AC2001 ACCOUNTING CONCEPTS 1 NCEA LEVEL

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te matĀuranga mahi kaute

accounting

AC2001

ACCOUNTING CONCEPTS 1

NCEA LEVEL 2

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accounting

ncea level 2

Expected time to complete work

This work will take you about 10 hours to complete.

You will work towards the following standard:

Achievement Standard 91174 (Version 1) Accounting 2.1

Demonstrate understanding of accounting concepts for a sole proprietor that operates accounting subsystems

Level 2, External 4 credits

In this booklet you will focus on these learning outcomes: • explaining and applying accounting concepts

• explaining the financial elements • explaining the financial statements.

You will continue to work towards this standard in booklet AC2002.

Copyright © 2012 Board of Trustees of Te Aho o Te Kura Pounamu, Private Bag 39992, Wellington Mail Centre, Lower Hutt 5045, New Zealand. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means without the written permission of Te Aho o Te Kura Pounamu.

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1 Nature and functions of accounting

2 Concepts

3 Qualitative characteristics

4 Financial elements

5 Financial statements 1

6 Financial statements 2

7 Goods and services tax

8 Answer guide

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2 AC2001 © te aho o te kura pounamu

how to do the work

When you see:

Complete the activity. Check your answers.

Your teacher will assess this work. Note this key point.

You will need: • a pen • a calculator. Resource overview

Complete your practice activities on your own paper and return them along with your completed teacher-marked activities in this booklet.

Ensure you have attempted all activities on your own before referring to the Answer guide. At the end of each lesson, mark your practice work (3/5) from the Answer guide. Add any corrections/amendments in a different colour.

Take particular note of the key points as they will help you in your assessments.

Refer to the glossary in the reference guide for an explanation of any new words you are not familiar with.

Each lesson begins with:

• Learning outcome: an overview of what you are learning in this achievement standard • Learning intentions: what you are learning in this lesson

• Success criteria: what you should be able to do by the end of this lesson. Assessment

In this booklet you will work towards meeting the following criteria. Refer to your Reference

guide for a full copy of this Achievement Standard. Achievement criteria 2.1

Achievement Achievement with merit Achievement with excellence

Demonstrate understanding of accounting concepts for an entity that operates accounting subsystems.

Demonstrate in-depth understanding of accounting concepts for an entity that operates accounting subsystems.

Demonstrate comprehensive understanding of accounting concepts for an entity that operates accounting subsystems.

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1 nature and functions of accounting

learning outcome

Explain and apply accounting concepts.

learning intention

To examine the nature and functions of accounting.

success criteria

You will be able to:

• describe the nature and functions of accounting

• describe how interested parties use financial information for decision making • recognise internal and external users of financial information.

introduction

Accounting is recording, classifying, summarising, interpreting and reporting financial information. Accounting is the language of business and brings to life the affairs of a business in monetary units. It is an integral part of our society. Almost everyone, at some point, will help prepare accounting information and use it to make decisions.

At NCEA Level 2 the focus is on accounting for a sole proprietor.

Key point

The main function of accounting is to interpret, report and communicate financial information to interested parties to aid in decision making.

Reporting and communicating financial information can be done in different ways such as:

• financial statements • management reports • graphs or tables • tax returns.

In addition to this list of financial information, non-financial information should also be considered such as:

• business location

• availability and quality of

employees

• competitors in the market • effect of operations on the

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nature and functions of accounting

Accounting information functions as a tool of management to:

• reduce the uncertainties of decision making – a

cash budget, for example, can indicate the funds available if a decision is made to purchase new machinery

• plan and control business operations – a

department store manager can use projected sales figures to employ adequate staff or to maintain desirable levels of inventory

• assess the accountability of staff and the efficiency of business operations – this could involve

comparing actual sales with budgeted sales to see if targets have been met.

users of accounting

information

Accounting information performs specific functions for a variety of people or interested parties who use financial information as an aid to decision making.

• Managers in a business use financial information about the business to make day-to-day

routine decisions and other long-term strategic decisions described above. They are the internal users of a business’ financial information.

• Bank managers have to decide whether to lend money to

businesses so they need accounting information to determine a business’ financial situation.

• Investors need to know the financial situation of businesses in

which they are or might be investing money.

• Creditors allow businesses credit to buy goods or services and

need to know of any risks involved in extending credit.

• Government departments such as the Department of Statistics

and the Inland Revenue Department (IRD) need information from businesses to determine the revenues earned and tax to be paid.

• Owners or potential owners need to be informed of the financial

stability and future prospects of the business.

• Employees may use financial information about the business to

back up their wage claims.

• Customers can use accounting information to check up on the reliability of businesses

they deal with, especially if they are dependent on the business for such things as medical equipment or supplies.

Banks will not lend money to a business without seeing a financial report of past and/or budgeted performance.

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nature and functions of accounting

The IRD is interested in businesses registered for Goods and Services Tax (GST) and also those businesses liable for Fringe Benefit Tax (FBT). Pay As You Earn tax (PAYE) must be deducted from any wages paid to employees and also accident compensation levies. All these activities must be recorded on appropriate forms.

A tax accountant who provides tax advice, taxation planning and the preparation of taxation returns must make sure that all the required information is available.

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specialist accountants

Other accountants who specialise in different areas of accounting include:

• chartered accountants (CA) who are fully qualified accountants are members of the New

Zealand Institute of Chartered Accountants (NZICA). They provide a range of financial and advisory services to the public and may also complete taxation returns.

• financial accountants who prepare and present financial reports showing business cash

flow, profit/financial performance and financial position

• cost accountants who calculate costs of production usually in a manufacturing or service

business also prepare cost budgets, production planning and reports

• management accountants who prepare ongoing information such as daily progress reports,

budgets and cash flow reports for management to use in day-to-day decision making

• auditors who check and report on whether accounting records are properly kept and

financial statements/reports show a true and fair view of the financial performance, cash flows and financial position of the entity

• accounting technicians who have completed two years of study (about half the

requirements of a chartered accountant) and assist in the preparation of accounting records and financial statements but do not give advice.

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nature and functions of accounting

You are a chartered accountant. Mark Brown is interested in buying Better Buys, a variety store in the local mall. Mark asks for your advice as to whether it would be a good investment to buy Better Buys.

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1. Suggest items of financial information you would need in order to advise Mark. Explain briefly how you would use the information.

2. Suggest one item of non-financial information that would be useful in advising Mark and explain briefly how this information would be used.

3. Explain why Mark’s bank manager would be interested in financial information about Better Buys when Mark mentions he would be interested in an overdraft facility.

4. What sort of information would the IRD want from Mark if he did buy the business?

Check your answers.

Numbers Work is an accountancy business that employs a variety of accountants. Identify the accountant who would carry out each of the following tasks.

1. Preparation of tax returns. 2. Preparation of budgets.

3. Calculation of the costs of producing goods and services. 4. Provision of financial advice to small businesses.

5. Preparation of accounts and financial statements.

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nature and functions of accounting

internal and external users of financial information

Managers, supervisors, foremen and other decision-makers in a business are the internal users of financial information. The management accountant prepares regular management reports for internal use such as:

• sales reports • budget reports • aged debtors’ reports • production reports • cost reports • profit reports.

External users are the interested parties outside the business such as investors, bank managers

and government departments as previously described. They use business financial reports which contain annual financial statements such as the:

• Income Statement

• Statement of Financial Position • Cash Flow Statement

• Statement of Accounting Policies.

financial reports

Financial reports are produced at least once or twice a year. The New Zealand Institute of Chartered Accountants, which is responsible for accounting practice in New Zealand, has produced the New Zealand Framework for General Purpose Financial Reporting.

The framework describes the principles and assumptions of accounting which accountants should apply when preparing annual reports.

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2 concepts

learning outcome

learning intention

To examine accounting notions, concepts and a measurement base.

success criteria

• explain and apply the notions accounting entity, reporting period and monetary measurement

in context

• explain and apply the concepts going concern

and accrual basis of accounting in context

• explain and apply the historical cost

measurement base in context.

introduction

It is important to become familiar with the principles and assumptions set out in The

New Zealand Framework for General Purpose Financial Reporting as well as other accounting

notions or concepts. These are applied to the financial statements produced for a sole proprietorship which is a business or entity owned and usually managed by one person. The businesses studied in Level 2 Accounting are sole proprietorships.

You are expected to know and apply these concepts using correct accounting terminology in your external examination.

notions

accounting entity

Before you can begin accounting you must know exactly what you are accounting for. The notion (or concept) of Accounting Entity defines the business as a separate entity from its owner and all other entities.

For example, Henry Graham owns his own home and a small yacht. He also owns and operates Sports First, a retail business selling a range of sporting equipment.

Henry must keep the financial affairs of Sports First separate from his personal financial affairs.

Key point

According to the notion of Accounting Entity all transactions are recorded from the point of view of the business and not the owner. We keep the owner’s personal financial transactions separate from the business’s financial transactions.

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concepts

Two special accounts are used to do this. When the owner puts money or goods in the business it is called capital. When the owner takes money or goods from the business for personal use it is called

drawings. Capital and drawings are two components of equity or investment in the business.

reporting period

Key point

This notion assumes that the entity’s continuing life is divided into nominated time periods. This is necessary to:

• measure profit or financial performance, financial position and cash flows on a regular and

timely basis

• make comparisons from one period to the next.

The IRD requires businesses to return a tax statement annually. The usual tax year is from 1 April to 31 March of the following year. Some businesses choose other time periods to suit the product or activity in which they are engaged.

The period for reporting financial information may be a month, two months, six months, or at most, a year. Once the timeframe has been decided we must report information relating to that period only. The reporting period must be shown in the heading for each financial statement.

Henry Graham prepares financial statements annually. Here are the headings for the Income Statement and the Statement of Financial Position prepared for Sports First at balance date 31 March 2015.

sports first

income statement for the year ended 31 march 2015

sports first

statement of financial position as at 31 march 2015

monetary measurement

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concepts

Key point

For reporting purposes, financial information is measured in monetary units. This means that unlike items can be added together, for example, the $ amount of buildings is added to the $ amount of inventory.

In New Zealand the monetary unit is the New Zealand dollar and it is used as a measure for business transactions. Foreign transactions, such as imports and exports, are recorded in equivalent New Zealand dollars.

Non-monetary items of value to a business such as the skills and loyalty of staff are not included in the financial statements.

assumptions

going concern

Key point

This assumes that the business will continue its present operations into the foreseeable future and management has neither the need nor the intention to liquidate. This means the business has no plans to close down.

When a business purchases property, plant and equipment it assumes that the economic benefits derived from these assets will continue into the foreseeable future.

accrual basis of accounting

Key point

In an accrual based system of accounting cash and credit transactions are recorded when they occur and reported in the accounting period they relate to. Adjustments are made at the end of the reporting period to bring into account any outstanding transactions.

Interest on loan owing on balance day of $5,000 is reported: 1. in the current Income Statement as:

• an increase in interest expense because the interest owing relates to the current reporting

period

2. in the Statement of Financial Position as:

• accrued expenses, a current liability, because the business currently has an obligation to

pay the interest of $5,000.

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concepts

measurement base – historical cost

Accountants use a measurement base to value assets. Historical cost (often called cost) is the measurement base for many businesses.

Key point

The historical cost measurement base states that:

• transactions (and assets) are recorded at the amount paid or received at the time the

transaction took place or original cost to the business.

The advantage of historical cost is that it is a reliable measure as it is a faithful representation of a transaction verifiable (there is proof) by a source document – usually an invoice.

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Assets may be remeasured. Examples:

• accounts receivable (amounts owing by customers for credit sales) can be remeasured

using an allowance for doubtful debts (to allow for amounts which may not be received from customers)

• the basic rule for the valuation of inventory is that it should be stated at the lower of cost and

net realisable value. (Net realisable value is the expected sale price of the inventory.)

• physical assets like property, plant and equipment are reported at cost less accumulated

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concepts

1. Games is a computer games store owned by Gill Bates. In preparing the financial statements Gill’s accountant has assumed that Games will continue to operate into the foreseeable future. What accounting concept is applied here?

2. Gill has paid a personal insurance bill using a business cheque from Games. Explain how the notion of accounting entity is applied in this situation.

3. Games has imported 100 new computer games from China. Explain how the notion of monetary measurement is applied in recording the computer games in the accounting records of Games.

4. The financial statements show that Gill’s accountant has reported all computer games at the price at which they were purchased. Name the accounting concept applied here and explain why it was used.

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concepts

accounting concept summary

The accounting entity, monetary measurement, going concern, reporting period, accrual basis and historical cost notions/concepts are shown in the table below so that you can recognise, define and apply these for a business such as Classic Cleaners.

accounting entity

Recognise Define Apply

Answer in context The business name is the

entity, for example: Classic Cleaners.

For accounting purposes the financial transactions of the business are kept separate from the personal financial transactions of the owner.

Financial statements are prepared for Classic Cleaners and do not include the owner’s personal assets, liabilities, income or expenses. If the owner takes cleaning products home for his own use they are a personal expense and recorded as drawings to keep them separate from the business expenses for Classic Cleaners.

monetary measurement

Items reported in financial statements of Classic Cleaners have a dollar value in a common

currency, for example New Zealand dollars ($NZ).

All transactions are recorded in a common dollar unit such as the $NZ which allows unlike items to be added together.

Classic Cleaners has added unlike items together as the $ amount of equipment is added to the $ amount of motor vehicles which were imported from Japan. The cost is shown in $NZ not Japanese Yen.

going concern

It is assumed that Classic Cleaners is a going concern.

It is assumed for accounting purposes that Classic Cleaners will continue its present operations into the foreseeable future.

The owner of Classic Cleaners has reason to think the business should keep operating as a

cleaning business and does not intend to stop being a cleaning business.

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concepts

reporting period

The Income Statement is for the year ended 31 March 2015.

The Statement of Financial Position is as at 31 March 2015.

In order to measure the financial performance or profit/loss and financial position of a business on a regular basis, the business life is divided into nominated time periods.

Classic Cleaners Income Statement for the year ended 31 March 2015 measures the profit/loss for the year.

The Statement of Financial Position as at 31 March 2015 shows assets, liabilities and owner’s equity as at balance day – the end of the accounting period.

Classic Cleaners can make comparisons of profit, financial performance and financial position from one period to the next and between similar businesses.

accrual basis

Cash and credit

transactions are included in the financial statements.

The effects of transactions and other events are recognised when they occur and are reported in the financial statements of the periods to which they relate.

Classic Cleaners includes all amounts owing and amounts received or paid in advance in the Income Statement by adjusting the relevant income or expense and also includes the amounts owing or paid or received in advance as assets or liabilities in the Statement of Financial Position, for example: accrued expenses for expenses incurred but not yet paid such as wages owing to employees for work already done.

historical cost

Property plant and equipment are shown in the Statement of Financial Position at their purchase cost.

Transactions (and assets) are recorded at their purchase or original cost to the business.

In the accounts and financial statements for Classic Cleaners, Equipment and Motor Vehicle are (first) recorded at their purchase or original cost to the business.

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concepts

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Hoani Kaituna owns a limousine rental business in Auckland called Vast Vehicles.

1. When Hoani’s relatives visit he allows them free use of a Vast Vehicles’ limousine for the length of their stay. In order to follow the accounting entity concept how should Hoani record the cost of the use of the limousine?

2. Explain how recording the cost as your answer to question 1, above, is following the accounting entity concept.

3. Vast Vehicles recently imported a new limousine from the United States with a price tag of $US60,000. Hoani is not sure whether to record the limousine in Vast Vehicle’s accounts in United States or New Zealand dollars. Give the name of the concept which applies here and explain to Hoani how the limousine should be recorded.

4. Hoani arranged a loan with a local bank so that Vast Vehicles could purchase the new limousine. At balance date the statement of financial position reports three months’ interest owing on the loan as accrued expenses. Fully explain how this is an example of the accrual basis of accounting.

5. Explain how the heading shown below is an example of the Reporting Period notion.

vast vehicles

income statement for the year ended 31 march 2015

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qualitative characteristics

3

learning outcome

learning intention

To explain and apply the qualitative characteristics of financial statements.

success criteria

• describe the qualitative characteristics of relevance, reliability, comparability

and understandability

• describe how materiality influences the qualitative characteristics.

introduction

Qualitative characteristics are the minimum requirements, in terms of quality, that financial statements should have in order to be useful in decision making. There are four qualitative characteristics.

Qualitative characteristics

Relevance Reliability Comparability Understandability

relevance

Information is relevant if it relates to or has an effect on the decision being made. For example if an investor can determine trends in profitability from an income statement, this could affect a decision of whether to invest in the business or not. (Be careful to note that this does not mean that the financial statement is predicting any future results.)

Information must be timely which means it must be available when required and up-to-date. A year-old income statement would not be very relevant to a current decision being made. Financial information must also be useful in making predictions about the future (its predictive role) and must be able to be used to confirm previous predictions (its confirmatory role).

Key point

To summarise, relevance has three possible roles:

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qualitative characteristics

reliability

Key point

Financial information is reliable if it is:

• free from error • unbiased (neutral)

• a faithful representation (can be depended upon to represent a transaction faithfully).

It fulfils these criteria if it can be verified, usually by source documents. For example, the cost of a vehicle can be verified by looking at the invoice. This cost is free from error, is unbiased and is true. Formal verification is sometimes through an internal spot check process but at other times can be by an independent auditor.

comparability

Users need to be able to compare financial information.

Key point

It should be possible to compare:

• the performance of one accounting period of a business with other accounting periods • the financial information of one business with other similar businesses.

It is therefore necessary to show figures for the previous financial year in the reports in addition to the current figures, so similarities and differences can be readily identified.

Information must be prepared consistently if it is to be comparable. This means that the same policies and methods should be used to prepare financial statements from period to period. A statement of accounting policies is included in reports outlining the policies and methods used to prepare the financial statements and any changes should be disclosed in this statement.

understandability

Key point

Financial information should be clearly presented so that it is understood by those using it. Users are expected to have some ability in studying business information but the accountant preparing a report should make the information clear and unambiguous.

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qualitative characteristics

Explain and state the name of the qualitative characteristic to which each of the following statements relates. 3A ist ockpho to .com

1. The annual report of Eco Light, a lighting store, was not prepared until 10 months after balance day.

2. The report did not show last year’s figures.

3. A financial adviser found the financial report very difficult to follow.

4. The general manager of Eco Light told the accountant to show the current valuation for land and buildings at $100,000 more than the registered valuation of five years ago. He considered they were currently worth more and that the higher figure would look more impressive in the Statement of Financial Position.

influences on the characteristics

Accountants preparing financial reports must use their judgement in deciding what should be included so that the reports are relevant, reliable, comparable and understandable. Their decisions are affected by influences such as materiality.

materiality

Materiality is linked to relevance.

Key point

A statement or fact is material if its disclosure is likely to influence any decision being made by users. Material items should be shown in financial reports or disclosed in a note to the financial statements.

To comply with materiality an accountant could be required to make decisions such as:

• which items of expense can be combined and which shown separately because of their dollar

amount or because of their nature or importance

• whether small amounts of stationery can be classified as an expense and not an asset • whether a contract to build new premises next year should be disclosed.

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qualitative characteristics

These decisions will be based on the item’s size in comparison to the business. For example:

Bulk Stationery is a large commercial stationery business owned by David Boxer and located in the Auckland CBD.

• The supply of stationery used for Bulk

Stationery’s record keeping and business correspondence is very small and of little significance compared with the inventory of stationery held for resale. It is unlikely to influence any decisions made by users of Bulk Stationery’s financial statements and is classified as an expense and not an asset.

• Bulk Stationery reports income, expenses,

assets, liabilities and equity rounded to the nearest dollar. Cents are excluded from the financial statements because they are not material.

• Bulk Stationery is about to open two new outlets, one in Takapuna and one in Manukau. This

is included in the Notes to the Statement of Financial Position of Bulk Stationery as it is likely to affect decision making by users such as suppliers, banks and other lending institutions.

constraints on relevance and reliability

Materiality is kept in mind when judgements are necessary.

Financial information is of no use if it is not available when needed. Any undue delay in reporting means the financial information may have lost its relevance.

Sometimes a preparer of financial reports may have to balance one accounting characteristic against another. For example, to produce timely information may mean reporting on transactions or events before everything is known about them. This affects the reliability of information. The aim is to achieve an appropriate balance.

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qualitative characteristics

1. Zing Bat is a large cricket supplies store located in Auckland. Explain, in terms of

materiality, why the many different items

of cricket equipment sold by Zing Bat are

not reported separately in the Statement

of Financial Position but are shown as one amount called inventory.

2. Give a reason whether the following highlighted facts or statements are material in terms of disclosure in the financial report of Zing Bat.

a. Cents in the statement of financial position. (Income this year is $500,000.) b. The market value of investments.

c. The increase in income was due to competitors leaving the market.

d. Zing Bat burn cardboard containers and other packing on an adjacent section. There was no mention in the report that the business was being sued for polluting the

environment.

Match the description in column B with the correct term in column A.

Column A Column B

Neutral Requires last year’s figures and consistency.

Reliability The presentation makes it reasonable to expect users to know

what it means.

Materiality Information must be available when needed.

Comparability This applies to a fact which may influence users in making

decisions.

Timely Decisions are unbiased and based on fact.

Consistency Information is true and verifiable.

Understandability The same policies and measurement bases are used each year.

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qualitative characteristics

State the qualitative characteristic that applies for each of the following comments. 1. ‘Delays in providing annual financial statements have generally been eliminated due to

computer technology.’

2. ‘Clear presentation may involve classification and columnar arrangements to highlight important results and aid analysis and interpretation of the reports.’

3. ‘Accounting reports must be as accurate as possible to enable correct decisions to be made.’ 4. ‘Reports must be simple enough to be understood by those for whom they are intended.’ 5. ‘Information must be properly arranged and classified so as to make it accessible and to

allow comparisons with other similar businesses.’ 6. ‘There have been no changes in accounting policies.’

balance between benefit and cost

The NZ Framework states that the benefits gained from information should be greater than the costs of providing it. It is difficult to measure benefits and costs especially when the costs do not always fall on the users who enjoy the benefits.

Financial analysts, for example, use financial reports but pay nothing towards their preparation. On the other hand, the owners of small businesses may also be managers who have worked closely with sales, budgets and other management reports all year and do not gain much further benefit from the financial statements.

Despite these difficulties, the NZ Framework insists that those who set financial reporting standards, as well as preparers and users of financial information, should be aware of the balance between benefit and cost.

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financial elements

4

learning outcome

Explain the financial elements.

learning intention

To explain the financial elements.

success criteria

• define assets, liabilities, equity, income and expenses • apply these definitions in context.

introduction

The financial elements are used to classify or group the effect of transactions in the financial statements. In the Statement of Financial Position the financial elements are assets, liabilities and equity. In the Income Statement the financial elements are income and expenses.

assets

Key point

Assets have three essential characteristics:

• a result of past events

• presently in the control of the entity

• and from which future economic benefits are expected to flow to the entity.

Note the words in bold which will help you remember the characteristics – past, present, future.

recognition criteria

Key point

An asset is only recognised in the Statement of Financial Position when it meets the definition of an asset and:

• it is probable that the future economic benefits will eventuate

• it possesses a value that can be measured with reliability (a source document).

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financial elements

You can now look at the essential characteristics of an asset and the recognition criteria applied to a delivery van.

For example, a delivery van is an asset because:

• it was purchased some time ago in a past transaction

• it is currently controlled by the business which is the only entity that can decide how to

use it as they own it

• future economic benefits are expected to flow to the entity as a result of its use since it

will be used to deliver goods which will help to earn income for the business. Recognition criteria for the delivery van:

• it must be more than likely that it will provide future economic benefit

• the delivery van must have a value that can be measured reliably (there will be an

invoice or receipt).

liabilities

Key point

Liabilities have three essential characteristics:

• a result of past events

• the entity presently has a financial obligation

• the settlement of which will require a future outflow of cash from the business.

A liability is only recognised in the statement of financial position when it meets the definition of a liability and:

• it is probable that the future economic sacrifice will eventuate

• the amount of the liability can be measured with reliability (a source document).

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financial elements

For example, a loan is a liability because:

• it is the result of a loan agreement with the bank made some time in the past • the business presently has an obligation to repay the loan to the bank

• settlement of the loan involves an outflow of cash from the business bank account in the future – cash that could have been used to earn income for the business.

Recognition criteria for the loan:

• it must be more than likely that there will be an outflow of cash from the business

(repayment is a condition of the loan agreement)

• the amount required to settle the loan can be measured with reliability (it is stated in the

loan agreement).

equity

Key point

Equity is the residual interest in the assets of the entity after deduction of the liabilities. This definition means that if a business is bankrupt or wound up, payment of liabilities must be made before the remainder of the assets can be distributed to the owner.

This definition means the same as the accounting equation:

Equity equals Assets less Liabilities (also expressed as Asset less Liabilities equals Equity). In an examination, however, give the formal definition (as stated initially).

The recognition of assets and liabilities provides the criteria for recognition of equity.

A business has assets of $890,000 and liabilities of $560,000, so the equity of the business is $330,000 because $890,000 minus $560,000 equals $330,000.

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financial elements

income and expenses

Income and expenses are the financial elements in the income statement.

income

Key point

Income is:

• increases in economic benefit in the form of inflows or enhancements of assets (or decreases

in liabilities) during the accounting period

• that result in increases in equity • and are not contributions by the owner.

Income is only recognised in the income statement when:

• the increase in future economic benefit related to an increase in an asset (or decrease

in a liability) has a sufficient degree of certainty (probable)

• the amount of income can be measured reliably.

Income includes:

• inflows of future economic benefits – for example, credit sales, commission received, interest

received

• savings in outflows of economic benefits – for example, discount received.

Cash sales are income because they cause an inflow of cash which increases the business bank account (or decreases the bank overdraft). Sales increase business profit which causes an increase in equity during the accounting period and is not a contribution by the owner. Recognition criteria for cash sales:

The inflow has a degree of certainty since it has already been received at balance day and the amount has been reliably measured from the sales dockets/EFTPOS receipts issued at the time of the cash sales.

expenses

Key point

Expenses are:

• decreases in economic benefits during the accounting period in the form of outflows or

depletions of assets (or increases of liabilities)

• a decrease in equity • not drawings by the owner.

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financial elements

Expenses include:

• consumption of future economic benefits – for example, wages, advertising, power,

depreciation of an asset

• loss of future economic benefit – for example, inventory revaluation, bad debts, discount

allowed).

Wages are an expense. When wages are direct debited they represent an outflow of cash which decreases the business bank account (or increases the business’ bank overdraft). Wages expense decreases business profits which causes a decrease in equity. The wages were not paid to the owner so are a business expense not drawings.

Recognition criteria for wages:

Wages have been paid so the outflow has occurred and the business bank account has decreased (or the overdraft increased) and the amount can be reliably measured by checking online exactly how much was direct debited as wages.

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financial elements

Key point

summary of financial elements

Asset

A resource controlled by the entity:

• as a result of past events (transactions) • from which future economic benefits

are expected to flow to the entity.

Example – A delivery truck

Only the business can exclusively benefit from the use of the truck:

• as a result of the truck having been

purchased by the business

• since the truck will be used to earn

income which brings cash into the business.

Liability

A present obligation of the entity:

• arising from past events • an outflow of cash.

Example – A bank loan

The loan has to be repaid:

• arising from the loan agreement with

the bank

• an outflow of cash from the business to

repay the loan.

Equity

• The residual interest in the assets of an

entity after deducting all its liabilities. Or assets minus liabilities.

Example – Capital

• The value left for the business owner

when liabilities are deducted from assets. Or business assets minus business liabilities.

Income

Increases in economic benefits during the accounting period in the form of increases in assets:

• that result in increases in profit which

increases equity

• other than those relating to

contributions by owners.

Example – A cash sale

An increase in cash:

• resulting in an increase in profit which

increases equity

• that has not been contributed by the

owner.

Expenses

Decreases in economic benefits during the accounting period in the form of decreases in assets:

• that result in decreases in profit which

decreases equity

Example – Payment of wages

Decreases in economic benefits during the accounting period in the form of cash paid for wages:

• that results in a decrease in profit that

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financial elements

The current liabilities section of the Statement of Financial Position for Supertyres included $5,600 for accrued expenses which related to interest on loan owing on balance day. 1. Explain fully why interest paid on a loan is an expense.

2. Explain fully why accrued expenses for interest are reported as a liability in the Statement of Financial Position.

Classify each of the following as assets, liabilities, income or expenses and give reasons for your answer according to the definitions of financial elements.

1. Accounts receivable (amounts owing from debtors) 2. Accounts payable (amounts owing to creditors) 3. Insurance

4. Inventory

5. Possible future refunds that may be necessary on faulty goods being returned after the Christmas sales. The financial period ends on 31 December.

In March 2015, Plum Computers received a large order for laptops from a customer. The value of the order was $2m. Delivery is not until 10 April. The managing director wants some of the income from the sale of the computers recognised in the financial period ended 31 March 2015. The accountant disagrees.

Explain the correct treatment for the income earned from the sale of the computers in accordance with the definition of income.

4A

4B

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financial statements 1

5

learning outcome

Explain the financial statements.

learning intention

To allocate financial elements to the appropriate financial statements.

success criteria

• explain the purpose of the Statement of Financial Position and Statement of Accounting

Policies

• describe the components of the Statement of Accounting Policies

• classify assets, liabilities and equity for presentation in the Statement of Financial Position.

introduction

Information useful for decision making is communicated to interested parties in the financial statements of a business.

statement of financial position (balance sheet)

Key point

The purpose of the Statement of Financial Position is to show the financial position of the business at a point in time by showing the assets, liabilities, and equity of the entity on balance day.

Information about the entity’s economic resources (or assets) is useful in assessing the entity’s ability to generate cash and/or provide services in the future.

Information about liabilities and equity is useful in assessing how successful the entity is likely to be in raising further finance.

statement of accounting policies

It is important to understand the accounting assumptions on which the Statement of Financial Position is based.

Key point

The purpose of the Statement of Accounting Policies is to set out the policies followed in the preparation of the financial statements. It allows users to more easily understand the significance of the information reported.

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financial statements 1

components

The Statement of Accounting Policies:

• identifies the entity by its name and nature

• states the measurement base used in the reports, such as historical cost • describes the accounting policies on which the reports are based such as:

– how GST applies in the statements

– the method used to depreciate items of property, plant and equipment

– the valuation method used for items such as accounts receivable, inventory, investments, and property, plant and equipment.

• includes a statement of changes (or a statement saying there are no changes) in the

measurement system or accounting policies used.

Note: you will not be asked to analyse or prepare a Statement of Accounting Policies at NCEA

Level 2 but you do need to be aware of its significance.

grow your greens

statement of accounting policies

Name and Nature

These financial statements are prepared for Grow Your Greens a sole proprietorship that specialises in garden supplies from three locations in Auckland.

Measurement Base

The financial statements have been prepared on the basis of historical cost.

Property, Plant and Equipment

Property, plant and equipment are stated at cost and, except for land, depreciated.

Depreciation

The cost less residual value of property, plant and equipment (except for land) is depreciated over their estimated useful lives.

Accounts Receivable

Receivables are stated at estimated realisable value after allowing for doubtful debts. Bad debts are expensed during the period in which they are identified.

Inventories

Inventories are stated at the lower of cost and net realisable value. Cost is determined on the first-in first-out basis.

Investments

Investments are stated at cost.

GST

All amounts are stated exclusive of Goods and Services Tax (GST), except for receivables and payables which are stated inclusive of GST.

Changes in Accounting Policy

There have been no significant changes in accounting policy. All policies have been applied on a basis consistent with those used in previous years.

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financial statements 1

statement of financial position presentation

You will prepare the Statement of Financial Position in later booklets in this course. Here you will look at the presentation of the various items included in this statement.

Within the Statement of Financial Position assets and liabilities are sorted into groups. Equity items are also shown.

Assets and Liabilities are normally classified (grouped) as follows:

Key point

assets

examples

Current Assets

An asset shall be classified as current when:

• it is cash; or

• it is expected to be realised (turned

into cash) within twelve months after the balance date.

Current Assets • Cash on hand • Bank

• Accounts Receivable or Debtors • Inventory or Stock (goods on hand to

sell in a trading business)

• Supplies on hand (needed to perform a

service in a service business)

• GST (receivable) • Prepayments • Accrued Income Non-current Assets

All other assets shall be classified as non-current. They are classified into three categories as follows:

Investments

• Money invested long-term which will

provide future income.

Property, Plant and Equipment

• Assets with long-term use in the

business which will provide future economic benefit to the business for more than one year.

Intangible Assets

• Long-term assets which have value and

will provide future economic benefit

Non-current Assets • Government Stock • Term Deposits • Shares • Vehicles • Land • Buildings • Office Equipment • Furniture and Fittings • Machinery

• Goodwill – the amount paid in excess

of net assets when a business is purchased for the estimated value of custom that has been built up.

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financial statements 1

liabilities

examples

Current Liabilities

Amounts owing which have to be repaid in the next year/normal operating cycle of the business.

Current Liabilities • Bank Overdraft

• Accounts Payable or Creditors • GST (payable)

• Accrued Expenses • Income in Advance Non-current Liabilities

Amounts owing over more than one year. Non-current Liabilities_{• Loan}

• Mortgage

We should, where we are told, show the term of the loan and its interest rate. (Note: A loan due in less than one year becomes a current liability.)

equity

Equity is also known as capital or proprietorship. It is the residual interest in the assets of the entity after deducting all its liabilities.

• Opening capital • Plus Profit for the year • Less Drawings

• Equals Closing capital

Financial elements are recognised in the financial statements when:

recognition

measurement

Elements are only recognised if it is

probable all essential characteristics are

true.

Elements must be able to be measured

reliably.

statement of financial position

Here is the Statement of Financial Position for Grow Your Greens as at 31 March 2015.

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financial statements 1

grow your greens

statement of financial position as at 31 march 2015

$ $ $

Current Assets

Bank 13,000

Accounts receivable (Note 1) 39,600

Inventory control 208,000 260,600

Non-current Assets Investment

Term deposit 40,000

Property, plant and equipment (Note 2)

Total carrying amount 960,000

Intangible Asset Goodwill 30,000 1,030,000 Total Assets 1,290,600 Less Liabilities Current Liabilities GST 11,200 Accounts payable 34,000 45,200 Non-current Liabilities Loan 30,000 Total Liabilities 75,200 Net Assets $1,215,400 Equity Opening capital 1,100,000

Plus Profit for the year 135,400

Less Drawings (20,000)

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financial statements 1

notes

Further detail of some figures is given in notes which accompany the Statement of Financial Position. This detail is included to improve understandability for the users of the Statement of Financial Position.

You will learn to prepare these notes in a later booklet in this course. In the external examination a template is provided which makes preparation quite straightforward.

The Notes to the Statement of Financial Position for Grow Your Greens are shown below.

notes to the statement of financial position

1. Accounts Receivable

Accounts receivable 42,000

Less Allowance for doubtful debts 2,400

$39,600

2. Property, Plant and Equipment

Land Buildings Equipment Total

$ $ $ $

For the year ended 31 March 2015

Opening carrying amount 475,600 360,000 150,000 985,600

Plus Additions 20,000 20,000

Less Disposals (10,000) (10,000)

Less Depreciation (3,600) (32,000) (35,600)

Closing carrying amount 475,600 356,400 128,000 960,000

As at 31 March 2015

Cost 475,600 396,000 192,000 1,063,600

Accumulated depreciation 39,600 64,000 103,600

Carrying amount 475,600 356,400 128,000 960,000

The owner of Grow Your Greens knows that you are an able accounting student and asks you the following questions.

1. What is the purpose of the Statement of Accounting Policies?

2. Name the qualitative characteristic applied in the reporting of Notes to the Statement of Financial Position.

3. Describe how the qualitative characteristic you have named in question 2, above, helps the users of the Statement of Financial Position.

4. How is Equity reported in the Statement of Financial Position?

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financial statements 1

5. How are Property, Plant and Equipment reported in the Statement of Financial Position?

Conrad Crete owns a sole proprietorship business called Cement Works that specialises in laying concrete foundations and other concrete building requirements. Cement Works has expanded its operations during 2014 and purchased an additional truck. This was financed by taking out a loan from the bank. The loan is due to be paid back by 2018.

1. The loan will be reported in the Statement of Financial Position of Cement Works. State the

purpose of the Statement of Financial Position.

2. Explain why the loan will be reported as a non-current liability in the Statement of Financial Position of Cement Works.

3. Explain why the asset Bank is reported as a current asset in the Statement of Financial Position of Cement Works.

4. Explain how the truck is reported in the Statement of Financial Position of Cement Works? 5. The Statement of Accounting Policies for Cement Works contains the following extract:

Measurement Base

The financial statements have been prepared on the basis of historical cost.

Explain how ‘historical cost’ affects the reporting of the truck in the Statement of Financial Position for Cement Works.

6. In the Statement of Financial Position of Cement Works there is a group of assets called

‘Intangible Assets’. Explain what is meant by this term and give an example of an intangible asset.

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financial statements 2

6

learning outcome

Explain the financial statements.

learning intention

To allocate financial elements to the appropriate financial statements.

success criteria

• explain the purpose of the Income Statement and the Cash Flow Statement • classify income and expenses for presentation in the Income Statement • identify cash items reported in the Cash Flow Statement

• explain the limitations of financial statements.

introduction

You have looked at the purpose of the Statement of Accounting Policies, Statement of Financial Position and the classification of assets and liabilities. Other financial statements used for decision making include the Income Statement and the Cash Flow Statement.

income statement

Key point

The purpose of the Income Statement is to report the financial performance and profit (or loss) for the period/year in order to compare income, expenses and profit with another period/year.

Income minus Expenses equals Profit/Loss

Reporting the profit for the period, and the relevant income and expenses related to the period, allow for the assessment of both past and future financial performance. Users can see if there has been an increase in profit from one period to the next.

income and expenses

Most businesses have one main way of earning their income. Service firms earn fees, charges or commission. Trading firms, which sell goods to earn income, call their income sales.

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financial statements 2

Business expenses however can be many and varied and are classified, usually into three groups, in the Income Statement.

In trading firms there are three common groups of expenses:

Distribution costs Administrative expenses Finance costs

Expenses related to distributing and selling the product or service: • advertising • salespersons wages/ salaries • shop rent • shop electricity • delivery expenses • delivery vehicle expenses • depreciation on shop

fittings

• depreciation on delivery

vehicles

Expenses related to managing and keeping the business going: • insurance • rates • rent/office wages/salaries • office expenses • stationery • telephone • general expenses • depreciation on office equipment Expenses related to financing the business:

• interest on loan • interest on mortgage • interest on bank

overdraft.

Interest expenses only

In service firms the Distribution costs group (also known as Group One expenses) is often replaced with something more appropriate to the service being provided.

For example:

• a hairdresser might use Cutting and Styling Expenses • a plumber might use Plumbing and Vehicles Expenses • a courier might use Vehicle Expenses.

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financial statements 2

Here is an example of an Income Statement for a service business. Clean Sweep provides cleaning services in the central business district of Wellington.

clean sweep

income statement for the year ended 31 march 2015

$ $ $

Revenue

Fees 195,000

Less Expenses

Cleaning expenses

Soap and cleaning materials 3,000

Wages of cleaners 45,000

Cleaning van expenses 10,000 58,000

Administrative expenses Telephone 1,500 Office wages 15,000 Electricity 3,000 Accounting fees 2,000 Stationery 1,000 22,500 Finance costs Interest on loan 1,500 Total expenses 82,000

Profit for the year $113,000

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financial statements 2

Moana Maniapoto is the sole proprietor of an express hair cutting business for men called Short Cuts. When Moana prepares the Income Statement for the business she sorts the expenses into appropriate groups. Prepare three columns for the following expense headings: Cutting and Styling Expenses, Administrative Expenses and Finance Costs and group the expenses listed below under the appropriate heading.

Insurance, scissor sharpening, electricity, receptionist wages, stylists wages, telephone, appointment cards, advertising, interest on loan, general expenses, clients’ magazines, window cleaning, clients’ tea and coffee, depreciation on salon

fittings, shampoo, conditioner and styling product expenses, depreciation on computer.

cash flow statement

Key point

The purpose of the Cash Flow Statement is to reconcile the opening cash (bank) balance with the closing cash (bank) balance by showing all cash inflows and cash outflows for the reporting period.

It is useful for decision making because it helps owners decide whether there is sufficient cash to pay employees and suppliers, pay back overdrafts or loans and whether further drawings should be taken.

components

The Cash Flow Statement includes:

• cash receipts (sources of cash) • cash payments (uses of cash)

• the effect of the cash movements on the bank balance at the beginning of the period.

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financial statements 2

Here is an example of a Cash Flow Statement.

clean sweep

cash flow statement for the year ended 31 march 2015

Receipts $ $

Fees 160,000

Sale of old van 5,000

Loan from bank 25,000

Total receipts 190,000 Payments Cleaning equipment 45,000 Van expenses 10,000 Wages 60,000 GST paid 2,500 Other expenses 7,500

Purchase of new van 43,000

Purchase of new computer system 10,000

Drawings 20,000

Interest on loan 1,500

Total payments 199,500

Net increase (decrease) in cash (9,500)

Opening bank balance (500)

Closing bank balance $(10,000)

On 1 April 2014 Clean Sweep had a bank overdraft of $500. During the financial year the business banked receipts of $190,000 and made cash payments of $199,500, an overall net decrease of $9,500 in cash. This resulted in a bank overdraft of $10,000 on 31 March 2015. The cash flow statement is only concerned with the flow of cash in and out of the business. It is the only cash-based financial statement. All the items listed are assumed to have been fully received or paid in cash.

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financial statements 2

Mike Angelo is the sole proprietor of a large art supplies business called Artful. He is preparing financial statements for the business and raises a few queries with you as his accountant. 1. What is the purpose of the Income Statement?

2. For what purpose is the Cash Flow Statement prepared?

3. Explain to Mike why credit transactions are not included in a Cash Flow Statement?

4. Mike is very concerned that Bad Debts are not included in the Cash Flow Statement. Give him an explanation.

decision making

Cash flow information is essential in business decision making.

Internal user

Owner

External user

Bank manager Potential buyer

Liquidity ‘I need to know if there’s enough money coming into the business to pay debt.’

‘Can the business meet its cash obligations and honour external financing?’

Budgeting ‘Previous cash flows form the basis

for future cash flow projections.’ ‘What is the business’ ability to generate positive future cash flows?’

Income and expenditure details shown in the Income Statement provide only limited information

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financial statements 2

A business may have a healthy profit but may, in the same reporting period, have liquidity problems.

2012 2013 2014

Profit for the year $125,000 $112,500 $130,000

Closing bank balance ($30,000) ($20,000) ($50,000)

The Income Statement calculates profit using only income and expense items. It does not include other cash transactions that will affect the cash flow situation.

Other cash transactions could include:

• purchase and sale of items of property, plant and equipment • new loans/repayments of loans.

Profit for the year does not give a full picture! It is essential that the liquidity of a business is also

known. A shortage of liquid resources can lead to bankruptcy.

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other limitations of financial statements

Financial limitations

Even when financial statements are prepared on a consistent basis there are financial limitations:

• there is a certain amount of estimation used in their preparation for items like Depreciation

expense and the Allowance for doubtful debts

• end-of-year data may not reflect the financial position during the year, nor the current position • inflation has an effect – the purchasing power of the dollar changes over time

• past financial history (as revealed in financial statements) is not an indicator of future

performance because of the non-financial factors mentioned below

• there are limitations to the amount of relevant financial information to be gained from

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financial statements 2

Non-financial limitations

Because everything in the financial statements is recorded in money terms, there is no way to quantify economically (put a dollar value on) the impact of things like:

• staff loyalty • staff expertise

• availability of skilled staff • changes in market conditions

• competition within the particular sector the business operates in.

Sara Windsor has just completed her first year as sole proprietor of her childcare agency Kiddicare.

Kiddicare has four employees and Sara is delighted that the first set of financial statements shows a healthy profit for the year. However, she has been warned that the annual financial statements have both financial and non-financial limitations.

In three short paragraphs explain to Sara:

• the importance of information relating to liquidity as well as profit • other financial limitations and

• non-financial limitations of Kiddicare’s annual financial statements.

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