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Module 1 – Accrual accounting and working capital

Module overview

Welcome to Financial accounting, the first course in the accounting major. In the first section of this module we provide on overview of the content of this course, discuss its place in the accounting major and how it fits into the 'financial accounting stream' of courses in particular. This section contains important information so please take a moment to read it. This module is a mixture of revision and new content. You are required to have completed ACC1101 Accounting for decision making before enrolling in this course. This course builds on what you have learnt in ACC1101 but we will review some of the key issues from that course before we move onto new material. In the second section we cover the role of the accounting system, to produce financial information for decision making, the users of financial statements and the business decisions they make. We also introduce you to the Goods and Services Tax (GST) and revise the process of analysing and recording common business transactions.

In the third section of this module we review 'accrual accounting' and the impact it has on both the income statement and the balance sheet. We compare and contrast 'cash based accounting' with 'accrual accounting' and highlight the effect the latter approach has on both net profit, as a measure of performance and on 'working capital', as a balance sheet measure of the resources available to the firm. Working capital, defined as current assets minus current liabilities, comes about as accrual accounting gives rise to various short term assets (accounts receivable, inventory, prepaid rent) and short term liabilities (obligations like accounts payable, wages payable and unearned revenue). Working capital is a critical indicator of the ability of the firm to meet its obligations as they fall due and the ability of the firm to expand its operations.

We will cover a number of working capital accounts in this module and throughout the course (e.g. inventory in modules 4 and 5). In this module, we deal with accounting for receivables; both accounts receivable and bills receivable. In relation to accounts receivable, we need to estimate 'bad debts' expense on credit sales (to avoid overstating revenue / accounts receivable and to achieve a better matching of revenue and expense for firms that have significant credit sales). In the final section of this module we cover some of the liability accounts that arise from the use of accrual accounting, including provision accounts (e.g. provision for warranty claims). Provisions are an interesting type of liability, as the firm does not know the exact amount of the liability, when the future payment will be made or even who will be paid.

A degree of estimation is involved in both bad debt expense and accounting for warranty costs. Accounting for provisions is an important issue in accounting as it has been a part of accrual accounting that has been manipulated by some firms in the past to increase or decrease net profit (called 'earnings management' but known colloquially as 'cooking the books'). Another issue we will investigate in this course is the various 'accounting choices' available under accounting standards, which can make reported net income higher or lower. As you can see, preparing financial statements requires a degree estimation and professional judgement – this is an important issue for both the preparers and auditors of financial statements.

Note

While this module appears quite long, it does contain a significant amount of

revision material, which you should complete quite quickly.

Study tip

Have you read the Introductory book yet? It only takes a few minutes and it

contains important information about the study process for this course.

The Study desk plays an important role in this course, so please make sure you

have accessed the Study desk and do so every week.

Learning resources

Text

This module needs to be read closely in conjunction with the pages selected from the following textbook:

Horngren, Harrison, Best, Fraser & Willett 2010, Financial accounting, 6th edn, Pearson Education Australia, Frenchs Forest.

●Chapter 1 pp. 4–5, 13–15 and 25–26

●Chapter 10 pp. 398–420

●Chapter 12 pp. 470–476

●Chapter 19 pp. 727–728

1.1 Introduction and welcome

Welcome to Financial accounting. We hope you find the course interesting and a rewarding learning experience. Please do not hesitate to raise any issues or queries you might have on the relevant discussion forum. Have a great semester!

1.1.1 Pre-requisites and the accounting major

This course is the first in the accounting major and should be studied in your first year, immediately following the completion of ACC1101 Accounting for decision making (a pre-requisite for enrolment in this course). In ACC1101, you focused on the use of the manual accounting system for firms with simple ownership structures, such as a sole trader, that

operated fairly simple businesses, such as service providers. In this course, we build on this knowledge; we will:

●study the use of a computerised accounting system by working through a detailed case

study using MYOB Accounting Plus (MYOB AP)

●investigate the use of companies (also called corporations) as another form of ownership

structure

●study the operation of retailers, using both manual and computerised accounting systems ●introduce you to some accounting issues for manufacturers (manufacturing operations are

covered fully in ACC2113 Management accounting 1)

●cover a range of accounting issues for all types of firms through the study of relevant

accounting standards.

Within the accounting major there is a 'financial accounting stream', which is a series of related courses focusing on various aspects of financial reporting. These courses have been designed to be studied in sequence, to help you build a body of knowledge that can be carried forward and built upon in subsequent courses. Following the recommended enrolment pattern provides the best way to study and complete these courses successfully.

Note

You can get help with your recommended enrolment pattern by sending an

email to business.support@https://www.wendangku.net/doc/7310850547.html,.au

To enrol in this course, you need to have completed ACC1101 Accounting for decision making. Following on from ACC1101, we recommend the following sequence of study:

●ACC1102 Financial accounting (this course), which is a pre-requisite for:

●ACC2115 Company accounting, which is a pre-requisite for both:

●ACC3116 Accounting and society and

●ACC3118 Auditing.

1.1.2 Course overview

In this section, we provide an overview of this course in particular and an appreciation of where this course fits within the 'financial accounting stream'.

Information and particularly the accounting information presented in a firm's financial statements is critical to decision makers, both inside and outside of the firm. You have heard the term the information age. Life in our modern society, whether as an individual or an organisation, seems to becoming increasingly dependent on information. Whether we are producers of accounting information or users of it, we all need to understand how financial accounting information is generated.

Our focus in this course is predominantly on organisations that have been established with a profit motive (e.g. firms can operate in primary production, mining, service industries, retailing, manufacturing and construction). Firms in each industry have their own unique accounting issues, including when to recognise revenue, whether an item is an asset or not or whether or not an event gives rise to a liability (e.g. an obligation to rectify environmental damage). We will deal with these and other financial reporting issues in this course (while financial information is also important for charitable organisations, not-for-profit organisations and government authorities and departments they are beyond the scope of this course).

Financial information is required by people inside and outside the organisation to make decisions. A major component of this course is to investigate how to set up a computerised accounting system, using MYOB Accounting Plus (MYOB AP – see modules 3, and 6 to 9).

A modern information system must be able to generate detailed financial information for internal users (management), while being able to produce summarised financial statements (balance sheet and income statement) for external decision-makers, such as investors, creditors and lenders.

The distinction between insiders and outsiders is important. Insiders have access to much more comprehensive financial information. Management accounting information is more detailed and includes product costings, financial plans and budgets to name a few. For example, while the income statement reports a single sales number (total sales), a good accounting information system (AIS) can produce management reports that provide sales by product, by department, by store, by salesperson, by time (per hour, day or week) and against budget forecasts, to name a few. Again, a good AIS will have a list of each individual asset, (e.g. every item of inventory and each individual fixed asset), when it was purchased, how much it cost, etc. While we will demonstrate how to set up MYOB AP to produce some of this detailed information, you will study accounting for manufacturing operations, the determination and use of budgets and related issues in detail in ACC2113 Management accounting 1.

Our main focus in this course is on the preparation of financial statements, which summarise much of the detail captured in the accounting system. Financial accounting summarises all of this information and presents it in four financial statements:

●The Statement of Comprehensive Income (previously called the Income Statement or the

Profit and Loss Statement)

●The Statement of Financial Position (also called the Balance Sheet)

●The Statement of Changes in Equity

●The Statement of Cash Flows.

The financial statements present key data items, such as total sales, cost of goods sold, net profit, total property plant and equipment, total long term bank loans, to name a few. Some firms will also provide a range of disclosures to support the information in the financial statements; for example, a breakdown of PPE assets into land, buildings, plant, equipment, etc.

The owners of the firm do not want the firm's proprietary information (it's detailed managerial information – also called inside information) to be made public. Information about the firm's most successful products and locations, its new products and expansion plans is commercially sensitive and would be extremely useful to the firm's competitors. As

such, managers of reporting entities have a financial reporting dilemma; they need to release enough financial information to allow outside resource providers (owners, lenders and creditors) to judge how well the firm is performing and meeting its objectives, without providing too much information and losing some of its competitive advantage. Managers also need to provide sufficient information so the owners can judge their performance and offer appropriate rewards (e.g. bonus payments or share options).

This particular problem is called information asymmetry, which basically means that the firm's various decision-makers have different levels of access to the financial information of the firm. For example, consider a company listed on the stock exchange; the executive level managers have an information advantage over all other users, lenders such as banks can demand access to more information (on a commercial-in-confidence basis) before they extend a loan to the company, while small shareholders cannot demand information at all (they must rely on information presented in a company's annual report). This being the case, how do we ensure that shareholders receive the information they need to make business decisions? While some theorists believe firms will voluntarily produce financial reports for outsiders, others believe it is necessary to legislate (e.g. the Corporations Act) to compel companies to produce financial statements and make other disclosures.

Another problem that arises due to information asymmetry relates to the issue of who will prepare these financial reports for outsiders. Managers are involved in the day-to-day operation of the firm and should have the best understanding and knowledge of the firm; so they are best placed to prepare the financial reports. However, as noted above, the owners rely on this information to make decisions about the performance of management and so managers are likely to provide biased reports. Without going into a long theoretical discussion, (you will discuss the issues of information asymmetry and the debate over the regulation of accounting in ACC3116 Accounting and society), there are two ways of dealing with this issue:

●accounting rules (called accounting standards), which govern how transactions are to be

measured and recorded, how reports are to be prepared and that additional information is to be disclosed

●the use of independent auditors, who must review the accounting and control systems

used by the firm and attest that the financial reports provide a true and fair view (you will cover this in ACC3118 Auditing).

We will cover the requirements of a number of accounting standards in this course, including:

●AASB 101 Presentation of Financial Statements (module 2)

●AASB 102 Inventories (module 4 and 5)

●AASB 107 Statement of Cash Flows (module 12)

●AASB 116 Property Plant and Equipment (module 10 and 11)

●AASB 118 Revenue (module 7)

●AASB 136 Impairment of Assets (modules 10 and 11)

●AASB 137 Provisions, Contingent Liabilities and Contingent Assets (module 1)

●AASB 138 Intangible Assets (module 11)

Your study of the requirements of the Corporations Act and other AASB accounting standards will continue in ACC3116 Company accounting.

As you will see in module 2, not all firms are reporting entities; that is, not all firms have to comply with accounting standards or have their accounts audited. However, non-reporting entities still have good reasons to prepare financial statements (see discussion in section 3). The accounting methods such firms use for inventory, depreciation, bad debt and other accounting issues, are largely consistent with those specified in the accounting standards. Accountants in a public practice work with a wide range of firms, with different ownership structures and different reporting needs. An important skill for public accountants is to assist clients by designing an accounting system that the client can use with confidence, while still meeting the reporting needs of the firm (you will study the design of information systems in detail in ACC3101 Accounting information systems).

In this course we focus on two primary issues; the set up and use of a computerised accounting system and the preparation of financial statements, based on the requirements of the relevant accounting standards. We hope you find the course interesting.

1.2 Accounting and the business environment

On completion of this section you should be able to:

●Define and use accounting vocabulary in verbal and written communication

●Describe and discuss in general terms the nature of the business environment and the role

of accounting information

●Define and discuss the nature and purpose of accounting

●Identify the users of accounting information and discuss their information needs

●Distinguish between management accounting and financial accounting

1.2.1 The business environment

Businesses (or firms) in Australia and most other countries operate in an economic system based on private enterprise (capitalism). In this economic system firms are owned by individuals using different ownership structures, such as a company, a partnership or even as a sole trader (you would have learned about these in ACC1101). The firm undertakes a variety of activities, including producing and selling goods and/or services for profit (also called Net Income, or in the case of companies Net profit after tax; net profit is now defined as difference between the $ value of income earned by the business and expenses paid). Owners of businesses are often referred to as ‘entrepreneurs’. These people usually create business ideas, find sources of capital to implement their ideas via the production of goods and/or services to make a profit. Inherent in any business is a certain amount of risk and the risk factor needs to be factored into business decisions. For most entrepreneurs an initial source of capital usually involves an up front investment by the owner themselves (owners' equity). Borrowing (debt) is another source of money for the business (also called debt

capital). However borrowing involves a certain level of risk in that in order to remain solvent a business must repay its debts on time.

As you can see we have already used a number of 'accounting' or 'business' terms. It is important to continue to build your ‘language of business’. You will find many terms throughout the course that you may not have used before.

Reflection

Can you think of three persons who are well known entrepreneurs in Australia?

Can you think of three well known international entrepreneurs?

1.2.2 The accounting information system

Without realising it, most people make a great number of decisions in any one day. Most decisions involve making a choice between alternatives. Some decisions may be trivial, like buying new clothes, while others are more significant, like buying a new car. When facing a major decision, such as buying a new car, we tend to seek out useful facts and figures about various makes an models, summarise the information to identify the critical factors (e.g. safety, fuel consumption, resale value) and then make a well informed choice.

In business, being able to make the best decision at the appropriate time could determine success or failure. The data gathering and summarisation process just described applies equally in business. A critical role for accountants is to provide the key information needed by decision-makers in the commercial environment.

Accounting is the information system that measures business activity, processes the data into reports, and communicates the results to decision-makers (Horngren et al. 2010, p. 4).

The main purpose of accounting is to provide relevant information for decision-making. For example, how much capital will you need to set up a business? Is the business making a profit? What level of activities must the business produce to make a reasonable profit?

The main aim of an effective integrated accounting system is to record the many millions of events that occur in an organisation (we call these events transactions, e.g. the purchase of goods) and to provide reliable and accurate accounting information. Accurate accounting information leads to sound control and informed decision making.

1.2.3 The users of accounting information

There are many users of accounting information. Individuals use accounting information to make decisions about purchases and investments and to manage their bank accounts. Businesses use accounting information to set goals for their businesses and to evaluate progress toward achieving those goals. Investors (shareholders) use accounting information to evaluate the prospect of future returns on their investments. Creditors use accounting information to evaluate a borrower’s ability to meet scheduled repayments of money loaned.

The accounting information system must be capable of producing the detailed information required by internal users and summarised financial statements for external users. The system must also meet the reporting requirements of tax authorities, which includes:

●Business Activity Statements (BAS), which reports the firm's obligation to pay any

Goods and Services Tax (GST ) collected during the reporting period (month or quarter) and ●Pay As You Go (PAYG) income tax deducted from employees' pay.

●Payment Summaries for employees at year end, which report each employee's gross

wage, total income tax deducted, together with other pay related amounts.

For larger reporting entities (a term we will define in module 2), such as companies listed on the stock exchange, the range of external users of information can also include:

trade unions,●government authorities, such as:

Australian Securities and Investment Commission (ASIC – see https://www.wendangku.net/doc/7310850547.html,.au ) and ●Australia Competition and Consumer Commission (ACCC – see https://www.wendangku.net/doc/7310850547.html,.au )●

special-interest groups (e.g. consumer groups and green groups), and ●the media and the general public.

While accountants may help various users interpret accounting data, there is still a need for each user to have a fundamental understanding of the type of information they are looking for and more importantly what that information is telling them about the business.

Reading

You should now read pages 4 – 5 of the Horngren et al. 2010 textbook.

As you just read, accounting is divided into two fields – financial and management. These two branches of accounting produce reports for different groups of people. Generally

management accounting produces reports that help internal users plan, control and manage the day to day operations of the business. Financial accounting helps record the daily operations of the business and produces reports which are used by external users to make various investment and other decisions. Listed below are the main similarities and differences between the two.

Similarities

●Both provide information to interested parties for decision making

●The rules used to record transactions apply in both as a means to providing information

required

Differences

●Management accounting focuses on providing information for internal decision makers,

while financial accounting provides information for both internal and external decision makers

1.3 Revision of accrual accounting / GST

Objectives

On completion of this section you should be able to:

●Describe and discuss the accounting cycle

●Discuss the basic operation of the goods and services tax (GST)

●Analyse business transactions, including the effects of the GST if any

●Record journal entries for business transactions, including the effects of GST

●Describe and discuss each of the four financial statements

●Describe and discuss the matching and profit recognition principles

●Describe and discuss the 'cash basis' and the 'accrual basis' of accounting

●Discuss the impact of the 'cash basis' and the 'accrual basis' of accounting on 'profit

recognition'

●Describe, discuss and calculate working capital

●Describe and discuss the current ratio and the acid-test ratio

●Calculate and analyse the current ratio and the acid-test ratio

●Discuss the importance of working capital management

●Describe and discuss the limitations of accrual accounting

1.3.1 The accounting cycle

In your prior accounting studies you would have learnt about the accounting cycle, which commences with transactions and source documents and is completed with the preparation of financial statements and closing entries at the end of each accounting period.

The accounting cycle can be summarised as follows:

1.3.2 The goods and services tax (GST)

In most introductory accounting courses (e.g. ACC1101 Accounting for decision making), the goods and services tax (GST) is ignored to simplify the transaction analysis process and the recording of business transactions and adjusting entries. In this course, we will be covering the GST, particularly in the modules covering the use of the MYOB AP software. As discussed above, the information system needs to capable of producing both summarised information in financial statements and reports such as the Business Activity Statement (BAS), which reports the firm's GST liability.

This is an opportune time to introduce you to the GST for two reasons. First, the GST liability account has a significant impact on the working capital management of the firm (see the later discussion of working capital). Second, it provides you with an opportunity to test your ability to analyse and record some common business transactions, but this time including the effects of GST. You might find your transaction analysis skills are a bit rusty and if this is the case some revision might be necessary (see the Study Desk).

Most transactions which occur in daily life in Australia attract GST. GST is broadly defined as a consumption tax or a value-added tax (VAT) – the rate being 10%. Taxes, such as GST or VAT, are applied in many countries around the world (so don't worry that you are learning something that applies only in Australia). Under the GST regime certain goods and services are charged at base rate plus GST e.g. Downs Computer Supplies (DCS) may charge $100 per hour plus GST for maintenance services. So if 50 hours work is done the charge is 50 x $100 = $5,000 plus 10% GST ($500) = total charge $5,500.

Note

GST is levied on goods and services. It is not levied on financial transactions of

the firm, such as on a bank loan or on capital received from the owners. Some

products and services are GST Free (e.g. fresh fruit). We do not expect you to

become experts on GST in this course. GST is covered in detail in LAW3130

Revenue law and practice.

In this course, we will indicate in each transaction whether GST applies or not.

There are two ways in which transaction amounts can be quoted, GST inclusive

(incl. GST) or GST exclusive (excl. GST). For example, imagine you receive a

quote for a purchase of inventory; if the price is quoted as $2,200 (incl. GST)

you divide by 11 to obtain the GST amount of $200, but if the price is quoted as

$2,000 (excl. GST) you multiply by 10% to determine the GST component of

$200 and add this to the quoted price to determine the amount payable as $2,200

(or simply multiple by 1.1, so 2,000 x 1.1 = 2,200).

Nearly all business entities in Australia must register for GST with the Australian Tax Office (ATO). For-profit entities with turnover greater than $75,000 and not-for-profit organisations with turnover above $150,000 must also register for GST (small entities do not have to charge and collect GST). GST registered businesses must charge GST on certain goods and services and the GST collected must be remitted to the ATO. All business entities must also register for an Australian Business Number (ABN). GST registered business are required to provide 'Tax invoices' (source document) which clearly indicate the ABN of the firm and the tax status of each item on the tax invoice (e.g. some items could be GST free while others include GST).

Each business collects GST on the goods and services it sells or delivers and this GST collected must be remitted to the ATO. Firms also pay GST on goods and services it purchases or acquires (it's inputs to production) and is entitled to an 'Input Tax Credit' for these amounts. For example, if Downs Computer Supplies (DCS) buys 6 'MYOB AP' software packages worth $500 each (excl. GST), the total cost will be $3,300 (6 x $500 = $3,000 plus 10% GST of $300); the amount of GST paid ($300) is an input tax credit and reduces the amount of GST to be remitted to the ATO.

In Australia, every business registered for GST is required to prepare a Business Activity Statement (BAS) periodically (monthly or quarterly) to report taxation obligations and entitlements (i.e. total GST collected and total input tax credits). In the case of DCS the business has collected GST of $500 and has paid GST of $300. As GST collected exceeds the GST paid (input tax credits), DCS is required to remit $200 to the ATO when it lodges its BAS statement. Most business activities will result in a GST liability but there can be circumstances where the input tax credits exceed the GST collected and so the firm would be

entitled to a refund from the ATO (this is particularly the case when the firm has purchased a major asset such as a car in the BAS period and is entitled to a large input tax credit).

In accounting for GST, a GST Clearing account (liability) is created in the ledger to record all GST collected (credits) and GST paid (debits). As just discussed, at the end of most reporting periods, the GST collected by the firm will be greater than the amount of the input tax credits, resulting in a credit balance in the GST Clearing account, which indicates the firm has a liability to the ATO. The following reading demonstrates the effect of GST on some ordinary business transactions.

Reading activity

You should now read pages 473 – 474 of the Horngren et al. 2010 textbook.

In MYOB AP, two GST accounts are maintained; a GST Collected account (liability) is used for revenue transactions and a GST Paid account (contra-liability) is used to record all input tax credits. These accounts are reported together in the balance sheet in the current liability section.

Note

Have you heard about contra-accounts before? A contra-account is coupled

with another account in the ledger (so GST Paid is coupled to the GST

Collected account). The GST Collected account is a liability account and it's

normal balance is Credit. Contra-accounts have the opposite balance of the

account to which they are coupled, so GST Paid has a normal balance of debit.

In the balance sheet the two accounts are displayed together, with the contra-

account being deducted from it's companion account (see the bottom of the

balance sheet on page 68 of your MYOB textbook).

We will use a number of contra-accounts as we move forward in the course.

Exercise

Downs Computer Services (DCS) is a business owned by MV Holdings Pty Ltd.

DCS sells software, repairs computers and provides maintenance and support

services. You are required to analyse the following transactions and to record

the necessary General Journal entries.

The solution is in the appendix to this module. Do not consult the solution

until you have attempted to complete the exercise yourself.

Study tip

How did you go with the DCS Exercise? Hopefully, you managed to get most

of the debits and credits correct.

If it has been some time since you completed your prior accounting studies you

might like to complete the revision materials available from the course

homepage. It is essential that you are comfortable with the transaction

analysis process, the recording of journal entries for 'daily transactions' and

the determination and recording of adjusting entries.

1.3.3 Financial statements

The primary output at the end of the accounting cycle is the financial statements. As indicated earlier, only 'reporting entities' are required to comply with all accounting standards, one of which is AASB 101 Presentation of Financial Statements. According to AASB 101 (para. 10), the main components of a set of financial statements are as follows:

(a) a statement of financial position as at the end of the period;

(b) a statement of comprehensive income for the period;

(c) a statement of changes in equity for the period;

(d) a statement of cash flows for the period;

(e) notes, comprising a summary of significant accounting policies and other

explanatory information

What is meant by the term 'comprehensive income'? How is the statement of comprehensive income different to the Income statement? What appears in the statement of financial

position? Is it the same thing as a balance sheet? Has the format of the balance sheet changed? We will discuss these issues in more detail in module 2.

In this module, we will focus on the preparation of financial statements by non-reporting entities. As you know now, non-reporting entities do not have to apply the requirements of the accounting standards but does this mean they do not have to prepare financial statements? Such firms still have incentives to prepare financial statements (to apply for a bank loan or when the owner/s want to sell the business). Most small to medium enterprises (SMEs) will prepare at least a profit and loss statement (or income statement) and a balance sheet for each financial year; those using a computerised accounting system can easily prepare a cash flow statement. The preparation of a statement of changes in equity is optional for many SMEs.

In the following short reading you should review the relationship between the four financial statements and review the details they report in Exhibit 1-8 (you might recall the details of the worked example Paula Lee eTravel (a sole trader – service provider).

Reading activity

You should now read pages 25 – 26 of the Horngren et al. 2010 textbook. Many small to medium firms use accrual accounting and use some (but not all) of the accounting techniques detailed in accounting standards, such as the average-cost method for inventory (see module 5), straight-line method of depreciation (see module 10) and the allowance method for bad debts (discussed later in this module). Accounting packages like MYOB make it fairly straightforward for many firms to use the accrual basis to prepare their annual accounts.

The alternative to accrual accounting for non-reporting entities is the cash basis (or more correctly the partial accrual system) and many small firms use this approach when preparing their accounts. The key difference relates to when the firm recognises its revenue and expenses (the profit recognition principle). It is therefore worthwhile reviewing the basics of financial statement preparation, so in the following sections we discuss the matching and profit recognition principles and we compare and contrast cash accounting and accrual accounting.

1.3.4 Matching and profit recognition

By now you should be familiar with the main accounting measurement concepts and principles (e.g. the entity concept, accounting period concept, the conservatism principle). Two important principles in relation to accrual accounting are the 'matching principle' and the 'profit recognition principle'.

Reading activity

You should now read pages 13 – 15 of the Horngren et al. 2010 textbook.

1.3.5 Cash accounting

Cash based accounting is very straightforward; revenue is recognised when the cash is received and expenses are recognised at the time of their payment. Under the pure-cash based system, not even long term assets such as motor vehicles or plant and equipment are recognised in the balance sheet. As such, the only asset on the balance sheet is cash on hand and cash at bank. On the other side of the balance sheet will be equity contributed by the owner and monetary liabilities such as a bank loan. To prepare accounts under the cash basis the only records you require are the firm's bank statements, cheque book and bank deposit records.

Reflection

You want to assess the performance of two plumbers for a week. Both

plumbers do the same job, they install toilets. The first plumber does 50 jobs at

$50 each; all jobs are paid by cash for total revenue of $2,500 (under either

basis of accounting). The second plumber does 60 jobs at $50 each; all jobs are

done on credit terms. Under the ‘cash basis’ the second plumber has revenue of

nil but under the ‘accrual basis’ the revenue is measured as $3,000.

Which plumber has the better performance for the week?

1.3.6 Partial accrual system

The partial accrual system is different to the pure-cash based approach in only one major way and that is in relation to the recognition of long term assets, such as buildings, plant, equipment and motor vehicles. Under this approach, revenue is recognised when the cash is received, expenses are recognised at the time of their payment, with the exception of those expenditures on long term assets, which are capitalised on the balance sheet and depreciated over their useful life. This approach is used by some small firms for tax purposes under the Simplified Tax System (STS). Under the STS, even the method of determining depreciation is simplified, with the use of a low cost pool being available. We will not require you to learn about the STS or low cost pools in this course, however, you should be aware that public accountants need to be familiar with the different approaches their clients choose for the preparation of their accounts.

As observed above, the bookkeeper only requires the bank statement, cheque book and deposit records to prepare the annual accounts / tax return. Under this approach, credit transactions are not recorded and the firm will recognise its expenses (payment) or revenue (receipt) at the time of the cash flow. As a result ledger accounts, such as Accounts payable and Accounts receivable, are not required. For retailers, an Inventory account is not required (we will cover retailers in detail in modules 4 and 5). For example, assume inventory is ordered from a supplier who offers 14 day credit terms:

●under the partial accrual system, an expense is recorded at the time of the payment (14

days after delivery of the goods), which could be after the goods were sold but is most likely to be before the goods were sold

●under accrual accounting, inventory would be recorded at the time of delivery of the

goods (DR Inventory CR Accounts Payable) and the expense would arise at the time of the sale of the goods DR Cost of goods sold and CR Inventory).

Note

Tax rules do not determine the accounting choices we make for financial

accounting / reporting purposes. Even small firms will prepare their financial

statements using accounting choices, judgements and measurements designed to

generate useful information. Where these differ to the tax rules the public

accountant will simply prepare a tax reconciliation as part of the tax return

preparation process. The tax reconciliation

●begins with net profit from the income statement

●adds back expenses that are not allowable deductions

●subtracts revenues that are not assessable income

●adds in any assessable income that was not recorded as revenue in the

current year P&L

●subtracts allowable deductions that were not included in the P&L

●therefore arriving at the taxable income for the firm.

1.3.7 Accrual accounting

You should all be familiar with the notion of accrual accounting from your studies in

ACC1101. Under this approach credit transactions are recorded, yielding:

●Revenue and Accounts receivable (e.g. credit sales)

●Expenses and Accounts payable (e.g. car repairs expense on credit terms) or

●Assets and Accounts payable (e.g. goods acquired on credit terms for use in the future –

DR Supplies CR Accounts payable).

Many cash transactions will occur during the accounting period and their 'profit effects' will relate entirely to the current accounting period, for example:

●sales revenue for the period (cash sales) or

●expenses in the current period (cash payment of administration wages).

However, there will also be cash transactions where there is a 'timing difference' between the recognition of revenue and expense and the timing of the cash flows. The use of accrual accounting and adjusting entries overcomes this 'timing' problem. Accrual accounting results in the recognition of revenue and expense in the income statement and assets and liabilities in the balance sheet, as follows:

●Deferred revenue – cash is received in the current year – we defer the recognition of

revenue until the next period, yielding liabilities such as unearned revenue in the

current period (e.g. DR Cash at bank CR Unearned revenue);

●Deferred expenses – cash payments are made in the current year – we defer the

recognition of the expense until the next period (or periods), yielding assets such as

inventory, prepaid insurance, prepaid rent and property, plant and equipment (e.g.

DR Prepaid Insurance and CR Cash at bank).

●Accrued revenue – cash receipts occur after the end of the financial year – revenue

recognition in the current period results in assets such as interest receivable (e.g. DR Interest receivable CR Interest revenue)

●Accrued expenses – cash payments are made after the end of the financial period –

expense recognition in the current period results in a liabilities such as wages payable and interest payable (e.g. DR Wages expense CR Wages payable)

In summary, we know that cash-based profit is simply measured as cash receipts minus cash payments. Under accrual accounting we make a series of adjustments to the cash receipts and cash payments (hence the term adjusting entries), so net profit is calculated as follows: (Cash receipts – deferred revenue + accrued revenue) – (cash payments – deferred expenses + accrued expenses)

1.3.8 Working capital

As we have just discussed, the use of the accrual system and adjusting entries affects the net profit reported in the Income statement and the assets and liabilities reported in the Balance sheet. Net profit will be increased by the recognition of assets from the accrual process (assets up, equity up); three types of assets arise:

●short term assets from the accrual of revenue (e.g. accounts receivable and interest

receivable)

●short term assets from the deferral of expenses (e.g. inventory and prepaid insurance)

●long term assets from the deferral of expenses (e.g. property plant and equipment)

Net profit will be decreased by the recognition of liabilities from the accrual process (liabilities up, equity down); two types of liabilities arise:

●short term liabilities from the deferral of revenue (e.g. unearned revenue)

●short term liabilities from the accrual of expenses (e.g. wages payable)

●long term liabilities from the accrual of expenses (e.g. provision for long service leave)

Firms include all of the short term assets and liabilities listed above in their Balance sheet, classified as 'Current assets' and 'Current liabilities' because most of these transactions will be completed within the next year (e.g. wages payable would be paid and accounts receivable would be settled). The short term assets and liabilities together represent the firm's working capital, defined as Current Assets minus Current Liabilities.

Note

Please note we will study the formal AASB 101 definitions of 'current assets'

and 'current liabilities' required for reporting entities in module 2.

Reading activity

You should now read pages 727 – 728 of the Horngren et al. 2010 textbook.

Self assessment 1.1

You should now attempt the following learning activities from the Horngren et

al. 2010 textbook:

●Starter S19-5 on pages 750 – 751

Solutions to learnings activities are available from the Study desk.

Stop and think

Complete Stop and Think 19-4 on page 728 of the Horngren et al 2010 textbook.

The solution is available from My Accounting Lab.

In summary, accrual based accounting:

●provides a better and more timely measure of performance (net profit) because revenue is

recognised at the point it is earned and expenses are recognised at the point they are incurred, regardless of the timing of the cash receipts and payments; and

●the balance sheet provides insight into the resources available to the firm in the short

term (e.g. inventory and accounts receivable) and its obligations (e.g. accounts payable, unearned revenue and wages payable).

These benefits do not occur under either the cash based or partial accrual system.

1.3.9 Working capital management

The management of working capital is critical to the firm's survival. As indicated, the firm must have sufficient short term resources to meet its short term obligations. A firm can have a very 'profitable' business model, but if it cannot pay its obligations as and when they fall due it can be forced into bankruptcy or insolvency (depending on the ownership structure of the firm); it only takes one creditor to take action for the business to fail. A major concern for many firms with the introduction of the GST was the impact it would have on the firms working capital (e.g. would the firm have the cash available to settle its GST liability each reporting period). It has been an ongoing issue and several changes have been made by the Federal government to lessen the impact on small business.

Working capital is an ongoing topic. We will investigate the various components of working capital in this module and throughout the course. Some of the more important working capital accounts include:

●Cash and cash equivalents (covered in detail in module 12 on cash flow statements)

●Accounts receivable (covered in section 1.4)

●Interest receivable (covered in section 1.4)

●Inventory (covered in modules 4 and 5)

●Prepaid expenses

●GST Clearing (discussed earlier)

●Accounts payable

●Bills payable (covered in section 1.5)

●Accrued expenses and Unearned revenue

●Provisions (covered in section 1.5)

1.3.10 Limitations of accrual accounting

A major downside of accrual accounting, which is based on the principles of matching and profit recognition, is that it is open to abuse by managers seeking to 'manage earnings' up or down over time. In the following sections, we will look at a number of scenarios where a degree of estimation is necessary in the formulation of adjusting entries. The first of these involves the estimation of bad debts expense in relation to accounts receivable (see section

1.4). Another area where estimation is involved is the recognition of provision liabilities

(e.g. provision for warranty claims). This is an area where significant accounting manipulation has occurred in the past. In section 1.5, we will investigate accounting for current liabilities, which includes accounting for provisions. Despite these downsides, the research evidence supports the usefulness of accrual accounting as it provides the clearest evidence about the profitability of the operations of the entity and the resources (working capital) available to the firm.

Study tip

Have you been making brief study notes for each of the objectives?

An easy way to do this is to copy the objectives from the on-line module on the

course homepage into a Word document. You need to go to the Course content

link on the course homepage and then select module one. You can click and

drag over the objectives and then paste them into a Word document.

Revision begins in week two! By frequently reading your study notes you will

soon find they become part of your long term memory. You will find you have

a much greater depth of understanding and the exam period will be far less

stressful.

1.4 Accounting for receivables

1.4.1 Accounts receivable and bad debts

Objectives

On completion of this section you should be able to:

●Define the various types of receivables

●Describe the principles involved in the management and control of accounts receivable ●Describe how accounts receivable are valued for reporting purposes

●Use the allowance method to calculate and account for bad debts by the percentage of

sales method and the ageing of accounts methods

●Use the direct write-off method to account for bad debts

●Discuss the limitations of the direct write-off method

1.4.1.1 Introduction

In the modern economy most business transactions are conducted on credit terms, creating receivables for the provider of the goods or services. If a firm is using accrual accounting and recognising revenue using the sales method (i.e. at the point of sale), accounts receivable will be recorded in the balance sheet. For many firms, accounts receivable can be its most significant asset. A number of issues arise in relation to the use of the sales method and the recording of accounts receivable:

●Will the firm collect all of the receivables?

●If not, are we overstating the firm's assets by showing the full amount of receivables

as an asset?

●If not, are we overstating profit in the period the sale is recognised as revenue?

The answer to the first question is obviously no. One of the problems with the recording receivables is that it can take some time before the firm realises that a particular debtor will not pay. Sometimes the sale will take place in one accounting period and the write-off of the debtor will occur in the next period. If we do not record the bad debt expense until the debtor is written-off, there are consequences for the current balance sheet (assets are overstated), the current income statement (profit is overstated) and the next period's income statement (profit is understated).

Reading activity

You should now read pages 398 – 400 of the Horngren et al. 2010 textbook.

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