ACCT1006 Notes TYPES OF FINANCIAL STATEMENTS

Transcription

1 ACCT1006 Notes TYPES OF FINANCIAL STATEMENTS - 4 financial statements o Statement of changes in equity Changes in OE s capital, reserves, and earnings How aspects in OE change over the period o Statement of profit/loss income minus expenses for particular period o Statement of financial position reports assets and claims on those assets

2 o Statement of Cash flows Cash in/out for a period

3

4

5 RATIO ANALYSIS - Ratio analysis expresses the relationship between selected items of financial statement data found in general purpose financial statements Profitability - Profitability ratios measure operating success of an entity for a given period of time. Two measures include return on assets and profit margin o Return on assets Indicates the amount of profit generated by each dollar invested in assets Return on assets =,-./ :69 e.g answer = 0.19 or 19% = firm generated 19 cents on every dollar invested in assets o Profit margin Measures the % of each dollar of sales that results in profit. Calculated by dividing profit/revenue Discount stores and like Coles are low-profit margin firms, where jewerly shops are high-profit margin firms Liquidity - Liquidity ratios measure the short-term ability of the entity to pay its maturing obligations and to meet unexpected needs for cash. Two measures include: working capital and current ratio o Current ratio Current assets/current liabilities Aka answer = 2.02% or $2.02; means, for every dollar of current liabilities, it has $2.02 of current assets o Working capital Measure of liquidity looking at difference between total current assets and current liabilities When figure is positive, firm is able to pay short-term creditors with existing current assets

6 Solvency - Solvency refers to entity s ability to meet its long-term financial obligations - Solvency ratios measure ability of business to survive long-term o Debt to total assets ratio Measures % of assets financed by creditors than shareholders; debt financing via creditors is riskier as they must be repaid at certain points Higher the % the more risker it is Calculated via total debt (current + non-current liabilities)/total assets Aka answer = 0.41; means 41cents of every dollar invested in assets has been provided by creditors o Interest cover ratio o Measures amount of profit available to cover interest expense o Ratio = EBIT/interest expense o Lower the profit; more risk to not pay lenders Relationship between amount financed by owners and the amount contributed by outside sources reflects degree of risk associated with business Benefits of financial ratios - Provide strength and weaknesses of a business based upon objective data - Condense accounting data into simplified ratios which can represent and provide information about key aspects of a business; which can aid both financial and management accounting o Financial accounting help ext. users better make choices Based on profitability Solvency o Management accounting Liquidity Inventory liquidity Limitations of ratios - They provide no causation factors. - Financial ratios are created using historical data, hence at the time of the creation of the ratios they may not be accurate - Nature of the business can limit the accuracy of the comparison of ratios between businesses - Ratios do not incorporate the cycle of the business, and this can distort the picture/health of a business o E.g a business is operating at an intro phase where earnings are not on par with operation costs DECISION MAKING PROCESS o Identify issue/decision to be made o Gather relevant info for the analysis o Identify the tool or technique that can provide the analysis of the issue so a decision may be made o Evaluate results of the analysis and make the decision

7 Lecture 2: - Steps in accounting cycle o Analyse transactions o Journalise transactions o Post transactions o Prepare a trial balance o Journalise and post adjusting entries o Adjusted trial balance o Prepare financial statements o Journalise and post-closing entries o Post-closing trials balance o Red coloured is during accounting period o Black is prepared at the end of the accounting period TYPES OF ACCOUNTING Cash based accounting - Accounting system which only recognises transactions when physical cash transfers occur, and hence only recognised revenue when cash is received, and expenses when cash is paid Accrual based accounting o All about recording transactions when rev. and expenses when they are earnt/incurred for specific periods, rather when physical cash transactions occur o Asset: resource controlled by an entity as a result of past events which future economic benefits are expected to flow to the entity Asset recognition: probable that future eco benefit will flow + value can be reliably measured o Revenue definition = revenue is increases in economic benefits arising in the course of ordinary activities of an entity. Other gains are not revenue as they do not arise in ordinary course of an entity Revenue recognition criteria A) probable that any future economic benefits associated with the revenue will flow to the entity (increase assets/decrease liabilities) and B) the revenue can be measured with reliability o Expenses definition = decrease in economic benefits during the accounting period in the form of costs that occur in the ordinary activities of the entity, such as cost of sales, wages. Expenses recognition criteria A) has arisen Outflow of future economic benefits (reduction assets/increase liabilities) associated with the expense is probable, and

8 B) The expense can be measured reliably Income definition CF defines income as an increase in economic benefits during the accounting period in the form of inflows or enhancements of assets or a decreases of liabilities that result in increases of equity, other than those relating to contributions from equity participants (shareholders) o Last line makes clear that cash from increase in equity contributions from shareholders does not count as revenue and thus income Recognition: has arisen and can be reliably measured ADJUSTING ENTRIES Why do we do adjusting entries? - We need adjusting entries to ensure that certain assets/liabilities and accounts are valued accurately to ensure proper information is published o Also to ensure asset, liability, equity, expense accounts are most updated o There are certain transactions which we don t record on an daily basis wages, which can then affect the totals and the accuracy of our financial statements Types of adjusting entries - Prepayments o Prepaid assets Original: dr rent; cr cash Adjusted: dr rent expense, cr asset o Prepaid expenses Original transaction Dr expense Cr cash Adjusted entry Dr asset left Cr expense left o What happens when you completely use the asset? Require another entry? 3 rd entry? o Unearned revenue Dr; cash; cr unearned revenue Dr unearned revenue, cr sales - Accruals o Accrued revenue Acc rec; cr sales Dr cash; cr accounts recievable

9 o Accrued expenses dr expense cr payabke dr payable expense cr cash What s the difference between prepayment and an accrual? - Prepayment when firm has prepaid for an expense, or an asset, or when an entity has earnt revenue before providing the service. Whereas, is when cash is received or paid after a service has been performed or consumed Preparing financial statements - Statement of profit or loss is prepared from the revenue and expense accounts - Current period profit or loss and \s paid are transferred to retained earnings account (part of statement of changes in equity) o Retained earnings = accumulated profit dividends - Statement of financial position prepared from asset, liability, equity and balance of retained earnings account CLOSING THE ACCOUNTS What are closing entries - Revenues, dividends, and expenses are related to only a given accounting period, and hence are considered temporary accounts - Permanent accounts are carried forward to the future accounting periods o E.g assets, liabilities, equity - At end of accounting period, temporary accounting balances are transferred to the permanent equity account retained earnings or capital through prep of closing entries - Closing entries formally recognise in the ledger the transfer of profit or loss and dividends to retained earnings - In addition to updating retained earnings account, closing entries produce a nil balance in each temporary account so that they are ready to be used for next accounting periods How to physically close the books (posting) 1. To make an account balance zil, we need to credit each expense account and debit each revenue account on T-accounts

10 a. Normal revenue accounts will have a cr balance, hence need to debit b. Normal expense accounts will have a dr balance, so need to credit 2. transfer each credit/debited revenue and expense to the profit or loss summary t- account. a. On t-accounts, you debit/credit the opposite side i. Do we need to say closing balance = 0 on t-accounts? 3. On the profit/loss t-account summary, when you have closed all expenses and revenue there will be a final figure representing profit or loss 4. Close the profit/loss T-account, and transfer the profit/loss value to the retained earnings account a. Incorporate the dividend and following this means the accounts are closed i. Remember dividend only incorporated at retained earnings account; as they are a distribution of capital, and not an expense 5. You need to similarly journalise the closing entries for expenses/revenue and profit/loss summary, and dividends a. You simply dr/cr as in line with the t-account, and the opposite dr/cr is profit or loss summary b. As you can see only need to journalise once for expenses, and once for revenue c. you must journalise profit/loss summary; with dr profit/loss, and cr retained earnings d. and must journalise closing of dividend accounts; you dr retained earnings as its taking away from its value 6. Prepare a post-closing trial balance; which is a list of all permanent accounts and their balances after closing entries are journalised and posted a. Purpose of post-closing trial balance is to prove equality of the permanent accounts that are carried forward to next accounting period b. Will only have permanent accounts on them; whole point is to ensure dr = cr