trim size: 215mm wide x 275mm deep full disclosure ... · 12 accounting: building business skills...

12 Accounting: Building business skills

TRIM SIZE: 215MM WIDE X 275MM DEEP

creditors might not know about this lawsuit. The full disclosure principle requiresthat all circumstances and events that would make a difference to financial statementusers should be disclosed. If an important item cannot reasonably be reported directlyin the financial statements, then it should be discussed in notes that accompany thestatements.

The accounting assumptions and principles are shown graphically in figure 1.5.

QUALITATIVE CHARACTERISTICSNow let’s turn our attention to the needs of external users of accounting information.Statement of Accounting Concepts (SAC) 2 identifies the objective of general-purposefinancial reports as the provision of information useful for making and evaluatingdecisions about the allocation of scarce resources. But how is that objective bestserved? In what format should financial information be presented? How should assets,liabilities, revenues and expenses be measured? SAC 3 provides guidance on the qual-itative characteristics that information contained in general-purpose financial reportsshould have in order to achieve the objective of providing useful information fordecision making.

The two main qualitative characteristics of information contained in general-purposefinancial reports are relevance and reliability. All relevant and reliable financial infor-mation should be included, if it passes the materiality test. SAC 3 also states thatgeneral-purpose financial reports should be comparable and understandable. We willconsider each of these characteristics in turn.

RelevanceInformation of any sort is relevant if it would influence a decision. Accounting infor-mation is relevant if it would make a difference in a business decision. For example,when Colorado Group Ltd issues financial statements, the information in the statementsis considered relevant because it provides a basis for forecasting future profits.Accounting information is also relevant to business decisions because it confirms or cor-rects previous expectations. Thus, Colorado Group Ltd’s financial statements help pre-dict future events and provide feedback about previous expectations for the financialhealth of the company.

Assets should be recorded at cost.

Historical cost

Only those things that can be expressed in terms of money should be included in the accounting records.

Monetary assumption

Accountingrecords• Salaries paidMeasure ofemployeesatisfaction

Salaries paid

Total numberof employees

Percentage ofinternationalemployees

Every entity can be separately identified and accounted for.

Accounting entity assumption

Toyota

Ford

GMH

GMH

FORD

CHRYSLER

The economic life of a business can bedivided into artificial time periods.

Period assumption

Start ofbusiness

End ofbusiness

1998

2000 2002 2004 2006

2008

J F

QTR1

QTR2

QTR3

QTR4

M A M J J A S O N D

The business will continue in operation longenough to carry out its existing objectives.

Going concern assumption

Now Future

Circumstances andevents that make adifference to financialstatement usersshould bedisclosed.

Full disclosure principle

Figure 1.5 Accountingassumptions and

principles

Ch 01 Accounting BBS 2 Tuesday, September 10, 2002 9:26 AM

Chapter 1: Introduction to financial statements 13


ReliabilityReliability of information means that the information can be depended on. To bereliable, accounting information must be without undue error. Also, the informationmust be a faithful representation of what it purports to be. If a company’s financial state-ments report sales of $20 million when it actually had sales of $10 billion, then the state-ments are not a faithful representation of the company’s financial performance. Finally,accounting information must be unbiased — it must not be selected, prepared or pre-sented to favour one set of interested users over another.

Materiality testThe inclusion of all relevant and reliable information in financial reports is subject to amateriality test. Information is material if its omission or misstatement has the potentialto adversely affect users’ decisions. Information that is immaterial does not need to beseparately identified. However, this does not mean that we should not record immaterialtransactions. For example, if Colorado Group Ltd sold a coathanger for $1 this would beconsidered immaterial; the sale would be recorded in the accounting records although itwould not be separately identified in the financial statements.

Being relevant, reliable and passing the materiality test is still not enough. SAC 3identifies two other qualitative characteristics, comparability and understandability. Twoconstraints, timeliness and cost versus benefit, are also identified in SAC 3.

ComparabilityLet’s say that you and a friend kept track of your height each year as you were growingup. If you measured your height in feet and your friend measured hers in centimetres,it would be difficult to compare your heights. A conversion would be necessary. Inaccounting, comparability results when different companies use the same accountingprinciples.

At one level, accounting standards are fairly comparable because they are basedon certain qualitative characteristics, basic principles and assumptions. However,standards still allow for some variation in methods. For example, there are differentways to measure inventory. Often these different methods result in differentamounts of net profit. To make comparison across companies easier, each companymust disclose the accounting methods used. From the disclosures, the external usercan determine whether the financial information is comparable and try to makeadjustments. Unfortunately, converting the accounting numbers of companies thatuse different methods is not as easy as converting your height from feet tocentimetres.

One factor that can affect the ability to compare two companies is their choice ofbalance date. Most companies choose 30 June as their balance date, but other dates arealso used. For example, look at Colorado Group Ltd’s balance date. Retailers often usebalance dates that coincide with the end of a week. However, this practice results insome years having 52 weeks whereas in other years (and for other companies) financialstatements may be for a 53-week period.

INTERNATIONAL NOTEAccounting standards differ between countries. This can complicate comparison of companies from different countries. Through the International Accounting Standards Board, standard setters around the world are working towards international harmonisation of accounting.

�

Helpful hintAn accounting time period that is 1 year long is called a financial year or a fiscal year.

B U S I N E S S I N S I G H T

Management perspectiveWhy do companies choose the particular year-ends that they do? Forexample, why doesn’t every company use 30 June as the accountingyear-end? Many companies choose to end their accounting year when

inventory or operations are at a low. This is advantageous because compilingaccounting information requires much time and effort by managers, so they wouldrather do it when they aren’t as busy operating the business. Also, inventory is easierand less costly to count when it is low. Some companies whose year-ends differ from30 June are Colorado Group Ltd, CSR Ltd and Freedom Group Ltd.

Ch 01 Accounting BBS Page 13 Tuesday, September 10, 2002 9:26 AM



Users of accounting information also want to compare the same company’s financialresults over time. For example, to track Colorado Group Ltd’s net profit over severalyears, you would need to know that the same principles have been used from year toyear; otherwise, you might be ‘comparing apples with oranges’. Comparability is not sat-isfied unless a company uses the same accounting principles and methods from year toyear. Thus, if a company selects one inventory accounting method in the first year ofoperations, it is expected to continue to use that same method in succeeding years.When financial information has been reported on a consistent basis, the financial state-ments permit meaningful analysis of trends within a company.

A company can change to a new method of accounting if management can justify thatthe new method produces more meaningful financial information or if it is required bya change in accounting standards. In the year in which the change occurs, the changemust be disclosed so that users of the statements are aware of the lack of consistency.

UnderstandabilityInformation contained in general-purpose financial reports should also be understand-able. But whether information is understandable depends on the capabilities of the indi-vidual user. In maintaining this qualitative characteristic, preparers should be mindful ofusers of general-purpose financial reports who have the proficiency to comprehend thesignificance of accounting practices, i.e. users who understand the effect of alternativeaccounting methods on financial statements. It is not practical to require financial state-ments to be understandable to novices. Entities often need to report on complex trans-actions that cannot always be simplified to the extent that someone with no knowledgeof accounting could understand them.

Figure 1.6 summarises the qualitative characteristics identified in SAC 3 to makegeneral-purpose financial reports serve their objective of providing information that isuseful for decision making. These characteristics can involve some trade-offs. Forexample, information about future profits is very relevant. However, as we are unable totell the future, such information lacks reliability. There is also some overlap between thequalitative characteristics identified in SAC 3 and the accounting assumptions and prin-ciples described in the preceding discussion. For example, the purpose of the full dis-closure principle is that relevant information be provided.

The accounting assumptions and principles and the qualitative characteristics,together with accounting standards, are collectively referred to as Australian generallyaccepted accounting principles (GAAP). Australian GAAP are different from GAAP inother countries, such as the United States. The differences arise mainly in the detailedprescriptions of accounting standards. Every Australian accounting standard issued bythe AASB includes a statement of conformity with New Zealand accounting standardsand with international accounting standards. Any differences are specified in the state-ment of conformity. Australian GAAP are almost identical to New Zealand GAAP. (Thedifferences between Australian GAAP and New Zealand GAAP in some accountingstandards are covered in intermediate and advanced accounting courses.)

INTERNATIONAL NOTEIn the United States, the term consistency is used to refer to comparability of financial statements of the same entity over time.

�

Relevance1. Provides a basis for predictions2. Confirms or corrects previous

expectations

Reliability1. Without undue error2. Faithful representation3. Unbiased

Comparability1. With different companies2. With different years of the

same company

UnderstandabilityAble to be understood byproficient users

BIGSHOT

Tell me only whatI need to know.

I promise to tellthe whole truth

Apples Oranges

Which is better?

Now I get it!

Figure 1.6 Qualitativecharacteristics of

information in general-purpose financial reports




CONSTRAINTS IN ACCOUNTINGThe characteristics we have discussed are intended to provide users of financial state-ments with the most useful information. Taken to the extreme, however, the pursuit ofuseful financial information could be far too costly to the company. Therefore, someconstraints have been acknowledged in SAC 3 to ensure that GAAP are applied in areasonable fashion, from the perspectives of both the company and the user. Con-straints permit a company to modify generally accepted accounting principles (otherthan accounting standards) without jeopardising the usefulness of the reported infor-mation. The constraints are timeliness and costs versus benefits.

These constraints are also very important considerations for standard setters. Whensetting the rules prescribed by accounting standards consistent with the qualitativecharacteristics identified in SAC 3, standard setters need to consider the amount of timeand the costs required to prepare the information to be reported. These constraints areconsidered below.

TimelinessFinancial information may lose its relevance if it is not reported in a timely manner. Forexample, if we were to wait until we could determine whether each customer makes awarranty claim before reporting the profit on a sale, the financial statements would bedelayed by years for some companies. Application of the timeliness constraint meansthat the preparer should not take so long to collect and prepare financial informationthat the reported information loses its relevance. Application of this principle may meanthat some transactions and events are reported on before all the facts are known. Con-versely, if we waited until all information were available, it may be too late for userswho have to make decisions in the interim.

Costs versus benefitsAn important consideration is the costs versus benefits of financial information. Pre-parers and standard setters seek to ascertain that the costs of preparing certain financialinformation are not greater than the benefits to be derived from using that information.Costs include collection, storage, retrieval, presentation, analysis and interpretation,potential loss of or reduction in competitive position, and the risk of misallocation ofresources that could result from decisions if the information is unreliable. Benefits arethe results of sound decisions made using the information contained in general-purposefinancial reports. The costs and, to a greater extent, the benefits, of financial informationare difficult to measure. Consequently, although this form of economic analysis of theprovision of financial information is very important, it is unavoidably subjective.

>> Review it1. What are generally accepted accounting principles?

2. What is the basic objective of financial information?

3. Describe the assumptions and principles underlying financial statements.

4. Explain the two main qualitative characteristics of information in general-purpose financial reports.

FINANCIAL STATEMENTS AND THE BASIC ACCOUNTING EQUATIONFinancial position, financial performance and cash flows are of interest to users ofaccounting information. For business purposes, it is customary to arrange this informationin the format of three different financial statements, which form the backbone of financialaccounting. To present a picture at a point in time of what your business controls (its

B E F O R E Y O U G O O N

LEARNING OBJECT IVE5

Describe the three main financial statements and the basic accounting equation relating to the statement of financial position.




assets) and what it owes (its liabilities), you would prepare a balance sheet. Assets areformally defined in SAC 4 as future economic benefits controlled by the entity as a resultof a past transaction or other past event. Liabilities are formally defined in SAC 4 asfuture sacrifices of economic benefits that the entity is currently obliged to make as aresult of a past transaction or other past events. We will look at assets and liabilities inmore detail in later chapters.

As of 30 June 2001, when a balance sheet is prepared in accordance with accountingstandards for external reporting, it is called a statement of financial position.Throughout this text we will use the term statement of financial position when referringto both the internal report (balance sheet) and the external report. Although their basiccomposition is the same, the statement of financial position and balance sheet are notusually identical. This is because the internal report (the balance sheet) typically showsmore detail than the external statement of financial position.

To show how successfully your business performed during a period of time, youwould report its revenues and expenses in the profit and loss statement. When aprofit and loss statement is prepared in accordance with accounting standards forexternal reporting, it is called the statement of financial performance. This title forthe external financial statement was introduced in June 2001. Throughout this text wewill use the term statement of financial performance when referring to both the internalreport (profit and loss statement) and the external report. They are not usually identicalbecause the internal report (the profit and loss statement) typically shows more detailthan the external statement of financial performance. The presentation of the statementof financial performance will be covered in more detail in later chapters.

Finally, of particular interest to you, your bankers and other creditors is the state-ment of cash flows to show where your business obtained cash during a period oftime and how that cash was used. The statement of cash flows is considered in moredetail in chapter 10.

To introduce you to these statements, we have prepared the financial statements for amarketing agency, Wong Pty Ltd, in figure 1.7. Take some time now to look at theirgeneral form and categories in preparation for the more detailed discussion that follows.

STATEMENT OF FINANCIAL PERFORMANCEThe purpose of the profit and loss statement is to report the success or failure of thecompany’s operations for a period of time. To indicate that Wong’s statement reports theresults of operations for a period of time, the statement is dated ‘for the month ended31 October 2003’. The statement lists the company’s revenues followed by its expenses.Finally, the net profit (or net loss) is determined by deducting expenses from revenues.This result is the famed ‘bottom line’ often referred to in business.

Why are financial statement users interested in the bottom line? Managers allocateresources based on their beliefs about the future performance of a company. If investorsbelieve that Wong Pty Ltd will be even more successful in the future they may bewilling to invest more capital. Investors are interested in a company’s past net profitbecause it provides some information about future net profit. Similarly, creditors alsouse the profit and loss statement to predict the future. When a bank lends money to acompany, it does so in the belief that it will be repaid in the future. If it didn’t think itwas going to be repaid, it wouldn’t lend the money. Therefore, before making the loanthe bank loan officer will use the profit and loss statement as a source of information topredict whether the company will be profitable enough to repay its loan.

INTERNATIONAL NOTEThe statement of financial performance is referred to as the income statement in the United States. Sometimes this term is used by businesses operating in Australia.

�

Helpful hintThe heading of every statement of financial performance identifies the company, the type of statement and the time period covered by the statement. Usually another line is added to indicate the unit of measure; when it is used, this fourth line usually indicates that the data are presented ‘in thousands’ or ‘in millions’.




WONG PTY LTDStatement of Financial Performance

for the month ended 31 October 2003

Service revenuesExpenses:

Salaries expenseSupplies expenseRent expenseInsurance expenseInterest expenseDepreciation expense

$ 3 2001 500

900505040

$10 600

5 740Profit before tax

Tax expense4 8602 000

Net profit after tax $ 2 860

WONG PTY LTDStatement of Financial Position

as at 31 October 2003

Assets

CashAccounts receivableAdvertising suppliesPrepaid insuranceOffice equipment

$15 200200

1 000550

4 960Total assets $ 21 910

Liabilities and owners’ equity

LiabilitiesAccounts payableInterest payableRevenue received in advanceSalaries payableBank loan

$ 2 50050

8005 0005 000

Total liabilitiesOwners’ equity

Share capital 10 000

$ 9 550

Retained profits 31/10/03 2 360Total owners’ equity 12 360

$ 21 910

WONG PTY LTDStatement of Cash Flows

for the month ended 31 October 2003

Cash flows from operating activitiesCash receipts from operating activitiesCash payments for operating activities

$11 200(5 500)

Net cash provided by operating activities

Cash flows from investing activitiesPurchased office equipment (5 000

$

)

5 700

Net cash used by investing activities

Cash flows from financing activitiesIssue of sharesProceeds from bank loanPayment of dividend

10 0005 000(500)

(5 000)

Net cash provided by financing activities 14 500Net increase in cashCash at beginning of period

15 2000

Cash at end of period $15 200

Calculation of retained profits

Retained profits 1/10/03Net profit after taxLess: Dividends

$ —2860(500)

Retained profits 31/10/03 2360

Figure 1.7 Wong Pty Ltd’s financial statements

Helpful hintNote that final sums in the statements are double-underlined.

Helpful hintThe arrows in this illustration show interrelationships of the three financial statements.




Note that the issue of shares and dividend distributions are not used in determiningnet profit. For example, $10 000 of cash received from issuing new shares was nottreated as revenue by Wong Pty Ltd, and dividends paid of $500 were not regarded as abusiness expense.

STATEMENT OF FINANCIAL POSITIONThe statement of financial position reports assets and claims to those assets at a specificpoint in time. These claims are subdivided into two categories: claims of creditors andclaims of owners. Claims of creditors are called liabilities. Claims of owners are calledowners’ equity (or shareholders’ equity). This relationship is shown in equation formin figure 1.8. This equation is referred to as the basic accounting equation.

Assets must be in balance with the claims to the assets.As you can see from looking at Wong’s statement of financial position in figure 1.7,

assets are listed first, followed by liabilities and owners’ equity. Owners’ equity comprisestwo parts: (1) share capital and (2) retained profits and reserves. As noted earlier, sharecapital results when the company issues shares. Wong Pty Ltd has share capital of $10 000.

But where did that number for retained profits come from, and what does it mean? IfWong Pty Ltd is profitable, at the end of each period, usually a year, it must decide whatportion of profits to pay to shareholders in dividends. In theory it could pay all of itscurrent-period profits, but few companies choose to do this. Why? Because they want toretain part of the profits to allow for further expansion. High-growth companies, forexample, often choose to pay no dividends. Retained profits is the net profit retainedin the company.

The amount of retained profits reported in the statement of financial position at the endof the period is the amount of retained profits at the beginning of the period, plus netprofit after tax for the period, less any amount distributed as a dividend during the period.This may be reported on the statement of financial position. Alternatively, it may be shownas a separate note or at the end of the statement of financial performance. Companies canchoose their own format for the presentation of internal financial statements.

Reserves also form part of owners’ equity. Some reserves are accumulated profit andresult from transferring amounts from retained profits to reserves. Other reserves resultfrom the application of accounting standards involving asset revaluations and the trans-lation of foreign currencies. Asset revaluations are dealt with in a later chapter; foreigncurrency translation is beyond the scope of this book.

Wong Pty Ltd has no reserves. The owners’ equity of Wong Pty Ltd is $12 360,consisting of share capital of $10 000 and retained profits of $2360.

DECISION TOOLKIT

Are the business’s operations profitable?

Statement of financial performance

The statement of financial performance reports on the success or failure of the business’s operations by reporting its revenues and expenses.

If the business’s revenues exceed its expenses, it will report net profit; otherwise it will report a net loss.

Decision checkpoints Info needed for decision Tool to use for decision How to evaluate results

Each chapter presents useful information about how decision makers use financial statements. Decision toolkits summarise discussions of key decision-making contexts and techniques.

Liabilities= Owners’ equity+Assets

Figure 1.8 Basicaccounting equation

Helpful hintThe heading of a statement of financial position must identify the entity, the type of statement and the date.

Alternative terminologyOther names for share capital are paid-up capital and contributed equity.

INTERNATIONAL NOTEIn the United States, it is common to prepare a separate statement reporting on the movement in retained profits, referred to as retained earnings, during the period.

�




Creditors use the statement of financial position as another source of information todetermine the likelihood that they will be repaid. They carefully evaluate the nature ofa company’s assets and liabilities. For example, does the company have assets thatcould easily be sold to repay its debts? Managers use the statement of financial positionto determine whether inventory is adequate to support future sales and whether cashon hand is sufficient for immediate cash needs. Managers also look at the relationshipbetween debt and owners’ equity to determine whether they have the best proportionof debt and equity financing.

STATEMENT OF CASH FLOWSThe main purpose of a statement of cash flows is to provide financial information aboutthe cash receipts and cash payments of a business for a specific period of time. To helpinvestors, creditors and others in their analysis of a company’s cash position, the state-ment of cash flows reports the cash effects of a company’s (1) operating activities, (2)investing activities and (3) financing activities. In addition, the statement shows the netincrease or decrease in cash during the period, and the cash amount at the end of theperiod.

Users are interested in the statement of cash flows because they want to know whatis happening to a company’s most important resource. The statement of cash flows pro-vides answers to these simple but important questions:• Where did cash come from during the period?• How was cash used during the period?• What was the change in the cash balance during the period?

The statement of cash flows for Wong, in figure 1.7, shows that cash increased by$15 200 during the year. This resulted because operating activities (services to clients)increased cash by $5700, financing activities increased cash by $14 500, and investingactivities used $5000 of cash for the purchase of equipment.

DECISION TOOLKIT

Does the business rely mainly on debt or owners’ equity to finance its assets?

Statement of financial position The statement of financial position reports the business’s resources and claims to those resources. There are two types of claims: liabilities and owners’ (shareholders’) equity.

Compare the amount of debt versus the amount of owners’ (shareholders’) equity to determine whether the business relies more on creditors or owners for its financing.

DECISION TOOLKIT

Does the business generate sufficient cash from operations to fund its investing activities?

Statement of cash flows The statement of cash flows shows the amount of cash provided or used by operating activities, investing activities and financing activities.

Compare the amount of cash provided by operating activities with the amount of cash used by investing activities. Any deficiency in cash from operating activities must be made up with cash from financing activities.


Helpful hintThe heading of a cash flow statement must identify the entity, the type of statement and the time period covered by the statement.





INTERRELATIONSHIPS OF STATEMENTSBecause the results on some statements are used as inputs to other statements, the state-ments are interrelated. These interrelationships are evident in Wong’s statements infigure 1.7.1. The statement of financial position depends on the results of the statement of finan-

cial performance. Wong reported net profit of $2860 for the period. This amount isadded to the beginning amount of retained profits as part of the process of deter-mining ending retained profits.

2. The statement of cash flows and the statement of financial position are also interre-lated. The statement of cash flows shows how the cash account changed during theperiod by showing the amount of cash at the beginning of the period, the sourcesand uses of cash during the period, and the $15 200 of cash at the end of the period.The ending amount of cash shown on the statement of cash flows is reflected inamounts reported on the statement of financial position.Study these interrelationships carefully. To prepare financial statements you must

understand the sequence in which these amounts are determined, and how each state-ment affects the next.

A quick look at Colorado Group Ltd’s financial reportsThe same relationships that you observed among the internal financial statements ofWong Pty Ltd are evident in the 2002 financial statements of Colorado Group Ltd, whichare presented in figures 1.9 to 1.14. We have simplified the financial statements to assistyour learning — but they may look complicated to you anyway. Do not be alarmed bytheir seeming complexity. (If you could already read and understand them, there wouldbe little reason to take this course.) By the end of the book, you’ll have a great deal ofexperience in reading and understanding financial statements such as these. ColoradoGroup Ltd’s actual financial statements are presented in appendix A at the back of thebook.

Before we dive in, we need to explain two points:1. Colorado Group Ltd, like most companies, presents its financial statements for more

than one year. Financial statements that report information for more than one periodare called comparative statements. Comparative statements allow users to comparethe financial position of the business at the end of an accounting period with that ofprevious periods.

2. Note that numbers are reported in thousands on Colorado Group Ltd’s financial state-ments — i.e. numbers are rounded to the nearest thousand. Thus, the company’s netprofit for 2002 was $17 146 000 not $17 146.

Statement of financial performanceColorado Group Ltd’s statement of financial performance is presented in figure 1.9. Itreports total revenues in 2002 of $381 890. It then subtracts three types of expenses —cost of goods sold; selling, borrowing, and administrative expenses; and income taxexpense — to arrive at net profit of $17 146. This is an 18.5% increase over profit for theprevious year. (Remember, the figures quoted are in thousands.)

Retained profitsColorado Group Ltd presented information about its retained profits in the statement offinancial performance (then termed the profit and loss statement) in 2001. As a result ofchanges in accounting standards, this information is contained in the notes to the finan-cial statements in 2002. The amount of $38 323 reported as retained profits at 26 January2002 reflects retained profits of $28 890 at the beginning of the reporting period, plus$17 146 profit for the year, less dividends of $7 713.

Helpful hintThe percentage change in any amount from one year to the next is calculated as follows:

Thus, the percentage change in profit is

Change during period×

100Previous value 1

Change in profit×

100Previous year’s profit 1




Statement of financial positionAs shown in its statement of financial position in figure 1.10 (p. 22), Colorado GroupLtd’s assets include receivables, cash, inventories, and property, plant and equipment,plus other types of assets that we will discuss in later chapters, such as prepaidexpenses. The company’s total assets increased from $102 327 on 27 January 2001 to$134 564 on 26 January 2002. Its liabilities include accounts payable as well as interest-bearing liabilities such as a bank loan.

You can see that Colorado Group Ltd relies more on equity financing than on debt —53% of its assets are financed by owners’ equity. As you learn more about financialstatements we will discuss how to interpret the relationships and changes in financialstatement items.

Statement of cash flowsFrom the cash flow statement we can see that Colorado Group Ltd’s cash increased by$10 361 during the year ended 26 January 2002. The reasons for this increase can bedetermined by examining the statement of cash flows in figure 1.11 (p. 23). The com-pany generated $35 756 from its operating activities during the year. Its investing activi-ties included capital expenditures (purchases of property, plant and equipment) as wellas proceeds from the sale of non-current assets. The net effect of its investing activitieswas an outflow of cash of $17 314. Its financing activities involved the payment of cashdividends. In all, the net effect of the cash generated from its operating activities, lessthe cash used in its investing and financing activities, was an increase in cash of$10 361.

COLORADO GROUP LTD AND ITS CONTROLLED ENTITIESStatement of Financial Performance

for the financial year ended 26 January 2002(in thousands)

Consolidated2002 2001

Revenue from sale of goodsDividends from subsidiariesOther revenues from ordinary activities

$377 993—

3 897

$323 754—

1 632Total revenueCost of goods soldSelling expensesBorrowing costsAdministration and other expenses

((

381 890198 067130 236

(1 750(27 120

))))

((

325 386172 606111 099

(1 255(18 519

))))

Profit from ordinary activities beforerelated income tax expense

Income tax expense relating to ordinary activities24 717(7 571)

21 907(7 433)

Profit from ordinary activities afterrelated income tax expense $ 17 146 $ 14 474

Figure 1.9 Statement of financial performance for Colorado Group Ltd

Helpful hintThe heading of every financial statement identifies the entity, the type of statement and the time period or date covered by the statement. Usually, another line is added to indicate the unit of measure; when it is used, this fourth line indicates that the data are presented ‘in thousands’ or ‘in millions’.




Other elements of an annual reportCompanies that are publicly traded must provide their shareholders with an annualreport each year. The annual report always includes the financial statements introducedin this chapter. In addition, the annual report includes other important sources of infor-mation such as notes to the financial statements, the directors’ report and an indepen-dent auditor’s report. If the concise form of financial reporting is used to report toshareholders, a general discussion and analysis section must be included. This is instead

COLORADO GROUP LTD AND ITS CONTROLLED ENTITIESStatement of Financial Position

as at 26 January 2002(in thousands)


Current assetsCash assetsReceivablesOther financial assets

(cash on short term deposit)InventoriesOther

$ 17 7583 882

14 00044 6681 654

$ 11 3972 320

10 00046 0681 052

Total current assets 81 962 70 837

Non-current assetsOther financial assetsProperty, plant and equipmentIntangible assetsDeferred tax assetsOther

—33 19713 2176 188

—

—27 578

–3 912

—Total non-current assets 52 602 31 490Total assets 134 564 102 327

Current liabilitiesPayablesInterest-bearing liabilitiesCurrent tax liabilitiesProvisions

18 2396 7606 285

15 405

13 9934 0003 460

10 628Total current liabilities 46 689 32 081

Non-current liabilitiesInterest-bearing liabilitiesDeferred tax liabilitiesProvisions

15 0401 675

320

8 000930388

Total non-current liabilities 17 035 9 318Total liabilities 63 724 41 399

Net assets $ 70 840 $ 60 928

EquityContributed equityRetained profits

$ 32 51738 323

$ 32 03828 890

Total equity $ 70 840 $ 60 928

Figure 1.10 Statement offinancial position forColorado Group Ltd




of some of the notes to the financial statements which are included in the full financialreport. No analysis of a company’s financial situation and prospects is complete withouta review of each of these items.

Notes to the financial statementsCompanies’ published financial statements are accompanied by explanatory notes andsupporting schedules that form part of the statements. The notes to the financialstatements clarify information presented in the financial statements, as well as expandon it where additional detail is needed. Information in the notes does not always haveto be quantifiable (numeric). Examples of notes are descriptions of the accounting poli-cies and methods used in preparing the statements, explanations of uncertainties andcontingencies, and statistics and details too voluminous to be included in the statements.The notes are essential to understanding a company’s operating performance and finan-cial position.

Figure 1.12 (p. 24) is an excerpt from the notes to Colorado Group Ltd’s financialstatements for 2002. It describes the methods the company uses to account for revenues.

COLORADO GROUP LTD AND ITS CONTROLLED ENTITIESStatement of Cash Flows

for the financial year ended 26 January 2002(in thousands)


Cash flows from operating activitiesCash receipts in the course of operationsCash payments in the course of operationsInterest receivedBorrowing costs paidIncome taxes paid

$(417 850375 245

537(1 750(5 636

)

))

$(346 155318 930

530(1 401

(892

)

))

Net cash provided by operating activities 35 756 25 462

Cash flows from investing activitiesPayments for controlled entity

(net of cash acquired on consolidation)Payment of dividends to former shareholders

of Palmer Corporation Pty LtdPayments for property, plant & equipmentProceeds on sale of non-current assets

(6 728

(3 583(7 461

458

)

))

—

—(12 731

6)

Net cash used in investing activities (17 314) (12 725)

Cash flows from financing activitiesProceeds from issue of sharesRepayment of borrowingsProceeds from borrowingsDividends paidLoan to controlled entities

479(15 53013 800(6 830

—

)

)

—(4 000

—(3 400

—

)

)

Net cash used in financing activities (8 081) (7 400)Net increase in cash heldCash at the beginning of the financial year

10 36121 397

5 33716 060

Cash at the end of the financial year $ 31 758 $ 21 397

Figure 1.11 Statement of cash flows for Colorado Group Ltd




Directors’ reportThe directors’ report section covers a number of issues which might affect theinterpretation of the financial statements by users. The contents of the report in Australiaare governed by the Corporations Act 2001 (ss. 298–300). Information required to bedisclosed in the report helps shareholders assess the performance of the company andthe directors. Among the things required to be included are a description of the busi-ness(es) undertaken by the company; details of dividends; a description of anythingimportant that has happened after the financial statements were prepared (but beforethey were printed); and various information about directors, including how many direc-tors’ meetings each one attended. Information that is already disclosed in the financialstatements or notes to the financial statements doesn’t need to be repeated in the direc-tors’ report. In their report, directors will try to avoid disclosing things that might givecompetitors an advantage. Figure 1.13 presents a part of Colorado Group Ltd’s directors’report.

COLORADO GROUP LTD AND ITS CONTROLLED ENTITIESNotes to the Financial Statements (extract)

for the financial year ended 26 January 2002

Figure 1.12 Excerpt fromthe notes to the financial

statements of ColoradoGroup Ltd

(D) REVENUE RECOGNITIONRevenues are recognised at fair value of the consideration received net of the amount of goods and services tax (GST). Exchanges of goods or services of the same nature and value without any cash consideration are not recognised as revenues.

Sale of goodsSales revenue comprises revenue earned (net of returns, discounts and allowances) from the provision of products to entities outside the consolidated entity. Sales revenue is recognised when the goods are provided, or set aside on the basis of a lay-by agreement.

Management feeServices provided to wholly owned subsidiaries of the Company are recovered through the payment of management fees. Services provided include finance, real estate, information technology and human resources.

Forfeited lay-bysDeposits and instalments paid for lay-bys that are subsequently forfeited

are recognised as revenue after 2 months.

RoyaltiesThe consolidated entity hascontracted out the right to usevarious brand names. For the useof these brand names theconsolidated entity receives royalty income. This income is recognisedon receipt.

Interest incomeInterest income is recognised as it accrues.

Sale of non-current assetsThe gross proceeds from sales of non-current assets not originally purchased with the intention ofresale are included as revenue ofthe consolidated entity. The profit or loss on disposal of assets isbrought to account at the date an unconditional contract of sale is signed. The gain or loss ondisposal is calculated as thedifference between the carrying amount of the asset at the time of disposal and the net proceeds on disposal.




Auditor’s reportAnother important source of information is the auditor’s report. An auditor is anaccountant who conducts an independent examination of the accounting data presentedby a company. Only accountants who meet certain criteria, such as chartered account-ants and certified practising accountants (CPAs), may perform audits. If the auditor issatisfied that the financial statements present fairly the financial position, results of oper-ations and cash flows in accordance with generally accepted accounting principles, thenan unqualified opinion is expressed. If the auditor expresses anything other than anunqualified opinion, then the financial statements should be used only with caution.That is, without an unqualified opinion, we cannot have complete confidence that thefinancial statements give an accurate picture of the company’s financial health.

Figure 1.14 (p. 26) is the auditor’s report from Colorado Group Ltd’s 2002 annualreport. The company received an unqualified opinion from its auditor, KPMG.

COLORADO GROUP LTD AND ITS CONTROLLED ENTITIESDirectors’ Report (extract)

Consolidated resultThe net profit after tax of the consolidated entity for the financial year was $17.1 million. This represents a $2.6 million (+ 18.5%) improvement on the 2001 result of $14.5 million.

Review of operationsThe consolidated revenue for the year was $381.9 million (2001: $325.4 million) and the consolidated net profit after tax was $17.1 million (2001: $14.5 million).

Further discussion of this year’s results are set out elsewhere in this Annual Report.

DividendsThe final dividend determined by the Directors, in respect of the year ended 26 January 2002, to be paid 19 April 2002, is an ordinary dividend of 7.0 cents per share, fully franked at 30% ($6.0 million). An interim ordinary dividend of 2.0 cents per share fully franked at 30% ($1.7 million) was paid on 2 November 2001.

State of affairsThe significant change in the state of affairs of the consolidated entity that occurred during the financial year under review was the acquisition of the wholesale and retail business Palmer Corporation Pty Ltd (formerly Palmer Corporation Limited) in March 2001. Details of the transaction are provided in Note 23 to the financial statements.

Significant events after balance dateAs disclosed in Note 29 to the financial statements, the Company has, since the end of the financial year, purchased the key assets of Diana Ferrari Pty Ltd, including well known womens’ footwear labels Diana Ferrari and DF Supersoft. Diana Ferrari Pty Ltd was primarily involved in wholesaling and retailing of footwear.

Other than discussed above, there has not arisen in the interval between the end of the financial year and the date of this report any item, transaction or event of a material and unusual nature likely, in the opinion of the Directors of the Company, to affect significantly the operations of the consolidated entity, the results of those operations, or the state of affairs of the consolidated entity, in future financial years.

Figure 1.13 Excerpts from the directors’ report for Colorado Group Ltd




>> Review it1. What questions might each of the following decision makers ask that could be

answered by financial information: manager, creditor, and bank manager?

2. What are the content and purpose of each statement: statement of financialperformance, statement of financial position, and statement of cash flows?

3. The accounting equation is: Assets = Liabilities + Owners’ equity. Replacing words inthe equation with dollar amounts, what is Colorado Group Ltd’s accounting equationat 26 January 2002? (Hint: Use figure 1.10 or the company’s annual report inappendix A.) (The answer to this question is on p. 64.)

4. Why are notes to the financial statements necessary? What kinds of items areincluded in these notes?

5. What is the purpose of the directors’ report in the annual report?

6. What is the purpose of the auditor’s report?

>> Do itDeanna’s Dog Parlour Pty Ltd began operations on 1 July 2002. The following informationis available for Deanna’s Dog Parlour on 30 June 2003: service revenue $17000; accounts

Independent Audit ReportTo the members of Colorado Group Ltd

ScopeWe have audited the financial report of COLORADO group ltd for the financial year ended 26 January 2002, consisting of the statements of financial performance, statements of financial position, statements of cash flows, accompanying notes (1 to 29), and the Directors’ declaration set out on pages 30 to 59. The financial report includes the consolidated financial statements of the consolidated entity, comprising the Company and the entities it controlled at the end of the year or from time to time during the financial year. The Company’s Directors are responsible for the financial report. We have conducted an independent audit of this financial report in order to express an opinion on it to the members of the Company.

Our audit has been conducted in accordance with Australian Auditing Standards to provide reasonable assurance whether the financial report is free of material misstatement. Our procedures included examination, on a test basis, of evidence supporting the amounts and other disclosures in the financial report, and the evaluation of accounting policies and significant accounting estimates. These procedures have been undertaken to form an opinion whether, in all material respects, the financial report is presented fairly in accordance with Accounting Standards and other mandatory professional reporting requirements and statutory requirements in Australia so as to present a view which is consistent with our understanding of the Company’s and the consolidated entity’s financial position, and performance as represented by the results of their operations and their cash flows.

An audit opinion expressed in this report has been formed on the above basis.

Audit opinionIn our opinion, the financial report of COLORADO group ltd is in accordance with:(a) the Corporations Act 2001, including:

(i) giving a true and fair view of the Company’s and consolidated entity’s financial position as at 26 January 2002 and of their performance for the year ended on that date; and

(ii) complying with Accounting Standards and the Corporations Regulations 2001; and

(b) other mandatory professional reporting requirements.

Figure 1.14 Auditor’sreport on the financial

statements of ColoradoGroup Ltd


Review it questions marked with this Colorado Group Ltd icon require that you use the company’s 2002 annual report at the back of the book.




receivable $4000; accounts payable $2000; building rental expense $9000; notes payable$5000; share capital $10000; retained profits ?; equipment $16000; insurance expense $1000;supplies (asset) $1800; supplies expense $200; cash $2000; dividends $0. Prepare a statementof financial performance and a statement of financial position using this information.

Reasoning: A statement of financial performance reports the success or failure of acompany’s operations for a period of time. A statement of financial position presents theassets, liabilities and owners’ equity of a company at a specific point in time.

Solution:

THE CLASSIFIED STATEMENT OF FINANCIAL POSITIONAs explained previously, the statement of financial position shows a snapshot of acompany’s financial position at a point in time. To improve users’ understanding of acompany’s financial position, companies group similar assets and similar liabilitiestogether. This is useful because it tells you that items within a group have similar

DEANNA’S DOG PARLOUR PTY LTDStatement of Financial Performance

for the year ended 30 June 2003

RevenuesService revenue

Expenses:Rent expenseInsurance expenseSupplies expense

$90001000200

$17 000

Total expenses 10 200Net profit $ 6 800

DEANNA’S DOG PARLOUR PTY LTDStatement of Financial Position

as at 30 June 2003

Assets

CashAccounts receivableSuppliesEquipment

$ 2 0004 0001 800

16 000Total assets $23 800

Liabilities and shareholders’ equity

LiabilitiesAccounts payableNotes payable

$ 2 0005 000

Total liabilities

Shareholders’ equityShare capitalRetained profits

10 0006 800

$ 7 000

Total shareholders’ equity 16 800Total liabilities and shareholders’ equity $23 800


Identify the sections of a classified statement of financial position




economic characteristics. Australian accounting standard AASB 1040 prescribesminimum disclosures on the face of a classified statement of financial position.These are listed in figure 1.15.

Companies may choose to report more classifications. For example, David Jones Ltdseparately identified prepayments as an asset on the face of its 2001 statement offinancial position. More classifications of assets are typically used for internal reports.

The standard also requires that the assets and liabilities be categorised as current andnon-current, unless categorisation by liquidity provides more relevant information.Almost all companies, other than financial institutions and insurance companies, choosethe current/non-current categories for presentation of the statement of financial position.Although not as informative as liquidity categories, the current/non-current categoriesprovide a crude measure of (1) whether the company has enough assets to pay its debtsas they come due and (2) the claims of short-term and long-term creditors on the com-pany’s total assets. Current and non-current categories are used extensively for internaland external reporting. These categories can be seen in the statement of financial pos-ition included in Colorado Group Ltd’s 2002 annual report at the back of this book.Each of the categories is explained below.

CURRENT ASSETSCurrent assets are assets that are expected to be converted to cash or used in the busi-ness within 1 year or the operating cycle. The operating cycle is the average timetaken to acquire goods and services and convert them to cash in producing revenues.Colorado Group Ltd reported current assets of $81 962. For most businesses the cut-offfor classification as current assets is 1 year from the balance date. For example, accountsreceivable are included in current assets because they will be converted to cash throughcollection within 1 year. Supplies are current assets because we expect that they will beused in the business within 1 year. However, some businesses use a longer period asthe cut-off if their operating cycle is longer than 1 year.

Assets Liabilities

Cash assetsReceivablesInventoriesInvestments in associates and joint

venture entitiesOther financial assetsProperty, plant and equipmentTax assetsIntangible assets

PayablesInterest-bearing liabilitiesTax liabilitiesProvisions

Equity

Contributed equity (capital)ReservesRetained profits or accumulated losses

Figure 1.15 Minimumdisclosures on the

statement of financialposition


Management perspectiveSome companies use a period longer than 1 year to classify assets andliabilities as current because they have an operating cycle longer than 1year. The operating cycle of a company is the average time that it takes

to go from cash to cash in producing revenues. For example, if your business sells TVs,your operating cycle would be the average length of time it would take for you to pur-chase your inventory, sell it on account, and then collect cash from your customers. Formost businesses this cycle takes less than a year, so they use a 1-year cut-off. But forsome businesses, such as vineyards or aeroplane manufacturers, this period may belonger than a year. Except where noted, we will assume that 1 year is used to determinewhether an asset or liability is current or non-current.




Common types of current assets are (1) cash, (2) marketable securities, such as sharesheld as a short-term investment, (3) receivables (notes receivable, accounts receivableand interest receivable), (4) inventories, and (5) prepaid expenses (insurance and sup-plies). Figure 1.16 shows the current assets reported in the 2001 financial statements ofDavid Jones Ltd.

A company’s current assets are important in assessing its short-term debt-payingability, as explained later in the chapter.

NON-CURRENT ASSETSNon-current assets are assets that are not expected to be consumed or sold within 1year or the operating cycle. They encompass a diverse range of assets. The mostcommon types of non-current assets include receivables that are due more than 1 yearfrom the date of the statement of financial position; investments; property, plant andequipment; and intangible assets. Figure 1.17 shows the non-current assets reported inthe 2001 financial statements of David Jones Ltd.

Property, plant and equipmentProperty, plant and equipment are assets with relatively long useful lives that are usedin operating the business. This category includes land, buildings, machinery and equip-ment, delivery equipment, and furniture. David Jones Ltd reported property, plant andequipment of $266 989 000 in its statement of financial position shown in figure 1.17.

Depreciation is the practice of allocating the cost of assets to a number of periods,rather than simply expensing the full purchase price of the asset in the year of purchase.Assets that the company depreciates should be reported on the statement of financialposition at cost less accumulated depreciation. For example, Colorado Group Ltdreported property, plant and equipment accumulated depreciation of $9 035 000 in thenotes to the financial statements. The accumulated depreciation is the total amount ofdepreciation to date over the life of the asset.

Intangible assetsMany companies have non-financial assets that have no physical substance yet often arevery valuable. These assets are referred to as intangible assets. They include patents,copyrights and trademarks or trade names that give the company exclusive right of use

DAVID JONES LTDStatement of Financial Position (partial)

(in thousands)

Current assetsCash assetsReceivablesInventoriesPrepayments

$ 11 55079 139

287 2989 904

Total current assets $387 891


(in thousands)

Non-current assetsProperty, plant and equipmentIntangiblesDeferred tax assetsOther assets

$266 98915 92414 9171 822

Total non-current assets $299 652

Figure 1.16 Current assets section

Figure 1.17 Non-current assets section

Alternative terminologyProperty, plant and equipment are sometimes called fixed assets.


GUEST

DAVID JONES LTD Statement of Financial Position (partial) (in thousands) Current assets Cash assets Receivables Inventories Prepayments $ 11 550 79 139 287 298 9 904 Total current assets $387 891

GUEST

DAVID JONES LTD Statement of Financial Position (partial) (in thousands) Non-current assets Property, plant and equipment Intangibles Deferred tax assets Other assets $266 989 15 924 14 917 1 822 Total non-current assets $299 652



for a specified period of time. David Jones Ltd reported intangible assets of $15 924 000,as shown in figure 1.17.

CURRENT LIABILITIESIn the liabilities section of the statement, the first grouping is current liabilities. Currentliabilities are obligations that are to be paid within the coming year. Commonexamples are accounts payable, wages payable, bank loans payable, interest payable,taxes payable, and current maturities of long-term obligations (payments to be madewithin the next year on long-term obligations).

Within the current liabilities section of the statement of financial position, payablesare usually listed first, followed by interest-bearing liabilities, tax liabilities and pro-visions. The current liabilities section adapted from the 2001 statement of financial pos-ition published by David Jones Ltd is shown in figure 1.18.

NON-CURRENT LIABILITIESObligations expected to be paid after 1 year are classified as non-current liabilities.Liabilities in this category include debentures payable, mortgages payable, unsecurednotes payable and lease liabilities. Many companies report long-term debt maturing after1 year as a single amount in the statement of financial position and show the details ofthe debt in notes to the financial statements. Others list the various types of long-termliabilities. In its statement of financial position, David Jones Ltd reported non-currentliabilities as shown in figure 1.19.

>> Review it1. What are the major sections in a classified statement of financial position?

2. What is the difference between current assets and non-current assets?

3. What was Colorado Group Ltd’s largest type of current asset at 26 January 2002? (The answer to this question is on p. 64.)

>> Do itThe following information relates to Hoffman Ltd’s statement of financial position at30 June 2003. All receivables are due within 30 days.


(in thousands)

Current liabilitiesPayablesInterest-bearing liabilitiesTax liabilitiesOther provisions

$166 331359

7 71833 982

Total current liabilities $208 390


(in thousands)

Non-current liabilitiesInterest-bearing liabilitiesDeferred tax liabilitiesOther provisions

$61 422288

11 166Total non-current liabilities $72 876

Figure 1.18 Currentliabilities section

Figure 1.19 Non-currentliabilities section



GUEST

DAVID JONES LTD Statement of Financial Position (partial) (in thousands) Current liabilities Payables Interest-bearing liabilities Tax liabilities Other provisions $166 331 359 7 718 33 982 Total current liabilities $208 390

GUEST

DAVID JONES LTD Statement of Financial Position (partial) (in thousands) Non-current liabilities Interest-bearing liabilities Deferred tax liabilities Other provisions $61 422 288 11 166 Total non-current liabilities $72 876



Prepare the assets section of Hoffman Ltd’s statement of financial position.

Reasoning: Current assets are cash and other resources that are reasonably expectedto be consumed in 1 year. Accumulated depreciation should be subtracted from prop-erty, plant and equipment to determine net property, plant and equipment.

Solution:

ANALYSING FINANCIAL STATEMENTSSo far, we have introduced the three main financial statements and discussed how thesestatements provide information about a company’s performance and financial position.Now it is time to extend this discussion by showing you specific tools that can be usedto analyse financial statements to make a more meaningful evaluation of a company.The analysis of financial statements is covered in more detail in chapter 11.

RATIO ANALYSISRatio analysis expresses the relationship among selected items of financial statementdata. A ratio expresses the mathematical relationship between one quantity andanother. The relationship is expressed in terms of a percentage, a rate, or a simple pro-portion. To illustrate, in 2001 Fantastic Furniture Holdings Ltd had current assets of$15 581 623 and current liabilities of $8 997 094. The relationship between these accountsis determined by dividing current assets by current liabilities, to get 1.73. The alternativemeans of expression are:

Percentage: Current assets are 173% of current liabilities.

Rate: Current assets are 1.73 times as great as current liabilities.

Proportion: The relationship of current assets to liabilities is 1.73:1.

For analysis of the main financial statements, ratios can be classified as shown infigure 1.20 (p. 32).

HOFFMAN LTDStatement of Financial Position (partial)

as at 30 June 2003

Assets

Current assetsCashAccounts receivableInventoryShort-term investments

$ 8001 1003 4002 300

Total current assets

Property, plant and equipmentLess: Accumulated depreciation

10 7002 700

$ 7 600

8 000Total assets $15 600

Short-term investments $2 300Cash 800Property, plant and equipment 10 700Inventory 3 400Accumulated depreciation 2 700Accounts receivable 1 100


Calculate ratios for analysing a company’s profitability, liquidity and solvency.




Ratios can provide clues to underlying conditions that may not be apparent frominspection of the individual components of a particular ratio. However, a single ratio byitself is not very meaningful. Accordingly, in this and the following chapters we will use:1. Intracompany comparisons covering 2 years for the same company.2. Intercompany comparisons based on comparisons with a competitor in the same

industry.

PROFITABILITYFantastic Furniture Holdings Ltd tries to generate a profit for its shareholders by sellingfurniture. The statement of financial performance reports how successful it is atgenerating a profit from its sales and other revenue. The statement reports the revenuefor the period and the expenses incurred during the period. Fantastic Furniture’sstatement of financial performance for the year ended 30 June 2001 is provided infigure 1.21.

From this statement we can see that Fantastic Furniture’s revenue increased signifi-cantly during the year from $58 607 589 in 2000 to $70 576 477 in 2001. In order toincrease net profit, the company needs its revenue to increase more than its expenses.However, this was not the case for Fantastic Furniture. Its expenses increased by almostas much as its revenue, resulting in stable profit for the 2 years.

FANTASTIC FURNITURE HOLDINGS LTDStatement of Financial Performance (partial)



Revenue from ordinary activitiesExpenses from ordinary activitiesBorrowing costs

$(70 576 47764 283 609

(75 425))

$(58 607 58952 332 694

(71 082))

Operating profit before income taxIncome tax expense attributable to operating profit

6 217 443(2 192 145)

$ 6 203 813(2 185 439)

Profit from ordinary activities after related incometax expense $ 4 025 298 $ 4 018 374

Liquidity ratiosMeasures of short-term abilityof the company to pay itsmaturing obligations and tomeet unexpected needs for cash

Profitability ratiosMeasures of the operating success of a companyfor a given period of time

Solvency ratiosMeasures of the ability ofthe company to surviveover a long period of time

– = Netprofit

Revenues Expenses

XYZ Ltd

Founded in 1892

Figure 1.20 Financialratio classifications

Figure 1.21 FantasticFurniture Holdings Ltd’s

statement of financialperformance




To evaluate the profitability of Fantastic Furniture, we will use ratio analysis.Profitability ratios measure the operating success of a company for a given periodof time. We will look at two examples of profitability ratios: return on assets andprofit margin.

Return on assetsAn overall measure of profitability is the return on assets ratio. This ratio is calculatedby dividing net profit by average assets. (Average assets are commonly calculated byadding the beginning and ending values of assets and dividing by 2.) The return onassets ratio indicates the amount of net profit generated by each dollar invested inassets. Thus, the higher the return on assets, the more profitable the company. The 2001statement of financial performance for Fantastic Furniture was presented in figure 1.21.The 2001 and 2000 return on assets ratios of Fantastic Furniture and Freedom Group (acompany operating in the same industry) are presented in figure 1.22.

We can evaluate Fantastic Furniture’s 2000 and 2001 return on assets ratios in anumber of ways. First we can compare the ratio across time. That is, did its perfor-mance improve? The decrease from 32.1% in 2000 to 21.3% in 2001 suggests decline inprofitability. The ratio tells us that in 2000 Fantastic Furniture generated 32 cents onevery dollar invested in assets, and in 2001 it generated 21 cents on every dollarinvested in assets. Then we can compare the ratios with those of another operator inthe industry, Freedom Group. In both years Fantastic Furniture’s return on assets ratiowas substantially better than that of Freedom Group. Thus, based on the return onassets ratio, Fantastic Furniture’s profitability appears stronger than Freedom Group’s.However, Fantastic Furniture’s profitability has declined, whereas Freedom Group’s hasimproved.

Profit marginThe profit margin ratio measures the percentage of each dollar of sales that results innet profit. It is calculated by dividing net profit by net sales (revenue) for the period.Businesses with high turnover, such as supermarkets and grocers (Coles or Woolworths)and discount stores (Big W or Chickenfeed) generally experience low profit margins.Low-turnover businesses, such as jewellery stores (Tiffany’s) or submarine manufac-turers (Australian Defence Industries), usually have high profit margins. Profit marginsfor Fantastic Furniture and Freedom Group are shown in figure 1.23 (p. 34). Note thatthe figure for sales revenue used in the calculation of the profit margin ratio is not thesame as total revenue reported in the statement of financial performance. This isbecause total revenue includes revenue other than sales.

Return on assets ratio = Net profitAverage total assets

* Amounts used to calculate average assets are taken from the statement of financial pos-ition (figure 1.24). Total assets in 1999 were $9 026 100. Also note that amounts in the ratiocalculations have been rounded to the nearest thousand.

** Freedom Group’s 2001 financial statements are for a 9-month period.

2001 2000

Fantastic Furniture($ in thousands) = 21.3% = 32.1%

Freedom Group 3.5%** 1.8%

$4025($21 745 + $16 044)/2*

$4018($16 044 + $9026)/2*

Figure 1.22 Return on assets ratio




Fantastic Furniture’s profit margin declined from 7.0% in 2000 to 5.8% in 2001. Thismeans that in 2000 the company generated 7 cents on each dollar of sales, and in 2001it generated 5.8 cents on each dollar of sales. But how does Fantastic Furniture comparewith its competitors? Its profit margin ratio was higher than Freedom Group’s in bothyears, even though Freedom Group’s profit margin improved in 2001. In subsequentchapters you will learn more about evaluating a company’s profitability.

>> Review it1. What are the three ways that ratios can be expressed?

2. What is the purpose of profitability ratios? Explain the return on assets ratio and the profit margin ratio.

LIQUIDITYYou can learn a lot about a company’s financial health by also evaluating the relationshipbetween its various assets and liabilities. However, any analysis of liquidity is incompletewithout looking at cash flows. First we will look at some ratios that use numbers fromthe statement of financial position. This will be followed by cash flow analysis.

Suppose you are a banker considering lending money to Fantastic Furniture, or youare a computer manufacturer interested in selling it computers. You would be con-cerned about Fantastic Furniture’s liquidity — its ability to pay obligations that areexpected to become due within the next year or operating cycle. You would lookclosely at the relationship of its current assets to current liabilities.

DECISION TOOLKIT

Is the company using its assets effectively?

Is the company maintaining an adequate margin between sales and expenses?

Net profit and average assets

Net profit and net sales

Higher value suggests favourable efficiency (use of assets).

Higher value suggests favourable return on eachdollar of sales

Profit margin ratio = Net profitNet sales

2001 2000

Fantastic Furniture($ in thousands) = 5.8% = 7.0%

Freedom Group 2.3% 0.8%

$4025$69 299

$4018$57 460

Figure 1.23 Profitmargin ratio


Return on assets ratio

=Net profit

Average total assets

Profit marginratio

=Net profitNet sales





Working capitalOne measure of liquidity is working capital, which is the difference between theamounts of current assets and current liabilities:

Working capital = Current assets − Current liabilities

When working capital is positive, there is greater likelihood that the company will payits liabilities. When the reverse is true, short-term creditors may not be paid, and thecompany may ultimately be forced into liquidation. Fantastic Furniture had workingcapital in 2001 of $6 584 529 ($15 581 623 − $8 997 094).

FANTASTIC FURNITURE HOLDINGS LTDStatement of Financial Position (partial)

as at 30 June 2001


Current assetsCashReceivablesInventoriesOther

$ 36 3301 882 615

13 298 687363 991

$ 2 210 2811 738 2738 416 928

92 560Total current assets 15 581 623 $12 458 042

Non-current assetsReceivablesProperty, plant and equipmentIntangiblesDeferred tax assetsOther

1 504 3002 704 1271 572 325

308 20274 762

—1 426 9321 682 836

284 890191 135

Total non-current assets 6 163 716 3 585 793Total assets 21 745 339 16 043 835


4 742 9993 140 483

331 314782 298

4 122 20222 118

1 766 098567 102

Total current liabilities 8 997 094 6 477 520

Non-current liabilitiesProvisions 325 487 344 365

Total non-current liabilities 325 487 344 365Total liabilities 9 322 581 6 821 885

Net assets $12 422 758 $ 9 221 950


$ 5 585 8116 836 947

$ 3 985 8115 236 139

Total shareholders’ equity $12 422 758 $ 9 221 950

Figure 1.24 Statement of financial position for Fantastic Furniture Holdings Ltd




Current ratioLiquidity ratios measure the short-term ability of the entity to pay its maturing obli-gations and to meet unexpected needs for cash. One liquidity ratio is the current ratio,which is calculated by dividing current assets by current liabilities.

The current ratio is a more dependable indicator of liquidity than working capital.Two companies with the same amount of working capital may have significantly dif-ferent current ratios. The 2001 and 2000 current ratios for Fantastic Furniture andFreedom Group are shown in figure 1.25.

What does the ratio actually mean? Fantastic Furniture’s 2001 current ratio of 1.73:1means that for every dollar of current liabilities, it has $1.73 of current assets. FantasticFurniture’s current ratio has decreased in 2001. However, when compared with FreedomGroup’s current ratio of 1.51:1, Fantastic Furniture appears to have more liquidity.

The current ratio is only one measure of liquidity. It does not take into account thecomposition of the current assets. For example, a satisfactory current ratio does not dis-close whether a portion of the current assets is tied up in slow-moving inventory. Thecomposition of the assets matters because a dollar of cash is more readily available topay the bills than is a dollar of inventory. For example, suppose a company’s cash bal-ance declined while its inventory increased substantially. If inventory increased becausethe company is having difficulty selling its products, then the current ratio might notfully reflect the reduction in the company’s liquidity. In a later chapter you will learnhow to analyse the liquidity of certain assets using turnover ratios.

Using the statement of cash flowsThe statement of cash flows provides financial information about the sources and usesof a company’s cash. Investors, creditors, and others want to know what is happeningto a company’s most liquid resource — its cash. In fact, it is often said that ‘cash is king’because if a company can’t generate cash, it won’t survive. To aid in the analysis ofcash, the statement of cash flows reports the cash effects of (1) a company’s operatingactivities, (2) its investing activities, and (3) its financing activities.

Sources of cash matter. For example, you would feel much better about a company’shealth if you knew that its cash was generated from the operations of the businessrather than borrowed. The statement of cash flows for Fantastic Furniture for the yearended 30 June 2001 is provided in figure 1.26.

In the long term, it is generally desirable that a company can generate enough cashfrom its operating activities to pay dividends and finance its investing needs. This needsto be assessed over a number of years because the timing of major capital investmentexpenditures and, to a lesser extent, cash paid for operating activities can cause con-siderable variation in the relationship between operating and investing cash flows fromyear to year. For example, consider investing cash flows of Fantastic Furniture. Cash

Current ratio = Current assetsCurrent liabilities

2001 2000

Fantastic Furniture($ in thousands) = 1.73:1 = 1.92:1

Freedom Group 1.51:1 1.43:1

$15 581$8997

$12 458$6478

Figure 1.25 Current ratio




used by operating activities for 2001 was $1 320 456, compared with $2 836 476 cashgenerated by operating activities in 2000. Much of the negative net operating cash flowsreflects the purchase of inventory. Net cash spent on investments in 2001 was$1 643 070 compared with $2 423 277 in 2000. In order to finance its dividends, loanrepayments and investing activities, in 2000 Fantastic Furniture had to supplement itsinternally generated cash with cash from outside sources, by issuing new shares and byborrowing.

Earlier we introduced you to the current ratio. The statement of cash flows can alsobe used to calculate additional measures of liquidity. The current cash debt coverageratio is a measure of liquidity that is calculated as cash provided by operating activitiesdivided by average current liabilities. It indicates the company’s ability to generate suf-ficient cash to meet its short-term needs. In general, a value below 0.40 times is con-sidered cause for additional investigation of a company’s liquidity. Figure 1.27 (p. 38)shows the current cash debt coverage ratio for Fantastic Furniture for 2000 and FreedomGroup for 2000 and 2001. As Fantastic Furniture has negative cash from operating activi-ties for 2001, the ratio is not calculated for that year.

FANTASTIC FURNITURE HOLDINGS LTDStatement of Cash Flows (partial)

for the year ended 30 June


Cash flows from operating activitiesCash receiptsCash payments to suppliers and employeesInterest receivedInterest paidIncome tax paid

$(77 466 98575 148 254

71 355(60 301

(3 650 241

)

))

$(57 807 70553 133 249

94 085(522 592

(1 409 473

)

))

Net cash provided by (used in) operatingactivities (1 320 456) 2 836 476

Cash flows from investing activitiesProceeds from sale of plant and equipmentPayments for acquisitions of plant and

equipmentPayments for goodwillLoans repaid by controlled entitiesLoans to controlled entities

(1 643 070———

)

1 887

(780 738(1 644 426

——

))

Net cash provided by (to) investing activities (1 643 070) (2 423 277)

Cash flows from financing activitiesProceeds from issue of sharesProceeds from borrowingsRepayments of borrowingsDividends paidShare issue costs

——

(22 118(2 328 790

—

))

4 965 000602 908

(1 586 397(3 155 619

(989 191

))

Net cash provided by (to) financing activities (2 350 908) (163 299)Net increase (decrease) in cash held (5 314 434) 249 900Cash at the beginning of the financial year 2 210 281 1 960 381Cash at the end of the financial year $ (3 104 153) $ 2 210 281

Figure 1.26 Statement of cash flows for Fantastic Furniture Holdings Ltd




We can use these measures to supplement the analysis using the statement offinancial position. Fantastic Furniture’s current cash debt coverage ratio of 0.51 in2000 exceeded the recommended minimum level of 0.40, suggesting that its liquiditywas adequate. But this changed dramatically in 2001. On the other hand, FreedomGroup’s value of 0.25 is less than the recommended level. Recall, however, thatFreedom Group’s 2001 current cash debt coverage ratio was based on only 9 monthsof cash flows. The ratios indicate that monitoring of liquidity for both companies iswarranted.

SOLVENCYNow suppose that instead of being a short-term creditor, you are interested in eitherbuying Fantastic Furniture’s shares or extending the company a long-term loan. Long-term creditors and shareholders are interested in a company’s long-term solvency — itsability to pay interest as it comes due and to repay the debt at maturity. Solvencyratios measure the ability of the business to survive over a long period of time. Thedebt to total assets ratio is one source of information about long-term debt-payingability. Cash flow ratios, such as the cash debt coverage ratio, are also useful tools ofanalysis.

Debt to total assets ratioThe debt to total assets ratio measures the percentage of assets financed by creditorsrather than shareholders. Debt financing is more risky than equity financing becausedebt must be repaid at specific points in time, whether the company is performingwell or not. Thus, the higher the percentage of debt financing, the riskier thecompany.

DECISION TOOLKIT

Can the company meet its short-term obligations?


Current assets and current liabilities

Current liabilities and cash provided by operating activities

Higher ratio suggests favourable liquidity.

A higher value indicates liquidity.

Current cash debt coverage ratio = Cash provided by operationsAverage current liabilities

* Amounts used to calculate average current liabilities are taken from the statement of finan-cial position (figure 1.24). Current liabilities at year-end 1999 were $4 642 714. Also notethat amounts in the ratio calculations have been rounded to the nearest thousand.

** Freedom Group’s 2001 financial statements were for a 9-month period.

2001 2000

Fantastic Furniture($ in thousands) Not calculated = 0.51 times

Freedom Group 0.25 times** 0.016 times

$2836($6478 + $4643)/2*

Figure 1.27 Current cashdebt coverage ratio


Current ratio =Current assets

Current liabilities

Current cash debt coverage ratio

=

Cash provided by operations

Average current liabilities

Helpful hintSome users evaluate solvency using a ratio of liabilities divided by shareholders’ equity. The higher this ratio, the lower a company’s solvency.




The debt to total assets ratio is calculated by dividing total debt (both current andnon-current liabilities) by total assets. The higher the percentage of total liabilities (debt)to total assets, the greater the risk that the company may be unable to pay its debts asthey come due. The ratios of debt to total assets for Fantastic Furniture and FreedomGroup for 2000 and 2001 are presented in figure 1.28.

The 2001 ratio of 43% means that 43 cents of every dollar invested in assets by Fan-tastic Furniture has been provided by its creditors. The higher the ratio, the lower theequity ‘buffer’ available to creditors if the company becomes insolvent. Thus, from thecreditors’ point of view, a high ratio of debt to total assets is undesirable. Fantastic Fur-niture’s solvency appears lower than that of Freedom Group in 2001. However, bothcompanies have low debt ratios.

The adequacy of this ratio is often judged in the light of the company’s profits andcash flows. Generally, companies with relatively stable profit can support higher debt tototal assets ratios than can cyclical companies with widely fluctuating profits, such asmany high-tech companies.

The cash debt coverage ratio is a measure of solvency that is calculated as cashprovided by operating activities divided by average total liabilities. It indicates thecompany’s ability to generate sufficient cash to meet its long-term needs. Figure1.29 (p. 40) presents the cash debt coverage ratio for Fantastic Furniture for 2000and for Freedom Group for 2000 and 2001. The ratio is not calculated for FantasticFurniture for 2001 because its net cash flows from operations were negative. Ageneral rule of thumb is that a ratio below 0.20 times is considered cause foradditional investigation.

Debt to total assets ratio = Total liabilitiesTotal assets

2001 2000

Fantastic Furniture($ in thousands) = 43% = 43%

Freedom Group 39% 44%

$9323$21 745

$6822$16 044

Figure 1.28 Debt to total assets ratio


Investor perspectiveDebt financing differs greatly across industries and companies. Here aresome debt to total assets ratios for selected companies:

Total debt to total assets as a percentage

Colorado Group Ltd (2001)Harvey NormanDavid JonesOPSM ProtectorAir New ZealandFletcher Challenge Forests

40%53%41%31%94%32%




Fantastic Furniture’s cash debt coverage ratio of 0.49 in 2000 was well in excess ofthe recommended minimum level of 0.2, suggesting that its solvency is also accept-able. However, the negative net cash flows from operations in 2001 suggest furthermonitoring is warranted. Note the similarity between the current debt coverage ratioand the cash debt coverage ratio for Fantastic Furniture. This reflects the low levels ofnon-current liabilities. In fact, Fantastic Furniture had no non-current liabilities at theend of 1999. Freedom Group’s ratio fell short of the recommended level in 2000 butimproved in 2001. We will investigate other measures of liquidity and solvency in laterchapters.

>> Review it1. What is liquidity? How can it be measured using a classified statement of financial

position?

2. What is solvency? How can it be measured using a classified statement of financialposition?

3. What information does the statement of cash flows provide that is not available in astatement of financial performance or statement of financial position?

4. What does the current cash debt coverage ratio measure? What does the cash debtcoverage ratio measure?

DECISION TOOLKIT

Can the company meet its long-term obligations?


Total liabilities and total assets

Total liabilities and cash provided by operating activities

A higher ratio indicates solvency risk because the company has fewer assets available for creditors.

A higher ratio indicates better solvency, that the companyis generating cash sufficient to meet its long-term needs.

Cash debt coverage ratio = Cash provided by operationsAverage total liabilities

* Amounts used to calculate average total liabilities are taken from Fantastic Furniture’sstatement of financial position (figure 1.24). Total liabilities at year-end 1999 were$4 642 714. Also note that amounts in the ratio calculations have been rounded to thenearest thousand.

2001 2000

Fantastic Furniture($ in thousands) Not calculated = 0.49 times

Freedom Group 0.25 times 0.18 times

$2836($6822 + $4643)/2*

Figure 1.29 Cash debtcoverage ratio


Debt to total assets ratio =

Total liabilitiesTotal assets

Cash debt coverage ratio

=

Cash provided by operationsAverage total

liabilities





>> Do itSelected financial data for Drummond Ltd at 30 June 2003 are as follows: cash $60 000;receivables (net) $80 000; inventory $70 000; total assets $540 000; current liabilities$140 000; and total liabilities $270 000. Calculate the current ratio and debt to total assetsratio.

Reasoning: The formula for the current ratio is: Current assets ÷ Current liabilities.The formula for the debt to total assets ratio is: Total liabilities ÷ Total assets.

Solution: The current ratio is 1.5:1 ($210 000 ÷ $140 000). The debt to total assets ratiois 50% ($270 000 ÷ $540 000).

USING THE DECISION TOOLKITUsing the decision toolkit exercises, which follow the final set of Review It questions in the chapter, ask you to use information from financial statements to make financial decisions. We encourage you to think through the questions related to the decision before you study the solution.

Figure 1.30 Harvey Norman’s statement of financial performance

Harvey Norman Holdings Ltd operates in the whitegoods and home electronics industries in Australia and New Zealand. Imagine that you are considering the purchase of shares in Harvey Norman.

RequiredAnswer these questions related to your decision whether to invest:(a) What financial statements should you be interested in?(b) What should these financial statements tell you?(c) Should you request audited financial statements? Explain.(d) Will the financial statements show the market value of Harvey Norman’s

assets? Explain.(e) Compare Harvey Norman’s profit for 2001 with its profit for 2000. Comparative

statements of financial performance are provided in figure 1.30.

HARVEY NORMAN HOLDINGS LTDStatement of Financial Performance (partial)

for the year ended 30 June 2001(in thousands)

2001 2000

Sales revenueCost of sales

$(358 409287 560)

$(220 577176 196)

Gross profitOther revenuesDistribution expensesMarketing expensesOccupancy expensesAdministrative expensesBorrowing costsOther expensesShare of net profit of associates, joint venture

entities and partnerships accounted forusing the equity method

(

70 849331 224

(3 008(8 827

(54 664(47 741(23 156102 337

623

))))))

$ 44 381300 186

(1 030(7 529

(38 835(34 728(17 714(71 637

803

))))))

Profit from ordinary activities before incometax expense

Income tax expense relating to ordinary activities

162 963

(56 504)

173 897

(62 626)Net profit $106 459 $111 271




(f) How much of Harvey Norman’s assets were financed by creditors at30 June 2001? Harvey Norman’s statement of financial position is shown in figure 1.31.

(g) Did Harvey Norman generate sufficient cash flows from its operating activities to finance its investing activities in 2001? A simplified statement of cash flows is provided in figure 1.32.

HARVEY NORMAN HOLDINGS LTDStatement of Financial Position (partial)

as at 30 June 2001(in thousands)

2001 2000

Current assetsCash assetsReceivablesOther financial assetsInventoriesOther

$ 23 024528 317

8 45888 05016 689

$ 39 436476 27210 03159 4473 521

Total current assets 664 538 $ 588 707

Non-current assetsReceivablesInvestments accounted for using equity methodOther financial assetsProperty, plant and equipmentIntangiblesDeferred tax assets

12 29136 46010 455

654 488692

2 292

9 63215 98610 394

535 015590

2 567Total non-current assets 716 678 574 184

Total assets 1 381 216 1 162 891

Current liabilitiesPayablesInterest-bearing liabilitiesTax liabilitiesOther provisionsOther

328 945101 61530 25823 7911 542

312 12435 64235 36222 7532 511

Total current liabilities 486 151 408 392

Non-current liabilitiesInterest-bearing liabilitiesOther provisionsOther

239 188511

1 555

203 220388565


Net assets $ 653 811 $ 550 326

EquityContributed equityReservesRetained profits

142 869115 891342 457

142 86984 626

278 028Parent entity interestOutside equity interest

601 21752 594

505 52344 803

Total equity $ 653 811 $ 550 326

Figure 1.31 HarveyNorman’s statement of

financial position




(h) Calculate Harvey Norman’s return on assets ratio for 2001 and profit margin for 2000 and 2001. Has profitability improved in the 2-year period?

(i) Calculate Harvey Norman’s current ratio for 2001 and 2000 and the current cash debt coverage for 2001. Does Harvey Norman have liquidity problems?

(j) Calculate Harvey Norman’s debt ratio for 2001 and 2000 and the cash debt coverage for 2001. Has solvency improved since 2000?

Solution(a) Before you invest, you should investigate the statement of financial

performance, statement of financial position, and statement of cash flows.(b) You would probably be most interested in the statement of financial

performance because it tells about past performance and thus gives an indication of future performance. The statement of cash flows reveals where the company is getting and spending its cash. This is especially important for a company that wants to grow. Finally, the statement of financial position reveals the types of assets and liabilities and the relationship between assets and liabilities.

(c) You would want audited financial statements — statements that an independent accountant has examined and expressed an opinion that the statements present fairly the financial position and results of operations of the company. Investors and creditors should not make decisions without studying audited financial statements of entities required to appoint auditors.

(d) The financial statements will not show the market value of the company’s assets. One important principle of accounting is the historical cost principle, which states that assets should be recorded at cost. Cost has an important advantage over other valuations: It is objective and reliable.

(e) Harvey Norman’s profit for 2001 is $106 459 000, a decrease of $4 812 000 on the 2000 profit of $111 271 000. This decline occurred notwithstanding an increase in sales.

(f) Harvey Norman’s debt ratio at 30 June 2001 was 53%, indicating that 53 cents of every dollar of assets was financed by creditors. The debt ratio is calculated as total liabilities divided by total assets ($727 405/$1 381 216 — all figures from here on are in thousands).

(g) Harvey Norman generated net cash flows of $61 147 from its operations in 2001 but spent $142 312 (net) on investing activities that year.

(h) The return on assets ratio for 2001 is 8.4% ($106459/[$1 381216 + $1 162891]/2). The profit margin for 2001 was 29.7% ($106459/$358409) and for 2000 was 50.4% ($111271/$220577). Although Harvey Norman’s profitability was high in 2001, this represents a decline since 2000.

HARVEY NORMAN HOLDINGS LTDStatement of Cash Flows (simplified)


2001 2000

Cash flows from operating activities (net)Cash used for investing activities (net)Cash flows from financing activities (net)

$(

61 147142 31253 087

)$(121 866123 89636 268

)

Net increase (decrease) in cash heldCash at beginning of period

(28 07837 385

) 34 2383 147

Cash at end of period $ 9 307 $ 37 385

Figure 1.32 Harvey Norman’s statement of cash flows




(i) Harvey Norman’s current ratio was 1.37:1 ($664 538/$486 151) in 2001 and 1.44:1 ($588 707/$408 392) in 2000. The current cash debt coverage for 2001 was 14% ($61 147/[$486 151 + $408 392]/2). Although Harvey Norman generated positive net cash flows from operating activities in 2001, the declining current ratio, the low current cash debt coverage ratio and the reduction in cash suggest that liquidity should be monitored.

(j) Harvey Norman’s debt ratio for 2001 was 53%, as calculated in part (f), and 53% for 2000 ($612 565/$1 162 891). This indicates that solvency was stable from 2000 to 2001. The cash debt coverage ratio for 2001 was 9% ($61 147/[$727 405 + $612 565]/2). Although solvency is stable, the low cash debt coverage ratio indicates solvency should be monitored.

SUMMARY OF LEARNING OBJECTIVES1 Describe the main forms of business organisation. A sole proprietorship is a business owned by one person. A partnership is a business owned by two or more people. A company is a separate legal entity for which evidence of ownership is provided by shares.

2 Describe the financial reporting environment. The Financial Reporting Council (FRC) oversees the Australian Accounting Standards Board (AASB) and advises the federal government on the standard-setting process and developments in international standard setting. The AASB issues accounting standards which certain companies, such as listed companies, must apply when preparing published financial statements. Auditors assist the Australian Securities and Investments Commission (ASIC) in monitoring compliance with accounting standards. Listed companies must also comply with additional financial reporting requirements of the Australian Stock Exchange. The AASB has jointly issued statements of accounting concepts (SACs) with the Australian Accounting Research Foundation (AARF). Although not mandatory, the SACs form part of Australian generally accepted accounting principles.

3 Identify the types of users of accounting reports and their information needs. Internal users are managers who need accounting information in planning, controlling and evaluating business operations. The main external users are investors and creditors. Investors (shareholders) use accounting information to help them decide whether to buy, hold or sell shares. Creditors (suppliers and bankers) use accounting information to assess the risk of granting credit or lending money to a business. Other groups who have an indirect interest in a business are customers and regulatory agencies. Users of financial reports are interested in information about financing activities, which involve collecting the necessary funds to support the business; investing activities, which

involve acquiring the resources necessary to run the business; and operating activities, which involve putting the resources of the business into action to generate a profit.

4 Explain the accounting assumptions, principles and qualitative characteristics underlying financial statements. The basic accounting assumptions and principles are the monetary assumption, the accounting entity assumption, the period assumption, the going concern assumption, historical cost, and the full disclosure principle. SAC 3 states that all relevant and reliable information should be included in general-purpose financial reports, subject to materiality tests. SAC 3 identifies other qualitative characteristics of information, namely comparability and understandability, but acknowledges timeliness and costs versus benefits as constraints on the implementation of the qualitative characteristics.

5 Describe the three main financial statements and the basic accounting equation relating to the statement of financial position. A statement of financial performance presents the revenues and expenses of a company for a specific period of time. A statement of financial position reports the assets, liabilities and shareholders’ equity of a business at a specific date. A statement of cash flows summarises information concerning the cash inflows (receipts) and outflows (payments) for a specific period of time. The basic accounting equation is: Assets = Liabilities + Owners’ equity. The statement of financial position reflects this equation.

6 Identify the sections of a classified statement of financial position. In a classified statement of financial position, both assets and liabilities are classified as current or non-current. There is also a shareholders’ equity section, which shows share capital, retained profits and reserves.




7 Calculate ratios for analysing a company’s profitability, liquidity and solvency. Profitability ratios, such as profit margin and return on assets, measure different aspects of the operating success of a company for a given period of time. Liquidity ratios, such as the current ratio, measure the short-term ability of a

company to pay its maturing obligations and to meet unexpected needs for cash. Solvency ratios, such as the debt to total assets ratio, measure the ability of an entity to survive in the long term. The current cash debt coverage ratio measures a company’s liquidity. The cash debt coverage ratio measures a company’s solvency.

DECISION TOOLKIT — A SUMMARY

Are the business’s operations profitable?

Statement of financial performance

The statement of financial performance reports on the success or failure of the business’s operations by reporting its revenues and expenses.

If the business’s revenues exceed its expenses, it will report net profit; otherwise it will report a net loss.

Does the business rely mainly on debt or shareholders’ equity to finance its assets?

Statement of financial position

The statement of financial position reports the business’s resources and claims to those resources. There are two types of claims: liabilities and owners’ (shareholders’) equity.

Compare the amount of debt versus the amount of owners’ (shareholders’) equity to determine whether the business relies more on creditors or owners for its financing.

Does the business generate sufficient cash from operations to fund its investing activities?

Statement of cash flows The statement of cash flows shows the amount of cash provided or used by operating activities, investing activities and financing activities.

Compare the amount of cash provided by operating activities with the amount of cash used by investing activities. Any deficiency in cash from operating activities must be made up with cash from financing activities.

Is the company using its assets effectively?

Net profit and average assets Higher value suggests favourable efficiency (use of assets).

Is the company maintaining an adequate margin between sales and expenses?

Net profit and net sales Higher value suggests favourable return on each dollar of sales.


Current assets and current liabilities

Higher ratio suggests favourable liquidity.


Current liabilities and cash provided by operating activities

A higher value indicates liquidity.


Total liabilities and total assets

A higher ratio indicates solvency risk because the company has fewer assets available for creditors.


Total liabilities and cash provided by operating activities

A higher ratio indicates better solvency, that the company is generating cash sufficient to meet its long-term needs.


Return on assets ratio

=Net profit

Average total assets

Profit marginratio

=Net profitNet sales

Current ratio =Current assets

Current liabilities

Current cash debt coverage ratio

=

Cash provided by operations

Average current liabilities

Debt to total assets ratio =

Total liabilitiesTotal assets

Cash debt coverage ratio

=

Cash provided by operationsAverage total

liabilities




GLOSSARYAccounting The information system that communicates the economic events of an entity to interested users (p. 7).

Accounting entity assumption An assumption that economic events can be identified with a particular unit of accountability, such that financial statements are prepared from the perspective of the entity, not its owners or other parties (p. 11).

Accounts receivable The right to receive cash (p. 9).

Annual report A report prepared by corporate management that presents financial information including financial statements, notes and the directors’ report (p. 22).

Assets Future economic benefits controlled by the entity as a result of a past transaction or other past event (p. 16).

Auditor’s report A report prepared by an independent accountant expressing an opinion as to the fairness of the presentation of the financial position and results of operations of an entity and their conformance with accepted accounting standards (p. 25).

Australian Accounting Standards Board (AASB) The organisation with the authority to issue accounting standards in Australia (p. 6).

Balance date The last date of each reporting period(p. 11).

Balance sheet A statement that reports on the assets, liabilities and owners’ equity of an entity at a specific date; now known as a statement of financial position(p. 16).

Basic accounting equation Assets = Liabilities + Owners’ equity (p. 18).

Cash debt coverage ratio A measure of solvency that is calculated as cash provided by operating activities divided by average total liabilities (p. 39).

Classified statement of financial position A statement of financial position that contains a number of standard classifications or sections, including current and non-current categories (p. 28).

Company A business organised as a separate legal entity having ownership divided into transferable shares (p. 4).

Comparability Ability to compare the accounting information of different companies or the same company over time because the same accounting principles are used (p. 13).

Comparative statements A presentation of the financial statements of a company for multiple years(p. 20).

Costs versus benefits A constraint on the pursuit of qualitative characteristics of financial reporting that the

costs of preparing and reporting financial information should not exceed the benefits to users (p. 15).

Creditors Suppliers, bankers and others who grant credit or lend money (p. 8).

Current assets Cash and other assets that are reasonably expected to be converted to cash or used in the business within 1 year or the operating cycle, whichever is longer (p. 28).

Current cash debt coverage ratio A measure of liquidity that is calculated as cash provided by operating activities divided by average current liabilities (p. 37).

Current liabilities Obligations reasonably expected to be paid within the next year or operating cycle, whichever is longer (p. 30).

Current ratio A measure used to evaluate a company’s liquidity and short-term debt-paying ability, calculated by dividing current assets by current liabilities (p. 36).

Debt to total assets ratio Measures the percentage of total financing provided by creditors; calculated by dividing total debt by total assets (p. 38).

Directors’ report A section of the annual report that presents information that provides information about the directors and their views on the performance of the company (p. 24).

Dividends Distributions of cash or other assets from a company to its shareholders (p. 9).

Expenses The cost of assets consumed or services used in the process of generating revenues (p. 10).

Financial accounting The preparation and presentation of financial reports for external users(p. 4).

Full disclosure principle Accounting principle that dictates that circumstances and events that make a difference to financial statement users should be disclosed (p. 12).

Generally accepted accounting principles (GAAP)A set of rules and practices, having substantial authoritative support, that are recognised as a general guide for financial reporting purposes (p. 14).

General-purpose financial reports Published financial statements prepared in accordance with applicable Australian accounting standards (p. 9).

Going concern assumption The assumption that the business will continue in operation in the foreseeable future (p. 11).

Historical cost The amount paid for an asset (p. 11).

Intangible assets Non-current, non-monetary assets that do not have physical substance (p. 29).

Investors People who make decisions to buy, hold or sell shares (p. 8).




Liabilities The future sacrifices of economic benefits that the entity is currently obliged to make as a result of a past transaction or other past event (p. 16).

Liquidity The ability of a company to pay obligations that are expected to become due within the next year or operating cycle (p. 34).

Liquidity ratios Measures of the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash (p. 36).

Management accounting The provision of accounting information within the business entity (p. 4).

Materiality The condition on reporting all relevant and reliable information of whether an item is large enough to be likely to influence the decisions of users of financial statements (p. 13).

Monetary assumption An assumption stating that only transaction data that can be expressed in terms of money be included in the accounting records of the entity (p. 10).

Net loss the amount by which expenses exceed revenues (p. 10).

Net profit The amount by which revenues exceed expenses (p. 10).

Non-current assets Assets that are not expected to be consumed or sold within 1 year or the operating cycle (p. 29).

Non-current liabilities Liabilities that are not expected to be paid within 1 year or the operating cycle (p. 30).

Notes to the financial statements Notes that clarify information presented in the financial statements, as well as expand on information where additional detail is needed (p. 23).

Operating cycle The average time required to go from cash to cash in producing revenues (p. 28).

Ordinary shares Shares representing the main ownership interests in a company (p. 5).

Owners’ equity The owners’ claims on total assets of the entity; also known as shareholders’ equity (p. 18).

Partnership A business owned and controlled by more than one person (p. 4).

Period assumption An accounting assumption that the economic life of an entity can be divided into discrete periods of time (p. 11).

Profit and loss statement A statement that reports on the revenues and expenses of an entity for a period, and the resulting net profit or net loss; also known as a statement of financial performance (p. 16).

Profit margin ratio Measures the percentage of each dollar of sales that results in net profit, calculated by dividing net profit by net sales (p. 33).

Profitability ratios Measures of the profit or operating success of a business for a given period of time (p. 33).

Property, plant and equipment Assets of a relatively permanent nature that are being used in the business and are not intended for resale (p. 29).

Ratio An expression of the mathematical relationship between one quantity and another; may be expressed as a percentage, a rate or a proportion (p. 31).

Ratio analysis A technique for evaluating financial statements that expresses the relationship among selected financial statement data (p. 31).

Relevance The quality of information that indicates the information makes a difference in a decision (p. 12).

Reliability The quality of information that gives assurance that it is unbiased, free of error and a faithful representation (p. 13).

Retained profits The accumulated profit from the current and previous accounting periods that has not been distributed to owners (p. 18).

Return on assets ratio An overall measure of profitability; calculated by dividing net profit by average assets (p. 33).

Revenues Sales and other increases in owners’ equity other than contributions from owners (p. 10).

Share capital The total amount paid in by shareholders for shares in the company (p. 9).

Sole proprietorship A business owned by one person (p. 4).

Solvency The ability of a company to pay interest as it comes due and to repay the face value of debt at maturity (p. 38).

Solvency ratios Measures of the ability of the business to survive over a long period of time (p. 38).

Statement of cash flows A financial statement that provides information about the cash inflows (receipts) and cash outflows (payments) for a specific period of time (p. 18).

Statement of financial performance A statement that reports on the revenues and expenses of an entity for a period, and the resulting net profit or net loss; previously known as a profit and loss statement (p. 16).

Statement of financial position A statement that reports on the assets, liabilities and owners’ equity of an entity at a specific date; previously known as a balance sheet (p. 16).

Timeliness Whether communication is in the time frame within which decisions are made (p. 15).

Understandability The extent to which information can be understood by proficient users (p. 14).

Users of accounting reports People within and outside the business who need financial information for decision making (p. 7).

Working capital The difference between the amounts of current assets and current liabilities (p. 35).




DEMONSTRATION PROBLEMJeff Andringa, a former Aussie Rules player, quit his job and started Footy Camp, a football camp for children aged 8 to 18. Eventually he would like to open football camps nationwide. Jeff has asked you to help him prepare financial statements at the end of his first year of operations. He relates the following facts about his business activities.

In order to get the business off the ground, he decided to incorporate. He issued shares in Footy Camp Pty Ltd to a few close friends, as well as buying some of the shares himself. He initially raised $25 000 through the issue of these shares. In addition, the company took out a $10 000 loan at a local bank. A bus for transporting children was purchased for $12 000 cash. Balls and other miscellaneous equipment were purchased with $1500 cash. The company earned camp fees during the year of $100 000 but had collected only $80 000 of this amount. Thus, at the end of the year it was still owed $20 000. The company rents time at a local school oval for $50 per hour. Total oval rental costs during the year were $8000, insurance was $10 000, salary expense was $20 000, and administrative expenses totalled $9000, all of which were paid in cash. The company incurred $800 in interest expense on the bank loan, which it still owed at the end of the year.

The company paid dividends during the year of $5000 cash. The balance in the company’s bank account at the end of the year, 30 June 2003, was $49 500.

RequiredUsing the format of the Wong Pty Ltd statements in this chapter, prepare a statement of financial performance, a statement of financial position and a statement of cash flows. (Hint: Prepare the statements in the order stated to take advantage of the flow of information from one statement to the next, as shown in figure 1.7.)

Solution to demonstration problem

FOOTY CAMP PTY LTDStatement of Financial Performance


RevenuesCamp fees revenue

ExpensesSalaries expenseInsurance expenseAdministrative expensesOval rental expenseInterest expense

$20 00010 0009 0008 000

800

$100 000

Total expenses 47 800Net profit $ 52 200

Calculation of retained profits

Retained profits, 1 July 2002Add: Net profit

$ 052 200

Less: Dividends52 2005 000

Retained profits, 30 June 2003 $47 200

Demonstration problems are a final review before you begin homework. Problem-solving strategies that appear in the margins give you tips about how to approach the problem, and the solution provided illustrates both the form and content of complete answers.

Problem-solving strategies1. The statement of financial

performance shows revenues and expenses for a period of time.

2. The statement of financial position reports assets, liabilities and shareholders’ equity at a specific date.

3. The statement of cash flows reports sources and uses of cash from operating, investing and financing activities for a period of time.




FOOTY CAMP PTY LTDStatement of Financial Position

as at 30 June 2003

AssetsCashAccounts receivableBusEquipment

$49 50020 00012 0001 500

Total assets 83 000

LiabilitiesBank loan payableInterest payable

$10 000800

Total liabilities 10 800Net assets $72 200


$25 00047 200

Total shareholders’ equity $72 200

FOOTY CAMP PTY LTDStatement of Cash Flows


Cash flows from operating activitiesCash receipts from operating activitiesCash payments for operating activities

$ 80 000(47 000)

Net cash provided by operating activities 33 000

Cash flows from investing activitiesPurchase of busPurchase of equipment

(12 000(1 500

))

Net cash used by investing activities (13 500)

Cash flows from financing activitiesProceeds from bank loanIssue of sharesDividends paid

10 00025 000(5 000)

Net cash provided by financing activities 30 000Net increase in cashCash at beginning of period

49 5000

Cash at end of period $ 49 500

This would be a good time to return to the Student owner’s manual at the beginning of the book (or look at it for the first time if you skipped it before) to read about the various types of homework materials that appear at the ends of chapters. Knowing the purpose of the different assignments will help you appreciate what each contributes to your accounting

skills and competencies. The tool icon indicates that an instructional activity uses one of the decision tools presented in the chapter. The pencil icon indicates that an instructional activity requires written communication by the student.




Answers are at the end of the chapter.

1. Which is not one of the three forms of business organisation?(a) Sole proprietorship.(b) Creditorship.(c) Partnership.(d) Company.

2. Which is an advantage of companies relative to partnerships and sole proprietorships?(a) Separation of ownership and control.(b) Harder to transfer ownership.(c) Reduced legal liability for investors.(d) Most common form of organisation.

3. The AASB is overseen by:(a) the FRC.(b) ASIC.(c) the AARF.(d) the ASX.

4. Which is not one of the three main business activities?(a) Financing.(b) Operating.(c) Advertising.(d) Investing.

5. Which statement about users of accounting information is incorrect?(a) Management is considered an internal

user.(b) Taxing authorities are considered external

users.(c) Present creditors are considered external

users.(d) Regulatory authorities are considered

internal users.

6. Generally accepted accounting principles are:(a) a set of standards and rules that are

recognised as a general guide for financial reporting.

(b) usually established by the Australian Taxation Office.

(c) the guidelines used to resolve ethical dilemmas.

(d) fundamental truths that can be derived from the laws of nature.

7. What organisation issues Australian accounting standards?(a) Australian Accounting Standards

Board.(b) Australian Taxation Office.(c) Australian Securities and Investments

Commission.(d) None of the above.

8. Being able to verify information is part of:

9. What accounting constraints are identifiedin SAC 3?(a) Comparability and conservatism.(b) Materiality and consistency.(c) Relevance and reliability.(d) Timeliness and costs versus benefits.

10. Net profit will result during a time periodwhen:(a) assets exceed liabilities.(b) assets exceed revenues.(c) expenses exceed revenues.(d) revenues exceed expenses.

11. What section of a cash flow statement indicates the cash spent on new equipment during the past accountingperiod?(a) The investing section.(b) The operating section.(c) The financing section.(d) The cash flow statement does not give

this information.

12. Which financial statement reports assets, liabilities and owners’ equity?(a) Statement of financial performance.(b) Profit and loss statement.(c) Statement of financial position.(d) Statement of cash flows.

13. As of 31 December 2002, Stoneland Pty Ltd has assets of $3500 and shareholders’equity of $2000. What are the liabilitiesfor Stoneland Pty Ltd as of 31 December2002?

14. Historical cost measurement means that:(a) assets should be recorded at cost and

adjusted when the market valuechanges.

(b) activities of an entity should be kept separate and distinct from its owner.

(c) assets should be recorded at theircost.

(d) only transaction data capable of being expressed in terms of money should be included in the accounting records.

(LO1)

(LO1)

(LO2)

(LO3)

(LO3)

(LO4)

(LO2)

Reliability Relevance

(a)(b)(c)(d)

YesNoYesNo

YesNoNoYes

(LO4)

(LO4)

(LO5)

(LO5)

(LO5)

(LO5)

(a) $1500.(b) $1000.

(c) $2500.(d) $2000.

(LO4)

SELF-STUDY QUESTIONS




BRIEF EXERCISESBE1.1 Match each of the following forms of business organisation with a set of characteristics: sole proprietorship (SP), partnership (P), company (C).(a) Shared control, increased skills and resources.(b) Simple to set up and maintains control with founder.(c) Easier to transfer ownership and raise funds, no personal liability.

15. Valuing assets at their market value rather than at their cost is inconsistent withthe:(a) period assumption.(b) entity assumption.(c) historical cost principle.(d) All of the above.

16. In a classified statement of financial position, assets are usually classified as:(a) current assets and cash.(b) current assets, non-current assets and

owners’ equity.(c) current assets and non-current assets.(d) current assets and intangible assets.

17. Which is not an indicator of profitability?(a) Current ratio.(b) Profit margin ratio.(c) Net profit.(d) Return on assets ratio.

18. For 2004 Plano Pty Ltd reported net profit $24 000; net sales $400 000; and average assets $600 000. What was the 2004 profit margin ratio?

19. The balance in retained profits is not affected by:(a) net profit.(b) net loss.(c) the issue of shares.(d) dividends.

20. Which of these measures is an evaluation of a company’s ability to pay current liabilities?(a) Profit margin ratio.(b) Current ratio.(c) Both (a) and (b).(d) None of the above.

(LO4)

(LO6)

(LO7)

(LO7)

(a) 6%.(b) 12%.

(c) 40%.(d) 200%.

(LO5)

(LO7)

QUESTIONS1. What are the advantages to a business of being

formed as a company? What are the disadvantages?

2. Who are the external users of accounting data? Give examples.

3. Listed here are some items found in the financial statements of Ruth Weber Ltd. Indicate in which financial statement(s) each item would appear.

4. What are the three main categories of the statement of cash flows? Why do you think these categories were chosen?

5. What is retained profits? What items increase the balance in retained profits? What items decrease the balance in retained profits?

6. What purpose does the going concern assumption serve?

7. Ray Aldag, the managing director of Raynard Pty Ltd is pleased. Raynard substantially increased its net profit in 2003 while keeping its unit inventory

relatively the same. Tom Erhardt, chief accountant, cautions Aldag, however. Erhardt says that since Raynard changed its method of inventory valuation, there is a consistency problem and it is difficult to determine whether Raynard is better off. Is Erhardt correct? Why or why not?

8. What is meant by the term operating cycle ?

9.(a) Tia Kim believes that the analysis of financial

statements is directed at two characteristics of a company: liquidity and profitability. Is Tia correct? Explain.

(b) Are short-term creditors, long-term creditors, and shareholders mainly interested in the same characteristics of a company? Explain.

10. Holding all other factors constant, indicate whether each of the following signals generally good or bad news about a company.(a) Increase in the profit margin ratio.(b) Increase in the current ratio.(c) Increase in the debt to total assets ratio.(d) Decrease in the return on assets ratio.

(a) Service revenue.(b) Equipment(c) Advertising expense.

(d) Accounts receivable.(e) Share capital.(f) Wages payable.

Describe forms of business organisation.(LO1)




BE1.2 Indicate whether each statement is true or false.(a) GAAP is a set of rules and practices established by the accounting profession and

regulatory bodies to serve as a general guide for financial reporting purposes.(b) Substantial authoritative support for GAAP usually comes from two standards-setting

bodies: the AASB and the Australian Taxation Office.

BE1.3 Match each of the following types of evaluation with one of the listed users of accounting information.1. Trying to determine whether the company complied with tax laws.2. Trying to determine whether the company can pay its obligations.3. Trying to determine whether a marketing proposal will be cost-effective.4. Trying to determine whether the company’s net profit will result in a share price

increase.5. Trying to determine whether the company should use debt or equity financing.

BE1.4 In alphabetical order below are items for DFV Takeaway Pty Ltd at31 December 2002. Prepare a statement of financial position following the format of figure 1.7.

BE1.5 Indicate which statement you would examine to find each of the following items: statement of financial performance (SFPe), statement of financial position (SFPo), or statement of cash flows (SCF).(a) Revenue during the period.(b) Inventory on hand at the end of the year.(c) Cash received from issuing new shares during the period.(d) Total debts outstanding at the end of the period.

BE1.6 A list of financial statement items for Swan Ltd includes the following: accounts receivable $16 500; prepaid insurance $3600; cash $18 400; supplies $5200; short-term investments $8200; property, plant and equipment, $10 000. Prepare the asset section of the statement of financial position, showing appropriate classifications.

BE1.7 The following information is available for Tay Ltd for 2003: sales revenue $9 346 911; cost of goods sold $6 348 945; net profit $2 053 646; total shareholders’ equity $2 233 303; average total assets $4 425 235. Calculate the return on assets ratio and profit margin ratio for Tay Ltd for 2003.

E1.1 Here is a list of words or phrases discussed in this chapter:

RequiredMatch each word or phrase with the best description of it.

(a) An expression about whether financial statements are presented in a reasonable fashion.

(b) An entity that raises money by issuing shares. (c) The portion of shareholders’ equity that results from receiving cash from

investors.

Accounts payableAccounts receivableCashShare capital

$90 00081 00040 50031 500

Recognise generally accepted accounting principles.(LO2, 4)

Identify users of accounting information.(LO3)

(a) Investors in shares.(b) Marketing managers.(c) Creditors.

(d) Chief Financial Officer.(e) Australian Taxation Office.

Prepare a statement of financial position.(LO5)

Determine proper financial statement.(LO5)

Prepare the assets section of a classified statement of financial position.(LO6)

Calculate return on assets ratio and profit margin ratio.(LO7)

EXERCISESMatch items with descriptions.(LO1, 5) 1. Company

2. Creditor3. Accounts receivable4. Partnership

5. Shareholder6. Share capital7. Accounts payable8. Auditor’s opinion




(d) Obligations to suppliers of goods. (e) Amounts due from customers. (f) A party to whom a business owes money. (g) A party that invests in shares. (h) A business that is owned jointly by two or more individuals but that

does not issue shares.

E1.2 This information relates to Geoff’s Gear Pty Ltd for the year 2003:

RequiredAfter analysing the data, prepare a statement of financial performance for the year ending 31 December 2003 and calculate retained profits at 31 December 2003.

E1.3 Deanna Veale is the bookkeeper for Brakes Ltd. Deanna has been trying to make the statement of financial position of Brakes Ltd balance. It finally balanced, but now she’s not sure it is correct.

RequiredPrepare a correct statement of financial position.

E1.4 The following items were taken from Black Ltd’s financial statements for 2003. (All dollars are in thousands.)

Retained profits $6 795 Non-current borrowings $11 386 Cost of sales 3 133 Inventories 8 Wages expense 3122 Net revenue 23 086 Cash 1 077 Non-current payables 7 Current payables 2 823 Reserves 11 Interest expense 769 Income tax expense 2 236 Other expense 6 894 Contributed equity 6 433 Depreciation andamortisation expense 2 871

RequiredPerform each of the following:(a) In each case identify whether the item is an asset (A), liability (L), owners’ equity

(OE), revenue (R) or expense (E).(b) Calculate net profit for Black Ltd for the year ended 30 June 2003.

Retained profits, 1 January 2003Advertising expenseDividends paid during 2003Rent expenseHire revenueElectricity expenseSalaries expense

$57 0001 8007 000

10 40061 0002 400

28 000

BRAKES LTDStatement of Financial Position

as at 30 June 2003

Assets Liabilities and shareholders’ equity

CashSuppliesEquipmentDividends

$18 5008 000

44 0007 000

Accounts payableAccounts receivableShare capitalRetained profits

$ 20 000(10 00040 00027 500

)

Total assets $77 500Total liabilities and

shareholders’ equity $ 77 500

Prepare a statement of financial performance and calculate retained profits.(LO5)

Correct an incorrectly prepared statement of financial position.(LO5)

Identify financial statement components and calculate profit.(LO5)




E1.5 Here are incomplete financial statements for Von Mises Ltd:

RequiredCalculate the missing amounts.

E1.6 Cheong Pty Ltd had three major business transactions during 2003.(a) Merchandise inventory with a cost of $208 000 is reported at its market value of

$260 000.(b) The owner of Cheong Pty Ltd, Cheong Kong, purchased a truck for personal use

and charged it to his expense account.(c) Cheong Pty Ltd wanted to make its 2003 profit look better, so it added 2 more

weeks to the year (a 54-week year). Previous years were 52 weeks.

RequiredIn each situation, identify the assumption or principle that has been violated, if any, and discuss what should have been done.

E1.7 The following items were taken from the 30 June 2001 statement of financial position of Harvey Norman Holdings Ltd. (All dollars are in thousands.)

RequiredPrepare the assets section of a classified statement of financial position.

VON MISES LTDStatement of Financial Position

Assets Liabilities and owners’ equity

CashInventoryProperty

$ 5 00010 00050 000

LiabilitiesAccounts payable

Owners’ equityContributed equityRetained profits

$ 5 000

(a)(b)

Total assets $65 000Total liabilities and owners’

equity $ 65 000

Statement of Financial Performance

RevenuesCost of goods soldAdministrative expenses, including tax

$80 000(c)

10 000Net profit $ (d)

Retained Profits Calculation

Beginning retained profitsNet profitDividends

$10 000(e)

(5 000)Ending retained profits $29 000

InventoriesReceivables — due after

30 June 2002Short-term financial assetsOther long-term financial

assetsInvestments (long term)

$88 050

12 2918 458

10 45536 460

IntangiblesOther current assetsProperty, plant and

equipmentCash assetsCurrent receivablesOther non-current assets

$ 69216 689

654 48823 024

528 3172 292

Calculate missing amounts.(LO5)

Identify the assumption or principle that has been violated.(LO4)

Classify items as current or non-current, and prepare assets section of statement of financial position.(LO6)




E1.8 These financial statement items are for Devonport Dinkies Pty Ltd at year-end, 31 July 2003:

Required(a) Prepare a statement of financial performance for the year. Devonport Dinkies Pty

Ltd did not issue any new shares during the year.(b) Prepare a classified statement of financial position at 31 July 2003.

E1.9 OPSM Protector Ltd operates stores in numerous states. Selected financial statement data (in thousands of dollars) for the year ended 30 June 2001 are as follows:

For the year, net sales were $562 475 and cost of goods sold was $315 663.

Required(a) Calculate the working capital and current ratio at the beginning of the year and at

the end of the current year.(b) Did OPSM’s liquidity improve or worsen during the year?(c) Using the data in the chapter, compare OPSM’s liquidity with Colorado Group Ltd’s.

E1.10 The following data were taken from the 2001 and 2000 financial statements of Freedom Group. (All dollars in thousands.)

RequiredPerform each of the following:(a) Calculate the debt to assets ratio for each year.(b) Calculate the cash debt coverage ratio for each year. (Total liabilities at year-end

1999 were $85 458 000.)(c) Discuss Freedom Group’s solvency in 2001 versus 2000.(d) Discuss Freedom Group’s ability to finance its investment activities with cash

provided by operating activities, and how any deficiency would be met.

Salaries expenseElectricity expenseEquipmentAccounts payableCommission revenueRent revenueUnearned rent revenueShare capitalCashAccounts receivableAccumulated depreciationDividendsDepreciation expenseRetained profits (beginning of the year)

$54 70024 90015 9006 220

61 1008 5001 800

16 00021 9408 7805 4004 0004 000

35 200

End of year Beginning of yearCashReceivables (net)Merchandise inventoryOther current assets

$ 31 69147 58355 1178 324

$ 18 42263 90888 85310 014

Total current assets $142 715 $181 197Total current liabilities $ 93 108 $ 88 969

2001 2000Current assetsTotal assetsCurrent liabilitiesTotal liabilitiesTotal owners’ equityCash provided by operating activities*Cash used in investing activities

$ 80 803138 06753 66984 91853 14915 177(5 686)

$ 97 120154 61967 95999 55555 0649 762

(11 889)* The 2001 financial statements reported on a period of 9 months.

Prepare financial statements.(LO5,6)

Calculate liquidity ratios and compare results.(LO7)

Calculate and interpret solvency ratios.(LO7)




P1.1 Presented below are five independent situations.(a) Three physics lecturers have formed a business to improve the speed of information

transfer over the Internet for stock exchange transactions. Each has contributed an equal amount of cash and knowledge to the venture. Although their approach looks promising, they are concerned about the legal liabilities that their business might confront.

(b) Joe Robbins, a university student looking for summer employment, opened a bait shop in a small shed at a local wharf.

(c) Robert Steven and Tom Cheng each owned separate shoe manufacturing businesses. They have decided to combine their businesses. They expect that within the coming year they will need significant funds to expand their operations.

(d) Darcy Becker, Ellen Sweet and Meg Dwyer recently graduated with marketing degrees. They have been friends since childhood. They have decided to start a consulting business focused on marketing sporting goods over the Internet.

(e) Anthony Troy wants to rent CD players and CDs in airports across the country. His idea is that customers will be able to rent equipment and CDs at one airport, listen to the CDs on their flights, and return the equipment and CDs at their destination airport. Of course, this will require a substantial investment in equipment and CDs, as well as employees and locations in each airport. Anthony has no savings or personal assets. He wants to maintain control over the business.

RequiredIn each case explain what form of organisation the business is likely to take — sole proprietorship, partnership or company. Give reasons for your choice.

P1.2 Financial decisions often place heavier emphasis on one type of financial statement over the others. Consider each of the following hypothetical situations independently.(a) North Sales Ltd is considering extending credit to a new customer. The terms of the

credit would require the customer to pay within 30 days of receipt of goods.(b) An investor is considering purchasing shares in Colorado Group Ltd. The investor

plans to hold the investment for at least 5 years.(c) Otago Bank is considering extending a loan to a small company. The company

would be required to make interest payments at the end of each year for 5 years, and to repay the loan at the end of the fifth year.

(d) The finance director of Pacific Pipes Ltd is trying to determine whether the company is generating enough cash to increase the amount of dividends paid to investors in this and future years, and still have enough cash to buy plant and machinery as needed.

RequiredIn each situation, state whether the decision maker would be most likely to place the main emphasis on information provided by the statement of financial performance, statement of financial position or statement of cash flows. In each case provide a brief justification for your choice. Choose only one financial statement in each case.

P1.3 Harbour Sails Pty Ltd was formed on 1 July 2003. At 30 June 2004, Brandon Copple, the managing director and major shareholder, decided to prepare a statement of financial position, which appeared as follows:

HARBOUR SAILS PTY LTDStatement of Financial Position

as at 30 June 2004


CashAccounts receivableInventoryBoat

$20 00055 00030 00015 000

Accounts payableNotes payableBank loanShareholders’ equity

$40 00015 00010 00055 000

PROBLEMSDetermine forms of business organisation.(LO1)

Identify users and uses of financial statements.(LO3,5)

Comment on proper accounting treatment and prepare a corrected statement of financial position.(LO4,5)




Brandon willingly admits that he is not an accountant by training. He is concerned that his statement of financial position might not be correct. He has provided you with the following additional information:1. The boat actually belongs to Brandon, not to Harbour Sails Pty Ltd. However,

because he thinks he might take customers out on the boat occasionally, he decidedto list it as an asset of the company. To be consistent he also listed as a liability ofthe company his personal loan that he took out at the bank to buy the boat.

2. The inventory was originally purchased for $10 000, but due to a surge in demandBrandon now thinks he could sell it for $30 000. He thought it would be best torecord it at $30 000.

3. Included in the accounts receivable balance is $10 000 that Brandon lent to hisbrother 5 years ago. Brandon included this in the receivables of Harbour Sails Pty Ltdso he wouldn’t forget that his brother owes him money.

Required(a) Comment on the proper accounting treatment of the three items above.(b) Provide a corrected statement of financial position for Harbour Sails Pty Ltd. (Hint:

To get the statement of financial position to balance, adjust shareholders’ equity.)

P1.4 Obscure Driving School Pty Ltd was started on 1 May with an investment of $45 000 cash. Following are the assets and liabilities of the company on 31 May 2003, and the revenues and expenses for the month of May, its first month of operations.

No further shares were issued in May, but a dividend of $1700 in cash was paid.

RequiredPrepare a statement of financial performance for the month of May, and calculate retained profits and prepare a balance sheet as at 31 May 2003.

P1.5 Presented below are selected financial statement items for Homeway Ltd for 31 December 2003:

RequiredDetermine which items should be included in a statement of cash flows, and then prepare the statement for Homeway Ltd.

P1.6 The following items are taken from the 2001 statement of financial position of OPSM Protector Ltd (in thousands):

CashAccounts receivableEquipmentService revenueAdvertising expenseAccounts payable

$ 7 80011 20060 0009 600

9002 400

Notes payableRent expenseRepair expenseFuel expenseInsurance expense

$30 0001 200

4003 400

400

InventoryCash paid to suppliersBuildingShare capitalCash dividends paidCash paid to purchase equipmentEquipmentRevenuesCash received from customers

$ 55 00095 000

400 00020 0008 000

26 00040 000

200 000165 000

Interest-bearing liabilities (short-term)Contributed equityProperty and equipment, netAccounts payable (due by 30 June 2002)Intangibles

$ 8 73267 35890 57452 67249 053

(continued)

Prepare a statement of financial performance and a statement of financial position.(LO5)

Determine items included in a statement of cash flows and prepare the statement.(LO5)

Prepare a classified statement of financial position.(LO6)




RequiredPrepare a statement of financial position, appropriately classified, for OPSM for 2001.

P1.7 Here are the comparative statements of Eric Clayton Pty Ltd:

Long-term financial assetsAccounts receivable (short term)Prepaid expenses and other current assetsLong-term receivablesRetained profitsCash assetsLong-term interest-bearing liabilitiesAccrued expenses (provisions) (short term)InventoryDeferred tax assetsReservesDeferred tax liabilities (non-current)Provisions (long term)

2 41647 5838 3241 549

39 34631 69187 45331 70455 11716 9747 3204 9623 734

ERIC CLAYTON PTY LTDStatements of Financial Performance


2004 2003Net salesCost of goods soldSelling and administrative expenseInterest expenseIncome tax expense

$2 218 5001 005 500

906 00098 00086 700

$2 100 500996 000879 00079 00077 000

Net profit 122 300 $ 69 500

ERIC CLAYTON PTY LTDStatements of Financial Position

as at 30 June 2004

2004 2003AssetsCurrent assets

CashShort-term investmentsAccounts receivable (net)Inventory

$ 60 10054 000

207 800123 000

$ 64 20050 000

102 800115 500

Total current assetsProperty, plant and equipment (net)

444 900625 300

332 500440 300

Total assets $1 070 200 $ 772 800

Liabilities and shareholders’ equityCurrent liabilities

Accounts payableIncome taxes payable

$ 200 00043 500

$ 65 40042 000

Total current liabilitiesDebentures payable

243 500210 000

107 400200 000

Total liabilitiesShareholders’ equity

Contributed equityRetained profits

453 500

330 000286 700

307 400

300 000165 400

Total shareholders’ equity 616 700 465 400Total liabilities and shareholders’ equity $1 070 200 $ 772 800

Calculate liquidity, solvency and profitability ratios.(LO7)




The cash provided by operating activities for 2004 was $190 800.

RequiredCalculate these values and ratios for 2004:

P1.8 Selected financial data (in thousands) of two competitors, Brown Wines Ltd and Brunswick Wines Ltd for 2003 are presented here:

RequiredFor each company, calculate these values and ratios:(a) Working capital.(b) Current ratio.(c) Debt to total assets ratio.(d) Return on assets ratio.(e) Profit margin ratio.(f) Compare the liquidity, solvency and profitability of the two companies.

Brown Wines Ltd

Brunswick Wines Ltd

Selected statement of financialperformance data for year

Net salesCost of goods soldBorrowing costs (interest expense)

$ 65 28936 046

638

$ 52 79338 5012 869

Profit before taxIncome tax

12 9114 258

4 6271 608

Net profit after tax 8 653 3 019

Condensed statement of financialposition (end of year)

Current assetsNon-current assets

$ 68 86838 381

$ 79 63463 430

Total assets $107 249 $143 064

Current liabilitiesNon-current liabilitiesTotal shareholders’ equity

$ 40 40320 82146 025

$ 27 31639 32076 428

Total liabilities and shareholders’ equity $107 249 $143 064

Beginning-of-year balances

Total assets $ 64 095 $119 987

(a) Working capital.(b) Current ratio.(c) Current cash debt coverage ratio.(d) Debt to total assets ratio.

(e) Cash debt coverage ratio.(f) Profit margin ratio.(g) Return on assets ratio.

Calculate ratios and compare liquidity, solvency and profitability for two companies.(LO7)




B U I L D I N G B U S I N E S S S K I L L S

FINANCIAL REPORTING AND ANALYSISFINANCIAL REPORTING PROBLEM: Colorado Group Ltd

BBS1.1 Colorado Group Ltd’s 2002 financial statements are provided in appendix A at the back of this book. You will need to refer to the notes to the financial statements.

RequiredUse Colorado Group Ltd’s consolidated data to answer these questions:(a) What were the company’s total assets at 26 January 2002? at 27 January 2001?(b) How much inventory did the company have on 26 January 2002?(c) What amount of accounts payable did the company report on 26 January 2002? on

27 January 2001?(d) What were the company’s sales in 2002? in 2001?(e) What is the amount of the change in net profit after tax from 2001 to 2002?(f) The accounting equation is: Assets = Liabilities + Owners’ equity. Replacing the

words in that equation with dollar amounts, give Colorado Group Ltd’s accounting equation at 27 January 2001.

(g) What were the current liabilities at 26 January 2002?

COMPARATIVE ANALYSIS PROBLEM: Colorado Group Ltd vs. Miller’s Retail Ltd

BBS1.2 Extracts from the 2001 financial statements of Miller’s Retail Ltd are presented below, and Colorado Group Ltd’s 2002 financial statements are in appendix A.

MILLER’S RETAIL LTDStatement of Financial Performance



Revenue from ordinary activitiesBorrowing costs expense

$650 739(4 464)

$237 735(574)

Profit from ordinary activities before income tax expenseIncome tax expense

37 266(13 714)

$ 19 331(7 079)

Profit from ordinary activities after income tax expense $ 23 552 $ 12 252

Statement of Financial Positionas at 30 June 2001

(in thousands)


Current assetsCashReceivablesInventoriesOther

$ 20 6937 841

139 4112 435

$ 5 2204 112

70 0551 951

Total current assets 170 380 81 338Non-current assets

Property, plant and equipmentDeferred tax assetsIntangible assetsOther

86 1596 901

96 086385

40 7293 205

44 530494

Total non-current assets 189 531 88 958Total assets 359 911 170 296


GUEST

MILLER’S RETAIL LTD Statement of Financial Performance for the year ended 30 June 2001 (in thousands) Consolidated 2001 2000 Revenue from ordinary activities Borrowing costs expense $650 739 (4 464) $237 735 (574) Profit from ordinary activities before income tax expense Income tax expense 37 266 (13 714) $ 19 331 (7 079) Profit from ordinary activities after income tax expense $ 23 552 $ 12 252 Statement of Financial Position as at 30 June 2001 (in thousands) Consolidated 2001 2000 Current assets Cash Receivables Inventories Other $ 20 693 7 841 139 411 2 435 $ 5 220 4 112 70 055 1 951 Total current assets 170 380 81 338 Non-current assets Property, plant and equipment Deferred tax assets Intangible assets Other 86 159 6 901 96 086 385 40 729 3 205 44 530 494 Total non-current assets 189 531 88 958 Total assets 359 911 170 296



Required(a) Based on the information in the companies’ financial statements, determine the

following for each company, using consolidated data.(1) Total assets.(2) Accounts receivable.(3) Total revenue.(4) Profit after tax.

(b) For each company calculate working capital and the current ratio.(c) Which company appears to have stronger liquidity?

INTERPRETING FINANCIAL STATEMENTS

BBS1.3 Mayne Group Ltd is one of Australia’s leading private healthcare providers. It is also one of the most diversified logistics operators. In 2001 the company’s statement of cash flows reported the following (all dollars in thousands):

In 2001 the most significant source of cash generation, other than operating activities, was the issue of shares ($206 million) and the sale of a business ($457 million).

RequiredUse the information above to answer each of the following:(a) If you were a creditor of Mayne, what reaction might you have to the 2000

statement of cash flows and the 2001 statement of cash flows?(b) If you were a shareholder of Mayne, what reaction might you have to the investing

cash flows in 2001?(c) If you were evaluating the company as either a creditor or a shareholder, what other

information would you be interested in seeing?

Statement of Financial Position (continued)



$139 50149 6606 743

13 740

60 79717 8955 6238 522

Total current liabilities 209 644 92 837Non-current liabilities

Interest-bearing liabilitiesDeferred tax liabilitiesProvisions

60 8901 7136 917

31 6341 4215 105


Net assets $ 80 747 $ 39 299

EquityContributed equityRetained profits

$ 77 6633 084

$ 31 4427 857

Total equity $ 80 747 $ 39 299

2001 2000Cash generated by operating activitiesCash generated (used) by investing activitiesCash provided (used) by financing activities

$ 84 985319 01556 140

$ 173 470(224 763(30 872

))

Net change in cash $460 140 $ (82 165)


GUEST

Statement of Financial Position (continued) Consolidated 2001 2000 Current liabilities Payables Interest-bearing liabilities Current tax liabilities Provisions $139 501 49 660 6 743 13 740 60 797 17 895 5 623 8 522 Total current liabilities 209 644 92 837 Non-current liabilities Interest-bearing liabilities Deferred tax liabilities Provisions 60 890 1 713 6 917 31 634 1 421 5 105 Total non-current liabilities 69 520 38 160 Total liabilities 279 164 130 997 Net assets $ 80 747 $ 39 299 Equity Contributed equity Retained profits $ 77 663 3 084 $ 31 442 7 857 Total equity $ 80 747 $ 39 299



A GLOBAL FOCUS

BBS1.4 Companies list on stock exchanges to make it easier to raise capital from the public. Stock exchanges facilitate investment by providing markets for securities (shares, bonds, notes and other financial instruments). In order to promote fair trading and maintain investor confidence, stock exchanges require listed companies to comply with listing rules, many of which require public disclosure of information about the company’s operating, financing and investing activities and how they affect financial performance and financial position. Companies with a full listing must comply with all applicable listing rules. Companies with a foreign-exempt listing do not have to comply with many of the listing rules of the Australian Stock Exchange (ASX). Recent changes to the ASX’s criteria for foreign-exempt listing rules have seen some New Zealand companies opt for full listing while others are considering ‘packing their bags and heading home’.

Consider the following article from the Sydney Morning Herald.

Changes push NZ firms into full listingsMost New Zealand corporates on the Aus-tralian Stock Exchange are moving towards afull listing to meet tougher conditions to beplaced on foreign companies.

This week a growing number of NZ com-panies said they were prepared to pay moreto meet the revised ASX foreign-exemptcategory thresholds.

They include Auckland International Airport,Sky City Entertainment Group, chemicals-based concern Nuplex Industries, and Air NewZealand.

Others are Telecom Corp of NZ, Tower,Genesis Research and Development Corp,Fletcher Building and Fletcher ChallengeForests.

Carter Holt Harvey has said it would mostlikely take a full listing.

Most of these companies aim to retain ahome listing in New Zealand.

Summit Resources said it planned to applyto the ASX for general admission, where itwas first admitted to the ASX official list.Summit won’t be required to pay a furtherinitial listing fee.

Those still deciding whether they willapply for full listing include Kiwi IncomeProperties and The Warehouse Group.

Those that ruled out a full listing includedContact Energy, which said it would delistfrom July 1. Contact chairman Phil Pryke saidthe company had decided the cost of duallisting under the new regime could not bejustified.

Contact has fewer than 100 investors inAustralia, holding around 350 000 shares.

Nuplex chairman Fred Holland said hiscompany would now have a dual primarylisting.

‘[But] the decision taken by Nuplex doesnot indicate acceptance that the positiontaken by the ASX is appropriate, or that theASX has provided credible reasons for thechange in rules,’ Mr Holland said.

‘Nuplex accepts that if the rule changes areinevitable, the company needs to maintainASX listing . . . the decision is also taken inrecognition of the significant capital invest-ment that Nuplex has in Australia.’

Air New Zealand chairman John Palmersaid the airline still had an Australian focus,and saw a full listing as a way of enhancingits recognition.

‘Australia remains and will continue toremain a market of critical importance to AirNZ,’ Mr Palmer said.

‘This applies not only to the company’scustomers in Australia but also to its existingand potential investors.’

The ASX said the tougher criteria forforeign companies was meant to strengthenits international reputation.

Overseas firms wanting a foreign-exemptlisting — allowing them to ignore most ASXrules — would now have to prove they had$2 billion in net tangible assets, up from thecurrent requirement of $50 million, or $200million profit after tax in each of the pre-vious three years.

Any entity not meeting either of these cri-teria may apply to convert to a full listing,requiring them to comply with all listingrules. The new threshold begins to takeeffect on 1 June and will be fully in placefrom 1 July.

Source: Sydney Morning Herald article, 13 April 2002, available from www.smh.com.au/articles/2002/04/12/1018333418525.html [cited 14 April 2002]. AAP.




RequiredUse the information in the article to answer each of the following:(a) Why has the ASX made it more difficult for companies to obtain a foreign-exempt listing?(b) Why might some companies prefer to obtain a foreign-exempt listing?(c) Why are some New Zealand companies considering delisting while others prefer to

obtain full listing on the ASX? In answering this question, consider the costs versus benefits constraint on providing information in financial reports.

FINANCIAL ANALYSIS ON THE WEB

BBS1.5 Purpose: This exercise is an introduction to some large accounting firms.

Addresses: Deloitte & Touche www.deloitte.com.au or www.deloitte.co.nzErnst & Young www.ey.com/global/acr.nsf/australia/homeKPMG Peat Marwick www.kpmg.com/au or www.kpmg.co.nzPriceWaterhouseCoopers www.pwcglobal.com/au or

www.pwcglobal.com/nz

Steps: Go to the homepage of a firm that is of interest to you.

RequiredAnswer the following questions:(a) Name two services provided by the firm.(b) What countries does it operate in?(c) Does it provide information for students? If so, briefly describe the type of

information.(d) Summarise one recent news item discussed on the firm’s website.

CRITICAL THINKINGGROUP DECISION CASE

BBS1.6 Temp Services Pty Ltd provides personnel for temporary office positions. Temp matches the qualifications of its standby personnel with the requirements of the companies using their services. The companies pay Temp Services; Temp Services, in turn, pays the employees.

In a recent annual report, Temp Services chronicled its contributions to community services over the past 10 years. The following excerpts illustrate the variety of services provided:1. During an Easter week customer appreciation event, Temp Services made donations

of stationery, office decorations and decals containing the company’s name.2. In support of the ‘Clean Up Australia’ campaign in 2003, the company donated, and

its employees planted, grevillea gardens in cities across Australia.3. The company held a competition in which customers throughout Australia and New

Zealand nominated their favourite children’s charities. Winning charities in the drawreceived a monetary donation from Temp Services in the name of the customer.

4. Temp Services expanded its Easter week events by donating temporary help.5. Temp Services executives often volunteer their time and resources to serve as role

models and mentors to young people in Auckland.

RequiredWith the class divided into groups, answer the following:(a) The economic entity assumption requires that a company keep the personal

expenses of its employees separate from business expenses. Which of the activities listed above were expenses of the business, and which were personal expenses of the employees? Be specific. If part of the donation is business and part is personal, note which part is each.




(b) For those items that were company expenses, state whether the expense was probably categorised as an advertising expense, employee wages expense, grounds maintenance expense, or charitable contribution expense. You may use any or all of the categories. Explain your answer.

COMMUNICATION ACTIVITY

BBS1.7 Amy Joan is the bookkeeper for J.B. Hamilton Ltd. Amy has finally got the company’s statement of financial position to balance, but she still isn’t sure that it is correct. Before sending the statement to the Board of Directors, she asks you to check it.

RequiredExplain to Amy in a memo (a) the purpose of a statement of financial position and (b) why this statement is incorrect and what she should do to correct it.

ETHICS CASE

BBS1.8 As the chief accountant of Breathless Perfume Pty Ltd, you discover a significant misstatement that overstated net profit in this year’s financial statements. The misleading financial statements are contained in the company’s annual report, which is about to be issued to banks and other creditors. After much thought about the consequences of telling the managing director, Eddy Kadu, about this misstatement, you gather your courage to tell him. Eddy says, ‘What they don’t know won’t hurt them. But just so we set the record straight, we’ll adjust next year’s financial statements for this year’s misstatement. We can absorb that misstatement better next year when we make more profit. Just don’t make that kind of mistake again.’

Required(a) Who are the stakeholders in this situation?(b) What are the ethical issues?(c) What would you do as the chief accountant?

J.B. HAMILTON LTDStatement of Financial Position

for the month ended 30 June 2003


EquipmentCashSuppliesAccounts payable

$20 5009 0002 000

(5 000)

Contributed equityAccounts receivableDividendsNotes payableRetained profits

$11 000(3 000(2 00010 50010 000

))

Total assets $26 500Total liabilities and

shareholders’ equity $26 500

Answers to self-study questions1. b 2. c 3. a 4. c 5. d 6. a 7. a 8. c 9. d 10. d 11. a 12. c 13. a 14. c15. c 16. c 17. a 18. a 19. c 20. b

Answer to Review It questionsQuestion 3, p. 26: $134 564 000 = $63 724 000 + $70 840 000Question 3, p. 30: Inventories


trim size: 215mm wide x 275mm deep full disclosure ... · 12 accounting: building business skills...

Documents