AFF1000 revision notes.docx

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Ellinor Allen

The conceptual framework In Australia, the AASB Framework provides guidance on the following: – Which entities must make their financial statements publicly available. – The purpose of external financial reporting. – Qualities that the financial statements should have. – The elements of accounting (from lecture 1). AASB - Australian Accounting Standards Board • The ‘Conceptual Framework’ provides characteristics that general purpose financial information should have if it is to be useful for decision making. • Fundamental characteristics: – relevance and reliability (faithful representation) (the latter is proposed to replace the current qualitative characteristic of ‘reliability’). • Enhancing characteristics: – Understandability – Comparability – Timeliness – Verifiability • Constraints: – Cost/benefit – Materiality Who must report? • ‘Reporting Entities’. • These are entities that are considered to have external users relying on their financial information to make decisions. • Statement of Accounting Concepts 1 (SAC1) defines a ‘Reporting Entity’ as any entity in which it is reasonable to expect the existence of users who depend on general-purpose financial statements for information to enable them to make economic decisions. • The key factor is dependence. • Many entities have users, but they are not all dependent users. • If the only users related to an entity are those who can command information when needed, they are not dependent, therefore the entity is not a reporting entity. • The users must not be in a position to command information, they are ‘dependent’. Owner’s Equity = Assets – Liabilities or Assets = Liabilities + Owner’s Equity Income Definition: “… increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants” Essential characteristics: • An increase in economic benefits • Assets or Liabilities • Result in an increase in equity, but • Excludes owner’s contributions of equity Expenses Definition: “…decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrence of liabilities that result in decreases in equity, other than those relating to distributions to equity participants” Essential characteristics: • A decrease in economic benefits • Assets or Liabilities • Result in a decrease in equity, but • Exclude distributions to owners Recognition Criteria for the elements We have discussed the definitions of the elements, but there are two ‘recognition criteria’ for the elements as well: – Probable Occurrence – Reliable Measurement An item cannot be recorded in the entity’s accounts unless it satisfies both of these recognition criteria. • Probable occurrence requires that there be a greater than 50% chance of the increase or decrease in economic benefits occurring. • Reliable measurement requires that to be recorded in the accounts, the item must have a cost or value that can be measured reliably. • To fully justify how a particular item should be recorded in the accounts requires an explanation of the element(s) affected, their definitions and recognition criteria. Extended accounting equation Assets = Liabilities + Equity + Income – Expenses - Drawings • Income is shown as a positive addition to owner’s equity, since income contributes to profit. • Expenses are shown as a deduction from owner’s equity, since expenses reduce profit. When rearranged: Assets + Expenses + Drawings = Liabilities + Owner’s Equity + Income Assets, Expenses and Drawings are treated in the same way: Liabilities, Income and Capital are treated in the same way: Cash-basis accounting • Records income when it the cash has been received (regardless of whether the income has been earned). • Records expenses when they have been paid (regardless of whether the expense has been incurred). • The profit (loss) is based on what was actually received/paid from income/expense related items. • Under cash-basis accounting: Profit/Loss = cash receipts for income items – cash payments for expense items. • Entities produce financial statements for a period of time, usually 12 months. • Cash accounting can cause transactions to be recorded in a different period from when the economic substance of the transaction actually took place, as it focuses on recording the cash flow. • This approach can be problematic if advance payments of cash or delays in payment of cash occur. Accrual-basis accounting • Records income when it has been earned (regardless of whether the cash has been received). • Records expenses when they have been incurred (regardless of whether the cash has been paid). • The profit (loss) for a period is based on what was actually earned/incurred during a period regardless of the cash received or paid. This better reflects the business performance for the period than cash- basis profit. • Most entities use accrual-basis accounting as it produces more relevant information about business performance. • An accrual-based accounting system manages transactions by recording ‘temporary’ asset or liability accounts to deal with the timing of the cash receipt or payment being different from the timing of the earning of revenue or incurring of expenses. Effects of accrual-basis accounting on financial reporting • Accrual-basis accounting records transactions when income is earned or expenses incurred, and ignores whether there has been a corresponding exchange of cash. • The accrual-basis income statement, showing profit or loss for a period, will not necessarily have a direct relationship to the cash received or paid during that same period. Chart of accounts • A Chart of Accounts is used to number accounts, and assist the accountant in locating ledger accounts and posting correctly. • The chart of accounts should show accounts used in the business, grouped according to the element to which they belong. • Each element must begin with a new number to avoid confusion with accounts. • The numbers chosen should be flexible to allow for more accounts to be added at a later date. Ledger accounts • An account is an individual accounting record of increases and decreases in a specific asset, liability, owner’s equity, income or expense item. • There are separate accounts for all of the items used in transactions such as cash, salaries expense and accounts payable. ‘Normal’ Balances Debit side Credit side Assets Liabilities Expenses Income Drawings Capital Trial Balancehe account on which the ‘normal • The Trial Balance is a list of accounts and their balances at a given date (‘as at …’). • The primary purpose of a trial balance is to prove debits equal credits in ledgers after posting. • If debits and credits do not agree, the trial balance can be used to uncover errors in journalising and posting. Limitations errors: trial balance may ‘balance’, the accounting system may still contain 1. A transaction posted to the wrong account. 2. A transaction recorded at an incorrect amount. 3. A transaction omitted. Inventory • One of the most valuable assets for a trading firm. • Usually the primary source of income. • Accurate records must be kept relating to inventory purchased, sold, on hand. • It must be safe-guarded to minimise loss, theft, damage, obsolescence. Income for a retailer The primary source of income is from the sale of inventory, known as ‘sales revenue’ or ‘sales’. Expenses for a retailer 1. Cost of sales (COS) = total cost of inventory sold during the period. 2. Other expenses = expenses incurred in the process of earning sales revenue. ‘Gross profit’ is sales revenue less COS, and this is shown in the entity’s income statement Gross profit • Represents the difference between cost price and selling price. • Gross profit is the ‘mark-up’ on goods either manufactured or purchased wholesale. • Gross profit must be sufficient to cover all other expenses of the entity and leave a profit. Perpetual Inventory System • Maintains detailed records of the cost of inventory purchased and sold. • Recording is made easier with the use of bar codes and optical scanners. • COS is determined at the time a sale occurs. The alternative recording system is known as the ‘periodic’ system Recording purchases Apr 1 Inventory (110) 38,000 Accounts Payable (200) 38,000 (To record goods purchased on credit from Music Imports) Purchase returns and allowances • A purchase return is the return of goods by the purchaser because … • Goods are damaged or defective. • Goods are of inferior quality. • Goods do not meet purchaser’s specifications. • The purchaser will receive a refund in the form of either credit or cash depending on how the goods were initially purchased. • A purchase allowance occurs where the seller keeps the goods and a reduction in price is granted. Apr 4 Accounts Payable (200) 700 Inventory (110) 700 Recording sales of inventory • Sales revenue is recorded when earned (under accrual accounting and the income recognition princi
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