Accounting Principles and Cash Flow Management

This assignment covers essential accounting concepts including revenue recognition, expense matching, and cash flow management. It delves into the importance of matching process for direct expenses and operating expenses, as well as inventory recording systems such as perpetual and physical or periodic inventory systems. The assignment also explores statement of cash flows, profit and loss statements, and adjustments to net income, providing a thorough understanding of accounting principles and their application in real-world scenarios.

BUS5IAF Theory
Week 2
Managers at all levels need to be able to:
 Read and interpret financial reports
 Understand how financial plans are made
 Understand how business are financed, and
 Understand how investment decisions are made
Accounting includes 4 stages:
 Information identification (collect)
 Information recording
 Information analysis
 Information reporting (communicate)
Accounting outputs include
 The Balance Sheet
 The Profit and Loss Statement and Cash Flow Statement
 Financial Statement Analysis
Users of accounting information:
 External users: Lenders, suppliers, government, investment analyst,
competitors, Community, owners.
 Internal users: managers, employees, and unions.
Financial accounting means the provision of reports and financial statements to
external users of accounting information. (based on historic events, does not need
to be timely)
Management accounting refers to the provision of information to internal users of
accounting information – managers and owners of small businesses – to aid in
decision-making. (can include non-financial information)
Finance means using accounting information to make financial decisions.
Types of decisions include:
 Investment decision (Asset side of the balance sheet)
 Financing decision (Liability and equity side of the balance sheet)
 Cash flow/ Working capital management decision
 Dividend decision

Accounting information must be:
 Relevant
 Reliable (free from material error or bias)
 Comparable
 Understandable
 Timely
 Cost effective (the benefit of the information must outweigh the cost of
providing it)
Critical factors in finance:
 Cash
 Time
 Risk
Integrated reporting or triple bottom line
 Financial
 Environmental
 Social
 Governance reporting
Three types of firm
 Sole traders
 Partnerships
 Corporations (companies): there is a separation of ownership and control,
easier to raise large amount of capital compared to sole trader, easier to
transfer ownership from one person to another compared to a partnership,
shareholders have limited liability (dis),
Three different types of companies
 Private companies: limited number of shareholders, no market for shares.
 Public companies: the public can buy share, but they are rarely traded.
 Listed public companies (listed with ASX, about 2000 listed public
companies): shares are traded on organized stock exchange.
Week 3

Source of finance include:
 Internal finance: capital generated with the firm (retained earning)
 External finance: capital that must be obtained with the agreement of people
outside the firm
External sources of finance include:
 Short term: are defined as those which need to be repaid within the next
12-months (bank overdrafts, commercial paper and bank bills, and
inventory financing).
 Long term: are defined to be those which do not need to be repaid within
the next 12-months (retained earnings, ordinary shares, preference shares,
venture capital, loans from banks and other financial institutions, bonds and
leases)
Source of finance
 Equity: refers to capital provided by the owners of the business. (retained
earnings, ordinary shares and preference shares)
 Debt: refers to capital that has been borrowed from others (venture capital,
loans from banks or other financial institutions, bonds and leases, bank
overdrafts, commercial paper and bank bills, factoring and inventory
financing).
Retained earnings advantages:
 The amount raises is certain
 Retained earnings are a cost-free source of financing
Retention ratio= Net income−Dividends
Net income
Ordinary shares: often receive variable dividend and are the riskiest form of
investment
 Advantages: dividends do not have to be paid if there is no money to pay
them
 Disadvantages: shareholders require a high rate of return to compensate
them higher risk associated with this form of investing.
Preferences shares: normally receive a fixed dividend
 Preference shareholders get preferential treatment compared to ordinary
shareholders (enjoy a higher ranking when it comes to their right to receive a
dividend, rank behind debtholders but ahead of ordinary shareholders in
terms of their right to receive their share of the firm’s assets)
Share market
 Public offer: lengthy and expensive process but a large amount of capital can
be raised.

 Private placement: quick and less expensive, but shares are sold at a
discounted price, dilution of ownership of existing shareholders.
 Rights issue: no dilution of ownership of existing shareholders if they buy new
shares or sell their rights.
Week 4:
Balance sheet convention
Business Entity Convention
Under this convention the business and its owners are treated as separate and
distinct. This is why the owners are shown as having a "claim" in the net assets of
the business in the equity section of the Balance Sheet. By following this
convention, the Balance Sheet shows the financial position of the business, as
distinct from the overall wealth of the owners.
It is important to note that this convention is not relevant to the legal difference, if
any, between the business and its owners. Recall from Lesson 4 that there is no
legal distinction between a sole proprietorship and its owner, or between a
partnership and the partners, while there is a clear legal distinction between a
company and its shareholders. These legal differences are not relevant to the
preparation of a Balance Sheet.
Historic Cost Convention
This convention calls for the values of assets in the Balance Sheet to be recorded at
the historical cost at which they were acquired. There are advantages and
disadvantages to this approach. Using historical costs is more accurate and
objective than using current values. Current values are sometimes difficult to
establish, and may be subject to opinion, which would make the financial statement
less credible and reliable. On the other hand, a statement based on current values,
notwithstanding its problems, would probably be more useful for decision-making.
As are result, departures from the historic cost convention are becoming more
frequent.
We will stick with the historic cost convention for the preparation of Balance Sheets
in this subject, but we will use the current value of the various securities on the
right-hand side of the Balance Sheet when calculating the Cost of Capital for a firm
in Lesson 19.
Prudence Convention
This convention requires that all losses - both actual and expected - be recorded
immediately in the financial statements, but that profits only be recorded when they
actually occur. The convention evolved over time to counteract the excessive
optimism of some managers, and to prevent the overstatement of the firm's
financial position.
The application of this convention requires judgement, because excessive use of the
convention could result in the consistent understatement of financial position. This

convention is therefore becoming somewhat less stringent over time, but it still
remains an important convention.
Going Concern Convention (or Continuity Convention)
This convention requires that financial statements be prepared on the assumption
that the business will continue to operate for the foreseeable future, unless there is
evidence to the contrary. The reason for this is that the price that might be received
for some assets, such as fixed assets, if the business was to be liquidated may be
much less than their recorded, or historic, cost. However, if the business is assumed
to continue to operate, this "liquidation" value isn't relevant and the assets can
continue to be recorded at historic cost.
Dual Aspect Convention
Under this convention, every transaction has a "dual aspect", in that it impacts on
the Balance in two ways. For example, buying a piece of land decreases cash and
increases the asset "land and buildings". Paying off a loan decreases cash and
decreases liabilities. In this way, the Balance Sheet will continue to balance. This is
related to "double entry bookkeeping", which involves a system of debits and
credits to record transactions. We won't be going into debits and credits in this
subject, but the dual aspect convention is important as we consider the effect of
transactions on a firm's financial statements.
Money Measurement Convention
Accounting and Finance generally deals with information and decision-making
involving things that can be reliably measured in monetary terms - dollars and
cents. This means that only things that can be measured in monetary terms are
included in the Balance Sheet. In some ways this limits the ability of the Balance
Sheet to show all of a firm's assets - things that are of value to the firm and improve
its ability to succeed and create wealth. For example, resources or "assets" such as
the quality of the workforce, the reputation of the business's products, the location
of the business, the relationship with customers and the quality of the management
cannot be reliably measured in monetary terms and excluded from the Balance
Sheet.
Stable Monetary Unit Convention
This convention assumes that the monetary unit used for measurement (e.g. the
Australian dollar) maintains its value over time and from one accounting period to
another. This is a limitation on the usefulness and accuracy of the Balance Sheet in
recording the true value of assets and liabilities, because we know that this
convention does reflect reality. We saw in Module 1 that money has time value, and
the value of a dollar decreases over time. A combination of the historic cost
convention and the stable monetary unit convention means that the values
recorded in the Balance Sheet are unlikely to accurately represent fair value, and
caution must be taken in making financial decisions based on those values.
Asset valuation

Depreciation (or Amortisation)
In most cases a non-current asset with a finite life will become less valuable over
time, as the economic benefit of the asset is "used up". For example, wear and tear
on a machine will make it less valuable over time, and at the end of its useful
working life it will be worth much less than it cost -- sometime, nothing at all. If such
as asset was to continually be recorded at historic cost, the Balance Sheet would
become less and less valuable over time. Depreciation (and amortisation) attempt
to address this.
Depreciation means reducing the value of a tangible asset on the balance sheet
over time. A tangible asset is a physical object, such as a machine or a building. The
reduction in value is treated as an expense which, in accordance with the dual
aspect convention, means that equity goes down when the value of the asset goes
down. Expenses will be discussed more fully in the next module, and the details of
how depreciation is calculated will be discussed in detail in Lesson 11.
An intangible asset is something of value to the business but which does not have a
physical presence, such as goodwill or patents. The reduction in value of intangible
assets is done in much the same way as depreciation, except that in the case of
intangible assets it is called amortisation.
Fair Value
Non-current Assets with infinite lives, such as land, can change in value over time,
and once again, the historic cost and stable monetary unit conventions could mean
that such assets are recorded on the Balance Sheet at values that bear no relation
to their true value. In this case it is possible to "revalue" those assets -- change their
value on the Balance Sheet to more accurate reflect their true, or fair, value.
Revaluation should only occur when the fair value of the asset can be reliable and
objectively measured -- e.g. by using the services of an independent valuer.
Again, the dual aspect convention requires that the asset goes up in value, so does
equity. In this case the increase in equity is neither paid-in capital from owners nor
retained earnings, and is recorded in a separate equity account called an Asset
Revaluation Reserve.
Asset Impairment
Just as non-current assets such as land can increase in value over time, due to
inflation of asset prices, assets can also suffer a fall in value. This is unrelated to
routine depreciation, but rather refers to a sudden event that results in the
reduction in the value of asset. For example, machinery can become obsolete due
to technological advances, inventory could become less valuable because of a
change in market tastes or as a result of damage, accounts receivable may become
unlikely to be collected, and so on.
If such a change in value means that that the historic cost on the Balance Sheet is
greater than what is expected to be recovered from the asset through continued
use or sale, the accuracy of the Balance Sheet can be improved by reducing the
recorded value of the asset to reflect its true value. This reduction in value is
referred to as Impairment and, in compliance with the dual aspect convention, the

value of equity is also reduced by treating the reduction in asset value as an
expense.
Accounting equation:
Equity= Assets−Liabilities
Assets=Liabilities+ Equity
Final value of equity:
Final value of equity=starting value+new issued shares+ profit −dividends+the value of asset revaluation
Week 5:
Income
There are two ways in which there can be an increase in economic benefit – an
increase in an asset (e.g. cash) or a decrease in a liability. There are two basic types
of income:
1. Revenue – income from the business’s operating activities (e.g. sales)
2. Other gains – this refers to income other than from the business’s operating
activities, such as the profit from the sale of an asset
Revenue can take various forms, such as:
 Sales of goods (e.g. of a manufacturer)
 Fees for services (e.g. of a solicitor)
 Subscriptions (e.g. of a club)
 Interest received (e.g. of an investment fund)
The different ways in which revenue is generated can result in differences in the
formatting of the Profit and Loss Statement. For simplicity, we will concentrate on
the Profit and Loss Statement produced by a manufacturer, but the principles that
we will discuss are generally applicable to all businesses.
Recognition of revenue
An important issue is when revenue is “recognised”, which means included in the
Profit and Loss Statement. For example, in the case of the sale of goods which are
ordered in advance by the customer and paid for on credit, there are three possible
points in time at which the revenue could be recognised:
 When the order is placed
 When the goods are provided to the customer
 When the goods are paid for

If these events occur near the end of the reporting period, the choice between these
options could greatly impact on reported profit. The convention is to recognise
revenue when (a) the amount can be reliably measured, (b) it is probable that the
economic benefit will be received, and (c) in the case of goods, ownership and
control passes to the buyer of the goods. These requirements are satisfied when the
goods are provided to the customer – even though the economic benefit has not yet
been received, because the goods haven’t been paid for, the firm has an
enforceable contract and it is probable that the benefit will be received.
Expenses
Recognition of expenses
Just as we saw with revenue, care must be taken as to when expenses are
recognised. Direct expenses – those that are directly linked to particular revenue,
such as cost of goods sold or sales commission – should be matched with the
applicable revenue, so that the gross profit for the period is accurately reported.
This should occur even if the loss of economic benefit resulting from the expense
does not occur in the same reporting period as the revenue (e.g. if the sales
commission has not yet been paid). The mechanism for handling this “matching
process” will be discussed in the next module.
Operating expenses – overheads that are not directly linked to revenue, such as
electricity and rent – should be reported in the period when the benefit from the
expenses (e.g. the electricity) was received, rather than when the expense was paid
for. Again, the way in which we do this will be discussed in the next module.
Inventory recording systems
 Perpetual inventory system – Increases and decreases in inventory are
separate identified and used to update the value of inventory, which might be
appropriate for large, high-value inventory such as motor vehicles for a car
dealership
 Physical or periodic inventory system – a stocktake is undertaken
periodically, during which inventory is physically counted, and this
information is combined with the value of purchases, the value of inventory
used (cost of sales) can be determined, in much the same way as was done
to illustrate the calculation of Cost of Sales in Lesson 9.
Week 6:
Recognition of revenue
 When the order is placed
 When the goods are provided to the customer
 When the goods are paid for

Unearned revenue is money received by an individual or company for a service or product that
has yet to be provided or delivered. As a result of this prepayment, the seller has a liability equal
to the revenue earned until the good or service is delivered.
Statement of cash flow
Cash is used to: purchase things, satisfy consumption, increase the wealth of shareholders.
Profit:
 a process of matching revenue with expenses to measure the success of a firm at
generating wealth within a specified period of time.
 Involves non-cash accounting entries based on accrual accounting.
Statement of cash flows: Show how much cash has come and gone out of the
business.
Profit and loss statement: Show how much profit has been made by the
business.
Cash at the beginning of the year + Cash receipts – Cash outlays = cash at the end
of the year.
Examples of cash flow from operating activities include:
 Cash received from customers
 Cash paid to suppliers
 Cash paid to employees
 Cash paid for other expenses
 Interest paid
 Income tax paid
Examples of cash flow from investment activities could include the buying or selling
of:
 Land and buildings
 Plant and equipment
 Motor vehicles
 Shares in other companies
 Loans made by the business
Cash flow from financing acitivities
 Proceeds from the issue of shares
 Proceeds from long-term borrowing
 Repayment of long-term borrowing
 Payment of finance lease liabilities
 Dividends paid

Adjustments to Net Income
Adjustments to Add to Net Income: Adjustments to Subtract from Net
Income:
Depreciation expense
Amortization of discount on bonds payable Amortization of premium on bonds payable
Amortization of intangibles or deferred
charges Decrease in deferred income taxes payable
Loss on sale of property, plant, and equipment Gain on sale of property, plant, and
equipment
Decrease in receivables Increase in receivables
Decrease in inventory Increase in inventory
Decrease in prepaid expenses Increase in prepaids
Increase in payables or accrued liabilities Decrease in payables or accrued liabilities