AC2001 ACCOUNTING CONCEPTS 1 NCEA LEVEL

Transcription

1 te matāuranga mahi kaute accounting AC2001 ACCOUNTING CONCEPTS 1 NCEA LEVEL /1

2 accounting ncea level 2 Expected time to complete work This work will take you about 10 hours to complete. You will work towards the following standard: Achievement Standard (Version 1) Accounting 2.1 Demonstrate understanding of accounting concepts for a sole proprietor that operates accounting subsystems Level 2, External 4 credits In this booklet you will focus on these learning outcomes: explaining and applying accounting concepts explaining the financial elements explaining the financial statements. You will continue to work towards this standard in booklet AC2002. Copyright 2012 Board of Trustees of Te Aho o Te Kura Pounamu, Private Bag 39992, Wellington Mail Centre, Lower Hutt 5045, New Zealand. All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means without the written permission of Te Aho o Te Kura Pounamu. te aho o te kura pounamu

3 contents 1 Nature and functions of accounting 2 Concepts 3 Qualitative characteristics 4 Financial elements 5 Financial statements 1 6 Financial statements 2 7 Goods and services tax 8 Answer guide te aho o te kura pounamu AC2001 1

4 how to do the work When you see: 1A Complete the activity. Check your answers. Your teacher will assess this work. Note this key point. You will need: a pen a calculator. Resource overview Complete your practice activities on your own paper and return them along with your completed teacher-marked activities in this booklet. Ensure you have attempted all activities on your own before referring to the Answer guide. At the end of each lesson, mark your practice work (3/5) from the Answer guide. Add any corrections/amendments in a different colour. Take particular note of the key points as they will help you in your assessments. Refer to the glossary in the reference guide for an explanation of any new words you are not familiar with. Each lesson begins with: Learning outcome: an overview of what you are learning in this achievement standard Learning intentions: what you are learning in this lesson Success criteria: what you should be able to do by the end of this lesson. Assessment In this booklet you will work towards meeting the following criteria. Refer to your Reference guide for a full copy of this Achievement Standard. Achievement criteria 2.1 Achievement Achievement with merit Achievement with excellence Demonstrate understanding of accounting concepts for an entity that operates accounting subsystems. Demonstrate in-depth understanding of accounting concepts for an entity that operates accounting subsystems. Demonstrate comprehensive understanding of accounting concepts for an entity that operates accounting subsystems. 2 AC2001 te aho o te kura pounamu

5 1 nature and functions of accounting learning outcome Explain and apply accounting concepts. learning intention To examine the nature and functions of accounting. success criteria You will be able to: describe the nature and functions of accounting describe how interested parties use financial information for decision making recognise internal and external users of financial information. introduction Accounting is recording, classifying, summarising, interpreting and reporting financial information. Accounting is the language of business and brings to life the affairs of a business in monetary units. It is an integral part of our society. Almost everyone, at some point, will help prepare accounting information and use it to make decisions. At NCEA Level 2 the focus is on accounting for a sole proprietor. Key point The main function of accounting is to interpret, report and communicate financial information to interested parties to aid in decision making. Reporting and communicating financial information can be done in different ways such as: financial statements management reports graphs or tables tax returns. In addition to this list of financial information, non-financial information should also be considered such as: business location availability and quality of employees competitors in the market effect of operations on the environment. istockphoto.com te aho o te kura pounamu AC2001 3

6 nature and functions of accounting Accounting information functions as a tool of management to: reduce the uncertainties of decision making a cash budget, for example, can indicate the funds available if a decision is made to purchase new machinery plan and control business operations a department store manager can use projected sales figures to employ adequate staff or to maintain desirable levels of inventory assess the accountability of staff and the efficiency of business operations this could involve comparing actual sales with budgeted sales to see if targets have been met. users of accounting information Accounting information performs specific functions for a variety of people or interested parties who use financial information as an aid to decision making. Managers in a business use financial information about the business to make day-to-day routine decisions and other long-term strategic decisions described above. They are the internal users of a business financial information. Bank managers have to decide whether to lend money to businesses so they need accounting information to determine a business financial situation. Investors need to know the financial situation of businesses in which they are or might be investing money. Creditors allow businesses credit to buy goods or services and need to know of any risks involved in extending credit. Government departments such as the Department of Statistics and the Inland Revenue Department (IRD) need information from businesses to determine the revenues earned and tax to be paid. Owners or potential owners need to be informed of the financial stability and future prospects of the business. Employees may use financial information about the business to back up their wage claims. Banks will not lend money to a business without seeing a financial report of past and/or budgeted performance. Customers can use accounting information to check up on the reliability of businesses they deal with, especially if they are dependent on the business for such things as medical equipment or supplies. istockphoto.com istockphoto.com 4 AC2001 te aho o te kura pounamu

7 nature and functions of accounting The IRD is interested in businesses registered for Goods and Services Tax (GST) and also those businesses liable for Fringe Benefit Tax (FBT). Pay As You Earn tax (PAYE) must be deducted from any wages paid to employees and also accident compensation levies. All these activities must be recorded on appropriate forms. A tax accountant who provides tax advice, taxation planning and the preparation of taxation returns must make sure that all the required information is available. bigstock.com specialist accountants Other accountants who specialise in different areas of accounting include: chartered accountants (CA) who are fully qualified accountants are members of the New Zealand Institute of Chartered Accountants (NZICA). They provide a range of financial and advisory services to the public and may also complete taxation returns. financial accountants who prepare and present financial reports showing business cash flow, profit/financial performance and financial position cost accountants who calculate costs of production usually in a manufacturing or service business also prepare cost budgets, production planning and reports management accountants who prepare ongoing information such as daily progress reports, budgets and cash flow reports for management to use in day-to-day decision making auditors who check and report on whether accounting records are properly kept and financial statements/reports show a true and fair view of the financial performance, cash flows and financial position of the entity accounting technicians who have completed two years of study (about half the requirements of a chartered accountant) and assist in the preparation of accounting records and financial statements but do not give advice. te aho o te kura pounamu AC2001 5

8 nature and functions of accounting 1A You are a chartered accountant. Mark Brown is interested in buying Better Buys, a variety store in the local mall. Mark asks for your advice as to whether it would be a good investment to buy Better Buys. istockphoto.com 1. Suggest items of financial information you would need in order to advise Mark. Explain briefly how you would use the information. 2. Suggest one item of non-financial information that would be useful in advising Mark and explain briefly how this information would be used. 3. Explain why Mark s bank manager would be interested in financial information about Better Buys when Mark mentions he would be interested in an overdraft facility. 4. What sort of information would the IRD want from Mark if he did buy the business? Check your answers. 1B Numbers Work is an accountancy business that employs a variety of accountants. Identify the accountant who would carry out each of the following tasks. 1. Preparation of tax returns. 2. Preparation of budgets. 3. Calculation of the costs of producing goods and services. 4. Provision of financial advice to small businesses. 5. Preparation of accounts and financial statements. Check your answers. 6 AC2001 te aho o te kura pounamu

9 nature and functions of accounting internal and external users of financial information Managers, supervisors, foremen and other decision-makers in a business are the internal users of financial information. The management accountant prepares regular management reports for internal use such as: sales reports budget reports aged debtors reports production reports cost reports profit reports. External users are the interested parties outside the business such as investors, bank managers and government departments as previously described. They use business financial reports which contain annual financial statements such as the: Income Statement Statement of Financial Position Cash Flow Statement Statement of Accounting Policies. financial reports Financial reports are produced at least once or twice a year. The New Zealand Institute of Chartered Accountants, which is responsible for accounting practice in New Zealand, has produced the New Zealand Framework for General Purpose Financial Reporting. The framework describes the principles and assumptions of accounting which accountants should apply when preparing annual reports. istockphoto.com te aho o te kura pounamu AC2001 7

10 2 concepts learning outcome Explain and apply accounting concepts. learning intention To examine accounting notions, concepts and a measurement base. success criteria You will be able to: explain and apply the notions accounting entity, reporting period and monetary measurement in context explain and apply the concepts going concern and accrual basis of accounting in context explain and apply the historical cost measurement base in context. introduction It is important to become familiar with the principles and assumptions set out in The New Zealand Framework for General Purpose Financial Reporting as well as other accounting notions or concepts. These are applied to the financial statements produced for a sole proprietorship which is a business or entity owned and usually managed by one person. The businesses studied in Level 2 Accounting are sole proprietorships. You are expected to know and apply these concepts using correct accounting terminology in your external examination. notions istockphoto.com istockphoto.com accounting entity Before you can begin accounting you must know exactly what you are accounting for. The notion (or concept) of Accounting Entity defines the business as a separate entity from its owner and all other entities. For example, Henry Graham owns his own home and a small yacht. He also owns and operates Sports First, a retail business selling a range of sporting equipment. Henry must keep the financial affairs of Sports First separate from his personal financial affairs. Key point According to the notion of Accounting Entity all transactions are recorded from the point of view of the business and not the owner. We keep the owner s personal financial transactions separate from the business s financial transactions. 8 AC2001 te aho o te kura pounamu

11 concepts Two special accounts are used to do this. When the owner puts money or goods in the business it is called capital. When the owner takes money or goods from the business for personal use it is called drawings. Capital and drawings are two components of equity or investment in the business. reporting period Key point This notion assumes that the entity s continuing life is divided into nominated time periods. This is necessary to: measure profit or financial performance, financial position and cash flows on a regular and timely basis make comparisons from one period to the next. The IRD requires businesses to return a tax statement annually. The usual tax year is from 1 April to 31 March of the following year. Some businesses choose other time periods to suit the product or activity in which they are engaged. The period for reporting financial information may be a month, two months, six months, or at most, a year. Once the timeframe has been decided we must report information relating to that period only. The reporting period must be shown in the heading for each financial statement. Henry Graham prepares financial statements annually. Here are the headings for the Income Statement and the Statement of Financial Position prepared for Sports First at balance date 31 March sports first income statement for the year ended 31 march 2015 sports first statement of financial position as at 31 march 2015 istockphoto.com monetary measurement te aho o t e k ur a p o un a m u AC2001 9

12 concepts Key point For reporting purposes, financial information is measured in monetary units. This means that unlike items can be added together, for example, the $ amount of buildings is added to the $ amount of inventory. In New Zealand the monetary unit is the New Zealand dollar and it is used as a measure for business transactions. Foreign transactions, such as imports and exports, are recorded in equivalent New Zealand dollars. Non-monetary items of value to a business such as the skills and loyalty of staff are not included in the financial statements. assumptions going concern Key point This assumes that the business will continue its present operations into the foreseeable future and management has neither the need nor the intention to liquidate. This means the business has no plans to close down. When a business purchases property, plant and equipment it assumes that the economic benefits derived from these assets will continue into the foreseeable future. accrual basis of accounting Key point In an accrual based system of accounting cash and credit transactions are recorded when they occur and reported in the accounting period they relate to. Adjustments are made at the end of the reporting period to bring into account any outstanding transactions. Interest on loan owing on balance day of $5,000 is reported: 1. in the current Income Statement as: an increase in interest expense because the interest owing relates to the current reporting period 2. in the Statement of Financial Position as: accrued expenses, a current liability, because the business currently has an obligation to pay the interest of $5,000. You will learn more about this in booklet AC AC2001 te aho o te kura pounamu

13 concepts measurement base historical cost Accountants use a measurement base to value assets. Historical cost (often called cost) is the measurement base for many businesses. Key point The historical cost measurement base states that: transactions (and assets) are recorded at the amount paid or received at the time the transaction took place or original cost to the business. The advantage of historical cost is that it is a reliable measure as it is a faithful representation of a transaction verifiable (there is proof) by a source document usually an invoice. istockphoto.com Assets may be remeasured. Examples: accounts receivable (amounts owing by customers for credit sales) can be remeasured using an allowance for doubtful debts (to allow for amounts which may not be received from customers) the basic rule for the valuation of inventory is that it should be stated at the lower of cost and net realisable value. (Net realisable value is the expected sale price of the inventory.) physical assets like property, plant and equipment are reported at cost less accumulated depreciation (to allocate the cost of the item over its useful life.) te aho o te kura pounamu AC

14 concepts 2A 1. Games is a computer games store owned by Gill Bates. In preparing the financial statements Gill s accountant has assumed that Games will continue to operate into the foreseeable future. What accounting concept is applied here? 2. Gill has paid a personal insurance bill using a business cheque from Games. Explain how the notion of accounting entity is applied in this situation. 3. Games has imported 100 new computer games from China. Explain how the notion of monetary measurement is applied in recording the computer games in the accounting records of Games. 4. The financial statements show that Gill s accountant has reported all computer games at the price at which they were purchased. Name the accounting concept applied here and explain why it was used. Check your answers. istockphoto.com 12 AC2001 te aho o te kura pounamu

15 concepts accounting concept summary The accounting entity, monetary measurement, going concern, reporting period, accrual basis and historical cost notions/concepts are shown in the table below so that you can recognise, define and apply these for a business such as Classic Cleaners. accounting entity Recognise Define Apply Answer in context The business name is the entity, for example: Classic Cleaners. For accounting purposes the financial transactions of the business are kept separate from the personal financial transactions of the owner. Financial statements are prepared for Classic Cleaners and do not include the owner s personal assets, liabilities, income or expenses. monetary measurement Items reported in financial statements of Classic Cleaners have a dollar value in a common currency, for example New Zealand dollars ($NZ). going concern It is assumed that Classic Cleaners is a going concern. All transactions are recorded in a common dollar unit such as the $NZ which allows unlike items to be added together. It is assumed for accounting purposes that Classic Cleaners will continue its present operations into the foreseeable future. If the owner takes cleaning products home for his own use they are a personal expense and recorded as drawings to keep them separate from the business expenses for Classic Cleaners. Classic Cleaners has added unlike items together as the $ amount of equipment is added to the $ amount of motor vehicles which were imported from Japan. The cost is shown in $NZ not Japanese Yen. The owner of Classic Cleaners has reason to think the business should keep operating as a cleaning business and does not intend to stop being a cleaning business. te aho o te kura pounamu AC

16 concepts reporting period The Income Statement is for the year ended 31 March The Statement of Financial Position is as at 31 March accrual basis Cash and credit transactions are included in the financial statements. historical cost Property plant and equipment are shown in the Statement of Financial Position at their purchase cost. In order to measure the financial performance or profit/loss and financial position of a business on a regular basis, the business life is divided into nominated time periods. The effects of transactions and other events are recognised when they occur and are reported in the financial statements of the periods to which they relate. Transactions (and assets) are recorded at their purchase or original cost to the business. Classic Cleaners Income Statement for the year ended 31 March 2015 measures the profit/loss for the year. The Statement of Financial Position as at 31 March 2015 shows assets, liabilities and owner s equity as at balance day the end of the accounting period. Classic Cleaners can make comparisons of profit, financial performance and financial position from one period to the next and between similar businesses. Classic Cleaners includes all amounts owing and amounts received or paid in advance in the Income Statement by adjusting the relevant income or expense and also includes the amounts owing or paid or received in advance as assets or liabilities in the Statement of Financial Position, for example: accrued expenses for expenses incurred but not yet paid such as wages owing to employees for work already done. In the accounts and financial statements for Classic Cleaners, Equipment and Motor Vehicle are (first) recorded at their purchase or original cost to the business. 14 AC2001 te aho o te kura pounamu

17 concepts 2B Hoani Kaituna owns a limousine rental business in Auckland called Vast Vehicles. 1. When Hoani s relatives visit he allows them free use of a Vast Vehicles limousine for the length of their stay. In order to follow the accounting entity concept how should Hoani record the cost of the use of the limousine? 2. Explain how recording the cost as your answer to question 1, above, is following the accounting entity concept. 3. Vast Vehicles recently imported a new limousine from the United States with a price tag of $US60,000. Hoani is not sure whether to record the limousine in Vast Vehicle s accounts in United States or New Zealand dollars. Give the name of the concept which applies here and explain to Hoani how the limousine should be recorded. 4. Hoani arranged a loan with a local bank so that Vast Vehicles could purchase the new limousine. At balance date the statement of financial position reports three months interest owing on the loan as accrued expenses. Fully explain how this is an example of the accrual basis of accounting. 5. Explain how the heading shown below is an example of the Reporting Period notion. Check your answers. vast vehicles income statement for the year ended 31 march 2015 istockphoto.com te aho o te kura pounamu AC

18 3 qualitative characteristics learning outcome Explain and apply accounting concepts. learning intention To explain and apply the qualitative characteristics of financial statements. success criteria You will be able to: describe the qualitative characteristics of relevance, reliability, comparability and understandability describe how materiality influences the qualitative characteristics. introduction Qualitative characteristics are the minimum requirements, in terms of quality, that financial statements should have in order to be useful in decision making. There are four qualitative characteristics. Qualitative characteristics Relevance Reliability Comparability Understandability relevance Information is relevant if it relates to or has an effect on the decision being made. For example if an investor can determine trends in profitability from an income statement, this could affect a decision of whether to invest in the business or not. (Be careful to note that this does not mean that the financial statement is predicting any future results.) Information must be timely which means it must be available when required and up-to-date. A year-old income statement would not be very relevant to a current decision being made. Financial information must also be useful in making predictions about the future (its predictive role) and must be able to be used to confirm previous predictions (its confirmatory role). Key point To summarise, relevance has three possible roles: Timely Predictive Confirmatory 16 AC2001 te aho o te kura pounamu

19 qualitative characteristics reliability Key point Financial information is reliable if it is: free from error unbiased (neutral) a faithful representation (can be depended upon to represent a transaction faithfully). It fulfils these criteria if it can be verified, usually by source documents. For example, the cost of a vehicle can be verified by looking at the invoice. This cost is free from error, is unbiased and is true. Formal verification is sometimes through an internal spot check process but at other times can be by an independent auditor. comparability Users need to be able to compare financial information. istockphoto.com Key point It should be possible to compare: the performance of one accounting period of a business with other accounting periods the financial information of one business with other similar businesses. It is therefore necessary to show figures for the previous financial year in the reports in addition to the current figures, so similarities and differences can be readily identified. Information must be prepared consistently if it is to be comparable. This means that the same policies and methods should be used to prepare financial statements from period to period. A statement of accounting policies is included in reports outlining the policies and methods used to prepare the financial statements and any changes should be disclosed in this statement. understandability Key point Financial information should be clearly presented so that it is understood by those using it. Users are expected to have some ability in studying business information but the accountant preparing a report should make the information clear and unambiguous. te aho o te kura pounamu AC

20 qualitative characteristics 3A Explain and state the name of the qualitative characteristic to which each of the following statements relates. istockphoto.com 1. The annual report of Eco Light, a lighting store, was not prepared until 10 months after balance day. 2. The report did not show last year s figures. 3. A financial adviser found the financial report very difficult to follow. 4. The general manager of Eco Light told the accountant to show the current valuation for land and buildings at $100,000 more than the registered valuation of five years ago. He considered they were currently worth more and that the higher figure would look more impressive in the Statement of Financial Position. Check your answers. influences on the characteristics Accountants preparing financial reports must use their judgement in deciding what should be included so that the reports are relevant, reliable, comparable and understandable. Their decisions are affected by influences such as materiality. materiality Materiality is linked to relevance. Key point A statement or fact is material if its disclosure is likely to influence any decision being made by users. Material items should be shown in financial reports or disclosed in a note to the financial statements. To comply with materiality an accountant could be required to make decisions such as: which items of expense can be combined and which shown separately because of their dollar amount or because of their nature or importance whether small amounts of stationery can be classified as an expense and not an asset whether a contract to build new premises next year should be disclosed. 18 AC2001 te aho o te kura pounamu

21 qualitative characteristics These decisions will be based on the item s size in comparison to the business. For example: Bulk Stationery is a large commercial stationery business owned by David Boxer and located in the Auckland CBD. The supply of stationery used for Bulk Stationery s record keeping and business correspondence is very small and of little significance compared with the inventory of stationery held for resale. It is unlikely to influence any decisions made by users of Bulk Stationery s financial statements and is classified as an expense and not an asset. Bulk Stationery reports income, expenses, assets, liabilities and equity rounded to the nearest dollar. Cents are excluded from the financial statements because they are not material. Bulk Stationery is about to open two new outlets, one in Takapuna and one in Manukau. This is included in the Notes to the Statement of Financial Position of Bulk Stationery as it is likely to affect decision making by users such as suppliers, banks and other lending institutions. constraints on relevance and reliability Materiality is kept in mind when judgements are necessary. Financial information is of no use if it is not available when needed. Any undue delay in reporting means the financial information may have lost its relevance. Sometimes a preparer of financial reports may have to balance one accounting characteristic against another. For example, to produce timely information may mean reporting on transactions or events before everything is known about them. This affects the reliability of information. The aim is to achieve an appropriate balance. istockphoto.com te aho o te kura pounamu AC

22 qualitative characteristics 3B 1. Zing Bat is a large cricket supplies store located in Auckland. Explain, in terms of materiality, why the many different items of cricket equipment sold by Zing Bat are not reported separately in the Statement of Financial Position but are shown as one amount called inventory. 2. Give a reason whether the following highlighted facts or statements are material in terms of disclosure in the financial report of Zing Bat. a. Cents in the statement of financial position. (Income this year is $500,000.) b. The market value of investments. c. The increase in income was due to competitors leaving the market. d. Zing Bat burn cardboard containers and other packing on an adjacent section. There was no mention in the report that the business was being sued for polluting the environment. istockphoto.com Check your answers. 3C Match the description in column B with the correct term in column A. Column A Column B Neutral Requires last year s figures and consistency. Reliability Materiality Comparability Timely Consistency Understandability The presentation makes it reasonable to expect users to know what it means. Information must be available when needed. This applies to a fact which may influence users in making decisions. Decisions are unbiased and based on fact. Information is true and verifiable. The same policies and measurement bases are used each year. Check your answers. 20 AC2001 te aho o te kura pounamu

23 qualitative characteristics 3D State the qualitative characteristic that applies for each of the following comments. 1. Delays in providing annual financial statements have generally been eliminated due to computer technology. 2. Clear presentation may involve classification and columnar arrangements to highlight important results and aid analysis and interpretation of the reports. 3. Accounting reports must be as accurate as possible to enable correct decisions to be made. 4. Reports must be simple enough to be understood by those for whom they are intended. 5. Information must be properly arranged and classified so as to make it accessible and to allow comparisons with other similar businesses. 6. There have been no changes in accounting policies. Check your answers. balance between benefit and cost The NZ Framework states that the benefits gained from information should be greater than the costs of providing it. It is difficult to measure benefits and costs especially when the costs do not always fall on the users who enjoy the benefits. Financial analysts, for example, use financial reports but pay nothing towards their preparation. On the other hand, the owners of small businesses may also be managers who have worked closely with sales, budgets and other management reports all year and do not gain much further benefit from the financial statements. Despite these difficulties, the NZ Framework insists that those who set financial reporting standards, as well as preparers and users of financial information, should be aware of the balance between benefit and cost. bigstock.com true and fair view If all four qualitative characteristics are applied (and so long as appropriate accounting standards are adhered to) then the financial statements produced show what is considered a true and fair view of the financial position, financial performance and changes in financial position of an entity. te aho o te kura pounamu AC

24 4 financial elements learning outcome Explain the financial elements. learning intention To explain the financial elements. success criteria You will be able to: define assets, liabilities, equity, income and expenses apply these definitions in context. introduction The financial elements are used to classify or group the effect of transactions in the financial statements. In the Statement of Financial Position the financial elements are assets, liabilities and equity. In the Income Statement the financial elements are income and expenses. assets Key point Assets have three essential characteristics: a result of past events presently in the control of the entity and from which future economic benefits are expected to flow to the entity. Note the words in bold which will help you remember the characteristics past, present, future. recognition criteria Key point An asset is only recognised in the Statement of Financial Position when it meets the definition of an asset and: it is probable that the future economic benefits will eventuate it possesses a value that can be measured with reliability (a source document). istockphoto.com 22 AC2001 te aho o te kura pounamu

25 financial elements You can now look at the essential characteristics of an asset and the recognition criteria applied to a delivery van. For example, a delivery van is an asset because: it was purchased some time ago in a past transaction it is currently controlled by the business which is the only entity that can decide how to use it as they own it future economic benefits are expected to flow to the entity as a result of its use since it will be used to deliver goods which will help to earn income for the business. Recognition criteria for the delivery van: it must be more than likely that it will provide future economic benefit the delivery van must have a value that can be measured reliably (there will be an invoice or receipt). liabilities Key point Liabilities have three essential characteristics: a result of past events the entity presently has a financial obligation the settlement of which will require a future outflow of cash from the business. A liability is only recognised in the statement of financial position when it meets the definition of a liability and: it is probable that the future economic sacrifice will eventuate the amount of the liability can be measured with reliability (a source document). istockphoto.com te aho o te kura pounamu AC

26 financial elements For example, a loan is a liability because: it is the result of a loan agreement with the bank made some time in the past the business presently has an obligation to repay the loan to the bank settlement of the loan involves an outflow of cash from the business bank account in the future cash that could have been used to earn income for the business. Recognition criteria for the loan: it must be more than likely that there will be an outflow of cash from the business (repayment is a condition of the loan agreement) the amount required to settle the loan can be measured with reliability (it is stated in the loan agreement). equity Key point Equity is the residual interest in the assets of the entity after deduction of the liabilities. This definition means that if a business is bankrupt or wound up, payment of liabilities must be made before the remainder of the assets can be distributed to the owner. This definition means the same as the accounting equation: Equity equals Assets less Liabilities (also expressed as Asset less Liabilities equals Equity). In an examination, however, give the formal definition (as stated initially). The recognition of assets and liabilities provides the criteria for recognition of equity. A business has assets of $890,000 and liabilities of $560,000, so the equity of the business is $330,000 because $890,000 minus $560,000 equals $330,000. istockphoto.com 24 AC2001 te aho o te kura pounamu

27 financial elements income and expenses Income and expenses are the financial elements in the income statement. income Key point Income is: increases in economic benefit in the form of inflows or enhancements of assets (or decreases in liabilities) during the accounting period that result in increases in equity and are not contributions by the owner. Income is only recognised in the income statement when: the increase in future economic benefit related to an increase in an asset (or decrease in a liability) has a sufficient degree of certainty (probable) the amount of income can be measured reliably. Income includes: inflows of future economic benefits for example, credit sales, commission received, interest received savings in outflows of economic benefits for example, discount received. Cash sales are income because they cause an inflow of cash which increases the business bank account (or decreases the bank overdraft). Sales increase business profit which causes an increase in equity during the accounting period and is not a contribution by the owner. Recognition criteria for cash sales: The inflow has a degree of certainty since it has already been received at balance day and the amount has been reliably measured from the sales dockets/eftpos receipts issued at the time of the cash sales. expenses Key point Expenses are: decreases in economic benefits during the accounting period in the form of outflows or depletions of assets (or increases of liabilities) a decrease in equity not drawings by the owner. Expenses are only recognised in the income statement when: the decrease in future economic benefits related to a decrease in assets (or increase in liabilities) has arisen (probable) the amount of the expenses can be measured reliably. te aho o te kura pounamu AC

28 financial elements Expenses include: consumption of future economic benefits for example, wages, advertising, power, depreciation of an asset loss of future economic benefit for example, inventory revaluation, bad debts, discount allowed). Wages are an expense. When wages are direct debited they represent an outflow of cash which decreases the business bank account (or increases the business bank overdraft). Wages expense decreases business profits which causes a decrease in equity. The wages were not paid to the owner so are a business expense not drawings. Recognition criteria for wages: Wages have been paid so the outflow has occurred and the business bank account has decreased (or the overdraft increased) and the amount can be reliably measured by checking online exactly how much was direct debited as wages. mychillybin.co.nz 26 AC2001 te aho o te kura pounamu

29 financial elements Key point summary of financial elements Asset A resource controlled by the entity: as a result of past events (transactions) from which future economic benefits are expected to flow to the entity. Liability A present obligation of the entity: arising from past events an outflow of cash. Equity The residual interest in the assets of an entity after deducting all its liabilities. Or assets minus liabilities. Income Increases in economic benefits during the accounting period in the form of increases in assets: that result in increases in profit which increases equity other than those relating to contributions by owners. Expenses Decreases in economic benefits during the accounting period in the form of decreases in assets: that result in decreases in profit which decreases equity other than those relating to drawings by the owner. Example A delivery truck Only the business can exclusively benefit from the use of the truck: as a result of the truck having been purchased by the business since the truck will be used to earn income which brings cash into the business. Example A bank loan The loan has to be repaid: arising from the loan agreement with the bank an outflow of cash from the business to repay the loan. Example Capital The value left for the business owner when liabilities are deducted from assets. Or business assets minus business liabilities. Example A cash sale An increase in cash: resulting in an increase in profit which increases equity that has not been contributed by the owner. Example Payment of wages Decreases in economic benefits during the accounting period in the form of cash paid for wages: that results in a decrease in profit that decreases equity that has not been paid out as drawings to the owner. te aho o te kura pounamu AC

30 financial elements 4A The current liabilities section of the Statement of Financial Position for Supertyres included $5,600 for accrued expenses which related to interest on loan owing on balance day. 1. Explain fully why interest paid on a loan is an expense. 2. Explain fully why accrued expenses for interest are reported as a liability in the Statement of Financial Position. Check your answers. 4B Classify each of the following as assets, liabilities, income or expenses and give reasons for your answer according to the definitions of financial elements. 1. Accounts receivable (amounts owing from debtors) 2. Accounts payable (amounts owing to creditors) 3. Insurance 4. Inventory 5. Possible future refunds that may be necessary on faulty goods being returned after the Christmas sales. The financial period ends on 31 December. Check your answers. 4C In March 2015, Plum Computers received a large order for laptops from a customer. The value of the order was $2m. Delivery is not until 10 April. The managing director wants some of the income from the sale of the computers recognised in the financial period ended 31 March The accountant disagrees. Explain the correct treatment for the income earned from the sale of the computers in accordance with the definition of income. Check your answers. 28 AC2001 te aho o te kura pounamu

31 5 financial statements 1 learning outcome Explain the financial statements. learning intention To allocate financial elements to the appropriate financial statements. success criteria You will be able to: explain the purpose of the Statement of Financial Position and Statement of Accounting Policies describe the components of the Statement of Accounting Policies classify assets, liabilities and equity for presentation in the Statement of Financial Position. introduction Information useful for decision making is communicated to interested parties in the financial statements of a business. statement of financial position (balance sheet) Key point The purpose of the Statement of Financial Position is to show the financial position of the business at a point in time by showing the assets, liabilities, and equity of the entity on balance day. Information about the entity s economic resources (or assets) is useful in assessing the entity s ability to generate cash and/or provide services in the future. Information about liabilities and equity is useful in assessing how successful the entity is likely to be in raising further finance. statement of accounting policies It is important to understand the accounting assumptions on which the Statement of Financial Position is based. Key point The purpose of the Statement of Accounting Policies is to set out the policies followed in the preparation of the financial statements. It allows users to more easily understand the significance of the information reported. te aho o te kura pounamu AC

32 financial statements 1 components The Statement of Accounting Policies: identifies the entity by its name and nature states the measurement base used in the reports, such as historical cost describes the accounting policies on which the reports are based such as: how GST applies in the statements the method used to depreciate items of property, plant and equipment the valuation method used for items such as accounts receivable, inventory, investments, and property, plant and equipment. includes a statement of changes (or a statement saying there are no changes) in the measurement system or accounting policies used. Note: you will not be asked to analyse or prepare a Statement of Accounting Policies at NCEA Level 2 but you do need to be aware of its significance. grow your greens statement of accounting policies Name and Nature These financial statements are prepared for Grow Your Greens a sole proprietorship that specialises in garden supplies from three locations in Auckland. Measurement Base The financial statements have been prepared on the basis of historical cost. Property, Plant and Equipment Property, plant and equipment are stated at cost and, except for land, depreciated. Depreciation The cost less residual value of property, plant and equipment (except for land) is depreciated over their estimated useful lives. Accounts Receivable Receivables are stated at estimated realisable value after allowing for doubtful debts. Bad debts are expensed during the period in which they are identified. Inventories Inventories are stated at the lower of cost and net realisable value. Cost is determined on the first-in first-out basis. Investments Investments are stated at cost. GST All amounts are stated exclusive of Goods and Services Tax (GST), except for receivables and payables which are stated inclusive of GST. Changes in Accounting Policy There have been no significant changes in accounting policy. All policies have been applied on a basis consistent with those used in previous years. 30 AC2001 te aho o te kura pounamu

33 financial statements 1 statement of financial position presentation You will prepare the Statement of Financial Position in later booklets in this course. Here you will look at the presentation of the various items included in this statement. Within the Statement of Financial Position assets and liabilities are sorted into groups. Equity items are also shown. Assets and Liabilities are normally classified (grouped) as follows: Key point assets Current Assets An asset shall be classified as current when: it is cash; or it is expected to be realised (turned into cash) within twelve months after the balance date. Non-current Assets All other assets shall be classified as non-current. They are classified into three categories as follows: Investments Money invested long-term which will provide future income. Property, Plant and Equipment Assets with long-term use in the business which will provide future economic benefit to the business for more than one year. Intangible Assets Long-term assets which have value and will provide future economic benefit but cannot be seen or touched. examples Current Assets Cash on hand Bank Accounts Receivable or Debtors Inventory or Stock (goods on hand to sell in a trading business) Supplies on hand (needed to perform a service in a service business) GST (receivable) Prepayments Accrued Income Non-current Assets Government Stock Term Deposits Shares Vehicles Land Buildings Office Equipment Furniture and Fittings Machinery Goodwill the amount paid in excess of net assets when a business is purchased for the estimated value of custom that has been built up. Patents the exclusive right to manufacture particular items. Registered Trademarks. te aho o te kura pounamu AC

34 financial statements 1 liabilities Current Liabilities Amounts owing which have to be repaid in the next year/normal operating cycle of the business. Non-current Liabilities Amounts owing over more than one year. equity Equity is also known as capital or proprietorship. It is the residual interest in the assets of the entity after deducting all its liabilities. examples Current Liabilities Bank Overdraft Accounts Payable or Creditors GST (payable) Accrued Expenses Income in Advance Non-current Liabilities Loan Mortgage We should, where we are told, show the term of the loan and its interest rate. (Note: A loan due in less than one year becomes a current liability.) equity Opening capital Plus Profit for the year Less Drawings Equals Closing capital Financial elements are recognised in the financial statements when: recognition Elements are only recognised if it is probable all essential characteristics are true. measurement Elements must be able to be measured reliably. statement of financial position Here is the Statement of Financial Position for Grow Your Greens as at 31 March istockphoto.com 32 AC2001 te aho o te kura pounamu

35 financial statements 1 Current Assets grow your greens statement of financial position as at 31 march 2015 $ $ $ Bank 13,000 Accounts receivable (Note 1) 39,600 Inventory control 208, ,600 Non-current Assets Investment Term deposit 40,000 Property, plant and equipment (Note 2) Total carrying amount 960,000 Intangible Asset Goodwill 30,000 1,030,000 Total Assets 1,290,600 Less Liabilities Current Liabilities GST 11,200 Accounts payable 34,000 45,200 Non-current Liabilities Loan 30,000 Total Liabilities 75,200 Net Assets $1,215,400 Equity Opening capital 1,100,000 Plus Profit for the year 135,400 Less Drawings (20,000) Closing capital $1, 215,400 te aho o te kura pounamu AC

36 financial statements 1 notes Further detail of some figures is given in notes which accompany the Statement of Financial Position. This detail is included to improve understandability for the users of the Statement of Financial Position. You will learn to prepare these notes in a later booklet in this course. In the external examination a template is provided which makes preparation quite straightforward. The Notes to the Statement of Financial Position for Grow Your Greens are shown below. notes to the statement of financial position 1. Accounts Receivable Accounts receivable 42,000 Less Allowance for doubtful debts 2, Property, Plant and Equipment For the year ended 31 March 2015 $39,600 Land Buildings Equipment Total $ $ $ $ Opening carrying amount 475, , , ,600 Plus Additions 20,000 20,000 Less Disposals (10,000) (10,000) Less Depreciation (3,600) (32,000) (35,600) Closing carrying amount 475, , , ,000 As at 31 March 2015 Cost 475, , ,000 1,063,600 Accumulated depreciation 39,600 64, ,600 Carrying amount 475, , , ,000 5A The owner of Grow Your Greens knows that you are an able accounting student and asks you the following questions. 1. What is the purpose of the Statement of Accounting Policies? 2. Name the qualitative characteristic applied in the reporting of Notes to the Statement of Financial Position. 3. Describe how the qualitative characteristic you have named in question 2, above, helps the users of the Statement of Financial Position. 4. How is Equity reported in the Statement of Financial Position? 34 AC2001 te aho o te kura pounamu

37 financial statements 1 5. How are Property, Plant and Equipment reported in the Statement of Financial Position? Check your answers. 5B Conrad Crete owns a sole proprietorship business called Cement Works that specialises in laying concrete foundations and other concrete building requirements. Cement Works has expanded its operations during 2014 and purchased an additional truck. This was financed by taking out a loan from the bank. The loan is due to be paid back by The loan will be reported in the Statement of Financial Position of Cement Works. State the purpose of the Statement of Financial Position. 2. Explain why the loan will be reported as a non-current liability in the Statement of Financial Position of Cement Works. 3. Explain why the asset Bank is reported as a current asset in the Statement of Financial Position of Cement Works. 4. Explain how the truck is reported in the Statement of Financial Position of Cement Works? 5. The Statement of Accounting Policies for Cement Works contains the following extract: Measurement Base The financial statements have been prepared on the basis of historical cost. Explain how historical cost affects the reporting of the truck in the Statement of Financial Position for Cement Works. 6. In the Statement of Financial Position of Cement Works there is a group of assets called Intangible Assets. Explain what is meant by this term and give an example of an intangible asset. Check your answers. istockphoto.com te aho o te kura pounamu AC

38 6 financial statements 2 learning outcome Explain the financial statements. learning intention To allocate financial elements to the appropriate financial statements. success criteria You will be able to: explain the purpose of the Income Statement and the Cash Flow Statement classify income and expenses for presentation in the Income Statement identify cash items reported in the Cash Flow Statement explain the limitations of financial statements. introduction You have looked at the purpose of the Statement of Accounting Policies, Statement of Financial Position and the classification of assets and liabilities. Other financial statements used for decision making include the Income Statement and the Cash Flow Statement. income statement Key point The purpose of the Income Statement is to report the financial performance and profit (or loss) for the period/year in order to compare income, expenses and profit with another period/year. Income minus Expenses equals Profit/Loss Reporting the profit for the period, and the relevant income and expenses related to the period, allow for the assessment of both past and future financial performance. Users can see if there has been an increase in profit from one period to the next. income and expenses Most businesses have one main way of earning their income. Service firms earn fees, charges or commission. Trading firms, which sell goods to earn income, call their income sales. istockphoto.com 36 AC2001 te aho o te kura pounamu

39 financial statements 2 Business expenses however can be many and varied and are classified, usually into three groups, in the Income Statement. In trading firms there are three common groups of expenses: Distribution costs Administrative expenses Finance costs Expenses related to distributing and selling the product or service: advertising salespersons wages/ salaries shop rent shop electricity delivery expenses delivery vehicle expenses depreciation on shop fittings depreciation on delivery vehicles Expenses related to managing and keeping the business going: insurance rates rent/office wages/salaries office expenses stationery telephone general expenses depreciation on office equipment Expenses related to financing the business: interest on loan interest on mortgage interest on bank overdraft. Interest expenses only In service firms the Distribution costs group (also known as Group One expenses) is often replaced with something more appropriate to the service being provided. For example: a hairdresser might use Cutting and Styling Expenses a plumber might use Plumbing and Vehicles Expenses a courier might use Vehicle Expenses. te aho o te kura pounamu AC

40 financial statements 2 Here is an example of an Income Statement for a service business. Clean Sweep provides cleaning services in the central business district of Wellington. Revenue clean sweep income statement for the year ended 31 march 2015 $ $ $ Fees 195,000 Less Expenses Cleaning expenses Soap and cleaning materials 3,000 Wages of cleaners 45,000 Cleaning van expenses 10,000 58,000 Administrative expenses Telephone 1,500 Office wages 15,000 Electricity 3,000 Accounting fees 2,000 Stationery 1,000 22,500 Finance costs Interest on loan 1,500 Total expenses 82,000 Profit for the year $113,000 istockphoto.com 38 AC2001 te aho o te kura pounamu

41 financial statements 2 6A Moana Maniapoto is the sole proprietor of an express hair cutting business for men called Short Cuts. When Moana prepares the Income Statement for the business she sorts the expenses into appropriate groups. Prepare three columns for the following expense headings: Cutting and Styling Expenses, Administrative Expenses and Finance Costs and group the expenses listed below under the appropriate heading. Insurance, scissor sharpening, electricity, receptionist wages, stylists wages, telephone, appointment cards, advertising, interest on loan, general expenses, clients magazines, window cleaning, clients tea and coffee, depreciation on salon fittings, shampoo, conditioner and styling product expenses, depreciation on computer. istockphoto.com Check your answers. cash flow statement Key point The purpose of the Cash Flow Statement is to reconcile the opening cash (bank) balance with the closing cash (bank) balance by showing all cash inflows and cash outflows for the reporting period. It is useful for decision making because it helps owners decide whether there is sufficient cash to pay employees and suppliers, pay back overdrafts or loans and whether further drawings should be taken. components The Cash Flow Statement includes: cash receipts (sources of cash) cash payments (uses of cash) the effect of the cash movements on the bank balance at the beginning of the period. istockphoto.com te aho o te kura pounamu AC

42 financial statements 2 Here is an example of a Cash Flow Statement. clean sweep cash flow statement for the year ended 31 march 2015 Receipts $ $ Fees 160,000 Sale of old van 5,000 Loan from bank 25,000 Total receipts 190,000 Payments Cleaning equipment 45,000 Van expenses 10,000 Wages 60,000 GST paid 2,500 Other expenses 7,500 Purchase of new van 43,000 Purchase of new computer system 10,000 Drawings 20,000 Interest on loan 1,500 Total payments 199,500 Net increase (decrease) in cash (9,500) Opening bank balance (500) Closing bank balance $(10,000) On 1 April 2014 Clean Sweep had a bank overdraft of $500. During the financial year the business banked receipts of $190,000 and made cash payments of $199,500, an overall net decrease of $9,500 in cash. This resulted in a bank overdraft of $10,000 on 31 March The cash flow statement is only concerned with the flow of cash in and out of the business. It is the only cash-based financial statement. All the items listed are assumed to have been fully received or paid in cash. Non-cash expenses such as bad debts and depreciation do not appear in a cash flow statement. 40 AC2001 te aho o te kura pounamu

43 financial statements 2 bigstock.com 6B Mike Angelo is the sole proprietor of a large art supplies business called Artful. He is preparing financial statements for the business and raises a few queries with you as his accountant. 1. What is the purpose of the Income Statement? 2. For what purpose is the Cash Flow Statement prepared? 3. Explain to Mike why credit transactions are not included in a Cash Flow Statement? 4. Mike is very concerned that Bad Debts are not included in the Cash Flow Statement. Give him an explanation. Check your answers. decision making Cash flow information is essential in business decision making. Liquidity Internal user Owner I need to know if there s enough money coming into the business to pay debt. External user Bank manager Potential buyer Can the business meet its cash obligations and honour external financing? Budgeting Previous cash flows form the basis for future cash flow projections. What is the business ability to generate positive future cash flows? Income and expenditure details shown in the Income Statement provide only limited information about the business. te aho o te kura pounamu AC

44 financial statements 2 A business may have a healthy profit but may, in the same reporting period, have liquidity problems Profit for the year $125,000 $112,500 $130,000 Closing bank balance ($30,000) ($20,000) ($50,000) The Income Statement calculates profit using only income and expense items. It does not include other cash transactions that will affect the cash flow situation. Other cash transactions could include: purchase and sale of items of property, plant and equipment new loans/repayments of loans. Profit for the year does not give a full picture! It is essential that the liquidity of a business is also known. A shortage of liquid resources can lead to bankruptcy. istockphoto.com other limitations of financial statements Financial limitations Even when financial statements are prepared on a consistent basis there are financial limitations: there is a certain amount of estimation used in their preparation for items like Depreciation expense and the Allowance for doubtful debts end-of-year data may not reflect the financial position during the year, nor the current position inflation has an effect the purchasing power of the dollar changes over time past financial history (as revealed in financial statements) is not an indicator of future performance because of the non-financial factors mentioned below there are limitations to the amount of relevant financial information to be gained from comparing two businesses over just one financial period. 42 AC2001 te aho o te kura pounamu

45 financial statements 2 Non-financial limitations Because everything in the financial statements is recorded in money terms, there is no way to quantify economically (put a dollar value on) the impact of things like: staff loyalty staff expertise availability of skilled staff changes in market conditions competition within the particular sector the business operates in. 6C Sara Windsor has just completed her first year as sole proprietor of her childcare agency Kiddicare. Kiddicare has four employees and Sara is delighted that the first set of financial statements shows a healthy profit for the year. However, she has been warned that the annual financial statements have both financial and non-financial limitations. In three short paragraphs explain to Sara: the importance of information relating to liquidity as well as profit other financial limitations and non-financial limitations of Kiddicare s annual financial statements. Check your answers. istockphoto.com te aho o te kura pounamu AC

46 7 goods and services tax learning outcome Explain the financial statements. learning intention To account for GST in a sole proprietorship. success criteria You will be able to: calculate GST for a sole proprietorship identify transactions exempt from GST describe the legal requirements of GST describe the three ways a business can account for GST determine when GST is a liability and when it is an asset from a business point of view. introduction istockphoto.com Goods and services tax (GST) is added by businesses to the selling price of the goods or services they sell. In 2010 GST was increased to 15 per cent. NCEA Level 2 requires you to account for GST in the transactions of a sole proprietorship. gst goods and services tax This is a domestic consumer tax which means it is only payable in New Zealand and is paid by the end user, that is, the consumer. If goods are exported GST is not collected on them. If goods are imported they incur GST when they are sold in New Zealand. At 15 per cent the GST tax on consumer spending means that for every $1.15 spent on an item, 15 cents goes to the government. This is collected by businesses who pay the Inland Revenue Department (Te Tare Taake) the GST they collect less the amount of GST they have paid out on purchases or expenses. Businesses are actually collection agents for the Inland Revenue Department (IRD) the government department that deals with taxation. 44 AC2001 te aho o te kura pounamu

47 goods and services tax Businesses usually owe money to the IRD as they collect more GST than they pay to other businesses. This means GST (received/collected) is a liability of the business. It is shown as GST payable, a current liability, in the Statement of Financial Position. If a business has paid out more in GST than they have collected GST becomes an asset. This can occur when a business is being set up and has to purchase computers, vehicles, plant and machinery, shop fittings, inventory or other physical assets. The business pays out a lot of GST initially and collects less at that time and is therefore owed a refund by IRD. This is classified as GST receivable, a current asset, in the Statement of Financial Position. If the business owes GST to the IRD it is a current liability. If the IRD owes the business a refund it is a current asset. Key point Most transactions will include GST. GST is not added to: bank transactions such as interest (paid or received), loans and bank fees owner s capital contributions or cash drawings dividends received wages or salaries as these are subject to PAYE (pay as you earn) income tax domestic rent but there is GST on commercial rent. There is no GST on a house rental if you live there but if you rent a shop for business purposes you have to pay GST. Details can be found on Inland Revenue s website, te aho o te kura pounamu AC

48 goods and services tax legal requirements A taxable activity is the business activity which is subject to tax, for example, a hairdresser supplying haircuts or a supermarket buying and selling groceries, meat and vegetables. People like accountants, lawyers and musicians have taxable activities when they supply their services. If the taxable activity of a business results in sales of $60,000 or more each year the business must register for GST. Once registered, the business must: keep full records so IRD can check GST liability charge GST on all relevant transactions complete GST returns and pay any tax owing by the due date include the GST number on all invoices provide GST invoices within 28 days if requested. accounting for gst There are three ways a business can account for GST: the payments basis, the invoice basis or the hybrid basis. At NCEA Level 2 the invoice basis is used to account for GST. Payments basis Account for GST when payments are made or received. (This is also known as the cash basis.) Invoice basis Account for GST when the business first issues or receives a GST invoice Hybrid basis The hybrid basis is a combination of the payments and invoice bases. GST on income is accounted for using the invoice basis and GST is claimed on expenses using the payments basis. invoice basis When using the invoice method, GST is due when an invoice is received or issued. At the end of each month, the amounts owing for GST on cash receipts and on invoices issued for accounts receivable (for credit sales) are entered in the GST account. Similarly, GST paid on cash payments and GST on invoices for accounts payable (credit purchases) is entered in the GST account. You will prepare a GST account later in this course. 46 AC2001 te aho o te kura pounamu

49 goods and services tax registering for gst All business with an annual turnover (sales) greater than $60,000 must register for GST by filling in a registration form. Many businesses with a smaller turnover will choose to register for GST so they can claim GST on assets, purchases and expenses. Once registered, a business will be given a GST number and it is required to collect GST on all its sales and prepare a GST return at regular intervals such as two monthly (most common), sixmonthly or monthly (for very large businesses). The return shows how much the business owes for GST or what the refund should be. Here is an example of a GST return. te aho o te kura pounamu AC

50 goods and services tax gst invoice A GST invoice must be issued for supplies of more than $50. The GST number must be put on the business invoices. GST records should be kept for seven years. CLEAN SWEEP TAX INVOICE P O Box 1234 GST NO Wellington Invoice Phone: Date: 10 May 2014 Customer Flash Interiors Customhouse Quay Wellington $ General cleaning services April 2,000 Plus GST (15%) 300 Total including GST $2,300 calculating gst Multiply by 1.15 GST exclusive price GST inclusive price Divide by 1.15 The business takes the GST exclusive amount and adds GST to get the GST inclusive figure. The difference between the exclusive and inclusive figures is the GST. 48 AC2001 te aho o te kura pounamu

51 goods and services tax Key point When there is a GST exclusive figure, you multiply by 1.15 to obtain the GST inclusive figure. To calculate the GST amount, subtract the GST exclusive figure from the GST inclusive figure. Example $550 exclusive GST X 1.15 = $ inclusive GST The difference = GST $82.50 Key point When there is a GST inclusive figure, you divide by 1.15 to obtain the GST exclusive figure. To calculate the GST amount, subtract the GST exclusive figure from the GST inclusive figure. Example $670 inclusive GST 1.15 = $ exclusive GST The difference = GST $87.39 case study Consider the following: Jed Brown, electrician and sole proprietor of Quick Spark, wants to charge Cassie Marks $500 for electrical repairs to wiring in her house. Jed must multiply this amount by 1.15 to get the GST inclusive figure of $575. The difference of $75 is the GST amount. Quick Spark charges Cassie $575. How can Cassie calculate the amount of GST she has been charged? Cassie must divide the GST inclusive amount $575 by 1.15 to get the GST exclusive price of $500. The difference of $75 is the GST amount. istockphoto.com te aho o te kura pounamu AC

52 goods and services tax at each stage gst is added The tax is intended for the final consumer, so businesses along the way are able to claim back any GST they have paid in the provision of goods and services to the consumer. The producer, wholesaler and retailer all claim back any GST they have paid. example 15% Final payer Producer Wholesaler Retailer Consumer 15% 15% istockphoto.com example 1. GST received A bike shop sells a bike for $1,150 including GST. The bike shop owes the IRD $150 in GST. (Liability) GST Exclusive amount is $1, GST paid A bike shop pays $230 for electricity to First Electric. The bike shop is entitled to claim $30 back from the IRD because they are not the final user of the bike. (Asset) GST Exclusive amount is $200. The bike shop claims back GST paid to suppliers GST paid reduces the GST liability to the IRD. 50 AC2001 te aho o te kura pounamu

53 goods and services tax The bike shop s liability for GST is $150 GST received Less $30 GST paid = $120 owing to the IRD Key point GST payable is determined by offsetting the GST paid against the GST received. 7A Try these GST calculations. 1. Calculate the GST inclusive price of the following exclusive prices: a. $1,120 b. $1,600 c.$6, Calculate the GST included in the following prices: a. $5,520 b. $2,300 c.$805 Check your answers. 7B State the word or words indicated by the following sentences with reference to GST. 1. Every GST invoice must have one. 2. This describes what the business does. 3. Supplies which are not subject to GST. 4. The length of time GST records must be kept. 5. This government department collects GST from businesses on behalf of the government. 6. These businesses must register for GST. 7. GST is accounted for when cash changes hands. 8. The shortest taxable period. 9. This is a mixture of GST accounting methods. 10. How to become registered for GST. Check your answers. te aho o te kura pounamu AC

54 goods and services tax 7C 1. Quick Spark is registered for GST on the invoice basis. If the business collected $40,000 GST for the period and paid out $15,040 for the same period what liability does the business have to IRD? 2. If Quick Spark collected $10,400 GST but paid out $22,160 in GST what would the business be entitled to from the IRD? 3. Indicate which of the following items Quick Spark would include GST. Answer Yes or No. a. paying staff wages b. paying back a $5,000 loan to the bank c. purchasing new office equipment d. paying bank fees e. Jed Brown taking money from Quick Spark for personal use f. paying interest to the bank g. Quick Spark receives dividends from Jupiter Energy h. paying for electrical equipment i. capital investment by Jed Brown in Quick Spark j. paying vehicle registration. Check your answers. what next Complete the teacher-marked activities AC2001TM and the self-assessment. 52 AC2001 te aho o te kura pounamu

55 8 answer guide How to use the answer guide. You will check your own answers except in assessed activities. The answers give you essential feedback. Use them well to help you learn. Always: check your answers carefully after you finish each exercise try to work out why any of your answers are wrong study any reasons given for the answer write any corrections on your work. Phone or your teacher if you are having any difficulties. 1A 1. nature and functions of accounting 1. Your answer may not be the same as shown below but it should include some of these items of financial information that could be used to advise Mark. Price of the business and a list of the assets and liabilities being sold in order to determine a fair price for the business. Financial statements for the last few years showing sales, expenses and profits so trends can be analysed. Financial information about similar businesses to compare Better Buys with them. Information on loans and interest rates if Mark intends to borrow in order to buy the business. This will help to find the best financial arrangement for Mark. 2. Non-financial items to consider could include any one of the following list of information. Location of the business and the mall in which it is situated so future custom can be assessed. Competition from other similar businesses that might affect prices and sales. Economic conditions generally to determine if potential customers will have the ability to buy the products Better Buys offers. 3. The bank manager needs financial information about Better Buys to assess the risk in lending to the business and whether or not Better Buys is able to meet repayments of the loan. 4. The IRD will need information about Better Buys for purposes such as: GST fringe benefit tax income tax PAYE tax Accident Compensation Corporation levies. te aho o te kura pounamu AC

56 answer guide 1B Numbers Work employs the accountants shown below to cover the tasks listed. 1. A tax accountant who prepares taxation returns. 2. A management accountant who prepares budgets. 3. A cost accountant who calculates the costs of producing goods and services. 4. A financial accountant who provides financial advice to small businesses. 5. An accounting technician who prepares accounts and financial statements. 2A 2. concepts 1. The accounting concept applied is Going Concern. 2. The notion of Accounting Entity requires that the personal financial transactions of the owner be kept separate from the business financial transactions. Gill s payment of a personal insurance bill using a business cheque is treated as Drawings in the business accounts of Games as this is not a business expense. 3. Monetary Measurement is applied in the accounting records of Games by entering the purchase of 100 computer games imported from China in New Zealand dollars. This allows the computer games to be added to other dissimilar items. They are not shown by quantity (100) or in Chinese Yen. 4. The accounting concept applied is Historical Cost. The computer games are reported at the price at which they were purchased (cost) which is a faithful representation of the transaction (also neutral and free of error) verifiable by a source document (the invoice for the purchase). 2B 1. Hoani should record the cost of his relatives free use of a Vast Vehicles limousine as drawings in the accounts of Vast Vehicles. 2. Recording the cost as drawings is in keeping with the requirement of the Accounting Entity concept that the personal financial transactions of the owner be kept separate from the financial transactions of Vast Vehicles. Hoani s relatives use of a limousine was a personal expense not a business expense. 3. The Monetary Measurement concept applies here. The new limousine imported from the United States is recorded in Vast Vehicles accounts in New Zealand dollars not US dollars. 4. Reporting the interest owing on Vast Vehicles loan in the Statement of Financial Position is an example of the accrual basis of accounting because the interest owing or accrued expenses is a current liability and Vast Vehicles currently has an obligation to pay the interest. 5. The heading is an example of the Reporting Period notion because the date for the year ended 31 March 2015 indicates the period of time the information refers to. The continuous life of Vast Vehicles is broken up into equal periods for reporting purposes in order to measure the financial performance or profit/loss and financial position of the business. 54 AC2001 te aho o te kura pounamu

57 answer guide 3A 3. qualitative characteristics 1. The usefulness of this annual report for Eco Light is questionable since the information in it will be out of date for decision making. The report is not timely. Additional financial information would be needed about the business. Characteristic is relevance. 2. Last year s figures should be shown in the financial statements of Eco Light so that the information in the statements can be compared with the previous year. Characteristic is comparability. 3. If the annual report of Eco Light is difficult to follow then it has not been presented in a way that users find easy to understand. It lacks the characteristic of understandability. 4. Financial reports should give a true and correct record of transactions and events and should be free from bias. The general manager of Eco Light is not neutral in his approach since he wants to report land and buildings at a figure he thinks they are worth so that they will look more impressive to influence users of the financial statements. There is no documentation or registered valuation to support the figure he is suggesting. Characteristic is reliability. 3B 1. Zing Bat does not report each item of inventory separately in the Statement of Financial Position as information is only material if its disclosure would affect a decision made by an interested party. Users of this statement would be interested in the total inventory held by Zing Bat but not the total of each item of stock. 2. a. Cents may be considered immaterial in businesses with a large turnover and figures would be rounded in the financial statements. b. The market value of investments should be shown in the notes to the financial statements to show a true and fair view of the business. c. The change in market conditions (competitors leaving the market) should be mentioned in the financial statements as this could be very important in decision making. d. The fact that Zing Bat is being sued for polluting the environment should be disclosed if the pending court case could result in a substantial fine that might affect the financial position of the business. 3C Match the description in column B with the correct term in column A. Column A Neutral Reliability Materiality Comparability Timely Consistency Understandability Column B Decisions are unbiased and based on fact. Information is true and verifiable. This applies to a fact which may influence users in making decisions. Requires last year s figures and consistency. Information must be available when needed. The same policies and measurement bases are used each year. The presentation makes it reasonable to expect users to know what it means. te aho o te kura pounamu AC

58 answer guide 3D 4A 1. Relevance 2. Understandability 3. Reliability 4. Understandability 5. Comparability 6. Consistency 4. financial elements 1. Interest on loan is an expense because: there has been a decrease in economic benefits during the accounting period in the form of a cash outflow from Supertyres (bank account) it caused a decrease in Supertyres profit which in turn has decreased the equity this outflow of cash was not drawings by the owner. 2. Accrued expenses for interest on loan is a liability because: as the result of a past transaction Supertyres has borrowed money from the bank (or other financial institution) to which the business now owes money in the form of interest Supertyres has a present obligation to pay the interest on the loan settlement will involve an outflow of cash (economic benefits) from Supertyres bank account in the future cash that could otherwise have been used to earn income for the business. 4B 1. Accounts receivable is an asset. As the result of a past transaction which involved providing goods/services to these customers the business has control over accounts receivable (this money is not owed to any other businesses). Accounts receivable represent future economic benefits in the form of an inflow of cash when these accounts receivable are settled. 2. Accounts payable is a liability. As the result of a past transaction which involved the purchase of goods/supplies on credit the business currently has an obligation to pay the amounts owing. In the future the business will use some of its cash to pay the suppliers and that will result in an outflow of the business cash resources. 3. Insurance is an expense. There is a decrease in economic benefits during the accounting period in the form of cash paid for insurance that results in a decrease in profit that decreases equity and has not been paid out as drawings to the owner. 4. Inventory is an asset. As the result of a past transaction when the inventory was purchased the inventory is presently controlled by the business in that no other businesses can use it. The inventory represents future economic benefits since cash will flow into the business when it is eventually sold to and paid for by customers. 56 AC2001 te aho o te kura pounamu

59 answer guide 5. None of these. Possible future refunds on faulty goods would not be recognised as a liability in the statement of financial position since a liability is not recognised unless it is probable an asset will be sacrificed and that the liability can be measured with reliability. 4C 5A The accountant is correct. Income can only be recognised when it is probable that an increase in assets has taken place. During the financial period ended 31 March 2015, Plum Computers received neither cash nor increased accounts receivable from this $2m order for computers. 5. financial statements 1 1. The purpose of the Statement of Accounting Policies is to set out the policies followed in the preparation of the financial statements. It allows users to more easily understand the significance of the information reported. 2. Understandability is the qualitative characteristic applied in the Notes to the Statement of Financial Position. 3. To satisfy the requirements of the qualitative characteristic of Understandability further details of items reported in the Statement of Financial Position are provided which help users to have a better understanding of the financial position of the business at a certain point in time. Users are therefore able to make better informed financial/economic decisions. 4. Equity is reported in the Statement of Financial Position under the heading Equity as: Opening capital Plus Profit/loss for the year (calculated in the income statement) Less Drawings (withdrawal of cash or assets from the business by the owner) Closing capital. 5. Property, Plant and Equipment are reported as a total carrying amount in the Statement of Financial Position. This is calculated in the Notes to the Statement of Financial Position where details are shown for each item of Property, Plant and Equipment. 5B 1. The purpose of the Statement of Financial Position is to show the financial position of Cement Works at a point in time by showing the assets, liabilities, and equity on balance day. 2. The loan will be reported in the Statement of Financial Position of Cement Works as a noncurrent liability because it is an amount owing over more than one year. The loan was taken out in 2014 and is not due to be repaid until The asset bank is reported in the Statement of Financial Position of Cement Works as a current asset because it is cash. Assets are classified as current if they are cash or expected to be turned into cash within twelve months after the balance date. te aho o te kura pounamu AC

60 answer guide 4. The truck is reported in the Statement of Financial Position of Cement Works as part of Property, Plant and Equipment a non-current asset. Details relating to the truck are shown in the Property, Plant and Equipment Note to the Statement of Financial Position. The truck will be used by Cement Works to provide future economic benefit to the business, in the form of earning income, for more than one year. 5. Historical cost affects the reporting of the truck in the Statement of Financial Position of Cement Works because this measurement base requires that transactions (and assets) are recorded at their purchase or original cost to the business. The truck will be reported at its original cost in the Note to the Statement of Financial Position. 6. In the Statement of Financial Position of Cement Works the group of assets called Intangible Assets reports the long-term assets which have value and will provide future economic benefit to the business but cannot be seen or touched. Intangible assets include goodwill, patents and registered trademarks. 6. financial statements 2 6A Cutting and Styling Expenses Administrative Expenses Finance Costs Scissor sharpening Stylists wages Appointment cards Advertising Clients magazines Clients tea and coffee Depreciation on salon fittings Shampoo, conditioner and styling product expenses Insurance Electricity Receptionist wages Telephone General expenses Window cleaning Depreciation on computer Interest on loan 6B 1. The purpose of the Income Statement is to report the financial performance and profit (or loss) for the period/year in order to compare income, expenses and profit with another period/year. 2. The Cash Flow Statement is prepared to reconcile the opening cash (bank) balance with the closing cash (bank) balance by showing all cash inflows and cash outflows for the reporting period. 3. Credit transactions such as accounts receivable and accounts payable are not included in the Cash Flow Statement until cash is actually received or cash is actually paid. The Cash Flow Statement reports only cash transactions. 4. Non-cash expenses such as Bad debts do not appear in the Cash Flow Statement because they do not involve the receipt or payment of cash. The expense or loss incurred is merely an accounting entry (sometimes known as a book entry ). 58 AC2001 te aho o te kura pounamu

61 answer guide 6C Although Kiddicare s first set of financial statements shows a healthy profit for the year Sara should be aware of the importance of information relating to liquidity as well as profit because profit for the year does not give a full picture. The income statement calculates profit using only income and expense items. It does not include other cash transactions that will affect the cash flow situation such as the purchase and sale of items of property, plant and equipment or new loans/repayments of loans. A shortage of liquid resources can lead to bankruptcy. Other financial limitations of the financial statements include: the amount of estimation used in their preparation for items like depreciation expense and the allowance for doubtful debts the Statement of Financial Position presents information at a certain point in time whereas end-of-year data may not reflect the financial position during the year, nor the current position the effect of inflation as the purchasing power of the dollar changes over time past financial history is not always an indicator of future performance because of nonfinancial factors and there are limitations to the amount of relevant financial information to be gained from comparing businesses over just one financial period. Financial statements record items in money terms and there is no way to quantify economically (put a dollar value on) the impact of non-financial items such as: staff loyalty staff expertise availability of skilled staff changes in market conditions competition within the particular sector the business operates in. 7A 7. goods and services tax 1. a. $1,288 b. $1,840 c. $7, a. $720 b. $300 c. $105 te aho o te kura pounamu AC

62 answer guide 7B 7C 1. GST number 2. Taxable activity 3. Exempt supplies 4. Seven years 5. Inland Revenue Department 6. Businesses with over $60,000 in income 7. Payments basis 8. One month 9. Hybrid 10. Fill in the GST registration form 1. Quick Spark s liability to IRD is the difference between $40,000 GST collected and $15,040 GST paid $24, Quick Spark would be entitled to a refund from the IRD of $11, a. No b. No c. Yes d. No e. No f. No g. No h. Yes i. No j. Yes 60 AC2001 te aho o te kura pounamu

63 acknowledgements Every effort has been made to acknowledge and contact copyright holders. Te Aho o Te Kura Pounamu apologises for any omissions and welcomes more accurate information. We would like to acknowledge the support of Elizabeth Pitu and the use of her NCEA Level 2 Accounting resources. Goods and services tax return form GST101A 2011 Inland Revenue, Wellington, N.Z. Used by permission. Photos istockphoto, Money bag, istockphoto, Graphs & charts Market share, istockphoto, Business team, istockphoto, Business team, istockphoto, Expense report, istockphoto, On sale, istockphoto, Financial report, istockphoto, Man in suit holding a football, istockphoto, Waterfront mansion, istockphoto, New Zealand dollars, istockphoto, Contract, istockphoto, On-line games, istockphoto, Graduation celebration out of a limousine, istockphoto, Analysing, istockphoto, Green light, istockphoto, Folders isolated on white, istockphoto, Cricket kit, istockphoto, Free delivery, istockphoto, Financial choices, istockphoto, Variety of herbs for sale, istockphoto, Cement truck, istockphoto, Cutting costs, istockphoto, Young maid with crossed arms looking at the camera, istockphoto, Haircut, istockphoto, Growing investment, istockphoto, Plunging into bankruptcy speedometer, istockphoto, Preschoolers, istockphoto, GST, te aho o te kura pounamu AC

64 acknowledgements istockphoto, Electrician wiring junction box, istockphoto, New bicycles shop, Bigstock, Tax returns due now, Bigstock, Choice concept, Bigstock, Paint tubes with different colours spread over a white surface, mychillybin, NZ money roll, _472. Illustrations Illustrations and diagrams copyrighted to Te Aho o Te Kura Pounamu, Wellington, NZ. 62 AC2001 te aho o te kura pounamu

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68 cover sheet ac2001 students place student address label below or write in your details. Full Name ID No. Address (If changed) authentication statement I certify that the assessment work is the original work of the student named above. Signed (Student) Signed (Supervisor) for school use only assessment