Accounting Theory Revision - Exam Prep

Question 1

What is the purpose of an Annual Report/GPFR?

Answer 1

To provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity.
* Provide information about the financial position.
* Information about a reporting entity’s financial performance.
* Information about a reporting entity’s cash flows.
* Assess its liquidity or solvency.

Question 2

What is the purpose of an internal audit?

Answer 2

An internal audit is the process of monitoring and reviewing internal procedures, systems and policies. The purpose of an internal audit is to identify deficiencies and errors in the company’s internal control systems, and then determine corrective action and new polices so that goals can be achieved. This function is carried out by internal auditors who report to the management of the company.

Question 3

What is the purpose of an external audit?

Answer 3

The purpose of an external audit is to check that the company’s financial records have been properly maintained and that they accurately represent the company’s performance and position for the period being audited. A formal report is to be distributed to shareholders and approved at the Annual General Meeting (AGM). The external auditor must be independent and acts on behalf of the shareholders and is appointed by them at the company’s AGM.

Question 4

What is the role of an accountant?

Answer 4

The accountant’s role is to perform financial functions related to the collection, recording, analysis and presentation of a business organisation or company’s financial operations. Accountants do this to provide sound financial advice to businesses.

Question 5

Functions of an accountant?

Answer 5

• Preparation of general purpose financial reports.
• Analysis of capital investment decisions.
• Preparation of taxation reports.
• Preparation of budgets.
• CVP analysis.

Question 6

Compare Internal vs External reporting.

Answer 6

Users:
* External users such as shareholders, future investors, lenders, government bodies and analysts, to assist them on making decisions.
* Internal users such as managers within the business.

Report format
* Internal reporting - May be in any format, depending on end-users needs
* External reporting - Approved format, particularly if company is a reporting entity.

Regulation/Accounting standards
* Internal reporting - No legal obligations are involved in meeting internal reporting requirements.
* External reporting - Regulation is required in relation to external reporting of financial statements, including the Corporations Act 2001, the Australian Accounting Standards, ASX Listing rules, ASIC also require the lodgment of annual reports for all public and large proprietary companies. Annual reports may also be required to be externally audited.

Timeliness
* Internal reporting - As required by management, reporting dates and accounting periods my differ, e.g. weekly, monthly, yearly, seasonally
* External reporting - Statutory reporting dates as required by the Corporations Act, ATO & ASX.

Types of reports
* Internal reporting - Reports prepared as required by internal end-users Internal reporting supports the managerial decision-making process and assists with day-to-day operations of the business. Internal reports include cash budgets, performance reports and budgeted income statements.
* External reporting - The main purpose of financial statements is to provide information about the financial position and performance of a company that is useful to a wide range of users in making economic decisions. General Purpose Financial Reports must be produced including a Statement of Comprehensive Income a Statement of Financial Position, a Statement of Cash Flows and a Statement of changes in Equity, as well as notes to those statements.

Question 7

What are the appropriate levels of investment in non-current assets?

Answer 7

• Businesses must have an sufficient level of non-current assets to maintain the supply of goods and services to generate cash inflows and revenue.
• Under-investment may result in a loss of sales.
• Over-investment inefficient use of resources.
• Ensure physical security and insurance of non-current assets.
• Maintain appropriate records e.g. fixed asset register.

Question 8

What is the appropriate management of cash?

Answer 8

1) Importance: most vulnerable asset to theft, too little cash can create liquidity problems for a business.
2) Separation of duties in handling cash, encouraging customers to pay electronically, regular bank reconciliation to accounting records and banking cash regularly.

Question 9

What is the appropriate management of accounts receivable?

Answer 9

1) Importance: too lenient credit policy can lead to bad debts.
2) Conducting thorough credit investigations prior to granting credit, issuing invoices at the time of sale, following up outstanding debtors in a timely manner, and developing good relationship with credit customers.

Question 10

What is the appropriate management of inventory?

Answer 10

1) Importance: large portion of the assets, significant costs in storage, become obsolete if not managed well, easily stolen.
2) Establishing a computer-based perpetual inventory system to manage inventory, establishing an ordering process to protect against over- or under-ordering, keeping inventory on hand in locked storage with access available to authorised personnel only and putting processes in place to manage inventory levels and avoiding obsolesce.

Question 11

What is the appropriate management of short-term and long-term debt?

Answer 11

• Too much: inability to repay short-term debts can leave a business insolvent.
• Too little: too little a business fails to utilise debt financing, they may, miss out on growth opportunities.

Question 12

What is the appropriate management of equity?

Answer 12

• Importance: The funds invested by the owners (ie. shareholders) of a business to finance the business.
• Undercapitalisation (too little equity) can cause a business to experience problems it terms of having insufficient capital to expand or invest.
• Overcapitalisation (too much equity) can also lead to lower returns for investors. If a business raises too much equity capital, it risks losing control of the company.

Question 13

What is ethics?

Answer 13

Are a set of moral standards that are relied upon to reach conclusions and make decisions.
Ethical problems:
* Conflict of interest – when a business owner or employee has competing interests in a decision that must be made, e.g. when directors might not be making decisions in the best interest of the company, but for their own interests. This could negatively affect the share price.
* Confidentiality – directors must not release information to others to the disadvantage of the company. This ensures that the investors’ financial interests are protected.
* Making use of financial information for personal gain –directors must not use this to benefit themselves or others because other investors would not have access to the information, which could have influenced them regarding where to invest their funds.
* Manipulation of financial information – financial information must be timely, readily available, comply with the guidelines of AASB to ensure that they are presenting relevant and comparable financial reports to those interested stakeholders, who can then make informed decisions about where to invest their funds.

Question 14

What are short-term sources of finance/investments?

Answer 14

• Cash management trusts: Where amounts from a range of investors are grouped and invested in short-term securities such as treasury notes.
• Money market: involving sale and purchase of debt instruments (such as promissory notes, commercial bills and bank bills). This is to cater for borrowers requiring cash for short periods of time.
• Term deposits: A liability that arises from borrowing from financial institutions with a set interest rate that must be repaid at a set time in the future
• Leasing: the ownership of the asset would remain with the funds provider. The company would have the rights of an owner except they would not be able to sell the asset. At the end of the lease there could be a provision to purchase the asset.

Question 15

What are long-term sources of finance/investments?

Answer 15

• Shares: The company could issue additional shares which will provide additional capital. The shareholders then become part owners of the company.
• Debentures: A loan made to the company by an investor and secured by the assets of the company. Interest is paid by the company to the investor at a fixed rate and the loan is repaid at some future date.
• Unsecured notes: A loan made to the company by an investor. Usually, a higher rate of interest is paid as compared to debentures, but the investor funds are not secured by company assets. The unsecured notes are repaid at some date in the future.
• Trusts: A trust is a form of collective investment which pools investors’ money into a single fund and then invests these funds into assets (such as large scale developments, shares and fixed interest bank deposits).
• Term deposits: same as above.

Question 16

What is the concept of insolvency?

Answer 16

• Insolvency is the situation where a company’s liabilities are greater than the value of its assets and it is unable to repay its debts when they fall due. It is the legal duty of the directors to ensure a company does not continue to trade after they become aware that it is insolvent.

Question 17

What is the order of priority of the distribution of funds when insolvent?

Answer 17

1. Liquidation fees
2. Secured creditors
3. Employee entitlements
4. Unsecured creditors
5. Shareholders

Question 18

What is the alternative actions for insolvent companies?

Answer 18

• Voluntary administration occurs where a business seeks external management (the administrator) to assist them to pay their debts to avoid liquidation. The administrators are responsible for determining the best solution for to be able to pay its debts and, where possible, to continue to trade.
• Receivership occurs where a secured creditor is appointed as a receiver. The receiver’s sole responsibility is to sell the secured assets of the company to repay the amount owing to the secured creditor(s). The Board of Directors remain responsible for managing the rest of the company’s operations.
• Liquidation occurs when a business in unable to pay its debts when they fall due. A liquidator is appointed to sell the assets of the business to pay its debts. If liquidated, the company will cease to exist, as the appointed liquidator will sell assets to pay the company’s debts in order of priority and wind down the company.

Question 19

Nature of Overheads.

Answer 19

These costs are not easily traceable or linked to a cost object or to a single unit of production. They need to be allocated to the total cost of a product using an appropriate allocation base such as direct labour hours or machine hours. E.g. factory insurance or the glue used in the construction of a timber table.

Question 20

What is a mark up and the considerations when deciding a mark up?

Answer 20

A mark-up involves adding a set proportion (usually a percentage) to the cost of a product to arrive at a selling price.

Considerations:
* Achievement of target investment return.
* What consumers believe to be an appropriate selling price.
* Competitor selling prices.
* All period costs covered.

Question 21

What is the relationship to cost object (direct, indirect)?

Answer 21

• Direct Costs – A cost that can be easily linked (or traced) to a particular cost object. Eg., Raw materials.
• Indirect Cost – Costs that cannot be easily linked (or traced) to a cost object and therefore must be allocated. Eg., Insurance.

Question 21

What is the treatment of cost object (production, period)?

Answer 21

• Product Costs – Relates to manufacture of a product that is expected to generate economic benefits when sold. Product costs can be held in an inventory. This includes Direct Materials, Direct Labour and Overheads.
• Period Costs – Period costs are not related to the manufacturing process and cannot be assigned to the cost of manufacturing products. Includes, Advertising, financial expenses etc.

Question 21

What is the behaviour of cost object (Fixed, variable, mixed)?

Answer 21

• Fixed Costs – Costs that remain the same irrespective of changes in a business’s level of activity. As production increases, fixed costs do not change. Eg., Rent.
• Variable Costs – Costs that change in proportion to a business’s level of activity. As production increases, variable costs increase. proportionally. Eg., Raw materials
• Mixed Costs – Costs that contain both fixed and variable elements. As production increases, only the variable component will increase. Eg) Telephone bill (have a connection component and usage component).

Question 21

What is the time of cost object (sunk, relevant)?

Answer 21

• Sunk Costs – Past costs that have already occurred and therefore cannot be changed. These costs should be excluded when making decision about future costs.
• Relevant Costs – Future costs that can be linked to a particular investment or proposal.

Question 22

What is margin of safety?

Answer 22

The margin of safety measures the gap between the level of sales and break-even point level of sales. The greater the margin of safety, the less risk for the business.

Question 22

What is CVP analysis?

Answer 22

A way to find out how changes in variable and fixed costs affect a business’ profit. Businesses can use the results of the analysis to see how many units they need to sell to break even (cover all costs) or reach a certain minimum profit margin. Uses of CVP analysis for decision-making include: * Identification of the break-even point- minimum number of sales required to neither make a profit nor a loss and can reveal what margin of safety. * Management is able to identify how changes in selling prices and/or variable costs per unit, product mix and/or total fixed costs can be made to achieve a target profit. * Facilitates the making of special decisions such as make or buy, accept a special order, close-down a product line or department. * Where a constraint exists or manufacturing capacity management is able to determine the optimal production mix decision for maximising business profits.

Question 23

What is the contribution margin?

Answer 23

The amount of revenue that remains after deducting variable costs from the total revenue earned by a company. It represents the amount of money that is available to cover fixed costs and generate a profit.

Question 24

What is the breakeven point?

Answer 24

Total revenue equals total costs, resulting in zero profit or loss.

Question 25

What are some qualitative factors to consider when making special order decisions?

Answer 25

* Price competition: Price relative to competitor prices. * Future business: Special order might attract repeat business in future. * Customer loyalty - reduced price: May be impacted if customers hear about the reduced selling price another customer receives for their special order. * Customer loyalty- current orders: May be impacted if the business ceases production of current customer orders to fulfil special order. I.e., delayed order fulfilment.

Question 26

What are some qualitative factors to consider when making shut down decisions?

Answer 26

* Investor interest: may view business is contracting. This reduces investor perception of future growth and therefore share price. * Existing customers: Shutdown of a store or product may reduce customers loyalty. * Employee impact: Store closure may result in employee redundancy or relocation. * Competition: Shut down could give competitors increase competitive advantage.

Question 27

What is the nature of capital investment decisions?

Answer 27

* The investment or purchase of assets for a long term involve a significant sum of money relative to the size of the business. * They are expected to generate future cash flows and create value for the business. * Cannot be easily reversed due to the long-term commitment of business resources. Examples: - Purchase of another business - Purchase of non-current asset e.g. motor vehicle.

Question 28

What are some non-financial factors affecting capital investment decisions?

Answer 28

* Consumer preferences, such as changes in consumer behaviour, can impact the demand for a company's products and services, and thus influence investment decisions. * Competitors can also affect investment decisions as they may introduce new products or services that could reduce demand for a company's offerings. A business should consider the likely reaction of its competitors to any investment that it makes. * Government regulation needs to be taken into account when making capital investment decisions to ensure that the business is able to comply or meet the regulatory requirements, such as changes in tax laws or environmental regulations.

Question 29

What is the concept of time value of money?

Answer 29

It recognizes that a dollar received today is worth more than a dollar received in the future due to the opportunity cost of waiting for the future payment. Therefore, businesses must consider the present value of future cash flows when evaluating investment opportunities and determining their potential return.

Question 30

What is a master budget?

Answer 30

Nature: Manages future entity activities Purpose/function: o Helps set KPIs and manage activities to meet KPIs. o Identify areas for improvement. o Plan, co-ordinate and control all activities of an enterprise o Can be used by a business to evaluate its performance. Components of a Master Budget: o Operating budget: focuses on the organization's day-to-day operations e.g. sales budget, production budget, budgeted income statement o Capital expenditure budget: sets out types and costs of non-current assets that must be purchased or sold to meet business objectives o Financial budget: focuses on the organisation's cash inflows and outflows to show funding needed for the planned operations and projected financial position e.g. cash budget, budgeted balance sheet.

Question 31

What is the purpose of a performance report?

Answer 31

Helps identify variations in financial performance between budgeted and actual performance. Helps identify positive and/or negative variances in financial performance.

Question 32

Cash vs Accrual.

Answer 32

* Cash accounting recognizes an income transaction when cash is actually received, and an expense is recognized when cash is actually paid. Example: In the budgeted income statement, sales are recognized at the time the sale is made whereas in the cash budget only cash sales and cash paid by debtors is recognised. * Accrual accounting recognizes a transaction at the time the income is actually earned, or expense actually incurred. Example: Rent expense for 3 months only is recognized in the budgeted income statement as this is the actual rent incurred, the cash budget records the cash actually paid for 6 months rent in advance.

Question 33

What is the importance of business planning?

Answer 33

* Objective of business strategies include changing goals and performance measurement. * Determines how to meet objectives- Cost leadership (lower price than its competitors) versus cost differentiation (product that is unique/different to competing products). A business needs to select the strategy that suits their product and marketplace. * Acts as a control mechanism by comparing actual performance against budgeted results; management can determine where improvements need to be made. * Predicting future costs will enable management to avoid cash shortages/excess. * Reduces risks and costs by helping management to identify areas not operating efficiently or requiring change.

Question 34

What is the importance of cash viability?

Answer 34

* Without adequate cash flow, a business may struggle to pay its bills, meet debt obligations, and invest in future growth. * A lack of cash can lead to missed opportunities, reduced profits, and ultimately, bankruptcy.

Question 35

What is the purpose of a cash budget?

Answer 35

Purpose: predicts future cash inflow and outflows during the budgeted period. Help avoid potential cash shortfalls or excess cash, ensuring the continuity of business activity and the future financial viability. A cash budget may assist to: * Plan ahead and source additional short-term credit (e.g. a bank overdraft) to cover short-term cash shortfalls and be able to meet obligations as they fall due. * Counteract the anticipated cash shortfall by delaying discretionary (i.e. non- urgent) cash payments (e.g. advertising) and capital expenditure (e.g. new office furniture).

Question 36

What is the purpose budgeted income statement?

Answer 36

Forecasts a business's expected revenues, expenses, and profits for a specific period. Helps businesses plan and monitor their financial performance, identify potential problems, and make informed decisions about future investments.

Question 37

What are the characteristics of public and large proprietary companies?

Answer 37

Limited Liability of a company limited by shares- The liability of a shareholder for the debts of a company limited by shares is restricted to the amount the shareholder owes on these shares. Number of Owners- BOTH Minimum of 1 shareholder. There is no upper limit for PUB. PTY maximum of 50 non-employee shareholders. Number of Directors- PUB minimum of 3 directors. A PTY must have at least 1 director. Continuity of Existence- BOTH continues to exist until it is deregistered. Separate Legal Entity- BOTH a separate legal entity. A company can own property and can enter into contracts in its own name and can sue and be sued in its own name. Transfer of Ownership- PUB can sell their shares at any time, without restriction. PTY may be prevented by the constitution of the company from selling their shares without the approval of the other shareholders. Separation of Ownership and Management- BOTH have separation of ownership and management. The owners of a company are the shareholders. The shareholders appoint directors to supervise the management of the company. Ability to raise capital- PUB can raise money from general public. PTY cannot.

Question 38

What must large proprietary companies satisfy?

Answer 38

- The total revenue is $50 million or more for the financial year. - The total gross assets is $25 million or more at the end of the financial year. - The company has 100 employees or more at the end of the financial year.

Question 39

What is the nature and purpose of the Corporations Act 2001?

Answer 39

The Corporations Act 2001 is a comprehensive piece of legislation in Australia that governs the operation and regulation of companies, financial markets, and financial services providers Purpose: 1) Defines and give a legal existence to a company. 2) Sets out the duties of the directors of a company. 3) Sets out the external audit requirements of a public company. 4) Sets out and defines the different types of companies that are permitted to exist under the Act, such as, public and proprietary companies. 5) Requires that the financial report for a financial year of public and large proprietary companies must comply with the AASB accounting standards.

Question 40

What are the powers of the directors?

Answer 40

1) The right to issue shares. 2) To borrow money. 3) To appoint and dismiss the senior managers of the company.

Question 41

What are the duties of the directors?

Answer 41

Duty of care and due diligence: directors are responsible for the affairs of a company and must comply with the legal obligations as a director under the Corporations Act 2001. Duty of not improperly use of position: directors must not use their position or information to cause detriment to the company or gain an unfair advantage (inside information) for themselves or for another person. Duty to not trade while insolvent: directors ensure that the company does not trade while insolvent. They must seek the appointment of a liquidator if the company becomes insolvent. Duty of good faith: directors must act in good faith and for a proper purpose for all decisions made that are in the company’s best interest.

Question 42

What are replaceable rules?

Answer 42

Are a set of default rules outlined in the Corporations Act 2001 that automatically apply to companies unless the company decides to adopt its own constitution or modify the rules.

Question 43

What is a written constitution?

Answer 43

Sets out the rules and regulations governing the internal management, structure, and operation of a company. A written constitution takes precedence over the Replaceable Rules. They cover matters including: - Appointment and removal of directors. - The powers of directors - Voting procedures. - Rights and obligations of shareholders. - Approval of dividends.

Question 44

What is a prospectus and what does it contain?

Answer 44

A document issued by a public company inviting the public to purchase the shares or debentures of that company. A prospectus must contain all the information that an investor would reasonably expect it to contain in order to make an informed assessment the future prospects of the company. Must be approved by ASIC and ASX before given to general public. It can contain: - Financial information about the company. - The number of shares that are being offered for sale and the offer price. - Key facts about the directors of the company. - An application form that investors wishing to apply for the shares must complete and return to the company. - An auditor's report showing that financial records comply with the Corporations Act 2001 and accounting standards.

Question 45

What are the main rights of ordinary shareholders?

Answer 45

1) The right to repayment of capital in the case of liquidation. 2) The right to attend and vote at shareholder’s meetings. 3) The right to receive annual financial reports. 4) The right to receive dividends once the dividend has been approved for payment.