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