Chapter 1 - Introduction To Financial Accounting

COMM1140: FINANCIAL ACCOUNTING
CHAPTER 1 – INTRODUCTION TO FINANCIAL ACCOUNTING
1.2 FINANCIAL ACCOUNTING
 ACCOUNTING is a process of identifying, measuring and communicating economic

information to allow informed decisions by the users of that information
 FINANCIAL MANAGEMENT enables a company to achieve its financial and operational

goals and thus drives shareholder value through appropriate resource utilization and decision-
making.
 FINANCIAL ACCOUNTING focuses on the provision of information about the financial
position and performance of the firm to users EXTERNAL to the enterprise (shareholders,
creditors, media and students)
 MANAGEMENT ACCOUNTING focuses on the provision of information to users
WITHIN the enterprise
 SOCIAL AND ENVIRONMENTAL ACCOUNTING focuses on the provision of non-
financial information to users EXTERNAL to the enterprise.
1.5 ACCRUAL ACCOUNTING VS CASH ACCOUNTING
 ACCRUAL ACCOUNTING includes the impact of transactions on the financial statements

in the time periods where revenues and expenses occur rather than when the cash is received
or paid.
 CASH ACCOUNTING only accounts for revenues and expenses when cash is paid or
received.
*ALWAYS ASSUME ACCRUAL ACCOUNTING IF NOT STATED
BENEFITS OFACCRUAL ACCOUNTING:
 Includes all assets and liabilities in the balance sheet to give a truer picture of the financial
position of the organisation (e.g. accounts receivable and accounts payable)
 Includes all revenues and expenses regardless of whether the cash has yet been received 
more accurately measured profit
 Assets are used over a number of years and will benefit the performance of each year.
Therefore, in measuring overall performance, a share of the costs should be allocated across
the life of the asset. This allocation, called depreciation, is included in an accrual accounting
system
1.6 KEY FINANCIAL STATEMENTS
BALANCE SHEET
o FINANCIAL POSITION of an enterprise at a particular point in time

o Financial position: enterprise’s set of financial resources and obligations at a
point in time
THREE MAIN ELEMENTS OF BALANCE SHEETS:
ASSETS: Resources controlled by the entity as a result of past events and from which future
economic benefits are expected to flow to the entity
1
o e.g. cash, accounts receivable (amounts owing from customers for goods and services),
inventory (cost of stock on hand, unsold products), property, plant and equipment
1. Future economic benefit: Assets are used to provide goods or services with the objective of
generating net cash flows
2. Controlled by an entity relates to the capacity of an entity to benefit from the asset in pursuing its
objectives and to deny or regulate the access of others
3. Occurrence of past transactions or past events means that the transaction or other event giving the
entity control over the future economic benefits must have occurred, e.g. paid cash or credit
LIABILITIES: A liability is a present obligation of the entity arising from past events, the settlement
of which is expected to result in an outflow from the entity of resources embodying economic benefits
 CURRENT liabilities are those that will be paid off within one year of the balance sheet date
 NON-CURRENT liabilities will remain liabilities for at least the next year
o e.g. accounts payable (amount owed to various suppliers for goods and services), wages
payable (accrued wages – work done by employees yet to be paid), provision for
employee entitlement, long-term loans)
 CONTINGENT LIABILITY: a liability that may occur depending on the outcome of an
uncertain future event
o e.g. lawsuit
1. A present obligation exists and the obligation involves settlement in the future
2. It has adverse financial consequences for the entity in that the entity is obligated to sacrifice
economic benefits to one or more other entities
EQUITY: what belongs to the owners, the residual i.e. what is left after liabilities are taken care of
e.g. share capital and retained profits
 Share capital is the amount that owners have directly invested in the company
 Retained profits represents the total cumulative amounts of profits that the company has
retained in the business rather than distributed as dividends
 Equity can be derived from direct contributions the owners have made, or from the
accumulation of profits that the owners have chosen not to withdraw. For a company, this
would mean profits that have not been distributed as dividends.
2
FEATURES OF BALANCE SHEET
 Title identifies the organisation, the point in time at which it is drawn up and the currency
in which amounts are measured
 Balances!!!!
 Assets are separated into current-assets (short term) and non-current assets (long term)
 Liabilities are separated into current-liabilities (short term) and non-current liabilities
(long term)
INCOME STATEMENT
3
 FINANCIAL PERFORMANCE of an enterprise over a period of time

o Financial performance: generating new resources from operations over a period
of time
o Reports revenue earned and any expenses incurred
 REVENUE: Increases in the company’s wealth arising from the provision of services or
the sale of goods to customers
o Revenue is recovered during shipping of goods
o e.g. sales revenue, service revenue, fees earned, dividend revenue, rent revenue
o only revenues from the sales of inventories should be included in calculating gross
profit
o Interest or dividends received are also revenues because they are increases in
wealth as a result of providing a service (lending or investing money in another
organisation)
 EXPENSES: Decreases in the company’s wealth that are incurred in order to earn revenue
o Revenue > Expenses = NET PROFIT

o Revenue < Expenses = NET LOSS
- A revenue increases wealth, so it either increases assets or decreases liabilities, and

therefore increases equity.
- An expense decreases wealth, so it either decreases assets or increases liabilities, and
therefore decreases equity.
- Positive net profit has the overall effect of increasing assets and/or decreasing
liabilities, and therefore increases equity (increases due to revenues exceed decreases
due to expenses).
- A net loss, which is negative net profit, does the opposite, decreasing equity
(decreases due to expenses exceed increases due to revenues).
4
CASH FLOW STATEMENT
 Cash inflows and outflows over a period of time

 Cash flows are normally categorised into:
o Operating activities: main revenue producing activities such as provision of goods
and services
o Investing activities: acquisition and disposal of non-current long-term assets
o Financing activities: changing the size and composition of the financial structure of
the entity including equity capital and borrowing
5
WEEK 2 – MEASURING/EVALUATING FINANCIAL POSITION

/PERFORMANCE
BALANCE SHEET
Provides information about:
 Financial structure (mix of debt/equity) – debt to equity ratio

 Liquidity – ease of converting assets to cash in normal course of business (short-term focus)
– working capital, current ratio
 Solvency – ability to pay debts when they fall due (longer-term focus) – debt to equity ratio
6
Balance sheet includes:
1. Name of the reporting entity

2. Type of financial statement – balance sheet
3. Date – what point in time it refers to
4. Currency used - $m, $AUD
Current assets = assets held for up to 12 months

 Cash and cash equivalents
 Trade and other receivables = Accounts receivable = sales made on credit that customers are
yet to pay
 Inventories = products sold by the company
Non-current assets = assets held for longer than 12 months

 Trade and other receivables
 Property, plant and equipment
Non-current liabilities:
 Trade and other payables = accounts payable

 Borrowings (> 12 months) (BORROWINGS IS ALWAYS NON-CURRENT UNLESS
STATED)
 Provisions
Current liabilities:
 Trade and other payables

 Borrowings (<12 months) (ONLY WHEN STATED)
Equity
 Contributed equity = share capital

 Retained earnings = profits earnt by the business over a period of time that is yet to be
distributed to shareholders
IMPORTANT: not all assets and liabilities are on the balance sheet!
To be reported on a balance sheet, assets and liabilities must meet RECOGNITION CRITERIA:
1. It is probable that any future economic benefit associated with the item will flow to or from
the entity, and
2. The item has a cost or value that can be measured reliable
RETAINED PROFITS
 Retained profits is a component of shareholder’s equity. It consists of the cumulative profits

earned by the business that have yet to be distributed to shareholders.
7
 Definition: the sum of net profits earned over the life of a company minus dividends declared
to shareholders since the beginning
 When a company earns a profit, that profit can be distributed to shareholders as dividends or
kept in the business to grow the business. The profit that is kept is called ‘retained profit’
 Retained profit is the link between the balance sheet and the income statement
Distributed to shareholders? Dividends – payments made to the shareholders by the company. It is a

reward for investing in the company
Retained profits are calculated as follows:
1. Opening retained profits = all the profits from the previous periods that are yet to be paid in
dividends
2. Add: profit (loss)
3. Less: dividends (DIVIDENDS ARE NOT AN EXPENSE)
4. Closing retained profits
RETAINED PROFIT = OPENING BALANCE + PROFIT/(LOSS) – DIVIDENDS
o Revenue increases retained profits and expenses reduce retained profits
CONSOLIDATED INCOME STATEMENT
8
 The last line of the income statement is transferred to the statement of retained profits (e.g. a
note to then balance sheet)
 Income tax is levied on a company’s profit because it is legally separate from its owners. Such
tax is usually a percentage of profit before income tax.
WEEK 3 – RECORDING BUSINESS TRANSACTIONS
9
3.1 TRANSACTION ANALYSIS

Transactions are events that affect the operations or finances of an organisation
To be considered a transaction, it must impact on the accounting equation: ASSETS = LIABILITY +
EQUITY
e.g. borrow $10000 from the bank

 a liability has increased (increase in loan)
 an asset has increased (increase in cash)
after this transaction, the accounting equation is in balance.
SE = SC + Op. RP + profit – dividends
SC = capital contributions by equity holders (share capital)
Op. RP = opening retained profits
Profit = revenue – expenses
CA + NCA = CL + NCL + SC + Op. RP + R – E – D
SUMMARY OF THE EFFECT OF TRANSACTIONS

1. Shareholders invested $200000 cash in the business
o Increases cash (asset)
o Increases share capital (shareholders’ equity account)
2. Land and building were purchased for $300000, which is financed by a loan from the seller
repayable in five years.
o Land and building (assets) are increased
o Financed through a loan (liability) so liability is increased
o This transaction does not affect shareholders’ equity
3. Inventory worth $50000 was bought on credit. Inventory is purchased for $50000, with an
agreement to pay the suppliers at a later date (often 30 days after the date of sale).
o Inventory = asset increases
o Agreement = liability increases
4. Equipment worth $90000 was purchased by paying $20000 cash and signing an agreement to
pay the remainder in 90 days
o Incurring a liability of $70000  notes payable (notes payable differs from accounts
payable because the liability is evidenced by a promissory note or bill of exchange)
o Notes payable increased by $70000. Therefore, overall increase in assets of $70,000
(equipment increases by $90000 and cash decreases by $20000)
5. Damaged inventory that was purchased on credit at a cost of $5000 was returned to the
supplier.
o Decreases inventory (asset decreases)
o As less money is now owed to the suppliers, account payable (liability) decreases
6. Paid $30000 on accounts payable
o Liability reduced  account payable reduced
o Cash = asset decreases
7. Purchased $10000 inventory using cash.
o Inventory increases and cash decreases = no overall change to assets
10
TRANSACTIONS FOR APRIL 2019:

COST OF GOODS SOLD = WHAT THE COMPANY PAYS TO ACQUIRE THE GOODS THAT
CUSTOMERS BUY  expense the company incurs to earn sales revenue
8. Cash sales of $30,000; cost of goods sold = $12000
o Increase assets
o Expense decreases
9. Credit sales of $40,000; cost of goods sold = $16000
o Accounts receivable (asset) increases
o Inventory decreases by $16000
10. $8000 payments to suppliers on the account
o Cash (asset) decreases
o The payment to suppliers reduces accounts payable = liability decreases
11. $20000 wages paid for first 2 weeks of April
o Wages = expenses increase
11
o Cash = asset decreases

12. Received invoice for $2000 for an advertisement on April 5
o Expense increased by $2000
o Liability (accounts payable) increase by $2000, as the amount has not yet been paid
13. Received $25000 from accounts receivable
o Asset increases
o Accounts receivable decreases
o No revenue is recognised as that occurred earlier when the sale was made
14. At the end of the month; $18000 wages is owing for last 2 weeks of the month. Due to be paid
on May 1
o As they have done work, an expense account (wages) increases
o As the amount is owed to them, liability (wages payable) increases
12
3.3 DOULE ENTRY BOOKKEEPING

THE GOLDEN RULE: the accounting equation must always balance. It means DEBITS = CREDITS
DEBIT-CREDIT CONVENTION:
Increases in Assets = debits (Dr)
Decreases in Assets = credits (Cr)
DR= CR, therefore increases in liabilities and equity must be credits, decreases must be debits
13
 Every transaction has two effects. One requires a debit entry and one requires a credit entry.
 An increase in revenue will increase profit and therefore shareholders’ equity so the normal
balance for revenue accounts is a credit. When a revenue account increases, you will credit the
account.
 An expense will decrease profit and therefore shareholders’ equity, so the normal balance for an
expense account is a debit. When an expense is incurred, you will debit the expense account.
 Declaring a dividend decreases retained profits. When dividends are declared, they are deducted
from retained profits. Therefore, there will be a debit to retained profits because this too reduces
shareholders’ equity. DIVIDENDS ARE A DISTRIBUTION OF PROFITS, NOT AN
EXPENSE!!!!!!!
 When shares are issued, share capital is increased and therefore this will result in a credit to share
capital.
JOURNAL ENTRIES
14
 The date should be entered first

 List debits first, then credits
 Use DR and CR
DEPRECIATION
 Allocation of the cost of a noncurrent asset to expense over the life of an asset
 To recognise the consumption of the asset’s economic value
o Dr Depreciation expense xxx (+E)
o Cr Accumulated depreciation xxx (-A)
 Accumulated depreciation (a contra asset account, B/S) shows all
depreciation charged against an asset to date
 Depreciation expense (I/S) shows only this year’s depreciation allocation
WEEK 4– ACCRUAL ACCOUNTING ADJUSTMENTS
15
RECAP PART 1: ACCRUAL VS CASH ACCOUNTING
 Cash accounting records when cash is received or paid

 Accrual accounting records:
o Revenues when they are earned, not received in cash
o Expenses when they are incurred, not paid in cash
o Some items that have no cash flow effect
 Accrual accounting differs from cash-based accounting because: the timing of revenue and
expense recognition differs from cash inflows/outflows.
 Two events (two time points):
o Transaction (delivering goods, performing services)
o Payment of cash
 Two parties:
o Customer (cash payer)
o Seller (cash payee)
Which produces 4 kinds of accrual accounts:
1. Unearned revenue  cash received before earned
2. Prepayment (prepaid xxx)  cash paid before incurred
3. Accrued revenue (xxx receivable)  cash received after earned
4. Accrued expense (xxx payable)  cash paid after incurred
SPECIAL ACCOUNTS IN BALANCE SHEET CATEGORY JOURNAL ENTRIES

Prepaid expense / Prepayment / Expiration of Asset When cash is paid:
assets DR prepaid expense (+CA)
(e.g. insurance, supplies) CR cash (-CA)
When expense is incurred:
DR XX Expense (+E)
CR prepaid expense (-CA)
Unearned revenue Liability When cash is received:
(e.g. rent/ service received in advance) DR cash (+CA)
CR unearned revenue (+CL)
When revenue is earned:
DR unearned revenue (+CL)
CR XX Revenue (+R)
Accrued expense / XX Payable Liability When expense is incurred:
(e.g. interest, wages) (payables) DR XX expense (+E)
CR Accrued XX expense (+CL)
When cash is paid:
DR Accrued XX expense (-CL)
CR cash (-CA)
Accrued revenue / XX Receivable Assets when revenue is earned:
(e.g. interest, commissions) (Receivables) DR Accrued XX revenue (+CA)
CR XX Revenue (+R)
When cash is received:
DR Cash (+CA)
CR Accrued XX revenue (-CA)
UNEARNED REVENUES
16
 Unearned revenue is future revenue where the cash has been received in advance of earning
revenue
 A liability account
o Liability becomes revenue when goods or services owing are provided
 E.g. insurance premiums, magazine subscriptions, rent received in advance
e.g. Let’s assume Cindy always pays the monthly rent of $1000 for the next month (e.g. she pays
$1000 on the last day of May to Sam for her rent of June)
1. On 31 May, Sam received a rent of $1000 which is the rent of June

Journal entry when cash received (31 May)
DR Cash (+A) $1000

CR Unearned revenue (+L) $1000
Journal entry when service provided (30 June)
DR Unearned revenue (-L) $1000

CR Rent revenue (+R) $1000
2. PREPAYMENT: on 31 May, Cindy paid a rent of $1000 which is the rent of June
Journal entry when cash paid (31 May)
DR Prepaid rent (+A) $1000

CR Cash (-A) $1000
Journal entry when service provided (30 June)
DR Rent expense (+E) $1000

CR Prepaid rent (-A) $1000
PREPAYMENTS
 Cash paid in advance of incurring expense:

o There is still value extending into the future
 Prepayments arise from accrual accounting, in cases where the EXPENSE RECOGNITION
FOLLOWS THE CASH FLOW
 An asset account
o May be classified as current or non-current asset depending on whether benefit
extends beyond next reporting period
 E.g. prepaid insurance, prepaid rent, office suppliers
Let’s assume Cindy always pays the monthly rent of $1000 for the current month (e.g. she pays
$1000 on the last day of May to Sam for her rent of May)
In this case, no accrual accounts involved:
For Sam, on 31 May:
DR Cash (+A) $1000
For Cindy, on 31 May:

17
CR Cash (-A) $1000
ACCRUED REVENUES (RECEIVABLES)
 Revenue has been earned, but cash has not been received
 An asset account
o E.g. interest receivable on loans, commissions earned, Inventory sold but not paid for
by customer
 E.g. Assume a company deposited $500000 with a bank for one year at 4% on 1 January 2019
(interest payable at the end of the period). At 30 June 2019, it would have earned $10,000
interest, although the total interest of $20,000 would not be received until 31 December 2019.
o Accrued interest revenue/ interest receivable, which is an asset, would be increased
by $10,000 and interest revenue would be increased by $10,000
Next, let’s assume Cindy always pays the monthly rent of $1000 for the previous month (e.g. she
pays $1000 on the last day of May to Sam for her rent of April)
On 31 May, Sam received a rent of $1000 which is the rent of April
Journal entry when service provided (31 April)
DR Rent receivable (+A) $1000

Journal entry when cash received (30 May)
DR cash (+A) $1000

CR Rent receivable (-A) $1000
ACCRUED EXPENSES
 Expenses incurred during the current period but not be paid until the following period.
o E.g. wages earned by employees but not paid after end of financial period, interest
payable on outstanding loan
 E.g. Assume wages are paid weekly on Thursday to cover the previous five working days
before the Thursday. If 30 June falls on a Friday, two days’ wages will be owing at 30 June. If
the weekly wages bill is $500,000, then $200,000 (Thursday and Friday) will be owing
o Wages expense is increased because it is an expense of the period, and accrued
wages/wages payable is increased because there is a liability at the end of the period.
On 31 May, Cindy paid a rent of $1000 which is the rent of April

Journal entry when service provided (31 April):

CR Rent payable (+L) $1000
Journal entry when cash paid (30 May)
18
DR Rent payable (-R) $1000

CR Cash (-A) $1000
ACCRUAL ACCOUNTING ADJUSTMENTS
Example 2: Prepayments
 Purchased office supplies of $1000 on 1 June 2012

 On June 30, 2012, $300 of the office supplies remained, i.e. $700 had been consumed
What was the journal entry on June 1?
DR Office supplies $1000

CR cash $1000
 What was the adjusting entry on June 30?
DR Office supplies expense $700

CR Office supplies $700
Example 3: prepayments
 Opening balance prepaid rent $3000
 Closing balance prepaid rent $4000
 Cash paid for rent during the year $6000
What was the rent expense for the year?
Opening balance 3000
Add: prepaid rent 6000
Less: rent expense x
Closing balance 4000
Therefore, rent expense is $5000
Example 4: accrued revenue

 On 1 March 2016, we deposit $100000 with a bank at 12% p.a.
 Interest is received on 31 August 2016 (every half year)
 Financial year-end date is 30 June 2016
Journal entries on 30 June 2016 and 31 August 2016?
30 Jun:
DR Accrued interest (+A) $4000

CR Interest revenue $4000
31 Aug:
19
DR Cash $6000
CR Accrued Interest (A) $4000
Interest revenue $2000
Example 5: Accrued Expense

 A firm pays weekly wages of $10000 each Friday
 Balance date is 30 June, which is a Wednesday
 Hence, in the week that June 30 falls:
o Three days’ wage will relate to June ($6000)
o Two days’ wage will relate to July ($4000)
Journal entries on June 30 and July 2?
On Wednesday:
DR Wages expense $6000

CR Wages payable $6000
On Friday:
DR Wages expense $4000

Wages payable $6000
CR cash $10000
EARNINGS MANAGEMENT
 Earnings management is the use of accounting techniques to produce financial statements that
present an overly positive (or negative) view of a company’s business activities and financial
position.
GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP)

Key Question: How do we determine what goes into financial statements? GAAP
Definition: Rules, standards and usual practices that companies are expected to follow when preparing
financial statements
Components of GAAP
 Accounting standards
o AASB = Australian Accounting Standards Board
o (refer to textbook pp. 228-231)
 The Framework (think of it as a rule book for all companies)
o Framework for the Preparation and Presentation of Financial Statements
 Some additional rules
o ASX listing requirements
o Corporations Law
THE FRAMEWORK (RULE BOOK)

Framework for the Preparation and Presentation of Financial Statements
20
 The Framework sets out the concepts that underlie the preparation of financial reports for
external users
 The Framework includes coverage of:
a) Objectives of financial reports
b) Assumptions underlying financial reports
c) Qualitative characteristics of financial information
d) Definition of elements of financial statements
e) Recognition and measurement of those elements
How does earnings management take place if Company’s must follow the rulebook?
 Many accounting rules and principles require that a company’s management make
judgements in following these principles.
 Earnings management happens when managers take advantage of how accounting rules are
applied and create financial statements that “inflate” or “smooth” earnings (revenue or
profitability)
Motivations to manage earnings (revenue and profitability)

- Market pressure to meet financial expectations
- Bonus dependent on certain revenue or profitability
- Stock options increase when profitability increases
- Senior management pressuring individual managers to improve performance
- Culture of company demands ‘high-growth’
Common approaches to manage earnings
- Improper recognition of revenue
- Recording fictitious revenue
- Channel stuffing (credit sales)
- Improper management salary estimates
- Improper capitalization of expenses
- Improper expense recognition
What is the risks of earnings management?

 Users are not basing their decision making on ‘true and fair’ information.
WEEK 5 – AUDIT AND INTERNAL CONTROL

ENSURING FINANCIAL REPORTING QUALITY (FRQ)
Three key questions:
1. Who prepares financial information?

o Who is responsible for the preparation and presentation of financial statements?
2. Who approves the financial statements?
3. Who adds credibility by assuring the financial statements?
Key concepts to address these three questions:
o Corporate governance and financial reporting process

o Hierarchy of a corporation
- Key players include management, board of directors, external auditors
ENSURING FRQ – CORPORATE GOVERNANCE AND FINANCIAL REPORTING

PROCESS
21
 The framework of rules, relationships, systems and processes within and by which authority is
exercised and controlled in corporations (ASX, 2010)
 For the financial reporting perspective, the financial reporting process is a 3-step process:
MANAGEMENT:
 Prepares financial statements
 Making subjective judgements about measurements of assets and liabilities, revenues and
expenses
 What is recognised on the B/S and I/S
 Impact on financial ratios (Week 9) and stock price
 Public companies include their set of financial statement in a much larger annual report
THE ANNUAL REPORT usually contains…
1. Summary performance data for the year and the comparisons for past few years
2. Chairperson’s report
3. CEO report – Review of operations
4. Corporate governance statement (listed companies)
5. Set of financial statements – (1) balance sheet (2) income statement (3) statement of changes
in equity (4) cash flow statement (5) notes
6. Directors’ statement (Corporations Act 2001 requirement)
7. Independent audit report
8. Directors’ report
9. Information about substantial shareholders (listed companies)
10. Sustainability reporting
11. Other voluntary information (text, p.252)
BOARD OF DIRECTORS:
 Approves financial statements by ‘signing’ off the financial statements
 Legally responsible for financial statements
 Example of a recent legal case regarding the duties of directors:
o Centro properties group
HIERACHY OF A CORPORATION
AGENCY THEORY: Principal and Agent relationship
 AGENT: the person who is to do something and be compensated
 PRINCIPAL: the person who wants it done
The people are unlikely to have the same interests
E.g. if the agent is to provide effort on behalf of the principal, the agent wants to work less
hard than the principal wishes while the principal wants the agent to maximise their effort.
22
EXTERNAL AUDITORS:
 An audit is an objective examination and evaluation of the financial statements of a company
to make sure those financial statements are a fair and accurate representation of all the
transactions they claim to represent
 An independent verification that managers have correctly applied accounting rules in the
preparation of the financial statement
 Shareholders can’t verify whether the financial statements:
o Present true and fair views
o Free from material misstatements
o Free from undue bias
 Evaluate the financial statement  do not prepare financial statements
 Appointed by the shareholders
 Working for the shareholders in verifying reports prepared by the management
External auditors must:
 Must have a close working relationship with the management  to obtain the necessary
information to carry out the audit
 Must be independent of the management
o Auditors should be unbiased, professionally sceptical reviewer of the financial
statements
o Add credibility to financial statements
o Maintaining independence is not easy
 Auditors should provide an independent, unbiased and professional opinion on whether the
financial statements:
o Provide true and fair view
o In accordance with Corporation Act 2001
o Complies with:
 Generally accepted accounting principles (GAAP)
 Applicable accounting standards
23
 Other professional mandatory reporting requirements
THE INDEPENDENT AUDITOR’S REPORT
 The audit firm and partner

 The audit opinion
 The basis for the opinion
 Key audit matters (most significant matters that arose during the audit)
AUDIT OPINIONS
 Type of audit opinions: Unmodified (or unqualified) Opinion
o An unmodified audit report indicates that the auditor believes the financial
statements give a true and fair view, that they are in accordance with the provisions
of the Corporations Act 2001, applicable accounting standards (GAAP) and other
professional mandatory reporting requirements
 Type of audit opinions: Qualified Opinion

o Issued when a specific part of the financial statements contains a material
misstatement or adequate evidence cannot be obtained in a specific, material area,
and the rest of the financial statements are found to present a true and fair view, in
accordance with accounting standards
 Auditors are generally satisfied except for a specified problem in doing their work or a
specified departure from GAAP in the statements
o E.g. auditors have a different view on the valuation of asset from that applied by the
management in the financial statements – the rest of the financial statements are free
from material misstatement.
24
 Type of audit opinions: Adverse Opinion

o Issued when the auditors believe that the misstatements are so pervasive that the
financial statements do NOT present a true and fair view or that they are NOT
presented in accordance with GAAP/accounting standards
 Type of audit opinions: Disclaimer opinion

o issued when the auditors are unable to express an opinion because of a limitation in
the work the auditors were able to do
o EXAMPLE 1: auditors cannot obtain adequate evidence to form an opinion on the
financial statements overall
o EXAMPLE 2: the company’s financial reporting information system is damaged and
the key data is lost
PROFESSIONAL ETHICS
 Threats to auditor’s independence (APES 110):

o Self-interest threats:
 The threat that a financial or other interest will inappropriately influence the
judgement or behaviour of auditors
 E.g. a financial interest in the client; undue dependence on the total fees of a
client; a loan to or from a client
o Self-review threats:
 The threat that an auditor will not appropriately evaluate the results of a
previous work performed by the auditor (or by another individual within the
audit firm) on which the auditor will rely when performing a current service;
 I.e. the auditor audits work that they have previously done for the client
 E.g. auditing systems on reports that you had been involved in the design or
development of
o Advocacy threats:
 The threat that an auditor will promote a client’s position or interest to the
point that auditor’s objectivity is compromised
 E.g. promoting shares in a listed company when you are also auditor of that
company
o Familiarity threats:
 The threat that due to a long or close relationship with a client, an auditor will
be too sympathetic to the client’s interests or too accepting of the client’s
work
 E.g. having a close or immediate family relationship with a director or officer
of a client; long association with senior personnel of an audit client
o Intimidation threats:
 The threat that an auditor will be deterred from acting objectively because of
actual or perceived pressures from the client
 This includes attempts to exercise undue influence over the auditor
 E.g. being threatened with dismissal, being pressured to reduce the extent of
the work performed in order to reduce fees.
25
 APES 110 sets out five fundamental principles:

1. INTEGRITY
o Straightforward and honest in professional and business relationships
o Includes fair dealing and truthfulness
2. OBJECTIVITY
o Not to compromise their professional or business judgement because of bias,
conflict of interest or the undue influence of others
3. PROFESSIONAL COMPETENCE AND DUE CARE
o Obligations of accountants:
o To maintain professional knowledge and skill at the level required to
ensure competent professional service;
o To act diligently in accordance with applicable technical and
professional standards when providing their services
4. CONFIDENTIALITY
o An obligation to refrain from:
o Disclosing confidential information acquired through business
relationships without proper and specific authority from the client;
o Using the confidential information to their advantage
5. PROFRESSIONAL BEHAVIOUR
o An obligation on accountants to comply with relevant laws and avoid actions
that may discredit the accounting profession
INTERNAL CONTROL – DEFINITION
 Internal control is a process effected by an entity’s board of directors, management and other
personnel, designed to provide reasonable assurance regarding the achievement of
objectives in the following categories:
1. EFFECTIVENESS AND EFFICIENCY OF OPERATIONS including
safeguarding assets against loss
2. RELIABILITY of internal and external financial and non-financial REPORTING
3. COMPLIANCE with applicable laws and regulations
INTERNAL CONTROL SYSTEMS – OBJECTIVES

 Safeguard assets against waste, fraud and inefficiency
o Locks, keys, insurance, patents, passwords, stocktakes
 Promote the reliability of accounting data
o Separation of accounting function, separation of duties
 Encourage compliance with laws and regulations
o Occupational health and safety, complaints, whistleblowing
 E.g.
o Secret receipt
o Balance sheet figures
o Missing inventory
o Missing cash
 Who is involved: everyone including directors, managers and employees
26
 Managing “operational risk”  all operating activities

 Responsibility of the CEO
INTERNAL CONTROL SYSTEMS – COMPONENTS

FIVE COMPONENTS:
1. Control environment: policies and procedures
2. risk assessment: identify and analyse sources of risk
3. control activities: preventive, detective
4. Information and communication: timely, flow, feedback
5. Monitoring: ongoing monitoring, separate evaluations
- All must be present and function effectively to ‘control’ reliability of financial reporting
E.g. internal control systems at CommBank:
1. CONTROL ENVIRONMENT = poor culture in the organisation

2. RISK ASSESSMENT = didn’t identify ATMS as a potential risk; CBA admits it failed to
meet risk assessment requirements for its deposit-taking ATMS
3. CONTROL ACTIVITIES = did not report necessary lodgement information to APRA
4. INFORMATION AND COMMUNICATION = compliance information was prepared but it
was ignored/not reported to appropriate individuals
5. MONITORING = management were aware of the problem but did not react
INTERNAL CONTROL SYSTEMS – FEATURES

 Tone from the top and human resources
 Clearly established lines of responsibility
 Security of assets
 Approvals, authorisations, verifications, reconciliations, reviews
 Maintenance of effective records
 Separation of duties
 Rotation of duties
 Internal auditing
 Physical protection of sensitive assets
 Adequate insurance
 Adequate pay and motivation for employees
 Employees take regular leave
what is segregation of duties? Provide 3 examples
 Segregation of duties involves the separation of record-keeping from handling assets

 One person collects the cash and another person maintains the cash records
 One person maintains approves an invoice (Account payable) another person processes the
bank payment for that invoice
 One person maintains a physical record of all stock that should be in a warehouse, another
person is responsible for conducting a stock-take in a warehouse periodically.
INTERNAL CONTROL SYSTEMS – EXAMPLES

 Cashier receiving cash from customers
 Banking cash at the end of the day
27
 Keeping the ledger-rotation policy

 Keeping the records of stock on hand
DQ 7.7) Provide three specific internal control procedures for:
1. Cash
o Access key for sales registers kept by a supervisor, who balances cash to sale records
o Unused cheques kept in a safe location
o Cheques should be endorsed with a stamp to prevent the possibility of them being
presented to a bank for cashing or deposited in some other account
2. Inventory
o Perpetual inventory records compared with inventory counts
o Inventory should be kept in a locked store to which access should be limited
o Record-keeping of inventory should be separated from handling inventory
3. Accounts receivable
o Account receivable control account kept by a person different from the person
responsible for the subsidiary ledger for accounts receivable
o Bad debts written off by a responsible person different from the accounts receivable
ledger keeper
o Follow-up of overdue accounts
HOW DO WE PREVENT THEFT OF INVENTORY?
- Undertake stock-take to match accounting records

- Install security cameras to prevent theft
HOW DO WE ENSURE CORRECT PAYMENT OF INVOICES/ACCOUNTS PAYABLE?
- Match invoice to purchase order

- Match invoice to delivery receipt
- Ensure two or more people approve all payments
- Rotate staff responsibility for payment of accounts payable
INTERNAL CONTROL SYSTEMS – LIMITATIONS

 REASONABLE (NOT ABSOLUTE) ASSURANCE
o Genuine mistakes
o Management override
o Collusion among employees
o Computer fraud
o Cost versus benefit of internal control systems
WEEK 7 – INCOME STATEMENT AND BALANCE SHEET
RATIO ANALYSIS
- The purpose of a ratio is to produce a scale-free, relative measure of a company that can be used
to compare with other companies, or other years for the same company.
28
PROFITABILITY RATIO – GENERATE EARNINGS COMPARED TO EXPENSES
 Company’s ability to earn profits

 Ratios:
o Return on assets (ROA)
o Return on equity (ROE)
o Profit margin (PM)
o Earnings per share (x)
o Dividend Payout Ratio
29
 Provides information on how well the company performed and guidance on how it is likely to
perform in the future
RETURN ON ASSETS (ROA)

 Ability to earn on the company’s assets:
( NET ) Operating Profit After Tax
Return on Assets =
Total Assets
 Assessing the effectiveness of asset utilisation
RETURN ON EQUITY (ROE)

 Rate of return on the amount of shareholder’s equity
Return on Equity = '
Shareholders equity
 How much return the company is generating on the shareholders’ investment (Contributed
share capital, reserves and retained earnings)
TREND ANALYSIS
 If ROE or ROA are negative or have declined materially relative to prior years or are lower
than their direct competitors, this is problematic
ROE and ROA will naturally tend to be lower (higher) in highly (less) competitive industries
 Cross-company comparisons of ROE and ROA are most meaningful when the companies
are direct competitors offering similar products
PROFIT MARGIN
 How much of sales revenue ends up as profit after all expenses are paid
30

Profit margin =
Sales Revenue
 E.g. 15% profit margin  15 cents of net operating profit is generated from each dollar of
sales, on average
 Profit margin gives some indication of pricing strategy or competition intensity in the
industry
o A discount retailer in a competitive market will have a LOW margin
o A high-end exclusive jeweller will have a HIGH margin
GROSS MARGIN
 Sales revenue a company retains after incurring the direct costs associated with producing the
goods it sells (COGS) and the services it provides
Gross profit
Gross margin =
Sales Revenue
 Measures profitability in buying (or manufacturing) and selling goods before other expenses
are covered
 Gross Margin provides a further indication of the company’s product pricing and product
mix
EARNINGS PER SHARE

 Relates earnings attributable to ordinary shares to number of ordinary shares issues
Earnings per share =
( NET ) Operating Profit After Tax−dividends on preference shares
Weighed average number of ordinary shares outstanding
DIVIDEND PAYOUT RATIO

 Measure of the portion of earnings paid to shareholders
Annual Dividends declared per share
Dividend payout ratio =
Earnings per share
 If the ratio is 0.3, then 30% of profit was distributed to shareholders, while 70% was retained
by the company (Retained profits)
SUMMARY: PROFITABILITY RATIOS
 These ratios should exceed zero (a positive return)

 You would prefer their values to be as HIGH as possible
 Values of these ratios generally range between 5% and 20%
ACTIVITY (TURNOVER) RATIOS – CONVERT ASSETS/LIABILITIES INTO CASH
 Activity ratios assess the efficiency of the company’s operations. These typically assess how
well the company uses assets to generate revenues or cash
ASSET TURNOVER
 Company’s ability to use its assets to generate sales:
31
sales
Asset turnover =
Total assets
 How much sales is associated with a dollar of assets? E.g. a ratio of 3 indicates that a
company generated $3 in sales for every $1 of assets
 Indication of operating efficiency
INVENTORY TURNOVER OR DAYS IN INVENTORY
 Number of times inventory is sold during the year

COGS
Inventory turnover =
Closing inventory
 Efficiency of inventory management
 Low turnover? Risking obsolescence or deterioration in inventory
365
Days in inventory =
Inventory Turnover
DEBTORS TURNOVER OR DAYS IN DEBTORS

 Proportion of credit sales to accounts receivable
Credit Sales
Debtor’s turnover =
Accounts receivable
 Efficiency of the company to collect the amount due from debtors
DAYS IN DEBTORS
365
Days in debtor =
Debtors Turnover
 Average number of days to collect accounts receivable
QUICK RATIO
 Company’s ability to pay its current liabilities with liquid current assets
Cash+ Accounts Receivable+ Short−term investment
Quick ratio =
Current Liabilities
LIQUIDITY RATIOS – ABILITY TO PAY FINANCIAL OBLIGATIONS
 Ability to pay its short-term debts when they are due

 Current ratio: current assets and current liabilities
 Quick ratio: acid test
CURRENT RATIO
 Company’s ability to pay its current liabilities with current assets

Current Assets
Current ratio =
Current Liabilities
 If too low… may indicate a problem in paying short term debts
 If too high… may indicate the company may not be efficiently using its current assets
QUICK RATIO
32
 Company’s ability to pay its current liabilities with liquid current assets
Cash+ Accounts Receivable+ Short−term investment
Quick ratio =
Current Liabilities
 Similar to current ratio but just current assets without ‘inventory’ as inventory needs to be
sold and is therefore less liquid
FINANCIAL STRUCTURE RATIOS
 Ability of the company to continue operations in the long term

 Debt to equity ratio: L/SE
 Debt to assets ratio: L/A
 Leverage ratio: A/SE
DEBT-TO-EQUITY RATIO
 A measure of the proportion of borrowings to owner’s investment

Total Liabiliites
Debt-to-equity ratio = '
Total Shareholder s Equity
 Indicates the company’s policy regarding financing of its assets
o > 1 = the assets are financed mostly with DEBT
o A very high ratio is associated with high risk (i.e. a company financed its growth
using a large amount of debt)
DEBT-TO-ASSET RATIO
 Indicates the proportion of assets financed by liabilities

Total Liabiliites
Debt-to-asset ratio =
Total assets
 The greater the risk that is associated with the firm’s operation, the HIGHER the ratio
LEVERAGE RATIO
 A measure of how much of assets is financed by equity

Total Assets
Leverage ratio = '
Total Shareholder s Equity
 The higher the ratio, the SMALLER the proportion of total assets funded by equity, the
HIGHER the proportion of TOTAL ASSETS funded by liabilities/debt
THE DU PONT SYSTEM
 The Du Pont system of ratio analysis identifies the following link:

ROE = ROA X Leverage
Operating profit after tax Operating profit after tax
' = x
Shareholders equity Total asset
Total assets
'
Shareholders equity
33
 Du Pont analysis is useful to analyse the different drivers of ROE. The decomposition of
ROE allows users to focus on the key metrics of financial performance individually to
identify strengths and weaknesses.
 There are three major financial metrics that drive return on equity (ROE): operating
efficiency, asset use efficiency and financial leverage. This allows an investor to determine
what financial activities are contributing the most to the changes in ROE
LIMITATIONS OF RATIO ANALYSIS

 Ratios need to be considered in the context of:
o Industry averages
o Past records
o Business strategy
o General market conditions
o ‘abnormal’ situations
 How can we reduce the limitations of ratio analysis?

o Read the financial news
o Keep up to date with economy-wide factors
o Research information about other companies
 Based on accounting numbers in Financial Statements

o Past, historical information
o Year-end information
o Different companies use different measurements
o Not all information recognised on the B/S and I/S?
o What if accounting numbers are incorrect?
 How can we reduce these limitations of ratio analysis?

o Ensuring financial reporting quality – as part of Corporate Governance
34
WEEK 8 – CASH FLOW ANALYSIS
CASH FLOW STATEMENT
 Reports the inflows and outflows of cash under the headings of Operating, Investing and
Financing Activities
 Statements of cash flows provide details of movements in an entity’s cash balance over a
specific time period
 The cash flows are normally categorised into:
o Operating activities: main revenue producing activities
o Investing activities: acquisition and disposal of long-term assets
o Financing activities: equity capital and borrowing
WHY IS THE CASH FLOW STATEMENT IMPORTANT?

 The cash flow report is important because it shows movements in cash flows
 The cash flow report is important because it informs the user of the business’ cash position
 For a business to be successful, it must have sufficient cash at all times. It needs cash to pay
its expenses, to pay bank loans, to pay taxes and to purchase new assets.
BENEFITS OF A CASH FLOW STATEMENT
 The balance sheet reveals the opening and closing balance of cash
 The cash flow statement provides information about what caused the movement in the cash
balance
 The cash flow statement helps to evaluate:

o The entity’s ability to generate future cash flows
o The entity’s ability to pay dividends and meet obligations
o The reasons for the difference between net income and net cash provided (used) by
operating activities
o The investing and financing transactions during the period
HOW CAN WE USE THE CASH FLOW STATEMENT?
 Did the company generate cash from operations?

 If it generated cash flow from operations, how did it use that cash?
 How did profit increase when there was a net decrease in cash flow from operations?
 Is cash flow greater or less than net profit?
 How was the expansion in the plant and equipment financed?
35
 Did investments increase or decrease? What were the changes?

 How much debt was repaid?
 How much money was borrowed during the year?
 What amount was paid in dividends?
OPERATING ACTIVITIES
 Cash flows related to the provision of goods and services:

o Receipts from customers
o Interest and dividends received
o Payments to suppliers and employees
o Interest paid
o Income tax paid
INVESTING ACTIVITIES
 Cash flows related to the sale and acquisition of non-current assets and investments that
are not cash equivalents:
o Purchases/sales of property and equipment
o Purchases/sales of equity investments
o Purchase/sales of businesses
o Collection/provision of loans to other businesses
o Dividends received
FINANCING ACTIVITIES
 Cash flows related to changing the size and/or composition of the financial structure:
o Borrowing/repaying debt
o Issuing shares/buying back shares
o Paying dividends
CASH FLOW RATIOS
 Cash flow ratios are closely related to liquidity. They can be divided into two categories:
o Cash sufficiency ratios: examine whether the company can generate sufficient cash
to meet its financial obligations
o Cash efficiency ratios: examine how well the company generates cash
CASH SUFFICIENCY RATIOS
 Helps users interpret whether a company can generate sufficient cash to meet its financial
obligations
o Current liability coverage ratio
o Long term debt coverage ratio
o Interest coverage
o Dividend coverage
o Cash generating power
36
CURRENT LIABILITY COVERAGE RATIO
 This ratio demonstrates the ability for operations to generate cash that can be used to cover
debts that need to be paid within a years’ time
net cash
Current liability coverage ratio = ¿ operating activities ¿
current liabilities
 A ratio of less than 1 indicates that the business is not generating enough cash from operations
to cover its short-term obligations
o It can suggest a company will struggle to pay its financial obligations as they fall due.
LONG TERM DEBT COVERAGE RATIO
 Assess whether a company could repay its long-term debt with annual cash flows from
operations
net cash
Long-term debt coverage ratio = ¿ operating activities ¿
long term debt
 A higher ratio reflects the firm’s financial flexibility, and its ability to pay its debts. A ratio of
more than 1 is desired (but may not be realistic in some industries)
 If the ratio is trending down, management may need to raise more capital or additional debt.
INTEREST COVERAGE (CASH FLOW MEASURE)
 Helps understand how easily a company can cover its interest payments with cash flows
net cash
Interest coverage ratio = ¿ operating activities ¿
Interest expense
 A higher coverage ratio is better, although the ideal ratio may vary by industry
 If the ratio is trending downwards, it may indicate future liquidity issues are on the horizon
DIVIDEND COVERAGE (CASH FLOW MEASURE)
 Helps understand how easily a company can cover its dividend payments with cash flows
net cash
Dividend coverage ratio = ¿ operating activities ¿
Dividend declared
 A higher coverage ratio is better, although the ideal ratio may vary by industry
 If the ratio is trending downwards, it may indicate the ability of the company to generate cash
is decreasing
CASH GENERATING POWER RATIO
37
 Measures the company’s ability to generate cash from its operations compared to the total
cash flows
Cash generating power ratio =
net cash
¿ operating activities ¿
net increase∈cash(¿ op . , fin.∧inv . activities)
 Provides users with a greater understanding of how cash is being generated (From sales
revenue, sales of assets or sale of shares)
 A reduction in this ratio over time should be seen as a concern
CASH EFFICIENCY RATIOS
 Helps users determine how efficient a company is at generating cash

o Asset efficiency
o Cash flow to sales
o Days in receivables (covered week 7)
o Days in inventory (covered week 7)
ASSET EFFICIENCY
 Similar to ROA, but uses cash flow from operations instead of net income. This is a basic
ratio to show you how well the company uses its assets to generate cash flow
net cash
Asset efficiency = ¿ operating activities ¿
total assets
 It’s best to look at historical trend or compare with competitors
CASH FLOW TO SALES
 Also called operating cash flow rate, this ratio assesses how many dollars of cash is generated
for every dollar of sales.
net cash
Cash flow to sales = ¿ operating activities ¿
sales revenue
 It’s best to look at historical trend or compare with competitors.
 TIP: make sure that the operating cash flow increases in line with sales over time. You
don’t want to see the ratio fall as sales increase. If you spot this trend, you need to examine
the cash flow statement in more detail to determine why cash generation is reducing.
WORKING CAPITAL MANAGEMENT (WCM)
 WCM is defined as a business strategy designed to ensure a company uses its current assets
and liabilities effectively
 Working capital management is crucial to ensure a company maintains sufficient cash flow to
meet its short-term operating costs and obligations
38
Net working capital = current assets – current liabilities
WHY IS WORKING CAPITAL IMPORTANT?
 Working capital management is closely linked to generating positive cash flows from
operating activities. Investors assess changes to working capital to determine the
effectiveness and efficiency of company management in achieving strategic objectives
 If working capital is too low: it may suggest a company may not be able to pay its financial
obligations. In worst case scenario, this may result in bankruptcy or may require the company
to undergo restructuring by selling off assets, reorganise or liquidate.
 If working capital is too high: may suggest the company invests excessively in cash and
liquid assets; this may be a poor use of company resources
CASH CONVERSION CYCLE
 Assesses the time (measured in days) it takes for a company to convert its investments in
inventory and other resources into cash flows from sales.
 A trend of decreasing or steady CCC values over multiple periods is a good sign while rising
ones should lead to more investigation and analysis based on other factors.
HOW CAN WE IMPROVE THE CASH CONVERSION CYCLE?
1. Reduce days in inventory

2. Reduce debtor’s days
3. Increase accounts payable days
IMPACTS OF TRANSACTIONS ON RATIOS – AN EXAMPLE
1. The company declared dividends
39
2. Purchased inventory on credit

3. Accounts payable were paid
What is the effect on each of the ratios above?
 What if both numerator and denominator increase by the same amount?

E.g. company took a long-term loan of $1000000.
o Debt to assets – currently is 2/3 = 0.66
o After loan is acquired, changes to ¾ = 0.75
REVISION QUESTION
The following question related to PQR Ltd, which has the following ratios:
Return on assets (ROA) 12%; Return on equity (ROE) 14%; and current ratio (CR) of 2:1
A customer provides a deposit of $500000 near year-end. The product will not be delivered until next
year. This transaction will:
a) Increase ROA and ROE but decrease CR
b) Increase ROA and ROE but has no effect on CR
c) Decrease CR but has no effect on ROA or ROE
d) Decrease ROA and CR but has no effect on ROE
- Increase in current assets (Cash)
40
- Increase in current liabilities (unearned revenue)

- ROA (net profit/total assets): current assets increases, profit unchanged  ROA decreases
- ROE (net profit/total equity): net profit unchanged, equity unchanged  ROE no effect
- CR (CA/CL): current assets and current liabilities increase by same amount  CR decreases
WEEK 9 – FINANCIAL APPLICATIONS
MINI LECTURE PART A
CASH VS NON-CASH EXPENSES
 Remember to distinguish cash vs non-cash expenses, e.g. wages vs depreciation

 Remember that major asset purchases are “Capitalized”, i.e. they do not count as an expense
in the year of purchase, but are depreciated over their useful lifetime via depreciation expense
 This has important consequences for corporate taxes:
o Depreciation lowers accounting profits before tax over the lifetime (but not cash
flow)
o Thus, the company pays less taxes than without depreciable expenses
o In finance, we call these tax savings the depreciation tax shield.
INTEREST AND TAXES
 Interest from debt financing is an expense (but it is also a very real drain on cash flow)
o Interest lowers accounting profits before tax
o The company pays less taxes than without interest-carrying debt
o These tax savings are called the interest tax shield
 The tax-reducing property of debt is a major driver of capital structure decisions by
companies
41
INTRODUCTION TO FINANCE
 The field of finance studies the many activities that are associated with the management of
capital and investments, e.g. the banking sector and money/credit markets; portfolio and
investment decisions, corporate financial management
 A major distinction in finance is the following:
o Corporate/business finance: the view of the firm/management
 Which projects to invest in? How to finance operations? How to pay out
earnings?
o Investments/asset pricing: the view of the investor
 What are assets/securities worth? How risky are they? How to form
portfolios?
ASSETS
 Physical asset – something that has value (Tangible and intangible): land, factories,
machinery, patents…
 Financial asset – contractual (paper) claim to ownership of a physical asset and/or to
contractually agreed upon cash flows: e.g. mortgages, bank loans, bonds, shares, bank
deposits
 Financial securities are a legally defined subset of financial assets. Typically, they split
ownership of assets/cash flows into equal-sized pieces and are usually tradable in a financial
market: e.g. bonds, shares, derivatives
 EXAMPLES:
o Publicly listed shares are traded on a stock exchange; each share represents a small
piece of ownership of the firm (and all of its assets). They are financial securities.
o An individual bank loan is a financial asset, but not a security. It is hard to sell to
another bank and is not an equal-sized piece of something bigger. But it conveys to
the bank a right to cash flows (interest payments)
o A mortgage is a bank loan that is explicitly tied to and secured by a piece of real
estate that the bank can repossess if the borrower fails to make his payments.
42
 In accounting, assets are all the things on the left side of the balance sheet. They represent
what the firm is using its funds for: buy inventory, build out production capabilities, invent a
patent etc. These are hopefully things that produce cash flows for the firm.
 In finance, there are always two sides to any financial asset: The owner enjoys the
aforementioned claims to ownership and/or cash flow. To the party that provided the asset to
the owner, it represents a liability as he/she is responsible to pay those cash flows to the
owner!
 EXAMPLES:
o The firm issues shares to shareholders, for whom these represent assets (Claims to the
firm’s stuff). To the firm, the shares are a liability that may come with the expectation
of dividend payments to shareholders. They are listed as issued capital on the liability
side of the balance sheet.
o The bank loan is an asset to the bank (receive interest payments). But to you as the
borrower, the loan needs to be paid back (cash outflows) and thus is a liability, a debt
you owe.
VALUE, PRICE & INFORMATION

ESTIMATING VALUE
Every day, investors and analysts use a variety of techniques to formulate some estimate of value or
future price for shares of companies
- FUNDAMENTAL ANALYSIS (FA): The collection and processing of relevant information
available in the public sphere to estimate intrinsic value
o Top-down FA: “Big picture” approach considers macro factors to forecast economy-
wide or industry-specific cash flows
 E.g. interest rates, economic growth, consumer spending, sector
trends
o Bottom-up FA: Firm-specific approach considers micro-factors to focus on future
cash flows of individual firms:
 E.g. Accounting ratios that assess a company’s capital structure,
liquidity, debt servicing, profitability, share price and risk.
FORECASTING PRICE
TECHNICAL ANALYSIS (TA): Aims to explain and forecast share price movements based on past
price behaviour (i.e. historical charts). It implicitly assumes markets are driven by mass psychology
and slow incorporation of information, which gives rise to certain regular price patterns. The TA
toolbox contains, among many others:
- Trend lines and support & resistance lines
- Moving averages (MA)
- Continuation and reversal patterns
ESTIMATING VALUE & FORECASTING PRICE

The primary goal of FA is to appraise value, not forecast price alone, but the lines can be blurred.
ABSOLUTE VALUATION TECHNIQUES: Very bottom-up; forecast/model individual cash flows
of the firm into the future and derive today’s intrinsic value, while accounting for risk
RELATIVE VALUATOIN TECHNIQUES: Value/price companies by comparing them to other
companies based on accounting information, especially financial ratios.
43
WEEK 9 – FINANCIAL APPLICATIONS
INTRODUCTION
 Recall the two main items on the liability side of the balance sheet: debt and equity (paid in
capital + retained earnings)
 These represent the source of the funds that the firm has at its disposal to “do things”
 The crucial difference is that equity represents fractional ownership of the firm, while debt
only entitles the holders to certain, regular payments
2 IMPORTANT MEASURES OF FIRM VALUE

1. MARKET CAPITALISATION (market value of equity)
= # of shares outstanding x Share price
2. ENTERPRISE VALUE (EV)

= Market value of Equity + Market Value of Debt – Cash
= Market Value of Equity + Net Debt
Important note: These 2 are based on market values, i.e. observed prices of tradable instruments.
Distinguish market cap from book equity, which is an accounting measure (book value assets minus
book value of liabilities) that can be very different.
PERFORMANCE MEASURES
Distinguish equity-based performance metrics such as…
 Net income or earnings (per share): Bottom-line for shareholders after all accounting
deductions and taxes
 Levered cash flow or free cash flow to equity (FCFE): A cash-flow based measure of what is
left for shareholders from operating profits after “paying bills with cash”, e.g. adding back
D&A, deducting capex, taxes and interest.
And company/enterprise-based metrics such as:
 EBITDA: “Earnings before everything”, in particular debt service
 Unlevered cash flow or Free cash flow to the firm (FCFF): A cash-flow based measure of
what is left for shareholders & debtholders from operating profits after paying most bills
except financing, e.g. adding back D&A, deducting capex and taxes (but NOT interest)
COMMON VALUATION METRICS
1. The Price-Earnings (P/E) Ratio:

- Share price divided by earnings per share (Equivalent to market cap over net income)
- Can be based on trailing (last year) or forward earnings (this year)
2. EV/EBITDA:
- Enterprise value over “earnings before everything:
- Very commonly used in M&A (Mergers & Acquisitions) context
44
OTHER VALUATION METRICS
1. Price/Sales Ratio:
- Market capitalisation divided by total revenue
- Often used for firms with negative earnings, during high growth phase
- Sales less volatile than earnings, but still open to manipulation through revenue recognition
- Sales do not necessarily translate into earnings, eventually or ever
2. Price/Book
- Market capitalisation divided by book value of equity
- Accountants think of book equity as a performance measure. But used less and less in finance
- Useful for financial firms
COMPARABLE COMPANY ANALYSIS (CCA)

- Attempts to value a target firm using valuation multiples of comparable/peer firms.
- Peer firms: firms that are similar along some crucial and relevant dimensions
- Multiples: A ratio of firm value relative to some performance metric of the firm (e.g. earnings,
cash flows, sales, book value)
- Key assumption: Holding other things constant, similar performance characteristics should be
worth the same, or in the language of analysts, should “Trade for the same multiples”
- Downside: Remember CCA is a relative valuation approach. Average valuations change with
the state of the market. If the market goes down, multiples do as well.
VALUATION BASED ON MULTIPLES/COMPARABLES
STEP 1: Find a number of peers, i.e. comparable companies with similar characteristics:
e.g. same industry, same leverage, same growth rate, same size
STEP 2: Collect data on several valuation metrics, “Cleanse” them of one-off/special effects, make
them comparable. Decide on which are best suited.
e.g. P/S = price to sales (maybe “normalising” sales, smooth out seasonality’s)
STEP 3: Apply peer valuation metrics to target
- Compute average metrics of peer group and apply that ratio to target firm
- E.g. peers have median P/S = 2 –> multiple target firm’s sales by 2 to get estimate for fair
market capitalisation of target firm
LIMITATIONS OF MULTIPLES
- When valuing a firm using multiples, there is no clear guidance about how to adjust for
differences in expected future growth rates, risk, or differences in accounting policies
- For some companies, especially young companies without any history of earnings/dividends and
wild swings in accounting performance, there is a lack of suitable metrics.
- What if different valuation metrics provide very different answers?
- Comps only provide information regarding the value of a firm to other firms in the comparison
set
PRO FORMA FINANCIAL STATEMENTS
45
- Pro forma financial statements are financial reports derived under assumptions and hypothetical
conditions for the future, with focus on income statements and cash flow projections.
- SITUATION A: The analyst is interested in either future dividends actually paid to shareholders
or so-called free cash flow to equity (FCFE) that could be paid out to shareholders.
- SITUATION B: The private equity firm is interested in so-called free cash flow to the firm
(FCFF) which measures money available to be paid out to both creditors and shareholders.
- SITUATION C: Management will want to estimate the so-called Incremental (After-tax) cash
flow (ICF) from a new project: What is left to all capital providers of the project (be it debt or
equity) after all bills are paid (including necessary working capital and investment spending)
CAPITAL BUDGETING
- A capital budget is a list of all the projects that a company has committed to undertaking during
the next period
- Capital budgeting is the internal analysis by the firm managers of
o How a potential project will affect earnings and cash flows and
o Whether to accept (i.e. pursue/invest) or reject it
- It is important to consider all and any incremental cash flows that occur or do not occur due to
the project.
PROJECT INCREMENTAL CASHFLOW
46
Incremental cash flow
CHANGES IN NET WORKING CAPITAL
NWC = CURRENT ASSETS – CURRENT LIABILITIES = CASH + INVENTORY +

RECEIVABLES – PAYABLES
- Net working capital is important because it reflects a short-term investment that ties up cash
flow that could be used elsewhere. For example, when a firm holds a lot of unsold inventory or
has a lot of outstanding receivables, cash flow is tied up in the form of inventory or in the form
of credit extended to customers.
- It is costly for the firm to tie up that cash flow because it delays the time until the cash flow is
available for reinvestment or distribution to shareholders.
NET CAPITAL SPENDING
- Net capital spending (NCS) = New purchase of fixed assets MINUS proceeds from the sale of
fixed assets.
e.g. new machinery bought for the project (Capitalised/depreciated), major upgrades/repairs
(Capitalised, depreciated), maintenance/minor repairs (not capitalised), new machine replaces an
existing machine, which is sold. The sale may have tax implications.
DEPRECIATION
 PRIME COST (straight-line) method

- Annual D = (Initial cost – Salvage) / number of years
- Most assets are depreciated straight-line to zero for tax purposes (i.e. salvage expected to be
zero)
 ACCELERATED OPTION: Diminishing value method
- Multiple percentage by the written-down value at the beginning of the year
- In final year, full depreciation to zero
47
AFTER-TAX SALVAGE
- At the end of its useful life (or before) a piece of machinery may be sold. If the salvage value is
different from the book value of an asset, there is a tax effect.
- Salvage value = pre-tax cash proceeds from the sale
- Book value = Initial cost – Accumulated depreciation
- Tax liability/saving = (Salvage value – Book value) X Tax Rate
INCREMENTAL CASH FLOWS

- Opportunity costs: costs of lost options/alternative uses. Use highest alternative value in
calculations
- Side effects: Benefits or costs to other operations of the firm as a consequence of the project
(e.g. cannibalisation of sales of existing products)
- Changes in net working capital (e.g. higher inventory or more cash to facilitate turnover)
- Taxes are real cash flows, despite being based on accounting profits.
ITEMS NOT CONSIDERED:
- Sunk costs  costs that have already accrued or been committed to in the past
- Financing costs (E.g interest)  not part of the investment decision
FREE CASH FLOW
 Free cash flow to the firm (FCFF), sometimes also called cash flow from assets (CFA)
considers operating cash flows from the core operating business of the firm, changes in net
working capital and capital spending but ignores ALL financing activities
 Free cash flow to equity (FCFE): cash available to shareholders to either reinvest or pay out.
Close to FCFF, but also considering effects of interest payments
FREE CASH FLOW TO THE FIRM
FCFF is very similar to how we computed the incremental cash flow from a project. Essentially, think
of the entire firm as “the project” (and ignore its financing):
FREE CASH FLOW TO EQUITY
FCFE differs from FCFF because it now explicitly accounts for the effects of debt and focuses on
what is left over for shareholders only:
48
CASH FLOW YIELDS FOR VALUATION
- Value-oriented investors like valuatoin metrics based around cash flow. We can define these as
yields (but multiples are just the inverse). As usual, there is one firm-level measure and one
equity-based measure:
FCFF yield = FCFF/EV
FCFE yield = FCFE / MV Equity
WEEK 9 READINGS
9.2 FORECASTING INCREMENTAL EARNINGS

- Incremental earnings = the amount by which a firm’s earnings are expected to change as a result
of an investment decision
- Suppose you are considering whether to upgrade your manufacturing plant to increase its
capacity by purchasing a new piece of equipment. The equipment cost $1 million, plus an
additional $20,000 to transport and install it. You will also spend $50,000 on engineering costs
to redesign the plant to accommodate the increased capacity. What are the initial earnings
consequences of this decision?
- straight-line depreication = a method of depreciation in which an asset’s cost is divided over its
life.
- In our example, the up-front costs associated with the decision to increase capacity have two
distinct consequences for the firm’s earnings. First, the $50,000 spent on redesigning the plant is
an operating expense reported in year 0. For the $1020000 spent to buy, ship and install the
machine, accounting principles as well as tax rules require you to depreciate the $1020000 over
the depreciable life of the equipment. Assuming that the equipment has a five-year depreciable
life and that we use the straight-line method, we would expense $102000/5 = $204000 per year
for five years.
- as the timeline shows, the up-front cash outflow of $1020000 to purchase and set up the
machine is not recognised as an expense in year 0. Instead, it appears as depreciation expenses
49
in year 1 to 5. Remember that these depreciation expenses do not correspond to actual cash
flows.
INCREMENTAL REVENUE AND COST ESTIMATES

- all our revenue and cost estimates should be incremental, meaning that we only account for
additional sales and costs generated by the project. For example, if we are evaluating the
purchase of a faster manufacturing machine, we are only concerned with how many additional
units of the product we will be able to sell (and at what price) and any additional costs created
by the new machine. We do not forecast total sales and costs because those include our
production using the old machine.
- Let’s return to our plant upgrade example. Assume that we have bought and installed the
machine and redesigned the plant, our additioanl capacity will allow us to generate incremental
revenue of $500,000 per year for 5 years. That incremental revenue will be associated with
%150,000 per year in incremental costs.
- S BEFORE INTEREST AND TAXES (EBIT) = INCREMENTAL REVENUE –

INCREMENTAL COSTS – DEPRECIATION
TAXES
- INCOME TAX = EBIT X FIRM’S MARGINAL CORPORATE TAX RATE

- Marginal corporate tax rate = the tax rate a firm will pay on an incremental dollar of pre-tax
income
- Assume our firm faces a marginal tax rate of 30% and that the firm as a whole as at least $50000
in profits in year 0 for the incremental costs in that year to offset.
- INCREMENTAL EARNINGS = (INCREMENTAL REVENUE – INCREMENTAL COST –

DEPRECIATION) X (1-TAX RATE)
9.3 DETERMINING INCREMENTAL FREE CASH FLOW

CONVERTING FROM EARNINGS TO FREE CASH FLOW
- Earnings include non-cash charges such as depreciation, but do not include expenditures on
capital investment.
50
- DEPRECIATION: Depreciation is not a cash flow, and is not included in the cash flow forecast.
However, the depreciation expense reduces the taxable earnings and in doing so, reduces taxes.
Taxes are cash flows, so because depreciatoin affects our cash flows, it still matters.
- E.g. if a project has incremental gross profit (revenue – costs) of $1 million and a $200,000
depreciation expense. If the firm’s tax rate is 30%, then the incremental earnings will be
($1000000- 200000) x (1-0.30) = $560,000. However, the firm will still have $760,000 because
the $200,000 depreciation expense is not an actual cash outflow.
IF USING THIS, DON’T FORGET LESS NCS AND LESS NWC AND TCF AFTER
ADDING BACK DEPRECIATION!
CALCULATING FREE CASH FLOW DIRECTLY

FREE CASH FLOW = (Revenue – cost – depreciation ) x (1-Tax rate) + Depreciation – Cap Ex –
Change in NWC
- We deduce depreciation when computing the project’s incremental earnings and then add it back
because it is a non-cash expense. Thus, the only effect of depreciation is to reduce the firm’s
taxable income.
9.4 OTHER EFFECTS ON INCREMENTAL FREE CASH FLOW

OPPORTUNITY COSTS
- Because the opportunity cost is lost when the resource is used by another project, we should
include the opportunity cost as an incremental cost of the project.
- Common mistake: concluding that if an asset is currently idle, its opportunity cost is zero.
Even if the firm has no alternative use for the asset, the firm could choose to sell or rent the
asset. The value obtained from the asset’s alternative use, sale or rental represents an
opportunity cost that must be included as part of the incremental cash flows.
SUNK COSTS
- Sunk costs will be paid regardless of the decision whether or not to proceed with the project.
Therefore, they are not incremental with respect to the current decision and should not be
included in its analysis.
ADJUSTING FREE CASH FLOW

LIQUIDATION OR SALVAGE VALUE: Assets that are no longer needed often have a resale value,
or some salvage value. When an asset is liquidated, any capital gain is taxed as income. We calculate
the capital gain as the difference between the sale price and the book value of the asset
- CAPITAL GAIN = SALE PRICE – BOOK VALUE
51
- The book value is equal to the asset’s original cost less the amount it has already been
depreciated for tax purposes:
- BOOK VALUE = PURCHASE PRICE – ACCUMULATED DEPRECIATION
- We must adjust the project’s free cashf lo to account for the after-tax cash flow that would result
from an asset sale:
- AFTER-TAX CASH FLOW FROM ASSET SALE = SALE PRICE – (TAX RATE X CAPITAL
GAIN)
10.2 VALUATION BASED ON COMPARABLE FIRMS

- Method of comparables: an estimate of the value of a firm based on the value of other,
comparable firms or other investments that are expected to generate very similar cash flows in
the future
VALUATION MULTIPLES
- Valuation multiples = a ratio of a firm’s value to some measure of the firm’s scale or cash flow
- Price-earnings ratio: (P/E RATIO) is equal to the share price divided by its earnings per share.
- E.g. a P/E ratio of 17.41 means that the share price is equal to 17.41 times its earnings per share.
- Enterprise value multiples value the entire firm

e.g. EBITDA of $50 million, cash of $20 million, debt of $100 million and 10 million shares
outstanding, average EV/EBITDA ratio of 8.5. What is one estimate of the enterprise value?
What is a corresponding estimate of its share price?
- enterprise value is $50 million x 8.5 = $425 million.
Next subtract the debt from its enterprise value and add in its cash:
425 – 100 + 20 = $345 million which is an estimate of the equity value.
It’s share price estimate is equal to its equity value estimate divided by the number of shares
outstanding = $345 million / 10 million = $34.50
52
WEEK 10 – RESPONSIBLE FINANCIAL MANAGEMENT
CORPORATE SOCIAL RESPONSIBILITY
 Corporate social responsibility represents a broad concept that refers to the responsibility for all
companies to integrate social and environmental matters in their business operations
 The basic idea of the concepts is that as companies operate in society, they must behave in a way
that satisfies not only shareholders, but also a company’s stakeholders (i.e. employees, customers,
supplies and the society as a whole)
CSR AND FINANCIAL MANAGEMENT
 CSR sets an expectation that all organisations manage the social and environmental impact of
their economic activities
 Just as the financial performance of a company is impacted when it fails to identify or manage
financial risks, the financial performance of a company can also be impacted when it fails to
identify and manage social and environmental risks.
 In explaining this phenomenon, it is suggested to every company holds notional ‘license to
operate’ which refers to the importance of the company being ‘accepted’ by society. When
companies pursue strategies that deviate with stakeholder expecations, they risk losing customers
and thus damaging their financial performance.
WHY IS RESPONSIBLE CORPORATE SOCIAL RESPONSIBILITY IMPORTANT?
53
 The United Nations Sustainable Development goals are a blueprint to address the major
challenges we face as a global society
 There is widespread recognition that companies must adopt how they operate to fulfil the UN
Sustainable Development Goals.
HOW ARE COMPANIES ENCOURAGED TO ADOPT STRONGER SOCIAL AND

ENVIRONMENTAL PRACTICES?
 Shareholders: force companies to adopt more sustainable practices through resolutions at an

annual general meeting
 Directors and management: set sustainability focus strategic objectivies
 Governments: set responsible business frameworks that outlines ‘best-practices’ thac companies
are expected to adopt
 Stakeholders: pursue legal cases when companies are in breach of their social and environmental
responsibilities.
DIRECTORS DUTIES AND RESPONSIBLE FINANCIAL MANAGEMENT
 In managing the business of a company, each of its directors is subject to a wide range of duties
under the Corporations Act and other laws. These duties include:
o To act in good faith
o To act in the best interests of the company
o To avoid conflicts between the interests of the company and the director’s interests
o To act honestly
o To exercise care and diligence
 A director who fails to perform their duties:
o May be guilty of a criminal offence with a penalty of $200,000 or imprisonment for up to
5 years or both; and
o May contravene a civil penalty provision
o May be personally liable to compensate the company or others for any loss or damange
they suffer
o And may be prohibited from managing a company
 Three contrasting theories are used to define a company purpose:

1. SHAREHOLDER ASSUMPTION
 The company is run with the sole interest in maximising return to shareholders
2. PLURALISTIC ASSUMPTION
 The company is not be run solely in the shareholders’ interests as directors would
have a primary duty to a wider group of stakeholders
3. ENLIGHTENED SHAREHOLDER VALUE
 Directors must focus on profit maximisation in the long run, while concentring on
building relationships with key stakeholders that would ensure its long-term
prosperity.
WHY IS IT IMPORTANT TO INTERPRET DIRECTORS’ DUTIES IN COMPANY LAW?
54
 Company law defines the responsibilities company directors must legally follow when acting in
the company’s interest
 The lack of clear legal obligations directors have to act in the interests of a company’s
stakeholders complicates the emergence of responsible business practices
 This is particularly important when stakeholders seek to hold companies accountable for the
social and environmental impact of their economic activities
TAXATION
 Governments levy taxes on individuals and businesses

 Businesses only get to keep the amount of profit/income generated AFTER taxes have been paid
 Financial statements are prepared in accordance with accounting standards (IFRS)
o Includes ‘income tax expense’ in the income statement, ‘income tax liability’ in the
Balance sheet, and ‘cash taxes paid’ in the cashflow statement
 On the other hand, tax returns are prepared in accordance with tax law
o Includes ‘assessable income’, ‘allowable deductions’, and ‘taxable income’
TYPES OF TAXPAYERS
 INDIVIDUALS
o Employement income, investment income, deductions
o Taxed at personal marginal tax rates
 SOLE TRADER
o An individual conducting a business in their own name
o Not legally different from the individual so their income forms part of the individual’s
income
 PARTNERSHIP
o Two or more people conducting a business together as partners
o Treated as a conduit for tax purposes (not a taxable entity separate from the owners) but
must lodge a tax return
 TRUST
o A legal entity where a trustee manages trust assets on behalf of their beneficiaries
55
o Not treated as a separate taxpayer but must lodge a tax return

o Treated as a conduit for tax purposes (income flows to the beneficiaries)
 COMPANY
o A separate legal entity
o Treated as a separate taxpayer and must lodge a tax return
o Taxed at the company tax rate of 30% or 26% if a small company (a ‘base rate entity’ has
aggregated turnover below $50m)
ADMINISTRATION OF THE TAX SYSTEM
TAX FILE NUMBER (TFN)
 A TFN is a unique personal reference number in the tax and superannuation systems
AUSTRALIAN BUSINESS NUMBER (ABN)
 An ABN is a unique 11-digit number assigned to each entity that is carrying on a business
 Must be displayed on all tac invoices issued
TYPES OF TAXES
DIRECT VS INDIRECT
1. Direct taxes
 Income taxes: personal, company, gift duties, inheritance tax
 Property taxes: wealth tax, death duty
3. Indirect taxes
- Sales taxes: goods and services tax (GST), value-added tax (VAT), stamp duty, turnover tax
- Factor taxes: payroll tax, land tax, carbon tax
THE MAIN AUSTRALIAN TAXES
56
RESPONSIBLE TAX MANAGEMENT
1. TAX PLANNING/TAX MINIMISATION

 Legality – legal
 Purpose – maximise tax efficiency
 Nature – use the law to reduce tax liabilities
 Examples – choice of business entity, income timing, capital structure (Debt v equity),
maximising use of concessions e.g. Research and development incentive
 Impact – optimise after-tax outcomes (e.g. increased cash flows, profit after tax)
WHAT HAPPENS IF TAXES ARE NOT PAID?
2. TAX EVASION
 Legality – illegal
 Purpose – not paying tax
 Nature – employ illegitimate means
 Examples – not declaring income, claiming inflated deductions, making false statements,
concealing or transferring assets illegally, not paying tax liability
 Impact – reduction of government revenue to fund essential public services (negative impact on
financial sustainability), undermines tax system integrity especially voluntary compliance
3. TAX AVOIDANCE
 Legality – legal
 Purpose – minimise tax liabilities
 Nature – aggressive exploitation of ‘loopholes’ in the tax law, grey area, activities are within the
‘letter of the law’ but contrary to the ‘spirit of the law’
 Examples – profit shifting (Artifically moving profits from a high-tax country to a low-tax
country or even to a no-tax country i.e. tax haven)
 Impact – reduction of government revenue to fund essential public services (negative impact on
financial sustainability), undermines tax system integrity especially volunatry compliance
CONSEQUENCES OF UNACCEPTABLE OR OVERLY AGGRESSIVE TAX

MANAGEMENT:
 Reputational effects – companies want to be seen as being “good corporate citizens”

 Companies need to demonstrate they pay their “fair share” of taxes (‘social contract’)
 ATO audits and/or audit penalties (penalties = tax shortfall + penalties + interest)
 Imprisonment
INCOME TAX FORMULA AND CALCULATION OF LIABILITY TO ATO
 Taxable income = Assessable income – Deductions

 Tax payable = (Taxable income x Relevant rate) – Tax offsets
57
 Tax offsets
o Different to deductions
o Deductions reduce assessable income
o Offsets reduce tax payable (more valuable)
SUSTAINABILITY REPORTING
 A sustainability report provides disclosures on an organisation’s impacts on the environment,

society and the economy
 It assists organisations in setting goals, measuring performance and managing change in order
to make their operations more sustainable
 The disclosure of sustainability reports remains a voluntary initiative in most jurisdictions.
However, the majority of large and medium sized companies release sustainability reports
annually.
The GRI sustainability reporting standard is divided into 3 sections:
1. ECONOMIC
 Provides a range of disclosures that demonstrate the economic value generated and
distributed by the organisation. The preparing entity is expected to compile information
for economic disclosures using figures from its audited financial statements or from its
internally-audited management accounts
 E.g. economic performance, indirect economic impacts, procurement practices, anti-
corruption, anti-competitive behaviour (including legal actions against the company for
anti-competitive behaviour)
2. ENVIRONMENTAL
 Report information related to organisations impacted related to environmental topics
 E.g. energy (including direct energy used, listed by source, and improvements in energy
usage), water (including the quantity of water withdrawn and the percentage of water
reused), emissions (including direct and indirect greenhouse gas emissions and
initiatives to reduce greenhouse gas emissions and the resulting achievements),
enviornmental compliance, supplier enviornmental assessment
3. SOCIAL
 Report information related to organisation’s impacted related to social topics
 Employment, health and safety, training and education, diversity and equal opportunity,
child labour, local communities (including assessments of the impact both negative and
positive on the local community), supplier social assessment, customer privacy
BENEFITS IN PRODUCING SUSTAINABILITY REPORTS
 Enhance transparency to stakeholders

 Strengthen reputation
 Achieve continuous improvement
 Improve regulatory compliance
58
 Strengthen risk awareness and management

 Encourage innovation
 Raise awareness, motivate and align staff, and attract talent
 Attract long-term capital and favourable financial conditions
GRI expects that organisation’s conduct stakeholder engagement
- Consulting with stakeholders in developing and achieving responses to sustainability issues

- Determining the relevance and significance of sustainability issues to the organisatoin and its
stakeholders
- Communicating with stakeholders and responding to stakeholder issues that affect the
organisation’s sustainability performance
HOW USEFUL ARE SUSTAINABILITY REPORTS TO USERS?
Research is critical of the nature of information presented in sustainabilty reports by companies. In

particular, researchers have consistently highlighted how reports regularly lack completeness and
lack credibility.
 Why do reports ‘lack completeness’?

Companies often only seek to include positive disclosures in their sustainability reports. The
ability to decide what is included means negative disclosures are often purposely unreported.
 Why do reports ‘lack credibility?
Sustainability reports do not have to be externally verified which means the information
presented lacks external verification.
What advantages does the accounting profession have in this area?

- Independence
- Familiarity with assurance (e.g. evidence collection)
- Ethical guidelines and well-structured procedures
What advantages does the non-accounting profession have in this area?

- Expertise in the measurements and assurance of scientific/technical data
- Training, understanding and skills in environmental science
- Knowledge of human right laws and other discipline specific expertise
59
60

Chapter 1 - Introduction To Financial Accounting

Uploaded by

Copyright:

Available Formats

Chapter 1 - Introduction To Financial Accounting

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chapter 1 - Introduction To Financial Accounting

Uploaded by

Copyright:

Available Formats

COMM1140: FINANCIAL ACCOUNTING

CHAPTER 1 – INTRODUCTION TO FINANCIAL ACCOUNTING

1.2 FINANCIAL ACCOUNTING

 ACCOUNTING is a process of identifying, measuring and communicating economic

 FINANCIAL MANAGEMENT enables a company to achieve its financial and operational

1.5 ACCRUAL ACCOUNTING VS CASH ACCOUNTING

 ACCRUAL ACCOUNTING includes the impact of transactions on the financial statements

*ALWAYS ASSUME ACCRUAL ACCOUNTING IF NOT STATED

BENEFITS OFACCRUAL ACCOUNTING:

1.6 KEY FINANCIAL STATEMENTS

o FINANCIAL POSITION of an enterprise at a particular point in time

THREE MAIN ELEMENTS OF BALANCE SHEETS:

FEATURES OF BALANCE SHEET

 FINANCIAL PERFORMANCE of an enterprise over a period of time

o Revenue > Expenses = NET PROFIT

- A revenue increases wealth, so it either increases assets or decreases liabilities, and

CASH FLOW STATEMENT

 Cash inflows and outflows over a period of time

WEEK 2 – MEASURING/EVALUATING FINANCIAL POSITION

Provides information about:

 Financial structure (mix of debt/equity) – debt to equity ratio

Balance sheet includes:

1. Name of the reporting entity

Current assets = assets held for up to 12 months

Non-current assets = assets held for longer than 12 months

 Trade and other payables = accounts payable

 Trade and other payables

 Contributed equity = share capital

 Retained profits is a component of shareholder’s equity. It consists of the cumulative profits

Distributed to shareholders? Dividends – payments made to the shareholders by the company. It is a

Retained profits are calculated as follows:

RETAINED PROFIT = OPENING BALANCE + PROFIT/(LOSS) – DIVIDENDS

o Revenue increases retained profits and expenses reduce retained profits

CONSOLIDATED INCOME STATEMENT

WEEK 3 – RECORDING BUSINESS TRANSACTIONS

3.1 TRANSACTION ANALYSIS

e.g. borrow $10000 from the bank

SUMMARY OF THE EFFECT OF TRANSACTIONS

TRANSACTIONS FOR APRIL 2019:

o Cash = asset decreases

3.3 DOULE ENTRY BOOKKEEPING

 The date should be entered first

WEEK 4– ACCRUAL ACCOUNTING ADJUSTMENTS

RECAP PART 1: ACCRUAL VS CASH ACCOUNTING

 Cash accounting records when cash is received or paid

SPECIAL ACCOUNTS IN BALANCE SHEET CATEGORY JOURNAL ENTRIES

1. On 31 May, Sam received a rent of $1000 which is the rent of June

DR Cash (+A) $1000

Journal entry when service provided (30 June)

DR Unearned revenue (-L) $1000

DR Prepaid rent (+A) $1000

Journal entry when service provided (30 June)

DR Rent expense (+E) $1000

 Cash paid in advance of incurring expense:

For Cindy, on 31 May:

CR Cash (-A) $1000

ACCRUED REVENUES (RECEIVABLES)

On 31 May, Sam received a rent of $1000 which is the rent of April

Journal entry when service provided (31 April)