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ACCT1501

Accounting and Financial Management 1A

Zhi Ying Feng

Contents Introduction to Financial Accounting .................................................................................................... 2

Measuring and Evaluating Financial Position and Performance ........................................................... 3

Double Entry System ............................................................................................................................. 5

Record-Keeping ..................................................................................................................................... 6

Accrual Accounting Adjustments .......................................................................................................... 8

Special Journals, Subsidiary Ledgers and Control Accounts .............................................................. 11

Internal Control .................................................................................................................................... 12

Inventory and Non-Current Assets ...................................................................................................... 16

Financial Reporting Principles, Accounting Standards and Auditing ................................................. 21

Ratio Analysis ...................................................................................................................................... 23

Management Accounting: Introduction and Cost Concepts ................................................................ 27

Management Accounting: Cost-Volume-Profit Analysis .................................................................... 30

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1. Introduction to Financial Accounting

Accounting is the process of identifying, measuring and communicating economic information to

assist users of that information to make informed decisions:

- Financial accounting: periodic financial statements provided to external decision makers,

- Management accounting: planning and performance reports to internal decision makers,

Accrual accounting: a financial accounting system where revenues and expenses are recorded when

they are incurred, regardless of whether cash has yet changed hands.

Financial accounting presents information through financial statements:

Balance Sheet

A balance sheet measures and describes a company’s financial position, i.e. its set of financial

resources and obligations at a point in time. Its 3 main components are assets, liabilities and

shareholder’s equity.

The relationship between assets, liabilities and equity is given by:

Assets Liabilities Equity

Income Statement

An income statement measures a company’s financial performance, i.e. profitability over a period of

time. It gives a net profit based on the revenues and expenses incurred during the period.

Statement of Cash Flow

A statement of cash flows shows the change in cash of one balance sheet during a period of time.

This is necessary because in an accrual system, revenues do not equal cash gained and expenses do

not equal cash paid

o Operating activities: provision of goods and services between customers, suppliers and etc.

o Investing activities: acquisition or disposal of noncurrent assets, e.g. properties

o Financing activities: change in size and composition of the financial structure

Financial Statement Assumptions:

- Accrual basis: effects of transactions are recognised as they occur

- Going concern: statements are prepared under the assumption that the organisation will

continue operating in the foreseeable future, otherwise it is necessary to report the liquidation

values of an organisation’s assets

- Accounting entity: the entity that prepares financial statements are separate from its owners

- Accounting period: the life of a business needs to be divided into discrete periods of equal

time to evaluate financial performance and position, e.g. quarterly, monthly, yearly

- Monetary: transactions are all measured in a common denominator, e.g. $AUD

- Historical cost: assets are recorded at their original cost at purchase

- Materiality: everything on the statement is material, i.e. its omission could influence the

economic decisions of users made on the basis of financial statements. Also, items that have a

small dollar value are expensed rather than included as asset, e.g. a packet of lollies

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2. Measuring and Evaluating Financial Position and Performance

Balance Sheet: For period up to/As at

A balance sheet presents information on an entity’s financial position at a point in time, such as:

- Assets, liabilities and shareholders’ equity

- Solvency: the ability to pay debts in the long term

- Liquidity: the ease with which assets can be converted to cash in normal course of business,

short term

Balance sheets are comparative, showing accounts at both beginning of the income statements

period and at the end.

Assets

Assets are resources controlled by the entity as a result of past events from which future economic

benefits are expected to flow to the entity. An asset must have:

- Future economic benefit to generate net cash flow for the entity

- Ownership and control, i.e. able to benefit from the assets and to deny access to others

- Obtained from past transactions or events through using cash, credit or barter transactions

- A cost or value that can be measured with reliability

Assets are classified into two types

o Current assets: short term assets that are expected to be used or sold within the next year

o Non-current assets: long term assets that will have benefit for more than a year into the

future, such as long term investments and properties

All assets are initially recorded at their historical cost, the cost at the time of purchase. During its

useful life it has a depreciable present value and when its useful life expires it has a realisable value,

the cost it could be sold at.

Liabilities

Liabilities are present obligations of the entity arising from past events, the settlements of which are

expected to result in an outflow from the entity of resources with economic benefits. The essential

characteristics of liabilities are:

- A present obligation (usually legally enforceable) exists and the obligation involves

settlement in the future via the sacrifice of economic benefits

- Adverse financial consequences for the entity

- A cost or value that can be measured reliably

Liabilities also have 2 types:

- Current liability: obligations expected to be settled in the normal course of the entity’s

operating cycle, or within a year of the end of the accounting period

- Noncurrent liability: obligations due more than a year into the future, e.g. mortgages

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Equity

Equity (owner for private, shareholders for public) is the residual interest in the assets after deducting

all of its liabilities. Sources of equity include:

- Direct contributions from owners or shareholders

- Accumulation of profit not withdrawn by owners

- Profit not distributed as dividends to shareholders

Manipulating the accounting equation:

Re Pr ReNet Assets Share Capital tained ofits venue Expenses Dividends

A L SE SC RP R E D

Definitions:

- Share capital: equity obtained through trading stock to shareholder for cash

- Retained profits: net income not distributed as dividends to shareholders

- Revenue: income received from normal business activities

- Expenses: outflow of cash to another company or person

- Dividend: portion of profit paid out to shareholders. This is NOT an expense

Income Statement: For period ending/As of

An income statement presents information through accrual accounting on the profit or loss for a

certain period of time. Profit or loss is calculated using:

Net Profit Revenue Expenses

Revenue

Revenue is defined as gross inflows of economic benefit (increase in wealth) during the period

arising from ordinary activities of the company (provisions of services or sales of goods).

Expenses

Expenses are decreases in economic benefits (wealth) during the period that are incurred when

generating revenue. It is in the form of outflows or depletions of assets or incurrence of liabilities

that results in a decrease in equity.

Relationship between profit and retained profits:

–Retained profit at end of period Retained profit at beginning of period Net profit dividend

Income statement and balance sheet cam be combined to gain useful information. This is called

articulation of the two statements. E.g. income statement tells how much profit a company has made,

on the balance sheet this contributes to total equity, but the balance sheet also explains where these

profits come from.

Capital Expenditure vs. Expenses

Capital expenditures are costs that create future benefits through purchase of fixed assets or adding

value to existing assets. When a firm spends money, if the resulting benefit is to be realised in the:

- Current accounting period, then it is an expense

- Next or future accounting period, then it is an asset

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3. Double Entry System

Transaction analysis is the analysis of how various transactions affect the accounting equation. The

golden rule as always is that the accounting equation must balance:

Assets Liabilities Equity

Double Entry Bookkeeping

Under the double entry system, every transaction always affects at least two different accounts in

order to maintain the balance in the accounting equation. The net effect of these amounts is called the

account’s balance, and it is influenced by:

- Debit (Dr) : increase to resources/assets, anything on the left hand side of a balance sheet

- Credit (Cr) : increase to sources/liabilities or equity, anything on the right hand side of a

balance sheet

Ever transaction incurs a debit and a credit entry so at any point in time:

Total Debit Total Credit

Type of account Normal balance Increase Decrease

Assets Debit Debit Credit

Liabilities Credit Credit Debit

Shareholder’s equity Credit Credit Debit

Revenue Credit Credit Debit

Expenses Credit Debit Credit

Journal entries are a method of recording transactions in terms of debit and credit. It can list as

many accounts as needed to record the transaction, but for each journal entry, debit must equal credit.

E.g. Company A bought $450 worth of supplies by paying $100 cash up front and the rest as credit

to be paid in the next month.

$ $

Dr Inventory (asset) 100

Cr Cash (asset) 100

Dr Inventory (asset) 350

Cr Accounts Payable (liability) 350

E.g. Company B made credit sales of $40 000 on goods that costed $16 000

$ $

Dr Accounts receivable 40 000

Cr Sales Revenue 40 000

Dr Cost of goods sold 16 000

Cr Inventory 16 000

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4. Record-Keeping

The accounting cycle is the collective process of recording and processing accounting events of a

company, starting from transactions to the preparation of financial statements. The stages are:

Source Documents

Source documents are documents that serve as evidence to show transactions have occurred. They

permit auditing and verifying of errors and also reflect the various events in the operation of the

business. Common source documents are:

- Cheques for cash payment

- Receipts for cash received

- Invoices for credit sales

Prepare Journal Entries

Accounting transactions are recorded based on source documents using journal entries. A journal

entry can list as many accounts as needed to record the transaction, but the sum of debits must

always be equal to the sum of credits.

Each journal entry has a posting reference to indicate which ledger account it affects. This number

corresponds to the company’s chart of accounts, the list of all ledger accounts.

Post to Ledgers

Ledgers are used to determine the total change to an account, e.g. cash, after all the journal entries in

a period. The general ledger is the complete set of all accounts: assets, liabilities, equity, revenues

and expenses.

A simplified version of ledgers is the T-account, which only lists debits and credits without

calculating balance after every entry.

The journal entries are still necessary, because ledgers split up the transactions so we won't know

what the debit and credit is in a particular transaction

Prepare a Trial Balance

A trial balance is an initial check for any mechanical errors while posting all journal entries to

ledgers. Since the general ledger contains all accounts which come from balanced journal entries, it

must also balance. In a trial balance, the credit and debit of every account is totalled and their sums

should equal.

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However, some errors are NOT can occur even if a trial balance balances:

- If a journal entry was not posted

- If a journal entry debited/credit the wrong account

- If the amount debited and credit is equal but both wrong

Adjusting Journal Entries

At the end of each accounting period, it is necessary to adjust the revenue and expense accounts

(and all related asset/liability accounts) to reflect:

- Expenses incurred but not yet paid

- Revenues earned but not yet received

- Cash received from customer in advance for work

- Using up of assets, which creates an expense such as depreciation

Prepare an Adjusted Trial Balance

Any adjusted entries are then posted to the relevant ledger accounts, which require another trial

balance to be prepared to make sure no mechanical error has occurred.

Prepare Closing Journal Entries

Closing entries formally translates the balances of revenue and expense accounts to a profit-loss

summary and then transfer the balances to retained profits. This is to prepare the company for the

next accounting period. Two types of accounts when preparing closing entries are:

o Temporary Accounts

- Accounts closed at end of accounting period, i.e. revenue and expense accounts

- DEBIT all revenue accounts and CREDIT profit-loss summary

- CREDIT all expense accounts and DEBIT profit-loss summary

- DEBIT profit-loss summary then CREDIT it to retained profits

- Credit balance in profit-loss summary is a PROFIT

- Debit balance in profit-loss summary is a LOSS

o Permanent Accounts

- Accounts NOT closed at end of accounting period, i.e. assets, liabilities and equity

- Balances in these accounts are carried forward to the next accounting period

Prepare a Post-Closing Trial Balance

Again, another trial balance is prepared after closing entries are made to ensure total credit equal to

total debit

Prepare Financial statements

The accounts in post-closing trial balance can then be used to prepare the balance sheet. The

accounts in the profit-loss summary translate to the retained profits.

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5. Accrual Accounting Adjustments

Accrual accounting is the recognition of events, estimates and judgements that are important to the

measurement of financial performance and position regardless of whether they are realised:

- Revenues are recorded in the period when they are earned, not received.

- Expenses are recorded in the period when they are incurred, not paid.

- Collection of cash when revenue/expense has been previously recognised only affects

assets/liabilities

Revenue and Expense Recognition

Recognition at the SAME time as cash flow

When the revenue/expense occurs at the same time as cash is exchanged, there is NO difference in

entries between cash and accrual accounting:

Recognition BEFORE cash flow

Revenue and expenses are recognised when they are made, not when the actual cash has exchanged

hands. Cash accounting doesn’t account for this and therefore UNDERSTATES revenue/expenses

E.g. manufacture estimates it will incur future warranty costs next year for goods sold in the current

financial year. Warranty expense should therefore be recognised in the current year, since it is the

year which the goods were sold

Cash Accounting

Accrual Accounting

Dr Nothing

Dr Warranty expenses (+E)

Cr Nothing

Cr Warranty liability (+L)

Cash collection/payment for PREVIOUSLY recognised revenue/expenses

When cash is finally collected or paid, they are recorded as a change in assets or liabilities and do not

affect the revenue/expense account

E.g. manufacture makes payment under warranty

Accrual Accounting

Dr Warranty liability (-L)

Cr cash (-A)

Cash Flow BEFORE Recognition

Sometimes, cash is received or paid in advance before the sale is made. These revenue/expenses are

yet to be realised. Cash accounting ignores this and thus OVERSTATES the sales or expenses.

E.g. prepaid insurance for a 24 month period starting next month. This should be recognised as an

asset because it provides benefit, the expense is deferred until next year.

Cash Accounting

Accrual Accounting

Dr Insurance Expense (+E) Dr Prepaid Insurance (+A)

Cr Cash (-A)

Cr Cash (-A)

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Recognition AFTER Cash Flow

When deferred revenue/expenses need to be recognised, but the cash flow has already occurred.

E.g. insurance policy purchased 24 month ago expires, recognised as an expense

Accrual Accounting

Dr Insurance Expense (+E)

Cr Prepaid Insurance (-A)

Accrual Adjustment

Entries often need to be adjusted to incorporate accrual accounting in order to improve the

measurement of financial position and position. These entries are internal transactions to make sure

assets and liabilities are recognised in the correct amount.

- Accrual: revenue/expenses recognised before cash flow

- Deferral: revenue/expenses deferred after cash flow

Deferral: Expiration of Assets – Prepayment

Prepayments are cash paid in advance that will incur expenses in the future. They are classified as

assets because expenditure has been made but there are future economic benefits as a result of past

transactions. Prepayments are current assets if the future value continues into only the next year.

E.g. a company whose balance date is 30th

June pays insurance on 1st January 2012 for the calendar

year 2012 at a cost of $12 000.

When the accounting statements are made, i.e. on balance date, only half the insurance have been

used up. The other half is recorded as an asset, as it can still be used into the next accounting year:

June Dr Insurance expense 6,000

Cr Cash

6,000

Dr Prepaid Insurance 6,000

Cr Cash

6,000

Deferral: Unearned Revenue

Unearned revenue is future revenue where the cash has been received in advance of actually

earning the revenue. Unearned revenue is classified as a liability, because it represents future

sacrifices of economic benefits the entity is presently obliged to make.

E.g. company receives subscription of $240 000 in January for a magazine to delivered monthly for

12 month in the next accounting period. Presently it is unearned revenue because no service is

provided, but the company is obliged to provide them. When they do, they sacrifice economic benefit.

Accrual Accounting $ $

Note

Jan Dr Cash 240,000

payment received in advance

Cr Unearned revenue

240,000

increase in liability, oblige to perform service

Feb Dr Unearned revenue 20,000

service performed, less liability

Cr Sales Revenue

20,000

revenue earned and now recognised

Mar Dr Unearned revenue 20,000

repeat every month for 12 month

Cr Sales Revenue

20,000

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Accrual: Accrued Revenues

Accrued revenue is when a service is provided but cash will not be received until the following

period, they are classified as assets.

E.g. In January, a company deposits $50 000 into a bank at 10% interest rates payable at end of the

period. Although the interest can't be collected yet, it is recorded as an asset:

Jan Dr Accrued Interest 5,000

Cr Interest Revenue

5,000

Accrual: Accrued Expenses

Accrued expenses are when an expense is incurred in a particular period but the cash will not be paid

until the following period, they are classified as liabilities.

E.g. A company pays weekly wages (5 day week) of $5000 each Friday. The balance is 30th

June

which falls on a Wednesday. So the 2 days’ wages after Wednesday for next period is:

Jul Dr Wages Expenses 2,000

Cr Wages Accrued

2,000

Contra and Control Accounts

Most accounts are control accounts, i.e. their value is supported by data and can be physically

measured. Contra accounts are in opposite direction to their control account counterparts. They

allow changes to control accounts without changing the underlying records and data.

Accumulated Depreciation:

To account for property, plant and other physical assets being used up by incurring a depreciation

expense. The asset account doesn’t change because their cost is the same, but their economic value is

being used up. Accumulated depreciation is the amount of depreciation over the life of the asset to

date, whereas depreciation charged this year is the depreciation expense

E.g. A company buys a truck for $50000 with an annual depreciation of $8000. After 2 years, the

truck is sold for $37000. Record the journal entries:

Dr Depreciation Expense 8,000

Cr Accumulated Depreciation

8,000

After two years, deducting the accumulated depreciation gives a net book value.

Cost

Acc. Depreciation

Net Book Value

End of 1st Year

50,000

8,000

42,000

End of 2nd year

50,000

16,000

34,000

When sold, company makes a revenue “gain on sale” of $3000, while the asset and contra is removed

Dr Cash 37,000

Cr Truck Asset

50,000

Dr Accumulated Depreciation 16,000

Cr Gain on sale of truck

3,000

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6. Special Journals, Subsidiary Ledgers and Control Accounts

Special Journals

Special journals are journals that record common transactions of the same type to streamline the

recording of transactions. Entries made in special journal are posted directly to their corresponding

ledger account. Transactions not included in special journals, such as depreciation, are recorded in

the general ledger instead. Common special journals are:

o Sales Journal: records credit sales of inventory

o Purchases Journal: records credit purchase of inventory

o Cash Receipts: records all cash inflows using cheques, including cash sales

o Cash Payment: records all cash outflows using cheques, including cash purchases

Subsidiary Ledger and Control Accounts

Subsidiary ledgers are a set of ledger accounts that collectively represent a detailed analysis of one

general ledger account, the control account. The aggregate balance and data in the control account

can be periodically against all the subsidiary ledgers for that category to ensure accuracy. The debit

and credit entries made to each subsidiary ledger must equal to the total debit and credit in the

control account.

Subsidiary ledgers are separate from the general ledger:

o Accounts receivable (debtors): separate account for each debtor

o Accounts payable (creditors): separate account for each creditor

o Property, plant and equipment: separate account for each property, plant and equipment,

commonly called the fixed asset register

o Raw materials inventory: separate account for each type of raw material held

o Finished goods inventory: separate account for each type of finished good held

Trade Discount

Trade discounts are reductions in the price charged to a customer for a good or service from the

standard price depending on the category of customer or their volume of business. For example,

manufacturer sells at standard price to general public, while giving trade discounts to retailers and

even bigger discounts to wholesalers. The amount of trade discounts are rarely recorded, only the

net amount of transactions are normally included in the accounting systems

Cash Discount

Cash discounts are conditional reductions after determining the selling price as an incentive for

credit customers to quickly settle debts, e.g. a 5% cash discount if payment made on credit purchases

is made within 10 days; otherwise net amount is payable within 30 days, which would be written as

5/10, n/30. Therefore, it does not actually change the original sale price, so it is normally recorded as

an extra transaction, incurring a discount allowed expense.

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7. Internal Control

Internal control systems are a process, affected by an entity’s board of directors, management and

other personnel, designed to provide reasonable assurance in achieving:

- Effectiveness and efficiency of operation

- Accurate and reliable financial data

- Compliance with applicable laws, regulations and management policies

Internal control consists of 5 components (C.R.I.M.E):

o Control activities: policies that ensure management directives are carried out and necessary

actions are taken to manage risks

o Risk assessment: assessment of risks to objectives both internally and externally.

o Information and communication: information must be identified and relayed in the

appropriate timeframe, such as financial reports

o Monitoring: the control system itself is monitored to assess its quality and any deficiencies

o Environment: a control environment that encourages good control activities

Effective Control Activities are:

- Separation of asset handling and recordkeeping so all power does not fall on one person

- Establish clear lines of responsibility

- Physical protection of assets using locks and safes

- Independent approval and reviews for transactions to spot irregularities

- Matching independently generated documents, such as checking sales invoices against orders

Internal Control over Cash

Cash is the asset that is most commonly the subject of theft or fraud, because of its liquidity and

anonymity, i.e. cash can be transferred easily and does not belong to a particular person.

Cash Control Activities:

- Separation of duties for receiving and paying cash

- Separation of duties for recording and handling cash

- All cash receipts and cheques banked in its entirety daily

- Authorised supporting documentation for payments

- Cheques signed by 2 people independent of accounting and invoice approval duties

- Payment invoices stamped so they cannot be fraudulently reused

- Mail opened by someone not involved in record keeping

For example, when a cheque payment comes by mail it should be opened by more than 1 person.

These people should not have duties involved with recordkeeping. Then the cheque should be

recorded on a list of cheque receive

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Bank Reconciliation

Bank statements are monthly statements from banks that summarise all financial transactions in a

bank account. However, usually the ending monthly balance of bank statements will not match the

cash at bank account of the company’s records, due to timing differences in recording.

Bank reconciliations the process to explain the information asymmetry of balances between bank

statements and cash accounts:

Items in company records but NOT bank statement

o Deposits in transit: deposits in company records but not yet processed by bank, e.g. if it was

deposited on the last day of the month

o Outstanding cheques: payment cheques written and recorded by company but not yet

presented to the bank or paid from the bank account

o Require reconciliation with bank statement

Items in bank statement but NOT in company records

o Non-sufficient funds (NSF): payments dishonoured due to lack of funds in account

o Interests collected by bank and notes receivable

o Interest earned on the account

o Bank service charges

o Require adjustments in accounting system, i.e. journal entries

Error in bank statement or accounting system

Steps in Preparing Bank Reconciliation:

1) Tick all information in both cash records, i.e. cash payment journal, cash receipt journal and

the last bank reconciliation and current bank statement.

2) Items in bank statement that are NOT ticked must be added to CPJ or CRJ to give an adjusted

cash balance, these are transactions not recorded by company yet, e.g. dishonoured cheques

3) Items in cash records that are NOT ticked must be outstanding deposits or cheques

Bank Reconciliation at 30th June 2011 $

Ending balance per bank statement

xxx

Add Increases recorded on company records but not on bank statement xxx

Less Decreases recorded on company records but not on bank statement xxx

Adjusted cash balance: Bank

XXX CR

Ending balance per company records

xxx

Add Increase recorded on bank statement but not in company records xxx

Less Decrease recorded on bank statement but not in company records xxx

Adjusted cash balance: Book

XXX DR

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Petty Cash

A petty cash fund is established for making small payments, especially those that are cheques are

impractical for. They are made by cashing a cheque from a company’s regular bank account. The

documents providing evidence for disbursements from petty cash account are vouchers. The petty

cash account is an asset and it is regularly replenished.

They are made by cashing a cheque from a company’s regular bank account.

Dr Petty Cash $200

Cr Cash

$200

Disbursement from Fund

When a voucher is placed in the petty cash box, i.e. a payment is made; NO journal entries are

recorded at the time. This is to avoid a lot of troublesome bookkeeping for small amounts of cash

Reimbursing the Fund

The petty cash fund needs to be replenished when the fund becomes low due to small expenses. At

that time, the vouchers are used to record the expense entries and CASH is credited. The petty cash

account is NOT affected by the reimbursement entry

E.g. after some time, only $32.40 is left in the petty cash fund. Record the reimbursement entries

Dr Cr

Dr Postage expenses $27.50

Dr Stationary expenses $50.80

Dr Motor vehicle expenses $73.40

Cr Cash at bank

$167.60

Value of Accounts Receivable

With accounts receivable there is always some uncertainty regarding whether all of it can be

collected due to accrual accounting. So reductions are often necessary to measure its true value.

There are two ways to record uncertainties in the amount collectable:

Direct Write-off

Debts are written off when there is direct evidence to suggest that the debt is unlikely to be repaid,

e.g. if a customer company goes into liquidation. To record this, the accounts receivable for that

company is directly credited

Dr Bad debts expenses 1,000

Cr Accounts receivable - Company X

1,000

However, this method is rarely used as it doesn’t give a full picture of what accounts receivable is

worth. It doesn’t relate to the revenue that has been earned either.

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Allowance Method

This method credits a contra asset account called allowances for doubtful debts for payments that

may not be collected, while debiting a bad debts expense account. The allowances for doubtful debts

reflect the percentage of the accounts receivable that might not be received, it doesn’t actually state

which customers will not pay.

Recognising bad debts are adjusting journal entries made at the balance date:

Dr Bad debts expense 1,000

Cr Allowance for doubtful debts

1,000

When the debt is determined to be definitely uncollectable, it is written off accounts receivable:

Dr Allowance for doubtful debts 1,000

Cr Accounts receivable

1,000

However, if the bad debt ended up being recovered, then the accounts receivable needs to be

reinstated first, before cash is debited

Dr Accounts receivable 1,000

Cr Allowance for doubtful debts

1,000

Dr Cash 1,000

Cr Accounts receivable

1,000

Estimation of Doubtful Debts

Since the allowance method is accrual accounting, the doubtful debts are estimated from either past

income statements or the age of the debt. In both cases, the journal entry is the same

Income Statement Method

The amount of bad debts is estimated from the net credit sales and past experiences on what % of

credit sales is normally not collected. It is based on the actual company itself.

E.g. Company X made credit sales of $100,000 but in the past it has failed to collect 5% of its sales.

Dr Bad debts expenses 5,000

Cr Allowance for doubtful debts

5,000

Balance Sheet Method

In this method, older the account receivable, the greater probability that the amount will not be

recovered. This gives an amount company is ready to accept as uncollectable.

Days outstanding 0-30 30-60 60-90 90+

Balance $250 $150 $75 $25

Provision factor 0.5% 1% 3% 5%

Provision $1.25 $1.5 $2.25 $1.25

Bad Debts on Balance Sheet

On balance sheet, allowances for doubtful debts are a contra asset account, so accounts receivable

less allowances for doubtful debts gives the net receivable value for the period.

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8. Inventory and Non-Current Assets

Inventory

Businesses that involve purchase, sale or transformation of goods are referred to as merchandising

operations. Merchandising operations hold a current asset called inventory:

- Held for sale in the ordinary course of business, e.g. merchandise

- In the process of production for sale, e.g. unfinished goods

- Materials or supplies to be consumed in the production process, e.g. raw material

Recording the sales of inventory and the cost of goods sold (COGS) uses 2 methods:

Perpetual Method

A method of controlling inventory that maintains continuous records on the flow of units of

inventory for ALL transactions.

- Begins with opening balance of inventory, supported with physical count

- Add cost of purchased inventory, supported with records

- Less cost of goods sold, supported with records

- Ends with closing balance of inventory, supported with physical count

If the physical count in the end does not match the closing balance, e.g. $5000 less, then managers

know that there is a shortage of inventory. Then adjusting journal entries are required:

Dr Inventory shortage expense 5,000

Cr Inventory

5,000

Perpetual method is the preferred method that we have been dealing with:

- Purchase involve crediting cash or accounts receivable

- Sales involves revenue and cost of goods sold

- Closing entries closes all revenues and expenses to P&L summary

Advantage Disadvantage

Provides more accurate control as it records

everything, stock losses easily determined

Costly, managers must pay someone to

constantly record, sort and compile data

Conclusion: perpetual method is better for firms that sell expensive goods. E.g. car dealerships,

since cars are a large investment for the dealers so it needs to be better protected.

Periodic Method

A method of calculating inventory that uses data of opening inventory, additions to inventory, and

end of period count to DEDUCE cost of goods sold. No records are maintained for individual

inventory items. In this method, changes to inventory ledger account only made at END of year.

Purchases Expense Account

Purchases of inventory are NOT recorded on inventory, but rather a purchase expense account.

Dr Purchase expense cost price

Cr Cash/Accounts payable

cost price

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Sales of inventory only needs to have revenue recorded, NOT changes to inventory and the COGS.

Dr Cash/Accounts receivable selling price

Cr Sales revenue

selling price

Closing Entries in Periodic Method

In the periodic method, closing entries not only close the temporary sales and purchases accounts,

they also adjust the balance sheet account of inventory

$ $

Dr Sales Revenue xxx

Cr P&L summary

xxx

Dr P&L summary xxx

Cr Purchase Expenses

xxx

Dr P&L summary xxx

Cr Inventory (opening)

xxx

Dr Inventory (closing) xxx

Cr P&L summary

xxx

Advantage Disadvantage

Lower costs and faster Does not reveal shortage of stock

Conclusion: periodic method is better for stock of low unit value with a large number of sales, such

as retail shops

Cost of Goods Sold

In reality, the cost of each unit of good varies, since goods can become cheaper or more expensive

throughout the year, so often stocks consist of goods purchased at different prices.

Specific Identification

This method tracks each individual item through inventory flow using barcodes or serial numbers:

- An accurate approach

- Based on physical flow of goods

- Time consuming and expensive, but improving with technology

- Used for high value items, e.g. cars and house

Cost Flow Assumption

For most low value items, it is not worthwhile to keep track of every item. Instead, of calculating the

exact COGS and inventory on hand, we make assumptions on cost flow to get a general idea. The 3

major types of cost flow assumptions with periodic systems are:

First-in First-out (FIFO)

Assumes that items acquired first are the first ones sold, so any remaining inventory on balance sheet

are the most recently acquired. This assumption:

- Results in a higher profit and inventory in times of rising prices

- Suitable for perishable items or those subject to obsolescence

- Closing balance is closer to current cost

18

Weighted Average Assumption (AVGE)

Assumes ending inventory are a mixture of old and new units and COGS is the average of cost of all

units, i.e. total cost divide by total units available. Also called moving average method for

perpetual systems. This assumption is suitable for homogeneous products that tend to mix a lot

Last-in Last-out (LILO)

Assumes that items acquired last are the first ones sold, so any remaining inventory on balance sheet

are the oldest units. This assumption:

- Results in higher reported COGS and lower profit level during times of rising prices

- Results in a lower and outdated inventory balance

Non-Current Assets – Property, Plant and Equipment

Property, Plant and Equipment (PPE) are tangible assets that are held for use in the production,

supply of goods or services, or administrative purposes, with benefits lasting more than one period.

Cost of Acquisition

PPE should initially be recorded under its historical cost. This cost includes:

- Purchase price including taxes, minus trade discount

- Costs directly attributable to bring the cost to location, e.g. transportation, and to a condition

necessary for usage, e.g. installation cost

- Estimate of costs associated with restoration and extending its life or value

- Estimates of costs associated with removal and dismantle

Depreciation

PPE usually have long but limited useful lives, i.e. its economic benefit are consumed over time.

Depreciation is the systematic allocation of the cost of an asset over its useful life as a deduction

from profit. It is NOT a system of valuation to measure the current value of assets. Depreciation

recognises an expense that matches the revenue generated by using up the asset’s economic value.

To calculate depreciation, 3 factors are considered:

Useful Life

The estimated useful life of PPE is the period of time over which an asset is expected to be available

for use OR the number of production expected to be obtained from an asset. Useful life is different to

the physical life of an asset!

Residual Value

The estimated residual value is the amount that an entity would obtain from the disposal of an asset

at the end of its useful life. It is used to calculate the depreciable amount, i.e. the amount of

depreciation allocated over an asset’s useful life:

Depreciable Amount Asset Cost Residual Value

Assumption on Flow of Benefit

Depending on how the asset brings economic benefit, the method of allocation of depreciable amount

is different:

19

Assumption Method of Allocation

Spread evenly over asset’s life Straight line depreciation – constant expense

Falls over the asset’s life Reducing balance method – increasing expense

Variable over the asset’s life Units of production – expense depends on volume of production

Straight Line Depreciation

Straight line depreciation is used when the decline in value of an asset is uniform.

Cost Residual ValueDepreciation Expense

Useful Life

Reducing Balance Method

Reducing balance method is used if the asset is expected to contribute more benefit in the earlier

years of its useful life. The depreciation expense is different every year and decreases gradually.

This method requires a depreciation rate and the current book value of the asset

The formula for depreciation expense:

. .

1 .n

Depreciation Expense Cost Acc Dep Depreciation Rate

Residual ValueBook Value where n no of years

Cost

Exception:

If residual value is 0, then this formula cannot be used. In general, the depreciation rate is taken to be

150% of the straight-line percentage of depreciation.

E.g. If a truck was purchased at $40,000, has an estimated useful life of 5 years and can be sold for

$5,000 after 5 years, what is the depreciation expense for the first 2 years?

55000

1 34%40000

: 5000 0 34% $13610

Depreciation Rate

First Year Depreciation Expense

Unit of Production Depreciation

The unit of production method is an activity-based method of allocating depreciation costs. In this

method, we find the depreciation for ONE unit of use or production first. To do so we need to

estimate the number of units to be used or produced over life of asset

/. /

/ . /

Cost Residual ValueDepreciation for ONE unit of use production

Estimated no of units used produced during life

Depreciation Expenes Depreciation for ONE unit of use production no of units used produced

20

E.g. If a truck was purchased at $40,000, has an estimated useful life of 5 years and can be sold for

$5,000 after 5 years. The truck can drive for up to 200,000 km with 20,000 in first year and 80,000

in second years what is the depreciation expense for the first 2 years?

40000 5000$0.175

200000

: 20000 0.175 $3500

: 80000 0.175 $14000

Depreciation per km per km

First Year Depreciation Expense

Second Year Depreciation Expense

Subsequent Expenditure

Any expenditure made on an asset can either increase the value of the asset or become an expense. If

the expenditure:

- Increase productivity, efficiency, output quality or useful life, then it IMPROVES the asset.

Therefore the expenditure is capitalised and added to the asset account

- MAINTAIN current level, i.e. needed for the asset to continue production, then the

expenditure is expensed

Disposal of Non-Current Assets

When PPE needs to be disposed, i.e. sold or scrapped, the steps to record it are:

1) Record depreciation up to the date of disposal

2) Record proceeds or losses from sale

3) Remove the non-current asset from company’s book

E.g. a machine with original cost of $50000 has accumulated depreciation of $24000 as of 30 June

2012. It is sold on 1 August 2012 for $21000 cash. The straight line depreciation is $12000 per year.

Depreciation expense from 30 June to 1 August is 1

12000 $100012

$ $

Dr Depreciation Expense 1,000

Cr Accumulated Depreciation

1,000

50000 24000 1000 $25000

25000 21000 $4000

Carrying Value

Loss on Sale

Final journal entries for disposal:

Dr Cash 21,000

Dr Accumulated Depreciation 25,000

Dr Loss on Sale 4,000

Cr Machinery

50,000

Intangible Assets

An intangible asset is an identifiable non-monetary asset without physical substance. It must also

fit the criteria for an asset in general. Intangible assets include: brand names, trademarks, patents and

copyrights. Intangible assets can also have limited life, in which case the depreciation is called

amortisation.

21

9. Financial Reporting Principles, Accounting Standards and Auditing

Generally Accepted Accounting Principles (GAAP)

GAAP is a set of rules and standards that companies are expected to follow when they prepare their

financial statements. In Australia, the GAAP is a combination of framework issued by the

Australian Accounting Standards Board (AASB) and generally accepted accounting rules.

Underlying Assumptions

The two key underlying assumptions to financial reports are:

- Accrual basis of accounting

- Going concern: assumption that the entity will continue in operation for the foreseeable

future. Otherwise, if must give the liquidation value of its asset, which will often be a lot

less than historical book value

Qualitative Characteristics of Financial Information

Qualitative characteristics are the attributes that make the information provided in financial reports

useful to users. The 4 key qualitative attributes are:

- Understandability: financial reports should be readily understandable to users with a

reasonable knowledge of accounting. However, complex information should not be omitted.

- Relevance: all information should assist users to make, confirm, or correct predictions about

the outcomes of past, present or future events. It is affected by nature and materiality

- Comparability: financial reports should be comparable to other periods and companies

- Reliability: affected by these subcategories:

o Faithful Representation: information must be a faithful representation of that which it

purports to portray, i.e. information must be true

o Substance and Form: transactions and events must be presented in accordance with

their substance and economic reality, not merely the legal or technical requirements

o Neutrality: unbiased information, i.e. the situation and presentation of information

should not be made to achieve a predetermined outcome, e.g. impressing analysts

o Prudence: degree of caution exercised in making accounting estimates in situation of

uncertainty. Make sure assets are not overstated and liabilities not understated

o Completeness: material information is not omitted

Standard Set of Financial Statements

- Balance sheet

- Income statement

- Statement of changes in equity

- Statement of cash flows

- Notes to financial statements, which provide information about accounting policies chosen

and other supplementary information to help interpret data of financial statements

22

Definition of Elements of Financial Statements

Asset

Essential Characteristics Recognition Criteria

- Control by entity

- Future economic benefit

- Result of past transactions

- Probable future economic benefit with

small uncertainty allowed

- A value that can be measured reliably

Liabilities

Essential Characteristics Recognition Criteria

- Present obligation

- Settlement involves loss of future

economic benefit

- Result of past transactions

- Probable that future sacrifices of

economic benefit required

- A value that can be measured reliably

External Auditors Report

External auditing is the evaluation of an organisation’s financial statements by an auditor who is

independent of the management. The role of auditors is to add credibility to financial statements

prepared by the management. The external auditor must:

- Render an independent, unbiased and professional perspective

- Render a competent opinion on the fairness of the financial statements

Types of Audit Opinions

- Unqualified opinion: financial statements are free from missing material information and are

represented fairly in accordance with GAAP

- Qualified opinion: auditor is generally satisfied except for a specific departure from GAAP

- Adverse opinion: financial statements are not presented fairly in accordance with GAAP

- Disclaimer: auditors are unable to express an opinion because of limitations in their work

Principal-Agent Problem

This problem describes the conflicts of interest and moral hazard issues when a principal hires an

agent to perform specific duties that are in the best interest of the principal, but not in the best

interest of the agent. E.g. it is difficult for shareholders of a company (principal) to monitor the

managers (agents) to perform tasks precisely as they want them to. Since the principal faces

information asymmetry and risk regarding whether the agent has effectively completed a contract,

principals create incentives for the agent to act as the principal wants.

Corporate Governance

Corporate governance is the system by which companies are directed and controlled. It is the

relationships between a company’s management, board of directors and its shareholders and

other stakeholders. Its aim is to mitigate or prevent conflicts of interests of stakeholders

- Adequate disclosures and effective decision making to achieve corporate objectives

- Transparency in business transactions

- Statutory and legal compliances

- Protection of shareholder interests by board of directors

- Commitment to values and ethical conduct of business

23

10. Ratio Analysis

Ratio analysis is a tool used to quantitatively analyse the information on financial statements.

Ratios allow comparison to other year, companies or the industry to evaluate the performance

Performance Ratios

Gives indication of a company’s potential for generating profits in the future. In general,

performance ratio should exceed zero and as high as possible, indicating a positive return

Types of Performance Ratios:

Return on Assets

ROA indicates the amount of return earned from a company’s assets. EBIT is usually not shown on

financial statements, but can be calculated by adding interest back to net profit before tax.

Earning Before Interes t & Tax (EBIT)Return on Assets =

Total Assets

Return on Equity

ROE indicates how much return the company is generating from accumulated shareholder’s equity.

It is useful to owners as it measures the efficiency of their equity at generating profits.

Operating Profit After TaxReturn on Equity =

Shareholder's Equity

Profit Margin

Profit margin indicates the percentage of sales revenue that ends up as profit, or the average profit on

each dollar of sales. A low profit margin indicates higher risks that a decline in sales will erase

profits and result in a net loss, or a negative margin. Profit margin also indicates the company’s

pricing strategy and how well it controls costs.

Operating Profit After TaxProfit Margin =

Sales Revenue

Gross Margin

Gross margin is similar to profit margin in that it indicates the company’s pricing strategy. An

increase in profit margin is either due to a better gross margin or a fall in expenses.

Gross ProfitGross Margin =

Sales Revenue

Earnings per Share

Earnings per share (EPS) is the amount of earnings per each outstanding share of a company’s stock.

Net Operating Profit - Dividends on Preferred SharesEarnings per Share =

Weighted Average Number of Outstanding Ordinary Shares

24

Activity (Turnover) Ratios

Gives indication of the company’s operations in certain areas.

Types of Activity Ratios:

Total Asset Turnover

Total asset turnover measures the efficiency of a company’s use of its assets in generating sales

revenue. It is related to profit margin:

- Low profit margin = high turnover, as company’s cut prices to sell more

- High profit margin = low turnover, as company’s raise prices to make more on each unit sold

Sales RevenueAsset Turnover =

Average Total Assets

Inventory Turnover

Inventory turnover is a measure of the number of times inventory is sold or used in a year, reflecting

the efficiency of inventory management. It relates the level of inventories to the volume of activity.

A company with low inventory turnover is in risk of obsolescence or deterioration in its inventory

COGSInventory Turnover

Average Inventory

Average days in inventory measure how long it takes to sell inventory items on average:

365Average Days in Inventory

Inventory Turnover Ratio

Debtors Turnover

Debtors turnover measures the number of times on average receivables are collected in a year. It

indicates the efficiency of the company to collect the amount due from debtors.

Credit SalesDebtors Turnover

Average Trade Debtors

Days in debtors measure how long it takes to recover debts on average:

365Days in Debtors

Debtors Turnover Ratio

- High days in debtor indicate a problem with granting of credit and/or collection policies

- Low days in debtor indicate the credit granting and/or collection policies are too strict

Liquidity Ratios

Liquidity ratios aim to give financial statement users some indication of the company’s ability to pay

its short term debts as they fall due. A company may be forced into liquidation if it cannot pay its

short term debts, even if it might be profitable in the long run

Types of Liquidity Ratios

Current Ratio

Gives indication whether a firm can pay its debts in the current period

Current AssetsCurrent Ratio

Current Liabilities

- Low ratio (< 1) indicate a problem in paying short term debts

- High ratio (> 2) indicates the company may not be efficiently using its current assets

25

Quick Ratio

Quick ratio, or “acid test”, measures the ability of a company to use its cash or quick assets to pay its

short term debts. Quick assets are cash, accounts receivable and short-term investments, i.e. current

assets not including inventory. It indicates whether current liabilities could be paid without having to

sell the inventory, useful for companies that cannot quickly convert its inventory to cash.

Cash + Accounts Receivable + Short -Term InvestmentQuick Ratio =

Current Liabilities

Financial Structure Ratio

Gives indication of the company’s ability to continue operations in the long term, i.e. the risks

Types of Financial Structure Ratio:

Debt-to-Equity Ratio

D/E ratio measures how a company is financed, through debts or shareholder investment.

- Value higher than 1 indicates the assets are mostly financed with debt, which is risky

- Value less than 1 indicates the assets are mostly financed by owners

'

Total LiabilitiesDebt to Equity Ratio

Total Shareholder s Equity

Debt-to-Asset Ratio

Debt-to-asset ratio (D/A) measures the proportion of assets that are financed via debts. The higher

the value, the greater the risks in firm’s operation

Total LiabilitiesDebt to Asset Ratio

Total Assets

Leverage Ratio

Leverage ratio measures the proportion of assets financed by equity. The higher the ratio, the less is

funded by equity and more by debt

'

Total AssetsLeverage Ratio

Total Shareholder s Equity

Du Pont System of Ratio Analysis

The Du Pont system of analysis links the ratios together using the concept of a leverage. Leverage

refers to any technique to multiply gains and losses.

'

Tota l AssetsLeverage

Total Shareholder s Equity

However, leverage is a double edge sword. E.g. a company can leverage its equity by borrowing

money because the more it borrows the less equity capital it needs. Thus, any profits are shared

among less owners so it is proprotionally larger. However, any losses are also burdened more on the

company and borrowing too much money may lead to bankruptcy in a financial downturn.

26

Du point systems links:

- ROA with profit margin and total asset turnover

- ROE with ROA and leverage

ROA = Profit Margin × Total Asset Turnover

Operating Profit After Tax Sales Revenue= ×

Sales Revenue Total Assets

Operating Profit After Tax=

Total Assets

ROE = ROA × Leverage

Operating Profit After Tax Total Assets= ×

Total Assets Total Shareholder's Equity

Operating Profit After Tax=

Total Shareholder's Equity

Limitations of Financial Statement Ratios

o Ratios rely on past information

- Ratios assume past relationships are useful in forecasting future performance

- Numerous factors can prove otherwise

o Ratios rely on historical cost financial statements

- Failure to adjust for inflation or market values result in current dollar amounts being

compared to past dollar amounts. E.g. current dollar profits with historical dollar assets

o Ratios are based on year end data

- Year-end data may not be reflective of the typical situation of company

- Management may improve ratios, e.g. current ratio, by using cash to pay off debts

o Not all required information will be disclosed

- E.g. foreign companies may not disclose COGS so inventory turnover hard to calculate

o The balance sheet and income statement may not provide all information

- Financial statement users should also examine director’s report, auditors report and etc.

Common Size Financial Statements

Common size financial statements present all balance sheet items as a percentage of total assets and

profit and loss items as a percentage of total sales. This way the financial statements factor out the

size of the company and assist in comparing companies and analysing trends.

Normal Common Size

Sales $500,000 100.00

Cost of Goods Sold $384,000 76.80

27

11. Management Accounting: Introduction and Cost Concepts

Management accounting is the processes and techniques that focus on the effective use of

organisational resources to support managers in their task of enhancing both customer value and

shareholder value:

o Customer value: the value that a customer places on a particular feature/product

o Shareholder value: the value that shareholders place on a business

Management accounting systems are information systems that produce the information for all

levels of management to manage resources and create value. The key functions of management are

planning, directing, motivating and controlling. Some common management accounting approaches

are:

o Total Quality Management: a comprehensive philosophy for continuously improving the

quality of products. It functions on the premise that the quality of products is the

responsibility of everyone involved in its production or consumption. I

o Just-in-Time Systems: a production strategy that strives to improve returns on investment

by reducing in-process inventory and associated carrying costs. It aims for zero defects and

reduced setup time, using a flexible workforce and a small number of suppliers.

o Customer Relationship Management: a model that seeks to find, attract and win new

clients while retaining existing customers, enticing former clients to return and reducing the

cost of marketing and client services.

Organisational Framework

In general, organisations can be classified into 3 categories with each type needing different cost

information:

o Manufacturing: produce goods by converting raw materials through use of labour and

capital inputs such as plant and machinery.

o Merchandising: buy goods already made by manufactures and sell them to consumers.

Those that sell directly to consumers are retailers while those that sell to other

merchandising firms are wholesalers

o Servicing: provide a service to customers, dealing with intangible products.

Cost Concepts

Cost is the cash or cash equivalent value sacrificed for goods and services that are expected to bring

a current or future benefit to the organisation. As costs expire in the production of revenues, they

become expenses whereas a cost that has not expired is an asset. Other cost terminologies are:

o Differential cost: amount by which a cost differs between two alternatives

o Controllable costs: costs heavily influenced by a manager, therefore all costs are somewhat

controllable to some degree, depending on which manager’s point of view

o Non-controllable cost: cost that cannot be influenced by a manager

28

Classification of Costs by Function

Manufacturing Costs

Manufacturing costs are the costs associated with the process of converting raw materials into

finished goods. It can be further classified as:

o Direct Manufacturing Costs: costs that can be traced to a cost object, i.e. items/activities to

which costs are assigned, e.g. cost raw materials and cost of labour

- Direct materials: raw materials that can be directly traceable to product

- Direct labour: cost of labour used to covert raw material to a finished product

o Indirect Manufacturing Costs: other overhead costs that are common to all products, i.e.

ones that cannot be associated with a particular cost object

- Indirect materials: generally material necessary for production that do not become or

become an insignificant part of finished product, e.g. glue

- Indirect labour: generally factory labour other than those that actually transform raw

materials into a finished good, e.g. supervisors, maintenance

Non-Manufacturing Costs

Costs not associated with the direct production of finished goods:

o Selling Costs: cost necessary to market and distribute a product, e.g. shipping, advertising

o Administrative Costs: costs associated with the general administration of the organisation

that cannot be assigned to either marketing or manufacturing, e.g. legal fees, R&D

Related Cost Concepts

o Period Cost: costs that are expensed in the period in which they are incurred. ALL selling

and administrative costs are period costs

o Product Cost: costs that have potential to produce revenues beyond current period. All

manufacturing costs that that leads to products not sold in the current period are product costs

o Prime Costs: combination of direct materials and direct labour

o Conversion Costs: combination of direct labour and manufacturing overhead

29

Financial Statements and the Functional Classification

When calculating profit, there are two major functional categories of expense:

- Cost of goods sold represents ALL manufacturing expenses

- Operating expenses represents ALL non-manufacturing expenses

Cost of goods sold is the cost of direct materials, direct labour and overhead attached to the units sold.

To calculate COGS, it is first necessary to determine cost of goods manufactured

Cost of goods manufactured represents the total cost of goods completed during the current period.

It is the sum of all manufacturing costs including direct materials, direct labour and overhead, then

added to the beginning work in progress, and then subtracting ending work in progress:

COGM Direct Material Direct Labour Overhead Costs Beginnning WIP Ending WIP

- Beginning WIP is added because that’s the cost of unfinished goods from last period

- Ending WIP is subtracted because that’s the cost of unfinished goods for next period

Work in progress (WIP) consists of all partially completed units found in production at a given

point in time. A manufacture usually has 3 types of inventory:

- Raw materials

- Work in progress

- Finished goods

The detail calculation of cost of goods manufactured is shown in a supporting schedule called the

statement of cost of goods manufactured:

Statement of Cost of Goods Manufactured

Direct Materials:

Beginning Raw Inventory

$400,000

Add Purchases

$900,000

Materials Available

$1,300,000

Less Ending Inventory

-$100,000

Direct Materials Used

$1,200,000

Direct Labour

$700,000

Manufacturing Overhead

$900,000

Add Beginning Work in Progress

$400,000

Total Manufacturing Costs

$3,200,000

Less Ending Work in Progress

-$800,000

Cost of Goods Manufactured

$2,400,000

Then cost of goods sold is given by:

Goods Available for Sale

COGS Beginning Finished Goods COGM Ending Finished Goods

30

12. Management Accounting: Cost-Volume-Profit Analysis

Cost Behaviour

Cost behaviour deals with how costs change with respect to changes in activity levels. Cost drivers

are factors that cause activity costs. Knowing how cost behaves in respect to a relevant cost driver is

essential for planning, controlling and decision making. 3 types of cost behaviours are:

Fixed Costs

Fixed costs are constant in total within the relevant range as the level of the cost driver varies. The

relevant range is the range over which the assumed fixed cost relationship is valid.

Variable Costs

Variable costs vary in direct proportion to changes in a cost driver. It has a linear relationship:

Total Variable Cost Variable Cost per unit Quantity

Mixed Costs

Mixed costs have both a fixed and a variable component. It also has a linear relationship:

Total Cost Fixed Cost Variable Cost per unit Quantity

Profit and Loss Statement – Cost Behaviour

o Variable cost of goods sold (product cost): total variable manufacturing costs attached to

units sold, e.g. direct materials, direct labour and variable overhead such as power.

o Contribution margin (period cost): sales revenue minus ALL variable expenses

o Variable-costing profit (period cost): contribution margin minus ALL fixed expenses

Cost-Volume-Profit (CVP) Analysis

CVP analysis focuses on volume of activity, unit selling prices, variable costs, fixed costs and sales

mix using variable-costing profit and loss statement:

Profit before Tax = Sales Revenue Variable Expenses Fixed Expenses

Unit-Sold Approach

This approach to CVP analysis measures sales activity in terms of the number of units sold.

Contribution margin per unit is the difference between unit revenue and unit variable cost.

31

Sales-Revenue Approach

This approach of CVP analysis measures sales activity in terms of the total dollars of revenue. This

approach is useful for when units are difficult to identify, e.g. service industry

- Variable cost ratio (vr): the proportion of each sales dollar used to cover variable cost

- Contribution margin ratio (1-vr): the proportion of each sales dollar available to cover

fixed costs and provide a profit

Limitations of CVP Analysis:

- It assumes a linear revenue and cost function

- It assumes that what is produced is sold

- It assumes that fixed and variable costs can be accurately identified

- Selling prices and costs are assumed to be known with certainty, which is often not the case