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Understanding accounting principles [7th edition.]
 9781927248140, 1927248140

Table of contents :
Full Title
Copyright
About the authors
Preface
Table of Contents
Chapter 1 Accounting and the New Zealand business environment
1.1 Introduction
1.2 Accounting — a personal view
1.2.1 Xero Limited as a case study
1.2.2 Business history — what is business about?
1.2.3 What is accounting?
1.3 Financial accounting — a professional view
1.3.1 What is financial accounting?
1.3.2 Development of accounting practice — accounting as a profession
1.3.3 Development of accounting practice — legal impacts
1.3.4 Development of accounting practice — taxation impacts
1.3.5 Development of accounting practice — the New Zealand Framework
1.3.6 Objectives, assumptions, and qualitative characteristics of financial statements
1.4 Preliminary look at financial reports
1.4.1 Balance sheet
1.4.2 Statement of changes in equity
1.4.3 Income statement
1.4.4 Statement of cash flows
1.4.5 Notes to the accounts
1.5 Management accounting
1.5.1 Tasks of management accountants
1.5.2 Management accounting failures
1.6 Limitations of accounting
1.7 Conclusion
1.8 Key words 1
1.9 Resource file 1
1.9.1 Accounting scandals
1.9.2 Comparisons
1.9.3 Goods and services tax
1.9.4 Purpose of business
1.10 Mastering accounting — questions
1.10.1 Short answer questions
1.10.2 Paragraph answers
1.10.3 Discussion questions
1.10.4 Writing exercise
1.11 Mastering accounting — solutions
1.11.1 Short answer questions
1.11.2 Paragraph answers
Chapter 2 Starting up a business
2.1 Introduction
2.1.1 Case study — Tearaway Paper Recycling
2.1.2 Considerations for business start up
2.2 Most common forms of business ownership
2.2.1 Partnerships
2.2.2 Companies
2.2.3 Sole traders
2.2.4 Some questions for discussion in relation to the case study
2.3 Business professional view
2.3.1 A closer look at the resourcing decision — long-term view
2.3.2 A closer look at the resourcing decision — working capital
2.3.3 The circulation of resources
2.3.4 A closer look at profit
2.4 An information system — the accounting equation
2.4.1 What does the accounting equation tell us?
2.4.2 Changes in the accounting equation
2.4.3 Placing values on assets and liabilities
2.4.4 Purchasing assets
2.5 Detailing what happens in the owner’s equity section
2.6 Conclusion
2.7 Key words 2
2.8 Resource file 2
2.8.1 Case study — Wade Waiwater: A change in the wind … from crew to skipper
2.8.2 Accounting policies
2.9 Mastering accounting — questions
2.9.1 Short answer questions
2.9.2 Paragraph answers
2.9.3 Discussion questions
2.9.4 Research assignments
2.9.5 Internet exercise
2.10 Mastering accounting — solutions
2.10.1 Short answer questions
2.10.2 Paragraph answers
2.10.3 Discussion questions
Chapter 3 Determining profit
3.1 Introduction
3.1.1 Case study — Welkom Enterprises expands … so do the profits
3.1.2 Some questions for discussion
3.2 Transactions affecting owner’s equity — a professional view
3.2.1 Selling a service
3.2.2 Selling a service for cash
3.2.3 Selling services on credit
3.2.4 Bad debts
3.2.5 Providing for doubtful debts
3.2.6 Prudence — a degree of caution
3.2.7 Encouraging prompt payment
3.2.8 Attracting new clients
3.2.9 Paying expenses
3.2.10 Effect of GST on the accounting equation
3.2.11 Analysing a range of transactions
3.3 Preparing an income statement
3.3.1 Making adjustments to revenue and expenses
3.3.2 Accrued expenses
3.3.3 Prepaid expenses
3.3.4 Income received in advance
3.3.5 Accrued income
3.4 Accounting for inventories
3.4.1 Physical inventory system
3.4.2 Perpetual inventory system
3.5 Capital and revenue expenditure
3.5.1 Capital expenditure
3.5.2 Revenue expenditure
3.5.3 How do we make the right decision?
3.6 Sorting out our accounting system — a chart of accounts
3.6.1 Classification in the income statement and balance sheet
3.6.2 Classification as a means of decision making
3.6.3 Aiming for consistency
3.7 The impact of information technology
3.8 Conclusion
3.9 Key words 3
3.10 Resource file 3
3.10.1 Case study — Jones’s hire services
3.10.2 Case study — NZ Catering Supplies Ltd: An example of business failure
3.11 Mastering accounting — questions
3.11.1 Short answer questions
3.11.2 Problems
3.11.3 Discussion questions
3.11.4 Research assignments
3.11.5 Integrated case — NZ Catering Supplies Ltd: An example of business failure
3.12 Mastering accounting — solutions
3.12.1 Short answer questions
3.12.2 Problems
Chapter 4 Issues in income determination and asset valuation
4.1 Introduction
4.2 Making accounting decisions
4.2.1 Introduction
4.2.2 Case study — new tools … new ways of measuring
4.3 Recognition of revenue and expenses
4.4 Depreciation of property, plant, and equipment
4.4.1 Case study — the working life of a photocopier
4.4.2 What happens when you buy an asset — the recording system
4.4.3 A word or two about estimates
4.4.4 Allocating the depreciable amount
4.4.5 Which method should be used?
4.4.6 How do we disclose depreciation in the accounts?
4.4.7 Taxation law and taxation rates of depreciation
4.4.8 What are the effects of providing for depreciation in the accounts?
4.4.9 A case study — Taghi Derhamy
4.5 Valuation of inventories
4.5.1 What value should be allocated to inventory?
4.5.2 What if the inventory has deteriorated or become obsolete?
4.5.3 What if inventory is acquired at different prices?
4.5.4 How do we disclose inventory valuation in the notes?
4.6 Valuation of accounts receivable
4.6.1 Allowance for doubtful debts
4.6.2 How do we arrive at the figure for doubtful debts?
4.6.3 How important is it to take doubtful debts into account?
4.7 The statement of accounting policies
4.8 Conclusion
4.9 Key words 4
4.10 Resource file 4
4.10.1 Extracts from accounting policies
4.10.2 IRD tax tables — computer equipment
4.10.3 Articles discussing the enticement costs of selling cellphones
4.10.4 Determination of profit — Shoeshine
4.11 Mastering accounting — questions
4.11.1 Short answer questions
4.11.2 Problems
4.11.3 Discussion questions
4.11.4 Research question
4.12 Mastering accounting — solutions
4.12.1 Short answer questions
4.12.2 Problems
Chapter 5 Tracking cash and controlling assets
5.1 Introduction
5.1.1 Outline
5.1.2 Case study — Spacemakers Hardware Ltd
5.2 Tracking cash
5.2.1 Elements of a cash flow forecast
5.2.2 Managing shortfalls
5.3 Internal control
5.3.1 Taking control
5.3.2 Modern tools to help internal control — the use of technology
5.4 Statement of cash flows
5.4.1 Description of a statement of cash flows
5.4.2 Preparation of a statement of cash flows
5.5 Conclusion
5.6 Key words 5
5.7 Resource file 5
5.7.1 Cash cycle article — money makes the world go round…
5.7.2 Fraud article — fraudsters a simple, sad bunch
5.7.3 More on internal accounting controls — white collar crime: Cooking the books in corporate us
5.7.4 More on fraud — David Ross gets 10 years, 10 months jail
5.7.5 Internal control — internet resources
5.8 Mastering accounting — questions
5.8.1 Short answer questions
5.8.2 Paragraph answers
5.8.3 Cash flow forecast
5.8.4 Internal control
5.8.5 Statement of cash flows
5.9 Mastering accounting — solutions
5.9.1 Short answer questions
5.9.2 Paragraph answers
5.9.3 Cash flow forecast
5.9.4 Internal control
5.9.5 Statement of cash flows
Chapter 6 The internal focus
6.1 Introduction
6.2 Planning for the future — an owner’s view
6.2.1 Case study — Spacemakers Hardware Ltd
6.2.2 Questions for discussion
6.3 Planning for the future — a professional’s view
6.3.1 Purpose of budgeting
6.3.2 Approaches to budgeting
6.3.3 Budgeting — behavioural issues
6.3.4 Handling uncertainty
6.3.5 Example — revenue and expenditure budget for Spacemakers Hardware
6.3.6 So how did we do?
6.4 How costs behave
6.5 Breakeven and beyond
6.6 Allowing flexibility in our budget process
6.6.1 Fixed versus flexible budgets
6.6.2 Preparing a flexible budget
6.7 Conclusion
6.8 Key words 6
6.9 Resource file 6
6.9.1 Formula — target profit after tax
6.9.2 Internet resources
6.10 Mastering accounting — questions
6.10.1 Short answer questions
6.10.2 Problems
6.10.3 Discussion questions
6.11 Mastering accounting — solutions
6.11.1 Short answer questions
6.11.2 Problems
Chapter 7 Analysing financial reports
7.1 Introduction
7.2 Case study — Uniforms Renewed
7.3 Analysing and interpreting — the professional view
7.3.1 Non-monetary facts
7.3.2 Economic events
7.3.3 So what do the financial statements tell us?
7.4 Analysing the balance sheet
7.4.1 Short-term solvency — working capital
7.4.2 Short-term solvency — a closer look
7.5 How do we analyse and interpret financial data?
7.5.1 Working capital ratio
7.5.2 Liquidity ratio
7.6 Analysing the statement of cash flows
7.7 Non-cash current assets — some efficiency measures
7.7.1 Rate of stock turn
7.7.2 Age of debtors
7.7.3 Other factors affecting short-term solvency
7.7.4 Concluding comments
7.8 Creditworthiness — how risky is it to lend to an entity?
7.8.1 Proprietorship and debt/equity ratios
7.8.2 Undercapitalisation and overcapitalisation
7.8.3 Capital gearing
7.8.4 Applying the solvency test
7.8.5 Other considerations for lenders
7.9 Profitability — how well did the business perform?
7.9.1 Return on investment
7.9.2 Return on assets
7.9.3 So what causes profit to change?
7.9.4 Changes in sales
7.9.5 Gross profit percentage
7.9.6 Expense percentages
7.9.7 Net profit percentage
7.10 Links between ratios
7.11 Valuing a share market investment
7.11.1 Closing quotes
7.11.2 Dividends per share
7.11.3 Earnings per share
7.11.4 Dividend yield
7.11.5 Price/earnings ratio
7.12 Conclusion
7.13 Key words 7
7.14 Resource file 7
7.14.1 Ratio analysis — a quick reference guide
7.14.2 Analysing financial reports — internet resources
7.14.3 Spacemakers Hardware Ltd
7.14.4 Accounting standards’ impact on earnings
7.15 Mastering accounting — questions
7.15.1 Short answer questions
7.15.2 Problems
7.15.3 Research exercise
7.16 Mastering accounting — solutions
7.16.1 Short answer questions
7.16.2 Problems
Appendix 1 Extracts from Xero Limited’s 2013 Annual Report
Appendix 2 The accounting cycle — journals and ledgers
A2.1 The accounting cycle
A2.2 Case study — Welkom Enterprises
A2.3 The accounting system
A2.3.1 Source documents
A2.3.2 Chart of accounts
A2.3.3 A set of books
A2.4 Journal entries
A2.5 Posting to the ledger
A2.6 Other journals
A2.7 Subsidiary ledgers
A2.8 Internal control — reconciliations
A2.9 Key words A2
A2.10 Resource file A2
A2.10.1 Solution — Welkom Enterprises
A2.10.2 Solution — Crosby & Co
A2.11 Mastering accounting — questions
A2.11.1 Tom Jones trading as Shy Lock
A2.11.2 Broke Ltd
A2.11.3 Aimless Accountancy Services
A2.11.4 A Starter
A2.12 Mastering accounting — solutions
A2.12.1 Tom Jones trading as Shy Lock
A2.12.2 Broke Ltd
A2.12.3 Aimless Accountancy Services
A2.12.4 A Starter
Appendix 3 NZQA unit standards for accounting
Appendix 4 NZQA prescription for Accounting Principles
Glossary
Index

Citation preview

Understanding Accounting Principles Seventh edition

Colleen Fisher MBS (Massey) Senior Lecturer, Manukau Institute of Technology

Jon Moses MCom (Hons), CA, FCIS, FFIN, M Ins Directors Senior Lecturer, Manukau Institute of Technology

LexisNexis NZ Limited Wellington

2014

LexisNexis NEW ZEALAND LexisNexis, PO Box 472, WELLINGTON AUSTRALIA LexisNexis Butterworths, SYDNEY ARGENTINA LexisNexis Argentina, BUENOS AIRES AUSTRIA LexisNexis Verlag ARD Orac GmbH & Co KG, VIENNA BRAZIL LexisNexis Latin America, SAO PAULO CANADA LexisNexis Canada, Markham, ONTARIO CHILE LexisNexis Chile, SANTIAGO CHINA LexisNexis China, BEIJING, SHANGHAI CZECH REPUBLIC Nakladatelství Orac sro, PRAGUE FRANCE LexisNexis SA, PARIS GERMANY LexisNexis Germany, FRANKFURT HONG KONG LexisNexis Hong Kong, HONG KONG HUNGARY HVG-Orac, BUDAPEST INDIA LexisNexis, NEW DELHI ITALY Dott A Giuffrè Editore SpA, MILAN JAPAN LexisNexis Japan KK, TOKYO KOREA LexisNexis, SEOUL MALAYSIA LexisNexis Malaysia Sdn Bhd, PETALING JAYA, SELANGOR POLAND Wydawnictwo Prawnicze LexisNexis, WARSAW SINGAPORE LexisNexis, SINGAPORE SOUTH AFRICA LexisNexis Butterworths, DURBAN

SWITZERLAND Staempfli Verlag AG, BERNE TAIWAN LexisNexis, TAIWAN UNITED KINGDOM LexisNexis UK, LONDON, EDINBURGH USA LexisNexis Group, New York, NEW YORK LexisNexis, Miamisburg, OHIO National Library of New Zealand Cataloguing-in-Publication Data Fisher, Colleen. Understanding Accounting Principles 7th edition. Previous ed: 2010. Includes index. ISBN 978-1-927248-14-0 (pbk). 978-1-927248-44-7 (ebk). I. Accounting. II. Moses, Jon. II. Series: Understanding series. 657.044—dc 23 Copyright © 2014 LexisNexis NZ Limited. All rights reserved. This book is entitled to the full protection given by the Copyright Act 1994 to the holders of the copyright, and reproduction of any substantial passage from the book except for the educational purposes specified in that Act is a breach of the copyright of the author and/or publisher. This copyright extends to all forms of photocopying and any storing of material in any kind of information retrieval system. All applications for reproduction in any form should be made to the publishers. Disclaimer Understanding Accounting Principles has been written, edited and published and is sold on the basis that all parties involved in the publication exclude any liability, including negligence or defamation, for all or any damages or liability in respect of or arising out of use, reliance or otherwise of this book. The book should not be resorted to as a substitute for professional research or advice for any purpose. Enquiries should be addressed to the publishers. Visit LexisNexis NZ at www.lexisnexis.co.nz

About the authors

Colleen Fisher currently lives in Auckland with her husband and enjoys the company of her two adult children. She studied for the professional accounting exams on a part-time basis during the 1970s and ’80s while teaching at secondary school level. After she joined Manukau Institute of Technology, she completed her Bachelor of Business (Accounting) degree there, and obtained her Master of Business Studies from Massey University. Colleen was involved in running a successful building business with her husband for twenty-five years, where she was responsible for the administrative side of the business, including the preparation of the business accounts. This provided many practical accounting and taxation examples to use in her teaching. Colleen is currently a senior lecturer at Manukau Institute of Technology and specialises in teaching all levels of financial accounting. She has recently stepped down from being the programme leader for the Bachelor of Business degree at MIT, but still enjoys the challenge of teaching accounting as well as travelling. Jon Moses was born in Auckland and obtained his Master of Commerce (Hons) from Auckland University. He commenced his employment with a firm of chartered accountants in Auckland and subsequently travelled extensively. He worked in London in a variety of accounting jobs, including in the commodity futures industry at its inception in England. After travelling extensively throughout Asia, he returned to New Zealand and worked as an

accountant in industry and thereafter as a chartered accountant. After venturing into the corporate banking arena, he returned to the commercial accounting sector, working as a financial controller and company secretary for several large listed companies. After a major accident in 1989, which required a year of recovery, Jon joined the education sector and has worked as a senior lecturer at Manukau Institute of Technology since 1990, specialising in financial accounting, finance, and banking. Jon resides in Auckland with his wife and adult son. He remains a chartered accountant and holds several other professional qualifications.

Preface

This seventh edition of Understanding Accounting Principles introduces a new author, Jon Moses, in addition to the lead author, Colleen Fisher. Jon is a senior lecturer at Manukau Institute of Technology and brings a wealth of experience in the areas of financial accounting, finance, and management accounting. Before Jon entered the education sector, he was a chartered secretary and financial controller for several large companies in New Zealand and worked in the corporate banking sector. He also worked as a chartered accountant for PriceWaterhouse Coopers and Ernst & Young, and owns and operates an investment portfolio with his wife. While accounting principles is a core topic for most business diploma and degree programmes, not all students will go on to study accounting in depth. The approach of Understanding Accounting Principles is to cater for students ranging from those who want to undertake a tourism or management or marketing option, to those who wish to continue to major in accounting. Therefore, multiple learning needs must be met. The book focuses on both the preparer and user of accounting information, with the link between correct classification and presentation of data, to the ability to analyse and use the accounting information for decision-making processes, being crucial. In Appendix 3, we list the updated standards issued by the New Zealand Qualifications Authority (NZQA) for accounting and set out where the

various unit standards are covered in this book. A copy of the prescription for Accounting Principles 500, as prescribed by NZQA for the New Zealand Diploma in Business, has been included as Appendix 4, the learning outcomes of which are all encompassed in this book. This edition includes updates of the current requirements of the NZ Framework, and provides relevant information on the preparation and presentation of financial statements. While the examples provided are more appropriate for students’ first exposure to accounting, they are nonetheless sufficiently advanced for students continuing further with their accounting studies. Appendix 2, which details the practical components of the accounting cycle (journals and ledgers), remains. We have retained Chapter 6, which was developed for the sixth edition to focus on cash management, the statement of cash flows, and relevant internal control processes. This was in response to user comments, and also recognised the continuing relevance of economic management post the 2007 global financial crisis, which has gradually improved in most parts of the world, but continues to cause problems for some countries in the OECD. This increased focus on cash flow reporting also reinforces the changing nature of accounting practice. As with previous editions, we have continued to deal with accounting concepts in a practical way. The concepts are equally useful for business people seeking a greater understanding of accounting and financial issues, as for those wanting to continue with the practice of accounting. The aim of this book is to focus on the skills required to become a business professional through the use of real or realistic case studies. Business professionals need a clear conceptual framework within which to work. Consequently, we work towards developing a sound accounting and decision-making knowledge base and, in addition, aim to foster a wide variety of the skills necessary for potential future business professionals. To achieve this level of skills, we have included a range of tasks and activities to develop students’ communication skills (written, oral, reading,

and negotiating), critical thinking, and problem solving. Teaching resources provided with this edition also work towards developing students’ comprehension of accounting principles, particularly within an accounting and business context. In each chapter, key words files contain definitions for key concepts and resource files contain further case studies, articles, reports, and other material which add depth to the text and breadth to the concepts covered. We have endeavoured to provide up to date articles to illustrate points. Where we have referred to older articles, it has been because we feel that the article is still pertinent and relevant. In reading the resource files, students will come to appreciate the complexity of the various topics, and start to see the complex interrelationships between business needs for accounting information; they will see the practical application of concepts to real business situations. Students will also appreciate and understand how decisions impact on peoples’ lives or the life of the business, and get a feel for the ethical considerations, which have become an important factor in producing and reporting financial information, and are required to run a successful business. In order to deal with problems posed, students will need to select relevant information from the key words and resource files, as well as review the concepts in the particular chapter. They may also need to search for information using various sources, such as libraries, online data bases, internet, journals, or appropriate news articles. We have tried not to compartmentalise the development of concepts or the tasks set. Where students have to communicate the results, the audience is defined so that they can choose the appropriate level or method of communication for the particular audience. For example, they may be asked to write a letter to a client or to the newspaper, or to draft notes for a talk to the class or a local industry group. We have aimed to provide an accounting text, which challenges both the demonstrator and the student to reflect on the reality of accounting. We acknowledge that no text book, whether it be introductory or advanced, can

attempt to cover every detail of a curriculum in the way that an individual lecturer covers it. What we have intended to do is provide enough variables and resources to build critical thinking and problem-solving skills, so as to enable a student to easily transition to the workplace having some vital understanding of the world of accounting. On a personal basis, we both wish to thank our families for their support in allowing us to spend time on producing this latest edition of Understanding Accounting Principles. We also wish to acknowledge our Publisher, LexisNexis, and our editors, Alex Wakelin, Jeanette Maree, and their team. Colleen Fisher

Jon Moses

September 2014

September 2014

Contents

Detailed contents About the authors Preface Chapter 1 Accounting and the New Zealand business environment Chapter 2 Starting up a business Chapter 3 Determining profit Chapter 4 Issues in income determination and asset valuation Chapter 5 Tracking cash and controlling assets Chapter 6 The internal focus Chapter 7 Analysing financial reports Appendix 1 Extracts from Xero Limited’s 2013 Annual Report Appendix 2 The accounting cycle — journals and ledgers Appendix 3 NZQA unit standards for accounting Appendix 4 NZQA prescription for Accounting Principles Glossary Index

Detailed contents

Contents About the authors Preface Chapter 1 Accounting and the New Zealand business environment 1.1 Introduction 1.2 Accounting — a personal view 1.2.1 Xero Limited as a case study 1.2.2 Business history — what is business about? 1.2.3 What is accounting? 1.3 Financial accounting — a professional view 1.3.1 What is financial accounting? 1.3.2 Development of accounting practice — accounting as a profession 1.3.3 Development of accounting practice — legal impacts 1.3.4 Development of accounting practice — taxation impacts 1.3.5 Development of accounting practice — the New Zealand Framework 1.3.6 Objectives, assumptions, and qualitative characteristics of financial statements

1.4

1.5

1.6 1.7 1.8 1.9

1.10

1.11

Preliminary look at financial reports 1.4.1 Balance sheet 1.4.2 Statement of changes in equity 1.4.3 Income statement 1.4.4 Statement of cash flows 1.4.5 Notes to the accounts Management accounting 1.5.1 Tasks of management accountants 1.5.2 Management accounting failures Limitations of accounting Conclusion Key words 1 Resource file 1 1.9.1 Accounting scandals 1.9.2 Comparisons 1.9.3 Goods and services tax 1.9.4 Purpose of business Mastering accounting — questions 1.10.1 Short answer questions 1.10.2 Paragraph answers 1.10.3 Discussion questions 1.10.4 Writing exercise Mastering accounting — solutions 1.11.1 Short answer questions 1.11.2 Paragraph answers

Chapter 2 Starting up a business 2.1 Introduction 2.1.1 Case study — Tearaway Paper Recycling

2.2

2.3

2.4

2.5 2.6 2.7 2.8

2.9

2.1.2 Considerations for business start up Most common forms of business ownership 2.2.1 Partnerships 2.2.2 Companies 2.2.3 Sole traders 2.2.4 Some questions for discussion in relation to the case study Business professional view 2.3.1 A closer look at the resourcing decision — long-term view 2.3.2 A closer look at the resourcing decision — working capital 2.3.3 The circulation of resources 2.3.4 A closer look at profit An information system — the accounting equation 2.4.1 What does the accounting equation tell us? 2.4.2 Changes in the accounting equation 2.4.3 Placing values on assets and liabilities 2.4.4 Purchasing assets Detailing what happens in the owner’s equity section Conclusion Key words 2 Resource file 2 2.8.1 Case study — Wade Waiwater: A change in the wind … from crew to skipper 2.8.2 Accounting policies Mastering accounting — questions 2.9.1 Short answer questions 2.9.2 Paragraph answers 2.9.3 Discussion questions

2.10

2.9.4 Research assignments 2.9.5 Internet exercise Mastering accounting — solutions 2.10.1 Short answer questions 2.10.2 Paragraph answers 2.10.3 Discussion questions

Chapter 3 Determining profit 3.1 Introduction 3.1.1 Case study — Welkom Enterprises expands … so do the profits 3.1.2 Some questions for discussion 3.2 Transactions affecting owner’s equity — a professional view 3.2.1 Selling a service 3.2.2 Selling a service for cash 3.2.3 Selling services on credit 3.2.4 Bad debts 3.2.5 Providing for doubtful debts 3.2.6 Prudence — a degree of caution 3.2.7 Encouraging prompt payment 3.2.8 Attracting new clients 3.2.9 Paying expenses 3.2.10 Effect of GST on the accounting equation 3.2.11 Analysing a range of transactions 3.3 Preparing an income statement 3.3.1 Making adjustments to revenue and expenses 3.3.2 Accrued expenses 3.3.3 Prepaid expenses 3.3.4 Income received in advance

3.4

3.5

3.6

3.7 3.8 3.9 3.10

3.11

3.12

3.3.5 Accrued income Accounting for inventories 3.4.1 Physical inventory system 3.4.2 Perpetual inventory system Capital and revenue expenditure 3.5.1 Capital expenditure 3.5.2 Revenue expenditure 3.5.3 How do we make the right decision? Sorting out our accounting system — a chart of accounts 3.6.1 Classification in the income statement and balance sheet 3.6.2 Classification as a means of decision making 3.6.3 Aiming for consistency The impact of information technology Conclusion Key words 3 Resource file 3 3.10.1 Case study — Jones’s hire services 3.10.2 Case study — NZ Catering Supplies Ltd: An example of business failure Mastering accounting — questions 3.11.1 Short answer questions 3.11.2 Problems 3.11.3 Discussion questions 3.11.4 Research assignments 3.11.5 Integrated case — NZ Catering Supplies Ltd: An example of business failure Mastering accounting — solutions 3.12.1 Short answer questions 3.12.2 Problems

Chapter 4 Issues in income determination and asset valuation 4.1 Introduction 4.2 Making accounting decisions 4.2.1 Introduction 4.2.2 Case study — new tools … new ways of measuring 4.3 Recognition of revenue and expenses 4.4 Depreciation of property, plant, and equipment 4.4.1 Case study — the working life of a photocopier 4.4.2 What happens when you buy an asset — the recording system 4.4.3 A word or two about estimates 4.4.4 Allocating the depreciable amount 4.4.5 Which method should be used? 4.4.6 How do we disclose depreciation in the accounts? 4.4.7 Taxation law and taxation rates of depreciation 4.4.8 What are the effects of providing for depreciation in the accounts? 4.4.9 A case study — Taghi Derhamy 4.5 Valuation of inventories 4.5.1 What value should be allocated to inventory? 4.5.2 What if the inventory has deteriorated or become obsolete? 4.5.3 What if inventory is acquired at different prices? 4.5.4 How do we disclose inventory valuation in the notes? 4.6 Valuation of accounts receivable 4.6.1 Allowance for doubtful debts 4.6.2 How do we arrive at the figure for doubtful debts? 4.6.3 How important is it to take doubtful debts into account?

4.7 4.8 4.9 4.10

4.11

4.12

The statement of accounting policies Conclusion Key words 4 Resource file 4 4.10.1 Extracts from accounting policies 4.10.2 IRD tax tables — computer equipment 4.10.3 Articles discussing the enticement costs of selling cellphones 4.10.4 Determination of profit — Shoeshine Mastering accounting — questions 4.11.1 Short answer questions 4.11.2 Problems 4.11.3 Discussion questions 4.11.4 Research question Mastering accounting — solutions 4.12.1 Short answer questions 4.12.2 Problems

Chapter 5 Tracking cash and controlling assets 5.1 Introduction 5.1.1 Outline 5.1.2 Case study — Spacemakers Hardware Ltd 5.2 Tracking cash 5.2.1 Elements of a cash flow forecast 5.2.2 Managing shortfalls 5.3 Internal control 5.3.1 Taking control 5.3.2 Modern tools to help internal control — the use of technology

5.4

5.5 5.6 5.7

5.8

5.9

Statement of cash flows 5.4.1 Description of a statement of cash flows 5.4.2 Preparation of a statement of cash flows Conclusion Key words 5 Resource file 5 5.7.1 Cash cycle article — money makes the world go round… 5.7.2 Fraud article — fraudsters a simple, sad bunch 5.7.3 More on internal accounting controls — white collar crime: Cooking the books in corporate us 5.7.4 More on fraud — David Ross gets 10 years, 10 months jail 5.7.5 Internal control — internet resources Mastering accounting — questions 5.8.1 Short answer questions 5.8.2 Paragraph answers 5.8.3 Cash flow forecast 5.8.4 Internal control 5.8.5 Statement of cash flows Mastering accounting — solutions 5.9.1 Short answer questions 5.9.2 Paragraph answers 5.9.3 Cash flow forecast 5.9.4 Internal control 5.9.5 Statement of cash flows

Chapter 6 The internal focus 6.1 Introduction 6.2 Planning for the future — an owner’s view 6.2.1 Case study — Spacemakers Hardware Ltd

6.3

6.4 6.5 6.6

6.7 6.8 6.9

6.10

6.11

6.2.2 Questions for discussion Planning for the future — a professional’s view 6.3.1 Purpose of budgeting 6.3.2 Approaches to budgeting 6.3.3 Budgeting — behavioural issues 6.3.4 Handling uncertainty 6.3.5 Example — revenue and expenditure budget for Spacemakers Hardware 6.3.6 So how did we do? How costs behave Breakeven and beyond Allowing flexibility in our budget process 6.6.1 Fixed versus flexible budgets 6.6.2 Preparing a flexible budget Conclusion Key words 6 Resource file 6 6.9.1 Formula — target profit after tax 6.9.2 Internet resources Mastering accounting — questions 6.10.1 Short answer questions 6.10.2 Problems 6.10.3 Discussion questions Mastering accounting — solutions 6.11.1 Short answer questions 6.11.2 Problems

Chapter 7 Analysing financial reports 7.1 Introduction

7.2 7.3

7.4

7.5

7.6 7.7

7.8

7.9

Case study — Uniforms Renewed Analysing and interpreting — the professional view 7.3.1 Non-monetary facts 7.3.2 Economic events 7.3.3 So what do the financial statements tell us? Analysing the balance sheet 7.4.1 Short-term solvency — working capital 7.4.2 Short-term solvency — a closer look How do we analyse and interpret financial data? 7.5.1 Working capital ratio 7.5.2 Liquidity ratio Analysing the statement of cash flows Non-cash current assets — some efficiency measures 7.7.1 Rate of stock turn 7.7.2 Age of debtors 7.7.3 Other factors affecting short-term solvency 7.7.4 Concluding comments Creditworthiness — how risky is it to lend to an entity? 7.8.1 Proprietorship and debt/equity ratios 7.8.2 Undercapitalisation and overcapitalisation 7.8.3 Capital gearing 7.8.4 Applying the solvency test 7.8.5 Other considerations for lenders Profitability — how well did the business perform? 7.9.1 Return on investment 7.9.2 Return on assets 7.9.3 So what causes profit to change? 7.9.4 Changes in sales 7.9.5 Gross profit percentage

7.10 7.11

7.12 7.13 7.14

7.15

7.16

7.9.6 Expense percentages 7.9.7 Net profit percentage Links between ratios Valuing a share market investment 7.11.1 Closing quotes 7.11.2 Dividends per share 7.11.3 Earnings per share 7.11.4 Dividend yield 7.11.5 Price/earnings ratio Conclusion Key words 7 Resource file 7 7.14.1 Ratio analysis — a quick reference guide 7.14.2 Analysing financial reports — internet resources 7.14.3 Spacemakers Hardware Ltd 7.14.4 Accounting standards’ impact on earnings Mastering accounting — questions 7.15.1 Short answer questions 7.15.2 Problems 7.15.3 Research exercise Mastering accounting — solutions 7.16.1 Short answer questions 7.16.2 Problems

Appendix 1 Extracts from Xero Limited’s 2013 Annual Report Appendix 2 The accounting cycle — journals and ledgers A2.1 The accounting cycle A2.2 Case study — Welkom Enterprises A2.3 The accounting system

A2.3.1

Source documents

A2.3.2 Chart of accounts A2.3.3 A set of books A2.4 Journal entries A2.5 Posting to the ledger A2.6 Other journals A2.7 Subsidiary ledgers A2.8 Internal control — reconciliations A2.9 Key words A2 A2.10 Resource file A2 A2.10.1 Solution — Welkom Enterprises A2.10.2 Solution — Crosby & Co A2.11 Mastering accounting — questions A2.11.1 Tom Jones trading as Shy Lock A2.11.2 Broke Ltd A2.11.3 Aimless Accountancy Services A2.11.4 A Starter A2.12 Mastering accounting — solutions A2.12.1 Tom Jones trading as Shy Lock A2.12.2 Broke Ltd A2.12.3 Aimless Accountancy Services A2.12.4 A Starter Appendix 3 NZQA unit standards for accounting Appendix 4 NZQA prescription for Accounting Principles Glossary Index

[page 1]

Accounting and the New Zealand business environment

CHAPTER

1

Contents Learning outcomes 1.1

Introduction

1.2

Accounting — a personal view 1.2.1 Xero Limited as a case study 1.2.2 Business history — what is business about? 1.2.3 What is accounting?

1.3

Financial accounting — a professional view 1.3.1 What is financial accounting? 1.3.2 Development of accounting practice — accounting as a profession

1.3.3 1.3.4 1.3.5 1.3.6 1.4

Development of accounting practice — legal impacts Development of accounting practice — taxation impacts Development of accounting practice — the New Zealand Framework Objectives, assumptions, and qualitative characteristics of financial statements

Preliminary look at financial reports 1.4.1 Balance sheet 1.4.2 Statement of changes in equity 1.4.3 Income statement 1.4.4 Statement of cash flows 1.4.5 Notes to the accounts [page 2]

1.5

Management accounting 1.5.1 Tasks of management accountants 1.5.2 Management accounting failures

1.6

Limitations of accounting

1.7

Conclusion

1.8

Key words 1

1.9

Resource file 1 1.9.1 Accounting scandals 1.9.2 Comparisons 1.9.3 Goods and services tax 1.9.4 Purpose of business

1.10

Mastering accounting — questions 1.10.1 Short answer questions

1.10.2 Paragraph answers 1.10.3 Discussion questions 1.10.4 Writing exercise 1.11

Mastering accounting — solutions 1.11.1 Short answer questions 1.11.2 Paragraph answers [page 3]

Learning outcomes After completing this chapter, you should be able to: understand the purpose of accounting and its relationship to the New Zealand business environment; explain some of the relationships between accounting, the legal system, and business activity; explain the impact of the accounting profession on how accounting is carried out; explain the impact of goods and services tax (GST) on business; understand the importance of the NZ Framework for the preparation and presentation of financial statements in order to: – explain the qualitative characteristics of accounting information; –

explain the purpose of the balance sheet;



explain the purpose of the income statement;



explain the purpose of the statement of changes in equity;



explain the purpose of the statement of cash flows; and

recognise and use appropriate (NZ Framework) definitions when preparing accounting information.

1.1

Introduction

Q:

If an accountant’s wife can’t get to sleep, what does she say?

A:

“Tell me about work today, dear.”

Q:

What is the difference between a tragedy and a catastrophe?

A:

A tragedy is a ship full of accountants going down in a storm … A catastrophe is when they can all swim!

Q:

What is the definition of an accountant?

A:

Someone who solves a problem you did not know you had in a way you don’t understand.

With this kind of reputation, you would be forgiven for thinking that the study of accounting is of little or no practical benefit. Over the last 15 years, “accounting fraud” and the reputation of “Wall Street financiers” have served to further tarnish the standing of the accounting profession, and leave people with the impression that accounting provides no assistance to modern business, and is of even less use to the man in the street. While this may be the perception, reality is very different. It is the aim of this book to introduce you to the concepts of accounting in a way that is understandable to a person with little understanding of accounting, while at the same time providing a strong foundation for those who have an ambition to become professional accountants. The first question to be answered is: why study accounting? [page 4] You get to understand your financial position. Accountants prepare financial reports for their clients or their companies. But who is really

responsible for the financial reports? Who takes the blame if it goes wrong? It is not usually the accountant. Take the time to learn the basics of accounting so that, next time you see a financial report, you at least know what it is you are reading and it will not look and sound completely alien. It also makes it easier for your accountant to speak with you about the report. Let us face it, some businesses fail because of bad accounting. Refer to Resource file 1, paragraph 1.9.1.

You get to analyse the accounting impact of your major decisions. Accountants record transactions after they are done. They focus on the monetary impact of the decision making, and results are determined over a relatively short time. If the management understands accounting, or at least keeps in mind that any decisions it makes may have an accounting impact, the management may make better decisions. A business owner is able to understand the strengths and weaknesses of accounting as a business language. You get to understand your numbers. Why did sales increase? Why did expenses increase? Where did our money go? Why is cash decreasing when our business is profitable? These are just some of the questions asked of accountants when managers and business owners see the financial reports. An accounting student needs to understand which numbers, which analyses, and which outcomes are important to the success of business. As we move through this chapter, you will be introduced to the term profit and given a standard definition for it. When you read financial statements, you will discover a range of profit numbers. Use the Glossary towards the end of the book to find the definition of the term profit. Note that words in bold brown type are defined in the Glossary.

As you use this book, remember that studying accounting is not like reading a novel. Each chapter builds on previous chapters — if you study Chapter 2 half-heartedly, you may be confused by Chapter 3, and completely lost by Chapter 6. While we have made every effort to make the writing readable, every sentence is important.

Read to understand “why”. This is a technical subject — it is logical and it requires reasoning. If you can understand “why” in accounting, there is little to memorise. Try to explain every new topic in your own words. Relate what is in the book to your own understanding of how business operates. Work on problems to understand “how”. This is a do-it-yourself course. Accounting is about repetition and refining skills. Remember the “how” and “why”. Go back to your previous work to refresh your memory. Never wait until the examination to review your accounting — review as you go. The forgetting curve is the mirror image of the learning curve. You forget as fast as you learn. Use the resources — the resource files, key words, questions and solutions for each chapter, and Glossary towards the end of the book — to develop your understanding.

1.2

Accounting — a personal view

Throughout the book, we will try to present a distinctly New Zealand perspective of accounting. This is not to say that accounting in New Zealand is different or in some way separate from the international scene, but we do want to make accounting more relevant to a person living in New Zealand. [page 5]

1.2.1

XERO LIMITED AS A CASE STUDY

Read more about Xero Limited’s history and the type of accounting packages it sells at www.xero.com.

In this edition, we have chosen to focus on Xero Limited. There are a number of things which make this company particularly interesting for an accounting

or business student, including the fact that it is involved in selling cloud computing accounting packages, and that it has experienced a rapid rise in its share price in the past twelve months, followed by a sudden selling off of shares, resulting in the share price falling sharply during March/April 2014 on the New Zealand Stock Exchange. Refer to www.nzx.com.

Xero Limited is a New Zealand registered company, with offices in New Zealand, Australia, the United States, and the United Kingdom. It was first registered in 2006, and listed on the New Zealand Stock Exchange in June 2007, and on the Australian Securities Exchange in November 2012. The company provides online accounting software for small businesses to accountants and bookkeepers. Xero Limited is a SaaS (Software as a Service) software company, whose products are accessible directly from the cloud through a standard browser. The accounting software has been designed to be simple to use, and has been developed directly as a cloudbased system. It is attracting more and more customers each year. Xero Limited’s “eco-system” of add-on services is the key, as customers add on what they require to the basic accounting packages. In 2013, the company had 157,000 paying customers, compared to 78,000 in 2012. The stock symbol assigned to Xero Limited by the New Zealand Stock Exchange is XRO.

Over the past year, the share price of Xero Limited continued to grow, until a fall in the price in March 2014. On 12 April 2013, the share price was $11.30 per share, and it continued to increase until it reached a peak of $44.98 per share on 10 March 2014. By 8 April 2014, the share price had fallen to $31.50. When Xero Limited’s share price reached $41 on the New Zealand Stock Exchange, its market capitalisation was $5.3 billion, making it New Zealand’s second most valuable listed company behind Fletcher Building Limited. For the year ended 30 June 2013, Fletcher Building had annual revenue of around $8.5 billion, 18,830 workers, and was likely to produce earnings before interest and tax of $650 million. By comparison, Xero Limited had only $28.7

million in revenue over a six month period to 30 September 2013, 507 staff, and has never made a profit. (Bernard Hickey, “Cloud computing signals bright days for investors”, The Herald on Sunday, 10 November 2013.) Table 1.1 sets out the performance highlights included in Xero Limited’s 2013 Annual Report. Note that figures are given for three years, so that the reader can compare the changes that have taken place.

TABLE 1.1: XERO-LIMITED’S PERFORMANCE HIGHLIGHTS Performance highlights

12 months ended 31 March 2013

12 months ended 31 March 2012

12 months ended 31 March 2011

Operating revenue

$39.0 m

$19.4 m

$9.3 m

Net loss after tax

($14.4 m)

($7.9 m)

($7.6 m)

Cash at bank

$78.2 m

$39.0 m

$16.9 m

Paying business customers

157,000

78,000

36,000

Annualised committed monthly revenue

$51.5 m

$25.5 m

$13.0 m

Source: Xero Limited’s 2013 Annual Report

[page 6]

FIGURE 1.1: XERO LIMITED’S SHARE PRICE

Source: www.findata.co.nz

The operating revenue and net loss after tax are both important accounting performance measures for Xero Limited. You will be introduced to other performance measures during the course of this book. Business students need to recognise that they operate in an environment in which there are conflicting requirements for scarce resources. For example, how would a Xero Limited executive choose between making a profit, developing further software, or implementing more sustainable business practice? Xero Limited has focussed on growth of the number of customers and markets served, as well as releasing several major software updates.

1.2.2

BUSINESS HISTORY – WHAT IS BUSINESS ABOUT?

Over the centuries, critics have argued that people who engage in business are

selfish in their motivation, narrow in their interests, and instrumental in their behaviour. In fact, since the time of Aristotle and perhaps before, those setting up and engaging in business (trading, or manufacturing and selling goods or services for profit), have been disparaged. In the latter years of the 20th century, this view of business people was modified. The transformation in perspective can probably be laid at the doorstep of Milton Friedman and the Chicago School of Economics. Since the 1960s, they have promoted the view that the free market is the most important factor in the operation of the economy. For them, market theory (prices are set solely by supply and demand), is a fundamental reality and is a voluntary exchange (of money for goods and services, labour for wages, etc). They emphasise the freedom of the market, and claim that supply and demand analysis can be applied to all other institutions and non-economic areas of life, such as education, health, the family, crime, and law. The market, then, is the most efficient and equitable way of organising human activities. Within this framework, the role of government is to provide the legal arrangements that can contribute to viable markets. [page 7] Government policies should increase opportunities for private gain and consumer choices; beyond this, they should not interfere with the workings of the market. The Chicago School believes that the power and wealth of business (and personal wealth), is greatly exaggerated by critics. During the 1970s and 1980s, these theories found favour throughout the western world, when they were enthusiastically implemented by the governments of Margaret Thatcher in the United Kingdom, Ronald Reagan in the United States, and the 1984 Labour Government of David Lange in New Zealand. Now, in the 21st century, profit is acceptable as the defining purpose of business activity. In New Zealand, organisations such as schools and hospitals

which have other primary purposes (education and taking care of sick people), now allocate their scarce resources (funding) according to market principles. Everyone, it is claimed, benefits from businesses and other organisations being profitable. As well as shareholders receiving their share of profit in terms of dividends, lenders obtain their share in the form of interest and principal payments. Government takes a portion for taxation, workers take their share as salaries and bonuses, and consumers have a greater choice of cheaper goods or services. The growth of different forms of private enterprise from the late 1980s coupled with exponential growth, led to the dominance of what can be called global informational capitalism. This is characterised by business being increasingly dominated by multinational companies, which work around the clock and have little regard for geopolitical boundaries. This has meant that many New Zealand companies are listed on several stock exchanges (eg Telecom on the New Zealand, Australian, and US stock exchanges). The movement of share prices overseas is often reflected in share prices in New Zealand. For instance, in October 1987, after a period of continued growth, share prices dropped sharply on Wall Street in New York, and the New Zealand stock market followed. Many companies were over-extended, and many investors, often “mum and dad” investors, lost heavily as many companies went into liquidation. The global financial crisis occurred twenty years later in 2007, when investors in the USA lost confidence in the value of sub-prime mortgages. This impacted on countries throughout the world, and in New Zealand it caused a decline in business and consumer confidence. National and regional governments, like that of New Zealand, with historically-rooted political institutions and processes, are becoming more aware of the increasing dangers of environmental degradation and social exclusion caused by unregulated global markets. Governments like New Zealand’s are constrained because, on the one hand they promise to pursue national competitiveness by making New Zealand goods and services

cheaper, thereby encouraging exports, however, the processes for reaching any agreements on international action are very slow. The problem is that, if the claimed benefits of global capitalism are to be harmonised with the requirements of just and sustainable development, there is a critical need for a new sense of citizenship — the idea that business has a broader societal responsibility, or that the role of citizenship is strengthening. Nike is an example of a company which gained notoriety because of the use of low-cost labour in China, and which changed some of its manufacturing processes to accommodate public opinion. This part of Chapter 1 is designed to challenge simplistic views of what business is about. Accounting practices take place within a business context. The role of business in New Zealand society is complex and is influenced by overseas factors, such as the [page 8] World Trade Organization, the International Monetary Fund, World Bank policies, the rise and fall of interest rates in the United States, and changes in the buying patterns of overseas consumers of New Zealand products. There is no consensus, in New Zealand or anywhere else, about the role of small or big business. So business professionals (those who provide services such as accounting) must be aware of influences and all sides of the argument. Without a working knowledge of economics, the law, ethics, geography, history, politics, and information technology, it is difficult to understand what is going on in the business sector. In modern society, business decisions impact everyone, so it is important that the ways in which businesses operate are understood by all members of society. Business activities impinge heavily on our everyday life, for example: Consider what the aim of each of the listed businesses is.

Drury Soccer Club requires funding for soccer uniforms. We eat out at a local McDonald’s franchise. I donate cash to the Salvation Army. I pay rates to the local city council. My employer pays taxes on my behalf to the Inland Revenue Department. An old aunt has 1,000 shares in Vodafone New Zealand. My young brother attends a local school, where the school is owned by the government, but is operated by a board of trustees.

1.2.3

WHAT IS ACCOUNTING?

Accounting is primarily concerned with financial information, and the preparation and analysis of financial reports. As such, accounting deals with those aspects of business activities that can be expressed in monetary terms. In this part of Chapter 1, we introduce some of the concepts that underpin accounting as an activity, and we stress that accounting is more than a mere technical process. The technical processes are carried out to meet the needs of particular people (users). People use accounting information to help them make decisions, and business professionals are involved in explaining what the financial reports indicate in terms of past and possible future business activities. However, while accounting information is gathered and turned into reports which are essential to business decision making, it is not the only information that will be needed or that will be relevant. For example, the income statement may tell us how profitable our business has been, but it does not tell us how pleased our customers are with the service we have provided. Similarly, the balance sheet identifies our assets, but it does not record one of the prime assets of any business — the staff. It is important to acknowledge the limitations of the information generated by an accounting

system. It will not simply provide answers to our business problems; rather, it will be an aid in decision making. Let us explore a simple example to illustrate this. Suppose that, after your first year in business as a self-employed computer technician, you want to evaluate whether you should continue in business. Your accountant could prepare reports on the profitability and financial stability of the business. But what else is relevant to your decision making? How about factors like the quality of life (are you working long [page 9] hours, or a regular work week?), your feelings of security or insecurity about being self-employed, the psychological value of self-employment? In the end, these factors may cause you to quit a reasonably profitable business, or to soldier on with one that was only marginally successful from a financial perspective, because you enjoy the freedom and the challenge. Remember that accounting is helpful to business decision making, but can only provide answers if the question is purely a financial one. Even then, there may well be alternative courses of action that could be followed. Identify a multinational bank operating in New Zealand. What benefits do you receive from this company’s operations? How have you defined “benefit”?

Accounting has existed throughout history. In all societies, and at all stages of history, accounting systems have been used as a basis for planning, deciding, and controlling economic activity. It is reflective of society. For example, Egyptian society contained groups of people known as scribes, who recorded the movement of goods and services into and out of temples, and reported to the Pharaoh. The advancement of individual ownership in Europe during the Middle Ages, led to the concept of stewardship, in terms of which stewards (custodians or guardians) acted on behalf of the landowner, and were entrusted with the responsibility of keeping track of the day-to-day

economic activities. As trading between various communities increased in the late 15th century, new systems were required. A Franciscan monk, Luca Pacioli, published a book describing the procedures which had been developed to record these trading transactions. His book was the first to codify the technique of double entry bookkeeping. The Industrial Revolution of the 18th century advanced the discipline of accounting. Large-scale manufacturing entities replaced family businesses, and accountability of people within an organisation became an important function. As the size of these entities increased, so too the source of funds changed, and managers acted as stewards for external owners who provided the capital for the business. Accounting rules are becoming more complex for some reporting entities, and accounting information is required to meet the needs of an increasingly diverse range of users. A stakeholder is someone with a particular interest in the business.

The importance of accounting information to users has been recognised in company legislation and other forms of regulation. Considered historically, the purpose of accounting regulation is to protect society from poor quality financial statements. The relationship between accounting, business, and society has already been alluded to. In this book, we recognise that there are many groups of different stakeholders in the business, any of whom are likely to use accounting information. Each group of stakeholders has a vested interest, and this leads to the potential for conflict. For example, management may choose to present a lower profit figure, which limits tax liabilities; or present a higher profit figure, which ensures higher bonuses. Can you think of any other instances of where conflict may occur between groups of users?

A feature of modern economic organisation, in whatever form, is that owners do not always have direct control over the day-to-day running of the organisation. Managers need to account for the management of the business to the owners. To do this, they need to maintain accounting records of their financial transactions. These records form the basis of the statements of account, showing the results of the business. The records can also be used to

inform management about costs and revenues, which helps them with the day-to-day running of the business. The same records are able to provide information from managers to owners (financial accounting) and, at the same time, provide information that managers themselves can use (management accounting). In [page 10] many cases the same records are able to produce the information required for taxation purposes (taxation accounting).

1.3

1.3.1

Financial accounting — a professional view WHAT IS FINANCIAL ACCOUNTING?

A definition of accounting often cited is that given by the American Accounting Association, namely “Accounting is the process of identifying, measuring and communicating information to permit informed judgments and decisions by users of that information”. Generally, accounting activities dealing with external users are referred to as financial accounting. The rules surrounding financial accounting recognise that the users of this information do not have sufficient power to obtain the real answers that they might require. These users require the protections afforded by the law and the Financial Markets Authority (New Zealand). Financial accounting is concerned with accurately reporting what has happened — dealing with the past.

Accounting is usually seen as a technical subject, involving the recording and classifying of financial activities. The technical aspect of accounting is often referred to as the accounting cycle. The accounting cycle describes the routine steps in processing accounting data during an accounting period. In sequence, these steps are as follows: 1.

occurrence of the transaction, as evidenced by a source document — for example a tax invoice, credit note, bank statement, direct debit, or electronic transaction;

2.

classification of each transaction in chronological order (journalising);

3.

recording the classified data into ledger accounts (posting);

4.

preparation of the trial balance (or initial preparation of financial statements);

5.

review of the trial balance to ensure “fair representation”, including adjusting entries; and

6.

preparation of final reports.

In today’s business environment, much of this part of the accounting function is completed by computerised systems. In this book, we will use a worksheet approach to replicate much of the accounting cycle. Appendix 2 includes a section on manual accounts. A broader definition of accounting emphasises accounting as a language, a means of communication, and a way of informing. The focus is on determining what the accounting reports mean. The following article by Paul Dunn, Chairman of Results Accountants’ Systems, titled “Accountancy … a language for communicating and informing” (Chartered Accountants Journal of New Zealand, March 1999, page 23), illustrates the challenge facing any student wishing to study accounting. While it is important to understand the technical aspects of accounting, more important is the ability to use that information to improve your situation. As people in business, you will be users of accounting information. The user determines the type of information

[page 11] required and how it might best be used. You need to communicate your needs to the preparer of the information and understand the responses given. You also need to be able to understand the underpinnings of accounting theory to understand the strengths and weaknesses of the accounting system. Recently I was introduced at a Conference in the UK. The man doing the introducing was Mark Spofforth, former Chairman of the General Practitioners’ Board and now Chairman of the Technical Group at the JCAEW in London. Mark had this to say: “Our clients see us in different ways — advisers, allies, friends, bean counters, protection from the taxman — we play all sorts of roles.” “But over the last 20 years my profession has become obsessed with the intricate detail of accounts, producing change after change in a drive to produce a set of accounts that will satisfy taxman, the banks, companies office, the Government, everyone it seems. Everyone except the people who really matter in nearly every one of the businesses we look after — the owners and managers.” “The result is that Chartered Accountants are often perceived by the public as boring bean counters obsessed with the detail of double entry, searching for the elusive Holy Grail — a correct set of accounts.” “What we have forgotten is that accountancy is a language, a means of communication, and a means of informing.” “But most of the people we are communicating with do not understand our arcane language. We have to get back to using it for the purpose for which it was invented, to help us to measure, interpret and analyse, make decisions and solve problems.” “It is a very powerful language. It can describe the actions of every business in every industry in the land, however disparate. It covers government and the public sector.” “It can help a child with its pocket money or Microsoft with its megabucks. It is very powerful.” “What we have forgotten in my profession is that we are experts in this language and it gives us a great deal of power to help. We train by visiting company after company, looking at how they run the business from the shop floor up.” “We look at systems, their control, and how successful they are. We gain experience all through our working lives about what mistakes not to make, about the clever tricks that business people use to build their firms. We understand how to structure deals, how to structure businesses, and how to make profits.” “And what do we do? We use all that experience to produce the perfect set of accounts that end up in clients’ filing cabinets. What a waste!”

“The pace of change in the world has accelerated dramatically — not just because of computer technology, but also because of better education, calls for greater social accountability, and because trade is becoming truly global.” “Some companies now have a turnover greater than the GDP of some small countries. The competition is hotting up. Communication is faster than ever before. We are deluged with data, regulations and new laws.” “Smaller companies need to know what to do with that data and information — there is too much to assimilate, too much to do and not enough time to do it in.” “We chartered accountants must stop spending so much time producing and checking clever numbers. We have to start using our expertise in interpreting the numbers.”

[page 12] “We have to start teaching the language, spend more time in sharing our expertise in management and more time helping clients to grow and achieve their objectives with the least stress.” “Even if we don’t have answers to all the problems ourselves, as business managers we know where to find it. Business development is a journey, and our job is to make it as smooth and comfortable as possible for clients.” “The press is having a field day, spreading gloom about another recession, a slowing down in the economy and about the country not being able to afford its public spending targets. As Chartered Accountants our job is to help clients not only survive an economic downturn, but to expand and grow through it.” “Research shows that the biggest barriers to growth facing small businesses is a lack of turnover and planned strategy for growth, and a lack of funding for that growth.” “We can show the way to overcome those problems and a strategy for those businesses to become more profitable. Forget the accounts and concentrate on using the language of accounting. Forget last year’s performance, and concentrate on next year’s. Forget the stress and concentrate on the fun of running a business.” What Mark said is spot on. What I really like about it is that it’s precisely and exactly the kind of introduction anyone in public practice could use at a client meeting today. Give it a whirl! It is exactly the language clients want to hear.

1.3.2

DEVELOPMENT OF ACCOUNTING PRACTICE — ACCOUNTING AS A

PROFESSION In this section we will focus on the relationships that have impacted on current accounting practice. Accounting existed before the advent of professional accounting bodies, which are a relatively recent phenomenon. Accounting practice has moved in response to legal and economic pressures. One example of the link between legal and economic pressures is the development of depreciation. In the 1850s, there was no practised form of accounting for capital consumption (that is, the cost of using up fixed assets). It could be argued that, prior to the 1830s, the accounting for using up fixed assets was not important, as most businesses at that time had little in the way of assets. There was, however, an increasing large middle class with spare money to invest, as well as the development of new industries (such as the ownership of railroads). These businesses required large amounts of ongoing investment, which were required in order to purchase long-lived assets (for example, tracks and infrastructure, as well as engines and carriages). The Limited Liability Act of 1855 (UK) allowed businesses the luxury of limited liability for the first time. The Companies Act 1862 (UK) provided that owners’ returns and dividends be distributed from profit, and not from capital. This combination of factors led to the “overstatement” of profit, by not making an allowance for depreciation. A number of railroad companies failed, causing investors to lose their money. By the late 1800s, legislation and accounting practice had formulated a methodology of accounting for using up fixed assets. Depreciation is now a common accounting practice, with accounting standards detailing the requirements for depreciation, and taxation legislation reinforcing current accounting practice. However, a quick referral to the Waste Management fraud in Resource file 1, paragraph 1.9.1, shows that manipulation of depreciation can still [page 13]

have a big effect on stated profits. The cycle of economic activity, business failure, and revision of accounting practice is relatively common. For example, the requirement of the statement of cash flows is a relatively recent phenomenon in New Zealand, arising as a direct result of the New Zealand stock market crash in 1987.

1.3.3

DEVELOPMENT OF ACCOUNTING PRACTICE — LEGAL IMPACTS

Over the last decade, there has been a move in favour of decreasing government intervention in daily living. In spite of this, businesses are still obliged to submit information to government agencies on a wide number of matters. Legislation relating to accident compensation, health and safety, employment, and training are just a few examples of the legislative impact of the government on the way that a business is forced to record its activities. In 2008, after six years of the Business NZ KPMG Compliance Cost Survey, it was found that there was no obvious indication that compliance costs for businesses were decreasing. The results showed that compliance costs for small businesses in particular were either the same or more than in previous years. These surveys provide an excellent indication of how government impacts on business activity. The 2008 survey found that the biggest compliance cost related to taxation issues. Employment-related compliance costs were also ranked significantly high (for instance, the Accident Compensation Act 2001, the Employment Relations Act 2000, the Health and Safety in Employment Act 1992, and the Holidays Act 2003). The survey shows that, in the period surveyed, the average small business paid nearly $3,500 per employee to meet the compliance needs of various government departments. An accountant may need to consider the following specific legislation:

Partnership Act 1908: The fact that this piece of legislation is by far the oldest, indicates the success and long-standing principles of partnership as a business entity. This Act outlines the rights and responsibilities of individuals acting together to carry out a business activity. Companies Act 1993: This Act sets out the law relating to companies. It replaced the earlier 1955 version, and was framed in response to the number of business failures in the late 1980s. It outlines the ability and methodology to incorporate a separate legal entity; the governance processes; and the protections afforded to various parties. Financial Reporting Act 2013: The Financial Reporting Act 2013 replaced the 1993 Act with effect from 1 April 2014. It is the principal Act governing the establishment of accounting standards in New Zealand, and outlines the way that financial reports are to be presented. The purpose of the Act is to: – define the functions and powers of the External Reporting Board (XRB); –

provide for the issue of financial reporting standards, and auditing and assurance standards; and



provide for auditor qualifications, and other standard provisions relating to financial reporting duties under other enactments. [page 14] Section 8 of the Financial Reporting Act 2013 provides the following definition of Generally Accepted Accounting Practice (GAAP): In this Act, financial statements, group financial statements, a report, or other information complies with generally accepted accounting practice only if the report, statements, or information comply with— (a) applicable financial reporting standards; and (b) in relation to matters for which no provision is made in applicable financial reporting standards, an authoritative notice.

The Act also continues the existence of the External Reporting Board established under the 1993 Act. Membership of the External Reporting Board consists of between four and nine members appointed by the relevant Minister of the Crown. The function of the External Reporting Board is to: –

prepare and issue financial reporting standards;



prepare and issue auditing and assurance standards;



prepare and issue authoritative notices for the purposes of defining GAAP;



develop and implement strategies for the issue of standards; and



liaise with international and national organisations that have functions that are similar or correspond to the External Reporting Board.

New Zealand Institute of Chartered Accountants Act 1996: This Act outlines the role of the New Zealand Institute of Chartered Accountants (NZICA) in maintaining the accounting profession, and in determining the standards required of those wanting to be chartered accountants. It requires the Institute to have rules governing, inter alia, membership and discipline, and a code of ethics governing the professional conduct of its members. In New Zealand, chartered accountants belong to the New Zealand Institute of Chartered Accountants and use the designatory letters “CA”. Some senior members may be elected fellows, and use the letters “FCA”. There is also a mid-tier qualification called associate chartered accountant, designated by the letters “ACA”. Associate chartered accountants are not eligible to hold a Certificate of Public Practice, and therefore cannot offer services to the public. Finally, there is an entry level qualification known as accounting technician. A student who has completed a two-year diploma (such as the New Zealand Diploma in Business), could be considered for this designation. In late 2013, the members of the New Zealand Institute of Chartered Accountants and the Institute of Chartered Accountants Australia voted to

amalgamate to become Chartered Accountants Australia and New Zealand. Enabling legislation is currently before the New Zealand Parliament.

1.3.4

DEVELOPMENT OF ACCOUNTING PRACTICE — TAXATION IMPACTS

Taxation is the area which is most intrusive into business operations. In New Zealand, the legislation that a business operator needs to understand includes the Income Tax Act 2007 and the Goods and Services Tax Act 1985. Income tax is a direct tax on income. It is levied at varying rates on individuals, companies, and trusts. The income that is subject to income tax is calculated in [page 15] accordance with rules in the Income Tax Act 2007. These rules are usually consistent with accounting principles for general purpose statements; however, there are some differences, and the tax profit and accounting profit are not always the same. Goods and services tax (GST) is an indirect tax levied at a rate of 15 per cent on goods and services consumed within New Zealand (for exceptions, refer to Resource file, paragraph 1.9.4). GST is sometimes known as an enduser tax, as the final consumer is the one who ends up paying it. This occurs as businesses along the supply chain are able to claim back the GST paid (inputs), against the GST collected (outputs). When accountants record the financial transactions, they recognise that the business acts as an agent of the Inland Revenue Department (IRD) for the GST portion. For a reproduction of GST Form 101, refer to Figure 1.2 in Resource file 1, paragraph 1.9.4.

GST is not an expense of the business, and accounting values do not usually include the GST component. However, the difference between output tax and input tax does represent a liability to the business. Except for this recognition, reports are generally exclusive of GST, except for amounts owing from debtors, and the amount owed to creditors. We have an example which includes GST in Chapter 3, but for the most part, examples will exclude GST. We have established that there are costs associated with complying with government legislation and regulations. Discuss whether keeping records for taxation purposes adds to the effectiveness of a small business owner (a self-employed builder, for example).

The prime significance of the tax rules for the accountant is the requirement to maintain records, and for the rules to be adhered to. The requirements from the IRD ensure that the completion of the GST 101 Form, being the form on which GST calculations are submitted to the IRD, represents a fairly simple method of collecting tax. The tax system relies on voluntary compliance. To ensure compliance, every registered business can expect to be audited from time to time. Taxpayers who do not fulfil their obligations, may be charged penalties. In Table 1.2 below, we have included figures taken from the financial statements of the Government of New Zealand for the year ended 30 June 2013, to provide an understanding of the percentage of the tax take represented by the various tax types. You will see that the government (as a business) earns large income. You will also note that goods and services tax represents a high proportion of this income. TABLE 1.2: TAX COLLECTION 30 June 2013

30 June 2012

Individuals’ income tax

$26,376m

$24,195m

Corporate income tax

$9,018m

$8,612m

Other direct taxes

$2,147m

$1,971m

$15,205m

$14,572m

$5,388m

$5,315m

$58,134m

$54,665m

GST Other indirect taxes TOTALS

Source: www.treasury.govt.nz/government/financialstatements/yearend/jun13/fsgnz-jun13.pdf

1.3.5

DEVELOPMENT OF ACCOUNTING PRACTICE — THE NEW ZEALAND FRAMEWORK

A flurry of activity took place between 2003 and 2005 to bring the New Zealand accounting standards in line with the International Financial Reporting Standards [page 16] (IFRS), which New Zealand adopted on 1 January 2007. There are currently approximately 120 countries and jurisdictions worldwide that permit or require IFRS for domestic companies, of which 90 fully conform to IFRS. The advantages of having international harmonised accounting standards are seen to be that: companies from different countries can prepare financial accounts that are similar and comparable; companies needing to raise finance on the international markets may find it easier to do so; and costs for companies listing in multiple countries should be lowered. There are also some disadvantages to applying international harmonised accounting standards. For example, New Zealand was considered to be a world leader in using the same set of standards for the public sector (not-forprofit), and the private sector, and there was a belief that New Zealand would lose this expertise, or not be able to contribute as effectively to standardsetting in the future. Additional costs were incurred by some entities in converting to the new accounting standards. IFRS was modified to enable New Zealand to use one set of accounting standards for both the private and

public sector. However, with effect from 2012, a new reporting framework was introduced in New Zealand, consisting of two separate sets of accounting standards — one for for-profit entities, and the other for public benefit entities. Within each set of accounting standards, there are different tiers of reporting required. The External Reporting Board, which is responsible for preparing and issuing accounting standards, was established in July 2011 by the New Zealand government to replace the previous issuer of accounting standards, the Accounting Standards Review Board (ASRB). In general, the International Accounting Standards Board prepares exposure drafts of accounting standards, which are issued in New Zealand by the External Reporting Board for comment. After due consultation, the particular financial reporting standard is issued by the IASB and adopted by the External Reporting Board. Prior to July 2011, the Financial Reporting Standards Board (a board set up by the New Zealand Institute of Chartered Accountants) was responsible for developing financial reporting standards in New Zealand, including the development of the New Zealand equivalents to the IFRS. The concepts that underlie the preparation and presentation of accounts in New Zealand, are set out in the New Zealand Equivalent to the IASB Conceptual Framework for Financial Reporting 2010 (NZ Framework) published by the External Reporting Board. According to the NZ Framework, the objective of general purpose financial reporting — namely that “the benefits of the accountability and decision usefulness of general purpose financial reporting outweigh the costs of providing that information” — forms the foundation of the NZ Framework (paragraph OB1). The NZ Framework covers: the objective of financial statements; the qualitative characteristics of useful financial information; the definition, recognition, and measurement of the elements, from which financial statements are constructed; and

concepts of capital and capital maintenance (not covered in this book). (NZ Framework, Scope) [page 17] In order to fulfil the accountability role, financial reports should reflect the nature and dimensions of performance relevant to the entity. While the NZ Framework does not override individual Financial Reporting Standards, it is intended to provide a conceptual benchmark against which the new accounting standards are set. The establishment of a framework is important for ensuring consistency among accounting practitioners. It sets out what is considered to be Generally Accepted Accounting Practice in New Zealand. New Zealand GAAP helps: users to interpret information contained within financial reports prepared in conformity with Generally Accepted Accounting Practice; preparers to apply financial reporting standards; and auditors to form an opinion as to whether the financial statements provide a fair representation.

1.3.6

OBJECTIVES, ASSUMPTIONS, AND QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS

The objective of financial statements, assumptions underlying financial statements, and the qualitative characteristics that determine the usefulness of information will be covered next. The definitions of the five accounting elements (assets, liabilities, equity, revenue, and expenses) will be introduced in later chapters to underline the practical effects of the NZ Framework on

accounting practice. The concepts relating to financial statements are defined below with reference to the paragraphs of the NZ Framework. This is done to model the behaviours that accounting practitioners use in practice, when they reflect back on particular International Financial Reporting Standards to inform their practice.

1.3.6.1

Objective of financial statements

The objective of financial statements is to provide information about the financial position and the financial performance of a business. General purpose financial reports are intended to meet the needs of external parties, who are unable to require special purpose reports to meet their individual requirements. They are therefore dependent on the protections offered within the standard-setting process. The quality of information provided in financial reports determines the usefulness of the reports to users. It is necessary to note that there are some dynamic developments associated with the way that businesses “account” that could influence the accounting reports (for example, triple bottom line and environmental reporting). However, as these do not fall within the accepted definition of financial statements, they are not described in this book.

1.3.6.2

Assumptions underlying financial statements

There are certain important assumptions which underlie the way that accounts are prepared: that the entity is a going concern; that the entity’s economic activity can be divided into specific time periods (period reporting); and that the entity will prepare the financial statements, except for the cash flow information, using the accrual basis of accounting. [page 18]

Management is required to make an assessment as to whether a business has the ability to continue in the foreseeable future. If it is considered that the business will carry on, and there is no intention to liquidate the business or stop trading, the financial statements are prepared on the going concern basis. This means that assets are valued as if they will be able to provide economic benefits to the business in the future, rather than at the amount they would earn if they had to be sold rapidly. The accounting period concept requires that the life of the business is divided into equal time periods — for example, two-monthly, six-monthly, or yearly — which are often aligned with the tax year or GST return periods of the business. The purpose of the accounting period concept is to prepare financial statements, such as the balance sheet and the income statement, so that owners and managers can see how the business is performing, to enable management to determine the amount of profit the business has made, and to make comparisons from one accounting period to another. Transactions or events are grouped into similar categories, so that the data constitutes meaningful information. Financial information from one period can be compared with others to see if trends emerge. This is useful for future planning, or for contingency planning should business needs change. While the law demands that financial statements be prepared at the end of the financial year (often 31 March) for taxation purposes, there is no reason why businesses should not have more frequent snapshots of their business situation. Indeed, it might be crucial for new businesses to have information provided more frequently within the first few years of operation. The frequency of reporting will depend on the complexity of the business and the extent to which its performance can be effectively monitored informally. More complex or larger businesses will certainly benefit from monthly reporting. However, small to medium enterprises can also benefit from shorter reporting, and reap the benefits of analysing their business, and thus understanding it more clearly. The accrual basis of accounting means that assets, liabilities, equity,

income, and expenses are recognised (entered into the accounting system) when they satisfy the definitions and recognition criteria for those accounting elements. Entries are made in the accounting system, based on the date the transaction takes place, rather than when money changes hands.

1.3.6.3

Qualitative characteristics

There are a wide range of users of general purpose financial reports, such as existing and potential investors, lenders and other creditors, employees, and the general public. For the information to be of use to these users, certain qualitative characteristics have been identified in the NZ Framework, which determine the usefulness of information in financial statements. The two fundamental characteristics are relevance and faithful representation. Relevance (paragraphs QC 6–11 of the NZ Framework): Information is relevant to users if it will impact upon the decision made by the user. It can be both used to assist in creating future outcomes (predictive value), and/or in providing feedback confirming or changing previous expectations (confirmatory value). [page 19] Materiality (paragraph QC 11 of the NZ Framework) forms part of relevance. Information is material if its omission or misstatement will influence the decision that a user will make. Materiality is therefore determined by value and/or by nature. Faithful representation (paragraphs QC 12–16 of the NZ Framework): Information presented in the financial statements should accurately represent what is occurring within the entity. A faithful representation of the events of an entity would have three characteristics: it would be complete; neutral (without bias); and free from error. There are four enhancing qualitative characteristics which improve the

usefulness of the information provided, namely comparability, verifiability, timeliness, and understandability. Comparability (paragraphs QC 20–25 of the NZ Framework): Information usefulness is determined by the ability of users to compare accounts over time, and to compare accounts of businesses in a similar industry. The NZ Framework emphasises that comparability is not necessarily about uniformity — rather it is about informing users. Verifiability (paragraphs QC 26–28 of the NZ Framework): Users are assured about the usefulness of the information if different knowledgeable and independent observers would be able to achieve a similar conclusion. Timeliness (paragraph QC 29 of the NZ Framework): Users need the information available to them in time in order to make decisions. Older information may be of less usefulness. Understandability (paragraphs QC 30–32 of the NZ Framework): Information is more understandable for a user if it is classified and presented clearly and concisely. The user of a financial report is expected to have a reasonable knowledge of business, and use some diligence in analysing the information. It is recognised that a trade-off between qualitative characteristics is often necessary. For example, in the effort to make accounts reliable through the audit process, there may be a delay in the timeliness of the reports. When choosing between conflicting perspectives, a trade-off based on professional judgment is required. Other trade-offs may also be required. The NZ Framework refers to the balance between benefits and costs. While there are no specific rules in this regard, paragraphs QC 35–39 of the NZ Framework alert standard setters to this constraint.

1.4

Preliminary look at financial

reports Accounting is primarily about reporting on the financial activities of a business or other organisation. It deals with the recording of financial transactions, and with classifying and summarising these transactions so that reports can be prepared. The analysis and interpretation of financial reports helps in decision making and maintaining financial control. This process of reporting, analysing, and interpreting needs, itself, to be supported by systems which record, classify, and summarise the financial transactions in which the business engages. [page 20] A practical illustration might help us to understand these various dimensions of accounting. Suppose you are in business as a landscape gardener. What sort of financial information do you think you might need to gather — why; and for whom? To start with, you will need to know whether you are charging out your time at an adequate rate, or whether you are sensibly pricing out jobs when you tender for work. You will need to set up your accounting record system to enable you to gather appropriate cost data. You will also want to know how well your business is doing: Are you making a profit? Are your customers paying on time? Are you able to pay your suppliers on time? Your accounting records will be set up to capture details that can be transformed into reports that will provide answers to such questions. For example, a monthly report might set out the total amount of money that customers owe the business, listing all those customers who have failed to pay on time, as well as the period for which their accounts are overdue. Such a report will facilitate more effective control over the granting of customer credit, and the collection of debts.

At this stage, we would like to introduce you to four key reports which are essential for all types of business in terms of monitoring performance and financial stability, namely: the balance sheet (also called the statement of financial position); the statement of changes in equity; the income statement (also called the statement of financial performance); and the statement of cash flows. Refer to the Xero Limited accounts in Appendix 1. Consider the way the accounts are presented. Are there any differences that you can see in the titles of the reports?

These statements will be studied in more detail as you proceed through this book. The examples that follow in Chapters 2, 3, and 4 are simplified reports, so that you can concentrate on their key elements. Appendix 1 contains the accounts of Xero Limited, a publicly listed company, of which the reports are quite different in appearance to those of a small business. However, the main elements are relatively similar. To assist you, we provide a brief description below of the reports that you will become familiar with as you work through this book. We will often refer you back to the NZ Framework, as we introduce you to more concepts. It is not necessary for you to understand the NZ Framework in its entirety, but it is useful to understand the historical foundations which forged the way that accounting is carried out.

1.4.1

BALANCE SHEET

This report tells us what the business controls (assets), what it owes (liabilities), and the owner’s financial interest in the business (equity). From another perspective, the balance sheet shows the sources of the funds the organisation uses (that is, owner’s equity, and liabilities), and the uses to which those funds have been put (that is, the assets). The statement also features categorisation of the principal elements — assets and liabilities are further divided into current and non-current portions. From this we can

establish the level of working capital, and monitor the debt/equity ratio of the business — that is, we can gain insights into the financial stability of the business. You will learn how to do this in Chapter 7. [page 21] The adoption of an economic principles approach to standard setting by the major standard setters, has meant a balance sheet approach to reporting. The balance sheet approach establishes assets and liabilities as the primary financial elements.

1.4.2

STATEMENT OF CHANGES IN EQUITY

This report primarily sets out the changes taking place in the owner’s equity section of the balance sheet. It acts as a link between the performance and position of an entity, and provides information that is useful for assessing the return on investment.

1.4.3

INCOME STATEMENT

This report primarily tells us whether or not the business has been profitable for the period under review. But is it a satisfactory profit? As discussed earlier, this is difficult to answer until we have still more information. Equally as important as knowing whether or not the business has been profitable, is knowing whether or not profitability has changed over time, and, if so, why? Thus, reports need to be analysed and interpreted, both in terms of what we expected, and what has happened in the past. The latter analysis may enable trends to be detected, which in turn may signal the need for corrective action or planning to take advantage of opportunities. To this

end, the frequency of reporting is important. Annual reports will not be nearly as helpful as monthly reports. Reports will also be more helpful if they are presented with comparative figures for the previous period. Indeed, this is considered good practice. What is important to appreciate at this stage is that it is not so much what is reported that is important, but rather what you are going to do or recommend as a result of the report. What we cannot see from the income statement is that it is the result of a classifying and summarising process. There will be detailed records that can tell us exactly what comprises the fees and all of the expense categories. If we were to judge the profit to be too low, we would want to examine this detailed information more carefully, to see if there was scope to make changes that could improve profitability. The net profit figure still represents an important indicator of the success of a business, and we will take a closer look at it in Chapter 3.

1.4.4

STATEMENT OF CASH FLOWS

This report tells us how the operating, investing, and financing activities of an organisation affect cash resources. It shows clearly where the business got its cash from, and what it used it for. It is therefore a useful report for understanding the financial stability of the business. We look at this report in more detail in Chapter 5.

1.4.5

NOTES TO THE ACCOUNTS

It is usual for accountants to have to explain the choices made when classifying accounting data. The notes give further details as to which choices are made in the accounts. The notes include a statement of accounting policies, and are a series of notes that are referred to in the main body of the financial statements. The importance of these notes should not be underestimated. The accounts are not complete without

[page 22] the notes, to the point that investors who rely on the main body of the accounts and ignore the notes, are likely to find themselves misled. Refer to the set of notes included in Appendix 1.

Generally, a small business might not have an extensive notes section, but a larger one (such as Xero Limited) would do so.

1.5

Management accounting

Much of the preceding discussion has focussed on external users of accounting information, and the resultant financial accounting. Internal users are more interested in what has happened in the past, what may happen in the future, and information that will enable them to make management decisions (see the article by Paul Dunn reproduced in paragraph 1.3.1). Generally, accounting activities dealing with internal users form part of management accounting. While financial accounting and management accounting overlap and often use the same information sources, there are some essential differences in the perspectives associated with the way that financial and management accountants operate.

1.5.1

TASKS OF MANAGEMENT ACCOUNTANTS

The management accountant supplies financial information which assists in making management decisions. Many management texts refer to the function of management as revolving around planning and controlling human behaviour.

The demand for management accounting differs, depending on the level of the organisation. At the operational level, information is primarily required to control and improve operations. Management accounting gives feedback about the efficiency and quality of tasks being performed. The information comes from many different sources, and is frequently updated. Higher up in the organisation, managers use accounting information to help them plan better. Management accounting measures the cost of resources used to make a product, or to provide a service. At the highest levels, management accounting information is used for longer-term strategic decisions. Information is used to measure the performance of management, and to make decisions on the long-run competitive advantage of the business. Human behaviour is moderated through the use of budgets. The management accountant would typically take the figures based on a projected sales volume, and join them with projections from other departments within the business. From these numbers, a plan of action could be produced, and subordinates could be monitored against the expectations. Under this type of decision focus, the tasks of a management accountant would be as follows: Planning: – to administer the annual budget cycle linked to the responsibility centres; –

to develop cost and other financial information systems, to monitor achievement, and to ensure continued profitability; and



to liaise with other departments on corporate plans, with a particular focus on capital expenditure proposals. [page 23]

Control: – to measure results against the annual budget and against standard costs;



to prepare reports detailing results and variances for responsible managers; and



to provide additional advice to help rectify variances.

We will focus on the process of management accounting in Chapter 6. The tasks of the management accountant have expanded over the years, and a more diverse set of skills is now required. Accounting data is designed to incorporate non-financial measures, such as cost of quality, recognition of brand values, intellectual property, and measures relating to service performance. Many of these changes reflect the increasing competitiveness and globalisation of business, as outlined at the beginning of this chapter. In the modern competitive environment, managers of manufacturing and service businesses need to have accurate, relevant information about costs. For manufacturers, managers need this information to do the following: signal where improvements in quality, efficiency, and speed are needed; guide product mix decisions; choose among suppliers, and what materials to use; negotiate price, product features, delivery, and after-sales service prescribed to the product; and decide on the continuation or closing of departments of the business, or whether to work overtime or not. One of the challenges facing management accountants relates to how proactive they should be in going beyond a reporting role into active participation in managerial decision making. Historically, management accounting evolved from cost accounting, in terms of which costs are recorded, reported, and controlled. With the advance of computerised systems, much of the decision making is integrated in such a way that the financial aspects are no longer divorced from the total business. Ecommerce solutions have placed increased pressure on the accuracy and speed of the financial system. The competitive nature of the modern global business

means that many traditional costing practices are no longer adequate, and new ways are required to accurately define the true costs of products and services. Management accountants are required to take a more strategic and forward-looking approach than that associated with the historical double entry accounting system.

1.5.2

MANAGEMENT ACCOUNTING FAILURES

We list below a couple of examples of instances where the internal preparers and users of accounting information did not follow correct procedures and obtain the appropriate approvals, leading to financial information for use by external users that was inaccurate and misleading. The end of the 20th century and the start of the 21st century have seen years of turmoil in the accounting profession. Abuses of power by executives, primarily but not solely in the United States, have led to a number of corporate accounting scandals. One [page 24] of the world’s premier accounting firms, Arthur Andersen, was forced to close for faulty auditing practices. One of the more famous examples of accounting failure relates to a business known as Tyco International. Its former chairman and chief executive officer (CEO), Dennis Kozlowski, and former chief financial officer (CFO), Mark Swartz, were accused of the theft of US$600 million from the company. As investigations continued, it was uncovered that Dennis Kozlowski, Mark Swartz, and Mark Belnick, the company’s chief legal officer, had taken over US$170 million in loans from Tyco, without receiving appropriate approval from Tyco’s compensation committee, or notifying

shareholders. For the most part, these loans were taken with low to no interest. Many of them were offset as bonuses without open approval. In 2003, in response to the Dennis Kozlowski scandal, the company adopted a Guide to Ethical Conduct, in order to guide and advise employees as to correct practices and procedures, and to warn what would be considered as unethical practices and behaviour when working for Tyco. Examples of unacceptable behaviour are included in the Guide, to help employees understand what the expected practices and procedures are, such as how to ask for help and raise concerns, protecting employees and the environment, conflicts of interest, doing business with integrity, and financial integrity. All Tyco employees are now required to take a brief ethics course, and sign an ethics statement annually. Bodies responsible for accounting professionals, such as the New Zealand Institute of Chartered Accountants, have introduced compulsory ethics components within their professional exams. This and other types of fraud focused the attention of accountants on the accuracy of financial reports, and set in motion finding ways to improve accounting accuracy. One of the responses was to ensure that management placed greater emphasis on internal controls, in order to limit abuses such as those undertaken by Dennis Kozlowski. (See Resource file 1, paragraph 1.9.1.)

1.6

Limitations of accounting

In this chapter, you have been introduced to the importance of business activity in modern society. You have also been provided with an insight into the way that accounting information is being used to measure business activity. Accounting deals with those aspects of business activity that can be expressed in monetary terms. While that information is essential to business decision making, it is not the only information that will be needed, or will be

relevant. In drawing this chapter to a close, we will identify some of the weaknesses associated with a reliance on accounting information. Not all activities can be measured in monetary terms. Some items, such as the value attached to a brand name like Coca-Cola, are too difficult to measure, and are ignored. Does this mean that items such as staff morale and training, the value of patents, and the geographical position of a business are worthless to the business? Of course not. Rather, these are examples of items which fall outside the accounting system. To establish other values, estimates are required. Accounting does not provide mathematical certainties, and external users in particular are reliant on the expertise [page 25] and professionalism of those making the estimates. The external users rely on the rules set in place by professional accounting bodies, such as the New Zealand Institute of Chartered Accountants and Certified Practicing Accountants Australia, as well as on the integrity of the audit process. As we proceed through the book, you will understand some of the estimates that are required. As an external user of accounting information, you would expect reports to be comparable and consistent. Yet the way that information may be classified within an accounting system, is also likely to be different. In Chapter 4, we see how two businesses carried out the same activity — the sale of discounted cell phones — and yet treated the value of the losses associated with the sales in quite different ways. As a result, one company’s profit was comparatively higher than the other, yet both treatments were acceptable to the auditors. Accountants provide no hard and fast rules concerning how historical accounting reports are to be viewed. Even when introduced to an array of

ratios and percentages, as in Chapter 7, the external user has to incorporate a range of information into a decision-making strategy. The ability to make appropriate comparisons, depends on the ratios and percentages having been calculated from information prepared on a consistent basis — for example, using the same stock or fixed assets valuation methods. Each ratio or percentage should be looked at as part of the overall picture — within this year, and compared to other years. The ratios and percentages also need to be studied in the context of other relevant information not appearing in the financial statements, for example: the general economic climate; competitiveness of market or future market prospects; major management policies; and condition or adequacy of fixed assets. Accounting reports are seen as resulting from an objective recording of historical data. While many accounting transactions are recorded in this manner, not all are. In this chapter, we have seen that the practice of accounting takes place within a business context, and that this context does not always present simple notions of “profitability” or “accounting success”. Therefore, a business professional wanting to understand accounting must understand the broader business context. This will allow the professional to make the required judgments of how best to use accounting information.

1.7

Conclusion

Accounting is primarily concerned with financial information and the preparation and analysis of financial reports. Financial accounting provides information about the past results to external users, such as shareholders, employers, creditors, and lenders, to enable users to make informed

decisions. Management accounting focuses on the internal users of financial information. Its primary purpose is to assist in internal decision making in order to control and improve operations, measure performance, [page 26] and plan ahead through the preparation of budgets, and to enable decisions on the long-run competitive advantage of the business. New Zealand adopted International Financial Reporting Standards (IFRS) in 2007, which govern the requirements and principles that reporting entities must follow in order to prepare financial statements. However, many of the small to medium sized businesses in New Zealand, do not now have to follow IFRS. The key financial statements of a business entity, which are essential in terms of monitoring performance and financial stability, are the balance sheet, the statement of changes in equity, the income statement, and the statement of cash flows. When preparing the accounts of a business entity, an accountant may need to consider legislation such as the Partnership Act 1908, the Companies Act 1993, and the Financial Reporting Act 2013. While the practice of accounting takes place within a business context, this context does not always present simple notions of “profitability” or “accounting success”. Therefore, a business professional wanting to understand accounting must understand the broader business context. This will allow the professional to make the required judgments of how best to use accounting information.

1.8

Key words 1

accounting

“The process of identifying, measuring and communicating information to permit informed judgments and decisions by users of that information” (The American Accounting Association). Accounting is primarily concerned with financial information and the preparation and analysis of financial reports. As such, it deals with those aspects of business activities that can be expressed in monetary terms.

accounting cycle

The routine steps in processing accounting data during an accounting period. In sequence, these are: 1. occurrence of the transaction as evidenced by a source document; 2. classification of each transaction in chronological order (journalising); 3. recording the classified data into ledger accounts (posting); 4. preparation of a trial balance (or initial preparation of financial statements); 5. review of the trial balance to ensure “fair representation”, including adjusting entries; and 6. preparation of final reports. [page 27]

accounting entity

The entity for which accounts are prepared.

accounting entity principle

This concept relates to deciding which

transactions should be included in the financial reports, and which should be excluded — for example, the financial affairs of the owner should be kept separate. accounting period

This concept requires that the life of a business is divided into equal time periods — for example, two-monthly, six-monthly, or yearly — which are often aligned with the tax year or GST return periods of the business.

accrual basis of accounting

Under the accrual basis of recognition, the effects of transactions are recognised when they occur, not necessarily when cash changes hands. They are then included in the accounting records in the periods to which they relate.

asset

A resource controlled by the entity as a result of past transactions or other past events, which has the ability to generate future economic benefits. An asset will be recognised when: it is probable that the future economic benefits of the asset flow to the business; and the asset possesses a cost or other value that can be measured with reliability. (NZ Framework, paragraphs 4.44–4.45)

balance sheet (or position statement)

A financial report showing what a business controls (assets), what it owes (liabilities), and the owners’ financial interest in the business (the owners’ equity) as at a specific

date. cash flow

Inflows and outflows of cash and cash equivalents.

comparability

Information in a financial report is comparable when users are able to identify similarities or differences between that information and the information in other reports. Comparisons may need to be made between different entities, or the same entity over different periods of time.

current assets

Assets that are either cash, or expected to be turned into cash or sold or consumed within the normal operating cycle of the business (usually 12 months).

current liabilities

Liabilities that are due to be settled (paid) within the normal operating cycle (usually 12 months). [page 28]

depreciation

The wearing out, consumption, or other loss of value of an asset, which may arise from use, passage of time, or obsolescence. It is accounted for by the allocation of the depreciable amount of the depreciable asset over its useful life.

earnings

An alternative term for profit — the difference between revenue and expenses.

equity

The residual interest in the assets of the

entity, after the deduction of its liabilities. expenses

Money paid or costs incurred by the business in order for the business to earn revenue, eg paying wages. It also includes losses, such as selling a non-current asset at less than the value recorded in the accounts.

External Reporting Board (XRB)

The purpose of this Board is to prepare and issue both accounting and auditing standards within New Zealand, and to liaise with international and national organisations that are similar functions.

faithful representation

This is achieved when transactions are accounted for and presented in a way which conveys their economic effect.

financial accounting

Accounting with the primary purpose of informing people who are external to the organisation. It is concerned with accurately reporting what has happened (in the past).

Financial Reporting Act 2013

An Act of Parliament which: is the principal Act governing the establishment of accounting standards in New Zealand; continues the existence of the External Reporting Board, and defines its function and powers; outlines the way that financial reports are to be presented, by providing for the issue of financial reporting standards, and accounting and assurance standards; and provides for auditor qualifications and

other standard provisions relating to financial reporting duties under other enactments. fixed (non-current) assets

Tangible assets, now usually referred to as property, plant, and equipment. They are expected to be of benefit to the business for more than one accounting period, and are included under the heading of non-current assets in the balance sheet. [page 29]

Generally Accepted Accounting Practice (GAAP)

For the purposes of the Financial Reporting Act 2013, financial statements, group financial statements, a report, or other information complies with Generally Accepted Accounting Practice only if those statements comply with: applicable financial reporting standards; and in relation to matters for which no provision is made in applicable financial reporting standards, an authoritative notice.

going concern principle

This concept assumes that the business entity will continue to operate indefinitely. This has the implication that assets and liabilities should be disclosed in the accounting reports at their value to the entity as a going concern,

rather than at the values that might be applicable if the business were to be wound up. For example, inventories will usually fetch much less than cost under a forced sale, compared with sale in the normal course of trading. goods and services tax (GST) A tax on consumer spending. Nearly all businesses have to charge their customers GST on goods and services sold and then forward this GST at regular intervals to the Inland Revenue Department. These businesses also get to claim back the GST charged to them by their own suppliers from the Inland Revenue Department. income statement (or statement of financial performance)

A financial report showing the revenue, expenses, and resulting profit (or loss) generated by a business for the period under review.

Inland Revenue Department A government department charged with the (IRD) collection and administration of all forms of taxation in New Zealand. International Financial International accounting standards are Reporting Standards (IFRS) issued by the International Accounting Standards Board on a global basis, although the USA still has its own standard-setting body. Accounting standards allow entities from many different countries to follow the same concepts and principles, so that financial statements are more comparable and understandable worldwide.

liability

The commitments that an entity is presently obliged to make to other entities, as a result of past transactions or other past events, which will result in an outflow of resources, eg cash. A liability is recognised when:

[page 30]

it is probable that there will be an outflow of resources; and the amount of the liability can be measured with reliability. (NZ Framework, paragraph 4.46) management accounting

Accounting with the primary purpose of assisting internal decision making.

materiality

An entity-specific aspect of relevance, based on the magnitude of the items to which the information relates in the context of an individual entity’s financial report. Information is considered material if its accuracy or omission has the ability to impact the decisions made by users. This concept is about the relative importance of accounting information, and provides for the separate disclosure in financial reports of all items that are considered to be material. An item may be material because of its nature and/or its amount, and both must be considered. For example, a change in

accounting policy is of a material nature, even if the economic effect is minor; and, while an item that affects profit for the year by 10 per cent would likely be material, one that affects a balance sheet figure by only 1 per cent, would probably be considered immaterial. neutrality

The characteristic that accounts are prepared in a manner which is free from bias.

New Zealand Framework 2010 (NZ Framework)

The New Zealand Equivalent to the IASB Conceptual Framework for Financial Reporting, which covers: the objective of financial statements; the qualitative characteristics of useful information that determine the usefulness of 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 (not covered in this book). (NZ Framework, Scope) [page 31]

New Zealand Institute of Chartered Accountants (NZICA)

One of the professional accounting bodies in New Zealand. It stipulates the requirements for members wishing to enter the various levels of accounting activity (accounting technicians, associate chartered accountants,

or chartered accountants), and has a disciplinary system that is aimed at maintaining standards of knowledge and ethical practice. The status of chartered accountant (CA) has preferred legal status, as only members of NZICA can use the term chartered accountant. New Zealand Stock Exchange (NZX), (also known as the New Zealand stock market)

The operator of the securities and energy markets in New Zealand, which is committed to developing these markets for the benefit of stakeholders.

non-current-fixed) assets

These assets include tangible assets, such as property, plant, and equipment, and intangible assets, such as goodwill. They are expected to benefit the business for more than one accounting period.

non-current liabilities

Long term liabilities that are not due for settlement or payment within the next 12 months.

notes to the accounts

A series of notes that are referred to in the main body of the financial statements. They give additional information not provided in the financial statements themselves as to the choices made in the accounts, and include a statement of accounting policies.

owner’s equity (also equity)

The difference between the assets and the liabilities of a business. It represents the investment by owners, partners, and shareholders.

posting

Recording the classified accounting data into

ledger accounts as part of the accounting cycle. profit

The difference between revenue and expenses. It represents the part of the operation which increases the owner’s equity.

relevance

Information is relevant to users if it can be used to confirm prior expectations (feedback value), or assist in creating new expectations about the future (predictive value).

revenue

Includes income and gains, and usually results in an inflow of cash into the business (eg goods sold for cash, or a reduction in a liability, such as discount received on an amount owing). (Refer to the NZ Framework, paragraph 4.25.) Revenue will be recognised when: [page 32]

it is probable that the inflow or other enhancement, or saving in outflows of service potential or future economic benefits has occurred; and the inflow or other enhancement, or saving in outflows of service potential or future economic benefits can be measured with reliability. (NZ Framework, paragraphs 4.47–4.48)

share price

The value given to individual shares — for publicly listed companies, these are quoted on the New Zealand Stock Exchange.

stakeholders

Various parties who are interested in the success and behaviours of an entity, such as shareholders, employees, lenders, suppliers, customers, and government departments.

statement of cash flows

A financial report showing where an organisation got its cash from, and what that cash was spent on for the period under review. The report classifies these cash inflows and outflows into three categories — operating, investing, and financing activities.

statement of changes in equity

A financial report showing what changes in owners’ equity took place during the period under review. This statement serves as a link between the income statement and balance sheet.

taxable supplies

The provision of goods and services in New Zealand in the course of a taxable activity for purposes of GST. A taxable activity is one carried on continuously or regularly, which involves goods and services, where payment is received for those goods and services.

taxation accounting

Accounting with the primary purpose of determining tax liability.

timeliness

The requirement that information be provided to users in a prompt manner, so that they are able to use it to make decisions.

trial balance

A list of balances from the accounts in the

general ledger that is used to confirm that double entry accounting has been carried out accurately. The debit balances (assets + drawings + expenses) are on one side of the trial balance; and the credit balances (liabilities + capital + revenue) are on the other side. Both sides should total to the same figure. [page 33] understandability

The principle that information is more understandable for a user if it is classified and presented clearly and concisely. The user of a financial report is expected to have a reasonable knowledge of business, and use some diligence in analysing the information.

verifiability

The principle that users of information would be assured about the usefulness of the information if different knowledgeable and independent observers would reach a similar conclusion, and prepare the accounts in a similar way.

1.9 1.9.1

Resource file 1 ACCOUNTING SCANDALS

Enron: This is the most infamous accounting scandal of them all, involving hiding debts, inflating revenues, and corruption. It resulted in the displacement of more than 20,000 people, the death of “America’s most innovative company” for six years in a row, and the dissolution of one of the Big 5 global accounting firms (Arthur Andersen). It also gave rise to the passage of the Sarbanes-Oxley Act of 2002 (US), and more rigorous auditing standards. Parmalat: Parmalat, a company based in Italy, used to be the biggest dairy company in Europe. It collapsed in 2003, and subsequently declared bankruptcy. The company went under for a variety of reasons: investment disasters; non-existent cash in bank; fake transactions; hidden debts; and the use of derivatives and accounting fraud to hide these facts. These illegal acts were carried out worldwide, and they affected not only the company and its people, but also international financial institutions. Waste Management: Waste Management is a large company which offers comprehensive waste management and environmental services in the United States. Unlike the two entities listed above, Waste Management still exists. The scandal was that it inflated income by a whopping US$1.7 billion, by understating the depreciation expense of the company. WorldCom: WorldCom, which emerged from bankruptcy in 2003, is now known as MCI Inc, and is part of the Verizon Communications group. The allegations were that it inflated total assets through capitalisation of operating costs in an amount estimated to be around US$11 billion. In the history of Chapter 11 bankruptcy filings in the United States, WorldCom’s is second only to that of Lehman Brothers in 2008. Qwest Communications: Qwest is a telecommunications company providing services to 14 states in the United States, and still exists. In 2002, it was found that the company had engaged in fraudulent accounting practices, resulting in the inflation of its revenues generated from its transactions with Enron. Tyco International: Tyco was an international manufacturing company with

diversified product lines, including safety products, fire protection, and electrical products. The [page 34] fraud involved the misuse of the company’s funds by its former CEO and CFO, who utilised improper accounting practices to cover up the misuse of these funds. Satyam Computer Services: Satyam was a company based in India, and is now known as Mahindra Satyam. This is the most recent scandal (declared only in 2009) among those on this list. The accounting fraud in this case involved overstating cash by US$1.5 billion, and receivables by US$100 million, and understating liabilities by US$250 million. Taken together, Satyam’s assets were inflated by about US$1.85 billion. Fortex: Fortex was a company based in New Zealand, which gained a strong reputation for innovative lamb manufacturing processes. Three types of fraud were discovered: stock was recoded so that lower-priced inventory was counted at a higher price; sales invoices were written for non-existent sales; and loans were treated as income. While the value is considerably smaller than the values referred to above, the fraud was still in excess of $25 million. Bernard Madoff: This is considered to be the largest ever Ponzi scheme in history By 2008, when the authorities caught up with Bernard Madoff, he had effectively stolen US$17.5 billion from more than 4,000 account holders with Bernard L. Madoff Investment Securities, as well as from thousands more third-party investors who were exposed through other funds. In 2009 Madoff was jailed for 150 years. Ross Asset Management: David Ross, the Wellington financier and former head of Ross Asset Management, was behind New Zealand’s largest Ponzi scheme. Investors were led to believe they had $351.5 million in client portfolios, but it was determined that an estimated $115.5 million was lost. In

November 2012, David Ross was charged with four counts of false accounting, and one charge of theft by a person in a special arrangement. He was sentenced in 2013 to 10 years and 10 months in jail.

1.9.2

COMPARISONS

TABLE 1.3: COMPARISON BETWEEN USERS OF ACCOUNTING INFORMATION Users:

Inland Revenue Department (IRD)

Internal (management)

External (shareholders, IRD, bank, NZX)

Used for:

Raising of taxes

Planning and control (eg budgets, variances analysis)

Financial reporting (eg final accounts)

View:

Backwards (historic)

Forward (projections)

Backwards (historic)

Frequency: As stipulated in the relevant Act

Monthly, daily, as required Yearly (half-yearly)

Control:

Income Tax Act 2007; Goods and Services Tax Act 1985

None. Need not comply with GAAP

Financial Reporting Act 2013, financial reporting standards, stock exchange requirements

Detail:

Summary of numbers to meet statutory requirements

Requires more detailed data about product costs, revenues, and profits

Summary of numbers to meet user requirements

[page 35] TABLE 1.4: COMPARISON OF FINANCIAL REPORTS Balance sheet

Statement of changes in equity

Reports on the financial position of a business. It shows what the business owns or controls and what it owes. It shows sources of funds and uses of

Acts as a link between position and performance statements. It shows the changes that

Income statement Reports on the profitability of a business — its performance. It shows whether the business has

Statement of cash flows Reports on the cash position of a business. It shows where the business got cash

funds. It is made up of: assets: items of value owned or controlled by the business (uses of funds); liabilities: amounts owed by the business to outside parties (external sources of funds); owner’s equity (or proprietorship): the owner’s claim on the business (internal source of funds).

1.9.3

have taken place within the owner’s claim on the business. It is made up of: original capital position; profit/loss from the income statement; contributions by owners; distributions to the owners.

made a profit or a loss. A profit is made when revenues exceed expenses. A loss is made when expenses exceed revenues. The income statement may be classified into further categories, depending on the information requirements of the users.

from and what it did with its cash. It analyses cash flows in three categories: cash flows from operating activities; cash flows from investing activities; cash flows from financing activities.

GOODS AND SERVICES TAX (GST)

For a more formal definition of “taxable supplies” refer to section four of the Inland Revenue Department’s GST Guide (IR375), which is available at www.ird.govt.nz.

GST is an indirect tax levied at a rate of 15 per cent on goods and services consumed within New Zealand (subject to certain exceptions discussed below), and certain imported goods and services. It is known as an end-user tax, as the final consumer is the one who ends up paying it. Supplies of goods or services which are subject to GST are known as taxable supplies. Most goods and services supplied in New Zealand have GST added to the price. The exceptions are goods and services supplied by businesses that are not required to register for GST, and exempt supplies. GST-registered businesses charge GST on their sales and income, and claim back the GST on their purchases and expenses. To reconcile the GST, you have paid or charged for your activity, you need to complete a GST return. If there is GST to pay, you pay this amount to the Inland Revenue Department (IRD). If there is GST to be refunded, the IRD will pay you this

amount. Businesses that are not GST registered cannot charge GST on their sales and income, or claim back the GST on their purchases and expenses. [page 36] You must register for GST if your turnover (sales from taxable supplies), including certain imported services you receive: was over $60,000 for the last 12 months; or is expected to go over $60,000 for the next 12 months (that is, $3,333 per month). You can choose to register even if your turnover is less than $60,000 per annum. After you have registered, you must add 15 per cent to all goods or services being sold. There are exceptions for exempt and zero-rated supplies. In order to claim back the GST component of purchases, you must retain a tax invoice (for details of what is required to be a tax invoice, refer to The GST Guide). It is important that the business owner retains documentation to confirm the GST claims made. GST cannot be charged on certain goods and services, which constitute exempt supplies. The most common exempt supplies are: letting property as a private dwelling; interest you receive; the sale of donated goods and services by a non-profit body; and certain financial services, eg bank charges, and interest paid. GST can be accounted for on a payments basis (where GST is recognised when cash changes hands), on an invoice basis (where GST is recognised as part of an accrual accounting system), or in terms of a hybrid system. GST returns can be prepared on a six-monthly, two-monthly, or one-monthly basis. The form (GST 101 form, refer to Figure 1.2 below) is relatively simple

to complete, but there is a reliance on the business owner being accurate in his or her returns. The calculation of GST is as follows: if you have a GST-exclusive price and wish to net up: multiply the price by 1.15 to obtain the GST-inclusive price; if you have a GST-inclusive price and wish to calculate the GST component: divide the total by 23 and multiply by 3. When accountants record the financial transactions, they recognise that the business acts as an agent of the Inland Revenue Department (IRD) for the GST portion. GST is not an expense of the business, and accounting values do not usually include the GST component. However, the difference between output tax and input tax does represent a liability of the business. Except for this recognition, reports are generally exclusive of GST, except for amounts owing from debtors, and amounts owed to creditors. We have an example which includes GST in Chapter 3, but for the most part examples will exclude GST for the sake of simplicity. The prime significance of the tax rules for the accountant is the requirement to maintain records, and for the rules to be adhered to. The requirements from the IRD ensure that the completion of the GST 101 Form (the form on which GST calculations are submitted to the IRD, and which is reproduced as Figure 1.2 below) represents a fairly simple method of collecting tax. The tax system relies on voluntary compliance. To ensure compliance, every registered business can expect to be audited from time to time. Taxpayers who do not fulfil their obligations, may be charged penalties. [page 37]

FIGURE 1.2: GST 101 FORM

[page 38]

1.9.4

PURPOSE OF BUSINESS

The following article by Bernard Hickey, titled “Shake-up needed to alter obsession with tax losses” (Herald on Sunday, 11 October 2009, at page 60, [email protected]), discusses the issue that, although the aim of business is to make a profit, those investing in property in New Zealand are often planning on making a loss in the short term, so as to save paying tax. Just imagine if we taught business students in schools and universities that the aim for any business was to lose money. Surely that would be ludicrous. How can any business or economy survive without profit? Eventually the cashflow runs out when creditors and shareholders stop pouring in good money after bad. The value of the assets is eroded by time and new technology, and the business has to reinvest to be able to keep going. Yet most New Zealand investors and many businesses are doing just that — deliberately losing money on at least $200 billion worth of assets. They believe they will get their money back through untaxed capital gains and by offsetting these losses against their regular incomes. A major sector of the New Zealand economy is genetically driven to lose money because our investment culture and business practice cares more about avoiding tax and making capital gains than about making a profit day in day out. New Zealanders are simply responding to the tax settings, tax policies and financial policies in front of them that say that PAYE income is taxed, profits are taxed, consumption is taxed (a bit), but capital gains are not taxed. This approach appeared to create more than $400 billion of wealth over the past six years because of the boom in house prices through untaxed and leveraged capital gains. But the powers that be are determined to change the perverse incentives which mean the biggest chunks in our economy — property and farming — run their businesses to make losses. Inland Revenue and Treasury revealed to the Tax Working Group advising the government that property investors owned assets worth $200 billion, but were generating losses for tax purposes of $500 million to $700 million. They also found 312 people who had traded properties and avoided $2.12 million in taxes because Inland Revenue did not have the resources to chase them. They then proposed either a capital gains tax or a land tax. One forecast presented to the Tax Working Group suggested a 1 per cent land tax would raise $4.6 billion, equivalent to 20 per cent of income tax. A full capital gains tax for all property and shares would raise more than $9 billion over time, although a capital gains tax for property that excluded owner-occupied property would raise just $1.5 billion. However, this would be enough to pay for a move to a flat tax rate of 30 per cent across income, corporate and family trust tax. An immediate 1 per cent land tax would reduce land prices by 17 per cent, the Tax Working Group was told. Introduction over 20 years would cut land prices by 11.5 per cent. A capital gains tax would be hard to administer and could cause “lock in” homeowners refusing to sell in a bid to avoid tax. A land tax would operate in the same way as

rates for local councils, but would mean foreigners were taxed and act as a brake on those owning properties to make tax losses. The one-off drop in land values would also be a dampener on the capital gains-driven model of many of these investors. These changes are drastic for the economy and the way our investing psyche has developed.

[page 39]

1.10 1.10.1 1.10.1.1

Mastering accounting — questions SHORT ANSWER QUESTIONS True/False

1.

Accounting is becoming increasingly irrelevant in modern business.

2.

The profit figure can be found in the income statement.

3.

The body responsible for issuing accounting standards in New Zealand is the External Reporting Board.

4.

Accounting was developed recently to meet the needs of larger business.

5.

Stewardship in a publicly listed company is the idea that managers are acting on behalf of absentee owners.

6.

The stability of a business can be calculated from its balance sheet.

7.

The main function of the accountant is to produce the numbers to be used by other managers.

8.

The main purpose of the New Zealand Stock Exchange (NZX) is to oversee the accounting profession.

9.

Management accounting is focused on the needs of investors.

10. The qualitative characteristic relating to ensuring that information accurately represents what is occurring in the business by being

complete, neutral, and free from bias, is known as faithful representation.

1.10.1.2

Multiple choice

Refer to the Xero Limited Annual Report for 2013 in Appendix 1. 1.

2.

3.

The net loss after taxation for the group in 2013 was: a.

$14,443,000;

b.

$7,904,000;

c.

$39,969,000;

d.

$19,771,000.

Taxation expense for the group in 2013 was: a.

No tax expense shown in the accounts;

b.

$110,000;

c.

$38,000;

d.

$296,000.

The operating profit for the group in 2013 was: a.

$19,370,000;

b.

$39,033,000;

c.

$15,186,000;

d.

$26,857,000. [page 40]

4.

The value of equity in the business (refer to group accounts for 2013) was: a.

$52,248,000;

b.

$110,422,000;

c.

$102,652,000;

d. 5.

6.

7.

8.

9.

$57,773,000.

The value of cash at bank for the group in 2013 was: a.

$78,244,000;

b.

$84,120,000;

c.

$41,999,000;

d.

$38,976,000.

The net cash flow from operating activities for the group in 2012 was: a.

($7,532,000);

b.

($4,861,000);

c.

($6,836,000);

d.

($11,943,000).

The statutory base used to underwrite Xero Limited reporting is: a.

Financial Reporting Act 1993;

b.

Companies Act 1993;

c.

Securities Act 1978;

d.

all of the above.

The following make up the financial statements of Xero Limited: a.

income statement, and statement of comprehensive income;

b.

statement of changes in equity;

c.

statement of financial position;

d.

all of the above.

The group cash flows in 2013 relating to investing activities were: a.

($8,559,000);

b.

($13,270,000);

c.

$59,982,000;

d.

$35,474,000.

10. The total current assets for the group for 2013 were: a.

$41,999,000;

b.

$26,302,000;

c.

$84,120,000;

d.

$15,774,000. [page 41]

1.10.2

PARAGRAPH ANSWERS

1.

Accounting information is used by internal and external users. List four different groups of external users, and identify the type of accounting information that would be the most useful to each group.

2.

State briefly why the international accounting environment has, in recent years, become so important for those responsible for setting accounting standards in New Zealand.

3.

Explain how the NZ Framework helps users and preparers of accounting statements.

4.

Calculate the GST to be paid or due to be received based the following figures: sales (inclusive of GST) for a two-month period were $13,788; expenses (inclusive of GST) which were properly documented and entitled to a claim, were $7,884.

5.

Briefly explain two types of purchases which cannot be claimed back by a GST-registered business.

6.

List the information that is presented in the following financial statements: a.

income statement;

b.

statement of changes in equity;

c.

balance sheet; and

d.

statement of cash flows.

7.

What is the purpose of each of the statements mentioned in question 6 above?

8.

What is the purpose of having “notes to the accounts”?

9.

Explain the sources of guidance for a preparer of financial reports.

10. Briefly define each of the following terms: a.

faithful representation;

b.

relevance; and

c.

comparability.

1.10.3

DISCUSSION QUESTIONS

Use resources, such as Resource file 1, the internet, newspaper articles, or articles from journals (such as the Chartered Accountants Journal), to answer the following questions. There are no right answers to these questions. 1.

2.

Modern business practice (the good) a.

Briefly discuss why accounting might be called the “language of business”.

b.

Why should business studies students regularly read the business press?

Modern business practice (the bad) a.

Summarise, in your own words, the Bernard Hickey article reproduced in Resource file 1, paragraph 1.9.4.

b.

Explain the linkages that the author draws between tax policy and the “will” of a business to make a profit. [page 42]

3.

Modern business practice (the ugly)

a.

b.

Write a letter to the editor of the newspaper for which you have submitted the article, explaining the failures of accounting identified in the case.

c.

Write a reply to the letter above, in which you explain the importance of ethics in accounting. Justify your response.

1.10.4 1.

2.

Use a search engine to find out about one of the corporate accounting scandals listed in Resource file 1, paragraph 1.9.1. Investigate what happened, and write a one-page newspaper article relaying the key facts of that case. Use more than one source and write it up in your own words.

WRITING EXERCISE

Throughout this chapter you were referred to a range of activities carried out by accountants. Many chartered accountants work in public practice (see the Paul Dunn article reproduced in paragraph 1.3.1). Imagine that you are about to start a small business, and you have been told by the agency lending you money to seek advice from a chartered accountant. a.

Define what is meant by the term “chartered accountant”.

b.

Describe briefly some of the services that are offered by a chartered accountant.

c.

Discuss how applicable each service might be to your own situation.

d.

Write a short report outlining the business you might wish to start, and the results of your investigations.

Write a short essay of about 250 words explaining what a profession is. In your essay describe the benefits of using an accountant who belongs to a profession.

1.11 1.11.1 1.11.1.1

Mastering accounting — solutions SHORT ANSWER QUESTIONS True/False

1.

False. With the increased complexity of financial markets, accounting information is becoming more relevant.

2.

True.

3.

True.

4.

False. Accounting has a long history.

5.

True. Stewardship is a concept from the Middle Ages, in terms of which stewards act on behalf of absentee landlords, and is still used in the modern context.

6.

True.

7.

False. See the Dunn article reproduced in paragraph 1.3.1. Accountants need to prepare information for decision making, and then communicate this in an understandable manner. [page 43]

8.

False. The NZX is the body overseeing the buying and selling of shares and other financial instruments.

9.

False. Management accountants focus on internal decision making.

10. True.

1.11.1.2

Multiple choice

1.

a. See page 4 of the Annual Report.

2.

d. See page 4 of the Annual Report.

3.

b. See page 4 of the Annual Report.

4.

c. See page 7 of the Annual Report.

5.

a. See page 7 of the Annual Report.

6.

b. See page 8 of the Annual Report.

7.

d. See page 9 of the Annual Report.

8.

d. See pages 4–8 of the Annual Report.

9.

b. See page 8 of the Annual Report.

10. c. See page 7 of the Annual Report.

1.11.2 1.

PARAGRAPH ANSWERS

Investors are the providers of risk capital. They are concerned with the risk inherent in, and the return provided by, their investment. They need information to determine whether they should buy, hold, or sell their investment. Shareholders are also interested in the amount of dividends that they might be expected to receive. Lenders are interested in information that enables them to determine whether their loans, and the interest owing on those loans, will be paid when due. The loan agreement may determine the access of the lender to that information, but does not guarantee the ability of the business to meet its commitments. Suppliers and other creditors are interested in information that enables them to make decisions regarding amounts owing to them. Their access is less certain, and the decision of suppliers to continue delivery of goods and services needs to be constantly revised in an underperforming business. Employees are interested in information about the stability and profitability of their employers. They are particularly interested in any

information that enables them to assess continued employment and possibilities of promotion. The public are affected by the business in a number of ways. Members of the public may want to know if the business will continue in the future in order to honour warranties; they may want to know whether or not they are making too much profit, because they are in a monopoly situation. The importance of the general public with regard to financial reporting is highlighted by pressures on businesses to be more socially and environmentally aware. [page 44] Customers have an interest in information about the continuance of an enterprise, especially if there are warranty commitments. 2.

The rapid globalisation of the world’s finance and consumer markets has created numerous financial interdependencies in international commerce. This has caused pressure to be brought to bear on international accounting standard setters to harmonise accounting standards.

3.

The NZ Framework helps: users to interpret information contained within financial reports prepared in conformity with GAAP; preparers to apply financial reporting standards; and auditors to form an opinion as to whether or not the financial statements provide a fair representation.

4.

Total sales: $12,500 — GST to be paid (divide by 23 and multiply by 3): $1,630.42; Total purchases: $7,850 — GST to be received (divide by 23 and multiply by 3): $1,023.91;

Therefore, GST due to be paid (outputs higher than inputs): $1,630.43 – $1,023.91 = $606.52. 5.

GST cannot be claimed on: the cost of financial transactions; services purchased from non-registered entities, unless it is secondhand goods (supported by appropriate documentation); and letting of private boarding facilities.

6.

7.

8.

a.

Sales (fees earned), cost of sales, gross profit, selling expenses, administration expenses, financial expenses, operating profit, nonoperating revenues and expenses, and net profit.

b.

Opening equity, net profit, drawings or dividends paid, and additional capital received.

c.

Equity, current assets, current liabilities, non-current assets, and non-current liabilities.

d.

Cash inflows and outflows from operating, investing, and financing activities, and cash balance.

a.

The income statement determines a business’s profitability.

b.

The statement of changes in equity shows the changes that relate to the owners’ interest in the business.

c.

The balance sheet shows what the business owns or controls, and what it owes.

d.

The statement of cash flows shows cash movements, and reconciles to the bank accounts.

The “notes to the accounts” gives readers of financial accounts some insight into some of the decisions made surrounding the preparation of those accounts. For example, the measurement basis (historical cost, or modified historical cost), and depreciation rates, are often declared. [page 45]

9.

Preparers of accounting reports gain their guidance from legislation (Companies Act, Financial Reporting Act, and taxation legislation), from Financial Reporting Standards (as authorised by External Reporting Board), and from current accounting practice (commonly known as GAAP).

10. Faithful representation: Information presented in the financial statements should accurately represent what is occurring within the entity. It should be complete, neutral, and free from error. Relevance: Information is relevant to users if it can be used to confirm prior expectations (feedback value), or assist in creating new expectations about the future (predictive value). Comparability: Information usefulness is determined by the ability of users to compare accounts over time, and to compare accounts of businesses in a similar industry. The NZ Framework emphasises that comparability is not necessarily about uniformity, but rather about informing users.

[page 47]

Starting up a business

CHAPTER

2

Contents Learning outcomes 2.1

Introduction 2.1.1 Case study — Tearaway Paper Recycling 2.1.2 Considerations for business start up

2.2

Most common forms of business ownership 2.2.1 Partnerships 2.2.2 Companies 2.2.3 Sole traders 2.2.4 Some questions for discussion in relation to the case study

2.3

Business professional view 2.3.1 A closer look at the resourcing decision — long-term view 2.3.2 A closer look at the resourcing decision — working capital 2.3.3 The circulation of resources

2.3.4

A closer look at profit

2.4

An information system — the accounting equation 2.4.1 What does the accounting equation tell us? 2.4.2 Changes in the accounting equation 2.4.3 Placing values on assets and liabilities 2.4.4 Purchasing assets

2.5

Detailing what happens in the owner’s equity section

2.6

Conclusion

2.7

Key words 2 [page 48]

2.8

Resource file 2 2.8.1 Case study — Wade Waiwater: A change in the wind … from crew to skipper 2.8.2 Accounting policies

2.9

Mastering accounting — questions 2.9.1 Short answer questions 2.9.2 Paragraph answers 2.9.3 Discussion questions 2.9.4 Research assignments 2.9.5 Internet exercise

2.10

Mastering accounting — solutions 2.10.1 Short answer questions 2.10.2 Paragraph answers 2.10.3 Discussion questions [page 49]

Learning outcomes After completing this chapter, you should be able to: understand the various forms of business ownership within an accounting context; explain the relationship between ownership of assets and the financing of them; identify the resources of a business; explain the circulation of resources as the basis of business activity; show how transactions affect the accounting equation; explain the effect of the accounting period and going-concern assumptions; understand the purpose of a balance sheet; identify the elements of a balance sheet; prepare a balance sheet; identify and explain contingent liabilities; understand the purpose of a statement of changes in equity; identify the elements of a statement of changes in equity; and prepare a statement of changes in equity.

2.1

Introduction

In this chapter, we will concentrate on the balance sheet, while viewing the

importance of profit to the longevity of a business.

2.1.1

CASE STUDY — TEARAWAY PAPER RECYCLING

The following case study is a practical example of some of the ideas introduced in Chapter 1. It also introduces some key accounting concepts, such as going concern, accounting period, and accounting entity. Tom collects waste paper from inner city offices for recycling. The message he gives his clients is “Don’t screw it up! Tear it up!” Re-educating people to tear up their paper and to put it in the recycle bin, rather than screw it up and throw it in the wastepaper basket, might seem simple, but old habits die hard! Clients pay a small fee to have large plastic recycling bins emptied twice a week. “I sell the paper to another firm, which uses it to make ‘used paper products’. I think they export some of the products,” says Tom. Tom is a patient, cheerful, former engineer, who enjoys tramping and working with bird rescue on the weekends — or used to, until he became selfemployed. He has a passion for conservation and environmental sustainability, both within his personal life and within the wider community. The idea for his business started when he read an [page 50] article in the local newspaper about the vast amounts of waste paper from photocopying, computers, and faxes being dumped in landfills. He took a risk starting his business, because he gave up his normal salaried job, and started with $10,000 of personal savings and a bank loan of $30,000, using his family home as security. “My wife, Margaret, and I discussed the idea for a year before putting together a business plan and really

going for it. Margaret is very supportive and also does the bookkeeping for me, because she is good at it, and I am often too busy to do it well.” Margaret: “Tom needed the special recycle bins and an adapted truck to start out. That took most of the money, so we used our garage, garden shed, and any house space we could for storage. But it did become a fire risk, so we had to do something about it. Tom found a warehouse in a new industrial park which had a small office attached, which he now leases. It is more professional, with work and home more separate.” Making the decision to start a business on your own is difficult, but running it is even more of a challenge! “The first step for me was difficult,” says Tom. “I left a secure job with a great salary. Some people might think that is crazy, but I wanted more in life than a secure job. I wanted to make a difference. I knew there was risk, but I am not sure I realised how much risk. Getting started was expensive, but it was all the things I didn’t think about that really made the difference. Margaret and I had calculated all the expenses, but there seemed to always be one more that we did not expect. Such as sourcing the bins — I thought that would be easy, but I had to travel around the country to find one to best suit the task. I soon realised that I wasn’t going to get one ‘off the shelf’. I had this loan that I was already paying off (with interest). I hadn’t done any business yet, and already the money was running out!” “You should have seen him,” says Margaret. “He was like a ball of worry by the end of the first month! He was busy trying to visit potential clients to get them to trial the bins, but couldn’t stop to chat too long because he had to move to the next potential client. Trying to balance time was nearly impossible. We called Tom the ‘Talk fast, walk fast guy’ for a while.” Tom admitted that he had underestimated how much travel he would need to do — in terms of time and money. Tom was full of enthusiasm, but had never worked in the service industry before. The nature of the business was quite different to that of engineering — communicating constantly with clients was new to him. Many

small to medium enterprises (SMEs) fail because the owners are unfamiliar with tracking their money, or have not started the business with enough of their own money in the business (owner’s equity). Tom is already feeling stressed because he is in debt to the bank, and does not have money coming in to pay it. What advice might he need? Thankfully, Tom went to his accountant (Ina) when he first started his business, and was told that, if he could not pay his debts, he would have to sell the “business assets” — the truck, office furniture, the bins, and other similar items. Ina explained that, if he were unable to pay his debts after selling the business assets, his personal assets would come next — this could include the house (remember that Tom used the house as security on the original loan). Tom knew the risk he was taking when he started his business. [page 51] “I am very careful to make sure all the businesses I collect from pay me on time, more or less, so that I can pay my debts, such as the loan, interest, lease, travel costs, and my many other business expenses. I also pay Margaret a small wage for doing the bookkeeping, and pay the accountant a fee for services. I feel more secure knowing that I can call on my accountant for financial and business advice.” At the end of the first year, Tom received his end-of-year financial statements. The accountant stressed the importance of checking weekly how the business was doing. Margaret learnt how to keep simple financial records (a cash book and statement of cash flows). To ensure that they really knew how the business was doing, Margaret and Tom were advised to keep their personal bank account and the business bank account separate. Margaret said, “When we first started the business, it was hard to separate business and personal, because we seemed to always be working, so they became the same. But we soon realised how important it was to keep them separate.”

During the first year, the accountant prepared a set of financial statements every three months, and met often with Margaret and Tom to discuss the meaning of the accounts and to give them a clear picture of the business and its finances. “Accounting jargon was pretty new to both of us, but having such a good accountant meant that we learnt pretty quickly what the jargon meant to our business. Cash flow was an important term in the first year,” laughed Tom. Tom’s paper recycling business did well and, by the end of the first year, was making a profit. “A good profit,” said Tom. “Not a great one, but a good one.” Both Tom and Margaret agreed that this first year in business had been the most challenging in their whole marriage, but were glad they decided to get Tom’s business up and running. “Most importantly,” said Tom with a big grin, “I get to keep the profits!”

2.1.2

CONSIDERATIONS FOR BUSINESS START UP

Tom chose to start his business as a sole trader and, although well prepared, he and Margaret did come across some surprises in the first year. Table 2.1 provides a brief list of some of the decisions and issues that Tom would have needed to consider before, and during, the start-up of his business. TABLE 2.1: CONSIDERATIONS FOR BUSINESS START UP DECISION AREA

ISSUES

To start up a new business

Expected rewards — financial and non-financial Impact on lifestyle — cost versus reward Personal objectives

Legal form of business

Sole trader, partnership, company

Resources needed to get started

Personal money or borrowed money Personal assets or rented/leased assets Working capital

Ongoing information needs

Customer relationship management Professional knowledge Legal and statutory requirements

Any sector-specific information needs

[page 52] Requirements for ongoing efficient operation

Budgets Stock levels Credit control Internal control Costings Pricing Monitoring

As a future business professional, you may be asked to assist in all or some of these decision-making areas. Understanding accounting will give you the framework to provide, or to confidently seek, the answers to many businessrelated questions. During the start-up period of Tom’s business, he had a lot of nonproduction time, where he did not generate any sales because he was busy building his client base by demonstrating his service. The business could have failed during this start-up period if he could not pay his creditors. This reinforces the need to understand the importance of having working capital in the business. Tom started the business with just $10,000 of his own (remember he borrowed $30,000 from the bank). He also used his own house for security on the bank loan, and ran the business from his house and garage — all a little risky. From the beginning, Tom knew there were real business risks. He was starting from scratch — not only in the sense of the business, but also his business idea. Tom chose to start as a sole trader, but there were other options he could have chosen. The second decision area in Table 2.1 suggests three options — sole trader, partnership, or company. Tom’s choice of legal form of business is a crucial one, which impacts on his future life as a business owner. Tom could have found a partner, someone who may have had

experience in recycling waste paper or had previous business experience. A partner could also bring in additional capital, be able to work alongside Tom in building the client base, or provide other capital items, such as the vehicle or warehouse. Tom could have formed a company — either on his own as the sole shareholder, or with Margaret as the other shareholder. This takes more time to set up, and is more expensive than a sole trader or partnership. However, neither Tom nor Margaret would be personally liable for any debts incurred should the business fail, unless they give a personal guarantee. A company would give Tom the protection of limited liability, thus lessening his risks. Read the case study again and see if you can add to the list of good decisions made by Tom and Margaret. Also list any decisions that you think were not so good.

Through the case study we can see that, although Tom was not experienced in business ownership or recycling, he did make some good decisions when starting up his business. He sought advice from an accountant, he prepared a business case to test the viability of the business before start-up, he spent a lot of time communicating with his potential clients, and he kept the business and his personal finances separate. A successful business is not just good luck — it is a decision-making process. [page 53]

2.2

2.2.1 2.2.1.1

Most common forms of business ownership PARTNERSHIPS Introduction

For more detailed information on partnerships, go to the New Zealand Legislation website, www.legislation.govt.nz, and search under “Acts” for the Partnership Act 1908.

Section 4 of the Partnership Act 1908 defines a partnership as “the relation which subsists between persons carrying on a business in common with a view to profit”. The minimum number of partners for a partnership is two. There is no maximum number of partners under the Partnership Act 1908, and there is currently no limit on the number of partners under the professional accounting body, NZICA.

2.2.1.2

Starting the partnership

In most cases, the partners will consult a solicitor, who will draw up a partnership agreement or deed of partnership. The deed covers the details of how the partnership will operate, and includes: the name of the partnership and who the partners are; what the business of the partnership will be; how much capital each partner introduced; what interest rate they will receive on their capital; how profits or losses are to be divided; what arrangements are to be made for partners’ drawings; and how the partnership is to be dissolved. What are some of the advantages and disadvantages for Tom if he chooses a partnership for his business structure? Hint: go to the Ministry of Economic Development’s website, www.business.govt.nz, and search for the phrase “Choosing a business structure”.

Where there is no formal agreement, partners are bound by the Partnership Act 1908. As in the case of a sole trader, partners are personally responsible for the debts of the business. They also have unlimited liability, and both business assets and their personal property can be sold to meet the debts of the partnership. If Tom went into partnership with Jeremy and the business debts could not be paid, Tom and Jeremy’s personal property as well as the business assets

could be sold to pay business debts. This is known as joint and several liability.

2.2.1.3

Responsibility for debts

Partners are jointly and severally liable for business debts. The partnership agreement is a private agreement between the partners — it is not a public document. Anyone considering giving credit to a partnership really has no way of ascertaining the role of each partner, and must assume that whoever signs on behalf of the business has the authority to do so. If Tom had formed a partnership, and his partner made a decision which meant that the business acquired a debt which it could not pay, then both the partner’s and Tom’s personal property may have to be sold to pay the business debt. The fact that Tom did not play a part in the decision, makes no difference. Obviously then, who makes what decisions should be clarified before a partnership is formed, and documented in [page 54] the partnership agreement. But, even if the agreement does not authorise a partner to take on debts, both partners are still liable for the debts of the business.

2.2.1.4

Accounting entity

All entities, whether they are sole traders, partnerships, companies, or other forms of business entity, follow the accounting entity principle. In terms of this principle, a partnership is seen as being separate from its partners for accounting purposes.

2.2.1.5

Profits and drawings

Suppose Tom entered into a partnership which made a profit of $28,000, and they had agreed that Tom would receive a salary of $10,000 a year and that his partner would receive $7,000 (because he worked fewer hours and had fewer responsibilities). The total salaries are $17,000, which reduces

the profit to $11,000. If this is shared equally, each partner receives $5,500 profit. We can see that, in fact, Tom would receive $15,500 as his share of the profit, and his partner’s share would be $12,500.

In the case of a partnership, the decision about how the profit is to be shared, is set out in the partnership agreement. The Partnership Act 1908 determines that, if there is no partnership agreement, profits are to be shared equally. Partners can take drawings in anticipation of profits, and it is important that accurate records are kept to account for each partner’s withdrawal of cash or goods from the business. Partners sometimes pay themselves a salary to reflect their different responsibilities within the partnership. However, this is really another way of distributing the profit.

2.2.1.6

The end of the partnership

The reasons for ending or dissolving the partnership will be detailed in the partnership agreement, or in the Partnership Act 1908. Common reasons for bringing the partnership to an end include the death or retirement of a partner, or when a partner wants to leave. If another person wants to join the business, then the partnership is dissolved, and a new partnership agreement is drawn up to include the new partner. A change in partner does not mean that the business must cease, but there may be some disruptions owing to changes in the legal relationships between partners.

2.2.2 2.2.2.1

COMPANIES Introduction

A company is a separate legal entity, which means that the company can enter into contracts in its own name; it can hold property in its own name; and it can sue or be sued. Companies function separately from their owners, who are shareholders. There are no limits to the number of shareholders a company may have. A person becomes a shareholder of a company by subscribing for shares in the company — that is, by agreeing to buy a number of shares at an agreed

price. According to the New Zealand Stock Exchange, “a share is a piece of ownership in a company. Buying shares in a company makes you a partial owner of that company. The more shares you buy, the bigger your ownership stake becomes, and the more say you can have in how the company is run” (http://www.nzx.com/investing). The amount of money that is paid for the original purchase of shares, represents the capital of the business. The law relating to companies is contained in the Companies Act 1993. [page 55]

2.2.2.2

Responsibility for business debts

Shareholders of companies are not personally liable for business debts. This means that shareholders’ personal assets cannot be forcibly sold to pay business debts. However, if the company is a small business, it is common practice for lenders to require the shareholders, or principal shareholders, to give personal guarantees. Unless a shareholder has given a personal guarantee, a limited liability company prevents his personal assets from having to be sold to pay off business debts. In this case, potential creditors bear the risk. Accordingly, they should seek to examine the company’s annual accounts to check its creditworthiness, or carry out a credit check through a company such as Baycorp before making a decision to extend credit. As mentioned above, a person becomes a shareholder in a company by agreeing to buy a certain number of shares at a set price. However, the shareholder may not be required to pay the entire agreed price at the time of purchase. This means that some of the issued capital of the company will be “uncalled”. For example, a company may issue 20,000 shares at a price of $4 per share, but requires shareholders to pay only $3 per share on issue. Uncalled capital is $1 per share. It is this $1 per share which represents the only liability of shareholders to the company. Thus, shareholders of companies have limited liability. If the business does poorly and goes into

liquidation or receivership, shareholders risk losing some or all of the value of their shares, but will not be required to cover any further debts.

2.2.2.3

Accounting and legal entity

In addition to being an accounting entity, a company is also a legal entity, which can be thought of as a “person” in its own right. This means that debtors and creditors have a legal relationship with the company, and not with Tom. Contracts will be written in the name of the company, and not in Tom’s name. Banks will lend to the company, and not to Tom personally. Lawyers will draw up legal documents on behalf of the company, even though, as director, Tom will sign them.

2.2.2.4

Capital

Capital comprises the issued capital of a company, which may or may not be fully issued at the commencement of a company’s start-up date. In addition, the amount of the shares issued may not be fully paid up. If Tom had formed a small private company with say, Margaret, as the other shareholder, their capital of $10,000 would have been 10,000 $1 shares. The company, not Tom, would have borrowed the $30,000 from the bank.

2.2.2.5

Profits and dividends

Unlike the profits of a sole trader or partnerships, company profits are taxed. Shareholders receive their share of profits through dividends, which are usually paid at the end of the accounting period, although interim dividends may be paid during the period. The profit of a company is taxed, and management must set aside funds for the payment of tax. Company profits are distributed as dividends according to the number (and type) of shares held by each shareholder. Dividends then become part of a [page 56]

shareholder’s personal income, and are subject to income tax. An adjustment is made in the shareholder’s return for tax already paid on that part of the profit distributed as a dividend. Directors of companies (who may also be shareholders) are entitled to be paid a director’s fee. Also, in many smaller companies, shareholders are also employees of the company, and sometimes receive a salary for the work they carry out.

2.2.2.6

The end of the company

For more detailed information on companies, visit the following websites: www.legislation.govt.nz — search under “Acts” for the Companies Act 1993; www.companies.govt.nz/companies — select “How do I…?” and then “Learn what a company is”. Browse around the website.

Unless a company goes into liquidation or receivership, it can have an indefinite life, which is one of the advantages of the company structure. People who do not want to remain shareholders are usually free to sell their shares, subject to the constitution of the company. A company is placed in receivership by the holders of a debenture when the company fails to meet the terms of the debenture agreement, such as the non-payment of interest or principal, or breaches the debt/equity ratio. A company may go into voluntary liquidation by a special resolution of the shareholders. A company may also be placed in liquidation by a court order or by a meeting of creditors if it fails to pay its debts.

2.2.3 2.2.3.1

SOLE TRADERS Introduction

Compare this with the more formal ways in which partnerships and companies are formed.

A sole trader is a form of business owned by one person. The sole trader may, however, hire others to work for the business. Anyone can go into business as a sole trader, provided they have the start-up money. Sole traders do not have to apply to go into business, or register their businesses, although they may

have to meet local body licensing requirements, such as the Resource Management Act 1991, or a District Plan. Often a sole trader will use a trading name — Tom traded as “Office Recycling”.

2.2.3.2

Responsibility for debts

Sole traders are personally responsible for all the debts of the business. This means they have unlimited liability. The personal assets of the owner can be sold in order to pay the debts of the business.

2.2.3.3

Accounting entity

If Tom does not follow the accounting entity principle, what would the effect be on the information he collects about his business?

No matter how small the business, sole traders should keep the financial affairs of the business separate from their own finances, so that meaningful information can be produced on the results and financial position of the business. This is known as the accounting entity concept — where the business unit is seen as being separate from the owner or owners. Ina would have stressed this when Tom first went to her for advice. Margaret simply opened a bank account in the name of the business, obtained a separate cheque book, banked cash and cheques from clients intact, and made sure she received a regular bank statement. All businesses follow the accounting entity principle, whether they are sole traders, partnerships, companies, or other forms of business entity. [page 57]

2.2.3.4

Capital

Money used to start the business is called capital. Additional capital may be contributed by the owner at any time during the life of the business. Tom used his own money to start his business, as well as an additional amount borrowed from the bank. Tom’s “equity” in his business was the

$10,000 he contributed in capital. The success of any business is measured in financial terms by measuring increases in equity. Tom hoped that his initial investment of $10,000 would yield a net profit, and indeed he did make a profit, thereby increasing his equity.

2.2.3.5

Profit and drawings

Was the small profit Tom made adequate when balanced against the fact that he had given up a job, had “sleepless nights”, and worked long hours? Only Tom can answer this. When Ina analyses the financial statements, she will help Tom to make an informed decision by discussing this. She will draw his attention to the link between his investment (capital) and the amount earned by this investment (the profit, that is, the return on investment).

At the end of the financial year, Tom made a small profit. In a sole trader business, the profit belongs to the owner. It is his or her income. The profit made by sole traders is not subject to company tax, but is taxed as personal income. During the year, most sole traders draw an amount from the business as their personal income, in anticipation of profit. Drawings take the place of wages. This is because sole traders do not pay themselves wages, which are classified as a business expense; they pay wages to others who work for them. Drawings can be taken in the form of cash or goods. The amount of drawings will often be a set amount, drawn on a regular basis to meet the personal financial needs of the sole trader. Drawings are taken into consideration when preparing the financial statements — they are a part of profit and are taxed accordingly.

2.2.3.6

Debtors and creditors

It is not always practical for businesses to pay for services at the time they receive them. In addition, to encourage clients to use the services of the business and to compete with other businesses, the sole trader may have to offer credit. The length of credit is usually based on what other similar businesses offer — seven days, 30 days, or the 20th of the following month, are examples of different lengths of credit. Businesses who use services of the business, but who do not pay for them

at the time that they are performed, are known as debtors (or accounts receivable). It is Margaret’s job to prepare the invoices and statements which are sent to debtors. When they pay, she banks the cheque in the business’s account. A good system of collecting money owed to the business is essential. Tom needs to have good cash flow, and collecting money in a timely manner is important to healthy cash flow. Creditors (or accounts payable) are businesses or individuals to whom Tom owes money for goods and services he has bought for the business. Making sure that creditors are paid on time is good business practice, and ensures that the business is seen as low risk and stable, which will enable it to get credit in the future.

2.2.3.7

The end of the business

The sole trader’s business will end when the owner retires, or decides that he is not interested in carrying on as owner. There are few formalities; business debts must be paid, including wages owing to employees; if there are contracts to fulfil, these should be honoured; and clients should be advised that the business is closing. [page 58] Do you think Tom has any goodwill in his business?

If the business is successful, Tom will probably be able to sell it to a new owner. If he has a good name and plenty of clients, he will be able to add goodwill into the price of the business.

2.2.4

SOME QUESTIONS FOR DISCUSSION IN RELATION TO THE CASE STUDY

Hint: Go to www.companies.govt.nz and search using the phrase “Choosing a business structure”.

Tom was a sole trader, but he could have formed a company. What are some of the advantages and disadvantages of choosing this business structure? When Tom considered forming a company, his accountant, Ina, talked to him about liquidation and receivership. What is the difference between these two terms? What New Zealand website could you go to for advice on the process of forming a company? Tom learned a new phrase: “cash flow”. Comment on Tom’s cash flow situation during the first year of business. Why is it important for Tom to keep his business and personal affairs separate? In the beginning, Tom ran his business from home and also stored the recycling bins there. List some of the items that Tom could have claimed as business expenses. How would he know what percentage to claim? Other possible types of business structure are a look through company (LTC), a trading trust, and a co-operative. Provide brief definitions for each of these types of business structure. At the end of the first year, Tom’s business made a net profit of $28,000; his initial capital was $40,000 — he used $10,000 of his own money, and borrowed the rest from the bank. Ina points out to Tom that; if he had invested his $10,000 in a term deposit, he could have received up to 5% interest. When he gave up his job as an engineer, his take-home pay was $50,000 per year, working a 40-hour week, with four weeks’ holiday a year plus statutory holidays. Although the business has a net profit of $28,000, there is only $4,500 in the bank. Tom was more than satisfied with this outcome after one year’s trading. Discuss what you think Tom achieved in his first year trading. Consider the following:

Why did Tom go into business? What were his expected rewards? What has Tom learnt about business and about himself? How big was the impact of the business on his family and personal hobbies or interests? What did he think of the future of the business? What could be changed for the next year’s trading? [page 59]

2.3

Business professional view

Let us now examine the business from the point of view of a business professional. In the case study in paragraph 2.1.1, Tom went to Ina, an accountant, and sought advice about the financial side of operating the business. Tom has clearly explained some of the problems associated with getting started — but only from a personal point of view. To extend our knowledge of operating a business, we must take a closer and more technical look at Tom’s business from the point of view of a business professional. This means taking some of Tom’s comments, and rephrasing them into the language and concepts of accounting.

2.3.1

A CLOSER LOOK AT THE RESOURCING DECISION — LONG-TERM VIEW

One of the prime causes of business failure stems from the initial failure of

the owner to put enough money (capital) into the business when setting it up — that is, the business is started with too much debt, and not enough equity. The relationship between debt and equity is a critical one. Let us explore this in more detail. Tom’s business required $40,000 to fund the necessary assets, and to provide sufficient cash to meet the ongoing operating overheads (rent, power, and telephone) once the business was established. What are our options for the initial financing of the business? We can either use our own savings, or we can borrow — perhaps from a bank or finance company. If we financed the business completely from our own savings with no borrowed funds, we would have 100% equity. If we were able to borrow the full amount, we would have 100% debt finance. If we borrowed half of the requirement, we would have a debt/equity ratio of 1:1.

2.3.1.1

The significance of the funding decision

In short, the more start-up funding we obtain from external sources (thus incurring debt), the more financial risk we are exposed to. This is because we have to service the debt — that is, we need to meet the interest payments (and repay the loan). With a business as new as Tom’s, there is generally more risk for the lender, which can often mean that the interest on the loan is higher or, as in Tom’s case, that a personal asset must be used to secure the loan. For example, if Tom were to borrow the whole $40,000 per our case study, and if interest rates were at 8% per annum, Tom must earn $3,200 each year just to pay the interest. If the business does well, it will not be a problem. If it does not do well, or if there is an economic downturn, Tom may find himself unable to service the debt, which may result in the lender (the bank) requiring repayment of the loan. This, in turn, may require Tom to sell some of the assets, which will clearly undermine the effectiveness of the business. In the most extreme case, Tom may be forced to close down the business. For Tom and Margaret this could be devastating, because Tom used the family home as security on the loan, so they would be forced to sell the house to pay

off the loan. If, however, Tom financed the business completely from his own funds, he will not be exposed to this risk of closure by an outside party. [page 60]

2.3.1.2

Should borrowing be avoided if possible?

Not at all. To restrict business funds to only the capital we ourselves can provide, may result in an inadequate level of funding, so that, for example, we carry an insufficient amount of stock, undertake inadequate marketing and advertising, or settle for less appropriate or low quality equipment or fixtures and fittings. Tom might choose to borrow so as to leverage (increase return on) his initial investment. This can be done if there is expected to be a high profit. Just what the right amount of borrowings is, depends on factors such as our expectations of short- and long-term business revenue, how quickly the business will establish an adequate share of the market, and how profitable trading is expected to be. This means that a careful plan is required before making financing decision, to ensure that any risk taken is reasonable in the circumstances — that the risks are calculated. Assumptions will have to be made about the future state of the economy in relation to the current and future business, and the likely trend in interest rates. The more equity is borrowed, the more we will be vulnerable if business predictions are not realised — for example, a downturn in sales, a failure to meet initial sales targets, an increase in interest rates, or an underestimation of expenses. Table 2.2 illustrates the concept of risk associated with debt funding. Case A assumes 75% of the required funding of $40,000 is obtained through externally borrowed funds (a debt/equity ratio of 3:1). Case B assumes only 25% is debt finance, with 75% owner’s equity (a debt/equity ratio of 1:3). The comparison is based on the failure of the business to meet the expected sales,

and the revenue initially planned for thus being less than predicted. A return on investment percentage is calculated to highlight the different results. TABLE 2.2: COMPARISON OF RISK AND RETURN OF DIFFERENT BORROWINGS

Revenue Less Expenses (other than interest)

CASE A ($30,000 BORROWED)

CASE B ($10,000 BORROWED)

Expected results

Actual results

Expected results

Actual results

$ 58,000

$ 31,000

$ 58,000

$ 31,000

(28,500)

(27,500)

(28,500)

(27,500)

Less Interest expense

(3,600)

(3,600)

(1,200)

(1,200)

Profit (loss)

25,900

(100)

28,300

2,300

Original capital

10,000

10,000

30,000

30,000

259%

(1%)

94.33%

7.66%

Return on investment

The findings set out in Table 2.2 indicate that the failure to achieve the expected revenue has resulted in the business making a loss in Case A — the interest on the loan has a higher impact than in Case B, because there is a higher proportion of debt funding. The outcome for Case B is that the business is still making a profit, even if it is greatly reduced. [page 61] While the business has not measured up to expectations in either case, in Case A there is a very real danger for the business if it is unable to reduce its non-interest expenses or increase revenue. Future decisions for Tom in Case A will be more risky, as he balances the need to increase sales, while reducing expenses. At a time when Tom may need to take some risks, he will be constrained by debt. In Case B, Tom will have more time to reconsider the decision to be in business, and the overall profitability, without the constraints of the inability to service the debt. While accepting that Case A is

riskier, the return that Tom is able to achieve because he makes the expected profit is also far higher. However, Tom is feeling the stress of working within the confines of a business with a high debt/equity ratio. We will discuss the relationship between risk and return again in Chapter 7. It should also be noted that the risk associated with a high debt/equity ratio is greater when there is a higher proportion of interest cost in relation to revenue. In the 1980s, interest rates doubled, reaching over 25% in a very short time. In Tom’s case, a doubling of interest rates, combined with a downturn in business, could prove disastrous. His small profit could easily become a loss.

2.3.2

A CLOSER LOOK AT THE RESOURCING DECISION — WORKING CAPITAL

We saw in the previous section that it is vital that a business has a sound financial structure in terms of the proportion of funding provided by way of equity finance. Equally as important, is the need for the business to have adequate working capital or liquidity — that is, to have sufficient cash coming in to pay the bills as they fall due. If this is the case, the business is said to have a positive cash flow. Cash flow simply refers to the relationship between cash coming into the business, and cash going out as a result of transactions with outside parties (the customers, suppliers, and lenders). The concept of a positive cash flow is a simple one, but in practice much can go wrong to prevent a positive cash flow, with potentially disastrous results. If the cash flowing out of a business exceeds the cash coming in, the business will eventually run out of cash and fail. Many a profitable business has failed because of the inability to pay bills when they fall due. Cash flow is often a matter of timing — the cash generated by a business must flow into the business in time to enable the bills to be paid. If this does

not happen, those owed money by the business (the creditors) may take legal steps to obtain their money (this is covered in more detail in Chapter 5). This may result in the business being wound up, even though it is profitable. The main timing differences between cash flowing in and cash flowing out arise out of the business’s policies and practices relating to inventory levels, and to buying and selling on credit. Let us look at some simple cases. Consider a service business such as Tom’s, which collects its fees at the time its service is provided, and is able to obtain its supplies on monthly credit — for example, Tom may have credit agreements to pay monthly for overheads such as petrol, telephone, and his building lease. In this case, the business will have a positive cash flow, provided sufficient jobs are secured to cover the bills when they fall due, and that all debtors pay at the time the service is provided. [page 62] Overhead expenses for July payable by August 20

$1,500

Contract fees collected in July

$2,000

Cash surplus for July

$2,000

Let us now complicate the situation by considering what might happen if the business’s major debtor did not pay immediately, but rather expected one month’s credit when purchasing the paper. Overhead expenses for July payable by August 20

$1,500

Contract fees collected in July, but not due for payment until August

$2,000

Cash surplus for August

$500

Clearly, no cash has flowed in or out during July. If a major debtor pays its account on time, there will still be a cash surplus in August, but the debtor will have had the use of Tom’s money for that month. This is not an uncommon situation and is usually expected in business, provided it is agreed

to prior to the debt being incurred. Consider what happens if the major debtor delays its payment for a month: Overhead expenses for July payable by August 20

$1,500

Contract fees collected in July and due for payment in August but not paid

$2,000

Cash surplus for August

$500

The business now has a cash flow problem. It has paid out more than it has collected, and will have to make up the difference by way of a loan (usually a bank overdraft), or out of cash held in the bank. Indeed, holding cash in reserve as working capital is essential in such cases, to ensure that the business can pay its bills without incurring further debt through loans. In this case, the debtor has had further use of Tom’s money. Tom will be paying interest if he has had to increase his loan, or will miss out on interest if he reduces his working capital. This is an important reminder that a business is not in the business of lending money, it is in the business of making money!

2.3.3

THE CIRCULATION OF RESOURCES

Tom operates a service business. What would be different about his working capital if, instead, he operated a business that bought and sold goods? For a start, inventory would now make up a large part of his working capital. Assuming he purchased inventory on credit terms, there would also be a big increase in the amount owed to creditors. For Tom to be able to pay his creditors when their bills were due, he would now have to focus not only on collecting money owed by his customers, but also on making sure that his inventory sold fairly promptly. Working capital on a financial statement appears to be static, but in reality it is a constantly circulating flow of resources. Think of this working capital as a cash production pipeline. Resources flow through this pipeline in

a cycle. First inventory is purchased; then this inventory may be sold on credit, so that business resources are now converted [page 63] into accounts receivable — that is, customers owing money (debtors); as customers pay, cash is released to buy more inventory (or to pay suppliers for inventory previously bought on credit); this inventory is then sold and turned into accounts receivable; and so on as the cycle repeats itself. Managing this cycle effectively is crucial to the success of a trading business. First and foremost, cash is essential for any business’s survival. As we saw in the previous section, businesses need cash to pay their bills. What happens if businesses do not do a good job of managing this circulation of resources? Inventory is bought, but sits too long on the shelf; sales are made on credit, but customers do not pay on time; the cash pipeline develops nasty bulges as cash is tied up first in inventory, and then in accounts receivable. Just like water through a pipeline, if cash builds up in bulges within the pipe, rather than flowing freely, it comes out the end of the pipe in a trickle. If cash flow is restricted to a trickle for too long, a business cannot pay its rent, wages, and other important expenses, or repay loans. Eventually, it may be forced to close its doors. A second reason why the circulation of resources is crucial to a trading business, is that it plays a key role in generating profit. In a normal healthy business, the cash within the cycle does not stay constant. It grows each time inventory is sold. How much it grows, depends on the level of mark-up and the volume of sales. Mark-up is how much the selling price of the inventory exceeds its cost price, and volume of sales is how many items are sold. Assume that a business buys an item for $100 and sells it for $120 — $100 of inventory goes into the pipeline, but $120 flows out. If the business buys one item and it takes seven days to sell, the business makes a profit of

$20 per week, provided the volume of sales and speed of sales is constant. What would happen if the business could manage its inventory more efficiently? What if it could increase the speed of the flow through the pipe? For example, what would happen if the item only sat on the shelf for one day before being sold? If the business is open seven days a week, it now makes $140 profit for the week — that is, $20 profit on each of the seven days. So, the faster the cash is pumped through the pipeline, the more cycles it completes each period, and the higher the profit for that period. The following two accounts regarding the Briscoe Group Ltd and its CEO, Rod Duke, are examples of a New Zealand business using its management of the cash cycle to strategic advantage. As reported in the Metro magazine (“The Category Killer” by Matt Philp, Metro Magazine, June 2003), Brian Gaynor (of the New Zealand Herald) believes the success of Rod Duke, Managing Director of the Briscoe Group, can be attributed to a few key elements, not least the way in which he stocks his stores. Many retailers have come to grief paying upfront for inventory that then sits unsold for six months. What Duke has been very good at is being able to buy product, but to effectively get the manufacturer to finance it. The way it works is that you allocate certain shelf life to someone who, let’s say, is supplying pots and pans, and effectively they keep the thing stocked for you. You sell it and take the margin, and you pay them once you’ve sold it.

From the beginning, the Briscoe style was fleet of foot — money that might otherwise be tied up in inventory was used to revamp old stores and open new ones; premises were [page 64] rented rather than owned, and always on short-term, easily-quit leases in locations well away from the shopping malls, with their potentially crippling

rents. Says Duke: “We’d rather put that money into stock that we can turn over five times a year.” The following extract from the Managing Director’s address to the Bricsoe Group’s Annual General Meeting of 22 May 2009 (www.nzx.com) highlights the cash flow effect of tight stock levels: You will recall that 2 years ago we informed you that we would need to invest in updating our merchandising and financial systems, and that this investment would pay back handsomely in incremental profits and cost savings. This is what you’re seeing now. You will have noticed at the end of January 2009 we had some $63 m in the bank compared to $49 m the prior year. Key reason was this investment we made two years ago. Our people now are able to review merchandise ranges every week, exploring new and different ways to remove poor selling goods from the stores and replacing with fast selling product. Total group inventory for the year just past was $57 m or 15% under that of the prior year.

This has been a simple introduction to the concepts of cash flow and working capital — topics we will explore further in Chapters 5 and 7. What is important to appreciate at this stage, is that poor cash flow and the mismanagement of working capital can seriously undermine the ability of a business to succeed, sometimes threatening its very survival.

2.3.4

A CLOSER LOOK AT PROFIT

“A good profit — not a great one, but a good one,” said Tom, implying that he was satisfied with the profit his business made after its first year of operation. The business earns its income from selling services. In order to earn income, Tom will incur expenses which, when deducted from his income, will give the net profit. It is important to understand that profit is not cash or money in the bank. As a business professional, you require a thorough knowledge about how profits are calculated and the factors involved in these calculations. In trying to calculate an accurate profit, the problem facing the accountant is that not all of the income earned during the period may have been received and banked. At the same time, it is unlikely that the business will have paid all

its creditors by the end of the period. Therefore, the business is owed money and it owes money. When accountants endeavour to work out how much income the business has earned, guidelines are used to select the point in time (a snapshot), which recognises that income has been earned, irrespective of whether it has been received. At which point in time do you think income is counted as income for accounting purposes? When the client rings up and orders a bin? When the service is performed (that is, the bin is emptied)? When the customer is sent an invoice for services at the end of each week or month? When the customer sends a cheque? When the cheque is banked? Obviously, these activities will occur on different dates. The recognition concept acts as a guide for making the decision as to when income is recognised, by stating [page 65] that income is counted when it is earned, whether or not it has been received in cash or cheques. Paragraph 4.38 of the New Zealand Equivalent to the IASB Conceptual Framework Financial Reporting 2010 (NZ Framework) states that: An item that meets the definition of an element should be recognised if: (a) it is probable that any future economic benefit associated with the item will flow to or from the entity; and (b) the item has a cost or value that can be measured with reliability.

It follows that, from the list above, we could say that “when the service is performed” is the point at which income is being earned. The selection of this

point is determined by the fact that a legally enforceable contract has been concluded. If, after ordering a bin and allowing Tom to come onto the premises to empty it, a client does not pay, Tom will be able to sue for his fees. In the same way, expenditure is recognised at the point when it is incurred, because a contract is deemed to have been concluded — thus Tom is legally responsible for paying the power company for electricity, and the telephone company for phones. If Tom uses these services, the accountant will classify them as expenditure for the accounting period in which they were consumed (used), irrespective of whether Tom has actually paid for them. More discussion on the recognition of revenue and the recognition of expenses is provided in Chapter 4. Adjustments to the accounting records are made at the end of every accounting period. Without them, it would be impossible to calculate a true and accurate profit for a particular period. A true and accurate profit calculation for year one, makes it possible to compare it to years two and three as a basis for predicting future trends. Cash flows in and out of the business every day, and for all sorts of reasons. However, when we take a “snapshot” of the business at the end of the accounting period — what we earned, what it owes, and what it is owed — both the cash in the bank and the profit are part of the snapshot.

2.4

An information system — the accounting equation

We now take a closer, more detailed look at the relationship between the assets and where the funds came from to finance those assets. We examine the business decisions Tom made at inception of the business, and consider

how those decisions brought about changes in the relationship between the assets, liabilities, and owner’s equity. In Tom’s case, the sources of funds for the assets of the business came from his own capital and the bank loan. Let us look at an accounting snapshot of the situation when the business started. The accountant records the snapshot as: assets = liabilities + owner’s equity

[page 66]

2.4.1

WHAT DOES THE ACCOUNTING EQUATION TELL US?

Define the following terms: assets, liabilities, and owner’s equity.

The accounting equation is a tool for analysing the effects of business transactions — it represents the accounting cycle in action. Let us use it to analyse the situation when Tom started up the business, and what happened when he made subsequent business decisions in those early days. We have seen that the value of the assets is always equal to the value of the funds provided to purchase them. The equation looks like this: assets = liabilities + owner’s equity

Remember, liabilities represent external sources of funds, whereas owner’s equity is an internal source of funds. The above equation can be expressed as follows with regard to the case study: Assets =

Liabilities +

Owner’s equity

Bank

Other assets

Loan

Instant finance

Accounts payable

Capital

40,000 +

0 =

30,000 +

0 +

0 +

10,000

2.4.2

CHANGES IN THE ACCOUNTING

EQUATION Every transaction brings about changes in the accounting equation. For instance:

2.4.2.1

Tom used his own car

Assume that the value of the car was $8,000. In contributing the car to the business, not only did Tom increase the value of the assets, but he increased the value of his capital, because he contributed an internal source of funds (owner’s equity). Assets = Bank

Other assets

40,000

Liabilities + Lone

Instant finance

Owner’s equity Accounts payable

30,000

10,000

8,000 i 40,000 + i

8,000 =

Capital

8,000 30,000 +

0 +

0 +

18,000

car

What is the name of the accounting entity for the balance sheet below? Why is the term “as at” used on the balance sheet?

The balance sheet is a way of presenting the accounting equation, namely assets equals liabilities plus owner’s equity. Note that this format for the balance sheet is one example — other balance sheets may use a different format, for example owner’s equity equals assets less liabilities. Assets are further classified into current assets (cash or assets expected to turn into cash within the next accounting period) and non-current assets (assets held for more long-term use within the business). [page 67]

Tearaway Paper Recycling Balance sheet As at 3 April 2014

$

$

Current assets Bank

40,000

Non-current assets Car

8,000

TOTAL ASSETS

48,000

Current liabilities Non-current liabilities Loan

30,000

TOTAL LIABILITIES

30,000

Owner’s equity Capital

18,000

TOTAL EQUITY

18,000

TOTAL LIABILITIES AND EQUITY

48,000

2.4.2.2

Tom purchased big plastic bins

Some of the first assets Tom purchased for the business were the big plastic bins, which he left in the offices. Assume that he paid $6,000 cash for them. Assets = Bank

Other assets

40,000

Liabilities + Loan

Instant finance

Owner’s equity Accounts payable

30,000

10,000

8,000 i (6,000)

6,000 ii

34,000 +

14,000 =

i

car

ii

equipment

Capital

8,000 30,000 +

0 +

0 +

18,000

Note that the accounting equation has changed, and that both changes occur on the assets side of the equation. [page 68]

2.4.2.3

Tom settled a portion of the loan

Assume that Tom paid off $500 of the loan. (For the time being, we will ignore interest.) Assets = Bank

Liabilities +

Other assets

40,000

Loan

Instant finance

Owner’s equity Accounts payable

30,000

10,000

8,000 i (6,000)

i

car

ii

equipment

8,000

6,000 ii

(500) 33,500 +

Capital

(500) 14,000 =

29,500 +

0 +

0 +

18,000

How would the accounting equation change if Tom took drawings of cash or some other asset from the business?

As the business purchases or sells assets, pays off loans, or takes out additional loans, or as the owner contributes further capital in the form of cash or items, or reduces capital by drawings, the accounting equation will change. Not only does the accounting equation change, but the values placed on assets change over time.

2.4.3

PLACING VALUES ON ASSETS AND LIABILITIES

Another problem the accountant faces is that of the changing values of assets. A reader of Tom’s balance sheet will see that the car has a value of $8,000, and the equipment has a value of $6,000. Where do these values come from? The most commonly used measurement for valuing assets is called “historical cost”.

2.4.3.1

Historical cost

Paragraph 4.55 of the NZ Framework states the following about historical cost: Assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of the acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business.

If a non-current asset (such as the car or equipment) is sold, it would be unusual for the business to receive exactly the same amount as the value on the balance sheet. Therefore, the values on the balance sheet are not a statement of current values. How can we decide what an asset is worth so that the balance sheet contains accurate information? How would you value fixed assets? At the original purchase price? At the original purchase price, plus the costs involved in repairs and maintenance? At the market value (what they might fetch if they were sold)? At the price the owner estimates they are worth? At the replacement value? [page 69] As time goes by, most fixed assets will depreciate in value. For example, the car and the bins will not be worth as much at the end of the year, because of continual use. Some assets, for example land, may increase in value. How would you value current assets, like inventories and accounts receivable? Remember, inventories are purchased in anticipation of consumer demand. Consumer demand is influenced by: the price of the goods; the price of similar goods;

the price of complementary goods; changes in taste and fashion; and changes in income. Would you take these factors into consideration when placing a value on inventories? Would you value them at the price paid, the selling price, or the price which will have to be paid to replace them? Even a more straightforward current asset like accounts receivable might not be accurate, because some debtors may not pay. Given all these alternatives, exactly how do accountants value assets? Accountants argue that there must be an objective basis to the information they provide in the financial statements. How this objective basis is arrived at, must be clearly understood by all readers of the statements. Therefore, they record assets on the balance sheet at the price which was paid at the time they were bought by the business. This is the historical cost concept. Accountants do, however, acknowledge that the assets will decrease in value over time, and we look at this in Chapter 4 when we study the concept of depreciation.

2.4.3.2

Evolution away from historical cost

Accountants also recognise that some non-current assets (such as land and buildings) increase in value over time. For this reason, a modified historical cost system has been allowed in New Zealand. Under particular circumstances, this type of asset is allowed to be revalued to its fair value. Paragraph 4.56 of the NZ Framework states that: Furthermore, some entities use the current cost basis as a response to the inability of the historical cost accounting model to deal with the effects of changing prices of non-monetary assets. Find the definition for the current cost basis. Refer to paragraph 4.55 of the NZ Framework.

The alteration to a specific principle comes about as there are times when there is a conflict between the conceptual framework and a particular definition. In the instance of long-standing assets, the principle of historical cost is at odds with the concept of providing a relevant report.

A similar conflict can also arise when it is known that an event will likely occur, owing to circumstances which exist at the time of the preparation of the accounts. The actual occurrence of the event, or the determination of the value involved, is dependent on one or more other events taking place. The preparation of a set of accounts requires many estimates (see Chapter 4). However the fact that an estimate is required, does not itself create the uncertainty which characterises a contingency. An example of a potential liability may be the situation which occurs under the Resource Management Act 1991, in which a company is sued for environmental damage. The [page 70] damage has occurred, but neither the guilt nor the cost that may arise is clear. This is known as a contingent liability. Paragraph 4.4 of the NZ Framework states that: The elements directly related to the measurement of financial position are assets, liabilities and equity. These are defined as follows: (a) An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. (b) A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. (c) Equity is the residual interest in the assets of the entity after deducting all its liabilities.

In terms of the accounts, the contingent liability should be disclosed in the notes, explanatory material, or supplementary schedules. However, the balance sheet should not reflect this value. (Refer to paragraph 4.43 of the NZ Framework for a further definition.) In this event, there are three stages of recognition: 1.

the event has occurred and there has been some monetary exchange, in which case the accounts already recognise the transaction;

2.

the event has occurred and reliable estimates can be made of the potential liability, in which case an adjustment is made to the accounts;

or 3.

the event has occurred, but a reliable assumption cannot be made, in which case the existence of the contingent liability is noted in the accounts.

2.4.3.3

Going concern principle

Accountants value assets and liabilities based on the assumption that the business will continue to exist indefinitely. This means that assets are valued at historical cost, taking depreciation into consideration. It is assumed that they will be used over a number of accounting periods to generate income, and not be sold off quickly tomorrow for what the owner can get. See paragraph 4.1 of the NZ Framework for a further definition.

2.4.3.4

Monetary convention

Given all of these problems with values, including the changing value of money itself (inflation, deflation), why use money as a way of measuring what the business owns and owes? It is likely that one of the first things someone reading the accounts will do, is find out the value of each item. The monetary convention is the principle that the transactions of a business are measured in terms of the money which is the legal tender within a country, and that the value given to them is determined by the historical cost principle.

2.4.3.5

Materiality concept

Paragraph QC 11 of the NZ Framework states that: Materiality is an entity-specific aspect of relevance based on the magnitude (or both) of the items to which the information relates in the context of an individual entity’s financial report.

[page 71] In this context, the word “materiality” means important or essential or

substantial. The accountant uses the materiality concept to decide which items are important, essential, or substantial enough to be recorded as assets or liabilities on the balance sheet — but important, essential, or substantial in relation to what? If Tom has a packet of envelopes on his desk valued at $2.75, would you consider this an asset? It fits the definition of “asset”, in that it is something of value controlled by the business which is used to earn an income. If you do not count the envelopes as an asset, would it make a substantial difference to the financial statements, and give a distorted view of what the business owes and owns? Might you record the envelopes as something else, such as “expenses”, perhaps, along with other minor items? Would it matter if you ignored all minor items? More important, would the omission of these items affect potential management decisions? What if Tom had purchased specially printed stationery like letterheads, receipts, or envelopes, as a replacement for other generic stationery? How would you advise Tom to deal with it if the value of unused stationery was $2,500? How might a decision maker react if the items were grouped — for example, “office equipment: $25,000”? Would it help to give a better picture of the business if each item of office equipment were listed individually with its value, for example “paper”? Consider these questions in relation to materiality. If paper amounted to $150 out of the $25,000, how would you list it? Some questions to consider might be: What is the value of this item relative to other items? Is it important to identify it as a separate item? Can I classify similar items under one heading? Shall I ignore it altogether? What effect would any of these decisions have on the users of the financial statement?

2.4.4

PURCHASING ASSETS

Let us now look at how some business decisions about assets and liabilities affect the accounting equation. Many times during the life of the business, the owner will buy and sell assets to improve the business’s ability to operate and earn income. Assets can be purchased: for cash; on credit; or for a combination of cash and credit.

2.4.4.1

Purchasing assets for cash

Tom’s decision to purchase a desk and some filing cabinets secondhand for $1,000, has two effects: reduces the asset bank by $1,000; and creates a new asset “furniture”, valued at $1,000. [page 72] The effect on the accounting equation is as follows: Assets = Bank

Other assets

40,000

Liabilities + Loan

Instant finance

Owner’s equity Accounts payable

30,000

10,000

8,000 i (6,000)

(500)

(1,000)

1,000 iii

32,500 +

15,000 =

car

ii

equipment

iii

furniture

8,000

6,000 ii

(500)

i

Capital

29,500 +

0 +

0 +

18,000

2.4.4.2

Purchasing assets on credit

Tom’s decision to acquire a multi-function printer (instead of a photocopier and a fax machine) on credit for $4,000, has two effects: the business has a new asset — a multi-function printer; and the business has a creditor, which creates a new liability — accounts payable. The new equation looks as follows: Assets = Bank

Other assets

40,000

Liabilities + Loan

Instant finance

Owner’s equity Accounts payable

30,000

10,000

8,000 i (6,000)

8,000

6,000 ii

(500) (1,000)

(500) 1,000 iii 4,000 iv

32,500 +

Capital

19,000 =

i

car

ii

equipment

iii

furniture

iv

office equipment

4,000 29,500 +

0 +

4,000 +

18,000

[page 73]

2.4.4.3

Purchasing an asset using a combination of cash and credit

Tom’s decision to buy a used truck for $25,000, for which he paid a cash deposit of $12,000 and obtained finance for the balance from a finance company, has three effects: the business has a new asset — a truck with a value of $25,000;

the business has reduced its asset “bank” by $12,000; and the business has acquired a liability — a loan of $13,000. The new equation looks as follows: Assets = Bank

Other assets

40,000

Liabilities + Loan

Instant finance

Owner’s equity Accounts payable

30,000

10,000

8,000 i

8,000

6,000 ii

(6,000) (500)

(500) 1,000 iii

(1,000)

4,000 iv

4,000

25,000 v

(12,000) 20,500 +

Capital

44,000 =

i

car

ii

equipment

iii

furniture

iv

office equipment

v

truck

13,000 29,500 +

13,000 +

4,000 +

18,000

The accounting equation can be set out as follows in the form of a balance sheet, which may be easier to understand by decision makers: Tearaway Paper Recycling Balance sheet As at 7 April 2014 $ Current assets Bank

20,500

Non-current assets Car

8,000

Equipment

6,000

Furniture

1,000

Office Equipment

4,000

Truck

25,000

$

TOTAL ASSETS

64,500

[page 74] $

$

Current liabilities Accounts Payable

4,000

Non-current liabilities Loan

29,500

Instant Finance

13,000

TOTAL LIABILITIES

46,500

Owner’s equity Capital

18,000

TOTAL EQUITY

18,000

TOTAL LIABILITIES AND EQUITY

64,500

Note that, for the purpose of the above exercise, non-current assets have been shown individually. However, generally, a fixed asset register would be used to detail individual assets and would be shown as a note to the balance sheet, detailing them as property, plant, and equipment. For an extended example, refer to Appendix 1, containing the Xero Limited 2013 Annual Report.

2.5

Detailing what happens in the owner’s equity section

In the transactions shown in paragraph 2.4, changes have taken place within the owner’s equity section of the accounting equation. Tom provided

additional capital, in the form of a car, to the business. However, this change is not shown in the balance sheet, but is shown in a separate statement, the statement of changes in equity. This statement shows the total owner’s equity at the beginning of the financial year, and then explains the changes that have taken place. For Tom’s business, the representation of the changes after one week of trading would be as follows: Tearaway Paper Recycling Statement of changes in equity For the week ended 7 April 2014 $ Equity at beginning 1/4/2014 Capital

10,000

Plus Additional capital

8,000

Equity at end 7/4/2014

18,000

[page 75] Compare the changes in equity between Tearaway Paper Recycling and Xero Limited (see Appendix 1). What other items are included for Xero Limited, but not for Tearaway Paper Recycling? Have the changes in equity been positive or negative for these entities?

Other changes should be included in the statement of changes in equity — the major relating to profit. Profit represents the difference between the income from activities related to the business, and the expenses required to generate that revenue. However, owner’s equity is also affected by additional capital supplied by the owners of the business, as well as drawings in the case of the sole trader, or dividends in the case of a company. A more detailed discussion of how the changes in equity figure may be derived, is provided in Chapter 3. Consider the impact of an owner taking cash for personal use. Tom’s decision to draw out $2,500 per month for his personal use, has two effects: reduces the asset “bank” by $2,500; and reduces owner’s equity by $2,500. The owner is usually keen to know the total amount of drawings taken from the business during the year, so we

create a separate column in our worksheet for “drawings”. As drawings reduce the amount of owner’s equity, we put it on the opposite side of the equation. Our new accounting equation is: assets + drawings = liabilities + owner’s equity

The new equation looks as follows: Assets = Bank

Drawings =

Other assets

Drawings

40,000

Liabilities + Loan

Instant finance

Owner’s equity Accounts payable

30,000

10,000

8,000 i (6,000)

8,000

6,000 ii

(500) (1,000)

(500) 1,000 iii 4,000 iv

(12,000)

4,000

25,000 v

(2,500) 18,000 +

Capital

13,000 2,500

44,000 +

i

car

ii

equipment

iii

furniture

iv

office equipment

v

truck

2,500 =

29,500 +

13,000 +

4,000 +

18,000

If we calculate that Tom made $28,000 profit for the full year (more about calculating profit in Chapter 3), how does the amount Tom drew for his personal use affect the profit? How does the $2,500 per month he drew relate to his wage before starting the business? [page 76]

Tearaway Paper Recycling

Statement of changes in equity For the year ended 31 March 2014 $

$

Equity at beginning 1/4/2013 Capital

10,000

Plus Net profit

28,000 38,000

Other changes Plus Additional capital Less Drawings ($2,500 × 12) Equity at end 31/3/2014

2.6

8,000 (30,000)

(22,000) 16,000

Conclusion

Starting a business is fraught with complex issues. We now know that there are processes and standards that help manage those complexities. Choosing the most appropriate type of business entity is important, as this will impact on the future of a business with regards to financing, stakeholder skills, and ultimately liability for decisions and debts. Every single decision impacts on another, and no decision should be taken without consideration of the impact on all parts of the business. People like Tom commence businesses with the intention of succeeding. They look to business professionals for help and guidance. If you purport to be a business professional, and therefore advise and mentor people like Tom, you must accept responsibility for playing a crucial role in the life of a business — both in the day-today running of the business, and in some of the more complicated and interesting challenges. The greatest challenge for new (and established) businesses is earning income and generating profits. The next chapter looks at running a business through expanding the principles of accounting, and builds your skills as a potential business professional/adviser.

2.7

Key words 2

accounting equation

A tool used by accountants to analyse the effects of each transaction. It is usually expressed as: assets = liabilities + owner’s equity. Each transaction will have at least two effects on the equation. [page 77]

audit

The process of checking and verifying the financial reports prepared by the accountant to ensure that: they are accurate and complete; they comply with the appropriate laws, regulations, and accounting standards; and they show a true and fair view of the financial results and the financial position of the entity.

called-up capital

The portion of the historical (original) issue price of the shares that the shareholders have been asked to pay in to the company.

capital

The amount invested into the business by the owners, and includes capital movements in relation to changes in equity. Terms relating to capital are: called-up capital; uncalled capital, and paid-up capital.

cash book

Consists of a receipts and payments

schedule, showing the amount and details of amounts paid to suppliers by a business for goods and services, as well as money received from cash sales, and receipts of money from debtors. company (also limited liability company)

A business entity created by incorporation under the Companies Act 1993, which is a separate legal entity from the owners (shareholders) of the business.

contingency

When it is known that an event will likely occur, due to circumstances which exist at the time of the preparation of the accounts, but the actual occurrence of the event, or the determination of the value involved, is dependent upon one or more other events taking place. In terms of the accounts, there is not enough certainty to enter the value(s) of the contingent liability or asset. Therefore, these should be disclosed in the notes, explanatory material, or supplementary schedules. The balance sheet should not reflect these values.

cost/benefit value of information

While it is theoretically possible for the accountant to disclose everything, in deciding what needs to be disclosed, the accountant needs to balance the costs of determining values, with the benefit of having the information available.

creditors (accounts payable) Suppliers of goods and services purchased on credit terms by the business.

[page 78]

debt/equity ratio

The level of debt compared to the amount of equity in a business, expressed as a ratio.

debtors (accounts receivable)

Customers owing debts for goods or services provided by the business.

dividend

Part of a company’s profits paid to shareholders as a reward for their investment in the company (see www.nzx.com). The procedure for declaring and paying dividends will be set out in the constitution of the company if it has one, or the company will follow the rules detailed in the Companies Act 1993. The company’s directors usually have the power to declare dividends, and may declare interim and final dividends. An interim dividend is declared and paid out during the accounting period. A final dividend is usually declared once profits for the year are known, and is recommended to the shareholders who must approve it at the company’s annual general meeting.

drawings

The amount of capital that is withdrawn from a partnership or sole trader by the owner(s) of the business for their own personal use. It can be in the form of cash, stock or other assets.

goodwill

The perceived value of a business which exceeds its book or accounting value. Unless it relates to a transaction, such as the

purchase of a business, it is not recognised in the accounts. historical cost

According to this concept, the monetary values used in accounting should be derived only from actual events — that is, assets are recorded at actual cost, and liabilities are recorded for the amounts at which they have been incurred. Under this concept, current values are ignored, and no attempt is made to account for inflation. This means that the accounts prepared under this concept are historical records, and are not intended to reflect the real worth of the business. This provides a limitation on the use of such accounts for certain types of decision making.

introduced capital

Funds invested from the owner’s private resources. [page 79]

joint and several liability

This relates to the liability of partners for the debts of the partnership. Each partner is fully liable, both individually and in conjunction with the others, for all business debts. A third party may choose to recover a debt from any one or all of the partners.

liquidation

Because a company is a legal entity, it must be liquidated for the life of the company to officially end. A company may go into

voluntary liquidation by a special resolution of the shareholders, or may be placed in liquidation by a court order, or by a meeting of creditors if it fails to pay its debts. loan

An amount of money borrowed by the business from another entity, such as a bank, finance company, or an individual. Loans are borrowed for a specific period of time at a set rate of interest. They are generally used for buying assets, for extending the business, or for other long-term projects. Lenders may require security (also known as “collateral”). Security is an item of value (for example, machinery or vehicles) which is owned by the borrower, and which the lender has a legal right to sell if the loan cannot be repaid.

materiality

An entity-specific aspect of relevance, based on the magnitude of the items to which the information relates in the context of an individual entity’s financial report. Information is considered material if its accuracy or omission has the ability to impact the decisions made by users. This concept is about the relative importance of accounting information, and provides for the separate disclosure in financial reports of all items that are considered to be material. An item may be material because of its nature and/or its amount, and both must be considered. For example, a change in accounting policy is

of a material nature, even if the economic effect is minor; and, while an item that affects profit for the year by 10 per cent would likely be material, one that affects a balance sheet figure by only 1 per cent, would probably be considered immaterial.

[page 80] monetary convention

This concept provides that all transactions must be valued in terms of money which is the legal tender within a country before they can be entered into an accounting record. This then gives rise to several limitations of accounting reports: The value of money itself changes due to inflation — this makes comparisons between accounting periods less useful. There are many aspects of business that cannot be reduced to monetary terms, and which cannot therefore be quantified in the reports — for example, loyalty and skills of staff, capacity for innovation, and goodwill to customers.

mortgage

A loan which is borrowed for a specific period of time, and for which interest is payable. Mortgages are usually used to buy land and/or buildings (also known as “premises”). Security for the mortgage is the land and/or building itself, which the lender

has a legal right to sell in the event of the mortgage not being repaid. ordinary shares

The most common type of share issued. They carry voting rights and earn dividends, dependent on the amount of profit made by the company. In the event that the company is wound up, ordinary shareholders will be the last to receive any payment. Ordinary shares may be differentiated, as provided for in the issuing company’s constitution. For example, ordinary A shares may carry different voting rights from ordinary B shares.

overdraft

An agreement with the bank to withdraw amounts from the business’s current account (cheque account), over and above money which has been deposited in the account. Interest is payable on overdrafts, but only on the amount of the overdraft which has been used. For example, the business may have an agreement for an overdraft limit up to $15,000; if they draw $5,000 of the overdraft, they will only be charged interest on the amount drawn. Overdrafts are generally used to pay short-term debts at a time when cash flow is tight. Because of the higher risk for the lending institution, overdrafts generally have a higher interest rate than many other loan types. The bank may have the right to cancel the overdraft at short notice.

[page 81]

paid-up capital

The portion of the called-up capital that shareholders have paid for. There is no requirement that all of the issued capital be paid up by the shareholders. The amount of unpaid capital, if any, represents the extent of the liability of shareholders to the company.

partnership

The relation which subsists between persons carrying on a business in common with a view to profit (Partnership Act 1908, section 4(1)).

preference shares

Shares that give their owners preferential rights over ordinary shares, usually in respect of dividends, and/or return of capital should the company be wound up. Preference shares usually have a fixed rate of dividend.

receivership

A company is placed in receivership by the holders of a debenture when the company fails to meet the terms of the debenture agreement, such as the non-payment of interest or principal, or breaches the debt/equity ratio.

recognition (realisation)

This concept requires that all expenses and income for a period be correctly recognised for that period in order to establish the true profit (or loss) for the period. Thus, expenses and income are counted when they are earned or incurred, whether or not they have been received or expensed in cash or

cheques. The point in time giving rise to such legal obligations will normally be when goods have changed hands (or legal ownership), or services have been performed. There may be exceptions to this rule, as provided for in a particular contract for the supply of goods or services. Formerly, the emphasis was on matching expenses to revenues; more recently, the emphasis has moved toward the definitions relating to the balance sheet. Paragraph 4.38 of the NZ Framework states that: An item that meets the definition of an element should be recognised if: (a) it is probable that any future economic benefit associated with the item will flow to or from the entity; and (b) the item has a cost or value that can be measured with reliability.

resources

Include any assets used to operate a business.

[page 82] shareholder

The owner or owners of a company. They own shares, which make up the capital of the company.

shares

The capital of a company. (See also ordinary shares and preference shares.)

sole trader

A business owned by one person with no legal distinction between the owner and their

personal assets. uncalled capital (unpaid capital)

Represents that portion of the issue price which shareholders have not yet been required to pay, and applies to companies only.

working capital

The difference between current assets and current liabilities. It is the amount of funds available to fund the activities of the business on a day-to-day basis.

2.8 2.8.1

Resource file 2 CASE STUDY — WADE WAIWATER: A CHANGE IN THE WIND … FROM CREW TO SKIPPER

Sometimes what you think is a hobby can become so time consuming that it becomes your job. Wade Waiwater was a commercial fisherman from an early age. He would help his father when he was young, and eventually began working full-time on a local fishing boat as a crew member. Wade had an interest in sports fishing, and decided to build his own 50-foot boat, equipped with sleeping berths, a galley for cooking, and plumbing for convenience. The boat was designed simply to make finding, hooking, and landing fish as easy as possible. Wade’s sports fishing boat was a huge success — so much so, that family and friends were recommending his overnight fishing trips. People were offering him money to go out on his boat with him as skipper. Wade’s wife

Terri suggested that he think about running the business full time, and resign his job as a crew member on a commercial fishing boat. Wade and Terri had about $10,000 in savings to start them off, and Wade had already halffinished building his next specially-designed boat. Two years later, Wade and Terri have a successful seasonal sports fishing business, and he employs his mate Jeremy to skipper the now-completed second sports-fishing boat. In the off-season Wade contracts to boat-building companies, designing and project managing large boat-building contracts. “Life has certainly not been easy, especially once we realised how reliant the business was on really good weather conditions. On the commercial fishing boat we would go out in all weathers. But not my customers, they want it all – calm sea, sunshine, and plenty of fish! Even my contract work is a bit unsteady at the moment, as economic conditions make luxury items such as boats less attractive.” “Realising his talent for designing and building boats, saved us. The offseason was really hard until then,” said Terri. “We just didn’t know how we were going to keep [page 83] our heads above water.” Wade agreed. “Although we had $10,000 in savings, it didn’t go far,” he said. “We had to refurbish the boat, upgrade all the fishing lines and gear, stock enough lifejackets for a variety of sizes, buy a van to take customers to the boat, complete the second boat, and finally market the business. We ended up taking a loan of $20,000 using the boats for security, just to keep us going that first season.” Wade’s business is now making a profit, but still has many challenges to come. What are some of the problems Wade is currently facing? “Well, making sure people pay their bills, for one, and paying my bills, for another!” he laughs. “I may have problems in the future because I’ve only got seasonal

work for Jeremy, and he really wants work year round, as he has just got married and wants to save for a house. It is not easy to get a qualified skipper with his experience. Also, I am not sure whether I will be able to get enough contract work in the off-season next year. Terri and I are busy thinking of what else we could do to earn money. Life was simpler working for someone else, but it is certainly an adventure working for myself!” Terri has suggested that she and Wade do a small business course run through a local tertiary institution. Although neither of them have done business courses in the past, Terri feels that the topics offered — accounting, marketing, and other areas of business — would help them in the future. “Wade’s enthusiasm for sports fishing has not decreased, but we need to address the uncertainty of the off-season income. Being a man of the sea, he is well used to weathering a storm.”

2.8.2 2.8.2.1

ACCOUNTING POLICIES Accounting policies from Fletcher Building Ltd’s 2013 Annual Report

The following is an extract of the statement of accounting policies, as set out in Fletcher Building Ltd’s 2013 Annual Report: Basis of presentation The financial statements presented are those of Fletcher Building Limited (the company) and its subsidiaries (the group). Fletcher Building Limited is a company domiciled in New Zealand, is registered under the Companies Act 1993, and is an issuer in terms of the Securities Act 1978 and the Financial Reporting Act 1993. The registered office of the company is 810 Great South Road, Penrose, Auckland. Fletcher Building Limited is a profit oriented entity. The financial statements comprise the earnings statement, statement of comprehensive income, statement of movements in equity, balance sheet, statement of cashflows, and significant accounting policies, as well as the notes to these financial statements. Accounting convention The financial statements are based on the general principles of historical cost accounting, except that financial assets and liabilities as described below are stated at their fair value. These financial

statements have been prepared in accordance with Generally Accepted Accounting Practice in New Zealand which is the New Zealand equivalent to International Financial Reporting Standards (NZ IFRS). They also comply with International Financial Reporting Standards. The accounting policies have been applied consistently by all group entities, except as disclosed in note 1, changes in accounting policies.

[page 84] Segmental reporting Segmental information is presented in respect of the group’s industry and geographical segments. The use of industry segments as the primary format is based on the group’s management and internal reporting structure, which recognises groups of assets and operations with similar risks and returns. Inter-segment pricing is determined on an arm’s length basis. Estimates The preparation of financial statements in conformity with NZ IFRS requires the directors to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of sales and expenses during the reporting period. Actual results could differ from those estimates. The estimates and assumptions are reviewed on an ongoing basis. For further information on areas of estimation and judgement, refer to the notes to the financial statements, in particular note 19. Basis of consolidation The consolidated financial statements comprise the company and its subsidiaries and the group’s interest in associates, partnerships and joint ventures. Inter-company transactions are eliminated in preparing the consolidated financial statements. Subsidiaries Subsidiaries are included in the consolidated financial statements using the acquisition method of consolidation, from the date control commences until the date control ceases. Associates The equity method has been used for associate entities in which the group has a significant but not controlling interest. Goodwill on acquisition

Fair values are assigned to the identifiable assets and liabilities of subsidiaries and associates of the group at the date they are acquired. Goodwill arises to the extent of the excess of the cost of the acquisition over the fair value of the assets and liabilities. Goodwill is stated at cost, less any impairment losses. Goodwill is allocated to cash generating units and is not amortised, but is tested annually for impairment. Goodwill in respect of associates is included in the carrying amount of associates. Any discount on acquisition is recognised directly in earnings on acquisition. Joint ventures and partnerships Where the ownership interest in the joint venture is in the net residue of the business and does not give rise to an economic or controlling interest in excess of 50 percent, the share of the net assets and liabilities and earnings of the investment is included on an equity basis. If the interest does give rise to a controlling interest in excess of 50 percent, the investment is consolidated. Joint ventures in which the ownership interest is directly in the assets and liabilities, rather than the net residue, are included on a proportional basis with assets, liabilities, revenues and expenses based on the group’s proportional interest.

[page 85]

2.8.2.2

Property, plant and equipment from Auckland International Airport Ltd’s 2013 Annual Report

The following extract deals with accounting policies relating to property, plant, and equipment, and appears in the summary of significant accounting policies in Auckland International Airport Ltd’s 2013 Annual Report. m / Property, plant and equipment Properties held for use in the supply of goods and services, for administrative purposes or for rental to others for airport operation purposes are classified as property, plant and equipment. Property, plant and equipment are initially recognised at cost. The cost of property, plant and equipment includes all costs directly attributable to bringing the item to working condition for its intended use. Expenditure on an asset will be recognised as an asset if it is probable that future economic benefits

will flow to the entity, and if the cost of the asset can be measured reliably. This principle applies for both initial and subsequent expenditure. Vehicles, plant and equipment are carried at cost less accumulated depreciation and impairment losses. Land, buildings and services, runway, taxiways and aprons and infrastructural assets are carried at fair value, as determined by an independent registered valuer, less accumulated depreciation and any impairment losses recognised after the date of any revaluation. Land, buildings and services, runway, taxiways and aprons and infrastructural assets acquired or constructed after the date of the latest revaluation are carried at cost, which approximates fair value. Revaluations are carried out with sufficient regularity to ensure that the carrying amount does not differ materially from fair value at the balance sheet date. Revaluations Revaluation increments are recognised in other comprehensive income and accumulated as a separate component of equity in the property, plant and equipment revaluation reserve, except to the extent that they reverse a revaluation decrease of the same asset previously recognised in the income statement, in which case the increase is recognised in the income statement. Revaluation decreases are recognised in the income statement, except to the extent that they offset a previous revaluation increase for the same asset, in which case the decrease is recognised in other comprehensive income and accumulated as a separate component of equity in the property, plant and equipment revaluation reserve. Accumulated depreciation as at the revaluation date is eliminated against the gross carrying amounts of the assets and the net amounts are restated to the revalued amounts of the assets. Upon disposal or derecognition, any revaluation reserve relating to the particular asset being disposed or derecognised is transferred to retained earnings. Depreciation Depreciation is calculated systematically on a straight-line basis to allocate the cost or revalued amount of an asset, less any residual value, over its estimated useful life.

[page 86] The estimated useful lives of property, plant and equipment are as follows: Land (including reclaimed land)

Indefinite

Buildings and services

5–50 years

Infrastructural assets

5–80 years

Runway, taxiways and aprons

12–40 years

Vehicles, plant and equipment

3–10 years

Disposal An item of property, plant and equipment is derecognised upon disposal or when no further future economic benefits are expected from its use. Gains or losses arising on derecognition of an asset, calculated as the difference between the net disposal proceeds and the carrying amount of the asset, are included in the income statement in the year the asset is derecognised.

2.8.2.3

Contingent liabilities from Auckland International Airport Ltd’s 2013 Annual Report

The following extract from the accounting policies set out in Auckland International Airport Ltd’s 2013 Annual Report, deals with a contingent liability (note 23): Noise insulation In December 2001, the Environment Court ratified an agreement that had been reached between Manukau City Council, the company and other interested parties on the location and future operation of a second runway to the north and parallel to the existing runway. The Environment Court determination includes a number of conditions which apply to the operation of the airport. These conditions include obligations on the company to mitigate the impacts of aircraft noise on the local community. The obligations include the company offering acoustic treatment packages to schools and existing homes within defined areas. Noise levels are monitored continually, and, as the noise impact area increases, offers will need to be made. The obligation does not extend to new houses. Overall, it is estimated that approximately 4,000 homes will eventually be offered assistance. As it is not possible to accurately predict the rate of change in aircraft noise levels over time, nor the rate of acceptance of offers of treatment to homeowners, the company cannot accurately predict the overall cost or timing of acoustic treatment. It is estimated that, overall, further costs would not exceed $9.0 million (refer to Note 24).

[page 87]

2.9 2.9.1 2.9.1.1

Mastering accounting — questions SHORT ANSWER QUESTIONS True/False

1.

A company is both a legal entity and an accounting entity.

2.

Shareholders of companies are personally liable for business debts.

3.

Unlike profits of a sole trader, company profits are taxed.

4.

Sharing responsibility and workload would be a disadvantage of a partnership.

5.

The Companies Act 2007 requires a sole trader to register as a legal entity.

6.

A “snapshot” of how the business is doing is also known as the accounting period concept. This divides the life of the business into time periods.

7.

The NZ Framework states a quantitative threshold for materiality.

8.

All assets are always recorded on the balance sheet at their historical cost value.

9.

A tool for analysing the effects of business transactions is known as the income statement.

10. A contingent liability is a certain debt, and therefore should be shown on the balance sheet.

2.9.1.2 1.

Multiple choice

The accounting entity principle states that: a.

Owner’s equity is the same as proprietorship.

2.

3.

b.

In law, the sole trader is the accounting entity.

c.

The life of the business is divided into small segments.

d.

The financial affairs of the business must be kept separate from those of the owner.

Historical cost means that assets are recorded at: a.

the amount of cash or cash equivalents paid, or the highest value of the consideration given to acquire them at the time of the acquisition;

b.

the amount of cash or cash equivalents that would be charged to an associated person;

c.

the amount of cash or cash equivalents paid, or the fair value of the consideration given to acquire them at the time of the acquisition;

d.

the value on the day that the balance sheet is prepared.

An example of a business liability is: a.

a creditor;

b.

a debtor;

c.

a computer;

d.

goodwill. [page 88]

4.

5.

Capital is: a.

the amount contributed by the owner to a business;

b.

the amount taken by the owner from the business;

c.

the amount of sales made by the business;

d.

fixed assets.

The accounting equation can be defined as: a.

the register used to record assets and calculate depreciation;

6.

7.

8.

9.

b.

a tool for analysing the effects of business transactions;

c.

assets = liabilities – owner’s equity;

d.

the balance sheet and income statement.

The concept that states that income is counted when it is earned, whether or not it has been received in cash or cheques, is known as the: a.

monetary concept;

b.

accounting entity concept;

c.

capital concept;

d.

recognition concept.

The principle that assumes that the business will continue to exist indefinitely is known as the: a.

future gain principle;

b.

going concern principle;

c.

accounting equation principle;

d.

infinity principle.

The materiality concept is about: a.

omission or misstatement of information;

b.

exclusion of expensive items in the accounts;

c.

demographics within the business sector;

d.

the amount taken by the owner from the business.

Drawings are: a.

the wage paid to employees;

b.

another word for capital;

c.

the amount paid to the owner, which increases net profit;

d.

the amount paid to the owner, which reduces owner’s equity.

10. The statement that shows the total owner’s equity at the beginning of the financial year, and then explains the changes that have taken place, is known as the:

a.

statement of changes in equity;

b.

statement of changes in owner’s equity;

c.

statement showing increase in owner’s equity;

d.

statement of capital and drawings. [page 89]

2.9.2. 2.9.2.1

PARAGRAPH ANSWERS Distinguishing between pairs of accounting terms

Distinguish between the following accounting terms by clearly defining what each term means: 1.

accounting entity and accounting period;

2.

assets and liabilities;

3.

debtors and creditors;

4.

loan and overdraft;

5.

capital and owner’s equity;

6.

accounting entity and legal entity;

7.

profit and cash flow;

8.

drawings and wages;

9.

materiality concept and recognition concept;

10. historical cost and current cost.

2.9.2.2

Definitions

Define the following terms: 1.

shareholder;

2.

dividends;

3.

audit;

4.

joint and several liability;

5.

recognition concept.

2.9.2.3

Understanding the accounting equation

Write a brief statement to describe what has occurred within each transaction of the business below:

2.9.2.4

Sources of finance — Wade Waiwater

Use the case of Wade Waiwater as presented in Resource file 2, paragraph 2.8.1, to answer the following: 1.

Name two resources which can be expressed in monetary terms which Wade brought into the business.

2.

Name two resources which cannot be expressed in monetary terms which Wade brought into the business.

3.

Name four assets that might appear in Wade’s accounting equation.

4.

Name two sources of finance that Wade might have used in commencing his business. [page 90]

2.9.2.5

Accounting concepts

1.

Why is the accounting entity concept so necessary in accounting?

2.

What are two weaknesses of the monetary concept?

3.

Why is it customary to divide the life of the accounting entity into a succession of equal periods?

4.

What major problem does this arbitrary division create?

2.9.2.6

Accounting equation to balance sheet — Allistragh Cottage Bed and Breakfast

Study the following balance sheet for Mr Hospitality’s Allistragh Cottage Bed and Breakfast carefully, and answer the questions that follow. Allistragh Cottage Bed and Breakfast Balance sheet As at 28 February 2014 $

$

ASSETS Bank Motor vehicle Inventory Equipment Accounts receivable Shares in Hospitality Enterprises Limited

1,456 30,000 267 1,540 250 2,000 35,513

CAPITAL

22,253

LIABILITIES Accounts payable Hire purchase ($4,000 payable in the 2015 year)

1,260 12,000 13,260 35,513

T-form is an alternative presentation, whereby the current and non-current assets are presented on the left-hand side; and the current, non-current liabilities, and owner’s equity are presented on the right-hand side of the balance sheet — the totals of each side must reconcile.

1.

How would Mr Hospitality be able to analyse his position better if the assets and liabilities were properly classified?

2.

Rewrite the above statement in T-form, making sure you present a full heading and classify the assets and liabilities appropriately.

3.

Of the $22,253 capital, $12,253 has been internally generated. Explain what that term means, and give a term that would describe the other $10,000.

4.

Calculate Mr Hospitality’s working capital. Do you think it is adequate? Briefly explain.

[page 91] 5.

If the shares in Hospitality Enterprises Limited had actually been bought by Mr Hospitality’s wife, what accounting principle would need to be considered? State whether the shares would be shown in the business’s balance sheet and briefly explain your answer.

6.

The motor vehicle is shown at its cost price of $30,000. What other information regarding the vehicle and its value might be useful for readers if it were added as a note to the financial statements?

7.

Mr Hospitality’s capital at 1 February 2014 was $15,570. If his average drawings were $4,000 per month, calculate Allistragh Cottage Bed and Breakfast’s estimated net profit for the month of February.

2.9.2.7

Accounting equation to balance sheet — Countdown Computers

Prepare a fully classified balance sheet for Countdown Computers as at 1 June 2014, after taking into account the following transactions that Cecelia incurred in starting up the business: Cecelia D Rom resigned from her job as sales manager at McApple Computers in May 2014, and used money from a superannuation scheme and a family inheritance to finance a business venture as a computer wholesaler called Countdown Computers. Cecelia deposited $165,000 in the new business bank account on 1 May 2014. Her Uncle Hewlett had lent her $60,000 of this amount (no interest and no set pay-back date), with the remainder being Cecelia’s own money. On 15 May 2014, Cecelia signed an agreement to buy a suitable warehouse, worth $340,000, for her business. She paid a deposit of $136,000. The remaining $204,000 would be paid in equal increments of $10,200 on 1 May each following year.

Finally, on 31 May 2014, Cecelia concluded the purchase of a computer business from Hugh Packard, whose lease had just expired on the building he had been using. The purchase agreement was for Cecelia to take over the following assets and liabilities for a purchase price of $85,000: – stock — $65,700; –

debtors — $14,650;



fittings — $24,000; and



creditors — $19,350.

You may find it helpful to analyse the effect of Cecelia’s three transactions in May on the accounting equation first, before preparing the formal statement.

A deposit of $25,000 was paid to Hugh on 31 May 2014, with the balance to be paid in six equal monthly instalments ending on 30 November 2014. [page 92]

2.9.2.8

Accounting equation to balance sheet — Tim’s Topiary

After completing a horticulture and landscaping qualification, Tim Trimmer decided to set up business as Tim’s Topiary. Below are the transactions for the first week. Tim used his house to raise a loan of $30,000. He then opened a separate business bank account, and deposited the $30,000 together with $10,000 from his personal savings account. Tim then: – purchased land valued at $80,000, using a $20,000 cash deposit and the balance on mortgage; –

paid $11,500 cash for a second-hand truck;



brought office furniture valued at $500 from home to use in the business;



obtained a loan of $3,000 from a finance company to buy topiary shears and other equipment;



bought new fencing for $2,000 cash;



paid $500 off the mortgage;



bought stocks of seedlings on credit from Garden World Wholesalers for $5,000.

1.

Prepare a worksheet to record the effects of the transactions on the accounting equation.

2.

After the last transaction, total the worksheet and prepare a classified balance sheet for Tim’s Topiary, using today’s date.

2.9.2.9

Accounting equation to balance sheet — Helen’s Hair Styling

After completing her hairdressing apprentice and qualification, Helen Hare decided to set up business as Helen’s Hair Styling. Below are the transactions for the first week. Helen opened a separate business bank account, and deposited $10,000 from her personal savings account. Helen deposited a further $10,000, which she borrowed from her parents, Sandy and Christopher Hare. Helen then: – purchased equipment valued at $12,000, using a $2,000 cash deposit and the balance on hire purchase; –

paid $3,500 cash for salon chairs;



brought a computer from home (valued at $800) to use in the business;



took $300 from the business cheque account for personal expenses;



paid $200 off the hire purchase;



bought stocks of shampoo and conditioner on credit from Hair Suppliers Ltd for $5,000.

[page 93] 1.

Prepare a worksheet to record the effects of the transactions on the accounting equation.

2.

After the last transaction, total the worksheet and prepare a classified balance sheet for Helen’s Hair Styling, using today’s date.

2.9.2.10

Statement of changes in equity — Earlybird Carriers Ltd

Use the trial balance below, to complete a statement of changes in equity and a balance sheet for Earlybird Carriers Ltd. Earlybird Carriers Ltd Trial balance As at 31 March 2014 $ Expenses

$

713,300 Revenue

830,300

Provisional tax paid

34,000 Issued capital (100,000 shares)

Interim dividend paid

13,200 Retained earnings 1/4/2013

60,600

Bank

22,600 Asset revaluation reserve (Land)

15,000

Land

38,000 Hire purchase

15,200

Buildings

165,000 Loan

Vehicles

320,000

275,000

110,000

1,306,100

1,306,100

Opening issued capital was $275,000. The directors were seeking an additional dividend of $12,000.

2.9.2.11

Income statement— Earlybird Carriers Ltd

The income statement for the year ended 31 March 2014 is as follows: Earlybird Carriers Limited Income statement For the year ended 31 March 2014 $

Operating revenues

830,300

Less Operating expenses

(713,300)

Net profit before taxation

117,000

Less Taxation (28%)

(32,760)

Net profit after taxation

84,240

Complete the statement of changes in equity and the balance sheet. [page 94]

2.9.3 2.9.3.1

DISCUSSION QUESTIONS Financing a business

Eng Nearing completed a Bachelor of Engineering (Civil Engineering) at Manukau Institute of Technology two years ago. Since then, she has been employed by her local city council in the area of road and bridge construction on a salary of $55,000 per annum. Although she enjoys her work and has been grateful for the work experience obtained with the council, Eng has always had a long-term goal of owning and operating her own business. The chances of her doing this recently improved, when she won $50,000 from a scratch and win ticket. Currently, she is investigating the option of doing freelance project management for a large roading company. Grange Green has a keen interest in all things electronic, but until now has only pursued this interest in hobby activities. Since leaving high school several years ago, he has worked for a golf club, assisting the golf pro and managing the golf shop. (Grange has played amateur golf since he was young.) His annual salary is $39,000. Lately he has been disappointed with the lack of opportunity to pursue his interest in electronics, and is desperately seeking a career move, including the possibility of setting up some sort of business of his own. As a result of careful saving and an inheritance, Grange has $80,000 invested in government bonds. Grange has recently found out

that an electrical goods sales and service outlet in Manukau is presently available for sale, and he is contemplating buying the business. Based on a strong business case and interest from the roading company, Eng predicts that her business should have a consistent annual turnover of approximately $450,000 for the next two or three years (potential future growth is difficult for Eng to predict). She also expects that her net profit percentage on services should be able to be maintained at 12%. Grange had budgeted for an initial net profit return of $40,000 for the first two years, with the expectation of an 8% increase in the third year. Both Eng and Grange have their respective $50,000 and $80,000 initial capitals currently invested at an annual interest rate of 6%. REQUIRED: For each prospective proprietor (that is, Eng and Grange), examine the financial implications of their going into business in terms of present and expected annual income. Discuss also any non-monetary considerations that should be taken into account for purposes of their decision. What recommendation would you make to Eng and Grange concerning the advisability of buying and operating their respective businesses (given the facts provided)?

2.9.3.2

Wade Waiwater — sports fishing

Use the case of Wade Waiwater as presented in Resource file 2, paragraph 2.8.1. 1.

Wade asks you to become his accountant. List some questions you might want to ask before you begin preparing his financial statements.

2.

Use the accounting equation to illustrate where the funds came from for the purchase of assets.

3.

How did the equation change when Wade took out a bank loan?

4.

Explain to Wade how you will value the assets on the balance sheet. [page 95]

5.

Wade had some stationery printed. How will you deal with this item? Which accounting principle will guide your decision?

6.

What length of accounting period would you advise Wade to consider? Why?

7.

Terri has suggested that Dave attend a course on running a small business, even though Wade has operated a small, but successful, business. He asks your advice. Do you think it is a good idea for him to attend, remembering the other demands on his time? What would you point out as the advantages and disadvantages?

8.

Wade has identified a problem: “Making sure people pay their bills, and paying my bills.”

9.

a.

Explain the concept of cash flow to Wade.

b.

Outline some things Wade can do to encourage debtors to pay.

c.

Discuss some problems Wade might encounter if he is unable to pay his creditors, and highlight how they will affect the business.

Wade has recently employed two more people to work for him as casual deckhands. He wonders whether he might contract the jobs out in the future, instead of taking on further employees. How would you advise him?

10. What sort of extra work has been generated by employing people? Who do you think should do this work? Why? 11. In what ways did Wade’s role change because of his decision to employ staff? 12. How might this affect the business in the future? 13. Wade wants to be a fair employer. What are some of the things you might advise with regard to providing a positive working environment for both Wade and his staff? 14. Would you accept Wade as a client? Why or why not?

2.9.3.3

Understanding a balance sheet

Larry Longstrand, Hair Colourist Balance sheet As at 31 March 2014 $

$

ASSETS Bank Motor vehicle

8,425 24,000

Inventory

1,253

Equipment

1,540

Accounts receivable Building

250 79,000 114,468

[page 96] $ CAPITAL

$ 72,899

LIABILITIES Accounts payable Loan

1,569 40,000 41,569

TOTAL EQUITY AND LIABILITIES

114,468

1.

List five questions you would ask Larry about his business.

2.

Why is it important to ask the questions you have listed?

3.

Larry wishes to borrow $6,000 to finance a computer to streamline the business’s record-keeping. What would you advise?

4.

On the balance sheet, where would the value of the computer be shown? Where would the debt be shown?

5.

One year later — Larry Longstrand, owner of Hair Colourist hairdressing salon: “I understand the historical cost concept, but my

6. 7.

common sense tells me that my business computer is not worth as much now as when I bought it a year ago. In my opinion, you should put it on the balance sheet at its market value, otherwise this statement sheet is not an accurate picture of my business today.” Explain the differences between the historical cost and market value with regard to assets. Is Larry correct? How accurate is a balance sheet? Identify the items on the accounting equation which will be affected by the decision to reduce the value of the computer.

2.9.3.4

Jessica Bowden’s bookshop

Jessica owns a bookshop in the main street of a tourist town on the South Island, which is experiencing a boom in tourism. She has received her balance sheet, but says, “I feel that the assets are undervalued, particularly the shop premises, because shops in the same street are selling for far more. I’m confused! Not only about the values of the assets, but some were missed out altogether. For instance, I gave the accountant the value of things like my electric pencil sharpener and the jug I use for making my coffee, but this sort of thing was missed off the balance sheet. Can you explain why?” 1.

Which concepts guided Jessica’s accountant when her financial statements were being prepared?

2.

Because times are good, Jessica is thinking of extending the premises to increase the size of her showroom. She comes to you for advice. “It will cost about $45,000. Shall I pay in cash? Shall I borrow the lot from the bank? Or, how about a combination of the two?” What are the advantages and disadvantages of each of these? [page 97]

2.9.3.5 1.

Explaining accounting ideas

You are asked to give a presentation to a group of non-accountants

about the accounting equation, and the effects of transactions upon the equation. Identify the main ideas you have noticed so far. Without discussion, prepare a brief statement, and then compare it with a partner. When you have seen your partner’s statement, either choose the one you think is the best, or write another statement combining the best of the ideas. Then share the statement with the rest of the class. 2.

You are asked to write an article for Small Business News entitled “Cash or Credit: Who wins — the customer or the business?” Write down your ideas, identifying the main idea you want to emphasise in your article. The emphasis of your article must be the business — advantages and disadvantages of cash versus credit.

3.

A client who runs a dance school is considering allowing credit to customers. “Usually I have asked for cash when they sign on, but I read an article which suggested that allowing credit would enable more people to buy.” What are some of the problems you foresee? How would you advise your client to minimise these?

2.9.3.6

Al Pea — Rotation Music

Al Pea owns and operates Rotation Music, a shop selling secondhand records, tapes, and CDs. He has come to you for help, having got confused about his accounts. He has been in business less than a year. He presented you with the below list of assets and liabilities, which he believed to be relevant to his business. After discussing things through with Al you establish the following: The savings account is a nest egg that Al has put aside for a trip to Nashville (Al being a country music fan). The vehicle is used 80% for business and 20% for private purposes. The ski gear was purchased through the business cheque account. The land and buildings were purchased by Al six years ago as an investment. The land was then valued at $35,000, and the shop buildings at $61,000. Al’s home was mortgaged earlier in the year to provide some additional

working capital for the business. The debts to suppliers really add up to $9,200, but Al believes he can “do a deal” with one of them to save $600. ASSETS

$

$

LIABILITIES

Cheque account

1,200 Loan (family Pea)

4,000

Savings account

12,500 Mortgage (house)

10,000

8,700 Debt to suppliers

8,600

Vehicle Stock of CD’s and records Ski gear

16,400 1,500

Land

50,000

Buildings (shop)

75,000

Debts from customers

1,800

[page 98] 1.

Calculate Al’s equity in his business based on the figures he has supplied.

2.

Calculate Al’s working capital based on the figures he has supplied.

3.

Al has not understood (or known about) some important accounting concepts when he assembled his list of assets and liabilities:

4.

a.

Identify each of the concepts, and write an explanatory paragraph about each one to guide Al’s thinking for the future. Refer to the specific instances where Al has gone wrong in his thinking.

b.

Write a draft classified balance sheet for Al, based on accepted accounting concepts, and showing the amount of working capital Al’s business has. Compare your results with your answers to question 1.

c.

How material do you think Al’s errors have been? Explain.

Identify any further accounting concepts you think Al should know about at this stage, and write a paragraph of advice on each one to guide Al’s thinking for the future.

2.9.3.7

Greg Savage and the circulation of resources

Greg Savage sells computers and computing products (laptops, multifunction printers, cameras, etc) to a range of business customers. All purchases and sales are made on credit terms. A frustrated Greg has just rung his chartered accountant complaining that “The financial reports show that I’m making a reasonable profit, and yet I don’t seem to have enough money to pay my suppliers, let alone take out any drawings for myself. How can that be?” The accountant has told Greg, “Check the level of your inventory and accounts receivable. You’re probably not managing your circulation of resources as well as you could be.” 1.

Explain what Greg’s accountant means by the “circulation of resources”.

2.

Explain why poor management of inventory and accounts receivable could be causing Greg’s cash problem. As part of this, state what trend you would expect to see in the level of Greg’s inventory and accounts receivable.

3.

Does the cash cycle (the circulation of resources) affect profit as well as cash flow? In answering this question, consider what would happen to profit for the period if the speed of the cycle either increased or decreased.

2.9.4 2.9.4.1

RESEARCH ASSIGNMENTS The changing accounting environment

Resource file 2, paragraph 2.8.2, provides notes to the accounts relating to the way that assets are valued within the businesses of Fletcher Building Ltd and Auckland International Airport Ltd, and Appendix 1 contains a copy of Xero Ltd’s 2013 Annual Report, including the notes to the financial statements dealing with asset valuation. Prepare a “cheat note” which provides an outline of the points you wish

to cover in a 20-mark essay (300 words) regarding the usefulness of historical cost as a basis of asset valuation. You know that you are expected to refer to the notes to the accounts. You need to make assessments as to the reliability of the historical cost concept, and decide whether that concept might be relevant in the instances provided. [page 99]

2.9.4.2

Setting up a business

Whichever type of business organisation Rena chooses, there will be a number of other factors which influence its success or failure. Economic events, changes in the law, and government policy are all factors over which Rena has no control, yet might affect her business.

Rena Readytogo recently visited China to investigate the possibility of trade in specialised wood furniture products between New Zealand and China. She found willing suppliers, and the Free Trade agreement between China and New Zealand made her feel confident to pursue her business. When she returned, she managed to get some orders from interested retailers and, at this point, comes to you for advice. She realises that she must give some thought to the type of business she should form. She is not sure of the differences between sole traders, partnerships, or companies, nor does she appreciate the advantages and disadvantages of each. www.nzte.govt.nz may assist in finding a relevant article.

1.

Prepare a report for Rena, making a recommendation with justification covering the following dimensions: a.

forming a business;

b.

any legal requirements;

c.

liability for debts of the business;

d.

taxation;

e.

scope for borrowing for future expansion;

f.

any personal issues involved.

2.

Select a newspaper article or go to a relevant website that describes a recent event which might contribute to the success or failure of Rena’s business. Explain why you have chosen this article, and describe how the event it covers might affect her business.

2.9.5

INTERNET EXERCISE

http://www.business.govt.nz/companies/learn-about/starting-a-company. Partnership Act 1908: www.legislation.govt.nz

This is a continuation of the Rena Readytogo exercise in paragraph 2.9.4.2. Go to the Companies Office website and find a sample constitution which can be used as a basis for Rena’s company rules, or use the Partnership Act 1908 to provide the basis of a partnership deed. Ensure that the partnership agreement is more favourable towards Rena.

2.10 2.10.1. 2.10.1.1

Mastering accounting — solutions SHORT ANSWER QUESTIONS True/False

1.

True. Refer to the accounting entity principle.

2.

False. Shareholders of companies are not personally liable for business debts.

3.

True. Unlike profits of a sole trader and of partnerships, company profits are taxed.

4.

False. Sharing responsibility and workload would be an advantage of a partnership.

5.

False. The Companies Act 1993 requires a company to register as a legal

entity. [page 100] 6.

True. See the term “accounting period” in the Glossary.

7.

False. Paragraph QC 11 of the NZ Framework defines materiality, and states that no quantitative threshold can be specified.

8.

False. Assets are recorded on the balance sheet at their historical cost value or fair value.

9.

False. A tool for analysing the effects of business transactions is known as the accounting equation.

10. False. A contingent liability should not be recognised (included in the accounts), but should be disclosed in the notes, explanatory material, or supplementary schedules.

2.10.1.2 1.

d.

2.

c.

3.

a.

4.

a.

5.

b.

6.

d.

7.

b.

8.

a.

9.

d.

Multiple choice

10. a.

2.10.2

PARAGRAPH ANSWER

2.10.2.1

Distinguishing between pairs of accounting terms

1.

The accounting entity is the organisational unit for which the accounts are being prepared. The accounting period is that period of time for which accounts are being prepared.

2.

Assets are items of monetary value to the business or other organisation; they are economic resources that will provide future service or benefit. Liabilities are the debts of the business — that is, amounts owing to outside parties.

3.

Debtors are people or other businesses that owe the business money; they are usually the business’s customers. Creditors are people or other businesses that the business owes money to; they are usually suppliers of goods or services.

4.

Loan is the generic term for money borrowed to finance some purchase by the business. An overdraft is a form of short-term loan, whereby the bank agrees to allow the business to withdraw amounts from the current account (cheque account), even if the account has no funds in it. [page 101]

5.

Capital represents the funds contributed to the business by the owner(s). It forms part of owner’s equity, which is a term generally used to denote the owner’s financial interest in the business. Sometimes these terms are used interchangeably.

6.

The accounting entity is the organisational unit for which the accounts are being prepared. The term legal entity refers to an organisational unit that has a recognised legal status distinct from the owners. Not all accounting entities are legal entities; for example, a sole trader business has no recognised legal status that is separate from the personal activities of the owner. Hence, a sole trader’s personal assets can be called on to

pay business debts. 7.

Profit represents the surplus that arises when revenue for a period exceeds expenses for that period. Profit is calculated taking into account revenue and expenses that are deemed to have been “realised”, whether cash is involved or not; but excludes capital transactions, such as purchasing a fixed asset. Cash flow is the relationship between receipts and payments of cash resources. When calculating cash flow, all movements of cash during the period are taken into account. Thus, profit and cash flow are quite distinct concepts and it is possible for a business to have a good profit, but still have a poor cash flow — usually accounted for by the level of non-cash transactions that have taken place.

8.

Drawings represent withdrawals of resources (usually cash, but sometimes stock) from the business by the owner, usually in anticipation of profit; drawings reduce the owner’s equity. Wages are a business expense paid to persons employed by the business; wages therefore reduce the profit available for the owner(s) to draw out of the business.

9.

Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Paragraph QC 11 of the NZ Framework defines materiality and states that no quantitative threshold can be specified. The recognition concept requires that revenue and expenses for an accounting period are recognised in the period in which they occur in order to ascertain the true profit for the period. The need to recognise expenses and revenue arises because the life of the entity is arbitrarily divided up into accounting periods for the purpose of reporting results.

10. Historical cost means that assets are recorded at the amount of cash or cash equivalents paid, or the fair value of the consideration given to acquire them at the time of the acquisition; liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal

course of business. Current cost means that assets are carried at the amount of cash or cash equivalent that would have to be paid if the same or an equivalent asset were acquired currently. [page 102]

2.10.2.2

Definitions

1.

Shareholder Companies function separately from their owners, who are their shareholders. There are no limits to the number of shareholders in a company. A person becomes a shareholder of a company by subscribing for shares in the company — that is, by agreeing to buy a number of shares at an agreed price.

2.

Dividends Company profits are distributed as dividends according to the number (and type) of shares held by each shareholder. Dividends then become part of a shareholder’s personal income, and are subject to income tax.

3.

Audit Audit is the process of checking and verifying the accuracy, completeness, and integrity of the accounting process, to ensure that the accounts show a true and fair view of the financial results and financial position of the entity.

4.

Joint and several liability This describes the liability of partners for business debts. Each partner is fully liable, both individually and in conjunction with the other partners, for all business debts. A third party may seek to recover a debt from any one or all of the partners, each one of whom is liable to the full extent of their personal assets.

5.

Recognition concept This requires that revenue and expenses for an accounting period are recognised in the period in which they occur in order to ascertain the true profit for the period. The need to recognise expenses and revenue arises because the life of the entity is arbitrarily divided up into accounting periods for the purpose of reporting results.

2.10.2.3

Understanding the accounting equation

1.

The owner has put $15,000 cash into the business.

2.

The business has received $10,000 by way of a loan.

3.

Equipment worth $7,000 has been purchased for cash.

4.

$1,000 has been paid off the loan.

5.

The owner has contributed a car worth $5,000 to the business.

6.

Equipment (originally recorded at a value of $7,000) has been sold for $6,000 cash, resulting in a loss on disposal of $1,000, which has reduced capital.

2.10.2.4

Sources of finance — Wade Waiwater

1.

Cash at bank and boat.

2.

Boat-building skills, fishing skills, time, and network of people.

3.

Bank, debtors, fishing gear, boats, and motor vehicle.

4.

Bank loan, hire purchase, loan from family/friends, bank overdraft, creditors for equipment, and loan from the finance company. [page 103]

2.10.2.5 1.

Accounting concepts

Refer to the definition of accounting entity in the Glossary. The accounting entity concept must be adhered to if any meaningful reports are to be prepared regarding the performance and financial position of the business itself. If the affairs of the owner(s) are not kept separate from the business affairs, it is impossible to judge how well the business is doing. For example, suppose the profit of a sole trader stood at $40,000, representing an apparent 50% return on capital of $80,000. If it is, however, known that the proprietor had included $20,000 of Lotto winnings in the business results, clearly, a different view of the business

is formed. Similarly, including private expenses in the business accounts distorts the level of business expenses, giving the impression that the business is performing less efficiently. 2.

The weaknesses of the monetary concept are, first, the fact that the change in the value of money (for example, as a result of inflation) makes comparisons between accounting periods less useful; second, many aspects of business cannot be reduced to monetary terms — for example, customer loyalty and employee commitment.

3.

The life of the accounting entity is divided into equal periods to determine the performance of the business over a given period, and to allow for comparison of those results with previous accounting periods.

4.

This arbitrary division creates the need for accounting entries to ensure that revenue and expenses are correctly matched, given that, at any point in time, income may be earned but not received or recorded, expenses may have been incurred but not paid or recorded, and amounts may have been paid or received that relate to a future period.

2.10.2.6 1.

Accounting equation to balance sheet — Allistragh Cottage Bed and Breakfast

If the assets and liabilities were properly classified into current (that is, one year) and non-current groupings, Mr Hospitality would be better able to analyse his short-term stability or his ability to pay his immediate debts. [page 104]

2. Note the alternati presentation. A vertical presentation is equally correct. Allistragh Cottage Bed and Breakfast Balance sheet As at 28 February 2014

$

$

CURRENT ASSETS Bank

$

$

CURRENT LIABILITIES 1,456

Accounts receivable

250

Inventory

267

Accounts payable

1,260

Hire purchase

4,000 5,260

1,973 NON-CURRENT ASSETS Equipment Motor vehicle Shares Hosp.Ent.Ltd

NON-CURRENT LIABILITIES 1,540

Hire purchase

8,000

30,000 2,000

OWNER’S EQUITY 33,540 35,513

Capital – Mr Hospitality

22,253 35,513

3.

Internally generated capital arises from earning profits and retaining them in the business (that is, net profit less drawings). The other $10,000 is described as introduced capital (that is, funds invested from the owner’s private resources).

4.

Working capital = current assets less current liabilities = $1,973 – $5,260 = $3,287. This is not adequate, as he has more debts falling due within the next year than he has assets that can be turned into cash within the year — that is, he has negative funding available for his operations in the short term.

5.

The accounting entity principle. The shares would not be shown in the business balance sheet, as it shows the financial position of the business. To reflect a true picture, the balance sheet should not include any assets or liabilities relating to other entities (for example, Mr Hospitality’s wife).

6.

The current market valuation of the vehicle and a physical description (for example, make, model, year, condition, suitability).

7.

The net profit for the month was large enough to cover an increase in capital of $6,683 ($22,253 – $15,570), and to cover Mr Hospitality’s

drawings of $4,000. Therefore, the entity’s estimated net profit for the month equals $10,683. (Alternatively, reconstruct the proprietorship section of the balance sheet.) [page 105]

2.10.2.7

Accounting equation to balance sheet — Cecelia D Rom, Countdown Computers

Countdown Computers Balance sheet As at 1 June 2014 $

$

ASSETS Current assets Bank

4,000

Debtors

14,650

Stock

65,700 84,350

Non-current assets Fittings

24,000

Building

340,000 364,000

TOTAL ASSETS

448,350

OWNER’S EQUITY Capital – C D Rom

105,000

LIABILITIES Current liabilities Creditors

19,350

Vendor – H Packard

60,000

Mortgage – current

10,200

89,550 Non-current liabilities Mortgage

193,800

Loan – Uncle Hewlett

60,000 253,800

TOTAL EQUITY AND LIABILITIES

448,350

[page 106]

2.10.2.8

Accounting equation to balance sheet — Tim’s Topiary

ASSETS = Bank

LIABILITIES +

Other assets

A/c pay

Loan

OWNER’S EQUITY Mortgage

40,000

40,000

(20,000)

80,000 i

(11,500)

11,500 ii

60,000

500 iii

500

3,000 iv (2,000)

3,000

2,000 v

(500) 6,000 i

Land & buildings

ii

Truck

iii

Office furniture

iv

Equipment

v

Fencing

vi

Inventory

Tim’s Topiary Balance sheet As at “today”

Capital

(500) 5,000 vi

5,000

102,000

5,000

3,000

59,500

40,500

$

$

ASSETS Current assets Bank

6,000

Inventory

5,000 11,000

Non-current assets Furniture

500

Equipment

3,000

Fencing

2,000

Truck

11,500

Land and buildings

80,000 97,000

TOTAL ASSETS

108,000

[page 107] $

$

LIABILITIES Current liabilities Accounts payable

5,000

Non-current liabilities Mortgage

59,500

Loan

3,000 62,500

TOTAL LIABILITIES

67,500

OWNER’S EQUITY Capital

40,500

TOTAL EQUITY AND LIABILITIES

2.10.2.9

108,000

Accounting equation to balance sheet —

Helen’s Hair Styling ASSETS + Bank

DRAWINGS =

Other assets

1.

20,000

2.

(2,000)

12,000 i

(3,500)

ii

3. 4.

Drawings

LIABILITIES + A/c pay

Loan

OWNER’S EQUITY Hire purchase

Capital

10,000 3,500

10,000 10,000

800 iii

5.

(300)

6.

(200)

7.

300 (200) 5,000

14,000

800

iv

21,300

i

Equipment

ii

Salon equipment

iii

Computer

iv

Inventory

5,000 300

5,000

10,000

9,800

10,800

[page 108]

Helen’s Hair Styling Balance sheet As at “today” $

$

ASSETS Current assets Bank Inventory

14,000 5,000 19,000

Non-current assets Computer Salon equipment Equipment

800 3,500 12,000 16,300

TOTAL ASSETS

35,300

LIABILITIES Current liabilities Accounts payable

5,000

Non-current liabilities Hire purchase Loan

9,800 10,000 19,800

TOTAL LIABILITIES

24,800

OWNER’S EQUITY Capital Less drawings

10,800 (300) 10,500

TOTAL EQUITY AND LIABILITIES

35,300

[page 109]

2.10.2.10 Statement of changes in equity — Earlybird Carriers Ltd Earlybird Carriers Limited Statement of changes in equity For the year ended 31 March 2014 $ Equity 1/4/13 (275,000 + 60,600 + 15,000) Add Net surplus

350,600 84,240

Less Interim dividend paid

(13,200)

Equity 31/3/14

421,640

Earlybird Carriers Limited Balance sheet As at 31 March 2014

$

$

ASSETS Current assets Bank

22,600

Taxation refund (34,000 – 32,760)

1,240 23,840

Non-current assets Vehicles

320,000

Land

38,000

Buildings

165,000 523,000 546,840

EQUITY Issued and paid-up capital

275,000

Asset revaluation reserve

15,000

Retained earnings 31/3/14 (60,600 + 84,240 – 13,200)

131,640 421,640

LIABILITIES Current liabilities

-

Non-current liabilities Loan

110,000

Hire purchase

15,200 125,200

TOTAL EQUITY AND LIABILITIES

546,840

Note that the proposed dividend is not included, because the acceptance of the dividend by shareholders is not certain. Refer to the definition of liability.

[page 110]

2.10.3

DISCUSSION QUESTION

2.10.3.1

Financing a business

Eng Nearing Financial implications Eng’s present annual income is $58,000, being earned from salary of $55,000, and interest of $3,000 (6% x $50,000). Eng’s expected annual income from her business is $54,000 ($4,000 x 17%). In financial terms, Eng could expect to be slightly worse off (by $4,000) if she were to operate as a freelance project manager. Note the difficulty in predicting any future growth.

Non-monetary considerations Going into business would give Eng the self-satisfaction and independence of being her own boss and being able to shape her own working future. It would also enable Eng to achieve her long-term goal of owning and operating her own business. Countering the potential positive nonmonetary aspect, would be the extra stresses involved in being sole owner of a business enterprise, compared to the job enjoyment she now has. She would also be giving up the chance of obtaining more hands-on engineering experience by managing the projects (including people and time lines), instead of being involved in the planning. Recommendation I would advise Eng against starting the business. Although she predicts a small increase in annual income from operating the business, it does not seem sufficient to justify the extra worry and risk of losing her investment. As a young person, it would perhaps be better for her to continue her engineering employment (with the possible chances of salary increases) until a “better” business opportunity arises. (There is also the possibility that Eng’s predictions might be overstated, which could lead to negative financial implications for her.) Equally, it could be argued for Eng buying the business.

Grange Green Financial implications Grange’s present annual income is $43,800, being earned from salary of $39,000, and interest of $4,800 (6% x $80,000). Grange’s expected annual income from his business is $40,000 (increasing to $43,200). In financial terms, Grange could expect to be worse off (initially by $3,800 or 8.5%, decreasing in the third year) if he were to buy and operate the electrical goods outlet. Non-monetary considerations Going into business would give Grange the independence of being his own boss, and being able to determine his own career moves. It would also give Grange a chance to escape from his present frustrating work situation. Countering this would be the extra stresses involved in sole business ownership, and concerns regarding Grange’s ability to apply a hobby interest in electronics to a successful business venture. Going into business would also effectively rule out any future management career at the Golf Club. [page 111] Equally, it could be argued against Grange buying the business.

Recommendation I would advise Grange to buy the business. Although the initial predictions are for a loss in earnings, it would appear that long-term earnings potential could keep increasing to exceed his current income, which seems to have reached its peak at present. (Much would depend on Grange’s attitude and confidence with regard to the business venture.)

[page 113]

Determining profit

CHAPTER

3

Contents Learning outcomes 3.1

Introduction 3.1.1 Case study — Welkom Enterprises expands … so do the profits 3.1.2 Some questions for discussion

3.2

Transactions affecting owner’s equity — a professional view 3.2.1 Selling a service 3.2.2 Selling a service for cash 3.2.3 Selling services on credit 3.2.4 Bad debts 3.2.5 Providing for doubtful debts 3.2.6 Prudence — a degree of caution

3.2.7 3.2.8 3.2.9 3.2.10 3.2.11 3.3

Encouraging prompt payment Attracting new clients Paying expenses Effect of GST on the accounting equation Analysing a range of transactions

Preparing an income statement 3.3.1 Making adjustments to revenue and expenses 3.3.2 Accrued expenses 3.3.3 Prepaid expenses 3.3.4 Income received in advance 3.3.5 Accrued income [page 114]

3.4

Accounting for inventories 3.4.1 Physical inventory system 3.4.2 Perpetual inventory system

3.5

Capital and revenue expenditure 3.5.1 Capital expenditure 3.5.2 Revenue expenditure 3.5.3 How do we make the right decision?

3.6

Sorting out our accounting system — a chart of accounts 3.6.1 Classification in the income statement and balance sheet 3.6.2 Classification as a means of decision making 3.6.3 Aiming for consistency

3.7

The impact of information technology

3.8

Conclusion

3.9

Key words 3

3.10

Resource file 3 3.10.1 Case study — Jones’s Hire Services 3.10.2 Case study — NZ Catering Supplies Ltd: An example of business failure

3.11

Mastering accounting — questions 3.11.1 Short answer questions 3.11.2 Problems 3.11.3 Discussion questions 3.11.4 Research assignments 3.11.5 Integrated case — NZ Catering Supplies Ltd: An example of business failure

3.12

Mastering accounting — solutions 3.12.1 Short answer questions 3.12.2 Problems [page 115]

Learning outcomes After completing this chapter, you should be able to: define and identify revenue and expenses; use the expanded accounting equation to prepare financial statements; explain the effect of goods and services tax (GST) on business; and prepare a properly classified income statement appropriate for a small

business.

3.1

Introduction

In the last chapter we concentrated on the balance sheet, while viewing the importance of profit to the longevity of a business. In this chapter, we focus on the factors involved in determining the profit of a business.

3.1.1

CASE STUDY — WELKOM ENTERPRISES EXPANDS … SO DO THE PROFITS

“Hospitality has always been a passion, so when an opportunity came up to buy a two-hectare property with a house and some accommodation on it that was previously used as a business, we jumped at the chance. John was not keen to leave his job as a chef, so we decided that the business would be for me to run, and John would continue with his full-time job. This also helped lessen our potential risks.” Judi and John Welkom had worked in the hospitality and tourism industry for many years, and both were ready to apply their skills to Judi’s business. How did they start? “Well, we had some cash set aside, and owned our own home, so decided to sell the house and use the money for the business — after all, we would be living and working on the same property. We found pretty quickly that owning and maintaining a business and a large property was more expensive than anticipated. Quickly I found a need to expand the business, as I found that customers didn’t just want to stay in the cottages, they expected some activities as well. We took out an additional loan for the

expansions.” Judi also decided to take a business course to get some knowledge in accounting to lessen the business compliance costs. Welkom has five self-contained cottages on a lifestyle farm with fully landscaped gardens. The atmosphere has been described as magical and relaxing. The cottages have all been refurbished with good quality chattels, and the tariff includes a country breakfast. “I’m always on the lookout for opportunities to improve the property or accommodation. I decided to leverage off the lifestyle farm and provide a real ‘Kiwi’ experience for our guests. It’s important for the image of the business that I provide a high quality experience,” says Judi thoughtfully, “because I want to have a competitive edge.” There are a number of tourist bed and breakfast businesses springing up in the [page 116] district now, and clients have lots of choice. “I prefer that they choose Welkom,” she adds with a smile. When you arrive at Welkom, you are struck by the professionalism of the hosts and that they seem so friendly and approachable; nothing seems to be a bother. “I’m always working with local business to ensure that we can offer local produce and products to our guests. We have local vineyards, olive growers, as well as fruit and vegetable suppliers. We have souvenirs available for sale. These are made by small local businesses and include art, sculptures, and other smaller souvenirs which are unique to the area — product sales are around 15% of our profit. As an extra, we provide all our guests with complimentary soaps made by a local supplier. They smell divine!” What about the day-to-day operation of the business? What are some of the problems? “Generally, earning a profit is probably the biggest problem. I offer a number of ways that people can pay, which encourages them to book,” answers Judi. “The other side is paying the bills for the goods for the souvenir

shop. We have to make sure that we pay for power, phone, insurance, and wages. Then there is the lease for the company vehicle, of course, and interest on the loans, as well as the loans themselves. I seem to spend a lot on print and internet advertising, but this generates the income, so I have learned to live with it.” “One of the biggest hassles is trying to meet the statutory requirements for the business. With PAYE, GST, income tax, ACC, and other compliance requirements, I got really frustrated and didn’t know whether my role was business owner or compliance officer! I had to go to a number of seminars to get the hang of what it was all about. My accountant set up a system, of course, but I still needed to understand what it was all about.” Can you anticipate what might happen to Welkom if New Zealand is no longer seen as a “clean, green, safe” tourism environment? Alternatively, what might some of the effects be if the government decided that businesses such as Welkom could not sell retail products from their premises?

The final word from Judi: “I was lucky to get into a sector of business which is expanding (there always seems to be growth in tourism — New Zealand is a popular destination), unlike so many others. New Zealand has been in the international spotlight a lot in the last few years with the America’s Cup, rugby, movies, etc. Who wouldn’t want to come here! Domestic tourism is also growing, as people have more leisure time and the economy is relatively strong. ‘Don’t leave town until you see the country’ is a motto I totally agree with.” Judi Welkom is an energetic entrepreneurial woman with loads of hospitality experience. Her professionalism is a benchmark for her staff and for other businesses such as hers. We can see from the case study that a business is a dynamic organisation of resources. Things change daily because of, among others, customer demand, new technology, management decisions, the economy, and the law. In the case of Welkom Enterprises, changes are brought about by the availability of time and money, the motivation to travel, and other factors that might stop people travelling.

3.1.2

SOME QUESTIONS FOR DISCUSSION

Where did the capital for this business come from? List some reasons why the business is successful. List some of the problems Judi might encounter if she expands Welkom. [page 117] Why is Judi spending on advertising when “New Zealand has been in the spotlight a lot in the last few years”? Some tourists would never think of visiting a lifestyle farm or staying there. Why not? What sort of things can Judi offer to encourage them to come to Welkom? Welkom leverages off the lifestyle farm and provides a real “Kiwi” experience “because we want to have a competitive edge”. – What is meant by the phrase “leverages off the lifestyle farm”? –

What is a competitive edge, and how can leveraging off the lifestyle farm help them get or keep a competitive edge?



What are some of the other things that Judi does, and can do, in order to ensure that Welkom keeps its competitive edge?

Judi felt frustrated and said she “didn’t know whether my role was business owner or compliance officer!” – What is goods and services tax (GST)? –

What is income tax?



What is pay as you earn (PAYE)?

Hint: Go to www.ird.govt.nz

Guests staying at Welkom have a choice of payment options: – cash or prepayment via bank transfer, in which event a discount

applies; –

invoiced, payable by the 20th of the following month (only if a preapproved debtor); or



by credit card, in which event no discount is offered.

Assume that Judi discussed these methods with you before advertising them, and asked your advice. –

Identify the advantages and disadvantages of each method.



Describe the ways in which each method will affect assets, liabilities, and owner’s equity.

3.2

Transactions affecting owner’s equity — a professional view

In Chapter 2 we looked at transactions which affect assets and liabilities, as well as changes in owner’s equity resulting from decisions by the owner which increase or decrease capital. In this chapter, we develop these ideas further to include changes in owner’s equity arising from the operation of the business. Remember that owner’s equity changes with changes in capital, profit, and drawings. Profit is increased because of income from sales of goods or services, but is reduced by the expenses incurred in selling goods and services. Welkom offered a number of options for payment to encourage guests to book. This is how income (and subsequently profit) is generated by the business. However, we know that the [page 118]

business has to pay expenses — wages, power, phone, lease, and interest, among others — which will reduce the profit. Define the terms revenue and expense.

We know that the business buys and sells souvenirs, and that the small shop sells large items, such as art and sculptures, as well as smaller local souvenirs. Therefore, there is a constant flow of cash and credit into and out of the business. This is made more complicated by the fact that the business must collect GST on behalf of the Inland Revenue Department whenever a sale occurs.

3.2.1

SELLING A SERVICE

Note: Throughout the accounting equations, negative amounts represent a decrease in the category, and positive amounts represent an increase in the category. Categories will have a number of decreases and increases — these are used to aid learning. You will see in the example in paragraph 3.2.11 that the totals of each category are an accumulation of the positive and negative transactions.

All of the following transactions will affect the owner’s equity part of the accounting equation, as well as the assets or liabilities part. Remember that revenue increases profit, and therefore increases owner’s equity. Expenses reduce the profit, and therefore reduce owner’s equity. In order to make the analysis clearer, separate columns have been included for expenses and revenue. The equation is now shown as: assets + expenses + drawings = liabilities + revenue + owner’s equity

So that the whole equation becomes: Assets +

Expenses +

Drawings =

Liabilities +

Revenue +

Owner’s equity

Let us look at Judi’s business, Welkom, and work through some transactions. A business may sell its services for cash or on credit to debtors. Judi sold the services of Welkom for both cash and credit and, in addition, encouraged

some of her clients to pay in advance by offering a discount. Below is a simple illustration of what happens when these transactions occur.

3.2.2

SELLING A SERVICE FOR CASH

Casual guests paying $600 cash at the beginning of their three-night stay, has two effects: asset “bank” is increased by $600; and revenue “sales” is increased by $600, which increases owner’s equity. The accounting equation looks as follows (note the subtle change of format): Assets + Bank 600

Expenses + A/rec

Drawings =

Liabilities +

Revenue + Sales

Owner’s equity

600

[page 119]

3.2.3

SELLING SERVICES ON CREDIT

As soon as businesses offer credit to customers, there is a risk that debts might not be paid. Business owners must weigh up the risks involved, and consider whether sales will increase if credit is offered, and whether the increase in sales income will offset any problems it might have with debtors who do not pay. At Welkom, corporate guests are offered the option of being invoiced (only when pre-arranged). Let us say that all five cottages were booked for a weekend, and it was agreed that the client would pay in two equal payments of $1,000 (owing to this being a large booking). The total cost is $2,000 (each cottage is $200 per night). This has two effects: asset “accounts receivable” (A/rec) is increased by $2,000; and revenue “sales” is increased by $2,000, which increases owner’s equity.

If, at the end of the first month, the client pays $1,000 (as agreed), it has the following two effects: asset “bank” is increased by $1,000; and asset “accounts receivable” is reduced by $1,000. The accounting equation looks as follows: Assets + Bank 1,000

Expenses +

Drawings =

Liabilities +

Revenue +

A/rec

Sales

2,000

2,000

Owner’s equity

(1,000)

3.2.4

BAD DEBTS

Allowing customers credit is likely to bring about the question: what happens when debtors do not pay? We can use the accounting equation to illustrate the effect of this. Two debtors owe a total of $800. They cannot be traced, and Welkom’s accountant decides to write them off as bad debts. Assume that the total amount owed by debtors stands at $7,600. The effects are as follows: The amount owed by debtors (“accounts receivable”) must be reduced by $800, because this asset cannot now be valued at $7,600. The risk — selling services on credit — must be borne by the owner, and therefore the profit will be decreased by $800, by way of an increase in the expense “bad debts”, which will ultimately mean a decrease in the owner’s equity. The accounting equation looks as follows: Assets + Bank

Expenses +

bad debts

Liabilities +

Revenue +

A/rec

Sales

7,600

7,600

(800)

i

Drawings =

800 i

Owner’s equity

[page 120] Note that no cash is involved. Writing off a bad debt is a non-cash expense, which reduces profit, but has no effect on cash. Although this will not impact directly on the bank balance, it can contribute to poor cash flow, as the cash will now not be realisable. The risks involved in granting credit are always present. As a business professional, you will almost certainly be involved in advising your clients about these risks and how to minimise them. To guide your decision, you might consider the question: is this business providing goods or services on credit? If a service has been provided, then what is “lost” is someone’s time and labour, which must be paid for. However, in the case of Welkom, what exactly has flowed out of the business? The accommodation was used and cannot be replaced — it has perished. Therefore, writing off a bad debt offsets income to take account of the costs associated with providing the service. The same principle applies if Welkom sells souvenirs and is not paid — they incur the cost of the goods, but do not receive the income. The cash which flows into the business is used for paying suppliers of goods, or for wages related to services. Clearly, the effect on cash flow when debtors do not pay in these circumstances is serious, and puts a strain on the business.

3.2.5

PROVIDING FOR DOUBTFUL DEBTS

When a business relies on selling goods or services on credit, it is a good strategy to be aware that a proportion of debtors might not pay. If a business suspects that an individual might not pay, it should naturally refuse credit facilities. However, no matter how strict its credit policy, a business might

allow credit to people who seem like a good risk, but who are subsequently unable (or unwilling) to pay. This is a real problem, because the figure given as accounts receivable on the balance sheet is intended to represent a future inflow of cash at some time during the current accounting period. Providing for doubtful debts is discussed further in Chapter 4. If some of the accounts receivable may not be turned into cash, this asset will be overvalued on the balance sheet. Remember that that balance sheet shows the working capital structure, and decisions about business liquidity and financial stability are made with reference to working capital.

3.2.6.

PRUDENCE — A DEGREE OF CAUTION

The concept of prudence acts as a guide for making the decision surrounding uncertain outcomes within a business. Given a range of possible values for assets, accountants choose the lowest value. Owners can then make a decision based on the lower expectation, rather than unproven assumptions about what cash might come into the business. Therefore, if we have good cause to doubt that all debtors will pay all they owe, we should take this into account when calculating profit, and when reporting the value of accounts receivable. We do this by creating an allowance for doubtful debts. [page 121]

3.2.7

ENCOURAGING PROMPT PAYMENT

One way of encouraging debtors to pay promptly, is to offer discount for

prompt payment, thus reducing the possibility of future bad debts. We know that Welkom allows corporate clients to pay on invoice, and that they generally pay by the 20th of the following month. Assume that they get a 2.5% prompt payment discount if they pay on or before the 20th of the month. A client who books two cottages for two nights would send $780 in payment for an $800 debt. This has three effects: The original sale would have affected sales and accounts receivable (A/rec).

asset “bank” is increased by $780; asset “accounts receivable” is reduced by $800, because this is the value given to the debt; and an increase in the expense “discount allowed” of $20 will reduce the profit, and will therefore reduce owner’s equity. The accounting equation looks as follows: Assets + Bank 780

i

Expenses + A/rec (800)

Drawings =

Liabilities +

Revenue + Sales

200

Owner’s equity

i

discount allowed

Whether or not this is a good business decision will depend upon a number of factors, including the cost of administration, and estimates about the likelihood of bad debts. Again, it is a decision which will impact upon cash flow and future business stability.

3.2.8

ATTRACTING NEW CLIENTS

One way to attract new clients is to offer a discount through incentives, such as booking via the internet, or using a voucher from an advertising brochure. Let us assume that Judi receives a booking via the internet, which is advertised as offering a 5% discount. When a 5% discount is offered, the amount paid by the guest for one night’s accommodation is reduced to $190. This has two effects:

The business has received $190 from the client, so the asset “bank” is increased by $190. The business has earned revenue of $190. The accounting equation looks as follows: Assets + Bank

Expenses +

Drawings =

Liabilities +

A/rec

Revenue + Sales

190

Owner’s equity

190

[page 122] In this case, we do not record the discount, because we deal with the discounted value of the sale. Compare this equation with the one showing the decision to grant discount to a client as an incentive for prompt payment of debt (refer to paragraph 3.2.7). Conceptually, they are quite different. There are two different effects depending upon the use of discount as a device: as a marketing device — as in the case of allowing a reduced course fee as an incentive for signing up; or as a debt-collecting strategy — to encourage prompt and regular payment. What appeared to be a straightforward decision to sell a service by offering a range of options, turned out to be more complex. All decisions impact upon the assets, liabilities, and owner’s equity, and will have quite different effects. As a business professional, you will be expected to explain alternatives, and show how choices result in quite different outcomes.

3.2.9

PAYING EXPENSES

So far, we have looked at how a business’s decision to offer a variety of payment options affects income. We have analysed the effects of these decisions on the accounting equation. In addition, we have analysed two non-

cash expenses — bad debts and discount allowed — and seen how they reduce profit, and therefore reduce owner’s equity. Let us look at some of the other expenses Judi mentioned, and analyse them using the accounting equation. We need to take into account the effect of goods and services tax (GST), which Judi is obliged to collect on behalf of the Inland Revenue Department (IRD). First though, let us look at a couple of expense transactions without the complications of GST. Will there be any change to our analysis if Judi paid the car lease by automatic payment through her bank account?

Assume that car lease for the month was $309, and that Judi paid this by cheque. This has two effects: asset “bank” is reduced by $309; and expense “car lease” is increased by $309, which reduces profit, and therefore reduces owner’s equity. The accounting equation looks as follows: Assets + Bank

Expenses +

Liabilities +

A/rec

(309)

i

Drawings =

Revenue + Sales

Owner’s equity

309 i

car lease

What about expenses incurred, but with no cash changing hands? This is conceptually the same as selling services on credit — in this case we buy services (or goods) on credit. For example, Judi has the cottages serviced by a contract cleaner and is invoiced (charged) $260 per week. See if you can do the analysis before reading on. This has two effects: liability “accounts payable” is increased by $260; and expense “cleaning” is increased by $260, which reduces owner’s equity. [page 123]

The accounting equation looks as follows: Assets + Bank

Expenses +

Liabilities +

A/rec

Revenue + Sales

260

i

Drawings =

i

Owner’s equity

260

cleaning

When Judi eventually pays the contract cleaner, it has the following two effects: asset “bank” is decreased by $260; and liability “accounts payable” is decreased by $260. The accounting equation looks as follows: Assets + Bank

Expenses +

i

Liabilities +

Revenue + Sales

260 i (260)

Drawings =

A/rec

Owner’s equity

260 (260)

cleaning

Now let us look at how we deal with transactions involving GST. When Judi set up her business, she estimated that her turnover would exceed $80,000, and was therefore obliged to register for GST. GST is a tax on consumer spending, and is collected by businesses on behalf of the Inland Revenue Department. As Welkom has a turnover of more than $60,000 per year, it must register with the Inland Revenue Department. A business or organisation registered for GST is known as a “registered person”. Every time a guest pays for accommodation or souvenirs. GST is collected, and will be paid to the Inland Revenue Department at the end of the taxable period. Equally, every time a supply is paid for that includes GST, a claim can be made against the GST collected. This is reconciled at the end of each GST period — monthly, two-monthly, or six-monthly.

3.2.10

EFFECT OF GST ON THE ACCOUNTING EQUATION

Refer to Resource file 1, paragraph 1.8.4, and www.ird.govt.nz to help with the taxation and paper work implications.

Judi has received a cash payment for three nights’ accommodation at $200 per night. The total received is $690, GST-inclusive. The GST-exclusive amount is calculated as $690 / 1.15, being $600 — thus the GST content is $90. If one wants to calculate the GST content of the inclusive price, it must be multiplied by 3/23. The accounting equation looks as follows: Assets + Bank

Expenses +

Drawings =

A/rec

Liabilities + A/pay

690

Revenue +

GST

Sales

90

600

Owner’s equity

[page 124] How would the accounting equation be different if the purchase was a zero-rated or exempt supply?

Assume that the car lease for the month was $300 plus GST ($300 × 1.15 = $45 GST), and a cheque was sent to cover this. The total amount of the cheque is $345. Judi will be able to claim back the GST she has paid on the car lease expense, which will reduce the amount she owes to the Inland Revenue Department. The accounting equation looks as follows: Assets + Bank

Expenses +

(345)

i

Drawings =

A/rec

Liabilities + A/pay

300 i

GST

Revenue + Sales

Owner’s equity

(45)

car lease

Judi sent a cheque to pay for advertising on National Radio, $1,150 GSTinclusive ($1,150 × 3 / 23 = $150 GST). The accounting equation looks as follows: Note how the IRD/GST column of the equation changes, depending on whether it is affected by a sale or purchase transaction. Assets + Bank (1,150)

Expenses + A/rec

Drawings =

Liabilities + A/pay

1,000 i

GST (150)

Revenue + Sales

Owner’s equity

i

advertising

3.2.11

ANALYSING A RANGE OF TRANSACTIONS

As we have seen, cash and credit flows in and out of the business all the time. Let us “freeze” the business for one day and look at a range of transactions to see how they accumulate and impact upon the business and upon each other. Examine each transaction carefully, and make sure you understand how each figure is arrived at. In each case, GST is charged at 15%. There are no exempt or zero-rated supplies – refer to Resource file 1 paragraph 1.8.4 for explanations of the terms exempt and zero-rated supplies.

1.

Ten guests pay cash for souvenirs of $6,210, GST-inclusive.

2.

Two corporate clients book and stay in three cottages for two nights, and choose to pay on credit. Accounts receivable increases by $1,380, since this is the total amount owed by the debtors.

3.

One of the clients sends a cheque for $460, which includes $60 GST. Note that both “bank” and “accounts receivable” are affected, but not the “IRD” liability. This is because this GST liability was recorded when the client was allowed credit. The business is “holding” the $60 in its bank account until the end of the taxable period, when it will pay all of the GST (less GST amounts paid to suppliers) to the IRD. At this point, the liability will be reduced. We could think of this in terms of “the debtor has reduced her liability to the business by paying part of what she owes”. The business has not yet reduced its liability to the IRD, but will do so at the end of the taxable period.

4.

Some casual tourists come in to buy souvenirs valued at $600, using a $25 cash discount voucher they found in their New Zealand guide book. They pay $575 (net of discount). The GST for their purchase is $75. [page 125]

5.

The power account for this month in the amount of $230, including GST, was paid. “Bank” is decreased by $230, and “IRD” is reduced by $30, since GST paid on supplies can be offset against GST collected from clients. Expenses are increased by $200, which was the cost of power.

6.

The accountant wrote-off a bad debt of $230. This is a tricky one, so let us spend some time examining this transaction. Remember that the $230 includes GST, which the business will be unable to collect. In writing off the bad debt, we need to: reduce accounts receivable by $230, because this asset is now overstated; create an expense, “bad debts”, which will reduce revenue; and reduce the liability to the IRD, since the debtor has not paid, and the business is unable to collect GST.

7.

Repairs were carried out on Cottage #2. The invoice for $345 included GST. “Accounts payable” increases by $345; “IRD” is reduced by $45 (assuming GST is accounted for on invoice basis); and expenses are increased by the cost of the repairs and maintenance of $300.

8.

At the end of the taxable period, a cheque must be sent to the IRD. “Bank” is reduced by $960.00, which is the amount owing to the IRD.

What is the final position? Is the accounting equation still in balance? The above transactions can be represented as follows in the accounting equation: Each side of the equation totals $7,445: assets + expenses + drawings = $7,445; liabilities + revenue + owner’s equity = $7,445. Assets + Bank 1.

Liabilities + A/pay

1,380 460

4.

575

5.

(230)

6.

Sales

810

5,400

180

1,200

75

500

200 i

(30)

200 ii

(30)

300 iii (960)

GST

Revenue +

(460)

(230)

7. 8.

A/rec

Drawings =

6,210

2. 3.

Expenses +

345

(45) (960)

Owner’s equity

6,055 +

690 +

i

electricity

ii

bad debts

iii

repairs & maintenance

700 +

0 =

345 +

0

7,100 +

0

Remember that, throughout the equations, a negative number represents a decrease in the category, and a positive number represents an increase in the category. Let us check that the accounting equation balances by using a trial balance. A trial balance is about balancing the debit balances (assets + expenses + drawings), and credit balances (liabilities + equity + revenue) in double entry accounting, to confirm that the accounting cycle has been carried out accurately. [page 126]

Welkom Enterprises Trial balance As at today $ Expenses

$ 700 Revenue

Bank

6,055 Accounts payable

Accounts receivable

690 IRD/GST Capital — owner’s equity 7,445

7,100 345 0 0 7,445

Many computerised accounting systems move directly to the accounting statements without using a trial balance. In this chapter, our approach is similar to computerised accounting systems, in that the balancing takes place within the accounting equation worksheet.

3.3

Preparing an income statement

If we now decide to calculate the profit, we can prepare a simple income statement: Welkom Bed and Breakfast Income statement For day ending [today] $

$

REVENUE Sales Less

7,100

EXPENDITURE Electricity

(200)

Bad debts

(200)

Repairs and maintenance

(300)

Total expenses PROFIT TRANSFERRED TO CAPITAL

(700) 6,400

The income statement is the financial statement which is prepared to show how the profit is arrived at. Note that it covers a specific period of time – the accounting period. All revenue earned and expenditure incurred for this period should be shown, in order to give a fair representation of net profit. Paragraph AOB18 of the NZ Framework states that: Information about a reporting entity’s financial performance during a period, reflected by changes in its economic resources and claims other than by obtaining additional resources, directly from investors and creditors (see paragraph AOB21), is useful in assessing the entity’s past and future ability to generate net cash inflows. That information indicates the extent to which the reporting entity has increased its available economic resources and thus its capacity for generating net cash inflows through its operations rather than obtaining additional resources directly from investors and creditors.

[page 127] Take another look at the accounting equation to see how the amounts for revenue and expenditure were arrived at. The income statement for Welkom shows that the amounts reflected as “revenue” and “expenditure” are not

necessarily amounts received or paid in cash. Revenue of $7,100 comprises $5,900 worth of cash sales, and $1,200 worth of credit sales. Expenditure of $700 comprises $200 for electricity paid in cash, $200 for bad debts written off (a non-cash expense), and $300 for repairs and maintenance not yet paid. All these expenses are exclusive of GST.

3.3.1

MAKING ADJUSTMENTS TO REVENUE AND EXPENSES

At the end of the accounting period, it is likely that a business will face four areas of adjustment: 1.

Some expenses may have been incurred, but will not have been paid for, nor recorded as payable. Some common examples are electricity, and telephone or cellphone expenses. It is usual to wait for the account to come in and pay by cheque, or direct debit, or credit the bill. At the end of the period it is possible that we have the account, but have not paid it yet; or even that the account for the end of the period has not yet arrived. Nevertheless, if we have used the service, we have incurred the expense (remember the recognition concept).

2.

Some expenses may have been paid in advance. This will be because we are paying for an ongoing service for a period different from our accounting period. Common examples are rent and insurance.

Can you think of another example?

3.

Some income may have been received in advance. For some reason our customers may have paid for services, but have not yet received them. An example would be in the case of Welkom where clients may prepay all or part of the booking to secure the accommodation in the peak season. To the extent that they had not benefited from the accommodation paid for, the business would have income in advance.

4.

Some income may have been earned, but not yet received nor

recorded as receivable. This arises with revenue items that are usually only recorded when they are actually received. Examples are interest on money deposited in a bank account, and commission earned on sales. What are some of the consequences of overstating profit? Who would this affect?

What adjustments have to be made? As mentioned earlier, the financial reports of a business must show a true and fair view. The important accounting concept known as the recognition concept is used as a guide to meeting the concept of “true and fair view”. This concept requires that all of the expenses and income for a period should be correctly recognised for that period in order to establish the true profit (or loss) for the period. This concept is no longer contained in the NZ Framework, and the Financial Reporting Act 2013 no longer refers to it. However, if we did not adhere to this concept, we could end up omitting some costs and thereby overstating profit, or including costs that rightly belonged to another period, thereby understating profit. The recognition concept therefore requires that periodend (or balance day) adjustments be made to the accounts. [page 128] Examine the following simple income statement prepared for Welkom as at 31 March (the end of the accounting period): Welkom Bed and Breakfast Income statement For year ending 31 March 2014 $

$

REVENUE Sales Less

136,000

EXPENDITURE Phone expenses (land and cell)

(1,250)

Advertising

(1,600)

Salaries

(35,000)

Repairs and maintenance

(2,225)

Electricity

(2,400)

Bad debts

(400)

Administration expenses

(360)

Purchases — souvenirs

(12,000)

Insurance

(1,800)

Total expenses

(57,035)

NET PROFIT TRANSFERRED TO CAPITAL

3.3.2

78,965

ACCRUED EXPENSES

Remember that, throughout the following accounting equations, negative amounts represent a decrease in the category, and positive amounts represent an increase in the category. We will look at the adjustments without the complications of GST, which will differ depending on whether we are accounting for GST on an “invoice basis” or on a “payments basis”.

Suppose that the latest account from Vodafone has not yet been paid. The amount owing is $265, excluding GST. This has two effects: A liability of $265 is created when the business uses the services of Vodafone, but has not yet paid. This is called “accrued expenses” (expenses due) and is a current liability. The expense “phone” should really be $265 higher. The accounting equation looks as follows: Assets + Bank

Expenses + A/rec

Liabilities + A/pay

265 i

i

Drawings =

Accrued expenses

Revenue Sales

Owner’s equity

265

phone

[page 129]

3.3.3

PREPAID EXPENSES

From the income statement, we can see that the figure given for insurance is $1,800. Assume that, when the cheque was sent off, it was for a full year — the balance date is 31 March. Therefore, the business has paid three months in advance. As it has not received a service of the full amount, we can say that the true figure for the period is $1,350 ($1,800 / 12 months × 9 months), and not $1,800 (total amount paid during the year). Three months is thus prepaid. This has two effects: The business has a $450 asset “prepayments”, which was created when the business paid for a year’s worth of insurance. The true amount for insurance expenditure during the accounting period is $1,350. We must therefore reduce the expense account “insurance”. The accounting equation looks as follows: The reduction in the expense increases profit, and therefore will increase owner’s equity by $450. Assets + Bank

Expenses +

Pre-pay 450

i

Drawings =

Liabilities + A/pay

(450)

Accr exp

Revenue + Owner’s equity Sales

i

insurance

3.3.4

INCOME RECEIVED IN ADVANCE

The sales for the year of $136,000 include $2,400 in respect of payments for accommodation booked in the peak season and prepaid. This means that the service has been paid for, but not yet used. We cannot say that this income has been earned in the current period (the recognition concept), so we must reduce the amount of sales. There are two effects: A liability “income in advance” is created, representing the money paid for which no services have yet been supplied. The revenue account “sales” is reduced.

The accounting equation looks as follows: Assets + Bank

Expenses +

Drawings =

Prepayments

Liabilities + A/pay

Revenue + Owner’s equity Sales

Income in advance 2,400

3.3.5

(2,400)

ACCRUED INCOME

Suppose Judi had cash on a term deposit at the bank on which $120 interest had accrued at balance date. This interest is income to the business, and should be reported in the income statement. There are two effects: An asset “accrued income” is created, representing money earned, but not yet received. The revenue account “interest” is increased. [page 130] The accounting equation looks as follows: What will the income statement now look like? Why don’t you draw it up before reading on? Assets + Bank

Expenses +

Drawings =

Accrued income

Liabilities + Accrued expense

Revenue + Sales

Interest

120

Owner’s equity

120

In this presentation, we have shown the income statement items rounded to the nearest dollar, which is a common method of presentation. Welkom Bed and Breakfast Income statement For year ending 31 March 2014 $

$

REVENUE Sales (136,000 - 2,400) Less

133,600

EXPENDITURE Phones (1,250 + 265)

(1,515)

Advertising Salaries

(1,600) (35,000)

Repairs and maintenance

(2,225)

Electricity

(2,400)

Bad debts

(400)

Administration expenses

(360)

Purchases – souvenirs

(12,000)

Insurance (1,800 - 450)

(1,350)

Total expenses

(56,850)

NET OPERATING PROFIT Plus

76,750 OTHER INCOME

120

NET PROFIT TRANSFERRED TO CAPITAL

76,870

In addition to arriving at a more accurate net profit, our adjustments mean a more accurate balance sheet. We have: two additional current assets: – accrued income of $120; –

prepayment of $450; and

two additional current liabilities: – accrued expenses of $265; –

income in advance of $2,400.

This makes quite a difference to the working capital of the business. [page 131] So far, we have examined the way in which the business earns income and pays its expenses. Welkom sells a service, and this is how it earns most of its income. However, we know that Judi sells some other items, such as art, sculptures, and smaller souvenirs. Therefore, some of the business income is earned from selling goods.

3.4

Accounting for inventories

Goods are tangible items which are bought from a supplier and sold at a higher price (marked up). The difference between the price the business paid for the goods, and the price it sells them for, is known as the gross profit. Business professionals usually refer to stocks of goods for sale as inventory. There are two ways in which a business can account for inventory: the physical (periodic) inventory system; or the perpetual (continuous) inventory system. With the physical inventory system, goods purchased for resale are initially recorded as an expense of the business; whereas with a perpetual inventory system, goods purchased are initially recorded as an asset. Let us look at each system in turn, and analyse the purchase and resale of goods using the accounting equation.

3.4.1

PHYSICAL INVENTORY SYSTEM

Suppose Judi purchases four sculptures for resale in the souvenir shop, each costing $450, excluding GST (that is $1,800 plus GST of $270, thus $2,070). She pays the supplier $2,070 by cheque. There are three effects on the accounting equation (taking into account GST): asset “bank” decreases by $2,070; expense “purchases” increases by $1,800, decreasing the profit and owner’s equity by $1,800; and liability “IRD/GST” decreases by $270. The accounting equation looks as follows: Assets +

Expenses +

Bank (2,070)

i

purchases

Drawings =

Liabilities + A/pay

1,800

i

IRD/GST (270)

Revenue + Sales

Owner’s equity

When goods are sold, they will be sold at a higher price — a mark-up (ie gross profit) will be added to the cost price. Businesses often have a standard mark-up for each line of goods, although competition may mean that decisions on mark-up need to be constantly reviewed. [page 132] Suppose Judi applies a mark-up of 40% to the sculptures. This means she will sell the sculptures for $630 each, plus GST. How did we calculate this? Cost price each (excl GST)

$450

Mark-up at 40% of cost

$180 $630

Assume that Judi sells three sculptures for cash in the course of one week. This means she will have made sales of $1,890, plus GST of $283.50. There are three effects on the accounting equation (taking into account GST): asset “bank” increases by $2,173.50; liability “IRD/GST” increases by $283.50; and revenue “sales” increases by $1,890. The accounting equation looks as follows: Assets + Bank 2,173.50

Expenses +

Drawings =

Liabilities + A/pay

Revenue +

IRD/GST

Sales

283.50

1,890

Owner’s equity

Let us assume that these purchase and sale transactions were the only ones for the week. Has Judi made a profit? We can see that sales revenue is $1,890, and that the purchase expense is $1,800. Has she made a loss? No — a small profit of $90. But this is not the real outcome, because she still has one sculpture left — that is, she has an inventory of one sculpture that originally cost $450

(excluding GST). Judi would have carried out a stocktake at balance date to establish the inventory on hand, and would then value that inventory at cost. This inventory is an asset, and will appear in the balance sheet. In fact, there are potentially quite a few complications with establishing the value of inventory. If we did not take into account the inventory on hand, we would be loading additional costs of purchases into the current period, when clearly the sculpture on hand will be sold in a subsequent period. Let us now see how we calculate profit on goods sold, by calculating the cost of goods sold. For our example, cost of goods sold is calculated as follows: Purchases

$1,800

Less Inventory (end of period)

($450)

Cost of goods sold

$1,350

Profit on sales, known as gross profit, is then calculated as follows: Sales Less Cost of goods sold Gross profit

$1,890 ($1,350) $540

[page 133] Clearly, by correctly including all assets and liabilities in the balance sheet, the subsequent impact on the costs and revenue means that we have established that the profit on sales is $540, not the smaller profit of $90 as indicated previously. We now need to consider the effect of inventory in the next accounting period, because inventory on hand at the end of one period is still there at the

start of the next period, and is available for sale. It will be part of the cost of goods sold in the next period. If Judi sold the new souvenirs for the same mark-up as the sculpture, what would the gross profit be?

Let us assume Judi buys other souvenirs for her shop costing $1,200 in the next month, and at the end of that month had stock left valued at $900. This means that the cost of goods sold for that period would be: Inventory (beginning) Plus Purchases

$450 $1,200 $1,650

Less Inventory (end) Cost of goods sold i

($900) $750

This $1,650 is the value of goods available for sale at the cost price. Clearly this value is correct, as there was one sculpture from the previous period, and the new purchases.

3.4.2

PERPETUAL INVENTORY SYSTEM

We have just seen how to account for the purchase of goods for resale if we regard this purchase as an expense (the physical inventory system). We have also seen that any goods unsold at the end of the period have to be identified and brought into account as an asset (inventory). With the perpetual inventory system, we treat the purchase of goods as an asset right from the start. We will not repeat the accounting equation for each transaction. You should create the equation for each one yourself.

Let us analyse the same example as previously used. Judi has purchased four sculptures for resale in the souvenir shop, costing $450 each plus GST. She pays the supplier $2,025 by cheque. There are three effects on the accounting equation (taking into account GST):

asset “bank” decreases by $2,070; asset “inventory” increases by $1,800; and liability “IRD/GST” decreases by $270. Compare this with the example in paragraph 3.4.1. What is different? What happens under the perpetual inventory system when goods are sold? First, the actual sale is recorded in the same way as under the physical inventory system. Go back now to paragraph 3.4.1 where we looked at the analysis when Judi sold three sculptures for $630 each, plus GST. Secondly, we must record the cost of goods sold as an expense. We know that the cost of the sculptures was $450 each; therefore, the cost of goods sold must be $1,350 (three sculptures x $450). In terms of the accounting equation, there are two effects: asset “inventory” decreases by $1,350; and expense “cost of goods sold” increases by $1,350. [page 134] Does the accounting equation still balance? Check this for yourself.

Let us now look at what we have: asset “inventory” now stands at $450 ($1,800 - $1,350). This is the same result as under the physical inventory method; revenue “sales” is $1,890; and expense “cost of goods sold” is $1,350. We know that gross profit is calculated as sales less the cost of goods sold. In this case, it is $540. The overall results of the two methods are the same. Which method should we use? This is really a matter of inventory control, taking into account issues of cost effectiveness. We have now been introduced to two concepts of profit. Gross profit is the profit derived from the sale of goods after deducting the cost of goods sold. The concept can apply to the sale of services, where we deduct direct

costs associated with the sale of the services — for example, a plumber sells the service of plumbing repairs; any costs of materials associated with a contract would be deducted from the revenue from that contract, still called “sales”, to arrive at the gross profit on the contract. Net profit is the final profit arrived at after deducting other expenses not directly related to the sales (called overheads) — for example rent, office expenses, salaries, interest, and insurance. These are not the only values which we may choose to differentiate between. The presentation of cumulative accounting data is about choices.

3.5

Capital and revenue expenditure

“I am always on the lookout for opportunities to improve the property or accommodation.” In addition to paying expenses and purchasing goods to sell in the souvenir shop, the business buys and sells souvenirs because “it’s important for the image of the business that I provide a high quality experience”. Not only is it important for Judi to provide souvenirs, it is equally important to present them in a manner that is professional and inviting. Therefore, display cabinets and presentation DVDs are used to show guests not only the products, but how they are created. If these types of expenditures are not separated, it will be impossible to calculate an accurate net profit. Equipment and machines are classified as assets. The loans taken out to pay for them are classified as liabilities. If the classification is inaccurate, the value of assets, liabilities, and owner’s equity will be distorted, and it will be impossible to faithfully represent what has taken place in the business

3.5.1

CAPITAL EXPENDITURE

Capital expenditure results in the acquisition of an asset which is expected to last for more than one accounting period. Over time, assets will decline in value — depreciation is covered in more detail in Chapter 4. In addition to the cost of the asset, the expenditure involved in bringing the asset into use is also classified as capital expenditure. [page 135] When Judi decided to take out a loan for the data projector, screen, and DVD for the souvenir shop, the accountant classified this as capital expenditure, since it affected assets (the data projector, screen, and DVD) and liabilities (the loan). The delivery costs, installation costs, costs of connecting the power, and costs of altering the room to accommodate the audio-visual gear, are also classified as capital expenditure, because these costs must be incurred before the items can operate. This expenditure increases the historical cost of the asset. Items which are capitalised (that is, classified as assets), are items which appear on the balance sheet. Let us follow this transaction on the accounting equation. Judi purchases a data projector, screen, and DVD for $7,000, paying a $1,000 cash deposit, and the rest on loan from the local bank. Assets +

Expenses +

Bank

Data projector, screen & DVD

(1,000)

7,000

Drawings =

Liabilities + Accounts payable

Loan

Revenue + Sales

Owner’s equity

6,000

She writes out some cheques for delivery, installation, and alterations to the shop to accommodate the audio-visual equipment, totalling $950. Assets +

Expenses +

Bank

Data projector, screen & DVD

(1,000)

7,000

(950)

950

Drawings =

Liabilities + Accounts payable

Loan 6,000

Revenue + Sales

Owner’s equity

She pays $250 off the loan. Assets +

Expenses +

Bank

Data projector, screen & DVD

(1,000)

7,000

(950)

950

Drawings =

Liabilities + Accounts payable

Loan

Revenue + Sales

Owner’s equity

6,000

(250)

(250)

[page 136]

3.5.2

REVENUE EXPENDITURE

Items of expenditure which relate to the current accounting period are treated as revenue expenditure. Examples are the sorts of costs incurred in earning an income, such as wages, rates, electricity, and heating. While the loan repayment is treated as capital expenditure, the interest on the loan is treated as revenue expenditure, because it is the cost of borrowing the money. In the same way, costs involved in bringing the asset into use, like installation costs, are treated as capital expenditure; but regular maintenance costs are classified as revenue expenditure. Judi pays $200 interest, and $600 for repairs and maintenance. Assets + Bank

Expenses +

Data projector, screen & DVD

Drawings =

Liabilities + Accounts payable

Loan

Revenue + Sales

Owner’s equity

6,000 (250)

(250)

(200)

200

(600)

600 ii

i

interest

ii

repairs & maintenance

i

If the $800 (interest and repairs and maintenance) were classified as capital expenditure, how would assets, liabilities, and owner’s equity be affected?

We can see that capital expenditure affects assets and liabilities, whereas

revenue expenditure reduces profit, and therefore affects owner’s equity.

3.5.3

HOW DO WE MAKE THE RIGHT DECISION?

Some items are clearly capital or revenue expenditure, but others are not so easy to determine. If a decision has to be made, “time” can be seen as a key element. If the item is used for more than one accounting period, then we usually classify it as capital expenditure. The data projector, screen, and DVD were installed to earn income for more than one period, therefore this is clearly capital expenditure. However, the towels in the cottages are replaced regularly; therefore the cost of the towels might be classified as revenue expenditure. The concept of recognition of assets can be used as a guide for the decision as to whether the expenditure should be classified as an asset on the balance sheet, or an expense on the income statement. Paragraph 4.45 of the NZ Framework discusses recognition of assets and states that: An asset is not recognised in the balance sheet when expenditure has been incurred for which it is considered improbable that economic benefits will flow to the entity beyond the current accounting period. Instead, such a transaction results in the recognition of an expense in the income statement.

If it cost $300 per year to replace worn towels, and we classify replacement costs as revenue expenditure, then the value of towels is not shown on the balance sheet [page 137] as an asset. Classifying replacement costs as revenue expenditure reduces the net profit. Would this decision on the part of the accountant mislead the reader of the final accounts? This is an example of one of the subjective

decisions you will have to make as a business professional. Remember the qualitative characteristic of faithful representation (refer to paragraph 1.3.6.3). In terms of AQC12 of the NZ Framework, the three characteristics of faithful representation are completeness, neutrality, and freedom from error.

3.6

Sorting out our accounting system — a chart of accounts

Another area of choice relates to how we choose to sort or classify our accounts. Many of the transactions that occur over a period of time are aggregated (combined). The choice of which values to aggregate, and which values to keep separate, is important to the users of the information. Judi would choose to separate the accommodation income from that earned through the sale of souvenirs. It is not so easy with expenses. The decision to aggregate information is dependent on how material that information is to the decision maker. There is a conflict between materiality and the cost-benefit of disclosing each piece of information separately.

3.6.1

CLASSIFICATION IN THE INCOME STATEMENT AND BALANCE SHEET

Judi might also find one big list of expenses confusing. We might prefer to further classify the overhead expenses into categories that relate to each other. Some common headings are selling and distribution, general and administration, and financial expenses. We would like to stress at this point that any classification of items is arbitrary, and is very much dependent on those setting up the system. For a

small business such as Welkom, it is suggested that three or four digits are used for accounts. It is best to think carefully about assigning the account numbers logically, and to follow generally-used standards. The following is an example of a general chart of accounts groupings: 1000–1999

asset accounts

2000–2999

liability accounts

3000–3999

equity accounts

4000–4999

revenue accounts

5000–5999

cost of goods sold

6000–6999

expense accounts

7000–7999

other revenue (interest, other income)

8000–8999

other expenses (income tax)

This allows for many sub-groupings and additional categories at a later stage. Manufacturing, goods, and/or services businesses will have different accounts, [page 138] depending on the business needs. Swimming NZ provides affiliated swimming clubs with a suggested chart of accounts to guide their accounting practice. Many industry associations do the same for their sectors. Alternatively, computerised accounting packages provide suggested charts of accounts categories within their setup options. Balance sheet items tend to be categorised by current assets first, followed by non-current assets; and current (short-term) liabilities, followed by non-current (long-term) liabilities. Income statement items tend to be categorised by operating income first, followed by non-operating income; and operating expenditure followed by non-operating expenditure.

Paragraphs A4.2 and A4.3 of the NZ Framework discuss the elements of financial statements and state that: A4.2 Financial statements portray the financial effects of transactions and other events by grouping them into broad classes according to their economic characteristics. These broad classes are termed the elements of financial statements … A4.3 The presentation of these elements in the balance sheet and the income statement involves a process of sub-classification. For example, assets and liabilities may be classified by their nature or function in the business entity …

Operating income and expenses are those incurred during the normal activities of the business. They arise from the entity’s ordinary operations. Most income and expenses will be of this nature. Non-operating income and expenditure are those which arise outside the scope of the entity’s ordinary operations. For example, rent received from temporarily leasing spare storage space, could be seen as non-operating revenue. Similarly, legal costs associated with appealing a local body zoning change, could be seen as a nonoperating expenditure. The distinction between operating and non-operating income and expenditure can be important, especially if the amounts involved are material. It means that we can more validly compare the results of the operation from one year to the next, and that users of the accounts are not misled because, say, a poor net profit has been disguised by the purchase of a once-off asset incorrectly classified as an expense.

3.6.2

CLASSIFICATION AS A MEANS OF DECISION MAKING

While in Chapter 2 we automatically classified the balance sheet into equity, current assets and liabilities, and non-current assets and liabilities, we did not dwell on the reason for this classification. By expanding the extract from paragraph A4.3 of the NZ Framework (refer to paragraph 3.6.1), which discusses the elements of financial statements, we see that the intention is to

“classify by the nature or function in the business or entity in order to display information in the manner most useful to users for the purposes of making economic decisions”. The challenge for the business owner and for you as the financial adviser is to ensure that the classifications assist in the process of meeting the qualitative characteristics of financial statements — namely understandability, relevance, reliability, completeness, and comparability. [page 139]

3.6.3

AIMING FOR CONSISTENCY

One of the enhancing characteristics of general purpose reports is that they are comparable. In order to be comparable, the accounting data needs to be processed consistently through the system. The principal activity in the processing phase is the analysis of a transaction in terms of its effect on the accounting equation. The level of detail required from the accounting reports directly affects the level of detail required from the processing. Once the level of detail has been determined, a chart of accounts is set up. A chart of accounts is a method of classification of accounts to simplify the capturing and recall of information. It is an itemised list showing the way in which a ledger has been arranged to record the operation of the entity. An orderly and systematic arrangement is achieved by grouping accounts of a similar function together along lines chosen for final accounting reports. There is no correct chart of accounts, as each organisation has different needs. However, certain practices are consistent, and indicate a degree of organisation. Let us have a look at Welkom to suggest a possible chart of accounts. The following are the accounts we have already used (assuming a perpetual system of inventory control), or may use in the chart of accounts: Sales – accommodation

Sales – souvenirs

Cost of goods sold

Phone

Advertising

Salaries

Repairs and maintenance

Electricity

Bad debts

Administration expenses

Interest income

Insurance

Bank

Stock

Prepayments

Accounts receivable

Accrued expenses

IRD

Accounts payable

Accrued income

Loan

Income in advance

Capital

Drawings

Audio-visual equipment * *

Numerous other non-current assets will probably need to be included. For the sake of simplicity, we will include one and leave space for others.

The process would be as follows: 1.

Sort accounts into categories, with particular reference to: categorising accounts into broad report classifications; keeping similar accounts together; and ensuring a logical ordering.

Remember that current items come before non-current items.

2.

Apply an ordering system: The ordering system may be alphabetical (such as a telephone book), alphanumeric (such as IRD forms), or numeric (such as student IDs). The accounts can be ordered in numeric (1, 2, 3), block (current assets are all numbered lXX), or structured (A-000 0-12, meaning that it is an asset account with a 0000 code belonging to branch 12). Ensure that you leave space to allow for further growth. [page 140]

If we applied the example of general chart of account groupings provided in paragraph 3.6.1 to the Welkom categories, the result might be as follows: ASSETS (1000–1999) Bank

Accrued income

Stock

Prepayments

Accounts receivable

Audio-visual equipment

Accounts payable

Accrued expenses

Income in advance

IRD

Loan

LIABILITIES (2000–2999)

EQUITY (3000–3999) Capital

Drawings

REVENUE (4000–4999) Sales – accommodation

Sales – souvenirs

COST OF GOODS SOLD (5000–5999) Souvenirs EXPENSES (6000–6999) * Administration expenses

Advertising

Bad debts

Electricity

Insurance

Phone

Repairs and maintenance

Salaries

OTHER REVENUE (7000–7999) Interest income OTHER EXPENSES (8000–8999) *

Sub-categorisation is often used within the expenses section.

See if you can find examples of the following types of coding: alpha, alphanumeric and numeric.

Assign code numbers to the accounts. Ensure that you leave room for any additional accounts that may be added in the future.

3.7

The impact of information technology

In Chapters 2 and 3 we examined the accounting equation, looking at how to record day-to-day business transactions. Yet, how do businesses cope with the volume of transactions and the complexity of reporting needs in the “real world”? For example:

How does a supermarket that stocks thousands of different products, effectively operate a perpetual inventory system? How does a business that deals with hundreds or thousands of transactions a day, actually use its chart of accounts to code these transactions? How does the senior management of Xero Limited get timely financial reports from dozens of branches spread all over New Zealand and internationally? How do small business owner-operators with no training in accounting still manage to effectively carry out the day-to-day accounting for their businesses? [page 141] The ultimate answer is: by using computerised accounting software. Packages such as MYOB, Xero, Quickbooks, CashManager, and Cashbook are off-theshelf accounting packages that can be customised for individual businesses. These packages are updated regularly to meet accounting, legal, and statutory requirements. Computerised accounting enables a business owner to quickly summarise data by providing customisable report queries within the programs, such as budgets, cash flows, bank reconciliations, balance sheet, income statement, inventories, contacts, and many other reports to aid business decision making. It is important to note that users of computerised accounting packages should have a sound knowledge of manual accounting, and/or should have a professional adviser such as an accountant overseeing the accounting system. We have demonstrated in the preceding chapters how important it is to correctly classify items to ensure that a “true and fair view” of the business entity is achieved.

3.8

Conclusion

We have seen that income is earned from the sale of goods and/or services, and that calculating the profit is a complex activity. When determining the profit for a period, the accountant must make a number of decisions, some of which are subjective (personal). Profit calculation involves adjusting the amount for debtors and creditors to account for amounts owed and owing, but not yet paid or received. We have further seen that expenditure does not always involve cash. Bad debts, allowance for doubtful debts, and discount are expenditures which are created based on subjective decisions that decrease the value of assets. Remember that the subjectivity is guided by the three qualitative characteristics of financial statements, namely, relevance, materiality, and faithful representation. It is also understood that these qualitative characteristics are constrained by timeliness, the balance between benefit and cost, and the balance between the various qualitative characteristics. In addition to the qualitative characteristics, the following enhancing qualitative characteristics are utilised: comparability, verifiability, timeliness, and understandability.

3.9

Key words 3

accrued expenses

Expenses that have been incurred, but have not yet been paid. Often they relate to services that have been consumed, where the entity has either not yet received or not yet paid the account. At period end, care must be taken to identify all of these items, and to bring them to account. The

accrued expense account is a current liability in the balance sheet.

[page 142] accrued income

Revenue earned, but not yet received or recorded as receivable. Common examples are interest from deposits and commission earned on sales. Businesses that only occasionally sell on credit, may have to account for money due on credit sales in this way at the end of the accounting period. The accrued revenue account is a current asset in the balance sheet.

bad debts

Amounts owed by individual debtors that they are unable or unwilling to pay. If, after having attempted to collect the debt, the business finds that the debt is irrecoverable, the amount is written off — that is, the debtor’s account is closed. The bad debt is treated as an expense, which has the effect of reducing the net profit.

capital expenditure

Expenditure that benefits more than one accounting period and is material in amount. Usually all costs associated with the acquisition and installation of an asset, are capitalised — that is, treated as part of the cost of the asset. This includes repairs needed to get the asset ready for use. Repairs which prolong the useful life of an asset beyond the original estimate of that life, or which make an asset more valuable or adaptable, should also be capitalised. Other expenditure,

such as repairs and maintenance of the asset, is called revenue expenditure. chart of accounts

An itemised list showing the way in which a ledger has been arranged to record the operation of the entity. A method of classification of accounts to simplify the capturing and recall of information.

cost of goods sold

The cost to the business of the goods that were purchased for resale: that have actually been sold. This cost constitutes the purchase price of the goods, plus other costs directly incurred in acquiring the goods (for example, freight, insurance, and import duty).

doubtful debts

Debtors (accounts receivable) who probably will not pay their accounts. A small proportion of debtors are likely to default on their obligations in spite of the business’s best efforts at credit screening. Doubtful debts constitute an expense which is recorded each year in order to match costs with revenue.

gross profit

The profit derived from the sale of goods or services after deducting the direct cost of sales. For someone selling goods, the gross profit will be calculated by deducting the cost of goods sold from sales. The formula for gross profit is: sales cost of goods sold. [page 143]

income in advance (revenue in advance)

Arises when customers pay for goods or services before they receive them. If this has happened, and if the money received has been recorded as revenue (for example, sales), then, in order to comply with the requirement of the balance sheet approach to record all assets and liabilities, it will be necessary to adjust the accounts at the end of the accounting period. The adjustment has the effect of reducing revenue to the correct level, and recognising the business’s liability to repay the customer’s money if the goods or services are not supplied. The income in advance account is a current liability in the balance sheet.

inventory-alsoinventories or stock)

Assets that are held by a business: (a) for sale on the ordinary course of business; or (b) in the process of production for such a sale; or (c) in the form of materials or supplies to be consumed in the production process or rendering of services. (NZ IAS 2, paragraph 6, definition)

mark-up

The profit margin added to the cost price of goods, usually expressed as a percentage. Cost price of $100, plus a margin of 20%, equals a total selling price of $120. If the selling price of the goods is $120 and the margin is 20% on cost. The formula to recalculate the cost price is: selling price × 100 / 120.

net profit

The final profit after deducting all operating and non-operating expenses from the income of the

business. It is often referred to as the “bottom line”. The formulas are: gross profit + other income - operating expenses = net operating profit; net operating profit + non-operating income - non-operating expenses = net profit. non-operatingexpenditure/expenses

Costs that arise outside the normal scope of the business’s everyday operations.

non-operatingincome/revenue

Income that arises outside the normal scope of the business’s ordinary operations.

operating expenditure/expenses

Everyday operating expenditure incurred in deriving operating income.

operating income/revenue

Everyday operating income arising from normal operating activities.

pay as you earn (PAYE)

Income tax withheld from the employee’s gross income by the employer, which is then forwarded on to the IRD. [page 144]

perpetual inventory (continuous inventory)

A system of accounting for inventories where goods purchased for resale, or for manufacturing into goods for resale, are recorded in the first instance as assets of the business. This system is used where a permanent record is needed for items of stock. Under this system, a separate record — a stock card — is kept for every item of stock, showing all movements in that stock item, and the balance on hand at any point in time. Stocktakes are conducted to verify the records of

stock on hand. physical inventory (periodic inventory)

A system of accounting for inventories where goods purchased for resale are recorded in the first instance as an expense of the business. Under this system, it is essential to conduct a stocktake to ascertain the value of unsold goods at the end of the accounting period in order to record the value of the asset called inventory.

prepayments (prepaid expenses)

Expenses that the business has paid for in advance. This often arises when an entity is buying services on a continuous basis, and the period of payment for such services is different from the entity’s accounting period — for example, insurance, rates, and leasing. Entities may pay for some goods in advance — for example, stocks of stationery. Prepayments are a current asset in the balance sheet.

prudence

This concept requires the inclusion of a degree of caution in the exercise of the judgments needed in making the estimate required under conditions of uncertainty, such that assets or income are not overstated, and liabilities or expenses are not understated. Expected gains are not accounted for until they occur. So, for example, inventory on hand is not valued at the selling price. If there is a belief that inventory will sell for less than the cost price, then the concept of prudence dictates that it be valued at the lower price.

revenue expenditure

All expenditure that is not capital expenditure. Its significance arises in respect of expenditure

on assets, in that it is expenditure incurred to maintain an asset in a satisfactory working order, and it does not add to the value of the asset, nor make it more adaptable. Revenue expenditure only benefits the current accounting period and gives rise to an expense. Examples are repairs to machinery, insurance on buildings, and replacement parts for equipment. Sometimes an item that has all of the attributes of capital expenditure is treated as revenue expenditure because the amount involved is immaterial. An example could be stationery or small tools.

[page 145] revenue income

Inflows resulting from the provision of goods and/or services during the accounting period.

trial balance

A list of balances from the accounts in the general ledger that is used to confirm that double entry accounting has been carried out accurately. The debit balances (assets + expenses + drawings) are on one side of the trial balance; and the credit balances (liabilities + equity + revenue) are on the other side. Both sides should total to the same figure.

3.10

Resource file 3

3.10.1

CASE STUDY — JONES’S HIRE SERVICES

See paragraph 3.11.3.1 for the discussion questions relating to Tom Jones’s business.

Tom Jones operates a hire service. After the first year of operation he asks you to prepare his final accounts. He makes an appointment to see you so that you can answer some questions. Jones’s Hire Service Income statement For the year ended 31 March 2014 $

$

FEES Less

$ 180,000

EXPENSES Heavy equipment Repairs Maintenance Painting Insurance Discount allowed

(2,000) (10,200) (1,500) (800) (1,800) (16,300)

Party hire Replacement (cutlery & glasses) Service fees

(5,000) (400)

Repairs (marquee)

(1,800)

Maintenance (portable toilets)

(1,900)

Discount allowed

(600) (9,700)

[page 146] Administrative expenses Advertising

(2,300)

Photocopying

(1,100)

Stationery

(400)

Electricity

(4,300)

Phone/fax/internet

(1,000)

Salaries (administration) Fire insurance Accountants fees

(15,000) (100) (2,000) (26,200)

Showroom expenses Salaries

(25,000)

Electricity

(5,600)

Staff uniforms

(2,500) (33,100)

Financial expenses Bad debts

(500)

Doubtful debts

(210)

Interest

(15,490)

Bank charges

(1,300)

Legal expenses

(1,200) (18,700)

Total operating expenses

(104,000)

NET OPERATING PROFIT Plus

76,000

NON-OPERATING INCOME Rent received

1,500

NET PROFIT TRANSFERRED TO CAPITAL

77,500

[page 147]

Jones’s Hire Service Balance sheet As at 31 March 2014 $ ASSETS

$

Current Assets Cash on hand

500

Prepayments

920

Accounts receivable

6,580 8,000

Non-current Assets Equipment for hire

85,000

Office equipment

11,700

Showroom fixtures

12,000

Building Shares in FC Ltd

150,000 10,000 268,700

Total assets

276,700

LIABILITIES Current liabilities Bank overdraft

2,000

IRD

1,700

Income in advance Accrued expenses

500 8,300 12,500

Non-current liabilities Mortgage Loan

125,000 2,900 127,900

Total liabilities

140,400

OWNER’S EQUITY Capital

90,000

Plus Net profit

77,500 167,500

Less Drawings

(31,200) 136,300

TOTAL LIABILITIES AND EQUITY

276,700

[page 148]

3.10.2

CASE STUDY — NZ CATERING SUPPLIES LTD: AN EXAMPLE OF BUSINESS FAILURE

The determination of the quality of the earnings of any company is complex. Self-interest can sometimes impact the accounting system, and it is generally difficult to track the massaging or manipulation that may take place within a company’s reporting of performance. Sometimes a business and its executives or employees may manipulate the accounting information system to provide personal benefits for the manipulator, or to try and keep the business afloat when, in reality, the business should be wound up so that its creditors can be repaid. When a company is liquidated, it ceases to trade, and the liquidator takes possession of, protects, realises, and distributes its assets in accordance with the Companies Act 1993. A case in point was the liquidation of NZ Catering Supplies Ltd, trading as Wholefoods Bakery, a large unlisted company providing bakery products to small bakeries, hospitals, parliamentary services, and delicatessens. According to Nick Churchouse (Dominion Post, 18 November 2006), Wholefoods was one of Wellington’s biggest smallgoods wholesalers, with about 800 product lines. In addition to its large commercial customers, it provided 4,500 quiches and 7,200 servings of cake to a Golden Oldies Rugby Festival, and turned out 600 pies a day for Air New Zealand Koru clubs. During its eight years in operation, it also provided pastries, breads, and cakes to parliamentary caterers Bellamys, to Wellington and Palmerston North hospitals, as well as to schools, cafes, and airports across the lower North Island. In his article, Nick Churchouse indicated that the director of the company was also a director of 28 other companies, of which 11 are in liquidation. Wholefoods seemed to be a successful business, so it was a

“shock” for the manager and 30 staff when the company went into liquidation and they were laid off. The manager is quoted as saying, “We thought everything was going quite well, the company has been growing steadily.” The following are extracts from the Liquidators First Report, dated 14 November 2006, by Shephard Dunphy, Insolvency Practitioners: Stock As a consequence of the nature of the industry, the bakery holds a significant level of stock comprising mainly of partially completed pastries, breads and cakes and also a small amount of dry goods. Employees The bakery employed 30 staff as at the date of liquidation. Inland Revenue The business of Wholefoods Bakery came to the attention of Inland Revenue 12 months ago as a consequence of the sale of the business. NZ Catering Supplies Limited (now in liquidation) failed to file the appropriate returns or make payment on time to Inland Revenue. Note The liquidators will consider with reference to the records of the company; or any other information received: (a) Whether the directors and officers have acted properly in the operation of the company’s business;

[page 149] (b) Whether proper records have been kept by the company; (c) Whether all of the company’s property has been accounted for; (d) Whether any creditors of the company have received any preferential treatment; (e) Whether there have been any voidable transactions; and will undertake any appropriate action arising as a result of those considerations; and (f)

Will establish the financial position of the company as at 6 November 2006, the date the liquidation of the company commenced, by calling for creditors’ claims; and

(g) Will realise all assets of the company and distribute the proceeds in accordance with statutory priorities. NZ Catering Supplies Limited (in liquidation) trading as Wholefoods Bakery Estimated balance sheet

As at 6 November 2006 Book value

Estimated to realise

$

$

Assets Cash on hand

14,000

14,000

Stock (estimated)

56,000

25,000

292,000

235,000

362,000

274,000

Accounts receivable Estimated funds available (subject to costs of liquidation) Less

Preferential creditors Wages

26,000

Holiday pay

35,000

Inland Revenue, PAYE and GST

Unknown 61,000

Less

Unsecured creditors Trade creditors Inland Revenue Department

195,000 98,000

Associated company debt (lessor)

120,000

Shareholder advance

250,000 663,000

Estimated shortfall (subject to costs of liquidation)

(450,000)

The information in this statement has been supplied by the company and the officers of the company. No audit has been conducted. Shephard Dunphy, its principals or staff accept no liability for the accuracy of the information.

[page 150]

3.11

Mastering accounting — questions

3.11.1

SHORT ANSWER QUESTIONS

3.11.1.1

Match the terms with the definitions

Terms a.

accrued expenses;

b.

capital expenditure;

c

revenue in advance;

d.

revenue expenditure;

e.

prepayment;

f.

accrued revenue.

Definitions i.

expenditure that will benefit only the current accounting period;

ii.

revenue earned but not yet received;

iii. expenditure that will be treated as part of the cost of an asset; iv.

expenditure that relates to a future accounting period;

v.

revenue recorded, but for which no goods or services have yet been supplied;

vi.

expenditure legally incurred, but not yet paid for.

3.11.1.2

Balance sheet position

For each of the terms listed in paragraph 3.11.1.1 above, state where (if at all) they will appear on the balance sheet.

3.11.1.3 1.

Multiple choice

Goods and services tax (GST) is a tax on: a.

income;

b.

savings;

c.

spending;

d. 2.

producers.

The effect of recording capital expenditure as revenue expenditure is: a.

understatement of the current year’s expense;

b.

overstatement of the current year’s net profit;

c.

understatement of the subsequent year’s net profit;

d.

understatement of the current year’s net profit. [page 151]

3.

4.

5.

6.

GST is not paid on: a.

electricity charges;

b.

commercial rentals;

c.

advertising charges;

d.

bank charges.

When a business writes off a bad debt, the effect on the accounting equation is: a.

decrease in assets, decrease in liabilities;

b.

increase in liabilities, decrease in owner’s equity;

c.

increase in owner’s equity, increase in liabilities;

d.

decrease in owner’s equity, decrease in assets.

When a business provides for doubtful debts, the effect on the accounting equation is: a.

decrease in bank, decrease in profit;

b.

increase in net accounts receivable, decrease in bank;

c.

decrease in net accounts receivable, decrease in profit;

d.

increase in expenses, increase in profit.

The concept of prudence means that accountants value:

7.

8.

9.

a.

assets at a conservative value;

b.

assets at their market value;

c.

assets and liabilities at their true value;

d.

assets and liabilities at their selling price.

When a business uses discounts to encourage prompt and regular payment, the effect on the accounting equation is: a.

increase in assets, increase in liabilities;

b.

reduction in assets, reduction in owner’s equity;

c.

reduction in liabilities, increase in owner’s equity;

d.

reduction in assets, reduction in liabilities.

A manufacturing business bought some equipment and recorded it as an expense. This will: a.

understate the profit in the current period;

b.

overstate the value of the assets in the current period;

c.

overstate the profit in the current period;

d.

overstate the profit in subsequent periods.

When a business buys equipment on credit, the effect on the accounting equation is: a.

increase in liabilities, increase in owner’s equity;

b.

increase in assets, increase in owner’s equity;

c.

increase in liabilities, decrease in owner’s equity;

d.

increase in assets, increase in liabilities. [page 152]

10. The recording of an expense causes owner’s equity to: a.

remain unchanged;

b.

decrease;

c.

increase;

d.

none of the above.

11. In order to determine whether something is material to influencing decisions by users of accounting information, the following concepts or principles can be used as a guide: a.

The user looks at the nature and magnitude of the item, and its effect in the context of the financial report.

b.

The user looks solely at whether the amount is relevant.

c.

The user disregards the value of the item.

d.

The user uses his own yardstick for determining whether it is material.

12. In deciding whether to classify expenditure as capital or revenue expenditure, the following concept or principle is least likely to be used as a guide: a.

materiality concept;

b.

timeliness;

c.

accounting period concept;

d.

legal entity principle.

13. When expenditure is classified as revenue expenditure, the following changes to the balance sheet may result: a.

owner’s equity increases, assets increase;

b.

liabilities decrease, assets decrease;

c.

owner’s equity decreases, liabilities decrease;

d.

owner’s equity decreases, assets decrease.

14. A business bought machinery for $10,000, using a bank loan. A junior employee is responsible for recording accounting information. Which of the following presentations would be incorrect in the final accounts? a.

Equipment is a current asset, not a fixed asset.

b.

Installation is usually classified as a revenue expense.

c.

The equipment should be on the balance sheet at $10,000.

d.

Maintenance is not usually a capital expense.

15. The effect of the error in question 14 is: a.

Net profit is overstated, and assets are overstated.

b.

Liabilities are understated, and assets are overstated.

c.

Net profit is understated, and liabilities are understated.

d.

Liabilities are overstated, and assets are understated. [page 153]

16. Which one of the following statements most clearly defines capital expenditure? a.

expenditure which purchases assets;

b.

expenditure which is “consumed” against income over a period of more than one year;

c.

expenditure which is made out of the proprietor’s capital;

d.

expenditure which is necessary for the business to make a profit.

3.11.1.4

True/False

1.

Revenue received in advance is recorded in the balance sheet for the current period.

2.

An expense may appear in the income statement during the current period, even though it has not yet been paid.

3.

If we do not make an adjustment for insurance paid in advance, the effect is that assets will be understated and owner’s equity will be overstated.

4.

Revenue received in advance is shown on the balance sheet as a current asset.

5.

Capital expenditure benefits more than one accounting period.

3.11.1.5

Anne Jennison, fashion designer

Anne Jennison is a successful fashion designer. The transactions which took place today are listed below. Analyse each transaction by completing the chart below. The first one is done for you: 1.

2.

Bought equipment for cash. Accounts affected

Type of account

Increase

Equipment

Asset



Bank

Asset

Type of account

Increase

Decrease

Sold design and will be paid next month. Accounts affected

4.



Sold design and received cash. Accounts affected

3.

Decrease

Type of account

Increase

Decrease

Increase

Decrease

Paid electricity account. Accounts affected

Type of account

[page 154] 5.

Bought supplies on credit. Accounts affected

Type of account

Increase

Decrease

6.

Paid GST to the Inland Revenue Department. Accounts affected

7.

Decrease

Type of account

Increase

Decrease

Paid the account for supplies provided earlier in the month. Accounts affected

9.

Increase

Cashed a business cheque for own use. Accounts affected

8.

Type of account

Type of account

Increase

Decrease

Paid $110 off a business loan, which included 10% interest. Accounts affected

Type of account

Increase

Decrease

Increase

Decrease

10. Wrote off a bad debt. Accounts affected

Type of account

11. Received cash in advance for exclusive design. Accounts affected

Type of account

Increase

Decrease

[page 155] 12. Sent a cheque to pay rent for next month. Accounts affected

3.11.2

2.

Increase

Decrease

PROBLEMS

3.11.2.1 1.

Type of account

Mark-up

Goods are acquired for resale at a cost of $90 each. Calculate the selling price if the mark-up is: a.

20% of cost;

b.

50% of cost;

c.

33⅓% of cost.

If the selling price of an item is $150, calculate the cost price if the markup is: a.

20%;

b.

50%;

c.

33⅓%.

3.11.2.2

Ted Arnold

Ted Arnold commenced business on 1 August 2014 by opening a business bank account with a deposit of $5,000. 1.

Set up an accounting equation on a spread sheet, starting with the position on 1 August 2014, and complete it for the transactions below. Assume Ted is accounting for inventory on a physical inventory basis. All figures are GST-exclusive. a.

Bought office equipment for $900 cash.

b.

Bought machinery for $2,300 cash.

c.

Paid rent of $800.

d.

Bought goods for $750 cash.

e.

Sold goods for $300 cash.

f.

Bought goods on credit from Wholesalers Ltd for $980.

g.

Paid power account of $36.

h.

Sold goods on credit for $150.

i.

Gave his daughter a cheque for $100 for her birthday from the business bank account.

j.

Paid wages of $220.

k.

Bought a station wagon on credit from Auto Traders Ltd for $7,600.

l.

Bought more machinery for $220 cash.

m. A stocktake at the end of August reveals stock on hand worth $1,430. 2.

Re-do the analysis for items d, e, f, and h, assuming that Ted is operating a perpetual inventory system, and that he applies a 50% mark-up to the cost of all goods. [page 156]

3.

Prepare the income statement and statement of changes in equity for the month ended 31 August 2014, and a balance sheet as at 31 August 2014.

3.11.2.3

Kim Fong, physiotherapist

Kim has been in practice for two years. Her assets, liabilities, and owner’s equity are as follows: ASSETS Bank account

$

LIABILITIES & OWNER’S EQUITY 1,300 Liabilities

$

Accounts receivable

1,500

Loan

3,000

Equipment

4,300

Accounts payable

2,000

Fixtures and fittings

2,700 Owner’s equity

Kiwi Bonds

1,000

1.

2.

5,800

Use this information to set up an accounting equation on a spreadsheet and record the following transactions: a.

Received $200 from debtors.

b.

Paid $150 to creditors.

c.

Sold services on credit for $250.

d.

Sold services for $600 cash.

e.

Received $100 interest on Kiwi Bonds.

f.

Sold services for $500 cash.

g.

Sent a $90 cheque to pay electricity account.

h.

Paid $400 off loan, which included $100 interest.

i.

Sold services for $400 cash.

Prepare the income statement, statement of changes in equity, and balance sheet, using today’s date.

3.11.2.4

Mark Hennessy, lawyer (fully-worked example)

Mark runs a law office and employs two people. He has been in business for a number of years and charges $100 per hour for his services. 1.

Review the accounts used in this example and provide a chart of accounts.

2.

Use his balance sheet shown at the end of this question to set up a spreadsheet to record the following transactions for the week’s work: a.

Paid $500, being an amount of accrued expenses for wages.

b.

Received $800 from debtors.

c.

Sold services for $1,500 cash.

d.

Bought some additional equipment for $1,200.

e.

Received an invoice for $650 for electricity.

f.

Wrote off a bad debt of $400. [page 157]

g.

Paid wages of $450.

h.

Provided for 2% of remaining debtors who may not pay.

i.

Paid Telecom $250 for telephone and internet use.

j.

Withdrew $1,000 from the bank for his own use.

k.

Paid $1,100 off the loan, including $100 interest.

l.

Withdrew $4,000 from his investments and deposited it into the bank.

m. Paid $100 for insurance. n.

Received an invoice from Colenso for $400 worth of advertising.

Mark Hennessy, lawyer Balance sheet As at 30 June 2014 $

$

ASSETS Current assets Bank

7,500

Accounts receivable

2,500 10,000

Non-current assets Premises Equipment

40,000 6,000

Car

18,000

Investments

25,000 89,000

Total assets

99,000

LIABILITIES Current liabilities Accounts payable

4,000

Accrued expenses

500 4,500

Non-current liabilities Loan

10,000

Total liabilities

14,500

OWNER’S EQUITY Capital

60,000

Plus Net profit

24,500 84,500

TOTAL LIABILITIES AND EQUITY

99,000

[page 158] 3.

Prepare Mark’s balance sheet, statement of changes in equity, and income statement after the month of trading.

3.11.2.5

Adjustments — effect on the accounting equation

Each adjustment at the end of the accounting period has two effects on the accounting equation. Can you identify these effects? The first question is done for you: Remember that, throughout your equations, negative amounts represent a decrease in the category, and positive amounts represent an increase in the category.

1.

wages owing to an employee of $80: Assets + Bank

Expenses +

A/rec

Drawings =

Liabilities + A/pay

80 i

Accrued expenses 80

Revenue + Sales

Owner’s equity

i

wages

2.

interest due, but not yet paid, of $100;

3.

rent paid to landlord in advance of $500;

4.

phone account not yet paid of $150;

5.

bad debts written off of $50;

6.

commission earned, but not yet received of $470; and

7.

$430 received for work not yet completed.

3.11.2.6

Adjustments — effect on net profit

How do adjustments affect net profit? When you examine the below “do it yourself” income statement, which was prepared by the business owner, you notice that no adjustments have been made. Use the information below to calculate a more accurate net profit: $ NET PROFIT

15,300

ADJUSTMENTS NOT MADE Wages due

500

Rates pre-paid

200

Interest owning on borrowings Commission not yet received Rent received in advance

3.11.3

DISCUSSION QUESTIONS

3.11.3.1

Case study — Jones’s Hire Services

50 2,400 400

You are acting as the accountant for Jones’s Hire Services. Tom Jones has asked the following questions about his financial statement (see Resource file 3, paragraph 3.10.1, for the case study). Prepare a written reply to each of these questions:

[page 159] 1.

“Why have you decided to list the accounts separately? Didn’t this take a long time to do? No wonder you charge so much!”

2.

“Why did you put the expenses together?”

3.

“I budgeted to spend about $3,000 on advertising this year. How am I doing?”

4.

“I know for a fact that I paid $600 for the fire insurance, because I wrote the cheque last week. You have put only $100 for fire insurance. What happened to the other $500?”

5.

“I earned $2,000 in rent from the room I let to a local artist. Why did you put this down as non-operating income? If I wasn’t operating, I wouldn’t have the space to let out now, would I? And here’s another mistake — I got paid $2,000 in full, and you have only put in $1,500 in the income statement.”

6.

“I wish that you had kept quiet about the bad debts… Why did you put the legal costs of chasing them up as a financial expense?”

7.

“What is the reason for dividing up the salaries and putting them as two different expenses?”

8.

“If I want to borrow to buy more equipment to hire out, do I tell them how much profit I made, how much cash I’ve got, or how good the working capital position is? Or what?”

9.

“I seem to have a lot of equipment for hire in the non-current assets section of the balance sheet, but of course, this is how I make my profit. I noticed that you put the replacement of glasses and cutlery as an expense. Why didn’t you count them as assets like you did with the replacement chainsaw and the two new chainsaws?”

10. “You haven’t got an accurate figure for the buildings. The factory at the end of the road sold for twice the value you put on my place. Shouldn’t you change it?”

11. “I notice that you think some of my clients will not pay. I know these people and they are friends of mine. They will pay — can’t you take the doubtful debts out? How did you get that number anyway?” 12. “You forgot to put my wages anywhere! I have had an automatic payment of $600 each week coming out of the business bank account and going into my personal bank account. Where does that show?” 13. “How do you think my business is doing? Any advice?”

3.11.3.2 1.

Capital and revenue expenditure

Which one of the following does not represent capital expenditure? a.

the cost of installing a new machine;

b.

the construction of a deck on a new truck;

c.

the cost of moving a machine from one part of the factory to another in a rearrangement;

d.

the reconditioning of a motor in a second-hand truck just purchased for use in the business;

e.

repairs to a new machine damaged in delivery and not covered by insurance. [page 160]

2.

Mrs Newman runs a secretarial, duplicating, and printing service. State whether the following items are revenue or capital expenditure: a.

extensions to existing premises;

b.

fire insurance premiums on premises;

c.

legal expenses incurred in purchasing land;

d.

installation costs for a new printing machine;

e.

500 reams of paper for use in the printing process; and

f.

payment of wages.

3.

Outline the main criteria you would use to decide whether an item of expenditure was capital expenditure or revenue expenditure.

4.

Explain the effect on the profit of a business if a revenue expense were capitalised in error.

5.

Explain how the concept of materiality relates to the decision whether to treat expenditure as capital expenditure or revenue expenditure.

3.11.3.3

Adjusting entries

1.

Identify four common adjustments that often need to be made to accounts at the end of the accounting period.

2.

What accounting concept(s) make these adjustments necessary?

3.

Explain the possible consequences of failing to make the adjustments you have identified in your answer to question 2. Illustrate your explanation with practical examples.

3.11.4

RESEARCH ASSIGNMENTS

Using examples of financial reports that you might have access to: 1.

Analyse the other (non-financial) reports found in the Annual Report to find the number of ways profit is referred to. In particular, you might want to view/copy the diagrams which present the profit in different ways. Compare these presentations of profit to the actual profit figure as it is represented in the balance sheet.

2.

Collect a series of newspaper clippings that announce the (expected) profit of a company listed on the stock exchange. Attempt to determine the source of the information (who wrote it and on which sources of information it is based), and determine which aspects of the company’s performance are emphasised in the article. Try to understand the accountant’s language, and the reasons for the descriptive characteristics of accounting. Questions you might want ask yourself in regard to the article are:

Is the article likely to be biased? How much knowledge does the writer have? How much, if any, comparative analysis was done? Are statements made in the article in line with other articles or your own knowledge? 3.

Compare the information found in the newspaper articles with that presented in the Annual Report being discussed. [page 161]

3.11.5

INTEGRATED CASE — NZ CATERING SUPPLIES LTD: AN EXAMPLE OF BUSINESS FAILURE

Imagine that you have recently been hired into the audit section of a large accounting firm, and a senior partner wants to determine your understanding of the accounting and financial reporting system. Refer to the case study in Resource file 3, paragraph 3.10.2. Note that these are not actual misstatements attributable to NZ Catering Supplies Ltd.

1.

You have been provided with an accounting equation worksheet, which mirrors the balance sheet as at 31 August 2014. You have been made aware of the following possible misstatements: i.

Work in progress and stock were recorded at the amount that was paid for them, while the actual level (net realisable value) was $55,000 lower than the recorded amount.

ii.

Stock codes of low-priced stock have been changed so that they were described as more expensive items. Stock was overvalued by $31,000.

iii. Loans to the value of $50,000 had been counted as revenue. iv.

Credit sales of $12,000 had been recorded as sales which had not occurred yet.

v.

The value of one of the assets was listed at $17,000. However, when it was sold a year later, it raised $5,000. Assets =

Liabilities +

Owner’s equity

Bank

A/rec

Inventory

Noncurrent assets

Current liabilities

Noncurrent liabilities

Paid-up capital

Reserves

Retained earnings

2,067

27,043

67,029

120,964

49,726

49,726

72,359

11,729

7,961

i. ii. iii. iv. v.

Required:

2.

a.

Decide whether the identified misstatements need to be adjusted in the accounting equation, and make the required adjustments to the equation. If an adjustment affects revenue or expenses, adjust retained earnings directly.

b.

Explain in one sentence why you did, or did not, alter the accounting equation. Use appropriate accounting terminology.

NZ Catering Supplies Ltd went into liquidation on 6 November 2006. Read the case study in Resource file 3, paragraph 3.10.2, and answer the following questions: a.

The liquidators of NZ Catering Supplies Ltd stated in note (e) that they would consider whether there were any voidable transactions. What does the term “voidable transactions” mean?

b.

Outline in about 40 words the responsibilities of the liquidator in the checking of the financial position of NZ Catering Supplies Ltd. [page 162]

c.

Should the manager have detected the cash flow issues indicated in the balance sheet? Explain your answer (in about 40 words).

d.

What were some of the early warning signs that this business was having cash flow problems?

e.

NZ Catering Supplies Ltd has about 800 product lines. Does this seem reasonable? Briefly explain your answer.

f.

One of the unsecured creditors is a “shareholder advance”. What does this mean?

g.

Comment on the information provided in the case study. What questions do the financial accounts and background information pose?

Hint: You may want to refer to Chapter 5.

3.

4.

Internal control plays an important part in ensuring the accuracy of the accounting system. a.

Most textbooks refer to four broad objectives of internal control. List them.

b.

Two attributes of an internal control system are “authorisation” and “separation of duty”. Define these terms and discuss briefly how the director of NZ Catering Supplies Ltd would have covered these aspects when drawing funds such as the “associated company debt” and the “shareholder advance”.

The collapse of NZ Catering Supplies Ltd would have a wide-ranging effect. Think about the estimated $663,000 liabilities and answer the following questions: a.

What is the difference between a receivership and a liquidation?

b.

Explain some of the repercussions for the staff, for suppliers, for the business communities in Wellington, and for investors.

3.12

Mastering accounting — solutions

3.12.1 3.12.1.1 a.

vi.

b.

iii.

c.

v.

d.

i.

e.

iv.

f.

ii.

3.12.1.2

SHORT ANSWER QUESTIONS Match the terms with the definitions

Balance sheet position

a.

current liabilities;

b.

non-current liabilities;

c.

current liabilities;

d.

not a balance sheet item; [page 163]

e.

current assets;

f.

current assets.

3.12.1.3 1.

c.

2.

d.

3.

d.

4.

d.

Multiple choice

5.

c.

6.

a.

7.

b.

8.

a.

9.

d.

10. b. 11. c. 12. d. 13. d. 14. d. 15. a. 16. a.

3.12.1.4

True/False

1.

False. Revenue in advance is a current liability.

2.

True. Refer to realisation concept.

3.

False. Failure to adjust for prepaid insurance means that expenses are overstated; therefore profit and owner’s equity are understated.

4.

False. It is a current liability.

5.

True. Refer to the definition of capital expenditure in Key words 3.

3.12.1.5 1.

Anna Jennison, fashion designer

Bought equipment for cash: Accounts affected

Type of account

Increase

Equipment

Asset



Bank

Asset

Decrease √

[page 164]

2.

Sold design and received cash: Accounts affected

Type of account

Increase

Sales

Revenue

√*

Bank

Asset



Decrease

* Results in an increase in owner’s equity.

3.

4.

Sold design and will be paid next month: Accounts affected

Type of account

Increase

Sales

Revenue



Accounts receivable

Asset



Decrease

Paid electricity account: Accounts affected

Type of account

Increase

Power

Expense

√*

Bank

Asset

Decrease √

* Results in a decrease in owner’s equity.

5.

6.

7.

Bought supplies on credit: Accounts affected

Type of account

Increase

Supplies

Asset



Accounts payable

Liability



Decrease

Paid GST to the Inland Revenue Department: Accounts affected

Type of account

Increase

Decrease

GST (IRD)

Liability



Bank

Asset



Cashed a business cheque for own use: Accounts affected

Type of account

Increase

Drawings

Drawings

√*

Bank

Asset

* Results in a decrease in owner’s equity.

Decrease √

8.

Paid the account for supplies provided earlier in the month: Accounts affected

Type of account

Increase

Decrease

Accounts payable

Liability



Bank

Asset



[page 165] 9.

Paid $110 off a business loan, which included 10% interest: Accounts affected

Type of account

Increase

Decrease

Interest

Expense

√*

Loan

Liability



Bank

Asset



* Results in a decrease in owner’s equity.

10. Wrote off a bad debt: Accounts affected

Type of account

Increase

Bad debts

Expense



Accounts receivable

Asset

Decrease √

11. Received cash in advance for exclusive design: Accounts affected

Type of account

Increase

Income in advance

Liability



Bank

Asset



Decrease

12. Sent a cheque to pay rent for next month: Accounts affected

Type of account

Increase

Rent

Expense



Bank

Asset

3.12.2

PROBLEMS

Decrease √

3.12.2.1 1.

Mark-up

a. selling price = $108

2.

b.

selling price = $135

c.

selling price = $120

a. cost price = $125 b.

cost price = $100

c.

cost price = $112.50 [page 166]

3.12.2.2

Ted Arnold

1.

i

office equipment

ii

machinery

iii

rent

iv

purchases

v

purchases

vi

power

vii

wages

viii motor vehicle ix

machinery

x

closing stock

[page 167] 2.

Under the perpetual inventory system, the following transactions would have changed:

i

cost of sales

ii

cost of sales

3.

The income statement, statement of changes in equity, and balance sheet would have looked like this:

Ted Arnold Income statement For the year ended 31 August 2010 $

$

REVENUE Sales Less

COST OF SALES Purchases

(1,730)

Inventory

1,430

Cost of goods sold GROSS PROFIT Less

450

EXPENSES

(300) 150

Rent

(800)

Power

(36)

Wages

(220)

Total expenses

(1,056)

NET LOSS

(906)

Ted Arnold Statement of changes in equity For the year ended 31 August 2014 $ Capital 1/8/2013

5,000

Less

(906)

Net loss

4,094 Less

Drawings

(100) 3,994

[page 168]

Ted Arnold Balance sheet As at 31 August 2014 $

$

ASSETS Current assets Accounts receivable Inventory

150 1,430 1,580

Non-current assets Office equipment

900

Machinery

2,520

Vehicle

7,600 11,020

Total assets

12,600

LIABILITIES Current liabilities Bank overdraft *

26

Accounts payable **

8,580

Total liabilities

8,606

OWNER’S EQUITY Capital

3,994

TOTAL LIABILITIES AND EQUITY

12,600

* Bank could be shown as a negative current asset. ** Assumes that Auto Traders is a short-term liability.

[page 169]

3.12.2.3

Kim Fong, physiotherapist

1. Assets +

Expenses =

Liabilities +

Bank

A/rec

Other assets

A/pay

1,300

1,500

4,300 i

2,000

2,700

Loan

Revenue + Sales

Interest rec

3,000

Owner’s equity Capital 5,800

ii

1,000 iii a.

200

b.

(150)

c.

(200) (150) 250

250

d.

600

e.

100

f.

500

g.

(90)

90 iv

h.

(400)

100 v

i.

400 2,460

600 100 500 (300) 400 1,550

i

equipment

ii

fixtures

iii

Kiwi Bonds

8,000

190

1,850

2,700

1,750

100

5,800

iii

electricity

iii

interest

2. Kim Fong, physiotherapist Income statement For the year ended (now) $

$

REVENUE Sales Less

1,750

EXPENSES Electricity

(90)

Interest paid

(100)

Total expenses

(190)

OPERATING PROFIT Plus

1,560 Other income Interest received

100

NET PROFIT

1,660

[page 170]

Kim Fong, physiotherapist Statement of changes in equity For the year ended (now) $ Capital Plus

5,800 Net profit

1,660 7,460

Kim Fong, physiotherapist Balance sheet As at (now) $ ASSETS Current assets

$

Bank

2,460

Accounts receivable

1,550 4,010

Non-current Assets Equipment

4,300

Fixtures

2,700

Kiwi Bonds

1,000 8,000

Total assets

12,010

LIABILITIES Current Liabilities Accounts payable

1,850

Non-current liabilities Loan Total liabilities

2,700 4,550

OWNER’S EQUITY Capital TOTAL LIABILITIES AND EQUITY

7,460 12,010

[page 171]

3.12.2.4

Mark Hennessy, lawyer

[page 172] i

premises

ii

equipment

iii

car

iv

investments

v

equipment

vi

electricity

vii

bad debts

viii wages ix

doubtful debts

x

doubtful debts

xi

telephone

xii interest xiii investment xiv insurance xv

advertising

3. Mark Hennessy, lawyer Income statement For the month ended 31 July 2014 $

$

$

REVENUE Fees Less

1,500

EXPENSES Selling expenses Advertising

(400) (400)

Administrative expenses Electricity

(650)

Insurance

(100)

Wages

(450)

Telephone

(250) (1,450)

Financial expenses Interest Doubtful debts Bad debts

(100) (26) (400) (526)

Total expenses NET LOSS

(2,376) (876)

[page 173]

Mark Hennessy, lawyer Statement of movements in equity For the month ended 31 July 2014 $ Capital Less

84,500 Net loss

(876) 83,624

Less

Drawings

(1,000) 82,624

Mark Hennessy, lawyer Balance sheet As at 31 July 2014 $

$

$

ASSETS Current assets Bank Accounts receivable Less Allowance for doubtful debts

9,200 1,300 (26) 1,274 10,474

Non-current assets Equipment

7,200

Car

18,000

Premises

40,000

Investments

21,000 86,200

Total assets

96,674

LIABILITIES Current liabilities Accounts payable

5,050

Non-current liabilities Loan

9,000

Total liabilities

14,050

OWNER’S EQUITY Capital TOTAL LIABILITIES AND EQUITY

82,624 96,674

[page 174]

3.12.2.5 2.

Adjustments — effects on the accounting equation

Interest due, but not yet paid, of $100: Assets + Bank

i

3.

Expenses +

A/pay

100i

100

Accrued expenses

Expenses +

Drawings =

500

(500)i

A/rec

Liabilities + Prepayments

A/pay

Expenses +

Drawings =

A/rec

Owner’s equity

Sales

Liabilities + A/pay

Accrued expenses

Revenue +

Owner’s equity

Sales

150

telephone

Bad debts written off of $50: Assets + Bank

Expenses +

Drawings =

A/rec (50)

6.

Revenue +

Phone account not yet paid of $150:

150i

i

Sales

rent

Bank

5.

Owner’s equity

Rent paid to landlord in advance of $500:

Assets +

i

Revenue +

interest

Bank

4.

Liabilities +

A/rec

Assets +

i

Drawings =

Liabilities +

Revenue +

A/pay

Sales

Owner’s equity

50i

bad debts

Commission earned, but not yet received, of $470: Assets + Bank

A/rec

Expenses + Accrued income 470

Drawings = Liabilities + Revenue + A/pay

Commission 470

Owner’s equity

[page 175] 7.

$430 received for work not yet completed: Assets + Bank

3.12.2.6

Expenses +

Drawings =

A/rec

Liabilities + A/pay

Revenue +

Revenue in advance

Sales

430

(430)

Owner’s equity

Adjustments — effect on net profit $

$

ORIGINAL PROFIT

15,300

Less (increase in expense or decrease in revenue) Wages due Interest Rent received

(500) (50) (400) (950) 14,350

Plus (decrease in expense or increase in revenue) Rates prepaid Commission not received

200 2,400 2,600

ADJUSTED PROFIT

16,950

[page 177]

Issues in income determination and asset valuation

CHAPTER

4

Contents Learning outcomes 4.1

Introduction

4.2

Making accounting decisions 4.2.1 Introduction 4.2.2 Case study — new tools … new ways of measuring

4.3

Recognition of revenue and expenses

4.4

Depreciation of property, plant, and equipment 4.4.1 Case study — the working life of a photocopier 4.4.2 What happens when you buy an asset — the recording system

4.4.3 4.4.4 4.4.5 4.4.6 4.4.7 4.4.8 4.4.9

A word or two about estimates Allocating the depreciable amount Which method should be used? How do we disclose depreciation in the accounts? Taxation law and taxation rates of depreciation What are the effects of providing for depreciation in the accounts? A case study — Taghi Derhamy

4.5

Valuation of inventories 4.5.1 What value should be allocated to inventory? 4.5.2 What if the inventory has deteriorated or become obsolete? 4.5.3 What if inventory is acquired at different prices? 4.5.4 How do we disclose inventory valuation in the notes?

4.6

Valuation of accounts receivable [page 178] 4.6.1 4.6.2 4.6.3

Allowance for doubtful debts How do we arrive at the figure for doubtful debts? How important is it to take doubtful debts into account?

4.7

The statement of accounting policies

4.8

Conclusion

4.9

Key words 4

4.10

Resource file 4 4.10.1 Extracts from accounting policies 4.10.2 IRD tax tables — computer equipment 4.10.3 Articles discussing the enticement costs of selling

cellphones 4.10.4 Determination of profit — Shoeshine 4.11

Mastering accounting — questions 4.11.1 Short answer questions 4.11.2 Problems 4.11.3 Discussion questions 4.11.4 Research questions

4.12

Mastering accounting —solutions 4.12.1 Short answer questions 4.12.2 Problems [page 179]

Learning outcomes After completing this chapter, you should be able to: use the recognition concept to determine revenue and expenses; undertake the record keeping surrounding property, plant, and equipment transactions; determine the valuation of non-current tangible assets; determine the valuation of inventories, using the methods: – first-in, first-out (FIFO); –

weighted average cost (WAC); or



specific identification;

calculate the fair value of accounts receivable; and

write accounting policies which clearly explain the choices taken.

4.1

Introduction

Can you explain how each of the following concepts impacts the preparation of accounting reports: accounting period; historical cost; and recognition.

In Chapter 3 we worked through a range of typical business transactions, and used the accounting equation to analyse the effects of transactions in terms of business profitability and financial structure. We also saw how any given transaction will result in a change in one or other of three key accounting reports: the income statement, the statement of changes in equity, and the balance sheet — the first reporting on profitability, the second on changes to the owner’s equity, and the last on financial stability. That accounting decision making is not all clear cut, will be reinforced in Chapter 7, where we look at the analysis and interpretation of financial reports.

We also examined the key accounting concepts that are followed by accountants to give meaning and consistency to financial reporting. The concepts of accounting period, historical cost, and recognition provide an important framework to guide professional decision making. We should also appreciate that accounting decision making is not all clear cut. Indeed, there are many areas where it would be possible to defend different decisions as to how a given transaction should be treated, and in other areas the decision making is so deceptively complex that it is easy to make a wrong decision. In this chapter we will look at four areas of routine professional judgment: decisions regarding the recognition of revenues and expenses; decisions concerning the depreciation and valuation of non-current assets; decisions concerning the valuation of inventories; and

decisions concerning the valuation of accounts receivable. [page 180] We touched on these decisions in earlier chapters, but now we will deal with them in more depth. In short, different decisions (or wrong decisions) in the areas mentioned above, will have two general effects: an income statement effect — reported profit will either be higher or lower compared with an alternative decision; and a balance sheet effect — our understanding of aspects of the financial stability of the organisation may be different, because the statement figures on which we base such understanding will be different.

4.2 4.2.1

Making accounting decisions INTRODUCTION

The potential exists for readers of the accounts to draw different conclusions about business profitability and financial stability and, in turn, they could make different decisions — either for better or worse. Whether this happens, depends on how significant the monetary effects of the accounting decisions are — that is, how material they are. Clearly, a decision that results in a $1,000 effect on net profit is significant if the net profit reported is in the vicinity of $10,000; but is irrelevant if the net profit reported is in the vicinity of $100,000. These decisions are important because we use accrual accounting as the basis of reporting. It can be argued that the decisions do not affect actual cash flows, and therefore only reflect timing differences. If there is no effect on

cash flows, why bother? The chief accountant of the SEC (the US equivalent of the New Zealand Stock Exchange surveillance panel), Lynn Turner, claims that investor losses from accounting fraud reached over US$100 billion between 1996 and 2001. Abuses in revenue recognition are deemed to be the number one source of these errors. In February 2001, Xerox released details of inaccuracies in their Mexican subsidiary’s accounts. Investigation revealed insufficient allowance for doubtful debts, billing inaccuracies, and the inaccurate classification of income as to whether it resulted from a sale, a lease, or a rental. The allowance for the shortfall in profit was US$120 million. Lucent Technologies, a telecommunications equipment maker, was said to have improperly recognised over US$600 million in revenue during its 2000 financial year. It was reported that enthusiastic sales people had counted contracts which had not been signed, as sales. The problem was made worse when combined with unexpected returns of equipment and cancellation of contracts. However, this process does not necessarily reflect fraud. More often, the decisions are made during the ordinary course of business. The choice is available because there is a need to allow for the wide range of business activities taking place. Throughout this chapter, we will show how accounting choices affect the income statement and balance sheet. We will also provide comparison of the results to actual cash flows. Until now, we have used the NZ Framework to guide us in our decision making. In this chapter, we will refer to the New Zealand International Financial Reporting Standards (NZ IFRS), which provides more detailed guidance for dealing with these issues. Students at this level are not expected to have knowledge of the financial reporting [page 181] standards (we leave that to other courses), but it is important for students to

recognise that there is an authority for Generally Accepted Accounting Practice (GAAP). In this chapter, we will be focusing on two standards in particular: NZ IAS 2 Inventories; and NZ IAS 16 Property, Plant and Equipment.

4.2.2

CASE STUDY — NEW TOOLS … NEW WAYS OF MEASURING

“When you are providing an internet service, like me, you have to have your fingers on the pulse.” This is the sentence that Andrew Kolose greets his accountant with each time they meet. He is a designer of websites for small business, and it had become a bit of an “in joke”. He is up to date on the latest computer trends, but the accountant maintains the heartbeat of GlobeNet Communications Ltd, the business in which Andrew owns 80% of the shares. Andrew provides the whole internet experience for his clients — the computer hardware, access to the internet, graphic design, shopping baskets, transaction processing, and the marketing information to make it all work for the client. GlobeNet Communications has doubled its turnover each year for the last three years. In this time, Andrew has built up a solid group of customers who return regularly. “I advise clients all the time on accounting and accountability issues,” says Andrew, “but I am still having problems understanding how to get my profits to turn into money in the bank.” This was of particular concern to Andrew, as he was working very long hours to maintain the levels of service that his clients expected. The fact that the initial set-up work was time-consuming, particularly as many clients changed their minds in the early design stages, made it more difficult. “I price my design work low, so as to attract the business,” explained Andrew, “I think that this is why the business has grown so quickly. This is my third year now, and I thought that I would be able to reap the benefits of the ongoing service agreements, which require less work.” Andrew’s

accountant confirms that GlobeNet Communications is a successful business, and points to the wages that Andrew draws from the business. Andrew’s response is to point at his bank account, which has nothing in it. Part of the problem relates to the business of computing. In order to remain a leader in the field, Andrew is obliged to upgrade equipment often. “This is costing me twice,” Andrew maintains, “the first when I have to spend the money to buy the equipment; and the second when my accountant takes depreciation away from my profit.” Depreciation is just one of the adjustments that the accountant makes to the accounts. Some of these adjustments require estimates, and Andrew is unsure if these estimates really represent what is going on with his business. Why do you think there might be a need for separate sets of accounts for the IRD and for GlobeNet Communications? Is Andrew trying to hide money from the tax department?

To make matters worse, the accountant maintains two sets of accounts: one is for Andrew to make decisions; and the other is for the IRD. Andrew believes that paying taxes is bad enough, “but having to pay an accountant, even a good one, to do the same work twice, is unbelievable!” Andrew has established an excellent relationship with many of his clients, and offers them credit. “This hasn’t caused any problems, they all pay,” he says. He has the advantage that each client has invested a lot of time and effort into the development of an internet presence, and non-payment would ensure a speedy denial of service. In spite of his lack of investment in stock and a good cash collection, Andrew has needed to borrow large amounts of money from the bank. The bank manager receives a [page 182] copy of the GlobeNet Communications’ monthly statements. This is an extra

pressure for Andrew but, as he says, “The business is growing, and the pulse is strong — I have no fear.” Andrew is a major shareholder and chief executive. Would he have a problem understanding the choices made?

We can see from the above example that there is a strong cohesion required between an entrepreneur and the person completing the accounts. In many circumstances, the closeness between the accountant and those using the accounts is taken for granted. Sometimes there is distance, as with the banker in the case above, or more often with shareholders in publicly-listed companies. The distance between preparers and users of the accounts means that the assumptions made by the accountant, or choices taken when estimates are made, need to be explained. As introduced in Chapter 1, this is done by way of notes to the accounts. Let us now have a look at some of the accounting decisions that need to be made.

4.3

Recognition of revenue and expenses

Andrew has a number of short-term and long-term contracts with his clients. Some of the contracts represent considerable sums of money. When does he recognise the revenue as being earned — is it when he receives the money, or is it at the beginning, middle, or end of the contract? These are important questions, as this decision has a direct effect on the profit of the business. Let us look at a specific example of income earned by GlobeNet Communications. Steve Gullikson is a distributor of Bee Products and wants to extend its market by way of the internet. Steve has approached Andrew for a quotation in this regard, which is written up as follows: Design of the site Setup — hardware

$10,000 $5,000

Initial marketing services Total due on completion of site

$1,000 $16,000

Continued internet service at $6,600 per year payable in advance Additional design services at $55 per hour

Steve accepts the quote and asks Andrew to get the site running as soon as possible. Steve pays $6,600 cash to secure non-stop, continued internet access. The whole team at GlobeNet Communications works for two weeks to ensure that the job is done. Although the job is completed in March, it is not signed off and invoiced until April. Which of the abovementioned incomes should be recognised in the March accounts for the bank manager? The NZ Framework (paragraph 4.38) stipulates the criteria for recognition of all elements of financial statements, including revenues, as follows: (a) it is probable that any future economic benefit associated with the item will flow to or from the entity; and (b) the item has a cost or value that can be measured with reliability.

Let us analyse the above situations in terms of these criteria. The $6,600 sitting in the bank relates to the future provision of internet access. The provision of the service [page 183] in exchange for this money has not occurred, therefore the revenue should not be recognised. However, work has been done for which there is a reasonable expectation of payment. This relates to the contractual relationship that exists between Steve Gullikson and GlobeNet Communications, and the setting up of an operational website. The event has occurred, and the value of the event is known with reasonable certainty. The $16,000 should be recognised, and an adjustment (as covered in Chapter 3) needs to be made. To help explain the effects of this choice on the profit, we

will assume that the cost to GlobeNet Communications of putting the site together was $10,000, and that all of this was paid by GlobeNet Communications at the end of March. Cash basis

Full recognition basis

$

$

Income

6,600

16,000

Expenses

10,000

10,000

Profit/(loss)

(3,400)

(6,000)

Which of these profit figures represents a more accurate depiction of the business’s operations? Which would be viewed in a better light by the bank manager? One-twelfth of the $6,600 would also need to be recognised as revenue each month that the service is being provided. At this stage, the issues being raised are not much more complex than those raised in the Chapter 3. Let us extend that reasoning a bit further. Another client asked for an advanced website requiring integration of the internet into its own accounting system. This involves the development of special software, and a considerable outlay of money for GlobeNet Communications. Andrew knows that the client would not accept paying for the development charges up-front. Andrew decides to include the development fees over the three years of the contract. How would we recognise the revenues and expenses over the three years? For a discussion of this type of problem, see Resource file 4, paragraph 4.10.

4.4

Depreciation of property, plant, and equipment

Non-current assets (also referred to as fixed assets), are those that have been

acquired with the intention of keeping. New Zealand International Accounting Standard 16 Property, Plant and Equipment (NZ IAS 16) defines property, plant, and equipment as: tangible items that: (a) are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes; and (b) are expected to be used during more than one period.

It should be borne in mind that it is not the physical characteristics of the asset that are important, but the intention in acquiring the asset. For example, motor vehicles appear as [page 184] fixed assets for many businesses, yet for a car dealer, motor vehicles are the stock-in-trade — a current asset. They are acquired with the intention of reselling at a profit, and within a single accounting period. Fixed assets pose particular problems for accountants, as they tend to wear out or lose value over time. This loss in value may be the result of use, obsolescence, or technological change, or merely of the passage of time. Accountants refer to this loss in value of fixed assets as depreciation. The accounting issue that we have to grapple with insofar as depreciation is concerned, is how to deal with this loss of value of a fixed asset in the accounts. In effect, this is a cost allocation issue. Fortunately, guidance on this issue is set out in NZ IAS 16, which deals with property, plant, and equipment. Note, however, that not every fixed asset will lose value — for example, it is very rare for land to devalue. It is useful, therefore, to think of assets which have a limited useful life and are therefore subject to depreciation, as depreciable assets. Let us now look at depreciation a little more closely, using the example of a photocopy machine as a case study.

4.4.1

CASE STUDY — THE WORKING LIFE OF A PHOTOCOPIER

GlobeNet Communications purchased a new photocopier on 11 April 2010 for $10,500. The model chosen was one which the office manager believed would meet the company’s copying needs for the next five years, estimated at three million copies. The copier gave good service for the first four years, and required only normal servicing under the maintenance contract, which was based on usage. However, there were more frequent breakdowns during the fifth year of use, although no major repairs were needed. As these breakdowns were annoying, the copier was traded in on 31 March 2015 for a new machine, with many more features and a far greater production capacity. This machine cost only $8,000, and the company was given a $1,000 trade-in for the old machine. This trade-in allowance was considered a bonus, because the company had expected to get no more than $500 after five years of heavy use. Over the five years, the copier’s actual annual usage was as follows: 31/3/2011:

510,000 copies

31/3/2012:

660,000 copies

31/3/2013:

640,000 copies

31/3/2014:

650,000 copies

31/3/2015:

730,000 copies

“Useful life” refers to either the period over which a depreciable asset is expected to be used, or the number of production units expected to be obtained from the asset.

The historical cost of the copier was clearly $10,500. The company had estimated that the useful life of the copier would be five years, or three million copies. The company had also estimated that the copier would be worth $500 at the end of its useful life. This is its residual value. As it turned out, it was worth $1,000, but unfortunately we do not have the benefit of hindsight when we make our accounting decisions about depreciation. Rather, we have to make estimates. Insofar as we are concerned, when we first make our decision, it is for a loss of value of $10,000. This $10,000 is the depreciable

amount of the copier, and is simply the historical cost less the estimated residual value. Our accounting problem, then, is to allocate this $10,000 to the various accounting periods for which the copier is used. Remember, the copier has contributed in its own [page 185] way to the revenue that the business has earned. In order to obtain a fair representation of the way that the business operates, we must match as closely as possible the costs of an accounting period, with the revenue earned in that period, in order to determine the true profit for the period.

4.4.2

WHAT HAPPENS WHEN YOU BUY AN ASSET — THE RECORDING SYSTEM

In the case to date, we have provided the historical cost of the photocopier as being $10,500, without informing you as to how we arrived at that number, nor how an entity might include that number in its accounting system. The historical cost represents the cash flow relating to the cost of an asset, such as a photocopier. Therefore, a user of the information would assume that the photocopier cost $10,500, and there would be a cheque made out for that value. However, decisions regarding the real cost of an asset are not always that simple. For example, let us assume that we bought the photocopier from Australia for NZ$9,000, but it cost $500 to ship it to New Zealand, and a further $1,000 to set up the wiring so that the computer network would be able to access the photocopier. The costs associated with “bringing the asset to the location and condition necessary for it to be capable of being operated

in the manner intended by management” (NZ IAS 16, paragraph 16(b)), are to be included. But what if the importation of the photocopier required the construction of a special space? What about lost income for GlobeNet Communications? What if the owners of GlobeNet Communications wanted to have a party to celebrate the arrival of this fantastic piece of equipment? Generally speaking, items such as site preparation, construction and installation, and testing costs are all added to the original cost of the asset. However, things such as opening costs, and postinstallation repairs would not be capitalised with the asset. It is possible that some serial numbers may be missing. This is because these assets may belong to other classes of asset. In some businesses, you will see the serial number of your asset as a barcode on the asset.

Once we have decided upon a cost of the equipment, we need to “account” for the asset in our accounting system. Some form of identification mechanism is required to identify the asset, and a register of identified assets (a fixed asset register) needs to be maintained. This register contains the working copies of historical cost, accumulated depreciation, and holding value of each asset. Each class of assets is then totalled, and used for note purposes in the annual accounts. GlobeNet Communications might choose to add the photocopier to a class of assets known as “office equipment”. Refer to the tax tables provided in Resource file 4, paragraph 4.10.2. If we were to base our asset depreciation rates on tax rates, should the “power supply” be included with other computer equipment? Description

Serial number

Cost price

Date purchased

Remarks

$ Power supply

721

890

01/10/2008

Personal computer

722

2,500

01/10/2008

Software

723

1,000

01/10/2008

Telephone system

729

490

28/08/2008

Fax

730

450

15/10/2008

Refrigerator

732

900

12/04/2010

Photocopier

733

10,500

11/04/2010

Added modem 1/02/2009

[page 186]

4.4.3

A WORD OR TWO ABOUT ESTIMATES

Before we look at the way in which the depreciable amount can be allocated to accounting periods, we should be clear about the estimates being made. We estimate both the useful life of the asset, and the residual value. These estimates must be informed estimates, taking due regard of manufacturer’s technical specifications and the opinions of experts, or drawing on the result of experience. The actual depreciable amount to be allocated may be influenced by wear and tear, technological or market obsolescence, or the passage of time. If circumstances turn out to be different from what we expected initially, we should revise the estimate of useful life, and adjust our cost allocation accordingly. We should also note that the useful life of an asset will often be much shorter than its actual physical life. Can you explain why?

4.4.4

ALLOCATING THE DEPRECIABLE AMOUNT

There are a number of acceptable methods for determining the amount of depreciation for any given accounting period. We will consider three possible methods, and examine the circumstances in which each might be used.

4.4.4.1

Straight-line (fixed instalment) method

“Carrying amount” is the historical cost of the asset less depreciation provided to date. Many businesses still use the term “book value”, which has been replaced in the accounting standards by the term “carrying amount”.

With the straight-line method, depreciation is calculated at a constant rate. It is based on the assumption that the services from the asset accrue evenly over its useful life. This is a reasonable assumption for many assets, especially those where usage will not vary from period to period — for example,

buildings, leases, and fittings and furniture. With this method, the same amount is allocated each year. Applying this to our case study, if we decided that the useful life of the copier was five years, we would allocate one-fifth of the depreciable amount each year — that is, one-fifth of $10,000, which equals $2,000 per year.

4.4.4.2

Diminishing value (reducing instalment) method

Note that it is acceptable to round the cost allocation to a whole dollar. Note that, in the first year, the carrying amount is the same as historical cost.

The diminishing value method apportions cost by progressively smaller instalments each year, based on the assumption that the services from the asset diminish steadily throughout the asset’s life — that is, the asset becomes less efficient as time goes by. This may well be the case with machinery and vehicles. With this method, the annual depreciation charge is calculated on the carrying amount (the book value or written down value) of the asset. Such an allocation is essentially arbitrary, but is quite popular because of its acceptability for tax purposes for many assets. Can you now calculate the depreciation for 2014 and 2015? You should get the following: 2014: $907; 2015: $544. What is the carrying amount at the end of 2015?

If we were to apply this to our case study, we would need to establish the rate that would be consistent with the depreciation of this type of asset. If the rate of depreciation was 40%, the cost allocation for the various years would be as follows: cost allocation = carrying amount × depreciation rate

2011: $10,500 × 40% = $4,200 2012: ($10,500 - $4,200) × 40% = $2,520 2013: ($10,500 - $6,780) × 40% = $1,512 [page 187]

4.4.4.3

Units of use method

With the units of use method, the depreciation charge is based on the actual usage of the asset. It is appropriate where the output of the asset varies from period to period, and where it is intended that the asset will be disposed of once it has reached its estimated usage. To apply this method, we need to calculate a rate of depreciation per unit of usage, which is done as follows: depreciation per unit of usage = depreciable amount / estimated usage

The company estimated that the copier would be used for 3,000,000 copies; the depreciable amount is $10,000; therefore the rate of depreciation is calculated as: $10,000 / 3,000,000 = $0.0033 per copy. We then apply this rate to the actual usage, to get our cost allocation for each year. Hence: $ 2011

1,683 (510,000 copies x 0.0033c)

2012

2,178

2013

2,112

2014

2,145

2015

2,409

Clearly, the cost allocation differs each year, reflecting actual usage. Check the calculations for yourself before you go on.

4.4.5

WHICH METHOD SHOULD BE USED?

We have considered three methods for allocating the cost of a depreciable asset. Which method should be used? To answer this question, we need to consider some of the underlying principles and concepts that guide accountants wherever they have choices to make. We need to present a financial picture of an organisation that is a fair representation of the operations for the period under review. To do this, we

match as best we can the costs of the period against the revenue earned in that period. Accordingly, we should select a method of allocation that corresponds to the expected way in which the asset’s usefulness to the business (its service potential) diminishes. If the asset will give better service in the early years of use, then a method which provides for a higher allocation early on should be used. If the use of the asset is expected to vary significantly from year to year, and if loss of service potential is directly linked to use, then a “units of use” method would be appropriate. Once we have made a choice as to the method of allocation to be used, for the sake of consistency, we should stay with that choice. Clearly, different methods of cost allocation will give different annual charges against profit, and, consequently, different profit figures. Let us check this out. Assume that the 2015 net profit of GlobeNet Communications was $120,000 prior to providing for depreciation. If we were then to deduct depreciation under each of the three methods we considered, the final net profit would be: [page 188]

Profit

Depreciation

New profit

$

$

$

Straight-line method

120,000

2,000

118,000

Diminishing value method

120,000

544

119,456

Units of use method

120,000

2,409

117,591

Clearly, the amount of profit is influenced by the method of allocating depreciation. Further, the amount of profit influences how various parties view the success of the enterprise, and can influence their decision making. Consequently, it is not acceptable to chop and change the method chosen. This does not mean that a change can never be made. If a new method will give a fairer allocation of the depreciable amount, then a change in method

can be made. But the fact that the change has been made, and the effects of the change on profit and asset values, must be fully disclosed, so that users of the accounts are fully informed when interpreting the accounts for their decision making. It should also be noted that the end product of the allocations will be evened out by the actual cash flows — that is, when we actually sell the asset. If we were to compare values at the end of 2015 (when the copier was sold), we would have the following: StraightDiminishing Units of use line method value method method $

$

$

Copier at cost

10,500

10,500

10,500

Accumulated depreciation

10,000

9,683

10,527

Carrying amount

500

817

(27)i

Less Inflow of sale

1,000

1,000

1,000

500

183

(928)

Profit/(loss) i

Obviously an asset cannot have a negative book value. However, this example is included because it emphasises the need for constant revision of estimates to ensure that allocations are consistent with expectations.

A review of all this information shows that, at the end of the life of the asset, the allocated cost for each style of depreciation is $9,500. The only difference relates to the timing of when depreciation is to be allocated. One could also see that a low carrying rate might lead to less effort to obtain the best price for the sale of the asset.

4.4.6

HOW DO WE DISCLOSE DEPRECIATION IN THE ACCOUNTS?

Depreciation is an expense and, as such, will appear in the income statement

under whatever classification is appropriate to the asset to which the depreciation relates. For example, depreciation on cars used by sales people would be a selling expense, while that on managers’ cars would be an administration expense. Depreciation also has the effect of reducing the carrying amount of the asset concerned. This effect is cumulative. Accordingly, accumulated depreciation is deducted from the historical cost of the appropriate asset in the balance sheet. [page 189] The following accounting equation shows only the purchase of the photocopier in April 2011: Assets +

Expenses =

Bank

Photocopier

(9,000)

9,000

(500)

500

(1,000)

1,000

(10,500)

10,500

Liabilities +

Revenue +

Owner’s equity

Sales

Accounting equation at the end of the 2011 year (relating to the photocopier only): Accumulated depreciation increases (that is, is positive), although the effect on the accounting equation is negative. Accumulated depreciation is treated as a negative asset. Assets + Bank

Photocopier

Expenses = Accumulated depreciation

Liabilities +

Revenue +

Owner’s equity

Sales

10,500 10,500

i

(4,200)

4,200i

(4,200)

4,200

depreciation

Accounting equation at the end of the 2012 year (relating to the photocopier only): Can you analyse the allowance for depreciation in terms of the accounting equation for the next three years?

Assets Bank

+

Photocopier

Expenses = Accumulated depreciation

Liabilities +

Revenue +

Owner’s equity

Sales

10,500 (4,200) 10,500

i

(2,520)

2,520i

(6,720)

2,520

depreciation

Note that depreciation is $2,520, while accumulated depreciation is $6,720. This occurs as a result of the depreciation calculations at the end of each year. The worksheets above indicate how depreciation is analysed through the accounting system. Let us now see what the balance sheet would look like for our photocopier. In this example, we are focusing on one asset. Normally you would show the total for property, plant, and equipment. GlobeNet Communications Ltd Balance sheet As at 31 March 2011 Notes

$

Non-current assets Property, plant, and equipment

1

6,300

[page 190] Policies note b. Property, plant and equipment Property, plant, and equipment are stated at cost and, other than land and buildings, are depreciated on a diminishing value (DV) basis. Buildings are considered to have a useful life of 50 years. The depreciation rates have been estimated as follows:

Buildings

2% on cost

Office equipment

33 ⅓% DV

Motor vehicles

20% DV

Furniture and fittings

10% DV

Plant and equipment

20% DV

All assets are included at acquisition cost less subsequent depreciation. Notes to the accounts Note 1 Asset

Plant and equipment

Cost

Accumulated depreciation

Carrying value

$

$

$

10,500

4,200

6,300

And after the next year: GlobeNet Communications Ltd Balance sheet As at 31 March 2011 Notes

$

Non-current assets Property, plant, and equipment

1

3,780

The policies and notes would be similar to those shown above. Now let us see some other examples of notes referring to the way depreciation may be noted in published accounts. Where the business owns many assets, it will be more convenient to have a fixed asset and depreciation schedule showing all the details, with summary figures appearing only in the balance sheet itself. The following is taken from the balance sheet of Auckland International Airport Limited for the year ended 30 June 2013: GROUP

PARENT

NOTES

2013 $000

2012 $000

2013 $000

2012 $000

Property, plant and equipment

11

3,020,247

3,021,865

3,020,247

3,021,865

Investment properties

12

635,902

579,783

635,902

579,783

Non-current assets

[page 191] Read the accounting policy note in 2.8.2.2 of Auckland International Airport Limited’s 2013 Annual Report, and note the difference between the valuation of some assets at historical cost, and some assets at revaluation (fair value).

An extract of note 11 of the accounts is reproduced below. It gives full information about the property, plant and equipment assets, accumulated depreciation, depreciation provided in the current year, disposals, and additions during the 2013 year. 11. Property, plant and equipment a / Reconciliation of carrying amounts at the beginning and end of the year GROUP AND PARENT

Year end 30 June 2013

Buildings and services Infrastructure $000 $000

Land $000

Runway, taxiways Vehicles, and plant and aprons equipment $000 $000

Total $000

Balances as at 1 July 2012 At fair value

1,908,808

520,859

285,045

280,012

-

2,994,724

At cost

-

-

-

-

65,710

65,710

Work in progress at cost

-

27,220

5,627

33,158

1,893

67,898

Accumulated depreciation

-

(33,706)

(10,778)

(12,899)

(49,084)

(106,467)

1,908,808

514,373

279,894

300,271

18,519

3,021,865

144

22,085

3,964

21,281

9,782

57,256

3,187

-

-

-

-

3,187

Disposals

-

-

-

-

(7)

(7)

Depreciation

-

(31,752)

(10,635)

(12,898)

(6,768)

(62,053)

3,331

(9,667)

(6,672)

8,383

3,007

(1,617)

1,912,139

546,442

286,226

298,381

-

3,043,188

At cost

-

-

-

-

70,021

70,021

Work in progress at cost

-

23,723

8,408

35,636

7,356

75,123

Accumulated depreciation

-

(65,459)

(21,412)

(25,363)

(55,851)

(168,085)

Balances as at 1 July 2012 Additions Transfers from/(to) investment property

Movement to 30 June 2013 Balances as at 30 June 2013 At fair value

Balances as at 30 June 2013

1,912,139

504,706

273,222

308,654

21,526

3,020,247

As a continuation of note 11, which has not been included, Auckland International Airport Limited describes how the fair value was obtained for: land; buildings and services; infrastructure; and runways, taxiways, and

aprons. The company also provides a further note showing the carrying amounts of the revalued assets, if they were to be measured at historical cost less accumulated depreciation. The total value of the revalued assets, and vehicles, plant and equipment using historical cost, would be $187,074,0 0 0 (compared to $3,020,247,000 above). Think about the impact this will have on the financial statements. The total asset value of the entity will be increased, and the amount of depreciation will also be increased, which reduces the net profit. [page 192]

4.4.7

TAXATION LAW AND TAXATION RATES OF DEPRECIATION

IRD rates allow computer equipment to be depreciated over four years. How appropriate might this be for a plumbing business, which is able to use its computing system for eight years?

The Inland Revenue Department (IRD) sets the maximum rates of depreciation which are allowable for taxation purposes. These rates vary for each type of asset. Examples of taxation rates are contained in Resource file 4, paragraph 4.10.2. Many accountants choose to use the IRD-approved rates for financial reporting purposes, but such rates should not be regarded as a substitute for informed judgment in a particular case. Remember, the accountant is charged with a responsibility for allocating costs so as to report a true and fair view of the business’s operations for the year. Consequently, two sets of accounts may be prepared in some cases — one for taxation purposes, which complies with taxation requirements; and one for management. Andrew offered the comment that the accountant charged different rates of depreciation for him than those specified by the IRD. Resource file 4, paragraph 4.10.2, contains rates of depreciation allowed by the IRD for

computer equipment. For ease of use, we will use only the estimated useful life as a basis of comparison. Routers and modems are the types of computer equipment that we might expect GlobeNet Communications to own in the provision of internet services. What is the estimated useful life for these assets according to the IRD? GlobeNet Communications makes heavy use of its computer equipment, and expects to benefit from it for a maximum of two to three years. Andrew needs to see accounts which show the “real” usefulness to him of the equipment, and not the arbitrary rate prescribed by the IRD.

4.4.8

WHAT ARE THE EFFECTS OF PROVIDING FOR DEPRECIATION IN THE ACCOUNTS?

We have already established that depreciation is part of the process of cost allocation — that is, the allocation of that part of the cost of a depreciable asset that has been consumed in a given accounting period. We have also established that depreciation affects the balance sheet valuation of the asset concerned, by recognising the decline in value of the asset. Our study of depreciation should also have reinforced our understanding of the historical cost concept on which financial reports are based. But we can now see that the balance sheet value of an asset is not the market value, but the unexpired or unallocated historical cost of the asset. It is important to appreciate this when trying to draw conclusions about the financial structure of an organisation with reference to the balance sheet. Providing for depreciation has two direct effects on the accounts: the net profit is reduced, and the carrying values of the asset in the balance sheet are also reduced. A third significant effect of providing for depreciation is that it retains funds in a business.

4.4.9

A CASE STUDY — TAGHI DERHAMY

Let us illustrate this point with a simple case study. Taghi Derhamy’s business has capital of $50,000, represented by current assets of $20,000, and property, plant, and equipment of $30,000. Taghi has a policy of limiting his drawings to a maximum of the net profit for the year. This is not a bad rule to follow if the business is adequately funded [page 193] in terms of the debt/equity ratio. If the business is inadequately funded, an attempt should be made to retain profits in the business, rather than draw them out. Suppose Taghi’s profit for the year before providing for depreciation was $15,000, all in cash. How will this affect the balance sheet? Capital would increase by $15,000 (increase in owner’s equity); and current assets (bank) would increase by $15,000 (increase in assets). Now let us allocate $5,000 depreciation for the year. This means the profit will drop to $10,000. However, the amount of money in the bank does not change. Rather, the carrying amount of the non-current assets (fixed assets) will fall by $5,000. So let us compare the two balance sheets as they would look if no depreciation were allowed for, compared to if it were allowed for. Remember that Taghi takes out the full amount of profit in cash. Taghi Derhamy Comparative balance sheets As at 1 April 2015 No depreciation $

$

Depreciation $

Assets Property, plant, and equipment

30,000

25,000

$

Bank

20,000

30,000 50,000

55,000

Equity Capital

50,000

50,000

Net profit

15,000

10,000

Less Drawings

(15,000)

(10,000) 50,000

55,000

What does this mean? Provided drawings do not exceed the annual profit, the effect of depreciation is to retain funds within the business equal to the amount of depreciation provided. From another point of view, if depreciation were not provided for, then a proprietor who withdrew all of the reported profits, would be steadily eroding the capital base of the business, because the non-current assets would be steadily diminishing in value. The financial reports would certainly not be showing a fair view. Does this mean that depreciation provides funds for replacing the noncurrent assets? No, not unless there is a special fund set up. In our example, there would be cash available for asset replacement (assuming the assets could be replaced for their historical cost), but only because we assumed that all revenues and expenses (other than depreciation) had been cash transactions. If these were credit transactions, and if the business held inventories, then the profit would not be a cash profit. In such a case, the current assets would still increase as a result of depreciation, but not wholly (or not at all) through more cash in the bank. What assets do you think could increase instead? [page 194]

4.5

Valuation of inventories

Most businesses carry inventory (or stock) of one kind or another. Retailers

and wholesalers have stocks of the goods they sell. Manufacturers have stocks of raw materials, as well as of partly completed items (work in progress), and of completed products. Many businesses have stocks of supplies of various sorts, such as stationery. The level of inventory an entity carries can have a major effect on both the financial stability and the profitability of the business. The importance of getting the inventory level right, and of adequately controlling stock levels, is explored in more detail in Chapters 6 and 7. There are many important decisions to be made in this area, including the issue of valuing inventory. Valuing inventory is an important accounting function because, if inventory is incorrectly valued, the reported profit of the business will be incorrect, as will the level of current assets on the balance sheet. This, in turn, may lead to inappropriate decision making because of poor information. Inventory may be incorrectly valued for two main reasons: errors may have been made in counting the stock; or incorrect values may be attached to existing stock. If inventory is undervalued or short-counted, it will result in the cost of goods sold being overstated, with the consequent effect of gross and net profit being understated. Current assets will also be understated. The reverse will be true if inventories are overvalued or extra-counted. These effects are illustrated in the following table. Comparison of net profit calculations based on different inventory valuations Column A $ Sales

Column B $

$

400,000

$ 400,000

Less Cost of goods sold Inventory 1/4/2014

45,000

45,000

Plus Purchases

175,000

175,000

Less Inventory 31/3/2015

(50,000)

(40,000) (170,000)

(180,000)

Gross profit

230,000

220,000

Less Expenses

(120,000)

(120,000)

Net profit

110,000

100,000

Column A shows the calculation of net profit when closing inventory is valued at $50,000; and Column B shows the net profit when the correct value of $40,000 is used. Clearly, with inventory on hand at 31 May 2015 overvalued by $10,000, the net profit of the business is reported as $10,000 more than it should be. What are some of the consequences of reporting a profit that is too high? Given that this year’s closing inventory is next year’s opening inventory, the incorrect valuing of the closing inventory will in fact affect next year’s profit as well. Will next year’s profit be overstated or understated? Work it out using an example similar to the one above. [page 195]

4.5.1

WHAT VALUE SHOULD BE ALLOCATED TO INVENTORY?

You may be wondering how it is that an incorrect value can be assigned to inventory. Surely, if the stock is counted accurately, it is only a simple matter of looking up what the stock cost the business, item by item? Unfortunately, it is not that easy. Let us look at a simple illustration. A car accessory firm has 20 units of a particular brand of mirror on hand at balance date. Purchase records show that these mirrors were acquired on three occasions during the last year, with a total purchase cost of $1,180. During the current year, the entity sold 86 mirrors for $25 each. Calculate the gross profit from selling these 86 mirrors, assuming that we chose each of the following values to calculate the value of the 20 units on hand at balance sheet date: (a) $13; (b) $15; and (c) $16. The solution is: (a) $840; (b) $880; and (c) $900.

20 units were bought on 16 May for $15 each; 16 units were bought on 3 August for $15 each; and 40 units were bought on 11 November for $16 each.

In addition, there were 30 units of stock carried forward from the previous year. These had been valued at $13 each, with a total value of $390. The question is: what cost figure do we use for the 20 units on hand at 31 March this year? The profit we end up reporting will depend on the value we select. How common is this situation likely to be in reality? Very common indeed. So long as purchase prices change in the course of the year (and they do with general inflationary trends, or with exchange rate fluctuations, or even with changes in the competitive environment), and stock is being purchased throughout the year, this valuation problem will arise.

4.5.2

WHAT IF THE INVENTORY HAS DETERIORATED OR BECOME OBSOLETE?

A further problem with valuing inventory arises when the particular stock items are subject to deterioration or obsolescence. In such cases, valuing the items at cost would not be appropriate if they could only be sold at a lower price. Fortunately, the accounting standards have provided a way to deal with these valuation dilemmas. The New Zealand Equivalent to International Accounting Standard 2 Inventories (NZ IAS 2) defines inventories as follows: Inventories are assets: (a) held for sale in the ordinary course of business; or (b) in the process of production for such a sale; or (c) in the form of materials or supplies to be consumed in the production process or rendering of services.

(NZ IAS 2, paragraph 6) NZ IAS 2 further provides that “[i]nventories shall be measured at the lower of cost and net realisable value” (paragraph 9). In this context, cost includes the costs of purchase of the stock, conversion costs, and any other costs incurred in bringing inventory to their present location and condition.

“Purchase cost” is taken to include not only the purchase price, but also transport and handling costs, and any other direct costs of acquisition. Let us take a look at some examples. [page 196] Example 1: Andrew has accepted a job to provide printed advertising materials for one of his clients. The advertising materials are to be stored by Andrew, and sold to the client when required. The paper used for the job represents one part of the stock value. There are also costs associated with printing and design, which need to be added to the value of the stock. There should also be some allocation of the costs of running the business (refer to Chapter 6). Example 2: GlobeNet Communications has stocks of a now superseded line of cellphones. These cost the firm $200 each, but it is expected that they could only be sold for $90 each, because the new models are so much better and more competitively priced. In this case, the cellphones would be valued in the accounts at $90 each. Therefore, NZ IAS 2 provides guidance for dealing with those situations where the stock we hold is unlikely to fetch its cost price when sold. It will be valued at its estimated selling price, which would be based on the most reliable evidence available at the time. The term net realisable value refers to the estimated selling price of the stock in the ordinary course of business, less any costs that might have to be incurred to complete the goods or to make the sale.

4.5.3

WHAT IF INVENTORY IS ACQUIRED AT DIFFERENT PRICES?

We still have not solved the problem raised earlier as to what cost figure to select if the business has acquired stock at different prices in the course of the year. This decision will need to be supported by an appropriate accounting policy. NZ IAS 2 lists the policies acceptable in New Zealand as follows: specific identification (NZ IAS 2, paragraph 23); first-in, first-out (FIFO) (NZ IAS 2, paragraph 25); and weighted average cost (NZ IAS 2, paragraph 25). Each of these policies will have a different effect in terms of the stock value arrived at, and consequently the amount of profit reported. These effects are illustrated in the examples that follow. Whatever policy is adopted, it must be applied consistently. Any change in policy must be fully disclosed by way of notes to the accounts, setting out the financial effects of the change.

4.5.3.1

Specific identification

Specific identification applies when it is possible to ascertain the actual cost of a given item of stock from purchase records. This may well be possible where a firm deals with, say, expensive machinery that turns over slowly. Another example would be that of a motor vehicle dealer who is able to track each individual vehicle.

4.5.3.2

First–in, first-out (FIFO)

The first-in, first out formula makes the assumption that the stock first bought, is the stock first to be used or sold. This is a reasonable assumption which keeps inventory values close to current prices. Let us work through a simple example to show how the first-in, first-out formula works. A hardware firm recorded the following stock movements for socket sets for the month ended 30 April 2014: [page 197]

stock on hand at 1/4/2014: 50 sets costing $20 each; during April, the following additional stocks were purchased: – 10 April: 40 sets costing $20 each; and –

23 April: 40 sets costing $25 each;

sales for each week in April were: – week ending 6 April, 20 sets; –

week ending 13 April, 30 sets;



week ending 20 April, 25 sets; and



week ending 27 April, 15 sets.

We can see that total stock available for sale during April was 130 sets, and that 90 sets were sold. This means that stock on hand at 30 April comprised 40 sets. If the first stock acquired was the first to be sold, then we assume that all the stock on hand at 1 April has gone, as has all the stock acquired on 10 April. This then leaves the stock acquired on 23 April, which cost $25 each. Therefore, our inventory at 30 April would be valued at $1,000 (40 x $25). Cost of sales is $1,800 (total stock $2,800 less stock on hand $1,000).

4.5.3.3

Weighted average cost (WAC)

With the weighted average cost method, a new calculation of the average cost of the inventory held is made at the time each new acquisition is made. This average cost is then applied until a new order is received. We can see that, in the case under discussion, when stock prices are increasing, this method provides a valuation that is lower than under FIFO. To determine the weighted average cost: 1.

find the average stock price; and

2.

divide the total value of stock by the number of items (total value of stock $2,800 divided by 130 items).

Therefore: $2,800 / 130 = $21.538; stock on hand = $21.54 x 40 = $861.60; cost of sales = $2,800 - $861.60 = $1,938.40.

4.5.3.4

Concluding comments

It is clear from the above examples that the decision as to the method of cost determination, will affect the reported profit and the inventory figure in the balance sheet. Similarly, correctly choosing to value stock at cost, or at net realisable value, is essential to providing a fair representation for the period, in order to provide quality information for decision making.

4.5.4

HOW DO WE DISCLOSE INVENTORY VALUATION IN THE NOTES?

The two items below have been taken from notes to the balance sheet of Fletcher Building Limited for the year ended 30 June 2013. The following explanation is included in the statement of accounting policies, setting out how inventories are valued in the financial statements. This company uses the lower of cost based on FIFO, or net realisable value as required by NZ IAS 2. [page 198]

Stocks Trading stock, raw materials and work in progress are valued at the lower of cost or net realisable value, determined principally on the first-in, first-out basis. Cost includes direct manufacturing costs and manufacturing overheads at normal operating levels.

Note 17 in the accounts discloses how the total inventory figure in the balance sheet is made up of raw materials, work in progress, finished goods, and consumable stores and spare parts. The note also includes details about the

future commitment to purchase land for residential construction — land being part of stock for this building company. 17 Stocks Fletcher Building Group June 2013 NZ$M

June 2012 NZ$M

Raw materials

300

338

Work in progress

138

126

Finished goods

856

912

59

58

1,353

1,434

1,252

1,351

101

83

1,353

1,434

Consumable stores and spare parts Stock held at cost Stock held at net realisable value

Fletcher Building Limited June 2013 NZ$M

June 2012 NZ$M

The group also has conditional commitments for the purchase of land to be used for residential construction totalling $192 million (June 2012: $42 million). Delivery of this land is expected to take place in the period to September 2017.

4.6

Valuation of accounts receivable

We saw in Chapter 3 that, if a debtor proves to be a bad debt, the decision will be made to write off the account, and thereby reduce the dollar value of accounts receivable in the balance sheet. The decision to write off an account will not be taken lightly. Every effort will have been made to collect the debt (we examine accounts receivable management in Chapter 7), and it will be clear that the entity is simply not going to see its money. At any point in time, it is likely that some debtors will be well behind with their payments (we would see this in an aged listing of debtors), and that actions are underway to chase up slow payers. Experience tells us that some of these slow payers will not pay, and some of the overdue accounts will

definitely not be collected. It is important to take the probability of noncollection into account when reporting the value of accounts receivable. We do this by creating an allowance for doubtful debts. [page 199] The two items below have been taken from the notes to the balance sheet of Fletcher Building Group Limited for the year ended 30 June 2013. The following explanation is included in the statement of accounting policies of how debtors are valued in the financial statements. Debtors Debtors are valued at estimated net realisable value. The valuation is net of a specific provision maintained for doubtful debts. All known losses are written off to earnings in the period in which it becomes apparent that the debts are not collectable. Trade debtors normally have 30 to 90 day terms.

Note 16 to the accounts discloses how the total debtors figure in the balance sheet is made up of trade debtors, contract debtors, and contract retentions. An allowance for doubtful debts has been provided of $41 million, to ensure that the debtors are valued at an amount they are expected to realise. Fletcher Building Group Limited also includes an aged list of debtors. This enables the reader to understand how much of the total debtors figure relates to slowpaying debtors. 16 Debtors Fletcher Building Group June 2013 NZ$M

June 2012 NZ$M

1,071

1,168

Contract debtors

95

89

Contract retentions

18

27

(41)

(47)

Trade debtors

Less provision for doubtful debts

Fletcher Building Limited June 2013 NZ$M

June 2012 NZ$M

Trade and contract debtors

1,143

1,237

203

223

26

27

1,346

1,460

26

27

Current

815

906

0–30 days over standard terms

255

267

31–60 days over standard terms

43

42

61+ days over standard terms

71

69

(41)

(47)

1,143

1,237

Other receivables

Provision Trade and contract debtors

[page 200]

4.6.1

ALLOWANCE FOR DOUBTFUL DEBTS

Let us see how the allowance for doubtful debts works by making use of the accounting equation. In this example, we will focus on a particular debtor for ease of explanation. Generally, the allowance is made relating to total debtors. Suppose Globe Net Communications has a debtor, Peter Dixon, who owes $300 for goods sold to him on credit. Initially, this would have been analysed for purposes of the accounting equation as: Assets +

Expenses =

Liabilities +

Revenue +

Accounts receivable

Sales

300

300

Owner’s equity

Remember, the costs incurred in earning the revenue must be recognised for the period being reported on.

If we do not believe we will get the money owed, but we have not yet exhausted our collection efforts, we will need to cancel the asset account, as well as the revenue. We therefore create a new expense account which we call “doubtful debts”, and a negative asset account which we call “allowance for

doubtful debts”. We cannot just cancel Peter Dixon’s account, because we are still trying to collect the money — we have not totally given up yet — but we need to take the probable bad debt into account in the current period, rather than waiting. The effect on the accounting equation will be: Assets +

Expenses =

Allowance for doubtful debts

Doubtful debts

(300)

Liabilities +

Revenue +

Owner’s equity

Sales

300

Clearly, so far as the income statement is concerned, there will now be no effect on profit from the initial credit sale, because we have created an expense amount which is equal to the initial revenue amount recorded. So far as the balance sheet is concerned, we deduct the allowance for doubtful debts from the total of accounts receivable, to give a more accurate value of that asset. The doubtful debtor, Dixon, is still included in the total of accounts receivable ($26,400). If the account is actually written off, it is removed. The balance sheet figure for accounts receivable now shows what we expect to collect. GlobeNet Communications Ltd (extract) Balance sheet As at 31 March 2015 $

$

Current assets Accounts receivable Less Allowance for doubtful debts

26,400 (300) 26,100

[page 201]

4.6.2

HOW DO WE ARRIVE AT THE FIGURE FOR DOUBTFUL

DEBTS? This is another area where professional judgment needs to be exercised, and will depend upon the sophistication of the accounting system that is operating. If the accounting system is able to generate a report on the currency of each individual debtor’s account (an aged listing of debtors), then this can be used to identify those unlikely to pay. There will still, however, be judgment involved, and we would need to take into account any known facts about the circumstances of the debt. Another approach would be to take a percentage of the total accounts receivable or of credit sales as being doubtful. Such percentages would be based on past experience, and would be arrived at following an analysis of actual bad debts. With this approach, it is necessary to review the percentage in light of changes in credit policy (see Chapter 7), and of the overall state of the industry in which we are operating. For example, we are likely to face more bad debts in times of economic downturn than in buoyant times.

4.6.3

HOW IMPORTANT IS IT TO TAKE DOUBTFUL DEBTS INTO ACCOUNT?

Why can we not just wait until doubtful debts become bad debts, and deal with them then? Simply because, to do so, would be to mislead those reading the financial reports and making their decisions on the basis of those reports. Reports that do not take into account doubtful debts, would not provide a fair representation of the accounts; the profit figure would be overstated, and working capital would be overstated, leading to a more favourable assessment of financial stability than would be warranted. Indeed, it is even more complicated than this. If we did not take doubtful debts into account, we would more likely than not distort the accounts for two accounting periods. Let us illustrate this, by adding some more detail to

the Peter Dixon example in paragraph 4.6.1 above. Suppose we initially sold goods to Dixon on 10 December 2014. At 31 March 2015, he has still not paid, having ignored all of our reminders to date. On 3 July 2015, we learn that Dixon has been adjudged bankrupt, and has no money to pay his debts. We write his account off at this stage. Let us analyse what has happened, and what the effects are of doing nothing until 3 July. The year to 31 March 2015 will include $300 revenue arising from the sale to Dixon. The year to 31 March 2016 will have a $300 expense (bad debts) offset against the revenue for that period. Clearly, the 2015 year will have its profit overstated, but the 2016 profit will be understated. Whether or not this would matter, depends on the materiality of the amounts involved. It is not inconceivable for very large amounts to be involved, with potential to significantly affect the decision making. What happens then when we do create an allowance for doubtful debts? Let us recap. The 2015 accounts will see the $300 revenue from the sale offset by the $300 expense (doubtful debts). Revenue and expense will be correctly matched. In 2016, when Dixon’s account is actually written off, we will remove Dixon from our schedule of accounts receivable, and we will remove that part of the allowance for doubtful debts that applies to Dixon’s account. In this way, there is no impact on this year’s profits, and we end up with the correct amount for accounts receivable in our balance sheet. [page 202] This section of the chapter has examined the issue of valuation of accounts receivable — specifically the process of providing for doubtful debts. Clearly, it is important to minimise bad debts, which requires the entity to pay attention to credit management.

4.7

The statement of accounting policies

Many people think of accounting as involving a set of specific, rigid rules, used to produce financial reports with some sort of mathematical precision. Yet, throughout this chapter, we have seen that the accounting rules for valuing assets allow for considerable variation, and leave much to the judgment of individual business managers. As a manager, you could be involved in making judgments such as: Should we depreciate this machinery over four years or over six years? What can we expect to sell this machinery for at the end of its useful life? How much should we write off as bad debts? What is the net realisable value of certain inventory? We have also seen that these different management decisions can cause company profits to differ significantly. This poses a challenge to the concept of comparability. How can readers of a company’s financial statements meaningfully compare that company with its competitors? If company management changes its mind on how to value assets, how do readers meaningfully compare that company’s results for one year to those for another? The answer to this challenge lies in the statement of accounting policies. So far you have been introduced to four financial statements that make up a business’s set of financial statements: the income statement, the balance sheet, the statement of changes in equity, and the statement of cash flows. However, more is required. The statement of accounting policies alerts readers to the rules and assumptions under which the other statements have been prepared. Different companies adopt different approaches and make different assumptions in preparing their financial statements, making it essential that readers understand these points of difference. If one fishing

company depreciates its trawlers over 20 years, and another over 30 years, we cannot fairly compare their reported profits. In assessing the financial stability and performance of a business, readers of financial statements focus on the balance sheet and income statement. The lesson of this chapter is that these statements are heavily influenced by the estimates and other management judgments made in valuing assets. Only a close review of the statement of accounting policies will alert readers to these judgments, and allow their assessment to be an informed one.

4.8

Conclusion

Many people think of accounting as involving a set of specific, rigid rules, used to produce financial reports with some sort of mathematical precision. Yet, throughout this chapter, we have seen that the accounting rules for valuing assets allow for considerable variation, and leave much to the judgment of individual business managers. We have [page 203] also seen that these different management decisions can cause company profits to differ significantly, posing a challenge to the concept of comparability. We have looked at four areas of routine professional judgment, namely: decisions regarding the recognition of revenues and expenses; decisions concerning the depreciation and valuation of non-current assets; decisions concerning the valuation of inventories; and decisions concerning the valuation of accounts receivable.

We have been alerted to the fact that different decisions (or wrong decisions) in these areas, will have two general effects: an income statement effect — reported profit will either be higher or lower compared with an alternative decision; and a balance sheet effect — our understanding of aspects of the financial stability of the organisation may be different, because the statement figures on which we base such understanding will be different. We have been introduced to the statement of accounting policies, which alerts users of financial statements to the rules and assumptions under which the other statements have been prepared. As financial statements are heavily influenced by the estimates and other management judgments made in valuing assets, only a close review of the statement of accounting policies will alert readers to these judgments, and allow their assessment to be an informed one.

4.9

Key words 4

accrual basis of accounting (accrual accounting)

Under the accrual basis of recognition, the effects of transactions are recognised when they occur, not necessarily when cash changes hands. They are included in the accounting records in the accounting periods to which they relate.

aged listing of debtors

A report listing a detailed account of debtors of an entity, how much they owe, and when they are supposed to complete payment.

amortisation

The allocation of the depreciable amount of an intangible asset over its useful life. (By

contrast to depreciation, which relates to property, plant, and equipment.) bad debts

Amounts owed by individual debtors that they are unable or unwilling to pay. If, after having attempted to collect the debt, the business finds that the debt is unrecoverable, the amount is written off — that is, the debtor’s account is closed. The bad debt is treated as an expense, which has the effect of reducing the net profit. [page 204]

carrying-amount-book value, written down amount)

The amount at which an asset is recognised after deducting any accumulated depreciation (NZ IAS 16, paragraph 6) — therefore the historical cost of the asset less any accumulated depreciation.

conversion cost

When applied to inventory, this includes the cost of direct labour and subcontract work, as well as other production costs, but does not include general administration, financing, marketing, or distribution costs.

cost of inventories

The total cost of purchasing the stock, of converting the stock into a manufactured product, and other costs incurred in bringing the stock to its present location and condition. When applied to inventory, it includes not only the purchase price inclusive of import duties and taxes (but not

GST), but also transport and handling costs, and any other costs directly attributable to acquisition. If trade discounts, rebates, or subsidies apply to the stock, these are deducted from the cost of purchase. depreciable asset

An asset which is expected to last more than one accounting period, has a limited useful life, and is held by the entity to produce or supply goods or services, or to provide administrative service. Not all fixed assets are depreciable assets (refer to the accounting policies in Resource file 4, paragraph 4.10.1).

depreciation

The wearing out, consumption, or other loss of value of an asset, which may arise from use, passage of time, or obsolescence. It is accounted for by the allocation of the depreciable amount of the depreciable asset over its useful life.

diminishing value (reducing A method of determining depreciation for instalment) purposes of cost allocation, in terms of which cost is apportioned by progressively smaller instalments each year, based on the assumption that the services from the asset diminish steadily throughout the asset’s life — that is, the asset becomes less efficient as time goes by. [page 205] doubtful debts

Accounts receivable (debtors) in respect of

which there is doubt as to whether or not the full amount due will be collected. A small proportion of debtors are likely to default on their obligations in spite of the business’s best efforts at credit screening. Doubtful debts constitute an expense which is recorded each year in order to match costs with revenue. fair value

The price that would be received if an asset were to be sold in an orderly transaction (ordinary business transaction) between market participants at the balance sheet date.

first-in, first-out (FIFO)

A method of stock valuation that makes the assumption that the stock first bought, is the stock first to be used or sold. (Refer to NZ IAS 2, paragraph 25.)

inventories-inventory, stock)

Assets that are held by a business: (a) for sale on the ordinary course of business; or (b) in the process of production for such a sale; or (c) in the form of materials or supplies to be consumed in the production process or rendering of services. (NZ IAS 2, paragraph 6, definitions)

net realisable value

The estimated selling price of inventory in the ordinary course of business, less any costs of converting the stock into a saleable form,

and less any other costs that must be incurred to make the sale. NZ IAS 2

The New Zealand Equivalent to International Accounting Standard 2 Inventories. An accounting standard which prescribes the treatment for measurement of inventories in the financial statements.

[page 206] NZ IAS 16

The New Zealand Equivalent to International Accounting Standard 16 Property, Plant and Equipment. An accounting standard which prescribes the requirements for recognition, measurement, and depreciation of property, plant, and equipment.

property, plant, and equipment

Tangible items that: (a) are held for use in the production or supply of goods or services, for rental to others, or for administrative purposes; and (b) are expected to be used during more than one period. (NZ IAS 16, paragraph 6)

residual value

“The estimated amount that an entity would currently obtain from the disposal of [an] 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 expected life.” (NZ IAS 16, paragraph 6) specific identification

A method of stock valuation that applies when it is possible to ascertain the actual cost of a given item of stock from purchase records. (Refer to NZ IAS 2, paragraph 23.)

statement of accounting policies

Alerts readers to the rules and assumptions under which the other financial statements have been prepared. Accounting policies are the “specific principles, bases, conventions, rules and practises applied by an entity in preparing and presenting financial statements” (NZ IAS 8, paragraph 5).

straight-line (fixed instalment)

A method for determining depreciation for purposes of cost allocation, in terms of which depreciation is calculated at a constant rate, with the result that the same amount is allocated each year.

unexpired cost

That proportion of the historical cost of an asset that has not yet been allocated to an accounting period as a charge against the revenue of that period. For a depreciable asset, it is calculated as historical cost less accumulated depreciation to date. [page 207]

units of use

A method for determining depreciation for purposes of cost allocation, in terms of which

the depreciation charge is based on the actual usage of the asset. It is appropriate where the output of the asset varies from period to period, and where it is intended that the asset will be disposed of once it has reached its estimated usage. To apply this method, we need to calculate a rate of depreciation per unit of usage, which is done as follows: depreciable amount / estimated usage. useful life

That period over which a depreciable asset is expected to give service to the entity; or the number of units of production or service that the asset is expected to generate for the entity.

weighted average cost

A method of stock valuation where a new calculation of the average cost of the inventory held is made at the time each new acquisition is made. This average cost is then applied until a new order is received. (Refer to NZ IAS 2, paragraph 25.)

4.10 4.10.1 4.10.1.1

Resource file 4 EXTRACTS FROM ACCOUNTING POLICIES Qantas 2013 — depreciation of property, plant, and equipment

Qantas sets out it policy regarding the depreciation of its property, plant, and equipment as follows in its 2013 Annual Report (Note 1(P)): Depreciation is provided on a straight-line basis on all items of property, plant, and equipment except for freehold land which is not depreciated. The depreciation rates of owned assets are calculated so as to allocate the cost or valuation of an asset, less any estimated residual value, over the asset’s estimated useful life to the Qantas Group. Assets are depreciated from the date of acquisition or, with respect to internally constructed assets, from the time an asset is completed and available for use. The costs of improvements to assets are depreciated over the remaining useful life of the asset or the estimated useful life of the improvement, whichever is the shorter. Assets under finance lease are depreciated over the term of the relevant lease or, where it is likely the Qantas Group will obtain ownership of the asset, the life of the asset.

[page 208] The principal asset depreciation periods and estimated residual value percentages are:

1

Years

Residual value (%)

Buildings and leasehold improvements

10–40

01

Plant and equipment

3–20

0

Passenger aircraft and engines

20–25

0–10

Freighter aircraft and engines

20–25

0–20

Aircraft spare parts

15–20

0–20

Certain leases allow for the sale of leasehold improvements for fair value. In these instances the expected fair value is used as the estimated residual value. Useful lives and residual values are reviewed annually and reassessed having regard to commercial and technological developments, the estimated useful life of assets to the Qantas Group and the long-term fleet plan.

4.10.1.2

Air New Zealand 2013 — policies

The following are extracts from Air New Zealand’s statement of accounting policies, included in its 2013 Annual Report:

REVENUE RECOGNITION Airline revenue Passenger and cargo sales revenue is recognized in revenue in advance at the fair value of the consideration received. Amounts are transferred to revenue in the Statement of Financial Performance when the actual carriage is performed. Unused tickets are recognised as revenue using estimates regarding the timing of recognition based on the terms and conditions of the ticket and historical trends. The Group operates various code share and alliance arrangements. Revenue under these arrangements is recognised when the Group performs the carriage or otherwise fulfils all relevant contractual commitments. Contract revenue Where contract related services are performed over a contractually agreed period and the amount of revenue, related costs and stage of completion of the contract can be reliably measured, revenue is recognized by reference to the stage of completion of the contract at balance date. Other contract related revenue is recognized on completion of the contract.

Investment revenue Dividend revenue is recognized when the right to receive payment is established. Interest revenue from investments and fixed deposits is recognized as it accrues, using the effective interest method where appropriate.

[page 209]

PROPERTY, PLANT AND EQUIPMENT Owned assets Items of property, plant and equipment are stated at cost or deemed cost less accumulated depreciation and accumulated impairment losses. Cost includes expenditure that is directly attributable to the acquisition of the item and in bringing the asset to the location and working condition for its intended use. Cost may also include transfers from equity of any gains or losses on qualifying cash flow hedges of foreign currency purchases of property, plant and equipment. Where significant parts of an item of property, plant and equipment have different useful lives, they are accounted for separately. A portion of the cost of an acquired aircraft is attributed to its service potential (reflecting the maintenance condition of its engines) and is depreciated over the shorter of the period to the next major inspection event, overhaul or the remaining life of the asset.

Leased assets

Leases under which the Group assumes substantially all the risks and new ards of ownership are classified as finance leases. All other leases are classified as operating leases. Upon initial recognition, assets held under finance leases are measured at amounts equal to the lower of their fair value and the present value of the minimum lease payments at inception of the lease. A corresponding liability is also established. Subsequent to initial recognition, the asset is accounted for in accordance with the accounting policy applicable to that asset.

DEPRECIATION Aircraft Depreciation of the aircraft fleet is calculated to write down the cost of these assets on a straight line basis to an estimated residual value over their economic lives. The aircraft and related engines, simulators and spares are being depreciated on a straight line basis as follows:

Air frame Engines Engine overhauls

10–22 years 5–17 years period to next overhaul

The residual values of aircraft are reviewed annually by reference to external projected values. Non-aircraft Non-aircraft assets are depreciated on a straight line basis using the following estimated economic lives:

Buildings Aircraft specific plant and equipment Non-aircraft specific leasehold improvements, plant, equipment, furniture and vehicles

50–100 years 10–20 years 2–10 years

Gains and losses on disposal are determined by comparing proceeds with carrying amounts. These are included in the Statement of Financial Performance.

[page 210]

4.10.2

IRD TAX TABLES — COMPUTER EQUIPMENT GENERAL DEPRECIATION RATES

The 20% depreciation loading doesn’t apply to assets acquired after 20 May 2010.

Est DV depn useful rate (%) life (years)

DV +20% loading (%)

SL depn SL +20% rate (%) loading (%)

Computers (COMP) Backup units (tape type)

4

50

60.0

40

48.0

6.66

30

36.0

21

25.2

Bridges

4

50

60.0

40

48.0

Cabling

6.66

30

36.0

21

25.2

CAD/CAM equipment

4

50

60.0

40

48.0

Communications controllers

4

50

60.0

40

48.0

Computer and associated equipment (used for typesetting)

5

40

48.0

30

36.0

Computer equipment (default class)

4

50

60.0

40

48.0

Control equipment (process, computer, if separately identified)

8

25

30.0

17.5

21.0

Data concentrators

4

50

60.0

40

48.0

Digitisers

4

50

60.0

40

48.0

Disk drives (for use with mini computers)

4

50

60.0

40

48.0

Disk drives (for use with personal computers)

4

50

60.0

40

48.0

EFTPOS terminals

4

50

60.0

40

48.0

Floors (for computer rooms)

20

10

12.0

7

8.4

Gas dowsing systems

20

10

12.0

7

8.4

4

50

60.0

40

48.0

6.66

30

36.0

21

25.2

4

50

60.0

40

48.0

Banknote dispensers

Laptop computers Mainframe computers Mini computers

Modems

4

50

60.0

40

48.0

Multiplexers

4

50

60.0

40

48.0

Network servers

4

50

60.0

40

48.0

Notebook computers

4

50

60.0

40

48.0

Personal computers

4

50

60.0

40

48.0

Plotters

5

40

48.0

30

36.0

Power conditioners

6.66

30

36.0

21

25.2

Power supplies (uninterruptable)

6.66

30

36.0

21

25.2

Printers

5

40

48.0

30

36.0

Routers

4

50

60.0

40

48.0

Scanners

4

50

60.0

40

48.0

6.66

30

36.0

21

25.2

4

50

60.0

40

48.0

Terminals (without capability of local storage capacity) Voice mail equipment

[page 211]

4.10.3

4.10.3.1

ARTICLES DISCUSSING THE ENTICEMENT COSTS OF SELLING CELLPHONES The Warehouse

We reproduce below extracts from two articles dealing with the way that The Warehouse, a company selling a wide range of consumer goods ranging from toys to clothing to appliances, accounted for some aspects of its performance through the recognition of its expenses. The first article is by Alan Robb, a then senior lecturer at Canterbury University, questioning The Warehouse’s approach; and the second is a response by Keith Smith, Chairman of The Warehouse. The issue addressed is that of deciding whether a loss on the sale of handpieces should be taken at the time of sale (expensed), or whether it can be carried over to the following months (capitalised).

Alan Robb’s article was titled “Why The Warehouse’s phone numbers still don’t add up”, and appeared in the National Business Review on 11 August 2000 at page 41. In my recent comment on The Warehouse Group accounts (National Business Review, July 14) I drew attention to the way the loss per cell-phone sold had apparently skyrocketed in the six months to January 31, 2000, from $12 to $179. I suggested possible causes and expressed the view the quality of The Warehouse report would be improved if the auditors rejected the reporting of trading losses as assets. My comments caused some consternation at The Warehouse and I was invited to meet its chief financial officer and the auditor to help me “better understand the company’s accounting policy concerning accounting for phone sales.” It was put to me that in treating losses on the phones as an asset The Warehouse followed a generally accepted practice, similar to that used by Sky Network TV in accounting for decoders and aerial installations, or by home security companies in accounting for alarm systems sold at a loss. In each case the losses on the decoder or alarm system are written off against the future revenue they will generate. In the same way the losses on the sale of the phones should be written off against the revenue from the sale of phone-cards. It is questionable whether a practice in these other industries can be said to be “generally accepted accounting practice” for vendors of prepaid phones. There is a significant difference in obligations on the customer. Both the decoders and household alarms involve a commitment by the customer to pay a monthly rental charge for a year or more: the prepaid phone buyer makes no commitment to buy phone-cards at the time of sale. An industry source tells me many users of prepaid phones subsequently migrate to post-paid cellphones where payment is made after the end of the month. If this is so, The Warehouse’s expectations of phone-card sales may prove disappointing. To safeguard against its expectations being over-optimistic The Warehouse monitors the actual usage of all phones sold against figures provided by Telecom. Where phones receive no usage for three months the loss relating to them is written off immediately and in all other cases the losses are written off over a maximum of 24 months.

[page 212]

The auditor checks these calculations of usage and amortisation as part of the audit. The justification for carrying forward the loss rests on the idea of matching expenses and revenue. The Institute of Chartered Accountants’ statement of concepts cautions this may result in decisions that are inconsistent with the definition of assets or liabilities. In such cases matching is inappropriate and not permitted according to paragraph 7.25. The Warehouse claims the loss on sales meets the statement of concepts’ definition of an asset in that “the entity is able to enjoy the benefits and deny or regulate access of others to the benefits.” My view is that if there were no competing phones on sale The Warehouse might be justified in claiming it has control over future economic benefits (that is, the sale of phone cards). But where there are competing phones and the customers have no commitment to any future purchase of phone cards the claim seems unreasonable. Indeed the phones are sold on the lure of “no need to keep adding airtime just to stay connected” (Warehouse advertisement, May 27). In my view, the so-called future economic benefits are merely a wish. Having carefully considered the situation, The Warehouse and its auditor believe the loss may be called an asset. I do not. ••• On the sale of 38,000 phones to July 31, 1999, the net amount capitalised was $866,000 or $22.79 per phone. On the sale of 74,000 phones $6,638,000 was capitalised, or $89.70 per phone. The result of this change has been to increase the profit for the six months by about $67 per unit or something close to $5 million. The loss carried forward, the “asset” has increased by a like amount …

Keith Smith’s reply was titled “Warehouse Group explains its phone subsidy treatment”, and appeared in the National Business Review on 8 September 2000 at page 54. Alan Robb has commented in two articles (National Business Review, August 11 and July 14) on the accounting treatment of the subsidy The Warehouse Group makes in supplying customers with Gold Pre-Paid mobile phones. Amid a number of inaccuracies the speculation he has tried to imply the company has falsely recognised costs of gaining potential service value. These arise through selling handsets at a loss to generate a customer base. These acquisition costs are initially recognised in the statement of financial position and are then amortised over a period of expected service potential of not more than 24 months. Discussions with Mr Robb suggest his views arise from his personal view of what should be

included as an asset rather than the company’s application of accounting standards. Our accounting policies fully comply with all New Zealand accounting standards and with GAAP. We have the full support of our auditors, Ernst & Young, for this. Ultimately, while Mr Robb may personally disagree with the accounting methodology adopted, he cannot reasonably assert the company has not complied with relevant accounting standards and not taken professional accounting advice.

[page 213] The company has treated its subsidy of handsets in accordance with the Institute of Chartered Accountants statement of concepts which states:

“The definition of assets identifies three essential characteristics: *

There must be service potential or future economic benefits; and

*

The entity must have control over the service potential or future economic benefits to the extent that the entity is able to enjoy the benefits, and deny or regulate access of others to the benefits; and

*

The transaction or other event which gives rise to the entity’s control over the service potential or future economic benefits must have occurred.”

There is service potential in every phone sold. It is likely that anyone buying one does so with an expectation of usage. Any service potential and the enjoyment of future economic benefits are controlled by us because the handsets cannot be used with any other mobile provider. To use a handset, the customer must buy air time through The Warehouse. The sale of a handset is an event giving rise to control over service potential and future benefits. Obviously, the company is not in the business of selling product at a loss. It made its decision in the same way it buys general merchandise in the expectation of selling at a profit. Mr Robb’s arguments are based on the premise the company cannot control whether a customer chooses to use our handset and commit to buy phone cards in the future. While customers do have the freedom to choose, the mobile phone market is driven by expanding a customer base to gain future economic benefits. Further, Mr Robb does not acknowledge the fact that in establishing what service potential is likely, the company takes into account potential factors that may limit future benefits. Should a customer decide to take their business elsewhere or simply stop using the service, handset usage statistics, which are readily available to the company, will reveal a pattern of non-use. In assessing service potential, the company took into account expected “churn” when setting its

initial recognition benchmark and has continued to make regular adjustments to the subsidy capitalised since entering the pre-paid market. It has taken a conservative view that churn occurs after three months’ usage. We believe the industry standard benchmark is six months. In any case any subsidy capitalised will be amortised within 24 months. Financial statements require a degree of assessment and valuation in arriving at a true and fair view. This is a necessity in valuing any assets. Inventory, for instance, while existing physically, is only worth what it is likely to realise. This amount can only be as expected and the company must diligently determine the basis of valuing each line. Mr Robb’s articles suggest a free for all in accounting for handset subsidies. The company does not capitalise every handset for the duration as it wishes; rather it capitalises the portion of the total cost that it expects to generate future economic benefits above those costs and amortises it over that expected period …

[page 214]

4.10.3.2

Telecom

By contrast to the above, the article reproduced below by Rob Hosking titled “Telecom could have muted mobile disappointment” (National Business Review, 17 November 2000, page 11), details Telecom’s approach to the same issue. A change in accounting treatment would have seen Telecom’s latest quarterly result look better to the tune of $17 million. The company writes off cellphone acquisition costs immediately, whereas most other carriers in the mobile market in this part of the world capitalise those costs and amortise them over the life of the contracts relating to those mobile handsets. That would have made mobile cost of sales lower by about $17 million for the three months to Sept 30, the company says. Chief executive Theresa Gattung said Telecom had considered changing the approach but was sticking to the current method as it was in line with North American GAAP standards. But that $17 million would have improved the look of the latest result. As the company reorientates itself to take advantage of an increasingly online and mobile market, the costs of doing so are beginning to bite hard on Telecom’s bottom line. And the weight on that bottom line is not confined to the company’s purchase of Australian

carrier AAPT. The overall quarterly result showed a net earnings drop from $209 million to $161 million. But even if AAPT is excluded from that, Telecom’s profit dropped from $212 million to $200 million. Revenues rose considerably during the three months — the top area being the internet-driven data services, which rose $19 million, or 18.4%. Of these, internet revenue was up $3 million, ISDN $4 million (23.5%) and new services such as ADSL, Lan Link and frame relay rose $8 million — more than a third up on the same quarter in 1999. But the big disappointment this quarter was mobile. Telecom has long identified it as a growth area and is spending $200 million on its new CDMA mobile network, which will come on stream in the second half of 2001. In the meantime though there is a tapering off of revenue at the same time as costs of providing those services balloon. Those costs rose by more than a quarter to $43 million while revenue dropped 15% to $134 million. This reflected the rise in the total number of mobile connections plus special attractions to attract new customers, Ms Gattung said. Those figures, however, do not include the costs or the revenue from interconnection from fixed lines to mobile networks. Overall interconnection revenue dropped over the quarter by $1 million, and the interconnection costs increased by $10 million, or 445%. Revenue from Telecom’s fixed line to mobile phones increased by $10 million, or 15.9%. The average price per minute of a call from Telecom’s fixed line to a cellphone dropped 2.23% but this was more than offset by increases in all volumes as the numbers of cellphones increased.

[page 215] The number of New Zealanders with a mobile phone continued to rise and was now at about 41%, Ms Gattung said. More than a million of these are Telecom handsets and the company still expects this market to keep growing for some time.

4.10.4

DETERMINATION OF PROFIT — SHOESHINE

The article reproduced below, titled “A profit without honour” (National Business Review, 29 November 2002), details a discussion about the use of

GAAP and accounting standards, and highlights possible loopholes, defects, and ambiguities. Shoeshine’s been hearing a lot lately about how New Zealand accounting standards are so much better than US standards at preventing companies from using accounting tricks that might be used to make things look rosy. Shoeshine’s mate Roger the Dodger is known in the trade as a highly principled accountant. That means he knows just which of the many generally accepted accounting practices (GAAPs) to follow to present things in the best possible way. Shoeshine and Roger have been discussing, hypothetically of course, how a local company might improve things by creating a friendly offbalance-sheet entity or two. The conversation went something like this: Shoeshine: I hear New Zealand accounting standards are principles-driven and that it would be impossible to create off-balance-sheet entities like Enron did. Is that so? Roger the Dodger: Yes and no. Our standards are principles-driven but it’s very easy to create offbalance-sheet entities. We don’t call them Special Purpose Entities as the Americans do but they produce similar results. Shoeshine: I know accounting standards require subsidiaries to be consolidated and associates to be equity accounted. How would you get around those standards? Roger: Easily. The first step is to create an associate, Invisible Ltd, and take up between 20% and 49% of the shares. Shoeshine: Who would hold the other shares? Roger: Two of the staff of Shoeshine Ltd. But they must not be directors or in key management positions. They would also be appointed as directors of Invisible Ltd. Shoeshine: Why use such low-level staff? Roger: You don’t want “related parties” involved or you will have to disclose quite a lot of information. Related parties are defined as directors and those in “key management positions”. So the principle is to comply strictly with the rules to ensure that Invisible’s directors and its other shareholders fall outside the category of related party. Shoeshine: But an associate company isn’t off balance sheet. Roger: Not when it’s formed but it will be when Shoeshine Ltd writes off its investment in Invisible. And you must write it off when it makes a loss equal to the capital invested. What’s more FRS38 bars you from resuming equity accounting until all the losses have been reversed. Provided the losses are not reversed, Invisible stays off Shoeshine Ltd’s balance sheet. Hey presto! You have your off-balance-sheet entity, and then you can use it to make things look much better for Shoeshine Ltd. Shoeshine: How? Roger: You said you wanted to improve Shoeshine Ltd’s profits and reduce its debt. So Shoeshine

Ltd sells goods and services to Invisible, at an “arm’s-length price” of course.

[page 216] Shoeshine’s profits improve and Invisible makes a loss. This way you can write off your investment and none of Invisible’s other transactions need be known to Shoeshine Ltd’s shareholders. Shoeshine: But where will Invisible get the money to pay Shoeshine Ltd for its purchases? It can’t trade while it’s insolvent. I know that much! Roger: No problem. Invisible can borrow the money which is guaranteed indirectly by Shoeshine Ltd. Shoeshine: But won’t that have to be disclosed in Shoeshine Ltd’s annual reports? Roger: There’s a GAAP that lets us get around that. If Shoeshine Ltd guaranteed the loan directly you would have to disclose that and, if Invisible were unlikely to be able to repay its debts, you might have to provide for repayment in Shoeshine Ltd’s financial reports. But if the other shareholders — who are merely Shoeshine’s low-level executives — provide the guarantees you don’t have to disclose that. Shoeshine: But would they provide guarantees? Roger: Of course they would — Shoeshine Ltd will indemnify them. Then they can happily provide guarantees to the bank knowing it won’t cost them anything personally. It’s quite common for a company to indemnify any of its staff holding shares, directorships or key management positions in companies in which it has an equity interest. Disclosing the fact that such an indemnity has been given won’t cause anyone to suspect you’ve created an off-balance-sheet entity. The possibilities are endless for off-balance-sheet arrangements in any of Shoeshine Ltd’s investee companies, even those that are not associates. Shoeshine: And this is all in accordance with New Zealand’s principles-based standards? Roger: Yes, and it’s all in accordance with GAAP, but it’s very important to be transparent about the things the standards cover. You should disclose that you have indemnified your staff and you must disclose material transactions and investments in related parties. So of course you make sure the transactions are not material in the context of the Shoeshine group’s total transactions. Shoeshine: But what about auditors? Won’t they have to audit the associate companies? Roger: No. You simply engage them to audit only the parent and group figures. That way the auditor never produces an audit report on each subsidiary or associate company. Shoeshine: But don’t you have to follow “substance over form” to comply with GAAP? Roger: No. There’s no principle of “substance over form” mentioned in New Zealand’s accounting standards. You simply have to follow the legal form where a standard exists. I’m sure Shoeshine

Ltd would have very tight audit schedules and that it would be trying to keep down audit costs. You would want the auditors to limit their audit to material associates and subsidiaries. If your investment in Invisible is small, then it will be immaterial. Shoeshine: Will this sort of thing still be possible when New Zealand adopts international accounting standards? Roger: Oh, indeed it will. International accounting standards are no tougher or more logical. If anything they have more defects and ambiguities and loopholes. Shoeshine is now taking a closer look at the balance sheets of listed companies.

[page 217]

4.11 4.11.1 4.11.1.1

Mastering accounting — questions SHORT ANSWER QUESTIONS True/False

1.

Property, plant, and equipment describes an asset acquired for use in the production or supply of goods and services.

2.

A characteristic of an asset is that it always has a limited useful life.

3.

The selection of a depreciation rate is an exact science.

4.

A cell phone was purchased for $600. It was expected to be beneficial to the entity for two years, and would be of no value at the end of the two years. The straight-line depreciation is $300 per year.

5.

Diminishing value always provides the most appropriate method of depreciation.

6.

Providing for depreciation has the following effect on the accounting equation: a decrease in owner’s equity, and a decrease in assets.

7.

If inventory on hand at the end of the period is overvalued, the gross profit for the period will be overstated.

8.

Problems with inventory valuation will be eliminated if the entity keeps track of the cost of each item held.

9.

When determining the cost of a particular inventory item, transport and handling costs, as well as the purchase price, should be included.

10. The concept of consistency, when applied to the issue of inventory valuation, means that, once a method of cost determination has been selected, it should always be used. 11. The FIFO formula for cost determination ensures that inventory values are close to current costs. 12. Inventory is valued at either cost or net realisable value, whichever is the lower, to give a more accurate value of the particular asset. 13. Failure to take into account doubtful debts, would result in a profit figure that was too high. 14. The allowance for doubtful debts is an expense which appears in the income statement. 15. One reason for bringing into account an allowance for doubtful debts, is to arrive at a more accurate valuation of accounts receivable. 16. Once debtors have been identified as doubtful, their accounts are written off. 17. The value of the asset after accumulated depreciation is deducted, is known as the historical cost. 18. Raw materials are not a stock item. 19. Specific identification is an acceptable method of inventory valuation. 20. Air New Zealand recognises its air fare income when it is paid. [page 218]

4.11.1.2

Multiple choice

1.

2.

3.

4.

5.

In determining annual depreciation charges for newly acquired machinery using the straight-line method, which of the following information is not required? a.

estimated residual value of the machinery;

b.

estimated economic life of the machinery;

c.

annual repairs and maintenance expense;

d.

initial cost of the machinery.

The straight-line method of computing depreciation: a.

generally gives the best results because it is easy to apply;

b.

is not appropriate when the usage rate of the asset fluctuates widely;

c.

should be used in a period of inflation, because it accumulates, at a uniform rate, the fund for the replacement of the asset;

d.

is the only method to use for income tax purposes.

An asset purchased for $12,000 has been depreciated at 10% per annum on diminishing value for three years. Its carrying value is now: a.

$8,400;

b.

$6,170;

c.

$9,120;

d.

$8,748.

Switching from straight-line depreciation in one year, to diminishing value depreciation in the next to offset a profit decline, is a violation of which concept? a.

materiality concept;

b.

accounting period concept;

c.

consistency concept;

d.

realisation concept.

A machine with an economic life of five years is acquired for $10,000 cash. Freight and installation charges amount to $600. It is expected that the machine will be traded in for a newer model at the end of its

economic life, with a probable trade-in value of $1,000. The depreciable amount of this asset is:

6.

a.

$10,000;

b.

$10,600;

c.

$9,000;

d.

$9,600.

For the machine in question 5, the depreciation expense (to the nearest dollar) in the second year, assuming a diminishing value depreciation rate of 33%, is: a.

$2,220;

b.

$2,344;

c.

$2,000;

d.

$2,133. [page 219]

7.

8.

For the machine in question 5, the carrying amount after two years, assuming a straight-line method for determining the depreciation expense, is: a.

$6,000;

b.

$6,360;

c.

$5,400;

d.

$6,760.

If the inventory at the end of the current year is understated and the error is not caught during the following year, the effect is: a.

to overstate income for the two-year period;

b.

to overstate income this year, and understate income next year;

c.

to understate income this year, and overstate income next year;

d. 9.

to understate income this year, with no effect on the income of the next year.

An overstatement in the 31 December 2015 inventory, due to an error in addition, would result in: a.

an understatement of net income for 2015;

b.

an understatement of cost of goods sold in 2015;

c.

an understatement of assets on the 31 December 2015 balance sheet;

d.

an understatement of owner’s equity on the 31 December 2015 balance sheet.

10. On checking, it is found that the beginning inventory was underrecorded by $2,000. This means that: a.

cost of sales for the current year will be $2,000 too low;

b.

gross profit for the current year will be $2,000 too low;

c.

closing inventory for the current year will be $2,000 too low;

d.

cost of sales for the current year will be $2,000 too high.

11. Industrial Blades Ltd sells a certain type of planer blade for $45. That type of blade was originally acquired from a supplier for $25, but the supplier has recently advised a price rise to $28. Industrial Blades Ltd estimates the cost of disposal of the blades at $10. The net realisable value of these blades is: a.

$45;

b.

$35;

c.

$25;

d.

$15.

12. Murphy Manufacturing changed its method of cost determination from FIFO to weighted average. This resulted in a small reported profit instead of a loss. No mention was made in the accounts of the change in method. Which accounting concepts has Murphy Manufacturing

breached? a.

consistency and historical cost;

b.

disclosure and materiality;

c.

consistency and disclosure;

d.

conservatism and materiality. [page 220]

13. The specific identification method for cost determination requires that: a.

invoices are kept for all stock items acquired;

b.

a stock card is kept recording the price paid for each stock item;

c.

the actual price paid for a particular stock item can be ascertained;

d.

stock be sold in the order in which it is acquired.

4.11.2 4.11.2.1

PROBLEMS Davina Woods — depreciation

On 3 April 2013, Davina Woods purchased a new sample fabricating machine for $16,000. The machine was expected to give service for 10,000 hours of production time, after which it would be scrapped. For the years ended 31/3/2014 and 31/3/2015, the actual usage was 2,800 and 3,600 hours respectively. 1.

Answer the following questions to determine the depreciation, using units of use. a.

What is the economic life of this machine?

b.

What is the residual value of the machine?

c.

What is the depreciable amount of the machine?

d.

Using the units of use method of allocating cost, what is the rate of

depreciation? e.

How much depreciation will be written off in each of the two years?

f.

Show how the machine will appear in the balance sheet at 31/3/2015 (extract only). Also show the note that would be required.

2.

Assume the machine was expected to give service for five years. How much depreciation will be provided each year if the straight-line method of allocating cost were used?

3.

Assume the machine was to be depreciated at a rate of 20% per annum diminishing value, following the maximum rate allowable for taxation purposes. Calculate the amount of depreciation for the years ended 31/3/2014 and 31/3/2015.

4.

Davina Woods’s business made a profit of $86,000 in the year ended 31/3/2015, before providing for depreciation. Calculate the final net profit for the year under each of the depreciation methods, that is: units of use; straight-line; and diminishing value. Which method gives the highest net profit? Will this always be the case? [page 221]

4.11.2.2

Richardson Catering Company

You are given the following details of the assets of Richardson Catering Company, which were all acquired on 11 May 2013: Cost ($)

Rate of depreciation

Motor vehicle

18,600

20% DV

Equipment

8,100

25% DV

Furniture

4,600

15% DV

Building

64,000

2% Straight-line

Land

80,000

nil

1.

Calculate the amounts of depreciation for the years ended 31/3/2014 and 31/3/2015. Note: provide for a full year’s depreciation for the year to 31/3/2014.

2.

Draw up a depreciation and fixed assets schedule for the year ended 31/3/2015.

3.

Show the non-current assets section of the balance sheet of Richardson Catering Company as at 31/3/2015.

4.11.2.3

Murtagh and Company

On 1 September 2013, Murtagh and Company purchased factory equipment with an invoice list price of $8,000. The terms were 5% cash discount if the equipment was paid for on delivery. The cost of installation and testing of the equipment amounted to $750, and freight charges of $250 were paid. The useful life was estimated at six years, with a residual value of $600. Payment was made on delivery and inspection of the equipment. One month after acquisition, $50 was paid for minor repairs on the equipment. 1.

What is the cost of this equipment?

2.

What is the depreciation expense for the part-year ended 31/3/2014 and the year ended 31/3/2015, assuming the straight-line method of cost allocation?

4.11.2.4 1.

Rollacut Mowers

From the following information, calculate the value of stock on hand at 30 June 2015. Assume that we are using the perpetual system of inventory valuation. Use the: a.

first-in, first-out (FIFO) method;

b.

weighted average cost (WAC) method. Item:

Rollacut Motor Mowers

On hand 1/4/2015:

5 mowers @ $375 each

Purchases from Masport Ltd:

15/4/2015

4 mowers @ $380

3/5/2015

5 mowers @ $390

9/6/2015

6 mowers @ $400

31/4/2015

5 mowers

31/5/2015

7 mowers

30/6/2015

5 mowers

Sales:

[page 222] 2.

Assuming that all the mowers were sold for $520, calculate the gross profit under each of the above methods of inventory valuation.

4.11.2.5

Pharmacy Distributors Ltd

Pharmacy Distributors Ltd buys and sells pharmaceuticals. Much of its stock is imported. List four types of costs that are likely to be included in the acquisition cost of the entity’s stock.

4.11.2.6

Tapiata Interiors

Tapiata Interiors imports and retails wallpapers and curtain material. Recently 1,000 rolls of wallpaper were purchased from France. Each roll had a catalogue price of NZ$40. However, a 10% bulk discount was offered by the supplier for all orders over $20,000. Other charges assumed by the buyer and seller were as follows: transportation costs (assumed by the buyer), $4,000; insurance costs (paid by the seller), $1,000; and insurance costs (assumed by the buyer), $500. Calculate the cost of the wallpaper, for the purposes of inventory valuation.

4.11.2.7 1.

Relationships and distinctions

State the relationship between the current value and depreciation of a

fixed asset. 2.

State the relationship between the concept of consistency and depreciation.

3.

The balance sheet figure for a fixed asset is not generally the value of the asset. What is it?

4.

The economic life of an asset may be determined primarily by its technical, commercial, or legal life. Distinguish between each of these concepts of economic life, and give examples of an asset where each would be applicable.

4.11.2.8

Valuation of accounts receivable

1.

Why is it important to consider any possible doubtful debts when determining the value of accounts receivable?

2.

State three ways for arriving at the amount of an allowance for doubtful debts.

4.11.2.9

Felicity Parker

Felicity Parker runs a business as a personnel consultant. In the year ending 31/03/2015, she charged out consultancy fees of $116,000. At 31/03/2015 she was still owed $26,000. An analysis of the outstanding accounts showed: $2,500 owed by International Imports Ltd overdue by 8 months; $1,000 owed by Able Manufacturing overdue by 4 months; and $1,200 owed by Mason Jewellers overdue by 3 months. [page 223] The balance of the accounts are less than six weeks old. Inquiries reveal that International Imports Ltd has now been liquidated, and there were no funds

to pay unsecured creditors such as Felicity. Both Able Manufacturing and Mason Jewellers have been ignoring follow-up letters and phone calls. 1.

What amount would you allow for doubtful debts? Why?

2.

If the profit before taking into account the above information is $59,000, what would the profit be after taking into account these additional expenses?

3.

Show the balance sheet extract for accounts receivable at 31/3/2015. Justify your figures.

4.11.2.10 Integrated example — Dora’s Dollar Deals Dora’s Dollar Deals is a retail store owned by Dora Bright. You are presented with the following trial balance (list of balances from the worksheet), and are required to prepare the finalised accounts after taking into consideration various adjusting entries. You might choose to reread Chapter 1 and review Appendix 2, which refers to the accounting cycle. Dora’s Dollar Deals Trial balance As at 31 March 2015 $

$

Accounts receivable

2,880 Accounts payable

Advertising

3,408 Capital

Buildings

120,460 Rent received

Cash at bank

9,700 Commission received

Cartage outwards

1,024 Accumulated depreciation:

Cost of sales

90,360

Building

Drawings

15,000

Office furniture

General expenses Insurance (1 June–31 May) Interest Lighting Office furniture Office salaries Plant and equipment

1,430

Plant and equipment

270 Mortgage on buildings 8% pa 4,500 Sales 250 3,120 10,000 7,480

6,270 76,354 1,590 490 12,863 846 1,421 60,000 177,280

Rates

680

Shop staff salaries

47,080

Stock 31 March

19,472 337,114

337,114

Additional information: a.

interest on mortgage accrued, $1,500;

b.

rates paid in advance, $130; [page 224]

c.

rent received in advance, $150.

d.

shop staff salaries owing, $290;

e.

commission earned but not received, $50;

f.

insurance premium expires on 31 May;

g.

depreciate both office furniture, and plant and equipment at 10% DV, and buildings 2% on cost (to nearest $).

1.

Complete a balance sheet as at 31 March 2015 after the adjustments have been made (the net profit is $15,651).

2.

Provide an example of an accounting policies statement and a particular note for depreciation.

4.11.3 4.11.3.1

DISCUSSION QUESTIONS Using the statement of accounting policies

Read Qantas’s note on depreciation and the policies and notes of Air New Zealand in Resource file 4, paragraph 4.10.1, and answer the following questions: 1.

Over what period are the airlines depreciating their aircraft? Is this

depreciation fixed, or does it vary? 2.

Are the depreciation rates sufficiently similar to allow proper comparison between the two airlines?

3.

Are the notes for both airlines sufficiently clear to inform the reader?

4.11.3.2

Stating your opinion

The articles written by Alan Robb and Keith Smith, reproduced in Resource file 4, paragraph 4.10.3 above, present two opposing interpretations of the same data. Opposing views are not uncommon in business practice, and debating skills are important in ensuring that your position is clearly stated. 1.

Read the two articles and decide with whom of the two authors you agree. Prepare a short speech that could be used as part of a classroom debate, explaining which of the arguments you consider to be particularly sound. Where possible, bring in your own ideas to add to the debate or to assist in refuting possible counter-arguments.

2.

The auditor provides an independent view of the estimates and judgments made by management. Write a brief essay which discusses the role of the auditor in the process of ensuring objectivity in the accounts. In your essay, refer to the accounts of Xero Limited in Appendix 1, and state the sort of pressures that an auditor might face.

4.11.3.3

Depreciation and trade union accounts

The general secretary of a trade union has approached you about the necessity of providing for depreciation of the union’s assets. “I can’t see the point really, our furniture and equipment is always maintained in first class condition — so to provide for depreciation is really double counting our costs. As for our land and buildings — they [page 225]

go up in value every year anyway. The members will be furious if we report a deficit this year, which is exactly what will happen if we show this darned depreciation.” Write a letter to the general secretary: 1.

identifying his misunderstandings about the nature of depreciation;

2.

explaining why depreciation must be shown in the accounts, even though to do so will result in a deficit for the year.

4.11.3.4

Earthworks Ltd

Earthworks Ltd acquired a bulldozer at a cost of $800,000 on 5 April 2012. At that time, its economic life was estimated at 10 years, or 20,000 production hours. Its residual value was estimated at $100,000. The initial decision was made to depreciate the bulldozer on a straight-line basis over its economic life. Accordingly, the accounts for the years ended 31/3/2013 and 31/3/2014 were prepared on this basis. During the 2015 financial year, there was a recession in the earthmoving industry, and Earthworks Ltd made very little use of the bulldozer. The directors of the company therefore resolved to change the method of cost allocation for the year ended 31/3/2015, to the units of use method. The original estimate of 20,000 production hours of use was still considered reasonable, as was the original estimate of residual value. 1.

Calculate the amount of depreciation to be provided under the units of use method for the year ended 31/3/2015. Note: The bulldozer logbook showed the following usage: To 31/3/2013: 2,200 hours To 31/3/2014: 1,600 hours To 31/3/2015: 400 hours

2.

Prepare a statement setting out fully the effects of this change in policy. Do you think this change in policy can be justified? Explain.

4.11.3.5

Valuing inventories

1.

“I can’t see why there is all this fuss about valuing inventories — surely it’s simply a case of looking up the invoices.” Explain why the valuation of inventory is an issue for accountants, and why it is more complicated than simply looking up invoices.

2.

“I don’t pay too much attention to stock valuation — it’s not worth the effort. Besides, because this year’s closing stock is next year’s opening stock, it will all come out in the wash anyway.” Critically analyse the attitude conveyed above, being sure to explain the potential consequences of not paying enough attention to stock valuation.

4.11.3.6

Calculating doubtful debts

You have just started working for a New Zealand subsidiary of an Australian company. You have noticed that the sales representatives appear to be avoiding procedures regarding the granting of credit. You know that failure to provide for bad and doubtful debts could have disastrous consequences for those relying on the accounting reports for making their decisions. [page 226] Write a brief memo to the financial officer of the business explaining the potential consequences of improper recognition of the non-payment by debtors. In your memo, make sure that you answer the questions below: Explain how the failure to provide for doubtful debts, or an inadequate allowance, could mislead users of accounts. Under what circumstances could this happen? Who are the users most likely to be affected? Why?

4.11.4

RESEARCH QUESTION

Accounting is a rapidly evolving aspect of business endeavour. The challenges faced by regulating agencies, such as the professional accounting bodies (New Zealand Institute of Chartered Accountants and CPA Australia) and the governing body of the New Zealand Stock Exchange, are increasing, as pressures on managers to perform are increasing. Choose a newspaper or magazine article that highlights a departure from Generally Accepted Accounting Practice by a business in the way its financial reports are presented. 1.

Write a letter to the editor of the paper or magazine in which you found the article, expressing your views on the issue. Where possible, obtain support for your position from other articles. In your own words, describe the issues at stake.

2.

State whether you agree with the presentation made by the business. Refer to the basic concepts and definitions which you have learnt to date to reinforce your statement.

4.12 4.12.1 4.12.1.1

Mastering accounting — solutions SHORT ANSWER QUESTIONS True/False

1.

False. Non-current assets have the distinguishing feature that they yield benefits to the organisation over more than one accounting period.

2.

False. Some fixed assets, such as land, do not generally diminish in value.

3.

False. There is a need for professional judgment.

4.

True. 600 divided by 2 years.

5.

False. Refer to paragraph 4.4. Other methods of cost allocation may give a fairer allocation of the depreciable amount.

6.

True. Depreciation as an expense reduces owner’s equity, while the accumulated depreciation account is a negative asset account.

7.

True. Overvalued closing inventory causes the cost of sales to be understated, which results in a higher reported gross profit.

8.

False. Much more information on stock movements is required than merely acquisition cost. There are also issues of stocktaking and stock obsolescence to consider. [page 227]

9.

True. Refer to paragraph 4.4.

10. False. Refer to paragraph 4.4. A change in policy may be justifiable with changed circumstances. Any such change must be fully disclosed. 11. True. 12. True. 13. True. If doubtful debts are ignored, expenses are understated, and profit and current assets are overstated. 14. False. This account is a negative asset account which appears in the balance sheet. 15. True. 16. False. Accounts are not written off until all efforts to collect the debts have failed. 17. False. Historical cost is the purchase price; the value of an asset after accumulated depreciation has been subtracted, is known as carrying amount. 18. False. Raw materials are a stock item — refer toparagraph (c) of the definition of inventory in NZ IAS 2, paragraph 6. 19. True. 20. False. Air New Zealand recognises its air fare income when the

passenger flies.

4.12.1.2 1.

c.

2.

b.

3.

d.

4.

c.

5.

d.

6.

b.

7.

d.

8.

c.

9.

b.

Multiple choice

10. a. 11. b. 12. c. 13. c.

4.12.2

PROBLEMS

4.12.2.1

Davina Woods — Depreciation

1. a.

Economic life: 10,000 production hours.

b.

Residual value: nil.

c.

Depreciable amount: $16,000. [page 228]

d.

Rate of depreciation:

depreciable amount: $16,000; units of use: 10,000 hours; therefore, the rate of depreciation is $1.60 per production hour. e.

Depreciation amount for year ended: 31/03/2014: 2,800 hours × $1.60 = $4,480; 31/03/2015: 3,600 hours × $1.60 = $5,760.

f. Balance sheet (extract) As at 31 March 2014 $ Non-current assets Property, plant and equipment

5,760

NOTE Asset

Machinery

Cost

Accumulated depreciation

Carrying value

$

$

$

16,000

10,240

5,760

2.

Annual depreciation using straight-line method: $3,200.

3.

Annual depreciation using diminishing value method: depreciation amount for year ended 31/03/2014: 20% × $16,000 = $3,200; depreciation amount for year ended 31/03/2015: 20% × $12,800 = $2,560.

4. Units of use

Straight-line value

Diminishing value

$

$

$

Profit before depreciation

86,000

86,000

86,000

Depreciation

5,760

3,200

2,560

Net profit

80,240

82,800

83,440

The highest profit is reported under the diminishing value (DV) method. This will not always be the case. In years of very low usage, the units of use method would probably result in a higher profit. In this case, the DV rate is not consistent with the five-year economic life under the straight-line method. If the economic life used as the basis of the DV rate was the same as for straight-line (and it should be), then profit would be higher under a straight-line depreciation regime compared with a diminishing value regime in the earlier years of the asset’s life, but lower in the later years. It is not possible, however, to generalise about the relative effects on profit under a units of use regime — it depends on the level of use. [page 229]

4.12.2.2

Richardson Catering Company

1. Depreciation 2014

Depreciation 2015

$

$

Motor vehicle

3,720

2,976

Equipment

2,025

1,519

690

587

1,280

1,280

nil

nil

Furniture Building Land

2.

Non-current asset and depreciation schedule:

Richardson Catering Company Non-current asset and depreciation schedule For the year ended 31/3/2015

Motor vehicle

Cost

Deprec 31/3/2014

Carrying value 31/3/2014

$

$

$

18,600

3,720

14,880

Rate

20% DV

Deprec 31/3/2015

Accum deprec

Carrying value 31/3/2015

$

$

$

6,696

11,904

2,976

Equipment

8,100

2,025

6,075

25% DV

1,519

3,544

4,556

Furniture

4,600

690

3,910

15% DV

587

1,277

3,323

Building

64,000

1,280

62,720

2% SL

1,280

2,560

61,440

Land

80,000

-

80,000

-

-

-

80,000

175,200

7,715

167,585

6,362

14,077

161,223

3. Balance sheet extract Non-current assets

$

Property, plant, and equipment

4.12.2.3

161,223

Murtagh and Company

1. $ Invoice price

8,000

Less 5% discount

(400)

Net purchase cost

7,600

Plus Installation

750

Plus Freight

250

Cost

8,600

[page 230] 2. Depreciable amount

= cost less residual value = $8,600 - $600 = $8,000

Annual depreciation charge

= $8,000 / 6 = $1,333 pa

Depreciation expense for year end 31/3/2014

= 7 months @ $1,333 per annum = $778

Depreciation expense for year end 31/3/2015

= $1,333

4.12.2.4 1.

Rollacut mowers

a.

FIFO three mowers remaining at the latest price = $1,200; cost of goods available for sale = (5 × $375) + (4 × $380) + (5 × $390) + (6 × $400) = $7,745; therefore, cost of goods sold = ($7,745 - $1,200) = $6,545.

b.

WAC total mowers available for sale: 20; dollar value invested: $7,745; therefore, each is worth $7745 / 20 = $387.25 and stock on hand is $1,161.75; cost of goods sold is 17 × $387.25 = $6,583.25, or $7,745 $1,161.75.

2. a.

FIFO total sales = $520 × 17 = $8,840; gross profit = $8,840 - $6,545 = $2,295.

b.

WAC total sales = $520 × 17 = $8,840; gross profit = $8,840 - $6,583.25 = $2,256.75.

4.12.2.5

Pharmacy Distributors Ltd

Acquisition costs of inventory may include: purchase price of the stock; cost of freight; cost of insurance while inventory is in transit; handling costs associated with locating the inventory to the entity’s warehouse; and costs of packaging bulk chemicals for sale.

[page 231]

4.12.2.6

Tapiata Interiors $

Cost of inventory Purchase cost 1,000 rolls @ $40 each

40,000

Less Bulk discount

(4,000)

Net purchase cost

36,000

Plus Transportation costs

4,000

Insurance

500

Total cost of inventory

40,500

4.12.2.7

Relationships and distinctions

1.

In providing for depreciation, the accountant is allocating the cost of the asset (less any residual value) over the useful life of the asset, in order to show the decreased value of the asset in the balance sheet. The emphasis is on the consumption of the asset, not on its value. When choosing a method of cost allocation (see paragraph 4.4), due regard should be paid to the pattern of the asset’s usefulness to the business (its service potential). For example, a business may purchase a fleet of cars, say 15 of the same make and model, for the benefit of the business. We know that, after a year’s use, the cars may have slightly different values if we were to sell them. However, from an accounting point of view, they all represent the same value to the business.

2.

Different methods of cost allocation will give different annual charges against profit, and consequently different profit figures. Accordingly, once the choice of allocation method has been made, the concept of consistency determines that this method should be applied consistently. This does not mean that the chosen method cannot be changed. If a change in information or circumstances means that a new method will give a fairer allocation, then a change may be made, provided such

change and its effects on profit and asset values, are fully disclosed. 3.

The balance sheet figure for a non-current asset is not generally the value of the asset. Under the historical cost basis of accounting (upon which most accounts are based), the balance sheet shows the unexpired or unallocated cost of the asset — that is, historical cost less accumulated depreciation to date.

4. The technical life of an asset refers to its practical physical life. Many assets simply wear out or become technically obsolete — for example, plant, machinery, and equipment. The commercial life of an asset refers to the period over which the asset is commercially viable. At the end of this life, the asset may still be capable of delivering a service, but perhaps with increasing maintenance costs, or necessary refurbishment costs, so that it would not be a sound business decision to continue with the asset — for example, motor vehicles. The concept of legal life applies only to those long-term assets that arise out of contractual arrangements which have a finite time attached to them — for example, a 10-year lease, or a licence to manufacture or distribute brand name goods. Once the agreed time has lapsed, the asset ceases to exist. [page 232]

4.12.2.8 1.

Valuation of accounts receivable

The net realisable value of debtors is based on the amount that debtors are expected to pay the business. To determine this amount, the value of any debtors who are unlikely to pay is deducted from the total amount owing to the business. This ensures that the amount shown in the

balance sheet for debtors, accurately represents what the business is expected to collect from its debtors, and is not overstated. A doubtful debts expense is recorded in the income statement, ensuring that the profit for the period is not overstated. 2.

The amount of allowance for doubtful debts could be arrived at by: a.

identifying actual debtors who are unlikely to pay; or

b.

taking a percentage of credit sales, based on experience; or

c.

taking a percentage of total debtors’ balances, based on experience.

4.12.2.9

Felicity Parker

1.

Able Manufacturing ($1,000) and Mason Jewellers ($l,200) are potential bad debts, given the circumstances cited. Therefore, doubtful debts of $2,200 should be allowed for. International Imports Ltd is a bad debt, and should be written off.

2.

Profit should be reported as: $

Draft profit

59,000

Less Bad debts

(2,500)

Less Doubtful debts

(2,200)

Profit

54,300

3.

Balance sheet as at 31/03/2015 (extract): $

Current assets Accounts receivable

23,500i

Less

(2,200)

Allowance for doubtful debts

21,300

i

Taking into account bad debts. [page 233]

4.12.2.10 Integrated example — Dora’s Dollar Deals Dora’s Dollar Deals Limited Balance sheet As at 31 March 2015 $

$

ASSETS Current assets Cash at bank

9,700

Accounts receivable

2,880

Stock at 31 March

19,472 $

Prepayments Accrued income

$

175 50 32,277

Non-current assets Property, plant, and equipment

112,688

Total assets

144,965

LIABILITIES Current liabilities Accounts payable

6,270

Accrued expenses

1,790

Income received in advance

150 8,210

Non-current liabilities Mortgage at 8%

60,000

Total liabilities

68,210

EQUITY Capital

76,354

Plus

Net profit

15,401

Less

Drawings

(15,000)

Total equity TOTAL LIABILITIES AND EQUITY

76,755 144,965

Statement of policies 1.

Statutory basis Dora’s Dollar Delight is a company registered under the Companies Act 1993. Reports are prepared according to Generally Accepted Accounting Practice. [page 234]

2.

Measurement base Unless otherwise specified, the measurement base adopted is historical cost.

Accounting policies Property, plant, and equipment Property, plant, and equipment is initially recorded at historical cost. The cost of an asset comprises its purchase price, and any directly attributable costs of bringing the asset to the location and working condition for intended use. The buildings were purchased in 1998 and no revaluation has been carried out in this time. Depreciation Fixed assets are depreciated so as to charge their cost or other acquisition value over their estimated useful life according to the details listed below. Depreciation rates are: Plant & equipment

10% DV

Office furniture

10% DV

Buildings

2% on cost price

Note Cost

Depreciation

Accum

Carrying

$

2015

deprec

value

$

$

$

Office furniture

3,120

227

1,073

2,047

Plant and equipment

7,480

606

2,027

5,453

120,460

2,409

15,272

105,188

131,060

3,242

18,372

112,688

Buildings

[page 235]

Tracking cash and controlling assets

CHAPTER

5

Contents Learning outcomes 5.1

Introduction 5.1.1 Outline 5.1.2 Case study — Spacemakers Hardware Ltd

5.2

Tracking cash 5.2.1 Elements of a cash flow forecast 5.2.2 Managing shortfalls

5.3

Internal control 5.3.1 Taking control 5.3.2 Modern tools to help internal control — the use of technology

5.4

Statement of cash flows

5.4.1 5.4.2

Description of a statement of cash flows Preparation of a statement of cash flows

5.5

Conclusion

5.6

Key words 5

5.7

Resource file 5 5.7.1 Cash cycle article — money makes the world go round… 5.7.2 Fraud article — fraudsters a simple, sad bunch 5.7.3 More on internal accounting controls — white collar crime: Cooking the books in corporate US 5.7.4 More on fraud — David Ross gets 10 years, 10 months jail 5.7.5 Internal control — internet resources [page 236]

5.8

Mastering accounting — questions 5.8.1 Short answer questions 5.8.2 Paragraph answers 5.8.3 Cash flow forecast 5.8.4 Internal control 5.8.5 Statement of cash flows

5.9

Mastering accounting — solutions 5.9.1 Short answer questions 5.9.2 Paragraph answers 5.9.3 Cash flow forecast 5.9.4 Internal control 5.9.5 Statement of cash flows [page 237]

Learning outcomes After completing this chapter, you should be able to: explain the importance to the survival of a business of tracking cash; complete a simple cash budget; explain the impact of poor accounting controls on the reliability of accounting information; apply simple internal-controls to accounting activities; explain the importance of the statement of cash flows to users of accounting information; and prepare a simple statement of cash flows, classifying it into its component parts, namely: – operating activities; –

investing activities; and



financing activities.

5.1 5.1.1

Introduction OUTLINE

In previous chapters, we touched on the importance of the reliability of accounting information. In Chapter 4, we focused on the choices that are available to accountants which have the potential of affecting the “net profit” figure. In Chapter 1, we asked you to investigate one of a number of

businesses which ended up failing. In this chapter, we will focus on the positive aspects of accounting practice which can help businesses survive. It is not just about fraud or poor accounting — more often it is about poor management. Lack of cash flow forecasting is the single largest problem small businesses face. National Bank specialist business manager, John Eaden, says not enough businesses map out their expected cash flow. “This affects their potential survival in a challenging economic climate.” He says businesses that do cash planning once a year, have a 36% survival rate over five years. This contrasts with those planning monthly, which have an 80% survival rate. “Amazingly, 70% of businesses which go bankrupt are profitable when they close their doors. A common misconception about cash flow problems is that growth will fix it, but this often leads to more cash pressures, especially if companies discounted to boost turnover.” (See “Poor Cashflow Planning Causes Business Failures”, The Main Report Business Alert, 6 April 2009, www.themainreport.co.nz.) [page 238]

5.1.2

CASE STUDY — SPACEMAKERS HARDWARE LTD

In this chapter and the next, we will focus on a mythical limited liability company — Spacemakers Hardware Ltd — run by Michael Bevan and his wife Michelle. This hardware store sells building, plumbing, and garden supplies in the thriving community of Blenheim, and the business has grown very quickly. Over the last two years, business activity has changed considerably with the opening of a branch of a national chain store in Blenheim. The biggest concern for Michael and Michelle is that their bank account has gone into overdraft, and the bank manager requires that the

overdraft be lowered. Michael and Michelle are able to do little about the increased competition, but can respond to it in a knowledgeable fashion. First, we will go through the concepts of planning cash flows as a part of the planning/control cycle. Cash flow planning or budgeting, which we will cover in more detail in Chapter 6, is an important part of a manager’s job — particularly if that manager is running his or her own small business. Following this, we will look at the strategies that Michael and Michelle might wish to employ to ensure that their business is running efficiently, and that resources are being properly controlled. More information about the new Accounting Standards Framework is available on the XRB website, www.xrb.govt.nz.

Finally, we will look at the formal presentation of a statement of cash flows. A statement of cash flows will not be required by the likes of Spacemakers Hardware, because it is a small business. (The presentation of a statement of cash flows is not required, unless a company is classified as belonging to Tier 1 or Tier 2 of the Accounting Standards Framework issued by the External Reporting Board (XRB).)

5.2

Tracking cash

Planning for cash requirements is a task that businesses should not take for granted. After all, if the cash runs out, the business fails. However, businesses often leave the cash planning to luck, and hope that there will be enough cash when the time comes. Cash is often called the lifeblood of the business, and for good reason. The lag between the time you have to pay your suppliers and employees, and when you collect from your customers, is the problem. The solution is cash flow management. Spacemakers Hardware could benefit from cash planning, even if they are not failing. The costs resulting from poor cash management can also be significant.

5.2.1

ELEMENTS OF A CASH FLOW FORECAST

The cash flow forecast identifies the anticipated sources and amounts of cash coming into a business, and the destinations and amounts of cash going out over a given period in the future. The forecast is usually done for a year or quarter in advance, and divided into weeks or months. In extremely difficult cash flow situations, a daily cash flow forecast might be helpful. It is best to pick periods during which most of the fixed costs, such as salaries, are paid. [page 239] The cash flow forecast lists: receipts; payments; excess of receipts over payments — with negative figures shown in brackets; the opening bank balance; and the closing bank balance. It is important to base initial sales forecasts on realistic values. Cash flow forecasts are not a glimpse into the future. They are educated guesses that balance a number of factors, including customers’ payment histories, the business’s ability to identify upcoming expenditures, and suppliers’ patience. First, we will explain how a cash flow forecast works, so that we can then move on and decide what to do as a result of it. Michael and Michelle are planning to take a slight break from their retail business in January. They would have obtained a range of figures based on their history, to allow them to make informed judgments about future activities. As a result of this, Michael has determined the following sales patterns: Cash

Credit

$

$

October

Actual

33,000

46,000

November

Actual

34,000

46,000

December

Actual

42,000

40,000

January

Budget

36,000

40,000

February

Budget

30,000

50,000

March

Budget

28,000

50,000

If 2% of credit sales remain unpaid, what may occur in the accounts in respect of the balances of these non-payers? Refer to Chapter 4 in this regard.

Michael also knows that certain percentages of credit customers pay within specific time frames: 30% of credit sales will pay one month later; 60% will pay two months later; and a further 8% will pay within three months. The cash outflow patterns are as follows: wages of $24,500; rent of $11,000; and interest and bank fees of $1,250. A number of costs are paid in cash in the month in which they occur. (For the sake of simplicity, we will assume that each cost is constant over the period being planned for.) Other purchases are made on credit; these are usually paid for in the following month. Michael has always paid his creditors when they fall due. The expected creditors are as follows: $38,000 for December; $34,000 for January; and $32,000 for February. [page 240]

At the end of December, Spacemakers Hardware will have a bank account balance in overdraft of $5,300. In order to prepare a cash flow forecast for January, February, and March, the following steps are required: 1.

calculate receipts;

2.

calculate payments; and

3.

calculate the difference between inflows and outflows; establish the opening bank balance; and determine the closing bank balance.

We expand on each of these steps below.

5.2.1.1

Calculate receipts

We have noted that debtors do not all pay during the month following the sale. Therefore, cash flow needs to be estimated. Based on past recoveries, Michael estimates as follows: In January they will receive: – 8% of October credit sales; –

30% of November credit sales; and



60% of December credit sales.

In February they will receive: – 8% of November credit sales; –

30% of December credit sales; and



60% of January credit sales.

In March they will receive: – 8% of December credit sales; –

30% of January credit sales; and



60% of February credit sales.

Be careful not to assume, without justification, that debtors will continue paying at the same rate as they have recently. For example, the construction business was hit hard by recession in 2009. Builders and plumbers, who represent a reasonable part of Spacemakers Hardware’s credit customers, may

themselves have restricted cash flow and choose to hold off paying their creditors for as long as possible. The table below illustrates the total collection of cash from both debtors and cash sales. It shows how credit sales are received over a three month period. For example, credit sales in October would be received in November, December, and January, but only the last amount received (January) would be recorded in this table. However, credit sales in December are received in January, February, and March, and are all recorded in this table. [page 241]

Cash sales

Credit Sales

$

$

January February $

$

March

Total credit collections

$

$

October

Actual

33,000

46,000

3,680

3,680

November

Actual

34,000

46,000

27,600

3,680

December

Actual

42,000

40,000

12,000

24,000

3,200

39,200

January

Budget

36,000

40,000

12,000

24,000

36,000

February

Budget

30,000

50,000

15,000

15,000

March

Budget

28,000

50,000

31,280

Cash from debt collection

43,280

39,680

42,200

Plus Cash sales

36,000

30,000

28,000

Cash inflows

79,280

69,680

70,200

5.2.1.2

Calculate payments

Michael pays for credit purchases when they fall due. Therefore, outflows for credit purchases occur in the following month. There are a number of cash purchases which fall in the month that they occur. For this example, we have assumed that these direct purchases are the same each month. However, if Michael were to prepare a statement of cash flows, it would be dangerous to make this assumption. For example, interest payments will vary, as in

December, January, and February there are a number of statutory holidays which will mean an increase in wages. January February $

March

$

$

Credit purchases December

38,000

January

34,000

February

32,000

Cash purchases Wages

24,500

24,500

24,500

Rent

11,000

11,000

11,000

1,250

1,250

1,250

74,750

70,750

68,750

Interest and bank fees Cash outflows

5.2.1.3

Calculate the difference between inflows and outflows, establish opening bank balance, and determine closing bank balance

Subtract the cash outflows from the inflows to determine the net cash flow. Be sure to indicate any negative flows with a clear minus or with numbers in brackets (as in this example). Once completed, Michael will have a clear idea of the business’s cash requirements. At this stage, Michael might need to review his calculations to ensure [page 242] accuracy. He needs to consider unusual items, such as tax payments and insurance payments, as well as the cash requirements of his family. He also needs to consider whether there are any items which he may have not included. January February

March

$ Cash inflows

79,280

$ 69,680

$ 70,200

Cash outflows

(74,750)

Net cash flow

4,530

(1,070)

1,450

(5,300)

(770)

(1,840)

(770)

(1,840)

(390)

Add Bank at beginning of month Bank at end of month

(70,750) (68,750)

Having established the cash position, Michael and Michelle might need to review their operations to see if improvements can be made. Obviously, such a review has to take place if there is a shortfall in cash.

5.2.2

MANAGING SHORTFALLS

Sooner or later, Michael and Michelle may find themselves in a situation where they lack the cash to pay their bills. This does not mean that they have failed. Times of hardship are common in many businesses, particularly small businesses. Michael and Michelle are normal business owners, who cannot perfectly predict the future. A good business is one in which the owners are able to plan for and use everyday business practices to manage any shortfall. The key to managing a cash shortfall is to be aware of the problem as early and as accurately as possible. Banks are wary of borrowers who have to have money today. They prefer lending to you before you need it — preferably months before. When the reason you are caught short is that you failed to plan, a banker is not going to be very interested in helping you out. Read Fiona Calderwood’s article in Resources file 5, paragraph 5.7.1. Ignoring the calculations at this stage, note the suggestions that she makes for improved working capital management.

If you assume from the beginning that you will someday be short of cash, you can arrange for an overdraft at your bank. This allows you to borrow money up to a pre-set limit any time you need it. Since it is far easier borrowing when you do not need it, arranging an overdraft before you need it is very important. Having prepared “breathing space” to get over the crises, some longer-term initiatives can be put in place. Longer-term initiatives focus

on working capital management — the way a business manages inventory, debtors, and creditors to ensure an efficient use of its resources. Below is a brief overview of ways to improve cash flow. More complex methods can be related to internal control procedures (refer to paragraph 5.3), or may form part of “analysis and interpretation” (which we will explore in Chapter 7).

5.2.2.1

Improving inventory efficiency

One of the keys to a healthy cash flow is making sure that your resources are represented by cash. Spacemakers Hardware sells products, and Michael and Michelle want a cash flow that reflects their efforts. Their goal needs to be to achieve as many “inventory turns” during the year as possible. Slow-selling items simply will not achieve this goal. [page 243] An inventory turn occurs when a product which is in stock, meets customer needs and wants. This sounds easy, but requires an excellent understanding of the market, the right product mix, and developing relationships with suppliers and customers. Some ways of keeping control of inventory turn are: competitive product pricing; controlling slow-moving product lines, by determining the cause of slowmoving items — for example, some stock lines may have become unfashionable, be subject to seasonal fluctuations, or have been inappropriate purchases in the first place; getting rid of “dated” inventory for whatever you can get for it; keeping lower levels of inventory in store, while being careful that there is sufficient stock available for sale; using promotion strategies to attract more customers into the store, resulting in more sales; it might be more profitable for the shop to make

fewer larger purchases, than to make many small ones; inventory turn might benefit from in-store promotions (for example, a demonstration of home handyman projects); and stocking a good mix of products across the store — once shoppers are in the habit of coming into the store for low-price items, they may also buy other more profitable items, which can make the transaction profitable.

5.2.2.2

Speeding up debtor receipts

If you were paid for sales the instant you made them, you would never have a cash flow problem. Unfortunately, that does not happen, but you can still improve your cash flow by receiving faster payment from your credit customers — that is, reducing your age of debtors. There are commonly-used business practices which can help to achieve this, such as: requiring credit checks on all new non-cash customers: a customer who does not pay, represents a loss which will never be recouped; it is therefore necessary to ensure that there are robust procedures around granting credit; issuing invoices promptly, and following up immediately if payments are slow to be received: some businesses, for example, Telecom and some electricity suppliers, are able to collect debts quicker than others; Spacemakers Hardware’s customers will make choices regarding the priority order of paying their debts; if they know that Spacemakers Hardware follows a consistent debt collection policy, including going to court, they are more likely to pay; and tracking accounts receivable to identify and avoid slow-paying customers: instituting a policy of cash on delivery, is an alternative to refusing to do business with slow-paying customers.

5.2.2.3

Slowing down creditor payments

A simple method of dealing with creditors at a time of cash crisis, is to not pay them at all. There are a number of disadvantages to this strategy, not least

of which is that the supply of certain goods or services will be cut off. Some less risky options are to: take full advantage of creditor payment terms — if a payment is due in 30 days, do not pay it in 15 days; [page 244] use electronic funds transfer to make payments on the last day they are due — you will remain current with suppliers while retaining use of your funds as long as possible; and communicate with suppliers so they understand your financial situation — if you ever need to delay a payment, you will need their trust and understanding.

5.3

Internal control

Internal control is the set of procedures put in place within an entity’s governance and accounting systems to: minimise the possibility of errors or fraud; prevent error or fraud from happening; detect error or fraud if they occur; help safeguard assets; and promote efficiency. When Michael and Michelle first met with their chartered accountant, they were told that it was crucial to set up a good system of internal control, but they did not understand exactly what internal control was. They figured that

“internal” must refer to controls put in place by internal users — by management. But what did “control” cover? Controlling staff — ensuring that staff followed company policies and procedures? Controlling business assets — protecting assets from theft and fraud? Controlling accounting information — making sure that everything was accurately accounted for? While different businesses may emphasise different areas of control, the reality is that internal control can cover all these things. Protecting a business against theft and fraud seems logical to Michael and Michelle, but what about the other types of control mentioned above — what are the underlying reasons for these? What real purpose would “following company policies and procedures” serve? It can ensure that Spacemakers Hardware meets its legal obligations — in terms of tax, health and safety, consumer, and employee legislation. It can put in place procedures so that staff work towards Spacemakers Hardware’s strategic goals — for example, meeting budget targets. It can encourage cost-effective behaviour — for example, requiring staff to get written quotes from three sources when looking to spend more than a certain amount. What about the need for complete and accurate accounting records? Think what could happen if Spacemakers Hardware’s accounting was incomplete or inaccurate. It could miss out on revenue, and not get paid if it failed to record a credit sale. It could run into cash flow problems if it underestimated its obligations by not recording some of its liabilities. [page 245]

It could upset or even lose customers if it missed recording some of their payments and then sent out “payment is overdue” notices. It could run into trouble with the IRD if it failed to record some of its sales or misrecorded some of its expenses — for example, if it claimed back GST on wages.

5.3.1

TAKING CONTROL

There is no one-size-fits-all package of measures that will suit all businesses. Businesses differ in size and in their operations — what suits Xero Limited cannot be expected to fit Spacemakers Hardware. Internal control is a subjective area. What Michael and Michelle see as appropriate for Spacemakers Hardware, a different set of owners might see as either insufficient or as excessive. Should a bank reconciliation be prepared on a weekly basis, or is a monthly reconciliation sufficient? Should all goods be counted and checked on arrival, or only high value items? Are security cameras needed? Different owner/managers may well come up with different answers to these types of questions.

5.3.1.1

Screening staff

Leave a jar of lollies with the lid off within easy reach of children, and inevitably some of the lollies will disappear — even if we have told the children not to take them. Does this mean that the children who took the lollies are inherently bad? No — they are just normal. If we really do not want to have any lollies taken, we should remove the temptation — perhaps put the jar in a cupboard out of reach. In a similar way, a business’s system of internal controls will often seek to remove temptation by putting in place procedures to deter people from taking cash or other assets. Putting the lolly jar up out of reach will deter most children, but there will always be at least one child who would somehow clamber up on the bench, open the cupboard, and steal the lollies, despite our best efforts at

deterring them. Business too, presents us with some individuals who will be determined to “beat the system”, despite the best precautions. Most internal controls put in place to counter staff fraud or theft, are based on deterring staff from doing something wrong. Will a really good system of deterrents stop all staff from illegally taking company assets? No. Making something difficult to steal without being caught, will deter the great majority of people from stealing, but not all. So what can a business do? One of the most important ways to deal with this threat is to try to screen out such employees from joining your business. Contact previous employers and check out a job applicant’s past (with the applicant’s signed approval to do so). Be cautious. Seek more information from the applicant if you come across: past employers who are not prepared to say anything about the applicant; applicants who provide names of past employers, all of whom are no longer in business; or applicants who have large unexplained gaps in their employment history. With the applicant’s approval, you could also run a check for any criminal convictions, accessing the Department of Courts Wanganui Computer (see www.courts.govt.nz). [page 246] The level of screening carried out should take into account the level of risk a job carries. Accountants, information technology managers, and senior management would all be positions where a high level of risk applies. These people will have access to high-value assets and knowledge of the internal controls in place. Therefore, a strong level of screening should apply.

5.3.1.2

Management’s attitude

Imagine that you work for one of the organisations in the following scenarios:

The senior partner in a professional services firm regularly directs staff to charge clients for more hours than were actually spent on a job; The general manager of a retail store often takes goods home for his own use, and charges private meals at local restaurants to the business credit card; Management at a local retailer have installed video surveillance cameras above all cashiers’ tills, and carry out a search of all bags as staff leave for the day. What effect are the above management practices likely to have on the staff in these organisations? Could you see staff working for the professional services firm claiming wages for more hours than they actually worked? Would employees working in the retail store follow their boss’s example and take goods home? If staff felt resentful about bag searches and constant video surveillance, would they advise management if they became aware of other staff stealing from the business? It is important that senior management sets the right example — it is naïve to expect staff to act honestly if management acts dishonestly. It is also true that you can alienate staff by overdoing security. If managers demonstrate good ethical behaviour and treat staff fairly, they are far more likely to find staff supporting business policies and procedures. In such a business, if an employee is doing something wrong, it is likely other employees will put pressure on them to stop, or turn them in to management.

5.3.1.3

Segregating duties

Imagine Spacemakers Hardware employed a staff member whose job it was to take each day’s cash takings to the bank, and deposit them in the business’s bank account. What if that person was also responsible for preparing Spacemakers Hardware’s bank reconciliations — a cross-check of the business’s accounting record to confirm that it has accurately recorded all bank transactions. What problems could this pose? Might the person be tempted to steal some of the cash he or she is meant to be banking? A

comparison of Spacemakers Hardware’s accounting records showing what was to be deposited that day and its bank statement would highlight that some money was missing. But as the person who is doing this cross-check would be the person who stole the money, the thief would cover up the discrepancy rather than alert Michael and Michelle to it. This situation highlights a basic rule of internal control: wherever possible, try to segregate the handling of cash/assets and the reporting/recording of these items. Do not let one person perform both roles, because of the temptation this poses. [page 247] What are other common situations where segregation of duties should apply? opening mail that includes cheques from debtors, and the debtors’ clerk role (reporting on debtors and chasing up overdue accounts); handling cash sales and tallying up the amount in the cash register to be banked; and issuing purchase orders and approving payment for purchases. In addition to discouraging theft, having more than one person involved in any particular business process can also improve the accuracy of a business’s records. An error that might not be obvious to one person, could be spotted by someone else at the next stage of the process.

5.3.1.4

Authorisation procedures

Michael and Michelle play an active part in the management of their business. However, they cannot be expected to do all the ordering, checking in of stock, creditor payments, wages, banking, and the broad range of other duties that are required to run a successful business. They would probably set up levels of

authorisation. What are common situations where authorisation should apply? a store manager who is able to authorise product returns for credit; cheque payments requiring two signatories; purchase orders required to be signed prior to ordering; credit applications required to be approved once all other information has been gathered.

5.3.1.5

Rotation of duties

Rotation of duties involves staff switching roles. For example, the person currently handling the accounts payable role might swap roles with the person currently carrying out the debtors’ clerk role from the first of next month. Note that we are not talking about one person doing both roles at one time; there is a separation of duties. Such rotation of duties offers practical benefits to both business and employees. The business has staff with a wider range of skills to call on, and employees get a greater variety of work experience. But such rotation also provides benefits in terms of internal control. Employees who take on duties that someone else has been carrying out, effectively act as a check on the work that their predecessor has been doing. This can result in uncovering genuine errors or the misappropriation of assets.

5.3.1.6

Carrying out checks — verification or reconciliation of balances

Michelle performs a bank reconciliation for Spacemakers Hardware each fortnight, checking that the receipts and payments recorded in the accounting records agree with those showing on the bank statement (or on the online transaction summary that Michelle can check by logging in to their bank’s website). What is the point of doing this? First, it improves the accuracy and completeness of the business’s accounting. The bank statement alerts Michelle to any items Spacemakers

Hardware has missed recording — for example, bank fees she was previously unaware of, or a cheque that [page 248] had not been recorded. Cross-checking the bank statement could also alert Michelle to any transaction recorded for the incorrect amount — if the bank statement shows cheque 100335 being for $83 but Spacemakers Hardware has recorded it as $88, the business may well have misrecorded the amount. The reconciliation also acts as a deterrent to staff who might otherwise be tempted to steal money that should be deposited in Spacemakers Hardware’s bank account. What if the business’s records show that $1,300 should have been banked on a particular day, but the bank statement shows that only $1,000 was actually banked? If other possible causes for the discrepancy (such as a $300 post-dated cheque having been held back for later banking) are eliminated, then the business is alerted to the likelihood that $300 has been stolen. If employees are aware that regular bank reconciliations are prepared, they will realise that any theft of money will come to light. But if reconciliations are not being done, any theft of money is unlikely to be detected. Could knowing that they would get away with it tempt some staff to steal from their employer? What other common types of checks do businesses carry out? A stock (inventory) reconciliation: This reconciliation is a count carried out of what is in stock, and it is compared to the accounting records. Any discrepancies may alert us to the possibility of errors in recording stock transactions, or to stock theft. Perhaps an item showing in the records but no longer actually in stock, has gone to a customer but someone has missed recording the sale; or perhaps the item has been stolen by staff, or by shoplifters. A fixed asset audit: This audit is a physical check carried out to confirm

that all the fixed assets that the business shows on its records (its fixed asset register), are actually still where they should be. A reconciliation of creditor accounts: This reconciliation checks that the amounts owed to each supplier in terms of our accounting records are agreed to the suppliers’ statements. Why do this? To make sure that we have got a complete and accurate picture of what we owe, so that we get our cash flow planning right (and claim back the correct amount of GST); and to double-check that we pay the right amount owed, as overpaying suppliers is not good for our cash flow, and underpaying them could cause problems getting future supplies from them. Petty cash checks: Petty cash is a relatively small amount of cash kept aside to pay for small items (for example, milk for morning tea), where it is not convenient to pay with cheques or by direct credit. When employees receive petty cash, a voucher is normally filled out showing what is being purchased. A receipt for the purchase is then attached to the voucher. A petty cash check involves checking to see that all of the petty cash is accounted for. For example, if we went to check Spacemakers Hardware’s petty cash tin, we should find that the total amount of the vouchers in the tin plus any cash in the tin, should add up to $100 — the set amount of Spacemakers Hardware’s petty cash. If it adds up to less than $100, then either someone has missed recording a legitimate purchase, or someone has illegally taken the money for personal use. Professional audits: Auditors are a particular type of accountant who can be hired by businesses to check their accounting records and systems. Auditors are mainly concerned with checking that the business’s financial records are accurate and [page 249] complete, and that they follow Generally Accepted Accounting Practice.

They can also give advice on steps a business can take to improve its system of internal control. What else should we consider when it comes to carrying out checks? Let us remember to keep things in perspective. For example, the frequency and effort put into checking a bank account handling high-value transactions, should be greater than that put into checking petty cash. A theft of $30 from petty cash would not cripple Spacemakers Hardware, but a theft of $50,000 from its bank account might. Checks can be carried out randomly, or at regular intervals. For example, we might prepare bank reconciliations at the end of each month to fit in with GST return needs (checking that all payments and receipts for a GST period have been captured). We would carry out regular year-end checks of stock, creditors, and bank accounts to ensure the accuracy and completeness of the annual financial statements. Regular checks work well when there is a need for accuracy and completeness of periodic reporting. But how effective are they at detecting employee theft? Let us imagine that I am a dishonest individual, that I am in charge of looking after petty cash, and that you carry out a check of petty cash at the end of every month. Would your check deter me from using petty cash for my own personal use? I doubt it. I could spend petty cash on myself throughout the month and then just temporarily reimburse it myself on the day that the check is to take place — taking the money back straight after you have finished the count! But what if you carried out the odd random check? Then I would be at risk of being caught — you could choose to check on any day and find that money was missing. Knowing this might well deter me from taking the money in the first place. Carrying out a check at random, every now and then, increases the value of checks in detecting and deterring employee theft.

5.3.1.7

Physical security of assets

If you have got a wallet full of cash or an expensive portable CD player, you

would not leave either on a public bench while you walk off to buy some lunch. In the same way, in business we should not make it easy for valuable assets to be stolen. Let us think about which assets are most vulnerable, and consider steps we could take to reduce the risk of them being stolen. Cash is an “at risk” asset, and should be kept physically secure. Michael and Michelle make sure that cash takings are banked daily, rather than allowing large amounts to build up and be kept on the premises overnight. Petty cash is kept in their office in a locked tin. The computer on which Michael and Michelle keep Spacemakers Hardware’s accounting records and action bank transactions, is kept in their office so that customers or unauthorised employees do not have easy access to it. Access to this computer could provide the opportunity to transfer sizeable funds out of the business’s bank account, to set the amount of pay that an employee receives, or to falsify records to cover up an existing fraud. Michael and Michelle keep Spacemakers Hardware’s cheque books and order books securely locked away when not in use. If a dishonest person, able to make a reasonable forgery of the cheque signatories’ signatures, had access to its cheque book, Spacemakers Hardware risks having the money in its cheque account cleaned out. An order book left lying around presents an invitation to a dishonest person to buy things in the name of the business that are really for their own personal use. [page 250] Storeroom stock should be kept in well-secured rooms with limited physical access. For goods on display, we should consider the value of the item and its portability when deciding where to display it. For example, a computer retailer might well display a small, expensive digital camera behind a locked glass cabinet, whereas a large and relatively inexpensive computer desk could be safely displayed near the store entrance.

Other measures available to protect stock from theft include equipping the store with a monitored security alarm, the electronic tagging of stock, and video camera surveillance of the store.

5.3.1.8

Accounting procedures

Imagine you bought this book from a bookstore, paying $80 cash, and one of the following things happened: The salesperson put the $80 in the till, but got interrupted by a phone call and forgot to record the transaction. The salesperson put the $80 in his back pocket, and deliberately failed to record the transaction. In the first situation, would the bookstore be likely to “catch” the slip-up? If they are carrying out regular bank reconciliations, they should spot that they have not yet recorded $80 banked (they might even carry out daily reconciliations of till takings, and spot it very quickly). They might well track it to being a sale of this book based on its price and a cross-check of stock — their accounting records should show one more of this book in stock than physically exists. But it would still be a time-consuming task that could have been avoided if the sale had been recorded in the first place. In the second situation, the bookstore would have no obvious way to spot the theft. A bank statement would show no sign of the money, as it was never banked. This would agree with the accounting records, because the transaction was not recorded. The key lesson to be learned is simple: if there is no record that an asset exists, then carrying out a check cannot tell us that it is missing. Whether you are concerned about the accuracy of information or about theft, it makes sense to try to record all transactions when they occur. What steps can we take to achieve this? Have procedures in place that encourage staff to record all sales promptly. For example, items can be priced so that change is required, forcing staff to ring up the sale on the cash register — a customer paying with a $20 note

will wait for change from a $19.90 item, but would not if it were priced at exactly $20. Some businesses issue customers with receipts that offer discounts at other businesses (for example, “$2 off your next video hire”), encouraging the customer to wait for the receipt and thereby encouraging staff to record the sale. Using a barcode scanner can make it easier for staff to record a sale, and reduces the chance for human error. Record all payments from debtors promptly. As well as ensuring that the records are accurate and up to date, this reduces the chance of upsetting customers (who will not appreciate a “payment is overdue” statement if they have actually already paid). [page 251] Keep a record of any purchase orders made. Orders, either in the form of a pre-numbered order book or an order electronically generated by accounting software, should be sequentially numbered, and businesses should require suppliers to quote the order number on their invoices. This confirms that the expenditure has been properly authorised, and helps keep track of what is on order. Documentation should be designed to obtain all the required information. Having serialised documentation is of little use if there is no audit to ensure that all documents (invoices, and particularly cheques), can be accounted for. Make sure that any fixed assets purchased are promptly entered in the fixed asset register (being a list of all fixed assets, showing their cost, purchase date, description, and other details). Have clear procedures in place for recording all stock movements. Make sure that these cover irregular situations, and not just standard sales. Perhaps clients may receive items from stock to try out on a trial basis. Perhaps staff take stock items with them on service call-outs, in case they are needed to carry out repair work for clients. Do not rely on human

memory — a record of what has happened to the stock must be made at the time it leaves the store.

5.3.1.9

“SAVERS” methodology

SAVERS is an acronym for the internal control method consisting of: S: separation of duty; A: authorisation; V: verification; E: efficient policies and procedures; R: reconciliation; and S: serialisation of documents.

5.3.2

MODERN TOOLS TO HELP INTERNAL CONTROL — THE USE OF TECHNOLOGY

Briefly think about the following questions: In what ways can technology improve the accuracy or completeness of a business’s accounting? In terms of protecting a business’s assets, does information technology represent an aid, or a threat, or both? Explain why. What problems may people using computerised accounting software be likely to face? What types of technology, besides accounting software, could improve a business’s internal control? Explain how they would do this. How might different types of business use information technology to assist internal control — for example, a business that sells on credit, an internet retailer, or a polytechnic? One of the key purposes of internal control is to improve the quality of

information — to improve the accuracy and completeness of a business’s accounting records. [page 252] Michael and Michelle have noted just some of the ways in which it does this. Some other ways in which technology can improve the quality of information, include: leaving calculations up to the accounting software so that the maths is always accurate; using barcode scanners to record sales, eliminating manual entry and the human error that goes with it; having checks programmed into accounting software — for example, the software not allowing a transaction to be recorded until all required cells have data entered in them, or refusing to save a transaction until the dollar values entered balance (that is, the accounting equation is in balance), or alerting us if a specific cheque number has already been recorded (reducing the risk of entering something twice); the use of the internet for the direct entry of transactions — for example, an order can be placed by a customer through a business website and the business’s records are automatically updated; in contrast, human error could occur if a paper-based order was received and manually keyed into the accounting system; accounting software “prompts” — for example, reminders to run data checks and back up your file when logging off; and software tools built into accounting packages, such as electronic bank reconciliations, that make it easier to check the accuracy and completeness of records. As Michael points out, technology cannot ensure perfect accuracy and

completeness — it still relies on its human masters to follow appropriate procedures — but it can improve things considerably.

5.4

Statement of cash flows

In Chapter 3, we referred to the requirement to alter our profit figure to represent events which have occurred, but for which there has not been a cash flow. Because a number of estimates are required, it is possible that the profit figure could provide a more favourable view than the business deserves. The statement of cash flows presents a summary of an entity’s receipts and payments (that is, cash inflows and cash outflows) for a certain time period, to explain the net increase or decrease in the entity’s cash balance. While the income statement and balance sheet are prepared on an accrual basis (that is, in relation to when the transaction occurred, and not necessarily when the cash was received or paid), the statement of cash flows reflects only transactions, or parts of agreed transactions, that occurred in cash during the accounting period. A properly prepared statement of cash flows is important in addressing the real success of a business. There are a number of reasons for this: Cash represents the lifeblood of a business, as it is required to meet shortterm commitments. By definition, a report is required which tracks how the cash is flowing through the business. [page 253] However, more important to external users is that the statement of cash flows is able to be compared to the bank account. The bank account balance is, in turn, able to be verified against the money held in bank accounts.

A user of the statement of cash flows is able to determine how much cash is derived from business activity, and to see the sources and applications of cash — for example, that the funds sourced from financing are being used to supplement operational activities. In the statement of cash flows, cash inflows and cash outflows are classified under three headings: operating activities, investing activities, and financing activities. Let us have a look at this in more depth.

5.4.1

DESCRIPTION OF A STATEMENT OF CASH FLOWS

For most entities, the statement of cash flows represents the movements in its bank account. This statement is based on cash accounting, rather than accrual accounting (income statement, statement of changes in equity, and balance sheet), and provides additional information to a user about the ability of the business to generate cash and how that cash is spent. The closing figure in the statement of cash flows is the total amount of cash and cash equivalents on the balance sheet. Cash, for the purposes of the statement of cash flows, is defined as coins and notes, demand deposits (including bank overdrafts), and other highly liquid investments. In terms of the New Zealand Equivalent to International Accounting Standard 7 Statement of Cash Flows (NZ IAS 7): Cash comprises cash on hand and demand deposits. Cash equivalents are short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value. Cash flows are inflows and outflows of cash and cash equivalents.

(NZ IAS 7, paragraph 6) The cash flows relating to the three sections of the statement of cash flows, are as follows: Cash flows from operating activities: These are cash flows from receipts

from customers (that is, cash sales, and debtors’ receipts), interest received, and dividends received; and cash outflows in respect of payments to suppliers (that is, cash stock purchases, and creditors’ payments), wages paid, other expenses, and interest paid. In terms of NZ IAS 7, operating cash flows include: (a) cash receipts from the sale of goods and the rendering of services; (b) cash receipts from royalties, fees, commissions and other revenue; (c) cash payments to suppliers for goods and services; (d) cash payments to and on behalf of employees; (e) cash receipts and cash payments of an insurance entity for premiums and claims, annuities and other policy benefits; (f)

cash payments or refunds of income taxes unless they can be specifically identified with financing and investing activities; and

(g) cash receipts and payments from contracts held for dealing or trading purposes.

[page 254] Cash flows from investing activities: These are cash inflows from the sale of non-current assets and liquidation of investments; and cash outflows in respect of the purchase of non-current assets and the purchase of investments. Cash flows from financing activities: These are cash inflows from owner’s capital investment and loan financing; and cash outflows in respect of drawings or dividends, and repayment of loans. The following items must be separately identified in the statement of cash flows: interest received and paid, dividends received and paid, and tax. The brief description above gives an indication of the relationships between the income statement and balance sheet, and the statement of cash flows. This is further illustrated in Figure 5.1 below. A brief review of the Xero Limited accounts (see Appendix 1) can give insight into how a more complex statement of cash flows might appear.

FIGURE 5.1: THE RELATIONSHIPS BETWEEN THE INCOME STATEMENT AND BALANCE SHEET, AND THE STATEMENT OF CASH FLOWS

Note that the net cash flow from operating activities will not normally equal the net profit (calculated on an accrual basis) for the corresponding period. The net operating cash flow includes items relating to the prior and future periods, and will not include items for this period not transacted in cash. Examples of items that are included in the income statement, but are not included in the statement of cash flows, are depreciation, bad and doubtful debts, amortisation, and deferred tax. [page 255]

5.4.2

PREPARATION OF A STATEMENT OF CASH FLOWS

To illustrate the preparation of a statement of cash flows, we will take the simplified scenario of a courier driver, Fastaway Couriers. We will be looking at the following transactions taking place in August 2015: i.

Proprietor invested additional cash of $3,500 into the business.

ii.

Sold a vehicle (book value $7,000) for $7,000 cash.

iii. Paid wages of $400. iv.

Earned $340 fees on credit.

v.

Incurred $760 vehicle expenses (petrol and oil) on credit.

vi.

Paid creditors on account of $910.

vii. Received $150 from debtors on account. viii. Banked $3,150 fees earned. ix.

Proprietor withdrew $2,800 cash for personal use.

x.

Bought a new vehicle for $30,000, paying a $10,000 deposit. [page 256]

After entering these transactions into a work sheet, you would be presented with the following accounting equation:

[page 257] You are required to complete a classified statement of cash flows in the appropriate form. We will use the direct method to prepare our statement of cash flows. The direct method reports major classes of gross cash receipts and payments. The other method (the indirect method) uses net profit as a starting point, makes adjustments for all transactions for non-cash items, then adjusts for all cash-based transactions. It incorporates changes in working capital. This method converts accrual-basis net profit (or loss) into cash flow, by using a series of additions and subtractions. This is an optional method now allowed in New Zealand. There is also a requirement that a reconciliation between cash flows from operations and operating profit be done — similar to the example provided in the Xero Limited accounts, where

the net loss after tax is reconciled to the net cash from operating activities (see Note 14 on page 23 of the Xero Limited 2013 Annual Report). The process for completing the statement of cash flows using the direct method, is as follows: We will create the structure of the statement with its appropriate headings, providing room to enter the analysis described in the next point. Moving down the bank column, we will note whether the flow is in (positive) or out (negative), and to which area of the statement of cash flows each flow pertains. We will enter the numbers into the appropriate section of the statement of cash flows. We will introduce the opening bank balance and closing bank balance, and ensure that all differences are explained in the statement. The above process should result in a statement of cash flows which looks as follows: Fastaway Couriers Statement of cash flows For month ended 31 August 2015 $

$

CASH FLOWS FROM OPERATING ACTIVITIES Receipts from customers

3,300

Payments to suppliers

(910)

Payments to employees

(400)

Net cash inflow from operating activities

1,990

CASH FLOWS FROM INVESTING ACTIVITIES Sale of vehicle Purchase of vehicle Net cash outflow from investing activities

7,000 (10,000) (3,000)

[page 258] $

$

CASH FLOWS FROM FINANCING ACTIVITIES Additional capital Drawings

3,500 (2,800)

Net cash inflow from financing activities NET DECREASE IN CASH HELD Add Cash at 1 August 2015 BALANCE OF CASH AT 31 AUGUST 2015

5.5

700 (310) 400 90

Conclusion

Review Chapter 1, in which the requirements for accounting information are explained.

In this chapter we began to see the nexus between financial accounting (mainly for external decision makers), and management accounting (mainly for internal decision makers). It is usual for the same system to deliver information to both sets of decision makers, and it is important that the information is accurate. Internal controls contribute to ensuring that accounting information is accurate. They also help to ensure that assets are safeguarded. One of the main assets, and the one most able to be stolen, is cash. Cash is vital for the running of a business, and plans need to be put in place to ensure that liquidity is maintained. A plan which tries to anticipate cash needs, is known as a cash flow forecast. A statement of cash flows is a report designed to give users additional information about how the business generates cash inflows, and the types of cash outflows for the business.

5.6

Key words 5

age of debtors

Indicates how long, on average, in days it takes debtors to pay their accounts. The higher the age of debtors, the longer debtors are taking to pay. Days to pay are calculated as: average debtors / credit sales x 365.

authorisation

The internal control function in terms of which various functions need to be authorised by an appropriate person before the activity can be carried out. [page 259]

bank reconciliation

A report that reconciles the bank balance shown in the business’s accounting records at a particular date, with the balance shown on its bank statement for the same date; and which cross-checks the business’s accounting record to confirm that all bank transactions have been accurately recorded.

cash

Comprises “cash on hand, and demand deposits”. (NZ IAS 7)

cash equivalents

“Short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value”. (NZ IAS 7)

cash flow forecast

A report showing the expected cash inflows and cash outflows for a future period.

cash flows

“Inflows and outflows of cash and cash equivalents”. (NZ IAS 7)

direct method for preparing a statement of cash flows

This method reports major classes of gross cash receipts and payments directly from the accounts. (Compare this method to the indirect method.)

financing activities

That part of the statement of cash flows which focuses on cash changes in the liability and equity sections of the balance sheet. “Those activities which result in changes in the size and composition of the contributed equity and borrowings of the entity.” (NZ IAS 7, paragraph 6)

fixed asset register

A list of all fixed assets, showing their cost, purchase date, description, and other details.

indirect method for This method uses net profit (or loss) as a preparing a statement of cash starting point, makes adjustments for all flows transactions for non-cash items, then adjusts for all cash-based transactions; it incorporates changes in working capital; it converts accrual-basis net profit (or loss) into cash flow, by using a series of additions and subtractions. This is an optional method now allowed in New Zealand. (Compare this method to the direct method.) internal control

The set of procedures put in place within an entity’s governance and accounting systems to: minimise the possibility of errors or fraud; prevent error or fraud from happening;

detect error or fraud if they take place;

[page 260]

help safeguard assets; and promote efficiency. inventory-turn-rate of stock The number of times, on average, that the turn, stock turnover, entire inventory is turned over in one year. It inventory turnover) is an indicator of both operational efficiency and financial stability. Generally, the higher the turnover, the more efficient the inventory management of a business. A low stock turnover is associated with liquidity problems. Inventory turn is calculated as: cost of goods sold / average stock. investing activities

That part of the statement of cash flows which focuses on the changes in non-current assets. “Those activities relating to the acquisition and disposal of fixed assets and of investments.” (NZ IAS 7, paragraph 6)

NZ IAS 7

New Zealand Equivalent to International Accounting Standard 7 Statement of Cash Flows. This accounting standard sets out the requirements and presentation of a statement of cash flows for entities required to apply this financial standard.

operating activities

That part of the statement of cash flows which focuses on profitability and working

capital timing differences. Those activities of the business that relate to its basic day-to-day business operations. Cash from operating activities is basically the difference between cash received from customers, and cash paid to suppliers and employees. (Refer to NZ IAS 7, paragraph 6.) petty cash

A relatively small amount of cash kept aside to pay for small items (for example, milk for morning tea), that are not convenient to pay for with cheques or by direct credit.

reconciliation

The internal control function in which internal accounting totals are reconciled to external balances, or to physical counts.

reliability

Information is reliable when it corresponds with the actual underlying transactions and events (representational faithfulness), is able to be independently confirmed (verifiability), and is free from bias (neutrality).

[page 261] SAVERS methodology for internal control

An acronym for the internal control method consisting of: S[eparation of duty], A[uthorisation], V[erification], E[fficient policies and procedures], R[econciliation], and S[erialisation of documents].

segregation of duties

The internal control function which seeks to separate activities, so that individuals are able

to check other people’s work. statement of cash flows

A financial report showing where an organisation got its cash from, and what that cash was spent on for the period under review. The report classifies these cash inflows and outflows into three categories — operating, investing, and financing activities.

working capital management

Management of inventory, debtors, and creditors to ensure an efficient use of a business’s resources.

5.7 5.7.1

Resource file 5 CASH CYCLE ARTICLE — MONEY MAKES THE WORLD GO ROUND…

In an article titled “Money makes the world go round…” by Fiona Calderwood (Her Business, September/October 2000, pages 22–23), she explains the length of time it takes for inventory to be sold and money to be received from debtors, and gives suggestions on how to reduce the waiting time. It’s a little ditty that echoes in your mind when someone mentions it, but have you recently (if ever…) plotted down just how long your money takes to go around in your business? By this, we mean measuring the length of time (usually in days) between when you pay your money out of your business and when you receive it back in. How long does your business have to “fund its working capital” — how many days does your business wait until money comes around again? Take for example the following business…

Sue makes scented candles and other aromatherapy products. She has on average $18,500 worth of stock in her workroom. Over a year, her raw materials cost, including waxes, scents, ribbons, bottles and oils, totals $54,000. To determine how long, on average, her stock waits to be sold, we calculate her stock turnover:

If we divide 365 days by 2.91 we get 125.42 days

[page 262] This means Sue’s stock, on average, sits in her workroom for 125 days, before being sold — over four months! Sue sells some candles for cash at fairs and shows, but the bulk of her candles and aromatherapy products are sold to exclusive tourist outlets. Sue on average is owed $37,000 at the end of a month by her retail customers. She sold $172,000 on credit to these customers during the year. To determine how long Sue waits for her debtors to pay her…

If we divide 365 days by 4.64 we get 78.66 days This means that Sue waits an average 78 days for her debtors to pay her — nearly two and a half months! So Sue is waiting 125 + 78 = 203 days (at least six months!) before seeing her money go round. No wonder Sue is going broke even though she is making a fair margin on her product and she has good customers.

Sales

$172,000

Cost of Goods Sold

$ 54,000

Gross Profit

$118,000

If we divide $118,000 by $172,000 we get 68.60% Gross Profit So how can Sue make her money go around more quickly? First lets look at Sue’s production cycle. Perhaps she could: Analyse what stock is waiting the longest before selling and stop making it!

Review her production timeframe — it would seem she is making her stock well in advance. Schedule production of different stock lines so that cheaper to produce stock is made first and more expensive product later (so it doesn’t sit on the shelf as long). Produce less stock herself and instead outsource production once a customer orders. How about her debtors cycle? Perhaps she could: Educate her clients to pay on time Offer incentives for early payments (not discounts…) Identify which debtors take the longest to pay (it may only be a couple) Request a 20 percent deposit up front (secured, of course, by her quality satisfaction or money back guarantee) Exclude debtors who are too slow (be fussy about who she sells to) Make payment terms seven days Send out invoices more regularly than once a month Send thank you cards when payment is received (positive behaviour reinforcement)

[page 263] What if she combined several of these together? Review production timeframe and sales records to determine seasonality of sales, and therefore stock required. Hold a “closed-door” sale (for invited customers) to move out (sell) stock that has been hanging around. Send a letter to existing clients advising new payment terms and offering incentives for early payment. Send out invoices twice a month. Follow up invoices within five days of late payment. So what happens to Sue’s cash cycle now? Sue now has $8,300 of stock on hand. Her average stock is now:

So Sue’s stock turnover is now:

If we divide 365 days by 4.02 we get 90.79 days Sue now has a better debt collection procedure and is educating her clients to pay on time. Her debtors now owe her $9,500. Her average debtors are now:

So Sue’s debtor turnover is now:

If we divide 365 days by 7.39 we get 49.3 days Sue now waits 140 days (four and a half months) before she sees her money going around. An improvement, yes, but still more room to do even better! So how long does your business have to wait until the money comes around again? Don’t just guess — grab a pen, your list of debtors, sales and production costs information and get to it! What? You don’t have that information? Now that’s another story.

5.7.2

FRAUD ARTICLE — FRAUDSTERS A SIMPLE, SAD BUNCH

In an article titled “Fraudsters a simple, sad bunch” by Greg Ansley (New Zealand Herald, 25 June 2003), he details the reasons why an Australian fraudster stole A$19 million, and the common types of fraud being carried out in Australia and New Zealand. In Melbourne last week a court heard Benjamin Beath’s bizarre dreams to bring peace and harmony to Australia, courtesy of the Beach Boys and A$19 million he is alleged to have stolen by fraud.

[page 264] Beath, a 23-year-old former teller with the Bank of Melbourne, allegedly siphoned the money from the bank into 31 accounts set up for the purpose, making up his own overdraft limits and cutting the debit interest to zero. Money went to a planned tour by Beach Boys musician Brian Wilson, various properties — including a restaurant and a stamp and coin shop — and as a deposit for a block of rainforest in Queensland to protect cassowaries, a brightly plumed species of flightless bird standing almost 2m tall. “I believed what I was doing was good and it was important and it was necessary,” Beath told

police in a statement read to the Melbourne Magistrate’s Court, which committed him to stand trial on 87 counts of obtaining financial advantage by deception. Beath’s alleged activities fit well into the pattern discerned in a new study of fraud in New Zealand and Australia by the Australian Institute of Criminology and PricewaterhouseCoopers. He allegedly acted alone, with simplicity and not a great deal of intelligence, and lasted long enough to amass such a large pile of loot because of an apparent hole in the bank’s internal checks. This, rather than organised and highly sophisticated, computer-aided crime, is the face of serious fraud in New Zealand and Australia, the study concluded. But it also said serious fraud in the two countries was both prevalent and costly, and New Zealand suffers the largest losses of any jurisdiction, exceeding even the roughly similar-sized states of New South Wales and Victoria. There were caveats: a relatively small sample size of 155 files drawn from police and prosecution agencies in each Australian state and territory, the Commonwealth of Australia and New Zealand’s Serious Fraud Office. The study also noted that some of the cases took place as far back as the early 1980s. But it said the work had identified some important failures in administrative and business practices. TransTasman costs were calculated by converting New Zealand dollars to Australian currency at a rate of NZ$1 for A$0.885. In total, the frauds covered by the study involved A$260.5 million. With A$13.5 million recovered as restitution before sentencing, this loss was reduced to A$143.9 million — A$44.82 million in New Zealand. The most common types of fraud were obtaining finance or credit by deception, crimes involving cheques and by ripping off federal benefits. One in three frauds were committed against financial services organisations, mainly because most of the crimes involved abuse of credit and financial products. Surprisingly, computers were used in 20 per cent of the crimes only, possibly because some of the frauds were committed when computers were less common. Most of the crimes involved false documents — often false or stolen identities — or false entries in ledgers or forged cheques. Fraudsters were by and large a fairly sad lot, aged mainly in their early 40s, 80 per cent male, many with prior criminal records, suggesting punishment through the courts had only limited deterrence.

[page 265] This was despite finding that in the cases covered by the study, three-quarters of the fraudsters

were sent to jail for an average maximum sentence of 3–4 years. Most of the others received various forms of periodic detention and release programmes. Just a handful received fines only. More than half were first-time offenders, relatively well-educated, mostly directors or employed in accounting duties, a high proportion at top management level. Their crimes involved significant breach of trust. Many were professionals and long-term employees — in some cases more than 20 years — who either ripped off their bosses or had a business relationship with victims. Most were caught by internal audit. Many simply failed to effectively cover their tracks — in some cases courts noted that the fraud was “simple, obvious and bound to be discovered”. The money they stole was overwhelmingly washed down a drain of greed and desperation. More than a quarter spent it on such luxuries as cars and travel, 20 per cent on financial problems and 16 per cent on gambling and high living. Just as Beath’s statement to police said he did not consider himself a thief because of the noble intentions behind his alleged crimes, most of the fraudsters covered in the study rationalised their actions. Most said they intended to use the funds to conduct legitimate business, and to repay the money they had stolen — especially among professional advisers who misappropriated client funds in the vain hope they could realise a profit and repay the cash without being discovered. From the corporate viewpoint, the study said most frauds involved prudential failures concerning the provision of finance and credit, and the verification of backgrounds of credit applicants. Other high-risk areas included problems with staff, such as inadequate employment screening and supervision, and failure to segregate staff duties or to notice employees living beyond their means. Further problems lay in auditing and accounting, including failing to note or act on unusual patterns in financial transactions or the use of unusual payment methods, or failure to analyse loss of profit.

5.7.3

MORE ON INTERNAL ACCOUNTING CONTROLS — WHITE COLLAR CRIME: COOKING THE BOOKS IN CORPORATE US

An article titled “White collar crime: Cooking the books in corporate US” by Jenni McManus (Independent Financial Review, 22 November 2006, page 21), which is reproduced below in abridged form, lists the five common frauds

identified by Arthur Levitt five years before the collapse of the US corporate Enron, and the questions which would often form part of an investigation by corporate fraud investigators. Waiving privilege means the company, and individuals, could be liable to both criminal and civil charges. White collar crime investigations have become battlefields of strategies and tactics in the United States. Five years before giant US corporate Enron collapsed, and long before a

[page 266] spate of white collar frauds ripped apart dozens of US companies, Arthur Levitt, then chairman of the Securities and Exchange Commission (SEC), drafted a list of accounting torts likely to cause problems for investors. Effectively a guide on how to cook the books, the practices on Levitt’s list could rip millions of dollars from shareholders, he warned. Few inside the Department of Justice (DoJ) and the SEC heeded his advice. In hindsight, New York lawyer Steven Kobe told the International Bar Association in Chicago last month, Levitt was offering the market an early warning of an avalanche of multi-billion-dollar white collar crime that is still grinding through the courts in downtown Manhattan. Firms seeking to hoodwink investors by “smoothing” their profits were likely to engage in one, or more, of about five common frauds, Levitt said. These included: “Big bath” restructuring: A corporate in trouble undertakes a “restructuring” where huge previous losses can be booked to a one-off restructuring charge; Acquisitions: Costs can be dumped into research and development budgets, thereby misleading the market by making these costs appear to have been used positively and productively; “Cookie jar” reserves: Expenses can be over-estimated and accrued. Then, two or three years later when income is down, expenses can be judiciously released from reserves to give investors the impression the company is still making money; Backdated executive options: This ensured the best price for the recipient was obtained but affects revenue recognition. Just how seriously the US courts and regulators view this sort of behaviour can be seen in the six-year jail term recently handed down to Dynegy tax lawyer Jamie Olis, Kobe said. Dynegy’s crime, in part, was to move revenues fraudulently from one quarter to another. Materiality: Corporates sometimes go to extraordinary lengths to convince themselves, and the financial regulators, that any problems are not significant, meaning they will not materially affect

investors and the share price. As Levitt saw it, big corporates’ efforts to prove an issue isn’t material simply indicates it is material. Why not just disclose it? Post-Enron regulators and prosecutors have lifted their aggression levels as US corporate bosses with fraud convictions face decades in jail. Typically, a corporate fraud investigation will be done independently of managers and other executives, says Albert Lilienfeld, of Deloitte Financial Advisory Services in New York. The company’s audit committee does the inquiry with outside counsel retained by the board. The initial “how, what, when, why and who” questions will scope the parameters of the investigation, followed by what Lilienfeld describes as “possibly the most critical stage” — gathering documents. “There is probably more critical information in emails and their attachments than in the accounting records,” he says, “as they disclose what people were thinking at the time and what their schemes were.” But the task can be arduous, with documents usually in more than one location and, often, on different systems and in many jurisdictions.

[page 267] Forensic advances mean emails can rarely be deleted permanently. Another hazard is metadata, also known as “data about data.” This can provide a significant audit trail. “Getting the documents is critical to understanding what went on and to assess the truthfulness of various witnesses,” Lilienfeld says. “You can often find a file on someone’s hard drive, even if that person thinks it has been deleted. Investigators should always ask whether there is an earlier version of a document.” Should they start their interviews with the most senior staff? “Investigators are interested in the senior people because they made the representations about the accounting information,” Lilienfeld says. “But they are also interested in talking to those at the bottom because these people can give you information about what the company was doing and what the employees were told.” In particular, he says, government agencies are interested in “the basic tone at the top”. Investigators find themselves asking: “What is the culture of this company that allowed these senior people to push the envelope?”

5.7.4

MORE ON FRAUD — DAVID ROSS GETS 10 YEARS, 10 MONTHS JAIL

In an article titled “David Ross gets 10 years, 10 months jail” by Hamish Fletcher (New Zealand Herald, 15 November 2013), details are provided of several serious recent New Zealand fraud cases, including the amounts stolen and the circumstances of the frauds. The man behind New Zealand’s largest Ponzi scheme has been sentenced to 10 years and 10 months in jail — a punishment deemed too lenient by one of his victims. David Ross, Wellington financier and former head of the Ross Asset Management (RAM), was sentenced at the Wellington District Court today by Judge Denys Barry. The 63-year-old’s elaborate fraud, spanning 12 years, cost hundreds of investors their life savings and retirement funds. In total, $115.5 million of investments is estimated to have been lost in the group, which folded last November. Prior to its collapse, Ross had led investors to believe they had $351.5m in client portfolios. His sentencing today follows guilty pleas to a combination of Serious Fraud Office (SFO) and Financial Markets Authority (FMA) charges. A minimum non-parole sentence of five years and five months was imposed by Judge Barry. Bruce Tichbon, who lost money with RAM and heads the victim’s group Ross Support, said outside court today the assigned jail time was not enough. “It is not a sufficient disincentive to stop further white collar fraud in this country. We have had a raft of it in the last five or six years, and I confidently predict that we will see more.” SFO director Julie Read said more than 1200 client accounts had been affected by Ross’ scheme. “The financial losses are not only significant to [t]hose individuals but they will have a flow-on effect as those investors’ dealings in the New Zealand economy are impacted.” FMA chief executive Sean Hughes said he had the utmost sympathy for investors who had placed their trust in Ross.

[page 268] “From next year financial advisers who manage a client’s portfolio under an investment authority will no longer be able to hold that money or property themselves,” he said. … David Ross, sentenced on eight charges Serious Fraud Office: four of false accounting, one charge of theft by person in special relationship. Financial Market Authority: one of supplying false information, one of dishonestly obtaining

authorisation to act as an authorised financial adviser, one for acting as a broker without authorisation. Reparations for victims: Ross’ lawyer Gary Turkington said all Ross’ assets would go towards reparations This included three properties in his family trust This was likely to be “infinitely small” compared to what investors had lost, with Mr Turkinton estimating the value of Ross’ assets to be between $1m and $2m. How it stacks up — recent white collar criminal sentences Michael Swann — 9 years, 6 months Michael Swann was sentenced to nine years six months jail in 2009 for his part in defrauding the Otago District Health Board of 416.9 million. He spent almost $11.6 million on boats, flash cars and properties — buying some with suitcases of cash. A former employee of the health board, Swann was released on Parole earlier this year after serving four years and eight months of his sentence. As at July, police had recovered about $3.6 million from Swann, mostly through the sale of assets seized under the Proceeds of Crime Act. Millions of dollars more remain unaccounted for. Neal Nicholls — 8 years, 6 months and Wayne Douglas — 8 years, 2 months The founders and beneficial owners of failed finance company Capital + Merchant, Neal Nicholls and Wayne Douglas are serving sentences of over 8 years in jail each. This followed a Serious Fraud Office trial where the men were found guilty of theft by a person in a special relationship for a series of loans totalling almost $20 million. The pair loaned investor money for their own benefit in ways that breached Capital + Merchant’s trust deed. In sentencing them, Justice Edwin Wylie said the director’ actions were cynical. “The offending was sophisticated,” he said. “Each of the offenders was driven by self-interest and greed.” The men both got 7 and a half years in jail and had their sentences extended to after pleading guilty to Financial Markets Authority charges. C + M collapsed in November 2007 owing $167 million to 7500 investors. They are likely to see none of their money back. Gavin Bennett — 8 years This Christchurch businessman was behind a $103 million fraud that funded his “lavish[”] and “grandiose” lifestyle. Gavin Bennett was sentenced to 8 years’ jail last year after pleading guilty to a running a Ponzi-style scheme which swindled South Canterbury Finance for at least $23 million. He is the former owner of IT firm DataSouth and pocketed millions from the six year scam, at times partying with models and drinking “Dom Peringnon like it was Speights”. Judge Jane Farish when sentencing Bennett said it was “an unprecedented level of fraud in our criminal history”.

[page 269] Jacqui Bradley— 7 years, 5 months

Jacqui Bradley swindled 28 investors out of around $15.5 million through her business, B’On Financial Services Ltd, which she ran with her non-deceased husband. In 2012 she was sentenced to seven years and five months’ jail for her prolonged and premeditated defrauding of clients. Bradley’s clients — who handed over millions of dollars — were told their money was securely invested with a Macquarie Bank fund in Australia, or had been used to buy New Zealand Government stock and gold futures. Instead, client money was in a “classic Ponzi scheme” being used by the Bradleys to repay clothes shopping, payments on a BMW and the mortgage on a Remuera home that was valued at $4.7 million in 2008, the Auckland District Court heard during her trial. Rod Petricevic— 6 years, 10 months One of the most vilified faces following the wave of finance company collapses around the global financial crisis, former Bridgecorp director Rod Petricevic is presently serving a sentence of six years, 10 months in jail for misleading investors and fraud charges. He was sentenced last year following two separate cases from the Serious Fraud Office and Financial Markets Authority[.] Bridgecorp collapsed in July 2007 owing 14,500 people about $490 million. Stephan Versalko — 6 years A former investment adviser at ASB Bank, Stephen Versalko sole $17.8 million from its customers over nine years before being discovered and jailed. Versalko spent most of the stolen funds on multimillion-dollar homes and a lavish lifestyle, this included paying at least $3.4 million to two prostitutes and showering them with $800,000 of gifts. He was sentenced to six year in jail in 2010.

5.7.5

INTERNAL CONTROL — INTERNET RESOURCES

The range of internet tools available to help business obtain high levels of internal control, include: http://en.wikipedia.org/wiki/Enron_scandal — for a readable history of Enron and its effects on the Andersen accounting firm. http://dnb.co.nz/Credit_Reporting/index.aspx and http://dnb.co.nz/Debt_Collection/index.aspx — Dun & Bradstreet is a major international credit management firm. Find out about the range of credit management services such a firm offers by accessing the URL addresses and checking out services such as Credit Reporting for both businesses and individuals, and Debt Collection.

http://www.cpaaustralia.com.au/~/media/Corporate/AllFiles/Document/professiona

resources/business/internal-controls-for-small-business.pdf — A guide produced by CPA Australia for small business owners regarding the type of internal controls they should have in place, and how to set them up. http://www.whistleblowing.com.au/information/documents/InternalControls.pdf — A guide for small business owners, which details the importance of internal controls, how to set them up, their limitations, and the positives from having internal controls. [page 270]

5.8 5.8.1 5.8.1.1

Mastering accounting — questions SHORT ANSWER QUESTIONS True/False

1.

The statement which plans for future cash needs, is a statement of cash flows.

2.

A company which is classified as falling within Tier 1 or Tier 2 of the Accounting Standards Framework, is required to complete a statement of cash flows.

3.

There are no similarities between a cash flow forecast and a statement of cash flows.

4.

Completing a proper cash flow forecast, requires making forecasts based on realistic values.

5.

Internal control is about the way that managers treat staff.

6.

Internal control is about detecting fraud.

7.

There is a manual of internal control which could suit all entities.

8. 9.

The cash which is received as a result of an asset sale, would show in the financing activities portion of the statement of cash flows. Depreciation, which is shown in the income statement, will be reflected in the operating activities portion of the statement of cash flows.

10. The cash received as a result of additional shares issued by a company, would be reflected in the financing activities section of the statement of cash flows.

5.8.1.2 1.

2.

3.

Multiple choice

The order in which a cash forecast is completed is: a.

payments, receipts, closing bank, opening bank;

b.

receipts, payments, opening bank, closing bank;

c.

opening bank, closing bank, excess receipts over payments, payments;

d.

cash flows from operating activities, cash flows from investing activities, cash flows from financing activities.

What is the internal control which is associated with checking balances against external sources? a.

physical security of assets;

b.

accounting procedures;

c.

reconciliation;

d.

segregation.

Which of the following classifications is used to include cash used for the acquisition and disposal of non-current assets? a.

operating activities;

b.

financing activities;

c.

investing activities;

d.

none of the above.

[page 271] 4.

5.

6.

7.

8.

Which of the following classifications is used for cash used for the payment of dividends? a.

operating activities or financing activities;

b.

financing activities or investing activities;

c.

investing activities or operating activities;

d.

none of the above.

Which of the following classifications is used for cash used for the payment of expenses? a.

operating activities;

b.

financing activities;

c.

investing activities;

d.

none of the above.

Which of the following classifications is used for the issue of bonus shares to shareholders? a.

operating activities;

b.

financing activities;

c.

investing activities;

d.

none of the above.

Which of the following transactions could be responsible for the difference between profit and cash flows from operations? a.

bad debts;

b.

staff wages;

c.

electricity payments;

d.

bank fees.

Under normal circumstances, the difference between the profit figure and the cash flow from operating activities, can be best explained as:

9.

a.

a result of incorrect accounting choices;

b.

a result of how revenues and expenses are recognised;

c.

a result of poor cash control by management;

d.

a result of timing differences between an activity taking place and the cash flow relating to it.

Why are cash flows from financing activities often compared to cash flows from investing activities? a.

to see how much money the owners are taking out;

b.

to see how much money the owners are adding to the business;

c.

the comparison provides insight into the financing arrangements of the business;

d.

to check the liquidity of the business. [page 272]

10. What is the qualitative characteristic which emphasises the importance of internal controls for preparing financial reports? a.

timeliness;

b.

reliability;

c.

consistency;

d.

comparability.

5.8.2

PARAGRAPH ANSWERS

1.

Briefly describe the role of professional auditors in the accounting system.

2.

Describe in one sentence the process surrounding an inventory reconciliation.

3.

List three things you would do to speed up debtor payments.

4.

Write a paragraph briefly explaining the importance of senior management setting the right example.

5.8.3 5.8.3.1

CASH FLOW FORECAST Cash flow forecast — Ti Harder

From the following information provided by Ti Harder, prepare a cash budget for the months of September, October, and November 2015. Estimated figures

September October November $

$

$

Cash sales

90,000

115,000

110,000

Credit sales

100,000

110,000

90,000

Cash purchases

50,000

45,000

55,000

Credit purchases

75,000

80,000

90,000

Rent received

1,000

1,000

1,000

Wages

6,800

6,800

7,500

10,400

10,400

11,400

Other operating expenses Land

150,000

Accounts receivable regularly settle their accounts as follows: – 90% in the month following sale; –

8% in the second month; and



2% in the third month.

Accounts payable are paid in the month after purchase. Actual credit sales in June, July, and August were $70,000, $75,000, and $80,000 respectively. Actual credit purchases in August were $50,000. Other operating expenses include an amount of $400 per month for depreciation. Bank balance at 31 August was $5,000 overdrawn.

[page 273]

5.8.3.2

Cash flow forecast — Ace Apples

Ace Apples is a local apple orchard. Ace, the owner-manager of Ace Apples, has hired you to prepare a cash flow forecast for the six months ending 30 June. You should prepare this on a spreadsheet. Ace has provided you with the following information: Ace Apples has an overdraft facility with its bank, under which it can borrow up to $5,000. As at 1 January, its bank account is $2,000 overdrawn. Ace Apples sells its apples through two channels: at auction to local buyers; and through ENZA for export overseas. Ace gets paid for apples sold at auction on the 20th of the month following the auction. Auction sales for the period are expected to be: – January:

$5,000;

– February: $7,000; – March:

$12,000;

– April:

$10,000;

– May:

$6,000;

– June:

$2,000.

No auction sales took place in December — that is, no debtors existed as at 1 January. Sales of apples to ENZA are expected to be $20,000 in March, and $20,000 in April. Half of each month’s sales is expected to be paid in the month of sale; the balance of both months’ sales will be paid in one lump sum in June. $2,000 in wages for part-time apple pickers is expected to be paid in each of April and May. $1,500 in packaging is expected to be purchased in January. Payment for

this will be due on the 20th of the month following purchase. $2,500 in lease payments is scheduled to be paid in each of February and May. Other expenses totalling $800 a month are expected to be paid in each of the six months. Drawings of $1,200 a month are expected to be paid in each of the six months. $500 in income tax is scheduled to be paid in February (terminal tax), and $1,600 in May (provisional tax). Ace plans to purchase and pay for a new tractor in the amount of $10,000, net of trade-in, in February. 1.

Prepare a cash flow forecast for Ace Apples for the six months ending 30 June. This should show cash inflows and cash outflows for each of the months, as well as overall totals for the six months; it should also show the cash in the bank at the start and at the end of each month.

2.

The cash flow forecast for Ace Apples should alert us to a problem in February — the business will exceed its overdraft limit if cash flow turns out as currently expected. What advice would you give to Ace Apples’s owner-manager? [page 274]

5.8.4 5.8.4.1 1.

INTERNAL CONTROL Internal control and working capital management

An entity which grants credit to customers, needs to have a good credit control policy in order to keep funds that are tied up in accounts receivable, to a minimum. Outline two important components in a

credit control policy, and explain how they would help control the level of accounts receivable. 2.

Stock levels are a significant factor in working capital management. What are the consequences for an entity if the level of stock which it carries is too high or too low? Give two consequences of each.

5.8.4.2

Internal control — Dixon’s Pharmacy Ltd

Dixon’s Pharmacy Ltd is a small chemist which sells most of its product through a telephone ordering system. This system is described briefly below. The customer rings an 0800 number. The person answering the phone works for a telephone company and relies on the computer system to provide the right questions to be answered. Dixon’s Pharmacy Ltd has provided the data entry form requiring: – the name and address of the customer; –

the address for delivery of the product;



the method of payment (cheque, credit card, invoice); and



the stock quantity and type.

This information is printed out in the storeroom at Retail Ltd. The storeman packs the pharmaceuticals, and arranges for them to be delivered by courier. The storeman orders replacement items whenever he thinks it might be necessary. Once the goods have been sent, the printout is transferred to a creditors’ clerk, who prepares the invoices. Invoices are handwritten on prenumbered documents, and sent by mail. When payment is received, the creditors’ clerk compares the payment to the original invoice. If the amount is correct, the invoice is destroyed. At the end of each month, the credit controller sends out photocopied letters to all those customers who have outstanding invoices showing in the file. Any invoices older than 12 months are thrown out. The credit controller is particularly careful about the large amounts of cash

he is paid. He accepts the cash, and puts it straight into a safe. At the end of the week, the credit controller prepares a bank deposit form, and gives the money and deposit form to the security driver to take to the bank. For each of the principles listed below, provide two examples of the principles being violated. Within each example, suggest an improvement that can be made. 1.

separation of duty;

2.

authorisation;

3.

verification; [page 275]

4.

efficient policies and procedures;

5.

reconciliations;

6.

serialisation of documents.

5.8.4.3

Internal control — determining the key facts

Read the article “Fraudsters a simple, sad lot” in Resource file 5, paragraph 5.7.2, and answer the following questions: 1.

The article states that many fraudsters have “prior criminal records”. Given this, what internal control procedures would you recommend businesses take regarding employees and customers.

2.

What is the likely reason for those “employed in accounting duties” making up a significant proportion of offenders?

3.

Given that “many simply failed to effectively cover their tracks”, explain the role of regular checks, such as bank reconciliations, as a part of a business’s internal controls.

4.

The study of fraud in New Zealand and Australia identifies “failure to

segregate staff duties” as one common business failing. Explain, giving examples, how the segregation of duties can help to detect or deter fraud.

5.8.4.4

Decision making at the top

Read the two articles on “white collar crime” in Resource file 5, paragraphs 5.7.3 and 5.7.4, and answer the following questions: 1.

Use the internet to find definitions or examples for the “big bath” accounting manipulations referred to in the “White collar crime” article.

2.

Use the internet to find the definition of a Ponzi scheme, and examples of other prominent Ponzi schemes.

3.

“Leishman recommends companies use a strategy to detect fraud across the board rather than focusing only on internal controls. These can be overridden by senior managers.” (Independent Financial Review, 20 July 2005). Comment on this statement with regard to the article, “White collar crime”.

5.8.5 5.8.5.1

STATEMENT OF CASH FLOWS Statement of cash flows — Quality Traders

Based on the following information, prepare a fully classified statement of cash flows for the month of October 2015. [page 276] $ Opening balance

17,500

Closing balance

104,800

Receipts Cash sales

48,000

Accounts receivable

86,000

Sale of equipment

27,000

Capital

18,000

Dividend received Term loan

5,000 120,000

Payments Operating expenses

124,000

Interest

20,000

Cash purchases

63,500

Accounts payable

125,000

Drawings

69,300

Motor vehicle

16,500

Loan repayment

5.8.5.2

8,000

Statement of cash flows — The Uniforme Shoppe Ltd

The Uniforme Shoppe Ltd had $7,000 in its bank account as at 30 June 2015. At the beginning of the year, there was an $8,000 overdraft balance as at 30 June 2014. Receipts and payments for the year ended 30 June 2015 were as follows: $ Receipts Cash sales

189,500

Debtor payments

211,000

Interest earned

1,500

Mortgage received

80,000

Sales of land

95,000

Payments Cash purchases Creditor payments Dividends Interest paid Land and building purchase Tax

22,000 178,000 20,000 6,500 190,000 19,000

25,000

Van purchase Wages and salaries

101,500

Prepare a fully classified statement of cash flows for the month of October 2015. [page 277]

5.9 5.9.1 5.9.1.1

Mastering accounting — solutions SHORT ANSWER QUESTIONS True/False

1.

False. It is a cash forecast.

2.

True.

3.

False. They are quite similar in that they relate closely to the cash available.

4.

True.

5.

False. It is about procedures to control business assets and accounting information, as well as staff.

6.

False. It is as much about preventing errors, as it is about fraud.

7.

False. There is no one size which fits all.

8.

False. It appears in the investing section of the statement of cash flows.

9.

False. Depreciation is not cash — it should not appear in the statement of cash flows at all.

10. True.

5.9.1.2

Multiple choice

1.

a.

2.

c.

3.

c.

4.

a.

5.

a.

6.

d.

7.

a.

8.

d.

9.

c.

10. b.

5.9.2

PARAGRAPH ANSWERS

1.

Auditors are a particular type of accountant who can be hired by businesses to check their accounting records and systems. Auditors are mainly concerned with checking that the business’s financial records are accurate and complete, and that the business follows generally accepted accounting principles. They can also give advice on steps a business can take to improve its system of internal control.

2.

For purposes of an inventory reconciliation, a business would carry out a count of what is in stock, and compare this to what the accounting records say there should be. [page 278]

3. Require credit checks on all new non-cash customers, and ensure that there are robust procedures around granting credit. Issue invoices promptly, and follow up immediately if payments are

slow in coming. (Some businesses, think of Telecom or your local electricity supplier, seem to be able to collect debts quicker than others.) Follow a consistent debt collection policy. Track accounts receivable to identify and avoid slow-paying customers. Instituting a policy of cash on delivery, is an alternative to refusing to do business with slow-paying customers. 4.

It is important that senior management sets the right example — it is naïve to expect staff to act honestly if management acts dishonestly. It is, however, also true that you can alienate staff by overdoing security. If managers demonstrate good ethical behaviour and treat staff fairly, they are far more likely to find staff supporting business policies and procedures. In such a business, if an employee is doing something wrong, it is likely that other employees will put pressure on them to stop, or else turn them in to the management.

5.9.3 5.9.3.1

CASH FLOW FORECAST Cash flow forecast — Ti Harder

Note that depreciation is not included, because it is a non-cash transfer. Ti Harder Cash flow forecast Total credit sales

September

October

November

$

$

$

$

June

70,000

1,400

July

75,000

6,000

1,500

August

80,000

72,000

6,400

1,600

90,000

8,000

September

100,000

October

110,000

99,000 79,400

97,900

108,600

CASH RECEIPTS Cash sales

90,000

115,000

110,000

Cash from customers

79,400

97,900

108,600

1,000

1,000

1,000

170,400

213,900

219,600

Rent received Total receipts

[page 279] PAYMENTS Cash purchases

50,000

45,000

55,000

Creditors

50,000

75,000

80,000

6,800

6,800

7,500

10,000

10,000

11,000

Wages Other operating expenses Land

150,000

Total payments

116,800

286,800

153,500

RECEIPTS LESS PAYMENTS

53,600

(72,900)

66,100

Plus Opening bank balance

(5,000)

48,600

(24,300)

CLOSING BANK BALANCE

48,600

(24,300)

41,800

5.9.3.2

Cash flow forecast — Ace Apples

1. Ace Apples Cash flow forecast Jan

Feb

Mar

Apr

May

Jun

Total 6 months

$

$

$

$

$

$

$

CASH IN Auction receipts

0

5,000

7,000

12,000

10,000

6,000

40,000

ENZA receipts

0

0

10,000

10,000

0

20,000

40,000

0

5,000

17,000

22,000

10,000

26,000

80,000

Wages

0

0

0

2,000

2,000

0

4,000

Packaging

0

1,500

0

0

0

0

1,500

CASH OUT

Other expenses Lease

800

800

800

800

800

800

4,800

0

2,500

0

0

2,500

0

5,000

1,200

1,200

1,200

1,200

1,200

1,200

7,200

Income tax

0

500

0

0

1,600

0

2,100

Tractor

0

10,000

0

0

0

0

10,000

2,000

16,500

2,000

4,000

8,100

2,000

34,600

Net change in cash

(2,000)

(11,500)

15,000

18,000

1,900

24,000

45,400

Bank start

(2,000)

(4,000)

(15,500)

(500)

17,500

19,400

(2,000)

Bank end

(4,000)

(15,500)

(500)

17,500

19,400

43,400

43,400

Drawings

NET CASH IN/(OUT)

[page 280] 2.

Ace Apples has a $5,000 limit on its bank overdraft facility. The current cash flow forecast shows that the business will exceed this limit in February. What steps should Ace take? First, he could look at delaying the purchase of the tractor until April. If it was essential to purchase the tractor in February, perhaps he could arrange credit terms with the tractor dealer. Delaying the purchase of and/or payment for the tractor until April, would improve February’s overdraft position by $10,000, but still leave the overdraft $500 over its limit. Options to reduce this $500 excess could include spreading part of the “packaging” purchases into March, and reducing “other expenses” and/or “drawings” to a bare minimum for January and February (allowing for some catch-up expenditure in March to compensate for this). In a worst case scenario, Ace could apply to his bank for a temporary extension on his overdraft. Having the cash flow forecast may help him convince the bank that his need is just temporary, and that he will quickly be in a position to repay any extended overdraft.

5.9.4 5.9.4.1 1.

INTERNAL CONTROL Internal controls and working capital management

Prospective customers need to be screened to check their creditworthiness. Checks on income, other commitments, and asset backing, should ensure that credit is not extended to slow payers. Existing customers need to receive invoices and statements promptly, and be approached should they become overdue in settling obligations. Regular chasing of slow payers should minimise losses through bad debts.

2 Overstocking: – spoilage or obsolescence of goods; –

increased interest costs;



pressure on cash flows;



pressure on storage space.

Understocking: – lost profit on sales; –

losing customers’ goodwill/loyalty;



increased purchase costs (lost discounts, extra freight).

5.9.4.2

Internal control — Dixon’s Pharmacy Ltd

Internal control using the “SAVERS” methodology, where SAVERS is an acronym for the internal control method consisting of S[eparation of duty], A[uthorisation], V[erification], Efficient policies and procedures], R[econciliation], and S[erialisation of documents].

1.

Separation of duty: The creditors’ clerk receives payment and is responsible for eliminating debtors. Money should be received by someone other than the creditors’ clerk. (The same should happen with the banking.) The storeman receives orders and prepares goods for delivery. The

creditors’ clerk should receive orders first and ensure that all goods ordered are invoiced. [page 281] 2.

Authorisation: There is no authorisation of purchases. Stock orders/purchases should be authorised by someone with overview of business. There is no authorisation for eliminating non-paying debtors. A clear process for allowing credit needs to be set up, ensuring that all credit applications are authorised.

3.

Verification: There is no check of stock on hand. The accounting system should provide information regarding the amount of stock on hand, and stocktakes should be done regularly to ensure accuracy of this information. There is no verification of the performance of orders — orders are accepted based on the information available. Checks should be initiated which allow closer integration of the two systems.

4.

Efficient policies and procedures: Efficient policies and procedures relating to control of cash, and recording and maintaining debtors’ records are not in place. Efficient policies should be documented, and management should check to ensure that the policies are being followed. Photocopied letters are sent to customers. To ensure prompt payment, all correspondence should be professional and aimed at indicating efficient processes.

5.

Reconciliation: There is no reconciliation of debtors or monthly statements prepared

for debtors. Reconciliation of credit sales to payments received, or between individual accounts and debtors control, is required. Individual accounts should be reconciled to the debtors’ control account (summary of all debtors). As invoices are destroyed when payment is made, no written reconciliation between total credit sales and total payments received from debtors is prepared. There is no reconciliation of cash received to cash banked. Reconciliations are required to prevent human error or fraud. 6.

Serialisation of documents: The orders are not recorded on pre-numbered documents. All orders should be pre-numbered, so that deliveries can be accounted for. The documentation is destroyed. A properly prepared documentation system includes filing, and verification that no orders are lost or misplaced. [page 282]

5.9.5 5.9.5.1

STATEMENT OF CASH FLOWS Statement of cash flows — Quality Traders

Quality Traders Statement of cash flows For the month ended 31 October 2015 $

$

CASH FLOWS FROM OPERATING ACTIVITIES Receipts from customers Dividend received

134,000 5,000

Payments to suppliers

(188,500)

Other operating expenses

(124,000)

Interest Net cash outflow from operating activities

(20,000) (193,500)

CASH FLOWS FROM INVESTING ACTIVITIES Equipment sales Motor vehicle

27,000 (16,500)

Net cash inflow from investing activities

10,500

CASH FLOWS FROM FINANCING ACTIVITIES Owner’s capital input Term loan Loan repayment Drawings

18,000 120,000 (8,000) (69,300)

Net cash inflow from financing activities

60,700

NET DECREASE IN CASH

(122,300)

Plus Opening bank balance 1/10/2015

17,500

CLOSING BANK BALANCE 31/10/2015

(104,800)

[page 283]

5.9.5.2

Statement of cash flows — Uniforme Shoppe Limited

Uniforme Shoppe Limited Statement of cash flows For the year ended 30 June 2015 $

$

CASH FLOWS FROM OPERATING ACTIVITIES Interest earned Receipts from customers

1,500 400,500

Interest payments

(6,500)

Supplier payments

(200,000)

Tax Wages and salaries Net cash inflows from operating activities

(19,000) (101,500) 75,000

CASH FLOWS FROM INVESTING ACTIVITIES Sale of land Purchase of van Purchase of land and buildings

95,000 (25,000) (190,000)

Net cash outflow from investing activities

(120,000)

CASH FLOWS FROM FINANCING ACTIVITIES Mortgage

80,000

Dividends

(20,000)

Net cash inflow from financing activities

60,000

NET INCREASE IN CASH

15,000

Opening cash position 1/7/2014

(8,000)

CLOSING CASH POSITION 30/6/2015

7,000

[page 285]

The internal focus

CHAPTER

6

Contents Learning outcomes 6.1

Introduction

6.2

Planning for the future — an owner’s view 6.2.1 Case study — Spacemakers Hardware Ltd 6.2.2 Questions for discussion

6.3

Planning for the future — a professional’s view 6.3.1 Purpose of budgeting 6.3.2 Approaches to budgeting 6.3.3 Budgeting — behavioural issues 6.3.4 Handling uncertainty 6.3.5 Example — revenue and expenditure budget for Spacemakers Hardware

6.3.6

So how did we do?

6.4

How costs behave

6.5

Breakeven and beyond

6.6

Allowing flexibility in our budget process 6.6.1 Fixed versus flexible budgets 6.6.2 Preparing a flexible budget

6.7

Conclusion

6.8

Key words 6 [page 286]

6.9

Resource file 6 6.9.1 Formula — target profit after tax 6.9.2 Internet resources

6.10

Mastering accounting — questions 6.10.1 Short answer questions 6.10.2 Problems 6.10.3 Discussion questions

6.11

Mastering accounting — solutions 6.11.1 Short answer questions 6.11.2 Problems [page 287]

Learning outcomes After completing this chapter, you should be able to: explain the purpose of budgeting; prepare a simple trading budget; report on variances between actual performance and budgeted performance; distinguish between fixed and variable costs; demonstrate an understanding of breakeven and contribution margin; and prepare a flexible budget.

6.1

Introduction

In previous chapters, we discussed how a business’s financial statements tell us about its past. The balance sheet provides a picture of the business’s assets, liabilities, and owner’s equity as they were on a particular date in the past. The income statement shows us how much profit the business earned over a previous period, and the revenues and expenses behind that profit. In Chapter 5 we began to think about how cash flow can be measured from a historical perspective (statement of cash flows), to help us plan ahead (cash flow forecast). There will, however, be questions about the future of the business that are not easily answered by these financial statements — questions such as:

How much do we need to sell to cover all our expenses? What profit can we expect in the coming year? What effect would a 10% cut in our selling prices be likely to have on our profit? Will we have enough money in the bank to be able to pay our bills next month? What steps should we take in the coming year to improve our control of operations? In this chapter, we will take a look at some tools to help us answer these questions. Rather than look at past events through the eyes of an external user of accounting, we sharpen our focus in two ways, by looking at: accounting from the viewpoint of the internal user — the owner/manager; and accounting tools that tackle the future, rather than the past. [page 288]

6.2

6.2.1

Planning for the future — an owner’s view CASE STUDY — SPACEMAKERS HARDWARE LTD

In the last chapter, we introduced you briefly to Spacemakers Hardware Ltd. This is the business run by Michelle and Michael in Blenheim. As you remember, they owned a hardware store selling building, plumbing, and gardening supplies. They went to a chartered accountant when they started

their business, and have kept a very good working relationship. Due to the arrival of competition in town, Michelle, Michael, and their accountant have had to be far more diligent in their use of accounting information. Michelle and Michael face a number of decisions over the next year or two. “We have to work out a number of things,” said Michael. “What price are we able to sell our stock at to be able to cover our expenses, including a reasonable salary for each of us? How much was enough? How much money would we need to come up with to advertise, pay our bills, and to maintain the building we were leasing? Should we develop a coffee shop to attract more customers? Should we target trade customers? There were a heap of things that we needed answers to.” What are the advantages to Michael and Michelle of using the company structure of business ownership?

“What we did first,” explained Michael, “was to carry out some research. We talked to our accountant, some builders, plumbers, and our suppliers. We’ve pulled together the information we gathered, added in a healthy dose of educated guesses, and put it all down in a spreadsheet. That’s how we came up with our first budget.” “It helps us answer lots of ‘what if’ scenarios. Things are always changing — sales increase, or product prices go up, or we decide we’d like to increase our advertising. Having our financial plan in the form of a spreadsheet gives us a great management tool; we’re able to figure out the likely effect of these changes on our profit and cash flow.” “I used to think budgeting was something that accountants handled,” said Michelle. “But now I reckon it’s as much a part of our job, as making sure that the store is open on time, and that all the money is being banked.”

6.2.2

QUESTIONS FOR DISCUSSION

Let us look at how Michael and Michelle approached their financial planning for Spacemakers Hardware:

They gave a number of reasons for preparing and using a budget. What do you think the two most important reasons are? Why? Would the benefits of budgeting for a larger organisation be any different from those for a smaller organisation such as Spacemakers Hardware? Give reasons for your answer. Will the budget for Spacemakers Hardware in years two and three of its operations, differ from that for their first year? Use examples to explain your answer. Why is a budget in the form of a spreadsheet a “great management tool”? [page 289]

6.3

6.3.1

Planning for the future — a professional’s view PURPOSE OF BUDGETING

As a business professional, you could be involved in helping business people like Michael and Michelle prepare a budget. A budget is a financial plan. It sets out, in financial terms, what a business anticipates will happen for a future period. Exactly what a budget covers and how detailed it is, can differ greatly from business to business. Unlike financial statements prepared for external users, there are no specific rules that must be followed in preparing a budget. The budget for Spacemakers Hardware could go into great detail — for example, forecasting sales by each individual product, or by groups of products; alternatively, it could provide a more summarised view — for example, forecasting sales under two or three categories, such as building

supplies, plumbing supplies, or garden supplies; their budget could cover some or all of the following areas: expected sales; expected production; expected purchases and operating expenses; expected fixed asset purchases and sales; forecast monthly cash flow; and forecast for balance sheet and income statement. How much depth a budget goes into, depends largely on the needs of the business’s owners or managers. Preparing a very detailed financial plan covering all aspects of the business, works for some people. Others may feel that they just need to plan a few key areas — that spending too much time planning, prevents them from actually getting on and taking advantage of business opportunities. While businesses may differ greatly in how they prepare their budgets, they are likely to share a number of common purposes in preparing them. Let us consider some possible purposes: A budget maps out the measures that a business will take to move it towards its long-term goals. Such goals are not just achieved by chance — a budget provides a way to express in practical terms the steps the business will take in the coming period to move it towards these goals. Budgets enable decision makers in the business to anticipate problems and opportunities before they arise. If Spacemakers Hardware’s plan shows that it will exceed its overdraft limit in three months’ time, then Michael and Michelle are in a position to take steps to avoid the problem. Perhaps they will delay buying that new computer or taking on new staff. Without planning, they would be left with very few options when their business cheques started bouncing. Budgets can help to control operations, making sure that Michael and

Michelle stick to the plan. They will monitor their actual revenues and expenses, compared to [page 290] their budgeted revenues and expenses. They might reward themselves for achieving or exceeding budgeted sales. They might follow a policy that prevents them from placing orders that will take them over their budgeted expenditure. How rigidly the budget is treated, and the consequences of it not being met, varies greatly between different entities. Budgeting can improve communication and coordination within an organisation. For example, if Michael and Michelle hire a manager of plumbing goods, that manager would have a better idea of what to buy and when, if they received sales forecasts. Purchases of inventory can then be coordinated in line with production forecasts.

6.3.2

APPROACHES TO BUDGETING

In this section, we list a number of terms which describe budgeting approaches. While each approach has an opposite (that is, its polar opposite), it is not unusual for budgets to incorporate a middle ground, using parts from each extreme.

6.3.2.1

Incremental budgeting

Incremental budgeting is the process of taking last year’s numbers as being a realistic view of performance, and adjusting those levels by incremental amounts to achieve the desired budget. For example, last year’s lease costs might be $5,000 and inflation is 2.5% — therefore this year’s lease costs will be $5,125. The incremental approach is the least precise method for preparing

a budget. Often, companies that rely on incremental budgets, repeat past mistakes.

6.3.2.2

Zero-based budgeting

Popularised in the 1970s, zero-based budgets operate on the premise that the amount an entity budgeted for a line item in one year, has little to do with what it should be budgeting in future years. While more accurate than incremental budgets, zero-based budgets require a tremendous amount of information, and are, therefore, time-consuming and expensive.

6.3.2.3

Fixed budget (also static budget)

A fixed (or static) budget is one which is based on a particular level of activity. It is perhaps more beneficial to businesses which have relatively low variable costs. Variable costs are those costs that change in proportion to changes in sales or production.

6.3.2.4

Flexible budget

A flexible budget is one which recognises that activity levels can have a big impact on budgetary performance — therefore costs are separated into variable costs and fixed costs (as opposed to the more traditional income statement format). Fixed costs are those costs that do not change in response to changes in sales volume —such as Spacemakers Hardware’s rent and salaries. [page 291]

6.3.2.5

Top-down budget

In terms of the top-down method of budgeting, upper-level management establish parameters under which the budget is to be prepared. Lower-level personnel have very little input in setting the overall goals of the entity.

6.3.2.6

Bottom-up budget (also participative budget)

In terms of the bottom-up (or participative) method of budgeting, all managers contribute to the completion of an integrated, universal budget. Top management may initiate the budget process with general budget guidelines, but it is the lower-level managers that drive the development of budgets for their areas of responsibility.

6.3.3

BUDGETING — BEHAVIOURAL ISSUES

One of the major purposes of budgeting, as outlined in paragraph 6.3.1, is as a way of controlling human behaviour. One definition of budgetary control is that it is the “methodical control of an organization’s operations through establishment of standards and targets regarding income and expenditure, and a continuous monitoring and adjustment of performance against them.” (http://www.businessdictionary.com/definition/budgetary-control.html) How fast would you run around a running track if you were told that the time it took you on the first run would be the benchmark (minimum) for all future runs?

As you would expect, the use of numbers to control human behaviour is prone to trouble, a full discussion of which is beyond an introductory text such as this one. It is, however, important to note the linkage between accounting (particularly in the area of budgeting), and the area of business knowledge, known as “management”. There is a close relationship between the budgeting process, particularly when linked to incentives and encouraging worker motivation. The success of a budget depends on the information obtained. Therefore, close participation with all department managers, as well other key people in the organisation, will ensure accurate data and more buy-in during the entire budget process. Participative budgeting is a process in which personnel at all levels of an organisation meaningfully and actively take part

in the creation of budgets. The premise is that, if every manager has participated in setting the goals of his or her unit, every manager will feel personally motivated to ensure the success of the budgeting process. Managers frequently play games with budgets and build in budgetary slack. This is the practice of underestimating revenues, overestimating costs, or overestimating time, in order to make the budget targets more easily achievable. This section is aimed at highlighting, again, the importance of communication in accounting work. If inaccurate information is fed into the accounting system, there are reasonable expectations that the outputs will also be inaccurate. Finally, in drawing this section to a close, it is important for students to recognise that the model of budgeting described here is relatively simplistic. It is done in this way to help student understanding, but at a cost of not realistically describing what actually occurs in the workplace.

6.3.4

HANDLING UNCERTAINTY

When Michael and Michelle prepare a budget, whether for their first year or for the next year, it will be based on evidence as well as goals. Evidence might be things like competitors’ sale prices and suppliers’ price lists, or “what Spacemakers Hardware sold [page 292] last year at the same time”, or “how much was paid for power and heating last year”. However, a budget is about what is going to happen in the future; and the future is never certain. No matter how much evidence Michael and Michelle collect, or how much work they put into evaluating it, how the business actually performs will never end up exactly as they planned. How

can we handle this uncertainty? Let us look at Michael and Michelle’s approach when budgeting for Spacemakers Hardware. One step they took was to prepare their financial plan using a Microsoft Excel spreadsheet. By using this, they were able to adjust their plan easily on an ongoing basis as more up-to-date information came to hand — information such as the new purchase price for inventory, or the latest weekly customer numbers. Being able to update their financial plan continually, helped them to forecast where they were going more accurately. If Michael and Michelle constantly revise their financial plan, what problem could this cause when using it to control operations?

Take the example of their budgeted purchases of timber products. The key factors here were the expected daily sales of timber products, and the purchase price. Michael and Michelle decided that their daily sales expectations were a bit optimistic, after revising their figures as a result of the economic downturn. Revising their budget only required them to change the expected daily timber sales figure in their spreadsheet. They could then see straight away the flow-through effect of these changes, as the spreadsheet formulae recalculated monthly purchases, profit, cash flow, and inventory levels. Originally, Michael and Michelle prepared not one forecast, but three: one for what they considered to be the most realistic level of sales; another based on a more optimistic level of sales; and one based on a pessimistic level of sales. This gave them a wider perspective of the likely future, and enabled them to prepare better for what actually took place. Remember that a budget is partly guesswork. Michael and Michelle could come up with a professionally presented, detailed budget telling them that next year’s profit will increase 60% on this year’s; but it will only be an accurate forecast if the assumptions it is built on come true. Will the volume of sales really increase 30% if they discount selling prices by 10%? Is it realistic to expect no new competitors? Can they really keep purchase prices at the same level as last year? The accuracy of the budget will depend on the

accuracy of the assumptions. Thus, Michael and Michelle must be prepared to examine the key assumptions closely, and subject them to a reality check.

6.3.5

EXAMPLE — REVENUE AND EXPENDITURE BUDGET FOR SPACEMAKERS HARDWARE

Let us imagine that Michael and Michelle have asked us to prepare a revenue and expenditure budget for Spacemakers Hardware’s next year of business. There are a number of ways we could do this, but the most common approach is to start by looking at how the business performed in its last year. Which area should we consider first? We generally start with sales. Why? Because, how much we sell will have a major impact on our expenses. We need to know what our sales are likely to be, before we can work out how much product we need to purchase, and how many staff we might need. If Spacemakers Hardware’s year’s sales are around $910,000, should we use this figure for our budgeted sales for next year? What differences could we expect? Sales over the last three years have decreased. We can probably expect next year’s sales to be down even further, as in its next year, some of the decisions made by Michael and Michelle will have an effect on Spacemakers Hardware’s income. How do we include this variability in our guesses? Let us assume that cash sales will be the [page 293] same, and the decision to attract trade customers has worked out. As a result, credit sales will increase by 5%. Then we need to consider what things will be different for next year’s sales. Are Michael and Michelle planning to offer a wider range of products? Are there any other new competitors, or previous competitors that have ceased trading? Do Michael and Michelle have any

plans to change sales prices? What would the effect be of opening a coffee shop inside the existing hardware store? Once we have settled on how much the business expects to sell next year, we are ready to consider what its cost of sales will be. If sales are expected to increase 5% in volume, then we would expect the quantity that Spacemakers Hardware purchases to increase by 5%. But what happens if the purchase price of each item goes down, or up? In order to achieve the increase in credit sales, Spacemakers Hardware would have to cut prices, so that gross profit will be 58% of sales. Gross profit of $543,750 represents 58% of budgeted sales of $937,500. Many other items will not be affected by a change in sales. Some, like the monthly rent for the building and rental of the EFTPOS equipment, may stay the same as for the current year. Others will not be affected by a change in the level of sales, but may change for other reasons. We may need to budget more for some expenses due to inflation, or for rates, if the city council has indicated that these are likely to increase. They expect rent to go up by the rate of inflation (2%), and will keep staff wages to this year’s levels by working more hours themselves. They calculate that pressure on their overdraft will cause the interest expense to be about $16,500, and they hope to keep remaining expenses as for the current year. Do you agree with Michael and Michelle reducing their salaries? Why?

There may be some expenses that the owners have discretion to change — do Michael and Michelle plan to increase their salaries, or the amount of advertising? In order to attract more custom, Michael and Michelle intend to increase advertising and promotion by 10%. To reduce pressure on cash flow, they will also reduce their own salaries by 20%. Taking this type of approach, we could build the following budget for Spacemakers Hardware for next year based on their current year’s performance.

[page 294]

Spacemakers Hardware Limited budget Current year actuals $

$

Next year budget $

Cash sales

360,000

360,000

Plus

550,000

577,500

Credit sales

Sales Less

Cost of sales

Gross profit Less

910,000

937,500

(370,600)

(393,750)

539,400

543,750

Selling expenses Shop staff wages Advertising and promotion Shop rent

(230,000)

(230,000)

(25,000)

(27,500)

(100,000)

(102,000) (355,000)

Less

(359,500)

General expenses Office staff wages Shareholder salaries General expenses

(65,000)

(65,000)

(110,000)

(88,000)

(37,600)

(37,600) (212,600)

Less

$

(190,600)

Financial expenses Interest Other

Net profit/(loss) before tax

(15,600)

(16,500)

(1,000)

(1,000) (16,600)

(17,500)

(44,800)

(23,850)

Is this “past-based” approach, the only way for us to tackle next year’s budget? No. While many businesses do take this approach, others prefer to start from scratch. Why would we not use the latest year as our starting point? By basing our expected performance on our previous performance, we might close our minds off to ways of doing much better. Perhaps you got 50% in a recent test.

Does this mean you should be targeting 50% to 55% in your next test? Instead, perhaps you should be looking at preparing in an entirely different way for the test, in which case a target score of 90% might be achievable. In the same way, Spacemakers Hardware may run the risk of not achieving its potential if its expected performance is based on its past performance. Are Michael and Michelle likely to be encouraged to be innovative with such a budget? The New Zealand business world is changing at an increasingly fast pace. Petrol prices, interest rates, and exchange rates change rapidly. Products and ideas arrive from overseas in weeks instead of years. The increasing influence of the internet has sped up this rate of change. Should our budget for Spacemakers Hardware be based on last year’s performance or not? Ultimately it is a matter of choice — of Michael and Michelle deciding what best suits them. Approaching each year’s budget as a blank canvas may [page 295] encourage more innovation but, with little grounding in reality, could give a quite inaccurate forecast of what actually happens. Starting with the key features sketched out based on the latest year’s actual results, may give a more accurate picture of how things will go, but may miss identifying new opportunities for improvement, and might hamstring growth. Both options can be valid for developing future budgets, and for subsequent comparisons with actual results in future years.

6.3.6

SO HOW DID WE DO?

How well has Spacemakers Hardware done in its “next year of trading”? In the earlier section we referred to the control aspects of budgeting. When our plan (budget) is not achieved, what do we do about it? Perhaps, the first

question to be asked relates to where the problem lies. The problem may exist because the plan is inaccurate. Were some of our guesses wrong? Were some of the expectations unrealistic? It may be that Michael and Michelle’s plans were not carried out properly. Refer to paragraph 6.3.3 to try to understand the issues which can result from enforcing behaviours based on a budgetary system.

6.3.6.1

Variance report — process

A variance is the difference between the actual amount and the budgeted amount for a particular revenue or expense. A positive variance means that the actual figures are better than forecast; and a negative variance means that the actual figures are worse than forecast. The variance report below compares Spacemakers Hardware’s actual revenues and expenses for the following year (2015) to the budget prepared earlier, applying the following process: 1.

Complete the budget.

2.

Enter the actual income and expenses from the accounting system.

3.

Calculate the variance.

4.

Indicate whether the variance is favourable or not.

5.

Comment on the variances. [page 296] BUDGET $

Cash sales Plus

Less

Less

ACTUAL $

$

VARIANCE $

360,000

360,000

Credit sales

577,500

570,000

Sales

937,500

930,000

Cost of sales

(393,750)

Gross profit

543,750

Selling expenses Shop staff wages

(230,000)

(230,000)

F/UF*

$ 7,500

UF

(395,000)

1,250

UF

535,000

8,750

UF

Advertising and promotion Shop rent

(27,500)

(25,000)

2,500

F

(102,000)

(104,000)

(2,000)

UF

(359,500) Less

(359,000)

General expenses Office staff wages

(65,000)

(65,000)

Shareholder salaries

(88,000)

(60,000)

28,000

F

General expenses

(37,600)

(40,000)

(2,400)

UF

(500)

UF

(190,600) Less

(165,000)

Financial expenses Interest Other

(16,500)

(17,000)

(1,000)

(1,000) (17,500)

Net profit/(loss) before tax

*

(23,850)

(18,000) (7,000)

(16,850)

F

Favourable/unfavourable variance

In light of this report, consider these questions: Would you expect Michael and Michelle to be happy with the business’s overall performance? What areas of the business appear to be going well? Which areas do not appear to be going so well, and may need looking into?

6.3.6.2

Variance report — analysis

How did you answer the three questions above? When thinking about your answers, you need to remember that it is “favourable” either when revenues are higher than expected, or when expenses are lower than expected; it is “unfavourable” either when revenues are lower than expected, or when expenses are higher than expected. The terms favourable and unfavourable are preferred, because the numbers in themselves are not good or bad. [page 297] We could reasonably expect Michael and Michelle to be happy about the overall performance — the $7,000 actual loss is better than expected. Which areas would Michael and Michelle be pleased with?

Cash sales have remained stable, while credit sales have not quite hit the original expectation. Spending less than budgeted is generally regarded as a good thing — as long as the expenditure still achieves its expected results. But spending less than budgeted is not always a good thing — sometimes the expenditure may not have achieved its intended purpose; underspending on the advertising budget if it causes sales to drop, cannot be good. What is the term used earlier which relates to deliberately setting easy targets, which could also impact on how targets may have been underspent?

And what about possible problem areas? “General expenses” is one area where the business has not done quite as well as expected. Michael and Michelle might well want to check out the underlying reasons for these expenses being over budget and, depending on the underlying reasons, take steps to bring these expenses back in line. “Shop rent” is another area where they have overspent their budget. While they might be disappointed with this, there may be little they can do — under their lease they are already committed in the immediate future to paying rent, and they have no control over the level of rent set. “Shareholder salaries” is another area where they have underspent their budget. What do you think about this? Take a moment to imagine the report without the budget information. Think about how much more difficult it would be to answer the questions posed above, without the budget: You could see that the business has made a smaller loss, but could you tell if the loss is good or disappointing? Could you identify the areas where the business is doing well, and those where it is not doing so well? The budget helps both us and the owners of Spacemakers Hardware to evaluate the business’s performance more easily, putting the actual results into perspective.

6.4

How costs behave

We have discussed how preparing financial plans for different and changing scenarios is an excellent management tool. But for the planning to be genuinely useful, the budget has to model realistically how revenue and costs actually behave — Michael and Michelle had to think carefully about how costs would react to changes in sales. If more (or fewer) customers came in than originally expected, which costs would change, and by how much? We saw in the previous section how some expenses are likely to change in proportion to sales, while others remain unaffected. Accountants use specific terms to describe the way that costs behave in response to changes in sales. Fixed costs are those costs that do not change in response to changes in sales volume —such as Spacemakers Hardware’s rent and its salaries, which would [page 298] stay the same whether Spacemakers Hardware’s sales increase or decrease. This does not mean that fixed costs never change. A landlord may increase the rent charged; a manager may get an increase in salary. But any changes in fixed costs that do occur, do so for reasons other than a change in sales volume. Variable costs are those costs that change in proportion to changes in sales or production — such as purchases of stock items for resale. When the business sells 5% more items, it expects its purchases of stock to increase by 5% as well. Does this mean that all costs are either fixed or variable? In reality, some costs are mixed costs — partly fixed, and partly variable. The cost of internet computing is an example of a mixed cost for Spacemakers Hardware. It pays

Vodafone a fixed monthly amount for its internet and phone line rental. While telephone and internet charges do increase as the shop gets busier, there is no direct relationship between the costs, and the number of customers using the store. In practice, it is often difficult to break down a mixed cost into its fixed and variable parts. Spacemakers Hardware treats wages as a fixed cost, but in reality it is a mixed cost. The amount of wages paid would change slightly, depending on how many customers are expected. But exactly how much of its wages expense is variable? There is no easy way to work it out. In Spacemakers Hardware’s case, the variable component is not considered to be material, and so the business treats the whole cost as fixed.

6.5

Breakeven and beyond

Michael and Michelle have noticed that a number of hardware stores have introduced a coffee shop as part of the services offered in-store. In the stores that they visited, the coffee shops appeared to be busy, and seemed to attract customers to the store. In assessing the potential of having a coffee shop in their store, one of the first pieces of financial planning Michael and Michelle carried out, was to work out Spacemakers Hardware’s breakeven point. The breakeven point is the level of sales at which the business makes neither a profit nor a loss, with its revenue matching its expenses. So why did Michael and Michelle bother to calculate this? It gave them a good idea of the level of sales needed for that part of the business to be viable. Knowing this, informed Michael and Michelle whether their idea of starting up a coffee shop was achievable, or whether it was an unrealistic dream. As their projected level of sales was quite a margin above their calculated breakeven point, Michael and Michelle felt reasonably confident in proceeding.

The breakeven point can be expressed either in unit terms (for the coffee shop, as the number of cups of coffee to be sold), or in dollar terms (the dollar value of coffee sales). How would we go about working out the coffee shop’s breakeven point? To simplify things for now, let us ignore Spacemakers Hardware’s sales of other products and services, and assume that it only sells cups of coffee. (All of the following figures used, exclude GST.) The coffee shop sells each cup of coffee for an average of $3. Its variable cost per cup has been calculated at $0.90. Fixed costs for each month (portion of the rent, salaries, advertising, etc), are expected to total $6,300. How many cups of coffee need to be sold each month to cover fixed costs? [page 299] Contribution margin per unit is the amount left over when the variable costs to buy or produce one unit of product, are deducted from the selling price for that product. Therefore, contribution margin = sales price per unit less variable cost per unit.

Every time the coffee shop sells a cup of coffee, it is $2.10 better off — $3 in revenue, less $0.90 in variable costs. This difference between the sales price and the variable cost per unit, is known as the contribution margin per unit. Selling ten cups would provide $21 (10 x $2.10) towards covering the fixed costs; selling 100 cups would cover $210 (100 x $2.10) of the fixed costs; and so on. So how many cups of coffee — if you like, how many lots of $2.10 — do we need to sell, to cover the $6,300 in fixed costs? Dividing $6,300 by $2.10 tells us that it is 3,000 cups. Let us not forget that our answer is correct as long as our assumptions are correct — that is, the business will break even by selling 3,000 cups of coffee, if the average sales price turns out to be $3, if the variable cost per cup turns out to be $0.90, and if the fixed costs for the month end up totalling $6,300. To calculate how many units (ie number of coffee sales) are needed to cover the fixed and variable costs, a standard costing formula can be used — this works for all products or services, as long as the fixed and variable costs can be isolated. Breakeven in units = total fixed costs/the contribution

margin per unit. This will give us the number of coffee sales required to achieve breakeven. This means that this point occurs at the production point when the sales dollars equal the fixed and variable cost.

We can also calculate the breakeven point in terms of the dollar value of sales. Why bother doing this? Sometimes we may not have details available of the number of units sold, but we do have the dollar value of sales available. Let us look again at Spacemakers Hardware’s situation, but this time leave out the unit information. Let us assume that the cost of goods sold is the only variable cost, and that the following information is taken from last month’s performance report: sales for the month were $12,000; cost of goods sold was $3,600. The total dollar contribution from selling coffee in this situation was $8,400 ($12,000 less $3,600). We can express this contribution as a ratio, by dividing the contribution dollars by the sales. Here, $8,400 divided by $12,000 equals 0.70 — in other words, every dollar of sales provides 70 cents in contribution margin. How many dollars of sales need to be made to generate enough lots of 70 cents to cover the $6,300 in fixed costs? Dividing $6,300 by 0.70 gives us $9,000 in sales. Another way to explain the findings, is to say that 70% of every sales dollar is absorbed by variable costs, leaving us with 30% to cover the fixed costs and any potential profit. What if Michael and Michelle wanted to work out how much they needed to sell to make a particular profit, rather than to just break even? Let us assume that they want the coffee shop to make a $630 profit each month. We know they need to sell 3,000 cups of coffee a month to cover their costs. How many more would they need to sell to come up with another $630? Once 3,000 cups have been sold, all fixed costs have been covered, so the contribution from any sales above the 3,000 level is all profit. Remember that each cup of coffee sold, provides a contribution of $2.10. How many more cups of coffee — how many more lots of $2.10 — need to be sold to generate $630? $630 divided by $2.10 gives us the answer: another 300 cups. So the

number of cups of coffee the coffee shop needs to sell in a month to make a profit of $630, is expected to be 3,300 — 3,000 to cover the fixed costs, and another 300 to provide the target profit. This process can be achieved by a slight modification of the above breakeven formula (by adding target profit to fixed costs on the top line), namely: target profit = (fixed costs + target profit) / contribution margin per unit

Therefore, sales needed = ($6,300 + $630) / $2.10 = 3,300 cups We can add to this formula by asking ourselves what we are trying to achieve in the business — which commonly is that we wish to achieve a certain level of profit that [page 300] will enable our business to plan new projects for the future, or to achieve a certain profit level to enable us to have a certain standard of living in our personal lives if we are self-employed.

6.6

Allowing flexibility in our budget process

Review the income statement of Spacemakers Hardware. Which costs are likely to be variable and which fixed?

Let us assume that Michael and Michelle have chosen to check their results against budget on a regular (monthly) basis. In November they discover that the cost of sales, wages, and rent are well in excess of the amount budgeted. They have looked at the December accounts, and the trend is continuing to deteriorate. What should they do? One option would be to stop spending

money in the areas that are causing concern. However, the idea of having a shop which does not have hardware to sell, would seem absurd. Perhaps the budget is unreliable and should be ignored.

6.6.1

FIXED VERSUS FLEXIBLE BUDGETS

Budgets are normally prepared for the particular level of activity expected in the period ahead. Forecast sales volume becomes the foundation on which the rest of the budget is built. But what if the sales forecast turns out to be wrong? What if actual sales are 30% below budget, or 20% above? Can the budget still be used to guide and control the business’s affairs when it is tied to a completely different level of activity? A fixed (static) budget is prepared at the beginning of a budgeting period and is valid only for the planned level of activity. It is suitable for planning, but is inappropriate for evaluating how well costs are controlled. If the actual level of activity differs from what is planned, it would be misleading to compare actual costs to the fixed budgeted costs. The uncertainties which exist when a budget is prepared, could mean that there is a good chance that the sales forecast will not turn out to be accurate. It could be argued that there is no point in trying to stick to a plan prepared for a set of conditions which do not happen. Consequently, a more flexible approach may be taken, in terms of which a budget is revised whenever the sales forecast on which it is based, proves to be seriously wrong. A modern approach to budgeting is that of flexible budgets, which takes into account the fixed and variable components so that, as volume levels change, the budget may be automatically amended. A flexible budget is designed to change with the level of activity. It is really a series of fixed budgets, each one tailored to a different sales level within the expected range, taking into account the behaviour of costs with volume. They can be for: different percentages of a business’s maximum capacity — for example,

70%, 80%, 90%, and 100%; or different forecasts of sales — for example, most optimistic (for a “good times” budget), most likely, and most pessimistic (for a “problem” budget). Flexible budgets make it easier to estimate what the costs should be for any level of activity within a specified range. When a flexible budget is used in performance evaluation, actual costs are compared to what the costs should have been for the actual level of activity during the period, rather than to the budgeted costs from the original budget. This is an important distinction, particularly in the case of variable costs. [page 301] For financial control, actual performance is compared with the budget for the particular level of activity achieved. A good understanding of the cost/volume/profit relationship, and an ability to separate costs into fixed and variable categories, are obviously essential when preparing a flexible budget. Since actual results can be compared more accurately with a flexible budget than with a budget for a single level of activity (fixed budget), better financial control of a business is possible. This more than compensates for the additional effort and costs of preparing several budgets.

6.6.2

PREPARING A FLEXIBLE BUDGET

In order to illustrate the process of preparing a flexible budget, we will use the analyses of the impact of different levels of activity in a coffee shop, to help Michael with the decision whether to introduce a coffee shop into Spacemakers Hardware. The first task is to determine what represents a measurable level of activity, which can help us to determine how some of the expenses may vary.

With a coffee shop, we might choose to count each item that is sold, and to calculate the variable cost element on that. This is possible with modern technology, but probably fails to meet the cost/benefit criteria for effective decision making. We could use a de facto measure of activity — the number of customers. This number would also be helpful for determining seating and staffing levels, measuring the success of advertising, and for use in benchmarking exercises with similar businesses. Based on the experience of a similar establishment, we know that the average customer spends around $10 (excluding GST); many of the customers order only a cup of coffee (as you will remember, coffee is quite profitable); the average spend has been consistent for the last six months; and the volume of customers has been between 940 and 950 per week. The next task is to isolate those costs which are fixed, and those which are variable. This was done in paragraph 6.5. We will again ignore mixed costs. We can prepare a flexible budget to represent what we would expect at various levels of activity. The following flexible budget for Spacemakers Café, based on the projected number of customers per week, presents data which shows what our expected coffee/food costs should be at various levels of activity. If there was an increase in store customers in the months of November and December, it would be quite safe to expect that coffee and food consumption would also go up. Spacemakers Café Flexible budget Per customer 900

950

1,000

1,050

$

$

$

$

10.00

9,000

9,500

10,000

10,500

Food variable cost

2.10

(1,890)

(1,995)

(2,100)

(2,205)

Coffee variable cost

1.00

(900)

(950)

(1,000)

(1,050)

Contribution margin

6.90

(6,210)

(3,705)

(6,900)

(7,245)

(2,000)

(2,000)

(2,000)

(2,000)

$ INCOME Less

Less

Number of customers

VARIABLE COSTS

FIXED COSTS

PROFIT

4,210

1,705

4,900

5,245

[page 302] One of the things that you will notice is that the flexible budget emphasises the concept that the busier the business is, the more profitable it is likely to be.

6.7

Conclusion

We have seen how accounting provides tools for a business to plan its future and manage its path to that future. Forecasting a business’s performance is not an exact science. Predicting how sales will react in response to increased competition, or how costs will behave to a change in sales, is not easy. Budgeting and cost/volume/profit analysis can, however, help managers better prepare for change. We have also seen how managers have to anticipate the threats posed to business assets and information, and how systems have to be in place to deter and detect these threats. In this chapter our focus has been on managers preparing for the future. In the next chapter our focus will be on the past, reviewing how the business actually performed.

6.8

Key words 6

bottom-up budget

A method of budgeting in terms of which all

(participative budget)

managers contribute upwards to the completion of an integrated universal budget. Top management may initiate the budget process with general budget guidelines, but it is the lower-level managers that drive the development of budgets for their areas of responsibility.

breakeven point

The level of sales at which the total contribution margin from a business’s sales exactly matches its fixed costs. At this point, the business makes neither a profit nor a loss.

budget

A financial plan which sets out, in financial terms, what a business anticipates will happen for a specified future period — for example, for the next year. Budgets can cover expected revenues and expenses, planned capital expenditure, forecast cash flow, or projected balance sheet.

budgetary control

The “methodical control of an organization’s operations through establishment of standards and targets regarding income and expenditure,

[page 303] and a continuous monitoring and adjustment of performance against them.” (http://www.businessdictionary.com/definition/budgetarycontrol.html) budgetary slack

The practice of underestimating revenues, overestimating costs, or overestimating time, in order to make the budget targets more easily achievable.

contribution margin per unit

The amount left over when the variable costs to buy or produce one unit of product, are deducted from the selling price for that product.

contribution margin percentage

The proportion of each sales dollar left over to cover a business’s fixed costs and then provide profit, expressed as a percentage. It is calculated as: contribution margin / sales x 100. For example, if a business’s contribution margin totals $30,000, and its sales total $100,000, it has an average contribution margin of 30%.

cost behaviour How costs change in response to changes in the level of sales or production. fixed budget A budget which is prepared at the beginning of a (static budget) budgeting period, is based on a particular level of activity, and is valid only for the planned level of activity. It is suitable for planning, but is inappropriate for evaluating how well costs are controlled. It is generally more beneficial to businesses which have relatively low variable costs. (By contrast to a flexible budget.) fixed cost

A cost that does not change in response to a change in the level of sales or production.

flexible budget A budget which recognises that activity levels can have a big impact on budgetary performance — therefore costs are separated into variable and fixed components (as opposed to the more traditional income statement format). (By contrast to a fixed budget.) incremental budgeting

The process of taking last year’s numbers as being a realistic view of performance, and adjusting those levels by incremental [page 304]

amounts to achieve the desired budget. For example last year’s lease costs might be $5,000 and inflation is 2.5%, therefore this year’s lease costs should be $5,125. mixed cost

A cost that contains both a fixed cost portion and a variable cost portion.

net profit after tax

The amount of profit available to the business entity after income tax has been paid to the Inland Revenue Department.

top-down budget

A method of budgeting in terms of which upperlevel management establishes parameters under which the budget is to be prepared; and lower-level personnel have very little input in setting the overall goals of the entity.

variable cost

A cost that changes in proportion to a change in the level of sales or production.

variance

The difference between the actual amount and the budgeted amount for a particular revenue or expense.

zero-based budgeting

A method of budgeting based on the premise that the amount an entity budgeted for a line item in one year, has little to do with what it should be budgeting in future years. While more accurate than incremental budgets, zero-based budgets require tremendous amounts of information, and are therefore time-consuming and expensive.

6.9

Resource file 6

6.9.1

FORMULA — TARGET PROFIT AFTER TAX

To work out the level of sales needed to provide a specific level of net profit after tax, use the following formulae:

[page 305] Example: A company’s contribution margin is $25 per product sold. Its contribution margin percentage is 20%. Its fixed costs for the year are $100,000. It pays income tax at a rate of 28% in 2014. Company tax rates have changed over the years, and could be higher or lower in future years, depending on Government policy at the time.

The number of units it needs to sell in order to make a profit of $69,444 after tax is:

The dollar sales it needs to make in order to make a profit of $69,444 after tax is:

6.9.2

INTERNET RESOURCES

http://www.bizfilings.com/toolkit/tools-forms.aspx provides some useful budgeting resources under its “Tools and Forms”, such as templates for: – a personal monthly cash budget — under “Business Forms” select “Startup”, and then “Personal Monthly Budget Worksheet”; and –

a cash flow budget —under “Business Forms” select “Finance”, and then “Cash Flow Budget Worksheet;

www.entrepreneur.com provides a range of resources and articles for entrepreneurial small businesses. Select the “How to” tab and then browse around the links offered under “Starting a Business”; www.business.govt.nz provides a range of resources and articles for New Zealand small businesses; and www.businessknowhow.com/money/breakeven.htm information aimed at the small business on breakeven analysis.

6.10 6.10.1 6.10.1.1

provides

Mastering accounting — questions SHORT ANSWER QUESTIONS True/False

1.

Budgets must be prepared in accordance with specific rules laid out by the New Zealand Institute of Chartered Accountants.

2.

The cash flow budget is normally the first part of the budget prepared.

3.

Budgeting can improve communication and coordination within an organisation.

4.

The difference between budgeted performance and actual performance is known as the budget variance.

[page 306] 5.

The contribution margin is the difference between a business’s fixed costs and its variable costs.

6.

If a business increases a product’s selling price, while its variable cost per unit remains unchanged, the product’s unit contribution margin will always increase.

7.

If a business increases a product’s selling price, while its variable cost per unit and its fixed costs stay the same, its total profit will always increase.

8.

A variance is the difference between expected outcome and actual outcome.

9.

Budgetary slack is the time delay that results from completing a participative budget.

10. A flexible budget is one which changes as a result of changing levels of activity.

6.10.1.2

Multiple choice

Select the most appropriate answer: 1.

2.

Budgets can be used to: a.

help evaluate the performance of the business;

b.

help managers anticipate future problems;

c.

coordinate different parts of an organisation, so that they focus on common goals;

d.

all of the above.

Giving sales staff sole responsibility for setting their own budget targets is likely to: a.

maximise the business’s level of sales;

b.

result in a better coordinated implementation of a business plan;

c.

encourage some staff to set low, easy-to-achieve, sales targets;

d. 3.

4.

5.

none of the above.

Which of the following terms relates to the cost of ice cream at an ice cream parlour? a.

variable cost;

b.

mixed cost;

c.

fixed cost;

d.

none of the above.

If a business lowers its product’s selling price, while its variable cost per unit stays the same, its contribution margin per unit will always: a.

decrease;

b.

remain unchanged;

c.

increase;

d.

none of the above.

Which of the following terms relates to the cost of salaries at an ice cream parlour? a.

variable cost;

b.

mixed cost;

c.

fixed cost;

d.

none of the above. [page 307]

6.

If a business sells a product with a unit variable cost of $7 for $10 each, and its fixed costs total $3,000 a month: a.

it will break even when monthly sales total $7,000;

b.

it has a contribution margin of $10 per unit;

c.

it will break even when it sells 1,000 units a month;

d.

none of the above.

7.

8.

CVP Ltd has a unit contribution margin of $20, and currently makes $2,000 profit a month. If it sold 50 more units a month, its monthly profit would: a.

increase by $2,000;

b.

increase by $1,000;

c.

remain unchanged;

d.

increase by $5,000.

Which of the following is most likely to be a variable cost for a corner dairy? a.

wages paid to the full-time staff;

b.

rent for the shop;

c.

purchases of grocery items;

d.

lighting and heating.

6.10.1.3

Cost behaviour

Complete the following table: Selling price

Unit variable cost

Unit contribution margin

$22

$18

?

$15

?

$5

?

$6.50

$3.50

Unit contribution margin

Fixed costs

Breakeven point (in units)

$10

$1,200

?

?

$5,000

1,000 units

$6

?

3,000 units

6.10.2 6.10.2.1

PROBLEMS Cost structure

Acme Meat Processing Ltd and Lecter Lamb Works Ltd are competitors in the sheep-meat processing industry. The two companies recorded virtually

identical profits and average sales prices for the year just completed. Acme Meat Processing Ltd has a relatively high level of fixed costs, and a low level of variable costs. Lecter Lamb Works Ltd has a relatively low level of fixed costs, and a high level of variable costs. Both companies expect to face lower production and sales volumes in the coming year because of a drop in New Zealand sheep numbers. [page 308] 1.

Which of the two companies is likely to suffer the most from the falling volumes? Explain the reason for this.

2.

Assume that production and sales volumes were to increase substantially. Which of the two companies is likely to improve its profit the most? Explain the reason for this.

6.10.2.2

Breakeven — The Warriors

You have been provided with the following (fictitious) budget information for New Zealand Warriors Rugby League Ltd: total player salaries for the year: $3 million; total fixed administration, advertising, and rent costs for the year: $1.2 million; variable costs: $2 per match ticket sold; average match ticket price: $27; and number of home games (for which match tickets are sold): 12. 1.

Calculate the average number of tickets that need to be sold for each match in order for the Warriors to break even.

2.

Calculate the average number of tickets that need to be sold for each match if the Warriors wanted to make an annual profit of $600,000.

3.

Warriors management is considering dropping the average price of a

match ticket to $22 to boost ticket sales. Calculate the average number of tickets they would need to sell for each match in order to break even, based on a match ticket price of $22.

6.10.2.3

Breakeven — Paulie’s Pizzas

Paulie’s Pizzas makes pizzas which it sells for an average of $10 each. The variable cost of making each pizza averages $4. Monthly fixed costs (rent, advertising, salaries, and depreciation) total $3,000. 1.

What is Paulie’s Pizzas’ contribution margin per pizza?

2.

Calculate the number of pizzas that Paulie’s Pizzas must sell each month in order to break even.

3.

Calculate the number of pizzas that Paulie’s Pizzas must sell each month for it to make a profit of $900.

4.

Explain why Paulie’s Pizzas’ monthly radio advertising would be treated as a fixed cost, while packaging (the pizza boxes) would be regarded as a variable cost.

5.

Paulie has calculated that, buying pizza bases instead of making his own, will cut variable costs and improve the contribution margin per pizza by 50 cents. What other issues should Paulie consider before he decides whether or not to make this change?

6.10.2.4 Preparing a budgeted income statement You have been invited to assist the board of the Kaiwaka Gymnastics Club to prepare a budget for the next year. You know that the club needs to have sufficient funds to buy some new equipment in 2015. You have been presented with the following 2014 income statement: [page 309]

Kaiwaka Gymnastic Club Inc Income statement

For year ended 31 December 2014 $

$

INCOME Competition days

2,477

Community use

3,053

Donations and grants

12,056

Fees — gym classes

41,101

Fees — holiday programmes Interest received Sale of badges (Net) Sale of uniforms (Net)

1,661 778 52 112 61,290

Less

EXPENDITURE Advertising

(1,224)

Affiliation fees

(2,911)

Bank fees

(159)

Cleaning expenses

(240)

Clubhouse supplies

(71)

Coaches reimbursements

(1,360)

Coaching/Judging clinics

(733)

Depreciation Entertainment First aid Insurance/ACC levies Coach’s salary

(6,709) (140) (1,283) (27,180)

Officers reimbursements

(400)

Printing, post, and stationery

(128)

Prizegiving

(600)

Rent Repairs and maintenance Sundries Telephone and tolls Wages

(2,567) (86) (111) (1,024) (14,289) (61,215)

SURPLUS/(DEFICIT)

75

[page 310] A brief discussion with the committee has enabled you to make the following assumptions: Fees from competition days will increase by 5%. Income from community use will be $2,000, and it is expected that there will be $28,000 of grants in the next year. Fees from gym classes and holiday programmes will both increase by 10%. In order to continue to grow, an additional 10% will be spent on advertising. Affiliation fees remain at 7% of “fees — gym classes”. It was decided to invest $50 in a new first aid kit. Rent will increase by 10% and wages by 5%. The coach’s salary is expected to be $28,000. All other costs and revenues are anticipated to remain the same in 2015. Complete a budgeted income statement for the 2015 year.

6.10.2.5

Understanding budget reports

Olivia France and her husband Derek own a small property, which has a little olive grove. The olive grove produces beautiful olives, which release highly flavoured olive oil. The olives themselves are quite small. Therefore, Olivia imports olives from Italy to put into her special glass containers. When in production, the monthly costs of her operation (budgeted and actual), Olivia’s Olives, are as follows: BUDGET QUANTITY PRODUCED (BOTTLES)

ACTUAL

450 $

540 $

COST OF PRODUCTION Direct materials Imported olives

6,300

7,830

Packaging

5,400

6,140

Picking

1,800

2,320

Packing

810

1,024

Electricity

248

272

Indirect materials

360

368

Repairs and maintenance

504

726

Rates

250

175

Insurance

300

250

2,000

1,200

Direct labour

Other variable costs

Fixed costs

Shareholder salaries Total cost of production

20,325

[page 311] 1.

Complete the below table to: flex the budget to allow for the additional capacity; calculate the variances; and indicate whether the variances are favourable or unfavourable. BUDGET BUDGET ACTUAL FLEXED (FLEXED) VARIANCE

QUANTITY PRODUCED (BOTTLES)

450

540

540

$

$

$

COST OF PRODUCTION Direct materials Imported olives

6,300

7,830

Packaging

5,400

6,140

Direct labour

$

F/UF *

Picking

1,800

2,320

Packing

810

1,024

Electricity

248

272

Indirect materials

360

368

Repairs and maintenance

504

726

Rates

250

175

Insurance

300

250

2,000

1,200

Other variable costs

Fixed costs

Shareholder salaries Total cost of production *

20,325

Favourable/unfavourable

2.

Comment on how you believe Olivia’s Olives is doing.

6.10.2.6

Flexible budget — Golden Sands

The motel which your relatives own is named the Golden Sands, and is open 365 days of the year. It has 20 rooms available for guests, and charges $76 per night for each room, regardless of how many people stay in it. The business is H&G Limited. You are given the following information regarding the actual costs of running the Golden Sands: [page 312] Telephone income

telephone costs + 10%

Wages for servicing rooms

16% of sales

Laundry and linen costs

3% of sales

Commission to travel agents

if sales are less than $325,000: 1% of sales; if sales are not less than $325,000: 0.5% of sales

Other expenses

1.5% of sales

Telephone costs

2.7% of sales

Administrative costs

$54,000 + 5% of sales

Maintenance and energy costs

$17,000 + 8.5% of sales

Insurance

$12,000

Rates

$13,200

Depreciation

$31,400

Tax rate

28% on profit

Prepare a flexible budget spreadsheet using the above information to determine net after-tax profit at 40%, 50%, 60%, and 70% levels of occupancy (that is, 40%, 50%, 60%, and 70% of rooms let). Round your calculation to whole numbers.

6.10.2.7

Trading budget — Alpha Computers

Alpha Computers provided you with the following details of its revenue and expenses for the year ended 31 March 2014: $ Sales

450,000

Advertising

15,000

Office expenses

5,200

Cost of sales

210,000

Electricity

12,000

Bad debts

10,000

Rates

20,000

Salaries (sales staff)

100,000

Additional information: For the next financial year (2015), Alpha Computers expects the following changes to its revenue and expenses: Sales

increase

3%

Advertising

5% of budgeted sales

Office expenses

increase

6%

Cost of sale

increase

20%

Electricity

increase

10%

Bad debts

decrease

(5%)

Rates

increase

2%

Salaries (sales staff)

increase

5%

Prepare a classified budgeted income statement for the year ending 31 March 2015. [page 313]

6.10.2.8

Breakeven analysis

Gama Electronics provides you with the following product information for the year ended 31 March 2014: $ Selling price per unit

500

Variable costs per unit

200

Fixed costs

900,000

Showing all your workings: 1.

Calculate the contribution margin per unit.

2.

Calculate the breakeven point in units.

3.

Calculate the breakeven point in total sales dollars.

4.

What are the total variable expenses at the breakeven point?

6.10.2.9

Report on variances

You have been provided with the following information for Smith Chemicals relating to the six months ended 31 March 2014: ACTUAL BUDGET VARIANCE Sales Less

Cost of sales

Gross profit

$

$

450,000

500,000

$

(340,000) (350,000) 110,000

150,000

40,000

Unfavourable

Less

Expenses Wages

(28,000)

(25,000)

Power and insurance

(5,000)

(5,500)

Telephone and faxes

(1,600)

(1,500)

Advertising

(3,600)

(3,000)

(38,200)

(35,000)

71,800

115,000

Total expenses Profit/(loss)

500

Favourable

600

Unfavourable

1.

Complete the above variance report for Smith Chemicals, ensuring that you indicate whether the variances are favourable or unfavourable. (Note that some variances have been completed for you.)

2.

Briefly discuss the outcome of any two variances in your report. [page 314]

6.10.3 6.10.3.1

DISCUSSION QUESTIONS Budgets and spreadsheets

Outline the benefits that a business is likely to get from using spreadsheet software (such as Excel) to prepare its budget, rather than simply drawing it up by hand.

6.10.3.2

To budget or not?

One of your business clients has just asked you why they should bother to prepare a budget. Write a letter to this client covering the following. 1.

Prepare a brief report outlining the likely benefits that a business can get from preparing and using budgets.

2.

Identify any potential disadvantage(s) that budgeting can bring.

6.10.3.3

Variance analysis

The following is an income and expenditure report for July 2014 for A Good Read Ltd, a book and magazine retailer. Note that the variance % is rounded to whole numbers ACTUAL BUDGET VARIANCE VARIANCE $

$

$

%

SALE Books

28,500

25,000

3,500

14%

8,280

12,000

(3,720)

(31%)

36,780

37,000

(220)

(6%)

(18,240)

(17,500)

740

4%

Magazines

(5,796)

(8,400)

(2,604)

(31%)

Freight

(1,500)

(900)

600

67%

(25,536)

(26,800)

(1,264)

(5%)

11,244

10,200

1,044

10%

Magazines Less

COST OF SALES Books

GROSS PROFIT

[page 315]

Less

$

$

$

%

(300)

(550)

(250)

(45%)

Wages — sales staff

(3,150)

(3,600)

(450)

(13%)

Salary — owner/manager

(3,200)

(3,000)

200

7%

Rent

(1,000)

(1,000)

-

0%

Telephone

(380)

(400)

(20)

(5%)

Power and heating

(310)

(250)

60

24%

Repairs and maintenance

(750)

(300)

450

150%

Office expenses

(480)

(110)

370

336%

General expenses

(170)

(200)

(30)

(15%)

Depreciation

(420)

(450)

(30)

(7%)

OPERATING EXPENSES Advertising

NET PROFIT/(LOSS)

(10,160)

(9,860)

300

3%

1,084

340

744

219%

1.

Should the owner/manager of A Good Read Ltd be pleased with the business’s performance in July?

2.

Which are the main areas of revenue or expense that appear to be causing problems? What steps would you expect the owner/manager to take regarding these problem areas?

3.

Which areas of revenue or expense appear to be the most positive? Other than noting their existence, should the owner/manager do anything about these positive areas? Explain why.

6.11 6.11.1 6.11.1.1

Mastering accounting — solutions SHORT ANSWER QUESTIONS True/False

1.

False. Budgets are not required for financial reporting.

2.

False. The sales budget is prepared first.

3.

True.

4.

True.

5.

False. Contribution margin is sales less variable cost.

6.

True.

7.

False. An increase in sales price may lead to a decrease in sales volume.

8.

True.

9.

False. Budgetary slack is the practice of underestimating targets to make them easier to achieve.

10. True. [page 316]

6.11.1.2 1.

d.

2.

c.

3.

a.

4.

a.

5.

c.

6.

c.

7.

b.

8.

c.

Multiple choice

6.11.1.3

Cost behaviour

Selling price

Unit variable cost

Unit contribution margin

$22

$18

$4

$15

$10

$5

$10

$6.50

$3.50

Unit contribution margin

Fixed costs

Breakeven point (in units)

$10

$1,200

120 units

$5

$5,000

1,000 units

$6

$18,000

3,000 units

6.11.2 6.11.2.1 1.

PROBLEMS Cost structure

The company with the higher level of fixed costs relative to its variable costs — Acme Meat Processing — will suffer the most when volumes

fall. In the short term, it is unable to reduce its fixed costs, and it only eliminates a relatively low level of variable costs. In contrast, Lecter Lamb Works, with its relatively low fixed cost/high variable cost structure, is able to reduce its total variable costs by a greater amount. 2.

When volumes increase, the company with the high fixed cost/low variable cost structure — Acme Meat Processing — will benefit the most. Its fixed costs remain unchanged, and it has only a relatively low level of increase in total variable costs. Lecter Lamb Works, however, has a higher variable cost per unit, and so will see a bigger increase in total variable costs as volume increases.

6.11.2.2 1.

Breakeven — The Warriors

Total fixed costs = $3 million + $1.2 million = $4.2 million Contribution margin per unit = sale price - variable cost = $27 - $2 = $25 per ticket Breakeven point for year = $4.2 million / $25 = 168,000 tickets for the year Breakeven point for match = 168,000 / 12 matches = 14,000 tickets [page 317]

2.

Target profit point for year = fixed costs + target profit Contribution margin per unit = ($4,200,000 + $600,000) / $25 = 192,000 tickets for the year Target profit point for match = 192,000 / 12 matches = 16,000 tickets

3.

Contribution margin per ticket would drop $5 to $20 Breakeven point for year = fixed costs = $4.2 million Contribution margin per ticket = $20 = 210,000 tickets for the year Breakeven point for match = 210,000 / 12 matches = 17,500 tickets

6.11.2.3

Breakeven — Paulie’s pizzas

1.

Contribution margin per pizza = $10 selling price - $4 variable cost = $6

2.

Monthly break even volume = fixed costs / contribution margin = $3,000 / $6 = 500 pizzas

3.

Monthly target profit volume = (fixed costs + target profit) / contribution margin = $3,900 / $6 = 650 pizzas

4.

Radio advertising would be a fixed cost, as the cost would not change simply because more or less pizzas were made or sold. The cost of pizza boxes would be a variable cost, as the more pizzas Paulie makes and sells, the more pizza boxes he would use — for example, if he sold 5% more pizzas, he should expect to use 5% more pizza boxes.

5.

Paulie would need to consider factors such as: whether the quality of the bought-in bases would be as good as those he makes; the reliability of supply and promptness of delivery of bought-in bases — what would happen if the supplier was not always able to supply enough bases when he needed them? the effect on his staff — will he have to lay off staff (and pay packages) or cut back their hours? What would the effect be on staff morale and, by extension, on customer service? the resale value of any surplus equipment no longer needed, if he stops making his own bases. [page 318]

6.11.2.4

Preparing a budgeted income statement

Kaiwaka Gymnastic Club Inc Budgeted income statement For year ended 31 December 2015

2014 ACTUAL

2015 BUDGET

$

$

INCOME Competition days

2,477

2,601

Community use

3,053

2,000

Donations and grants

12,056

28,000

Fees — gym classes

41,101

45,211

1,661

1,827

778

778

52

52

112

112

61,290

80,581

Advertising

(1,224)

(1,347)

Affiliation fees

(2,911)

(3,165)

Bank fees

(159)

(159)

Cleaning expenses

(240)

(240)

Clubhouse supplies

(71)

(71)

Coaches reimbursements

(1,360)

(1,360)

Coaching/Judging clinics

(733)

(733)

(6,709)

(6,709)

(140)

(140)

-

(50)

(1,283)

(1,283)

(27,180)

(28,000)

Officers reimbursements

(400)

(400)

Printing, post and stationery

(128)

(128)

Prizegiving

(600)

(600)

(2,567)

(2,823)

(86)

(86)

(111)

(111)

(1,024)

(1,024)

(14,289)

(15,003)

(61,215)

(63,432)

Fees — holiday programmes Interest received Sale of badges (net) Sale of uniforms (net) EXPENDITURE

Depreciation Entertainment First aid Insurance/ACC levies Coach’s salary

Rent Repairs and maintenance Sundries Telephone and tolls Wages

SURPLUS/(DEFICIT)

75

17,149

[page 319]

6.11.2.5

Understanding budget reports

1. BUDGET BUDGET ACTUAL FLEXED (FLEXED) VARIANCE QUANTITY PRODUCED (BOTTLES)

450

540

F/UF*

540

$

$

$

$

Imported olives

6,300

7,560

7,830

(270)

UF

Packaging

5,400

6,480

6,140

340

F

Picking

1,800

2,160

2,320

(160)

UF

Packing

810

972

1,024

(52)

UF

Electricity

248

298

272

26

F

Indirect materials

360

432

368

64

F

Repairs and maintenance

504

605

726

(121)

Rates

250

250

175

75

F

Insurance

300

300

250

50

F

2,000

2,000

1,200

800

F

21,057

20,305

752

F

COST OF PRODUCTION Direct materials

Direct labour

Other variable costs

UF

Fixed costs

Shareholder salaries Total cost of production *

2.

Favourable/unfavourable

While overall performance was favourable, namely $752, there are some outstanding issues which should be of concern to Olivia.

Direct materials were favourable, due to a saving on the purchase of packaging for the olives. However, cost of imported olives increased. This may be due to foreign currency rate change, or increase in cost of raw materials. Labour costs have become more expensive than expected — either more hours are being worked, or pay rate has increased. While costs relating to electricity and indirect materials have done better than expected, the costs related to repairs are very high. More observation is required. [page 320] Fixed costs are all favourable. While this appears positive, fixed costs are generally outside the manager’s control. Therefore, there is no direct relationship between Olivia’s ability to manage, and the favourable nature of the costs. Most importantly, the most favourable outcome relates to the shareholders not taking the expected wages. This is far from ideal, as it would be expected that the shareholders anticipate working hard in their business and need to be rewarded for the effort and for risk.

6.11.2.6

Flexible budget — Golden Sands

SALES Plus

Less

554,800 TELEPHONE

40%

50%

60%

70%

$

$

$

$

221,920

277,400

332,880

388,360

6,591

8,239

9,887

11,535

228,511

285,639

342,767

399,895

VARIABLE COSTS Wages

0.16

(35,507)

(44,384)

(53,261)

(62,138)

Laundry

0.03

(6,658)

(8,322)

(9,986)

(11,651)

Commission

(1,664)

(1,942)

0.015

(3,329)

(4,161)

(4,993)

(5,825)

Telephone costs

0.027

(5,992)

(7,490)

(8,988)

(10,486)

0.05

(11,096)

(13,870)

(16,644)

(19,418)

0.085

(18,863)

(23,579)

(28,295)

(33,011)

(83,664)

(104,580)

(123,831)

(144,471)

(144,847)

181,059

218,936

255,424

127,600 (127,600)

(127,600)

(127,600)

(127,600)

17,247

53,459

91,336

127,824

(4,829)

(14,969)

(25,574)

(35,790)

12,418

38,490

65,762

92,034

Maintenance

CONTRIBUTION MARGIN FIXED COSTS

PROFIT Less

(2,774)

Other expenses Admin

Less

(2,219)

Tax

0.28

PROFIT AFTER TAX

[page 321]

6.11.2.7

Trading budget — Alpha Computers

Alpha Computers Classified trading budgeted income statement ACTUAL

BUDGET

$

Sales Less

Cost of sales

$

$

450,000

0.03

463,500

(210,000)

0.2

(252,000)

Gross profit Less

$

211,500 Operating expenses Selling expenses Advertising

Salaries sales staff

(100,000)

5% budgeted sales

(23,175)

0.05

(105,000) (128,175)

Admin expenses Office expenses

(5,200)

0.06

(5,512)

Electricity

(12,000)

0.1

(13,200)

Rates

(20,000)

0.02

(20,400)

(39,112) Financial expenses Bad debts

(10,000)

-0.05

(9,500)

Total operating expenses

(176,787)

Net budgeted profit

6.11.2.8

34,713

Breakeven analysis

Breakeven analysis: Selling price

$500

Variable cost per unit

$200

Fixed costs

$900,000

1.

Contribution margin per unit = selling price - variable cost = $500 $200 = $300

2.

Breakeven in units = fixed costs / contribution margin per unit = $900,000 / $300 = 3,000 units

3.

Breakeven in sales $ = breakeven in units × sales price = 3,000 × $500 = $1,500,000

4.

Total variable costs at breakeven volume = 3,000 units × $200 = $600,000 [page 322]

6.11.2.9

Report on variances

1.

Sales Less

Cost of sales

Gross profit

ACTUAL

BUDGET

VARIANCE

$

$

$

450,000

500,000

(340,000)

(350,000)

10,000

Favourable

110,000

150,000

40,000

Unfavourable

(50,000) Unfavourable

Less

Expenses Wages

(28,000)

(25,000)

Power and insurance

(5,000)

(5,500)

500

Telephone and faxes

(1,600)

(1,500)

100 Unfavourable

Advertising

(3,600)

(3,000)

600 Unfavourable

(38,200)

(35,000)

3,200 Unfavourable

71,800

115,000

43,200 Unfavourable

Total expenses Profit/(loss)

2.

3,000 Unfavourable Favourable

Wages are unfavourable, as they exceed budget by $3,000; Power and insurance is favourable, as actual is less than budget by $500.

[page 323]

Analysing financial reports

CHAPTER

7

Contents Learning outcomes 7.1

Introduction

7.2

Case study — Uniforms Renewed

7.3

Analysing and interpreting — the professional view 7.3.1 Non-monetary facts 7.3.2 Economic events 7.3.3 So what do the financial statements tell us?

7.4

Analysing the balance sheet 7.4.1 Short-term solvency — working capital 7.4.2 Short-term solvency — a closer look

7.5

How do we analyse and interpret financial data? 7.5.1 Working capital ratio

7.5.2

Liquidity ratio

7.6

Analysing the statement of cash flows

7.7

Non-cash current assets — some efficiency measures 7.7.1 Rate of stock turn 7.7.2 Age of debtors 7.7.3 Other factors affecting short-term solvency 7.7.4 Concluding comments [page 324]

7.8

Creditworthiness — how risky is it to lend to an entity? 7.8.1 Proprietorship and debt/equity ratios 7.8.2 Undercapitalisation and overcapitalisation 7.8.3 Capital gearing 7.8.4 Applying the solvency test 7.8.5 Other considerations for lenders

7.9

Profitability — how well did the business perform? 7.9.1 Return on investment 7.9.2 Return on assets 7.9.3 So what causes profit to change? 7.9.4 Changes in sales 7.9.5 Gross profit percentage 7.9.6 Expense percentages 7.9.7 Net profit percentage

7.10

Links between ratios

7.11

Valuing a share market investment 7.11.1 Closing quotes 7.11.2 Dividends per share

7.11.3 Earnings per share 7.11.4 Dividend yield 7.11.5 Price/earnings ratio 7.12

Conclusion

7.13

Key words 7

7.14

Resource file 7 7.14.1 Ratio analysis — a quick reference guide 7.14.2 Analysing financial reports — internet resources 7.14.3 Spacemakers Hardware Ltd 7.14.4 Accounting standards’ impact on earnings

7.15

Mastering accounting — questions 7.15.1 Short answer questions 7.15.2 Problems 7.15.3 Research exercise

7.16

Mastering accounting — solutions 7.16.1 Short answer questions 7.16.2 Problems [page 325]

Learning outcomes After completing this chapter, you should be able to: explain the usefulness and the purpose of financial statement analysis; calculate and explain ratios, rates, and percentages, which measure

effectiveness in the following areas: – financial stability; –

asset utilisation; and



profitability of operations;

explain the importance of the solvency test; analyse the performance of a business and report on: – trends; –

problems identified;



remedies available;



recommendations for action; and

explain the use of stock market statistics.

7.1

Introduction

The balance sheet gives us a picture of an entity’s financial position at a point in time. We see the assets, liabilities, and owner’s equity as they were on a particular day. The income statement shows the profit that the entity earned and the expenses it paid over the accounting period. If we want a more dynamic, moving picture, we need to examine a series of financial statements, and then we will see the story of the entity begin to unfold. By examining what went on in the past, we are better able to plan for what might happen in the future. A major part of the job of a business professional is to be able to read the messages the financial statements give, for which there are tools to help us. However, a good business professional will also understand what financial statements do not tell us. Communicating this to business owners and managers is an interesting aspect of the job of a business professional, and requires a broad understanding of the

environment in which a business is operating. Financial statements can tell us: regarding short-term solvency (liquidity), whether the business can pay its debts when they fall due; regarding long-term stability (creditworthiness), whether it is safe to lend money to the business; and regarding profitability, whether the business is being efficiently managed. [page 326]

7.2

Case study — Uniforms Renewed

“I got the idea when my daughter wanted to become a Brownie!” Marjorie McKenzie is a vivacious, hard-working woman, who somehow finds the time to bring up three teenage children, and run her own business. “You see, when I went to buy a Brownie uniform, I couldn’t believe my eyes! Like many women bringing up children single-handed, I didn’t have much cash, so I put a small advert in the ‘wanted’ column of the local paper. The number of replies I had was amazing, so I thought, ‘There must be a lot of folks wanting to sell second-hand uniforms. I wonder if there are as many who want to buy?’” And that was how it started. Marjorie started small, buying all kinds of uniforms: Scouts, karate suits, Girl Guides, Boys and Girls Brigade, and some school uniforms. She rented space in a shopping centre. “A downturn in the economy at the time meant that space was cheap to rent. There were a lot of empty spaces and renting was better than buying. I just couldn’t have afforded to buy premises, and I still prefer renting.” “I love dealing with people and I don’t mind washing and mending the

uniforms, but the trickiest part of being in business is doing the books.” Marjorie is not alone in this. Many people go into business in a similar way to Marjorie. They have an idea. They tentatively try it out. Then, as they experience small amounts of success, their confidence builds. Like any sensible business person, one of the first things Marjorie did was contact the experts — a solicitor to look over the rental agreement, and an accountant to advise on the financial side of the business. “In my case, I still feel uncomfortable discussing finance, and to be honest, doing the books bores me to death! However, I enjoy preparing business plans, and I do two each year. It’s interesting to see what stops you from achieving the goals you set. I’ve found I have learnt so much from planning, and it’s a real challenge to try and stick to the plan.” How is business? “My business is slowly growing,” answers Marjorie. “Most children grow out of their uniforms, rather than wear them out. Sports uniforms are worn only once a week, and children sometimes get tired of the activity. Parents don’t want to spend large amounts on something that might only be worn for a couple of months.” Looking around Marjorie’s busy shop, you can see rows of neatly pressed uniforms on racks. There are changing rooms and big mirrors all around. “To spot shop lifters as well as for my many customers to admire themselves,” smiles Marjorie. In one corner is a pile of children’s books and toys to keep the tiny tots occupied, whilst parents give full attention to older children and their new uniforms. “I’m moving into second-hand ballet tutus and riding clothes,” says Marjorie. “I have a small workroom adjoining the shop, with a sewing machine, iron, and ironing board, so that, when I have a slack period, I’m in there, fixing things up.” Is Marjorie, like many retailers, feeling the pinch in these tough economic times? “I’m not sure,” she replies. “I’ve never sold new things. I think, though, that in difficult economic times, parents turn to my shop first. So maybe I’m lucky. I’ve tried to keep out of debt, but recently I had to take

out an overdraft to buy a new sewing machine, and more equipment and fittings for the shop. I don’t give credit to individuals, though I did let a nearby school have a number of uniforms, and they were paying me at the end of the month. You have to play it by ear and weigh up each situation. Another example is when [page 327] a junior football club asked me for jerseys. I didn’t have enough, but I agreed to make the rest, and they collected them last Thursday. They are into a lot of fundraising activities, and I will get paid in a couple of weeks. I suppose I want to be seen as someone who will always consider a business proposition. I’m realistic enough to know that I might not get paid, but you have to take some things on trust.” In these tough economic times, it is often difficult to plan for the future. “Well, I’ve been in business for three years now and have three years of financial statements. If you examine them, you see that my business can pay its debts and, although the profit isn’t fantastic, it’s reasonable enough. You can, for example, use the balance sheet to see how I have done in the past, and this might give an indication as to where I might go in the future. But who knows?” So, where to from here? “I’m not sure,” replies Marjorie thoughtfully. “Probably, I will stay put for a few more years yet. My eldest daughter is doing a business course at the polytech and keeps pointing out my mistakes. Teenagers know everything, don’t they?” she laughs. “However, I think I’ll keep doing it ‘my way’, as the song says.” Let us look at how Marjorie has interpreted her own business: Do you think that she is pleased with the way the business is going? Give the reasons for your answer. What, if any, potential problems has she recognised?

How did Marjorie “read” the economy and turn the situation at the time to her advantage? Has she made any plans for what might happen if the economy changes? If so, what are they? What does she say are some of the things she likes, with regard to running a business? What does she identify as some of the things she is not good at? Marjorie says her eldest daughter, who is doing a business course, “keeps pointing out my mistakes”. What do you think these might be?

7.3

Analysing and interpreting — the professional view

List some of the limitations of accounting. Remember that we had a brief look at the limitations in Chapter 1.

We need to take a look at Marjorie’s financial statements for the past three years to get a picture of how the business is doing.

7.3.1

NON-MONETARY FACTS

Decision makers must be aware of the events that occur in a particular business that cannot be measured in terms of money. The facts and figures on, say, a balance sheet, do not tell us that: the creditors are demanding instant payment; the assets are so specialised that they have little market value (for example, equipment at a dentist surgery); [page 328]

the assets are so outdated that the business cannot keep up with its competitors; the owner is willing to work 100 hours a week; the owner is up to date and innovative (or the opposite); the business cannot keep staff because of poor working conditions and inefficient management (or the opposite); the business is located in an area appropriate to its business activities (or the opposite); or customers have a high or low opinion of the business and its products. Marjorie’s statement that “I want to be seen as someone who will always consider a business proposition”, reveals a willingness that is likely to attract customers. We know that she has made football jerseys, rather than let the customer down. As a business professional, taking time to get to know your clients means that you are able to build a more accurate and complete picture of the business.

7.3.2

ECONOMIC EVENTS

“You see, a downturn in the economy at that time meant that space was cheap to rent …” A business selling second-hand uniforms is more likely to succeed when the economy is depressed, and people think carefully before spending in case of job loss. If the economy picks up and jobs are plentiful, people become confident and are willing to spend. Do you think they will buy second-hand goods for their children in good economic times? Marjorie said that rents in the shopping centre were low. What do you think will happen to rents if demand for space increases due to more consumer spending? The government might decide to subsidise the domestic clothing industry, which would reduce the price of New Zealand-made clothes. If uniforms are manufactured in New Zealand, they will become cheaper. Will parents want to buy second-hand uniforms? Or the country may import

cheaper cloth, which may reduce the price of clothing. Good business professionals understand the economy, and how economic decisions impact their clients.

7.3.3

SO WHAT DO THE FINANCIAL STATEMENTS TELL US?

Financial statements contain a large number of figures, some of which are significant (for example, the total amount of liabilities owing), and some of which are insignificant (for example prepaid rates for the next two weeks). Financial statements are a combination of fact and professional judgment. The facts include the historical cost of an asset, and expenditure of the business in paying its debts, and in reducing loans and mortgages. Professional judgment includes valuation of the stock of goods to be sold, and providing for doubtful debts, and for depreciation of fixed assets. Business professionals are asked to advise people and businesses. Knowledge about the business, the owner, the economy, and the law, will help you understand the figures more completely, and will enable you to offer more carefully considered advice. Business owners want to know: Is my business using its resources (assets, cash, people) efficiently? Will my business survive a downturn? Can my business expand successfully? [page 329] Figures appearing in the financial statements cannot be interpreted in isolation. For example, “a profit of $75,000 is excellent”, is a pointless statement unless we know something about the business (The Warehouse Limited, or the local dairy?), what the profit has been in the past ($15,000 or $150,000), and what the business anticipated it would make.

7.3.3.1

Who might be interested in analysing and interpreting financial statements?

A number of interested parties use financial information, for instance: owner(s); partners; shareholders; members of non-profit organisations; managers; directors; employees; creditors; and banks and other lending institutions.

7.3.3.2

Some questions that might be asked by a user of financial information

Can you identify which interested party/parties may have asked the following questions? What was the cause of the decline in profitability this year? Why can we not afford a new gym without having to pay extra subs? Is it really worthwhile having my money tied up in this business? Maybe there is a better use for it that is a lot less hassle for me. How safe is it to lend to this business? Can they service the loan and pay the interest? What security is there? If we let them have the things they have ordered, will they be able to pay for them on time? Each group of users relies on the accounting system to provide them with the appropriate information, and yet their requirements are slightly different. It is the role of the person preparing the analysis to ensure that they select the right information and communicate it properly to the intended audience. The

real skill of a professional is to make the numbers look easy. The professional will report in a language that meets the needs of, and is addressed to, the particular audience. Providing financial statements gives the bare facts about a business’s financial performance and position. These financial statements might tell us that sales are $400,000; or net profit is $38,000; or inventory is $46,000. But we need financial analysis to add [page 330] meaning to these figures. We need to compare these figures to make sense of them — to put them in perspective. What if we had comparisons for these figures, such as: sales of $400,000 were 20% less than last year’s sales of $500,000; the actual net profit of $38,000 compares to a budgeted net profit of $90,000 and inventory of $46,000 meant that stock spent an average of 42 days sitting on the shelves before being sold, which compares to an industry average of 30 days. These comparisons give us a much better feel for how the business has really performed. Imagine you have just received the results of a test and you got 60%. How would you feel about your mark? Pleased, disappointed, indifferent? Now think about how you decided whether the mark was good, bad, or indifferent. Perhaps you assessed this mark based on: what you planned or expected to get — if you were aiming for 90%, you are probably feeling disappointed; how much effort you put into preparing for the test — if you put in weeks of study, you might be disappointed with 60%; or you might feel pretty relieved if you did no preparation at all;

how it compares to your previous test results — if you got 40% in the previous test, you might be pleased with 60%; but you would probably feel quite differently if your previous test marks were around 90%; how the mark compared to the rest of the class — to the average mark, or to the top mark? A mark of 60% in a test where the average mark was 35% and the top mark was 64%, indicates that you did pretty well in a tough situation; but a test average of 75% and top mark of 98%, paints a less impressive picture. The mark on its own does not tell us a lot. It is the comparisons we make, that give it meaning. So, is the gap between the student who intuitively uses comparisons to figure out how well they did, and the business professional analysing financial statements, as big as you thought?

7.4

Analysing the balance sheet

We have seen that accountants make balance sheets easier to read, by classifying assets and liabilities into groups. Items within a group are similar to each other. For example, cash and money at the bank for paying bills, and other items which are expected to become cash within the current accounting period, are grouped together as current assets. Amounts which are owing and due to be paid within the current accounting period, are grouped as current liabilities. Examples of these are overdrafts, accounts payable, and GST payable. It is critical that the business has an appropriate balance between borrowed funds and owner’s equity. The following balance sheets have been provided by Marjorie McKenzie for her business, Uniforms Renewed: [page 331]

Uniforms Renewed Balance sheets As at 31 March

2015

2014

2013

$

$

$

Current assets Bank

-

3,200

5,400

2,200

-

-

13,400

9,600

6,800

15,600

12,800

12,200

11,200

5,000

4,200

26,800

17,800

16,400

Bank overdraft

5,200

-

-

Accounts payable

5,600

5,800

4,400

10,800

5,800

4,400

Opening equity

12,000

12,000

20,000

Profit

48,000

38,000

28,000

Less Drawings

(44,000)

(38,000)

(36,000)

Closing equity

16,000

12,000

12,000

TOTAL LIABILITIES AND EQUITY

26,800

17,800

16,400

Accounts receivable Inventory Non-current assets Property, plant, and equipment TOTAL ASSETS Current liabilities

Equity

We will now explore the relationship between owner’s equity, current liabilities, and non-current liabilities in more depth. We will look closely at these important relationships, and use tools such as rates and ratios to help us make better judgments. Analysing the balance sheet can give us specific information on the short-term solvency and the long-term stability of the business.

7.4.1

SHORT-TERM SOLVENCY – WORKING CAPITAL

One method of measuring short-term solvency (liquidity), is to examine the working capital of the entity. Working capital is the difference between the total amount of current assets and current liabilities. Working capital is used as a guide to signal the solvency of the business — that is, can Uniforms Renewed pay its immediate debts? Under normal trading conditions, Uniforms Renewed would have a period of credit. But what if the creditors will not wait, and they demand immediate payment? [page 332] If Uniforms Renewed has money in the bank, or can raise money, then it can pay its creditors. Based on the Uniforms Renewed balance sheet (refer to paragraph 7.4), Uniforms Renewed’s working capital for the various years is as follows: 2015: $4,800; 2014: $7,000; and 2013: $7,800. However, if the business relies on debtors paying their debts, or cash from the sales of goods or services, then paying its bills might pose some problems. If you look at 2015, you can see that, if creditors were to demand immediate payment, the business would have to sell its stocks of goods (inventory) at a reduced price, and start demanding immediate payment from its debtors. However, if we know that the creditors are satisfied with the business, we can say that the business has $4,800 with which to operate. So, when we analyse for short-term financial stability, we need to distinguish those circumstances where normal operations will continue, from those where the business might be pressured to pay immediately. Knowing the background to

your client’s business, and being aware of economic events which might affect it, will help you to give guidance.

7.4.2

SHORT-TERM SOLVENCY – A CLOSER LOOK

The most important criterion of a business’s ability to survive, is its ability to pay its debts. If a business is unable to pay its debts, it has become insolvent. If this happens, it might be forced to sell inventory, investments, or even fixed assets in order to pay its debts. In the worst case, bankruptcy may result. The current liabilities for Uniforms Renewed in 2015 total $10,800. It has no immediate cash with which to pay creditors. Creditors who supply the business with stocks of goods for sale, are generally not willing to allow credit to a business running into financial difficulties. Therefore, the business may be unable to purchase stock on credit, and may consequently earn less income from sales. Marjorie would have to sell off her stock more cheaply if creditors demanded payment and she could not raise cash elsewhere. But, remember that the stock is specialised, and demand may not depend on price alone. The property, plant, and equipment are also specialised, and she may not be able to sell them quickly for what they are really worth. Coping with insolvency may have serious consequences. By selling property, plant, and equipment, the business has fewer assets with which to earn its income. Marjorie may be able to contribute extra capital to avoid this. She could try to get a long-term loan, using the fixed assets as security. This might be an option, and we need to analyse the balance sheet in greater depth. We will need to examine the debt/equity ratio before considering this as an option. [page 333]

7.5

How do we analyse and interpret financial data?

Before any evaluation can take place, we need to reduce large amounts of financial data into smaller, more readily understood sets of data. This is why we classify the balance sheet. We can then examine the significant groups of figures, and consider the relationships between them. We use three tools or measuring devices: ratios — in terms of which a 1 to 1 relationship is expressed as 1 : 1; percentages — for example, “the owner’s return on investment was 16%”; and rates — for example, “the rate of stock turn is 4.5 times per annum”. Ratio analysis is the most widely used technique for interpreting financial statements. Ratios are useful because they can be used to summarise relationships and results. They are useful for comparing performance from year to year. Ratios can be used to compare trends and to highlight significant changes. We can use past behaviour to predict future trends. Ratios themselves do not provide answers. They should be compared with budgets, previous periods, industry averages (if available), and with results from similar businesses (if available). Analysis of financial statements clarifies and highlights significant trends. It is always useful to show comparative figures, which are the figures from previous years. This helps the analysis to be dynamic and show the significant changes. Before analysing financial statements, it is useful to identify the questions we are interested in answering. What exactly are we looking for? Remember too, that different interested parties may arrive at different conclusions, even though they may use the same data. One of the questions we might ask about Uniforms Renewed is “Can the business pay its debts if creditors demand payment?” If we are talking about

normal trading conditions, we use the working capital (current) ratio; but, if we are talking about immediate payment, we use the liquidity (acid test) ratio.

7.5.1 7.5.1.1

WORKING CAPITAL RATIO Formula

The working capital or current ratio formula can be expressed as follows:

This ratio is a rough guide to liquidity. It provides an indicator of the business’s ability to meet its current obligations in the normal course of trading. The more that current assets exceed current liabilities, the less likely the business will suffer from liquidity problems. Although, a very high ratio could mean that the best use is not being made of funds. [page 334]

7.5.1.2

Example

Based on Uniforms Renewed’s balance sheets, the working capital ratios would be as follows for the various years: 2015: $15,600 / $10,800 = 1.44 : 1; 2014: $12,800 / $5,800 = 2.21 : 1; and 2013: $12,200 / $4,400 = 2.77 : 1.

7.5.1.3

What it means

In 2013, the business had $2.77 of current assets for every $1 of current liabilities; by 2014, this had reduced to $2.21; and by 2015, had reduced

further to $1.44. If we examine the trends, we can see that the working capital ratio has declined over the three years. We need to know more about the business, before we can comment on this. We know that in 2015, Marjorie sold goods on credit for the first time (to the local school, and the junior football club). Acquiring debtors increased the current assets. She purchased more inventory in 2015, and a large proportion of resources are tied up in stocks of goods for sale. In addition, the business bank account went into overdraft in 2015. If we re-examine the balance sheet, we can see that Marjorie improved the appearance of the shop, and she used the overdraft to finance this. She would have updated the shop fittings to attract customers, and we see from the balance sheet that profit increased, so perhaps this was a good decision. What would you advise Marjorie as she moves into year four?

7.5.2 7.5.2.1

LIQUIDITY RATIO Formula

The liquidity or acid test ratio formula can be expressed as follows:

This ratio tests a business’s ability to pay debts immediately. Therefore, we take out any current assets which cannot be turned into cash immediately. This is different for each business, but we can make some generalisations. For example, most inventories take time to sell, and so are not included in the calculation for the liquidity ratio. Selling inventories quickly may require heavy discounting, which defeats the purpose of having them. Sometimes a business may face cash flow pressure from buying large amounts of inventory which it finds difficult to resell. The working capital ratio will not highlight this problem, as it treats stock as a source of short-

term funds — when, in this situation, it is actually tying up funds. In contrast, the liquidity ratio will highlight the problem, as it excludes stock as an immediate source of funds. Prepaid assets (prepayments), such as prepaid rent, would also be excluded from the liquidity ratio, as they are not a source of funds from which to pay current liabilities — the money has already been paid and committed to other future expenses. [page 335]

7.5.2.2

Example

Generally, banks will not require a secured overdraft (like the one for Uniforms Renewed) to be repaid within the current period, so it is omitted from current liabilities. However, if the overdraft is unsecured, it should be included in the calculation for current liabilities. In the end, the real issue may be how supportive the bank is. We therefore deduct any overdraft from current liabilities, if we have good reason to believe that it will not be called up — that is, the overdraft is, in effect, long-term finance. Based on this reasoning, the liquidity ratios for the three years under consideration for Uniforms Renewed are as follows: 2015: ($15,600 – $13,400) / ($10,800 – $5,200) = 0.39 : 1; 2014: ($12,800 – $9,600) / ($5,800 – $0) = 0.55 : 1; and 2013: ($12,200 – $6,800) / ($4,400 – $0) = 1.23 : 1.

7.5.2.3

What it means

In its first year of operation, the business could immediately raise $1.23 for every $1 owed in the short-term; by the second year, it could raise 55 cents for every $1 it owed; but by 2015, it could only raise 39 cents for every $1 owed. Clearly, if Marjorie were pressured by her creditors, she could not pay them, unless she has access to other funds. When you prepare the balance sheet,

these are the sorts of messages it will give, and you will have to communicate these to owners like Marjorie. When she asks, “How am I doing?”, what will you tell her?

7.6

Analysing the statement of cash flows

The working capital and liquidity ratios are important indicators of shortterm stability, but can be manipulated. A business could choose to overvalue inventory to improve its working capital ratio; it may decide not to write off what are, in reality, bad debts to increase both its working capital and liquidity ratios; or it may even sell fixed assets to major shareholders just before balance date, only to repurchase them immediately afterwards — at balance date, its debtors (and therefore its current assets) will be temporarily boosted, improving its working capital and liquidity ratios. Ultimately, a business’s financial stability depends on whether it can generate enough cash to pay its bills. This makes the statement of cash flows a valuable source of information when trying to analyse a business’s financial stability. So what benefits does the statement of cash flows offer? Unlike balance sheets and income statements, cash flow is not easily manipulated. How much cash comes in, and how much cash goes out, is clear cut. A business can overvalue its stock or its debtors, but that will not disguise how much cash came in and went out; a business can inflate its profit by taking asset revaluations into its income statement, but that will not change what its net operating cash flow is. A statement of cash flows does not simply tell us how much cash a business has; much more importantly, it tells us where the cash came from, and what it was spent on.

[page 336] The bank balances of two companies might both increase by $100,000 during a year, but there is a world of difference if one increase came from taking out a loan, and the other from increased sales receipts. The figure for the net cash flow from operating activities provides a simple but critical measure of a business’s health. It represents the lifeblood of the business. A business needs a healthy operating cash flow surplus to replace and increase its fixed assets. It needs it to be able to pay out dividends or drawings. It needs it to be able to repay loans. An increase in net operating cash flow indicates a healthy business, while a decline indicates a drop in business health. A decline into negative operating cash flow — a business spending more on its day-to-day operations than it receives — sounds a very serious warning. Uniforms Renewed Statements of cash flows For the years ended 31 October

2015

2014

$

$

83,800

68,000

(40,200)

(31,600)

43,600

36,400

600

-

(2,600)

-

Purchase of fittings

(1800)

-

Purchase of equipment

(4,200)

(600)

(8,000)

(600)

(44,000)

(38,000)

CASH FLOWS FROM OPERATING ACTIVITIES Cash received from customers Less Cash paid to suppliers Net cash inflows from operating activities CASH FLOWS FROM INVESTING ACTIVITIES Sales of equipment Less Purchase of machinery

Net cash outflows from investing activities CASH FLOWS FROM FINANCING ACTIVITIES Less

Drawings paid

Net cash outflows from financing activities NET DECREASE IN CASH HELD Add

Opening cash

ENDING CASH

(44,000)

(38,000)

(8,400)

(2,200)

3,200

5,400

(5,200)

3,200

At this point, it would be useful to review what we can learn from the statements of cash flows for Uniforms Renewed’s 2014 and 2015 years, to see if we can detect any trends. In 2015, the business showed a positive increase in net operating cash — the $83,800 received from customers exceeded the $40,200 in payments to suppliers by $43,600. However, the business then spent a combined $52,000 on its net purchases of fixed assets ($8,000), and on drawings by Marjorie ($44,000). The result was that [page 337] the bank account went into overdraft. The business lived beyond its means, spending $8,400 more on drawings and fixed assets than it generated from operations. As the business did not start with a sizeable amount of cash to fall back on, it is now reliant on its bankers to continue providing an overdraft facility. If the bank called up the overdraft, Uniforms Renewed would be in financial difficulties. Can we offer Marjorie any solutions? If we go back to examining the balance sheet, we can see that Marjorie has no long-term debts. Basically, she has financed the business using shortterm credit only. If she negotiated a longer term loan with the bank, the business would be more stable. We know that she is taking some tentative steps towards expansion — she has an important order to fulfil and she has operated successfully for three years — so there are a number of factors in her favour. Are there any other indicators of how financially stable the business is?

7.7

Non-cash current assets — some efficiency measures

In addition to the bank, Uniforms Renewed’s current assets consist of inventories and accounts receivable. How well Marjorie manages these assets, will have a major impact on both profit and solvency. Remember that the business must sell its inventories before it can earn profit, and that a large amount of cash may be tied up in inventories. It is important to keep an eye on how quickly (or slowly) stock is selling. There is a formula, rate of stock turn, to calculate this. Accounts receivable represents credit given to customers. This year has been the first time that Marjorie has allowed credit. It would be useful to show her how to calculate the length of time that it is taking debtors to pay. This will help her to decide on a credit policy for her business. The age of debtors formula will assist her in this regard.

7.7.1 7.7.1.1

RATE OF STOCK TURN Formula

The rate of stock turn formula can be expressed as follows:

The formula shows the number of times (on average) that stock is sold and replaced during the period. For example, if stock took three months to sell before it was replaced, the rate of stock turn, per year, would be four, because it would be replaced four times.

7.7.1.2

Example

The cost of goods sold figure is obtained from the income statement. Average stocks can be calculated by adding this year’s and last year’s stock and dividing it by two; or it can be [page 338] found from inventory records if a perpetual inventory system is used. The rate of stock turn for the three years under consideration for Uniforms Renewed is as follows: 2015: $67,000 / (($13,400 + $9,600) / 2) = $67,000 / $11,500 = 5.8 times; 2014: $56,800 / (($9,600 + $6,800) / 2) = $56,800 / $8,200 = 6.9 times; and 2013: $40,600 / (($6,800 + $5,000*) / 2) = $40,600 / $5,900 = 6.9 times. * This was the stock Marjorie commenced the business with.

We can express this same information in terms of the number of days, on average, that the stock sits on the shelves before being sold. We do this by dividing the number of days in the year, by the stock turn figure. Doing this tells us that Uniforms Renewed’s stock took on average 53 days to sell in both 2013 (365 / 6.9), and 2014 (365 / 6.9), but took 63 days to sell in 2015 (365 / 5.8).

7.7.1.3

What it means

In the first two years of trading, stock turnover was stable, with uniforms taking an average 53 days to sell. In 2015, stock turnover fell, with uniforms now taking an average 63 days to sell. The extra 10 days that it took to turn the stock into cash in 2015 meant Marjorie either had to delay paying her creditors on time, or else borrow the money to do so because she was already in overdraft. What has caused stock turnover to slow? The reason might be out of Marjorie’s control — for example, people may have less money to spend, so they are cutting down; it may be that there is more money around, so people

are less likely to consider secondhand goods; it may be that Marjorie has overstocked; or that she is selling a wider range of uniforms. She has purchased more, but her stock is not selling as quickly as it has done in the past. While Marjorie’s profits are rising, the higher inventory levels will be contributing to her poor liquidity position. What can she do? Marjorie could revise her purchasing policy. Perhaps she could look at selling on behalf of people instead of purchasing outright. She could consider a quick sale, where stock is sold at reduced prices to release cash. Perhaps an increase in advertising would increase turnover — for example, placing advertisements in the newsletters of the sports club and schools whose uniforms she stocks.

7.7.2 7.7.2.1

AGE OF DEBTORS Formula

The age of debtors formula can be expressed as follows:

In order to maintain financial stability, prompt collection of debts is essential. Marjorie has recently allowed credit, so she needs an indication of whether or not it was a good decision. The age of debtors tells us how long debtors, on average, take to pay. This should be compared with the actual time allowed for payment. [page 339]

7.7.2.2

Example

We will use another business than Uniforms Renewed for our example, as

they have only been offering credit sales in the last year. Greengold Limited made total sales of $400,000 for the current year, of which 80% were on credit. Debtors at the beginning of the year totalled $40,000, and at the end of the year $50,000. Average debtors is therefore: $45,000 ($40,000 + $50,000 / 2 = $45,000); and age of debtors is: $45,000 / $320,000 × 365 = 51 days (51.33 days rounded).

7.7.2.3

What it means

Marjorie will interpret Uniforms Renewed’s age of debtors in relation to her credit policy. “I did let a nearby school have a number of uniforms and they are paying at the end of the monthg … The local junior football club asked me for jerseys … They are into a lot of fundraising activities and I will get paid in couple of weeks.” Clearly, Marjorie is expecting to be paid within one month normal credit terms. What if her debtors actually took 60 days to pay? This would put more pressure on her cash flow. What could she do about this? She could take more care who she grants credit to, perhaps checking out the credit history of potential debtors with credit agencies, such as Baycorp or Dun and Bradstreet. Marjorie could change her credit terms to allow her to charge penalty interest on overdue accounts, or she could offer discount for prompt payment of accounts. She would first have to decide whether the benefits these would provide, would outweigh their cost — a possible loss of customer goodwill for those charged late payment interest, and a loss of profit margin for those claiming the discount. Perhaps the key step Marjorie needs to take, is to chase up overdue accounts more promptly. Taking the time, once a week, to print off a debtors’ report and phone up those debtors who are overdue, could improve the collection rate considerably. If Marjorie does not do this, it is very likely that she will find herself well down the queue for payment — behind those who have chased their clients for payment. If debtors who are well overdue do not respond to her requests for payment, Marjorie could consider arranging for a credit collection agency to pursue these debts for her. For Greengold Limited (in the example in paragraph 7.7.2.2 above) they

will also interpret the result in relation to their credit policy. If they allow debtors to pay on the 20th of the month following sale, then the usual time frame for payment would be approximately 40–45 days. The debtors of Greengold Limited are taking too long to pay, and both the credit policy relating to granting credit and the monitoring of overdue accounts needs to be more strictly applied. A business would also compare the number of days taken by debtors to pay with previous years to identify any trends. Even if debtors are paying in less than 40 days, but the number of days taken is increasing, eg from 35 days to 39 days, the company should investigate why.

7.7.3

OTHER FACTORS AFFECTING SHORT-TERM SOLVENCY

In addition to rate of stock turn and age of debtors, other factors that affect short-term solvency are: Size of operating costs: A business may need large amounts of cash in the near future to pay current operating costs, such as payroll and rent that are not included in accounts payable. [page 340] Bank credit: A business which has an overdraft facility at a bank, may have a lower working capital or liquidity ratio, but be in a good position to borrow extra cash if it so requires. Seasonal patterns of trade: Where a business normally expects seasonal patterns of trade (for example, a souvenir shop in a tourist town), there will be distortions in the solvency ratios owing to: – seasonal build-up of inventories; and –

lower levels of trade debtors and cash between peak periods.

The methods the business has adopted for buying and selling:



for instance, regarding selling, if a business sells inventory for cash only, there is no waiting for payment when a sale is made; the length of time given to debtors to pay (eg within 7 days, or by the 20th of the following month) needs to be determined, communicated, and monitored; whether purchases are made for cash or credit and the terms of credit which creditors grant must be established.



regarding buying, a calculation of the age of creditors will indicate whether the business is taking full advantage of the credit terms offered, or is paying early or late; the formula for age of creditors can be expressed as follows:

7.7.4

CONCLUDING COMMENTS

Is there a margin of safety of current assets over current liabilities, to avoid financial disaster? We need to think about the nature of the business and how it operates. A business which sells for cash, immediately avoids bad debts and all the expenses involved with managing debtors. It could possibly operate with a lower working capital ratio than a business which gives credit. The working capital ratio for an established business might be unsatisfactory for a new business. Can the working capital ratio be too high? A high working capital ratio of say 4 : 1, may indicate that the current assets are not being used efficiently. For example, a high level of cash in the business’s cheque account, could be more usefully employed in a long-term investment which earns interest. Large amounts invested in inventories will give a high working capital ratio but, until sold, no profit or cash flow is generated. What do you think would be a reasonable rate of stock turn for a business like Uniforms Renewed?

Should Marjorie allow credit, or stick to a cash only policy? How long should her debtors take to pay? Finally, how can she encourage prompt payment? As a business owner, Marjorie will be constantly confronted with the conflict between managing a strong liquidity position, and using assets to achieve her profit goal. As a business professional, you will be required to give advice which will help her make informed decisions. [page 341]

7.8

Creditworthiness — how risky is it to lend to an entity?

One suggestion which we considered earlier, was to improve Uniforms Renewed’s liquidity position by applying to the bank for a long-term loan to replace the overdraft. As Marjorie’s financial adviser, you may provide information to the lending institution, so that it can consider her application for a loan. In making an application, Marjorie will need to provide financial statements, and copies of contracts and orders. Remember that the assets of a business are acquired by using funds from two sources: the owners; and outsiders like banks, finance companies, and other individual creditors. Therefore, both the owner and creditors have a “claim” on the assets of the business. Creditors need an indication of how much protection they have in the event of the business assets having to be sold to pay creditors. When an entity goes out of business, it might not be able to sell its assets for the dollar amounts shown on the balance sheet. The more the business assets are “owned” by outside creditors, the greater the risk that an individual creditor will not receive the full amount due. By law, creditors must be paid before the owner. If creditors own a large

proportion of total assets, then it is unlikely that they will all receive the full amount owing to them in the event of a business failure. If a large proportion of the business is funded by the owner, creditors take less risk when they lend to the business because, in the event of the business failing, they are not competing with other creditors for funds. Where a large proportion of assets are funded by the owner, the business is probably less likely to fail. How do we know whether a business is a good risk? To determine this, we should start by looking at how the assets were financed — how much finance has been provided by the owner, and how much by trade creditors and other lenders. There are a number of ratios that we can choose from to give us a picture of the relative funding of a business’s assets. Let us look at two common alternatives.

7.8.1 7.8.1.1

PROPRIETORSHIP AND DEBT/EQUITY RATIOS Proprietorship ratio

Formula The proprietorship ratio (also called the equity or owner’s equity ratio) can be expressed as follows:

or

[page 342]

Example The proprietorship ratios for the three years under consideration for Uniforms Renewed are as follows: –

2015: $16,000 / $26,800 = 0.60 : 1;



2014: $12,000 / $17,800 = 0.67 : 1; and



2013: $12,000 / $16,400 = 0.73 : 1.

What it means In 2013, Marjorie provided 73% of the funding, which means that outsiders provided 27%; in 2014, Marjorie’s contribution had dropped to 67%; and by 2015 it had dropped further to 60%. Another way of looking at this is that in 2013, Marjorie financed 73 cents of every $1 of assets; in 2014, 67 cents; and in 2015, 60 cents. If Marjorie takes out a short-term loan from the bank, and uses all of it to repay her overdraft or to pay creditors, her proprietorship ratio will stay the same. If she uses a loan partly to purchase more assets, then the proprietorship ratio will drop. The bank staff considering Marjorie’s loan application would consider what the level of owner’s equity would be if the loan were granted.

7.8.1.2

Debt/equity ratio

The debt/equity ratio provides the same information as the proprietorship ratio. It shows how much of the entity is being financed by the owner, and how much is financed by external liabilities. Both methods can be used. There are also other ratios which exclude the current liabilities from the calculation. Formula The debt/equity ratio can be expressed as:

* where total debt = current liabilities + non-current liabilities

Example The debt/equity ratios for the three years under consideration for Uniforms Renewed are as follows: –

2015: $10,800 / $16,000 = 0.68 : 1;



2014: $5,800 / $12,000 = 0.48 : 1; and



2013: $4,400 / $12,000 = 0.37 : 1.

What it means In 2013, for every $1 that Marjorie contributed, outsider creditors contributed 37 cents; by 2014, outside creditors were contributing 48 cents for every $1 Marjorie contributed; and by 2015, outside creditors were contributing 68 cents. What should we make of this trend? Marjorie is certainly providing a lower proportion [page 343] of total funds than previously, but still more than the outside creditors. This would generally be regarded as satisfactory, subject to her liquidity position being sound.

7.8.2

UNDERCAPITALISATION AND OVERCAPITALISATION

Let us look at the adequacy of the owner’s contribution in a little more detail. A business is said to be undercapitalised when insufficient funds have been contributed by the owner to finance adequate working capital and fixed assets. How do you know that this has occurred? Generally, there will be poor working capital and liquidity ratios, and a low proprietorship ratio. The significance of this is that the business may have difficulty in funding day-today activities. If it wants to expand and uses external sources of finance, this will worsen its liquidity position, and because of this, it will not be able to

benefit from discounts for bulk buying or prompt payment. Should the fixed assets need upgrading to make them more productive, it will be difficult to get finance. It also leaves the business in a vulnerable position if there is an unexpected market setback. A business is said to be overcapitalised when the owner has contributed too much equity finance. In this case, it may have lost the opportunity to borrow and use outsiders’ funds to create profits. Is there an ideal debt/equity ratio, and at what point does it become unwise to rely on outsiders’ funds? The answer to these questions will be different for every business. You will require a sound knowledge of your clients and the business world, and be required to use your professional judgment when helping an owner to consider these questions. Using outsiders’ funds can be productive in the long-term. Most owners do not have a ready reserve of cash to inject into the business, and they rely on outsiders’ funds for expansion. We have looked at Uniforms Renewed in some depth, and have acquired some tools for helping make professional judgments. Marjorie said, “I enjoy preparing business plans … It’s interesting to see what stops you achieving the goals you set.” What advice would you give Marjorie as she prepares her next business plan? What might stop her from achieving the goals she sets?

7.8.3

CAPITAL GEARING

Capital gearing indicates the extent to which a business relies on fixed interest-bearing funds for its long-term financing requirements. Such funds will be the long-term liabilities in the balance sheet — for example, mortgages, term loans, and for companies, debentures. A business is said to be highly geared if it has significant long-term liabilities relative to other sources of funds, and low geared if it has a relatively low proportion of funding from long-term liabilities. A highly geared business is subject to more financial risk — there is a

greater fixed commitment of profits each year to servicing the debt, which can be detrimental in bad years. A highly geared company has the potential to secure a higher return on the owner’s contribution. Let us illustrate these points. [page 344]

Businesses A, B, and C Simplified balance sheets ASSETS

A

B

C

$

$

$

100,000

100,000

100,000

Creditors

-

10,000

10,000

Mortgage (10%)

-

30,000

60,000

Owner’s equity

100,000

60,000

30,000

LIABILITIES AND EQUITY

100,000

100,000

100,000

Gearing is calculated as follows:

Applied to the above simplified balance sheets, the gearing for the various businesses is as follows, showing that Business A has the lowest gearing, and business C has the highest gearing: for business A: $0 / 100 = nil; for business B: $30,000 / $60,000 × 100 = 50%; and for business C: $60,000 / $30,000 × 100 = 200%. What are the risks and benefits of gearing? Consider the three businesses under three different scenarios:

7.8.4

APPLYING THE SOLVENCY TEST

Outsiders considering lending money or granting credit to Marjorie, would clearly be interested in assessing the financial stability of her business. But what about Marjorie herself? The consequences of not maintaining a sound level of owner’s equity and liquidity can be high — banks could turn down loan applications, suppliers could refuse to grant further credit, Marjorie could even be forced into bankruptcy. To avoid these outcomes, it makes sense for Marjorie to keep a close eye on her business’s financial structure and liquidity. [page 345] If Marjorie operated Uniforms Renewed under a company structure, rather than as a sole trader, she would have a statutory obligation to ensure that her business was solvent. The Companies Act 1993 requires that a company remain solvent when paying dividends (or repaying share capital) to its shareholders. This provides some protection to creditors of the company against shareholders who might otherwise recklessly drain the company of funds. The company’s directors are required to apply a solvency test, which

has two parts: immediately after paying the dividends, the company must be able to pass both: a liquidity test — the company must be able to pay its debts as they become due in the normal course of business; and a balance sheet test — the value of the company’s assets must be greater than the value of its liabilities, including contingent liabilities. Exactly when a company becomes insolvent, is not a simple calculation — it depends heavily on personal judgment. What is “the normal course of business”? What level of cash sales can we expect to occur before suppliers’ bills become due for payment? What is the value of contingent liabilities? From a legal point of view, we could debate exactly when a company becomes insolvent. Common sense would suggest that, if a company’s solvency is in any doubt, it should not be paying dividends. The Companies Act 1993 provides directors with a strong incentive to monitor and maintain the solvency of their company. Authorising dividends when a company is not solvent, removes the protection of limited liability, and enables directors to be sued personally for the losses that creditors suffer. Ensuring that solvency is monitored — statements reviewed, ratios calculated, and cash flow forecasts prepared — is the key to reducing that risk.

7.8.5 7.8.5.1

OTHER CONSIDERATIONS FOR LENDERS Context

If Marjorie applied to her bank manager for a loan, she could certainly expect the bank to require a reasonable level of owner’s funding, as well as sound liquidity. What other factors would the bank take into account? The bank manager’s knowledge and assessment of Marjorie herself would matter. Has a level of trust in Marjorie been built up over time? Does she impress them as someone with good business skills?

Future trading prospects will also be important. Is Uniforms Renewed’s business sector seen as having positive or poor growth prospects? Is there new competition looming that could make trading conditions difficult for Marjorie? The financial forecasts that Marjorie prepares should anticipate any significant changes, and demonstrate to the bank how Uniforms Renewed is going to deal positively with these. While sound liquidity and a good level of owner’s equity are important, the bank will also be interested in Uniforms Renewed’s profitability. A business may start with a very high level of owner’s equity, and these funds may be kept in the form of cash or other liquid assets, but in the long run, if the business continues to make losses, the cash will be drained, and the business will be forced to close. Understandably, the bank will want to be reassured that a business is profitable enough to be able to service its debt, to be able to pay interest, and to meet loan repayments. [page 346]

7.8.5.2

Interest cover

Interest cover is a calculation designed to show lenders whether the entity which is seeking to borrow funds has sufficient profit in order to meet the interest expense involved. This calculation shows the number of times that the current amount of profit would be able to meet the interest expense. Formula The formula to determine interest cover can be expressed as follows:

Example Baxters’ Appliances’ income statement (see paragraph 7.9.4) shows that its

2015 net profit before tax was $107,300. If we assume that all the financial expenses relate to an interest expense of $19,100, and that this interest expense was deducted in arriving at this profit, its net profit before allowing for interest would have been $126,400 — in other words, we add the interest expense back to the profit, to get the profit before interest. Therefore, Baxters’ Appliances’ interest cover is: $126,400 / 19,100 = 6.62 times What it means This tells us that Baxters’ Appliances made enough pre-interest profit to cover its interest expense more than six times over. The interest certainly needs to be covered more than once, as most lenders will also want enough profit available to cover repayments of loan principal, and still allow something as a safety margin. Generally, an interest cover of six times would indicate that Baxters’ Appliances is in a sound position to service its debt. In working out the interest cover relevant to 2016, lenders would still need to consider the expected profit for 2016, and any planned change in Baxters’ Appliances’ borrowings.

7.9

7.9.1 7.9.1.1

Profitability — how well did the business perform? RETURN ON INVESTMENT Formula

We have seen that a business’s financial stability depends on it having an adequate level of owner’s funds and reasonable liquidity. Equally as important in the medium- to long-term is that the business is profitable. So, if a business is financially stable, can we say that it is successful? Or does success involve

something more? Ultimately, success depends on what owners want from their business. For some small business owners, the sense of pride and control in being their own boss may be more important than making a huge profit. At the other extreme, shareholders in a large listed company may [page 347] want the greatest possible financial return, relative to the riskiness of their investment. Where does this leave us? We can confidently say that there will always be a level of profit that is not acceptable to owners. They may tolerate this unacceptable level for one or two years, but if it persists, they will shift their capital to other ventures that do yield the desired profit — that is, that give them that adequate rate of return on their investment. Of course, it is quite possible that poor profitability may itself be a cause of cash flow problems, which in turn may force a business to close. While judging the adequacy of business profit relies heavily on each investor’s own expectations, it is possible to evaluate the profitability of a given business with reference to other possible uses of the owner’s capital. We do this by considering the rate of return on the owner’s funds invested. This measure, known as return on investment or return on equity, expresses net profit as a percentage of the owner’s funds invested. The return on investment formula can be expressed as follows:

7.9.1.2

Example

Baxters’ Appliances is a small company that sells whiteware and electrical goods. In the financial year ended 31 March 2015, the company made a net profit after tax of $107,300. Shareholders’ funds totalled $570,000 at the start of the year, and $630,000 at year-end.

return on investment = $107,300 / $600,000 * × 100 = 17.9% * average owner’s equity = ($570,000 + $630,000) / 2 = $600,000

7.9.1.3

What this means

We can compare this rate of return with other possible uses of the shareholders’ $600,000 — for example, it could be deposited in the bank and generate 3.6% after tax (5% before tax). Even allowing for the extra risk that investing in a small company carries, 17.9% compares favourably. We could look at the rate of return on investment for other whiteware and electrical goods businesses. If these were returning 23%, then Baxters’ Appliances is a poor performer by comparison. Return on equity is another factor to consider is the trend in profitability. Perhaps Baxters’ Appliances’ return on equity was 13% in 2014, and 10% in 2013. If this trend of improving profitability continues, shareholders could well expect to match or better the industry average return within a couple of years.

7.9.2 7.9.2.1

RETURN ON ASSETS Formula

Does an increase in the rate of return on equity for a business automatically mean that its profit has increased, and what else, besides increased profit, could increase the rate of return? Remember how increasing the gearing of a business, can improve the rate of return on equity. Why would the solvency test be involved if this occurred? It could be that the rate of return has gone up, not because of increased profits, [page 348] but because shareholders’ funds have been withdrawn and replaced with debt.

It could be that a business has improved its return on equity, but at the risk of reducing its financial stability. To remove the effect of gearing, we could use another measure of profitability, namely return on assets. The return on assets formula can be expressed as follows:

7.9.2.2

Example

If Baxters’ Appliances’ assets averaged $894,000 over the 2015 year, its return on assets is: $107,300 / $894,000 × 100 = 12%

7.9.2.3

What it means

Baxters’ Appliances made 12 cents profit for every $1 of assets that it owns. Is this a good level of profit? To answer this, we would need to compare it. Compared to a previous year’s return on assets of 9%, management has done well, making more profitable use of the company’s assets. If other businesses in its sector averaged a return on assets of 14%, then 12% would be a little disappointing.

7.9.3

SO WHAT CAUSES PROFIT TO CHANGE?

Judging how well a business has performed financially, requires us to put the business’s profit in some kind of perspective. We can do this by comparing the profit, to the resources it took to generate it (the business’s assets), or to the owner’s funds invested. We can also judge how well the profit measures up, as we saw in Chapter 5, by comparing it to what was budgeted. Yet another way, is to compare it to the business’s profit from previous years.

So, how does Baxters’ Appliances’ 2015 net profit of $107,300 stack up, compared to its previous year’s profit? The 2015 net profit is $14,800 more than the 2014 net profit of $92,500. To help us make more sense of the significance of this change, we can express it in percentage terms — the company’s 2015 profit is up 16% on the previous year. In itself, a 16% increase in profit in one year, seems reasonably good. We would have a better idea of how good, if we knew how other businesses in the whiteware/electrical appliances sector did (was 2015 simply a good year for everyone?), and whether the level of funding had changed (does the increase in profit reflect an increase in assets?). As business professionals or potential investors, we need to identify when profit is changing, and the level of that change. More importantly, we need to work out why profit has changed. Why is it important to know the underlying reasons? As business professionals, we need to identify the things that have worked well, so that we are able to apply the lessons learned there to other parts of the business. We need to spot the problem areas that have held back profit, so that we can develop solutions to these problems. As potential investors, we need to be able to recognise whether an increase in profit reflects good management, or simply a buoyant economy. [page 349] So what caused Baxters’ Appliances’ increase in profit? The cause(s) lie in the answers to the following questions: Is profit up because sales increased? Is profit up because gross profit margins improved? Did the company make more gross profit on each sale? Is profit up because the company had better control of its operating expenses? Let us now try to answer these questions by taking a closer look at a

summarised income statement for Baxters’ Appliances.

7.9.4

CHANGES IN SALES

Profit is the difference between a business’s revenue and its expenses. Changes in revenue can clearly be a key cause of changes in profit. Baxters’ Appliances’ sales for the 2015 financial year have increased in dollar terms, as indicated by its income statements for 2014 and 2015: Baxters’ Appliances Ltd Income statements For the years ended 31 March 2015 and 31 March 2014

Sales

2015

2014

CHANGE

$

$

$

CHANGE

1,513,000

1,441,000

72,000

+5%

(1,073,000)

(1,052,000)

21,000

+2%

Gross profit

(440,000)

(389,000)

51,000

+ 13.2%

Less

Selling expenses

(161,100)

(140,000)

21,100

+ 15.1%

Administration expenses

(152,500)

(147,000)

5,500

+3.8%

(19,100)

(9,500)

9,600

+ 101.1%

(332,700)

(296,500)

36,200

+ 12.2%

107,300

92,500

14,800

+ 16%

Less

Cost of goods sold

Financial expenses Total expenses Net profit before tax

In itself, an increase in sales is generally a good thing, but a more detailed assessment of the 5% increase would depend on a number of factors: How does this change compare to previous years? If sales have been increasing at an average of 20% a year over the last few years, the 5% increase for 2015 could signal that Baxters’ Appliances’ ability to continue to grow is under threat. If sales over recent years had been flat or in decline, the 5% increase could be a very positive sign. It could be an indicator that the steps company management has taken to improve sales, are working. How does the 5% increase compare to budget? Were the company’s

managers expecting a bigger increase, or has the increase bettered their target? How does the increase compare to the sales being achieved by their competitors? A 5% increase might be a very good result in tough market conditions, where most competitors are recording declining sales; but it might be a substandard result in a buoyant economy that has seen most electrical appliance stores increasing sales by over 10%. [page 350] Did Baxters’ Appliances have to significantly increase its assets in order to generate the sales? If a large increase in inventory, accounts receivable, or fixed assets was needed to support the extra sales, we would be less positive about the 5% increase in sales. A check of the ratios that measure asset utilisation — rate of stock turnover, age of debtors, and return on assets — should alert us to any significant increase in assets. Is the increase in dollar sales the result of the company selling more items, or the result of an increase in selling prices, or a combination of both? If we only have access to their income statement, we would have to rely on gross profit trends to try to work this out. Baxters’ Appliances’ managers would instead be able to use their accounting software to report on product sales in terms of both dollar value, and volume of units sold. If Baxters’ Appliances’ managers were not satisfied with the current level of sales, what should they do about it? Finding out which products had sold poorly would be a good starting point. Their accounting software would be able to provide detailed reports of this. Finding out the underlying causes why particular products were not selling well, would rely on their knowledge of their customers and competitors. Perhaps some lines are overpriced compared to the competition; perhaps some products simply are not meeting the quality demands of customers; perhaps some lines are being poorly

promoted. The specific remedies that the managers would take to improve sales, would depend on their assessment of the underlying problems, but could include: discounting selling prices on specific product lines to match (or better) competitors; offering extended payment terms on specific product lines; increasing advertising or changing the mode of advertising (for example, from radio advertisements to mail-box drops); and increasing opening hours, or even offering 24 hours a day, seven days a week sales via an internet site.

7.9.5 7.9.5.1

GROSS PROFIT PERCENTAGE Context

Discounting selling prices was one of the options identified for boosting sales. Should we expect dropping selling prices to increase profit? Let us consider this by looking at a Baxters’ Appliances’ product that has not sold as well as anticipated — the Ace mini sound system. The company has been purchasing the Ace mini system for $300 and selling it for $450, giving a gross profit on the sale of each mini system of $150. In retailing terms, this gross profit is referred to as the “mark up” — the difference between the purchase price and the selling price. We can express it in percentage terms, by saying that the Ace has been marked up on cost by 50%. Thus, gross profit as a percentage of the cost price can be expressed as:

Baxters’ Appliances sold an average of 10 Ace mini systems a month during

the past year. The company’s sales manager believes that sales would be much higher if the [page 351] selling price was dropped to make it more competitive with similar mini systems sold by other retailers. She estimates that the company would sell between 14 and 18 Ace mini systems a month if the price was dropped to $400. Let us look at the likely effect of the change on the company’s total gross profit: Current pricing

Proposed pricing

Sales price

$450

$400

$400

Purchase price

$300

$300

$300

Gross profit per unit

$150

$100

$100

10

14

18

$1,500

$1,400

$1,800

Number of units sold/month Total gross profit

The proposed drop in sales price would seem to be a good move if it lifted Ace sales to 18 a month, but would make the company worse off if sales only increased to 14 a month. Whether the company is better off cutting their sale price, will depend on: how sensitive customers actually are to price when it comes to buying mini systems (remember your economics course); how their competitors will react to the price cut — if competitors respond by dropping prices further, Baxters’ Appliances’ move may well end up reducing their overall profit; and whether price is the real underlying problem with the Ace product — if, in fact, sales are poor because Ace is regarded as low quality, or as having an out-of-date image, price cuts will hurt profit margins without boosting sales.

Baxters’ Appliances may have specific concerns about the contribution that the Ace mini system made to gross profit, but how have they performed overall in the 2015 year in terms of gross profit? Their income statement shows us that total gross profit was up by $51,000 on the 2014 year. Does this simply reflect the lift in sales? If we look at the percentage changes from the 2014 year, we see that sales increased by 5%, but that gross profit did even better, increasing by just over 13%. The fact that the gross profit increased by more than 5%, tells us that the company was able to improve its average mark-up, in addition to increasing its sales. This becomes clearer if we express gross profit as a percentage of sales.

7.9.5.2

Formulas

Gross profit can be expressed in percentage terms in two ways: as a percentage of the cost price (mark-up percentage) as follows:

or as a percentage of sales (gross profit percentage) as follows:

[page 352]

7.9.4.3

Example

The gross profit percentages for the two years under consideration for Baxters’ Appliances are as follows: 2015: $440,000 / $1,513,000 × 100 = 29.1%; and 2014: $389,000 / $1,441,000 × 100 = 27%.

7.9.5.4

What it means

In 2014, out of every $100 of sales, $27 was left over after the cost of sales had been covered. In 2015, an extra $2.10 profit was left over from every $100 of sales. The extra 2.1% in gross profit may not sound like a lot, but it is 2.1% of a large figure — sales. This extra profit margin has added a very important $31,800 (2.1% of $1,513,000 in sales) to Baxters’ Appliances’ net profit. To be able to increase profit margins at the same time as increasing sales, is a particularly good result. How the company increased its profit margins, is something we cannot tell without further information. The increase in the gross profit percentage will be due to one of the following: buying goods at a lower purchase price, while still maintaining selling prices; increasing the selling price, while still buying at the same purchase price; or a combination of both of the above — the company may have been able to not only source the product more cheaply, but also to increase its selling price. If Baxters’ Appliances’ gross profit percentage had in fact dropped, the same factors of purchase price and selling price would be involved. Work out what could cause a drop in the gross profit percentage. What would happen to purchase prices to cause a drop? What change in selling prices would cause a drop? A business faced with falling gross profit margins, could take a number of steps to try to reverse the problem, including: sourcing better products to replace those not currently meeting customer expectations; trying to find a cheaper source of supply; purchasing more of a particular item at a time, in order to qualify for bulk buying discounts; dropping products that have low profit margins, and introducing new

products for resale at a higher mark-up; or increasing spending on promoting features, which could increase the value of products from a customer perspective — for example, product warranties or the servicing of products sold.

7.9.6

EXPENSE PERCENTAGES

Expense percentages indicate the relationship of various expenses or expense categories to net sales. An analysis to determine expense percentages can be done by way of either a horizontal analysis or a vertical analysis of the income statement. [page 353] Horizontal analysis is the comparison of historical financial information over a series of reporting periods, and simply expresses the change in an expense in percentage terms. Vertical analysis results in every income statement amount being presented as a percentage of sales.

7.9.6.1

Horizontal analysis

Formula Horizontal analysis simply expresses the change in an expense in percentage terms between different accounting periods. The formula can be expressed as follows:

Example The percentage change in Baxters’ Appliances’ selling expense for 2015 is:

($161,100 – $140,000) / $140,000 × 100 = $21,100 / $140,000 × 100 = 15.1% What it means This measure gives us a better feel for the relative size of the increase in expenses, than simply saying that selling expenses are up by $21,100. But it does not tell us what Baxters’ Appliances got as a result of the extra spending. Perhaps the extra spending reflects a salary increase made to keep the marketing manager from taking a job elsewhere; perhaps it was for new radio advertising that has brought in a lot of new customers. How effective the extra spending was — what the company got out of it — is the crucial issue. If the extra spending was on advertising or promotion, what extra sales does it appear to have generated? Sales were up 5% or $72,000. As just under 30% of this extra $72,000 of sales would end up in gross profit, the extra spending is barely covered by the extra gross profit generated. What is less easy to assess, but also needs considering, is: –

Would sales have declined without the extra spending?



Is the extra spending partly responsible for the improvement in gross profit margins? Perhaps money spent promoting the quality of the business’s products and service, has enabled Baxters’ Appliances to sell its products at a higher mark-up.

We could assess Baxters’ Appliances’ control of its administration expenses and its financial expenses by looking at the percentage change from the previous year. Another option available to us is to relate these expenses directly to sales, by carrying out vertical analysis.

7.9.6.2

Vertical analysis

Vertical analysis expresses each item in the income statement as a percentage of total sales for the year. While we did not call it that, we already used vertical analysis when we worked out the gross profit percentage. Just as we expressed gross profit as a percentage of sales, so we can express expenses as a percentage of sales.

[page 354] Example The following table shows vertical analysis applied for Baxters’ Appliances’ 2015 and 2014 income statements. Baxters’ Appliances Ltd Income statements For the years ended 31 March 2014 and 31 March 2015 2015

% of sales

$ Sales Less

% of sales

$

1,513,000

100%

1,441,000

100%

(1,073,000)

70.9%

(1,052,000)

73.0%

440,000

29.1%

389,000

27.0%

Selling expenses

(161,100)

10.6%

(140,000)

9.7%

Administration expenses

(152,500)

10.1%

(147,000)

10.2%

(19,100)

1.3%

(9,500)

0.7%

(332,700)

22.0%

(296,500)

20.6%

107,300

7.1%

92,500

6.4%

Cost of goods sold

Gross profit Less

2014

Financial expenses Net profit before tax

What it means For every $100 of sales in 2015, $10.10 was spent on administration. A comparison to 2014, when $10.20 of every $100 of sales was spent on administration, shows that administration spending has remained relatively stable.

7.9.6.3

How do we interpret expense percentages?

An overall comparison of 2015 to 2014, shows that less of each $100 of sales is being eaten up by cost of goods sold (only $70.90, down from $73), but that more is being eaten up by other expenses (total expenses using up $22, up from $20.60). As a general rule, an increase in an expense percentage will be regarded as unsatisfactory, and a decrease as an improvement. The increase in the total expenses percentage for 2015 is due to the growth in selling expenses

and financial expenses. Baxters’ Appliances’ management would want to examine the underlying reasons for the increases in these two areas. If an increase in advertising and promotion has helped improve gross profit margins as well as boost sales, then management may be content with the increase in selling expenses. Otherwise, management will look at ways to bring selling expenses back under control — for example, finding cheaper advertising alternatives or reviewing sales staffing levels. Finding the underlying cause of the increase would be important. It might be due to a large increase in bad debts. In this case, management may look at tightening the criteria for giving credit, enforcing prompter follow up of slow-paying debtors, or even contracting out the credit control function to a debt collection agency. The increase in financial expenses could, however, be due to an increase in company borrowings, causing interest costs to increase. If the increased borrowing was a planned management move, then the increase in financial expenses will have been expected, and must have been considered to be acceptable. [page 355]

7.9.7

NET PROFIT PERCENTAGE

We have seen that Baxters’ Appliances’ gross profit margin has improved, but that selling and financial expenses have grown. Let us look at how this has affected the net profit. The net profit percentage indicates the overall profitability of the business, by showing the proportion of sales revenue resulting in net profit. The higher the net profit percentage, the greater the profitability of the business. Changes in the net profit percentage are caused by changes in the gross profit percentage and/or changes in expense percentages. The net profit percentage is calculated as follows:

In 2014, Baxter’s Appliances kept $6.40 from every $100 of sales. This improved slightly in 2015, with sales yielding an extra 70 cents in every $100. Why is the net profit percentage up? Because the improvement in the gross profit percentage, has more than made up for the extra yield being eaten up by selling and financial expenses.

7.10

Links between ratios

When analysing financial statements, we often break down our analysis into segments, such as financial stability, profitability, and management of assets. We do this to give structure to the analysis, and to make it easier for particular users to focus on areas of specific concern to them. One of the consequences of segmenting our analysis, is that we tend to fall into the habit of treating the segments as independent, and understate the significance of the links between them. In reality, profitability, financial stability, and management of assets overlap and interlock. Poor management of debtors can lead to significant bad debts, reducing profitability. The slow or noncollection of debts can make it difficult to pay creditors, affecting financial stability. Insufficient owner’s funds can restrict the ability of a business to purchase an appropriate level and quality of stock, affecting profit margins and stock turn. The linkages mean that we cannot simply consider a rate or ratio in isolation. Let us look at some of the important relationships in the world of ratios: The liquidity ratio and the age of debtors: Considering changes in the age of debtors, gives us a better understanding of the quality of our liquidity. A build up in debtors can actually improve the liquidity ratio, whereas the

reality is that the business may well be less able to pay its bills on time. An increase in the age of debtors will warn us of this. The working capital ratio, and both age of debtors and rate of stock turn: A build-up of either slow-selling stock, or of slow-paying debtors, will worsen a business’s short-term stability, but may actually improve the working capital ratio. Watch out for the warning signs of a rising age of debtors or a slowing rate of stock turn. [page 356] Interest cover and the gearing ratio or the proprietorship ratio: A substantial increase or decrease in the level of debt, will cause a significant change in interest expense and, therefore, in interest cover. Such a change will be highlighted by the gearing ratio and the proprietorship ratio. Return on equity and the gearing ratio or the proprietorship ratio: Increases in net profit improve both return on equity and stability. Increases in gearing may increase return on equity, but are likely to worsen stability. Keeping an eye on the gearing ratio or the proprietorship ratio, will alert us to the main cause of a change in return. Why focus on such relationships? Because the relationship can clarify the meaning of an individual ratio, as in the case of the liquidity ratio and the age of debtors; or alert us to the cause of change, as in the case of return on equity and the gearing ratio; or simply make us aware that business is complicated — that making a change in one area, will have a consequence elsewhere, as in the case of gross profit percentage and change in sales.

7.11

Valuing a share market investment

In this section, we will return to what we know about listed companies, such as Xero Limited or The Warehouse, or Air New Zealand. Some of the calculations provided here can be relatively complicated. It is not the object of this section to make you a share market analyst, but rather to help you understand what the analysts are writing about. How do we know whether or not Xero Limited or The Warehouse is doing well? Should we buy shares in it? Table 7.1 below shows the share market indicators as they appeared in the NZ Herald on 9 April 2014. Refer to Chapter 1, where we showed the movement of the Xero Limited share price over the last year. The information below serves to provide more insight as to where Xero Limited’s share price is going. [page 357] Note that the prices are always quoted in cents.

TABLE 7.1: SHARE MARKET INDICATORS

Source: NZ Herald, 9 April 2014

[page 358] Review the price movements of Xero Ltd presented in Chapter 1. Is demand for Xero Ltd shares increasing or decreasing? Compare this to the movement in the share price for The Warehouse.

For investors in listed companies (companies whose shares are publicly traded on stock exchanges, such as the New Zealand Stock Exchange), a number of ratios are available to help them assess whether or not a company represents a good buy. It is not necessary to calculate them (as you can see in the excerpt above, they are already calculated), but it is helpful to understand what the information is telling you.

7.11.1

CLOSING QUOTES

These figures represent the market in action — there are willing buyers prepared to pay $35.05 per share for Xero shares; however, the sellers want $35.60 per share. In the last 52 weeks (a year), the shares have sold for as much as $45.99 each, and for as low as $11.00 per share.

7.11.2

DIVIDENDS PER SHARE

Investors in companies can benefit financially in two ways: they can benefit from receiving dividends from the company, and they can benefit by selling their shares at a profit. It is easy for the observer to find the dividends per share (also dividend cents per share, or dividend CPS) number, as dividends are usually announced on a “per share basis”. Compare the share market information provided above with that from other sources (for example, www.findata.co.nz). It is important to recognise that the source of your investment information needs to be reliable. This is particularly the case if using internet resources. All that dividends per share tells us, is how much dividends shareholders received last year for each share that they owned. Xero Limited did not pay any dividends; but deciding whether 25.69 cents per share is a good, poor, or indifferent level of dividend for The Warehouse, requires us to compare it to what we would need to pay to own one share. We need to work out the dividend yield, which compares the dividend to the current share price. But

what we can comment on, is the amount of earnings per share that is being retained for future growth — that is, it goes towards increasing the future share price.

7.11.3

EARNINGS PER SHARE

The earnings per share (EPS) figure is not provided in the NZ Herald information provided in Table 7.1 above. However, if we were to look at page 4 of the Xero Limited annual report (see Appendix 1), we can find a calculation of that figure. It shows that Xero Limited made a loss of 13 cents per share. How profitable a company is, can obviously influence its share price. If a company’s profitability is improving, we would generally expect its share price to improve; if profits are dropping, we would expect the share price to drop. So how does the negative earnings relate to the increase in share price for Xero Limited over the last year? Compare the earnings per share figures for The Warehouse. This company made a net profit after tax of $145,328,000, and the earnings per share was 46.7 cents per share. Earnings per share does not, by itself, tell us a lot. We already knew what profit or loss was. What we have done is made that profit more comparable to dividends per share, and to share price. An investor also needs to understand the actions behind the figures. [page 359]

7.11.4

DIVIDEND YIELD

Dividend yield gives us our return on investment if we purchased today. Is this good or bad? It could be either. Consider the following: The greater the proportion of profits paid out by a company, the higher its dividend yield, but the less is left in the company to help fund expansion.

And without expansion, the company’s share price is less likely to rise. So investors may gain in dividends, but lose in share price. Dividend yield is calculated based on last year’s dividends. The actual return for an investor buying shares today, will depend on the level of dividends in the current and future years. The dividend yield may be high, not because the level of dividends is high, but because the share price has slumped to a low level. Why would it be low? Perhaps because most investors see the company as having a difficult future; perhaps it is facing tough competition; perhaps it has financial stability problems. There may be a very real risk that the company will not be able to continue paying dividends at last year’s level. Does this bring us closer to deciding whether a particular dividend yield is good or bad? Not really. Ultimately, it will depend on our individual assessment of the company’s future. If we expect The Warehouse to remain financially stable, and to still show healthy increases in its share price, then an 8.03% dividend yield represents an attractive buy. If we expect the share price to slump further, and the company to struggle financially, then it represents a very poor investment. At this time, most companies were retaining their earnings, and dividends were comparatively low. Note that Xero Ltd has not paid a dividend, so there is no dividend yield.

A final consideration in deciding whether or not a dividend yield is satisfactory, is understanding the needs of the investor. Some investors may enjoy higher levels of risk, and are prepared to forgo current dividends in favour of an expected increase in share price (such as Xero Limited). Others prefer a steady dividend stream as a regular source of income. The element of risk also applies to the type of company we might choose to invest in. A blue chip company (one which is conservatively run and is well respected in the investment world), such as an insurance company, will attract money from investors seeking high levels of certainty. Other less conservative investors may prefer a high risk approach of an erratic dividend stream, on the basis of big promises for potential gains.

7.11.5

PRICE/EARNINGS RATIO

Xero Limited’s accounts reflect no figure in the P/E (price/earnings) ratio column in Table 7.1 above. This is because Xero Limited made a loss (earnings per share of negative 13 cents) in 2013. Shares in The Warehouse (four lines above Xero Limited) are currently selling for 25.69 times earnings — to put it another way, investors are prepared to pay $25.69 for every $1 of profit made last year. Is a P/E ratio of 25.69 a positive sign or not? To tell, we need to know what the P/E ratios are for other similar companies. If the average P/E ratio for other companies in the same business sector as The Warehouse (that is, retail, such as Briscoes), is 15.23, then we can say that investors rate The Warehouse more highly than its competitors. Why would investors be [page 360] prepared to pay 25.69 times the latest year’s earnings when they could pay just 15 times the earnings for another company? Investors must see the future of The Warehouse as being brighter than that of its competitors; they must expect its future level of earnings to improve above current earnings per share, and to improve at a faster rate than the industry average. Many hightech companies with high expectations, such as Amazon and Google, are currently selling at significantly higher P/E ratios than New Zealand companies. Just as a high P/E ratio signals that investors are optimistic about a company’s future, so a low P/E ratio signals that investors are pessimistic about a company’s future — they do not expect the company to be able to sustain its past earnings level into the future. Should we automatically share the average investor’s view of a company? We should not ignore it — they have all the information we have, and we cannot assume that we know best. But we are free to form our own opinion. Perhaps a company has a low P/E

ratio, but our analysis indicates that the company is financially sound, and that its profitability is improving. Based on this, we may decide that its current price represents a good buy. If our assessment is correct and the business does improve its profitability, we are likely to see the company’s share price improve; if our assessment is wrong, we will come to realise what the average investor realised earlier — that the company was indeed a poor investment. Ratios and trends from a company’s past financial performance, can give us some insight into how the company will perform in the future. Ultimately, however, how the company and its share price will perform in the future, will depend on many unknowns that cannot be seen in past financial statements — factors such as: how the New Zealand economy in general performs — will the company be trading in an environment of depressed consumer spending, or will a weak New Zealand dollar put up the cost of its imported products? the economic environment for, and investor confidence in, the specific industry sector a company operates in — will a strong overseas competitor enter the New Zealand market for the household appliances sector? Will the government regulate the electricity industry more tightly? Will a slump in investor confidence in United States technology companies occur and cause technology share prices in New Zealand to drop? company management changes — the resignation of a company’s chief executive officer (CEO) or one of its directors, could cause a loss of confidence in the company; the appointment of a highly respected business person as CEO or to the board of directors, could have the opposite effect; and a potential takeover bid for the company — if a takeover bid were launched, the company’s shares would be in demand, and its share price could well increase significantly. [page 361]

7.12

Conclusion

Analysing and interpreting accounts is not easy. There are many variables to consider, and important interrelationships to look for. A good way to develop your skills is to play around with different strategies and study the changes that appear in the ratios. You should remember that the point of analysis is not to calculate a ratio, but to try and learn something about business efficiency and profitability, about liquidity and long-term financial stability. To achieve this, you need to go behind the figures, to see what forces are actually at work on the business.

7.13

Key words 7

age of creditors

Indicates how long, on average, in days it takes to pay creditors. A calculation of the age of creditors will indicate whether the business is taking full advantage of the credit terms offered, or is paying early or late. The formula for age of creditors is: average creditors / credit purchases × 365.

age of debtors

Indicates how long, on average, in days it takes debtors to pay their accounts. The higher the age of debtors, the longer debtors are taking to pay. Days to pay are calculated as: average debtors / credit sales × 365.

dividend yield

Indicates the level of dividends declared by a company relative to the company’s share price. A high dividend yield can be the result

of a high proportion of profit being paid out in dividends, or the result of a slump in the company’s share price or both. dividends-per-share (dividend cents per share, dividend CPS)

Measures the value of dividends declared to shareholders for the year, relative to the number of shares issued. This enables the level of dividends to be more comparable to the company’s share price (see dividend yield).

earnings before interest and The amount of net profit made by an entity tax (EBIT) before the deduction of interest expense (financing costs) and tax. [page 362] earnings per share (EPS)

Measures the profitability of a company, relative to the number of shares issued. This enables a company’s profit to be more comparable to its share price (see price/earnings ratio). It is calculated as: net operating profit after tax / number of shares.

expense percentages

Indicate the quality of expense management, by showing the proportion of sales revenue consumed by each expense category or major expense item. Any expenses rising at a faster rate than sales, should be investigated as potential areas of poor management. Fixed expenses percentages should fall as sales rise, except where a higher capacity level has been established. For example, moving to larger

premises could see the rent rise initially, in spite of rising sales. These percentages are calculated as: expense (or expense category) / sales × 100. financing activities

“Those activities which result in changes in the size and composition of the contributed equity and borrowings of the entity.” (NZ IAS 7, paragraph 6)

gearing (capital gearing)

The relationship between long-term fixedinterest debt, and equity finance. It indicates the extent to which the business relies on fixed interest-bearing funds for its long-term capital requirements. High gearing can increase the profitability of the business, provided the business earns more on the borrowed funds than it pays to service these funds. High gearing increases the financial risk of the business. It is calculated as: longterm liabilities / owner’s equity × 100.

gross profit percentage

Indicates trading efficiency, by showing the proportion of sales revenue resulting in gross profit. The higher the rate, the greater the gross profit for every dollar of sales. An increase in the rate means that the average mark-up on stock has increased. It is calculated as: gross profit / sales × 100.

horizontal analysis

The comparison of historical financial information over a series of reporting

periods; expressing a change in percentage terms. interest cover

Shows the number of times the business earns its interest bill, and is therefore an indicator of the business’s ability to service its debt out of operating profits. A low cover signals possible liquidity problems. It is calculated as: earnings before interest and tax (EBIT) / interest. [page 363]

investing activities

“Those activities relating to the acquisition and disposal of fixed assets and of investments.” (NZ IAS 7, paragraph 6)

liquidity-ratio (quick asset ratio, acid test ratio)

Indicates the capacity of the business to pay immediate debts. It takes into account the liquidity of individual components of working capital. Inventories are excluded, because they usually cannot be quickly turned into cash at their book value: bank overdraft is excluded to the extent to which it can be regarded as long-term finance (thus not an immediate debt); any overdraft in excess of the agreed limit would not be excluded; any other current liabilities that are not due to be repaid within the immediate future, would also be excluded (for example, income tax payable, but not due to be paid for another 10 months). If this ratio is less

than 1:1, the business could face immediate problems in meeting debts. It is calculated as: (current assets -(inventories + prepayments)) / (current liabilities - bank overdraft). listed company

A company that offers shares to the public, by being listed on the New Zealand Stock Exchange.

mark-up

The difference between the purchase price of a product, and its selling price. Mark-up is often expressed in percentage terms — for example, a product bought for $10 and sold for $15, is said to have a mark-up of 50% ($5 being 50% of the $10 cost). In retailing terms, gross profit is referred to as the mark-up.

net profit percentage

Indicates the overall profitability of the business, by showing the proportion of sales revenue resulting in net profit. The higher the rate, the greater the profitability of the business. Changes in the ratio are caused by changes in the gross profit percentage and/or changes in expense percentages. It is calculated as: net profit / sales × 365.

operating activities

Those activities of the business that relate to its basic day-to-day business operations. Cash from operating activities is basically the difference between cash received from customers, and cash paid to suppliers and employees. (Refer to NZ IAS 7, paragraph 6.) [page 364]

price/earnings ratio (P/E ratio)

This measures the cost of buying shares in a company, relative to the company’s most recent profit. It is a measure of investor confidence in a company. A high P/E ratio indicates a high level of investor confidence in the company’s future; a low P/E ratio indicates a low level of investor confidence. It is calculated as: price per share / earnings per share.

proprietorship ratio/rate (equity ratio)

Indicates the extent to which a business is financed by equity finance, as opposed to outside finance. The greater the proportion of equity finance, the safer the business is from the point of view of actual or potential investors or lenders. The ratio is calculated as: owner’s equity / total assets; or owner’s equity / (liabilities + owner’s equity).

rate

A way of expressing a relationship between two variables, such as net profit and sales, in percentage terms.

rate-of-stock-turn (stockturnover, stock turn, inventory turnover, inventory turn)

The number of times, on average, that the entire inventory is sold in one year. It is an indicator of both operational efficiency and financial stability. Generally, the higher the turnover, the more efficient the inventory management of a business; while a low turnover is associated with liquidity problems. It is calculated as: cost of goods sold / average stock.

ratio

A way of expressing a relationship between two variables, such as net profit and sales, by

way of the number of times one variable contains the other. return on assets

Shows how much profit is made for every dollar of assets. This is a measure of both the relative profitability of a business, and the relative overall efficiency with which it uses its assets. It is calculated as: net profit / average assets × 100.

return on equity (return on investment)

Shows how much the owners receive for each dollar invested. This should be compared with returns on similar risk investments, as well as low risk investments (such as bank term deposits). In the case of sole proprietors (or partnerships), a more meaningful result is obtained if allowance is made for a reasonable salary for the proprietor (or partners). It is calculated as: net profit / (average) owner’s equity × 100. [page 365]

solvency test

The Companies Act 1993 requires that a company remain solvent when paying dividends (or repaying share capital) to its shareholders. Immediately after paying the dividends, the company must be able to pass both: a liquidity test — the company must be able to pay its debts as they become due in the normal course of business; and

a balance sheet test — the value of the company’s assets must be greater than the value of its liabilities, including contingent liabilities. vertical analysis

An analysis in terms of which income statement amounts are presented as a percentage of sales.

working capital

The difference between current assets and current liabilities. It is the amount of funds available to fund the activities of the business on a day-to-day basis.

working-capital-ratio (current ratio)

This is a rough guide to liquidity. It provides an indicator of the business’s ability to meet its current obligations in the normal course of trading. The more that current assets exceed current liabilities, the less likely it is that the business will suffer from liquidity problems; although a very high ratio could mean that the best use is not being made of funds. It is calculated as: current assets / current liabilities.

7.14 7.14.1 7.14.1.1

Resource file 7 RATIO ANALYSIS – A QUICK REFERENCE GUIDE Which ratio to use

Analysing profitability – Overall profitability net profit percentage; return on equity (return on investment) percentage; return on assets percentage; percentage change in net profit. –

Identifying causes of changes in profitability percentage change in sales; gross profit percentage; percentage change in expenses (or expense categories). [page 366]

Analysing efficiency in asset management return on assets; stock turnover; age of debtors; bad debts as a percentage of credit sales. Analysing financial stability – Short-term stability liquidity (acid test/quick asset) ratio; working capital (current) ratio; age of creditors. –

Longer-term stability equity (owner’s equity/proprietorship) ratio; gearing ratio; percentage change in net operating cash flow;

interest cover.

7.14.1.2

What might ratio changes mean?

Analysing profitability – Changes in gross profit percentage need to be investigated. The change may reflect: changed business conditions (for example, competition); changed business philosophy (for example, regarding mark-up); and/or changed efficiency of trading. –

How might the gross profit percentage change if: more competitors set up in business in the same market? the decision was taken to position the business “upmarket”? inventory was acquired at lower prices?



A change in gross profit percentage means that average mark-up has changed — for example, a higher gross profit percentage means a higher average mark-up. This may be: deliberate; or unanticipated or unplanned.



Changes in expense percentages: decreases indicate improved control of expenses; increases will pinpoint areas contributing to lower profitability.



Changes in net profit percentage: improvements will result from higher gross profit percentage and/or lower expense percentages; decline will result from lower gross profit percentage and/or higher expense percentages. [page 367]

Analysing efficiency in asset management – Changes in stock turnover: Low or declining stock turnover may indicate: poor purchasing; obsolete stock; possible excess stock; and/or liquidity problems — a business carrying excess stocks may have difficulty paying short-term debts. –

Changes in age of debtors: An increase means debtors are taking longer to pay and may indicate: slack credit policy; poor screening of customers; poor monitoring of overdue accounts; poor follow-up of overdue accounts; tighter economic environment — either generally or in the industry; a deliberate change in credit terms — for example, offering extended credit terms to move obsolete stock; and/or poor credit management and a high age of debtors increases risk of bad debts and undermines liquidity.

Analysing financial stability – Changes in working capital ratio Increases generally indicate an improved ability to meet current debts and vice versa. The quality of the working capital ratio is subject to accurate values attached to debtors and inventory; whether or not debtors are likely to pay and pay on time; and whether the inventory figure is overstated because of obsolete stock. –

Changes in liquidity ratio This ratio is a better test of liquidity than the working capital ratio,

as it takes into account the liquidity of the individual components of working capital. Increases generally indicate an improved ability to meet immediate debts and vice versa. Less than a 1 : 1 ratio, generally indicates liquidity problems. The ratio should be interpreted in light of stock turnover and age of debtors. Short-term stability can be improved through: better inventory management; better accounts receivable management; and/or the injection of long-term funding — equity or debt, if the proprietorship ratio permits. [page 368] –

Changes in age of creditors An increase in the age of creditors indicates worsening liquidity — the business struggling to pay its bills as promptly as previously. A decrease in the age of creditors indicates improving liquidity. A change in supplier terms (or in supplier) can also cause a change in the age of creditors — for example, a supplier may offer extended credit terms for purchases of a particular range of stock.



Changes in interest cover A high or increasing interest cover indicates a business’s improved ability to service debt and vice versa. Interest cover can change because of: an increase or decrease in profit;

a change in debt levels, causing interest expense to change; or a change in interest rates, causing interest expense to change. –

Changes in the equity/proprietorship ratio Increases (that is, a higher proportion of equity funding) indicate a safer business from the point of view of outside creditors. If the rate is too low, the business is vulnerable, depending on the mix of outside debt, debt servicing costs, and timing of repayments. If the rate is too high, the business may not be taking advantage of external sources of finance to improve the level of return for its investors. Changes in the gearing ratio effectively work in reverse to the equity ratio — increases in the gearing ratio indicate decreased financial stability and vice versa.



Percentage change in net operating cash flow Increases in the level of operating cash flow indicate improved financial stability and vice versa. A business’s investing and financing cash flows should be considered in light of its operating cash flow — for example, whether a business can afford to pay out a certain level of dividends or invest in a certain level of fixed assets, depends on the level of operating cash surplus generated. [page 369]

7.14.2

ANALYSING FINANCIAL REPORTS – INTERNET

RESOURCES The following are just some of the many internet sites that provide a range of information on financial analysis: www.biz.org.nz Use the Search tool to find a range of articles on topics, such as ratio analysis. www.entrepreneur.com Type in an appropriate key word, such as “ratios” or “analysis”, in their Search box, and check out some of the articles that your search produces. www.nbr.co.nz This is the web-based version of the popular New Zealand weekly business magazine, National Business Review. Use the Search facility to find articles on financial analysis topics and New Zealand companies that you want to find out more about. www.irg.co.nz This investment research site provides another option for getting up-to-date share market ratio information on listed New Zealand companies. On their home page, select the “Free Services” option and then the “Latest prices/ratios” option to view earnings per share, P/E ratios, dividends per share, and dividend yield information for companies listed on the New Zealand Stock Exchange. The efficiency with which a business manages its debtors, can have a significant impact on its financial stability and profitability. See Chapter 5, paragraph 5.7.5, for information on a website by Dun & Bradstreet covering credit management issues and remedies.

7.14.3

SPACEMAKERS HARDWARE LTD

In the earlier chapters, we introduced you to Spacemakers Hardware Ltd. It is a retail store owned by Michael and Michelle Bevan. They own a hardware store (selling building, plumbing, and garden supplies) in the thriving community of Blenheim, and the business has grown very quickly. Over the

last two years, business activity has changed considerably with the opening of a branch of a national chain store in Blenheim. The biggest concern for Michael and Michelle is that their bank account has gone into overdraft, and the bank manager is requiring that the overdraft be lowered. After preparation of a revised cash flow forecast (refer to Chapter 5), and a decision to introduce a coffee shop (refer to Chapter 6), they require some long-term changes to improve their position. Such changes will come as a result of an analysis of their annual accounts for the previous three years. Refer to the income statements and balance sheets set out below. [page 370]

Spacemakers Hardware Ltd Income statements For the years ended 31 March

2015

2014

2013

$

$

$

Cash Sales

360,000

350,000

368,445

Credit Sales

550,000

560,000

590,000

Sales

910,000

910,000

958,445

(370,600)

(370,000)

(400,000)

539,400

540,000

558,445

(230,000)

(215,000)

(210,000)

(25,000)

(23,000)

(35,000)

(100,000)

(100,000)

(100,000)

(355,000)

(338,000)

(345,000)

(65,000)

(62,000)

(60,000)

(110,000)

(95,000)

(85,000)

(37,600)

(34,550)

(43,445)

(212,600)

(191,550)

(188,445)

Less

Cost of Sales

Gross profit Less

Selling expenses Shop staff wages Advertising and promotion Shop rent

General expenses Office staff wages Shareholder salaries General Expenses

Financial expenses Interest Other

Total expenses Net profit/(loss) before tax Less

(15,600)

(8,450)

(4,000)

(1,000)

(1,000)

(1,000)

(16,600)

(9,450)

(5,000)

(584,200)

(539,000)

(538,445)

(44,800)

1,000

20,000

-

(300)

(6,000)

(44,800)

700

14,000

Tax

Net profit/(loss) after tax

[page 371]

Spacemakers Hardware Ltd Balance sheets As at 31 March

2015

2014

2013

$

$

$

Current assets Bank

-

-

5,000

Accounts receivable

80,000

45,000

35,000

Inventory

90,000

68,000

65,000

-

-

-

170,000

113,000

105,000

45,000

60,000

58,000

215,000

173,000

163,000

Bank overdraft

20,000

1,000

-

Accounts payable

32,600

19,000

7,000

-

300

6,000

52,600

20,300

13,000

Other current assets Non-current assets Plant and equipment TOTAL ASSETS Current liabilities

Tax payable Non-current liabilities

Bank loan - ANY Bank

96,500

42,000

40,000

149,100

62,300

53,000

Opening equity

110,700

110,000

96,000

Plus

(44,800)

700

14,000

65,900

110,700

110,000

215,000

173,000

163,000

Total liabilities Equity Profit

Closing equity TOTAL LIABILITIES AND EQUITY

7.14.4

ACCOUNTING STANDARDS’ IMPACT ON EARNINGS

The following article under the by-line Shoeshine, titled “Accounting standards, Joe Blow investor and the death of the PE ratio” (National Business Review, 27 August 2004, www.Knowledge-basket.co.nz), illustrates how the changes in accounting standards can impact upon the profit figure, and the difficulties this may cause for small investors trying to understand why figures have changed. Along with a slightly dubious profit result, Sky City Entertainment this week announced it would be reporting its December first half using international financial reporting standards IFRS, one of the first New Zealand listed companies to do so. By January 2007, everyone will be using IFRS. Screeds have been written about the Herculean effort companies are going to have to make to meet the deadlines, with, of course, their trusty beancounting advisors constantly by their side.

[page 372] Less attention has been paid to the coming revolution in investor communications. For listed companies, for the sharebroking and investment advisory community, for company valuers, and even for the media, the change will throw up a big challenge — and it’s one some market observers are already worrying about. “There is a big issue for the mum and dad investors because they’re going to see earnings going all

over the place,” says Paul Hocking, executive director of Infinz, the institute of finance professionals. The intentions behind developing IFRS and pushing for countries to adopt them are to enhance transparency and the comparability of companies’ financial reporting across borders. Most observers feel the effort is likely to be successful. The problem is the changes will fundamentally affect indicators — earnings per share, PE ratios and other earnings multiples — that smaller investors, company valuers and the media have used for decades. For New Zealand companies, the main culprits are changes to the accounting treatment of goodwill, intangible assets and financial instruments. Of these, probably the best recognised and understood is goodwill, which has the virtue of being easy to explain. Under the current standard, goodwill — a somewhat vague concept roughly approximating the difference between what a company pays for something and the tangible assets acquired — is held on the balance sheet and amortised. That is, it’s reduced by a set amount each year. Reported profits are reduced by the amount of each year’s amortisation. Freightways, by way of example, took a $4.9 million charge for goodwill amortisation through its profit and loss account last year. Under IFRS 3, goodwill will no longer have to be amortised. Had Freightways reported this year under IFRS, it would have been able to add $4.9 million to its reported profit, jacking it up 31% to $20.6 million. The flip side of this is that the goodwill on Freightways’ balance sheet will be subjected to an annual “impairment test.” That means that, should the earnings of one of the companies Freightways bought take a dive, its valuation on the balance sheet would have to be written down, resulting in a one-off charge to reported profit. Bogeyman number two is IAS 38, an international accounting standard governing intangible assets — that is, “an identifiable non-monetary asset without physical substance”. This has been one of the bloodiest battlegrounds of the IFRS revolution; in Australia, it’s reckoned $30–40 billion will be wiped off company balance sheets. That’s because companies will no longer be allowed to carry on their balance sheets any value for brands that are “internally generated” — that is, brands they’ve built up themselves, and not bought from somebody else. This is arguably the change Joe Blow investor is going to have the most trouble getting his head around. Even accountants are starting to find this stuff hard to understand. The change is something of a problem for Lion Nathan and Fairfax but not for Freightways. The trucker has $87.4 million of brands on its balance sheet, but they were all paid for and so will, under IFRS, be subject to the same impairment test as its goodwill number.

[page 373] Culprit number three is IAS 32, which deals with financial instruments. But Shoeshine, in consultation with his spirit medium, feels readers’ attention might be starting to flag a little here. The point of all this is that the time-honoured bottom line, net profit after tax, has been under attack as a meaningful indicator of companies’ performance and wellbeing for many years and IFRS may deliver a fatal blow. The increased volatility of net profit will undermine the price-to-earnings PE ratio, a timehonoured way of comparing the share price level of companies in similar industries. Earnings will be affected even up to the ebitda earnings before interest, tax, depreciation and amortisation line, so the earnings multiples comparison used by independent appraisers of takeover offers, for instance, will also be undermined. What will be used instead? Analysts generally value companies by discounting future free cash flows, but that’s hardly a method available to Mr Blow. Even so, it’s possible that in newspaper share tables a measure such as the ratio of enterprise value to free cash flow could replace the PE. Another question is, who’s going to explain all this to Mr Blow? Sharebrokers don’t see it as their problem, They’ll educate their own clients; why should they bother about anybody else’s? The New Zealand Exchange doesn’t appear to have thought about it yet. In the absence of any lead from the securities industry it looks as if companies themselves are going to have to do the explaining. Look for a surge of demand in the investor relations market.

7.15 7.15.1 7.15.1.1 1.

Mastering accounting — questions SHORT ANSWER QUESTIONS Multiple choice

The income statement is a combination of facts and personal judgments. Therefore, when we analyse and interpret, we must be aware that: a.

measuring business performance is highly subjective;

b.

only objective facts are taken into consideration;

2.

c.

we must omit items where subjective judgments have to be made;

d.

it is both a subjective and objective measurement of business performance.

We measure long-term financial stability to try to determine: a.

how efficiently the business is using its resources;

b.

whether it is safe to lend money to the business;

c.

whether the business can pay its immediate debts;

d.

whether the business is making an adequate profit. [page 374]

3.

4.

5.

6.

Another term which is used to describe short-term solvency is: a.

liquidity;

b.

creditworthiness;

c.

profitability;

d.

efficiency.

Ratios are useful because: a.

they can be used to predict future results;

b.

they provide answers to questions about solvency;

c.

they can be used to summarise relationships and results.;

d.

they provide objective answers when used with subjective data.

The quick assets ratio is also known as the: a.

current ratio;

b.

liquidity ratio;

c.

total assets ratio;

d.

working capital ratio.

A working capital ratio of 0.65 : 1 shows that:

7.

8.

a.

for every $1 payable during the current accounting period, the business has 65 cents available to meet the payments;

b.

there is currently 65 cents in the bank for every $1 owed;

c.

the business can raise $1 for every 65 cents it owes.;

d.

for every $1 owed to outsiders, the business has 65 cents.

In calculating the liquidity ratio, you would generally leave out: a.

cash in till;

b.

petty cash;

c.

short-term loans;

d.

stocks of goods for resale.

A small business which is largely financed by outsiders, has applied to the bank for a loan to expand. The bank is more likely to: a.

grant the loan because others have lent to the business, and therefore it must be a good risk;

b.

grant the loan because the business has shown that it can use other people’s money more efficiently than its own;

c.

turn down the application because of the risk of competing with other creditors if the business goes into liquidation;

d.

turn down the application because, if the business goes into liquidation, the owner gets paid first. [page 375]

9.

A business with low gearing: a.

has a low amount of assets compared to its liabilities;

b.

is not a good risk for investors;

c.

relies on owner’s equity funds;

d.

uses a greater proportion of funds from outsiders.

10. General Enterprises is granted a five-year loan from the bank to update its equipment. The bank loan is shown on the balance sheet as: a.

an investment asset;

b.

a long-term liability;

c.

a current asset;

d.

an intangible asset.

11. A fall in the gross profit percentage is most unlikely to be caused by: a.

inaccurate stocktaking;

b.

increase in mark-ups;

c.

theft of inventory;

d.

change in sales mix.

12. Which of the following ratios should be most valuable in helping you assess the short-term financial stability of a retail business? a.

gross profit percentage;

b.

proprietorship ratio;

c.

working capital ratio;

d.

net profit percentage.

13. The net profit percentage for a retailer showed the following movement: 2014: 22%; 2015: 18%. Which of the following could explain this change? a.

expenses have increased;

b.

liquidity is decreasing;

c.

the business is becoming insolvent;

d.

sales have increased.

14. The gross profit percentage for a retailer showed the following movement: 2014: 41%; 2015: 35%. Which of the following would not be a possible cause of the change? a.

unforeseen increases in freight charges on stock purchased;

b.

increased competition from new retailers;

c.

increased rent on store premises;

d.

reduced selling prices to clear slow-moving stock. [page 376]

15. An increase in a company’s share price is likely to cause: a.

an increase in the dividends per share;

b.

a decrease in the company’s P/E ratio;

c.

a decrease in dividend yield;

d.

an increase in dividend yield.

16. A company’s P/E ratio could drop due to: a.

an increase in profit for the latest year;

b.

a general loss of investor confidence in the share market;

c.

the company announcing that profits for the coming year are likely to drop;

d.

any of the above.

17. If a company’s dividend yield has increased at the same time that its dividends per share have decreased: a.

the company’s earnings per share must have increased;

b.

the company’s share price must have increased;

c.

the company’s P/E ratio must also have increased;

d.

the company’s share price must have decreased.

18. A decrease in a company’s interest cover is likely to result from: a.

a decrease in interest rates;

b.

an increase in profit;

c.

an increase in income tax;

d.

an increase in borrowing.

19. Which of the following is not likely to cause an improvement in the working capital ratio? a.

extra capital being put into the business to pay creditors;

b.

a term loan being taken out, with the funds being used to repay an overdraft;

c.

using an overdraft facility to pay creditors;

d.

selling off a fixed asset and putting the proceeds in the bank.

20. The underlying aim of the solvency test is to: a.

improve return on shareholders’ funds;

b.

restrict the ability of a company to invest in risky ventures;

c.

protect the interests of a company’s creditors/lenders;

d.

ensure that Companies Act financial reporting requirements are followed. [page 377]

7.15.1.2 1.

Paragraph answers

Sort the following into current assets and current liabilities, and calculate the working capital for each question: a.

inventories $400; cheque account in overdraft $750; accounts payable $12,970; accounts receivable $14,500; petty cash $100; accrued expenses $280;

b.

accounts payable $13,769; accounts receivable $12,400; cheque account $1,200; inventory $18,760;

c.

petty cash $90; accounts payable $12,450; cheque account in overdraft $2,700; inventory $10,984; mortgage $18,000; accounts receivable $9,970; prepayments $136.

d.

cheque account $2,005; net profit $15,000; accounts receivable

$1,760; vehicles $12,500; wages owing $2,150; accounts payable $12,000. 2.

Distinguish between a rate and a ratio.

3.

Explain the difference between the working capital ratio and the liquidity ratio.

4.

Give two advantages and two disadvantages for a business which relies on a large proportion of outside funds (gearing) for expansion.

5.

Why are rates/ratios a useful technique for interpreting financial reports?

6.

Give an example of non-monetary information that would be useful to an interpreter of financial reports, and state why it would be useful.

7.

Give an example of an economic event that may affect a business’s performance, and state how performance might be affected.

8.

A dairy has a working capital ratio of 2.5 : 1. What does this mean?

9.

A furniture shop has a rate of stock turn of 4. What does this tell us?

10. Two businesses sell electrical appliances on credit. The average age of debtors for Business A is 1.5 months, and for business B is 2.9 months. Which business is more likely to experience liquidity problems and why? 11. In order to determine whether a given rate of return is acceptable, we should compare it with current rates of interest. What are the rates of interest currently being offered by financial institutions? 12. The owner of a small business currently has capital invested of $150,000, and the business earns a net profit of $45,000. If finance companies were offering 7% for long-term investments, and the owner could earn a salary in the $35–40,000 range with a car and four weeks’ paid leave a year, what is the financial cost that the owner giving up to stay in business? 13. Analysing trading results: Consider the trading results summarised below: 2015

2014

$

$

Sales

320,000

260,000

Cost of goods sold

240,000

180,000

Average inventory

30,000

30,000

[page 378] a.

Calculate for each year: i.

the gross profit percentage;

ii.

the average mark-up;

iii. the stock turnover. b.

Explain whether your results in a. above indicate an improvement or deterioration in trading efficiency.

14. Net profit percentages: a.

A business’s net profit percentage has fallen. In general terms, what two factors could have caused this decline?

b.

List six specific causes of a fall in the net profit percentage.

15. Age of debtors:

Average debtors

2015

2014

$

$

40,000

25,000

Credit sales

320,000

310,000

Total sales

395,000

405,000

a.

From the information provided above, calculate the age of debtors for the two years.

b.

What do your results mean?

c.

State two possible causes of the change you have calculated.

16. The following information relates to AB Traders for 2014 and 2015:

Sales

2015

2014

$

$

167,000

146,000

21,000

15,000

108,000

78,000

Stock (31 March)

29,000

21,000

Net profit

21,000

26,000

Stock (1 April) Purchases

a.

Calculate for each year: i.

the gross profit percentage;

ii.

the net profit percentage.

b.

Explain why this business has increased sales by $21,000 from 2014 to 2015, yet net profit has dropped by $5,000.

c.

Indicate whether the following items would cause the gross profit percentage to rise, fall, or remain unchanged: i.

increased theft of stock;

ii.

the overvaluing of closing stock;

iii. greater competition from other businesses; iv.

recording the proceeds of the sale of fixed assets as “sales”. [page 379]

d.

Calculate stock turnover for AB Traders for 2014 and 2015.

e.

The age of debtors of AB Traders changed from 68 days in 2014, to 43 days in 2015. i.

Provide the formula for calculating “age of debtors”.

ii.

Outline two policies the business could have followed to bring about the above result.

17. Joan Scott has extracted the following figures from her accounts in respect of cost of sales and inventory levels:

Cost of sales Average inventory

2015

2014

2013

$

$

$

492,000

25,000 28,000

70,000

310,000 41,000

a.

Calculate the stock turnover rate.

b.

What do your results indicate? Why?

c.

What practical actions could Joan Scott take to improve the rate of stock turnover?

18. Arnold Manufacturing had a working capital ratio of 1.6 : 1 in 2014, and a liquidity ratio of 1.2 : 1. The following figures have been extracted from the business’s balance sheet at 31 March 2015: $ Debtors

12,900

Stock

14,000

Creditors

16,000

Goodwill

10,000

Machinery

15,000

Prepayments

1,000

Petty cash Bank overdraft Accrued expenses

100 12,000 2,000

The arranged overdraft limit was $10,000. a.

Calculate the working capital ratio and the liquidity ratio for 2015.

b.

Comment on your results compared with those of 2014.

19. Proprietorship ratio: a.

What does the proprietorship ratio show?

b.

What problems would a business be likely to have if it were undercapitalised?

20. Trevor Arnold gave up his shop manager job to run his own retail shop. His salary as a shop manager had been $30,000 a year. To buy his

business, required him to invest $50,000 of his savings, and his reported profit for the first year’s trading was $33,000. His drawings during the year totalled $18,000. Calculate Trevor’s return on his investment of $50,000, and explain your workings. [page 380]

7.15.2 7.15.2.1 1.

PROBLEMS Spacemakers Hardware Ltd

You work as a financial analyst for an investment bank. You have been asked to prepare a report assessing the financial results and investment attractiveness of Spacemakers Hardware Ltd. This report is to be based on the set of the annual financial statements for Spacemakers Hardware presented in Resource file 7, paragraph 7.14.3. Your report should cover your assessment of the following: the company’s profitability — consider both how good or poor the profit performance is; identify the reasons for any change in profitability; the company’s financial stability, both immediate and longer term; how well Spacemakers Hardware’s management has utilised its working capital; your conclusion as to whether the company represents a good investment or not; your assessment should be based on the following appropriate ratios/rates — calculate these for the year 2015 and preceding years, and include these as an appendix to your report: – sales increase; –

gross profit;

2.



expenses;



net profit before tax;



net profit after tax;



return on assets;



return on equity;



liquid ratio;



current ratio;



proprietorship;



times interest covered;



age of debtors; and



stock turn.

Assume that one of the clients of your investment bank has decided to purchase a controlling stake in Spacemakers Hardware. The client now needs to consider what steps to take to remedy or reduce the problems that Spacemakers Hardware has. For the purposes of this question, assume that the following problems exist: decreasing net profit (moving to loss); poor and decreasing stock turnover; debtors taking too long to pay; and poor liquidity. For each of these problems, identify a range of possible remedies. [page 381]

7.15.2.2

New Zealand Stock Exchange

Find an up-to-date listing of share prices and share market ratios for New Zealand companies listed on the New Zealand Stock Exchange. You could find this information in a current issue of the National Business Review, or by

going to the IRG website (see Resource file 7, paragraph 7.14.2, for details on this site). Compare the share market ratios for companies that operate within the same sector — for example, Hallenstein Glasson and Kathmandu (retail clothing sector), Ryman Healthcare and Summerset Group Holdings (retirement village sector), or Telecom and Telstra (telecommunications sector). Answer the following questions: 1.

Are the dividend yields for companies within the same sector similar or different? If they differ, does this appear to be due to the level of dividends being paid, or to depressed/high share prices?

2.

Are the P/E ratios for companies within the same sector similar or different? If they differ, what does this tell you about the difference in investor attitudes to the companies?

3.

Compare the P/E ratios of Restaurant Brands, a fast food company, and SkyCity Entertainment Group, which runs casinos. The P/E ratios are likely to differ quite widely. What does this indicate about investor attitudes to each of these industry sectors?

7.15.2.3

Liquidity

You are asked to prepare a talk for the local Furniture Retailers Association on the topic, “Liquidity: some considerations”. In briefing you on what the association members might be interested in, the president asked you to cover rate of stock turn and rate of debtors’ turnover/age of debtors. “Members have heard these terms, but often don’t understand them. They don’t see the relationship with liquidity. Can you explain the links?” Prepare your talk, using examples which association members will be able to understand.

7.15.2.4

Xero Limited

Refer to the Xero Limited accounts in Appendix 1. You have been asked to prepare a review of Xero Limited’s 2013 financial results to appear in the financial pages of your local newspaper. Your article must cover the following issues:

your assessment of the company’s sales performance; your view of the company’s profitability, identifying the ratios and trends that this is based on; your assessment of the company’s financial stability, identifying the specific ratios and trends that support your assessment; and your assessment of the company’s level of dividends — is it good or poor? Is the level of dividends appropriate? [page 382]

7.15.3

RESEARCH EXERCISE

Read the article “Accounting standards, Joe Blow investor and the death of the PE ratio” in Resource file 7, paragraph 7.14.4, which raises a number of issues around analysing accounting reports that can be used as a basis for research. Prepare a 300-word research report covering one of the following topics: 1.

Write on the importance of consistency and comparability in the preparation of accounting reports.

2.

Write for (or against) the need for the internationalisation of accounting standards.

3.

Choose any company with a published set of accounts, and determine the difference in profitability as a result of moving to international accounting standards.

4.

One of the issues referred to relates to the treatment of “goodwill”. Write a report describing goodwill.

7.16

Mastering accounting — solutions

7.16.1 7.16.1.1 1.

d.

2.

b.

3.

a.

4.

c.

5.

b.

6.

a.

7.

d.

8.

c.

9.

c.

SHORT ANSWER QUESTIONS Multiple choice

10. b. 11. b. 12. c. 13. a. 14. c. 15. c. 16. d. 17. d. 18. d. 19. c. 20. c. [page 383]

7.16.1.2

Paragraph answers

1.

Working capital:

2.

Rate and ratio: These are different ways of expressing a relationship between two variables, such as net profit and sales. The rate expresses the relationship in percentage terms, whereas the ratio expresses the relationship by way of the number of times one variable contains the other.

3.

Working capital ratio versus liquidity ratio: The working capital ratio is a rough guide to business liquidity. It provides an indicator of the business’s ability to meet its current obligations in the normal course of trading. The liquidity ratio, on the other hand, takes into account the liquidity of individual components of working capital. Some current assets are difficult to turn into cash quickly (for example, inventories), and some current liabilities may not in fact have any particular immediate repayment requirements (for example, bank overdraft). By taking these factors into account, the liquidity ratio provides a more

stringent test of the business’s liquidity. [page 384] 4. Advantages of gearing: – The business can do more than if relying solely on equity finance — therefore a greater scale of operations is possible. –

The business can secure a higher return on the owner’s investment, due to higher gearing.

Disadvantages of gearing: – The higher the debt, the more cash is needed to service it by paying interest and making repayments of principal. In particular, if there is a downturn in trading profitability and operating cash flow, the business may find it difficult to meet the continuing servicing requirements. This increases the risk that lenders could seek to take legal action to recover the debt, which could ultimately result in the business having to be wound up. –

High debt will mean high interest expenses. Profit will drop if the business finds that the return it gets from the borrowed money is less than the interest rate being paid.

5.

Percentages and ratios are a useful technique for interpreting financial reports, because they summarise relationships and results in such a way that trends can be isolated, and comparisons can easily be made with past years, budgets, or the industry norm.

6.

Refer to paragraph 7.3.1 for examples of non-monetary information that may be useful to those seeking to interpret the accounts. Such events provide a context for financial results, enabling more useful interpretations to be made.

7.

Refer to paragraph 7.3.2 for examples of economic events that may affect

a business’s performance. Such economic events generally affect: either the demand for the business’s goods or services, and thereby revenue; or the cost structure of the business, and thereby profit. In addition, different economic conditions can affect the ability of customers to pay their accounts, and may well influence cash flow. 8.

A working capital ratio of 2.5 : 1 means that, for every dollar of current liabilities, the dairy has $2.50 of current assets. This would generally be seen as a sound working capital position.

9.

A rate of stock turn of four times tells us that, on average, stock is turned over (that is, sold) four times a year — effectively, furniture took 91 days on average to sell (365 days / 4). This may or may not be a good thing. We need to understand the past performance of the business, and the typical rate for similar businesses, to be able to tell.

10. Business A takes 1.5 months to collect its debts, while Business B takes 2.9 months. Business B is more likely to experience liquidity problems, all other things being constant, because of the relative slowness in collecting debts, which may well place a strain on cash flow. 11. The interest rates will depend in part on the length of time that the money would be invested, and on relative risk involved — for example, a small finance company may pose more risk, and therefore need to offer a higher interest rate to attract investors, than a large trading bank. To find out the current rates of interest being offered by trading banks, go to one of the following websites of our trading banks: www.asb.co.nz, www.bnz.co.nz, www.tsb.co.nz, and www.westpac.co.nz. [page 385] 12. Adjust net profit downwards, to take into consideration the salary ($45,000 - $40,000); now recalculate return on investment: $150,000 / $5,000 × 100 = 3.3%; compare this return to the return from question 11

(interest rates being offered by trading banks). Which provides a better return? There are also non-financial considerations, such as the loss of the car, paid leave, and the additional risks involved in business ownership. 13. Analysing trading results: a.

b.

The business has increased sales volume, but its cost of sales has risen at a greater rate than sales, thereby causing the gross profit percentage to fall. This reflects a deterioration in trading efficiency, which may well result from poor purchasing (paying too much, or buying the “wrong” goods), or simply from increased competition so that mark-ups cannot be maintained.

14. Net profit percentages: a.

Net profit percentage falls, because gross profit has fallen and/or expenses have risen.

b.

Specific causes of a fall in net profit percentage are: increased purchasing costs; reduction in selling prices because of competition; stock theft (by customers or staff); reduction in selling prices to clear slow-moving lines; increased rates for variable expenses — for example, higher freight rates or commission rate; and increased fixed costs, such as interest on loans.

15. a. Age of debtors = average debtors / credit sales × 365 2015: $40,000 / $320,000 × 365 = 4.6 days 2014: $25,000 / $310,000 × 365 = 29.4 days b.

These results show that the business is taking, on average, over 15 days longer to collect money owed by debtors. This suggests a slackening off of credit control. [page 386]

c.

Possible causes: Customers are not being screened as carefully before credit is granted. The accounting system is no longer producing timely data about overdue accounts. This can happen when a business outgrows a simple manual system. Overdue accounts are not being followed up promptly. There was a substantial deterioration in general economic conditions, resulting in business’s general inability to meet obligations.

16. AB Traders: a. i. Gross profit percentage = gross profit / sales × 100 2014: cost of goods sold

= $15,000 + $78,000 - $21,000 = $72,000

gross profit

= $146,000 - $72,000 = $74,000

gross profit percentage

= $74,000 / $146,000 × 100 = 50.7%

2015: cost of goods

= $21,000 + $108,000 - $29,000 =

ii.

sold

$100,000

gross profit

= $167,000 - $100,000 = $67,000

gross profit percentage

= $67,000 / $167,000 × 100 = 40.1%

Net profit percentage = net profit / sales × 100 2014: net profit percentage

= $26,000 / $146,000 × 100 = 17.8%

2015: net profit percentage

= $21,000 / $167,000 × 100 = 12.6%

b.

The decline in net profit is entirely a result of the decline in gross profit, which was partly compensated for by a $2,000 fall in expenses.

c.

i. fall; ii.

rise;

iii. may cause a fall; iv.

rise.

d.

Stock turnover = cost of goods sold / average stock

e.

i.

Age of debtors = average debtors / credit sales × 365

ii.

This is an improvement in the rate of debt collection, possibly resulting from: more careful screening of customers prior to granting credit; closer monitoring of overdue accounts and prompt followup of overdue accounts.

[page 387] 17. a.

Stock turnover = cost of sales / average stock

b.

These results show that stock turnover is declining. Joan is carrying significantly more stock in 2015 compared to 2013 (a 70% increase), and is not selling this stock as rapidly. It is also possible that some stock is of a slow-selling line, or has become obsolete.

c.

To improve the stock turnover rate, Joan needs to reduce the amount of stock carried, but without compromising customer service. This can be achieved by more carefully monitoring levels and reordering quantities of each stock line. Obsolete stock may be cleared through a discounting policy.

18. Arnold Manufacturing: a.

b.

19.

Both the working capital and liquidity ratios have declined significantly, to the extent that the business will be experiencing problems paying its accounts — both on a day-to-day basis, and even more so if creditors push for payment.

a.

b.

The proprietorship ratio shows the extent to which the business is financed by equity (owner) funds, and is therefore an indicator as to the long-term financial stability of the business. An undercapitalised business is likely to face difficulties in funding its day-to-day operations. It is also likely to have difficulty raising finance for expansion or asset renewals, and is particularly vulnerable if there is an unexpected downturn in the economy.

20. Return on investment = net profit / capital × 100 A simple analysis suggests that this would be: $33,000 / $50,000 = 66%. However, this does not recognise the hours worked by the proprietor. It is misleading to suggest that the profit is simply a return on the capital invested. Therefore, a notional salary for the owner should be deducted from profit, before calculating the [page 388] return on capital. Such a notional salary should reflect the hours worked and the expertise involved, and be linked to a marketplace standard. In this case, the former manager’s salary may be a good guide. Therefore, return on investment

7.16.2 7.16.2.1 1.

=

adjusted net profit / capital × 100

=

($33,000 – $30,000) / $50,000 = 60%

PROBLEMS Spacemakers Hardware Ltd

List of ratios: Sales increase

2015

2014

0.00%

(5.05%)

2013

Gross profit

59.27%

59.34%

58.27%

Expenses

64.20%

59.23%

56.18%

Net profit before tax

(4.92%)

0.11%

2.09%

Net profit after tax

(4.92%)

0.08%

1.46%

Liquid ratio

1.52 : 1

2.22 : 1

3.08 : 1

Current ratio

3.23 : 1

5.57 : 1

8.08 : 1

Proprietorship

30.65%

63.99%

67.48%

Times interest earned

(1.87 times)

1.12 times

6 times

Age of debtors

53.09 days

29.33 days

21.65 days

4.69×

5.56×

6.15×

Return on assets

(23.1%)

0.60%

8.59%

Return on equity

(50. 6%)

0.63%

13.59%

Stock turn

An analysis of Spacemakers Hardware may vary, but the following are some suggested key points: Profitability – Sales have remained fairly static for the past two years. There was a decrease in sales between 2013 and 2014. There may have been some aggressive marketing in 2013, which has not been repeated, or the business is now facing competition from other similar retail businesses. –

The company’s gross profit has stayed fairly consistent. Comparison to other similar businesses would help indicate if Spacemakers Hardware’s pricing was in line.



Overhead expenses, in dollar terms and in percentage terms, have increased. An observation of the income statements shows that wages (sales, administration and shareholders) have all increased substantially.



The decreasing stock turn and slower payment of accounts receivable, contribute to the large increase in interest payments over the last three years. The company has had to more than double its bank loan and increase their overdraft.

[page 389] Financial stability – Long-term stability, as measured by the proprietorship ratio, has deteriorated. Owner’s funds represent less than a third of the financing used by the company (30.65%). This makes the company more risky to lend to and affects the potential interest rate. The rapid increase in long-term bank borrowing contributes to this change from 67.48% three years ago. The lender will expect interest and other repayments to be made on time. Failure to do so could cause the entity to be forced into receivership. –

Short-term solvency (current ratio) at 3.23 : 1, appears reasonably secure. However, the current ratio is almost three times higher than that in 2013, and the trend is a concern. The ability of Spacemakers to meet its short-term commitments is dependent on the quality of its working capital. The slowing stock turn, increasing age of debtors, and negative cash position confirm that there are issues with the current ratio.



Short-term solvency (liquidity ratio) indicates that Spacemakers has $1.52 of potential cash inflows for every $1.00 of potential cash outflows within the next month. At this ratio, Spacemakers would consider itself safe, but attention must be paid to the fact that the debtors are taking an additional 24 days to pay.



Interest cover (the amount of profit available to meet interest payments) has deteriorated from 6 times to a negative number. This is a concern, particularly as the company has taken on additional debt.

Working capital management – Age of debtors has increased from 21.65 days to 53.09 days over the three years. Despite a decrease in credit sales, accounts

receivable has doubled in that time. The extra debtors are costing Spacemakers $5,400 per year (($80,000 – $35,000) × 0.12), assuming an interest rate on overdraft of 12%. –

Stock management is a problem area, with stock turnover having declined from 6.15 times a year in 2013, to 4.69 times a year in 2015. Management needs to identify the cause of this. Does it reflect a build-up of apparently difficult to sell inventory? Or does it reflect excessive stock levels? Inventory has increased by 38% in three years, yet the volume of sales has decreased.

Investment value – Management is currently making a negative return on assets, and a negative return on equity. This would indicate a poor option for investment. 2.

Possible measures to remedy or improve on the problems identified: Declining profit – Review product line sale history and cut back or cease selling poor-selling lines. Reinvest funds and efforts into lines showing good turnover. –

Increase advertising and promotion expenditure. Seek particular niches which are different from the newly arrived competition.



Review pricing. Drop prices to match competitors on lines where the current price is seen as holding back sales. [page 390] –

Review staff wage levels and staff employment timing. Review the part-time/full-time mix of staffing to ensure efficient use of the resource.



Review cash flow issues to reduce cost of finance.

Poor stock turnover – Identify and cut back purchases of slow-moving items. –

Consider moving to more of a just-in-time purchasing system if this does not compromise customer responsiveness. (It may be difficult if products have to be imported.)



Discount prices on slow-moving/“dead” stock and promote a special sale of these items.



Invest in improved computerised inventory tracking system to aid prompt identification of downturns in demand for particular lines.

Poor credit control – Tighten criteria for granting credit, and tighten screening of those applying for credit. –

Offer discount for prompt payment.



Include interest charges for late payers as part of agreed credit terms.



Ensure prompt preparation and forwarding of invoices and statements.



Ensure regular preparation and review of aged debtors report.



Ensure prompt follow up of all overdue debtors.



Make use of a credit collection agency when own efforts are unsuccessful.



Consider making use of factoring.

Poor liquidity – Seek injection of share capital and use this to pay creditors. –

Take out a short- or long-term loan and use these funds to pay creditors.



Discount and sell off surplus stock and use funds to pay creditors.



Improve debtor collection rate to improve quality of current

assets. –

Consider leasing premises and selling land and buildings, using money from the sale to pay creditors.

[page 391]

Extracts from Xero Limited’s 2013 Annual Report

APPENDIX

1

XERO LIMITED – INCOME STATEMENTS – FOR THE YEAR ENDED 31 MARCH 2013

Notes

Group Group 2013 2012 ($000s) ($000s)

Parent Parent 2013 2012 ($000s) ($000s)

Operating revenue

4

39,033

19,370

26,857

15,186

Other income

4

936

401

936

427

39,969

19,771

27,793

15,613

55,954

28,385

45,778

24.720

(8,614) (17,985)

(9,107)

Total revenue & other income Operating expenses

4

Operating deficit Net interest income

(15,985) 4

Net operating loss before tax

1,838 (14,147)

612

1,827

607

(8,002) (16,158)

(8,500)

Gain on investment in associate

-

170

-

178

Share of profit of associate

-

38

-

-

(7,794) (16,158)

(8,322)

Net loss before tax Income tax expense Net loss after tax for the year attributable to the shareholders of the Company

(14,147) 5

(296) (14,443)

(110)

-

-

(7,904) (16,158)

(8,322)

Earnings per share Basic & diluted loss per share

6

($0.13)

($0.08)

($0.15)

($0.09)

[page 392] XERO LIMITED – STATEMENTS OF COMPREHENSIVE INCOME – FOR THE YEAR ENDED 31 MARCH 2013 Group Group 2013 2012 ($000s) ($000s) Net loss after tax

(14,443)

Parent Parent 2013 2012 ($000s) ($000s)

(7,904) (16,158)

(8,322)

Other comprehensive income Exchange difference on translation of international subsidiaries

(11)

(39)

-

-

Total other comprehensive (expense)/income for the year

(11)

(39)

-

-

Total comprehensive loss for the year attributable to the shareholders of the company

(14,454)

(7,943) (16,158)

(8,322)

The accompanying notes form an integral part of these financial statements XERO LIMITED – STATEMENTS OF CHANGES IN EQUITY – FOR THE YEAR ENDED 31 MARCH 2013 Sharebased payment Accumulated reserve losses ($000s) ($000s)

Foreign currency translation reserve ($000s)

Total equity ($000s)

Share capital ($000s)

Treasury stock ($000s)

Balance at 1 April 2012

93,251

(6,874)

1,883

(35.951)

(61)

52,248

Net loss after tax

-

-

-

(14,443)

(14,443)

-

Currency translation movements

-

-

-

-

(11)

(11)

Total comprehensive income

-

-

-

(14,443)

(11)

(14,454)

Notes Year ended 31 March 2013 Group

Transactions with owners:

Issue of shares (net of issue costs)

13

59,882

-

-

-

-

59,882

Accrual for equity portion of purchase of Max Solutions Holdings Limited

11

-

-

2,222

-

-

2,222

[page 393] Vesting of shares - purchase of Max Solutions Holdings Limited

-

1,333

(1,333)

-

-

-

-

-

489

-

489

-

-

431

(431)

-

-

-

600

-

-

-

-

600

1,818

(1,818)

-

-

-

-

Accrual of sharebased employee benefits

-

-

1,665

-

-

1,665

Vesting of shares - employee restricted share plan

-

1,399

(1,399)

-

-

-

155,551

(5,529)

3,096

(50,394)

(72)

102,652

Balance at 1 April 2011

50,168

(1,113)

702

(28,047)

(22)

688

Net loss after tax

-

-

-

(7,904)

-

(7,904)

Currency translation movements

-

-

-

-

(39)

(39)

Accrual for equity portion of purchase of Paycycle assets

11

Vesting of shares - purchase of Paycycle assets Issue of shares purchase of Spotlight Workpapers Limited Issue of shares employee restricted share plan

Balance at 31 March 2013

11

Year ended 31 March 2012 Group

-

Total comprehensive income

-

-

(7,904)

(39)

(7,943)

[page 394] Transactions with owners: Issue of shares (net of issue costs)

36,365

-

-

-

-

36,365

Issue of shares – purchase of Paycycle assets

11

1,294

(1,294)

512

-

-

512

Issue of shares – purchase of Max Solutions Holdings Limited

11

4,000

(4,000)

407

-

-

407

1,424

(1,424)

-

-

-

-

Accrual of share– based employee benefits

-

-

1,219

-

-

1,219

Vesting of shares – employee restricted share plan

-

957

(957)

-

-

-

93,251

(6,874)

1,883

(35,951)

(61)

52,248

Issue of shares – employee restricted share plan

Balance at 31 March 2012

[page 395] XERO LIMITED – STATEMENTS OF FINANCIAL POSITION – AT 31 MARCH 2013

Notes

Group 2013 ($000s)

Group 2012 ($000s)

Parent 2013 ($000s)

Parent 2012 ($000s)

Cash at bank

7

78,244

38,976

75,511

36,722

Trade & other receivables

8

5,876

3,023

7,177

3,696

Assets Current assets

Total current assets

84,120

41,999

82,688

40,418

9

7,274

4,195

4,588

3,990

Intangible assets

10

17,585

10,260

15,001

8,033

Investment in subsidiaries

22

-

-

3,438

2,638

Deferred tax benefit

5

102

85

-

-

Trade & other receivables

8

1,341

1,234

1,213

1,169

26,302

15,774

24,240

15,830

110,422

57,773

106,928

56,248

3,090

3,046

3,573

2,759

4,471

2,408

2,822

1,657

209

71

-

(1)

Total current liabilities

7,770

5,525

6,395

4,415

Total liabilities

7,770

5,525

6,395

4,415

102,652

52,248

100,533

51,833

150,022

86,377

150,022

86,377

3,096

1,883

3,096

1,883

(50,394)

(35,951)

(52,585)

(36,427)

(72)

(61)

-

-

102,652

52,248

100,533

51,833

Non-current assets Property, plant & equipment

Total non-current assets Total assets Liabilities Current liabilities Trade & other payables

12

Employee entitlements Income tax

5

Net assets Equity Share capital

13

Share-based payment reserve Accumulated losses Foreign currency translation reserve Total equity

The accompanying notes form on integral port of these financial statements

[page 396] XERO LIM ITED – STATEMENTS OF CASH FLOWS – FOR THE YEAR ENDED 31 MARCH 2013 Notes

Operating activities

Group 2013 ($000s)

Group 2012 ($000s)

Parent 2013 ($000s)

Parent 2012 ($000s)

Cash was provided from Receipts from customers Dividends received Other income Interest received

37,476

18,560

24,171

14,774

-

26

-

26

788

283

788

283

1,208

632

1,196

627

39,472

19,501

26,155

15,710

(44,639)

(23,379)

(37,433)

(22,217)

(2,190)

(833)

(666)

(329)

(175)

(150)

-

-

(47,004)

(24,362)

(38,098)

(22,546)

(7,532)

(4,861)

(11,943)

(6,836)

-

259

-

-

158

-

250

-

20

-

20

-

178

259

270

-

Cash was applied to Payments to suppliers & employees Sales tax Income tax

Net cash flows from operating activities

14

Investing activities Cash was provided from Cash acquired on acquisition of subsidiary Net rent al bonds repaid Disposal of property, plant & equipment net

[page 397] Cash was applied to Purchase of property, plant & equipment

(4,566)

(3,963)

(1,897)

(3,777)

Capitalised development costs

(7,654)

(3,519)

(6,395)

(3,499)

(28)

(37)

(28)

(38)

-

(299)

-

(253)

(1,200)

(1,000)

(1,200)

(1,000)

(13,448)

(8,818)

(9.520)

(8,567)

Intangible assets Other assets Investment in subsidiary

Net cash flows from investing activities

(13,270)

(8,559)

(9,250)

(8,567)

100

100

100

100

-

100

-

100

60,000

35,638

60,000

35.638

60,100

35,838

60,100

35,838

(118)

(364)

(118)

(364)

Net cash flows from financing activities

59,982

35,474

59,982

35,474

Net increase in cash held

39,180

22,054

38,789

20,071

88

-

-

-

Financing activities Cash was provided from Repayment of Director’s loan Repayment of other loans Share issue

Cash was applied to Cost of share issue

Foreign currency translation adjustment Cash at bank at beginning of the year

7

38,976

16,922

36,722

16,651

Cash at bank at end of the year

7

78,244

38,976

75,511

36,722

The accompanying notes form on integral port of these financial statements

[page 398]

NOTES TO THE FINANCIAL STATEMENTS 1. CORPORATE INFORMATION Xero Limited is a limited liability company, domiciled and incorporated in New Zealand and registered under the New Zealand Companies Act 1993. The registered office of the Company is 3 Market Lane, Wellington 6011, New Zealand. The financial statements presented are for Xero Limited (the “Parent”/“Company”) and its subsidiaries (together “the Group”) for the year ended 31 March 2013.

Xero Limited is an issuer for the purposes of the Financial Reporting Act 1993. The consolidated financial statements of the Group for the year ended 31 March 2013 were authorised for issue in accordance with a resolution of the Directors on 23 May 2013. The Group’s principal activity is the provision of a platform for online accounting and business services to small businesses and their advisors. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) Basis of preparation The financial statements have been prepared in accordance with New Zealand Generally Accepted Accounting Practice. They comply with New Zealand Equivalents to International Financial Reporting Standards (“NZ IFRS”), and other applicable Financial Reporting Standards, as appropriate for profit-oriented entities. The financial statements comply with International Financial Reporting Standards (“IFRS”). The financial statements have been prepared in accordance with the requirements of the Financial Reporting Act 1993 and Companies Act 1993. The Company and Group are profit-oriented entities for financial reporting purposes. The consolidated financial statements have been prepared using the historical cost convention. The preparation of financial statements requires management to make judgements, estimates and assumptions that affect the application of accounting policies and the reported amounts of assets, liabilities, income and expenses. The areas involving a higher degree of judgement or complexity, or areas where assumptions and estimates are significant to the consolidated financial statements, are disclosed in Note 3. (b) Changes in accounting policies & disclosures The accounting policies adopted are consistent with those of the previous year. (c) Basis of consolidation Subsidiaries are all entities over which the Group has the power to govern the financial and operating policies

generally accompanying a shareholding of more than one half of the voting rights. Subsidiaries are fully consolidated from the date on which control is transferred to the Group. They are de-consolidated from the date that control ceases. The acquisition method of accounting is used to account for the acquisition of subsidiaries by the Group. The consideration transferred for an acquisition is measured as the fair value of the assets given, equity instruments issued and liabilities incurred or assumed at the date of exchange. Costs directly attributable to the acquisition are expensed in the Income Statement. Inter-company transactions, balances and unrealised gains on transactions between Group companies are eliminated. Unrealised losses are also eliminated. Accounting policies of subsidiaries are consistent with the policies adopted by the Group. (d) Revenue Subscriptions, conference and training revenues are recognised to the extent that it is probable that the economic benefits will flow to the Group and the revenue can be reliably measured. Revenue is recorded net of sales tax and discounts and after eliminating sales within the Group. The following specific recognition criteria must also be met before revenue is recognised: Services – Revenue is recognised in the accounting period in which the service is rendered. Consideration received prior to the service being rendered is recognised in the Statements of Financial Position as income in advance and included within trade and other payables. Revenue for which services have been rendered but invoices have not been issued is recognised within the Statement of Financial Position as accrued income and included within trade and other receivables. Interest – Interest income is recognised on an accruals basis using the effective interest rate method. [page 399] Government grants – Government grants are recognised at their fair value where there is reasonable assurance that the grants will be received and all attaching conditions will be complied with. When a grant relates to an

expense item, it is recognised as income over the period necessary to match the grant on a systematic basis to the costs that it is intended to compensate. (e) Income tax In the Income Statement income tax comprises current and deferred tax. Current tax is the expected tax payable on the taxable income for the year, using tax rates enacted or substantially enacted at the reporting date, and any adjustment to tax payable in respect of previous years. Deferred tax is recognised, using the liability method, on temporary differences arising between the tax bases of assets and liabilities and their carrying amounts in the consolidated financial statements. Deferred income tax is determined using tax rates (and laws) that have been enacted or substantially enacted by the reporting date and are expected to apply when the related deferred income tax asset is realised or the deferred income tax liability is settled. A deferred tax asset is recognised to the extent that it is probable that future taxable profits will be available against which temporary differences can be utilised. Deferred tax assets are reviewed at each reporting date and are reduced to the extent that it is no longer probable that the related benefits will be realised. Deferred income tax is provided on temporary differences arising on investments in subsidiaries and associates, except for deferred income tax liabilities where the timing of the reversal of the temporary difference is controlled by the Group and it is probable that the temporary difference will not reverse in the foreseeable future. Deferred income tax assets and liabilities are offset when there is a legally enforceable right to offset current tax assets against current tax liabilities and when the deferred income tax assets and liabilities relate to income tax levied by the same taxation authority on either the same taxable entity or different entities where there is an intention to settle the balance on a net basis. (f) Sales tax The Income Statements and the Statements of Cash Flows have been prepared so that all components are stated exclusive of sales tax, except where sales tax is not recoverable. All items in the Statements

of Financial Position are stated net of sales tax with the exception of receivables and payables, which include sales tax invoiced. Commitments and contingencies are disclosed net of the amount of sales tax recoverable from, or payable to the taxation authority. Sales tax includes Goods and Services Tax (GST) and Value Added Tax (VAT) where applicable. (g) Foreign currency translation Items included in the financial statements of each of the Group’s entities are measured using the currency of the primary economic environment in which the entity operates (“the functional currency”). The consolidated financial statements are presented in New Zealand dollars ($) (the “presentation currency”), which is the Company’s functional currency. Foreign currency transactions are translated into the functional currency using the exchange rates prevailing at the dates of the transactions. Foreign exchange gains and losses resulting from the settlement of such transactions and from the translation at year-end exchange rates of monetary assets and liabilities denominated in foreign currencies are recognised in the Income Statement. Foreign exchange gains and losses are presented in the Income Statement within operating expenses. The Group translates the results of its foreign operations from their functional currencies to the presentation currency of the Group using the closing exchange rate at balance date for assets and liabilities and the average monthly exchange rates for income and expenses. The difference arising from the translation of the Statements of Financial Position at the closing rates and the Income Statement at the average rates is recorded within the foreign currency translation reserve. (h) Property, plant & equipment In the balance sheet property, plant and equipment is stated at historical cost less depreciation. Historical cost includes expenditure that is directly attributable to the acquisition of the items. Depreciation on assets is calculated using the straight-line method to allocate the difference between their original costs and their residual values over their estimated useful lives, as follows:

Leasehold improvements

Terms of lease

Motor vehicles

3–5 years

Furniture & equipment

2–7 years

Computer equipment

2–3 years [page 400]

The assets’ residual values and useful lives are reviewed and adjusted if appropriate at each balance date. An asset’s carrying amount is written down immediately to its recoverable amount if the asset’s carrying amount is greater than its estimated recoverable amount. Gains and losses on disposals are determined by comparing proceeds with carrying amounts and are recognised in the Income Statement. (i) Intangible assets (I) Research costs are expensed as incurred. Costs associated with maintaining internal computer software programs are recognised as an expense as incurred. Costs that are directly associated with the development of the software products controlled by the Group are recognised as intangible assets where the following criteria are met: – it is technically feasible to complete the software product so that it will be available for use; – management intends to complete the software product and use or sell it; – there is an ability to use or sell the software product; – it can be demonstrated how the software product will generate probable future economic benefits; – adequate technical, financial and other resources to complete the development and to use or sell the software product are available; and – the expenditure attributable to the software product during its

development can be reliably measured. Directly attributable costs that are capitalised as part of the capitalised software development costs include the software development employee costs. Other development expenditures that do not meet these criteria are recognised as expenses as incurred. Development costs previously recognised as expenses are not recognised as assets in a subsequent period. Computer software development costs recognised as assets are amortised over their estimated useful lives. (II) Other intangible assets acquired are initially measured at cost. Internally generated assets, excluding capitalised development costs, are not capitalised and expenditure is recognised in the Income Statement in the year in which the expenditure is incurred. The useful lives of the Group’s intangible assets are assessed to be finite. Assets with finite lives are amortised over their useful lives and tested for impairment whenever there are indications that the assets may be impaired. (III) Amortisation is recognised in the Income Statement on a straight-line basis over the estimated useful life of the intangible asset, from the date it is available for use. The estimated useful lives are: Trademarks/patents

10 years

Domains

10 years

Capitalised development costs

2–5 years

(u) Impairment of non-financial assets At each reporting date, the Group assesses whether there is any indication that an asset may be impaired. Where an indicator of impairment exists, the Group makes a formal estimate of the recoverable amount. Where the carrying value of an asset exceeds its recoverable amount, the asset is considered impaired and is written down to its recoverable amount. Recoverable amount is the greater of fair value less costs to sell or the asset’s value in use. For the purposes of assessing impairment, assets are grouped at the lowest levels for which there are separately identifiable

cash flows (cash-generating units). Non-financial assets other than goodwill that suffered an impairment are reviewed for possible reversal of the impairment at each reporting date. (k) Loans & receivables The Group classifies its financial assets as loans and receivables. Management determines the classifications of its financial assets at initial recognition. The Group’s loans & receivables are nonderivative financial assets with fixed or determinable payments that are not quoted in an active market. They are included in current assets, except for those with maturities greater than 12 months after the reporting date. These are classified as non-current assets. The Group’s loans and receivables comprise “trade & other receivables” and cash and cash equivalents in the Statements of Financial Position. Loans and receivables are carried at amortised cost using [page 401] the effective interest method. The Group assesses at each reporting date whether there is objective evidence that a financial asset or a group of financial assets is impaired. Impairment testing of trade receivables is described in Note 2.(m). (l) Cash & cash equivalents Comprise cash in hand, deposits held at call with banks, other short-term and highly liquid investments with original maturities of six months or less. (m) Trade & other receivables The Group recognises trade and other receivables initially at fair value and subsequently measured at amortised cost using the effective interest method less provision for impairment. A provision for impairment of trade receivables is established when there is objective evidence that the Group will not be able to collect all amounts due according to the original terms of the receivables. The carrying amount of an asset is reduced through the use of a provision account, and the amount of the loss is recognised in the Income Statement. When a receivable is uncollectible, it is written off against the provision account for

receivables. Subsequent recoveries of amounts previously written off are credited against the Income Statement. (n) Trade & other payables The Group recognises trade and other payables initially at fair value and subsequently measured at amortised cost using the effective interest method. They represent liabilities for goods and services provided to the Group prior to the end of the financial year that are unpaid. The amounts are unsecured, non-interest bearing and are usually paid within 45 days of recognition. (o) Provisions The Group recognises a provision when it has a present legal or constructive obligation as a result of past events, it is probable that an outflow of resources will be required to settle the obligation, and the amount has been reliably estimated. Provisions are not recognised for future operating losses. Where there are a number of similar obligations, the likelihood that an outflow will be required in settlement is determined by considering the class of obligations as a whole. A provision is recognised even if the likelihood of an outflow with respect to any one item included in the same class of obligations may be small. Provisions are measured at the present value of the expenditures expected to be required to settle the obligation using a pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the obligation. The increase in the provision due to the passage of time is recognised as an interest expense in the Income Statement. (p) Employee entitlements The liability for employees’ compensation for future leave is accrued in relation to the length of service rendered by employees and relates to the vested and unvested entitlements. The Group operates both short-term and long-term incentive plans. Employee incentive obligations are measured at the amounts expected to be paid when the liability is settled and are expensed as the related service is provided. The Group operates an equity settled, share-based compensation plan, under which employees render services in exchange for non-transferable share options and shares. The value of the employee services rendered for the grant of non-transferable share options and shares is recognised as an expense over the vesting period, and the

amount is determined by reference to the fair value of the options and shares granted. (q) Earnings per share The Group presents basic and diluted earnings per share (“EPS”) data for its ordinary shares. Basic EPS is calculated by dividing the Group profit or loss attributable to ordinary shareholders of the Company by the weighted average number of ordinary shares on issue during the period. Diluted EPS is determined by adjusting the profit or loss attributable to ordinary shareholders and the weighted average number of ordinary shares on issue for the effects of all dilutive potential ordinary shares, which comprise treasury stock and share options granted to employees. (r) Share capital Ordinary shares are classified as equity. Incremental costs directly attributable to the issue of new shares are shown in equity as a deduction, net of tax, from the proceeds. Where any Group company purchases the Company’s equity share capital (treasury shares), the consideration paid is deducted from equity attributable to the Company’s equity holders until the shares are cancelled or transferred outside the Group. [page 402] (s) Volume Weighted Average Price (VWAP) is calculated by summing the dollar value of shares traded over the previous 20 days and dividing by the total volume of shares traded over the same period. (t) Segment reporting An operating segment is a component of an entity that engages in business activities from which it may earn revenue and incur expenses, whose operating results are regularly reviewed by the entity’s Chief Operating Decision Maker to make decisions about resources to be allocated to the segment and assess its performance, and for which discrete financial information is available. Operating segments are aggregated for disclosure purposes where they have similar products and

services, production processes, customers, distribution methods and regulatory environments. (u) Standards or interpretations issued but not yet effective and relevant to the Group NZ-IFRS 9 Financial Instruments (effective for accounting periods beginning on or after 1 January 2015) – This standard is being compiled in phases with the first phase addressing financial assets and the second phase, addressing financial liabilities. The standard is not expected to have a material impact on the Group financial statements. The Group will adopt the standard for the year ending 31 March 2016. NZ-IAS 1 Presentation of Financial Statements (effective for accounting periods beginning on or after 1 July 2012) – This standard requires entities to group items presented in other comprehensive income on the basis of whether they are potentially reclassifiable to profit or loss in subsequent periods. The standard is not expected to have a material impact on the Group financial statements. The Group will adopt the standard for the year ending 31 March 2014. NZ-IFRS13 Fair Value Measurement (effective for accounting periods beginning on or after 1 January 2013) – This standard provides a single source of guidance for determining the fair value of assets and liabilities. The application of this guidance may result in different fair values being determined for the relevant assets. The standard expands the disclosure requirements for all assets and liabilities carried at fair value. This includes information about the assumptions made and the qualitative impacts of those assumptions on the fair value determined. The standard is not expected to have a material impact on the Group financial statements. The Group will adopt the standard for the year ending 31 March 2014. There are a number of other amendments to accounting standards as part of the ongoing improvement process. None of these changes is expected to have a significant impact on the Company or Group. The Company and Group have not adopted any standards prior to their effective date. 3. SIGNIFICANT ACCOUNTING JUDGEMENTS

In applying the Group’s accounting policies management continually evaluates judgements, estimates and assumptions based on experience and other factors including expectations of future events that may have an impact on the Group. All judgements, estimates and assumptions made are believed to be reasonable based on the most current set of circumstances available to the Group. Actual results may differ from the judgements, estimates and assumptions. The significant judgements, estimates and assumptions made by management in the preparation of these financial statements are outlined below. (a) Deferred tax assets The Group recognises a deferred tax asset in relation to tax losses, only to the extent of the Group’s deferred tax liabilities. It is not considered prudent to recognise a deferred tax asset in respect of losses and other temporary differences given the uncertainty of the timing of profitability and the requirement for ownership continuity. (b) Capitalised development costs The Group capitalises its development costs based on a proportion of employee costs. The percentages applied are in line with industry standards. The Group regularly reviews the carrying value of capitalised development costs to ensure they are supported by the associated future economic benefits. The development costs are amortised over three to five years, being the expected useful life of the software. [page 403] 4. REVENUES & EXPENSES Group Group Parent Parent 2013 2012 2013 2012 Notes ($000s) ($000s) ($000s) ($000s) Operating revenue from the rendering of services

39,033 19,370 26,857 15,186

Other income Government grants* Dividends received Total revenue & other income

936

401

936

401

-

-

-

26

936

401

936

427

39,969 19,771 27,793 15,613

Operating expenses Employee entitlements

29,272

15,389

22,097

11,612

Employee entitlementsshare-based payments

5,270

2,492

4,262

1,938

Employee entitlements capitalised

(8,466) (4,035) (8,393) (4,014)

IT infrastructure costs

7,662

3,266

6,536

2,856

Advertising & marketing

5,623

2,976

1,603

1,231

Consulting & subcontracting

1,922

1,222

1,308

792

Lease/rental

1,771

958

1,174

766

Travel related

1,453

839

642

487

Communication & office administration

1,370

778

942

543

Staff recruitment

824

409

6os

290

Superannuation costs

765

330

467

139

Listing costs

618

158

618

158

Loss/(gain) on foreign exchange transactions

442

(8)

417

(8)

Directors’ fees

16

243

220

243

220

Fees paid to auditors

15

183

167

134

142

Intercompany market support payments (Gain)/loss on disposal of property, plant & equipment Other operating expenses Total operating expenses excl. depreciation & amortisation

-

-

7,551

4,703

(13)

119

(14)

121

2,468

1,211

1,658

906

51,407 26,491 41,850 22,882

[page 404]

Depreciation & amortisation expense Property, plant & equipment

9

1,130

320

948

259

Amortisation of other intangible assets

10

12

11

12

10

Amortisation of development costs

10

3,405

1,563

2,968

1,569

4,547

1,894

3,928

1,838

Total depreciation & amortisation Total operating expenses

55,954 28,385

45,778 24,720

Interest Income Interest income – bank Interest income – loan to related party

16

1,794

587

1,783

582

44

20

44

20

Interest income – other Net interest income Net operating loss before tax

-

5

-

5

1,838

612

1,827

607

(14,147) (8,002) (16,158) (8,500)

* Government grants have been received from the Ministry of Business, Innovation and Employment (2012: Ministry of Science and Innovation). The grants were claimed retrospectively on qualifying expenditure, and all conditions have been fulfilled at balance date.

[page 405] 14. RECONCILIATION OF OPERATING CASH FLOWS Group Group Parent Parent 2013 2012 2013 2012 ($000s) ($000s) ($000s) ($000s) Reconciliation from the net loss after tax to the net cash from operating activities Net loss after tax

(14,443) (7,904) (16,158) (8,322)

Adjustments Depreciation

1,130

320

948

259

Amortisation

3,417

1,574

2,980

1,579

Deferred tax

(17)

(50)

-

-

Associate profit

-

(38)

-

-

Gain on investment in associate

-

(170)

-

(178)

Loss/(gain) on foreign exchange transactions

442

(8)

417

(8)

(Gain)/loss on disposal of property, plant & equipment

(13)

119

(14)

121

Employee entitlements

3,979

1,380

2,864

950

Interest on loans

(44)

(18)

(44)

(18)

Bad debts

114

32

40

21

Changes in working capital items (Increase)/decrease in trade receivables & prepayments Increase/(decrease) in trade payables & accruals

(3,130) (1,162)

(4,001) (3,718)

(743)

(318)

341

1,793

138

10

(1)

(1)

Increase/(decrease) in employee entitlements

1,572

1,282

674

668

Increase/(decrease) in income in advance

69

90

11

18

Increase/(decrease) in current tax payable

Net cash from operating activities (7,532) (4,861) (11,943) (6,836)

[page 406] 15. AUDITORS’ REMUNERATION Group Group Parent Parent 2013 2012 2013 2012 ($000s) ($000s) ($000s) ($000s) Amounts received or due & receivable by PricewaterhouseCoopers for: Audit of financial statements

97

69

52

47

Accounting advice and other assurance services*

43

57

39

57

Taxation services**

43

38

43

38

-

3

-

-

183

167

134

142

Amounts received or due & receivable by Argents for: Audit of financial statements Total fees paid to auditors

* Services relate to procedures on the Group’s half year result, audit of the Company’s shore register and technical accounting advice. ** Services relate to the provision of assurance services for the annual tax return. tax advice on the Group’s long-term incentive plans and taxation of offshore employees.

[page 407]

The accounting cycle — journals and ledgers

Contents Learning outcomes A2.1

The accounting cycle

A2.2

Case study — Welkom Enterprises

A2.3

The accounting system A2.3.1 Source documents A2.3.2 Chart of accounts A2.3.3 A set of books

A2.4

Journal entries

A2.5

Posting to ledger

A2.6

Other journals

APPENDIX

2

A2.7

Subsidiary ledgers

A2.8

Internal control — reconciliations

A2.9

Key words A2

A2.10 Resource file A2 A2.10.1 Solution — Welkom Enterprises A2.10.2 Solution — Crosby & Co A2.11 Mastering accounting — questions A2.11.1 Tom Jones trading as Shy Lock A2.11.2 Broke Ltd A2.11.3 Aimless Accountancy Services A2.11.4 A Starter [page 408] A2.12 Mastering accounting — solutions A2.12.1 Tom Jones trading as Shy Lock A2.12.2 Broke Ltd A2.12.3 Aimless Accountancy Services A2.12.4 A Starter

[page 409]

Learning outcomes By the end of this Appendix, you should be able to: use a manual accounting system; and apply internal control objectives to a manual accounting system.

A2.1

The accounting cycle

A definition of “accounting” often cited is that given by the American Accounting Association, namely “the process of identifying, measuring and communicating information to permit informed judgments and decisions by users of that information”. Accounting is usually seen as being a technical subject involving the recording and classifying of financial activities. The technical aspect of accounting is often referred to as the accounting cycle. The accounting cycle describes the routine steps in processing accounting data during an accounting period. In sequence, these are: 1.

occurrence of the transaction as evidenced by a source document;

2.

classification of each transaction in chronological order (journalising);

3.

recording the classified data into ledger accounts (posting);

4.

preparation of a trial balance (or initial preparation of financial

statements); 5.

review of the trial balance including adjusting entries, to ensure “faithful representation”;

6.

preparation of financial reports; and

7.

closing of revenue and expense accounts.

The following figure shows the flow of information in an accounting system. Inputs are gathered from various sources and represented by the raw data which is entered (processed) into the accounting system. The data is classified and summarised so that the information that flows out of the accounting system by way of various accounting reports can be used to provide feedback to the users of the accounting system. The output is used to enable users to make decisions. [page 410] The use of journals and ledgers is a relatively mechanistic function, at which students will become more adept, the more they practice. Practitioner will benefit from doing more and more examples until such time as they become proficient.

FIGURE A2.1: ACCOUNTING AS AN INFORMATION SYSTEM

A2.2

Case study — Welkom Enterprises

Review Chapter 3 — the accounting equation and the chart of accounts.

For the learning exercise, we will revisit the accounting equation we used in Chapter 3 (paragraph 3.2.11). Do you remember these transactions? 1.

Ten guests pay cash for souvenirs $6,210 each inclusive of GST.

2.

Two corporate clients book and stay in three cottages for two nights and choose the credit option. “Accounts receivable” increases by $1,380, since this is the total amount owed by the debtors.

3.

One of the clients sends a cheque for $460, which includes $60 GST. Note that both “bank” and “accounts receivable” are affected, but not the “IRD” liability. This is because this liability was recorded when the client was allowed credit. The business is “holding” the $60 in its bank account until the end of the taxable period, when it will send all of the GST (less

amounts paid) to the IRD. At this point, the liability will be reduced. We could think of this in terms of “the debtor has reduced her liability to the business by paying part of what she owes”. The business has not yet reduced its liability to the IRD, but will do so at the end of the taxable period. 4.

Some casual tourists come in to buy souvenirs valued at $600 using a $25 cash discount voucher they found in their NZ guide book. They pay $575 (net of discount). The GST for their purchase is $75. [page 411]

5.

The power account for this month of $230, which includes GST, was paid. “Bank” is decreased by $230, and “IRD” is reduced by $30, since GST paid on supplies can be off set against GST collected from clients. “Expenses” are increased by $200, which was the cost of power.

6.

Wrote off a bad debt of $230. This is a tricky one, so let us spend some time examining this transaction. Remember that the $230 contains GST, which the business will be unable to collect. In writing off the bad debt, we need to: reduce “accounts receivable” by $230 because this asset is now overstated; create an expense “bad debts”, which will reduce revenue; and reduce the liability to the IRD, since the debtor has not paid and the business is unable to collect GST.

7.

Had some repairs carried out on Cottage No 2 and was invoiced for $345 including GST. “Accounts payable” increases by $345; “IRD” is reduced by $45 (assuming GST is accounted for on invoice basis); and “expenses” are increased by the cost of the repairs and maintenance of $300.

8.

At the end of taxable period, Welkom sends a cheque to the IRD. “Bank”

is reduced by $960, which is the amount owing to the IRD.

A2.3

The accounting system

A2.3.1

SOURCE DOCUMENTS

A source document is a form which provides the evidence and details of a transaction that has taken place. Source documents are extremely important because they: provide evidence for both internal and external auditors as to the validity of transactions; are used as the basis for entries in the accounting records; collect and transmit information on transactions which usually occur in a section of the business different from where the accounting entries are done; keep a record of information before an entry can be made in the records; and form an important part of internal control (see Chapter 5). Source documents include purchase orders; invoices, including tax invoices; credit notes; cheque butts; and bank statements. [page 412]

Ordinarily the source document provides primary evidence of a transaction. During the course of the exercises, we will name the source documents as we describe the transactions.

A2.3.2

CHART OF ACCOUNTS

In setting up the accounting system, the first thing we should do is prepare a chart of accounts. The chart of accounts becomes our way of numbering the ledger accounts. For Welkom Enterprises, we started on something similar to the following chart of accounts: Welkom Enterprises Chart of accounts ASSETS (1000–1999) 1100

Bank

1200

Accounts receivable

1310

Inventory – accommodation materials

1320

Inventory – souvenirs

1410

Accrued income

1420

Prepayments

1610

Audio-visual equipment

LIABILITIES (2000–2999) 2100

Accounts payable

2199

IRD/GST

2210

Accrued expenses

2220

Income in advance

2510

Loan

EQUITY (3000–3999) 3010

Capital

3020

Drawings

REVENUE (4000–4999) 4100

Sales – accommodation

4200

Sales – souvenirs

COST OF GOODS SOLD (5000–5999)

5100

Cost of sales – accommodation

5200

Cost of sales – souvenirs

[page 413]

EXPENSES (6000–6999) 6100

Advertising

6200

Administration expenses

6310

Electricity

6320

Phone

6400

Insurance

6500

Repairs and maintenance

6600

Salaries

6710

Bad debts

OTHER REVENUE (7000–7999) 7100

Interest income

OTHER EXPENSES (8000–8999)

A2.3.3

A SET OF BOOKS

A complete set of books for any business will likely consist of three parts: journals; general ledger; and subsidiary ledgers. Each part provides information that will be valuable to a business owner.

A2.3.3.1

Journals

The journals are the data entry tool of accounting and the front door to the accounting system. Each time we enter a transaction into an accounting system, it will go into one of five journals. All entries to the accounting system

must be entered into a journal before being processed further. The owner will use these books to locate individual entries. Purchases journal: This is a list of tax invoices and credit notes received from suppliers. Only transactions that involve purchases or returns on credit are recorded in this journal. These may be purchases or returns of merchandise, equipment, supplies, or other items. Returns of items are entered as negative figures. Note that purchases paid for in cash are recorded in the cash payments journal. Sales journal: This is a list of tax invoices and credits notes issued by the entity. Only transactions that involve sales or returns on credit of inventory are recorded in this journal. Therefore, every sales transaction in this journal will be the same: a debit to “accounts receivable” and a credit to “sales”. When returns are made, the entry will be the opposite to the sales entry: a debit to “sales” and a credit to “