesses must learn and comply with the regulations issued by the different levels of government where the businesses are located and in the areas where they conduct business.

1.4 Outline how accounting systems play a role in providing information to enable informed business decisions. 7

What information does the accounting system provide to support management activities?

Accounting information helps people both inside and outside businesses to make decisions. It supports management activities by providing managers with quantitative information about their business to aid them in planning, operating and evaluating the business’s activities. Accounting information supports external decision making by providing people outside the business – such as investors, creditors, stockbrokers, financial analysts, bankers, suppliers, labour unions, customers and governments – with financial statements containing economic information about the performance of the business. Managers strive to make their business successful through setting and achieving the goals of the business, making decisions and committing the resources of the business to the achievement of these goals. Planning provides the organisation with direction for the other activities. Operating involves gathering the necessary resources and employees, and implementing the plans. Evaluating measures actual progress against standards or benchmarks so that problems can be corrected. 8

How does accounting provide support and information to people who are external to the business when they are making decisions?

So external users can understand the meaning of accounting information, businesses follow agreed-upon principles in their external reports. These generally accepted accounting principles (GAAP) are the standards, or rules, that businesses must follow. A business may publish its income statement, balance sheet and cash flow statement (and statement of changes in owner’s equity), along with other related financial accounting information, in its annual report. This report must present a true and accurate record of the activities of the business so as to enable informed decisions to be made by interested parties, particularly external parties.

1.5 Understand how ethics and sustainability impact business outcomes. 9

What roles do ethics and sustainability play in the business environment?

Since the world is a complex place, where issues are not always clear, decisions must be made in an ethical context using the best available information. Accounting information can be relied on only if it is generated in an ethical environment. Many groups have established codes of ethics. Adopting an ethical approach to business will also increase the business’s chances of sustainability. Sustainability refers not only to environmentally ‘green’ aspects of the business but also to planning for survival and growth using an effective business plan.

1.6 Discuss the skills required by accountants and those involved in business to solve problems and make decisions. 10

What skills are required from accountants of the twenty-first century?

Besides being willing to change, businesspeople can develop skills that will better prepare them for problem solving and decision making in the current environment. Businesspeople can become broadly proficient in all forms of communication: speaking, writing, listening, reading and teamwork (working cooperatively with others). Businesspeople can also develop their interpersonal skills and personal management skills. These include the ability to lead and influence others, to motivate others, to withstand and resolve conflict, to organise and delegate tasks, and to prioritise and manage their own tasks. Judgement is another type of skill that businesspeople can develop. Beyond these skills, an ability to think critically and to apply knowledge and skills to problems in order to make decisions is needed in a rapidly changing business environment.

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Accounting Information for Business Decisions

11

How can people learn to think critically?

People can learn to think critically first by learning new forms and techniques of thinking, and then by practising these techniques to improve their decision-making skills. An awareness of their current thinking patterns helps people recognise their strengths and weaknesses; this knowledge provides a starting point for modifying and improving their thinking performance. 12

How can critical thinking help people to make better business decisions?

The ideas generated by innovative thinking provide the raw materials of the decision-making process. Critical thinking helps decision makers analyse decision alternatives for faulty logic, unsupported assumptions and emotional appeals. Furthermore, it helps decision makers evaluate the relevance of evidence used to support decision alternatives, the credibility of the sources of evidence, and the consistency of the evidence with the decision alternatives it supports. Finally, critical thinking helps decision makers to be sure that all relevant information, all points of view and all workable solutions have been considered. 13

What are the logical stages in problem solving and decision making?

Many business problems are difficult and complicated. A systematic approach is therefore necessary to clarify the problem and to decide on a solution to it. The four stages in problem solving and decision making are: (1) recognise the problem; (2) identify alternatives; (3) evaluate the alternatives; and (4) make the decision. The accounting information system plays a big part in the business’s decision-making process.

Key terms accounting system

financial accounting

net loss

agent

financial statements

objectivity

annual report

general knowledge

operating

brainstorming

generally accepted accounting

organisational and business knowledge

budgeting

principles (GAAP)

partnership

capital

income statement

partnership agreement

company/corporation

independent

planning

cost analysis, or cost accounting

internal users

profit

creative thinking

joint ownership

service business

critical thinking

judgement

shareholders

e-commerce

limited life

sole proprietorship or sole trader

entrepreneur

management accounting

solvency

equity

manufacturing business

statement of changes in owner’s equity

evaluating

merchandising business

sustainability

external users

net income

unlimited liability

Online research activity This activity provides an opportunity to gather information online about real-world issues related to the topics in this chapter. For suggestions on how to navigate various businesses’ websites to find their financial statements and other information, see the related discussion in the Preface. Put your skills to the test and find answers to the following questions by visiting the listed websites. u Find out and note what resonates with you in the Code of Ethics for Professional Accountants at the website of the Accounting Professional and Ethical Standards Board (APESB): http://www.apesb.org.au/page.php?id¼12. u Discover what the benefits of being a member of CPA Australia (CPAA) and how to become a member of the organisation at http://www.cpaaustralia.com.au. u Are there any notable differences between the following three professional bodies: CPAA (see above), Chartered Accountants Australia and New Zealand (or CAANZ; see https://www.charteredaccountantsanz.com) and the Institute of Public Accountants (or IPA; see https://www.publicaccountants.org.au)?

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u

In one paragraph, define the role of each of the following organisations: – Australian Taxation Office (ATO): http://www.ato.gov.au – Australian Competition and Consumer Commission (ACCC): http://www.accc.gov.au – Australian Securities and Investments Commission (ASIC): http://www.asic.gov.au.

Integrated business and accounting situations Answer the following questions in your own words.

Testing your knowledge 1-1 1-2 1-3 1-4 1-5 1-6 1-7 1-8 1-9 1-10 1-11 1-12 1-13 1-14 1-15 1-16 1-17 1-18 1-19 1-20 1-21 1-22

1-23 1-24 1-25 1-26 1-27 1-28 1-29 1-30

What do we mean when we refer to different categories of business? What distinguishes a service business from a merchandising business? How is a merchandising business different from a manufacturing business? How are the two types of business the same? What is entrepreneurship? Suppose you were an entrepreneur. Where might you go for business capital? Describe the factors that are affecting the current business environment and the impact of each of these factors. What impact does changes in interest rates have on the business environment? What distinguishes a sole proprietorship from a company and a partnership? What are the types of regulations with which businesses must comply in different jurisdictions? What is an accounting management system? How would you describe the similarities and differences between management accounting and financial accounting? Why are they different and why are they similar? How do management accounting reports help managers with their activities? What are generally accepted accounting principles (GAAP)? Which groups of users require financial accounting reports to make decisions and what type of information do they need? What does the term ‘ethics’ mean in business? Why are ethical codes of conduct important for professional groups such as accountants and who monitors these codes of conduct? What does ‘sustainability’ mean in regard to business? What is internal control? In addition to knowledge of accounting, what other skills and knowledge prepare a university graduate to enter the profession of accountancy? What is auditing? What are three professional organisations of accountants and who are their members? Think of a recent discovery, technological innovation, world event, regulation or other factor affecting the business environment (one not mentioned in this chapter). What effect has this factor had on the business environment? What future effect do you think this factor will have on the business environment? What are the broad skills, as outlined by the accounting community, that are necessary for practising accounting and for effectively conducting business? Explain the characteristics of a critical thinker. How do critical thinking skills improve problem solving? What is the difference between being independent and being objective? Why is it important to evaluate the credibility of a source of information? How do general knowledge and organisational and business knowledge support decision making? Describe the stages of problem solving. What pitfalls might you encounter at each stage? Describe how accounting information is used in each of the stages of problem solving. What is ‘judgement’, and how does it apply in business? Give three examples.

Applying your knowledge 1-31

Give an example of a service business and of a manufacturing business. Explain the similarities and differences between the two.

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Accounting Information for Business Decisions

1-32

1-33 1-34

1-35

1-36 1-37 1-38 1-39

1-40 1-41

1-42

1-43

1-44

40

How might knowledge of a business’s cash receipts and payments affect a bank’s decision about whether to loan the business money? What financial statement would the loan officer want to look at to begin to understand the business’s cash receipts and payments? What factors would you consider in deciding whether to operate your business as a sole proprietorship, a partnership or a company? Suppose you are Samuel Cook, CEO of DeFlava Coffee. DeFlava currently operates in south-eastern Australia, and you are considering opening a factory and sales office in Queensland. What questions do you want answered before you proceed with this idea? Refer to question 1-34. Suppose, instead, that you were considering opening a factory and sales office in Bejing, China. What questions would you want answered before proceeding with this idea? How do you explain the similarities and differences in your answers to this and the previous question? What are some examples of business information in which both internal and external users have an interest? Suppose you are a manager of The Foot Note, a small retail store that sells socks. Give an example of information that would help you in each of the management activities of planning, operating and evaluating the operations of the store. How do generally accepted accounting principles (GAAP) affect the accounting reports of businesses in Australia? Why might the owner(s) of a business be concerned about a proposed new accounting principle? A friend of yours, Timorous Ghostly (‘Tim’ for short), who has never taken an accounting subject, has been assigned a short speech in his public-speaking class. In this speech, Tim must describe the financial statements of a business. Tim has come to you for help (with his teacher’s permission). He says, ‘Please describe what financial statements are, what the major financial statements are and what each financial statement includes.’ Prepare a written response to Tim’s request. How do codes of ethics help businesspeople to make decisions? Consider the following opposing sides of an issue: a All businesses, even those in other countries, should have to follow generally accepted accounting principles (GAAP). b All businesses should not have to follow GAAP. Required: Identify reasons that support each side of the issue. Suppose your job is beginning to eat into your personal time. During the last six months, you have noticed that you have been taking home files to work on after dinner and at the weekend. Even so, you are having trouble keeping up. After explaining this to your boss, she suggests that you find a way to work more efficiently. Furthermore, she points out that there are many people who would be glad to take over your job. Required: a What are some alternative ways to approach your boss? What reasons, information and evidence might support your point of view? b What reasons, information and evidence might support your boss’s point of view? In what ways might these reasons affect the approach you take in presenting your problem to your boss? You have just been promoted in your job working for an established Australian fashion label, Aussie Designs, operating out of Sydney. The business specialises in hats. Your new boss wants your opinion about whether to open a new branch office in Auckland, New Zealand. You desperately want to make a good impression on your first assignment, and want to ensure you have a good grasp of the situation before you form your opinion. Required: a What questions do you want answered before you offer your opinion to your boss? b Where might you find the answers to your questions? Suppose your brother, the owner of Muscle Up, a fitness centre, has asked you for a substantial loan to help him expand his business. Required: What would you like to know about Muscle Up before you make a decision about whether to loan the company money? How could the answers to each of your questions affect your decision? What accounting information could your brother provide you that could affect your decision?

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Chapter 1 Introduction to business accounting and the role of professional skills

1-45

1-46

1-47

Refer to question 1.44. At your request, your brother provides you with the following information: Revenues for previous year

$80 000

Expenses for previous year

$65 000

Profit for previous year

$15 000

Required: How could this information be presented differently to make it more meaningful for you in reaching your loan decision? What could be added to this particular information to make it more meaningful for you? The office photocopier has just stopped working and is beyond repair. The big question now is what to do with it. Your boss is offering a cash prize for each of the following: u the longest list of ideas for what to do with the copier u the most unusual idea u the widest variety of ideas. Required: See whether you can win all the cash by providing a written list of your ideas. Your new co-worker just came into the office and made the following statement: ‘Every Friday is casual day around here; people wear casual clothes to work on Fridays. Jan, over there, is wearing jeans and a T-shirt today. It must be Friday. TGIF!’ Required: What’s wrong with your co-worker’s logic?

Making evaluations 1-48

1-49

1-50 1-51

1-52

Your friend, Vito Guarino (an incredible cook), plans to open a restaurant when he graduates from university. One evening, while extolling the virtues of linguine to you and some other friends, he glances down at your accounting textbook, which is open at Exhibit 1.4. ‘What kind of a business is a restaurant?’ Vito asks, ‘How would a restaurant fit into this exhibit?’ Everyone in the room waits with great anticipation for your answer and the rationale behind it. What will you say? You and your cousin, Harvey, have decided to form a partnership and open a landscaping business in town. Before you do, you and Harvey would like to ‘iron out’ a few details about how to handle various aspects of the partnership, then write a partnership agreement outlining the details. What specific issues would you like to see addressed in the partnership agreement before you begin your partnership with Harvey? As an ongoing activity, read a daily newspaper every day over the next week. What evidence do you find that supports the need for business codes of ethics? Is a business suit the most appropriate attire to wear to a business meeting? Required: Answer the question based on what you believe to be true (answer ‘Yes’, ‘No’ or ‘Not sure’). Explain why you answered the way you did. Now give reasons and evidence (e.g. authorities, references, facts, personal experience) that you believe support your answer. Consider again the plight of Jenny, the manager at DeFlava Coffee Corporation, whose boss wants to manufacture and sell the new Decaffi Bean coffee product, perhaps using it to replace the Double Shot coffee product. Suppose the accounting department has projected that profit per kilo will be $2.00 higher for Double Shot coffee than for Decaffi Bean coffee. The marketing department predicts that DeFlava Coffee can sell 1000 kg of Decaffi Bean coffee in the first year, and then more each year for the next 10 years, if it drops Double Shot coffee. During that same time period, the marketing department forecasts that sales of Double Shot coffee will be 800 kg in the first year, with sales decreasing slightly after that if the company does not produce Decaffi Bean coffee. However, if the company produces both types of coffee, predicted sales for Decaffi Bean reduce to 700 kg in the first year, with a slow and steady increase in sales over the next 10 years. Predicted sales for Double Shot coffee will decrease to 650 kg during the first year, and decrease slightly each year for the next 10 years. The production department has determined that the new Decaffi Bean coffee is possible to manufacture, and that the factory can be reconfigured to accommodate the new coffee while continuing to produce the old Double Shot coffee. If DeFlava Coffee drops Double Shot coffee, it can convert the equipment so that this can be used to produce Decaffi Bean coffee. The human resources department is confident that numerous qualified people are available to work if the company wants to

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Accounting Information for Business Decisions

1-53

produce both types of coffee. If the company drops Double Shot coffee, those people currently working on that product can easily be retrained to work on Decaffi Bean coffee. The chief financial officer has arranged for financing if it is needed. Required: a Based on the above information, what are the advantages and disadvantages of: (i) dropping the Double Shot product line and producing Decaffi Bean; (ii) continuing production of Double Shot and not producing Decaffi Bean; (iii) producing both Double Shot and Decaffi Bean; and (iv) producing neither coffee bean? How would you decide which alternative is best? b What additional information would make your decision in the previous question easier? c What other alternative solutions can you think of? The changing business environment provides many challenges for today’s businessperson, but also opportunities. Required: What opportunities do you see that result from this environment? How would you prepare yourself to take full advantage of these opportunities?

Dr Decisive You’ve just accepted a great job, joining a team of consultants who write an advice column, ‘Dear Dr Decisive’, for the local newspaper. Yesterday, you received your first letter.

Dear Dr Decisive, Today is my lucky day. I have just graduated from a course in body art and received $10 000 from my rich aunt as a graduation present. My long-term goal has been to start up a ‘Body Beautiful’ Salon. I believe it would be best located in a beachside area and have found premises on the Gold Coast. My boyfriend, who is an accountant, says he might assist me financially but needs to know that we have done the right research and have the right skills to embark on this venture. Do you think I have the right skills to go into this business? And what research should I do? Also, do you have any advice on how i can convince a bank to lend me enough money to get the business up and running? Very excited, Body Beautiful. Required: Meet with your Dr Decisive team and write a response to ‘Body Beautiful’.

Endnotes a

The Executive’s Book of Quotations (1994) Julia Vitullo-Martin and J. Robert Moskin (eds). Oxford: Oxford University Press, 41. Language Resources (nd) ‘Translation blunders: Don’t let this happen to you’. http://www.languageresources.com/blunders.html. Accessed 14 April 2017. c See http://www.dynamicbusiness.com.au/entrepreneur-profile/australian-bureau-statistics-count-australian-businesses-2141.html. d Hill, A (2011) ‘Ten years on, Enron remains an open sore’. Financial Times, 17 October. http://www.ft.com/intl/cms/s/0/9d57f8da-f66d-11e0-86dc-00144feab49a.html#axzz2mNOWBza6. Accessed 15 June 2013. e Levering, R & Moskowitz, M (2000) ‘With labor in short supply, these companies are pulling out all the stops for employees’. Fortune, 10 January. http://archive.fortune.com/magazines/fortune/fortune_archive/2000/01/10/271718/index.htm. Accessed 14 April 2017. f Lane, C (2005) ‘Justices overturn Andersen conviction’. Washington Post, 1 June. http://www.washingtonpost.com/wp-dyn/content/article/2005/05/31/AR2005053100491.html. Accessed 22 April 2017. g International Federation of Accountants (2002) Recognition of Pre-Certification Education Providers by IFAC Member Bodies. New York, IFAC, 2. b

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Chapter 1 Introduction to business accounting and the role of professional skills

h i

j

International Federation of Accountants (2006) Code of Ethics for Professional Accountants. New York: IFAC. Freeman, M & Ball, C (2010) Learning and Teaching Academic Standards Statement for Accounting. Canberra, Australian Government, 10. Institute of Chartered Accountants of Scotland (2012) A Professional Judgement Framework for Financial Reporting: An International Guide for Preparers, Auditors, Regulators and Standard Setters. Edinburgh: ICAS, 3.

List of company URLs u u u u u u u u u u u u u u u u u u u u

Amazon: http://www.amazon.com.au ASX Group: http://www.asx.com.au Black & Decker: http://www.blackanddecker.com.au BlueScope Steel Ltd: http://www.bluescopesteel.com.au Cisco Systems, Inc: http://www.cisco.com Citigroup: http://www.citigroup.com Dell Inc.: http://dell.com.au eBay: http://www.ebay.com.au Ford Australia: http://www.ford.com.au JPMorgan Chase & Co.: http://www.jpmorganchase.com KFC: http://www.kfc.com.au LJ Hooker: http://www.ljhooker.com.au London Stock Exchange: http://www.londonstockexchange.com NASDAQ Stock Market: Inc. http://www.nasdaq.com New York Stock Exchange: http://www.nyse.com New Zealand Stock Exchange: NZX http://www.nzx.com Qantas Airlines Limited: http://www.qantas.com.au Stefan Hair Fashions: http://www.stefan.com.au The Good Guys: http://www.thegoodguys.com.au Woolworths Supermarkets: http://www.woolworths.com.au

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2 DEVELOPING A BUSINESS PLAN: COST–VOLUME–PROFIT ANALYSIS ‘He who every morning plans the transaction of the day, and follows out that plan, carries a thread that will guide him through the maze of the most busy life. But where no plan is laid, where the disposal of time is surrendered merely to the chance of incidence, chaos will soon reign.’ Victor Hugo

Learning objectives After reading this chapter, students should be able to do the following: 2.1 Understand the importance of planning for a new business and what to include in the plan. 2.2 Understand the concepts of cost–volume–profit analysis (CVP) and cost behaviour. 2.3 Be able to apply CVP analysis to estimate break-even, target profits and assess alternatives. 2.4 Consider other planning issues and effects.

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Chapter 2 Developing a business plan: Cost–volume–profit analysis

Understanding the learning objectives is assisted in the chapter by asking key questions:

Key questions 1

Since the future is uncertain and circumstances are likely to change, why should a business bother to plan?

2

What should a business include in its business plan?

3

In Chapter 1, we referred to accounting as the language of business. How does accounting information contribute to the planning process?

4

What must decision makers be able to predict in order to estimate profit at a given sales volume?

5

How can decision makers predict the sales volume necessary for estimated revenues to cover estimated costs?

6

How can decision makers predict the sales volume necessary to achieve a target profit?

7

How can decision makers use accounting information to evaluate alternative plans?

As mentioned in Chapter 1, your friend Emily Della has asked you to help her set up and open her cafe´. When you finish your course, you plan to join her in the business and form a partnership, but the initial structure will be a sole trader as Emily is providing the capital. Emily, who earned her degree last year with a major in marketing, has a congenial personality and always enjoys a chat over a good cup of coffee. She has always aspired to own a coffee shop. After long and lively discussions with you about the name of the business, Emily’s decision is to name it Cafe´ Revive. You and Emily arrange to obtain retail space, purchase display fixtures, supplies and coffee products, and hire a barista and a university student on a casual basis to serve in the cafe´. You also develop a marketing strategy using social media and the campus weekly newspaper. Now you are ready to open for business. But whoa not so fast … have you thought of everything? If you and Emily want Cafe´ Revive to succeed, you need to consider several other issues before you open the business. Instead of rushing into business when the idea is fresh, it would be smart to first develop a detailed business plan that addresses these issues.

2.1 Planning in a new business Planning is an ongoing process for successful companies. It begins before a business opens for operations and continues throughout the life of the business. A business plan is an evolving report that describes a business’s goals and its current plans for achieving those goals. The business plan is used by both internal and external users. A business plan typically includes the elements shown in Exhibit 2.1. We will discuss these various elements individually in later sections of this chapter. In general, a business plan has three main purposes. First, it helps an entrepreneur to visualise and organise the business and its operations. Remember from Chapter 1 how Jenny tested the strengths and weaknesses of the proposal to make the Decaffi Bean coffee? Similarly, thinking critically about your hopes for the business and putting a plan on paper will help you and Emily to imagine how the plan will work, and to evaluate the plan, develop new ideas and refine the plan. By looking at the plan from different perspectives, such as those of managers who have responsibility for marketing the business’s products or purchasing its inventory of products, you can discover and correct flaws before implementing the plan. Then ‘paper mistakes’ won’t become real mistakes! Second, a business plan serves as a benchmark, or standard, against which the entrepreneur can later measure the actual performance of a business. You and Emily will be able to evaluate differences between the planned performance of Cafe´ Revive, as outlined in its business plan, and its actual performance. Then you will be able to use the results of your evaluation to adjust Cafe´ Revive’s future activities. For Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

business plan Describes a business’s goals and its plans for achieving those goals

1

Since the future is uncertain and circumstances are likely to change, why should a business bother to plan? 2

What should a business include in its business plan?

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Accounting Information for Business Decisions Exhibit 2.1 Business plan elements

risk Amount of uncertainty that exists about the future operations of a business return Money received from investment and credit decisions

Step 1

A description of the business

Step 2

A marketing plan

Step 3

An operating plan

Step 4

An environmental management plan

Step 5

A financial plan

instance, suppose that in the first month of business, sales are higher than you and Emily predicted. If you decide that sales will continue at this level, you can use that information to increase Cafe´ Revive’s future coffee purchases. Third, a business plan helps an entrepreneur to obtain the financing that new and growing companies often need. When you and Emily start looking for additional funding for Cafe´ Revive, potential investors and creditors may request a copy of the business plan to help them decide whether or not to invest in Cafe´ Revive or to loan it money. For example, as part of its loan-making decisions, the Commonwealth Bank (http://www.commbank.com.au) routinely evaluates the business plans of companies that apply for business loans at the bank. Investors and creditors, such as the Commonwealth Bank, have two related concerns when they are making investment and credit decisions. One concern is the level of risk involved in their decisions. Risk usually refers to how much uncertainty exists about the future operations of the business. The other concern is the return, or money back, that they will receive from their investment and credit decisions. A thorough business plan will provide useful information for helping investors and creditors evaluate their risk and potential return. Now let’s look at the parts of a business plan.

Description of the business A business plan usually begins with a description of the business and its basic activities. Details of this description include information about the organisation of the business, its product or service, its current and potential customers, its objectives, where it is located and where it conducts its business. Cafe´ Revive is a new hospitality business located at a university campus in a high-growth suburb in the northern part of a major metropolitan area. Initially, Cafe´ Revive will sell a typical selection of coffees for consumption both in-cafe´ and takeaway. It will also sell a limited range of pre-packaged coffee gift packs. You and Emily will expand this product line to include other types of coffee and coffee products as the business grows. You and Emily are eager to begin marketing and operating the business, but are waiting to do so after you finish writing the business plan and obtain financing. You realise that writing the plan is helping you to think through the various aspects of the business, so that you don’t miss something important in planning your activities. Case Exhibit 2.2 illustrates how you might describe Cafe´ Revive in its business plan. The organisation of a business and its personnel can have a major influence on the success of the business. Therefore, the description of the business also includes a listing of the important people within the business and the major roles they will play. This listing can include the individuals responsible for starting the business, significant investors who also are providing expertise and direction to the business, and influential employees and consultants who have a strong impact on the business. Case Exhibit 2.3 gives examples of how you might discuss Cafe´ Revive’s organisation in its business plan. Notice how this part of the plan highlights the combination of your major in business and Emily’s degree in marketing.

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Chapter 2 Developing a business plan: Cost–volume–profit analysis Case Exhibit 2.2 Description of Cafe´ Revive How company is organised

Type of company and product

Café Revive is a new retail café organised as a sole proprietorship (trader)* and owned by Emily Della. It rents space in the University Hub, a centre located on a university campus in the north west of Brisbane. In the last 10–20 years, many companies have begun to locate their corporate headquarters to the west of Brisbane, so the population in this area has surged. Demographic Location and surveys indicate that growth should continue steadily for the where it foreseeable future. The university campus is also growing. does business Objectives

Café Revive has the following objectives: 1

2 3 4

To initially provide the cups of coffee and coffee gift packs from DeFlava Coffee to students on the university campus in the north west of Brisbane. To expand the product line within three years to include other types of coffee. To open new stores in 3–5 years in nearby suburbs. To remain privately owned.

Potential customers

*Note the definition of sole proprietor in Chapter 1.

Case Exhibit 2.3 Organisation of Cafe´ Revive The team at Cafe´ Revive is composed of four people, one of whom is a financial consultant. The members of this team are as follows:

Emily Della

Owner

[Your name]

Advisor/potential partner

Jackson Downes

Employee

Briana Small

Consultant

List of important people and the roles they will play

Each of these individuals brings special skills to Cafe´ Revive. Emily Della graduated last year with a BCom in marketing from UQ. She has already earned a reputation for her marketing and business skills. At university, she won the State Finalist Award from the Australian Marketing Institute and the coveted CPA Australia’s Student Award. She graduated with first-class honours. While studying, Emily worked for three retail stores, two of which were start-up companies. One of the start-up companies was a boutique specialist food and beverage store. [Your name] is a business honours student at QUT and will be graduating this year. [Your first name] has worked 20 hours per week ‘keeping the books’ at a local restaurant for the past two years. Prior to that, [your first name] worked during the summer break and part-time during the academic year doing miscellaneous jobs at the same restaurant.

Qualifications of important people

Jackson Downes is a business honours student at UQ. Jackson has worked in the summer breaks at several restaurants in Brisbane. Briana Small is a partner in the management advisory services area of Cracknell Ltd, a large public accounting firm in Brisbane. Her firm specialises in consulting with start-up companies. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions This part may also contain the business’s policies or strategies for selecting, training and rewarding employees. These issues are particularly important for the long-term success of the business.

Stop & think The long-term plan for Cafe´ Revive is for the ownership structure to change to a partnership as you finish your degree and join Emily. Recall what you read about partnerships in Chapter 1. What steps should you take to set up the partnership?

Marketing plan The marketing section of a business plan shows how the business will make sales, and how it will influence and respond to market conditions. This section receives a lot of attention from investors and creditors because the business’s marketing strategy and its ability to implement that strategy can be very important for the business’s success. The marketing section provides evidence of demand for the business’s products or services, including any market research that has been conducted. It describes current and expected competition in the market, as well as relevant government regulations. It outlines how the business will promote, price and distribute its products (the business’s ‘marketing strategy’), as well as the predicted growth, market share and sales of products (its ‘sales forecast’) by period. This information is helpful to the entrepreneur as a starting point for thinking about the business’s other activities related to sales, such as timing the purchase of its inventories. The marketing section of the business plan is also helpful to people outside the business, such as bank loan officers, because it shows how well the entrepreneur has thought through the business’s sales potential, and how the business will attract and sell to customers. Cafe´ Revive’s business plan may be centimetres thick! We don’t have room to show every part of its plan, so in the following sections, we will ask you to think in general terms about what to include in the plan. Following is a brief description of Cafe´ Revive’s market conditions. Initially, Cafe´ Revive will have a temporary marketing advantage as there are not currently any good coffee facilities on campus offering DeFlava Coffee – in fact, students and staff members actually drive off campus to get a good coffee in between lectures! After evaluating the available retail space (and plans for building retail space), you and Emily believe that there will be very little competition during the next five years. However, you expect competing outlets to eventually open on campus and close to the campus. In the meantime, part of your marketing plan is to build a reputation for friendly service, quality products and environmentally friendly packaging. Your advertising will focus on the quality of the coffee that you provide. Your initial advertising ‘punch’ will also include the fact that Cafe´ Revive sells only ‘everyone’s favourite’, DeFlava Coffee. You believe that selling DeFlava Coffee gives Cafe´ Revive a distinct advantage because of the established good reputation and popularity of the DeFlava Coffee brand.

Stop & think What information about market conditions facing Cafe´ Revive would you include in the marketing section of your business plan?

Operating plan Since a business is organised to deliver a product or service to a market, the business plan must address how the business will develop and enhance its products or services. The business operations section of a business plan includes a description of the relationships among the business, its suppliers and its customers, as well as a description of how the business will develop, service, protect and support its products or services. This section also includes any other influences on the operations of the business. 48

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Chapter 2 Developing a business plan: Cost–volume–profit analysis The business operations section of the business plan is important because it helps the entrepreneur to think through the details of making the idea work. It also helps outside users to evaluate the entrepreneur’s ability to successfully carry out the idea. Here is a brief description of Cafe´ Revive’s operations. Cafe´ Revive has a ready supply of coffee products. DeFlava Coffee has no sales agreements with any other outlets within a 20 kilometre radius of Cafe´ Revive. Furthermore, you know of other potential suppliers (i.e. coffee roasting companies) that have high production standards, quality ingredients and good reputations in the industry, as well as an environmentally friendly product. In fact, Emily is now talking with representatives of these companies and visiting their premises so that, if and when Cafe´ Revive is ready to sell other coffee products, she will have identified and selected other suppliers. Other influences on the operations of the business might also be described in this section. These might include the availability of employees, concerns of special-interest groups, regulations (including environmental), the impact of international trade and the need for patents, trademarks and licensing agreements.

Discussion If Cafe´ Revive’s major supplier of coffee was a company in India, rather than the DeFlava Coffee Corporation, what additional issues do you think would need to be included in this part of the business plan? What else do you think managers, owners, creditors and investors would like to know?

Environmental management plan and sustainability Today, there is a growing expectation that businesses will demonstrate corporate social responsibility (CSR) and report on environmental and social as well as economic aspects of their business (Triple Bottom Line). Hence Cafe´ Revive and businesses such as DeFlava Coffee need to be aware of their environmental and social impacts, and to account for these costs. According to the Global Reporting Initiative (GRI) Sustainability Reporting Standards (https://www.globalreporting.org/standards), the environmental dimension of sustainability concerns an organisation’s impacts on living and non-living natural systems, including ecosystems, land, air and water. Environmental disclosures cover performance related to inputs (e.g. material, energy, water) and outputs (e.g. emissions, effluents, waste). In addition, they cover performance related to biodiversity and environmental compliance, as well as other relevant information such as environmental expenditure and the impacts of products and services. This is particularly relevant for DeFlava Coffee in relation to the manufacturing processes it adopts and the environmental impacts of its waste disposal. The GRI Standards are required for all reports or other materials published on or after 1 July 2018. Emily has checked the ‘green’ (environmental) credentials of their supplier DeFlava Coffee and knows that the coffee used in the gift packs is sourced from coffee farms in northern Australia and ethically farmed and produced. In 2018 the Australian Government introduced the Modern Slavery Act, requiring any business operating in Australia with a turnover of more $100 million ($50 million in New South Wales) to report annually on the risks of modern slavery in their operations and supply chains and actions taken to address those risks. Forced labour can be an issue in the coffee supply chain. As DeFlava Coffee is a large company, the Act applies to it.

Discussion The Modern Slavery Act 2018 does not include penalties for failing to lodge a statement or have independent oversight of the statements made. There is however a public register. How then do you think business could be held accountable?

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Accounting Information for Business Decisions

Ethics and Sustainability

In accounting for environmental costs, DeFlava Coffee will need to employ an environmental management accounting system, an approach that provides for the transition of data from both financial accounting and cost accounting, to increase material efficiency, reduce environmental impact and risk, and reduce costs of environmental protection. (For more on this topic, refer to Chapter 10.)

Environmental costs and decision making The main problem of environmental management accounting is the lack of a standard definition of environmental costs. Depending on various interests, they include a variety of costs – for example, waste disposal costs or investment costs, and sometimes external costs (i.e. costs incurred outside the company, mostly to the general public, such as greenhouse gas emissions). Of course, these differences in accounting methods are also true for the reported profits of corporate environmental activities (i.e. environmental cost savings). Moreover, environmental costs are often not traced systematically or attributed correctly to the responsible processes and products, but instead are simply included in general overheads and therefore ‘hidden’. Because of this inconsistency of definition, caution needs to be taken when using this information to make decisions. In the manual Environmental Management Accounting Procedures and Principles, published by the United Nations Division for Sustainable Development, it was noted that the fact that: environmental costs are not fully recorded often leads to distorted calculations for improvement options. Environment protection projects aiming to prevent emissions and waste at the source (avoidance option) by better utilising raw and auxiliary materials, and requiring less (harmful) operating materials are not recognised and implemented. The economic and ecological advantages to be derived from such measures are not used. The people in charge are often not aware that producing waste and emissions is usually more expensive than disposing of them.a Put simply a business cannot seek to improve its environmental performance without the tools to measure that performance, so a business aiming to achieve sustainable operations needs to develop management systems capable of measuring financial and non-financial (often physical) information to make informed decisions. This requires a constant evolution of tools and controls to measure environmental (and social) impacts, specific to a business.b For Cafe´ Revive, this might be developing a method of recording the number of disposable coffee cups used or the packing wasted, in order to seek to minimise the environmental impact of these and reduce waste.

Public-sector reporting

Ethics and Sustainability

50

The public sector comprises organisations that are owned and operated by the government, and that provide services for its citizens. These organisations do not strive to make a profit. The public sector has in place several rules and regulations requiring organisations within it to report on their environmental impact and costs. Under section 516A of the Environment Protection and Biodiversity Conservation Act 1999, Australian Government organisations are required to include in their annual reports information about their environmental performance and contribution to ecologically sustainable development. Some Australian Government organisations are also required to report against National Environmental Protection Measures (NEPMs). NEPMs are designed to ensure consistency of environmental regulations across jurisdictions. They are also aimed at ensuring Australians, wherever they live, will enjoy the benefits of equivalent protection from air, water and soil pollution and noise. A recent tool available for organisations to assist them in complying with these statutory requirements is an environmental management system (EMS), a structured system or management tool designed to help an organisation reduce its negative impacts on the environment and improve its environmental performance. It can provide ‘a methodical approach to planning, implementing and reviewing an organisation’s environmental management’.c Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 2 Developing a business plan: Cost–volume–profit analysis

Stop & think List the sorts of environmental costs that DeFlava Coffee would be likely to incur. Suggest ways that DeFlava Coffee could measure these costs. How could the business turn waste into profit? (Refer also to Chapter 10.)

Financial plan Since Cafe´ Revive is a new business, it has no credit history or recent financial statements. Therefore, you and Emily should also provide a detailed, realistic financial plan in Cafe´ Revive’s business plan. The purpose of the financial plan section is to identify the business’s capital requirements and sources of capital, as well as to describe the business’s projected financial performance. For a new business, this section also highlights the business’s beginning financial activities, or start-up costs. Before we begin the discussion of start-up costs, it is important to note that the Australian economy has a goods and services tax (GST), which is a tax levied on the supply of goods and services. The tax is charged at a flat percentage (currently 10%). Each business that meets certain criteria is required to register for GST. The business collects GST on the goods and services it supplies and pays tax on the goods and services it buys. The business then deducts the GST paid from the GST collected, and pays (or receives a refund of) the balance to the Australian Taxation Office (ATO). How this is accounted for will be discussed in Chapters 4 and 5. For our purposes, the figures in this chapter are all GST-inclusive – that is, the expense is calculated based on its cost plus GST. This is done because the calculations in this chapter will be used to make decisions, so we need to recognise the full cost, inclusive of the GST component. Note that New Zealand also has a GST, which at the time of publication was at a rate of 15 per cent. Emily has worked out the following information about Cafe´ Revive’s start-up costs (GST inclusive where appropriate): • Emily will invest $22 000 of her own money as capital. • The monthly rent for shop space is estimated at $1320 per month based on the rent charged for space in the campus building. Cafe´ Revive is required to pay six months’ rent in advance, totalling $7920, when Emily signs the rental in December 20X1. • Based on a supplier’s cost quotation, Cafe´ Revive can buy equipment to fit out the cafe for $1650. The supplier will allow a $250 down-payment and Emily will sign a note (a legal document referred to as a note payable – effectively a loan to be paid at a later date) for the remaining amount, due at the end of three months (March 20X2). • Based on the purchases budget (which we will discuss in Chapter 3), Cafe´ Revive will purchase 50 coffee gift packs in December 20X1 at a cost of $1430 (50  $28.60 per pack) from DeFlava Coffee. Although they have different contents, all of these gift packs will be acquired for the same cost price of $28.60 per pack. DeFlava Coffee has agreed to allow Cafe´ Revive to pay for this inventory in January 20X2. • Cafe´ Revive will also purchase $2255 of coffee supplies in December 20X1, paying DeFlava Coffee for the supplies at that time.

Stop & think What information about Cafe´ Revive’s start-up costs would you include in the financial section of its business plan?

Identifying capital requirements Most businesses eventually need additional funding, or capital. The financial section of a business plan should include a discussion of the business’s capital requirements, as well as potential sources of that capital. For new businesses and small businesses, this discussion can be the most important part of the Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions business plan. As you may have noticed while reading the business section of your local newspaper, if a business does not have enough capital and sources of capital, it will have a difficult time surviving. An entrepreneur can determine a business’s capital requirements by analysing two major issues: what the business needs and the amount of capital this will require. The steps are shown in Exhibit 2.4. Exhibit 2.4 Steps for determining capital requirements Step 1 Determine the resources needed – for example, buildings, equipment, furniture Step 2 Determine the capital needed to acquire the resources (via cost quotations, appraisals and sales agreements, etc.) Step 3 Analyse the business’s projected cash receipts and payments

Alamy/Richard Levine

Step 4 Determine available cash and any need for borrowing

Start-up costs for a business can be significant.

Planning capital requirements involves projections, not guarantees, so the entrepreneur must expect and provide for reasonable deviations from plans. Suppose, for example, that cash sales for a month turn out to be less than expected. To allow for ‘surprises’ like this, the entrepreneur should plan to have a cash ‘buffer’, which is extra cash on hand above the projected short-run cash payments of the business. One purpose of this buffer is to protect the business from differences between actual cash flows and projected cash flows, as well as from unanticipated problems, such as having to replace a refrigerated display case sooner than expected. A cash buffer lets the business operate normally through downturns without having to look for financing. It also lets the business take advantage of unexpected opportunities that require cash.

Stop & think Can you think of an example of an unexpected opportunity for which an entrepreneur or manager might find a cash buffer handy?

Sources of capital

short-term capital Capital that will be repaid within a year or less

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Once the entrepreneur knows the business’s capital requirements, potential sources of capital can be identified. Government agencies also offer advice to small business, with regular initiatives such as the Entrepreneurs’ Programme (https://www.business.gov.au/assistance/entrepreneurs-programme) and grants may be available. The entrepreneur must know both the length of time for which the business plans to use the capital before paying it back to creditors or returning it to investors, and the availability of short- and long-term sources of capital. They can determine how long the business will need to use the capital by analysing the business’s projected cash receipts and payments. We will discuss the tools of this analysis more thoroughly in Chapter 3. Short-term capital will be repaid within a year or less. Short-term capital can come from two sources. First, suppliers provide short-term capital to some of their customers through what is called credit or trade Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 2 Developing a business plan: Cost–volume–profit analysis credit. This involves allowing a customer to purchase inventory ‘on credit’ if the customer agrees to pay soon, usually within 30 days. Emily, for example, has an arrangement with DeFlava Coffee that will allow Cafe´ Revive to buy coffee supplies and gift packs on credit and pay DeFlava Coffee 30 days later.

Discussion If Cafe´ Revive took longer than 30 days on average to sell its inventory of coffee, do you think its arrangement with DeFlava Coffee would be valuable? What other questions would you like answered to help you determine the answer to this question?

Second, financial institutions, such as commercial banks, provide loans to companies, many of which are guaranteed by government agencies such as the AusIndustry Programs (https:// www.business.gov.au/advisory-services/ausindustry-qld-state-office). These institutions require a more formal agreement with a business than do issuers of credit or trade credit. They also charge interest on these short-term loans. At some point, Emily may talk with her banker to arrange a small line of credit for Cafe´ Revive. A line of credit allows a business to borrow money ‘as needed’, with a pre-arranged, agreedupon interest rate and a specific payback schedule. Long-term capital will be repaid to creditors or returned to investors after more than a year. Initially, as we mentioned in Chapter 1, businesses obtain capital from the owner(s) and from bankers. Cafe´ Revive obtained its initial capital from Emily, who invested money from her savings account. Other sources of long-term capital can include friends and relatives, commercial banks and lending organisations.

line of credit Amount of money a business is allowed to borrow with a prearranged, agreedupon interest rate and a specific payback schedule

long-term capital Capital that will be repaid to creditors or returned to investors after more than one year

Discussion All institutions require a formal agreement with the business about payment dates and interest rates. But suppose Cafe´ Revive borrows money from Emily’s and your friends and relatives. Do you think it is necessary to have a formal written agreement between Cafe´ Revive and these friends and relatives? Why or why not?

FINANCIAL STATEMENT EFFECTS After finding it hard to raise a bank loan, the owner of Cheeta Australia, an Australian company that manufactures automated self-loading hand trucks, took his company’s business plan and applied for a Commercialising Emerging Technologies (COMET) grant from the Australian Government. After reviewing the plan, the government granted $64 000 for a business adviser to help him attract potential investors and source manufacturers.d

Eventually, as a business grows too large to be financed by the owner and these other sources, it may offer private placements or public offerings. Private placements are securities that are sold directly to private individuals or groups (called investors). Public offerings involve issuing bonds or shares to the public (investors) through securities firms or investment bankers. For the near future, several of Emily’s and your friends and relatives have agreed to lend Cafe´ Revive specific amounts of money, as needed. Emily and these friends and relatives have agreed that the interest rate on these loans will match the market interest rate at the time of each loan. Cafe´ Revive includes this information in its financial plan.

Projected financial performance This section of the financial plan projects the business’s financial performance. Suppose Emily has assigned you the responsibility of preparing this section of Cafe´ Revive’s financial plan. Remember that, although projecting a business’s financial performance involves uncertainty, if you follow some guidelines the financial performance information will be more dependable.

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Accounting Information for Business Decisions Case Exhibit 2.5 Steps in projecting financial performance

Step 1

The data you use should be as reliable as possible Since Café Revive is a new business, you don’t have historical data to use for planning purposes. When you have unclear data (or no data at all), industry averages found in such sources as Moody’s (http://www.moodys.com.au), Standard and Poor’s (http://www.standardandpoors.com/home/en/au) and Austrade (https://www.austrade.gov.au) can serve as a guide.

Step 2

Consider several scenarios because predicting a business’s financial performance is uncertain ‘What if’ questions are useful for this type of planning. For example, what if coffee sales fall below expectations by 30 per cent? What if we sell only 100 coffee gift packs? What if we can sell 300 coffee gift packs? The scenarios should be realistic; perhaps you should consider the best case, the worst case and the most probable case.

Step 3

Revise your projections as more facts become available

Step 4

Ensure that the financial plan is consistent with the information in the other sections of the business plan For example, since the marketing section of Café Revive’s business plan refers to the advertising that you plan to do, the financial plan section must show advertising costs.

Stop & think If you use Moody’s, Standard & Poor’s or Austrade reports for industry information, you must be able to identify the industry in which Cafe´ Revive is operating. What are some key words that you could use to identify the industry? The financial performance section of the financial plan includes projected financial statements, supported by cost–volume–profit (CVP) analysis and budgets. Budgets include reports on such items as estimated sales and purchases of inventory and expenses, as well as estimated cash receipts and payments. In the remainder of this chapter, we will discuss CVP analysis and its relationship to the projected income statement (the income statement was discussed briefly in Chapter 1, and will be covered in depth in Chapter 7). In Chapter 3, we will discuss budgets and how they fit into a business’s financial plan. In summary, you have just learned that the business plan shows the direction a business will be taking during the next year. You have also learned that the business plan includes a description of the business, a marketing plan, a description of business operations, an environmental management plan and a financial plan. Accountants are most involved with the financial plan, which includes an analysis of predicted costs, sales volumes and profits. We will thus spend the remainder of this chapter discussing CVP analysis and its use in planning.

3

In Chapter 1, we referred to accounting as the language of business. How does accounting information contribute to the planning process?

54

2.2 Cost–volume–profit (CVP) planning Determining whether a business will be profitable is difficult before it begins operations. This uncertainty is part of the risk that the entrepreneur takes in starting a business. (Although it can be scary, it is also part of the fun.) Uncertain profit does not mean the entrepreneur should disregard any type of analysis before beginning the operations of a business; however, it is possible to take educated risks based on estimations of costs, sales volumes and profits. The financial plan should include an analysis of these three factors. One type of analysis that takes these into account is called cost–volume–profit (CVP) analysis. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 2 Developing a business plan: Cost–volume–profit analysis

Cost–volume–profit (CVP) analysis Cost–volume–profit (CVP) analysis shows how profit will be affected by alternative sales volumes, selling

prices of products and various costs of the business. CVP analysis is sometimes also called break-even analysis. Entrepreneurs use CVP analysis to help them understand how the plans they make will affect profits. This understanding can produce better informed decisions during the ongoing planning process. CVP analysis is based on a simple profit calculation involving revenues and costs. This calculation can be shown in an equation or in a graph. Although equations provide precise numbers, CVP graphs provide a convenient visual form for presenting the analysis to decision makers. However, to understand a CVP equation or graph, decision makers must also understand how costs behave.

cost–volume–profit (CVP) analysis Shows how profit is affected by changes in sales volume, selling prices of products and the various costs of a business

Cost behaviour A careful cost analysis considers the activity level of the operation that causes the cost. For example, DeFlava Coffee, a manufacturing business, might measure its activity by using the number of kilograms of coffee produced or the number of hours worked in producing so many kilograms of coffee. On the other hand, Cafe´ Revive, a retail business, might measure its activity by using the number of coffees or gift packs sold. This activity level (i.e. the number of cups of coffee or gift packs sold) is often referred to as volume. The relationship between an activity’s cost and its volume helps us determine the cost’s behaviour pattern. To understand what CVP equations and graphs reveal about a business’s potential profitability, let’s first look at two cost-behaviour patterns that describe how most costs behave. These are called fixed costs and variable costs.

volume Activity level in a business

Fixed costs Fixed costs are constant in total for a specific time period – that is, they are not affected by differences

in volume during that same time period. Managers’ annual salaries are usually fixed costs, for instance. For another example, think about the $1320 monthly rent that Cafe´ Revive will pay for its retail space. Cafe´ Revive’s activity level is its sales volume – the number of coffees or gift packs sold. The rent cost of the retail space will not change as a result of a change in the sales volume, assuming you have planned carefully and have leased enough retail space. Cafe´ Revive will pay its monthly rent of $1320 no matter how much coffee it sells that month. Since the rent cost does not change as volume changes, it is a fixed cost. Let’s assume that half of the cafe´ space is used by the gift packs and half for making the coffees. Hence, $660 rent cost is allocated to gift pack expenses and $660 is allocated to coffee-making expenses. We will examine how costs and CVP analysis works using the gift packs sold by Cafe´ Revive. A business would need to do this analysis for its entire business (all products), however, and the analysis for the coffee supplies/cups of coffee sales is included in the Appendix at the end of this chapter. The graph in Case Exhibit 2.6 illustrates the relationship between the rent cost and the sales volume. As you can see, the rent cost for the gift packs will be $660 whether Cafe´ Revive sells 50 or 200 gift packs. Also note in Case Exhibit 2.6 that we show a fixed cost as a horizontal straight line on the graph, indicating that the cost will be the same (i.e. fixed) over different volume levels. It is important not to be misled about fixed costs. Saying that a cost is fixed does not mean it cannot change from one time period to the next. In the next period, Cafe´ Revive could rent more retail space if needed, or the landlord could raise the rent when the lease is renewed, causing the rent cost to be higher. To be fixed, a cost must remain constant for a time period in relation to the volume attained in that same time period and be within the relevant range (see below). For example, most companies consider the costs of using their buildings, factories, office equipment and furniture – called depreciation – to be fixed.1 That is, depreciation costs within a specific time period will not change even if volume changes within that time period. Relevant range is the range of activity levels over which the particular (fixed) cost behaviour 1

fixed costs Costs that are constant in total and that are not affected by changes in volume

relevant range Range of volumes over which cost estimates are needed for a particular use and over which observed cost behaviours are expected to remain stable

We will discuss in Chapter 4 how a business determines its depreciation costs. We include a brief discussion here because

most companies have some depreciation costs to consider in evaluating their operations. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions Case Exhibit 2.6 Fixed cost behaviour – coffee gift packs Total monthly rent cost $1 200 $900

$660 Rent cost

$600 $300 $0

50

100 Sales volume (in coffee gift packs)

200

pattern remains valid. For example, if we lease the retail space mentioned above and that space is only large enough to stock between 50 and 200 coffee gift packs, then the rent cost will be fixed at $660. But if Cafe´ Revive needs to stock more than 200 gift packs, then it will need to lease other premises for $1980; hence, when volume is outside the relevant range, the fixed rent cost will be different. You have estimated that Cafe´ Revive’s monthly fixed costs will include the $1320 rent cost, plus $2360 for total salaries (wages of $2050 & PAYG2 of $310) for you and Jackson Downes – the employee Emily hired to work in the shop – $330 consulting costs, $231 advertising costs, $159 depreciation of fixtures, $143 mobile/wifi and $209 energy costs (gas for heating and electricity).3 Cafe´ Revive’s total fixed costs will be the sum of the individual fixed costs, or $4752. Again, based on equal use of floor space for the products, assume that these costs are shared equally between coffee gift packs (fixed costs $2376) and cups of coffee (fixed costs $2376).

Stop & think What would the graph look like for Cafe´ Revive’s $4752 total fixed costs? Why?

Shutterstock.com/Africa Studio

Decision makers sometimes state fixed costs as a dollar amount per unit, calculated by dividing the total fixed costs by the volume in units. This can be misleading and should be avoided. For instance, if we use only coffee gift pack sales, at a sales volume of 200 gift packs, Cafe´ Revive’s fixed cost per gift pack will be $11.88 ($2376 fixed costs  200 packs). At a sales volume of 300 gift packs, the fixed cost per pack will be only $7.92 ($2376 fixed costs  300 packs). Comparing $11.88 with $7.92, you might think that total fixed costs decrease as sales volume increases. This is not true! Cafe´ Revive’s total fixed costs for gift packs will still be $2376, regardless of the sales volume. If this coffee gift pack contained more items, would the business’s total fixed costs decrease?

variable cost Cost that is constant per unit and that changes in total in direct proportion to changes in volume

Variable costs

A variable cost is constant per unit of volume, and changes in total in a time period in direct proportion to the change in volume. For instance, consider Cafe´ Revive’s cost of purchasing coffee products from DeFlava Coffee to resell to its customers. You have estimated that each coffee

2

Note that PAYG will be explained in Chapter 4.

3

Some telephone and utility costs may have minimum charges, but their total costs are affected by changes in the volume of

usage. Here, for simplicity, we assume they are fixed costs.

56

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 2 Developing a business plan: Cost–volume–profit analysis gift pack that Cafe´ Revive purchases will cost it $28.60. The total cost of coffee gift packs sold varies in proportion to the number sold. If Cafe´ Revive sells 100 gift packs in January, the total variable cost of these packs of coffee sold will be $2860 (100 packs  $28.60). If the volume doubles to 200 packs, the total variable cost of packs sold will also double, to $5720 (200  $28.60). It is important to remember that the total variable cost for a time period increases in proportion to volume in that same time period, based on the variable cost of each unit. Case Exhibit 2.7 shows the estimated total variable costs of coffee gift packs sold by Cafe´ Revive at different sales volumes. Note that total variable costs are shown by a straight line sloping upwards from the origin of the graph. This line shows that the total variable cost increases as volume increases. If no coffee gift packs are sold, the total variable cost will be $0. If 100 are sold, the total variable cost will be $2860. The slope of the line is the rate at which the total variable cost will increase each time Cafe´ Revive sells another coffee gift pack. This rate is the variable cost per unit of volume sold – that is, $28.60 per pack. Case Exhibit 2.7 Variable cost behaviour – coffee gift packs Total monthly variable cost $6 000 $5 720 $5 000 $4 862 $4 000

sts

le iab

co

r

Va

$3 000 $2 860

$2 000

$1 000

$0

50

100

150 Sales volume (in gift packs of coffee)

170

200

250

Stop & think How could rent be a variable cost? If it were a variable cost, how do you think it would affect Cafe´ Revive’s variable costs line in Case Exhibit 2.7? Because graphs are easy to see, we used them to show Cafe´ Revive’s fixed and variable costs in Case Exhibits 2.6 and 2.7. For CVP analysis, however, it is often better to use equations because they show more precise numbers. For instance, the equation for the total amount of a variable cost is as follows: Total variable cost ¼ vX Where: v ¼ Variable cost per unit sold X ¼ Sales volume.

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Accounting Information for Business Decisions The equation for the variable cost line in Case Exhibit 2.7 is: Total variable cost of gift packs of coffee sold ¼ $28.60X

Total costs total costs Sum of the fixed costs and variable costs at a given volume

Total costs at any volume are the sum of the fixed costs and the variable costs at that volume. For example, at a sales volume of 100 coffee gift packs, Cafe´ Revive’s estimated fixed costs share for coffee packs are $2376 and its estimated variable costs are $2860 (100  $28.60), for an estimated total cost of $5236 at that volume. At a sales volume of 200 coffee gift packs, estimated fixed costs are still $2376, estimated variable costs are $5720 (200  $28.60) and the estimated total cost is $8096. Case Exhibit 2.8 illustrates the total cost in relation to sales volume of gift packs. Notice that if no gift packs are sold, the total cost will be equal to the fixed costs of $2376. As sales increase, the total cost will increase by $28.60 per pack, the amount of the variable cost per pack. Case Exhibit 2.8 Total cost behaviour – coffee gift packs $8 096 $8 000 $7 238

$7 000

sts

l co

$6 000 $5 720 $5 236

a Tot

$5 000

$4 950 $4 000

$3 000 Fixed costs

$2 376 $2 000

$1 000

$0

0

20

40

60 80 90 100 120 140 Sales volume – coffee gift packs

160 180 170

200

The equation for the total cost is: Total cost ¼ f þ vX where: f ¼ Total fixed costs v ¼ Variable cost per unit sold, and X ¼ Sales volume: The equation for the total cost line in Case Exhibit 2.8 is: Total cost of coffee gift packs sold ¼ $2376 þ $28.60X Where X ¼ sales volume. Now that you understand the relationships of volume, fixed costs and variable costs to the total cost, we can use CVP analysis to estimate profit.

58

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Chapter 2 Developing a business plan: Cost–volume–profit analysis Case Exhibit 2.9 Projected income statement for external users – coffee gift packs Cafe´ Revive Projected income statement – coffee gift packs For the month ended 31 January 20X2 Revenues: Sales revenues – coffee gift packs (170  55)

$ 9 350

Expenses: Cost of gift packs sold (170  28.60) Rent expense

$4 862.00 660.00*

Salaries expense

1 180.00

Consulting expense

165.00*

Advertising expense

115.50*

Depreciation expense: fixtures

79.50

Mobile and wifi expenses

71.50*

Energy expense

104.50*

Total expenses

(7 238)

Net income

$ 2 112

* These figures are GST-inclusive. Recall also that all fixed expenses are shared equally between the two product lines based on their equal use of space.

Profit calculation According to its marketing plan, Cafe´ Revive expects to sell 170 coffee gift packs at $55 each and 880 cups of coffee at an average price of $5.50 in January. Case Exhibit 2.9 shows Cafe´ Revive’s projected income statement for coffee gift packs and Case Exhibit 2.10 shows a combined income statement for coffee gift packs and cups of coffee (see Case Exhibit 2.20 in this chapter’s Appendix for a coffee cup sales income statement). These income statements are in the format that is presented to external users. This is the same format that we discussed in Chapter 1 and illustrated in Exhibit 1.8 in Chapter 1. External decision makers find this format easy to understand, and use this form of income statement for their investment and credit decisions. This income statement results from the following equation: Net income (Profit) ¼ Revenues – Expenses In this equation, revenues (the selling prices of all cups of coffee and coffee gift packs sold to customers) include cash and credit sales, and expenses (the costs of providing coffee and gift packs to customers) include the cost of cups of coffee and gift packs sold and the expenses of operating the business.

Profit graph One way of graphing a business’s net income (profit) is to show both its revenues and its costs (expenses) on the same graph. Recall that the graph of a business’s total costs includes its fixed costs and its variable costs, as we illustrated for Cafe´ Revive in Case Exhibit 2.8. The graph of a business’s revenues is shown by a straight line sloping upwards from the origin. The slope of the line is the rate (selling price per unit) at which the total revenues increase each time the business sells another unit. Given that Cafe´ Revive has two different products, it is necessary to calculate the CVP analysis for each of the products (see this chapter’s Appendix for details of the sales of cups of coffee). Recall that as half of the cafe´’s space is used by the gift packs and half for making the coffees, the fixed costs have been divided evenly across the two products. Hence, the fixed cost of coffee gift packs will be $2376.

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59

Accounting Information for Business Decisions Case Exhibit 2.10 Projected income statement for external users – both products Cafe´ Revive Projected income statement For the month ended 31 January 20X2 Revenues: Sales – coffee gift packs

$ 9 350

Sales – cups of coffee

4 840

Total revenues

$ 14 190

Expenses: Cost of gift packs sold

$4 860

Cost of coffee supplies used

1 936

Rent expense

1 320*

Salaries expense

2 360

Consulting expense

330*

Advertising expense

231*

Depreciation expense – fixtures

159

Mobile & wifi expenses

143*

Energy expense

209*

Total expenses Net income

(11 550) $ 2 640

* These figures are GST-inclusive.

break-even point Unit sales volume at which a business earns zero profit

The graph in Case Exhibit 2.11 shows the estimated total revenue line and the estimated total cost line for Cafe´ Revive’s gift packs. Note that the total revenue line crosses the total cost line at 90 coffee gift packs. At this point, the total revenues will be $4950 (90  $55), and the total costs will also be $49504 (Fixed costs $2376 þ Variable costs $2574 [90  $28.60]); refer to the note under the heading ‘Finding the break-even point’ later in this chapter), so there will be zero profit. The unit sales volume at which a business earns zero profit is called the break-even point. Above the break-even unit sales volume, the total revenues of the business are more than its total costs, so there will be a profit. Below the break-even point, the total revenues are less than the total costs, so there will be a loss. The profit graph in Case Exhibit 2.11 at a sales volume of 170 coffee gift packs shows that Cafe´ Revive will earn a profit of $2112 (as we computed in the income statement in Case Exhibit 2.9), the difference between the $9350 estimated total revenue and $7238 estimated total cost at this volume. Although some decision makers use this type of graph, many others prefer to use a different graph that shows a business’s contribution margin, as we discuss next.

Contribution margin To estimate profit at different volume levels, the entrepreneur needs CVP information in a form that relates the estimated revenues and estimated variable costs to the estimated fixed costs. Case Exhibits 2.12, 2.13 and 2.14 show income statements containing the same information as given in Case Exhibits 2.9, 2.20 (in Appendix) and 2.10, but in a format that is more useful for internal decision makers in performing CVP analysis because it shows expenses as variable and fixed. This income statement format is sometimes called the contribution margin approach. Note that, on the income statement in Case Exhibit 2.12, Cafe´ Revive first calculates its estimated sales revenue for coffee gift packs ($9350) by multiplying the number of gift packs it expects to sell (170) by the selling price per pack ($55). Cafe´ Revive next determines the total estimated 4

60

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Chapter 2 Developing a business plan: Cost–volume–profit analysis Case Exhibit 2.11 Profit graph for Cafe´ Revive – coffee gift packs

$10 000 $9 350 Profit $2 112

$8 000 $7 238

Profit

$6 000

$4 950 Break-even point

al

To tal

re

ve

Tot

ts cos

nu es

$4 000

Loss $2 000

$0

0

20

40

60

80

90 100

120

140

160 170 180

200

Sales volume – coffee gift packs

Case Exhibit 2.12 Projected income statement for internal users – coffee gift packs (contribution margin approach) Cafe´ Revive Projected income statement – coffee gift packs For the month ended 31 January 20X2 Total sales revenues ($55  170 coffee gift packs)

$ 9 350.00*

Less: Total variable costs Cost of coffee gift packs sold ($28.60  170 packs)

(4 862.00)*

Total contribution margin

$ 4 488.00

Less: Total fixed costs Rent expense

$ 660.00*

Salaries expense

1 180.00

Consulting expense

165.00*

Advertising expense

115.50*

Depreciation expense: display cases Mobile and wifi expenses Energy expense

79.50 71.50* 104.50*

Total fixed costs Net income

(2 376.00)* $ 2 112.00

* These figures are GST-inclusive.

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions

total contribution margin Difference between the total sales revenue and the total variable costs

contribution margin per unit Difference between the sales revenue per unit and the variable costs per unit

variable costs of selling the 170 gift packs of coffee ($4862) by multiplying the number of packs it expects to sell (170) by the variable cost per pack of coffee ($28.60). These total variable costs are then subtracted from total sales revenue. The $4488 ($9350 – $4862) difference is called the total contribution margin. Case Exhibit 2.20 (in Appendix) calculates net income using this approach for cups of coffee and the income statement in Case Exhibit 2.13 shows the combined figures for Cafe´ Revive. As you can see, the total contribution margin, at a given sales volume, is the difference between the estimated total sales revenue and the estimated total variable costs. It is the amount of revenue remaining after subtracting the total variable costs, which will contribute to covering the estimated fixed costs. To compute the estimated profit, we subtract the total estimated fixed costs for the month from the total contribution margin. If the contribution margin is more than the total fixed costs, there will be a profit. If the contribution margin is less than the total fixed costs, there will be a loss. Case Exhibit 2.9 shows that Cafe´ Revive’s estimated profit for coffee gift packs is $2112 ($4488 total contribution margin – $2376 total fixed costs). Case Exhibit 2.20 shows that Cafe´ Revive’s estimated profit for cups of coffee is $528 ($2904 total contribution margin – $2376 total fixed costs). Case Exhibit 2.13 shows that Cafe´ Revive’s estimated profit is $2640 ($7392 total contribution margin – $4752 total fixed costs). The contribution margin may also be shown on a per-unit basis. The contribution margin per unit is the difference between the estimated sales revenue per unit and the estimated variable costs per unit. For Cafe´ Revive, the contribution margin for gift packs per unit is $26.40 ($55 sales revenue – $28.60 variable costs). This may also be expressed as a percentage: $26.40/$55 ¼ 0.48 or 48% contribution margin percentage. At 170 units, the total contribution margin will be $4488 (170  $26.40), which is the same as that shown in Case Exhibit 2.12. Note that the contribution margin percentage remains unchanged: $4488/$9350 ¼ 48%. This is the percentage of sales remaining to pay for – or contribute Case Exhibit 2.13 Projected income statement for internal users – combined (contribution margin approach) Cafe´ Revive Projected income statement For the month ended 31 January 20X2 Revenues: Sales – coffee gift packs ($55  170)

$ 9 350*

Sales – cups of coffee ($5.50  880)

4 840* $14 190

Less: Total variable costs Cost of coffee gift packs sold ($28.60  170 boxes)

4 862*

Cost of cups of coffee sold ($2.20  880)

1 936* (6 798)

Total contribution margin

$ 7 392

Less: Total fixed costs Rent expense Salaries expense

$1 320* 2 360

Consulting expense

330*

Advertising expense

231*

Depreciation expense – display cases

159

Mobile and wifi expenses

143*

Energy expense

209*

Total fixed costs Net income * These figures are GST-inclusive.

62

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

(4 752) $ 2 640

Chapter 2 Developing a business plan: Cost–volume–profit analysis towards – the fixed costs. Later, you will see that computing the total contribution margin (by either method described above) is the key to understanding the relationship between profit and sales volume. Case Exhibit 2.14 shows what the total contribution margin will be at different unit sales volumes of coffee gift packs. In this graph, since the contribution margin of one coffee gift pack is $26.40, the total contribution margin increases at a rate of $26.40 per gift pack sold. For example, at a volume of 100 gift packs, the contribution margin will be $2640 (100 gift packs  $26.40). At a volume of 300 gift packs of coffee, the contribution margin will be $7920 (300 gift packs  $26.40). At a volume of 170 gift packs of coffee, the contribution margin will be $4488 (170 gift packs  $26.40), as calculated in Case Exhibit 2.14. Case Exhibit 2.14 Relationship between total contribution margin and unit sales volume – coffee gift packs Contribution margin

$8 000 $7 920 $7 000

$6 000

n

rgi

o

uti

ib ntr

$5 000

a nm

Co

$4 488 $4 000

$3 000 $2 640 $2 376 $2 000

$1 000

$0

0

50

90 100 150 170 200 Sales volume – coffee gift packs

250

300

Stop & think If variable costs were higher per unit, would you expect the contribution margin line in Case Exhibit 2.14 to be steeper or flatter than it is? Why or why not?

Discussion Examine Case Exhibit 2.14 and note the contribution margin for Cafe´ Revive level at a sales level of 90 gift packs. Where have you seen this figure before? Why do you think this level of contribution from 90 coffee gift pack sales is significant?

Showing CVP relationships Now that you understand the contribution margin and fixed costs, we can show the estimated profit or loss at different sales volumes in a graph. Case Exhibit 2.15 shows how sales volume affects the estimated profit (or loss) for Cafe´ Revive for coffee gift packs. Two lines are drawn on these graphs. One Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

63

Accounting Information for Business Decisions Case Exhibit 2.15 Cost–volume–profit relationships for Cafe´ Revive – coffee gift packs

$8 000 $7 920 $7 000 in

arg

$3 987.50 $6 000 $3 495.50

m ion

ut

trib

n Co

$5 000 $4 448 $4 000

Profit $5 544

$3 000 $2 376 $1 320

Total fixed costs

$2 000

Loss

$–1 056

Break-even point

$1 000 $0

0

50

100 150 170 200 250 90 Sales volume – coffee gift packs

300

line shows the estimated total contribution margin at different sales volumes. This is the same line as shown in Case Exhibit 2.14. The other line shows the $2376 total estimated fixed costs. The vertical distance between these lines is the estimated profit or loss at the different sales volumes for each product. Remember, estimated profit is the total contribution margin minus the estimated total fixed costs. Note that Exhibit 2.15 shows that Cafe´ Revive will earn $0 profit if it sells 90 gift packs of coffee; this is its break-even point. Above the break-even unit sales volume (such as at a volume of 300 gift packs), the total contribution margin ($7920) is more than the total estimated fixed costs ($2376), so there would be a profit ($7920 – $2376 ¼ $5544). Below the break-even point, such as at a volume of 50 gift packs, the total contribution margin ($1320) is less than the total estimated fixed costs, so there would be a loss ($1320– $2376 ¼ –$1056).

Stop & think If fixed costs were greater, would you expect Cafe´ Revive to break even at a lower sales volume or a higher sales volume? Why?

Profit calculation (equation form) In Case Exhibit 2.15 we graphed the CVP relationship for Cafe´ Revive’s coffee gift packs. Graphs are usually a helpful tool, allowing an entrepreneur (and students!) to see a ‘picture’ of these relationships. Sometimes, however, an entrepreneur (or student) does not need a picture to understand the relationships. In this case, using equations may be a better and faster way to understand CVP relationships. (You may have thought of these equations as you studied Case Exhibit 2.15.) In this section, we look at how to use equations for CVP analysis to answer the following questions: 1 How much profit will the business earn at a given unit sales volume? 2 How many units must the business sell to break even? 3 How many units must the business sell to earn a given amount of profit? (The given amount is usually a desired profit that the business uses as a goal.) In the following discussion, we use Cafe´ Revive’s revenue and cost information from the projected income statement for internal decision makers for coffee gift packs in Case Exhibit 2.12. We determined the total 64

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Chapter 2 Developing a business plan: Cost–volume–profit analysis sales revenue by multiplying the selling price per unit by the estimated sales volume. We determined the total estimated variable costs by multiplying the variable cost per unit by the same sales volume. We subtracted the total estimated variable costs from the estimated revenue to calculate total contribution margin. Finally we subtracted the fixed costs from the total contribution margin to determine the estimated profit. We can show this in a profit equation, as follows: 3 2 3 2 Total Variable Unit Profit Selling Unit (for a given ¼ 4 price 3 sales 5  4 cost 3 sales 5  fixed costs per unit volumes sales volume) per unit volumes The profit equation can be used in CVP analysis. For Cafe´ Revive, for instance, if we use X to stand for a given sales volume of coffee gift packs, and if we include the estimated selling price and variable cost per unit, the equation is as follows: Profit ¼ $55X  $28:60X  $2376 ¼ ð$55  $28:60ÞX  $2376 ¼ $26:40X  $2376 These equations can be used to solve various CVP questions for Cafe´ Revive. Note in the last line of the equation that for coffee gift packs, the $26.40 is the contribution margin per unit. This can come in handy as a ‘shortcut’ when using the profit equation, so that the equation becomes: 2 3 Total Profit Contribution Unit (for a given ¼ 4 margin 3 sales 5  fixed costs sales volume) per unit volume

2.3 Using CVP analysis CVP analysis is useful in planning because it shows the impact of alternative plans on profit. This analysis can help the entrepreneur make planning decisions, and can help investors and creditors evaluate the risk associated with their investment and credit decisions. For instance, suppose Emily has asked you to answer, for Cafe´ Revive, the three questions listed in the previous section. In this section, we describe how to do so.

4

What must decision makers be able to predict in order to estimate profit at a given sales volume?

Estimating profit at given unit sales volume Suppose Emily wants you to estimate Cafe´ Revive’s monthly profit for coffee gift packs if it sells 250 gift packs (i.e. a unit sales volume of 250 gift packs) a month. Remember that Cafe´ Revive’s selling price for gift packs is $55 per unit and its variable cost is $28.60 per unit. You can estimate monthly profit when 250 gift packs of coffee are sold in a month by using the profit equation, as follows: 2 3 2 3 Selling Unit Variable Unit Total Profit ¼ 4 price 3 sales 5  4 cost 3 sales 5  fixed per unit volume per unit volume costs ¼ ð$55 3 250Þ  ð$28:60 3 250Þ  $2376 ¼ $13 750  $7150  $2376 ¼ $4224 Thus, you can tell Emily that Cafe´ Revive will make a monthly profit of $4224 if it sells 250 coffee gift packs a month. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions

Finding the break-even point Suppose Emily wants you to estimate how many coffee gift packs Cafe´ Revive must sell to break even each month. Recall that the break-even point is the unit sales volume that results in zero profit. This occurs when total sales revenue equals total costs (total variable costs plus total fixed costs). To find the break-even point, we start with the profit equation. Remember that the contribution margin per unit is the difference between the sales revenue per unit and the variable costs per unit. With this in mind, we can rearrange the profit equation5 into a break-even equation, as follows: Unit sales volume (to earn zero profit) ¼

Total fixed costs Contribution margin per unit

So, for Cafe´ Revive, you can tell Emily that the break-even point is 90 coffee gift packs, computed using the break-even equation as follows (letting X stand for the unit sales volume): Unit sales volume (to earn zero profit) ¼

$2376 Total fixed costs ð$55 Selling price  $28:60 Variable cost per unitÞ

Which can also be remembered as: Total fixed costs $ 2376 Contribution margin per unit $ 26.40 $ 2376 X¼ $ 26.40 X ¼ 90 coffee gift packs

Break-even unit sales volume ¼

You can verify the break-even sales volume of 90 coffee gift packs with the following schedule: Total sales revenue (90 gift packs @ $55.00 per pack)

$ 4 950

Less: Total variable costs (90 gift packs @ $28.60 per pack)

(2 574)

Total contribution margin (90 gift packs @ $26.40 per pack)

$ 2 376

Less: Total fixed costs

(2 376)

Profit

5

$

0

For those of you who want ‘proof’ of this break-even equation, since the contribution margin per unit is the selling price per

unit minus the variable cost per unit, we can substitute the total follows: 2 Contribution Profit ¼ 4 margin 3 per unit

contribution margin per unit into the profit equation as 3 Unit Total sales 5  fixed volume costs

Since break-even occurs when profit is zero, we can omit the profit, move the total fixed costs to the other side of the equation, and rewrite the equation as follows: 2 3 Contribution Unit Total fixed costs ¼ 4 margin 3 sales 5 per unit volume Finally, we can divide both sides of the equation by the contribution margin per unit to derive the break-even equation: Total fixed costs ¼ Unit sales volume (to earn zero profit) Contribution margin per unit

66

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Chapter 2 Developing a business plan: Cost–volume–profit analysis

Finding the unit sales volume to achieve a target profit Finding the break-even point gives the entrepreneur useful information. However, most entrepreneurs are interested in earning a profit that is high enough to satisfy their goals and those of the business. A business often states its profit goals at amounts that result in a satisfactory return on the average total assets used in its operations. Since this is an introduction to CVP analysis, we will wait until Chapters 7 and 8 to discuss what is meant by ‘satisfactory return’ and ‘average total assets’. Here, we will assume an amount of profit that is satisfactory. Suppose Emily’s goal is that Cafe´ Revive earns a profit of $2112 per month for coffee gift packs and a profit of $528 for cups of coffee. How many gift packs must Cafe´ Revive sell per month to earn $2112 profit? How many cups of coffee must Cafe´ Revive sell per month to earn $528 for cups of coffee? To answer these questions, we modify the break-even equation. The break-even point is the sales volume at which the total contribution margin is equal to, or ‘covers’, the total fixed costs. Therefore, each additional unit sold above the break-even sales volume increases profit by the contribution margin per unit. Hence, to find the sales volume at which the total contribution margin covers both total fixed costs and the desired profit, we can modify the break-even equation simply by adding the desired profit to fixed costs, as follows: Unit sales volume (to earn desired profit) ¼

5

How can decision makers predict the sales volume necessary for estimated revenues to cover estimated costs?

6

How can decision makers predict the sales volume necessary to achieve a target profit?

Total fixed costs þ Desired profit Contribution margin per unit

So, if we let X stand for the unit sales volume, Cafe´ Revive needs to sell 170 coffee gift packs to earn a profit of $2112 a month, calculated as follows: $2376 þ $2112 ð$55  $28:60Þ $4488 X¼ $26:40 per coffee gift pack X ¼ 170 coffee gift packs

Unit sales volume required (X) ¼

You can verify the $2112 profit with the following schedule: Total sales revenue (170 gift packs @ $55.00 per pack)

$ 9 350

Less: Total variable costs (170 gift packs @ $28.60 per pack) Total contribution margin (170 gift packs @ $26.40 per pack)

($4 862) $ 4 488

Less: Total fixed costs Profit

(2 376) $ 2 112

Since Emily had included the desired profit of $2112 per month in Cafe´ Revive’s business plan, the income statement for internal decision makers shown in Case Exhibit 2.12 is an expanded version of the preceding schedule. The calculations for the target profit from coffee cup sales are shown in the Appendix.

Summary of CVP analysis calculations Case Exhibit 2.16 summarises the equations that we used in our discussion of CVP analysis. Although it may be tempting to try to memorise these, you should strive to understand how the equations relate to one another.

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Accounting Information for Business Decisions Case Exhibit 2.16 Summary of cost–volume–profit calculations Profit



(for a given ¼ sales volume)

   Total fixed Unit sales Variable cost Unit sales Selling price     costs volume per unit volume per unit



 Total fixed Unit sales Contribution margin   costs volume per unit Total fixed costs Unit sales volume (to earn zero profit) ¼ Contribution margin per unit ¼

Unit sales volume (to earn a profit) ¼

Total fixed costs þ Desired profit Contribution margin per unit

Using CVP for ‘what if’ scenarios Providing answers to the previous three questions showed how CVP analysis is useful in planning. There are many other planning issues for which CVP analysis also provides useful information. CVP is often used to examine what would happen in changing circumstances, or a range of different circumstances, sometimes called sensitivity analysis or ‘what if’ scenarios. For instance, suppose you and Emily are considering alternative plans to raise Cafe´ Revive’s monthly profit. These plans include the following: 1 Raise the selling price of the coffee gift packs to $60 per pack. With this alternative, the variable costs per pack and the total fixed costs do not change. 2 Purchase a premium line of coffee to include in coffee gift packs, rather than the existing line, thus increasing variable costs to $30 per pack. You and Emily are considering this alternative because an improvement in the coffee’s quality may cause the sales volume of the gift packs to increase. With this alternative, neither the selling price per unit nor the total fixed costs change. 3 Increasing the total fixed costs by spending $110 more on advertising. With this alternative, the selling price per unit and the variable costs per unit do not change, but the additional advertising may cause an increase in sales volume.

Stop & think How would you modify the graph in Case Exhibit 2.15 to provide information for Plan 1? We raise these issues here to get you to think about how to use CVP equations or graphs to provide helpful information. The CVP analyses for these three alternative plans, however, do not provide all the information you need to make a decision. CVP is a helpful tool, but is most effective when used in conjunction with critical thinking. In the ‘what if’ scenarios above, for example, you must also think about the effects each of the alternatives will have on your customers. For instance, each of the alternatives is likely to affect the number of coffee gift packs that Cafe´ Revive can sell. A change in selling price would certainly affect your customers’ decisions to purchase coffee gift packs. A decrease in selling price would bring the gift packs into the spending range of more people (probably increasing the number of coffee gift packs you could sell), whereas an increase in selling price (alternative 1) may make the gift packs too expensive for some customers (possibly decreasing the number of packs you could sell). Selling a higher quality of coffee (alternative 2) may attract a different, or additional, group of customers, thus affecting sales volume. Increasing advertising (alternative 3) may make more people aware of, and may attract more customers to, Cafe´ Revive. Before you make a decision, you should consider how it will affect customers’ interest in your product and estimate the probable unit sales volume for each alternative. Then, for whatever sales volume you expect, the analysis can provide a more realistic profit estimate.

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Chapter 2 Developing a business plan: Cost–volume–profit analysis

2.4 Other planning issues and effects What can happen if a business doesn’t have a business plan

7

How can decision makers use accounting information to evaluate alternative plans?

As the last century ended, many internet companies were in such a rush to join their apparently wildly successful dot.com peers that they forgot one small detail: a sound business plan. By the end of 2002, more than 862 dot.com companies had failed in the United States.e Some went bankrupt; others had to make radical adjustments to the way they conducted business, including through massive layoffs (98 522 employees in 2000). Some, such as Art.com and Wine.com, began again with new owners and business plans, while yet others simply shut down their websites.f A look back at this period reveals that many of these companies needed huge revenue growth just to break even. For example, the revenue of Tickets.com increased by 38.77 per cent during 2000 – but in order to break even, the business’s revenue would have had to grow by 606.7 per cent! A number of companies faced even grimmer situations. The worst was E-Loan, whose revenue had increased by 85.24 per cent during 2000 – but whose revenue would have had to grow 5065.2 per cent in order for the business to break even! Both of these companies had failed by the end of 2000.g The problem with a lot of these companies was that huge investments in expenses were incurred up front, without the necessary inflows of revenue arriving in a timely manner to cover these expenses. Information about all of these cases can be found online, including a notorious Australian example of dot.com failure, One.Tel.h

Stop & think Read what media articles/journals said about One.Tel. Can you summarise the main problems leading to the collapse? Try these suggested links (or search for your own!): https://www.abc.net.au/news/2009-11-20/28324 https://www.theregister.co.uk/2017/08/01/onetel_liquidation_ending_after_16_years https://www.academia.edu/25879736/The_OneTel_Collapse_Lessons_from_Corporate_Governance So what happened? Many business owners, in an effort to compete and attract customers, thought they could start out selling their products for less than they paid for them then, after increasing their volume of customers, make up the difference later by raising the selling prices of their products. This meant that they started out with negative contribution margins, causing them to lose money on every sale that they made right from the outset. (For some companies, even the low selling prices didn’t attract enough customers.) Unfortunately, there was no ‘later’ because these companies ran out of capital or attracted an insufficient number of customers to ‘make a go of it’. Additionally, some owners didn’t consider the extremely high costs involved in running and advertising a website (particularly marketing and salary costs), as well as the costs of storing and distributing their companies’ products. A business plan, along with its CVP analysis, could have helped the owners of these companies to discover the flaws in their thinking before their companies got into trouble. With CVP analysis, it would have been easy for them to confirm that the planned initial selling prices of their products would not have been high enough, at any volume, for the companies to break even. Furthermore, a business plan would have focused the owners’ attention on the high marketing and salary costs, and on the product storage and distribution costs, thereby helping the owners to determine the selling prices that would most likely help their companies break even and earn desired profits. A business plan could also have helped the owners to see the possible effects on their companies’ profits of sales predictions that were too optimistic or too pessimistic. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions

Business issues and values: Waste not, want not CVP accounting information is one factor that influences business decisions, but entrepreneurs also need to consider the non-financial effects of their decisions. For example, if the managers of a business are thinking about lowering the business’s total costs by omitting the clean-up of toxic waste around the factory, they must ask questions such as the following: • •

What will be the impact on the environment? What health effects might employees suffer later?

•

What might be the health impact on the business’s neighbours?

• Legally, can we even consider not cleaning up the toxic waste? Although omitting toxic waste clean-up may reduce total costs dramatically, these managers might consider that other, more-difficult-to-measure costs involved are simply too high. Therefore, after Ethics and Sustainability

70

weighing all the factors surrounding the alternatives, the managers may choose a more socially acceptable alternative that results in a lower profit margin.

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Chapter 2 Developing a business plan: Cost–volume–profit analysis

STUDY TOOLS Summary 2.1 Understand the importance of planning for a new business and what to include in the plan. 1

Since the future is uncertain and circumstances are likely to change, why should a business bother to plan?

A business plan helps the owners or managers of a business to organise the business, serves as a benchmark against which owners/managers can evaluate actual business performance and helps the business to obtain financing. The business plan consists of a description of the business, a marketing plan, a description of the business’s operations and a financial plan. Accounting information contributes to the planning process by providing information for CVP analysis, and by including in the financial plan the effects that estimated revenues, variable costs and fixed costs have on the business’s profits. 2

What should a business include in its business plan?

A business plan should include a description of the business, a marketing plan, a description of the operations of the business, an environmental management plan and a financial plan. The description should include information about the organisation of the business, its products or services, the business’s current and potential customers, its objectives, where it is located and where it conducts business. The marketing plan shows how the business will make sales, and how it will influence and respond to market conditions. The business operations section includes a description of the relationships among the business, its suppliers and its customers, as well as a description of how the business will develop, service, protect and support its products or services. The financial plan identifies the business’s capital requirements and sources of capital, and describes its projected financial performance.

2.2 Understand the concepts of cost–volume–profit analysis (CVP) and cost behaviour. 3

In Chapter 1, we referred to accounting as the language of business. How does accounting information contribute to the planning process?

Accountants determine how revenues, variable costs and fixed costs affect profits, based on their observations of how costs behave and on their estimates of future revenues and costs. By observing cost-behaviour patterns, accountants are able to classify the costs as either fixed or variable, and to then use this classification to predict the amounts of the costs at different activity levels. Accounting information, then, can help decision makers to evaluate alternative plans by using CVP analysis to show the profit effect of each plan. CVP analysis is a tool that helps managers think critically about the different aspects of each plan. 4

What must decision makers be able to predict in order to estimate profit at a given sales volume?

To estimate profit at a given sales volume, decision makers must be able to predict the product’s selling price, the costs that the business will incur and the behaviour of those costs (whether they are fixed or variable costs). Fixed costs will not change because of sales volume, but variable costs will change directly with changes in sales volume.

2.3 Be able to apply CVP analysis to estimate break-even, target profits and assess alternatives. 5

How can decision makers predict the sales volume necessary for estimated revenues to cover estimated costs?

To predict the sales volume necessary for estimated revenues to cover estimated costs, decision makers must rearrange the profit equation into the break-even equation. Using what they know about the product’s selling price and the behaviour of the business’s costs, decision makers can determine the contribution margin per unit of the product by subtracting the estimated variable costs per unit from the product’s estimated selling price. They can then substitute the contribution margin and the estimated fixed costs into the equation and solve for the necessary sales volume. 6

How can decision makers predict the sales volume necessary to achieve a target profit?

Predicting the sales volume necessary to achieve a target profit is not very different from predicting the sales volume necessary for estimated revenues to cover estimated costs. The only difference is that decision makers must modify the break-even equation by Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions

adding the desired profit to the estimated fixed costs. Then, after substituting the contribution margin and the estimated fixed costs plus the desired profit into the equation, they can solve for the necessary sales volume.

2.4 Consider other planning issues and effects. 7

How can decision makers use accounting information to evaluate alternative plans?

Decision makers can determine how changes in costs and revenues affect the business’s profit. Based on accounting information alone, the alternative that leads to the highest profit will be the best solution. However, decision makers should also consider the non-financial effects that their decisions may have.

Key terms break-even point

line of credit

short-term capital

business plan

long-term capital

total contribution margin

contribution margin per unit

relevant range

total costs

cost–volume–profit (CVP) analysis

return

variable cost

fixed costs

risk

volume

Online research activity This activity provides an opportunity to gather information online about real-world issues related to the topics in this chapter. For suggestions on how to navigate various businesses’ websites to find their financial statements and other information, see the related discussion in the Preface. u Go to http://www.business.gov.au. What is the aim of this website? What types of loans or grants are available? How do you get access to these funds? u Go to http://www.business.gov.au. Investigate the starting a business guide. What key decisions are suggested? How is it suggested that you plan for success? How do these compare with what we discussed in this chapter? u Go to https://www.business.gov.au/assistance/entrepreneurs-programme. What are the four elements of support for businesses mentioned?

Integrated business and accounting situations Answer the following questions in your own words.

Testing your knowledge 2-1 2-2 2-3 2-4

2-5 2-6 2-7 2-8 2-9

72

Since the future is uncertain and circumstances are likely to change, why should the managers and owners of a business bother to plan? How are ‘risk’ and ‘return’ each defined? Do you think there is a relationship between them? Describe the three main functions of a business plan. Describe the components of a business plan. How does each of these components help the following people to make decisions about a business? (a) An investor. (b) A creditor. (c) A manager or owner. Why is it important for businesses to have an environment management plan? List 10 possible environmental costs that a breakfast cereal manufacturing business might incur. Why is it important for a business to have a cash buffer on hand? How can an entrepreneur determine a business’s capital requirements? What is the difference between short-term and long-term capital? Explain what cost–volume–profit (CVP) analysis is. How does CVP analysis help entrepreneurs to develop their companies’ business plans? Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 2 Developing a business plan: Cost–volume–profit analysis

2-10 2-11 2-12 2-13 2-14

2-15 2-16 2-17 2-18

2-19

How can you tell whether a cost is a variable cost or a fixed cost? Define relevant range. Why is it important? What is a contribution margin? Explain what it means when a business breaks even. Indicate the effect (increase, decrease, no change, or not enough information) that each of the following situations has on break-even unit sales. If you answered, ‘not enough information’, list the information that you need in order to be able to determine the effect. a A retail business purchases price tags to use in place of the stickers it has used in the past. b An athletic equipment store leases more retail space. c A bakery increases its advertising expenditure. d A merchandiser plans to increase the selling price of its product. To counteract potential decreases in sales, the merchandiser also plans to increase the amount of per-product commission earned by the sales staff. e An accounting firm plans to increase its billing rate per hour. f A retail business has found a supplier that will provide the same merchandise its old supplier provided, but at a lower price. g A private boarding school in Sydney installs air conditioning in its dormitories. h A retail business reduces advertising expenses and increases the commissions of its sales force. i Instead of having its office building cleaned by a cleaning service, a business plans to hire its own cleaning crew. If the total variable cost per unit increases while the selling price per unit and the fixed costs and sales volume remain the same, how would you expect the change in variable costs to affect (a) profit; and (b) the break-even point? If total fixed costs increase while the selling price per unit, the variable costs per unit and the sales volume remain the same, how would you expect the change in fixed costs to affect (a) profit; and (b) the break-even point? How does the format of the income statement shown in Case Exhibits 2.12, 2.13 and 2.22 help internal decision makers perform cost–volume–profit (CVP) analysis? A business is considering two type of containers to package its product, one made of plastic and the other of biodegradable cardboard with native wild flower seeds embedded in the packaging, designed to germinate after disposal. A cost–volume– profit (CVP) analysis has been undertaken and the contribution margin per unit is $1 less with the biodegradable packaging. Should the business make the decision about which to use based on CVP alone, or can you think of other considerations? Complete the crossword puzzle below: 1 2

3

4 3 6

9

7

8

10

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Clues Across 2 Amount of uncertainty that exists about the future operations of a business 4 The ‘V’ in CVP analysis 6 The amount provided by the sale of a product after variable costs have been deducted 9 The S in GST 10 This type of cost changes in total in proportion to changes in volume of the cost driver Down 1 The point at which revenue equals total costs and neither a profit nor a loss is made 3 This type of cost does not change in total in response to changes in volume 5 The purpose of this plan is to identify the business’s capital requirements, sources of capital, and describe the business’s projected performance 7 A part of the business plan that details how the plan will be actioned 8 Triple bottom line (TBL) refers to reporting on economic, environmental and __________________________ aspects of a business

Applying your knowledge 2-20

2-21

2-22

2-23

2-24

74

Imagine that you are going to start your own business. Think about the concept for a minute. Required: What will you call your business? What kind of product or service will you sell? What price will you charge for your product(s) or service? Why? What variable costs and what fixed costs do you think you will incur? Suppose you want to start a business that sells sports equipment. Required: Go to the reference section of your library or use internet resources. What type of information can you find through Moody’s or Standard & Poor’s to help you prepare projected financial statements for your business? TLC Company sells a single product, a food basket (containing fruit, cheese, nuts and other items) that friends and family can purchase for university students who need ‘a little TLC’. This product, called the Exam-O-Rama, sells for $10 per basket. The variable cost is $6 per basket, and the total fixed cost is $24 000 per year. Required: Draw one graph showing TLC’s (i) total revenues; and (ii) total costs as volume varies. a Locate the break-even point on the graph. b What is TLC’s profit equation in terms of units sold? c What is TLC’s break-even point in units? ExamChoc Company sells a single product, a chocolate basket that friends and family can purchase for university students studying for their exams. This product, called the Exam-O-Choc, sells for $20 per basket. The variable cost is $14 per basket, and the total fixed cost is $48 000 per year. Required: Draw one graph showing ExamChoc’s (i) total revenues; and (ii) total costs as volume varies. a Locate the break-even point on the graph. b What is ExamChoc’s profit equation in terms of units sold? c What is ExamChoc’s break-even point in units? Bathtub Rings is a business that sells shower-curtain rings for $1.60 per box. The variable cost is $1.20 per box, and fixed costs total $20 000 per year. Required: a What is Bathtub Rings’ profit equation in terms of boxes of shower-curtain rings sold? b Draw a graph of Bathtub Rings’ (i) total contribution margin; and (ii) total fixed costs as volume varies. Locate the break-even point on this graph. c What is Bathtub Rings’ break-even point in units? d What would total profits be if Bathtub Rings sold 500 000 boxes of shower-curtain rings? e How many boxes of shower-curtain rings would Bathtub Rings have to sell to earn $50 000 of profit?

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Chapter 2 Developing a business plan: Cost–volume–profit analysis

2-25

2-26

2-27

2-28

Tube Rings is a business that sells inner tubes for $50 per box. The variable cost is $30 per tube, and fixed costs total $400 000 per year. Required: a What is Tube Rings’ profit equation in terms of inner tubes sold? b Draw a graph of Tube Rings’ total contribution margin and total fixed cost as volume varies. Locate the break-even point on this graph. c What is Tube Rings’ break-even point in units? d What would total profits be if Tube Rings sold 500 000 inner tubes? e How many inner tubes would Tube Rings have to sell to earn $100 000 of profit? Go Green is a business selling worm farm start-up kits for $12 each. This year, Go Green’s fixed cost totals $110 000. The variable cost per kit is $7. Required: a What is the break-even point in number of kits? b How many kits does Go Green need to sell to earn a profit of $70 000? c If the total fixed cost increases to $160 000 next year: i what will Go Green’s break-even point be in number of kits? ii what profit (or loss) will Go Green have if it sells 30 000 kits? iii how many kits will Go Green have to sell to earn a profit of $70 000? Green Grow is a business selling bags of organic fertiliser for $24 each. This year, Green Grow’s fixed cost totals $110 000. The variable cost per bag is $14. Required: a What is the break-even point in number of bags? b How many bags does Green Grow need to sell to earn a profit of $70 000? c If the total fixed cost increases to $160 000 next year: i what will Green Grow’s break-even point be in number of bags? ii what profit (or loss) will Green Grow have if it sells 30 000 bags? iii how many bags will Green Grow have to sell to earn a profit of $70 000? Silencer Company sells a single product, mufflers for leaf blowers. The business’s profit calculation for last year is shown here: Sales revenue (2000 units @ $25)

$ 50 000

Less: Variable costs

(20 000)

Contribution margin

$ 30 000

Less: Fixed costs Profit

(22 000) $ 8 000

Silencer has decided to increase the price of its product to $30 per muffler. The business believes that if it increases its fixed advertising (selling) cost by $3400, sales volume next year will be 1800 mufflers. Variable cost per muffler will be unchanged. Required: a Using the above income statement format, show the calculation of expected profit for Silencer’s operations next year. b How many mufflers would Silencer have to sell to earn as much profit next year as it did last year? c Do you agree with Silencer’s decision? Explain why or why not.

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Accounting Information for Business Decisions

2-29

Below is an income statement for Rosie’s Flowers, prepared for internal management use. Rosie’s Flowers Projected income statement For the year ended 31 December 20X9 Revenues: Sales (16 000 units)

$80 000

Less: Total variable costs

2-30

$20 000

Less: Total fixed costs

$ 8 000

Profit for year

$52 000

Required: Rewrite the income statement so that it is more useful for decision making. (Hint: There is a missing subtotal.) Below is an income statement for Rosie’s Flowers, prepared for internal management use. Rosie’s Flowers Projected income statement For the year ended 31 December 20X9 Revenues: Sales (16 000 units)

2-31

$80 000

Less: Total variable costs

$20 000

Less: Total fixed costs

$ 8 000

Profit for year

$52 000

Required: Rewrite the income statement using a contribution margin approach and a sales level of 20 000 units. Topsy’s Trailers makes small trailers for towing light loads. The business’s accountant has undertaken CVP analysis on its main product – the Tipping Trailer – and presented the results to the owner, Topsy, in the following profit graph: Profit graph – Tipping Trailer $1 200 000 $1 000 000 $800 000 $600 000 $400 000 $200 000 $–

0

50

100

150

200

250

300

350

400

450

Required: a Label the lines on the graph b Use the graph to determine: i the break-even point in units ii the fixed costs. c Use the break-even formula in units to determine the contribution per unit.

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Chapter 2 Developing a business plan: Cost–volume–profit analysis

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2-33

2-34

Rapunzel is a small business that currently sells a single product, shampoo, for $4 per bottle. The variable cost per bottle is $3. Rapunzel’s fixed costs total $6000. Required: a Calculate the following amounts for Rapunzel’s business: i contribution margin per bottle of shampoo ii break-even point in bottles of shampoo iii the profit that Rapunzel will earn at a sales volume of 25 000 bottles of shampoo iv the number of bottles of shampoo that Rapunzel must sell to earn a profit of $16 000. b Rapunzel is considering increasing its total fixed cost to $8000 and then also increasing the selling price of its product to $5. The variable cost per bottle of shampoo would remain unchanged. Repeat the calculations from (a) using this new information. Will this decision be a good one for Rapunzel? Why or why not? c Draw a graph with six lines to show the following: i total contribution margin earned when Rapunzel sells from 0 to 10 000 bottles of shampoo at a selling price of $4 per bottle ii total contribution margin earned when Rapunzel sells from 0 to 10 000 bottles of shampoo at a selling price of $5 per bottle iii Rapunzel’s fixed cost total of $6000 iv Rapunzel’s fixed cost total of $8000 v Rapunzel’s break-even point in bottles of shampoo before and after the selling price and fixed cost changes. d Does the graph support your conclusion in (b)? If so, how? If not, what new or different information did you get from the graph? Thumper is a small business that currently sells a single product, gluten-free bread, for $6 per loaf. The variable cost per loaf is $4. Thumper’s fixed costs total $6000. Required: a Calculate the following amounts for Thumper’s business: i contribution margin per loaf ii break-even point in loaves iii the profit that Thumper will earn at a sales volume of 25 000 loaves iv the number of loaves that Thumper must sell to earn a profit of $16 000. b Thumper is considering increasing its total fixed cost to $8000 and then also increasing the selling price of its product to $8. The variable cost per loaf would remain unchanged. Repeat the calculations from (a) using this new information. Will this decision be a good one for Thumper? Why or why not? c Draw a graph with six lines to show the following: i total contribution margin earned when Thumper sells from 0 to 10 000 loaves at a selling price of $6 per loaf ii total contribution margin earned when Thumper sells from 0 to 10 000 loaves at a selling price of $8 per loaf iii Thumper’s fixed cost total of $6000 iv Thumper’s fixed cost total of $8000 v Thumper’s break-even point in loaves before and after the selling price and fixed cost changes. d Does the graph support your conclusion in (b) above? If so, how? If not, what new or different information did you get from the graph? The Body Shop Equipment Company (BSEC) sells a small, relatively lightweight, multipurpose exercise machine. This machine sells for $700. A recent cost analysis shows that BSEC’s cost structure for the coming year is as follows: Variable cost per unit Total annual fixed costs

$

325 125 000

Required: a Draw a graph that clearly shows (i) total fixed cost; (ii) total cost; (iii) total sales revenue; and (iv) total contribution margin as the sales volume of exercise machines increases. Locate the break-even point on the graph. b Calculate the break-even point in number of machines.

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2-35

c How many machines must BSEC sell to earn $30 000 of profit per year? d How much profit would be earned at a sales volume of $420 000? e Sean McLean, the owner of BSEC, is considering travelling to visit a circuit of gyms and fitness centres around Australia each year to demonstrate the exercise machine, distribute information and obtain sales contracts. He estimates that this will cost about $6000 per year. How many additional exercise machines must the business sell per year to cover the cost of this effort? The Water Ski Equipment Company (WSEC) sells a small, relatively lightweight kneeboard. This kneeboard sells for $350. A recent cost analysis shows that WSEC’s cost structure for the coming year is as follows: Variable cost per unit Total annual fixed costs

2-36

78

$ 162.50 125 000

Required: a Draw a graph that clearly shows (i) total fixed cost; (ii) total cost; (iii) total sales revenue; and (iv) total contribution margin as the sales volume of exercise machines increases. Locate the break-even point on the graph. b Calculate the break-even point in number of machines. c How many machines must WSEC sell to earn $30 000 of profit per year? d How much profit would be earned at a sales volume of $420 000? e Sally Morgan, the owner of WSEC, is considering visiting a circuit of water-ski schools around Australia each year to demonstrate the kneeboard, distribute information and obtain sales contracts. She estimates that this will cost about $6000 per year. How many additional kneeboards must the business sell per year to cover the cost of this effort? Lady MacBath is a business selling bottles of dry-cleaning solvent (spot remover) for $10 each. The variable cost for each bottle is $4. Lady MacBath’s total fixed cost for the year is $3600. Required: a Answer the following questions about the business’s break-even point: i How many bottles of spot remover must Lady MacBath sell to break even? ii How would your answer to (a-i) change if Lady MacBath lowered the selling price per bottle by $2? What if, instead, it raised the selling price by $2? iii How would your answer to (a-i) change if Lady MacBath raised the variable cost per bottle by $2? What if, instead, it lowered the variable cost by $2? iv How would your answer to (a-i) change if Lady MacBath increased the total fixed cost by $60? What if, instead, Lady MacBath decreased the total fixed cost by $60? b Answer the following questions about the business’s profit: i How many bottles must Lady MacBath sell to earn $4800 profit? ii How would your answer to (b-i) change if Lady MacBath lowered the selling price per bottle by $2? iii Suppose that for every $1 the selling price per bottle decreases below its current selling price of $10 per bottle, Lady MacBath predicts sales volume will increase by 325 bottles. Assume that before lowering the selling price, Lady MacBath predicts that it can sell exactly 1400 bottles. Can Lady MacBath earn $4800 profit by lowering the selling price per bottle by $2? Explain why or why not. iv Suppose that for every $1 the selling price per bottle increases above its current selling price of $10 per bottle, Lady MacBath predicts sales volume will decrease by 200 bottles. Assume that before raising the selling price, Lady MacBath predicts that it can sell exactly 1400 bottles. Can Lady MacBath earn $4800 profit by raising the selling price per bottle by $2? Explain why or why not. v How would your answer to (b-i) change if Lady MacBath raised the variable cost per bottle by $2? What if, instead, it lowered the variable cost per bottle by $2? vi How would your answer to (b-i) change if Lady MacBath raised the total fixed cost by $60? What if, instead, Lady MacBath lowered the total fixed cost by $60?

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Chapter 2 Developing a business plan: Cost–volume–profit analysis

2-37

2-38

2-39

2-40

2-41

The Brickhouse Company is planning to lease a fuel-efficient, hybrid delivery van for its northern sales territory. It can choose to lease the van under three alternative plans: • Plan A: Brickhouse pays $0.34 per kilometre and buys its own fuel. • Plan B: Brickhouse pays $320 per month plus $0.10 per kilometre and buys its own fuel. • Plan C: Brickhouse pays $960 per month, and the leasing company pays for all fuel. The leasing company will pay for all repairs and maintenance, insurance, registration and so on. Fuel should cost $0.06 per kilometre. Required: Using kilometres driven as the units of volume, do the following: a Write out the cost equation for the cost of operating the delivery van under each of the three plans. b Graph the three cost equations on the same graph (put cost on the vertical axis and kilometres driven per month on the horizontal axis). c Determine at what kilometres per month the cost of Plan A would equal the cost of Plan B. d Determine at what kilometres per month the cost of Plan B would equal the cost of Plan C. e Calculate the cost, under each of the three plans, of driving 3 500 kilometres per month. Mallory Motors sells small electric motors for $2 each. Variable costs are $1.20 per unit, and fixed costs total $60 000 per year. Required: a Write out Mallory’s profit equation in terms of motors sold. b Draw a graph of Mallory’s total contribution margin and total fixed cost as volume varies. Locate the break-even point on this graph. c Calculate Mallory’s break-even point in units. d What total profit would Mallory expect if it sold 500 000 motors? e How many motors would Mallory have to sell to earn $40 000 profit? Simmons Kitchens sells small electric knives for $4 each. Variable costs are $2.40 per unit, and fixed costs total $60 000 per year. Required: a Write out Simmons’ profit equation in terms of knives sold. b Draw a graph of Simmons’ total contribution margin and total fixed cost as volume varies. Locate the break-even point on this graph. c Calculate Simmons’ break-even point in units. d What total profit would Simmons expect if it sold 500 000 knives? e How many knives would Simmons have to sell to earn $80 000 profit? Campcraft is a small manufacturer of camping trailers. The business manufactures only one model and sells the units for $2500 each. The variable costs of manufacturing and selling each trailer are $1900. The total fixed cost amounts to $180 000 per year. Required: a Calculate Campcraft’s contribution margin per trailer. b Calculate Campcraft’s profit (or loss) at a sales volume of 160 trailers. c Calculate the number of units that Campcraft must sell for it to break even. d Calculate the number of units that Campcraft must sell for it to earn a profit of $30 000. This year, Babco’s fixed costs total $110 000. The business sells recyclable one-litre thermos drink containers for $13 each. The variable cost per container is $8. Required: a Compute the break-even point in number of containers. b Compute the number of containers that Babco must sell to earn a profit of $70 000. c If the total fixed cost increases to $150 000 next year: i what will be Babco’s break-even point in containers? ii what profit (or loss) will Babco have if it sells 28 000 containers? iii how many containers will Babco need to sell to earn a profit of $70 000?

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2-42

2-43

The Cardiff Company sells a single product for $40 per unit. Its total fixed cost amounts to $360 000 per year, and its variable cost per unit is $34. Required: a Compute the following amounts for the Cardiff Company: i contribution margin per unit ii break-even point in units iii the number of units that must be sold to earn a $30 000 profit. b Repeat all calculations in (a), assuming Cardiff decides to increase its selling price per unit to $44. Assume that the total fixed cost and the variable cost per unit remain the same. You have worked out the following facts about three of your business’s products: A Expected number of unit sales

B 1 400

C 5 000

6 600

Sales price per unit

$

200

$

50

$

160

Variable cost per unit

$

80

$

10

$

120

Total fixed costs

$96 000

$120 000

$160 000

Target (desired) profit

$78 000

$ 75 000

$100 000

Required: Calculate: Contribution margin per unit Contribution margin ratio (%) Breakeven point in units Breakeven point in sales dollars Unit sales needed to achieve target profit Profit at expected sales level Will the product achieve/exceed the target profit with expected sales? Note: Try putting the information into a spreadsheet and using the CVP formulas to complete the table.

2-44

An internationally renowned professor specialising in management accounting has agreed to conduct a one-day seminar at a university for management executives. The head of the Graduate School initially offered the professor the regular compensation package of a business-class airfare and accommodation ($3000) and a $2000 lecture fee. The university will charge $260 for each executive attending the one-day seminar. The fixed costs for conducting the seminar will be as follows: Advertising in magazines

$ 4 000

Mailing of brochures

$ 3 000

Administrative labour

$ 2 000

Charge for use of lecture auditorium

$ 1 000 $10 000

The variable costs per participant attending the seminar are expected to be:

80

Meals and drinks

$25

Binders and photocopying

$35

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Chapter 2 Developing a business plan: Cost–volume–profit analysis

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2-46

Required: a Calculate the university’s break-even point in sales dollars if the professor accepts the regular compensation package of $3000 for expenses and a $2000 lecture fee. b Suppose the professor views the $2000 lecture fee as limiting his potential earnings, and has requested that he instead receive 50 per cent of the university’s net operating profit from the one-day seminar, and no other payments (including airfare and accommodation costs). The head of the Graduate School agrees after confirming that the professor is willing to pay his own airfare and accommodation (which will cost the professor $3000) and deliver the seminar irrespective of the number of executives signed up to attend. Calculate: i the number of executives who must attend in order for the professor to receive a total payment from the university of $6000 ii the minimum number of executives who must attend in order that the university does not make a loss on running the seminar (i.e. the professor receives no fee at all). Bellevue Amateur Dramatics club produces Shakespearian plays in a rural country setting. There are two productions every year and each production has five performances. The average performance sells 150 tickets. The cast are not paid; however, the director is paid $500 per year. Stage backdrops are made and painted locally by a TAFE art school which charges $400 for the two sets. Guests receive a programme and a ticket at a cost of $4 for printing per guest and also a complimentary drink at an average cost of $2 per guest. Members of the club act as staff for the performance and are paid $30 per show and each show needs three such students to help. The shows are popular and are always sold out in advance; tickets sell for $30 each. Required: a Calculate the annual fixed costs. b Calculate the variable expenses per show. c Calculate the contribution margin per ticket sold/patron. d Calculate the break-even point in terms of number of ticket sales/patrons. e Calculate the annual profit or loss of the business with the expected number of shows planned for the year. Doggy Day Care is a proposed new business venture that will look after pet dogs for their owners during the day while the dogs’ owners are at work. The following costs have been identified by the business owner: Annual registration of the business with the local council

$ 240

Annual lease costs for the new premises

$3 000

Utilities costs per month

$

30

Daily food costs per dog

$

2

Monthly salary for staff

$ 560

Other sundry daily expenses per dog

$

Monthly cleaning expenses for the business

$ 200

Proposed daily fee charged per dog per day

$

Number of days expected to be open per year

3

15 245

Expected number of dogs cared for per day

10

Required: a Calculate the annual fixed costs of the proposed business. b Calculate the variable expenses per dog. c Calculate the contribution margin per dog. d Calculate how many dogs would need to be cared for each year for the business to break-even. e Calculate the annual profit or loss of the business with the expected number of dogs in care currently expected.

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Making evaluations 2-47

2-48

2-49

2-50

Suppose your wealthy aunt gave you and your cousins $10 000 each. Assume for a moment that you are not associated with Cafe´ Revive, and that you are considering loaning the $10 000 to Cafe´ Revive. Required: From the information included in Cafe´ Revive’s business plan so far, do you think this would be a wise investment on your part? Why or why not? What else would you like to know before making a decision? (You don’t have to limit your thinking to Cafe´ Revive.) Refer to Question 2.47. What if your aunt instead gave you $100 000 and you were interested in investing this amount in Cafe´ Revive? Required: Would this change your answers to Question 2.47? Why or why not? The John Williams Company sells a single product – bush hats – for $24 per hat. The total fixed cost is $180 000 per year, and the variable cost per hat is $15. Required: a Compute the following amounts for the John Williams Company: i contribution margin per hat ii break-even point in hats iii the numbers of hats that must be sold to earn $27 000 profit. b Repeat all calculations in (a) assuming that John Williams decides to increase its selling price per hat to $25. Assume the total fixed cost and the variable cost per hat remain the same. c Do you agree with the John Williams Company’s decision to increase its selling price per hat? What other factors should the managers consider in making this decision? The Vend-O-Bait Company operates and services fishing-bait vending machines placed in service stations, motels and restaurants surrounding a large lake. Vend-O-Bait rents 200 machines from the manufacturer. It also rents the space occupied by the machines at each location where it places them. Arnie Bass, the business’s owner, has two employees who service the machines. Monthly fixed costs for the business are as follows: Machine rental: 200 machines  $100 per month

$20 000

Space rental: 200 locations  $60 per month

12 000

Employee wages: 2 employees  $800 per month Other fixed costs Total

1 600 2 400 $36 000

Currently, Vend-O-Bait’s only variable cost is the bait, which it purchases for $1.20 per pack. Vend-O-Bait sells this bait for $1.80 per pack. Required: a Answer the following questions: i What is the monthly break-even point (in packs sold)? ii Compute Vend-O-Bait’s monthly profit at monthly sales volumes of 52 000, 56 000, 64 000 and 68 000 packs, respectively. b Suppose that instead of paying $60 fixed rent per month, Arnie Bass could arrange to pay $0.20 for each pack of bait sold at each location to rent the space occupied by the machines. Repeat all calculations in (a). c Would it be desirable for Arnie Bass to try to change his space rental from a fixed cost ($60 per location) to a variable cost ($0.20 per pack sold)? Why or why not?

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Chapter 2 Developing a business plan: Cost–volume–profit analysis

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2-52

2-53

Refer to Question 2-36. Suppose your boss at Lady MacBath is considering some alternative plans and would like your input on the following three independent alternatives: i Increase the selling price per bottle by $3. ii Decrease the variable cost per bottle by $2 by purchasing an equally effective, but less environmentally-friendly solvent from your supplier. iii Decrease the total fixed cost by $1260. Assume again that Lady MacBath currently sells bottles of dry-cleaning solvent for $10 each, that the variable cost for each bottle is $4 and that the total fixed cost for the year is $3600. Required: a How many bottles would Lady MacBath have to sell to break even under each of the three alternatives? Using this accounting information alone, write your boss a memo in which you recommend an alternative. b Your boss would like to earn a profit of $4320. How many bottles would Lady MacBath have to sell to earn a profit of $4320 under each of the alternatives? Which of the three alternatives would you recommend to your boss? Is this consistent with your recommendation in (a)? Why or why not? What other issues did you consider when making your recommendation? Fred Sports manufactures trucks and four-wheel drive vehicles (4WDs). The company has announced that it plans to eliminate 1000 jobs (25% of its workforce) over the next three years. Fred Sports plans to achieve these job cuts through normal attrition, a freeze on hiring and an early-retirement program. The business had experienced years of losses, but predicted it would earn a profit as early as the following year. Required: a What effect would you expect this decision to have on (i) Fred Sports’ break-even point; (ii) the number of trucks and 4WDs that Fred Sports would have to sell to earn a desired profit? b What non-financial issues do you think Fred Sports’ owners had to resolve in order to make this decision? c What questions do you think the owners had to answer in order to resolve these issues? Suppose you work for the Miniola Hills Bus Company. The business’s 10 buses made a total of 80 trips per day on 310 days last year, for a total of 350 000 kilometres travelled. Another year like last year will put the business out of business (and you out of a job!). Your boss has come to you for help. Last year, instead of earning a profit the business lost $102 000, as shown below. Revenue from passengers (496 000 @ $0.50)

$ 248 000

Less: Operating costs Depreciation on buses

$100 000

Garage rent

20 000

Registrations, fees and insurance

40 000

Maintenance

15 000

Drivers’ salaries

65 000

Tyres

20 000

Petrol and oil

90 000

Loss

(350 000) ($102 000)

Your boss is considering the following two plans for improving the business’s profitability: – Plan A: Change the bus routes and reduce the number of trips to 60 per day in order to reduce the number of kilometres driven. – Plan B: Sell bulk bus tickets (five for $1.00) and student passes ($2.50 for a week’s use) in order to increase the number of passengers. Required: a Write your boss a memo discussing the effect that each of these plans might have on the costs and revenues of the company. Identify in your memo any assumptions you have made. b If you were making this decision, what questions would you like answered before making the decision? Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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2-54 2-55

2-56

Generally speaking, in the context of fixed and variable costs, if my company’s sales volume doubles, should I also expect my profits to double? Explain why or why not. Killweed sells weed killers. It is currently considering importing a weed killer for bindii (Soliva sessilis), a weed commonly found in grass, which produces painful prickly seeds, to replace its existing Australian made brand. The cost per litre of this imported weed killer is $1 compared with $2.50 for the commonly used weed killer for bindii manufactured in Australia. The selling price for the Australian made brand is $15 per litre. Import costs are $0.20 per litre for the new brand. Killweed currently sells 80 000 litres of bindii poison per year. Killweed estimates that it needs to spend $10 000 per annum advertising the new brand to achieve these sales levels and would have to sell the new spray for $1 less per litre. Required: a Calculate the contribution margin per unit for both bindii weed killers. b From a financial point of view, should Killweed replace their existing brand of weed killer with the new imported brand? Show calculations. c Are there any non-economic considerations that you can think of? d What course of action do you recommend, and why? Refer to Question 2-45 regarding Bellevue Amateur Dramatics. The drama club is uncertain about some of its estimates and wants to conduct some sensitivity analysis or ‘what if’ scenario analysis: Required: For each of the change in estimates listed below, calculate a new contribution margin per ticket sale (if appropriate), breakeven point in ticket sales and estimate a revised annual profit/loss. a The club is uncertain whether the director will continue next year unless he has a significant increase in his annual fee. They are considering offering him $4700 per year. b Alternatively the club could pay a different director the original planned amount, but if they do this they estimate that ticket sales will fall to 100 patrons/ticket sales per show. Which course of action is preferable economically – (a) or (b)? c A third alternative is to pay a different director the original planned amount but offer guests two complimentary drinks each instead one just one. If this is done they estimated that ticket sales will be 120 patrons per show. Is this worthwhile trying compared to options (a) and (b)?

Dr Decisive Yesterday, you received the following letter for your advice column at the local paper:

Dear Dr Decisive, What do you think about this situation? My boyfriend refuses to meet me for lunch until I admit I am wrong about this, which I’m not. The other day, when we went to lunch at the Pizza Place, a restaurant on campus, he noticed that they had raised the price of Hawaiian pizzas. He got mad because he thinks the only reason they raised the price was to increase their profit. I told him that, first of all, their profit might not increase. And second, he was basing his conclusion on some assumptions that might not be true, and if he would just open up his mind, he might see how those assumptions were affecting his conclusion. Well, then he got mad at me. I’m really upset because I know I’m right and because now I have to buy my own lunch. Will you please explain why I’m right? I know he’ll listen to you (he reads your column daily). Until you answer, I’ll be . . . ‘Starving’

Required: Meet with your Dr Decisive team and write a response to ‘Starving’.

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Chapter 2 Appendix: CVP analysis for cups of coffee

Endnotes a

United Nations Division for Sustainable Development (2001) Environmental Management Accounting Procedures and Principles. New York: United Nations, p. 7, https://sustainabledevelopment.un.org/content/documents/proceduresandprinciples.pdf. b Gibassier, D & Alcouffe, S (2018) ‘Environmental management accounting: The missing link to sustainability?’, Social and Environmental Accountability Journal, 38(1), 1–18. c Department of the Environment, Water, Heritage and the Arts (2009) Environmental Management System Tool: Guidance Notes. Canberra: Australian Government, 2. d Australia Business Financing Centre (n.d.) ‘$64,000 funding grant helps inventor turn dream into successful small business’, http://www.australiangovernmentgrants.org/articleview.php?id¼50&t¼64000-funding-grant-helps-inventor-turn-dream-into-successfulsmall-business. Accessed 26 May 2017. http://www.australiangovernmentgrants.org/articleview.php?id¼50&t¼64000-fundinggrant-helps- inventor-turn-dream-into-successful-small-business e Krantz, M (2000) ‘What detonated dot-bombs?’ USA Today, 4 December, 2A, 2B; Florian, E (2001) ‘Dead and (mostly) gone’. Fortune, 24 December, 46, 47; Chait, M (2002) ‘Is the dot com bust coming to an end?’, http://www.clickz.com/clickz/stats/ 1701286/is-dot-com-bust-coming-end. f Rovenpor, J (2004) ‘Explaining the e-commerce shakeout: Why did so many internet-based businesses fail?’ e-Service Journal, 3(1), 53–76; Cook, T (2001) ‘Collapse of Australia’s fourth largest telco adds to growing list of corporate failures’. World Socialist Website,http://www.wsws.org/ articles/2001/jun2001/onte-j08.shtml. g Razi, MA, Tarn, JT & Siddiqui, FA (2004) ‘Exploring the failure and success of DotComs’. Information Management & Computer Security, 12(3), 228–44. h Cook, T (2001) ‘Collapse of Australia’s fourth largest telco adds to growing list of corporate failures’. World Socialist Website, http://www.wsws.org/articles/2001/jun2001/onte-j08.shtml.

List of company URLs u u u u u

AusIndustry Programs: https://www.rdalc.org.au/wp-content/uploads/2016/01/AusIndustry_Programme_Summary_July_2016_002.pdf Austrade: https://www.austrade.gov.au Commonwealth Bank: http://www.commbank.com.au Moody’s: https://www.moodys.com/Pages/default_au.aspx Standard & Poor’s: https://www.standardandpoors.com/en_AU/web/guest/home

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APPENDIX CVP analysis for cups of coffee Fixed costs Recall from page 55–6 that the fixed cost of rent is divided equally between coffee gift packs and sale of cups of coffee. As you can see in Case Exhibit 2.17, the rent cost for the coffee-making will be $660 whether Cafe´ Revive sells 500 or 1000 cups of coffee.

Case Exhibit 2.17 Fixed cost behaviour – cups of coffee Total monthly rent cost $1 200 $900

$660 Rent cost

$600 $300 $0

100

500 Sales volume (in cups of coffee)

1 000

Just as with the sales of gift packs (see Case Exhibit 2.6), in Case Exhibit 2.17 we show a fixed cost as a horizontal straight line on the gra ph, indicating that the cost remains the same over different volume levels.

Variable costs Case Exhibit 2.18 shows the estimated total variable costs of cups of coffee sold by Cafe´ Revive at

different sales volumes. Total variable costs are shown by a straight line sloping upwards from the origin of the graph. This line shows that the total variable cost increases as volume increases. If no cups of coffee are sold, the total variable cost will be $0. Given that the variable cost per cup of coffee is calculated at $2.20, if 500 cups of coffee are sold, the total variable cost will be $1100. The slope of the line is the rate at which the total variable cost will increase each time Cafe´ Revive sells another cup of coffee. This rate is the variable cost per unit of volume sold – that is, $2.20 per cup of coffee. The equation for the variable cost line in Case Exhibit 2.18 is: Total variable cost of cups of coffee sold ¼ $2.20X Where X ¼ Sales volume.

86

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Chapter 2 Appendix: CVP analysis for cups of coffee

Case Exhibit 2.18 Variable cost behaviour – cups of coffee Total monthly variable cost $5 000 $4 500 $4 000 $3 500 $3 000 $2 500 $2 200 $2 000 $1 500 $1 100

osts

ble c

$1 936

Varia

$1 000 $500 $0

100

500 Sales volume (in cups of coffee)

880

1 000

Total costs Case Exhibit 2.19 shows the total costs for cups of coffee sales. At a sales volume of 500 cups of coffee, Cafe´ Revive’s share of estimated fixed costs for coffee cups is $2376 and its estimated variable costs are $1100 (500  $2.20), for an estimated total cost of $3476 at that volume. At a sales volume of 1000 cups of coffee, estimated fixed costs are still $2376 and estimated variable costs are $2200 (1000 

Case Exhibit 2.19 Total cost behaviour – cups of coffee $5 000 $4 576 $4 312 $4 000 $3 960 $3 476 ts

l cos

Tota

$3 000 $2 376

Fixed costs

$2 000

$1 000

$0

0

250

500 750 720 Sales volume – cups of coffee

880

1 000

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Accounting Information for Business Decisions

$2.20) and the estimated total cost is $4576. Case Exhibit 2.19 illustrates the total cost in relation to the sales volume of cups of coffee. Notice that if no cups of coffee are sold, the total cost will be equal to the fixed costs of $2376. As sales increase, the total cost will increase by $2.20 per cup, the amount of the variable cost per cup of coffee. The equation for the total cost line in Case Exhibit 2.19 is: Total cost of cups of coffee sold ¼ $2376 þ $2.20X Where X = sales volume.

Profit calculation The projected income statement is shown in Case Exhibit 2.20.

Case Exhibit 2.20 Projected income statement for external users – cups of coffee Cafe´ Revive Projected income statement – cups of coffee For the month ended 31 January 20X2 Revenues: Sales revenues – cups of coffee (880  $5.50)

$ 4 840

Expenses: Cost of coffee supplies used (880  $2.20) Rent expense Salaries expense

$1 936.00 660.00* 1 180.00

Consulting expense

165.00*

Advertising expense

115.50*

Depreciation expense: fixtures Mobile and wifi expense Utilities expense

79.50 71.50* 104.50*

Total expenses Net income

(4 312) $ 528

* These figures are GST-inclusive.

Profit graph The graph in Case Exhibit 2.21 shows the estimated total revenue line and the estimated total cost line for Cafe´ Revive’s cups of coffee. Note that the total revenue line crosses the total cost line at 720 cups of coffee. At this point, the total revenues will be 720 cups at $5.50 ¼ $3960, and the total costs will be variable costs of 720 cups at $2.20 ($1584) þ fixed costs of $2376 ¼ $3960. (These figures are GSTinclusive). At a sales volume of 880 cups of coffee, the graph in Case Exhibit 2.21 shows that Cafe´ Revive will earn a profit of $528 (as we computed in the income statement in Case Exhibit 2.20), the difference between the $4840 estimated total revenue and $4312 estimated total cost at this volume.

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Chapter 2 Appendix: CVP analysis for cups of coffee

Case Exhibit 2.21 Profit graph for Cafe´ Revive – cups of coffee $6 000 $5 500 $5 000 $4 840 $4 500 $4 312

Profit

Profit $528

$4 000 $3 960 $3 500

Break-even point

s

cost Total

$3 000 $2 500 Loss $2 000

es

nu

ve

re tal

To

$1 500 $1 000 $500 $0

0

100

200

300

400

500

600

Sales volume – cups of coffee

700

720

800

880

900

1 000

Contribution margin Recall that a more useful analysis of profit for internal managers of a business uses a contribution margin approach - relating the estimated revenues and estimated variable costs to the estimated fixed costs. Case Exhibit 2.22 shows an income statement containing the same information as given in Case Exhibit 2.20, but in a format that is more useful for internal decision makers in performing CVP analysis because it shows expenses as variable and fixed – that is, a contribution margin approach. In the income statement in Case Exhibit 2.22, Cafe´ Revive first calculates its estimated sales revenue for cups of coffee ($4840) by multiplying the number of cups of coffee it expects to sell (880) by the selling price per cup ($5.50). Cafe´ Revive next determines the total estimated variable costs of selling the 880 cups of coffee ($1936) by multiplying the number of cups it expects to sell (880) by the variable cost per pack of coffee ($2.20). These total variable costs are then subtracted from total sales revenue. The $2904 ($4840 – $1936) difference is the total contribution margin. Fixed costs are then deducted from this ($2904 – $2376) to work out net income (or profit) of $528. The per unit contribution margin for a cup of coffee is $3.30 ($5.50 sales revenue – $2.20 variable costs). At 880 units, the total contribution margin will be $2904 (880  $3.30), which is the same as that shown in Case Exhibit 2.22. The contribution margin percentage (contribution/selling price) would therefore be: $3.30/$5.50 ¼ 60% or $2904/$4840 ¼ 60%. Case Exhibit 2.23 shows what the total contribution margin will be at different unit sales volumes of cups of coffee. In this graph, since the contribution margin of one cup of coffee is $3.30, the total contribution margin increases at a rate of $3.30 per cup of coffee sold. For example, at a volume of 500 cups of coffee, the

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Accounting Information for Business Decisions

Case Exhibit 2.22 Projected income statement for internal users – cups of coffee (contribution margin approach) Cafe´ Revive Projected income statement – cups of coffee For the month ended 31 January 20X2 Total sales revenues ($5.50  880) cups of coffee

$ 4 840*

Less: Total variable costs Cost of cups of coffee sold ($2.20  880)

(1 936)*

Total contribution margin

$ 2 904

Less: Total fixed costs Rent expense Salaries expense

$ 660.00 1 180.00

Consulting expense

165.00*

Advertising expense

115.50*

Depreciation expense: display cases

79.50

Mobile and wifi expenses

71.50*

Energy expense

104.50*

Total fixed costs Net income

(2 376)* $ 528

* These figures are GST-inclusive.

contribution margin will be $1650 (500 cups  $3.30). At a volume of 1000 cups of coffee, the contribution margin will be $3300 (1000 cups  $3.30).

Showing CVP relationships We can show the estimated profit or loss at different sales volumes in a graph similar to Case Exhibit 2.15 for the coffee cup sales. Again we estimate total contribution margin at different sales volumes and compare this to the estimated $2376 fixed costs for the coffee cup sales, the difference being the profit (if the contribution is greater than the fixed costs) or loss (if contribution is less than the fixed costs). Case Exhibit 2.24 shows that Cafe´ Revive will earn $0 profit if it sells 720 cups of coffee as this is its breakeven point. Above the break-even unit sales volume (e.g. at a volume of 1000 cups of coffee), the total contribution margin ($3300) is more than the total estimated fixed costs ($2376), so there would be a profit ($3300 – $2376 ¼ $924). Below the break-even point (e.g. at a volume of 500 cups of coffee), the total contribution margin ($1650) is less than the total estimated fixed costs, so there would be a loss ($1650 – $2376 ¼ –$726).

Profit calculation (equation form) In Case Exhibit 2.20 we graphed the CVP relationships for Cafe´ Revive’s coffee cup sales, but recall that we can also use equations to understand CVP relationships. Cafe´ Revive’s projected income statement for coffee cup sales prepared for internal decision makers in Case Exhibit 2.22 used the format sales revenue (Unit selling x Estimated sales volume) less variable costs (Unit variable cost x That same sales volume) to

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Chapter 2 Appendix: CVP analysis for cups of coffee

Case Exhibit 2.23 Relationship between total contribution margin and unit sales volume – cups of coffee $4 000 $3 500

$3 300

$3 000 $2 500 $2 000 $1 650

n

argi

on m

uti ntrib

Co

$1 500 $1 000 $500 $0

100

500 Sales volume – cups of coffee

1 000

Case Exhibit 2.24 Cost–volume–profit relationships for Cafe´ Revive – cups of coffee $3 300

Contribution margin $3 000

Profit Total fixed costs

$2 376 $2 000

–$726

$1 650 $1 000 $0

$924 Break-even point

Loss 500 720 Sales volume – cups of coffee

1 000

work out total contribution margin. Then we subtracted the total fixed costs from the contribution margin to determine the estimated profit. In profit equation form, this is: 3 2 3 2 Total Variable Unit Profit Selling Unit (for a given ¼ 4 price 3 sales 5  4 cost 3 sales 5  fixed costs per unit volumes sales volume) per unit volumes Using X to stand for the volume of coffee cup sales, the equation is as follows: Profit ¼ $5:50X  $2:20X  $2 376 ¼ ð$5:50  $2:20ÞX  $2 376 ¼ $3:30X  $2 376 Recall that in the last line of the equation that for cups of coffee, the $3.30 is the contribution margin per unit. As a ‘shortcut’ when using the profit equation, we can use: 2 3 Total Profit Contribution Unit (for a given ¼ 4 margin 3 sales 5  fixed costs sales volume) per unit volume

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Accounting Information for Business Decisions

Using CVP analysis Estimating profit for coffee cup sales Suppose Emily wants you to estimate Cafe´ Revive’s monthly profit for cups of coffee if it sells 1000 cups of coffee (i.e. a unit sales volume of 1000 cups) a month. Remember that Cafe´ Revive’s selling price is $5.50 per unit and its variable cost is $2.20 per unit. You can estimate monthly profit when 1000 cups of coffee are sold in a month by using the profit equation, as follows: 2 3 2 3 Selling Unit Variable Unit Total Profit ¼ 4 price 3 sales 5  4 cost 3 sales 5  fixed per unit volume per unit volume costs ¼ ð$5:50 3 1000Þ  ð$2:20 3 1000Þ  $2376 ¼ $5500  $2200  $2376 ¼ $924 Thus, you can tell Emily that Cafe´ Revive will make a monthly profit of $924 if it sells 1000 cups of coffee a month. Or, using the ‘short cut’: 2 3 Profit Contribution Unit Total (for a given = 4 margin 3 sales 5  fixed sales volume) per unit volume Profit ¼ $3:30 3 1000  $2376 ¼ $924

Finding the break-even point for coffee cup sales Using the break-even equation, as follows: Unit sales volume (to earn zero profit) ¼

Total fixed costs Contribution margin per unit

You can also tell Emily that the break-even point is 720 cups of coffee (letting X stand for the unit sales volume): $2376 total fixed costs ($5:50 selling price  $2:20 variable) per unit $2376 X¼ $3:30 X ¼ 720 cups of coffee

Unit sales volume (to earn zero profit) ¼

You can verify the break-even sales volume of 720 cups of coffee with the following schedule: Total sales revenue (720 cups of coffee @ $5.50 per cup)

$ 3 960

Less: Total variable costs (720 cups of coffee @ $2.20 per cup) Total contribution margin (720 cups of coffee @ $3.30 per cup)

(1 584) $ 2 376

Less: Total fixed costs Profit

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(2 376) $

0

Chapter 2 Appendix: CVP analysis for cups of coffee

Finding the unit sales volume to achieve a target coffee cup sales profit Assume that Emily’s goal is for Cafe´ Revive to earn a profit of $528 per month for cups of coffee. How many cups of coffee must Cafe´ Revive sell per month to earn $528 for cups of coffee? Unit sales volume (to earn zero profit) ¼

Total fixed costs þ Desired profit Contribution margin per unit

So, if we let X stand for the unit sales volume, Cafe´ Revive needs to sell 880 cups of coffee to earn a profit of $528 a month, calculated as follows: $2376 þ $528 $3:30 per cup of coffee X ¼ 880 cup of coffee

X¼

You can verify the $528 profit with the following schedule: Total sales revenue (880 cups of coffee @ $5.50 per cup) Less: Total variable costs (880 cups of coffee @ $2.20 per cup) Total contribution margin (880 cups of coffee @ $3.30 per cup) Less: Total fixed costs Profit

$ 4 840 (1 936) $ 2 904 (2 376) $ 528

Since Emily had included the desired profit of $528 per month in Cafe´ Revive’s business plan, the income statement for internal decision makers shown in Case Exhibit 2.22 is an expanded version of the preceding schedule.

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3 DEVELOPING A BUSINESS PLAN: APPLIED BUDGETING

‘Adventure is the result of poor planning.’ Colonel John Nicholas Blashford-Snell

Learning objectives After reading this chapter, students should be able to do the following: 3.1 Understand why budgeting is needed to align business activities with strategy. 3.2 Understand the difference in operating cycles between retail and service businesses. 3.3 Understand that the interrelated budgets provide a framework for planning. 3.4 Know how the master budget is used to evaluate performance. 3.5 Understand that a budget should include all key values of the business.

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Chapter 3 Developing a business plan: Applied budgeting

Understanding the learning objectives is assisted in the chapter by asking key questions:

Key questions 1

How does a budget contribute to helping a business achieve its goals?

2

Do the activities of a business have a logical order that drives the organisation of a budget?

3

What is the structure of the budgeting process, and how does a business begin that process?

4

What are the similarities and differences between the master budget of a retail business and that of a service business?

5

After a business begins the budgeting process, is there a strategy it can use to complete the budget?

6

How can a manager use a budget to evaluate the performance of a business and then use the results of that evaluation to influence the business’s plans?

7

What key values of the business need to be taken into account in a budget

8

What non-economic goals might be included in Cafe´ Revive’s budget?

Unless you have been lucky enough to win the lottery, you probably have to budget your money. Think for a moment about where you get your money. Do you receive money from a job, a scholarship, financial aid, your parents or some combination of these sources? Now think about where you spend your money. You probably spend it on day-to-day living expenses such as food, rent, utilities and miscellaneous items, as well as on university-related costs such as course fees and textbooks. Budgeting helps you estimate when – and how much – cash will come in, and it also helps you figure out when – and how much – cash you will need to pay out. With these estimates, you can plan your activities so that you will have enough cash to cover them.

Discussion Suppose that, in budgeting your future cash payments, you realise that unless something changes, you will not have enough cash to pay your next car insurance bill. What alternatives do you have to solve this problem?

Businesses must budget their resources too. For most businesses, budgeting is a formal part of the ongoing planning process and periodically results in a set of related reports called budgets. A budget is a report that gives a financial description of one part of a business’s planned activities for the budget period. For example, a budget might show how many products the business plans to sell during the next year, the dollar amount of these sales and when the business will collect the cash from these sales. Another budget might show how much cash a business plans to spend during the same year renting business space, employing workers and advertising its products, as well as when the business plans to incur these costs.

budget Report that gives a financial description of one part of a business’s planned activity

3.1 Why budget? Budgeting is a tool to align the activities of the business with the strategy of the business. It will include both long- and short-term goals. Any aspect of the business considered key to its success should be included. Budgeting improves the planning, operating and evaluating processes by helping an entrepreneur to: • add discipline, or order, to the planning process • recognise and avoid potential operating problems • quantify plans • create a benchmark for evaluating the business’s performance. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions 1

How does a budget contribute to helping a business achieve its goals?

Budgeting adds discipline Businesses survive or fail because of the financial results of their activities. Therefore, before implementing planning decisions, effective entrepreneurs think carefully about what is likely to happen as a result of these decisions. That’s where budgeting comes in: the more complete and detailed the planning process, the easier it is for an entrepreneur to foresee what might happen. Budgets add discipline because of their orderliness and detail.

Budgeting highlights potential problems Using budgeting to describe a business’s plans allows the entrepreneur to uncover potential problems before they occur, and to spot omissions or inconsistencies in the plans. For example, you and Emily may plan for Cafe´ Revive to sell more gift packs and cups of coffee in February than during other months because of expected Valentine’s Day sales. Through the budgeting process, you may discover that unless something changes, Cafe´ Revive will not have enough coffee gift packs on hand in February to fill the expected customer orders. By seeing this problem ahead of time, you and Emily can adjust your purchase plans, perhaps preventing disappointed customers from having to go elsewhere to buy coffee gift packs. If you and Emily decide to purchase more gift packs and coffee in January and February because of expected increases in sales, Cafe´ Revive will also have a higher bill from DeFlava Coffee. You and Emily will need to plan to have enough cash on hand to pay the bill when it is due. This plan will show up in the part of the budget that shows expected purchases. The budgeting process helps the entrepreneur to see and evaluate how changes in plans affect different parts of a business’s operations.

Budgeting quantifies plans As we described in Chapter 2, a business plan includes all the operating activities needed to meet the business’s goals. A budget quantifies, or expresses in numbers, these operating activities and goals. For example, most businesses have a goal of earning a specific profit for the budget year. This is stated in their business plan. Recall from Chapter 2 that Cafe´ Revive included in its business plan a goal of earning a profit of $2112 per month from coffee gift packs and $528 from cups of coffee, or $31 680 (($2112 þ 528)  12) during the coming year. The CVP analysis included in the business plan in Chapter 2 indicates that to earn this profit, Cafe´ Revive must have monthly sales averaging 170 coffee gift packs and 880 cups of coffee, so during the year it must sell at least 2040 coffee gift packs (170  12) and 10 560 cups of coffee (880  12). Cafe´ Revive’s budget will indicate how many gift packs and how many cups of coffee it plans to sell each month of the year to meet its profit goal, and how many gift packs and how much coffee it must purchase each month to support its projected sales. Budgeting also quantifies the resources that the business expects to use for its planned sales and purchasing activities. For example, if Cafe´ Revive must purchase 300 coffee gift packs to cover its expected sales for any given month, the budget will indicate how much (and when) Cafe´ Revive expects to pay for these coffee gift packs. Likewise, with the cups of coffee, if Cafe´ Revive plans to sell 1000 cups of coffee in any given month, you and Emily will need enough coffee supplies (coffee granules, sugar, cups, spoons, etc.) to meet those expected sales. You will also need to establish that the business has enough funds to cover the cost when it falls due.

Budgeting creates benchmarks Since budgets help to quantify plans, an entrepreneur also uses budgets as benchmarks. The entrepreneur periodically compares the results of the business’s actual operating activities with the related budget amounts. These comparisons measure the business’s progress towards achieving its goals and help the entrepreneur to evaluate how efficiently the business is using its resources. The comparisons also help the entrepreneur to focus 96

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Chapter 3 Developing a business plan: Applied budgeting on what changes, if any, should be made to bring the business’s operating activities more in line with its goals. To save time and effort, the entrepreneur uses a management principle known as management by exception. Under this principle, the entrepreneur focuses on improving the activities that show significant differences (or exceptions) between budgeted and actual results. These activities have the greatest potential to positively influence the operations of the business. Entrepreneurs should focus on both the favourable and unfavourable differences so they can capitalise on opportunities as well as locate problem areas.

3.2 Operating cycles Earlier, we referred to the operating activities of a business. The operating activities of a business depend on whether it is a retail, service or manufacturing business because each business type has a different operating cycle. In budgeting, a business quantifies its planned activities in relation to its operating cycle. This process is similar to when you prepare your personal budget for the semester. Before we get into the details of budgeting, we will briefly discuss the operating cycles of retail and service businesses.

management by exception Management principle where an entrepreneur or manager focuses on improving the activities that show significant differences between budgeted and actual results

2

Do the activities of a business have a logical order that drives the organisation of a budget?

A retail business’s operating cycle The operating cycle of a retail business is the average time it takes the business to use cash to buy goods for sale (called inventory), to sell these goods to customers and to collect cash from customers. Cafe´ Revive’s operating cycle is the time it takes to pay cash to purchase coffee gift packs from DeFlava Coffee, to sell these gift packs to customers and to collect the cash from customers. DeFlava Coffee allows Cafe´ Revive to ‘charge’ its purchases of coffee gift packs. These purchases are made on ‘charge accounts’ set up directly between Cafe´ Revive and DeFlava Coffee; they are not made on credit cards. From Cafe´ Revive’s perspective, these are called credit purchases, and they result in accounts payable. Similarly, although most of Cafe´ Revive’s sales are cash sales, it also allows some of its customers to ‘charge’ their purchases of coffee gift packs and allows the university’s lecturers to run an account for their cups of coffee. From Cafe´ Revive’s perspective, sales to these customers are called credit sales, and they also result in accounts receivable.

operating cycle of a retail business The average time it takes a retail business to use cash to buy goods for sale (called inventory), to sell these goods to customers and to collect cash from its customers

Stop & think What do you think Cafe´ Revive’s credit sales to customers are called from the customers’ perspective? Cafe´ Revive will pay cash for its accounts payable to DeFlava Coffee within 30 days of the purchases. Similarly, Cafe´ Revive will collect cash from customers’ accounts receivable within 10 days after their purchases of coffee gift packs or cups of coffee. We will talk more about how a business decides to extend credit to customers later in this chapter and in Chapter 6. Case Exhibit 3.1 shows Cafe´ Revive’s operating cycle. As you will see later, Cafe´ Revive’s budgeting process quantifies its operating cycle and its other activities.

A service business’s operating cycle Service businesses have a budgeting process that is very similar to that of retail businesses. One major difference between these two types of businesses, however, involves their operating cycles. The operating cycle of a service business is the average time it takes the business to use cash to acquire supplies and services, to sell the services to customers and to collect cash from customers. Case Exhibit 3.2 shows the operating cycle of Express Transfer Company, a shipping company hired by DeFlava Coffee to ship its coffee to Cafe´ Revive and other retail businesses around the country. This operating cycle may be shorter than that of a retail business because there is no inventory to purchase.

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operating cycle of a service business The average time it takes a service business to use cash to acquire supplies and services, to sell the services to customers and to collect cash from its customers

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Accounting Information for Business Decisions Case Exhibit 3.1 Cafe´ Revive’s operating cycle Cash sources

Cash

Collection of cash Accounts receivable

Cash purchases of Credit purchases of coffee gift packs or coffee gift packs and coffee supplies and coffee supplies

Credit sales of Cash sales of coffee gift packs or coffee gift packs and coffee supplies and coffee supplies

Accounts payable

Coffee gift packs and coffee supplies

Payment of cash

Case Exhibit 3.2 Express Transfer Company’s operating cycle Cash sources

Cash

Collection of cash

Deliveries for cash

Deliveries on credit

Accounts receivable

Advertising campaigns for Weet-Bix have been around for decades. Do you think the agency’s operating cycle is that long?

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The operating cycle for some service businesses can be much longer than the cycle for most retail businesses because, for certain service businesses, one service or job can take months or years. For example, think about the longevity of some of the advertising campaigns you have observed recently – for example, Weet-Bix (cereal) and the Energizer Bunny (batteries) have been around for decades, and is still being used, although the 1989 Energizer Bunny may be introducing Dancing Bots on YouTube in 2019! Many service companies with lengthy jobs try to shorten their operating cycles by periodically collecting payments from their customers for completed segments of the work. Express Transfer’s operating cycle, on the other hand, might average only two or three days, since it delivers perishable coffee to businesses in the same city in which DeFlava Coffee’s factory is located, as well as to businesses around the country. The length of Express Transfer’s operating cycle depends on Express’s collection

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Chapter 3 Developing a business plan: Applied budgeting policies and when it expects to be paid by its customers. Like Cafe´ Revive, Express Transfer quantifies its operating cycle and other activities in a budget.

Stop & think How long do you think a university’s operating cycle is? What are the components of its operating cycle?

3.3 The budget as a framework for planning Budgeting is most useful in decision making when it is organised to show different aspects of operations. The master budget is the overall structure a business uses to organise its budgeting process. It is a set of interrelated reports (or budgets) showing the relationships among a business (Exhibit 3.3). A business includes the master budget with the CVP analysis in the financial plan section of its business plan (refer to Chapter 2). Exhibit 3.3 Elements of the master budget

1

Goals to be met

2

Activities to be performed in its operating cycle

3

Resources to be used

4

Expected financial results

3

What is the structure of the budgeting process, and how does a business begin that process? master budget Set of interrelated reports showing the relationships among a business’s goals to be met, activities to be performed, resources to be used and expected financial results

The individual budgets in the master budget may be different from business to business. These differences are due to the number of different products each business sells, the varying sizes and complexities of the businesses and their operations, and whether it is a retail, service or manufacturing business. Regardless of the differences, each master budget describes the relationships among a business’s goals, activities, resources and results. A master budget for a retail business usually includes the following budgets and projected financial statements: 1 sales budget 2 purchases budget 3 selling expenses budget 4 general and administrative expenses budget 5 cash budget (projected cash flow statement) 6 projected income statement 7 projected balance sheet.

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Accounting Information for Business Decisions 4

What are the similarities and differences between the master budget of a retail business and that of a service business?

projected balance sheet Statement summarising a business’s expected financial position (assets, liabilities and owner’s equity) at the end of a budget period

A service business’s master budget does not include a purchases budget, and usually combines the expenses budgets. A manufacturing business’s master budget includes additional budgets related to its manufacturing activities – for example, direct material purchases, direct labour and cost of goods sold. A business prepares its annual master budget for a year or more into the future. It breaks down the master budget by each budget period – generally by quarter (three-month period). Within each quarter, it shows the budget information on a monthly basis. Some businesses develop budgets for each department, which they then combine to form a master budget. For example, Kmart (http://www.kmart.com.au) might develop budgets for women’s apparel, homewares, bed and bath accessories, and stationery. Exhibit 3.4 shows the important relationships among the reports in the master budget of a retail business like Cafe´ Revive. Notice that the last budgets prepared in a business’s budgeting process are the projected financial statements for the budget period: the cash budget (also called a projected cash flow statement) and the projected financial statements (projected income statement and projected balance sheet). The projected financial statements give managers a ‘preview’ of what the business’s actual financial statements should look like at the end of the budget period if everything goes according to plan. The information for these projected financial statements comes from the other budgets.

Exhibit 3.4 Interrelationships among budget schedules in the master budget – retail

Purchases budget

Cash budget (projected cash flow statement)

Selling expenses budget

Projected income statement

General and administrative expenses budget

Projected balance sheet

Sales budget

We will discuss the nature and the relationships among Cafe´ Revive’s budgets to illustrate how a retail business plans and describes its operating activities. Since Cafe´ Revive is a small business, the illustrations will be simple. The larger a business is, the more complex and detailed its budget reports must be in order to be useful. Often, though, managers of large businesses prepare summaries similar to the simpler budgets that we use in this chapter. Large manufacturing businesses, like Sanitarium (https://www.sanitarium.com.au), the manufacturer of Weet-Bix, would have more budgets, as is shown in Exhibit 3.5. When you look at the budgets for Cafe´ Revive, try to understand the logic of their development and how they interrelate. As you study the budgets, remember the following ‘start-up’ information from Chapter 2. Note that the monetary figures used in this chapter are GST-inclusive (refer to Chapter 2). During December 20X1, Emily plans to: • invest $20 000 in Cafe´ Revive • rent shop space for $1320 per month, paying $7920 in advance for six months’ rent • buy $1650 of shop equipment by making a $250 down-payment and signing a note payable (a loan) for the remaining amount • order 50 coffee gift packs from DeFlava Coffee for $1430, to be paid for in January 20X2 • purchase and pay for $2255 of coffee supplies. In discussing each of Cafe´ Revive’s budgets in the following sections, we will also briefly discuss the corresponding budget for Express Transfer, a service business.

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Chapter 3 Developing a business plan: Applied budgeting Exhibit 3.5 Interrelationships among budget schedules in the master budget – manufacturing Selling expenses budget Capital expenditures budget General and administrative expenses budget Sales budget

Production budget

Direct materials purchases budget

Cash budget (projected cash flow statement)

Direct labour budget

Projected income statement

Factory overhead budget

Projected balance sheet

The sales budget The budgeting process begins with the sales budget because product sales/service contracts affect all the other operating activities of a business. (Without sales of coffee, why would Cafe´ Revive be in business? Without arrangements with DeFlava Coffee and other businesses to ship coffee and other goods, why would Express Transfer exist?) A retail business without sales would not need employees, inventory, retail space, shop equipment, supplies, advertising or utilities. As you will soon see, the same is true for a service business. For this reason, the sales budget affects all the other budgets. It is the cornerstone of the budgeting process.

5

After a business begins the budgeting process, is there a strategy it can use to complete the budget?

The retail business’s sales budget For a retail business, the sales budget shows the number of units of inventory that the business expects to sell each month, the related monthly sales revenue and the months in which the business expects to collect cash from these sales. To estimate the number of units of inventory it will sell in each month, a business gathers various types of information, such as past sales data, industry trends and economic forecasts. If Cafe´ Revive were an older business, you and Emily might analyse its past sales trends to get an idea about what sales level to expect for the future. You and Emily should consider the current economic conditions or circumstances that are affecting the coffee industry. For example, if the economy has worsened and people are struggling to put food on the table, customers may view the purchase of coffee as a luxury, and sales may drop regardless of the level of past sales. On the other hand, if the economy is improving, people may have extra income to spend (disposable income) and sales of coffee may increase. New findings and breakthroughs can also affect sales. For example, in 2011 Di Bella Coffee (http://dibellacoffee.com) began to manufacture TORQ Natural Instant Coffee, a liquid coffee concentrate designed for use wherever a specialty coffee option is needed – for instance, while camping, at conferences and in other corporate hospitality contexts. To add to its range of coffee solutions, the company also introduced a range of Nespresso¤-compatible specialty coffee capsules.a Do you think that after Di Bella Coffee marketed its coffee concentrates, sales of these products would have affected sales of other coffees the company already had on the market? Marketing Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

sales budget Budget showing the number of units of inventory that a business expects to sell each month, the related monthly sales revenue, and the months in which the business expects to collect cash from these sales

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Accounting Information for Business Decisions should not be static, but part of the plan – and budget – for the future. In 2018, Di Bella merged four businesses to expand in the United States and New Zealand, and now sells related products such as teas, hot chocolate and sugar. Businesses need adaptable plans to be able to respond to changing circumstances, such as the increase in Di Bella’s online sales in response to the Covid-19 restrictions imposed in 2020.

Stop & think How do you think a well-publicised discovery that sugar was actually good for people would affect your prediction of coffee sales for the next year? Market analysts or consultants are another source of information about the estimated number of products to be sold. Although Emily has a marketing degree, she is busy getting the business up and running, and you are only able to work at the business part time, given your university commitments. Therefore, she has hired Briana Small (see Case Exhibit 2.3 in Chapter 2), a consultant, to study the market for gift-packed coffee in the area north of the university campus and to provide an analysis of it, including a report on the effect that different prices would have on potential sales of the coffee. Briana’s research should help Emily to predict sales during Cafe´ Revive’s first year of operations. Large businesses have additional sources of market information, including their sales teams, and marketing and advertising specialists. After a business has estimated the amount of inventory it expects to sell, it determines its estimated sales revenue by multiplying the number of units of inventory it expects to sell by the unit selling price. After calculating its monthly estimated sales revenue, the business determines how much cash it expects to collect each month from sales. If all sales are cash sales, the cash to be collected each month is equal to the sales revenue of that month. For most businesses, however, a portion (sometimes substantial) of their sales consists of credit sales. If a business allows credit sales, its cash collections of accounts receivable will lag behind its sales revenues.

Stop & think What do you think is the difference between cash sales and sales revenue? Are they the same thing? The credit-granting policy of a business can have a major impact on the amount of time between the sale of its product and the collection of cash from that sale. You and Emily would certainly not grant credit to a customer with a poor credit history because there would be a good chance that the customer would either pay you a long time after the sale, pay you only part of the bill or not pay you at all. Many businesses spend a lot of time and effort studying the paying habits of their customers and deciding on an appropriate credit-granting policy. The goals are to shorten the amount of time between sales and collections of cash, and to reduce the risk of not being able to collect from customers. At the same time, businesses don’t want an overly restrictive credit policy that discourages customers from buying on credit.

Stop & think What information about a customer do you think would be helpful in Cafe´ Revive’s decision about whether or not to grant the customer credit? You and Emily have decided to grant credit for sales of coffee gift packs to a few nearby businesses in the hope that they will make numerous purchases. In the future, you aim to extend credit for sales of cups of coffee to trusted customers, but at this early stage cups of coffee will be purchased as cash sales only. To start, you estimate that the coffee gift pack credit sales will be about 6 per cent of total sales. You have also decided to give these credit customers terms of n/10 (net 10), which means that they will pay 102

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Chapter 3 Developing a business plan: Applied budgeting Cafe´ Revive within 10 days of when they make credit purchases. You selected n/10 because Cafe´ Revive is a new business and Emily does not think the business should wait more than 10 days to receive cash from its credit customers. Because of this policy, Cafe´ Revive will collect roughly two-thirds of each month’s coffee gift pack credit sales in the month of the sales, and the remaining one-third of the credit sales in the following month. Case Exhibit 3.6 shows the relationship between Cafe´ Revive’s January coffee gift pack credit sales and its cash collections from these sales. It shows that the sales revenue is earned at the time of the credit sale. However, the cash collection from the credit sale occurs 10 days after the sale takes place. As you can see in the exhibit, cash collections from January credit sales occur partly in January and partly in February. For instance, the cash collections from the 1 January credit sales occur on about 11 January, and the cash collections from the credit sales on 31 January occur on about 10 February. Case Exhibit 3.7 shows the sales budget of Cafe´ Revive for the first quarter of 20X2 for coffee gift packs. Case Exhibit 3.8 shows the sales budget of Cafe´ Revive for the first quarter of 20X2 for cups of coffee. The sales amounts are based on Briana Small’s market analysis. Notice that the exhibit shows budgeted sales for each month in both units (coffee gift packs, cups of coffee) and dollars of sales revenue, and that the monthly sales amounts are added across to show the quarter totals (620 units and $34 100 sales revenue for coffee gift packs, and 2900 units and $15 950 sales revenue for cups of coffee). Also notice that the sales budget for coffee gift packs divides total sales each month between cash sales and credit sales. Case Exhibit 3.6 Relationship between credit sales and cash collections Date of:

January

February

Sales revenues 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31

Cash collections

11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 1 2 3 4 5 6 7 8 9 10

Stop & think How do you think dividing total monthly sales between cash sales and credit sales helps in the creation of the rest of the sales budget?

The service business’s sales budget The sales budget of a service business is very similar to the sales budget of a retail business, except that the former is selling services rather than products. When Express Transfer budgets its sales, it is budgeting sales of delivery services. Expected cash collections from customers depend on Express’s collection policies. For example, Express may expect to be paid by its customers when it picks up merchandise that customers want to ship. On the other hand, Express may expect to be paid by its customers only after it delivers the customers’ merchandise. Also, Express may grant credit to some of its customers – a policy that will also affect the timing of its cash receipts. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions Case Exhibit 3.7 Sales budget – coffee gift packs CAFE´ REVIVE Sales budget – coffee gift packs First quarter 20X2 January Budgeted total unit sales – coffee gift packs

February 170

March 250

55

$

55

Quarter 200

Budgeted selling price per gift pack

$

Budgeted total sales revenue

$9 350

$13 750

$11 000

$34 100

Budgeted cash sales (94% of total sales revenue)

$8 789

$12 925

$10 340

$32 054

825

$

55

620

$

$

55

Budgeted credit sales (6% of total sales revenue)

$ 561

$

660

$ 2 046

Budgeted total sales revenue

$9 350

$13 750

$11 000

$34 100

From cash sales

$8 789

$12 925

$10 340

$32 054

From January credit sales (2/3; 1/3)

$ 374*

Expected cash collections: $ 187*

From February credit sales

$ 550*

From March credit sales Total cash collections

$9 163

$13 662

$

561

$ 275*

$

825

$ 440*

$

440

$11 055

$33 880

* Cafe ´ Revive estimates that it will collect two-thirds of each month’s credit sales during the month of sale. It will collect the remaining one-third in the month following the sale. All figures rounded to the nearest dollar.

Case Exhibit 3.8 Sales budget – cups of coffee CAFE´ REVIVE Sales budget – cups of coffee First quarter 20X2 January Budgeted total unit sales – cups of coffee

February

March

Quarter

880

1 320

700

2 900

Budgeted selling price per cup

$ 5.50

$ 5.50

$ 5.50

$ 5.50

Budgeted total sales revenue

$ 4 840

$ 7 260

$3 850

$15 950

Total cash collections

$4 840

$7 260

$3 850

$15 950*

* Cafe ´ Revive does not intend at this stage to allow customers to buy cups of coffee on credit therefore the sales figure for the month should be the same as the cash collected, as they are all cash sales. This may change in the future if it allows credit terms for regular customers.

Discussion In the mid-2000s, Jetstar began flying from Brisbane, Queensland, to Newcastle, New South Wales. Suppose the fare for the trip at that time was $49 plus taxes. How do you think Jetstar would have budgeted its cash receipts?

Seasonal sales Some businesses’ sales occur evenly throughout the year, while other businesses experience seasonal sales – that is, these businesses’ customers purchase the inventory or services more often in some months than in others. The sale of water-ski apparel is an example of seasonal sales. Although water-ski shops sell inventory throughout the year, most of their sales occur immediately before and during summer. 104

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Chapter 3 Developing a business plan: Applied budgeting A business offering water-skiing lessons (a service) may not even be open during the winter. The sale of coffee is not as extreme, but it does have some seasonality. For Cafe´ Revive, monthly sales differences during its first quarter reflect an expected increase in sales as Valentine’s Day approaches.

Stop & think What other seasonal effects would you expect for Cafe´ Revive? Will sales be influenced by the location?

The retail business’s purchases budget Once a business has estimated (budgeted) its unit sales for each month of the quarter, it can determine the best approach to purchasing the needed inventory. Cafe´ Revive expects to sell 620 coffee gift packs and 2900 cups of coffee this quarter (from the sales budgets in Case Exhibits 3.7 and 3.8. You may now be wondering how many of those gift packs Cafe´ Revive should be ordering. In making this purchase decision, you should consider several factors. First, there are the costs of keeping the business’s money invested in inventory (rather than investing it somewhere else), storing and handling inventory, and paying for insurance and taxes on inventory. Higher inventory levels also increase the risk of theft, damage and obsolescence. If Cafe´ Revive holds too many coffee gift packs, you and Emily risk either selling coffee that is not fresh, and thereby losing future customers, or having to throw away old coffee. (Or, with more coffee around, you may be more tempted to drink the inventory!) There is also a physical limit to the number of gift packs you can stock in the cafe´. For these reasons, some businesses use just-in-time (JIT) inventory systems, in which they purchase inventory only when an order has been placed and they need it immediately. On the other hand, it can also be very expensive not to carry enough inventory (which is called stockout). For example, if Cafe´ Revive starts running low on coffee, it may have to pay Express Transfer higher shipping costs for rush orders or pay DeFlava Coffee higher costs per gift pack for smaller, lastminute orders. You may also risk alienating customers if you run out of inventory. Every business must plan its own inventory levels while considering the costs of both carrying and not carrying inventory, and trying to keep the combined total at the lowest possible amount. Even though the purchases budget does not address all the above factors, it will help you and Emily make the best purchase decision. The purchases budget shows the purchases (in units) required in each month to make the expected sales (from the sales budget) in that month and to keep inventory at desired levels. It also shows the costs of these purchases and the expected timing and amount of the cash payments for these purchases. Frequently, businesses set desired end-of-month inventory levels at either a constant percentage of the following month’s budgeted unit sales or at large enough levels to meet future sales for a specified time. Since many businesses base their purchase orders on sales estimates, they want to have extra inventory available to sell in case they have underestimated their sales, or in case their next shipment of inventory arrives later than expected. You and Emily plan to order coffee from DeFlava Coffee once every month. Emily has also decided that, during any month, Cafe´ Revive should have enough coffee on hand to cover that month’s coffee sales, and also to have an ending inventory large enough to cover one-fifth (20%) of the next month’s sales of gift packs and half (50%) of the next month’s sales of coffee cups. For example, projected sales for the first quarter of 20X2 (from the sales budgets in Case Exhibits 3.7 and 3.8) and for April (from projections for the second quarter) are as follows:

Budgeted total unit sales – coffee gift packs

Budgeted total unit sales – cups of coffee

January

February

March

April

170

250

200

225

January

February

March

April

880

1320

700

1200

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purchases budget Budget showing the purchases (in units) required in each month to make the expected sales in that month (from the sales budget) and to keep inventory at desired levels

105

Accounting Information for Business Decisions Based on Emily’s purchasing policy, Cafe´ Revive must have enough inventory during January to equal budgeted sales for January plus one-fifth (20%) of budgeted gift pack sales for February, or 220 coffee gift packs (170 packs þ (20%  250)). The ending inventory estimate would be rounded up to a whole number as necessary because Cafe´ Revive cannot buy part of a gift pack. (Then if Cafe´ Revive sells 170 gift packs during January, it will have inventory at the end of January equal to one-fifth or 20% of February’s budgeted sales in units.) Since Cafe´ Revive will start business in January with the 50 coffee gift packs purchased in December, January purchases must be 170 gift packs (220 total packs needed – 50 packs already on hand). Cafe´ Revive uses the same calculations to determine each month’s purchases of coffee gift packs. Case Exhibit 3.9 illustrates how budgeted purchases and budgeted sales for coffee gift packs are linked together for the first quarter of the year. A similar schedule would be developed for the purchase of coffee supplies (see Case Exhibit 3.10). Case Exhibit 3.9 The link between budgeted purchases and budgeted sales – coffee gift packs First quarter 20X2 December Budgeted sales*

January

February

March

April

170 gift packs

250 gift packs

200 gift packs

225 gift packs

× ¹⁄5 34

Budgeted purchases

× 4⁄5 136

× ¹⁄5 + 50

× 4⁄5 200

× ¹⁄5 + 40

× 4⁄5 160

50 gift packs#

186 gift packs#

240 gift packs

205 gift packs

December

January

February

March

× ¹⁄5 + 45

April

First quarter 20X2 *From Case Exhibit 3.7, except April, which was estimated as part of second-quarter projections. #Ordered 50 instead of 34 because of the difficulty of estimating sales for the first month of a start-up business and because

Café Revive did not want to run out of stock. Café Revive would only need to purchase 170 gift packs in January (186 – the extra 16 from December (50 – 34)) if they keep to the budget.

Case Exhibit 3.10 The link between budgeted purchases and budgeted sales – cups of coffee First quarter 20X2 December Budgeted sales*

January

February

March

April

880 cups of coffee

1 320 cups of coffee

700 cups of coffee

1 200 cups of coffee

×½ 440#

Budgeted purchases

×½ ×½ 440# + 660

×½ 660

×½ + 350

×½ 350

1 025 cups of coffee

1 100 cups of coffee#

1 010 cups of coffee

950 cups of coffee

December

January

February

March

×½ + 600

April

First quarter 20X2 *From Case Exhibit 3.8, except April, which was estimated as part of second-quarter projections. Figures are rounded for simplicity. # Ordered 1 025 instead of 440 (585 extra) because Café Revive did not want a stockout situation.

The excess (1 025 – 440 = 585) reduces those required in January to 515 (1 100 – 585).

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Chapter 3 Developing a business plan: Applied budgeting

Stop & think What do you think are the advantages of Emily’s plans to order coffee once per month rather than more often? Normally, Cafe´ Revive will make purchases during the first week of each month and receive delivery of the purchases at the beginning of the second week of the month. However, since Cafe´ Revive will open for business in January, Emily has chosen to purchase 50 coffee gift packs in mid-December so that these will be available to sell on the first day of business in January. (Note that the 50 is more than the required onefifth or 20%, of January [34] as Emily was concerned that the sales estimate for January might not be accurate, as it is hard to predict for a start-up business, and she wanted to avoid any possible stock shortages. No sales of coffee will occur in December, so the amount of coffee that Cafe´ Revive purchases in December will still be in Cafe´ Revive’s inventory at the end of December (and at the beginning of January). Case Exhibit 3.11 shows the purchases budget of Cafe´ Revive for the first quarter of 20X2 for coffee gift packs. Remember that Cafe´ Revive wants to purchase enough gift packs each month to meet budgeted sales during the month, and to have enough gift packs left at the end of the month to cover one-fifth or 20 per cent of the next month’s sales. These gift packs must come from the inventory on hand at the beginning of the month and from any purchases that the business makes during the month. By subtracting the budgeted beginning inventory from the total inventory required for any given month, you can determine how many purchases (in gift packs) to budget for that month. Since purchases are a variable cost, the cost of coffee gift packs purchased is determined by multiplying the number of gift packs by $28.60 per unit. Since Cafe´ Revive has an agreement with DeFlava Coffee to pay for its purchases within 30 days of the purchases, the payment for each month’s purchase is budgeted for the following month. For instance, the budgeted January purchase of 170 coffee gift packs costing $28.60 per pack amounts to a total purchase cost of $4862, which is budgeted to be paid in February. A similar budget would be prepared for the supplies for the cups of coffee, but with one half of the next month’s sales as the desired level of ending inventory (see Case Exhibit 3.12). Case Exhibit 3.11 Purchases budget – coffee gift packs CAFE´ REVIVE Purchases budget First quarter 20X2 January Budgeted total unit sales (coffee gift packs) Add: Desired ending inventory of coffee gift packs* Total gift packs required Less: Beginning inventory of coffee gift packs§ Budgeted purchases of coffee gift packs

February

March

170

250

50

40

220

290

Quarter 200 45  245

620 45à 655

(50)*

(50)

(40)

(50)**

170

240

205

615

Purchase price per coffee gift packs

$28.60

$28.60

$28.60

$ 28.60

Cost of purchases

$4 862

$6 864

$5 863

$17 589

Cash payments for purchases

$1 430{

$4 862

$6 864

$13 156

* The desired ending inventory is 1/5 or 20% of next month’s budgeted sales. † April’s budgeted sales are 225 coffee gift packs, therefore March-ending inventory equals (225  1/5). ‡ The desired ending inventory at the end of the quarter is the same as the desired ending inventory at the end of March (which is the end of the quarter). § The beginning inventory is the same as the previous month’s ending inventory. { 50 coffee gift packs, at a total purchase price of $1430, ordered in December 20X1 to prepare for the start of business. **The quarter’s beginning inventory is the same as December’s ending inventory (January’s beginning inventory). Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

107

Accounting Information for Business Decisions Case Exhibit 3.12 Purchases budget – cups of coffee CAFE´ REVIVE Purchases budget First quarter 20X2 January

February

March

Quarter

Budgeted total unit sales (cups of coffee)

880

1 320

Add: Desired ending inventory of coffee supplies*

660

350

Total coffee supplies required

1 540

1 670

1 300

Less: Beginning inventory of coffee supplies§

(1 025){

(660)

(350)

Budgeted purchases of coffee supplies

700

2 900

600 

600à 3 500 (1 025)**

515

1 010

950

2 475

Purchase price per cup of coffee

$ 2.20

$ 2.20

$ 2.20

$ 2.20

Cost of purchases

$ 1 133

$2 222

$2 090

$ 5 445

Cash payments for purchases

$

$1 133

$2 222

$ 3 335

0{

* The desired ending inventory is 1/2 (50%) of next month’s budgeted sales. † April’s budgeted sales are 1200 cups of coffee. ‡ The desired ending inventory at the end of the quarter is the same as the desired ending inventory at the end of March (which is the end of the quarter). § The beginning inventory is the same as the previous month’s ending inventory. { Supplies for approximately 1025 cups of coffee, at a total purchase price of $2255, ordered in December 20X1 to prepare for the start of business were paid for with cash in December, so nothing is due in January. As with the gift packs, DeFlava Coffee from then on is allowing Cafe ´ Revive to pay for purchases the following month. **The quarter’s beginning inventory is the same as December’s ending inventory (January’s beginning inventory).

Stop & think Suppose that January sales turn out to be 210 coffee gift packs. Should Cafe´ Revive change its plans for February and March? What questions should you ask before deciding whether the plans should change, which part of the plans should change, and by how much? Businesses that purchase their inventories from suppliers in other countries sometimes pay for those purchases in the currency of the other country (e.g. in yen or euros rather than dollars). However, these businesses should budget their purchases in dollars. Suppose, for example, that Cafe´ Revive purchased coffee gift packs from a Belgian business instead of from DeFlava Coffee. Since Belgium is a member of the European Union (EU), which uses a currency called the euro, Cafe´ Revive would have to convert euros to dollars when preparing its purchases budget. Remember that budgets represent a business’s plans, and that they are based on estimates. As new information becomes available, the business sometimes changes its plans.

selling expenses budget Budget showing the expenses and related cash payments associated with planned selling activities

108

The retail business’s selling expenses budget To sell its inventory, a retail business must engage in selling activities. The selling expenses budget shows the expenses and related cash payments associated with planned selling activities. Examples of selling expenses include salespeople’s salaries and commissions, shop rent and advertising. Each of these expenses relates directly to sales.

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Chapter 3 Developing a business plan: Applied budgeting A selling expenses budget is developed by reviewing past selling expenses (if they are available) and then adjusting them for current plans. It is important for the entrepreneur to understand prior costbehaviour patterns when creating a selling expenses budget because some selling expenses are variable and change directly with the amount of inventory sold, whereas some remain fixed regardless of the sales volume. By applying these behaviour patterns, the entrepreneur can predict what each selling expense will be at a given estimated sales volume. Sales commissions are an example of variable selling expenses, since total sales commissions increase in direct proportion to increases in sales. Shop rent and advertising, on the other hand, are in many cases fixed selling expenses because total rent and advertising expenses stay the same while sales increase during the period. In developing a selling expenses budget, the entrepreneur should also be able to distinguish selling expenses from general and administrative expenses. Sometimes fixed expenses must be allocated on a reasonable basis between the two types of expenses. Case Exhibit 3.13 shows the selling expenses budget for Cafe´ Revive for the first quarter of 20X2. The January expenses are the same items listed in Case Exhibit 2.13 in Chapter 2. These expenses are all fixed expenses, so Cafe´ Revive expects them to be the same in all three months. (Remember, though, that selling expenses can also be variable expenses.) Not all the amounts from Case Exhibit 2.13 are related to selling activities, however. You and Emily have estimated that three-quarters of each of the following expenses is tied directly to selling activities. The other one-quarter of each expense is tied to the administrative activities of Cafe´ Revive and will be included in the general and administrative expenses budget. These expenses are allocated to the selling expenses budget as follows: Rent

$1320  3/4 ¼ $990.00

Salaries

$2360  3/4 ¼ $1770.00

Consulting

$ 330  3/4 ¼ $247.50

Mobile & wifi

$ 143  3/4 ¼ $107.25

Energy

$ 209  3/4 ¼ $156.75

Case Exhibit 3.13 Selling expenses budget CAFE´ REVIVE Selling expenses budget First quarter 20X2 January

February

March

Quarter

$ 990.00

$ 2 970.00

Budgeted selling expenses:* Rent expense

$ 990.00

Salaries expense

$1 770.00

$1 770.00

$1 770.00

$ 5 310.00

Consulting expense

$ 247.50

$ 247.50

$ 247.50

$

742.50

$ 231.00

$ 231.00

$ 231.00

$

693.00

Advertising expense

#

$ 990.00

Depreciation expense: fixtures

$ 159.00

$ 159.00

$ 159.00

$

477.00

Mobile and wifi expense

$ 107.25

$ 107.25

$ 107.25

$

321.75

Energy expense

470.25

$ 156.75

$ 156.75

$ 156.75

$

Total budgeted selling expenses

$3 661.50

$3 661.50

$3 661.50

$10 984.50

Budgeted cash payments for selling expenses 

$2 512.50

$2 512.50

$2 512.50

$ 7 537.50

* Case Exhibit 2.13 (Chapter 2) shows Cafe ´ Revive’s projected expenses for the month of January. Since these are fixed expenses, they are expected to be the same for February and March. # Advertising expenses are only in the selling expenses not in the general and administration expenses as they relate only to the selling of the coffee, as does the depreciation expenses. † The $1149 ($3661.50 – $2512.50) difference between the total budgeted selling expenses and budgeted cash payments for selling expenses each month occurs because the expenses for rent and depreciation ($990 þ $159) relate to Cafe´ Revive’s planned December expenditures for rent, and equipment. They are not counted again as cash payments. Note: Depreciation is a non-cash item (refer to Chapter 4).

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109

Accounting Information for Business Decisions Like the purchases budget, the selling expenses budget includes a schedule of budgeted cash payments for each month in the budget period. The business’s payment policies and how they apply to the individual expenses determine the budgeted cash payments. For now, Cafe´ Revive’s payment policy is to pay for all of its expenses (except rent, supplies and depreciation) in the month in which they occur. However, if its policy were to make payments in the month following the expenses, the cash payment schedule of the selling expenses budget would resemble the cash collection schedule illustrated in the sales budget in Case Exhibit 3.7. Notice that there is an $1149 ($3661.50 – $2512.50) difference between the budgeted total selling expenses each month and the budgeted monthly cash payments for these expenses. This is because Cafe´ Revive expects to pay cash in advance for six months’ rent, to purchase supplies with cash and to make a cash down payment to buy shop equipment in December 20X1 to get ready to open for business. The $1149 ($990 rent expense þ $159 depreciation expense) monthly expenses related to these planned December cash expenditures, and so are not counted again as planned cash payments in January, February or March. Note that depreciation is not included in the cash payments because it is a non-cash item.

The retail business’s general and administrative expenses budget general and administrative expenses budget Budget showing the expenses and related cash payments associated with expected activities other than selling

For a retail business, the general and administrative expenses budget shows the expenses and related cash payments associated with expected activities other than selling. Examples of general and administrative expenses include administrative staff salaries, consulting charges and the cost of renting office space. To prepare the general and administrative expenses budget, the entrepreneur reviews past expenses (if they are available), identifies them as fixed or variable, and adjusts them for current plans. Case Exhibit 3.14 shows the general and administrative expenses budget for Cafe´ Revive for the first quarter of 20X2. These expenses are all fixed, although general and administrative expenses can

Case Exhibit 3.14 General and administrative expenses budget CAFE´ REVIVE General and administrative expenses budget First quarter 20X2 January

February

March

Quarter

Budgeted general and administrative expenses:* Rent expense

$ 330.00

$ 330.00

$ 330.00

$ 990.00

Salaries expense

$ 590.00

$ 590.00

$ 590.00

$1 770.00

Consulting expense

$

82.50

$

82.50

$

82.50

$ 247.50

Mobile and wifi expense

$

35.75

$

35.75

$

35.75

$ 107.25

Energy expense

$

52.25

$

52.25

$

52.25

$ 156.75

Total budgeted general and administrative expenses

$1 090.50

$1 090.50

$1 090.50

$3 271.50

Budgeted cash payments for general and administrative expenses 

$ 760.50

$ 760.50

$ 760.50

$2 281.50

* Case Exhibit 2.13 (Chapter 2) shows Cafe ´ Revive’s projected expenses for the month of January. Since these are fixed expenses, Cafe ´ Revive expects them to be the same for February and March. † The $330.00 ($1090.50 – $760.50) difference between the total budgeted general and administrative expenses and the budgeted cash payments for these expenses each month occurs because the monthly expenses ($330) related to the planned December cash expenditures for rent are not counted again as cash payments.

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Chapter 3 Developing a business plan: Applied budgeting also be variable expenses. As we discussed earlier, Cafe´ Revive allocates the total of certain monthly expenses between selling activities and general and administrative activities. Recall that you and Emily estimated that one-quarter of each of the expenses is tied directly to administrative activities. The other three-quarters of each is tied to sales activities, and appears on the selling expenses budget. These expenses are allocated to the general and administrative expenses budget as follows: Rent

$1320  1/4 ¼ $330.00

Salaries

$2360  1/4 ¼ $590.00

Consulting

$ 330  1/4 ¼ $ 82.50

Mobile and wifi

$ 143  1/4 ¼ $ 35.75

Energy

$ 209  1/4 ¼ $ 52.25

Like the selling expenses budget, the general and administrative expenses budget includes a schedule of budgeted cash payments for each month in the budget period. These cash payments are determined according to the business’s payment policies. Cafe´ Revive plans to pay for all the expenses listed on the general and administrative expenses budget in the month they occur, except for rent, which it paid for in December.

The service business’s expenses budget Service businesses do not have a purchases budget for inventory, since they are selling a service rather than a product. Nor do they usually divide their budgeted expenses into two different budgets, one for selling expenses and one for general and administrative expenses. Instead, in budgeting expenses, service businesses simply prepare an operating expenses budget. Budgeting is a management accounting exercise designed for internal control of the business by internal users of the information, so each business will design a system of budgeting (and formats) that suits their particular business needs. Be prepared to be flexible! Remember that our discussion of cost behaviours in Chapter 2 noted that variable costs vary in total in direct proportion to volume. Volume can refer to a variety of activities. One measure of volume used by retail businesses is number of unit sales. Because they are selling a service, though, service businesses are very labour-intensive. Salaries are a major expense for these businesses, and many of their other expenses vary with the number of hours that employees work. Therefore, many service businesses use the number of hours that employees work as a measure of volume. Regardless, service businesses have many of the same fixed expenses as retail businesses, such as rent and advertising. Today, businesses are also increasingly aware that their customers and the government expect them to be sustainable organisations, so they are devising methods of accounting for such costs and ways to promote their views of sustainability to their customers. Some businesses are trying to make potential clients or customers aware of their environmental policies and commitment to sustainability by giving customers an option to offset their carbon imprints. For example, Virgin Australia (http://www.virginaustralia.com/au/en) and Europcar (http://www.europcar.com.au) give their customers a chance to opt to include, on top of their travel costs, a small charge that will be used by these companies to offset carbon emissions.

Ethics and Sustainability

Cash management and the cash budget The way in which a business manages its cash can be the difference between the business’s success and failure. Cash management involves keeping an eye on the business’s cash balance to make sure that: 1 there is enough cash on hand to pay for planned operations during the current period 2 there is a cash buffer on hand 3 there is not too much cash on hand. An insufficient cash balance can cause problems for a business. Without enough cash, a business will have trouble operating at a normal level and paying its bills. In the most extreme case, an entrepreneur Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions will no longer be able to operate the business at all because it will have failed. Therefore, a good entrepreneur is always looking for long- and short-term financing sources – such as lines of credit at a bank – that allow the business to borrow money as needed and loan guarantees from government agencies such as the AusIndustry Programs https://www.business.gov.au and Support for Small Business (http://www.innovation.gov.au/audience/business). A good entrepreneur also watches the business’s cash balance to determine when to pay back the finance. As we introduced in Chapter 2, a cash buffer means having some extra cash on hand (or available through a line of credit) to cover normal, but unexpected, events. For example, an unexpected surge in coffee sales would cause Cafe´ Revive to have to purchase more inventory than planned. A cash buffer would help to cover this purchase. A business’s insurance policy would usually cover abnormal and unexpected events, such as natural disasters or fires. Too much cash on hand may seem like an odd problem to have because almost everyone would like to have more cash. An excessive cash balance is a problem for a business, though, because this cash balance is not productive. That is, cash earns nothing for the business unless the business invests it internally in profitable projects, or externally in an interest-bearing account or in government or business securities that earn dividends or interest. Therefore, a successful entrepreneur continually watches for good investment opportunities – even short-run opportunities.

The retail business’s cash budget (projected cash flow statement) cash budget Budget showing a business’s expected cash receipts and payments and how they affect the business’s cash balance

operating activities section Section of a business’s cash flow statement (or cash budget) that summarises the cash receipts and payments from its actual (or planned) operating activities

investing activities section Section of a business’s cash flow statement (or cash budget) that shows the cash receipts and payments from its actual (or planned) investing activities

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The cash budget shows the business’s expected cash receipts and payments, and how these affect the business’s cash balance. The cash budget is very important in cash management. It helps the entrepreneur to anticipate cash shortages, thus avoiding the problems of having too little cash on hand to operate the business and to pay its bills. This budget also helps the business to avoid having excess cash that could be better used for profitable projects or investments. Besides helping the entrepreneur to anticipate cash shortages and excesses, the cash budget can also help external users. For example, a potential lender (e.g. a bank) may want to evaluate the business’s cash budget to see how the business plans to use the borrowed cash, and to anticipate whether and when the business will have enough cash to repay the loan. A business’s cash budget is similar in many respects to the cash flow statement we discussed in Chapter 1. However, the cash budget shows the cash receipts (inflows) and cash payments (outflows) that the business expects as a result of its plans (which is why it sometimes is called a projected cash flow statement). On the other hand, a business’s cash flow statement reports its actual cash receipts and payments. Like the cash flow statement (see Exhibit 1.12 in Chapter 1, and Chapter 9), a cash budget can have three sections: it always has an operating activities section, and if the business plans for investing or financing activities, the cash budget will have separate investing activities and financing activities sections. The operating activities section of the cash budget summarises the cash receipts and payments the business expects as a result of its planned operations. These expected cash flows come from the sales, purchases and expenses budgets we discussed earlier. This section also shows the net cash inflows (excess of cash receipts over cash payments) or the net cash outflows (excess of cash payments over cash receipts) expected from operations. Adding the net cash inflows to the beginning cash balance (or subtracting the net cash outflows) results in the expected cash balance from operations at the end of the budget period. The investing activities section of the cash budget – if needed – shows the cash payments and receipts the business expects from planned investing activities. A business’s investing activities include, for instance, purchases or sales of land, buildings and equipment, or investments in the stocks and bonds of governments or other businesses. Recall that Cafe´ Revive purchased $1650 worth of equipment in December 20X1 and paid a cash deposit of $250. The deposit would have been an investing activity in December’s budget. The remaining $1400 is still owed and is recorded as an investing activity in the cash budget when the cash is paid. As it was a three-month loan, this amount is due to be paid in March 20X2 and is included in the cash budget for March. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 3 Developing a business plan: Applied budgeting

Stop & think Why do you think cash receipts from the sale of land, buildings and equipment, as well as from dividends received on investments, are included in the investing activities section of the cash budget? Although investing activities can occur at any time, businesses usually have policies about investing cash balances on hand in excess of a predetermined amount. For instance, based on planned operating activities, you and Emily have decided that Cafe´ Revive should invest any cash on hand in excess of $35 000 in any month. The financing activities section of the cash budget – if needed – shows the cash receipts and payments that the business expects from planned financing activities. A business’s financing activities include borrowings and repayments of loans and investments and withdrawals by owners. The cash budget helps a manager to decide when financing activities will be necessary. For example, in considering the need for a cash buffer, you and Emily have decided that Cafe´ Revive will begin financing activities when its cash balance drops below $7000. Case Exhibit 3.15 shows Cafe´ Revive’s cash budget for the first quarter of 20X2. Notice that the cash budget summarises the receipts and payments you saw in the budgets we discussed earlier. The cash

financing activities section Section of a business’s cash flow statement (or cash budget) that shows the cash receipts and payments from its actual (or planned) financing activities

Case Exhibit 3.15 Cash budget projected cash flow statement CAFE´ REVIVE Cash budget First quarter 20X2 January

February

March

Quarter

Cash receipts from sales of coffee gift packs*

$ 9 163.00

$13 662.00

$11 055.00

$33 880.00

Cash receipts from sales of cups of coffee

$ 4 840.00

$ 7 260.00

$ 3 850.00

$15 950.00

$14 003.00

$20 922.00

$14 905.00

$49 830.00

Cash flow from operating activities:

Cash payments for: Purchases of gift packs 

$ 1 430.00

$ 4 862.00

$ 6 864.00

$13 156.00

Supplies: cups of coffee

$

–

$ 1 133.00

$ 2 222.00

$ 3 355.00

Selling expensesà

$ 2 512.50

$ 2 512.50

$ 2 512.50

$ 7 537.50

General and administrative expenses§

$

$

$

760.50

$ 2 281.50

Total payments

760.50

760.50

$ 4 703.00

$ 9 268.00

$12 359.00

$26 330.00

Net cash inflow (outflow) from operations

$ 9 300.00

$11 654.00

$ 2 546.00

$23 500.00

Cash (outflow) from investing activities Purchase of equipment

$

$

–

$ (1 400.00)

$ (1 400.00)

Net increase (decrease) in cash

$ 9 300.00

$11 654.00

$ 1 146.00

$22 100.00

Add: Beginning cash balance{

$11 575.00

$20 875.00

$32 529.00

$11 575.00

Ending cash balance from operations

$20 875.00

$32 529.00

$33 675.00

$33 675.00

–

* From sales budget (Case Exhibits 3.7 and 3.8) † From purchases budget (Case Exhibits 3.11 and 3.12) ‡ From selling expenses budget (Case Exhibit 3.13) § From general and administrative expenses budget (Case Exhibit 3.14) { The cash balance at the beginning of January is the result of cash receipts and payments in December: $22 000 capital – rent $7920 – deposit for equipment $250 – coffee supplies $2255 ¼ $11 575.

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Accounting Information for Business Decisions receipts amounts come from the sales budget, and the cash payments amounts come from the purchases budget, the selling expenses budget, and the general and administrative expenses budget. The $11 575 beginning cash balance for January (and the quarter) is Cafe´ Revive’s cash balance at the end of December, assuming preparations for the start of business go according to plan. The ending cash balance for each month is also the beginning cash balance for the next month. Cafe´ Revive has no investment activities planned for this quarter, since the expected cash balances in the first three months of 20X2 are not more than $35 000. Also, none of the monthly cash balances during the quarter are less than $7000, so no financing activities are planned during this quarter. Thus, Cafe´ Revive’s cash budget does not include a financing activities section. We will discuss planned cash flows from both investing and financing activities in Chapter 9.

The service business’s cash budget (projected cash flow statement) The cash budget of a service business is similar to that of a retail business, except that the service business reports cash flow information that is obtained from fewer budgets. In Cafe´ Revive’s cash budget, information came from the sales, purchases, selling expenses, and general and administrative expenses budgets. A service business’s cash budget information, on the other hand, would be obtained from its sales budget and its operating expenses budget. Information from these budgets would be used in the same way that a retail business uses its information to prepare the projected financial statements, as we discuss in the next sections.

The projected income statement projected income statement Statement summarising a business’s expected revenues and expenses for the budget period

A projected income statement summarises a business’s expected revenues and expenses for the budget period, assuming the business follows its plans. Note that the projected income statement is not the same as the cash budget. In Case Exhibit 3.7, we showed the relationship between sales revenues from credit sales and cash collections from sales. If a business has credit sales, cash receipts occur later than the related sales. The same thing can happen with expenses. Often, the cash payment for an expense occurs later than the activity that causes the expense. For example, employees usually work before being paid. If the work occurs late in March, the business may not pay the employees until early in April. The projected salaries expense will appear on the projected income statement for the quarter that ends in March (since the work occurred in March), but the projected cash payment will appear on April’s cash budget. In other words, timing differences between the operating activities and the related cash receipts and payments cause the differences between the projected income statement and the cash budget. The projected income statement reports on the business’s planned operating activities, whereas the cash budget reports on the expected cash receipts and payments related to those activities. The projected income statement is important because it shows what the business’s profit will be if the business follows its plans. At this point in the budgeting process, if the expected profit for the budget period is not satisfactory, the entrepreneur may revise the business’s plans to try to increase the profit. In Chapter 2, we discussed how a business uses CVP analysis to estimate how some changes in plans will affect its profit. If, as a result of this analysis, the entrepreneur changes the business’s plans, then the budgets are changed according to these revised plans.

Stop & think What changes do you think an entrepreneur might make in a business’s plans to increase its expected profit? Case Exhibit 3.16 shows Cafe´ Revive’s projected income statement for the first quarter of 20X2. Cafe´ Revive includes this income statement in its business plan. There are three differences between this

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Chapter 3 Developing a business plan: Applied budgeting

Case Exhibit 3.16 Projected income statement CAFE´ REVIVE Projected income statement# For the quarter ended 31 March 20X2 Total sales revenue ($34 100 þ $15 950)

$ 50 050*

Less: Total variable costs Cost of coffee gift packs sold

$

(17 732) 

Cost of cups of coffee sold

$

(6 380)^

Total contribution margin

$(24 112) $ 25 938

Less: Total fixed costs Selling expenses

$10 984.50à

General and administrative expenses

$ 3 2 71.50§

Total fixed costs Profit

$ (14 256) $ 11 682

# This exhibit is shown in contribution margin format. * From the sales budget (Case Exhibits 3.7 and 3.8). † The 620 budgeted total sales in number of gift packs (Case Exhibit 3.6) times the $28.60 cost per gift pack (Case Exhibit 3.9). ^ The 2900 budgeted total sales in number of cups of coffee (Case Exhibit 3.7) times the $2.20 cost per cup of coffee (Case Exhibit 3.12). ‡ From the selling expenses budget (Case Exhibit 3.13). § From the general and administrative expenses budget (Case Exhibit 3.14). Note: For some businesses, selling expenses and general and administration expenses can be made up of both variable and fixed costs, in which case the appropriate amount would be included in both the variable and the fixed sections of the income statement. In Case Exhibit 2.13, we listed each expense separately and did not attempt to categorise them. Finally, we do not list all the separate expenses here because they are shown in the selling expenses and general and administrative expenses budgets.

statement and the income statement1 for internal decision makers that we showed in Case Exhibit 2.13 in Chapter 2. First, the income statement in Exhibit 3.16 is for the first quarter of 20X2. To keep the discussion simple, we showed only the income statement for January in Exhibit 2.13. (If Cafe´ Revive had chosen to show an income statement for each month of the first quarter in Exhibit 3.16, the January profits of Exhibits 2.13 and 3.16 would be identical.) Second, in Exhibit 3.16 we group the fixed costs into two categories: selling expenses and general and administrative expenses. Notice that the amounts of most of the revenues and expenses in the projected income statement in Case Exhibit 3.16 come from the budgets we discussed earlier. The format used in this income statement is a contribution margin approach (splitting costs between fixed and variable – see Chapter 2), as it is an income statement for management purposes and based on the budgets. External reports typically use a different format (as discussed in Chapter 7). The variable cost of coffee gift packs sold, however, is calculated by multiplying the budgeted number of gift packs sold during the quarter (620, from the sales budget in Case Exhibit 3.7) by Cafe´ Revive’s cost per gift pack ($28.60, from the purchases budget in Case Exhibit 3.11). So the cost of coffee gift packs sold that Cafe´ Revive listed on its projected income statement is different from the cost of coffee gift packs purchased that Cafe´ Revive listed on its purchase budget. This is because the number of gift packs sold is different from the number of gift packs purchased. The variable cost of cups of coffee sold is calculated by multiplying the budgeted number of cups sold during the quarter (2900, from the sales budget in Case Exhibit 3.8) by Cafe´ Revive’s cost per cup ($2.20, from the purchases budget in Case Exhibit 3.12). So the cost of cups of coffee sold that Cafe´ Revive listed on its projected income statement is different from the cost of cups of coffee purchased that Cafe´ Revive 1

We could rearrange this income statement so that it would look similar to the income statement for external users that we show

in Case Exhibit 2.13 in Chapter 2. To save space, we do not include the rearranged income statement in Case Exhibit 3.16. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions listed on its purchase budget. This is because the number of cups sold is different from the number of cups purchased. Many businesses preparing a projected Income statement will also produce a projected balance sheet, which shows the assets (resources owned or controlled by the business), liabilities (amounts owed by the business to external entities) and equity (the amount of owner investment in capital and past profits) of the business, at a particular date (recall Exhibit 1.11). The balance sheet date will match the end of the budget period, to match the end of the projected income statement. For Cafe´ Revive, that would be the end of the first quarter, which is 31 March 20X2. Case Exhibit 3.17 shows Cafe´ Revive’s projected balance sheet at that date. The assets include the cash according to the cash budget, money still owed on the gift pack sales by customers (accounts receivable), the value of the ending inventory (gift packs and coffee supplies), the three out of the original six months’ rent still paid in advance, and the value of the equipment purchased less the estimated decline in the equipment value (depreciation) for the period. The liability owed by the business is the amount owed for purchases. The owner’s equity is the capital amount invested by the owner, Emily Della, plus the profit for the first quarter, which belongs to the owner. Case Exhibit 3.17 Projected balance sheet CAFE´ REVIVE Projected balance sheet As at 31 March 20X2 Assets

Liabilities

Cash

$33 675 Accounts payable

Accounts receivable

$

Inventory

$ 2 607

Prepaid rent

$ 7 953

220

$ 3 960

Equipment

$1 650

Less: Accumulated depreciation

$ 477

Owner’s equity $ 1 173 Capital – E.Delta

$22 000

Profit for quarter

$11 682

$41 635

$33 682 $41 635

Remember that a business should include in its budgeting any aspect of the business that is important to its strategy. Increasingly stakeholders expect businesses to be concerned about their social and environmental impacts, in addition to their economic results. This means that businesses need to plan for these aspects of their business (and their related costs and benefits) as well. In global reporting therefore, there is a recognition that, organisationally, businesses need to be more focused and accountable socially and environmentally. Hence there is a move towards global reporting and guidelines regarding the reporting for such costs. In 2006, the Global Reporting InitiativeTM (GRI) issued a paper called Sustainability Reporting Guidelines, which outlined suggestions for content, disclosures and format of sustainability reports. The Guidelines were replaced by GRI Standards in 2016, which came into effect on 1 July 2018. As it is something that Emily Della identified as being important to the business, Cafe´ Revive needs to consider what sort of environmental and social expenses it might be incurring. Some sample expenses of this type have been included in Exhibit 3.18. Note that some organisations will have separate budgets for environmental and social expenses. To keep our budgets simple, we have not included any figures for environmental and social expenses in this chapter. Ways in which businesses can build sustainability into their corporate budgeting are considered in the section ‘Budgets: Business issues and values’.

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Chapter 3 Developing a business plan: Applied budgeting Exhibit 3.18 Environmental and social expenses budget Recycling research

Maternity leave

Carbon emissions reduction project

Childcare centre expenses

Efficiency improvement

Product compliance

Site clean-up

Employee training

3.4 Using the master budget in evaluating the business’s performance

6

Managers of all types of businesses use budgets as planning tools. Budgeting is also a valuable tool for evaluating how a business, division, department or team actually performed.b There has been considerable research on the use of budgeting as a motivational tool, with most suggesting that staff participation in the budgeting process and a sense of ‘ownership’ contribute to success.c Done well, it should be a tool for communicating the aims of the business and aligning these with staff expectations and aspirations. A good budget should promote a sense of teamwork, but this can be difficult to achieve. By analysing differences between a business’s budgeted results and its actual results, a manager can determine where plans went wrong and where to take corrective action next time. In this way, the budget becomes an important tool for controlling the business. Done well, the budgeting exercise should motivate all those involved in the business to achieve the aims of the business.

How can a manager use a budget to evaluate the performance of a business and then use the results of that evaluation to influence the business’s plans?

Finding differences between actual and budgeted amounts Comparing budgeted amounts to actual results is an important part of the budgeting process. By using the budgets discussed in this chapter as benchmarks, a manager can evaluate the differences between the actual performance of the business and its planned performance. By understanding why the differences occurred, a manager can decide what actions to take for future time periods. For example, Case Exhibit 3.19 shows a Case Exhibit 3.19 Comparison of actual versus budgeted amounts CAFE´ REVIVE Cost report For the quarter ended 31 March 20X2

Budgeted Rent expense

Difference: Favourable/ (unfavourable)

Actual

$ 3 960

$ 3 960

–

7 080

7 080

–

Consulting expense

990

990

–

Advertising expense

693

693

–

Depreciation expense

477

477

–

Mobile and wifi

429

429

–

Energy

627

580

$47

$14 256

$14 209

$47

Salaries expense

Total

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Accounting Information for Business Decisions cost report Report showing a comparison between a business’s budgeted and actual expenses for an accounting period

comparison (called a cost report) between Cafe´ Revive’s budgeted and actual expenses for the first quarter of 20X2. A large business would usually divide its cost report into selling expenses, and general and administrative expenses, and would also divide it by division, department, manager, product or some other identifiable unit. This breakdown is not necessary for Cafe´ Revive’s cost report because it has only a few items. With a quick glance at this cost report, you can see that Cafe´ Revive’s actual expenses were $47 less than budgeted expenses in the first quarter of 20X2. You can even see that the difference between total planned and actual expenses occurs because the energy expense was less than expected. However, knowing that there are differences is not enough information for a manager to use in explaining the differences and planning the next time period’s activities. It is at this point in the evaluation process that a manager must use creative and critical thinking skills. A manager can learn about the causes of the differences by asking questions and investigating further. As we discussed in Chapter 1, the answers to these questions will generally lead to additional questions. The cost report gives the manager a starting point from which to begin an investigation.

Learning why differences occur While analysing the difference between the budgeted and the actual telephone and utility expenses, you and Emily might ask yourselves questions such as those shown in Case Exhibit 3.20. Case Exhibit 3.20 Reasons for differences between budgeted and actual expenses Which of the monthly energy bills was higher or lower than expected?

What other explanations are there for the differences?

Why were these bills different from what was expected? Was there a difference because Cafe´ Revive has just begun operations and you had no previous experience to use in estimating what the expenses would be?

Did the difference occur because of selling activities or general and administrative activities (or both)?

After formulating the questions you want answered, you and Emily can devise a strategy to find the answers. Looking for them will require your creative thinking skills. Suppose Emily decides to start her investigation by first looking at the monthly energy bills. If she finds minor differences between planned and actual expenses for all the bills except the energy bill, then these can be attributed to her use of estimates. Minor differences from estimates are to be expected, so there would be no need to plan any correcting activities for the future. Suppose, however, that, in looking at the energy bill, Emily discovers that the energy supplier has introduced a 10 per cent discount for business customers since the budget was created. Before planning for the next quarter, you and Emily must ask another question: Will the same discount be in effect next quarter? If so, you will use this information in your future planning and budgeting activities, and the next master budget will include the 10 per cent decrease in Cafe´ Revive’s planned energy expenses.

Stop & think What questions do you think you and Emily should ask about the differences between planned and actual supplies expenses?

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A manager can use information from the master budget to help identify the causes of differences between budgeted and actual expenses, and then to decide what to change in the future. As you just saw, an analysis of the causes of these differences may lead an owner or manager to make changes in future budgets. On the other hand, the same analysis may lead the owner or manager to change future activities rather than future budgets. For example, suppose packaging workers at DeFlava Coffee are working overtime repackaging coffee gift packs because of a sudden decrease in the quality of purchased packaging materials. Because of this unplanned problem, the actual salary expense for DeFlava Coffee will be higher than its budgeted salary expense. An analysis of the cause of this salary difference may lead the packaging manager to look for a new supplier of packaging materials. Differences between planned and actual expenses can also be positive. For example, Cafe´ Revive’s energy expense was less than the budgeted expense. Suppose you and Emily based Cafe´ Revive’s budgeted energy expense on a well-publicised planned increase in electricity rates. If Trade and Investment Queensland later turns down the rate increase, this would explain why Cafe´ Revive’s actual expense was less than its budgeted expense. You and Emily will use this rate information, which you noticed because of your analysis of the difference between the planned and the actual expenses, for future planning activities. Unless circumstances change between this budget period and the next budget period, you and Emily will use the old rate to budget Cafe´ Revive’s energy expense. At other times, differences between planned and actual Do you think Hungry Jack’s estimate of Whopper sales would have results can have both positive and negative consequences. affected its estimated sales of French fries? Hungry Jack’s (http://www.hungryjacks.com.au) introduced its ‘Whopper’ burger as competition against McDonald’s Australia’s (http://www.mcdonalds.com.au) ‘Big Mac’ burger. Let us assume that Hungry Jack’s estimated that it would sell one million Whoppers per day. Let us also assume that the burger was so popular at that time that Hungry Jack’s could have sold nearly 1.8 million per day – about 80 per cent more than it had expected! Since Hungry Jack’s would have budgeted – and hence purchased materials – based on anticipated sales, what impact would the extra sales have on Hungry Jack’s, both immediately and in the future?

Business issues and values: Budgets The accounting information included in budgets affects, and is affected by, business decisions. In using this information for decision making, entrepreneurs must also consider other, non-financial issues. For example, suppose a small new airline has entered a market dominated by a large, well-established airline. To effectively compete, the new business determines that it must cut

7

What non-economic goals might be included in Cafe´ Revive’s budget?

costs. A look at the budget shows that one of the largest costs, and an easy one to reduce, is maintenance costs on the fleet. When making the decision about whether to reduce maintenance costs, the entrepreneur would need to consider whether reducing these costs now would drive up

Ethichs and Sustainability

future maintenance costs. More importantly, the entrepreneur would need to consider the safety of the passengers and crew. In this case, the safety concern may outweigh the financial gain resulting from reducing the maintenance costs. As already discussed, a business should include in the budget all issues relevant to its business strategy. The budget should reflect any non-economic aims of the organisation, although these may also have an economic effect on the business. The issue of business sustainability is of increasing concern to businesses and their stakeholders. Businesses can build sustainability into their corporate budgeting and planning by following the five basic steps shown in Exhibit 3.21.

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119

Newspix/James Croucher

Chapter 3 Developing a business plan: Applied budgeting

Accounting Information for Business Decisions Case Exhibit 3.21 Five basic steps to sustainability

120

1

Understand what is really meant by sustainability.

2

Define ‘sustainability’ for your organisation and determine the factors that are to be included and excluded during planning and budgeting.

3

Determine your time horizon for achieving profitability.

4

Ensure that upper management’s definition of sustainability is understood widely throughout the organisation and that it is embedded into corporate strategy and objectives.

5

Ensure that the performance management system reports and rewards initiatives related to sustainability.c

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Chapter 3 Developing a business plan: Applied budgeting

STUDY TOOLS Summary 3.1 Understand why budgeting is needed to align business activities with strategy. 1

How does a budget contribute to helping a business achieve its goals?

A budget helps a business by providing a financial description of the activities planned by the business to help it achieve its goals. It also helps by adding order to the planning process, by providing an opportunity to recognise and avoid potential operating problems, by quantifying plans and by creating a benchmark for evaluating the business’s performance.

3.2 Understand the difference in operating cycles between retail and service businesses. 2

Do the activities of a business have a logical order that drives the organisation of a budget?

The operating activities of a business make up what is called the business’s operating cycle, which is the average time it takes the business to use cash to buy goods and services, to sell these goods to or perform services for customers, and to collect cash from these customers. The order of activities, and the cash receipts and payments associated with these activities, influence how a business organises its budget.

3.3 Understand that the interrelated budgets provide a framework for planning. 3

What is the structure of the budgeting process, and how does a business begin that process?

The master budget is the overall structure used for the financial description of a business’s plans. It consists of a set of budgets describing planned business activities, the cash receipts or payments that should result from these activities and the business’s projected financial statements (what the financial statements should look like if the planned activities occur). The budgeting process begins with the sales budget because product or service sales affect all other business activities. By gathering various types of information, such as past sales data, knowledge about customer needs, industry trends, economic forecasts and new technological developments, a business estimates the amount of inventory (or employee time) to be sold (used) in each budget period. Cash collections from sales are planned by examining the business’s credit-granting policies. Cash payments for expenses are planned by examining the business’s payment policies. 4

What are the similarities and differences between the master budget of a retail business and that of a service business?

For a retail business, the master budget usually includes a sales budget, a purchases budget, a selling expenses budget, a general and administrative expenses budget, a cash budget and a projected income statement (some businesses may also include a projected balance sheet). A service business does not have a purchases budget, and it usually has one operating expenses budget. 5

After a business begins the budgeting process, is there a strategy it can use to complete the budget?

A retail business follows a strategy similar to the following. After budgeting sales, the business plans the amount and timing of inventory purchases. To budget purchases, the business examines the costs associated with inventory purchases and storage, as well as the costs of not carrying enough inventory. It also considers its policy on required inventory levels. After budgeting purchases, the business plans the cash payments for inventory purchases by reviewing its payment agreements with suppliers. To budget expenses, the business must first determine the behaviours of these expenses. It budgets fixed expenses by evaluating previous fixed expenses and then adjusting them (if necessary) according to the plans for the coming time period. It budgets variable expenses by first observing what activity causes these expenses to vary and then calculating the total expenses by multiplying the cost per unit of activity by the budgeted activity level. For a retail business, the activity level is usually sales. The business budgets the cash payments for these expenses by reviewing the business’s policy on the payment of expenses. The information for developing the cash budget comes from the other previously prepared budgets, as does the information for creating the projected income statement. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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3.4 Know how the master budgeting is used to evaluate performance. 6

How can a manager use a budget to evaluate a business’s performance and then use the results of that evaluation to influence the business’s plans?

A manager uses a master budget to evaluate a business’s performance by comparing the information in the various budgets with the results that occur after the planned activities are implemented. The manager identifies the differences between budgeted and actual results, and learns about the causes of these differences by asking questions and investigating further. Based on these investigations, a manager may adjust the business’s activities and plans, as well as its future budgets.

3.5 Understand that a budget should include all key values of the business. 7

What key values of the business need to be taken into account in a budget

The budget needs to include staff welfare costs and the business needs to measure how effective these are. This may be done via surveys or interviews. Quality products depend on quality suppliers, and this requires developing good relationships with suppliers and working with them to provide the quality expected by customers. Identifying what adds value to the product through the eyes of customers is also important, and again may require research and customer surveys, which should be included in the budget. The results of such research should also inform future planning. A budget should seek to provide information on, and targets for, all aspects of the business that are considered important for its success. Environmentally friendly packaging requires designing products to minimise packaging, sourcing packaging that that is appropriate (e.g. biodegradable) and investigating recycling, again working with suppliers and identifying customer concerns. This may involve tracking non-economic information that is not captured by a traditional accounting system – for example, physical weight of packing used. 8

What non-economic goals might be included in Cafe´ Revive’s budget?

Recall that Cafe´ Revive’s objectives included building a reputation for friendly service, quality products and environmentally friendly packaging. In order for staff to maintain a positive attitude, they should feel involved in the budgeting process, so staff training, welfare and retention are all important. The budget needs to include staff welfare costs and the business needs to measure how effective these are. This may be done via surveys or interviews. Quality products depend on quality suppliers and this requires developing good relationships with suppliers, and working with suppliers to provide the quality customers expect. Identifying what adds value to the product through the eyes of the customers is also important, and again may require research and customer surveys, which should be included in the budget. The results of such research should also inform future planning. Environmentally friendly packaging also requires designing products to minimise packaging, sourcing packaging that is appropriate (e.g. biodegradable) and investigating recycling, again working with suppliers and identifying customer concerns. This may involve tracking non-economic information not captured by a traditional accounting system, for example physical weight of packing used. A budget should seek to provide information on, and targets for, all aspects of the business that are considered important for its success.

Key terms budget

management by exception

projected income statement

cash budget

master budget

purchases budget

cost report

operating activities section

sales budget

financing activities section

operating cycle of a retail business

selling expenses budget

general and administrative expenses budget

operating cycle of a service business

investing activities section

projected balance sheet

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Chapter 3 Developing a business plan: Applied budgeting

Online research activity Here is an opportunity to gather information online about real-world issues related to the topics in this chapter. For suggestions on how to navigate various businesses’ websites to find their financial statements and other information, see the related discussion in the Preface. u Go to http://www.business.gov.au and click on the ‘Business plans’ link to view the Business Plan Guide and Business Plan Template. What is a cash flow forecast, and how does it compare with the cash budget that we discussed in this chapter? What are the steps involved in preparing a cash flow forecast? How would preparing the budgets discussed in this chapter help an entrepreneur in preparing a cash flow forecast? u Go to http://www.business.gov.au and click on the ‘Business plans’ link then in the Business Planning section look up the information on environmental, water and energy management. What are the benefits of environmental management? What tips are there for saving energy? Ethichs and Sustainability u Go to http://www.business.gov.au. How often should a business update its business plan? What are the benefits to a business of keeping its business plan current? u Go to https://www.nbs.net/articles/5-steps-for-building-sustainability-into-corporate-budgeting-and-planning. Looking at the example from Africa, what do you think about HIV medication and its drain on long-term profits?

Integrated business and accounting situations Answer the following questions in your own words.

Testing your knowledge 3-1 3-2 3-3 3-4 3-5 3-6 3-7 3-8 3-9 3-10 3-11 3-12 3-13 3-14 3-15 3-16

3-17 3-18 3-19

What is it about budgeting that adds discipline to the planning process? If a problem comes to light during the budgeting process, what is the manager likely to do? ‘Budgeting serves as a benchmark for evaluation.’ Explain what this statement means. Describe a master budget. Why might a master budget be different from one business to another? How are the master budgets of a retail business and a service business similar to each other? How are they different from each other? Describe the operating cycle of a retail business. How are the operating cycles of a retail business and a service business similar to and different from each other? What are the considerations for an appropriate credit-granting policy? Why must the sales budget be developed before any of the other budgets? Where does information for sales forecasts come from? If you have just finished budgeting sales for next year, what information will you need to be able to budget cash collections from sales? How does knowing forecasted sales help a manager develop a purchases budget? What else besides forecasted sales would a manager have to know to complete the purchases budget? When developing a selling expenses budget and a general and administrative expenses budget, why do you have to know how expenses behave? Why must you complete all the other budgets before you can develop the cash budget? Why is it important to know about anticipated cash shortages ahead of time? What is a cash buffer, and what is an example of a circumstance where a business could use one? Why is having too much cash on hand a problem? On the cash budget, why is the beginning cash balance for July the same as the beginning cash balance for the first quarter of the year? Why is the September ending cash balance the same as the first quarter’s ending cash balance? How do you determine the first quarter’s cash receipts from sales? How is the cash budget similar to a cash flow statement? How are they different from each other? Why is the cash budget not the same as the projected income statement? What items included on the projected income statement are not included on the cash budget? Why do you think budgeting is described as a cycle? How is that related to the control of the business?

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3-20 3-21 3-22

In evaluating a business’s performance, why do managers or owners need to learn the causes of differences between actual and budgeted amounts? Can you think of some circumstances where the budget or the budget-setting process might demotivate rather than motivate employees? Ethichs and Why should a business consider sustainability in its budget? Sustainability

Applying your knowledge 3-23

3-24

3-25

3-26

3-27

Wivenhoe Wines is based in the Brisbane Valley and makes boutique wines sold online to customers on credit (70% of sales) and to customers visiting the vineyard and purchasing bottles of wine at the cellar door for cash (30% of sales). Wivenhoe Wines is preparing a sales budget for the October–December quarter. Sales are estimated at 100 bottles in October, 200 bottles in November and 350 bottles in December. The average selling price per bottle is $30. Credit customers pay 95 per cent in the month after sale. The remaining credit sales are bad debts. September sales were 220 bottles. Required: a Prepare the Sales Budget and a schedule of cash collections for the October–December quarter (each month and quarter total). b Explain why bad debts are not included in the cash collections. Would these appear in any other financial report? Jaime’s Hat Shop sells hats with school logos on them for $22 each. This year, Jaime’s expects to sell 350 hats in August, 300 in September, 400 in October, 800 in November, 1040 in December and 750 in January. On average, 25 per cent of customers purchase on credit. Jaime’s allows those customers to pay for their purchases the month after they have made their purchases. Required: Prepare a sales budget for Jaime’s Hat Shop for the second quarter of this financial year. Include the expected cash collection schedule for the second quarter of this financial year. Refer to 3-24. Jaime’s business policy is to plan to end each month with an ending inventory equal to 20 per cent of the next month’s projected sales. Jaime’s pays $8 for each hat that it purchases. Jaime’s and its supplier have an arrangement that allows Jaime’s to pay for each purchase 60 days after the purchase. Required: Prepare a purchases budget for the second quarter of this financial year for Jaime’s Hat Shop. Refer to Question 3-24. Assume Jaime’s ended the first quarter of this financial year with 60 hats on hand. Required: a Notice that Jaime’s ended the first quarter with less than 20 per cent of projected sales for October. What do you think accounts for the difference? b How many hats should Jaime’s purchase in October? Refer to Question 3-24. Jaime’s Hat Shop expects to incur the following expenses for each month of the second quarter of this financial year: Rent (30% general and administrative, 70% selling)

$1 200

Utilities (30% general and administrative, 70% selling)

600

Advertising

400

Salaries (50% general and administrative, 50% selling) Commissions (for each hat sold)

3-28

124

5 000 2

In April, Jaime’s had prepaid the rent for the whole year. Jaime’s plans to pay for all the other expenses in the month they occur. Required: a Prepare a selling expenses budget for the second quarter of this financial year. b Prepare a general and administrative expenses budget for the second quarter of this financial year. Refer to Questions 3-24 to 3-27. Jaime’s Hat Shop ended September with a cash balance of $10 343. Required: Prepare a cash budget for the second quarter of this financial year.

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Chapter 3 Developing a business plan: Applied budgeting

3-29

3-30

3-31

Refer to Questions 3-24 to 3-27. Required: Prepare a projected income statement for the second quarter of this financial year. Robert and Gwen are partners in a new superannuation search business called Super Lost and Found, which will begin operations in December. The business finds lost accounts from superannuation companies where the super fund no longer knows the current contact details of the holder(s) of the superannuation policy. Robert estimates that the employees of Super Lost and Found will spend 500 hours in December, 700 hours in January, 800 hours in February and 725 hours in March working on finding current contact information for Super Lost and Found’s clients. Super Lost and Found will bill each of its clients at the end of the month, charging $400 per hour spent working for that client during the month. On average, 60 per cent of the billings for any month will be collected during the following month, 25 per cent during the second month following the billing, and 15 per cent during the third month following the billing. Required: Prepare a sales budget and expected cash collection schedule for Super Lost and Found for the quarter (January through March). Maid Company sells a single product for $12 per unit. Sales estimates (in units) for the last four months of the year are as follows: Units

3-32

September

50 000

October

55 000

November

45 000

December

50 000

Ninety per cent of Maid’s sales are credit sales, and it expects to collect each account receivable 15 days after the related sale. Assume that all months have 30 days. Required: Prepare a sales budget for the last three months of the year, including estimated collections of accounts receivable. Helena’s Chocolates is preparing a sales budget for the quarter (3 months) April–June 202X for their gift chocolate box product and a schedule of cash collections. The majority of their sales are cash via their retail shop (80%), but they also supply chocolate boxes to hotels (20% of their sales) on credit. Credit customers (accounts receivable) may claim a 5% discount if they pay within the month of sale. Accounts receivable at 31st March were $64 000. In the past, 10 per cent of credit customers have been able to claim the discount, with the remainder paying in the month following sale. Sales in units for April-July 202X are estimated as 60 000, 70 000, 80 000 and 80 000 chocolate boxes. The selling price per box is $6. Boxes of chocolates are purchased for $2.50 and Helena’s has a policy of keeping sufficient ending inventory for 60 per cent of the following month’s sales in units. Purchases are paid for in the month following purchase. Accounts payable for chocolate boxes were $170 000 on 31st March. Required: a Prepare the sales budget for the boxes of chocolate, including estimated cash receipts for April–June 202X. Show each month separately and a total for the quarter. (Hint: split the sales between cash and credit; then for the credit sales spit the sales between those able to claim the settlement discount, and those who receive no discount). b Prepare a purchases budget for the boxes of chocolate (in units and then dollars), and a schedule of cash payments for purchases.

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3-33

The sales budget for Merita Medallion Company shows budgeted sales (in medallions) for December and the first four months of next year: Medallions December January

40 000

February

90 000

March April

3-34

100 000

150 000 50 000

Required: Prepare a budget for the number of medallions Merita needs to purchase in the first three months of next year for each of the following two independent situations: a The business’s policy is to have inventory on hand at the end of each month equal to 15 per cent of the following month’s sales requirement. b The business’s policy is to keep each month’s ending inventory to a minimum without letting it fall below 5000 medallions. Assume that the 1 December inventory has 5000 medallions and that the business’s only supplier is willing to sell a maximum of 125 000 medallions to the business per month. The sales budget for Astra Trophy Company shows budgeted sales (in awards) for December and the first four months of next year: Trophies December January

40 000

February

90 000

March April

3-35

100 000

150 000 50 000

Required: Prepare a budget for the number of trophies Astra needs to purchase in the first three months of next year for each of the following two independent situations: a The business’s policy is to have inventory on hand at the end of each month equal to 20 per cent of the following month’s sales requirement. b The business’s policy is to keep each month’s ending inventory to a minimum without letting it fall below 10 000 trophies. Assume that the 1 December inventory has 10 000 trophies and that the business’ only supplier is willing to sell a maximum of 130 000 trophies to the business per month. Total Pet Shop sells pet food in 20-kilogram bags for $20 per bag, which it buys from its supplier for $12 per bag. Total estimates that its sales of bags of pet food for the second quarter of the year will be as follows: Bags April

2 400

May

2 800

June

3 000

Total’s policy is to have bags of pet food on hand at the end of each month equal to 15 per cent of the next month’s budgeted sales (bags). It expects to have 240 bags of pet food on hand at the end of March and to sell 3300 bags in July. Total expects its cost of purchases to be $26 340 in March; it pays for its purchases in the following month. Required: a Prepare Total’s purchases budget for bags of pet food for the second quarter of this year. b How many bags of pet food did Total expect to sell in March?

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Chapter 3 Developing a business plan: Applied budgeting

3-36

3-37

Fred’s Electronics Machines estimates its monthly selling expenses as follows: Advertising

$22 000 per month

Sales salaries

$18 000 per month

Sales calls on customers

$70 per machine

Commissions paid to sales personnel

$100 per machine

Delivery

$40 per machine

Assume that Fred pays selling expenses in the month after they are incurred. Based on the current plans of Fred’s sales department, monthly sales estimates are as follows: March: 80 units; April: 90 units; May: 100 units; June: 120 units. Required: Prepare a selling expenses budget for the June quarter for Fred’s Electronics Machines. Well Feed Company sells pet food in 10-kilogram bags for $12.40 per bag. Sales estimates for the first three months of the year are as follows: Bags

3-38

3-39

January

20 000

February

17 000

March

15 000

December sales were 16 000 bags of pet food. Well Feed’s desired ending inventory of pet food each month is 25 per cent of the next month’s sales estimate (in bags). All sales are cash sales. Well Feed purchases bags of pet food at $9.40 per bag and pays for them the month after the purchase. General and administrative expenses total $18 000 per month (including $10 000 depreciation), and Well Feed pays for these expenses (except for depreciation) in the same month they are incurred. January’s current liabilities (all to be paid in January) total $35 500. The business’s cash balance on 1 January is $38 000. Required: Prepare a cash budget for each of the first two months of the year. Refer to 3-37. Required: Prepare a projected income statement for Well Feed for February. How do you explain the differences between the income statement and the cash budget? Taylor Pty Ltd is based in Brisbane and sells ’glamping’ yurt tents imported from China at a cost of $150 each plus import duties and other costs of $60. These purchase and import costs are paid cash in the month that they incur and are not expected to change in the next six months. Taylor Pty Ltd sold 1500 yurts per month from July to September, but intends spending $1500 per month on advertising from October to December inclusive in the lead-up to the Australian summer. As a result, the company expects that sales will increase to 3000 yurts in October and then by 200 units per month until May the following year when they are expected to decrease to 2000 yurts. Currently yurts sell for $480 but the price will be increased in the lead-up to Christmas with the selling price increasing to $500 in November and December and then reverting to $480 in January. Yurts are packaged and sent to customers by courier at a cost of $30 each (for which the customers pay in addition to the price of the tent, so it is added to their invoice). Taylor Pty Ltd has an account with the courier company and pays the delivery costs the month following delivery. Other fixed costs are expected to be $3000 per month for the next six months, paid in the month of expenditure. Sales are 60 per cent cash and 40 per cent credit. Credit sales customers pay 80 per cent in the month following sale and 20 per cent in the month after that. To prevent loss of sales due to stock outs, Taylor Pty Ltd has a target ending inventory level of 20 per cent of the next month’s sales in units. Taylor Pty Ltd’s bank balance at 1 October is $100 000. Required: Prepare the following budgets for the October–December quarter (each month and quarter total): a sales budget and a schedule of cash collections b purchases budget c cash budget. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Making evaluations 3-40

Suppose you are a banker, and the controller of a small business asks you for a short-term $10 000 loan due in 120 days. Interest on the loan would be 12 per cent, due when the loan is paid back. To support his request, he gives you the following information from his business’s cash budget for the next quarter: January

February

March

Quarter

Cash flow from operations: Cash receipts from sales

$20 000

$14 400

$13 600

$48 000

$15 000

$10 800

$10 200

$36 000

Selling expenses

3 300

3 300

3 300

9 900

General and administrative expenses

1 650

650

650

2 950

Total payments

$19 950

$14 750

$14 150

$48 850

Net cash inflow (outflow) from operations

$

$ (350)

$ (550)

$ (850)

Cash payments for: Purchases

50

Cash flow from investments: Cash receipt from sale of equipment Net cash inflow (outflow) from operations and investments Add: Beginning cash balance Ending cash balance from operations and investments

3-41

128

3 000 $

3 000

50

$ 2 650

$ (550)

$ 2 150

4 880

4 930

7 580

4 880

$ 4 930

$ 7 580

$ 7 030

$ 7 030

Required: a What is your first reaction? b Before making your decision, what else would you like to know about this business? Could any of what you would like to know be found in any of the business’s other budgets or financial statements? What other budgets or statements would you like the owner to provide for you? What information would you hope to get from each of these budgets or statements? c What other information would help you make your decision? d Can you think of any circumstances in which it would be a good idea to loan this business $10 000? e Depending on the information you are able to get, what alternatives are there to loaning or not loaning this business $10 000? Jimmy, Matt and Andy are business partners who own Jimmy/Matt/Andy’s Beach Wear. Jimmy/Matt/Andy’s arrangement with all of its clothing suppliers allows it to pay for its merchandise purchases one month after the purchases have been made. About 15 per cent of the business’s customers make purchases on credit. These customers pay for their purchases one month after they have made their purchases. All the partners agree that a bank loan would allow Jimmy/ Matt/Andy’s to revamp the shopfront (perhaps causing more customers to want to come inside and shop). The partners are having a disagreement, however, about the cash budget that they plan to include in their loan application package. Jimmy and Andy believe that the budget should be revised to present the bank with the most positive projected cash flows. To accomplish this revision, they are suggesting that on the cash budget, payments for purchases be shown two months after the purchases have been made, instead of one month after they have been made, as agreed to by Jimmy/ Matt/Andy’s suppliers. Jimmy and Andy are also suggesting that cash receipts from credit customers be budgeted in the same month as the related sales rather than one month later, even though they expect these customers to wait a month before paying for their purchases. Matt thinks the budget should reflect the partners’ actual expectations. The partners have come to you for advice.

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Chapter 3 Developing a business plan: Applied budgeting

3-42

3-43

3-44

Required: a What ethical issues are involved in this decision? b If the partners make the revisions, what effect will the revisions have on (i) the sales budget; (ii) the purchases budget; (iii) the cash budget? c Who stands to gain and who stands to lose by this budget revision? Is the gain or loss temporary or permanent, short term or long term? d How might the bank be hurt by the changed budget? How might the business be hurt by the changed budget? e Since the budget represents a plan of action, how might the changed budget affect the activities of the business during the budget period? f Are there other alternatives to choose from apart from changing the budget or not changing the budget? g What do you recommend that the partners do? Assume that a business collects two-thirds of its sales revenue in the month of sale and the remaining one-third in the following month. Required: a How much revenue has the business actually earned in the month of sale? b Should the business record revenue on the income statement in the month when it collects the cash or when the work to earn the revenue was done? c What are your reasons for choosing one alternative over the other? What are your reasons for not choosing the other alternative? The airline industry is very competitive – management is under constant pressure to improve business profits. Ideas that could improve profits include the following: a increasing the price of tickets b reducing the number of flight attendants c reducing the number of flights on which meals are served d serving smaller meals or serving snacks instead of meals e limiting the size of – or eliminating – salary increases f reducing the number of baggage handlers. Required: For each of these ideas, describe the effect the idea would have on each of the budgets and on the projected financial statements. What other issues should management consider in deciding whether to implement any of these ideas? Bill Morgan is the manager of the sales department of Rise & Shine Company, which sells deluxe bread makers. At the beginning of each month, Bill estimates the total cost of operating the department for the month. At the end of the month, he compares the total estimated costs to the total actual costs to determine the difference. If the difference is ‘small’, he doesn’t investigate any further because he prefers to spend his time on ‘more important’ issues. At the beginning of April, Bill estimated that the total operating costs of the sales department would be $60 500. For April, actual operating costs were $60 400. At the end of April, Bill says, ‘The sales department is doing pretty well. We came in $100 under budget for the month.’ Alice Hoch, the CEO of the business, has come to you for help. She says, ‘I am concerned that we are not doing enough analysis of our costs, and I need your assistance. Start with the sales department and prepare a cost report for me to help me review costs for April. You can have whatever information you need.’ Upon investigation, you find the sales department was expected to sell 500 units (bread makers) in April. Based on these projected sales, its budgeted fixed costs were as follows: Advertising: $18 000 Salaries: $25 000 Budgeted variable costs were $25 commission per unit sold and $10 delivery cost per unit sold. You determine that, during April, 500 units were sold and the sales department spent $19 300 on advertising and $22 600 on salaries. It also paid the $25 commission per unit sold and paid $6000 for delivering the 500 units.

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3-45

3-46

3-47

Required: Write a report for the CEO that: a includes a cost report for the sales department that compares budgeted costs to actual costs for April b identifies the questions you think the CEO should ask to analyse any differences you find c suggests some potential answers to the questions raised. Joe Collagen is the CEO of a small retail business that sells a skin-smoothing lotion. The business has been operating for several years. Joe keeps meticulous records of his actual operating activities, including monthly sales, purchases and operating expenses, as well as the related cash receipts and payments. However, Joe has never prepared a master budget for the business. He comes to you for help, saying, ‘My profits have been slowly decreasing, and I don’t know why. Also, sometimes, when I least expect it, the business runs short of cash and I have to invest more into it. I’ve heard that preparing a master budget is a good thing to do, but I don’t know what is involved or where to begin.’ Required: Prepare a report for the CEO that: a explains what budgets and projected financial statements are included in a master budget b clearly specifies how he would use the information from his previous actual operating activities to develop each of these budgets and the projected income statement. Steve and Tammy are thinking of opening a fitness centre with facilities for aerobics, weight training, jogging and lap swimming, as well as dietary and injury consultation. They plan to buy land and build their facility near a new shopping centre. They want to employ a director, an assistant director, experts to supervise members in each fitness area, and numerous consulting dietitians and sports medicine professionals. They hope to have the entire facility, including an outdoor all-weather track and an indoor swimming pool, completed by the end of the year. They believe that it will be important to have the facility fully equipped and staffed before they begin taking memberships. Although their estimates indicate that the fitness centre can be profitable if they can establish a growing membership over the first five or six years, many small businesses in town have failed because of cash flow problems (excess of cash payments over cash receipts). Before committing themselves to this venture, Steve and Tammy have come to you for advice and for help in preparing a cash budget. Required: Write Steve and Tammy a memo explaining why they might have cash flow problems during their early periods of operations. Show them how they can identify these cash flow problems through careful cash budgeting. Make a few suggestions that might help them reduce such problems if they do decide to open the fitness centre. The owner of the small business Wivenhoe Wines has completed a report analysing the results of the business for the quarter ended 31st December. He has compared the actual results with the original budget for the quarter. As budgets are only estimates, the business has a policy of not investigating differences between the actual and budgeted figures (variances) of less than $1,000. None of the variances is greater than $1,000, so the owner believes the results are reasonable, even though profit is $850 less than planned. Wivenhoe Wines Income statement Analysis For the quarter ended 31st December Oct-Dec Actual Sales Variable costs

Oct-Dec Budget

Variance

19 600

19 500

100

5 950

5 200

750

13 650

14 300

650

Fixed costs

4 000

3 800

200

Profit

9 650

10 500

850

Contribution margin

You have discovered that the original budget expected sales of 650 bottles of wine for the quarter, but in fact 700 bottles were sold. You are concerned that, given 700 bottles were sold, the profit should have been greater than budgeted, not less. Can you think of a way of presenting the report that would improve the analysis?

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Chapter 3 Developing a business plan: Applied budgeting

Dr Decisive Yesterday, you received the following letter for your advice column in the local paper:

Dear Dr Decisive, Please help me persuade my mother to budget! She says that life is short and that she probably won’t live long enough to enjoy her savings. The trouble is that she is only 45, and even though I have pointed out that the average life expectancy in Australia is over 80, she can’t see the point in budgeting when ’the future is too unpredictable’. ’How can you plan for the unexpected?’ she says. ’Bills can vary too much. How could I know when the car is going to need repairs and how much that will be?’So she uses her credit card to pay for unexpected items and then can’t afford to pay it off and the interest and repayments are getting higher. She won’t listen to me, but she reads your column and would take your advice seriously. ‘Dwindling Inheritance’ Required: Meet with your Dr Decisive team and write a response to ‘Dwindling Inheritance’.

Endnotes a

Di Bella Coffee online shop. http://dibellacoffee.com/shop. Accessed 15 May 2017. Shields, JF & Shields, MD (1998) ‘Antecedents of participative budgeting’. Accounting, Organizations and Society, 23(1), 49–76; Searfoss, DG & Monczka, RM (2017) ‘Perceived participation in the budget process and motivation to achieve the budget’, Academy of Management Journal, 16(4), 541–54. c Based on Network for Business Sustainability (2012) ‘5 steps for building sustainability into corporate budgeting and planning’. http://nbs.net/knowledge/5-steps-for-building-sustainability-into-corporate-budgeting-and-planning. Accessed 14 April 2017. b

List of company URLs u u u u u u u u u

AusIndustry Programs: https://www.business.gov.au Di Bella Coffee: http://dibellacoffee.com Europcar: http://www.europcar.com.au Hungry Jack’s: http://www.hungryjacks.com.au Kmart: http://www.kmart.com.au McDonald’s Australia: http://www.mcdonalds.com.au Sanitarium: https://www.sanitarium.com.au Support for Small Business: https://www.industry.gov.au/strategies-for-the-future/boosting-innovation-and-science Virgin Australia: http://www.virginaustralia.com/au/en

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4 THE ACCOUNTING SYSTEM: CONCEPTS AND APPLICATIONS ‘Profits are the mechanism by which society decides what it wants to see produced.’ Henry C Wallicha

Learning objectives After reading this chapter, students should be able to do the following: 4.1 Understand how to interpret and evaluate financial accounting information in order to make informed decisions. 4.2 Understand the basic concepts and terms that help identify and record the activities of a business. 4.3 Describe the basic components of the accounting equation: assets, liabilities and owner’s equity. 4.4 Understand the impact that individual transactions have on the accounting equation. 4.5 Define revenue and expenses and expand the accounting equation to include the impact of revenue and expenses on net income. 132

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Chapter 4 The accounting system: Concepts and applications

4.6 Identify types of adjusting entries and why they are necessary at the end of the financial period. 4.7 Compile basic financial reports from the running totals in the accounting equation.

Understanding the learning objectives is assisted in the chapter by asking key questions:

Key questions 1

Why do managers, investors, creditors and others need information about the operations of a business?

2

What are the basic concepts and terms that help identify the activities recorded by the accounting records of a business?

3

What do users need to know about the accounting equation for a business?

4

Why are at least two effects of each transaction recorded in a business’s accounting system?

5

What are revenues and expenses, and how is the accounting equation expanded to record these items?

6

What are the accounting principles and concepts related to net income?

7

Why are adjustment entries necessary at the end of a financial period?

8

Is it possible to prepare basic financial reports for a business from the running totals of the accounting equation?

Do you have a system for keeping track of your financial activities? Do you plan your monthly cash receipts and payments by using a budget, as described in the previous chapter? When you get your wage or salary, do you always review it to ensure you have been paid correctly for the hours that you worked? Do you record every bill you pay, and keep a running total of the amount you have in your bank account? At the end of each month, do you check all entries on your bank statement? When you charge something on your credit card, do you always check the amount on the receipt before you sign it? Do you keep your credit-card receipts and compare them with the charges on your monthly credit card statement before you pay your bill? When you pay your landlord, do you always pay your rent at the beginning of the month? Do you have your bank automatically deduct your car payments from your savings account? Do you pay for your car insurance soon after you get the bill? At the end of each month, do you compare your actual receipts and payments with what you budgeted to see how you stand? If you answered yes to the majority of these questions, then you are already managing the financial aspects of your life quite well. After you graduate, you may want to become a manager or owner of a business. As we discussed in Chapters 2 and 3, accounting methods, such as cost–volume–profit (CVP) analysis and budgeting, help managers to carry out the planning, operating and evaluating activities of a business. However, managers must also keep track of the business’s operations in order to evaluate its performance, as well as their own performance as managers. To do this, managers develop and use an accounting system. For example, an accounting system shows managers the total value of products sold in a certain period of time, what cash payments have been made, whether the business is staying within its budgets and, more particularly, whether the business is generating sufficient cash flow. Managers are not the only people interested in the operations of a business. External users need information about the business’s operations to help them make decisions, such as whether they want to invest in or lend money to the business. In this chapter, we will discuss the role of financial accounting in Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions decision making, explain the basics of the financial accounting process and illustrate how the figures provided by the financial accounting process support the day-to-day decisions that managers or business owners must make.

4.1 Financial accounting information and decision making The main function of recording and accounting for business activities is to provide financial information that is useful in making decisions. Let’s return to our discussion of DeFlava Coffee Corporation, the coffee manufacturer, to see why external users need accounting information. As you can imagine, it takes lots of coffee beans to make good coffee. Suppose for a moment that you are the CEO of Green Trees Coffee Farm, and that DeFlava Coffee is considering a purchase of coffee-bean supplies from your business. DeFlava wants to make bulk purchases on credit and pay for them 30 days later when it has collected money from its customers for coffee products that have been supplied.

Stop & think As CEO of Green Trees Coffee Farm, how would you initially react to this request? Why? What facts may change your mind?

1

Why do managers, investors, creditors and others need information about the operations of a business?

Although your immediate response may be to sell the coffee beans to DeFlava Coffee, you should think carefully before agreeing to the credit (buy now and pay later) arrangement. Certainly, businesses like to make sales. However, increasing sales by allowing credit is a good decision only if you are reasonably sure that credit customers will pay their bills. If DeFlava doesn’t pay its bills, Green Trees Coffee Farm will have given up some of its resources and have nothing to show for it. The four-step problem-solving process we discussed in Chapter 1 provides an excellent framework for making decisions of a financial nature, and for analysing the credit decision being considered here. You’ve already taken the first step – recognising that the problem is to decide whether to sell coffee beans to DeFlava Coffee on credit. You now can move on to the second step: identifying your business’s alternatives. You might decide not to extend credit to DeFlava, to extend credit under stricter or more lenient terms or to agree to the original request. The third step, evaluating each alternative by weighing its advantages and disadvantages, helps you to decide which alternative best helps your business meet its goals of remaining solvent and earning a satisfactory profit. The alternative you choose will depend partly on your business’s ability to extend credit and on its existing credit policies. When you perform this step, financial accounting information about DeFlava Coffee will play a big role in helping you to determine how good a customer DeFlava will be. Case Exhibit 4.1 shows a simplified income statement and a simplified balance sheet for DeFlava Coffee Corporation for the first quarter of 20X1.1 When you analyse these financial statements, you learn from the income statement that during the most recent quarter DeFlava earned $18.1 million of revenue from selling coffee and made $720 000 net income. From the balance sheet, you learn that on 31 March 20X1, DeFlava had $1.2 million cash in the bank, inventory (stock of coffee) of $1.3 million and other assets (trucks, factory, etc.) totalling $16.8 million, and that it owed $3 million to suppliers and $2 million to the bank. Each of these items should affect the specific credit terms, if any, that you are willing to offer. After evaluating the alternatives, you are ready to make a decision about DeFlava’s credit request. This is just one example of how financial accounting information can help external decision makers choose whether or not to do business with another business. Another is when a banker studies a business’s financial statements to decide the conditions for granting a loan. Businesspeople routinely 1

For simplicity, we assume here that DeFlava Coffee sells only one type of coffee. We will relax this assumption in later chapters. Additionally, DeFlava Coffee’s actual financial statements have many more items, which we don’t show here because you have not yet studied them. We will show more complete financial statements in later chapters.

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Chapter 4 The accounting system: Concepts and applications Case Exhibit 4.1 Income statement and balance sheet DEFLAVA COFFEE CORPORATION Income statement For quarter ended 31 March 20X1 (in thousands of dollars) Revenues: Sales revenue

$ 18 100

Expenses: Cost of sales

$11 500

Selling expenses

3 460

General and administrative expenses

1 940

Total expenses

(16 900)

Income before income taxes

$ 1 200

Income tax expense

(480)

Net income

$

720

DEFLAVA COFFEE CORPORATION Balance sheet 31 March 20X1 (in thousands of dollars) Assets Cash

Liabilities $ 1 200 Accounts payable (suppliers)

Inventories

$ 3 000

1 300 Loan payable (bank)

Other assets

2 000

16 800 Total liabilities

$ 5 000 Shareholders’ equity

Total shareholders’ equity Total assets

$19 300 Total liabilities and shareholders’ equity

$14 300 $19 300

make decisions like these. In each case, financial statements provide information that is important for solving business problems. Making good decisions based on information in financial statements assumes that there is agreement about what is included in those statements and about how the amounts are measured. Without agreement on what accounting information the balance sheet, income statement and cash flow statement should contain, the statements would essentially be useless. If every business defined and measured financial statement items such as assets, liabilities, revenues and expenses differently, there would be no way to compare the information of one business with that of another.

Discussion What difficulties do you think would be caused if each Australian state and territory defined traffic laws differently (for example, laws stipulating which side of the road to drive on) and used different traffic signs?

The generally accepted accounting principles (GAAP) that we introduced in Chapter 1 were developed to overcome this problem by setting rules for businesses to follow when they prepare financial statements. Thus, if you know that a business’s financial statements are prepared according to GAAP, and you know what rules are included in GAAP, you can confidently use the information in the business’s financial statements for your decision making. The rest of this chapter will provide you with a basic understanding of the financial accounting Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions process. This process provides the information a business needs to prepare financial statements according to GAAP. Once you have learned some fundamental concepts, we will discuss how the accounting process accumulates and reports information about a business’s activities. In addition, accounting standards prescribe rules for the measurement and disclosure of items reported in the financial statements. Accounting standards are issued by bodies such as the Australian Accounting Standards Board (AASB); more recently, many countries have adopted the International Financial Reporting Standards (IFRS).

4.2 Basic concepts and terms used in accounting Several basic concepts and terms help us to identify the activities that a business’s accounting process records: 1 entity concept 2 transactions 3 source documents 4 monetary unit concept 5 historical cost concept. Each of these items is important for understanding the process of accumulating and reporting information about a business’s activities.

Entity concept

entity Separation of accounting records of a business from the records of the business’s owner or owners

As you saw in Chapter 1, there are three broad forms of business structure: sole proprietorships, partnerships and companies/corporations. Regardless of the form of a business, its accounting records must remain separate from those of its owner(s). Even though Emily Della is the sole proprietor of Cafe´ Revive, she doesn’t consider her personal assets to belong to Cafe´ Revive, nor does she consider Cafe´ Revive’s assets to be hers. If you or Emily owned all or part of several businesses, you would keep separate records for each of them. This separation is the basis of the entity concept. An entity is considered to be separate from its owner(s) and from any other business. Thus, each business is an entity and has its own accounting system and accounting records. An owner’s personal financial activities are not included in the accounting records of the business unless the activity has a direct effect on the business. For instance, if Emily bought a car for personal use only, the purchase would not affect Cafe´ Revive’s accounting records. On the other hand, if Emily used personal funds to buy a delivery van to be used by the business, the purchase would affect the records of the business.

Stop & think 2

What are the basic concepts and terms that help identify the activities recorded by the accounting records of a business?

Why do you think it is important to treat each entity separately? Combining business-related items and personal items would make it hard to tell which items are intended for business purposes and which are for personal use. External users interested in the activities of a business would gain little information if you gave them financial statements that included both sets of items. With a separate accounting system for a business, it is much easier to identify, measure and record activities, and to prepare financial statements. Therefore, financial statements provide useful information to managers and external users for evaluating the effectiveness of the business’s operations, allowing these users to make better decisions.

Transactions Recall from Chapter 1 that accounting involves identifying, measuring, recording, summarising and communicating economic information about the activities of a business for use in decision making. The 136

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Chapter 4 The accounting system: Concepts and applications accounting process usually begins with a business transaction, which is an exchange of property or service with another entity. For example, when DeFlava Coffee purchases gas for the roaster, it exchanges cash (or the promise to pay cash) for the products needed to roast the coffee. Businesses engage in numerous transactions every day. Each of them must be recorded based on information from source documents.

transaction Exchange of property or service by a business with another entity

Source documents A source document is a business record that is used as evidence that a transaction has occurred. A source document may be a sales receipt, a printout from an electronic funds transfer (EFT) machine, an electronically generated acknowledgment of an order and/or receipt for payment of an order, an invoice or a bill from a supplier, an invoice or bill sent to a customer, an electronic payroll timesheet printout or a log of the kilometres driven in the business’s delivery truck. Although the accounting process begins when a transaction occurs, the identification, measurement and recording of information are based on an analysis of the related source documents. For instance, if DeFlava Coffee pays for a bulk purchase of coffee beans by electronic funds transfer, details such as the date of the transaction, the dollar amount, the name of the person or business to whom the payment was made (called the payee) and the reason for the payment are all noted in the funds transfer notification. Additionally, all transfers made by DeFlava Coffee electronically are recorded automatically and included in a printout of the bank statement. Several source documents may be used as evidence of a single transaction. For example, DeFlava Coffee’s purchase of coffee beans will include the sales invoice from the supplier and a report from the loading dock stating that the coffee arrived at DeFlava Coffee’s factory.

source document Business record used as evidence that a transaction has occurred

Monetary unit concept The source documents for a transaction show the value of the exchange in terms of money. This is known as the monetary unit concept. In Australia and New Zealand, the monetary unit is the dollar, so businesses will show their financial statements in dollars. The monetary unit used depends on the national currency of the country in which the business operates. For example, Sony (http:// www.sony.com.au) uses the Japanese yen, while Audi (https://www.audi.de/de/brand/de.html) and Benetton (http://www.benetton.com) use the euro.

Stop & think If an organisation, such as Aldi (http://www.aldi.com.au), does business in a number of countries, what currency do you think it uses to prepare its financial statements? Why?

monetary unit concept Concept that transactions are to be recorded in terms of money or currency

historical cost concept Concept that a business records its transactions based on the dollars exchanged at the time the transaction occurred

As we all know, the value of every country’s currency changes. Also, the values of particular goods and services change in the marketplace as supply and demand change. So a business has to decide whether to adjust the recorded amounts to include these types of changes, and, if buying from overseas, whether to factor in foreign currency translation rates. Under GAAP, businesses generally do not record the change in the value of either the currency or the individual goods and services. Instead, they use the historical cost concept, or simply the cost concept. The historical cost concept states that a business records its transactions based on the dollars exchanged (the cost) at the time the transaction occurred. The related source documents show this cost, and the business’s accounting records continue to show the cost involved in each transaction, regardless of whether

AAP Images/Audi Images

Historical cost concept

If DeFlava Coffee purchased an Audi from a dealership in Germany, do you think this purchase should be recorded in dollars or euros? Why?

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Accounting Information for Business Decisions the value of the property or service owned increases (or decreases) and whether the value of the currency changes over time. For instance, suppose that a business acquires land for $100 000, and that one year later, the value of the land has increased to $130 000. Under the historical cost concept, the business continues to show the land in its accounting records at $100 000, the acquisition cost. However, businesses may adjust some assets for changes in their values in certain circumstances.

Stop & think In this example, why do you think most accountants wouldn’t want to change the recorded value for the land from $100 000 to $130 000? Why might some want to change? In Case Exhibit 4.2, we combine the entity concept, the monetary unit concept and the historical cost concept to develop DeFlava Coffee’s balance sheet that we showed in Case Exhibit 4.1. In this balance sheet, we (a) separate business items from personal items according to the entity concept; and (b) use the monetary unit concept and the historical cost concept to show dollar values for each item of the business.

Case Exhibit 4.2 DeFlava Coffee Corporation’s assets and liabilities and balance sheet

Business items

Personal items

Cash

House

Cash Factory

Mortgage

Note Trucks Car Inventory

$ Paid or Owed

DeFlava Coffee Corporation Balance sheet 31 March 20X1 (in thousands of dollars) Assets Cash Inventories Other assets

Liabilities $ 1 200 1 300 16 800

Accounts payable Notes payable Total liabilities

$ 3 000 2 000 $ 5 000

Shareholders’ equity

Total assets

138

$19 300

Total shareholders’ equity Total liabilities and Shareholders’ equity

$14 300 $19 300

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Chapter 4 The accounting system: Concepts and applications These three concepts are the foundation of what the accounting process shows. With this in mind, you can see how that process functions. The accountant, or the owner, uses the entity concept to separate the activities of a business from the owner’s activities, which are not related to the business. The business’s transactions are identified by analysing source documents. The accountant or owner then enters the transactions into the business’s accounting records using monetary units (dollars) based on the costs involved in its activities. Every time a business activity occurs, the accountant or owner uses these concepts to help decide the proper way to record that activity. After the financial information about a business’s activities is recorded and accumulated, the ultimate goal of the accounting process is to communicate this information in the business’s balance sheet, income statement and cash flow statement, each prepared according to GAAP.

4.3 Components of the accounting equation We can now begin to discuss how the accounting system works. Using financial information to make decisions usually involves the following processes to identify and measure, record, report, analyse and interpret, and retain information about the activities of a business so that owners and managers can make effective decisions. Most decisions are made on the basis of information provided in the financial statements, which summarise the results of the financial activities of a business for a period, culminating in the balance sheet. Every time a business records the exchange of property or services with another party, the transaction affects at least one of the sections of the balance sheet. As discussed in previous chapters, a balance sheet has three sections: assets, liabilities and owner’s equity. So, before moving on, let’s consider the following expanded definitions of these terms.

Assets Assets are a business’s economic resources that will provide future benefits to the business. A business may own many assets, some of which are physical in nature – such as land, buildings, supplies to be used and inventory that the business expects to sell to its customers. Other assets do not have physical characteristics but are economic resources because of the legal rights (benefits) they convey to the business. These assets include amounts owed by customers to the business (accounts receivable), the right to insurance protection (prepaid insurance) and investments made in other businesses and items, such as trademarks or copyrights. We will discuss assets further in Chapter 8.

prepaid insurance Cost paid for the right to insurance protection

Stop & think Can you think of more examples of assets? How does each of these examples meet the definition of assets?

Liabilities Liabilities are the economic obligations (debts) of a business. The external parties to whom a business owes the debts are referred to as the creditors of the business. Liabilities include amounts owed to suppliers for credit purchases (accounts payable), amounts owed to employees for work they have done (wages and salaries payable) and amounts owing to financial institutions for money lent to the business (loans payable). Legal documents are often evidence of liabilities. These documents establish a claim by the creditors against the assets of a company. We will discuss liabilities in more detail in Chapter 8.

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creditors External parties to whom a business owes debts wages and salaries payable Amounts owed to employees for work they have done loans payable Amounts owing to financial institutions for money lent to the business

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Accounting Information for Business Decisions

Stop & think Can you think of more examples of liabilities? How does each of these examples meet the definition of liabilities?

Owner’s equity partners’ equity The partners’ current investment in the assets of the business

residual equity Term used to refer to owner’s equity because creditors have first legal claim to a business’s assets

The owner’s equity of a business is the owner’s current investment in the assets of the business. (A partnership’s balance sheet would refer to partners’ equity, and a company’s balance sheet would call this shareholders’ equity, as you saw in Case Exhibits 4.1 and 4.2 and as we will discuss in Chapter 5.) The capital invested in the business by the owner, the business’s earnings from operations and the owner’s withdrawals of capital (drawings or dividends) from the business all affect owner’s equity. For a sole proprietorship, the balance sheet shows the owner’s equity by listing the owner’s name, the word ‘capital’ and the amount of the owner’s current investment in the business. As you will see later, partners’ equity and shareholders’ equity appear slightly differently. Owner’s equity is sometimes referred to as residual equity because creditors have first legal claim to the assets of a business. Once the creditors’ claims have been satisfied, the owner is entitled to the remainder (i.e. residual) of the assets. We will discuss owner’s equity in greater detail in Chapter 8.

Using the accounting equation

3

What do users need to know about the accounting equation for a business? accounting equation Assets ¼ Liabilities þ Owner’s equity

balance The amount in an account column at the beginning of the period plus the increases and minus the decreases recorded in the column during the period

In summary, accountants use the term assets to refer to a business’s economic resources, and the terms liabilities and owner’s equity to describe claims on those resources. All of a business’s economic resources are claimed by either creditors or owners. Therefore, the financial accounting system is built on a simple equation:

Economic resources ¼ Claims on economic resources Using the accounting terms you have learned, we can restate the equation:

Assets ¼ Liabilities þ Owner’s equity This mathematical expression is known as the basic accounting equation. Both sides of the equation must always be equal; that is, the total of the assets must equal the total of the liabilities plus owner’s equity. This is the reason a business’s statement of financial position is called a balance sheet: the monetary total for the economic resources (assets) of the business must always be in balance (or equal) with the monetary total for the claims (Liabilities þ Owner’s equity) on the economic resources. Like the components of any other equation, the components of this equation may be transposed. Another way of showing the equation is:

Owner’s equity ¼ Assets  Liabilities In this form of the equation, the right-hand side (i.e. Assets – Liabilities) is referred to as net assets. This form of the equation also stresses that owner’s equity may be thought of as a residual amount. In a similar fashion, we can calculate liabilities from the equation:

Liabilities ¼ Assets  Owner’s equity Regardless of what form the equation takes, both sides must always balance (or be equal). Because a transaction normally begins the accounting process, a business must record each transaction in a way that maintains this equality. Keeping this equality in mind will help you to understand other aspects of the accounting process.

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Chapter 4 The accounting system: Concepts and applications

The dual effect of transactions To keep the accounting equation in balance, a business must make at least two changes in its assets, liabilities or owner’s equity when it records each transaction. This is called the dual effect of transactions. For instance, when an owner invests $20 000 in a business, assets (cash) are increased by $20 000 and owner’s equity (owner’s capital) is increased by $20 000. This transaction causes two changes: one change in the asset section of the business’s balance sheet, and one change in the owner’s equity section of its balance sheet. Because the left side and the right side both increase by the same amount, the accounting equation (Assets ¼ Liabilities þ Owner’s equity) stays in balance. The fact that transactions always have a dual effect does not mean that every transaction will affect both sides of the equation – or even two components of the equation. A transaction may affect only one side, by increasing one asset and decreasing another asset by the same amount. For example, assume a business buys office equipment by paying $400 cash. In this case, the asset ‘Office equipment’ increases by $400 and the asset ‘Cash’ decreases by $400. The accounting equation still balances after the business records this transaction because the transaction does not affect the right side of the equation, since the total for the asset (left) side of the equation is not changed. To understand how the accounting equation and the dual effect of transactions provide structure to a business’s accounting system, think about these concepts as the scales of a business’s transactions. Exhibit 4.3 shows a set of transaction ‘scales’. Instead of measuring the weight of various objects using grams or kilograms as measuring units, these scales measure transactions using dollars (historical cost monetary units). Suppose a business currently has assets of $100 000, liabilities of $25 000 and owner’s equity of $75 000. Assume that the business’s accountant or owner ‘places’ the business’s current economic resources (assets of $100 000) on the left side of the scales and the current claims on those resources (Liabilities of $25 000 þ Owner’s equity of $75 000) on the right side of the scales. Remember that after each transaction, the scales must balance. The dual effect of transactions provides a way to keep the scales in balance as business activities are placed (recorded) on the scales. Note that in Exhibit 4.3 the left side of the scales holds $100 000 in total assets, and the right side holds $25 000 in liabilities and $75 000 in owner’s equity. The scales balance according to the accounting equation:

dual effect of transactions A business must make at least two changes in its assets, liabilities or owner’s equity when it records each transaction 4

Why are at least two effects of each transaction recorded in a business’s accounting system?

Assets ¼ Liabilities þ Owner’s equity $100 000 ¼ $25 000 þ

$75 000

Exhibit 4.3 The dual effect of transactions – transaction ‘scales’

$25 000

$100 000

Liabilities ⴙ Owner’s equity

Assets

Assets $100 000

$75 000

ⴝ ⴝ

Liabilities ⴙ Owner’s equity $25 000 ⴙ $75 000

As we stated earlier, regardless of the type of transaction that occurs, the accounting equation – like our set of transaction scales – must always balance. Exhibits 4.4 and 4.5 use the scales to illustrate two more transactions. In Exhibit 4.4, you can see what happens when the owner deposits $5000 from personal funds into the business’s bank account. The first frame shows the accounting equation in balance before the owner’s deposit. The second frame shows the equation out of balance because only one Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions Exhibit 4.4 Transaction ‘scales’ – increase in assets and owner’s equity

The transaction ‘scales’ balance in this frame because the business’s assets ($100 000) equal the business’s liabilities ($25 000) plus owner’s equity ($75 000).

$25 000

$100 000

Liabilities ⴙ Owner’s equity

Assets

In this frame, the transaction ‘scales’ are out of balance. This happens because the $5 000 increase in assets has been added to the asset side of the scales, but the $5 000 increase in owner’s equity has not yet been added to the liabilities and owner’s equity side $5 000 of the scales.

$75 000

$25 000

$75 000

Liabilities ⴙ Owner’s equity

$100 000 Assets

The transaction ‘scales’ are in balance again once the $5 000 increase in owner’s equity has been added to the liabilities and owner’s equity side of the scales.

$5 000

$100 000 $25 000 $5 000

Assets

$75 000

Liabilities ⴙ Owner’s equity

change, the $5000 increase in business assets on the left side of the equation, has been recorded. In the last frame, the scales again balance, showing that the $5000 owner’s equity increase on the right side of the equation has been recorded. After this transaction, the accounting equation is as follows: Assets ¼ Liabilities þ Owner’s equity $105 000 ¼ $25 000 þ $80 000 Exhibit 4.5 shows what happens when the business pays $20 000 off a bank loan. The accounting equation stays in balance because assets and liabilities decrease by the same amount:

Assets ¼ Liabilities þ Owner’s equity $85 000 ¼ $5 000

þ

$80 000

Stop & think Do you think that businesses in other countries use this same structure? Why or why not? In Chapters 2 and 3, you saw how managers use accounting information to develop a business plan to show potential investors or lenders. Managers also use accounting information for internal decision 142

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Chapter 4 The accounting system: Concepts and applications Exhibit 4.5 Transaction ‘scales’ – decrease in assets and liabilities

The transaction ‘scales’ balance in this frame because the business’s assets ($105 000) equal the business’s liabilities ($25 000) plus owner’s equity ($80 000). $105 000

$80 000

Liabilities ⴙ Owner’s equity

Assets

The transaction ‘scales’ do not balance in this frame because, although the $20 000 decrease in assets has been taken off the scales, the liabilities have not yet been changed.

$25 000

$85 000 Assets

$25 000

$80 000

Liabilities ⴙ Owner’s equity

The transaction ‘scales’ are in balance again once the $20 000 decrease in liabilities is removed from the liabilities and owner’s equity side of the scales.

$85 000 Assets

$5 000

$80 000

Liabilities ⴙ Owner’s equity

making. CVP analysis and budgeting provide accounting information that helps managers answer questions such as: • How much money does the business need to have on hand to start operations? • How much inventory should the business have available? • How much money can the business spend to advertise a grand opening? These initial considerations are undertaken for one purpose: so that managers can pursue the goal of earning a satisfactory income (profit) for the owners. The profit goal is met by selling products or services to customers at prices that are higher than the costs of providing the products or services.

4.4 Accounting for transactions to start a business Once a business starts operating, it uses financial statements to report to external users about its operations. To prepare these financial statements, the business’s accountant or owner identifies transactions and records them in the business’s accounting system. This analysis uses the accounting equation and recognises the dual effect of transactions. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

143

Accounting Information for Business Decisions

Stop & think If you loaned money to a business, how often would you want the company to report on its operations? Why? The transactions recorded in the accounting system are the basis for the internal and external reports that the business issues. Therefore, it is very important that the transactions are entered correctly, since they ‘live on’ in the system for many years. With the accounting equation (and the dual effect of transactions) in mind, watch your friend Emily Della as she analyses and records the December 20X1 transactions involved in starting her business, Cafe´ Revive. Note how Emily uses accounting concepts, the accounting equation and the dual effect of transactions to build an effective accounting system.

Investing cash (transaction 1) Emily Della starts her business on 1 December 20X1 by transferring $22 000 to a bank account she opened for Cafe´ Revive. Emily wants to open the coffee shop to customers as soon as possible so that she can build some customer traffic as people start Christmas shopping. The business’s bank account is separate, of course, from her personal account because of the entity concept. Emily decides to establish on a spreadsheet a basic accounting system for Cafe´ Revive, by listing assets, liabilities and owner’s equity as headings of separate columns. Each column is called an account – that is, a place a business uses to record and retain information about the effect of its transactions on a specific asset, liability or owner’s equity item. Emily records each transaction by entering the amounts in the appropriate account columns. She uses the receipt issued by Cafe´ Revive for the $22 000 and the bank printout of the business’s bank account as evidence for the first transaction. Case Exhibit 4.6 shows how she records this first transaction. Case Exhibit 4.6 Emily invests cash in Cafe´ Revive Assets Trans

Date

(1)

1/12/X1

Balances

¼

Cash

Liabilities

þ

Owner’s equity E Della, capital

þ$22 000 $22 000

þ$22 000 ¼

$22 000

Stop & think Why does Emily’s personal transfer of funds need to be recorded for Cafe´ Revive? Note that Emily makes two $22 000 entries to record the dual effect of the transaction – one to an asset account, ‘Cash’ (or ‘Cash at bank’) and one to an owner’s equity account, ‘E Della, capital’ – and that the accounting equation balances because she increases both sides of the equation by the same amount. At the end of each day, Emily calculates the balance of each account – that is, the amount in the account at the beginning of the day plus the increases and minus the decreases recorded in the column that day. In this case, since Emily has recorded only one transaction, Cafe´ Revive now has a balance of ‘$22 000’ in the ‘Cash’ account and a balance of $22 000 in the ‘E Della, Capital’, as we indicate by the double lines under these amounts.

144

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Chapter 4 The accounting system: Concepts and applications

Prepaying rent (transaction 2) To open Cafe´ Revive at the University Hub, Emily signed, in the company’s name, a rental agreement with the centre’s manager on 1 December 20X1. The monthly rent is $1320 – $1200 plus goods and services tax (GST) of $120 – and the agreement requires that rent for six months be paid in advance. Since the space is empty, the centre manager agrees to let Emily begin setting up her business immediately but not start charging her rent until 1 January 20X2. This arrangement works well for Emily because now she can begin purchasing shop equipment, supplies and inventory. When Emily signs the rental contract on 1 December, she pays $7920 ($1320  6 months) to the University Hub. Cafe´ Revive receives an electronic receipt, and this and the signed rental agreement are the source documents for the transaction. Case Exhibit 4.7 shows how Emily records this second transaction. Case Exhibit 4.7 Cafe´ Revive prepays rent ¼

Assets Trans.

Date

Cash

(1)

1/12/X1

þ$22 000

(2)

1/12/X1

$ 7 920

Balances

$14 080

þ

Prepaid rent

þ

Liabilities

GST paid

þ

Owner’s equity E Della, capital þ$22 000

þ$7 200 þ

$7 200

þ$720 þ

$720

¼

$22 000

The benefit of using the University Hub space to conduct business for six months represents an economic resource or asset to Cafe´ Revive. As a result, Emily records $7200 as an increase in a new asset account, ‘Prepaid rent’. She also records $720 in the ‘GST paid’ account. This account will attract a rebate from the taxation office, and so is treated in the same manner as an account receivable. Because cash is paid out, Emily decreases the asset ‘Cash’ by the total amount paid, $7920. At the end of the day, she subtracts this amount from the previous amount of cash to show a new balance of $14 080. She then checks the accounting equation to see that it remains in balance. She does this by adding the assets ($14 080 þ $7200 þ $720) and comparing this $22 000 amount with the total of the liabilities ($0) plus owner’s equity ($22 000). As you can see, the equation still balances.

Stop & think How many changes did Emily make in the accounting equation to record this transaction? Why?

Purchasing supplies with cash (transaction 3) On 7 December 20X1, Cafe´ Revive purchases $2255 of coffee supplies from City Supply Company by transferring $2255 in cash. Emily receives an invoice that lists the items purchased, the cost of each item and the total cost. She uses the invoice as the source document to record this third transaction, as we show in Case Exhibit 4.8. Because the supplies will be used to conduct business, Emily records them as an asset, or ‘Supplies’, of $2050. She also records $205 in the ‘GST paid’ account. Because the purchase is made with cash, she reduces the asset ‘Cash’ by $2255. Note that the changes in these two assets offset each other on the left side of the accounting equation, and so it remains in balance.

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145

Accounting Information for Business Decisions Case Exhibit 4.8 Cafe´ Revive purchases supplies with cash ¼

Assets þ Prepaid rent þ

Trans

Date

Cash

(1)

1/12/X1

þ$22 000

(2)

1/12/X1

$ 7 920

(3)

7/12/X1

$ 2 255

þ

Owner’s equity

E Della, capital

Trans

Date þ$22 000

þ$7 200

þ$720 þ$2 050

$11 825 þ

Balances

þ GST paid

Supplies

Liabilities

$7 200 þ

þ$205

$2 050 þ

$925 ¼

$22 000

Purchasing inventory on credit (transaction 4) On 12 December 20X1, Cafe´ Revive purchases $1430 of coffee gift packs (50 gift packs for $28.60 each; that is, $26 plus GST of $2.60) on credit from DeFlava Coffee Corporation. Cafe´ Revive agrees to pay for the gift packs within 30 days of purchase. An invoice from DeFlava Coffee is the source document for the transaction. Case Exhibit 4.9 shows how Emily records this fourth transaction. Cafe´ Revive needs a way to keep track of the cost of the coffee gift packs that it buys from manufacturers and has on hand to sell to its retail customers. Case Exhibit 4.9 Cafe´ Revive purchases inventory on credit Assets Trans

Date

Cash

(1)

1/12/X1

þ$22 000

(2)

1/12/X1

$ 7 920

(3)

7/12/X1

$ 2 255

(4)

12/12/X1

Balances

þ

Prepaid rent

þ

Supplies

þ

Inventory

þ

Liabilities

þ

Owner’s equity

¼

Accounts payable

þ

E Della, capital þ$22 000

þ$7 200

þ$ 720 þ$2 050

þ$ 205 þ$1 300

$11 825

GST paid

¼

þ

$7 200

þ

$2 050

þ

$1 300

þ$ 130 þ

$1 025

þ$1 430 ¼

$1 430

þ

$22 000

Emily thus adds an account column to assets to record inventory. She increases ‘Inventory’ by the cost of the gift packs, $1300, and ‘GST paid’ by $130, but does not reduce ‘Cash’ because none was paid out. Since Cafe´ Revive agrees to pay for the inventory later, it incurs a debt, or liability. Emily calls the liability an account payable because it is an amount to be paid by the business, and she increases ‘Accounts payable’ by $1430. Note that DeFlava Coffee, not Emily, finances this increase in Cafe´ Revive’s assets (economic resources). DeFlava Coffee Corporation is now Cafe´ Revive’s creditor (liability) because it has a claim of $1430 of the cafe´’s assets. The $1430 increase in economic resources matches the $1430 increase in the claims on those resources. So the left side of the accounting equation and the liability component of the right side both increase by $1430. The accounting equation balances after the transaction is recorded.

146

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Chapter 4 The accounting system: Concepts and applications

Purchasing shop equipment with cash and credit (transaction 5) On 20 December 20X1, Cafe´ Revive purchases shop equipment from Restaurant Equipment at a cost of $1650. It pays $250 immediately and takes a small loan payable agreeing to pay the remaining $1400 (plus interest of $33) at the end of three months. Emily records this fifth transaction, as we show in Case Exhibit 4.10. Because the shop equipment is an economic resource to be used in the business, Emily increases the asset ‘Shop equipment’ by the total cost of $1500. She also records $150 in the ‘GST paid’ account. She decreases the asset ‘Cash’ by the amount paid, $250. Since Cafe´ Revive incurs a $1400 liability by taking a small loan, Emily increases the liability ‘Loan payable’ by this amount. She does not record any interest now because interest accumulates as time passes, and will be accumulated at the end of each of the three months. This transaction affects three asset accounts and a liability account, but the accounting equation remains in balance. Case Exhibit 4.10 Cafe´ Revive purchases shop equipment with cash and credit ¼

Assets Trans

Date

Cash

(1)

1/12/X1

þ$22 000

(2)

1/12/X1

$ 7 920

(3)

7/12/X1

$ 2 255

(4)

12/12/X1

(5)

20/12/X1 $

þ Prepaid þ Supplies þ Inventory þ Shop þ rent equipment

þ$ 720 þ$2 050

þ$ 205 þ$ 130 þ$1 500

250

$11 575 þ

¼ Accounts þ Loan þ E Della, payable payable capital

GST paid

þ$22 000 þ$7 200 þ$1 300

Balances

þ Owner’s equity

Liabilities

$7 200 þ

$2 050 þ

$1 300 þ

þ$1 430

þ$ 150

$1 500 þ

þ$1400

$1 205 ¼

$1 430 þ

$1 400 þ

$22 000

Selling extra shop equipment on credit (transaction 6) Cafe´ Revive obtained a special price on its shop equipment by buying a ‘package’ that included an extra computer desk the company did not need. So, on 22 December 20X1, Cafe´ Revive sells the desk for $440 to Beau Flowers Store, another shop in the University Hub. The manager of Beau Flowers agrees to pay for the desk on 7 January. Case Exhibit 4.11 shows how Emily records this sixth transaction. Case Exhibit 4.11 Cafe´ Revive sells extra shop equipment on credit ¼

Assets

(1)

1/12/X1

þ$22 000

(2)

1/12/X1

$ 7 920 $ 2 255

7/12/X1 12/12/X1

(5)

20/12/X1

(6)

22/12/X1

Balances

þ$22 000 þ$7 200

þ$ 720 þ$2 050

þ$ 205 þ$1 300

$

þ$ 130 þ$1 500

250

$ 400 $11 575 þ

$7 200 þ

$2 050 þ

$1 300 þ

8 > > > > > > > > > > > > > > > > > > > > > > > > > > > > > > > > > > >
> > > > > > > > > > > > > > > :

Cash

8 > > > > > > > > > > > > > > > >
> > > > > > > > > > > > > > > > > > > > > > > > > > > > > > > > > > :

Trans

þ Owner’s equity

Liabilities

$24 870

147

Accounting Information for Business Decisions Because Cafe´ Revive sells one of its economic resources, Emily decreases the asset ‘Shop equipment’ by $400, the cost of the desk. She also records $40 in the ‘GST collected’ account. This account records amounts payable to the taxation office, and so is treated in the same manner as an account payable. Because the amount to be received from Beau Flowers in January is an economic resource for Cafe´ Revive, Emily also records an increase of $440 in the asset ‘Accounts receivable’. Again, note the equality of the accounting equation. Note that after six transactions the end result as shown in Exhibit 4.11 is that the accounting equation still balances with Assets total $24 870 ¼ Liabilities ($2 870) þ Owner’s equity ($22 000).

5

What are revenues and expenses, and how is the accounting equation expanded to record these items?

4.5 Expanding the accounting equation Until now, we have focused on how a business records transactions that occur when it is preparing to open for business. You have learned how the accounting equation changes as the business uses its accounting system to record an owner’s investment, the purchases of assets with cash and on credit, and the sale of equipment. After the business opens and begins trading, internal and external users of financial statements need income information to evaluate how well the business has been operating. By recording the transactions of its day-to-day operations, a business develops this income information. As you continue reading, keep in mind the accounting equation and the dual effect of transactions. Emily had no problem using the basic accounting equation to record the start-up transactions in the balance sheet columns. However, she needs to modify the accounting system to record revenues (the inflows or income-producing transactions, such as sales to customers) and expenses (the outflows or costs, such as wages paid); these transactions do not fit easily into the equation as it is currently stated.

Discussion If you were Emily, how would you expand Cafe´ Revive’s accounting system so that you could record revenue and expense transactions? What column headings would you add to the accounting system?

To modify the accounting system, Emily separates the owner’s equity part of the equation into two sections. The first, the ‘Owner’s capital’ account, lets her record transactions relating to her investments and withdrawals of capital from the company. The second section lets her record net income (revenues and expenses). For recording both types of transactions, the equality of the accounting equation is maintained because of the dual effects of transactions. The expanded accounting equation is as follows:

8 > > > > > > > > > >
> > > > > > > > > :

Owner’s equity

Assets ¼ Liabilities þ Owner’s capital þ

Net income Revenues  Expenses

revenues Prices charged to a business’s customers for the goods or services the business provides to them expenses Costs a business incurs to provide goods or services to its customers during an accounting period

148

Recall from Chapter 1 that the profit of a business is commonly referred to as net income. Net income is the excess of revenues over expenses for a specific time period; it is sometimes called net profit, net earnings or simply earnings. Revenues are the amounts earned by charging customers for goods or services the business provided during a specific time period. Expenses are the costs of providing the goods or services to customers during the time period. Emily records revenue and expense transactions by expanding the columns in the simple accounting system she uses. To find out how much net income Cafe´ Revive earned over a specific time period, such as the month of January, she subtracts the total in the expense column from the total in the revenue column. We will demonstrate how to use the expanded accounting equation later in the chapter. But first we will discuss various principles and concepts related to net income, since the expanded equation deals with revenues and expenses – the two items that affect net income. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 4 The accounting system: Concepts and applications

Accounting principles and concepts related to net income

6

What are the accounting principles and concepts related to net income?

Earlier in the chapter, we explained several basic concepts and terms used in accounting. Before you learn how a business records its daily transactions to determine net income, it is helpful to know several additional accounting principles and concepts that are part of GAAP.

Accounting period A business typically operates for many years. The business’s owner (internal user) needs information about its net income on a regular basis to make operating decisions. External users of financial statement information also need to know about the business’s net income on a regular basis to make timely business decisions. Suppliers need this information for granting credit, creditors need it for renewing bank loans and investors need it for providing additional capital. Given that both internal and external users benefit when a business routinely reports its net income, the question is: How often should a business do so? Earlier, we said that net income is the excess of revenues over expenses for a specific time period. An accounting period is the time span for which a business reports its revenues and expenses. Most businesses base their financial statements on a 12-month accounting period called a financial year. The financial year may be the same as the calendar year; however, most businesses regard the financial year as being from 1 July to 30 June because this corresponds to the financial year for tax purposes. Many businesses also calculate and report their net income on a quarterly basis. These and other accounting periods shorter than a year are referred to as interim periods. In this book, we often present simplified examples that use one month as the accounting period.

Earning and recording revenues Revenues result from operating activities of a business that contribute to the business’s earning process. Broadly speaking, every activity of a business contributes to its earning process. More specifically, a business’s earning process includes purchasing (or producing) inventory, selling the inventory (or services), delivering the inventory (or services), and collecting and paying cash. Although a business earns revenues continuously during this process, it generally records revenues near or at the end of the earning process.2 This is because (1) the earning process is complete (the business has made the sale and delivered the product or performed the service); and (2) the prices charged to customers are collectable (accounts receivable) or collected. So we can say that a business is recording revenues during the accounting period in which they are earned and are collectable (or collected).

Matching principle Expenses are subtracted from revenues to calculate net income. Another way of saying this is that the costs used up are matched against the prices charged to customers to determine net income. The matching principle states that to determine its net income for an accounting period, a business calculates the expenses involved in earning the revenues of the period and deducts the total expenses from the total revenues earned in that period. By matching expenses against revenues, a business has a good idea of how much better off it is at the end of an accounting period as a result of its operations during that period.

accounting period Timespan for which a business reports its revenues and expenses

earning process Purchasing (or producing) inventory, selling the inventory (or services), delivering the inventory (or services), and collecting and paying cash recording revenues A business does this during the accounting period in which the revenues are earned and are collectable (or collected) matching principle To determine its net income for an accounting period, a business computes and deducts the total expenses from the total revenues earned during the period

2

Construction companies sometimes take several years to complete a project such as an office building. To more fairly report their yearly net income, these businesses record a portion of their total revenues each year based on the amount earned during the year. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

149

Accounting Information for Business Decisions

Going concern

going concern An assumption that an entity is able to continue as a viable entity for the foreseeable future

This principle assumes that the entity is able to continue as a viable entity for the foreseeable future. Financial statements that are not prepared using this assumption are usually prepared for liquidation purposes. AASB 101 Presentation of Financial Statements (paragraphs 25 and 26) requires an entity to assess its ability to operate as a going concern and prepare its financial statements accordingly, and to disclose if this is not the case. Ensuring an entity is a going concern is a fundamental financial reporting issue that requires regular and careful assessment, especially when economic conditions are challenging.

Accrual accounting accrual accounting Recording revenues and related expense transactions in the same accounting period that goods or services are provided, regardless of when cash is received or paid

Accrual accounting is related to both the recording of revenue and the matching principle. When a business uses accrual accounting, it records its revenue and related expense transactions in the same accounting period that it provides goods or services (i.e. in the period in which it earns the revenue), regardless of whether it receives or pays cash in that period. To accrue means to accumulate. Accrual accounting makes accounting information helpful to external users because it does not let cash receipts and cash payments distort a business’s net income. Otherwise, the amount of revenues the business earned during an accounting period could be distorted because the business may have received cash earlier or later than it sold goods or provided services. The amount of expenses could also be distorted because the business may have paid cash earlier or later than it incurred (or used up) the related costs.

Discussion Do you think that by requiring accrual accounting to be used in the preparation of a business’s income statement, GAAP implies that the company’s cash receipts and payments are not important? Why or why not?

Under accrual accounting, a business must be certain that it has recorded in each accounting period all revenues that it earned during that period, even if it received no cash during the period. Similarly, at the end of each accounting period, the business must be certain that it has matched all expenses it incurred during the period against the revenues it earned in that same period, even if it paid no cash during the period. You may be wondering how these concepts relate to a business’s accounting system. In summary, a company sets up and uses its accounting system based on the accounting equation and the dual effect of transactions. A business, which is a separate entity from its owners, analyses source documents to record its transactions. It records the transactions in the accounting system in monetary units based on the historical costs involved in the company activity. In keeping with accrual accounting, a business records its revenue transactions when the revenues are earned and collectable, and records expenses when it incurs the costs. The matching principle ensures that all expenses are matched with the revenues they helped earn so that the business can calculate its net income for each accounting period.

4.6 Recording daily operations The following sections describe how Emily uses the expanded accounting equation to record the January 20X2 day-to-day operations of Cafe´ Revive.

Cash sale (transaction 1) Cafe´ Revive is fully operational by 2 January 20X2, and on that day sells a total of 30 coffee gift packs at $55 a box (for cash). For each sale, the cash-register tape lists the date, type and number of gift packs sold, and the total dollar amount of the sale. Emily uses the cash register tape as the source document for the 30 cash sales, which total $1650. At the end of the day, Emily increases the ‘Revenues’ column of ‘Owner’s equity’ by $1500. 150

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Chapter 4 The accounting system: Concepts and applications She also records $150 in the ‘GST collected’ account. She increases ‘Cash’ by an amount of $1650. Of course, Cafe´ Revive had to give customers 30 gift packs in order to make the $1500 in sales. By checking the purchasing records, Emily knows that the gift packs originally cost Cafe´ Revive $780 plus $78 GST paid, or $858 ($28.60  30 boxes), when purchased from DeFlava Coffee. Because Cafe´ Revive no longer owns the gift boxes, Emily decreases ‘Inventory’ by $780. In addition, because the cost of the gift packs is a cost of providing goods that were sold to customers, she increases ‘Expenses’ by $780. Case Exhibit 4.12 shows Cafe´ Revive’s accounting equation at the close of its first business day, assuming no other transactions occur. The first line shows the balances in each of Cafe´ Revive’s assets, liabilities and owner’s equity accounts at the start of its first business day. These balances came from the transactions that Emily recorded in December as she prepared for business (see the balances in Case Exhibit 4.11). The next line shows how Emily records the cash sale on 2 January. Note that on this line, Emily shows that the increase in expenses causes a decrease in net income (and therefore in owner’s equity) by putting a minus sign in the column before the increased amount [i.e. |–| þ $780] in the ‘Expense’ column. Note also how the accounting equation remains in balance because of the dual effect of the cash sales transaction. Cash sales will take place every day that Cafe´ Revive is open. Although Emily would record these cash sales transactions every day as they occur, to keep things simple in Case Exhibit 4.20 (later in the chapter), we include a transaction (no. 13) to represent all the cash sales (200 boxes) that took place from 3 January 20X2 to 31 January 20X2.

Stop & think Do you think it is typical to have customers purchase 30 gift packs from a small retail shop during its first day of business? How could you verify your opinion?

Payment for credit purchase of inventory made in December (transaction 2) Recall that Cafe´ Revive purchased its beginning inventory on credit from DeFlava Coffee on 12 December 20X1. Emily recorded this transaction as a $1300 increase in ‘Inventory’, a $130 increase in ‘GST paid’ and an $1430 increase in ‘Accounts payable’. On 3 January 20X2, Emily pays DeFlava Coffee Corporation for the 12 December 20X1 purchase. An invoice from DeFlava Coffee is the source document for the transaction. To show the results of this transaction, Emily decreases the asset ‘Cash’ by $1430. Because the business no longer owes DeFlava Coffee for its purchase, she also decreases the liability ‘Accounts payable’ by $1430.

Purchase of Inventory of Gift Packs (transaction 3) On 4 January 20X2, Cafe´ Revive purchases 190 gift packs (at $28.60 per pack) on credit from DeFlava Coffee for $5434. As a result of this purchase, Emily increases ‘Inventory’ by $4940. She also records $494 in the ‘GST paid’ account and, because the purchase is made on credit, increases ‘Accounts payable’ by $5434. Case Exhibit 4.13 shows the changes in the accounting equation resulting from these two transactions.

Stop & think Does this purchase correspond to the expected purchase noted in Cafe´ Revive’s purchases budget for January, as we discussed in Chapter 3?

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151

152

1/1/X2

2/1/X2

Balances

(1)

¼ Liabilities

(2)

$7 200 þ

$7 200 $2 050 þ

$2 050

$1 300 $ 520 þ

$ 780

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1/1/X2

2/1/X2

3/1/X2

4/1/X2

6/1/X2

Balances

(1)

(2)

(3)

(4)

Balances

Date

Trans

$1 100 þ

$1 100 $440 þ

$440 þ $1 205 ¼

$1 205 ¼ $1 430 þ

$1 430 $1 400 þ

$ 1400

¼ Liabilities

$ 40

$22 000 $1 500 

þ$1 500 

þ Owner’s þ capital

$780

þ$780

Net income

Owner’s equity

$190 þ $22 000 þ

þ$150

$7 200 þ

$7 200

$2 050 þ

$2 050

$1 300

$5 460 þ

þ$4 940

$ 780

Assets

$1 100 þ

$1 100

$440 þ

$440 þ

¼

$1 699 ¼

þ$ 494

$1 205

$5 434 þ

þ$5 434

$1 430

$1 430

Liabilities

$ 1400

$1 400

$ 40

$22 000

$1 500 

þ$1 500 

$780

þ$780

Net income

Owner’s equity þ Owner’s þ capital

$190 þ $22 000 þ

þ$150

$7 200 þ

$7 200

$2 050 þ

$2 050

$5 260 þ

$ 260

þ$4 940

$ 780

$1 360

$1 100 þ

$1 100

$990 þ

þ$550

$440 þ

$1 699 ¼

þ$ 494

$1 205

$5 434 þ

þ$5 434

$1 430

$1 430

$1 400 þ

$1 400

$22 000

$240 þ $22 000 þ

þ$ 50

þ$150

$ 40

$2 000 

þ$ 500 

þ$1 500 

$1 040

þ$ 260

þ$ 780

þ Prepaid þ Supplies þ Inventory þ Shop þ Accounts þ GST paid ¼ Accounts þ Loan þ GST þ E Della, þ Revenues  Expenses rent equipment receivable payable payable collected capital

$11 795 þ

$ 1 430

þ$ 1 650

$11 575

Cash

Net income

þ Prepaid þ Supplies þ Inventory þ Shop þ Accounts þ GST paid ¼ Accounts þ Loan þ GST þ E Della, þ Revenues  Expenses rent equipment receivable payable payable collected capital

$11 795 þ

$ 1 430

þ$ 1 650

$11 575

Cash

Assets

Case Exhibit 4.14 Cafe´ Revive sells coffee gift packs on credit

Balances

4/1/X2

3/1/X2

(1)

(3)

1/1/X2

2/1/X2

Balances

Date

Trans

þ Owner’s þ capital

Owner’s equity

þ Prepaid þ Supplies þ Inventory þ Shop þ Accounts þ GST paid ¼ Accounts þ Loan þ GST þ E Della, þ Revenues  Expenses rent equipment receivable payable payable collected capital

$13 225 þ

þ$ 1 650

$11 575

Cash

Assets

Case Exhibit 4.13 Cafe´ Revive pays for credit purchases and makes additional credit purchases of inventory

Balances

Date

Trans

Case Exhibit 4.12 Cafe´ Revive makes cash sales

Accounting Information for Business Decisions

Chapter 4 The accounting system: Concepts and applications

Credit sale (transaction 4) On 6 January 20X2, Cafe´ Revive sells 10 gift packs for $550 (including GST) on credit to Bud Salcedo, owner of Beau Flowers Shop, next door to Cafe´ Revive. The sales invoice lists the date, the type of gift pack sold, the flower shop’s name and account number, and the total dollar amount of the sale. Emily assigns each of Cafe´ Revive’s credit customers a unique account number to help her identify transactions the company has with each of these customers. (This will be particularly useful as the number of credit customers grows.) Having the account number on the sales invoice lets Cafe´ Revive keep track of the money each customer owes. Emily increases the ‘Revenues’ column of ‘Owner’s equity’ by $500. She also records $50 in the ‘GST collected’ account. Because Cafe´ Revive sold the gift packs on credit instead of receiving cash, Emily increases the asset ‘Accounts receivable’ by $550. Remember, Cafe´ Revive has to dip into its inventory of coffee gift boxes to make the sale. By checking the purchasing records, Emily knows that the boxes originally cost $260. Because the business no longer owns the gift packs, Emily decreases ‘Inventory’ by $260. In addition, because the cost of the gift packs is a cost of providing the goods sold, she increases ‘Expenses’ by $260. Case Exhibit 4.14 shows the four changes in the accounting equation from this transaction. The accounting equation remains in balance.

Receipt of payment for credit sale of extra shop equipment (transaction 5) Cafe´ Revive receives a funds transfer for $440 from Beau Flowers on 7 January 20X2. This is to pay for the shop equipment that Cafe´ Revive sold on credit to Beau Flowers on 22 December 20X1. As you can see in Case Exhibit 4.15, Emily reduces the asset ‘Accounts receivable’ by $440 because Beau Flowers has settled its account and no longer owes Cafe´ Revive the money for the equipment. She increases the asset ‘Cash’ by $440 to show the receipt of the money.

Withdrawal of cash by owner (transaction 6) On 20 January 20X2, Emily Della withdraws $250 cash from the business for personal use, transferring $250 to her personal bank account from the Cafe´ Revive bank account. The EFT notification and receipt is the source document for the transaction. A withdrawal is a payment from the business to the owner, known as drawings. It is a removal of assets by the owner from the business. As we show in Case Exhibit 4.16, Emily records a decrease in ‘Cash’ and a decrease in ‘E Della, capital’ by the amount of the withdrawal ($250). Note there is no GST recorded on this withdrawal.

withdrawal A payment from the business to the owner

Stop & think What do you think Emily would record if she took 10 gift packs instead of cash?

Stop & think Can you think of any possible ethical issues involved in withdrawals? We will discuss withdrawals again in Chapter 7.

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153

154

6/1/X2

7/1/X2

(4)

(5)

440

(5)

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Balances

Liabilities

$7 200 þ

$7 200

$2 050 þ

$2 050

$1 300

$5 200 þ

$ 260

þ$4 940

$ 780

Assets

$1 100 þ

$1 100

$550 þ

$440

þ$550

$440 þ

¼

$1 699 ¼

þ$ 494

$1 205

$5 434 þ

þ$5 434

$1 430

$1 430

Liabilities

$1 400

$1 400

$ 40

$7 200 þ

$7 200

$2 050 þ

$2 050

$1 300

$5 200 þ

$ 260

þ$4 940

$ 780

$1 100 þ

$1 100

$550 þ

$440

þ$550

$440 þ

$1 699 ¼

þ$ 494

$1 205

$5 434 þ

þ$5 434

$1 430

$1 430

$1 400

$1 400

$ 40

$240 þ

þ$ 50

þ$150

$2 000 

þ$ 500 

þ$1 500 

$1 040

þ$ 260

þ$ 780

250 $21 750 þ

$

$22 000

$2 000 

þ$ 500 

þ$1 500 

$800

þ$260

þ$780

E Della, þ Revenues  Expenses capital

Net income

Owner’s equity

$22 000 þ

$22 000

þ Owner’s þ capital

$240 þ

þ$ 50

þ$150

E Della, þ Revenues  Expenses capital

Net income

Owner’s equity þ Owner’s þ capital

þ Prepaid þ Supplies þ Inventory þ Shop þ Accounts þ GST paid ¼ Accounts þ Loan þ GST þ rent equipment receivable payable payable collected

$11 985 þ

250

7/1/X2

(4)

$ 1 430

20/1/X2 $

6/1/X2

(3)

(6)

4/1/X2

(2)

$11 575

þ$ 1 650

440

3/1/X2

(1)

Cash

þ$

1/1/X2

2/1/X2

Balances

Date

Trans

¼

þ Prepaid þ Supplies þ Inventory þ Shop þ Accounts þ GST paid ¼ Accounts þ Loan þ GST þ rent equipment receivable payable payable collected

$12 235 þ

þ$

$ 1 430

þ$ 1 650

$11 575

Cash

Case Exhibit 4.16 Emily withdraws cash from Cafe´ Revive

Balances

4/1/X2

(3)

(1)

3/1/X2

1/1/X2

2/1/X2

Balances

(2)

Date

Trans

Assets

Case Exhibit 4.15 Cafe´ Revive receives payment from credit sale of extra shop equipment

Accounting Information for Business Decisions

Payments for consulting and advertising (transactions 7 and 8) To prepare for the start of the university year and its orientation-week grand opening sale, Cafe´ Revive hires the Dana Media Group as consultants to build a website for the business. The design group charges $363 and presents the website on 25 January 20X2. Cafe´ Revive pays for the full amount that day. The receipt received from Dana Media is the source document. As a result of this transaction, Emily increases ‘Expenses’ by $330, records $33 Do you think Cafe´ Revive’s location next to the flower shop Beau Flowers in the ‘GST paid’ account and decreases ‘Cash’ by $363. Also on 25 January 20X2, Cafe´ Revive pays for a small will improve its sales of Valentine’s Day gift packs? Why or why not? advertisement to be published in University Hub’s end-of-January promotional flyer. The quarter-page advertisement cost $121. The bill from University Hub’s management office is the source document for the transaction. As we show in Case Exhibit 4.17, to record this transaction, Emily increases ‘Expenses’ by $110, increases ‘GST paid’ by $11 and decreases ‘Cash’ by $121. Note that the accounting equation remains in balance after these transactions are recorded.

Stop & think If ‘Cash’ was mistakenly decreased by only $100 when the last transaction was recorded, how would you find out that an error had been made?

Purchase of extra supplies (transaction 9) On 29 January 20X2, because sales are anticipated to increase as the university year commences, Cafe´ Revive purchases more supplies of coffee and flavour additives. Cafe´ Revive transfers $275 in cash for these supplies. As you can see in Case Exhibit 4.18, Emily increases ‘Supplies’ by $250, increases ‘GST paid’ by $25 and decreases ‘Cash’ by $275.

Payment of salaries (transaction 10) Cafe´ Revive employs two people (you and Jackson Downes) to help make and sell coffee. On 31 January 20X2, you both receive payment totalling $2050 for your services during January. Your timesheets, wagerate schedules and payslips are the source documents for the transactions. As you can see in Case Exhibit 4.19, Emily decreases the asset ‘Cash’ by $2050. Wages of salaries of employees attract PAYG tax, in this case $310. Because paying an employee’s salary is a cost of providing goods and services to customers, she increases ‘Expenses’ (salaries) by $2360 and records an amount of $310 as ‘PAYG (pay as you go) tax payable’. Under the Australian tax system, all businesses must deduct PAYG tax from employee wages and pay the PAYG tax to the government. This is recorded as a liability because the amount will have to be submitted to the taxation office.

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155

Shutterstock.com/Alessandro Cristiano

Chapter 4 The accounting system: Concepts and applications

156

2/1/X2

(1)

$2 050 þ

$2 050

$1 360

$5 200 þ

$ 260

þ$4 940

$ 780

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

11

33 $5 434 þ

þ$5 434

$1 430

$1 430

Liabilities

$1 400

$1 400

$ 40

$240 þ

þ$ 50

þ$150

250

$7 200 þ

$7 200

$2 300 þ

þ$ 250

$2 050

$5 200 þ

$ 260

þ$4 940

$ 780

$1 360

Assets

$1 100 þ

$1 100

$550 þ

$440

þ$550

$440 þ

25

11

33

$1 768 ¼

þ$

þ$

þ$

þ$ 494

$1 205

$5 434 þ

þ$5 434

$1 430

$1 430

$1 400

$1 400

$ 40

$240 þ

þ$ 50

þ$150

250

$2 000 





þ$ 500 

þ$1 500 

$1 480

þ$ 110

þ$ 330

þ$ 260

þ$ 780

$2 000 





þ$ 500 

þ$1 500 

$1 480

þ$ 110

þ$ 330

þ$ 260

þ$ 780

þ Revenues  Expenses

Net income

Owner’s equity þ

$21 750 þ

$

$22 000

Net income

þ Revenues  Expenses

þ

Owner’s equity

$21 750 þ

$

$22 000

E Della, capital

¼

$1 743 ¼

þ$

þ$

þ$ 494

$1 205

þ Prepaid þ Supplies þ Inventory þ Shop þ Accounts þ GST paid ¼ Accounts þ Loan þ GST þ rent equipment receivable payable payable collected

$11 226 þ

121 275

25/1/X2 $

29/1/X2 $

(8)

(9)

Balances

250 363

20/1/X2 $

25/1/X2 $

(6)

(7)

440

þ$

7/1/X2

(5)

$ 1 430

4/1/X2

3/1/X2

(2)

$11 575

þ$ 1 650

6/1/X2

2/1/X2

(1)

(3)

1/1/X2

Balances

Cash

(4)

Date

Trans

$550 þ

$440

þ$550

$440 þ

Owner’s capital

$1 100 þ

$1 100

þ

Case Exhibit 4.18 Cafe´ Revive purchases more supplies

$7 200 þ

$7 200

E Della, capital

Liabilities

þ Prepaid þ Supplies þ Inventory þ Shop þ Accounts þ GST paid ¼ Accounts þ Loan þ GST þ rent equipment receivable payable payable collected

$11 501 þ

121

25/1/X2 $

(8)

Balances

250 363

20/1/X2 $

25/1/X2 $

(6)

7/1/X2

(5)

(7)

440

þ$

4/1/X2

6/1/X2

(3)

$ 1 430

þ$ 1 650

$11 575

Cash

(4)

3/1/X2

1/1/X2

Balances

(2)

Date

Trans

¼ Owner’s capital

Assets

þ

Case Exhibit 4.17 Cafe´ Revive pays for consulting and advertising

Accounting Information for Business Decisions

1/1/X2 2/1/X2 3/1/X2 4/1/X2 6/1/X2 7/1/X2 20/1/X2 25/1/X2 25/1/X2 29/1/X2 31/1/X2

Balances (1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

Balances

Date

Trans

Assets

¼

$7 200

$2 300 þ

þ$ 250

$2 050

$5 200 þ

þ$4 940 $ 260

$1 300 $ 780

$3 800 þ

$1 100

$550 þ

þ$550 $440

$440 þ

33 11 25 $1 768 ¼

þ$ þ$ þ$

þ$ 494

$1 205

$1 400

$5 434 þ $1 400

$1 430 þ$5 434

$1 430

þ

$310

þ$310 $240 þ

þ$ 50

$ 40 þ$150

PAYG þ GST þ tax collected payable

Liabilities

þ Prepaid þ Supplies þ Inventory þ Shop þ Accounts þ GST paid ¼ Accounts þ Loan rent equipment receivable payable payable

$ 9 176 þ $7 200 þ

þ$ 440 $ 250 $ 363 $ 121 $ 275 $ 2 050

$11 575 þ$ 1 650 $ 1 430

Cash

Case Exhibit 4.19 Cafe´ Revive pays salaries

250

$2 000 



 

$ 500 

þ$1 500 

$3 840

þ$2 360

þ$ 330 þ$ 110

þ$ 260

þ$ 780

Expenses

Net income þ Revenues 

þ

$21 750 þ

$

$22 000

E Della, capital

Owner’s capital

Owner’s equity

Chapter 4 The accounting system: Concepts and applications

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157

Accounting Information for Business Decisions

Payment of mobile and wifi and energy bills (transactions 11 and 12) On 31 January 20X2, Cafe´ Revive pays its mobile and wifi and energy bills for January for $143 and $209, respectively. Emily records each transaction separately, using the invoices as the source documents. As you can see in Case Exhibit 4.20, for mobile and wifi, she decreases ‘Cash’ by $143, and increases ‘Expenses’ by $130 and ‘GST paid’ by $13. For energy, she decreases ‘Cash’ by $209, and increases ‘Expenses’ by $190 and ‘GST paid’ by $19.

Summary cash sales (transactions 13 and 14) Case Exhibit 4.20 also shows the summary transaction for the sale of 200 coffee gift packs, which we discussed earlier in transaction 1 (noting that all of the cash sales from 3 January to 31 January would be recorded in one transaction – that is, transaction 13). These sales of gift packs total $11 000 ($55  200 boxes), so Emily increases ‘Revenues’ by $10 000 and ‘GST collected’ by $1000. Cash will increase by $11 000. She also decreases ‘Inventory’ by $5200 (200 boxes  $26 ($28.60 less $2.60 GST paid)) and increases expenses by $5200. Emily also needs to record in transaction 14 that during January, 976 cups of coffee were sold at an average price of $5.50 each. Emily records in ‘Revenue’ an increase in cups of coffee sold of $4880 and in ‘GST collected’ of $488. Because all sales of coffee beverages are for cash, she records an increase in ‘Cash’ of $5368. As with all previous transactions, the accounting equation still balances.

Stop & think How many additional coffee gift packs did Cafe´ Revive sell for cash from 3 January to 31 January? Why were expenses increased by $5200?

Managing inventory level (transaction 15) On 31 January, after a request from a customer, Emily realises she is very low on inventory of coffee gift packs. She takes the order from the customer and then immediately places an emergency order with DeFlava Coffee for 50 boxes of gift packs, in order to have stock on hand for the next few days of trading. The boxes are delivered on the same day, but the price has increased to $29.70 ($27.00 plus GST of $2.70). Emily increases ‘Inventory on hand’ by $1350 and ‘GST paid’ by $135. DeFlava Coffee allows Emily 30 days’ credit, so ‘Accounts payable’ also increases by $1485.

Stop & think What are the consequences for a business of having a ‘stock-out’ situation? How could Emily have avoided this situation?

158

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Balances

1/1/X2 2/1/X2 3/1/X2 4/1/X2 6/1/X2 7/1/X2 20/1/X2 25/1/X2 25/1/X2 29/1/X2 31/1/X2 31/1/X2

Balances (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15)

31/1/X2

Date

Trans

¼

$7 200

$2 300 þ

þ$ 250

$2 050

$1 350 þ

þ$1 350

$5 200

þ$4 940 $ 260

$1 300 $ 780

$1 100 þ

$1 100

$550 þ

þ$550 $440

$440

13 19

þ$ þ$

$1 935 ¼

þ$ 135

33 11 25

þ$ þ$ þ$

þ$ 494

$1 205

$1 400

$6 919 þ $1 400

þ$1 485

$1 430 þ$5 434

$1 430

þ

$310 þ

þ$310

50

$1 728 þ

þ$1 000 þ$ 488

þ$

$ 40 þ$ 150

PAYG þ GST þ tax Collected payable

Liabilities

þ Prepaid þ Supplies þ Inventory þ Shop þ Accounts þ GST paid ¼ Accounts þ Loan rent equipment receivable payable payable

$25 192 þ $7 200 þ

þ$ 440 $ 250 $ 363 $ 121 $ 275 $ 2 050 $ 143 $ 209 þ$11 000 $ 5 368

$11 575 þ$ 1 650 $ 1 430

Cash

Assets

Case Exhibit 4.20 Cafe´ Revive pays mobile and wifi and energy bills and records sales for 3 January to 31 January

250

Net income

  

 

500 

$16 880 

þ$10 000 þ$ 4 880 

þ$

þ$ 1 500 

$9 360

þ$2 360 þ$ 60 þ$ 190 þ$5 200

þ$ 330 þ$ 110

þ$ 260

þ$ 780

þ Revenues  Expenses

þ

$21 750 þ

$

$22 000

E Della, capital

Owner’s capital

Owner’s equity

Chapter 4 The accounting system: Concepts and applications

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159

Accounting Information for Business Decisions 7

Why are adjustment entries necessary at the end of a financial period?

4.7 End-of-period adjustments Remember, revenues are the amount earned by charging a business’s customers for goods or services that the business provided during the accounting period, and expenses are the costs of providing those goods or services during the period. Net income is the excess of revenues over expenses for the period. To calculate net income for a month, for example, a business counts the dollar totals for all the revenue and expense transactions of that specific month, and subtracts the expense total from the revenue total – that is, it matches the expenses against the revenues for the month. To calculate a business’s net income under accrual accounting, the business must make sure that all its revenues and expenses for the accounting period are included in the totals. For Cafe´ Revive, Emily can easily verify that the revenue total is correct because every sale is listed on a source document (a sales invoice or a cash-register tape) that she uses to record each sales transaction. Emily can verify that most of Cafe´ Revive’s expenses are correct because she also has source documents (invoices, utility bills and timesheets) relating to these.

Stop & think Do you think it may sometimes be difficult to identify when a sale has occurred? Why?

end-of-period adjustments Increases or decreases to account balances at the end of the period to reflect the costs of providing goods or services that are not supported by source documents

It is more difficult for a business to make sure that all of the expenses it incurred during the month are included in the net income calculation because some of the costs of providing goods or services occur without a source document. Since these expense transactions don’t have source documents, there is no ‘automatic trigger’ to record the transactions. Before calculating its net income, a business must analyse its unique expenses (and a few unique revenues, which we will briefly discuss later) to see if it needs to adjust (increase) the total expenses (or revenues) to include those without source documents. These adjustments are called end-of-period adjustments.

Stop & think What types of expenses can you think of that occur without source documents? In general, end-of-period adjustments involve assets that a business had at the beginning of the accounting period, but that it used during the period to earn revenues. Because assets are used during the period to provide benefits or earn revenues, they are changed to expenses. Emily must analyse Cafe´ Revive’s assets to see what additional expenses to record. As you will see, the end-of-period adjustments may also include liabilities that a company owes because of expenses that have not been paid or recorded. Let’s take a look at the four end-of-period adjustments that Emily makes before calculating Cafe´ Revive’s net income for January 20X2, its first month of operations.

Supplies used (transaction 16) Recall that on 7 December 20X1, Cafe´ Revive purchased $2255 of supplies (coffee, essences, paper cups, sweeteners, etc.), including GST, from City Supply Company. At this time, Emily increased the asset ‘Supplies’ by $2050 to show the cost of this new asset. Similarly, Emily purchased extra supplies on 29 January for $275. This further increased the amount of the asset supplies on hand by $250 after GST paid of $25 was recorded. Because Cafe´ Revive operated during January, it used some of these supplies. Thus, at 31 January 20X2, the $2300 amount in ‘Supplies’ is not correct. Emily must adjust the amount to show that, since some of the supplies were used, they now are an expense, and only part of the $2300 of supplies is still an asset. Emily determines that office supplies used during January amount to $1955. She makes an endof-period adjustment to increase ‘Expenses’ by $1955 and decrease the asset ‘Supplies’ by $1955, as we 160

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Chapter 4 The accounting system: Concepts and applications show in Case Exhibit 4.21. When she subtracts the $1955 from the original $2300 amount, the $345 ending balance is the cost of supplies the company still owns at the end of January. Notice how this adjustment (and each of the following adjustments) maintains the equality of Cafe´ Revive’s accounting equation and has a dual effect on the equation.

Stop & think How do you think Emily determined the amount of supplies used?

Expired rent (transaction 17) Recall that Cafe´ Revive paid $7920 to University Hub on 1 December 20X1 to pay in advance for six months’ rent, starting from 1 January 20X2. At that time, Emily recorded a $7200 asset, ‘Prepaid rent’, to show that Cafe´ Revive had purchased the right to use space in the University Hub for six months (January to June) at a price of $1200 per month. At the end of January, Cafe´ Revive has used up one month of prepaid rent – for January – because the business occupied the rented space for that entire month. Therefore, Emily must include the cost of the rented space as an expense in the calculation of Cafe´ Revive’s net income. Since Cafe´ Revive made the $7200 payment on 1 December 20X1, no other source documents relating to the rental of the space exist. Although Cafe´ Revive has used up one of its six months of rent, the amount listed for prepaid rent is still $7200. Emily must adjust the prepaid rent amount to show that only five months of prepaid rent remain. To do so, she increases ‘Expenses’ for January by $1200 and reduces ‘Prepaid rent’ by the same amount, as we show in Case Exhibit 4.21. Now ‘Prepaid rent’ shows the correct balance of $6000 ($1200  5) for the remaining five months.

Stop & think What adjustment do you think Emily would make at the end of January if Cafe´ Revive occupied the rented space for January but did not pay for any rent until February?

Depreciation of shop equipment (transaction 18) At the beginning of January, the amount for the asset ‘Shop equipment’ was listed at the cost of $1100. Cafe´ Revive purchased the shop equipment because it would help earn revenue. The equipment includes, for instance, display cases, a cash register and a moving trolley. Although Cafe´ Revive doesn’t expect any equipment to wear out completely after one month, or even after one year, it does not expect it all to last indefinitely. At some point in the future, the display cases will become outdated, the cash register will stop working and the moving trolley will fall apart. At that time, Emily will decide to sell or dispose of the equipment. The shop equipment provides benefits to the business for every period in which it is used. Because Cafe´ Revive used the shop equipment in January to help earn revenue, and because the shop equipment has a finite life, a portion of the cost of the equipment is included as an expense in the January net income calculation. Depreciation is the part of the cost of a physical asset allocated as an expense to each time period in which the asset is used. The simplest way to calculate depreciation is to divide the cost by the estimated life of the asset. For now, assume that depreciation for the shop equipment is $19 a month. Emily makes an end-of-period adjustment for January’s depreciation by increasing ‘Expenses’ by $19 and decreasing the asset ‘Shop equipment’ by $19, as we show in Case Exhibit 4.21. Now shop equipment shows the $1081 remaining Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

depreciation The systematic periodic transfer of the cost of a fixed asset to an expense account during its expected useful life

161

162

31/1/X2

31/1/X2

31/1/X2

31/1/X2

31/1/X2

31/1/X2

Balances

(16)

(17)

(18)

(19)

Balances

Date

Trans

þ

$25 192 þ

$25 192

Cash

$6 000 þ

$1 200

$7 200

$ 345 þ

$1 955

$2 300

$1 350 þ

$1 350

19

$1 081 þ

$

$1 100

$1 935

GST paid

$6 919 þ

$6 919

$1 411

þ$ 11

$1 400

þ

$310 þ

$310

$1 728 þ

$1 728

PAYG þ GST þ tax collected payable

Liabilities

¼ Accounts þ Loan payable payable

¼

$550 þ $1 935 ¼

$550

Prepaid þ Supplies þ Inventory þ Shop þ Accounts þ rent equipment receivable

Assets

Case Exhibit 4.21 Cafe´ Revive makes end-of-period adjustments

$ 9 360

$16 880 

19 11 $12 545

 þ$

 þ$

 þ$ 1 200

 þ$ 1 955

$16 880 

þ Revenues  Expenses

Net income

Owner’s equity þ

$21 750 þ

$21 750

E Della, capital

Owner’s capital

Accounting Information for Business Decisions

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 4 The accounting system: Concepts and applications cost (called its book value). As Cafe´ Revive uses the shop equipment in each future month, the equipment will record an additional $19 depreciation, which will reduce the book value of the equipment. Therefore, at any point in time the difference between the original cost and the book value is the accumulated depreciation to date.

Accrual of interest (transaction 19) Towards the end of December 20X1, Cafe´ Revive purchased shop equipment by establishing a $1400 loan payable, to be paid at the end of three months. Generally, all loans payable also involve the payment of interest for the amount borrowed. This interest is an expense of doing business during the time between the signing of the note and the payment of the note. Cafe´ Revive agreed to pay $33 total interest for the note, so that at the end of the three months Cafe´ Revive will pay $1433 ($1400 þ $33). Interest accumulates (accrues) over time until it is paid. Since Cafe´ Revive owed the loan during all of January, Emily must record one month of interest on the loan as an expense of doing business during January. Because Cafe´ Revive will not pay the interest until it pays the loan, it records the January interest as an increase in liability. For now, assume that the interest is $11 per month ($33  3). Emily makes an end-of-period adjustment for the January interest by increasing ‘Expenses’ by $11 and increasing the liability ‘Loans payable’ by $11, as we show in Case Exhibit 4.21. We will discuss how to calculate interest later in the book.

End-of-period revenue adjustments There are a few end-of-period adjustments that a business may need to make to ensure that its revenues are correct for the accounting period. Here, we briefly discuss two. First Emily stocked and sold a product (fig jam) on behalf of another small business. She receives commission on the sales when all the products are sold. At the end of the accounting period, the business must record any commission that has accumulated (accrued) by increasing ‘Revenues’ and increasing the asset ‘Accrued Revenue/Accounts Receivable’. Second, a business might collect cash in advance from a customer for sales of products that it will deliver to the customer, or for services that it will perform for the customer later in the current accounting period or in the next accounting period. In this case, the business has not earned the revenue at the time of the cash collection. Therefore, it records the receipt by increasing ‘Cash’ and increasing a liability that is called unearned revenue. At the end of the current accounting period, the business must decrease ‘Unearned revenue’ and increase ‘Revenue’ for the amount of revenue it has earned during the period. We will discuss end-of-period revenue adjustments more completely in later chapters.

Stop & think How would the interest of $11 be recorded by the lender making the loan to Cafe´ Revive?

Net income and its effect on the balance sheet After recording the results of all the transactions and end-of-period adjustments (shown in Case Exhibit 4.21), Emily calculates Cafe´ Revive’s net income for January:

8

Is it possible to prepare basic financial reports for a business from the running totals of the accounting equation?

Net Income ¼ Revenues  Expenses $4335 ¼ $16 880  $12 545 A business will normally prepare an income statement that lists the various types of revenues and expenses included in net income. For simplicity, in this chapter we use a simple accounting system, which does not help in the preparation of a detailed income statement. In Chapter 7, we will expand the accounting system and show you how to prepare an income statement. Emily can, however, compare the Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

163

Accounting Information for Business Decisions actual net income amount for January with the projected net income that she calculated when she planned Cafe´ Revive. Since Emily is the owner, the net income (Revenues – Expenses) will be transferred to her capital for operations. In Chapter 3, she calculated a projected net income or profit $7524 for the first quarter (or three months) of 20X2. Emily should be very pleased; by achieving an actual net income of $4335 for the first month of the quarter, Cafe´ Revive has done better than she expected. Later in this text, we will discuss how internal and external users analyse the financial statements of a business to understand how well it did for a specific time period. To prepare the 31 January 20X2 balance sheet for Cafe´ Revive, Emily uses the end-of-the- month balances for each asset, liability and owner’s equity account listed in Case Exhibit 4.21. Case Exhibit 4.22 shows Cafe´ Revive’s balance sheet at 31 January 20X2. You should be able to trace the asset and liability amounts directly to the ending balances listed in Case Exhibit 4.21. The assets on the balance sheet are rearranged, however, to show them in the order of their liquidity, or how quickly the assets can be converted to cash or used up. (We will discuss liquidity more in later chapters.) Also notice that Emily must calculate the balance sheet amount for owner’s equity (‘E Della, Capital’) at the end of January. It is the sum of all of the owner’s equity items included in Case Exhibit 4.21. Expressed another way, it is the sum of ‘E Della, Capital’ and ‘Net income’; in this case, a profit of $4335 ($16 880 – $12 545) ($21 750 þ $4335 ¼ $26 085). We will explain how to update the balance of the owner’s capital account for net income in Chapter 7. Case Exhibit 4.22 Cafe´ Revive’s balance sheet at 31 January 20X2 CAFE´ REVIVE Balance sheet 31 January 20X2 Assets

Liabilities

Cash

$25 192

Accounts payable

$ 6 919

Accounts receivable

$

550

Loan payable

$ 1 411

GST paid

$

207** PAYG tax

Inventory

$ 1 350

Supplies

$

Prepaid rent

$ 6 000

Shop equipment

$ 1 081

Total assets

$

Total liabilities

310

$ 8 640

345

$34 725

Owner’s equity E Della, capital

$26 085*

Total owner’s equity

$26 085

Total liabilities and owner’s equity

$34 725

* $21 750 þ $16 880 – $12 545 from Exhibit 4.21. **$1 935 GST Paid  $1 728 GST Collected.

E Della, capital

$ 21 750* þ16 880

Revenues

12 545

Expenses Owner’s Equity

$ 26 085

* $21 750 is the original $22 000 invested in the business less Emily’s withdrawal of $250 on 20 January.

Since Emily is the owner, the net income (Revenues – Expenses) is included in her capital amount on the 31 January 20X2 balance sheet. Using the total amounts for the assets, liabilities and owner’s equity sections of Cafe´ Revive’s balance sheet, we can state the accounting equation on 31 January 20X2 as follows: Assets ¼ Liabilities þ Owner’s equity $34 725 ¼ $8 640

164

þ $26 085

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Chapter 4 The accounting system: Concepts and applications Because Emily properly recorded Cafe´ Revive’s transactions, the company’s accounting equation is in balance at 31 January 20X2. Just as we expanded the accounting equation to record revenue and expense transactions, we will discuss other changes in the accounting system throughout this book. These changes make it easier to keep track of the activities of the business, and increase the usefulness of the accounting system. We will also introduce additional accounting concepts to help you understand why businesses make changes to the accounting system. In the following chapters, we will take a detailed look at the recording process for a business, and at three very important outputs of the accounting process: the income statement, the balance sheet and the cash flow statement. We will continue to answer questions concerning what accounting is, how accounting works, why accounting is performed and how accounting information is used for problem solving and decision making. We will also discuss how to minimise errors that, among other things, can cause major embarrassments, as we illustrate below.

Business issues and values: A billion here, a billion there In one year, US fund manager Fidelity Investments (http://www.fidelity.com.au) estimated that it would make a year-end distribution of $4.32 per share to shareholders in its Magellan Fund. But the company then admitted to an error. Included in a letter sent to shareholders was the following statement: ‘the error occurred when the accountant omitted the minus sign on a net capital loss of $1.3 billion and incorrectly treated it as a net capital gain on [a] separate spreadsheet.

Ethics and sustainability

b

This meant that the dividend estimate spreadsheet was off by $2.6 billion’. The error had no effect on the fund’s results or on the shareholders’ taxes, but was clearly an embarrassment to the company’s management!

Stop & think Do you know of any recent cases where a business may have made errors of a similar nature? What were the circumstances and what was the impact for owners? For investors?

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STUDY TOOLS Summary 4.1 Understand how to interpret and evaluate financial accounting information in order to make informed decisions. 1

Why do managers, investors, creditors and others need information about the operations of a business?

Internal and external users need information about a business’s operations to evaluate alternatives. For instance, a manager needs this information to decide which alternative best helps the business meet its goals of remaining solvent and earning a satisfactory profit. A banker also needs this information to decide the conditions for granting a loan.

4.2 Understand the basic concepts and terms that help identify and record the activities of a business. 2

What are the basic concepts and terms that help identify the activities recorded by the accounting records of a business?

The basic concepts and terms that help identify the activities that a business’s accounting system records are the entity concept (each business is separate from its owners); transactions (exchanges between a business and another entity); source documents (business records as evidence of transactions); the monetary unit concept (transactions are recorded in monetary terms); and the historical cost concept (transactions are recorded based on dollars exchanged).

4.3 Describe the basic components of the accounting equation: assets, liabilities and owner’s equity. 3

What do users need to know about the accounting equation for a business?

Users need to understand the accounting equation: Assets ¼ Liabilities þ Owner’s equity. They need to know that assets are a business’s economic resources, liabilities are a business’s debts and owner’s equity is the owner’s current investment in the assets of the company.

4.4 Understand the impact that individual transactions have on the accounting equation. 4

Why are at least two effects of each transaction recorded in a business’s accounting system?

A business’s accounting system is designed so that two effects of each transaction are recorded in order to maintain the equality of the accounting equation. Under the dual effect of transactions, recording a transaction involves at least two changes in the assets, liabilities and owner’s equity of a business.

4.5 Define revenue and expenses and expand the accounting equation to include the impact of revenue and expenses on net income. 5

What are revenues and expenses, and how is the accounting equation expanded to record these items?

Revenues are the amounts earned by a business charging customers for goods or services provided during an accounting period. Expenses are the costs of providing the goods or services during the period. Net income is the excess of revenues over expenses for the period. The accounting equation is expanded as follows to record revenues and expenses: Assets ¼ Liabilities þ [Owner’s capital þ (Revenues – Expenses)]. 6

What are the accounting principles and concepts related to net income?

The accounting principles and concepts related to net income are the accounting period, earning and recording revenues, the matching principle, and accrual accounting. The accounting period is the timespan used by a business to report its net income. A business records revenues during the accounting period in which they are earned and collectable. The matching principle states that a business matches the total expenses of an accounting period against the total revenues of the period to determine its net income. Accrual accounting means that a business records its revenues and expenses in the accounting period in which it provides goods or services, regardless of whether it receives or pays cash. 166

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Chapter 4 The accounting system: Concepts and applications

4.6 Identify types of adjusting entries and why they are necessary at the end of the financial period. 7

Why are adjustment entries necessary at the end of a financial period?

End-of-period adjustments are necessary to record any expenses that a business has incurred (or any revenue that the business has earned) during the accounting period but that it has not yet recorded. Adjustments ensure that these expenses (and revenue) are included in the business’s net income calculation.

4.7 Compile basic financial reports from the running totals in the accounting equation. 8

Is it possible to prepare basic financial reports for a business from the running totals of the accounting equation?

We use the total totals for revenue and expenses in the owner’s equity section of the equation to calculate net income. We use the totals in the assets section to find total assets and relate this to total liabilities plus owner’s equity total after adding or subtracting the net income (profit) or loss.

Key terms accounting equation

entity

recording revenues

accounting period

expenses

residual equity

accrual accounting

going concern

revenues

balance

historical cost concept

source document

creditors

loans payable

transaction

depreciation

matching principle

wages and salaries payable

dual effect of transactions

monetary unit concept

withdrawal

earning process

partners’ equity

end-of-period adjustments

prepaid insurance

Online research activity This activity provides an opportunity to gather information online about real-world issues related to the topics in this chapter. For suggestions on how to navigate various businesses’ websites to find their financial statements and other information, see the related discussion in the Preface. Examine the websites for Fortescue Metals Group (http://www.fmgl.com.au) and Origin Energy (http:// www.originenergy.com.au).

1 2 3 4

List the differences between the activities of the two companies. What are the similarities? Which company recorded the highest profit? Which company paid the better dividend?

Integrated business and accounting situations Answer the following questions in your own words.

Testing your knowledge 4-1 4-2 4-3 4-4 4-5

List external users who need financial accounting information about a business? List five external users and discuss the type of information that each might require. What does GAAP mean? Why is this important when financial statements are being prepared for a business? What is the difference between an accounting entity and a legal entity? What is the entity concept? How does it affect the accounting for a specific business? What is a ‘going concern’, and why is it important in accounting?

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Accounting Information for Business Decisions

4-6 4-7 4-8 4-9 4-10 4-11 4-12 4-13 4-14 4-15 4-16 4-17 4-18 4-19 4-20 4-21 4-22 4-23

What is a source document? Why does a business need to prepare source documents? What are the monetary unit and historical cost concepts? How do they affect the recording of transactions? Define assets. Give four examples. Define liabilities. Give two examples. Define owner’s equity. What items affect owner’s equity positively? What items affect owner’s equity negatively? Why is a business’s statement of financial position called a balance sheet? What are a business’s net assets? How do they relate to owner’s equity? What is meant by the dual effect of transactions? How does it relate to the accounting equation? What is an ‘accounting system’? Why is it important that a business has an effective accounting system? What is an account? What is an account balance? Define revenues, expenses and net income. How is the accounting equation expanded to record income-related transactions? Name and briefly define four principles or concepts relating to net income. What is an accounting period? What is the usual length of an accounting period? For a service business, what is the business’s earning process, and when does the business record revenues? What is the matching principle and what types of accounts are matched according to this principle. What is the outcome for a business? What is accrual accounting, and why is it important? Why are adjustment entries needed at the end of a period? Give four examples of adjustments that might be necessary. How does an understanding of the accounting equation facilitate the preparation of financial reports?

Applying your knowledge 4-24

4-25

Arrange the following items from the books of Lucy Breen, Beautician, under the correct column headings: Assets, Liabilities, Owner’s Equity, Revenue or Expense: a Equipment b Malcolm Black (a client to whom the business provided services) c Ava Pty Ltd who provide supplies to the business d Cash at Bank e Service fees f Energy costs g Mortgage on Building h Drawings – Lucy Breen i Salon furniture j Loan from Bank k Commission received on sale of products l Wages of staff. Each of the following cases is independent of the others. Case 1

4-26

168

Assets

Liabilities A

Owner’s equity

$30 000

$62 000

2

$ 95 000

B

$54 000

3

$102 000

$44 000

C

Required: Determine the amounts for A, B and C. At the beginning of the year, Thomas Lighting had total assets of $78 000 and total liabilities of $22 000. During the year, the total assets increased by $16 000. At the end of the year, owner’s equity totalled $64 000. Required: Determine: a owner’s equity at the beginning of the year b total liabilities at the end of the year.

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Chapter 4 The accounting system: Concepts and applications

4-27

4-28

At the end of the year, a business’s total assets are $43 000 and its total owner’s equity is $22 000. During the year, the business’s liabilities decreased by $8000, while assets increased by $4000. Required: Determine the business’s: a ending total liabilities b beginning total assets c beginning owner’s equity. The following transactions are taken from the records of Phantom Security Company:

Assets ¼ Liabilities þ Owner’s equity

4-29

a Rex Simpson, the owner, invested $12 000 cash in the business. b Phantom paid $6000 cash to acquire security equipment. c Phantom received a $7000 cash loan from Story Regional Bank. Required: Determine the overall effect of each transaction on the assets, liabilities and owner’s equity of Phantom Security Company. Use I to indicate an increase, D a decrease and N no change. Also show the related dollar amounts. Jamieson Enterprises was established recently. The balance of each item in its accounting equation is shown below for 6 March and for each of the following business days.

Date

4-30

Cash at bank

Accounts receivable Supplies

Inventory

Land

Accounts payable

Loan payable

Owner’s equity

06 Mar.

$4 000

$6 000

$200

$ 800

$11 000

$4 000

$18 000

11 Mar.

3 500

6 000

700

800

11 000

4 000

18 000

13 Mar.

3 500

6 000

700

800

16 000

4 000

5 000

18 000

17 Mar.

3 500

6 000

700

1 600

16 000

4 800

5 000

18 000

19 Mar.

3 250

6 000

700

1 600

16 000

4 800

5 000

17 750

20 Mar.

5 250

4 000

700

1 600

16 000

4 800

5 000

17 750

21 Mar.

5 000

4 000

700

2 150

16 000

5 100

5 000

17 750

23 Mar.

7 000

4 000

700

2 150

16 000

5 100

5 000

19 750

25 Mar.

7 000

5 500

700

2 150

16 000

5 100

5 000

21 250

31 Mar.

7 000

5 500

200

2 150

16 000

5 100

5 000

20 750

Required: Assuming a single transaction took place on each day, describe briefly the most likely transaction to have occurred, beginning with 11 March. Indicate which accounts were affected and by what amount. On 31 August 20X2, Hernandez Engineering Company’s accounting records contained the following items (listed in alphabetical order): Accounts payable

$3 700

Accounts receivable

4 000

Cash

5 200

GST collected L Hernandez, capital

500 ?

Loans payable

6 000

Office equipment

8 900

Office supplies

600

Prepaid insurance

800

Required: Prepare a balance sheet for Hernandez at 31 August 20X2. Insert the correct amount for ‘L Hernandez, capital’. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions

4-31

Determine the missing elements in the accounting equation. Treat each case separately.

A ¼ L þ OE R  E P/L Case

Total Assets

A

96 000

B

90 000

Total Liabilities

C D E

4-32

46 000

$ 38 000 50 000

40 000

Cash Supplies Accounts payable Building A Ridge, capital

170

38 000 83 000

64 000

54 000

57 000

18 000 50 000 95 000 $35 000

56 000

60 000

20 000 32 000

Listed below, in random order, are all the items included in Ridge Rental Company’s balance sheet at 31 December 20X1:

Accounts receivable

4-34

Total Total Net Profit OE at beg. Revenues Expenses or (Loss) of period

21 000

Land

4-33

Owner’s Equity

$ 2 200 3 500 ? 900 4 600 19 000 ?

Rental equipment

6 800

Loans payable

5 700

Total assets on 31 December 20X1 are $33 800. Required: Prepare a balance sheet for Ridge Rental on 31 December 20X1. Insert the correct amounts for ‘Cash’ and for ‘A Ridge, capital’. In the chapter, we stated that a business transaction is an exchange of property or service with another entity. We also explained that in the recording of a transaction, at least two changes must be made in the assets, liabilities or owner’s equity of a business. Required: In each case, describe a transaction that will result in the following changes in the contents of a business’s balance sheet: a increase in an asset and increase in a liability b decrease in an asset and decrease in a liability c increase in an asset and decrease in another asset d increase in an asset and increase in owner’s equity e increase in an asset and increase in revenues f increase in expenses and decrease in an asset. In the chapter, we defined a source document as a business record used as evidence that a transaction has occurred. Required: Name the source documents that you think a business would use as evidence for each of the transactions listed below: a receipt of cash from the owner for additional investment in the business b payment by EFT to purchase office equipment c purchase of office supplies on credit d sale of office equipment at its original purchase price to a local accountant e purchase of fire and injury insurance protection f sale of inventory on credit.

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Chapter 4 The accounting system: Concepts and applications

4-35

4-36

4-37

During October, the Wilson Company incurred the following costs: a At the beginning of the month, the company paid $1200 to an insurance agency for a two-year comprehensive insurance policy on the company’s building. b The company purchased office supplies costing $970 on credit from Bailey’s Office Supplies. c The company paid the telephone company $110 for telephone service during October. d The owner withdrew $1200 for personal use. e The company found that, of the $970 of office supplies purchased in (c), only $890 remained at 31 October. Required: Identify whether each of the above items would be recorded by the Wilson Company as an asset or an expense for October. List the dollar amount and explain your reasoning. Gertz Rent-A-Car is in the business of providing customers with quality rental cars at low rates. The business engaged in the following transactions during March: a The owner, Jim Gertz, deposited an additional $1900 of his personal cash into the cash account. b The business collected $1500 in car rental fees for March. c The business borrowed $7000 from the Nation Bank, to be repaid in one year. d The business completed arrangements to provide fleet service to a local company for one year, starting in April and collected $18 000 in advance. Required: For each of the above transactions, identify which revenues, liabilities or owner’s equity would be recorded as revenues by Gertz Rent-A-Car for March. List the dollar amounts and explain your reasoning. The Slidell Auto Supply Company entered into the following transactions during the month of July: Date

Transaction

1 July

Joan Slidell, the owner, deposited $12 000 in the cash account.

11

Slidell Auto Supply purchased $800 of office supplies from Jips Paper Company, agreeing to pay for half of the supplies on 31 July and the rest on 15 August.

16

Slidell Auto Supply purchased a three-year fire insurance policy on a building owned by the company, paying $600 cash.

31

Slidell Auto Supply paid Jips Paper Company half the amount owed for the supplies purchased on 11 July.

Required: Using the basic accounting equation that we introduced in this chapter, record the above transactions. Use headings for the specific kinds of assets, liabilities and owner’s equity. Set up your answer in the following form: Date

4-38

¼

Assets

þ

Liabilities

Owner’s equity

The financial balances for Steve’s Car Rentals on 31st May, 2019 are provided below in a table in accounting equation format. You are required to: a draw up the table and list the balances for May b record the effects of each of the transactions listed. Show the total of each column after each transaction to ensure the accounting equation balances. c calculate the profit or loss made by comparing revenues with expenses. d prepare a balance sheet at 31st May.

Asset ¼ Liabilities þ Equity Transaction Balances

Cash at Bank 12 000

Accounts Office Receivable Equipment 13 800

1 800

Motor Vehicle 93 700

Supplies

Accounts Payable

200

3 000

Loan Payable

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13 500

Equity 105 000

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Accounting Information for Business Decisions

Transactions for the month of May:

4-39

4-40

172

i Collected $2800 of accounts receivable. ii Billed customers for services performed on credit $13 700. iii Paid $1200 of accounts payable. iv Purchased supplies worth $700 on credit. v Purchased another motor vehicle for $21 000. Paid $1000 in cash and borrowed the rest as a loan. vi Steve withdrew $650 in cash. vii Received $3900 cash for services performed. viii Paid wages $1500 and advertising $200 in cash. ix Recorded supplies used of $600. x Recorded interest on loan $235. Amy Dixon opened the Dixon Travel Agency in January, and the company entered into the following transactions during January: i On 2 January, Amy deposited $23 000 in the cash account. ii To conduct its operations, the company purchased land for $3300 (including GST of $300) and a small office building for $16 500 (including GST $1500) on 3 January, paying $19 800 cash. iii On 5 January, the company purchased $770 (including GST $70) of office supplies from City Supply Company, agreeing to pay for half of the supplies on 15 January and the remainder on 15 February. iv On 12 January, the company purchased office equipment from Ace Equipment Company at a cost of $3300 (including GST $300). It paid $1300 down and signed a note agreeing to pay the remaining $2000 at the end of one year. v On 15 January, the company paid City Supply Company half the amount owed for the supplies purchased on 5 January. vi On 28 January, Amy decided that the company did not need a desk it had purchased on 12 January for $440. The desk was sold for $440 cash to Chris Watson, an insurance agent, for use in his office. vii On 30 January, the company collected $990 (including GST $90) of commissions for travel arrangements made for customers during January. viii On 31 January, the company paid Frank Jones $550 (including GST $50) for repair work done during January. ix On 31 January, the company received its telephone bill totalling $132 (including GST $12) for January. It will pay for this bill in early February. x On 31 January, Amy withdrew $600 from the company for her personal use. Required: a Using the accounting system we developed in the chapter, record the preceding transactions. b Prove the equality of the accounting equation at the end of January. c List the source documents that you would normally use in recording each of the transactions. Parsons Fashion Designers was started on 1 June. The following transactions of the business occurred during June: i E Parsons started the business by investing $18 000 cash. ii Land and an office building were acquired at a cost of $5500 (including GST $500) and $19 800 (including GST $1800), respectively. The company paid $6300 immediately and established a short-term loan for the remaining balance of $19 000. The payment is due in two years. iii Design equipment was purchased. The cash price of $2860 (including GST $260) was paid by cheque to the supplier. iv Office supplies totalling $275 (including GST $25) were purchased on credit. The amount is due in 30 days. v A one-year fire insurance policy was purchased for $880 (including GST $80). vi Fashion design commissions (fees) of $1320 (including GST $120) were collected from clients for June. vii An assistant’s wage of $660 was paid for June. PAYG tax included in this amount was $160. viii E Parsons withdrew $500 from the business for personal use. ix Utility bills totalling $165 (including $15 GST) for June were received and will be paid in early July. Required: a Using the accounting system shown in the chapter, record the above transactions. b Prove the equality of the accounting equation at the end of June. c List the source documents that you would normally use in recording each of the transactions.

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Chapter 4 The accounting system: Concepts and applications

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4-42

L Snider, a young accountant, started Snider Accounting Services on 1 September. During September, the following transactions of the business took place. (Note: where appropriate, GST is included in the amount.) i On 1 September, Snider invested $7000 to start the business. ii On 1 September, the business paid $3300 for one year’s rent of office space in advance. iii On 2 September, office equipment was purchased at a cost of $5500. A down-payment of $1500 was made and a $4000, one-year note was signed for the balance owed. iv On 5 September, office supplies were purchased for $660 cash. v On 18 September, $1100 (including $100 GST) was collected from clients for accounting services performed. vi On 28 September, $500 wages were paid to an accounting assistant; $100 PAYG tax was included. vii On 29 September, Snider withdrew $800 for personal use. viii On 30 September, the business billed clients $1320 (including $120 GST) for accounting services performed during the second half of September. ix On 30 September, the September electricity bill of $110 (including $10 GST) was received; it will be paid in early October. x On 30 September, Snider recorded the following adjustments: – Rent expense of $250 – Depreciation of $60 on office equipment – Interest expense of $40 on loan payable – Office supplies used of $50. Required: a Using the accounting system shown in this chapter, record the above items. b Prove the equality of the accounting equation at the end of September. c Calculate the net income of the company for September. d Prepare a balance sheet for the company on 30 September. The Johnson Drafting Company, which draws blueprints for building contractors, was started on 1 March. The following transactions of the company occurred during March: Date

Transactions

1 Mar.

M Johnson, the owner, started the business by investing $14 000 cash

2

Land and a small office building were purchased at a cost of $4400 and $22 000, respectively including GST. A down payment of $8000 was made, and a loan for $18 400 was signed. The loan is due in one year

3

Cash of $4840 (including GST) was paid to purchase computer drafting equipment

8

Drafting supplies totalling $880 (including GST) were purchased on credit. The amount is due in early April

15

The company collected $1500 (excluding GST) from contractors for drafting services performed

28

M Johnson withdrew $1000 for personal use

29

The company received a $110 (including GST) utility bill for March, to be paid in April

30

The company paid $7600 in salary to a drafting employee. PAYG tax payable included in this amount was $420

30

The company billed contractors $2200 (including GST) for drafting services performed during the last half of March

31

The company recorded the following adjustments: i Depreciation of $80 on the office building ii Depreciation of $100 on computer drafting equipment iii Interest of $160 on loan payable iv Drafting supplies used of $150

Required: a Using the accounting system shown in the chapter, record the preceding transactions. b Prove the equality of the accounting equation at the end of March. c Calculate the net income of the company for March. d Prepare a balance sheet for the company on 31 March.

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4-43

The five transactions that occurred during June, the first month of operations for Brown’s Gym, were recorded as follows (excluding GST implications): ¼

Assets þ

Trans

Date

Cash

a

01/6

þ$24 000

b

05/6

8 000

c

07/6

270

d

17/6

4 000

e

26/6

Balances

30/6

Gym þ supplies

Land

þ Building þ

Gym þ equipment

þ Owner’s equity

þ

þ Tom Brown, capital

Loans payable

þ$24 000 þ$5 000

þ$23 000

þ$20 000

þ$270 þ$10 000

þ6 000

þ480 $11 730 þ

$750 þ

þ$480 $5 000 þ

$23 000 þ

$10 000 ¼

þ$480 þ

$26 000 þ

$24 000

Required: a Describe the five transactions that took place during June. b Prepare a balance sheet on 30 June. The following transactions were recorded by the Sutton Systems Design Company for May, its first month of operations (excluding GST implications):

4-44

¼

Assets þ

Trans

Date

Cash

a

01/5

þ$55 000

b

02/5

8 000

c

08/5

3 500

d

10/5

e

22/5

Balances

31/5

4-45

Liabilities Accts payable

Office þ supplies

Land

þ Building þ

Office þ equipment

þ Owner’s equity

þ

þ Steve Sutton, capital

Loans payable

þ$55 000 þ$6 000

þ$18 000

þ$16 000 þ$7 500

þ$1 100

þ4 000 þ$1 100

þ300 $43 800 þ

Liabilities Accts payable

300 $1 100 þ

$6 000 þ

$18 000 þ

$7 200 ¼

$1 100 þ

$20 000 þ

$55 000

Required: a Describe the five transactions that took place during May. b Prepare a balance sheet at 31 May. At the beginning of July, Patti Dwyer established PD Company, investing $20 000 cash in the business. On 5 July, the company purchased land and a building, making a $6000 down payment (which was 10 per cent of the purchase price) and signing a 10-year mortgage for the balance owed. The land was 20 per cent of the cost and the building was 80 per cent of the cost. On 17 July, the company purchased $3800 of office equipment on credit, agreeing to pay half the amount owed in 10 days and the remainder in 30 days. On 27 July, the company paid the amount due on the office equipment. On 31 July, the company sold $900 of the office equipment that it did not need to another company for $900. That company signed a note requiring payment of the $900 at the end of one year. Required: Based on the above information, prepare a balance sheet for PD Company on 31 July. Show supporting calculations. Ignore GST in this question.

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174

Your friend Maxine plans to supplement her job salary by running her own company at night and on weekends. When the company earns enough money for her to pay for a holiday house in Fiji, she plans to pay the company’s bills, sell its remaining assets, withdraw all its cash and shut it down. Since Maxine will be extremely busy with her regular job and with running her new company, she plans to wait until she is ready to shut down the company to prepare a balance sheet, income statement and cash flow statement. You think this is a bad idea.

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Chapter 4 The accounting system: Concepts and applications

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Required: Do your best to convince Maxine that she should prepare financial statements more often, giving her examples of how doing this can help her and her company. Chris Schandling is a loan officer at the Nation Bank in Brisbane, Australia. One day, Nathan Wooten, who owns KidzLand (an indoor playground for young children), comes to the bank to see Chris about getting a $50 000 loan. Required: a What types of questions do you think Chris will ask Mr Wooten? Come up with at least three types of questions. b What types of financial information do you think Chris will ask Mr Wooten to provide? c If Mr Wooten asks Chris why this financial information is needed, how should Chris respond? Is it important that KidzLand’s financial statements follow GAAP? Why or why not? Andrew Poist works for a public accounting firm in Melbourne, Australia. On 4 October 20X1, Sydney Langston, who started selling decorative carved wooden ducks out of a booth at Cypress Court Shopping Centre during the first week in September, comes to see Andrew for some accounting help. Mr Langston walks into Andrew’s office carrying a small cardboard box. He tells Andrew the following: ‘After I retired, I decided I needed something to help keep me busy. I started this little business, The Woodshed, a month ago. It is open only on Fridays, when the shopping centre has its Craft Market. I leased the booth for one year. So every Friday until 1 September 20X2, I will display my ducks in the booth and sell them. I know I should have come to see you before I got started, but I kept putting it off. So here’s what I did. During September, I tossed everything to do with The Woodshed’s finances into this box. It has all kinds of documents in it. I have all of my bank deposits for the month, cheques I wrote that were paid by my bank, the receipts for the woodworking supplies I bought the day I started, and so on. I sorted out some items, like payments I made to the grocery shop and the electricity company. Anyway, it’s the first part of October, and I can’t figure out how well The Woodshed did in September. Can you?’ ‘Of course I can’, replies Andrew. ‘I’ll have something for you in a couple of days.’ Mr Langston leaves, and Andrew opens the small box. Inside is a small pile of documents: i Five deposit slips from Mr Langston’s bank account. They total $2300. Andrew notices that on four of the deposit slips, Mr Langston has written ‘Craft Sales’. Each of the deposit dates corresponds to each of the four Fridays in September. On the other deposit slip, which is for $1300, Mr Langston has written ‘Centrelink payment’. ii There are six cheques honoured by Mr Langston’s bank account, totalling $3350; four cheques written to Miranda’s Woodworking Supplies, total $600; one cheque for $350 written to Circuit City; and one cheque for $2400 written to Cypress Court Shopping Centre management. iii A handwritten schedule reads as follows: Mallard

$ 60

Sold

Grey Goose

$100

Sold

Baby Duck

$ 40

Sold

Swan

$200

Donald Duck

$ 70

Sold

Large Mallard

$130

Sold

Required: a Using the information Mr Langston supplied to Andrew, calculate your best estimate of the revenues, expenses and net income for The Woodshed for September 20X1. b How could your calculations of revenues, expenses and net income be misstated? When Andrew meets with Mr Langston to discuss The Woodshed’s operating results for September, what questions should he ask concerning the information Mr Langston supplied?

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4-49

In this assignment, we are going to chronicle the changes in value and ownership of one asset – a one-hectare plot of land on the corner of Cedar Springs Road and McKinney Avenue in Tamborine Mountain, Gold Coast – from January 20X1 to December 20X2. Here are the significant events that happened to that plot of land during this time period: 4 January 20X1

The land is purchased for $450 000 by Dalton Realty

25 April 20X1

Dalton Realty receives an assessment notice stating that the council now values the land at $510 000 for local rate purposes

12 December 20X1

The land is sold by Dalton Realty to Park Cities Development for $515 000. Park Cities pays in cash

22 May 20X2

Using the land as collateral (meaning that if Park Cities fails to repay its loan, the bank may get ownership of the land), Park Cities borrows $550 000 from the bank

14 June 20X2

Park Cities rents the land to Crescent Court Construction for six months. Crescent Court will store construction equipment on the land while making renovations to a nearby housing estate

31 December 20X2

Park Cities sells the land to Crescent Court Constructions for $590 000

Required: When business closes for each day listed below, state: a which company shows this land in its accounting records as an asset b at what dollar amount the land is shown in that company’s accounting records.

Date

Company showing the land as its asset

Dollar amount shown

04/01/20X1 25/04/20X1 12/12/20X1 22/05/20X2 14/06/20X2 31/12/20X2

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Five years ago, Linda Monroe became the sole owner of LM Electronics, which sells home entertainment centres, car audio equipment and computers. LM advertises that it sells only the best brands, purchasing its inventory from well-known manufacturers in Japan, Germany, Norway and the United States. Before opening this company, Linda was the accountant for The Music Warehouse. She understands accounting extremely well, and maintains LM Electronics’ accounting records according to GAAP. On the morning of Friday 12 September, one of Linda’s best customers, Sandy Wheeler, purchased a German-made CD player for $600. Linda was excited about making the sale because LM had only recently started carrying this particular brand. Linda filled out the sales invoice, collected the money and helped Sandy carry the CD player to her car. Later that day, Linda’s friend Chris Rucker came into the shop, also wanting to purchase a CD player. After browsing for a while, Chris went to leave the shop. Linda stopped him and asked, ‘Chris, didn’t you find a CD player that you’d like to own?’ Chris replied, ‘Well, Linda, I saw several items I’d love to own, but I hadn’t realised how expensive the equipment was. I guess I really can’t afford to buy a new CD player.’ Except for the deposit of the day’s cash sales in the bank, no other activity took place at LM Electronics that day. After the shop closed, Linda began thinking about Chris’s comment. Early that evening, she telephoned Chris and said, ‘Chris, I know you were wanting a new CD player, but if you’re interested in saving money, I’d like to sell you the CD player I use at home. It’s about two years old and in great shape. I would sell it to you for $100.’ Chris was excited about Linda’s offer. He drove over to her house that night, gave her $100 in cash and took the CD player home. Linda immediately deposited the $100 in the bank night depository. Required: Given the facts presented above and the information you learned in the chapter, (a) indicate whether you agree or disagree with the following statements, and (b) explain each answer (this is the most important part, so think through the following statements carefully). i Linda Monroe sold two CD players on 12 September. ii LM Electronics sold two CD players on 12 September. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 4 The accounting system: Concepts and applications

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iii LM Electronics should record CD player sales of $700 on 12 September. iv Linda Monroe should deposit $700 in the bank on 12 September. Paul Jenkins is the sole owner of Friendly Exchange Shop, which buys and sells jewellery, musical instruments, televisions, telephones and small kitchen appliances. Paul has owned the shop for almost one year, and the shop has developed a reputation as an honest, reliable place for families to buy or sell their used items. Until now, Friendly Exchange has bought and sold goods only from retail customers. Paul believes that Friendly Exchange is overstocked with jewellery, and he thinks the shop does not have enough musical instruments to meet the demand that will occur after the new school year starts. Paul believes the shop needs to sell some of its jewellery, which cost about $1500. He anticipates that he could sell the jewellery for $4000 and replace this with several trumpets, trombones and flutes. Friendly Exchange Shop advertises in the newspaper when it wants to buy particular types of used items. This way Paul has the opportunity to inspect the goods before they are purchased, and to discuss the history of each item with its current owner. In the present situation, however, Paul is considering making a merchandise trade with a wholesale exchange broker. Although Paul is almost convinced that the trade will be the best way for his business to obtain the musical instruments, he has two major concerns. First, Paul is concerned about maintaining the shop’s reputation for reliable merchandise. He knows almost all of his customers and he has earned their trust. Because Paul does not know where the wholesaler’s musical instruments were purchased, he worries that he will be trading good jewellery for inferior quality musical instruments. He would not find out that the instruments are inferior until the customers told him of their dissatisfaction. Second, Paul does not know how to record the trade in Friendly Exchange Shop’s accounting records. As mentioned earlier, he knows that the jewellery he plans to trade cost $1500, and that he was going to try to sell the jewellery for $4000. Paul does not know how much the wholesaler paid for the musical instruments or what price to charge his customers for each item. Required: a Using the four-step approach you learned in this chapter and earlier in this book, discuss how you think Paul should solve this business problem. b Assuming Friendly Exchange Shop trades the jewellery for the musical instruments owned by the wholesaler, discuss how you think this transaction should be recorded in the accounting records. Be sure to include references to the accounting concepts introduced in this chapter. Your friend Jane Thomson is about to prepare the 31 January balance sheet for her new business, Tasty Bites cupcake shop. This is Tasty Bites’ first month of operation, and Jane is also going to calculate the first month’s net income. She needs to prepare the balance sheet and calculate net income so she can pass the information along to her parents. They loaned her $5000 so that she could start Tasty Bites. Although Jane thinks that business is booming, she has a big problem. She does not know enough about accounting to prepare the balance sheet or calculate January’s net income. As a matter of fact, Jane had never heard the words ‘balance sheet’ and ‘net income’ until her parents asked her to promise to give them these statements every month before they would agree to loan Jane the $5000. Luckily, Jane saves every piece of paper associated with Tasty Bites. She kept copies of all of the business agreements she signed. She deposited all of the money Tasty Bites earned in the company’s bank account and she retained copies of every deposit slip. Jane also paid every company bill with a cheque and saved all of the related documents. Required: Assume Jane wants to prepare Tasty Bites’ 31 January balance sheet and January’s income statement according to GAAP. Describe to Jane, in your own words, how she should organise the information about Tasty Bites’ January transactions so that she can prepare a balance sheet and an income statement and keep her promise to her parents. Samson Construction Company is a small business that constructs buildings. Usually, the amount of time it takes Samson to complete the construction of a building is about six months. At the beginning of this year, Samson signed a contract to build a three-storey office building at a selling price of $2 million. Samson will collect this amount when it completes construction of the building. Because this is a larger building than it usually builds, Samson expected that it would take two years to complete the construction, at a total cost of $1.4 million. This is the only building on which Samson worked during the year. By the end of the year, construction was on schedule: the office building was half-complete and Samson had paid $700 000 costs. At this time, Samson’s bookkeeper came to Bill Samson, the owner, and said, ‘Samson Construction Company didn’t do very well this year; it had a net loss of $700 000 because its revenue was zero and its expenses were $700 000.’

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Bill comes to you for advice. He says, ‘Usually, my company records the revenue and related expenses for constructing a building when it is completed. However, this three-storey building will take much longer than usual. My construction crews have already been working on the building for one year, and will continue to work on it for another year. My company has paid for one year’s worth of salaries, materials and other costs, and will continue to pay for all of these costs incurred next year, so a lot of money will be tied up in the contract and won’t be recovered until my company collects the selling price when the building is completed. How and when should my company record the revenue and expenses on this building? Do I really have a $700 000 net loss for the current year?’ Required: Prepare a written answer to Bill Samson’s questions.

Dr Decisive Yesterday, you received the following letter for your advice column at the local paper:

Dear Dr Decisive, My girlfriend and I have just started out on our studies of accounting and are thinking of starting up a fitness business together. We recently had a bit of an argument about the terms ‘asset’ and ‘liability’. I feel that because I am tall, fit, dark and handsome, those qualities will be an asset to the business and should be recorded. It will help to bring in customers and ultimately make profit. She says I have the concept completely wrong but if we are going to do that insists, that we should also focus on my liabilities, which are my ego and tardiness in getting work done, which will cost the business money. She insists that we should only record tangible things that are of value to the business as assets and things that are negative as liabilities. Can you give me examples of what she means? And what is tangible? Also, can you explain to me why my business ‘qualities’ should not be recorded as assets of the business? Yours sincerely, ‘Dark and Handsome’

Required Meet with your Dr Decisive team and write a response to ‘Dark and Handsome’.

Endnotes a b

Quoted in Metcalf, M (2014) The Biteback Book of Humorous Business Quotations. London: Biteback Publishing, np. Godfrey, K (1995) ‘Computing error at Fidelity’s Magellan fund’. The Risks Digest, 16(72). http://catless.ncl.ac.uk/risks/16.72.html.

List of company URLs u u u u u u u

Aldi: http://www.aldi.com.au Benetton: http://www.benetton.com Fidelity Investments: http://www.fidelity.com.au Fortescue Metals Group: http://www.fmgl.com.au Origin Energy: http://www.originenergy.com.au Sony: http://www.sony.com.au Audi: http://www.audi.de/de/brand/de.html

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5 RECORDING, STORING AND REPORTING ACCOUNTING INFORMATION ‘The system of bookkeeping by double entry is perhaps the most beautiful one in the wide domain of literature and science.’ Edwin T. Freedley, 1852a

Learning objectives After reading this chapter, students should be able to do the following: 5.1

Understand the rules for recording transactions in a business’s accounting system records.

5.2 Identify and complete the major steps in a business’s accounting cycle. 5.3 Journalise and post to accounts the transactions of a business and prepare a trial balance. 5.4 Complete adjusting and closing entries. 5.5 Prepare financial reports – income statement and balance sheet.

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Understanding the learning objectives is assisted in the chapter by asking key questions:

Key questions 1

What is a debit entry, and what is a credit entry?

2

What are the rules for recording increases and decreases in asset and liability accounts?

3

What are the rules for recording increases and decreases in owner’s equity accounts?

4

What are the major steps in a business’s accounting cycle?

5

What is the difference between journalising and posting?

6

What are adjusting entries, and what are the three types of adjusting entries?

7

What are closing entries, and how do they relate to the income summary account?

8

How are accounting procedures modified for companies?

9

What circumstances might cause directors to act unethically when making dividend distribution decisions for owners?

In Chapter 4, we explained transactions and source documents, as well as the entity, monetary unit and historical cost concepts as they apply to a business’s accounting process. We explained that the accounting process accumulates information and reports the results of the business’s activities. We introduced a basic accounting system in terms of the accounting equation: Assets ¼ Liabilities þ Owner’s equity. We noted that the accounting system included columns for recording and retaining information from transactions related to the business’s assets, liabilities and owner’s equity accounts, so that the business can report the information on its balance sheet. We also explained the dual effect of recording transactions. We discussed several accounting principles and concepts related to net income, including the concepts of an accounting period, the earning process, the matching principle and accrual accounting. In Chapter 7, we will expand the accounting system to include columns for recording and retaining information from transactions relating to each of the business’s revenue and expense accounts, so that the business can report the information on its income statement. We will use the accounting equation to explain the impact of transactions on a business’s accounting system. We will also explain the effect of each transaction on the financial statements. The accounting-equation approach to a business’s accounting system works well to explain the accounting process without getting ‘bogged down’ in specific accounting procedures. This approach enables you to focus more on understanding how to use the information generated by this process. However, the column method for a business’s accounting system is unmanageable when the business has many transactions involving numerous accounts (sometimes hundreds!) for which it needs to keep detailed records. In this case, the business uses a more complex accounting system. Many of you will need to have a basic understanding of the specific accounting procedures used by a business to operate a more complex accounting system. Others may also be interested in understanding these procedures that will enable you to better evaluate financial statements as a manager or as an investor. The purpose of this chapter is to explain rules for double entry (i.e. debit and credit rules), the accounting cycle and how businesses record transactions in journals, post and retain transaction information, record adjusting and closing entries, and prepare financial statements. To help explain some of these procedures, we will review what we discussed in earlier chapters. For simplicity, our discussion will initially focus on a sole proprietorship, but we will explain the differences for companies later in the chapter.

5.1 Accounts Ethics and Sustainability

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Recall that an accounting system is a means by which a business identifies, measures, records and retains accounting information about its activities so that it can report this information in its financial Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 5 Recording, storing and reporting accounting information statements. Most businesses will use an electronic accounting system. For small to medium businesses this will most likely be a package like MYOB or XERO. Business transactions are entered into the system, processed electronically in order to produce the reports required by the owners or managers to make decisions. Understanding the process that takes place in an electronic accounting system such as MYOB or XERO helps shed light on the information or output produced by the system. In an accounting system, a business uses accounts to record and retain the monetary information from its transactions. It uses a separate account for each asset, liability and owner’s equity item, as well as for each revenue and expense item. The number of accounts, as well as the types and names of the accounts, will depend on the particular business’s operations, and on whether it is a sole proprietorship, partnership or company. A general ledger is the entire set of accounts that a business uses. For this reason, accounts are sometimes referred to as general ledger accounts.

accounts Documents used to record and retain the monetary information from a business’s transactions

general ledger Entire set of accounts for a business

Stop & think Why is it necessary to have a separate account for each item that the business must record?

Stop & think How does keeping records of the financial transactions of a business help to make a business more sustainable? 1

An account can take several physical forms. Today, most accounting is done using software packages, and records are stored on computer hard drives and in back-up files. Very few businesses now use a manual system to record daily operations, and the general ledger is usually a computer file. Regardless of their physical form, a business uses each account for recording and accumulating accounting information about a financial statement item.

Stop & think How do we decide what name to call an account?

Debits and credits In a manual system, accounts may have several different forms. For convenience, in this chapter we will use the T-account form. The title of the account is written across the top of each T-account, and each T-account has a left side and a right side. The left side is called the debit (DR) side, and the right side is called the credit (CR) side. The left (debit) and the right (credit) sides of each account are used for recording and accumulating the monetary information from transactions. A debit entry is a monetary amount recorded (debited) on the left side of an account. A credit entry is a monetary amount recorded (credited) on the right side of an account. Title of account Left (debit) side

Right (credit) side

Recording rules Each account accumulates information about how much it has increased or decreased as a result of various transactions. Whether a business records increases or decreases on the left or the right side of an account depends on the type of account (i.e. on where the account ‘fits’ within the accounting equation), and is based on the debit and credit rules. For assets, liabilities and owner’s equity accounts, these rules

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What is a debit entry, and what is a credit entry?

T-account Accounts used to record transactions for individual types of assets, liabilities and owner’s equity, as well as revenues and expenses debit entry Monetary amount recorded (debited) on the left side of an account credit entry Monetary amount recorded (credited) on the right side of an account 2

What are the rules for recording increases and decreases in asset and liability accounts? 3

What are the rules for recording increases and decreases in owner’s equity accounts?

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double entry rule In the recording of a transaction, the total amount of the debit entries must be equal to the total amount of the credit entries for the transaction

relate to the side of the accounting equation on which the account is located.1 For withdrawal,2 revenue and expense accounts, these rules relate to whether the transactions increase or decrease owner’s equity. That is, when an owner withdraws money from the business, the effect of the withdrawal is that the owner’s equity in the business decreases. When the business earns revenue, the ultimate effect of the revenue increase is to increase the owner’s equity. When the business incurs expenses, the ultimate effect of the expense increase is to decrease the owner’s equity. The debit and credit rules are as follows: 1 Asset accounts (accounts on the left side of the accounting equation) are increased by debit (DR) entries (amounts recorded on the left side of a T-account) and decreased by credit (CR) entries. 2 Liability accounts (accounts on the right side of the equation) are increased by credit (CR) entries (amounts recorded on the right side of a T-account) and decreased by debit (DR) entries. 3 Permanent owner’s equity, or capital, accounts (accounts on the right side of the equation) are increased by credit (CR) entries and decreased by debit (DR) entries. Temporary owner’s equity accounts have the following rules: a Withdrawal accounts are increased by debit (DR) entries and decreased by credit (CR) entries. b Revenue accounts are increased by credit (CR) entries and decreased by debit (DR) entries. c Expense accounts are increased by debit (DR) entries and decreased by credit (CR) entries. Exhibit 5.1 illustrates the debit and credit rules as they relate to the accounting equation.3 As we introduced in the previous chapter, a business uses the double entry rule for recording its accounting information. The double entry rule states that in the recording of a transaction, the total Exhibit 5.1 The accounting equation and debit–credit rules

Assets

Asset accounts (debit) increase ⴙ

(credit) decrease ⴚ

ⴝ

Permanent accounts Liabilities

Liability accounts (debit) decrease ⴚ

(credit) increase ⴙ

ⴙ

Temporary accounts Owner’s equity

Owner’s Equity (capital) accounts

Withdrawals accounts

(debit) decrease ⴚ

(debit) increase ⴙ

(credit) increase ⴙ

(credit) decrease ⴚ

Revenue accounts (debit) decrease ⴚ

(credit) increase ⴙ

Expense accounts (debit) increase ⴙ

1

(credit) decrease ⴚ

Owner’s equity accounts may be permanent or temporary. Permanent owner’s equity accounts are those that a business

reports on its balance sheet. Temporary owner’s equity accounts are used only to calculate a business’s net income or withdrawals for the accounting period. 2

In earlier chapters, we recorded withdrawals as reductions in the owner’s capital account column. Many businesses keep track

of withdrawals separately, and use a withdrawals or drawings account to do so. 3

The debit and credit rules for increasing and decreasing a contra-account are the opposite of the account to which it relates.

We discuss contra-accounts later in this chapter.

182

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Chapter 5 Recording, storing and reporting accounting information amount of the debit entries must equal the total amount of the credit entries for the transaction. The use of both the double entry rule and the debit and credit rules in recording transactions ensures that the accounting equation remains in balance. At any given time, an account may have a number of debit and credit entries. The balance of an account is the difference between the total increases and the total decreases recorded in the account. Typically, total increases exceed total decreases. Therefore, each asset account normally has a debit balance because the total increases (debits) exceed the total decreases (credits) in the account. Similarly, each liability and permanent owner’s equity (capital) account normally has a credit balance because the total increases (credits) exceed the total decreases (debits) in each account. For the temporary owner’s equity items, revenue accounts normally have credit balances, whereas expense and withdrawal accounts normally have debit balances. The following list summarises the normal balances in the various accounts. Account

Normal balance

Assets

Debit

Liabilities

Credit

Owner’s capital

Credit

Owner’s withdrawals

Debit

Revenues

Credit

Expenses

Debit

5.2 Accounting cycle Now that you are familiar with the rules for recording and accumulating information in the various accounts, we will discuss the steps that a business completes during each accounting period to record, retain and report the monetary information from its transactions. These steps are called the accounting cycle. The major steps include: 1 recording (journalising) the transactions in the general journal 2 posting the journal entries to the accounts in the general ledger 3 recording (and posting) adjusting entries 4 preparing the financial statements 5 recording (and posting) closing entries. We will discuss and illustrate each of these steps, along with several sub-steps, in the following sections.

balance of an account Difference between the total increases and the total decreases recorded in the account

4

What are the major steps in a business’s accounting cycle? accounting cycle Steps that a business completes during each accounting period to record, retain and report the monetary information from its transactions

5.3 Recording (journalising) transactions Recall that a source document (an invoice, a receipt or a printout from an EFT machine) is the record from which a business obtains the information for each transaction. The business uses this information to record each transaction in a journal, after which it transfers the information to its accounts. A general journal includes the following information about each transaction: • the date of the transaction • the accounts to be debited and credited • the amounts of the debit and credit entries • an explanation of each transaction. In a manual system, the general journal is a book of columnar pages. A business can use a general journal to record all types of transactions. The general journal is the kind of journal we will discuss in this chapter; however, some businesses may have a number of special journals, each of which is used to record a particular type of transaction. The common special journals are the sales (for recording credit sales), purchases (for credit purchases of inventory), cash Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

general journal Includes the following information about each transaction: the date of the transaction, the accounts to be debited and credited, the amounts of the debit and credit entries and an explanation of each transaction

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journalising Process of recording a transaction in a business’s general journal

journal entry Recorded information for each transaction

receipts (for cash inflows) and cash payments (for cash outflows) journals. We do not discuss these special journals in this chapter. A general journal consists of a date column, a column to list the accounts affected by each transaction (and an explanation of the transaction), a column to list the account numbers of the affected accounts, and debit and credit columns to list the amounts to be recorded in each account. Journalising is the process of recording a transaction in a business’s general journal. A journal entry is the recorded information for each transaction. We show an example of transactions and how they are recorded in a general journal in Case Exhibits 5.2 and 5.3 later in this chapter.

Stop & think Why is it so important to ensure that the journal entry is correct when entering it into the system? A business gains several advantages by using a general journal for initially recording its transactions. First, this process helps prevent errors. Since the business initially records the accounts and the debit and credit amounts for each transaction on a single journal page, rather than directly in the many accounts, this method makes it easier to prove that the debits and the credits are equal, thus keeping the accounting equation in balance. Second, all the information about each transaction (including the explanation) is recorded in one place, thereby providing a complete ‘picture’ of the transaction. This is useful in the auditing process or if an error is discovered because it will be easy to review all of the transaction information. Third, the business records the transactions chronologically (i.e. day to day), so that the journal provides a ‘history’ of its financial transactions.

Key procedures in journalising

narration A description of the transaction that has been entered into the general journal

184

The following list outlines the journalising procedures for each column of the general journal. Study it carefully, referring to the completed general journal in Case Exhibit 5.3. 1 Enter the day, month and year of the first transaction in the ‘Date’ column. It is not necessary to repeat the month and year of later transactions until the beginning of a new journal page, a new month or a new year. 2 Enter the title of the account to be debited at the far left of the column titled ‘Account titles and explanations’. Enter the amount of the debit to this account in the ‘Debit’ column on the same line as the account title. Dollar signs are typically not used in the debit (or credit) columns. 3 Enter the title of the account to be credited on the next line below the title of the debited account. Indent the title of the credit account slightly to the right, so that a reader looking at the journal page can easily identify which account titles are debited and which are credited. Enter the amount of the credit to this account on the same line in the ‘Credit’ column. 4 Some transactions involve two or more debits, two or more credits, or both. (Remember that for each transaction, the total amount of the debit entries must equal the total amount of the credit entries.) In this case, the type of journal entry a business uses is called a compound entry. When recording a compound entry, first list all the accounts and amounts to be debited (list each account on a separate line), followed by all the accounts to be credited (indent and list each account on a separate line). Because of GST, most of the entries in Case Exhibit 5.3 are examples of a compound journal entry. 5 Enter a brief explanation of the transaction on the line below the last credit entry of the transaction. Write the explanation at the far left of the column entitled ‘Account titles and explanations’. Leave a blank line before beginning another journal entry, to set off each entry. The explanation is called a narration. 6 During the process of journalising, do not record a number in the column entitled ‘Acct no.’ (‘Account number’). You will enter a number in this column during the ‘posting’ process, which we will discuss later. (When you are referring to Case Exhibit 5.3, note that this is what the general journal page looks like after the posting process is complete.)

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Chapter 5 Recording, storing and reporting accounting information Case Exhibit 5.2 Cafe´ Revive’s December 20X1 transactions and analysis Date

Transaction

Analysis

1/12

E Della makes initial investment in Cafe´ Revive of $22 000.

Asset account ‘Cash’ is increased (debited) by $22 000; owner’s equity account ‘E Della, capital’ is increased (credited) by $22 000

1/12

Cafe´ Revive pays $7920 (including GST) to University Hub for six months’ rent in advance.

Asset account ‘Prepaid rent’ is increased (debited) by $7200; asset account ‘GST paid’ is increased (debited) by $720; asset account ‘Cash’ is decreased (credited) by $7920

7/12

Cafe´ Revive pays $2255 (including GST) for the purchase of coffee supplies from City Supply Company.

Asset account ‘Supplies’ is increased (debited) by $2050; asset account ‘GST paid’ is increased (debited) by $205; asset account ‘Cash’ is decreased (credited) by $2255

12/12

Cafe´ Revive purchases coffee gift packs inventory of $1430 (including GST) on credit from DeFlava Coffee Corporation.

Asset account ‘Inventory’ is increased (debited) by $1300; asset account ‘GST paid’ is increased (debited) by $130; liability account ‘Accounts payable’ is increased (credited) by $1430

20/12

Cafe´ Revive purchases shop equipment from Restaurant Equipment for $1650 (including GST), paying $250 cash and taking a loan of $1400.

Asset account ‘Shop equipment’ is increased (debited) by $1500; asset account ‘GST paid’ is increased (debited) by $150; asset account ‘Cash’ is decreased (credited) by $250; liability account ‘Loan payable’ is increased (credited) by $1400

22/12

Cafe´ Revive sells $440 (including GST) of unneeded shop equipment on account to Beau Flowers Store.

Asset account ‘Accounts receivable’ is increased (debited) by $440; asset account ‘Shop equipment’ is decreased (credited) by $400; liability account ‘GST collected’ is increased (credited) by $40

After journalising the debit and credit entries of a transaction, journalise the next transaction for the day and continue the process until all the transactions have been recorded. By strictly following these journalising procedures, you will minimise the chance of error.

Illustration of journal entries Recall from Chapter 4 that Emily Della started Cafe´ Revive, a retail coffee shop, by investing $22 000 on 1 December 20X1. During the remainder of December, the shop engaged in several transactions to get ready to open for customers. Also recall that Cafe´ Revive is a retail coffee shop that uses a perpetual inventory system4 and leases shop space in the University Hub. We have prepared Case Exhibit 5.2 to help you remember the December transactions of Cafe´ Revive. This exhibit summarises the six transactions and analyses the debit and credit entries for each transaction. To illustrate the general journal and the journalising process, Case Exhibit 5.3 shows the journal entries for these six transactions. In studying Case Exhibit 5.3, you should do the following: 1 Review each transaction listed in Case Exhibit 5.2. 2 Think of the source documents for the transaction. 3 Understand the impact of the transactions on the accounting equation. 4 Determine the debit and credit entries. 5 Think of the journalising procedures. 6 Compare these procedures with the journal entries that we made in Case Exhibit 5.2.

4

Alternatively, a business could use a periodic inventory system, as we will discuss in Chapter 6. Under this system, the

business does not keep a continuous record of the inventory on hand and sold. Instead it determines its inventory by taking a physical inventory at the end of the period. The business derives its cost of goods sold by adding its purchases to the beginning inventory and then subtracting the ending inventory. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

185

Accounting Information for Business Decisions Case Exhibit 5.3 Cafe´ Revive’s general journal entries – December 20X1 Date

Account titles and explanations

Acct no.

Debit

Credit

20X1 1 Dec.

Cash E Della, capital

101

22 000

301

22 000

Made initial investment in Cafe´ Revive 1

Prepaid rent

107

7 200

GST paid

109

720

Cash

101

7 920

Paid 6 months’ rent in advance to University Hub 7

Supplies

106

2 050

GST paid

109

205

Cash

101

2 255

Purchased coffee supplies from City Supply Company 12

Inventory

105

1 300

GST paid

109

130

Accounts payable

201

1 430

Purchased inventory on credit from DeFlava Coffee Corporation 20

Shop equipment

123

1 500

GST paid

109

150

Cash

101

250

Loan payable

204

1 400

Purchased shop equipment from Restaurant Equipment, making cash down payment and taking a loan 22

Accounts receivable

103

GST collected

203

440 40

Shop equipment

123

400

Sold unneeded shop equipment (desk) on credit to Beau Flowers Store

Ethics and Sustainability

To understand the journalising process, look at the 12 December 20X1 transaction, in which Cafe´ Revive purchased $1430 (including GST) of inventory on credit from DeFlava Coffee Corporation. The source document for the transaction is the invoice that Cafe´ Revive received from DeFlava Coffee. The effect of this purchase on the accounting equation is that asset ‘Inventory’ is increased by $1300, asset ‘GST paid’ is increased by $130, and liability (‘Accounts payable’) is increased by $1430. To record the transaction in the general journal, Cafe´ Revive skipped a line after the previous transaction. It then entered the date, and the account title (‘Inventory’) and amount ($1300) of the account to be debited, and moved to the next line, entering the account title (‘GST paid;) and the amount ($130). It indented the next line and entered the account title (‘Accounts payable’) and amount ($1430) to be credited. On the next line, it wrote a brief explanation of the journal entry. After following this process for each transaction, Cafe´ Revive stored all the source documents in its files.

Discussion From a business sustainability perspective, why is it important to ensure that the amount of inventory on hand is always recorded correctly?

186

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Chapter 5 Recording, storing and reporting accounting information

Discussion Currently, Cafe´ Revive sells its merchandise pre-packed. If the business is concerned about environmental matters, what changes might it consider?

After a business records the journal entries, it transfers (or posts) the amounts to the related accounts in the ledger. It records the number (which we discuss later) of each of these accounts in the ‘Acct no.’ column of the general journal. To save space, we do not show this posting process for Case Exhibit 5.3, but continue our example of journalising in Case Exhibits 5.4 and 5.5. Case Exhibit 5.4 summarises and analyses the transactions of Cafe´ Revive for January 20X2, including revenue and expense transactions, along with other transactions.5 Case Exhibit 5.4 Cafe´ Revive’s January 20X2 transactions and analysis Date

5

Transaction

Analysis

02/1

Cafe´ Revive sells inventory (coffee gift packs) at total cash selling price of $1650 (including GST).

Asset account ‘Cash’ is increased (debited) by $1650; liability account ‘GST collected’ is increased (credited) by $150; revenue account ‘Sales revenue’ is increased (credited) by $1500

02/1

Cafe´ Revive records cost of goods sold of $780 on cash sale.

Expense account ‘Cost of goods sold’ is increased (debited) by $780; asset account ‘Inventory’ is decreased (credited) by $780

03/1

Cafe´ Revive pays $1430 to DeFlava Coffee Corporation for inventory purchased on 12/12/X1.

Liability account ‘Accounts payable’ is decreased (debited) by $1430; asset account ‘Cash’ is decreased (credited) by $1430

04/1

Cafe´ Revive purchases $5434 (including GST) of inventory (coffee gift packs) on credit from DeFlava Coffee Corporation.

Asset account ‘Inventory’ is increased (debited) by $4940; asset account ‘GST paid’ is increased (debited) by $494; liability account ‘Accounts payable’ is increased (credited) by $5434

06/1

Cafe´ Revive makes credit sale of $550 (including GST).

Asset account ‘Accounts receivable’ is increased (debited) by $550; liability account ‘GST collected’ is increased (credited) by $50; revenue account ‘Sales revenue’ is increased (credited) by $500

06/1

Cafe´ Revive records cost of goods sold of $260 on credit sale.

Expense account ‘Cost of goods sold’ is increased (debited) by $260; asset account ‘Inventory’ is decreased (credited) by $260

07/1

Cafe´ Revive collects $440 of accounts receivable from Beau Flowers Store.

Asset account ‘Cash’ is increased (debited) by $440; asset account ‘Accounts receivable’ is decreased (credited) by $440

20/1

E Della withdraws $250 for personal use.

Owner’s equity account ‘E Della, withdrawals’ is increased (debited) by $250; asset account ‘Cash’ is decreased (credited) by $250

25/1

Cafe´ Revive pays $363 (including GST) to a consultant for promotion coordination.

Expense account ‘Consulting expense’ is increased (debited) by $330; ‘GST paid’ is increased (debited) by $33; asset account ‘Cash’ is decreased (credited) by $363

For simplicity, on 31 January we recorded the sum of Cafe´ Revive’s cash sales. Normally, a business records its cash sales

each day. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

187

Accounting Information for Business Decisions

Date

Transaction

Analysis

25/1

Cafe´ Revive pays $121 (including GST) for advertising in promotional flyer.

Expense account ‘Advertising expense’ is increased (debited) by $110; ‘GST paid’ is increased (debited) by $11; asset account ‘Cash’ is decreased (credited) by $121

29/1

Cafe´ Revive purchases more supplies of coffee $275 (including GST).

Asset account ‘Supplies’ is increased (debited) by $250; ‘GST paid’ is increased (debited) by $25; asset account ‘Cash’ is decreased (credited) by $275

31/1

Cafe´ Revive records salaries totalling $2360. This amount includes $310 in PAYG tax payable to employees.

Expense account ‘Salaries expense’ is increased (debited) by $2360; ‘PAYG tax payable’ liability account is increased (credited) by $310; asset account ‘Cash’ is decreased (credited) by $2050

31/1

Cafe´ Revive pays mobile and wifi bill of $143 (including GST).

Expense account ‘Mobile and Wifi’ is increased (debited) by $130; ‘GST paid’ is increased (debited) by $13; asset account ‘Cash’ is decreased (credited) by $143

31/1

Cafe´ Revive pays an energy bill of $209 (including GST).

Expense account ‘Energy expense’ is increased (debited) by $190; ‘GST paid’ is increased (debited) by $19; asset account ‘Cash’ is decreased (credited) by $209

31/1

Cafe´ Revive records $11 000 (including GST) of cash sales for 3/1/X2 to 31/1/X2.

Asset account ‘Cash’ is increased (debited) by $11 000; liability account ‘GST collected’ is increased (credited) by $1000; revenue account ‘Sales revenue’ is increased (credited) by $10 000

31/1

Cafe´ Revive records cost of goods sold of $5200 on cash sales.

Expense account ‘Cost of goods sold’ is increased (debited) by $5200; asset account ‘Inventory’ is decreased (credited) by $5200

31/1

Cafe´ Revive records sales of cups of coffee $5368 (including GST).

Asset account ‘Cash’ is increased (debited) by $5368; liability account ‘GST collected’ is increased (credited) by $488; revenue account ‘Sales of coffee’ is increased (credited) by $4880

31/1

Cafe´ Revive purchases inventory of 50 coffee gift packs on credit for $1485 (including GST).

Asset account ‘Inventory’ is increased (debited) by $1350; asset account ‘GST paid’ is increased (debited) by $135; liability account ‘Accounts payable’ is increased (credited) by $1485

Case Exhibit 5.5 illustrates the journal entries that Cafe´ Revive made to record the January transactions. In studying this exhibit, you should review Case Exhibit 5.4 and think through the steps of the journalising process. Once again, note that Cafe´ Revive did not enter the account numbers at the time it recorded the journal entries; it entered them during the posting process, which we will discuss next. Case Exhibit 5.5 Cafe´ Revive’s general journal entries for January 20X2 Date

Account titles and explanations

Acct no.

Debit

101

1 650

Credit

20X2 2 Jan.

Cash GST collected

203

150

Sales revenue

401

1 500

Made cash sales

188

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Chapter 5 Recording, storing and reporting accounting information

Date 2

Account titles and explanations Cost of goods sold Inventory

Acct no.

Debit

501

780

105

Credit

780

To record cost of goods sold on cash sales 3

Accounts payable Cash

201

1 430

101

1 430

Paid DeFlava Coffee Corporation for inventory purchased on 20/12/X1 4

Inventory

105

4 940

GST paid

109

494

Accounts payable

201

5 434

Purchased inventory on credit from DeFlava Coffee Corporation 6

Accounts receivable

103

550

GST collected

203

50

Sales revenue

401

500

Made credit sale 6

Cost of goods sold Inventory

501

260

105

260

To record cost of goods sold on credit sale 7

Cash

101

Accounts receivable

440

103

440

Collected amount owed from Beau Flowers for shop equipment sold on 22/12/X1 20

E Della, withdrawals Cash

304

250

101

250

Withdrew cash for personal use 25

Consulting expense

502

330

GST paid

109

33

Cash

101

363

Paid consultant for promotion coordination 25

Advertising expense

503

110

GST paid

109

11

Cash

101

121

Paid for advertising in promotional flyer 29

Supplies

106

250

GST paid

109

25

Cash

101

275

Purchased shop equipment 31

Salaries expense

504

2 360

PAYG tax payable

209

310

Cash

101

2 050

Paid employees’ salaries 31

Mobile and wifi expense

505

130

GST paid

109

13

Cash

101

143

Paid Mobile and wifi bill

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189

Accounting Information for Business Decisions

Date 31

Account titles and explanations

Acct no.

Debit

Energy expense

506

190

GST paid

109

19

Cash

101

Credit

209

Paid energy bill 31

Cash

101 11 000

GST collected

203

1 000

Sales revenue

401

10 000

To record cash sales for 3/1/X2 to 31/1/X2 31

Cost of goods sold Inventory

501

5 200

105

5 200

To record cost of goods sold on cash sales 31

Cash

101

5 368

GST collected

203

488

Sales of cups of coffee

402

4 880

To record sales of coffee cups Inventory

105

1 350

GST paid

109

135

Accounts Payable

201

1 485

Purchased inventory on credit from DeFlava Coffee Corporation

5.4 Posting from journals to the accounts posting Process of transferring the debit and credit information for each journal entry to the accounts in a business’s general ledger

In the journalising process, a business records each transaction in its general journal. However, at this point it has not yet recorded the accounting information from each transaction in the accounts, the ‘storage units’ for the business’s accounting information. To do so, the business must post (transfer) the amounts from the general journal to the related accounts. Posting is the process of transferring the debit and credit information for each journal entry to the accounts in a business’s general ledger. The ledger is a list of all accounts being used by the business. The ledger is useful because it summarises the information for each account in the one place and provides a quick way to determine the balance of any particular account at any time, as opposed to sorting through a large number of journal entries. In other words, the focus of the ledger is the account rather than the transaction. Because of this focus, the ledger summarises the basic transaction data in accounts to provide more useful information to the managers of the business. When posting occurs, the accounting cycle becomes: Transaction fi Source document fi Journal fi Ledger Note that an account is simply the mechanism used to record changes in individual items. Accounts are most commonly drawn up in T-account form or running balance (three-column) account form.

190

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Chapter 5 Recording, storing and reporting accounting information When the T-account form is used, accounts are drawn up in a ledger ruled as follows. Ledger of a business Cash at bank A/c

DR Date

Particulars

Folio

Amount

CR

Date

Particulars

Folio

Amount

1 Jan

Balance

5 000 31 Jan

Payments

5 500

31

Receipts

4 500

Balance c/d

4 000

9 500 Feb

Balance b/d

9 500

4 000

When the three-column account form is used, accounts are drawn up in a ledger ruled as below. Note that in most electronic accounting systems such as MYOB and Xero the format for accounts is always the three column format. Ledger of a business Cash at bank A/c Date

Particulars

1 Jan

Balance

31

Receipts

31

Payments

Debit

Credit

Balance Dr 5 000

4 500

9 500 5 500

4 000

Stop & think In your everyday life, which method of drawing up accounts (e.g. your bank account) have you encountered?

Stop & think Which method do you think is most practical, and why?

Account numbers and chart of accounts To help in the accounting process, a business assigns a number to each of its accounts and lists that number to the right of the account title on a T-account. The business obtains the account number from its chart of accounts. A chart of accounts is a numbering system designed to organise a business’s accounts efficiently, and to reduce errors in the recording and accumulating process. A business usually sets up its chart of accounts so that the cash account is assigned the lowest number, followed (in order) by all the other asset accounts, all the liability accounts, the permanent owner’s equity (capital) account, the withdrawals account, the income summary account (discussed later), the revenue accounts and the expense accounts. The business then includes the accounts in its general ledger in the order in which they are listed in the chart of accounts. As you will see shortly, ordering the accounts in the general ledger in this way helps in preparing the financial statements. Case Exhibit 5.6 lists Cafe´ Revive’s chart of accounts. Notice that the asset account numbers begin at 101, the liabilities at 201, the owner’s equity at 301, the revenues at 401 and the expenses at 501. A business uses a numbering system such as this to help to identify and classify its accounts. (Some large corporations use numbers of as many as six digits for classifying their accounts, and even use decimals to further sub-classify their accounts.) Note also that the accounts are not numbered consecutively. Cafe´ Revive follows this procedure so it can insert any new accounts into its chart of accounts (and general ledger) later and still assign account numbers in their proper order.

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5

What is the difference between journalising and posting?

chart of accounts Numbering system designed to organise a business’s accounts efficiently and to reduce errors in the recording and accumulating process

191

Accounting Information for Business Decisions Case Exhibit 5.6 Cafe´ Revive’s chart of accounts Account title

Account number

Cash

101

Accounts receivable

103

Inventory

105

Supplies

106

Prepaid rent

107

GST paid

109

Shop equipment

123

Accumulated depreciation

124

Accounts payable

201

GST collected

203

Loan payable

204

Interest payable

205

PAYG tax payable

209

E Della, capital

301

E Della, withdrawals

304

Income summary

306

Sales revenue – coffee gift packs

401

Sales revenue – cups of coffee

402

Interest revenue

405

Cost of goods sold

501

Consulting expense

502

Advertising expense

503

Salaries expense

504

Mobile and wifi expense

505

Energy expense

506

Supplies expense

507

Rent expense

508

Interest expense

509

Depreciation expense

510

Bank charges

515

Key procedures in posting A business with a manual accounting system usually posts at the end of each day. In an automated system, accounts are updated automatically. As with the journalising process, the business follows a set of procedures for posting to the individual accounts. The following list outlines these procedures: 1 In the general ledger, locate the first account of the first transaction to be posted from the general journal. 2 Enter the day, month and year of the transaction and the debit amount (as listed in the general journal) in the debit (left) side of the account. 3 Go back to the general journal and, on the same line as the account title, enter in the ‘Acct no.’ column the number of the account in which the debit amount was posted. A number in this column indicates that the posting process has been completed for that line of the general journal. It also indicates to which account that amount was posted. This is the last step before continuing with the posting of the next line. (Caution: Remember that the business completes this procedure after it posts the amount in the account.) 192

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Chapter 5 Recording, storing and reporting accounting information 4 For the next line of the transaction in the general journal (usually the credit entry, unless a compound entry is involved), repeat steps 2 and 3, except that the date and amount are posted to the credit (right) side of the appropriate account. After posting the debit and credit entries for the first transaction to the related accounts, post the next journal entry for the day and continue the process until the daily postings are completed. By strictly following these posting procedures, you will minimise the chance of error.

Stop & think Why is it important that accounts have both a number and a title?

Illustration of posting process Case Exhibit 5.7 illustrates the posting process for the 2 January 20X2 sales transactions of Cafe´ Revive. The

arrows from the general journal to the general ledger indicate the debit and credit postings. Note that Cafe´ Revive transferred the date of the transaction from the general journal to each ledger account. It posted the amount ($1650) in the debit column of the ‘Cash’ account, an amount ($150) in the credit column of ‘GST collected’, and the amount ($1500) in the credit column of the ‘Sales revenue’ account in the general ledger. It then listed the account numbers (101, 203 and 401) on the respective lines in the ‘Acct no.’ column of the general journal, as we indicate by the arrows from the general ledger to the general journal. Note, in Case Exhibit 5.7, that the cash account has a beginning (1/1/X2) balance of $11 575. This was the ending balance from December 20X1, after Cafe´ Revive posted the December transactions listed in Case Exhibit 5.3. Note also that the sales revenue account did not have a beginning balance. Later in this chapter, we will discuss the calculation of account balances and why some accounts have beginning balances and some accounts do not have beginning balances. Case Exhibit 5.7 Illustration of posting General journal Date 20X2 2 Jan.

Account titles and explanations

Acct No 101 203 401

Cash GST collected Sales revenue Made cash sales.

Debit

Credit

1 320 120 1 200

General ledger 1/01/X2 Bal 2/01/X2

Cash 8 825 1 320 GST collected 2/01/X2

No. 101

Sales revenue 2/01/X2

No. 401 1 200

No. 203 120

Cafe´ Revive completes the posting process at the end of each day in January. Case Exhibit 5.8 shows all of the general ledger accounts of Cafe´ Revive at the end of January (before it makes its adjusting and closing entries). They are listed according to the chart of accounts shown in Case Exhibit 5.6. You should study the postings to the accounts, referring to the journal entries listed in Case Exhibit 5.5. Again, note that in Case Exhibit 5.5, the ‘Acct no.’ column had not been completed when the journal entry was made, but was completed during the posting process. You should think of the account numbers that would be listed in this column based on the chart of accounts in Case Exhibit 5.6. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

193

Accounting Information for Business Decisions

Ledgers – general and subsidiary

accounts payable subsidiary ledger The subsidiary ledger containing each of the individual accounts for suppliers (creditors)

accounts receivable subsidiary ledger The subsidiary ledger containing each of the individual accounts for customers (debtors)

In the discussion so far, we have assumed the existence of a single ledger that contains all the accounts of the business. This ledger is known as the general ledger. It is the most important ledger, in that balances of accounts contained in this ledger will be used to draw up the trial balance, and subsequently the financial reports. Most businesses will also maintain subsidiary ledgers or files for accounts receivable and accounts payable. The reason for this is that the general ledger contains one account for accounts receivable (control account) and one account for accounts payable (control account). But the business will usually have multiple people who owe money to the business, and multiple suppliers to whom the business owes money. While the balance in the accounts payable control account tells us how much the business owes in total to suppliers or creditors for accounts payable, it does not tell us how much we owe each individual supplier. This would make paying the right amount to the right person very difficult unless an accounts payable subsidiary ledger or file was kept. The balance in the accounts payable control account must always equal the total of all the accounts in the accounts payable subsidiary ledger or file. Similarly, the balance in the accounts receivable account tells us how much is owed in total by debtors (accounts receivable), but it does not tell us which debtors owe which amounts. Establishing an accounts receivable subsidiary ledger allows details of what is owed by individual debtors to be maintained in accounts for each debtor. In principle, the accounts receivable account in the general ledger becomes a control account, which records in total details of what is owed to the business. This is supported by an accounts receivable subsidiary ledger, which records specific details for each customer of what they owe to the business. At any time, the balance of the accounts receivable control account in the general ledger will equal the sum of the balances of all the individual debtors accounts in the accounts receivable subsidiary ledger or file. The same principle applies to accounts payable. Subsidiary ledgers are kept outside of the general ledger. Unnecessary detail, such as the names of all debtors or creditors, is then omitted from the general ledger, making preparation of the trial balance much quicker. See the following example. General ledger extract

Accounts receivable subsidiary ledger

Cash at bank A/c 31/1 Accs rec.

M More

380

1/1 Balance

300 20/1 Cash at bank

15/1 Sales rev.

500

140

Accounts receivable control A/c 1/1 Balance 31/1 Sales rev. Balance

540 31/1 Cash at bank

380

920 1 080

O Over 1/1 Balance

240 20/1 Cash at bank

15/1 Sales rev.

420

240

Sales revenue 31/1 Accs rec.

920

As you can see, entries made in total in the general ledger accounts receivable control account are made in detail in each account in the subsidiary ledger accounts for individual debtors; for example, sales total $920 DR in the control account was split up as $500 worth of sales to M More and $420 worth of sales to O Over. It is also important to understand that it is only in the general ledger that the rule for double entry accounting has to be applied. The subsidiary ledger is kept separate from the general ledger. Individual debtors’ accounts refine in detail what is included in total in the accounts receivable control account. At the end of the period, the total of the balances of the individual debtors’ accounts for M More and O Over should equal the balance of the accounts receivable account in the general ledger. As such, using subsidiary ledgers provides a means of control, or an ability to check for errors in individual accounts when a discrepancy occurs; for example: Schedule of accounts receivable balances – as at 31 January M More

660

O Over

420

Total

194

1 080

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 5 Recording, storing and reporting accounting information The total of $1080 reconciles with the balance of the accounts receivable control account in the general ledger.

Stop & think If subsidiary ledgers for accounts receivable are not kept, how would the business determine who owes them what amount?

Stop & think In the case of Cafe´ Revive, do you know how much each individual debtor owes the business?

Case Exhibit 5.8 Cafe´ Revive’s general ledger – January 20X2

Cash 01/1/X2

Bal

No. 101

GST paid

11 575 03/1/X2

1 430

01/1/X2

1 650 20/1/X2

250

04/1/X2

494

06/1/X2

440 25/1/X2

121

25/1/X2

33

31/1/X2

11 000 25/1/X2

363

25/1/X2

11

31/1/X2

5 368 29/1/X2

275

29/1/X2

25

31/1/X2

2 050

31/1/X2

13

31/1/X2

143

31/1/X2

19

31/1/X2

209

31/1/X2

02/1/X2

31/1/X2

Bal

25 192 Accounts receivable

01/1/X2

Bal

440 07/1/X2

31/1/X2

Bal

550

01/1/X2

Bal

06/1/X2

440

04/1/X2 31/1/X2

1 205

135 Bal

1 935

01/1/X2

Bal

1 100

31/1/X2

Bal

No. 103

550 Inventory

Bal

Shop equipment 1 100 Accumulated depreciation

No. 124

780

4 940 06/1/X2

260

1 350 31/1/X2

5 200

03/1/X2

Accounts payable

No. 201

1 430 01/1/X2

5 434 1 485

1 350

01/1/X2

Bal

2 050

GST collected

250

01/1/X2

Bal

2 300

02/1/X2

Prepaid rent 01/1/X2

Bal

7 200

No. 107

1 430

31/1/X2

Bal

No. 106

Bal

04/1/X2

31/1/X2

25/1/X2

No. 123

No. 105

1 360 02/1/X2

Supplies

No. 109

31/1/X2

Bal

6 919 No. 203

Bal

40 150

06/1/X2

50

31/1/X2

1 000

31/1/X2

488 Bal

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

1 728

195

Accounting Information for Business Decisions

Loan payable 01/1/X2

No. 204 Bal

1 400

Interest payable

No. 205

PAYG tax payable

No. 209

Consulting expense 25/1/X2

Advertising expense 25/1/X2

31/1/X2

310

E Della, capital

No. 301

01/1/X2

Bal

E Della, Withdrawals 20/1/X2

31/1/X2

250

130 Energy expense

31/1/X2

No. 505 No. 506

190

Income summary

No. 306

Supplies expense

No. 507

Sales revenue – coffee gift packs

No. 401

Rent expense

No. 508

Interest expense

No. 509

Depreciation expense

No. 510

02/1/X2

1 500

06/1/X2

500

31/1/X2

10 000

31/1/X2

Bal

12 000

Sales revenue – cups of coffee

No. 402

31/1/X2

4 880 Bal

Cost of goods sold 02/1/X2

780

06/1/X2

260

31/1/X2 31/1/X2

22 000

No. 504

2 360 Mobile and wifi expense

No. 304

No. 503

110 Salaries expense

31/1/X2

No. 502

330

4 880 No. 501

5 200 Bal

6 240

5.5 Trial balance

trial balance Schedule that lists the titles of all accounts in a business’s general ledger, the debit or credit balance of each account, and the totals of the debit and credit balances

196

In discussing the journalising and posting process, we set up procedures ensuring that the double entry rule is followed. That is, the total amount of the debit entries equals the total amount of the credit entries in both the general journal and the general ledger accounts. By following these procedures, the accounting equation remains in balance and errors are minimised. However, mistakes may still occur. Therefore, it is important to set up a procedure that will help to detect a journalising or posting error. This procedure involves proving the equality of the debit and credit balances in the accounts by preparing a trial balance. A trial balance is a schedule that lists the titles of all the accounts in a business’s general ledger, the debit or credit balance of each account, and the totals of the debit and credit columns, to ensure that the ledger balances. Normally, a business prepares a trial balance at the end of the accounting period, before proceeding with the adjusting entries (which we discuss next). To prepare a trial balance, first calculate the balance of each account and list it (along with the date on which it is calculated) on the appropriate side of the account. Next, list the account titles and debit or credit balances on the trial balance in the order in which the accounts are listed in the general ledger. Finally, total the debit and credit columns to determine their equality. To save space, we do not show the trial balance of Cafe´ Revive here because we will show an adjusted trial balance (which is similar to, but more extensive than, a trial balance) later in Case Exhibit 5.11. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 5 Recording, storing and reporting accounting information

Stop & think If a trial balance is only an internal document, why is it so necessary to complete one?

5.6 Preparing adjusting entries A business prepares financial statements to report the results of its operations (the income statement), its cash receipts and payments for operating, investing and financing activities (the cash flow statement), and its financial position (the balance sheet) at the end of the accounting period. The business prepares these financial statements from the balances in its general ledger accounts. To make sure its financial statements are accurate, the business must be certain that its account balances are up to date. This is important because most businesses use the accrual basis of accounting, where they record revenues in the accounting period when they sell products to, or perform services for, customers and not necessarily when they collect cash. Then they match all the related expenses against these revenues, regardless of whether they have paid cash. In many cases, not all of a business’s revenue and expense account balances are up to date at the end of the accounting period. In these cases, the business must adjust certain amounts so that it can report the correct net income on its income statement and the correct ending financial position on its balance sheet. The business makes these adjustments by preparing adjusting entries. Adjusting entries are journal entries that a business makes at the end of its accounting period to bring the business’s revenue and expense account balances up to date, and to show the correct ending balances in its asset and liability accounts. An adjusting entry usually affects both a permanent (balance sheet) account and a temporary (income statement) account. Adjusting entries may be grouped into three types: 1 apportionment of prepaid items and unearned revenues 2 recording of accrued items 3 recording or apportionment of estimated items. We will discuss the adjusting entries for each type in the following sections.

6

What are adjusting entries, and what are the three types of adjusting entries?

adjusting entries Journal entries that a business makes at the end of its accounting period to bring the business’s revenue and expense account balances up to date and to show the correct ending balances in its asset and liability accounts

Apportionment of prepaid items and unearned revenues This category of adjusting entries includes adjustments of prepaid items and unearned revenues. A prepaid item (sometimes called a prepaid expense) is an economic resource for which a business has paid cash, and which the business expects to use in its operating activities in the near future. When a business purchases goods or services involving a prepaid item, it records the cost as an asset. By the end of the accounting period, the business has used a part of the goods or services to earn revenues. Therefore, it must record the ‘expired’ part of the cost as an expense to be matched against the revenues on its income statement, while retaining the unexpired part of the cost as an asset on its ending balance sheet. Examples of prepaid items include supplies, prepaid rent and prepaid insurance. A business records the apportionment (allocation) of the cost of each prepaid item between an expense and an asset in an adjusting entry in its general journal. The adjusting entry involves a debit (increase) to an appropriately titled expense account (e.g. ‘Rent expense, obtained from the business’s chart of accounts’) and a credit (decrease) to the asset account (e.g. ‘Prepaid rent’). The calculation of the amount of the adjusting entry depends on the type of prepaid item. For instance, in the case of supplies, the business takes a physical count of the supplies on hand (and related costs) at the end of the accounting period. In the case of prepaid rent or insurance, the business apportions the total cost evenly over the number of months of the rent agreement or insurance coverage. For example, recall that Cafe´ Revive purchased $2050 of coffee supplies on 7 December 20X1, and recorded an asset – ‘Supplies’ – for that amount. On 25 January, a further $250 worth of supplies was Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

prepaid item Current asset (economic resource) that a business records when it pays for goods or services before using them

197

Accounting Information for Business Decisions purchased. The amount of supplies that was available for operations during January 20X2 was $2300. At the end of January, by counting the supplies, the business determined that it had $345 of supplies on hand. Based on this information, the business must have used $1955 ($2300 – $345) of supplies during January. To record this expense, on 31 January 20X2, Cafe´ Revive debits (increases) ‘Supplies expense’ for $1955, and credits (decreases) the asset ‘Supplies’ for $1955 in the general journal, as we show in Case Exhibit 5.9. Note in Case Exhibit 5.10 that after Cafe´ Revive posts this adjusting journal entry to its general ledger accounts (as indicated by an ‘Adj’ in the account), the ‘Supplies expense’ account has a debit balance of $1955. Also note that the ‘Supplies’ account has a debit balance of $345. Case Exhibit 5.9 Cafe´ Revive’s adjusting entries – 31 January 20X2

Date

Account titles and explanations

Acct no.

Debit

Credit

Adjusting entries 20X2 31 Jan.

Supplies expense

507

Supplies

106

1 955 1 955

Supplies used during January 31

Rent expense Prepaid rent

508

1 200

107

1 200

Expiration of one month’s rent paid in advance on 01/12/X1 31

Depreciation expense Accumulated depreciation

510

19

124

19

Depreciation on shop equipment for January 31

Interest expense Interest payable

509 205

11 11

Interest accrued on loan payable

unearned revenue Obligation of a business to provide goods or services in the future, resulting from an advance receipt of cash

198

Cafe´ Revive records its rent expense in a similar manner. Recall that Cafe´ Revive paid $7200 for six months’ rent in advance on 1 December 20X1, and recorded this amount as an asset, prepaid rent. The rental agreement stated that rent would not be charged for the last half of December. Therefore, at the end of January 20X2, one month’s rent has expired, and the business has incurred rent expense of $1200 ($7200  6). To record this expense, on 31 January the business debits (increases) ‘Rent expense’ for $1200 and credits (decreases) ‘Prepaid rent’ for $1200, as we show in Case Exhibit 5.9. After posting, the ‘Rent expense’ account has a debit balance of $1200 and the ‘Prepaid rent’ account has a debit balance of $6000, as we show in Case Exhibit 5.10. In some cases, customers may make an advance payment to a business for goods or services that the business will provide in the future. At the time of the advance receipt, even though the business’s asset ‘Cash’ has increased, the business has not earned revenue because it has not yet provided the goods or services. Instead, the business has incurred a liability because it has an obligation to provide the future goods or services. An unearned revenue is an obligation of a business to provide goods or services in the future, and results from an advance receipt of cash. A business records an unearned revenue as a liability when it receives the cash. At the end of the accounting period, the business examines all such liabilities and related source documents to determine whether it has provided the goods or services. If it has, the business makes an adjusting entry to reduce the liability and increase its revenues of the period. The adjusting entry involves a debit (decrease) to the liability account and a credit (increase) to a related revenue account. Cafe´ Revive does not have any unearned revenues at the end of January, so we will use a different example. Recall that University Hub collected $7200 from Cafe´ Revive on 1 December 20X1 for six months’ rent in advance. At that time, University Hub debited (increased) an asset – ‘Cash’ – for $7920, credited ‘GST collected’ for $720 and credited (increased) a liability – ‘Unearned rent’ – for $7200. On 31 Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 5 Recording, storing and reporting accounting information Case Exhibit 5.10 Cafe´ Revive’s general ledger after adjusting entries – 31 January 20X2

Cash 01/1/X2

Bal

No. 101

Accounts payable

No. 201

11 575 03/1/X2

1 430

1 650 20/1/X2

250

04/1/X2

5 434

06/1/X2

440 25/1/X2

121

31/1/X2

1 485

31/1/X2

11 000 25/1/X2

363

31/1/X2

5 368 29/1/X2

275

30/1/X2

2 050

01/1/X2

31/1/X2

143

02/1/X2

31/1/X2

143

06/1/X2

50

31/1/X2

1 000

31/1/X2

488

02/1/X2

31/1/X2

Bal

01/1/X2

Bal

31/1/X2

No. 103

440 07/1/X2

440

Bal

04/1/X2 31/1/X2 31/1/X2

Bal Bal

25/1/X2 31/1/X2

01/11/X2 No. 105

1 360 02/1/X2

780

31/11/X2

260

PAYG tax payable

1 350 31/1/X2

5 200

2 050 31/1/X2

Adj

01/11/X2

1 955

345

Bal

7 200 31/1/X2

31/1/X2

Bal

6 000

6 919 40 150

Bal

1 728 No. 204

Bal

1 400 No. 205

Adj

11 No. 209

Bal

310 No. 301

Bal

E Della, withdrawals 20/1/X2

01/1/X2

22 000 No. 304

250 Income summary

No. 306

Sales revenue – coffee gift packs

No. 401

No. 107 Adj

GST paid Bal

Bal

E Della, capital No. 106

250 Bal

31/1/X2

1 350

1 430

No. 203

Interest payable

4 940 06/1/X2

Prepaid rent

01/1/X2

31/1/X2

550

Supplies 01/1/X2

Bal

Loan payable

Inventory 01/1/X2

31/1/X2

Bal

GST collected

550 Bal

1 430 01/1/X2

25 192 Accounts receivable

06/1/X2

03/1/X2

1 200 No. 109

02/11/X2

1 500

06/11/X2

500

1 205

31/11/X2

10 000

04/1/X2

494

31/11/X2

12 000

25/1/X2

33

25/1/X2

11

29/1/X2

25

31/1/X2

13

31/1/X2

19

02/1/X2

31/1/X2

135

06/1/X2

260

31/1/X2

1 935

31/1/X2

5 200

31/1/X2

6 240

Sales revenue – cups of coffee 31/1/X2

Shop equipment 01/1/X2

Bal

1 100

31/1/X2

Bal

1 100

4 880 Bal

Cost of goods sold

No. 123

Accumulated depreciation 31/1/X2

Adj

No. 124 19

No. 501

No. 502

330 Advertising expense

25/1/X2

4 880

780

Consulting expense 25/1/X2

No. 402

No. 503

110

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

199

Accounting Information for Business Decisions

Salaries expense 31/1/X2

No. 504

Mobile and wifi expense 31/1/X2 31/1/X2

Adj

31/1/X2

Adj

No. 508

1 200 Interest expense

No. 506

No. 509

11 Depreciation expense

190

31/1/X2

Supplies expense Adj

31/1/X2 No. 505

130 Energy expense

31/1/X2

Rent expense

2 360

Adj

No. 510

19

No. 507

1 955

January 20X2, since University Hub earned one month of rent by providing shop space to Cafe´ Revive during January, University Hub makes an adjusting entry to reduce the liability and increase its revenue. The journal entry is a debit (decrease) to ‘Unearned rent’ and a credit (increase) to ‘Rent revenue’ for $1200, as shown in the following; note that for simplicity, we do not show the ‘Acct No.’ column in the general journal). Date 31 Jan.

Account titles and explanations Unearned rent

Debit

Credit

1 200

Rent revenue

1 200

To record rent earned from Cafe´ Revive

The remaining $5000 ($6000 – $1000) balance in University Hub’s ‘Unearned rent’ account represents the obligation to provide shop space to Cafe´ Revive for five more months.

Accrued items accrued expense Incurred by a business during the accounting period but not paid or recorded

accrued revenue Earned by a business during the accounting period but neither collected nor recorded

200

The accrued items category of adjusting entries includes adjustments for accrued expenses and accrued revenues. A business records most of its expenses when it pays for them. At the end of an accounting period, however, it has not paid some expenses. An accrued expense is an expense that a business has incurred during the accounting period but that it has not paid or recorded. A common type of accrued expense is unpaid employees’ salaries. Other common accrued expenses include unpaid interest, taxes and utility bills. To match all expenses against revenues, and to report all the liabilities at the end of the period, a business makes an adjusting entry to record each accrued expense. The journal entry involves a debit (increase) to an appropriately titled expense account and a credit (increase) to the related liability account. Recall that on 12 December 20X1, Cafe´ Revive signed a $1400, three-month loan payable. It agreed to pay $33 total interest, so that at the end of three months it will repay $1433 ($1400 þ $33). Since Cafe´ Revive owed the loan during all of January, one month of interest, or $11 ($33  3 months), has accrued and is an expense of doing business during January. To record this expense, on 31 January 20X2 Cafe´ Revive debits (increases) ‘Interest expense’ and credits (increases) the liability account ‘Interest payable’ for $11, as we show in Case Exhibit 5.9. It would record other accrued expenses in a similar way. A business records most revenues at the time it provides goods or services to a customer. At the end of an accounting period, however, it may not have recorded a few revenues. An accrued revenue is a revenue that a business has earned during the accounting period but that it has neither collected nor recorded. To report all the revenues of the period and all the assets at the end of the period, a business makes an adjusting entry for each accrued revenue. The journal entry is a debit (increase) to an asset account and a credit (increase) to a related revenue account. There are not many types of accrued revenues, and Cafe´ Revive has none. However, one common accrued revenue is the interest that has accumulated on a loan given by a business. Recall that the $1400, a Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 5 Recording, storing and reporting accounting information three-month loan was made available by Restaurant Equipment Company. On 31 January 20X2, Restaurant Equipment Company would record accrued interest revenue of $11. The journal entry would be a debit (increase) to the asset account ‘Interest receivable’ and a credit (increase) to the revenue account ‘Interest revenue’ for $11, as follows: Date 31 Jan.

Account titles and explanations Interest receivable

Debit

Credit

11

Interest revenue

11

To record accrued interest revenue on note earned from Cafe´ Revive

A business would record other accrued revenues similarly.

Estimated items A few other adjusting entries involve estimated amounts because they are based partly on expected future events. Adjusting entries involving estimated amounts include the recording of (1) depreciation on buildings and equipment; (2) amortisation of intangible assets; and (3) recognition of uncollectable accounts receivable. The adjusting entry for depreciation is a debit (increase) to the expense account ‘Depreciation expense’ and a credit (increase) to the contra-asset account ‘Accumulated depreciation’. Note that a business uses a contra-account to record an amount that is subtracted from the balance in a related account. Thus, the rule for increasing a contra-account is the opposite of the rule for increasing the related account. ‘Accumulated depreciation’ is a contra-asset account, which is why it is increased by a credit entry. Also, recall that an increase of $19 in the ‘Accumulated depreciation’ account decreases the book value of the related depreciable asset account equipment to $1081 because the amount of accumulated depreciation to date is subtracted from the cost of the depreciable asset. Similarly, the adjusting entry for amortisation is a debit (increase) to the expense account ‘Amortisation expense’, and a credit to the related intangible asset contra-account ‘Accumulated amortisation’. When making credit sales, a business records the value of these sales as an asset accounts receivable and a sales revenue. Sometimes accounts receivable amounts are not paid; that is, they become uncollectable and result in the business losing money as a result of a bad debt. The adjusting entry for uncollectable accounts receivable is a debit (increase) to the expense account ‘Bad debts expense’ and a credit (increase) to the contra-asset account ‘Allowance for bad debts’. The balance of the ‘Allowance for bad debts’ account is subtracted from the balance of the ‘Accounts receivable’ account to determine the net realisable value of the accounts receivable. To understand the adjustment process for an estimated item, recall that at the end of December, Cafe´ Revive had an asset shop equipment recorded at $1100, and then used this in its operations during January.6 Cafe´ Revive estimates that the simplest way to calculate depreciation is to divide the cost by the estimated life of the asset. For now, assume that the depreciation for the shop equipment is $19 a month. On 31 January 20X2, Cafe´ Revive records a debit entry to depreciation expense of $19 and a credit entry to accumulated depreciation, as we show in Case Exhibit 5.9.

Discussion Why do we need to make adjusting entries? What are they? What are the three types of adjusting entries?

6

Cafe´ Revive purchased $200 of shop equipment at the end of January. Since it did not use this shop equipment in January, it did not depreciate the equipment for that month. Cafe´ Revive will include the depreciation on this shop equipment as an expense in later months when it uses the equipment. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

201

Accounting Information for Business Decisions

Posting adjusting entries After a business prepares its adjusting entries, the business posts these entries from its general journal to the accounts in its general ledger. Cafe´ Revive posts the adjusting entries that it recorded in Exhibit 5.9 to its general ledger, as we show in Case Exhibit 5.10. Note that Case Exhibit 5.10 is similar to Case Exhibit 5.8, except that the adjusting entries (as indicated by ‘Adj’) are included. This completes the adjusting entry process for Cafe´ Revive.

5.7 Adjusted trial balance adjusted trial balance Schedule prepared to prove the equality of the debit and credit balances in a business’s general ledger accounts after it has made the adjusting entries

transposition Occurs when two digits in a number are mistakenly reversed

slide Occurs when the digits are listed in the correct order but are mistakenly moved one decimal place to the left or right

After a business journalises and posts its adjusting entries, it balances its accounts, and all the account balances are then up to date for the accounting period. But before preparing the business’s financial statements, it is useful to prepare an adjusted trial balance, which is a schedule prepared to prove the equality of the debit and credit balances in a business’s general ledger accounts after it has made the adjusting entries. An adjusted trial balance is similar to a trial balance, except that it also includes all the revenue and expense accounts. An adjusted trial balance is an accountant’s working paper and is not a financial statement. It is used to (1) help prevent the business from including debit and credit errors in its financial statements; and (2) make preparing the financial statements easier, as you will see. Case Exhibit 5.11 shows the adjusted trial balance of Cafe´ Revive on 31 January 20X2. The account balances listed were taken from the general ledger in Case Exhibit 5.10. Note that the $49 267 total of the debits is equal to the total of the credits. If an adjusted trial balance (or a trial balance) does not balance – that is, the total debits do not equal the total credits – the business has made an error. To find the error, the business should re-add the debit and credit columns of the adjusted trial balance. If the column totals still do not agree, the business should check the amounts in the debit and credit columns to be sure that it did not mistakenly list a debit or credit account balance in the wrong column. If it still does not find the error, the business should calculate the difference in the column totals and divide it by 9. When the difference is evenly divisible by 9, there is a good chance that a transposition or a slide has occurred. A transposition occurs when two digits in a number are mistakenly reversed. For instance, if the $25 192 cash balance in Case Exhibit 5.11 had been listed as $25 912, the debit column would have totalled $49 987 instead of $49 267. The difference between the debit column and the correct credit column total, $720, is evenly divisible by 9. A slide occurs when the digits are listed in the correct order but are mistakenly moved one decimal place to the left or right. For instance, if the $1400 loan payable balance in Case Exhibit 5.11 had been listed as $140, the credit column would have totalled $48 007 instead of $49 267. The $1260 difference between this and the correct debit column total is evenly divisible by 9. A transposition or slide may have occurred when the business transferred the account balances from the accounts to the adjusted trial balance or when it initially calculated the account balances. Thus, the business should compare the account balances listed on the adjusted trial balance with the account balances listed in the general ledger. If it properly transferred the balances, it should re-calculate the ledger account balances; if it finds no error, it should double-check the postings. Finally, if the business still does not find the error, it should review the journal entries for accuracy. As you can imagine, detecting where an error has been made is time-consuming and frustrating. That is why it is very important to follow the set procedures in the journalising and posting process.

Stop & think When the trial balance balances, does that mean that all transactions have been recorded correctly in the books of the business? Give examples.

202

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 5 Recording, storing and reporting accounting information Case Exhibit 5.11 Adjusted trial balance Cafe´ Revive Adjusted trial balance 31 January 20X2 Account titles Cash

Debits

Credits

$25 192

Accounts receivable Inventory

550 1 350

Supplies

345

Prepaid rent

6 000

GST paid

1 935

Shop equipment

1 100

Accumulated depreciation

19

Accounts payable

6 919

GST collected

$ 1 728

Loan payable

1 400

Interest payable

11

PAYG Tax payable

310

E Della, capital E Della, withdrawals

22 000 250

Sales revenue – Coffee gift packs

12 000

Sales revenue – Cups of coffee Cost of goods sold

4 880 6 240

Consulting expense

330

Advertising expense

110

Salaries expense Telephone expense Utilities expense

2 360 130 190

Supplies expense

1 955

Rent expense

1 200

Interest expense

11

Depreciation expense

19

Totals

$49 267

$49 267

5.8 Preparing the financial statements A business prepares its financial statements for the accounting period after it completes the adjusted trial balance. It prepares the income statement first because the amount of net income (or net loss) affects the owner’s capital account on the balance sheet. A sole proprietorship prepares the statement of changes in owner’s equity (a supporting schedule for the balance sheet) next. Then it prepares the balance sheet and, finally, the business completes its cash flow statement.7 7

For simplicity, we do not prepare a cash flow statement in this chapter. Refer to Chapter 9 for an in-depth discussion of the

cash flow statement. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

203

Accounting Information for Business Decisions

Income statement An income statement is the financial statement that summarises the results of a business’s earnings activities – that is, revenues, expenses and net income – for its accounting period. Case Exhibit 5.12 shows Cafe´ Revive’s income statement for January 20X2. Cafe´ Revive prepared its income statement from the accounts listed on the lower part of the adjusted trial balance in Case Exhibit 5.11. Because the revenue and expense accounts are listed at the end of each business’s chart of accounts (and, therefore, its general ledger), these accounts are always listed in the lower portion of each business’s adjusted trial balance. This procedure simplifies preparation of the income statement. Case Exhibit 5.12 Income statement Cafe´ Revive Income statement For month ended 31 January 20X2 Sales revenue – Coffee gift packs

$12 000

Sales revenue – Cups of coffee

$ 4 880

16 880

Cost of goods sold – Coffee gift packs

(6 240)

Gross profit

$10 640

Operating expenses: Consulting expense Advertising expense Salaries expense

$

330 110 2 360

Telephone expense

130

Utilities expense

190

Supplies expense

1 955

Rent expense

1 200

Depreciation expense

19

Total expenses Operating income

(6 294) $ 4 346

Other item: Interest expense Net Income

(11) $ 4 335

Statement of changes in owner’s equity A statement of changes in owner’s equity is a schedule that shows the impact on owner’s equity of any additional investments by the owner in the business, the business’s net income, and owner withdrawals during the accounting period. A business presents this statement as a supporting schedule to the owner’s capital account balance listed on the balance sheet. Case Exhibit 5.13 shows Cafe´ Revive’s statement of owner’s equity for January 20X2. Emily made no additional investments during January. Cafe´ Revive obtained the beginning balance of the ‘E Della, capital’ account and the amount of the withdrawals from the middle portion of the adjusted trial balance in Case Exhibit 5.11. It obtained the net income from the income statement in Case Exhibit 5.12.

Balance sheet A balance sheet is the financial statement that reports the financial position – that is, assets, liabilities and owner’s equity – of a business on a particular date. Case Exhibit 5.14 shows Cafe´ Revive’s balance 204

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Chapter 5 Recording, storing and reporting accounting information Case Exhibit 5.13 Statement of changes in owner’s equity Cafe´ Revive Statement of changes in owner’s equity For month ending 31 January 20X2 E Della, capital, 1 January 20X2 Add: Net income for January

$22 000 4 335 $26 335

Less: Withdrawals for January E Della, capital, 31 January 20X2

(250) $26 085

sheet on 31 January 20X2. The business prepared the balance sheet from the accounts listed on the upper portion of the adjusted trial balance in Case Exhibit 5.11. Use of the adjusted trial balance makes the preparation of the balance sheet very easy. The assets, liabilities and owner’s capital accounts are the first accounts in a business’s chart of accounts and its general ledger. Therefore, these accounts are always listed in the upper portion of a business’s adjusted trial balance. Note, however, that the amount listed as the owner’s capital on the adjusted trial balance is not the amount the business lists on the ending balance sheet because the amount has not been updated for the net income or withdrawals for the period. Instead, the business obtains the ending owner’s capital account balance from the statement of changes in owner’s equity. Cafe´ Revive obtained the owner’s capital account balance in Case Exhibit 5.14 from the statement in Case Exhibit 5.13.

5.9 Preparation of closing entries Earlier, we made two points that are relevant to our discussion of closing entries. The first was that the revenue, expense and withdrawals accounts are temporary accounts. A business uses these accounts to determine the changes in its owner’s equity in the current accounting period resulting from its net income (or net loss) and from owner’s withdrawals. Second, a business does not use the owner’s capital account listed on the adjusted trial balance in preparing its balance sheet because this account balance is not up to date for the net income and withdrawals of the period. To begin the next accounting period, the business needs to (1) update the balance in the owner’s capital account; and (2) show zero balances in the revenue, expense and withdrawals accounts. The owner’s capital account balance should be up to date, so as to show the owner’s current investment in the assets of the business. The business will use the revenue, expense and withdrawals accounts in the next accounting period to accumulate the business’s net income and any of the owner’s withdrawals for that period. Therefore, it is important to start with a zero balance in each of these accounts at the beginning of the period, so that, at the end of the period, the balances in the accounts will show the revenue, expense and withdrawal amounts for only that period. Closing entries are journal entries that a business makes at the end of its accounting period to create a zero balance in each revenue, expense and withdrawal account and to transfer these account balances to the owner’s permanent capital account. It makes closing entries after preparing the financial statements. Like other journal entries, a business records closing entries in the general journal and then posts them to the respective accounts. It does not close the revenue and expense accounts directly to the owner’s capital account. Instead, it first transfers these account balances to an account entitled ‘Income summary’. The income summary account is a temporary account a business uses to facilitate the closing process and to accumulate the amount of the business’s net income (or net loss) before it transfers this amount to the owner’s capital account.

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7

What are closing entries, and how do they relate to the income summary account? closing entries Entries made by a business at the end of an accounting period to create a zero balance in each revenue, expense and withdrawals T-account, and to update the owner’s equity by transferring the balances in the revenue, expense, and withdrawals T-accounts to the T-account for owner’s capital

income summary Temporary account used in the closing process to accumulate the amount of net income (or net loss) before transferring it to the T-account for owner’s capital

205

Accounting Information for Business Decisions Case Exhibit 5.14 Balance sheet Cafe´ Revive Balance sheet 31 January 20X2 Assets Current assets: Cash

$25 192

Accounts receivable

550

Inventory

1 350

Supplies

345

Prepaid rent

6 000

GST paid

1 935

Total current assets

$35 372

Property and equipment: Shop equipment

$1 100

Less: Accumulated depreciation

(19)

Total assets

1 081 $36 453

Liabilities Current liabilities: Accounts payable

$ 6 919

Loan payable

1 400

Interest payable

11

GST collected

1 728

PAYG tax payable

310

Total current liabilities

$10 368 Owner’s equity

E Della, capital Total liabilities and owner’s equity

$26 085 $36 453

Closing the revenue accounts Recall that each revenue account has a credit balance (prior to closing). To reduce this credit balance to zero, the business makes a debit entry in the revenue account for an amount equal to that of the credit balance. At the same time, it transfers the revenue amount to the income summary account by a credit entry to that account. It first records these debit and credit entries in the general journal, and then posts them to the related accounts in the general ledger. We show Cafe´ Revive’s closing entries in Case Exhibit 5.15. The $16 880 journal entry of Cafe´ Revive to close its revenue accounts is the first closing entry in Case Exhibit 5.15. Cafe´ Revive obtained the amount of the sales revenue from the adjusted trial balance in Case Exhibit 5.11. It obtained the account number of the income summary account from the chart of accounts shown in Case Exhibit 5.6. In this example, Cafe´ Revive has two sales revenue accounts. When a business has more than one revenue account, it makes a compound entry in which it first debits each revenue account for the amount of the balance in the account, then credits the total of the revenues to the income summary account.

206

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Chapter 5 Recording, storing and reporting accounting information

Closing the expense accounts Each expense account has a debit balance (prior to closing). To reduce each debit balance to zero, the business makes a credit entry in each expense account for an amount equal to that of the debit balance. It transfers this expense amount to the income summary account by a debit entry to that account. A business typically has many expense accounts, so it usually closes all the expense accounts by making a compound entry in the general journal in which it credits each expense account for the amount of the balance in the account and debits the income summary account for the total amount of the expenses. (Remember, however, that it always lists the debit entry first in the general journal.) The $12 545 journal entry of Cafe´ Revive to close its expense accounts is the second closing entry at the end of Case Exhibit 5.15. Cafe´ Revive obtained the amounts of the various expenses from the adjusted trial balance shown in Case Exhibit 5.11. (Remember that ‘Cost of goods sold’ is an expense account.) Case Exhibit 5.15 Cafe´ Revive’s closing entries – 31 January 20X2

Date

Account titles and explanations

Acct No.

Debit $

Credit $

Closing entries 20X2 31 Jan.

Sales revenue – Coffee gift packs

401

12 000

Sales revenue – Cups of coffee

402

4 880

Income summary

306

16 880

To close revenue account 31

Income summary

306

12 545

Cost of goods sold

501

6 240

Consulting expense

502

330

Advertising expense

503

110

Salaries expense

504

2 360

Telephone expense

505

130

Utilities expense

506

190

Supplies expense

507

1 955

Rent expense

508

1 200

Interest expense

509

11

Depreciation expense

510

19

To close expense accounts 31

Income summary E Della, capital

306

4 335

301

4 335

To close net income to owner’s capital account 31

E Della, capital E Della, withdrawals

301 304

250 250

To close withdrawals to owner’s capital account

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207

Accounting Information for Business Decisions

Closing the income summary account After a business closes the revenue and expense accounts to the income summary account, the balance in the account is the amount of the net income (or net loss). A credit balance indicates that the business earned a net income for the period because revenues exceeded expenses. A debit balance indicates a net loss because expenses exceeded revenues. A business transfers the amount of its net income (or net loss) to the owner’s permanent capital account in the third closing entry. In the case of net income, the closing entry in the general journal is a debit to the income summary account for an amount equal to its balance and a credit to the owner’s capital account for the same amount. The credit to the owner’s capital account increases that account by the amount of the net income. (The business would handle a net loss in the opposite way, with a debit to the owner’s capital account and a credit to the income summary account.) The $4 335 journal entry of Cafe´ Revive to close the income summary account to the ‘E Della, capital’ account is the third closing entry at the end of Case Exhibit 5.15.

Closing the withdrawals account A business closes the debit balance of the withdrawals account directly to the owner’s permanent capital account, since withdrawals are disinvestments by the owner. The closing entry in the general journal is a debit to the owner’s permanent capital account and a credit to the withdrawals account for the amount of the total withdrawals of the period. The debit entry brings the owner’s capital account balance up-to-date at the end of the period. The credit entry to the withdrawals account reduces the account balance to zero so that it can accumulate the withdrawals of the next period. A business never closes the withdrawals account to the income summary account because withdrawals are not part of net income. The $250 journal entry to close the ‘E Della, withdrawals’ account balance to the ‘E Della, capital’ account is the last closing entry at the end of Case Exhibit 5.15. Cafe´ Revive obtained the amount of the withdrawals from the adjusted trial balance in Case Exhibit 5.11.

Posting the closing entries After a business records its closing entries, the business posts these entries from its general journal to the accounts in its general ledger. Cafe´ Revive posts the closing entries that it prepared in Case Exhibit 5.15 to the appropriate accounts in its general ledger, as we show in Case exhibit 5.16. Note that Case Exhibit 5.16 is similar to the right side of Case Exhibit 5.10, except that the closing entries (as indicated by a ‘Cl’) are included. Also note that after the closing entries are posted, all the revenue, expense and withdrawals accounts have zero balances. The ‘E Della, capital’ account has a balance of $26 085, the amount Cafe´ Revive listed as the owner’s equity on its 31 January 20X2 balance sheet in Case Exhibit 5.14. This completes the closing entry process for Cafe´ Revive.

Post-closing trial balance post-closing trial balance Schedule a business prepares after making its closing entries to prove the equality of the debit and credit balances in its asset, liability and owner’s equity accounts

208

After a business journalises and posts its closing entries, the only accounts with non-zero balances should be the permanent accounts – that is, the assets, liabilities and owner’s capital accounts. As a check to make sure that no debit or credit errors were made during the closing entries, a business prepares a post-closing trial balance. A post-closing trial balance is a schedule a business prepares after making the closing entries to prove the equality of the debit and credit balances in its assets, liabilities and owner’s capital accounts. The post-closing trial balance includes only these permanent accounts because all the temporary accounts have zero balances after the closing process. After the business prepares the post-closing trial balance, the accounting cycle for the current period is complete. The business then begins the accounting cycle for its next accounting period. To save space, we do not show the post-closing trial balance of Cafe´ Revive here.

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Chapter 5 Recording, storing and reporting accounting information Case Exhibit 5.16 Cafe´ Revive’s postings of closing entries – 31 January 20X2 E Della, capital 31/1/X2

Cl

22 000

25/1/X2

31/1/X2

Cl

4 335

31/1/X2

31/1/X2

Bal

E Della, withdrawals 20/1/X2 31/1/X2

250 31/1/X2 Bal

Cl

Cl

31/1/X2

Cl

12 545 31/1/X2

Cl Bal

12 000 31/1/X2 31/1/X2

Bal

31/1/X2

Bal

Bal

6 240 31/1/X2

Cl

31/1/X2

330 31/1/X2 Bal

No. 306

31/1/X2

16 880

31/1/X2

0

31/1/X2

No. 401

31/1/X2

No. 504 Cl

Bal

No. 505 Cl

31/1/X2

Adj

31/1/X2

Bal

0

31/1/X2

Adj

No. 501

31/1/X2

Bal

Cl

31/1/X2

Adj

31/1/X2

Bal

190

1 955 31/1/X2

No. 507 Cl

1 955

0 1 200 31/1/X2

No. 508 Cl

1 200

0 Interest expense 11

31/1/X2

No. 509 Cl

11

0 Depreciation expense

330

0

Cl

0

Rent expense

6 240 No. 502

No. 506

Supplies expense

0

130

0 190 31/1/X2

Bal

2 360

0 130 31/1/X2

No. 402

0 Consulting expense

25/1/X2

Bal

4 880

Cost of goods sold Bal

31/1/X2

12 000

4 880 31/12/X2 31/1/X2

31/1/X2

250

2 360 31/1/X2

Energy expense

Sales revenue – coffee 31/12/X2 Cl

30/1/X2

110

0 Salaries expense

26 085 No. 304

4 335 31/1/X2

Cl

Bal

No. 503 Cl

Mobile and wifi expense

Sales revenue – coffee gift packs 31/1/X2

110 31/1/X2

0 Income summary

31/1/X2

Advertising expense

No. 301 Bal

250 01/1/X2

31/1/X2

Adj

19

31/1/X2

Bal

0

31/1/X2

5.10 Modifications for companies For simplicity, earlier we discussed and illustrated the procedures in the accounting cycle of a sole proprietorship (Cafe´ Revive). However, many businesses are companies or corporations, and you should also be familiar with the accounting procedures for these. Fortunately, the procedures we discussed for sole proprietorships need to be modified only slightly for companies. The modifications involve differences in how a business records and reports investments by owners, distributions to owners, and some income statement and balance sheet items. To illustrate, we will modify the Cafe´ Revive example by assuming the business is a company instead of a sole proprietorship.

No. 510 Cl

19

8

How are accounting procedures modified for companies?

Investments by owners One difference between the accounting for companies and that for sole proprietorships involves investments in the business by owners (shareholders). Assume that on 15 December 20X1, Cafe´ Revive was incorporated and issued 1000 ordinary shares of $10 par value to Emily Della for $10 per share. Cafe´ Revive would make the following journal entry to record this transaction:

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209

Accounting Information for Business Decisions Date

Account titles and explanations

Debit

Credit

20X1 15 Dec.

Cash

10 000

Paid-up capital

10 000

Issued 1000 ordinary shares for $10 per share

In addition to a paid-up capital account, a company has a retained earnings account, which lists its total lifetime earnings (net income or net loss) that have not been distributed to shareholders as dividends.

Distributions to owners Ethics and Sustainability

The decision to pay dividends to owners is made by a company’s board of directors. In order to be ethical, company directors are required to make this decision with the best interest of owners in mind. The payment of dividends to shareholders by a corporation is recorded differently from the owner’s withdrawals from a sole proprietorship. Since the retained earnings account includes total earnings not distributed to shareholders as dividends, a business records any dividend payments directly as a reduction in retained earnings by a debit (decrease) to ‘Retained earnings’ and a credit (decrease) to ‘Cash’. For example, assume that on 20 January 20X2, Cafe´ Revive Company Ltd declared and paid a dividend of $0.05 per share. Cafe´ Revive makes the following journal entry to record the dividend of $50 (1000 shares $0.05). Date

Account titles and explanations

Debit

Credit

20X2 20 Jan.

Retained earnings

50

Cash

50

Declared and paid dividends

Cafe´ Revive reports the dividends as a reduction of retained earnings in the statement of retained earnings.

9

What circumstances might cause directors to act unethically when making dividend distribution decisions for owners?

Income statement items Another difference between a company and a sole proprietorship is that a company must pay income taxes on its earnings. These income taxes are considered an expense of doing business. Normally a company pays its income taxes at the end of the financial year. Goods and services tax (GST), though, is dealt with quarterly. Since income taxes are an expense, they should be matched against the income in the period in which the income is earned. Thus, in addition to the adjusting entries described earlier, a company also makes an adjusting entry for accrued income taxes at the end of each period. Because Cafe´ Revive, in this example, is a company, it must pay income taxes based on a return submitted at the end of the financial year. During January 20X2, Cafe´ Revive earned $4335 of income before income taxes. If we assume a 30 per cent tax rate, then it records the $1300.50 ($4335  0.30, rounded) income taxes in the following adjusting entry. Date

Account titles and explanations

Debit

Credit

20X2 31 Jan.

Income tax expense Income taxes payable

1 300.50 1 300.50

To record income taxes for January

Cafe´ Revive reports the income tax expense on its income statement for January, and reports the income taxes payable as a current liability on its 31 January 20X2 balance sheet. 210

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Chapter 5 Recording, storing and reporting accounting information A company’s income statement is similar to that of a sole proprietorship, with two exceptions. First, the income tax expense is deducted from net income before income taxes to determine net income after tax. Second, earnings per share is shown directly below net income. The income statement of Cafe´ Revive for January 20X2 would look exactly like Case Exhibit 5.12, except for the lower portion, which would appear as follows. Income before income taxes

$ 4 335.00

Income tax expense

(1 300.50)

Net income after tax

$ 3 034.50

Earnings per share (1000 shares)

$

3.03

Balance sheet items The balance sheet of a company is similar to that of a sole proprietorship, with two exceptions. In addition to including income taxes payable as a current liability, a company’s balance sheet also has a modified owner’s equity section. The owner’s equity of a company is called shareholders’ equity, and consists of two parts: contributed capital and retained earnings. Contributed capital includes both the paidup capital account balances from the adjusted trial balance. The business obtains the retained earnings amount from the statement of retained earnings. This statement is very similar to the statement of changes in owner’s equity, which we discussed earlier. The balance sheet of Cafe´ Revive on 31 January 20X2 would look like Case Exhibit 5.14, except that the liabilities and the shareholders’ equity sections would appear as follows:

shareholders’ equity The shareholders’ interest in the business, which is the difference between total assets and total liabilities – that is, the amount that the business owes to the owner (shareholders)

Liabilities Current liabilities: Accounts payable

$ 6 919.00

Loan payable

1 400.00

Interest payable

11.00

GST collected

1 728.00

PAYG tax payable

310.00

Income taxes payable Total liabilities

1 300.50 $11 668.50

Shareholders’ equity Contributed capital: Paid-up capital, 1000 shares $10 par Total contributed capital Retained earnings

$10 000.00 $10 000.00 $ 2 984.50

Total shareholders’ equity

$12 984.50

Total liabilities and shareholders’ equity

$24 673.00

Cafe´ Revive would have obtained the income taxes payable, paid-up capital amounts from its adjusted trial balance. It would have obtained the $2984.50 retained earnings amount ($0 beginning retained earnings þ $3034.50 net income – $50 dividends) from its statement of retained earnings. There is also a slight difference in the closing entries of a company compared with those of a sole proprietorship. A company closes the balance of the income summary account to the retained earnings account. Also, since it recorded any dividends during the period directly as a reduction of retained earnings, there is no closing entry at the end of the period for dividends.

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211

Accounting Information for Business Decisions

5.11 Other journal entries Earlier in the chapter, we discussed the journal entries made by Cafe´ Revive. Other businesses may record journal entries for transactions such as sales discounts, purchases discounts, sales returns and allowances, and purchases returns and allowances. The way a business records these transactions depends on the business’s accounting system and on whether it uses a perpetual or a periodic inventory system. Exhibit 5.17 shows a general framework for recording these types of transactions, although we show only a few of them. However, by using your knowledge of the accounting equation, debit and credit rules, contra-accounts, revenues and expenses, and assets, liabilities, and owner’s equity, you can develop the correct journal entries for recording other transactions. These types of entries will be discussed in more detail in Chapter 7 Appendix. Exhibit 5.17 Illustrations of additional journal entries Sales discounts

Purchases discounts

Cash (net)

X

Sales discounts taken

X

Accounts receivable (gross)

Accounts payable (gross) X

Sales returns and allowances Sales returns and allowances

X

Cash (net)

X

Purchases returns and allowances

X

Accounts receivable (or cash)

X

Accounts payable (or cash) Inventory (or purchases returns and allowances*)

Inventory (at cost) Cost of goods sold

X

Inventory (or purchases discounts taken*)

X X

X X

* Accounts used under periodic inventory system

Business issues and values: Accounting information In this chapter and Chapter 4, we explained how businesses need to record and report transactions that occur as part of daily operations using generally accepted accounting principles (GAAP). We also explained the importance of recording transactions correctly and how managers, investors and creditors use financial statements to assess a business’s financial position. Because investors and creditors make business decisions that are based on their assessment of the business’s financial statements, and often a manager’s bonus payments are based on these results, a manager may be tempted to make the business appear more financially flexible than it really is, or to not report on pending matters, such as environmental issues, likely to have an impact on profitability and even sustainability. For example, a business may opt to record credit sales very aggressively, stretching its interpretation of GAAP. By recording credit sales before the revenue is earned, a business may overstate its accounts receivable and net income for the accounting period. Alternatively, a business Ethics and Sustainability

might understate or not mention at all the impact of legislation on ‘green’ businesses in terms of how products are packaged – for example, the abolition of plastic packaging. In a similar fashion, a business may intentionally under-estimate warranty liabilities by using a lower estimate of warranty claims outstanding at year-end. In this case, a business may indicate that a loss contingency is only remotely possible even though it knows that the probability is much higher. When revenues are overstated or costs and expenses understated or not recorded, a business may appear to have more financial flexibility than is actually the case, and wrong decisions will occur.

212

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Chapter 5 Recording, storing and reporting accounting information

By relying on this incorrect information, external users may make wrong business decisions – for example, make a loan to a business that is riskier than they thought, or pay more than they should for shares in a business. If managers intentionally misstate financial statements, they have broken the law, breached professional regulations and failed to conduct themselves ethically. They have committed what is called management fraud, and can be arrested and prosecuted for their actions.

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213

Accounting Information for Business Decisions

STUDY TOOLS Summary 5.1 Understand the rules for recording transactions in a business’s accounting system records. 1

What is a debit entry, and what is a credit entry?

A debit entry is a monetary amount recorded (debited) on the left side of an account. A credit entry is a monetary amount recorded (credited) on the right side of an account. 2

What are the rules for recording increases and decreases in asset and liability accounts?

Asset accounts (accounts on the left side of the accounting equation) are increased by debit entries (amounts recorded on the left side) and decreased by credit entries. Liability accounts (accounts on the right side of the equation) are increased by credit entries (amounts recorded on the right side) and decreased by debit entries. 3

What are the rules for recording increases and decreases in owner’s equity accounts?

Permanent owner’s equity, or capital, accounts (accounts on the right side of the equation) are increased by credit entries and decreased by debit entries. Temporary owner’s equity accounts have the following rules: (a) withdrawal accounts are increased by debit entries and decreased by credit entries; (b) revenue accounts are increased by credit entries and decreased by debit entries; and (c) expense accounts are increased by debit entries and decreased by credit entries.

5.2 Identify and complete the major steps in a business’s accounting cycle. 4

What are the major steps in a business’s accounting cycle?

The major steps in a business’s accounting cycle are: (1) recording (journalising) the transactions in the general journal; (2) posting the journal entries to the accounts in the general ledger; (3) recording (and posting) adjusting entries; (4) preparing the financial statements; and (5) recording (and posting) closing entries.

5.3 Journalise and post to accounts the transactions of a business and prepare a trial balance. 5

What is the difference between journalising and posting?

Journalising is the process of recording a transaction in a business’s general journal. A journal entry is the recorded information for each transaction. Posting is the process of transferring the debit and credit information for each journal entry to the accounts in a business’s general ledger.

5.4 Complete adjusting and closing entries. 6

What are adjusting entries, and what are the three types of adjusting entries?

Adjusting entries are journal entries that a business makes at the end of its accounting period to bring the business’s revenue and expense account balances up to date, and to show the correct ending balances in its asset and liability accounts. Adjusting entries may be grouped into three types: (1) apportionment of prepaid and unearned items; (2) recording of accrued items; and (3) recording or apportionment of estimated items. 7

What are closing entries, and how do they relate to the income summary account?

Closing entries are journal entries that a business makes at the end of its accounting period to create a zero balance in each revenue, expense and withdrawals account, and to transfer these account balances to the owner’s permanent capital account. The income summary account is a temporary account used in the closing process to accumulate the amount of the business’s net income (or net loss) before transferring this amount to the owner’s capital account. 214

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Chapter 5 Recording, storing and reporting accounting information

5.5 Prepare financial reports – income statement and balance sheet. 8

How are accounting procedures modified for companies?

Accounting procedures are modified for companies or corporations as follows: (1) investments by owners (shareholders) are recorded in paid-up capital accounts; (2) distributions (dividends) to shareholders are recorded as a decrease in the retained earnings account; (3) the income statement includes income tax expense and earnings per share; and (4) the balance sheet includes income taxes payable in the current liabilities section, and contributed capital and retained earnings in the shareholders’ equity section. 9

What circumstances might cause directors to act unethically when making dividend distribution decisions for owners?

Directors may find themselves in an ethical dilemma when they also own shares in the company. All directors on boards are required to declare conflicts of interest. When a conflict of interest arises, the director should declare it and most appropriately extract themselves from the decision-making process.

Key terms accounting cycle

closing entries

post-closing trial balance

accounts

credit entry

posting

accounts payable subsidiary ledger

debit entry

prepaid item

accounts receivable subsidiary ledger

double entry rule

shareholders’ equity

accrued expense

general journal

slide

accrued revenue

general ledger

T-account

adjusted trial balance

income summary

transposition

adjusting entries

journal entry

trial balance

balance of an account

journalising

unearned revenue

chart of accounts

narration

Online research activity This activity provides an opportunity to gather information online about real-world issues related to the topics in this chapter. For suggestions on how to navigate various businesses’ websites to find their financial statements and other information, see the related discussion in the Preface. Explore the website of Qantas (http://www.qantas.com.au).

1 How does Qantas ensure its fleet of aircraft is up to date? Does it lease or buy its planes? 2 What measures is Qantas taking to reduce the business’s carbon footprint?

Integrated business and accounting situations Answer the following questions in your own words.

Testing your knowledge 5-1 5-2 5-3 5-4 5-5

Define an account. Which format is better: T-account or three column? What is a debit entry? What is a credit entry? What are the debit and credit rules? How do these rules relate to each of the account types in the accounting equation? Explain the double entry rule. How (if at all) does this rule change in the case of an entry where more than two accounts are involved? What is a general journal? List the advantages of initially recording a business’s transactions in a general journal.

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Accounting Information for Business Decisions

5-6 5-7 5-8 5-9 5-10 5-11 5-12 5-13

What does journalising of transactions refer to? Briefly describe the steps in the process. What is posting? Briefly describe the posting process. Where are entries posted to? What are adjusting entries? Why are they necessary? What is an adjusted trial balance? Why is it used? What are closing entries? Describe how (a) revenue accounts; (b) expense accounts; and (c) the withdrawals account are closed. How does the lower portion of the income statement for a company differ from that of a sole proprietorship? Why it is different? How does a company report its income taxes payable on its financial statements? How is the owner’s equity of a company shown on its balance sheet?

Applying your knowledge Note: For the exercises below, GST is included unless otherwise stated. 5-14 During the month of July, Sands Insurance entered into the following transactions:

5-15

5-16

Date

Transaction

1 July

Nancy Sands deposited $30 000 in the business’s cash at bank account

10

Purchased land and an office building at a cost of $110 000 and $220 000, respectively, paying $80 000 down and signing a loan payable for the remaining $250 000

20

Sold insurance policies worth $33 000 to clients

25

Purchased office supplies costing $880 on credit

Required: a Prepare journal entries to record the preceding transactions. b List the source documents that might normally be used in recording each of these transactions. Albert Mitchell started Worldwide Travel Service on 1 April of the current year, and the business engaged in the following transactions during April: Date

Transaction

1 Apr.

Albert Mitchell opened the business by depositing $30 000 in the new business’s bank account

3

Purchased land and a small office building for $2750 and $30 800, respectively, paying $10 850 down and signing a loan payable for $22 700

15

Sold travel services to clients worth $5500. The clients paid 20 per cent deposit with balance to be paid later

20

Purchased office equipment at a cost of $7700. Half of the cost was paid in cash, and the remainder is due at the end of May

Required: a Prepare journal entries to record the preceding transactions. Include GST entries. b List the source documents normally used in recording each of these transactions. Bothwell Plumbing entered into the following transactions during the month of May. GST applies. Date

Transaction

4 May

Installed plumbing in new house under construction; contractor agreed to pay contract price of $1980 in 30 days

15

Made plumbing repairs for customer and collected $88 for services performed

28

Paid $77 for May telephone bill

31

Paid $9000 to employees for May salaries, including PAYG tax payable of $900

31

Received $110 electricity bill, to be paid in early June

Required: a Prepare journal entries to record the preceding transactions. b List the source documents normally used to record these transactions.

216

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Chapter 5 Recording, storing and reporting accounting information

5-17

5-18

5-19

Aline Taxi Service entered into the following transactions during September. Where applicable, GST applies. Date

Transaction

1 Sept.

Paid $550 rent on garage for the month of September

15

Cash receipts for taxi fares for the first half of the month totalled $1760

23

Paid $990 for September fuel bill from Wildcat Garage

29

PL Aline withdrew $400 for personal use

30

Paid salaries amounting to $1200 to employees, including PAYG tax payable of $160

30

Cash receipts for taxi fares for the second half of the month totalled $1540

Required: a Prepare journal entries to record the preceding transactions. b List the source documents normally used to record these transactions. In August, Healthcheck Sales, a medical supplies wholesaler, entered into the following transactions (the business uses the perpetual inventory system): Date

Transaction

1 Aug.

Purchased $5500 of medical supplies on credit from Nead Company

3

Returned $220 of defective medical supplies purchased on 1 August from Nead Company for credit

5

Sold $2200 of medical supplies on credit to P & H Drugs. The cost of the inventory sold was $1200

8

Granted $330 credit to P & H Drugs for return of medical supplies purchased on 5 August. The cost of the inventory returned was $180

9

Purchased $1100 of medical supplies for cash

10

Paid balance due to Nead Company for purchase of 1 August

15

Received balance due from P & H Drugs for medical supplies purchased on 5 August

30

Sold $880 of merchandise to customers for cash. The cost of the inventory sold was $500

Required: Prepare journal entries to record the preceding transactions. Taylor Art Supplies Company sells various art supplies to local artists. The business uses a perpetual inventory system, and the cost of its inventory of art supplies at the beginning of August was $2500. Its cash balance was $800 at the beginning of August, and it entered into the following transactions during August: Date

Transaction

1 Aug.

Purchased $440 of art supplies for cash

4

Made a $990 sale of art supplies on credit to P Marks, with terms of n/15. The cost of the inventory sold was $550

6

Purchased $770 of art supplies on credit from Tott Company, with terms of n/20

10

Returned, for credit to its account, $110 of defective art supplies purchased on 6 August from Tott Company

12

Made cash sales of $275 to customers. The cost of the inventory sold was $160

13

Refunded a $22 allowance to a customer for damaged inventory sold on 12 August

15

Received payment from P Marks of the amount due for inventory sold on credit on 4 August

25

Paid balance due to Tott Company for purchase on 6 August

Required: a Prepare journal entries to record the preceding transactions. b Set up appropriate T-accounts, post the journal entries to the accounts (for simplicity, it is not necessary to assign numbers to the accounts) and determine the ending account balances.

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217

Accounting Information for Business Decisions

5-20

5-21

5-22

Ralph Antonio operates an architectural design business. The following transactions were recorded for the month of March. Date

Transaction

2 Mar.

Antonio invested a further $10 000 into the business

3

Invoiced clients for work completed $4400

7

Purchased a new 3D equipment for $5500. Paid $500 with the balance payable in 30 days

10

Paid wages $2370 including payroll tax of $370

11

Paid rent on premises for 6 months $2200

15

Invoiced clients for work performed $6600

20

Paid telephone and internet connection bill $330 for the month

22

Antonio withdrew $150 from the business

25

Received $1750 as a deposit for work to be performed for a client in April

26

Received a water bill to be paid in two months $421

31

Paid bank fees incurred on the business bank account $37

Required: a Prepare journal entries for the above transactions. b Post to appropriate accounts in the ledger (use three-column format). c Prepare a trial balance to ensure posting has been completed correctly. At the end of the current year, Rulem Hair Styling provides you with the following information (ignore GST): i Depreciation expense on styling equipment totals $1360 for the current year. ii Accrued interest on a note payable issued on 1 October amounts to $850 at year-end. iii Unearned rent in the amount of $1000 has been earned (the business records all receipts in advance in an unearned rent account). iv Hair styling supplies used during the year total $210 (the business records all purchases of supplies in an asset account). Required: Prepare adjusting entries at the end of the current year based on the above information. On 30 June of the current year, Washington Background Music Company showed the following trial balance: Account titles Cash

Debits

Credits

$10 150

Office supplies

368

Sound system

6 500

Accounts payable

$

295

DL Washington, capital

15 000

Music system revenues

3 198

Salary expense

1 000

Rent expense

300

General expenses

175

Totals

$18 493

$18 493

The following adjustments are needed (ignore GST): i Office supplies used during the month of June totalled $62. ii Depreciation expense on the sound system for the month of June totalled $75. June was the first month of operations for Washington Background Music Company. Required: a Prepare adjusting entries to record the preceding adjustments. b Prepare the 30 June adjusted trial balance for Washington Background Music Company.

218

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Chapter 5 Recording, storing and reporting accounting information

5-23

5-24

5-25

On 1 October of the current year, Bourdon Company paid $396 for a two-year comprehensive insurance policy on the business’s building. Required: a Prepare the journal entry to record each of the following: i the purchase of this insurance policy ii the adjusting entry at the end of the year (31 December). b If the adjusting entry had not been made in (a-ii), discuss what effect this error would have on the accounts and totals listed on the income statement and balance sheet. On 1 October of the current year, Sagir Appraisal Company received $1980 in advance from the Land-Ho Real Estate Agency for six months’ rent of office space. Required: a Prepare the Sagir Appraisal Company journal entries to record the following: i the receipt of the payment ii the adjustment for rent revenue at the end of the current year. b If the adjusting entry had not been made in (a-ii), discuss what effect this error would have on the accounts and totals listed on the income statement and balance sheet. The Cobbler Company shows the following revenue, expense and withdrawals account balances on 31 December of the current year, before closing: Account titles AB Cobbler, withdrawals

Debits

Credits

$2 100

Shoe service revenues

$14 230

Salaries expense

3 700

Utilities expense

350

Supplies expense

197

Rent expense

880

Depreciation expense

125

Commission Received

5-26

Required: a Prepare closing entries. b Prepare an income statement. The following are various accounts related to the income statement and owner’s equity of Lynn Company (a sole proprietorship) for the current year. P Lynn, withdrawals

$ 30 000

Salaries expense

31 400

Delivery expense

9 300

Utilities expense

14 700

Sales Depreciation expense Cost of goods sold

5-27

1 050

189 500 5 600 73 800

Required: From the information given, prepare the 31 December closing entries. For the year ended 30 June 20X1, Newhard Corporation had sales revenues of $120 000, operating expenses of $68 000 and other revenue of $2800. The company is subject to a 30 per cent income tax rate and currently has 10 000 shares held the entire year by shareholders.

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219

Accounting Information for Business Decisions

5-28

Required: a Prepare the journal entry on 30 June 20X1 to record Newhard Corporation’s 20X0 income taxes. b Prepare a 20X0 income statement for Newhard Corporation. On 1 January 20X1, ACE Corporation showed the following account balances: Paid-up capital ($10 par) Retained earnings

$100 000 69 700

During 20X1, the following events occurred: i The corporation issued 1000 shares of additional stock for $30 000. ii Net income for the year was $39 000. iii Dividends in the amount of $12 000 were declared and paid to shareholders. Required: Prepare the shareholders’ equity section of ACE Corporation’s balance sheet on 31 December 20X1.

Making evaluations 5-29

5-30

220

The Cameron Copy-Quick Company was recently set up by Joseph Cameron. The business’s transactions during October, the first month of operations, are given below: Date

Transaction

3 Oct.

Joseph Cameron deposited $28 000 in the business’s bank account

4

Acquired land and a building for $33 000 and $44 000, respectively, paying $5000 cash and signing a five-year mortgage for the remaining balance

15

Copy equipment costing $8800 was purchased on credit from Tailor Equipment Company

20

Office supplies costing $1760 were purchased for cash

24

Purchased office furniture costing $2530 from Freddy’s Furniture, paying $300 cash. The balance of $2230 is due in 30 days

28

Purchased a three-year insurance policy for $9900 cash

31

Paid balance due to Tailor Equipment Company for copy equipment purchased on 15 October

Required: a Set up the following general ledger T-accounts (and account numbers): ‘Cash’ (101), ‘GST paid’ (108), ‘Office supplies’ (105), ‘Prepaid insurance’ (106), ‘Land’ (110), ‘Building’ (112), ‘Copy equipment’ (114), ‘Office furniture’ (118), ‘Accounts payable’ (201), ‘Mortgage payable’ (220) and ‘J Cameron, capital’ (301). b Record the preceding transactions in a general journal. c Post the journal entries to the general ledger accounts and determine the ending account balances. d Prepare a trial balance. The Foster Tax Services Company was established on 2 January of the current year to help clients with tax planning and preparation of their tax returns. The business engaged in the following transactions during January: Date

Transaction

2 Jan.

R Foster set up the business by investing $33 000 cash in the business’s bank account

3

Acquired land and a building at a cost of $99 000 and $231 000, respectively. A $60 000 down-payment was made, and a mortgage was signed for the remaining balance

4

Purchased office equipment costing $7700 by signing a loan due in one year

10

Office supplies costing $880 were purchased for cash

21

Performed tax planning services for customer and collected $3300

31

Paid $1595 for employee’s salary, $325 of this for PAYG tax

31

Paid utilities bill of $88 for January

31

R Foster withdrew $850 cash for personal use

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 5 Recording, storing and reporting accounting information

5-31

5-32

Required: a Set up the following T-accounts (and account numbers): ‘Cash’ (101), ‘Office supplies’ (105), ‘GST paid’ (108), ‘Land’ (110), ‘Building’ (112), ‘Office equipment’ (115), ‘Notes payable’ (220), ‘PAYG tax payable’ (231), ‘GST collected’ (232), ‘Mortgage payable’ (221), ‘R Foster, capital’ (301), ‘R Foster, drawings’ (302), ‘Tax service revenues’ (401), ‘Salary expense’ (501), ‘Utilities expense’ (502) and ‘Supplies expense’ (503). b Prepare journal entries to record the preceding transactions. c Post the journal entries to the accounts. d Prepare a trial balance at 31 January. Ryan Landscaping Service had the following account balances at the start of March: cash $2310; accounts receivable $440; GST paid $330; supplies of landscaping materials $3200; land $40 000; buildings $82 000; accounts payable $123; GST collected $380; and mortgage payable $60 000. Ryan Landscaping Service entered into the following transactions during March. Date

Transaction

1 Mar.

Provided landscaping service for customer, collecting $572 cash

2

Paid three months’ rent in advance at $297 per month on storage and office building

4

Paid accounts payable owing from previous month

5

Purchased $55 of repair parts on credit from JR’s, a small-engine service business; the parts are to be used immediately in repairing several of the business’s mowers

6

Received accounts receivable from previous month

6–10

Provided landscaping service for a customer; customer agreed to pay the contract price of $2695 in 15 days

12

Owner withdrew supplies $100

15

Paid amount due to JR’s for repair parts purchased on 5 March

25

Collected amount owing from customer for service provided on 6–10 March

31

Paid $44 for March utilities bill

31

Paid $1980, including PAYG tax of $280, to employees for March salaries

31

Received $88 March telephone bill, to be paid in early April

31

A stocktake of supplies indicated $1350 worth of supplies on hand

Required: a Calculate Ryan’s capital account balance at 1 March. b Prepare journal entries to record the preceding transactions. c Set up the following T-accounts (and account numbers): ‘Cash’ (101), ‘Accounts receivable’ (103) ‘GST paid’ (104), ‘Supplies’ (108), ‘Land’ (110), ‘Building’ (112), ‘Accounts payable’ (215), ‘GST payable’ (220), ‘PAYG tax payable’ (231), ‘Mortgage payable’ (221), ‘R Foster, capital’ (301), ‘R Foster, drawings’ (302), ‘Landscaping services revenue’ (401), ‘Repairs expense’ (501), ‘Supplies expense’ (503), ‘Utilities expense’ (502), ‘Telephone expense’ (505) and ‘Salaries expense’ (507). d Prepare a trial balance at 31 March. Watson Heater Company sells portable heaters and related equipment. The business uses a perpetual inventory system, and the cost of its inventory at the beginning of November was $2600. Its cash balance was $1500 at the beginning of November, and it entered into the following transactions during November. Date

Transaction

1 Nov.

Made $550 cash sales to customers; the cost of the inventory sold was $300

3

Purchased $1870 of heaters for cash from Tyler Supply Company

5

Received $275 cash allowance from Tyler Supply Company for defective inventory purchased on 3 November

6

Paid $231 for parts and repaired defective heaters purchased from Tyler Supply Company on 3 November

8

Made $1650 sale of heaters on credit to Nate Nursing Home, with terms of 2/10, n/20. The cost of the inventory sold was $850

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221

Accounting Information for Business Decisions

5-33

5-34

Date

Transaction

15

Purchased $1100 of heaters on credit from Miller Supplies, with terms of n/15

18

Received amount owed by Nate Nursing Home for heaters purchased on 8 November, less the cash discount

30

Paid for the inventory purchased from Miller Supplies on 15 November

Required: Prepare journal entries to record the preceding transactions. Morg Building Supplies sells building supplies and small tools to retail customers. It entered into the following transactions (the business uses the perpetual inventory system) during September. Date

Transaction

1 Sept.

Purchased $2090 of building supplies on credit from Doe Company, with terms 2/10, n/30

2

Returned $165 of defective building supplies purchased on 1 September from Doe Company for credit

5

Sold $990 of small tools (which cost $660) to customers for cash

6

Purchased $385 of small tools for cash

6

Granted $77 cash allowance to customer for minor defects found in small tools sold on 5 September

10

Paid balance due to Doe Company for purchase of 1 September

21

Sold $1650 of building supplies (which cost $1100) on credit to R Bailey, with terms 1/10, n/30

30

Received balance due from R Bailey for building supplies purchased on 21 September

Required: a Prepare journal entries to record these transactions. b What were net sales for the month? The trial balance of Halsey Architectural Consultants on 30 June of the current year (the end of its annual accounting period) included the following account balances before adjustments. Accounts receivable Prepaid insurance

$ 16 000 debit 1 560 debit

Building

92 000 debit

Drafting equipment

12 000 debit

Unearned rent

6 240 credit

Note payable

10 000 credit

Supplies Capital

1 500 debit 106 820 credit

In reviewing the business’s recorded transactions and accounting records for the current year, you find the following information pertaining to the 30 June adjustments: i On 1 January, the business had accepted a $16 500, one-year, 10 per cent note receivable from a customer. The interest is to be collected when the note is collected. ii On 1 April, the business had paid $1760 for a three-year insurance policy. iii The building was acquired several years ago and is being depreciated using the straight-line method over a 20-year life with no residual value. iv The drafting equipment was purchased on 1 June. It is to be depreciated using the straight-line method over an eight-year life with no residual value. v On 1 January, the business had received $6644 for two years’ rent in advance for a portion of its building rented to Shields Company. vi On 1 May, the business had issued a $10 000, three-month, 9 per cent note payable to a supplier. The $225 total interest is to be paid when the note is paid.

222

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Chapter 5 Recording, storing and reporting accounting information

vii

5-35

5-36

On 1 July, the business had $200 of supplies on hand. During the year, the business purchased $1300 of supplies. A count on 30 June determined that $90 worth of supplies were still on hand. viii On 1 June an entry to record prepaid rates of $6600 for 12 months had not been recorded. Record the entry and make the adjustment required at 30 June to report rates expenses. Required: Prepare the adjusting entries that are necessary to bring Halsey’s accounts up to date on 30 June. Each journal-entry explanation should summarise your calculations. VirusFree Janitorial Services engaged in the following transactions during the current year and properly recorded them in its balance sheet accounts. Date

Transaction

1 Jan.

Purchased cleaning equipment for $14 300, paying $3000 down and taking out a two-year, 12 per cent loan payable for the balance. The equipment has an estimated life of 10 years and no residual value; straight-line depreciation is appropriate. The interest on the note will be paid on the maturity date

24 May

Purchased $330 of office supplies. The office supplies on hand at the beginning of the year totalled $145

1 June

Purchased a two-year comprehensive insurance policy for $990

1 Jan.

Received six months’ rent in advance at $550 per month and recorded the $3300 receipt as unearned rent

1 Jan.

Accepted a $3000, six-month, 10-per-cent note receivable from a customer. The $150 total interest is to be collected when the note is collected

Additional information: a On 31 December, office supplies on hand totalled $58. b All employees work Monday to Friday. The weekly payroll of Paribus amounts to $6000. All employees are paid at the close of business each Friday for the previous five working days (including Friday). This year, 31 December falls on a Thursday. Required: On the basis of the preceding information, prepare journal entries to record whatever adjustments are necessary on 31 December. Each journal-entry explanation should show any related calculations. The adjusted trial balance for Swish Interior Decorating Company on 30 November 20X1 (the end of its monthly accounting period) is as follows: Account titles Cash

Debits

Credits

$ 7 042

Accounts receivable

4 394

Office supplies

1 074

Prepaid insurance

1 240

GST control Land Building

300 6 000 29 400

Accumulated depreciation: building Office equipment

$

130

2 880

Accumulated depreciation: office equipment

40

Accounts payable

1 580

Mortgage payable

10 000

A Swire, capital A Swire, drawings

40 000 800

Interior decorating revenues

3 105

Salaries expense

850

Insurance expense

140

Telephone expense

177

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

223

Accounting Information for Business Decisions

Account titles

Debits 276

Office supplies expense

112

Depreciation expense: building

130

Depreciation expense: office equipment Totals

5-37

Credits

Utilities expense

40 $54 855

$54 855

Required: a Prepare a November income statement, a statement of changes in owner’s equity and a 30 November 20X1 balance sheet for Swire Interior Decorating Company. b Prepare the closing entries on 30 November 20X1. c Prepare a post-closing trial balance. On 31 May 20X1, the bookkeeper of Marina Boat Storage prepared the following closing entries for the month of May: (a) Storage revenues

4 060

Income summary

4 060

(b) Income summary

2 724

Depreciation expense: building

140

Depreciation expense: equipment

110

Supplies expense

233

Salaries expense

1 650

Telephone expense

92

Utilities expense

264

Insurance expense

235

(c) Income summary

1 336

L Marina, capital

1336

(d) L. Marina, capital

830

L Marina, withdrawals

830

In addition, the following post-closing trial balance was prepared: Account titles Cash

Debits

Credits

$ 6 120

Accounts receivable

4 989

Supplies

1 117

Land

16 000

Building

25 200

Accumulated depreciation: building Equipment

140 10 560

Accumulated depreciation: equipment Accounts payable GST clearing

110 2 150 200

Notes payable (due 1/5/X3)

7 000

Mortgage payable

20 000

L Marina, capital Totals

224

34 386 $63 986

$63 986

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 5 Recording, storing and reporting accounting information

5-38

Required: a Prepare an income statement for the month ended 31 May 20X1. b Prepare a statement of changes in owner’s equity for the month ended 31 May 20X1. c Prepare a 31 May 20X1 balance sheet (in report form). Finestein Corporation showed the following balances on 1 January 20X1. Paid-up capital (14 500 shares, $10 par) Retained earnings

$145 000 64 000

On 4 January 20X1, the company issued 1000 shares for $40 000. For the year ended 31 December 20X1, the company had sales revenues of $102 000, cost of goods sold of $48 000, operating expenses of $17 000 and other revenues of $3000. In addition, the company declared and paid dividends of $6000 on 31 December. Finestein Corporation is subject to a 30 per cent income tax rate and uses a perpetual inventory system. Required: a Prepare journal entries to record the issue of common shares on 4 January 20X1, and the declaration and payment of the cash dividends on 31 December 20X1. (Assume that the company appropriately recorded the journal entries for the other transactions during the year.) b Prepare the journal entry on 31 December 20X1 to record the 20X1 income taxes of Finestein Corporation. c Prepare an income statement for the year ended 31 December 20X1. d Prepare the shareholders’ equity section of the 31 December 20X1 balance sheet. e Prepare the 31 December 20X1 closing entries.

Dr Decisive Yesterday, you received the following letter for your advice column in the local paper:

Dear Dr Decisive My brother and I are having a fight over bad debt expenses, and have bet one another on the outcome. I think he owes me $100; he disagrees. He is a civil engineer, and you know how they like their numbers and measurements to be precise. The other day I showed him a newspaper report in which a bank’s CEO was saying that the bank had some tenuous first-homeowner property loans, and so would be recording estimated amounts for large bad-debt expenses this year and for the next couple of years in anticipation that borrowers would not be able to pay back their loans as interest rates rose. My brother said that the CEO’s statement was crazy, and that the bank should wait until the loans are written off before recording them as an expense. I tried to tell him that the bank should record all the loans as expenses now. Whoever is right, we both disagree with the bank’s CEO about interest-rate rises. I do need the $100, though, and would appreciate your help. Call me . . . ‘Confused Again’

Required Meet with your Dr Decisive team and write a response to ‘Confused Again’.

Endnote a

Quoted in RJ Chambers (ed.) (1995), An Accounting Thesaurus: 500 Years of Accounting. New York: Permagon, 7.

Company URL u

Qantas: http://www.qantas.com.au Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

225

6 INTERNAL CONTROL: MANAGING AND REPORTING WORKING CAPITAL ‘Most people have wrong-minded ideas about why companies fail. They think it’s because of a lack of money. In most cases, it has very little to do with that.’ Michael E. Gerber

Learning objectives After reading this chapter, students should be able to do the following: 6.1

Define the concept of ‘working capital’ and reasons for exercising control over working capital items.

6.2 Discuss why managing the asset cash in terms of cash receipts and cash payments is so important. 6.3 Understand how to properly monitor and control accounts receivable. 6.4 Identify control procedures and methods for inventory. 6.5 Explain the need to manage accounts payable.

226

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Chapter 6 Internal control: Managing and reporting working capital

Understanding the learning objectives is assisted in the chapter by asking key questions:

Key questions 1

What is working capital, and why is its management important?

2

How can managers control cash receipts in a business?

3

How can managers control cash payments in a business?

4

What is bank reconciliation, and what are the causes of the difference between a business’s cash balance in its accounting records and its cash balance on its bank statement?

5

How can managers control accounts receivable in a business?

6

How can managers control inventory in a business?

7

How can managers control accounts payable in a business?

How do you protect your cash? Do you organise your money in your wallet so that five-dollar notes are in front and larger denominations behind? Do you keep a jar of change to pay for small items? Do you store your wallet in a secret place? Do you have a credit card or a savings account? Do you earn interest on the balance you keep in the account? Do you split your pay into savings and other accounts each week? Do you record each payment that you make automatically? Do you reconcile your record of cash transactions each time you get a bank statement? Have any of your friends asked you to lend them money? Did you consider the likelihood that they would pay you back before you decided whether to lend them the money? If you loaned them money, did you make them sign an agreement to pay you back? When you pay for several items at a shop by using your credit card, do you examine the receipt to make sure the shop has not overcharged you? These are all ways by which individuals might keep ‘control’ over their cash, amounts owed to them and amounts they owe. To be successful, businesses also require sound controls over their cash, accounts receivable and accounts payable. According to Michael E Gerber, accounting issues are the basis for three of the top 10 reasons why small businesses, in particular, fail. They are: 1 a lack of management systems, such as financial controls 2 a lack of financial planning and review 3 an inadequate level of financial resources.a The third reason can be interpreted to mean ‘a lack of money’. The first two reasons, however, focus on the management of a business’s financial resources. Often, it is difficult for a new business to keep an adequate amount of financial resources. Because so many businesses start with very little cash, they operate under very tight financial constraints. Some very successful businesses – for example, Dell Inc. (http://www.dell.com.au) and Woolworths Supermarkets (http://www.woolworths.com.au) – started business with very limited resources, but were able to manage their resources effectively and grow into big companies. In this chapter, we will build on the knowledge you gained in previous chapters. We will take a closer look at how businesses manage and report four important balance sheet items: cash, accounts receivable, inventory and accounts payable. How a business manages these items affects its cash flows, financial performance and financial reporting. More specifically, we will define working capital, discuss its importance, examine its major components and explain how managers and external users evaluate it. We believe that through proper short-term financial management, many small businesses can increase their likelihood of success.

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Accounting Information for Business Decisions .

1

What is working capital, and why is its management important?

working capital A business’s current assets minus its current liabilities

6.1 Working capital A business’s working capital is the excess of its current assets over its current liabilities. That is, working capital is current assets minus current liabilities.

Discussion Why do you think this amount is called ‘working’ capital? Why do you think a business is concerned with its working capital?

Recall that the current assets section of a business’s balance sheet includes assets that the business expects to convert into cash, to sell or to use up within one year. The current liabilities section includes liabilities that it expects to pay within one year by using current assets. The term working capital represents the net resources that managers have to work with (manage) in the business’s day-to-day operations. To demonstrate working capital, we will assume – even though we have only just started to record transactions up to January 20X2 – that Cafe´ Revive has operated for two full years and has recorded all its transactions correctly. Case Exhibit 6.1 shows Cafe´ Revive’s balance sheets for 31 Case Exhibit 6.1 Cafe´ Revive’s balance sheets CAFE´ REVIVE Comparative balance sheets 31 December 20X2 and 20X3 Assets

31 December 20X2

31 December 20X3

Current assets Cash ($5783 þ petty cash $35)

$ 5 818

$ 5 014

Accounts receivable (net)

7 340

8 808

Inventory

1 570

Total current assets

1 300 $14 728

$15 122

Property and equipment: Store equipment (net)

$13 500

Total property and equipment Total assets

$10 420 13 500

10 420

$28 228

$25 542

Liabilities Current liabilities: Accounts payable GST clearing

$ 6 200

$ 7 500

1 340

231

Total current liabilities

$ 7 540

$ 7 731

Non-current liabilities: Notes payable Total non-current liabilities

$ 5 000

$ 5 000 5 000

5 000

$12 540

$12 731

E Della, capital

$15 688

$12 811

Total liabilities and owner’s equity

$28 228

$25 542

Total liabilities Owner’s equity

Working capital ¼ Current assets – Current liabilities 31/12/20X2: Working capital ¼ $14 728 – $7540 ¼ $7188 31/12/20X3: Working capital ¼ $15 122 – $7731 ¼ $7391

228

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Chapter 6 Internal control: Managing and reporting working capital December 20X2 and 31 December 20X3. We highlight the current sections of the balance sheet and calculate Cafe´ Revive’s working capital at the bottom of Case Exhibit 6.1. Note that the amount of the current liabilities (accounts payable) is subtracted from the total amount for the current assets (cash, accounts receivable and inventory) to calculate working capital. Changes in any of these four items affect Cafe´ Revive’s working capital. The decisions managers make regarding any of these items are considered part of working capital management. Other terms for working capital management are operating capital management and short-term financial management.

Stop & think

Businesses manage working capital because they want to keep an appropriate amount of it on hand. But what is an appropriate amount of working capital for a business? An appropriate amount is enough working capital to finance the business’s day-to-day operating activities plus an extra amount in case something unexpected happens. For instance, the extra amount may enable the business to buy inventory when it is offered at a reduced price, or to cover the lost cash when a customer doesn’t pay their account. If a business has too little working capital, it risks not having enough liquidity. If it has too much working capital, the business risks not putting its resources to their best use. In summary, businesses manage working capital to keep an appropriate balance between (1) having enough working capital to operate and to handle unexpected needs for cash, inventory or short-term credit; and (2) having so much excess cash, inventory or available credit that profitability is reduced. Keeping the right amount of working capital requires careful planning and monitoring. For instance, the timing of inventory purchases usually does not coincide with the timing of sales. So a business may find itself, at any given time, with either too little or too much inventory. Cash receipts usually do not coincide with the business’s need to use its cash. Thus, a business may have excess cash sitting idly in its bank account, or it may need additional short-term financing. The fact that customers have some control over when they make their payments affects a business’s management of cash collections from its accounts receivable. The longer customers take to pay, the longer the business must wait between the time when it purchased inventory and the time when it receives cash from the sale. The business can manage this aspect of working capital by setting policies that encourage early payment of accounts receivable. On the other hand, the business must also manage the payments of its obligations. It should make these payments on time, as well as take advantage of purchases discounts available from its suppliers. Managing working capital affects all aspects of a business’s operating activities. Case Exhibit 6.2 shows a timeline of Cafe´ Revive’s operating activities. The top half of the exhibit shows Cafe´ Revive’s (CR) transactions with its supplier, DeFlava Coffee Corporation (DFC). These consist of Cafe´ Revive purchasing coffees (increasing inventory) on credit (increasing accounts payable), paying invoices as they come due (decreasing cash and accounts payable) and monitoring inventory to determine when to restock (not How can a business encourage its customers shown). to pay their bills more quickly?

Stop & think Why do you think Cafe´ Revive waits almost until the invoice’s due date to process its cash payment to DeFlava Coffee? The bottom half of Case Exhibit 6.2 shows Cafe´ Revive’s transactions with its customers. These consist of Cafe´ Revive making coffee sales (decreasing inventory) on credit (increasing accounts receivable) or for cash (not shown), and of credit customers posting payments based on the credit terms Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

229

Getty Images/Photodisc

How much working capital do you need in your personal life? Why?

Accounting Information for Business Decisions Case Exhibit 6.2 Working capital flows

DeFlava Coffee (DFC) Purchasing and cash payments 1 CR purchases coffee products from DFC on credit. 2 CR waits until almost the invoice due date to process cash payment.

4

3 Coffee products

Deposit CR’s cheque/EFT CR’s cheque/EFT

1

Banking system

2 8

3 CR sends cheque or electronic payment.

Deposit customer’s cheque/EFT

4 DFC processes receipt from CR; CR’s bank deducts payment Café Revive (CR) payment from CR’s bank Cash account. Accounts receivable Accounts payable Inventory

5

7

Coffee products

Customer’s cheque/EFT

Sales and cash receipts 5 CR sells coffee products to a customer on credit. 6 Customer waits until almost the due date to process cash payment. 7 Customer transfers funds electronically for payment to CR. 8 CR processes receipt and checks the deposit with other daily receipts in its bank account.

6 Customer

internal control structure Set of policies and procedures that directs how employees should perform a business’s activities

cash Money on hand, deposits in bank accounts, and cheque and credit card invoices that a business has received from its customers but not yet deposited

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of the sales (decreasing accounts receivable). When Cafe´ Revive receives customers’ payments, it deposits them in the bank (increasing cash). These deposits are then available to make cash payments. Managers control each aspect of the operating cycle to ensure that operating activities are performed in accordance with business objectives. As you will see, they do this by establishing an internal control structure, which is a set of policies and procedures that directs how employees should perform a business’s activities. The reporting by a business of the amount of each current asset and current liability on its balance sheet provides external users with information about the ability of the business to keep an appropriate level and mix of working capital. In turn, this reporting helps managers and users evaluate the business’s liquidity. To put it another way, working capital is to a business what water is to a plant. If the plant does not have enough water, it will not grow, and eventually it will wither and die. If the plant receives too much water, it will drown. Just as plants need the right amount of water in order to grow, businesses need the right amount of working capital to achieve desired levels of profitability and liquidity. In the following sections, we will discuss how a business manages and reports its working capital items – cash, accounts receivable, inventory and accounts payable.

6.2 Cash A business’s cash includes money on hand, deposits in bank accounts and other documents that are convertible to cash, such as cheques that it has received from customers but not yet deposited. A simple rule is that cash includes anything that a bank will accept as a deposit. In addition to being an integral part of a business, cash is also the most likely asset for employees and others to steal or for the business to misplace. For example, cash received from customers in a retail shop Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 6 Internal control: Managing and reporting working capital has no identification marks that have been recorded by the shop. So when cash goes ‘missing’, it is very difficult to prove the cash was stolen or who stole it. Also, cash that is illegally transferred from a business bank account involves no physical possession of the cash by the thief, and if the thief can conceal or destroy the records, the theft of the money may not be traceable. Although internal control procedures are necessary for all phases of a business’s operations, they are usually most important for cash.

Simple cash controls For businesses of all sizes, the best way to prevent both intentional and unintentional losses is to hire competent and trustworthy personnel, and to establish cash controls. We will discuss two categories of simple cash controls. These are internal controls over (1) cash receipts and (2) cash payments. These controls apply to all cash transactions except those dealing with a business’s petty cash fund, which we will discuss later in the chapter.

Controls over cash receipts A business uses internal control procedures for cash receipts to ensure that it properly records the amounts of all cash receipts in the accounting system, and to protect these from being lost or stolen. Cash receipts from a business’s operating activities result from cash sales and from collections of accounts receivable from its customers.

2

How can managers control cash receipts in a business?

Stop & think How might an employee steal from their employer when working at the business’s cash register? For cash sales, a business should use three control procedures. The most important is the proper use of a cash register. Managers should make sure that a pre-numbered sales receipt is completed for every sale, and that the salespeople ring up each sale on the register. In most businesses, the cash register produces the receipt as well as a tape containing a chronological list of all sales transactions rung up on the register. This step is important because it is the first place sales are entered into the accounting system. The fact that customers expect to receive a copy of the receipt helps to ensure that each sale is entered. As a customer, you may have been part of a business’s cash controls without even knowing it. For example, a pizza shop could have a sign near the cash register that reads:

Dear Customer: If we fail to give you a receipt for your pizza purchase, let us know and your next meal is free! This added control increases the likelihood that salespeople will enter all sales into the cash register, and it signals to employees the importance of this activity.

Stop & think Could an employee still steal money from a business even though receipts are issued for every transaction? If so, how? Second, if a cheque or voucher is accepted for payment, the salesperson should make sure that the customer has proper identification in order to minimise the likelihood that the bank might not accept it. Even this procedure is not always adequate.

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Accounting Information for Business Decisions Third, at the end of each salesperson’s work shift, the employee should match the total of the amounts collected (cash plus credit card sales) against the total of the cash register tape and report any difference between the two totals to a supervisor. Some companies, such as Coles (http://www.coles.com.au), use a fourth control procedure for cash sales. These companies remove the ‘big notes’ from cash registers during a single employee’s shift. For example, if more than five 50-dollar notes are in the register, the employee inserts the excess notes into a slot that leads to a locked safe kept behind the counter; only the shop manager knows the combination to the safe. A business should use three control procedures to safeguard collections of cash from accounts receivable (Exhibit 6.3): Exhibit 6.3 Control procedures to safeguard cash from accounts receivable

1

Separation of duties. Either the owner–manager or an employee who does not handle accounting records should open the mail. Separating duties that involve handling accounting records from activities that involve receiving cash, such as opening the mail or taking cash at point of sale, prevents an employee from stealing undeposited amounts of cash and covering up the theft by making a fictitious entry in the accounting records. 2 List details. Immediately after opening the mail or receiving cash, the employee should list or input all of the details of the money received. Later, if a customer claims to have previously paid a bill, the business can review documentation. You may be wondering what happens if the customer did pay the bill but the money is not deposited because the employee stole the undeposited money. Review of documentation may help the business discover that its employee is stealing money. 3 Endorsement. Employees should ensure each incoming amount is registered at the cash register. At Cafe´ Revive, this is done by ensuring that all cash received is placed in the cash register till and the amount entered into the system. Cafe´ Revive accepts only cash or card, cheques are a thing of the past. 3

How can managers control cash payments in a business?

Stop & think Why do you think an owner might be interested in not recording all cash receipts?

Getty Images/Ryan McVay

Finally, a business should adopt one additional procedure to help it safeguard the cash collected from both its cash sales and its accounts receivable: it should deposit all cash receipts intact daily. This means that at the end of each day, the business should take all of its cash (i.e. everything included in our definition of cash), fill out a deposit slip and make a bank deposit. These daily bank deposits help in two ways. First, keeping a substantial amount of cash at the business overnight is taking an unnecessary risk of theft. By depositing all cash receipts on a daily basis, the business does not leave cash unattended overnight. Second, the bank’s deposit records show the business’s cash receipts for each day. When the business receives its monthly bank statement, it can check the daily bank deposits listed in the bank statement against its ‘Cash’ account to determine that it deposited all its recorded cash receipts in the bank and that it properly recorded all bank deposits in its ‘Cash’ account.

Controls over cash payments How can this customer help the supermarket keep control of the cash in this register?

232

The basic rule for good internal control over cash payments is to have all payments authorised before they are made. A very small business operated by the owner may have little need for any additional internal control procedures – the owner purchases items and pays employees, either electronically or by cheque. As the business grows, though, two

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Chapter 6 Internal control: Managing and reporting working capital more controls over cash payments can provide added security over cash. First, the business should pay only for approved purchases that are supported by proper documents. These documents generally include an approved copy of the business’s purchase order providing evidence that the business actually ordered the items (which we will discuss in detail later in the chapter), a freight receipt showing evidence that the business received the items it ordered, and the supplier’s invoice. This procedure reduces the chance that the business will pay for either items that it did not want to purchase or items that it has not received. Second, immediately after payment, the owner should stamp ‘Paid’ on the supporting documents, along with the date paid and the receipt number. Cancelling the documents in this way prevents the business from paying for items more than once.

Discussion Why do you think an employee might want to deceive a business about its cash payments? Why do you think an owner might be interested in not recording all cash payments?

Bank reconciliation Despite all of the procedures used to control the receipts and payments of cash, errors can still occur in a business’s records. Since the bank also keeps a record of the business’s cash balance, the business can use both sets of records to determine what its correct cash balance should be. However, the time when the business records its receipts and payments differs from the time when the bank records them, so a business uses a bank reconciliation to determine the accuracy of the balance in its cash account. In this section, we discuss what a bank reconciliation is, why it is necessary and how it is performed.

4

What is bank reconciliation, and what are the causes of the difference between a business’s cash balance in its accounting records and its cash balance on its bank statement?

Stop & think Do you reconcile your bank statement every month? What risks do you take if you don’t reconcile your records of cash transactions with the bank statement? A business’s bank independently keeps track of the business’s cash balance. Each month, the bank produces a bank statement for the business that summarises the business’s banking activities (e.g. deposits and payments) during the month. A business uses its bank statement, along with its own cash records, to prepare a bank reconciliation. When a business uses the internal control procedures of depositing daily receipts and ensuring all payments are approved and documented, the ending balance in its cash account should be the same as the bank’s ending cash balance for the business’s bank account, except for a few items. (We will discuss the various causes of the difference between the two balances later.) A business prepares a bank reconciliation to analyse the difference between the ending cash balance in its accounting records and the ending cash balance reported by the bank in the bank statement. Through this process, the business learns what changes, if any, it needs to make in its ‘Cash’ account balance. This enables the business to report the correct cash balance on its balance sheet. Exhibit 6.4 summarises the causes of the difference between the ending cash balance listed on the bank statement and the ending cash balance listed in the business’s records. The causes include: (1) deposits in transit; (2) outstanding payments/cheques; (3) deposits made directly by the bank; (4) charges made directly by the bank; and (5) errors.

bank statement Statement that summarises a business’s banking activities during the month

bank reconciliation Schedule used to analyse the difference between the ending cash balance in a business’s accounting records and the ending cash balance reported by the bank on the business’s bank statement

Stop & think Which of the five listed items are most important when you reconcile your bank account?

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Accounting Information for Business Decisions Exhibit 6.4 Causes of difference in cash balances

deposit in transit A cash receipt that a business has added to its cash account but that the bank has not deducted from the cash balance reported on the bank statement because the cheque has not yet ‘cleared’ the bank

NSF (not sufficient funds) A customer’s cheque that has ‘bounced’ (the business’s bank is unable to collect because the customer’s bank account has insufficient funds to cover the cheque)

234

1

Deposits in transit. A deposit in transit is a cash receipt that the business has added to its ‘Cash’ account but that the bank has not included in the cash balance reported on the bank statement. When a business receives a transfer of money or other receipt, it records an increase to its ‘Cash’ account. As illustrated in Case Exhibit 6.2, a short period of time may pass before the business deposits the money and the bank records it. At the end of each month, the business may have deposits in transit (either cash, cheques or pending electronic funds transfers) that cause the deposits recorded in the business’s cash account to be greater than deposits reported on the bank statement. For businesses using electronic transfer of funds (EFT), there is usually less delay between when a receipt is made and when it is recorded into the business’s bank account; however, delays may still occur. 2 Outstanding or pending payments. For example, an outstanding payment might be an amount that the business has paid and deducted from its cash account but that the bank has not deducted from the cash balance reported on the bank statement because the payment has not yet ‘cleared’ the system. As illustrated in Case Exhibit 6.2, a period of time is necessary for a cheque to be received by the payee (the business to whom the cheque is written), deposited in the payee’s bank and forwarded to the business’s bank (physically or electronically) for subtraction from the business’s bank balance. So at the end of each month, a business usually has some outstanding or pending payments that cause the cash payments recorded in its ‘Cash’ account to be more than the honoured payments itemised on the bank statement. 3 Deposits made directly by the bank. Many bank accounts earn interest on the balance in the account. For these accounts, the bank increases the business’s cash balance in the bank’s records by the amount of interest the business earned on its account; the bank lists this amount on the bank statement. This causes deposits listed on the bank statement to be greater than the deposits listed in the business’s cash account. The business is informed of the amount of interest when it receives the bank statement. 4 Charges made directly by the bank. A bank frequently imposes a service charge for managing a depositor’s account, and deducts this charge directly from the bank account. Banks also charge for the cost of maintaining the account and other services delivered. The business is informed of the amount of the charge when it receives the bank statement showing the amount of the deduction. When the business receives a customer’s cheque, it adds the amount to its cash account and deposits the cheque in its bank account for collection. The business’s bank is occasionally unable to collect the amount of the customer’s cheque. That is, the customer’s cheque has ‘bounced’. A customer’s cheque that has ‘bounced’ is referred to as NSF (not sufficient funds). Because the bank did not receive money for the customer’s cheque, it lists the cheque as an NSF cheque on the bank statement. Although the bank usually informs the business immediately of each NSF cheque, there may be some NSF cheques that are included in the bank statement and that the business has not recorded. At the end of the month, the bank lists any service charges and NSF cheques as deductions on the bank statement – deductions not yet listed in the business’s ‘Cash’ account. 5 Errors. Despite the internal control procedures established by the bank and the business, errors may arise in either the bank’s records or the business’s records. The business may not discover these errors until it prepares the bank reconciliation. For example, a bank may include a deposit in the wrong depositor’s account, or may make an error in recording an amount. Or a business may record a deposit for an incorrect amount, or may forget to record a cash transaction.

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Chapter 6 Internal control: Managing and reporting working capital

The structure of bank reconciliation Exhibit 6.5 shows a common way to structure bank reconciliation. Notice that the reconciliation has two

sections: an upper section starting with the bank’s record of the business’s ending cash balance, and a lower section starting with the business’s record of its cash balance. It is logical to set up these two sections because the purpose of the bank reconciliation is to determine the business’s correct ending cash balance. By adjusting the cash balance in each section for the amounts that either are missing or are made in error, the business is able to determine its reconciled (correct) ending cash balance. Exhibit 6.5 Structure of a bank reconciliation Business name Bank reconciliation Date for cash balance being reconciled Ending cash balance from the bank statement þ

Deposits in transit

–

Outstanding cheques

þ/– ¼

Errors made by the bank Ending reconciled cash balance Ending cash balance from business cash account

þ

Deposits made directly by the bank

–

Charges made directly by the bank

þ/– ¼

Must be the same

Errors made by the business Ending reconciled cash balance

For example, in the upper section, a deposit in transit is added to the ending cash balance from the bank statement because this deposit represents a cash increase that the bank has not yet added to the business’s bank account. In the lower section, a service charge made by the bank is subtracted from the ending balance in the business’s ‘Cash’ account because this charge represents a cash decrease that the business has not yet recorded. The bank reconciliation is complete when the ending reconciled cash balances calculated in these two sections are the same. This ending-reconciled cash balance is the correct cash balance that the business includes in its ending balance sheet. This form of bank reconciliation acts as another type of internal control over cash because it enables a business to identify errors in its cash-recording process and to know its correct cash balance at the end of each month.

Preparing a bank reconciliation When you prepare a bank reconciliation, keep in mind that you are doing it to determine the correct ending cash balance to be shown on the business’s balance sheet. The cash balance at the end of the month is correct if it includes all of the business’s transactions and events that affected cash. As you work through the upper section of the reconciliation, ask yourself, ‘What cash transactions (e.g. payments and deposits made) have taken place that the bank doesn’t know about?’ In the lower section, ask yourself, ‘What is not included in calculating the business’s ending cash balance but should be (e.g., bank service charges and interest earned)?’ Keep these questions in mind as you work through the reconciliation until the reconciled balances are the same. To prepare a bank reconciliation, you need two sets of items: (1) the bank statement for the month being reconciled, along with all of the items returned with the statement; and (2) the business’s cash records. With these items, you can work through a reconciliation in a step-by-step manner. Exhibit 6.6 summarises the eight steps to follow in preparing a bank reconciliation. In the following section, we illustrate the reconciliation process by preparing Cafe´ Revive’s 31 January 20X2 bank reconciliation. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions Exhibit 6.6 Steps in preparing a bank reconciliation

1 2

3

4

5

Set up the proper form for the bank reconciliation. Fill in the information you already know (e.g. ending unadjusted cash balances from the bank statement and the ‘Cash’ account). Look for deposits in transit. Compare the increases in cash listed in the business’s ‘Cash’ account with the deposits shown on the bank statement. Check to see whether any increase in the business’s ‘Cash’ account is not listed as a deposit on the bank statement. For any deposit in transit, add the amount to the ending cash balance from the bank statement listed on the reconciliation. At the same time, check for differences or discrepancies that may be as a result of errors. Look for outstanding, transfers payments or cheques. Compare the decreases in cash listed on the business’s ‘Cash’ account with the payments shown on the bank statement. Identify any decrease that is shown in the business’s ‘Cash’ account during the month but that is not matched with a corresponding bank deduction on the bank statement. Starting from the business’s records, trace each decrease to its cheque listing on the bank statement. Subtract the amounts of the outstanding cheques, or payments from the ending cash balance, from the bank statement listed on the bank reconciliation. At the same time, check for differences or discrepancies that may be as a result of errors. Identify any deposits that were made directly by the bank but that are not included as increases in the business’s ‘Cash’ account. Look through the bank statement for bank deposits that the business has not recorded as increases in its ‘Cash’ account. Usually, these deposits are for interest earned on the business’s bank account balance. Add these deposits to the balance of the business’s ‘Cash’ account listed on the bank reconciliation. Identify any charges that were made directly by the bank but that are not included as decreases in cash on the business’s records. Look through the bank statement for bank charges that the business has not recorded as decreases in its ‘Cash’ account. Usually, these charges result from bank services such as printing cheques or handling the business’s own NSF cheques. Deduct these charges from the balance of the business’s ‘Cash’ account listed on the bank reconciliation.

6 Determine the effect of any errors. While completing steps 1 to 5, you may discover that the bank or the business (or both) made an error during the processing of the cash transactions. If you find a bank error, contact the bank to get the error corrected in the business’s bank account, and ensure you have already corrected the amount of the error in the upper section of the bank reconciliation. If the business made an error, correct the amount of the error by adjusting the ending balance on the bank statement accordingly in the reconciliation statement. 7 Complete the bank reconciliation. After you have finished steps 1 to 6, the reconciled (correct) cash balances in the ‘Cash at bank’ account and the bank reconciliation should be the same. If not, trace back through the process carefully to locate any mistakes (e.g. outstanding cheques or transfers that you failed to include and errors in maths). 8 Journalise and post entries for amounts adjusted in the books of the business – that is, those items recorded on the bank statement but not recorded in the ‘Cash at bank’ account before reconciliation.

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Chapter 6 Internal control: Managing and reporting working capital

Cafe´ Revive’s bank reconciliation Case Exhibit 6.7 shows the following documents:

Cafe´ Revive’s ‘Cash’ account for January (for illustrative purposes, it is set up in three-column form, showing increases in the left – or debit – column and decreases in the right – or credit – column, with the running balance after each transaction in the balance column) • the January bank statement the business received from City Bank • the completed bank reconciliation statement. Case Exhibit 6.7 also summarises steps 1 to 7 from Exhibit 6.6, which Emily Della followed to prepare the reconciliation. We use an arrow and a number to trace each step on the documents. In step 8, Emily entered the reconciling items listed in the lower section of Cafe´ Revive’s bank reconciliation (interest earned, bank service charge and correction of error) into the business’s accounting records on 31 January 20X2. The effect of these changes on the accounting equation is as follows: •

Owner’s equity ¼

Assets

Liabilities

þ

Net income Revenues

Cash

Accounts payable



Interest revenue

þ$25.00

Expenses Banking expense

þ $25.00

$35.00



þ$35.00

 $10.00

þ$25.00

þ$35.00

Case Exhibit 6.7 also shows that, after Emily recorded the reconciling items, Cafe´ Revive’s ‘Cash’

account balance is the correct amount: $25 182. Emily will add this amount to the total amount in the petty cash fund (discussed later), and will show the combined total as ‘Cash’ on Cafe´ Revive’s 31 January 20X2 balance sheet. Similar to the end of period adjustment entries (number 16, 17, 18 and 19) recorded in chapters 4 and 5, the adjustments to cash at bank in the reconciliation process shown in Case Exhibit 6.7 are reflected in the following adjustment journal entries (number 20 and 21), as per step 8: Trans

Date

(20)

31/01/X2

Cash Interest revenue

CR

(21)

31/01/X2

Bank charges/expenses

DR

Cash

DR

CR

25 25 35 35

Note that the adjustment for the error made in recording the deposit of $8800 (incorrectly recorded by the bank as $8880) was done by notifying the bank of its error and adjusting the balance taken from the bank statement to commence the bank reconciliation statement, as per the following adjustment of the bank balance for the error. Balance in bank taken from bank statement Less: Correction of error (deposit recorded as $8880 instead of $8800) Adjusted balance

21 324 (80) 21 244

Additional controls over cash There are two other steps in preparing a bank reconciliation that help a business keep control over its cash. First, the business should ensure that any deposit in transit listed on the bank reconciliation for the previous month is listed as a deposit on the current bank statement. If it is not listed, the business should Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

237

Accounting Information for Business Decisions Case Exhibit 6.7 Cafe´ Revive’s bank reconciliation

Steps to complete bank reconciliation 1

Step 1. Emily transferred the $25 324 cash balance from the bank statement to the reconciliation and noted the $25 192 balance from Cafe´ Revive’s Cash account.

2

Step 2. Emily compared the increases in the Cash account with the bank deposits. She found that an amount for cash sales of $11 000 had been incorrectly recorded in the bank statement by the bank as $11 080. In Step 6 she will adjust for this. She also found the January 31 increase of $5368 was not listed on the bank statement. She entered $5368 on the reconciliation as a deposit in transit.

3

Step 3. Emily compared the bank statement’s listing of withdrawals and Cafe´ Revive’s record of decreases in its Cash account and found that all but one of the decreases (cheque no. 939 for $1430) were deducted on the current month’s bank statement. She subtracted this outstanding cheque from the balance in the bank statement in the reconciliation.

4

Step 4. Emily began completing the lower section of Cafe´ Revive’s reconciliation. Emily reviewed the deposits listed in the bank statement and found that Cafe´ Revive had not recorded a $25 bank deposit for interest earned as an increase in its Cash account. She added the $25 deposit to the Cash at Bank account.

5

Step 5. Emily reviewed the charges on the bank statement and found that Cafe´ Revive had not recorded a $35.00 bank service charge as a decrease in its Cash account. She subtracted the $35 charge from the company’s Cash at Bank account.

6

Step 6. Emily adjusted for the error discovered in Step 2. Because the amount that the bank should have recorded is $80 more than the amount that it did record ($11 080  $11 000), Emily subtracted $80 from the ending balance from the bank statement.

7

Step 7. After completing the bank reconciliation, Emily calculated the reconciled ending cash balance to be $25 182. Emily also observed that the reconciled balance shown in the bank reconciliation statement is the same. This indicates that she completed the bank reconciliation properly.

8

238

Step 8. In accordance with Exhibit 6.6, Emily completed end of period adjustment entries.

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Chapter 6 Internal control: Managing and reporting working capital

Cash + (DR)

– (CR)

Beginning balance 1/1/20X2 (1)

2/1/20X2

(2)

3/1/20X2

Balance 11 575

1 650 Chq no 939

13 225 1 430

11 795

(5)

7/1/20X2

(6)

20/1/20X2

EFT

250

11 985

(7)

25/1/20X2

EFT

363

11 622

(8)

25/1/20X2

EFT

121

11 501

(9)

25/1/20X2

EFT

275

11 226

(10)

31/1/20X2

EFT

2 050

9 176

(11)

31/1/20X2

EFT

143

9 033

(12)

31/1/20X2

EFT

(13)

31/1/20X2

(14)

31/1/20X2

440

31/1/20X2

Interest earned

31/1/20X2

Bank charges

12 235

209

8 824

11 000

19 824

5 368

25 192

25

25 217 35 $ 25 182

Café Revive PO Box 45 Westaway, Brisbane

City Bank Westaway Centre, Brisbane

Account no 137-187-8

Bank statement January 20X2 + (DR)

(CR)

Beginning balance 1/1/20X2

Balance 11 575

4/1/20X2

Deposit

1 650

13 225

8/1/20X2

Deposit

440

13 665

21/1/20X2

250

13 415

26/1/20X2

363

13 052

27/1/20X2

121

12 931

27/1/20X2

275

12 656

31/1/20X2

25

Interest earned 2 050

10 631

31/1/20X2

143

10 488

31/1/20X2

209

31/1/20X2

35

3

4

5

6

7

10 279 11 080

Bank charges

2

12 681

31/1/20X2

31/1/20X2

1

21 359 21 324

Bank reconciliation statement as at 31 January 20X2 Balance from bank statement Adjusted for bank error (Dep on 31/1 $8880 instead of $8800)

21 324 (80) 21 244

Add: Deposit in transit

5 368 26 612

Less: Outstanding payments Chq 939

(1 430) $ 25 182

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239

Accounting Information for Business Decisions investigate to determine what happened to the deposit. It may be that the deposit was misplaced or even stolen. Second, the business should investigate any outstanding cheque from the previous month that is still outstanding for the current month. It may be that the cheque was misplaced or perhaps lost in the mail. Cafe´ Revive has neither of these situations.

Petty cash fund

petty cash fund Specified amount of money that is under the control of one employee and that is used for making small cash payments for a business

Although paying for all items electronically is an excellent internal control, there may be instances when cash is required, particularly for small amounts. (e.g. some businesses will not allow the use of EFT for amounts under $5.) To make it easier for employees to make small but necessary purchases, a business may set up a petty cash fund. A petty cash fund is a specified amount of money under the control of one employee that is used for making small cash payments for the business. A business uses a petty cash fund because some payments can be made only with ‘currency’, or because use of a card to pay electronically is restricted to amounts over a certain value or writing a cheque would be cumbersome. There is less control over these expenditures, but the amounts involved are so small that an employee probably will not be tempted to steal.

Discussion What items do you always pay for with cash?

To start a petty cash fund, a business gives an employee called the petty cashier, who is in charge of petty cash, an amount of money – say, $50 – to be kept at the business. Usually, the petty cashier keeps the money in a locked box or drawer. Each time a payment is made from the fund, the employee makes a record of the payment (e.g. ‘Postage $22’, or ‘Stationery $16’) and keeps a written receipt. No payments are reimbursed out of petty cash without a receipt or invoice to substantiate the payment. At any time, the total of the receipts plus the remaining cash should equal the amount (in this case, $50) that was originally given to the employee. When the fund gets low, or on the date of its balance sheet, the business replenishes the fund to the original amount and uses the receipts to record the various cash transactions in its accounting system. For each receipt, the business records an increase in the related expense (or asset) account (e.g. postage expense or office supplies) and a decrease in its cash account (e.g. ‘Postage DR 22’, ‘Stationery DR 16’ or ‘Cash CR 38’). This ensures that all of the petty cash payments are included in the amounts reported in the business’s financial statements. Cafe´ Revive keeps a petty cash fund totalling $55. As we will discuss in the following section, Emily adds this amount to Cafe´ Revive’s ending reconciled cash balance for its bank account so that Cafe´ Revive shows the total cash on its balance sheet.

Reporting the cash balance on the balance sheet Cash is usually the first asset listed on the balance sheet because it is the most liquid current asset. Recall that cash includes money on hand, deposits in bank and savings accounts, and cheques and credit card receipts that a business has received but not yet deposited. As we discussed in previous sections, a business’s accounting system keeps track of these items separately. When reporting cash on its balance sheet, a business must combine the balances of each of these items. Cafe´ Revive’s total cash balance at 31 January 20X2 consists of two items: 1 The 31 January reconciled cash balance in its bank account

$25 182.00

2 The amount in its petty cash fund Total cash balance on 31 January 20X2

240

55.00 $25 239.00

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Chapter 6 Internal control: Managing and reporting working capital Notice that Cafe´ Revive shows this amount as Cash on its 31 January 20X2 balance sheet. A business that sells on credit cannot manage its cash without managing its accounts receivable. We will discuss the management of accounts receivable next.

Stop & think Have you ever applied for credit? What steps did you have to go through? Why do you think you had to go through that process in order to get credit?

6.3 Accounts receivable Accounts receivable are the amounts owed to a business by customers from previous credit sales. The

business intends to collect these amounts in cash. Businesses make sales on credit for three basic reasons. The first is that selling on credit may be more convenient than selling for cash. For example, when a business is selling goods that must be shipped, it is common for the purchaser to pay for the goods after receiving them. Between the time that the purchaser receives the goods and the time that the seller collects the payment, the seller has extended credit to the purchaser. The second reason why a business makes credit sales is that managers believe offering credit will encourage customers to buy items they might not otherwise purchase. This is common in retail sales, when the customer may not have enough cash to make the purchase. The third reason why a business makes credit sales is to signal product quality. By allowing customers to pay after receiving, seeing and using the goods, a business shows that it is confident about the level of its quality.

accounts receivable Amounts owed by customers to the business

Stop & think Do credit card sales result in accounts receivable? Credit sales using accounts receivable are not the same as ‘credit card sales’. If you use a credit card to pay for goods that are sold to you, it is the credit card company – for example, Visa (http:// www.visa.com.au), MasterCard (http://www.mastercard.com.au) or Virgin Money (http:// www.virginmoney.com.au) – that is extending credit to you, not the business that sold you the goods. A retail shop deposits its credit card receipts into its bank account, just as it does its cash receipts. Because of this, credit card sales receipts are sometimes referred to as instant cash.

If accounts receivable increase the sales of a business, why not automatically decide to grant all customers credit? The decision is not automatic because accounts receivable also have two disadvantages. One disadvantage of credit sales is that having accounts receivable requires significant management effort. Managers must make credit investigations, prepare and send bills, and encourage payments from customers. All these activities involve a cost to the business in money and in employee time. The second disadvantage is that when a business makes credit sales, there is always the chance that the purchaser will not pay. However, just because a business has some uncollectable accounts (bad debts), it does not mean that the business should not make credit sales. If, given the additional revenues and costs of managing accounts receivable, the business’s profits are increased

AAP Images/AP/Julia Malakie

The decision to extend credit

Who is extending credit in this transaction?

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241

Accounting Information for Business Decisions by extending credit, then credit sales help the business to achieve its goals. A business uses a form of Cost– volume–profit (CVP) analysis for this evaluation (see Chapter 2).

Stop & think Has anyone ever asked to borrow money from you? If they did, what factors affected your decision? Will you deal with the next situation in the same way? Why or why not?

5

How can managers control accounts receivable in a business?

Simple controls over accounts receivable Accounts receivable provide a greater increase in profit if credit sales are monitored properly. Internal controls over accounts receivable focus on procedures that help maximise the increase in profit from granting credit. For a small business, such as Cafe´ Revive, three control procedures should be used with accounts receivable. First, before extending credit, a business should determine that a customer is likely to pay. The risk of not collecting customers’ accounts is greatly reduced if a business extends credit only to customers who have a history of being financially responsible. But how does a business decide whether a customer is creditworthy? And how much credit should a business extend?

Discussion Some businesses grant credit ‘on the spot’ with no credit checks. Why would a business do this? What problems could these businesses encounter later?

To answer these questions, a business asks each potential credit customer to complete a credit application (similar to one you would fill out for a car loan). Normally, a credit application requests that the applicant provide the following information: 1 the name of the applicant’s employer and the applicant’s income 2 the name of the applicant’s bank, her/his bank account numbers, and the balances in his/her accounts 3 a list of assets 4 credit card account numbers and amounts owed 5 a list of other debts. The business will contact the applicant’s employer, bank and credit card businesses to verify the application information and to ask questions about the applicant’s credit history. If the applicant has been financially responsible – that is, has earned a minimum level of income, has not issued many NSF (not sufficient funds) cheques, and has made bank and credit card payments in a timely manner – the business approves the application. The amount of credit that it approves depends on the applicant’s income, amounts of other debt and the specific results of the business’s investigation. Credit sales should be made only to customers whose credit it has approved. Second, a business should monitor the accounts receivable balances of its customers. Credit customers agree to accept certain payment terms – a concept we have already raised, and which we will discuss in detail in Chapter 7. Common credit terms include ‘2/10, net/30’, where the customer agrees that a 2 per cent cash discount will be granted if they make payment within 10 days, and that, if they do not make payment, then the full amount is due in 30 days. To monitor customer credit effectively, a business needs to have an accounting system that is capable of keeping track of each customer’s credit activity. The business also needs to have an organised collection effort. It should post monthly statements to customers, and should consider payments not received in 30 days (in this case) to be past due. It should send personalised letters to customers whose accounts become past due, and should deny these customers additional credit until it collects the past-due amounts. If accounts become very overdue – say, 90 days or more – the business can use telephone calls to encourage payments. At some point, it may consider an overdue account to be uncollectable and decide not to make any further effort to collect the account, or to turn it over to a collection agency. 242

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Chapter 6 Internal control: Managing and reporting working capital Third, a business should monitor its total accounts receivable balance. If the balance increases, the business should investigate the reasons for the increase. If the increase resulted from an increase in credit sales from creditworthy customers, the business will continue with its standard collection efforts. However, if the increase resulted from a slowdown in cash collections, the business should re-examine its credit and collection policies to try to solve the problem. Regardless of the collection effort made by a business, it can expect that some of its accounts receivable will not be uncollectable. The point of the collection effort is to improve the percentage of accounts receivable that are collected. Most financial statement users know that some of a business’s accounts receivable are not collectable. In the next section, we will discuss how a business includes this information when reporting the amount of its accounts receivable on its balance sheet.

Stop & think Would you rather know the amount you are owed or the amount you expect to receive? Why?

Accounts receivable balance The amount of accounts receivable that a business reports on its balance sheet is the amount of cash it expects to receive from customers as payments for previous credit sales. The words ‘expects to receive’ reflect the fact that the business may not collect all of its accounts receivable, so the amount a business shows on its balance sheet as accounts receivable is the total owed by customers (the ‘gross’ amount) less an amount that it expects to be uncollectable. Generally accepted accounting principles (GAAP) refer to this amount as the net realisable value of accounts receivable. A business shows its accounts receivable at their net realisable value because, as part of an analysis of its liquidity, financial statement users are concerned with the business’s ability to turn accounts receivable into cash. As you will see in Chapter 9, predicting a business’s cash flows helps external users to make business decisions. The gross amount of the total accounts receivable at year-end is calculated by adding all individual customers’ balances. However, the dollar amount of accounts receivable that are uncollectable requires an estimate. This is because the business doesn’t know which customers won’t pay. (If, at the time of the credit sale, the business thought a particular customer would not pay for the goods, it would not have granted the credit!) Given the uncertainties of collecting accounts receivable, how does a business estimate the amount that it expects will be uncollectable? In general, a business bases this estimate on its past experience with collections. Using the business’s history as a guide, it either calculates the estimate as a percentage of credit sales (e.g. 1 per cent of credit sales) or bases the estimate on an ageing analysis of the accounts receivable (i.e. the older a receivable is, the more likely it is to be uncollectable). To inform financial statement users that a business is showing its accounts receivable at the net realisable value, the business places the word ‘net’ after accounts receivable on the balance sheet – that is, ‘Accounts receivable (net)’. For illustrative purposes, in Case Exhibit 6.1, Cafe´ Revive shows its accounts receivable on its 31 December 20X2 balance sheet as follows: Accounts receivable (net)

$7 340

To determine this net amount, Cafe´ Revive calculated its dollar estimate of uncollectable accounts receivable based on the age of outstanding accounts and subtracted it from the total amount of accounts receivable listed in the accounting records. Assuming Cafe´ Revive’s gross accounts receivable are $7874 (the business’s accounting system keeps track of this amount), we can determine that its estimated uncollectable accounts receivable at 31 December 20X2 are $534 ($7874 – $7340). Many businesses’ accounts receivable result from selling inventory on credit. We will discuss inventory management in the next section. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions

6.4 Inventory inventory Merchandise a retail business is holding for resale

A business’s inventory is the merchandise being held for resale. In Chapter 7, we will discuss how a business uses either a perpetual inventory system or a periodic inventory system to keep track of its merchandise. The discussion focuses on the calculation of a business’s cost of goods sold. The cost of goods sold is the cost a business has incurred for the merchandise (goods) it has sold to customers during the accounting period. The business includes the cost of goods sold as an expense on its income statement. In this section, we focus on the calculation of a business’s ending inventory. Accounting for, controlling and reporting inventory are important for several reasons. First, selling inventory is the primary way a retail or manufacturing business gets cash from operating activities (and earns a profit). If the amount of inventory is too low, the business could have future difficulties providing the cash it will need for operations. Second, a business usually expects to turn over its inventory (i.e. purchase it, sell it and replace it with newly purchased inventory) several times during the year. If inventory sales slow down, investors and creditors may become concerned about the business’s ability to continue to sell the inventory at a satisfactory profit. Third, storing inventory is expensive, due to storage space, utilities and insurance costs. Finally, inventory can be stolen and/or become obsolete. For these reasons, a business must effectively account for, control and report on its inventory.

Discussion Why do businesses sometimes sell their goods for 50 per cent off the retail price? Why do they advertise that they are having a ‘stocktake sale’? Should this affect the way they account for their inventory?

6

How can managers control inventory in a business?

purchase order Document authorising a supplier to ship the items listed on the document at a specific price

Simple inventory controls A business should establish several simple internal controls that will help safeguard its inventory and improve record-keeping. First, it should control the ordering and acceptance of inventory deliveries. In a small business, the owner is usually the only person who places orders for inventory. But even in a small business, the owner should place orders using a purchase order. A purchase order is a document authorising a supplier to ship the items listed on the document at a specific price. It is signed by an authorised person in the business. Use of purchase orders helps ensure that purchasing activities are efficient and that no unauthorised person can purchase inventory. A business should keep a list of the purchase orders (or copies of the purchase orders) where employees have access to it. Employees receiving inventory need to know what has been ordered because they should accept only approved orders. In addition, employees should check the quantity and condition of every order received. If, on further inspection, an employee finds that the order was not filled properly (e.g. boxes of the wrong coffee are received) or that the goods are damaged (e.g. bags of coffee were ripped or coffee gift packs were broken), the supplier should be notified immediately. Second, a business should establish physical controls over inventory while the inventory is being held for sale. One physical control involves restricting access to inventory. You have probably seen signs on certain business doors that state:

FOR EMPLOYEES ONLY Businesses post the signs to help to keep customers out of storage areas. Other controls include locked display cases, magnetic security devices and camera surveillance systems. Finally, to make sure that inventory records are accurate, a business should periodically take a physical count of its inventory. Whether a business uses a perpetual or a periodic inventory system (discussed in Chapter 7), by physically counting inventory, it can determine the accuracy of its inventory records and estimate losses from theft, breakage or spoilage. Almost all businesses count inventory at least once a year. Many businesses count inventory after closing on the date of their year-end balance sheet. By 244

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Chapter 6 Internal control: Managing and reporting working capital counting inventory at the end of the financial year, a business can use the inventory count to help determine the dollar amount of inventory that it will show on its balance sheet and the cost of goods sold that it will show on its income statement.

Stop & think Think about the last time you went shopping. What physical controls over inventory did you notice? Recall that Cafe´ Revive uses a perpetual inventory system, so it keeps a running balance of its inventory and cost of goods sold in its accounting records. To verify the accuracy of these balances, Emily Della and Jackson Downes spent two hours counting bags/supplies of coffee and gift packs on hand in Cafe´ Revive’s inventory after it closed on 31 January 20X2. When they were finished the stocktake, Emily calculated that Cafe´ Revive owned 50 coffee gift packs and that supplies of coffee remaining on hand were worth $345 at month-end.

Determining the cost of ending inventory A business shows its inventory on its ending balance sheet as a dollar amount. So, after the business has counted the number of units in its ending inventory, it must determine the appropriate unit cost for each item. How does a business figure out the cost of each inventory item? To answer that question, we need to explain two things: (1) the relationship among cost of goods available for sale, cost of goods sold and year-end inventory; and (2) the concept of cost flows.

Cost of goods for sale, sold and held in inventory At the start of any month, a business has a certain number of inventory items available for sale – its beginning-of-the-month inventory. For example, say Cafe´ Revive starts the month of January 20X2 with 50 coffee gift packs. During the month, a business like Cafe´ Revive sells some of its inventory and makes purchases to restock for additional sales. Ideally, at the end of the month, one of two things has happened to all the items that were available for sale during the month: either the goods were sold, or the goods remain in inventory. If Cafe´ Revive purchases an additional 240 gift packs during January and sells 240, 50 gift packs remain in inventory on 31 January. These calculations for the month of January can be summarised as: Beginning inventory for January

50 packs

þ

January purchases

240 packs

¼

Goods available for sale during January

290 packs



Goods sold during January

¼

Goods in inventory on 31 January 20X2

(240) packs 50 packs

As discussed in earlier chapters, when Cafe´ Revive prepares its financial statements for the month, it includes the cost of the goods sold during the month in the monthly income statement and the cost of the ending inventory in the month-end balance sheet, based on its perpetual inventory records. For December, Cafe´ Revive’s ‘Cost of goods sold’ account shows a balance of $6240, and its ‘Inventory’ account shows an ending balance of $1350. To arrive at these amounts, Cafe´ Revive converted the number of coffee gift packs purchased, sold and on hand to dollar amounts. Cafe´ Revive recorded these dollar amounts in its ‘Inventory’ and ‘Cost of goods sold’ accounts, as we will illustrate in Chapter 7. Case Exhibit 6.8 shows the December inventory information for Cafe´ Revive. Notice that Cafe´ Revive’s beginning inventory cost $28.60 per pack ($26 plus GST $2.60). The purchases it made on 31 January increased so the last 50 gift packs cost $29.70 ($27 plus GST $2.70). When goods cost different Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

245

Accounting Information for Business Decisions Case Exhibit 6.8 Cafe´ Revive’s inventory information 50 packs

50 @ $26 per pack ¼ $1 300

Jan. purchases

240 packs

190 @ $26 per pack ¼ 4 940

Cost of goods available for sale

290 packs

Beg. inventory, 1 Dec.

50 @ $27 per pack ¼ 1 350 Dec. sales End. inventory, 31 Dec.

7 590

(240) packs 50 packs

50 packs @ $27 1 350

unit prices, Cafe´ Revive would have to decide which cost to assign to the packs it sold and which cost to assign to the gift packs left in inventory. Or should it use both costs and, if so, to which packs should it assign $27 and to which ones $26? Or should it use the average of both costs? A business must have a method for deciding how to calculate the dollar amounts for inventory and cost of goods sold. It may use one of several methods to do so: specific identification; first in, first out (FIFO); last in, first out (LIFO), which is not used in Australia; or weighted average. (The latter three methods are discussed briefly later in this chapter and again, in more detail, in Chapter 7.) The business should use its chosen method consistently from year to year, unless a different method would better reflect the business’s operations, so that users of its financial statements can compare its performance from year to year. We will discuss the specific identification method in the next section.

Specific identification method specific identification method Allocates costs to cost of goods sold and to ending inventory by assigning to each unit sold and to each unit in ending inventory the cost to the business of purchasing that particular unit

The specific identification method allocates costs to cost of goods sold and ending inventory by assigning to each unit sold and each unit in ending inventory the cost to the business of purchasing that particular unit. Under this method, a business keeps track of the cost of each inventory item separately. Usually, it does this tracking through a computer system or an inventory coding system. For example, every coffee gift pack that Cafe´ Revive receives from DeFlava Coffee is stamped with the date that the coffee was made. Because DeFlava Coffee sends out its coffee freshly made, Cafe´ Revive can use this date to tell which shipment a gift pack came from and the exact cost of the pack. (We will use the specific identification method in our inventory discussion in Chapter 7.) Many businesses have point of sale cash register systems that scan inventory codes to keep track of the costs of inventory sold and inventory on hand. FINANCIAL STATEMENT EFFECTS

1

1

Increases current assets and total assets on balance sheet Increases revenues, which increases net income on income statement (and therefore increases owner’s equity on balance sheet). Increases cash flows from operating activities on cash flow statement

2

FINANCIAL STATEMENT EFFECTS

2

Decreases current assets and total assets on balance sheet Increases expenses (cost of goods sold), which decreases net income on income statement (and therefore decreases owner’s equity on balance sheet)

3

FINANCIAL STATEMENT EFFECTS

3

Decreases current assets and total assets on balance sheet Increases expenses (cost of goods sold), which decreases net income on income statement (and therefore decreases owner’s equity on balance sheet)

The inventory amount that Cafe´ Revive shows on its 31 January 20X2 balance sheet is calculated from the results of the physical inventory count. (This amount should be the same as the amount that it shows in its accounting records.) Recall that 50 gift packs remained in inventory on 31 January. Under the specific identification method, in addition to counting the inventory, Emily and her employee must keep track of the 246

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Chapter 6 Internal control: Managing and reporting working capital gift packs according to the stamped dates. Case Exhibit 6.9 shows Emily’s inventory count instructions, the results of the count, and the year-end inventory and cost of goods sold calculations. Case Exhibit 6.9 Cafe´ Revive’s year-end inventory calculation The inventory count After Cafe´ Revive closes on the evening of 31 January 20X2, Emily and one employee, Jackson, spend two hours counting the business’s inventory. Emily tells Jackson how the count will work: ‘You and I will count all of the items independently. I will follow along behind you. We will count one section of the shop at a time. Both of us will mark our findings on inventory count sheets, noting separately the number of gift packs. After we finish each section of the shop, we will compare our results to see that we agree on the count. If the numbers don’t match, we will recount the section. After we count all of the inventory, we will compute a total for the number of gift packs and the supplies of coffee on hand.’

Results of the inventory count Cafe´ Revive’s inventory count ran smoothly. After compiling all the inventory count sheets, Emily concluded that the year-end inventory consisted of the following: 50 gift packs purchased on 31 January at a cost of $27.00. These calculations are shown in the following.

31 January 20X2 inventory calculation 50 packs @ $27

1 350.00

Ending inventory

$1 350.00

January cost of goods sold calculation Cost of goods available for sale (see Case Exhibit 6.7)

$ 7 590.00

– Ending inventory

(1 350.00)

Cost of goods sold

$ 6 240.00

Using the information contained in Case Exhibit 6.9, can you see what the calculations for each other inventory method would be? This is outlined below in the following. (Note that there is more discussion of each of these methods in Chapter 7, where their implications for net income are discussed.)

FIFO Ending inventory Cost of goods sold

LIFO

50 @ 27

1 350

50 @ 26

1 300

240 @ 26

6 240

190 @ 26

4 940

50 @ 27 7 590

Weighted average *50 @ 26.17

1 309

1 350 240 @ 26.17

6 281

7 590

7 590

* Weighted average cost (6 240þ1 350) / 290 ¼ $26.17

Discussion As a manager, would you choose the specific identification method for a coffee business? Why?

Because Cafe´ Revive’s physical inventory count of 50 gift packs is the same as the calculation of its ending inventory from its perpetual inventory records of beginning inventory, purchases and sales shown earlier, the $1350 cost of the ending inventory calculated in Case Exhibit 6.9 is the same as the amount in its Inventory account. Also, the $6240 cost of goods sold calculated in Case Exhibit 6.9 is the same as the amount in its ‘Cost of goods sold’ account. So by taking a physical count, Cafe´ Revive has verified that the amounts in its accounting records are correct. Now suppose that Emily and her employee counted 45 gift packs. In this case, five gift packs are missing, and the cost of the ending inventory is $1215 (45  $27). Emily should try to find out why these gift packs are missing. For instance, they may have been given away as ‘free samples’, stolen (or consumed by the employees) or thrown away because they were presumed stale. Whatever the reason, she should adjust the Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions accounting records by increasing the ‘Cost of goods sold’ account and decreasing the Inventory account by $135 (5  $27) for the missing gift packs.

Stop & think Suppose that the year-end count of inventory is less than the accounting records show as ending inventory because Emily threw away some boxes of stale coffee. How might this information affect Emily’s future decisions?

Other methods to determine inventory at end and cost of goods sold As mentioned earlier in the chapter, there are several methods for determining dollar amounts for inventory at year-end and cost of goods sold. Cafe´ Revive has chosen the specific identification method, but how would the figures have appeared had the FIFO LIFO or weighted average methods been used? The adoption of different methods leads to different value for cost of goods sold and ending inventory. A brief description of each of these methods follows. The FIFO method means that when valuing inventory that is sold and on hand at the end, goods or stock that is purchased first is sold first. This means that the cost of inventory on hand at the end is valued at the last price paid as inventory that was purchased at earlier prices would have been sold and recorded as part of cost of goods sold. The LIFO method means that goods purchased last (or most recently) are sold first. This method may result in unsold stock becoming out of date, but means that the cost of valuing inventory on hand at the end is usually at the earlier price, while costs of goods sold throughout the period are valued at most recent prices. The weighted average method requires the unit price of inventory to be calculated and updated after each transaction. The value is determined by recalculating the average price. For example, if, at 1 February, there are 50 units at $26.17 worth $1309, and the purchases another 20 units at $27 worth $540, then the value of each unit would be calculated as: 1 309 þ 540 ¼ 1 849 50 þ 20 ¼ 70 Unit Value ¼ 1 849=70 ¼ $26:41 per unit Inventory will be discussed further in Chapter 7.

Stop & think As a manager, which method would you use to calculate cost of goods sold and ending inventory? Why?

6.5 Accounts payable accounts payable Amounts owed to suppliers for credit purchases

248

As we explained earlier in the chapter, businesses often sell to customers on credit. These credit sales result in accounts receivable. Similarly, businesses often make purchases on credit, which result in the liability accounts payable. Accounts payable are the amounts that a business owes to its suppliers for previous credit purchases of inventory and supplies. The reasons for purchasing on credit are similar to the reasons for selling on credit. The first reason is that it is often more convenient than purchasing with cash. The second reason for purchasing on credit is to delay paying for purchases and, by doing so, to obtain a short-term ‘loan’ from the supplier. Many businesses – particularly small businesses – are often short of cash and find it difficult to pay for their purchases immediately. Managers of these businesses therefore try to delay payment until their businesses receive the cash from the eventual sale of their products; they then use this cash to pay the amounts their businesses owe. This delay is the reason many suppliers offer their customers cash discounts for prompt payment. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 6 Internal control: Managing and reporting working capital

Simple controls over accounts payable A business’s accounts payable represent promises to pay the amounts due to other businesses. As is the case with accounts receivable, a business needs controls over accounts payable. Controls over accounts payable should focus on three primary concerns. The first concern involves the ability of employees to make the business responsible for an account payable. Giving too many employees the authority to place orders for business purchases makes it more difficult for managers to coordinate and monitor credit purchases, and makes it easier for untrustworthy employees to make the business responsible for personal expenditures. In response to this concern, a business should limit the number of employees who have the authority to make business purchases. In a small business, this authority may be given only to the owner. Larger businesses usually have a purchasing department that controls all purchases. Second, once a business incurs an account payable, the business is concerned that it makes each payment at the appropriate time and that the supplier records each payment properly. A business monitors the timeliness of its payments by having an employee keep track of the credit terms of each account payable. If cash discounts are available, the business should take advantage of the cash savings by making the payment within the cash discount period. A business makes sure that the supplier records its payments properly by checking the supplier’s monthly statements. If the payment is not recorded properly, an employee should investigate the discrepancy and perhaps contact the supplier. Finally, managers, investors and creditors are concerned about a business’s total dollar amount of accounts payable because, in the very near future, the business will need to use its cash to pay these liabilities. If the accounts payable are large, relative to the business’s current assets, the business may experience liquidity problems. Managers will investigate relatively large increases in accounts payable. If the increase is a result of planned increases in inventory, they assume that increased sales will provide the cash needed to pay the liabilities. If the increase is a result of cash flow problems, managers may postpone purchases of inventory and/or property and equipment, or may contact suppliers to try to arrange an extension of the credit terms.

7

How can managers control accounts payable in a business?

Accounts payable balance The amount of accounts payable that a business owes on the balance sheet date is listed in the current liabilities section of the ending balance sheet. A business calculates this amount by summing the accounts payable owed to individual suppliers. As Case Exhibit 6.1 shows, on 31 December 20X2, after one year of operations Cafe´ Revive’s total accounts payable is $6200.

Discussion Has anyone ever forgotten to repay you for money that they borrowed? Has it ever been difficult for you to pay off a debt? How should a business handle these situations? What factors should it consider when developing policies concerning late payments by its customers or to its suppliers?

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Accounting Information for Business Decisions

Business issues and values: Working capital We began this chapter by stating that managing working capital effectively is an important part of financial management. This is especially true for new businesses that have a relatively small amount of capital, and that may be prone to liquidity problems. But how aggressive should a business be in managing its working capital? When trying to collect accounts receivable payments, some businesses repeatedly telephone customers at their offices and homes. On the other hand, when trying to hold off paying their own debts, some businesses continue to tell suppliers that ‘the cheque is in the mail’ when it really is not. The ethics of aggressive working capital management have been questioned by some business leaders and critics. Instead of being seen as conscientious, a business that uses aggressive collection efforts can be viewed as intimidating and harassing. A business that signs a purchase agreement, even though it knows that it will make suppliers wait an additional 30 or 60 days before paying for the goods, can be viewed as untrustworthy, not as a shrewd financial planner. In addition, managing working capital is critical for both the present liquidity and the longer-term sustainability of the business. Effective working capital management will enable the business to Ehnics and Sustainability

250

have sufficient funds on hand not only for its usual operations but also to take advantage of growth opportunities for the business.

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Chapter 6 Internal control: Managing and reporting working capital

STUDY TOOLS Summary 6.1 Define the concept of ‘working capital’ and reasons for exercising control over working capital items. 1

What is working capital and why is its management important?

Working capital is current assets minus current liabilities. A business needs to manage its working capital so that it will keep an appropriate balance between having enough to conduct its operations and to handle unexpected needs, and having too much so that profitability is reduced.

6.2 Discuss why managing the asset cash in terms of cash receipts and cash payments is so important. 2

How can managers control cash receipts in a business?

Managers can control cash receipts by requiring the proper use of a cash register, separating the duties of receiving and processing collections of accounts receivable, and depositing receipts every day. 3

How can managers control cash payments in a business?

Managers can control cash payments by paying all bills by cheque, paying only for approved purchases supported by source documents, and immediately stamping ‘Paid’ on the supporting documents after payment. 4

What is a bank reconciliation, and what are the causes of the difference between a business’s cash balance in its accounting records and its cash balance on its bank statement?

A bank reconciliation is an analysis that a business uses to resolve the difference between the cash balance in its accounting records and the cash balance reported by the bank on its bank statement. The causes of the difference are deposits in transit, outstanding payments/cheques, deposits made directly by the bank, charges made directly by the bank and errors.

6.3 Understand how to properly monitor and control accounts receivable. 5

How can managers control accounts receivable in a business?

Managers can control accounts receivable by evaluating a customer’s ability to pay before extending credit, monitoring the accounts receivable balance of each customer, and monitoring the total accounts receivable balance.

6.4 Identify control procedures and methods for inventory. 6

How can managers control inventory in a business?

Managers can control inventory by establishing policies for ordering and accepting inventory, establishing physical controls over inventory being held for sale and taking a periodic physical count of the inventory.

6.5 Explain the need to manage accounts payable. 7

How can managers control accounts payable in a business?

Managers can control accounts payable by coordinating and monitoring credit purchases, making payments at the appropriate time and monitoring the total accounts payable balance.

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Accounting Information for Business Decisions

Key terms accounts payable

deposit in transit

purchase order

accounts receivable

internal control structure

specific identification method

bank reconciliation

inventory

working capital

bank statement

NSF (not sufficient funds)

cash

petty cash fund

Online research activity This activity provides an opportunity to gather information online about real-world issues related to the topics in this chapter. For suggestions on how to navigate various businesses’ websites to find their financial statements and other information, see the related discussion in the Preface. Go to the websites of Woolworths Supermarkets (http://www.woolworths.com.au) and Coles (http://www.coles.com.au). 1 What credit control policies does each company exercise? 2 Which inventory methods does each company use? 3 What controls over inventory are exercised by each company?

Integrated business and accounting situations Answer the following questions in your own words.

Testing your knowledge 6-1 6-2 6-3 6-4 6-5 6-6 6-7 6-8 6-9 6-10 6-11 6-12 6-13 6-14 6-15 6-16 6-17 6-18 6-19 6-20 6-21 6-22 6-23 6-24 6-25

252

What is a business’s working capital, and what do its two components comprise? Why does a business need to manage its working capital? What is included in ‘cash’ for a business? Why is it so important that cash and cash flow be managed in a business? Briefly discuss the controls over cash sales. Briefly discuss the controls that should be put in place to manage over collections of cash from accounts receivable. Briefly discuss the controls that should be put in place to ensure cash payments are authorised and made in a timely manner. What is a bank reconciliation? Identify the causes of the difference between the ending cash balance in a business’s records and the ending cash balance reported on its bank statement. Briefly explain what is meant by the terms ‘deposits in transit’ and ‘outstanding cheques’? What does ‘insufficient funds’ mean in relation to a transaction on a bank statement? Briefly explain what are included in deposits made directly by the bank and charges made directly by the bank. Prepare an outline of a bank reconciliation for a business. Briefly explain what a petty cash fund is and how it works. Why do businesses make sales on credit? Briefly discuss the controls over accounts receivable. Briefly explain how a business reports its accounts receivable on its ending balance sheet. Why is accounting for, controlling and reporting of inventory important? Briefly discuss the controls over inventory. What does a ‘stock out’ mean? What are the implications of this? How can it be prevented? Briefly explain how the specific identification method works for determining inventory costs. To what does FIFO refer? How is the LIFO method of costing different from the FIFO method in terms of the effect on net profit for a period? Evaluate this statement: ‘My business uses a perpetual inventory system, so it doesn’t need to take a periodic physical inventory.’ Briefly discuss the controls over accounts payable.

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Chapter 6 Internal control: Managing and reporting working capital

6-26 6-27

Why is it important that a business pays accounts payable in a timely manner? ‘If all employees behave ethically, there is no need for expensive control systems to manage working capital.’ Do you agree or disagree with this statement? Why?

Applying your knowledge 6-28

6-29

6-30

6-31

Following are several internal control weaknesses of a small retail business in regard to its cash receipts and accounts receivable: i Sales invoices are not pre-numbered. ii Receipts from daily sales are deposited every Tuesday and Thursday evening. iii One employee is responsible for depositing customer cheques from collections of accounts receivable and for recording their receipt in the accounts. iv For credit sales on terms of 2/10, net/30, customers are allowed, for convenience, a discount if payment is received within 20 days. v A money box is used instead of a cash register to store both the sales invoices and cash from sales. vi Credit sales of a large dollar amount can be approved by any sales employee. vii When customers write cheques for payment, only the identification of customers who ‘look untrustworthy’ is verified. Required: a For each internal control weakness, explain how the weakness might result in a loss of assets. b For each internal control weakness, explain what action should be taken to correct the weakness. The following are several internal control weaknesses of a retail business in regard to its cash payments, accounts payable and inventory: i The inventory of gold jewellery for sale is kept in unlocked display cases. ii One employee is responsible for ordering inventory and writing cheques. iii Some purchases are made by phone, and no purchase order is written up. iv The business takes a physical inventory every two years. v Employees are allowed to bring coats, bags and handbags into working areas. vi Inventory received at the loading dock is rushed immediately to the sales floor before it is counted. vii When inventory is low, any sales employee can prepare a purchase order and post it to the supplier. viii For efficiency, the business pays invoices on credit purchases once a month, even if it has to forgo any cash discounts for prompt payment. Required: a For each internal control weakness, explain how the weakness might result in a loss of the assets of the business. b For each internal control weakness, explain what action should be taken to correct the weakness. A Robetto & Co. is preparing its bank reconciliation, and discovers the following items: i outstanding cheques ii deposits in transit iii deposits made directly by the bank into business account with the bank iv charges made directly by the bank to the business account with the bank v the bank’s erroneous under-recording of a deposit vi the business’s erroneous under-recording of a cheque it wrote. Required: Indicate how each of these items would be used to adjust: a the business’s cash balance b the bank balance to calculate the reconciled cash balance. At the end of March, the Elbert Company records showed a cash balance of $7027. When comparing the 31 March bank statement with the business’s ‘Cash’ account, the business discovered that deposits in transit were $725, outstanding cheques totalled $862, bank service charges were $28 and NSF cheques totalled $175. Required: a Calculate the 31 March reconciled cash balance of the Elbert Company. b Calculate the cash balance listed on the 31 March bank statement.

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6-32

6-33

At the end of September, the Cyclops Bicycle Company’s records showed a cash balance of $3513. When comparing the business’s 30 September bank statement, which showed a cash balance of $1860, with its ‘Cash’ account, the business discovered that outstanding cheques were $462, bank service charges were $23 and NSF cheques totalled $89. Required: a Calculate the 30 September reconciled cash balance of the Cyclops Bicycle Company. b Calculate the September deposits in transit. The following five situations (columns 1–5) are independent.

Ending balance in the business’s bank account

254

3

4

5

(a)

$2 000

$4 000

$12 000

$3 000

(b)

500

450

200

Deposits in transit

700

800

(c)

500

900

Outstanding cheques

450

1 200

600

(d)

1 000

6 000

3 000

4 100

12 000

(e)

Ending cash balance from bank statement

6-35

2

$200

Deposits made directly by the bank

6-34

1

Required: Calculate each of the unknown amounts, items (a) to (e). An examination of the accounting records and the bank statement of the Evans Company at 31 March provides the following information: i The ‘Cash’ account has a balance of $6351.98. ii The bank statement shows a bank balance of $3941.83. iii The 31 March cash receipts of $3260.95 were deposited in the bank at the end of that day, but were not recorded by the bank until 1 April. iv Cheques issued and mailed in March but not included among the cheques listed as paid on the bank statement were: Cheque no. 706

$869.38

Cheque no. 717

212.00

v A bank service charge of $30 for March was deducted on the bank statement. vi A cheque received from a customer for $185 in payment of his account and deposited by the Evans Company was returned marked ‘NSF’ with the bank statement. vii Interest of $20.42 earned on the business’s bank account was added on the bank statement. viii The Evans Company discovered that cheque no. 701, which was correctly written as $562 for the March rent, was recorded as $526 in the business’s accounts. Required: a Prepare a bank reconciliation on 31 March. b Record the appropriate adjustments in the business’s accounts. Calculate the ending balance in the ‘Cash’ account. You have been asked to help the Rancher Company prepare its bank reconciliation. You examine the business’s accounting records and its bank statement at 31 May, and find the following information: i The ‘Cash’ account has a balance of $7753.24. ii The bank statement shows a bank balance of $3783.04. iii The 31 May cash receipts of $4926.18 were deposited in the bank at the end of that day, but were not recorded by the bank until 1 June. iv Cheques issued and mailed in May but not included among the cheques listed as paid on the bank statement were: Cheque no. 949

$518.65

Cheque no. 957

699.95

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Chapter 6 Internal control: Managing and reporting working capital

6-36

v A bank service charge of $27 for May was deducted on the bank statement. vi A cheque received from a customer for $241 in payment of her account and deposited by the Rancher Company was returned marked ‘NSF’ with the bank statement. Interest of $25.18 earned on the business’s bank account was added on the bank statement. vii The Rancher Company discovered that cheque no. 941, which was correctly written as $647.21 for the May electricity bill, was recorded as $627.41 in the business’s accounts. Required: a Prepare a bank reconciliation on 31 May. b Record the appropriate adjustments in the business’s accounts. Calculate the ending balance in the ‘Cash’ account. Munro Pty Ltd presented you with the following information relating to the June bank reconciliation process. You are required to reconcile the records of the business with the bank statement and: a adjust the ‘Cash at bank’ account b prepare a bank reconciliation statement as at 30 June c journalise the entries required in Munro’s books. Note: Assume any errors in amounts have been made by the bank. Bank reconciliation statement at 31 May 20X1 Balance as per bank statement

12 367.90

Add: Deposits in transit

1 980.50 14 348.40

Less: Outstanding cheques and payments

No. 2470

(1 530.20)

No. 2471

(844.50)

No. 2472

(1 426.80)

(3 801.50)

Adjusted cash balance

$10 546.90

The June bank statement shows the following withdrawals and deposits: Date

Details

1 June

Balance 2470

Debit

Credit

Balance 12 367.90

1 530.20

Deposit

10 837.70 1 980.50

844.50

12 818.20

2

2471

11 973.70

4

Deposit

5

2475

1 640.70

12 543.70

2 850.00

9 693.70

55.00

9 638.70

2 210.70

8

2476

10

Bank fees

13

Deposit

15

2478

1 750.00

18

Dishonoured cheque – insufficient funds

2 120.00

21

Deposit

25

Dividend

2 575.00

14 184.40

12 213.70 10 463.70 8 343.70

2 945.00

11 288.70

500.00

11 788.70

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Accounting Information for Business Decisions

The records for the cashbooks are as follows: Cash at bank balance 1 June

$10 546.90

Cash receipts Date

6-37

Cash payments

Amount

2475

1 640.70

12 June

2 575.00 12 June

2476

2 830.00

20 June

2 945.00 24 June

2477

678.00

27 June

2 855.00 28 June

2478

1 750.00

30 June

2479

1 230.00

The Huron Company keeps a petty cash fund of $80. On 30 June, the fund contained cash of $36.87 and these petty cash receipts:

Miscellaneous

6-40

Amount

2 210.70 1 June

Postage

6-39

Cheque no.

3 June

Office supplies

6-38

Date

$10.00 27.48 5.65

Required: a If the business’s fiscal year ends on 30 June, should the petty cash fund be replenished on 30 June? Why? b How much cash is needed to replenish the petty cash fund? c Prepare entries in the business’s accounts to record the petty cash payments. On 31 December, the Big Hole Property Management Company had a balance of $70 in its petty cash fund, a reconciled balance of $1283 in its bank account and a $4627 balance in its savings account. Required: Show how the business would report its cash on its 31 December balance sheet. On 1 January, the balance in the accounts receivable account for James Pty Ltd was $4125. During the next six months, credit sales amounted to $13 075 and clients paid $14 560 to settle their accounts after allowances for goods returned by clients of $240. At 30 June, James Pty Ltd has decided to write off accounts receivable of $450 as a bad debt. Required: a Calculate the ending balance of ‘Accounts receivable’ at 30 June. b What steps might the business take to reduce the possibility of incurring bad debts in future? Johnson and Bates run a small business and are worried about their accounts receivable spiralling out of control. a Advise them of the steps they can take to manage credit and recover outstanding accounts. They are thinking about which method to calculate an amount for debts that might become bad. They are considering two methods: i percentage of credit sales @ 1% of credit sales annually ii ageing of debtors. Suppose their credit sales average $235 000 for a six-month period, and they have accounts receivable of $93 000 at present, with days outstanding and expected uncollectable rates being as follows: 0 to 30 days

$51 000 1% uncontrollable

31 to 60 days

$24 000 1.5% uncontrollable

61 to 90 days

$12 000 5% uncontrollable

Over 90 days

$ 6 000 50% uncontrollable

b What method would you recommend they choose to calculate uncollectable debts and why? c What would be the difference between the amount recorded in the balance sheet for accounts receivable for each method?

256

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Chapter 6 Internal control: Managing and reporting working capital

6-41

6-42

The Heat Be Gone business sells one type of air conditioner, and uses the perpetual inventory system. At the beginning of January, the business had a balance in its cash account of $2100 and an inventory of eight units (air conditioners) costing $100 each. During January, it made the following purchases and sales of inventory: 5 Jan.

Purchases

4 units @ $102 per unit

12

Sales

11 units @ $150 per unit

18

Purchases

12 units @ $104 per unit

25

Purchases

6 units @ $103 per unit

29

Sales

13 units @ $150 per unit

All purchases and sales were for cash. The business uses barcodes to verify each sale (i.e. specific identification). Of sales on 12 January, eight were units from the beginning inventory and three were units purchased on 5 January. Of the sales on 29 January, nine were units purchased on 18 January and four were units purchased on 25 January. Required: a Record the beginning balances in the ‘Cash’ and ‘Inventory’ accounts. Using account columns, record the purchases and sales transactions during January, and calculate the ending balances of all the accounts you used. b Assume that the business counted its inventory at the end of January and determined that it had six air conditioners on hand. Prove that the ending balance in the inventory account that you calculated in (a) is correct. c Calculate the business’s gross profit. The Short Cut Lawnmower Store sells one type of lawnmower at a price of $200 per unit. On 1 June, it had an $800 accounts receivable balance and a $600 accounts payable balance, as well as an inventory of 10 mowers costing $120 each. During June, its purchases and sales of mowers were: Purchases 8 June

7 mowers @ $125 each

15

11 mowers

21

6 mowers @ $121 each

26

4 mowers @ $124 each

30

Sales

8 mowers

All purchases and sales were on credit. No payments or collections were made during June. The business has a perpetual inventory system and uses barcodes to verify each sale, which allows the specific identification method of inventory valuation to be used. Of the 15 June sales, eight were mowers from the beginning inventory and three were mowers purchased on 8 June. Of the 30 June sales, two were mowers from the beginning inventory, five were mowers purchased on 21 June and one was a mower purchased on 26 June. Required: a Assume that the business uses the specific identification method and that it counted its inventory at the close of business on 30 June to determine that it had eight mowers in stock. Calculate the ending balance in the inventory account and the cost of goods sold. b Following on from (a) above, record the beginning balances in the accounts receivable, inventory and accounts payable accounts. Using account columns, record the purchases and sales transactions during June, and calculate the ending balances of all the accounts you used. c Assume that the business uses the first-in, first-out (FIFO) method, and that it counted its inventory at the close of business on 30 June and determined that it had eight mowers in stock. Calculate the ending balance in the inventory account and the cost of goods sold. d Use the same information as for (c) above, but assume that the business uses the last-in, first-out (LIFO) method to calculate the ending balance in the inventory account and the cost of goods sold. e Use the same information as (c) above, but assume that the business uses the weighted average method to calculate the ending balance in the inventory account and the cost of goods sold. f Calculate the business’s gross profit percentage for June using the specific identification method. How does this compare with its gross profit percentage of 40.8 per cent for May? What might account for the difference? Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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6-43

Bugs-Be-Gone sells two types of screen doors: Model A, which sells for $30, is the basic screen door, and Model B, which sells for $50, is the deluxe screen door. At the beginning of July, the business had a balance in its cash account of $1600 and an inventory consisting of 12 units of Model A, costing $20 each, and 15 units of Model B, costing $35 each. During July, it made the following purchases and sales of inventory: Model A 6 July

Sales

13

Purchases

20

Sales

24 29

8 units @ $30 each

Model B 10 units @ $50 each

9 units @ $19 each

10 units @ $36 each

10 units @ $30 each

12 units @ $50 each

Purchases

7 units @ $21 each

6 units @ $37 each

Sales

7 units @ $30 each

3 units @ $50 each

All purchases and sales were for cash. The business has a perpetual inventory system that uses barcodes to verify each sale. For the 20 July sales, three units of Model A were from the beginning inventory and seven were units purchased on 13 July; five units of Model B were from the beginning inventory and seven were units purchased on 13 July. For the 29 July sales, one unit of Model A was purchased on 13 July and six were units purchased on 24 July; one unit of Model B was purchased on 13 July and two were units purchased on 24 July. On 31 July, the business counted its inventory and determined that it had three units of Model A and six units of Model B on hand. However, one of the three units of Model A was run over by a customer’s truck and had to be thrown away. This unit had been in the beginning inventory. Required: a Record the beginning balances in the ‘Cash’ and ‘Inventory’ accounts. Using account columns (use one account column for inventory), record the purchases and sales transactions during July, and calculate the ending balances of all the accounts you used. b Record the disposal of the damaged unit and prove the accuracy of the ending balance in the inventory account. c Calculate the gross profit percentage. How was this affected by the damaged inventory? d Do you think your work would have been easier if you had used two inventory accounts in (a)? How do you think a business with many items of inventory keeps track of these items under a perpetual inventory system?

Making evaluations 6-44

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6-46

258

Your friend, an avid sports fan, recently purchased a cricket bat from a catalogue. While he was filling out the order form, he noticed the warning, ‘Don’t send cash!’ He asked you, ‘Does it seem odd to you that a business wouldn’t appreciate receiving cash? You’re taking accounting. Don’t they teach you that businesses need cash? Why would they say such a thing?’ Required: Tell your friend why you think the business puts this warning in its catalogues and give him some examples of what might happen if customers paid for their purchases with cash. Explain how EFT and credit cards might prevent this from happening. Sam Lewis has been operating a ‘full-service’ service station for several years. Although he has occasionally employed students part time, he has collected the cash and cheques for petrol and repair work himself. He now has decided to open a second ‘full-service’ service station and to put himself more in the role of manager. He will hire employees to run the service stations, to pump petrol and to do repair work. Required: How should Sam Lewis implement internal control procedures over cash receipts for the service stations? Who should be in charge of making payments on behalf of the second service station? Your father’s friend Frank has a business, Frank’s Franks, which is involved in the street-corner vending of sausages, pies and soft drinks. It’s a small business with an office and four vending carts located in different areas of the city. When you asked Frank what kind of internal controls his business has in place, Frank said, ‘We don’t have a formal system of internal controls – don’t need them. My employees are family members and friends, and I trust them completely! When the business grows and I have to hire strangers, then I’ll think about those controls. But for now, the business is

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Chapter 6 Internal control: Managing and reporting working capital

6-47

6-48

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profitable, and I’m happy.’ After Frank left, you talked to your father about what you had learned in accounting and asked whether he thought Frank would appreciate hearing about it. He assured you that Frank would be open to your suggestions. Required: Write a letter to Frank questioning whether ‘trust’ is enough. Explain how you think his business would benefit from a system of internal controls, even though he trusts his employees. Also describe specific controls that Frank could use in his business. Your sister, Ella, works at a bar in an upmarket hotel located above a shopping centre that includes a bank. She often works the late shift and doesn’t leave work until 1 or 1.30 a.m. One day, when you were having lunch with her, she began complaining about an aspect of her job: ‘My boss is a real stickler for procedures. Even though it’s really late when the last customer leaves, and even though we’re exhausted, we still have to follow procedure. Before the boss and I can leave, we have to count the money in the register and match it against the register tape and match both amounts against the dollar total of the bills the customers paid. And, as if that’s not enough, we have to make sure that every bill number is accounted for. Every night, the manager writes down the numbers of the bills each staff member has been given to use that night for taking customer orders. At the end of the night, the bar staff gives the cashier all the bills that weren’t used. If any money is missing, guess who takes the blame and has to make up the difference? After we count the money, we have to put it and the tape in a deposit bag, walk it across the parking area to the bank and deposit it in the bank’s night-deposit box, even though there is a safe right under the cash register! Like we’re not sitting ducks for anybody who wants to rob us. I don’t understand why she would risk our lives like that. Also, she unlocks the part of the register that contains a copy of the tape we took to the bank, and uses that tape to enter the day’s cash receipts amount into the accounting system. Like, she trusts me so much that she has to keep the tape copy under lock and key. What a jerk!’ Now that you are studying accounting, you have a little better insight into why the boss is so interested in these procedures. Required: Explain to Ella what’s going on before she does something rash, like quit her job. The Anibonita Company is a retail shop with three sales departments. It also has a small accounting department, a purchasing department and a receiving department. All inventory is kept in the sales departments. When the inventory for a specific item is low, the manager of the sales department that sells the item notifies the purchasing department, which then orders the merchandise. All purchases are on credit. Anibonita pays the freight charges on all its purchases after being notified of the cost by the freight business. When the inventory is delivered, it is inspected and checked in by the receiving department, then sent to the sales department, where it is placed on the sales shelves. After notification that the ordered inventory has been received, the accounting department records the purchase. Upon receipt of the supplier’s invoice or the freight bill, the accounting department verifies the invoice (or freight bill) against the purchase order and the receiving report before making payment. Required: Briefly explain the internal controls that the Anibonita Company uses for its purchasing process. Include in your discussion what source documents it probably uses. The JeBean Company makes sales only on credit. All of JeBean’s customers order online and receive stock via a freight company. The business has a small accounting department, a credit department, an inventory department and a despatch department. After approval of an order by the credit department, the merchandise is assembled in the inventory department and then sent to the despatch department. Despatch packs the merchandise in cardboard boxes; it is then picked up by the freight company to be sent to the customer. The JeBean Company pays for freight charges on all items sent to customers after being notified of the cost by the freight company. After verification of despatch, the accounting department posts an invoice to the customer and records the sale. On receipt of the customer’s bank details, the accounting department records the collection. Required: Briefly explain the internal controls that the JeBean Company uses for its sales process. Include in your discussion what source documents it probably uses. Oliver Bauer, owner of Bauer’s Retail Store, has been very careful to establish good internal control over inventory purchases for his shop. The shop has several employees and, since Oliver cannot devote as much time as he would like to running the shop, he has entrusted a long-term employee with the task of purchasing inventory. This employee has

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worked for Oliver for 15 years and knows all the shop’s suppliers. Whenever inventory must be purchased, the employee prepares a purchase order and posts it to the supplier. When a rush order is needed, the employee occasionally calls in the order and does not prepare a purchase order. This procedure is acceptable to the suppliers because they know the employee. When the merchandise is received from the supplier, this employee carefully checks in each item to verify the correct quantity and quality. This job is usually done at night, after the shop is closed, thus allowing the employee to help with sales to customers during normal working hours. After checking in the items, the employee initials the copy of the supplier invoice received with the merchandise, staples the copy to the purchase order (if there is one), records the purchase in the business’s accounts and prepares a cheque for payment. At this point, Oliver Bauer examines the source documents (purchase order and initialled invoice) and signs the cheque, and the employee records the payment. Oliver has become concerned about the shop’s gross profit, which has been steadily decreasing even though he has heard customers complaining that the shop’s selling prices are too high. He has a discussion with the employee, who says, ‘I’m doing my best to hold down costs. I will continue to do my purchasing job as efficiently as possible – even though I’m overworked. However, I think you should hire another salesperson and spend more on advertising. This will increase your sales and, in turn, your gross profit.’ Required: Why do you think the gross profit of the shop has gone down? Prepare a report for Oliver Bauer that summarises any internal control weaknesses existing in the inventory purchasing procedure, and explain what the result might be. Make suggestions for improving any weaknesses you uncover. In the chapter, we mentioned that if Cafe´ Revive came up short four coffee gift packs, it should increase its cost of goods sold account and decrease its inventory account by the cost of those gift packs. Suppose Emily wanted to keep a record of coffee shortages in the accounting system. Required: Design a way that Cafe´ Revive’s accounting system could be changed to accommodate Emily’s request. Suppose that one of your business’s largest customers has written an NSF cheque for $9734, and your boss has just found out about it. He comes flying into your office demanding to know how this NSF cheque will affect specific accounts in the business’s financial statements. You examine the bank statement that came in the morning’s post, and notice that not only has the customer written an NSF cheque but the bank has charged you a fee of $75 for processing this cheque. Required: List the accounts that will be affected by this turn of events, and indicate how much they will be affected. What do you think should happen next? You are a consultant for several businesses. The following are independent situations you have discovered, each of which may or may not have one or more internal control weaknesses. (The names of the businesses have been changed to protect the innocent.) i In Business A, one employee is responsible for counting and recording all the receipts (remittances) received in the post from customers paying their accounts. Customers usually pay by cheque, but occasionally they mail cash. Every day, after the mail is delivered, this employee opens the envelopes containing payments by customers. She carefully counts all remittances and places the cheques and cash in a bag. She then lists the amount of each cheque or cash received and the customer’s name on a sheet of paper. After totalling the cash and cheques received, she records the receipts in the business’s accounts, endorses the cheques in the business’s name, and deposits the cheques and cash in the bank. ii Business B has purchased several calculators for use by office and sales employees. So that these calculators will be available to any employee who needs one, they are kept in an unlocked storage cabinet in the office. Anyone who takes and uses a calculator ‘signs out’ the calculator by writing their name on a sheet of paper posted near the cabinet. When the calculator is returned, the employee crosses out their name on the sheet. iii Business C owns a van for deliveries of sales to customers. No mileage is kept of the deliveries, although all petrol and oil receipts are carefully checked before being paid. To advertise the shop, Business C has two signs with the shop’s name hung on either side of the van. These signs are easily removable so that the van can be cleaned periodically without damaging the signs. The business allows employees to borrow the van at night or on the weekends if they need it for personal use. No record is kept of personal use, but the employee who borrows the van must fill the petrol tank before returning it.

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Chapter 6 Internal control: Managing and reporting working capital

iv Employee Y is in charge of employee records for Business D. Whenever a new employee starts, the new employee’s name, address, salary and other relevant information are properly recorded. On payday, all employees are paid by cheque. At this time, Employee Y makes out each employee’s cheque, signs it and gives it to each employee. After distributing the pay cheques, Employee Y makes an entry in the business’s accounts, increasing ‘Salaries expense’ and decreasing ‘Cash’ for the total amount of the salary cheques. v To reduce paperwork, Business E places orders for purchases of inventory from suppliers by phone. No purchase order is prepared. When the goods arrive at the business, they are immediately brought to the sales floor. An employee then authorises payment based on the supplier’s invoice, writes and signs a payment authorisation and makes payment to the supplier. Another employee uses the paid invoice to record the purchase and payment in the business’s accounts. vi All sales made by Business F, whether they are for cash or on account, are ‘rung up’ on a single cash register. Employee X is responsible for collecting the cash receipts from sales and the customer charge slips at the end of each day. The employee carefully counts the cash, preparing a ‘cash receipts’ slip for the total. Employee X sums the amount on the cash receipts slip and the customer charge slips, and compares this total with the total sales on the cash register tape to verify the total sales for the day. The cash register tape is then discarded and the cash is deposited in the bank. The cash receipts slip and the customer charge slips are turned over to a different employee, who records the cash and credit sales in the business’s accounts. Required: a List the internal control weakness or weaknesses you find in each of the above independent situations. If no weakness can be found, explain why the internal control is good. b In each situation in which there is an internal control weakness, describe how you would remedy the situation to improve the internal control.

Dr Decisive Yesterday, you received the following letter for your advice column in the local paper:

Dear Dr Decisive Well, this takes the cake! I thought my boss was a little on the shady side, and now I’m pretty convinced but some of my friends think I’m wrong. What do you think? Here’s some background. The business for which I work uses the specific identification method to assign costs to inventory and cost of goods sold. This year, our inventory consisted of two batches of goods. We paid $6.00 per unit for each inventory item in the old batch, and $6.75 for each item in the batch we purchased this year. As it turned out, most of the inventory items we sold this year came out of the new batch (the $6.75 ones). The effect was that our cost of goods sold for the year is higher than it would have been if we had sold the old batch of items before we sold items from the new batch. My attitude was, ‘Well, que sera sera’. But that’s not my boss’s attitude. This morning, he came into my office and actually asked me to ‘re-cost’ the inventory and cost of goods sold assuming that we had sold the items in the old batch first, and then sold items from the new batch. But we didn’t! Of course, his method would make the cost of goods sold that we report in our income statement lower and our net income higher, so the business would look better. But something about this really galls me. My friends say: ‘So what? What difference does it make?’ Help! You can call me . . . ‘Ethical Ethyl’ (or not)

Ethics and Sustainability

Required: Meet with your Dr Decisive team and write a response to ‘Ethical Ethyl’.

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Endnote a

Shao, M (1994). Interview with Michael E Gerber. Des Moines Register, 14 February, 15–B.

List of company URLs u u u u u u

Coles: http://www.coles.com.au Dell Inc: http://www.dell.com.au MasterCard: http://www.mastercard.com.au Virgin Money: http://www.virginmoney.com.au Visa: http://www.visa.com.au Woolworths Supermarkets: http://www.woolworths.com.au

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7 THE INCOME STATEMENT: COMPONENTS AND APPLICATIONS ‘Business without profit is not business any more than a pickle is candy.’ Charles F. Abbotta

Learning objectives After reading this chapter, students should be able to do the following: 7.1 Explain the purpose of the income statement. 7.2 Understand the importance of measuring financial performance. 7.3 Discuss the definition and classification of revenue/income. 7.4 Discuss the definition and classification of expenses. 7.5 Evaluate the performance of business using ratios. 7.6 Link outcomes from the income statement to owner’s equity and close the accounts.

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Understanding the learning objectives is assisted in the chapter by asking key questions:

Key questions 1

Why is a business’s income statement important?

2

How are changes in a business’s income statement accounts recorded in its accounting system?

3

What are the parts of a retail business’s classified income statement, and what do they contain?

4

What are inventory and cost of goods sold, and what inventory systems may be used by a business?

5

What are the main concerns of external decision makers when they use a business’s income statement to evaluate its performance?

6

What type of analysis is used by external decision makers to evaluate a business’s profitability?

7

Why does a business close off its revenue and expense accounts at the end of each period?

How much did you earn last year working during the holidays or the school year? How did you keep track of your earnings? Did you make enough to cover all of your expenses? Or did your parents have to help you out? If so, what percentage of your expenses did your earnings cover? Businesses, like individuals, keep track of their earnings. For instance, for the year ended 30 June 2018, Woolworths Group Ltd reported $56 965 million in revenue in its income statement. It also reported $40 256 million as the cost of goods sold, and a gross profit of $16 709 million.b Woolworths obtained these numbers from its accounting system. Did Woolworths charge enough for the products it sold to customers, given that its net profit after tax was $1795 million for the year? Did Woolworths make enough net profit as a percentage of its revenues? In Chapter 4, we looked at the fundamentals of the financial accounting process. You saw how basic accounting concepts, such as the entity concept, the accounting equation and accrual accounting, provide the framework for the accounting system that a business uses to record its day-to-day activities. The system provides internal users with valuable information that helps managers in their planning, operating and evaluating activities. The revenue and expense transactions are also the basis of a business’s income statement, which shows external users the business’s profit (income) for the accounting period.

Stop & think Overall, do the numbers show that Woolworths had a ‘good’ or a ‘bad’ year? What other information would you like to have to answer this question? In this chapter, we will discuss the importance of the income statement, expand Chapter 4’s discussion of the accounting system, describe and present a classified income statement, show how the income statement helps managers and external users make business decisions, and introduce the statement of comprehensive income.

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Chapter 7 The income statement: Components and applications

7.1 Why the income statement is important

1

Why is a business’s income statement important?

A business’s income statement plays a key role in the decision making of users of financial information by communicating the business’s revenues, expenses and net income (or net loss) for a specific time period. A business earns income by selling inventory (goods) or by providing services to customers during an accounting period. Recall that revenues are amounts earned by a business in charging its customers for goods or services. Expenses are the costs of providing the goods or services during the period. An income statement is based on the equation we showed in Chapter 4:

Net income ¼ Revenues  Expenses You may also hear the income statement referred to as a profit and loss (or P&L) statement, but in this book, we refer to it as the income statement. Later, we will introduce the statement of comprehensive income, which is effectively the income statement plus all other comprehensive income. Recall from Chapter 3 that a business prepares a projected income statement for internal use as part of its master budget. Exhibit 7.1 shows how internal users (managers) use a business’s projected income statement and actual income statement in their decision making, as well as how external users use a business’s actual income statement to make economic decisions. We now explain the impact of the income statement on users’ decisions. Exhibit 7.1 Uses of a business’s income statement

Management activities

Business

Business environment

Internal users

External users

Reports and analyses

Planning decisions

Projected income statement

Operating decisions

Actual income statement

Evaluating decisions

Comparisons of projected and actual income statements

Company’s income statement

Comparisons

Over several years

With other companies’ income statements

Evaluating decisions

The income statement summarises the results of a business’s operating activities for a specific accounting period. These stem from the planning and operating decisions that managers made during the period. A business’s income statement shows the relationship between managers’ decisions and the results of those decisions. This information helps both internal and external users to evaluate how well the business’s managers have ‘managed’ during the period. By comparing a business’s income statement information from period to period, users can also evaluate managers’ ability over the longer term. Let’s look first at how managers use the income statement to make comparisons. Remember from Chapter 4 that a business keeps track of its activities by using an accounting system based on the accounting equation and the dual effect of transactions. The accounting system provides the information that managers need to compare actual results with expected (budgeted) results, and to prepare external financial statements. At the end of an accounting period (e.g. one year), a business’s income statement will show how well many of its managers’ business decisions worked out.

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265

Accounting Information for Business Decisions For example, the revenue and expense information shows the results of managers’ cost–volume–profit (CVP) analysis and budgeting decisions. In Chapter 2, we saw how you and Emily Della used CVP analysis to develop your business plan. CVP analysis showed you and Emily how Cafe´ Revive could break even and how it could earn a satisfactory profit. You calculated that Cafe´ Revive needed to sell 90 coffee gift packs at $55 per pack for the business to break even. In addition to helping managers predict a business’s breakeven point, CVP analysis improves managers’ operating decisions, such as estimating how much inventory to purchase, what sales price to charge and what effect on profit to expect from price changes. We determined that if Cafe´ Revive could sell 170 gift packs at $55 per pack, it would earn a profit of $2112. Consider the decisions that managers must make about what sales price to charge. If you and Emily set prices too high, Cafe´ Revive would risk not selling enough cups of coffee or coffee gift packs to break even. If you set prices too low, Cafe´ Revive might sell many cups of coffee and gift packs, but may not earn high enough revenues to cover the costs of operating the business. Later, when the accounting system keeps track of every sale, it records those sales at the prices that the customers actually paid. (Remember that every sale generates a sales invoice to document the transaction and the amount of the sale.) If you and Emily do a good job of assessing the market and establishing appropriate prices, Cafe´ Revive will make sales, earn revenues high enough to cover its expenses and make a profit, which it will report on its income statement. In Chapter 3, we discussed how budgets help managers make plans, control business expenses and evaluate business performance. If you were the manager of Cafe´ Revive, budgeting would allow you to compare your expectations for revenue and expense amounts (reported in the projected income statement) with the actual amounts (reported in the actual income statement). If sales were higher or expenses lower than expected, you could find out what you did right and keep doing it. If, on the other hand, sales were lower or expenses higher than expected, you could analyse your mistakes and try to improve.

Stop & think How do you think a business’s decision to decrease the price of its product will affect the revenues that it reports on its income statement? How will this decision affect its expenses? As valuable as CVP analysis and budgets are for internal decision making, businesses do not report much of the information they provide to external decision makers. For one thing, businesses don’t want to reveal specific cost or budget information to their competitors. For another, many businesses prepare internal accounting reports daily, so external users may be more confused than helped by the sheer volume of information. External users need accounting information that lets them compare a business’s actual operating performance over several years, or compare this with the operating performance of other businesses. For instance, if the business is a public company, potential investors and current shareholders use its income statement information to help them decide whether to buy or hold shares in the business. By comparing the business’s current operating performance with that of prior years, they can get a sense of the business’s future operating performance. By comparing the business’s current operating performance with that of other businesses, they can get a sense of whether the business is doing ‘better’ or ‘worse’ than these businesses. Banks and other financial institutions also use a business’s income statement in a similar way to evaluate whether or not to give the business a loan. Finally, suppliers also use a business’s income statement information. Suppliers do not have the resources to grant credit to all customers. A supplier can compare its customers’ income statements to determine which customers might represent the best credit risks. Generally accepted accounting principles (GAAP) (see Chapter 4) ensure that all businesses calculate and publish financial statement information in a similar, and thus comparable, manner. So understanding GAAP is important – to the accountant who prepares financial statements and to the external decision maker who uses these statements to make business decisions. In Chapter 4, we introduced a simple accounting system, as well as several concepts and terms that form the foundation of GAAP. In this chapter, we will expand that accounting system, extend our discussion of GAAP as it relates to the income statement and begin to explain how external users evaluate income statement information for decision making. 266

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Chapter 7 The income statement: Components and applications

7.2 Measuring financial performance: The income statement In Chapter 4, we kept track of Cafe´ Revive’s transactions using the accounting equation to set up columns for recording amounts for assets, liabilities and/or owner’s equity. We then expanded the accounting equation to include revenue and expense transactions. Adding revenue and expense columns lets us keep track of these transactions separately from owner investments and withdrawals. However, a business needs to know more than its total revenues and total expenses. A business must know the total of each of its revenues and the total of each of its expenses for the accounting period, so it can report these items in a useful manner on its income statement for that period. In this chapter, we will continue to use columns for each asset and liability account. However, we will create a separate column under ‘Owner’s equity’ for each revenue account and each expense account, while still retaining an owner’s capital account column. A business uses these revenue and expense accounts for only one accounting period to record the effects of its transactions on its net income, and so they are called temporary accounts. The asset, liability and owner’s capital accounts are called permanent accounts because they are used for the life of the business to record the effects of its transactions on its balance sheet. By using this expanded accounting system, we show how a business keeps track of the changes in (and balances of) each asset, liability, owner’s capital, revenue and expense account. After showing how a business records a transaction in this accounting system, we include a marginal note to help you understand the effect of the transaction on the business’s financial statements. (There’s an example in the next section.) We use this columnar accounting system because it allows us to see easily the effects of a business’s transactions on its various accounts, accounting equation and financial statements. You should realise, however, that a real business has many (sometimes hundreds) different types of assets, liabilities, revenues and expenses. Imagine how wide the paper would need to be to record transactions involving hundreds of account columns! So a real business uses either a computerised accounting system, or a more complex manual accounting system, that involving journals, ledgers, debits and credits, and different forms of accounts. As we discussed earlier, the income statement is an important part of the decision-making process for both internal and external users. It is an expansion of the income equation introduced in Chapter 4:

2

How are changes in a business’s income statement accounts recorded in its accounting system?

permanent accounts Accounts used for the life of a business to record the effects of its transactions on its balance sheet (assets, liabilities and owner’s capital accounts)

Net income ¼ Revenues  Expenses Revenues may be thought of as the ‘accomplishments’ of a business during an accounting period. They are the amounts earned, and result in increases in assets (cash or accounts receivable) or decreases in liabilities (unearned revenues). Expenses may be thought of as the ‘efforts’ or ‘sacrifices’ made by a business during an accounting period to earn revenue. They are the costs of providing goods and services, and result in decreases in assets or increases in liabilities. Keep these definitions in mind while we discuss how a business matches revenue and expenses in its ‘classified’ income statement in order to provide information to external users about the profit or loss the business is making as a result of activiities for a certain period of time. Let’s now return to Cafe´ Revive to see how Emily records and reports the results of its first month of operations. To reinforce your understanding of the columnar accounting system, we will show how to record a few revenue and expense transactions. We will also show Cafe´ Revive’s classified income statement. As you look at it, focus on understanding the income statement sections, but also think about how Emily recorded the individual revenue and expense transactions. The classified income statement of a retail business like Cafe´ Revive has two parts: an operating income section and an other items section. Operating income includes all the revenues earned and expenses incurred in the primary operating activities of the business. The operating income section has three subsections: (1) revenues; (2) cost of goods sold; and (3) operating expenses. Other items include any revenues and expenses that are not directly related to the primary operations of the business – items such Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

3

What are the parts of a retail business’s classified income statement, and what do they contain? operating income All the revenues earned less the expenses incurred in the primary operating activities of a business

other items Revenues and expenses that are not directly related to the primary operations of a business

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Accounting Information for Business Decisions as interest revenue and interest expense. Case Exhibit 7.2 shows Cafe´ Revive’s classified income statement for January 20X2. In the next sections, we will discuss various issues related to recording and reporting revenues and expenses, referring to Case Exhibit 7.2 to show how Cafe´ Revive reports certain items.

Operating income, other items and net income On a business’s income statement, the total operating expenses are deducted from gross income to determine net income. We have already completed the Income Statement in Exhibit 5.12. However this version did not include the adjustments made for the bank reconciliation in Chapter 6. So in Case Exhibit 7.2, Emily also includes in operating income the $25 interest, making a total of $10 665.00. Emily adds the total selling expenses to the total general and administrative expenses and financial expenses to determine the $6340 total operating expenses. Note that this is different to the total in Case Exhibit 5.12 because Emily now needs to include the expenses from the bank (i.e. bank charges $35). She deducts the total operating expenses from the gross profit and other revenue of $10 665 to determine Cafe´ Revive’s operating income of $4325. Case Exhibit 7.2 Cafe´ Revive’s classified income statement CAFE´ REVIVE Income statement For the month ended 31 January 20X2 Sales revenues – coffee gift packs (net)

$12 000.00

Cost of goods sold

(6 240.00)

Gross profit

$ 5 760.00

Sales revenues – cups of coffee (net)

4 880.00

Interest revenue

25.00 19 665.00

Operating expenses:* Selling expenses

$5 241.50

General and administrative expenses Financial expenses

^

1 052.50 46.00

Total operating expenses Net income

(6 340.00) $ 4 325.00

*See Case Exhibit 7.4. ^ (Interest expense $11 plus Bank Charges $35)

The ‘Other items’ (sometimes called the non-operating income) section of a business’s income statement includes items that are not related to the primary operations of the business. This section reports revenues and expenses related to investing activities or to financing the business’s operations (e.g. interest revenue and interest expense), revenues and expenses (called gains and losses) related to selling property and equipment assets, and incidental revenues and expenses (e.g. miscellaneous rent revenue and losses due to theft or fire). We will discuss these items more fully later in the book. The total amount of the other items (non-operating income) section is added to (or subtracted from) the operating income to determine a business’s net income. The net income of Cafe´ Revive (shown in Case Exhibit 7.2) for the month ended 31 January 20X2 is $4325.

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Chapter 7 The income statement: Components and applications

7.3 Defining and classifying revenues/income Revenue is income that arises during the course of the ordinary activities of a business. Most commonly, revenue is recognised at the point of sale or delivery of a service. For example, a retail business sells goods to customers either for cash or on credit. As such, sales revenue is the major source of revenue for a retail business and is recognised at the time the sale takes place. When goods are sold on credit, some retail businesses offer an incentive for prompt payment. Whether the sales are for cash or on credit, customers sometimes return the goods they purchased. Let’s see how businesses record these aspects of sales.

Sales revenue Whether a customer buys goods for cash or on credit, retail businesses use a ‘Sales revenue’ (or ‘Sales’) account to record the transaction. Recall from Chapter 4 that the source document for a sale is a sales invoice (or invoice). Some businesses that sell only a few products or have a computerised accounting system may use a cash-register tape or credit-card receipt as the source document. Case Exhibit 7.3 shows a sales invoice that Cafe´ Revive used for one of its sales. It shows that on 6 January 20X2, Cafe´ Revive sold 10 coffee gift packs for $55 per pack (including GST), bringing the total amount to $550. Notice that the invoice also tells you that the invoice number is 0006, that the gift packs had an inventory identification number (ID no.) of 0122, that it was a credit sale, and that the credit sale was made to Beau Flower Shop. It is important that the invoice includes all of the sales information needed to record this transaction. Case Exhibit 7.3 Cafe´ Revive’s sales invoice Sales invoice Cafe´ Revive INVOICE: 0006

Cash

Sold to: Beau Flower Shop

Credit

Acct: 0103 Date 06/01/20X2

Description Coffee gift packs

ID

Number of units 0122

10

Unit price

Amount

$50.00

$500.00

GST (10%)

50.00

Total

$550.00

Thank you for your business.

Emily records the 6 January credit sale by first increasing ‘Accounts receivable’ by $550 to show that Beau Flower Shop owes Cafe´ Revive that amount. Notice that the beginning balance of accounts receivable was $440; this is the amount Beau Flower Shop already owes to Cafe´ Revive for the shop equipment it purchased from Emily (see Case Exhibit 4.11 in Chapter 4). So ‘Accounts receivable’ now has a balance of $990. Emily also increases the ‘Sales revenue’ account column under the ‘Net income’ heading of ‘Owner’s equity’ by $500, to show that Cafe´ Revive earned that amount from the sale, and increases the ‘GST collected’ account column by $50, to show the 10 per cent GST on the sale. Notice that the previous balance of sales revenue was $1500, due to a sale on 2 January, so that ‘Sales revenue’ now has a balance of $2000. FINANCIAL STATEMENT EFFECTS Increases assets on balance sheet Increases revenues, which increases net income on income statement (and therefore increases owner’s equity on balance sheet)

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Accounting Information for Business Decisions

¼

Assets Accounts receivable

Liabilities

þ

Owner’s equity

GST collected

Net income Sales revenue

Bal.

440

190

1 500

6/1/20X2

550

50

500

Bal.

990

240

2 000



Expenses

To illustrate how an account balance changes, we showed above the beginning and ending balances of the ‘Accounts receivable’, ‘GST collected’ and ‘Sales revenue’ accounts. For simplicity, later in this chapter and in future chapters we will include the balance of an account only when it is critical to the discussion. At first glance in the previous example, it does not appear that Cafe´ Revive’s accounting equation is in balance. Remember, though, that Cafe´ Revive has many accounts in its accounting system, and that we are showing only three of its accounts in this example. Cafe´ Revive’s accounting equation was in balance before Emily recorded this transaction, as we showed in Case Exhibit 4.13 in Chapter 4. What is important to notice is that in the above example, assets (‘Accounts receivable’) increased by $550, liabilities (‘GST collected’) increased by $50 and owner’s equity (‘Sales revenue’) increased by $500. So Cafe´ Revive’s accounting equation remained in balance after Emily recorded the transaction, as we showed in Case Exhibit 4.14. Remember that Cafe´ Revive had to dip into its inventory of coffee gift packs to make the sale. Emily uses the identification numbers on the gift packs that Cafe´ Revive sold to determine the $260 cost of the packs (10 gift packs at $26 per pack; note that the cost price is $26, not $28.60, because it includes GST). So Emily records the cost of the sale by first decreasing ‘Inventory’ by $260, as we show below. Note that the balance of ‘Inventory’ prior to the sale was $5460 (see Case Exhibit 4.13), and the balance is $5200 after the sale. Emily also increases ‘Cost of goods sold’ (an expense) under the ‘Net income’ heading of ‘Owner’s equity’ by $260, to show the cost of the gift packs that Cafe´ Revive sold on 6 January. Remember that as cost of goods sold (an expense) increases, both net income and owner’s equity decrease. That is why we include a minus (–) sign in the column to the left of the ‘Cost of goods sold’ column. Notice that the previous balance of ‘Cost of goods sold’ was $780 due to the sale on 2 January, so that ‘Cost of goods sold now has a balance of $1040. ¼

Assets

Liabilities

þ

Owner’s equity Net income Revenue



Inventory Bal. Bal.

Cost of goods sold $ 5 460

1/6/X2

Expenses

$

780

260



þ 260

$ 5 200



$ 1 040

FINANCIAL STATEMENT EFFECTS Decreases assets on balance sheet Increases cost of goods sold, which decreases net income on income statement (and therefore decreases owner’s equity on balance sheet)

Although we do not show all the account balances in Cafe´ Revive’s accounting system, notice that the accounting equation continues to remain in balance after Emily records these two transactions because the $240 total increase in assets ($550 increase in ‘Accounts receivable’, less $50 GST collected and $260 decrease in ‘Inventory’) is equal to the $240 total increase in owner’s equity ($500 increase in ‘Sales revenue’, a revenue, less $260 increase in ‘Cost of goods sold’, an expense). Emily records each sales transaction for January in the same way (except she records cash sales in the ‘Cash’ account column rather than the ‘Accounts receivable’ column). At the end of the accounting period, she 270

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Chapter 7 The income statement: Components and applications calculates the $16 880 balance in ‘Sales revenue’ (sales of coffee gift packs $12 000, sales of cups of coffee $4880), and Cafe´ Revive reports it as revenue on its income statement for January, as we showed in Case Exhibit 7.2. Emily calculates the $6240 balance in the ‘Cost of goods sold’ account column, and Cafe´ Revive reports this as an expense on its income statement.

How sales policies affect income statement reporting Businesses may have several policies related to the sales of their goods or services. There are three types of policies: discount policies, sales return policies and sales allowance policies. Businesses want to encourage customers to buy their merchandise or services, and sales policies help them to do this. A retail business’s specific policies will also have an impact on its net sales – the net dollar amount of sales reported on its income statement – because its revenues for an accounting period should include only the prices actually charged to customers for goods or services sold during the period. In the following sections, we will discuss each of these sales-related policies.

Discounts Have you ever taken advantage of a two-for-one special, paid a lower price because you bought a larger quantity of the same item or used a coupon to get three dollars off the price of your pizza? If so, the business you bought from offered you a discount. A quantity (or trade) discount is a reduction in the sales price of goods or a service because of the number of items purchased or because of a sales promotion. Businesses use discounts to attract customers and increase sales. Suppose that in early February, Cafe´ Revive puts in its front window a sign that reads, ‘Valentine’s Day special: Buy four or more coffee gift packs and receive a 10 per cent discount’. By using this sales promotion, Cafe´ Revive hopes that people walking by will notice the sign, come into the shop and buy coffee gift packs. In addition, the business hopes that customers who had planned to buy only one or two gift packs will instead buy four, so that they can get the discount. Emily also hopes the policy will encourage repeat customers. Before deciding to start a specific quantity discount policy, Cafe´ Revive uses CVP analysis to determine the discount that is most likely to improve the business’s profits. Once a quantity discount policy is set, the business keeps track of the impact the policy has on sales, costs and profits. However, the business does not record quantity discounts in its accounting system. A business also may decide to offer a discount for early payment on credit sales. A sales discount is a percentage reduction of the invoice price if the customer pays the invoice within a specified period. A sales discount is frequently called a cash discount because when taken by a customer, the discount reduces the cash received. The sales invoice shows the terms of payment. These terms vary from business to business, although most competing businesses have similar credit terms. Sales (cash) discount terms might read, for example, ‘5/7, n/31’ (i.e. ‘five seven, net 31’). The first number is the percentage discount (5%), and the second number (7) is the number of days in the discount period. The discount period is the time, starting from the date of the invoice, within which the customer must pay the invoice to get the sales discount. The term n/31 means that the total invoice price is due within 31 days of the invoice date. Thus, ‘5/7, n/31’ is read as, ‘A 5 per cent discount is allowed if the invoice is paid within seven days; otherwise, the total amount of the invoice is due within 31 days’. If Cafe´ Revive makes a $66 (including $6 GST collected) sale on credit with the terms 5/7, n/31 and the customer pays the invoice within seven days, the customer would pay $62.70 ($66 – [0.05  $66]), and $3.30 would be the sales discount taken. GST collected would now become $62.70 – ($62.70/1.1), and $5.70 would be the GST collected and the sales revenue $57 ([$57 þ $5.70 ¼ $62.70). Sometimes businesses offer cash discounts by charging a lower price for cash sales (rather than credit sales). For example, The Good Guys’ (http://www.thegoodguys.com.au) catchphrase is ‘Pay less, pay cash’. A business’s accounting system keeps track of sales (cash) discounts by reducing sales revenue by the amount of sales discounts taken when customers pay for their credit purchases. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

quantity discount Reduction in the sales price of a good or service because of the number of items purchased or because of a sales promotion

sales discount Percentage reduction of the invoice price if the customer pays the invoice within a specified period

cash discount Percentage reduction of the invoice price if the customer pays the invoice within a specified period

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Accounting Information for Business Decisions

Stop & think How do you think that a sales discount taken by a credit customer when paying the account receivable is recorded in the customer’s accounting system?

Sales returns and allowances

sales return When a customer returns previously purchased merchandise and receives a refund

When a customer buys merchandise, both the business and the customer assume that it is not damaged and will be acceptable to the customer. Occasionally, on checking the merchandise after the purchase, a customer may find that it is damaged, of inferior quality or simply the wrong size or colour. Most retail businesses have a policy allowing customers to return merchandise. For example, David Jones (http:// www.davidjones.com.au) has a very liberal return policy. A sales return occurs when a customer returns previously purchased merchandise. The effect of a sales return is to cancel the sale (and the related cost of goods sold).

Discussion Have you ever returned merchandise to a shop? Did the customer service representative ask to see your sales receipt? Did you or the customer service representative fill out additional source documents? Why?

DAVID JONES RETURN POLICY ‘We appreciate that you want to shop with the confidence of knowing that if you are not completely satisfied with your purchase, you can simply return it to any David Jones department store and we will provide you with an exchange, refund or repair.’c

sales allowance When a customer agrees to keep damaged merchandise and the business refunds a portion of the original sales price

If a customer discovers that merchandise is damaged, a business may offer the customer a sales allowance, which occurs when a customer agrees to keep the merchandise, and the business refunds a portion of the original sales price. Although this transaction is not part of our ongoing analysis of Cafe´ Revive, assume that one of its customers, Jake McAdams, pays cash for four coffee gift packs at $55 per box ($200 sales þ $20 GST collected). Remember that each gift pack has a base cost price of $26. Emily would record this transaction by increasing Cafe´ Revive’s ‘Cash’ account by $220 (4  $55) and ‘Sales revenue’ by $200 (4  $50), and by increasing ‘GST collected’ by $20 ($4  5), decreasing ‘Inventory’ by $104 (4  $26) and increasing ‘Cost of goods sold’ (an expense) by $104. What would happen if, when Jake opens the gift packs later that day, he notices that one of them is damaged? If he returns to the shop, Emily might ask him whether he wants to exchange the gift pack for a new gift pack, return the gift pack for a refund or accept a $55 sales allowance and keep the gift pack. If the gift pack is still usable, Jake might decide to accept the sales allowance. Because Jake paid for his purchase with cash, Cafe´ Revive would grant the sales allowance by refunding him $55 cash. Emily would record this sales allowance transaction in Cafe´ Revive’s accounts as follows: Assets

¼

Cash

Liabilities

þ

Owner’s equity

GST collected

Net income Sales revenue

55

5



Expenses

50

FINANCIAL STATEMENT EFFECTS Decreases assets on balance sheet Decreases revenues, which decreases net income on income statement (and therefore decreases owner’s equity on balance sheet)

272

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Chapter 7 The income statement: Components and applications If Jake originally purchased the goods on credit, Cafe´ Revive would grant the sales allowance by decreasing Jake’s ‘Account receivable’ balance, instead of the ‘Cash’ balance, by $55.

Stop & think If Jake returned the coffee for a refund, how would you record the transaction? Whether a business grants a sales return or a sales allowance, it prepares a source document called a credit memo. (Remember that a source document serves as evidence that a transaction has occurred.) A credit memo is a business document that lists information about a sales return or allowance. It includes the customer’s name and address, how the original sale was made (cash or credit), the reason for the sales return or allowance, the item(s) returned or on which the allowance was given, and the amount of the return or allowance. The credit memo is the source document used to record the return or allowance. It is also the document used to keep track of and measure external-failure costs – those stemming from customer dissatisfaction. The effect of recording sales discounts, sales returns and sales allowances is to reduce sales revenue, as we will discuss in the next section.

credit memo Business document that lists the information for a sales return or allowance

Discussion How can a business’s sales return policy help increase profits? Do you think a sales return policy can ever hurt more than it helps? How?

Net sales At the end of the accounting period, the balance of a business’s ‘Sales revenue’ account includes the initial sales revenue, less the sales returns and allowances and the sales (cash) discounts taken. The balance of the ‘Sales revenue’ account is called sales revenue (net) or net sales, and is reported on the business’s income statement. In January 20X2, Cafe´ Revive did not allow any cash discounts and did not have any customers return their purchases or ask for an allowance. The business thus reports total sales revenue of $16 880 on its income statement, as we showed in Case Exhibit 7.2. It seems that Cafe´ Revive’s customers were satisfied with the quality of the coffee and gift packs they bought. In general, the amounts that a business records as sales returns and allowances (and sales discounts) provide useful information about the quality of the business’s products (and the effect of its cash discount policy).

Stop & think Do you think a business should report to its managers a single net sales amount, or both the total sales and the sales returns, allowances and discounts? Should this amount be reported to external users? Why or why not?

Revenue from other sources As well as revenue from the main operations of the business (i.e. sales or service fees), a business may receive revenue from other sources, such as commission, interest on investments and gains on the sale of assets. These revenues are recorded as part of the accounting process, and should be included in the income statement when calculating the business’s profit. Following the bank reconciliation process (outlined in Chapter 6), Emily now knows that she received interest of $25 on her account with the bank. The amount of $25 will be included in the income statement as ‘Other revenue’. This will result in ‘Revenues’ increasing from $10 640, in Case Exhibit 5.12, to $10 665 in Case Exhibit 7.2.

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273

Accounting Information for Business Decisions 4

What are inventory and cost of goods sold, and what inventory systems may be used by a business?

7.4 Defining and classifying expenses An old business aphorism states, ‘You have to spend money to make money’. Managers of businesses should understand that planning and controlling expenses is an important part of running a business. Expenses are outflows that arise as a result of the ordinary activities of a business. They are recognised when the cost incurred can be measured reliably. Most expenses result from the production or delivery of goods and/or services during the accounting period. In the previous section, you saw how Cafe´ Revive, a retail business, recorded and reported its revenues. In this section, we focus on expenses.

Cost of goods sold cost of goods sold Major expense of a retail business consisting of the cost of the goods (merchandise) that it sells during the accounting period

One of the major expenses of a retail business is the cost of the goods (merchandise) that it sells during the accounting period. A classified income statement shows this expense as the cost of goods sold. Although all retail businesses report their costs of goods sold, how a retail business calculates the amount depends on the type of inventory system it uses. Remember that inventory is the merchandise a retail business is holding for resale. A business uses an inventory system to keep track of the inventory it purchases and sells during an accounting period, and thus of the inventory it still owns at the end of the period. Businesses use either a perpetual inventory system or a periodic inventory system. Because the type of inventory system used by a business affects its managers’ decisions, as well as income statement calculations, we will briefly discuss the cost of goods sold in each type of system.

Perpetual inventory system perpetual inventory system System that keeps a continuous record of the cost of inventory on hand and the cost of inventory sold

A perpetual inventory system keeps a continuous record of the cost of inventory on hand and the cost of inventory sold. Under this system, when a business purchases an item of inventory, it increases the asset ‘Inventory’ by the invoiced cost of the merchandise, plus any freight charges (sometimes called transportation-in) it paid to have the inventory delivered. When the business sells merchandise, it records the sale in the usual way. It also reduces ‘Inventory’ and increases ‘Cost of goods sold’ by the cost of the inventory that it sold. (We illustrated this earlier for one of Cafe´ Revive’s sales.) In this way, the business will have inventory and cost of goods sold accounts that are always up to date, and it will always know the physical quantity of inventory that it should have on hand.

Stop & think Do you think perpetual inventory records could be wrong? What could cause the records to show either too much or too little inventory? Because of the widespread use of computer technology, many retail shops use a perpetual inventory system. When you buy something in a shop, if the salesperson uses a scanner to record your purchase, the business is using a perpetual inventory system. Computers help shops to record sales transactions and to keep their perpetual inventory records. For instance, a supermarket uses an optical scanner to read a barcode and record the price of the item into the cash register. The shop’s computer simultaneously increases the assets ‘Cash’ (or ‘Accounts receivable’) and ‘Sales revenue’ for the item’s sales price, reduces ‘Inventory’ and increases ‘Cost of goods sold’ by the amount of that item’s cost and updates the count of the quantity of inventory on hand. Most department stores use a perpetual inventory system, as do most retail stores that sell a relatively small number of very expensive items, such as cars and jewellery. Whether a business sells expensive jewellery or generic grocery items, the business’s perpetual inventory system keeps up-to-date amounts for both inventory and cost of goods sold. This information helps 274

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Chapter 7 The income statement: Components and applications managers with decisions about day-to-day operations. By monitoring the daily changes in inventory amounts, managers can decide when to make inventory purchases, thus ensuring that inventory items are always in stock. Because the cost of goods sold information is current, managers can also compare the revenues and costs of recent sales, and estimate the business’s profitability. However, before deciding to use a perpetual inventory system, managers should evaluate the costs of various systems and technology, employee training and the other support needed to operate it. In some cases, the benefits may not justify the added costs of keeping perpetual records. But, as computer technology becomes more affordable and competition increases, businesses are typically finding that perpetual systems, and the added control over inventory they offer, are worth the costs. At the end of an accounting period, a business includes the balance of its inventory account on its balance sheet. It includes the balance of its cost of goods sold account on its income statement. As we illustrated earlier, Cafe´ Revive uses a perpetual inventory system. Cafe´ Revive also uses the specific identification method, which we discussed in Chapter 6 (refer also to the Appendix at the end of this chapter), to determine its cost of goods sold because it identifies the cost of each coffee gift pack sold based on the gift pack’s identification number. At the end of January 20X2, its ‘Inventory’ account has a balance of $1000, and its ‘Cost of goods sold’ account has a balance of $4800 from the purchases and sales transactions recorded in that month. We show these account columns below (the amounts are the same as those listed in Case Exhibit 4.20 in Chapter 4). Inventory

Cost of goods sold

Bal 1/1

$

2/1

–$

1 360

2/1

+$ 780

780

6/1

+$ 260

4/1

+$ 4 940

3/1–31/1

+$5 200

Bal 1/31

6/1

–$

3/1–31/1

–$5 200

260

Bal 31/1

$1 350

$6 240

Cost of inventory purchased Cost of inventory sold

The $6240 cost of goods sold is reported on the income statement, as we showed in Case Exhibit 7.2. The $1350 ending inventory of gift packs is reported on the balance sheet shown in Case Exhibit 4.22 in Chapter 4.

periodic inventory system System that does not keep a continuous record of the inventory on hand and sold, but determines the inventory at the end of each accounting period by physically counting it

A periodic inventory system does not keep a continuous record of the inventory on hand and sold, but instead determines the inventory at the end of each accounting period by physically counting it. Because a periodic inventory system does not reduce the ‘Inventory’ account each time a sale occurs, the only time the business knows the cost of its inventory on hand is when it counts the inventory. Why would a business choose not to keep perpetual inventory records? There are two common reasons. First, many businesses that use a periodic inventory system are small enough to manage their inventory without perpetual records. Second, many businesses sell a high volume of similar, inexpensive Assuming this person is ‘taking inventory’, what information do you goods. If these items are not expensive, perpetual records may suppose he is recording? not be as important for keeping day-to-day physical control over the inventory. For these reasons, a business may decide that the costs of a perpetual system – that is, record-keeping costs, and computer hardware and software costs – are not worth the benefits.

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275

Alamy Stock Photo/Bill Lyons

Periodic inventory system

Accounting Information for Business Decisions Because a business using a periodic system does not keep perpetual records, it must physically count its inventory at year-end. Physically counting the inventory is the only way for the business to determine an accurate inventory amount to be reported in the business’s ending balance sheet. Therefore, a business usually counts its inventory (in a process generally referred to as stocktaking) immediately after the last working day of its financial or fiscal year.1 This is a difficult and time-consuming task. Thus, most businesses end their financial year when inventory levels are likely to be low and business is slow. In Australia and New Zealand, a fiscal year can be based on either a calendar year (1 January to 31 December) or a financial year (1 July to 30 June), depending on which of these best suits an individual business’s ongoing activities. Perhaps you have noticed a business’s advertisement saying something like this:

STOCKTAKE CLEARANCE SALE!!! WE’D RATHER SELL IT THAN COUNT IT! This business is reducing its prices in order to sell more goods so that it will not have to spend as much time counting inventory. Near the end of the financial year, it is not unusual for a business to close temporarily so that it can count its inventory. If you peeked in the window of a business displaying a sign like the one shown, you would likely see people moving from one aisle to the next and counting the merchandise on each shelf. How does a business using a periodic system know its cost of goods sold? Since the business does not record the cost of the goods sold when each sales transaction takes place, it must calculate its cost of goods sold for an accounting period as follows: Cost of goods Cost of goods not sold available for sale zfflfflfflfflfflffl}|fflfflfflfflfflffl{ zfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl}|fflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflfflffl{ Cost of Cost of Cost of  ending Cost of goods sold ¼ beginning þ net inventory inventory purchases

net purchases Amount of merchandise purchases adjusted for purchase returns, allowances and discounts cost of ending inventory Dollar amount of merchandise on hand, based on a physical count, at the end of the accounting period

gross profit Net sales minus cost of goods sold

A business knows the cost of its beginning inventory because the beginning inventory for a new accounting period is the same as the ending inventory for the previous accounting period. A business’s cost of net purchases is the dollar amount it recorded during an accounting period for the merchandise it bought for resale. The term net purchases is used because the amount of merchandise purchases (invoice cost and transportation-in) is adjusted (reduced) for purchases returns, allowances and discounts. (These adjustments are similar to the net sales adjustments we discussed earlier.) A business’s cost of ending inventory is the dollar amount of merchandise on hand, based on a physical count at the end of the accounting period.

Cost of goods sold and gross profit Because cost of goods sold is usually a retail business’s largest expense, many businesses subtract cost of goods sold from net sales to determine gross profit (refer to this chapter’s Appendix). Gross profit is the amount of revenue that a business has ‘left over’ (after recovering the cost of the products it sold) to cover its operating expenses. Cafe´ Revive subtracts its $6240 cost of goods sold for coffee gift packs from its $12 000 sales revenue (net) for coffee gift packs to get its $5760 gross profit, as we showed in Case Exhibit 7.2.

1

A business using a perpetual inventory system also physically counts its inventory at year-end. Even though its accounting records show what should be in the inventory, the business takes a physical count to determine its actual inventory so it can test the accuracy of its accounting records and estimate the amount of lost or stolen inventory.

276

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Chapter 7 The income statement: Components and applications

Stop & think Do you think Emily is pleased with Cafe´ Revive’s gross profit on gift packs? Why or why not?

FINANCIAL STATEMENT EFFECTS Decreases assets on balance sheet Increases operating expenses, which decreases net income on income statement (and therefore decreases owner’s equity on balance sheet)

Operating expenses Of course, the cost of goods sold is not the only expense that a retail business incurs. Activities such as having a sales staff, occupying building space or running advertisements in the newspaper also cost money. These types of expenses are called operating expenses. Operating expenses are the expenses (other than cost of goods sold) that a business incurs in its day-to-day operations. ¼

Assets

Liabilities

þ

Owner’s equity

operating expenses Expenses (other than cost of goods sold) that a business incurs in its day-to-day operations

Net income Revenue



Cash

Expenses Advertising expense

 $121 (GST paid þ11)



þ $110

A business records its operating expenses in account columns, as we discussed earlier. For instance, when Cafe´ Revive paid $121 for advertising on 25 January 20X2, Emily recorded the transaction as shown. Notice, again, that an increase in an expense causes a decrease in owner’s equity, as indicated by the minus (–) sign in the column in front of the $110 advertising expense. Likewise, on 31 January 20X2, when Emily prepared the end-of-period adjustment of $19 for depreciation, she recorded the expense as follows: Assets

¼

Liabilities

þ

Owner’s equity Net income Revenue

–

Shop depreciation Bal.

Depreciation expense

$1 100 $

Bal.

Expenses

19



þ$19

$1 081



$19

As we noted in Chapter 5, businesses refer to the recording of end-of-period adjustments as making adjusting entries. A business may divide the operating expenses section of its income statement into three parts: one for selling expenses, one for general and administrative expenses and one for financial expenses. Selling expenses are operating expenses related to the sales activities of a business. Sales activities are activities involved in the actual sale and delivery of merchandise to customers. Selling expenses include such items as sales salaries expense, advertising expense and delivery expense (sometimes called transportation-out) for merchandise sold. General and administrative expenses are the operating expenses related to the general management of a business. They include such items as office salaries expense, insurance expense and office supplies expense. Financial expenses relate to the financing of the business and its operations Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

selling expenses Operating expenses related to the sales activities of a business general and administrative expenses Operating expenses related to the general management of a business financial expenses Expenses related to financing of the business and its operations, and to debt collection

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Accounting Information for Business Decisions and debt collection. They include bank charges, interest expense, discounts allowed to customers, bad debts and debt collectors’ fees.

Stop & think Why do you think that businesses may report selling expenses separately from general and administrative expenses? Some operating expenses involve both sales activities and the general management of a business. Consider utilities, for example. Suppose a business keeps telephones at sales desks and office desks, and both sales areas and office spaces are provided with electricity. In these cases, the business allocates part of the total expense to selling expenses and the remainder to general and administrative expenses, based on an estimate of how much is used for each activity, as we discussed in Chapter 4. Case Exhibit 7.4 shows a detailed schedule of Cafe´ Revive’s operating expenses for January 20X2. Emily developed this schedule from the balances in Cafe´ Revive’s expense accounts at the end of January. These balances are based on all the expense transactions Emily recorded in the accounts in January. Although we do not show these expense accounts here, the amounts she recorded are the same as those in the ‘Expenses’ column in Case Exhibits 4.20 and 4.21 in Chapter 4. For clarity, we have identified the number of the 20X2 transaction listed in Chapter 4 that caused each expense. Most of Cafe´ Revive’s Case Exhibit 7.4 Cafe´ Revive’s operating expenses CAFE´ REVIVE Schedule 1: Operating expenses For month ended 31 January 20X2 Chapter 4 transaction no.

Amount Selling expenses: Consulting expense

$ 247.50

(7)

Advertising expense

110.00

(8)

Sales salaries expense

1 770.00

(10)

97.50

(11)

142.50

(12)

1 955.00

(16)

Sales mobile and wifi expense Sales energy expense Sales supplies expense Rent expense Depreciation expense Total selling expenses

900.00

(17)

19.00

(18)

$5 241.50

General and administrative expenses: Consulting expense

$

Office salaries expense Office mobile and wifi expense Office energy expense Rent expense Total general and administrative expenses

82.50

(7)

590.00

(10)

32.50

(11)

47.50

(12)

300.00

(17)

$1 052.50

Financial expenses: Bank charges Interest Total financial expenses

278

$

35.00

(21)

11.00

(21)

46.00

(21)

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Chapter 7 The income statement: Components and applications operating expenses are selling expenses. However, Emily estimates that one-quarter of each total for consulting ($330), salaries ($2360), mobile and wifi ($130), energy expenses ($190) and rent ($1200) expenses are general and administrative expenses.2 Cafe´ Revive includes the $5241.50 total selling expenses and the $1052.50 total general and administrative expenses on its income statement in Case Exhibit 7.2. The detailed schedule of expenses is included with its income statement so that users interested in specific types of expenses can get the information they need.

Stop & think Are you wondering about the $11 interest expense on the loan payable? Should we include it as an expense even though we have not yet paid it? Many business expenses are related to waste. Initiatives to reduce waste, such as improving water use efficiency, installing energy-efficient light globes and increasing the use of recycling, can reduce costs, and thus increase profitability, while at the same time improving a business’s environmental credentials.

7.5 Evaluating the income statement using ratios To help you understand how internal and external decision makers use income statements, we will first briefly review why businesses prepare financial statements and what the statements show. Recall that accounting information helps managers plan, operate and evaluate business activities. Managers use accounting information on a day-to-day basis to help them make decisions (e.g. about what type of sales return policy to use, or how much inventory to order) that will achieve their objective of earning a profit, and thereby increase the business’s value. At the end of a specific time period, managers prepare financial statements to report the cumulative results of their day-to-day decisions to external users. By analysing a business’s financial statements, external users can evaluate how well managers’ decisions have worked and decide whether to work with the business. If you are a creditor, a business’s financial statements help you decide whether to loan money to the business and, if so, under what loan arrangements (e.g. the interest rate to charge, the amount of time to allow before the loan must be repaid and the restrictions to place on the business’s ability to borrow additional money). If you are an investor, a business’s financial statements help you estimate the return you may expect on your investment and to decide whether you want to become or continue to be an owner.

Ethics and Sustainability

5

What are the main concerns of external decision makers when they use a business’s income statement to evaluate its performance?

Stop & think Who else do you think is interested in a business’s financial statements? Why? Investors use the income statement to help judge their return on investment and creditors use it to help make loan decisions. On what do these users base their evaluations? To make their business decisions, financial statement users evaluate a business’s risk, operating capability and financial flexibility. Although these may sound like complicated terms, once we have explained them, you will see that they describe the main concerns of most investors and creditors. When investors or creditors use the income statement to evaluate a business’s risk, they are estimating the chances that the business will not earn a satisfactory profit, or that it will earn a higher-than-expected profit, in the future. As we introduced in Chapter 2, risk refers to this uncertainty about the future earnings potential of a business. The greater the chance that a business will earn a satisfactory or higher-than-

2

For simplicity, the salaries, supplies and utilities expense allocations are rounded to the nearest dollar. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions

expected profit, the less risk there is in investing in that business. As the likelihood that a business will earn a satisfactory profit decreases, or the likelihood that it will earn a lower-than-expected profit increases, the risk of investing in that business increases. A business’s ‘risk factor’ affects the expected investment return that is needed to attract investors, as well as the interest rate that creditors charge on that business’s loans. The greater the risk, the higher the required rate of return and the interest rate will be. External users evaluate a business’s operating capability and financial flexibility because these factors help to determine a business’s level of risk. Operating capability refers to a business’s ability to continue a given level of operations in the future. For example, by comparing a business’s current set of financial statements with those of previous years, external users can learn about the business’s ability to earn a stable stream of operating income. If the statements show that the business can do this, the chances are good that the business will be able to maintain its current level of operations in the future. Financial flexibility refers to a business’s ability to adapt to change in the future. External users want to see evidence of financial flexibility because this means that a business will be able to take advantage of business opportunities, such as introducing a new product or building a new warehouse. As you would expect, investors want the business to grow, so they prefer businesses that have financial flexibility. We will discuss these concepts further in Chapter 8.

Discussion Do you think your level of personal financial flexibility is high or low? Why?

Ratios ratio analysis Calculations made in financial analysis in which an item on a business’s financial statements is divided by another related item

To evaluate a business’s operating performance, managers and external users may perform ratio analysis. Ratio analysis consists of calculations in which an item on the business’s financial statements is divided by another related item. Although individual users may calculate ratios themselves, groups that specialise in financial analysis calculate and publish ratios for many businesses and industries. The ratios are benchmarks that are used to compare a business’s performance with that of previous periods and with that of other businesses. There are many commonly calculated ratios, which we will discuss in later chapters. As an introduction, we will discuss two that relate to profitability – the profit margin and gross profit percentage – since profitability affects risk, operating capability and financial flexibility.

Profit margin profit margin Net income divided by net sales 6

What type of analysis is used by external decision makers to evaluate a business’s profitability?

One ratio is the profit margin (sometimes called the return on sales), which is usually expressed as a percentage. A business’s profit margin is calculated as follows: Profit margin =

Net income Net sales

If a business’s profit margin is higher than that of previous years, or higher than that of other businesses, it usually means that the business is doing a better job of controlling its expenses in relation to its sales. The profit margin of Cafe´ Revive for January 20X2 is calculated as follows, based on the information in Case Exhibit 7.2: 4 325 ¼ 25:62% 16 880 This means that, on average, 2.56 cents of every sales dollar is profit (net income) for Cafe´ Revive. Since this is Cafe´ Revive’s first month of operation, we cannot compare the 25.62 per cent profit margin for January with the profit margins of previous months. However, this profit margin during initial operations is a positive sign.

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Chapter 7 The income statement: Components and applications

Gross profit percentage A second ratio is the gross profit percentage (sometimes called the gross profit margin), which relates a business’s gross profit to its net sales. A business’s gross profit percentage is calculated as follows: Gross profit percentage ¼

Gross profit Net sales

gross profit percentage Gross profit divided by net sales

A retail business’s gross profit generally ranges from 20 per cent to 60 per cent of net sales, depending on the types of products it sells or its pricing strategy. For example, some businesses use a pricing strategy of offering lower selling prices to increase their sales volume, thereby increasing their total gross profit. We can calculate the gross profit percentage of Cafe´ Revive for coffee gift packs for January 20X2 as: 5760 ¼ 48% 12000 This means that, on average, 48 cents of every sales dollar (after the cost of goods sold is subtracted) is left to cover operating expenses and other expenses and to increase Cafe´ Revive’s net income. Again, we cannot make comparisons with previous months, but this 48 per cent gross profit margin for January for coffee gift packs is within the range of a retail business’s usual gross profit. This is another positive sign of Cafe´ Revive’s successful initial operating capability. The managers of a retail business keep a close watch on the business’s gross profit because changes in gross profit typically result in large changes in net income.

Profitability ratios of actual businesses To illustrate ratio analysis, we will use information from the financial statements of two retail businesses, Super Retail Group Limited (which includes Supercheap Auto, BCF, Amart Allsports, Ray’s Outdoors, Rebel Sports and Goldcross Cycles; see http://www.superretailgroup.com.au) and Woolworths Group Limited (which includes Big W and BWS and see https://www.woolworthsgroup.com.au). These two companies’ profit margin percentages3 for the year ended 30 June 2018 were as follows: Super Retail Group Profit margin percentage

4.94%

Woolworths

d

3.15%

When we compare these two ratios, Super Retail Group was more successful at generating net income from its revenues than Woolworths.

Stop & think Would you expect Super Retail Group’s gross profit percentage also to be higher than Woolworths’? Why or why not? Now let’s compare the gross profit percentages4 for the two businesses. Super Retail Group Gross profit percentage

45.22%

Woolworths 29.33%

3

We use well-known corporations such as Super Retail Group and Woolworths in this illustration because the financial statements of most small entrepreneurial businesses are not publicly available. For simplicity, we do not show the calculations of the ratios, although the numbers were taken from each business’s financial statements. For instance, we calculated profit margin percentage by dividing net income by sales. 4

Gross profit percentage is calculated as ([Revenue – Cost of goods sold]/Revenue). Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

281

Accounting Information for Business Decisions Notice that Super Retail Group had a higher gross profit percentage and a higher profit margin percentage than Woolworths. Based on a comparison of these ratios, we can say that Super Retail Group was more efficient than Woolworths in controlling both the costs of merchandise and the costs of operating expenses.

Stop & think How else might you explain the differences in the ratios of the two businesses? We will expand the discussion of operating capability and financial flexibility in Chapter 8, adding new ratios for analysis and continuing our comparison of Super Retail Group and Woolworths.

Statement of comprehensive income In addition to the income statement, the Australian Accounting Standards Board AASB 101 Presentation of Financial Statements requires that entities present a statement of comprehensive income, which is effectively the income statement plus all other comprehensive income. According to paragraph 7 of AASB 101, other comprehensive income ‘comprises items of income and expense (including reclassification adjustments) that are not recognised in profit or loss as required or permitted by other Australian Accounting Standards’.e AASB 101 requires disclosures of comprehensive income that allow users of the financial statements to analyse changes in an entity’s equity resulting from transactions with owners in their capacity as owners (e.g. dividends and share repurchases), separately from ‘non-owner’ changes (e.g. transactions with third parties). Owners have been defined as holders of instruments classified as equity. Other comprehensive income includes non-owner changes in equity, such as asset revaluations, fairvalue movements on available-for-sale financial assets, and the tax implications arising from non-owner changes in equity. Examples of other comprehensive income from AASB 101, paragraph 7 are: • changes in revaluation surplus (see AASB 116 Property, Plant and Equipment and AASB 138 Intangible Assets) • actuarial gains and losses on defined benefit plans recognised in accordance with paragraph 93A of AASB 119 Employee Benefits • gains and losses arising from translating the financial statements of a foreign operation (see AASB 121 The Effects of Changes in Foreign Exchange Rates) • gains and losses on remeasuring available-for-sale financial assets (see AASB 139 Financial Instruments: Recognition and Measurement) • the effective portion of gains and losses on hedging instruments in a cash flow hedge (see AASB 139 Financial Instruments: Recognition and Measurement). Therefore, ‘profit or loss’ represents the change in equity during a period resulting from transactions and other events, while ‘other comprehensive income’ represents changes in equity resulting from transactions with owners in their capacity as owners. In presenting the statement of profit or loss and other comprehensive income, entities can choose to present either: • a single income statement and statement of other comprehensive income • two statements: the income statement immediately followed by the statement presenting other comprehensive income.

282

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Chapter 7 The income statement: Components and applications Example 1 Income statement and statement of comprehensive income in one statement Statement of comprehensive income Revenue from continuing operations

20X1 ($000s) 2 100

Other income

420

Raw materials and consumables used

(735)

Employee benefits expense

(525)

Depreciation and amortisation expense

(210)

Impairment of goodwill

(42)

Other expenses

(252)

Finance costs

(105)

Profit before income tax

651

Income tax expense

(189)

Profit from continuing operations

462

Profit for the year

462

Other comprehensive income: Gain on revaluation of land and buildings

210

Fair value movements on financial assets available for sale

(126)

Income tax relating to components of other comprehensive income

(42)

Other comprehensive income for the year, after tax

42

Total comprehensive income for the year

504

Note: Figures used are for illustration only.

7.6 Linking profit to owner’s equity and closing the accounts A business owner’s equity is affected by the owner’s investments and withdrawals, as well as by the business’s revenue and expense transactions. Although an income statement and its supporting schedules help external users to understand the results of revenue and expense activities, the statement and schedules do not include all the activities that affect owner’s equity. A business prepares a supplementary schedule, called a statement of changes in owner’s equity, for this purpose. This summarises the transactions that affected owner’s equity during the accounting period. A business presents this statement to ‘bridge the gap’ between its income statement and the amount of owner’s capital it reports on its balance sheet. The schedule begins with the balance in the owner’s capital account at the beginning of the accounting period. Then the total amount of the owner’s investments for the accounting period is added, because this amount increases the owner’s claim on the business’s assets. Next, the amount of the business’s net income is added, because this amount also increases the owner’s claim on the business’s assets as a result of its operating activities for the accounting period. Finally, the amount of withdrawals that the owner made during the accounting period is subtracted. Note that the owner’s withdrawals are recorded directly in the owner’s capital account, as we illustrated in Chapter 4 for Emily’s $250 withdrawal in transaction 6 and in Case Exhibit 4.16. It is important to understand that withdrawals are not expenses because they are not costs of providing goods or services to customers. Withdrawals are recorded as reductions of the owner’s capital account because they are disinvestments of assets by the owner. The final amount on a business’s statement of changes in owner’s equity is the owner’s capital balance at the end of the accounting period. The business reports this amount on its ending balance sheet. By summarising all the transactions affecting the owner’s equity of a business, the statement of changes in owner’s equity helps to complete the picture of the business’s financial activities for the Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

283

Accounting Information for Business Decisions Example 2 Income statement and statement of comprehensive income in separate statements When this option is selected, the statement of comprehensive income is to be presented immediately after the income statement, as follows:

Income statement

20X1 ($000s)

Revenue from continuing operations

2 100

Other income

420

Raw materials and consumables used

(735)

Employee benefits expense

(525)

Depreciation and amortisation expense

(210)

Impairment of goodwill

(42)

Other expenses

(252)

Finance costs

(105)

Profit before income tax

651

Income tax expense

(189)

Profit from continuing operations

462

Profit for the year

462

Statement of comprehensive income

20X1 ($000s)

Profit for the year

462

Other comprehensive income: Fair value movements on financial assets available-for-sale Income tax relating to components of other comprehensive income Other comprehensive income for the year, after tax Total comprehensive income for the year

(126) (42) 42 504

Note: Figures used are for illustration only.

accounting period. External users find this information helpful in evaluating the changes in the claims on the business’s assets, and changes that have an impact on its risk, operating capability and financial flexibility.

Stop & think If you saw a large amount of withdrawals reported in a business’s statement of changes in owner’s equity, how would this affect your evaluation of its risk? Why? Case Exhibit 7.5 shows Cafe´ Revive’s statement of changes in owner’s equity for the month ended 31 January 20X2. The $22 000 beginning amount of owner’s capital comes from the ‘E Della, capital’ account (shown in Case Exhibit 4.6 in Chapter 4). Emily made no additional investments during the accounting period, so the next item is net income. The $4325 net income comes from the income statement in Case Exhibit 7.2. The $250 of withdrawals comes from the ‘E Della, capital’ account in Cafe´ Revive’s accounting records, as we just discussed. The $26 075 ending amount for ‘E Della, capital’ is the amount to be reported as owner’s equity in Cafe´ Revive’s 31 January 20X2 balance sheet as illustrated in Case Exhibit 7.5. Managers and external users know that a business’s income statement and statement of changes in owner’s equity do not provide all the financial information needed for business decisions. Information that is not reported on the business’s income statement can have a big impact on its ability to earn profits in the future. In the next chapter, we will discuss how managers, investors and creditors use the balance sheet in conjunction with the income statement to make business decisions.

284

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Chapter 7 The income statement: Components and applications Case Exhibit 7.5 Cafe´ Revive’s statement of changes in owner’s equity CAFE´ REVIVE Statement of changes in owner’s equity For month ended 31 January 20X2 E Della, capital, 1 January 20X2

$22 000

Add: Net income

4 325 $26 325

Less: Withdrawals

(250)

E Della, capital, 31 January 20X2

$26 075

Closing the temporary accounts Earlier in the chapter, we explained that revenue and expense accounts are temporary accounts used to accumulate a business’s net income amounts for the accounting period. After a business prepares its income statement, statement of changes in owner’s equity, balance sheet and cash flow statement for the accounting period, it prepares closing entries. As we discussed in Chapter 5, closing entries are entries made by a business to transfer the ending balances from its temporary revenue and expense accounts into its permanent account for owner’s capital. A business uses closing entries so that when a new accounting period starts: 1 the revenue and expense accounts (temporary accounts) have zero balances, and no longer contain the amounts of any transactions from previous periods 2 the accounting system keeps the revenue and expense transactions of the current period separate from the revenue and expense transactions of other periods 3 the permanent (balance sheet) accounts are up-to-date (i.e. net income has been added to the previous balance of the owner’s capital account). We do not illustrate the closing entries for each revenue and expense account because it is too timeconsuming and not necessary for your understanding of how a business’s accounting system works. To provide an idea of closing entries, however, we will show you a ‘summary closing entry’ for Cafe´ Revive. Recall from Case Exhibit 4.21 that the amounts of the ‘E Della, capital’, ‘Revenues’ and ‘Expenses’ columns at the end of January 20X2 (prior to closing) were ‘E Della, capital’ $21 750 Revenues $16 880 minus Expenses $12 545, which resulted in a net income or profit of $4335. After adjusting for journal entries for Bank Reconciliation Case Exhibit 6.6 Step 4, Revenues equal $16 905 ($16 880 þ $25) and Step 5 Expenses $12 580 ($12 545 þ $35) as illustrated in the following table:

7

Why does a business close off its revenue and expense accounts at the end of each period?

temporary accounts Accounts used for one accounting period to record the effects of a business’s transactions on its net income (revenues and expenses)

Owner’s equity Owner’s capital E Della, capital Balances prior to closing Summary closing entry Balances after closing

þ

Net income 

Revenues

Expenses

$21 750

$16 905



$12 580

þ$ 4 325

$16 905



$12 580

$26 075

$

0

$

0

Emily prepares the summary closing entry as follows. To decrease the ‘Revenues’ account column to zero, she subtracts $16 905 from it. Similarly, to decrease ‘Expenses’ to zero, she subtracts $12 580 from this column. Emily then adds the $4325 difference (which is the net income shown in Case Exhibit 7.2) to the ‘E Della, capital’ account column. After this summary closing entry, the ‘Revenues’ and ‘Expenses’ columns both have zero balances and are ready to accumulate the revenue and expense information for February 20X2. Similarly, the Withdrawals (drawings) account is also closed by subtracting the $250 and transferring this to E Della, capital account (to reduce the capital). After these closing entries the ‘E Della, Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions

capital account’ has a balance of $26 075, which is the amount shown in Case Exhibit 7.5. We emphasise that this is a summary closing entry because in an actual closing entry, a business would close each revenue account and each expense account to the owner’s capital account. Further, a business’s accounting period is usually one year, so it would normally prepare its closing entries at the end of the year rather than at the end of each month.

Stop & think Which accounts in Cafe´ Revive’s accounting system have non-zero balances at 1 February 20X2?

Business Issues and Values: Corporate social responsibility What is corporate social responsibility (CSR)? Have you ever had a casual job? If so, then you know that many businesses depend on casual employees in their operations. For some businesses, casual employees make up a large percentage of their staff. By using casual employees, these businesses may significantly enhance their financial flexibility because they can hire and lay off employees quickly. They also avoid having to pay for items such as holiday pay and sick leave, which businesses normally only pay for full-time or part-time employees. Other businesses, while using some casual employees to help improve their financial flexibility, have a different view regarding their commitment to their employees, and believe that it is part of their social responsibility to hire, train and retain full-time employees. Although these businesses may have less financial flexibility than those that depend more on casual employees, some investors and creditors feel that a commitment to full-time employees offsets this limitation. Environmental disasters can result in costs that have significant impacts on business profitability. Consider the impact of the BP Gulf of Mexico oil spill in 2010, when an estimated four million barrels of oil spilt into the ocean over a three-month period. A compensation fund of over Ethics and Sustainabiity

286

A$20 billion was set up by BP in 2010 to address the social and environmental issues resulting from the oil spill.f The reputational and financial damage to BP is ongoing.

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Chapter 7 The income statement: Components and applications

STUDY TOOLS Summary 7.1 Explain the purpose of the income statement. 1

Why is a business’s income statement important?

A business’s income statement is important because it summarises the results (revenues, expenses and net income) of the business’s operating activities for an accounting period. This information is useful in the decision making of both internal and external users because it helps to show how well the business’s management has performed during the period and how it is performing from period to period.

7.2 Understand the importance of measuring financial performance. 2

How are changes in a business’s income statement accounts recorded in its accounting system?

Changes in a business’s balance sheet accounts are recorded in its accounting system by creating a separate column for each asset, liability and owner’s capital account. These accounts are called permanent accounts because they are used for the life of the business to record its balance sheet transactions. Changes in a business’s income statement accounts are recorded in its accounting system by creating a separate column under ‘Owner’s equity’ for each revenue account and each expense account, while still retaining the ‘Owner’s capital’ account column. A business uses these revenue and expense accounts to record its net income transactions for only one accounting period, so they are called temporary accounts.

7.3 Discuss the definition and classification of revenue/income. 3

What are the parts of a retail business’s classified income statement, and what do they contain?

The classified income statement of a retail business includes two parts: an ‘Operating income’ section and an ‘Other items’ section. The operating income section includes revenues, cost of goods sold and operating expenses subsections related to a business’s primary operating activities. The other items section includes any revenues or expenses that are not directly related to the business’s primary operations.

7.4 Discuss the definition and classification of expenses. 4

What are inventory and cost of goods sold, and what inventory systems may be used by a business?

Inventory is the merchandise a retail business is holding for resale. Cost of goods sold is the cost to the business of the merchandise that it sells during the accounting period. A business may use either a perpetual inventory system or a periodic inventory system. A perpetual inventory system keeps a continuous record of the cost of inventory on hand, the cost of inventory sold and the cost of goods sold. A periodic inventory system does not keep a continuous record of the inventory on hand and sold, but uses a physical count to determine the inventory on hand at the end of the accounting period and the cost of goods sold.

7.5 Evaluate the performance of business using ratios. 5

What are the main concerns of external decision makers when they use a business’s income statement to evaluate its performance?

When external decision makers use a business’s income statement to evaluate its performance, they are concerned with the business’s risk, operating capability and financial flexibility. Risk is uncertainty about the future earnings potential of the business. Operating capability refers to the business’s ability to continue a given level of operations. Financial flexibility refers to the business’s ability to adapt to change.

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Accounting Information for Business Decisions

6

What type of analysis is used by external decision makers to evaluate a business’s profitability?

Ratio analysis is used by external users to evaluate a business’s profitability. It involves calculations in which an item on the business’s financial statements is divided by another related item. The ratios are compared with the business’s ratios in previous periods, or with other businesses’ ratios. The ratios used to evaluate a business’s profitability include the profit margin (net income/net sales) and the gross profit percentage (gross profit/net sales).

7.6 Link outcomes from the income statement to owner’s equity and close the accounts. 7

Why does a business close off its revenue and expense accounts at the end of each period?

The income statement summarises the results of the business by matching revenues and expenses to determine profit or loss. This result should flow onto the owners of the business. The statement of changes in owner’s equity helps to complete the picture in terms of the accounting cycle and the financial outcome (profit or loss) of the business which flows to the owners. Revenue and expense accounts are viewed as temporary accounts used to accumulate information about the total revenues and expenses for a period. At the end of the period, balances are transferred to a profit and loss summary to enable calculation of the profit or loss for the period and close the accounts to zero balance.

Key terms cash discount

gross profit percentage

profit margin

cost of ending inventory

in transit

quantity discount

cost of goods sold

net purchases

ratio analysis

credit memo

operating expenses

sales allowance

financial expenses

operating income

sales discount

FOB destination point

other items

sales return

FOB shipping point

periodic inventory system

selling expenses

general and administrative expenses

permanent accounts

temporary accounts

gross profit

perpetual inventory system

Online research activity This activity provides an opportunity to gather information online about real-world issues related to the topics in this chapter. For suggestions on how to navigate various businesses’ websites to find their financial statements and other information, see the related discussion in the Preface. Put your skills to the test and find answers to the following questions by visiting the listed websites: u Go to Super Retail Group’s website (http://www.superretailgroup.com.au). Find the business’s income statements. Calculate the profit margin and the gross profit percentage for the most current year. How do these results compare with the year-ended 30 June 2016 ratios we discussed in this chapter? u Go to Woolworths’ website (https://www.woolworthsgroup.com.au). Find the business’s income statements. Calculate the profit margin and the gross profit percentage for the most current year. How do these results compare with the year ended 30 June 2016 ratios we discussed in this chapter?

Integrated business and accounting situations Answer the following questions in your own words.

Testing your knowledge 7-1 7-2 7-3 7-4 7-5 288

In terms of the accounting equation, where are changes in revenue and expense accounts recorded? Explain how managers use a business’s income statement for decision making. What are the main types of accounts included in the Income statement to determine profit or loss? Define each. What is the difference between temporary and permanent accounts? What is the matching principle? Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 7 The income statement: Components and applications

7-6 7-7 7-8 7-9 7-10 7-11 7-12 7-13 7-14 7-15 7-16 7-17 7-18 7-19 7-20 7-21 7-22 7-23 7-24

7-25

7-26

Identify the parts and subsections of a retail business’s classified income statement. What is included in each part? When do businesses normally recognise and record (a) revenues and (b) expenses? Explain the difference between a quantity discount and a sales (cash) discount. Explain the difference between a sales return and a sales allowance. What is a perpetual inventory system? How is a business’s cost of goods sold determined under this system? What is a periodic inventory system? How is a business’s cost of goods sold determined under this system? What is the difference between operating expenses and non-operating expenses. Give examples of each. Explain the difference between selling, general and administrative, and financial expenses. What is the link between the income statement and the statement of owner’s equity? Explain the meaning of the terms ‘risk’, ‘operating capability’ and ‘financial flexibility’. What is ratio analysis and what is it used for? Explain how to calculate a business’s profit margin. What is this ratio used for? Explain how to calculate a business’s gross profit percentage. What is this ratio used for? Explain what is included in a business’s statement of changes in owner’s equity and how the statement is used. What are closing entries and why are they used? What is ‘other comprehensive income’? Explain the importance of trends in analysing business performance. What methods and indicators would you use to analyse performance trends? What are the limitations of using ratio analysis to make decisions about the performance of a business? Short-term profits may come at the expense of long-term profits if consideration is not given to the environmental and social implications of a decision. a How could a decision that is profitable now have an impact on the social aspects of a business’s operations and reduce long-term profitability? b How could environmental risks from a decision that increases profits now reduce long-term profitability? State whether you think a business would recognise the following as revenue. When would it be recognised? a Cash sale by business $20 000 b Sale of excess equipment by a restaurant $350 c Hairdressing services for which clients paid cash $120 d Sale of goods on credit by a retailer $180 e A printer received deposit on an order to print stationery for a client $200 f A real estate business receives commission on advance of a sale of a house $3000. State whether you think a business would recognise the following as an expense. When would it be recognised? a Depreciation $350 b Wages to be paid in the next month $1200 c Electricity bill due to be paid next month $430 d Purchase of goods for resale $500 e Insurance amount paid at the start of the year in January (now June) $1400

Applying your knowledge 7-27

7-28

On 1 October, Cooper’s Appliance purchased $8800 of goods including GST for resale. On 11 October, it sold $4500 of these goods that cost $4400 including GST to customers at a selling price of $6600 (including GST). The business uses a perpetual inventory system, and all transactions were for cash. Required: Prepare the following accounts to record this information: Cash at bank, Inventory, Costs of goods sold and Sales. On 9 February, Simmons Toy Shop made a $198 cash sale (including GST) of merchandise to a customer. The business uses a perpetual inventory system. The merchandise had cost Simmons Toy Shop $110. On 12 February, the customer was given a sales allowance of $55 cash (including GST) for a defective item that the customer chose to keep. Required: a Prepare account column entries to record this information. b What source documents would be used to record each transaction?

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289

Accounting Information for Business Decisions

7-29

7-30

290

The Swanlake Tax Services business was established on 1 March of the current year to help clients with their tax planning. During January, the business entered into the following transactions: Date

Transactions

2 Mar.

Mr Swan set up the business by investing $15 000 in the business’s bank account

3

The business paid $6600 (including GST) in advance for one year’s rent of office space

4

Office equipment was purchased at a cost of $12 100 (including GST). A down payment of $2000 was made, and a loan payable was signed for the balance owed. The note is due in one year

7

Office supplies were purchased for $1870 cash (including GST)

16

Fees of $5500 (including GST) were collected from clients for tax services provided during the first half of March

29

A salary of $2300, which included $300 PAYG tax, was paid to the office secretary

30

Mr Swan withdrew $2500 for personal use

31

The March electricity bill of $264 (including GST) was received; it will be paid in early April

31

Clients were billed $6600 including GST for tax services performed during the second half of March

31

Swan recorded the following adjustments: a Rent expense for the month b Depreciation of $90 on office equipment c Interest expense of $110 on the loan payable d Office supplies used (the office supplies on hand at the end of the month were $1440).

Required: a Using the following column headings or account titles, prepare a worksheet to record the above transactions: date, cash, prepaid rent, office equipment, office supplies, accounts receivable, GST paid, notes payable, electricity payable, GST collected, PAYG payable, capital, tax service revenue, salary expense, electricity expense, rent expense, depreciation, interest expense, office supplies expense. b Prepare a trial balance. c Prepare a classified income statement for the business for March. d Prepare a balance sheet for the business on 31 March. e Briefly comment on how well the business did during March. The Speedy Answering Service business was started on 1 July of the current year to answer the phones of doctors, lawyers and accountants when they are away from their offices. The following transactions of the business occurred and adjustments were made in July: Date

Transactions

1 Jul.

M Salmon started the business by investing $7500 cash

2

The business paid cash of $2475 (including GST) in advance for six months’ rent of office space

3

The business purchased telephone equipment costing $13 750 (including GST), paying $3750 down and signing a $10 000 note payable for the balance owed

6

Office supplies totalling $1237.50 (including GST) were purchased on credit. The amount is due in early August

15

The business collected $2200 (including GST) from clients for answering services performed during the first half of July

28

M Salmon withdrew $1500 for personal use

29

The April $275 (including GST) utility bill was received; it is to be paid in August

30

The business paid $875 salary to a part-time employee. This includes $125 PAYG tax

30

Clients were billed $1925 (including GST) for answering services performed during the last half of July

30

M Salmon recorded the following adjustments: a Rent expense for July b Depreciation of $105 on telephone equipment c Interest of $100 on the note payable d Office supplies used of $145.

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Chapter 7 The income statement: Components and applications

7-31

7-32

Required: a As for question 7-29a, record the above transactions in appropriate accounts. b Prepare a simple income statement for the business for July. c Prepare a balance sheet for the business on 31 July. d Briefly comment on how well the business did in July. The Jung Art Supplies business sells various art supplies to local artists. The business uses a perpetual inventory system. The balance of its inventory of art supplies at the beginning of October was $3000. Its cash balance was $960 and the ‘Jung, capital’ balance was $3960 at the beginning of October. Ms Jung entered into the following transactions in October: Date

Transactions

1 Oct.

Ms Jung invested another $1200 cash into the business

2

Purchased $528 (including GST) of art supplies for cash

4

Made an $1188 (including GST) sale of art supplies on credit to P Tarrant, with terms of n/15; the cost of the inventory sold was $660

6

Purchased $924 (including GST) of art supplies on credit from Ray’s Paints, with terms of n/20

10

Returned, for credit to its account, $120 of defective art supplies purchased on 6 October from Ray’s Paints

12

Made cash sales of $396 (including GST) to customers; the cost of the inventory sold was $240

13

Granted a $30 allowance to a customer for damaged inventory sold on 12 October

15

Received payment from P Tarrant of the amount due for inventory sold on credit on 4 October

25

Paid balance due to Ray’s Paints for purchase on 6 October

Required: a Record the above transactions in appropriate accounts. b Determine the balances in all the accounts at the end of October. c Calculate the gross profit and the gross profit percentage for October. The Khan Heater business sells portable heaters and related equipment. The business uses a perpetual inventory system, and its inventory balance at the beginning of September was $3900. Its cash balance was $2250, and the ‘I Khan, capital’ balance was $6150 at the beginning of September. Khan entered into the following transactions during September: Date

Transactions

1 Sep.

I Khan invested another $1350 cash into the business

2

Made $825 (including GST) cash sales to customers; the cost of the inventory sold was $420

3

Purchased $2805 (including GST) of heaters for cash from Djokovic Supply

5

Received $412.50 (including GST) cash allowance from Djokovic Supply for defective inventory purchased on 3 September

6

Paid $330 (including GST) for parts and repaired defective heaters purchased from Djokovic Supply on 3 September

8

Made a $2475 (including GST) sale of heaters on credit to Botham Nursing Home, with terms of 2/10, n/20; the cost of the inventory sold was $1275

15

Purchased $1815 (including GST) of heaters on credit from Donaldson Supplies, with terms of n/15

18

Received amount owed by Botham Nursing Home for heaters purchased on 8 September, less the cash discount

30

Paid for the inventory purchased from Donaldson Supplies on 15 September

Required: a Record the above transactions in appropriate accounts. b Determine the balances in all the accounts at the end of September. c Calculate the gross profit and the gross profit percentage for September.

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Accounting Information for Business Decisions

7-33

The following information is available for the Miller & Keen business for the year: Beginning inventory

$135 000

Ending inventory

150 000

Purchases

306 000

Purchases returns and allowances

7-34

12 000

Required: Prepare a schedule that calculates the cost of goods sold for the year. The income statement information of Walten Furniture business for 20X2 and 20X3 is as follows. 20X2 Cost of goods sold

(a)

$95 360

Interest expense

960

00

Selling expenses

(b)

17 280

Operating income

34 880

(d)

153 600

(e)

12 640

(f)

Net income

(c)

34 560

Interest revenue

0

960

62 400

64 320

Sales (net) General expenses

Gross profit

7-35

Required: Fill in (a)–(f). All the necessary information is given. (Hint: It is not necessary to find the answers in alphabetical order.) The following information is taken from the accounts of Harrison’s Moto Shop for the month of January of the current year: Cost of goods sold

$ 97 200

Sales revenue (net)

158 400

Selling expenses

9 000

Interest expense

1 800

General and administrative expenses

7-36

21 600

Required: a Prepare a classified income statement for Harrison’s Moto Shop. b Calculate Harrison’s profit margin. The following information is taken from the accounts of Xeno’s Music Store for the current year ended 31 December: Depreciation expense: office equipment Interest revenue

$ 1 920 870

Sales salaries expense

9 840

Rent expense

2 160

Depreciation expense: shop equipment

2 880

Sales revenue (net) Office salaries expense

113 040 4 800

Interest expense

300

Office supplies expense

720

Cost of goods sold Advertising expense

292

$

20X3

71 280 432

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 7 The income statement: Components and applications

7-37

Of the rent expense, five-sixths is applicable to the shop and one-sixth is applicable to the office. Required: a Prepare a classified income statement for Xeno’s Music Store for the current year. b Calculate the profit margin. c Calculate the gross profit percentage. Does this percentage fall near the high or the low end of the range of typical retail businesses’ gross profit percentages? The 31 December 20X3 income statement accounts and other information of Lyon’s Fashion are shown below. Advertising expense

$ 6 450

Depreciation expense: shop equipment

2 400

Depreciation expense: building (shop)

5 550

Depreciation expense: office equipment

3 450

Depreciation expense: building (office)

1 650

Interest revenue

2 550

Interest expense

1 350

Cost of goods sold

95 850

Insurance expense

525

Sales (net)

7-38

153 000

Office supplies expense

720

Shop supplies expense

1 200

Sales salaries expense

5% of net sales

Office salaries expense

3 900

Utilities expense (shop)

2 250

Utilities expense (office)

600

Required: a Prepare a classified 20X3 income statement for Lyon’s Fashion. b Calculate the profit margin for 20X3. If the profit margin for 20X2 was 12.5 per cent, what can be said about the 20X3 results? Four independent cases related to the owner’s equity account of the Schmidt business are as follows: Schmidt, capital

Net income

Withdrawals

Schmidt, capital

1 May

for May

in May

31 May

(a)

$5 400

Case 1

7-39

$

2

74 000

3

54 400

1 800

(b)

4

68 000

7 640

$2 000

$51 400

3 440

80 500

(c) 3 000

49 600 (d)

Required: Determine the amounts of (a)–(d). The beginning balance in the ‘S Carton, capital’ account on 1 March of the current year was $36 800. For March, the Carton business reported total revenues of $12 800 and total expenses of $6800. In addition, S Carton withdrew $2240 for her personal use on 25 March. Required: Prepare a statement of changes in owner’s equity for March for the Carton business.

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7-40

The Maximo business shows the following amounts in its owner’s equity accounts at the end of December: R Maximo, capital: $45 080 u Revenues: $80 220 u Expenses: $59 920. Required: Set up the account balances in account columns and prepare summary closing entries at the end of December. A business engages in many types of activities. Required: For each of the following sets of changes in a business’s accounts, give an example of an activity that the business could engage in that would cause these changes, and explain why you think the activity would cause these particular changes: a Increase in an asset and decrease in another asset b Increase in an asset and increase in a liability c Increase in an asset and increase in owner’s equity d Increase in an asset and increase in a revenue e Decrease in an asset and increase in an expense f Decrease in an asset and decrease in a liability. During the current accounting period, the bookkeeper for Foley made the following errors in the year-end adjustments: u

7-41

7-42

Effect of error on: Error Example: Failed to record $240 of salaries owed at the end of the period

Net income

Revenues

Expenses

N

U

O

$240

$240

Assets

Liabilities

Owner’s equity

N

U

O

$240

$240

1 Failed to adjust prepaid insurance for $480 of expired insurance 2 Failed to record $600 of interest expense that had accrued during the period 3 Inadvertently recorded $360 of annual depreciation twice for the same equipment 4 Failed to record $120 of interest revenue that had accrued during the period 5 Failed to reduce unearned revenues for $720 of revenues that were earned during the period

7-43

7-44

294

Required: Assuming that the errors are not discovered, indicate the effect of each error on revenues, expenses, net income, assets, liabilities and owner’s equity at the end of the accounting period. Use the following code: O ¼ Overstated, U ¼ Understated and N ¼ No effect. Include dollar amounts. Be prepared to explain your answers. The statement of profit and loss for JT Andrews for the financial year ended 30 June 2019 reports that the business had increased its gross profit from $123 000 in 2018 to $147 000 in 2019. Its net profit for 2019 was $59 000 compared with $49 000 in 2018. Suggest reasons why Required: a the gross profit may have risen b the net profit changed. Suppose you own a retail business and are considering whether to allow your customers to have quantity discounts, sales discounts and sales allowances. Required: How do you think quantity discounts, sales discounts and sales allowances would affect the results of a business’s CVP analysis and its budgets? Explain what the effects would be. If a business gives quantity discounts, sales discounts and sales allowances, what information would it need to conduct CVP analysis and develop budgets? (What questions would you have to ask?) Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 7 The income statement: Components and applications

7-45

7-46

7-47

7-48

Your friend Georgia is planning to open an automobile parts shop and has come to you for advice about whether to use a perpetual or a periodic inventory system. Required: Before you advise Georgia, list the questions you would like to ask her. How would the answer to each question help you advise her? Explain to her the advantages and disadvantages of each system. Yvonne Martin owns a hairdressing shop, In-style Now. It is September 20X3 and Yvonne thinks she might need a bank loan. Her bank has asked Yvonne to prepare a projected income statement and to calculate the projected profit margin for next year. Although she has never developed this information before, she understands that to do so, she must make a ‘best guess’ of her revenues and expenses for 20X4, based on past activities and future estimates. She asks for your help, and provides you with the following information: a Styling revenues for 20X3 were $98 000. Yvonne expects these to increase by 10 per cent in 20X4. b In-style Now employees are paid a total ‘base’ salary of $42 000 plus 20 per cent of all styling revenues. c Hairdressing supplies used have generally averaged 15 per cent of styling revenues; Yvonne expects this relationship to be the same in 20X4. d In-style Now recently signed a two-year rental agreement on its shop, requiring payments of $560 per month, payable in advance. e The cost of utilities (electricity, water, phone) is expected to be 25 per cent of the yearly rent. f In-style Now owns styling equipment that cost $16 800. Depreciation expense for 20X4 is estimated to be one-sixth of the cost of this equipment. Required: Prepare a projected income statement for In-style Now for 20X4 and calculate its projected profit margin. Show your calculations. The Hewitt Newsagency had a fire and lost some of the accounting records it needed to prepare its 20X3 income statement. Dave Hewitt, the owner, has been able to determine that his capital in the business was $38 400 at the beginning of 20X3 and was $39 600 at the end of 20X3. During 20X3, he withdrew $16 800 from the business. Dave has also been able to remember or determine the following information for 20X3: a Cash service revenues were three times the amount of net income; credit service revenues were 40 per cent of cash service revenues. b Rent expense was $600 per month. c The business has one employee, who was paid a salary of $24 000 plus 20 per cent of service revenues. d The supplies expense was 15 per cent of the total expenses. e The utilities expense was $120 per month for the first nine months of the year and $240 per month during the remaining months of the year, due to the cold winter. Dave also knows that the business owns some office equipment, but he cannot remember the cost or the amount of depreciation expense. Required: Using the above information, prepare Hewitt Newsagency’s 20X3 income statement and calculate its profit margin. Show supporting calculations. Your boss has given you two businesses’ income statements from last year and asked you to recommend the one in which your business should invest. The income statements include the following information (in thousands): Consolidated Confectionery Net sales

Groovy Foods

$2 720 000

$4 000 000

1 768 000

2 720 000

Selling expenses

410 588

624 000

General and administrative expenses

229 082

220 000

Net income

312 330

436 000

Cost of goods sold

Required: a Based on this information alone, which business would be the better investment choice? Explain your answer. b What other information would you like to have in order to make a more informed decision? How would this information help you recommend the business in which you think you should invest? Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions

7-49

7-50

A paragraph in the recent financial statements of Winfred Discount Stores begins as follows: ‘Advertising, selling, administrative and general expenses increased as a percentage of sales in 20X1 compared to 20X0. This occurred because of the slower growth rate of sales during the year as compared to prior years.’ Required: How does the second sentence explain the first? Explain in more detail how this could happen. On 3 January 20X2, Drew Kent agreed to buy Sharp Repair and Services from Nadine Joyner. They agreed that the purchase price would be five times the 20X3 net income of the business. To determine the price, Nadine prepared the following condensed income statement for 20X3: Revenues

$ 144 000

Expenses

(108 000)

Net income

7-51

$ 36 000

Nadine said to Drew, ‘Based on this net income, the purchase price of the business should be $180 000 ($36 000  5). Of course, you may look at whatever accounting records you would like.’ Drew examined the business’s accounting records and found them to be correct, except for several balance sheet accounts. These accounts and their 31 December 20X3 balances are: u two asset accounts – ‘Prepaid rent’: $10 800; and ‘Equipment’: $14 400 u one liability account – ‘Unearned repair service revenues: $0. Drew gathered the following business information related to these accounts. The business was started on 2 January 20X0. At that time, the business rented space in a building for its operations and purchased $19 200 of equipment. At that time, the equipment had an estimated life of eight years, after which it would be worthless. On 1 July 20X3, the business paid one year of rent in advance at $900 per month. On 1 September 20X3, customers paid $1800 in advance for cleaning services to be performed by the business for the next 12 months. Drew asks for your help. He says, ‘I don’t know how these items affect net income, if at all. I want to pay a fair price for the business.’ Required: a Discuss how the 20X3 net income of Sharp Repair and Services was affected, if at all, by each of the items listed. b Prepare a corrected condensed 20X3 income statement. c Calculate a fair purchase price for the business. Neil Russell, the owner and bookkeeper for Jiffy Couriers, was confused when he prepared the following financial statements: Jiffy Couriers profit and expense statement 31 December 20X3 Expenses: Salaries expense

$ 31 500

Utilities expense

5 100

Accounts receivable

2 400

N Russell, withdrawals

30 000

Office supplies

2 250

Total expenses

$(71 250)

Revenues: Service revenues

$ 70 500

Accounts payable

1 650

Accumulated depreciation: office equipment

2 700

Total revenues Net revenues

296

$ 74 850 $ 3 600

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Chapter 7 The income statement: Components and applications

Jiffy Couriers balancing statement For year ended 31 December 20X3 Liabilities Mortgage payable Accumulated depreciation: building Total liabilities

Assets $40 500 Building 9 600 Depreciation expense: building $50 100 Office equipment Depreciation expense: office equipment

N Russell, capital* Total liabilities and owner’s equity

$66 000 2 400 14 550 1 350

40 500 $90 600 Cash Total assets

6 300 $90 600

* $36 900 beginning capital þ $3600 net revenues.

Neil asks for your help. He says, ‘Something is not right! My business had a fantastic year in 20X3; I’m sure it made more than $3600. I don’t remember much about accounting, but I do recall that ‘‘accumulated depreciation’’ should be subtracted from the cost of an asset to determine its book value.’ You agree, based on your understanding of the depreciation discussion in Chapter 4. After examining the business’s financial statements and related accounting records, you find that, with the exception of office supplies, the amount of each item is correct, even though the item might be incorrectly listed in the financial statements. You determine that the office supplies used during the year amount to $1200, and that the office supplies on hand at the end of the year amount to $1050. Required: a Review each financial statement and indicate any errors you find. b Prepare a corrected 20X3 income statement, statement of changes in owner’s equity and ending balance sheet. c Calculate the profit margin for 20X3 to verify or refute Mr Russell’s claim that his business had ‘a fantastic year’.

Dr Decisive Yesterday, two letters arrived for your advice column in the local paper, as follows:

Dr Decisive, I can’t believe I am writing to you. In the past, I have always tried to solve my own problems but now I have one I can’t solve on my own. My housemate and I are studying accounting together. Late one night - or maybe I should say early one morning - we were debating where insurance goes on an income statement. I think it should go in the ‘Other items’ section, but my housemate thinks it should go in ‘Operating expenses’under financial expenses. We could argue about this forever, since neither of us is willing to give in. My housemate agrees that we will accept your answer. If I win, I don’t have to pay my housemate interest on the money I owe her. ‘Interested’

Required Meet with your Dr Decisive team and write a response to ‘Interested’.

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Accounting Information for Business Decisions

Dear Dr Decisive, I think I must be losing my mind! I have just been looking over some annual reports with my girlfriend. I was trying to impress her with my knowledge. But then I started to explain to her about inventory, cost of goods sold, and measures of performance like gross profit and inventory turnover. I got lost trying to explain why some companies use one method, other similar companies use a different method and others use three different methods. Is all this just to help keep accountants in jobs? My girlfriend made sense when she said, ‘When I go into a clothing store, I just pick the one that is on top of the pile, but when I buy food, I always look for the package with the latest expiry date. Is there an accountant watching me through the security camera to check which I buy?’ Call me . . . ‘Inventor-ially Impaired’

Required: Meet with your Dr Decisive team and write a response to ‘Inventor-ially Impaired’.

Endnote a

Quoted in Miller, RL (2015) Business Law Today, Comprehensive: Text and Cases: Diverse, Ethical, Online, and Global Environment (10th ed.). Stamford, CT: Cengage Learning, 755. b All Woolworths Group figures sourced from the company’s 2016 annual report, available at https://wow2016ar.qreports.com.au/. c David Jones Limited, https://www2.davidjones.com.au/services/returns_policy.jsp. d All Super Retail Group figures sourced from the company’s 2016 annual report, available at http://media.supercheapauto.com.au/ corp/files/documents/SRG_AnnualReport20.pdf. e AASB Standard (AASB101) Presentation of Financial Statements July 2015 ª Australian Accounting Standards Board. f United States Environmental Protection Agency (2017) ‘Deepwater Horizon – BP Gulf of Mexico oil spill’. https://www.epa.gov/ enforcement/deepwater-horizon-bp-gulf-mexico-oil-spill.

List of company URLs u u u u

David Jones: http://www.davidjones.com.au Super Retail Group: http://www.superretailgroup.com.au The Good Guys: http://www.thegoodguys.com.au Woolworths Group Limited: http://www.woolworthslimited.com.au

298

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Chapter 7 Appendix: Calculating the cost and the amount of inventory

APPENDIX Calculating the cost and the amount of inventory Why is inventory management one of the key functions for managing the profitability of a business? Under AASB 102 Inventories, the cost of each unit of inventory includes all the costs incurred to bring the item to its existing condition and location. Thus, the cost of inventory includes the purchase price (less any purchases discounts), GST, applicable transportation costs, insurance, customs duties and similar costs. When a cost, such as the cost of ordering the inventory, is difficult to associate with a particular inventory item, many companies record it as a general and administrative expense. A business determines the cost of each unit of inventory by reviewing the source documents (e.g. invoices) that it uses to record the purchase of the inventory. AASB 102 also states that ‘inventories shall be measured at the lower of cost and net realisable value’. This means that if the net realisable value of inventory falls below its cost, it must be revalued so that its value is not overstated and reflects net realisable value. Net realisable value is equal to the selling price of the inventory goods less the selling costs. A business needs to continuously examine the value of inventory to see if its recorded cost should be reduced due to factors such as obsolescence, damage or spoilage, which result in reduced demand from customers. For example, suppose that DeFlava Coffee Corporation has 100 coffee gift packs for which it paid $55 per box (including GST). Only the cost excluding GST is recorded as the cost of inventory; the $5 is recorded as GST paid. Therefore, if the replacement cost of the gift packs declines to $40 per box (excluding GST), the business will revalue the inventory on its balance sheet at $40 per box because $50 is an overstatement of the value of the asset – inventory – that the company will use to generate future revenues. The business will report the total of the $10 per unit loss on each coffee gift pack on its income statement. Revaluing the cost of inventory avoids carrying forward any losses for recognition in a future period. Thus, the use of lower of cost or net realisable value is a way to ensure the conservative measurement of the value of inventory.

Calculating the amount of inventory When a business takes a physical inventory (stocktake), it counts the units of inventory in its stores and warehouses (and factories). The company may also own additional units of inventory that are in transit. In transit means that a freight company is in the process of delivering the inventory from the selling company to the buying company. The company (the buyer or the seller) that has economic control over the items in transit includes them in its inventory. Typically, economic control transfers at the same time legal ownership transfers. A company may buy or sell inventory under terms of free on board (FOB) shipping point or FOB destination. FOB shipping point means that the selling company transfers ownership to the buyer at the place of sale (shipping point) – that is, before the inventory is in transit. The selling company excludes these items in transit from its inventory; the buying company includes them in its inventory. The buying company is responsible for any transportation costs incurred to deliver the items, and includes those costs as a cost of its inventory (rather than immediately recording them as an expense). The free on board (FOB) destination point refers to the selling company transferring ownership to the buyer at the place of Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

in transit When a freight company is in the process of delivering the inventory from the selling company to the buying company. The company (the buyer or the seller) that has economic control over the items in transit includes them in its inventory. Typically, economic control transfers at the same time legal ownership transfers free on board (FOB) shipping point The selling company transfers ownership to the buyer at the place of sale (shipping point) – that is, before the inventory is in transit. The selling company excludes these items in transit from its inventory; the buying company includes them in its inventory. The buying company is responsible for any transportation costs incurred to deliver the items, and includes those costs as a cost of its inventory (rather than immediately recording them as an expense) free on board (FOB) destination point The selling company transfers ownership to the buyer at the place of delivery (after transit is completed). The selling company includes these items in transit in its inventory until delivery takes place; the buyer excludes them. In this case, the selling company is responsible for any transportation costs incurred to deliver the items and includes those costs in its selling expenses

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Accounting Information for Business Decisions

delivery (after transit is completed). The selling company includes these items in transit in its inventory until delivery takes place; the buyer excludes them. In this case, the selling company is responsible for any transportation costs incurred to deliver the items, and includes those costs in its selling expenses.

Using alternative inventory cost flow assumptions During the course of business operations, inventory will be purchased at different times and at different prices. So, in determining cost of goods sold, which of the varying cost prices should be used? Businesses that use perpetual inventory systems cross-check the actual number of units in their perpetual inventory records by performing a physical stocktake. In contrast, businesses that use periodic inventory systems perform a physical stocktake to establish the cost of goods sold at the end of a specific accounting period. However, the physical flow of inventory is not necessarily the same as the cost flow assumptions. Once a business has determined the number of units in its ending inventory and the cost of the units it purchased during the period, it must determine how to allocate the total cost of these units (the cost of goods available for sale) between the ending inventory (balance sheet) and the cost of goods sold (income statement). The following diagram shows this relationship: Cost of beginning inventory

Cost of purchases (or goods manufactured)

Cost of goods available for sale

Cost of ending inventory

Cost of goods sold

Balance sheet

Income statement

If the cost of each unit of inventory is the same during the period, the business simply allocates these costs to ending inventory and cost of goods sold according to how many units it has left and how many it has sold. It is more difficult to determine which costs a business includes in the ending inventory and which costs it includes in the cost of goods sold when the costs it incurred to acquire the units changed during the period. Such changes are common, and under Australian Accounting Standard AASB 102 Inventories, a business can choose one of three alternative cost flow assumptions to allocate its cost of goods available for sale between ending inventory and cost of goods sold: 1 specific identification 2 first-in, first-out (FIFO) 3 weighted average cost. As mentioned in Chapter 6, there is also a fourth method that is often used in the US: last-in, first-out (LIFO). While the use of LIFO is not permitted under the Australian Accounting Standard AASB 102 Inventories, it is still important to understand the LIFO method from a conceptual perspective because it provides a contrast to FIFO. A business must disclose in its annual reports the method it uses, and it must use that method consistently every year. Since we discussed the specific identification method in Chapter 6, in this Appendix, we will focus on the FIFO, weighted average cost and LIFO methods of inventory cost flow assumptions. To illustrate, we will discuss each of these methods for the fictional business Echidna Supplies Ltd using the information in Exhibit 7.6. (For simplicity, we use a month rather than the more common quarterly or annual accounting period used by actual companies.) The business has a beginning inventory of $10 500 (1500 units) and makes two purchases (of 750 and 1350 units) during January for a total cost of $17 115 ($5775 þ $11 340). During the month, it sold 1950 units (600, 1050 and 300). Therefore, it must divide its cost of goods available for sale (for its 3600

300

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Chapter 7 Appendix: Calculating the cost and the amount of inventory

Exhibit 7.6 Echidna Supplies – inventory information Beginning inventory, 1 January

1 500 units @ $7.00 per unit

7 January sale

(600) units

12 January purchase

750 units @ $7.70 per unit

20 January sale

(1 050) units

24 January purchase

1 350 units @ $8.40 per unit

26 January sale

$10 500 5 775 11 340

(300) units

Cost of goods available for sale Ending inventory, 31 January

$27 615 1 650 units

Notes: 1. The units are sold for $13 per unit. 2. Echidna Supplies Ltd uses the perpetual inventory system. 3. 3600 units are available for sale during January (1500 þ 750 þ 1350).

units available) of $27 615 ($10 500 þ $17 115) among the 1950 units it sold (the cost of goods sold) and its ending inventory of 1650 units. For our purposes, we assume that Echidna Supplies Ltd uses the perpetual inventory system. We also assume the company makes only three sales during the month. When the costs to acquire the inventory have changed during the period, each of the inventory cost flow assumptions produces different amounts for the cost of goods sold and the ending inventory balance. It is important to understand that these cost flow assumptions may not be related to the actual physical flow of the goods in inventory. Typically, a business will use a FIFO physical flow of its inventory to reduce the risk of obsolescence, but it may still use any of the three allowable cost flow assumptions to allocate its cost of goods available for sale between ending inventory and cost of goods sold.

First-in, first-out (FIFO) When a business uses the first-in, first-out (FIFO) cost flow assumption, it includes the earliest (first) costs it incurred in the cost of goods sold as it sells its products, leaving the latest costs in ending inventory. (In other words, the business assumes that it sells the inventory in the same order as it purchased it – even if it may not actually sell the inventory in the same order.) Under the FIFO cost flow assumption, Echidna Supplies Ltd calculates the cost of goods sold to be $13 965 and the ending inventory to be $13 650, as we show in Exhibit 7.7. The exhibit has two parts: the upper part shows a diagram of the ‘flow’ of costs, and the lower part shows schedules calculating the cost of goods sold and the ending inventory. The business sold 1950 units. Using the FIFO cost flow assumption, the business moves the first costs it incurred into cost of goods sold first. The most recent costs it incurred remain in inventory. Therefore, the 600 units sold on 7 January have a cost of $7 per unit from the beginning inventory. After the sale, the cost of 900 units from the beginning inventory remains in inventory. On 12 January, the business purchased 750 units at $7.70 per unit. For the 20 January sale of 1050 units, 900 units have a cost of $7 per unit from the beginning inventory and 150 units have a cost of $7.70 from the 12 January purchase. After this sale, the cost of 600 units from the 12 January purchase remains in the ‘Inventory’ account. On 24 January, the business purchased 1350 units at $8.40 per unit. For the 26 January sale, the 300 units have a cost of $7.70 from the 12 January purchase. This leaves the cost of the other 300 units from the 12 January purchase in the Inventory account. The cost of the ending inventory includes the cost of these 300 units remaining from the 12 January purchase ($2310), as well as the cost of the 1350 units the company purchased on 24 January ($11 340). So the total cost of the 1650 units in ending inventory is $13 650.

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Accounting Information for Business Decisions

Exhibit 7.7 Echidna Supplies Ltd – FIFO cost flow assumption Diagram Inventory Units in inventory 1/1 Beg. inv. 7/1 Sale

Cost of goods sold

Cost per unit

Total cost of units in inventory

8 1 500 < 600

7.00

¼10 500

7.00

(4 200)

: 900

7.00

¼ 6 300

750

7.70

¼ 5 775

12/1 Purchase

1 650 20/1 Sale

Units sold

Cost per unit

Total cost of units sold

600

7.00

¼4 200

12 075

900

7.00

(6 300)

900

7.00

¼6 300

150

7.70

(1 155)

150

7.70

¼1 155

7.70

¼2 310

600

7.70

4 620

24/1 Purchase

1 350

8.40

¼11 340

26/1 Sale

300

1 950 1 650

15 960 (

300

1350

7.70

(2 310)

300

7.70

13 650

1 950

13 965

8.40 Schedules

Cost of goods sold (1950 units): 7 January

600 units @ $7.00 per unit (from beginning inventory)

$ 4 200

20 January

1 050 units: 900 units @ $7.00 (from beginning inventory)

$ 6 300

26 January

300 units @ $7.70 per unit (from 12 January purchase)

150 units @ $7.70 (from 12 January purchase) 1 950

$ 1 155 $ 2 310 $13 965

Ending inventory (1650 units): Ending inventory ¼ Beginning inventory þ Purchases  Cost of goods sold $13 650

¼

$10 500

þ $17 115 

$13 965

or Ending inventory ¼ 300 units @ $7.70 (from 12 January purchase) þ 1350 units @ $8.40 (from 24 January purchase)

$ 2 310 $11 340 $13 650

Weighted average cost When a business uses the weighted average cost flow assumption under the periodic inventory system, it allocates the average cost per unit for the period to both the ending inventory and the cost of goods sold. That is, it combines the costs of all the units available for sale, calculates the average cost, and assigns the resulting average cost to the units in both the ending inventory and the cost of goods sold. As we show in Exhibit 7.8, Echidna Supplies Ltd calculates its average cost per unit of $7.67 (rounded) by dividing the total cost of goods available for sale ($27 615) by the number of units available for sale during the period (3600, which includes the 1500 units in the beginning inventory plus the 2100 units purchased).

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Chapter 7 Appendix: Calculating the cost and the amount of inventory

The business calculates the cost of the ending inventory balance to be $12 656.88 for the 1650 units remaining on hand at the average cost of $7.67 per unit, and calculates the cost of goods sold to be $14 957, which includes the 1950 units sold at the average cost of $7.67 per unit (adjusted for a $2 rounding error). When a business uses the weighted average cost flow assumption under the perpetual inventory system, it must calculate an average cost per unit after each purchase and then assign this new average cost to items sold until the next purchase (when it calculates another new average cost). This method is called the moving average cost flow assumption; because it involves tedious calculations, it is not discussed further in this book. Exhibit 7.8 Weighted average cost 1 500 units

$7.00 per unit

$10 500

12 January purchase

Beginning inventory, 1 January

750 units

7.70 per unit

5 775

24 January purchase

1 350 units

8.40 per unit

11 340

3600 units

7.67 per unit

27 615

Notes: 1. Weighted average cost: $27 615/3600 ¼ $7.67 per unit. 2. Cost of goods sold: 1950  7.67 ¼ 14 957 (rounded to whole figures). 3. Ending inventory: 1650  7.67¼ 12 656 (rounded to whole figures).

Last-in, first-out (LIFO) As stated earlier, the use of last in, first out (LIFO) is not permitted under the Australian Accounting Standard AASB 102 Inventories. This is because at the end of an accounting period, ending inventory does not reflect the current cost of inventory, so it is not an accurate method of valuation. When a business uses the last-in, first-out (LIFO) cost flow assumption, it includes the latest (last) costs it incurred before a sale in its cost of goods sold and the earliest costs (part or all of which are costs it incurred in previous periods) in ending inventory. (In other words, it assumes that the order in which it sells the inventory items is the reverse of the order in which it purchased them. Remember, however, that these cost assumptions are not necessarily the same as the actual physical flows of the inventory.) Under the LIFO cost flow assumption, Echidna Supplies Ltd calculates the cost of goods sold to be $14 595 and the ending inventory to be $13 020, as we show in Exhibit 7.9. Again, this exhibit has two parts: the upper part shows a diagram of the ‘flow’ of costs, and the lower part shows schedules calculating the cost of goods sold and the ending inventory. The business sold 1950 units. Using the LIFO cost flow assumption, the business moves the most recent costs it incurred to purchase inventory into cost of goods sold first. The earliest costs it incurred remain in the ‘Inventory’ account. The 600 units sold on 7 January have a cost of $7 per unit from the beginning inventory. On 12 January, the business purchased 750 units at $7.70 per unit. For the 20 January sale of 1050 units, the first 750 of these units have a cost of $7.70 per unit from the 12 January purchase, and the remaining 300 units have a cost of $7 from the beginning inventory. (Remember we are assuming that the most recent units purchased are sold first, even though that may not be the case.) On 24 January, the business purchased 1350 units at $8.40 per unit. For the 26 January sale, the 300 units sold have a cost of $8.40 per unit from the 24 January purchase. The cost of the ending inventory includes the cost of the remaining 1050 units from the 24 January purchase and the cost of 600 units from January’s beginning inventory. So the total cost of the 1650 units in ending inventory ($13 020) includes the cost of 600 units remaining from the beginning inventory ($4200) plus the cost of 1050 units remaining from the purchase on 24 January ($8820).

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Accounting Information for Business Decisions

Exhibit 7.9 Echidna Supplies Ltd – LIFO cost flow assumption Diagram Inventory Units in inventory 1/1 Beg. inv. 7/1 Sale

Cost of goods sold

Cost per unit

Total cost of units in inventory

@$7.00 @$7.00

¼$ 6 300

750

@$7.70

$ 5 775

(4 200)

Total cost of units sold

600

@$7.00

$ 4 200

¼$12 075

1650 20/1 Sale

Cost per unit

¼10 500

8 1500

 400

$4 400

$1 200

Notice that the $400 decrease in the asset ‘Accounts receivable’ resulted in a $400 increase in ‘Cash’. Also, if a business sells property or equipment for cash, ‘Property and equipment’ decreases and ‘Cash’ increases. A second type of transaction that may cause cash inflows involves increases in liabilities. An increase in a liability causes an inflow (increase) of cash when a business receives cash in exchange for the liability. For example, assume that the business’s account balances for ‘Cash’ and ‘Loans payable’ are $4400 and $3000, respectively. If the business borrows $8000 from a bank, it records this transaction as follows: Assets Cash Beg. bal.

$ 4 400

¼

Liabilities

þ

Owner’s equity

Loans payable $ 3 000

—————— >þ $ 8 000 þ $ 8 000 < End. bal.

$12 400

$11 000

The cash balance increases from $4400 to $12 400 as a result of the $8000 increase in a liability. A third type of transaction that may cause cash inflows involves increases in owner’s equity. Owner’s equity increases mainly because of: (1) investments by owners; and (2) generation of net income. An additional investment causes an inflow (increase) of cash because the owner has used cash from personal sources to increase his/her investment in the business. Net income is slightly more complicated because the cash inflows and outflows for operating activities are usually not equal to the revenues and expenses included in net income. This is because net income is based on the accrual concept, whereas here we are concerned with cash flows. We will discuss revenues, expenses and net income, and their effects on cash flows, later in the chapter. In this example, assume the business’s account balances for ‘Cash’ and ‘Owner’s capital’ are $12 400 and $100 000, respectively. If the owner invests an additional $2000 in the business, the business records this transaction in its accounting system as follows: Assets

¼

Liabilities

þ

Cash Beg. bal.

$12 400

Owner’s equity Owner’s capital $100 000

——————————————————————— >þ $ 2 000 þ $ 2 000 < End. bal.

$14 400

$102 000

The cash balance increases from $12 400 to $14 400 as a result of the $2000 increase in owner’s equity.

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Chapter 9 The cash flow statement: Components and applications

Stop & think Think of additional examples of each type of transaction that causes cash inflows. How would each of these transactions affect the business’s accounts?

Outflows (payments) of cash As we introduced earlier, there also are three types of transactions that may cause a business to have cash outflows. Instead of showing the accounts separately to explain each type, in this section we will discuss a series of transactions and show their results in Exhibit 9.3. One type of transaction that may cause cash outflows involves increases in assets other than cash. An increase in an asset other than cash causes an outflow (decrease) of cash when a business pays cash for the asset. When the business pays $100 to purchase coffee supplies, this type of transaction occurs. See transaction 1 in Exhibit 9.3. A second type of transaction that may cause cash outflows involves decreases in liabilities. A decrease in a liability causes an outflow (decrease) of cash when a business uses cash to pay some of the loan. When the business pays $1000 to reduce its loan payable, this type of transaction occurs. See transaction 2 in Exhibit 9.3. A third type of transaction that may cause cash outflows involves decreases in owner’s equity. For example, owner’s equity decreases because of the owner’s withdrawals. When the owner withdraws $600 from the business, this type of transaction occurs. See transaction 3 in Exhibit 9.3. Exhibit 9.3 Outflows of cash ¼

Assets Cash Beg. bal.

$14 400

Liabilities

Owner’s equity

Loans payable

Owner’s capital

$4 400

$8 000

$102 000

Trans. 1

$

Trans. 2

$ 1 000 < ———————————— >

Trans. 3

$

End. bal.

þ

Shop supplies

100 < —— > þ$ 100 $1 000

600 < ——————————————————————— >$

$12 700

$4 500

$7 000

600

$101 400

Stop & think Think of additional examples of each type of transaction that causes cash outflows. How would each of these transactions affect the business’s accounts? If you’re having trouble, don’t move on; you need to understand this before you continue.

9.3 The organisation of the cash flow statement

3

What do users need to know about a business’s cash flow statement?

Now that you know where to find information about cash transactions, you also need to know the best way to present this information in a business’s cash flow statement. This is challenging. Think about trying to develop a report that summarises the cash you received and paid out during the last month or year!

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Accounting Information for Business Decisions

Stop & think How would you summarise your cash flows for last month? Imagine getting out your bank statement or credit card statement and summarising all of the deposits and payments in a useful manner. Were any of the deposits related to youth allowance? Did you buy any durable goods (for instance, a computer or a mobile phone)?

operating activities The primary activities of buying, selling and delivering goods for sale, as well as providing services investing activities Transactions that affect investments in noncurrent assets of the company

financing activities Obtaining capital from the owner and providing the owner with a return on investment, as well as obtaining capital from creditors and repaying the amounts borrowed

The cash flow statement shows a business’s cash flows in three sections that are based on the type of activity that caused the increase or decrease in cash. The three sections are: (1) cash flows from operating activities; (2) cash flows from investing activities; and (3) cash flows from financing activities. Operating activities include the primary activities of buying, selling and delivering goods for sale, as well as providing services. They also include the activities that support the primary activities, such as administrative activities. Investing activities include lending money and collecting on loans, investing in other companies, and buying and selling property and equipment. Financing activities include obtaining capital from the owner and providing the owner with a return on the investment, as well as obtaining capital from creditors and repaying the amounts borrowed. Exhibit 9.4 lists examples of cash inflows and cash outflows from each type of activity. For each type of cash activity, notice that the net cash flow provided by that type of activity is calculated by subtracting the cash outflows from the cash inflows. Thus we can restate the link between the cash balances shown in a business’s beginning and ending balance sheets and its cash flow statement as: Beginning cash balance (1/1/X1) þ or – Net cash flows from operating activities þ or – Net cash flows from investing activities þ or – Net cash flows from financing activities ¼ Ending cash balance (31/1/X1)

Exhibit 9.4 Examples of cash flows Cash Beginning cash balance Cash inflows (receipts) Cash outflows (payments) Ending cash balance Operating cash flows Inflows Cash sales Collections of accounts receivable Collections of interest revenue

Inflows Receipts from selling property and equipment Collections on long-term notes receivable Receipts from selling investments Inflows Owner investments Receipts from issuing long-term notes payable

358



Outflows Cash purchases of inventory and supplies Payments of credit purchases of inventory and supplies Payments for employees’ salaries and other expenses Payments of interest

 Net cash flows from operating activities

Investing cash flows



Outflows Cash purchases of property and equipment Making loans on long-term notes receivable Payments for purchases of investments

 Net cash flows from investing activities

Financing cash flows 

Outflows Owner withdrawals Payments on long-term notes payable

 Net cash flows from financing activities

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Chapter 9 The cash flow statement: Components and applications

Net cash flows from operating activities There are two methods of calculating and reporting a business’s net cash flows from operating activities: one is called the direct method and the other is called the indirect method. A business using the direct method subtracts operating cash outflows from operating cash inflows to determine the net cash provided by (or used in) operating activities. Under the direct method, a business may report operating cash inflows in as many as three categories: (1) collections from customers; (2) collections of interest; and (3) other operating receipts. It may report operating cash outflows in as many as four categories: (1) payments to suppliers; (2) payments to employees; (3) payments of interest; and (4) other operating payments. Using the direct method, a business organises the cash flows from the operating activities section of its cash flow statement as follows: Cash flows from operating activities Cash inflows:

4

How does a business report the cash flows from its operating activities on its cash flow statement using the direct method? direct method Subtracting the operating cash outflows from the operating cash inflows to determine the net cash provided by (or used in) operating activities on the cash flow statement

Collections from customers Collections of interest Other operating receipts Cash inflows from operating activities Cash outflows: Payments to suppliers Payments to employees Payments of interest Other operating payments Cash outflows for operating activities Net cash provided by operating activities

Using the indirect method, a business adjusts its net income to calculate the net cash flow from operating activities. That is, it lists net income first, and then makes adjustments (additions or subtractions) to net income. It makes these adjustments for two reasons: • to eliminate expenses, such as depreciation expense, that were included in the calculation of net income but did not involve a cash outflow for operating activities • to include those changes in current assets (other than cash) and current liabilities that affected cash flows from operating activities differently than they affected net income. In other words, under the indirect method, income flows are converted from an accrual basis to a cash basis. Under the indirect method, a business might organise the cash flows from operating activities section of its cash flow statement as follows:

indirect method Adjusting net income to compute net cash provided by operating activities on the cash flow statement

Cash flows from operating activities Net income Adjustments for differences between net income and cash flows from operating activities: Add: Depreciation expense Decrease in accounts receivable Less: Decrease in accounts payable Decrease in salaries payable Net cash provided by operating activities

In the main part of this chapter, we will discuss how to calculate and report a business’s operating cash flows using the direct method on its cash flow statement. We will discuss the indirect method further in this chapter’s Appendix. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions

9.4 Construct cash flow statements based on the direct method To explain how to prepare the cash flow statement, we now turn to Cafe´ Revive’s January 20X2 activities. This is the same set of transactions we used in Chapters 4, 7 and 8 (see Case Exhibit 4.20 in Chapter 4). Case Exhibit 9.5 shows the ‘Cash’ account, which kept track of the business’s January 20X2 cash transactions. Note

Case Exhibit 9.5 Cafe´ Revive’s cash account Café Revive Cash account for January 20X2 Type of cash inflow

Transaction explanation

Cash

Transaction explanation

Type of cash outflow

1 Jan. Bal $ 11 575 Operating

Receipt – cash sale

Investing

Receipt – sale of equipment

$ 1 650* $ 1 430* $ 440* $ $ $ $

Operating Operating

250 363* 121* 275*

$ 2 050 $ 143* $ 209* $ 11 000 Receipts – cash Coffee gift packs $ 5 368 sales for Jan. Receipt – interest revenue $ 25 $ 35 31 Jan. Bal $ 25 182

Payment – inventory

Operating

Owner withdrawal Payment – consulting Payment – advertising Payment – supplies purchase Payment – salaries Payment – mobile and wifi Payment – energy

Financing Operating Operating Operating

Payment – bank charges

Operating

Operating Operating Operating

Cash flows from operating activities Inflows Outflows Cash sales Cash purchases of Collections of accounts receivable inventory and supplies Collections of interest Payments of credit purchases of inventory and supplies Payments for employees’ salaries and other expenses Cash flows from investing activities Inflows Outflows Receipts from selling property Cash purchases of property and equipment and equipment Collections on long-term notes receivable Making loans on long-term notes Receipts from selling investments receivable Payments for purchases of investments Cash flows from financing activities Inflows Owner investments Receipts from issuing long-term notes payable

Outflows Owner withdrawals Payments on long-term notes payable

* These figures are GST-inclusive.

360

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Chapter 9 The cash flow statement: Components and applications that we show two columns of information on either side of this account. The inner columns provide a brief explanation of each transaction recorded in the account. We then use the explanations to classify the items according to the type of cash flow activity. The outer columns label each item as an operating, investing or financing cash inflow or cash outflow. As Case Exhibit 9.5 shows, we determined the type of cash flow activity for each item by comparing the item explanations with the more general descriptions of activities that we presented in Exhibit 9.4. Case Exhibit 9.6 shows Cafe´ Revive’s cash flow statement for the month ending 31 January 20X2. The statement gives a summary of the business’s cash flows by category of activity. In the following two sections, we will use Cafe´ Revive’s ‘Cash’ account to explain the information provided within each section of Cafe´ Revive’s cash flow statement. Case Exhibit 9.6 Cafe´ Revive’s cash flow statement CAFE´ REVIVE Cash flow statement For month ended 31 January 20X2 Cash flows from operating activities Cash inflows: Collections from customers

$18 018

Collections from interest

25

Cash inflows from operating activities

$18 043

Cash outflows: Payments to suppliers

$ (1 430)

Payments to employees

(2 050)

Other operating payments

(1 146)

Cash outflows for operating activities

(4 626)

Net cash provided by operating activities

$13 417

Cash flows from investing activities Receipt from sale of shop equipment

$

440

Net cash provided by investing activities

440

Cash flows from financing activities Withdrawals by owner

$ (250)

Net cash used for financing activities Net increase in cash Cash, 1 January 20X2 Cash, 31 January 20X2

(250) $13 607 11 575 $25 182

Cash flows from operating activities The cash flows from operating activities section of a business’s cash flow statement provides financial statement users with information about its ability to obtain cash from its day-to-day activities. Cafe´ Revive’s cash inflows for January are listed as ‘Collections from customers’ $18 018 and ‘Collection from interest’ $25 in Case Exhibit 9.6, and total $18 043. In Case Exhibit 9.7, we show that the $18 018 ‘Collections from customers’ is the sum of three items in the ‘Cash’ account: (1) a cash sale of $1650; (2) an $11 000 summary cash sale, which is used for all the other January cash sales of coffee gift packs; and (3) the cash summary of $5368 collected from coffee sales in January. The $4626 operating cash outflows consist of the following: • an $1430 inventory purchase • $2050 for salary payments • $363 for consulting • $121 for advertising Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

361

Accounting Information for Business Decisions Case Exhibit 9.7 Explanation of cash flow statement – operating activities Cash account for January 20X2 Type of cash inflow

Transaction explanation

Transaction explanation

Cash

Type of cash outflow

1 Jan. Bal $11 575 Operating

Receipt – cash sale

Investing

Receipt – sale of equipment

1$ 1 650* 2$ 1 430* 1$ 440* 2$ 250 2$ 363* 2$ 121* 2$ 275*

2$ 2050 2$ 143* 2$ 209* 1$ 11 000 Receipts – cash sales for Jan. $ 5 368 Receipt – interest revenue 25 1$ 2$ 35 31 Jan. Bal $ 25 182

Operating Operating

1

Cash outflows: Payments to suppliers Payments to employees Other operating payments Cash outflows for operating activities Net cash provided by operating activities

Operating

Owner withdrawal Payment – consulting Payment – advertising Payment – suppllies purchase Payment – salaries Payment – mobile and wifi Payment – energy

Financing Operating Operating Investing

Payment – bank charges

Operating

Operating Operating Operating

1 $1650* cash sale made on 2 January 20X2 plus $16 368* summary item representing all other January cash sales equals $18 018* in receipts from customers.

Cash flow statement (operating activities only) For month ended 31 January 20X2 Cash flows from operating activities Cash inflows: Collections from customers (11 000 + 5368 + 1650) Collection from interest Cash inflows from operating activities

Payment – inventory

2 $ 18 018* 25 $ 18 043

$ (1 430)* (2 050) (1 146)*

3 (4 626) $ 13 417

4

2 $1430* cheque written on 3 January 20X2 to pay for an inventory purchase made on credit in December 20X1. 3 On 30 January 20X2, cheques totalling $2050 were written to you and Jackson Downes in payment for working in January. 4 The $1146 total for other operating expenses includes $363* paid to a promotion consultant, $121* for the advertisement in University Hub’s January promotional flyer, $143* for mobile and wifi and $209* for energy and supplies $275 and bank charges $35.

* These figures are GST-inclusive.

• • • •

$275 for coffee-making supplies $143 for mobile and wifi charges $209 for energy $35 for bank charges. Notice that we combined the consulting, advertising, supplies, mobile and wifi, energy, bank charges and cash payments into an ‘Other’ category of operating cash outflows.

Stop & think Why do you think we combined the consulting, advertising, supplies, telephone and utilities payments? In summarising your personal cash flows, would you combine certain categories of items? Why or why not? 362

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Chapter 9 The cash flow statement: Components and applications Cafe´ Revive’s net cash flows from operating activities total $13 417. We calculate this by subtracting the $4626 total operating cash outflows from the $18 043 total operating cash inflows.

Cash flows from investing and financing activities Case Exhibit 9.8 shows that Cafe´ Revive’s $440 net cash provided by investing activities during January 20X2 consisted of one item: $440 investing cash inflow resulted from the sale of shop equipment. Cafe´ Revive’s $250 net cash outflow for financing activities consisted of one item, Emily Della’s $250 withdrawal. Case Exhibit 9.8 Explanation of cash flow statement – investing and financing activities Cash account for January 20X2 Type of cash Inflow

Transaction explanation

Transaction explanation

Cash

Type of cash outflow

1 Jan. Bal $ 11 575 Operating

Receipt – cash sale

Investing

Receipt – sale of equipment

Operating

Receipts – cash sales for Jan.

Operating

Receipt – interest revenue 31 Jan. Bal

$ 1 650* $ 1 430* $ 440* $ 250 $ 363* $ 121* $ 275* $ $ $ $ $ $ $ $

2 050 143* 209* 11 000 5 368 25 35 25 182

Café Revive 5 Cash flow statement For month ended 31 January 20X2 Net cash provided by operating activities (from Case Exhibit 9.7) $ 13 417 Cash flows from investing activities: $ 440* Receipt from sale of shop equipment Net cash provided by investing activities 440* Cash flows from financing activities: $ (250) Withdrawals by owner Net cash used for financing activities (250) Net increase in cash $ 13 607 Cash, 1 January 20X2 11 575 Cash, 31 January 20X2 $ 25 182

6

Payment – inventory

Operating

Owner withdrawal Payment – consulting Payment – advertising Payment – supplies purchase Payment – salaries Payment – mobile and wifi Payment – energy

Financing Operating Operating Investing

Payment – bank charges

Operating

Operating Operating Operating

5 $440* cheque received on 7 January 20X2 in payment for shop equipment sold in December 20X1.

6 Emily Della made an owner withdrawal of $250 on 20 January 20X2.

* These figures are GST-inclusive.

Reconciliation of cash balances At the bottom of Case Exhibit 9.8, we also show the net increase in cash, and we ‘reconcile’ the beginning cash balance to the ending cash balance. The $13 607 net increase in cash is determined by adding the $13 417 net cash provided by operating activities and the $440 net cash provided by investing activities, and subtracting the $250 net cash used for financing activities. We add this Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

363

Accounting Information for Business Decisions $13 607 increase in cash to the $11 575 1 January 20X2 cash balance to show the $25 182 31 January 20X2 cash balance. This $25 182 cash balance is the same amount we showed in Cafe´ Revive’s 31 January 20X2 balance sheet in Case Exhibit 8.2.

Expanded discussion of calculations for the direct method A business does not always prepare its cash flow statement each month. Usually, a business will do so each quarter or each year. When a cash flow statement is not prepared for a long time, the business may have hundreds of entries in its ‘Cash’ account, so it becomes very time-consuming to analyse each entry to see whether it involved a cash inflow or outflow from an operating, investing or financing activity. Also, sometimes an external user, such as a bank, evaluating a business’s performance may have the business’s income statement and balance sheet, but not its cash flow statement. In these cases, the business or other external user may use a ‘shortcut’ approach to preparing a cash flow statement. This approach involves analysing the business’s income statement amounts and changes in its balance sheet amounts to determine the change in cash. In the Appendix at the end of this chapter, we will study how to analyse changes in balance sheet amounts to determine cash inflows and cash outflows from investing and financing activities. Here, we focus on determining cash inflows and cash outflows from operating activities. To understand how to determine a business’s operating cash flows, remember how a business operates. Recall from Chapter 3 that a business’s operating cycle is the average time required to pay for inventory, sell the inventory and collect on the sales. To begin its operating cycle, a business buys inventory for cash or on credit (increasing accounts payable). When a business makes cash or credit sales during the current accounting period, it increases cash (or accounts receivable) and revenues, and increases cost of goods sold and reduces inventory. It increases other expenses and either decreases cash or increases liabilities, such as salaries payable, for the expenses. When the business collects its accounts receivable, it increases cash and decreases accounts receivable. When it pays its accounts payable, it decreases cash and decreases accounts payable. This collection of accounts receivable and payment of accounts payable may occur weeks or even months later, in the next accounting period. When the business records all of these transactions, it always keeps the accounting equation in balance and maintains the dual effect of transactions. To determine its cash inflows and outflows from operating activities, a business can analyse its income statement accounts and changes in its balance sheet accounts related to its day-to-day operations – that is, current assets and current liabilities. The reason a business does this analysis relates to accrual accounting, which we discussed in Chapter 4. Under accrual accounting, a business records its revenue and related expense transactions in the same accounting period that it provides goods or services, regardless of whether it receives or pays cash in that period. Thus, the analysis for the operating cash flows involves converting accrual accounting information into operating cash flow information. From our earlier discussion, recall that a business must report several types of cash inflows and outflows from operating activities. To keep this discussion simple, we will focus on determining the collections from customers, the payments to employees, and the payments to suppliers. These are the major operating cash flows.

5

How do users combine the changes in a business’s current assets and current liabilities with its revenues and expenses for the accounting period to determine the business’s operating cash flows?

364

Collections from customers To determine a business’s collections from customers during the accounting period, recall that the business can make sales for cash or for credit. Its ‘Sales revenue’ account includes both cash and credit sales. Its ‘Accounts receivable’ account (a current asset) includes increases due to credit sales and decreases due to collections of accounts receivable. So if the ‘Accounts receivable’ account balance decreases during the accounting period, this means that more cash was collected (from current and previous credit sales) than the amount of current credit sales that were made. If, on the other hand, the ‘Accounts receivable’ account balance increases during the accounting period, this means that less cash was collected than the amount of credit sales. By taking the balance in its ‘Sales revenue’ account and adding Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 9 The cash flow statement: Components and applications to it the decrease in ‘Accounts receivable’ (or subtracting the increase in ‘Accounts receivable’), a business can determine its cash collections from customers during the accounting period. The upper part of Exhibit 9.9 shows how to calculate a business’s cash collected from customers. In this example, assume that a business made cash sales of $60 000 and credit sales of $80 000 during its first year of operations, and collected $70 000 of the related accounts receivable. At year-end, its ‘Sales revenue’ account shows a balance of $140 000, and its ‘Accounts receivable’ account shows an increase of $10 000 above its balance at the beginning of the year. The $130 000 cash collected from customers is determined by subtracting the $10 000 increase in ‘Accounts receivable’ from the $140 000 in ‘Sales revenue’. (You can confirm the $130 000 cash collected by adding the cash sale of $60 000 to the accounts receivable collection of $70 000.) Exhibit 9.9 Calculations for major operating cash flows Sales revenue  $ 60 000  $ 80 000 Bal $140 000

Sales revenue  $140 000 

Increase in accounts receivable $10 000

 

Cash collected from customers $130 000

Salaries expense $28 000

Increase in salaries payable $2 000

 

Cash paid to employees $26 000

Accounts receivable Bal   Bal

$ 0 $80 000 $70 000 $10 000

Salaries expense  $ 26 000  $ 2 000 Bal $ 28 000

 

Salaries payable Bal $ 0  $ 2 000 Bal $ 2 000

Cost of goods sold  $ 36 000  $ 48 000 Bal $ 84 000

Cost of goods sold $84 000 Inventory Bal    Bal

0 $126 000 $ 36 000 $ 48 000 $ 42 000

 

Increase in inventory $42 000

 

Increase in accounts payable $30 000

 

Cash paid to suppliers $96 000

$126 000 (Inventory purchased)

Accounts payable Bal 0  $126 000  $ 96 000 Bal $ 30 000

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Payments to employees To determine a business’s payments to employees, recall that its ‘Salaries expense’ account includes the amount of salaries earned by employees during the period. This amount includes both salaries that were paid to employees and salaries that were recorded at the end of the accounting period as being owed to employees for work they did during the period. The ‘Salaries payable’ account (a current liability) includes increases due to salaries owed to employees at the end of the current accounting period and decreases due to payments of employees’ salaries from the previous accounting period. So if the ‘Salaries payable’ account balance decreases during the period, this means that more cash was paid during this period for salaries than employees earned this period. If the ‘Salaries payable’ account balance increases during the period, this means that less cash was paid during this period for salaries than employees earned this period. By taking the balance in the ‘Salaries expense’ account and adding the decrease in ‘Salaries payable’ (or subtracting the increase in ‘Salaries payable’), a business can determine the amount of cash it paid to employees during the accounting period. The middle part of Exhibit 9.9 shows how to calculate the cash payments to employees. In this example, assume that the business paid salaries of $26 000 and recorded salaries owed of $2000 at the end of its first year of operations. At year-end, the ‘Salaries expense’ account shows a balance of $28 000, and its ‘Salaries payable’ account shows an increase of $2000. The $26 000 cash paid to employees is determined by subtracting the $2000 increase in ‘Salaries payable’ from the $28 000 in ‘Salaries expense’.

Stop & think Using this type of analysis, how would you determine the amount of rent that was paid during the year?

Payments to suppliers The calculations of the cash collected from customers and paid to employees each involved one income statement account and one balance sheet account. The calculation of the cash paid to suppliers is slightly more complicated because it involves one income statement account and two balance sheet accounts. To determine a business’s payments to suppliers, recall that its ‘Cost of goods sold’ account includes the cost of inventory sold to customers during the accounting period. The ‘Inventory’ account (a current asset) includes entries for both the purchase and the sale of inventory. So if the ‘Inventory’ account increases during the accounting period, this means that more inventory was purchased than sold. If it decreases, more inventory was sold than purchased. The inventory was purchased either by paying cash or using credit. The ‘Accounts payable’ account (a current liability) includes increases due to credit purchases of inventory and decreases due to payments of accounts payable. So if the ‘Accounts payable’ account balance decreases during the accounting period, this means that more cash was paid (for current and previous credit purchases) than the amount of credit purchases of inventory that were made during the current period. If the ‘Accounts payable’ account balance increases during the period, this means that less cash was paid than the amount of credit purchases of inventory. Because the cost of inventory (both cash and credit) ‘flows’ into the ‘Inventory’ account at the time of purchase and ‘flows’ out at the time of sale (and into the ‘Cost of goods sold’ account), two calculations must be made to determine the cash paid to suppliers for inventory. First, the total amount of inventory purchased must be determined. This is done by adding the increase in the ‘Inventory’ account to (or subtracting the decrease from) the balance in the ‘Cost of goods sold’ account. Then the impact of the credit purchases must be eliminated. This is done by adding the decrease in ‘Accounts payable’ to (or subtracting the increase in ‘Accounts payable’ from) the total amount of inventory purchased. The end result is the cash paid to suppliers during the accounting period. The lower part of Exhibit 9.9 shows how to calculate the cash paid to suppliers. In this example, assume that the cost of goods sold related to the cash sales and credit sales were $36 000 and $48 000, 366

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Chapter 9 The cash flow statement: Components and applications respectively, so that the ‘Cost of goods sold’ account shows a balance of $84 000. The ‘Inventory’ account shows an increase of $42 000 during the year. The ‘Accounts payable’ account shows an increase of $30 000. The $126 000 total amount of inventory purchased is determined by adding the $42 000 increase in ‘Inventory’ to the $84 000 in ‘Cost of goods sold’. The $96 000 cash paid to suppliers is determined by subtracting the $30 000 increase in ‘Accounts payable’ from the $126 000 total amount of inventory purchased. For the sake of discussion, we have used a simple example which had only a few numbers in each balance sheet account. To some of you, it may appear that our analysis could have been shortened even more. In reality, balance sheet accounts may have many numbers in them, and for external users only the balances (from the beginning and ending balance sheets) are known. So the method we have explained will work under complex or simple circumstances. We also explained how to calculate only three operating cash flows. The analysis used for calculating other operating cash flows is the same. We show a diagram of the calculations for all operating cash flows in Exhibit 9.10, and provide an example later in the chapter. Exhibit 9.10 Calculations for all operating cash flows Income statement amounts

Cash flows from operating activities

Adjustments

Sales revenue

 Decrease in accounts receivable or  Increase in accounts receivable



Collections from customers

Interest revenue

 Decrease in interest receivable or  Increase in interest receivable



Collections of interest

Other revenues

 Increase in unearned revenues* or  Decrease in unearned revenues*



Other operating receipts

Cost of goods sold

 Increase in inventory or  Decrease in inventory  Decrease in accounts payable or  Increase in accounts payable



Payments to suppliers

Salaries expense

 Decrease in salaries payable or  Increase in salaries payable



Payments to employees



Payments of interest



Other operating payments

Interest expense

Other expenses

*Unless

 Decrease in interest payable or  Increase in interest payable  Increase in prepaid expenses or  Decrease in prepaid expenses  Depreciation**

Net operating cash flows

Cash inflows from operating activities

Cash outflows for operating activities

related to normal sales; then the adjustment is made to sales revenue listed as separate item on income statement

**Unless

9.5 Analysis of the cash flow statement Financial statement users think that cash flows are a critical part of a business’s ability to remain solvent. A comment from a bank executive sums up why evaluating a business’s cash flows is important: ‘A bank lends cash to its customers, collects interest from them, and requires the customers to repay the loan in cash. It’s all about cash.’c Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

6

Why do internal and external users study a business’s cash flow statement in conjunction with its income statement and balance sheet?

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iStockphoto/PeopleImages

Accounting Information for Business Decisions By reviewing a business’s cash flow statement, external users can see how the business obtained and used its cash. Because a business summarises its cash flows through operating, investing and financing activities, users can compare the amounts in each section of the statement to see whether important changes have occurred. External users can evaluate the business’s need for additional cash to pay for its existing operations or for the expansion of its operations. They can also evaluate the ability of the business to make interest payments and to pay off debt when it comes due. A comparison with the cash flows of other companies can also show, for instance, that the business is obtaining a greater proportion of its cash from investing activities than are similar companies. This situation may indicate a problem with the business’s net cash flows from operating activities. One possible explanation is that the business is selling a relatively large portion of its assets to get the cash it needs for operations. If it does not replace the assets, the business might hamper its ability to obtain cash from operations in the future. For example, suppose you owned a lawnmowing business and because your business was short on cash, you sold several of the business’s lawnmowers for cash. Would the business be able to mow as many lawns after the sale as it could before the sale? Managers are able to use the information in the cash flow statement in much the same way that external users do. They can determine whether the net cash flow from operating activities is large enough to finance existing operations, whether excess cash from operating activities may be sufficient to finance expansion projects or whether additional cash must be obtained from external parties. In addition, both managers and external users use the cash flow statement, in conjunction with the balance sheet and the income statement, to help evaluate a business. All three financial statements help users analyse three important business characteristics: (1) liquidity and solvency; (2) ability to make property and equipment purchases; and (3) cash flow returns (which we will discuss later). Financial statement users assess a business’s liquidity and solvency to see whether a business is generating enough cash to pay its debts. Recall from Chapter 8 that liquidity refers to how quickly a business can convert its assets to cash to pay its bills. In that chapter, we showed you how decision makers use the current assets and current liabilities sections of the balance sheet to calculate the current ratio and the quick ratio. Solvency refers to a business’s ability to pay its long-term debts as they come due. The debt ratio is calculated from balance sheet information to help assess solvency. These balance sheet ratios are important in assessing a business’s liquidity and solvency. However, they focus on the relationship between a business’s assets and liabilities without regard for the business’s ability to generate the cash needed to pay its debts. By showing a business’s sources and uses of cash, the cash flow statement provides additional information about a business’s management of cash. In addition to paying its debts, a business must have enough property and equipment to continue earning a satisfactory profit. For example, Cafe´ Revive may need to have cash available to buy additional equipment. If, for instance, a DeFlava Coffee frozen coffee drink were to become popular, Cafe´ Revive would need to be able to purchase refrigerated display cases. What are the operating cash flows related to this student’s Assessing a business’s ability to make these types of purchases helps car washing activities? decision makers determine how well the business can continue to perform. It is unlikely that a business can continue to be successful unless it can obtain most of its cash from its operating activities. Thus financial statement users want to know whether or not the cash the business received from selling goods or services is more than the cash it paid to provide the goods or services. cash flow returns External users can compare the business’s net cash flow from operating activities for a given year with A business’s cash flows that year’s income from operations to assess how well its operating activities provide cash. divided by the dollar A business’s ability to generate enough cash to remain in business and earn a satisfactory profit can amount of its assets or owner’s equity also be studied by computing its cash flow returns. By cash flow returns, we mean the business’s cash 368

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Chapter 9 The cash flow statement: Components and applications flows divided by the dollar amount of its assets or owner’s equity. This is similar to the return on total assets or return on owner’s equity calculations, which we explained in Chapter 8. We will discuss each of these evaluations in the following sections.

Relationship between the cash flow statement and the cash budget Remember from Chapter 3 that a cash budget gives a description of a business’s planned cash activities. Also recall that one purpose of a budget is to provide a benchmark for the evaluation of a business’s performance. One way in which managers evaluate their business’s operating performance for an accounting period is by comparing the information from the operating activities section of the business’s cash flow statement with the projected operating cash flows in its cash budget. Following is a comparison of the January 20X2 cash budget information for Cafe´ Revive (taken from Case Exhibit 3.14 in Chapter 3) and the actual cash flow from operations information for January: Item

Cash receipts from sales – coffee gift packs Cash receipts from sales – cups of coffee Cash receipts from interest Cash paid to suppliers – gift packs Cash paid to suppliers – coffee supplies Cash paid to employees Cash paid for other operating items Net cash provided by operations

Budget

Actual

Effect of difference on cash balance

$ 9 163

$12 000

$2 837

4 840

5 368

528

0

25

(25)

(1 430)

(1 430)

0

0

(275)

(275)

(2 360)

(2 050)

310

(913)

(871)

42

$ 9 300

$12 717

þ$3 417

As you can see, Cafe´ Revive did not closely follow its January operating cash budget. Cash receipts from sales were $2837 greater than budgeted for coffee gift packs and $528 for cups of coffee. So Cafe´ Revive ended January with $3417 more cash than it expected. Because Cafe´ Revive is so small, and it is the business’s first period of operation, it is difficult to budget accurately, particularly regarding the amount of operating cash inflow for January. The cash flow information for sales reinforces our conclusion that Cafe´ Revive had a successful first month of operations.

Stop & think How do you think this comparison will affect the cash budget for the next period? Why? In the remainder of this chapter, we will discuss some additional, more specific ways that managers and external decision makers use the cash flow statement to evaluate a business’s performance.

Relationship between the cash flow statement and the income statement The income statement and the cash flow statement are related because both report on a business’s activities during an accounting period. The difference between the two is that the income statement reports on activities using accrual accounting, whereas the cash flow statement reports only on cash activities. Because of the differences in the way in which these statements measure income and cash flows, and because of the type of information that results from these differences, managers, investors and creditors are interested in both measures of operating performance. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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What cash flow ratios are used to evaluate a business’s performance?

9.6 Calculate the relevant cash flow ratios We explained in Chapter 7 that a business’s profit margin (Net income / Net sales) is an important measure of profitability. Information from the cash flow statement is used to calculate an additional profitability (and liquidity) measure. The operating cash flow margin is calculated as: Operating cash flow margin ¼

Net cash flow provided by operating activities Net sales

This ratio describes how much net cash the business generated from each dollar of net sales. It is similar to a profit margin measure, but in this case, the higher the ratio, the better the business is at generating cash from operating activities and the greater is its liquidity. For example, Case Exhibit 9.6 (earlier in this chapter) shows that in January Cafe´ Revive’s net cash provided by operating activities was $13 417. Its net sales for January were $16 880 (see Case Exhibit 7.2). Therefore, its operating cash flow margin was 0.7948 ($13 417 / $16 880). This means that Cafe´ Revive generated $0.79 net cash for each dollar of its net sales.

Discussion What do you think causes the difference between the amount of Cafe´ Revive’s net sales and the net amount of cash it generated from its net sales?

REL Consultancy Group specialises in helping companies improve their working capital and cash flow positions. Every year, REL compiles and publishes a survey on the working capital efficiency of over 1000 companies. One of the key ratios that REL calculates is what it calls the cash-conversion efficiency (CCE) ratio, which is calculated in the same way as the operating cash flow margin we just discussed. REL considers the CCE ratio to be very important in evaluating a business’s cash flow (and liquidity) performance, and its annual survey provides benchmarks to help a business compare its performance with that of other companies.d

Operating cash flow margins of actual companies To illustrate ratio analysis, we continue our evaluation of Super Retail Group Limited (http://www. superretailgroup.com.au) and Woolworths Group Limited (https://www.woolworthsgroup.com.au), which we began in Chapters 7 and 8. The companies’ operating cash flow margins for 2018 were as follows: Super Retail Group (%) Woolworths (%) Operating cash flow margin

12.0

5.2

Notice that Super Retail Group was more efficient than Woolworths at generating cash from sales, indicating that Super Retail Group had more liquidity for the year ended 30 June 2018.

Discussion In the figures we presented in Chapter 7, Super Retail Group’s profit margin was higher than that of Woolworths. Why do you think Super Retail Group’s operating cash flow margin is higher than that of Woolworths?

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Chapter 9 The cash flow statement: Components and applications

Relationship between the cash flow statement and the balance sheet The balance sheet is related to the cash flow statement in much the same way as it is related to the income statement. Recall from Chapter 8 that a business’s balance sheet shows the amount of its resources at a specific date, and that the business’s income statement shows the ‘flow’ of its operating activities for an accounting period. Further, remember that a business’s income statement and balance sheet are used together to assess how well the business performed, given its level of resources. Because net cash flow from operating activities provides an alternative measure (i.e. ‘flow’) of business performance, it also can be used with balance sheet information to assess how well a business performed, given its resources.

Cash return ratios Two ratios used to assess a business’s cash flow performance in relation to its resources are: (1) the cash return on total assets; and (2) the cash return on owner’s equity. These ratios are calculated as follows: Cash return on total assets ¼

Net cash flow provided by operating activities þ Interest paid Average total assets

Cash return on owner’s equity ¼

Net cash flow provided by operating activities Average owner’s equity

A business’s cash return on total assets measures how well the business is using its resources to generate net cash from operating activities. Interest payments are added back in the numerator because they are returns to the creditors who loan the business money to purchase some of the assets. Case Exhibit 9.6, earlier in this chapter, shows that in January, Cafe´ Revive’s net cash provided by operating activities was $13 417. Its average total assets for January were $29 792.50 ([$24 870 total assets on 1 January þ $34 715 total assets on 31 January] / 2; see Case Exhibit 8.2 in Chapter 8). Therefore, its cash return on total assets was 45 per cent ($13 417 / $29 792.50). Notice that we did not add back interest payments in the numerator because Cafe´ Revive made no interest payments in January. A cash return on total assets of 45 per cent means that every dollar Cafe´ Revive invested in assets in January generated net cash from Cafe´ Revive’s operating activities of 45 cents. A business’s cash return on owner’s equity measures how much net cash from operating activities the business generated with each dollar of owner’s capital. Cafe´ Revive’s average owner’s equity during January was $24 037.50 ([$22 000 owner’s equity on 1 January þ $26 075 owner’s equity on 31 January] / 2; see also Case Exhibit 8.2). Its cash return on owner’s equity was 55.8 per cent ($13 417 net cash flow from operating activities / $24 037.50). This means that each dollar of Emily Della’s capital generated net cash from operating activities of 55.8 cents. The two cash return ratios are used much in the same way as the return on total assets and return on owner’s equity ratios discussed in Chapter 8. These cash return ratios help managers and external users to assess whether or not the business is generating enough cash from its operating activities.

Cash return ratios of actual companies The ratios used to evaluate the cash returns of Super Retail Group and Woolworths for the year ended 30 June 2018 were as follows: Super Retail Group (%) Woolworths (%) Cash return on total assets

18.6

12.6

Cash return on owner’s equity

39.7

28.3

These ratios indicate that Super Retail Group generated a little more cash for each dollar of assets and less cash for each dollar of owner’s equity than Woolworths. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Stop & think Would it be possible for a business, A, to have a higher return on total assets figure than another business, B, and for business B to have a higher cash return on total assets than business A? If so, why?

Interrelationships among financial statements In Chapters 7, 8 and 9, we introduced the major financial statements of a business and began to show how decision makers use the information in these financial statements. These decision makers understand the interrelationships among the various items on a business’s financial statements. We show these relationships in the following diagram: Partial beginning balance sheet (1.1.X1)

Partial income statement

Partial statement of changes in owner’s equity

Beginning cash —————————————————— >

Partial cash flow statement

Partial ending balance sheet (31.12.X1)

Net change in cash þ Beginning cash ¼ Ending cash ——— > Ending cash

> Beginning capital Beginning capital ————————— Net income

——— > þ Net income ¼ Ending capital ———————————— > Ending capital

We have only scratched the surface regarding how managers, investors and creditors use accounting information to make business decisions. Businesses are now also exploring how accounting information can be used to help them measure sustainability. Gray is attributed with much of the conceptual development of sustainability accounting. Graye identifies three different methods of sustainability accounting: sustainable cost, natural capital inventory accounting and input–output analysis. These methods are described in the sustainability text box below. A brief history of sustainability accounting

Ethics and Sustainability

372

1 Sustainable cost is the (hypothetical) cost of restoring the earth to the state it was in prior to an organisation’s impact – that is, ‘the amount of money an organisation would have to spend at an end of an accounting period in order to place the biosphere back into the position it was in at the start of the accounting period’.f Gray draws on the accounting concept of capital maintenance and applies it to the biosphere, recognising the need to maintain the stock of natural capital for future generations. A sustainable organisation would be one that maintains natural capital intact for future generations. Sustainable cost is deducted from the accounting profit (calculated using generally accepted accounting principles, GAAP) to arrive at a notional level of sustainable profit or loss. 2 Natural capital inventory accounting involves the recording of stocks of natural capital over time, with changes in stock levels used as an indicator of the (declining) quality of the natural environment. Various types of natural capital stocks are distinguished, enabling the recording, monitoring and reporting of depletions or enhancements within distinct categories. Gray suggests four categories of natural capital: (a) critical – for example, the ozone layer, tropical hardwood and biodiversity (b) non-renewable or non-substitutable – for example, oil, petroleum and mineral products (c) non-renewable or substitutable – for example, waste disposal and energy usage

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Chapter 9 The cash flow statement: Components and applications

(d) renewable – for example, plantation timber and fisheries. Natural capital inventory accounting could be predominantly non-financial, tracking resource flows in quantitative but non-monetary units. 3 Input–output analysis accounts for the physical flow of materials and energy inputs, and product and waste outputs, in physical units. It aims to measure all materials inputs into the process, and outputs of finished goods, emissions, recycled materials and waste for disposal. Resource flows are accounted for using units of volume, although accounting in financial units is considered feasible. Input–output analysis uses a balancing technique familiar to accountants, applying the principle ‘what goes in must come out’, and providing a disciplined approach to the provision of environmental information. Reported advantages of input–output analysis include identification of potential resource and energy savings; it is often the first step in an environmental audit process; and it can facilitate product innovation and pollution-prevention strategies, particularly when it forms part of a product and/or process life-cycle analysis.g Source: Adapted from Lamberton, G (2005) ‘Sustainability accounting – a brief history and conceptual framework’. Accounting Forum, 29(1), 7–26.

Stop & think Having read the sustainability text box, how does each of these three methods of accounting for sustainability have elements in common with the idea of a cash flow statement?

Business issues and values: Cash flows As the end of an accounting period approaches, an entrepreneur may notice that unless something changes, the business’s net cash flows for the period will not be as high as planned. In an effort to remedy this unhappy realisation, the owner may postpone payments to the business’s suppliers and employees. The effect is to reduce the cash payments from operations for the period, and therefore to increase the business’s net cash flows from operating activities. The business’s operating cash flow margin, cash return on total assets and cash return on owner’s equity will all be higher than they would have been if the business had not postponed payments to suppliers and employees. But although this action may make the business ‘look better’ in the short run, it also has some negative effects. External users of the business’s cash flow statement might think that the business is more liquid (and healthier) than it really is, perhaps leading them to make ill-informed decisions about the business. A more immediate effect is the reduced cash flows of the suppliers and employees. In deciding whether to take actions such as this, managers and owners must look ‘beyond the numbers’ and consider all the stakeholders in the decision. In other words, managers must consider who will be affected by the different decision alternatives (in this case, the business, the external users, the employees and the suppliers, at a minimum) and how the alternatives will affect these people. According to a report from the Boston College Center for Corporate Citizenship and Ernst & Young, more than half of all companies surveyed say sustainability reporting leads to higher cash flows and helps improve firm reputation. Although issuing a sustainability report in accordance with the Global Reporting Initiative (GRI) Framework or another standard requires a lot of work, value of sustainability reporting finds strong evidence that transparency gives companies a number of financial and social advantages that make it more than worth its costs.h

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STUDY TOOLS Summary 9.1 Understand the importance of the cash flow statements to organisations and users. 1

Why is a business’s cash flow statement important?

A business’s cash flow statement is important because it summarises the changes in the business’s cash by listing the cash inflows and cash outflows from its operating, investing and financing activities during an accounting period. This information cannot be obtained from the business’s income statement or balance sheet. The information is useful to decision makers in evaluating the business’s solvency and liquidity.

9.2 Identify the types of transactions that generate cash inflows and outflows. 2

What types of transactions may cause cash inflows and cash outflows for a business?

The types of transactions that may cause cash inflows (receipts) for a business are decreases in its assets other than cash, increases in its liabilities and increases in its owner’s equity. The types of transactions that may cause cash outflows (payments) for a business are increases in its assets other than cash, decreases in its liabilities and decreases in its owner’s equity.

9.3 Understand the organisation of the cash flow statement. 3

What do users need to know about a business’s cash flow statement?

Users need to know that a business’s cash flow statement shows its cash inflows and cash outflows according to the type of activity that caused the increase or decrease in cash. There are three sections: the cash flows from operating activities, the cash flows from investing activities and the cash flows from financing activities. The net cash flows from each section are summed and the total increase (decrease) in cash is added to (or subtracted from) the beginning cash balance to determine the ending cash balance.

9.4 Construct cash flow statements based on the direct method. 4

How does a business report the cash flows from its operating activities on its cash flow statement using the direct method?

Under the direct method, a business reports its cash flows from operating activities in two parts: operating cash inflows and operating cash outflows. A business may report as many as three categories of operating cash inflows (e.g. collections from customers) and as many as four categories of operating cash outflows (e.g. payments to suppliers). 5

How do users combine the changes in a business’s current assets and current liabilities with its revenues and expenses for the accounting period to determine the business’s operating cash flows?

The change in accounts receivable is combined with the sales revenue to determine the collections from customers. The change in salaries payable is combined with the salaries expense to determine the payments to employees. The change in inventory and the change in accounts payable are combined with the cost of goods sold to determine the payments to suppliers.

9.5 Explain how the cash flow statement can be used in conjunction with the financial statements for decision making. 6

Why do internal and external users study a business’s cash flow statement in conjunction with its income statement and balance sheet?

Internal and external users study a business’s cash flow statement in conjunction with its income statement and balance sheet to evaluate the business’s liquidity and solvency, its ability to purchase property and equipment, and its cash flow returns.

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Chapter 9 The cash flow statement: Components and applications

9.6 Calculate the relevant cash flow ratios. 7

What cash flow ratios are used to evaluate a business’s performance?

The operating cash flow margin (Net cash flow from operating activities / Net sales) is used to evaluate a business’s profitability (and liquidity). The cash return on total assets ([Net cash flow from operating activities þ Interest paid] / average total assets) and the cash return on owner’s equity (Net cash flow from operating activities / Average owner’s equity) are used to evaluate a business’s performance in relation to its available resources.

Key terms cash flow returns

financing activities

cash flow statement

indirect method

direct method

investing activities

operating activities

Online research activity This activity provides an opportunity to gather information online about real-world issues related to the topics in this chapter. For suggestions on how to navigate various businesses’ websites to find their financial statements and other information, see the related discussion in the Preface. Put your skills to the test and find answers to the following questions by visiting the listed websites. u Go to the Dell Technologies website (https://www.delltechnologies.com). What kinds of services does Dell provide to its customers? Find Dell’s statements of cash flows. How much cash did Dell receive from customers for the most current year? How much cash did Dell pay to suppliers and employees during the most current year? Find Dell’s balance sheets. What is Dell’s cash return on owners’ (shareholders’) equity for the most current year? u Go to the Gamestop (owner of EB Games) website (http://news.gamestop.com/financial-information/annual-reports). What kinds of products and services does Gamestop provide, and where does it do business? Find Gamestop’s statement of cash flows. How much cash did the business receive from customers during the most current year? How much cash did the business pay to its suppliers and employees for the current year? How does the business’s net cash provided by operating activities for the current year compare to the previous year? Find the business’s balance sheets. What was the business’s cash return on total assets for the most current year? u Melbourne’s Tyre Crumb Australia Pty Ltd (http://www.tyrecrumbaustralia.com/index-2.html) is able to recycle everything from wheelie-bin tyres to earthmover treads. It recycles every component, including rubber, steel and polyester fibre. The result is tiny granules, which manufacturers prefer because it is versatile. Tyre Crumb’s product is used in everything from playground and sporting surfaces to roads, brake linings, mats and the soles of shoes. How did the Melbourne tyre recycler increase its cash flow? u Brisbane’s Replas (https://www.replas.com.au) is an innovative plastics recycling plant that produces all kinds of products from recycled plastic – for example, bollards, decking, fencing, fitness trails, furniture, garden products and signs. What is the company’s strategy in trying to increase its cash flow?

Integrated business and accounting situations Answer the following questions in your own words.

Testing your knowledge 9-1 9-2 9-3 9-4 9-5 9-6 9-7

What is a cash flow statement and what types of questions can a user answer by studying a business’s cash flow statement? Write out a cash flow equation that links the beginning and the ending cash balances. What three types of transactions related to balance sheet items may cause cash inflows? Give an example of each. What three types of transactions related to balance sheet items may cause cash outflows? Give an example of each. Identify the three sections of a business’s cash flow statement and briefly explain what is included in each section. How is the net cash provided by operating activities determined under the direct method? What are the three categories of operating cash inflows under the direct method? Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions

9-8 9-9 9-10 9-11 9-12 9-13 9-14

What are the four categories of operating cash outflows under the direct method? Describe how to calculate a business’s collections from customers during an accounting period, based on an analysis of its income statement and its beginning and ending balance sheets. Describe how to calculate a business’s payments to employees during an accounting period, based on an analysis of its income statement and its beginning and ending balance sheets. Describe how to calculate a business’s payments to suppliers during an accounting period, based on an analysis of its income statement and its beginning and ending balance sheets. How is the operating cash flow margin of a business computed and what does it describe? How is the cash return on total assets of a business computed and what does it measure? How is the cash return on owner’s equity of a business computed and what does it measure?

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Flightboat Ltd borrowed $60 000, issued $20 000 worth of ordinary shares, paid a dividend of $50 000 and the owner withdrew $10 000 in cash. What was Flightboat’s net cash provided (used) by financing activities? Fredski Coaching School had accounts receivable of $30 000 at the beginning of the year and $60 000 at the year end. The revenue for the year was $120 000. How much cash did Fredski collect from his customers? Greengrass Mowing Service had operating expenses for the year of $60 000. At the beginning of the year, Greengrass owed $15 000 on accrued liabilities. The closing balance of accrued liabilities was $20 000. How much did Greengrass pay in cash for the operating expenses? Simmo Education had cost of goods sold of $42 000 for the year. The beginning inventory was $40 000 and the ending inventory was $61 000. The beginning accounts payable was $35 000 and the closing balance was $50 000. How much inventory was purchased during the period? How much cash was paid to the suppliers? Nadine’s Fitball Pty Ltd began on 1 July 20X0 with cash of $140 000. During the year, Fitball earned service revenue of $650 000 and collected $620 000 from customers. Fitball expenses for the year totalled $ 450 000, of which $420 000 cash was paid to employees and suppliers. Fitball also brought sports equipment for $200 000 and during the year it paid a cash dividend of $60 000 to its shareholders. Required: Prepare the company’s cash flow statement for the year ended 30 June 20X1, using the direct method. The following are transactions and activities of a business: i Receipt from sale of building ii Withdrawal by owner iii Decrease in accounts receivable iv Payment for purchase of investment v Receipt from issuance of long-term note payable vi Payment for purchase of inventory. Required: Indicate in which section of the business’s cash flow statement each of the above items would appear. Would each be a cash inflow or outflow? The following are transactions and activities of a business: i Cash sales ii Decrease in accounts payable iii Payment for purchase of equipment iv Investment by owner v Payment of long-term note payable vi Receipt from selling investment. Required: Indicate in which section of the business’s cash flow statement each of the above items would appear. Would each be a cash inflow or outflow? The following is selected information taken from the ‘Cash’ account of Noreen Novelties for June: i Cash sales: $40 000 ii Payment of interest: $2400 Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 9 The cash flow statement: Components and applications

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iii Payment for inventory: $4000 iv Collection of accounts receivable: $8000 v Payments to employees: $20 000 vi Collection of interest: $2000. Required: Using the direct method, prepare the cash flows from the operating activities section of Noreen’s Novelties’ cash flow statement for June. Tube Tunnel has the following information in its ‘Cash‘ account for July: i Paid employees: $18 000 ii Paid suppliers: $8000 iii Cash sales: $44 000 iv Collected interest: $3200 v Paid interest: $2000 vi Collected accounts receivable: $20 000. Required: Using the direct method, prepare the cash flows from the operating activities section of Tube Tunnel’s cash flow statement for July. The following is selected information taken from the ‘Cash’ account of Steven Steel for June: i Cash sales: $20 000 ii Payment of interest: $1200 iii Payment for inventory: $2000 iv Collection of accounts receivable: $4000 v Payments to employees: $10 000 vi Collection of interest: $1000. Required: Using the direct method, prepare the cash flows from the operating activities section of the Steven Steel business’s cash flow statement for June. The Water Ski business has the following information in its ‘Cash’ account for July: i Paid employees $9000 ii Paid suppliers $4000 iii Made cash sales of $22 000 iv Collected $1600 interest v Paid $1000 interest vi Collected $10 000 of accounts receivable. Required: Using the direct method, prepare the cash flows from the operating activities section of Water Ski business’s cash flow statement for July. This list of items is to be included in the cash flow statement of Brockman Lawn Sprinklers for the current year: i Payment for purchase of trenching equipment: $6000 ii Payments to suppliers: $3200 iii Receipt from sale of land: $1000 iv Collections from customers: $15 800 v Withdrawals by owner: $2500 vi Receipt from issuance of note payable: $4000 vii Payments to employees: $5600 viii Beginning cash balance: $1200. Required: a Prepare the business’s cash flow statement. b If net sales were $69 000, calculate Brockman Lawn Sprinklers’ operating cash flow margin.

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Items to be included in Nadine’s Giftware’s cash flow statement for the current year are as follows: i Investment by owner: $6000 ii Payments to employees: $16 200 iii Receipt from sale of investments: $2600 iv Ending cash balance: $14 600 v Payments for inventory: $12 000 vi Cash collected from customers: $34 800 vii Withdrawals by owner: $3600 viii Payment for purchase of warehouse: $18 400 ix Payment of interest: $1000. Required: a Prepare the business’s cash flow statement. b If the average owner’s equity was $31 000, calculate the business’s cash return on owner’s equity. What is your evaluation if last year the business’s cash return was 17.2 per cent? An analysis of the Toney business’s Cash account for September shows these entries: i Beginning cash balance: $800 ii Collections from customers: $21 500 iii Payment for purchase of storage shed: $9500 iv Investment by owner: $5000 v Payment to suppliers: $12 800 vi Collection of interest: $600 vii Receipt from sale of equipment: $2100 viii Payments of employees’ salaries: $4500 ix Payment of interest on loan: $700 x Ending cash balance: $2500. Required: Prepare the business’s cash flow statement for September. Items to be included in the Mitchell’s Mechanics business’s cash flow statement for the current year are as follows: i Investment by owner: $12 000 ii Payments to employees: $32 400 iii Receipt from sale of investments: $5200 iv Ending cash balance: $29 200 v Payments for inventory: $24 000 vi Cash collected from customers: 69 600 vii Withdrawals by owner: $7200 viii Payment for purchase of warehouse: $36 800 ix Payment of interest: $2000. Required: a Prepare the business’s cash flow statement. b If the average owner’s equity was $62 000, calculate the business’s cash return on owner’s equity. What is your evaluation if last year the business’s cash return was 17.2 per cent? An analysis of the Barty Battles business’s Cash account for October shows these entries: i Beginning cash balance: $1600 ii Collections from customers: $43 000 iii Payment for purchase of storage shed: $19 000 iv Investment by owner: $10 000 v Payment to suppliers: $25 600 vi Collection of interest: $1200 vii Receipt from sale of equipment: $4200 viii Payments of employees’ salaries: $9000

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Chapter 9 The cash flow statement: Components and applications

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ix Payment of interest on loan: $1400 x Ending cash balance: $5000. Required: Prepare the business’s cash flow statement for October. The Fredette business’s Cash account shows the following entries for April: i Beginning cash balance: $800 ii Receipt from issuance of note: $20 000 iii Payment of interest on loan: $1800 iv Payment for purchase of sales fixtures: $3600 v Collections from customers: $66 800 vi Owner withdrawal: $8000 vii Payment of employees’ wages: $14 000 viii Payment for delivery van: $24 000 ix Payments to suppliers: $32 400 x Ending cash balance: $3800. Required: Prepare the business’s cash flow statement for April. Among other items, Andy’s business’s income statement for the year shows sales revenue of $156 000, cost of goods sold $92 600 and salaries expense $24 400. An analysis of its beginning and ending balance sheets for the year shows an increase in accounts receivable of $5800, a decrease in inventory of $14 200, a decrease in accounts payable of $11 200 and a decrease in salaries payable of $5600. Required: Determine the business’s collections from customers, payments to suppliers and payments to employees for the year. While reviewing Taber business’s income statement for the year, you find that it had sales of $81 500, cost of goods sold of $50 000 and wages expense of $30 200. A review of its beginning and ending balance sheets shows a decrease in accounts receivable of $3400, an increase in inventory of $4500, an increase in wages payable of $3300 and an increase in accounts payable of $7800. Required: Determine the business’s collections from customers, payments to suppliers and payments to employees for the year. The Thorpe business’s 20X1 cash flow statement, as developed by its bookkeeper, is as follows: THORPE Cash flow statement 31 December 20X1 Cash inflows: Receipt from sale of equipment Collections from customers Receipt from issuance of note payable

$ 3 000 101 600 11 800

Total inflows

$116 400

Cash outflows: Payments to employees

$ 48 600

Withdrawals by owner

10 000

Payment to purchase land

16 000

Payments to suppliers

38 800

Total outflows Increase in cash Cash, 1 January 20X1 Cash, 31 December 20X1

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113 400 $ 3 000 8 800 $ 11 800

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You determine that the amounts of the items listed on the statement are correct, but that they are incorrectly classified. Required: Prepare a correct 20X1 cash flow statement for Thorpe. The cash flow statement information of the Fairview Flowers Shop for 20X1 is as follows: Net cash provided by operating activities

$18 000

Cash, 1 January 20X1

8 500

Receipt from sale of equipment

6 400

Owner withdrawals

25 000

Net cash used for investing activities

(a)

Cash paid to employees

9 200

Cash, 31 December 20X1

(b)

Cash received from customers

44 300

Receipt from issuance of note payable

(c)

Net cash used for financing activities

5 000

Cash paid to suppliers

(d)

Payment to purchase building

23 000

Net decrease in cash

9-36

Required: Fill in the letters (a)–(e). All the necessary information is given. (Hint: It is not necessary to find the answers in alphabetical order.) The cash flow statement information of the Bray Tyre Company for 20X1 is as follows: Net increase in cash Cash received from customers

(a) 60 200 5 000

Cash, 1 January 20X1

(b)

Cash paid to suppliers Net cash provided by operating activities Cash, 31 December 20X1 Payment to purchase equipment Cash paid to employees

380

$

Receipt from sale of land

Net cash used for investing activities

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(e)

7 800 25 900 (c) 11 000 (d) 19 100

Net cash used for financing activities

(e)

Receipt from issuance of note payable

10 000

Owner withdrawals

16 000

Required: Fill in the letters (a)–(e). All the necessary information is given. (Hint: It is not necessary to find the answers in alphabetical order.) Border Collie Company has asked for your assistance in preparing its cash flow statement for 20X3. Among other items, its 20X3 income statement shows sales revenue (net) of $135 000, cost of goods sold of $72 000 and salaries expense of $36 800. You analyse its 20X3 beginning and ending balance sheets and find a beginning cash balance of $16 200, an increase in accounts receivable of $13 600, an increase in inventory of $4400, an increase in accounts payable of $9200 and a decrease in salaries payable of $4200. Further investigation shows the owner withdrew $24 000, and that the business sold land for $11 000, issued a note payable for $16 000 and purchased a van for $29 600. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 9 The cash flow statement: Components and applications

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Required: a Using your findings, prepare the business’s 20X3 cash flow statement. b Calculate the business’s 20X3 operating cash flow margin. If the business’s operating cash flow margin was 10.1 per cent in 20X2, what is your evaluation of the business’s liquidity in 20X3? Poodle Pets Company has asked for your assistance in preparing its cash flow statement for 20X1. Among other items, its 20X1 income statement shows sales revenue (net) of $270 000, cost of goods sold of $144 000 and salaries expense of $73 600. You analyse the business’s 20X1 beginning and ending balance sheets and find a beginning cash balance of $32 400, an increase in accounts receivable of $27 200, an increase in inventory of $8800, an increase in accounts payable of $18 400 and a decrease in salaries payable of $8400. Further investigation shows that the owner withdrew $48 000 and the business sold a vehicle for $22 000, issued a note payable for $32 000 and purchased a truck for $59 200. Required: a Using your findings, prepare the business’s 20X1 cash flow statement. b Calculate the business’s 20X1 operating cash flow margin. If the business’s operating cash flow margin was 10.1 per cent in 20X0, what is your evaluation of the business’s liquidity in 20X1? You have been hired by Seeser Flappits to prepare its 20X2 cash flow statement. The business provides you with its 20X2 income statement, as follows: Sales (net)

$ 56 600

Cost of goods sold

(31 400)

Gross profit Salaries expense

$ 25 200 $19 200

Depreciation expense

2 800

Other expenses (all cash)

1 000

Total operating expenses Net income

(23 000) $ 2 200

You determine that these numbers are correct. You review the business’s 20X2 beginning and ending balance sheets and find that the cash balance was $1900 on 1 January 20X2 and $5100 on 31 December 20X2. You also find the following changes: Accounts receivable

$4 200 decrease

Inventory

5 600 decrease

Accounts payable

2 500 decrease

Salaries payable

1 200 increase

You additionally determine that during 20X2, the business sold equipment for $4800, purchased land for $13 000 and issued a note payable for $7500, all for cash. The owner also withdrew $9600. After all these changes, the business had average total assets of $74 000 for 20X2. Required: a Using your findings, prepare the business’s 20X2 cash flow statement. (Use the direct method for operating cash flows.) b Calculate the business’s 20X2 cash return on total assets.

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Accounting Information for Business Decisions

9-40

You have been hired by Freddy Flintstone to prepare its 20X1 cash flow statement. The business provides you with its 20X1 income statement, as follows: Sales (net)

$113 200

Cost of goods sold

(62 800)

Gross profit Salaries expense

$ 50 400 $38 400

Depreciation expense

5 600

Other expenses (all cash)

2 000

Total operating expenses Net income

(46 000) $ 4 400

You determine that these numbers are correct. You review the business’s 20X1 beginning and ending balance sheets and find that the cash balance was $3800 on 1 January 20X1 and $10 200 on 31 December 20X1. You also find the following changes: Accounts receivable Inventory

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$ 8 400 decrease 11 200 decrease

Accounts payable

5 000 decrease

Salaries payable

2 400 increase

You additionally determine that during 20X1 the business sold equipment for $9600, purchased a van for $26 000 and issued a note payable for $15 000, all for cash. The owner also withdrew $19 200. After all these changes, the business had average total assets of $148 000 for 20X1. Required: a Using your findings, prepare the business’s 20X1 cash flow statement. (Use the direct method for operating cash flows.) b Calculate the business’s 20X1 cash return on total assets. In 20X2, Franklin Fibres had net cash provided by operating activities of $9400. A review of its 20X2 financial statements shows that the business had net income of $9000, average total assets of $93 800 and average owner’s equity of $50 000. Included in the net income were sales (net) of $77 000 and interest expense (all cash) of $600. Required: Using the above information, calculate, for 20X2, the business’s: a operating cash flow margin b cash return on total assets c cash return on owner’s equity. Nibbets Baskets had net cash provided by operating activities of $4300 for 20X3. The business’s income statement showed sales (net) of $40 000, interest expense of $400 and net income of $4000. Its 20X3 beginning balance sheet listed total assets of $42 000 and owner’s equity of $18 000, and its 20X3 ending balance sheet listed total assets of $48 000 and owner’s equity of $22 000. Interest payable decreased by $100 during the year. Required: Using the above information, calculate the business’s: a operating cash flow margin b profit margin c cash return on total assets d return on total assets e cash return on owner’s equity f return on owner’s equity. Ryan Rebel Footy had net cash provided by operating activities of $8600 for 20X0. The business’s income statement showed sales (net) of $80 000, interest expense of $800 and net income of $8000. Its 20X0 beginning balance sheet listed total assets of $84 000 and owner’s equity of $36 000, and its 20X0 ending balance sheet listed total assets of $96 000 and owner’s equity of $44 000. Interest payable decreased by $200 during the year. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 9 The cash flow statement: Components and applications

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Required: Using the above information, calculate the business’s: a operating cash flow margin b profit margin c cash return on total assets d return on total assets e cash return on owner’s equity f return on owner’s equity. The management of Pink Ltd is worried because its bank overdraft has increased by a substantial amount over the financial year ended 30 June 20X4, despite a large profit and the introduction of additional capital. The balance sheets as at 30 June 20X3 and 20X4 were as follows: PINK LTD Comparative balance sheets As at 30 June 20X3

20X4

300 000

385 000

–

15 000

Shareholders’ equity Share capital Asset revaluation reserve General reserve

50 000

85 000

Retained profits

49 000

78 500

399 000

563 500

Land

10 000

25 000

Buildings

60 000

60 000

Accumulated depreciation – buildings

(30 000)

(35 000)

Plant and equipment

207 000

300 000

Accumulated depreciation – plant and equipment

(27 000)

(55 500)

220 000

294 500

200

300

Accounts receivable

107 500

200 000

Allowance for doubtful debts

(10 000)

(20 000)

Inventory

182 500

305 500

280 200

485 800

Accounts payable

36 200

29 300

Current tax liability

15 000

37 500

Bank overdraft

50 000

150 000

101 200

216 800

Working capital

179 000

269 000

Total net assets

399 000

563 500

Non-current assets

Current assets Petty cash

Less: Current liabilities

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Accounting Information for Business Decisions

The internal income statement for the year ended 30 June 20X4, prepared for management purposes, showed the following details: PINK LTD Income statement For the year ended 30 June 20X4 Operating revenue Sales revenue (net)

550 000

Less: Cost of goods sold

277 000

Gross profit

273 000

Proceeds from sale of plant and equipment

47 500

Discount received

750 321 250

Expenses Carrying amount of plant and equipment sold

45 000

Salaries and wages expenses

60 250

Depreciation on buildings

5 000

Depreciation on plant and equipment

38 500

Electricity expense

3 000

Bad debt expense

30 000

Operating profit before tax Income tax expense Underprovision for income tax Operating profit after tax

181 750 139 500

50 000 2 500

52 500 87 000

Additional information: u During the year, the land was revalued upwards by $15 000. u During the year, a dividend of $22 500 was paid. u Plant and equipment, which had originally cost $55 000 and had depreciated by $10 000, was sold during the year for $47 500. u The likely tax payable for the years ended 30 June 20X3 and 20X4 were $20 000 and $50 000, respectively. u For the year ended 30 June 20X3, the Australian Taxation Office (ATO) issued an amended assessment of $22 500, resulting in an underprovision of $2500 being recorded in 20X3. Required: Prepare a cash flow statement in accordance with AASB 107 Statement of Cash Flows, including all relevant notes. (The full text of the AASB Standards is available online.)

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Now you have begun studying accounting, it seems as though everyone is coming to you for advice. Yesterday, your mother’s friend Juanita asked you to explain the following, which she read in the notes to recent financial statements of Simmons Department Stores: ‘In 20X2, the business generated $199.1 million in cash from operating activities, as compared to $295.3 million in 20X1 and $214.5 million in 20X0. The primary reason for the decrease [this year] was an increase in merchandise inventories.’ Since you didn’t have time to explain it or to get your thoughts together then, you asked Juanita whether you could email her an explanation. Required: Write Juanita that email, being careful to use language she can understand, given that she has never studied accounting. The owner of Fine Cuisine, a business that publishes ‘kitchen-tested’ recipes, has come to your bank for a loan. He states: ‘In each of the last two years, our cash has gone down. This year, we need to increase our cash by $8000 so that we have a $20 000 cash balance at year-end. We have never borrowed any money on a long-term basis, and are reluctant to do so.

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Chapter 9 The cash flow statement: Components and applications

However, we definitely need to purchase some new, more advanced equipment to replace the old equipment we are selling this year. We also want to invest in the share market. Given our expected net income and the money we will receive from our depreciation expense, I estimate we will have to borrow $11 000, based on the following schedule’: Schedule of cash flows for the year 20X1 Inflows of cash: Collections from customers

$ 35 000

Collections of interest

2 000

Other operating receipts

4 000

Receipt from sale of old equipment

8 000

Depreciation expense

6 000

Bank loan (estimated)

11 000

Total inflows

$ 66 000

Outflows of cash: Purchase of equipment Salaries

$(20 000) (28 000)

Other operating payments

(3 000)

Payments to suppliers

(7 000)

Total outflows

(58 000)

Increase in cash

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$ 8 000

The owner explains that the business will purchase $5000 of kitchen furniture from him. The payment of $5000 from the business to him for the kitchen equipment was not included in the schedule of cash flows because it would involve only a transaction between him and the business and would be of no interest to ‘outsiders’. The owner also states that if his figures are ‘off a little bit’, the most the business wants to borrow is $16 000. You determine that the amounts he has listed for each item are correct, except the bank loan. Required: a Prepare a projected cash flow statement (using the direct method for operating cash flows) that shows the necessary bank loan for Fine Cuisine to increase cash by $8000. b Explain to the owner why his $11 000 estimate of the bank loan is incorrect. c Suggest ways to reduce the necessary bank loan and still increase cash. d Make a list of questions you would like the owner to answer before you decide whether or not to make a loan to Fine Cuisine. Your friend Basil Nutt has come to you for advice. He says, ‘I don’t understand it. My business, Nutts and More, had a net income of $4300 in 20X2, so I expected the balance in the business’s cash account to go up. But the cash went down from $8000 to $800! The business is almost broke, and it didn’t buy any equipment, and I didn’t make any withdrawals. The business used its cash only for operating activities. Help me figure out what is going on.’ You study the business’s accounting records and find that it prepared an income statement and a balance sheet. The business’s 20X2 income statement follows: Sales

$ 72 300

Cost of goods sold

(40 000)

Gross profit Salaries expense

$ 32 300 $18 000

Depreciation expense

4 100

Other expenses (all cash)

5 900

Total operating expenses Net Income

(28 000) $

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300

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You determine that the income statement is correct. You also find that during 20X2, the business’s accounts receivable increased by $6300, its inventory increased by $7300, its accounts payable decreased by $3000 and its salaries payable increased by $1000. Required: Prepare a report for Basil Nutt (using the direct method) that explains why his business’s cash decreased during 20X2. The following are pairs of ratios related to the income statement, the cash flow statement and the balance sheet: a Profit margin

and

Operating cash flow margin

b Return on total assets

and

Cash return on total assets

c Return on owner’s equity

and

Cash return on owner’s equity

Required: For each of the above pairs of ratios, explain the similarities and the differences. Be sure to include an explanation of the interpretation of each ratio. Suppose that, at a party, your friend Queenie mentioned to you, in confidence, that her business was in the middle of a big scandal. She said the business needed a loan in order to enter into a top-secret marketing effort. In preparing the financial statements necessary for securing the loan, the business’s bookkeeper noticed that cash flows from operations had been declining over the past five years, although total cash flows had been increasing. Afraid that the bank would turn down the business’s request for a loan if it saw the business’s decreasing trend in cash flows from operations, the bookkeeper decided to reclassify cash receipts from the sale of equipment as collections from customers. Required: a What do you think the bookkeeper hoped to accomplish by making the reclassification? b Who do you think might be affected by this decision, and how might they be affected? c If you were the business’s owner, how would you have reacted to the bookkeeper’s ‘help’? On 1 January 20X3, Paula Randolph opened a boutique called PR’s Boutique. At that time, she deposited $30 000 cash in the business’s cheque account. Paula then immediately wrote business cheques to purchase $7000 of inventory and $16 000 of shop equipment, and to pay two years’ rent in advance for shop space. Paula estimated that the shop equipment would last 10 years and then be worthless. During the year, PR’s appeared to operate successfully. Paula did not know anything about accounting, although she did keep an accurate business cheque book. The business chequebook showed the following summarised items on 31 December 20X3: Payment for shop equipment Payment for two years’ rent of shop space

$16 000 2 400

Payments for purchases of inventory*

23 000

Receipts from cash sales

39 000

Payments for operating expenses

12 000

Withdrawals of cash for personal use

11 000

* Including $7000 beginning inventory

On 31 December 20X3, Paula asks for your assistance. She says, ‘The ending cash balance in the business cheque book is $4600. Since my initial investment was $30 000, the business seems to have had a net loss of $25 400. Something must be wrong. I am sure the business did better than that. Please find out what the business’s earnings were for 20X3, why the cash went down so much during 20X3 and what the business’s financial position is at the end of 20X3. Also, for what the business sold in 20X3, how does its profit percentage compare with its operating cash intake percentage?’ You agree to help Paula. She tells you that the business used a periodic inventory system during 20X3, that she has just finished taking inventory and that the cost of the 20X3 ending inventory is $9000. She has kept copies of invoices made out to customers who purchased merchandise on credit. These uncollected invoices total $12 000. Paula also has a file of unpaid invoices from suppliers for purchases of inventory. These unpaid invoices add up to $8000. Just as you begin your calculations, Paula says, ‘Oh yes: $10 000 of the payments for operating expenses were employees’ salaries. I also owe my employees $700 of salaries that they have earned this week.’

386

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 9 The cash flow statement: Components and applications

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Required: a Prepare a 20X3 income statement, a 20X3 cash flow statement (using the direct method for operating activities) and a 31 December 20X3 balance sheet for PR’s Boutique. Include explanations for all amounts shown. b Answer Paula’s question about the comparison of the ‘profit percentage’ with the ‘operating cash intake percentage’. Jay Ryan owns Jay’s Skateboard Shop, which he opened on 1 April 20X4. At that time, Jay invested $20 000 cash into the business. With this money, the shop immediately purchased shop equipment for $8000. Jay estimated that this equipment would last 10 years and would have no value after that time. The shop also purchased $6000 of inventory for cash and paid $1800 for one year of shop rent in advance. During the year, the shop was open for business six days a week. Over the ninemonth period in 20X4, Jay withdrew $1000 per month for his personal expenses. He used a periodic inventory system, employed one part-time helper and paid the shop’s bills by business cheque. For most of the year, the shop made only cash sales and paid for purchases before the goods were shipped from the shop’s supplier. However, near the end of the year, the shop began to sell items on credit to a few ‘responsible customers’. Jay kept a small notebook of the amounts of these credit sales. They totalled $3000 at the end of 20X4, and none had been collected yet. Because the shop was such a good customer, its suppliers allowed the shop to purchase $4000 of inventory on credit near the end of 20X4. The shop had not yet paid for these purchases at the end of 20X4. At the end of 20X4, Jay wanted to know how well the shop was doing, so he prepared the following income statement: Income statement for 20X4 Cash receipts: Cash sales

$ 36 000

Cash payments: Salary to part-time help Cash purchases of inventory

$ 3 200 20 000

Rent expense

1 800

Utilities expense

1 300

Withdrawals

9 000

Net income

(35 300) $

700

Jay does not feel comfortable with this information, and comes to you, a small-business consultant, for help. He says, ‘The shop shows net income of $700, but there is $12 700 in the business’s cheque account, so cash went down by $7300. I don’t understand. I just ‘‘took inventory’’, and it amounts to $5000 (including the credit purchases), but the shop owes $400 of salary to my employee. I want to know how much the shop earned in 20X4, what were its cash flows in 20X4 and where the shop stands financially at the end of 20X4. I also am interested in the return ratios on my investment in the business over the last nine months. Finally, I need a recommendation about my accounting system. Please prepare a report for me that answers these questions.’ Required: Prepare for Jay a report that includes an income statement and a cash flow statement (using the direct method for operating cash flows) for the nine months ended 31 December 20X4, as well as a balance sheet on 31 December 20X4, for his shop. Include explanations for all amounts shown, as well as a discussion that answers Jay’s questions and recommends an accounting system.

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9-52

Ava Mendleson operates a small fabric shop. She has been earning a satisfactory profit but is short of cash. Here is an accurate but unclassified balance sheet of the shop on 31 December 20X0: Mendleson’s Fabric Shop Balance sheet 31 December 20X0 Cash

$ 2 500

Shop equipment (net)

6 400

Inventory

9 500

Accounts receivable

3 000

Total assets

$21 400

Accounts payable

$ 4 500

A Mendleson, capital Total liabilities and owner’s equity

16 900 $21 400

On 2 January 20X1, Ava went to her bank to get a loan for her business. The bank agreed to loan her $5000 under the following conditions. First, the note payable would be a three-year note, so the business would repay $5000 plus $1500 interest on 31 December 20X3. Second, she must prepare a forecasted classified income statement for 20X1 to show that the business expects to earn a net income of at least $11 000, and that it will have satisfactory profit margin and return ratios. Third, she must prepare a forecasted cash flow statement for 20X1 that shows the business expects to have cash on hand at the end of 20X1 of at least $10 000 (including the cash from the bank loan) and that it will have satisfactory operating cash flow ratios. Finally, she must prepare a forecasted classified balance sheet, as of 31 December 20X1, that shows a current ratio of at least 3.0 and a debt ratio of no more than 40 per cent. Ava has never prepared any forecasted financial statements. She understands, however, that they are prepared using the best estimates she can make, based on the shop’s previous operations and her future expectations. Ava has come to you for help, and gives you the following information: i Sales for 20X1 are expected to be $80 000. Of these, half will be cash sales and half credit sales. There are no cash discounts. Of the credit sales, 10 per cent will not be collected until 20X2. The accounts receivable on 31 December 20X0 will be collected in 20X1. ii Purchases of inventory for 20X1 are expected to be $50 000. All purchases are on credit; there are no cash discounts. Of the purchases, 12 per cent will not be paid until 20X3. The accounts payable on 31 December 20X0 will be paid in 20X1. iii Sales returns and purchases returns are expected to be insignificant. iv The business’s gross profit percentage has been 40 per cent of sales, and this rate is expected in 20X1. v The shop rents space in a local shopping centre. The rent is $200 per month; the rent for the whole year is due on 6 January 20X1. vi The shop equipment that originally cost $8000 has a 10-year estimated life, after which it is expected to have no value. vii Ava pays her one salesperson a basic salary of $7000 per year, plus 10 per cent of gross sales. The total salary for 20X1 will be paid in cash by the end of the year. viii Ava expects to withdraw $8000 during 20X1 to cover her personal living expenses. Other operating expenses are expected to be $1600 in 20X1; these will be paid in cash by the end of the year. You determine that the information Ava has gathered is reasonable and includes her best estimates. Required: a Prepare a forecasted classified income statement for 20X1. Show supporting calculations. b Prepare a forecasted cash flow statement for 20X1. Use the direct method for operating cash flows. Show supporting calculations. c Prepare a forecasted classified balance sheet as of 31 December 20X1. Show supporting calculations. d Calculate the applicable ratios, and briefly discuss whether the business has met the bank’s conditions.

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Chapter 9 The cash flow statement: Components and applications

Dr Decisive Yesterday, you received the following letter for your advice column in the local paper:

Dear Dr Decisive, My mum and I haven’t had a major disagreement since I was 16, but now we can’t see eye to eye (and it isn’t even about my social life!). It all started from a comment that her friend made when visiting us the other day. It went something like this: ‘I don’t know how to interpret the financial reports for my shop that my accountant gave me the other day. I do know this: the shop had a huge profit last year, but it ended up with less cash this year than it did last year.’ Well, that led to a discussion between my mum and her friend, but I just couldn’t leave well enough alone. I thought they were ‘barking up the wrong tree’, so I had to interject with my two cents’ worth. Here’s the issue: is it possible for a business to have a positive cash flow from operations in the same year that it has a net loss, or to have a negative cash flow from operations in the same year that it has a net income? I think it isn’t possible. Income and cash flows may be different, but they will both be either positive or negative. Mum disagrees. In fact, she disagrees so strongly, she says that if you say I am right, she will raise the amount of the monthly cheque she sends me. In the meantime, I am . . . ‘Knowledge Rich, But Cash Poor’ Required: Meet with your Dr Decisive team and write a response to ‘Knowledge Rich, But Cash Poor’.

Endnotes a

Franklin, B & Stueber, H (1838) The Life and Essays of Dr Benjamin Franklin. London: John McGowan, 182. All Woolworths Group figures sourced from the company’s 2018 annual report, available at https://www.woolworthsgroup. com.au/icms_docs/195396_annual-report-2018.pdf. c Hammerschmidt, RA Jr (2001) President and CEO, Southwest Missouri Region, Commerce Bank, 17 July. d See, for example, http://www.relconsultancy.com. e Gray, R (1993) Accounting for the Environment. London: Paul Chapman. f Gray, R (1994) ‘Corporate reporting for sustainable development: Accounting for sustainability in 2000 AD’. Environmental Values, 3(1), 17–45 at 33. g Jasch, C (1993) ‘Environmental information systems in Austria’. Social and Environmental Accounting, 13(2), 7–9. h Lyons Hardcastle, J (2013) ‘Sustainability reporting ‘‘leads to higher cash flows’’’. Environmental Leader, 24 May. http://www. environmentalleader.com/2013/05/24/sustainability-reporting-leads-to-higher-cash-flows. b

List of company URLs u u u u u u u

Brisbane’s Replas: https://www.replas.com.au Dell Technologies: https://www.delltechnologies.com Gamestop (EB Games): http://news.gamestop.com/financial-information/annual-reports Super Retail Group Limited: http://www.superretailgroup.com.au Tyre Crumb Australia Pty Ltd: http://www.tyrecrumbaustralia.com/index-2.html Westfarmers: https://www.wesfarmers.com.au Woolworths Group Limited: https://www.woolworthsgroup.com.au

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APPENDIX Indirect method for reporting cash flows from operating activities As we mentioned in the chapter, there are two methods of computing and reporting a business’s cash flows from operating activities on its cash flow statement: the direct method and the indirect method. We discussed and illustrated the direct method because it is conceptually sound, easier to understand and more closely follows how a business analyses its forecasted operating cash flows in its cash budget. Here, we explain the indirect method because it is the method that most companies use in the cash flow statements they present to external users.1 Under the indirect method, a business determines its net cash provided by operating activities indirectly by converting its net income to operating cash flows. It does this by adding amounts to and subtracting amounts from its net income to calculate its net cash flow from operating activities. We will discuss this later in this section. First, we need to briefly review a business’s operating cycle. In this chapter, we discussed how each part of a business’s operating cycle affects both its net income and its operating cash flows. We explained that each may be affected differently, however, because of differences between when the business records revenues and expenses and when it receives or pays cash. We illustrated these differences as they related to changes in current assets (accounts receivable and inventory) and changes in current liabilities (accounts payable and salaries payable). Also, changes in some non-current assets (property and equipment) affect the business’s net income but do not result in an operating cash inflow or outflow. For instance, when the business records depreciation for equipment, it increases depreciation expense and decreases the equipment’s book value. Although depreciation expense decreases net income (and a non-current asset), there is no operating cash outflow. Since most companies use the indirect method in the cash flow statements they present to external users, you (as an external user) need to understand how the changes in each of a business’s current assets and current liabilities, as well as its depreciation expense, affect its net cash flows from operating activities under this method. To help you understand the indirect method, in the next section, we use an example that compares the direct and the indirect methods.

Review of direct method As we discussed in the chapter, under the direct method, a business subtracts its operating cash outflows from its operating cash inflows to determine the net cash provided by (or used in) operating activities. A business’s operating cash inflows may include: (1) collections from customers; (2) collections of interest; and (3) other operating receipts. The operating cash outflows may include: (1) payments to suppliers; (2) payments to employees; (3) payments of interest; and (4) other operating payments.2 A business computes its operating cash inflows and operating cash outflows based on an analysis like the one we

1

Companies have the option of using either the direct method or the indirect method. However, if a business uses the direct

method, it must provide much more additional information. As a result, most companies continue to use the indirect method. 2

If a business is a company or corporation, it also reports its payments of income taxes (under both the direct and indirect

methods).

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Chapter 9 Appendix: Indirect method for reporting cash flows from operating activities

used in Exhibit 9.9. To understand this method, suppose that Frank’s Cookies, a retail business, shows the following income statement information for the current year: Sales

$ 360 000

Cost of goods sold

(150 000)

Gross profit

$ 210 000

Operating expenses: Salaries expense

$70 000

Depreciation expense

30 000

Other operating expenses

56 000

Total operating expenses

(156 000)

Net income

$ 54 000

A comparison of the business’s balance sheets at the beginning and end of the year shows the following changes in its current assets and current liabilities: Accounts receivable decreased by $15 000 Inventory increased by $20 000 Accounts payable increased by $13 000 Salaries payable decreased by $4000

Under the direct method, Frank’s Cookies reports its cash flows from operating activities on the cash flow statement as follows: Cash flows from operating activities: Cash inflows: Collections from customers

$ 375 000

Cash inflows from operating activities

$ 375 000

Cash outflows: Payments to suppliers

$(157 000)

Payments to employees

(74 000)

Other operating payments

(56 000)

Cash outflows for operating activities

(287 000)

Net cash provided by operating activities

$ 88 000

Next, we provide a schedule that shows how Frank’s Cookies calculated each of the above amounts, followed by an explanation of each calculation: Income statement amount

Balance sheet change

Cash flow

$ 360 000

þ

Decrease in accounts receivable

Cost of goods sold

(150 000)

þ

Increase in inventory

(20 000)



Increase in accounts payable

Salaries expense

(70 000)

þ

Decrease in salaries payable

Depreciation expense

(30 000)

Sales revenue

Other operating payments Income flow

(56 000) $ 54 000

¼

$ 375 000

13 000

¼

(157 000)

(4 000)

¼

(74 000)

$ 15 000

Not included No change Operating cash flow

(56 000) $ 88 000

Because accounts receivable decreased between the beginning and the end of the year, we know that the business’s cash collections this year were more than its sales revenue. So, part of the cash collected from customers was for sales the business made to them last year. So, we calculate the $375 000 cash received from customers by adding the decrease in accounts receivable ($15 000) to this year’s sales Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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revenue ($360 000). This is the only cash receipt, so that the cash inflows from operating activities were $375 000. Because inventory increased between the beginning and the end of the year, we know that the business purchased more inventory than it sold. So we calculate the purchases of $170 000 by adding the increase in inventory ($20 000) to the cost of goods sold ($150 000). Because accounts payable increased between the beginning and the end of the year, we know that the business paid for less inventory than it purchased. So we calculate the $157 000 cash paid to suppliers by subtracting the increase in accounts payable ($13 000) from the purchases ($170 000). Because salaries payable decreased between the beginning and the end of the year, we know that the business paid its employees more than they earned this year (and more than the business recorded as an expense). In other words, part of the payments to employees was for work they did last year. So we calculate the $74 000 cash paid to employees by adding the decrease in salaries payable ($4000) to the salaries expense ($70 000). For simplicity, we assume that all of the $56 000 other operating expenses were paid in cash. So the $375 000 cash inflows from operating activities less the $287 000 cash outflows for operating activities ($157 000 payments to suppliers þ $74 000 payments to employees þ $56 000 other operating payments) result in $88 000 net cash provided by operating activities of Frank’s Cookies for the current year. Note that the $30 000 depreciation expense is not included because it did not involve a cash flow. Note also that we did not introduce any new concepts here. We just used summary amounts from Frank’s Cookies’ income statement and balance sheet (which were provided to external users), rather than having internal information about transactions. The direct method has the advantages of being easy to understand and similar to the upper part of the cash budget that we discussed in Chapter 3. External users have criticised the method, however, because it does not tie the net income that a business reports on its income statement to the net cash provided by operating activities that the business reports on its cash flow statement. Also, the direct method does not show how the changes in the parts (i.e. current assets and current liabilities) of a business’s operating cycle affected its operating cash flows.

Illustration of indirect method When a business uses the indirect method to report the net cash provided by operating activities on its cash flow statement, the two criticisms of the direct method are resolved. Under the indirect method, a business adjusts its net income to the net cash provided by operating activities. To do this, it lists net income first, and then makes adjustments (additions or subtractions) to the net income to: (1) include any changes in the current assets (other than cash) and current liabilities involved in the business’s operating cycle that affected cash flows differently than they affected net income; and (2) eliminate amounts that were included in its net income but that did not involve an operating cash flow. In other words, under the indirect method, a business’s income flows are converted from an accrual basis to a cash basis.

Stop & think Would you expect that a typical business’s net cash flow from operating activities would be greater or less than its net income? Explain your answer. We use Frank’s Cookies’ income statement and balance sheet information, shown earlier, to illustrate the indirect method. The business reports its net cash flow from operating activities under the indirect method on its cash flow statement:

392

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Chapter 9 Appendix: Indirect method for reporting cash flows from operating activities

Cash flows from operating activities: Net income

$ 54 000

Adjustments for differences between net income and cash flows from operating activities: Add: Decrease in accounts receivable

15 000

Increase in accounts payable

13 000

Depreciation expense Less: Increase in inventory Decrease in salaries payable Net cash provided by operating activities

30 000 (20 000) (4 000) $ 88 000

First, note that the net cash provided by operating activities ($88 000) is the same under both the direct and the indirect methods. Now, why did we make each adjustment to convert net income to the net cash provided by operating activities? We will discuss these adjustments as they relate to sales revenue, cost of goods sold, expenses and non-cash items. As we discussed earlier, since accounts receivable decreased by $15 000, we know that the business’s cash collections were more than its sales revenue, so it must have collected some accounts receivable related to sales from the previous period. Since the current sales of $360 000 are lower than the amount of cash that the business collected, its net income of $54 000 is lower than it would have been if the business had counted the amount of cash it collected this period from sales of the previous period. Therefore, we add the $15 000 decrease in accounts receivable to net income as one step in computing the net cash provided by operating activities. Also note that adding the decrease in accounts receivable to sales revenue (the direct method) has the same effect as adding the decrease to net income (the indirect method). Next, because inventory increased by $20 000, we know that the business purchased more inventory than it sold. So the cost of goods sold is not the same as the amount of inventory that the business purchased. Since the cost of goods sold is subtracted from sales in computing income, we subtract the increase in inventory from the net income to show the additional outflow from purchasing more inventory. Because accounts payable increased by $13 000, we know that the business paid for less inventory than it purchased. Therefore, we add the increase in accounts payable to net income to calculate the net cash inflow. Remember that a lower cash outflow means that the net cash inflow is higher. Also note that: (1) adding the increase in inventory to cost of goods sold (the direct method) has the same effect as subtracting the increase from net income (the indirect method); and (2) subtracting the increase in accounts payable from purchases (the direct method) has the same effect as adding the increase to net income (the indirect method).

Stop & think Does this make sense? Why does adding the increase in inventory to cost of goods sold have the same effect as subtracting the increase from net income? Because salaries payable decreased by $4000, we know that the business paid its employees more than it recorded as an expense, so we subtract the decrease in salaries payable from net income to calculate the net cash inflow. Note that adding the decrease in salaries payable to salaries expense (the direct method) has the same effect as subtracting the decrease from net income (the indirect method).

Stop & think Explain how to adjust net income for an increase in salaries payable.

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Since all of the business’s other operating expenses were paid in cash, it does not have any changes in other current assets (e.g. prepaid rent) or other current liabilities (e.g. interest payable). If it did have changes in these accounts, we would also need to adjust net income for these changes. Next, we add the $30 000 depreciation expense to the net income because it was subtracted to determine net income but there was no cash outflow. So, by making these adjustments, we converted Frank’s Cookies’ $54 000 net income to its $88 000 net cash provided by operating activities. To help you understand the effect of various items on the net cash provided by operating activities under the indirect method, we show the common adjustments to net income in Exhibit 9.11. Exhibit 9.11 Adjustments to convert net income to net cash provided by operating activities Net income Plus Decrease in accounts receivable Decrease in inventory Decreases in other current assets related to operating activities Increase in accounts payable Increase in salaries payable Increases in other current liabilities related to operating activities Depreciation expense Minus Increase in accounts receivable Increase in inventory Increases in other current assets related to operating activities Decrease in accounts payable Decrease in salaries payable Decreases in other current liabilities related to operating activities Equals Net cash provided by operating activities

Stop & think If a business uses the indirect method in its cash flow statement, would you be able to calculate its operating cash flows under the direct method?

Steps to complete under the indirect method Based on the previous example, we can identify six steps that a business completes under the indirect method to calculate the net cash provided by operating activities that it reports on its cash flow statement: 1 Calculate the increase or decrease during the year in each current asset and current liability account. 2 List the business’s net income first in the cash flows from operating activities section. 3 Add the decrease in each current asset and the increase in each current liability to the net income. 4 Subtract the increase in each current asset and the decrease in each current liability from the net income. 5 Add the depreciation expense on the business’s property and equipment assets to the net income. 6 Calculate the net cash provided by (or used in) operating activities.

394

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Chapter 9 Appendix: Indirect method for reporting cash flows from operating activities

To illustrate, we assume that Simmons Syrup earned net income of $36 000 for 20X1. It included depreciation expense of $17 000 in the operating expenses deducted from sales revenue to determine this net income. Step 1 involves determining the changes in the current assets and current liabilities. A review of the 20X1 ending and beginning balance sheets for Simmons Syrup shows the following current assets and current liabilities: Balances Accounts Accounts receivable

31/12/20X1

Changes

31/12/20X0

(Step 1)

$14 000

$10 000

$ 4 000

Inventory

20 000

28 500

(8 500)

Accounts payable

11 500

21 000

(9 500)

Salaries payable

6 000

4 000

2 000

Based on this information, the cash flows from the operating activities section of Simmons Syrup’s 20X1 cash flow statement are given below. (Steps 2 to 6 are in parentheses before the items.) Cash flows from operating activities (2) Net income

$ 36 000

Adjustments for differences between net income and cash flows from operating activities: (3) Add: Decrease in inventory Increase in salaries payable (4) Less: Increase in accounts receivable (5) Depreciation expense Decrease in accounts payable (6) Net cash provided by operating activities

(8 500) (2 000) (4 000) (17 000) (9 500) $ 50 000

Simmons Syrup would include this section with the cash flows from investing activities and the cash flows from financing activities sections to complete its cash flow statement for 20X1.

Stop & think If a business uses the direct method in its cash flow statement, would you be able to calculate its operating cash flows under the indirect method?

Using information about cash flows from operating activities under the indirect method If a business reports its net cash flows from operating activities on its cash flow statement using the indirect method, an external user can calculate the ratios we discussed in the chapter – for example, operating cash flow margin – to evaluate the business’s performance. In addition, a user may be interested in looking at the difference between the business’s net income and its net cash provided by operating activities, because this difference may provide additional useful information. This analysis is sometimes referred to as evaluating the business’s quality of earnings. For example, if the net cash provided by operating activities is less than net income because of a significant increase in accounts receivable, this may indicate that the business is having difficulty collecting its bills or has changed the type of customer to which it makes sales and to which it has extended its credit terms. As another example, if the net cash provided by operating activities is greater than net income because of a significant increase in accounts payable, this may indicate that the business is having difficulty paying its bills or is delaying payment so much that it may damage its relationships with its suppliers.

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Accounting Information for Business Decisions

Since a business may use either the direct or the indirect method to report its net cash provided by operating activities, a user may have difficulty comparing two companies that use different methods. Fortunately, when a business uses the direct method, it must also disclose the results of the indirect method in the notes to its financial statements. When a business uses the indirect method, it must disclose its payments for interest. However, the business has no obligation to report the other operating cash inflows or outflows. Many users find the direct method easier to understand. So when a business uses the indirect method, a user may want to calculate the cash flows under the direct method, using the logic that we discussed earlier in the chapter.

Testing your knowledge of this chapter’s Appendix A9-1 A9-2

How does a business determine its net cash provided by operating activities under the indirect method? Identify the steps a business completes under the indirect method to calculate its net cash provided by operating activities.

Applying your knowledge of this chapter’s Appendix A9-3

A9-4

The following information is taken from the accounting records of Ward’s business for the current year: 1 Net income: $34 000 2 Increase in inventory: $9200 3 Decrease in accounts receivable: $17 000 4 Depreciation expense: $20 000 5 Decrease in salaries payable: $2000 6 Increase in accounts payable: $12 400 Required: Using the indirect method, prepare the cash flows from the operating activities section of Ward’s cash flow statement for the current year. In 20X3, Faldo earned net income of $61 000. Included in the calculation of net income was $12 500 of depreciation expense. During the year, the business had the following changes in its current assets and current liabilities: Increases

A9-5

Accounts receivable:

$5 700 Inventory:

$7 400

Salaries payable:

$3 000 Accounts payable:

$9 600

Required: a Using the indirect method, prepare the cash flows from the operating activities section of Faldo’s cash flow statement for 20X3. b What does your answer to (a) reveal compared with Faldo’s net income? During the current year, Nash’s business earned net income of $56 000. Depreciation expense of $11 000 was included in the calculation of net income. Nash’s accounting records show the following beginning and ending balances in its current assets and current liabilities for the year: Accounts Accounts receivable Inventory Prepaid rent

396

Decreases

Ending balance

Beginning balance

$113 400

$74 400

68 800

86 200

4 000

0

Accounts payable

51 200

66 000

Salaries payable

2 600

0

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Chapter 9 Appendix: Indirect method for reporting cash flows from operating activities

Required: a Using the indirect method, prepare the cash flows from the operating activities section of Nash’s cash flow statement for the current year. b What does your answer to (a) reveal compared with the business’s net income?

Making evaluations A9-6

Refer to the information in 9-39 for the Seeser Flappits business. In addition to this information, you find the following average ratio results in 20X2 for similar companies in the same industry: Operating cash flow margin:

10.1%

Cash return on total assets:

15.7%

Required: a Using the indirect method for operating cash flows, prepare Seeser Flappits Business’s 20X2 cash flow statement. b Calculate the business’s: (i) operating cash flow margin; and (ii) cash return on total assets. Briefly evaluate how well the business is doing in 20X2 compared to similar businesses in the same industry. c Now consider how the decrease in accounts receivable and decrease in inventory affected the business’s ratio results. Re-evaluate your answers to (b).

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10 SUSTAINABLE AND PROFITABLE BUSINESS PRACTICES ‘There is no business on a dead planet.’ David Browera

Learning objectives After reading this chapter, students should be able to do the following: 10.1 Understand and demonstrate corporate social responsibility (CSR). 10.2 Understand the components of the triple bottom line and sustainability reporting. 10.3 Be able to implement practical measures to achieve a triple bottom line. 10.4 Understand and be able to apply suitable methods for environmental project appraisal. 10.5 Understand the concept of social accounting. 10.6 Understand that sustainability should be a business strategy for the ongoing success of the business. 398

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Chapter 10 Sustainable and profitable business practices

Understanding the learning objectives is assisted in the chapter by asking key questions:

Key questions 1

What is corporate social responsibility (CSR)? How does a company such as Nike define CSR?

2

What are the components of the triple bottom line?

3

What is sustainability reporting and why is it important?

4

What is the Global Reporting Initiative (GRI)?

5

What is integrated reporting?

6

What is life cycle analysis and what are its limitations?

7

What is material flow cost accounting?

8

What is eco-efficiency and how is it measured?

9

What is share percentage and how is it calculated?

10

What methods are used for environmental project appraisal and how are they calculated?

11

What is social accounting?

12

What is social cost–benefit analysis and how do we measure it?

13

What is intergenerational equity?

14

How can sustainability be a successful business strategy?

Humanity has been causing a steady ecological decline on our planet for a number of decades, with the global annual demand on resources exceeding what the Earth can regenerate each year. At present, humanity’s total ecological footprint is estimated at one-and-a-half planet Earths, which means we are using resources one-and-a-half times as fast as they can be renewed.b Clearly, this is not sustainable. What is clear is that business must play a key role if we are to achieve global sustainability. In the business world, responsibility for exercising good sustainability practices comes back to the people managing and controlling the business. In big companies, the board of directors is responsible for corporate governance, which generally ‘encompasses the rules, relationships, policies, systems and processes whereby authority within organisations is exercised and maintained’.c Good corporate governance involves balancing the interests of a company’s many stakeholders, such as shareholders, management, customers, suppliers, financiers, government and the community. The directors and owners of a business must weigh up the impact of the business’s activities on the environment and the community, while at the same time driving the business to be profitable and therefore sustainable. Notice that, in the context of the business world, the word ‘sustainable’ is used to refer to both a business as a going concern that will survive, and the practices of a business that lead to it being viewed as working to preserve the environment. We often see reports of the negative impacts to the environment caused by businesses, and of businesses’ disregard for society. We do not often see reports of businesses that are taking major steps to reduce their environmental impacts and engage with communities to bring about positive social change. Yet many businesses are working to become more environmentally sustainable and socially responsible. It is clear that a range of benefits stem from this, including improving the business’s reputation, reducing costs, strengthening communities in which businesses operate and, of course, improving profitability. Business sustainability is about ensuring that management develops and implements strategies to facilitate long-term success. As we noted above, this success is not just financial, but also environmental and social. This is referred to as the triple bottom line, which takes into account the economic,

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Accounting Information for Business Decisions environmental and social value added and destroyed as a result of business activities. The triple bottom line was first described by John Elkington in 1980: The triple bottom line focuses corporations not just on the economic value that they add, but also on the environmental and social value they add – or destroy.d Source: Elkington, J (2013) ‘Enter the triple bottom line’. In Henriques, J. & Richardson J., The Triple Bottom Line: Does it All Add Up? (p.3). Earthscan Publications, London (2013)

Businesses that operate sustainably not only help to maintain the wellbeing of the society and the environment, but are also more likely to be profitable in the long term. Leading businesses around the world understand that successful sustainability strategies can translate into successful bottom-line performance. The motivation for business to pursue sustainable business practices and to report on these has not arisen out of legislation, but rather is a result of the expectations that society is placing on businesses to conduct their activities in a sustainable way, and the subsequent recognition of the importance of sustainability for long-term business success. In the 1990s, for example, Nike was exposed to censure by revelations about the use of child labour and poor working conditions in its outsourced supply chain. Early attempts by Nike to defend its position that it had no control over the supply chain further damaged the brand name. To turn this around after 2004, the company embraced a transparent approach, reporting failures but also the strategies it was employing to improve its social and environmental credentials. This improved Nike’s reputation, promoted innovation and boosted sales.e Investors are attracted to organisations that are sustainable and focus on long-term business profitability and competitive advantage. This is evidenced by development of indexes such as the Dow Jones Sustainability Index (DJSI), the first global indexes to track the financial performance of leading sustainability-driven companies globally. The Australian SAM Sustainability Index (AuSSI)f tracks the performance of Australian companies that lead their industries in corporate sustainability, and the FTSE4Good Index Seriesg has been designed to measure the performance of companies that meet globally recognised corporate responsibility standards, and facilitate investment in those companies.

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What is corporate social responsibility (CSR)? How does a company such as Nike define CSR? corporate social responsibility (CSR) An organisation’s commitment to act in an ethical way in order to contribute positively to society and the environment. It is often referred to as the corporate triple bottom line, because it takes into account the economic, social and environmental impacts of business activities.

10.1 Corporate social responsibility (CSR) So far in this book, we have learned about the planning and decision-making aspects of business purely from an accounting and financial perspective. Increasingly, though, concepts of sustainability and the triple bottom line are being integrated into the broader Corporate social responsibility debate. Businesses that have strong corporate governance usually have a focus on corporate social responsibility. Corporate social responsibility (CSR) calls into question the role of business in facilitating sustainable environmental and social change. It highlights problems that have arisen, or are perceived to have arisen, from the commercial activities of businesses. CSR incorporates the public interest into business planning and decision making. Parkinson describes CSR as ‘behaviour that involves voluntarily sacrificing profits, either by incurring additional costs in the course of the business’s production processes or by making transfers to non-shareholder groups out of the surplus thereby generated, in the belief that such behaviour will have consequences superior to those flowing from a policy of pure profit maximisation’.h

Stop & think Read an article in the series ’The ROI (return on investment) of Sustainability’ on Nike and find at least one more of example of a firm embracing CSR and improving profits: https://www.triplepundit.com/story/2015/how-nike-embraced-csr-and-went-villain-hero/57726 Do you know of any other examples? Nevertheless, financial and economic considerations still underpin CSR decisions. Without profits, businesses will cease to exist, and with them any possibility of CSR initiatives will also cease to exist. This chapter provides a background to the considerations that underpin the triple bottom line and CSR, and 400

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Chapter 10 Sustainable and profitable business practices outlines some key accounting principles and techniques that encourage and promote business sustainability and sustainability reporting. The first section will explain the reporting aspects of the triple bottom line; the chapter then looks at how the triple bottom line underpins sustainability reporting. The 2010 Gulf of Mexico oil spill: A triple bottom line disaster

One of the key issues for accountants is that environmental and social impacts are often business costs. Take, for example, the 2010 BP (http://www.bp.com.au) oil spill in the Gulf of Mexico. As we noted in Chapter 7, this event has cost BP many billions of dollars, and the damage it caused to the environment will be long-lasting, as will its impact on BP’s corporate reputation. In addition to these financial and environmental impacts, there are also social impacts. These triple bottom line effects (economic, environmental and social) on Gulf communities will be felt for many years into the future. While we can clearly see the triple bottom line impacts in the case of the BP Gulf of Mexico disaster, in the day-to-day business activities of many businesses, the environmental and social impacts of doing business are not always considered, and are often seen by management as secondary to financial performance. However, good environmental management and social responsibility tend to improve longterm profitability rather than reduce it. Given that investors place a high value on environmental responsibility, and that many people are now willing to pay more for products and services that are environmentally friendly, it is in the interest of businesses to be ‘green’. Consider two of the key elements that have an impact on most businesses: the use of water and energy; and the generation of waste. These are costs to the business, and more efficient management of them can lead to considerable cost savings, and often facilitate new income streams through recycling or reusing materials and emissions, rather than putting them in landfill or into the atmosphere.

Stop & think How will the Gulf of Mexico oil spill continue to have an impact on BP’s corporate image, profitability and shareholder returns in the foreseeable future?

10.2 The triple bottom line As mentioned above, the triple bottom line consists of the economic, environmental and social impacts of business activities. The following sections will provide more detail about each aspect, and about the relationship among the three aspects, as it relates to sustainability accounting. The key contribution of the triple bottom line is that it clearly communicates strategies that a business can utilise to improve both its short- and long-term value through integrated management of its economic, environmental and social performance. A key part of the triple bottom line is integration of the three components in order to manage economic, environmental and social risk. This is consistent with the fundamental CSR premise that businesses have obligations to the wider community and the environment that extend much further than simply maximising shareholder returns and following the letter of the law.

Economic To be sustainable, a business has to be profitable – or, in the case of not-for-profit organisations, financially self-sustaining. As we have learned in previous chapters, a business’s economic performance is reported in its annual financial reports (cash flow statement, income statement and balance sheet). Some of the financial Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Ethics and Sustainability

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What are the components of the triple bottom line?

triple bottom line Reporting that provides information about the economic, environmental and social performance of an entity sustainability accounting A set of statements providing cost data about economic, environmental and social impacts, from both financial accounting and cost accounting – for example, data about increasing material efficiency, reducing environmental impact and risk, and reducing costs of environmental protection

401

Accounting Information for Business Decisions metrics (or measures) used to evaluate business performance include debt to equity, return on equity, return on assets, cash flows, profit, investments in human resources such as training, wages and salaries, and revenues and expenses relating to things like research and development. However, the triple bottom line also accounts for and reports the environmental and social performance of the business over the same period.

Environmental

‘greenwashing’ Occurs when a business spends considerable time and money emphasising its green credentials through marketing and advertising but does not actually implement business practices that reduce its environmental impacts

Ethics and Sustainability

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Environmental performance includes measures of the amount of energy consumed and its origin (e.g. electricity, gas or diesel fuel), raw material usage, greenhouse gas emissions, effluent and waste, as well as land use and the management of natural habitats and ecosystems affected by business. The key premise is based on the knowledge that if a business degrades the natural environment as part of its activities, then it is not sustainable. Sustainable environmental management is not always straightforward. Many organisations involved in industries such as mining, manufacturing, plantation forestry and agriculture may carry out activities that are at odds with sustainable environmental management. However, these businesses can take significant steps to reduce and/or offset those effects by putting aside for natural habitat or ecosystem services areas that are larger than those negatively affected by the business’s activities. The costs of doing this can be prohibitively expensive and may affect the profitability of a business or a project. If the argument for not conducting business activities in an environmentally sustainable way is that doing so will reduce business profitability, then this is not a sustainable approach and should not be adopted. Given the ongoing global demand for energy and fossil fuels, there are many business activities that are not sustainable, but that will nevertheless continue to exist. The focus must therefore be on reducing environmental impacts until more sustainable options can be found. The shift in technology in the power generation industry in Australia, for example, has made large mining and energy companies reluctant to invest in new coal-fired generating plants but rather to use a blend of existing plants and new technologies to shift to greener and cheaper generating options. A view that is supported by the CSIRO in their GenCost 2018 report which found solar and wind technologies to be lowest cost. These present a lower risk than a long term investment in coal power when the future of carbon emissions legislation and the future comparative cost of production is uncertain.i There are increasing expectations among stakeholders for businesses to be ‘green’. As such, there is considerable motivation for some businesses to exaggerate their ‘green’ credentials. ‘Greenwashing’ occurs when a business spends considerable time and money emphasising its environmental credentials through marketing and advertising, but does not actually implement business practices that reduce environmental impacts. As an example, consider an electricity-generation company that undertakes an extensive marketing campaign to highlight its solar-power generation initiatives, when, in reality, this represents less than 1 per cent of the company’s electricity-generation capacity. Closer examination might reveal that the vast majority of the company’s electricity comes from its not-so-green, brown-coal-fired power stations. This means that businesses have to ‘walk the talk’, and back up their claims with hard facts, to demonstrate their ‘green’ credentials. Independent auditing and assurance is one way in which businesses can validate the sustainability of their environmental initiatives. Well-documented and validated environmental credentials help to develop and sustain a good business reputation, and, as a consequence, increase profitability. A 2012 survey of executives and thought leaders in the area of corporate environmental strategy and performance carried out by Ernst & Young, in cooperation with GreenBiz Group, found that about half (51%) of those surveyed said they anticipated that their company’s core business objectives would be affected by natural-resource shortages (e.g. water, energy, forest products, and rare-earth minerals and metals) in the next three to five years.j Competition for scarce resources is increasing with the Organisation for Economic Co-operation and Development (OECD 2018) estimating global materials use will be more than double 2011 levels by 2060. Coupled with population growth and a scarcity of access to fresh water, this is was characterised as the ‘water, energy, land nexus’ in a discussion of issues and megatrends by PWC (2019) and many leading accounting firms offer advice on this type of risk management.k On 25 September 2015, the United Nations released 17 Sustainable Development Goals (SDGs) (Exhibit 10.1), which more than 150 countries adopted. The SDGs are designed to end poverty, protect the planet and ensure prosperity for all as part of a new sustainable-development agenda. Each goal has Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 10 Sustainable and profitable business practices Exhibit 10.1 United Nations Sustainable Development Goals

Source: United Nations Sustainable Development Goals, https://www.un.org/sustainabledevelopment/. The content of this publication has not been approved by the United Nations and does not reflect the views of the United Nations or its officials or Member States.

specific targets to be achieved over the next 15 years. The goals have a strong focus on preservation of natural resources (e.g. clean water and waterways), clean energy, sustainable cities and communities, the effects of climate change and impacts of human activity on land.l In 2018, Australia presented its first Voluntary National Review summarising progress towards the Sustainable Development Goals, as a baseline for future progress. It also launched an official National Reporting Platform, inviting case studies to be uploaded. A key issue identified was simply raising awareness of the SDGs in Australia. Each nation’s government is expected to lead the agenda; however, business, universities, non-government societies and youth groups are expected to participate. The National Review included a summary of key national policies and commitments to the relevant SDGs.

Discussion What are the SDGs developed by the UN which specifically relate to sustainability of the environment? Do you think these are achievable? Why or Why not?

Adequate response to climate change is urgent with increasing numbers of scientists warning of a ‘climate emergency’ and calling for a ‘major transformations in the ways our global society functions and interacts with natural ecosystems’ according to a declaration signed in November 2019 by over 11 000 scientists from 153 countries.m Corporations are potential major influencers and stakeholders in any global response, with the likely effects of climate change having significant environmental and social consequences.

Social Social performance addresses interactions between business and the community. It includes issues such as human resource management, work health and safety (WHS), ratio of wages to cost-of-living expenses, non-discrimination, Aboriginal and Torres Strait Islander rights, community involvement initiatives, and customer and stakeholder satisfaction. Factors such as where materials are sourced or manufactured are an important consideration. A business does not want to be associated with issues such as child labour, or with processes or products that endanger people’s health. By ensuring that the business operates in a socially responsible way, economic value can be derived while delivering community benefits. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions

Measuring the triple bottom line

Ethnics and Sustainability

The components of the triple bottom line are measurable, and their contribution to business and community values should be communicated to both internal and external business stakeholders. It is important to note that the triple bottom line is not a new financial accounting bottom-line metric; rather, it is an approach to management and performance assessment that focuses on the importance and interdependence of economic, environmental and social business performance. In principle, this means that the three components should be integrated into the business’s operations, with each having equal status. The aim is for business to analyse its sustainability from a perspective that is underpinned by its performance in relation to its social, environmental and financial spheres of operation. The Dow Jones Sustainability Index (DJSI), launched in 1999, tracks the performance of the world’s leading companies in terms of economic, environmental and social criteria. Its indexes serve as benchmarks for investors who consider corporate sustainability a key part of their investment strategies, as well as providing an engagement platform for companies that are working to adopt sustainable best practices. A core premise of the DJSI is that: corporate sustainability leaders can achieve long-term shareholder value by gearing their strategies and management to harness the market’s potential for sustainability products and services while at the same time successfully reducing and avoiding sustainability costs and risks.n Source: RobecoSAM Indices (http://www.sustainability-indices.com/sustainability-assessment/corporate-sustainability.jsp)

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What is sustainability reporting and why is it important? sustainability reporting The practice of measuring, disclosing and being accountable to internal and external stakeholders for organisational performance towards the goal of sustainable development – that is, reporting on economic, environmental and social impacts

Sustainability reporting Businesses demonstrate corporate responsibility by measuring and publicly reporting on their economic, social and environmental performance and impacts. Given the lack of an international mandatory reporting framework, both the type and extent of reporting vary widely. Sustainability reporting can be part of a business’s annual report; a standalone sustainability report, such as a triple bottom line report; coverage of sustainability or environmental issues on a business’s website; or an environmental or social impact report. Ideally, a business should take an integrated reporting approach whereby the business develops a strategy for value creation in a holistic report covering all areas of the environment in which it operates (including social and natural), rather than seeing the economic aspect as being separate from the whole picture. Integrated reporting will be discussed in more detail below. Businesses choose to prepare sustainability reports for a range of reasons. These include the demands of stakeholders who are requiring greater accountability and transparency about environmental and social impacts; a requirement to report performance; strategies to improve social and environmental impacts; the need to inform shareholders and the market about how well the business is managing non-financial and financial risks; the identification of risks; and the analysis of performance. As such, it is good business practice to report on business sustainability, since it can have an impact on factors such as share price, as well as on demand for products and services. Many corporations actively promote their global sustainability initiatives – Nescafe´, for example, supports responsible coffee farming, production and consumption (http://www.nestle.com/brands/coffee/coffeecsv).

Australian sustainability reporting guidelines A number of sustainability reporting guidelines have been developed in Australia. In 2003, the Department of Environment and Heritage (now the Department of Agriculture, Water and the Environment) released Triple Bottom Line Reporting in Australia: A Guide to Reporting Against Environmental Indicators. Also in 2003, the Group of 100, which represents the chief financial officers (CFOs) of large business enterprises in Australia, released Sustainability: A Guide to Triple Bottom Line Reporting. While these are voluntary guidelines, there are some legal obligations on sustainability reporting in Australia. These fall under the Corporations Act 2001 and include: • requiring companies to include details of breaches of environmental laws and licences in their annual reports (section 299(1)(f) of the Corporations Act 2001) 404

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Chapter 10 Sustainable and profitable business practices •

requiring providers of financial products with an investment component to disclose the extent to which labour standards or environmental, social or ethical considerations are taken into account in investment decision making (subsections 1013(A) to 1013(F) of the Corporations Act 2001). Other specific requirements relate to greenhouse gas emissions, which are overseen by the Australian Government’s Clean Energy Regulator (CER). The CER administers Australian legislation to reduce carbon emissions and increase the use of clean energy. A key piece of legislation is the National Greenhouse and Energy Reporting (NGER) legislation.o Under NGER, businesses must report their carbon emissions if: • an operational control of a facility emits equal to or greater than 25 000 tonnes of carbon dioxide equivalent (CO2–e), and/or produces equal to or greater than 100 terajoules (TJ) of energy, and/or consumes equal to or greater than 100 TJ of energy • the corporate group emits equal to or greater than 50 000 tonnes CO2–e, and/or produces equal to or greater than 200 TJ of energy, and/or consumes equal to or greater than 200 TJ of energy. If a business meets these thresholds and does not report, there are substantial penalties for noncompliance.1p To combine the warming effects of different greenhouse gases, a unit called carbon dioxide equivalent (CO2–e) is used to convert amounts of each gas to an amount of CO2 that would give the equivalent warming, often over 100 years. For example, over 100 years, methane is 21 times stronger as a greenhouse gas, and nitrous oxide 310 times stronger. It is inevitable that the level of regulation relating to environmental impacts will continue to increase. Society is demanding more transparent environmental standards and greater levels of CSR. While some businesses see the benefits of becoming more sustainable and are undertaking voluntary initiatives, there are many that still do not see the benefits. Appropriate legislation is needed to ensure minimum standards are reached in critical areas. Unfortunately attempts to legislate – for example, to include a measure of ‘externalities’ (environmental costs not captured by traditionally cost accounting systems such as greenhouse gas emissions) – are hampered by inconsistent policies as political parties have different views on how to address sustainability issues such as climate change. Adequate responses require a long-term, consistent strategy. As large businesses have a potentially infinite life, in some ways large corporations are in a good position to set standards, and put in place long-term, sustainable strategies, thus leading the way in improving environmental credentials. Many who are doing so (as Nike did in response to criticism from consumers) find that this leads to innovation and value-added customer products that then have a market advantage. While increased legislation is certain, a number of organisations have already developed voluntary triple-bottom-line reporting frameworks, and some of the principles contained in these are likely to be incorporated into future legislation. While the reporting frameworks we have described vary in their nature and scope, they are all founded on triple bottom line principles (see Exhibit 10.2).

Discussion Can you think of a profitable business that reports on its environmental and social performance as well as on its financial performance?

The Global Reporting Initiative (GRI), introduced in the next section, is one of the most globally recognised and comprehensive sustainability reporting frameworks; it is used in this chapter to demonstrate sustainability reporting.

The Global Reporting Initiative (GRI) The Global Reporting Initiative (GRI), which has operated since 1997, is an independent international organisation developing sustainability reporting guidelines in consultation with industry and other key stakeholders. The G4 Framework was the latest of the guidelines in effect until 1 July 2018 and then

1

Global Reporting Initiative (GRI) A network-based organisation that has developed the world’s most widely used sustainability reporting framework

For more information on NGER and related government activities, refer to the CER website: http://www.

cleanenergyregulator.gov.au. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions Exhibit 10.2 Examples of voluntary triple bottom line reporting frameworks Organisation/body

Governance

Main focus of guidance

Global Reporting Initiative (GRI)*

Independent body controlled by the board of directors who are elected through a stakeholder council

Content of sustainability reports, and standards for preparing sustainability reports

International Standards Organisation (ISO) 

Independent international body composed of national standards organisations

Procedural standards, with a particular emphasis on environmental management processes. At present, no guidance is given on what to report or how to report

European Eco-Management and Audit Scheme (EMAS)à

European Commission

A voluntary environmental management system (EMS) under which companies and other public organisations evaluate, manage and continuously improve their environmental performance (some link to ISOs)

The World Business Council for Sustainable Development (WBCSD)§

Coalition of 200 international companies

How sustainability reporting could be used to improve the economic, social and environmental performance of organisations, using sustainable development goals

BS 8900-1 & 8900-2 Managing sustainable development of organizations (Guide & Framework) (2013) (outcome of the SIGMA project and guidelines)^

British Standards Institution – the national standards body of the United Kingdom.

A Principles Based standard. Part 1 – principles e.g. organisational inclusivity, integrity, stewardship and transparency. Part 2 – framework for sustainable development

Group of 100#

The Group of 100, the representative body for the CFOs of Australia’s largest enterprises, has developed a Code of Conduct for the nation’s CFOs. The Group of 100 set up a working party to prepare a guide to reporting on environmental, social and economic performance of business

Focus of the 2003 report Sustainability: A Guide to Triple Bottom Line Reporting is on reporting the environmental, social and economic performance of business to stakeholders. Subsequent publication focus has been on including sustainable reporting into ASX corporate governance e.g. Principle 7 Recognise and manage risk (2015). They have also issued policy on the IIRC’s International Integrated Reporting framework (2014). There are a series of G100 Roundtables on Climate Risk in 2019/2020.

* See https://www.globalreporting.org/Pages/default.aspx. † See diverts to https://www.iso.org/iso-14001-environmental-management.html. ‡ See http://ec.europa.eu/environment/emas/index_en.htm. § See http://www.wbcsd.org/. ^ See https://www.bsigroup.com/en-AU. # See https://group100.com.au/communications/publications.

superseded by the first set of sustainability GRI Standards. The Framework and the Standards are intended to serve as a generally accepted framework for reporting on an organisation’s economic, environmental and social performance. They incorporate triple bottom line and CSR principles with the key aim of making sustainability reporting by all organisations as routine as, and comparable to, financial reporting. The GRI standards are designed for use by organisations of any size, sector or location. They take into account the practical considerations faced by a diverse range of organisations – from small enterprises to those with extensive, geographically dispersed operations. The G4 framework provided general guidelines for all businesses, supported by Sector Disclosures tailored for the following industry sectors: • airport operators • construction and real estate • electric utilities • event organisers • financial services 406

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Chapter 10 Sustainable and profitable business practices • • • • •

food processing media mining and metals non-government organisations oil and gas. The GRI Global Sustainability Standards Board (GSSB) is undertaking a sector program to develop sector standards starting with selected industries: oil, gas, coal, agriculture and fishing. While the sector standards are under development, the GRI G4 Sector Disclosures (although retired and no longer being updated) may be used for additional sector guidance alongside the GRI Standards. The GRI continually seeks to update and improve reporting standards through a process of consensus. GRI works with a global multi-stakeholder network from over 60 countries that includes experts from key stakeholder groups, including business, society, academia, labour and other professional institutions. This process was designed to be open and inclusive in order to adopt a global perspective and improve the GRI’s understanding of how best to report on key business sustainability issues. The GRI Standards are modular in nature, which allows for specific standards to be updated as needed and new standards to be introduced, without altering the overall structure. (The GRI’s latest standards can be downloaded from the website https://www.globalreporting.org/standards.) Under the G4 Guidelines, GRI reporting could be undertaken by business at three levels: beginners, those who are advanced reporters and those organisations somewhere in between. The application levels were titled C, B and A to reflect the extent of the application or coverage of the GRI Reporting Framework in a sustainability report by a given organisation. Reports at all levels that have been independently audited and assured gained a ‘þ’ rating. Since 2018, the three core GRI standards have applied to all reporting organisations: GRI101 Foundation (starting point for using the standards), GRI102 General Disclosures (to report background/ contextual information about the reporting organisation) and GRI103 (to report how the business manages its material topics). There are then three series of topic-specific standards: the GRI200 series of Economic standards, the GRI300 series of Environmental standards and the GRI400 series of Social Standards. Organisations report on each material topic by selecting relevant standards from the three series of standards under which to report. A useful animated introduction to the standards can be found at: https://www.globalreporting.org/standards. Exhibit 10.3 shows an overview of the structure of the GRI standards.2

4

What is the Global Reporting Initiative (GRI)?

5

What is integrated reporting?

Stop & think Watch the quick animated introduction to the GRI standards, ‘Sustainability reporting with the GRI Standards’, on the GRI web site: https://www.globalreporting.org/information/media/ Pages/Sustainability-reporting-with-the-GRI-Standards.aspx. Why may businesses chose to report under the standards? What benefits might there be?

Integrated reporting The Prince’s Accounting for Sustainability project (A4S) was established in 2004 by HRH the Prince of Wales to bring together major accounting organisations ‘to help ensure that sustainability – considering what we do not only in terms of ourselves and today, but also of others and tomorrow – is not just talked and worried about, but becomes embedded in organisations’ DNA.’q This in turn lead to the 2010 foundation of the International Integrated Reporting Council (IIRC) and subsequent Integrated Reporting (IR) Framework in 2013. Integrated reporting is much more than combining an business’s annual report and financial statements with its sustainability report. It is a complete rethink of the reporting system and taking an 2

For more detailed information about the G4 Guidelines, GRI Standards and industry sector disclosures, refer to the GRI

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integrated reporting connects the short-, medium- and longterm strategies of an organisation to the complete range of resources and interconnections that must be harnessed and managed in harmony to create value without diminishing those resources or ‘capitals’. ‘An integrated report looks at how the activities and capabilities of an organisation transform these six capitals into outcomes.’ (International Integrated Reporting Council [IIRC]). It develops critical and systems thinking and promotes innovation

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Accounting Information for Business Decisions Exhibit 10.3 GRI process overview

Source: Using the GRI Standards for sustainability reporting, https://www.globalreporting.org/standards/media/1381/using-the-gri-standards-reporting-process.pdf. Retrieved 01 April 2020. Global Reporting Initiative (GRI) is the independent international organization – headquartered in Amsterdam with regional offices around the world – that helps businesses, governments and other organizations understand and communicate their sustainability impacts.l

overall systems view of the interrelationships between types of business capital needed to add value and achieve long term sustainability (see Exhibit 10.4). “Integrated Reporting results in a broader explanation of performance than traditional reporting. It makes visible an organization’s use of and dependence on different resources and relationships or Exhibit 10.4 The six capitals

Mission and vision Governance

Financial Manufactured

Risk and opportunities

Intellectual

Financial Manufactured

Strategy and resource allocation

Intellectual

Business model Inputs

Human

Business activities

Outputs

Performance

Outcomes

Outlook

Social and relationship

Human Social and relationship

Natural

Natural External environment Value creation (preservation, diminution) over time Source: With permission from the International Integrated Reporting Council (C) 2020’

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Chapter 10 Sustainable and profitable business practices “capitals” (financial, manufactured, human, intellectual, natural and social), and the organization’s access to and impact on them. Reporting this information is critical to: • a meaningful assessment of the long-term viability of the organization’s business model and strategy; • meeting the information needs of investors and other stakeholders; and • ultimately, the effective allocation of scarce resources.”r The six capitals are shown in Exhibit 10.4.

10.3 Triple-bottom-line accounting: Practical measures Sustainability reporting frameworks such as the GRI and Integrated Reporting are underpinned by a range of environmental management accounting techniques for quantifying and measuring sustainability performance. One of the more involved of these techniques is life cycle analysis.

Life cycle analysis A key part of business sustainability is understanding how products and services have an impact on the environment. The aim of this section is to provide an overview of the principles of life cycle analysis, rather than a detailed guide on how to undertake this, since it is a very complex and often expensive process. Given its complexity, life cycle analysis is generally a compromise between practicality and completeness, with the aim of ensuring that the benefits are maximised. For example, life cycle analyses can be used to enable business to identify areas where environmental improvements can be made. A life cycle analysis can also be used to provide environmental data for the public or for government. Some companies cite life cycle analyses in their marketing and advertising to demonstrate that their products are environmentally sustainable. To manufacture products and deliver services, raw materials and energy need to be extracted from land, forests and oceans. For example, consider the manufacture of a car. We need steel, aluminium, plastic and other raw materials to make it. We also need energy, perhaps from coal-fired power stations, to form these materials into the car’s components, as well as to combine them in the car’s assembly. Over its life cycle, the car will consume fuel, oil, tyres and spare parts, all of which have environmental costs associated with their manufacture and use. Finally, we need to consider what happens when the car is no longer serviceable. Life cycle analysis is used to assess the potential and real environmental impacts occurring during all stages of a product’s life (often referred to as ‘cradle to grave’, ‘womb to tomb’ or sometimes ‘cradle to cradle’). The goal of life cycle analysis is to facilitate the design of products and services in such a way as to minimise their environmental impacts over their entire lives. Key issues include considerations such as efficiency in manufacture, reduced use of energy, reduced packaging and higher proportions of recyclable materials. The International Standards Organisation (ISO) 14040 standards provide guidance on environmental management systems for products and the use of life cycle analysis to manage the environmental impacts of products. ISO 14040 does not provide detailed guidance on life cycle analysis technique, or specify how the individual phases of the life cycle analysis should be undertaken.3 Generally, there are five stages in a product’s life cycle – sometimes termed ‘cradle to grave’ (Exhibit 10.5): 1 raw material extraction and processing 2 product design and manufacturing 3 packaging and distribution 4 product use 5 end of product’s life. 3

environmental management accounting Involves the management of the financial and environmental performance of business through the development and implementation of accounting systems and practices that reduce the environmental impacts of business activities. Environmental management accounting typically involves processes such as life cycle analysis, cost benefit analysis, material flow cost accounting and metrics such as ecoefficiency and share percentage to facilitate strategic environmental management initiatives

6

What is life cycle analysis and what are its limitations?

life cycle analysis An analysis of the environmental impact of a product or service throughout its entire life cycle, from beginning (womb) to the end (tomb)

Refer to the ISO website for more information on ISO 14040: http://www.iso.org/iso/home.html. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions Exhibit 10.5 A closed life cycle loop

1 Raw material Close loop ? 6 Recycle/upcycle Parts of product recycled or preferably use to create a new product

Raw material extraction and processing

2 Product Product design and manufacturing

A closed life cycle loop 5

3

End of Life End of product life and disposal or recycle

Distribution Packaging and distribution

4 Use Product use

Ethics and Sustainability

410

A sixth stage may be added if the product is recycled or repurposed to create a new higher or equal value product (sometimes termed ‘upcycling’). The ultimate aim of life cycle analysis is to ‘close the loop’. This means reaching the point where, at the end of a product’s life, the majority of materials contained in the product are recycled and used to make new products (i.e. ‘cradle to cradle’). However, this is not possible for 100 per cent of all materials. Therefore, during each stage of a product’s life cycle, there are always inputs of raw materials, energy and natural resources, as well as outputs of wastes in water, air and as solids. Outputs can also include other environmental impacts, such as global warming, depletion of natural resources, and loss of habitat and biodiversity. These outputs are secondary to the main output (the product) and, given that the secondary outputs are frequently hidden, there is often a much higher environmental price that is not taken into account in the purchase price of a product. In life cycle analysis, the environmental impacts of products are analysed over their entire life in order to design, make and market more sustainable products. Life cycle analysis normally involves three stages: 1 an inventory of possible materials and energy required for a product 2 an assessment of potential and actual environmental impacts 3 a review of the product, to assess and/or improve its sustainability (these reviews are continuous, so as to ensure improvements). In summary, life cycle analysis is undertaken to facilitate a better informed understanding of the environmental impacts of a product. It avoids generalisations about the environmental performance of a material in isolation from its total life cycle. Life cycle analysis can give transparency to environmental impact assumptions by testing the robustness of these assumptions, as well as provide a basis for comparison of environmental impacts. Life cycle analysis is an objective measure of the environmental impacts of products, and is useful in helping people to make more informed consumer choices. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 10 Sustainable and profitable business practices The concept of ecological balance

Today, many organisations promote the reduction of their total environmental impacts. The Ricoh Group (https://www.ricoh.com), for example, uses its Eco Balance system and life cycle analysis. To effectively reduce the company’s environmental impacts, the Eco Balance system identifies the environmental effects caused by each business activity (e.g. procurement of materials and parts, manufacturing, logistics, etc). Life cycle analysis identifies and analyses the environmental impact of each process, and of each product throughout its life cycle. It helps to determine the company’s total environmental impact, identify areas of need (i.e. what is wrong), assess quantitative improvements (i.e. how much has been done) and carry out effective environmental measures. The Ricoh Group has constructed an environmental impact information system for its overall corporate activities as a way of reducing their impacts, as well as disclosing this information.s

Material flow cost accounting A key part of life cycle analysis is material flow cost accounting. This system allows a business to trace input materials that flow through production processes and to measure the output of those production processes in terms of finished products and waste. Material cost flow accounting is another technique that is often used in life cycle analysis. As you learned in earlier chapters, the balance sheet equation (Assets ¼ Liabilities þ Equity) is always in balance. Similarly, material inputs and outputs should also balance, but in practice this is difficult to achieve because many waste outputs are especially difficult to identify and quantify. For example, if 100 kilograms of raw materials goes into a production process as an input, resulting in 80 kilograms of finished products, the remaining 20 kilograms is the waste produced from the process. How do we measure this waste? What are the waste components – waste water, air emissions, solid waste, recyclable waste? It is important to break down the input materials as far as is practical, as well as waste outputs and product outputs. The environmental impacts of waste outputs can be better managed if it is clear what those wastes are and how they are generated. Improvement of the production process should centre on how waste outputs can be reduced relative to product outputs. From a sustainability perspective, increases in the use of water, electricity, gas, and so on have both cost and environmental implications. The more electricity used for a given output, for example, the higher the costs and the greater the increase in carbon emissions will be (if that electricity is generated from a coal-fired power station). Higher water use for a given output will result in higher costs, as well as more waste water, and thus result in higher volumes of water needing to be processed at water-treatment plants, which will in turn use more electricity to process the extra waste water – and so on. To summarise, identifying areas and processes where waste occurs is important so that measures can be taken to improve efficiency where and when it is practical to do so. When we look at the simplified material cost flow accounting example for DeFlava Coffee given in Case Exhibit 10.6, we can see that 12 per cent of the output from making coffee is waste. To reduce this waste, DeFlava needs to examine where the waste is occurring in the manufacturing process and determine if the process can be improved in such a way that this waste will be reduced relative to positive product output. Case Exhibit 10.6 shows only a few of the actual inputs and outputs that may be involved in the material cost flow accounting process for DeFlava Coffee. Therefore, an important aspect of MFCA is identifying all of the relevant types of inputs and outputs. An overview of these follows:t • Raw materials are those materials that become part of the finished product – for example, steel used in car manufacture, plastic used in computer manufacture or coffee beans used in coffee manufacture. • Auxiliary materials are materials that become part of the finished product, but are not considered a major component of the product – for example, the welding materials used to manufacture a car, the glue holding furniture together or ingredients that increase product life. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Ethics and Sustainability

7

What is material flow cost accounting?

material flow cost accounting A system that allows a business to trace input materials that flow through production processes and to measure the output of those production processes in terms of finished products and waste

411

Accounting Information for Business Decisions Case Exhibit 10.6 Example of estimating waste from material balance data

Input materials used

Output waste

Output products

Major materials

Quantity

Waste (negative products)

Quantity

Company products (positive products)

Quantity

Solid inputs

Weight (kg)

Solid waste

Weight (kg)

Solid outputs

Weight (kg)

Coffee beans

500 Industrial waste

250

Sugar

2 000 Recyclable waste

50

Milk powder

1 500

Packaging

500

Flavourings

750

Total (kg)

2 500 Total (kg)

Quantity %

100%

Cost of solid input materials Total Liquid inputs

300 Total (kg) 12% Cost of solid output waste

$40 000 Total Volume (L)

Water

900 Waste water 100

Cleaning chemicals

Volume (L)

Quantity %

100%

Cost of input liquid materials Total

$35 200 Liquid outputs

Volume (L)

650 10

50 Hazardous chemicals 1 050 Total (L)

88% Cost of solid output products

$4 800 Total Liquid waste

Milk Total (L)

2 200

50 750 Total (L)

300

71% Cost of liquid output waste

$ 1 000 Total

29% Cost of liquid output products

$ 714 Total

$

286

Overall totals (solids and liquids) Total inputs

$41 000 Total waste outputs

• •

•

•

•

•

•

412

$5 514 Total product outputs

$35 486

Merchandise is components manufactured by external suppliers and added to the final product – for example, the stereo system in car manufacture or decorations on coffee gift packs. Packaging is used for shipping final products, and is also involved in sourcing materials purchased to be used in the manufacturing process – for example, the packaging for a new television would include the cardboard box, the moulded polystyrene that holds the television in place in the box and a plastic bag to protect against moisture. For DeFlava Coffee, this would include bags and boxes for coffee. Operating materials are inputs used that do not become part of the final product. Examples include office materials, cleaning materials, maintenance parts, energy, water or fuel. However, they may also be part of the finished product. For example, in DeFlava’s coffee manufacturing, the use of gas or electricity to generate heat in roasting ovens will be a major part of producing the final product. Products and by-products include all physical products and their packaging. By-products are incidental products that arise from the manufacture of the primary product. For example, a by-product of processing macadamia nuts is the shells, which can be used by the processing plants as fuel for the cogeneration of electricity. Waste and emissions are outputs that are not product outputs; these are also called non-product outputs. Generally, these are solid and liquid waste, wastewater and air emissions. For DeFlava Coffee, the main waste product in this category would be cleaning chemicals. Solid waste incorporates recyclable materials such as paper, plastic, glass, aluminium, steel or copper. If these are sold, they can be classified as by-products. Hazardous waste, such as chemicals, solvents and other harmful substances, is subject to environmental legislation. Wastewater is all water used that does not make up part of products or by-products. Wastewater can represent a significant cost, so methods of recycling it can be important cost-saving measures.

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Chapter 10 Sustainable and profitable business practices •

Air emissions are pollutants, such as carbon dioxide, methane, nitrous oxide and hydrofluorocarbons, that can result from combustion of fuel and industrial processes. Once a product is manufactured, it will often require inputs to operate, as well as produce outputs in the form of waste. The efficiency of operation is referred to as eco-efficiency. 8

Eco-efficiency

What is eco-efficiency and how is it measured?

Determining the eco-efficiency of products and services forms another key part of life cycle analysis, as well as being used as a standalone metric. Eco-efficiency is a management concept that encourages managers to investigate environmental improvements to business that will also provide parallel financial benefits. The concept of eco-efficiency, or ‘doing more with less’, was developed by the World Business Council for Sustainable Development (WBCSD) in 1992. The term is now widely recognised by business, and brings together the essential ingredients of economic and environmental progress to deliver goods and services with less resource use and pollution, resulting in increased profitability.u Eco-efficiency has three broad objectives: 1 reducing the consumption of resources 2 reducing business’s impact on nature 3 increasing product or service value. Eco-efficiency can be increased by providing more value with a decrease in the environmental impact or resources consumed for a given product or service. Eco-efficiency links physical units such as kilograms, kilowatt hours or kilolitres to monetary variables such as turnover and profit. By combining physical accounting data with cost data, eco-efficiency indicators can be calculated. The eco-efficiency ratio is represented as follows: Eco-efficiency ¼

eco-efficiency First described by the World Business Council for Sustainable Development (WBCSD) in 1992, it is based on the concept of using fewer resources to deliver goods and services and thus reduce waste and pollution

Ethics and Sustainability

Product or service value Environmental influence

Eco-efficiency indicators used in this ratio must be clearly defined, so that they will reflect the needs of different stakeholders. There are a large number of possible numerator and denominator indicators that can be used to calculate eco-efficiency; as such, these need to be matched to ensure relevance. Consider Case Exhibit 10.7. Case Exhibit 10.7 Purchasing new fleet cars DeFlava Coffee is considering purchasing a number of new cars for its fleet. To assist with this decision, the company accountant uses a well-known eco-efficiency ratio: the fuel consumption of a car expressed in kilometres per litre of fuel used. The numerator for value is a function of performance, expressed as kilometres travelled. The denominator is energy used, expressed in both kilometres per litre and litres per hundred kilometres. Suppose Car A has a 50-litre fuel tank and Car B a 70-litre fuel tank. Car A is able to travel 700 kilometres on a tank of fuel, and car B can travel 950 kilometres on a tank of fuel. Which car should DeFlava adopt because it is the more efficient?

Ethics and Sustainability

Car A: 700 ¼ 14:00 kilometres per litre 50 100 ¼ 7:14 litres per 100 kilometres 14 Car B: 950 ¼ 13:57 kilometres per litre 70 100 ¼ 7:37 litres per 100 kilometres 13:57 Therefore, Car A is the more efficient: it uses 7.14 litres per 100 kilometres, compared with Car B, which uses 7.37 litres of fuel per 100 kilometres.

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413

Accounting Information for Business Decisions

Taking this a step further, we can estimate the monetary savings. If fuel is $1.35 per litre, this means that Car A costs $67.50 ($1.35  50) to fill with fuel, and Car B costs $94.50 ($1.35  70) to fill with fuel. Therefore: 7:14  $1:35 ¼ $9:64 per 100 kilometres in fuel for Car A: 7:37  $1:35 ¼ $9:95 per 100 kilometres in fuel for Car B: $9:95  $9:64 ¼ 31c So when fuel is $1.35 per litre, Car A uses 31 cents less fuel per 100 kilometres than Car B does. In summary, this means that Car A has a higher eco-efficiency ratio than Car B. However, it is important to note that if Car A drives double the average kilometres of Car B, even though the eco-efficiency ratio is lower, the total fuel consumed will be higher; as such, the subsequent environmental impacts from exhaust emissions will also be greater.

Stop & think What would be the difference between the two cars if Car A were able to travel 800 kilometres on a tank of petrol? A business with good eco-efficiency ratios is not necessarily sustainable. Ratios are measures of particular performance aspects of a business related to their influence on the environment. It is important to be aware of what is actually being measured, and of the relevance of that measure in terms of what it tells us about the business. Comparing the performance of a business on a number of eco-efficiency ratios with industry averages for the sector in which the business operates is useful, since it allows us to examine relative performance. A business may appear to have good performance for a particular eco-efficiency ratio but, when compared with industry averages, it may in fact be below average. The difficulty with this at present is that eco-efficiency data for industry are not always available, so it requires significant work to make comparisons. If data are unavailable, it is important to evaluate performance in the context of what practical, cost-effective actions could be taken to improve performance in key areas.

9

What is share percentage and how is it calculated?

share percentage Ratio of a sub-group to a total amount, commonly calculated in relation to a baseline; for example, the share of recycling waste as a percentage of total waste

recycling rate The percentage of total waste that is recycled

Share percentage We often want to know the proportional outputs of particular activities relative to total outputs. This is a particularly useful process in material cost flow accounting. A share percentage is the ratio of a subgroup to a total amount. Share percentages are commonly calculated in relation to a baseline, such as the share of recycling waste as a percentage of total waste. This gives us the recycling rate, which is calculated as follows: Quantity of recycled waste in tonnes Quantity of total waste in tonnes 4 000 Recycling rate ¼ 5 000 ¼ 80% Another example is the share that different energy companies have of the total electrical energy input, in percentages. For example, what is the energy share of a solar power station that produces 100 megawatt hours of electricity per day when the total produced by all power stations is 1000 megawatt hours per day? We can calculate this as follows: Recycling rate ¼

100 gigawatt hours per day 1000 gigawatt hours per day ¼ 10%

Energy share ¼

414

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Chapter 10 Sustainable and profitable business practices

• • • • • • • •

Some generic indicators for share percentages are: share of different materials in a product share of materials for product and packing share of products complying with defined environmental criteria (e.g. eco-labelled or organic) as a percentage of total products share of renewable energy sources as percentage of total energy input share of kilometres on railway/ship/truck in percentages share of passenger kilometres of business trips or means of transport in percentages share of hazardous waste in relation to total waste production in percentages recycling rate (share of recycled waste in relation to total waste production in percentages).

10.4 Environmental project appraisal In previous sections of this chapter, we have highlighted that the business case for resource efficiency is often overlooked or incomplete. Opportunities can be overlooked because their financial attractiveness is hidden, meaning that not all benefits and/or costs are taken into consideration. Decisions based on capital costs alone may not include resource-efficiency improvements or reductions in business risk that may provide more stable returns. Benefits may include reduced input costs, reduced waste or more efficient processes resulting in reduced operating costs. Financial evaluation is only one element of comprehensive project appraisal. Other considerations may include WHS issues, quality of work environment, environmental impacts, social impacts, implications for business reputation and other non-financial considerations that may have an impact on the business. One of the most important considerations affecting decisions that have an impact on resource-efficiency improvements is projected cash flows and the time it takes to generate returns. There are two commonly used methods for determining this: the payback period and net present value (NPV), which we will explain in the following sections (and return to in Chapter 12). To understand NPV, it will first be necessary to understand the time value of money and present value.

10

What methods are used for environmental project appraisal and how are they calculated?

Calculating payback periods The payback method evaluates a capital expenditure proposal based on the payback period, which is the length of time required for a return of the initial investment. That is, it is the length of time needed for the future net cash receipts to ‘pay back’ the initial cash payment for the capital expenditure. Case Exhibit 10.8 demonstrates the use of the payback period. Case Exhibit 10.8 Example of calculation of payback periods The manager of DeFlava Coffee is considering an upgrade of the lighting in the business’s head office. The project will involve changing existing lights to energy-efficient fluorescent bulbs, which will reduce the number of light fittings needed by 30 per cent. Time-delay switches, occupancy sensors and devices that detect daylight to control lighting levels will also be installed as part of the project. An initial investment of $27 000 is required to buy and install the new lighting system, which, it is calculated, will save the business $8750 per year in electricity costs. To calculate the required payback period, the business does the following: a Calculation of payback period – energy only Initial investment: $27 000 Net annual savings: $8750 per year Payback period ¼

27 000 ¼ 3:09 years 8750

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415

Accounting Information for Business Decisions

b

On further investigation, the manager of DeFlava Coffee has also found that having 30 per cent fewer lights to operate and a 100 per cent longer lamp life before failure will lead to 65 per cent fewer lamp changes per year. The reduction in maintenance time and replacement lamps will increase the annual cost savings by an additional $1500 per year. It is expected that the better lighting quality delivered by the tri-phosphor lamps will also reduce the product defect rate by 5 per cent, saving another $500 per year over the next five years. Payback Initial investment $27 000 Net annual savings $8750 þ ð$1500 þ 500Þ ¼ $10 750 per year $27 000=10 750 ¼ 2:51 years

The time value of money and present value Since capital expenditure decisions involve cash payments and cash receipts occurring at different times, often over several years, a manager must consider the time value of money in sustainability-related decisions. No analysis that ignores the time value of money can provide a sound basis for making decisions involving large-scale improvements to energy and resource efficiency. To understand the time value of money, consider whether you would rather receive $1 today or $1 next year. Your answer should be that you would rather receive $1 today because a dollar held today is worth more than a dollar received a year from now. If you received $1 today and put it in an interest-bearing account, you would have more than $1 a year from now. If you waited until next year to receive $1, you would have only $1 a year from now. The difference between the two amounts is interest, which reflects the time value of money. To illustrate the time value of money, suppose that you have $100 on 1 January 20X1 and can invest it at 10 per cent. This money will grow over the next three years as shown:

Year

Amount at beginning of the year

20X1

$100

Interest at 10%

Amount at end of the year

$10.00

$110.00

20X2

110

11.00

121.00

20X3

121

12.10

133.10

Thus, you would rather have $100 today than $100 in one year because the $100 today grows to $110 in one year. Alternatively, the table shows that the following amounts, given the 10 per cent interest rate and their respective dates, all have equivalent values: • $100 at the beginning of 20X1 • $110 at the end of 20X1 (beginning of 20X2) • $121 at the end of 20X2 (beginning of 20X3) • $133.10 at the end of 20X3 (beginning of 20X4).

Stop & think Why do you think these four amounts are equivalent? Since these amounts have equivalent values, if you were asked which amount you wanted to receive on the respective date, you could be indifferent about the four alternatives given the 10 per cent rate. It is important to know that the dollar amounts have a time and an interest rate attached to them. Whenever you are considering the time value of money, you must always know the date at which the dollar amount is measured and the appropriate interest rate. A dollar received or paid in 20X2 does not have the same value as a dollar received or paid in 20X3. 416

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Chapter 10 Sustainable and profitable business practices

Definition of present value An important term that is commonly used whenever the time value of money is being considered is present value. Present value is the value today of a certain amount of dollars paid or received in the future. Either the payer or the receiver of money can use the present value concept. (Another concept sometimes used is future value. Future value is the value at a future date of a certain amount of dollars paid or received today. Since present value is more commonly used, for simplicity, we do not discuss future value in this book.) In the preceding example, $100 is the present value at the beginning of 20X1 of $133.10, to be paid or received at the end of 20X3 when the interest rate is 10 per cent. The concept underlying present value is compound interest. Compound interest is interest that accrues on both the principal and the past (unpaid) interest. So, during 20X1, interest of 10 per cent accrues on the principal of $100, making a total of $110 at the end of 20X1. In 20X2, interest of 10 per cent accrues on the $110 (the principal and the 20X1 interest). The interest amounts to $11 for 20X2. Similarly, in 20X3, interest of $12.10 is accrued on $121 ($100 þ $10 þ $11) so that the total amount is $133.10 at the end of 20X3. The calculation of a present value is necessary in many situations. In this chapter, we will use present value calculations in evaluating capital expenditure proposals. As you will see, formulas and tables simplify present value calculations. Formulas or tables may be used instead of preparing year-by-year calculations of present values. But first you must understand that there are two types of future cash flows: a single amount and an annuity.

present value Value today of a certain amount of dollars to be paid or received in the future

compound interest Interest that accrues on both the principal and the past (unpaid) interest

Present value of a single future amount A single future amount is a one-time future cash flow. For example, if DeFlava Coffee plans to use a roasting machine for three years and then sell it, the cash it will receive from the sale is a single future amount. The general relationship between the present value and a future amount is shown in the equation: PV ¼

single future amount A one-time future cash flow

FA ð1 þ iÞn

where: PV ¼ present value FA ¼ future amount i ¼ interest rate n ¼ number of periods. Using the same example of 10 per cent and three years, if the future amount of $133.10 is known, the present value is calculated as: PV ¼ ¼

FA ð1 þ iÞn $133:10

ð1 þ 0:10Þ3 $133:10 ¼ ð1:331Þ ¼ $100 A table can simplify the calculation process even more. You can use Table 10.1 to calculate the present value of any single future amount. With this information, you can calculate a present value by using the formula: PV ¼ FA  present value of $1 factor

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417

Accounting Information for Business Decisions factor Decimal amount in a present value table

A factor is a decimal amount from the table. If you look up the factor for 10 per cent and three periods in Table 10.1,4 you will find that it is 0.7513. Present value factor for a single future amount PV ¼ (1 þ i )n 1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

1

0.9901

0.9804

0.9709

0.9615

0.9524

0.9434

0.9346

2

0.9803

0.9612

0.9426

0.9246

0.9070

0.8900

0.8734

0.9259

0.9174

0.9091

0.8573

0.8417

0.8264

3

0.9706

0.9423

0.9151

0.8890

0.8638

0.8396

0.8163

0.7938

0.7722

0.7513t

4

0.9610

0.9238

0.8885

0.8548

0.8227

0.7921

0.7629

0.7350

0.7084

0.6830

5

0.9515

0.9057

0.8626

0.8219

0.7835

0.7473

0.7130

0.6806

0.6499

0.6209

t

n/i

This represents the present value of $1 received or paid at the end of three years. The present value of $133.10 received or paid at the end of three years, using a 10 per cent interest rate, is 133.10 times the present value of $1. Another way of saying this is that the present value of $133.10 is $133.10 times the 0.7513 factor, as follows: PV ¼ FA 3 present value of $1 factor for 3 periods at 10% ¼ $133:10 3 0:7513 ¼ $100

Stop & think What do you think the present value of $10 received or paid at the end of three years is, using a 10 per cent interest rate?

discount rate The rate used to convert a future amount to a present value

The process of converting a future amount to a present value is known as discounting, and the rate used is often called the discount rate. So we can say that the $133.10 future amount is discounted to the $100 present value by multiplying it by the 0.7513 present value of $1 factor for three periods at the 10 per cent discount rate.

Present value of an annuity annuity Series of equal periodic future cash flows

In many situations, we are not concerned with the present value of a single future amount, but with the present value of an annuity. An annuity is a series of equal periodic future cash flows. These cash flows may be either received or paid. For example, if on 1 January DeFlava Coffee purchased a new roasting machine that will require $200 of maintenance at the end of each of the next three years, the three $200 payments are an annuity. In this book we will assume that the first cash flow in an annuity occurs at the end of the first year. So if an annual annuity begins on 1 January 20X2, the first cash flow occurs on 31 December 20X2. We could calculate the present value on 1 January 20X2 of a three-year $200 annuity at 10 per cent by treating it as three separate single future amounts and using Table 10.1, but there is an easier way: we can use Table 10.2.

Stop & think How would you calculate the present value for the preceding example using Table 10.1?

4

The factors in Table 10.1 were calculated using the equation for the present value of $1 factor shown at the beginning of

Table 10.1.

418

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6%

7%

8%

9%

10%

11%

12%

13%

14%

15%

16%

17%

18%

18%

19%

20%

0.675 0.6575 0.6407 0.8765 0.6086 0.8769 0.8743 0.5787

0.8787

13

0.415 0.3677 0.3262 0.2897 0.2575 0.2292 0.9099 0.1821 0.1625 0.1452 0.9290 0.1163 0.9410 0.9448 0.0935

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0.8034 0.6468 0.5219

0.7954 0.6342 0.5067 0.4057 0.3256 0.2618 0.2109 0.1703 0.1378 0.1117 0.0907 0.0738 0.9254 0.0491 0.0402 0.0329 0.9597 0.0222 0.9722 0.9763 0.0151

0.7876 0.6217 0.4919 0.3901 0.3101

0.7798 0.6095 0.4776 0.3751 0.2953

22

23

24

25

0.056 0.0462 0.0382 0.9574 0.0262 0.9700 0.9742 0.0181

0.146

0.116 0.0923 0.0736 0.0588 0.9282 0.0378 0.0304 0.0245 0.9641

0.016 0.9761 0.9800 0.0105

0.7568 0.5744 0.4371 0.3335 0.2551 0.1956 0.1504 0.1159 0.0895 0.0693 0.0538 0.0419 0.9322 0.0255

0.7493 0.5631 0.4243 0.3207 0.2429 0.1846 0.1406 0.1073 0.0822

0.7419 0.5521

28

29

30

0.02 0.0157 0.9698 0.0097 0.9810 0.9846 0.0061

0.023 0.0182 0.9680 0.0115 0.9795 0.9832 0.0073

0.412 0.3083 0.2314 0.1741 0.1314 0.0994 0.0754 0.0573 0.0437 0.0334 0.9347 0.0196 0.0151 0.0116 0.9730

0.007 0.9837 0.9870 0.0042

0.063 0.0485 0.0374 0.9335 0.0224 0.0174 0.0135 0.9714 0.0082 0.9824 0.9858 0.0051

0.7644 0.5859 0.4502 0.3468 0.2678 0.2074 0.1609 0.1252 0.0976 0.0763 0.0597 0.0469 0.9309 0.0291

0.772 0.5976 0.4637 0.3607 0.2812 0.2198 0.1722 0.1352 0.1064 0.0839 0.0663 0.0525 0.9296 0.0331 0.0264 0.0211 0.9661 0.0135 0.9779 0.9817 0.0087

0.233 0.1842

0.247 0.1971 0.1577 0.1264 0.1015 0.0817 0.0659 0.9268 0.0431 0.0349 0.0284 0.9620 0.0188 0.9742 0.9783 0.0126

0.422 0.3418 0.2775 0.2257 0.1839 0.1502 0.1228 0.1007 0.0826 0.9240

27

26

0.8114 0.6598 0.5375 0.4388 0.3589 0.2942 0.2415 0.1987 0.1637 0.1351 0.1117 0.0926 0.9225 0.0638 0.0531 0.0443 0.9549 0.0309 0.9676 0.9719 0.0217

21

0.673 0.5537 0.4564 0.3769 0.3118 0.2584 0.2145 0.1784 0.1486 0.1240 0.1037 0.9210 0.0728 0.0611 0.0514 0.9522 0.0365 0.9651 0.9694 0.0261

0.8195

20

0.13 0.9180 0.0946 0.0808 0.0691 0.9465 0.0508 0.9594 0.9638 0.0376

0.8277 0.6864 0.5703 0.4746 0.3957 0.3305 0.2765 0.2317 0.1945 0.1635 0.1377 0.1161 0.9195 0.0829 0.0703 0.0596 0.9494 0.0431 0.9624 0.9667 0.0313

0.212 0.1799 0.1528

19

0.836 0.7002 0.5874 0.4936 0.4155 0.3503 0.2959 0.2502

0.06 0.9562 0.9606 0.0451

0.093 0.9401 0.0708 0.9528 0.9571 0.0541

0.605 0.5134 0.4363 0.3714 0.3166 0.2703 0.2311 0.1978 0.1696 0.1456 0.9164 0.1078 0.0929 0.0802 0.9434

0.8444 0.7142

17

18

0.8528 0.7284 0.6232 0.5339 0.4581 0.3936 0.3387 0.2919 0.2519 0.2176 0.1883 0.1631 0.9148 0.1229 0.1069

0.481 0.4173 0.3624 0.3152 0.2745 0.2394 0.2090 0.1827 0.9132 0.1401 0.1229 0.1079 0.9366 0.0835 0.9492 0.9534 0.0649

16

0.743 0.6419 0.5553

0.8613

0.87 0.7579 0.6611 0.5775 0.5051 0.4423 0.3878 0.3405 0.2992 0.2633 0.2320 0.2046 0.9115 0.1597 0.1413 0.1252 0.9329 0.0985 0.9452 0.9493 0.0779

0.681 0.6006 0.5303 0.4688

0.444 0.3971 0.3555 0.3186 0.2858 0.2567 0.9081 0.2076 0.1869 0.1685 0.9249 0.1372 0.9364 0.9400 0.1122

0.322 0.9046 0.2697 0.2472 0.2267 0.9161 0.1911 0.9262 0.9292 0.1615

15

14

0.8874 0.7885 0.7014 0.6246 0.5568

12

0.773

0.8963 0.8043 0.7224 0.6496 0.5847 0.5268 0.4751 0.4289 0.3875 0.3505 0.3173 0.2875 0.9064 0.2366 0.2149 0.1954 0.9206 0.1619 0.9315 0.9348 0.1346

11 0.497

0.9053 0.8203 0.7441 0.6756 0.6139 0.5584 0.5083 0.4632 0.4224 0.3855 0.3522

10

0.266 0.9145 0.9164 0.2326 0.263 0.9113 0.2255 0.9205 0.9230 0.1938

0.305 0.9062

0.9143 0.8368 0.7664 0.7026 0.6446 0.5919 0.5439 0.5002 0.4604 0.4241 0.3909 0.3606 0.9028 0.3075 0.2843

0.582 0.5403 0.5019 0.4665 0.4339 0.4039 0.9009 0.3506 0.3269

0.9235 0.8535 0.7894 0.7307 0.6768 0.6274

9

0.547 0.5132 0.4817 0.4523 0.8991 0.3996 0.3759 0.3538 0.9008 0.3139 0.9079 0.9092 0.2791

0.705 0.6663 0.6302 0.5963 0.5645 0.5346 0.5066 0.8972 0.4556 0.4323 0.4104 0.8952 0.3704 0.9009 0.9015 0.3349

0.713 0.6806 0.6499 0.6209 0.5935 0.5674 0.8952 0.5194 0.4972 0.4761 0.8893 0.4371 0.8935 0.8931 0.4019

0.683 0.6587 0.6355 0.8932 0.5921 0.5718 0.5523 0.8831 0.5158 0.8855 0.8841 0.4823

8

0.888 0.8375 0.7903 0.7462

0.735 0.7084

0.9327 0.8706 0.8131 0.7599 0.7107 0.6651 0.6227 0.5835

0.942

0.9515 0.9057 0.8626 0.8219 0.7835 0.7473

0.961 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629

0.889 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513 0.7312 0.7118 0.8912

0.89 0.8734 0.8573 0.8417 0.8264 0.8116 0.7972 0.8892 0.7695 0.7561 0.7432 0.8696 0.7182 0.8677 0.8638 0.6944

7

6

5

4

0.907

0.9706 0.9423 0.9151

5%

3

4%

0.9803 0.9612 0.9426 0.9246

3%

2

2%

0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 0.9009 0.8929 0.8871 0.8772 0.8696 0.8621 0.8623 0.8475 0.8579 0.8525 0.8333

1%

Present value interest factor ðPVIFÞ formula 1 Factor ¼ ð1 þ i Þn

1

(n) Periods

Table 10.1 Present value of $1 due in n periods

Chapter 10 Sustainable and profitable business practices

419

420

13.8651 12.8493 11.9379 11.1184 10.3797

14.7179 13.5777 12.5611 11.6523 10.8378 10.1059

15.5623 14.2919 13.1661 12.1657 11.2741 10.4773

16.3983

15

16

17

18

9.7122

9.295

8.8527

8.3838

9.7632

9.4466

9.1079

8.7455

8.3577

7.9427

9.8181

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

22.0232 19.5235 17.4131 15.6221 14.0939 12.7834 11.6536 10.6748

22.7952

23.5596 20.7069

24.3164 21.2813 18.7641 16.6631 14.8981 13.4062 12.1371 11.0511 10.1161

25.0658 21.8444 19.1885 16.9837 15.1411 13.5907 12.2777 11.1584 10.1983

25.8077 22.3965 19.6004

25

26

27

28

29

30

10.81

9.929

9.8226

9.7066

12.409 11.2578 10.2737

14.643 13.2105 11.9867 10.9352 10.0266

17.292 15.3725 13.7648

18.327 16.3296

20.121 17.8768 15.9828 14.3752 13.0032 11.8258

15.247 13.7986 12.5504 11.4693 10.5288

21.2434 18.9139 16.9355

24

9.5802

9.4424

9.2922

20.4558 18.2922 16.4436 14.8568 13.4886 12.3034 11.2722 10.3711

13.163 12.0416 11.0612 10.2010

9.1285

8.9501

8.7556

8.5436

8.3126

8.0607

7.7862

7.4869

7.1607

6.8052

6.4177

5.9952

5.5348

5.033

4.4859

3.8897

3.2397

2.5313

1.7591

0.9174

9%

23

17.658 15.9369 14.4511

15.415 14.0292 12.8212 11.7641 10.8355 10.0168

10.594

9.6036

9.3719

9.1216

8.8514

8.5595

8.2442

7.9038

7.5361

7.139

6.7101

6.2469

5.7466

5.2064

4.6229

3.9927

3.3121

2.5771

1.7833

0.9259

8%

19.6604

18.857 17.0112

18.0456 16.3514 14.8775 13.5903 12.4622 11.4699

17.226 15.6785 14.3238 13.1339 12.0853 11.1581 10.3356

14.992 13.7535 12.6593 11.6896 10.8276 10.0591

9.8986

9.3936

8.8633

7.4987

7.0236

6.5152

5.9713

5.3893

4.7665

4.1002

3.3872

2.6243

1.808

0.9346

7%

9.4269

9.3696

9.3066

9.2372

9.1609

9.077

8.9847

8.8832

8.7715

8.6487

8.5136

8.3649

8.2014

8.0216

7.8237

7.6061

7.3667

7.1034

6.8137

6.4951

6.1446

5.759

5.3349

4.8684

4.3553

3.7908

3.1699

2.4869

1.7355

0.9091

i

8.6938

8.6501

8.6016

8.5478

8.4881

8.4217

8.3481

8.2664

8.1757

8.0751

7.9633

7.8393

7.7016

7.5488

7.3792

7.1909

6.9819

6.7499

6.4924

6.2065

5.8892

5.5370

5.1461

4.7122

4.2305

3.6959

3.1024

2.4437

1.7125

0.9009

11%

1  ð½1þi1 n Þ

10%

Factor ¼

8.0552

8.0218

7.9844

7.9426

7.8957

7.8431

7.7843

7.7184

7.6446

7.562

7.4694

7.3658

7.2497

7.1196

6.974

6.8109

6.6282

6.4235

6.1944

5.9377

5.6502

5.3282

4.9676

4.5638

4.1114

3.6048

3.0373

2.4018

1.6901

0.8929

12%

Present value interest factor of an annuity ðPVIFAÞ form

22

21

20

19

13.0037 12.1062 11.2961 10.5631

9.9856

9.3851

7.8869

7.3601

6.8017

14

9.954 10.635

8.3064

7.7217

7.1078

6.2098

5.5824

12.1337 11.3484

8.7605

8.1109

7.4353

6.4632

5.7864

11.2551 10.5753

9.2526

8.5302

7.7861

6.7327

6.0021

4.9173

13

9.7868

8.9826

8.1622

7.0197

6.2303

5.0757

4.2124

3.4651

2.673

1.8334

0.9434

6%

12

8.566

9

6.472

7.3255

5.2421

4.3295

3.546

2.7232

1.8594

0.9524

5%

9.4713

7.6517

8

5.4172

4.4518

3.6299

2.7751

1.8861

0.9615

4%

10.3676

6.7282

7

5.6014

4.5797

3.7171

2.8286

1.9135

0.9709

3%

11

5.7955

6

4.7135

3.8077

2.8839

1.9416

0.9804

2%

10

3.902

4.8534

2.941

3

5

1.9704

4

0.9901

2

1%

1

(n) Periods

Table 10.2 Present value of an annuity of $1 per period

7.1942

7.1595

7.1215

7.0800

7.0346

6.9847

6.9300

6.8698

6.8035

6.7304

6.6496

6.5603

6.4612

6.3512

6.2289

6.0926

5.9405

5.7705

5.5801

5.3664

5.1262

4.8556

4.5501

4.2047

3.8131

3.3684

2.8623

2.2850

1.6250

0.8686

13%

7.0027

6.983

6.9607

6.9352

6.9061

6.8729

6.8351

6.7921

6.7429

6.687

6.6231

6.5504

6.4674

6.3729

6.2651

6.1422

6.0021

5.8424

5.6603

5.4527

5.2161

4.9464

4.6389

4.2883

3.8887

3.4331

2.9137

2.3216

1.6467

0.8772

14%

6.566

6.5509

6.5335

6.5135

6.4906

6.4641

6.4338

6.3988

6.3587

6.3125

6.2593

6.1982

6.128

6.0472

5.9542

5.8474

5.7245

5.5831

5.4206

5.2337

5.0188

4.7716

4.4873

4.1604

3.7845

3.3522

2.855

2.2832

1.6257

0.8696

15%

6.1772

6.1656

6.152

6.1364

6.1182

6.0971

6.0726

6.0442

6.0113

5.9731

5.9288

5.8775

5.8178

5.7487

5.6685

5.5755

5.4675

5.3423

5.1971

5.0286

4.8332

4.6065

4.3436

4.0386

3.6847

3.2743

2.7982

2.2459

1.6052

0.8621

16%

18%

19%

20%

4.303 3.6764

4.031

4.656 3.9647 4.3271

5.2047 5.5168 4.8779 4.9789

5.1860 5.5098 4.8621 4.9747

5.1655 5.5016 4.8448 4.9697

5.1431 5.4919 4.8257 4.9636

5.1187 5.4804 4.8047 4.9563

5.0918 5.4669 4.7816 4.9476

5.0624 5.4509 4.7561 4.9371

5.0300 5.4321 4.7279 4.9245

4.9942 5.4099 4.6966 4.9094

4.9547 5.3837 4.6618 4.8913

4.9108 5.3527 4.6232 4.8696

4.8621 5.3162 4.5800 4.8435

4.8077 5.2732 4.5318 4.8122

4.7470 5.2223 4.4776 4.7746

4.6788 5.1624 4.4168 4.7296

4.6020 5.0916 4.3480 4.6755

4.5154 5.0081 4.2702 4.6106

4.4171 4.9095 4.1817 4.5327

4.3051 4.7932 4.0806 4.4392

4.1772

4.0301 4.4941 3.8311 4.1925

3.8604

3.6635 4.0776 3.4961 3.8372

3.4338 3.8115 3.2849 3.6046

3.1643 3.4976 3.0357 3.3255

2.8462 3.1272 2.7396 2.9906

2.4682 2.6901 2.3852 2.5887

2.0161 2.1743 1.9574 2.1065

1.4713 1.5656 1.4365 1.5278

0.8098 0.8475 0.7959 0.8333

17%

Accounting Information for Business Decisions

Chapter 10 Sustainable and profitable business practices You can use Table 10.2 to calculate the present value of an annuity of any amount. The present value is calculated using the following equation: PV of an annuity ¼

Present value of Periodic amount of 3 an annuity factor an annuity

If you look up the factor for 10 per cent and three periods in Table 10.2,5 you will find that it is 2.4869. This is the present value of $1 received or paid at the end of each of the next three years using a 10 per cent discount rate. So you can calculate the present value of an annuity of $200 received or paid at the end of each year for the next three years using a 10 per cent discount rate, as follows: PV of annuity ¼ Annuity 3 Present value of an annuity factor for three periods at 10% ¼ $200 3 2:4869 ¼ $497:38 Another way of saying this is that the annuity of $200 received or paid at the end of each year for the next three years is discounted to a present value of $497.38. Many calculators have the capacity to compute the present value of a single future amount and the present value of an annuity. The calculation process follows the same concepts we discussed earlier. These calculators use equations to determine each factor whenever a calculation is made. If you use a calculator to make your present value calculations, you may find an occasional rounding error between your answer and the answer shown in this book. That is because the calculator does not round its factors, whereas the factors in Tables 10.1 and 10.2 are rounded to four decimal places.

Present value examples In making capital expenditure decisions, you may need to calculate both the present value of a single future amount and the present value of an annuity. To help you better understand these calculations, we provide the following examples.

Example 1 Calculate the present value of a $100 cash receipt at the end of five years if the interest rate is 12 per cent. Present value ¼ Future amount 3 Present value of $1 factor ¼ $100 3 0:5674 ¼ $56:74 ðreceiptÞ

Example 2 Calculate the present value of cash receipts of $300 at the ends of years 1, 2 and 3 if the interest rate is 14 per cent. Present value ¼ Annuity 3 Present value of annuity factor ¼ $300 3 2:3216 ¼ $696:48 ðreceiptÞ

The factors in Table 10.2 were calculated using the equation for the present value of an annuity factor, shown at the beginning of Table 10.2. The factor in Table 10.2 for a given year and interest rate may also be calculated by summing

5

the factors in Table 10.1 for each year prior to and including the given year for that interest rate. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

421

Accounting Information for Business Decisions

Example 3 Calculate the present value of a $200 cash receipt at the ends of years 1 and 2, and a $300 cash receipt at the end of year 3, if the interest rate is 10 per cent. Present value ¼ ð$200 3 1:7355Þ þ ð$300 3 0:7513Þ ¼ $572:49 ðreceiptÞ

Example 4 Calculate the present value of a $500 cash receipt at the end of 10 years together with a $300 cash payment at the end of two years, if the interest rate is 8 per cent. Present value ¼ ð$500 3 0:4632Þ þ ð$300 3 0:8573Þ ¼ ð$25:59Þ ðnet paymentÞ

Example 5 Calculate the present value of a $500 cash receipt at the end of each year for five years, together with a $200 cash payment at the end of each year for five years, if the interest rate is 12 per cent. Present value ¼ ð$500 3 $200Þ 3 3:6048 ¼ $1 081:44 ðnet receiptÞ If you use a calculator to solve these examples, your answers might be a few cents different because of rounding errors. Also, in Examples 3, 4 and 5, there are other ways to calculate the present value of the cash receipts and payments, but all result in the same present values that we calculated.

Stop & think What is another way of calculating the present value for Example 3? Now that you understand the time value of money and what is meant by present value, we can discuss how a business makes capital expenditure decisions. As we mentioned earlier, a business has the choice of using one or more of several approaches to evaluate capital expenditure proposals. We will begin with the NPV method.

Net present value (NPV) As discussed above, present value is the value today (year 0) of a certain amount in dollars paid or received in the future. The computation of a present value is necessary in many situations. In this case, using figures from Case Exhibit 10.8, we want to determine whether the investment of $27 000 in energy-efficient lighting is warranted given the net cash flows of $10 750 per year from year 1 onwards. Year 0 represents the starting point, and year 1 represents the end of that year. Therefore, year 0 to year 1 ¼ one year; year 1 to year 2 ¼ one year; and so on. As we will explain more fully in Chapter 12, the required rate of return on an investment is the minimum return required by investors on the amount invested. In this case, the required rate of return is 8 per cent on the initial investment of $27 000. The net cash flows represent the cash inflows less cash outflows for each of the five years we are looking at. Cash flows are used as a standard measure in project appraisal, and, as such, profit or other accrual accounting measures of income are not suitable. Project appraisal is a cash flow measure, not an accounting measure, of financial performance. The net present value (NPV) of a capital expenditure proposal is the present value of the expected future net cash receipts and payments, minus the expected initial cash payment (investment). To calculate 422

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 10 Sustainable and profitable business practices Table 10.3 Present value discount factors for different rates of return Required rates of return Year

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

1

0.9901

0.9804

0.9709

0.9615

0.9524

0.9434

0.9346

0.9259

0.9174

0.9091

2

0.9803

0.9612

0.9426

0.9246

0.9070

0.8900

0.8734

0.8573

0.8417

0.8264

3

0.9706

0.9423

0.9151

0.8890

0.8638

0.8396

0.8163

0.7938

0.7722

0.7513

4

0.9610

0.9238

0.8885

0.8548

0.8227

0.7921

0.7629

0.7350

0.7084

0.6830

5

0.9515

0.9057

0.8626

0.8219

0.7835

0.7473

0.7130

0.6806

0.6499

0.6209

the NPV on our investment in energy-efficient lighting with a required rate of return of 8 per cent, we need to use a present value table. Table 10.3 represents the present value discount factors for different required rates of return for up to five years. Given the time value of money concept (that $1 today is worth more than $1 in a year’s time), we need to discount future cash flows using a required rate of return of 8 per cent to determine their value today. This process allows us to more effectively evaluate the viability of proposed investments, since we can compare opportunities with different timeframes on the same basis to determine their value today. Given that the initial investment happens now (year 0), it does not need to be discounted back to its value today. However, all net cash flows from year 1 on must be discounted back to their value today. It is important to remember that $1 in five years’ time will be worth less than $1 in four years’ time, three years’ time, two years’ time, and so on. Therefore, we multiply the net cash flow in years 1, 2, 3, and so on by the corresponding present value factor for 8 per cent from Table 10.3: • Year 1: $10 750  0.9259 ¼ $9953 • Year 2: $10 750  0.8573 ¼ $9216 And so on, up to and including year 5. This will give us the present value of the net cash flows for each year. Now we want to take this one step further and calculate the NPV. We add together all the present values of each of the five years to get the present values. To get the NPV, we need to subtract the original investment of $27 000 from the sum of the present values: NPV ¼ ð9953 þ 9216 þ 8533 þ 7901 þ 7316Þ  27 000 ¼ 42 919  27 000 ¼ $15 919 NPV If the NPV is negative, it means the project is not financially viable because we have not met our 8 per cent required rate of return; if the NPV ¼ 0, we have exactly met our 8 per cent required rate of return; and if the NPV is positive, it means we have exceeded our 8 per cent required rate of return and that the investment is financially viable. As a general rule, if the NPV is negative, do not proceed with the project, and if the NPV is positive, proceed with the project. In this case, we can see, in Table 10.4, we can see that we have a positive NPV of $15 919, which indicates that the proposed investment in energy-efficient lighting is financially viable and, as such, should be undertaken. Table 10.4 Calculating NPVs with a required rate of return of 8 per cent Year

0

Net cash flows Present value interest factors from tables Present value calculations Present values NPV (sum of present values)

$

1

2

3

4

5

 27 000

10 750

10 750

10 750

10 750

10 750

NA

0.9259

0.8573

0.7938

0.7350

0.6806

NA

10 750  0.9259

10 750  0.8573

10 750  0.7938

10 750  0.7350

10 750  0.6806

 27 000

9 953

9 216

8 533

7 901

7 316

15 919

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

423

Accounting Information for Business Decisions Case Exhibit 10.9 Reusable coffee cup project A number of students using the university hub have expressed concerns about the landfill created by disposable coffee cups. Recall from Chapter 2 Cafe Revive’s marketing plan ‘to build a reputation for friendly service, quality products and environmentally friendly packaging’. The business has ensured that the supplier chosen has environmentally friendly products, which are ethically sourced. A rudimentary life cycle analysis identifies that there is an issue with end of life and waste disposal of the coffee cups. Emily Della agrees to work with some of the local business students to discover the extent of the problem and propose a solution. The students wish to replace all cups with biodegradable cups and recyclable lids. They also wish to sell reusable coffee cups and offer students a discounted price per coffee for using their reusable cup. The students present the following findings (Table 10.5).

Table 10.5 Data for reusable cups DATA Current level of coffee cup sales in disposable cups þ lids (per week) Charge for waste disposal per week

300

100% landfill

$ 50.00

Weeks campus open per year

48

ALL ESTIMATES ARE EXCLUDING GST

Cost

Carton size

Each

Current cost of 8oz disposable coffee cups

$

4.00

50

$ 0.08

Current cost of disposable coffee cups lids (recyclable)

$

2.50

50

$ 0.05

Cost

Carton size

Each

Biodegradable 8oz cups

$100.00

1000

$ 0.10

(paper sourced from managed plantations and coated witha bioplastic made from plants). þ compostable bioplastic PLA (Polylactic Acid) lids

$ 80.00

1000

$ 0.08

Recyclable, reusable coffee cup

$170.40

48

$ 3.55

Cost of buying & installing recycle bins – 10 bins in Unihub

$

320

10

$3,200

Service cost for emptying bins per week

$

45

Usual selling price for a cup of coffee

$

5.00

Discounted price for use of reusable/owner provided cup

$

4.50

Coffee supplies used per cup

$

2.00

Estimated life of recycle bins (years)

3

Required rate of return p.a.

5%

Percentage of all sales using reusable cups (100 customers pledged to buy a cup)

25%

Increase in sales - students prefer recycling

10%

Usual required rate of return for projects

6%

usual payback period required (years)

2

CALCULATIONS Contibution margin per coffee cup (one time use) Selling price

Now

Recyclable

$

5.00

$ 5.00

Cost of cup & lid

$

0.13

$ 0.18

Other Supplies used

$

1.87

$ 1.87

VC – supplies

$

2.00

$ 2.05

CMU

$ 3.00

$ 2.95

Increase

Variable costs:

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$ 0.05

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DATA Cups of coffee in reusable cups Selling price

n/a

$ 4.50

Variable costs: Supplies used

$ 1.87

CMU

$ 2.63

Reuseable cup sales Selling price

$ 4.00

Cost of reusable cup

$ 3.55

CMU

$ 0.45

Having gathered relevant data, the students decide to calculate the annual cash flows under the existing system and for the introduction of recyclable cups and reusable cups. Once the incremental cash flow was calculated, they used the payback period tool and the net present value calculation to evaluate the project (Table 10.6). The payback period is 1.26 years, which is less than the maximum of two years and the calculated net present value (NPV) is positive, so the project is acceptable and would make a positive economic contribution. However, as the figures are all estimates, the students are anxious to make the project as attractive as possible. What additional reasons might there be to go ahead with the project (economic or other considerations)?

Table 10.6 Project analysis – recyclable cups Current

New

Annual coffee cup sales

14 400

15 840

One time use sales

14 400

11 880

Contribution margin per cup

$

3.00

$ 43 200.00

$

2.95

$ 35 046.00

Reusable cup – coffee sales

3 960

Contribution margin per cup

$

2.63

$ 10 414.80 Sales of reusable cups

100

Contribution margin per cup

$

0.45

$

45.00

Waste disposal charges

$

2 400.00

$ 2 160.00

Annual cash flows

$ 40 800.00

$43 345.80

Additional annual cash flows (a)

$ 2 545.80 PAYBACK PERIOD (annuity method)

Initial costs of bins

$

3 200.00

Annual incremental cash flows

$

2 545.80

payback =

1.26 years

(b)

NET PRESENT VALUE PV factor

Initial costs of bins Annual incremental cash flows (3 years at 6% – Table 10.2)

$

$3 200.00

1

2 545.80

2.673 NPV

PV $3 200.00 $

6 804.92

$

3 604.92

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Accounting Information for Business Decisions This is a very short overview of the concept of present values and NPV. Capital expenditure decisions and project appraisal are covered in more detail in Chapter 12. You will note that the principles applied here are the same as those in Chapter 12, but applied with consideration of the impacts of sustainability initiatives. It is important to be aware that the techniques do not change, but the context in which they are used can be adapted to evaluate the financial viability of projects with sustainability goals in mind.

11

What is social accounting?

social accounting Aims to provide information on, and assess the impact of, business activities on people internal and external to the organisation (stakeholders), covering issues such as product safety and education, community relations and training initiatives

Ethics and Sustainability

10.5 Social accounting Social accounting seeks to place a value on the impact of business operations on society. While it is beyond the scope of this text to provide detailed examples of social accounting metrics, it is important to raise awareness of the potential social implications of business activities and the need for business to provide a net social benefit. Waste, packaging and the amount of fuel a business uses in its company cars are all factors that can have an impact on the local community. This includes employees, customers, suppliers, neighbours and so on. Social accounting requires businesses to examine in detail what they do, and to better understand the impact their activities have on people, the landscape and the environment. Social accounting does not deal with the same types of assets that are dealt with in financial accounting, but rather focuses on business behaviours and the impacts those behaviours have on society as a whole. Social accounting attempts to put a financial figure on the costs and benefits of a business’s activities in relation to both society and the environment. A business may measure the impact of its greenhouse gas emissions on a surrounding region. Alternatively, a business may examine the impact of its community involvement in the region in which it operates. It could also measure the effectiveness of operations in creating jobs and on reducing the local unemployment rate. Therefore, social accounting is about understanding the contributions, or lack thereof, that a business makes to society. It concerns itself with business behaviours that contribute to the best interests of people and the environment. Calculating the present value of future cash flows

The James Hardie asbestos case in Australia revealed the human suffering endured by many former employees and the general public from asbestos-related cancers. It also demonstrated how poor social accounting can inflict financial damage on a business. The best-known product containing asbestos made by James Hardie was the building material known as ‘fibro’. Asbestos causes chronic asbestosis, a respiratory disease that often progresses to become terminal mesothelioma (a type of lung cancer). It was found in court that James Hardie had known the effects of asbestos but continued to expose workers and the general public to risk without giving adequate warnings of the dangers. James Hardie fought hard to avoid liability, but ultimately suffered serious damage to the business’s reputation, as well as multi-million-dollar compensation claims that continue today. How could social accounting have helped to prevent these tragic and damaging events? (For more on the James Hardie asbestos case, see http:// lawgovpol.com/case-study-james-hardie-and-asbestos.)

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There are many examples of cases where the products we buy have hidden social costs, but there are ways to ensure that these costs are minimised. The concept of ethical coffee, for example, has become more prevalent, and there are now guides to help businesses choose between suppliers (e.g. see http:// guide.ethical.org.au/company/?company¼465). To illustrate, suppose the manager of DeFlava Coffee were to raise concerns that a large proportion of the coffee beans used in the manufacture of the business’s coffee comes from developing countries where there is evidence of child labour. At present, DeFlava Coffee sources its coffee beans based on price and quality only. It has no stated commitment to ethical coffee sourcing. Companies such as Nestle´ (www.nestle.com.au) are suppliers of coffee and are signatories to ensuring ethical treatment of workers on coffee plantations. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 10 Sustainable and profitable business practices

Stop & think How could DeFlava Coffee indicate a commitment to ensuring that the coffee beans it purchases are UTZ-certified?6

Qualitative social cost–benefit analysis Social cost–benefit analysis is a technique for evaluating the benefits and costs of a business investment or planned business activity in order to determine whether the benefits outweigh the costs. Cost–benefit analysis is often used in conjunction with project appraisal techniques, taking into account the time value of money.7 This approach can be quite complex, in that non-monetary items need to be priced in monetary terms to enable comparison of costs and benefits on the same basis; as such, it is beyond the scope of this text. Here, we will look at qualitative social cost–benefit analysis (which we will refer to as QSCBA). In this approach, decision makers weigh up more general costs and benefits of business activities to society and the environment. These costs and benefits can be either monetary, non-monetary or both. The key aim of the QSCBA process is to evaluate whether the outcome will have an overall benefit or an overall cost to society and the environment. In its simplest form, QSCBA is undertaken by rating the importance of each benefit and cost on a scale of 1 to 10, with 1 being of low benefit or cost and 10 being of maximum benefit or cost. When we divide the sum of the benefits by the sum of the costs, if the ratio is greater than 1, then the benefits outweigh the costs; a ratio of less than 1 indicates that the costs outweigh the benefits. The importance of each cost and benefit can be established by having stakeholders rate the potential impacts using the 1 to 10 scale in a cost–benefit matrix. A cost–benefit matrix (or a spreadsheet) allows us to sum the value for costs and benefits. When we divide the sum of the benefits by the sum of the costs, if the ratio is greater than 1, then the benefits outweigh the costs; a ratio of less than 1 indicates that the costs outweigh the benefits. While this is largely subjective because it is based on people’s perceptions, it is still very important to understand community expectations, so that these can be taken into account. Doing so will increase a project’s overall benefits, as well as reduce its costs, and thus improve overall community acceptance of the project.

12

What is social cost– benefit analysis and how do we measure it?

qualitative social cost– benefit analysis A way to calculate social cost–benefit analysis that rates the perceived costs and benefits of a proposed business activity or project on a scale of 1 to 10 (with 1 being of low benefit or cost and 10 being of maximum benefit or cost). The sum of perceived benefits is divided by the sum of the perceived costs. A ratio greater than one indicates benefits are higher than costs, a ratio less than one indicates that costs are higher than benefits

Stop & think Give an example of where a business could use QSCBA.

Intergenerational equity Environmental and social sustainability are critical to the long-term financial viability of business as a whole. Therefore, planning for the future to ensure that business is managed in sustainable ways beyond the current generation is also crucial. If the creation of enduring business cultures that foster and develop sustainability practice as part of normal business activities is not a priority, the efforts made in pursuit of sustainable practice today may be lost in the future. In recent decades, the term intergenerational equity has been used in discussing sustainable development. It refers to the idea that development to meet the needs of the present should not 6

UTZ Certified is a program aimed at creating an open and transparent marketplace for agricultural products. Since it was

launched in 2002, UTZ has grown to be one of the leading coffee certification programs worldwide, and has expanded to become a multi-commodity program. UTZ’s vision is to achieve sustainable agricultural supply chains that meet the growing needs and expectations of farmers, the food industry and consumers alike. With its in-depth code of conduct, the program gives independent assurance of sustainable production and sourcing, and offers online real-time traceability of agricultural products back to their origin. See https://utz.org. 7

See Chapter 12 for further details on the time value of money. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

13

What is intergenerational equity?

intergenerational equity Equity between current and future generations. It recognises that the over-consumption of natural resources to meet current needs may compromise the ability of future generations to meet their needs

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Accounting Information for Business Decisions compromise the ability of future generations to meet their needs. Although some could argue that future generations might gain from economic progress made now, those gains might be more than offset by environmental deterioration.u As discussed earlier in the chapter, businesses that adopt the triple bottom line approach must consider the economic, environmental and social impacts of business activities. Example of QSCBA

Suppose a business is considering building a new housing estate on 50 hectares of biologically important coastal wetland. Conserving the area has environmental benefits – it provides a habitat for a variety of animals, including native ducks, waterbirds and frogs, as well as being a popular bushwalking area. The wetland also helps to maintain water quality and reduces flooding in neighbouring housing areas. This loss in use from conversion from a wetland to housing is an opportunity cost. Landowners may also incur direct costs in protecting the wetland, or some opportunity costs associated with not using the area in another way, such as for a sports complex or shopping centre. The following simplified cost–benefit matrix demonstrates how aggregated stakeholder ratings could be used to evaluate costs and benefits of a proposed project. Risk factor Loss of wetland habitat

Increased population Total

Benefits Reduction of mosquito-borne disease

Improved infrastructure

Value (1 to 10)

Costs

Value (1 to 10)

Loss of habitat

9

Alternative flood mitigation measures

7

Increased traffic flows

5

7

6 13

21

Overall benefit–cost ratio (13/21) ¼ 0.62

This shows that the benefit–cost ratio is 0.62, and thus the stakeholders’ perceived costs of losing the wetland outweigh the benefits of the new housing estate by almost 5 to 3. It is important to note that the above outcome should not be a definitive answer on its own, but rather a guide on how to proceed. Given that the project is not acceptable in its current form, perhaps only part of the wetland should be developed and the rest preserved, providing a more balanced outcome. A range of options may be available, so it is important to explore all the viable alternatives to arrive at the best outcome from a triple-bottom-line perspective. There is often much more at stake in these situations than company profits. In many contexts, sustainable business is taken to refer to ‘green’ business or enterprise that has no negative impact on the global or local environment, community, society or economy. A sustainable business is one that ensures that all processes, products and activities maintain a profit while addressing current environmental concerns. Today, a great deal of legislation is administered through bodies such as the Environmental Protection Agency (EPA) to ensure that businesses eliminate or decrease the impact made on the environment by harmful processes, products, activities and waste. Many businesses are aware of the impact of their activities in terms of the greenhouse gases produced and measured in units of carbon dioxide, and monitor their carbon footprint. This has led to an emphasis, in planning activities, on alternative products and processes that can produce the same or better outcomes, preferably at a lower cost; for example, going paperless or eliminating plastic packaging.

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Chapter 10 Sustainable and profitable business practices

10.6 Sustainability as a business strategy

14

How can sustainability be a successful business strategy?

While our discussion here has centred around sustainability in the ‘green’ sense, a business’s sustainability in an economic sense requires proactive business management and a strategic approach if the best results for the business are to be achieved. Business sustainability is an overarching concept that involves doing everything better and more efficiently, and which makes good business sense because the benefits feed directly back into the bottom line. True sustainability must be integrated into all operations of business – from policy and management through to on-ground activities such as purchasing, production and distribution. It is important that the development of a sustainability strategy be strongly aligned to the business plan. As discussed in earlier chapters, every business should have a business plan in order to clarify the nature of the business and its activities and to chart a course for success.

Discussion Discuss an example of a business you know of that is concerned about intergenerational equity.

Characteristics of sustainable businesses Many factors contribute to a business’s longevity – its survival, growth and improvement. The first is that a business needs to operate efficiently and productively to remain profitable and allow the business to grow. The second is that a business must engage responsibly and ethically with the triple bottom line issues it faces. In general, the characteristics of a sustainable business are usually associated with: • a well-written business plan against which performance is monitored regularly • a clear understanding of the key drivers of business operations or activities, and being able to closely monitor these drivers regularly. It is important to have a contingency plan when the business environment changes, such as the financial crisis of 2007–08 • strong corporate governance and an ethical framework for setting standards around the conduct of triple-bottom-line business activities • a long-term investment in human capital and knowledge, including people, know-how and the need for succession planning – that is, the question of who will continue to lead the business into the future • an understanding that clients’ and customers’ requirements are the main drivers of the business • established partnerships and networks for business expansion, innovation and improvement. From a business perspective, strategic planning is about making better investment decisions for longterm prosperity and sustainability. The success of the business must be underpinned by sustainable business practices. These practices relate to everyday operations that assist the business to perform better, improve productivity, manage risk and increase competitiveness in order to expand its customer or client base and enhance its value, reputation and growth.

Stop & think

succession planning The process of identifying, developing and training people within a business so they can take on key management roles as current managers leave or retire. Succession ensures there are experienced and capable employees to assume management roles as required

What sorts of strategies might a business implement to: (a) manage risk; and (b) increase competitiveness?

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Long-term strategic planning for business sustainability is perhaps the main challenge facing business managers around the world today. Faced with triple-bottom-line pressures and intergenerational equity concerns, many managers encounter dilemmas when endeavouring to meet the needs of the present, in terms of profits, while not compromising the ability of future generations to meet their needs by ignoring the environmental impacts of certain business activities. Reducing carbon emissions, finding new processes for recycling waste, and developing eco-efficient products and services are examples of how businesses worldwide are ‘greening’ their business practices in order to avoid having an adverse impact on society or the physical environment. Given that investors place a high value on environmental responsibility, and many people are now willing to pay more for products and services that are environmentally friendly, it is in the interest of business to be ‘green’.

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Chapter 10 Sustainable and profitable business practices

STUDY TOOLS Summary 10.1 Understand and demonstrate corporate social responsibility (CSR). 1

What is corporate social responsibility (CSR)? How does a company such as Nike define CSR?

Corporate social responsibility (CSR) incorporates the public interest into business planning and decision making. It implies a continuing commitment by business to behave ethically and contribute to economic development, while at the same time minimising impacts on the environment and supporting society at large. CSR is underpinned by the triple bottom line, which is based on the economic, environmental and social value added and destroyed as a result of business activities. As such, CSR is based on the concept that all businesses have obligations to the wider community and the environment that extend much further than simply maximising shareholder returns and following the law.

10.2 Understand the components of the triple bottom line and sustainability reporting. 2

What are the components of the triple bottom line?

The triple bottom line is used as a framework for measuring and reporting corporate performance against economic, social and environmental parameters. The triple bottom line means that businesses do not focus only on the economic value added, but also on the environmental and social value they add and destroy. 3

What is sustainability reporting, and why is it important?

A sustainability report can be part of a business’s annual report, a standalone sustainability report, a triple bottom line report, or an environmental or social impact report. Usually, the triple bottom line is used as a basis for comprehensive sustainability reports. It is important, because stakeholders are demanding greater transparency and accountability from business, and failure to report may affect a business’s share price and demand for its products and services. 4

What is the Global Reporting Initiative (GRI)?

The GRI is intended to serve as a generally accepted framework for making sustainability reporting of triple bottom line impacts as common and accepted as financial reporting. Performance indicators provide comparable information on the economic, environmental and social performance of the business; namely: (a) economic performance indicators; (b) environmental performance indicators; and (c) social performance indicators, such as labour practices and decent work conditions, human rights, society and product responsibility. 5

What is integrated reporting?

Integrated reporting connects the short- medium- and long-term strategies of an organisation to the complete range of resources and interconnections that must be harnessed and managed in harmony to create value without diminishing those resources, or ‘capitals’. The capitals are categorised in the integrated reporting framework as financial, manufactured, intellectual, human, social and relationship, and natural. ‘An integrated report looks at how the activities and capabilities of an organization transforms these six capitals into outcomes.’ (International Integrated Reporting Council (IIRC)). Integrated reporting develops critical and systems thinking and promotes innovation.

10.3 Be able to implement practical measures to achieve a triple bottom line. 6

What is life cycle analysis and what are its limitations?

In life cycle analysis, the environmental impacts of products are analysed over products’ entire lives, with the aim of designing, making and marketing more sustainable products and services and minimising their environmental impacts over their lives.

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Considerations, such as efficiency in manufacture, less energy use, less packaging and higher proportions of recyclable materials, are key issues. 7

what is material flow cost accounting?

Material flow cost accounting is a system that allows a business to trace input materials that flow through production processes, and measure the output of those production processes in terms of finished products and waste. 8

What is eco-efficiency and how is it measured?

Eco-efficiency is a management concept that encourages managers to investigate environmental improvements to business that will also provide parallel financial benefits. The term is now widely recognised by business, and refers to economic and environmental progress towards delivering goods and services with less resource use and pollution, while increasing profitability. Eco-efficiency can be increased by providing more value with a decrease in the environmental impact or resource consumed for a given product or service. Eco-efficiency links physical units, such as kilograms, kilowatt hours or kilolitres, to monetary variables such as turnover and profit. By combining physical accounting data with cost data, eco-efficiency indicators can be calculated using the eco-efficiency ratio. Product or service value Environmental influence 9

What is share percentage, and how is it calculated?

A share percentage is the ratio of a sub-group to a total amount. Share percentages are commonly calculated in relation to a baseline, such as the share of recycled waste as a percentage of total waste. This gives us the recycling rate: Recycling rate ¼

Quantity of recycled waste in tonnes Quantity of total waste in tonnes

10.4 Understand and be able to apply suitable methods for environmental project appraisal. 10

What methods are used for environmental project appraisal, and how are they calculated?

Two methods are used in this text: the payback period and net present value (NPV). The payback period is the length of time needed for the future net cash receipts generated from an investment project to ‘pay back’ the initial cash or capital expenditure invested in the project. The NPV takes into account the time value of money to establish the return on the project at a given required rate of return. An NPV greater than zero indicates that the project has a positive return on investment.

10.5 Understand the concept of social accounting. 11

What is social accounting?

Social accounting requires businesses to examine what they do in detail to better understand the impact of their activities on society as a whole. Social accounting attempts to put a financial figure on the costs and benefits of a business’s activities in relation to both society and the environment. A business may measure the impact of its greenhouse gas emissions on a surrounding region. Alternatively, a business may examine the impact of its community involvement in the region in which it operates. It could also measure the effectiveness of operations in creating jobs and reducing the local unemployment rate. As such, social accounting is about an understanding of the contributions, or lack thereof, that business makes to society, and behaviour that contributes to the best interests of people and the environment. 12

What is social cost–benefit analysis, and how do we measure it?

Social cost–benefit analysis is a technique used to weigh up the environmental and social benefits and costs of a business investment or planned activity. It can be used to understand community expectations and concerns about the potential social and environmental impacts of a project, so as to enable the business to address these and make the project more acceptable. In qualitative social cost benefit analysis (QSCBA), the benefits and costs of a business investment or activity are rated on a scale of 1 to 10 to appraise whether the venture is worth undertaking.

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13

What is intergenerational equity?

In relation to sustainable development, intergenerational equity refers to the idea that development to meet the needs of the present should not compromise the ability of future generations to meet their needs.

10.6 Understand that sustainability should be a business strategy for the ongoing success of the business. 14

How can sustainability be a successful business strategy?

Sustainability is about a business’s long-term survival, and requires integrating sustainability into the business’s strategy and systems with a view to operating productively and efficiently. It encourages strong corporate governance and long-term planning for success. This approach leads to a better understanding of the business and its social and natural environment, and should promote improvement and innovation.

Key terms annuity

‘greenwashing’

share percentage

compound interest

intergenerational equity

single future amount

corporate social responsibility (CSR)

integrated reporting

social accounting

discount rate

life cycle analysis

succession planning

eco-efficiency

material flow cost accounting

sustainability accounting

environmental management accounting

present value

sustainability reporting

factor

qualitative social cost–benefit analysis

triple bottom line

Global Reporting Initiative (GRI)

recycling rate

Online research activity This activity provides an opportunity to gather information online about real-world issues related to the topics in this chapter. For suggestions on how to navigate various businesses’ websites to find their financial statements and other information, see the related discussion in the Preface. Put your skills to the test and find answers to the following questions by visiting the listed websites.

1 Go to Interface Global’s website (https://www.interface.com) and review the company’s approach to sustainability (https://www.interface.com/APAC/en-AU/campaign/climate-take-back/Climate-Take-Back-en_AU). a How do Interface’s sustainability reports relate to its financial reports? b Why has Interface developed its own set of sustainability measures (metrics)? c What is the motivation for ‘Mission Zero’?

2 Go to James Hardie’s website (https://www.jameshardie.com.au) and review the company’s perspective on sustainability. a How does James Hardie’s sustainability focus compare to that of Interface Global? b Which aspects of the triple bottom line are James Hardie focusing on and to what extent?

Integrated business and accounting situations Answer the following questions in your own words.

Testing your knowledge 10-1 10-2 10-3 10-4 10-5

What is meant by corporate social responsibility (CSR)? What is the meaning of the term ‘greenwashing’? Define a ‘stakeholder’. Suggest some examples of stakeholders at a university or at your own workplace. What are the three components of the triple bottom line? What is sustainability reporting?

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10-6 10-7 10-8 10-9 10-10 10-11 10-12 10-13 10-14 10-15 10-16 10-17 10-18 10-19 10-20 10-21 10-22 10-23

What is life cycle analysis and why is it important for sustainable products and processes? What is meant by ‘closing the loop’ in life cycle analysis? What is the eco-efficiency ratio formula? Briefly discuss the relationship between product and service value and environmental influence. Briefly explain what is meant by ‘share percentage’, using recycling as an example. How can project appraisal be used to evaluate the social and environmental aspects of investment alternatives? Explain what is meant by the term the ‘time value of money’ and provide an example. Briefly outline the role of social accounting and explain its importance. What is the Global Reporting Initiative (GRI)? Outline its key components. What are the legislative requirements relating to sustainability reporting in Australia? What are the thresholds for reporting under the National Greenhouse Emissions Reporting Legislation? What does ‘intergenerational equity’ mean? Is sustainability for a business all about environmental matters? Why or why not? What is succession planning? Why is succession planning important for small businesses? What are the key benefits of material flow cost accounting and what are its major constraints? Why is social cost–benefit analysis important? What is ecological balance and how is it related to life cycle analysis? (For this question and Question 10-24, refer to the box ‘The concept of ecological balance’ earlier in this chapter.) 10-24 What is the difference between eco-efficiency and ecological balance? 10-25 Explain why business sustainability is a key consideration for management.

Applying your knowledge 10-26 Suppose you have $100 000 to invest in the share market. a Using the triple bottom line to analyse company performance what company would you invest in, and why? b Would your decision differ if you only used financial performance data to make your investment decision? Why or why not? 10-27 Consider the current ecological footprint of the Earth, where we currently need one-and-a-half planets to approach sustainability in terms of current resource use. Given that the world’s population will increase to an estimated nine to 10 billion people by 2050, what role can business play in reducing the global ecological footprint? 10-28 Corporate social responsibility (CSR) is sometimes described as the ‘conscience of business’. However, there is a vast difference in how businesses view CSR, with some undertaking activities that endanger the health of society and the environment to maximise profit. Why would a business choose profit over the wellbeing of society and the environment? Alternatively, what motivation is there for a business to engage in CSR strategies that benefit society and the environment? 10-29 The triple bottom line encompasses economic, environmental and social sustainability. If we look carefully at each of these components, without the environment, the economic and social system cannot function. If it can be argued that environmental sustainability underpins economic and social sustainability, why are all three aspects given equal importance? 10-30 Consider the BP oil spill in the Gulf of Mexico in 2010. As we outlined in Chapter 7, by the end of that year, the costs associated with clean-up, compensation and other factors had reached the tens of billions. While the financial costs of the disaster are easy to measure, outline at least six of the environmental and social costs (three for each) that are associated with the oil spill but are more difficult to measure in financial terms. 10-31 Explore the Integrated Reporting website: http://integratedreporting.org/ Required: a What is integrated reporting? b What is the aim of integrated reporting? (Hint: try the FAQs.) 10-32 The International Integrated Reporting Framework describes six categories of capital that organisations must consider as a benchmark in preparing an integrated report. Briefly describe each capital. Do you think all of these apply to your university or the organisation where you work? Explain why or why not.

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10-33 Explain the importance of life cycle analysis and how it can drive the development of sustainable products and services. 10-34 A manufacturing business that makes photocopiers has annual net sales of $30 million from selling 60 000 photocopiers per year. As a part of its manufacturing process, it consumes 150 000 kilograms of raw material inputs including plastic, aluminium, copper and purchased electronic components. Required: a What is the business’s eco-efficiency ratio? b Do you have sufficient information to tell whether this is a good or bad ratio? 10-35 Refer to question 10-34. The photocopier manufacturer last year reported selling 60 000 photocopiers using 150 000 kilograms of material and achieving sales of $30 million. In their sustainability report they published an eco-efficiency ratio of 200:1 – that is, they achieved $200 of sales for every 1 kilogram of materials used. In the following year they report an improvement in their sustainability report, based on a new eco-efficiency ratio of 209:1 – that is, they used 1 kilogram of materials to achieve $209 of sales revenue. They claim that this means that they are using materials with greater efficiency. However you can see from their annual report that sales were $31.35 million and that 55 000 photocopiers were made and sold. Is the claim of greater efficiency with regard to materials efficiency this year justified? 10-36 A large factory is considering the installation of warm-air hand dryers in its toilets in place of paper-towel dispensers. The factory has a total of 10 sets of toilets, and feels that, while the hand driers operate on electricity, this cost will be offset by no longer having to purchase paper towels and pay for waste-paper disposal. In addition, there is expected to be a reduction in the time taken for staff members to service the bathrooms. The related costs and savings are as follows: u Initial cost of warm-air hand dryers: $48 400 u Annual paper towel purchases avoided: $28 200 u Annual waste paper disposal avoided: $770 u Annual bathroom servicing costs avoided: $1650 u Increase in annual electricity costs: ($2530). The required annual rate of return over five years is 5 per cent. Required: a Calculate the payback period. b Calculate the NPV. c Given your answers to (a) and (b), explain whether the investment should be made. d What other considerations should be taken into account? 10-37 Given the following input and output data, prepare a simple material flow cost table. Pineapple Ltd manufactures a line of 140-centimetre LCD televisions, producing 1000 of these per week. The raw material inputs for each television are as follows: Product inputs per television Item Plastic Packaging

Quantity 9.6 kg 4 kg

Positive product outputs per television Price per kg

Item

Quantity

$ 5.60 Plastic

7.2 kg

$ 1.60 Packaging

3.2 kg

Auxiliary materials

1.6 kg

$12.00 Auxiliary materials

1.2 kg

Merchandise

1.6 kg

$64.00 Merchandise

1.6 kg

Operating materials

8 kg

0.08

Required: a What proportion of inputs become positive product outputs? b What is the overall amount of negative product outputs? c What steps could management take to improve the proportion of positive product outputs relative to inputs?

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Making evaluations 10-38 The following table provides a summary comparison of the financial performance of three businesses: Business A

Business B

Business C

Sales

$150 000

$390 000

$600 000

Goods and services purchased

$ 30 000

$156 000

$420 000

96 megalitres

120 megalitres

144 megalitres

Water use

Required: a Calculate the value added by each business. b Calculate the eco-efficiency ratios for water use for the three businesses. c Which business has the most efficient water use? d What other data would be useful to gain more insights into the overall eco-efficiency of each business? 10-39 An electronics manufacturing business is designing a new range of digital radios. The business is environmentally aware, and has found a way to recycle old analogue radios in addition to its new digital radios. The business is undertaking a life cycle analysis of the radios that are to be manufactured. Outline at least three key considerations at each stage of the life cycle analysis for minimising the environmental impacts of the manufacture, sale, use and disposal of the new digital radios. 10-40 An automotive battery manufacturer has undertaken a life cycle analysis of its products. For every 750 batteries sold, enough materials are recycled to make 300 new batteries. In addition, the equivalent of another 300 batteries can be recycled into other automotive products. The remaining 150 batteries are waste products. a What is the recycling rate associated with battery manufacturing? b What other information is needed to comprehensively assess the efficiency of the battery manufacturing process? 10-41 The Whirlpool distillery is considering a redevelopment of its wastewater treatment facilities. The distillery generates large amounts of wastewater containing high levels of organic materials that make it unsuitable for discharge into local waterways without treatment. Currently, Whirlpool process wastewater using an anaerobic filtering system that moves through a series of lagoons. The distillery is considering updating this to an aerobic system that will require new equipment to aerate the water in the lagoons. The aerobic process is more efficient, enabling the wastewater to be used for irrigating the distillery’s own crops, with the potential to sell any remaining water to surrounding farmers with irrigated pastures. The local water utility will provide a grant of 18 per cent of the total project cost. The required rate of return on the project is 8 per cent. Project details are as follows: Cost of plant and equipment

$150 000

Engineering consultant fees

6 250

Water authority grant received

31 250

Reduced waste water disposal costs per year

37 500

Reduced water purchasing costs per year

12 500

Sales of treated water per year

6 250

Additional operating costs for new system per year

2 500

Required: a Calculate the total initial investment and the net annual savings from installing the new aerobic system. b Calculate the payback period of the new aerobic system. c If the new plant and equipment are expected to last five years before needing a major overhaul, calculate the NPV of the project. d Explain what other factors should be taken into account when deciding whether or not the project should proceed, and why. e Explain whether the project should proceed, given the payback period, NPV and other considerations.

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Chapter 10 Sustainable and profitable business practices

10-42 Solmere Capital is considering investing in an open-cut coal mine close to a regional town with a population of 1200 people. The mine will create up to 1500 new jobs in the region, and will facilitate improved education, medical services and shopping facilities. Additional housing will be required, so the local building industry is also likely to benefit. The mine has an expected life of 30 years. Beyond that, it will be decommissioned, with many of the 1500 workers expected to leave the town in the five years leading up to closure. Five years after the mine is closed, the population of the town is expected to stabilise at 900 people. This will result in a loss of facilities over the 10-year transition period. In addition, up to 7500 hectares of highquality agricultural land will be lost for the mine. Even with rehabilitation, after the mine’s closure, this land will not be suitable for growing crops, which is what the land is currently used for. There is also a significant risk that the town’s underground water supply may be contaminated by the mine’s activities, meaning water would have to be piped in from over 100 kilometres away at a high cost. The coal exports will add to global carbon emissions, and there will be increased traffic on local roads designed for low traffic volumes. Required: a Use a qualitative cost–benefit matrix to weigh up the cost and benefits of the proposed project. b What are five other possible benefits and five other potential costs not mentioned above? c What could Solmere Capital do to improve the project’s social cost benefit ratio? 10-43 A local council has been approached to set up a new industrial precinct at the edge of a suburb. A number of proposals have been put forward for the use of the land, and the community has been approached, as part of the consultation period, to provide input. One proposal is for a large industrial fabrication plant to be given approval. Your job as a planner is to evaluate the overall merits of this project so that the council can make a decision. Some of the particulars are as follows: 300 people will be directly employed in the factory, with an average salary of $40 000 per person per annum, and another 100 people in the local economy will have contracts or trade with the factory valuing an average $10 000 per annum of additional business. The revenues for the factory are expected to be $28 million, and costs of production (excluding labour) will be $14 000 000 per annum. The factory will take two years to construct and will cost a total of $7 million in NPV terms. However, this includes $3 million spent within the local community. The decision to provide planning approval is complicated by other considerations, such as that surrounding land cannot be used for purposes such as residential zoning, which, compared to other uses it may have, devalues the land by $8 million in NPV terms. This will result in a loss of rates for the council of $100 000 per annum. There will also be some pollution impact, which, as with similar developments elsewhere, is expected to increase costs in the local hospital by $200 000 per year as more people attend hospital for treatment. a Determine the NPV if the required rate of return from the fabrication plant for the owners is 10 per cent and, given the costs of establishing the plant, what actual rate of return they will receive on their investment. b Determine the overall social benefit or cost of the project, and discuss whether the council should approve the plan, based on your evaluation. 10-44 Skatelove Ltd is a manufacturer of skate boards, based in Jacksonville, Florida. The skateboards have three main parts: the deck (wood and PVA glue); an aluminium truck (holding the wheels to the deck); and the wheels (polyurethane based). The wood used in manufacture of the boards is maple, sourced from the Great Lakes region of North America (generally between 60 and 80 years old), which is processed using machinery and large quantities of water into maple veneer (thin wood layers) and glue. Seven layers of veneer are used. The alternative to using wood is a high-tech plastic that is currently more than four times the price of the wood. Pricing of skateboards is very competitive and the additional cost could not be passed on to customers. Electricity use is high in the current production process due to the need to temperature control the wet wood for the deck ply and the heating process for the wheel manufacture. Skatelove has a design team that makes the business’s trademark shape template and uses computer programs to design artwork for decoration. Recycling of wheel material is expensive so these currently go to landfill. The PVA glue is a non-toxic biodegradable water-based glue but the catalyst used in the manufacturing process is toxic so decks cannot be recycled for their wood component and go to landfill unless they can be repurposed. The majority of the non-water components of the glue are products of the petrochemical industry. The polyurethane based wheels are also made by a production process using petrochemical industry (oil-based production) products. The aluminium is purchased from a company importing aluminium processed from bauxite mined in Weipa, Queensland, Australia. It can be recycled. Skatelove skateboard trucks may be replaced every six months, the four wheels annually and the entire life of a skateboard averages three years. Skateboards are packaged in bubble wrap and cardboard and shipped within the United States and also overseas. Skatelove has been concerned about their environmental impact and accepts used skateboards returned by customers.

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The aluminium is sent to a recycling plant and the used decks are sent to a company that up-cycles the maple wood to make expensive designer jewellery and decorative household items. Some 20 per cent of customers currently return their used decks and the entire board at the end of its life. Required: a Prepare a qualitative social/environmental cost versus benefits analysis for the manufacture of these skateboards, including as many environmental impacts or externalities (costs not included in economic measurement) and social considerations as you can. b Design a basic life-cycle analysis diagram for the skate boards. Note: Actual life-cycle analysis would be much more complex. For your own interest only (not for this question), you may like to do further reading and research about the manufacture of skateboards and upcycling via the internet. Some suggested sites: https://maplexo.com; http://www.madehow.com/Volume-6/Skateboard.html; https:// www.skatedeluxe.com/blog/en/10-things-you-didnt-know-about-the-construction-of-skateboard-decks.

Dr Decisive Yesterday, you received the following letter for your advice column in the local paper:

Dear Dr Decisive, My friend Johan and I are arguing over the term ‘sustainability’. Johan reckons that for a business to be sustainable, it must have strong leadership and be profitable. He says, ‘What’s the use of being in business if you aren’t making profits?’ I think that a business should be more concerned with the impacts it is having on the environment and society; the business needs to be sustainable because what’s the use of having a business if there is no Earth on which to operate it? Johan argues that the most important responsibility of business is to maximise profits, and therefore returns to shareholders. He thinks that social issues and environmental issues are less important, and that, so long as a business complies with its minimum legal obligations, it can report that it is a good corporate citizen. I think that, while business must be profitable, it also needs to go beyond its legal obligations on environmental and social issues. Johan says that anything beyond legal responsibilities is a waste of resources, and thus reduces the returns of shareholders, doing them a disservice. How can I convince Johan that there are other advantages from corporate social responsibility that go far beyond financial returns? ‘Carbon-conscious’ Required Meet with your Dr Decisive team and write a response to ‘Carbon-conscious’. Who is right? As an accountant, what key points would you make to help settle this argument?

Endnotes a

Quoted by Architects of Peace Foundation (nd) ‘Dr David Brower: Biography’. http://www.architectsofpeace.org/architects-ofpeace/david-brower. b See http://www.footprintnetwork.org/resources/educational-resources. c Australian Institute of Company Directors (2017) ‘What is corporate governance?’ http://aicd.companydirectors.com.au/ resources/all-sectors/what-is-corporate-governance. d Elkington, J (1980) The Ecology of Tomorrow’s World. Chichester: John Wiley & Sons. e Abnett, K (2016) ‘Just fix it: How Nike learned to embrace sustainability’. The Business of Fashion, 1 November. https:// www.businessoffashion.com/articles/people/just-fix-it-hannah-jones-nike.

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f

The Australian SAM Sustainability Index (AuSSI) is published by SAM Indexes, a subsidiary of SAM Group, a pioneer in sustainability investing. The SAM Group’s index business also includes the publication and licensing of the Dow Jones Sustainability Indexes. See http://www.aussi.net.au. g See https://www.ftserussell.com/products/indices/ftse4good. h Parkinson, JE (1993) Corporate Power and Responsibility: Issues in the Theory of Company Law. Oxford: Oxford University Press. i CSIRO (2018) ‘Annual update finds renewables arecheapest new-build power’. https://www.csiro.au/en/News/News-releases/ 2018/Annual-update-finds-renewables-are-cheapest-new-build-power; Stevens, M (2018) Australia needs its old coal generators, but it doesn‘t need a new one. Financial Review, 10 July. https://www.afr.com/business/australia-needs-its-old-coal-generatorsbut-it-doesnt-need-a-new-one-20180710-h12i48. j See https://www.sustainable.org/governance/policies-ordinances-a-taxes/1747-six-growing-trends-in-corporate-sustainability. k Organisation for Economic Co-operation and Development (OECD) (2018) ‘Global Material Resources Outlook to 2060 Economic drivers and environmental consequences highlights’. https://www.oecd.org/environment/waste/highlights-global-material-resourcesoutlook-to-2060.pdf; PWC UK (2019) ‘Climate change and resource scarcity’ https://www.pwc.co.uk/issues/megatrends/climatechange-and-resource-scarcity.html#1. l United Nations Development Programme (2017) ‘World leaders adopt Sustainable Development Goals’. http://www.undp.org/ content/undp/en/home/presscenter/pressreleases/2015/09/24/undpwelcomes-adoption-of-sustainable-development-goals-by-world-leaders.html. m Ripple, WJ, Wolf, C, Newsome, TM, Barnard, P & Moomaw WR (2019) ‘World scientists’ warning of a climate emergency’ Bioscience, 5 November. https://doi.org/10.1093/biosci/biz088. n RobecoSAM Indices (nd) ‘Corporate sustainability’. http://www.sustainability-indices.com/sustainability-assessment/corporatesustainability.jsp. o See https://www.legislation.gov.au/Series/C2007A00175. p GRI is an independent international organisation that has pioneered sustainability reporting since 1997. GRI helps businesses and governments worldwide understand and communicate their impact on critical sustainability issues such as climate change, human rights, governance and social well-being. This enables real action to create social, environmental and economic benefits for everyone. The GRI Sustainability Reporting Standards are developed with true multi-stakeholder contributions and rooted in the public interest. q CIMA (2010) ‘The Prince‘s Accounting for Sustainability Project. https://www.cimaglobal.com/Research–Insight/The-Princesaccounting-for-sustainability-project. r IIRC, September 2011 Discussion Paper & 2.1 p. 4 ‘Capitals - Background Paper for IR’, March 2013, http://integratedreporting. org/wp-content/uploads/2013/03/IR-Background-Paper-Capitals.pdf. s Ricoh Group (nd) ‘Eco Balance environmental impact analysis’. https://www.ricoh.com/environment/report/pdf2000/11-12.pdf. t Adapted from Jasch, CM (2008) Environmental and Material Cost Flow Accounting, Principles and Practices. New York: Springer, 38. u Schmidheiny, S (1992) Changing Course: A Global Business Perspective on Development and the Environment. Cambridge, MA: MIT Press.

List of company URLs u u u u u u

BP: http://www.bp.com.au Interface Global: http://www.interfaceglobal.com James Hardie: http://www.ir.jameshardie.com.au/jh/home.jsp Nestle´: http://www.nestle.com.au Nike: https://www.nike.com/au Ricoh Group: (https://www.ricoh.com)

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11 SHORT-TERM PLANNING DECISIONS

‘The absence of alternatives clears the mind marvellously.’ Henry Kissingera

Learning objectives After reading this chapter, students should be able to do the following: 11.1

Define and describe relevant costs and relevant revenues.

11.2 Explain and distinguish between incremental costs, avoidable costs and opportunity costs. 11.3 Calculate short-term decisions based on relevant costs and revenues regarding (a) special orders, (b) dropping a product, (c) make versus buy and (d) selling as is or processing further. 11.4 Understand non-financial issues in decision making.

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Chapter 11 Short-term planning decisions

Understanding the learning objectives is assisted in the chapter by asking key questions:

Key questions 1

How do relevant costs and revenues contribute to sound decision making?

2

What types of costs and revenues are relevant to decision making?

3

What types of costs and revenues need to be considered in deciding whether to accept or reject a special order?

4

How does a business determine when to drop a product?

5

What is a make-or-buy decision and what issues does a business consider in this decision?

6

How does a business determine whether to sell a product ‘as is’ or to process it further?

7

What non-financial issues need to be considered when businesses are choosing whether to take on a one-off contract or special order?

Think about the decisions you have made so far today: what to wear, what to have for breakfast, whether to wash the breakfast dishes right away or later, whether to stop for petrol on the way to university or on the way back, what route to take to university, how fast to drive, whether to change lanes, where to park, what route to walk to your lecture, where to buy your coffee, how strong, how many sugars … whew! Now think about the decisions you made in the last year. They included decisions similar to the ones we have just listed, but they may have also included major decisions, such as where to go to university, what to major in, what career to choose or even whether to get married. Some of these decisions are easy to make, while others require processing a mind-boggling amount of information and possible outcomes. (What if you consider and weigh all the pertinent factors and still end up in a career that you dislike, or married to the wrong person?) Whether decisions affect just today or have long-term impacts, organising and analysing this information and these possibilities helps with the decision-making process. A business also faces a wide array of decisions, from very simple to extremely complicated. To help a business make sense of the information and possibilities related to business decisions, managers use accounting information as one input in their decision-making processes. In this chapter, we will discuss the use of accounting information for short-term decisions involving resource and inventory planning. Both merchandising and manufacturing businesses make short-term inventory-planning decisions. However, because of the production function, a manufacturing business faces a larger number and variety of these decisions than a merchandising business does. Some common resource and inventory-planning decisions involve determining answers to the following questions: • Should the business accept a special order? • Should the business drop an unprofitable product? • Should the business make or buy a component that becomes a part of a product? • Should the business sell a product ‘as is’ or process it further into a different product? • Which products should the business advertise? In this chapter, we will emphasise the resource and inventory decisions made by manufacturing companies. Before we look at each of these decisions, though, we will briefly review decision making, discuss the relevant costs and revenues for decision making, and present the general characteristics or types of information that help managers to make better or more informed decisions. Recall from our Chapter 1 discussion of critical thinking that there are four steps in decision making: (1) recognising the need for a decision (defining the problem); (2) identifying alternative solutions; (3) evaluating the alternative solutions; and (4) making the decision (choosing the best alternative). Although accounting information may be useful in any of these steps, it is particularly helpful in evaluating alternatives (step 3). When a business evaluates each decision alternative, the key question is, ‘What difference does it make?’ One important area where decision alternatives make a difference is in a business’s profit. It is important that a business analyses the changes in its costs and revenues caused by Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

1

How do relevant costs and revenues contribute to sound decision making?

441

Accounting Information for Business Decisions each decision alternative to understand the profit impact of each alternative. This information can then be weighed against any other considerations important to the decision, such as how the alternative affects employees, the community or the environment.

2

What types of costs and revenues are relevant to decision making?

relevant costs Future costs that will change as a result of a decision

relevant revenues Future revenues that will change as a result of a decision

11.1 Relevant costs and revenues The profit impact of a decision is often one of the most important issues in evaluating decisions like those we have listed. To understand the profit impact of a decision, managers must carefully analyse the costs and revenues that the decision affects – or, the relevant costs and revenues. Relevant costs and relevant revenues are future costs and revenues that will change as a result of a decision. That is, the cost or revenue will differ among the alternatives. It is important to know that a cost or a revenue relevant to one decision may not be relevant to another. For example, the weather outside is relevant to a decision about whether to take an umbrella to university today, but is irrelevant to a decision about whether to go out to dinner with your friends at the weekend. Similarly, the cost of the flavouring DeFlava Coffee uses in producing its Ultra Indulgence coffee is relevant to deciding whether to continue producing the coffee, but is irrelevant to deciding whether the business should make or buy packaging for the Ultra Indulgence coffee packs. An important part of preparing an analysis for a decision is to identify the costs and/or revenues that are relevant to that decision. All relevant costs and revenues should be included in this analysis because incomplete profit information could result in an incorrect decision. Costs and revenues that are not relevant to a decision should be omitted from the analysis because they are not helpful. Also, if treated improperly, they might result in an incorrect decision. That is, costs or revenues that do not differ among the alternatives can be ignored because they will not help us choose between the alternatives (see Exhibit 11.1). Exhibit 11.1 Relevant and irrelevant costs in making a decision

Relevant costs • Expected future costs & revenues that differ between alternatives: • i.e avoidable • eliminated (in whole or part) by choosing one alternative over another

Irrelevant costs • Historical costs: • irrelevant to decision • used for predicting future costs • Sunk costs: • costs already incurred • unavoidable, therefore irrelevant to decision • Future costs that do not differ between alternatives: • unavoidable, therefore irrelevant to decision

For a particular decision, a manager must ask two questions to identify the relevant costs and/or revenues: 1 What activities are necessary for the business to carry out the decision? 2 By how much will the costs and/or revenues be affected if the business undertakes the activities? As you will see, many resource and inventory decisions involve only costs. Hence, in the remainder of this chapter, we focus the discussion primarily on identifying relevant costs for an activity. However, the same procedures are used to identify relevant revenues for an activity.

What activities are necessary for the business to carry out the decision? The key to identifying potentially relevant costs is to have a good understanding of those activities that are necessary to implement the decision. These activities are the cause of all relevant costs, so only costs 442

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Chapter 11 Short-term planning decisions that the business incurs as a result of performing these activities can be relevant. Thus, two large groups of costs can immediately be eliminated from consideration. First, no cost incurred prior to making the decision is relevant. Since the decision must be made before the activities can be carried out, all costs that the business incurs as a result of the activities must be future costs. Therefore, only future costs are relevant. As such, past costs (sometimes called sunk or historical costs) can be eliminated from consideration. Consider the following situation: suppose you are driving to a party at a friend’s new house and you take a wrong turn. Now you have a decision to make about what route to take from your present location to your friend’s house. (The decision involves an action you will take from now into the future.) The fact that you took a wrong turn in the past has nothing to do with the decision alternative (what route to take) that you must choose now. For this decision, the costs of the driving that you have done so far (the kilometres) and of the wrong turn (your lost time) are sunk costs. (Whatever decision you make now, you will not regain either the kilometres or your lost time.) Similarly, the cost of a machine that a business purchased last year is not relevant to a decision about how the business should use the machine in production this year. (The business already purchased the machine, and has incurred this cost whether or not it uses the machine in production this year.)

Stop & think Suppose it is November, and you are trying to decide whether to go to Hawaii or skiing in Japan for the summer break. Do you think the cost of the swimwear you bought last year is relevant to this decision? Why or why not? Do you think the cost of the flights to Hawaii or Japan is relevant to the decision? Why or why not?

Source: Shutterstock.com/aines; iStock.com/Kenneth-Maxwell

Second, future costs that a business will incur for activities that are not necessary to carry out the decision are not relevant. These costs relate to other activities that would be undertaken regardless of the outcome of this decision. For example, the cost of flavourings to be used in the next year’s production of coffee gift packs, although a future cost, is not relevant to DeFlava Coffee’s decision to replace an old machine with a new one. This is because the business will use the flavourings in the production of coffee gift packs whether it uses the old machine or a new one.

Hmm . . . the beach in Hawaii or skiing in Japan?

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Stop & think Assuming you have already decided to go somewhere for the summer break, do you think your rent for your flat in March or your rent over summer is relevant to the decision about whether to go to Hawaii or to a Japan Why or why not? Remember, the key question in evaluating a decision is, ‘What difference does it make?’ Past costs, as well as future costs associated with activities that are not related to the decision, remain the same no matter what the decision is. For these costs, the answer to the above question is, ‘It makes no difference.’ Hence, these costs are irrelevant and should not be considered in the analysis.

By how much will the costs and/or revenues be affected if the business undertakes the activities? The costs that remain for further analysis are the costs required by the decision. Even some of these costs may not be relevant, however. A specific cost is relevant only if the total amount that the business will incur is affected by the decision. This fact cannot always be determined until the amounts of the potential relevant costs are estimated. Thus, the cost-estimation step has two purposes: to provide estimates of relevant costs and to further eliminate irrelevant costs. For example, suppose as we did in Chapter 10 that DeFlava Coffee is deciding between using its current disposable cups, biodegradable cups and the more environmentally friendly reusable cups. For this decision, we analysed several relevant amounts: direct materials, variable costs and sales volume. The disposable cups cost DeFlava Coffee $0.13 and the biodegradable cups cost $0.18. The reusable cups cost $3.55, but they sell for $4.00. Numerous customers have been asking about whether DeFlava Coffee has reusable cups, and have stated that they would support the business rather than their competitors if they did. This has been supported by a survey DeFlava Coffee has run in the immediate vicinity of the business. DeFlava believes its sales will increase by 10 per cent if it starts using the biodegradable cups and selling the reusable cups. But the sales price for a coffee in the reusable cups will be lower than in the disposable cups by $0.50, to try to encourage more people to be environmentally friendly. DeFlava will require storage space for the reusable cup inventory. Are any of these amounts relevant to DeFlava Coffee? The direct materials cost for the disposable cups, the biodegradable cups and the reusable cups are relevant because they differ between the alternatives. Therefore the revenue earned on selling the reusable cups and the cost of the disposable cups are important to the decision. The sales volume is also relevant, as this too differs between the alternatives, with increased sales if using the biodegradable cups and the reusable cups. But there will also be a decrease in revenue due to the drop in the selling price for the coffee in the reusable cups. Note that the storage costs are irrelevant as DeFlava has to rent the property anyway and has already incurred this cost. Exhibit 11.2 shows the three-step process by which a manager identifies and separates relevant costs from irrelevant costs. Notice that in the first step, we removed all past costs. In the second step, we removed any future costs not needed to carry out the decision. In the third step, we eliminated those costs that would not differ from one decision alternative to another. The only costs left are future costs that a business would incur in different amounts to carry out the decision alternatives. These are the relevant costs to include in the decision analysis.

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Chapter 11 Short-term planning decisions Exhibit 11.2 Three-step process of identifying relevant costs

All costs

Step 1

Step 2

Step 3

Eliminate past costs

Eliminate costs not necessary to carry out decision alternatives

Eliminate costs that would not differ from one alternative to another

Past costs

Unnecessary costs

Costs that would not differ

Costs relevant to decision

Costs not relevant to decision

Discussion Which of the following costs are relevant and which are irrelevant to your decision about whether to go to Hawaii or Japan, and why? 1

The cost of the plane tickets for the trip to Hawaii and Japan.

2

The cost of paying your little brother to feed your fish and pick up your mail while you are away.

3

The cost of ski rental and lift passes.

4 5

The cost of summer clothing that you bought last year. The cost of your March car repayment.

11.2 Other cost (and revenue) concepts for short-term decisions

3

What types of costs and revenues need to be considered in deciding whether to accept or reject a special order?

Three additional cost (and revenue) concepts are important for short-term decisions about inventory because they suggest the reason why certain costs (or revenues) might be relevant for a given decision.

Incremental costs In some decisions, one of the options may require activities that a business does not need if it chooses another alternative. In many other decisions, one of the alternatives may require activities at a higher volume than required by another. When either situation occurs, the additional activity usually causes additional costs to be incurred. Cost increases of this type are called incremental costs. Incremental costs are cost increases resulting from a higher volume of activity or from the performance of an additional activity. They are always relevant when the higher volume of activity, or the additional activity, is not necessary for all the alternatives. For example, suppose DeFlava Coffee must decide whether or not to accept a customer’s special order for its Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

incremental costs Cost increases resulting from the performance of an additional activity

445

Accounting Information for Business Decisions Ultra Indulgence coffee. The customer wants special packaging with its name displayed prominently on the boxes it has ordered. The incremental costs of the special packaging are relevant because DeFlava would have to incur these costs only if it accepted the order. The incremental revenues also are relevant because DeFlava Coffee would receive them only if it accepted the order.

Avoidable costs avoidable costs Costs that must be incurred to perform an activity at a given level, but that can be avoided if that activity is reduced or discontinued

In many other short-term inventory decisions, one of the alternatives involves either discontinuing an activity or decreasing its volume. When a business discontinues an activity or decreases its volume, it may reduce certain costs necessary to support that activity, or it may no longer incur these. Avoidable costs are the costs that a business must incur to perform an activity at a given level, but that it can avoid if the business reduces or discontinues the activity. For example, consider whitegoods maker Fisher & Paykel (http://www.fisherpaykel.com/au), which claimed that rising manufacturing costs forced it to shift its only Australian operations offshore. It had a base in Australia for almost 20 years and in New Zealand for nearly 70 years, but the company has now said it can no longer compete with low-cost labour countries. Hence, in 2009 it moved its operations to Thailand, Italy and Mexico. More than 300 staff members at the company’s Cleveland plant, east of Brisbane, lost their jobs, as did 430 staff members from Dunedin in New Zealand. The projected cost savings were $50 million a year.b

Stop & think Suppose a business currently makes a part that it uses in one of its products. If it decides to buy that part instead of making it, the cost of the raw materials used in producing the part is an avoidable cost. If the business stops making the part, do you think the depreciation cost of the factory is an avoidable cost? Why or why not?

Opportunity costs

Dilbert ª (1993) Scott Adams. Used by permission of ANDREWS MCMEEL SYNDICATION. All rights reserved.

opportunity costs Profits that a business forgoes by following a particular course of action

Performing the activities needed for one of the alternatives in a decision sometimes disrupts a business’s other profitable activities or reduces its opportunity to engage in other future profitable activities. If you decide to go to Hawaii during the summer break, you must not only pay for your trip but also give up the opportunity to work and earn additional money during the break. A business has similar concerns when making production decisions. The profit impact of this disruption or lost opportunity must be included in the decision analysis. This is commonly done by including the opportunity costs among the costs to be incurred for that alternative. Opportunity costs are the profits that a business forgoes by following a particular course of action. For example, suppose that DeFlava Coffee continuously uses a refining machine to produce its standard packs of coffee. A decision to use the refining machine for a short period of time to produce packs of Ultra Indulgence coffee would cause DeFlava to decrease production and sales of its usual type of coffee. The profits that DeFlava forgoes because of the lost sales of the usual coffee are opportunity costs that it must include in its analysis of whether to use the refining machine to produce Ultra Indulgence coffee packs.

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Chapter 11 Short-term planning decisions

Illustration of determining relevant costs and revenues (special order) In this section, we show how DeFlava Coffee used the three-step process we described in Case Exhibit 11.3 to determine the relevant costs and revenues for a simple inventory decision. Suppose DeFlava Coffee’s sales manager recently returned from a trip to Sydney, where a business on another university campus offered him $250 000, or $20 per pack, for 12 500 packs of Ultra Indulgence coffee. Although he had been tempted to jump at this opportunity to increase sales, the sales manager decided to analyse the decision alternatives first. A quick check with the production supervisor assured the sales manager that the plant had the excess capacity to produce an additional 12 500 packs of Ultra Indulgence coffee without giving up production of DeFlava’s standard coffee packs. So DeFlava would not incur an opportunity cost by choosing to accept the offer. Because the offer was below the company’s usual $25 per pack selling price, the sales manager decided to make an analysis of the relevant costs and revenues before deciding whether or not to accept it. Case Exhibit 11.3 Three steps to identify relevant costs: Special order

Step 1

Eliminate past costs e.g. omit the trip to Sydney

Step 2

Eliminate unnecessary costs to carry out the decision alternatives e.g. omit advertising as it is not required

Step 3

Eliminate costs that do not differ between the alternatives: i.e. accept or reject special order e.g. add shipping costs

The sales manager asked DeFlava Coffee’s accountant to provide him with some cost information from the business’s records. We show this information in Case Exhibit 11.4. The sales manager recognised that these data could be misleading because the accountant based the amounts on records of DeFlava Coffee’s past operations, whereas the decision involved future operations. Therefore, before looking at the data, he thought through the decision in the following way. Case Exhibit 11.4 Cost data for the Sydney offer Manufacturing costs per unit: Direct materials

$12.00

Direct labour

4.00

Factory overhead: Variable

0.50

Fixed

1.50

Total manufacturing costs

$18.00

Selling costs: Advertising

$50 000

Trip to Sydney

$

550

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447

Accounting Information for Business Decisions

Steps 1 and 2 From the sales manager’s perspective, there were only two alternatives to the decision: the business could either refuse to accept the offer or accept it. If DeFlava Coffee refused the offer, it would not engage in cost-incurring activities related to accepting it, and it would earn no additional revenue. In other words, DeFlava would incur no incremental costs or revenues if it did not accept the offer. If it did accept the offer, however, DeFlava would have to manufacture the 12 500 packs of Ultra Indulgence coffee and ship them to Sydney in order to earn the sales revenue. These activities would generate incremental costs and revenues.

Stop & think Do you agree with the sales manager’s conclusion that there were only two alternatives? Can you think of any others? After looking at the data in Case Exhibit 11.4, the sales manager pencilled in some comments on the projected cost sheet as a result of his thinking in step 1. Case Exhibit 11.5 shows the revised data. By thinking through the activities needed to carry out the decision to accept the offer, the sales manager recognised that two of the listed costs were not relevant. As we show in Case Exhibit 11.5, he eliminated the cost of the sales manager’s trip to Sydney because it was a past cost (step 1). He also eliminated advertising because this cost was related to activities not necessary to carry out the decision (step 2). The offer had already been made, so no advertising would be needed. Finally, he recognised that costs related to shipping (incremental costs) would be incurred if the offer was accepted. Case Exhibit 11.5 Cost data for the Sydney offer – revised

Manufacturing costs per unit: Direct materials

$12.00

Direct labour

4.00

Factory overhead: Variable

0.50

Fixed

1.50

Total manufacturing costs

$18.00

Selling costs: Advertising

$50 000 omit;

Trip to Sydney

$

Shipping costs

activity not required 550 omit; past cost ?

Step 3 Next, after deciding what costs he thought might be relevant, the sales manager estimated these costs. After obtaining a bid of $6000 from Express Transfer Company to ship the packs of coffee to Sydney, he gathered additional information about manufacturing costs for the coffee packs. He found that the past direct materials, direct labour and factory overhead costs per unit were still good estimates of those costs for the coming year. The total fixed factory overhead would not increase if DeFlava Coffee were to accept the offer and produce 12 500 additional packs of Ultra Indulgence coffee.

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Chapter 11 Short-term planning decisions With this information, the sales manager eliminated the fixed factory overhead from the analysis (step 3) because, although it would be a future cost incurred to support manufacturing activity, the amount would not be affected by the decision. That is, fixed factory overhead costs would be the same amount in the future whether DeFlava accepted or rejected the special order. Having finally identified and estimated all the relevant costs, the sales manager included the relevant revenue and then made a decision. The analysis in Case Exhibit 11.6 clearly shows all the incremental costs and revenues from accepting the order. It shows that accepting the order would result in an increase in business revenues of $250 000, but an increase in business costs of only $212 250. Therefore, DeFlava Coffee’s profit (before income taxes) would increase by $37 750. Since rejecting the offer would produce no additional profit, the sales manager should accept the offer – if he were basing his decision only on the accounting information. Case Exhibit 11.6 Relevant costs and revenues for the Sydney sale Accept offer (12 500 packs) Relevant revenues

Reject offer

$ 250 000

$0

Relevant costs: Manufacturing costs Direct materials ($12.00 per pack) Direct labour ($4 per pack) Variable factory overhead ($0.50 per crate) Total manufacturing costs Shipping costs Total relevant costs Increase in profit

$150 000

$0

50 000

0

6 250

0 $206 250

$0

6 000

0 (212 250)

(0)

$ 37 750

$0

Stop & think How do you think DeFlava Coffee’s staff and regular customers would react to DeFlava selling Ultra Indulgence coffee to another university in Sydney at less than its normal selling price? Would there be any opportunity costs for DeFlava?

11.3 Calculating short-term decisions

4

How does a business determine when to drop a product?

Now that we have described and illustrated the steps involved in identifying relevant costs and revenues for decision making, we will discuss several common short-term inventory decisions for a variety of companies. The kinds of decisions we discuss below can be very complex, and in some situations can be more properly evaluated as long-term decisions (which we will discuss in Chapter 12). We have made the illustrations relatively simple in order to emphasise the treatment of relevant costs and revenues in the decisions. For simplicity, we ignore income taxes and goods and services tax (GST).

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449

Accounting Information for Business Decisions

Deciding whether to drop a product Over its life, a business that sells more than one product will change the mix of specific products it sells. For example, music stores used to sell mostly records and tapes. Now, they sell mostly CDs, DVDs and accessories and equipment (although vinyl records are making a comeback). Part of the change in product mix occurs because a business drops a product from its inventory. The business’s managers may decide to drop a product for a number of reasons – for example: • because of changing technology and competition • because it is no longer profitable • because customers’ interest in the product has decreased • because the product is becoming obsolete • because the product has a poor safety record • because new information indicates that the product may harm the environment • any combination of these and other reasons. The integrated accounting system helps a business’s managers to evaluate one factor in the decision to drop a product: the profitability of the product in question. Products do not usually become unprofitable overnight. More often, there is a gradual decline in profitability. As a business’s managers begin to notice a product’s decline in profitability, they normally do whatever they can to slow that decline, including reducing prices, increasing advertising, searching for new markets and/or modifying the product. We do not consider the decisions related to these efforts in this book because they can be very complex; however, we do consider management accounting information that will highlight the profitability (or decline in profitability) of individual products. This information helps a business’s managers to decide whether the business should continue to produce and sell a product when it is profitable or drop it when it is unprofitable. Proper analysis of the business’s cost and revenue information can also help managers avoid decisions that result in either carrying a product too long or dropping it too soon. The key to evaluating the profit effects of a business’s decision to drop a product is to determine the costs that it would not incur (the avoidable costs) and the revenues that it would not earn if it discontinued production and sale of the product. Avoidable costs are always relevant to this evaluation. These costs are the only future costs that the business would not incur if it dropped the product. All other costs would be the same in either case. Once a business’s managers determine the avoidable costs, the product profitability component of their decision to drop the product is straightforward. Based on accounting information alone, a business should drop a product only if the total avoidable costs are more than the revenue it would lose if it dropped the product. Another way of saying this is that a business should drop a product if the relevant cost savings from dropping the product are greater than the relevant lost revenues. Under this condition, the total business profit will be higher if it drops the product than if it continues to produce and sell the product. You probably noticed that we said what the best decision would be using only the accounting information. Management accounting information provides useful information to help managers make decisions, but it shouldn’t be used in a vacuum. Other issues affect decisions as well, and a business’s managers might make decisions that have undesirable consequences if they don’t consider the full range of issues. For example, in some cases dropping an unprofitable product might affect sales of another related product. (If cinemas stopped making and selling popcorn, for example, the sale of soft drinks would be likely to decrease!) Furthermore, managers should consider the effect on the business’s employees of dropping a product. What if dropping an unprofitable product necessitated making employees redundant?

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Chapter 11 Short-term planning decisions

iStock.com/ai_yoshi

Stop & think

Air New Zealand has announced that it is offering a new service to South Korea. What do you think the airline included in its analysis before deciding to add this service?c

Even if a product turns out to be profitable, a business’s managers might consider dropping it for some other reason. For example, if new research indicates that a product is hazardous, managers would be disregarding the wellbeing of the business’s customers (and perhaps the community in which it manufactures the product) by continuing to produce it. Management accounting provides an excellent means of determining relevant revenues and costs for particular decisions. By combining this information with other relevant issues, managers can make informed, intelligent decisions. In the following discussion, we show how DeFlava Coffee would analyse the relevant costs and revenues for a decision about dropping another of its products, Divinely Delicious coffee. Suppose the managers at DeFlava Coffee wonder whether Divinely Delicious coffee is really a profitable product. The accounting department has assembled preliminary estimates for next year’s operations to analyse the expected profitability of the product. We show these estimates in Case Exhibit 11.7. Unfortunately, this information suggests that DeFlava Coffee would produce and sell Divinely Delicious at a $10 900 loss. Notice that the profit calculation we show in Case Exhibit 11.7 separates the variable and fixed costs, and lists the fixed costs so they can be analysed individually. The first question DeFlava Coffee’s managers should ask is, ‘Which costs can be avoided if DeFlava drops the Divinely Delicious coffee pack?’ The following information about the costs listed in the exhibit is important to DeFlava Coffee’s managers: 1 The variable costs for each product are accurate. Therefore, DeFlava Coffee expects the variable costs assigned to the Divinely Delicious coffee packs ($15 462 500) to be very close to the actual variable costs incurred. So these variable costs are avoidable costs. 2 The advertising expense of $1.92 million for the Divinely Delicious coffee packs consists of $1.4 million specifically related to advertising this product and $520 000 allocated to Divinely Delicious from general advertising for all business products. Therefore, only the $1.4 million cost specifically related to the Divinely Delicious coffee packs is avoidable. (DeFlava will continue general advertising for all the business’s products whether or not it drops Divinely Delicious coffee.) 3 The depreciation of $825 000 on the portion of the factory buildings that DeFlava Coffee uses to manufacture Divinely Delicious coffee packs is a sunk cost because it is based on the past purchase cost of the buildings. It is not relevant to this decision. However, if DeFlava stops production of Divinely Delicious coffee, it will be able to use the space it currently uses for this production to spread out its production facilities for other types of coffee. This would improve the efficiency of the Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

451

Accounting Information for Business Decisions Case Exhibit 11.7 Expected profit calculation DEFLAVA COFFEE CORPORATION Expected profit of Divinely Delicious coffee packs and other coffee packs

Sales revenue

Divinely Delicious coffee packs

Other coffee packs

$ 21 647 500

$ 57 984 500

Total $ 79 632 000

Less: Variable costs

(15 462 500)

(32 912 500)

(48 375 000)

Contribution margin

$ 6 185 000

$ 25 072 000

$ 31 257 000

$ 1 920 000

$ 2 880 000

$ 4 800 000

Depreciation: Buildings

825 000

1 675 000

2 500 000

Depreciation: Equipment

69 400

990 600

1 060 000

Less: Fixed costs: Advertising

Insurance

128 000

352 000

480 000

Warehousing

302 000

1 062 000

1 364 000

Salaries

351 500

7 048 500

7 400 000

General and administrative Total fixed costs Profit (loss)

2 600 000

5 100 000

7 700 000

$ (6 195 900)

(19 108 100)

$(25 304 000)

$ 5 963 900

$ 5 953 000

$

(10 900)

production of the other coffees. DeFlava estimates that this improved efficiency would increase the profit it earns on the other types of coffee by $910 000. If DeFlava continues to produce Divinely Delicious coffee packs, it will lose this profit increase. So DeFlava will incur an opportunity cost of $910 000 related to space usage if it continues the production of Divinely Delicious coffee. 4 The depreciation of $69 400 on the factory equipment used to produce Divinely Delicious coffee is also a sunk cost because it is based on the past purchase cost of the equipment. It is not relevant to this decision. Because of the age of the equipment, DeFlava Coffee cannot sell it. Furthermore, it cannot use the equipment in the production of other types of coffee. So DeFlava will give the equipment to a metal recycler if it discontinues production of Divinely Delicious coffee packs.

Discussion What if DeFlava Coffee could sell this equipment? Do you think the selling price would be relevant to this decision? If so, would it affect DeFlava’s profit under each alternative? How? If not, why not?

5 A discussion with DeFlava Coffee’s insurance agent suggests that the business’s insurance expense for insurance coverage on equipment and inventories would decrease by $128 000 if DeFlava were to discontinue production of Divinely Delicious coffee packs. 6 DeFlava Coffee would also avoid warehousing costs of $302 000 if it were to discontinue production of Divinely Delicious coffee, as a result of this product no longer being in the inventory. 7 Salaries related to the production of Divinely Delicious coffee packs are for four shift managers and a production superintendent, and total $351 500. DeFlava Coffee would lay off all four shift managers if it were to discontinue production of Divinely Delicious coffee, so these staff members’ total salaries of $279 000 are avoidable. Instead of laying off the production superintendent, DeFlava Coffee would make her the new manager of the production planning and scheduling department. Her salary ($72 500) is not avoidable. If DeFlava continues to produce and sell Divinely Delicious coffee packs, the business will need to hire, from outside the business, a new manager for production planning and scheduling. The personnel department estimates that to hire such a person would cost the business 452

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Chapter 11 Short-term planning decisions $46 000. This $46 000 is therefore avoidable if DeFlava discontinues production of Divinely Delicious coffee packs. So the total avoidable salaries cost is $325 000 ($279 000 þ $46 000). 8 DeFlava Coffee does not expect the $2.6 million of general and administrative expenses allocated to Divinely Delicious coffee pack production to be affected by the decision to drop the product. These are not avoidable. As a result of this analysis, we can show the profit effects of a decision to stop the production and sale of Divinely Delicious coffee packs by comparing the costs that DeFlava Coffee would avoid with the revenues it would lose. We show this comparison in Case Exhibit 11.8. It shows the cost savings, or relevant costs, of $18 527 500 that DeFlava would avoid if it dropped the Divinely Delicious coffee pack. It also shows the lost revenues, or relevant revenues, of $21 647 500 that DeFlava would not earn if it dropped the Divinely Delicious coffee pack. DeFlava Coffee’s unavoidable costs and the revenues it would not lose are not relevant to this decision, and are therefore not shown in the analysis. Note that the revenues lost exceed the avoidable costs by $3.12 million. Thus, profit would decrease by $3.12 million if DeFlava Coffee discontinued production and sale of the Divinely Delicious coffee pack. Based on this information alone, DeFlava’s decision would be to continue the production and sale of Divinely Delicious coffee packs. Case Exhibit 11.8 Analysis for the decision to drop a product DEFLAVA COFFEE CORPORATION Relevant costs and revenues for the decision to drop Divinely Delicious coffee packs Stop production Avoidable costs: Variable costs

$ 15 462 500

Fixed costs: Advertising

$1 400 000

Opportunity cost for space usage

910 000

Insurance

128 000

Warehousing

302 000

Salaries

325 000

Total fixed costs Total avoidable costs (cost savings) Sales revenue lost Profit lost

3 065 000 $ 18 527 500 (21 647 500) $ (3 120 000)

Discussion Suppose DeFlava Coffee learned that its South American supplier of the cocoa beans that give Divinely Delicious coffee its distinctive flavour is paying its workers $0.20 an hour to pick the beans. Should DeFlava drop Divinely Delicious coffee? What alternatives might it consider?

As we show in Case Exhibit 11.9, we could rearrange the relevant costs and revenues into an income statement format to calculate the $6 185 000 contribution margin ($21 647 500 sales revenues lost – $15 462 500 variable costs avoided) that DeFlava Coffee would lose if it discontinued the product, and we can then deduct from this amount the $3 065 000 of avoidable fixed costs. The contribution margin that DeFlava would lose exceeds the avoidable fixed costs by $3.12 million ($6 185 000 – $3 065 000), confirming that profit would decrease by $3.12 million if DeFlava were to discontinue the production and sale of Divinely Delicious coffee packs.

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453

Accounting Information for Business Decisions Case Exhibit 11.9 Alternative analysis for the decision to drop a product Stop production Sales revenue lost

$(21 647 500)

Less: Variable costs avoided

15 462 500

Contribution margin lost

$ (6 185 000)

Less: Avoidable fixed costs (cost savings) Advertising

$1 400 000

Opportunity cost for space usage

910 000

Insurance

128 000

Warehousing

302 000

Salaries

325 000

Profit lost

3 065 000 $ (3 120 000)

Deciding whether to make or buy a part

5

What is a make-or-buy decision and what issues does a business consider in this decision?

Ethics and Sustainability

Many products require a manufacturing process to convert basic direct materials into completed products of inventory. These products are seldom produced entirely by one business. For example, think about the many businesses involved in the manufacture of cars. There are companies that manufacture steel, glass, paint, rubber, plastic and so on. Other businesses use these materials to produce parts such as lights, radios, CD players, air conditioners, fuel pumps and tyres. Any business that buys parts from other companies may question whether it would be less costly to produce a part than to purchase it from an outside supplier. That is, the business faces a make-or-buy decision. Many factors affect the make-or-buy decision. If a business must buy the equipment required to manufacture a particular part, and must develop the know-how to produce that part, it may be much costlier to make the part than to buy it from the present supplier. But this is not always the case. Consider Interface Global (https://www.interface.com/APAC/en-AU/homepage?r=1). In 2007, it became the first carpet manufacturer to implement a process for the ‘clean separation’ of carpet fibre from backing, allowing for a maximum amount of post-consumer material to be recycled into new products with minimal contamination. Through a process called ReEntry¤ 2.0, clean, post-consumer Nylon 6.6 fibre is returned to Interface’s fibre supplier, where it is combined with some virgin material to be recycled into new Nylon 6.6 for use in new carpet fibre. At the same time, the post-consumer vinyl carpet backing is recycled into new backing using Interface’s Cool BlueTM backing technology. Plastics that cannot be used for Interface processes or products are distributed to other industry suppliers for reuse in their material streams. Essentially, this puts a value on what was formerly viewed as a waste product.d

Stop & think How do you think the public’s knowledge of Interface Inc.’s production methods affects the general perception of the company’s environmental consciousness? Do you think this public perception has the potential to affect the company’s profits? If so, how and why? If not, why not? A business can sometimes obtain a short-term cost advantage by making a part. This might occur when the business already has the equipment required for making the part and when it is not fully using that equipment for other production. In this situation, the business might be able to produce the part with little or no incremental costs. This cost advantage may not be long-lasting, however. (What if the business finds that it needs to use the equipment soon for other production?) A decision to make a 454

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Chapter 11 Short-term planning decisions currently purchased part to obtain a short-term cost advantage may be unwise if the business is likely to reverse the decision in the near future. Valuable business relationships with suppliers might be damaged by a decision to make a part instead of buying it.

Stop & think Read the following article and reflect on your thoughts about this topic. Livio Cricelli Battagello and Michele Grimaldi, ‘Prioritization of Strategic Intangible Assets in Make/Buy Decisions’, Sustainability (2019) (15), doi.10.3390/su11051267 Another reason for making a part that a business is currently purchasing relates to issues of quality and supplier reliability. Both factors can also affect the business’s overall costs. Poor-quality parts can cause increases in production costs for a business. A business may need to rework products that do not meet minimum quality standards, or replace parts that break during the manufacturing process or after customers purchase the products. Reworking products and replacing parts add to the cost of manufacturing the product. For example, even though DeFlava Coffee doesn’t use parts in its products, poor-quality ingredients can have the same effect for it as poor-quality parts have for other manufacturers. Sub-standard cocoa beans might make it more difficult to refine the coffee, for example. To overcome this problem, DeFlava might decide to lengthen the refining process; but this action would also raise the cost of manufacturing packs of coffee. Poor-quality parts can also cause customer dissatisfaction with a business’s product. This dissatisfaction may lead to a loss of sales (resulting in opportunity costs).

Stop & think In 2018, car manufacturing companies worldwide, including BMW, Toyota, Honda, Ford and Nissan, recalled large numbers of their vehicles to have their Takata airbags replaced. They did this in an effort to protect customers and to avoid future costs from malfunctioning airbags in an accident. What specific additional costs do you think these motor vehicle companies incurred as a result of these measures? What potential liabilities were they trying to minimise?e If the supplier of parts is unreliable, production delays may result, which also cause increases in production costs and lost sales. For example, if late parts cause production delays, the business may later ask its employees to work overtime in order to meet expected product sales. Without the overtime production, the business might temporarily or permanently lose sales if its customers purchase from its competitors. When negotiations with a supplier fail to correct quality and reliability problems, a business may consider producing its own parts. The decision to make or buy a part involves an analysis of the relevant costs for each alternative. In the following illustration, we show how to consider various activities and their related costs in a make-or-buy decision. Process Control Company manufactures the electronic control panel that DeFlava Coffee uses to control some of its production processes. Process Control currently purchases 1000 computer chips per month from an outside supplier at a cost of $5.40 per chip for use in manufacturing the panel. Due to the discontinuation of another product, Process Control has some unused and unsalable machinery that could make as many as 2000 chips in one production run. Process Control’s managers believe the company’s employees have the production skills to make the chips and that they can in fact make a better-quality chip than is available from Process Control’s current supplier. Because of the lower quality of the purchased chip, the company’s managers estimate that Process Control currently incurs excess manufacturing costs of $0.60 for each purchased chip used in production. Process Control can avoid this cost by making the higher-quality chip. Case Exhibit 11.10 shows the relevant cost comparison for this make-or-buy decision. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

455

Accounting Information for Business Decisions Case Exhibit 11.10 Analysis for the make-or-buy decision PROCESS CONTROL COMPANY Relevant costs for the make-or-buy decision Make chip Expected monthly requirements (chips)

1 000

Buy chip 1 000

Relevant costs: Direct materials Direct labour Variable overhead

$2 200 1 050 550

Chip purchase cost

$5 400

Excess manufacturing costs incurred in production of electronic control panels as a result of lower-quality purchased chips

–

600*

Total relevant costs

$3 800

$6 000

Relevant costs per unit

$ 3.80

$ 6.00

ª 2011 InterfaceFLOR, LLC. All rights reserved.

* $0.60  1000

Notice in Case Exhibit 11.10 that Process Control’s cost study shows no incremental fixed costs related to making or buying the chip. All relevant costs in this situation are variable costs. The comparison shows that making 1000 chips per month rather than buying them would save Process Control $2200 ($6000 – $3800) per month. A comparison of the per-unit variable costs shows that the company would save $2.20 ($6.00 – $3.80) for each chip made. In this case, based only on the costs of the two alternatives and not considering the other factors that could influence this decision, the company would decide to make as many chips as it needed, up to the maximum that the available machinery could produce. The decision is not so straightforward, however, if some relevant fixed costs are involved. Suppose that Process Control does not have the machinery it needs to make the chip, but can lease the machinery for a fixed cost of $2640 per month. All the other costs remain the same. In this case, the cost of making 1000 chips is $6440 ($3800 þ $2640) per month, and the cost of purchasing 1000 chips is $6000 per month. So Process Control’s managers would prefer to buy the chip (again, considering this information alone). When fixed costs are involved, the managers should consider the total cost of each alternative, rather than compare the total (fixed þ variable) costs per chip. If the company needs more or fewer than 1000 chips, its managers may be misled by comparing total costs per chip because fixed costs per chip change when the volume changes, as discussed in Chapter 2. Do you think that Interface has an unlimited If the number of chips that Process Control needs is likely to change, a different supply of materials for its carpets? Why or form of analysis is more helpful. The cost of buying the chip is $6.00 per chip why not? purchased. The total cost of making the chip now includes a fixed cost of $2640 per month and a variable cost of $3.80 per chip made. Case Exhibit 11.11 shows a graph of the expected costs of both making and buying the chip as the volume needed per month varies. Note, in Case Exhibit 11.11, that Process Control’s expected total cost of making the chip is higher than the total cost of buying the chip at a volume of 1000 units. The graph also shows that at a volume below 1200 units, the total cost of making the chip is always higher, and at a volume above 1200 units, the total cost of buying the chip is always higher. (Recall our discussion of break-even analysis in Chapter 2.) This form of analysis is useful because it helps in making the correct current decision, and also shows the volume level at which the decision would change. Based on this accounting information alone, the correct decision would be to continue buying the chip because the purchase cost at the expected volume 456

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Chapter 11 Short-term planning decisions Case Exhibit 11.11 Expected costs of making and buying chips Cost ($) $7 200

6 440 6 000

2 640

Cost of making = $2 640 ⫹ ($3.80 ⫻ number of chips)

Cost of = $6.00 ⫻ number of chips buying

0

1 000

1 200

Number of chips (volume)

of 1000 chips is less than the cost of making the chips. But remember that the cost difference between the two alternatives is one of many factors a business’s managers consider when deciding whether to make or buy a part. Decisions of the types mentioned in this chapter should not be analysed and decided on based on financial data alone. Any relevant non-financial data should also be considered. For example, in the previous decision, let’s assume that Process Control’s current supplier does not care about the environment, and simply dumps its electronic-chip waste into landfill, whereas Process Control, on the other hand, has a policy of recycling such waste and a strong ethos of sustainability. Should Process Control take into consideration its supplier’s waste-disposal methods when making its decision about whether to make or buy?

Ethics and Sustainability

Stop & think Can you think of any alternatives other than continuing to purchase parts from the current supplier or making them? How can accounting information help?

Deciding whether to sell a product or process it further Many businesses face the decision of whether to sell a product ‘as is’ or to use it as a direct material in the manufacture of another product. For instance, a meatpacker can sell animal fat ‘as is’ or make soap out of it; a textile mill can sell yarn ‘as is’ or weave cloth out of it; and an oil refinery can sell the kerosene Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

6

How does a business determine whether to sell a product ‘as is’ or to process it further?

457

Accounting Information for Business Decisions produced in refining oil or process it further to increase petrol output. (You will make a similar decision when you graduate. Will you take the ‘product’ of your education – your mind – and ‘sell’ it to the job market as is, or will you process it further by working towards a more advanced degree?) Consider Tyson Foods, Inc (http://www.tyson.com), which became the market leader in the poultry industry in the United States by deciding to process chicken further. Instead of only selling whole chickens to supermarket and restaurant chains, Tyson anticipated the market for prepared chicken items that would only need cooking or reheating. (e.g. the company supplied McDonald’s (http:// www.mcdonalds.com.au) with its first Chicken McNuggets.) These innovations resulted in Tyson Foods possessing a 25 per cent share of the poultry market. The company has pursued a similar strategy with pork and fish products.f Now suppose that DeFlava Coffee can currently sell all of the crates of Ultra Indulgence coffee packs that it makes. On the other hand, by further processing Ultra Indulgence coffee packs, it can convert them into fancy gift-packed coffees. However, for the business to make any of the fancy gift-packed coffees, it must give up sales of some of its normal Ultra Indulgence coffee packs. The problem is to determine whether DeFlava should forgo selling some of the crates of Ultra Indulgence coffee in order to convert them into the fancy gift-packed coffees. That is, the business faces a sell-or-process-further decision. In a sell-or-process-further decision, a business’s managers consider a number of items, such as: • the difference in business profits between the two alternatives • whether the customers who like the product ‘as is’ will refuse to buy the product when it is processed further (an issue DeFlava Coffee’s managers must consider) • whether the further processing will have a negative effect on the environment • whether the business has access to employees (either present or potential employees) with the skills necessary to do the further processing • whether the business will be able to continue to employ those factory employees who do not have those skills. Management accounting information helps managers compare the ‘profit’ from selling the product ‘as is’ with the ‘profit’ from using the product as a direct material in the manufacture of another product. This analysis involves subtracting the relevant costs (incremental costs and opportunity costs) from the relevant revenues under each alternative and selecting the alternative (sell or process further) that provides the higher ‘profit’. For DeFlava Coffee, none of the costs it incurs in producing Ultra Indulgence coffee packs to the point at which they are ready for further processing into fancy gift-packed coffees are relevant to the decision. These costs must be incurred whether DeFlava sells Ultra Indulgence coffee packs ‘as is’ or processes them further and sells them as fancy gift-packed coffees. The only costs that are relevant are the incremental costs of selling crates of Ultra Indulgence coffee packs (costs that DeFlava Coffee incurs if it sells the coffee packs, but not if it processes them further) and the incremental costs of further processing and selling fancy gift-packed coffees (costs that DeFlava Coffee incurs if it further processes the coffee packs into fancy gift-packed coffees, but not if it sells the coffee packs). Both the revenue from the sale of Ultra Indulgence coffee packs (if not processed further) and the revenue from the fancy gift-packed coffees (if processed further) are relevant, as long as they are different from each other. Next, we show how to consider the relevant costs and revenues in a sell-or-processfurther decision. DeFlava Coffee’s managers believe that the business might increase its profits by giving up the sale of some of its Ultra Indulgence coffee packs so as to produce and sell the higher-priced fancy gift-packed coffees. To analyse this alternative, DeFlava estimates its relevant revenue and cost information. First, DeFlava Coffee’s managers estimate its revenues. They determine that the business would have to give up sales of 12 000 boxes of Ultra Indulgence coffee packs at $41.50 per box, totalling $498 000, if it were to process the coffee packs further into fancy gift-packed coffees. If it processes the coffee packs further, the marketing department estimates that it can sell 20 000 boxes of the fancy gift-packed coffees at $50 per box, totalling $1 million. (These are the relevant revenues for this decision that we show in Case Exhibit 11.12.)

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Chapter 11 Short-term planning decisions Case Exhibit 11.12 Analysis for the sell-or-process-further decision DEFLAVA COFFEE CORPORATION Relevant costs and revenues for the sell-or-process-further decision

Sell (as coffee packs) Revenue

Process further (into fancy gift-packed coffees) $1 000 000 

$498 000*

Relevant costs: Fixed leasing costs

$14 000

Variable opportunity cost of using fully utilised moulding equipment ($0.50  20 000)

10 000

Variable labour and overhead costs ($4.00  20 000) Variable selling costs Total incremental costs Difference (profit)

80 000 19 400§

$9 960à (9 960)

(123 400)

$ 488 040

$ 876 600

* 12 000 boxes  $41.50 † 20 000 boxes  $50 ‡ 12 000 boxes  $0.83 § 20 000 boxes  $0.97

Although DeFlava Coffee would not need to expand the factory for the additional processing, it would need to lease new packaging equipment at a fixed cost of $14 000 per year. In addition, DeFlava would reassign to this added processing the moulding equipment that it is currently being used fulltime in the production of other coffee packs. This reassignment would slightly reduce the production capability for other coffee packs. The lost sales for the other coffee packs would result in variable opportunity costs of $0.50 per box of fancy gift-packed coffees packaged, or a total of $10 000. Further, variable costs of converting the coffee packs into fancy gift-packed coffees include direct labour and variable overhead costs of $4.00 per box, or a total of $80 000. DeFlava’s managers expect delivery costs and the cost of fancy display cartons to cause variable selling costs to be $0.97 for each fancy giftpacked coffee (totalling $19 400), as compared to $0.83 for each box of coffee packs (totalling $9960). We show the estimates of these relevant costs for this decision in Case Exhibit 11.12. Case Exhibit 11.12 shows that the difference between the relevant revenue and relevant costs is $388 560 ($876 600 – $488 040) higher under the ‘process further’ alternative than it is under the ‘sell’ alternative. This means that processing coffee packs further to make and sell 20 000 boxes of fancy giftpacked coffee results in a profit increase of $388 560. This occurs because the increase in revenue of $502 000 ($1 000 000 – $498 000) is $388 560 more than the $113 440 ($123 400 – $9960) increase in costs. So if DeFlava Coffee’s managers only considered the accounting information, their decision should be to further process enough coffee packs to satisfy the demand for fancy gift-packed coffees. But, of course, the managers would also consider other factors that might influence this decision. Notice that we didn’t show the manufacturing costs required to produce the coffee packs. DeFlava Coffee must incur the same amount of cost whichever alternative it chooses, so these costs are not relevant to the decision.

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What non-financial issues need to be considered when businesses are choosing whether to take on a one-off contract or special order?

11.4 Non-financial issues in decision making When businesses are choosing whether to take on a one-off contract or special order, they need to be aware of the following non-financial issues besides the financial calculations: • Impact on workers if the order requires non-standard adjustments, both in terms of the learning curve of performing a non-routine task and the workers willingness to perform tasks differently. • Impact on the current customers, especially if the order is sold at a reduced price. You could lose current customers as they feel hard done by. • Also, they could expect you to then drop your prices in the future, having a long-term impact financially. In the case of dropping products you would need to consider some of the following issues: • Loss of customers to competitors because they cannot get the full range of products from your business anymore. • Drop in morale because of lay-off of other workers, people fear for their jobs and productivity drops. • Need to consider alternate uses for now unused machinery or space. In terms of make and buy decisions, the following type of issues would need to be considered: • If we stop making are there alternate uses for the equipment or machinery. • Morale of workers if other workers are laid-off due to the business now buying components. • Reliability, quality and reputation of the supplier, as the customer will be unhappy with you not the supplier is the reliability or quality is not up to standard. • What will you do if the supplier goes on strike, need to have multiple suppliers? In the case of sell as is or process further, some issues would be: • Environmental impact of processing further. • Skill level of employees to do the work in processing the product further and the learning curve involved. • If machines do the processing further, will there be loss of jobs leading to behavioural and morale issues?

Business issues and values: Decision making As you may have guessed, some decisions are more straightforward than others. Business managers use accounting information to help them make the types of decisions we discussed in this Ethics and Sustainability

chapter. But, as we said earlier, managers don’t make these decisions using accounting information alone. They also must consider other relevant factors. Consider the decision made by Fuji Xerox Australia (www.fujixerox.com.au), which has a long-term commitment to improving sustainability performance, both its own and that of their customers. The company developed a sustainable office document system aimed at reducing environmental impact, maximising productivity, improving document accessibility and lessening the total cost of ownership, while providing a flexible, reliable and responsive document platform for organisational needs. Fuji Xerox also developed an EA–Eco toner for its printers that will achieve power savings of 15–30 per cent.g Do you think Fuji Xerox made these decisions based on financial data only? If not, why not?

Stop & think Can you think of other non-financial issues around the decisions of (a) special orders, (b) drop or keep a product, (c) make vs buy, or (d) sell as is or process further decisions.

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Chapter 11 Short-term planning decisions

STUDY TOOLS Summary 11.1 Define and describe relevant costs and relevant revenues. 1

How do relevant costs and revenues contribute to sound decision making?

Both merchandising and manufacturing companies make short-term inventory-planning decisions. Regardless of the type of inventory-planning decisions they make, one factor that these companies consider is the profit impact of the decision. They can determine the profit impact of the decision by analysing relevant costs and revenues. 2

What types of costs and revenues are relevant to decision making?

Relevant costs and revenues are future costs and revenues that will change as a result of a decision. If they do not change from one decision alternative to another, costs and revenues are not considered relevant to the decision. They will not sway the decision one way or another. By considering only relevant costs and revenues, managers eliminate the possibility of misusing irrelevant information, and thereby making incorrect decisions. To identify relevant costs and revenues, managers first identify the business activities necessary to carry out the decision, and then estimate the costs and/or revenues that are affected by these activities. These costs and revenues can include incremental costs and revenues, avoidable costs and opportunity costs.

11.2 Explain and distinguish between incremental costs, avoidable costs and opportunity costs. Incremental costs are cost increases resulting from a higher volume of activity or from the performance of an additional activity. Avoidable costs are the costs that a business must incur to perform an activity at a given level, but that it can avoid if the business reduces or discontinues the activity. Opportunity costs are the profits that a business forgoes by following a particular course of action rather than an alternative action.

11.3 Calculate short-term decisions based on relevant costs and revenues regarding (a) special orders, (b) dropping a product, (c) make versus buy and (d) selling as is or processing further. 3

What types of costs and revenues need to be considered in deciding whether to accept or reject a special order?

In the example in this chapter, the incremental costs of the special packaging are relevant because DeFlava Coffee would have to incur these costs only if it accepted the order. The incremental revenues are also relevant because DeFlava would receive them only if it accepted the order. 4

How does a business determine when to drop a product?

A business determines when to drop a product by estimating whether the costs that it would not have to incur – that is, the avoidable costs – would be greater than the revenues that it would not earn if production and sale of the product were discontinued. They would also consider the customer’s interest in the product, its safety record, the impact the product has on the environment and other similar issues. 5

What is a make-or-buy decision, and what issues does a business consider in this decision?

In a make-or-buy decision, a business’s managers decide whether producing a part would be less costly than purchasing it from an outside supplier. In making this decision, the business’s managers compare the relevant incremental costs of producing the part with the relevant costs of purchasing the part. In addition to cost factors, they should consider the quality of the produced part versus the quality of the purchased part, the reliability of the supplier, and the business’s desired long-term business relationship with the supplier. 6

How does a business determine whether to sell a product ‘as is’ or to process it further?

A business determines whether to sell a product or to process it further by comparing the ‘profit’ from selling the product ‘as is’ with the ‘profit’ from using the product as a direct material in the manufacture of another product. This analysis involves subtracting the relevant Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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costs from the relevant revenues under each alternative, and selecting the alternative (sell or process further) that provides the higher ‘profit’. The business also considers customers’ potential responses to the product when it is processed further, the effects on the environment of processing it further, whether the business’s current or potential employees have the skills to process it further, whether it will have to lay off employees and other similar issues.

11.4 Understand non-financial issues in decision making. 7

What non-financial issues need to be considered when businesses are choosing whether to take on a one-off contract or special order?

Non-financial issues that need to be considered when businesses are choosing whether to take on a one-off contract or special order include: impact on workers if the order requires non-standard adjustments, impact on the current customers and their future expectations. In the case of dropping products, the issues to consider include loss of customers to competitors, a drop in morale, a drop in productivity and the need to consider alternate uses for machinery or space. For make and buy decisions, issues include alternate uses for equipment or machinery, worker morale, reliability, quality and reputation of the supplier. In the case of sell as is or process further, some issues would be the environmental impact of processing further, the skill level of employees and potential job losses leading to falling morale. Both accounting information and other relevant factors need to be considered.

Key terms avoidable costs

opportunity costs

incremental costs

relevant costs

relevant revenues

Online research activity This activity provides an opportunity to gather information online about real-world issues related to the topics in this chapter. For suggestions on how to navigate various businesses’ websites to find their financial statements and other information, see the related discussion in the Preface. Put your skills to the test and find answers to the following questions by visiting the listed websites. u Step-by-step guide to make or buy decision: https://www.cleverism.com/make-or-buy-decision-step-by-step-guide; make or buy analysis accounting tools: https://www.accountingtools.com/articles/make-or-buy-analysis.html The make or buy decision involves whether to manufacture a product in-house or to purchase it from a third party. The outcome of this analysis should be a decision that maximises the long-term financial outcome for a company.

Integrated business and accounting situations Answer the following questions in your own words.

Testing your knowledge 11-1 11-2 11-3

Define the characteristics of relevant costs and relevant revenues. Explain why sunk costs are irrelevant. Since sunk costs are irrelevant in decision making, why do you think keeping past cost records can be helpful in the decision-making process? 11-4 Why should irrelevant costs and revenues be omitted from a decision analysis? 11-5 What is the difference between incremental costs and avoidable costs? 11-6 What is an opportunity cost? Are these costs always able to be quantified? 11-7 ‘All future costs are irrelevant.’ Do you agree? Why or why not? 11-8 Under what circumstances is an avoidable manufacturing cost relevant in the make-or-buy decision? 11-9 ‘If a product line is making a loss, should it be discontinued.’ Why or why not? 11-10 Under what circumstances is an incremental manufacturing cost relevant in a make-or-buy decision?

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Chapter 11 Short-term planning decisions

11-11 In a decision to make a previously purchased part, think of two incremental costs that might not be avoidable if the decision is reversed a year later. Why would they not be avoidable? 11-12 Suppose your friend tells you, ‘My colleague offered me $200 to rent my boat over the weekend, but I decided that I would use it myself to go water skiing at a cost of $90.’ What costs are involved in making this decision? Would you have rented the boat or used it yourself? Why? 11-13 Explain, by using an example, how a fixed cost can be a relevant cost. 11-14 Why might it be valuable to distinguish between relevant fixed costs and relevant variable costs for a short-term decision? 11-15 When are fixed costs relevant in a short-term decision? 11-16 Define an opportunity cost, and outline an example of such a cost. 11-17 What is the decision rule for a special order decision? 11-18 An airline company is considering giving rates reduced by up to 50 per cent to members of the families of businesspeople at certain times of the week, in order to encourage businesspeople to take more trips. What relevant costs would the airline be considering in order to make this decision? 11-19 Actionwear makes clothing and accessories for the fitness industry. The company is considering dropping its line of Fitbands. What costs would be considered relevant to this decision? Are there costs that are not relevant? If so, provide examples.

Applying your knowledge 11-20 Lisa Cooper is an employee of a company that manufactures tear-proof tracksuits. Lisa is paid $60 per hour, and is the only person on staff who is trained to operate a piece of technology that is critical to the production of tear-proof tracksuits. Each tear-proof tracksuit has a contribution margin of $45 and requires 30 minutes of processing time. Sales of tear-proof tracksuits are restricted only by limits on production time. Required: What is the opportunity cost to the business if Lisa becomes sick and leaves work two hours early one day? 11-21 Pete Panda has just discontinued its poorest-selling line of high-quality upholstery. In its inventory, Pete has 6000 metres of material that cost $10 per metre. At the current selling price of $20, it may take as long as eight years to sell the material. A foreign buyer has just offered the business $70 000 for all the material. Required: Is the $10 per metre relevant in deciding whether or not to accept the offer? List the costs and revenues that you think would be relevant. 11-22 Float Tube ended its busy season with an inventory of 1000 plastic blow-up tubes, which cost $12 000 to manufacture. The business has two options. One is to store the tubes for six months and sell them for $80.00 each the following year. Storage would cost $1500, and Float Tube knows that at least 20 per cent of the plastic blow-up tubes would deteriorate during storage. The deteriorated tubes would have no value. The only alternative is to have a clearance sale now and sell the tubes for $60.00 each. Float Tube believes that all of the tubes can be sold if it spends $2000 to advertise the sale. Required: Based on this information, prepare an analysis showing the relevant costs and revenues of each alternative, and decide which option Float Tube should choose. 11-23 Smartime manufactures three products from a common input in a joint processing operation. Joint processing costs up to the split-off point total $100 000 annually. The company allocates these costs to the joint products on the basis of their total sales value at the split-off point. These sales values are as follows: u Product A: $40 000 u Product B: $80 000 u Product C: $30 000. Each product may be sold at the split-off point or processed further. Additional processing requires no special facilities. The additional processing costs and the sales value after further processing for each product (on an annual basis) are as follows: Product

Additional processing costs

Sales value

A

$25 000

$ 65 000

B

$40 000

$160 000

C

$20 000

$ 50 000

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Required: a Which product or products should be sold at the split-off point, and which product or products should be processed further? Show workings. b What comments would you make with respect to joint costs and their allocation and the decision to process further? 11-24 On a chilly Sunday morning, Shaz Granger bought 30 dozen doughnuts for $75, prepared 10 litres of hot coffee and went to a farm auction. There, she sold all the coffee and all but six dozen of the doughnuts before heading home late in the afternoon. Knowing that she could not eat six dozen doughnuts herself, and that they would be worthless by the next day, she began to consider how she might sell the remaining doughnuts. Only one possibility occurred to her. If she drove across town and left the doughnuts in the lunchroom at the plant where she worked, she was sure that workers on the late shift would be happy to buy the doughnuts. She felt that the 10 kilometre round trip to the plant would cost her about $0.40 per kilometre. It would take her about half an hour to make the trip, and she decided that it would be worthwhile to drive to the plant if she were compensated $20 for her time. Shaz believes that workers will ‘forget’ to pay for one dozen doughnuts. Required: Prepare an analysis to determine how much Shaz would have to charge per doughnut for the doughnuts she sells at the plant in order to recover her profit goal of $20 for her time. 11-25 Electro Company produces small electrical engines. The manufacturing costs per unit to produce a small engine are as follows: Direct materials Direct labour Variable overhead Fixed overhead Total manufacturing cost per unit

$13.00 11.50 8.50 12.00 $45.00

Variable selling costs to obtain and fill orders normally average $3.00 per unit when Electro sells the engines to local customers. Recently, however, Electro paid $80 000 to advertise its various products in an international trade magazine. The company has just received an order from a large mail-order merchandising company in France for 700 engines at a total offering price of $24 000. The merchandising company is willing to pay all shipping charges except the initial packaging, which costs $1.50 per engine. Required: Calculate the total incremental cost that Electro would expect to incur if it accepted and filled this order. Should Electro produce the 700 engines and sell them to the French company? 11-26 Steveo Company produces small gelblasters. The manufacturing costs per unit to produce a small gelblasters are as follows: Direct materials

$26.00

Direct labour

$23.00

Variable overhead

$17.00

Fixed overhead

$24.00

Total manufacturing cost per unit

$90.00.

Variable selling costs to obtain and fill orders normally average $6.00 per unit when Steveo sells the gelblasters to local customers. Recently, however, Steveo paid $50 000 to advertise its various products in an international trade magazine. The company has just received an order from a large mail-order merchandising company in New Zealand for 800 gelblasters at a total offering price of $58 000. The merchandising company is willing to pay all shipping charges except the initial packaging, which costs $3.00 per gelblaster. Required: Calculate the total incremental cost that Steveo would expect to incur if it accepted and filled this order. Should Steveo produce the 800 gelblasters and sell them to the New Zealand company? 464

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Chapter 11 Short-term planning decisions

11-27 Williamson Company, a furniture manufacturer, produces 10 000 units of Product X-100 each year for use in its production line. The costs per unit for Product X-100 are as follows: u Direct materials: $4.60 u Direct labour: $7.10 u Variable overhead: $3.30 u Fixed overhead: $10.00. Norejects Ltd, an overseas supplier, has offered to produce and sell to Williamson 10 000 units of Product X-100 for $25.50 each, stating that their products are of much better quality. If the offer is accepted, the facilities currently being used to make Product X-100 could be rented to another business at an annual rent of $40 000. In addition, $6 per unit of the fixed overhead being allocated to Product X-100 would be completely eliminated. Required: a Prepare a report to management showing computations of the net dollar advantage of outsourcing the production of X-100 to Norejects Ltd at the quoted price and recommending whether to proceed or not. b If Norejects reduces the price to $22.00 for a lower quality product, would that change the decision recommended in your report in part (a)? 11-28 Simmons Skates produces several products that are sold by toy shops across the country. Production of one item, longboard skates, uses all available machine hours on machine 24B. The long-boards, which provide a contribution margin of $9.60 per unit, require 0.20 machine hours per unit to produce. Simmons Skates would like to use machine 24B in the production of other products. This production would take about 250 hours. Required: Calculate the opportunity cost of using 250 machine hours on machine 24B for other production. If you were a manager at Simmons Skates, how would you use the opportunity cost that you calculated? 11-29 Simmons Skates produces several products that are sold by toy shops across the country. Production of short-board skates, uses all available machine hours on machine 2A. The short-boards, which provide a contribution margin of $4.80 per unit, require 0.10 machine hours per unit to produce. Simmons Skates would like to use machine 2A in the production of other products. This production would take about 125 hours. (Assume 0.10 machine hours per unit equals 10 units an hour). Required: Calculate the opportunity cost of using 125 machine hours on machine 2A for other production. If you were a manager at Simmons Skates, how would you use the opportunity cost that you calculated? 11-30 Armand Leggitt Company manufactures table legs and chair arms. It owns a lathe that it is not currently using. The lathe, which Armand Leggitt purchased nine years ago for $40 000, has a current book value of $4000. Armand Leggitt can get $4800 for the lathe if it sells it now. Armand Leggitt has just received an order for 50 000 table legs; it cannot accept the order unless it keeps the lathe for use in producing the order. If Armand Leggitt keeps the lathe for this purpose, it will have no residual value after the company completes the order. The direct materials, direct labour and variable overhead costs that Armand Leggitt would incur to produce the order total $49 900. The customer has offered $55 000 for the table legs. Required: Prepare a schedule to help Armand Leggitt Company determine whether it should accept the order for the table legs. 11-31 The Possum Transport Company produces bikes, skates and mopeds. Bikes are not as popular as they used to be, and the company is considering dropping this product. Possum currently sells 5 000 bikes per year for $20 each. Variable manufacturing and selling costs total $17 per bike. Fixed costs of $40 000 can be avoided if the bikes are not produced. Required: Prepare an analysis to answer each of the following independent questions. a Given this information, by how much would Possum’s profit increase if production of bikes were discontinued? b If Possum can increase the sales volume of bikes to 6000 units per year by spending an additional $10 000 per year on advertising, should it continue bike production? c If Possum can increase the sales volume of bikes to 7000 per year by reducing its selling price to $19 per bike, should it continue bike production?

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11-32 Buzz Telephone Company manufactures landline telephones. Buzz currently buys a connector for its phones for $1.80 per unit. Buzz’s president asked for cost estimates for making this product, and received the following report: Costs per unit of making connectors Direct materials

$0.75

Direct labour

0.30

Variable overhead

0.35

Fixed overhead

0.80

Total manufacturing cost per unit

$2.20

If Buzz makes the connector, production would take place in its machine shop. No additional plant and equipment would be necessary; however, the company would have to hire someone to inspect the connectors before they could be used in producing the company’s other products. The inspector’s salary would be $15 000 per year. Required: a Calculate the incremental costs of making and of buying the connector in quantities of 40 000 units per year. Should the company make the connector or buy it? b Calculate the incremental costs of making and of buying the component in quantities of 20 000 units per year. Should the company make the component or buy it? c How many units of the component would have to be produced so that the total costs of making them would be equal to the total costs of buying them? 11-33 Phonegrip Company manufactures mobile phone holders. Phonegrip currently buys a magnet for its phones for $0.90 per unit. Phonegrip’s president asked for cost estimates for making this product, and received the following report: u Direct materials: $0.37 u Direct labour: $0.15 u Variable overhead: $0.18 u Fixed overhead: $0.40. u Total manufacturing cost per unit: $1.10 If Phonegrip makes the magnet, production would take place in its machine shop. No additional plant and equipment would be necessary; however, the company would have to hire someone to inspect the magnets before they could be used to produce the company’s other products. The inspector’s salary would be $25 000 per year. Required: a Calculate the incremental costs of making and of buying the magnet in quantities of 80 000 units per year. Should the company make the magnet or buy it? b Calculate the incremental costs of making and buying the component in quantities of 40 000 units per year. Should the company make the component or buy it? c How many units of the component would have to be produced so that the total costs of making them would be equal to the total costs of buying them? 11-34 Mane Street normally sells 3000 economy-size bottles of shampoo for $10.00 per bottle. The cost to manufacture the shampoo is $5.00 per bottle. Further variable processing costs of $4.00 per bottle would convert the shampoo into a shampoo–conditioner, which Mane Street could sell for $16 per bottle. Variable selling costs are $1 per bottle for the shampoo, but would be $2.50 per unit for the shampoo–conditioner. Required: Based on this information, and assuming that Mane Street can sell 3000 bottles of shampoo–conditioner, prepare an analysis to answer each of the following questions. a Should Mane Street process the shampoo further into a shampoo–conditioner? b If the selling price per unit of the shampoo–conditioner dropped to $15 per bottle, should Mane Street process the shampoo further into a shampoo–conditioner?

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Chapter 11 Short-term planning decisions

11-35 6 Ingredients produces a single cookbook. The cost of producing and selling one book at the company’s normal activity level of 8000 books per month is as follows: u Direct materials: $2.50 u Direct labour: $4.00 u Variable overhead: $1.50 u Fixed overhead: $5.00 u Variable selling and administrative expenses: $1.50 u Fixed selling and administrative expenses: $1.00. The normal selling price is $22 per book. At present, the business has capacity to produce 10 000 units per month. The book is growing in popularity overseas, and an order for 2500 books at a price of $20.00 has been received from an overseas company. This order would not cause a decline in regular sales, but would require the production of an extra 500 books for the month with no change in cost base. Required: a If the order is accepted, by how much will monthly profits be increased or decreased? b What other factors might the owners of 6 Ingredients consider in making their decision to accept or reject the new order from overseas? c Assume that 6 Ingredients has 1000 books left over from last year, which are inferior to the current edition. The books must be sold through regular channels at reduced prices. What unit cost figure is relevant for establishing a minimum selling price for these books? Explain.

Making evaluations 11-36 Let’s assume that in a recent 10-year period, the percentage of Australians who drank coffee was constant at 50 per cent. But the type of coffee that Australians purchased shifted during that time. Growing at a rate of seven to 10 per cent per year, by the end of the 10 years the number of coffee drinkers who purchased coffee beans rather than ground coffee reached 20 per cent. Let’s assume that, rather than change their product mix to reflect the market, two major sellers of coffee, Kraft Foods and Nestle´, cut prices on their Maxwell House and Nescafe´ coffee. Suppose Kraft Foods cut its price per tin of Maxwell House ground coffee by $0.30. Required: What factors and issues do you think Kraft Foods and Nestle´ would have weighed up in making this (hypothetical) decision? 11-37 Show Time Company currently manufactures the hands it uses in the assembly of grandfather clocks. Cost estimates to make each set of hands follow: Direct materials Direct labour Variable overhead Fixed overhead

$

8.00 per set 4.00 per set 2.00 per set 13 000.00 per year

Required: a Prepare an analysis to answer each of the following independent questions: i Assume that all variable costs are avoidable and that the company needs 3000 sets of hands annually. How much of the fixed overhead must be avoidable in order for the company to prefer to buy the sets from an outside supplier at $17 per set instead of continuing to make them? ii Assume that all variable costs are avoidable, that the company needs 3000 sets of hands annually, and that only $6000 of fixed costs are avoidable. Below what purchase price per set of hands would the company prefer to buy the components from an outside supplier instead of continuing to make them? iii Assume that all variable costs are avoidable, that $3000 of fixed overhead is avoidable and that the purchase price of a set of hands is $24. Below what number of sets needed would the company prefer to buy the sets of hands from an outside supplier instead of continuing to make them?

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b Suppose fixed overhead costs include the following: Rent

$ 5 000

Depreciation, equipment

3 600

Foreman’s salary

3 300

Routine maintenance

600

Utilities

500 $13 000

List the fixed costs that you think Show Time could avoid (at least partially) if it purchased sets of hands. What are your reasons for including each of these costs on the list? 11-38 Cooper Manufacturing produces high-quality cabinets. Cooper has been forced to increase prices by about 40 per cent over the last few years, mostly because of the increased costs of purchasing quality wood and other direct materials used in the manufacture of its cabinets. Although Cooper will always have a market for its products among builders of excellence who appreciate quality, the company is losing much of its business to companies manufacturing lower-quality cabinets. Some of Cooper’s departments are operating at about half of their usual capacity. Greg Cooper, the company’s founder and CEO, does not want his name to be associated with poor-quality cabinets. However, he feels that some price reductions are necessary to keep sales from falling. He is more concerned about providing jobs for his employees than with earning a large profit. If sales fall much further, he will not be able to do either. Not a single employee has been laid off, and nor has anyone received less than a full pay cheque, even though many skilled craftspeople have ’pushed brooms’ and done odd jobs these last few months. Recently, one of Greg’s foremen suggested that the company attempt to manufacture some of the components currently being purchased. Greg and the foreman choose to study the possibility of manufacturing a two-way hinge to be used on the doors. The staff was quite excited when it was decided that the kind of equipment needed to manufacture the hinge was owned by the company already and not currently in use. Production would be no problem for the skilled craftspeople employed by Cooper. It took about a week for Greg’s accountant to find all the information necessary to prepare the report that follows. Greg knows you are studying Accounting, and has asked your opinion.

22 December Dear Greg,

I’m sorry to report that, after careful study of the costs of manufacturing two-way hinges, I’ve concluded that we can’t afford to make them. We currently use about 5000 hinges of this type per month and are now buying them for $2.50 each. The costs to manufacture 5000 hinges per month would be: Direct materials Direct labour Variable overhead Fixed overhead Total

$ 4 850 3 700 2 175 4 000 $14 725

I’m sorry to bring you this bad news just before the holidays, Greg. We buy hundreds of other components. Perhaps one of them would be cheaper to make than to buy. I’ll be glad to make the cost estimates. Fred West

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Chapter 11 Short-term planning decisions

Required: Prepare a brief analysis of this situation, and write Greg a letter explaining your recommendation about whether his company should make or buy this component. Consider whether it would also be worthwhile to make rather than buy other components. What other issues should Greg consider in making his decision? 11-39 Sunnydays Pre-school has been in operation for about five years. The school has never had any trouble filling its limit: 36 children for the morning session, 36 different children for the afternoon session, and 18 children who stay all day and who are served a hot lunch. Monthly fees are $60 for half-day children and $120 for all-day children. The school has a long waiting list of children whose parents want to enrol them for half-days. All-day children are accepted at the pre-school if their parents qualify for assistance under a government day-care program. Under this program, the government pays half of the monthly tuition up to a maximum of $100. New regulations taking effect on 1 January would require accreditation before funds can be paid under this program. This would require that at least one teacher be certified by the state for teaching at the pre-school level. Currently, none of the pre-school’s three teachers is qualified for certification. The director of the pre-school feels that the loss of government funds would pose a serious threat to the school. She believes that a certified teacher could be hired, although this would cost the school $900 per month. Monthly fees could be raised to $75 for half-day children and $150 for all-day children. The director is uncertain how this would affect enrolment, however. Alternatively, the school could give up the all-day children who currently receive funding. Several other local pre-school centres (some charging as little as $100 per month) have room to take all of the allday children. Monthly operating costs for the pre-school are as follows: Rent

$ 300

Utilities

160

Salaries

2 400

Insurance

100

Toys and supplies

360

Lunches

378

Total monthly cost

$3 698

Toys and supplies are variable at rates of $5 per half-day child per month and $10 per all-day child per month. Required: a What problem does the director have to solve? b Suppose the director has placed you on an advisory committee formed to make a recommendation about a solution to the problem. With your committee, make a list of possible alternatives that she could consider. c Assume the director has reviewed all possible choices and has reduced the decision to two possible alternatives: (i) to close the all-day program, do not raise tuition and do not hire the new teacher; and (ii) to keep the all-day program open, raise tuition and hire the new teacher. List the costs and revenues that you think will be relevant in the analysis of these two alternatives, and give a reason for including each on the list. d With your committee, make a list of other information you would like to have before advising the director on which of the two alternatives she should choose.

Challenging questions 11-40 Pringle Paper Products is considering converting some of its fine writing paper into fancy stationery. The company currently is able to sell all of the fine writing paper it can produce, but believes that its profit might be improved by giving up some of its fine writing paper sales to produce higher-priced stationery. Although the factory would not have to be expanded for this new processing, new printing equipment would have to be leased at a cost of $19 680 per year. In addition, packaging equipment currently in full-time use in other production would be reassigned to this new processing, thus slightly reducing production capability for another product. The lost sales for this other product would result in opportunity costs of $0.02 per box of stationery packaged. Costs of converting the fine writing paper into fancy stationery

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include direct labour and overhead costs totalling $0.40 per box of stationery. Increased delivery costs and the cost of fancy display cartons are expected to cause variable selling costs to be higher for fancy stationery than for writing paper. The company believes that customer demand will be 10 000 boxes of stationery per year for an indefinite number of years. Pringle estimates that if it does not convert some of its writing paper into fancy stationery, it will earn $50 000 revenue and incur $2000 in variable selling costs on that writing paper. It also estimates that if it does convert this writing paper into stationery, it will earn $90 000 revenue and incur $5000 in variable selling costs for the stationery. Required: a Prepare an analysis showing the relevant costs and revenues of each alternative, and decide which alternative should be chosen based on this analysis. b Do you think your decision might change if you knew the manufacturing costs required to produce the fine writing paper? Why or why not? c What if customer demand turns out to be lower than 10 000 boxes of stationery per year? At a minimum, how many boxes of stationery must Pringle sell to justify your decision in (a)? 11-41 Music, Music, Music Company has just completed a study suggesting that sales of two of its products, sheet music and CDs, could be increased by spending more on advertising. The following table shows how many additional units of the two products could be sold if advertising for each were increased: Amount spent on advertising sheet music

Additional sales of sheet music (units)

$1 000

400

2 000

800

3 000

1 100

4 000

1 200

Amount spent on advertising CDs

Additional sales of CDs

$1 000

400

2 000

800

3 000

1 200

4 000

1 600

Sheet music has a contribution margin of $7.00 per unit, and CDs have a contribution margin of $6.00 per unit. The company has a total of $4000 to spend on additional advertising. The head of marketing, Harry Hill, has asked your boss for a recommendation about how much to spend on advertising for each product in order to increase profit by the greatest amount, and your boss has passed the question on to you. Required: a Calculate the increase in the company’s profit if the $4000 is spent on advertising sheet music alone. b Calculate the increase in the company’s profit if the $4000 is spent on advertising CDs alone. c Calculate the increase in the company’s profit if only $3000 is spent on advertising sheet music alone. How do you explain the difference between this increase in profit and the increase in profit you calculated in (a)? d Write a memo to Mr Hill to send to your boss recommending how much additional advertising to spend on each product (up to $4000 total) in order to increase profit by the greatest amount. Be sure to include the reasoning behind your recommendation.

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Chapter 11 Short-term planning decisions

Dr Decisive Yesterday, you received the following letter for your advice column in the local paper:

Dear Dr Decisive, My Dad is a very organised person (control freak) and prefers to think things through before he does anything, especially if it involves money. I, on the other hand, process information very quickly and value experience and ‘snapchat’ (memories) over material things. He claims that he is just being conservative and wants me to have the material things in life that he did not have. This is becoming a real problem for us, and I am beginning to wonder if we can ever see eye to eye. Here’s a typical example of how different we are. Yesterday, I was telling him about my plans for a holiday with my closest friends and all the decisions and plans we were needing to make. My best friends and I are planning to go to visit Uluru. This has been a dream of mine for a long time. My Dad, knowing I have a very limited budget, does not want me to go. He thinks I should stay home and increase my savings so I can buy a house. Despite my Dad’s badgering and belittling, I still want to go. I have made the following list of choices that my friends and I have to make: Travel to Uluru:

Fly Drive

Length of stay:

Three days Five days

Transportation:

Car (hire) Bus

Go or not:

Go Stay at home and work

Lodging:

Tent Motel Apartment

Food/Meals:

Take food Buy Food

I need your help. I know there’s an organised way of making sense of all of these choices and deciding what to do. My Dad says I should ’just not go’ (that’s what he would do). Now that he’s made the decision (in his mind), he doesn’t want to talk about it anymore. Help! How can I make a decision? Is there a process? Maybe when my Dad sees your response, he will see the value of lifetime memories. Call me . . . ‘Frustrated and Undecided’ P.S. Why do you think my Dad cannot see my point of view?

Required Meet with your Dr Decisive team and write a response to ‘Frustrated, and Undecided’.

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Endnotes a

Kissinger, H (1978) ‘Man of the year: They are fated to succeed’. Time, 111(1). ABC News (2008) ‘Fisher & Paykel to shut down Australian Operations’ (17 April). http://www.guide2.co.nz/money/news/ business/workers-shocked-as-jobs-moveoffshore/11/586. Accessed 11 May 2017. c Anthony, J (2019) ‘Air New Zealand announces sweeping changes including launch of new Seoul route following company-wide review’, stuff.co.nz, 28 March, https://www.stuff.co.nz/travel/news/111606433/air-nz-announces-sweeping-changes-includinglaunch-of-new-seoul-route-following-companywide-review. d See https://www.interface.com/APAC/en-AU/sustainability/climate-take-back-en_AU. e Australian Competition & Consumer Commission (2020), ‘Takata airbag recalls list’, https://www.productsafety.gov.au/recalls/ compulsory-takata-airbag-recall/takata-airbag-recalls-list. f Heath, T (1995) ‘Tyson Foods finds unwelcome spotlight blazing upon it’. Des Moines Register, 30 July, Sec. J, 1, 2. g See http://www.fujixerox.com.au (‘Environmental scorecard’, ‘Crate studies’ and ‘Design for the environment’). b

List of company URLs u u u u u u

Fisher & Paykel: http://www.fisherpaykel.com/au Fuji Xerox: http://www.fujixerox.com.au Interface Global: http://www.interfaceglobal.com McDonald’s: http://www.mcdonalds.com.au Air New Zealand: https://www.airnewzealand.com.au Tyson Foods, Inc: http://www.tyson.com

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12 CAPITAL EXPENDITURE DECISIONS

‘There will be no profit if the outlay exceeds the receipts.’ Plautusa

Learning objectives After reading this chapter, students should be able to do the following: 12.1 Understand what a capital expenditure decision is and realise its significance to a business. 12.2 Know what to assess and consider when making a capital expenditure decision. 12.3 Understand how to use net present value (NPV) as a tool to evaluate a capital expenditure decision. 12.4 Be familiar with the use of additional assessment tools, particularly payback and the accounting rate of return (ARR) methods for capital expenditure decisions. 12.5 Understand how to assess and select between alternative investment proposals, including consideration of non-financial aspects, such as social and environmental impacts. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions

Understanding the learning objectives is assisted in the chapter by asking key questions:

Key questions 1

What is capital expenditure and what are the four steps in a capital expenditure decision?

2

What does a business include in the initial cost of a capital expenditure proposal?

3

What are the relevant costs of a capital expenditure proposal, and how do operating income, depreciation and ending cash flows affect these costs?

4

How does a business determine the rate of return it requires on a capital expenditure proposal?

5

How does a business use the net present value (NPV) method to evaluate a capital expenditure proposal?

6

What is the difference between the payback method and the accounting rate of return on investment method for evaluating a capital expenditure proposal?

7

How does a business decide which capital expenditure proposal to accept when it has several proposals that accomplish the same thing, or when it cannot obtain sufficient cash to make all of its desired investments?

8

Why are non-financial considerations, such as the environmental and social impacts of an investment, important?

Have you ever purchased, or considered purchasing, a car? If so, you probably thought about how the car looked, how much power it had, how comfortable it was, how it performed on the road and how it compared with other cars. More importantly, you very likely weighed not only the price of the car but also how much the payments would be, and when you would make them (including costs for upkeep and repairs). Also, you probably considered how well the car would retain its value, and what its potential value would be when you were ready to sell it. A business makes a similar decision when it invests in property and equipment, and in certain long-term projects. In this chapter, we will discuss a business’s long-term decision making involving capital expenditures. Like the decision to purchase a car, a capital expenditure decision involves considering related cash receipts and payments that occur at different times, perhaps over several years. So in this type of decision making, a manager must understand such issues as how to estimate cash receipts and payments, what cash receipts and payments are relevant to the decision to make a capital expenditure and what steps must be completed in the process of making the decision. For long-term decision making, a manager needs to consider the time value of money, and therefore must have an understanding of present value calculations, concepts we introduced in Chapter 10.

12.1 Capital expenditure decisions capital expenditure Cost that increases the benefits a business will obtain from an asset

474

A capital expenditure decision is a long-term decision in which a business determines whether or not to make an investment (cash payment) at the time of the decision in order to obtain future net cash receipts totalling more than the investment. The future net cash receipts related to the investment provide a return on the investment. This return is what makes a business want to make a capital expenditure (investment). Most companies have a large number and a wide variety of investment (capital expenditure) opportunities each year. They can expand factory or office size, replace old equipment, purchase additional new equipment, introduce new products, increase inventories, start an employee training program, or engage in a special advertising campaign, to name just a few possible activities. These opportunities or Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 12 Capital expenditure decisions projects come to the attention of a business’s managers in the form of proposals to invest cash. Because these proposals involve estimating future cash receipts and payments over several years, capital expenditure decisions are sometimes referred to as capital budgeting decisions.

Stop & think Do you plan to own your own home? According to the Australian Bureau of Statistics, in 2017–18 about two thirds (66 per cent) of Australian households owned their own home with or without a mortgage, a decrease from 68 per cent in 2015–16. This is a significant capital investment. What planning and assessment might you need to do if home ownership were your goal?b Many institutional investors are now also screening investments using some sustainability or corporate responsibility criteria. The Ceres Investor Network, which includes the Investor Network on Climate Risk (INCR), for example, is a network of over 170 institutional investors, managing more than US$26 trillion in assets, and is committed to addressing the risks, as well as seizing the opportunities, resulting from climate change and other sustainability challenges. Members work together and share best practice on environmental, social and governance issues to seek strategies and policy solutions, with advice from Ceres on managing carbon, water and supply chain risks. Members also seek to promote improved disclosure on sustainability issues via capital markets and stock exchanges, encourage sustainable investment and seek to influence government policy.c

Ethnics and Sustainability

When do businesses make capital expenditure decisions? Generally, large capital expenditure decisions, such as the purchase of a new building or relocation and upgrade of facilities, will be taken as part of the organisation’s strategic planning process. (This was discussed in Chapter 1, when the process for decision making was outlined.) Good planning is essential to success. However, unexpected opportunities may arise in any business, and decisions will need to be made about whether to accept those opportunities and expend or accept funds to take advantage of the situations. Examples include a larger company offering a large sum of money for a percentage of the operations of a business, an offshore company wanting to market a business’s products overseas or a company offering a great sponsorship deal in exchange for exclusive rights.

12.2 Making a capital expenditure decision Before making significant decisions, it is important to understand how your business is performing. As discussed in Chapter 3, businesses should monitor actual results and compare them with budgeted results throughout the year. It is important to undertake this exercise (for the whole year) at the end of each financial year.

Comparing actual results with budgeted results When making both short- and long-term decisions – in particular, capital expenditure decisions – it is necessary to understand your business and how it is performing. Comparing trends across years and monitoring actual results in relation to budgeted results allows managers to make informed decisions. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Accounting Information for Business Decisions Case Exhibit 12.1 contains the financial statements of DeFlava Coffee. These allow comparison of the actual results achieved for the year with the results that were budgeted at the start of the year. Given that budgets are only estimates, variances often occur. It is important to understand what the variances are, what their value is, whether they are positive or negative, and why the variances occurred. Some variances occur simply because of the way in which budget figures are estimated. Many companies will use the actual results from the year before and adjust for a certain percentage. Others will use zero-based budgeting, which does not start with previous figures but rather sets all budgets back to zero, and requires all budgeted expenses to be justified again for each new period. Other variances also occur that are beyond the control of the organisation, such as changes in legislation or compliance requirements, changes in price by suppliers and repairs to assets that were not envisaged. In interpreting the figures contained in Case Exhibit 12.1, note that for the purpose of the example, positive variances are highlighted in black and negative variances are in brackets in blue. A positive variance occurs when the actual results are better than expected. For income, that means greater than budgeted; for expenses, it means actual figures were less than expected. After examining the figures and the variances highlighted in the income statement, it is clear that production costs for DeFlava Coffee Case Exhibit 12.1 DeFlava Coffee’s financial statements DEFLAVA COFFEE CORPORATION Income statement For year ended 30 June 20X1 Budgeted results $

$

Sales

Actual results $

$

Variance

$

1 356 000

$

$

1 459 000

103 000

Less: Production costs Materials

398 000

376 600

21 400

Labour

203 000

127 000

76 000

Production overhead

158 000

208 000

(50 000)

Total production costs

759 000

711 600

47 400

Gross profit

597 000

747 400

150 400

Less: Selling expenses Marketing

42 000

49 560

(7 560)

Distribution

34 215

37 000

(2 785)

Salaries

32 455

37 800

(5 345)

Total selling expenses

108 670

124 360

(15 690)

Administration Utilities

36 750

54 990

(18 240)

Salaries

41 950

38 560

3 390

Insurance

14 015

15 600

(1 585)

Customer service

12 110

Total administrative expenses

13 200 104 825

(1 090) 122 350

(17 525)

Financial Interest on loan Bad debts Total financial expenses

476

18 900

15 600

3 300

6 780

3 450

3 330

25 680

19 050

6 630

Total expenses

239 175

265 760

(26 585)

Net profit

357 825

481 640

(123 815)

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Chapter 12 Capital expenditure decisions

Balance sheet As at June 20X1 Budgeted results

Actual results

Variance

Current assets Cash at bank

101 000

142 000

41 000

Accounts receivable

35 000

57 000

22 000

Inventory

49 000

31 500

(17 500)

GST paid

54 000

57 000

3 000

Prepaid expenses Total current assets

3 300

3 300

0

242 300

290 800

48 500

Non-current assets Property, plant and equipment Less: Accumulated depreciation

545 000 85 000

Land

545 000 460 000

85 000

400 000

Total non-current assets Total assets

0 460 000

0

450 000

50 000

860 000

910 000

50 000

1 102 300

1 200 800

98 500

Less: Current liabilities Accounts payable

23 000

GST collected

61 000

31 000

(8 000)

63 000

(2 000)

84 000

94 000

(10 000)

500 000

500 000

0

Non-current liabilities Loans payable Total liabilities

584 000

Owners’ equity/shareholders’ funds Total liabilities and shareholders’ funds

594 000

(10 000)

518 300

606 800

88 500

1 102 300

1 200 800

98 500

were $47 400 less than expected. Further investigation might reveal that this was due to a reduction in materials cost of $21 400 as a result of sourcing coffee beans from a different supplier at a cheaper rate. At the same time, labour costs were $76 000 less than budgeted, and production overhead costs were $50 000 greater than expected. The explanation for this might be that cheaper labour has been employed, or that upgrades to production equipment have occurred, resulting in a smaller labour force. However, the increase in production costs might also be a result of repairs to old equipment, prompting a need to make capital expenditure on new equipment. Another aspect that management would discuss is the higher than expected selling expenses. However, there has also been a positive variance in the sales revenue figure of $103 000, and the better than expected sales figures could be a result of the decision made to increase selling costs by $15 690 to achieve a better revenue result. The utilities cost of $18 240 is significantly greater than expected. Investigation might reveal that this was largely due to increases in energy costs, so consideration should be given to capital expenditure outlays to install alternative energy sources or more energy-efficient systems. Some variances might be explained by comparing the variances in both the income statement and the balance sheet. The interest on loans, for example, is less than expected. This could be due a partial repayments of the loan, but the balance sheet shows that the amount owed is unchanged and as expected at $500 000. A more likely explanation might be a reduction in the interest rates charged - whether as a result of macro economic conditions beyond the business’s control, or the result of a renegotiation with the lender. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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1

What is capital expenditure, and what are the four steps in a capital expenditure decision?

2

What does a business include in the initial cost of a capital expenditure proposal? initial cost Expected cash payment to put a capital expenditure proposal into operation

When examining the balance sheet, it is important to note how cash is ‘tracking’ in terms of capacity to undertake capital expenditure decisions. Actual cash result was $41 000 better than budgeted. Accounts receivable was also higher than budgeted, by $22 000. However, this indicates that debtors are taking longer to pay their debts, which will, in the long term, affect liquidity. As you can see, it is critical to understand your business and how it is performing before establishing capital expenditure proposals and advancing to the next step, beginning an analysis of these proposals. As a general rule, a capital expenditure proposal is acceptable to a business when its return on investment is greater than the cost to the business of providing the cash to make the investment. Therefore, to determine whether a capital expenditure proposal is acceptable, a business must complete four more steps. First, the business must estimate the initial cash payment needed to make the investment. Second, the business must estimate the future cash receipts and payments (cash flows) expected from the investment, and the time period over which it expects these future cash receipts and payments to occur. Third, the business must determine the cost of providing the cash to make the investment. Finally, the business must determine whether the estimated future cash flows will provide it a return that is sufficient (after adjusting for the time value of money) to cover the cost of providing the cash to make the investment. If the cash flows of a proposal will produce a return on investment that is higher than the cost of providing the cash to make the investment, the difference contributes to the longterm profitability of the business. This makes the proposal acceptable for the business. If the return on investment will be less than the cost, the proposal is undesirable and should be rejected. We will discuss each of the preceding steps in the following sections.

Estimating the initial cash payment Whenever a business makes a capital expenditure decision, one of the first questions it asks is, ‘What is this going to cost?’ The question may be broken down into two parts: (1) the initial cost; and (2) the cost(s) incurred in later years. We will discuss any costs incurred in later years in the estimated future cash receipts and payments section of this chapter. The initial cost is the expected cash payment to be made to put the proposal into operation. In other words, it is the capital that the business must expend (capital expenditure) to make the investment. For instance, a business may be deciding whether or not it should invest in a new machine that it will use for six years. A supplier has quoted a price of $22 000 (including GST) for the machine. The business expects to pay transportation costs of $1760 (including GST) to get the machine to its factory, and costs of $880 (including GST) for installing the machine. The estimated initial cost of this capital expenditure proposal is $22 400, calculated as: Cost of machine Transportation costs Installation costs Estimated initial cost

$20 000 1 600 800 $22 4001

This $22 400 is the estimated cash payment that the business must make to put the machine into operation (the initial cash payment is the total amount paid less GST). In some cases, a capital expenditure proposal may require the investment of additional working capital. For instance, a new piece of equipment may require an investment in additional raw materials inventory. In this case, for capital expenditure decision making, the additional cost of the investment in raw materials inventory should be included in the estimated initial cost of the equipment. However, with just-in-time (JIT) inventory systems, additional investments in inventory may not be necessary.

1

GST is not included in the estimated initial cost calculations because it is a tax, not part of the asset value. The effects of

GST are therefore ignored in the remainder of this chapter.

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Chapter 12 Capital expenditure decisions

Stop & think Why do you think additional investments in inventory may not be necessary when using a JIT inventory system? You may think that determining the estimated initial costs of a proposed capital expenditure is easier than estimating expected future cash flows because initial costs are incurred at the present time, and are therefore more definite or accurate. This is true in many situations, but not always. In some cases, initial costs involve the use of estimates that are not very precise, and that include large numbers. For instance, take the example of a business that is considering a capital expenditure to build a new 10 000-square-metre factory. What is the initial cost of the factory? The estimated initial cost includes the cost of construction, the cost of all the equipment that goes into building the factory, training costs for the employees and many other costs. A contractor may give a rough estimate of the cost of construction, but is not likely to spend much time on this estimate if the business is only considering building the factory. Estimates of ‘per metre’ costs of construction are available, but they are just that – estimates. These estimates vary from city to city, state to state, and by type of construction, so determining the initial cost of this type of capital expenditure can rely heavily on estimates. Still, a good estimate is better than a guess!

Estimating future cash flows Expected future net cash receipts help to provide the return on an investment. As we show in the following diagram, these net future cash receipts may come in three forms: (1) future cash receipts only; (2) future cash receipts that are more than future cash payments; or (3) savings of future cash payments. Return on investment

Future cash receipts only

Future cash receipts in excess of future cash payments

Savings of future cash payments

The return from some investments comes from future cash receipts only. An example of this is when a business buys shares/stocks or bonds of another business to receive dividends or interest. The dividends or interest received plus the eventual selling price of the securities (all cash receipts) provide a return when they are more than the amount initially invested in the securities. In other cases, both future cash receipts and payments affect the return from the investment. For example, suppose DeFlava Coffee invests in additional equipment to be able to produce and sell more bags of coffee beans. If the cash receipts from increased sales are more than the cash payments for increased production and selling costs, the increase in the net cash receipts (the difference between the future cash receipts and cash payments) provides a return on the investment when it is more than the amount that DeFlava Coffee initially invested in the additional equipment. Finally, some investments do not involve increasing future cash receipts, but instead involve reducing future cash payments. The effect on a business’s cash, however, is the same. The benefit received by the decrease in future cash payments can also provide a return on the investment. For example, suppose a local newspaper invests $4500 today in an employee training program that is expected to save $1500 in payments for labour costs each year for five years. This investment has the same expected return for the newspaper as would investing $4500 to increase cash receipts from sales of advertising space in the paper by $1500 each year for five years.

Discussion What impacts could social and environmental issues have on cash flows? Consider different

Ethnics and Sustainability

issues that could have positive and negative impacts. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

479

Accounting Information for Business Decisions 3

What are the relevant costs of a capital expenditure proposal, and how do operating income, depreciation and ending cash flows affect these costs?

relevant cash flows Future cash flows that differ, either in amount or in timing, as a result of accepting a capital expenditure proposal

Estimating relevant cash flows Whether you are dealing with future cash receipts only, net future cash receipts or savings in future cash payments, it is important to identify the expected relevant cash flows and to estimate the number of years over which these cash flows will occur. Relevant cash flows are future cash flows that differ, either in amount or in timing, as a result of accepting a capital expenditure proposal. That is, relevant cash flows are: (1) the expected additional future cash flows (either future receipts or payments) over and above a business’s existing cash flows; or (2) the expected savings in future cash payments. Relevant cash flows may be either variable or fixed cash flows. Again, the key is whether there is a change to the business’s cash flows as a result of accepting the proposal. The reason that cash flows differ in amount or timing is relevant is that this affects the business’s long-term profitability. Capital expenditure decisions involve whether or not to make a long-term investment – to buy a machine or not to buy it, to expand the size of the factory or not to expand it, to introduce a new product or not to introduce it, and so on. We refer to alternatives such as not buying the machine, not expanding the size of the factory or not introducing the new product as the do-nothing alternative. Choosing the do-nothing alternative does not change a business’s cash flows. On the other hand, choosing to accept a capital expenditure proposal – whether it is to buy a new machine, expand the size of a factory or introduce a new product – does cause changes in the business’s cash flows. In evaluating a capital expenditure proposal, it is useful to think of the do-nothing alternative as having zero cash flows, and the capital expenditure proposal as having cash flows equal to the changes it causes. This approach helps you focus on the relevant cash flows from the proposal. Deciding which cash flows are relevant for a capital expenditure decision is similar to deciding what costs are relevant for a short-term decision. Cash receipts and payments that occurred prior to the capital expenditure decision are irrelevant because they cannot be affected by the decision. They are sunk or historic costs. Cash flows that result from activities not required for any of the decision alternatives also cannot be relevant (even if they are future cash flows) because selecting any of the alternatives will not affect them. Such cash flows would be the same regardless of the decision made, and so are not relevant to the decision. A relevant cash flow must be one that differs between the alternative course of action. To be relevant to a particular capital expenditure decision, cash flows must: • occur in the future • result from activities that are required by the proposal • cause a change in the business’s existing cash flows.

Operating income and annual cash flows When a business estimates its relevant future cash flows from a capital expenditure proposal, it uses the best available information for its predictions. Frequently, the best available information is its expected future additional operating revenues and/or expenses. Most revenues and expenses of a business result in related cash receipts and payments of the same amounts at approximately the same points in time. For example, a business usually collects cash from credit sales very soon after the sales occur. Similarly, a business normally pays salaries to employees soon after the employees earn them. As a result, cash receipts from accounts receivable and cash payments for salaries payable in a year are likely to be about the same as the sales revenue and salaries expense for the year. Of course, sometimes large differences occur. For example, sometimes a business prepays expenses for several years. In this case, the business considers the amount of the cash payment and the year in which it makes the payment rather than the annual expense.

Treatment of depreciation Depreciation is another expense for which the related cash flows occur in different years and in different amounts than the expense. For example, if DeFlava Coffee plans to purchase a machine for $12 000 cash and use the machine until it sells it, at the end of 10 years, for the estimated residual value of $2000, the yearly straight-line depreciation expense for each of the 10 years will be $1000 ([$12 000 – $2000] / 10). 480

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Chapter 12 Capital expenditure decisions However, since it plans to pay cash for the machine on the date of purchase, DeFlava Coffee would make no cash payments for the machine in any of those years. The planned purchase and the resale of this machine involve only two relevant cash flows. The first is the cash payment of $12 000 to purchase the machine. The second is the $2000 cash receipt at the end of the tenth year. A capital expenditure analysis should focus on the amounts and timing of these cash flows, and not on the $1000 yearly depreciation expense. It is important to understand that we are not ignoring this major cost; we are simply treating it in a different way.2

Stop & think Even though depreciation is not a cash flow, it affects a business’s income tax payments. How do you think depreciation expense would affect a business’s income tax payments over the life of the related asset? (Hint: a business is usually able to claim depreciation of most assets used in the business as a tax deduction in their tax return. However the method of calculation of tax allowable depreciation will be stipulated by the Australian Tax Office.)

Ending cash flows

2

Newspix/Nathan Richter

A capital expenditure proposal may have some relevant cash flows occurring at the end of the project’s life. For instance, in the example we just presented for depreciation, there was a cash receipt (the residual value) at the end of the machine’s life. Another example relates to the possibility of investing in additional working capital – that is, inventory – at the beginning of a project. If this occurs, the business will recover the working capital at the end of the project (when the business sells the final items of inventory), and will treat this recovery as a cash receipt. Not all proposals have cash receipts at the end of the project’s life. In fact, in some cases there will be an additional cash payment. For instance, it is sometimes necessary to pay to have fully depreciated and used-up factory equipment removed. A business therefore needs to determine not only the relevant case flows of the capital expenditure proposal, but also the timing of the cash flows, to fully evaluate the potential return on investment. When a business decides to accept a capital expenditure proposal, it stores the information it used to analyse the proposal in its integrated accounting system. Later, it may use the information in its accounting process. For instance, based on a capital expenditure analysis, a business decides to purchase a new machine. As the business uses this machine, it retrieves information about the machine’s estimated life and estimated residual value from its integrated accounting system for use in its depreciation expense calculations. Large and small businesses, local councils and governments all need to consider capital expenditure proposals to meet their future needs. Such projects often represent huge investments and predicting cash flows can be difficult. An example in Queensland, Australia, is Brisbane City Council’s TransApex Plan, designed to meet demands for cross-city transport. In the 2000s, the council planned five main infrastructure projects and completed three tunnels (Clem 7, Legacy Way and Airport Link) and one bridge (the Go-Between Bridge) between 2010 and 2015, with the fifth project (the East-West Link) not mentioned in the 2018 Transport Plan for Brisbane - Strategic Directions, with other projects taking priority. Difficulties in estimated costs of construction and forecasting revenues from tolls caused controversy with the operator of the Clem7 tunnel (RiverCity Motorway) going into receivership in 2011.d

The depreciation that a business includes on its tax return provides yearly cash savings in income taxes. However, for

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481

Accounting Information for Business Decisions 4

How does a business determine the rate of return it requires on a capital expenditure proposal?

cost of capital Weighted average cost (rate of return) a business must pay to all sources of capital

Determining the required return on investment For any capital expenditure proposal, the question arises of the business’s required return on its investment. The required return is equal to the cost of providing cash for the investment, and is expressed as a percentage rate. For instance, a 15 per cent rate means that the cost is 15 cents per year for every dollar invested. A business’s financial position improves as a result of accepting a capital expenditure proposal only when the proposal provides a return on investment that is higher than the cost of providing the cash for the investment (in this case, greater than 15 per cent). The rate that measures the cost to a business of providing cash for investments is called the business’s cost of capital. A business’s cost of capital is the weighted-average cost (rate of return) it must pay to all sources of capital. Remember that a business receives its capital from short-term borrowing (e.g. issuing notes payable), long-term borrowing (e.g. issuing bonds payable) and shareholders (e.g. selling shares). Each of these creditor and shareholder groups demands a return on its investment in the form of interest, dividends or increased market value. The key to determining a business’s cost of capital is to combine these returns into an average return. There are several ways a business may calculate its average cost of capital. One simple way is to determine the return demanded by each group and then weight this rate by the proportion of the business’s total capital that the group has provided. For instance, suppose a business’s total capital consists of 40 per cent liabilities and 60 per cent shareholders’ equity. The liabilities pay an interest rate of 8 per cent, and shareholders expect a return of 12 per cent. In this example, the business’s weighted average cost of capital is 10.4 per cent, calculated as follows: Proportion of equity

Required return

Debt

40%



8%

¼

3.2%*

Shareholders’ equity

60%



12%

¼

7.2%

Cost of capital

10.4%

* The tax rate can also affect this percentage, so the formula can be expanded to include tax as follows:

WACC ¼ E/V  RE þ D/V  RD  (1  Tc) where: WACC ¼ Weighted average cost of capital E ¼ Market value of firm’s equity D ¼ Market value of firm’s debt RE ¼ Cost of equity RD ¼ Cost of debt V¼EþD E/V ¼ Percentage of financing that is equity D/V ¼ Percentage of financing that is debt Tc ¼ Company tax rate.

required rate of return Cut-off rate used to distinguish between acceptable and unacceptable capital expenditure proposals

482

A business’s cost of capital is the cut-off rate used to distinguish between acceptable and unacceptable capital expenditure proposals. In other words, the return on the proposed capital expenditure must be equal to or greater than the business’s cost of capital to be acceptable. In this example, the return must be equal to or greater than 10.4 per cent. We are not concerned here with calculating a business’s cost of capital. We stress that a proper cut-off rate must be set and used consistently in evaluating whether capital expenditure proposals will benefit a business. In the rest of this chapter, and in the end-of-chapter questions, we will refer to this cut-off rate as the business’s required rate of return. (Note that required rate of return, which we introduced in Chapter 10, can also be referred to as the discount rate.)

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Chapter 12 Capital expenditure decisions

Determining acceptable capital expenditure proposals The return on an investment comes from the receipt of future net cash receipts that total more than the investment. For example, if a $300 investment provides a net cash receipt of $363 two years later, the investment earns a return. The receipt of $363 can be thought of as the sum of: (1) a return of the investment ($300) plus (2) a return on the investment ($63). Regarding a capital expenditure proposal, the question is whether the expected return on the investment is high enough to make the investment acceptable. An acceptable rate of return on a capital expenditure proposal is one that is equal to or higher than the business’s required rate of return. An unacceptable rate of return is lower than the required rate of return, in which case the proposal should be rejected. A business may use several methods to analyse whether the rate of return on a capital expenditure proposal is acceptable. In Chapter 10, we discussed the time value of money and what we mean by present value. We learned how to use Table 10.1 to calculate the present value of a single sum of money to be paid at the end of, say, three years using a required rate of return of, say, 10 per cent. We understood that the process of converting a future amount to a present value is called discounting. Using Table 10.2, we learned how to calculate the present value of an annuity, which is a series of equal periodic future cash flows to the business. We now discuss further how a business makes capital expenditure decisions. As we mentioned earlier, a business has the choice of using one or more of several approaches to evaluating capital expenditure proposals. We will discuss three of these: (1) the net present value (NPV) method, (2) the payback method, and (3) the average rate of return on investment method.

Discussion How should non-financial factors such as social and environmental impacts be considered in determining acceptable capital expenditure proposals? Are you able to think of two capital projects local to you that would have social and/or environmental impacts as well?

12.3 Net present value (NPV) method The net present value (NPV) method is one approach to evaluating whether or not to undertake a capital expenditure proposal. We introduced this method in Chapter 10. You will remember that the NPV method takes into consideration the time value of money and involves a three-step process, shown in Exhibit 12.2.

Ethnics and Sustainability

5

How does a business use the net present value (NPV) method to evaluate a capital expenditure proposal?

Case Exhibit 12.2 NPV method three-step process

1

Determine the initial expected cash payment (investment) required to implement the capital expenditure proposal.

2

Determine the present value of the expected future net cash receipts from the capital expenditure proposal.

3

Determine the net present value by subtracting the amount of step 1 from the amount of step 2.

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483

Accounting Information for Business Decisions

Source: Dilbert ª (1993) Scott Adams. Used by permission of ANDREWS MCMEEL SYNDICATION. All rights reserved.

net present value (NPV) Present value of the expected future net cash receipts and payments minus the initial cash payment for a capital expenditure proposal

Step 1 involves determining the expected cash payment (investment) needed to put the proposal into operation. This investment is already stated at its present value, since it takes place at the present time, just before beginning the project. Step 2 involves first estimating the expected future cash receipts and payments (including the timing of the cash flows and the length of time over which the business expects these cash receipts and payments to occur), as we discussed earlier. It then involves discounting the expected future net cash receipts (Future cash receipts – Future cash payments) for each year to their present value using the business’s required rate of return (its cost of capital). Step 3 involves calculating the NPV. The net present value (NPV) of a capital expenditure proposal is the present value of the expected future net cash receipts and payments minus the expected initial cash payment (investment). When the NPV is zero or positive, the capital expenditure proposal is acceptable because the project will earn at least the business’s required rate of return. When the net present value is negative, the capital expenditure proposal is not acceptable because it will earn less than the business’s required rate of return. As the cash flows are estimates, however, it is unlikely that a business will invest in a capital project with a near-zero expected return unless there are significant non-financial considerations making the project worthwhile. We can summarise these decision rules as follows.

When the NPV is:

The decision rule is:

Zero

Acceptable; rate of return on the proposal is equal to the required rate of return.

Positive

Acceptable; rate of return on the proposal is greater than the required rate of return.

Negative

Not acceptable; rate of return on the proposal is less than the required rate of return.

We will illustrate the NPV method with two examples.

Example 1: Capital expenditure proposal – build new factory In the first example, DeFlava Coffee is considering building a new factory. The factory will be 10 000 square metres in size. Construction costs are estimated to be $700 per square metre, or a total of $7 000 000 (10 000  $700). Equipment, installation and training costs are expected to be $1.92 million. The business estimates that the new factory will be used for 12 years, after which it (and the equipment) will be sold for $1 million (the residual value). Therefore, it calculates its expected depreciation on the factory and equipment to be $660 000 per year. The factory is expected to increase the business’s operating revenues by $8 million per year, and to increase its operating expenses (including depreciation) by $6.66 million per year. DeFlava Coffee’s required rate of return is 14 per cent. Should DeFlava Coffee build this factory? To analyse this capital expenditure proposal, DeFlava Coffee first determines the expected initial cost of the investment. In this case, the initial cost is $8.92 million ($7 000 000 þ $1 920 000). The business then determines the amounts and timing of its expected additional future cash flows. DeFlava estimates it will have $8 million additional cash receipts from operations in years 1 to 12. The business estimates it will have $6 million additional cash payments for operations in years 1 to 12. (Note that, although DeFlava estimated that operating expenses would be $6.66 million per year, it excluded the $660 000 484

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Chapter 12 Capital expenditure decisions depreciation from the analysis because the depreciation does not involve a yearly cash payment.) So its expected future net operating cash receipts are $2 million per year for years 1 to 12. DeFlava also estimates it will have a $1 million cash receipt from the residual value at the end of year 12. Since the business’s required rate of return is 14 per cent, it uses this percentage as the discount rate to calculate the present value of the future cash flows. We show the calculation of the NPV of building this new factory in Case Exhibit 12.3. DeFlava Coffee calculated the present value of its expected future cash flows first. Note that the business listed each type of cash flow, along with the year(s) during which it expects the cash flow to occur and the future amount of the cash flow. It then multiplied each future amount by the appropriate present value factor for the 14 per cent required rate of return. Case Exhibit 12.3 Capital expenditure proposal: build new factory Present value of expected future net cash receipts Years Future amount 

Type Net operating cash receipts

1–12

Residual value

12

14% discount factor

¼

5.6603 

$ 2 000 000* 1 000 000

0.2076

Present value $11 320 600

à

207 600

Present value of expected future net cash receipts

$11 528 200

Expected investment (initial cash payments) Type

Amount 1

2

Factory (10 000 m  $700 m )

$7 000 000

Equipment, installation, training

1 920 000

Initial investment

(8 920 000)

Net present value

$ 2 608 200

Decision: Project is acceptable. * $8 000 000 operating receipts – $6 000 000 operating payments † From Table 12.1 (annuity), n ¼ 12, i ¼ 14% ‡ From Table 12.2 (single amount), n ¼ 12, I ¼ 14%

The net operating cash receipts are an annuity because they occur in the same amounts each year. The present value factor of an annuity for 12 years at 14 per cent can be found in Table 12.1; it is 5.6603. Table 12.1 Present value of an annuity of $1 per period Present value interest factor of an annuity ðPVIFAÞ form Factor ¼ (n) Periods

1%

2%

3%

1  ð½1þi1 n Þ i

4%

5%

6%

7%

8%

9%

10%

11%

12%

13%

14%

1

0.9901

0.9804 0.9709

0.9615

0.9524

0.9434

0.9346

0.9259

0.9174

0.9091

0.9009

0.8929

0.8850

0.8772

2

1.9704

1.9416 1.9135

1.8861

1.8594

1.8334

1.808

1.7833

1.7591

1.7355

1.7125

1.6901

1.6681

1.6467

3

2.941

2.8839 2.8286

2.7751

2.7232

2.673

2.6243

2.5771

2.5313

2.4869

2.4437

2.4018

2.3612

2.3216

3.902

3.8077 3.7171

3.6299

3.546

3.4651

3.3872

3.3121

3.2397

3.1699

3.1024

3.0373

2.9745

2.9137

5

4.8534

4.7135 4.5797

4.4518

4.3295

4.2124

4.1002

3.9927

3.8897

3.7908

3.6959

3.6048

3.5172

3.4331

6

5.7955

5.6014 5.4172

5.2421

5.0757

4.9173

4.7665

4.6229

4.4859

4.3553

4.2305

4.1114

3.9975

3.8887

7

6.7282

6.472 6.2303

6.0021

5.7864

5.5824

5.3893

5.2064

5.033

4.8684

4.7122

4.5638

4.4226

4.2883

8

7.6517

7.3255 7.0197

6.7327

6.4632

6.2098

5.9713

5.7466

5.5348

5.3349

5.1461

4.9676

4.7988

4.6389

9

8.566

8.1622 7.7861

7.4353

7.1078

6.8017

6.5152

6.2469

5.9952

5.759

5.5370

5.3282

5.1317

4.9464

10

9.4713

8.9826 8.5302

8.1109

7.7217

7.3601

7.0236

6.7101

6.4177

6.1446

5.8892

5.6502

5.4262

5.2161

11

10.3676

9.7868 9.2526

8.7605

8.3064

7.8869

7.4987

7.139

6.8052

6.4951

6.2065

5.9377

5.6869

5.4527

9.3851

8.8633

8.3838

7.9427

7.5361

7.1607

6.8137

6.4924

6.1944

5.9176

5.6603

12

"

11.2551 10.5753

9.954

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"

4

485

Accounting Information for Business Decisions The present value of the net operating cash receipts is $11 320 600. Since the $1 million residual value is a single cash receipt at the end of year 12, the 0.2076 present value factor comes from Table 12.2. The present value of the residual value is $207 600. Table 12.2 Present value of $1 due in n periods Present value interest factor ðPVIFÞ formula 1 Factor ¼ ð1 þ i Þn (n) Periods

2%

3%

4%

5%

6%

7%

8%

9%

10%

11%

12%

13%

14%

0.9901

0.9804

0.9709

0.9615

0.9524

0.9434

0.9346

0.9259

0.9174

0.9091

0.9009

0.8929

0.8850

0.8772

2

0.9803

0.9612

0.9426

0.9246

0.907

0.89

0.8734

0.8573

0.8417

0.8264

0.8116

0.7972

0.7831

0.7695

3

0.9706

0.9423

0.9151

0.889

0.8638

0.8396

0.8163

0.7938

0.7722

0.7513

0.7312

0.7118

0.6931

0.675

4

0.961

0.9238

0.8885

0.8548

0.8227

0.7921

0.7629

0.735

0.7084

0.683

0.6587

0.6355

0.6133

0.5921

5

0.9515

0.9057

0.8626

0.8219

0.7835

0.7473

0.713

0.6806

0.6499

0.6209

0.5935

0.5674

0.5428

0.5194

6

0.942

0.888

0.8375

0.7903

0.7462

0.705

0.6663

0.6302

0.5963

0.5645

0.5346

0.5066

0.4803

0.4556

7

0.9327

0.8706

0.8131

0.7599

0.7107

0.6651

0.6227

0.5835

0.547

0.5132

0.4817

0.4523

0.4251

0.3996

8

0.9235

0.8535

0.7894

0.7307

0.6768

0.6274

0.582

0.5403

0.5019

0.4665

0.4339

0.4039

0.3762

0.3506

9

0.9143

0.8368

0.7664

0.7026

0.6446

0.5919

0.5439

0.5002

0.4604

0.4241

0.3909

0.3606

0.3329

0.3075

10

0.9053

0.8203

0.7441

0.6756

0.6139

0.5584

0.5083

0.4632

0.4224

0.3855

0.3522

0.322

0.2946

0.2697

11

0.8963

0.8043

0.7224

0.6496

0.5847

0.5268

0.4751

0.4289

0.3875

0.3505

0.3173

0.2875

0.2607

0.2366

0.8874

0.7885

0.7014

0.6246

0.5568

0.497

0.444

0.3971

0.3555

0.3186

0.2858

0.2567

0.2307

0.2076

12

"

"

1%

1

The sum of the two present values of the future cash flows is the $11 528 200 present value of the expected future net cash receipts. This amount minus the $8.92 million expected initial investment results in the $2 608 200 positive NPV. The capital expenditure proposal to build the new factory is acceptable because it has a positive NPV. This means that the rate of return on the proposal is greater than the 14 per cent rate of return that DeFlava Coffee requires on its capital expenditures.

Example 2: Capital expenditure proposal – purchase packaging machine Now assume that DeFlava Coffee is considering replacing its existing packaging machine with a new, improved one. In addition to packaging the coffee beans in bags of different sizes and weights, the new packaging machine would also count and identify different product codes. Currently, this counting and identifying is done by an employee. The new machine costs $30 000 to buy, and installation costs are expected to be $500. The old machine could be sold for $400. DeFlava Coffee expects to use the new machine for four years, after which it can sell the machine for $1000 (the residual value). The new machine will not increase production. However, because the new machine does both bagging and counting, DeFlava Coffee estimates that it will save $10 000 per year in employee labour costs. DeFlava’s required rate of return is 14 per cent. Should it purchase the new packaging machine? The expected initial cost of the investment is $30 100, which is the $30 000 cost of the new machine plus the $500 installation cost, less the $400 received from the residual value of the old machine. The future cash flows consist of expected savings in cash payments of $10 000 each year for four years (remember, these are treated like cash receipts) and a $1000 cash receipt from the residual value at the end of year 4. DeFlava Coffee used its 14 per cent required rate of return as the discount rate to calculate the present value of its expected future cash flows. We show the calculations of the NPV of purchasing the packaging machine in Case Exhibit 12.4. 486

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Chapter 12 Capital expenditure decisions Case Exhibit 12.4 Capital expenditure proposal: packaging machine Present value of expected future net cash receipts Years Future amount 

Type Savings in wages Residual value

14% discount factor

¼

Present value

1–4

$10 000

2.9137*

$29 137

4

1 000

0.5921 

592

Present value of expected future net cash receipts

$29 729

Expected investment (initial cash payments) Type

Amount

Cost of machine

$30 000

Installation and testing Less: Residual value of old machine

500 (400)

Present value of initial investment Net present value

(30 100) $

(371)

Decision: Project is not acceptable. * From Table 12.1 (annuity), n ¼ 4, i ¼ 14% † From Table 12.2 (single amount), n ¼ 4, i ¼ 14%

The present value of the future net cash receipts totals $29 729. It consists of two present values: the $29 137 present value of the $10 000 annuity from the savings in labour costs for each of years 1 to 4, and the $592 present value of the new machine’s $1000 residual value received at the end of year 4. DeFlava Coffee subtracted the $30 100 initial investment from the $29 729 to determine the negative NPV of $371. The capital expenditure proposal to purchase a new packaging machine is not acceptable because it has a negative NPV. This means that the rate of return on the project is less than the 14 per cent rate of return that DeFlava requires on its capital expenditures.

Stop & think Can you think of a social consideration for this project, even had the NPV been positive? (Hint: employee.)

Ethnics and Sustainability

Capital expenditure proposal: Purchase shares Determining the price of a share uses a present value formula rather than the NPV used in the previous examples. In this case, we do not know how much the initial investment will be (i.e. the price of the share), but we should have reasonable knowledge of what the dividends from the share will be if the share is purchased. So the price that we should pay for the share is the present value of its predicted future dividends. Let’s look at a simple example to begin. Assume that you want to determine whether a particular share is a worthwhile investment, and that if you buy the share, you will hold it for one year and then sell it. Given past information, you know that the share price has increased, on average, at 5 per cent (0.05) per year over the past five years. At present, the share is trading at $10. The dividend is expected to be 15c per share at the end of the year. If you

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487

Accounting Information for Business Decisions require a 10 per cent (0.10) return on your investment, what is the most you would pay for the share given the information above? 1 If the share value is increasing at 5 per cent per year, we expect the price of the share in 12 months to be: $10  1.05 ¼ $10.50. 2 At the end of one year, if we sold the share, we would have: ($10.50 þ $0.15) ¼ $10.65.

10:65 ¼ $9:68; or, if we use the present value table that folð1 þ 0:10Þ1 lows, $10.65 3 0.9091 ¼ $9.68.

3 The present value is therefore

So $9.68 is the value you would assign to the share today. Given this information, we would not purchase the share for $10, since it would not give us our 10 per cent return. Present value factor for a single future amount PV ¼ (1 þ i)n n/i

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

1

0.9901

0.9804

0.9709

0.9615

0.9524

0.9434

0.9346

0.9259

0.9174

0.9091

2

0.9803

0.9612

0.9426

0.9246

0.9070

0.8900

0.8734

0.8573

0.8417

0.8264

3

0.9706

0.9423

0.9151

0.8890

0.8638

0.8396

0.8163

0.7938

0.7722

0.7513

4

0.9610

0.9238

0.8885

0.8548

0.8227

0.7921

0.7629

0.7350

0.7084

0.6830

5

0.9515

0.9057

0.8626

0.8219

0.7835

0.7473

0.7130

0.6806

0.6499

0.6209

There are three possible options when using this model: 1 Zero dividend growth 2 Constant dividend growth 3 Non-constant dividend growth.

Zero dividend growth In the case of zero dividend growth, let us assume that, if: P0 ¼ Current share price P1 ; P2 ; P3 . . . Pn represent the share price from year 1 onwards D1 ¼ Dividend to be paid at the end of period 1 ðD2 period 2 and so onÞ R ¼ Required rate of return then: P0 ¼

ðD1 þ P1 Þ þ ðD2 þ P2 Þ . . . ð1 þ rÞ1 ð1 þ rÞ2

Since the dividend is always the same in zero growth, the formula can be abbreviated to:   D P0 ¼ r where: D is constant (i.e. the dividend stays the same). Assume Aussie Surfing Company has a policy of paying a 10 cents (0.10) per share dividend each year, and that this is to be continued indefinitely. What is the value of a share in Aussie Surfing if the required return is 20 per cent (0.20)? $0:10 ¼ $0:50; or 50c per share 0:20

488

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Chapter 12 Capital expenditure decisions

Constant dividend growth Suppose we know that the dividend for a given company always grows at a steady or constant rate. Continuing on from the zero growth formula: g ¼ Growth rate D0 ¼ The dividend just paid D1 ¼ The next dividend to be paid ðD1 Þ þ ðD2 Þ P0 ¼ ð1 þ rÞ1 ð1 þ rÞ2 If g > r, the constant growth formula leads to a negative stock price, which cannot occur, so the constant growth model can only be used if: • r > g; and • g is expected to be constant forever. So as long as the growth rate, g, is less than the discount rate, r, the formula for the dividend growth model can be written as: P0 ¼

D0 3 ð1 þ gÞ rg

Suppose that the dividend just paid, D0, is 0.23, r is 13 per cent and g is 5 per cent. The share price is: ð0:23 3 1:05Þ ð0:13  0:05Þ 0:2415 ¼ 0:08 ¼ 3:02 or $3:02 per share today The dividend growth model can be used to estimate the share price at any point in time: P0 ¼

Pt ¼ Share price at a given point in time Dt ¼ Dividend at a given point in time Dt 3 ð1 þ gÞ Dt þ 1 Pt ¼ ¼ ðr  gÞ ðr  gÞ

dividend growth model A formula that can be used to estimate the share price at any point in time

If we take the example above, and want to know the price of the share in five years’ time: Dt ¼ ð0:23 3 1:05Þ5 ¼ 0:2935 ð2:935 3 1:05Þ Pt ¼ ð0:13  0:05Þ Dt ¼ 3:85 or $3:85 per share today In a case where we are given the price in five years’ time (Dt), we only need to use the second part of the formula using Dt: Dt þ 1 rg

Non-constant dividend growth In reality, share prices rarely grow at a constant rate in the short term, so we often need to provide nonconstant estimates of future growth. To do this, we can use a modified version of the dividend growth model. While dividend growth may not be constant in the short term, at some point we have to assume that dividend growth will become constant; otherwise, we would have to calculate the present value for each year in perpetuity – an impossible task.

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489

Accounting Information for Business Decisions Suppose the required rate of return on a share is 10 per cent and dividends are forecast as follows: Year

Expected growth (%)

1

10

2

15

3

20

Year 4 onwards

5

What is the value of a share today? As always, the value of the share is the present value of all future dividends. So we have to first calculate the present value of the share price in three years’ time:   ð1 þ gÞ P3 ¼ D3 3 ðr  gÞ   ð1:05Þ ¼ 0:20 3 ð0:10  0:05Þ ¼ $4:20 in three years’ time Therefore, the price of the share now is: D1 D2 D3 P3 þ þ þ ð1 þ rÞ1 ð1 þ rÞ2 ð1 þ rÞ3 ð1 þ rÞ3         0:10 0:15 0:20 4:20 þ þ þ ¼ 1:101 1:102 1:103 1:103

P0 ¼

¼ 0:91 þ 0:124 þ 0:165 þ 3:156 ¼ 4:354; or $4:35 per share today We can also calculate this using the present value table given in Table 10.1 (Chapter 10). We multiply each of the expected dividends in each of the three years and the value of the share in year 3 by the appropriate present value factors.

Internal rate of return method internal rate of return (IRR) A method of analysis of proposed capital investments that uses present value concepts to compute the rate of return from the net cash flows expected from the investment

The internal rate of return (IRR) is an alternative method for evaluating projects, and is often used in conjunction with net present value (NPV). IRR is the rate of return, or discount rate, r, at which NPV will be equal to zero. For a project to be acceptable, the rate of return as measured by IRR has to be equal to or greater than the required rate of return. IRR is an indicator of the efficiency or quality of an investment, as opposed to NPV, which indicates value or magnitude. IRR can only be calculated accurately if the cash flows from a project are conventional; that is, there is only one change of sign from negative to positive. If there is more than one sign change from negative to positive, as indicated in Exhibit 12.5, then the cash flows are unconventional and IRR is no longer a Exhibit 12.5 Conventional versus unconventional cash flows Conventional cash flows Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

IRR

(20 000)

7 000

7 000

9 000

10 000

5 000

26%

(30 000)

(7 000)

7 000

11 000

12 000

14 000

5%

Unconventional cash flows Year 0

490

Year 1

Year 2

Year 3

Year 4

Year 5

IRR

(20 000)

7 000

7 000

9 000

(10 000)

5 000

N/A

(40 000)

(7 000)

7 000

(10 000)

12 000

11 000

N/A

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Chapter 12 Capital expenditure decisions reliable measure. This is because there are as many possible solutions for the IRR as there are changes of sign between negative and positive cash flows. It is also important to note that if all cash flows are negative for all years of a project, there will be no IRR solution, since there is no return on the investment. Given these issues, NPV is always the most reliable measure of a project’s viability. Calculating IRR is an iterative process – that is, you need to keep adjusting the discount rate used until the NPV equals zero. This rate of return then represents the IRR. IRR can be calculated manually through trial and error, with a financial calculator or with formulas in an electronic spreadsheet. Given the complexity of IRR, its calculation is beyond the scope of this book. However, it is important to understand what IRR represents in relation to NPV.

12.4 Alternative methods for evaluating capital expenditure proposals

6

In addition to the NPV and IRR methods, there are several other methods a business might use to evaluate a capital expenditure proposal. We will discuss two of these: (1) the payback method; and (2) the accounting rate of return method.

What is the difference between the payback method and the accounting rate of return on investment method for evaluating a capital expenditure proposal?

Payback method The payback method evaluates a capital expenditure proposal based on the payback period. We discussed this method briefly in Chapter 10. The payback period is the length of time required for a return of the initial investment. That is, it is the length of time needed for the future net cash receipts to ‘pay back’ the initial cash payment for the capital expenditure. To illustrate, we will return to the previous example, in which DeFlava Coffee was considering whether to purchase a packaging machine. The initial investment was $30 100, and the expected future net cash receipts were $10 000 in years 1 to 4 and $1000 at the end of year 4. The following schedule shows how DeFlava Coffee calculated the payback period: Amount to pay back at beginning of year

Net annual cash receipts expected

Total amount paid back at year-end

payback period Length of time required for a return of the initial investment in a capital expenditure proposal

Amount left to pay back at year-end

Year 1

$30 100

$10 000

$10 000

$20 100

Year 2

20 100

10 000

20 000

10 100

Year 3

10 100

10 000

30 000

100

Year 4

100

11 000

30 100

–

The schedule shows that $30 000 of the investment would be paid back by the end of year 3. Since only $100 of the investment would remain unpaid at the beginning of year 4, and $11 000 of net cash receipts are expected in year 4, the $100 would be paid back in 0.009 years ($100 / $11 000), or after a little more than three days (0.009  365 days) of year 4. Thus, the payback period is 3.009 years. Sometimes a business will use the payback period calculation to determine whether a capital expenditure proposal is acceptable. It does this by setting a maximum payback period for acceptable proposals. A capital expenditure proposal with a payback period longer than the maximum period would not be acceptable. In addition, a business also might use the payback period to judge whether one capital expenditure proposal is better than another. The business would judge the proposal with the shorter payback period to be better. Although this acknowledges that it is preferable to be paid back sooner rather than later, it is not an accurate method of accounting for the time value of money. Unfortunately the payback period is not a good measure for either purpose. There is no objective way to determine an appropriate payback period. So, setting a maximum payback period is arbitrary. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

491

Accounting Information for Business Decisions A project may have a short payback period for a return of the investment and be considered an acceptable proposal. However, the project may provide no return on the investment. Therefore, such a project would not contribute to the overall profitability of the business, and the business should not consider it acceptable. Moreover, the payback period is only calculated using the cash flows up to the payback point. Any cash flows past that point in time, even though they might be large inflows, are ignored in the calculation. In other words, it does not take into account all the cash flows of the proposed investment.

Stop & think Think of a numerical example to illustrate a project that has a short payback period but no return on the investment. Another project may have a payback period longer than the maximum payback period and be judged to be unacceptable under this method. However, the project may provide a large return on the investment later in the project’s life and thus may be considered acceptable under another method. The problem with the payback method is that the payback period focuses on the return of the investment and completely ignores the return on the investment. The payback period calculation cannot by itself provide a sound basis for making capital expenditure decisions.

Accounting rate of return method accounting rate of return A measure of return on investment calculated by dividing the average net profit from an asset by the average investment in the asset

Another approach that a business will use sometimes in making capital expenditure decisions is the accounting rate of return (ARR) on investment. As the name ’accounting’ rate of return suggests, ARR focuses on the profitability of an asset, and gives an average rate of return over the useful life of the asset. This is in contrast to both the NPV and payback methods, which use net cash flows in their calculations. ARR is useful in comparing several different projects, and its focus on profit figures means that is readily understood by users of financial statements and is comparable to other profitability analysis. However, the ARR method has two main drawbacks. The use of income rather than cash flows means some subjective accounting estimates may be included, such as depreciation, and ARR ignores the time value of money. So the AAR method should be used in support of the NPV method, rather than as a standalone measure. If the ARR is greater than the required rate of return, then you only invest in the asset if the NPV is also positive. Average net profit from asset Average investment in asset Annual net cash flow from asset  Annual depreciation on asset ¼ (Amount invested in asset þ Residual valueÞ=2

Accounting rate of return ¼

To calculate ARR, we need to work through three main steps. 1 Calculate average net profit. If you have the accounting profit figures for the life of the project and they vary each year then you need to work out an average by adding the profit figures together (total profit) and dividing by the number of years of the project. If you have cash flow figures then these would first needed to be converted to accounting figures. The main difference will be that the cash flows relating to the asset (purchase and residual value if sold at the end) would not be included in profit figures, but rather an annual estimate of the asset’s depreciation would be used instead. This would mean that you would have to calculate the depreciation (step 2). For example, suppose a business plans to spend $200 000 to buy an asset that has a five-year useful life with a residual value of $35 000. Not including the original cash outflow to buy the asset, the cash flows from the project each year are expected to be as follows: a Year 1: $50 000 b Year 2: $35 000 c Year 3: $45 000 d Year 4: $50 000 e Year 5: $55 000. 492

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Chapter 12 Capital expenditure decisions As these are cash flow figures for the project, they would need to be converted into profit figures, which means deducting depreciation each year and excluding cash flows relating to the asset. The residual value (the amount the business expects to sell the asset for at the end of year 5) would be deducted from the year 5 cash flow and depreciation deducted from each year. The depreciation calculation is shown in step 2. The average yearly profit can be calculated as follows: Year

Cash flow

Residual value

Depreciation

Annual profit/(loss)

1

$50 000

$33 000

$ 17 000

2

35 000

33 000

2 000

3

45 000

33 000

12 000

4

50 000

33 000

17 000

5

55 000

33 000

13 000

Total profit

$ 35 000

$35 000

Average profit

$

7 000

(Note that the cash outflow for the purchase of the machine happened at time zero [prior to the start of the project] and is not included in the year 1 cash flow here.)

2 If necessary, calculate the annual depreciation. Assuming the straight-line method, this is calculated as the initial cost of the asset less the residual value, divided by the useful life of the asset. For example – continuing our calculations – if the cost of the asset was $200 000 and the residual value was $35 000, then the annual depreciation would be $33 000: Annual depreciation ¼

ð200 000  35 000Þ ¼ 33 000 per year 5

3 Calculate the average investment, which is the amount that is invested halfway through the asset’s useful life. This is based on a reduction in the business’s investment in the asset over time due to depreciation. In other words, it is the average of the difference in value from the beginning to the end of the investment’s worth. So to find the average amount invested in the asset, we take the initial investment, add the residual value and divide by two. If the residual value is zero, then the average investment is half that of the initial investment or cost of the asset. Therefore, if our initial investment was $200 000 and residual $35 000 (as above), then: Average investment ¼

annual depreciation The amount by which the value of an asset depreciates per year. This can be calculated as the initial cost of the asset less the residual value, divided by the useful life of the asset

average investment The amount that is invested halfway through the asset’s useful life

ð200 000 þ 35 000Þ ¼ 117 500 2

4 Calculate ARR as follows: Average net profit from asset Average investment in asset 7 000 ¼ 117 500 ¼ 5:96% rounded

ARR ¼

Thus, the ARR is 5.96 per cent. Although businesses sometimes use the payback and the ARR methods to evaluate capital expenditure proposals, these methods do not account for the time value of money. So they should not be used by themselves for capital expenditure decisions. Some businesses use these methods in conjunction with the NPV method to help screen potentially acceptable proposals and to provide supporting analyses.

Stop & think Given what you have learned about present value analysis, how do you think the averaging process might lead a business to accept a proposal that has cash flows occurring late in the life of the project, so that the project would not contribute to its profitability? Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

493

Accounting Information for Business Decisions Exhibit 12.6 summarises the above discussion. Exhibit 12.6 Comparison of capital budgeting models

The net present value (NPV) model is conceptually superior to the payback and accounting rate of return (ARR) models. It takes into account the time value of money and includes all cash flows.

The main strength of the ARR method is that it is based on profitability, but it ignores the time value of money.

The payback period is easy to calculate, highlights risks and is based on cash flows, but it ignores the time value of money and cash flows beyond the payback period (the pattern of cash flows), as well as profitability.

Stop & think What additional information do you think a combination of the three methods could provide that a business would not get using the NPV method alone?

7

How does a business decide which capital expenditure proposal to accept when it has several proposals that accomplish the same thing, or when it cannot obtain sufficient cash to make all of its desired investments?

12.5 Selecting alternative proposals for investment Capital expenditure decisions would be much easier if a business could invest in all proposals that it identified as being acceptable. This is not always possible, however. Consider the two situations we will describe in the next sections, in which a business must select among two or more proposals that it has identified as being acceptable.

Mutually exclusive capital expenditure proposals mutually exclusive capital expenditure proposals Proposals that accomplish the same thing, so that when one proposal is selected, the others are not

494

Capital expenditure proposals often arise because of alternative ways a business has to perform an activity, do a job or provide a service. Sometimes there are several alternatives. In this situation, the capital investment alternatives are called mutually exclusive. Mutually exclusive capital expenditure proposals that accomplish the same thing, so that when one proposal is selected, the others are not. For example, a business might be considering installing air conditioning its offices. Although several makes and models of air conditioners may be available, each with a different set of cash flows, one is enough to do the job. A business evaluating mutually exclusive capital expenditure proposals completes a two-step process. In the first step, the business analyses each proposal to determine whether or not it is acceptable. The business does this analysis using the NPV method. If more than one proposal is acceptable – that is, has a positive NPV – then a second step is necessary. In the second step, the business selects one of the acceptable alternatives by choosing the proposal with the highest positive NPV. When the business selects a proposal in this way, the analysis in the first step provides the information needed for the second step. For example, suppose that DeFlava Coffee is considering replacing its roasting oven with a new, improved one. There are three different roasting ovens on the market, only one of which can be selected. All have the same life and cost about the same, but each would provide different savings in electricity, Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Chapter 12 Capital expenditure decisions labour costs, and so on. As the first step in analysing these mutually exclusive proposals, DeFlava Coffee prepared an NPV analysis for each proposal: Machine

NPV

A

$ 6 300

B

(2 200)

C

4 700

In this situation, DeFlava Coffee would eliminate Oven B after the first step because it has a negative NPV. In the second step, it would select Oven A because it has a higher positive NPV than Oven C.3 Occasionally, a business considers several mutually exclusive capital expenditure proposals with the requirement that it must select one proposal. That is, the alternative of not investing at all is not an available choice. This might happen, for instance, when a business must obtain equipment or facilities to comply with a law. When one of the capital expenditure proposals must be accepted, the best proposal is the one with the highest (most positive) NPV even if that NPV is negative. Suppose, for example, that a recent safety regulation requires that DeFlava Coffee add additional lights to its factory car park. The additional lights require a cash payment, although they will provide no cash receipts. Normally, DeFlava would not make such a capital expenditure because it would result in a negative NPV. Because of the new law, however, not investing in additional lights is an unacceptable alternative. If several different proposals for additional lighting complied with the safety ordinance, DeFlava would choose the proposal with the least negative NPV.

Capital rationing The previous analyses identified acceptable capital expenditure proposals. If a business has enough cash available, all acceptable capital expenditures could be made (including one selected from each set of mutually exclusive proposals). Sometimes, however, a business finds itself with a larger number of acceptable capital expenditure proposals than it can finance. When this occurs, the business must make its capital expenditure decisions in a situation known as capital rationing, which occurs when a business cannot obtain sufficient cash to make all of the investments that it would like to make. A difficult decision arises when this happens. The business must choose which of the acceptable proposals to invest in, which to delay until sufficient funds become available, and which to forget altogether, if necessary. Many approaches to handling this problem have been suggested. A detailed study of these approaches is beyond the scope of this book, but we will discuss the general idea for one approach. This approach involves looking at the acceptable capital expenditure proposals to find all possible combinations that do not require a larger total investment of cash than is available. Under this approach, a business chooses the combination of capital expenditure proposals that provides the highest total net present value for the total investment available. For example, suppose that DeFlava Coffee has $200 000 cash available for capital expenditures during the current budget period, and has three proposals that are acceptable because of their positive NPVs, as follows: Proposal

Initial investment required

capital rationing Occurs when a business cannot obtain sufficient cash to make all of the investments that it would like to make, and thus must choose which of the acceptable proposals to invest in

NPV

A

$200 000

$120 000

B

110 000

80 000

C

90 000

50 000

DeFlava Coffee could accept Proposal A, which would use the entire $200 000 cash available for investment. Or it could undertake both proposals B and C with the $200 000 cash available. In this case, DeFlava should select proposals B and C, because together they provide a higher total NPV of $130 000 ($80 000 þ $50 000) than Proposal A’s $120 000 NPV. 3

Choosing the better alternative may be more complicated when the mutually exclusive capital expenditure proposals require a different amount of investment, or when the numbers of years over which they affect the business’s cash flows differ. We do not discuss these situations in this book. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

495

Accounting Information for Business Decisions

Business issues and values: Capital expenditure Although the methods we have discussed seem to be relatively easy to implement through tables and formulas, not all capital expenditure proposals are easy to quantify. For example, consider a decision about whether to invest in an employee fitness program. A business would be able to measure such factors as the percentage decline in employee smoking as a result of the program, and Ethics and Sustainability

the decline in rates of absenteeism and sick leave for smokers versus non-smokers and exercisers versus non-exercisers. However, many of these factors cannot be measured for years after the initial investment, and some factors can’t be quantified at all. For example, the increase in employee morale from a fitness program is harder to measure, but no less important. We saw in Chapter 10 that capital budgeting can be used by business to compare and prioritise investments in sustainability projects and initiatives, provided there are sufficient social and

8

environmental metrics that can be converted and measured in financial terms. The value of projects and initiatives driven by triple-bottom-line thinking are often not captured in long-term

Why are non-financial considerations, such as the environmental and social impacts of an investment, important?

planning. There are intangible and societal impacts, such as more efficient use of natural resources, lower risks, improved stakeholder relations, or innovations that can benefit the business in the long term either by reducing or avoiding costs or increasing profits. Although, given that it can be difficult to measure social and environmental risks in financial terms, they are often not considered. Approaches such as those outlined in Chapter 10, which assess the full value of sustainability projects and initiatives, are important for triple-bottom-line thinking, and can be successfully integrated into capital budgeting. In making capital expenditure decisions, businesses need to consider all the relevant factors, including the difficult-to-measure ones. Otherwise, in cases such as evaluating an investment in an

Shutterstock.com/Kzenon

employee fitness program or an office consumables recycling initiative, a business might put an arbitrary limit on the time horizon of the project (and so not see the long-term benefits), or might not consider the non-quantifiable or environmental benefits. Thus, the If you were deciding whether or not to purchase an exercise bike, what costs and benefits would you consider?

business might decide against a capital expenditure that actually in its best interests.

is

A 2011 report commissioned by CPA Australia, surveying G100 Australian listed companies and interviewing sustainability managers and chief financial officers, found that sustainability issues influenced decisions about capital expenditure projects as part of managing risk and corporate stakeholder reputation. Other reasons given for considering CSR aspects of capital projects were competitive advantage, community impacts and employee motivation or engagement. The majority of chief financial officers who responded valued non-economic considerations in decision making and 40 per cent suggested that they would not always reject a project that had a negative net present value if sustainability benefits were identified.e

496

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Chapter 12 Capital expenditure decisions

STUDY TOOLS Summary 12.1 Understand what a capital expenditure decision is and realise its significance to a business. 1

What is capital expenditure and what are the four steps in a capital expenditure decision?

Capital expenditure is a long-term investment (cash payment) made by a business in order for it to obtain future net cash receipts totalling more than the investment. In making a capital expenditure decision, a business completes four steps: (1) determine the expected initial cash payment needed to make the investment; (2) estimate the future cash receipts and payments (cash flows) expected from the investment and the time period over which it expects these future cash receipts and payments to occur; (3) determine the cost of providing the cash to make the investment; and (4) determine whether the estimated future cash flows will provide a return that is sufficient (after adjusting for the time value of money) to cover the cost of providing the cash to make the investment.

12.2 Know what to assess and consider when making a capital expenditure decision. 2

What does a business include in the initial cost of a capital expenditure proposal?

A business should consider its economic performance and budgets, calculate the initial cash outlay and expected net cash flows from the capital investment, and determine the business’s required rate of return from the investment. The initial cost of a capital expenditure proposal is the expected cash payment necessary to put the proposal into operation. In other words, it is the capital that the business must expend to make the investment. It includes such items as the cost of an asset, transportation costs and installation costs. 3

What are the relevant costs of a capital expenditure proposal, and how do operating income, depreciation and ending cash flows affect these costs?

The relevant costs of a capital expenditure proposal are future cash flows that differ, either in amount or in timing, as a result of accepting a capital expenditure proposal. That is, relevant costs are: (1) the additional future cash flows (either receipts or payments) to a business’s existing cash flows; or (2) the savings in future cash payments. Frequently, the best available information to use in predicting these relevant costs is the expected future additional operating revenues and/or expenses. Most revenues and expenses of a business (the business’s operating income) result in related cash receipts and payments of the same amounts at approximately the same points in time. But depreciation is an expense for which the related cash flows occur in different years and in different amounts than the expense, so a business does not consider depreciation expense when it predicts relevant cash flows. A business considers ending cash flows related to the capital expenditure to be relevant costs. 4

How does a business determine the rate of return it requires on a capital expenditure proposal?

The rate of return that a business requires on a capital expenditure proposal is the cost to the business of providing the cash for the investment. It is the weighted-average cost the business must pay to all its sources of capital. This rate of return is called the business’s cost of capital.

12.3 Understand how to use net present value (NPV) as a tool to evaluate a capital expenditure decision. 5

How does a business use the net present value (NPV) method to evaluate a capital expenditure proposal?

A business evaluates a capital expenditure proposal using the net present value (NPV) method by considering the time value of money in a three-step process. Step 1 involves determining the expected cash payment needed to put the proposal into operation (the investment). This investment is already stated at its present value, since it takes place at the present time, just prior to putting the project into operation. Step 2 involves first estimating the expected future cash receipts and payments (and the length of time over which the business expects these cash receipts and payments to occur). It then involves discounting the expected future net cash receipts (Future cash receipts – Future cash payments) for each year to their present values using the business’s Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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required rate of return (its cost of capital). Step 3 involves calculating the NPV by subtracting the initial cash payment (from step 1) from the present value of the expected future net cash receipts and payments (from step 2). When the NPV is zero or positive, the capital expenditure proposal is acceptable. When the NPV is negative, the capital expenditure proposal is not acceptable because it will earn less than the business’s required rate of return.

12.4 Be familiar with the use of additional assessment tools, particularly payback and the accounting rate of return (ARR) methods for capital expenditure decisions. 6

What is the difference between the payback method and the accounting rate of return on investment method for evaluating a capital expenditure proposal?

Various assessment tools and techniques are available to help a business assess the capital investment, including net present value (NPV), payback method and the accounting rate of return. These methods each provide different insights and have advantages and disadvantages in their use, which require interpretation. A business using the payback method evaluates a capital expenditure proposal based on the length of time required for the initial investment to be recouped. A business using the accounting rate of return (ARR) method focuses on the profitability of a capital expenditure decision, and gives an average rate of return over the life of the investment.

12.5 Understand how to assess and select between alternative investment proposals, including consideration of non-financial aspects, such as social and environmental impacts. 7

How does a business decide which capital expenditure proposal to accept when it has several proposals that accomplish the same thing, or when it cannot obtain sufficient cash to make all of its desired investments?

The business may need to choose between alternative capital investments using appropriate appraisal techniques. Full assessment of capital expenditure projects also requires non-financial aspects to be considered, such as social and environmental impacts, in line with a TBL or CSR approach. A business evaluating several proposals that accomplish the same thing (called mutually exclusive proposals) completes a two-step process. In the first step, the business analyses each proposal to determine whether or not it is acceptable. The business does this analysis using the NPV method. If more than one proposal is acceptable (i.e. has a positive NPV), a second step is necessary. In the second step, the business selects one of the acceptable alternatives by choosing the proposal with the highest positive NPV. One approach to deciding which capital expenditure proposal to accept when a business cannot obtain sufficient cash to make all of its desired investments (called capital rationing) involves looking at the acceptable capital expenditure proposals to find all possible combinations of proposals that do not require a larger total investment of cash than is available. A business chooses the combination of capital expenditure proposals that provides the highest total NPV for the total investment available. 8

Why are non-financial considerations, such as the environmental and social impacts of an investment, important?

Non-financial considerations, such as environmental and social impacts of an investment, are important because more efficient use of natural resources, lower social and environmental risks, improved stakeholder relations and innovations that are difficult to measure financially can significantly benefit the business financially in the long-term.

Key terms accounting rate of return

cost of capital

net present value (NPV)

annual depreciation

dividend growth model

payback period

average investment

initial cost

relevant cash flows

capital expenditure

internal rate of return (IRR)

required rate of return

capital rationing

mutually exclusive capital expenditure proposals

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Online research activity This activity provides an opportunity to gather information on the internet about real-world issues related to the topics in this chapter. For suggestions on how to navigate various businesses’ websites to find their financial statements and other information, see the related discussion in the Preface. Put your skills to the test and find answers to the following questions by visiting the listed websites. • Go to the website of Super Retail Group (http://www.superretailgroup.com.au) and click on ‘Investors and Media’, then ‘Reports and Publications’ to find the company’s 2019 annual report. What factors do you think Super Retail Group considered when it invested $90.5 million in capital expenditure during 2019? Does the business make reference to social and environmental (sustainability) issues?

Integrated business and accounting situations Answer the following questions in your own words.

Testing your knowledge 12-1 12-2 12-3 12-4 12-5 12-6 12-7 12-8 12-9 12-10 12-11 12-12 12-13 12-14 12-15 12-16 12-17 12-18 12-19

Why is it important to understand how your business is performing before making capital expenditure decisions? How is this understanding achieved? What is a capital expenditure decision? Give three examples of capital expenditure opportunities. When is a capital expenditure proposal acceptable to a business? What four steps must a business complete to determine whether or not a capital expenditure proposal is acceptable? What is the initial cost of a capital expenditure proposal? Give three examples of items included in the initial cost of purchasing a machine. Identify three forms of expected net future cash receipts. What are relevant cash flows? How are cash inflows and outflows that occurred prior to a capital expenditure decision included in relevant cash flows? Briefly discuss how depreciation expense on a machine is treated in a capital expenditure analysis. What is a business’s cost of capital? How does it relate to the required rate of return on a capital expenditure? What is an acceptable accounting rate of return (ARR) on a capital expenditure proposal? What is meant by the term ‘the time value of money’? What is the relationship between present value and compound interest? Explain how to calculate the present value of a future amount. Explain how to calculate the present value of an annuity. Define the net present value (NPV) of a capital expenditure proposal. Identify what amount of NPV indicates an acceptable (unacceptable) proposal. Define the term ‘payback period’. Why is the payback period a poor measure for determining whether a capital expenditure proposal is acceptable? Briefly explain the advantages and disadvantages of the ARR and the payback period. What are mutually exclusive capital expenditure proposals? Give an example. Define the term ‘capital rationing’. Identify an investment approach that a business could use in a capital rationing situation.

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Applying your knowledge 12-20 From the following table, calculate the variances and discuss each one in relation to the following questions: i Is the variance positive or negative in terms of business performance? ii What are the reasons why the variance may have resulted? Budgeted Sales

Actual

Variance

420 000

467 890

Production costs

98 000

128 132

Selling expenses

45 000

47 625

Administration expenses

38 000

36 237

Financial expenses

18 500

21 312

Total expenses

199 500

233 306

Net profit

220 500

234 584

Less:

12-21 These are four sets of cash flows: i A single $1000 cash inflow at the end of year 5. ii A series of $2500 cash inflows at the end of years 1, 2, 3, 4 and 5. iii A cash inflow of $360 at the end of year 3 and a cash inflow of $480 at the end of year 5. iv A series of cash outflows of $80 at the end of years 1 to 10. Required: Determine the present value of each of the sets of cash flows using a discount rate of 12 per cent. 12-22 These are four sets of cash flows: i A single $450 cash inflow at the end of year 6. ii A series of $800 cash inflows at the end of years 1, 2, 3, 4 and 5. iii A cash inflow of $55 000 at the end of year 3 and a cash inflow of $650 at the end of year 5. iv A series of cash outflows of $90 at the end of years 1 to 10. Required: Determine the present value of each of the sets of cash flows using a discount rate of 10 per cent. 12-23 These are two independent questions. a The Danforth company sells a new type of macadamia nut-shelling machine that it claims will save a continual amount of labour costs at a particular business each year for 10 years. Danforth suggests that this saving would have a present value (at 16 per cent) of $21 460.50 to the business. What is the amount of the annual labour cost savings being claimed? b The Solenoid group sells a small mechanical apparatus with a complicated solid-state control unit that attaches to a car’s carburettor. Solenoid claims the apparatus will save the average car owner $120 per year in fuel bills that should be worth over $1000 (present value) to the owner, using a discount rate of 10 per cent. If the apparatus can save $120 per year, how many years would it have to be used for the present value of the savings to exceed $1000? Required: Prepare an analysis to answer each of the questions. 12-24 Tina Harper is considering investing $7840 in some farmland that a group of her friends is planning to buy. Her share of the expected selling price of the land after five years would be $13 440. Required: a Calculate the NPV of the land investment, assuming a 12 per cent required rate of return. b Should Tina make the investment? Why or why not?

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12-25 Simpson is considering buying a machine that would increase the business’s cash receipts by $3300 per year for five years. Operation of the machine would increase the business’s cash payments by $150 in each of the first two years, $300 in the third and fourth years, and $450 in the fifth year. The machine would cost $9000 and would have a residual value of $750 at the end of the fifth year. Required: a Assuming a 16 per cent required rate of return, calculate the NPV of the machine investment being considered by Simpson. b Should Simpson make the investment? Why or why not? 12-26 Fernandez Radio a distributor of radio towers and antennas, is considering buying the entire inventory of Southern Tower, which manufactures extremely large, heavy-duty towers, and which is going out of business. These towers would cost $300 000, delivered to Fernandez’s warehouse. Fernandez plans to sell these towers to special customers. Fernandez’s required rate of return is 20 per cent. Required: Calculate the NPV of Fernandez’s investment for each of the following assumed patterns of cash inflows that could result from the sale of the towers: a Cash inflows of $120 000 each year for six years. b Cash inflows of $72 000 each year for eight years. c Cash inflows of $240 000 during the first year, $120 000 in each of the second and third years, and $60 000 in each of the fourth and fifth years. 12-27 Rooney Company is considering purchasing a packaging machine for $40 000 that will have a residual value of $400 after 10 years. It would be depreciated using the straight-line method. The machine would reduce labour costs in despatch by $16 000 per year. Experience with such machines suggests that finished goods that could be sold for $6400 would be ruined each year by the packaging machine. Ownership of the machine also would increase property taxes and insurance (paid annually) by $600 per year. Rooney’s required rate of return is 20 per cent. Required: a Prepare an analysis to determine whether the purchase of this machine is an acceptable capital expenditure for Rooney. b What is the highest price Rooney should be willing to pay for the packaging machine? 12-28 Nelson is considering purchasing an overhead conveyor system for $350 000 that will have a residual value of $5250 after eight years. This conveyor system would be depreciated on a straight-line basis. The conveyor system would reduce labour costs in despatch by $105 000 per year. Experience with such systems indicates that $12 250 would be spent each year on maintenance to keep it operating properly. Ownership of the new conveyor system also would increase property taxes and insurance by $3500 per year. Nelson’s required rate of return is 16 per cent. Required: a Prepare an analysis to determine whether the purchase of this overhead conveyor system is an acceptable capital expenditure for Nelson. b What is the highest price Nelson should be willing to pay for the overhead conveyor system? 12-29 A business is considering the following three capital expenditure proposals: • Proposal A: An investment of $15 000 promising cash receipts of $5400 per year for five years. • Proposal B: An investment of $15 000 promising a single cash receipt of $30 000 after five years. • Proposal C: An investment of $15 000 promising a cash receipt of $3000 each year for four years and $18 000 in the fifth year. Required: a Prepare an analysis to determine the acceptability of each of the capital expenditure proposals, assuming a 16 per cent minimum required rate of return. b If only one of the three proposals can be selected for investment, which one should it be? Write a brief justification for your selection. 12-30 A business is considering the following three capital expenditure proposals: • Proposal A: An investment of $24 000 promising cash receipts of $5400 per year for 20 years. • Proposal B: An investment of $24 000 promising a single cash receipt of $390 000 after 20 years.

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•

12-31

12-32

12-33

12-34

12-35

Proposal C: An investment of $24 000 promising a cash receipt of $4600 each year for 19 years and $90 000 in the twentieth year. Required: a Prepare an analysis to determine the acceptability of each of the capital expenditure proposals, assuming a 20 per cent minimum required rate of return. b If only one of the three proposals can be selected for investment, which one should it be? Write a brief justification for your selection. A business is considering the following investment proposals: i $15 000 invested in a savings account that pays $300 (in cash) quarterly. ii $15 000 invested in a delivery van, which would reduce delivery expenses so that cash payments are decreased by $1500 per year for 10 years. iii $15 000 invested in land, on which rates of $125 would be paid each year. The business expects to be able to sell the land after eight years for $31 250. Required: Calculate the payback period for each of the proposals. Refer to 12.25. Required: Calculate the payback period of Simpson for this machine. Refer to 12.25. Required: Calculate the accounting rate of return (ARR) for the machine being considered by Simpson. Refer to the example given in the accounting rate of return (ARR) section of the text (pages 492–3), a summary of which is given below. Required: a Calculate the net present value (NPV) of the proposal to buy the new machine, given a cost of capital for the business of 5 per cent. Should the machine be purchased considering both its calculated ARR (5.96%) and NPV? Initial purchase of the machine: $200 000 – Estimated useful life 5 years Cash flows during the life of the project (including $35,000) residual value in year 5: Year 1: $50 000 Year 2: $35 000 Year 3: $45 000 Year 4: $50 000 Year 5: $55 000 b Will the internal rate of return of the project be higher or lower than 5 per cent? Infinite Ltd is considering two investment options. The first option involves an upgrade to an existing food-processing facility, and the second building a new food-processing facility. Infinite can only undertake one of the two options, and so is evaluating which option it should choose. The company uses the straight-line method of depreciation, and the residual value for both Option A and Option B is expected to be $125 000 at the end of five years. Infinite’s required rate of return on investments is 20 per cent. The cash flows for options A and B are as follows. Option A: Upgrade existing facility

Year 0

Cash inflows Cash outflows Option B: Build new facility

 487 500 Year 0

Cash inflows Cash outflows

502

 500 000

Year 1

Year 2

Year 3

Year 4

400 000

450 000

500 000

550 000

Year 5 60 000

175 000

175 000

225 000

225 000

250 000

Year 1

Year 2

Year 3

Year 4

Year 5

612 500

575 000

500 000

450 000

40 000

250 000

225 000

200 000

175 000

150 000

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Chapter 12 Capital expenditure decisions

Required: a Calculate the payback period for options A and B. b Calculate the ARR for options A and B. c Calculate the NPV for options A and B. d Make a recommendation on which option Infinite should invest in, based on your calculations. 12-36 Cosmic Investments can accept either of two capital expenditure proposals, A and B, or it can reject both proposals. Proposal A requires an investment of $1400 and promises increased net cash inflows of $440 for each of the next five years. Proposal B requires an investment of $1400 and promises increased net cash inflows of $460 per year for the next four years and $200 in the fifth year. The business’s required rate of return is 20 per cent. Required: a Prepare an analysis to determine which (if either) of the proposals should be selected for investment. b How would your answer to (a) be altered if one of the two proposals must be selected? 12-37 The Anderson Group has identified the following capital expenditure proposals as acceptable. Only $150 000 is available for investment. Investment proposal

Required investment

Net present value

A

$30 000

$12 000

B

60 000

36 000

C

30 000

15 000

D

90 000

48 000

E

30 000

21 000

F

60 000

39 000

Required: Determine the combination of proposals to be selected.

Making evaluations 12-38 Cairns Farming is a small family run dairy farm, which is finding it hard to continue in business. After visiting a farm in Nienberg, Germany, it is considering buying equipment that will enable it to produce electricity on the farm by converting manure into biogas. There is a $10 000 local government grant available for such projects (so if it goes ahead $10 000 of the cost will be paid by the government, effectively reducing the cost to Cairns Farming). Costs to date and equipment needed are given below, along with the benefits: i The cost of the fact-finding trip to Nienberg, Germany, made by Mr Cairns earlier in the year was $4000. ii The farm will need to install a digester and generator building (with a tank to collect the cow manure and keep it for 3 weeks at 38 degrees Celsius to produce methane gas) – cost to install $650 000. (Estimated life 20 years). iii Purchase and installation of modified natural gas engine to convert methane to electricity $45 000. (Estimated life 20 years). iv The electricity generated will replace 50 per cent of Cairns Farming’s own needs. Currently it pays 30 cents per kWh (kilowatt hour) and use 40 000 kWh per year. v In addition, it will sell enough power for 200 homes to the local electricity grid which will total 975 000 kWh at 20 cents per kWh. vi The business’s required rate of return (cost of capital) is 10 per cent. vii Cairns Farming has previously preferred all capital expenditure items to pay for themselves (payback) within three years. Required: a Calculate the total relevant cost of the project. b Calculate the total cash inflows/savings of the project. c Assume all costs (for all equipment) are incurred at the start of the project and annual cash flows occur at the end of each year. Calculate the net present value of the project. d Calculate the payback period of the project. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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e

Based on these calculations alone, should Cairns Farming invest in the building and equipment? Use your calculations to justify your answer. f Are there any non-economic considerations in making this decision? 12-39 Merton Medical is considering replacing an old machine that cost the business $100 000 five years ago. This machine could be used for 10 more years, at which time it would have no residual value. If it were sold now, net receipts from its disposal would be $31 250. The old machine requires four operators to run it, each earning $35 000 per year. The new machine, which costs $181 250, has an estimated life of 10 years and a residual value of $7500 at the end of that time. The new machine requires only three operators, each earning $37 500 per year. Actual direct materials costs would be slightly less with the new machine because materials waste (currently $5000 per year) could be cut in half. Maintenance on the old machine, which currently costs approximately $3750 per year, would be decreased by 40 per cent with the new machine. At present, power costs are $25 000 per year. The new machine would require 5 per cent less power. Merton estimates that the revenues associated with the product produced by the old machine, $187 500 per year, would not be changed by purchasing the new machine. Merton Medical’s required rate of return is 20 per cent. Required: a Prepare a schedule of the relevant cash flows for this capital expenditure proposal to replace the old machine. Indicate any cash flows that are not relevant, and explain why they are not relevant. b Calculate the NPV of the proposal. Is this proposal acceptable? c What maximum amount should Merton Medical be willing to pay for the new machine? 12-40 Several years ago, Catherine’s Cattery Supplies signed a contract to deliver 5000 units of a special product each year to one of its customers at a price of $15 per unit. This contract, which runs for five more years, is non-cancellable. Catherine is currently making the product with an old machine that can be kept running for five more years if $9000 of maintenance cost per year is incurred. Other operating costs to produce it with the old machine (excluding maintenance) total $45 000 per year. The old machine has no residual value now, and will have none after the contract is fulfilled. Pedro’s Pet Products recently offered to sell Catherine 5000 units of the product per year over the next five years for $10.50 per unit. Catherine had almost decided to accept the offer from Pedro as the best possible way to satisfy its contract, when a new machine capable of producing the 5000 units each year for $42 000 total cash operating costs per year became available. This new machine would cost $41 250 and would have a residual value of $7500 after five years. Catherine’s required rate of return is 16 per cent. Required: a Is purchasing 5000 units of the product per year from Pedro’s Pet Products preferable to producing them with the old machine? Explain. b By calculating its NPV, determine the acceptability of the proposed capital expenditure to buy the new machine. c If Pedro’s Pet Products withdrew its offer to supply the units, would your answer to (b) change? Explain, supporting your explanation with calculations if necessary. 12-41 Monica’s Metal Fabrication has just been ordered by a court to install a pollution-control device on the exhaust system of one of its production processors. The business’s required rate of return is 20 per cent. Two devices are on the market. Device A costs $45 000 and is expected to last 12 years, after which it would have zero residual value. It costs $1500 per year to operate and maintain. Device B costs $30 000 and would last only six years, after which it would have a residual value of $2500. If Device B is purchased, Monica would have to replace it in six years. The Device B replacement unit would have an expected cost at that time of $45 000. This second unit would also be expected to have a residual value of $2500 at the end of its six-year life. Both the first and second unit of Device B cost $2000 per year to operate and maintain. Required: a By calculating the net present value of the investment for each of the devices, determine which pollution-control device Monica should purchase. b How much per year would the court have to fine Monica for ignoring the order to ensure that it would be less expensive (in terms of present value of costs) for the business to comply with the court order by purchasing one of the devices? c Suppose the fine is less than the cost of complying with the court order. What else should Monica’s Metal Fabrication consider as it decides what to do?

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12-42 Bruce Industries is considering introducing a new product. Bruce believes it can sell 32 000 units of this product per year for 10 years at a price of $18 per unit. Bruce estimates that the cost of producing the product would be $6 per unit. Additional production costs of $150 000 would be required during the first year, however, while the production department became familiar with the techniques required to produce the new product. Cash payments for advertising this product are expected to be $100 000 per year. Variable selling costs are expected to be about $4 per unit sold. Bruce Industries has already spent $600 000 on research and development of this product. If the new product is introduced, an additional $440 000 would have to be invested immediately to obtain the additional plant and equipment necessary for production. This additional plant and equipment would have a residual value of $200 000 after 10 years. Bruce’s required rate of return is 20 per cent. Required: a Prepare a schedule of the relevant annual net cash flows for this capital expenditure proposal to introduce this new product. b Calculate the NPV of the proposal. c Discuss whether Bruce should accept this proposal. 12-43 The current dividend of a share in Osmium Company is $6, and investors require a rate of return of 9 per cent. Dividends are expected to grow at the following rate: Year

Expected growth rate (%)

1

14

2

14

3

14

Year 4 onwards

4

Required: Calculate the price investors would be willing to pay for a share in Osmium Company. 12-44 The required rate of return for a share in Gamma Company is 12 per cent. The current dividend per share is $7 and dividends are expected to grow at the following rate. Year

Expected growth rate (%)

1

3

2

5

3

9

Year 4 onwards

7

Required: Calculate the price investors would be willing to pay for a share in Gamma Company. 12-45 Quick Coffee Shops, a chain of fast-food shops serving breakfast 24 hours a day, is considering opening a shop in Jonestown. The shop could be opened in one of two ways, either by building the shop between a west-side shopping centre and Jonestown’s small university campus or by buying a vacant building on the edge of the central business district. The expected investment required in either case is $150 000. An extensive analysis of the potential of these two locations suggests that the expected cash inflows and outflows from their operations would be very different. As a location, the central business district would have a much greater volume of customers than the west-side location for at least five years. This volume would be concentrated between 6 a.m. and 11.30 p.m., allowing considerable savings in wages during the early-morning hours. The volume of the west-side location would be smaller and more uniform throughout the day and night. The costs of upkeep for the new west-side building should be considerably less than for the older building in the central business district, however. A highway currently under construction 100 kilometres to the north is expected to eventually come through Jonestown, within three blocks of the west-side location, after five or more years, considerably increasing the potential volume of customers to that shop.

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Required: Assume that you are a consultant to Quick Coffee and have been assigned to make a recommendation to the business about what to do in Jonestown. Write a memo to the CEO describing the approach that should be used to make this decision, listing the important factors that you expect to influence the decision and requesting specific information you will need to evaluate the decision alternatives. 12-46 Susan lives with her mother, and is a secretary for a large architectural business. She earns $27 500 per year. She dreams of being an architect, however. Salaries for new architects in her business start at $44 000 per year. Susan has been accepted at several universities, and believes she can graduate in four years (including summer school) unless she works part-time, in which case she would need five years to graduate. She has been looking at university websites for several months, calculating the total costs for tuition, fees, room and board, books and supplies, and so on. She has ruled out all but one university because of the generally high tuition fees. Susan has estimated the following costs per year of attending university: Tuition and fees

$4 180

Room and board

3 850

Books and supplies

550

Car

660

Clothes

440

Miscellaneous

220

Annual cost

$9 900

Although it seems like a lot of money, Susan believes her total cost over four years ($39 600) would be paid back before she finished her first year working as an architect. Before she resigns from her current job, she comes to you for your opinion. Required: Write Susan a letter describing how she should evaluate this decision. Make some tentative calculations using any of the above information that you feel is relevant and assuming any additional information necessary to demonstrate how she should consider the monetary aspects of her decision. Disregard income taxes. 12-47 Yesterday, Megan received a note from her father, who is now 47 years old, asking for advice about starting his plans for retirement. The relevant parts of the note are as follows: ‘[A]nd you know how much your mum and I like to travel. I was thinking that my small earnings from the business plus any pension wouldn’t be enough to allow us much travel during these years while we’re still young enough to be active. Assuming our health continues, we’d like to supplement our retirement income until we’re about 75. I thought you might be able to clear my thinking a bit, since you’re taking those business classes at the university. ‘It isn’t investment advice that I’m asking for. You know that I’ll just put anything I save in the bank. I think I should be able to average about 6 per cent interest per year there. The main things I’m having trouble thinking about are whether I should start saving now or wait until you finish university, and whether to retire at 55, 60 or 65. ‘Incidentally, your Grandpa just told me that he placed $20 000 in a fixed deposit in my name when he sold his business. I was 20 years old then. This has probably earned only about 5 per cent per year, so I doubt whether it will help much. What do you think? ‘Someone at work told me that if I had a certain amount of money saved when I retired, I could withdraw about 8 per cent of that amount every year for 20 years before the money ran out. Could that be possible? By my reckoning, that would be 160 per cent of what I started with. If it’s true, maybe I could retire at 55 after all. I’d like your explanation, though, before I rely on that idea.’ Required: Suppose that you are Megan. Write a note to your dad to answer his questions in order to help him begin his retirement planning. (Ignore income tax considerations.)

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12-48 Frangipani Fragrances currently reimburses its 40 salespeople for the use of their personal cars for business purposes. Cassandra, a business sales manager, has been trying, without success, to persuade the business to buy a number of cars to be used by her sales staff in the future. Cassandra’s assistant has estimated the costs of operating business-owned cars for an expected 30 000 kilometres per year, on the basis of accounting records for cars used by business executives. The cost estimates in comparison with average mileage reimbursements are as follows: Comparisons of annual costs of business cars with annual mileage reimbursements Business-owned car Fuel and oil

$ 2 700

Tyres

450

Maintenance

600

Insurance

750

Registration, parking, tolls, etc.

300

Washing and cleaning Depreciation ($24 750 – $2250) þ 3 years Total annual operating costs

150 7 500 $12 450

Mileage reimbursement 30 000 @ $0.45

$13 500

The business is currently paying $0.45 per kilometre on an average of 30 000 kilometres driven by each salesperson, and the sales manager believes that considerable savings are possible through the business buying cars to be used by sales personnel. Cassandra was recently questioned by Kelvin Lawry, the business’s chief financial officer (CFO), about high costs in her department. She responded that the business could save $42 000 per year by buying cars for the sales staff instead of paying that high mileage rate. She had the annual cost comparison to show him if he challenged her on her statement. At previous meetings, Cassandra had emphasised that a fleet of clean new cars with the business’s name on them would improve the business’s image and increase brand-name recognition, and that both factors would lead to increased future sales. She emphasised that this would be especially so given that many sales routes would be lengthened next year to an average of 36 000 kilometres per year, and would include areas where the business’s products had not previously been sold. Cassandra had been told repeatedly that it would be too expensive for the business to buy cars for the sales staff to use, which is why she had instructed her assistant to prepare the cost comparison shown above. Required: a Assume that Frangipani Fragrances has a cost of capital of 10 per cent, and that you are the business’s financial manager. Write the sales manager a brief memo explaining why it would not be desirable for the business to buy cars for her staff, in spite of the annual costs estimated by her assistant. Ignore the lengthening of sales routes and the possibility that sales might be increased. b Now assume that you are the sales manager. Write the CFO a memo describing how the analysis in (a) would be affected by: (i) longer sales routes; and (ii) possible sales increases due to an improved business image and name recognition.

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Accounting Information for Business Decisions

Dr Decisive Yesterday, you received the following letter for your advice column in the local paper:

Dear Dr Decisive, Last weekend, my housemate (let’s just call him ‘Red’) and I were visiting my father. Red and my father have a lot in common. Red is a football player and Dad is a keen football fan. Red and I were looking through one of Dad’s old football magazines and came across an article describing the contracts of two players. A good weekend suddenly got better because we were soon in the middle of a debate. We couldn’t (and still can’t) agree on which player got the better deal. According to the article, each player received a six-year contract. ‘Player A’ would earn a total of $3 375 000, or an average of $562 500 per year, and ‘Player B’ would earn a total of $3 262 500, or an average of $543 750 per year. So the article said that, based on annual average salaries, Player A was the higher-paid player. I agree with the article – it’s an obvious conclusion. But Red disagrees with me. According to the contracts, here’s how each was supposed to be paid: Year

Player A

Player B

19X0

$ 225 000

$ 975 000

19X1

$ 750 000

$ 750 000

19X2

$ 621 000

$ 675 000

19X3

$ 491 250

$ 506 250

19X4

$ 586 500

$ 225 000

19X5

$ 701 250

$ 131 250

Total

$3 375 000

$3 262 500

Before contract negotiations, Player A was about to enter the last year of a previous contract in which he was supposed to earn $337 500 in 19X3. To negotiate a better contract in later years, and to help his team, he ‘gave up’ $112 500 in salary in 19X3. (This gave his team enough room below the salary cap to hire a top draft pick in 19X3.) Player B negotiated a $225 000 signing bonus (which he received at the beginning of 19X3) as part of his $975 000 19X3 salary. You can see that, even after giving up $112 500 in 19X3, Player A is clearly getting the better deal. Red says Player B has the better deal because he is getting more money ‘up front’. Please help me convince Red that, even though he knows his football (and is quite good at playing football), I’m right about this. A lot is riding on this. Whoever loses (and your answer is the deciding factor) must buy the winner two tickets to the next big football game. I’m still trying to decide whom to take with me (maybe Red . . . maybe not). ‘Undecided’

Required Meet with your Dr Decisive team and write a response to ‘Undecided’.

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Chapter 12 Capital expenditure decisions

Endnotes a

Quoted in Fantham, E (2011) Roman Readings: Roman Response to Greek Literature from Plautus to Statius and Quintilian. Berlin: Walter de Gruyter, 187. b Australian Bureau of Statistics (2018) Survey of Income and Housing 2017/18, https://www.abs.gov.au/AUSSTATS/[email protected]/ Lookup/4130.0Main+Features12017-18?OpenDocument. c See https://www.ceres.org/networks/ceres-investor-network. d Brisbane City Council (2018) Transport Plan For Brisbane - Strategic Directions, https://www.brisbane.qld.gov.au/sites/default/ files/20181115_-_transport_plan_for_brisbane_-_strategic_directions.pdf; Guest, A (2011) ’Clem7 operator placed in receivership’, ABC News, 25 February, https://www.abc.net.au/news/2011-02-25/clem7-operator-placed-in-receivership/1958924. e Vesty, G (2011), The Influence and Impact of Sustainability Issues on Capital Investment Decisions, CPA Austalia, https:// www.cpaaustralia.com.au/~/media/corporate/allfiles/document/professional-resources/sustainability/influence-sustainabilityissues-report.pdf?la=en..

Company URL u

Super Retail Group: http://www.superretailgroup.com.au

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509

GLOSSARY accounting cycle

accrual accounting

annuity

Steps that a business completes during each accounting period to record, retain and report the monetary information from its transactions

Recording revenues and related expense transactions in the same accounting period that goods or services are provided, regardless of when cash is received or paid

Series of equal periodic future cash flows

accounting equation

accrued expense

Assets ¼ Liabilities þ Owner’s equity

Incurred by a business during the accounting period but not paid or recorded

accounting period

Timespan for which a business reports its revenues and expenses accounting rate of return

A measure of return on investment calculated by dividing the average net profit from an asset by the average investment in the asset accounting system

Process used to identify, measure, record and retain information about a business’s activities so that the business can prepare its financial statements accounts

Documents used to record and retain the monetary information from a business’s transactions accounts payable

Amounts owed to suppliers for credit purchases accounts payable subsidiary ledger

The subsidiary ledger containing each of the individual accounts for suppliers (creditors) accounts receivable

Amounts owed by customers to the business accounts receivable subsidiary ledger

The subsidiary ledger containing each of the individual accounts for customers (debtors) accounts receivable turnover

Net credit sales divided by average accounts receivable

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assets

A business’s economic resources that it expects will provide future benefits to the business average investment

The amount that is invested halfway through the asset’s useful life

accrued revenue

Earned by a business during the accounting period but neither collected nor recorded accumulated depreciation

Total amount of depreciation expense recorded over the life of an asset to date adjusted trial balance

Schedule prepared to prove the equality of the debit and credit balances in a business’s general ledger accounts after it has made the adjusting entries adjusting entries

Journal entries that a business makes at the end of its accounting period to bring the business’s revenue and expense account balances up to date and to show the correct ending balances in its asset and liability accounts agent

A person who has the authority to act for another person annual depreciation

The amount by which the value of an asset depreciates per year. This can be calculated as the initial cost of the asset less the residual value, divided by the useful life of the asset annual report

Document that includes a business’s income statement, balance sheet and cash flow statement, along with other related financial accounting information

avoidable costs

Costs that must be incurred to perform an activity at a given level, but that can be avoided if that activity is reduced or discontinued balance

The amount in an account column at the beginning of the period plus the increases and minus the decreases recorded in the column during the period balance of an account

Difference between the total increases and the total decreases recorded in the account balance sheet

Accounting report that summarises a business’s financial position (assets, liabilities and owner’s equity) on a given date; also known as a statement of financial position bank reconciliation

Schedule used to analyse the difference between the ending cash balance in a business’s accounting records and the ending cash balance reported by the bank on the business’s bank statement bank statement

Statement that summarises a business’s banking activities during the month book value

Asset’s original cost minus the related accumulated depreciation

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Glossary

brainstorming

cash discount

Process where members of a group try to generate as many solutions as possible to a particular problem

Percentage reduction of the invoice price if the customer pays the invoice within a specified period

break-even point

cash flow returns

Unit sales volume at which a business earns zero profit

A business’s cash flows divided by the dollar amount of its assets or owner’s equity

budget

Report that gives a financial description of one part of a business’s planned activity budgeting

Process of quantifying managers’ plans and showing the impact of these plans on a business’s operating activities business activity statement (BAS)

A form used by businesses that facilitates the payment and offset of tax instalments to the Australian Taxation Office for a given period. It is used for reconciling the goods and services tax instalments, pay-asyou-go instalments, company tax instalments and fringe benefit tax instalments business plan

Describes a business’s goals and its plans for achieving those goals capital

Funds a business uses to operate or expand its operations

cash flow statement

Accounting report that summarises a business’s cash receipts, cash payments and net change in cash for a specific time period chart of accounts

Numbering system designed to organise a business’s accounts efficiently and to reduce errors in the recording and accumulating process classified balance sheet

Balance sheet that shows subtotals for assets, liabilities and owner’s equity in related groupings closing entries

Entries made by a business at the end of an accounting period to create a zero balance in each revenue, expense and withdrawals T-account, and to update the owner’s equity by transferring the balances in the revenue, expense, and withdrawals T-accounts to the T-account for owner’s capital company/corporation

capital expenditure

Cost that increases the benefits a business will obtain from an asset capital rationing

Occurs when a business cannot obtain sufficient cash to make all of the investments that it would like to make, and thus must choose which of the acceptable proposals to invest in

A business entity that has been incorporated and registered by the Australian Securities and Investments Commission (ASIC) under the Corporations Act 2001 compound interest

Interest that accrues on both the principal and the past (unpaid) interest contribution margin per unit

cash

Money on hand, deposits in bank accounts, and cheque and credit card invoices that a business has received from its customers but not yet deposited cash budget

Budget showing a business’s expected cash receipts and payments and how they affect the business’s cash balance

Difference between the sales revenue per unit and the variable costs per unit corporate social responsibility (CSR)

An organisation’s commitment to act in an ethical way in order to contribute positively to society and the environment. It is often referred to as the corporate triple bottom line, because it takes into account the

economic, social and environmental impacts of business activities cost analysis, or cost accounting

Process of determining and evaluating the costs of specific products or activities of a business cost of capital

Weighted average cost (rate of return) a business must pay to all sources of capital cost of ending inventory

Dollar amount of merchandise on hand, based on a physical count, at the end of the accounting period cost of goods sold

Major expense of a retail business consisting of the cost of the goods (merchandise) that it sells during the accounting period cost report

Report showing a comparison between a business’s budgeted and actual expenses for an accounting period cost–volume–profit (CVP) analysis

Shows how profit is affected by changes in sales volume, selling prices of products and the various costs of a business creative thinking

Process of actively generating new ideas to discover solutions to a problem credit entry

Monetary amount recorded (credited) on the right side of an account credit memo

Business document that lists the information for a sales return or allowance creditors

External parties to whom a business owes debts creditors’ equity

Claims by creditors against the assets of a business critical thinking

Process that evaluates the ideas generated by creative thinking

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Glossary

current assets

Cash and other assets that a business expects to convert into cash, sell or use up within one year current liabilities

Obligations that a business expects to pay within one year by using current assets

drawing analogies

Making connections among facts, ideas or experiences that are normally considered separately dual effect of transactions

that reduce the environmental impacts of business activities. Environmental management accounting typically involves processes such as life cycle analysis, cost benefit analysis, material flow cost accounting and metrics such as eco-efficiency and share percentage to facilitate strategic environmental management initiatives

Current assets divided by current liabilities

A business must make at least two changes in its assets, liabilities or owner’s equity when it records each transaction

days’ sales in receivables

e-commerce

A ratio that tells us how many days’ worth of sales are tied up in accounts receivable

A method of conducting business where companies and consumers buy and sell goods and services online

debit entry

earning process

Monetary amount recorded (debited) on the left side of an account

Purchasing (or producing) inventory, selling the inventory (or services), delivering the inventory (or services), and collecting and paying cash

expenses

eco-efficiency

external users

current ratio

debt ratio

Total liabilities divided by total assets deposit in transit

A cash receipt that a business has added to its cash account but that the bank has not deducted from the cash balance reported on the bank statement because the cheque has not yet ‘cleared’ the bank

First described by the World Business Council for Sustainable Development (WBCSD) in 1992, it is based on the concept of using fewer resources to deliver goods and services and thus reduce waste and pollution end-of-period adjustments

depreciation

The systematic periodic transfer of the cost of a fixed asset to an expense account during its expected useful life

Increases or decreases to account balances at the end of the period to reflect the costs of providing goods or services that are not supported by source documents

direct method

entity

Subtracting the operating cash outflows from the operating cash inflows to determine the net cash provided by (or used in) operating activities on the cash flow statement discount rate

The rate used to convert a future amount to a present value dividend growth model

A formula that can be used to estimate the share price at any point in time double entry rule

In the recording of a transaction, the total amount of the debit entries must

512

be equal to the total amount of the credit entries for the transaction

Separation of accounting records of a business from the records of the business’s owner or owners entrepreneur

Individual who is willing to risk the uncertainty of starting a business in exchange for the reward of earning a profit (and the personal reward of seeing the business succeed) environmental management accounting

Involves the management of the financial and environmental performance of business through the development and implementation of accounting systems and practices

equity

Claims by creditors and owner(s) against the assets of a business evaluating

Management activity that measures a business’s actual operations and progress against standards or benchmarks Costs a business incurs to provide goods or services to its customers during an accounting period Individuals outside of a business who use the business’s information for decision making factor

Decimal amount in a present value table financial accounting

Identification, measurement, recording, accumulation and communication of economic information about a business for external users to use in their various decisions financial assets

Items such as notes receivable, government bonds, bonds and share capital of companies, and other securities financial expenses

Expenses related to financing of the business and its operations, and to debt collection financial flexibility

A business’s ability to adapt to change financial statements

Accounting reports used to summarise and communicate financial information about a business

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Glossary

financing activities

general journal

in transit

Obtaining capital from the owner and providing the owner with a return on investment, as well as obtaining capital from creditors and repaying the amounts borrowed

Includes the following information about each transaction: the date of the transaction, the accounts to be debited and credited, the amounts of the debit and credit entries, and an explanation of each transaction

When a freight company is in the process of delivering the inventory from the selling company to the buying company. The company (the buyer or the seller) that has economic control over the items in transit includes them in its inventory. Typically, economic control transfers at the same time legal ownership transfers

financing activities section

Section of a business’s cash flow statement (or cash budget) that shows the cash receipts and payments from its actual (or planned) financing activities fixed costs

Costs that are constant in total and that are not affected by changes in volume free on board (FOB) destination point

The selling company transfers ownership to the buyer at the place of delivery (after transit is completed). The selling company includes these items in transit in its inventory until delivery takes place; the buyer excludes them. In this case, the selling company is responsible for any transportation costs incurred to deliver the items and includes those costs in its selling expenses

general knowledge

A category of the businessperson’s knowledge base that encompasses knowledge about history and cultures, an ability to interact with people who have dissimilar ideas, and experience in making value judgements general ledger

Entire set of accounts for a business generally accepted accounting principles (GAAP)

Currently accepted principles, procedures and practices that are used for financial accounting in many countries of the world, including Australia

general and administrative expenses

A network-based organisation that has developed the world’s most widely used sustainability reporting framework

income summary

Temporary account used in the closing process to accumulate the amount of net income (or net loss) before transferring it to the T-account for owner’s capital incremental costs

Cost increases resulting from the performance of an additional activity In the process of evaluating ideas, relying on one’s own conclusions rather than relying on the conclusions of others indirect method

going concern

An assumption that an entity is able to continue as a viable entity for the foreseeable future

Adjusting net income to compute net cash provided by operating activities on the cash flow statement initial cost

‘greenwashing’

Occurs when a business spends considerable time and money emphasising its green credentials through marketing and advertising when in fact it does not actually implement business practices that reduce its environmental impacts gross profit

Net sales minus cost of goods sold

Operating expenses related to the general management of a business

gross profit percentage

general and administrative expenses budget

historical cost concept

Budget showing the expenses and related cash payments associated with expected activities other than selling

Accounting report that summarises the results of a business’s operating activities for a specific time period

independent Global Reporting Initiative (GRI)

free on board (FOB) shipping point

The selling company transfers ownership to the buyer at the place of sale (shipping point) – that is, before the inventory is in transit. The selling company excludes these items in transit from its inventory; the buying company includes them in its inventory. The buying company is responsible for any transportation costs incurred to deliver the items, and includes those costs as a cost of its inventory (rather than immediately recording them as an expense)

income statement

Gross profit divided by net sales Concept that a business records its transactions based on the dollars exchanged at the time the transaction occurred

Expected cash payment to put a capital expenditure proposal into operation Integrated reporting

connects the short- medium- and long-term strategies of an organisation to the complete range of resources and interconnections that must be harnessed and managed in harmony to create value without diminishing those resources or ‘capitals.’ ‘An integrated report looks at how the activities and capabilities of an organisation transform these six capitals into outcomes.’ (International Integrated Reporting Council [IIRC]). It develops critical and systems thinking and promotes innovation

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513

Glossary

intergenerational equity

thinking to decide between two alternatives based on objective facts or data

on improving the activities that show significant differences between budgeted and actual results

liabilities

manufacturing business

A business’s economic obligations (debts) owed to its creditors

A business that makes its products and then sells these products to its customers

internal control structure

life cycle analysis

master budget

Set of policies and procedures that directs how employees should perform a business’s activities

An analysis of the environmental impact of a product or service throughout its entire life cycle, from beginning (womb) to the end (tomb)

Set of interrelated reports showing the relationships among a business’s goals to be met, activities to be performed, resources to be used and expected financial results

Equity between current and future generations. It recognises that the over-consumption of natural resources to meet current needs may compromise the ability of future generations to meet their needs

internal rate of return (IRR)

A method of analysis of proposed capital investments that uses present value concepts to compute the rate of return from the net cash flows expected from the investment internal users

Managers within a business who use information about the business for decision making

Business that will cease when the business is sold or when a specific project is completed is said to have a limited life. For example, a sole proprietorship has a limited life because it ceases to exist if the business is sold

matching principle

line of credit

A system that allows a business to trace input materials that flow through production processes, and to measure the output of those production processes in terms of finished products and waste

Merchandise a retail business is holding for resale

Amount of money a business is allowed to borrow with a prearranged, agreed-upon interest rate and a specific payback schedule

inventory turnover

liquidity

Cost of goods sold divided by average inventory

Measure of how quickly an asset can be converted into cash or a liability can be paid

inventory

investing activities

Transactions that affect investments in non-current assets of the company investing activities section

loans payable

Amounts owing to financial institutions for money lent to the business

Section of a business’s cash flow statement (or cash budget) that shows the cash receipts and payments from its actual (or planned) investing activities

long-term capital

joint ownership

long-term investments

The idea that all partners jointly own the assets of a partnership

Items such as notes receivable, government bonds, bonds and capital stock of companies, and other securities which a business intends to hold for more than one year

journal entry

Recorded information for each transaction

Capital that will be repaid to creditors or returned to investors after more than one year

To determine its net income for an accounting period, a business computes and deducts the total expenses from the total revenues earned during the period material flow cost accounting

merchandising business

A business that purchases goods (sometimes referred to as merchandise or products) for resale to its customers monetary unit concept

Concept that transactions are to be recorded in terms of money or currency mutually exclusive capital expenditure proposals

Proposals that accomplish the same thing, so that when one proposal is selected, the others are not narration

A description of the transaction that has been entered into the general journal

management accounting

journalising

Process of recording a transaction in a business’s general journal judgement

Involves the evaluation of evidence to make a decision, choice or recommendation. We exercise judgement when we use our critical 514

limited life

Identification, measurement, recording, accumulation and communication of economic information about a business for internal users in management decision making

net income

management by exception

net loss

Management principle where an entrepreneur (or manager) focuses

Excess of a business’s expenses over its revenues from providing goods

Excess of a business’s revenues over its expenses from providing goods or services to its customers during a specific time period

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Glossary

or services to its customers during a specific time period net present value (NPV)

Present value of the expected future net cash receipts and payments minus the initial cash payment for a capital expenditure proposal net purchases

Amount of merchandise purchases adjusted for purchase returns, allowances and discounts non-current liabilities

Obligations that a business does not expect to pay within one year NSF (not sufficient funds)

A customer’s cheque that has ‘bounced’ (the business’s bank is unable to collect because the customer’s bank account has insufficient funds to cover the cheque) number of days in the collection period

Number of days in a business’s business year divided by its accounts receivable turnover number of days in the selling period

Number of days in a business’s business year divided by its inventory turnover objectivity

Quality of being unbiased in critical thinking operating

Management activity that enables a business to conduct its business according to its plan operating activities

The primary activities of buying, selling and delivering goods for sale, as well as providing services operating activities section

Section of a business’s cash flow statement (or cash budget) that summarises the cash receipts and payments from its actual (or planned) operating activities operating capability

A business’s ability to continue a given level of operations

operating cycle of a retail business

The average time it takes a retail business to use cash to buy goods for sale (called inventory), to sell these goods to customers and to collect cash from its customers operating cycle of a service business

The average time it takes a service business to use cash to acquire supplies and services, to sell the services to customers and to collect cash from its customers operating expenses

Expenses (other than cost of goods sold) that a business incurs in its day-to-day operations

time and/or talent into the business and share in its profits and losses partnership agreement

Contract signed by partners of a partnership before the business begins operations payback period

Length of time required for a return of the initial investment in a capital expenditure proposal periodic inventory system

System that does not keep a continuous record of the inventory on hand and sold, but determines the inventory at the end of each accounting period by physically counting it

operating income

All the revenues earned less the expenses incurred in the primary operating activities of a business opportunity costs

Profits that a business forgoes by following a particular course of action organisational and business knowledge

permanent accounts

Accounts used for the life of a business to record the effects of its transactions on its balance sheet (assets, liabilities and owner’s capital accounts) perpetual inventory system

System that keeps a continuous record of the cost of inventory on hand and the cost of inventory sold

A category of the businessperson’s knowledge base that includes an understanding of the effects of economic, social, cultural and psychological forces on companies; an understanding of how companies work; an understanding of methods and strategies for managing change; and an understanding of how technology helps organisations

petty cash fund

other items

post-closing trial balance

Revenues and expenses that are not directly related to the primary operations of a business owner’s equity

Owner’s current investment in the assets of a business

Specified amount of money that is under the control of one employee and that is used for making small cash payments for a business planning

Management activity that establishes a business’s goals and the means of achieving these goals Schedule a business prepares after making its closing entries to prove the equality of the debit and credit balances in its asset, liability and owner’s equity accounts posting

The partners’ current investment in the assets of the business

Process of transferring the debit and credit information for each journal entry to the accounts in a business’s general ledger

partnership

prepaid insurance

Business owned by two or more individuals who each invest capital,

Cost paid for the right to insurance protection

partners’ equity

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515

Glossary

prepaid item

Current asset (economic resource) that a business records when it pays for goods or services before using them present value

Value today of a certain amount of dollars to be paid or received in the future profit

Difference between the total revenues of a business and the total costs (expenses) of the business during a specific time period profit margin

Net income divided by net sales projected balance sheet

Statement summarising a business’s expected financial position (assets, liabilities and owner’s equity) at the end of a budget period projected income statement

Statement summarising a business’s expected revenues and expenses for the budget period

costs, a ratio less than one indicates that costs are higher than benefits

purchase order

Document authorising a supplier to ship the items listed on the document at a specific price

Reduction in the sales price of a good or service because of the number of items purchased or because of a sales promotion

return on owner’s equity

quick assets

Consist of cash, short-term securities, accounts receivable and short-term notes

Net income and interest expense are added together and then divided by average total assets

quick ratio

revenues

Quick assets divided by current liabilities

Prices charged to a business’s customers for the goods or services the business provides to them

ratio analysis

Calculations made in financial analysis in which an item on a business’s financial statements is divided by another related item

Net income divided by average owner’s equity return on total assets

risk

Amount of uncertainty that exists about the future operations of a business

recording revenues

sales allowance

A business does this during the accounting period in which the revenues are earned and are collectable (or collected)

When a customer agrees to keep damaged merchandise and the business refunds a portion of the original sales price

recycling rate

sales budget

The percentage of total waste that is recycled

Budget showing the number of units of inventory that a business expects to sell each month, the related monthly sales revenue and the months in which the business expects to collect cash from these sales

relevant cash flows

Future cash flows that differ, either in amount or in timing, as a result of accepting a capital expenditure proposal

sales discount relevant costs

Future costs that will change as a result of a decision

Percentage reduction of the invoice price if the customer pays the invoice within a specified period

Budget showing the purchases (in units) required in each month to make the expected sales in that month (from the sales budget) and to keep inventory at desired levels

relevant range

sales return

Range of volumes over which cost estimates are needed for a particular use and over which observed cost behaviours are expected to remain stable

When a customer returns previously purchased merchandise and receives a refund

qualitative social cost–benefit analysis

relevant revenues

purchases budget

A way to calculate social cost–benefit analysis that rates the perceived costs and benefits of a proposed business activity or project on a scale of 1 to 10 (with 1 being of low benefit or cost and 10 being of maximum benefit or cost). The sum of perceived benefits is divided by the sum of the perceived costs. A ratio greater than one indicates benefits are higher than 516

Money received from investment and credit decisions

quantity discount

property and equipment

All of the physical (tangible), long-term assets a business uses in its operations

return

selling expenses

Future revenues that will change as a result of a decision

Operating expenses related to the sales activities of a business selling expenses budget

required rate of return

Cut-off rate used to distinguish between acceptable and unacceptable capital expenditure proposals

Budget showing the expenses and related cash payments associated with planned selling activities service business

residual equity

Term used to refer to owner’s equity because creditors have first legal claim to a business’s assets

A business that performs services or activities that benefit individuals or business customers

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Glossary

share percentage

Ratio of a sub-group to a total amount, commonly calculated in relation to a baseline; for example, the share of recycling waste as a percentage of total waste

statement of changes in owner’s equity

A summary of the changes in the shareholders’ (owner’s) equity in a company that have occurred during a specific period of time

shareholders

succession planning

Individuals who own shares (stock) in a company

The process of identifying, developing and training people within a business so they can take on key management roles as current managers leave or retire. Succession ensures there are experienced and capable employees to assume management roles as required

shareholders’ equity

The shareholders’ interest in the business, which is the difference between total assets and total liabilities – that is, the amount that the business owes to the owner (shareholders) short-term capital

Capital that will be repaid within a year or less single future amount

A one-time future cash flow slide

Occurs when the digits are listed in the correct order but are mistakenly moved one decimal place to the left or right social accounting

Aims to provide information on, and assess the impact of, business activities on people internal and external to the organisation (stakeholders), covering issues such as product safety and education, community relations and training initiatives

sustainability

The recognition of intergenerational and intragenerational equity, where the meeting of the needs and wants of a person or group now should not compromise the ability of a future person or group to meet their needs and wants sustainability accounting

A set of statements providing cost data about economic, environmental and social impacts, from both financial accounting and cost accounting – for example, data about increasing material efficiency, reducing environmental impact and risk, and reducing costs of environmental protection sustainability reporting

total costs

Sum of the fixed costs and variable costs at a given volume transaction

Exchange of property or service by a business with another entity transposition

Occurs when two digits in a number are mistakenly reversed trial balance

Schedule that lists the titles of all accounts in a business’s general ledger, the debit or credit balance of each account, and the totals of the debit and credit balances triple bottom line

Reporting that provides information about the economic, environmental and social performance of an entity unearned revenue

Obligation of a business to provide goods or services in the future, resulting from an advance receipt of cash unlimited liability

Indefinite or unlimited personal liability for the debts incurred by the business. For a sole proprietorship, this means that the owner’s personal assets may be at risk if things go wrong in the business variable cost

Business owned by one individual who is the sole investor of capital into the business

The practice of measuring, disclosing and being accountable to internal and external stakeholders for organisational performance towards the goal of sustainable development – that is, reporting on economic, environmental and social impacts

solvency

T-account

wages and salaries payable

Amounts owed to employees for work they have done

source document

Accounts used to record transactions for individual types of assets, liabilities and owner’s equity, as well as revenues and expenses

Business record used as evidence that a transaction has occurred

temporary accounts

sole proprietorship or sole trader

A business’s long-term ability to pay off its debts

specific identification method

Allocates costs to cost of goods sold and to ending inventory by assigning to each unit sold and to each unit in ending inventory the cost to the business of purchasing that particular unit

Accounts used for one accounting period to record the effects of a business’s transactions on its net income (revenues and expenses)

Cost that is constant per unit and that changes in total in direct proportion to changes in volume volume

Activity level in a business

withdrawal

A payment from the business to the owner working capital

A business’s current assets minus its current liabilities

total contribution margin

Difference between the total sales revenue and the total variable costs

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INDEX A AASB 101 – Presentation of Financial Statements, 150, 282 AASB 102 – Inventories, 299, 300 AASB 116 – Property, Plant and Equipment, 282 AASB 119 – Employee Benefits, 282 AASB 121 – The Effects of Changes in Foreign Exchange Rates, 282 AASB 138 – Intangible Assets, 282, 316 AASB 139 – Financial Instruments: Recognition and Measurement, 282 account form of balance sheet, 164, 313 account numbers, and chart of accounts, 191–2 accountant, in a changing society, 26–35 accounting cycle, 183 modifications for companies, 209–11 posting from journals to the accounts, 190–6 preparing closing entries, 205–9 preparing the financial statements, 203–5 recording adjusting entries, 197–202 recording (journalising) transactions, 183–90 accounting equation and the balance sheet, 312–18 components, 139–40 and debit–credit rules, 182–3 and dual effect of transactions, 141–3 expanding, 148 using the, 140 accounting for transactions to start a business, 143–8 accounting information business issues and values, 212–13 and decision making, 35 accounting methods for GST, 331 accrual basis, 332 cash basis, 331–2 accounting period, 149 accounting principles and concepts related to net income, 149–50 accounting process, foundations, 120 Accounting Professional and Ethical Standards Board (APESB), Code of Ethics for Professional Accountants, 25 accounting rate of return (ARR) method, 492–4 accounting support

518

for external decision making, 19–20 for management activities, 18–19 accounting system, 15–23 accounting terms and concepts, 136–9 accounts, 180–1 debit and credit rules, 182–3 debits and credits, 181 posting from journals to the, 190–3 recording rules, 181–3 accounts payable, 97, 139, 248–9, 317, 366 controls, 249 accounts payable balance, 249 accounts payable subsidiary ledger, 194 accounts receivable, 97, 139, 241–3, 364–5 control procedures to safeguard cash from, 232 decision to extend credit, 241–2 simple controls over, 242–3 uncollected, 201 accounts receivable balance, 243 accounts receivable subsidiary ledger, 194 accounts receivable turnover, 328–9 accrual accounting, 150 for GST, 332 accrual of interest, 163 accrued expenses, 200 accrued items, recording, 200–1 accrued revenue, 200–1 accumulated amortisation, 201 accumulated depreciation, 163, 201, 316 acid-test ratio, 320 activities necessary for the business to carry out the decision, 442–4 future costs that a business will incur for activities that are not necessary to carry out the decision are not relevant, 443 no cost incurred prior to making the decision is relevant, 443 actual amounts, differences from budgeted amounts, 117–19, 475–9 adapting to change, 6 adjusted trial balance, 202–3 adjusting entries, 197–202 apportionment of prepaid items and unearned revenues, 197–200 posting, 202 recording of accrued items, 200–1 recording or apportionment of estimated items, 201 advertising, payment for, 155, 156

agents, 12 air emissions, 412, 413 allowance for bad debts, 201 alternative proposals for investment, 494 capital rationing, 495–6 mutually exclusive capital expenditure proposals, 494–5 amortisation of intangible assets, 201 annual depreciation, 493 annual report, 23 annuity, present value of, 418–21 apportionment of estimated items, 201 of prepaid items and unearned revenues, 197–200 asset accounts, 182, 183 assets, 139, 140, 314–16 Australian Accounting Standards Board (AASB), 20, 136 see also AASB Australian SAM Sustainability Index (AUSSI), 400 Australian Securities and Investments Commission (ASIC), 20 Australian sustainability reporting guidelines, 404–5 Australian Taxation Office (ATO), 14, 51, 331 auxiliary materials, 411 average investment, 493 avoidable costs, 446

B bad debts, 201 balance, 140 balance of an account, 183 balance sheet, 22–3, 134–5, 204–5, 206, 228–9, 312–13 and the accounting equation, 312–18 for companies, 211 CVP analysis and budgeting, 311–12 effect of net income on, 163–5 importance of, 310–12 and income statement for evaluations, 324–9 and income statement, limitations, 329–30 and income statement, why users need both, 310–11 relationship with cash flow statement, 354, 355, 370–1

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Index

relationship with income statement, 323–4 reporting cash balance on, 240–1 using the figures for evaluation, 318–21 bank reconciliation, 233–40 additional controls over cash, 237–40 preparing, 235–6 structure, 235 bank statement, 233 BAS see business activity statement benchmarks, 17, 45 budgets as, 96–7 book value, 163, 316 borrowing, 9 ‘bounced’ cheque, 234 BP Gulf of Mexico oil spill (2010): A triple bottom line disaster, 401 brainstorming, 33 break-even analysis, 55 break-even point, 60, 66, 92 budgeted amounts, differences from actual amounts, 117–19, 475–8 budgeting, 18–19 CVP analysis and the balance sheet, 311–12 reasons for, 95–6 budgets, 54, 95 add discipline, 96 as benchmarks, 96–7 business issues and values, 119–20 as a framework for planning, 99–117 highlight potential problems, 96 quantify business plans, 96 building a new factory – capital expenditure proposal, 484–6 buildings and equipment, depreciation, 201 business activity statement (BAS), 331 completing, 332–5 GST calculation worksheet, 333 illustration, 334–5 business enterprise categories, 7–9 business environment, factors affecting, 4–7 business performance, master budget to evaluate, 117–19 business plan, 45–54 description of the business, 46–8 elements, 46 environmental management plan and sustainability, 49–50 financial plan, 51–4 marketing section, 48 operations section, 48–9

purposes, 45–6 quantifying through budgeting, 96 what happens if a business does not have a, 69 business structures, 9–13 by-products, 412

C Cafe´ Revive (coffee shop) adjusted trial balance, 202, 203 adjusting entries, 198 balance sheet, 164, 204–5, 206, 228, 313 bank reconciliation, 237, 238–9 BAS statement, 334–5 business plan, 45–54 cash account, 360 cash budget, 113–14 cash flow statement, 361, 362, 363 chart of accounts, 191, 192 classified balance sheet, 313–14 classified income statement, 267–8 closing entries, 207 comparison of actual versus budget amounts, 118 CVP analysis – coffee gift packs, 55–68 CVP analysis – cups of coffee, 86–93 description, 46, 47 end-of-period adjustments, 160–3 financial plan, 51–4 fixed costs, 55–6 general and administrative expenses budget, 110–11 general journal entries, 185–7, 188–90 general ledger, 194–5 general ledger after adjusting entries, 199–200 GST calculation worksheet for BAS, 333 income statement, 204 inventory information, 245–6, 247–8 marketing plan, 48 master budget, 100 net income and its effect on the balance sheet, 163–5 operating cycle, 97, 98 operating expenses, 278–9 operations, 49 organisation, 46, 47 posting of closing entries, 208, 209 posting process, 193 profit calculation, 59–65 projected balance sheet, 116

projected income statement, 114–16 purchases budget, 105–8 recording daily operations, 150–9 recyclable cups, 425 reusable coffee cup project, 424–5 sales budget, 101–3, 104 selling expenses budget, 109–10 as sole proprietorship, 10 start-up costs, 51 statement of changes in owner’s equity, 204, 205, 284–5, 318 taxable income, 11 total costs, 58–9 transactions and analysis, 185, 187–8 transactions for starting the business, 143–8 variable costs, 56–8 working capital flows, 229–30 year-end inventory calculation, 247 capital, 8, 23, 51, 318 sources of, 9, 52–3 capital expenditure, 474 initial cost, 478–9 capital expenditure decisions, 474–5 accounting rate of return method, 492–4 business issues and values, 496 comparing actual results with budgeted results, 475–8 comparison of models, 494 determining acceptable proposals, 483 determining the required return on investment, 482 estimating future cash flows, 479 estimating the initial cash payment, 478–9 estimating relevant cash flows, 480–1 internal rate of return (IRR) method, 490–1 making, 475–83 net present value (NPV) method, 483–91, 494 payback method, 491–2, 494 selecting alternative proposals for investment, 494–5 when do businesses make?, 475 capital expenditure proposals build a new factory, 484–6 purchase packaging machine, 486–7 purchase shares, 487–90 capital rationing, 495–6 capital requirements, 51–2 cash, 230–41, 315, 354 bank reconciliation, 233–40 controls, 231–3, 237, 240

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

519

Index

investing (in the business), 143–4 withdrawal by owner, 153, 154 cash balances causes of difference, 234 reconciliation, 363 reporting on the balance sheet, 240–1 cash basis of accounting for GST, 331–2 cash budget relationship with cash flow statement, 369 retail business, 112–14 service business, 114 cash buffer, 52, 112 cash discount, 271 cash flow returns, 368–9 cash flow statement, 23, 354 analysis, 367–73 importance of, 354 organisation, 357–8 preparing, 360 relationship with balance sheet, 354, 355, 370–1 relationship with cash budget, 369 relationship with income statement, 369–70 understanding, 354–7 cash flows annual, and operating income, 480 business issues and values, 373 ending, 481 from financing activities, 358, 363 from investing activities, 358, 363 from operating activities, 358, 359, 361–2, 364–7, 390–6 future, 479, 480 relevant, 480–1 cash inflows, 354, 355–6 cash management, 111–12, 330 cash outflows, 354, 355, 357 cash payments, controls over, 232–3 cash purchase of shop equipment, 147 of supplies, 145–6 cash receipts, controls over, 231–2 cash return on owner’s equity, 371 cash return ratios, 371 of actual companies, 371 cash return on total assets, 371 cash sales, 150–1, 152, 153 summary, 158 charges made directly by the bank, 234 chart of accounts, 191–2 Chartered Accountants Australia and New Zealand, 25 choosing a solution (problem-solving process), 34

520

classified balance sheet, 313–14 classified income statement, 267–8 Clean Energy Regulator (CER), 405 climate change, 5, 403 closed life cycle loop, 410 closing entries, 205 expense accounts, 207, 295–6 income summary account, 208 posting, 208 preparation of, 205–9 revenue accounts, 206, 285–6 withdrawals account, 208 Code of Ethics for Professional Accountants, 25 codes of ethics, 25 coffee manufacture and sale, businesses involved in, 3 collections from customers, 364–5 communication skills, 27, 28 companies/corporations, 10, 13, 209 balance sheet items, 211 distributions to owners, 210 income statement items, 210–11 investments by owners, 209–10 competition, 14 Competition and Consumer Act 2010, 14 complex business activities, 5 compound entry, 184 compound interest, 417 constant dividend growth, 489 consulting, payment for, 155, 156 contra-account, 201 contributed capital, 211 contribution margin, 60–3, 89 contribution margin per unit, 62, 89 controls over accounts payable, 249 over accounts receivable, 242–3 over cash payments, 232–3 over cash receipts, 231–2, 237, 240 over inventory, 244–5 corporate social responsibility (CSR), 49, 286, 312, 400–1 Corporations Act 2001, 20 sustainability reporting, 404–5 cost accounting, 19 cost analysis, 19 cost behaviour, 55–9 cost–benefit matrix, 427 cost of capital, 482 cost of ending inventory, 245–8, 276, 300–4 cost of goods for sale, relationship with cost of goods sold and held inventory, 245–6 cost of goods sold, 274, 300–1, 366

first in, first out (FIFO) method, 246, 248, 301–2 and gross profit, 276 last in, first out (LIFO) method, 246, 248, 300, 303–4 periodic inventory system, 275–6 perpetual inventory system, 274–5, 276 relationship with cost of goods for sale and year-end inventory, 245–6 specific identification method, 246–8 weighted average cost method, 246, 248, 302–3 see also inventory cost reports, 117 for products and services, 19 cost–volume–profit (CVP) analysis, 54–65 budgeting and the balance sheet, 311–12 for coffee gift packs, 55–65 for cups of coffee, 86–93 estimating profit at given unit sales volume, 65, 92 finding the break-even point, 66, 92 finding the unit sales volume to achieve a target profit, 67, 93 summary of calculations, 67–8 ‘what if’ scenarios, 68 CPA Australia, 25 ‘cradle to grave’, 409–10 creative thinking, 30 credit, 52 decision to extend, 241–2 credit balance, 193 credit entry (CR), 181, 182 credit memo, 273 credit purchase, 97 of shop equipment, 147 credit purchase of inventory, 146 payment for, 151 credit sales, reasons for, 241 credit sales of shop equipment, 147–8 receipt of payment, 153, 154 creditors, 9, 139 creditors’ equity, 317 critical thinkers characteristics, 29 strategies, 30 critical thinking, 27, 28–30 applying to business decisions, 30 and four stages in problem solving and decision making, 30–4 CSR see corporate social responsibility current assets, 206, 228, 229, 315

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Index

current liabilities, 206, 211, 228, 229, 317 current ratio, 320, 368 CVP analysis see cost–volume–profit (CVP) analysis

D days’ sales in receivables, 329 debit balance, 183 debit–credit rules, 182 and accounting equation, 182–3 debit entry (DR), 181, 182 debt ratios, 322, 368 of actual businesses, 322 decision making and accounting information, 35 calculating short-term decisions, 449–59 deciding whether to drop a product, 450–4 deciding whether to make or buy a part, 454–7 deciding whether to sell a product or process it further, 457–9 and environment costs, 50 and financial accounting information, 134–6 four stages in, 30–4 non-financial issues, 460 other cost and revenue concepts, 445–6 relevant costs and revenues, 442–5 relevant costs and revenues – special order, 447–9 DeFlava Coffee Corporation, 10 accounting information and decision making, 35 balance sheet, 23, 134, 135, 138, 477 budget, 19 capital expenditure proposal – build new factory, 484–6 capital expenditure proposal – purchase packaging machine, 486–7 as a company, 13 cost analysis, 19 critical thinking and four stages in decision making, 30–4 determining relevant costs and revenues (special order), 447–9 environmental management, 49–50 and external decision making, 19–20 income statement, 134, 135, 476 material flow cost accounting, 411–13 operating, 17

purchasing new fleet cars (ecoefficiency), 413–14 regulatory environment, 14 sell-or-process-further decision, 458–9 Della, Emily (owner of Cafe´ Revive), 10 business plan, 45–6 financial plan, 51–4 personal taxable income, 11 deposit in transit, 234 deposits made directly by the bank, 234 depreciation, 55, 161 annual, 493 on buildings and equipment, 201 shop equipment, 161–3 treatment of, 480–1 description of the business, 46–8 differences between actual and budgeted amounts, 117, 475–9 why differences occur, 117–19 direct method (for calculating net cash flows from operating activities), 359, 364–7 collections from customers, 364–5 illustration, 390–2 payments to employees, 366 payments to suppliers, 366–7 discount rate, 418, 482 discounts, 271–2 disinvestments, 208, 283 distributions to owners, 210 dividend growth model, 489 dividends, 210 from shares, 479, 487–90 double entry rule, 182 Dow Jones Sustainability Index (DJSI), 400, 404 drawing analogies, 310 drawings, 153 dual effect of transactions, 141–3 transaction ‘scales’, 141–3

E e-commerce, 5 earning process, 149 eco-efficiency, 413–14 ecological balance, concept of, 411 ecologically sustainable development, 50 economic performance, 402–3 emissions, 412, 413 employees payment of, 139, 155, 157, 366 value of, 330 end-of-period adjustments, 160–3 revenue adjustments, 163 ending cash flows, 481

energy bills, payment of, 158, 159 energy share, 414 Enron Corporation, corporate collapse, 24–5 entity concept, 136, 138, 139 entrepreneurs, 9 entrepreneurship, 9 environment costs, and decision making, 50 environmental and social expenses budget, 117 environmental and social issues, 286 see also social accounting environmental management accounting, 409 eco-efficiency, 413–14 life cycle analysis, 409–10 material flow cost accounting, 411–13 share percentage, 414–15 environmental management plan, 49–51 environmental management system (EMS), 50 environmental performance, 402–3 environmental project appraisal, 415–26 calculating payback periods, 415–16 time value of money and present value, 416–22 equipment and buildings, 316 depreciation, 201 equity, 12 errors in bank or business records, 234 checking for (adjusted trial balance), 202 estimated items, 201 ethics at the business level, 25–6 in business and accounting, 24–5 professional organisations’ codes of ethics, 25 toxic waste clean-up, 70 evaluating, 17 financial flexibility, 321–6 income statement using ratios, 279–82 liquidity, 319–21 operating capability, 326–9 profitability, 325–6 using the balance sheet and income statement, 324–9 using the balance sheet figures, 318–21 evolving forms of business, 5 excessive cash balance, 112 expanded accounting equation, 148 recording daily operations, 150–9

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521

Index

expense accounts, 182, 183 closing, 207, 285–6 expenses, 20, 21, 148, 267 defining and classifying, 274–9 expenses budget, service business, 111 expired rent, 161 Express Transfer Company, operating cycle, 97–9 extending credit, decision to, 241–2 external-failure cost, 273 external users, 19 accounting support for, 19–20 use of income statement, 266 extra supplies, purchase of, 155, 156

F factor, 418 federal regulatory issues, 15 financial accounting, 15, 19 financial accounting information, 16 and decision making, 134–6 financial assets, 316 financial expenses, 277–8 financial flexibility, 280, 321–2 evaluating, 321–6 financial performance measured from income statement, 267–8 projected, 53–4 financial plan, 51–4 financial statements, 20–3 decision making based on, 134–5 interrelationships among, 371–2 preparing, 203–5 see also balance sheet; cash flow statement; income statement financing activities section (cash budget), 113 financing activities section (cash flows), 358, 363 first in, first out (FIFO) method, 246, 248, 300, 301–2 fixed assets, 316 fixed costs, 55–6, 86 free on board (FOB) destination point, 299–300 free on board (FOB) shipping point, 299 FTSE4Good Index Series, 400 future cash flows, 480 estimating, 479 future cash payments, reducing, 479 future value, 417

G general and administrative expenses, 277, 299

522

general and administrative expenses budget, 110–11 general journal information in, 183–4 recording (journalising) transactions, 183–90 general journal entries, 185–7, 188–90 general knowledge, 26–7 general ledger, 180, 194 and subsidiary ledgers, 194–6 general ledger accounts, 180 posting journal entries to, 190–3 generally accepted accounting principles (GAAP), 16, 20, 135–6, 149, 212, 243, 266 Global Reporting Initiative (GRI), 116, 373, 405–7 G4 Framework, 405–6 G4 Guidelines, 407 Global Sustainability Standards Board (GSSB) Sector Program, 407 GRI 101 – Foundation, 407, 408 GRI 102 – General Disclosures, 407, 408 GRI 103 – Management Approach, 407, 408 GRI 200 – Economic standards, 407, 408 GRI 300 – Environmental standards, 407, 408 GRI 400 – Social standards, 407, 408 Sustainability Reporting Standards, 49, 116, 406, 407, 408 global sustainability, 399, 404 globalisation, 5 glossary, 510–17 going concern, 150 goods and services tax (GST), 14, 51, 331 accounting for on an accrual basis, 332 accounting for on a cash basis, 331–2 calculation worksheet for BAS, 333 tax periods, 331 government agencies, 14 green economy, 330 greenhouse gas emissions, 405 ‘greenwashing’, 402 gross profit, 276 gross profit margin, 281 gross profit percentage, 281 GST see goods and services tax guidelines for reporting to people outside the business, 20 Gulf of Mexico oil spill (2010): A triple bottom line disaster, 401

H historical cost concept, 137–8, 330 holders of instruments classified as equity, 282 how much will the costs and/or revenues be affected if the business undertakes the activities?, 444 specific cost is relevant only if the total amount that the business will incur is affected by the decision, 444

I identifying alternative solutions (problem-solving process), 33 in transit, 299 income, defining and classifying, 269–73 income statement, 21, 134–5, 204, 264 and balance sheet for evaluations, 324–9 and balance sheet, limitations, 329–30 and balance sheet, why users need both, 310–11 classified, 267–8 for companies, 210–11 evaluating using ratios, 279–82 operating income section, 267, 268 other items section, 267–8 projected, 60–2, 63 relationship with balance sheet, 324–5 relationship with cash flow statement, 369–70 sales policies affect on, 271–3 and statement of comprehensive income, 282–3, 284 to measure financial performance, 267–8 uses of, 264–6 income summary account, 205 closing, 208 income tax (companies), 210–11 incremental costs, 445–6 independent, 29 indirect method (for calculating net cash flows from operating activities), 359, 390, 392–6 illustration, 392–4 steps to complete under, 394–5 using information from, 395–6 information explosion, 4 initial cost (of proposed capital expenditure), 478–9 input–output analysis, 373 Institute of Public Accountants (IPA), 25 intangible assets, 316

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Index

amortisation, 201 integrated reporting, 407–9 six capitals, 408–9 Integrated Reporting (IR) Framework, 407 interest, accrual of, 163 intergenerational equity, 427–8 internal control structure, 230 internal rate of return (IRR), 490–1 internal users, 18 use of income statement, 265–6 International Accounting Standards Board (IASB), 20 International Federation of Accountants (IFAC), 25 code of ethics, 25 International Financial Reporting Standards (IFRS), 20, 136 International Integrated Reporting Council (IIRC), 407 international regulations, 15 inventory, 97, 244–8, 299, 315, 366 calculating the amount of, 299–300 controls, 244–5 cost of ending, 245–8, 276, 300–4 first in, first out (FIFO) method, 246, 248, 301–2 last in, first out (LIFO) method, 246, 248, 300, 303–4 purchasing on credit, 146, 151, 152 specific identification method, 246–8 using alternative inventory cost flow assumptions, 300–4 weighted average cost method, 246, 248, 302–3 see also cost of goods sold inventory level, managing, 158 inventory systems periodic inventory system, 185, 212, 275–6 perpetual inventory system, 185, 212, 274–5, 276 inventory turnover, 327–8 investing activities section (cash budget), 112–13 investing activities section (cash flows), 358, 363 investing cash, 143–4 investment alternative proposals for, 494–6 long-term, 315 short-term, 315 investment in the business, 9 by owners (shareholders), 209–10 invoice, 145, 269 irrelevant costs, 442 ISO 14040, 409

J James Hardie asbestos case, 426 joint ownership, 12 journal entries, 184 additional, 212 illustration, 185–7, 188–90 journalising transactions, 183–90 key procedures, 184–5 judgement, 27

K knowledge, 26–7

L language of business, 6–7 last in, first out (LIFO) method, 246, 248, 300, 303–4 laws, 14 Learning Standards for accounting, 26–30 ledgers, 194 general, 180, 194 subsidiary, 194 legal form of business, 10–13 lenders, 9 liabilities, 139, 140, 317–18 liability accounts, 182, 183 life cycle analysis, 409–10 and eco-efficiency, 413–14 and material flow cost accounting, 411–13 limited liability, 12 limited life, 11 line of credit, 53 liquidity, 164, 319, 326–7, 368 evaluating, 319–21 liquidity ratios, 319–21 of actual businesses, 321 loans, 53 loans payable, 139 local government regulatory issues, 15 long-term capital, 53 long-term investments, 315 long-term liabilities, 317

M make-or-buy decision, 454–7 management accounting, 15, 19 management accounting information, 16 management accounting reports, 18–19 management activities, 16–18 accounting support for, 18–19 management by exception, 97 management fraud, 213 managing inventory level, 158

manufacturing business, 7, 8 interrelationships among budget schedules in the master budget, 100, 101 master budget, 100 marketable securities, 315 marketing plan, 48 master budget, 99 elements of, 99 manufacturing business, 100 retail business, 99, 101 service business, 100 to evaluate the business’s performance, 117–19 matching principle, 149 material flow cost accounting, 411–13 share percentage, 414–15 merchandise, 7, 412 merchandising businesses, 7, 8 mobile and wifi, payment of, 158, 159 Modern Slavery Act 2018, 49 monetary unit concept, 137, 138, 139 mutually exclusive capital expenditure proposals, 493–5

N narration, 184 National Environmental Protection Measures (NEPMs), 50 National Greenhouse and Energy Reporting (NGER) legislation, 405 natural capital, 330, 372 natural capital inventory accounting, 372 net cash flows from operating activities, 359 direct method, 359, 364–7, 390–2 indirect method, 359, 390, 392–6 net income, 20, 21, 23, 268 accounting principles and concepts related to, 149–50 effect on the balance sheet, 163–5 net loss, 21 net present value (NPV), 422 of a capital expenditure proposal, 422–6, 483–90, 494 and internal rate of return (IRR), 490–1 and required rate of return, 422–3 three-step process, 483–4 net purchases, 276 net realisable value, 243, 299 net sales, 273 non-constant dividend growth, 489–90 non-current assets, 315, 316 non-current liabilities, 317–18

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523

Index

non-current marketable securities, 316 non-financial issues in decision making, 460 non-operating income section (income statement), 268 not-for-profit organisations, 13 NPV see net present value NSF (not sufficient funds), 234 number of days in the collection period, 328 number of days in the selling period, 328

O objectivity, 29 operating, 17 operating activities section (cash budget), 112 operating activities section (cash flows), 358, 361–2 net cash flows from, 359, 364–7, 390–6 operating assets, 316 operating capability, 280 evaluating, 326–9 operating capability ratios, 327–9 of actual businesses, 329 operating capital management, 229 operating cash flow margin, 370 of actual companies, 370 operating cycles, 364 retail business, 97 service business, 97–9 operating expenses, 21, 277–9 operating income, 268 and annual cash flows, 480 operating materials, 412 operating plan, 48–9 opportunity costs, 446 organisation of the business, 46, 47 organisational and business knowledge, 27 other comprehensive income, 282 other items (income statement), 268–9 outstanding payments, 234 owner’s equity, 23, 140, 318 linking profit to, 283–5 permanent and temporary, 182, 183

P packaging, 412 partner’s equity, 140 partnership agreement, 11 partnerships, 10, 11–12 characteristics, 11–12 equity, 12 payback method, 491–2, 494

524

payback periods, calculating, 415–16 PAYG withholding tax, 331 payment(s) of cash, 357 for consulting and advertising, 155, 156 for credit purchase of inventory, 151, 152 of mobile and wifi and energy bills, 158, 159 of salaries, 139, 155, 157, 366 to employees, 366 to suppliers, 366–7 pending payments, 234 periodic inventory system, 185, 212, 275–6 permanent accounts, 267 permanent owner’s equity, 182, 183 perpetual inventory system, 185, 212, 274–5, 276 petty cash fund, 240 planning, 17 budget as framework for, 99–117 cost–volume–profit (CVP), 54–65 a new business, 45–54 wastes, 70 what happens if a business doesn’t have a business plan?, 69 post-closing trial balance, 208 posting, 190–3 adjusting entries, 202 closing entries, 208, 209 illustration, 193 key procedures, 192–3 prepaid insurance, 139 prepaid items, 315 adjustments, 197–8 preparing adjusted trial balance, 202–3 adjusting entries, 197–202 bank reconciliation, 235–6 closing entries, 205–9 financial statements, 203–5 prepaying rent, 145 present value of an annuity, 418–21 definition, 417 examples, 421–2 of future cash flows, 426 share purchase, 487–90 of a single future amount, 417–18 see also net present value Prince’s Accounting for Sustainability project (A4S), 407 private enterprises, relationship between types of, 8 private placements, 53

problem solving, four stages in, 30–4 Process Control Company, make-or-buy decision, 455–7 product life cycle, stages, 409–10 products, 7, 412 deciding whether to drop a product, 450–4 deciding whether to sell a product or process it further, 457–9 professional organisations’ codes of ethics, 25 profit, 20, 23 at given unit sales volume, 65, 92 linking to owner’s equity, 283–5 profit and loss statement, 21, 282 profit calculation, 59–65, 88–90 equation form, 64–5, 90–1 showing CVP relationships, 63–4, 90 profit graph, 59–60, 61, 88–90 profit margin, 280 profitability, evaluating, 280–1, 325–6 profitability ratios, 280–1, 325–6 of actual businesses, 281–2, 326 projected balance sheet, 100, 116 projected cash flow statement, 100, 112–14 projected income statement, 114–17 property and equipment, 201, 316 provisions, 317 public offerings, 53 public-sector reporting, 50 purchase extra supplies, 155, 156 inventory on credit, 146, 151, 152 inventory of gift packs, 151 shop equipment with cash and credit, 147 supplies with cash, 145–6 purchase order, 244 purchase packaging machine – capital expenditure proposal, 486–7 purchases budget, retail business, 105–8

Q qualitative social cost–benefit analysis (QSCBA), 427, 428 quantity discount, 271 quick assets, 320 quick ratio, 320–1, 368

R ratio analysis, 280 ratios debt, 322, 368 liquidity, 319–21 operating capability, 327–9

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Index

profitability, 280–2, 325–6 to evaluate income statement, 279–82 raw materials, 411 receipt of payment for credit sale of shop equipment, 153, 154 receipts of cash, 355–6 receivables, 315 recognising and defining the problem (problem-solving process), 30–2 reconciliation cash balances, 363 see also bank reconciliation recording accrued items, 200–1 daily operations, 150–9 estimated items, 201 revenues, 149 transactions, 183–90 recyclable cups, 425 recycling rate, 413 regulatory environment, 14–15 relevant cash flows, estimating, 480–1 relevant costs, 442 activities necessary for the business to carry out the decision, 442–4 how much will the costs be affected if the business undertakes the activities, 444 illustration (special order), 447–9 three-step process to identify, 445 relevant range, 55 relevant revenues, 442 activities necessary for the business to carry out the decision, 442–4 how much will the costs be affected if the business undertakes the activities, 444 illustration (special order), 447–9 rent expired, 161 prepayment, 145 report form of balance sheet, 313 required rate of return, 422–3, 479, 482 residual equity, 140, 318 retail business cash budget, 112–14 general and administrative expenses budget, 110–11 interrelationships among budget schedules in the master budget, 101 master budget, 99 operating cycles, 97 purchases budget, 105–8 sales budget, 101–3 selling expenses budget, 108–9 retailers, 7, 8

retained earnings, 211 return, 46 return on owner’s equity, 326 return on sales, 280 return on total assets, 325 reusable coffee cup project, 424–5 revenue accounts, 182, 183 closing, 206, 285–6 revenues, 20, 21, 148, 267 defining and classifying, 269–73 earning and recording, 149 end-of-period adjustments, 163 from other sources, 273 risk, 46, 279–80 Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, 25

S salaries, payment of, 139, 155, 157, 366 salaries payable account, 317, 366 sales allowances, 272–3 sales budget, 101 retail business, 101–3 service business, 103 sales discount, 271 sales invoice, 269 sales policies, affect on income statement reporting, 271–3 sales returns, 272, 273 sales revenue, 269–71 sales revenue (net), 273 seasonal sales, 104–5 self-management skills, 27, 28 sell-or-process-further decision, 457–9 selling expenses, 277 selling expenses budget, retail business, 108–9 service business, 7 cash budget, 114 expenses budget, 111 master budget, 100 operating cycle, 97–9 share percentage, 414–15 share purchase, 487–8 constant dividend growth, 489 non-constant dividend growth, 489–90 zero dividend growth, 488 shareholders, 13, 209–10 shareholders’ equity, 23, 211 shop equipment depreciation, 161–3 purchasing with cash and credit, 147 receipt of payment for credit sale of, 153, 154

selling extra on credit, 147–8 short-term capital, 52–3 short-term financial management, 229 short-term investments, 315 short-term loans payable, 317 short-term planning decisions, 441–2 calculating, 449–59 deciding whether to drop a product, 450–4 other costs (and revenue) concepts, 445–6 relevant costs and revenues, 442–5, 447–9 single future amount, 417 future value, 417–18 slide, 202 social accounting, 426 intergenerational equity, 427–8 qualitative social cost–benefit analysis, 427, 428 social and environmental issues, 286 social cost–benefit analysis, 427 social performance, 403 sole proprietorships, 10–11 see also Cafe´ Revive sole traders, 10 solid waste, 412 solvency, 9, 20, 368 source documents, 137, 139 special journals, 183–4 specific identification method, 246–8 state/territory regulatory issues, 15 statement of changes in owner’s equity, 22, 204, 283–5, 318 statement of comprehensive income, 282–3, 284 statement of financial position, 22–3 statement of profit and loss, 21, 282 stocktaking, 276 subsidiary ledgers, 194–6 successful businessperson, 5–6 succession planning, 429 summary cash sales, 158 suppliers, payments to, 366–7 supplies, purchasing with cash, 145–6 supplies used, 160–1 Sustainability: A Guide to Triple Bottom Line Reporting, 404 sustainability in business, 14, 25–6, 49, 399–400, 428, 496 as a business strategy, 429–30 five basic steps to, 120 sustainability accounting, 401 history, 372–3 see also triple-bottom-line accounting

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525

Index

sustainability reporting, 373, 404 Australian guidelines, 404–5 GRI standards, 49, 116, 405–7, 408 sustainable business, 399–400, 428 characteristics, 429–30 sustainable cost, 372 Sustainable Development Goals (SDGs), 402–3 Australia’s first Voluntary National Review towards, 403 National Reporting Platform, 403

T T-account form, 181, 190–1 target profit, finding unit sales volume to achieve, 67, 93 tax periods, 331 taxation, 14 teamwork skills, 27, 28 technological advances, 4–5 temporary accounts, 197, 205, 208, 267, 285 closing, 285–6 temporary investments, 315 temporary owner’s equity, 182, 183 three-column account form, 190–1 time value of money, and present value, 416–22, 423 total contribution margin, 62, 63, 89 total costs, 58–9, 87–8 toxic waste clean-up, 70 trade credit, 52–3 trade discount, 271 transaction ‘scales’, 141 decrease in assets and liabilities, 143 increase in assets and owner’s equity, 142 transactions, 136–7 dual effect of, 141–3

526

recording, 183–90 to start a business, 143–8 transposition, 202 trial balance, 196 adjusted, 202–3 post-closing, 208 triple bottom line, 49, 399–400, 401–3 disaster (example), 401 economic performance, 402–3 environmental performance, 402–3 integrated reporting, 407–9 measuring, 404 relationship to sustainability accounting, 401 social performance, 403 sustainability reporting, 404–7, 408 voluntary reporting frameworks, 406 triple-bottom-line accounting, practical measures, 409–15 Triple Bottom Line Reporting in Australia: A Guide to Reporting Against Environmental Indicators, 404

U uncollectable accounts receivable, recognition of, 201 unearned revenues, 163, 317 adjusting, 197, 198–9 unit sales volume estimating profit at, 65, 92 to achieve target profit, 67, 93 United Nations, Sustainable Development Goals, 402–3 United Nations Environment Programme (UNEP), 330 unlimited liability, 11, 12

V variable costs, 56–8, 86–7 volume, 55

W wages and salaries payable, 139, 155, 157, 366 waste and emissions, 412, 413 waste clean-up, 70 wastewater, 412 weighing the advantages and disadvantages of each solution (problem-solving process), 33–4 weighted average cost method, 246, 248, 302–3 withdrawals, 153, 283 of cash by owner, 153, 154 withdrawals account, 182, 183 closing, 208 work health and safety, 14 working capital, 228–30, 319, 478 business issues and values, 249–50 what is the appropriate amount?, 229 working capital flows, 229–30 working capital management, 229 workplace discrimination, 14 World Business Council for Sustainable Development (WBCSD), 413

Y year-end inventory see cost of ending inventory

Z zero dividend growth, 488

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