Australian practical accounting guide [1 ed.] 9781925554533, 1925554538

Table of contents :
Product Information
1 INTRODUCTION TO BOOKKEEPING
Users of Accounting Information
Types of Business Entities
Accounting Assumptions
Content of External Financial Statements
2 RECORDING TRANSACTIONS
The Accounting Equation Revisited
Accounts
3 ADJUSTING ENTRIES AND PREPARATION OF THE FINANCIAL STATEMENTS
Measurement of Profit
Preparing Adjusting Entries
The Adjusted Trial Balance
Closing Entries
4 ACCOUNTING FOR GST
Tax Periods
Completing the Business Activity Statement
5 ACCOUNTING FOR CASH, DEBTORS AND CREDITORS
Controls Over Cash
Petty Cash
Bank Reconciliations
Accounts Receivable
Accounts Payable
6 ACCOUNTING FOR INVENTORY
Valuation of Inventory
7 ACCOUNTING FOR NON-CURRENT ASSETS
Depreciation of Property, Plant and Equipment
The choice of depreciation method
Sale of Depreciable Assets
Financing Options
Leases
Hire Purchase
Chattel mortgage
Intangible Assets
8 FINANCIAL STATEMENT ANALYSIS
Horizontal Analysis
Vertical Analysis
Ratio Analysis
Profitability ratios
Liquidity ratios
Financial stability ratios
GLOSSARY OF TERMS
INDEX
A
B
C
D
E
F
G
H
I
L
M
N
O
P
Q
R
S
T
U
V
W

Citation preview

Product Information

Disclaimer No person should rely on the contents of this publication without first obtaining advice from a qualified professional person. This publication is sold on the terms and understanding that (1) the authors, consultants and editors are not responsible for the results of any actions taken on the basis of information in this publication, nor for any error in or omission from this publication; and (2) the publisher is not engaged in rendering legal, accounting, professional or other advice or services. The publisher, and the authors, consultants and editors, expressly disclaim all and any liability and responsibility to any person, whether a purchaser or reader of this publication or not, in respect of anything, and of the consequences of anything, done or omitted to be done by any such person in reliance, whether wholly or partially, upon the whole or any part of the contents of this publication. Without limiting the generality of the above, no author, consultant or editor shall have any responsibility for any act or omission of any other author, consultant or editor.

About Wolters Kluwer Wolters Kluwer is a leading provider of accurate, authoritative and timely information services for professionals across the globe. We create value by combining information, deep expertise, and technology to provide our customers with solutions that contribute to the quality and effectiveness of their services. Professionals turn to us when they need actionable information to better serve their clients. With the integrity and accuracy of over 45 years’ experience in Australia and New Zealand, and over 175 years internationally, Wolters Kluwer is lifting the standard in software, knowledge, tools and education. Wolters Kluwer — When you have to be right Enquiries are welcome on 1300 300 224. Cataloguing-in-Publication Data available through the National Library of Australia ISBN: 978-1-925554-53-3 © 2017 CCH Australia Limited All rights reserved. No part of this work covered by copyright may be reproduced or copied in any form or by any means (graphic, electronic or mechanical, including photocopying, recording, recording taping, or information retrieval systems) without the written permission of the publisher.

Preface Accounting has often been described as the “language of business”. Every business, regardless of whether it is a listed public company, a non-profit organisation or a small corner shop, butcher or newsagent, requires accurate and timely financial information so that the owners or directors of these businesses can make informed business decisions. These decisions have financial consequences that impact on a wide range of stakeholders, from the business owners (or shareholders), customers, suppliers, employees, lenders, creditors and government regulators. As a result, many people with little knowledge of accounting must interpret financial data. Thus, accounting plays a significant role in society and, in a broad sense, everyone is affected by accounting information. For this reason, a basic understanding of accounting principles is vital not only for those students studying an accounting degree at university or completing their professional studies, but also for those students who will perhaps only complete one accountancy unit in their entire course. Accountants are required for all types of businesses and the financial statements produced by accountants are used by both internal and external users to make and evaluate important business decisions.

Australian Practical Accounting Guide is not only designed to assist accountancy students gain an appreciation of key accounting concepts and principles, but is also aimed at those students who do not necessarily require a detailed or in-depth understanding of accounting and wish to go on to become a qualified accountant. A deliberate attempt has been made to write the book in simple-to-understand terms. The book is practical in nature and contains numerous worked examples, diagrams, checklists and flowcharts for easy reference. Each chapter also concludes with a list of commonly asked accounting and taxation questions pertinent to each topic. What distinguishes this book from many other introductory accounting textbooks on the market is that this book can also be used as a handbook for practising bookkeepers and accountants. Many of the worked examples contained in the book are “real” clients of mine (although their names have been changed to protect their identity). The reason for doing this is to give the reader a real-world insight into typical day-today accounting issues encountered by Australian businesses. It is also designed to provide the reader with a greater understanding of the issues faced by accountants when dealing with their clients on a dayto-day basis. The other important distinction about this book is the discussion of the GST. Most other introductory accounting textbooks which span hundreds of pages only tend to devote a handful of pages to the GST. The GST was introduced in Australia on 1 July 2000 and applies to 2.6 million Australian businesses that are currently registered for the GST. This book deals with the impact of the GST on businesses in each chapter. The book provides an overview of the key accounting principles. Chapters 1 and 2 provide an overview of the types of business entities, the type of accounting information required by businesses and how transactions flow through the accounting cycle, from source documents to the general journal to the general ledger and ultimately into the trial balance, which forms the basis of the preparation of the financial statements. These financial statements are further explained in Chapter 3 and include the Income Statement (or Profit and Loss Statement), Statement of Changes in Equity, Balance Sheet and Cash Flow Statement. Chapter 3 also discusses the role and importance of adjusting and closing entries in completing the accounting cycle. Chapter 4 provides a comprehensive summary of the GST. It explains the various types of supplies for GST purposes, how GST impacts on businesses and most importantly, how these transactions are recorded in the accounting system. A standard chart of accounts is provided at the end of the chapter incorporating “typical” GST tax codes. The chapter also outlines how a Business Activity Statement (or BAS) is prepared under both the cash and non-cash (accruals) basis of accounting. Chapter 5 outlines the accounting issues relating to cash, debtors and creditors. This chapter discussed the types of internal controls that an entity should have over its cash receipts and cash payments and the importance of preparing a bank reconciliation. The steps necessary to perform a bank reconciliation are explained in this chapter as is the concept of bad debts. The chapter concludes with an overview of the importance of an aged debtors’ and aged creditors’ analysis. Chapter 6 deals with accounting for inventory (also known as trading stock). For many businesses, particularly those in the retail sector, inventory is one of their most important assets. This chapter outlines the specific rules relating to accounting for inventory, including what is included in the “cost” of inventory, the concept of inventory on hand and the various ways that inventory can be valued. The chapter also discusses the differences between a periodic and perpetual inventory system, with full illustrations of the journal entries provided under each system. Chapter 7 deals with accounting for non-current assets. This chapter outlines the various types of noncurrent assets (both tangible and intangible) including what is included in the cost of acquisition and the issue of subsequent expenditure. There are various ways that an asset can be financed. This ranges from the purchase of the asset outright, to a finance lease, hire purchase or a chattel mortgage arrangement. These options are explained in considerable detail in this chapter with detailed explanations (and examples) provided dealing with the accounting, income tax and GST treatments of each option. The chapter also explains the concept of intangible assets including the difference between goodwill and other intangible assets such as patents, trademarks, copyrights and license fees. The chapter also covers the

concept of impairment and depreciation (which applies to tangible assets such as property, plant and equipment) and amortisation (which applies to intangible assets) including the various depreciation methods permitted. A sample fixed asset register and sample depreciation schedule are also included in this chapter. Chapter 8 provides an overview of the most common financial statement analysis techniques used to analyse and interpret business performance and highlight any trends or “problem areas” that may require attention, and ultimately, corrective action. A range of typically used financial statement ratios are discussed in this chapter, including a comprehensive worked example illustrating how these ratios are calculated and how they should be interpreted. The book concludes with a comprehensive glossary of commonly used accounting and tax terms. As a final comment, regardless of whether you are a practising bookkeeper or accountant, or whether you are embarking on an accountancy career or simply a student studying an accounting unit as part of your course, I hope you find this book useful, interesting and informative. Stephen J Marsden February 2017

Wolters Kluwer Acknowledgments Wolters Kluwer wishes to thank the following who contributed to and supported this publication: Managing Director: Michelle Laforest Head of TAA: Diana Windfield Head of Content — Books: Alicia Cohen Books Coordinator: Hui Ling Lee Editor: Karen Bang Cover Designer: Jessica Crocker

About the Author Stephen Marsden is a full-time lecturer employed in the QUT Business School at the Queensland University of Technology in Brisbane where he is responsible for lecturing and tutoring a wide range of undergraduate and postgraduate financial accounting and taxation law subjects. Stephen has a Master of Business (Accountancy) and is a Member of Chartered Accountants Australia and New Zealand, CPA Australia, The Australian Institute of Company Directors and the National Tax and Accountants Association. He is also a Chartered Tax Advisor of The Taxation Institute of Australia. Stephen has presented hundreds of professional development seminars and workshops over the past 25 years in the areas of financial accounting, taxation, GST and FBT for professional bodies, accounting firms, listed companies, non-profit organisations and government departments. Stephen also runs his own accountancy practice where he attends to the accounting and taxation affairs of a variety of clients in both the public, private and non-profit sectors.

Acknowledgments I am indebted to several people over the period that it has taken me to write this book. In particular, I would like to thank my family, friends and colleagues for their ongoing support, patience and encouragement. Special mention goes to my partner, Elizabeth Jones, who has been very supportive in allowing me to sit at my computer early in the mornings, late at night and for large chunks of the weekend when writing this book. Elizabeth also provided a wonderful sounding board for me over many months and played a vital role in reviewing key aspects of the book and providing helpful comments and suggestions. Thanks are also extended to Karen Bang and Alicia Cohen from Wolters Kluwer for their role and contribution to this book. Lastly, I would like to sincerely thank my mother, Colleen Marsden, for her love, encouragement and support over many, many years. I would like to dedicate this book to my late father, Jack, who passed away a few years ago and to his enduring memory and legacy.

1 INTRODUCTION TO BOOKKEEPING Purpose of bookkeeping

¶1-000

Brief history of bookkeeping

¶1-050

Users of accounting information

¶1-100

The accounting profession in Australia

¶1-200

The bookkeeping profession in Australia

¶1-250

Types of business entities

¶1-300

Accounting assumptions

¶1-400

Content of external financial statements

¶1-500

The reporting entity concept

¶1-600

Reporting entities

¶1-610

Non-reporting entities

¶1-620

Disclosure of status in financial statements

¶1-630

Introduction to bookkeeping — commonly asked questions ¶1-700 Extract from the 2016 Annual Report of Qantas Ltd

¶1-750

¶1-000 Purpose of bookkeeping Every business is required to keep a record of its business transactions. A bookkeeper is the person who typically assists in recording financial transactions of a business. This process often involves the use of a computerised accounting system but it may also be done manually. Accounting can be defined as the process of: • identifying • measuring • recording, and • communicating economic information to permit informed judgments and decisions by users of the information. Bookkeeping can be viewed as a subset of accounting and is primarily concerned with the first three phases identified above (ie the processes of identifying, measuring and recording business transactions). Bookkeepers ensure these transactions are accurately recorded in the accounting system. The primary purpose of bookkeeping is for the bookkeeper to record, classify and report information about a business’ financial transactions. The bookkeeper prepares a set of books (usually called the “accounts”) for the business owner. This is typically done on a weekly, fortnightly, monthly or quarterly basis depending on the volume of transactions as well as the size and complexity of the business. Once these accounts have been prepared by the bookkeeper, they are usually passed onto and reviewed by the external accountant. The external accountant checks these accounts, makes any relevant adjustments and prepares a set of external financial statements that comply with the Australian Accounting Standards issued by the Australian Accounting Standards Board (AASB). The external accountant or tax agent also uses these financial statements as the basis for preparing the annual income

tax return of the business for lodgment with the Australian Taxation Office (ATO). In reality, the distinction between bookkeeping and accounting is not an important one, as sometimes bookkeepers perform accounting work and accountants will sometimes perform bookkeeping work. Since the advent of the goods and services tax (GST) in Australia on 1 July 2000, many bookkeepers prepare monthly or quarterly Business Activity Statements (BAS) for their clients. The BAS is typically reviewed by the external accountant before lodgment with the ATO. It should be noted, however, that in the case of a contracting bookkeeper they are only permitted to assist a client in preparing and lodging a BAS if they are a “BAS agent” (see ¶4-800 in Chapter 4 for further details). Despite the formal distinction between bookkeeping and accounting noted above, in reality, bookkeepers and accountants often work closely together sharing information relating to the financial affairs of the business. The overall objective of both bookkeeping and accounting is to ensure that financial transactions of the business are accurately recorded and the information (in the form of financial statements) is presented to users (both internal and external) so that these users can make sound and informed decisions. As bookkeeping and accounting are so closely aligned, it is essential that bookkeepers develop a solid understanding of accounting doctrines and principles. Regardless of whether the business is a listed public company, small business, government department, non-profit organisation, family trust or an individual trading as a sole trader, bookkeeping principles apply universally across each type of business entity. All of these entities engage in business activities and, hence, users require financial information that is reliable, relevant, understandable and timely. Many people who need to interpret financial data have little knowledge of accounting. Thus, bookkeeping and accounting play a significant role in society and, in a broad sense, everyone is affected by financial information. As Jane Gleeson-White stated in her book entitled Double Entry (2011): “Our world is governed by the numbers generated by the accounts of nations and corporations. We depend on these numbers to direct our governments, economies and societies often in ways we are barely aware of.”

¶1-050 Brief history of bookkeeping Bookkeeping has a long history. Accounting records date back to the ancient civilisations of China, Babylonia, Greece and Egypt in around 3600 BC. The rulers of these civilisations used accounting information to keep track of the costs of labour and materials used in building structures such as the pyramids. The need for accounting information has existed for as long as there has been business activity. The first record of a complete accounting system was found in Genoa, Italy in 1340. The Italian domination of accounting was cemented in 1494 with the publication of the first formal treatise on bookkeeping by Luca Pacioli (1445–1517), a Franciscan monk, mathematician and university teacher in Venice. Pacioli learned the Italian method of bookkeeping while working as a tutor in various Italian universities. In 1494, he wrote these principles in a book entitled Summa de Arithmetica, Geometria, Proportioni et Proportionalita (Everything about Arithmetic, Geometry and Proportion). In this book, Pacioli formally explained the concept of double-entry bookkeeping and the basic and fundamental principle of bookkeeping. For this reason, Pacioli is often referred to as the grandfather of accounting. The great German writer Johann Wolfgang von Goethe (1749–1832) wrote in 1796 that he regarded double-entry bookkeeping as “among the finest inventions of the human mind”. The need for accounting increased during the 19th and 20th centuries as a result of the industrial revolution. The basic form of business organisations shifted from partnerships to companies with widespread and diverse share ownership. As the separation between ownership and management spread, the need for greater and more sophisticated accounting information developed. Responsibility for the company was delegated to management by shareholders. The preparation and publication of financial statements were seen as an important way of keeping shareholders informed about the progress of the company and how funds were being spent. This period also witnessed the

growth and development of auditing. With the advent of economic globalisation and world capital markets, the accounting community has responded to these changes. The International Accounting Standards Board (IASB) based in London, which was established on 1 April 2001, has the responsibility for issuing the International Accounting Standards (termed “International Financial Reporting Standards” or IFRS). According to Deloitte’s IAS Plus publication, Use of IFRSs by Jurisdiction, which can be accessed at www.iasplus.com/country/useias.htm, as at the date of writing, a total of 131 jurisdictions either permit or require IFRS for domestic-listed companies. The European Union (EU) requires listed companies incorporated in its member states whose securities are listed on an EU-regulated stock exchange to prepare their financial statements in accordance with IFRS. Australia and New Zealand have essentially adopted IFRS as their national Accounting Standards. However, while the Australian Accounting Standards (termed “AASBs”) are essentially word-for-word equivalents to IFRS, the Australian Accounting Standards setters have retained the right to: • delete an option, and/or • add extra disclosure requirements. For this reason, several AASB Accounting Standards contain Australian-only paragraphs. These paragraphs are represented with the prefix “Aus”. These paragraphs mainly apply to accounting issues relevant to not-for-profit entities (see ¶7-050 in Chapter 7 for an example of such). Furthermore, the AASB has kept or developed specific Accounting Standards relevant to Australian financial reporting requirements (eg AASB 1053 Application of Tiers of Australian Accounting Standards and AASB 1054 Additional Australian Disclosures). It is argued that adopting IFRS results in greater comparability and consistency in financial reporting by entities throughout the world. The United States of America (US) has yet to adopt IFRS. Instead, US domestic companies must report under US generally accepted accounting principles (GAAP), not IFRS. The IASB and the US Financial Accounting Standards Board (FASB) have been working together since September 2002 to achieve the convergence of IFRSs and US GAAP. In November 2008, the US Securities and Exchange Commission (SEC) released its proposed written roadmap to convergence and in February 2010, it released a statement reaffirming its commitment to one global set of accounting standards. In 2011, the SEC was expected to make an announcement about a possible date for transition to IFRS. However, this decision was deferred. In February 2014, the SEC released their Strategic Plan for 2014–2018. In that document, the SEC stressed that “the SEC will continue to promote the establishment of high-quality accounting standards in order to meet the needs of investors. Due to the increasingly global nature of capital markets, the agency will work to promote higher quality financial reporting worldwide and will consider, among other things, whether a single set of high-quality global accounting standards is achievable”. However, nowhere in the entire document does the SEC refer to IFRS or IASB. This has been interpreted by several commentators that the SEC has backtracked from the possibility that US domestic companies would one day file financial reports with the SEC under IFRS. However, from March 2018, non-US companies registered with the SEC (approximately 1,150) are given the choice to prepare and submit their financial statements under either US GAAP or IFRS.

Users of Accounting Information Introduction

¶1-100

Internal users

¶1-110

External users

¶1-120

¶1-100 Introduction Users of accounting information are a diverse group. They may generally be categorised as either: • internal users (¶1-110), or • external users (¶1-120).

¶1-110 Internal users Internal users are users of financial information within an organisation. These include the business owner(s), executives, managers, department heads and the board of directors. Internal decision-makers need financial information for the purposes of planning and controlling the operations of a business. Internal users are typically concerned with questions such as: • What assets do we own? • How much do we owe to banks and other creditors? • How much are we owed from our debtors? • How much money do we have in the bank account? • What are our investments worth? • What are our sales and expenses for the month? • Should we increase the selling price of our goods or cut expenses? • What is our net profit before tax for the month? • How much tax do we owe? • How much stock do we have on hand? • Do we have enough cash available to meet our debt obligations or to pay dividends to our shareholders? Providing reports to help answer these and many other questions is part of the role of the bookkeeper. The bookkeeper prepares a set of statements typically referred to as “management accounts”. The primary purpose of management accounting is to provide financial information to parties inside the organisation such as managers or directors (or other internal users). Management accounts (usually consisting of the profit and loss statement and balance sheet) are typically prepared monthly or quarterly and are usually tailored to the specific needs of management. There is no specific format that must be followed. Management accounts are typically prepared using computerised accounting software packages such as MYOB, Xero and QuickBooks. Some bookkeepers export the reports produced by computerised accounting software packages into electronic spreadsheets such as Microsoft Excel for manipulation and comparison of actual results to the budget and preparation of a variety of charts and graphs.

¶1-120 External users External users are users of financial information outside an organisation. These include: • shareholders • lenders and financial institutions

• suppliers • creditors • employees • customers • regulators such as the ATO, Australian Securities and Investments Commission (ASIC), Australian Securities Exchange (ASX), Australian Competition and Consumer Commission (ACCC), and • special interest groups such as trade unions and shareholder associations. External users are typically concerned with questions such as: • Should I invest my money into this business? • How much dividends am I likely to receive if I invest in this business? • Should I lend money to this business? • Should I supply goods or services to this business? • Should I work for this business? • Is the business financially sound? Providing reports to help answer these and many other questions is part of the role of an accountant. The accountant prepares a set of reports typically referred to as “financial statements”. The primary purpose of financial accounting is to provide financial information to parties outside the organisation (or external users). Financial statements (sometimes called the “statutory” accounts) usually consist of: • a statement of profit or loss and other comprehensive income for the period (also referred to as the “profit and loss statement” or “income statement”) • a statement of changes in equity for the period • a statement of financial position as at the end of the period (or the “balance sheet”), and • a statement of cash flows for the period. These financial statements are required to be prepared in accordance with the Accounting Standards issued by the AASB. Unlike management accounts which can be tailored to meet the specific needs of management, the format of external financial statements are standardised as they must be prepared in accordance with the requirements contained in the AASB Accounting Standards. Adopting the same rules across all entities enhances the comparability and consistency of the information, thereby allowing users to compare “apples with apples”. The distinction between management accounts and external financial statements is shown in Table 1.1. Table 1.1: Differences between management accounts and financial statements Issue

Management accounts

Financial statements

Users

Users are within the organisation (ie management)

Users are external to the organisation (ie shareholders, lenders, creditors, customers, regulatory agencies, etc)

Prepared by

Usually prepared by the bookkeeper

Usually prepared by the external

using a computerised accounting package

accountant

Format of reports

Flexible — tailored to meet the needs and requirements of management or owner(s) of the business

Standardised — structure and content dictated by the contents of AASB Accounting Standards

Frequency of reports

As requested by management (usually monthly)

Usually annually as per the requirements of the Corporations Act 2001

External verification Management accounts are not usually audited

Depending on the type of the entity, external financial statements may be subject to audit by an independent auditor

¶1-200 The accounting profession in Australia The accounting profession in Australia is self-regulating and is largely controlled by the following three major professional accounting associations: • CPA Australia (CPAA) • Chartered Accountants Australia and New Zealand (CAANZ), and • The Institute of Public Accountants (IPA). CPAA was established in 1952 under the name of the Australian Society of Accountants. In 1990, the name was changed to the Australian Society of Certified Practising Accountants and then to CPA Australia in 2000. CPAA has a global membership of more than 155,000 members working in 118 countries with more than 25,000 members working in senior leadership positions, making it one of the world’s largest professional accountancy bodies. CAANZ (formerly known as the Institute of Chartered Accountants in Australia or ICAA) was constituted by the Royal Charter in 1928. The Institute now operates under the Supplemental Royal Charter (amended from time to time) granted by the Governor-General on behalf of Queen Elizabeth II on 19 August 2005. In October 2013, more than 54,000 members of the Institute of Chartered Accountants in Australia and the New Zealand Institute of Chartered Accountants voted to amalgamate both bodies to create a new institute — CAANZ, which has more than 110,000 members across both countries. The IPA was established in 1923 under the name of the Institute of Factory and Cost Accountants. In 1988, it changed its name to the National Institute of Accountants and in 2011, to the Institute of Public Accountants. The IPA represents more than 35,000 members and students in over 80 countries working in industry, commerce, government, academia and private practice. To become a member of these professional accounting bodies, a person is typically required to have completed a degree in accounting at a tertiary institution accredited for entry purposes by the professional bodies. The candidate must subsequently complete a structured education program which typically takes two to three years. Before being admitted as a member, the candidate must also complete three years of relevant supervised accounting work experience. A member of CPAA is referred to as a “Certified Practising Accountant” (CPA), while a member of CAANZ is referred to as a “Chartered Accountant” (CA).

¶1-250 The bookkeeping profession in Australia There are several professional bookkeeping associations in Australia. The two major professional bookkeeping associations are:

• the Association of Accounting Technicians (AAT), and • the Institute of Certified Bookkeepers (ICB). The AAT was formed in 1980 in the United Kingdom (UK). Sponsored by the chartered accountancy bodies in the UK, there are more than 100,000 AAT members and students worldwide. The AAT is the world’s largest dedicated body for qualified accounting technicians. Established in Australia in 2002, AAT Australia is supported by the three professional accounting bodies — CPAA, CAANZ and the IPA and has a membership base of over 3,800 members. There are four levels of membership, ranging from student, affiliate, member and fellow. The member level requires an applicant to hold a Certificate IV in Financial Services (Accounting) or (Bookkeeper) or a Diploma of Accounting and one year’s work experience. Members can use the post-nominals “AAT” after their name. The ICB is the largest bookkeeping institute in the world. The ICB has more than 3,600 Australian members. The ICB contains five levels of membership, ranging from student member, educator member, affiliate member, associate member and member. To progress through each level of membership, the applicant is required to hold a Certificate IV in Bookkeeping or Accounting. Members can use the post-nominals “MICB” after their name. There are also several bookkeeping associations that provide bookkeeping training and certificate and diploma courses for bookkeepers, such as the Bookkeeping Institute of Australia. Other bookkeeping associations such as the Australian Bookkeeping Network provide assistance to practising bookkeepers through discussion forums and newsletters as well as offering avenues for qualified accountants and registered tax agents to review the BAS prepared by the bookkeepers who may not be qualified.

Types of Business Entities Introduction

¶1-300

Sole trader

¶1-310

Partnership

¶1-320

Trust

¶1-330

Companies

¶1-340

¶1-300 Introduction Businesses may operate under a number of different structures. However, the four most common types of business structures include: • sole trader (or sole proprietorship) (¶1-310) • partnership (¶1-320) • trust (¶1-330), and • companies (¶1-340). Each of these business structures is discussed in more detail in the following paragraphs.

¶1-310 Sole trader A sole trader is a business that is owned by one person (typically called the “principal”). Many small service enterprises, retail stores and professional practices operate as a sole trader. If a business trades

in a name other than the person’s own legal name, the owner of the business must register a business name with ASIC Connect. From a legal perspective, a business is not a separate legal entity distinct from its owner. This means that a sole trader has unlimited liability. In other words, if the business is sued, not only are the business’ assets at risk but also the sole trader’s personal assets. For this reason, operating as a sole trader can be somewhat risky. From an accounting perspective, a business entity is regarded as an entity separate from its owner, and the accounting relates only to the affairs of the business entity. The owner’s personal affairs are kept separate from those of the entity. Hence, bookkeepers and accountants typically prepare financial statements for sole traders. The capital of a sole trader can be determined by reference to the equity section of the balance sheet. The equity section would reveal the following: Owner’s Equity Joanne Howard, capital

$ 178,770

From a taxation perspective, a sole trader is not a separate entity. Hence, the profit made by a sole trader from running their business is included in that person’s individual tax return (in the business and professional items schedule comprising Items P1 to P19) with their other income. Hence, the net profit of the business is taxed at the taxpayer’s marginal tax rate. According to the Australian Business Register, as at the date of writing, a total of 3.091 million actively trading individual taxpayers had been issued with an Australian Business Number (ABN). Of these, a total of 662,024 had gone onto register for the GST.

¶1-320 Partnership According to s 1(1) of the Partnership Act 1892 (NSW), a partnership is defined as two or more persons carrying on a business with a view to profit. Similar definitions are found in the Partnership Acts throughout the other states in Australia. No special legal requirements need to be met to form a partnership. All that is necessary is an agreement among people joining together as partners. Although the partnership agreement may be oral, a written agreement which formalises the terms and conditions of the partnership will help resolve disagreements which may arise between the partners. The partners usually supply the resources and share the profits and losses. From a legal perspective, a partnership is not a separate legal entity. Consequently, partners are jointly and severally liable for the debts of the partnership. Each partner is bound by the other partner’s actions. As such, partners are considered agents for one another, meaning that if one partner is sued, all partners are equally liable. However, from an accounting perspective, like a sole trader, a partnership is regarded as an entity separate from its owners. The accounts are prepared only for the affairs of the business entity, with the partners’ personal affairs kept separately from those of the partnership. Hence, bookkeepers and accountants typically prepare financial statements for partnerships. The capital accounts of a partnership can be determined by reference to the equity section of the balance sheet. The equity section would reveal the following: Partners’ Equity

$

Jenny Adams, capital

100,000

Drew Adams, capital

50,000

Belinda Adams, capital

50,000

Total Partners’ Equity

200,000

At the end of each financial year, the net profit (or loss) of the partnership is distributed to each partner in accordance with their profit sharing ratio as outlined in the partnership agreement. Each partner’s share of the profit is combined with their “capital” account (as shown earlier), or shown separately under “retained profits”. If the latter option is taken, the equity section of the balance sheet would appear as follows: Partners’ Equity

$

Jenny Adams, capital

100,000

Drew Adams, capital

50,000

Belinda Adams, capital

50,000

Jenny Adams, retained profits

32,800

Drew Adams, retained profits

16,400

Belinda Adams, retained profits

16,400

Total Partners’ Equity

265,600

From a taxation perspective, a partnership is not a separate entity. This means that it does not have a taxable income and, as such, it does not pay tax in its own right (s 92(1), Income Tax Assessment Act 1936 (ITAA36)). However, a partnership is still required to lodge a partnership tax return (P form) each year with the ATO. The tax profit (or loss) of a partnership (called the “net income of the partnership”) is determined and distributed to each partner to be included in their respective income tax returns. Each partner includes their share of the partnership profit in their own income tax return (at Item 13) and pays tax on their share of the partnership profit at their respective marginal tax rates. According to the Australian Business Register, as at the date of writing, more than 642,900 actively trading partnerships had been issued with an ABN. Of these, a total of 301,058 had gone onto register for the GST.

¶1-330 Trust Trusts have been legally recognised since the 17th century. A trust comprises a fiduciary relationship under which a person (called the trustee) holds and administers property (ie assets) under the terms of a trust deed for the benefit of someone else (ie the beneficiaries of the trust). The four essential elements of any trust are: • a trustee • trust property • a beneficiary or beneficiaries, and • an obligation in respect of the trust property. The structure of a trust is diagrammatically represented in Diagram 1.1. Diagram 1.1: A typical trust arrangement

The various parties to a trust arrangement are described as follows. Table 1.2: Parties to a trust arrangement Title

Description

Settlor or creator

The person who creates the trust. This person provides the initial property to create the trust. A trust does not exist without the trust property.

Appointer

The person nominated in the trust deed as having the power to remove or appoint trustees.

Trustee

A trustee is the legal owner of the trust property and the business manager of the trust. The trustee controls and administers the trust property (assets of the trust). A trustee can be a natural person or a company. Any person (including a company) who acts as a trustee can be sued.

Trust property

The trust property refers to the property (assets) of the trust held by the trustee.

Trust deed

Broadly, the document which contains the rules that govern the operations of the trust relationship and the duties and obligations of the trustee identifies the beneficiaries and sets out their rights.

Beneficiaries

Beneficiaries have a beneficial interest in the trust property. The beneficiaries are usually listed in the trust deed. A trustee can also be a beneficiary of the trust, but not the sole beneficiary.

A fiduciary obligation

The trustee has a fiduciary obligation to act in the best interests of the beneficiaries. The trustee is required to undertake a range of duties and obligations and exercise certain powers in relation to the trust property. These duties, obligations and powers are usually found in the trust deed.

Vest

To vest a trust means to wind it up or for the trust to cease. The vesting period refers to the life of the trust and is usually: • a period of no longer than 80 years, or • the period ending 25 years from the death of someone living at the time of the

creation of the trust. The three most common types of trusts are as follows: Discretionary trusts A discretionary trust gives the trustee a wide discretion to determine which beneficiaries are entitled to distributions of income and/or capital of the trust on a year-by-year basis. A discretionary trust offers significant opportunities for income-splitting due to its flexibility with respect to the distribution of income and capital. Each year, the trustee decides how much (if any) of the net income of the trust estate to distribute to each beneficiary. This often makes the discretionary trust popular as a tax planning vehicle for family businesses. A discretionary trust is also commonly referred to as a family trust (eg “The Barker Family Trust”). Fixed trusts A fixed trust is a trust in which the beneficiaries’ entitlements to a share in the income or capital of the trust are fixed under the terms of the trust deed. A fixed trust usually entitles the beneficiary to receive a fixed percentage of the net income of the trust estate (eg pay 50% of the net income of the trust estate to Marcus Taylor, 25% to Annabelle Taylor and the remaining 25% to Sean Taylor). Unit trusts A unit trust is a type of fixed trust. However, under the unit trust structure, unitholders’ capital and income entitlements are determined in proportion to the number of units held in the trust. For example, a unit trust may have a total of 100 issued units. If Marcus owns 30 units out of the 100 units, then he is entitled to 30% of the net income of the trust estate. If he acquires another 20 units from another unitholder in the following year, he now has 50 units and is entitled a 50% share of the net income of the trust estate. Unit trusts are commonly used where investors who are not related to each other wish to pool their resources together to purchase a property or other forms of investments. From a legal perspective, a trust is not a separate entity. Consequently, the trustee is responsible for the debts of the trust. A person who wishes to sue a trust must sue the trustee. From an accounting perspective, a trust is regarded as an entity separate from the trustee and beneficiaries. Hence, bookkeepers and accountants typically prepare financial statements for trusts. The capital of a trust can be determined by reference to the equity section of the balance sheet. The equity section should reveal the account “corpus” or “settled funds”. This refers to the amount contributed by the settlor when the trust is established. Trust Equity Corpus

$ 100

Like a partnership, at the end of each financial year, the profit (or loss) of the trust is required to be distributed to the beneficiaries (unitholders) in accordance with the trust deed. When a profit is distributed to the beneficiaries, instead of crediting an equity account, the profit distribution is credited to each beneficiary’s loan account (usually shown as a non-current liability in the balance sheet). Hence, the liability section of the trust’s balance sheet would appear as follows: Non-Current Liabilities

$

Beneficiary loan account — Jeremy Barker

53,225

Beneficiary loan account — Grace Barker

36,790

Beneficiary loan account — Trinity Barker

4,064

Total Beneficiary Loans

94,079

On the other hand, if the trust were to incur a loss, this loss is not distributed to the beneficiaries. Instead, the loss is “trapped” within the trust and is carried forward to be offset against future profits of the trust. Accordingly, a trust can have an “accumulated losses” line in the equity section of the balance sheet. This is illustrated as follows: Trust Equity Corpus (Accumulated losses)

$ 100 (28,603)

From a taxation perspective, a trust is not a separate entity. Hence, according to s 95(1) of ITAA36, a trust does not pay tax in its own right. Despite this fact, a trust is still required to lodge a trust tax return (T form) each year with the ATO. The tax profit (or loss) of the trust (called the “net income of the trust estate”) is determined and distributed to each beneficiary to be included in their respective income tax returns. Each beneficiary includes their share of the net income of the trust in their own income tax return (at Item 13) and pays tax on their share of the net income of the trust at their respective marginal tax rates. According to the Australian Business Register, as at the date of writing, more than 904,000 actively trading trusts had been issued with an ABN. Of these, a total of 504,783 had gone onto register for the GST.

¶1-340 Companies At law, a company is regarded as a separate legal entity distinct from its shareholders. Company owners are called shareholders and their ownership interests are represented by shares in the company. Shareholders appoint directors to manage the business on their behalf. There are two types of companies: • public companies (designated by the abbreviation “Ltd”), and • proprietary companies (designated by the abbreviation “Pty Ltd”). According to s 114 of the Corporations Act 2001, a proprietary company must have at least one shareholder. Section 113(1) prescribes that it cannot have more than fifty shareholders. A proprietary company must have at least one director. Most family companies are proprietary companies. According to s 9 of the Corporations Act 2001, a public company is defined as a company incorporated in Australia other than a proprietary company. A public company must have at least one shareholder (s 114). There is no maximum number of shareholders. According to s 201A(2), a public company must have at least three directors, two of whom must ordinarily reside in Australia. Some public companies are listed on ASX. These are referred to as listed companies. As at the date of writing, there were 2,087 companies listed on the ASX. A total of 118 of these companies were foreign companies. From a legal perspective, a company is a separate legal entity distinct from its owners (ie shareholders). Because a company is a separate legal entity, shareholders in a limited company are not liable for the company’s debts once the shares have been paid in full. This feature is known as “limited liability” and the abbreviation for this is “Ltd”. From an accounting perspective, a company is regarded as an entity separate from its shareholders. Hence, accountants and bookkeepers typically prepare financial statements for companies. The capital of a company can be determined by reference to the equity section of the balance sheet. The equity section would reveal the following: Shareholders’ Equity

$

Share capital

100,000

Retained profits

389,178

Total Shareholders’ Equity

489,178

From a taxation perspective, a company is a separate entity. Hence, a company pays income tax in its own right on its taxable income. A company is required to lodge a company income tax return (C form) each year with the ATO. Companies are taxed at a flat rate of tax equivalent to 30 cents in the dollar (from 1 July 2015, the company tax rate for small business entities was reduced from 30% to 28.5%. As a result of recent legislative changes, this rate will be further reduced from 1 July 2016 to 27.5%. This company tax rate will apply to those small businesses with an annual turnover of less than $10m (previously $2m). From 1 July 2017 and 1 July 2018, companies with an annual turnover of up to $25m and $50m respectively will also see their company tax rate reduce from 30% to 27.5%). According to the Australian Business Register, as at the date of writing, more than 1.5 million actively trading companies had been issued with an ABN. Of these, a total of 922,258 had gone onto register for the GST.

Accounting Assumptions Introduction

¶1-400

The accounting entity assumption

¶1-410

The cost assumption

¶1-420

The going concern assumption

¶1-430

The accrual accounting principle

¶1-440

The accounting period assumption

¶1-450

The conceptual framework and the AASB Framework

¶1-460

The objective of general purpose financial reporting

¶1-465

Qualitative characteristics of useful financial information ¶1-470 The accounting equation

¶1-480

¶1-400 Introduction Accounting is based upon several key concepts and assumptions. Collectively, these concepts are referred to as “generally accepted accounting principles” or GAAP. These assumptions are used by both bookkeepers and accountants and are described in the following paragraphs.

¶1-410 The accounting entity assumption The accounting entity assumption states that a business is a separate entity from its owner. It is assumed that an entity controls its own assets and incurs its own liabilities. Hence, personal assets and liabilities of Michael Sullivan are not included in the financial statements of Michael Sullivan’s tennis coaching business because they do not constitute part of the activities of the business entity. It is common for a business to have a separate bank account distinct from that of its owner. This way, all of the business transactions that need to be recorded by the bookkeeper are processed by reference to deposits and payments made through the business bank account.

¶1-420 The cost assumption Traditionally, assets of a business entity are recorded initially at their cost under the cost assumption. The “cost” of an item in a purchase and sale transaction is assumed to represent its economic value on

acquisition. The cost assumption is also referred to as the historical cost assumption. For example, if Michael Sullivan’s tennis coaching business purchased the land for $620,000 in 2010, the land will be recorded in the balance sheet of the business in 2010 at $620,000. However, assume that in 2017, a valuation undertaken revealed that the market value of the land has increased to $940,000. Although the land may have a current market value of $940,000, under the cost assumption it will continue to be reported at its historical cost of $620,000 in the business’ balance sheet. Thus, it is important to be aware when reading a balance sheet that the amounts reported may not necessarily represent the true market value of the assets in today’s terms, but rather the price at which the assets were purchased.

¶1-430 The going concern assumption Financial statements are normally prepared on the assumption that the existing business entity will continue to operate in the future — this is referred to as the going concern assumption. It is assumed that the entity will not be sold in the near future but will continue its activities. Accordingly, the historical cost of an asset is generally reported rather than its current market value. If, however, the entity is about to be sold or liquidated in the near future, then the financial statements must be prepared using the value of estimated sales or liquidated values.

¶1-440 The accrual accounting principle For accounting purposes, transactions of a business are prepared under the accrual accounting concepts. Under the accrual basis of accounting, revenues are recorded in the period in which the business sells goods or performs services. This may or may not be the same as the accounting period in which the cash is received. In other words, under the accrual accounting concepts, revenue is recognised in the period in which the revenue has been derived, not when the cash has been received. Similarly, expenses are recognised in the period when the expenses have been incurred or consumed. This may or may not be the same accounting period in which the cash is paid. In other words, under the accrual accounting concepts, expenses are recognised in the period in which they have been incurred. The effect of this is that under the accrual accounting concepts, revenues and expenses are effectively matched in the same accounting period. This is referred to as the “matching principle”.

¶1-450 The accounting period assumption All entities need to report their results in the form of net profit or loss. Profit or loss is determined for particular periods of time, such as a month or a year, in order to ensure the comparability of results. This division of the life of an entity into equal time intervals is known as the accounting period assumption. The financial year in Australia normally commences on 1 July and concludes on 30 June in the following year (although some entities may choose to adopt a different financial year). This is the same as the income year for taxation purposes.

¶1-460 The conceptual framework and the AASB Framework A number of attempts have been made to develop a conceptual framework that provides a definitive statement of the nature and purpose of financial accounting and reporting. A conceptual framework can be defined as follows: “The Conceptual Framework is a set of interrelated concepts that define the nature, subject, purpose and broad content of financial reporting. It is an explicit rendition of the thinking of the standardsetting body as it lays down requirements for general purpose financial reporting.” At its highest theoretical level, the conceptual framework states the scope and objective of financial reporting. At the next level, and the most fundamental level, the qualitative characteristics of financial information (such as relevance, reliability, comparability, timeliness and understandability) and the basic

elements of accounting reports (such as assets, liabilities, equity, revenues and expenses) are identified and defined. At the lower operations level, the conceptual framework deals with the principles and rules of recognition and measurement of the basic elements and the type of information to be displayed in financial reports. Fundamentally, however, a conceptual framework can be viewed as a structured normative (or prescriptive) theory of accounting. In July 1989, the International Accounting Standards Committee (IASC) released their version of the conceptual framework entitled “The Framework for the Preparation and Presentation of Financial Statements”. In April 2001, the IASB adopted the framework when it replaced the IASC. On 1 July 2004, the AASB released the AASB Framework, which was closely modelled on the IASC’s conceptual framework document. When originally issued, the AASB Framework applied to annual reporting periods beginning on or after 1 January 2005. The AASB Framework has been reissued on several occasions, with the most recent version being amended on 4 June 2014. This version which is entitled “Framework for the Preparation and Presentation of Financial Statements” (hereafter referred to as the “The Framework”) applies to annual reporting periods beginning on or after 1 July 2014. This document can be downloaded in pdf format from the AASB website at www.aasb.gov.au/admin/file/content105/c9/Framework_07-04_COMPjun14_07-14.pdf. It is important to note that The Framework does not have authority under the Corporations Act 2001. In other words, it is not binding on directors or companies. Furthermore, The Framework does not override the requirements of the AASB Accounting Standards, and in the event of a conflict between The Framework and an AASB Accounting Standard, the requirements of the latter prevail (The Framework, para 3). According to para 5, The Framework deals with: • the objective of financial statements • the qualitative characteristics that determine the usefulness of the information in financial statements • the definition, recognition and measurement of the elements from which financial statements are constructed, and • concepts of capital and capital maintenance. The Framework contains an appendix which forms an integral part of The Framework and has the same status as other parts of The Framework. The appendix comprises two chapters — Chapter 1: The objective of general purpose financial reporting (¶1-465) and Chapter 3: Qualitative characteristics of useful financial information (¶1-470). There is no Chapter 2.

¶1-465 The objective of general purpose financial reporting According to para OB1 of Chapter 1 of The Framework: “The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling or holding equity and debt instruments, and providing or settling loans and other forms of credit.” It will be noted that the two primary external user groups of general purpose financial statements are: • existing and potential investors, and • lenders and other creditors. Interestingly, para OB7 states that while other parties such as regulators and members of the public may also find general purpose financial statements useful, financial statements are not primarily directed to these groups. Furthermore, the management of an entity is also interested in financial information about the entity. However, management does not need to rely on general purpose financial statements because

it is able to obtain the financial information it needs internally. Chapter 1 of the appendix of The Framework emphasises that general purpose financial statements are not designed to show the value of a reporting entity; but rather, they provide information to help existing and potential investors, lenders and other creditors to estimate the value of the reporting entity. Finally, para OB12 states that: “General purpose financial reports provide information about the financial position of a reporting entity, which is information about the entity’s economic resources and the claims against the reporting entity. Financial reports also provide information about the effects of transactions and other events that change a reporting entity’s economic resources and claims. Both types of information provide useful input for decisions about providing resources to an entity.” This information is reflected in the following financial statements produced, namely: • a statement of profit or loss and other comprehensive income for the period (or income statement) • a statement of financial position as at the end of the period (or balance sheet), and • a statement of cash flows for the period.

¶1-470 Qualitative characteristics of useful financial information Chapter 3 of The Framework deals with the qualitative characteristics of useful financial information. Specifically, this chapter of The Framework identifies the types of information that are likely to be most useful to existing and potential investors, lenders and other creditors for making decisions about the reporting entity on the basis of the information contained in the entity’s financial report. According to para QC5 of Chapter 3, the fundamental qualitative characteristics are relevance and faithful representation. In other words, information must be both relevant and faithfully represented if it is to be useful. Relevance means that financial information is useful for decision-making by users. This means that the information is capable of making a difference in the decisions made by users. Information may be capable of making a difference in a decision even if some users choose not to take advantage of it or are already aware of it from other sources. Faithful representation means that for financial information to be useful, the information must not only represent relevant phenomena, but it must also faithfully represent the phenomena that it purports to represent. To be a perfectly faithful representation, it needs to be complete, neutral and free from error. Faithful representation does not mean being accurate in all respects. Free from error means there are no errors or omissions in the description of the phenomenon, and the process used to produce the reported information has been selected and applied with no errors in the process. In this context, free from error does not mean being perfectly accurate in all respects. Furthermore, if the financial statements are audited, this improves the reliability and credibility of the financial statements. In order to enhance the usefulness of financial information that is both relevant and faithfully represented, para QC19 considers the following qualitative characteristics to be important, namely: comparability, verifiability, timeliness and understandability. Comparability means that users must be able to compare financial information of an entity over time as well as between entities. This means that accounting policies should be consistently applied between reporting periods so that accurate and meaningful comparisons can be made. Verifiability helps assure users that the information faithfully represents the economic phenomena it purports to represent. Verifiability means that different knowledgeable and independent observers could reach consensus, although not necessarily complete agreement, that a particular depiction is a faithful representation. Timeliness means having information available to decision-makers in time to be capable of influencing their decisions. Generally, the older the information the less useful it is. Hence, the timing (or lag) of the

publication of financial information, or the length of time between the reporting date and the date when the financial statements are presented to users, affects the usefulness of the information. Financial reports should be presented as soon as possible after the end of the reporting period. A substantial delay before the publication of financial reports would reduce their relevance to the users. Understandability means that the information provided in the financial statements should be able to be readily understood by users. However, para OC32 acknowledges that financial reports are prepared for users who have a reasonable knowledge of business and economic activities and who review and analyse the information diligently. As such, users may need to seek the aid of an adviser to understand the information about complex economic phenomena. In addition to the above four qualitative characteristics, there are two additional characteristics that affect financial information. Materiality. Information is material if omitting it or misstating it could influence decisions that users make on the basis of financial information about a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude, or both, of the items to which the information relates in the context of an individual entity’s financial report. In this respect, materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic. Furthermore, the AASB have acknowledged that it cannot specify a uniform quantitative threshold for materiality or predetermine what could be material in a particular situation. The role of a bookkeeper is to record all transactions of the business regardless of their materiality. If not, then management accounts will not balance and the bank reconciliation will not reconcile. From a bookkeeping perspective, the issue of materiality refers to the extent to which an account (or accounts) is used to separately record transactions. For example, considering the questions such as, should there be separate printing, postage and stationery accounts or should these three expense accounts be combined into one expense account entitled “postage, printing and stationery”? Would combining these accounts impair the usefulness of the accounts to the users? From a financial accounting perspective, an external accountant and auditor consider materiality at a higher level when reviewing the financial statements. If errors are found by the external accountant, they are often reported back to the owner and bookkeeper but may not be adjusted as they are not material and the extra processing and review costs associated with any adjustment may outweigh the benefits which may be achieved. Finally, when preparing financial statements, accountants must also consider the economic substance of a transaction. Economic substance means that financial statements should reflect the underlying substance of the transaction, rather than its legal form. This characteristic is also referred to as “faithful representation”.

¶1-480 The accounting equation The entire accounting framework is based on the accounting equation. The accounting equation is expressed as follows:

A= [ L + E ]

Assets = [Liabilities + Equity]

Put another way:

[Assets − Liabilities] = Equity

The accounting equation is key to understanding the concept of double-entry bookkeeping (¶2-200). This equation states that if an asset is increased, then to keep the equation in balance, either a liability or equity must increase by the same amount. Conversely, if an asset decreases, either a liability or equity account must decrease by the same amount. Looking at the above equation, an asset can be funded in one of two ways: • by debt, or • by equity. A simple example illustrates this principle. Assume that Jean-Paul Bouchez, a sole trader, intends to start his own business and decides to purchase a French cafe in the NSW suburb of Paddington costing $1,500,000. He has saved $300,000 of his own money but needs to borrow $1,200,000 in order to fund the purchase of the cafe. According to the accounting equation, the cafe (an asset of $1,500,000) is equal to the sum of liabilities ($1,200,000) and equity ($300,000). This can be illustrated in Diagram 1.2. Diagram 1.2: How the purchase of the French cafe is funded

Assets

=

[ Liabilities + Equity ]

$1,500,000

=

[ $1,200,000 + $300,000 ]   

$1,500,000

=

     $1,500,000

It will be observed that after the above transaction, the accounting equation remains in balance. Assets of $1,500,000 on the left-hand side of the equation must equal the sum of the liabilities and equity (total of

$1,500,000) on the right-hand side of the equation. When processing each business transaction, bookkeepers must ensure that the accounting equation is kept in balance at all times. Put simply, if the accounting equation does not balance, an error has been made. The importance of the accounting equation cannot be understated and it forms the cornerstone of doubleentry bookkeeping.

Content of External Financial Statements Introduction

¶1-500

Statement of profit or loss and other comprehensive income ¶1-510 Statement of changes in equity

¶1-520

Statement of financial position

¶1-530

Statement of cash flows

¶1-540

¶1-500 Introduction An accountant is usually responsible for the preparation of an entity’s external financial statements (also referred to as the “statutory accounts”). For some types of entities such as listed public companies, these financial statements must also be audited. Some entities, such as public companies, registered schemes, large proprietary companies and some small proprietary companies, are required to lodge their audited financial statements with ASIC by certain deadlines. However, for the vast majority of entities, such as partnerships, family trusts and most small proprietary companies, lodgment of their financial statements with a regulator, such as ASIC, is generally not required. Regardless of whether entities are required to lodge their financial statements with a regulator or not, annual financial statements are required to be prepared as these statements are used by a variety of external parties, such as shareholders, creditors, banks and financial institutions, lenders, debtors and creditors and even employees to make financial decisions about the entity. In September 2007, the AASB released AASB 101 Presentation of Financial Statements. This standard has been revised on several occasions with the most recent amendment made on 24 July 2015. AASB 101 outlines the minimum requirements for the format, content and presentation of the external financial statements. According to para 10 of AASB 101, an entity is required to prepare a “complete set of financial statements”. A complete set of financial statements comprises: (a) a statement of profit or loss and other comprehensive income for the period (b) a statement of financial position as at the end of the period (c) a statement of changes in equity for the period (d) a statement of cash flows for the period, and (e) the notes comprising a summary of significant accounting policies and other explanatory information. Note Where an entity applies an accounting policy retrospectively, and makes a retrospective restatement of items in its financial

statements or when it reclassifies items in its financial statements, it will be required to present a statement of financial position as at the beginning of the earliest comparative period. This is often referred to as the “third balance sheet”. For example, for a 30 June 2017 reporting entity who had changed an accounting policy, balance sheets would be required for 1 July 2015, 30 June 2016 and 30 June 2017.

A complete set of financial statements can be illustrated diagrammatically as follows. Diagram 1.3: Complete set of financial statements

It is important to note that entities are permitted to use other appropriate titles (eg profit and loss statement and balance sheet). This is confirmed in para 10 of AASB 101. Each of these financial statements is considered in turn.

¶1-510 Statement of profit or loss and other comprehensive income The statement of profit or loss and other comprehensive income is analogous to the profit and loss statement (the term used when preparing and presenting management accounts). The statement of profit or loss and other comprehensive income is usually headed “for the period ended …”. The statement of profit or loss and other comprehensive income is divided into two parts. The first part shows the income (or revenue) and expenses of an entity during the reporting period. This is similar in concept to the profit and loss statement for management accounting purposes. Revenues are inflows derived by an entity as a result of the sale of goods or provision of services. Revenues typically include (but are not limited to): • sale of goods • provision of services • interest received • dividends received • rents received, and • royalties received. Expenses are day-to-day outflows incurred by a business in providing goods or services to customers. Expenses typically include (but are not limited to): • accounting fees • advertising

• bank charges • cleaning • depreciation • electricity • insurance • interest paid • motor vehicle expenses • postage, printing and stationery • rent • repairs and maintenance • salaries and wages • superannuation, and • telephone. The difference between revenues and expenses is referred to as the net profit/(loss). Some organisations, particularly non-profit organisations, refer to this amount as the net surplus/(deficit). Net profit/(loss) is defined as:

Net profit/(loss) = [Revenues − Expenses]

The first part of the statement of profit or loss and other comprehensive income concludes with the words “net profit before income tax”. In the case of a for-profit entity, income tax expense is deducted to derive the “net profit after income tax” figure. Some entities simply refer to this item as “profit for the year”. The second part of the statement of profit or loss and other comprehensive income reports any unrealised gains and/or losses that arose during the reporting period. Examples of unrealised gains and losses include: • unrealised foreign exchange gains and/or losses arising from translating financial statements of a foreign operation under AASB 121 The Effects of Changes in Foreign Exchange Rates • unrealised gains and losses on remeasuring available-for-sale financial instruments under AASB 139 Financial Instruments: Recognition and Measurement • revaluation increments resulting from the revaluation of non-current assets under AASB 116 Property, Plant and Equipment • unrealised gains and losses on remeasuring cash flow hedges under AASB 139, and • actuarial gains and losses on remeasuring defined benefit plan assets under AASB 119 Employee Benefits. These items are collectively referred to in AASB 101 as “other comprehensive income” and must be

shown net of income tax in the statement of profit or loss and other comprehensive income. The sum of the two amounts (ie “net profit after tax” plus “other comprehensive income”) is referred to as “total comprehensive income, net of tax”. This is usually the last line shown in the statement of profit or loss and other comprehensive income. The statement of comprehensive income of Cabcharge Ltd for the year ended 30 June 2016 (shown on p 61 of the company’s 2016 Annual Report) is reproduced as follows:

AASB 101 allows an entity a choice in presenting their statement of profit or loss and other comprehensive income either as: • one statement (called a statement of profit or loss and other comprehensive income which includes all items of income and expenses as well as unrealised gains and losses), or • two statements (ie a separate income statement which shows all income and expenses during the reporting period and a separate statement of comprehensive income showing only the unrealised gains and losses). In other words, instead of showing the two parts as one statement, AASB 101 allows an entity the choice to separate these two parts into two separate statements — one called the “income statement” which includes revenues and expenses and the second statement entitled “statement of comprehensive income” which includes those unrealised gains and losses. Regardless of whether the entity decides on presenting one statement or two separate statements, the net profit for the period (being the first part of the statement) is added to the “other comprehensive income for the period” (being the second part of the statement) to come up with the “total comprehensive income for the period”. The amount entitled “total comprehensive income for the period” is then transferred to the statement of changes in equity (¶1-520).

Some listed Australian companies such as Cabcharge, Ten Network Holdings, Flight Centre, The Reject Shop, Southern Cross Media Group and the Mirvac Property Group have adopted the “one-statement approach”. Conversely, others such as Harvey Norman Holdings, Wesfarmers, Qantas Ltd, Virgin Australia, Woolworths, Telstra and JB Hi-Fi have adopted the “two-statement approach”. The income statement (1st statement) and the statement of comprehensive income (2nd statement) of Qantas Ltd for the year ended 30 June 2016 (shown on pp 52 and 53 of the company’s 2016 Annual Report) are reproduced at the end of this chapter (¶1-750).

¶1-520 Statement of changes in equity The purpose of the statement of changes in equity is to show the link between the statement of profit or loss and other comprehensive income (¶1-510) and the statement of financial position (¶1-530). This statement is specifically to be included in the external financial statements under AASB 101. It is not a statement typically contained within management accounts. Essentially, the statement of changes in equity shows the movement in equity (shown in the last line of the statement of the financial position) between two reporting periods. Not only are the net profit and other comprehensive income figures transferred to this statement from the statement of profit or loss and other comprehensive income, but this statement also shows additional capital contributions made by the owners (or shareholders) and any drawings made by the owners (or dividends paid to shareholders) during the reporting period. AASB 101 also requires a reconciliation of the opening and closing balance of each item of equity to the lines used in the statement of financial position. The statement of changes in equity of Qantas Ltd for the year ended 30 June 2016 (shown on p 55 of the company’s 2016 Annual Report) is reproduced at the end of this chapter (¶1-750).

¶1-530 Statement of financial position The statement of financial position (or balance sheet) reports an entity’s: • assets • liabilities, and • equity as at the end of the reporting period. The statement of financial position is usually headed “as at … ” as it provides a snapshot of the business at a particular point in time. Assets are defined as future economic benefits owned or controlled by an entity. Assets are essentially anything owned by the entity that is valuable and contributes to revenue generation. Assets typically include (but are not limited to): • cash at bank • accounts receivable • inventory • plant and equipment • land and buildings, and • intangibles. Assets are usually classified as either current or non-current assets. If an asset is expected to be “realised” (or converted into cash) within the next 12 months, it is classified as a current asset. Conversely, if an asset is not expected to be converted into cash within the next 12 months, it is classified as a non-current asset in the balance sheet.

Liabilities are defined as future “sacrifices” of economic benefits that an entity is presently obliged to make to other entities. Essentially, liabilities are amounts owed by the entity to external parties. Liabilities typically include (but are not limited to): • bank overdraft • accounts payable • provisions for annual leave and long service leave • tax liabilities, and • loans payable. Once again, liabilities are classified as either current or non-current. If a liability is expected to be settled (or paid) within the next 12 months, it is classified as a current liability. Conversely, any liability not expected to be settled within the next 12 months is classified as a non-current liability in the balance sheet. Equity represents investments (both initial and ongoing) made by the owners of an entity and the sum of accumulated profits made over the years. The higher the equity, the more the business is worth. When a business makes a profit, equity increases. Conversely, if a business makes a loss, this has the effect of decreasing equity. Equity is generally made up of: • capital • retained profits (or accumulated losses), and • reserves. While AASB 101 does not stipulate a strict format for the statement of financial position, paras 54 to 80 of the standard prescribe minimum line items that must be presented on the face of the statement of financial position. These line items are summarised in Table 1.3. Table 1.3: Minimum line disclosures in the statement of financial position Assets

Liabilities

Equity

Current:

Current:

•

Issued capital

•

•

Trade and other

•

Reserves

payables

•

Retained profits

Cash and cash equivalents

•

Trade and other

•

Borrowings

receivables

•

Employee benefits —

•

Inventories

•

Financial assets

•

Current tax liabilities

•

Other current

•

Provisions

assets

•

Other current liabilities

Non-current

•

Liabilities directly

•

current

assets classified

associated with non-

as held for sale

current assets classified as held for sale

Non-Current:

Non-Current:

•

Receivables

•

Investments

•

Employee benefits — non-current

accounted for

•

Borrowings

using the equity

•

Deferred tax liabilities

method

•

Other non-current

•

Financial assets

liabilities

•

Property, plant and equipment

•

Investment property

•

Intangible assets

•

Biological assets

•

Deferred tax assets

•

Other non-current assets

The balance sheet of Qantas Ltd for the year ended 30 June 2016 (shown on p 54 of the company’s 2016 Annual Report) is reproduced at the end of this chapter (¶1-750). The following is a summary of the relevant accounting formulae:

Total assets = [Current assets + Non-current assets] Total liabilities = [Current liabilities + Non-current liabilities] Net assets = [Total assets − Total liabilities] Net Assets is also referred to as Equity. Equity = [Total Assets − Total Liabilities]

¶1-540 Statement of cash flows A statement of cash flows reports the cash position of an entity during the reporting period. It is usually headed “for the period ended …”. The statement of cash flows reports the cash inflows and outflows of an entity during the financial year. Cash inflows are usually represented by positive numbers while cash outflows are represented by negative amounts and are usually shown as amounts in brackets. The statement of cash flows reconciles the amount of cash on hand at the beginning and the end of the reporting period. Cash inflows and outflows are categorised as one of the following three activities: • operating activities • investing activities, and • financing activities. The most important one is the cash flows from operating activities. In essence, these are the cash inflows

and outflows arising from the day-to-day activities of an entity. Common operating cash inflows and outflows are shown in Table 1.4. Table 1.4: Examples of cash inflows and outflows from operating activities Cash inflows

Cash outflows

• Receipts from customers (eg cash received from • Payments to suppliers and employees (typically the sale of goods and services) purchases of stock and payment of day-to-day expenses) • Interests received*

• Interest paid

• Dividends received*

• Income tax paid

* Some entities show these cash flow as part of their investing activities. The difference between the cash inflows and cash outflows from operating activities is essentially the cash profit of an entity, which will typically be different to the net profit after tax figure in the profit and loss statement (due to the existence of non-cash items, such as the depreciation expense as well as accruals). You would prefer the cash inflows from operating activities to be greater than the cash outflows from operating activities as this would indicate that the business has derived a cash profit for the reporting period greater than the net profit for the period as per the profit and loss statement. The second type of cash flows is those inflows and outflows from investing activities. Investing cash flows relate to the acquisition and disposal of long-term assets and other investments. Cash flows from investing activities typically include the purchase and sale of non-current assets. Most investing cash inflows and outflows will come from analysing the movements in the non-current assets accounts in the balance sheet. Examples of cash inflows and outflows from investing activities are shown in Table 1.5. Table 1.5: Examples of cash inflows and outflows from investing activities Cash inflows

Cash outflows

• Proceeds from the sale of property, plant and equipment

• Purchase of property, plant and equipment

• Proceeds from the sale of investments

• Purchase of investments

• Interest received*

• Purchase of other businesses

• Dividends received* * Some entities show these cash flow as part of their operating activities. It is quite typical that the cash outflows from investing activities to be greater than the cash inflows. This indicates that the entity has purchased more assets than it has sold during the reporting period. This also indicates that the business is in a growth phase of its business life cycle or is updating or replacing old assets with new assets. The third and final type of activity is the cash inflows and outflows from financing activities. Financing cash flows relate to changes in financing activities of an entity (ie movements in debt and equity). Examples of cash inflows and outflows from financing activities are shown in Table 1.6. Table 1.6: Examples of cash inflows and outflows from financing activities Cash inflows

Cash outflows

• Proceeds from the issue of shares

• Dividends paid

• Proceeds from borrowings

• Repayment of borrowings • Share buy-backs

It is important to note that while the statement of profit or loss and other comprehensive income (¶1-510) is prepared under the accrual accounting principles, the statement of cash flows is prepared under the cash accounting concepts (ie cash in and cash out). For this reason, many people consider the statement of cash flows to be more useful than the profit and loss statement. In terms of the statement of cash flows, it is important to note the following: • the three cash flows described above (operating, investing and financing) are added together to calculate the overall net increase or decrease in cash for 12 months • this net increase or decrease in cash is then added to or subtracted from the opening cash balance to determine the closing cash balance, and • the closing cash balance figure in the statement of cash flows should equal the closing cash balance shown in the balance sheet. This is an important checking mechanism. While statements of cash flows are often included in the financial statements prepared by external accountants, they are not typically prepared by bookkeepers. For that reason, we do not devote any more discussion in this book to the statements of cash flows. The statement of cash flows of Qantas Ltd for the year ended 30 June 2016 (shown on p 57 of the company’s 2016 Annual Report) is reproduced at the end of this chapter (¶1-750).

¶1-600 The reporting entity concept Before June 1991, all entities (regardless of how big they were) were required to comply with all Accounting Standards. This meant that the “mum and dad” companies had to comply with as many Accounting Standards as did Rio Tinto Ltd or News Corporation Ltd. This led to increased financial reporting compliance costs and reports that an average business owner did not need (due to the size and complexity). In August 1990, the Australian Accounting Standard setters introduced the notion of “differential reporting” by releasing Statement of Accounting Concepts SAC 1 Definition of the Reporting Entity. This effectively means that there are different levels of financial reporting requirements for different entities. Essentially, the type of external financial statements to be prepared depends on whether the entity is classified as a: • reporting entity, or • non-reporting entity. If an entity is regarded as a reporting entity, it must prepare general purpose financial statements. Conversely, if an entity is regarded as a non-reporting entity, it need only prepare special purpose financial statements. Paragraph 40 of SAC 1 defines a reporting entity as: “… all entities in respect of which it is reasonable to expect the existence of users dependent on general purpose financial statements for information which will be useful to them for making and evaluating decisions about the allocation of scarce resources.” Put simply, a reporting entity is one which has many (and varied) users of its financial statements who require this report to be prepared and published so that they can make informed decisions about the entity. The primary question to ask in determining whether an entity is a reporting entity is: “Who are the external users of the financial statements?”. The more users there are, the more likely the entity is a reporting entity. If those users are dependent on the general purpose financial statements for information, the entity will be considered a reporting entity. Conversely, an entity will not be considered a reporting entity if there are fewer users who can specifically command the preparation of special purpose financial statements tailored so as to satisfy all of their

information needs. Further guidance is included in paras 20 to 22 of SAC 1 to assist when deciding whether an entity is considered to be a reporting entity. These criteria include: (a) Separation of ownership and management (para 20): “The greater the spread of ownership/membership and the greater the extent of the separation between management and owners/members or others with an economic interest in the entity, the more likely it is that there will exist users dependent on general purpose financial statements as a basis for making and evaluating resource allocation decisions.” (b) Economic or political importance/influence (para 21): “Economic or political importance/influence refers to the ability of an entity to make a significant impact on the welfare of external parties. The greater the economic or political importance of an entity, the more likely it is that there will exist users dependent on general purpose financial statements as a basis for making and evaluating resource allocation decisions.” (c) Financial characteristics (para 22): “Financial characteristics that should be considered include the size (for example, value of sales or assets, or number of employees or customers) or indebtedness of an entity. In the case of nonbusiness entities in particular, the amount of resources provided or allocated by governments or other parties to the activities conducted by the entities should be considered. The larger the size or the greater the indebtedness of resources allocated, the more likely it is that there will exist users dependent on general purpose financial statements as a basis for making and evaluating resource allocation decisions.” It is important to note that the decision as to whether an entity is considered to be a reporting entity or a non-reporting entity ultimately rests with the directors (or owners). However, in reality, this decision is usually made in consultation with the entity’s external accountant. Bookkeepers do not need to consider the application of the reporting entity concept and whether the entity should prepare general purpose financial statements or special purpose financial statements. This is a decision that impacts upon the preparation of external financial statements, and not management accounts.

¶1-610 Reporting entities Reporting entities typically include: • companies whose securities are publicly listed • listed trusts and other trusts which raise funds from the public • government-controlled business undertakings • federal, state and territorial governments • local governments • large superannuation funds, and • large non-profit organisations and statutory authorities. Once an entity has been identified as a reporting entity, it must prepare general purpose financial statements. In essence, general purpose financial statements are the ones that are prepared in accordance with: • all AASB Accounting Standards • all Australian Accounting Interpretations, and

• all other authoritative pronouncements of the AASB. As at the date of writing, there were 57 AASB Accounting Standards on issue. Furthermore, where the general purpose financial statements have been prepared, the financial statements must also contain a statement of compliance with IFRS issued by the IASB.

¶1-620 Non-reporting entities Non-reporting entities would typically include: • sole traders • partnerships • family trusts • small proprietary companies • self managed superannuation funds, and • small non-profit organisations and clubs. Where an entity is considered to be a non-reporting entity, it can elect to prepare special purpose financial statements. For non-reporting entities, who prepare special purpose financial statements, there is no requirement to prepare their financial statements in accordance with all AASB Accounting Standards and Australian Accounting Interpretations. Instead, non-reporting entities who prepare special purpose financial statements are only required to apply the recognition and measurement principles of those AASB Accounting Standards and Australian Accounting Interpretations which are considered necessary to present a “true and fair” view. For example, if an entity has depreciable assets, it must apply the rules for calculating and recording depreciation contained in AASB 116 Property, Plant and Equipment. Similarly, if an entity has leases (either operating or finance), it must follow the rules contained in AASB 117 Leases. However, non-reporting entities who prepare special purpose financial statements are not required to comply with the disclosure requirements of these standards. This means that a non-reporting entity may only need to comply with a handful of Accounting Standards when preparing its external financial statements. This is considerably cheaper as compliance with all AASB Accounting Standards and Australian Accounting Interpretations is not required. It should be noted that the entity is still required to use the accrual accounting principles in preparation of its financial statements. Diagram 1.4 summarises the financial reporting obligations for both reporting and non-reporting entities. Diagram 1.4: Financial reporting obligations for reporting and non-reporting entities

¶1-630 Disclosure of status in financial statements According to para 9 of AASB 1054 Additional Australian Disclosures, an entity is required to disclose in their financial report whether the financial statements are general purpose financial statements or special purpose financial statements. The following is a sample accounting policy for a non-reporting entity that has prepared special purpose financial statements:

1. Summary of Significant Accounting Policies These financial statements are special purpose financial statements which have been prepared for the sole use by the Directors and members of the company. In the opinion of the Directors, the entity is not a reporting entity, as defined in SAC 1 Definition of the Reporting Entity, as the Directors do not believe that users exist who are unable to command the preparation of reports tailored so as to satisfy, specifically all of their information needs. The financial statements have been prepared in accordance with the recognition and measurement requirements of those Australian Accounting Standards that the Directors consider necessary to apply in order to give a true and fair view. No presentation and disclosure requirements have been adopted.

Because special purpose financial statements have been prepared, compliance with IFRS is not possible. Compliance with IFRS is only achieved where the general purpose financial statements have been prepared. This is why the statement that the financial statements comply with IFRS is not mentioned in the above accounting policy note. The following is an extract from the 2016 financial statements of Qantas Ltd which confirms that the company has prepared general purpose financial statements and has complied with the requirements of the Corporations Act 2001 and all of the Australian Accounting Standards and Accounting Interpretations. The statement of compliance with IFRS is also specifically mentioned.

¶1-700 Introduction to bookkeeping — commonly asked questions Question What is the difference between management accounts and external financial statements?

Answer The bookkeeper is usually responsible for preparing management accounts.

Management accounts (usually consisting of the profit and loss statement and balance sheet) are typically prepared monthly or quarterly. These accounts are usually provided to parties inside an organisation (or internal users such as management or the owner of a business). As such, management accounts are usually tailored to management’s needs. They are typically prepared using computerised software accounting packages such as MYOB, Xero and QuickBooks.

On the other hand, the external accountant usually takes management accounts and prepares external financial statements. The primary purpose of financial accounting is to provide financial information to parties outside the organisation (or external users). Financial statements (sometimes called the “statutory” accounts) usually consist of: • a statement of profit or loss and other comprehensive income (or income statement) • a statement of changes in equity • a statement of financial position (or balance sheet), and • a statement of cash flows.

Financial statements are required to be prepared in accordance with the Accounting Standards issued by the AASB. Unlike management accounts which can be tailored to meet the specific needs of management, the format of external financial statements are standardised as they must be prepared in accordance with the requirements contained in the AASB Accounting Standards. What are the different types of business structures?

Businesses may operate under a number of different structures. The four most common types of business structures are: • sole trader (sole proprietorship) • partnership • trust, and • company.

A sole trader is a business that is owned by one person (typically called the “principal”). The profit of the business is entirely attributable to the owner.

A partnership is a business operated by two or more persons. At the end of each financial year, the profit (or loss) of the partnership is distributed to each partner in accordance with their profit sharing ratio.

A trust is a fiduciary relationship under which a person (called the trustee) holds and administers property (ie assets) under the terms of a trust deed for the benefit of someone else (ie the beneficiaries of the trust). At the end of each financial year, the profit of the trust is distributed to the beneficiaries. Where a trust derives a net loss, the loss is not able to be distributed to the beneficiaries, but must be carried forward in the trust to be offset against future profits.

A company is a separate legal entity. The owners of the company are called shareholders and their ownership interests are represented by shares in the company. Shareholders appoint directors to manage the business on their behalf. In small

proprietary companies, shareholders are normally the directors.

Shareholders receive a share of the company’s profits via distribution of dividends. How do I determine the legal structure of my client’s business?

One of the quick and simple ways to determine the legal structure of a business is to look at the equity section of the balance sheet.

In the case of a sole trader, the equity section should contain the term “owner’s equity” with the name of the owner shown next to the capital account.

In the case of a partnership, the equity section should contain the term “partners’ equity” with the name of each of the partners shown next to their respective capital account.

In the case of a trust, the equity section should contain the term “corpus” or “settled funds”. This represents the amount contributed by the settlor when the trust was established.

In a discretionary trust, the beneficiaries do not own the “equity” in the trust. Because they are entitled to a share of the profits, when the profit is distributed, their beneficiary loan accounts are credited with their share of the profit distribution.

In the case of a company, the equity section should contain the term “share capital” or “issued capital” showing the amounts contributed by the shareholders.

As profits are retained within a company, the equity section of the balance sheet should also show the term “retained profits” or “accumulated losses”. Some companies also provide for reserves, which are also shown in the equity section of the balance sheet.

There is another way to determine the legal structure of a particular entity. The bookkeeper can visit the ABN LookUp website at www.abr.business.gov.au.

Typing in the legal name or trading name of the business will reveal the legal structure of the business under the description “entity type”.

If the bookkeeper is still unsure as to the legal structure of a business, the client’s external accountant or tax agent should be contacted for clarification. The computerised accounting software package that I use automatically produces a profit and loss statement and balance sheet.

How come some packages do not produce a statement of changes in equity and statement of cash flows?

All computerised accounting packages generate a series of financial statements. However, the types of report can differ between the packages. Most (if not all) packages will produce a profit and loss statement and balance sheet. Some will also produce a statement of cash flows, although typically extra coding is required when entering transactions. Most accounting software packages do not produce a statement of changes in equity.

The reason for this is that the statement of changes in equity and the statement of cash flows are required to be included in the external financial statements of certain types of entities, but not in management accounts.

An external accountant is typically responsible for preparing these two additional statements, not the bookkeeper. What is meant by the accounting equation and is it The entire accounting framework is based on the supposed to remain in balance after every accounting equation. The accounting equation is transaction? expressed as follows:

[Assets − Liabilities] = Equity

This equation states that if one side of the equation changes, then to keep the equation in balance, the other side of the equation must also change by the same amount.

When processing each business transaction, bookkeepers must ensure that the accounting equation is kept in balance at all times. This is referred to as the concept of “double-entry bookkeeping”, meaning that every transaction impacts at least two accounts.

Put simply, if the accounting equation does not balance, an error has been made. What is meant by the terms revenues, expenses, assets, liabilities and equity?

Revenues are inflows derived by an entity as a result of the sale of goods or provision of services.

Expenses are day-to-day outflows incurred by the business in providing goods or services to customers.

Revenues and expenses form the basis of the profit and loss statement (or income statement).

Assets are defined as future economic benefits owned or controlled by an entity. Assets are essentially anything owned by the entity that is valuable and contributes to revenue generation.

Liabilities are defined as future “sacrifices” of economic benefits that an entity is presently obliged to make to other entities. Essentially, liabilities are amounts owed by the entity to external parties.

Equity represents investments (both initial and ongoing) made by the owners of an entity and the sum of accumulated profits made over the years. The higher the equity, the more the business is worth.

Assets, liabilities and equity form the basis of the balance sheet. What is the purpose of a statement of cash flows?

The statement of cash flows reports the cash inflows and outflows of a business during the financial year. The statement of cash flows reconciles the amount of cash on hand at the beginning and the end of the reporting period.

Cash flows are categorised as arising from the following three activities: • operating activities • investing activities, and • financing activities.

While the profit and loss statement shows revenues and expenses under accrual accounting principles, the statement of cash flows is prepared under the cash accounting concepts (ie cash in and cash out).

For this reason, many people consider the statement of cash flows to be more useful than the profit and loss statement. What do the terms “reporting entity” and “nonreporting entity” mean? What type of external financial statements does each of these types of entities produce and what is the fundamental difference between the two?

The Australian financial reporting framework is based on the notion of differential reporting. This effectively means that there are different levels of reporting requirements for different entities.

The type of financial statements to be prepared depends on whether an entity is classified as a: • reporting entity, or • non-reporting entity.

Whether an entity is a reporting entity or not depends on an analysis of the users of the financial statements. Where there are many (and varied) users who are dependent upon the financial statements for information, the entity will be considered a reporting entity.

Conversely, if there are few users who are dependant upon the financial statements as a basis for making financial decisions about the entity, then the entity will more likely be a nonreporting entity.

Publicly listed companies, government departments and large superannuation funds are likely to be considered reporting entities.

Conversely, a self managed superannuation fund with a few members is likely to be considered a non-reporting entity.

The decision as to whether an entity is considered a reporting entity or a non-reporting entity rests with the directors of the company (or owners of the business).

If an entity is regarded as a reporting entity, it must prepare general purpose financial statements. These external financial statements are required to be prepared in accordance with all 57 AASB Accounting Standards and Australian Accounting Interpretations.

Conversely, if an entity is regarded as a nonreporting entity, it need only prepare special purpose financial statements. Non-reporting entities who prepare special purpose financial statements are only required to apply the recognition and measurement principles of those AASB Accounting Standards and Australian Accounting Interpretations which are considered necessary to present a “true and fair” view.

A user is able to determine whether an entity has prepared general purpose financial statements or special purpose financial statements as the entity is required to disclose this in its accounting policy note (which is usually the first note to the external financial statements).

¶1-750 Extract from the 2016 Annual Report of Qantas Ltd

2 RECORDING TRANSACTIONS The accounting equation revisited

¶2-000

Accounts

¶2-100

Double-entry bookkeeping

¶2-200

The accounting cycle

¶2-300

Business transactions

¶2-400

Source documents

¶2-500

The general journal

¶2-600

Posting from the journal to the ledger

¶2-700

The trial balance

¶2-800

Preparation of the financial statements

¶2-900

Recording transactions — commonly asked questions ¶2-950 Sample chart of accounts (for a company)

¶2-970

The Accounting Equation Revisited Introduction

¶2-000

What are transactions?

¶2-010

Worked example

¶2-020

¶2-000 Introduction It will be remembered from Chapter 1 (¶1-480) that the accounting equation is expressed as:

Assets = [Liabilities + Equity]

The sum of the assets of a business must always equal the sum of its liabilities and equity. Transactions result in changes to assets, liabilities and equity. Even though the elements of this equation change after each transaction, the accounting equation must always remain in balance.

¶2-010 What are transactions? The term “transaction” refers to any event that is recorded in the accounting system. It is important to distinguish between the three types of transactions. 1. External transactions An entity may engage in transactions with outside parties that affect the accounting equation. Examples include: • purchasing office equipment

• selling goods or services • borrowing money from a bank, and • payment of expenses such as rent, telephone and salaries to employees. External transactions are usually evidenced by supporting documentation (eg a tax invoice, receipt, etc). External transactions are recorded by bookkeepers because they affect the accounting equation, involve an external party and the financial effect of the transaction can be quantified. 2. Internal transactions Internal transactions are transactions that occur within an entity. Hence, they do not involve external parties. However, if the transaction results in a change to the recorded assets, liabilities or equity in the accounting equation and can be quantified, then it is recorded. 3. Non-event transactions Non-event transactions are transactions that have no financial effect on the entity and do not result in recorded assets, liabilities or equity in the accounting equation. Examples include: • signing a contract to purchase an asset in the future • making a telephone call to a customer or client • hiring a new employee, and • changing the interest rates. Non-event transactions are not recorded by the bookkeeper because they do not have a financial effect on the entity. Initially such events do not have a financial effect on the accounting equation, although they may be recorded in a future period if they later result in changes to the accounting equation.

¶2-020 Worked example To illustrate the effect of transactions on the accounting equation, we will work through the following example. Assume that Gary Richardson has recently qualified as a lawyer and decided to open his own legal practice under the trading name of “Gary Richardson Legal Practice”. He operates this business as a sole trader; hence, we would expect to see “owner’s equity” in the balance sheet (¶1-310). We will not be considering the effects of the goods and services tax (GST) at this point, as the focus of this chapter is on recording transactions. The effects of the GST on transactions will be discussed in Chapter 4 (commencing at ¶4-000). The following transactions occurred during the month of January 2017. Transaction 1: Starting the business with a $250,000 cash deposit January 2: Gary Richardson opens up a business cheque account with his local bank and deposits $250,000 from his own personal savings account into the business bank account. ASSETS Date

Cash at bank

LIA= BILITIES+

+Accounts +Furniture +Computer Receivable Equipment

Accounts Payable =

OWNER’S EQUITY

DESCRIPTION

G  Richardson Capital

Jan 2

+250,000

=

+250,000

Totals

$250,000

=

$250,000

Owner’s investment

Analysis In the first transaction, the owner, Gary Richardson, invests $250,000 of his own money into the business. This transaction results in an increase to “cash at bank” (an asset account) with a corresponding increase in “Gary Richardson’s capital” (an equity account). There was no impact on liabilities. Note that after this transaction has been recorded, the accounting equation is still in balance (A = L + E). Transaction 2: Purchasing furniture and computer equipment costing $124,200 January 4: Gary Richardson purchases furniture costing $80,000 and computer equipment costing $44,200 by paying cash. LIA= BILITIES+

ASSETS Date

Cash at bank

+Accounts +Furniture +Computer Receivable Equipment

Accounts Payable =

Jan 2

+250,000

=

Jan 4

−124,200

+80,000

+44,200 =

Totals

$125,800

$80,000

$44,200 =

OWNER’S EQUITY

DESCRIPTION

G  Richardson Capital +250,000

Owner’s investment Asset purchases

$250,000

Analysis In the second transaction, Gary Richardson purchased furniture costing $80,000 and computer equipment costing $44,200. Since he has paid cash for these two assets, “cash at bank” (an asset account) is reduced by a total of $124,200. However, there has been a corresponding increase in the two assets, “furniture” ($80,000) and “computer equipment” ($44,200). There is no effect on liabilities or equity as a result of this transaction. One asset account (cash at bank) has decreased, while two other asset accounts (furniture and computer equipment) have increased. Note that after this transaction has been recorded, the accounting equation is still in balance (A = L + E). Transaction 3: Hiring a legal assistant January 5: After interviewing several candidates during the week, Gary Richardson offers Amanda Young a full-time position in his practice as his legal assistant. Amanda duly accepts the offer of employment. LIA= BILITIES+

ASSETS Date

Cash at bank

+Accounts +Furniture +Computer Receivable Equipment

Accounts Payable =

Jan 2

+250,000

Jan 4

−124,200

Jan 5 Totals

= +80,000 No transaction recorded

$125,800

$80,000

OWNER’S EQUITY G  Richardson Capital +250,000

$44,200 =

Owner’s investment Asset purchases

+44,200 = =

DESCRIPTION

No transaction recorded $250,000

Analysis The third transaction is an example of a non-event transaction. The hiring of an employee does not immediately give rise to a change in the accounting equation. As there is no financial effect on the

accounting equation at this point, the transaction is not recorded. At a future point when Gary pays wages to Amanda, the accounting equation will be impacted and the transaction recorded. Transaction 4: Purchasing stationery on credit for $1,200 January 8: Gary Richardson opens an account with Officeworks and proceeds to purchase stationery costing $1,200 on credit. The account is payable within 30 days. LIA= BILITIES+

ASSETS Date

Cash at bank

+Accounts +Furniture +Computer Receivable Equipment

Accounts Payable =

Jan 2

+250,000

Jan 4

−124,200

Jan 5

= +80,000 No transaction recorded

=

$125,800

$80,000

DESCRIPTION

G  Richardson Capital +250,000

Owner’s investment Asset purchases

+44,200 =

Jan 8 Totals

OWNER’S EQUITY

No transaction recorded

=

+1,200

−1,200

$44,200 =

$1,200

$248,800

Stationery expense

Analysis In the fourth transaction, Gary purchases stationery for his legal practice. Purchasing an item of stationery is an example of an expense. Expenses have the effect of reducing equity. Hence, there has been a decrease in equity of $1,200. However, instead of paying cash to buy the stationery, Gary agrees to pay the account within 30 days. This is an example of “accounts payable” (a liability account). Gary owes Officeworks $1,200 within 30 days. As a result of this transaction, “accounts payable” has increased by $1,200. There was no impact on assets as a result of this transaction. Note that after this transaction has been recorded, the accounting equation is still in balance (A = L + E). Transaction 5: Earning legal fees revenue of $3,200 cash January 10: Gary Richardson earns revenue of $3,200 by performing legal services for clients over the past week. All of these clients pay by cash. LIA= BILITIES+

ASSETS Date

Cash at bank

+Accounts +Furniture +Computer Receivable Equipment

Accounts Payable =

Jan 2

+250,000

Jan 4

−124,200

Jan 5

+80,000 No transaction recorded

Jan 8 Jan 10

=

=

=

DESCRIPTION

G  Richardson Capital +250,000

Owner’s investment Asset purchases

+44,200 =

= +3,200

OWNER’S EQUITY

No transaction recorded +1,200

−1,200

Stationery expense

+3,200

Client fees revenue

Totals

$129,000

$80,000

$44,200 =

$1,200

$252,000

Analysis In the fifth transaction, Gary performs legal services for clients and derives revenue of $3,200. These clients pay by cash. In this transaction, “cash at bank” (an asset account) increases by $3,200 with a corresponding increase in “client fees revenue” (a revenue account). Revenues have the effect of increasing equity. Hence, there has been an increase in equity of $3,200. There was no impact on liabilities as a result of this transaction. Note that after this transaction has been recorded, the accounting equation is still in balance (A = L + E). Transaction 6: Earning client fees revenue of $5,600 on credit January 12: Gary Richardson earns revenue of $5,600 by performing legal services for clients. These clients are invoiced and they agree to pay the account within 14 days. LIA= BILITIES+

ASSETS Date

Cash at bank

+Accounts +Furniture +Computer Receivable Equipment

Accounts Payable =

Jan 2

+250,000

Jan 4

−124,200

Jan 5

= +80,000 No transaction recorded

Jan 8 Jan 10 Jan 12 Totals

=

+5,600 $129,000

$5,600

$80,000

DESCRIPTION

G  Richardson Capital +250,000

Owner’s investment Asset purchases

+44,200 =

No transaction recorded −1,200

Stationery expense

=

+3,200

Client fees revenue

=

+5,600

Client fees revenue

= +3,200

OWNER’S EQUITY

$44,200 =

+1,200

$1,200

$257,600

Analysis In the sixth transaction, Gary performs legal services for clients and derives revenue of $5,600. However, this time instead of receiving cash, clients are invoiced, requiring them to pay the account within 14 days. Hence, Gary is owed money by these clients. In this instance, “accounts receivable” (an asset account) has increased by $5,600. Because services have been performed, revenue has been derived. This is the case despite the fact that the business has not received any money from these clients. This highlights an important point about accrual accounting. Under the accrual accounting principles (¶1-440), revenue is recorded in the financial period in which goods have been sold or services have been provided, not the financial period in which the cash is received. Revenues have the effect of increasing equity. Hence, there has been an increase in equity of $5,600. There was no impact on liabilities as a result of this transaction. Note that after this transaction has been recorded, the accounting equation is still in balance (A = L + E). Transaction 7: Payment of various expenses totalling $4,330 January 19: Gary Richardson pays fortnightly wages to his assistant Amanda totalling $1,260. At the same time, he pays insurance of $2,800 and electricity of $270 for the month of January 2017.

LIA= BILITIES+

ASSETS Date

Cash at bank

+Accounts +Furniture +Computer Receivable Equipment

Accounts Payable =

Jan 2

+250,000

Jan 4

−124,200

Jan 5

= +80,000 No transaction recorded

=

Jan 12 Jan 19

Totals

+5,600 −4,330

$124,670

$5,600

$80,000

+250,000

Owner’s investment Asset purchases

No transaction recorded −1,200

Stationery expense

=

+3,200

Client fees revenue

=

+5,600

Client fees revenue

=

−1,260

Wages expense

=

−2,800

Insurance expense

=

−270

Electricity expense

= +3,200

DESCRIPTION

G  Richardson Capital

+44,200 =

Jan 8 Jan 10

OWNER’S EQUITY

$44,200 =

+1,200

$1,200

$253,270

Analysis In the seventh transaction, Gary pays several expenses totalling $4,330 by cash. This has the effect of reducing “cash at bank” (an asset account) by $4,330. Expenses have the effect of reducing equity. Hence, there has been a decrease in equity of $4,330. Each expense is separately recorded in the worksheet so that the owner can keep track of each individual expense incurred in the business. There was no impact on liabilities as a result of this transaction. Note that after this transaction has been recorded, the accounting equation is still in balance (A = L + E). Transaction 8: Payment of Officeworks account of $1,200 January 22: Gary Richardson pays $1,200 owing to Officeworks for the stationery he purchased on 8 January 2017. LIA= BILITIES+

ASSETS Date

Cash at bank

+Accounts +Furniture +Computer Receivable Equipment

Accounts Payable =

Jan 2

+250,000

Jan 4

−124,200

Jan 5

= +80,000 No transaction recorded

+44,200 = =

OWNER’S EQUITY

DESCRIPTION

G  Richardson Capital +250,000

Owner’s investment Asset purchases

No transaction recorded

Jan 8

Jan 10

=

+3,200

Jan 12 Jan 19

+5,600 −4,330

Jan 22

−1,200

Totals

$123,470

$5,600

$80,000

+1,200

−1,200

Stationery expense

=

+3,200

Client fees revenue

=

+5,600

Client fees revenue

=

−1,260

Wages expense

=

−2,800

Insurance expense

=

−270

Electricity expense

=

−1,200

$44,200 =

$—

Paid account $253,270

Analysis In the eighth transaction, Gary pays the Officeworks account. This has the effect of decreasing “cash at bank” (an asset account) by $1,200. When Gary purchased the stationery on 8 January 2017, he was extended credit and subsequently owed Officeworks $1,200. At the time, this was recorded as “account payable” (a liability account). As Gary has now paid this account, the liability (accounts payable) is reduced to $nil. He no longer owes $1,200 to Officeworks. There is no effect on equity as a result of this transaction. Note that after this transaction has been recorded, the accounting equation is still in balance (A = L + E). Transaction 9: Collection of amounts owing by clients — $4,200 January 25: Gary Richardson receives $4,200 from the clients whom he invoiced for the legal services undertaken on 12 January 2017. LIA= BILITIES+

ASSETS Date

Cash at bank

+Accounts +Furniture +Computer Receivable Equipment

Accounts Payable =

Jan 2

+250,000

Jan 4

−124,200

Jan 5

= +80,000 No transaction recorded

Jan 8 Jan 10 Jan 12 Jan 19

=

+5,600 −4,330

DESCRIPTION

G  Richardson Capital +250,000

Owner’s investment Asset purchases

+44,200 =

No transaction recorded −1,200

Stationery expense

=

+3,200

Client fees revenue

=

+5,600

Client fees revenue

=

−1,260

Wages expense

= +3,200

OWNER’S EQUITY

+1,200

Jan 22

−1,200

Jan 25

+4,200

−4,200

Totals

$127,670

$1,400

=

−2,800

Insurance expense

=

−270

Electricity expense

=

Paid account

−1,200

Received payment $80,000

$44,200 =

$—

$253,270

Analysis In the ninth transaction, Gary receives $4,200 from the clients who owed him money in respect of the legal services performed on 12 January 2017. This has the effect of increasing “cash at bank” (an asset account) by $4,200. At the time, this was recorded as “account receivable” (an asset account). As Gary has now received some of these monies, the asset account (accounts receivable) is reduced by $4,200. There is no effect on liabilities or equity as a result of this transaction. One asset account (cash at bank) has increased, while another asset account (accounts receivable) has decreased. Note that after this transaction has been recorded, the accounting equation is still in balance (A = L + E). Transaction 10: Gary Richardson withdraws $1,000 cash from his business January 30: Gary Richardson withdraws $1,000 cash from the business for his own personal use. LIA= BILITIES+

ASSETS Date

Cash at bank

+Accounts +Furniture +Computer Receivable Equipment

Accounts Payable =

Jan 2

+250,000

Jan 4

−124,200

Jan 5

= +80,000 No transaction recorded

Jan 8 Jan 10 Jan 12 Jan 19

Jan 22

=

+5,600 −4,330

−1,200

DESCRIPTION

G  Richardson Capital +250,000

Owner’s investment Asset purchases

+44,200 =

No transaction recorded −1,200

Stationery expense

=

+3,200

Client fees revenue

=

+5,600

Client fees revenue

=

−1,260

Wages expense

=

−2,800

Insurance expense

=

−270

Electricity expense

= +3,200

OWNER’S EQUITY

=

+1,200

−1,200

Paid account Received

Jan 25

+4,200

Jan 30

−1,000

Totals

$126,670

−4,200

=

payment

= $1,400

$80,000

$44,200 =

−1,000 $—

Owner’s drawings

$252,270

Analysis In the tenth and final transaction, Gary withdraws cash from his business. This has the effect of decreasing “cash at bank” (an asset account) by $1,000. In the case of a sole trader, amounts paid to the owner are not considered a business expense, but termed “drawings”. Drawings have the effect of reducing equity. There is no effect on liabilities as a result of this transaction. Note that after this transaction has been recorded, the accounting equation is still in balance (A = L + E). Completed worksheet LIA= BILITIES+

ASSETS Date

Cash at bank

+Accounts +Furniture +Computer Receivable Equipment

Accounts Payable =

Jan 2

+250,000

Jan 4

−124,200

Jan 5

= +80,000 No transaction recorded

Jan 8 Jan 10 Jan 12 Jan 19

=

+5,600 −4,330

Jan 22

−1,200

Jan 25

+4,200

Jan 30

−1,000

Totals $126,670

+250,000

Asset purchases No transaction recorded +1,200

−1,200

=

+5,600 Client fees revenue

=

−1,260

Wages expense

=

−2,800

Insurance expense

=

−270

Electricity expense

−1,200

Paid account

=

$80,000

Stationery expense

+3,200 Client fees revenue

Received payment

= $1,400

Owner’s investment

=

= −4,200

DESCRIPTION

G  Richardson Capital

+44,200 =

= +3,200

OWNER’S EQUITY

$44,200 =

−1,000 $—

$252,270

Owner’s drawings

Assets  =  $252,270

Liabilities  +  Equity  =  $252,270

A review of this example highlights several important points: • Every transaction affects at least two components in the accounting equation. The process of recording the effects of these transactions in the accounting system is referred to as “double-entry bookkeeping” (see ¶2-200). • After every transaction, the accounting equation must remain in balance. In other words, the sum of the assets of the business must always equal the sum of its liabilities and equity.

Accounts Introduction

¶2-100

Assets

¶2-110

Liabilities

¶2-120

Equity

¶2-130

Revenues

¶2-140

Expenses

¶2-150

¶2-100 Introduction Preparing a new equation of A = L + E for each transaction would be cumbersome and costly, especially where there are numerous transactions. Instead, bookkeepers and accountants summarise transactions into accounts. An account acts as a record of increases, decreases and balances for each individual item of asset, liability, equity, revenue or expense. Accounts are grouped into five broad categories: • assets (¶2-110) • liabilities (¶2-120) • equity (¶2-130) • revenues (¶2-140), and • expenses (¶2-150).

¶2-110 Assets Assets are defined as resources (or future economic benefits) owned or controlled by an entity. Assets are essentially anything owned by the entity that is valuable and contributes to revenue generation. Assets are usually classified as either current or non-current. If an asset is expected to be “realised” (ie converted into cash) within the next 12 months, it is classified as a current asset. Conversely, if an asset is not expected to be converted into cash within the next 12 months, it is classified as a non-current asset in the balance sheet. In some countries, non-current assets are referred to as fixed assets; however, in Australia, they are referred to as non-current assets. The most common asset accounts include:

Cash at bank: The cash at bank account is used to record the deposits into and withdrawals from a bank account. An entity could have several accounts at one bank and/or at several banks. These bank accounts may be savings accounts, cheque accounts or transactions accounts. Petty cash and cash on hand are also regarded as cash. A negative cash at bank account is referred to as “bank overdraft” and is reported as a current liability. Accounts receivable: Accounts receivable are amounts owed by customers or clients to an entity primarily because the entity has provided goods or services on credit. An account receivable is generally recognised when an invoice or tax invoice has been provided at the time the goods are sold and delivered to the customer or when the services have been provided. Accounts receivable are also known as trade debtors. Other receivables: At the end of the reporting period, an entity may have receivables resulting from a variety of other transactions, eg there may have been deposits made to electricity authorities and the landlord, etc. Furthermore, an entity may have short-term investments (such as term deposits). Prepaid expenses: Prepaid expenses represent payments made by an entity in advance (eg prepaid insurance, prepaid rent, etc) that have yet to be used. At the time of the payment, an asset is recorded and subsequently expensed as incurred. This is consistent with what is known as the matching principle. This concept is covered in more detail in Chapter 3 (see ¶3-310). Land: The land account is used to record the land controlled by an entity. Land is one of the rare assets not subject to depreciation, as it is deemed to have an infinite useful life. Buildings: The building account is used to record the purchases or construction costs of buildings to be used by an entity to carry out its business activities. Buildings are subject to depreciation. Plant and equipment: Physical items used by an entity such as furniture and fittings, office equipment, computer equipment, motor vehicles, machinery and store equipment are all termed “plant and equipment”. A separate account is usually used for each major class of plant and equipment. Furthermore, a fixed asset register is often maintained detailing when the asset was acquired, its cost, and the serial number. These assets are subject to depreciation. Intangible assets: These are assets controlled by the entity which do not have a physical substance. Examples include purchased goodwill, licences, brand names, trademarks, license agreements and patents. For accounting purposes, computer software (such as Microsoft Office) is regarded as intangible assets. These assets are usually subject to amortisation.

¶2-120 Liabilities Liabilities are defined as future sacrifices of economic benefits that an entity is presently obliged to make to other entities that result in an outflow of resources. Essentially, liabilities are amounts owed by the entity to external parties. Liabilities are classified as either current or non-current. If a liability is expected to be settled (or paid) within the next 12 months, it is classified as a current liability. Conversely, any liability not expected to be settled within the next 12 months is classified as a non-current liability in the balance sheet. The most common liability accounts include: Accounts payable: An account payable is the opposite of an account receivable. In other words, an obligation to pay an amount to an outside party who has provided goods or services to an entity is called “accounts payable”. The account is also commonly called “trade creditors”. Unearned revenue: Also known as “revenue received in advance”, this account represents the cash received from customers for goods or services yet to be delivered. It is not yet reported as revenue as the goods or services have not yet been provided. When the goods have been delivered or the services performed, an amount is transferred from the unearned revenue account (a liability) to the revenue account. The revenue represents reduction in the liability account. Examples include rent collected in advance from a tenant and subscriptions. Other current liabilities: At the end of the reporting period, an entity may owe money to external parties, such as GST and Pay As You Go (PAYG) withholding tax that may be payable to the Australian Taxation

Office (ATO). Employee benefits: An entity may employ staff. At the end of the reporting period, the entity may need to record a range of employee entitlements (typically called “provisions”). These may include annual leave, sick leave and long service leave. Loans payable: If an entity has borrowed money, this will be shown as loans payable. The entity may have also acquired assets via a finance lease, hire purchase contract or chattel mortgage, and there may be liabilities owing in respect of these commitments at the end of the reporting period.

¶2-130 Equity Equity represents investments (both initial and ongoing) made by the owners of an entity and the sum of accumulated profits made over the years. The higher the equity, the more the business is worth. The most common equity accounts include: Capital: The capital account represents the amounts contributed by the owners into the business. As we saw in Chapter 1, for a sole trader, this is referred to as the “owner’s equity” (¶1-310). For a partnership, it is called the “partners’ equity” (¶1-320), for a trust it is called the “corpus” (¶1-330) and for a company, it is referred to as the “shareholders’ equity” (¶1-340). Drawings: In the case of a sole trader, drawings represent amounts withdrawn by the owner of the business for his/her own personal use. Drawings have the effect of reducing equity. In the case of a company, drawings are typically referred to as “dividends”. Reserves: Sometimes an entity will set aside monies for future events (commonly referred to as “creating a reserve”). An example is the asset revaluation reserve which is used when an entity revalues a noncurrent asset (such as land) from its original cost to its current market value. The increment is taken to the asset revaluation reserve. The asset revaluation reserve represents the unrealised gain in the value of the asset. Retained profits: This account represents the accumulated profits (or losses) of a business since its establishment (after distributions to the owners).

¶2-140 Revenues Revenues are inflows derived by an entity as a result of the sale of goods or provision of services. Revenues typically include sale of goods, provision of services, interest received, rent received and dividends received. Another term for revenue is “income”. This term is commonly used in external financial statements, whereby “revenue” is more commonly used in management accounts. Revenues (or income) derived by an entity during the reporting period has the effect of increasing equity.

¶2-150 Expenses Expenses are day-to-day outflows incurred by a business in providing goods or services to the customers. Expenses typically include such items as accounting fees, advertising, bank charges, cleaning, electricity, insurance, interest paid, motor vehicle expenses, postage, printing and stationery, rent, repairs and maintenance, salaries and wages, superannuation and telephone. Expenses incurred by an entity during the reporting period have the effect of decreasing equity.

¶2-200 Double-entry bookkeeping Bookkeeping is based on a double-entry system. The principle of double-entry bookkeeping is that every business transaction affects at least two accounts. After every transaction is recorded, the accounting equation must remain in balance. Instead of using the terms “increase” and “decrease” to record business transactions, it is said that the accounts are “debited” and “credited”.

Transactions are entered into accounts. The most commonly used account is called the T-account, because it takes the shape of the capital letter “T”. The vertical line in the T-account splits the account into two sides — the left-hand side of the T-account is referred to as a “debit” and the right-hand side of the Taccount is referred to as a “credit”. Diagram 2.1 illustrates this concept. Diagram 2.1: Debits and credits in the T-account Cash at Bank (Asset) (Left side)  Debit 

(Right side)  Credit 

When an amount is entered on the left-hand side of the T-account, the amount is “debited”. Conversely, when an amount is entered on the right-hand side of the T-account, the amount is “credited”. The abbreviations for debit and credit are “Dr” and “Cr” respectively. For any given account, all increases are recorded on one side of the T-account, while all decreases are recorded on the other side. However, whether a debit or credit results in an increase or decrease to a given account depends on whether the account is an asset, liability, equity, revenue or expense. In determining the rules for debits and credits, an assumption is made that assets are of a debit nature. From the accounting equation, it follows that liabilities and equity are of a credit nature. Hence, total debits equal total credits. In summary:

Debit = Credit Assets = Liabilities + Equity

Put another way: Assets Debit to Increase

Normal balance

Credit to Decrease

=

Liabilities Debit to Decrease

Credit to Increase

Normal balance

+

Equity Debit to Decrease

Credit to Increase

Normal balance

Hence, an increase in an asset account is recorded as a debit. An increase in a liability or equity account is recorded as a credit. Conversely, a decrease in an asset account is recorded as a credit. A decrease in a liability or equity account is recorded as a debit. The debit/credit rules for revenues and expenses can be developed by examining the relationship of revenue and expense accounts to the equity account. Revenues increase equity and expenses decrease equity. Thus, increases in revenue are recorded as credits consistent with recording the increases in equity. Increases in expenses are recorded as debits, because they reduce the equity. Although a debit to an expense account is a reduction in equity, it is also an increase in the expense account.

The debit and credit rules for revenues and expenses are shown as follows: Revenues Debit to Decrease

Expenses

Credit to Increase

Debit to Increase

Normal balance

Credit to Decrease

Normal balance

The rules relating to debits and credits are summarised in the following table: Rules relating to debits and credits Account

Increases

Decreases

Normal balance

Assets

Debit

Credit

Debit

Liabilities

Credit

Debit

Credit

Equity

Credit

Debit

Credit

Revenues

Credit

Debit

Credit

Expenses

Debit

Credit

Debit

It will be observed that the normal account balance is the same side as the increase. Hence, to increase an asset is to debit the asset. The normal balance of an asset account is debit. Conversely, to increase a liability is to credit the liability. The normal balance of a liability account is credit.

¶2-300 The accounting cycle The accounting cycle is the process or sequence of accounting procedures that takes place during the accounting period from the occurrence and recording of business transactions to the preparation of financial statements. The primary purpose of the accounting cycle is to ensure that all transactions are properly and correctly recorded and records are accurately maintained so that the financial statements can be prepared at the end of each accounting period. The accountant and bookkeeper are primarily responsible for maintaining the accounting cycle. The accounting cycle is shown in the following diagram: Diagram 2.2: The accounting cycle

¶2-400 Business transactions The first step in the accounting cycle is that a business transaction occurs. As previously discussed, only transactions that have a financial effect on the accounting equation are recorded (¶2-010). These transactions usually involve an external party (although not always) and the financial effect of the transaction can be quantified.

¶2-500 Source documents Most transactions are evidenced by a source document. A source document provides verification that a transaction has occurred. Examples include a purchase order, invoice, tax invoice, receipt, cash register tape or credit card statement. For every transaction recorded by the bookkeeper, a source document should exist — this is the second step in the accounting cycle. Apart from accounting purposes, the need to keep accurate source documents evidencing transactions is paramount. For example, under s 286(2) of the Corporations Act 2001, companies are required to keep the records for a period of seven years. For taxation purposes, every taxpayer is required to keep appropriate records for a period of five years (s 262A(4), Income Tax Assessment Act 1936 (ITAA36)).

¶2-600 The general journal The third step in the accounting cycle involves recording of transactions into a journal. In a traditional manual accounting system, transactions are usually entered into a journal. A journal is simply a chronological record of an entity’s transactions during the accounting period. For each transaction entered

into a journal, the debits must equal the credits. As such, it is based on the concept of double-entry bookkeeping (¶2-200). There are several types of journals; however, the most common type of journal is the general journal. In most computerised accounting packages, transactions are generally entered directly into the screens that simulate deposit slips and cheques, thereby alleviating the need for the bookkeeper to record transactions into journals. However, most computerised accounting packages also provide the option to enter journal entries. The process of entering transactions into a general journal is called “journalising”. The journalising process contains four steps: (1) Identify the accounts involved. Remember every transaction must affect at least two accounts. (2) Classify each account as an asset, liability, equity, revenue or expense. (3) Determine whether the accounts are increasing or decreasing. (4) Apply the debit/credit rules from the table in ¶2-200. We will now apply the journalising process to the transactions of Gary Richardson Legal Practice discussed at ¶2-020. The first transaction occurred on 2 January 2017. The owner of the business, Gary Richardson, deposited $250,000 of his own cash into the business bank account to start the business. In order to verify that this transaction has actually occurred, the bookkeeper would need to work from the source document, which could be a deposit slip or a $250,000 cheque written from Gary Richardson’s personal bank account. The amount deposited is usually verified against the business’s bank statement. Once the transaction has been verified, the next step is to determine which accounts are affected by the transaction. In this transaction, “cash at bank” (an asset account) has increased. Gary Richardson’s “capital” (an equity account) has also increased. According to the rules discussed at ¶2-200, assets are debit accounts by nature, while equity is a credit account by nature. Both accounts have increased. An increase in assets is recorded as a debit, while an increase in equity is recorded as a credit. Following this logic, the first journal entry to be recorded on 2 January 2017 is as follows: DATE Jan 2

PARTICULARS

POST REF

Cash at bank Gary Richardson, capital (Recording the initial $250,000 investment made by Gary Richardson into the business)

As can be seen, the journal entry contains: • the date of the transaction • the name of the account debited (on the left-hand side) • the name of the account credited (indented slightly) • the amount of the debit entered in the left-hand column • the amount of the credit entered in the right-hand column, and • a short explanation of the transaction (called the narration).

¶2-700 Posting from the journal to the ledger

DEBIT

CREDIT

250,000 250,000

Once all the transactions for the relevant accounting period have been entered into the journal, they are posted (or transferred) to the general ledger. This is the fourth step in the accounting cycle. A general ledger contains each account maintained by the entity (ie all assets, liabilities, equity, revenues and expenses). Accounts contained in the general ledger are usually organised in the order in which they appear in the balance sheet and profit and loss statement. Each account has a unique identification number (termed the account number) which is used for reference and for cross-referencing the transactions entered into a specific account. A list of all the account numbers and account names is referred to as a “chart of accounts”. A logical and systematic numbering system is assigned to assets, liabilities, equity, revenues and expenses. For example, assets may be assigned numbers ranging from 1000 to 1999; liabilities may be assigned numbers ranging from 2000 to 2999; equity items may be assigned numbers ranging from 3000 to 3999; revenues may be assigned numbers ranging from 4000 to 4999; and expenses may be assigned numbers ranging from 5000 to 5999. Usually, the bookkeeper creates a client’s chart of accounts. However, once established, the chart of accounts is usually passed onto the external accountant for review and comment. The external accountant may specifically wish to add or rename certain accounts or organise the list in a certain manner. Most computerised accounting software packages have standard chart of account templates (typically referred to as “account lists”) which can be used as a starting point for bookkeepers setting up a chart of accounts for their clients. The chart of accounts for Gary Richardson Legal Practice is shown as follows: Gary Richardson Legal Practice Chart of Accounts Assets [1-000 – 1-999] 1-100 Cash at bank 1-200 Accounts receivable 1-300 Furniture 1-400 Computer equipment Liabilities [2-000 – 2-999] 2-100 Accounts payable Equity [3-000 – 3-999] 3-100 Gary Richardson, capital 3-200 Gary Richardson, drawings Revenues [4-000 – 4-999] 4-100 Client fees revenue Expenses [5-000 – 5-999] 5-100 Electricity expense 5-200 Insurance expense 5-300 Stationery expense 5-400 Wages expense For example, MYOB designates all assets as starting with the numbers 1-0000, liabilities are represented

by 2-0000, equity as 3-0000, revenue as 4-0000, cost of goods sold as 5-0000 and expenses as 6-0000. A sample chart of accounts using the MYOB accounting numbering system is included at the end of this chapter (¶2-970). The process of transferring the amounts entered in the journal to the ledger is called “posting”. The aim of posting transactions from the journal to the ledger is to group the effects of all transactions on each individual asset, liability, equity, revenue and expense account. In computerised accounting systems, the posting process is carried out automatically by the software package. Posting from the journal to the ledger involves five steps: (1) Decide which side of the ledger you are posting to — the left-hand (or debit) side, or the right-hand (or credit) side. (2) Transfer the date of the transaction from the journal to the ledger. (3) Write the corresponding name of the account from the journal entry. (4) Transfer the amount from the journal to the ledger. (5) Write the posting reference in the journal to indicate that the transaction has been posted to the ledger. We will now apply this posting process to the previous worked example regarding Gary Richardson (¶2020). Transaction 1: Starting the business with a $250,000 cash deposit We were told that on 2 January 2017, Gary Richardson opened up a business cheque account with his local bank and deposited $250,000 from his own personal savings into the business bank account to start the business. The journal entry that would have been recorded is as follows: DATE Jan 2

POST REF

PARTICULARS Cash at bank

DEBIT

CREDIT

250,000

Gary Richardson, capital

250,000

(Recording the initial $250,000 investment made by Gary Richardson into the business) The ledger posting to the two affected accounts is as follows: Cash at Bank 2 Jan

Capital

1-100

250,000 Gary Richardson, Capital 2 Jan

3-100

Cash at bank

250,000

From this point onwards, we will continue to post journal entries for Gary Richardson Legal Practice for the month of January 2017 to the general ledger. Transaction 2: Purchasing furniture and computer equipment costing $124,200 We are told that on 4 January 2017, Gary Richardson purchased furniture costing $80,000 and computer equipment costing $44,200 by paying cash. The journal entry that would have been recorded is as follows: DATE

PARTICULARS

POST REF

DEBIT

CREDIT

Jan 4

Furniture

80,000

Computer equipment

44,200

Cash at bank

124,200

(Gary Richardson purchased furniture and computer equipment by paying cash) The ledger posting to the three affected accounts is as follows: Cash at Bank 2 Jan

Capital

250,000 4 Jan

1-100 Furniture and computer equipment

Furniture 4 Jan

Cash at bank

1-300

80,000 Computer Equipment

4 Jan

124,200

Cash at bank

1-400

44,200

Transaction 3: Hiring a legal assistant We are told that on 5 January 2017, Gary Richardson employed Amanda Young as a full-time legal assistant in his legal practice. As this transaction does not have a financial effect on the accounting equation, no journal entry is recorded. Hence, there is no impact on the general ledger. Transaction 4: Purchasing stationery on credit for $1,200 We are told that on 8 January 2017, Gary Richardson opened an account with Officeworks and purchased stationery costing $1,200 on credit. The journal entry that would have been recorded is as follows: DATE Jan 8

PARTICULARS

POST REF

Stationery expense

DEBIT

CREDIT

1,200

Accounts payable

1,200

(Purchase of stationery from Officeworks on credit) The ledger posting to the two affected accounts is as follows: Stationery Expense 8 Jan Accounts payable

5-300

1,200 Accounts Payable 8 Jan Stationery

2-100 1,200

Transaction 5: Earning legal fees revenue of $3,200 cash We are told that on 10 January 2017, Gary Richardson performed legal services for clients and received cash of $3,200. The journal entry that would have been recorded is as follows: DATE Jan 10

PARTICULARS Cash at bank

POST REF

DEBIT 3,200

CREDIT

Client fees revenue

3,200

(Provision of legal services to clients for cash) The ledger posting to the two affected accounts is as follows: Cash at Bank 2 Jan

Capital

250,000 4 Jan

8 Jan

Client fees

1-100 Furniture and computer equipment

revenue

124,200

3,200 Client Fees Revenue

4-100

8 Jan Cash at bank

3,200

Transaction 6: Earning client fees revenue of $5,600 on credit We are told that on 12 January 2017, Gary Richardson performed legal services and invoiced clients for $5,600. The journal entry that would have been recorded is as follows: DATE Jan 12

POST REF

PARTICULARS

DEBIT

Accounts receivable

CREDIT

5,600

Client fees revenue

5,600

(Provision of legal services to clients on credit) The ledger posting to the two affected accounts is as follows: Accounts Receivable 12 Jan Client fees

1-200

5,600 Client Fees Revenue 8 Jan

4-100

Cash at bank

3,200

12 Jan Accounts receivable

5,600

Transaction 7: Payment of expenses totalling $4,330 We are told that on 19 January 2017, Gary Richardson paid fortnightly wages to his assistant Amanda of $1,260, insurance of $2,800 and electricity of $270. The journal entry that would have been recorded is as follows: DATE Jan 19

PARTICULARS

POST REF

DEBIT

CREDIT

Wages expense

1,260

Insurance expense

2,800

Electricity expense

270

Cash at bank (Payment of expenses for the month of January 2017) The ledger posting to the four affected accounts is as follows:

4,330

Cash at Bank 2 Jan

Capital

250,000 4 Jan

8 Jan

Client fees

1-100 Furniture and computer equipment

revenue

124,200

3,200 19 Jan Wages expense 19 Jan Insurance expense

2,800

19 Jan Electricity expense

270

Wages Expense 19 Jan Cash at bank

1,260

5-400

1,260 Insurance Expense

19 Jan Cash at bank

5-200

2,800 Electricity Expense

19 Jan Cash at bank

5-100

270

Transaction 8: Payment of Officeworks account of $1,200 We are told that on 22 January 2017, Gary Richardson paid the $1,200 owing to Officeworks for the stationery he purchased on 8 January 2017. The journal entry that would have been recorded is as follows: DATE Jan 22

POST REF

PARTICULARS

DEBIT

Accounts payable

CREDIT

1,200

Cash at bank

1,200

(Payment of amount owing to Officeworks) The ledger posting to the two affected accounts is as follows: Cash at Bank 2 Jan

Capital

8 Jan

Client fees revenue

250,000 4 Jan

1-100 Furniture and computer equipment

3,200 19 Jan Wages expense

1,260

19 Jan Insurance expense

2,800

19 Jan Electricity expense

270

22 Jan Accounts payable

22 Jan Cash at bank

124,200

Accounts Payable

2-100

1,200 8 Jan

1,200

Stationery

1,200

Transaction 9: Collection of amounts owing by clients — $4,200 We are told that on 25 January 2017, Gary Richardson received $4,200 from the clients whom he invoiced for the legal services undertaken on 12 January 2017. The journal entry that would have been recorded is as follows: POST

DATE Jan 25

PARTICULARS

REF

DEBIT

Cash at bank

CREDIT

4,200

Accounts receivable

4,200

(Collection of accounts receivable from clients) The ledger posting to the two affected accounts is as follows: Cash at Bank 2 Jan

Capital

8 Jan

Client fees

25 Jan

250,000 4 Jan

1-100 Furniture and computer equipment

124,200

revenue

3,200 19 Jan Wages expense

1,260

Accounts receivable

4,200 19 Jan Insurance expense

2,800

19 Jan Electricity expense

270

22 Jan Accounts payable

Accounts Receivable 12 Jan Client fees

1,200

1-200

5,600 25 Jan Cash at bank

4,200

Transaction 10: Gary Richardson withdraws $1,000 cash from his business Finally, we are told that on 30 January 2017, Gary Richardson withdrew $1,000 cash from the business for his own personal use. The journal entry that would have been recorded is as follows: DATE Jan 30

POST REF

PARTICULARS Drawings, Gary Richardson

DEBIT

CREDIT

1,000

Cash at bank

1,000

(Drawings made by Gary Richardson) The ledger posting to the two affected accounts is as follows: Cash at Bank 2 Jan

Capital

8 Jan

Client fees

25 Jan

250,000 4 Jan

1-100 Furniture and computer equipment

124,200

revenue

3,200 19 Jan Wages expense

1,260

Accounts receivable

4,200 19 Jan Insurance expense

2,800

19 Jan Electricity expense

270

22 Jan Accounts payable

1,200

30 Jan Drawings

1,000

Gary Richardson, Drawings 30 Jan Cash at bank

3-200

1,000

Once the entries have been posted from the general journal to the ledger, each ledger account must be

balanced. This is a process whereby each side of the ledger account is totalled. The difference between the total debits and total credits is referred to as the balance. Let us look at the “cash at bank” account. On 31 January 2017, after all the transactions have been posted, the “cash at bank” ledger account reads as follows: Cash at Bank 2 Jan

Capital

8 Jan

Client fees

25 Jan

250,000 4 Jan

1-100 Furniture and computer equipment

124,200

revenue

3,200 19 Jan Wages expense

1,260

Accounts receivable

4,200 19 Jan Insurance expense

2,800

19 Jan Electricity expense

270

22 Jan Accounts payable

1,200

30 Jan Drawings

1,000

In balancing the ledger account, the first step is to add both sides (ie the debit side and the credit side of the ledger account). The total of the debits comes to $257,400. The total of the credits comes to $130,730. The larger of these two amounts is the debit side of $257,400. This amount is entered as the total of both sides of the ledger account. In order for the credit side of the “cash at bank” account to equal this total, an amount of $126,670, being the difference between the two amounts, must be entered on the credit side on the last date of the relevant accounting period. Hence, an amount of $126,670 is entered on the credit side on 31 January 2017. This is the difference between the total of $257,400 and the sum of the credit side of $130,730. The words “balance c/d” is entered next to this amount. The term “balance c/d” stands for “balance carried down”. This balance is transferred to the debit side of the account on the last date of the relevant accounting period below the two totals with the term “balance b/d” written next to this amount. Balance b/d stands for “balance brought down”. This amount subsequently becomes the opening balance for the month of February 2017. The completed “cash at bank” account appears as follows: Cash at Bank 2 Jan

Capital

8 Jan

Client fees

25 Jan

250,000 4 Jan

1-100 Furniture and computer equipment

revenue

3,200 19 Jan Wages expense

1,260

Accounts receivable

4,200 19 Jan Insurance expense

2,800

19 Jan Electricity expense

270

22 Jan Accounts payable

1,200

30 Jan Drawings

1,000

31 Jan Balance c/d

126,670

257,400 31 Jan

124,200

Balance b/d

257,400

126,670

The process of balancing each general ledger account continues along the same line. The general ledger accounts (balanced on 31 January 2017) appear as follows: Accounts Receivable 12 Jan Client fees

5,600 25 Jan Cash at bank

1-200 4,200

31 Jan Balance c/d 5,600 31 Jan Balance b/d

5,600

1,400 Furniture

4 Jan

Cash at bank

31 Jan Balance b/d

1-300

80,000 31 Jan Balance c/d

80,000

80,000

80,000

80,000 Computer Equipment

4 Jan

Cash at bank

31 Jan Balance b/d

1,400

1-400

44,200 31 Jan Balance c/d

44,200

44,200

44,200

44,200

It will be observed that for each asset account, the balance brought down after balancing each general ledger account appears on the debit side. This is expected, as asset accounts have debit balances. In the case of liability and equity accounts, the balance brought down after balancing each general ledger account will be a credit amount.

22 Jan Cash at bank

Accounts Payable

2-100

1,200 8 Jan

1,200

Stationery

Gary Richardson, Capital 31 Jan

Balance c/d

250,000 2 Jan

3-100

Cash at bank

250,000

250,000

250,000 31 Jan

Balance b/d

250,000

In the case of drawings, this account is regarded as a negative equity account, because drawings have the effect of reducing equity. Hence, we would expect drawings to have a debit balance. Gary Richardson, Drawings 30 Jan Cash at bank

31 Jan Balance b/d

3-200

1,000 31 Jan Balance c/d

1,000

1,000

1,000

1,000

In the case of revenue accounts, the balance brought down after balancing each general ledger account will be a credit amount.

31 Jan Balance c/d

Client Fees Revenue

4-100

8,800 8 Jan

Cash at bank

3,200

12 Jan Accounts receivable

5,600

8,800

8,800 31 Jan Balance b/d

8,800

In the case of expense accounts, the balance brought down after balancing each general ledger account

will be a debit amount. Electricity Expense 19 Jan Cash at bank

31 Jan Balance b/d

5-100

270 31 Jan Balance c/d

270

270

270

270 Insurance Expense

19 Jan Cash at bank

31 Jan Balance b/d

5-200

2,800 31 Jan Balance c/d

2,800

2,800

2,800

2,800 Stationery Expense

8 Jan

Cash at bank

31 Jan Balance b/d

5-300

1,200 31 Jan Balance c/d

1,200

1,200

1,200

1,200 Wages Expense

19 Jan Cash at bank

31 Jan Balance b/d

5-400

1,260 31 Jan Balance c/d

1,260

1,260

1,260

1,260

Once each journal entry has been posted to the respective ledger accounts, the general ledger account number is written next to each journal entry to indicate that the transaction has been posted to the ledger. The completed journal entries for the month of January 2017 for Gary Richardson appear as follows (taking into account posting references): DATE Jan 2

PARTICULARS Cash at bank Gary Richardson, capital

POST REF 1-100

DEBIT

CREDIT

250,000

3-100

250,000

(Recording the initial $250,000 investment made by Gary Richardson into the business)

Jan 4

Furniture

1-300

80,000

Computer equipment

1-400

44,200

Cash at bank

1-100

124,200

(Gary Richardson purchased furniture and computer equipment by paying cash)

Jan 8

Stationery expense Accounts payable

5-300 2-100

1,200 1,200

(Purchase of stationery from Officeworks on credit)

Jan 10

Cash at bank Client fees revenue

1-100

3,200

4-100

3,200

(Provision of legal services to clients for cash)

Jan 12

Accounts receivable Client fees revenue

1-200

5,600

4-100

5,600

(Provision of legal services to clients on credit) Jan 19

Wages expense

5-400

1,260

Insurance expense

5-200

2,800

Electricity expense

5-100

270

Cash at bank

1-100

4,330

(Payment of expenses for the month of January 2017)

Jan 22

Accounts payable

2-100

Cash at bank

1-100

1,200 1,200

(Payment of amount owing to Officeworks)

Jan 25

Cash at bank Accounts receivable

1-100

4,200

1-200

4,200

(Collection of accounts receivable from clients)

Jan 30

Drawings, Gary Richardson Cash at bank

3-200 1-100

1,000 1,000

(Drawings made by Gary Richardson)

¶2-800 The trial balance The double-entry bookkeeping system requires that the debit and credit are recorded for every transaction. Hence, if transactions have been entered without mistakes, the total of the debits should equal the total of the credits. A trial balance is a list of all the accounts of the business in an account number order with their current balances. The trial balance contains two columns — the first column is the total of the debits, and the second column is the total of the credits. The purpose of the trial balance is to ensure mathematical accuracy of the debits and credits. In other words, the two columns of the trial balance should equal each other. When this occurs, the books are said to be “in balance”. Preparation of the trial balance is the fifth step in the accounting cycle. A trial balance may be prepared at

any time to ensure the equality of debits and credits. However, typically, a trial balance is prepared at the end of each month. In a computerised accounting system, the software will automatically check the equality of debits and credits. Any difference is highlighted to the user for correction. However, there are several limitations of the trial balance. The fact that the sum of the debit column equals the sum of the credit column in the trial balance does not guarantee that errors have not been made. For example, errors which a trial balance will not reveal include: • transactions omitted entirely or entered twice • entries of an equal amount made to the wrong side of each account • entries of an equal amount made in the wrong accounts, but on the correct sides, and • incorrect amounts of the same value which have been entered on both sides of the general ledger. Hence, it is important to check the balance of every account in the trial balance. Don’t simply just check the totals. The trial balance of Gary Richardson Legal Practice as at 31 January 2017 is shown as follows: Gary Richardson Legal Practice Trial balance as at 31 January 2017 Account title Cash at bank

Account No 1-100

Debit 126,670

Credit

Accounts receivable

1-200

1,400

Furniture

1-300

80,000

Computer equipment

1-400

44,200

Gary Richardson, capital

3-100

Gary Richardson, drawings

3-200

Client fees revenue

4-100

Electricity expense

5-100

270

Insurance expense

5-200

2,800

Stationery expense

5-300

1,200

Wages expense

5-400

1,260

Totals:

250,000 1,000 8,800

$258,800

$258,800

¶2-900 Preparation of the financial statements Once the trial balance has been prepared, the accounting cycle can be completed by preparing the financial statements for Gary Richardson Legal Practice. This is the sixth and final step in the accounting cycle. The financial statements for Gary Richardson Legal Practice are shown on the following pages. It will be remembered from Chapter 1 (¶1-120) that the financial statements consist of: • a statement of profit or loss and other comprehensive income for the period (also referred to as “profit and loss statement” or “income statement”) • a statement of changes in equity for the period • a statement of financial position as at the end of the period (or “balance sheet”), and • a statement of cash flows for the period. Most computerised accounting packages do not produce the statement of changes in equity as a separate report. Instead, the profit for the period is automatically transferred to the “retained profits” accounts in the equity section of the balance sheet. Similarly, some computerised accounting software packages do not produce the statement of cash flows, but it is shown here for completeness as the statement of cash flows is typically prepared by accountants and form part of external financial statements.

Gary Richardson Legal Practice Profit and Loss Statement for the month ended 31 January 2017 $ Revenue

Client fees

8,800

Total Revenue

8,800

Less: Expenses

Electricity expense

270

Insurance expense

2,800

Stationery expense

1,200

Wages expense

1,260

Total Expenses

5,530

Net Profit

$ 3,270

Gary Richardson Legal Practice Statement of Changes in Equity for the month ended 31 January 2017 $ Opening capital as at 1 January 2017 Add: Investments by owner

– 250,000

Add: Net profit for the month of January 2017 (from profit and loss statement)

3,270 253,270

Less: Owner’s drawings

(1,000)

Closing capital as at 31 January 2017

$ 252,270

Gary Richardson Legal Practice Balance Sheet as at 31 January 2017 $ Current Assets

Cash at bank Accounts receivable

126,670 1,400

Total Current Assets

128,070

Non-Current Assets

Furniture, at cost

80,000

Computer equipment, at cost

44,200

Total Non-Current Assets

124,200

Total Assets

$ 252,270

Owner’s Equity

Gary Richardson, capital (from above)

Owner’s Equity

252,270

$ 252,270

Gary Richardson Legal Practice Statement of Cash Flows for the month ended 31 January 2017 $

$

Cash Flows from Operating Activities Receipts from customers Payments to suppliers and employees

7,400  (5,530)

Net cash from operating activities

1,870

Cash Flows (Used in) Investing Activities

Purchase of furniture

(80,000)

Purchase of computer equipment

(44,200)

Net cash (used in) investing activities

(124,200)

Cash Flows from Financing Activities Capital investment by owner

250,000

Drawings by owner

(1,000)

Net cash from financing activities

249,000

Net increase in cash for the month of January 2017

126,670

Cash at beginning of January 2017

Cash at the end of January 2017

–

$ 126,670

It will be noted that the closing cash at bank balance as shown in the statement of cash flows of $126,670 equates to the cash at bank account shown in the balance sheet as at 31 January 2017.

¶2-950 Recording transactions — commonly asked questions Question What is a transaction and what types of transactions should I record in the accounting system?

Answer A transaction refers to any event that is recorded in the accounting system. There are three types of transactions: • external transactions • internal transactions, and • non-event transactions. An external transaction is a transaction involving an outside party, for example, when goods are bought or sold or rent is paid to the landlord. External transactions are usually evidenced by supporting documentation (eg a tax invoice, receipt, etc). External transactions have a financial effect on the accounting equation; hence, they are recorded by bookkeepers.

Internal transactions are transactions that occur within an entity, and as a result, do not involve external parties. These transactions are not usually recorded by the bookkeeper unless they can be shown to have an effect on the accounting equation (eg use of office supplies by employees).

Non-event transactions are transactions that have no financial effect on an entity and do not affect the accounting equation. Non-event transactions are not recorded by the bookkeeper. What is the difference between a current and non-

If an asset is expected to be “realised” (ie

current asset? Similarly, what is the difference between a current and non-current liability?

converted into cash) within the next 12 months, it is classified as a current asset.

Conversely, if an asset is not expected to be converted into cash within the next 12 months, it is classified as a non-current asset in the balance sheet. Some countries refer to non-current assets as fixed assets.

Similarly, in the case of liabilities, if the liability is expected to be settled (or paid) within the next 12 months, it is classified as a current liability.

Conversely, any liability not expected to be settled within the next 12 months is classified as a noncurrent liability in the balance sheet. What is meant by the term “T-account” and on which side of a T-account is the debit and credit entered?

Bookkeeping is based on a double-entry system. The principle of double-entry bookkeeping is that every business transaction affects at least two accounts. Accounts are “debited” and “credited” in the accounting system.

Transactions are entered into accounts. The most commonly used account is called the T-account, because it takes the shape of the capital letter “T”.

The vertical line in the T-account splits the account into two sides: the left-hand side of the T-account is referred to as “debit” and the right-hand side of the T-account is referred to as “credit”.

When an amount is entered on the left-hand side of the T-account, the amount is debited. Conversely, when an amount is entered on the right-hand side of the T-account, the amount is credited. The abbreviations for debit and credit are “Dr” and “Cr” respectively.

For any given account, all increases are recorded on one side of the T-account, while all decreases are recorded on the other side. However, whether a debit or credit results in an increase or decrease

to a given account depends on whether the account is an asset, liability, equity, revenue or expense.

In determining the rules for debits and credits, an assumption is made that assets are of a debit nature. From the accounting equation, it follows that liabilities and equity are of a credit nature and hence, total debits equal total credits.

Revenues are also credit in nature, as they have the effect of increasing equity, while expenses are debit by nature, as they have the effect of decreasing equity. What is meant by the term “accounting cycle”?

The accounting cycle is the process or sequence of accounting procedures that takes place during the accounting period from the occurrence and recording of business transactions to the preparation of financial statements.

The primary purpose of the accounting cycle is to ensure that all transactions are properly and correctly recorded and maintained so that financial statements can be prepared at the end of each accounting period.

The accountant and bookkeeper are primarily responsible for maintaining the accounting cycle. The accounting cycle is shown in Diagram 2.2 included in this chapter at ¶2-300. What is the difference between a general journal and a general ledger?

Transactions are entered by the bookkeeper into a journal. A journal is merely a chronological record of an entity’s transactions during the accounting period. It is based on the concept of double-entry bookkeeping. There are several types of journals; however, the most common type is the general journal.

In most computerised accounting software packages, transactions are generally entered directly into the screens that simulate deposit slips and cheques, thereby alleviating the need for the bookkeeper to record transactions into journals. However, most accounting packages also have the option to record journal entries.

Once all the transactions for the relevant accounting period have been entered into the journal — they are posted (or transferred) to the general ledger. A general ledger contains each account maintained by the entity (ie all assets, liabilities, equity, revenues and expenses).

Accounts contained in the general ledger are usually organised in the order in which they appear in the balance sheet and profit and loss statement.

Each account has a unique identification number (termed the account number) which is used for reference and for cross-referencing the transactions entered in a specific account. What is a chart of accounts? Who is responsible for creating the client’s chart of accounts?

A chart of accounts is a complete listing of all the account numbers and account names used by an entity. Usually, a logical and systematic numbering system is assigned to assets, liabilities, equity, revenues and expenses.

For example, assets may be assigned numbers ranging from 1000 to 1999; liabilities may be assigned numbers ranging from 2000 to 2999; equity items may be assigned numbers ranging from 3000 to 3999; revenues may be assigned numbers ranging from 4000 to 4999; cost of goods sold may be assigned numbers ranging from 5000 to 5999 and expenses may be assigned numbers ranging from 6000 to 6999.

Usually, the bookkeeper creates a client’s chart of accounts. However, once established, the chart of accounts is usually passed onto the external accountant for review and comment. The external accountant may specifically wish to add or rename certain accounts or organise the list in a certain manner. Furthermore, the accountant will often check that the correct GST tax codes have been used (see Chapter 4, commencing at ¶4-000).

Most computerised accounting software packages, such as MYOB, Xero and QuickBooks have standard chart of account templates (termed

“account lists”), which can be used as a starting point for bookkeepers setting up a chart of accounts for their clients. What is a trial balance and what is its major purpose?

A trial balance is a complete list of all the accounts of a business in account number order with their current balances. The trial balance contains two columns — the first column is the total of the debits, and the second column is the total of the credits. The totals of the two columns should be equal. When this occurs, the books are said to be “in balance”.

A trial balance may be prepared at any time to ensure the equality of debits and credits. However, typically, the trial balance is prepared at the end of each month. In a computerised accounting system, the package will automatically check the equality of debits and credits. Any difference is highlighted to the user for correction.

The trial balance is the second last step in the accounting cycle. Once the trial balance has been prepared, the accounting cycle can be completed by preparing the financial statements of the entity. The trial balance is usually passed onto the external accountant.

¶2-970 Sample chart of accounts (for a company) Account number

Account name

1-0000

Assets

1-1000

Cash on hand

1-1100

Petty cash

1-1200

Cash float

1-1300

Cash at bank – cheque account

1-1400

Cash at bank – savings account

1-2000

Accounts receivable

1-2100

Provision for doubtful debts

1-3000

Inventory

1-4000

Prepaid expenses (eg prepaid rent)

1-4500

Income tax receivable

1-5000

Other current assets

1-6000

Land

1-7000

Buildings

1-7100

Accumulated depreciation

1-7200

Plant and equipment

1-7300

Accumulated depreciation

1-7400

Computer equipment

1-7500

Accumulated depreciation

1-7600

Furniture & fittings

1-7700

Accumulated depreciation

1-7800

Motor vehicles

1-7900

Accumulated depreciation

1-8000

Intangibles

1-8100

Accumulated amortisation

1-8200

Other non-current assets

1-8300

GST deferred

2-0000

Liabilities

2-1000

Bank overdraft

2-2000

Accounts payable

2-2100

Accrued expenses

2-2200

Customer deposits (lay-bys)

2-2300

Credit cards (eg Visa, Mastercard)

2-2400

Revenue received in advance (or unearned income)

2-2500

GST payable

2-2600

GST receivable

2-2700

PAYG withholding

2-2800

PAYG instalment

2-2900

FBT instalment payable

2-3000

ABN withholding payable

2-3100

Income tax payable

2-3200

Superannuation payable

2-3300

Provision for annual leave

2-3400

Provision for sick leave

2-3500

Provision for long service leave (current portion)

2-3600

Loans payable (current portion)

2-3700

Other current liabilities

2-4000

Lease liability

2-4100

Hire purchase liability

2-4200

Chattel mortgage liability

2-4300

Loans payable (non-current portion)

2-4400

Provision for long service leave (non-current portion)

2-4500

Other non-current liabilities

2-4600

GST deferred

3-0000

Shareholders’ equity

3-1000

Share capital

3-2000

Retained profits/(accumulated losses)

3-3000

Reserves (eg asset revaluation reserve)

4-0000

Revenues

4-1000

Sales

4-2000

Sales returns and allowances

4-3000

Services income

4-4000

Consulting fees

5-0000

Cost of goods sold (assuming periodic)

5-1000

Opening inventory

5-2000

Purchases

5-3000

Purchase returns and allowances

5-4000

Closing inventory

6-0000

Expenses

6-1000

Accounting fees

6-1100

Advertising and promotion

6-1200

Amortisation expense

6-1300

Annual leave expense

6-1400

ASIC lodgment fees

6-1500

Assets costing less than $20,000

6-1600

Bad debts expense

6-1700

Bank charges

6-1800

BAS rounding

6-1900

Bookkeeping fees

6-2000

Borrowing costs

6-2100

Car parking

6-2200

Cash over and short

6-2300

Chattel mortgage repayments

6-2400

Christmas party

6-2500

Cleaning

6-2600

Courier fees

6-2700

Computer accessories

6-2800

Depreciation expense

6-2900

Electricity

6-3000

Employee benefits (GST)

6-3100

Employee benefits (no GST)

6-3200

Entertainment – employees (deductible)

6-3300

Entertainment – employees (non-deductible)

6-3400

Entertainment – clients (non-deductible)

6-3500

Freight charges

6-3600

Fringe benefits tax paid

6-3700

General expenses

6-3800

Formation costs

6-3900

Hire purchase repayments

6-4000

Impairment loss

6-4100

Insurance

6-4200

Interest paid

6-4300

Internet fees

6-4400

Inventory writedown expense

6-4500

Land tax

6-4600

Late fees/fines and penalties

6-4700

Lease payments

6-4800

Legal expenses

6-4900

Licences

6-5000

Long service leave expense

6-5100

Loss on sale of non-current assets

6-5200

Merchant fees

6-5300

Motor vehicle expenses

6-5310

 – depreciation (deductible)

6-5320

 – depreciation    (non-deductible)

6-5330

 – fuel & oil

6-5340

 – insurance

6-5350

 – interest

6-5360

 – other

6-5370

 – registration

6-5380

 – repairs and maintenance

6-5400

Office supplies

6-5500

Payroll tax

6-5600

Postage, printing and stationery

6-5700

Registration fees

6-5800

Rates

6-5900

Rent

6-6000

Repairs and maintenance

6-6100

Salaries and wages

6-6200

Security expenses

6-6300

Sick leave expense

6-6400

Staff amenities (eg tea, coffee, biscuits)

6-6500

Staff training

6-6600

Subscriptions

6-6700

Sundry expenses

6-6800

Superannuation expense

6-6900

Taxi fares

6-7000

Telephone

6-7100

Travel & accommodation

6-7200

Uniforms

6-7300

Water charges

6-7400

Website costs

6-7500

Workers compensation

8-0000

Other income

8-1000

Dividends received

8-2000

Gain on sale of non-current assets

8-3000

Interest received

8-4000

Rent received

8-5000

Royalties received

8-6000

Bad debts recovered

8-7000

Grants received

8-8000

Donations received

9-0000

Other expenses

9-1000

Income tax expense

9-2000

Dividends paid

Notes: 1. The account numbers used in the chart of accounts have been spaced approximately 100 items apart to allow for inclusion of additional accounts. 2. The equity section of the chart of accounts is based on the fact that the legal structure of the entity is a company. The equity section of the chart of accounts (comprising chart of account numbers 3-0000 to 3-3000) would differ if the entity were a sole trader, partnership or trust (refer ¶1-310 to ¶1-340 of Chapter 1 for a discussion and illustration of the equity section of each business structure). 3. The cost of goods sold section of the chart of accounts is based on the company adopting a periodic inventory system, rather than a perpetual inventory system (refer to Chapter 5, commencing at ¶5000, for the difference between the two types of inventory systems). 4. Expenses are shown in alphabetical order. However, expenses are able to be grouped together according to their classification (eg administration expenses, operating expenses, selling expenses, etc). 5. The account “assets costing less than $20,000” is based on the simplified depreciation rules relating to small business entities (SBEs). These are defined as entities with an annual turnover of less than $2m per year. An SBE is entitled to an immediate 100% deduction for any depreciating asset costing less than $20,000 acquired from 7.30 pm on 12 May 2015 to 30 June 2017. 6. The GST tax codes have been excluded from the chart of accounts at this point. However, they will specifically be incorporated into the chart of accounts at ¶4-970 in Chapter 4.

3 ADJUSTING ENTRIES AND PREPARATION OF THE FINANCIAL STATEMENTS Measurement of profit

¶3-000

The purpose of adjusting entries

¶3-100

Completing the accounting cycle

¶3-200

Preparing adjusting entries

¶3-300

The adjusted trial balance

¶3-400

Closing entries

¶3-500

Adjusting entries — commonly asked questions ¶3-600

Measurement of Profit Introduction

¶3-000

Cash basis of accounting

¶3-010

Accrual basis of accounting

¶3-020

¶3-000 Introduction It will be remembered from Chapter 1 (¶1-510) that the profit and loss statement (or income statement) shows the profit or loss for the period. It is usually headed “for the period ended …”. The profit and loss statement includes: • revenues, and • expenses of an entity for the relevant period. The difference between revenues and expenses is referred to as the net profit/(loss). Some organisations, particularly non-profit organisations, refer to this amount as the net surplus/(deficit). Net profit/(loss) is defined as:

Net profit/(loss) = [Revenues − Expenses]

The measurement of profit depends on whether the business uses a cash basis of accounting (¶3-010) or an accrual basis of accounting (¶3-020). These two principles are discussed in the following.

¶3-010 Cash basis of accounting Under the cash basis of accounting, revenues are recorded in the period in which the cash is received, not the period in which the goods have been sold or services have been provided. Similarly, expenses are recorded in the period in which the cash is paid, not the period in which the expenses have been incurred. Under the cash basis of accounting, net profit of a business is determined as the difference between the

cash inflows from revenues and the cash outflows from expenses during the reporting period. Bookkeepers who enter transactions into the accounting system from deposit slips, cheque butts and bank statements are using the cash basis of accounting. This concept is illustrated in the two worked examples presented as follows. Worked Example 1 On 27 June 2017, Rugs’ R’ Us Pty Ltd sells a Persian rug to a customer for $1,200 on credit. The customer pays the account on 14 July 2017. Under the cash basis of accounting, revenue is recognised in the profit and loss statement on 14 July 2017, being the date on which the cash was received from the customer. The date the rug was sold to the customer is irrelevant under the cash basis of accounting.

Worked Example 2 On 21 June 2017, Rugs’ R’ Us Pty Ltd receives its telephone bill from Telstra for the month of June 2017 showing an amount payable of $186. The bill is paid on 16 July 2017. Under the cash basis of accounting, the expense is recorded in the profit and loss statement on 16 July 2017, being the date on which the telephone bill is paid. The date of the telephone bill is irrelevant under the cash basis of accounting.

¶3-020 Accrual basis of accounting For accounting purposes, transactions of a business are prepared under the accrual accounting concepts. Under the accrual basis of accounting, revenues are recorded in the period in which the business sells the goods or performs the services. This may or may not be the same as the accounting period in which the cash is received. In other words, under the accrual accounting concepts, revenue is recognised in the period in which the revenue has been derived, not when the cash has been received. Similarly, expenses are recognised in the period when the expenses have been incurred or consumed. This may or may not be the same accounting period in which the cash is paid. The effect of this is that under the accrual accounting concepts, revenues and expenses are effectively matched in the same accounting period. This is referred to as the “matching principle”. Once again, this concept is illustrated in the two worked examples presented as follows. Worked Example 3 Refer to the facts of Worked Example 1 in ¶3-010. Under the accrual accounting concepts, Rugs’ R’ Us Pty Ltd would record the sales revenue of $1,200 on 27 June 2017, being the date on which the rug was sold to the customer, not on 14 July 2017 when the cash was received. Accordingly, sales revenue of $1,200 would be recorded in the profit and loss statement for the year ended 30 June 2017.

Worked Example 4 Refer to the facts of Worked Example 2 in ¶3-010. Under the accrual accounting concepts, Rugs’ R’ Us Pty Ltd would record the telephone expense of $186 on 21 June 2017, being the date on which the telephone expense was incurred, not on 16 July 2017 when the telephone bill was paid. Accordingly, the telephone expense of $186 would be recorded in the profit and loss statement for the year ended 30 June 2017.

While the cash basis of accounting is typically used by micro-businesses who conduct most of their activities in cash, it is not suitable for many businesses who conduct their business activities using a combination of cash and credit. For this reason, for accounting purposes, most businesses use the accrual basis of accounting. It is argued that accrual accounting provides a more complete and comprehensive picture of the activities of a business during the reporting period than the cash basis of accounting. Under the cash basis of accounting, sale of goods on credit is not reflected in the financial statements

until the cash is received. Furthermore, under the cash basis, accounts receivable and accounts payable are not recorded, meaning that the entity is not able to track exactly how much money its debtors owe the business, nor how much money the business owes its creditors. Hence, when entering transactions into the accounting system, the bookkeeper should process transactions under the accrual accounting principles. Taxation consequences For taxation purposes, businesses are required to recognise revenues using the accrual basis of accounting (Henderson v FC of T 70 ATC 4016; (1970) 119 CLR 612). For some small businesses, this may result in considerable cash flow problems as they would be required to pay the income tax on the amounts invoiced prior to 30 June but were not collected until after this date.

¶3-100 The purpose of adjusting entries The primary objective of bookkeeping is to record transactions of a business that have occurred during the reporting period. As a result, there may be some transactions which affect the revenues and expenses of the business for which no cash has been received or paid by the end of the reporting period. Worked Examples 3 and 4 contained in ¶3-020 illustrate this point. As a result, the accounts of the entity may need to be adjusted on the last day of the reporting period (whether it be monthly, quarterly or yearly) to reflect certain non-cash transactions that may have occurred. These entries, referred to as “adjusting entries”, are required in order to: • recognise the revenues derived but not yet received at the end of the reporting period in the profit and loss statement • recognise the expenses incurred but not yet paid at the end of the reporting period in the profit and loss statement, and • recognise the assets (receivables) and liabilities (payables) in the balance sheet resulting from the abovementioned revenues and expenses. Adjusting entries are fundamental to the accrual basis of accounting and are typically entered into the accounting system by the accountant or bookkeeper on the last day of the entity’s reporting period. As part of the bookkeeping process, the bookkeeper is usually responsible for recording the adjusting entries at the end of the accounting period. However, in some cases the external accountant will put through the adjusting entries on the last day of the relevant period (eg depreciation). The bookkeeper should consult with the external accountant to clarify exactly who is responsible for processing the adjusting entries in the client’s books.

¶3-200 Completing the accounting cycle The accounting cycle was introduced in Chapter 2 (¶2-300). The accounting cycle is defined as the process or sequence of accounting procedures that takes place during the accounting period from the occurrence and recording of a business transaction to the preparation of financial statements. The preparation of adjusting entries is an important step in the accounting cycle. The accounting cycle represented in the following diagram is adapted from Diagram 2.2 in Chapter 2 (¶2-300) by adding Steps 6, 7 and 8 to the process. The revised accounting cycle is shown in the following diagram. Diagram 3.1: The revised accounting cycle

The penultimate step in the accounting cycle from Chapter 2 (commencing at ¶2-000) was the preparation of the trial balance. This trial balance is now referred to as the “unadjusted trial balance” (Step 5). On the last day of the reporting period, the bookkeeper (or the accountant) will make appropriate adjusting entries in the general journal (Step 6). These entries are subsequently posted to the general ledger (Step 7). At this point, an adjusted trial balance is prepared (Step 8). The adjusted trial balance is simply the unadjusted trial balance adjusted for the adjusting entries. The financial statements are subsequently prepared from the adjusted trial balance (Step 9).

Preparing Adjusting Entries Introduction

¶3-300

Prepaid expenses

¶3-310

Revenue received in advance

¶3-320

Accrued expenses

¶3-330

Accrued revenue

¶3-340

Depreciation

¶3-350

¶3-300 Introduction There are five types of adjusting entries that are considered in this chapter: • prepaid expenses (¶3-310) • revenue received in advance (or unearned revenue) (¶3-320) • accrued expenses (¶3-330) • accrued revenue (¶3-340), and • depreciation of non-current assets (¶3-350). The first four adjusting entries can be categorised as either: • accruals, or • deferrals. An accrual is the adjustment required when a transaction has occurred, but no cash has been received or paid. In the case of accrued revenue, revenue has been earned or derived before the end of the reporting period, although no cash has been received until after the end of the reporting period. Similarly, an accrued expense is an expense which has been incurred before the end of the reporting period, although the cash is not paid until the following reporting period. A deferral is the reverse situation in which the cash is received or paid upfront, although the revenue or expense to which the transaction relates refers to a future accounting period. Table 3.1 summarises the concept of accruals and deferrals. Table 3.1: Accruals and deferrals Adjusting entry

Asset

Liability

Accruals

Accrued revenue: revenue that has been earned or derived for which no cash has been received at the reporting date.

Accrued expenses: expenses that have been incurred which have not been paid at the reporting date.

Deferrals

Prepaid expenses: expenses which have been paid in advance by the entity, although the benefit relates to a future accounting period.

Revenue received in advance: cash has been received in advance by the entity for the goods or services that will be provided in a future accounting period.

¶3-310 Prepaid expenses Entities often prepay expenses (such as rent, insurance and interest) in advance. These expenses are referred to as prepaid expenses. In these instances, there is an initial outflow of cash; however, the period to which the expense relates falls into a future accounting period. Under the accrual accounting principles, an expense is recognised in the period during which it is used or consumed, not in the period in which the cash is paid. The remaining amount of the cost that is yet to be consumed is reported in the balance sheet as an asset called “prepaid expense”, since it represents a future economic benefit to be used in future periods. Take the following worked example. Worked Example 5

Lauren Hawkins runs her own dance studio called “Dance the Night Away”. She operates as a sole trader and conducts dance classes for beginners to advanced dancers. Lauren rents premises close to the heart of Melbourne city at a cost of $2,500 per month. On 1 June 2017, Lauren decides to prepay the rent for two months by paying her landlord a total of $5,000.

The journal entry to record the prepayment of two month’s rent of $5,000 that Lauren Hawkins made on 1 June 2017 is as follows: DATE

POST REF

PARTICULARS

June 1

Prepaid rent

DEBIT

1-4000

Cash at bank

CREDIT

5,000

1-1300

5,000

(Paid two months’ rent in advance totalling $5,000) The asset account “cash at bank” is credited for $5,000. Because the rent is paid in advance, the asset account “prepaid rent” is debited for the same amount. Prepaid rent is shown in the balance sheet as a current asset. The reason an asset is recorded is that by prepaying her rent, Lauren’s business is entitled to receive the benefit of two months’ rent from 1 June 2017 to 31 July 2017. Hence, it represents a future economic benefit to Lauren. After posting this entry to the general ledger, the current asset account “prepaid rent” is shown as follows: Prepaid Rent 1 June Cash at bank

1-4000

5,000

On 30 June 2017, the bookkeeper will need to process the following adjusting journal entry: DATE June 30

POST REF

PARTICULARS Rent expense

DEBIT

6-5900

Prepaid rent

CREDIT

2,500

1-4000

2,500

(Expiration of one month’s rent for June 2017) Analysis In the above journal entry, the rent expense for the month of June 2017 of $2,500 is debited to the “rent expense” account. This is in recognition that, by the end of June, the rent for that month has expired (or been used). The current asset account “prepaid rent” is credited for $2,500. The balance of the “prepaid rent” account in the balance sheet as at 30 June 2017 has been reduced to $2,500 (ie $5,000 − $2,500). This remaining balance as at 30 June 2017 effectively represents the rent for the month of July 2017. On 31 July 2017, the bookkeeper or accountant will put through a similar adjusting entry to the one described above. After posting this entry to the general ledger, the balance of the “prepaid rent” account as at 30 June 2017 is shown as follows: Prepaid rent 1 June

Cash at bank

5,000 30 June Rent expense 30 June Balance c/d

1-4000 2,500 2,500

5,000 30 June Balance b/d

5,000

2,500

The “rent expense” account as at 30 June 2017 is also shown as follows: Rent expense 30 June Prepaid rent

30 June Balance b/d

6-5900

2,500 30 June Balance c/d

2,500

2,500

2,500

2,500

Taxation consequences of prepayments From a taxation viewpoint, a deduction is only allowed for prepayments in limited circumstances. Sections 82KZL to 82KZO of the Income Tax Assessment Act 1936 (ITAA36) provide that if the amount prepaid is more than $1,000, then a business is generally only able to claim a pro rata tax deduction equivalent to the amount relating to that particular financial year. Hence, in the previous example, for taxation purposes, Lauren’s business would only be entitled to claim a deduction of $2,500 relating to the rent incurred for the month of June 2017, despite the fact that she paid $5,000 on 1 June 2017. The other $2,500 would be deductible in July 2017 (ie the 2018 financial year). However, in the case of small business entities, they are entitled to claim an upfront tax deduction for the amount of prepayment provided that the period covered by the prepayment: • did not exceed 12 months, and • ends in the next income year. Hence, in the above example, if Lauren’s business, Dance the Night Away, was an SBE and elected to take advantage of the prepayment concession, then it would be entitled to a tax deduction for the entire $5,000 prepaid rent on 1 June 2017, despite the fact that half of this amount relates to July 2017 (ie the next financial year, being 2018). If the amount of prepayment exceeds 12 months, then the expenditure must be apportioned over the period to which the expenditure relates, up to a maximum of 10 years (called the eligible service period).

¶3-320 Revenue received in advance Some entities receive monies from clients or customers in advance of performing the services. In this case, while the cash has been received from the customer, no service has been performed. No revenue should be recognised at this point as the entity has not provided any services to the customer. Instead, a liability account entitled “revenue received in advance” is created to reflect the future obligation of the entity to provide the services. This account is also referred to as “unearned income”. Take the following worked example. Worked Example 6 Assume that Lauren charges $100 for a one-hour individual dance lesson. Some customers elect to pay Lauren $500 in advance for five dance lessons. These dance lessons are provided once per fortnight. On 23 June 2017, Lauren receives $500 from one student for five dance lessons. The first dance lesson is to be conducted on 30 June 2017.

On 23 June 2017, the bookkeeper will record the following journal entry: DATE

PARTICULARS

POST REF

DEBIT

CREDIT

June 23

Cash at bank

1-1300

Revenue received in advance

500

2-2400

500

(Receiving $500 in advance from a customer for five dance lessons) Analysis As Lauren has received $500 cash on 23 June 2017, the account “cash at bank” is debited with this amount. However, at this point, Lauren has not provided any dance lessons to the student. Hence, the amount should not be credited to the “dance lessons revenue” account as, under the accrual accounting principles, no revenue has been derived by Lauren as no lessons have been provided yet. Instead, the bookkeeper must create a liability account entitled “revenue received in advance”, being the amount of dance lessons paid in advance. At this point in time, a liability is created because Lauren “owes” the student five dance lessons (worth $500). After posting this entry to the general ledger, the “revenue received in advance” account is shown as follows: Revenue received in advance 23 June

2-2400

Cash at bank

500

On 30 June 2017, one dance lesson (costing $100) has been provided to the student. On this date, the bookkeeper will need to process the following adjusting journal entry: PARTICULARS

POST REF

Revenue received in advance

2-2400

DATE June 30

Dance lessons revenue

DEBIT

CREDIT 100

4-3000

100

(To record dance lessons revenue for one lesson provided during the month of June 2017) In the above entry, “dance lessons revenue” of $100 has been credited because Lauren has provided the service and earned the revenue. The liability account “revenue received in advance” has been debited for $100 to reflect the fact that Lauren no longer owes the student that dance lesson. After each dance lesson, Lauren’s bookkeeper will transfer $100 from the liability account “revenue received in advance” to the revenue account “dance lessons revenue”. After the completion of the fifth dance lesson, the liability account will have been reduced to $nil and the revenue account will equal $500 (of which $100 was recognised in the 2017 financial year and $400 will be recognised in the 2018 financial year). After posting this entry to the general ledger, the balance of the “revenue received in advance” account as at 30 June 2017 is shown as follows: Revenue received in advance 30 June Dance lessons rev

100 23 June Cash at bank

30 June Balance c/d

400 500

2-2400 500

500 30 June Balance b/d

400

The “dance lessons revenue” account as at 30 June 2017 is also shown as follows:

Dance lessons revenue 30 June Balance c/d

4-3000

100 30 June Rev rcd in advance

100

100

100 30 June Balance b/d

100

Taxation consequences of revenue received in advance The taxation implications of unearned revenue (or revenue received in advance) were decided by the High Court of Australia in Arthur Murray (NSW) Pty Ltd v FC of T (1965) 114 CLR 314. The High Court disagreed with the Commissioner and held that the payments received upfront were not income even though the monies had been received by the taxpayer. Instead, the receipts were assessable in the income year in which the dance lessons were provided. Hence, the accrual basis of accounting was appropriate. According to Barwick CJ: “In our opinion, it would be out of accord with the realities of the situation to hold, that the amount received has the quality of income derived by the company. This conclusion accords with established accountancy and commercial principles. We have not been able to see any reason which should lead the court to differ from accountants and commercial men on this point.” However, this special treatment is only granted where: • the taxpayer’s accounts are prepared on an accrual basis and the amounts received in advance are credited to the liability account “revenue received in advance”, and • there is a possibility of refunds being provided to customers. In other words, if the upfront receipt is non-refundable, the entire amount will be regarded as assessable income in the year that the cash is received (Taxation Ruling TR 95/7). In Lauren’s case, for taxation purposes, only $100 would be assessable in respect of the 2017 income year, provided that the refunds were available. However, if refunds are not provided, the entire $500 received on 23 June 2017 would be assessable to Lauren’s business for taxation purposes in the 2017 income year.

¶3-330 Accrued expenses Businesses often incur expenses before they are actually paid in cash. At the end of the accounting period, there may be some expenses which the business has incurred during the period that are yet to be paid. These are referred to as “accrued expenses”. Under the accrual accounting principles, expenses are recognised in the period in which they are incurred (or consumed), rather than in the period in which the payment is made. A liability is also recorded recognising that an amount remains owing by the entity to a third party at the end of the accounting period. Take the following worked example. Worked Example 7 Assume that on 28 June 2017, Lauren receives her telephone bill from Telstra for the month of June 2017 showing an amount payable of $300 by no later than 24 July 2017. She subsequently pays this bill on 22 July 2017.

On 30 June 2017, the bookkeeper will need to process the following adjusting journal entry: DATE June 30

PARTICULARS Telephone expense

POST REF 6-7000

DEBIT

CREDIT 300

Telephone account payable

2-2000

300

(To record the telephone bill for the month of June 2017) The “telephone expense” account is debited for $300, while a liability account entitled “telephone account payable” is credited for the same amount. It is also acceptable for the bookkeeper to credit “accounts payable” instead of “telephone account payable”. After posting this entry to the general ledger, the “telephone expense” and “telephone account payable” accounts are shown as follows: Telephone expense 30 June

Telephone account payable

6-7000

300

Telephone account payable

2-2000

30 June Telephone expense

300

On 22 July 2017, when the telephone bill is paid, the bookkeeper will process the following journal entry: DATE July 22

PARTICULARS Telephone account payable Cash at bank

POST REF 2-2000

DEBIT

CREDIT 300

1-1300

300

(Payment of telephone account for the month of June 2017) As a result of this payment, on 22 July 2017, “telephone account payable” will be reduced to $nil. Taxation consequences of accrued expenses The taxation implications of accrued expenses to a business fall within the general deduction provisions contained in s 8-1 of the Income Tax Assessment Act 1997 (ITAA97). Section 8-1(1) states that a taxpayer can claim a deduction for any loss or outgoing to the extent that it is necessarily incurred in carrying on a business for the purposes of gaining or producing assessable income. The word “incurred” is not defined in either ITAA36 or ITAA97. However, over the years, the courts have held that “incurred” is not synonymous with “paid”. The Commissioner of Taxation has issued Taxation Ruling TR 97/7 setting out his views on the word “incurred” for the purposes of s 8-1 of ITAA97. The Commissioner confirms that a taxpayer need not actually have paid money to have incurred an outgoing, provided that the taxpayer is “definitively committed” to making the payment. Paragraph 6(a) of TR 97/7 states: “A loss or outgoing may be incurred within Section 8-1 even though it remains unpaid, provided the taxpayer is ‘completely subjected’ to the loss or outgoing.” Hence, provided that the tax invoice is dated on or before 30 June, it will be regarded as incurred even though it is not paid until the following income year. As a result, Lauren’s business would be entitled to claim a deduction for the $300 telephone bill in the 2017 income year, as she is definitively committed to making the payment, despite the fact that it remains unpaid at 30 June 2017.

¶3-340 Accrued revenue In the same way that businesses incur expenses before the payment is made, an entity may earn or derive revenue before the cash is received.

Under the accrual accounting principles, revenues are recognised in the period in which they are earned, rather than in the period in which the cash is received. A receivable is also recorded, recognising that an amount remains owing to the entity by a customer at the end of the accounting period. Take the following worked example. Worked Example 8 Assume that on 30 June 2017, Lauren invoices customers $1,400 for the dance lessons provided during the last two weeks of June 2017. Payment is received from these customers on 17 July 2017.

On 30 June 2017, the bookkeeper will need to process the following adjusting journal entry: DATE June 30

PARTICULARS Accounts receivable Dance lessons revenue

POST REF

DEBIT

1-2000

CREDIT

1,400

4-3000

1,400

(To record accounts receivable at 30 June 2017) Revenue is credited because it has been earned during the month of June 2017, while the asset account “accounts receivable” is debited. After posting this entry to the general ledger, the “accounts receivable” account is shown as follows: Accounts receivable

1-2000

30 June Dance lessons revenue

1,400

Assume that on 17 July 2017, Lauren receives the payment from these customers. On this date, her bookkeeper will process the following journal entry: DATE July 17

PARTICULARS Cash at bank Accounts receivable

POST REF 1-1300

DEBIT

CREDIT

1,400

1-2000

1,400

(Collection of accounts receivable) As a result of the payment on 17 July 2017, the “accounts receivable” account will be reduced to $nil. Taxation consequences of accrued income The taxation implications of accrued income fall within the provisions of s 6-5 of ITAA97. Section 6-5 states that a resident taxpayer is required to include in their assessable income, all income derived from all sources whether in or out of Australia during the income year. The word “derived” is not defined in either ITAA36 or ITAA97. However, over the years, the courts have clarified exactly when income is assessable for income tax purposes. The message to come out of the courts is that the correct basis of accounting (ie cash or accrual) is dependent upon the type of income derived, not the type of taxpayer. Table 3.2 summarises the various categories of income for tax law purposes and whether the income is assessable under the cash basis of accounting or accrual basis of accounting. Table 3.2: Summary of rules relating to derivation of income Type of income

Cash or accrual basis

Income from personal exertion

When received

Trading (business) income

Accruals

Revenue received in advance

Accruals (if refunds are provided) Cash (if no refunds are provided)

Interest income

When received or credited to the bank account

Dividend income

When received or credited to the shareholder’s bank account

Rental income

When received

The important point to note is that the above tax rules apply to the type of income derived by the taxpayer, not the type of taxpayer. In other words, the fact that a taxpayer derives trading income does not mean that all of their income is to be treated on an accrual basis. So, for example, a shoe store would account for its trading income on an accrual basis. However, if it earned residual interest income or dividend income, these would be regarded as income in the period when the cash was received (ie the cash basis). Referring back to our worked example, we are told that on 30 June 2017, Lauren invoiced customers $1,400. These customers paid the amount owing on 17 July 2017. As this income can be classified as business (or trading) income, it is assessable for income tax purposes under the accrual accounting principles. Accordingly, Lauren’s business is taken to have “derived” $1,400 in the 2017 income year. Table 3.3 summarises the two types of adjustments that may be required for deferrals (ie prepaid expenses and revenue received in advance) at the end of the accounting period. Table 3.3 summarises the original journal entry required as well as the adjusting entry required on the last day of the reporting period. Table 3.3: Summary of adjusting entries — deferrals Adjustment

Original entry required Dr Prepaid expense

Prepaid expenses

Cr

Cash at bank

Dr Cash at bank Revenue received in advance

Cr

xxx

Adjusting entry required Dr Expense xxx Cr

xxx

Revenue received in advance

xxx

Prepaid expense

xxx

Dr Revenue received in xxx advance xxx Cr

Revenue

xxx

Furthermore, Table 3.4 summarises the two types of adjustments that may be required for accruals (ie accrued revenue and accrued expenses) at the end of the accounting period. Table 3.4 summarises the adjusting journal entry required on the last day of the reporting period as well as the subsequent journal entry required in the following period. Table 3.4: Summary of adjusting entries — accruals Adjustment Accrued expenses

Accrued revenue

¶3-350 Depreciation

Adjusting entry required Dr Expense Cr

Accounts payable

Dr Accounts receivable Cr

xxx

Revenue

Subsequent entry required Dr Accounts payable xxx Cr

xxx

Cash at bank

Dr Cash at bank xxx Cr

xxx xxx xxx

Accounts receivable

xxx

The concept of depreciation is often widely misunderstood. Depreciation only applies to tangible noncurrent assets. It will be remembered from Chapter 1 (¶1-530) that a non-current asset is an asset that is not expected to be converted into cash within the next 12 months. Examples of non-current assets include land and buildings, plant and equipment, and furniture and fittings. All physical or tangible non-current assets (with the exception of land, which is considered to have an indefinite useful life) are assumed to have limited useful lives, and are therefore subject to depreciation. Accounting for depreciation represents the process whereby the decline in future economic benefits of an asset through usage, wear and tear and obsolescence is progressively recognised over the life of the asset as an expense in the profit and loss statement. According to para 6 of AASB 116 Property, Plant and Equipment, depreciation is defined as the systematic allocation of the cost of an asset over its estimated useful life. Depreciation recognises the fact that assets contribute to the generation of revenues of an entity over a number of years, not just in the year in which they are acquired. As such, the cost of the asset must be “spread” over a number of accounting periods. This is the process of depreciation. The depreciation formula can be expressed as follows:

Depreciation expense

=

[Cost − Estimated residual value] Estimated useful life

The cost of the asset is the price for which the asset was initially acquired. The residual value is the estimated proceeds expected to be recovered from the sale or disposal of the asset at the end of its useful life. The useful life of an asset is the estimated period of time over which the asset is expected to be consumed by the entity. The useful life is expressed on a time basis (usually in years). Take the following worked example. Worked Example 9 Assume that on 1 June 2017, Lauren purchased a new desktop computer for her dance studio at a cost of $2,400. The desktop computer is expected to have an estimated useful life of four years with an estimated residual value of $nil.

The annual depreciation charge for the computer is calculated as follows:

[$2,400 − $nil] = $600 per annum  4 years    

Based on this formula, it is estimated that the computer will wear (or depreciate) by $600 per annum. This $600 is transferred from the asset account to an expense account, entitled “depreciation expense”. Depreciation expense (which is a non-cash expense) is recognised as an expense in the profit and loss statement of the entity. However, instead of reducing the cost of the asset in the balance sheet by $600 each year, a separate account entitled “accumulated depreciation” is created. Accumulated depreciation is shown as a reduction from the original cost of the asset in the balance sheet and is referred to as a “contra asset” account. By crediting the account “accumulated depreciation”, users of financial statements can still see the original cost of the asset and gauge how old the asset is (by looking at the amount of accumulated depreciation). The higher the amount of accumulated depreciation, the older the asset is. As the name suggests, accumulated depreciation represents the cumulative balance of the depreciation expense.

Referring back to the example of Lauren Hawkins, the annual depreciation expense for the computer was determined to be $600. However, the computer was acquired on 1 June 2017. On 30 June 2017, only one month’s depreciation should be recognised. The monthly depreciation charge is therefore calculated as $50 (or $600/12 months). The adjusting journal entry to record depreciation for the month of June 2017 is as follows: DATE June 30

POST REF

PARTICULARS Depreciation expense — computer

DEBIT

6-2800

Accumulated depreciation — computer

CREDIT 50

1-7500

50

(Recording depreciation on the desktop computer for the month of June 2017) After posting this entry to the general ledger, the “depreciation expense” account as at 30 June 2017 is also shown as follows: Depreciation expense 30 June Accum dep’n

30 June Balance b/d

6-2800

50 30 June Balance c/d

50

50

50

50

The balance of the “accumulated depreciation — computer” account as at 30 June 2017 is shown as follows: Accumulated depreciation — computer 30 June Balance c/d

1-7500

50 30 June Dep’n expense

50

50

50 30 June Balance b/d

50

The depreciation expense of $50 is recorded as an expense in the 30 June 2017 profit and loss statement. The non-current asset section of the balance sheet of Dance the Night Away as at 30 June 2017 appears as follows: Dance the Night Away Balance Sheet as at 30 June 2017 Non-Current Assets Desktop computer, at cost Less: Accumulated depreciation

$ 2,400 (50) $2,350

The $2,350 is referred to as the: • carrying amount • written down value, or • book value.

For the 2018 financial year, Lauren would record depreciation of $600 in respect of the computer. The journal entry that the bookkeeper would put through to record depreciation for the entire 2018 financial year is as follows: DATE June 30

POST REF

PARTICULARS Depreciation expense — computer

DEBIT

6-2800

Accumulated depreciation — computer

CREDIT 600

1-7500

600

(Recording depreciation on the desktop computer for the 2018 financial year) The balance sheet of Dance the Night Away as at 30 June 2018 appears as follows: Dance the Night Away Balance sheet as at 30 June 2018 Non-Current Assets

$

Desktop computer, at cost

2,400

Less: Accumulated depreciation

(650) $1,750

The accumulated depreciation amount of $650 shown previously comprises the depreciation expense for 2017 (of $50) plus the depreciation expense for 2018 (of $600). As can be seen, the carrying amount (or written down value or book value) of the computer as at 30 June 2018 is now $1,750. By 1 June 2021 (ie exactly four years after the purchase of the desktop computer), the carrying amount of the asset will be $nil and this equates to the estimated residual value of the desktop computer at this date. Taxation consequences of depreciation For taxation purposes, Div 40 of ITAA97 allows a taxpayer a deduction for the “decline in value” of a depreciating asset that is owned and used by the taxpayer in the course of gaining or producing assessable income. For taxation purposes, depreciation is calculated based on the asset’s effective life (expressed in years). While a taxpayer is able to self-assess the effective life of a depreciating asset, to assist taxpayers, in January 2001, the Commissioner published his own determination of effective lives of depreciating assets. This listing is included in a taxation ruling which is updated and re-issued every year. The latest version, Taxation Ruling TR 2016/1, was issued by the Commissioner on 29 June 2016 and applies in respect of income years beginning on or after 1 July 2016. This 258-page ruling can be accessed at the ATO’s website at tinyurl.com/zkaqh2e. In most cases, a taxpayer will usually adopt the useful life for accounting purposes as the effective life for taxation purposes. Referring back to the example of Lauren Hawkins’ dance studio, the useful life of a desktop computer for accounting purposes was assessed to be four years. According to TR 2016/1, the Commissioner considers the effective life of a desktop computer to also be four years. This results in the same depreciation claim for both accounting and taxation purposes. Accounting for depreciation is explained in more detail in Chapter 7 (commencing at ¶7-000). The following is a summary of all the adjusting entries to be recorded as at 30 June 2017 relating to Dance the Night Away.

REF (a)

PARTICULARS Rent expense

POST REF 6-5900

Prepaid rent

DEBIT

CREDIT

2,500

1-4000

2,500

(Expiration of one month’s rent for June 2017) (b)

Revenue received in advance Dance lessons revenue

2-2400

100

4-3000

100

(To record dance lessons revenue for one lesson provided during the month of June 2017) (c)

Telephone expense

6-7000

Telephone account payable

300

2-2000

300

(To record the telephone expense for the month of June 2017) (d)

Accounts receivable Dance lessons revenue

1-2000

1,400

4-3000

1,400

(To record accounts receivable at 30 June 2017) (e)

Depreciation expense — computer Accumulated depreciation — computer

6-2800

50

1-7500

50

(Recording depreciation on the desktop computer for the month of June 2017)

The Adjusted Trial Balance Introduction

¶3-400

Worked example

¶3-410

¶3-400 Introduction Once these adjusting entries have been posted to the ledger (Step 7), the final step in the accounting cycle (¶3-200) is to prepare an adjusted trial balance. The purpose of preparing an adjusted trial balance is to ensure the equality of debits and credits in the accounts after the adjusting entries have been processed. The adjusted trial balance is usually prepared in a worksheet. A worksheet is essentially a spreadsheet, either prepared manually or electronically, which summarises all the transactions of a business for the relevant accounting period in one place. The worksheet also facilitates the preparation of financial statements. The worksheet has three columns: • unadjusted trial balance • adjustments, and • adjusted trial balance. The table in ¶3-410 shows the worksheet of Dance the Night Away for the year ended 30 June 2017.

To determine the figures in the adjusted trial balance, the amounts from the other two columns are added together. All accounts with debit balances are added together, as are the accounts with credit balances. Where an account has a debit balance and an adjustment in the credit column is made, the amount in the credit column is deducted. Likewise, where an account has a credit balance and an adjustment is made in the debit column, the amount in the debit column is subtracted. Some worksheets also contain two final columns, namely: • the profit and loss statement, and • the balance sheet. The worksheet can be an important tool in the preparation of financial statements and is commonly used by both accountants and bookkeepers. The worksheet of Dance the Night Away for the year ended 30 June 2017 is shown in ¶3-410.

¶3-410 Worked example Dance the Night Away Worksheet for the year ended 30 June 2017 Account Title

Unadjusted Trial Balance Debit

Cash at bank

Credit

Adjustments Debit

Credit

25,550

Accounts receivable

2,150

Prepaid rent

5,000

Desktop computer, at cost

2,400

Debit

(d) 1,400

3,550 (a) 2,500

2,500 2,400

(e) 50

Accounts payable

50

1,720

Revenue received in advance

500

1,720 (b) 100

Telephone account payable

400 (c) 300

Lauren Hawkins, capital

300

25,000

25,000

8,400

Dance lessons revenue

8,400 77,500

(b) 100

79,000

(d) 1,400 Accounting fees

1,750

1,750

Bank charges

860

860

Cleaning

670

670

Depreciation expense

Credit

25,550

Accumulated depreciation — computer

Lauren Hawkins, drawings

Adjusted Trial Balance

(e) 50

50

Electricity expense

2,150

2,150

Insurance

2,680

2,680

Postage, printing & stationery

1,470

1,470

Rent expense

27,500

Salaries and wages

20,000

20,000

Superannuation expense

1,800

1,800

Telephone expense

2,340

Totals

$104,720

(a) 2,500

$104,720

30,000

(c) 300

2,640

$4,350

$4,350 $106,470

$106,470

From the adjusted trial balance, the financial statements (excluding the cash flow statement) can be prepared for Dance the Night Away for the year ended 30 June 2017. These financial statements are shown on the following pages.

Dance the Night Away Profit and Loss Statement for the year ended 30 June 2017 $ Revenue

Dance lessons revenue

79,000

Total Revenue

79,000

Less: Expenses

Accounting fees

1,750

Bank charges

860

Cleaning

670

Depreciation expense

50

Electricity expense

2,150

Insurance expense

2,680

Rent expense

30,000

Salaries and wages

20,000

Postage, printing & stationery

1,470

Superannuation expense

1,800

Telephone expense

2,640

Total Expenses

64,070

Net profit $ 14,930

Dance the Night Away Statement of Changes in Equity for the year ended 30 June 2017 $ Lauren Hawkins, opening capital as at 1 July 2016 (assumed)

25,000

Add: Net profit for the year ended 30 June 2017 (from profit and loss statement)

14,930 39,930

Less: Owner’s drawings

(8,400)

Lauren Hawkins, closing capital as at 30 June 2017

$ 31,530

Dance the Night Away Balance Sheet as at 30 June 2017 $ Current Assets

Cash at bank

25,550

Accounts receivable

3,550

Prepaid rent

2,500

Total Current Assets

31,600

Non-Current Assets Desktop computer, at cost Less: Accumulated depreciation

Total Non-Current Assets

2,400 (50)

2,350

Total Assets

33,950

Current Liabilities Accounts payable

1,720

Revenue received in advance

400

Telephone account payable

300

Total Current Liabilities

2,420

Net Assets

$ 31,530

Owner’s Equity

Lauren Hawkins, capital (from above)

31,530

Owner’s Equity

$ 31,530

Closing Entries Introduction

¶3-500

Closing revenue accounts

¶3-510

Closing expense accounts

¶3-520

Closing net profit/(loss)

¶3-530

Closing owner’s drawings

¶3-540

¶3-500 Introduction The profit and loss statement shows revenues and expenses of an entity during the reporting period. The period assumption states that the entity reports its results for equal periods, whether monthly, quarterly or yearly. In Australia, the financial year normally commences on 1 July and concludes on 30 June. This is the same for taxation purposes. However, whereas accountants refer to this period as the “financial year”, ITAA97 refers to this as the “income year”. Unlike the balance sheet, which shows the assets, liabilities and equity of an entity as at a certain date, the profit and loss statement is prepared “for the period ending”. On the last day of the financial year, all revenue and expense accounts must be closed (or cleared), so that on 1 July, the balances shown in all revenue and expense accounts are restated to zero. For this reason, revenue and expense accounts are referred to as temporary, or nominal accounts. On the other hand, asset, liability and equity account balances (with the exception of the drawings

account) are never closed. Their balances continue into the new financial year. As such, these accounts are referred to as permanent or real accounts and are not considered part of the closing process. Processing the closing entries is the final step in the accounting cycle and is usually done after the adjusted trial balance is prepared. The complete accounting cycle is shown in the following diagram: Diagram 3.2: The complete accounting cycle

As mentioned previously, closing entries are processed on the last day of the reporting period. The closing process involves four steps: (1) close revenue accounts (¶3-510) (2) close expense accounts (¶3-520) (3) close net profit/(loss) (¶3-530) (4) close drawings (¶3-540). Each of these closing entries is discussed in turn.

¶3-510 Closing revenue accounts

The first step in the closing process is to close each revenue account. Revenue accounts are credit in nature. In order to close (or clear) the balance of each revenue account to zero, a journal entry is required which results in a debit to revenue. The corresponding credit is taken to a temporary account entitled “profit and loss summary”. From our example, Lauren Hawkins derived dance lessons revenue of $79,000 for the year ended 30 June 2017. The closing entry is: DATE

PARTICULARS

POST REF

June 30

Dance lessons revenue

4-3000

Profit and loss summary

DEBIT

CREDIT

79,000

9-3000

79,000

(Closing the revenue account for the year ended 30 June 2017) This journal entry zeros off the revenue account and temporarily transfers the total of $79,000 to the temporary “profit and loss summary” account.

¶3-520 Closing expense accounts The second step in the closing process is to close each expense account. Expense accounts are debit in nature. In order to close (or clear) the balance of each expense account to zero, a journal entry is required which results in a credit to each expense. The corresponding debit is taken to the “profit and loss summary”. From our previous example, Lauren Hawkins incurred several expenses during the year ended 30 June 2017. The closing entry is: DATE June 30

PARTICULARS

POST REF

DEBIT

CREDIT

Profit and loss summary

9-3000

64,070

Accounting fees

6-1000

1,750

Bank charges

6-1700

860

Cleaning

6-2500

670

Depreciation expense

6-2800

50

Electricity expense

6-2900

2,150

Insurance expense

6-4100

2,680

Postage, printing & stationery

6-5600

1,470

Rent expense

6-5900

30,000

Salaries and wages

6-6100

20,000

Superannuation expense

6-6800

1,800

Telephone expense

6-7000

2,640

(Closing expense accounts for the year ended 30 June 2017) This journal entry zeros off each expense account and temporarily transfers the total of $64,070 to the “profit and loss summary” account.

¶3-530 Closing net profit/(loss) At this point, the balance of the “profit and loss summary” account is a credit of $14,930. This is also the amount of net profit of the entity for the year ended 30 June 2017. The third step in the closing process is to close this profit. It will be remembered from Chapter 1 (¶1-510) that the net profit has the effect of increasing equity. Hence, the net profit of $14,930 is transferred to the “Lauren Hawkins’s capital” account. The closing entry is: DATE

PARTICULARS

POST REF

June 30

Profit and loss summary

9-3000

Lauren Hawkins, capital

3-1000

DEBIT

CREDIT

14,930 14,930

(Closing the profit and loss summary account by transferring the net profit of $14,930 for the year ended 30 June 2017 to Lauren Hawkins’ capital account) This journal entry zeros off the “profit and loss summary” account and transfers the net profit of $14,930 to the “Lauren Hawkins’ capital” account.

¶3-540 Closing owner’s drawings The final step in the closing process is to close the owner’s drawings account to the owner’s capital account. Drawings have the effect of decreasing equity. The closing entry is: DATE

PARTICULARS

POST REF

June 30

Lauren Hawkins, capital

3-1000

Lauren Hawkins, drawings

3-2000

DEBIT

CREDIT

8,400 8,400

(Transferring owner’s drawings of $8,400 for the year ended 30 June 2017 to Lauren Hawkins’ capital account) This entry has the effect of transferring the owner’s drawings of $8,400 to the capital account. After these closing entries have been processed, all revenue and expense items will have reverted back to zero for the start of the new financial year. The net profit for the financial year has been transferred to the owner’s capital account. Drawings for the year have also been transferred to the capital account. At the conclusion of the closing process, the “Lauren Hawkins’ capital” account will be shown as $31,530 in the balance sheet. It should be noted that most computerised accounting software packages contain a “rollover” function which the bookkeeper can activate. It automatically processes these closing entries and rolls over the entity’s data file for the start of a new financial year. This alleviates the need for the bookkeeper to manually process the closing entries.

¶3-600 Adjusting entries — commonly asked questions Question What is the difference between the cash basis and accrual basis of accounting? As a bookkeeper, which method should I adopt in preparing management accounts for my client?

Answer Under the cash basis of accounting, revenues are recorded in the period in which the cash is received, not in the period in which the goods have been sold or services have been provided. Similarly, expenses are recorded in the period in which the cash is paid, not in the period in which the expenses have been incurred.

Under the accrual basis of accounting, revenue is recognised in the period in which the revenue has been derived, not when the cash has been received. Similarly, expenses are recognised in the period in which they have been incurred.

When entering transactions into the accounting system, the bookkeeper should process transactions under the accrual accounting principles.

Despite the fact that some small business entities are entitled to use a “cash accounting method” for income tax purposes, management accounts and external financial statements should be prepared under the accrual accounting principles. What are adjusting entries? Who is responsible to record adjusting entries at the end of the accounting period in the client’s books?

Under the accrual accounting principles, all transactions that have occurred during the reporting period must be recorded in the client’s accounts.

However, there may be some transactions which affect the revenues and expenses of the business for which no cash has been received or paid by the end of the reporting period.

As a result, the accounts of the business may need to be adjusted on the last day of the reporting period to reflect certain non-cash transactions.

These entries, referred to as “adjusting entries”, are required in order to recognise revenues,

expenses, receivables and payables in the correct accounting period. This ensures that the net profit/(loss) for the period is correctly stated. There are five main adjusting entries: •

prepaid expenses

•

revenue received in advance

•

accrued expenses

•

accrued revenue

•

depreciation of non-current assets.

As part of the bookkeeping process, the bookkeeper is usually responsible for recording the adjusting entries at the end of the accounting period.

However, in some cases, the external accountant will put through the adjusting entries on the last day of the relevant period (eg depreciation). The bookkeeper should consult with the external accountant to clarify who is responsible for processing the adjusting entries in the client’s books. Adjusting entries are classified as either “accruals” or “deferrals”. What do these two terms mean?

An accrual is an adjustment required when a transaction has occurred, but no cash has been received or paid. In the case of accrued revenue, the revenue has been earned or derived before the end of the reporting period, but no cash has been received until after the end of the reporting period.

Similarly, in the case of expenses, an accrued expense is an expense which has been incurred before the end of the reporting period, but the cash is not paid until the following reporting period. Accruals include accrued revenue (assets) and accrued expenses (liabilities).

A deferral is the reverse situation in which the cash is received or paid upfront, but the revenue or expense to which the transaction relates refers to a future accounting period. Deferrals include prepaid expenses (assets) and revenue received in advance (liabilities). What is the purpose of closing entries?

The profit and loss statement shows an entity’s revenues and expenses for the accounting period. In the case of a financial year, it will show all revenues and expenses for a 12-month period. On 1 July (being the beginning of the new financial

year), revenues and expenses must revert back to $nil.

Hence, on the last day of the financial year, all revenue and expense accounts must be closed (or cleared). For this reason, accounts that appear in the profit and loss statement are referred to as “temporary” or “nominal” accounts.

On the other hand, asset, liability and equity account balances are never closed. Their balances continue into the new financial year. As such, these accounts are referred to as “permanent” or “real” accounts.

In order to clear all revenue and expense accounts to zero, the bookkeeper must process the closing entries on the last day of the financial year. Temporary accounts, consisting of revenues, expenses and net profit/(loss), are closed to a profit and loss summary account. Drawings is closed to the owner’s capital account.

There are four steps involved in the closing process: (1) close revenue accounts (2) close expense accounts (3) close net profit/(loss) (4) close drawings. The closing process has the effect of resetting each of the abovementioned accounts to zero, so that the new financial year begins with $nil balances for each of these accounts.

However, most computerised accounting software packages contain a “rollover” function which the bookkeeper can activate. It automatically processes these closing entries and rolls over the entity’s data file for the start of a new financial year.

This alleviates the need for the bookkeeper to

manually process the closing entries.

4 ACCOUNTING FOR GST Overview of the GST

¶4-000

Charging GST

¶4-100

Accounting for the GST charged

¶4-110

Paying the GST

¶4-120

Accounting for the GST paid

¶4-130

GST registration

¶4-200

Tax invoices

¶4-300

Tax periods

¶4-400

Net amount

¶4-500

Cash vs accrual basis of accounting for GST

¶4-600

Comprehensive worked example on accounting for GST ¶4-700 Completing the accounting cycle

¶4-800

Completing the business activity statement

¶4-900

Accounting for GST — commonly asked questions

¶4-950

Sample Statement by a Supplier form

¶4-955

Sample business activity statement (BAS)

¶4-960

GST calculation worksheet

¶4-965

Sample chart of accounts (for a company)

¶4-970

¶4-000 Overview of the GST Up until this point, we have not discussed the impact of the goods and service tax (GST) on accounting transactions. GST and its implications will be specifically dealt with in this chapter. It is important that the bookkeeper understands the basic principles of the GST as it is typically the bookkeeper who is responsible for entering information into the accounting system. Entering the correct GST tax codes in the chart of accounts is also very important, as financial statements generated both manually and via computerised accounting systems are based on these codes. Despite the fact that most computerised accounting packages automatically generate GST reports which detail the amounts of GST collected and paid by an entity for any given month, it is important that the bookkeeper understands how GST operates, the types of transactions which are subject to GST and the documentation associated with the GST. The GST commenced in Australia on 1 July 2000 replacing the wholesale sales tax and some state indirect taxes. The principal Act governing the operation of GST is the A New Tax System (Goods and Services Tax) Act 1999 as amended (hereafter referred to as the “GST Act”). In addition to the GST Act, the Deputy Commissioner of Taxation has issued a number of GST Rulings and GST Determinations outlining the Australian Taxation Office (ATO)’s interpretation of the legislation. According to the most recently published ATO Annual Report, in 2016, the GST raised $57.5b for the federal government (representing 16.8% of total net tax collections of $342b). The main collections come from the wholesale sector and the property, personal and other services sector. The major principles of GST are:

• the GST is a flat 10% broad-based indirect tax on private consumption of most goods and services in Australia and importations into Australia • the price of all goods and services are required to be shown inclusive of GST. In order to calculate the amount of GST included in the price of goods or services, you simply divide by 11 • the tax is charged and collected by registered entities at each stage in the production chain • the supplier is required to provide the customer/client with a “tax invoice” • at the same time, the supplier of goods or services is entitled to claim a credit for any GST paid. This credit is known as an “input tax credit” • the “net amount” of GST (ie GST collected minus GST paid) is remitted by the registered entity to the ATO each month or quarter on a form called the “Business Activity Statement” (BAS), and • the tax is ultimately borne by the end consumer, not by producers or suppliers.

¶4-100 Charging GST The following diagram illustrates how GST operates from the perspective of an entity charging the GST: Diagram 4.1: How GST works

Diagram 4.1 illustrates that while the GST is a tax charged by each registered business, the subsequent business can claim a credit for the tax it has paid. As the final customer cannot claim any credit, this means that the tax itself is ultimately borne by the consumer. This is why the GST is also referred to as the “consumption tax”. Only registered entities are able to charge GST and are entitled to claim an input tax credit in respect of the GST paid. Therefore, businesses that choose not to register for GST (discussed in ¶4-200) are treated as end consumers and bear the additional cost of the GST on acquisitions in the same manner as private consumers (as shown previously). It is also important to note that the supplier of goods or services is liable for their portion of the tax and is required to remit the net tax payable to the ATO on a monthly or quarterly basis. For this reason, GST is regarded as an indirect tax, because it is the registered supplier of goods or services that pays the tax to the ATO, not the end consumer.

Worked Example 1 Robert is an accountant who is registered for GST. On 14 May 2017, Robert completes the annual financial statements and income tax return for Olivia. Olivia has her own business trading as a florist. She is also registered for GST. The value of the work performed by Robert is $3,000. As Robert is registered for GST, he is required to add 10% GST to his invoice. Hence, Robert provides Olivia with a tax invoice for $3,300. Robert has derived revenue of $3,000. The additional $300 represents the GST, which Robert will be required to collect from Olivia and remit to the ATO. Robert remits this $300 on his next BAS.

GST is payable on taxable supplies and taxable importations According to s 7-1(1) of the GST Act, GST is payable on “taxable supplies” and “taxable importations”. Section 9-10 of the GST Act defines a taxable supply as: • the supply of goods • the supply of services • the provision of advice or information • a grant, assignment or surrender of real property • a creation, grant, transfer, assignment or surrender of any right • a financial supply, and • an entry into or release from an obligation to do anything, to refrain from an act, or to tolerate an act or situation. As a general rule, the act of providing something by one entity to another entity is a supply for GST purposes. As well as taxable supplies, GST is also payable on goods imported into Australia (s 7-1, GST Act). These are termed “taxable importations”. However, in this case, the liability to pay the GST falls on the importer (s 13-15, GST Act) and not the overseas supplier. GST is payable at the time of the importation of the goods, regardless of whether the person who imports the goods is registered for GST or not. In Worked Example 1, Robert has made a “taxable supply” as he has provided accountancy services to Olivia. As Robert is registered for GST, he is required to charge GST at the rate of 10%. GST (10%) is added to the “value” of the supply. In our example, the value of the supply is $3,000. Adding 10% GST to this amount gives us $3,300, which is referred to as the “price” (s 9-70, GST Act). Put another way:

Price = [Value + 10%]

In Australia, according to the Competition and Consumer Act 2010 (formerly, the Trade Practices Act 1974), all prices are required to be shown inclusive of all taxes and charges. Hence, to calculate the amount of GST that has been included in the price of goods sold or services provided, the quoted or advertised price is simply divided by 11. Put another way, the GST payable on a taxable supply is 1/11th of the price displayed. The supplier must account for, and remit, the GST irrespective of whether the supplier actually included any GST component in the price or not. There are four types of supplies for the purposes of the GST Act. These are: • taxable supplies

• GST-free supplies • input taxed supplies, and • out-of-scope supplies. Diagram 4.2 summarises these four types of supplies. Diagram 4.2: Four types of supplies for GST purposes

GST-free supplies A GST-free supply is one that is specifically made exempt under the GST Act. If a supply is GST-free, it means that the registered entity (ie the supplier) is not required to charge the 10% GST. However, the registered entity can claim back input tax credits on the inputs used to produce the GST-free supply. A summary of the GST-free supplies listed in Div 38 of the GST Act are outlined in Table 4.1. Table 4.1: GST-free supplies Subdivision

GST-free supply

38-A

Basic food

38-B

Health

38-C

Education

38-D

Child care

38-E

Exports and other supplies that are for consumption outside Australia

38-F

Religious services

38-G

Activities of charitable institutions, etc

38-H

Raffles and bingos conducted by charitable institutions

38-I

Water, sewerage and drainage

38-J

Supplies of going concerns

38-K

Transport and related matters

38-L

Precious metals

38-M

Supplies through inwards duty-free shops

38-N

Grants of land by governments

38-O

Farm land

38-P

Cars for use by disabled persons

38-Q

International mail

Hence, a fresh food grocer who is registered for GST that sells fresh fruit and vegetables does not charge the GST on these items upon sale as these items qualify as “basic food” as per s 38-3 of the GST Act. However, in the case of a GST-free supply, the fresh food grocer is still able to claim back the GST paid (ie input tax credits) in respect of the assets purchased or expenses incurred in running the business (eg electricity, commercial rent, telephone, etc). Input taxed supplies An input taxed supply is one on which a registered entity (ie the supplier) is not required to charge the 10% GST to the consumer. However, unlike a GST-free supply, the supplier is not able to claim an input tax credit on the inputs used to produce the input taxed supply. A summary of the input taxed supplies listed in Div 40 of the GST Act are outlined in Table 4.2. Table 4.2: Input taxed supplies Subdivision

Input taxed supply

40-A

Financial supplies (such as loans, bank charges, dividends and interest)

40-B

Residential rent

40-C

Sale of residential premises

40-D

Precious metals

40-E

School tuckshops and canteens

40-F

Fundraising events conducted by charitable institutions

Hence, the landlord of a residential property does not charge the tenant GST as residential rent is an input taxed supply. And, as this is an input taxed supply, the landlord is unable to claim back input tax credits associated with rental property expenses (eg property agent’s fees, cleaning, repairs and maintenance, etc). Out-of-scope supplies

Out-of-scope supplies are those supplies which fall outside the scope of the GST Act. GST cannot be charged in respect of revenue and cannot be claimed back in respect of expenses. As outlined in Diagram 4.2, examples of out-of-scope supplies include: • amortisation expense • annual leave, sick leave and long service leave expenses • donations made • depreciation expense • fringe benefits tax paid • government fees and charges, such as the Australian Securities and Investments Commission (ASIC) fees, business name registration fees and stamp duty • gain and loss on sale of non-current assets • land tax • payroll tax • salaries and wages • superannuation contributions • transfer of monies between bank accounts • owner’s contributions, and • owner’s drawings. These expenses are usually coded to “no tax” in management accounts and are not reported in the BAS. A summary of the four types of GST supplies is shown in Table 4.3. Table 4.3: Summary of the four types of GST supplies Type of supply

Charge the 10% GST?(ie GST collected)

Claim back the input tax credit?(ie GST paid)

Taxable (Div 7)

✓

✓

GST-free (Div 38)

X

✓

Input taxed (Div 40)

X

X

Out-of-scope

N/A*

N/A*

*outside the scope of the GST Act

¶4-110 Accounting for the GST charged In the first Worked Example (¶4-100), it will be remembered that on 14 May 2017, Robert (who is registered for GST) provided accounting services to Olivia and provided her with a tax invoice of $3,300 (inclusive of $300 GST). Journal entry 1: Invoicing Olivia (a client) for $3,300 From Robert’s perspective, his bookkeeper will put through the following journal entry on 14 May 2017 (ie the date Robert provided a tax invoice to Olivia):

DATE

PARTICULARS

POST REF

May 14

Accounts receivable

1-2000

DEBIT

CREDIT

3,300

Service fees revenue

4-3000

3,000

GST payable

2-2500

300

(Invoicing a client for accounting services rendered including GST) Analysis Robert has invoiced Olivia $3,300 inclusive of GST. The “accounts receivable” account is debited for the full GST-inclusive amount of $3,300. Of this amount, $3,000 (or 10/11ths of the amount invoiced) represents Robert’s revenue. Accordingly, $3,000 will be shown as “service fees revenue” in Robert’s profit and loss statement. The remaining $300 (being $3,300 × 1/11th) represents the GST component. The $300 should be credited to the “GST payable” account which is shown as a current liability in Robert’s balance sheet because it represents the amount of GST owing to the ATO. It is important to note from the previous journal entry that in the case of an entity that is registered for GST, revenues shown in the profit and loss statement are always shown exclusive of GST. Journal entry 2: Collection of the $3,300 from Olivia Assume that on 29 May 2017, Olivia pays Robert the amount owing ($3,300). On this date, the bookkeeper will process the following journal entry in Robert’s books: DATE May 29

PARTICULARS Cash at bank

POST REF

DEBIT

1-1300

Accounts receivable

1-2000

CREDIT

3,300 3,300

(Collection of accounts receivable from Olivia) Analysis In this transaction, Robert receives the $3,300 owing by Olivia. The “cash at bank” account is debited for $3,300 with the “accounts receivable” account credited for the same amount. Journal entry 3: Remitting the $300 GST to the ATO Assume that on 17 July 2017, with the assistance of his bookkeeper and accountant, Robert lodges the BAS for the quarter ended 30 June 2017. Assuming that the work undertaken for Olivia was his only taxable supply for the June 2017 quarter, when Robert lodges the BAS with the ATO, he will be required to remit the GST collected of $300 (which was included in $3,300 received from Olivia on 29 May 2017). Assuming that Robert remits the GST to the ATO on this date, the journal entry to record this transaction is: DATE July 17

PARTICULARS GST payable Cash at bank

POST REF 2-2500 1-1300

DEBIT

CREDIT 300 300

(Payment of $300 GST owing to the ATO) Analysis In this transaction, when Robert lodges the June 2017 BAS, he is required to remit $300 GST to the ATO that he collected from Olivia. Hence, the “GST payable” account is debited for $300 with the “cash at bank” account credited for the same amount.

¶4-120 Paying the GST Up until this point, we have only considered the GST consequences from the perspective of the supplier of services. We will now briefly consider the GST implications for the purchaser. Section 11-20 of the GST Act states: “You are entitled to the input tax credit for any creditable acquisitions that you make.” Entities that are registered for GST can claim back the GST they have paid on “creditable acquisitions”. This credit is known as an “input tax credit”. A creditable acquisition is essentially the purchase or acquisition of something that is used in carrying on a business or enterprise. According to s 11-5 and 11-10 of the GST Act, an entity can claim an input tax credit for a creditable acquisition if: • the entity provides, or is liable to provide, consideration for the supply • the entity is registered or required to be registered • the entity acquires anything (defined in s 11-10, primarily to include good or services) • the acquisition was solely or partly for a creditable purpose, and • the item supplied was a taxable supply. All five components listed in the definition of creditable acquisition must be present in order for the entity to claim an input tax credit. In order to claim back any input tax credits, the acquisition must be for a “creditable purpose”. According to s 11-15 of the GST Act, a “creditable purpose” means that: • it is acquired in carrying on an enterprise • the acquisition is not of a private or domestic nature, and • the acquisition cannot relate to making supplies that would be input taxed (eg financial supplies, residential rent, etc). Section 11-25 of the GST Act states that the amount of input tax credit for a creditable acquisition is the amount of GST paid for the acquisition. This will generally be 1/11th of the total price paid to acquire the goods or services. However, an acquisition may be made only partly for a creditable purpose. For example, in the case of a mobile telephone bill, 60% may be for a creditable (business) purpose and 40% for a non-creditable (private) purpose. In this case, according to s 11-30 of the GST Act, only 60% of the input tax credit can be claimed. The Commissioner expects an apportionment to be done on a fair and reasonable basis. According to s 69-5(3) of the GST Act, an input tax credit cannot be claimed if the expense is not deductible under the Income Tax Assessment Act 1936 (ITAA36) or the Income Tax Assessment Act 1997 (ITAA97). In our earlier example, Olivia received a tax invoice from Robert showing an amount payable of $3,300 (inclusive of GST). As Olivia is also registered for GST, she is able to claim the GST paid to Robert of $300 in respect of his accounting fees because the expenditure incurred by Olivia related to a creditable

(or business) purpose. This is referred to as an “input tax credit”.

¶4-130 Accounting for the GST paid Journal entry 1: Receiving an accounting bill for $3,300 from Robert From Olivia’s viewpoint, her bookkeeper will put through the following journal entry on 14 May 2017 (the date on which Olivia receives the tax invoice from Robert): DATE May 14

PARTICULARS

POST REF

DEBIT

Accounting fees

6-1000

3,000

GST receivable

2-2600

300

Accounts payable

2-2000

CREDIT

3,300

(Accounting fees including GST) Analysis Olivia has received a tax invoice from Robert for $3,300 inclusive of GST. “Accounts payable” is credited for the full GST-inclusive amount of $3,300. Of this amount, $3,000 (or 10/11ths of the amount invoiced) represents the accounting fees expense. Accordingly, $3,000 will be shown as “accounting fees” in Olivia’s profit and loss statement. The remaining $300 (being $3,300 × 1/11th) represents the GST component. An amount of $300 is shown as “GST receivable” in Olivia’s balance sheet because she is able to claim back the GST paid to Robert. The bookkeeper should create an account entitled “GST receivable” and debit this account for $300. While the “GST receivable” account is essentially an asset account, it is common for this account to be shown as a contra-current liability underneath the “GST payable” account. This way the “GST payable” and the “GST receivable” accounts can be netted off and shown next to each other in the current liabilities section of the balance sheet. Once again, it is important to note that in the case of an entity that is registered for GST, expenses shown in the profit and loss statement are exclusive of GST. Journal entry 2: Paying the $3,300 to Robert On 29 May 2017, Olivia pays Robert the amount owing ($3,300). On this date, Olivia’s bookkeeper will process the following journal entry: DATE May 29

PARTICULARS

POST REF

Accounts payable

2-2000

Cash at bank

1-3000

DEBIT

CREDIT

3,300 3,300

(Payment of Robert’s accounting fees) Analysis In this transaction, Olivia pays $3,300 owing to Robert. The “accounts payable” account is debited for the gross amount owing and the “cash at bank” account is credited. Journal entry 3: Claiming back input tax credit of $300 Assume that on 9 July 2017, with the assistance of her bookkeeper and accountant, Olivia lodges the BAS for the quarter ended 30 June 2017. Assuming that the payment to Robert is her only creditable acquisition for the quarter, when Olivia lodges the BAS with the ATO, she will be able to claim the GST paid of $300 (which is included in the $3,300 she

paid to Robert). Assume that on 17 July 2017, the ATO refunds Olivia the $300 GST owing to her. At this point, the bookkeeper will record the following journal entry: DATE July 17

PARTICULARS Cash at bank GST receivable

POST REF 1-1300

DEBIT

CREDIT 300

2-2600

300

(Collection of $300 GST from the ATO) Analysis In this transaction, when Olivia lodges the June 2017 BAS, she is entitled to receive the $300 GST back from the ATO. Hence, the “cash at bank” account is debited for $300 and the contra-current liability account “GST receivable” is credited for the same amount.

¶4-200 GST registration According to Div 23 of the GST Act, an entity is required to register for GST if it carries on an enterprise and its GST (annual) turnover exceeds $75,000 per annum. In the case of non-profit organisations, the registration threshold is set at $150,000 per year. An entity above the GST registration thresholds must register for GST. However, if the thresholds are not met, GST registration is voluntary (s 23-10, GST Act). Entities can register online at abr.gov.au/ForBusiness,-Super-funds---Charities/Applying-for-an-ABN/Apply-for-an-ABN. According to s 25-1 of the GST Act, registration must be made within 21 days of becoming required to register. The ATO notifies the entity in writing that the registration has taken effect. For those for-profit entities with a turnover of less than $75,000 (or not-for-profit entities with a turnover of less than $150,000), GST registration is not required. However, they must still register for an Australian Business Number (ABN) from the ATO. The ABN is a unique 11-digit number. Their ABN must be displayed on all invoices issued; however, they are not permitted to charge the customer the 10% GST (as only businesses registered for the GST can do so). When an entity registers for GST, it is issued with an ABN. The ABN must be displayed on all tax invoices issued by the entity.

¶4-300 Tax invoices Where an entity is registered for GST and makes a taxable supply, it must provide a tax invoice (s 29-70, GST Act). Section 29-70(2) of the GST Act specifies that a supplier must issue a tax invoice within 28 days of the date of sale for all supplies with a total GST-exclusive price exceeding $75 (ie $82.50 inclusive of GST). According to s 29-70(1) of the GST Act, a tax invoice is required to include the following: • that it is issued by the supplier (except for recipient created tax invoices) • it must be in the approved form • that the document is intended as a tax invoice (usually with the words “tax invoice” clearly displayed) • the supplier’s identity (eg its legal name, business name or trading name) • the supplier’s ABN • the date the tax invoice was issued • a brief description of what is sold, including the quantity (if applicable) and the price of what is sold

• the GST amount (if any) payable in relation to the sale — this can be shown separately or, if the GST to be paid is exactly 1/11th of the total price, as a statement such as “total price includes GST”, and • the extent that each sale to which the document relates is a taxable sale. Where the price of the supply is $1,000 or more (including GST), the tax invoice must also include the buyer’s identity or ABN. The GST included in the price can either be shown separately or must contain a statement stating that the amount payable is inclusive of GST. A sample tax invoice for goods and services that consists exclusively of taxable supplies is shown in Diagram 4.3. Diagram 4.3: Sample tax invoice (consisting exclusively of taxable supplies)

Where the amount of GST is not exactly 1/11th of the price (ie the supply consists of a taxable supply and a GST-free supply), then the amount of GST payable must be separately disclosed. This is referred to as a “mixed supply”. A sample tax invoice for a mixed supply (ie where the invoice consists of taxable supplies and GST-free supplies) is shown in Diagram 4.4. Diagram 4.4: Sample tax invoice (consisting mixed supplies)

It is important to remember that an entity must also hold valid tax invoices for all creditable acquisitions to be able to claim input tax credits. If an entity is not registered for GST, it should not issue a “tax invoice”. Instead, it should simply issue an “invoice”. An invoice should still contain the 11-digit ABN, but it should not contain GST. A sample invoice for goods and services that does not include GST is shown in Diagram 4.5. Diagram 4.5: Sample invoice (not registered for GST)

If an entity provides either a tax invoice or invoice without a valid 11-digit ABN, then the payer is required

to withhold 49% of the gross payment and remit this amount to the ATO on its next BAS. This is referred to as “ABN withholding tax”. This applies in all cases, unless: • the supplier is not entitled to an ABN as they are not carrying on an enterprise in Australia • they are an individual under 18 years and the payment does not exceed $350 per week • the payment does not exceed $75, excluding any GST • they are an individual or a partnership without a reasonable expectation of profit or gain • the supply that the payment relates to is wholly input taxed • the whole of the payment is exempt income of the supplier, or • the supplier is an individual and has given the payer a written statement in the ATO approved “Statement by a Supplier” form which states that the supply is either: – made in the course or furtherance of an activity done as a private recreational pursuit or hobby, or – wholly of a private or domestic nature (from the supplier’s perspective). The “Statement by a Supplier” form can be downloaded from the ATO’s website at www.ato.gov.au/uploadedFiles/Content/MEI/downloads/Statement%20by%20a%20supplier.pdf. A sample “Statement by a Supplier” form is included at the end of this chapter at ¶4-955.

Tax Periods Introduction

¶4-400

Quarterly tax periods

¶4-410

Monthly tax periods

¶4-420

¶4-400 Introduction An entity that is registered for GST must lodge a BAS for each tax period. According to Div 27 of the GST Act, there are two tax periods for GST purposes: • quarterly (¶4-410), and • monthly (¶4-420). An entity has a choice of either quarterly or monthly tax periods. However, according to s 27-15 of the GST Act, an entity must use a monthly tax period if it: • has a GST turnover of $20m or more • is only carrying on an enterprise for less than three months, or • has a history of failing to comply with tax obligations.

¶4-410 Quarterly tax periods Section 31-8 of the GST Act sets out a table showing the dates when entities with quarterly tax periods are required to lodge their BAS with the ATO. This table is as follows. Table 4.4: Quarterly GST taxpayers

Quarter

Lodgment date of BAS

Time to complete

30 September

28 October

4 weeks

31 December

28 February

8 weeks

31 March

28 April

4 weeks

30 June

28 July

4 weeks

¶4-420 Monthly tax periods Section 31-10 of the GST Act provides that entities with monthly tax periods are required to lodge their BAS with the ATO no later than the 21st day of the month following the end of a tax period. The due dates for lodgment of the monthly BAS are shown in Table 4.5. Table 4.5: Monthly GST taxpayers Month

Lodgment date of BAS

Time to complete

31 July

21 August

3 weeks

31 August

21 September

3 weeks

30 September

21 October

3 weeks

31 October

21 November

3 weeks

30 November

21 December

3 weeks

31 December

21 January

3 weeks

31 January

21 February

3 weeks

28 February

21 March

3 weeks

31 March

21 April

3 weeks

30 April

21 May

3 weeks

31 May

21 June

3 weeks

30 June

21 July

3 weeks

¶4-500 Net amount When lodging the BAS, a GST-registered entity is required to remit to the ATO the “net amount” for the relevant month or quarter. The “net amount” is Item 9 on the BAS. According to s 17-5 of the GST Act, the net amount is defined as:

Net amount = [GST collected − GST paid]

If the net amount is (Item 9) positive (ie Item 8A is more than Item 8B on the BAS), the registered entity must remit the GST owing to the ATO when the BAS is lodged. Conversely, if the net amount (Item 9) is negative (ie Item 8A is less than Item 8B on the BAS), this means that the registered entity is entitled to a refund. The ATO must process the refund within 14 days of the receipt of the BAS. A sample BAS is included at the end of this chapter at ¶4-960.

¶4-600 Cash vs accrual basis of accounting for GST According to Div 29 of the GST Act, an entity has a choice of two methods in accounting for GST: • the cash method, or • the non-cash (accrual) method. The choice as to whether the entity adopts the cash or accrual basis of accounting for GST is usually made by the accountant or tax agent when the entity registers for the GST. According to the ATO statistics published in April 2004, 74% of the entities registered for GST have elected to use the cash basis. Cash basis According to s 29-40 of the GST Act, an entity may elect to use the cash basis if it meets at least one of the following conditions: • the entity is a small business entity (SBE). An SBE is any entity that has an annual GST turnover of $2m or less (see below) • the entity uses the cash basis for income tax purposes • the Commissioner determines that the enterprise is one for which the cash basis can be used, or • regardless of the entity’s GST turnover, the entity is an endorsed charitable institution, trustee of an endorsed charitable fund, gift-deductible entity or government school.

STOP PRESS In the 2016 Federal Budget handed down on Tuesday 3 May 2016, the government announced that from 1 July 2016, the SBE turnover threshold will be increased from $2m to $10m. It has been estimated that the increased $10m turnover threshold will allow an additional 90,000 to 100,000 business entities to have the choice to account for GST on a cash basis (rather than the accruals basis). On 1 September 2016, the Treasury Laws Amendment (Enterprise Tax Plan) Bill 2016 was introduced into Parliament. On 31 March 2017, an amended version of the Bill was passed by a majority of the Senate. Royal Assent has now been guaranteed by the Federal Treasurer on the basis that formal passage through the Coalition-majority House of Representatives will occur when Parliament resumes in early May 2017. However, as this has not occurred as at the date of writing, for the rest of this chapter, reference will be made to the $2m SBE turnover threshold, and not the new $10m SBE turnover threshold.

If an entity meets any one of the above conditions, it has a choice whether to adopt the cash or non-cash basis of accounting for GST. If an entity does not meet any of the above four conditions, it must use the non-cash basis of accounting for GST. Under the cash basis of accounting, GST is payable on a taxable supply in the tax period when the cash is received from the customer in respect of a taxable supply and not necessarily the period in which the service was provided or the tax invoice was issued. Similarly, an input tax credit for a creditable acquisition can only be claimed in the tax period when the entity makes the payment and not necessarily the period in which the expense occurred or the tax invoice was issued (s 29-5(2) and 29-10(2), GST Act).

Accrual (non-cash) basis According to s 29-5(1) of the GST Act, under the non-cash (or accrual) basis of accounting for GST, the GST payable on a supply made is attributed to the tax period in which: • the taxpayer received a payment in relation to the supply, or • the date the invoice was issued whichever is the earlier. Similarly, according to s 29-10(1) of the GST Act, under the non-cash basis of accounting for the GST, the input tax credit is able to be claimed in the tax period in which: • the taxpayer paid for the goods or services, or • the date of the invoice. whichever is the earlier. It is important to note that regardless of whether the cash or accrual basis is adopted for GST purposes, an entity must have a valid tax invoice in its possession at the time the input tax credit is claimed in the BAS (s 29-10(3), GST Act). In GST Determination GSTD 2005/2, the Commissioner confirms that an invoice posted on a website is “issued” for the purposes of the attribution rules. Finally, it is worth remembering that regardless of whether an entity has elected to account for its GST on a cash or accrual basis, the bookkeeper should still record transactions in the accounting system using accrual accounting concepts.

¶4-700 Comprehensive worked example on accounting for GST In this section, we will consider the effects of GST on Gary Richardson Legal Practice. It will be remembered from Chapter 2 (see ¶2-020) that Gary Richardson owns his own legal practice. In the journal entries recorded in Chapter 2, the effects of GST were ignored. We will now introduce GST into the 10 transactions that occurred during the month of January 2017 using the same chart of accounts for Gary Richardson contained in ¶2-700. This chart of accounts is reproduced as follows (with two additional accounts added, namely GST payable and GST receivable). Gary Richardson Legal Practice Chart of Accounts Assets [1-000–1-999] 1-100

Cash at bank

1-200

Accounts receivable

1-300

Furniture

1-400

Computer equipment

Liabilities [2-000–2-999] 2-100

Accounts payable

2-200

GST payable

2-300

GST receivable

Equity [3-000–3-999] 3-100

Gary Richardson, capital

3-200

Gary Richardson, drawings

Revenues [4-000–4-999] 4-100

Client fees revenue

Expenses [5-000–5-999] 5-100

Electricity expense

5-200

Insurance expense

5-300

Stationery expense

5-400

Wages expense

Transaction 1: Starting the business with a $250,000 cash deposit January 2: Gary Richardson opens up a business cheque account with his local bank and deposits $250,000 from his own personal savings account into the business bank account. The journal entry that would have been recorded is as follows: DATE Jan 2

PARTICULARS Cash at bank

POST REF 1-100

Gary Richardson, capital

DEBIT

CREDIT

250,000

3-100

250,000

(Recording the initial $250,000 investment made by Gary Richardson into the business) Analysis In this transaction, the owner, Gary Richardson, has contributed $250,000 of his own funds into the business. A deposit of money is an out-of-scope supply. Hence, there is no GST impact relating to this transaction. Transaction 2: Purchasing furniture and computer equipment costing $124,200 January 4: Gary Richardson purchases furniture costing $80,000 (inclusive of GST) and computer equipment costing $44,200 (inclusive of GST) by paying cash. The journal entry that would have been recorded is as follows: DATE Jan 4

PARTICULARS

POST REF

DEBIT

Furniture

1-300

72,727

Computer equipment

1-400

40,182

GST receivable

2-300

11,291

Cash at bank

1-100

CREDIT

124,200

(Gary Richardson purchased furniture and computer equipment inclusive of GST by paying cash) Analysis In the second transaction, Gary Richardson purchased furniture costing $80,000 (inclusive of GST) and computer equipment costing $44,200 (inclusive of GST). The “furniture” account is debited for its GST-exclusive amount of $72,727 (being $80,000 × 10/11ths) while the “computer equipment” account is debited for its GST-exclusive amount of $40,182 (being $44,200 × 10/11ths). The “GST receivable” account is debited for $11,291, being the amount of GST

included in both items (ie $124,200 × 1/11th). The “GST receivable” account is usually shown as a contracurrent liability account in the balance sheet. It is important to note that in the case of an entity that is registered for GST, the asset accounts in the balance sheet are shown exclusive of GST. Transaction 3: Hiring a legal assistant January 5: After interviewing several candidates during the week, Gary Richardson offers Amanda Young a full-time position in his practice as his legal assistant. Amanda duly accepts the offer of employment. Analysis The third transaction is an example of a non-event transaction. Hence, no transaction is recorded at this point and there are no GST implications. Transaction 4: Purchasing stationery on credit for $1,200 January 8: Gary Richardson opens an account with Officeworks and proceeds to purchase stationery costing $1,200 (inclusive of GST) on credit. The account is payable within 30 days. The journal entry that would have been recorded is as follows: DATE Jan 8

PARTICULARS

POST REF

DEBIT

CREDIT

Stationery expense

5-300

1,091

GST receivable

2-300

109

Accounts payable

2-100

1,200

(Purchase of stationery from Officeworks on credit inclusive of GST) Analysis In the fourth transaction, Gary purchased stationery for his business costing $1,200 inclusive of GST. The “stationery expense” account is debited for its GST-exclusive amount of $1,091 (being $1,200 × 10/11ths). The “GST receivable” account is debited for $109, being the amount of GST (ie $1,200 × 1/11th). It is important to note that in the case of an entity that is registered for GST, all expenses shown in the profit and loss statement are shown exclusive of GST. Transaction 5: Earning legal fees revenue of $3,200 cash January 10: Gary Richardson earns revenue of $3,200 (inclusive of GST) by performing legal services for clients over the past week. All of these clients pay by cash. The journal entry that would have been recorded is as follows: DATE Jan 10

PARTICULARS Cash at bank

POST REF 1-100

DEBIT

CREDIT

3,200

Client fees revenue

4-100

2,909

GST payable

2-200

291

(Provision of legal services to clients for cash inclusive of GST) Analysis In the fifth transaction, Gary performs legal services for clients and derives revenue of $3,200 inclusive of

GST. As Gary is registered for GST, he is required to charge GST for the legal services provided to clients. Hence, the $3,200 is shown inclusive of GST. The revenue account “client fees revenue” is credited for its GST-exclusive amount of $2,909 (being $3,200 × 10/11ths). The “GST payable” account is credited for $291, being the amount of GST (ie $3,200 × 1/11th). Once again, it is important to note that in the case of an entity that is registered for GST, all income shown in the profit and loss statement are shown exclusive of GST. Transaction 6: Earning client fees revenue of $5,600 on credit January 12: Gary Richardson earns revenue of $5,600 (inclusive of GST) by performing legal services for clients. These clients are invoiced and they agree to pay the account within 14 days. The journal entry that would have been recorded is as follows: DATE Jan 12

PARTICULARS Accounts receivable

POST REF 1-200

DEBIT

CREDIT

5,600

Client fees revenue

4-100

5,091

GST payable

2-200

509

(Provision of legal services to clients on credit inclusive of GST) Analysis In the sixth transaction, Gary performs legal services for clients on credit and derives revenue of $5,600 inclusive of GST. As Gary is registered for GST, he is required to charge GST for the legal services provided to clients. Hence, $5,600 is shown inclusive of GST. The revenue account “client fees revenue” is credited for its GST-exclusive amount of $5,091 (being $5,600 × 10/11ths). The “GST payable” account is credited for $509, being the amount of GST (ie $5,600 × 1/11th). Transaction 7: Payment of various expenses totalling $4,330 January 19: Gary Richardson pays fortnightly wages to his assistant Amanda of $1,260 (no GST), insurance of $2,800 (see below) and electricity of $270 (inclusive of GST) for the month of January 2017. A closer inspection of the insurance statement received from the insurance company revealed that $2,800 was broken down as follows: • insurance $2,640 (inclusive of GST of $240), and • stamp duty of $160 (no GST). There is no GST in respect of stamp duty as it is a government charge and is therefore considered an out-of-scope supply. The journal entry that would have been recorded is as follows: DATE Jan 19

PARTICULARS

POST REF

DEBIT

CREDIT

Wages expense

5-400

1,260

Insurance expense

5-200

2,560

GST receivable (insurance)

2-300

240

Electricity expense

5-100

245

GST receivable (electricity)

2-300

Cash at bank

25

1-100

4,330

(Payment of expenses for the month of January 2017 inclusive of GST) Analysis In the seventh transaction, Gary pays salaries and wages of $1,260 to his assistant, Amanda. Salaries and wages are regarded as an out-of-scope supply for GST purposes. Hence, there is no GST applicable. As a result, the entire $1,260 is coded to “wages expense”. At this stage, for simplicity, we will ignore the effects of Pay As You Go (PAYG) withholding tax and superannuation. In terms of the insurance statement, we are told that the total insurance payable was $2,800. This amount was broken down into two components. Firstly, an amount of $2,640 included GST of $240. Hence, the GST-exclusive amount of this component of the insurance bill was $2,400. Secondly, we are told that there was $160 stamp duty. There is no GST on stamp duty. Hence, the total GST-exclusive amount that is debited to the “insurance expense” account is $2,560 (being $2,400 + $160). The GST associated with the insurance statement of $240 is debited to the “GST receivable” account. In terms of electricity, the “electricity expense” account is debited for its GST-exclusive amount of $245 (being $270 × 10/11ths). The “GST receivable” account is debited for $25, being the amount of GST (ie $270 × 1/11th). Transaction 8: Payment of Officeworks account of $1,200 January 22: Gary Richardson pays the $1,200 owing to Officeworks for the stationery that he purchased on 8 January 2017. The journal entry that would have been recorded is as follows: DATE Jan 22

PARTICULARS

POST REF

Accounts payable

2-100

Cash at bank

1-100

DEBIT

CREDIT

1,200 1,200

(Payment of $1,200 owing to Officeworks) Analysis In the eighth transaction, Gary pays the Officeworks account of $1,200. There is no GST impact from this transaction as the GST on this expense has already been recorded in the journal entry on 8 January 2017. Hence, “accounts payable” is debited for $1,200 with a corresponding credit to “cash at bank”. Transaction 9: Collection of amounts owing by clients $4,200 January 25: Gary Richardson receives $4,200 from the clients whom he invoiced for the legal services undertaken on 12 January 2017. The journal entry that would have been recorded is as follows: DATE Jan 25

PARTICULARS Cash at bank Accounts receivable (Collection of $4,200 accounts receivable from clients)

Analysis

POST REF 1-100 1-200

DEBIT

CREDIT

4,200 4,200

In the ninth transaction, Gary receives $4,200 from the clients who he invoiced on 12 January. There is no GST impact from this transaction as the GST on revenue has already been recorded in the journal entry on 12 January 2017. Hence, “cash at bank” is debited for $4,200 with a corresponding credit to “accounts receivable”. Transaction 10: Gary Richardson withdraws $1,000 cash from his business January 30: Gary Richardson withdraws $1,000 cash from the business for his own personal use. The journal entry that would have been recorded is as follows: DATE Jan 30

PARTICULARS Drawings, Gary Richardson Cash at bank

POST REF 3-200

DEBIT

CREDIT

1,000

1-100

1,000

(Drawings of $1,000 made by Gary Richardson) Analysis In the tenth and final transaction, Gary withdraws $1,000 from his business. A withdrawal of funds constitutes an out-of-scope supply. Hence, there is no GST on this transaction. The completed journal entries for the month of January 2017 for Gary Richardson appear as follows: DATE Jan 2

PARTICULARS Cash at bank Gary Richardson, capital

POST REF 1-100

DEBIT

CREDIT

250,000

3-100

250,000

(Recording the initial $250,000 investment made by Gary Richardson into the business)

Jan 4

Furniture

1-300

72,727

Computer equipment

1-400

40,182

GST receivable

2-300

11,291

Cash at bank

1-100

124,200

(Gary Richardson purchased furniture and computer equipment inclusive of GST by paying cash)

Jan 8

Stationery expense

5-300

1,091

GST receivable

2-300

109

Accounts payable

2-100

1,200

(Purchase of stationery from Officeworks on credit inclusive of GST)

Jan 10

Cash at bank Client fees revenue

1-100 4-100

3,200 2,909

GST payable

2-200

291

(Provision of legal services to clients for cash inclusive of GST)

Jan 12

Accounts receivable

1-200

5,600

Client fees revenue

4-100

5,091

GST payable

2-200

509

(Provision of legal services to clients on credit inclusive of GST)

Jan 19

Wages expense

5-400

1,260

Insurance expense

5-200

2,560

GST receivable (insurance)

2-300

240

Electricity expense

5-100

245

GST receivable (electricity)

2-300

25

Cash at bank

1-100

4,330

(Payment of expenses for the month of January 2017 inclusive of GST) Jan 22

Accounts payable

2-100

Cash at bank

1-100

1,200 1,200

(Payment of $1,200 owing to Officeworks)

Jan 25

Cash at bank

1-100

Accounts receivable

4,200

1-200

4,200

(Collection of $4,200 accounts receivable from clients)

Jan 30

Drawings, Gary Richardson Cash at bank

3-200

1,000

1-100

1,000

(Drawings of $1,000 made by Gary Richardson)

¶4-800 Completing the accounting cycle The ledger accounts for GST payable and GST receivable as at 30 January 2017 are shown as follows: GST Payable

2-200

10 Jan Client Fees

291

12 Jan Client Fees

509 800

GST Receivable 4 Jan

2-300

Furniture and Computer equip

8 Jan

11,291

Stationery

109

19 Jan Insurance

240

19 Jan Electricity

25 11,665

The “GST payable” account is shown in the balance sheet as a current liability. As previously explained, the “GST receivable” account is usually shown as a contra-current liability. While the “GST receivable” account is essentially an asset account, it is common for this account to be shown as a contra-current liability directly below the “GST payable” account. The reason for this is that rather than showing the two accounts on separate sides of the balance sheet (one as a current asset and the other as a current liability), they can be shown next to each other in the current liabilities section of the balance sheet, thereby allowing them to be netted off. Once all the journal entries have been posted to the general ledger, the trial balance of Gary Richardson Legal Practice can be prepared for the month ended 31 January 2017. Gary Richardson Legal Practice Trial Balance as at 31 January 2017 Account title

Account no

Debit

Cash at bank

1-100

126,670

Accounts receivable

1-200

1,400

Furniture

1-300

72,727

Computer equipment

1-400

40,182

GST payable

2-200

GST receivable

2-300

Gary Richardson, capital

3-100

Gary Richardson, drawings

3-200

Client fees revenue

4-100

Electricity expense

5-100

245

Insurance expense

5-200

2,560

Stationery expense

5-300

1,091

Wages expense

5-400

1,260

Totals:

Credit

800 11,665 250,000 1,000 8,000

$258,800

$258,800

Once the trial balance has been completed, the financial statements for Gary Richardson Legal Practice can be prepared for the month ended 31 January 2017. These are shown on the following pages:

Gary Richardson Legal Practice Profit and Loss Statement for the month ended 31 January 2017 $ Revenue

Client fees

8,000

Total Revenue

8,000

Less: Expenses

Electricity expense

245

Insurance expense

2,560

Stationery expense

1,091

Wages expense

1,260

Total Expenses

5,156

Net Profit

$ 2,844

Gary Richardson Legal Practice Statement of Changes in Equity for the month ended 31 January 2017 $

Opening capital as at 1 January 2017 Add: Investments by owner

250,000

Add: Net profit for the month of January 2017 (from profit and loss statement)

2,844 252,844

Less: Owner’s drawings

(1,000)

Closing capital as at 31 January 2017

$ 251,844

Gary Richardson Legal Practice

Balance Sheet as at 31 January 2017 $ Current Assets

Cash at bank Accounts receivable

Total Current Assets

126,670 1,400

128,070

Non-Current Assets

Furniture, at cost

72,727

Computer equipment, at cost

40,182

Total Non-Current Assets

Total Assets

112,909

$ 240,979

Current Liabilities

GST payable

800

Less: GST receivable

(11,665)

Total Current Liabilities

(10,865)

Net Assets

$ 251,844

Owner’s Equity Gary Richardson, capital (from above)

Owner’s Equity

251,844

$ 251,844

It will be noted from the balance sheet as at 31 January 2017 that the GST payable was $800 and the GST receivable was $11,665. Accordingly, the net GST receivable owing by the ATO to Gary Richardson is $10,865. The amount is shown as a negative current liability, meaning that the input tax credits claimed for the month of January 2017 exceeded the GST collected. In other words, the amount of $10,865 is

refundable by the ATO when the entity lodges its BAS. It can be quite common in the first months of a business to have paid more GST than it collected. However, once initial expenses are eliminated and the business begins to become profitable, the GST collected will normally exceed the GST paid, meaning that the entity will be in a net GST payable position in future periods. Furthermore, as previously noted throughout the chapter, in the case of an entity that is registered for GST, all items in the profit and loss statement and balance sheet are shown GST-exclusive. The only exception to this rule is “accounts receivable” and “accounts payable”, which are shown in the balance sheet on a GST-inclusive basis. A sample chart of accounts incorporating “typical” GST tax codes using the MYOB accounting numbering system is included at the end of this chapter (¶4-970). However, the chart of accounts is not intended to be used as a template in all circumstances. The GST tax codes shown in the chart of accounts at the end of the chapter may vary depending on the circumstances of the client. In other words, specific transactions may have different GST tax codes than the ones identified in the chart of accounts at the end of the chapter. Accordingly, if the bookkeeper has created a chart of accounts, they are strongly advised to send the chart of accounts (and the GST tax codes) to the client’s external accountant for review.

INFORMATION FOR CONTRACT BOOKKEEPERS The role of bookkeepers prior to 1 July 2000 Prior to the introduction of GST in Australia, the primary role of a bookkeeper was to ensure that transactions were correctly recorded in the accounting system and all relevant reconciliations were attended to. Typically, at the end of the financial year, the bookkeeper would print off management accounts (consisting of the trial balance, profit and loss statement and balance sheet) and provide them to the external accountant or tax agent, who would then prepare external financial statements and the income tax return of an entity. Introduction of the GST on 1 July 2000 All of that changed with the introduction of the GST on 1 July 2000. From this date, the role of the bookkeeper greatly expanded. Not only were bookkeepers required to prepare the books on behalf of the entity, but they were generally preparing and lodging their client’s BAS’s with the ATO. The BAS requires an entity not only to report key figures like sales, purchases, salaries and wages and assets acquired every month of every quarter, but also to report the amount of GST collected and paid and calculate and report the entity’s PAYG instalments, PAYG withholding, fringe benefits tax (FBT) instalments, luxury car tax (LCT) and fuel tax credit laws. Within a year after the introduction of the GST, it was reported that bookkeepers lodged around 8% of all BAS with the ATO on behalf of their clients. The Tax Agent Services Act 2009 and formation of the Tax Practitioners Board (TPB) Many bookkeepers provide BAS services to their clients, including the preparation of the monthly or quarterly BAS. For instance, according to a speech given by Mr Dale Pinto, the former Chair of the TPB on the Gold Coast on Friday, 19 March 2010, at the time, it was estimated that there were over 120,000 people working in the bookkeeping profession in Australia with around 12,000 to 18,000 (or around 10% to 15%) acting as contracting bookkeepers charging their clients a fee to prepare and lodge BAS’s on their behalf. The ATO reported that more than 18.6 million activity statements were lodged in the 2014/15 income year, the majority of which were prepared and lodged by tax agents and BAS agents. This caused a potential problem due to the operation of s 251L(6) of ITAA36, which at the time prevented a person from providing tax advice to a client and charging them a fee unless they: • were working under the direction of a registered tax agent, or

• were a member of a recognised professional accounting association. The definition of “tax advice” included GST, PAYG and FBT. Hence, it was realised that many bookkeepers (who were not registered tax agents, nor working directly under the supervision of a registered tax agent) who were charging a fee for preparing and lodging their clients’ BAS were technically in breach of s 251L(6) of ITAA36. To be in breach of s 251L(6) was regarded as a criminal offence and the person was subject to a substantial fine. To partly address this problem, the Tax Agent Services Bill 2008 was introduced into parliament on 13 November 2008 and Royal Assent was given to the Tax Agent Services Act 2009 on 26 March 2009. The Act came into operation on 1 March 2010. The TPB is an independent national body established to administer the Tax Agent Services Act 2009 and to regulate the conduct of tax agents, bookkeepers (referred to as “BAS agents”) and tax (financial) advisers (collectively referred to as “tax practitioners”) in Australia. The TPB is responsible for the registration and regulation of 41,227 tax agents, 14,715 BAS agents and 19,494 tax (financial) advisers in Australia. The TPB consists of a Board and Chair appointed by the Assistant Treasurer and seven part-time board members and include people with backgrounds in tax, accounting, bookkeeping, law, financial services, academia and business. The website of the TPB is www.tpb.gov.au. BAS agents and provision of BAS services The Tax Agent Services Act 2009 requires that any bookkeeper who provides a bookkeeping service for a fee, including providing a BAS advice and lodging BAS on behalf of a client, must be registered as a “BAS agent”. These bookkeepers are also referred to as “contract bookkeepers”. Services provided by a BAS agent are referred to as “BAS services”. It is important to note that the requirement to register with the TPB as a BAS agent only applies to self-employed bookkeepers (also known as “contract bookkeepers”) who charge clients a fee for providing BAS-related services. They do not apply to a bookkeeper who is an employee of a business and prepares the BAS on behalf of his/her employer in return for being paid a salary or wage. According to s 90-10 of the Tax Agent Services Act 2009, a BAS service is defined as a tax agent service that relates to attending to compliance work, providing advice and representing the entity in dealings with the ATO on behalf of a taxpayer in regards to a “BAS provision”. The definition of a “BAS provision” is therefore relevant. According to s 995-1(1) of ITAA97, a BAS provision includes: • GST law • wine equalisation tax (WET) law • LCT law • fuel tax law • fringe benefits tax law (relating to collection and recovery only) • PAYG withholding, and • PAYG instalments. The scope of services that a BAS agent can potentially offer a client is therefore restricted to indirect taxes, whereas a tax agent can consult on all taxes (including indirect taxes) if the relevant eligibility criteria relating to tax agents are met. Income tax and superannuation obligations are not a BAS provision and as such, fall under the scope of tax agent responsibilities.

The TPB has prepared an information sheet containing a table identifying common services provided by self-employed bookkeepers and whether the service meets the definition of a “BAS service”. Their website contains a table which provides a non-exhaustive list of the types of services that may, and may not, constitute a BAS service under the Tax Agent Services Act 2009. On 1 June 2016, following consultation with external stakeholders, the definition of a BAS service was further extended. This table (taking into account these extended BAS services) can be downloaded at www.tpb.gov.au/TPB/Register/0320_BAS_services.aspx and is reproduced below. Example of BAS services Service Applying to the Registrar for an ABN on behalf of a client

BAS service

X

Installing computer accounting software without determining default GST and other codes tailored to the client Coding transactions, tax invoices and transferring data onto a computer program for clients through processes that require the interpretation or application of a BAS provision

Not a tax agent service or BAS service

X

X

Coding transactions, tax invoices and transferring data onto a computer program for clients through processes that do not require the interpretation or application of a BAS provision

X

Confirming figures to be included on a client’s activity statement

X

Completing activity statements on behalf of an entity or instructing the entity which figures to include

X

General training in relation to the use of computerised accounting software not related to client’s particular circumstances

X

Preparing bank reconciliations

X

Entering data without involvement in or calculation of figures to be included on a client’s activity statement

X

Confirming the withholding tax obligations for the employees of a client

X

Services declared to be a BAS service by way of a legislative instrument issued by the TPB

X

Preparation and provision of a payment summary that may include reportable fringe benefits amounts and the reportable employer superannuation contributions

X

Registering or providing advice on registration for GST or PAYG withholding

X

Services under the Superannuation Guarantee (Administration) Act 1992 to the extent that they relate to a payroll function or payments to contractors

X

Determining and reporting the superannuation guarantee shortfall and associated administrative fees

X

Dealing with superannuation payments made through a clearing house

X

Completing and lodging the taxable payments annual report to the ATO on behalf of a client

X

Sending a tax file number (TFN) declaration to the Commissioner on behalf of a client

X

Registration of BAS agents with the TPB A person applying for registration as a BAS agent must apply to the TPB using the online registration form, which can be accessed from the TPB’s website at www.tpb.gov.au/TPB/Registering/Register_as_a_BAS_agent/TPB/Register/0325_Registration_as_a_BAS_agent.aspx Sole practitioners, partnerships and companies are all potentially eligible for registration as a BAS agent. Once the TPB has approved a BAS agent application, the registration is valid for three years. Requirements for registration In order to be eligible for registration as a BAS agent, the following requirements must be met: 1. the applicant must be at least 18 years of age to be eligible to apply 2. the applicant must be a fit and proper person 3. the applicant must satisfy the qualification and experience requirements (see below) 4. the applicant must maintain, or will be able to maintain, professional indemnity insurance cover that meets the TPB’s requirements, and 5. the applicant must complete an online application and provide supporting documents. Qualification requirements In terms of the qualifications required, a person seeking registration as a BAS agent must meet one of the following two educational requirements outlined in Item 101 or Item 102 of the Tax Agent Services Regulations 2009. The diagram below (reproduced from the TPB’s website) summarises the requirements under three items, namely: • primary qualification • Board approved GST/BAS course • relevant experience.

Option 1 — Item 101 Accounting qualifications Under Option 1, the applicant has been awarded a Certificate IV Financial Services (Bookkeeping) or a Certificate IV Financial Services (Accounting) from a registered training organisation or an equivalent institution. The certificate must include verification of successful completion of a course in basic GST and/or BAS taxation principles that has been approved by the TPB. Furthermore, the applicant must be able to prove that they have undertaken at least 1,400 hours of relevant experience (ie work by an individual as a registered agent or work under the supervision and control of a registered agent) in the past four years. This criteria is explained in further detail below. Option 2 — Item 102 Membership of professional association Under Option 2, the applicant has been awarded a Certificate IV Financial Services (Bookkeeping) or a Certificate IV Financial Services (Accounting) from a registered training organisation or an equivalent institution. The certificate must include verification of successful completion of a course in basic GST and/or BAS taxation principles that has been approved by the TPB. Furthermore, the applicant must be able to prove that they have undertaken at least 1,000 hours of relevant experience (ie work by an individual as a registered agent or work under the supervision and control of a registered agent) in the past four years. This criteria is explained in further detail below.

However, an added requirement is that the applicant must be a voting member of a recognised professional association. The full list of recognised professional associations and their relevant accreditation date can be accessed from the TPB’s website at www.tpb.gov.au/TPB/Qualifications_and_experience/Recognised_professional_associations/TPB/Qualifications_and_ex As at the date of writing, the following seven BAS agent professional associations have been recognised by the TPB: • Association of Accounting Technicians (Australia) Ltd • Association of Chartered Certified Accountants Australia and New Zealand • Australian Bookkeepers Association Ltd • Chartered Accountants in Australia and New Zealand • CPA Australia • Institute of Certified Bookkeepers, and • Institute of Public Accountants. Relevant experience requirements As explained earlier, an applicant must be able to prove that they have undertaken at least 1,000 hours (in the case of Option 2), or 1,400 hours (in the case of Option 1) of relevant experience (ie work by an individual as a registered agent or work under the supervision and control of a registered agent) in the past four years.

Under this requirement, the applicant must be able to demonstrate that they have worked: • as a registered tax agent or BAS agent • under the supervision and control of a registered tax agent or BAS agent, or • of another kind approved by the TPB. This work must have included substantial involvement in providing one or more BAS services (defined above). Most work in preparing the books and records of a business for the purposes of that business completing their BAS obligations, including their PAYG withholding and PAYG instalment obligations, will be considered as relevant experience for the purposes of registration as a BAS agent. However, work in preparing a return for a state tax obligation, such as payroll tax, is not considered relevant experience. In making a new application for registration as an individual BAS agent, the applicant will need to attach a completed “Statement of relevant experience for BAS agent (SRE)” form to their application. The information contained in the SRE form should provide evidence of the applicant’s substantial involvement in one or more types of BAS services. An SRE form contains the following information: • how the relevant experience was gained • the period of the relevant experience • a summary of BAS services provided for the relevant period, including the number of clients and activity statements prepared • comments from the applicant’s supervising agent or employer about their level of competence in the provision of BAS services, and • any additional information considered relevant in relation to the applicant’s relevant experience. The SRE must be signed by the supervising registered BAS or tax agent for the activities undertaken. Finally, the applicant must also provide independent verification of their experience. This may include providing a reference from a registered BAS or tax agent or references from two other individuals who are able to verify the type and amount of the applicant’s experience. Other individuals may include colleagues or clients. Complete an online application and provide supporting documents An applicant applying for registration as a BAS agent is required to complete the online registration form at myprofile.tpb.gov.au/TPBMember/My_Profile/New_Registration/TPBMember/New_Registration.aspx. The applicant is required to provide the TPB with the following documents: • electronic copies of academic transcripts from a registered training organisation or an equivalent institution, evidencing the completion of a Certificate IV Financial Services (Accounting) or a Certificate IV Financial Services (Bookkeeping) • statement/s of relevant experience from the relevant supervising tax agent, BAS agent or employer demonstrating required amount of experience • the name and contact details of two independent referees, and • membership details of any recognised BAS or tax agent association, if applicable. The TPB will advise the applicant after the decision is made to either grant or reject the application for registration. The TPB aims to process complete applications within 30 days of receiving them.

Pay the application fee As at the date of writing, the application fees for BAS agent registration were: • $100 — carrying on a business as a BAS agent, and • $50 — not carrying on a business as a BAS agent. The applicant must pay the application fee in full when he/she applies for the registration. Payment of the application fee can be made by BPay or credit card. Maintain professional indemnity (PI) insurance The Tax Agent Services Act 2009 requires all registered tax agents, BAS agents and tax (financial) advisers (collectively known as tax practitioners) to maintain PI insurance cover that meets the TPB’s minimum requirements. An agent that does not maintain adequate PI insurance will not continue meeting an ongoing registration requirement and may be in breach of the Code of Professional Conduct (Code). This can result in termination of their registration. The primary purpose of the TPB’s PI insurance requirements is to ensure that registered tax practitioners have adequate cover against claims made by their clients who suffer loss due to an act, error or omission in their provision of tax agent, BAS or tax (financial) advice services. The minimum amount of PI cover is based on a sliding scale corresponding to the agent’s turnover. As at the date of writing, a tax agent or BAS agent with an annual turnover of up to $75,000 (excluding GST) is required to maintain a minimum PI insurance cover of $250,000. For those tax agents and BAS agents with annual turnovers between $75,001 and $500,000 (excluding GST), the minimum PI insurance cover increases to $500,000, while for those agents with an annual turnover in excess of $500,000, the minimum PI insurance cover required is $1m. The policy must cover: • the agent • directors, principles, partners and employees who provide tax agent or BAS services on behalf of the agent • contractors if they do not have their own PI insurance cover. Agents must have the cover that includes the work of contractors for which the agent is liable, and • any other individuals or entities that provide tax agent or BAS services on behalf of the agent. Tax and BAS agents are required to provide the TPB with the details of their PI insurance within 14 days of receiving notification of their registration by completing the online notification form, which can be accessed at www.tpb.gov.au/myprofile. The Code of Professional Conduct The Tax Agent Services Act 2009 also prescribes the Code that applies to all registered tax agents, BAS agents and tax (financial) advisers. The Code is a set of legislated principles outlining the professional and ethical standards required of tax agents and BAS agents. The Code was issued on 16 December 2010 and is established under s 30-10 of the Tax Agent Services Act 2009. The Code includes 14 items grouped under the following five categories: • honesty and integrity • independence • confidentiality

• competence, and • other responsibilities.

For tax and BAS agents, each of these categories are fully detailed in TPB (EP) 01/2010 Code of Professional Conduct. The Code and its explanatory paper can be downloaded at www.tpb.gov.au/TPB/Publications_and_legislation/Board_policies_and_explanatory_information/TPB/Publications_and_ Continuing professional education (CPE) CPE is a requirement for the renewal of registration. This means that when renewing the tax agent, BAS agent or tax (financial) advice registration, the applicant must demonstrate that they have completed the CPE that meets the TPB’s requirements. The TPB may request the applicant to provide evidence of CPE that they have completed. Ensuring that tax and BAS agents maintain their knowledge and skills relevant to the services they provide is one of the obligations under the Code. The TPB has developed a CPE policy to assist agents to meet their obligations under the Code. A tax or BAS agent must ensure that the record of their CPE activities is maintained. There are a minimum number of CPE hours that should be completed over a CPE period. The CPE period is the agent’s registration period, which is usually three years. BAS agents are required to complete a minimum of 45 hours of CPE within a standard of three-year registration period, with a minimum of five hours each year. BAS agents with the condition of fuel tax credits should complete a minimum of six hours of CPE within a standard three-year registration period, with a minimum of two hours each year. Tax agents are expected to complete a minimum of 90 hours of CPE within a standard three-year registration period, with a minimum of 10 hours each year. Tax (financial) advisers are expected to complete a minimum of 60 hours of CPE within a standard three-year registration period, with a minimum of seven hours each year. Any education activity relevant to BAS services provided by a BAS agent that maintains, develops or promotes an applicant’s skills, knowledge or attributes is considered to be a CPE activity under the TPB’s CPE policy. CPE activities considered appropriate under the TPB’s policy include: • seminars, workshops, courses and lectures • structured conferences and discussion groups (including by phone or video conference) • tertiary courses provided by universities, registered training organisations, other registered higher education institutions or other approved course providers • other education activities provided by an appropriate organisation • research, writing and presentation by a registered tax (financial) adviser, tax or BAS agent of technical publications or structured training • peer review of research and writing submitted for publication or presentation in structured training • computer/internet-assisted courses, or audiotape or videotape packages • attendance at structured in-house training on tax related subjects by persons or organisations with suitable qualifications and/or practical experience in the subject area covered • attendance at appropriate ATO seminars and presentations • relevant CPE activities provided to members and non-members by a recognised professional association, and

• a unit of study or other CPE activity on the Tax Agent Services Act 2009 including the Code. A course that has been completed to obtain the registration or a renewal of registration will not generally constitute a CPE activity. However, a subsequent or higher level course relevant to the tax (financial) advice, tax agent or BAS services provided may be acceptable. The TPB has advised that no more than 25% of CPE should be undertaken through the relevant technical or professional reading. Furthermore, the provision of a tax (financial) advice, tax agent or BAS service will not, of itself, constitute a CPE activity. Register of tax agents and BAS agents As required by the Tax Agent Services Act 2009 and the Tax Agent Services Regulations 2009, details of each tax agent and BAS agent’s registration are made available to the public on the TPB’s register. The TPB register contains registration details of registered and deregistered tax agents, BAS agents and tax (financial) advisers. This register can be accessed at www.tpb.gov.au/TPB/Finding_and_using_a_practitioner/Search_the_register/tpb/agent_register.aspx. The search facility allows a member of the public to search for a tax agent, BAS agent or tax (financial) adviser by name, agent number, and street, suburb or postcode. Final word Finally, it is worth noting once again that the abovementioned provisions only apply to self-employed bookkeepers (also known as “contract bookkeepers”) who charge clients a fee for providing BASrelated services. They do not apply to a bookkeeper who is an employee of a business and prepares the BAS on behalf of his/her employer. In other words, if you are employed by a client as a bookkeeper (in the capacity of an employee), you are not required to register as a BAS agent as you are providing an employment service for a salary or wage. According to s 251L(6) of ITAA36, only registered tax agents, BAS agents and tax (financial) advisers can charge or receive a fee for providing tax agent, BAS or tax (financial) advice services to taxpayers. An unregistered person who provides a tax agent service (including a BAS service) contravenes s 50-5 of the Tax Agent Services Act 2009 and faces civil penalties of up to $45,000 (250 penalty units) for unregistered individuals who charge or receive a fee for providing BAS services and $225,000 (1,250 penalty units) for unregistered body corporates that charge or receive a fee for providing BAS services. Each penalty unit is equivalent to $180 (s 4AA, Crimes Act 1914).

Completing the Business Activity Statement Introduction

¶4-900

The GST section of the BAS

¶4-910

Accounting for GST on the accrual basis ¶4-920 Accounting for GST on the cash basis

¶4-930

¶4-900 Introduction Every month or quarter, an entity will receive a personalised, pre-printed activity statement from the ATO. These activity statements are sent via either the internet or to the nominated postal address on the Australian Business Register. Activity statements fall into one of two categories:

• Instalment Activity Statements (IAS), or • Business Activity Statements (BAS). An IAS is generally issued to entities that have an ABN but are not registered for GST. In contrast, a BAS is generally issued to entities that are registered for GST. The IAS allows entities to report and pay the following obligations to the ATO: • PAYG instalment • PAYG withholding • FBT instalment, and • deferred company/fund instalment (if applicable). In contrast, a BAS is generally issued to entities that are registered for GST. The BAS allows entities to report and pay the following obligations to the ATO: • GST obligations • PAYG instalment • PAYG withholding • FBT instalment • deferred company/fund instalment (if applicable), and • a range of other tax obligations including WET, LCT and fuel tax credits. A sample BAS is included at the end of this chapter (¶4-960). Many bookkeepers prepare the BAS on behalf of their clients, or assist their clients to prepare the BAS. If GST is understated in the BAS, the client is potentially exposed to an administrative penalty (being $180 for every 28 days that the BAS is lodged late) as well as the general interest charge (GIC) being levied by the ATO. Despite the fact that most computerised accounting packages automatically generate a BAS, it is important that bookkeepers understand how to prepare a BAS and how information contained in management accounts is used in preparing a BAS. The BAS is divided into six separate sections: 1. GST 2. PAYG tax withheld 3. PAYG income tax instalment 4. FBT instalment 5. Summary, and 6. Payment or refund? For the rest of this chapter, we will only focus on completing the GST section of the BAS.

¶4-910 The GST section of the BAS The “Goods and services tax (GST)” section of the BAS summarises the GST collected and paid by an

entity during the relevant period. The BAS will have the words “for the MONTH from …” or “for the QUARTER from …” printed underneath the heading “Goods and services tax (GST)” on the first page. The pre-printed BAS received from the ATO will also include the attribution basis (ie cash or accrual) next to the title “GST accounting method”.

¶4-920 Accounting for GST on the accrual basis To illustrate how the GST section of the BAS is completed, we will rely on the financial statements prepared for Gary Richardson Legal Practice (¶4-800) for the month ended 31 January 2017. At this point, we will assume Gary Richardson has adopted the accrual basis for reporting the GST. It is assumed that Gary is on a monthly tax period. In other words, the January 2017 BAS is required to be lodged no later than 21 February 2017. There are two methods that can be adopted in preparing the BAS: (a) the calculation worksheet method, or (b) the accounts method. (a) The calculation worksheet method The calculation worksheet method is a step-by-step way of calculating the GST on sales, purchases and importations using a GST calculation worksheet. The GST calculation worksheet is prepared using the information from the client’s accounts. There are 20 boxes to complete in the worksheet. Ultimately, seven of these figures are transferred to the BAS. The ATO has developed an interactive GST calculation worksheet designed to assist bookkeepers, which automatically adds, subtracts and calculates the amount of GST to be reported in the BAS. This interactive pdf document can be downloaded from the ATO’s website at www.ato.gov.au/WorkArea/DownloadAsset.aspx?id=10473. A copy of the GST calculation worksheet is included at the end of this chapter at ¶4-965. Furthermore, the ATO has provided a comprehensive example of how the GST calculation worksheet applies in the situation where the bookkeeper maintains a cashbook on behalf of the client. This example is contained on pp 44 to 47 of the ATO’s publication entitled GST — Completing Your Activity Statement (NAT 7392). This publication can be downloaded from the ATO website in pdf format at www.ato.gov.au/uploadedFiles/Content/ITX/downloads/BUSqc17458n7392.pdf. The GST calculation worksheet is generally prepared for businesses that use manual cash books. For this reason, the calculation worksheet method is not widely used and, as such, is not discussed in detail in this chapter.

IMPORTANT TIP REGARDING THE GST CALCULATION WORKSHEET METHOD If the BAS is prepared using the GST calculation worksheet, all figures entered into the worksheet must be shown GST-inclusive.

A sample of the completed GST calculation worksheet is shown as follows:

(b) The accounts method The accounts method derives its name due to the fact that the BAS is completed directly from the numbers contained within an entity’s management accounts (ie profit and loss statement and balance sheet). If the accounts method is used, Item G1 (Total sales) can be reported as either GST-inclusive or GST-exclusive. This choice must be indicated with a tick next to the question “Does the amount shown at Item G1 include GST?”. However, G1 is the only box where you indicate a choice to report either the GST-exclusive or GSTinclusive amounts. If the accounts method is used, all of the figures are derived from the entity’s management accounts. Provided that the entity is registered for GST, all figures in management accounts will be shown GSTexclusive as the GST would have been extracted from these figures (with the exception of accounts receivable and accounts payable, which are the only two figures that are shown inclusive of GST). It should be noted that many computerised accounting packages produce GST reports to assist bookkeepers and accountants prepare the BAS. Many of these reports show sales and purchases as GST-inclusive. If these figures are entered into the BAS, then the “yes” box should be ticked underneath Item G1. However, if the bookkeeper prints off the profit and loss statement and balance sheet of the business for

the relevant tax period, and uses these figures as the basis for entering the data into the BAS, then all of the figures entered into the BAS will be shown GST-exclusive. In this case, the “no” box should be ticked.

IMPORTANT TIP REGARDING THE ACCOUNTS METHOD If the BAS is prepared using the accounts method, the figures shown can either be entered as a GST-inclusive or GST-exclusive basis. This is to be contrasted to the GST calculation worksheet method, where all figures entered into the GST calculation worksheet are required to be shown GSTinclusive.

For the rest of this chapter, to illustrate how the GST section of the BAS is completed for Gary Richardson Legal Practice, we will be adopting the “accounts method”. As the figures will be derived from the profit and loss statement and balance sheet (as distinct from automatically-generated GST reports), all figures reported in the BAS will be on a GST-exclusive basis. The “Goods and services tax (GST)” section of the BAS contains five labels, namely: G1: Total sales G2: Export sales G3: Other GST-free sales G10: Capital purchases G11: Non-capital purchases. These figures form the basis of Item 1A “GST on sales” and Item 1B “GST on purchases” which are pivotal in determining the amount of GST payable to (or refundable by) the ATO for the relevant tax period. An extract of the GST section of the BAS is shown as follows:

G1: Total sales An entity is required to report the total sales during the relevant month or quarter at Item G1. For the purposes of Item G1, total sales comprise the sum of:

• all taxable sales • all GST-free sales, and • all input taxed sales made by an entity during the reporting period. An entity is required to advise whether the amount shown at Item G1 is GST-inclusive or GST-exclusive. Generally, if the amounts have been directly taken from the profit and loss statement, the amount shown at Item G1 will be shown on a GST-exclusive basis. In which case, the “no” box should be ticked in response to the question “Does the amount shown at G1 include GST?”. As previously mentioned, some computerised accounting systems produce GST reports that are generated using GST-inclusive figures. If the BAS is prepared using the figures contained in these GST reports, then the “yes” box should be ticked in response to the question “Does the amount shown at G1 include GST?”. Hence, bookkeepers should be very careful to ensure whether the amounts entered into the BAS are shown on a GST-inclusive or GST-exclusive basis. In the case of Gary Richardson (¶4-800), according to the profit and loss statement for the month ended 31 January 2017, his total sales were $8,000 (GST-exclusive). Accordingly, this amount should be entered at Item G1 on the BAS with a tick placed in the box underneath, indicating that this amount does not include GST. G2: Export sales As there were no export sales for the relevant tax period, Item G2 is left blank. There is no need to put a zero or any other mark in any box on the BAS where there is a $nil amount. G3: Other GST-free sales Once again, as there were no other GST-free sales during the relevant tax period, Item G3 is also left blank. G10: Capital purchases Item G10 requires an entity to report all capital purchases made during the relevant tax period. Capital purchases include the amounts of non-current assets acquired by the entity during the relevant tax period, such as plant and equipment, computer equipment, furniture and fittings, motor vehicles and land and buildings. Capital purchases do not include purchases of trading stock, normal expenses in running the business, such as postage, printing, stationery and repairs and maintenance or equipment rentals of leases. These items will be included at Item G11. The ATO has advised on pp 27 and 28 of their publication entitled GST — Completing Your Activity Statement (NAT 7392) that if an entity has an annual GST turnover of less than $1m, then it only needs to report assets acquired at Item G10 during the period if each asset acquired exceeds $1,000. Conversely, where an asset is acquired for $1,000 or less, it should be reported at Item G11 (Non-capital purchases). The amount to be reported at Item G10 can be ascertained by looking at the movement in the non-current assets section of the balance sheet from the previous BAS tax period. In the case of Gary Richardson, it will be observed from the balance sheet that Gary acquired furniture costing $72,727 (GST-exclusive) and computer equipment costing $40,182 (GST-exclusive) during January 2017 by paying cash. Accordingly, the total of these two GST-exclusive amounts (ie $112,909) should be entered at Item G10 of the BAS. G11: Non-capital purchases An entity is required to report all non-capital purchases made during the relevant month or quarter at Item G11 of the BAS. Non-capital purchases refer to the day-to-day expenses of the business. These expenses are derived from the profit and loss statement.

If these figures have been taken from management accounts, the amounts shown at Item G11 will be shown on a GST-exclusive basis. Conversely, if the amounts have been taken from the manual cash books prepared, the amount shown at Item G11 will generally be shown GST-inclusive. An entity has a choice as to whether it reports the figures at Item G11 on a GST-exclusive or GST-inclusive basis. However, out-of-scope supplies are not entered at Item G11. In other words, the following items are excluded from Item G11: • amortisation expense • annual leave, sick leave and long service leave expenses • donations made • depreciation expense • FBT paid • government fees and charges, such as ASIC lodgment fees, business name registration fees and stamp duty • gain and loss on sale of non-current assets • land tax • loan repayments • payroll tax • salaries and wages • superannuation contributions • transfer of monies between bank accounts • owner’s contributions, and • owner’s drawings. It is debatable whether those expenses in the profit and loss statement that are GST-free and input-taxed should be included as part of the “non-capital purchases” figure at Item G11. For example, council rates paid by an entity are coded to “FRE” as are most staff amenities paid for, such as tea, coffee and milk. Furthermore, bank charges and interest paid by an entity are input-taxed and, as such, no GST is included in these expenses in the profit and loss statement. Most computerised accounting packages produce GST reports which break down the capital and noncapital purchases made by an entity during the relevant tax period into the following four supplies, namely: • GST (taxable supplies) • FRE (GST-free supplies) • INP (input taxed supplies), and • N-T (out-of-scope supplies). The question is what amounts should be entered at Item G11 of the BAS — all four, three of them or only the ones with GST included? There are two options available to the bookkeeper:

• Option 1: Only include those non-capital purchases that have GST included, and, as such, exclude GST-free and input taxed non-capital purchases from Item G11, or • Option 2: Enter the total of all three supplies at Item G11 of the BAS (ie GST, FRE and INP). If Option 1 is adopted and only the amounts subject to GST were included, and if the accounts method was adopted to prepare the BAS, then the figures entered at Item G11 in the BAS would be on a GSTexclusive basis. This means that the amount of GST on purchases at Item 1B of the BAS would be equivalent to 1/10th of the amount shown at Item G11 (if the accounts method was used) or 1/11th of the amount recorded at Item G11 (if the GST calculation worksheet method was used). This provides a simple and useful reconciliation for the bookkeeper. Under Option 2, the bookkeeper will report the sum of those non-capital purchases that included GST as well as those non-capital purchases that were GST-free and input taxed. In this situation, as the amount of GST-free and input taxed non-capital purchases are included at Item G11, the amount of GST on purchases at Item 1B of the BAS would not be equivalent to 1/10th or 1/11th of the amount recorded at Item G11. The question is which option should be adopted when preparing the BAS. Unfortunately, the ATO’s GST — Completing your Activity Statement Guide (NAT 7392) is unclear on this issue and provides no specific clear guidance as to which option should be adopted. However, it is interesting to note that in the interactive GST calculation worksheet, in determining the figure to enter at Item G11 of the BAS, the ATO includes the sum of those non-capital purchases that included GST as well as those non-capital purchases that were GST-free and input taxed. In other words, the ATO has adopted Option 2. However, in determining the amount to be recorded at Item 1B of the BAS, the GST worksheet proceeds to deduct the amount of non-capital purchases that were GST-free and input taxed to determine the figure entitled “total non-capital purchases subject to GST”. This is Item G17 in the GST calculation worksheet. This amount is then divided by 11 to calculate the amount to be included at Item 1B. This is also consistent with what is required for Item G1 for “Total sales”. This interactive worksheet can be downloaded from the ATO’s website at www.ato.gov.au/WorkArea/DownloadAsset.aspx?id=10473. For this reason, Option 2 will be adopted in the worked examples throughout this chapter. In other words, the amount to be reported at Item G11 will be the sum of those non-capital purchases that included GST as well as those non-capital purchases that were GST-free and input taxed. This approach is consistent with the worked example contained on pp 41 to 48 of the ATO’s Record Keeping for Small Businesses (NAT 3029). In this worked example, the ATO includes bank charges of $15 (which is an input taxed transaction) as part of the amount to be reported at Item G11 (Non-capital purchases). This is the case despite the fact that no GST was attributable to bank charges and no part of the $15 bank charges in the worked example is recorded at Item 1B (GST on purchases). In the case of Gary Richardson, the following expenses (or non-capital purchases) for the month of January 2017 will be entered at Item G11 of the BAS: $ Electricity expense

245

Insurance expense**

2,400

Stationery expense

1,091

Total non-capital purchases

3,736

Note that in the case of insurance expense, despite the fact that an amount of $2,560 appears in the profit and loss statement for the month of January 2017, stamp duty of $160 is specifically excluded when entering the amount at Item G11. In other words, only $2,400 is shown as part of Item G11 of the BAS.

The reason for this is that the ATO has advised on p 29 of their publication entitled GST — Completing Your Activity Statement (NAT 7392) that stamp duty is to be specifically excluded from insurance premiums to be entered at Item G11. Furthermore, wages of $1,260 paid to Amanda are also excluded from Item G11 as this constitutes an out-of-scope supply. This is also confirmed on p 29 of the ATO publication referred to above. In summary, an amount of $3,736 should be included at Item G11. At this stage, the GST section of the BAS for the month of January 2017 appears as follows:

The next step is to complete the “summary” section of the BAS on the second page. The GST components of the summary section comprise: 1A: GST on sales 1B: GST on purchases. 1A: GST on sales (GST payable) The amount to be included at Item 1A of the BAS represents the amount of GST that an entity has charged the customers during the relevant tax period. As such, this amount represents the amount of GST owing by the registered business to the ATO (ie GST payable). As Gary Richardson accounts for GST using the accrual basis, the amount to be entered at Item 1A on the second page of the BAS should come directly from the balance of the “GST payable” account in the balance sheet. Accordingly, an amount of $800 should be entered at Item 1A of the BAS. This amount can be verified via the following formula:

[(G1 total sales − G2 export sales − G3 GST-free sales − GST payable  =

G4 input taxed sales included at Item G1) × 1/10th]

GST payable = [$8,000 − $nil − $nil − $nil] × 1/10th = $800

As the amount at Item G1 is reported as GST-exclusive (because the accounts method has been adopted), the amount reported at Item G1 should be divided by 10 in order to calculate the GST payable of $800. As can be seen, this amount reconciles to the balance of the “GST payable” account in the balance sheet as at 31 January 2017 (¶4-800). If the amounts entered at Item G1 were shown GST-inclusive, then the amount derived above would be multiplied by 1/11th and not 1/10th. If the entity accounts for GST under the cash basis, then the amount of GST payable in the balance sheet will not necessarily equal the amount to be included at Item 1A. The reason for this discrepancy is that under the GST cash basis, the amount to be entered at Item 1A is the amount of GST collected (in cash) during the relevant month or quarter. This takes into account the opening and closing accounts receivable balances. This concept is further explained in the illustrative example in ¶4-930 of this chapter. 1B: GST on purchases (GST receivable) The amount to be included at Item 1B on the BAS represents the amount of GST that an entity has been charged by the suppliers in acquiring assets, goods or services during the relevant tax period. As such, this amount represents the amount of GST that the entity can claim back from the ATO. As Gary Richardson accounts for GST using the accrual basis of accounting, the amount to be entered at Item 1B on the second page of the BAS should come directly from the balance of the “GST receivable” account in the balance sheet (¶4-800). Accordingly, an amount of $11,665 should be entered at Item 1B of the BAS. This amount can be verified via the following formula:

[(G10 capital purchases + G11 non-capital purchases – GST receivable

=

G13 input-taxed purchases – G14 GST-free purchases – G15 private purchases) × 1/10th]

GST receivable

=

[($112,909 + $3,736 − $nil − $nil − $nil) × 1/10th]

=

$116,645 × 1/10th

=

$11,665 (rounded)

Hence, the amount to be entered at Item 1B of the BAS is $11,665. As the amounts reported at Items G10 and G11 are reported as GST-exclusive (because the accounts method has been adopted), the amount derived from applying the above formula needs to be divided by 10 in order to determine the amount of GST receivable. If the amounts entered at Items G10 and G11 were shown GST-inclusive, then the amount derived above would be multiplied by 1/11th, and not 1/10th. If the entity accounts for GST under the cash basis, then the amount of GST receivable in the balance sheet will not necessarily equal the amount to be included at Item 1B. The reason for this discrepancy is that under the GST cash basis, the amount to be entered at Item 1B is the amount of GST paid (in cash) during the relevant month or quarter. This takes into account the opening and closing accounts payable balances. This concept is further explained in the illustrative example in ¶4-930 of this chapter.

IMPORTANT TIP REGARDING HOW TO CALCULATE THE AMOUNTS TO BE ENTERED FOR BOXES 1A AND 1B UNDER BOTH THE GST CALCULATION WORKSHEET METHOD AND THE ACCOUNTS METHOD

If the BAS is prepared using the “GST calculation worksheet method”, then all of the figures entered into the worksheet are shown GST-inclusive. Hence, in determining the amounts to be entered into Items 1A and 1B of the BAS, the amounts shown at Items G1, G10 and G11 must be divided by 11, and not 10. Most GST reports automatically generated by computerised accounting systems report these figures on a GST-inclusive basis. However, if the “accounts method” is used to prepare the BAS and the figures are taken directly from management accounts (ie the profit and loss statement and balance sheet) printed off by the bookkeeper, then the figures will be GST-exclusive. This means that in determining the amounts to be entered into Items 1A and 1B of the BAS, Items G1, G10 and G11 must be divided by 10, and not 11.

An extract from the second page of the BAS for the month of January 2017 is shown as follows:

The final step in preparing the BAS is to complete the “payment or refund?” section. The amounts on the left-hand side of the summary section of the BAS shown above are totalled and entered at Item 8A. In the case of Gary Richardson, it can be seen that Item 8A totals $800. Similarly, the amounts on the right-hand side of the summary section of the BAS shown above are totalled and entered at Item 8B. In the case of Gary Richardson, it can be seen that Item 8B totals $11,665. As item 8B (ie $11,665) is greater than Item 8A (ie $800), the net amount of $10,865 is refundable by the ATO. This amount is entered at Item 9 of the BAS as follows:

It will be noted that the net amount refundable of $10,865 reconciles to the net amount shown in the current liability section of the balance sheet of Gary Richardson Legal Practice as at 31 January 2017 (¶4800). An extract of the balance sheet is shown as follows: $ GST payable Less: GST receivable

800 (11,665)

($10,865)

The reason the two numbers reconcile is that management accounts have been prepared under the accrual accounting principles, which is the same GST attribution basis for the BAS. As will be seen in the next section (¶4-930), this will not necessarily be the case if the entity adopts the cash basis for GST. Finally, the declaration on the back of the second page of the BAS should be signed and dated. The entity is now ready to lodge its January 2017 BAS with the ATO. The due date for lodgment of the January 2017 BAS with the ATO is 21 February 2017. Gary should receive a refund of $10,865 in his nominated bank account within 14 days of the lodgment of the BAS. An extract of the declaration and payment advice section of the BAS is shown as follows:

Assume that on 22 February 2017, the ATO refunds Gary the $10,865 owing to him. This deposit is automatically paid to his business cheque account via EFT. The bookkeeper will record the following journal entry on this date: DATE Feb 22

PARTICULARS

POST REF

DEBIT

CREDIT

Cash at bank

1-100

10,865

GST payable

2-200

800

GST receivable

2-300

11,665

(Recording the net GST received from the ATO for the month of January 2017) Analysis The above journal entry will have the effect of reducing the balances of both the “GST payable” and “GST receivable” accounts. It is important that the bookkeeper debits “GST payable” for the gross amount of $800 and credits “GST receivable” for the gross amount of $11,665. This will have the effect of clearing both balances at 31 January 2017. The net amount received of $10,865 is debited to the “cash at bank” account. It is important that both GST accounts are debited and credited for their gross amounts. A common mistake made by many bookkeepers is to debit the “cash at bank” account for $10,865 and credit the “GST receivable” account for the net amount of $10,865 received from the ATO. If this journal entry is put through, the net, not the gross amounts, will be incorrectly posted to the “GST payable” and “GST receivable” accounts.

¶4-930 Accounting for GST on the cash basis Using the same information for Gary Richardson Legal Practice for the month of January 2017, we will

illustrate how the January 2017 BAS is prepared, assuming that the entity has elected to use the cash basis for GST. As Gary’s annual GST turnover is expected to be less than $2m, he is permitted to adopt the cash basis of GST. It will be remembered that under the cash basis, GST is payable to the ATO on the date when the cash has been received from the customers, not on the date when the tax invoice has been issued. Similarly, an input tax credit can be claimed when the payment for an expense or capital acquisition has been made, not when the tax invoice has been received. For bookkeeping purposes, as management accounts are prepared using accrual accounting principles, adjustments will need to be made to convert the figures contained in management accounts from an accrual basis to the cash basis for GST purposes. G1: Total sales An entity is required to report the total sales during the relevant month or quarter at Item G1. For the purposes of Item G1, total sales comprise the sum of: • all taxable sales • all GST-free sales, and • all input taxed sales made by the entity during the reporting period. In the case of Gary Richardson, according to the profit and loss statement for the month ended 31 January 2017 (¶4-800), his total sales were $8,000 (GST-exclusive). However, as management accounts have been prepared under the accrual accounting principles, revenue reported in the profit and loss statement may not only include cash sales but also the sales made on credit for which the cash has not yet been collected. Hence, the sales shown in the profit and loss statement may not necessarily be equivalent to the cash sales that need to be entered into the BAS if the cash basis of GST is adopted. In other words, if the entity adopts the cash basis of accounting for GST, then only the cash collected from the customers during January 2017 should be included at Item G1 of the BAS. Put simply, the amount to be included at Item G1 represents the sum of the sales made during the month of January 2017 plus monies collected from the debtors during the month of January 2017. However, as the business only commenced in January 2017, there were no receipts from any outstanding debtors as at 31 December 2016. The closing accounts receivable balance as at 31 January 2017 must be excluded as this amount represents sales made on credit, for which the cash has yet to be collected as at 31 January 2017. The formula to calculate the total sales for the purposes of Item G1 in the BAS if the cash basis of GST is used is as follows:

Total sales (G1)  =

[Total revenue + (10/11ths × Opening accounts receivable) – (10/11ths × Closing accounts receivable)]

As previously mentioned, all items of revenue are shown in the profit and loss statement on a GSTexclusive basis. However, accounts receivable balances shown in the balance sheet are GST-inclusive. As Item G1 is reported on a GST-exclusive basis under the “accounts method”, the opening and closing balances of accounts receivables must be converted from a GST-inclusive basis to a GST-exclusive basis. This is achieved by taking 10/11ths of the accounts receivable balances in the balance sheet at the beginning and the end of the relevant tax period. In Gary Richardson’s case, there was no opening balance of accounts receivable (¶4-800). However, according to the balance sheet as at 31 January 2017, the closing balance of accounts receivable was

$1,400. Applying the above formula results in the following calculation: Total sales (Item G1) = [$8,000 + ($10/11ths × $nil) – (10/11ths × $1,400)] = [$8,000 + $nil − $1,273] = $6,727 Accordingly, this amount should be entered at Item G1 on the BAS. As this amount is GST-exclusive, the “no” box should be ticked in response to the question, “Does the amount shown at G1 include GST?”. G2: Export sales As there were no export sales for the relevant tax period, Item G2 is left blank. There is no need to put a zero or any other mark in any box on the BAS where there is a $nil amount. G3: Other GST-free sales Once again, as there were no other GST-free sales during the relevant tax period, Item G3 is also left blank. G10: Capital purchases Under the cash basis, Item G10 requires an entity to report all capital purchases paid for in cash during the relevant tax period. This amount can be ascertained by looking at the movement in the non-current assets section of the balance sheet from the previous BAS tax period. In the case of Gary Richardson, it will be observed from the balance sheet that Gary acquired furniture costing $72,727 (GST-exclusive) and computer equipment costing $40,182 (GST-exclusive) during January 2017 by paying cash. There was no opening balance of property, plant and equipment. Hence, it can be concluded that the total amount of capital purchases made during the month of January 2017 was $112,909. This amount should be entered at Item G10 of the BAS. G11: Non-capital purchases An entity is required to report all non-capital purchases made during the relevant month or quarter at Item G11. Non-capital purchases generally refer to the day-to-day expenses of the business. Most of the expenses shown in the profit and loss statement will be entered at Item G11 of the BAS. However, out-of-scope supplies are not entered at Item G11. Furthermore, as previously explained, the approach adopted in this book is to include at Item G11, the sum of those non-capital purchases that included GST as well as those non-capital purchases that were GST-free and input taxed. In the case of Gary Richardson, the following expenses (or non-capital purchases) for the month of January 2017 will be entered at Item G11 of the BAS: $ Electricity expense

245

Insurance expense **

2,400

Stationery expense

1,091

Total non-capital purchases

3,736

Note that in the case of insurance expense, despite the fact that an amount of $2,560 appears in the profit and loss statement for the month of January 2017, stamp duty of $160 is specifically excluded when entering the amount at Item G11. In other words, only $2,400 is shown as part of Item G11 of the BAS. Furthermore, wages of $1,260 paid to Amanda are also excluded from Item G11 as this constitutes an out-of-scope supply.

This gives a subtotal of $3,736 for non-capital purchases. However, as management accounts have been prepared under the accrual accounting principles, these expenses may not only include cash expenses but also the expenses incurred on credit for which the cash has not yet been paid as well as various month-end expense accruals. Hence, expenses shown in the profit and loss statement may not necessarily be equivalent to the cash expenses that need to be entered into the BAS if the cash basis of GST is adopted. In other words, if the entity adopts the cash basis of accounting for GST, then only the cash paid in respect of the expenses during January 2017 should be included at Item G11 of the BAS. Put simply, the amount to be included at Item G11 represents the sum of cash expenses paid for during the month of January 2017 plus monies paid to creditors during the month of January 2017. However, as the business only commenced in January 2017, there were no payments to any outstanding creditors as at 31 December 2016. The closing accounts payable balance as at 31 January 2017 must be excluded as this amount represents expenses incurred on credit, for which the cash has yet to be paid as at 31 January 2017. The formula to calculate the non-capital purchases for the purposes of Item G11 in the BAS if the cash basis of GST is used is as follows:

Non- purchases (G11)  = [Total revenue + (10/11ths × Opening accounts receivable) – (10/11ths × Closing accounts receivable)]

As previously mentioned, all expenses are shown in the profit and loss statement on a GST-exclusive basis. However, accounts payable balances shown in the balance sheet are GST-inclusive. As Item G11 is reported on a GST-exclusive basis under the “accounts method”, the opening and closing balances of accounts payable must be converted from a GST-inclusive basis to a GST-exclusive basis. This is achieved by taking 10/11ths of accounts payable balances in the balance sheet at the beginning and the end of the relevant tax period. In Gary Richardson’s case, there was no opening or closing balances of accounts payable. Applying the above formula results in the following calculation: Non-capital purchases (Item G11)

=

[$3,736 − (10/11ths × $nil) – (10/11ths × $nil)]

=

[$3,736 + $nil − $nil]

=

$3,736

Accordingly, an amount of $3,736 should be entered at Item G11 on the BAS. The reason that this amount is the same under both the accrual basis and cash basis is that all expenses were paid in cash during the month of January 2017. Hence, there was no closing balance of accounts payable in the balance sheet. At this stage, the GST section of the BAS appears as follows:

The next step is to complete the “summary” section of the BAS on the second page. The GST components of the summary section comprise: 1A: GST on sales 1B: GST on purchases. 1A: GST on sales (GST collected) The amount to be included at Item 1A of the BAS represents the amount of GST (in cash) that an entity has collected from the customers during the relevant tax period. As such, this amount represents the amount of GST owing by the registered business to the ATO (ie GST payable). As Gary Richardson accounts for GST using the cash basis, the amount to be entered at Item 1A on the second page of the BAS represents the actual amount of GST collected (in cash) from the customers during the month of January 2017. This amount is not necessarily the same figure that appears in the “GST payable” account in the balance sheet as at 31 January 2017. As management accounts are prepared using the accrual accounting principles, the “GST payable” account balance in the balance sheet is based on the date the invoices were issued to the customers, not when the cash has been received. In order to verify the amount of GST collected (Item 1A), the following formula can be applied:

[(G1 total sales − G2 export sales − G3 GST-free sales − GST payable  =

G4 input taxed sales included at Item G1) × 1/10th]

GST payable = [$6,727 − $nil − $nil − $nil] × 1/10th = $672 As the amount at Item G1 is reported as GST-exclusive (because the accounts method has been adopted), the amount reported at Item G1 should be divided by 10 in order to calculate the “GST payable” figure of $672. If the amounts entered at Item G1 was shown GST-inclusive, then the amount derived would be multiplied by 1/11th, and not 1/10th. Under the GST cash basis, the GST payable (Item 1A) is calculated as $672. It will be observed from the balance sheet of Gary Richardson Legal Practice, as at 31 January 2017 (¶4-800) that the “GST payable” balance is shown as $800. However, it needs to be remembered that this amount has been determined using the accrual accounting principles, not cash accounting concepts. As such, these two amounts will never be the same unless there is no opening or closing balances of accounts receivable or where both the opening and closing balances of accounts receivable are the same. Where an entity adopts the cash basis of accounting for GST, then the “GST payable” and “GST receivable” amounts reported in the BAS will be based on the actual cash amounts of GST collected and paid by the entity during the tax period. As such, it is highly unlikely that the “GST payable” and “GST receivable” balances in the balance sheet will ever match the amounts included at Items 1A and 1B of the BAS. 1B: GST on purchases (GST paid) The amount to be included at Item 1B on the BAS represents the amount of GST that an entity has actually paid to the suppliers in acquiring assets, goods or services during the relevant tax period. As such, this amount represents the amount of GST that the entity can claim back from the ATO. As Gary Richardson accounts for GST using the cash basis, the amount to be entered at Item 1B on the second page of the BAS represents the actual amount of GST paid (in cash) to the suppliers for the month of January 2017. This amount is not necessarily the same figure that appears in the “GST receivable” account in the balance sheet as at 31 January 2017. As management accounts are prepared using the accrual accounting principles, the “GST receivable” account balance in the balance sheet is based on the dates of invoices issued by the suppliers, not when the cash has been paid. In order to verify the amount of GST on purchases, the following formula can be applied:

[(G10 capital purchases + G11 non-capital purchases – GST receivable

=

G13 input-taxed purchases – G14 GST-free purchases – G15 private purchases) × 1/10th]

GST receivable = [($112,909 + $3,736 − $nil − $nil − $nil) × 1/10th] = $116,645 × 1/10th = $11,665 (rounded) Hence, the amount to be entered at Item 1B of the BAS is $11,665. It will be noted from the balance sheet of Gary Richardson Legal Practice as at 31 January 2017 that the “GST receivable” balance is shown as $11,665 (¶4-800), which is the same amount as the figure entered at Item 1B of the BAS. The reason that these two figures are the same in this instance is that there are no opening and closing balances of accounts payable.

An extract from the second page of the BAS for the month of January 2017 is shown as follows:

The final step in preparing the BAS is to complete the “payment or refund?” section. The amounts on the left-hand side of the summary section of the BAS shown above are totalled and entered at Item 8A. In the case of Gary Richardson, it can be seen that Item 8A totals $672. Similarly, the amounts on the right-hand side of the summary section of the BAS shown above are totalled and entered at Item 8B. In the case of Gary Richardson, it can be seen that Item 8B totals $11,665. As Item 8B (ie $11,665) is greater than Item 8A (ie $672), the net amount of $10,993 is refundable by the ATO. This amount is entered at Item 9 of the BAS as shown as follows:

Finally, the declaration on the back of the second page of the BAS should be signed and dated. The entity is now ready to lodge its January 2017 BAS with the ATO. The due date for lodgment of the January 2017 BAS with the ATO is 21 February 2017. Gary should receive a refund of $10,993 in his nominated bank account within 14 days of the lodgment of the BAS. An extract of the declaration and payment advice section of the BAS is shown as follows:

Assume that on 22 February 2017, the ATO refunds Gary the $10,993 owing to him. This deposit is automatically paid into his business cheque account via EFT. The bookkeeper will record the following journal entry on this date: DATE Feb 22

PARTICULARS Cash at bank

POST REF 1-100

DEBIT 10,993

CREDIT

GST payable

2-200

GST receivable

672

2-300

11,665

(Recording the net GST received from the ATO for the month of January 2017) Analysis The above journal entry will have the effect of reducing the balances of both the “GST payable” and “GST receivable” accounts. It is important that the bookkeeper debits “GST payable” for the gross amount of $672 and credits “GST receivable” for the gross amount of $11,665. The net amount received of $10,993 is debited to the “cash at bank” account. It is important that both GST accounts are debited and credited for their gross amounts. A common mistake made by many bookkeepers is to debit the “cash at bank” account for $10,993 and credit the “GST receivable” account for the net amount of $10,993 received from the ATO. If this journal entry is put through, the net, and not the gross amounts, will be incorrectly posted to the “GST payable” and “GST receivable” accounts.

¶4-950 Accounting for GST — commonly asked questions Question What is the GST and when did it commence in Australia?

Answer The GST commenced in Australia on 1 July 2000 replacing the wholesale sales tax and some state indirect taxes.

The principal Act governing the operation of GST is the A New Tax System (Goods and Services Tax) Act 1999 as amended (the “GST Act”).

The major principles of GST are: • GST is a flat 10% broad-based indirect tax on the private consumption of most goods and services in Australia and importations into Australia • the price of all goods and services are required to be shown inclusive of GST. In order to calculate the amount of GST included in the price of goods or services, you simply divide by 11 • the tax is charged and collected by registered entities at each stage in the production chain • the supplier is required to provide the customer/client with a “tax invoice” • at the same time, the supplier of goods or services is entitled to claim a credit for any GST paid. This credit is known as an “input tax credit” • the “net amount” of GST (ie GST collected minus GST paid) is remitted by the registered

entity to the ATO each month or quarter on a form called the “Business Activity Statement” (BAS), and • the tax is ultimately borne by the end consumer, not by producers or suppliers. What is GST charged on?

According to s 7-1(1) of the GST Act, GST is payable on “taxable supplies” and “taxable importations”. Section 9-10 of the GST Act defines a taxable supply as: • the supply of goods • the supply of services • the provision of advice or information • a grant, assignment or surrender of real property • a creation, grant, transfer, assignment or surrender of any right • a financial supply, and • an entry into or release from an obligation to do anything, to refrain from an act, or to tolerate an act or situation.

As a general rule, the act of providing something by one entity to another entity is a supply for GST purposes. How do I work out the GST on a taxable supply?

The rate of GST in Australia is currently 10%. GST of 10% is added to the “value” of the supply to give the “price” of the goods or services. In other words:

Price = [Value + 10%]

In Australia, according to the Competition and Consumer Act 2010 (formerly, the Trade Practices Act 1974), all prices are required to be shown inclusive of all taxes and charges.

Hence, to calculate the amount of GST that has been included in the price of goods or services being sold, you divide the price by 11. Put another way, the GST payable on a taxable supply is 1/11th of the price displayed.

For GST purposes, what are the four types of supplies?

For the purposes of the GST Act, there are four types of supplies: • taxable supplies • GST-free supplies • input taxed supplies, and • out-of-scope supplies.

A taxable supply is one on which the supplier charges the 10% GST. In this situation, the registered entity is able to claim back input tax credits on the inputs used to provide the taxable supply.

A GST-free supply is one on which the supplier is not required to charge the 10% GST. However, the registered entity is able to claim back any input tax credits in making those supplies.

An input taxed supply is one which the supplier is not required to charge the 10% GST to the consumer. However, unlike a GST-free supply, the supplier is not able to claim an input tax credit on the inputs used to produce the input taxed supply.

An out-of-scope supply is one which falls outside the scope of the GST Act and, as such, has no GST implications whatsoever. At what point do I need to register for the GST?

According to Div 23 of the GST Act, an entity is required to register for GST if it carries on an enterprise and its GST (annual) turnover exceeds $75,000 per annum. In the case of non-profit organisations, the registration threshold is set at $150,000 per year.

If these thresholds are exceeded, an entity must register for GST. However, if the thresholds are not

met, GST registration is voluntary. Entities can register online at abr.gov.au/For-Business,-Superfunds---Charities/Applying-for-an-ABN.

GST registration must be made within 21 days of becoming required to register. The ATO notifies the entity in writing that the registration has taken effect.

When an entity registers for GST, it is issued with an ABN. The ABN must be displayed on all invoices issued by the entity.

An entity with a turnover of less than $75,000 is not required to register for GST. However, they must still register for an ABN from the ATO. The ABN is a unique 11-digit number.

Their ABN must be displayed on all invoices issued; however, they are not permitted to charge the customer the 10% GST (as only the businesses registered for the GST can do so).

What is the difference between the cash and accrual basis of accounting for GST? How do I know which attribution basis my client is using?

According to Div 29 of the GST Act, an entity has a choice of two methods in accounting for GST: • the cash method, or • the (non-cash) accrual method.

The choice of whether an entity uses the cash or accrual basis of accounting for GST is usually made by the accountant or tax agent. This choice is made on the application form.

Under the cash basis of accounting, GST is payable on a taxable supply in the tax period when the cash is received from the customer in respect

of a taxable supply, not on the date of the tax invoice. Similarly, an input tax credit for a creditable acquisition can only be claimed when the entity makes the payment, not on the date of issue of the tax invoice (s 29-5(2) and 29-10(2), GST Act).

Under the accrual basis of accounting, GST is payable on a taxable supply in the tax period in which the entity received consideration for the supply, or the tax invoice is issued to a customer, whichever is the earlier.

Similarly, an input tax credit for a creditable acquisition can be claimed in the tax period in which the entity paid for the goods or services or the tax invoice has been received, whichever is the earlier.

Regardless of whether the entity has elected to account for GST on a cash or accrual basis, the bookkeeper should still record transactions in the accounting system using the accrual accounting concepts.

You can tell which attribution basis (ie cash or accrual) your client has adopted as this is preprinted on the top right-hand corner of the first page of the BAS next to the words “GST accounting method”. Where should I show the “GST payable” and “GST The “GST payable” account should be shown as a receivable” accounts in the chart of accounts? current liability account in the balance sheet. This account represents the amount of GST charged to the clients. The account is considered a liability as it represents the amount of GST owing by the registered business to the ATO.

The “GST receivable” account represents the amount of GST paid by the business in respect of the expenses and assets used for business purposes.

While the “GST receivable” account is essentially an asset account, it is common for this account to be shown as a contra-current liability underneath the “GST payable” account. This way the “GST payable” and “GST receivable” accounts can be netted off and shown next to each other in the current liabilities section of the balance sheet. When do I need to issue a tax invoice? What information needs to be included on the tax invoice?

Where an entity is registered for GST and makes a taxable supply, it is required to issue a tax invoice within 28 days of the date of sale for all supplies with a total GST-exclusive price exceeding $75 (ie $82.50 inclusive of GST).

According to s 29-70(1) of the GST Act, a tax invoice is required to include the following: • that it is issued by the supplier (except for recipient created tax invoices) • it must be in the approved form • that the document is intended as a tax invoice (usually with the words “tax invoice” clearly displayed) • the supplier’s identity (eg its legal name, business name or trading name) • the supplier’s ABN • the date the tax invoice was issued • a brief description of the items sold, including the quantity (if applicable) and the price of what is sold • where the price of the supply is $1,000 or more (including GST), the tax invoice must also include the buyer’s identity or ABN • the GST amount (if any) payable in relation to the sale — this can be shown separately or, if the GST to be paid is exactly 1/11th of the total price, as a statement such as “total price includes GST”, and • the extent that each sale to which the document relates is a taxable sale.

The GST included in the price can either be shown separately or must contain a statement stating that the amount payable is inclusive of GST.

Where the amount of GST is not exactly 1/11th of the price (ie the supply consists of a taxable supply and a GST-free supply), then the amount of GST payable must be separately disclosed. This is referred to as a “mixed supply”.

It is important to remember that an entity must also hold valid tax invoices for all creditable acquisitions to be able to claim input tax credits. What is a tax period for GST purposes?

An entity that is registered for GST must lodge a BAS for each tax period. According to Div 27 of the GST Act, there are two tax periods for GST purposes: • quarterly, and • monthly.

Generally speaking, an entity has a choice of either quarterly or monthly tax periods. There are some exceptions for entities which are required under the GST Act to adopt a monthly tax period. When do I need to lodge my BAS with the ATO?

An entity has a choice of either quarterly or monthly tax periods. However, an entity must use a monthly tax period if it: • has a GST turnover of $20m or more • is only carrying on an enterprise for less than three months, or • has a history of failing to comply with tax obligations.

In the case of an entity with a quarterly tax period, the BAS is required to be lodged with the ATO no later than the 28th day of the month following the end of the tax period. For example, for the quarter ending on 30 September, the BAS must be lodged no later than 28 October.

The only exception is the December quarter,

where the BAS is not required to be lodged with the ATO until 28 February (instead of 28 January).

In the case of an entity with a monthly tax period, the BAS is required to be lodged with the ATO no later than the 21st day of the month following the end of a tax period. For example, for the month ending on 30 September, the BAS must be lodged no later than 21 October. My client has elected to use the cash basis for GST purposes.

In the case of the cash basis, GST is payable to the ATO in the tax period when the cash is received, not in the tax period in which the invoice is issued. Similarly, GST is claimed back in the period during which the amount was paid to Why does the amount at Item 1A (GST on sales) in suppliers, not in the period in which the supplier’s the BAS not equate to the “GST payable” amount invoice was received by the entity. in the balance sheet at the end of the tax period?

For accounting purposes, transactions are entered Similarly, why does the amount at Item 1B (GST into the accounting system based on the accrual on purchases) in the BAS not equate to the “GST accounting principles. receivable” amount in the balance sheet at the end of the tax period? If a client adopts the cash basis for GST, the GST payable to the ATO is based on the amount of cash actually collected from the customers during the tax period. The GST payable account in the balance sheet is based on 1/11th of the amount invoiced to the clients. For this reason, an adjustment is required to convert the amount from accrual to cash by taking into account the opening and closing balances of accounts receivable.

Similarly, in the case of GST receivable, GST receivable from the ATO is based on the amount of cash actually paid to the suppliers during the tax period. The GST receivable account in the balance sheet is based on 1/11th of the invoices received from the suppliers. These amounts may not have necessarily been paid during the tax period. For this reason, an adjustment is required to convert the amount from accrual to cash by taking into account the opening and closing balances of accounts payable. For these reasons, under the GST cash accounting method, the amounts shown at Items 1A and 1B of the BAS will not necessarily equal the balances of GST payable and GST receivable

accounts at the end of the relevant tax period in the balance sheet.

¶4-955 Sample Statement by a Supplier form

¶4-960 Sample business activity statement (BAS)

¶4-965 GST calculation worksheet

¶4-970 Sample chart of accounts (for a company)1 Account number

Account name

GST tax code2

1-0000

Assets

1-1000

Cash on hand

N-T

1-1100

Petty cash

N-T

1-1200

Cash float

N-T

1-1300

Cash at bank — cheque account

N-T

1-1400

Cash at bank — savings account

N-T

1-2000

Accounts receivable

N-T

1-2100

Provision for doubtful debts

N-T

1-3000

Inventory

N-T

1-4000

Prepaid expenses (eg prepaid rent)3

GST

1-4500

Income tax receivable

N-T

1-5000

Other current assets

N-T

1-6000

Land

CAP

1-7000

Buildings

CAP

1-7100

Accumulated depreciation

N-T

1-7200

Plant and equipment

CAP

1-7300

Accumulated depreciation

N-T

1-7400

Computer equipment

CAP

1-7500

Accumulated depreciation

N-T

1-7600

Furniture and fittings, at cost

CAP

1-7700

Accumulated depreciation

N-T

1-7800

Motor vehicles

CAP

1-7900

Accumulated depreciation

N-T

1-8000

Intangibles4

CAP

1-8100

Less: Accumulated amortisation

N-T

1-8200

Other non-current assets

N-T

1-8300

GST deferred

N-T

2-0000

Liabilities

2-1000

Bank overdraft

N-T

2-2000

Accounts payable

N-T

2-2100

Accrued expenses

N-T

2-2200

Customer deposits (lay-bys)

N-T

2-2300

Credit cards (eg Visa, Mastercard)

N-T

2-2400

Revenue received in advance (or unearned income)5

GST

2-2500

GST payable

N-T

2-2600

Less: GST receivable

N-T

2-2700

PAYG withholding

N-T

2-2800

PAYG instalment

N-T

2-2900

FBT instalment

N-T

2-3000

ABN withholding payable

N-T

2-3100

Income tax payable

N-T

2-3200

Superannuation payable

N-T

2-3300

Provision for annual leave

N-T

2-3400

Provision for sick leave

N-T

2-3500

Provision for long service leave (current portion)

N-T

2-3600

Loans payable (current portion)

N-T

2-3700

Other current liabilities

N-T

2-4000

Lease liability

N-T

2-4100

Hire purchase liability

N-T

2-4200

Chattel mortgage liability

N-T

2-4300

Loans payable (non-current portion)

N-T

2-4400

Provision for long service leave (non-current portion)

N-T

2-4500

Other non-current liabilities

N-T

2-4600

GST deferred

N-T

3-0000

Shareholders’ equity

N-T

3-1000

Share capital

N-T

3-2000

Retained profits/(accumulated losses)

N-T

3-3000

Reserves (eg asset revaluation reserve)

N-T

4-0000

Revenues

4-1000

Sales

GST

4-2000

Sales returns and allowances

GST

4–3000

Services income

GST

4-4000

Consulting fees

GST

5-0000

Cost of goods sold (assuming periodic)6

5-1000

Opening inventory

N-T

5-2000

Purchases

GST

5-3000

Purchase returns and allowances

GST

5-4000

Closing inventory

N-T

6-0000

Expenses7

6-1000

Accounting fees

GST

6-1100

Advertising and promotion

GST

6-1200

Amortisation expense

N-T

6-1300

Annual leave expense

N-T

6-1400

ASIC lodgment fees

N-T

6-1500

Assets costing less than $20,000 8

GST

6-1600

Bad debts expense

GST

6-1700

Bank charges

INP

6-1800

BAS rounding9

N-T

6-1900

Bookkeeping fees

GST

6-2000

Borrowing costs

INP

6-2100

Car parking

GST

6-2200

Cash over and short

N-T

6-2300

Chattel mortgage repayments

N-T

6-2400

Christmas party10

GST

6-2500

Cleaning

GST

6-2600

Courier fees

GST

6-2700

Computer accessories

GST

6-2800

Depreciation expense

N-T

6-2900

Electricity

GST

6-3000

Employee benefits (GST)

GST

6-3100

Employee benefits (no GST)

N-T

6-3200

Entertainment — employees (deductible)10

GST

6-3300

Entertainment — employees (non-deductible)10

GST

6-3400

Entertainment — clients

N-T

6-3500

Formation costs

GST

6-3600

Freight charges

GST

6-3700

Fringe benefits tax paid

N-T

6-3800

General expenses

GST

6-3900

Hire purchase repayments

N-T

6-4000

Impairment loss

N-T

6-4100

Insurance (put in note for partial GST)

GST

6-4200

Interest paid

INP

6-4300

Internet fees

GST

6-4400

Inventory write-down expense

N-T

6-4500

Land tax

N-T

6-4600

Late fees/fines and penalties

N-T

6-4700

Lease payments11

GST

6-4800

Legal expenses

GST

6-4900

Licences

GST

6-5000

Long service leave expense

N-T

6-5100

Loss on sale of non-current assets

N-T

6-5200

Merchant fees

GST

6-5300

Motor vehicle expenses

6-5310

– depreciation (deductible)

N-T

6-5320

– depreciation (non-deductible)

N-T

6-5330

– fuel and oil

GST

6-5340

– insurance (partial GST note)

GST

6-5350

– interest

N-T

6-5360

– other

GST

6-5370

– registration

FRE

6-5380

– repairs and maintenance

GST

6-5400

Office supplies

GST

6-5500

Payroll tax

N-T

6-5600

Postage, printing and stationery

GST

6-5700

Registration fees

GST

6-5800

Rates

FRE

6-5900

Rent

GST

6-6000

Repairs and maintenance

GST

6-6100

Salaries and wages

N-T

6-6200

Security expenses

GST

6-6300

Sick leave expense

N-T

6-6400

Staff amenities (eg tea, coffee, biscuits)

6-6500

Staff training

GST

6-6600

Subscriptions

GST

6-6700

Sundry expenses

GST

6-6800

Superannuation expense

N-T

6-6900

Taxi fares

GST

6-7000

Telephone and facsimile charges

GST

6-7100

Travel and accommodation12

GST

6-7200

Uniforms

GST

6-7300

Water charges

FRE

6-7400

Website costs

GST

6-7500

Workers compensation13

GST

GST/FRE

8-0000

Other income

8-1000

Dividends received

INP

8-2000

Gain on sale of non-current assets

N-T

8-3000

Interest received

INP

8-4000

Rent received

GST

8-5000

Royalties received

GST

8-6000

Bad debts recovered

GST

8-7000

Grants received

GST

8-8000

Donations received

N-T

9-0000

Other expenses

9-1000

Income tax expense

N-T

9-2000

Dividends paid

INP

Abbreviations: N-T

= No tax (out-of-scope supply)

GST = Goods and services tax CAP = Capital acquisitions INP

= Input taxed

FRE

= GST-free

Notes: 1. In preparing this chart of accounts, it is assumed that the entity is a company. 2. The GST tax codes shown next to each account in the chart of accounts are based on “typical” tax codes. For example, in the expense codes, it is assumed that the accountant, bookkeeper, cleaner, landlord and lawyer are registered for GST. For this reason, the tax code is “GST”. However, if they were not registered for GST, then this tax code would change to “N-T” as the entity would not be able to claim back any input tax credits. Similarly, general and sundry expenses may comprise a combination of individual expenses that may or may not include GST. For this reason, bookkeepers should take care in making sure that the correct amount of GST has been recorded in respect of each transaction. 3. In the case of prepaid expenses, GST can be claimed in the tax period when the prepayment is made or in the tax period when the tax invoice is received, whichever is the earlier (s 29-10, GST Act). 4. In the case of intangibles, some intangibles that are purchased may have GST included, while others do not. This is particularly so in the case of purchase of a going concern, where a business may be acquired GST-free under certain conditions. 5. In the case of revenue received in advance, GST must be paid to the ATO in the tax period in which the tax invoice is provided or in the tax period in which the monies are received, whichever is the earlier (s 29-5, GST Act). 6. The cost of goods sold section of the chart of accounts is based on the company adopting a periodic

inventory system, rather than a perpetual inventory system (refer to Chapter 5, commencing at ¶5000 for the difference between the two types of inventory systems). In the case of a periodic inventory system, the “inventory” account balance in the balance sheet is coded to “N-T” with the “purchases” and “purchases returns and allowances” accounts coded to “GST”. In the case of a perpetual inventory system, the “inventory” account in the balance sheet would be coded to “GST”. 7. Several expenses (eg insurance) have been coded to “GST” in the chart of accounts; however, typically in these expenses, the amount of GST included in the total price is not necessarily 1/11th of the total amount of the tax invoice. This is known as a mixed supply. Bookkeepers should take particular care in ensuring that the correct amount of GST has been recorded for these and other transactions. 8. The account “assets costing less than $20,000” is based on the simplified depreciation rules relating to SBEs. These are defined as entities with an annual turnover of less than $2m per year. An SBE is entitled to an immediate 100% deduction for any depreciating asset costing less than $20,000 acquired from 7.30 pm on 12 May 2015 to 30 June 2017. 9. The expense account “BAS rounding” has been included due to the fact that the amounts shown on the BAS must be shown in whole dollars, whereas accounts appearing in the balance sheet (eg GST payable, GST receivable, PAYG withholding and PAYG instalment) usually include cents. The difference in rounding is usually coded to this account. 10. The expense accounts “Christmas party” and “entertainment — employees (deductible)” have been coded to GST on the basis that these transactions are subject to FBT. However, if the company has adopted the actual method of valuing meal entertainment fringe benefits, then these items may be exempt for FBT purposes by virtue of the application of the “s 41 property fringe benefit” and “s 58P minor fringe benefit” exemptions. In this case, these items should be coded to “entertainment — employees (non-deductible)”as these are not subject to FBT. Accordingly, no input tax credits can be claimed back which is why these are coded to “N-T”. Alternatively, if the entity has used the 50/50 split method, then half of entertainment is coded to clients and the other half to employees. 11. The chart of accounts contains the account “lease payments”. In the case of a lease, the input tax credit is claimable when each lease payment is made (in the case of the cash basis) or when the obligation to make each lease payment occurs (in the case of the accrual basis). The accounting, taxation and GST considerations of leases are specifically outlined in Chapter 7 (commencing at ¶7770). 12. In the case of “travel and accommodation”, the account is coded to “GST” on the basis that all travel and accommodation occurs within Australia. In the case of overseas travel and accommodation, the GST code “FRE” will apply instead. 13. In the case of “workers compensation”, in some states and territories the entire workers compensation premium includes GST, while in other states and territories, only part of the premium is subject to GST, with the other part being coded to “N-T”.

Finally, it is stressed that the abovementioned GST tax codes only apply to “typical” transactions, not specific transactions. The chart of accounts is not intended to be used as a template in all circumstances. These GST tax codes may vary depending on the circumstances of the client. In other words, specific transactions may have different GST tax codes than the ones identified in the above chart of accounts. Accordingly, if the bookkeeper has created the chart of accounts, they are strongly advised to send the chart of accounts (and the GST tax codes) to the client’s external accountant for review. If the GST tax codes have been incorrectly established, this will affect the amount of GST shown in the client’s BAS. This could potentially expose the client to a range of

penalties, fines and interest charges being imposed by the ATO.

5 ACCOUNTING FOR CASH, DEBTORS AND CREDITORS Importance of cash

¶5-000

Controls over cash

¶5-100

Petty cash

¶5-200

Bank reconciliations

¶5-300

Accounts receivable

¶5-400

Accounts payable

¶5-500

Cash, debtors and creditors — commonly asked questions ¶5-600

¶5-000 Importance of cash Every business, regardless of its size, is dependent on cash and cash flows. For this reason, cash is one of the most important assets of a business. Without adequate cash flows, the business will surely fail. The amount of cash a business has represents the ability of that business to meet its short-term and longterm obligations and determines its rate of expansion for the future. However, because cash is the most liquid asset, it is susceptible to theft and misappropriation, particularly in small organisations where controls are often weak and one person is responsible for a variety of functions. In practice, virtually every transaction involves a flow of cash. In the case of revenue, a business may sell goods for cash or on credit. Cash sales result in an immediate cash inflow. In the case of credit sales, cash is ultimately received from debtors resulting in a cash inflow at a later point. Similarly, expenses may be settled in cash or on credit. Cash payments result in an immediate cash outflow. Payments made to creditors result in a cash outflow at a later point. From an accounting perspective, the term “cash” is used to describe coins, notes, cheques, money orders, cash on hand, petty cash, EFTPOS and credit card sales. The sum of all cash items is usually reported as current assets in the balance sheet under the following headings: • cash on hand • petty cash, and • cash at bank. If a business has a bank overdraft (ie a negative cash at bank balance), this is usually disclosed as a current liability. The following is an extract from the 2016 financial statements of Virgin Australia Ltd. Note E2 on p 68 reproduced below shows the breakdown of the various cash accounts in their 2016 financial statements under the heading entitled “cash and cash equivalents”. The total cash balance of Virgin Australia Ltd as at 30 June 2016 was $1.124b.

Controls Over Cash Introduction

¶5-100

Controls over cash receipts

¶5-110

Controls over cash payments

¶5-120

¶5-100 Introduction Because cash is the easiest asset to misappropriate, it is vitally important that the owner or owners of the business set up a good system of internal control over cash. Diagram 5.1 summarises the two controls over cash. Diagram 5.1: Controls over cash

¶5-110 Controls over cash receipts Cash receipts may originate in a number of ways. The two most common controls are cash received through over-the-counter sales and mail receipts of cheques from debtors. The following controls over cash receipts are recommended: • ensure that only designated personnel are authorised to handle the cash receipts (ie cashiers) • in the case of cash and cheques received through mail, ensure wherever possible that mail receipts are opened in the presence of two employees • if cash or cheques are received through mail, ensure that a list of cheques and remittance advice is prepared, summarising all cash and cheques received and sent to the person responsible for banking the monies. A copy of this remittance advice should be sent to the person responsible for entering the transaction into the accounting system • in the case of cash sales, an entity should use the cash register to record each sale. A cash register tape is locked into the register until removed by a supervisor or manager. The tape accumulates all of the daily cash, EFTPOS and credit card transactions that have occurred. When the tape is removed at the end of each day, the total takings on the tape should reconcile to the total amount of cash plus EFTPOS and credit card slips in the cash register. Ideally, a second individual should count these receipts from the cash register and verify them against the tape. The second person should then prepare a deposit slip and attend to banking the money and any manual credit card vouchers • all cheques and cash received through mail and over-the-counter sales should be banked daily. Monies should not be left in the office overnight. If this is necessary because the bank is closed or it is not practical to deposit the monies that day, make sure that it is locked away securely, preferably in an office safe. It is not advisable to take the money home • wherever possible, ensure that different individuals are responsible for handling the cash and

cheques, recording transactions into the accounting system and banking the monies • ensure that there is a cash register which keeps a record of the amount of cash sales during the day. At the end of each day, this tape should be printed off and reconciled to the amount of cash and EFTPOS and credit card receipts in the cash register. Ideally, a second individual should count these receipts from the cash register and verify them against the tape. The second person should then prepare a deposit slip and attend to banking the money and any manual credit card vouchers, and • lock away petty cash in a small office safe.

¶5-120 Controls over cash payments Cash may be disbursed in a number of ways and for a number of reasons. For example, a business may pay wages or rent, repay borrowings owing to the bank or purchase non-current assets. Generally, internal controls over cash payments are more effective when the payment is made by cheque or electronic transfer, rather than by cash. The following controls over cash payments are recommended: • establish a business cheque account to enable all major payments to be made by cheque or electronic transfer • establish a petty cash fund to cover small incidental cash payments (eg paying taxi fares) • ensure that only designated personnel are authorised to sign the cheques (ie the owner) • where possible, ensure that at least two signatories are required for each cheque drawn • never leave the cheque books lying around • never sign blank cheques • wherever possible, ensure that different individuals are responsible for approving and making payments and recording transactions into the accounting system • ensure that only appropriate people have access to the internet banking account passwords and access codes (or devices) • ensure that all payments are made with a properly approved invoice or tax invoice attached • for all petty cash reimbursements, ensure that a “petty cash voucher” slip is completed with the receipt or invoice stapled to the voucher • once paid, the invoice should be stamped “paid” and the cheque number should be written underneath the stamp to prevent the possibility of the invoice being paid twice, and • perfom bank reconciliations for all bank accounts regularly.

Petty Cash Introduction

¶5-200

Establishing the petty cash fund

¶5-210

Making payments from the petty cash fund ¶5-220 Replenishing the petty cash fund

¶5-200 Introduction

¶5-230

Many businesses maintain a petty cash fund to deal with small incidental cash payments. For example, it would be impractical to draw a cheque to buy tea, coffee or milk from the local convenience store for employees. Similarly, to purchase the stamps from Australia Post, it is easier to pay by cash than by cheque. A petty cash fund is maintained to enable these and other small expenses to be paid in cash. The money itself is usually stored in a small petty cash box or tin and maintained under the supervision of the petty cashier. There are three steps to maintaining a petty cash fund: • establishing the fund (¶5-210) • making payments from the fund (¶5-220), and • replenishing the fund (¶5-230). Each of these steps is discussed in turn.

¶5-210 Establishing the petty cash fund The first decision that needs to be made is how much petty cash is required. This amount varies between organisations; however, an amount of $100 or $200 is relatively common. To establish the petty cash fund, a cash cheque is usually drawn from the main business bank account. The monies are then placed in the petty cash box and controlled by an individual known as the petty cashier. Assume that on 1 May 2017, McMahon & Tate, a firm of architects who are registered for GST, set up a petty cash fund by depositing $200 from their main business cheque account. The journal entry to record the establishment of the petty cash fund on this date is as follows: DATE May 1

PARTICULARS Petty cash Cash at bank

POST REF 1-1100 1-1300

DEBIT

CREDIT 200 200

(Establishing the petty cash fund) The petty cash account is shown as a current asset in the balance sheet.

¶5-220 Making payments from the petty cash fund When a payment is made from the fund, an employee is required to complete a “petty cash voucher” and present it to the petty cashier together with the receipt or invoice for the expenditure. An example of a petty cash voucher is shown as follows:

Once the employee is reimbursed, the petty cashier usually stamps the voucher “paid” to indicate that the payment has been made. The employee and the petty cashier should also sign or initial the petty cash voucher. The receipt (or tax invoice) provided by Officeworks is usually provided to the petty cashier who then staples it to the back of the petty cash voucher. No accounting journal entry is made to record the payment from the petty cash fund at this time. Preparing a journal entry for every disbursement would give rise to a considerable amount of bookkeeping work and posting for relatively small amounts of money. Instead, accounting entries are made when the petty cash fund is replenished (usually at the end of each month). At all times, the sum of petty cash vouchers and the amount of cash remaining in the fund should equal the initial amount of petty cash (in our example, $200). Hence, after the payment of the abovementioned amount of $16, the amount of cash and vouchers in the petty cash box should equal $200, which comprises: $ Cash remaining in the petty cash fund

184.00

Petty cash vouchers

16.00

Initial amount in the petty cash fund

200.00

¶5-230 Replenishing the petty cash fund When the amount of cash remaining in the petty cash fund decreases, it will need to be replenished. At this point, the petty cashier provides a summary of petty cash vouchers to the finance officer or owner of the business. Petty cash vouchers and accompanying receipts are examined by the finance officer or business owner to verify their validity. At that point, the bookkeeper enters petty cash vouchers into the accounting system. At the same time, the finance officer or business owner reimburses the petty cashier for the total amount of petty cash vouchers. For example, assume that on 31 May 2017, the cash in the petty cash fund has declined to $24. In other words, the petty cash box contains $24 in cash and $176 in petty cash vouchers consisting of the following: • stationery receipts $36.80 (GST-inclusive) • taxi receipts $58.30 (GST-inclusive) • car parking receipts $16.70 (GST-inclusive) • tea, coffee and milk bought for the staff room $64.20 (GST-exclusive). Assume that a decision is made to also replenish the petty cash fund on this date. The journal entry recorded by McMahon & Tate is: DATE

PARTICULARS

POST REF

May 31

Postage, printing and stationery

6-5600

33.45

Taxi fares

6-6900

53.00

Car parking

6-2100

15.18

Staff amenities (tea, coffee and milk)

6-6400

64.20

GST receivable

2-2600

10.17

Cash at bank

1-1300

DEBIT

CREDIT

176.00

(To replenish the petty cash fund) The “GST receivable” account of $10.17 comprises those items that attract GST (ie stationery, taxi fares and car parking). There is no GST on tea, coffee and milk as these items are GST-free. The $10.17 debited to the “GST receivable” account comprises $111.80 × 1/11th. Note that the petty cash account itself is not affected by the reimbursement. The balance of the petty cash fund as at 31 May 2017 remains at $200 (being the balance of $24 plus the $176 deposited into the fund). Even if the petty cash fund is not running low, the fund should still be replenished at the end of each month so that the expenses (and the GST paid) can be recorded by the bookkeeper in the correct reporting period for accounting and GST purposes. As illustrated above, the total of the cash remaining in the petty cash box ($24) plus the petty cash vouchers and receipts ($176) should equal $200. However, there may be occasions where the petty cashier has made a mistake resulting in a cash shortage or overage in the petty cash fund. In this case, the account “cash over and short” is debited or credited for the difference. To illustrate, assume that in the previous example, the balance of cash in the petty cash box as at 31 May 2017 was only $20 instead of $24. Petty cash vouchers totalled $176. The total of cash plus the vouchers equals $196, not $200. Hence, there has been a cash shortage of $4. The journal entry on 31 May 2017 to record the $4 shortage, and to replenish the petty cash from $20 to $200 is as follows: DATE

PARTICULARS

POST REF

May 31

Postage, printing and stationery

6-5600

33.45

Taxi fares

6-6900

53.00

Car parking

6-2100

15.18

Staff amenities (tea, coffee and milk)

6-6400

64.20

Cash over and short

6-2200

4.00

GST receivable

2-2600

10.17

Cash at bank

DEBIT

CREDIT

1-1300

180.00

(To replenish the petty cash fund) The account “cash over and short” is usually recorded as an expense in the profit and loss statement if there is an understatement or as “other income” if there is an overstatement. There is no GST applicable in respect of this account.

Bank Reconciliations ¶5-300 Bank reconciliations Most businesses have one or more bank accounts. These may include a cheque account, high-interest bearing savings account or at call investment account. The use of a business cheque account contributes significantly to the effective internal control of cash. Each period (usually fortnightly, monthly or quarterly) the bank sends the account holder a bank statement detailing all of the transactions for the period. These transactions include: • all deposits made into the bank account (shown as credits on the bank statement) • all payments made from the bank account (shown as debits on the bank statement), and

• the opening and closing balances of the bank account (may either be debit or credit). A typical bank statement is shown as follows:

It will be noted that the balance of the cheque account as at 31 March 2017 is $13,790 credit. The bank statement is prepared from the bank’s perspective, not the entity’s perspective. Hence, $13,790 is shown as a liability of the bank as it owes this money to The Barber Shop Pty Ltd. From the perspective of The Barber Shop Pty Ltd, the $13,790 represents an asset and, hence, will be shown as a debit balance in their accounts. When the bank issues a bank statement, the bookkeeper should prepare a bank reconciliation. As the name suggests, the purpose of the bank reconciliation is to reconcile the closing cash at bank balance shown on the bank statement (ie what the bank says the cash balance is) to the “cash at bank” account shown in the entity’s general ledger account at that date. There are several reasons why these two amounts may differ: • Time lags occur between when the business records the transaction in its books and when the bank records the transaction. For example, a deposit may have been entered in the business’ management accounts but the bank may not have processed the deposit. These are referred to as “outstanding deposits”. Similarly, the business may have written a cheque and recorded the outgoing in the business’ management accounts, although the payee has not yet presented the cheque to their

bank. These are referred to as “unpresented cheques”. • Amounts reported on the bank statement that have not yet been entered into the accounting records of the entity, such as bank charges, account keeping fees, interest earned or any other direct receipts. • Errors were made by the bank or the business. For example, a cheque may have been written for $182; however, the bookkeeper may have inadvertently entered it into the business’ records as $128. The bank statement will correctly show an amount of $182, causing a discrepancy of $54 between the bank’s balance and the entity’s cash at bank balance. Accordingly, the purpose of bank reconciliation is to reconcile the closing cash balance that appears on the bank statement to the cash at bank balance shown in the entity’s balance sheet. Specifically, bank reconciliation serves three important purposes: • Firstly, it allows the business owner to keep track of the cash flow. • Secondly, it provides an important security measure — business owners can be sure all monies have been deposited as intended and that all cheques have cleared — nothing has gone missing or remains unaccounted for. • Thirdly, it allows the bookkeeper to pick up any amounts shown in the bank statement that are not recorded in the books, such as bank charges levied by the bank, interest received and other direct receipts, and make appropriate adjustments in the entity’s books. Before performing a bank reconciliation, it is important to have the following documents on hand: • the bank statement received from the bank (in this chapter, all examples are based on the assumption that the bank issues monthly bank statements) • the most recent bank reconciliation prepared • a printout of all cash receipts and cash payments for the month (generally taken from a printout of the “cash at bank” account in the general ledger), and • a printout of the balance sheet showing the closing cash at bank balance at the end of the month. Once all of these documents are close at hand, the bookkeeper should perform the following steps as part of the reconciliation process: Step 1: Refer to the previous bank reconciliation for any outstanding items The first step is to refer to the bank reconciliation prepared for the previous month. Any outstanding items appearing in the previous bank reconciliation (eg unpresented cheques or outstanding deposits) that now appear in the current month’s bank statement (either on the debit or credit side) should be ticked off. These amounts have now been accounted for in the current month’s bank statement. If any of these amounts still do not appear on the current month’s bank statement, they should be included as outstanding items in the current bank reconciliation. Step 2: Compare cash receipts in the entity’s books to the amounts appearing on the credit side of the bank statement Compare the cash receipts for the month (which appear on the debit side of the “cash at bank” account in the general ledger) to the amounts shown on the credit side of the bank statement. Items that appear in both sets of records should be ticked off. In other words, if a deposit for $1,440 appears as a cash receipt in the entity’s books and on the credit side of the bank statement, both items should be ticked off. This means that the deposit has been picked up by the bank and recorded in the entity’s books. Conversely, if an amount appears in the entity’s books as a deposit, but is not shown on the credit side of the bank statement, this is referred to as an “outstanding deposit”. This means that while the deposit has

been recorded in the entity’s books, the bank has not yet processed the deposit, ie it has not yet been reflected in the bank’s records. Outstanding deposits are noted in the bank reconciliation. Step 3: Items that appear on the credit side of the bank statement but not in the entity’s books There may be amounts that appear on the credit side of the bank statement (ie deposits made to the entity’s account) that do not appear in the “cash at bank” account in the general ledger. There are two common examples — interest received and direct receipts from customers. Firstly, interest credited by the bank will appear as a deposit on the credit side of the bank statement. Typically, the amount of interest cannot be determined until the bank statement arrives. Hence, interest received will not appear in the entity’s accounting records until the bookkeeper enters the amount from the bank statement. Secondly, some customers may have paid their accounts directly into the entity’s bank account via EFT or direct credit and have not notified the entity of this payment. In some cases, the customer may not identify the invoice number they have paid, so the bookkeeper may need to conduct further investigations to determine where these deposits have come from and ensure that they are credited. Accordingly, interest received and other deposits that appear on the credit side of the bank statement that have not been entered in the entity’s records should be circled on the bank statement and noted in the bank reconciliation. These amounts will now need to be entered into the accounting system by the bookkeeper via a general journal entry. Step 4: Compare cash payments in the books of the entity to the amounts appearing on the debit side of the bank statement Compare the cash payments for the month (which appear on the credit side of the “cash at bank” account in the general ledger) to the amounts shown on the debit side of the bank statement. Items that appear in both sets of records should be ticked off. In other words, if a payment for $280 appears as a cash payment in the entity’s books and on the debit side of the bank statement, both items should be ticked off. This means that the payment has been picked up by the bank and recorded in the entity’s books. Conversely, if an amount appears in the entity’s books as a payment, and is not shown on the debit side of the bank statement, this is referred to as “unpresented cheque”. This means that while a cheque has been written and recorded in the entity’s books, the cheque has not yet been presented by the payee. Unpresented cheques are noted in the bank reconciliation. Step 5: Items that appear on the debit side of the bank statement but not in the entity’s books There may be amounts that appear on the debit side of the bank statement (ie withdrawals or payments made from the entity’s bank account) that do not appear in the entity’s “cash at bank” account in the general ledger. A common example is bank charges or account keeping fees. The bank will automatically deduct these bank charges or account keeping fees from the bank account. Typically, a business will become aware of these bank charges when the bank statement is issued. Any debits on the bank statement which do not appear in the “cash at bank” account in the general ledger should be circled on the bank statement and noted in the bank reconciliation. These amounts will need to be entered into the accounting system by the bookkeeper via a general journal entry. Other direct debits which have been set up by the business for the payment of regular expenses such as rent, lease payments, electricity and other utility expenses should also be recorded by the bookkeeper upon the receipt of monthly invoices rather than waiting until the bank statement arrives to record these expenses in management accounts. Step 6: Adjust for any errors made by the bank or the entity Errors can be made by the entity or the bank. Once the nature of the error has been ascertained, it must be accounted for in the reconciliation statement. For example, if the entity made an error (eg recording a cheque for $467 instead of $476 in its books), the $9 adjustment needs to be recorded in the accounts. In this case, the “cash at bank” account in the general ledger will need to be reduced by $9. Conversely, if the bank has made an error, no adjustment needs to be made in the entity’s books.

Instead, the bank should be contacted immediately regarding the error. If (and when) corrected, it is expected that the correction will come through in the next bank statement. Step 7: Prepare the bank reconciliation The final step involves the bookkeeper preparing bank reconciliation. The “cash at bank” account figure in the balance sheet should equal the balance as per the bank statement. If these two amounts correspond, bank reconciliation has been completed correctly. Worked Example 1 We will now apply these steps to perform a bank reconciliation for The Barber Shop Pty Ltd for the month of March 2017.

Step 1: Refer to the previous bank reconciliation for any outstanding items As it is the first month of its operation, there is no previous bank reconciliation. The bank has provided us with the bank statement (see earlier). A printout of the “cash at bank” general ledger account for the month of March 2017 is as follows: Cash at Bank 25,000 4 Mar

1-1300

2 Mar

Share capital

Computer system

16 Mar

Client fees

3,200 9 Mar

Printer

634

25 Mar

Client fees

4,400 12 Mar

Wages

1,260

27 Mar

Client fees

1,750 17 Mar

Legal fees

980

30 Mar

Client fees

2,440 19 Mar

Printing & stationery

147

20 Mar

Accounting fees

410

23 Mar

Rent Telephone

36,790 31 Mar

Balance b/d

26 Mar

Wages

28 Mar

Petty cash

30 Mar

Insurance expense

31 Mar

Balance c/d

12,400

2,820 270 1,260 212 1,560 14,837 36,790

14,837

Step 2:  Compare cash receipts in the entity’s books to the amounts appearing on the credit side of the bank statement The second step in preparing a bank reconciliation is to compare the cash receipts for the month of March 2017 (which appear on the debit side of the “cash at bank” general ledger account) to the amounts shown on the credit side of the bank statement. Items that appear in both sets of records should be ticked off. It will be observed that the deposits on 2, 16, 25 and 27 March shown in the general ledger account have cleared on the bank statement. However, the last deposit on 30 March 2017 for $2,440 is not shown on the credit side of the March 2017 bank statement. This means that the bank has not yet processed the deposit. Presumably, this will be shown in the April 2017 bank statement. This is referred to as “outstanding deposit”. Outstanding deposits are noted in the bank reconciliation. Step 3: Items that appear on the credit side of the bank statement but not in the entity’s books It will be observed that on 31 March 2017, the bank has credited the entity’s bank account with $38 interest. This amount does not appear on the debit side of the “cash at bank” general ledger account as

the business generally only becomes aware of interest received when the bank statement is issued by the bank. Hence, the $38 interest received needs to be recorded in the books of the entity. This is done via the following journal entry: DATE Mar 31

PARTICULARS Cash at bank

POST REF

DEBIT

1-1300

Interest received

CREDIT 38

8-3000

38

(To record interest received from the Bank of Australia for the month of March 2017) Step 4:  Compare cash payments in the books of the entity to the amounts appearing on the debit side of the bank statement The fourth step is to compare the cash payments for the month of March 2017 (which appear on the credit side of the “cash at bank” general ledger account) to the amounts shown on the debit side of the bank statement. Items that appear in both sets of records should be ticked off. This means that the payment has been picked up by the bank. It will be observed that all payments appearing on the credit side of the “cash at bank” general ledger account have been cleared by the bank, except for the following two amounts: • legal fees (cheque 102) — $980 • accounting fees (cheque 105) — $410. While these cheques have been written, they have not been presented to the bank by the respective payees by 31 March 2017. Accordingly, they do not appear on the 31 March 2017 bank statement. These are referred to as outstanding cheques and need to be reflected in the bank reconciliation. Step 5: Items that appear on the debit side of the bank statement but not in the entity’s books It will be observed that on 31 March 2017, the bank has charged an account keeping fee of $13 (no GST) and merchant fee of $22 (GST-inclusive). These amounts do not appear on the credit side of the “cash at bank” general ledger account as the business only becomes aware of these charges when the bank statement is issued by the bank. Hence, both amounts need to be recorded in the books of the entity. This is done via the following journal entry: DATE Mar 31

PARTICULARS

POST REF

DEBIT

CREDIT

Bank charges

6-1700

13

Merchant fees

6-5200

20

GST receivable

2-2600

2

Cash at bank

1-1300

35

(To record bank charges and merchant fees for the month of March 2017) There is no GST associated with bank fees. These are input taxed supplies. However, merchant fees attract GST, so these are shown inclusive of GST on the bank statement. The amount debited to the “merchant fees” account is for $20 (being $22 × 10/11ths) with the “GST receivable” account debited for the GST of $2 (being $22 × 1/11th). Step 6: Adjust for any errors made by the bank or the entity As all amounts have been correctly identified in both sets of records (ie the “cash at bank” general ledger account and the bank statement), it can be concluded that there were no errors made by the entity or the

bank. Step 7: Prepare the bank reconciliation The final step involves the bookkeeper preparing bank reconciliation. The bank reconciliation for The Barber Shop Pty Ltd for the month of March 2017 is shown as follows:

After making the necessary adjustments, the “cash at bank” general ledger account appears as follows: Cash at Bank 25,000 ✓ 4 Mar

1-1300

Share capital

16 Mar

Client fees

3,200 ✓ 9 Mar

Printer

634 ✓

25 Mar

Client fees

4,400 ✓ 12 Mar

Wages

1,260 ✓

27 Mar

Client fees

1,750 ✓ 17 Mar

Legal fees

980 u/p

30 Mar

Client fees

2,440 o/s 19 Mar

Printing & stationery

147 ✓

31 Mar

Interest received

Accounting fees

410 u/p

38 ✓ 20 Mar 23 Mar

Computer system

12,400 ✓

2 Mar

Rent Telephone

31 Mar

Balance b/d

270 ✓ 1,260 ✓

26 Mar

Wages

28 Mar

Petty cash

30 Mar

Insurance expense

31 Mar

Account keeping fees

13 ✓

Merchant fees

22 ✓

31 Mar 36,828

2,820 ✓

Balance c/d

212 ✓ 1,560 ✓

14,840 ✓ 36,828

14,840

* o/s = outstanding deposit u/p = unpresented cheque

It will be observed that the “cash at bank” general ledger account shown above now totals $14,840. This is $3 more than the bank balance prior to Step 1 of the bank reconciliation process (ie $14,837). This small increase is due to the recording of extra transactions which have been discovered during this

process, ie addition of interest received of $38 on the debit side and the accounting keeping fee of $13 and merchant fees of $22 on the credit side. Now that all the adjustments have been recorded, we can now see that the balance of the “cash at bank” account equals the bank statement and this means that the bank reconciliation has been completed correctly. A copy of the bank statement (complete with ticks and circled amounts) is shown as follows:

Accounts Receivable Controls over accounts receivable

¶5-400

Initial recording of accounts receivable ¶5-410 Valuation of accounts receivable

¶5-420

Writing off bad debts

¶5-430

Recovery of a bad debt

¶5-440

¶5-400 Controls over accounts receivable

Accounts receivable represent amounts owing by customers and other entities to a business. Accounts receivable are also known as trade debtors. An account receivable is generally recognised when goods or services are sold to customers on credit. The customer is given a specified period of time to pay the account. Most businesses require customers to settle their accounts within 14 days, 30 days or 60 days. Accounts receivable are shown as a current asset in the balance sheet because they represent the right to receive cash in the future. Accounts receivable are an important asset of an organisation. Delays or failure to collect the accounts owing can result in cash flow shortages and profit erosion. The following general controls over accounts receivable are recommended: • ensure that credit and collection policies are in writing • conduct credit checks on new credit customers • regularly perform the ageing of accounts and have an independent review of the report • cross-check transactions such as non-cash credits and write-off of bad debts • have a well-documented and strict policy for the follow-up of overdue accounts • ensure cross-checking of early payment discounts and penalties on overdue accounts, and • reconcile trial balances with general ledger control accounts.

¶5-410 Initial recording of accounts receivable When an entity sells goods or provides services to a customer on credit for $3,300 (GST-inclusive), the following journal entry is put through: DATE May 26

PARTICULARS Accounts receivable — Joshua Brookes

POST REF 1-2000

DEBIT

CREDIT

3,300

Sales

4-1000

3,000

GST payable

2-2500

300

(Sale of goods to Joshua Brookes, on credit) In this example, the entity has sold goods to Joshua Brookes on credit for $3,300. “Accounts receivable” is debited for the full GST-inclusive amount of $3,300. Of this amount, $3,000 (or 10/11ths of the amount invoiced) is credited to “sales” (revenue), and the remaining $300 is (being 1/11th of $3,300) credited to the “GST payable” account in the balance sheet. The above journal entry assumes that the entity accounts for GST using the accrual basis. Assuming that Joshua Brookes pays the amount owing to the entity on 12 June 2017, the bookkeeper will put through the following journal entry: DATE June 12

PARTICULARS Cash at bank Accounts receivable — Joshua Brookes (Collection of accounts receivable from Joshua Brookes)

POST REF 1-1300 1-2000

DEBIT

CREDIT

3,300 3,300

¶5-420 Valuation of accounts receivable One of the risks associated with extending the credit to a customer is the risk that the customer may not pay. A potentially uncollectible amount is called a “bad debt” and is recognised as an expense in the profit and loss statement. It is therefore vitally important that an entity regularly reviews its accounts receivable in order to determine whether a debt is likely to become “bad”. Typically, this analysis is performed at the end of each month. There are two methods that are commonly used to estimate the amount of bad debts: • the percentage of credit sales method, or • the aged debtors analysis method. Each of these methods will be discussed in turn. The percentage of credit sales method Using this method, management estimates the percentage of credit sales that will be uncollectible based on past experience. This percentage is subsequently applied to the total credit sales for the period. To illustrate this method, take the following worked example. Worked Example 2 You Beaut Aussie BBQs Pty Ltd sells barbeques. It is registered for GST. During the month of August 2017, the company sold $74,250 (GST-inclusive) worth of barbecues to customers on credit. This equated to $67,500 (ie $74,250 × 10/11ths) worth of GSTexclusive credit sales appearing in the company’s profit and loss statement. It will be remembered that in the case of an entity that is registered for GST, all revenues and expenses shown in the profit and loss statement are shown GST-exclusive. Assume that as at 31 August 2017, the company has $24,000 worth of outstanding accounts receivable. Based on past experience, the company estimates that on average, 2% of the total credit sales have proven to be uncollectible.

The journal entry to record the estimate of bad debts for the month of August 2017 using the percentage of credit sales method is as follows: DATE Aug 31

PARTICULARS

POST REF

DEBIT

CREDIT

Bad debts expense

6-1600

1,350

GST deferred

1-8300

135

Provision for doubtful debts

1-2100

1,485

(To record the estimated bad debts for the month of August 2017) Analysis The estimated bad debts expense of $1,350 is calculated by multiplying the total GST-exclusive credit sales for the month of August 2017 of $67,500 by the 2% estimate. The “bad debts expense” account is debited for $1,350. This amount is shown as an expense in the profit and loss statement and matched against the revenue for the current period. From a GST perspective, according to s 21-5 of the GST Act, an entity is only entitled to claim the GST in respect of a bad debt when: • the whole or part of the consideration has not been received, and • the entity writes off the whole or part of the debt as a bad debt, or the whole or part of the debt has been due for 12 months or more.

This is referred to as a “decreasing adjustment” for GST purposes. The amount of decreasing adjustment is equivalent to 1/11th of the amount of debt written off. However, it is important to note that the GST can only be claimed by the entity in the period in which the bad debt has been written off, not when the provision for doubtful debts is made. This causes a deferral as to when the GST can be claimed. Hence, instead of debiting the “GST receivable” account, a “GST deferred” account is created equivalent to 1/10th of the bad debts expense or alternatively, 1/11th of the amount of provision for doubtful debts. This gives a debit to the “GST deferred” account of $135 (being $1,350 × 1/10th). The credit of $1,485 is taken to a contra-asset account entitled “provision for doubtful debts”. “Provision for doubtful debts” is disclosed as a reduction of the “accounts receivable” account. This account is used instead of a direct credit to “accounts receivable” because at this point we do not know exactly which customers will not pay. The “provision for doubtful debts” account merely represents an estimate of the amount that the entity expects to go “bad”. When the debt is physically written off, the input tax credit can be claimed by transferring the amount in the “GST deferred” account to the “GST receivable” account. The “GST deferred” account is usually shown as either a current asset or non-current asset in the balance sheet. The amount of $1,350 shown previously excludes the GST because revenues are shown in the profit and loss statement exclusive of GST. The profit and loss statement for the month ended 31 August 2017 is shown as follows: You Beaut Aussie BBQs Pty Ltd Profit and Loss Statement for the month ended 31 August 2017 Expenses

$

Bad debts expense

1,350

The current assets section of the balance sheet of You Beaut Aussie BBQs Pty Ltd as at 31 August 2017 appears as follows: You Beaut Aussie BBQs Pty Ltd Balance Sheet as at 31 August 2017 Current Assets

$

Accounts receivable

24,000

Less: Provision for doubtful debts

(1,485) 22,515

The amount of $22,515 shown above as at 31 August 2017 represents the net accounts receivable amount that the entity expects to receive from the debtors, after providing for an estimated 2% probability of non-collection. It will be noted that both figures shown in the balance sheet are GST-inclusive. The aged debtors analysis method The second method used to estimate the bad debts expense is called the “aged debtors analysis” method. This is the method most commonly used by businesses to estimate their bad debts at the end of each accounting period. Under this method, the estimate of uncollectible debts is based on an analysis of the “age” of accounts receivable at the end of the reporting period. At the end of each accounting period, the bookkeeper prepares and prints off a schedule of accounts

receivable. This schedule is dissected based on the “age” of the debt. Most computerised accounting software packages, such as MYOB, Xero and QuickBooks produce aged debtors reports. Typically, the aged debtors schedule lists each debt broken down into: • 1 to 30 days • 31 to 60 days • 61 to 90 days, and • over 90 days. After the outstanding accounts receivable have been aged, management assigns a percentage of uncollectability based on past experience to the totals in each category. Generally, the longer the debt remains outstanding, the higher the percentage of uncollectability. An example of an aged debtors schedule is shown as follows: You Beaut Aussie BBQs Pty Ltd Ageing of Accounts Receivable as at 31 August 2017 Customer

Total

1–30 days

31–60 days

R Craig

$6,800

$4,800

$2,000

A Gardiner

$6,450

$3,200

$3,250

D White

$4,150

T Reid

$5,680

D McKenzie TOTAL

$3,000

$24,000

$1,681

Over 90 days

$1,150 $5,680

$920

Estimated percentage uncollectible TOTAL ESTIMATED BAD DEBTS

61–90 days

$920 $8,000

$8,250

$5,680

$2,070

1%

5%

10%

30%

$80

$412

$568

$621

Based on the above analysis, the total estimated bad debts expense for the month ended 31 August 2017 comes to $1,681. However, unlike the “percentage of credit sales” method which is based on a percentage of credit sales that appears in the profit and loss statement, and therefore excludes the GST, the $1,681 is derived based on a percentage of the accounts receivable balance that appears in the balance sheet. The accounts receivable balance of $24,000 is GST-inclusive. Under the aged debtors analysis method, the amount of $1,681 calculated above becomes the balance of the “provision for doubtful debts” account in the balance sheet at the end of the reporting period. If there is an existing balance in the “provision for doubtful debts” account, then a journal entry is required for the difference between the existing amount and the required amount to increase or decrease the balance of this account. Assume that as at 31 July 2017 (one month earlier), the balance of the “provision for doubtful debts” account was $314. As indicated above, the balance of this account as at 31 August 2017 should be $1,681. Hence, a journal entry is required on 31 August 2017 to increase the “provision for doubtful debts” balance from $314 to $1,681. The journal entry required to record this subsequent increase of $1,367 is as follows:

DATE Aug 31

POST REF

PARTICULARS

DEBIT

CREDIT

Bad debts expense

6-1600

1,243

GST deferred

1-8300

124

Provision for doubtful debts

1-2100

1,367

(To increase the balance of the provision for doubtful debts account from $314 to $1,681 as at 31 August 2017) Analysis The “provision for doubtful debts” account is credited for an amount of $1,367. The credit to “provision for doubtful debts” is shown GST-inclusive. The debit to the “bad debts expense” account of $1,243 is GST-exclusive, which is equivalent to 10/11ths of $1,367. All expenses shown in the profit and loss statement are required to be shown GST-exclusive where the entity is registered for GST. The GST of $124 (equivalent to 1/11th) is debited to the “GST deferred” account. The bad debts expense of $1,243 will be shown in the August 2017 profit and loss statement as follows: You Beaut Aussie BBQs Pty Ltd Profit and Loss Statement for the month ended 31 August 2017 Expenses

$

Bad debts expense

1,243

The current assets section of the balance sheet of You Beaut Aussie BBQs Pty Ltd as at 31 August 2017 appears as follows: You Beaut BBQs Pty Ltd Balance Sheet as at 31 August 2017 Current Assets

$

Accounts receivable

24,000

Less: Provision for doubtful debts

(1,681) 22,319

The amount of $22,319 shown above represents the net accounts receivable amount that the entity expects to receive from the debtors, after providing for the probability of non-collection. Once again, it will be noted that both figures shown in the balance sheet are GST-inclusive. The following is an extract from the 2016 financial statements of JB Hi-Fi Ltd. Note 8 reproduced below shows the breakdown of accounts receivable and provision for doubtful debts.

As can be seen above, as at 30 June 2016, JB Hi-Fi Ltd has gross outstanding trade receivables of $31.505m. Based on the aged debtors analysis, directors have provided for the bad debts totalling $478,000 (which represents 1.52% of their gross trade receivables). Based on the ageing analysis, 83% of this $478,000 provision comes from the debts that are between 61 and 90 days old, while the remaining 17% comes from the debts that are more than 91 days old.

¶5-430 Writing off bad debts The discussion in ¶5-420 focused on how an entity estimates its bad debts for an accounting period. It is important to note that the provision for doubtful debts is merely an estimate. When a customer does not pay the amount owing by the due date, the entity may take a number of steps to recover the debt. For example, this may include sending out a reminder notice, making a follow-up telephone call, serving a formal demand notice or possibly even commencing a legal action. Unfortunately, there may be instances where all attempts to collect the debt become fruitless and the debt needs to be written off. For example, the business may receive a letter confirming that the debtor has gone into bankruptcy and there is no likelihood of receiving the payment. In this case, the business will need to physically write off the debt. Worked Example 3

Refer to the aged debtors analysis (¶5-420) for You Beaut Aussie BBQs Pty Ltd. It will be observed that Debbie McKenzie owes the entity an amount of $920. This amount has been outstanding for more than 90 days. Assume that on 7 September 2017, the entity receives a letter from Debbie McKenzie confirming that due to financial difficulties, she is unable to pay the debt owing of $920.

On 7 September 2017, the bookkeeper will need to write off the $920 debt by putting through the following journal entry: DATE Sept 7

PARTICULARS Provision for doubtful debts Accounts receivable — D McKenzie

POST REF

DEBIT

1-2100

CREDIT 920

1-2000

920

(To write off Debbie McKenzie’s debt owing of $920) Analysis When a debt is physically written off, the account entitled “provision for doubtful debts” is debited. The “bad debts expense” account is not debited at this time as this account was originally debited when the estimate of bad debts was made on 31 August 2017. The “accounts receivable” account is credited for the gross amount owing as this account contains the full balance of bad debt including the GST component which was to be received. “Provision for doubtful debts” is also debited for the full amount, including GST. At this point, according to s 21-5 of the GST Act, the entity is entitled to claim an input tax credit for the bad debt. This will result in a decreasing adjustment as the entity had previously remitted 1/11th of $920 when the sale was made (assuming the entity is using the accrual basis for GST). A second journal entry is required to take into account the GST consequences of writing off a bad debt. The journal entry required is as follows: DATE Sept 7

PARTICULARS GST receivable GST deferred

POST REF 2-2600 1-8300

DEBIT

CREDIT

83.64 83.64

(To recognise GST receivable in respect of writing off the bad debt equivalent to 1/11th of $920 by transferring this amount from GST deferred to GST receivable) Analysis For GST purposes, an entity is entitled to claim an input tax credit when the debt is physically written off. Accordingly, the “GST receivable” account is debited for $83.64 with the credit taken to the “GST deferred” account. This amount is equivalent to 1/11th of the bad debt written off ($920). It is also perfectly acceptable to debit the “GST payable” account instead of the “GST receivable” account. If the entity is using the accrual basis for GST, the original entry would have been credited to the “GST payable” account when the sale occurred. Debiting the “GST payable” account merely reverses the original entry made to this account when the sale was initially made. Most computerised accounting packages take this approach and debit the “GST payable” account instead of the “GST receivable” account. At this point, the current assets section of the balance sheet of You Beaut Aussie BBQs Pty Ltd as at 7 September 2017 appears as follows (under the aged debtors analysis method):

You Beaut Aussie BBQs Pty Ltd Balance Sheet as at 7 September 2017 Current Assets

$

Accounts receivable ($24,000−$920) Less: Provision for doubtful debts ($1,681−$920)

23,080 (761) 22,319

It will be noted that the balance of “accounts receivable” has been reduced by $920. However, the balance of the “provision for doubtful debts” account has also reduced by the same amount. Accordingly, the net receivables balance of $22,319 has not changed. Both figures shown in the balance sheet above are GST-inclusive. Taxation consequences of bad debts written off For income tax purposes, s 25-35 of the Income Tax Assessment Act 1997 (ITAA97) provides that a bad debt can only be claimed as an income tax deduction in the period in which the debt is physically written off, not in the period in which the estimate (or the provision for doubtful debts) is made (Point v FC of T 70 ATC 4021). Hence, in the previous worked example, You Beaut Aussie BBQs Pty Ltd will not be entitled to an income tax deduction when the provision for doubtful debts is made, but rather, the company will be entitled to a tax deduction equivalent to the GST-exclusive value of Debbie McKenzie’s debt when it is physically written off (ie $836.36). In addition to the journal entry writing off a debt as bad, there must be something in writing which indicates that the taxpayer has treated the debt as bad. According to Taxation Ruling TR 92/18, a deduction for bad debts is only allowed if: • a board meeting before the end of the income year authorises the writing off of the debt, even though the physical write-off of the debt in the books does not occur until after the year-end, or • a written recommendation by the managing director to the financial controller or bookkeeper to write off the debt before the end of the income year is made, followed by the physical write-off of the debt in the books after the year-end.

¶5-440 Recovery of a bad debt In some cases, an account that has been previously written off as a bad debt may be collected in part or in full at some stage in the future. If this occurs, the entity must not only record the receipt of cash, but must also reinstate the accounts receivable. This is illustrated as follows. Assume that on 4 October 2017, Debbie McKenzie unexpectedly pays $638 towards her account of $920 that was previously written off on 7 September 2017. The two journal entries required to record the receipt of $638 are as follows: DATE Oct 4

PARTICULARS

POST REF

DEBIT

CREDIT

Accounts receivable — D McKenzie

1-2000

Bad debts recovered (revenue)

8-6000

580

GST payable

2-2500

58

(To reinstate Debbie McKenzie’s account of

638

$638) Analysis This journal entry reinstates the accounts receivable of $638 (being the gross amount ultimately paid by Debbie McKenzie). The account entitled “bad debts recovered” is usually shown as “other income” in the chart of accounts and is credited for $580 being equivalent to 10/11ths of the amount received of $638. The remaining amount of $58, being 1/11th of $638, is credited to the “GST payable” account. Under s 21-10 of the GST Act, an entity is required to remit 1/11th of the amount recovered from a debtor to the Australian Taxation Office (ATO) in the period in which the monies are received. This gives rise to an “increasing adjustment” under s 21-10 of the GST Act. DATE Oct 4

PARTICULARS Cash at bank

POST REF

DEBIT

1-1300

Accounts receivable — D McKenzie

CREDIT 638

1-2000

638

(Collection of $638 from Debbie McKenzie) Analysis This journal entry recognises the cash received of $638 from Debbie McKenzie. Taxation consequences of bad debts recovered Any bad debts recovered from a debtor are specifically made assessable under Item 1.4 of s 20-30(1) of ITAA97. Hence, in the above worked example, You Beaut Aussie BBQs Pty Ltd will be required to include the GST-exclusive value of the amount recovered from Debbie McKenzie as assessable income in the tax period in which the money is received (ie $580).

Accounts Payable Controls over accounts payable

¶5-500

Initial recording of accounts payable ¶5-510 Aged creditors analysis

¶5-520

¶5-500 Controls over accounts payable Accounts payable represent the amounts owing by an entity to outside parties such as suppliers. Accounts payable are also known as trade creditors. An account payable is recorded when an entity receives a tax invoice from the supplier which requires settlement. Accounts payable arise because the business has purchased items on credit. Most suppliers require settlement of their accounts within 14 days, 30 days or 60 days. Accounts payable is shown as a current liability in the balance sheet because it represents the amounts owing by an entity to external parties. Keeping track of accounts payable is as important as keeping track of accounts receivable. Many entities have found that mistakes in their purchasing and accounts payable can be very costly to the business. The following general controls over accounts payable are recommended: • document the purchasing and accounts payable procedures • ensure that a valid tax invoice or invoice has been received before processing the payment. The tax invoice must have the words “tax invoice” on it and contain the 11-digit Australian Business Number (ABN) of the supplier. If in doubt, check that it is a valid ABN by going to www.abr.business.gov.au. If

an entity receives an invoice that the entity believes is not a valid tax invoice, the entity should contact the supplier and request that a new tax invoice in the prescribed format be reissued. Do not pay the amount until the correct tax invoice has been received, otherwise the entity will not be able to claim back the input tax credit • ensure that payments are on original invoices only (not copies or faxes), otherwise they may be paid more than once • once paid, the invoice should be stamped “paid” and the cheque number should be written underneath to prevent the possibility of invoices being paid twice • put in place controls to check for any identical payments • ensure that the refund cheques from suppliers are handled by someone other than the person processing the invoices • check tax invoices with only a post office box address carefully • verify the identity of any unfamiliar vendors by checking the ABN at www.abr.business.gov.au or in the telephone directory • ensure that the person who approves new vendors is different from the person responsible for the payment process • check any rapidly increasing purchases from any one vendor, and • check out the competitor’s prices if the entity relies heavily on one supplier. Above all, try to ensure that all invoices are paid on time. A good reputation with suppliers is hard to build and very easy to lose.

¶5-510 Initial recording of accounts payable When an entity buys goods or receives services from a supplier on credit for $1,100 (GST-inclusive), the following journal entry is initially put through: DATE Jan 18

PARTICULARS

POST REF

DEBIT

CREDIT

Inventory

1-3000

1,000

GST receivable

2-2600

100

Accounts payable — Ace Manufacturers Pty Ltd

2-2000

1,100

(Purchase of inventory on credit from Ace Manufacturers Pty Ltd) The above journal entry assumes that the entity accounts for GST using the accrual basis. When the business pays this amount owing to Ace Manufacturers Pty Ltd, it will put through the following journal entry: DATE Feb 4

PARTICULARS Accounts payable — Ace Manufacturers Pty Ltd Cash at bank

POST REF 2-2000 1-1300

DEBIT

CREDIT

1,100 1,100

(Payment of amount owing to Ace Manufacturers Pty Ltd)

¶5-520 Aged creditors analysis An entity may keep track of its accounts payable in a similar way to accounts receivable. For this reason, an entity typically prepares an aged creditors analysis. At the end of each accounting period, the bookkeeper usually prints off a schedule of accounts payable. This schedule is based on the “age” of the outstanding debt. Hence, this is referred to as an “aged creditors analysis”. Once again, most computerised accounting software packages, such as MYOB, Xero and QuickBooks produce aged creditors reports. It is important to keep track of these outstanding monies for a number of reasons. One reason is to enable the business to budget for when its payments are due. Secondly, there is a danger in not paying an outstanding invoice by the due date. The business runs the risk of obtaining a bad credit rating, which may significantly affect any future business dealings. Furthermore, it can ultimately lead to a reduction of goods or services available to the business — an unpaid telephone or electricity account can lead to the loss of these services. It may also make it difficult for a business to obtain any additional credit if it has a record of being slow or late in paying its bills. In some cases, in order to encourage an early payment, businesses provide discounts if the payment is made within a specific time period. An example of an aged creditors schedule is shown as follows: You Beaut Aussie BBQs Pty Ltd Ageing of Accounts Payable as at 30 June 2017 Supplier

Balance

1–30 days

31–60 days

Isis Constructions

$42,000

Matrix Energy Ltd

$2,175

Orion Holdings Ltd

$1,156

Trinity Holdings Ltd

$18,357

$18,357

TOTAL

$63,688

$60,357

61–90 days

Over 90 days

$42,000 $2,175 $1,156

$2,175

$1,156

¶5-600 Cash, debtors and creditors — commonly asked questions Question What internal controls should my client have in place over cash receipts and cash payments?

Answer Because cash is the easiest asset to misappropriate, it is vitally important that the business sets up a strong system of internal control over cash. This comprises a control system over both cash receipts and cash payments.

¶5-110 outlines the recommended controls over cash receipts, while ¶5-120 outlines the recommended controls over cash payments. My client has established a petty cash fund of $100. How should I record the fund establishment

When the petty cash fund is established (usually by way of cheque from the main business cheque

in management accounts and when should I record the petty cash vouchers in management accounts?

account), the asset account “petty cash” is debited and “cash at bank” is credited.

When a payment is made from the fund, a “petty cash voucher” is completed with the receipt stapled to the voucher. At all times, the amount shown on the petty cash vouchers plus the cash on hand should equal the initial amount of the petty cash fund.

The bookkeeper should record the relevant expenses in management accounts when the petty cash fund is replenished.

It is important that the petty cash fund be replenished on a regular basis, as the GST on the individual petty cash vouchers should be recorded in management accounts and claimed in the entity’s Business Activity Statement (BAS) for the relevant month or quarter. How often should I prepare bank reconciliations?

Bank reconciliations should be prepared for each bank account maintained by the entity.

Whenever the bank statement is issued from the bank (usually fortnightly, monthly or quarterly), the bookkeeper should prepare a bank reconciliation.

The “cash at bank” account should always be reconciled prior to lodging the monthly or quarterly BAS with the ATO. Why does the closing balance on the bank statement issued by the bank at the end of each month differ from the cash at bank balance in the client’s general ledger?

The purpose of bank reconciliation is to reconcile the closing cash at bank balance as per the bank statement to the cash at bank balance shown in management accounts. There are several reasons why these two amounts will differ: • time lags exist between when the business records the transaction in its books and when the bank records the transaction. This is usually because of outstanding deposits or unpresented cheques • amounts reported on the bank statement have not yet been entered into the accounting records of the entity, eg interest received and other direct deposits (which appear on the credit side

of the bank statement) as well as bank charges, account keeping fees and other direct debits (which appear on the debit side of the bank statement), or • errors made by the bank or the business. Bank reconciliation ensures that all monies have been deposited into the bank account (as reflected in the accounting records) and all payments have been processed by the bank.

It also ensures that any account keeping fees, bank charges, etc, charged by the bank as well as any interest credited or other direct receipts are recorded in management accounts. It is now 30 June. My client has a large accounts receivable balance in the balance sheet. Should my client review this balance and make an estimate of potentially uncollectible debts?

It is important that an entity regularly reviews its accounts receivable balance in order to determine the percentage of the balance that is likely to become “bad”.

There are two methods commonly used to estimate the amount of bad debts: • the percentage of credit sales method, or • the aged debtors analysis method. The aged debtors analysis method is more popular of the two methods.

Once an estimate is made of the debts that are likely to go “bad”, the bookkeeper should record a journal entry by crediting the contra-asset account “provision for doubtful debts” for the full amount.

“Bad debts expense” should be debited for 10/11ths of this amount and the account entitled “GST deferred” should be debited for the remaining 1/11th.

For GST purposes, an entity can only claim the GST on a bad debt when it is physically written off, not when the provision is made. Hence, when the debt is physically written off, the GST on the bad debt can be claimed (this is referred to as an increasing adjustment event).

From an accounting perspective, the “GST deferred” account is credited and the “GST receivable” account is debited. I have just received a written confirmation from one of my client’s customers who owes my client $4,800 that they have gone into liquidation and, as such, will not be paying the amount owing. How do I write off this debt in management accounts?

When the debt is confirmed to be “bad”, the debt must be written off by debiting the “provision for doubtful debts” account and crediting the “accounts receivable” account.

For income tax purposes, according to s 25-35 of ITAA97, this is the point at which the bad debt becomes tax-deductible, not when the provision is initially made.

Similarly, in terms of the GST treatment, it is at the point of physically writing off the bad debt that an entity is allowed to claim back the input tax credit associated with the bad debt (s 21-5, GST Act). My client performs an “aged debtors analysis” on a Yes. For the same reason that an entity keeps regular basis. Should an aged creditors analysis track of its accounts receivable, it should keep also be performed? track of its accounts payable by performing an aged creditors analysis.

This will enable the entity to keep track of any amounts outstanding. Knowing when a debt is due and payable may result in the entity taking advantage of any early settlement discounts offered by the supplier.

Furthermore, there is danger in not paying an outstanding invoice by the due date. The business runs the risk of obtaining a bad credit rating, which may significantly affect any future business dealings. Likewise, not paying the telephone bill, electricity bill or rent on time may lead to a loss of those services.

6 ACCOUNTING FOR INVENTORY Introduction

¶6-000

What is inventory?

¶6-100

Inventory systems

¶6-110

Accounting for inventory under a perpetual inventory system ¶6-200 Accounting for inventory under a periodic inventory system

¶6-300

Determining the cost of inventory

¶6-400

When is inventory on hand?

¶6-410

Valuation of inventory

¶6-500

The lower of cost and net realisable value (NRV) rule

¶6-600

Accounting for inventory — commonly asked questions

¶6-700

¶6-000 Introduction This chapter is devoted to the discussion of accounting for inventory. Inventory refers to goods or property purchased, manufactured, or acquired by an entity in the ordinary course of business and held for the purposes of resale. Inventory is one of the largest assets of many businesses, particularly in the retail industry. For example, according to the 2016 financial statements of JB Hi-Fi Ltd, as at 30 June 2016, its total assets were $992m. Inventory accounted for $546m (or 55% of the total assets). This was the company’s largest asset followed by property, plant and equipment ($183m). An extract of the company’s 2016 balance sheet is shown as follows:

One of the reasons why accounting for inventory is so important is that inventory affects both the profit and loss statement (through the cost of goods sold) and the balance sheet (inventory on hand at the end of the year is disclosed as a current asset). The Australian Accounting Standards Board (AASB) has issued AASB 102 Inventories dealing with this topic. This chapter discusses the two types of inventory systems (periodic and perpetual) as well as typical journal entries involving the purchase and sale of inventory under both systems. We will also be

discussing what is included in the cost of inventory and various inventory valuation rules, including the concept of net realisable value (NRV).

¶6-100 What is inventory? The accounting treatment of inventories is covered in AASB 102. According to para 6 of this standard, inventories are defined as assets: “(a) held for sale in the ordinary course of business (b) in the process of production for such sale, or (c) in the form of materials or supplies to be consumed in the production process or in the rendering of services.” Essentially, inventory refers to goods or property purchased, manufactured, or acquired by an entity in the ordinary course of business held for the purposes of resale. Inventory includes goods, property or services in the process of production, but not yet completed (ie work in progress). Inventory is also commonly referred to as trading stock. In the case of a manufacturer, inventory not only includes finished goods, but also raw materials used in the production of goods and work in progress (uncompleted finished goods). Inventory is recorded as a current asset in the balance sheet. However, goods acquired for the purpose of hire or rental to customers (eg videos and DVDs for hire by video shops) do not constitute inventory. Worked Example 1 Which of the following constitutes inventory?

(a)

shoes held for sale by a shoe retailer

Yes

(b)

cars held for hire by a car hire company

No

(c)

a DVD store which lends DVDs to customers

No

(d)

a DVD store that sells ex-rental DVDs to customers

Yes

(e)

wood used by a furniture manufacturer in making desks

Yes

(f)

hot and cold chickens sold by a fast food retailer

Yes

(g)

aquarium fish sold by a pet store

Yes

(h)

petroleum held for sale by a petrol station

Yes

(i)

chocolates, snacks, drinks, magazines, newspapers and cigarettes held for sale by a petrol station

Yes

(j)

a motor vehicle sold by a dentist that was used for business purposes in his dental surgery

No

¶6-110 Inventory systems A retailer keeps track of inventory using an inventory system in order to determine how much is available for sale and how much has been sold. There are two generally accepted inventory systems: • perpetual, and • periodic.

Perpetual inventory system Under a perpetual inventory system, detailed records of inventory movements are recorded by an entity through the inventory account. Every time an item of inventory is bought by the entity, inventory account increases and every time an item of inventory is sold by the entity, inventory account decreases. Under a perpetual inventory system, a continuous record of inventories is maintained. At any point in time, the owner of the business can quickly and easily ascertain the balance of how much inventory is on hand by looking at the balance of the inventory account in the general ledger. Details of the actual quantity and value of each stock item will be held in the inventory subsidiary ledger. Most computerised accounting software packages have inventory modules that allow for inventories to be tracked using a perpetual inventory system. Some of these accounting systems can be integrated with the barcoding and optical scanning point-of-sale equipment which will then allow inventory records to be updated instantaneously upon completion of any sale transaction. Historically, perpetual inventory systems were most popular with entities that have a low volume of inventory items which sell for relatively high prices, for example, motor vehicle dealers, jewellers, and furniture, computer and electrical goods retailers. In a manual accounting system, maintaining a perpetual inventory system can be extremely laborious and time-consuming. However, with inventory modules now existing in most computer accounting systems, many businesses (both large and small) are adopting perpetual inventory systems. The major advantage of a perpetual inventory system is that an entity knows exactly how much inventory is on hand at any point in time as well as how much profit has been made on any given day. A perpetual inventory system allows the business to keep accurate up-to-date records of the number of items purchased, the number of inventory items sold and the number (and value) on hand at any point in time. For a perpetual inventory system to work properly, the unit cost value for each stock item bought needs to be known and each item of stock needs to be clearly identified. We will look at this issue later in this chapter at ¶6-200. Periodic inventory system In a periodic inventory system, detailed records of inventory movements are not maintained. There is no continuous record of how much inventory is on hand at any particular point in time. The only way that the amount of inventory on hand can be ascertained is by performing a physical stocktake (ie counting the inventory on hand). Periodic inventory systems were typically used by entities that have a high volume of inventory items that retail for a relatively low price. For example, periodic inventory systems are typically used by fruit and vegetable stores, corner stores, newsagents and restaurants. It is much simpler to use a periodic inventory system in a manual accounting system. The distinction between the periodic and perpetual inventory systems is summarised in Table 6.1. Table 6.1: Periodic vs perpetual inventory system Issue

Periodic

Perpetual

Low volume/high dollar value

X

✓

High volume/low dollar value

✓

X

¶6-200 Accounting for inventory under a perpetual inventory system Under a perpetual inventory system, a current and continuous record of inventory is maintained. In other words, every time an entity purchases an item of inventory, inventory account is increased. Conversely, every time an item of inventory is sold, inventory account is decreased. To illustrate how the perpetual inventory system works, we will refer to the following worked example of TV World Pty Ltd. Worked example: TV World Pty Ltd

TV World Pty Ltd is a small suburban retailer of colour television sets and TV accessories. As at 1 June 2017, it had opening inventory comprising 12 television sets it purchased for $900 each (excluding the goods and services tax (GST)). Hence, opening inventory totalled $10,800. TV World Pty Ltd is registered for GST and uses the accrual basis for GST. The following transactions occurred during the month of June 2017. Transaction 1: Recording purchases of inventory June 5:

TV World Pty Ltd purchases eight television sets at $990 each including GST on credit from Sony Ltd.

The journal entry to record this purchase under a perpetual inventory system is as follows: DATE June 5

PARTICULARS

POST REF

DEBIT

CREDIT

Inventory

1-3000

7,200

GST receivable

2-2600

720

Accounts payable

2-2000

7,920

(Purchase of eight television sets on credit) Analysis In a perpetual inventory system, when an item of inventory is purchased, the “inventory” account is debited. As TV World Pty Ltd is registered for GST, the “inventory” account is debited for the GSTexclusive value of $7,200 (being $7,920 × 10/11ths), the “GST receivable” account is debited for $720 (being $7,920 × 1/11th) and the “accounts payable” account is credited for the full amount owing of $7,920. As at 5 June 2017, the inventory account appears as follows: Inventory 1 June Bal b/d

1-3000

10,800

(12 TVs @ $900) 5 June Accounts payable

7,200

(8 TVs @ $900) Transaction 2: Recording the sales of inventory June 12:

TV World Pty Ltd sells four television sets to customers on credit for $2,200 each including GST.

The journal entries to record this sale under a perpetual inventory system are as follows: DATE June 12

PARTICULARS Accounts receivable

POST REF 1-2000

DEBIT

CREDIT

8,800

GST payable

2-2500

800

Sales

4-1000

8,000

(Sale of four television sets on credit) Analysis This journal entry records the sale of four television sets on credit. The “accounts receivable” account is

debited for the entire amount owing by the customer, being $8,800. As TV World Pty Ltd is registered for GST, it owes the Australian Taxation Office (ATO) the GST of $800 (being $8,800 × 1/11th). The remaining amount of $8,000 (being $8,800 × 10/11ths) is credited to the “sales” revenue account. DATE June 12

PARTICULARS

POST REF

Cost of goods sold

5-0000

Inventory

1-3000

DEBIT

CREDIT

3,600 3,600

(To record the cost of the four television sets sold) Analysis Under a perpetual inventory system, we must recognise that when an item of inventory is sold, there is a decrease in the inventory balance. The above journal entry records the cost of inventory sold (a term called “cost of goods sold”) and credits the “inventory” account for the cost price of the four television sets sold at $900 each (being a total of $3,600). As at 12 June 2017, the “inventory” account appears as follows: Inventory 1 June Bal b/d

1-3000

10,800 12 Jan Cost of goods sold

3,600

(12 TVs @ $900) 5 June Accounts payable

7,200

(8 TVs @ $900) Transaction 3: Purchases returns and allowances June 18:

TV World Pty Ltd returns one of the television sets it purchased on 5 June 2017 which turned out to be defective.

The journal entry to record this purchase return under a perpetual inventory system is as follows: DATE June 18

PARTICULARS Accounts payable

POST REF 2-2000

DEBIT

CREDIT 990

GST receivable

2-2600

90

Inventory

1-3000

900

(To record the return of one television set by TV World Pty Ltd) Analysis This journal entry records the return to the supplier of the television set that was purchased on 5 June 2017. “Accounts payable” is debited for the entire amount of $990. In the original entry on 5 June, the “GST receivable” account was debited for $720 and now $90 of that entry needs to be reversed (ie credited). This represents the input tax credit that TV World Pty Ltd is no longer able to claim for one television. The remaining amount of $900 is credited to the “inventory” account. This credit to the “inventory” account recognises that we have one less television set on hand. As at 18 June 2017, the inventory account appears as follows:

Inventory 1 June Bal b/d

10,800 12 June

(12 TVs @ $900) 5 June Accounts payable

18 June 7,200

1-3000 Cost of goods sold Accounts payable

3,600 900

(1 TV @ $900)

(8 TVs @ $900) Transaction 4: Sales returns and allowances June 25:

One of the customers who purchased a television set from TV World Pty Ltd on credit on 12 June 2017 returns the television set.

The journal entries to record this sales return under a perpetual inventory system are as follows: DATE June 25

PARTICULARS

POST REF

DEBIT

CREDIT

Sales returns and allowances

4-2000

2,000

GST payable

2-2500

200

Accounts receivable

1-2000

2,200

(To record the return of one television set by a customer) Analysis This journal entry records the return of one television set by a customer. “Accounts receivable” is credited for the entire amount of $2,200. In the original entry on 12 June, the “GST payable” account was credited for $800. This represented the GST payable by TV World Pty Ltd to the ATO for the four televisions included in those sales. However, with the return of one television set, the GST payable of $200 ($2,200 × 1/11th) must be reversed. The remaining amount of $2,000 ($2,200 × 10/11ths) is debited to an account entitled “sales returns and allowances”. This account is a contra-revenue account and is shown as a deduction from sales revenue in the profit and loss statement. DATE June 25

PARTICULARS Inventory

POST REF

DEBIT

1-3000

Cost of goods sold

CREDIT 900

5-0000

900

(To record the cost of goods returned) Analysis Under a perpetual inventory system, we must recognise that when an item of inventory is returned by a customer, there is an increase in the inventory balance. The above journal entry increases the balance of inventory and decreases (ie reverses) the cost of goods sold. The amount of $900 is the original GSTexclusive cost of inventory initially purchased. As at 25 June 2017, the “inventory” account appears as follows: Inventory 1 June

Bal b/d

10,800 12 June Cost of goods sold

1-3000 3,600

(12 TVs @ $900) 5 June

Accounts payable

18 June Accounts payable 7,200

900

(1 TV @ $900)

(8 TVs @ $900) 25 June Cost of goods sold

900

(1 TV @ $900)

It is now 30 June 2017. The various ledger accounts of TV World Pty Ltd are as follows:

TV World Pty Ltd Ledger Perpetual Inventory System Accounts receivable 12 June Sales

8,800 25 June Sales returns 30 June Balance c/d 8,800

30 June Balance b/d

Bal b/d

Accounts payable

1-3000

10,800 12 June Cost of goods sold 18 June Accounts payable 7,200

(8 TVs @ $900) 25 June Cost of goods sold

6,600

6,600

(12 TVs @ $900) 5 June

2,200

8,800

Inventory 1 June

1-2000

3,600 900

(1 TV @ $900) 30 June Balance c/d

900

14,400

(16 TVs@$900)

(1 TV @ $900) 18,900 30 June Balance b/d

18,900

14,400 Accounts payable

18 June Inventory 30 June Balance c/d

990 5 June

2-2000 Inventory

7,920

6,930

7,920

7,920 30 June Balance b/d

GST payable 25 June

Accounts receivable

200 12 June

30 June

Balance c/d

600

800

6,930 2-2500

Accounts receivable

800

800

30 June

Balance b/d

600

GST receivable 5 June

Accounts payable

2-2600

720 18 June Accounts payable

90

30 June Balance c/d

630

720 30 June Balance b/d

720

630 Sales

4-1000

12 June

Accounts receivable

8,000

Sales returns & allowances 25 June

Accounts receivable

4-2000

2,000

Cost of goods sold 12 June Inventory

5-0000

3,600 25 June Inventory

900

30 June Balance c/d

2,700

3,600 30 June Balance b/d

3,600

2,700

On 30 June 2017, TV World Pty Ltd performs its annual stocktake to verify the amount of television sets in the ending inventory. The physical stocktake reveals that there are 16 television sets in the closing inventory. As these television sets were purchased for $900 each, this equates to $14,400. These figures match the inventory records which reveal the following: TV World Pty Ltd Perpetual Inventory Records Item:

Television sets

Code:

LG139 Purchases

Date

Explanation

1/6

Beginning balance

5/6

Purchases

12/6

Sales

18/6

Purchase return

25/6

Sales return

Units

8

Unit cost

900

Sales

Total cost

Units

900

Total cost

7,200 4

(1)

Unit cost

Balance

900

3,600

(900) (1)

900

(900)

Units

Unit cost

Total cost

12

900

10,800

20

900

18,000

16

900

14,400

15

900

13,500

16

900

14,400

Despite the benefits of a perpetual inventory system, it is still advisable to conduct a physical stocktake at the end of the accounting period. A physical stocktake will confirm whether the computer records are accurate. A physical stocktake will also detect any inventory losses or shortages that may have resulted from theft, shrinkage, breakage or clerical error. The profit and loss statement of TV World Pty Ltd for the month ended 30 June 2017 is shown as follows: TV World Pty Ltd Profit and Loss Statement for the month ended 30 June 2017 (under a perpetual inventory system) $ Sales revenue

8,000

Less: Sales returns and allowances Net sales

(2,000) 6,000

Less: Cost of goods sold

(2,700)

Gross profit

$3,300

There are several new terms that have been used in the format of the profit and loss statement. These terms apply when a perpetual inventory system is used. A summary of these new terms appears as follows:

Net sales = [Sales − Sales returns and allowances] Gross profit = [Net sales − Cost of goods sold] Net profit = [Gross profit − Expenses]

The inventory account in the balance sheet of TV World Pty Ltd as at 30 June 2017 is as follows: TV World Pty Ltd Balance Sheet as at 30 June 2017 (under a perpetual inventory system) $ Inventory Television sets, at cost

14,400

¶6-300 Accounting for inventory under a periodic inventory system Under a periodic inventory system, an entity does not maintain a current and continuous record of inventory movements. The only way that the business owner knows how much inventory is on hand at

any particular point in time is to perform a physical stocktake. Unlike the perpetual inventory system, inventory account is not debited or credited every time an item of inventory is bought and sold. Therefore, under a periodic inventory system, the amount of inventory shown in the balance sheet during the year is not the current value of inventory on hand at that point in time. Instead, the dollar value of inventory shown in the balance sheet represents the amount of inventory recorded at the last physical stocktake. Typically, this was the value recorded on the last day of the last financial year. This account balance remains the same for the entire financial year and only changes at the end of the financial year when a physical stocktake is conducted. Under a periodic inventory system, instead of debiting and crediting the “inventory” account every time an item of inventory is bought and sold, the purchase of inventory is debited to an account entitled “purchases” and the sale of inventory is credited to an account entitled “sales”. To illustrate how the periodic inventory system works, we will refer to the same facts contained in the previous worked example in ¶6-200 relating to TV World Pty Ltd. Worked example: TV World Pty Ltd Transaction 1: Recording purchases of inventory June 5:

TV World Pty Ltd purchases eight television sets at $990 each including GST on credit from Sony Ltd.

The journal entry to record this purchase under a periodic inventory system is as follows: DATE June 5

PARTICULARS

POST REF

DEBIT

CREDIT

Purchases

5-2000

7,200

GST receivable

2-2600

720

Accounts payable

2-2000

7,920

(Purchase of eight television sets on credit) Analysis In the case of a periodic inventory system, when an item of inventory is purchased, the “purchases” account is debited. This purchase is immediately expensed to the profit and loss statement and forms part of the cost of goods sold. As TV World Pty Ltd is registered for GST, the “purchases” account is debited for the GST-exclusive value of $7,200 (being $7,920 × 10/11ths), the “GST receivable” account is debited for $720 (being $7,920 × 1/11th), and “accounts payable” is credited for the full amount owing of $7,920. Transaction 2: Recording the sales of inventory June 12:

TV World Pty Ltd sells four television sets to customers on credit for $2,200 each including GST.

The journal entry to record this sale under a periodic inventory system is as follows: DATE June 12

PARTICULARS Accounts receivable

POST REF 1-2000

DEBIT

CREDIT

8,800

GST payable

2-2500

800

Sales

4-1000

8,000

(Sale of four television sets on credit)

Analysis This journal entry records the sale of four television sets on credit. The “accounts receivable” account is debited for the entire amount owing by the customer (being $8,800). As TV World Pty Ltd is registered for GST, it owes the ATO the GST of $800 (being $8,800 × 1/11th). The “GST payable” account is credited for this amount. The remaining amount of $8,000 (being $8,800 × 10/11ths) is credited to “sales” revenue. Unlike the perpetual system, there is no second journal entry to the “inventory” and “cost of goods sold” accounts. Transaction 3: Purchases returns and allowances June 18:

TV World Pty Ltd returns one of the television sets it purchased on 5 June 2017 which turned out to be defective.

The journal entry to record this purchase return under a periodic inventory system is as follows: DATE June 18

PARTICULARS Accounts payable

POST REF

DEBIT

2-2000

CREDIT 990

GST receivable

2-2600

90

Purchases returns and allowances

5-3000

900

(To record the return of one television set by TV World Pty Ltd) Analysis This journal entry records the return to the supplier of the television set that was purchased on 5 June 2017. “Accounts payable” is debited for the entire amount of $990. In the original entry on 5 June, the “GST receivable” account was debited for $720 and now $90 of that entry needs to be reversed (ie credited). This represents the input tax credit that TV World Pty Ltd is no longer able to claim for one television. The remaining amount of $900 is credited to the account entitled “purchases returns and allowances”. Under the perpetual inventory system, the credit was recorded against the “inventory” account. Transaction 4: Sales returns and allowances June 25:

One of the customers who purchased a television set from TV World Pty Ltd on credit on 12 June 2017 returns the television set.

The journal entry to record this sales return under a periodic inventory system is as follows: DATE June 25

PARTICULARS

POST REF

DEBIT

CREDIT

Sales returns and allowances

4-2000

2,000

GST payable

2-2500

200

Accounts receivable

1-2000

2,200

(To record the return of one television set by a customer) Analysis This journal entry records the return of one television set by a customer. “Accounts receivable” is credited for the entire amount of $2,200. In the original entry on 12 June, the “GST payable” account was credited for $800. This represented the GST payable by TV World Pty Ltd to the ATO for the four televisions

included in those sales. However, with the return of one television set, the GST payable of $200 ($2,200 × 1/11th) must be reversed. The remaining amount of $2,000 ($2,200 × 10/11ths) is debited to an account entitled “sales returns and allowances”. This account is a contra-revenue account and is shown as a deduction from sales revenue in the profit and loss statement. Unlike the perpetual system, there is no second journal entry to the “inventory” and “cost of goods sold” accounts. The various ledger accounts of TV World Pty Ltd are as follows:

TV World Pty Ltd Ledger Periodic Inventory System Accounts receivable 12 June Sales

8,800 25 June Sales returns 30 June Balance c/d

8,800 30 June Balance b/d

30 June Balance c/d

990 5 June

2-2000 Inventory

7,920

GST payable 25 June

Accounts receivable

200 12 June

30 June

Balance c/d

600

6,930 2-2500

Accounts receivable

800

800

800 30 June

Balance b/d

GST receivable

600

2-2600

720 18 June Accounts payable

90

30 June Balance c/d

630

720 30 June Balance b/d

7,920

6,930

30 June Balance b/d

Accounts payable

6,600

6,600

7,920

5 June

2,200

8,800

Accounts payable 18 June Inventory

1-2000

720

630 Sales 12

4-1000 Accounts receivable

8,000

June

Sales returns & allowances 25 June

Accounts receivable

4-2000

2,000

Purchases 5 June

Accounts payable

5-2000

7,200

Purchases returns & allowances 18 June

53000

Accounts receivable

900

It is now 30 June 2017. TV World Pty Ltd performs a physical stocktake and counts 16 television sets on hand as at 30 June 2017. As each of these 16 television sets costs $900, this equates to a closing inventory value of $14,400. At this point, two journal entries are required under the periodic inventory system to: • remove the value of opening inventory of $10,800 as at 1 June 2017 from the accounts, and • record the value of closing inventory as at 30 June 2017 of $14,400 in the accounts. The first journal entry transfers the value of opening inventory of $10,800 from the balance sheet to the profit and loss statement of TV World Pty Ltd. DATE

PARTICULARS

POST REF

June 30

Inventory (opening — profit and loss statement)

5-1000

Inventory (opening — balance sheet)

DEBIT

CREDIT

10,800

1-3000

10,800

(To remove the value of opening inventory of $10,800 from the accounts) Analysis The purpose of this journal entry is to transfer the value of opening inventory from the balance sheet to the cost of goods sold calculation section in the profit and loss statement. The “inventory” account in the profit and loss statement is debited for $10,800 (being the opening value as at 1 June 2017). The opening inventory is effectively expensed to the profit and loss statement (under the cost of goods sold) as it is assumed that this inventory was sold during the 2017 financial year. As the value of opening inventory is recorded in the “inventory” account in the balance sheet, it must be removed so that the updated closing inventory amount of $14,400 can be included. For this reason, the opening inventory balance of $10,800 is credited in the balance sheet. The bookkeeper will also record the following journal entry on 30 June 2017 in relation to the closing inventory of $14,400: DATE

PARTICULARS

POST REF

DEBIT

CREDIT

June 30

Inventory (closing — balance sheet)

1-3000

Inventory (closing — profit and loss statement)

14,400

5-4000

14,400

(To record the value of closing inventory of $14,400 as at 30 June 2017) Analysis The purpose of this journal entry is to record the value of closing inventory in the balance sheet as well as the cost of goods sold calculation section of the profit and loss statement. The “inventory” account in the balance sheet is debited for $14,400 (being the value of closing inventory as at 30 June 2017). The “inventory” account (which forms part of the cost of goods sold) in the profit and loss statement is credited for $14,400 (being the closing value). This is because these goods have not yet been sold and, therefore, represent a reduction in the cost of goods sold. When eventually sold, these goods will form part of the cost of goods sold in a subsequent financial year. The profit and loss statement of TV World Pty Ltd for the month ended 30 June 2017 is as follows: TV World Pty Ltd Profit and Loss Statement for the month ended 30 June 2017 (under a periodic inventory system) $

$

Sales revenue

$ 8,000

Less: Sales returns and allowances

(2,000)

Net sales

6,000

Less: Cost of goods sold Opening inventory

10,800

Purchases

7,200

Less: Purchases returns and allowances

(900)

Net purchases

6,300

Cost of goods available for sale Less: Closing inventory

17,100 (14,400)

Cost of goods sold

(2,700)

Gross profit

$3,300

There are several new terms that have been used in the format of the profit and loss statement. These terms apply when a periodic inventory system is used. A summary of these new terms appears as follows.

Net sales = [Sales − Sales returns and allowances]

Gross profit = [Net sales − Cost of goods sold] Net purchases = [Purchases − Purchases returns and allowances] Cost of goods available for sale = [Opening inventory + Net purchases] Cost of goods sold = [Cost of goods available for sale − Closing inventory]

The inventory account in the balance sheet of TV World Pty Ltd as at 30 June 2017 is as follows: TV World Pty Ltd Balance Sheet as at 30 June 2017 (under a periodic inventory system) $ Inventory Television sets, at cost

14,400

Comparison of journal entries under the perpetual and periodic inventory systems A comparison of the journal entries made under both inventory systems is shown as follows: TV World Pty Ltd Perpetual Inventory System

Periodic Inventory System

Inventory

Inventory

12 TVs @$900

$10,800

12 TVs @ $900

$10,800

Transaction 1: Purchased eight TVs on credit for $990 each: Inventory (8 × $900)

7,200

GST receivable

Purchases

720

Accounts payable

7,200

GST receivable 7,920

720

Accounts payable

7,920

Transaction 2: Sold four TV sets on credit for $2,200 each: Accounts receivable

8,800

Sales (4 × $2,000) GST payable

Cost of goods sold

Accounts receivable 8,000 800

3,600

Inventory (4 × $900)

Sales GST payable

No entry 3,600

8,800 8,000 800

Transaction 3: Purchases returns and allowances — one TV set: Accounts payable

990

Accounts payable

Inventory (1 × $900)

900

GST receivable

990

Purchases returns

90

900

GST receivable

90

Transaction 4: Sales returns and allowances — one TV set: Sales returns

2,000

Sales returns

2,000

GST payable

200

GST payable

200

Accounts receivable

Inventory (1 × $900)

2,200

900

Accounts receivable

No entry

Cost of goods sold

900

Closing inventory 16 TVs @$900

2,200

Closing inventory $14,400

16 TVs @$900

$14,400

Conclusion It will be noted that under both the periodic and the perpetual inventory systems, the value of net sales, cost of goods sold and gross profit in the profit and loss statement are the same. Similarly, under both inventory systems, the value of closing inventory shown in the balance sheet is the same.

¶6-400 Determining the cost of inventory Determining the cost of inventory is governed by AASB 102. According to para 9 of AASB 102, inventories must be measured at the lower of cost and NRV. Paragraph 10 of AASB 102 states that the “cost” of inventory comprises: • the cost of purchase • the cost of conversion, and • all other costs incurred in bringing the inventories to their present location and condition. The cost of inventory can be shown diagrammatically as follows. Diagram 6.1: Determining the cost of inventory

Costs of purchase According to para 11 of AASB 102, the costs of purchase include the purchase price of inventory, import duties, other taxes, freight, transportation, shipping and handling costs and all other costs directly attributable to purchasing the inventory.

If the entity is registered for GST, it excludes the GST paid to acquire the inventory. The amount of GST paid represents the input tax credit that the entity is able to claim from the ATO. This will be shown in the contra-liability account entitled “GST receivable”. Worked Example 2 Mobile Phone World Pty Ltd is registered for GST. The company buys and sells mobile phones to the public. On 4 May 2017, Mobile Phone World Pty Ltd acquires 100 mobile phones costing $22,000 (inclusive of GST). The company also pays freight and transportation costs of $1,650 (inclusive of GST) to have the phones delivered to its warehouse. The total cost of inventory not only includes the purchase price, but also the freight and transportation costs relating to the inventory (ie $23,650). The total cost of inventory to be shown in the balance sheet will be $21,500 (ie a total of $23,650 × 10/11ths). Furthermore, the company is entitled to claim an input tax credit of $2,150 (ie $23,650 × 1/11th) in its June 2017 Business Activity Statement (BAS).

Paragraph 11 of AASB 102 also confirms that trade discounts, settlement discounts and rebates are deducted in determining the cost of inventory. A settlement discount is the discount received by the purchasing entity for paying the account early. Take the following example relating to the settlement discount. Assume that on 14 March 2017, an entity acquires goods from a supplier for $11,000 on credit. The tax invoice specifies that the amount must be paid within 30 days. However, at the bottom of the tax invoice it states that if the entity pays the amount owing within 10 days, it will receive a settlement discount of 2% (which equates to $220). Assuming that the payment is made on 19 March 2017 (ie within the discount period), the journal entry required under AASB 102 on the date of the payment is as follows: DATE Mar 19

PARTICULARS Accounts payable

POST REF 2-2000

DEBIT

CREDIT

11,000

Cash at bank

1-1300

10,780

Inventory

1-3000

200

GST receivable

2-2600

20

(To record the early payment of the inventory in order to receive the 2% discount) Analysis The full amount of “accounts payable” of $11,000 is debited. As the company has paid within the discount period, it is entitled to the settlement discount of $220. Hence, the amount of cash paid of $10,780 is credited. In terms of the remaining credit of $220, AASB 102 requires that the settlement discount be credited to the “inventory” account. This has the effect of reducing the cost of inventory. However, as the entity is registered for GST, the credit of $220 is split between the “inventory” account for $200 (being 10/11ths × $220) and “GST receivable” for $20 (being $220 × 1/11th). Previously, some entities credited the account entitled “discount received” for the $200. This account was often shown as part of “other income” in the profit and loss statement. However, para 11 of AASB 102 makes it clear that the discounts received by an entity in acquiring inventory should be credited directly to the “inventory” account as the journal entry above indicates. Costs of conversion Conversion costs relate predominantly to the activities of manufacturing entities. Conversion costs are defined in para 12 of AASB 102 as those costs directly related to the conversion of raw materials into finished goods. This typically includes the cost of direct labour as well as a share of all fixed and variable overhead costs incurred in producing or manufacturing inventory (referred to as the full absorption costing).

The cost of conversion is defined as:

Conversion costs = [Direct labour + Factory overhead]

Table 6.2 summarises those costs which are included (and excluded) in determining the cost of inventory. Table 6.2: Costs included and excluded in determining the cost of inventory Costs generally included

Costs generally excluded

• factory light and power

• marketing expenses

• factory rent, repairs and

• storage expenses

maintenance

• advertising expenses

• factory rates and taxes

• selling expenses

• insurance of factory, plant and

• other distribution expenses

machinery • wages, including annual leave, sick leave, long service leave paid,

• research and experimental expenses including engineering and product development

workers compensation and

• income taxes

superannuation

• general administrative expenses

• payroll tax

• employee benefits such as training,

• indirect materials and supplies

profit sharing, employee shares,

• indirect labour

first aid stations, cafeteria and

• royalties relating to the production

recreational facilities

process • tools and equipment not capitalised

• costs associated with strikes, rework labour, scrap and spoilage

• quality control and inspection • factory administration expenses • raw materials — handling and storage • depreciation on factory and factory plant and equipment Factory overheads may be either fixed or variable costs. Fixed production overheads are those indirect costs of production that remain relatively constant regardless of the volume of production. Conversely, variable production costs are those indirect costs of production that vary directly, or nearly directly, with the volume of production. Paragraph 12 of AASB 102 confirms that in determining the factory overhead, an entity must assign a share of both fixed and variable overhead costs. This is referred to as the full absorption costing. Other costs

Other costs are defined in para 15 of AASB 102 as all other costs necessarily incurred in bringing inventories to their present location and condition. Other costs include costs of designing the inventory and costs incurred in transporting raw materials to the factory. Worked Example 3 Which of the following types of packaging are included in the cost of inventory under AASB 102?

(a)

takeaway plastic food containers used by a Chinese takeaway restaurant

Yes

(b)

a shoe box in which shoes are sold

Yes

(c)

drinking straws attached to fruit juice boxes

Yes

(d)

paper serviettes, plastic knives and forks and a refresher towel provided by a fast food restaurant with every takeaway meal

No

(e)

plastic bags provided by a supermarket for customers to put their fruit and vegetables in

Yes

(f)

padded boxes in which jewellery is sold, or intended to be sold

Yes

Excluded costs Some costs are specifically excluded from the cost of inventories (paras 16 to 18, AASB 102). Examples include: • abnormal amounts of inventory wastage • storage costs of finished goods • administrative (or head office) costs • interest expense, and • selling costs, such as advertising and marketing costs. These costs are expensed in the profit and loss statement rather than included in the cost of inventories.

¶6-410 When is inventory on hand? For an item of inventory to be recorded in the accounts, it must be “on hand”. AASB 102 confirms that for accounting purposes whether an item of inventory is “on hand” is based on who has the power to dispose of the inventory. Generally, the power of disposal lies with the person who legally owns the stock. Hence, whether an item of inventory is on hand is not necessarily a question of who is in physical possession of the inventory but who has the legal title. Where inventory is in the process of being shipped or in the process of being received into a warehouse, the question of who legally owns the goods (ie the buyer or the seller) generally comes back to the terms of shipment. Where the terms of shipment are free-on-board (FOB) shipping point, legal title to the goods passes to the buyer at the point of shipping. In this case, the buyer usually pays the freight costs. If the terms of shipment are FOB destination, legal title to the goods remains with the seller until the goods are received by the buyer at the point of destination. Typically, in this instance, the seller pays the freight costs. The concept of FOB shipping point and FOB destination is illustrated in the following two diagrams.

Diagram 6.2: FOB shipping point

Diagram 6.3: FOB destination

Hence, an item of inventory may be on hand even though the taxpayer does not have physical possession of the goods. Worked Example 4 The Perfume Outlet Pty Ltd is a perfume retailer. On 24 June 2017, the company purchases 100 boxes of perfumes and aftershaves from France at a cost of $26,800. The goods are shipped with the terms FOB shipping point. On 30 June 2017, the goods are on their way to Australia. The goods eventually arrive in Australia on 19 July 2017. Despite the fact that The Perfume Outlet Pty Ltd does not have physical possession of the goods, it is deemed to have the stock “on hand” as at 30 June 2017 as the company has the dispositive power. Accordingly, the company must include $26,800 in its closing inventory as at 30 June 2017. If the goods were shipped with the shipping terms of FOB destination, the goods would not be considered “on hand” and The Perfume Outlet Pty Ltd would not include the value of perfumes and aftershaves in its closing inventory as at 30 June 2017. The goods will considered to be “on hand” when they arrive at the point of their destination (ie on 19 July 2017).

Lay-bys For accounting purposes, goods subject to a lay-by arrangement remain the goods of the seller until the final instalment has been paid by the buyer. Hence, in this situation, the goods must be included in the closing inventory of the seller at year-end. The same treatment applies for taxation purposes (Taxation Ruling TR 95/7). However, a service fee or upfront deposit received by the seller which is non-refundable is considered as assessable income at the time of receipt. From a GST perspective, according to GST Ruling GSTR 2000/12, if an entity is using the cash basis, it must remit the GST to the ATO as each payment is made. Conversely, if the entity is using the accrual basis, GST is not remitted to the ATO until the “sale” has been made (ie upon the payment of the final instalment). Take the following example. Assume that on 14 May 2017, a customer enters into a lay-by arrangement with TV World Pty Ltd to purchase a 139cm Full HD LED Smart TV. The television set has a retail price of $2,200 (inclusive of GST). On 14 May 2017, the customer pays a deposit of $500. Under the lay-by arrangement, the customer has a maximum of six months to pay off the remaining amount owing of $1,700. The journal entry that TV World Pty Ltd will record on 14 May 2017 in relation to the initial $500 deposit paid by the customer (assuming that TV World Pty Ltd is on the accrual basis for GST) is as follows: DATE May 14

PARTICULARS Cash at bank

POST REF 1-1300

DEBIT

CREDIT 500

Lay-by deposits

2-2200

500

(To record the initial $500 lay-by deposit received by the customer) Analysis As TV World Pty Ltd is on the accrual basis for GST, no GST is remitted to the ATO as no “sale” has taken place. Accordingly, “cash at bank” is debited for $500 with the liability account entitled “lay-by deposits” credited for the same amount. Each time the customer makes a progressive payment, TV World Pty Ltd will record the same journal entry as the one above. Assume that on 25 October 2017, the customer makes the final $400 payment and takes the television set. The journal entry that TV World Pty Ltd will record on this date is as follows: DATE Oct 25

PARTICULARS Cash at bank

POST REF

DEBIT

1-1300

Lay-by deposits

CREDIT 400

2-2200

400

(To record the final lay-by payment of $400 received from the customer) After the final payment is received, TV World Pty Ltd records the sale and remits the GST to the ATO on its next BAS. The journal entry to record the sale of the television set on 25 October 2017 is as follows: DATE Oct 25

PARTICULARS

POST REF

DEBIT

CREDIT

Lay-by deposits

2-2200

2,200

Sales

4-1000

2,000

GST payable

2-2500

200

(To record the sale of the television set) Analysis This journal entry records the sale of the television set. The liability account “lay-by deposits” is debited for the total amount the customer has paid from 14 May 2017 to 25 October 2017. This amount should equal $2,200. As TV World Pty Ltd is registered for GST, it owes the ATO the GST of $200 (being $2,200 × 1/11th). The remaining amount of $2,000 (being $2,200 × 10/11ths) is credited to the “sales” revenue account. Assuming that TV World Pty Ltd is using a perpetual inventory system and the goods cost $900 (GSTexclusive) to acquire, the following journal entry is also required on 25 October 2017: DATE Oct 25

PARTICULARS

POST REF

Cost of goods sold

5-0000

Inventory

1-3000

DEBIT

CREDIT 900 900

(To record the cost of inventory sold) Analysis Under a perpetual inventory system, we must recognise that when inventory is sold, there is a decrease in the inventory balance. The above journal entry records the cost of inventory sold (through the account

entitled “cost of goods sold”) and credits the “inventory” account for the GST-exclusive cost price of the television set sold, being $900.

Valuation of Inventory Introduction

¶6-500

Specific identification

¶6-510

First-in, first-out (FIFO)

¶6-520

Weighted average cost

¶6-530

Standard cost

¶6-540

Retail inventory method

¶6-550

Comparison of the inventory valuation methods ¶6-560

¶6-500 Introduction At the end of each financial year, the cost of closing inventory needs to be determined. The first step in valuing closing inventory is to determine the number of inventory items on hand at the end of the accounting period. This is achieved by performing a physical stocktake. A stocktake is merely a physical count of inventory on hand at the end of the reporting period. Once counted, these items of inventory need to be assigned a cost or value. In our previous example of TV World Pty Ltd in ¶6-300, a physical stocktake on 30 June 2017 revealed that the company had 16 television sets on hand. As all of these 16 television sets were purchased for $900 each, the closing inventory is valued at $14,400. In this simple example, the costs of television sets have remained constant during the period. However, in reality, prices vary during the period. For example, an entity may have 100 items in the opening inventory that it purchased for $10 each. During the current period, it may have bought a further 50 items at $11 each, an additional 100 items at $12 each and a further 50 items at $15 each. In other words, the total number of items acquired during the period is 300. Assume that during the period, the entity sold 250 items for $20 each. A physical stocktake conducted at the end of the accounting period will reveal that the entity has 50 items on hand (ie 100 + 50 + 100 + 50 − 250). However, two problems arise: • How does the entity determine the cost of the 250 items sold during the period? In other words, what was the purchase price of the 250 items sold? • How does the entity value the remaining units on hand (50 units) at the end of the accounting period? From which batch or batches did these 50 items originate? A perpetual inventory system overcomes these two problems due to the fact that each item of inventory is individually recorded in the system. The system keeps track of the price of each item bought and the date on which it was acquired. However, under a periodic inventory system, no continuous record of inventory movement is maintained. The only way that inventories can be valued is to perform a physical stocktake. However, a stocktake only reveals the quantity (ie the number of items) on hand at the end of the accounting period. In order to ascertain the total dollar value of closing inventory to be recorded in the profit and loss statement and balance sheet, these items must be valued. This leads us to the concept of inventory valuation, known as the “cost flow assumption”. Under this assumption, costs are assigned to inventories (both sold and those remaining on hand at the end of the accounting period). According to para 9 of AASB 102, inventories are required to be measured at the lower of cost and NRV. The concept of “net realisable value” is discussed in more detail at ¶6-600.

The various inventory valuation methods for accounting purposes can be shown diagrammatically as follows. Diagram 6.4: Inventory valuation methods

As the diagram above illustrates, the five acceptable inventory valuation methods for accounting purposes are: • specific identification (¶6-510) • first-in, first-out (FIFO) (¶6-520) • weighted average cost (¶6-530) • standard cost (¶6-540), and • retail inventory method (¶6-550). An entity can choose to value different lines of inventory under a different inventory valuation method. However, once chosen, generally, this valuation method must continue to be used. The only circumstance in which an entity can change its inventory valuation method is when the new valuation method results in more relevant and reliable information (para 14(b), AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors). If a change of inventory valuation method is made, the change must be applied retrospectively as if the new accounting policy had always applied (para 22, AASB 108). The cumulative financial effect of the new policy must be accounted for in the current financial report. In other words, AASB 108 requires a “catch up” of the effect (by an adjustment to assets, liabilities and equity) in the opening comparative balance sheet. Furthermore, management must disclose the nature of the change, reasons for the change as well as the financial effect of the change (para 29, AASB 108). For this reason, the bookkeeper should consult the external accountant if the entity wishes to change its inventory valuation method. In order to illustrate the effects of the abovementioned inventory valuation methods, we will refer to the following worked example. Worked example: Printers-R-Us Pty Ltd Printers-R-Us Pty Ltd buys and sells mono and colour laser printers. On 1 April 2017, Printers-R-Us Pty Ltd had 20 printers in the opening inventory that were valued at $100 each. Hence, its opening inventory totalled $2,000 (GST-exclusive). Assume that the following transactions occurred during the month of April 2017 and that all the following figures are shown GST-inclusive: • 4 April: Purchased 10 printers for $132 each (total purchase of $1,320) • 7 April: Sold 12 printers for $330 each (total sales of $3,960)

• 11 April: Purchased 18 printers for $154 each (total purchase of $2,772) • 26 April: Sold 14 printers for $330 each (total sales of $4,620). It is now 30 April 2017. Based on a physical stocktake, the company has 22 printers on hand at the end of the reporting period. The question is how to value these items on hand. We will now consider the valuation of these items of inventory using the five different valuation methods. For each inventory valuation method, we will use the periodic inventory method (¶6-300) to calculate the cost of goods sold and this should confirm the manual calculation of the value in each situation.

¶6-510 Specific identification The specific identification method specifically identifies the date and the cost of each item of inventory. In other words, there are no assumptions required as to which batch or batches the 22 items of inventory on hand as at 30 April 2017 came from. The entity is specifically able to track each item of inventory. However, for this inventory valuation method to be used, an entity must be able to tag each item of inventory using serial numbers, stock tags or barcoding. This method is typically used by manufacturers, wholesalers and retailers of high value inventory items (such as motor vehicles, jewellery, boats, planes, etc). Under this method, when an item of inventory is sold, the entity is specifically able to identify which batch that particular item of inventory was purchased from and its exact cost price. Similarly, at the end of the accounting period, if that item is on hand, the entity is able to specifically identify the cost of that item of inventory by scanning the item or referring to its serial number or stock tag. Specific identification is the most accurate of all of the inventory valuation methods, but it is also the most expensive and time consuming. The entity must have appropriate systems in place to be able to keep track of all of its inventory items. While it is commonly used in perpetual inventory systems, it is rarely used in a periodic inventory system. Worked example: Printers-R-Us Pty Ltd We will apply the specific identification inventory valuation method to Printers-R-Us Pty Ltd. Assume that the company has been able to specifically identify that the 22 printers on hand as at 30 April 2017 came from the following batches: • six came from the batch purchased on 4 April 2017 at $132 each (total of $792), and • 16 came from the batch purchased on 11 April 2017 at $154 each (total of $2,464). Hence, under the specific identification method, closing inventory of 22 printers will be valued at $3,256 (GST-inclusive). As the GST would have been claimed, the amount of inventory to be shown in the accounts will be its GST-exclusive amount. This is calculated as $2,960 (ie $3,256 × 10/11ths). The 26 printers that were sold during the month of April 2017 were specifically identified as follows: • 20 came from the opening inventory at $100 each (total of $2,000 GST-exclusive) • four came from the batch purchased on 4 April 2017 at $132 each (total of $528 GST-inclusive), and • two came from the batch purchased on 11 April 2017 at $154 each (total of $308 GST-inclusive). Hence, the cost of goods sold under the specific identification inventory valuation method equates to $2,760 (being [$2,000 + (($528 + $308) × 10/11ths)]). Assuming that the specific identification method was used, the profit and loss statement of Printers-R-Us Pty Ltd for the month ended 30 April 2017 is shown as follows: Printers-R-Us Pty Ltd Profit and Loss Statement

for the month ended 30 April 2017 (under the specific identification method) Revenue

$

Sales revenue (26 printers sold at $300 each)

$ 7,800

Less: Cost of goods sold Opening inventory (20 printers at $100 each)

2,000

Add: Purchases

3,720

Cost of goods available for sale

5,720

Less: Closing inventory (22 printers)

(2,960)

Cost of goods sold

2,760

Gross profit

$5,040

The inventory account in the balance sheet of Printers-R-Us Pty Ltd (using the specific identification method) as at 30 April 2017 is as follows: Printers-R-Us Pty Ltd Balance Sheet as at 30 April 2017 (under the specific identification method) Inventory Printers, at cost

$ 2,960

Note: All figures shown above in both the profit and loss statement and balance sheet are GST-exclusive.

¶6-520 First-in, first-out (FIFO) The first-in, first-out (or “FIFO”) inventory valuation method is based on the assumption that the first items of inventory purchased were the first ones sold. Therefore, items of inventory on hand at the end of the reporting period are assumed to consist of the most recent acquisitions of inventory immediately before the end of the reporting period. Similarly, inventory items sold during the reporting period came from the earliest batch. If prices are rising, then generally speaking, the ending inventory will be the highest under this method, as inventory consists of those items purchased closest to the end of the year. Worked example: Printers-R-Us Pty Ltd We will apply the FIFO inventory valuation method to Printers-R-Us Pty Ltd. Under the FIFO method, the 22 printers on hand as at 30 April 2017 are assumed to have come from the most recent acquisitions prior to 30 April 2017. In other words, in order to ascertain the value of the 22 printers in the closing inventory, we count backwards from 30 April. Under FIFO, the 22 printers will be valued as follows: • 18 came from the batch purchased on 11 April 2017 at $154 each (total of $2,772 GST-inclusive), and • four came from the batch purchased on 4 April 2017 at $132 each (total of $528 GST-inclusive). Hence, under the FIFO inventory valuation method, the closing inventory of 22 printers as at 30 April 2017 will be valued at $3,300. However, once again, this is the GST-inclusive amount. As the GST would

have been claimed, the amount of inventory to be shown in the accounts will be its GST-exclusive amount. This is calculated as $3,000 (ie $3,300 × 10/11th). Conversely, the 26 printers that were sold during the month of April 2017 came from the earliest batch of purchases, namely: • 20 from the opening inventory at $100 each (total of $2,000 GST-exclusive), and • six from the batch purchased on 4 April 2017 at $132 each (total of $792 GST-inclusive). Hence, the cost of goods sold under FIFO equates to $2,720 (being [$2,000 + ($792 × 10/11ths)]). Assuming the FIFO method was used, the profit and loss statement of Printers-R-Us Pty Ltd for the month ended 30 April 2017 is shown as follows: Printers-R-Us Pty Ltd Profit and Loss Statement for the month ended 30 April 2017 (under the FIFO method) Revenue

$

Sales revenue (26 printers sold at $300 each)

$ 7,800

Less: Cost of goods sold Opening inventory (20 printers at $100 each)

2,000

Add: Purchases

3,720

Cost of goods available for sale

5,720

Less: Closing inventory (22 printers) Cost of goods sold

(3,000) 2,720

Gross profit

$5,080

The inventory account in the balance sheet of Printers-R-Us Pty Ltd (using FIFO) as at 30 April 2017 is as follows: Printers-R-Us Pty Ltd Balance Sheet as at 30 April 2017 (under the FIFO method) Inventory Printers, at cost

$ 3,000

Note: All figures shown above in both the profit and loss statement and balance sheet are GST-exclusive.

¶6-530 Weighted average cost Under the weighted average cost method, an average cost of inventory for the reporting period is calculated. This calculation is made by taking the total purchase price of all inventory acquired during the period

(including the opening inventory) and dividing it by the number of items purchased (including the number of items on hand at the beginning of the reporting period). This gives the average price of inventory for the reporting period. This average cost is then multiplied by the number of goods on hand at the end of the year. The formula for determining the average cost of inventory is as follows:

[Opening inventory   +   Purchases] [Number of items in opening inventory + Number of items purchased during period]

Worked example: Printers-R-Us Pty Ltd We will now apply the weighted average cost inventory valuation method to Printers-R-Us Pty Ltd. Using the weighted average cost method, the average cost of inventory is determined as follows: $2,000 + $3,720 (ie $4,092 × 10/11ths)  20 + 10 + 18 printers  $5,720 48

= $119.17 per printer (GST-exclusive)

Hence, the 22 printers on hand as at 30 April 2017 will be valued using the weighted average cost method at $2,622 (ie 22 printers × $119.17). The 26 printers that were sold during the month of April 2017 will be valued at $3,098 (ie 26 printers × $119.17). This is the amount of cost of goods sold in the profit and loss statement. Assuming the weighted average cost method was used, the profit and loss statement of Printers-R-Us Pty Ltd for the month ended 30 April 2017 is shown as follows: Printers-R-Us Pty Ltd Profit and Loss Statement for the month ended 30 April 2017 (under the weighted average cost method) Revenue

$

Sales revenue (26 printers sold at $300 each)

$ 7,800

Less: Cost of goods sold Opening inventory (20 printers at $100 each)

2,000

Add: Purchases

3,720

Cost of goods available for sale

5,720

Less: Closing inventory (22 printers)

(2,622)

Cost of goods sold

3,098

Gross profit

$4,702

The inventory account in the balance sheet of Printers-R-Us Pty Ltd (using weighted average cost) as at 30 April 2017 is as follows: Printers-R-Us Pty Ltd

Balance Sheet as at 30 April 2017 (under the weighted average cost method) Inventory

$

Printers, at cost

2,622

Note: All figures shown above in both the profit and loss statement and balance sheet are GST-exclusive.

¶6-540 Standard cost Standard cost is primarily used by manufacturers who set a predetermined price for inventory items. This budgeted price is used for all items of inventory acquired during the reporting period. However, this price must be reviewed regularly and updated if necessary, particularly if prices change. This inventory valuation method is mainly used in large manufacturing businesses. For this reason, we will not be discussing standard costing any further in this chapter.

¶6-550 Retail inventory method According to para 22 of AASB 102, the retail inventory method is often used in the retail industry for measuring inventories of large numbers of rapidly changing items with similar margins for which it is impracticable to use other costing methods. Under this method, the cost of inventory is determined by reducing the sales value of inventory by the appropriate percentage gross margin. The percentage used takes into consideration inventory that has been marked down to below its original selling price. An average percentage for each retail department is often used. Not surprisingly, this inventory valuation method is not particularly common.

¶6-560 Comparison of the inventory valuation methods The following two tables summarise the three inventory valuation methods used in the example, PrintersR-Us Pty Ltd, in terms of their effect on the profit and loss statement and balance sheet. Profit and loss statement

Specific identification

Sales

FIFO

$7,800

Weighted average cost

$7,800

$7,800

Less: Cost of goods sold Opening inventory

2,000

2,000

2,000

Add: Purchases

3,720

3,720

3,720

Cost of goods available for sale

5,720

5,720

5,720

Less: Closing inventory

(2,960)

(3,000)

(2,622)

Cost of goods sold

2,760

2,720

3,098

Gross profit

$5,040

$5,080

$4,702

Balance sheet Inventory, at cost

Specific identification $2,960

FIFO $3,000

Weighted average cost $2,622

The reason for the differences between the three methods is that prices have changed during April 2017. If prices had not changed during the month of April 2017, then all three methods would have resulted in

the same gross profit and inventory value in the balance sheet. It can be seen that the choice of inventory valuation method can have a significant effect on the profit and the amount of inventory shown in the balance sheet. The higher the inventory value, the higher the reported profit and the amount shown in the balance sheet. Conversely, the lower the inventory value, the lower the reported profit and the amount shown in the balance sheet. From the above comparison, it can be seen that FIFO gives the highest gross profit and value of inventory in the balance sheet. This is because in a period of rising prices, closing inventory will consist of items that were most recently purchased. Also in the above comparison, the weighted average cost method has resulted in the lowest profit and closing inventory balance. The amounts attributed to the specific identification method will vary depending on which batch the items in the closing inventory were purchased from. AASB 102 allows an entity the choice of any one of the five inventory valuation methods. However, para 23 of AASB 102 provides that where inventories are not ordinarily interchangeable and segregated for specific projects, the specific identification method should be used. Conversely, the specific identification method is inappropriate where there are large number of items of inventory that are ordinarily interchangeable. Where the specific identification method is not considered appropriate, then the entity should use either the FIFO or weighted average cost method. Once a valuation method has been chosen, the entity should not randomly switch methods, as this could have a significant effect on reported profits and asset balances. An entity can only change inventory valuation methods where it can show that the change will result in more relevant and reliable information. Furthermore, an entity can only value its closing inventory, but not the opening inventory. Once it assigns a cost to its closing inventory, this automatically becomes the opening inventory for the start of the next accounting period.

¶6-600 The lower of cost and net realisable value (NRV) rule In some cases, the selling price of inventory may fall. This may be due to: • the falling demand for the product • physical deterioration of inventories • damaged stock • commercial or technical obsolescence • a deliberate decision made by management to sell the inventory at below its cost (eg the entity is having a stocktake sale and is discounting some items of inventory to below cost), or • an increase in the estimated costs of completion or estimated costs of selling the product. Whatever the reason, when the selling price of inventory falls below the cost price of each item, inventory must be written down to its net realisable value or NRV (para 9, AASB 102). NRV is defined as the estimated selling price of inventory in the ordinary course of business less the estimated costs to sell each item. The rationale in writing down inventories below cost to its NRV is consistent with the view that assets should not be valued at amounts in excess of what is expected to be realised from their sale or use. The NRV of each item of inventory must be determined at the reporting date. It is therefore not acceptable to compare the total cost of inventory shown in the financial statements with its total NRV. The cost of each item of inventory must be compared to its individual NRV.

Refer back to the worked example of Printers-R-Us Pty Ltd. Assume that the entity has adopted the FIFO method of inventory valuation. It will be remembered that under FIFO, the 22 printers on hand as at 30 April 2017 were valued at $3,000 (GST-exclusive) or $3,300 (GST-inclusive). A further examination of the 22 printers revealed the following breakdown: • 18 × Vortex ML1480 laser printers at $140 each (total of $2,520 GST-exclusive), and • 4 × Merlin HP301 laser printers at $120 each (total of $480 GST-exclusive). Assume that it is now 30 April 2017 and the 18 Vortex printers are currently being advertised for sale by Printers-R-Us Pty Ltd at $198 (GST-inclusive). This equates to $180 (GST-exclusive) per printer. However, the four Merlin printers have proved to be poor sellers and have recently been superseded by a later and more superior printer, Merlin HP401. Consequently, as at 30 April 2017, the four Merlin HP301 printers currently in stock have been marked down in price and are advertised for sale for only $88 each (GST-inclusive). This equates to $80 (GST-exclusive) per printer. Furthermore, assume that there are no anticipated direct selling costs associated with the sale of these printers. As the inventory figures for both printer models are shown in the balance sheet at their GST-exclusive values, in determining whether their cost exceeds the NRV, a comparison must be made on a GSTexclusive basis. The sale prices outlined above are shown on a GST-inclusive value, as the company is registered for GST. The GST-exclusive selling price of the Vortex printers equates to $180 each (being $198 × 10/11ths) while the GST-exclusive selling price of the Merlin printers equates to $80 each (being $88 × 10/11ths). Table 6.3 summarises the lower of cost and NRV amounts for each of the two types of printers. Table 6.3: Comparison of cost and NRV per printer model Printer model

GST-exclusive cost

GST-exclusive NRV

Vortex ML1480 laser printer

$140

$180

Merlin HP301 laser printer

$120

$80

It can be seen that the Vortex laser printers are being sold for more than their cost. However, the four Merlin laser printers are being sold for less than their cost. In other words, the cost of each printer (being $120 each) is greater than its NRV of $80. As such, the NRV rule contained in para 9 of AASB 102 requires that the four Merlin laser printers be written down to their NRV of $80 each. This will require a write-down of $40 per printer (from $120 to $80 per printer), resulting in a total write-down of $160. The journal entry to record this write-down is as follows: DATE Apr 30

PARTICULARS Inventory write-down expense Inventory

POST REF 6-4400 1-3000

DEBIT

CREDIT 160 160

(Writing down 4 Merlin printers from their GST-exclusive cost of $120 each to their NRV of $80 each) This journal entry will have the effect of reducing the GST-exclusive cost of inventory in respect of the four Merlin laser printers in the balance sheet from $480 to $320. The debit to “inventory write-down expense” will appear as an expense in the profit and loss statement. The Vortex laser printers do not need to be written down as their NRV of $180 each is higher than their cost of $140 each. Hence, these printers can continue to be shown at cost in the balance sheet. Table 6.4 summarises how the 22 printers will be valued as at 30 April 2017. Table 6.4: How the 22 printers will be valued

Printer Model

Total cost

Total NRV

18 Vortex ML1480 printers

$2,520 (18 × $140 each)

$3,240 (18 × $180 each)

4 Merlin HP301 printers

$480 (4 × $120 each)

$320 (4 × $80 each)

Total

Lower of cost and NRV $2,520 $320 $2,840

Paragraph 36 of AASB 102 requires that for financial accounting purposes, inventories are required to be disclosed in the balance sheet separately, at either cost or NRV. The inventory account in the balance sheet of Printers-R-Us Pty Ltd as at 30 April 2017 is shown as follows: Printers-R-Us Pty Ltd Balance Sheet as at 30 April 2017 Inventory Vortex ML 1480 printers, at cost Merlin HP301 printers, at NRV Total

$ 2,520 320 $2,840

It is interesting to note that according to para 33 of AASB 102, if, in a subsequent accounting period, the NRV of the inventory that has been written down subsequently increases (due to a rise in the selling price), the inventory write-down expense can be reversed (subject to the original amount of inventory write-down). The reversal of inventory write-down will be shown as “other income” in the profit and loss statement. However, this reversal is very rare as once inventory is written down, very rarely does it subsequently increase in value. The following is an extract from the 2016 financial statements of The Reject Shop Ltd. According to the company’s 2016 balance sheet, its total assets were $230.6m. Inventory accounted for $98.5 (or 43% of total assets). Note 6 reproduced in the following shows the detailed inventories note in the company’s 2016 financial statements:

As can be seen above, the total inventories figure of $98.5m is divided into those inventories which have been valued at cost (ie $96.6m) and those inventories valued at NRV (ie $1.879m). The inventories shown at NRV account for 1.91% of the total inventories on hand at year-end. The company’s inventory valuation method (ie moving or weighted average cost) and policy relating to NRV is included in Note 1(e) of the Summary of Significant Accounting Policies, which is reproduced as follows:

¶6-700 Accounting for inventory — commonly asked questions Question

Answer

What is inventory and how should it be disclosed in The term “inventory” refers to goods or property the financial statements? purchased, manufactured or acquired by an entity in the ordinary course of business held for the purposes of resale.

Inventory includes goods, property or services in the process of production, but not yet completed (ie work in progress). Inventory is also commonly referred to as trading stock.

Inventory is recorded as a current asset in the balance sheet. How does the choice of a periodic or perpetual inventory system impact on the chart of accounts?

Under the perpetual inventory system, a continuous record of inventories is maintained. At any point in time, the owner of the business can ascertain how much inventory is on hand.

Under a perpetual inventory system, detailed records of inventory movements are recorded by the entity through the inventory account.

In other words, every time an item of inventory is bought by the entity, inventory account increases. Similarly, every time an item of inventory is sold by the entity, inventory account decreases.

For this reason, under the perpetual inventory system, the bookkeeper should set up two accounts in the chart of accounts: an account entitled “cost of goods sold” in the profit and loss statement (underneath “revenue”) and the “inventory” account in the balance sheet as a current asset.

In a periodic inventory system, detailed records of inventory movements are not maintained. There is no continuous record of how much inventory is on hand at any particular point in time. The only way that the amount of inventory on hand can be ascertained is by performing a physical stocktake (ie counting the inventory on hand).

Unlike the perpetual inventory system, inventory account is not debited or credited every time an item of inventory is bought and sold. Therefore, under the periodic inventory system, the amount of inventory shown in the balance sheet during the year is not the current value of inventory on hand at that point in time.

For this reason, under a periodic inventory system, the bookkeeper should set up five accounts in the chart of accounts. The profit and loss statement should contain the following four accounts (underneath “revenue”): • opening inventory • purchases • purchases returns and allowances • closing inventory.

An “inventory” account should also be created in the balance sheet as a current asset.

What is included in the cost of inventory?

The cost of inventory is the sum of: • the cost of purchase • the costs of conversion, and • all other costs incurred in bringing the inventories to their present location and condition.

Hence, when acquiring inventories, the bookkeeper should include not only the purchase price of inventory, but all additional costs incurred in bringing the inventory to the client’s premises. This includes the cost of freight, transportation and insurance.

If an entity is registered for GST, it excludes the GST paid to acquire the inventory. The amount of the GST paid represents the input tax credit the entity is able to claim from the ATO.

Trade, rebates and settlement discounts are taken into account in determining the cost of inventory. However, in the case of settlement (or early payment) discounts, they are debited against the cost of inventory. How are lay-bys accounted for?

From an accounting, income tax and GST perspective, goods subject to a lay-by arrangement remain the goods of the seller until the final instalment has been paid by the buyer.

Hence, in this situation, the goods must be included in the closing inventory of the seller at year-end.

From a bookkeeping perspective, when a customer pays a deposit for a lay-by item (or continues to make payments), the bookkeeper should debit “cash at bank” and credit the current liability account entitled “lay-by deposits”.

When the final instalment is paid by the customer and the goods are delivered to the customers, the

bookkeeper should debit “lay-by deposits” and credit “sales revenue”.

To recognise that an item of inventory is no longer in stock, the “inventory” account is credited and “cost of goods sold” is debited (assuming a perpetual inventory system is being used). It is now 30 June. Should my client perform a physical stocktake?

At the end of each financial year, the client should determine the number of inventory items on hand by performing a physical stocktake.

Is a physical stocktake really necessary if my client maintains a perpetual inventory system and the A stocktake is merely a count of inventory on hand value of closing inventory can easily be at the end of the reporting period. ascertained by verifying the computer records at 30 June? Even if the client uses a perpetual inventory system, a physical stocktake should nevertheless be performed to verify the amount of closing inventory.

If there is a discrepancy between the physical stocktake count and the amount as per the computer records, the physical count should be trusted.

The discrepancy could be due to a number of reasons, including inventory damage, theft or misplaced stock. An adjustment must be made, with the account “inventory shortage” debited or credited for the difference. It is now 30 June. How should inventory be valued Once the inventory items have been counted, they in the profit and loss statement and balance sheet? must be assigned a cost or value.

There are five acceptable inventory valuation methods, namely: • specific identification • FIFO • weighted average cost • standard cost, and • retail inventory method.

An entity can value different lines of inventory using a different inventory valuation method. However, once chosen, generally this inventory valuation method must continue to be used. Changes are allowed only in limited circumstances. I have valued my closing inventory at cost using FIFO.

However, I noticed that several items of inventory have been damaged and the price that I am now advertising these items for are actually below their cost price. Is there anything that I need to record in the accounts?

In some cases, the selling price of inventory may fall. This may be due to the falling demand for the product, physical deterioration of inventories, damaged stock, commercial or technical obsolescence or a deliberate decision made by management to sell the inventory at below its cost (eg an entity is having a stocktake sale and is discounting some items of inventory to below cost).

Whatever the reason, when inventory is being advertised for sale at an amount below its purchase price, inventory must be written down to its NRV (para 9, AASB 102).

NRV is defined as the estimated selling price of inventory in the normal course of business less estimated costs to sell each item. The NRV of each item of inventory must be determined at the reporting date.

The journal entry to be recorded is the difference between the selling price of inventory (less estimated costs of sale) and the cost price of inventory. The journal entry will have the effect of reducing the inventory (ie credit to the “inventory” account) with the debit being taken to the “inventory write-down expense” account which appears as an expense in the profit and loss statement.

7 ACCOUNTING FOR NON-CURRENT ASSETS Introduction

¶7-000

Determining the cost of property, plant and equipment

¶7-050

Subsequent costs

¶7-100

Fixed asset register

¶7-200

Depreciation of property, plant and equipment

¶7-300

Sale of depreciable assets

¶7-600

Depreciation schedule

¶7-700

Financing options

¶7-750

Intangible assets

¶7-850

Appendix 1: Sample fixed asset register

¶7-900

Appendix 2: Sample depreciation schedule

¶7-940

Appendix 3: Lease schedule — Mixmaster Pty Ltd

¶7-950

Appendix 4: Hire purchase schedule — Mixmaster Pty Ltd

¶7-960

Appendix 5: Chattel mortgage schedule — Mixmaster Pty Ltd ¶7-980 Non-current assets — commonly asked questions

¶7-990

¶7-000 Introduction According to para 49(a) of the AASB Framework issued by the Australian Accounting Standards Board (AASB) in July 2004 and amended in December 2007, assets are defined as “a resource controlled by an entity as a result of past events and from which future economic benefits are expected to flow to the entity”. Assets are classified as either: • tangible, or • intangible. Diagram 7.1 summarises the various types of assets. Diagram 7.1: Assets

AASB 116 Property, Plant and Equipment deals exclusively with tangible assets. A tangible asset is one with physical substance. The term “property, plant and equipment” is defined in para 6 of AASB 116 as assets that: • are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes, and • are expected to be used during more than one period (ie they are considered non-current assets). Examples of property, plant and equipment include: • land • buildings • plant and equipment • office equipment • computer equipment (excluding computer software) • furniture and fittings, and • motor vehicles. Importantly, these assets are expected to be used by an entity to produce its goods and services. This definition specifically excludes items that are bought for the purposes of resale. In that situation, the asset would be classified as inventory and the provisions of AASB 102 Inventories would apply. Furthermore, if a decision is made by management to sell a non-current asset, it will be reclassified as a current asset in the balance sheet. In this instant, AASB 5 Non-Current Assets Held for Sale and Discontinued Operations applies. Another distinguishing feature of these assets is that the benefits embodied in them span more than one accounting period. For many Australian companies, property, plant and equipment is the largest reported asset. For example, according to the 2016 financial statements of Qantas Group Ltd, as at 30 June 2016, its total assets were $16.7b. Property, plant and equipment accounted for $11.67b (or 70% of total assets). An extract of the company’s 2016 balance sheet is shown as follows:

Similarly, in the case of Telstra Corporation Ltd, for the year ended 30 June 2016, property, plant and equipment accounted for $20.58b, representing 47.5% of its total assets of $43.29b. AASB 138 Intangible Assets is the accounting standard dealing with intangible assets. Paragraph 8 of AASB 138 defines an intangible asset as an identifiable non-monetary asset without physical substance. Examples of identifiable intangible assets include: • trademarks • patents • copyrights • motion picture films • publishing titles • customer lists • computer databases • licenses • royalty agreements • brandnames • franchise agreements • internet domain names • trade secrets such as secret formulas, processes or recipes • newspaper mastheads, and • computer software (except where it is an integral part of the related hardware, such as the operating system).

While goodwill is regarded as an intangible asset, it is regarded as an unidentifiable intangible asset. In other words, unlike the assets detailed above, it cannot be sold separately. Goodwill is sold when the business is sold. For this reason, goodwill does not fall within the provisions of AASB 138, but is instead covered by AASB 3 Business Combinations. Goodwill is discussed in more detail at ¶7-870. This chapter covers the accounting implications for both tangible and intangible assets.

¶7-050 Determining the cost of property, plant and equipment According to para 7 of AASB 116, an item of property, plant and equipment shall be recognised as an asset in the accounts of an entity if: • it is probable that future economic benefits associated with the item will flow to the entity, and • the cost of the item can be measured reliably. According to para 15 of AASB 116, all items of property, plant and equipment that meet the definition and recognition criteria are to be initially recognised as an asset in the balance sheet at cost. In the case of not-for-profit entities, if an item of property, plant and equipment is acquired at no cost (or for a nominal cost), the cost is deemed to be its fair (or market) value as at the date of acquisition (para Aus 15.1, AASB 116). This applies to assets that may have been donated to a not-for-profit entity. When a tangible non-current asset is acquired by an entity, para 16 of AASB 116 requires the asset to be initially recorded in the balance sheet at cost. The cost of an asset includes: • its purchase price, including import duties, transport, freight, insurance, shipping and handling costs and stamp duty directly attributable to purchasing the asset. Any trade discounts or rebates received must be deducted from the purchase price of the asset. If the entity is registered for the goods and services tax (GST), it excludes the GST paid to acquire the asset. The amount of GST paid represents the input tax credit that the entity is able to claim from the Australian Taxation Office (ATO). As such, the cost of the asset will be shown exclusive of GST in the balance sheet, provided the entity is registered for GST • any incidental costs directly attributable to bringing the asset to its present location and condition necessary for it to be capable of operating in the manner intended by management, and • initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located. Examples of incidental costs directly attributable to the cost of the asset include (para 17, AASB 116): • employee benefits arising directly from the construction or acquisition of the item of property, plant and equipment • costs of site preparation • initial delivery, freight and handling costs • installation and assembly costs • costs of testing whether the asset is functioning properly, and • professional fees. Incidental costs that are not able to be included in the cost of property, plant and equipment include (para 19 and 20, AASB 116): • costs of opening a new facility (eg opening party) • advertising and promotional costs

• costs of conducting a business in a new location • administration and other general overhead costs • initial operating losses, such as those incurred while the demand for the item’s output builds up, and • costs of relocating or reorganising part or all of the entity’s operations. These costs are required to be expensed to the profit and loss statement. The following worked example demonstrates these principles. Worked Example 1 Labtec Pty Ltd conducts genetic research. It is registered for GST. On 12 May 2017, the company acquired a piece of scientific equipment for its laboratory on credit. The cost of the machine was $85,000 including GST. The company was able to secure a trade discount of 5% upon the purchase of the machine. Freight and transportation costs totalled $1,750 including GST. The cost of the machine to be included in the balance sheet of Labtec Pty Ltd is as follows:

$ Purchase price of the machine (including GST)

85,000

Less: Trade discount ($85,000 × 5%)

(4,250) 80,750

Add: Freight and transportation costs (including GST)

1,750

Total purchase price (including GST)

82,500

Less: GST ($82,500 × 1/11th)

(7,500)

Cost of machine (excluding GST)

$75,000

The bookkeeper will need to put through the following journal entry to record the purchase of the machine:

DATE May 12

PARTICULARS

POST REF

DEBIT

Plant and equipment

1-7200

75,000

GST receivable

2-2600

7,500

Accounts payable

2-2000

CREDIT

82,500

(Recording the purchase of plant and equipment) Analysis “Plant and equipment” is debited for its GST-exclusive cost of $75,000 as calculated above. This amount includes the purchase price less the trade discount plus freight and transportation costs. As these costs were directly incurred in acquiring the asset and bringing the asset to the entity’s premises, the costs are capitalised into the cost of the asset, and not expensed. The term “capitalised” means that costs are added to the cost of the asset rather than being expensed. The amount of GST paid of $7,500 is debited to the “GST receivable” account, which is the sum of the GST paid in respect of the purchase of the equipment of $7,341 (being $80,750 × 1/11th) plus the GST paid in respect of freight and transportation of $159 (being $1,750 × 1/11th). “Accounts payable” is credited for the gross amount owing of $82,500.

It is important to note that only the reasonable and necessary expenditures should be included in the cost of an asset. Expenditures that could have been avoided or do not increase the future economic benefits of the asset should be treated as expenses. For example, expenditure incurred to repair an item of plant and equipment that was accidentally damaged during the installation process should not be included as forming part of the cost of the asset.

Instead, these costs should be expensed to the profit and loss statement as repairs. Land and buildings The cost of land includes not only the purchase price of the land, but any incidental costs, such as real estate agent’s fees, stamp duty on the signing of the contract, title search, and conveyancing and search fees. If there is a building on the land purchased which is subsequently demolished in order to construct a new building, the demolition costs of the old building form part of the cost of the land, rather than the cost of the new building. The total purchase price plus the cost of demolishing the old building is included in the cost of the land. These costs do not form part of the acquisition price of the new building as the costs were incurred in bringing the land into a condition for its intended use.

¶7-100 Subsequent costs During the life of an asset, an entity may incur subsequent costs to maintain, upgrade or improve the asset. These costs range from routine repairs and maintenance to major capital improvements or overhauls to the asset. From an accounting viewpoint, the question to be asked is whether subsequent costs should be expensed to the profit and loss statement or included (ie capitalised) as part of the cost of the asset. According to paras 12 to 14 of AASB 116, subsequent costs incurred after the acquisition of an item of property, plant and equipment should only be capitalised if the costs: • extend the useful life of the asset • improve the quality of its output, or • reduce the operating costs associated with the use of the asset. In these instances, AASB 116 requires that the cost of capital improvement be capitalised into the cost of the asset. This will have the effect of increasing the value of the asset, thereby increasing the future depreciation charges. This issue is discussed further in ¶7-400. Worked Example 2 On 4 February 2017, Titan Holdings Pty Ltd replaces the engine in one of its motor vehicles at a cost of $8,800 inclusive of GST. The motor vehicle is used exclusively for business purposes. The installation of the new engine has the effect of increasing the useful life of the vehicle by four years. As the engine has the effect of extending the useful life of the motor vehicle, the cost of replacing the engine should be capitalised (ie added to the cost of the original asset). In this instance, the revised carrying amount of the asset will be depreciated over the remaining (now extended) useful life of the asset. The bookkeeper will need to put through the following journal entry to record the cost of replacing the engine in the motor vehicle:

DATE Feb 4

PARTICULARS

POST REF

DEBIT

Motor vehicle

1-7800

8,000

GST receivable

2-2600

800

Cash at bank

1-1300

CREDIT

8,800

(To record the installation of a new engine) Analysis The installation of the new engine has had the effect of increasing the asset’s useful life. As such, the cost should be capitalised in accordance with AASB 116. The asset account “motor vehicle” is debited by $8,000 (being the GST-exclusive amount). The “GST receivable” account is debited for $800 (being $8,800 × 1/11th). The “cash at bank” account is credited for the amount paid, being $8,800.

Regular repairs and maintenance While the expenditure that has the result of extending the useful life of an asset or improving the quality of the asset is capitalised, the expenditure incurred in repairing or maintaining an asset is expensed to the profit and loss statement. Expenditures incurred on regular maintenance or repairs to assets used for business purposes generally do not increase the level of future economic benefits that flow to the asset in future periods. For example, costs incurred in annual servicing of a motor vehicle or minor electrical repairs made to a machine used for business purposes would be regarded as repairs and maintenance. These costs do not extend the useful life of the asset, nor do they improve the quality of its output. Hence, these costs are expensed, not capitalised. Worked Example 3 On 3 August 2017, Titan Holdings Pty Ltd paid $220 (GST-inclusive) to make repairs to one of its computers that was accidentally damaged. Repairing the asset to bring it back to its original condition before the damage occurred does not constitute capital improvement. The asset’s useful life has not been extended, hence, the repair will be expensed to the profit and loss statement. The bookkeeper will put through the following journal entry:

DATE Aug 3

PARTICULARS

POST REF

DEBIT

CREDIT

Repairs and maintenance expense

6-6000

200

GST receivable

2-2600

20

Cash at bank

1-1300

220

(To record ordinary repairs to a computer) Analysis The “repairs and maintenance expense” account is debited by $200 (being the GST-exclusive amount). The “GST receivable” account is debited for $20 (being $220 × 1/11th). The “cash at bank” account is credited for the amount paid, being $220.

¶7-200 Fixed asset register Because of the importance of property, plant and equipment, many entities maintain a fixed asset register. Typically, this register is prepared in a spreadsheet and updated each time an asset is bought or sold. The fixed asset register usually contains the following information: • the date the asset was acquired • a description of the asset • from whom the asset was purchased • the cost of the asset • the serial number of the asset • the date on which the asset was sold, and • gross sale proceeds of the asset. It is common practice for entities to attach a serial number to each asset for identification purposes. A photograph of each asset listed in the fixed asset register should also be taken and maintained, primarily for insurance purposes. A sample fixed asset register is included at ¶7-900.

Depreciation of Property, Plant and Equipment What is depreciation?

¶7-300

Depreciation of property, plant and equipment ¶7-400 Estimating the asset’s residual value

¶7-410

Estimating the asset’s useful life

¶7-420

The choice of depreciation method

¶7-430

Revision of residual value or useful life

¶7-510

¶7-300 What is depreciation? All non-current assets are deemed to provide future economic benefits over a number of years. For this reason, all items of property, plant and equipment, with the exception of land, are considered to have a limited useful life and are required to be depreciated. Accounting for depreciation represents the process whereby the decline in future economic benefits of an asset through usage, wear and tear and obsolescence is progressively recognised over the life of the asset as an expense in the profit and loss statement. According to para 6 of AASB 116, depreciation is defined as “the systematic allocation of the depreciable amount of an asset over its estimated useful life”. The term “depreciable amount” is defined in the same paragraph as “the cost of the asset or other amount substituted for cost, less its residual value”. Depreciation is not a process of valuation. Recording depreciation does not purport to produce an asset value equivalent to the current market value. Hence, an asset must be depreciated even if its value increases. Depreciation commences when the asset is available for use by an entity (ie when it is in the location and condition necessary for it to be operating in the manner intended by management). In effect, depreciation recognises the fact that assets contribute to the generation of revenues of an entity over a number of years, not just in the year in which they are acquired. As such, the cost of the asset must be “spread” over a number of accounting periods. This is the process of depreciation. The following section discusses the accounting for depreciation.

¶7-400 Depreciation of property, plant and equipment The depreciation formula can be expressed as follows:

Depreciation expense

=

[Cost − Estimated residual value] Estimated useful life

The numerator in the formula is known as the “depreciable amount”. According to para 50 of AASB 116, the depreciable amount of an asset is the amount which shall be allocated on a systematic basis over the asset’s estimated useful life. The amount of depreciation expense is to be recognised in the profit and loss statement (para 48, AASB 116). The amount of depreciation expense is dependant upon three factors: • estimating the asset’s residual value (¶7-410) • estimating the asset’s useful life (¶7-420), and • the choice of depreciation method (¶7-430).

¶7-410 Estimating the asset’s residual value Firstly, an estimate must be made of the asset’s residual (or disposal) value. Paragraph 6 of AASB 116 defines the “residual value” of an asset as: “the estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life.” The estimate is based on the net amount that the entity could recover for similar assets which have already reached the end of their useful lives and were operated under similar conditions to those under which the asset will be used. The disposal value may be based on the asset’s scrap value or on its expected trade-in value. If this value cannot be ascertained, then a value of $nil should be assigned. The residual value is also known as the salvage value or trade-in value. The residual value of every asset should be reviewed at least at the end of each financial year and revised if necessary (para 51, AASB 116).

¶7-420 Estimating the asset’s useful life Secondly, the asset’s estimated useful life must be determined. According to para 6 of AASB 116, an asset’s useful life is defined as: • the period over which an asset is expected to be available for use by an entity, or • the number of production or similar units expected to be obtained from the asset by an entity. The useful life of an asset is expressed on a time basis (usually in years). Paragraph 56 of AASB 116 states that in determining the useful life of a depreciable asset, consideration should be given to the following: • expected usage of the asset • expected physical wear and tear • technical or commercial obsolescence • legal or similar limits on the use of the asset. The useful life of an asset is normally the shortest of the above alternatives. Furthermore, the definition of useful life refers to the estimated useful life to the entity, not the actual useful life of the asset. This means that if a motor vehicle has a physical useful life of eight years, but the owner of the vehicle intends to dispose it in five years’ time, the useful life of the motor vehicle is five years, not eight years. Practically, it is very difficult for bookkeepers, accountants or the owners of a business to determine the useful lives of assets. To assist taxpayers in determining the useful (or effective) lives of depreciable assets, in January 2001, the Commissioner of Taxation published his own determination of effective lives of depreciating assets. This listing is included in a taxation ruling which is updated and reissued every year. The latest version, Taxation Ruling TR 2016/1, was issued by the Commissioner on 29 June 2016 and applies in respect of income years beginning on or after 1 July 2016. This 258-page ruling can be accessed on the ATO’s website at tinyurl.com/hbnv5pr. While it is possible to use different useful lives for a depreciable asset for accounting and taxation purposes, in most cases, a taxpayer will usually adopt the useful life for accounting purposes as the effective life for taxation purposes. This means that the depreciation expense for accounting purposes is the same as that claimed for taxation purposes. Land and buildings In the case of land and buildings, para 58 of AASB 116 confirms that land and buildings are regarded as

separate assets and, as such, should be accounted for separately, even when they are acquired together. Land has an unlimited useful life and is therefore not depreciated. However, buildings have a limited useful life and are therefore considered depreciable assets. An increase in the value of a building does not mean that the building should not be depreciated.

The choice of depreciation method Acceptable depreciation methods

¶7-430

Straight-line method

¶7-435

Diminishing balance method

¶7-440

Units of production method

¶7-445

Comparison of depreciation methods ¶7-450 Changing depreciation methods

¶7-500

¶7-430 Acceptable depreciation methods AASB 116 requires depreciation to be allocated on a systematic basis over an asset’s useful life. Paragraph 62 of AASB 116 prescribes three acceptable depreciation methods: • the straight-line method (¶7-435) • the diminishing balance method (¶7-440), and • the units of production method (¶7-445). AASB 116 does not specify a particular depreciation method to be adopted by the entity. An entity has a choice of any of the three abovementioned depreciation methods. Furthermore, an entity can choose one depreciation method (eg straight-line) for one asset and another depreciation method (eg diminishing balance) for another asset. Paragraph 60 of AASB 116 states that the depreciation method chosen should reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity. The accountant usually determines which depreciation method (ie straight-line, diminishing balance or units of production) the client should adopt. In practice, most entities use a combination of the straight-line and diminishing balance depreciation methods. The units of production method is rarely used and has limited application to those assets which keep a “count” of its output (eg photocopying machines). Each of the three depreciation methods permitted by AASB 116 is discussed in the following paragraphs.

¶7-435 Straight-line method The straight-line depreciation method results in an equal amount of depreciation for each year of the asset’s useful life. Under the straight-line method, the depreciation expense is calculated by applying the following formula:

[Cost − Estimated residual value] Estimated useful life

As mentioned at ¶7-050, if an entity is registered for GST, the “cost” in the abovementioned formula is the GST-exclusive cost. The input tax credit (equivalent to 1/11th of the cost of the asset) will be claimed by

the entity in its next Business Activity Statement (BAS). If a depreciating asset is acquired during the income year, the amount of depreciation is calculated on a pro rata basis from the date of acquisition to the end of the financial year on a daily basis. The following graph demonstrates the pattern of the recognition of depreciation expense using the straight-line method.

The following worked example of McKenzie Consultants Pty Ltd illustrates the application of the straightline depreciation method. Worked Example 4 On 1 January 2017, McKenzie Consultants Pty Ltd, a firm of management consultants who is registered for GST, purchased a colour photocopier for use in its office at a cost of $13,200 inclusive of GST. The company claimed an input tax credit of $1,200 in its March 2017 BAS. The GST-exclusive value of the colour photocopier of $12,000 will be shown in the company’s balance sheet. The company estimates that the photocopier will produce approximately 40,000 copies and have an estimated useful life of five years. The directors of the company estimate the residual value of the photocopier to be $2,000 in five years’ time.

Using the straight-line depreciation method, the depreciation expense for the 2017 financial year is calculated as follows: $12,000 − $2,000 5 years = $2,000 depreciation per annum However, as the colour photocopier was purchased on 1 January 2017, depreciation for 2017 is calculated for six months only. Hence, depreciation for the financial year ended 30 June 2017 is $1,000 (ie $2,000 × ½ year). The bookkeeper should put through the following journal entry on 30 June 2017 to record depreciation for the 2017 financial year under the straight-line depreciation method: DATE June 30

PARTICULARS Depreciation expense — photocopier Accumulated depreciation — photocopier (To record depreciation for the 2017 financial year for the colour photocopier using the straight-line depreciation method)

POST REF 6-2800 1-7300

DEBIT

CREDIT

1,000 1,000

Analysis In the above journal entry, debit is made to “depreciation expense”. Depreciation expense (which is a non-cash expense) is recognised as an expense in the profit and loss statement. Instead of directly crediting the asset account, a credit is made to an account entitled “accumulated depreciation — photocopier”. Accumulated depreciation is shown as a reduction from the original cost of the asset in the balance sheet and is referred to as a “contra-asset” account. By crediting the account “accumulated depreciation”, users of financial statements can still see the original cost of the asset and gauge how old the asset is (by looking at the amount of accumulated depreciation). The higher the amount of accumulated depreciation, the older the asset is. As the name suggests, “accumulated depreciation” represents the cumulative balance of the depreciation expense. The non-current assets section of the balance sheet of McKenzie Consultants Pty Ltd as at 30 June 2017 appears as follows: McKenzie Consultants Pty Ltd Balance Sheet as at 30 June 2017 Non-Current Assets

$

Photocopying machine, at cost

12,000

Less: Accumulated depreciation

(1,000) $11,000

The $11,000 is referred to as the: • carrying amount • written down value, or • book value. For the 2018 financial year, McKenzie Consultants Pty Ltd would record depreciation of $2,000 in respect of the colour photocopier. The bookkeeper should put through the following journal entry to record depreciation for the 2018 financial year under the straight-line depreciation method: DATE

PARTICULARS

June 30

POST REF

Depreciation expense — photocopier

6-2800

Accumulated depreciation — photocopier

1-7300

DEBIT

CREDIT

2,000 2,000

(To record depreciation for the 2018 financial year for the colour photocopier using the straight-line depreciation method) The non-current assets section of the balance sheet of McKenzie Consultants Pty Ltd as at 30 June 2018 appears as follows: McKenzie Consultants Pty Ltd Balance Sheet as at 30 June 2018 Non-Current Assets

$

Photocopying machine, at cost

12,000

Less: Accumulated depreciation

(3,000) $9,000

The accumulated depreciation amount of $3,000 shown previously comprises the depreciation expense for 2017 (of $1,000) plus the depreciation expense for 2018 (of $2,000). As can be seen, the carrying amount (or the written down value or book value) of the colour photocopier as at 30 June 2018 is $9,000 under the straight-line depreciation method. Table 7.1 summarises the depreciation expense and carrying amount of the photocopier using the straight-line depreciation method. Table 7.1: Straight-line depreciation of the colour photocopier 30 June

Depreciation expense

Cost of asset

Accumulated depreciation

Carrying amount at end of year

2017

$12,000

$1,000*

$1,000

$11,000

2018

$12,000

$2,000

$3,000

$9,000

2019

$12,000

$2,000

$5,000

$7,000

2020

$12,000

$2,000

$7,000

$5,000

2021

$12,000

$2,000

$9,000

$3,000

2022**

$12,000

$1,000*

$10,000

$2,000

* depreciation for six months ** the asset will be fully depreciated to its residual value of $2,000 by 31 December 2021

Note that under the straight-line depreciation method, depreciation expense is the same amount each year (except for 2017 and 2022 where only a half-year’s depreciation is recorded). Accumulated depreciation represents the cumulative amount of depreciation expense. The carrying amount of the photocopier (ie original cost minus accumulated depreciation) is reduced each year. It will be noted that the carrying amount of the colour photocopier as at 31 December 2021 is $2,000, which equates to the asset’s estimated residual value.

¶7-440 Diminishing balance method The diminishing balance method is an example of the accelerated depreciation method. It assumes that the asset will yield more service potential in the earlier years than in the later years. Hence, it allocates greater amounts of depreciation in earlier years of an asset’s life than in later years. It does this by “weighting” or increasing the straight-line depreciation rate by a percentage of say 150% or 200%. The formula for calculating the depreciation rate for the diminishing balance method is as follows:

DB rate =

100% Useful life (in years)

× 150%

For example, if the useful life of an asset was five years, the formula will give a diminishing balance depreciation rate of 30% (based on a 150% rate). Once this diminishing balance depreciation rate has been determined, depreciation expense is calculated by applying the following formula:

Opening carrying amount ×

DB rate

Under this formula, the diminishing balance percentage is applied to the carrying amount of the asset at the beginning of each year to calculate the depreciation expense for the relevant year. Where a depreciating asset is acquired during the income year, the amount of depreciation is calculated on a pro rata basis from the date of acquisition to the end of the financial year on a daily basis. The following graph demonstrates the pattern of the recognition of depreciation expense using the diminishing balance method.

We will now apply the diminishing balance depreciation method to the colour photocopier purchased on 1 January 2017 by McKenzie Consultants Pty Ltd. Under the diminishing balance depreciation method, the diminishing balance depreciation rate is calculated as follows: 100% 5 years =

×

150%

30% DB rate

The amount of depreciation for the 2017 financial year is calculated as follows: Opening carrying amount ×

DB rate

=

$12,000

30%

=

$3,600

×

Note that the opening carrying amount of $12,000 shown previously is the original cost of the asset. Under the diminishing balance depreciation method, the residual value of $2,000 is ignored. However, as McKenzie Consultants Pty Ltd acquired the colour photocopier on 1 January 2017, depreciation for the year ended 30 June 2017 is calculated for six months only. Hence, depreciation for the 2017 financial year is $1,800 (ie $3,600 × ½ year). The bookkeeper should put through the following journal entry on 30 June 2017 to record depreciation for the 2017 financial year under the diminishing balance depreciation method: DATE June 30

PARTICULARS Depreciation expense — photocopier

POST REF 6-2800

DEBIT 1,800

CREDIT

Accumulated depreciation — photocopier

1-7300

1,800

(To record depreciation for the 2017 financial year for the colour photocopier using the diminishing balance depreciation method) The non-current assets section of the balance sheet of McKenzie Consultants Pty Ltd as at 30 June 2017 appears as follows: McKenzie Consultants Pty Ltd Balance Sheet as at 30 June 2017 Non-Current Assets

$

Photocopying machine, at cost

12,000

Less: Accumulated depreciation

(1,800) $10,200

For the 2018 financial year, McKenzie Consultants Pty Ltd would record the depreciation of $3,060 in respect of the colour photocopier. This is calculated as follows: Opening carrying amount ×

DB rate

=

$10,200

30%

=

$3,060

×

Under the diminishing balance method, the depreciation charge is calculated by multiplying the asset’s opening written down value (or the carrying amount) by the depreciation rate. By contrast, under the straight-line depreciation method, each year, depreciation expense is calculated by multiplying the asset’s original cost minus its residual value by the depreciation rate. The bookkeeper should put through the following journal entry to record depreciation for the 2018 financial year under the diminishing balance depreciation method: DATE June 30

PARTICULARS

POST REF

Depreciation expense — photocopier

6-2800

Accumulated depreciation — photocopier

1-7300

DEBIT

CREDIT

3,060 3,060

(To record depreciation for the 2018 financial year for the colour photocopier using the diminishing balance depreciation method) The non-current assets section of the balance sheet of McKenzie Consultants Pty Ltd as at 30 June 2018 appears as follows: McKenzie Consultants Pty Ltd Balance Sheet as at 30 June 2018 Non-Current Assets

$

Photocopying machine, at cost

12,000

Less: Accumulated depreciation

(4,860)

$7,140

The accumulated depreciation amount of $4,860 shown above comprises the depreciation expense for 2017 (of $1,800) plus the depreciation expense for 2018 (of $3,060). As can be seen, the carrying amount (or the written down value or book value) of the colour photocopier as at 30 June 2018 is $7,140 under the diminishing balance depreciation method. Table 7.2 summarises the depreciation expense and carrying amount of the photocopier using the diminishing balance depreciation method. Table 7.2: Diminishing balance depreciation of the colour photocopier 30 June

Carrying amount at beginning of year

Depreciation expense

Accumulated depreciation

Carrying amount at end of year

2017

$12,000

$1,800*

$1,800

$10,200

2018

$10,200

$3,060

$4,860

$7,140

2019

$7,140

$2,142

$7,002

$4,998

2020

$4,998

$1,499

$8,501

$3,499

2021

$3,499

$1,050

$9,551

$2,449

2022**

$2,449

$449

$10,000

$2,000

* depreciation for six months ** the asset will be fully depreciated to its residual value of $2,000 by 31 December 2021

As previously explained in Table 7.2, depreciation expense in each year is calculated at 30% of the opening carrying amount of the asset, not on the depreciable amount of the asset (ie original cost minus the residual value) as in the straight-line method. The carrying amount at the end of one year automatically becomes the opening carrying amount for the start of the following year. At the beginning of the 2022 financial year (ie 1 July 2021), the opening carrying amount of the photocopier is $2,449. In effect, this is the closing balance as at 30 June 2021. At this point, the asset has been depreciated for a total of 4½ years. It has only six months’ depreciation left. However, in order to calculate the depreciation for the last six months, instead of applying the diminishing balance rate of 30% to the opening carrying amount of $2,449, depreciation expense of $449 is calculated as the difference between the opening carrying amount of $2,449 and the asset’s estimated residual value of $2,000.

¶7-445 Units of production method The units of production (or units of usage) depreciation method allocates depreciation based on the physical use of the asset. This method can only be used where the asset’s output can be measured (either in time or in number of units). For example, a machine may produce a certain number of units of output per year or operate for a certain number of machine hours per year. The formula for calculating the depreciation expense under the units of production method is as follows:

[Cost − Estimated residual value] Total estimated number of units

=

Depreciation per unit

Depreciation expense

= [Depreciation per unit × no of units per year]

We will now apply the units of production depreciation method to the colour photocopier purchased on 1 January 2017 by McKenzie Consultants Pty Ltd. We were told that the photocopier is expected to generate 40,000 copies over five years. Assume that in the six months to 30 June 2017, the photocopier made 6,000 copies. Under the units of production depreciation method, depreciation expense for the 2017 financial year is calculated as follows: ($12,000 − $2,000) = 25 cents per copy 40,000 copies = 6,000 copies × 25 cents per copy  = $1,500 depreciation The bookkeeper will put through the following journal entry on 30 June 2017 to record depreciation for the 2017 financial year under the units of production method: DATE June 30

PARTICULARS

POST REF

Depreciation expense — photocopier

6-2800

Accumulated depreciation — photocopier

1-7300

DEBIT

CREDIT

1,500 1,500

(To record depreciation for the 2017 financial year for the colour photocopier using the units of production depreciation method) The non-current assets section of the balance sheet of McKenzie Consultants Pty Ltd as at 30 June 2017 appears as follows: McKenzie Consultants Pty Ltd Balance Sheet as at 30 June 2017 Non-Current Assets

$

Photocopying machine, at cost

12,000

Less: Accumulated depreciation

(1,500) $10,500

Assume that for the year ended 30 June 2018, the colour photocopier made 10,000 copies. The amount of depreciation for the 2018 financial year is calculated as follows: 10,000 copies × 25 cents per copy = $2,500 depreciation The bookkeeper will put through the following journal entry to record depreciation for the 2018 financial year under the units of production method:

DATE June 30

PARTICULARS

POST REF

Depreciation expense — photocopier

DEBIT

6-2800

Accumulated depreciation — photocopier

CREDIT

2,500

1-7300

2,500

(To record depreciation for the 2018 financial year for the colour photocopier using the units of production depreciation method) The non-current asset section of the balance sheet of McKenzie Consultants Pty Ltd as at 30 June 2018 appears as follows: McKenzie Consultants Pty Ltd Balance Sheet as at 30 June 2018 Non-Current Assets

$

Photocopying machine, at cost

12,000

Less: Accumulated depreciation

(4,000) $8,000

The accumulated depreciation amount of $4,000 shown previously comprises the depreciation expense for 2017 (of $1,500) plus the depreciation expense for 2018 (of $2,500). As can be seen, the carrying amount (or the written down value or book value) of the colour photocopier as at 30 June 2018 is $8,000 under the units of production depreciation method. Depreciation expense under the units of production method will vary from year to year based on the number of units produced by the asset. However, each year the carrying amount will continue to decline until it reaches its estimated residual value at the end of its useful life.

¶7-450 Comparison of depreciation methods Table 7.3 compares the depreciation expense of the colour photocopier using each of the three depreciation methods. Table 7.3: Comparison of depreciation methods Year

Straight-line

Diminishing balance Units of production

2017

$1,000

$1,800

$1,500

2018

$2,000

$3,060

$2,500

2019

$2,000

$2,142

$1,800

2020

$2,000

$1,499

$2,000

2021

$2,000

$1,050

$1,600

2022

$1,000

$449

$600

Total

$10,000

$10,000

$10,000

Note: Depreciation expense for the units of production method is based on the following number of copies made per year: 2017

6,000 copies (based on six months from 1 January 2017 to 30 June 2017)

2018

10,000 copies

2019

7,200 copies

2020

8,000 copies

2021

6,400 copies

2022

2,400 copies (based on six months from 1 July 2021 to 31 December 2021)

While the total depreciation expense under each of the three depreciation methods comes to $10,000 over the five-year period, the annual depreciation expense varies between each method from year to year. As mentioned in the introduction to this section of the chapter (¶7-430), each of these three depreciation methods is considered acceptable for accounting purposes under AASB 116 as each method systematically allocates the cost of an asset over its useful life. The following graph illustrates the depreciation expense for each method.

¶7-500 Changing depreciation methods As Table 7.3 in ¶7-450 illustrates, the choice of depreciation method can have a significant effect on the net profit and carrying amount of an asset shown in the balance sheet. For this reason, AASB 116 requires disclosure in the financial report of the depreciation method(s) used. While AASB 116 allows an entity the choice of any one of the three depreciation methods, para 60 reiterates that the depreciation method chosen should reflect the pattern in which the asset’s future economic benefits are expected to be consumed by the entity. Once a depreciation method for a particular asset has been chosen, the entity should not randomly switch between the depreciation methods, as this could have a significant effect on reported profits and assets. An entity can only change the depreciation methods where there has been a significant change in the expected pattern of the consumption of future economic benefits embodied in the asset (para 61, AASB 116). If an entity decides to change its depreciation method, it must account for the change in accordance with AASB 108 Accounting Policies, Changes in Accounting Estimates and Errors. If the depreciation method is changed, the change must be applied retrospectively as if the new accounting policy had always applied (para 22, AASB 108). The cumulative financial effect of the new policy must be accounted for in the current financial report. In other words, AASB 108 requires a “catch up” of the effect (by an adjustment to assets, liabilities and

equity) in the opening comparative balance sheet. Furthermore, management must disclose the nature of the change, reasons for the change and the financial effect of the change (para 29, AASB 108). For this reason, the bookkeeper should consult the external accountant if the client wishes to change its depreciation method for accounting purposes.

¶7-510 Revision of residual value or useful life Both the residual value and useful life of an asset require estimation. Paragraph 51 of AASB 116 requires that the residual value and the useful life be reviewed at least at the end of each financial year and revised if necessary. Any changes to these estimates must be accounted for prospectively and not retrospectively. Small revisions are generally ignored because of their immaterial impact on the financial statements. However, major revisions to the residual value or the useful life of an asset may have a major (or material) effect on financial statements. Refer back to Worked Example 4 involving McKenzie Consulting Pty Ltd (see ¶7-435). Assume that on 1 July 2020, directors of the company consider that the colour photocopier’s useful life will be extended by an additional 1½ years but the residual value of $2,000 will not be changed. As at 1 July 2020, being the date of the revision, 3½ years’ depreciation has already been recognised. There is still a further 1½ years’ depreciation remaining. Under the straight-line depreciation method, the carrying amount of the colour photocopier as at 1 July 2020 is $5,000. The revised depreciation expense is calculated as follows: $ Carrying amount of the asset as at 1 July 2020

5,000

Less: Estimated residual value (no change)

(2,000)

Remaining depreciable amount

$3,000

Useful life remaining (1.5 years original life remaining + 1.5 years’ extension)

3 years

Revised annual depreciation expense per annum ($3,000/3 years)

$1,000

On 30 June 2021, the bookkeeper for McKenzie Consultants Pty Ltd would put through the following journal entry: DATE June 30

PARTICULARS Depreciation expense — photocopier Accumulated depreciation — photocopier (To record depreciation for the 2021 financial year for the colour photocopier using the straight-line depreciation method)

Sale of Depreciable Assets Recognising a gain or loss on sale ¶7-600 Gain on sale

¶7-610

Loss on sale

¶7-620

POST REF 6-2800 1-7300

DEBIT

CREDIT

1,000 1,000

¶7-600 Recognising a gain or loss on sale There may be instances where a depreciable asset such as a computer or motor vehicle is sold by an entity or disposed of involuntarily (eg destroyed) before the end of its useful life. The sale or disposal of a depreciable asset will give rise to a gain or loss on sale. For example, if an asset is sold for more than its carrying amount on the date of sale, a gain on sale arises. A gain on sale is shown as “other income” in the profit and loss statement. Conversely, if an asset is sold for less than its carrying amount, a loss on sale results. This loss on sale is shown as an expense in the profit and loss statement. These rules are summarised in Table 7.4. Table 7.4: Recognising a gain or loss on sale of an asset Sale proceeds

Gain or loss

If sale proceeds are greater than the carrying amount

The difference is a gain on sale

If sale proceeds are less than the carrying amount

The difference is a loss on sale

¶7-610 Gain on sale Refer back to Worked Example 4 involving McKenzie Consulting Pty Ltd (¶7-435). Assume that on 31 December 2020 (being four years after initially purchasing the colour photocopier), the company sells its colour photocopier for $4,950 including GST because it wishes to buy a new colour photocopier that has come onto the market. As at 30 June 2020, the carrying amount of the asset in the balance sheet (under the straight-line depreciation method) is shown as follows: McKenzie Consultants Pty Ltd Balance Sheet as at 30 June 2020 Non-Current Assets

$

Photocopying machine, at cost

12,000

Less: Accumulated depreciation

(7,000) $5,000

As the balance sheet reveals, as at 30 June 2020, the carrying amount of the colour photocopier is $5,000. However, we are told that the colour photocopier was sold on 31 December 2020. We must firstly ascertain the written down value (or the carrying amount) of the colour photocopier up to the exact date of the sale which is 31 December 2020. Accordingly, the first step will be to record six months’ depreciation from 1 July 2020 to 31 December 2020. The bookkeeper would record the following journal entry on 31 December 2020 (being the date of sale): DATE Dec 31

PARTICULARS Depreciation expense — photocopier

POST REF 6-2800

DEBIT 1,000

CREDIT

Accumulated depreciation — photocopier

1-7300

1,000

(To record depreciation for six months from 1 July 2020 to 31 December 2020 in respect of the colour photocopier using the straight-line depreciation method) As at 31 December 2020 (being the date of sale), the carrying amount of the asset in the balance sheet under the straight-line depreciation method is shown as follows: McKenzie Consultants Pty Ltd Balance Sheet as at 31 December 2020 Non-Current Assets

$

Photocopying machine, at cost

12,000

Less: Accumulated depreciation

(8,000) $4,000

At this point, the gain on sale of the colour photocopier can be calculated. $ Cost of the asset (GST-exclusive)

12,000

Less: Accumulated depreciation (from 1 January 2017 to 31 December 2020)

(8,000)

Carrying amount of the asset as at 31 December 2020

4,000

Sale proceeds (net of GST, being $4,950 × 10/11th)

4,500

Gain on sale

$500

The bookkeeper would record the following journal entry to record the sale of the colour photocopier on 31 December 2020: DATE Dec 31

PARTICULARS

POST REF

DEBIT

Cash at bank

1-1300

4,950

Accumulated depreciation — photocopier

1-7300

8,000

CREDIT

Photocopying machine, at cost

1-7200

12,000

GST payable

2-2500

450

Gain on sale (revenue)

8-2000

500

(To record the gain on sale of the colour photocopier on 31 December 2020) Analysis We are told that on 31 December 2020, McKenzie Consultants Pty Ltd sold their colour photocopier for $4,950 (GST-inclusive). Hence, “cash at bank” is debited for this amount. The asset account “photocopying machine” is credited for its original GST-exclusive cost of $12,000. “Accumulated depreciation” up to the date of the sale (ie 31 December 2020) is debited for $8,000. The difference

between the GST-exclusive cost of the asset of $12,000 and its accumulated depreciation of $8,000 as at 31 December 2020 is therefore $4,000. This is effectively the asset’s carrying amount as at the date of sale. However, there is no account in our chart of accounts entitled “carrying amount”. The carrying amount of an asset is simply the difference between its cost and accumulated depreciation. It will be remembered that the colour photocopier was sold for $4,950. Where a GST-registered entity sells an asset, the sale constitutes a taxable supply for the purposes of the A New Tax System (Goods and Services Tax) Act 1999 (GST Act). This means that the entity is required to remit 1/11th of the gross sales proceeds (or trade-in price) to the ATO in its next BAS. In the case of McKenzie Consultants Pty Ltd, this means that it is required to include an amount of $450 (being $4,950 × 1/11th) in its December 2020 BAS. The “GST payable” account is credited for $450. The balancing item in the journal entry outlined above is a credit of $500. This amount represents “gain on sale” of the colour photocopier which is shown as part of “other income” in the profit and loss statement.

¶7-620 Loss on sale Refer back to the original Worked Example 4 involving McKenzie Consulting Pty Ltd (¶7-435). Assume this time that on 31 December 2020, the company sells its colour photocopier for $3,850 including GST. The loss on sale of the colour photocopier is calculated as follows: $ Cost of the asset (GST-exclusive)

12,000

Less: Accumulated depreciation (from 1 January 2017 to 31 December 2020)

(8,000)

Carrying amount of the asset at 31 December 2020

4,000

Sale proceeds (net of GST, being $3,850 × 10/11th)

3,500

Loss on sale

$500

The bookkeeper would record the following journal entry to record the sale of the colour photocopier on 31 December 2020: DATE Dec 31

PARTICULARS

POST REF

DEBIT

CREDIT

Cash at bank

1-1300

3,850

Accumulated depreciation — photocopier

1-7300

8,000

Loss on sale (expense)

6-5100

500

Photocopying machine, at cost

1-7200

12,000

GST payable

2-2500

350

(To record the loss on sale of the colour photocopier on 31 December 2020) Analysis In this instance, on 31 December 2020, McKenzie Consultants Pty Ltd sold their colour photocopier for $3,850 (GST-inclusive). Hence, “cash at bank” is debited for this amount. The asset account “photocopying machine” is credited for its original cost (ie $12,000) and accumulated depreciation up to the date of the sale (ie 31 December 2020) is debited for $8,000. Once again, the carrying amount of the

colour photocopier as at 31 December 2020 is $4,000. This time, the photocopier was sold for $3,850. As this sale constitutes a taxable supply under the GST Act, the entity is required to remit 1/11th of this amount to the ATO in its next BAS. Accordingly, McKenzie Consultants Pty Ltd is required to include an amount of $350 (being $3,850 × 1/11th) in its December 2020 BAS. The “GST payable” account is credited for $350. The balancing item in the journal entry outlined above is a debit of $500. This time, the amount represents “loss on sale” of the colour photocopier which is shown as an expense in the profit and loss statement.

¶7-700 Depreciation schedule Due to the fact that an entity may have many depreciable assets, a depreciation schedule is often maintained. In many cases, the accountant prepares the depreciation schedule on behalf of the client. However, in other cases, the bookkeeper may be responsible for preparing this schedule. Some computerised accounting packages produce the depreciation schedule, in which case a separate spreadsheet does not need to be maintained. However, where this is not the case, the depreciation schedule is typically prepared as a spreadsheet and updated each time an asset is bought or sold. A depreciation schedule usually contains the following information: • description of the asset • date of acquisition • original cost • residual value • opening written down value • number of days for which the asset was held during the current financial year • useful life (in years) • depreciation rate (expressed as a percentage) • depreciation method (straight-line, diminishing balance or units of production) • depreciation expense • details of disposal (including the date sold, sale proceeds and the resultant gain or loss on sale), and • closing written down value. The depreciation schedule serves as a useful reconciliation. For example, the total cost of assets shown in the depreciation schedule should equal the total cost of depreciable assets shown in the balance sheet. The total opening written down value of depreciable assets in the depreciation schedule should equate to the opening carrying amount of depreciable assets in the balance sheet at the beginning of the financial year. The amount of depreciation expense for the period in the depreciation schedule should equate to the amount of depreciation expense shown in the profit and loss statement. Finally, the total closing written down value of depreciable assets in the depreciation schedule should equate to the closing carrying amount of depreciable assets in the balance sheet at the end of the financial year. A sample depreciation schedule is included at the end of this chapter at ¶7-940.

Financing Options

Financing options

¶7-750

Buy outright

¶7-760

Leases

¶7-770

Hire purchase

¶7-800

Chattel mortgage

¶7-840

¶7-750 Financing options A non-current asset can be purchased or financed, in a variety of ways, namely: • purchased outright (¶7-760) • via a finance lease arrangement (¶7-770) • via a hire purchase agreement (¶7-800), or • via a chattel mortgage arrangement (¶7-840). These options are summarised in Diagram 7.2. Diagram 7.2: Financing options

The accounting, taxation and GST consequences of each of these four financing options are outlined in considerable detail in this chapter. We will also briefly discuss operating leases although these are traditionally short-term leases which are in substance a rental agreement whereby the lessee has no intention of acquiring the asset.

¶7-760 Buy outright An entity may acquire an asset using the existing cash reserves. This does not involve any borrowings. The advantage of this option is that the entity is not required to borrow monies from a bank or financial institution to finance the acquisition. As such, it saves the cost of borrowings, bank establishment fees and stamp duty on arranging the loan as well as ongoing interest charges. The disadvantage is that the entity may substantially deplete its existing cash reserves by purchasing a new asset (that may cost tens or even hundreds of thousands of dollars). The accounting, taxation and GST consequences of buying an asset outright are illustrated in Table 7.5. Table 7.5: Accounting, taxation and GST consequences of buying an asset outright Accounting The entity will record the cost of the noncurrent asset in the balance sheet at its GST-exclusive cost.

Income tax For taxation purposes, an item of property, plant and equipment is considered a depreciable asset and is

GST

If the entity is on the accrual basis f GST, the input tax credit is able to b claimed back when the tax invoice i

subject to depreciation in accordance with Div 40 of the Income Tax Assessment Act 1997 (ITAA97).

All non-current assets (other than land) will be depreciated over their estimated useful life in accordance with AASB 116. As such, the entity will calculate and For taxation purposes, the depreciation record the depreciation expense in the rules vary depending on the type of the profit and loss statement and credit the taxpayer. contra asset account “Less: accumulated depreciation” in the balance sheet.

received from the vendor.

If the entity is on the cash basis for the input tax credit is able to be clai back when the payment to acquire t asset is actually made and the entit receives the tax invoice from the ve

However, generally speaking, an asset is depreciated over its effective life at the No interest expense will appear in the rates set out by the Commissioner in income statement as no borrowings have Taxation Ruling TR 2016/1. been incurred in relation to the acquisition of the asset.

Leases Leases

¶7-770

Distinction between a finance and operating lease ¶7-775 Finance leases

¶7-780

Allocation of monthly lease payments

¶7-785

Amortisation (depreciation) of the leased assets

¶7-790

Operating leases

¶7-795

¶7-770 Leases Leasing is a very common means of financing the acquisition of an asset. A lease arrangement is one in which one party (the lessee) has the use of the property for a specified period in return for a series of payments. The entity who grants the lease (the lessor) remains the legal owner of the property. Leased assets range from physical assets such as land, plant and equipment and motor vehicles to intangible assets such as patents, copyright and mineral rights. Lease agreements may also result in the eventual transfer of ownership from the lessor to the lessee (but this is not considered essential). Accounting for leases is covered in AASB 117 Leases. According to para 4 of AASB 117, a lease is defined as an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time. Under a lease agreement, the lessee does not acquire the asset, but has the right to use the asset for a set period of time. For this reason, the lessor continues to be the legal owner of the leased asset until such time as the lessee pays out the lease residual and acquires the asset. In essence, the lessee leases or rents the asset from the lessor and can acquire the asset outright if, and when, the lease residual is paid out (usually at the end of the lease term). The duties and obligations of both the lessor and the lessee are usually detailed in a legal document called the lease agreement. Typically, a lease agreement sets out: • the period of the lease • the amount and timing of the lease payments (usually monthly)

• whether the lease is cancellable by either party • what happens to the asset at the end of the lease term • the asset’s residual value, and • who is responsible for the asset’s operating costs, such as repairs and maintenance. In most lease agreements, the interest rate is not specified. This is usually required to be calculated by the accountant. For this reason, AASB 117 refers to the interest rate as the “implicit interest rate”. Paragraphs 7 and 8 of AASB 117 require that a lease be classified at the inception of the lease as either: • a finance lease (¶7-780), or • an operating lease — either cancellable or non-cancellable (¶7-795). The two types of leases are shown in Diagram 7.3. Diagram 7.3: Types of leases

¶7-775 Distinction between a finance and operating lease A finance lease is defined in para 4 of AASB 117 as a lease that transfers substantially all the risks and rewards incidental to ownership of an asset from the lessor to the lessee. Title may or may not eventually be transferred. An operating lease is defined in the same paragraph of the standard as any lease “other than a finance lease”. Essentially, an operating lease is a lease where substantially all the risks and rewards incidental to ownership of a leased asset remain with the lessor. Under this classification, there is no “middle ground” — a lease is classified either as a finance lease or an operating lease. If substantially all the risks and rewards incidental to the ownership of a leased asset pass to the lessee, then the lease will be classified as a finance lease. Conversely, if the risks and rewards incidental to the ownership of a leased asset remain with the lessor, the lease will be classified as an operating lease. In practice, it can be very difficult to look at the terms and conditions of a lease agreement and determine exactly which party substantially bears the risks and rewards of the ownership of a leased asset. Paragraphs 10 and 11 of AASB 117 outline a series of guidelines to assist users in determining whether a lease should be classified as a finance or an operating lease. These guidelines are detailed in Diagram 7.4.

Diagram 7.4: Is the lease a finance or operating lease?

If a lease is classified as a finance lease, the lessee is required to record a leased asset and the lease liability equivalent to the fair value of minimum lease payments in the balance sheet. This is referred to as “lease capitalisation”. Conversely, an operating lease is not shown on the balance sheet. Instead, lease payments (usually monthly) are simply recorded as an expense in the profit and loss statement. The leased asset and the associated lease liability are not recorded in the balance sheet as the lessee is merely renting the asset from the lessor (usually for a short period of time) and has no intention of ever buying the asset at the end of the lease term. The following definitions are relevant (para 4, AASB 117): Fair value

The amount for which the asset could be exchanged or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.

Guaranteed residual value

At the commencement of a lease, a lessor estimates the residual value (fair value) of the asset at the end of the lease term. Usually the lessor does not want to expose themselves to the risk of drop in value of the leased asset. Under a finance lease, the lessee guarantees that the lessor will receive at least that amount. The guarantee may be a fixed dollar amount or expressed as a percentage of the fair value of the asset (from 1% to 100%). The existence of a guaranteed residual value indicates that the lessor has transferred the risks associated with movements in the

residual value to the lessee. This points to the classification of the lease as a finance lease. Lease term

The period of the original lease term plus any period of renewal flowing from an option, express or implied, which allows the lessee to renew the lease. This additional period is added to the original lease term where it is “reasonably certain” that the lessee will exercise the option to renew.

Minimum lease payments

The (lease rental) payments required to be made by the lessee over the lease term, plus the exercise price of any bargain purchase, and any guaranteed residual value option that the lessee or any party related to the lessee is required to outlay to acquire the leased asset.

Non-cancellable lease

A lease that is cancellable only upon the occurrence of some remote contingency, and can be cancelled only with the express permission of the lessor — where, if cancelled, the lessee incurs penalty on cancellation sufficient to ensure that continuation of the lease is reasonably certain.

Present value of minimum lease payments

The discount rate to be used in calculating the present value of the lease payments is the interest rate implicit in the lease agreement. If this is not practicably determined, then it should be based on the lessee’s incremental borrowing rate.

How to apply the guidelines Assuming that the lease is non-cancellable and ownership of the leased asset does not automatically transfer to the lessee at the end of the lease term (and does not contain a bargain purchase option), the main two tests are: • Is the lease term a major part of the economic life of the leased asset? • Is the present value of minimum lease payments substantially all of the fair value of the leased asset? The former AASB 1008 Leases provided quantitative guidelines. These guidelines stated that a lease was to be regarded as a finance lease if: • the lease term was 75% or more of the useful life of the leased asset, or • the present value of minimum lease payments was 90% or more of the fair value of the leased asset. The 75% guideline The following formula is relevant:

    Lease term     Useful life of the leased asset

For example, if the lease term (as specified in the lease agreement) was three years and the useful life of the leased asset was five years, then the lease would be classified as an operating lease (60%) under this guideline. However, if the lease term was four years and the useful life of the leased asset was five years, then the lease would be classified as a finance lease. The 90% guideline The following formula is relevant:

Present value of minimum lease payments (including residual) Fair value of the leased asset

For example, if the present value of minimum lease payments came to 92% of the fair value of the leased asset at the inception of the lease, then the lease would be classified as a finance lease under this guideline. While quantitative guidelines are not contained in the new standard, the wording of AASB 117 suggests that they should still be viewed as reasonable interpretations of those criteria. Economic substance override Despite these guidelines, para 10 of AASB 117 emphasises that these criteria should be viewed as guidelines, not strict rules or tests. The overriding test to determine whether a lease should be classified as a finance lease or operating lease is the “economic substance” of the transaction, not the legal form of the agreement. The economic substance test can be viewed as the “final override”. This “substance over form” approach was a deliberate attempt by the AASB and the International Accounting Standards Board (IASB) to avoid many of the problems encountered by the United States standard setters with the Statement of Financial Accounting Standards SFAS 13 Leases in which classification of leases is just based on quantitative criteria. For example, in the United States, a lease whose lease term is for 74% of the useful life of the leased asset and whose minimum lease payments represent 89% of the fair value of the leased asset is classified as an operating lease. SFAS 13 does not contain an economic substance override test. Worked Example 5 ACME Pty Ltd has entered into a non-cancellable lease with a six-year lease term to acquire a piece of manufacturing equipment which is expected to have a useful life of 10 years. At the end of the six years, a clause in the lease agreement allows the lessee to renew the lease for a further two-year period at an amount equal to one-quarter of the prevailing commercial rates at the time of renewal. The present value of minimum lease payments is equal to 70% of the fair value of the equipment at the inception of the lease. The remaining 30% of the fair value will be represented by the lease residual which is guaranteed by the lessee. Is the lease a finance lease or an operating lease? Going through each of the guidelines contained in paras 10 and 11 of AASB 117, the lease is non-cancellable. There is nothing in the lease agreement to indicate that the ownership of the leased asset automatically transfers to the lessee at the end of the lease term, nor is there any evidence of a bargain purchase option. We are told that the lease term is six years and the useful life of the asset is 10 years. This means that the lease term represents only 60% of the useful life of the asset. However, we must take into account the fact that the lease agreement contains an option allowing the lessee to extend the lease for a further two-year period at an amount equal to one-quarter of the prevailing commercial rates at the time of renewal. The additional two-year extension needs to be taken into account if it is “reasonably certain” that the lessee will exercise the option to renew. Given the renewal is at one-quarter of the prevailing commercial rates, its renewal in six years’ time is considered reasonably certain. This takes the lease term to eight years which, therefore, represents 80% of the useful life of the equipment. In any case, the present value of minimum lease payments equals 100% of the fair value of the leased equipment, as the definition of “minimum lease payments” includes not only the present value of minimum lease payments (of 70%), but also the guaranteed residual value (of 30%). Overall, it can be concluded that the lease is a finance lease.

Non-cancellable operating leases and AASB 16 As previously mentioned, operating leases are not shown on the balance sheet. Instead, the lease payments are simply recorded as an expense in the profit and loss statement. This is an example of “offbalance sheet financing”. Some operating leases are non-cancellable, in the sense that if the lessee breaks the lease or walks

away from making the payments, then the lessor has a right of recourse. Non-cancellable operating leases are usually long-term and include such arrangements as the lease of commercial office space, retail space, aircrafts and cars. However, as the lease agreement does not make any provision for the lessee to acquire the asset at the end of the lease term, these leases are still operating leases, not finance leases. Hence, they are not recorded on balance sheets. For example, in its 2016 annual report, Virgin Australia reported leases totalling $3.481b, which comprised $3.454b worth of non-cancellable operating leases and $27.2m worth of finance leases. While the $27.2m of finance leases were recorded on the balance sheet, the $3.454b of non-cancellable leases remained “off-balance sheet”. Similarly, in its 2016 annual report, Wesfarmers reported $20b worth of non-cancellable operating leases and no finance leases whatsoever. Over the years, the accounting profession has been dealing with and discussing ways on the accounting treatment of non-cancellable operating leases. There is a strong feeling by numerous parties that noncancellable operating leases are more analogous to finance leases than they are operating leases and as such, should be recognised as liabilities on the face of the balance sheet. Responding to those concerns, the International Accounting Standards Board (IASB) and the US national standard-setter, the Financial Accounting Standards Board (FASB), undertook research to determine the extent of “off-balance sheet financing”. The IASB and FASB found that most leases were structured as non-cancellable operating leases and as such, most lease transactions were not reported on the company’s balance sheet. They found that US listed companies disclosed almost US$3 trillion of off-balance sheet lease obligations. After years of discussion (and several draft versions), finally, in January 2016, the IASB released IFRS 16 Leases. The following month, the AASB released the Australian equivalent standard, AASB 16 Leases. AASB 16 will eventually replace the existing lease standard, AASB 117. AASB 16 is effective for annual reporting periods beginning on or after 1 January 2019, with early adoption permitted. The major features of AASB 16 are summarised as follows: • removal of the classification of leases as either operating leases or finance leases. Instead, all leases will be treated as finance leases. The only optional exemptions are for short-term leases with a duration of less than 12 months • all leases will be recognised on the balance sheet as a “right-of-use asset” with a corresponding lease liability recorded by the lessee, and • recognise depreciation of leased assets and interest on lease liabilities in the income statement over the lease term. The new lease standard will greatly impact entities that have entered into significant lease contracts that are currently classified as operating leases under AASB 117. Once these leases are brought onto their balance sheet, this will have the effect of substantially increasing both assets and liabilities.

¶7-780 Finance leases In the case of a finance lease, para 20 of AASB 117 requires that at the commencement of a lease, the lessee should recognise a leased asset and an equivalent lease liability at the lower of the: • fair value of the leased asset, and • present value of minimum lease payments. The lessee may bear some initial costs in negotiating or arranging the lease (eg commissions, legal fees and the stamp duty associated with stamping of the lease agreement). Paragraph 24 of AASB 117 requires that a lessee capitalise any initial direct costs that relate to a finance lease as part of the cost of the leased asset. These costs will be subsequently amortised (¶7-790). Take

the following example. Worked Example 6 Assume that on 28 January 2017, Mixmaster Pty Ltd acquires a piece of equipment for its factory under a finance lease. The amount financed is $40,000. The fair value of plant and equipment at the inception of the lease is $40,000 (GST-exclusive). The equipment has an estimated useful life of five years. The lease term is for three years. Under the lease agreement, Mixmaster Pty Ltd is required to make 36 monthly lease payments of $1,100 (including GST) on the 28th day of each calendar month. The first lease payment of $1,100 is due in advance on 28 January 2017, with the last payment due on 28 December 2019. As the first lease payment is made in advance on 28 January 2017, there is no interest in respect of the first payment. Under the lease agreement, on 28 December 2019, Mixmaster Pty Ltd can choose to acquire the plant and equipment by paying out its guaranteed residual value of $12,000 (including GST), which is estimated to be the market value of the equipment on 28 December 2019. Mixmaster Pty Ltd is committed to paying out the guaranteed lease residual and taking over the legal title of the equipment. The total lease payments owing by Mixmaster Pty Ltd over the three-year period comes to $51,600 (comprising 36 monthly lease payments of $1,100, which total $39,600, plus the guaranteed lease residual of $12,000). Based on an implicit interest rate of 9.11969%, the present value of minimum lease payments (including the guaranteed lease residual) equals $40,000. Assume that Mixmaster Pty Ltd is registered for GST and accounts for GST using the cash basis.

In accordance with the guidelines contained in AASB 117, the lease will be classified as a finance lease. Despite the fact that the lease term represents only 60% of the useful life of the asset (3/5 years), the lease will nevertheless be classified as a finance lease as the total present value of minimum lease payments (including the guaranteed lease residual) totalling $40,000 equals 100% of the fair value of the leased asset (of $40,000). (a) Initial journal entry On 28 January 2017, the bookkeeper will put through the following journal entry: DATE Jan 28

PARTICULARS Leased plant and equipment Lease liability

POST REF 1-7200 2-4000

DEBIT

CREDIT

40,000 40,000

(To record the leased asset and lease liability at the inception of the lease) Analysis In the case of a finance lease, the leased asset is debited for $40,000. This is the amount that has been financed, which is effectively the GST-exclusive price of the asset. As previously mentioned, in the case of a finance lease the lessee does not own the asset, but is merely leasing (or renting) the asset. Legal ownership of the asset does not pass to the lessee until such point at which the lessee pays out the guaranteed lease residual. As such, the tax invoice for the plant and equipment goes to the leasing company who would deal with making the claim for any GST on the purchase price of the plant and equipment, not Mixmaster Pty Ltd. For this reason, as no asset has been legally acquired, Mixmaster Pty Ltd cannot claim back any GST at this point. In the case of a lease, where the lessee accounts for GST on a cash basis, the lessee is entitled to claim an input tax credit (equivalent to 1/11th of each lease payment) when the lease payment is made. Where a lessee accounts for GST on an accrual basis, the entitlement to claim the input tax credit arises in the tax period in which the lease payment is due and payable as outlined in the lease payment schedule contained in the lease agreement. (b) First lease payment made on 28 January 2017 In the above example, Mixmaster Pty Ltd makes monthly lease payments of $1,100 on the 28th day of each calendar month. This amount includes $100 GST. For the first payment on 28 January 2017, the bookkeeper will record the following journal entry:

DATE Jan 28

PARTICULARS

POST REF

DEBIT

CREDIT

Lease liability

2-4000

1,000

GST receivable

2-2600

100

Cash at bank

1-1300

1,100

(To record the monthly lease payment of $1,100 made under the lease agreement on 28 January 2017) Analysis We are told in the example that Mixmaster Pty Ltd accounts for GST on a cash basis. Hence, it is entitled to claim the GST when each lease payment is made (ie on the 28th day of each month). The “lease liability” account is debited for $1,000. This amount represents reduction in the lease liability. This amount represents the GST-exclusive amount of each lease payment. The “GST receivable” account is debited for $100. The “cash at bank” account is credited for the GST-inclusive amount of each lease payment (ie $1,100). (c) Subsequent lease payments For each of the next 35 months, the bookkeeper will record the following journal entry on the 28th day of each month: DATE Feb 28

PARTICULARS

POST REF

DEBIT

CREDIT

Lease payments (expense)

6-4700

1,000

GST receivable

2-2600

100

Cash at bank

1-1300

1,100

(To record the monthly lease payment of $1,100 made under the lease agreement on the 28th day of each month) Analysis This time, the “lease payments” account, which is shown as an expense in the profit and loss statement is debited for $1,000 each month. This amount represents the GST-exclusive amount of each lease payment. The “GST receivable” account is debited for $100. The “cash at bank” account is credited for the GST-inclusive amount of each lease payment (ie $1,100). For taxation purposes, the amount of lease payments made in the relevant income year is tax-deductible. Hence, by 30 June 2017, if Mixmaster Pty Ltd has made six monthly lease payments, it will be able to claim an income tax deduction of $6,000 (GST-exclusive).

¶7-785 Allocation of monthly lease payments From an accounting perspective, para 25 of AASB 117 requires that monthly GST-exclusive lease payments be apportioned by the lessee between: • the interest expense, and • reduction of the lease liability. The interest expense component is calculated by applying the interest rate implicit in the lease agreement to the outstanding lease liability at the beginning of each lease payment period. The remainder of the

periodic payment is treated as a repayment of the principal of the lease liability. The amount of interest calculated each period will decrease as the outstanding principal balance decreases each period. The accountant usually prepares a lease schedule detailing the split between the interest expense and the lease liability. A copy of the lease schedule prepared for Mixmaster Pty Ltd using the facts contained in Worked Example 6 (¶7-780) is included at ¶7-950. According to the lease schedule, there is no interest in respect of the first payment, as we are told that under the lease agreement, the first payment is made in advance. Therefore, we booked the whole of the first lease payment to the “lease liability” account and therefore there is no need for us to do any extra reallocation of this payment. If we now look at the second lease payment on 28 February 2017 for example, in accordance with the lease schedule, the interest component comes to $296 (rounded). Therefore, the reduction of the lease liability totals $704 (rounded). The bookkeeper will record the following journal entry on 28 February 2017: DATE Feb 28

PARTICULARS

POST REF

DEBIT

CREDIT

Interest expense — leased asset

6-4200

296

Lease liability

2-4000

704

Lease payments (expense)

6-4700

1,000

(To record the allocation of the GST-exclusive lease payment of $1,000 between the interest expense and reduction in the principal component of the lease liability) Analysis For accounting purposes, under AASB 117, the amount of each GST-exclusive lease payment should be apportioned between the interest expense and reduction of the lease liability. The debit to the account entitled “interest expense — leased asset” of $296 will be shown as an expense in the profit and loss statement. The debit to “lease liability” of $704 represents reduction in the principal component of the lease liability. At this point, the lease liability shown in the balance sheet of Mixmaster Pty Ltd will be $38,296 (as per the closing balance of the lease schedule on this date (¶7-950)). The credit to “lease payments” effectively reverses the lease payment amount of $1,000 originally recorded as an expense by the bookkeeper in the profit and loss statement. At the end of the financial year, the “lease payments” account in the profit and loss statement will be reduced to $nil. The lease payments of $1,000 per month are effectively split between the interest expense and reduction of the lease liability. According to the lease schedule, the balance of the “lease liability” account as at 30 June 2017 should be $35,428. Even though the “lease payments” account will have a zero balance in the profit and loss statement, it is important for the bookkeeper to code the lease payments to this account for two reasons. Firstly, the accountant will usually prepare a journal entry to split the lease payments between the interest expense and reduction of the lease liability components, in accordance with the lease schedule. Secondly, as mentioned above, for taxation purposes it is the lease payments that are tax-deductible. By printing off the “lease payments” expense account in the general ledger, the accountant or tax agent will be able to easily identify the amount of lease payments made by an entity during the financial year. (d) Payout of the guaranteed lease residual of $12,000 On 28 December 2019, the final monthly lease payment of $1,100 will be made. However, on this date, assuming that Mixmaster Pty Ltd decides to buy the plant and equipment, the company will also pay out the guaranteed lease residual of $12,000 (GST-inclusive). At this point, the bookkeeper will record the following journal entry in relation to the payout of the guaranteed lease residual:

DATE Dec 28

PARTICULARS

POST REF

DEBIT

Lease liability

2-4000

10,909

GST receivable

2-2600

1,091

Cash at bank

CREDIT

1-1300

12,000

(To record the payout of the guaranteed lease residual) Analysis We are told that on 28 December 2019, Mixmaster Pty Ltd pays out the guaranteed lease residual of $12,000. The account “cash at bank” is credited for the full $12,000. “Lease liability” is debited for the GST-exclusive amount of $10,909 (being $12,000 × 10/11th) while the “GST receivable” account is debited for $1,091 (being $12,000 × 1/11th). At this point, the lease liability should be $nil (as per the lease schedule). There is no interest in respect of the payment of the guaranteed residual value of $12,000 as the interest has already been paid in the final monthly lease payment which is made on this same date.

¶7-790 Amortisation (depreciation) of the leased assets Paragraphs 27 and 28 of AASB 117 require that a leased asset be depreciated (or amortised) in accordance with the principles contained in AASB 116. It is important to note that the asset being depreciated is not the leased property, but the lessee’s right to use the leased property. For this reason, some accountants refer to the depreciation of leased assets as “amortisation”, not “depreciation”. The question is whether the leased asset should be amortised (or depreciated) over the estimated useful life of the asset, or over the lease term. For example, in Worked Example 6 (¶7-780), the question is whether the leased plant and equipment of $40,000 shown in the balance sheet should be amortised (or depreciated) over its estimated useful life of five years, or the lease term of three years. According to para 28 of AASB 117, where there is a reasonable certainty that the lessee will obtain the ownership at the end of the lease term, by paying out the guaranteed lease residual which is usually the case, the leased asset should be amortised over the useful life of the asset. Otherwise, if it is not reasonably certain that the lessee will obtain the ownership of the leased asset at the end of the lease term, the leased asset should be amortised over the shorter of the lease term or the useful life of the asset. Recording annual amortisation of the leased asset In the above example, we are told that the leased plant and equipment has a useful life of five years. The lease term is for three years. We are also told that Mixmaster Pty Ltd is committed to paying out the guaranteed residual value of $12,000 and taking the legal title of the plant and equipment at the end of the lease. In this case, the leased asset should be amortised over a five-year period. Assuming that the company elects to use the straight-line depreciation method, the bookkeeper will put through the following journal entry on 30 June 2017: DATE June 30

PARTICULARS Amortisation expense — leased asset Accumulated amortisation — leased asset (To record the amortisation expense of the

POST REF 6-1200 1-7300

DEBIT

CREDIT

3,375 3,375

leased asset for 154 days in the 2017 financial year) Analysis The useful life of the leased plant and equipment is five years. Each year, the amortisation (or depreciation) expense of $8,000 will be recorded (ie $40,000/5 years). However, in the first year, Mixmaster Pty Ltd has only held the asset for 154 days. Hence, the amortisation expense for the period from 28 January 2017 to 30 June 2017 is calculated at $3,375. Credit is taken to “accumulated amortisation — leased asset” which is shown as a reduction from the cost of the leased asset. For the following year, the amortisation expense will be $8,000. Amortisation expense is recorded for accounting purposes. However, it is not deductible for taxation purposes. An extract from the profit and loss statement of Mixmaster Pty Ltd for the year ended 30 June 2017 is shown as follows: Mixmaster Pty Ltd Profit and Loss Statement for the year ended 30 June 2017 Expenses

$

Amortisation expense

3,375

Interest expense — leased asset**

1,428

** this amount comprises the total interest expense for the period from 28 January 2017 to 30 June 2017 (as per the lease schedule in ¶7950).

An extract from the balance sheet of Mixmaster Pty Ltd as at 30 June 2017 is as follows: Mixmaster Pty Ltd Balance Sheet as at 30 June 2017 Non-Current Assets

$

Leased plant and equipment, at cost

40,000

Less: Accumulated amortisation

(3,375) 36,625

Current Liabilities Lease liability

9,145

Non-Current Liabilities Lease liability

26,283 35,428

The leased asset is shown at its GST-exclusive cost of $40,000 minus the accumulated amortisation of $3,375. The carrying amount of the leased asset as at 30 June 2017 is therefore $36,625. As per the lease schedule, the total lease liability owing as at 30 June 2017 is $35,428. However, this amount must be split between its current and non-current components. The current portion of the outstanding lease liability of $9,145 represents the amount owing by the entity in the next 12 months.

This amount is calculated by taking the outstanding lease liability as at 30 June 2017 (being $35,428) and deducting the outstanding lease liability as at 30 June 2018 (being $26,283). The non-current portion of $26,283 is disclosed as a non-current liability in the balance sheet. The carrying amount of a leased plant and equipment and the outstanding balance of the lease liability will never be the same amounts after the initial journal entry. The leased asset is required to be amortised over its useful life, while the lease liability is reduced by the principal component of each lease payment over the term of the lease. Finally, from a taxation perspective, the interest expense ($1,428) and the amortisation expense ($3,375) recorded in the profit and loss statement are not tax-deductible. Instead, the GST-exclusive amount of monthly lease payments of $6,000 (being $1,000 per month × 6 months) is tax-deductible under s 8-1 of ITAA97. The accounting, taxation and GST consequences of acquiring an asset under a finance lease are illustrated in Table 7.6. Table 7.6: Accounting, taxation and GST consequences of a finance lease Accounting

Income tax

The lessee will record a leased asset and For taxation purposes, the Commissioner the lease liability in the balance sheet does not consider the lessee to be the equivalent to the lower of the fair value of legal owner of the asset. the leased asset or the present value of minimum lease payments.

GST

Where the lessee accounts for GST cash basis, the lessee is entitled to an input tax credit (equivalent to 1/1 the lease payment) when the lease payment is made.

Hence, in the case of a finance lease, the GST-exclusive amount of lease The leased asset will be amortised (or payments made by the lessee are taxWhere the lessee accounts for GST depreciated) over its estimated useful life deductible under s 8-1 of ITAA97, not the an accrual basis, the entitlement to in accordance with AASB 117. As such, interest and amortisation expenses. an input tax credit will arise in the ta the entity will calculate and record the period in which the lease payment i amortisation expense in the profit and and payable as outlined in the lease loss statement and credit the contrapayment schedule contained in the The lessor is the legal owner of the asset account “Less: accumulated agreement. leased asset and is the entity who is amortisation” in the balance sheet. entitled to claim the depreciation as a tax deduction. The GST-exclusive amount of each lease payment must be split between the interest expense and reduction of the lease liability.

Both the “interest expense — leased asset” and the “amortisation expense” in relation to the leased asset will appear in the profit and loss statement.

¶7-795 Operating leases An operating lease is akin to a rental agreement. Ownership of an asset does not pass from the lessor to the lessee. Instead, the lessee merely rents the assets from the lessor. Most operating leases are shortterm arrangements. In the case of an operating lease, no asset or liability is recorded in the balance sheet of the lessee. The lease payments are simply expensed to the profit and loss statement.

Take the following example. Assume that on 16 March 2017, Archers Engineering Consultants Pty Ltd enters into an arrangement to rent a laptop computer for two months at a cost of $110 per month (GSTinclusive). As this is a short-term rental agreement, there is no provision in the lease agreement for the company to acquire the laptop computer. As such, the lease agreement will qualify as an operating lease under AASB 117. Assuming that the company is registered for GST, the bookkeeper will put through the following journal entry on the 16th day of March and April 2017: DATE Mar 16

PARTICULARS

POST REF

DEBIT

CREDIT

Lease rental expense

6-4700

100

GST receivable

2-2600

10

Cash at bank

1-1300

110

(To record the operating lease payments in respect of the laptop computer) From a taxation viewpoint, the GST-exclusive amount of each operating lease payment is tax-deductible. Hence, in the above example, the company can claim a tax deduction for $100. The accounting, taxation and GST consequences of an operating lease are illustrated in Table 7.7. Table 7.7: Accounting, taxation and GST consequences of an operating lease Accounting The lessee will record a “lease rental expense”, being the GST-exclusive amount of the lease payments in the income statement.

No leased asset or lease liability is recorded in the balance sheet under an operating lease.

Income tax

GST

For taxation purposes, in the case of an operating lease, the GSTexclusive amount of each lease payment is taxdeductible.

Where the lessee accounts for GST on a cash basis, the lessee is entitled to claim an input tax credit (equivalent to 1/11th of the lease payment) when the lease payment is made.

Where the lessee accounts for GST on an accrual basis, the entitlement to claim an input tax credit will arise in the tax period in which the lease payment is due and payable as outlined in the lease payment schedule contained in the lease agreement.

Hire Purchase Hire purchase

¶7-800

Hire purchase: GST on accrual and cash basis ¶7-810

¶7-800 Hire purchase Accounting treatment A hire purchase arrangement is one under which the goods are purchased by payments of instalments. The hirer has the use of the goods while the payment is being made, but does not become the legal owner until the final instalment is paid. This final instalment is often referred to as a balloon payment.

From an accounting perspective, a hire purchase is treated in the same way as the finance lease. This is confirmed in para 6 of AASB 117, which states: “The definition of a lease includes contracts for the hire of an asset that contain a provision giving the hirer an option to acquire title to the asset upon the fulfilment of agreed conditions. These contracts are sometimes known as hire purchase contracts.” Hence, the accounting treatment of hire purchase agreements is, in substance, no different to that of a finance lease. However, the main difference is that unlike a finance lease where there is no obligation to acquire the goods at the end of the lease term, a hire purchase arrangement provides for this obligation and, as such, the asset will eventually be owned by the purchaser. Therefore, when an entity enters into a hire purchase agreement, there is an obligation to eventually acquire the asset at the end of the term of the agreement. However, while the accounting treatment of a finance lease and a hire purchase arrangement is essentially the same, the taxation and GST treatments differ as discussed in the following. Income tax treatment The taxation consequences of hire purchase agreements are covered in Div 240 of ITAA97. Division 240 applies to hire purchase agreements entered into after 27 February 1998. Under s 995-1 of ITAA97, an arrangement will qualify as a hire purchase agreement for taxation purposes if it is: “(a) a contract for the hire of goods where: (i) the hirer has the right, obligation or contingent obligation to buy the goods at the end of the term (an example of a contingent obligation is a put option) (ii) the total amount payable under the arrangement (consisting of rental charges plus any lump sum balloon payment at the end of the term) exceeds the price of the goods, and (iii) legal title to the goods does not pass to the hirer until the option referred to above is exercised, or (b) an agreement for the purchase of goods by instalments where legal title to the goods does not pass until the final instalment is paid.” Only goods can be the subject of a hire purchase agreement. This means that real property can never be the subject of a hire purchase agreement. If the requirements of Div 240 of ITAA97 are satisfied, the Commissioner effectively treats a hire purchase agreement as a financing arrangement which facilitates the sale and purchase of goods via a loan. Under a hire purchase agreement, when an asset is hired, the hirer is regarded as the owner of the asset and can claim a tax deduction for the amount of interest and depreciation on the asset being hired. This is to be contrasted with a lease, for which the lessee is entitled to a tax deduction for the monthly lease payments. Worked Example 7 Paris Technologies Pty Ltd is proposing to hire a computer system from a computer retailer. The normal retail price of the computer system is $18,000. The agreement is for a term of five years. Rent payable under the agreement is $3,000 per annum. The retailer has a put option requiring Paris Technologies Pty Ltd to purchase the system at the end of the agreement for its market value. The computer system is expected to have a market value of $5,000 in five years’ time. Does the arrangement qualify as a hire purchase agreement? Yes. The arrangement is a hire purchase agreement under Div 240 of ITAA97 because all of the requirements contained in s 995-1 of ITAA97 are satisfied, namely: • Paris Technologies Pty Ltd is hiring goods • Paris Technologies Pty Ltd has a contingent obligation to buy the goods at the end of the agreement • the total rent payable of $15,000 (ie $3,000 × 5 years) plus the exercise price at the end of the agreement of $5,000 (giving a total of $20,000) exceeds the price of the computer system (ie $18,000), and • legal title in the computer system does not pass until the option is exercised.

Because all of the conditions outlined in s 995-1 are met, Div 240 will apply to deem the arrangement to constitute a hire purchase agreement. For taxation purposes, this means that Paris Technologies Pty Ltd will be entitled to claim a tax deduction for the interest component of each repayment. Furthermore, it will also be able to claim the depreciation on the computer system as Paris Technologies Pty Ltd is deemed to be the “owner” of the asset.

GST treatment The GST treatment of hire purchase agreements changed with effect from 1 July 2012. Prior to this date, from a GST perspective, a hire purchase arrangement was treated as a sale of goods and a separate supply of finance. However, unlike leases, hire purchase agreements were not considered progressive supplies and, as such, did not fall under Div 156 of the GST Act. This meant that prior to 1 July 2012, if the hirer was on the accrual basis for GST, the entity was able to claim an input tax credit on the purchase of the asset used for a creditable purpose in the tax period in which the hire purchase contract was signed. This was usually upfront. However, where the hirer accounted for GST on a cash basis and the asset purchased was used for a creditable purpose, the entity was only entitled to claim an input tax credit when each repayment was made. The amount of input tax credit able to be claimed was equivalent to 1/11th of the principal component of each hire purchase repayment. Under the cash basis of GST, the ATO took the view that the asset was being progressively acquired over time as each instalment was made. This led to an inconsistent treatment in the way that an entity could claim back input tax credits depending on whether they were under the accrual or cash basis for GST. This inconsistent treatment led many taxpayers who were on the GST cash basis to prefer chattel mortgage as a form of finance over hire purchase because under a chattel mortgage agreement, an entity is entitled to claim back the full amount of input tax credits in the period it purchased the goods (ie upfront). From 1 July 2012, Div 156 and 158 of the GST Act have been amended such that all supplies made or credit provided under a hire purchase agreement are no longer regarded as financial supplies, but taxable supplies regardless of whether or not the term charges (ie interest) have been separately identified and disclosed in the hire purchase agreement. In other words, a supply of credit under a hire purchase agreement which is separately identified and disclosed by the supplier will no longer be an input taxed supply. The way that GST is accounted for under hire purchase agreements has also changed. Hire purchase agreements are now no longer treated as supplies made on a progressive or periodic basis — instead they are treated as a stand alone supply in the relevant tax period. From 1 July 2012, all taxpayers are entitled to claim the full amount of input tax credits in respect of a hire purchase acquisition in the tax period in which they receive a tax invoice from the financier or pay the first instalment under the agreement regardless of whether they account for GST under the cash or accrual basis. In effect this means that an entity is able to claim back the sum of 1/11th of the purchase price of the asset plus 1/11th of the total interest paid under the hire purchase agreement. It is important to note that these amendments only apply to hire purchase agreements entered into on or after 1 July 2012. Hire purchase agreements entered into before this date will still be accounted for under the old GST rules described earlier. Refer to Worked Example 6 (¶7-780). This time assume that on 28 January 2017, Mixmaster Pty Ltd acquires a piece of equipment for its factory under a hire purchase arrangement for $44,000 (including GST). It will be remembered that the plant and equipment has an estimated useful life of five years. Assume that under the hire purchase agreement, Mixmaster Pty Ltd is required to make 36 monthly repayments of $1,100 on the 28th day of each calendar month. Furthermore, on 28 December 2019, Mixmaster Pty Ltd is required to make a balloon payment of $12,000, which is the estimated fair value of the plant and equipment on that date.

¶7-810 Hire purchase: GST on accrual and cash basis

The following journal entries will be necessary to record the various payments made over the life of a hire purchase agreement. (a) Initial journal entry On 28 January 2017, the bookkeeper will put through the following journal entry: DATE Jan 28

PARTICULARS

POST REF

DEBIT

CREDIT

Plant and equipment

1-7200

40,000

GST receivable (on asset)

2-2600

4,000

GST receivable (on interest)

2-2600

690

Hire purchase liability

2-4100

44,000

GST deferred (non-current liability)

2-4600

690

(To record the purchase of plant and equipment under a hire purchase arrangement) Analysis We are told that Mixmaster Pty Ltd acquired factory plant and equipment under a hire purchase arrangement for $44,000 (including GST). The “plant and equipment” account is debited for the GSTexclusive amount of $40,000 (being $44,000 × 10/11th). As the hire purchase agreement was entered into after 1 July 2012, the “new” GST rules relating to hire purchase agreements apply. Under the new rules, the company is able to claim back an input tax credit totalling $4,690 (being $4,000 for the GST attributable to the cost of the new plant and equipment, plus $690 GST receivable in relation to the interest that will be paid over the three-year period). The $690 interest is effectively equal to 1/11th of $7,600 (refer to the hire purchase schedule contained at ¶7-960). The $4,690 GST able to be claimed back by the company is shown in two separate lines in the above journal entry to illustrate how both GST components have been calculated. It is important to note that the company was able to claim back the entire GST of $4,690 in the tax period ended 31 March 2017 (being the tax period in which the first instalment was paid). The credit to “hire purchase liability” is for the gross amount payable (inclusive of GST) of $44,000. The remaining $690 (representing the GST on the interest over the three-year period) is credited to a noncurrent liability account entitled “GST deferred”. This account will be progressively reversed over the three-year period when each monthly payment is made. (b) First hire purchase repayment made on 28 January 2017 In the above example, Mixmaster Pty Ltd makes a monthly hire purchase repayment of $1,100 on the 28th day of each calendar month. For the first payment on 28 January 2017, the bookkeeper will record the following journal entry: DATE Jan 28

PARTICULARS

POST REF

Hire purchase liability

2-4100

Cash at bank

1-1300

DEBIT

CREDIT

1,100 1,100

(To record the first monthly hire purchase repayment of $1,100 made under the hire purchase agreement on 28 January 2017) Analysis The “hire purchase liability” account is debited for $1,100. This amount represents reduction in the hire

purchase liability. The “cash at bank” account is credited for the same amount. (c) Subsequent hire purchase repayments For each of the next 35 months, the bookkeeper will record the following journal entry on the 28th day of each month: DATE Feb 28

PARTICULARS Hire purchase repayments (expense) Cash at bank

POST REF 6-3900

DEBIT

CREDIT

1,100

1-1300

1,100

(To record the monthly hire purchase repayment of $1,100 made under the hire purchase agreement on the 28th day of each month) Analysis This time, the “hire purchase repayments” account, which is shown as an expense in the profit and loss statement is debited for $1,100 each month. The “cash at bank” account is credited for the same amount. (d) Allocation of the monthly hire purchase repayments From an accounting perspective, under AASB 117, monthly hire purchase repayments must be apportioned by the hirer between: • the interest expense, and • reduction of the hire purchase liability. The interest expense component is calculated by applying the interest rate implicit in the hire purchase agreement to the outstanding hire purchase liability at the beginning of each repayment period. The remainder of the periodic payment is treated as a repayment of the principal of the hire purchase liability. Usually, the amount of interest calculated each period will decrease as the outstanding principal balance decreases each period. The accountant usually prepares a hire purchase schedule detailing the split between the interest expense and the hire purchase liability. A copy of the hire purchase schedule prepared for Mixmaster Pty Ltd using the facts contained in Worked Example 6 (¶7-780) is included at ¶7-960. According to the hire purchase schedule, there is no interest in respect of the first payment, as we are told that under the hire purchase agreement, the first payment is made in advance. Therefore, we booked the whole of the first hire purchase repayment to the “hire purchase liability” account. Therefore there is no need for us to do any extra reallocation of this payment. However, for all subsequent monthly hire purchase repayments, we will need to apportion the amount of monthly repayment between the interest expense, reduction of the hire purchase liability and GST deferred liability. The bookkeeper will record the following journal entry on 28 February 2017: DATE Feb 28

PARTICULARS

POST REF

DEBIT

CREDIT

Interest expense

6-3800

296

GST deferred (non-current liability)

2-4600

30

Hire purchase liability

2-4100

774

Hire purchase repayments (expense) (To record the allocation of the $1,100 hire purchase repayment between the interest

6-3900

1,100

expense and reduction in the principal component of the hire purchase liability and the GST deferred liability) Analysis For accounting purposes, under AASB 117, each hire purchase repayment must be apportioned between the interest expense and reduction of the hire purchase liability. In accordance with the hire purchase schedule at ¶7-960, the interest component is $326 (rounded). However, this is the GST-inclusive amount of the interest for the month of February 2017. The GST on this amount (equivalent to 1/11th of $326) comes to $29.64. Hence, the debit to “interest expense” is for the GST-exclusive amount of $296.39. This amount will be shown as an expense in the profit and loss statement. The “GST deferred” account is debited (ie reversed) for the amount of $29.64 (representing the interest for the month of February 2017). The debit to “hire purchase liability” of $774 (rounded) represents reduction in the principal component of the hire purchase liability. At this point, the hire purchase liability in the balance sheet of Mixmaster Pty Ltd will be $42,126 (as per the closing balance of the hire purchase schedule on this date (¶7-960)). The credit to “hire purchase repayments” effectively reverses the hire purchase repayment of $1,100 originally recorded as an expense by the bookkeeper in the profit and loss statement. At the end of the financial year, the “hire purchase repayments” account in the profit and loss statement will be reduced to $nil. The hire purchase repayments of $1,100 per month are effectively split between the interest expense reduction of the hire purchase liability and GST deferred liability. According to the hire purchase schedule, the balance of the GST deferred liability account as at 30 June 2017 should be $38,971. (e) Final balloon payment of $12,000 On 28 December 2019, Mixmaster Pty Ltd makes the final balloon payment of $12,000. The bookkeeper will record the following journal entry in relation to the final balloon payment:

DATE

PARTICULARS

Dec 28

POST REF

Hire purchase liability

2-4100

Cash at bank

1-1300

DEBIT

CREDIT

12,000 12,000

(To record the final balloon payment) Analysis We are told that on 28 December 2019, Mixmaster Pty Ltd makes the final balloon payment of $12,000. As such, “hire purchase liability” is debited for this amount and “cash at bank” is credited for the same figure. Once again, unlike a finance lease, there is no debit or credit to the “GST receivable” account as the GST was claimed back in the first journal entry. There is no interest in respect of the final balloon payment of $12,000 as it is made on the last day of the hire purchase agreement period. (f) Recording annual depreciation of the plant and equipment Paragraphs 27 and 28 of AASB 117 require that an asset be depreciated over its estimated useful life in accordance with the principles contained in AASB 116. In the above example, we are told that the plant and equipment has a useful life of five years. Assuming that the company elects to use the straight-line depreciation method, the bookkeeper will put through the following journal entry on 30 June 2017: DATE

PARTICULARS

Jun 30

POST REF

Depreciation expense

6-2800

Accumulated depreciation — plant and equipment

1-7300

DEBIT

CREDIT

3,375 3,375

(To record the depreciation expense in relation to the plant and equipment for the 154 days of the 2017 financial year) Analysis The useful life of the plant and equipment is five years. Therefore, each year the depreciation expense of $8,000 will be recorded (ie $40,000/5 years). However, in the first year, Mixmaster Pty Ltd has only held the asset for 154 days. Hence, the depreciation expense for the period from 28 January 2017 to 30 June 2017 is calculated as $3,375. The credit is taken to “accumulated depreciation — plant and equipment”. For the following year, the depreciation expense will be $8,000. An extract from the profit and loss statement of Mixmaster Pty Ltd for the year ended 30 June 2017 is shown as follows: Mixmaster Pty Ltd Profit and Loss Statement for the year ended 30 June 2017 Expenses

$

Depreciation expense

3,375

Interest expense**

1,428

** this amount comprises the total GST-exclusive interest expense for the period from 28 January 2017 to 30 June 2017 (as per the hire purchase schedule in ¶7-960).

An extract from the balance sheet of Mixmaster Pty Ltd as at 30 June 2017 is as follows: Mixmaster Pty Ltd Balance Sheet as at 30 June 2017 Non-Current Assets

$

Plant and equipment, at cost

40,000

Less: Accumulated depreciation

(3,375) 36,625

Current Liabilities Hire purchase liability

10,060

Non-Current Liabilities Hire purchase liability

28,911 38,971

GST deferred*

548

* this number comprises the total remaining GST deferred in respect of the period from 28 July 2017 to 28 December 2019 as per the hire purchase schedule in ¶7-960.

As per the hire purchase schedule, the total hire purchase liability owing as at 30 June 2017 is $38,971. However, this amount must be split between its current and non-current components. The current portion of the outstanding hire purchase liability of $10,060 represents the amount owing by the entity in the next 12 months. This amount is calculated by taking the outstanding hire purchase liability as at 30 June 2017 (being $38,971) and deducting the outstanding hire purchase liability as at 30 June 2018 (being $28,911). The non-current portion of $28,911 is disclosed as a non-current liability in the balance sheet. As in the case of a lease, the carrying amount of the asset and the outstanding balance of the hire purchase liability will never be the same amounts after the initial journal entry. The asset is depreciated over its useful life, while the hire purchase liability is reduced by the principal component of each hire purchase repayment. Finally, from a taxation perspective, the interest expense ($1,428) and the depreciation expense ($3,375) recorded in the profit and loss statement are both tax-deductible, but not the monthly hire purchase repayments of $1,100. It will be observed that the taxation treatment of hire purchase arrangements differ from those of leases, as in the case of a lease, monthly lease payments are tax-deductible. The accounting, taxation and GST consequences of acquiring an asset under a hire purchase arrangement are illustrated in Table 7.8. Table 7.8: Accounting, taxation and GST consequences of a hire purchase arrangement Accounting The hirer will record the cost of the asset and the equivalent hire purchase liability as at the date of the hire purchase

Income tax For taxation purposes, under Div 240 of ITAA97, a hire purchase arrangement is effectively a financing arrangement,

GST

From 1 July 2012, all supplies made credit provided under a hire purchas agreement are no longer regarded a

agreement.

The asset will be depreciated over its estimated useful life in accordance with AASB 116. As such, the entity will calculate and record the depreciation expense in the profit and loss statement and credit the contra-asset account “Less: accumulated depreciation” in the balance sheet.

Each hire purchase repayment must be split between the interest expense and reduction of the hire purchase liability.

Both the “interest expense” and the “depreciation expense” in relation to the asset will appear in the profit and loss statement.

whereby the hirer is deemed to be the owner of the asset.

financial supplies, but taxable suppl

All taxpayers will be entitled to claim full amount of the input tax credit in respect of a hire purchase acquisitio the tax period in which they receive invoice from the financier or pay the instalment under the agreement regardless of whether they account For taxation purposes, depreciation rules GST under the cash or accrual basi vary depending on the type of taxpayer. However, generally speaking, an asset is depreciated over its effective life at the rates set down by the Commissioner in In effect this means that an entity w Taxation Ruling TR 2016/1. able to claim back the sum of 1/11 the purchase price of the asset plus 1/11 interest paid under the hire purchas The hirer is also able to claim a tax agreement. deduction for the amount of the GSTexclusive interest expense attributable to each hire purchase repayment (as per the split in the hire purchase schedule). Accordingly, the hirer is able to claim a tax deduction for the depreciation in accordance with Div 40 of ITAA97.

Chattel mortgage Chattel mortgage

¶7-840

Chattel mortgage: GST on accrual and cash basis ¶7-845

¶7-840 Chattel mortgage Accounting treatment A chattel mortgage is an arrangement whereby the purchaser of goods (including motor vehicles) borrows money from the lender to finance the acquisition. In exchange, the lender takes security over the goods being financed in the event of default by the borrower (purchaser). Under a chattel mortgage arrangement, the purchaser obtains title in the chattel from the time of purchase, meaning that the entity takes immediate ownership of the asset from the beginning of the loan. Hence, under a chattel mortgage arrangement, the title of the goods passes to the purchaser immediately. This is to be contrasted to a hire purchase arrangement (¶7-800), under which the title to the goods does not pass until the purchaser exercises an option at the end of the agreement to acquire the asset or obtain the legal title to the asset when the final instalment is paid. This is the fundamental difference between a chattel mortgage arrangement and a hire purchase agreement. The purchaser has legal title to the goods from the time of purchase. Income tax treatment From a taxation perspective, an entity acquiring the asset is regarded as the legal owner of the asset for taxation purposes. This enables them to claim the depreciation as the legal owner of the asset pursuant to Div 40 of ITAA97. As the asset has been effectively financed via a loan, the acquirer is also able to claim a tax deduction for the interest associated with the loan.

GST treatment From a GST perspective, under a chattel mortgage arrangement, the acquiring entity is regarded as the owner of the asset being financed. The entity simply acquires the asset by way of a loan. Hence, in the case of a chattel mortgage arrangement, regardless of whether the entity is on the cash basis or accrual basis for GST purposes, the entity is entitled to claim back the entire input tax credit associated with the purchase of the asset in the tax period in which the borrowed funds have been applied to acquire the asset. For this reason, goods financed under chattel mortgage arrangements have significant cash flow advantages over leases. Under a chattel mortgage arrangement, the entity is able to claim back the entire amount of input tax credits when the chattel mortgage arrangement is entered into and a tax invoice is received regardless of whether they are on the cash or accrual basis for GST. This is to be contrasted to all the other financing options (except for hire purchase), where the entity is unable to claim back the input tax credits associated with the acquisition of the asset upfront. Refer to Worked Example 6 in ¶7-780. This time assume that on 28 January 2017, Mixmaster Pty Ltd acquires a piece of equipment for its factory under a chattel mortgage arrangement for $44,000 (including GST). It will be remembered that the plant and equipment has an estimated useful life of five years. Assume that under the chattel mortgage agreement, Mixmaster Pty Ltd is required to make 36 monthly repayments of $1,100 on the 28th day of each calendar month. Furthermore, on 28 December 2019, Mixmaster Pty Ltd is required to make the final payment of $12,000, which is the estimated fair value of the plant and equipment on that date.

¶7-845 Chattel mortgage: GST on accrual and cash basis As the GST consequences of a chattel mortgage arrangement are identical regardless of whether the taxpayer is on the cash or accrual basis for GST, the answer to the following example of Mixmaster Pty Ltd is the same for both situations. For the purposes of illustrating the GST consequences of chattel mortgage arrangements, we will assume that Mixmaster Pty Ltd is registered for GST and accounts for GST using the accrual basis. (a) Initial journal entry On 28 January 2017, the bookkeeper will put through the following journal entry: DATE Jan 28

PARTICULARS

POST REF

DEBIT

Plant and equipment

1-7200

40,000

GST receivable

2-2600

4,000

Chattel mortgage liability

2-4200

CREDIT

44,000

(To record the purchase of plant and equipment under a chattel mortgage arrangement) Analysis We are told that Mixmaster Pty Ltd acquires the factory plant and equipment under a chattel mortgage arrangement for $44,000 (including GST). The “plant and equipment” account is debited for the GSTexclusive amount of $40,000. As previously explained, regardless of whether the company is on the cash or accrual basis for GST, the company is entitled to claim 100% of the input tax credit at the time of purchase, as Mixmaster Pty Ltd is regarded as the owner of the goods at the time of entering into the chattel mortgage agreement. Hence, the “GST receivable” account is debited for $4,000. The credit to “chattel mortgage liability” is for the gross amount payable (inclusive of GST).

(b) First chattel mortgage payment made on 28 January 2017 In the above example, Mixmaster Pty Ltd makes monthly chattel mortgage payments of $1,100 on the 28th day of each calendar month. For the first payment on 28 January 2017, the bookkeeper will record the following journal entry: DATE Jan 28

PARTICULARS Chattel mortgage liability Cash at bank

POST REF 2-4200

DEBIT

CREDIT

1,100

1-1300

1,100

(To record the first monthly chattel mortgage repayment of $1,100 made under the chattel mortgage agreement on 28 January 2017) Analysis The “chattel mortgage liability” account is debited for $1,100. This amount represents reduction in the chattel mortgage liability. The “cash at bank” account is credited for the same amount. (c) Subsequent chattel mortgage payments For each of the next 35 months, the bookkeeper will record the following journal entry on the 28th day of each month: DATE

PARTICULARS

POST REF

Feb 28

Chattel mortgage repayments (expense)

6-2300

Cash at bank

1-1300

DEBIT

CREDIT

1,100 1,100

(To record the monthly chattel mortgage repayment of $1,100 made under the chattel mortgage agreement on the 28th day of each month) Analysis This time, the “chattel mortgage repayments” account, which is shown as an expense in the profit and loss statement is debited for $1,100 each month. The “cash at bank” account is credited for the same amount. (d) Allocation of the monthly chattel mortgage repayments From an accounting perspective, each monthly chattel mortgage payment must be apportioned between: • the interest expense, and • reduction of the chattel mortgage liability. The interest expense component is calculated by applying the interest rate implicit in the chattel mortgage agreement to the outstanding chattel mortgage liability at the beginning of each repayment period. The remainder of the periodic payment is treated as a repayment of the principal of the chattel mortgage liability. Usually, the amount of interest calculated each period will decrease as the outstanding principal balance decreases. The accountant usually prepares a chattel mortgage schedule detailing the split between the interest expense and the chattel mortgage liability. A copy of the chattel mortgage schedule prepared for Mixmaster Pty Ltd using the facts contained in Worked Example 6 (¶7-780) is included at ¶7-980. According to the chattel mortgage schedule, there is no interest in respect of the first payment, as we are

told that under the chattel mortgage agreement, the first payment is made in advance. Therefore, we booked the whole of the first chattel mortgage repayment to the “chattel mortgage liability” account. Hence, there is no need for us to do any extra reallocation of this payment. However, for all subsequent monthly chattel mortgage repayments, we will need to apportion the amount of the monthly repayment between the interest expense and reduction of the chattel mortgage liability. If we now look at the second chattel mortgage repayment on 28 February 2017, for example, in accordance with the chattel mortgage schedule, the interest component comes to $326 (rounded). Therefore, the reduction of the chattel mortgage liability totals $774 (rounded). The bookkeeper will record the following journal entry on 28 February 2017: DATE Feb 28

PARTICULARS

POST REF

DEBIT

CREDIT

Interest expense

6-4200

326

Chattel mortgage liability

2-4200

774

Chattel mortgage repayments (expense)

6-2300

1,100

(To record the allocation of chattel mortgage repayments between the interest expense and reduction in the principal component of the chattel mortgage liability) Analysis For accounting purposes, each chattel mortgage repayment must be apportioned between the interest expense and reduction of the chattel mortgage liability. The debit to the account entitled “interest expense” of $326 will be shown as an expense in the profit and loss statement. The debit to “chattel mortgage liability” of $774 represents reduction in the principal component of the chattel mortgage liability. At this point, the chattel mortgage liability in the balance sheet of Mixmaster Pty Ltd will be $42,126 (as per the closing balance of chattel mortgage schedule on this date (¶7-980)). The credit to “chattel mortgage repayments” effectively reverses the chattel mortgage repayment of $1,100 originally recorded as an expense by the bookkeeper in the profit and loss statement. At the end of the financial year, the “chattel mortgage repayments” account in the profit and loss statement will be reduced to $nil. The chattel mortgage repayments of $1,100 per month are effectively split between the interest expense and reduction of the chattel mortgage liability. According to the chattel mortgage schedule, the balance of the “chattel mortgage liability” account as at 30 June 2017 should be $38,971. (e) Final lump sum payment of $12,000 On 28 December 2019, the final repayment of $1,100 will be made. However, on this date, Mixmaster Pty Ltd will also make the final lump sum payment of $12,000 (GST-inclusive). At this point, the bookkeeper will record the following journal entry in relation to the lump sum payment: DATE Dec 28

PARTICULARS

POST REF

Chattel mortgage liability

2-4200

Cash at bank

1-1300

DEBIT

CREDIT

12,000 12,000

(To record the final lump sum payment) Analysis We are told that on 28 December 2019, Mixmaster Pty Ltd makes the final payment of $12,000. As such,

“chattel mortgage liability” is debited for this amount and “cash at bank” is credited for the same figure. There is no interest in respect of the final lump sum payment of $12,000 as the interest has already been paid in the final monthly chattel mortgage repayment which is made on this same day. (f) Recording annual depreciation Being a depreciable non-current asset, the asset must be depreciated over its estimated useful life in accordance with the principles contained in AASB 116. In the above example, we are told that the plant and equipment has a useful life of five years. Assuming that the company elects to use the straight-line depreciation method, the bookkeeper will put through the following journal entry on 30 June 2017: DATE Jun 30

PARTICULARS

POST REF

Depreciation expense

6-2800

Accumulated depreciation — plant and equipment

DEBIT

CREDIT

3,375

1-7300

3,375

(To record the depreciation expense in relation to the plant and equipment for the 154 days in the 2017 financial year) Analysis The useful life of the plant and equipment is five years. Therefore, the depreciation expense of $8,000 will be recorded each year (ie $40,000/5 years). However, in the first year, Mixmaster Pty Ltd has only held the asset for 154 days. Hence, the depreciation expense for the period from 28 January 2017 to 30 June 2017 is calculated at $3,375. Credit is taken to “accumulated depreciation — plant and equipment”. For the following year, the depreciation expense will be $8,000. An extract from the profit and loss statement of Mixmaster Pty Ltd for the year ended 30 June 2017 is shown as follows: Mixmaster Pty Ltd Profit and Loss Statement for the year ended 30 June 2017 Expenses

$

Depreciation expense

3,375

Interest expense**

1,571

** this amount comprises the total interest expense for the period from 28 January 2017 to 30 June 2017 (as per the chattel mortgage schedule in ¶7-980).

An extract from the balance sheet of Mixmaster Pty Ltd as at 30 June 2017 is as follows: Mixmaster Pty Ltd Balance Sheet as at 30 June 2017 Non-Current Assets

$

Plant and equipment, at cost

40,000

Less: Accumulated depreciation

(3,375) 36,625

Current Liabilities Chattel mortgage liability

10,060

Non-Current Liabilities Chattel mortgage liability

28,911 38,971

As per the chattel mortgage schedule, the total chattel mortgage liability owing as at 30 June 2017 is $38,971. However, this amount must be split between its current and non-current components. The current portion of the outstanding chattel mortgage liability of $10,060 represents the amount owing by the entity in the next 12 months. This amount is calculated by taking the outstanding chattel mortgage liability as at 30 June 2017 (being $38,971) and deducting the outstanding chattel mortgage liability as at 30 June 2018 (being $28,911). The non-current portion of $28,911 is disclosed as a non-current liability in the balance sheet. As in the case of a lease and a hire purchase agreement, the carrying amount of the asset and the outstanding balance of the chattel mortgage liability will never be the same amounts after the initial journal entry. The asset is depreciated over its useful life, while the chattel mortgage liability is reduced by the principal component of each chattel mortgage repayment over the term of the chattel mortgage agreement. Finally, from a taxation perspective, the interest expense ($1,571) and the depreciation expense ($3,375) recorded in the profit and loss statement are both tax-deductible, but not the monthly chattel mortgage repayments of $1,100. The accounting, taxation and GST consequences of acquiring an asset under a chattel mortgage arrangement are illustrated in Table 7.9. Table 7.9: Accounting, taxation and GST consequences of a chattel mortgage arrangement Accounting The acquiring entity will record the cost of the asset and the equivalent chattel mortgage liability as at the date of the chattel mortgage agreement.

The asset will be depreciated over its estimated useful life in accordance with AASB 116. As such, an entity will calculate and record the depreciation expense in the profit and loss statement and credit the contra asset account “Less: accumulated depreciation” in the balance sheet.

Each chattel mortgage repayment must be split between the interest expense and reduction of the chattel mortgage liability.

Income tax

GST

For taxation purposes, the entity acquires the asset under a financing arrangement, and, as such, the entity is the legal owner of the asset.

In the case of a chattel mortgage arrangement, regardless of whether entity is on the cash basis or accrua basis for GST purposes, the entity i entitled to claim back the entire inpu credit associated with the purchase the asset in the tax period in which Accordingly, the purchaser is able to borrowed funds have been applied claim a tax deduction for the depreciation acquire the asset. in accordance with Div 40 of ITAA97.

The entity must ensure that they rec For taxation purposes, depreciation rules a tax invoice prior to making the cla vary depending on the type of taxpayer. the BAS. However, generally speaking, an asset is depreciated over its effective life at the rates set down by the Commissioner in Taxation Ruling TR 2016/1.

The acquiring entity is also able to claim a tax deduction for the amount of interest

Both the interest expense and the depreciation expense in relation to the asset will appear in the profit and loss statement.

expense attributable to each chattel mortgage repayment (as per the split in the chattel mortgage schedule).

Intangible Assets Introduction

¶7-850

Amortisation of intangible assets ¶7-860 Goodwill

¶7-870

¶7-850 Introduction Intangible assets are covered by AASB 138 Intangible Assets. An intangible asset is defined in para 8 of AASB 138 as a non-monetary asset without physical substance. Examples of intangible assets include: • trademarks • patents • copyrights • motion picture films • publishing titles • customer lists • computer databases • licences and royalty agreements • brand names • franchise agreements • internet domain names • trade secrets such as secret formulas, processes or recipes • newspaper mastheads • computer software (except where it is an integral part of the related hardware, such as the operating system). These assets are regarded as identifiable intangible assets because they can be separately identified and sold. Another example of an intangible asset is goodwill. However, goodwill is specifically covered by AASB 3 Business Combinations and is discussed at ¶7-870. Over the past 25 years, more and more companies all over the world have been recognising intangible assets in their balance sheets. This is an indication of the value and importance of these assets to companies. In Australia, intangible assets can often form a significant part of a company’s total asset base. Table 7.10

shows the value of intangible assets expressed against the total assets of 10 selected Australian-listed companies in respect of the 2016 financial year. Table 7.10: Intangible assets of 10 selected listed Australian companies Company

Total intangible assets**

Total assets

Intangible assets as a percentage of total assets

Telstra Corporation Ltd

$9.23b

$43.29b

21.32%

Woolworths Ltd

$5.98b

$23.5b

25.45%

Fairfax Media Ltd

$754.3m

$1.645b

45.85%

Wesfarmers Ltd

$19.07b

$40.78b

46.76%

Myer Holdings Ltd

$904.1m

$1.88b

48.09%

Nine Entertainment Ltd

$983.0m

$2.00b

49.15%

Ten Network Holdings Ltd

$346.5m

$680.6m

50.91%

Seven West Media Ltd

$1.55b

$2.67b

58.25%

Southern Cross Austereo Ltd

$1.29b

$1.69b

76.33%

MYOB Ltd

$1.2b

$1.42b

84.5%

** includes goodwill

AASB 138 allows only purchased (or acquired) intangible assets to be recognised as assets in the balance sheet. The recognition of internally generated intangible assets is not allowed. An internally generated intangible asset is one which an entity has developed itself. Because these assets are not acquired, they do not possess a cost that enables them to be objectively valued, and for this reason they are not allowed to be recognised in the balance sheet (para 63, AASB 138). A purchased intangible asset must be initially measured at cost (para 24, AASB 138). According to paras 27 and 28 of AASB 138, the cost of an acquired identifiable intangible asset includes: • its purchase price, including import duties, and purchase taxes after deducting trade discounts and rebates, and • any incidental costs directly attributable to preparing the intangible asset for its intended use. Costs that are considered “directly attributable” to the purchase of an intangible asset include: • employee costs arising directly from bringing the asset to its working condition • professional fees arising directly from bringing the asset to its working condition, and • costs of testing whether the intangible asset is functioning properly. Incidental costs not able to be included as directly attributable to the cost of an acquired intangible asset include (para 29, AASB 138): • costs of introducing a new product or service (including the costs of advertising and promotional activities) • costs of conducting business in a new location or with a new class of customers (including the costs of staff training), and • administration and other general overhead costs. Take the following example. Assume that on 4 February 2017, Topstar Holdings Pty Ltd pays a franchise

fee of $110,000 (GST-inclusive) to become a franchisee in “Harry’s Hamburgers” chain of fast food restaurants. The franchise fee qualifies as a purchased identified intangible asset and will be recorded in the balance sheet. On 4 February 2017, the bookkeeper would record the following journal entry: DATE Feb 4

PARTICULARS

POST REF

DEBIT

Franchise fee

1-8000

100,000

GST receivable

2-2600

10,000

Cash at bank

1-1300

CREDIT

110,000

(To record the payment of $110,000 to acquire a Harry’s Hamburgers franchise) Analysis The intangible asset “franchise fee” is debited for the GST-exclusive value of $100,000 and recorded as a non-current asset in the balance sheet. The “GST receivable” account is also debited for 1/11th of the $110,000, being $10,000. The account “cash at bank” is credited for the $110,000 paid to acquire the franchise agreement.

¶7-860 Amortisation of intangible assets Like tangible assets, most intangible assets are considered to have limited useful lives. As such, AASB 138 requires these assets to be amortised. The terms “amortisation” and “depreciation” can be used interchangeably. However, the term amortisation generally refers to the systematic allocation of the cost of an intangible asset over its estimated useful life. In contrast, the term depreciation refers to the systematic allocation of the cost of a tangible asset over its estimated useful life. Paragraph 88 of AASB 138 permits an entity to determine whether the entity’s intangible assets have a finite or indefinite useful life. Paragraph 90 goes on to outline the factors to be considered in determining whether an intangible asset is considered to have a finite or indefinite useful life. These factors include: • the expected usage of the asset by the entity • typical product life cycles for the asset and public information on the estimates of useful lives of similar assets • technical, technological or commercial obsolescence • stability of the industry in which the asset operates • changes in the market demand for the output from the asset • expected actions by competitors or potential competitors • the level of maintenance expenditure required to obtain the expected future economic benefits from the asset and the entity’s ability and intention to reach such a level • the period of control over the asset and legal or similar limits on the use of the asset, such as expiry dates, and • whether the useful life of the asset is dependent on the useful life of other assets of the entity. Intangible assets with finite useful lives Patents, trademarks, licences and franchise agreements often have expiry dates. These intangible assets will generally be regarded as having a finite useful life. In this instance, para 97 of AASB 138 provides

that intangible assets that are considered to have a finite useful life must be amortised on a systematic basis over its estimated useful life. However, where it gets slightly problematic is that some identifiable intangible assets, such as licences, franchise agreements, etc, have periods of renewal. According to para 94 of AASB 138, where the term of the intangible asset can be renewed, the useful life shall include the renewal period(s) only if there is evidence to support the renewal by the entity without significant cost. Refer to the previous worked example in ¶7-850 regarding the franchise fee paid ($110,000) to acquire a franchise of “Harry’s Hamburgers” chain of fast food restaurants. Assume that the franchise agreement is for a limited period of 10 years. As the franchise agreement has a limited useful life, it will be regarded as having a finite life. Accordingly, the GST-exclusive cost of the franchise fee should be amortised over this 10-year period. Assuming that the straight-line method is used, an annual amortisation charge of $10,000 will be recorded. However, as the franchise fee was paid on 4 February 2017, the amortisation expense for the 2017 financial year will be based on 147 days (ie 4 February 2017 to 30 June 2017). The bookkeeper will make the following journal entry to record the amortisation expense in respect of the franchise fee for the year ended 30 June 2017: DATE June 30

PARTICULARS

POST REF

Amortisation expense

6-1200

Accumulated amortisation — franchise fee

DEBIT

CREDIT

4,027

1-8100

4,027

(To record the amortisation expense in respect of the franchise agreement for the 2017 financial year, being $10,000 × 147/365 days) Analysis In the above journal entry, a debit of $4,027 is made to “amortisation expense”, which is recorded in the profit and loss statement. This amount is calculated as $10,000 × 147/365 days. Instead of directly crediting the asset account, credit is taken to an account entitled “accumulated amortisation — franchise fee”. “Accumulated amortisation” is a contra asset account. It is shown as a reduction from the noncurrent asset in the balance sheet. The non-current assets section of the balance sheet of Topstar Holdings Pty Ltd as at 30 June 2017 appears as follows: Topstar Holdings Pty Ltd Balance Sheet as at 30 June 2017 Non-Current Assets

$

Franchise fee, at cost

100,000

Less: Accumulated amortisation

(4,027) $95,973

In the following year, the bookkeeper will record the following journal entry to record the amortisation expense in respect of the franchise fee for the year ended 30 June 2018: DATE

PARTICULARS

POST REF

DEBIT

CREDIT

June 30

Amortisation expense

6-1200

Accumulated amortisation — franchise fee

1-8100

10,000 10,000

(To record the amortisation expense in respect of the franchise agreement for the 2018 financial year) The non-current assets section of the balance sheet of Topstar Holdings Pty Ltd as at 30 June 2018 appears as follows: Topstar Holdings Pty Ltd Balance Sheet as at 30 June 2018 Non-Current Assets

$

Franchise fee, at cost

100,000

Less: Accumulated amortisation

(14,027) $85,973

Intangible assets considered to have an indefinite useful life In other instances, intangible assets such as brand names are considered by many companies to have an indefinite useful life. Many well-known brand names have been around for more than 100 years. For example, Arnotts is one of Australia’s oldest brand names, having opened as a small bakery in Hunter Street in Newcastle and registering its trademark in 1907. In 1997, The Campbell Soup Company (a US company) acquired Arnotts. For 90 years, the brand name was not recorded in the financial statements of Arnotts. However, upon acquisition, it was recognised as an intangible asset in the books of The Campbell Soup Company. This brand name is not amortised in the financial statements of The Campbell Soup Company because it is considered to have an indefinite useful life. This accounting treatment is permitted as per para 107 of AASB 138. However, in the case of an intangible asset that is not amortised, para 108 of AASB 138 requires the entity to test for impairment: • annually, and • whenever there is an indication that it might be impaired. This is referred to as “impairment testing” and is covered by the provisions of AASB 136 Impairment of Assets. Under AASB 136, if an asset’s carrying amount exceeds its recoverable amount, then the asset is “impaired”. As such, the asset must be written down to its recoverable amount. The amount of the writedown is referred to as an impairment loss (para 6, AASB 136). Conversely, if the carrying amount of an asset is lower than its recoverable amount, then the asset is not regarded as impaired. As such, it can be left on the balance sheet at its carrying amount. According to para 6 of AASB 136, the recoverable amount of an asset or a cash-generating unit (broadly defined as a group of assets that generate cash flows) is defined as the higher of its fair value less costs to sell and its value in use. “Fair value less costs to sell” is defined in para 6 of AASB 136 as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. “Value in use” is defined as the present value of future cash flows expected to be derived from an asset or

cash-generating unit (para 6, AASB 136). In determining “value in use”, cash flow projections should be based on budgets and forecasts approved and signed off by management. It should represent estimated cash inflows and outflows associated with holding (ie using) the asset in its current condition and present use over the remaining useful life of the asset. The cash flows should be shown on a pre-tax basis, as income tax is excluded from the value in use calculations. If an entity intends to dispose of the asset at the end of its useful life, it must include the estimated net cash flow from the asset’s disposal (para 52, AASB 136). The concept of recoverable amount is shown in Diagram 7.5. Diagram 7.5: The recoverable amount test

The rules relating to impairment and whether an impairment loss exists is summarised in Table 7.11. Table 7.11: Rules relating to impairment If carrying amount < recoverable amount = asset is not impaired

Leave asset on the balance sheet at its carrying amount

If carrying amount = recoverable amount = asset is not impaired

Leave asset on the balance sheet at its carrying amount

If carrying amount > recoverable amount = asset is impaired

Impairment loss

To illustrate the accounting treatment of an intangible asset which has been determined to have an indefinite useful life, refer to the previous worked example in ¶7-850 regarding the franchise fee paid to acquire a franchise of “Harry’s Hamburgers” chain of fast food restaurants. Assume this time that the franchise agreement permits the franchisee to renew the agreement after every 10 years. At this stage, the franchisee intends to renew the franchise agreement indefinitely, and there are no prevailing reasons to indicate that the renewal of the franchise agreement would not take place. Accordingly, the company determines that the intangible asset has an indefinite useful life and, as such, no amortisation is provided for in the profit and loss statement. Because the asset is not amortised, “franchise fee” will remain in the balance sheet at its GST-exclusive cost of $100,000. Under the provisions of AASB 136, at each reporting period, the entity is required to test the franchise fee for impairment. In other words, the company must ascertain whether the carrying amount of the franchise fee of $100,000 exceeds its recoverable amount. Assume that on 30 June 2018, the company discovers that the franchisor is selling identical franchises for $92,000. This is the fair value less costs to sell. Assume that based on the cash flow projections prepared by the directors of Topstar Holdings Pty Ltd using Microsoft Excel, the value in use has been determined to be $88,000. A summary of these amounts is shown in Table 7.12. Table 7.12: Comparison of the values of the franchise fee Carrying amount of the asset in the balance sheet Fair value less costs to sell

$100,000 $92,000

Value in use (based on net present value calculations)

$88,000

The recoverable amount is defined as the higher of the fair value less costs to sell ($92,000) and value in use ($88,000). Hence, the recoverable amount of the franchise fee will be $92,000. However, as the carrying amount of the franchise fee of $100,000 is more than the recoverable amount of $92,000, the asset is impaired (or overvalued) by $8,000. Accordingly, the intangible asset must be written down from its cost of $100,000 to its fair value less costs to sell of $92,000. This results in an impairment of $8,000. The journal entry required to record this impairment loss on 30 June 2018 is as follows: DATE June 30

PARTICULARS

POST REF

Impairment loss — franchise fee

6-4000

Accumulated impairment — franchise fee

DEBIT

CREDIT

8,000

1-8100

8,000

(To recognise an impairment loss resulting from a fall in value of the franchise fee) Analysis In the above journal entry, a debit is made to “impairment loss — franchise fee”, which is recorded as an expense in the profit and loss statement. This impairment loss is not tax-deductible. Instead of directly crediting the asset account, credit is taken to an account entitled “accumulated impairment — franchise fee”. “Accumulated impairment” is a contra asset account, similar in nature to “accumulated depreciation”. It is shown in the balance sheet as a reduction from the intangible asset account. By crediting the account “accumulated impairment”, users of financial statements can still see the original cost of an asset and determine the extent of impairment losses in relation to the asset. The non-current assets section of the balance sheet of Topstar Holdings Pty Ltd as at 30 June 2018 appears as follows: Topstar Holdings Pty Ltd Balance Sheet as at 30 June 2018 Non-Current Assets

$

Franchise fee, at cost

100,000

Less: Accumulated impairment

(8,000) $92,000

The issue of impairment is one that is generally dealt with by an external accountant or auditor when preparing an entity’s external financial statements at year-end. It is generally not an issue that the bookkeeper is expected to deal with or consider and for this reason any further discussion on impairment testing is considered to be outside the scope of this book. Diagram 7.6 summarises the options regarding amortisation of intangible assets and the respective accounting treatments under AASB 138. Diagram 7.6: Finite or indefinite useful life?

¶7-870 Goodwill Goodwill is another example of an intangible asset. However, unlike identifiable intangible assets covered by AASB 138, such as patents, trademarks, licences and brand names, goodwill is regarded as an unidentifiable intangible asset. The relevant accounting standard dealing with the concept of goodwill is AASB 3 Business Combinations. Goodwill refers to those unidentifiable benefits that accrue to an entity by virtue of circumstances such as a favourable location, good customers or suppliers, and motivated employees. Because no cost can be reasonably assigned to these attributes, AASB 3 does not allow internally generated goodwill to be recognised as an asset in the balance sheet. However, an entity is able to recognise purchased goodwill. Purchased goodwill is defined in AASB 3 as the excess amount of money paid to acquire another entity over the fair value of identifiable net assets and contingent liabilities of another business. Put simply, goodwill is the “excess” or “premium” paid by the buyer of a business over the fair value of identifiable net assets and contingent liabilities of the entity being acquired. For example, assume that the balance sheet of Apple Pty Ltd shows net assets of $180,000 (ie assets of $260,000 and liabilities of $80,000). Assume that all assets shown in the balance sheet of Apple Pty Ltd are stated at fair value. If Peach Pty Ltd acquires 100% of the share capital of Apple Pty Ltd for $200,000, then it has paid $20,000 in excess of the fair value of the net assets. This $20,000 is referred to as the purchased goodwill. Purchased goodwill of $20,000 will be shown as a non-current asset in the balance sheet of Peach Pty Ltd in accordance with para B67 which is contained in the Appendix of AASB 3. Goodwill is not subject to amortisation. However, goodwill is required to be tested annually for impairment, or more frequently, if required (para 10(b), AASB 136). If there is evidence that the purchased goodwill has fallen in value, then goodwill is considered to be impaired and, as such, an impairment loss must be recognised. It is important to note the difference between the purchased goodwill and internally generated goodwill. Only purchased goodwill is recognised as a non-current asset in the balance sheet. Internally generated goodwill (eg where a business builds up a strong rapport with customers, or has a good reputation, great location or professionally trained and friendly staff, etc) is not permitted to be recognised in the financial statements (para 48, AASB 138). The reason for this is the subjectivity involved in determining an amount attributable to such items. Only purchased goodwill is able to be recognised as an asset in the balance sheet of the acquirer. To illustrate goodwill, the following extract has been taken from Flight Centre Ltd’s 2016 Annual Report. According to Note A6 of the 2016 financial statements, on 27 August 2014, Flight Centre acquired a 90% holding of Top Deck Tours Ltd, an unlisted company based in the United Kingdom that specialises in tour operations for a total consideration of $51.983m.

As at the date of acquisition, the fair value of the identifiable net assets (ie assets minus liabilities) of Top Deck Tours Ltd was $14.943m. Accordingly, Flight Centre Ltd paid a premium of $37.04m to acquire Top Deck Tours Ltd. This “premium” is referred to as goodwill and is shown in the balance sheet of Flight Centre Ltd as a non-current asset. The goodwill will be subject to annual impairment testing under AASB 136. “Note A6 Business Combinations” taken from the company’s 2016 financial statements is reproduced as follows: Extract from Note A6 of the 2016 financial statements of Flight Centre Ltd

¶7-900 Appendix 1: Sample fixed asset register

¶7-940 Appendix 2: Sample depreciation schedule

¶7-950 Appendix 3: Lease schedule — Mixmaster Pty Ltd

¶7-960 Appendix 4: Hire purchase schedule — Mixmaster Pty Ltd

¶7-980 Appendix 5: Chattel mortgage schedule — Mixmaster Pty Ltd

¶7-990 Non-current assets — commonly asked questions Question My client has just bought a depreciable asset. What should I include in the cost of this asset?

Answer Generally speaking, the rules as to what is included in the “cost” of a depreciable asset are the same for both accounting and taxation purposes.

For accounting purposes, under AASB 116, the cost of a depreciable asset not only includes its original purchase price, but also the incidental costs directly attributable to bringing the asset to its present location and condition.

Hence, apart from the purchase price, incidental costs include customs duty, transport, freight and insurance, and shipping and handling costs directly attributable to purchasing the asset. Stamp duty is also included in the cost of the asset.

Any trade discounts or rebates received must be deducted from the cost of the asset. If the entity is registered for GST, it excludes the GST paid to acquire the asset. Should subsequent costs incurred on the asset be capitalised or expensed?

From an accounting viewpoint, subsequent costs incurred after the acquisition of an item of property, plant and equipment should only be capitalised if the costs: • extend the useful life of the asset • improve the quality of its output, or • reduce the operating costs associated with the use of the asset. In these instances, AASB 116 requires that the cost of capital improvement be added (or debited) to the cost of the asset account in the balance sheet.

Conversely, expenditure incurred on regular maintenance or repairs to assets used for business purposes generally do not extend the useful life of an asset, nor do they improve the quality of its output. Hence, these costs are usually expensed. What is depreciation? Should I continue to record According to para 6 of AASB 116, depreciation is depreciation in management accounts even defined as the systematic allocation of the though the value of the asset has increased? depreciable amount of the asset over its estimated useful life.

The term “depreciable amount” is defined in the same paragraph as “the cost of the asset, or other amount substituted for cost, less its residual value”.

Accounting for depreciation represents the process whereby the decline in future economic benefits of an asset through usage, wear and tear and obsolescence is progressively recognised over the life of the asset as an expense in the profit and loss statement.

Depreciation is not a process of valuation. Recording depreciation does not purport to produce an asset value equivalent to the current market value. Hence, an asset must be depreciated even if its value increases. Should I prepare a depreciation schedule, and is it up to me to record depreciation in management accounts or is it the responsibility of the external accountant?

In some cases, the accountant or tax agent is responsible for calculating the depreciation, preparing the depreciation schedule and advising the bookkeeper of the amount of depreciation expense. The bookkeeper subsequently records this amount in management accounts.

In other cases, the bookkeeper is responsible for preparing the depreciation schedule and recording depreciation in management accounts.

The bookkeeper should consult with the external accountant to determine who is responsible for preparing the depreciation schedule and for recording depreciation. As the bookkeeper, is it up to me to choose which No. This decision as to the depreciation method to accounting depreciation method the client should adopt for accounting purposes is usually made by adopt and determine the useful lives of the accountant or tax agent. depreciable assets? Furthermore, determining the estimated useful lives of assets is also usually done by the accountant.

Practically, it is very difficult for bookkeepers, accountants or the owners of a business to determine the useful lives of assets. To assist taxpayers in determining the useful (or effective) lives of depreciable assets, in January 2001, the Commissioner published his own determination of the effective lives of depreciating assets.

This listing is included in a taxation ruling which is updated and reissued every year. The latest version, Taxation Ruling TR 2016/1, was issued by the Commissioner on 29 June 2016 and applies in respect of income years beginning on or after 1 July 2016. This 258-page ruling can be accessed on the ATO’s website at tinyurl.com/hbnv5pr.

While it is possible to use different useful lives for a depreciable asset for accounting and taxation purposes, in most cases, a taxpayer will usually adopt the useful life for accounting purposes as the effective life for taxation purposes. This means that the depreciation expense for accounting purposes is the same as that claimed for taxation purposes. My client has disposed of a depreciable asset. How do I record this disposal in management accounts?

Where a depreciable asset is sold, the first step is to record depreciation up to the date of the sale. This will determine the asset’s carrying amount as at the date of disposal.

The sale or disposal of a depreciable asset will give rise to a gain or loss on sale. If an asset is sold for more than its carrying amount, a gain on sale results. This gain on sale is recorded as “other income” in the profit and loss statement.

Conversely, if an asset is sold for less than its carrying amount, a loss on sale results. This loss on sale is shown as an expense in the profit and loss statement.

If the client is registered for GST, GST must be remitted to the ATO based on 1/11th of the gross sale proceeds. In this case, “cash at bank” is debited for the cash received with the “GST payable” account credited. What is a lease? How many different types of leases are there?

A lease is an agreement whereby the lessor transfers the right to use an asset for an agreed period of time to the lessee in return for a series of payments. Hence, under a lease agreement, the lessee does not acquire the asset, but the right to use the asset for a set period of time.

For this reason, the lessor continues to be the legal owner of the leased asset until such time as the lessee pays out the lease residual and acquires the asset.

There are two types of leases. A finance lease is essentially a lease that substantially transfers all the risks and rewards (benefits) incidental to the ownership of the asset. At the end of the lease term, the lessee usually has the option to acquire the

asset.

An operating lease is essentially a rental arrangement. The lessee leases (or rents) an asset from the lessor for a period of time. However, there is no intention to acquire the asset. Operating leases, in turn, can be classified as either “cancellable” or “non-cancellable”. Is there any difference as to how a finance lease and operating lease are recorded in the financial statements?

If a lease is classified as a finance lease, the lessee is required to record a leased asset and the lease liability equivalent to the fair value of minimum lease payments in the balance sheet. This is referred to as “lease capitalisation”.

Conversely, an operating lease is not shown on the balance sheet. Instead, lease payments (usually monthly) are simply recorded as an expense in the profit and loss statement.

The leased asset and associated lease liability are not recorded in the balance sheet as the lessee is merely renting the asset from the lessor (usually for a short period of time) and has no intention of ever buying the asset at the end of the lease term.

An operating lease is not shown in the balance sheet. It is simply recorded as an expense in the profit and loss statement. This is the case regardless of whether the operating lease is cancellable or non-cancellable.

What journal entries are required to account for an asset acquired under a finance leasing arrangement?

The leased asset is debited with a corresponding credit made to the “lease liability” account. Each lease payment (usually monthly) is taken to the profit and loss statement.

However, this lease payment must be apportioned (split) between the interest expense and reduction in the principal component. A lease schedule is usually prepared by the accountant showing the split in the lease payments between these two components over the lease term. It can be relatively time consuming to prepare this schedule because it may be necessary to use a trial and error basis to

calculate the interest rate implicit in the lease agreement.

The leased asset must also be amortised (or depreciated) over its useful life. What are the income tax and GST treatments of leases?

The Commissioner makes no distinction between a finance lease and an operating lease. For this reason, regardless of whether the lease is classified as a finance or an operating lease, the GSTexclusive amount of lease payments made by the lessee are tax-deductible under s 8-1 of ITAA97. The interest and amortisation expenses are not deductible.

From a GST perspective, where the lessee accounts for GST on a cash basis, the lessee is entitled to claim an input tax credit (equivalent to 1/11th of the lease payment) when the lease payment is made.

Conversely, where a lessee accounts for GST on an accrual basis, the entitlement to claim the input tax credit will arise in the tax period in which the lease payment is due and payable as outlined in the lease payment schedule contained in the lease agreement. What is a hire purchase arrangement? How is this A hire purchase arrangement is one under which transaction accounted for in the financial goods are purchased by the payment of statements? instalments. The hirer has the use of goods while the payments (usually monthly) are being made, but does not become the legal owner until the final instalment is paid. This final instalment is often referred to as a balloon payment.

The accounting treatment of hire purchase agreements is, in substance, no different to that of a finance lease.

However, the main difference is that unlike a finance lease where there is no obligation to acquire the goods at the end of the lease term, a hire purchase arrangement provides for this obligation and, as such, the asset will eventually be owned by the purchaser.

What journal entries are required to account for a hire purchase agreement?

The asset subject to the hire purchase agreement is debited with a corresponding credit made to the “hire purchase liability” account.

Each hire purchase repayment (usually monthly) is apportioned (or split) between the interest expense and reduction in the principal component.

A hire purchase schedule is usually prepared by the accountant showing the split in the payments between these two components over the hire term.

The asset subject to hire must also be depreciated over its estimated useful life. What are the income tax and GST treatments of hire purchase agreements?

From an income tax perspective, the Commissioner regards a hire purchase arrangement as a financing arrangement which facilitates the sale and purchase of goods via a loan.

This means that for taxation purposes, the hirer is deemed to be the owner of the hired goods and, as such, is able to claim a tax deduction for depreciation.

Additionally, the hirer is also able to claim a tax deduction for the amount of interest expense attributable to each hire purchase repayment (as per the split in the hire purchase schedule, which is usually prepared by the accountant).

From 1 July 2012, all supplies made or credit provided under a hire purchase agreement are no longer regarded as financial supplies, but taxable supplies.

Furthermore, all taxpayers are entitled to claim the full amount of the input tax credit in respect of a hire purchase acquisition in the tax period in which they receive a tax invoice from the financier or pay the first instalment under the agreement regardless of whether they account for GST under the cash or

accrual basis.

In effect this means that an entity will be able to claim back the sum of 1/11th of the purchase price of the asset plus 1/11th of the total interest paid under the hire purchase agreement. What is a chattel mortgage? How is this transaction accounted for in the financial statements?

A chattel mortgage is an arrangement whereby the purchaser of goods (including motor vehicles) borrows money from the lender to finance the acquisition. In exchange, the lender takes security over the goods being financed in the event of default by the borrower (purchaser).

Under a chattel mortgage arrangement, the purchaser obtains the title in the chattel from the time of purchase, meaning that the entity takes immediate ownership of the asset from the beginning of the loan.

From an accounting perspective, the non-current asset is debited and a loan for the amount financed is credited in the balance sheet. What journal entries are required to account for a chattel mortgage?

The asset subject to the chattel mortgage is debited with a corresponding credit made to the “chattel mortgage liability” account.

Each chattel mortgage repayment (usually monthly) is apportioned (or split) between the interest expense and reduction in the principal component.

A chattel mortgage schedule is usually prepared by the accountant showing the split in the payments between these two components over the hire term.

The asset is depreciated over its estimated useful life. What are the income tax and GST treatments of chattel mortgage agreements?

From a taxation perspective, the entity acquiring an asset is regarded as the legal owner of the asset for taxation purposes. This enables the entity to claim the depreciation as the legal owner of the asset pursuant to Div 40 of ITAA97.

As the asset has been effectively financed via a loan, the acquirer is also able to claim a tax deduction for the interest associated with the loan.

From a GST perspective, under a chattel mortgage arrangement, the acquiring entity is regarded as the owner of the asset being financed. The entity simply acquires the asset by way of a loan.

Hence, in the case of a chattel mortgage arrangement, regardless of whether the entity is on the cash basis or accrual basis for GST purposes, the entity is entitled to claim back the entire input tax credit associated with the purchase of the asset in the tax period in which the borrowed funds have been applied to acquire the asset.

For this reason, goods financed under chattel mortgage arrangements have significant cash flow advantages over leases. What is an intangible asset and how should I record it in management accounts?

An intangible asset is defined as a non-monetary asset without physical substance. Examples of intangible assets include: • trademarks • patents • copyrights • motion picture films • publishing titles • customer lists • computer databases • licences and royalty agreements • brand names • franchise agreements • internet domain names • trade secrets such as secret formulas, processes or recipes • newspaper mastheads, and • computer software (except where it is an integral part of the related hardware, such as the operating system).

These assets are regarded as identifiable intangible assets because they can be separately identified and sold. Another example of an intangible asset is goodwill.

Under AASB 138, only purchased (or acquired) intangible assets are allowed to be recognised as assets in the balance sheet. Purchased intangibles must be measured at cost. This will be the amount paid to acquire the asset and will usually be documented in the purchase contract.

Internally generated intangible assets are not allowed to be recognised in financial statements. An internally generated intangible asset is one which the entity has developed itself.

In respect of acquired intangible assets, an entity must determine whether the intangible asset has a limited or indefinite useful life. Intangible assets that are considered to have a limited useful life are required to be amortised.

Conversely, if the entity determines that the intangible asset has an indefinite useful life, it is not required to be amortised. In this case, the asset will remain in the balance sheet at its cost. However, in the case of intangible assets that have not been amortised, each year the carrying amount of the intangible asset must be compared against its recoverable amount in order to determine whether the asset’s value has fallen. This process is referred to as “impairment testing”.

If an asset’s carrying amount exceeds its recoverable amount, then the asset is “impaired”. As such, the asset must be written down to its recoverable amount. The amount of write-down is referred to as an impairment loss which appears as an expense in the profit and loss statement.

Conversely, if the carrying amount of an asset is lower than its recoverable amount, then the asset is not regarded as impaired. As such, it can be left on the balance sheet at its carrying amount.

8 FINANCIAL STATEMENT ANALYSIS Introduction

¶8-000

Horizontal analysis

¶8-100

Vertical analysis

¶8-200

Ratio analysis

¶8-300

Benchmarking and industry information

¶8-500

Limitations of financial statement analysis

¶8-600

Summary of financial ratios used in this chapter

¶8-650

Financial statement analysis — commonly asked questions ¶8-700

¶8-000 Introduction As we saw in Chapter 1 (commencing at ¶1-000), accounting is defined as the process of: • identifying • measuring • recording, and • communicating economic information to permit informed judgments and decisions by the users of information. Without accurate financial information, the owner of a business may find it difficult to make sound economic decisions about their business. Bookkeeping can be viewed as a subset of accounting and is primarily concerned with the first three phases (ie the process of identifying, measuring and recording business transactions) of accounting. The primary role of the bookkeeper is to ensure that transactions are accurately recorded in the accounting system. However, bookkeepers also have an important role to play in communicating financial information to the owners of a business. As the bookkeeper has prepared management accounts (consisting of the profit and loss statement and balance sheet), in many ways, they are more familiar with the financial information than the external accountant, who may only review the accounts every quarter when the Business Activity Statement (BAS) is required to be lodged, or even only as infrequently as once per year when the year-end financial statements and tax returns are required. For this reason, the bookkeeper may be able to assist the owner of a business in interpreting this financial information. In some instances, the bookkeeper may detect the trends in a business or calculate the financial statement ratios for the owner of the business. This chapter discusses some of the basic tools and techniques required to analyse the financial statements of an entity. One technique is called the “financial statement analysis” and is typically used by parties external to the organisation, such as shareholders, lenders and financial analysts. However, it can also be used by internal decision makers, such as the owner of a business, to highlight the trends and areas of the business which need attention and possible corrective action. All of the information contained in the financial statements is expressed in monetary terms. While it is useful to draw conclusions about the business by focusing on the dollar amounts contained in the financial statements, this analysis on its own may be misleading. For example, just because Company A makes a profit of $1m and Company B makes a profit of $10,000

does not necessarily mean that Company A is 100 times better than Company B. This amount needs to be compared to other information such as: • last year’s profit • sales • total assets • total shareholders’ equity • retained profits • number of shareholders • profits of other businesses in the same industry, and • comparison of actual results to budgeted data (if applicable). For this reason, dollar value comparisons are somewhat limited. To overcome this deficiency, these dollar amounts are converted into percentages and ratios to enable the user to identify trends and relationships in the financial data and to make decisions. This technique is referred to as the “financial statement analysis” and is a useful tool designed to overcome some of the deficiencies in drawing conclusions about an entity based solely on dollar values contained in financial statements. Financial statement analysis can be used to: • determine the trends within an entity over a number of years • make comparisons between entities, and • compare an entity with industry benchmarks. Various tools are used to evaluate financial statement data. However, the three most commonly used techniques are: • horizontal analysis (¶8-100) • vertical analysis (¶8-200), and • ratio analysis (¶8-300). Each of these techniques will be discussed in turn. Some bookkeepers present this information to their clients in the form of tables and charts. Given that management accounts of most computerised accounting software packages can be imported into a spreadsheet such as Microsoft Excel, it is relatively easy for bookkeepers to present this information in tables or charts for their clients each month or quarter.

Horizontal Analysis Introduction

¶8-100

Trend analysis

¶8-110

¶8-100 Introduction Horizontal analysis can be best described as an analysis which compares the performance of an entity across at least two reporting periods, which may be monthly, quarterly or even annually.

This technique is particularly useful in making intra-firm comparisons. The primary purpose of horizontal analysis is to determine the percentage increase or decrease in a particular account or total of accounts. There are three steps in horizontal analysis: • Step 1: Calculate the dollar amount of the change from the earlier period to the later period. • Step 2: Calculate the percentage change between the two periods by dividing the change in the two periods (derived from Step 1) by the earlier period amount. • Step 3: Multiply the result obtained in Step 2 by 100 to calculate the percentage increase or decrease for the period. For example, assume that for the year ended 30 June 2016, gross sales for Sunshine Florists Pty Ltd was $2.5m. In 2017, total sales increased to $3m. The increase in dollar value is $500,000. The percentage change between the two years is calculated as follows: $500,000  $2,500,000 

× 100% =

20% increase

If the change is positive, this means that sales have increased from the previous period. Conversely, if the change is negative, then sales have decreased from the previous period. Horizontal analysis enables the user to identify which accounts in the financial statements have increased or decreased, whether these changes are favourable or unfavourable, and whether any identified trends are expected to continue. To further illustrate horizontal analysis, we will use the financial statements of Chic Furniture Pty Ltd, which are presented as follows: Chic Furniture Pty Ltd Comparative Profit and Loss Statements for the years ended 30 June 2016 and 2017 Increase/(Decrease) 2017

2016

Amount $

Percentage %

Sales

9,000,000

8,125,000

875,000

10.8

Less: Cost of goods sold

6,300,000

5,687,000

613,000

10.8

Gross profit

2,700,000

2,438,000

262,000

10.7

Less: Expenses (excluding interest expense)

1,260,000

1,382,000

(122,000)

(8.8)

400,000

256,000

144,000

56.3

Total expenses

1,660,000

1,638,000

22,000

1.3

Net profit before income tax

1,040,000

800,000

240,000

30.0

Less: Income tax expense

140,000

150,000

(10,000)

(6.7)

Net profit after income tax

900,000

650,000

250,000

38.5

Less: Interest expense

Chic Furniture Pty Ltd Comparative Balance Sheets as at 30 June 2016 and 2017 Increase/(Decrease)

2017

2016

Amount

Percentage

Current Assets

$

$

$

%

Cash at bank

700,000

300,000

400,000

133.3

Inventory

2,400,000

750,000

1,650,000

220.0

Accounts receivable

1,900,000

1,695,000

205,000

12.1

Less: Provision for doubtful debts

(250,000)

(195,000)

(55,000)

28.2

Total Current Assets

4,750,000

2,550,000

2,200,000

86.3

Buildings

6,750,000

6,015,000

735,000

12.2

Plant and equipment

1,200,000

1,010,000

190,000

18.8

Total Non-Current Assets

7,950,000

7,025,000

925,000

13.2

12,700,000

9,575,000

3,125,000

32.6

1,700,000

1,600,000

100,000

6.3

200,000

250,000

(50,000)

(20.0)

1,900,000

1,850,000

50,000

2.72

Long-term borrowing

3,850,000

1,575,000

2,275,000

144.4

Total Non-Current Liabilities

3,850,000

1,575,000

2,275,000

144.4

Total Liabilities

5,750,000

3,425,000

2,325,000

67.9

Net Assets

6,950,000

6,150,000

800,000

13.0

Share capital

3,500,000

3,500,000

0

0

Retained profits

3,450,000

2,650,000

800,000

30.2

Total Shareholders’ Equity

6,950,000

6,150,000

800,000

13.0

Non-Current Assets

Total Assets Current Liabilities Accounts payable Accrued expenses Total Current Liabilities Non-Current Liabilities

Shareholders’ Equity

¶8-110 Trend analysis Trend analysis is a variation of horizontal analysis. Trend analysis is a technique commonly used when several periods of financial data are available. Trend analysis is particularly useful in determining the trends of a business. There are three steps in trend analysis: • Step 1: The earliest period in trend analysis is called the base period. This is set at 100%. • Step 2: Divide the current period’s amount by the base period’s amount. • Step 3: Multiply the result obtained in Step 2 by 100 to calculate the percentage change from the base period. To illustrate, consider the following information:

2014 Sales revenue

2015

2016

2017

$1,200,000 $1,560,000 $1,920,000 $2,400,000

Net profit after tax

$325,000

$455,000

$585,000

$780,000

A trend analysis reveals the following: 2014

2015

2016

2017

Sales revenue

100% 130% 160% 200%

Net profit after tax

100% 140% 180% 240%

In the example above, 2014 is regarded as the base period as this is the earliest financial year. Sales increased from $1,200,000 in 2014 to $1,560,000 in 2015. Dividing the sales figure of $1,560,000 in 2015 by the sales figure of $1,200,000 in 2014 (the base period) gives an amount of 1.30. Multiplying this figure by 100 gives us an answer of 130%. In 2017, sales of $2,400,000 are divided by the sales figure of $1,200,000 in 2014 (the base period) to give an amount of 2.00. Multiplying this figure by 100 gives us the answer of 200%. Similarly, the net profit after tax has increased from $325,000 in 2014 to $455,000 in 2015. Dividing $455,000 by $325,000 (the base period) gives us an amount of 1.40. Multiplying this figure by 100 gives us an answer of 140%. In 2017, the net profit of $780,000 is divided by the net profit after tax of $325,000 in 2014 (the base period) to give an amount of 2.40. Multiplying this figure by 100 gives us the answer of 240%. Based on this simple trend analysis, it can be seen that the net profit after tax is increasing faster than the sales revenue. This indicates that the entity has been successful in reducing its cost of goods sold or expenses. It is common to present this trend analysis in the form of a bar graph or line graph. This is illustrated as follows:

Vertical Analysis Introduction

¶8-200

Common size statements

¶8-250

¶8-200 Introduction

While horizontal analysis demonstrates the increase or decrease in a particular account over two or more years, vertical analysis involves analysing each item within the financial statements as a percentage of the base amount. Vertical analysis can be very useful in comparing entities which differ greatly in terms of the size of their operations. For example, in the case of the profit and loss statement, sales revenue is set at a base amount of 100%. Each expense is calculated and presented as a percentage of sales. This is illustrated in the following worked example. Chic Furniture Pty Ltd Comparative Profit and Loss Statements for the years ended 30 June 2016 and 2017 2017

2016

Amount Percentage $ Sales

Amount Percentage

%

$

%

9,000,000

100.0

8,125,000

100.0

(6,300,000)

70.0

(5,687,000)

70.0

2,700,000

30.0

2,438,000

30.0

(1,260,000)

14.0

(1,382,000)

17.0

Less: Interest expense

(400,000)

4.4

(256,000)

3.2

Total expenses

1,660,000

18.4

1,638,000

20.2

Net profit before income tax

1,040,000

11.6

800,000

9.8

Less: Income tax expense

(140,000)

1.6

(150,000)

1.8

900,000

10.0

650,000

8.0

Less: Cost of goods sold Gross profit Less: Expenses (excluding interest expense)

Net profit after income tax

In the case of the balance sheet, the base amount is typically the total assets. This amount is set at 100%. All items in the balance sheet are expressed as a percentage of total assets. This is illustrated in the following worked example. Chic Furniture Pty Ltd Comparative Balance Sheets as at 30 June 2016 and 2017 2017

Current Assets Cash at bank

2016

Amount

Percentage

Amount

Percentage

$

%

$

%

700,000

5.5

300,000

3.1

Inventory

2,400,000

18.9

750,000

7.8

Accounts receivable

1,900,000

15.0

1,695,000

17.7

Less: Provision for doubtful debts

(250,000)

(2.0)

(195,000)

(2.0)

Total Current Assets

4,750,000

37.4

2,550,000

26.6

Non-Current Assets

Buildings

6,750,000

53.1

6,015,000

62.8

Plant and equipment

1,200,000

9.4

1,010,000

10.5

Total Non-Current Assets

7,950,000

62.6

7,025,000

73.4

12,700,000

100.0

9,575,000

100.0

1,700,000

13.4

1,600,000

16.7

200,000

1.6

250,000

2.6

1,900,000

15.0

1,850,000

19.3

Long-term borrowings

3,850,000

30.3

1,575,000

16.4

Total Non-Current Liabilities

3,850,000

30.3

1,575,000

16.4

Total Liabilities

5,750,000

45.3

3,425,000

35.8

Net Assets

6,950,000

54.7

6,150,000

64.2

Share capital

3,500,000

27.5

3,500,000

36.6

Retained profits

3,450,000

27.2

2,650,000

27.6

Total Shareholders’ Equity

6,950,000

54.7

6,150,000

64.2

Total Assets Current Liabilities Accounts payable Accrued expenses Total Current Liabilities Non-Current Liabilities

Shareholders’ Equity

Some computerised accounting packages can produce horizontal and vertical analysis reports. However, if this is not the case, management accounts from most computerised accounting packages can easily be exported into Microsoft Excel. This makes it relatively easy for the bookkeeper to perform a horizontal and vertical analysis by creating the formulas in Microsoft Excel that will enable these calculations to be performed automatically. Furthermore, it should be noted that while we have performed horizontal and vertical analysis in respect of the annual figures in the previous two worked examples, the same principles can be applied to the monthly management accounts. In other words, the bookkeeper can present the trends by analysing two sets of monthly data derived from management accounts.

¶8-250 Common size statements The percentages in the percentage columns of the profit and loss statement and balance sheet shown in ¶8-200 can simply be presented as a separate statement with no dollar amounts shown. This type of statement is referred to as a “common size statement” and is especially useful when comparing reports from different businesses. This is a form of vertical analysis. Once again, some computerised accounting packages can produce common size statements as part of their reporting functions.

Ratio Analysis Introduction

¶8-300

Profitability ratios

¶8-310

Liquidity ratios

¶8-350

Financial stability ratios

¶8-400

¶8-300 Introduction Financial ratios are commonly used to analyse an entity’s business performance. Ratios are typically calculated by dividing the dollar amount of one item reported by the dollar amount of another item to express the relationship between them. Ratio analysis involves the use of financial statements (particularly the profit and loss statement and balance sheet) to draw conclusions about the financial performance and the financial position of an entity over a period of time. The three general categories of ratio analysis which are commonly used to evaluate an entity are: • profitability ratios (¶8-310) • liquidity ratios (¶8-350), and • financial stability ratios (¶8-400). A financial statement ratio is calculated by dividing the dollar amount of one item in the financial statements by the dollar amount of another item. The purpose is to express a relationship between the two items, and ratios are used to interpret an entity’s viability and performance. Each of these ratios will be discussed in turn and applied to Chic Furniture Pty Ltd. For the purposes of convenience, we will drop the “000”s in all of the following calculations. In other words, while the sales figure for 2017 was $9,000,000, we will simply refer to it as $9,000.

Profitability ratios Overview

¶8-310

Gross profit margin

¶8-315

Mark-up percentage

¶8-320

Net profit margin

¶8-325

Return on total assets

¶8-330

Return on shareholders’ equity ¶8-335

¶8-310 Overview Profitability ratios are designed to assess the financial performance (or profitability) of an entity for a given period of time. Profitability ratios are typically compared over time, with other entities or with industry averages (where available). The goal of every for-profit entity is to generate a profit. Profitability is important to creditors, lenders and, most importantly, business owners or shareholders. This is primarily the case as dividends are paid from the company’s profit. If a company derives a profit for any given reporting period, then it has the ability to pay dividends to its shareholders. In the case of a listed public company, the firm’s profit also impacts on the company’s share price. The following are the most commonly used profitability ratios: • gross profit margin (¶8-315) • mark-up percentage (¶8-320) • net profit margin (¶8-325) • return on total assets (¶8-330)

• return on shareholders’ equity (¶8-335). Other profitability ratios include: • earnings per share (EPS) • price-earnings ratio (P/E ratio), and • dividend yield. However, these ratios apply predominantly to publicly listed companies. For this reason, these profitability ratios will not be covered in any further detail in this chapter.

¶8-315 Gross profit margin It will be remembered that gross profit is calculated as the difference between sales and the cost of goods sold. In other words:

Gross profit

=

[Revenue − COGS]

Gross profit margin measures the portion of each dollar from the revenue that represents the gross profit. The ratio is calculated as follows:

Gross profit × 100%

Gross profit margin =

Sales

The ratio is expressed as a percentage — the higher the ratio the higher the gross profit percentage. This ratio is dependent on the type of business. High volume entities such as supermarkets and retail stores generally have low gross profit margins. Conversely, low-volume entities, such as car yards or high fashion retail stores, generally have high profit margins. The gross profit margin of Chic Furniture Pty Ltd is shown as follows: Chic Furniture Pty Ltd Gross profit margin 2017

$2,700 × 100%  $9,000 

2016

=

30.00%

$2,438 × 100%  $8,125 

=

30.01%

As can be seen, Chic Furniture Pty Ltd has virtually maintained the same gross profit margin in 2017 that it had in 2016. These percentages should also be compared with previous years as well as similar businesses in the same industry (if possible). The gross profit margin of Chic Furniture Pty Ltd can be shown graphically as follows:

¶8-320 Mark-up percentage It is important to note that gross profit margin is not the same as mark-up. Mark-up is the amount that an entity adds to the purchase price of goods to determine the sales price. The formula to calculate the mark-up percentage is:

Mark-up percentage

Gross profit × 100% Cost of goods sold

=

The mark-up percentage of Chic Furniture Pty Ltd is shown as follows: Chic Furniture Pty Ltd Mark-up percentage 2017

$2,700 × 100%  $6,300 

2016

=

42.86%

$2,438 × 100%  $5,687 

=

42.87%

It can be seen that the mark-up percentage does not equate to the gross profit margin. In the case of Chic Furniture Pty Ltd, the gross profit margin for 2017 was calculated as 30.00%. However, the mark-up percentage in 2017 was calculated as 42.86% meaning that the entity is marking up its goods by 42.86% from the cost price to the selling price.

¶8-325 Net profit margin It will be remembered that net profit before income tax is calculated as the difference between the gross profit and expenses. In other words:

Net profit

=

[Gross profit − Expenses]

Net profit after income tax is simply the net profit before tax minus income tax expense. The net profit margin measures the percentage of each dollar of sales that results in profit. The ratio is calculated as follows:

Net profit after tax × 100%

Net profit margin =

Sales

The ratio is expressed as a percentage — once again, the higher the ratio the more profitable the entity. This ratio is dependant on the industry. The net profit margin of Chic Furniture Pty Ltd is shown as follows: Chic Furniture Pty Ltd Net profit margin 2017

$900 × 100%  $9,000 

2016

=

10.00%

$650 × 100%  $8,125 

=

8.00%

The above analysis reveals that Chic Furniture Pty Ltd has increased its net profit margin from 8% in 2016 to 10% in 2017. These percentages would be compared with previous years as well as similar businesses in the same industry. The net profit margin of Chic Furniture Pty Ltd can be shown graphically as follows:

¶8-330 Return on total assets The return on total assets (or ROA) measures the rate of return earned by management on the entity’s

assets. This ratio shows the success a company has in utilising its assets to derive profit. The ratio is calculated as follows:

ROA  =

(Net profit before tax + Interest expense) × 100% Average total assets

The numerator is sometimes referred to as EBIT (earnings before interest and tax). While bookkeepers refer to the term as “net profit”, many financial commentators, including sections of the financial press, financial analysts and even directors of companies prefer to use the term “earnings” instead of the term “net profit”. In either case, the term EBIT is effectively the net profit (or earnings) before income tax and interest. The reason that interest expense is added back in the formula is that the effects of financing are taken out of the equation. In other words, if Entity A funded its assets by debt, whereas Entity B funded its assets with equity, the return on assets for Entity A would be lower and a comparison between the two entities would be meaningless. Hence, interest expense is added back in the numerator. The denominator refers to “average total assets”. The reason that average total assets is used is because profits were derived from utilising the assets throughout the financial year, not simply by utilising the assets at the beginning or end of the financial year. The denominator is calculated by adding the value of total assets at both the beginning and the end of the financial year and dividing the sum by two. Given what we have learnt about carrying forward balances in Chapter 2 (commencing at ¶2-000), we can use the balance from the prior year-end as the beginning balance for the current year’s asset balance. The ratio is expressed as a percentage — the higher the ratio the higher the return on assets. However, this ratio can differ between entities in different industries. Some businesses require significant assets, such as manufacturers, construction and mining companies. Conversely, other entities, such as professional service firms, including accounting and legal firms, require relatively fewer assets to generate profits. As such, the ROA can vary significantly between industries and businesses. Assume that the total assets of Chic Furniture Pty Ltd as at 30 June 2015 were $8,678,000. The ROA of Chic Furniture Pty Ltd is shown as follows: Chic Furniture Pty Ltd Return on total assets 2017

2016

($1,040 + $400) × 100%

($800 + $256) × 100%

($12,700 + $9,575)/2

($9,575 + $8,678)/2

= 12.93%

= 11.57%

As can be seen, the ROA for Chic Furniture Pty Ltd has increased from 11.57% in 2016 to 12.93% in 2017. This indicates that the company has been utilising its assets more profitably in 2017 compared with 2016. The ROA of Chic Furniture Pty Ltd can be shown graphically as follows:

¶8-335 Return on shareholders’ equity The return on shareholders’ equity (or ROE) measures the return on funds invested by ordinary shareholders. The ratio is calculated as follows:

ROE

Net profit after tax × 100%

=

Average total shareholders’ equity

The denominator refers to the “average total shareholders’ equity”. Once again, the reason that average total shareholders’ equity is used is because profits have been derived from the funds contributed by shareholders (or owners of the business) throughout the financial year, not necessarily at the beginning or end of the financial year. The denominator is calculated by adding the value of total shareholders’ equity at both the beginning and the end of the financial year and dividing the sum by two. Once again, we should use the balance as at the end of the prior financial year for the beginning balance value. The ratio is expressed as a percentage — the higher the ratio the higher the return on shareholders’ funds. A comparison is usually made from previous years and to other companies in the same industry. Assume that the total shareholders’ equity of Chic Furniture Pty Ltd as at 30 June 2015 was $5,990,000. The ROE of Chic Furniture Pty Ltd is shown as follows: Chic Furniture Pty Ltd Return on total shareholders’ equity 2017

2016

$900 × 100%

$650 × 100%

($6,950 + $6,150)/2

($6,150 + $5,990)/2

= 13.74%

= 10.71%

As can be seen, the ROE for Chic Furniture Pty Ltd has increased from 10.71% in 2016 to 13.74% in

2017. This indicates that the company has increased its return on shareholders’ funds during the 2017 year. The ROE of Chic Furniture Pty Ltd can be shown graphically as follows:

Liquidity ratios Overview

¶8-350

Current ratio

¶8-355

Quick ratio

¶8-360

Receivables collection period

¶8-365

Inventory turnover period

¶8-370

¶8-350 Overview Liquidity ratios are designed to assess the ability of an entity to meet its short-term obligations with its current assets. The emphasis of these ratios is on working capital.

Working capital

=

[Current assets − Current liabilities]

In other words, working capital is the excess of current assets over current liabilities. An entity would prefer to have an excess of working capital — this occurs when the entity’s current assets exceed its current liabilities. Conversely, if current liabilities exceed current assets, the entity has what is referred to as “deficiency of working capital”, which could indicate an inability to pay its debts as and when they fall due. This is one of the key financial indicators that the entity is potentially facing insolvency. The following are the most commonly used liquidity ratios: • current ratio (¶8-355)

• quick ratio (¶8-360) • receivables collection period (¶8-365) • inventory turnover period (¶8-370).

¶8-355 Current ratio The current ratio measures an entity’s ability to be able to pay its short-term debts as and when they fall due. In other words, it is a measure of whether the entity has enough cash and other current assets to pay all creditors and current liabilities now or in the very near future. The ratio is calculated as follows:

Current assets

Current ratio =

Current liabilities

The ratio is expressed as X:Y, where X represents current assets and Y represents current liabilities. Generally, the higher the ratio, the better. A lower ratio indicates a possible inability to meet current and short-term debts in an emergency. On the other hand, while a high ratio is considered favourable to creditors (suppliers), it may mean that the entity has too much cash invested in non-interest bearing accounts or is not utilising its cash reserves effectively. This money should be invested into assets which will generate profits for the owners. Too much idle cash sitting in the bank accounts will not generate much of a return for the owners of the business. Analysts use 1.5:1 to 2.0:1 as a benchmark for this ratio. In other words, an entity should maintain $1.50 of current assets for every $1.00 of current liabilities. The current ratio of Chic Furniture Pty Ltd is shown as follows: Chic Furniture Pty Ltd Current ratio 2017

2016

$4,750

$2,550

$1,900

$1,850

= 2.50:1

= 1.38:1

Chic Furniture Pty Ltd’s current ratio has increased from 1.38:1 to 2.50:1. This indicates that the company’s liquidity has significantly improved during 2017. The current ratio of Chic Furniture Pty Ltd can be shown graphically as follows:

¶8-360 Quick ratio The quick (or acid-test) ratio measures an entity’s ability to pay all of its current liabilities if they became due and payable immediately. The ratio is calculated as follows:

Quick ratio

=

Cash + Net receivables Current liabilities

Net receivables in the numerator is derived from subtracting provision for doubtful debts from gross accounts receivable. In the case of Chic Furniture Pty Ltd, in 2017, net receivables came to $1,650,000 (ie $1,900,000−$250,000) and in 2016, the net receivables balance was $1,500,000 (ie $1,695,000− $195,000). The ratio is expressed as X:Y. Once again, the higher the ratio, the more liquid the entity. A lower ratio may indicate that, in an emergency, the entity would be unable to meet its immediate obligations. An acidtest ratio of 1:1 is considered satisfactory. Analysts use 0.75:1 to 1:1 as a benchmark for this ratio. The quick ratio of Chic Furniture Pty Ltd is shown as follows: Chic Furniture Pty Ltd Quick ratio 2017

2016

$700 + $1,650

$300 + $1,500

$1,900

$1,850

= 1.24:1

= 0.97:1

Chic Furniture Pty Ltd’s quick ratio has increased from 0.97:1 to 1.24:1. This indicates that Chic Furniture Pty Ltd has enough cash and highly liquid assets on hand to satisfy its short-term obligations. The quick ratio of Chic Furniture Pty Ltd can be shown graphically as follows:

¶8-365 Receivables collection period The receivables (or debtors) collection period measures the number of days it is taking an entity to collect its accounts receivable (from the date of the tax invoice). The ratio is calculated as follows:

Receivables collection period =

Average net receivables balance × 365         Sales        

The numerator refers to the “average net receivables balance”. The reason for using average net receivables is that sales have been generated from debtors throughout the financial year. The numerator is calculated by adding net receivables (ie accounts receivable less the provision for doubtful debts) at both the beginning and the end of the financial year and dividing the sum by two. Once again, we should use the balance as at the end of the prior financial year for the beginning balance value. In the case of Chic Furniture Pty Ltd, for the 2017 financial year, the average net receivables balance is calculated as the opening net receivables of $1,500,000 as at 30 June 2016 plus the closing net receivables balance as at 30 June 2017 of $1,650,000 and dividing the total (being $3,150,000) by two. For the 2016 financial year, it is assumed that the closing net receivables balance as at 30 June 2015 was $1,520,000. Hence, the average net receivables balance is calculated as the closing balance in 2015 of $1,520,000 plus the closing net receivables balance as at 30 June 2016 of $1,500,000 and dividing the total (being $3,020,000) by two. This ratio is expressed in terms of the number of days it takes to collect debts. The ratio is compared to the firm’s credit terms. For example, if an entity provides credit terms of 14 days and the receivables collection period comes to 27 days, then this indicates that it is taking the entity almost twice as long to collect its accounts receivable than the terms provided. The lower the number of days, the shorter the period of time it is taking the entity to collect its outstanding debts. Conversely, the higher the number of days, the longer it is taking for debtors to pay their outstanding debts, resulting in a greater probability that bad debts will arise. The receivables collection period of Chic Furniture Pty Ltd is shown as follows: Chic Furniture Pty Ltd Receivables collection period 2017

2016

($1,650 + $1,500)/2 × 365

($1,500 + $1,520)/2 × 365

$9,000

$8,125

= 63.9 days

= 67.8 days

In 2017, on average, it is taking Chic Furniture Pty Ltd 63.9 days to collect its accounts receivable compared to 67.8 days in 2016. While this represents a slight improvement, this should be compared to the entity’s credit and collection policies. If the credit policy allows customers 90 days to pay its debts, then this is acceptable. However, if the terms of payment are 60 days, then this is still relatively poor. The receivables collection period of Chic Furniture Pty Ltd can be shown graphically as follows:

¶8-370 Inventory turnover period The inventory turnover period measures the average number of days from the date of purchase of inventory to the date of sale. The ratio is calculated as follows:

Inventory turnover period =

Average inventory balance × 365 Cost of goods sold

The numerator refers to the “average inventory balance”. The numerator is calculated by adding the inventory balance at the end of both financial years and dividing the sum by two. In the case of Chic Furniture Pty Ltd, for the 2017 financial year, the average inventory balance is calculated as the closing inventory balance in 2016 of $750,000 plus the closing inventory balance in 2017 of $2,400,000 and dividing the total (being $3,150,000) by two. For the 2016 financial year, it is assumed that the closing inventory balance as at 30 June 2015 was $1,280,000. Hence, the average inventory balance is calculated as the closing balance in 2015 of $1,280,000 plus the closing inventory balance as at 30 June 2016 of $750,000 and dividing the total (being $2,030,000) by two. This ratio is expressed in terms of the number of days it takes to sell the inventory. The lower the number of days, the shorter the period of time it is taking the entity to sell its inventory. Conversely, the higher the number of days, the greater the probability of slow-moving or obsolete stock. This ratio is particularly important for businesses with high levels of inventory (eg retail businesses).

The inventory turnover period is particularly industry-specific. For example, the inventory turnover period for a fruit and vegetable shop will be dramatically different from that of a luxury car dealer selling motor vehicles. Hence, the comparison is usually made from year to year or between like-entities. The inventory turnover period of Chic Furniture Pty Ltd is shown as follows: Chic Furniture Pty Ltd Inventory turnover period 2017

2016

($2,400 + $750)/2 × 365

($750 + $1,280)/2 × 365

$6,300

$5,687

= 91.25 days

= 65.14 days

In 2017, on average, it is taking Chic Furniture Pty Ltd 91.25 days to sell its inventory, whereas in 2016, the period was only 65.14 days. This represents an increase of approximately 26 days. This raises potentially serious concerns and may be the cause for management investigation and corrective action. The average inventory turnover period of Chic Furniture Pty Ltd can be shown graphically as follows:

Financial stability ratios Overview

¶8-400

Debt ratio

¶8-405

Debt/equity ratio

¶8-410

Times interest earned ratio

¶8-415

¶8-400 Overview Financial stability ratios measure the ability of an entity to meet its long-term commitments. External parties such as shareholders, lenders and creditors are interested in these indicators as they assist in determining the risk and long-term stability of a business. Financial risk is the risk that a business will not be able to repay its borrowed funds.

An entity will usually use a combination of both debt and equity funding to finance the acquisition of its assets. Some entities rely heavily on debt funding. This means that the entity is “highly geared”. Conversely, other entities have minimal reliance on debt funding. This means that they are predominantly financed via equity. There is no one “right” mix of debt and equity. The level of gearing depends on the nature of the organisation and asset type. The following are the most common financial stability ratios used: • debt ratio (¶8-405) • debt/equity ratio (¶8-410) • times interest earned ratio (¶8-415). Each of these three ratios will be discussed in turn in the following paragraphs.

¶8-405 Debt ratio The debt ratio measures the proportion of an entity’s assets financed by debt. Specifically, it measures the relationship between total liabilities and total assets. The ratio is calculated as follows:

Debt ratio

=

Total liabilities × 100% Total assets

This ratio is a measure of safety to creditors — the lower the ratio the greater the asset protection to creditors. Conversely, the higher the ratio, the more likely that the entity is in financial difficulty. Lenders such as financial institutions become concerned when the debt ratio approaches or exceeds 70%. However, this ratio is heavily dependent on the entity’s profits. If a company has strong profits, then its lenders are more willing to accept a higher debt ratio than an entity with a poor track record of profitability. This ratio, in particular, is also industry-specific and varies according to the industry concerned. The debt ratio of Chic Furniture Pty Ltd is shown as follows: Chic Furniture Pty Ltd Debt ratio 2017

2016

$5,750 × 100%

$3,425 × 100%

$12,700

$9,575

= 45.28%

= 35.77%

It can be seen that Chic Furniture Pty Ltd has borrowed more money in 2017, and as a result, its debt ratio has increased from 35.77% to 45.28%. A quick review of the balance sheet confirms that the company increased its long-term borrowings from $1,575,000 in 2016 to $3,850,000 in 2017. While there has been an increase in this ratio, it is still relatively safe. The debt ratios of Chic Furniture Pty Ltd over a two-year period can be shown graphically as follows:

¶8-410 Debt/equity ratio The debt/equity ratio measures the proportion of an entity’s liabilities to the total equity. The higher the ratio the higher the proportion of assets financed by debt and lower the proportion financed by members. The debt/equity ratio is calculated as follows:

Debt/equity ratio =

Total liabilities × 100% Total shareholders’ equity

A ratio of less than 100% indicates that the entity is financed predominantly by equity. Conversely, a ratio of more than 100% indicates that the entity is financed predominantly through debt. This can be illustrated in the following diagram:

The debt/equity ratio of Chic Furniture Pty Ltd is shown as follows: Chic Furniture Pty Ltd Debt/equity ratio 2017

2016

$5,750 × 100%

$3,425 × 100%

$6,950

$6,150

= 82.73%

= 55.69%

As indicated by the increase in the debt ratio, the company borrowed more money during the 2017 financial year. This has also meant that the debt/equity ratio has increased from 55.69% in 2016 to 82.73% in 2017. Despite the increase in the debt/equity ratio, the ratio is still below 100%, meaning that the company is still predominantly funded by equity compared to debt. The debt/equity ratio of Chic Furniture Pty Ltd can be shown graphically as follows:

¶8-415 Times interest earned ratio The times interest earned ratio is an indication of an entity’s ability to meet its interest payments from its current year’s profit. The ratio is calculated as follows:

Times interest earned

=

Net profit before tax + Interest expense Interest expense

Interest expense and income tax is added back to the net profit in the numerator because the ratio is a measure of profit available to pay the interest. Once again, the numerator is also known as EBIT (earnings before interest and tax). The higher the ratio, the safer the entity. Analysts use a rule of thumb of three to four times as a benchmark for this ratio. The times interest earned ratio of Chic Furniture Pty Ltd is shown as follows: Chic Furniture Pty Ltd Times interest earned ratio 2017

2016

$1,040 + $400

$800 + $256

$400

$256

= 3.60 times

= 4.13 times

The times interest earned ratio has dropped slightly from 4.13 times in 2016 to 3.60 times in 2017. The main reason for this drop was due to the increase in the interest paid between the two financial years. In 2016, the company paid $256,000 in interest, while in 2017, it paid $400,000. This was largely due to the overall increase in long-term borrowings. Despite the slight drop in the times interest earned ratio, the company is still within the acceptable range and, therefore, it can be concluded that Chic Furniture Pty Ltd is well placed to cover its interest payments in respect of borrowed funds. The times interest earned ratio of Chic Furniture Pty Ltd can be shown graphically as follows:

¶8-500 Benchmarking and industry information All of these financial ratios are calculated for a particular entity and are usually compared over time. However, a limitation of the analysis is that it is confined to the particular entity. It is also useful to be able to compare these ratios to other businesses in the same industry as many of the financial ratios are industry-specific. For example, if a fast food restaurant has a gross profit margin of 32% and a net profit margin of 11%, is

this good, bad or simply okay? One way is to compare these ratios to other fast food restaurants. This process is referred to as “benchmarking” and allows an entity to compare their financial performance to other like-businesses and draw attention to those financial aspects of the business that may be underperforming and may need investigation and corrective action. For example, if a butcher calculates its gross profit margin at 32% and discovers that the industry average for all butcher businesses is 40%, then the owner of the business is aware that something is wrong. Perhaps, they are either selling their meat at lower prices than their competitors or are buying their stock (ie meat) at a higher price from their suppliers than their competitors. Either or both reasons could possibly explain why their gross profit margin is significantly lower than the industry average. There is a range of benchmarking tools and reports which can be purchased online. These reports are usually per industry (eg hospitality, mining, retail, manufacturing, etc) and have been compiled using publicly available information from the companies operating in each industry. Not only do these reports provide aggregated financial information per industry, but they also provide a range of “high”, “average” and “low” financial ratios for entities within each industry. A range of organisations provide benchmarking reports, such as: • IbisWorld (www.ibisworld.com.au) • Focus Based Management — PracDev Key Indicator Reports (www.fbm.com.au/products_pracdev.php) • Maus (www.maus.com.au/business_benchmarking.html). Most of these benchmarking reports are available for sale. However, in some cases, sample reports consisting of the first few pages are freely available for each industry so that the person contemplating purchasing the full report can get a glimpse of what information is available before deciding whether to purchase the full report or not. The Australian Taxation Office (ATO) has also developed, and published, its own small business benchmarks to compare the financial performance of businesses with a turnover of up to $15m against similar businesses in the same industry. This information has been collected from information supplied by more than 1.3 million small businesses in their income tax returns and BAS. The ATO has devoted $9.965m over four years to develop these small business benchmarks and has indicated its plans to conduct compliance activities based on these benchmarks. These benchmarks consist of key financial ratios that assist small businesses in more than 100 industries with different turnover ranges in comparing their performance against similar businesses in the same industry and assess their business performance. These 100 industries are grouped according to the following categories: • accommodation and food • building and construction trade services • education, training, recreation and support services • health care and personal services • manufacturing • other services • professional, scientific and technical services • retail trade, and • transport, postal and warehousing. These benchmarks are published as a range representing the ratios reported by businesses grouped on

either side of the average. The ATO has stated that publishing the benchmarks as a range allows for variations across financial years, geographical regions and business models. For example, based on the 2013/14 income year (being the latest set of benchmarks available), for coffee shops with an annual turnover of between $250,000 and $600,000, the ATO benchmarks identify that the average cost of goods sold figure is 37% of gross sales (ie equates to a 63% gross profit margin) and average total expenses (including COGS) represent 88% of gross sales. This translates to an average net profit margin before income tax of 12%. Labour costs, on average, represent between 19% to 28% of the annual turnover and rent ranges between 10% and 17% for coffee shops within this annual turnover range. In the case of toy stores with an annual turnover of between $150,000 and $550,000, the average cost of goods sold figure is 59% of gross sales (ie equates to a 41% gross profit margin) and average total expenses (including COGS) represent 87% of gross sales. This translates to an average net profit margin before income tax of 13%. Labour costs, on average, represent between 10% to 14% of the annual turnover and rent ranges between 8% and 13% for toy stores within this annual turnover range. The ATO has publicly stated on their website that: “We use benchmarks and other risk indicators to identify businesses that may be avoiding their tax obligations by not reporting some or all of their income. Information reported in your income tax returns or activity statements is compared with the key benchmark for your industry. We do this by identifying the appropriate benchmark for your business based on your business industry code (derived from the Australian and New Zealand Standard Industrial Classification). Your calculated benchmark might be above or below the range for your business turnover in your industry. If you have included all your income there may be reasons for this difference, such as higher costs or lower selling prices than others in the industry. When we see a business outside of the key ratio for their industry it indicates something is unusual and it may prompt us to get further information from the business or its suppliers or customers.” The ATO’s small business benchmarks for these 100 industries, including an overview of how these benchmarks are calculated can be freely accessed from the ATO’s website at www.ato.gov.au/business/small-business-benchmarks. In a report to the Assistant Treasurer from the Inspector-General of Taxation in July 2012 entitled “Review into the ATO’s Use of Benchmarking to Target the Cash Economy”, the ATO stated in its 2011/12 compliance program that it had identified 46,000 businesses that may have been under-reporting their cash income based on these small business benchmarks. The report went onto state that the small business benchmarking strategy was predicted to raise $18.5m in revenue over four years (from 2009/10 to 2012/13).

¶8-600 Limitations of financial statement analysis While financial statement analysis is very useful, it should be pointed out that there are some inherent limitations. These include: • Financial ratios are calculated using accounting data which is based on historical cost accounting — generally, market/current values are not used. • Financial ratios are calculated using past years’ data and may not take into account changes in demand, economic and industry environments, etc. • Financial ratios are based on data contained in the financial statements prepared at year-end. Yearend data may not necessarily be indicative of the entity’s position during the year. • Financial statements contain several estimates (eg useful lives of non-current assets, provision for doubtful debts, etc). If these estimates are inaccurate, financial ratios will be distorted. • Several of the financial ratios discussed in this chapter can be calculated in numerous ways and

involve interpretations by the analyst. • Despite the benefits of financial statement analysis, organisations may not be directly comparable due to different activities, size and disclosure practices. • Entities may not be comparable due to the use of different accounting policies (eg different depreciation methods, different inventory valuation methods, etc). • Financial ratios are based only on financial information. Non-financial information is not considered in the ratio analysis. • Past performance is not necessarily indicative of the future performance of an entity. A summary of Chic Furniture Pty Ltd’s financial ratios for the years ended 30 June 2016 and 2017 is provided as follows: Financial ratio

2017

2016

Gross profit margin

30.00%

30.01%

Mark-up percentage

42.86%

42.87%

Net profit margin

10.00%

8.00%

Return on total assets

12.93%

11.57%

Return on shareholders’ equity

13.74%

10.71%

Current ratio

2.50: 1

1.38: 1

Quick (or acid-test) ratio

1.24: 1

0.97: 1

Receivables collection period

63.9 days

67.8 days

Inventory turnover period

91.25 days

65.14 days

Debt ratio

45.28%

35.77%

Debt/equity ratio

82.73%

55.69%

3.60 times

4.12 times

Profitability ratios

Liquidity ratios

Financial stability ratios

Times interest earned ratio

¶8-650 Summary of financial ratios used in this chapter Financial ratio

Formula

Measures

Profitability ratios Gross profit margin

Mark-up percentage

Gross profit × 100%  Sales 

Gross profit × 100%  Cost of goods sold 

Measures the gross profit generated by each dollar of sales revenue Measures the mark-up percentage an entity applies to the purchase price of goods to

determine the sales price Net profit after  tax × 100%   Sales 

Net profit margin

Return on total assets

Return on shareholders’ equity

Measures the net profit generated by each dollar of sales revenue

(Net profit before tax + Interest expense) × 100%  Average total assets 

Measures the rate of return earned by utilising the entity’s assets

Net profit after  tax × 100%   Average total shareholders’ equity 

Measures the net profit generated from shareholders’ funds

Liquidity ratios  Current assets   Current liabilities 

Measures an entity’s ability to pay its short-term debts from its current assets

Quick (or acid-test) ratio

Cash + Net receivables  Current liabilities 

Measures an entity’s ability to immediately pay its short-term debts from its liquid current assets

Receivables collection period

Average net receivables   balance × 365    Sales 

Measures the average number of days it takes an entity to collect its receivables

Average inventory  balance × 365   Cost of goods sold 

Measures the average number of days it takes an entity to sell its inventory

Current ratio

Inventory turnover period

Financial stability ratios Total liabilities × 100%  Total assets 

Debt ratio

Debt/equity ratio

Times interest earned ratio

Measures the percentage of an entity’s assets funded by debt

Total liabilities × 100%  Total shareholders’ equity 

Measures the relationship between an entity’s debt financing and equity financing

Net profit before tax +  Interest expense   Interest expense 

Measures the ability of an entity to meet interest payments out of current year’s profit

¶8-700 Financial statement analysis — commonly asked questions Question What are the various types of financial statement analysis that I can undertake?

Answer To overcome the deficiency in drawing conclusions about an entity based solely on dollar values contained in financial statements, a range of financial statement analysis techniques can be used. The objective of financial statement analysis is to convert the dollar amounts in the financial statements into percentages and ratios to enable

the user to identify the trends and relationships in the financial data and to make decisions.

Various tools and techniques are used to evaluate financial statement data. However, the three most commonly used financial statement analysis techniques are: • horizontal analysis • vertical analysis, and • ratio analysis. While I have seen these techniques used to evaluate external financial statements of listed entities, do they have any application to my client’s management accounts?

Yes. While financial statement analysis techniques are typically used by financial analysts in evaluating financial performance of listed entities, the same principles equally apply to the financial information contained in management accounts.

Instead of comparing the annual amounts, the bookkeeper can use the same techniques to analyse the financial data derived from management accounts.

This way, the bookkeeper can make comparisons and analyse the trends on behalf of the client on a monthly or quarterly basis. I prepare monthly management accounts for my client using a computerised accounting software package. However, this software package does not calculate the financial ratios for me. How can I calculate these ratios electronically?

Most computerised accounting software packages that are designed for small and medium-sized businesses do not automatically calculate the financial ratios.

However, management accounts derived from most computerised accounting packages can easily be exported directly into Microsoft Excel.

Once the data has been imported into Excel, the bookkeeper can calculate the financial ratios using the formulas contained in ¶8-650.

Once these financial ratios have been calculated, it is relatively easy to create tables, graphs and charts using Excel’s chart wizard.

Some clients may prefer to receive monthly or quarterly reports containing colour charts and graphs summarising the financial performance of their entity rather than receiving detailed reports in the form of a profit and loss statement and balance sheet.

GLOSSARY OF TERMS ABN withholding tax

The amount withheld from a supplier who provides either an invoice or tax invoice where the eleven-digit Australian Business Number (ABN) has not been quoted. Where a supplier does not quote their ABN, the payer is required to deduct and remit 49% of the gross amount of the invoice to the ATO on the next Business Activity Statement (BAS).

Accounting

The process of identifying, measuring, recording, and communicating economic information to permit informed judgments and decisions by users of the information.

Accounting cycle

The process or sequence of accounting procedures that takes place during the accounting period from the occurrence and recording of the business transaction to the preparation of the financial statements.

Accounting entity assumption

The assumption that a business is a separate entity from its owner.

Accounting equation

An algebraic expression of the equality of assets to liabilities and owners equity. The accounting equation is expressed as: Assets = [ Liabilities + Equity ].

Accounting period

A period of time covered by a set of financial statements.

Accounting principles

Rules which guide in the measurement, classification and interpretation of financial information.

Accounts

Records of financial transactions relating to or associated with a business.

Accounts list

Also referred to as the chart of accounts. This is a list of general ledger accounts.

Accounts payable

Also known as trade creditors. This account represents amounts owed by the business to suppliers for goods and services purchased on credit. Usually shown as a current liability in the balance sheet.

Accounts receivable

Also known as trade debtors. This represents amounts owed to the business by customers for goods or services sold on credit. Usually shown as a current asset in the balance sheet.

Accrual basis of accounting

The method of accounting which states that transactions should be recorded in the period they occur, rather than in the period in which the cash is received or paid.

Accumulated depreciation

The amount of depreciation that has been recorded and accumulated on a non-current asset since it was acquired. It is usually recorded in a contra account.

Activity statement

An activity statement is used to report the business tax entitlements and obligations to the ATO. The activity statement allows businesses to report the following: GST, luxury car tax, wine equalisation tax, pay as you go (PAYG) withholding and instalments, FBT instalments and deferred company

instalments. The ATO sends out personalised, pre-printed activity statements either via the internet or to the nominated postal address on the Australian Business Register. Adjusted trial balance

A trial balance prepared after adjusting entries have been processed.

Adjusting entries

Entries made on the last day of the accounting period to ensure that all revenues and expenses are recorded in the correct accounting period.

Adjustment

In the case of GST, where the amount of GST reported in a previous BAS needs to be adjusted. Adjustments are classified as either an “increasing adjustment event” or a “decreasing adjustment event”. An increasing adjustment event has the effect of increasing the net amount of GST reported in the BAS, while a decreasing adjustment event has the effect of reducing the net amount of GST reported in the BAS.

Aged creditors analysis

The process of classifying accounts payable on the basis of length of time for which they have remained unpaid.

Aged debtors analysis

The process of classifying accounts receivable on the basis of length of time for which they have been outstanding.

Allowance

An allowance is an up-front payment made by an employer to an employee at a predetermined amount to cover an estimated expense (eg a travel allowance or uniform allowance). It is paid regardless of whether or not the employee incurs the expected expense. The recipient usually has the discretion whether or not to expend the allowance. Allowances are usually considered “wages” and are subject to PAYG withholding.

Amortisation

Similar concept to depreciation. Amortisation refers to the systematic allocation of the cost of an intangible asset over its estimated useful life.

Annual leave

Annual leave includes any leave described as annual leave or recreational leave and annual holidays, being leave to which a taxpayer is entitled by law, award or contract. Most employment agreements and industrial awards entitle employees to four or five weeks of annual leave per year. Annual leave accrues to an employee on a day-to-day basis throughout the year. Annual leave is recorded as an expense and a current liability in the accounts.

Annual report

An annual document summarising information about the operations and financial position of an organisation for the financial year and includes the directors’ report, the financial statements, the directors’ declaration and the auditor’s report.

Assets

Future economic benefits (or resources) controlled by the entity as a result of past transactions. Assets are essentially anything owned by the entity that is valuable and contributes to revenue generation.

Attribution

Attribution rules determine the attribution of GST payable and GST receivable to tax periods. An entity can choose one of two attribution methods of accounting for the GST: the cash method and the non-cash (or accruals) method.

Australian Accounting Standards Board

The standard setting body responsible for issuing accounting standards in Australia.

(AASB) Australian business number

Abbreviated to ABN. A unique eleven-digit number assigned to each entity that is carrying on an enterprise.

Australian Securities and Abbreviated to ASIC. The regulatory body in Australia responsible for Investments regulating the affairs of Australian companies. Commission Australian Taxation Office

Abbreviated to ATO. The regulatory body in Australia responsible for administering the collection of income tax, superannuation, FBT and GST in Australia.

Audit

The examination of the financial statements of an entity by an auditor with a view to expressing an opinion as to whether the accounts comply with AASB accounting standards and have been drawn up so as to give a “true and fair” view.

Bad debts

Also known as uncollectable debts. The amount of accounts receivable that the entity’s management has concluded are uncollectable. Usually written off in the profit and loss statement.

Balance sheet

Also known as the statement of financial position. The balance sheet shows the balance of the entity’s assets, liabilities and members’ equity as at the end of the reporting period.

Bank reconciliation

A statement detailing the differences between balance shown on the bank statement and the cash at bank balance shown in the balance sheet.

Bookkeeping

A subset of accounting that is primarily concerned with the process of identifying, measuring and recording business transactions. Bookkeepers ensure these transactions are accurately recorded in the accounting system.

Book value

The amount at which an asset is carried in the balance sheet. In the case of a depreciable asset, the book value is the cost of the asset minus its accumulated depreciation. Also referred to as the “carrying amount” or “written down value”.

Budget

A detailed estimate of the planned income and expenses for the next financial period.

Business Activity Statement

Abbreviated to BAS. A document issued to entities that are registered for GST. A pre-printed document issued by the ATO either monthly or quarterly which reports the business’ entitlements and obligations to the ATO. The BAS allows businesses to report the following: GST, luxury car tax, wine equalisation tax, fuel tax credits, PAYG withholding and instalments, FBT instalments and deferred company instalments. The ATO sends out personalised, pre-printed activity statements either via the internet or to the nominated postal address on the Australian Business Register.

Carrying amount

The amount at which an asset is carried in the balance sheet. In the case of a depreciable asset, the carrying amount is the cost of the asset minus its accumulated depreciation. Also referred to as the “book value” or “written down value”.

Cash basis of accounting

The method of recording transactions which reports revenues in the period in which the cash is received and expenses in the period in which the cash has been paid.

Chart of accounts

A list of all of the account names and account numbers used in the accounting system.

Company

A form of business structure that is a separate legal entity under the Corporations Act 2001. The ownership interest consists of shareholders who hold shares in the company. Directors are appointed by the shareholders and are entrusted with responsibility for managing the business.

Contra account

An account that is offset against a related account. For example, accumulated depreciation is a contra-asset account.

Cost centre

A sub-unit of a business which has all its costs and income grouped together in order to measure and monitor performance of that unit.

Credit

An amount entered on the right-hand side or in the credit column of an account.

Creditor

See accounts payable.

Current assets

Cash and other types of assets of the entity that would reasonably be expected to be converted to cash, sold or consumed by the business entity within 12 months after the end of the financial year.

Current liabilities

Obligations of the entity that are reasonably expected to be settled or paid within 12 months after the end of the financial year.

Current ratio

A financial ratio that measures the entity’s ability to immediately pay its shortterm debts utilising its current assets.

Debit

An amount entered on the left-hand side or in the debit column of an account.

Debt ratio

A financial ratio that measures the percentage of the entity’s assets funded by debt. Expressed as a percentage.

Debt/equity ratio

A financial ratio that measures the relationship between the entity’s debt financing to equity financing. Expressed as a percentage.

Deficit

Also known as a net loss. The excess of total expenses over total revenues for the entity during the reporting period.

Depreciable amount

The cost of an asset minus its estimated residual value.

Depreciable asset Depreciation

A non-current asset having a limited useful life. The allocation of the cost of an asset over its estimated useful life. Depreciation recognises that an asset is subject to wear and tear over its useful life. All non-current assets are depreciated, except land. For accounting purposes, an entity is permitted to use one of three depreciation methods, namely straight-line, diminishing value and the units of production method.

Depreciation schedule

A schedule (usually a spreadsheet) showing the amount of depreciation for each depreciable asset.

Diminishing value

An accounting and tax depreciation method. The diminishing balance method is an example of an accelerated depreciation method. It assumes that the asset will yield more service potential in the earlier years than in the later years. Hence, it allocates greater amounts of depreciation in the earlier years of the asset’s life than in the later years. It does this by applying a percentage rate initially to the original cost of the item, but subsequently to the base value (ie written down value) at the commencement of each year thereafter. The diminishing value depreciation rate is calculated by dividing a percentage (say 150% or 200%) by the useful life of the asset.

Dividend

A distribution of profit made to the shareholders (owners) of a company in proportion to their ownership interest. A dividend is declared by the directors of the company.

Double-entry accounting The accounting system whereby every transaction affects at least two accounts in the accounting equation. Drawings

A withdrawal of cash made by the owner of the business. Applies in the case of sole traders and partnerships.

Equity

Calculated as the difference between total assets and total liabilities. Often referred to as shareholders’ equity.

Expense

A loss or outgoing incurred by the entity during the reporting period.

Fair value

The amount for which an asset could be exchanged between a knowledgeable willing buyer and a knowledgeable willing seller in an arm’s length transaction. Also known as market value.

FBT Year

The FBT year runs from 1 April to 31 March.

Finance lease

A lease that substantially transfers all of the risks and rewards (benefits) incidental to ownership of the asset to the lessee. Legal title may or may not eventually be transferred at the end of the lease term. If a lease is classified as a finance lease, the lessee is required to record a leased asset and lease liability equivalent to the fair value of the minimum lease payments. This is referred to as “lease capitalisation”.

Financial statements

Comprises the statement of profit or loss and other comprehensive income (or income statement), statement of financial position (or balance sheet), statement of changes in equity, statement of cash flows and detailed notes.

Financial year

The financial year in Australia normally commences on 1 July and concludes on 30 June in the following year (although some entities may choose to adopt a different financial year). This is the same as the income year for taxation purposes.

First-in, first-out (FIFO)

A cost flow assumption technique used in valuing inventory. It assumes that the first inventory items purchased are the first inventory items sold. The cost of ending inventory is therefore comprised of items of inventory most recently purchased before the end of the relevant accounting period.

Fixed asset register

A schedule (usually a spreadsheet) itemising the non-current assets owned by the entity.

FOB (Free On Board)

This is freight terminology which helps indicates who is responsible for paying the cost of transportation and who is the appropriate legal owner while the goods are in transit. This is important for legal disputes and also for year-end accounting purposes.

FOB destination

Where the terms of the shipment are FOB destination, the legal title to the goods remains with the seller until the goods are received by the buyer at the point of destination. Typically, in this instance, the seller pays the freight and any related insurance costs.

FOB shipping point

Where the terms of the shipment are FOB shipping point, the legal title to the goods passes to the buyer at the point of shipping. In this case, the buyer usually pays the freight and any related insurance costs.

Fringe benefit

A fringe benefit is defined as any benefit provided at any time during the FBT year by the employer or an associate of the employer to an employee or their associate in respect of the employee's employment.

Fringe benefits tax

FBT is a tax payable by the employer on the total value of fringe (or noncash) benefits provided to employees or their associates during the FBT year. The FBT year starts on 1 April and ends on 31 March.

Fund

An account set up to show monies received for specific purposes.

GAAP

Abbreviation for “generally accepted accounting principles”.

Gain on sale

Also known as “profit on sale”. Calculated when a non-current asset is sold and the gross proceeds exceed the written down value as at the date of disposal. A gain on sale is usually recorded as “other income” in the profit and loss statement.

General journal

A chronological record of the entity’s transactions during the accounting period. It is based on the concept of double-entry accounting. In a computerised accounting software package, typically used to record adjusting entries such as depreciation.

General ledger

A collection of accounts maintained by an entity (ie all assets, liabilities, equity, revenues and expenses) which enables the preparation of the entity’s financial statements. Accounts contained in the general ledger are usually organised in the order in which they appear in the balance sheet and profit and loss statement.

General purpose financial statements

Financial statements that are intended to meet the information needs of a wide range of users. General purpose financial statements are prepared by reporting entities. These entities must comply with all of the AASB accounting standards.

Going concern assumption

The assumption that a business entity will continue to operate in the future — as distinct from closing its operations.

Goodwill

Goodwill refers to those unidentifiable benefits that accrue to an entity by virtue of circumstances such as a favourable location, good customers or

suppliers, and motivated employees. Because no cost can be reasonably assigned to these attributes, AASB 3 does not allow internally generated goodwill to be recognised as an asset in the balance sheet. However, an entity is able to recognise purchased goodwill. Purchased goodwill is defined in AASB 3 as the excess amount of money paid over to acquire another entity over the fair value of the identifiable net assets and contingent liabilities of another business. Put simply, goodwill is the “excess” or “premium” paid by the buyer of a business over the fair value of the identifiable net assets and contingent liabilities of the entity being acquired. Goods and services tax

GST is a broad-based tax of 10% on the supply of most goods, services and anything else consumed in Australia, and the importation of goods into Australia.

Gross profit

The difference between sales revenue and cost of goods sold.

Gross profit margin

A financial ratio which measures the percentage of gross profit generated by each dollar of sales revenue. Expressed as a percentage.

GST credit

Another term for “input tax credit”.

GST-free supply

A GST-free supply is one in which the supplier is not required to charge the 10% GST to the customer. However, the supplier can claim back the GST paid on any purchases made in making the supply.

GST-exclusive value

10/11ths of the GST-inclusive market value.

GST-inclusive value

The price of the goods or services including GST.

GST payable

The amount of GST collected by the entity from the sale of goods and services to customers. Some computerised accounting software packages refer to this term as “GST collected”.

GST receivable

The amount of GST paid by the entity on the acquisition of goods and services from suppliers. Some computerised accounting software packages refer to this term as “GST paid”. Also known as an input tax credit.

Hire purchase

A hire purchase arrangement is one under which the goods are purchased by instalment payments. The hirer has the use of the goods while payment is being made, but does not become the legal owner until the final instalment is paid. From an accounting perspective, hire purchase agreements are in substance, no different to that of a finance lease.

Horizontal analysis

An analysis of the change in an account balance over two reporting periods. Usually expressed as a percentage increase or decrease.

Income statement

Refer to the profit and loss statement.

Income year

The income tax year in Australia commences on 1 July and concludes on 30 June in the following year. This is confirmed in s 995-1 of the ITAA97. In taxation terms, financial year means income year.

Input tax credit

The credit claimed for the GST component of the price of goods or services acquired in carrying on an enterprise. A tax invoice is required to claim an input tax credit (except for purchases of $75 or less).

Input taxed supply

An input taxed supply is one in which the supplier is not required to charge the 10% GST to the customer. However, unlike a GST-free supply, the supplier is not able to claim an input tax credit on the inputs used to produce the input taxed supply.

Instalment activity statement

Abbreviated to IAS. A pre-printed document issued by the ATO either monthly or quarterly which reports the business’ entitlements and obligations to the ATO. An IAS is generally issued by the ATO to those entities that are not registered for the GST as well as for those entities that are registered for the GST but are classified as medium PAYG withholders. An entity is classified as a medium withholder if it withholds between $25,001 and $1m in PAYG withholding tax during a financial year. These entities are required to report (and remit) their PAYG withholding to the ATO within 21 days of the end of each month. The IAS allows businesses to report the following: pay as you go withholding and instalments, FBT instalments and deferred company instalments. The ATO sends out personalised, pre-printed activity statements either via the internet or to the nominated postal address on the Australian Business Register.

Intangible asset

An asset that does not have physical substance. Examples include trademarks, patents, brand names, customer lists and databases, computer software, research and development, licences, franchise agreements and purchased goodwill.

Internal controls

Methods and procedures collectively adopted by an entity to safeguard its assets and to ensure that the financial information is accurate and reliable.

Inventory

Goods or property acquired by an entity carrying on business for the purposes of resale within the ordinary course of business. Referred to as “trading stock” for taxation purposes.

Inventory turnover period

A financial ratio that measures the average number of days that it takes an entity to sell its inventory.

Investments

Assets held by the entity for investment purposes, rather than for use in the operating activities of the entity.

Invoice

A document issued by a supplier who is not registered for GST. This document must still have an ABN, otherwise the payer is required to withhold 49% of the gross amount and remit it to the ATO on the next BAS. See also “tax invoice”.

Journal

A record in which transactions are initially recorded. The process of entering transactions into a journal is called “journalising”.

Lease

A lease arrangement is one in which one party (the lessee) has the use of property for a specified period in return for a series of payments. The entity which grants the lease (the lessor) remains the legal owner of the property. Lease agreements may also result in the eventual transfer of ownership from lessor to lessee (but this is not considered essential).

Liabilities

Future sacrifices of economic benefits that an entity is presently obliged to make to other external entities as a result of past transactions.

Loss on sale

Calculated when a non-current asset is sold and the gross proceeds are less than the written down value as at the date of disposal. A loss on sale is recorded as an expense in the profit and loss statement.

Liquidity

The ability of an entity to satisfy its short-term financial obligations.

Liquidity ratios

Ratios which provide a measure of an entity’s ability to pay its short-term obligations as and when they fall due.

Long service leave

Long service leave includes long service leave, long leave, furlough, extended leave or leave of a similar kind (however described) to which a person is entitled by law, award or contract. Long service leave allows extended paid leave (usually 13 weeks paid leave for every 10 or 15 years of continuous service) to employees as a reward for uninterrupted service to the same employer. Long service leave is recorded as an expense and a noncurrent liability in the accounts (unless the leave is expected to be taken within the next 12 months).

Long-term stability ratios Ratios which provide a measure of an entity’s ability to meet its long-term commitments. Mark-up percentage

Measures the mark-up applied to the purchase price of goods to arrive at the sales price. Expressed as a percentage.

Net amount

The net amount of GST that must be paid to the ATO on the BAS. The net amount is calculated as the difference between GST payable and GST receivable. If the net amount is positive, the entity must remit the GST owing to the ATO when the BAS is lodged. Conversely, if the net amount is negative, this signifies that the entity is entitled to a refund.

Net loss Net profit

See deficit. See surplus.

Net assets

Total assets minus total liabilities. Also equals total equity.

Net profit margin

A financial ratio which measures the net profit generated by each dollar of sales revenue. Expressed as a percentage.

Net realisable value

The selling price of inventory minus the estimated costs to sell.

Non-current assets

Assets other than current assets. Assets of the entity which would not be expected to be converted to cash, sold or consumed by the business entity within 12 months after the end of the financial year.

Non-current liabilities

Liabilities other than current liabilities. Obligations of the entity that do not require payment within 12 months after the end of the financial year.

Operating lease

An operating lease is defined as a lease where substantially all of the risks and rewards incidental to ownership of the leased asset remain with the lessor. An operating lease is not shown on the lessee’s balance sheet. It is simply recorded as an expense in the profit and loss statement.

Out-of-scope supplies

Out-of-scope supplies are those supplies which fall outside the scope of the GST Act. GST cannot be charged in respect of revenue and cannot be

claimed back in respect of expenses. These expenses are usually coded to “no-tax” in the management accounts and are not reported in the BAS. PAYG payment summary

Formerly known as a group certificate. The PAYG payment summary is an annual statement prepared by businesses in respect of each worker who has received payments under the PAYG withholding system. The payment summary reports a variety of information including the gross income derived by each worker as well as the amount of PAYG withholding tax deducted.

Payroll tax

A state-based tax which is levied on employers by the states and territories based on the amount of the annual payroll. Payroll tax is a tax levied on “wages” provided by employers to employees. While the laws vary between states and territories, payroll tax is levied on the annual Australian taxable wages of an employer or group of related employers. Each state legislation specifies different registration thresholds and rates of payroll tax.

Periodic inventory system

Under a periodic inventory system, every time an entity buys inventory, it records that purchase in the profit and loss statement as an expense. There is no continuous record of how much inventory is on hand at any particular point in time. The amount of inventory can only be ascertained by performing a physical stocktake (ie by actually counting the inventory).

Perpetual inventory system

Under a perpetual inventory system, an inventory account is maintained to record increases and decreases in inventory from sale and purchase transactions.

Posting

The process of transferring information in the general journal to the individual accounts contained in the general ledger.

Prepayment

A payment in advance for goods or services that will be consumed by the entity in the next reporting period. For example, includes prepaid insurance, prepaid rent and prepaid advertising. Usually shown as a current asset in the balance sheet.

Price

The amount of consideration for a supply, including GST. In Australia, the rate of GST is 10%. GST of 10% is added to the “value” of the supply to give the “price” of the goods or services. In other words: Price = [ Value + 10% ]. In Australia, prices of goods and services are required to be shown inclusive of all taxes and charges.

Profit & loss statement

A financial statement listing the revenues, expenses and net profit/surplus or net loss/deficit of an entity for the reporting period. Also known as the income statement.

Quick ratio

A financial ratio that measures the entity’s ability to immediately pay its shortterm debts from its liquid current assets.

Receivables collection period

A financial ratio that measures the average number of days that it takes an entity to collect its receivables.

Reconciliation

Ensuring two or more balances agree, often used in reference to checking bank balances with the accounting system.

Reimbursement

Occurs where the recipient is compensated exactly for all or an agreed part of an expense already incurred. A requirement that the recipient vouch

expenses lends weight to a presumption that the payment is a reimbursement rather than an allowance. A reimbursement of work-related expenditure is not assessable and not deductible to the recipient. However, if the reimbursement is for the employee’s private expenses, this may constitute an expense payment fringe benefit. Reserves

Amounts set aside to provide for future programs or to act as a buffer against changing circumstances.

Residual value

The estimated sale proceeds from the disposal of a non-current asset at the end of its useful life.

Retained profits

The accumulated profits of a company that have been retained rather than distributed to shareholders as dividends. Also known as retained earnings.

Return on total assets

A financial ratio that measures the rate of return earned by utilising the entity’s assets. Expressed as a percentage.

Return on shareholder’s equity

A financial ratio that measures the net profit generated from shareholders’ funds. Expressed as a percentage.

Revaluation

The increase or decrease in the value of a non-current asset. Often the result of comparing the book value of an asset with its market value. This increase or decrease is recorded in the asset revaluation reserve.

Revenue

Income derived by the entity from the sale of goods or services during the reporting period.

Salary

A fixed amount paid to an employee, rather than payment on an hourly basis.

Salary sacrifice arrangement

An arrangement between the employer and employee whereby the employee agrees to forgo part of their future entitlement to salary or wages in return for the employer or associate providing them with benefits of a similar value.

Small business entity

Also known as SBE. A term defined in Div 328 of the ITAA97. A small business entity is defined as a business that carries on business and has an aggregated turnover of less than $2m per annum. In the 2016 Budget, the federal government announced, as from 1 July 2016, that the SBE turnover threshold will be increased from $2m to $10m. However, as at the date of writing, these changes are also yet to be passed as law. Under Div 328, a small business entity has a choice of adopting a range of “simplified” or “streamlined” tax concessions that are generally unavailable to large business entities. These concessions include simplified depreciation rules, simplified trading stock rules, the ability to claim an up-front tax deduction for certain prepaid business expenses and a range of CGT and GST concessions.

Sole trader Special purpose financial statements

A form of business structure operated by a single proprietor. A set of financial statements prepared for users who have specialised needs and possess the authority to obtain information to meet those needs. Special purpose financial statements are prepared by non-reporting entities. These types of entities only need to comply with the recognition and measurement requirements of those AASB Accounting Standards considered necessary to give a true and fair view.

Specific identification

A cost flow assumption technique used in valuing inventory. It assumes that the cost of each item of inventory on hand at the end of the reporting period can be specifically identified.

Statement of cash flows

A financial statement which reports the cash inflows and outflows of an entity during the financial year. These cash inflows and outflows are classified into operating, investing and financing activities.

Statement of changes in The purpose of the statement of changes in equity is to show the movement equity in equity between the two reporting periods. Not only are the net profit and other comprehensive income figures transferred to this statement, but this statement also shows additional capital contributions made by the owners (or shareholders) and any drawings made by the owners (or dividends paid to shareholders) during the reporting period. AASB 101 also requires a reconciliation of the opening and closing balance of each item of equity to the lines used in the statement of financial position. It is not a statement typically contained within the management accounts. Statement of profit or loss and other comprehensive income

See income statement.

Statement of financial position

See balance sheet.

Stocktake

A physical count of inventory on hand at the end of the reporting period.

Straight-line method

An accounting depreciation method. The straight-line depreciation method results in an equal amount of depreciation for each year of the asset’s useful life. The depreciation expense is calculated by dividing the depreciable amount of the asset (ie its original cost less its estimated residual value) by its estimated useful life. If the entity is registered for the GST, the “cost” of the asset is the GST-exclusive cost.

Superannuation

Since 1983, every employer in Australia (regardless of their taxation status) has been required to make employer-sponsored superannuation contributions on behalf of its employees. This is referred to as the “superannuation guarantee scheme”. Since the 2003 income year, employers have had to provide each employee with minimum superannuation support based on a percentage of their earnings base (referred to as the “ordinary times earnings”). This is referred to as the “superannuation guarantee percentage”. For the 2016 and 2017 income years, the superannuation guarantee percentage is 9.5%.

Supply

For GST purposes, the term supply is very broad and includes the supply of services, provision of advice or information, a grant, assignment or surrender of real property, a creation, grant, transfer, assignment, a financial supply and an entry into or release from an obligation to do anything, to refrain from an act, or to tolerate an act or situation. Not all supplies are taxable.

Surplus

The excess of total revenues over total expenses for the entity over the reporting period. Also known as a net profit.

Taxable income

The entity’s profit for tax purposes. Calculated as the difference between an entity’s assessable income and its allowable deductions. Tax is payable on

taxable income. Taxable supply

A taxable supply is one for which the supplier is required to charge the 10% GST to the customer. However, the supplier can claim the GST paid on any purchases incurred in making the supply.

Tax invoice

A document issued by a supplier who is registered for GST. This document should have the supplier’s ABN and the amount of GST included in the supply. See also invoice.

Tax period

A tax period is a period for which an entity calculates its GST and lodges its BAS. A tax period is either quarterly or monthly depending on the entity’s annual turnover. Quarterly tax periods end on 30 September, 31 December, 31 March and 30 June. Monthly tax periods end on the last day of each calendar month.

Times interest earned

A financial ratio that measures the ability of the entity to meet interest payments out of current year’s profit.

Trading stock

For taxation purposes, trading stock is defined in s 70-10 of ITAA97 as including anything produced, manufactured or acquired that is held for the purposes of manufacture, sale or exchange in the ordinary course of a business and livestock. Referred to as “inventory” for accounting purposes.

Transaction Trial balance

A financial event which results in an entry in the accounts. A statement listing all of the accounts in the general ledger and their respective debit and credit balances. A trial balance is prepared to verify the equality of debits and credits made to the accounts.

Unadjusted trial balance A trial balance prepared before adjusting entries have been processed. Unearned income

Cash received and recorded as a liability before income is earned.

Useful life

The estimated period of time (usually expressed in years) that a non-current asset is expected to be used by the entity. This is used in determining the amount of depreciation of non-current assets. For taxation purposes, the useful life is referred to as the “effective life”.

Value

For GST purposes, 10/11ths of the price of the goods or services.

Vertical analysis

An analysis of each item in the financial statements expressed as a percentage of a specific item on the same statement (the base amount). In the case of the profit and loss statement, revenue is usually set at a base of 100%. In the case of the balance sheet, total assets are set at a base of 100%.

Wages

Amounts paid to an employee based on an hourly rate, rather than as a fixed amount.

Weighted average

A cost flow assumption technique used in valuing inventory. It uses an average cost of inventory determined by dividing the total inventory purchases during a period (including the number of items in opening inventory). This average cost is then multiplied by the number of items in ending inventory to arrive at a closing inventory value. This average cost is

multiplied by the number of items in ending inventory to arrive at a closing inventory value. Workers compensation

Workers compensation is an insurance scheme whereby employees are compensated for work-related injuries, loss of limbs, illnesses and loss of life while at work. Under the legislation in each state and territory, it is compulsory for all employers to take out a WorkCover insurance policy in respect of “workers”. The requirements of the legislation varies from state to state.

Written down value

The amount at which an asset is carried in the balance sheet. In the case of a depreciable asset, the written down value is the cost of the asset minus its accumulated depreciation. Also referred to as the “book value” or “carrying amount”.

INDEX A AASB — see Australian Accounting Standards Board (AASB) AAT — see Association of Accounting Technicians (AAT) ABN withholding tax

¶4-300

Accounting assumptions bookkeeping

¶1-400

— accounting entity

¶1-410

— accounting equation

¶1-480

— accounting period

¶1-450

— accrual accounting principle

¶1-440

— conceptual and AASB framework

¶1-460

— cost

¶1-420

— general purpose financial reporting, objective

¶1-465

— going concern

¶1-430

— qualitative characteristics of useful financial information

¶1-470

Accounting cycle

¶2-300

business transactions

¶2-400

closing entries

¶3-500

completion

¶3-200

— GST

¶4-800

general journal

¶2-600

general ledger

¶2-700

preparation of financial statements

¶2-900

source documents

¶2-500

trial balance

¶2-800; ¶3-400

Accounting, defined

¶1-000

Accounting entity assumption

¶1-410

Accounting equation

¶1-480; ¶2-000

Accounting for cash accounts payable — aged creditors analysis

¶5-520

— controls

¶5-500

— initial recording

¶5-510

accounts receivable — controls

¶5-400

— initial recording

¶5-410

— recovery of bad debt

¶5-440

— valuation

¶5-420

— writing off bad debts

¶5-430

bank reconciliations

¶5-300

commonly asked questions

¶5-600

controls

¶5-100

— cash payments

¶5-120

— cash receipts

¶5-110

importance

¶5-000

petty cash fund

¶5-200

— establishment

¶5-210

— payments

¶5-220

— replenishment

¶5-230

Accounting for inventory — see Inventory Accounting information, qualitative characteristics

¶1-470

Accounting information, users

¶1-100

external

¶1-120

internal

¶1-110

Accounting period assumption

¶1-450

Accounting profession

¶1-200

Accounting Standards

¶1-050

Accounts

¶2-100

assets

¶2-110

equity

¶2-130

expenses

¶2-150

liabilities

¶2-120

revenues

¶2-140

Accounts method

¶4-920

Accounts payable

¶2-120

aged creditors analysis

¶5-520

controls

¶5-500

initial recording

¶5-510

Accounts receivable

¶2-110

controls

¶5-400

initial recording

¶5-410

recovery of bad debts

¶5-440

valuation

¶5-420

writing off bad debts

¶5-430

Accrual accounting principle

¶1-440

Accrual basis of accounting

¶3-020

chattel mortgage

¶7-845

GST

¶4-600

— completing BAS

¶4-920

hire purchase

¶7-810

— schedule

¶7-960

Accruals

¶3-300

Accrued expenses

¶3-330

Accrued revenue

¶3-340

Adjusted trial balance

¶3-400

worked example

¶3-410

Adjusting entries

¶3-300

accrued expenses

¶3-330

accrued revenue

¶3-340

commonly asked questions

¶3-600

depreciation

¶3-350

prepaid expenses

¶3-310

purpose

¶3-100

revenue received in advance

¶3-320

Aged debtors analysis method

¶5-420

Amortisation — see also Depreciation intangible assets

¶7-860

leased assets

¶7-790

Assets

¶1-530; ¶2-110

definition

¶1-530; ¶2-110; ¶7-000

intangible

¶7-000

tangible

¶7-000

Association of Accounting Technicians (AAT)

¶1-250

ATO — see Australian Taxation Office (ATO) Australian Accounting Standards Board (AASB)

¶1-000

Accounting Standards

¶1-050

framework

¶1-460

Australian Taxation Office (ATO)

¶1-000

activity statements — Business Activity Statements

¶4-900

— Instalment Activity Statements

¶4-900

B Bad debts methods used in estimating amount — aged debtors analysis method

¶5-420

— percentage of credit sales method

¶5-420

recovery

¶5-440

writing off

¶5-430

Bank reconciliations

¶5-300

BAS — see Business Activity Statements (BAS) BAS agents

¶1-000

registration with the TPB

¶4-800

services — information for contract bookkeepers

¶4-800

statement of relevant experience

¶4-800

BAS provision, defined

¶4-800

BAS services agents — information for contract bookkeepers

¶4-800

definition

¶4-800

Benchmarking and industry information

¶8-500

Bookkeeping accounting assumptions

¶1-400

— accounting entity

¶1-410

— accounting equation

¶1-480

— accounting period

¶1-450

— accrual accounting principle

¶1-440

— conceptual and AASB framework

¶1-460

— cost

¶1-420

— general purpose financial reporting, objective

¶1-465

— going concern

¶1-430

— qualitative characteristics of useful financial information

¶1-470

accounting profession

¶1-200

bookkeeping profession

¶1-250

business entities

¶1-300

— companies

¶1-340

— partnership

¶1-320

— sole trader

¶1-310

— trust

¶1-330

commonly asked questions

¶1-700

content of external financial statements

¶1-500

— cash flow statement

¶1-540

— statement of changes in equity

¶1-520

— statement of financial position

¶1-530

— statement of profit or loss and other comprehensive income

¶1-510

disclosure of status in financial statements

¶1-630

double-entry bookkeeping

¶2-200

example

¶1-750

history

¶1-050

purpose

¶1-000

— accounting, definition

¶1-000

reporting entity concept

¶1-600

— non-reporting entities

¶1-620

— reporting entities

¶1-610

users of accounting information

¶1-100

— external

¶1-120

— internal

¶1-110

Bookkeeping profession

¶1-250

Buildings

¶2-110

demolition costs

¶7-050

Business Activity Statements (BAS) accounts method calculation worksheet method

¶1-000; ¶4-960 ¶4-920 ¶4-920; ¶4-965

completion

¶4-900

— accrual basis

¶4-920

— cash basis

¶4-930

— GST section

¶4-910

— sample business activity statement (BAS)

¶4-960

services — information for contract bookkeepers

¶4-800

Business entities

¶1-300

companies

¶1-340

partnership

¶1-320

sole trader

¶1-310

trust

¶1-330

Business transactions

¶2-400

C CAANZ — see Chartered Accountants Australia and New Zealand (CAANZ) Calculation worksheet method Capital account

¶4-920; ¶4-965 ¶2-130

Cash — see Accounting for cash Cash at bank

¶2-110

Cash basis of accounting

¶3-010

chattel mortgage

¶7-845

GST

¶4-600

hire purchase

¶7-800; ¶7-810

Cash flow statement

¶1-540

Cash payments

¶5-120

Cash receipts

¶5-110

Chart of accounts sample

¶2-970; ¶4-970

Chartered Accountants Australia and New Zealand (CAANZ)

¶1-200

Chattel mortgage

¶7-840

GST on accrual and cash basis

¶7-845

schedule

¶7-980

Closing entries

¶3-500

expense accounts

¶3-520

net profit/loss

¶3-530

owner's drawings

¶3-540

revenue accounts

¶3-510

Code of professional conduct

¶4-800

Commonly asked questions accounting for GST

¶4-950

accounting for inventory

¶6-700

adjusting entries

¶3-600

bookkeeping

¶1-700

cash, debtors and creditors

¶5-600

financial statement analysis

¶8-700

non-current assets

¶7-990

recording transactions

¶2-950

Companies

¶1-340

proprietary

¶1-340

public

¶1-340

Conceptual framework, defined

¶1-460

Continuing professional education (CPE)

¶4-800

Controls over cash

¶5-100

cash payments

¶5-120

cash receipts

¶5-110

Cost assumption

¶1-420

Cost of inventory conversion costs

¶6-400

cost of purchase

¶6-400

other costs

¶6-400

CPA Australia (CPAA)

¶1-200

CPAA — see CPA Australia (CPAA) CPE — see Continuing professional education (CPE) Creditable acquisitions

¶4-120

Creditors — see Accounting for cash Current ratio

¶8-355

D Debt ratio

¶8-405

Debt/equity ratio

¶8-410

Debtors — see Accounting for cash Debts — see Bad debts Deferrals

¶3-300

prepaid expenses

¶3-310

revenue received in advance

¶3-320

Definitions accounting

¶1-000; ¶8-000

accounting cycle

¶2-300; ¶3-200

accruals

¶3-300

accrued expenses

¶3-300

accrued revenue

¶3-300

amortisation

¶7-860

assets

¶1-530; ¶2-110; ¶7-000

asset’s useful life

¶7-420

BAS provision

¶4-800

BAS service

¶4-800

capitalised

¶7-050

chattel mortgage

¶7-840

companies

¶1-340

comparability

¶1-470

conceptual framework

¶1-460

conversion costs

¶6-400

costs of purchase

¶6-400

creditable acquisition

¶4-120

creditable purpose

¶4-120

deferral

¶3-300

depreciable amount depreciation economic substance

¶7-300; ¶7-990 ¶3-350; ¶7-300; ¶7-860 ¶1-470

equity

¶1-530; ¶2-130

expenses

¶1-510; ¶2-150

external transactions

¶2-010

fair value

¶7-775

fair value less costs to sell

¶7-860

faithful representation

¶1-470

finance lease

¶7-775

GST-free supply

¶4-100

guaranteed residual value

¶7-775

horizontal analysis

¶8-100

input taxed supplies

¶4-100

intangible assets

¶7-000; ¶7-850

internal transactions

¶2-010

inventory

¶6-100

lease lease term

¶7-770; ¶7-800 ¶7-775

liabilities

¶1-530; ¶2-120

mark-up

¶8-320

materiality

¶1-470

minimum lease payments

¶7-775

net amount

¶4-500

net profit/(loss)

¶1-510; ¶3-000

net realisable value (NRV)

¶6-600

non-cancellable lease

¶7-775

non-event transactions

¶2-010

operating lease

¶7-775

other costs

¶6-400

out-of-scope supplies

¶4-100

partnership

¶1-320

prepaid expenses

¶3-300

present value of minimum lease payments

¶7-775

property, plant and equipment

¶7-000

public company

¶1-340

purchased goodwill

¶7-870

recoverable amount

¶7-860

relevance

¶1-470

reporting entity

¶1-600

residual value

¶7-410

revenue received in advance

¶3-300

revenues

¶1-510; ¶2-140

sole trader

¶1-310

taxable supply

¶4-100

timeliness

¶1-470

transaction

¶2-010

trial balance

¶2-800

trust

¶1-330

understandability

¶1-470

value in use

¶7-860

verifiability

¶1-470

Demolition costs

¶7-050

Depreciable assets, sale gain on sale

¶7-610

loss on sale

¶7-620

recognising a gain or loss

¶7-600

Depreciation — see also Amortisation chattel mortgage

¶7-840

— GST on accrual and cash basis

¶7-845

— schedule

¶7-980

depreciable assets, sale — gain

¶7-610

— loss

¶7-620

— recognising a gain or loss on sale

¶7-600

hire purchase

¶7-800

— GST on accrual basis

¶7-810

— GST on cash basis

¶7-810

intangible assets

¶7-850

— amortisation

¶7-860

— goodwill

¶7-870

leased assets

¶7-790

methods — acceptable depreciation methods

¶7-430

— changing depreciation methods

¶7-500

— comparison of depreciation methods

¶7-450

— diminishing balance

¶7-440

— straight-line

¶7-435

— units of production

¶7-445

non-current assets

¶3-350

property, plant and equipment

¶7-300; ¶7-400

— estimating residual value

¶7-410

— estimating useful life

¶7-420

— revision of residual value or useful life

¶7-510

schedule

¶7-700; ¶7-940

Depreciation methods acceptable

¶7-430

changing

¶7-500

comparison

¶7-450

diminishing balance

¶7-440

straight-line

¶7-435

units of production

¶7-445

Depreciation schedule

¶7-700

Diminishing balance method

¶7-440

Discretionary trusts

¶1-330

Double-entry bookkeeping

¶2-200

Drawings

¶2-130

closing entries

¶3-540

E Economic substance

¶7-775

Employee benefits

¶2-120

Equity

¶1-530; ¶2-130

Expenses

¶2-150

closing entries

¶3-520

External financial statements

¶1-120; ¶1-500

cash flow statement

¶1-540

distinction between leases

¶7-775

financial position statement

¶1-530

general purpose — disclosure of status

¶1-630

— reporting entities

¶1-610

special purpose — disclosure of status

¶1-630

— non-reporting entities

¶1-620

statement of changes in equity

¶1-520

statement of profit or loss and other comprehensive income

¶1-510

External transactions

¶2-010

External users of accounting information

¶1-120

F FASB — see Financial Accounting Standards Board (FASB) FIFO — see First-in, first-out method of inventory valuation Finance leases

¶7-780

definition

¶7-775

Financial Accounting Standards Board (FASB)

¶1-050

Financial stability ratios

¶8-400; ¶8-650

debt ratio

¶8-405

debt/equity ratio

¶8-410

times interest earned ratio

¶8-415

Financial statement analysis

¶8-000

accounting — definition

¶8-000

benchmarking and industry information

¶8-500

commonly asked questions

¶8-700

horizontal analysis

¶8-100

— trend analysis

¶8-110

limitations

¶8-600

ratio analysis

¶8-300

— financial stability ratios

¶8-400–8-415

— liquidity ratios

¶8-350–8-370

— profitability ratios

¶8-310–8-335

summary of financial ratios

¶8-650

vertical analysis

¶8-200

— common size statements

¶8-250

Financial statements, preparation

¶2-900

adjusted trial balance

¶3-400

— worked example

¶3-410

adjusting entries, preparation

¶3-300

— accrued expenses

¶3-330

— accrued revenue

¶3-340

— commonly asked questions

¶3-600

— depreciation

¶3-350

— prepaid expenses

¶3-310

— revenue received in advance

¶3-320

adjusting entries, purpose

¶3-100

closing entries

¶3-500

— expense accounts

¶3-520

— net profit/loss

¶3-530

— owner's drawings

¶3-540

— revenue accounts

¶3-510

completion of accounting cycle

¶3-200

measurement of profit

¶3-000

— accrual basis of accounting

¶3-020

— cash basis of accounting

¶3-010

Financing activities cash flow statement

¶1-540

Financing options

¶7-750

non-current assets — chattel mortgage arrangement — finance lease arrangement

¶7-840; ¶7-845 ¶7-770–7-795

— hire purchase arrangement

¶7-800; ¶7-810

— purchased outright

¶7-760

First-in, first-out method of inventory valuation

¶6-520

Fixed asset register Fixed trusts

¶7-200; ¶7-900 ¶1-330

FOB — see Free-on-board (FOB) Free-on-board (FOB) destination

¶6-410

shipping point

¶6-410

G GAAP — see Generally accepted accounting principles (GAAP) General journal

¶2-600

General ledger

¶2-700

Generally accepted accounting principles (GAAP) Going concern assumption Goods and services tax (GST)

¶1-050; ¶1-400 ¶1-430 ¶1-000; ¶4-000

accounting for GST charged

¶4-110

accounting for GST paid

¶4-130

accrual basis of accounting

¶4-600

cash basis of accounting

¶4-600

charging

¶4-100; ¶4-110

chattel mortgage arrangements

¶7-840

— accrual and cash basis

¶7-845

— schedule

¶7-980

commonly asked questions

¶4-950

completing BAS

¶4-900

— accrual basis

¶4-920

— cash basis

¶4-930

— GST section

¶4-910

— sample business activity statement (BAS)

¶4-960

completion of accounting cycle

¶4-800

comprehensive worked example on accounting for GST

¶4-700

GST calculation worksheet

¶4-965

GST-free supplies

¶4-100

hire purchase arrangements

¶7-800

— accrual basis

¶7-810

— cash basis

¶7-810

input taxed supplies

¶4-100

net amount

¶4-500

out-of-scope supplies

¶4-100

payment

¶4-120

registration

¶4-200

sample chart of accounts

¶4-970

sample statement by a supplier form

¶4-955

tax invoices

¶4-300

tax periods

¶4-400

— monthly

¶4-420

— quarterly

¶4-410

taxable importations

¶4-100

taxable supplies

¶4-100

Goodwill Gross profit margin

¶7-000; ¶7-870 ¶8-315

GST — see Goods and services tax (GST) GST-free supplies

¶4-100

H Hire purchase agreements

¶7-800

Hire purchase arrangement

¶7-800

Horizontal analysis

¶8-100

trend analysis

¶8-110

I IAS — see Instalment Activity Statement (IAS) IASB — see International Accounting Standards Board (IASB) ICB — see Institute of Certified Bookkeepers (ICB)

IFRS — see International Financial Reporting Standards (IFRS) Impairment testing

¶7-860

Incidental costs

¶7-050

Input taxed supplies

¶4-100

Instalment Activity Statement (IAS)

¶4-900

Institute of Certified Bookkeepers (ICB)

¶1-250

Institute of Public Accountants (IPA)

¶1-200

Intangible assets

¶2-110; ¶7-000; ¶7-850

amortisation

¶7-860

finite and indefinite useful life

¶7-860

goodwill

¶7-000; ¶7-870

identifiable

¶7-000

unidentifiable

¶7-000

Internal transactions

¶2-010

Internal users of accounting information

¶1-110

International Accounting Standards Board (IASB)

¶1-050

International Financial Reporting Standards (IFRS)

¶1-050

Inventory

¶6-000

commonly asked questions

¶6-700

cost of inventory

¶6-400

inventory, definition

¶6-100

inventory on hand

¶6-410

lower of cost and net realisable value (NRV) rule

¶6-600

systems

¶6-110

— periodic

¶6-110; ¶6-300

— perpetual

¶6-110; ¶6-200

valuation

¶6-500

— comparison of valuation methods

¶6-560

— first-in, first-out (FIFO)

¶6-520

— retail method

¶6-550

— specific identification

¶6-510

— standard cost

¶6-540

— weighted average cost

¶6-530

Investing activities cash flow statement

¶1-540

IPA — see Institute of Public Accountants (IPA)

L Land

¶2-110; ¶7-000

determining the cost

¶7-050

Lay-by arrangement

¶6-410

Leases

¶7-770

allocation of monthly lease payments

¶7-785

amortisation (depreciation) of the leased assets

¶7-790

distinction between leases

¶7-775

finance

¶7-780

operating

¶7-795

schedule

¶7-950

Liabilities

¶1-530; ¶2-120

Liquidity ratios

¶8-350; ¶8-650

current ratio

¶8-355

inventory turnover period

¶8-370

quick ratio

¶8-360

receivables collection period

¶8-365

Loans payable

¶2-120

M Management accounts

¶1-110

distinction from financial statements

¶1-120

Mark-up percentage

¶8-320

Mixed supply tax invoice

¶4-300

Monthly tax periods

¶4-420

N Net amount of GST

¶4-500

Net profit margin

¶8-325

Net profit/loss closing entries

¶3-530

Net realisable value (NRV)

¶6-600

Non-current assets — see Non-current assets, accounting Non-current assets, accounting

¶7-000

commonly asked questions

¶7-990

depreciation of property, plant and equipment

¶3-350; ¶7-300; ¶7-400

— choice of depreciation method

¶7-430–7-500

— depreciable assets, sale

¶7-600–7-620

— estimating residual value

¶7-410

— estimating useful life

¶7-420

— revision of residual value or useful life

¶7-510

financing options

¶7-750

— chattel mortgage arrangement

¶7-840; ¶7-845

— finance lease arrangement

¶7-770–7-795

— hire purchase arrangement

¶7-800; ¶7-810

— purchased outright fixed asset register

¶7-760 ¶7-200; ¶7-900

intangible assets

¶7-850

— amortisation

¶7-860

— goodwill

¶7-870

property, plant and equipment — definition

¶7-000

— determining the cost

¶7-050

schedule — chattel mortgage — depreciation

¶7-980 ¶7-700; ¶7-940

— hire purchase

¶7-960

— lease

¶7-950

subsequent costs

¶7-100

Non-event transactions

¶2-010

O

Operating activities cash flow statement

¶1-540

Operating leases

¶7-795

cancellable definition non-cancellable Out-of-scope supplies

¶7-770; ¶7-775 ¶7-775 ¶7-770; ¶7-775 ¶4-100

P Partnership

¶1-320

Percentage of credit sales method

¶5-420

Periodic inventory system

¶6-110; ¶6-300

Perpetual inventory system

¶6-110; ¶6-200

Petty cash fund

¶5-200

establishment

¶5-210

payments

¶5-220

replenishment

¶5-230

Petty cash voucher

¶5-220

Plant and equipment

¶2-110

Prepaid expenses

¶2-110; ¶3-310

Professional indemnity (PI) insurance

¶4-800

Profit measurement

¶3-000

accrual basis of accounting

¶3-020

cash basis of accounting

¶3-010

Profitability ratios

¶8-310; ¶8-650

gross profit margin

¶8-315

mark-up percentage

¶8-320

net profit margin

¶8-325

return on shareholders’ equity

¶8-335

return on total assets

¶8-330

Property, plant and equipment definition

¶7-000

depreciation — choice of method

¶3-350; ¶7-400 ¶7-430–7-500

— definition

¶7-300

— estimating residual value

¶7-410

— estimating useful life

¶7-420

— revision of residual value or useful life

¶7-510

fixed asset register

¶7-200

incidental costs

¶7-050

subsequent costs

¶7-100

Proprietary companies

¶1-340

Public companies

¶1-340

Purchased outright

¶7-760

Q Quarterly tax periods

¶4-410

Quick ratio

¶8-360

R Ratio analysis

¶8-300

financial stability ratios

¶8-400

— debt ratio

¶8-405

— debt/equity ratio

¶8-410

— times interest earned ratio

¶8-415

liquidity ratios

¶8-350

— current ratio

¶8-355

— inventory turnover period

¶8-370

— quick ratio

¶8-360

— receivables collection period

¶8-365

profitability ratios

¶8-310

— gross profit margin

¶8-315

— mark-up percentage

¶8-320

— net profit margin

¶8-325

— return on shareholders’ equity

¶8-335

— return on total assets

¶8-330

Receivables collection period

¶8-365

Recording transactions accounting cycle

¶2-300

— business transactions

¶2-400

— completion

¶3-200

— general journal

¶2-600

— posting from journal to ledger

¶2-700

— preparation of financial statements

¶2-900

— source documents

¶2-500

— trial balance

¶2-800

accounting equation

¶2-000

accounts

¶2-100

— assets

¶2-110

— equity

¶2-130

— expenses

¶2-150

— liabilities

¶2-120

— revenues

¶2-140

— sample chart for a company

¶2-970

commonly asked questions

¶2-950

double-entry bookkeeping

¶2-200

types

¶2-010

worked example

¶2-020

Recoverable amount

¶7-860

Registration BAS agent, requirements

¶4-800

GST

¶4-200

Reporting entity concept

¶1-600

non-reporting entities

¶1-620

— disclosure of status

¶1-630

reporting entities

¶1-610

— disclosure of status

¶1-630

Reserves

¶2-130

Residual value of assets

¶7-410

Retail inventory method

¶6-550

Retained profits

¶2-130

Return on shareholders’ equity (ROE)

¶8-335

Return on total assets (ROA)

¶8-330

Revenue received in advance

¶3-320

Revenues

¶2-140

closing entries

¶3-510

unearned

¶2-120

ROA — see Return on total assets (ROA) ROE — see Return on shareholders’ equity (ROE)

S SBE — see Small business entity (SBE) SEC — see Securities and Exchange Commission (SEC) Securities and Exchange Commission (SEC)

¶1-050

Significant accounting policies summary

¶1-630

Small business entity (SBE) cash basis of accounting

¶4-600

Sole trader

¶1-310

Source documents

¶2-500

Specific identification method of inventory valuation

¶6-510

SRE — see Statement of relevant experience (SRE) Standard cost method of inventory valuation

¶6-540

Statement by a supplier

¶4-955

Statement of changes in equity

¶1-520

Statement of profit or loss and other comprehensive income

¶1-510

Statement of relevant experience (SRE)

¶4-800

Straight-line depreciation method

¶7-435

Subsequent costs

¶7-100

T Tangible assets

¶7-000

Tax Agent Services Act 2009 information for contract bookkeepers

¶4-800

Tax invoices

¶4-300

Tax periods

¶4-400

monthly

¶4-420

quarterly

¶4-410

Tax Practitioners Board (TPB) registration of BAS agents

¶4-800

Taxable importations

¶4-100

Taxable supplies

¶4-100

tax invoice

¶4-300

Taxation consequences accounts receivable — recovery of bad debt

¶5-440

— writing off bad debts

¶5-430

accrual basis of accounting

¶3-020

hire purchase agreements

¶7-800

preparation of financial statements — accrued expenses

¶3-330

— accrued revenue

¶3-340

— depreciation

¶3-350

— prepaid expenses

¶3-310

— revenue received in advance

¶3-320

Times interest earned ratio

¶8-415

TPB — see Tax Practitioners Board (TPB) Trend analysis

¶8-110

Trial balance

¶2-800

Trusts

¶1-330

discretionary

¶1-330

fixed

¶1-330

parties to a trust arrangement

¶1-330

unit

¶1-330

U Unearned revenue

¶2-120

Unit trusts

¶1-330

Units of production depreciation method

¶7-445

Useful life of assets

¶7-420

intangible asset, finite and indefinite useful life

¶7-860

V Valuation inventory

¶6-500

— comparison of valuation methods

¶6-560

— first-in, first-out (FIFO)

¶6-520

— retail method

¶6-550

— specific identification

¶6-510

— standard cost

¶6-540

— weighted average cost

¶6-530

Vertical analysis

¶8-200

common size statements

¶8-250

W Weighted average cost of inventory valuation

¶6-530

Worksheet

¶3-400