SOLUTIONS MANUAL for Fundamentals of Accounting and Financial Management 8th Edition by Ken Trotman by StudyGuide

SOLUTIONS MANUAL for Fundamentals of Accounting and Financial Management 8e Ken Trotman, Kerry Humphreys, Victoria Clout, Kate Morgan Chapter 1: Introduction to financial accounting

Discussion questions 1 The basic purpose of financial accounting is to produce useful information which is used in many and varied ways. People use the information generated by financial accounting to improve their decision-making in allocating scarce resources. 2 Financial performance means generating new resources from day-to-day operations over a period of time. Financial position is the organisation’s set of financial resources and obligations at a point in time. 3 Managerial accounting is a branch of accounting that is oriented towards helping managers and others inside the enterprise make decisions. Financial accounting has a more external focus, and is often used by parties external to the enterprise, such as, shareholders, investors, bankers, legislators and employees etc. 4 The main parties that comprise the social setting of accounting are: – the information users (the decision makers) – the information preparers, who put the information together to facilitate the users’ decision-making – the auditors, who assist the users by enhancing the credibility of the information, providing a professional opinion that the information is fair and appropriate. 5 Credible periodic reporting means that trustworthy and competently prepared financial reports are provided on a regular basis. The cost involved in making the reports absolutely accurate and perfect would be enormous, and may outweigh the benefit obtained in achieving the highest level of credibility possible. The information has to be worth its cost! 6 User Owner Potential owner Creditors and potential creditors Managers

Usage of the financial accounting information To evaluate the success of the business, and whether or not the business is functioning well, and is achieving its financial goals. To gain an insight into the enterprise, and make a decision as to whether or not to invest in the enterprise. Also to use the past financial results as an indicator of the future functioning of the business. To ascertain the ability of the enterprise to repay any debts or potential debts that the enterprise may have. To ascertain whether or not the business has achieved its financial goals, and to provide a basis for development of future business goals and business plans. Also to compare the results of their enterprise with those of its competitors, using financial information as a common denominator.

Chapter 1: Introduction to financial accounting

Employees

Regulators and other government bodies and agencies Financial and market analysts

Out of interest to gain further insight into the functioning of the business they work for. Also to assess: whether or not the business is able to pay wages as they fall due, the employers future demand for the employees’ services, and to use the information in bargaining for wage increases. To check that the enterprise is functioning well, and is not carrying on business in any manner that may contravene any laws or regulations. Also, to provide some knowledge of businesses, which may be used to develop new regulations, or modify existing regulations. The results would be scrutinised in depth, and further analysed to provide deep insight into the enterprise. This information could then be used by the analysts to make investment decisions, or the information could be sold to interested parties. The financial results of many enterprises could be analysed and compared to gain an understanding of the market as a whole.

7 Users of financial statements do not all have the same information needs. They are all different people, with differing objectives, preferences and capabilities, so they are likely to need different information to meet these differences in decision-making. Probably most users share an interest in fair, timely information, but the details of that information depend on the decision(s) each user is making. 8 Similarities Both parties would be interested in past profits and cash flows to provide them with the relevant information. Differences Shareholders are particularly interested in dividends and potential growth in share price, bankers are more concerned with the ability of the company to repay its debt. 9 The following are some suggested situations where judgement is required by preparers of financial information, however, this list is not exhaustive! – deciding which accounting policies to use – deciding on the level of depth of information that is provided in financial reports – deciding on when to provide financial information, including how often, as well as at what time of the year – deciding in which period a transaction occurs – deciding on how to measure a transaction, for example, a property that cost $100,000 ten years ago may be worth $500,000 today. Therefore, how do preparers decide on the value of assets/ liabilities to be reported. 10 An audit enhances the credibility of an organisation’s financial statements. An auditor provides an opinion on whether the financial statements are fairly presented. 11 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 by the enterprise. 12 Most businesses and organisations use accrual accounting. The only exceptions are very small businesses with few credit transactions. 13 Term Accounts payable Accounts receivable Cash Inventory

a) Accrual accounting Yes Yes Yes Yes

b) Cash accounting No No Yes Yes

Chapter 1: Introduction to financial accounting

14 The key financial statements and the information they provide are: i a balance sheet which shows the financial position at a point in time; ii an income statement which measures financial performance over a defined period (such as a month or a year) by deducting expenses from revenues during the period to obtain profit for the period; iii a statement of cash flows which shows the sources and uses of cash during the period. Operating, financing and investing activities are included in this statement. 15 a. Accounting entity: under this concept the accounting entity is separate and distinguishable from its owners. For example, the accounting entity of a sole trader is differentiated from the financial affairs of the owner. Similarly, a company is a separate entity from its shareholders. If either the sole trader or a shareholder of a company goes out and buys a new set of golf clubs, it may affect their personal finances but does not affect the accounting entity. Accounting entities do not necessarily correspond to legal entities. For example, as noted above the personal financial affairs of the sole trader can be separated from the finances of the business, even though there is no legal distinction. This concept puts a boundary on what transactions are to be recorded for any particular accounting entity. It also allows the owner to evaluate the performance of the business. b. Accounting period: the life of a business needs to be divided into discrete periods to evaluate performance for that period. Dividing the life of an organisation into equal periods to determine profit or loss for that period is known as the accounting period concept. The time periods are arbitrary, but most organisations report at least annually, with large companies preparing half-yearly and quarterly financial statements for outside purposes and at least monthly (sometimes more frequently) for management purposes. c. Going concern: financial statements are prepared on the premise that the organisation will continue operations in the foreseeable future. If this is not the case then it is necessary to report the liquidation values of an organisation’s assets. d. Materiality: under this concept, all transactions are recorded, but items that have a small dollar value are expensed rather than included as an asset on the Balance Sheet. For example, a box of pens that costs $13 and has a useful life of two years would be treated as a stationery expense rather than as an asset. 16 The fundamental qualitative characteristics of information are: • Relevance • Faithful representation. The enhancing qualitative characteristics of information are: • Comparability • Verifiability • Timeliness • Understandability. 17 An example of trade-offs among accounting principles is faithful representation versus relevance. To get more faithful representative information it may be necessary to wait until some major uncertainties are resolved, so that you do not have to estimate them. However decision-makers need timely information relevant to their decisions. 18 Understandability assumes that users have a reasonable knowledge of business and accounting, and a willingness to study the information with reasonable diligence. © 2022 Cengage Australia Pty Limited. All Rights Reserved.

Chapter 1: Introduction to financial accounting

While there have been many suggestions for the need to reduce unnecessary complexity, information about complex matters, if relevant to users, should not be excluded on the grounds that it is too difficult for users to understand. 19. A Balance sheet may be called the ‘Statement of Financial Position’ and the Income statement may be referred to as the “Profit or Loss Statement’.

Chapter 1: Introduction to financial accounting

Problems Problem 1.1 Person

Information wanted

How affected Salary and bonus Continuity of employment Salary and bonus Continuity of employment Recommend dividend Recommend share issue Recommend borrowing of funds Provide: unqualified opinion except for opinion adverse opinion inability to form opinion Whether calculated in accordance with legislation Sell shares or buy additional shares

CEO

CFO

Chairperson of Board of Directors

Profitability Financial stability or growth Profitability Liquidity Adequacy of capital, profitability, growth, market share

Partner of auditing firm

Whether financial statements are fairly presented

Taxable income

Local manager of tax collections Shareholder

7 8

Potential shareholder Local bank manager

Profitability Dividends proposed Market price of shares Ability to pay bills As for shareholder Liquidity Profitability Regular payment of interest

Purchase shares Require payment of loan Take control of assets given as security

Problem 1.2 1

– –

The profit for the period which is revenue minus expenses. Profit will be one of the performance indicators for the CEO. If the club is making a loss, there will be issues about the financial viability of the club. Financial position: as provided by the balance sheet. A strong balance sheet will make it easier for the CEO to carry out their strategic initiatives, e.g., new training facilities.

– –

Cash flow is critical as the players’ payments depend on it. The higher the profit the more likely the players can argue for pay increases.

The supporters are most concerned about the long-term viability of the club. They may take a more long-term perspective than even the CEO and players. The balance sheet is important here. Obviously, they are also interested in the profitability and cash flow of the club. These will impact the short-term viability including their ability to buy new players.

The key here is the number of people attending the game. It is likely to be correlated with sales revenue. The more profitable the club, the more likely it can look after its players and fans and therefore get people to the ground.

Chapter 1: Introduction to financial accounting

Problem 1.3 User

Type of Information

Company Management Bankers Shareholders Suppliers

The profitability of each division of the company The likelihood of the company meeting its interest payment on time Prospects for future dividend payments Probability that the company will be able to pay for its purchases on time Profitability of company based on tax law Profitability of company since last contract with employees was signed Financial position and performance of a company issuing shares to the public for the first time

Australian Tax Office Trade Unions ASIC

Problem 1.4 Revenue Expenses Interest (40,000 x 0.05) Wages (12,000 + 2,400) Depreciation (8,000  4) Other Profit

60,000 (2,000) (14,400) (2,000) (10,000) $31,600

Problem 1.5 Sales Cash sales Credit sales Total sales

650,000 270,000 920,000

Expenses Total expenses (400,000 + 220,000)

620,000

Accrual profit

= Total sales – Total expenses = 920,000 – 620,000 = 300,000

Problem 1.6 $ Revenue Less expenses Interest (40,000 x 10/100 x 6/12) Depreciation (8,000 x 6/48) Wages Advertising Other expenses Net profit

2,000 1,000 17,000 3,000 12,000

$ 37,000

35,000 2,000

Chapter 1: Introduction to financial accounting

Problem 1.7 1 Sales revenue for the year ended 30/06/22 = $100,000 + $200,000 = $300,000 2 Accrual accounting expenses for the year ended 30/06/22 = $60,000 + $10,000 – $5,000 = $65,000 3 Accrual accounting profit for the year ended 30/06/22 = Revenue – accrued expenses = $300,000 – $65,000 = $235,000

Problem 1.8 1 Willow Tree Limited Balance sheet as at 30 June 2022 $

Assets Cash at bank Accounts receivable Inventory Buildings Total assets

40,000 90,000 200,000 200,000 530,000

Liabilities and shareholders’ equity Liabilities Bank loan Accounts payable Wages payable Total liabilities

40,000 90,000 50,000 180,000

Shareholders’ equity Share capital Retained profits Total shareholders’ equity Total liabilities and shareholders’ equity

260,000 90,000 350,000 530,000

Profit for year ended 30 June 2022 = Retained profits at end of year – Retained profits at start of year = 90,000 – 70,000 = $20,000

Chapter 1: Introduction to financial accounting

Problem 1.9 Item

Income Statement 

Balance Sheet

Wages expense Cash paid for equipment Cash at bank Equipment Cash flow from customers Accounts payable Cash paid to employees Sales revenue

Statement of Cash Flows  

 

   

NB: Transactions often affect more than one statement, e.g., cash paid for equipment would also result in a change in the balance sheet; sales revenue would also affect the balance sheet (either cash or accounts receivable; if cash the cash flow statement would also be affected).

Problem 1.10 1 2 3 4

Net Profit -96,800 +243,300 -26,800

Cash +60,000 -56,800 +143,300 -16,800

Problem 1.11 Item Inventory Cleaning expenses Cash at bank Marketing expenses Buildings Income taxes payable Loans from banks Accounts payable Retained profits Accounts receivable Income tax expense Cost of goods sold Sales Revenue

Asset

Liability

Shareholders’ Equity

Revenue

Expense

         

  

Chapter 1: Introduction to financial accounting

Problem 1.12 1 Account Accounts receivable Sales Electricity Retained profits Loan Transportation costs

Classification Asset Revenue Expense Equity Liability Expense

2 Income Statement For the year ending 31 December 2022 $ $ Sales 250,000 Electricity 30,000 Transportation costs 10,000 40,000 Net profit 210,000

Problem 1.13 1 Cardigan’s shareholders’ equity as at 30/06/21

2 Cardigan’s assets as at 30/06/22 Cardigan’s liabilities as at 30/06/22 Cardigan’s shareholders’ equity as at 30/06/22

3 Cardigan’s shareholders’ equity as at 30/06/22 Cardigan’s liabilities as at 30/06/22 Cardigan’s assets as at 30/06/22

4 Cardigan’s assets as at 30/06/22 Cardigan’s shareholders’ equity as at 30/06/22 Cardigan’s liabilities as at 30/06/22

= Assets – Liabilities = $150,000 – $ 70,000 = $80,000 = $150,000 + $63,000 = $213 000 = $ 70,000 + $25,000 = $ 95,000 = Assets – Liabilities = $213,000 – $ 95,000 = $118,000 = $80,000 – $12,000 = $68,000 = $70,000 + $20,000 = $90,000 = Shareholders’ equity + Liabilities = $68,000 + $90,000 = $158,000 = $150,000 x 2 = $300,000 = $80 000 = Assets – Shareholders’ equity = $300,000 – $80,000 = $220,000

Chapter 1: Introduction to financial accounting

Problem 1.14 1 Liabilities = Assets – Owners’ equity Pillow’s opening balance of liabilities Pillow’s closing balance of liabilities 2 Closing balance of Owners’ equity

= $80,000 – $50,000 = $30,000 = $30,000 / 2 = $15,000 = Opening balance of Owners’ equity + Net profit = (O/b assets – O/b liabilities) + Net profit Buffalo Ltd’s closing bal. of Owners’ equity = ($60,000 – $25,000) + $43,000 = $78,000 3 Assets = Liabilities + Owners’ equity Sparkle Industries closing balance of assets = $57,000 + $15,000 = $72,000 Sparkle Industries opening balance of assets = $72,000  3 = $24,000

Problem 1.15 1

2 3 4 5 6 7 8 9 10 11 12

R L E L A A L SE A E E

Problem 1.16 PK Ltd Income Statement for the year ended 30 June 2022 Sales revenue Less cost of goods sold Gross profit Less operating expenses – wages – rent – advertising – training Net profit

$ 700,000 400,000 300,000 150,000 60,000 50,000 18,000

278,000 22,000

Chapter 1: Introduction to financial accounting

Problem 1.17 Bush Traders Income Statement for the year ended 30 June 2022 $ 480,000 210,000 270,000

Sales revenue Less cost of goods sold Gross profit Less operating expenses – wages – electricity – travel – advertising Net profit

80,000 40,000 20,000 10,000

150,000 120,000

Problem 1.18 Revenue (47,000 + 750) Cost of Goods Sold Gross profit Expenses (14,000 + 680) Net profit

47,750 (16,000) 31,750 (14,680) 17,070

Problem 1.19 1 Assets Cash Accounts receivable Equipment

$ 200,000 340,000 400,000

Liabilities Loan Accounts payable

$ 300,000 220,000

Total assets

940,000

Total liabilities

520,000

2 Shareholders’ equity

= Assets – Liabilities = $940,000 – $520,000 = $420,000

Problem 1.20 Shareholders’ equity = Assets – Liabilities = ($2,800,000 + $340,000 + $410,000) - ($250,000 + $600,000 + $104,000) = $3,550,000 - $954,000 = $2,596,000

Chapter 1: Introduction to financial accounting

Problem 1.21 1 2 3 4 5 6 7 8 9 10

O F I O F F O I O F

Problem 1.22 1 2 3 4

Historical cost Accounting period Consistency over time and comparability across companies Accounting entity

Problem 1.23 1a Relevance is one of the fundamental qualitative characteristics of useful accounting information. Relevant information is capable of making a difference in a decision. Relevant information helps users to make predictions about the outcomes of past, present, and future events, or to confirm or correct prior expectations. Information must also be timely in order to be considered relevant. b Faithful representation is one of the two fundamental qualitative characteristics of useful accounting information. The financial statements should report the economic substance of events happening to the company, and the numbers should measure the events neutrally, neither overstating nor understating their impact. Reliable information will, without bias or undue error, faithfully represent those transactions and events that have occurred. To have perfect faithful representation the financial information needs to be complete, neutral and free from error. c Understandability is an enhancing qualitative characteristic of information. Information is understandable when it permits reasonably informed users to perceive its significance. Understandability is a link between users, who vary widely in their capacity to comprehend or utilise the information, and the decision-specific qualities of information. Information is more useful if it is understandable to informed decision makers. Understandability can be increased by presenting information in a clear and concise manner. The Framework states that users are expected to have a reasonable knowledge of business, economic activities and accounting, and a willingness to study the information with reasonable diligence. However, there is a caveat: information about complex matters, if relevant to users, should not be excluded on the grounds that it is too difficult for users to understand. d Comparability means that information about enterprises has been prepared and presented in a similar manner. Comparability enhances comparisons between information about two different enterprises at a particular point in time. Information about one organisation is more useful when it can be compared with © 2022 Cengage Australia Pty Limited. All Rights Reserved.

Chapter 1: Introduction to financial accounting

e f

similar information from another organisation and also is comparable over time within the same organisation. Timeliness is about providing information in time for the user to incorporate the information in their decisions. Verification is an enhancing characteristic of information. The numbers in the financial statements can be verified directly by looking at documentation (e.g. the cost price of equipment) or through direct observation (e.g. counting cash or inventory). They can also be verified indirectly by checking inputs to a model formula and recalculating the outputs.

2 There are a multitude of answers possible here. The suggestions below are intended to serve as examples. a Relevance and verification: Forecasts of future operating results and projections of future cash flows may be highly relevant to some decision-makers. However, forecasts are more difficult to verify. b Faithful representation and timeliness: Certain estimates such as write-offs of bad debts become more accurate with time however decision makers need relevant information now c Compatibility and relevance: There presently exists much diversity among acceptable accounting methods and procedures. In order to facilitate comparability between enterprises, the use of only one accepted accounting method for a particular type of transaction could be required. However, relevance could be impaired for those firms changing to the new required methods. d Relevance and understandability: Occasionally, relevant information is exceedingly complex. Judgment is required in determining the optimum trade-off between relevance and understandability. Information about the impact of general and specific price changes may be highly relevant but not understandable by all users.

Chapter 1: Introduction to financial accounting

Cases 1A 1 27 June 2021. 2 Two years: 2021 and 2020. 3 Indicators that Woolworths uses accrual accounting: Trade and Other Receivables Trade and Other Payables Provisions Depreciation Amortisation Prepayments Accruals Unearned Revenue Note 1 4 Total assets at 27 June 2021 = $39,236m 5 Total Liabilities at 27 June 2021 = $37,497m 6 Shareholders’ equity at 27 June 2021 = $1,739m 7 Accounting equation in dollar figures at 27 June 2021 A = L + SE $39,236m $37,497m + $1,739m 8 Net profit before tax = $2,210m 9 Net profit after tax = $1,606m from continuing operations 10 Largest cash inflow = Receipts from customers = $72,688m Largest cash outflow = Payments to suppliers and employees = $66,526m 11 Cash flow from operations is a different figure to operating profit after tax because the latter is calculated on an accrual basis and includes a number of items omitted from the cash flow from operations including: – Revenue earned but received in other periods – Expenses incurred but paid for in other periods – Expenses not involving cash outlays including depreciation and bad debts In addition the cash flow from operations includes revenues and expenses relating to prior or subsequent periods. 12 Total assets increased from $38,472m to $39,236m. 13 Woolworth Limited had $3,132m worth of inventory as at 27 June 2021. 14 Yes, they are. There is auditor's declaration (by Deloitte) in the report. 15 The answer would depend upon users selected, below are two examples Investors make decisions about whether to continue to own shares in the company and whether to buy additional shares. They would be particularly interested in the future growth in share price and the ability of the company to pay dividends. Of particular interest will be the income statement but they will also have an interest in the balance sheet in order to assess financial stability. Lenders are particularly interested in the company’s ability to make repayments on the loans as they fall due. The balance sheet will be particularly useful here in looking at such relationships as debt to equity. The cash flow statement will also be useful in gaining an understanding of the company’s ability to meet its interest payments.

Chapter 1: Introduction to financial accounting

16 Materiality: – the fact that all numbers are reported in millions – reference to ‘critical accounting estimates and judgements’ Comparability: – references to significant accounting policies and critical accounting estimates help to compare to other organisations and across time

1B The purpose of this case is to have the students think about the various types of users of financial statements and how the needs of these users can be served by a single set of general purpose financial statements. The discussion might proceed as follows: • Definition of a user: someone who makes decisions on the basis of financial statements. • List of possible users: – owners or potential owners – creditors and potential creditors – managers – employees – taxation authorities, regulators and other government bodies – financial and market analysts – competitors – accounting researchers – miscellaneous third parties. Why should the CEO provide information to the users? • At this point you might want to go through the list of users and discuss why the CEO would want to provide information to each type of user. Some examples: • We know that the company is at least in part, financed by debt. The creditors will, therefore, be concerned about the company’s ability to pay back the debt. • If the company were a sole proprietorship with no debt, perhaps the only users would be the owner manager and the taxation authorities. • User’s main demand is for credible periodic reporting of an organisation’s financial position and performance. – A large publicly traded company may have to meet the needs of all of the users mentioned above. – It would be very costly to provide different information to all of the different users. – Therefore, financial accounting measures performance over time using standard ways of determining whether a company has done well. – This information is not necessarily useful for insiders (i.e. management). • Net profit versus Cash from operations – In accrual accounting, attempts are made to measure the value of incomplete transactions. Accrual accounting is used to determine net profit. (You may want to provide examples here (e.g. uncollected revenue at year-end increased by $43,000).) – Discuss why it is valuable to provide information about completed transactions. In doing this, refer to users of financial statements. For example,

Chapter 1: Introduction to financial accounting

owners and potential owners may want to predict future performance of the firm on the basis of past performance in making investment decisions. Another example is assessment of management performance. – Cash from operations measures the amount of cash generated from the day-today activities of the company over a period in time. – Why would any of the users noted above find this information useful? – Example: creditors may use this information to assess the ability of the company to pay interest and principal on debt.

1C 1

The person giving the assurance is independent of those preparing the financial statements. This would include having no conflict of interest, e.g., owning shares in the company, lending/borrowing money for the company; having a spouse or other family member in a key executive role.

– the client accounts for 70% of the audit firm’s total revenue – owning shares in the company – being an employee/director of the company.

The expectation gap is that users of financial statements often expect more from an audit report than is actually provided, i.e., the audit report does not guarantee the company will not fail or there is no material misstatement in the financial statements. The audit report gives an opinion on whether the financial statements are free from material misstatement.

Management prepare the financial statements while auditors express an opinion on the financial report.

Management need to make judgements in the preparation of financial statements. It is important that they have integrity and that those judgements are not biased towards their self-interests.

Chapter 2 The balance sheet and the incomestatement

Discussion questions 1 a Revenue examples include: Sales revenue, service revenue and rental revenue. Expense examples include: Cost of goods sold, wages expense, interest expense and tax expense. b. Credit and cash sales increase revenue. A loan from the bank will increase cash (an asset) and loan (a liability). The issue of share capital will increase cash (an asset) and share capital (shareholders’ equity). 2 Assets are usually separated into shorter-term ones (current assets) and longer-term ones (noncurrent assets). Current assets are those that are expected to be used, sold, or collected within the next year, and noncurrent assets therefore are expected to have benefits for more than a year into the future. 3 Like assets, liabilities are usually separated into shorter-term ones (current liabilities) and longer-term ones (noncurrent liabilities). Current liabilities are those that are due (expected to be paid or otherwise discharged) within the next year, and noncurrent liabilities therefore are due more than a year into the future. Some liabilities, such as many loans, extend for years into the future but are partly paid each year, so the balance sheet would show both a current and a noncurrent portion for them. 4 Not all liabilities are expected to be paid in cash; some are ‘paid’ by providing goods or services. An example is a deposit received from a customer for goods to be shipped later. The enterprise has the money (an asset) and records a corresponding liability for the deposit, but expects to give the customer the agreed-upon goods to discharge the liability. In the meantime, the customer has a claim on the enterprise, expecting either to get the goods or the cash back if the goods are not supplied. Also some liabilities such as provision for warranty require future work to be done. 5 The company could have paid a dividend, thereby reducing retained profits. Alternatively, retained profits also decrease when the entity makes a loss. 6 a A balance sheet can indicate whether a company is financially sound by a comparison of the amount of finance raised by debt with the amount raised from owners. The higher the proportion raised by the debt, the higher the risk to the creditors. b The working capital, i.e. current assets less current liabilities indicates a company’s ability to pay its bills on time. This assumes that the current assets can be readily turned into cash. c To declare a dividend a company must have adequate cash (or overdraft facilities) and adequate retained profits. The decision will be influenced by shareholder expectations.

Chapter 2: The balance sheet and the income statement

d The age of equipment can be ascertained by comparing cost of equipment to accumulated depreciation. 7 –

Some long-term loans have portions that are repayable in the coming year, whilst the remainder is due in the longer term. – Employee entitlements may be partly payable within 12 months and partly payable in the longer term. – Income tax liability may be partly payable in the coming year and partly due in following years. 8 An asset is defined as a future economic benefit controlled by the entity as a result of a past transaction. It is debatable whether or not staff are actually ‘controlled’ by an entity, as they could leave if they so choose. Also, the criteria that are required for an asset to be recognised are that: the value of the asset can be measured reliably, and it is probable the future benefits will eventuate. Even though employees may provide future benefits to a business, it is very hard to reliably measure with any consistency the benefits they provide to the enterprise. 9 Your explanations will have been in your own words, perhaps something like the following: Companies earn profits when their revenues are greater than the expenses incurred in earning those revenues. Dividends are a distribution of profit to shareholders, not an expense of running a business. 10 Inventory and accounts receivable are normally current assets, because the inventory is expected to be sold within a year of its purchase, and accounts receivable are expected to be collected within a year. These assets would not be current assets if inventory was not expected to be sold within a year, and accounts receivable is not expected to be collected within a year. 11 An indicator of whether a company is financially sound is the relationship between borrowed funds and shareholders’ funds. This is known as the debt/equity ratio. A higher ratio is a warning about risk. 12 To pay its bills on time an organisation will have to collect cash from its customers either by getting them to pay what they already owe or by selling them some unsold products for cash. To predict whether an entity will be able to pay its bills on time, a calculation of working capital (current assets – current liabilities) may provide insight, as would the working capital ratio (also called the current ratio), which is current assets/current liabilities. If the working capital is positive, and the current ratio indicates there is more current assets than current liabilities (i.e., is greater than 1), the entity’s ability to pay bills on time would probably be good. 13 The list might look something like this: Person (decision-maker) Manager Owner (e.g., investor) Lender (creditor) Regulator Employee (alone or union)

Use (decision to be made) Resource acquisition/allocation Improving the way company is managed Invest/divest/hold Hire/fire managers New lending, extension of credit Response to inadequate repayment Monitoring company’s actions Assessing any needed penalties Whether to be/stay employed

Chapter 2: The balance sheet and the income statement

Public interest group Competitor Customer Supplier Taxation authority

Contract negotiations Social impact of company Cost of improving environment Improve competition strategy Learn from successes/ failures Assurance of ability to deliver services Assurance of ability to pay Assessment of some taxes

14 A few centuries ago it was common practice to wait until the conclusion of a trading venture before extracting any information regarding the result of the operations. In modern times, however, frequent and regular information is needed by owners, management, leaders and government. To meet these demands it is customary to divide the life of accounting entities into a succession of equal periods and to prepare reports for these periods. For some parties, such as taxation authorities and shareholders, annual or six-monthly accounts may be adequate, whereas for others such as management, weekly reports may be required. Normally there is some delay before such reports are available. However these reports relate to the past. Financial analysts and the stock market react quickly to information. They are likely to have reacted to any ‘news’ included in the financial statements by the time they are published and analysed. It is difficult to ‘beat the market’ using financial statement information, because the statements reflect business events people already know something about and there are many others trying to analyse what is happening. Although financial reports may be of limited use in investment decisions they do provide a useful way to develop a good understanding of the financial and operating strategy of the company. 15 Those that are current need to be repaid within one year or refinanced. This is where the immediate pressure is.

Chapter 2: The balance sheet and the income statement

Problems Problem 2.1 1 2 3 4 5 6 7 8 9 10

SE L A A L L L A A SE

Problem 2.2 Both statements refer to a strong balance sheet. Recall the basic accounting equation is A = L + SE. A strong balance sheet usually refers to the fact that the percentage of assets financed by debt (liabilities) is relatively small. The lower levels of debt mean it is easier for the company to borrow more if they wish to expand or buy other companies. Companies with strong balance sheets are in a better position to acquire other companies, e.g., it is easier to borrow.

Problem 2.3 PQR Limited Statement of financial position as at 30 June 2022 $000 Current Assets Cash 63,382 Accounts Receivable 98,264 Inventory 110,234 271,880 Non-Current Assets Property, plant and equipment 181,148 Total Assets 453,028 Current Liabilities Accounts Payable Interest-bearing liabilities Provisions Shareholders’ Equity Share Capital Retained Profits Total Liabilities and Equity

105,344 192,370 70,876 368,590 47,184 37,254 84,438 453,028

Chapter 2: The balance sheet and the income statement

Problem 2.4 Current assets Cash and cash equivalent Accounts receivable Inventory Prepayments Noncurrent assets Long-term investments Property, plant and equipment Less accumulated depreciation Patents and trademarks

Cobin Ltd Balance Sheet as at 30 June 2022 $

550,000 190,000

$ 43,000 68,000 81,000 10,000 202,000 110,000

360,000 44,000 514,000

716,000

Current liabilities Accounts payable Notes payable Income taxes payable Current portion of long-term debt Noncurrent liabilities Long-term debt Provision for employee entitlements Total liabilities Shareholders’ equity Share capital Retained profits

$ 61,000 30,000 32,000 25,000 148,000 200,000 34,000 234,000 382,000 150,000 184,000 334,000 716,000

Problem 2.5 1 The balance sheet is a history: it reports the assets, liabilities and equity that have built up over time until the date of balance sheet. Such a history is useful mainly if it indicates things that will affect the future. Two examples of such things might be: (1) if your company has a lot of debt, which the balance sheet will show, that will certainly affect your ability to operate in the future because the debt has to be repaid; (2) if the balance sheet indicates you’ve been a good financial manager (or a bad manager) that might suggest you will continue to be good (or bad) in the future. 2 The accountants and auditors were probably thinking of the accounting definition of an asset, as being something owned or controlled that will provide future benefit. As we don’t have slavery; it is hard to count people as assets, because people can leave any time they like. Employment contracts don’t amount to ownership of the person because it is difficult to force productive effort on a reluctant person who wants to leave. (You might be interested to know that some sports teams do show amounts spent to acquire or develop players as assets, because players can be sold or traded.)

Chapter 2: The balance sheet and the income statement

Problem 2.6 Current assets Cash Accounts Receivable (49,132 – 1,549) Inventory Prepayments Noncurrent assets Property plant and equipment Accounts receivable Intangibles Other financial assets

Total assets

SPOM Ltd Balance Sheet as at 30 June 2022 $000 Current liabilities 32,000 Accounts Payable 47,583 Interest bearing liabilities 55,117 Provisions 8,324 143,024 Noncurrent liabilities Provisions (35,438 – 31,704) Interest bearing liabilities 90,574 1,549 Total liabilities 49,053 19,390 Shareholders’ equity 160,566 Share capital Retained profits 303,590

Total liabilities and shareholders’ equity

$000 57,634 8,732 31,704 98,070 3,734 87,453 91.187 189,257 71,667 42,666 114,333 303,590

Problem 2.7 1

Retained profits is the accumulation of net profit minus dividends for each year of the company’s history. It is the accumulated residual undistributed earnings of the company and is on the balance sheet because it is a source of present assets (because assets created in the process of earning profit were not all distributed to owners). Ending retained profits were $12,220. Subtracting profit that had been added ($2,350) and adding back dividends that had been deducted ($1,200) gives beginning retained profits of $11,070. To check this, going the other way gives $11,070 + $2,350 – $1,200 = $12,220. Ending retained profits would be $12,220 – 20,000 = -7,780. This would be classified as accumulated losses rather than a retained profit.

Problem 2.8 1

Century Cinemas Income Statement For the year ended 31 December 2022 $ Ticket revenue Confectionery sales Less Cost of confectionery sold Gross profit Less operating expenses Advertising expense 42,780 Rent expense 33,200 Electricity expense 5,090 Net profit

$ 81,700 12,300 (10,500) 83,500

(81,070) 2,430

Chapter 2: The balance sheet and the income statement

Problem 2.8 (continued) 2

Century Cinemas Statement of retained profits For the year ended 31 December 2022 Retained profits, 1 January 2022 Net profit for 2022

$ 59,720 2,430

Retained profits, 31 December 2022

62,150

Century Cinemas Balance Sheet as at 31 December 2022 Current assets $ Cash 4,610 Accounts receivable 13,450 Inventory 18,000 36,060 Noncurrent assets Furniture and fittings 34,000 Land and buildings 60,000 Projection equipment 41,000 135,000 Total assets

171,060

Current liabilities Accounts payable

13,910

Noncurrent liabilities Loan payable Total liabilities Shareholders’ equity Share capital Retained profits Total liabilities and shareholders’ equity

35,000 48,910 60,000 62,150 122,150 171,060

Chapter 2: The balance sheet and the income statement

Problem 2.9 1 2 3 4 5 6 7 8

Profit NE -$20,000 +$60,000 NE -$40,000 -$14,000 NE NE

Cash -$80,000 NE NE -$16,000 -$40,000 -$14,000 -$200,000 -$26,000

Problem 2.10 1 2 3 4 5 6 7 8 9

Assets Increase Increase NE Increase NE Decrease NE Increase Decrease

Liabilities NE Increase NE Increase NE Decrease NE Increase Decrease

Shareholders’ equity Increase NE NE NE NE NE NE NE NE

Notes

Assets increased and decreased Assets increased and decreased Assets increased and decreased

Problem 2.11 Asset Prepayment

Amount ($) 36,667

50,000

3 4

Intangible asset No Land

Equipment

1,300,000

Computer

2,700

$3M or $5M

Assumptions The insurance policy is used evenly over the period. Have used (expensed) 1 months, 11 months of insurance remain. It is probable that the benefits the patent gives to XYZ will provide future economic benefit. Generally, the land will be recorded at historical cost, i.e., it will be valued at $3,000,000. If the land has recently been revalued the company can record it at the revalued amount of $5,000,000. As the installation was necessary to the operation of the machine, then the cost of installation is added to the purchase cost of the machine, to give its opening book value. It is the price paid for the computer that is relevant.

Chapter 2: The balance sheet and the income statement

Problem 2.12 1 2 3 4 5

Liability Tax payable Wages payable Provision for warranty claims Revenue received in advance (also called ‘Unearned Revenue’). No

Problem 2.13 Revenue for the month of February 2022 $ 1 Sales – credit 200,000 2 Sales – cash 160,000 3 Rental revenue 9,000 4 – 5 – Total revenue 369,000

Problem 2.14 Revenue for the year 1 Sales – credit, $30,000 2 Nil 3 Nil 4 5

Sales – credit, $22,000 Nil

Sales – cash, $400

Motor vehicle will be recognised at cost of $31,200. The ink cartridges are not delivered. The sales have not taken place yet. Money received from shares issuing will be recognised as share capital instead of revenue. The remaining $4,400 will be recognised as Unearned Revenue and will be realised when the product is delivered in the future.

Problem 2.15

1 2 3 4 5 6 7

Revenue Rationale earned Y Sales are $9,500, this is revenue. Revenue is independent of the cost of goods sold. The cost of goods sold, deducted from the revenue is an expense. Y Sales are $7,000, this is revenue. Y Sales are $4,500, this is revenue. Y This is revenue for the surveyor, as even though he/she has not yet received the cash, he/she has performed the service, and therefore earned the revenue. N This is an expense, not a revenue. Y Dividends received are a revenue (for a financial services company, dividends may be a main source of revenue). Y The $1,600 is still revenue. Revenue needn’t be paid in cash in order to be recognised. It is the receipt of benefit, in this case it is a saving of an outgoing.

Chapter 2: The balance sheet and the income statement

Problem 2.16 Expenses for the month of February, 2022 $ 1 Salaries 15,000 2 – This would be a January expense 3 Rent 6,000 4 Repairs & maintenance 800 5 – This is an asset not an expense. Land is not depreciated. Total expenses 21,800

Problem 2.17 1 2 3 4 5

$10,000 $1,200 N/A $6,000 N/A

Problem 2.18 The following list includes points for discussion. Other points not included here may also be valid. • What are the CEO’s motivations? • Will the proposed change to the balance sheet affect the CEO’s bonus? • Is the CEO worried that the performance of the company is so poor that he/she may lose his/her position as CEO? • Is the enterprise experiencing financial difficulties, such that it needs additional financing? • Does the CEO’s suggested change to the balance sheet involve a change from one acceptable accounting method to another acceptable accounting method? • If so, does the proposed accounting method better reflect the circumstances of the enterprise? • Does the CEO’s proposed change involve recording transactions which have not yet occurred (e.g. recording fictional sales)? • Does the CEO’s proposed change involve changes in estimates (e.g. lower allowance for uncollectable accounts)? • If so, does recent experience support the lower estimate? • Is the CEO aware that the financial statements must be prepared according to acceptable accounting methods? The chief accountant should make the CEO aware that this is the case. • Might the chief accountant jeopardise his/her employment with the company if he/she fails to agree with the CEO? • The chief accountant should assess the CEO’s motivations. • The chief accountant should assess whether the CEO’s proposed change falls within acceptable accounting methods, and best reflects the economic circumstances of the enterprise. • If it doesn’t, the chief accountant can either record or not record the change.

Chapter 2: The balance sheet and the income statement

• • • • •

If he/she records the change in these circumstances, he/she violates the rules of professional conduct for accountants. During the course of the audit, the auditors are likely to discover the change if the change is significant. The chief accountant could explain to the CEO the likelihood that the auditors would discover the change. Auditors report directly to the board of directors. The chief accountant could explain this to the CEO, if he/she is unaware of the fact, and persuade the CEO that making the change could damage the reputation of the CEO in the opinion of the board of directors.

Chapter 2: The balance sheet and the income statement

Cases 2A 1 Point of time at which the balance sheet is drawn up – 27 June 2021. 2 Currency in which accounts in the balance sheet are measured – Australian dollars. 3 The 2021 balance sheet of Woolworths Limited balances as follows: Assets ($39,236m) = Liabilities ($37,497m) + Shareholders’ Equity ($1,739m) 4 The assets of $39,236m were financed by current liabilities $23,117m, noncurrent liabilities$ 14,380m and shareholders’ equity $1,739m 5 The ‘net assets’ figure of $1,739m is determined by deducting total liabilities from total assets. $ million 6 Balances at 27 June 2021 – current assets 15,786 – current liabilities 23,117 – noncurrent assets 23,450 – noncurrent liabilities 14,380 7 Balance of Working Capital at 27 June 2021= current assets – current liabilities = $15,786m – $23,117m = –$7,331m. 8 Dividends paid $1,104m as per statement of cash flows, plus $50m to minority interests. 9 Amount of share capital issued – $5,253m (contributed equity). 10 The revenue earned in 2021 as seen on the Statement of Profit or Loss was $55,694 from sale of goods and services and $117m from other revenue. 11 In 2021 the cost of goods sold amounted to $39,366m. Referred to as cost of sales in the statement of profit and loss. 12 As you would expect the two figures are different. Net profit after income tax is $2,139 million, whereas the cash balance has decreased from $2,068 million in 2020 to $1,009 million in 2021. 13 $2,139 million. 14 $3,132 million. 15 Cash decreased by $1,060 million (from $2,068 million in 2020 to $1,009 million).

2B 1 Recall the basic accounting equation is A = L + SE. A strong balance sheet usually refers to the fact that the percentage of assets financed by debt (liabilities) is relatively small. The lower levels of debt mean it is easier for the company to borrow more if they wish to expand or buy other companies. 2 By issuing shares, cash increases and so does share capital. The increase in these items reduces ratios such as debt/equity and debt/assets, i.e. it increases the strength of the balance sheet. 3 A share buyback is when a company buys back its own shares from the market. 4 Recall that A = L + SE. With a share buyback, assets (cash) will decrease (or liabilities will increase if they borrow the cash) and SE will decrease (via decrease in share capital). In either case, ratios such as debt/equity and debt/assets change.

Chapter 2: The balance sheet and the income statement

5 Companies are given a debt rating which is an indication of how secure the company is, for example, how certain it is that the debt will be repaid by the company. As the debt rate gets lower, the company has to pay a higher rate of interest. 6 Even for State Governments a strong balance sheet is important. If the economy goes into recession it is more likely it can still borrow to maintain its activities.

Chapter 3 Recording accounting transactions

Discussion questions 1 • • •

Another asset may have decreased A liability may have increased and/or Shareholders’ equity may have increased.

2 A = L + SE a not possible, as the right-hand side of the accounting equation will exceed the left-hand side b possible, e.g. share capital issued to reduce debt c not possible, as the left-hand side of the accounting equation will exceed the right-hand side 3 • •

Revenues increase profit, and profit increases retained profits, which is a part of shareholders’ equity. It is likely that revenues (sales) also increase an asset, such as cash, or accounts receivable.

4 •

•

Expenses decrease profit. A decrease in profit results in a decrease in retained profits. Retained profits are a category of shareholders’ equity, therefore, a decrease in retained profits, decreases shareholders’ equity. The other parts of the accounting equation likely to be affected will either be an increase in liabilities (for example an increase in a payable when an expense is incurred) or a decrease in an asset (for example, when cash is paid out upon occurrence of an expense).

5 • • • •

cash decreases a prepayment decreases (e.g. the using up of insurance prepaid) when depreciation expense is increased, accumulated depreciation increases thus reducing total assets. inventory decreases when cost of goods sold increases

Chapter 3: Recording accounting transactions

6 •

•

• •

•

Assets normally have a debit balance, while liabilities and equity normally have a credit balance. Revenues have a credit balance, and expenses have a debit balance. Therefore, some examples of asset accounts that normally have a debit balance are: – Cash – Accounts receivable – Inventory – Equipment – Land and buildings – Investments – Intangibles – Prepayments Some liability accounts that normally have a credit balance are: – Accounts payable – Loan – Other payables (income tax, wages, etc.) – Revenue received in advance – Loan – Provisions Some equity accounts that normally have a credit balance are: – Share capital – Retained profits Some revenue accounts that have a credit balance are: – Sales – Dividends received from investments – Other revenue Some expense accounts that normally have a debit balance are: – Electricity expense – Income tax expense – Salaries and wages expense – Rent expense – Sundry expenses – Depreciation expense

7 Accounting accumulates information about activities and the financial statements are prepared from the accounts that are produced as the information is accumulated. The balance sheet and the income statement fit together or articulate because they are both based on the double-entry accounting system. A set of accounts is created which is in balance. From these accounts are produced: – The income statement, the bottom line net profit after tax being transferred to – The statement of retained profits, the bottom line ending retained profits being transferred to – The balance sheet, which summarises all the accounts

Chapter 3: Recording accounting transactions

Thus activities affecting profit affect the balance sheet through the double-entry system. In particular, recognition of revenue and expense relies on the fact that a revenue causes a change in the balance sheet, as does an expense. 8 a. Woolworths – cost of goods sold, transport expense, wages b. Commonwealth Bank – interest expense, rent expense c. Qantas – fuel, maintenance d. Salvation Army – telephone costs, wages (e.g. counsellors, administration) 9 An example of each has been provided below but there are other correct transactions for these scenarios. a. A credit sale of inventory (increase of accounts receivable and decrease in inventory on the balance sheet and increase in sales revenue and COGS expense on the income statement) b. A cash sale of inventory (similar to part a however there will be an increase in cash rather than accounts receivable which will then also impact the statement of cash flows). c. Cash received from accounts receivable (increase in cash and decrease in accounts receivable, both balance sheet accounts).

Chapter 3: Recording accounting transactions

Problems Problem 3.1 1 2 3 4 5 6 7

A customer pays his account (i.e. an amount is received from a debtor). Inventory is purchased on credit. A company with a cash balance issues shares for cash. A company with a bank overdraft issues shares for cash. Inventory purchased on credit is returned to the supplier. A company with a bank overdraft pays a supplier’s account. A company pays a cash dividend.

Problem 3.2 1 2 3 4 5 6 7 8

Purchased equipment for cash Purchased motor vehicle on credit Received payment in cash for repairing equipment Borrowed from finance company to pay trade creditor Paid creditor from bank account Consumed electricity to be paid for in three months’ time Shareholders contributed additional cash as capital Goods costing $20 000 were sold (COGS increases, inventory decreases)

Problem 3.3 a Revenues

Expenses

Assets +500 000 +320 000 +9000 NE +140 000 –100 000 NE –44 000 –12 000

NE NE NE

–40 000 +20 000 +150 000

Liabilities

1 2 3 4 5 6 7 8 9 10 11 12

+400 000 +12 000

+80 000 +3000

NE NE

NE +180 000

• • • •

accounts receivable: $72 000 + $400 000 – $300 000 = $172 000 inventory: $94 000 + $140 000 – $83 000 = $151 000 accounts payable: $35 000 + $140 000 – $100 000 = $75 000 tax payable: $17 000 – $12 000 = $5000.

NE NE NE NE NE NE

NE NE

NE NE +140 000 –100 000 +180 000 –44 000 –12 000 NE +20 000 +150 000

Chapter 3: Recording accounting transactions

Problem 3.4 1 Assets 500 000 Opening retained profits 10 000 Shareholders’ equity capital 350 000 2 Assets 500 000 Shareholders’ equity 350 000 Closing retained profits 50 000 Revenue 100 000 3 As for 1 & 2 As for 2 Closing retained profits 50 000 Revenue 90 000 4 Opening retained profits 100 000 Share capital 500 000 Shareholders’ equity 630 000 Total assets 780 000 5 Assets 500 000 Shareholders’ equity 350 000 Opening retained profits 20 000 6 Assets 600 000 Shareholders’ equity 450 000 Closing retained profits 150 000

– – + + –

Liabilities = Shareholders’ equity 150 000 = 350 000 Net profit = Closing retained profits 20 000 = 30 000 Closing retained profits = Share

– – – – – – – – –

30 000 = $320 000 Liabilities = Shareholders’ equity 150 000 = 350 000 Share capital = Closing retained profits 300 000 = 50 000 Opening retained profits = Net profit 20 000 = 30 000 Net profit = Expense 30 000 = $70 000 Shareholders’ equity = 350 000 Closing retained profits = 50 000 Opening retained profits = Net profit 80 000 = (30 000) Net loss = Expense 30 000 = $120 000 Net profit = Closing retained profits 30 000 = 130 000 Closing retained profits = Shareholders’ equity 130 000 = 630 000 Liabilities = Total assets 150 000 = 780 000 Noncurrent assets = Current assets 500 000 = $280 000 Liabilities = Shareholders’ equity 150 000 = $350 000 Share capital = Closing retained profits 300 000 = 50 000 Net profit – Closing retained profits = Dividend 50 000 – 50 000 = $20 000 Liabilities = Shareholders’ equity 150 000 = 450 000 Share capital = Closing retained profits 300 000 = 150 000 Dividend – Net profit = Opening retained profits 20 000 – 50 000 = $120 000

– – + + + + + + + + – – – – – – + + – – – – + +

Chapter 3: Recording accounting transactions

Problem 3.5 Retained profits 30/6/22

Liabilities 1/7/21

Assets 30/6/22

= Retained profits 1/7/21 + Net profit –Dividends = 200 + 150 – 50 = 300 = Assets – (Share capital + Retained profits) = 600 – (180 + 200) = 220 Liabilities + (Share capital + Retained profits) = 300 + (190 + 300) = 790

Problem 3.6 1 Revenue Sales Interest revenue

$ 110 000 5 000 100 000

2 Expense Depreciation (50% x 300 000 x 10%) Rent Interest (120 000 x 5% x 50%) COGS Salaries (18 000 + 4 000)

15 000 3 000 3 000 45 000 22 000 88 000

Problem 3.7

Account Affected Cash

2 3 4

Cash Cash Office equipment

5 6 7

Cash Cash Patent (noncurrent asset)

Increase/Decrease Account Affected Increase Notes payable (current liabilities) Decrease Investments Decrease Land Increase Notes payable (current liabilities) Decrease Prepaid rent Decrease Vehicle Increase Cash Notes payable

Increase/Decrease

Increase

200 000

Increase Increase Increase

15 000 400 000 1500

Increase Increase Decrease Increase (noncurrent liability)

45 000 63 000 900 000

Chapter 3: Recording accounting transactions

Problem 3.8

1 2 3 4 5 6

Account Affected Cash Cash Cash Brand name

Increase/Decrease Decrease Increase Decrease Increase

Account Affected Loan Share capital Prepayment Cash

Problem 3.9 1 2 3 4 5 6

Debit Credit Debit Credit Credit Credit

7 8 9 10 11

Credit Debit Debit Credit Debit

Increase/Decrease Decrease Increase Increase Decrease

4 000 1 200 000 50 000 170 000

Chapter 3: Recording accounting transactions

Problem 3.10 Assets = Cash 1

Accounts receivable

Liabilities + shareholders’ equity Machinery

Accumulated depreciation

Accounts payable

Unearned revenue

Loan payable

Revenue

Expense

+43 000

–8000

–8000 +110 000

–45 000

+110 000

+2000

–27 000

–30 000

–24 000

+45 000

–1100

–4000

–45 000 –2000

+27 000 –30 000 –24 000 –45 000 –1100 +9000

+5000

+3500

–3500

–1000

+6000

+8000 208 900

Share capital +250 000

+43 000

Accrued expenses

+250 000

2 3

Inventory

Accrued revenue

+8000 65 000

25 000

6000

9000

–1000

13 000

5500

8000

Note: Transaction 16 is not recorded in the books of the company as it is between two outside parties.

5000

116 000

–84 600

250 000

Chapter 3: Recording accounting transactions

Problem 3.11 1 2 3 4 5 6 7 8 9 10 11 12

Non-current asset Non- current liability Current asset Shareholders’ equity Current asset Non-current liability Current liability Current asset Non-current asset Current liability Non-current asset Shareholders’ equity

DR CR DR CR DR CR CR DR DR CR DR CR

Problem 3.12 1 2 3 4 5

6 7

DR CR

Cash Loan

80 000

DR CR

Inventory Cash

64 000

DR CR

Inventory Accounts payable

30 000

DR CR

Cash Revenue received in advance

16 000

DR CR DR CR

COGS Inventory Accounts receivable Sales

16 000

DR CR

Cash Accounts receivable

11 000

DR CR

Accounts Payable Cash

10 000

80 000 64 000 30 000 16 000

29 000

16 000 29 000 11 000 10 000

Chapter 3: Recording accounting transactions

Problem 3.13 1 ASSETS

a b c d e f g h i j k l Total

+ SHAREHOLDERS’ EQUITY

= LIABILITIES

Cash

Accounts receivable

Inventory

Office Equipment

Accounts payable (current)

Expenses Payable

Accounts Payable (noncurrent)

Share Capital

Revenue

Expenses

$ +200 000 -20 000 -4000

$ +200 000

+20 000 -4000 +30 000

+30 000 +1000

+90 000 -25 000 +30 000 -15 000 -900 -3000

-40 000

+90 000 -25 000

-30 000 -15 000 -900 +6 000

+3 000 +2 000 3000

162 100

60 000 10 000 6000 5000 3000 200 000 238 100 = 238 100 NB. Increases in expenses have been entered as minus figures as they are deducted off revenues to get profit figure.

-1000 -40 000

Hoad Ltd Income statement For the month of November 2022 $

Sales Less Cost of goods sold Gross profit Less Operating Expenses Rent Advertising Wages Sales Commission Net Profit

90 000

$ 90 000 40 000 50 000

4 000 1 000 17 000 900 22 900 27 100 Hoad Ltd Balance sheet as at 30 November 2022

Current Assets Cash Accounts Receivable Inventory Noncurrent Assets Office Equipment

Total Assets * 90 000 – 62 900 = 27 100

$ 162 100 60 000 10 000 232 100

Current Liabilities Accounts Payable Expenses Payable

Noncurrent Liabilities Accounts Payable 6 000 Total Liabilities Shareholders’ equity Share Capital Retained Profits

238 100 Total Liabilities and Equity

$ 5 000 3 000 8 000 3 000 11 000 200 000 27 100 * 227 100 238 100

-2000 -62 900

Chapter 3: Recording accounting transactions

Problem 3.13 (continued) 3 a

DR Cash CR Share Capital

200 000 200 000

b DR Inventory CR Cash

20 000

4000

DR Rent Expense CR Cash

20 000 4000

d DR Inventory CR Accounts Payable

30 000

DR Advertising Expense CR Expenses Payable

1000

DR Accounts Receivable CR Sales Revenue

90 000

DR Cost of goods sold CR Inventory

40 000

g DR Accounts Payable CR Cash

25 000

h DR Cash CR Accounts Receivable

30 000

DR Wages Expense CR Cash

15 000

DR Sales commission expense CR Cash

900

DR Office Equipment CR Cash CR Accounts Payable

6000

DR Wages Expense CR Expenses Payable

2000

30 000 1000 90 000 40 000 25 000 30 000 15 000 900 3000 3000 2000

Balances for each account can be determined from the answer to part 1.

Chapter 3: Recording accounting transactions

Net Profit No effect No effect Decrease No effect Decrease Increase No effect No effect Decrease Decrease No effect Decrease

a b c d e f g h i j k l

Total Assets Increase No effect Decrease Increase No effect Increase Decrease No effect Decrease Decrease Increase No effect

Problem 3.14 1

The journal entries are shown below:

$ 8 000

DR Accounts payable CR Cash

DR Cash CR Accounts receivable

13 280

DR Inventory CR Accounts payable

8 000

DR Cash CR Share capital

50 000

DR Long term loan CR Cash

50 000

DR Land CR Cash CR Long term loan

54 000

DR Equipment CR Accounts payable CR Long term loan

33 900

c d

$ 8 000 13 280 8 000 50 000 50 000 14 000 40 000 13 900 20 000

Chapter 3: Recording accounting transactions

Problem 3.14 (continued)

Current Assets

Noncurrent Assets

Current Liabilities

Transaction Op Balance

Cash

Accts Rec

Inventories

Land

Equipment

Acc Dep'n

Accts Payable

Taxes payable

Wages Payable

20 000

70 000

110 000

200 000

400 000

-100 000

80 000

20 000

10 000

-8 000

13 280 50 000 -50 000

f g

-14 000

Cl Balance

11 280

200 000

Employee entitlements 100 000

Share capital 200 000

Retained profits 90 000

-13 280 8 000

Long term loan

Equity

-8 000

c d

Noncurrent Liabilities

8 000 50 000 -50 000 54 000 33 900

56 720

118 000

254 000

433 900

40 000 20 000

13 900 -100 000

93 900

20 000

10 000

210 000

100 000

250 000

90 000

Chapter 3: Recording accounting transactions

Problem 3.14 (continued) 2

Assets Current assets Cash Accounts receivable Inventories, cost Noncurrent assets Land, cost Factory and equipment cost Accumulated depreciation

North Shore Manufacturing Pty Ltd Balance sheet as at 31 July 2022 $ Liabilities and shareholders’ equity Current liabilities 11 280 Accounts payable 56 720 Taxes payable 118 000 Wages payable 186 000 Noncurrent liabilities

$ 93 900 20 000 10 000 123 900

254 000 Long term loan 433 900 Employee entitlements 687 900 (100 000) 587 900 Shareholders’ equity Share capital Retained profits

210 000 100 000 310 000

773 900

250 000 90 000 340 000

Chapter 3: Recording accounting transactions

Problem 3.15 1 Assets Balance a b c d e f g h i j k Total

= Liabilities

+ Shareholders’ equity

Cash

Accounts receivable

Inventory

Prepayme nts

Equipment

Accumulated depreciation

Accounts payable

Long-term loan

Share capital

110 000 –100 000 +300 000

410 000

610 000

80 000

610 000

–140 000

210 000 –100 000

310 000

910 000

Retained profits

Revenue

Expenses

+700 000

–450 000 –30 000 –10 000 –10 000

250 000

–300 000 +700 000

+200 000 –450 000

+200 000

–30 000 –10 000 –10 000 –20 000 –100 000 +500 000 –50 000 610 000

-20 000 –100 000 +500 000 810 000

360 000

70 000

610 000

–150 000 2 310 000

310 000 = 2 310 000

NB. Increases in accumulated depreciation, dividends and expenses have been entered as minus figures.

210 000

1 410 000

230 000

700 000

–50 000 –550 000

Chapter 3: Recording accounting transactions

Problem 3.15 (continued) 2

Roche Ltd General journal a b c d

e f g h*

i j k

Accounts payable Cash Cash Accounts receivable Inventory Accounts payable Accounts receivable Sales Cost of goods sold Inventory Administrative expenses Cash Depreciation expense Accumulated depreciation Other expenses Prepayments Retained profits Dividend payable Dividend payable Cash Long-term loan Cash Cash Share capital Wages expense Cash

* Alternatively DR Retained profits CR Cash

DR$ 100 000 300 000 200 000 700 000 450 000 30 000 10 000 10 000 20 000 20 000 100 000 500 000 50 000

CR$ 100 000 300 000 200 000 700 000 450 000 30 000 10 000 10 000 20 000 20 000 100 000 500 000 50 000

20 000

Chapter 3: Recording accounting transactions

Problem 3.15 (continued) 2 (cont’d)

Roche Ltd Determination of account balances

Cash (+ $110 000 – $100 000 + $300 000 – $30 000 – $20 000 – $100 000 + $500 000 – $50 000) Accounts receivable (+ $410 000 – $300 000 + $700 000) Inventory (+ $610 000 + $200 000 – $450 000) Prepayments (+ $80 000 – $10 000) Equipment (+ $610 000) Accumulated depreciation ($140 000 + $10 000) Accounts payable ($210 000 – $100 000 + $200 000) Dividend payable (+ $20 000 – $20 000) Long-term loan ($310 000 – $100 000) Share capital ($910 000 + $500 000) Retained profits ($250 000 – $20 000) Sales (+ $700 000) Cost of goods sold (+ $450 000) Administrative expenses (+ $30 000) Depreciation expense (+ $10 000) Wages (+ $50 000) Other expenses (+ $10 000)

3 a b c d e f g h i j k

Net Profit No effect No effect No effect Increase by $250 000 Decrease by $30 000 Decrease by $10 000 Decrease by $10 000 No Effect No Effect No Effect Decrease by $50 000

Total Assets Decrease by $100 000 No effect Increase by $200 000 Increase by $250 000 Decrease by $30 000 Decrease by $10 000 Decrease by $10 000 Decrease by $20 000 Decrease by $100 000 Increase by $500 000 Decrease by $50 000

Debits $ 610 000

Credits $

810 000 360 000 70 000 610 000

450 000 30 000 10 000 50 000 10 000 3 010 000

150 000 310 000 — 210 000 1 410 000 230 000 700 000

3 010 000

Chapter 3: Recording accounting transactions

Problem 3.16 1

• Debits: $14 300 (Bank account balance), $102 100 (Building), $2500 (Cash on hand), $37 900 (Fixtures and equipment), $48 000 (Land), $6200 (Owing from customers), $29 600 (Unsold finished products), $1400 (Unused office suppliers), $18 700 (Unused product raw materials), total $260 700. • Credits: $63 700 (Accumulated depreciation), $21 200 (Bank loan), $600 (Employees tax not yet remitted), $71 000 (Long-term part of mortgage owing), $21 900 (Owing to suppliers), $47 500 (Retained earnings), $25 000 (Share capital issued), $8000 (Short-term part of mortgage), $1800 (Unpaid employee wages), total $260 700. Note that in order to answer this, reasonable assumptions may have to be made about some accounts.

2 BML Products Ltd Balance sheet as at 30 June 2022 Assets $ Liabilities and equity Current assets: Current liabilities: Cash on hand 2 500 Bank loan Bank account balance 14 300 Owing to suppliers Owing 6 200 Unpaid employee wages from customers Employees tax not yet remitted Inventories: Short-term part of mortgage Unsold finished products 29 600 Total current Unused office supplies 1 400 Noncurrent liabilities: Unused product raw materials 18 700 Long-term part of mortgage owing Total current 72 700 Total liabilities Noncurrent assets: Shareholders’ equity: Land 48 000 Share capital issued Building 102 100 Retained earnings Fixtures and equipment 37 900 Total equity 188 000 Less accumulated depreciation (63 700) Total noncurrent 124 300 Total 197 000 Total Note that reasonable assumptions are also necessary here. For example, bank loans are shown as current liabilities because they can be due more or less on demand, but this one may not be and could be a longterm (noncurrent) loan. It is also assumed that all amounts due from customers and to suppliers are current, but again for a particular company this may not be true. A valid balance sheet for any company cannot be prepared without some (often a great deal of) knowledge beyond the titles and amounts of the accounts.

$ 21 200 21 900 1 800 600 8 000 53 500 71 000 124 500 25 000 47 500 72 500

197 000

Chapter 3: Recording accounting transactions

Problem 3.16 (continued) 3

BML Products Ltd Balance sheet as at 30 June 2022

Current assets Cash on hand Cash in bank Accounts receivable Inventory

Noncurrent assets Land Building Fixtures and equipment Less accumulated depreciation Total assets Current liabilities Bank loan Accounts payable Wages payable Tax payable Mortgage (current portion)

$ 2 500 14 300 6 200 49 700 48 000 102 100 37 900 188 000 63 700

21 200 21 900 1 800 600 8 000

Noncurrent liabilities Mortgage (noncurrent portion) Total liabilities Shareholders’ equity Share capital Retained profits Total liabilities and shareholders’ equity

72 700

124 300 197 000

53 500 71 000 124 500

25 000 47 500

72 500 197 000

Note: In practice, comparative figures for the previous year would be provided as well as footnotes furnishing details of inventory, accumulated depreciation on various categories of assets, due date for repayment of mortgage loan, etc. 4 Here are two brief comments. First, the company has more current assets than current liabilities, $72 700 to $53 500, so it has $19 200 of working capital and a working capital ratio of 1.36 ($72 700/$53 500). It appears able to pay its bills as they come due, but if the bank and the suppliers were to demand payment, the company would have to sell its inventory before it could pay. (Maybe children’s toys products would be easy to sell quickly, maybe not.) Second, the company is financed more by debt than equity. Its balance sheet equation (A = L + E) is $197 000 = $124 500 + $72 500, giving it a debt/equity ratio of 1.72 ($124 500/$72 500). This indicates that the creditors are taking some risk in that they have more to lose should the company go under than the owners do, but there is no indication from the balance sheet that any financial problems are imminent.

Chapter 3: Recording accounting transactions

Problem 3.17 1

Transaction Credit sale for service revenue

$50 000

Paid $2 000 of this year’s wages and $8000 of wages payable from previous year

Purchased inventory on credit

Paid off loan

Customer paid $500 before goods or service provided $600 paid to auditors, and $2400 still owing

6 7 8

$4000

$6000

Equipment acquired for an agreed price of $5200 in return for shares Goods costing $4800 sold for $9000. $2400 sales were for cash and $6600 were on credit

Journal entry Accounts receivable 50 000 Service revenue Wages payable 8000 Wages expense 2000 Cash Inventory 4000 Accounts payable Loan 6000 Cash Cash 500 Revenue received in advance Auditing Expense 3000 Accounts payable Cash Equipment 5200 Share capital Cost of goods sold 4800 Inventory Cash 2400 Accounts receivable 6600 Sales

Problem 3.18

Credit sales DR Accounts receivable CR Sales revenue

Dragons Ltd Journal entries

Cash sales DR Cash CR Sales revenue

200 000 200 000 6 000 6 000

Collection from customers DR Cash CR Accounts receivable

150 000

Purchase of inventory DR Inventory CR Accounts payable

70 000

Payments of accounts payable DR Accounts payable CR Cash

50 000

Cost of goods sold DR COGS CR Inventory

80 000

150 000

70 000

50 000

80 000

50 000 10 000 4000 6000 500 2400 600 5200 4800 9000

Chapter 3: Recording accounting transactions

Problem 3.18 (continued) 7

Wages expense DR Wages expense CR Wages payable

90 000

Wages paid DR Wages payable CR Cash

22 000

Income tax payable DR Tax payable CR Cash

6 000

Cash dividends declared, and paid DR Retained profits CR Dividends payable

20 000

DR Dividends payable CR Cash

90 000

22 000

6 000

20 000 20 000

20 000

Dragons Ltd Income Statement for the year ended 30 June 2022 Sales Cost of goods sold Gross margin

$ 206 000 80 000 126 000

Operating expenses: Wages expense Net profit before tax Income tax expense Net profit after tax

90 000 36 000 0 36 000

Dragons Ltd Note of changes to retained profits for the year ended 30 June 2022 $ Add retained profits, 1 July 2021 34 000 Net profit after tax 36 000 70 000 Dividends declared 20 000 Retained profits, 30 June 2022 50 000

Chapter 3: Recording accounting transactions

Problem 3.18 (continued) Dragons Ltd Balance Sheet as at 30 June 2022

Current assets Cash Accounts receivable Inventory

72 000 86 000 32 000

Total assets

190 000

Current liabilities Accounts payable Income tax payable Wages payable Total liabilities

32 000 0 68 000 100 000

Net assets

90 000

Shareholders’ equity Share capital Retained profits

40 000 50 000

Total shareholders’ equity

90 000

Problem 3.19 Australian RST Limited Statement of retained profits for year ended 30 June 2022 $000 Operating profit before income tax 58 884 Income tax attributable to operating profit (571) Operating profit after income tax 58 313 Retained profits at the beginning of the period 35 697 Total available for appropriation 94 010 Dividends declared 51 444 Retained profits at the end of the period 42 566

Chapter 3: Recording accounting transactions

Problem 3.20 Sales revenue Investment revenue

$ 3 519 400 7 950 3 527 350

Less operating expenses

2 403 170

Net profit before income tax Income tax expense Net profit after tax

1 124 180 210 250 913 930

Statement of retained profits Retained profits, beginning of year Add net profit after tax Less dividend declared Retained profits, end of the year

260 090 913 930 1 174 020 (75 000) $1 099 020

Problem 3.21 1 Cash in the bank as at the end of 2022: $12 430 + $1000 + $68 990 – $1480 – $36 910 = $44 030. 2 Accrual accounting profit for 2022: $68 990 + $850 – $36 910 – $2650 – $3740 = $26 540. Problem 3.22 Cash profit Add uncollected revenue (included in accrual profit) Deduct unpaid bills (included as accrued expenses in accrual profit) Add back expenses for next year (these relate to next year’s accrual profit) Deduct depreciation expense (this affects accrual profit, not cash profit) Accrual profit

75 200 21 750 (26 180) 5 100 (15 540) 60 330

Problem 3.23 1

Here is how the accountant calculated the $45 290 profit: Collected from customers Plus incomplete sales transactions: Still owing by customers Accrual accounting revenue Paid for products to resell and other expenses Plus incomplete purchase transactions: still owing to suppliers Minus incomplete transactions: unsold products still on hand Plus estimate of equipment wear and tear (Depreciation) Accrual accounting expenses Accrual profit

$ 143 710 15 220 158 930 128 670 9 040 (26 070) 2 000 113 640 45 290

Chapter 3: Recording accounting transactions

Problem 3.23 (continued) 2

Cash on hand at the end of the first year reflects only the completed cash transactions: $ Cash collections 143 710 Less payments for products and expenses (128 670) Cash on hand 15 040

Problem 3.24 1

Income statement accounts: – Salaries expense – Income tax expense – Employee benefits expense – Credit sales revenue – Cash sales revenue – Interest revenue – Depreciation expense – Miscellaneous expenses – Cost of goods sold – Interest expense – Insurance expense – Office expenses

Net profit, based on part 1, is: Sales:

Credit Cash Expenses (other than income tax): Salaries Depreciation Insurance Miscellaneous Employee benefits Cost of goods sold Office Interest* Profit before interest revenue and tax Interest revenue Income tax expense Net profit

$ 346 200 21 600 71 000 26 700 11 200 8 200 13 100 161 600 31 100 16 800

$ 367 800 CR

(339 700)DR 28 100 CR 1 700 CR (6 900)DR 22 900 CR

* This is grouped with interest revenue in the income statement below which therefore shows operating expenses as $322 900 and net interest expense as $15 100. 3

Ending retained profits Beginning retained profits Add net profit (above) Deduct dividends declared Ending retained profits

$ 92 800 CR 22 900 CR (11 000)DR 104 700 CR

Chapter 3: Recording accounting transactions

Problem 3.24 (continued) 4

a Geewhiz Productions Income Statement for the year ended 30 November 2021 Revenue Operating expenses* Operating profit Interest expense, net of interest revenue Profit before income tax Income tax expense Net profit for the year

$ 367 800 322 900 44 900 15 100 29 800 6 900 22 900

* All expenses are aggregated here. It would be quite acceptable to list them all though most companies do not because such a list clutters the statement and gives information to competitors. The amount of depreciation expense and certain other expenses are required to be disclosed. b Geewhiz Productions Note showing changes to Retained profits for the year ended 30 November 2021 Retained profits, beginning of year Add net profit for the year Deduct dividends declared Retained profits, end of year

$ 92 800 22 900 115 700 11 000 104 700

c Geewhiz Productions Balance sheet as at 30 November 2021 Assets Liabilities and equity Current assets $ Current liabilities Cash 18 000 Bank loan* Accounts receivable 16 400 Accounts payable Inventory 68 000 Other payables** Prepaid insurance 2 400 104 800 Noncurrent liabilities Noncurrent assets Mortgage payable* Land 63 000 Building 243 000 Shareholders’ equity Trucks and equipment 182 500 Share capital 488 500 Retained profits Less accumulated depreciation 94 000 394 500 499 300

* Bank loan assumed all current, mortgage assumed all noncurrent. ** $2800 + $5400 + $4100 + $5500 = $17 800.

$ 21 800 41 000 17 800 80 600 114 000 194 600 200 000 104 700 304 700 499 300

Chapter 3: Recording accounting transactions

Problem 3.24 (continued) 5

Brief points: • The company had a positive profit, equalling 6.2% of revenue and 7.5% of year-end equity. • Dividends declared equalled half of the net profit, so the board of directors determined that proportion was better in the shareholders’ hands than in the company’s hands. • The company had positive year-end working capital ($104 800 – $80 600 = $24 200; ratio 1.3:1), so it was likely able to pay its bills on time (as long as it could sell its inventory). • The year-end debt-equity ratio was 0.64 ($194 600/$304 700) so the company was mostly financed by equity and was not particularly risky.

Problem 3.25 Given the way the question is asked, ‘manipulation’ is usually seen as unethical for reasons such as: i The performance measures are biased and therefore less useful; investors, creditors, etc. can make the wrong decision based on these manipulated numbers. ii Such manipulation is seen as self-serving. iii Such behaviour reduces the credibility of the whole measurement (accounting) system and so hurts ‘honest’ managers too. iv If manipulation costs money to do, that money is paid out of company funds which could otherwise be used to pay dividends or otherwise benefit owners or others. v If the manipulation results in additional rewards for managers, this adversely affects the owners.

Chapter 3: Recording accounting transactions

Cases 3A 1 Period covered by the profit and loss statement – 52 weeks ended 27 June 2021. 2 Main types of revenues i Revenue from the sale of goods 55 694m ii other revenue 117m 3 Larger expenses incurred in earning revenue – expenses not provided in detail (below are some examples of the disclosed expenses): i Cost of sales 39 366m ii Branch expense 9 838m iii Administrative expenses 3 784m iv Financing costs 613m v Income tax 604m 4 Interest expense for the year (Note 2.3) 613m Interest revenue - Not reported for 2021 5 Called Cost of sales 39 366m 6 Total depreciation (Note 3.4) 1 045m Total amortisation (Note3.5) (335)m 7 Retained earnings increase from 2 329m in 2020 to 3 115m in 2021, the main changes resulted from net profit from the period less dividends declared. 8 Income tax expense for the year 604m 9 Basic earnings per share for 2021 127.7cents 10 DR for trade debtors, inventory, investment, land and building, advance to employees; CR for trade creditors, provision for income tax, provision for dividends and retained profits.

Chapter 4 Accrual accounting adjustments

Discussion questions 1

Specific transactions are recorded in the accounting records if they have the following characteristics:

Three fundamental economic and legal characteristics: i Exchange: the event must involve an exchange of goods, money, financial instruments (such as cheques), legal promises, or other items of economic value; ii Past: The exchange must have happened, even if just seconds ago (financial accounting is essentially a historical information system); iii External: the exchange must have been between the entity being accounted for and someone else, such as a customer, an owner, a supplier, an employee, a banker, or a tax collector (the exchange must have been across the entity’s boundary, so to speak); Two supplementary characteristics, needed for accounting’s record-keeping: i Evidence: there must be some documentation of what has happened (on paper or electronically recorded); ii Dollars: the event must be measurable in dollars or the currency unit relevant in the country where the transaction happens. 2 The purpose of this problem is to prompt thinking about the effects of size on accounting systems and therefore to reinforce the idea that accounting should match the organisation’s information needs. Some of the differences we might expect are (worded from the larger organisation’s point of view for expository convenience): • more complex and elaborate • more costly • more departmentalised (separated from other functions of the organisation) • tracks more accruals (e.g. receivables and payables) as routine and less likely to be mainly oriented to cash transactions • more likely run by trained accountants, even professionals • more computerised (though many small organisations have largely computerised systems too) • more features providing accounting data for internal control purposes (e.g. inventory control, records of long-term assets) • more capability to produce performance reports for management (e.g. monthly) • less flexible and ‘personal’ to the manager(s) • more systematic documentation and other ‘audit’ functions.

Chapter 4: Accrual accounting adjustments

3 a

Disagree. Such an event should be recorded, but there is always room for error or deliberate failure to record, and some enterprises may have bookkeeping systems that define transactions a little differently (e.g. recording only cash transactions). Agree. When a share is first issued by a company, the company debits cash and credits share capital. If the shares are subsequently sold to another person, the original owner receives the cash and the company makes no records in the books of account. However the company is obliged to record details of the new owner in the share register to enable it to provide accounting reports and remit dividends to the appropriate person. It is essential that an accurate source document be prepared for every transaction because the source documents provide the input into the accounting system. Failure to prepare a source document for a transaction or preparation of an inaccurate document results in introducing errors into the system, which in turn, will lead to incorrect output from the system, i.e. the financial statements. In addition, source documents furnish evidence of transactions and in the absence of an accurate source document a business would be at a disadvantage in establishing what has occurred for auditors or in the event of disagreement with an outside party such as a debtor.

5 a

Transactions A cash payment

b c d

A cash receipt A credit sale Cost of goods sold

A purchase of inventory

Receipt of inventory

Source Documents Listings of cash payments; evidence such as creditor’s statement, invoices and receipt or payroll statement Duplicate copy of receipt or cash register Duplicate copy of invoice Duplicate copy of invoice or cash receipt or separate summary Invoice received from supplier, delivery docket and order Goods received advice and supplier’s packing slip

6 Revenues are inflows of economic resources from customers earned through providing goods and services. It can exist regardless of whether or not the customer pays the cash at the time. A cash receipt is the payment by the customer. 7 Revenue but not receipt: credit sales. Receipt but not revenue: unearned revenue – cash advances for work yet to be performed. Both revenue and receipt: cash sales. 8 Expense: cost of assets used or costs incurred in producing revenue. Recognition of expense may precede, accompany or follow payment of cash (cash disbursement). 9 Expense but not disbursement: depreciation, accrued interest, COGS (contrast with cash purchases of inventories). Disbursement but not expense or cash paid to suppliers for inventory previously received: purchase asset, reduce a payable, pay dividends. Both expense and disbursement: utilities, wages. Wages incurred and wages paid in the one period are the same. 10 In a cash accounting system an occurrence is recognised as a transaction only if it involves an immediate cash inflow or outflow. In a system employing accrual

Chapter 4: Accrual accounting adjustments

accounting the basis of recognition is extended to include a variety of non-cash transactions. These usually involve credit extended to or by the entity. Cash flows are easy to recognise but do not provide a satisfactory measure of the performance of most organisations. Accrual accounting employs wider criteria to decide whether revenue has been realised or expense has been incurred. This provides more informative results, which are more useful to those using accounting reports. As tests other than cash flows are less easy to define precisely, some certainty and objectivity is lost. 11 Cash flows – receipts and payments – are easy to recognise and may be measured with precision. However, reports of cash flows are limited and less informative than those based on accrual accounting. Accrual basis accounting employs wider criteria to decide whether revenue has been earned or expense has been incurred. This provides more informative results, which are of greater significance to recipients of accounting reports. Unfortunately some certainty and objectivity is lost because tests other than cash flows are more difficult to define precisely. 12 Cash flow information is inadequate for the assessment of financial performance or financial position. To enable economic performance to be assessed more broadly it is necessary to go beyond cash flow. However this obliges us to make estimates and judgements that make the results less precise than would be desired and more subjective than transaction-based cash flow figures. Accrual accounting attempts to measure economic performance and financial position in a more complex way than cash accounting. 13 The purpose of accrual accounting adjustments is to make the financial statements as reliable as possible. The intention is to identify with each accounting period the revenue earned in that period and to determine the expenses associated with generating the period’s revenue. The difference between the revenue and expense for the period then represents the profit or loss for the period. Thus the adjustments augment the cash-based figures to implement accrual accounting. 14 • Expiration of assets: Prepaid expenses are assets that arise because an expenditure has been made, but there is still value extending into the future. If they have been treated as assets at the time of expenditure, an adjustment is necessary at balance date to reduce the amount of the asset and to treat the expired portion of the asset as an expense, reducing profit for the period. • Unearned revenues: These are future revenues where cash has been received in advance of earning revenue. They are treated as liabilities at the time of receipt. At balance date any revenue earned must be recognised (i.e. increase profits) and the liability reduced. • Accrued expenses: These are expenses which have been incurred during the current period but will not be paid until the following period. At balance date expenses must be increased reducing profit and a liability recorded in the balance sheet. • Accrued revenue: This arises when a service has been provided but cash will not be received until the following period. At period end an adjustment must be made increasing an asset as well as revenue. 15 At the time customers pay for the flights this is recorded as a liability because the airline has an obligation to make a future sacrifice of economic benefits. When the flight has been made revenue is recognised. Profit is increased by the amount of revenue less costs incurred in providing the service.

Chapter 4: Accrual accounting adjustments

16 The mining company has the advantage of the use of cash until the contractors submit their bills. At year-end this does mean that the company must record the liability for unpaid accounts. In many cases it is necessary for the company to make an estimate of the value of work undertaken to date. 17 The depreciating of noncurrent assets spreads the costs of the assets over their useful lives to match the consumption of those costs to the benefits (revenue) gained from their use. 18 Depreciation is the allocation of the cost of a noncurrent asset to expense each period over the life of the asset to recognise the consumption of the asset’s economic value. Accumulated depreciation is an account that accumulates total depreciation expense over a number of years. The account balance is deducted from the asset’s cost to arrive at book value. 19 Book value is the amount shown in the accounts for an asset after deducting accumulated depreciation. It is important for a manager thinking about disposing of some assets because the difference between the book value and the amount received on disposal will be recorded in the accounts of the organisation as a loss or a profit. A loss on such a transaction may reflect badly on the manager. 20 Some points that might be made: • measuring availability and use of ‘real resources’ involves more than cash flow, because the resources do not necessarily generate cash immediately or smoothly. • therefore something besides cash is needed to do the measurement job the business person seems to want: ‘profit’ is an attempt to do that. • ‘profit’ measures economic performance, which is the generation of returns before, after or even coincidentally with cash flow. • therefore, accrual accounting does not so much diverge from measuring cash flow as enrich or augment it. • cash flow may be affected by forces beyond the organisation’s earnings performance, such as customers’ ability to make payments, debt payment deadlines or unexpected opportunities, so using it as a performance measure contaminates the measure with non-performance events: profit avoids this similarly, cash flow tends to be a ‘lumpy’ measure but profit is smoother (because it is not mixed with non-performance events) and therefore may better measure the organisation’s basic performance. • profit also reflects the ‘matching’ principle, in which revenue generation and expense incurrence are measured consistently, producing a more meaningful net figure (profit): cash flow does not reflect any similar principle. 21 Here are example circumstances, illustrated in journal entry form: a DR Interest expense CR Interest payable DR Wage expense CR Wages payable b DR CR DR CR

Depreciation expense Accumulated depreciation Bad debts expense Allowance for doubtful debts

Interest receivable

Chapter 4: Accrual accounting adjustments

CR DR CR d DR CR

Interest revenue Commission receivable Commission revenue Unearned revenue Sales revenue

22 a

Prepayments: not record the full adjustment at year end; therefore expenses would be understated (and profit overstated). b Unearned revenue: recognising revenue before it is actually earned, i.e. reducing unearned revenue and increasing revenue prematurely would overstate revenues (and therefore overstate profit). c Accrued expenses: not recognising a particular accrued expense would understate both liabilities and expenses (and therefore overstate profit). d Accrued revenue: recognising accrued revenue before it has been earned would overstate assets and revenue (and therefore profit). 23 Some examples of the information provided in accrual-based financial reports but not cash-based financial reports: • Depreciation on motor vehicles, and plant and equipment. • The value of receivables (such as the amount owing to departments or governments from others but not yet received). • The value of payables (such as amounts owed by departments or governments for goods or services that have been purchased but not yet paid for). • Liabilities, including those relating to employee entitlements that have not yet been paid. • The cost of consuming assets, which is included in expenses (such as depreciation and prepayments).

Chapter 4: Accrual accounting adjustments

Problems Problem 4.1 The following are definitely transactions: 3, 5 & 6. Item 7 is a transaction, assuming that the amount stolen can be determined. (Probably it would be recorded as a reduction in cash as best could be determined, and whether recorded as an expense, or instead as an amount due from the employee or Beach Ltd’s insurance company, would depend on whether a recovery was expected.) Items 1, 2, 4, 8 and 9 are not transactions, at this point in time but may become transactions later.

Problem 4.2 1 No – no service has yet been provided. 2 No – the exchange must have been between the entity being accounted for and someone else, in this example it is a shareholder rather than the entity being accounted for that purchased the shares. 3 Yes 4 Yes 5 Yes 6 No – the exchange must have been between the entity being accounted for and someone else, in this example the entity accounted for is not involved in this transaction. 7 No – the event must involve an exchange of goods or money which has not occurred at this point. The accounting transaction would occur once the goods are delivered and/or invoiced. 8 Yes

Problem 4.3 1 2 3 4 5 6 7 8 9 10

No transaction since no exchange yet. Yes, an exchange of money for advice. No transaction for Bartlett as the exchanges that changed share price were between investors, not involving Bartlett. Yes, an exchange of advertising received for a promise to pay, so a credit transaction. Yes, for same reason as 4 – work received in exchange for a promise to pay for it. Yes, an exchange of a sort. The teenager received cash and the company got some benefit (e.g. avoided a later lawsuit or other problem). Yes, goods received in exchange for a combination of cash and promise to pay. Yes, an exchange of cash for a removal of the promise to pay. Yes, an exchange of cash for political benefit. The illegality doesn’t change the fact that a transaction happened. Yes, an exchange of cash for a promise to repay it.

Chapter 4: Accrual accounting adjustments

Problem 4.4 Greenthumbs Pty Ltd Income statement for August 2022 Accrual basis $ $ 12,000

Revenue Less expenses:

Interest ($80,000 x 6% x 1/12) 400 Rent 300 Depreciation 1,000 Wages 800 Electricity 100 Insurance 50 Other expenses 400 Net profit

Cash basis $ 8,000

– 900 – 600 – 600 400

3,050 8,950

2,500 5,500

Problem 4.5 $

Operating receipts ($9,500 – $2,000) Operating expenditures ($2,200 + $3,500 + $1,300 + $900) Cash profit for this year Revenue less COGS ($3,500-$1,200)

9,500 (2,300) 7,200

Expenses: Rent 1,100 Wages 1,300 Administrative costs 900 Advertising 1,100 Utilities 385 Operating profit 25,000 x 2 –2,200 + (9,500–2,000) –1,300 –900 = $53,100 Have assumed no cash was paid for inventory purchases.

4,785 2,415

Problem 4.6 1 2

Total Revenue (60 x 7,000) = $420,000. List of expenses: Rent (1/3 x $36,000) Wages ($60,000 + 10,000) Interest ($24,000 x 10% x 1/12) Depreciation

$ 12,000 70,000 200 5,000 87,200

Closing balance of cash account: Opening balance From accounts receivable Paid rent Received payment for 30 days of training Received deposit Paid for equipment and installation

$ 600,000 62,000 (36,000) 210,000 6,000 (600,000)

$ 7,500 7,900 (400)

Chapter 4: Accrual accounting adjustments

Paid wages Paid a dividend Loan Closing balance

(60,000) (40,000) 24,000 166,000

Problem 4.7 1 Revenue Sales Interest revenue 2 Expense Depreciation (50% x 400,000 x 20%) Rent Interest (400,000 x 7% x 50%) COGS Salaries (20,000 + 6,000) 3 Cash Flow (from Operations) Cash received from customers Deposit received Cash paid to suppliers Rent paid Salaries paid

$ 180,000 15,000 195,000 40,000 5,000 14,000 100,000 26,000 185,000 90,000 8,000 (50,000) (10,000) (20,000) 18,000

4 Cash:

Equipment:

Inventory:

Accounts Receivable:

Interest Receivable

300,000 (10,000) 400,000 (50,000) 90,000 (20,000) 8,000 718,000 400,000 (40,000) 360,000 115,000 (100,000) 15,000 180,000 (90,000) 90,000 15,000

Chapter 4: Accrual accounting adjustments

Problem 4.8 1 Revenues: Sales Interest Revenue Service Revenue ($256,000 – $10,000) 2 Expenses: Rent Expense COGS Depreciation ($3,200,000 x 10%) Interest ($150,000 x 10%) Insurance (9/12 x $30,000) Wages ($170,000 + $30,000 – $16,000) 3 Liabilities: Accounts Payable ($200,000 + $90,000 – $56,000) Interest Payable (15,000 - $13,000) Wages Payable Unearned Revenue

380,000 9,500 246,000

88,000 200,000 320,000 15,000 22,500 184,000

234,000 2,000 30,000 10,000

Problem 4.9 a

Expense increases (insurance expense)

Asset decreases (prepaid insurance)

Asset increases (dividend receivable)

Revenue increases (dividend revenue)

Expenses increase (commission expense)

Liabilities increase (commission payable)

Revenue decreases (sales)

Liabilities increase (unearned revenue)

e f

Assets increase (supplies) Expenses increase (interest expense)

Expenses decrease (office supplies expense) Liabilities increase (accrued interest)

Problem 4.10 1 Insurance expense 2 Wage expense 3 Insurance expense

= $52,000,000 + 70,000,000 – 50,800,000 = $71,200,000 = $500,000,000 + 306,700,000 – 297,100,000 = $509,600,000 = 34,400,000 + 30,000,000 – 36,200,000 = 28,200,000

Chapter 4: Accrual accounting adjustments

Problem 4.11 1 Commission receivable Commission revenue 2 Wages expense Wages payable (accrued salaries) 3 Accrued revenue Interest revenue 4 Office supplies expense Office supplies inventory

$ 2,000

1,200 1,200 2,000 2,000 8,100 8,100

Problem 4.12 1 Assets

Liabilities

Revenues

Expenses

+1,000

-12,000

+12,000

-13,500

+13,500

+43,000

+7,000

-2,600

+2,600

Problem 4.13 1 Insurance expense increases Prepayments (asset) decreases. 2 $6,000 3 Net profit overstated by $2,000; assets overstated by $2,000.

Problem 4.14 1 Expense increases; liability increases. 2 Net profit overstated by $90,000; liabilities understated by $90,000; owner’s equity overstated by $90,000. 3 Salaries expense increases $60,000 Salaries payable (liability) increases $90,000 Cash (asset) decreases $150,000.

Chapter 4: Accrual accounting adjustments

Problem 4.15 1 Unearned rental revenue $2,000 Rental revenue $2,000 2 Net profit understated by $2,000; liabilities overstated by $2,000; owner’s equity understated by $2,000. 3 Unearned rental revenue $4,000 Rental revenue $4,000

Problem 4.16 1 Balance Sheet Shareholders’ Liabilities Equity

Income Statement Revenues

Expenses

Net Profit

U 1,400

O 15,000

U 15,000

O 15,000

O 1,500

U 1,500

O 1,275

U 1,275

O 1,275

U 1,275

O 650

U 650

O 650

Transaction

Assets

U 1,400

O 15,000

2 Adjusting entries that were or should have been made at 30 June: a No entry was made. Entry that should have been made: Rent receivable ............................................................................ Rent revenue ................................................................... b No entry was made. Entry that should have been made: Depreciation expense .................................................................. Accumulated depreciation ………… ............................. c No entry was made. Entry that should have been made: Unearned fee revenue .................................................................. Fee revenue .................................................................... d Entry that was already made: Interest expense ........................................................................... Interest payable ............................................................... ($17,000 x .09 x 12/12 months) Entry that should have been made: Interest expense ........................................................................... Interest payable................................................................ ($17,000 x .09 x 2/12 months) e No entry was made. Entry that should have been made: Insurance expense......................................................................... Prepaid insurance ...........................................................

1,400 1,400 15,000 15,000 1,500 1,500 1,530 1,530

255 255

650 650

Chapter 4: Accrual accounting adjustments

Problem 4.17 1 2 3

Cash

$500,000

Unearned Revenue Prepaid Venue Expense Cash Unearned Revenue Concert Revenue Venue Expense Prepaid Venue Expense

$500,000 $90,000 $90,000 $500,000 $500,000 $90,000 $90,000

Problem 4.18 1 a

DR Wages expense $92,000 $92,000 CR Wages payable b Net profit will be overstated. Liabilities will be understated. c DR Wages payable $92,000 DR Wages expense $23,000 $115,000 CR Cash 2 a DR Interest expense $6,000 CR Interest payable $6,000 b Net profit will be overstated. Liabilities will be understated. c DR Interest expense $6,000 DR Interest payable $6,000 $12,000 CR Cash

Problem 4.19 1 Accounts receivable Service revenue 2 Advertising expense Prepaid advertising 3 Interest expense Interest payable 4 Unearned storage revenue Storage revenue 5 Depreciation expense Accumulated depreciation 6 Supplies expense Supplies 7 Wages expense Wages payable

$ 2,700

900 900 5,000

$1,200 x 9/12 =$900 used

$250,000 x .12 x 2/12 (since last 5,000 payment) = $5,000 incurred

750 750 22,000 22,000 50,100

Given

$4,500 x 1/6 =$750 earned Given

$16,500 + $46,000 – $12,400 = 50,100 $50,100 used

3,800 3,800 Given

Chapter 4: Accrual accounting adjustments

Problem 4.20 1 a

Total sales

Cash Sales + Credit Sales

= =

Opening Accounts Receivable + Credit Sales – Cash Received from Accounts Receivable 25,000 +100,000 – 10,000 115,000

= =

150,000 + 115,000 265,000

= = = = = = =

Total sales – Cost of goods sold 265,000 – 132,000 133,000 Cash salaries + Accrued salaries 65,000 + 7,000 72,000 7,000

Closing Accounts Receivable

Gross profit

Salaries expense

Accrued salaries d

Interest expense

= $80,000 x 10/100 = 8,000 Accrued interest = ¼ x 10% x 80,000 = 2,000 Assumes loan of $80,000 has been O/S for entire year. In fact loan must have been taken out 31 December, 2021.

Insurance expense

= =

Prepaid insurance

= = (Assume first time taking out insurance)

25% x 8,000 2,000 8,000 – 2,000 6,000

2 Income Statement of ABC Ltd as at 31 December 2022 $ Sales Less: Cost of goods sold Gross profit Less: Selling, administration and financial expenses Salaries (72,000) Interest (8,000) Insurance (2,000) Repairs (2,000) Rates and taxes (3,000) Depreciation* (25,000) Net profit *10% x 250,000 (original cost)

$ 265,000 132,000 133,000

112,000 21,000

Chapter 4: Accrual accounting adjustments

Problem 4.20 (continued) 3 Balance Sheet of ABC Ltd as at 31 December 2022 $

Assets Cash

41,000

Accounts receivable

25,000

Prepaid insurance Inventory

6,000 23,000

Plant and equipment

250,000

Less: accumulated depreciation

75,000

175,000

Land

100,000

Total assets

370,000

Liabilities Accounts payable

15,000

Accrued interest Accrued wages

2,000 7,000

Bank loan Total liabilities

80,000 104,000

Net assets

266,000

Shareholders’ equity Share capital Retained profits Total shareholders’ equity

200,000 66,000 266,000

Chapter 4: Accrual accounting adjustments

Cases 4A 1 a Cash register record b Customer invoice c Payment authorisation and/or bank statements d Payroll records e Bank statements. 2 Indication in the accounts a Prepayments – Yes in Note 3.1 Trade and other receivables ($169 million) b Unearned revenue – Yes in Note 3.7 Trade and other payables as Contract liabilities ($364 million) c Accrued expenses – Yes in Note 3.8 Trade and other payables as Accruals ($1,271 million) d Accrued revenues – No (but would be included in other receivables in Note 3.1) 3 $million a Net book value of land and buildings 1.317.6 b Net book value of plant and equipment 4,906.0 4 Indicators that Woolworths uses accrual accounting: Trade and Other Receivables Trade and Other Payables Provisions Prepayments Depreciation Amortisation Accruals Unearned Income Note 1 5 Depreciation for the year – $845.9m (Note 3.3 part c) Accumulated depreciation – $9,109.4m (Note 3.3)

4B a Prepayments – shown as $265 million. b Accrued expenses – included under Trade and other payables’. c Unearned revenue - $1,611 million called ‘Contract liabilities and other revenue received in advance’; d Accrued revenue – included under ‘Trade and other receivables’.

4C Answers are based on the 2020 annual report of Australia Post. 1 2 3 4

Prepayments of $153 million under current assets. Accrued expenses of $104.8 million + $3.3 million + $136.2 million (?) Note B6. Unearned revenue of $92.2 million + $168.1 million in Note B6. Accrued revenue of $139.9 million in Note B1.

Chapter 5 Annual Reports, Regulation,Internal Control, Ethics and Auditing

Discussion questions 1 Accounting standards require a complete set of financial statements, with five components: • a statement of financial position at the end of the period (commonly referred to as a ‘balance sheet’) • a statement of profit or loss and other comprehensive income for the period (commonly referred to as an ‘income statement’) • a statement of changes in equity for the period • a statement of cash flows for the period • notes to the financial statements, comprising a summary of significant accounting policies and other explanatory information. 2 The standard financial statements are not enough to transmit all the information felt to be needed by users of the statements. Therefore, GAAP require that notes be appended to the statements. The purpose of these notes is to provide information about the accounting policies chosen and other supplementary information helpful to interpreting the figures. 3 In addition to the financial statements the following are usually included in an annual report: • summary data on the company’s performance for the year; • a letter to the shareholders from the company’s chairperson of the board of directors, or the managing director; • an often extensive ‘chief executive officer’s report’, including a description of the economic, financial and other factors behind the company’s business; • for a listed company, a corporate governance statement, which is required under stock exchange regulation; • a directors’ statement • an independent audit report • a directors’ report; and • for listed companies, information on substantial shareholders, distribution of ownership of shares, twenty largest shareholders and voting rights of shareholders. • Sustainability reporting 4 Answer will vary according to the company selected. 5 Some points that might be made:

Chapter 5: Annual reports, regulation, internal control, ethics and auditing

•

As in other areas of society like health and education, standards provide some protection against abuse; • It is not easy to figure out how to prepare good financial statements, so GAAP help preparers do a good job; • The existence of GAAP helps everyone’s efficiency because once you know GAAP, you don’t have to take the time and money to solve every problem from the beginning; • GAAP help make various companies comparable to each other and comparable to themselves over time, thus clarifying performance measurement; • There is a credibility problem if managers prepare information about their performance on any basis they like, so GAAP help good managers because users are more likely to believe the information; • GAAP provide rules ahead of time, which makes for a smoother system than if there were no rules and dissatisfied people had to sue or fight each other after the information came out; • Without GAAP, therefore, there would be chaos, lack of trust and, overall, much less useful information. 6 A decision made in advance about how, when and whether to record or recognise something. 7 • when and how to recognise revenue (chapter 15) • how to compute depreciation on plant and equipment assets (chapter 13) • how to value inventories (chapter 12) • how to value receivables, including how to estimate the allowance for doubtful debts (chapter 11) • which expenditures on fixed assets should be capitalised (added to the asset accounts) and which should be included with expenses such as repairs and maintenance (chapter 13) • how to compute amortisation on intangible assets (chapter 13) • which assets and liabilities should be included in cash and cash equivalents for the purpose of preparing a statement of cash flows (chapter 16) 8 i Should revenue be recognised partly this year (percentage of completion) or all in future years (completed contract method)? Choosing the former will increase profits and total assets (work in progress) this year. ii Choosing FIFO instead of weighted average in a period of rising prices. High profits and high closing inventory this year. iii Capitalising of borrowing costs increases profits (i.e. reduces expenses) and total assets (interest capitalised) this year. iv Choosing reducing balance depreciation method instead of straight-line for a new machine. Higher depreciation expense, therefore lower profit and total assets this year. v Choosing to depreciate over 10 years instead of 8 years increases profits and total assets this year. Note: all these issues are discussed in later chapters so students are unlikely to provide much detail, but it does get them thinking. 9 It can be argued that different accounting policies are more suited to the circumstances of the business. 10 For example for some companies noncurrent assets may wear out evenly each year and therefore straight-line depreciation is appropriate. For other companies the asset © 2022 Cengage Australia Pty Limited. All Rights Reserved.

Chapter 5: Annual reports, regulation, internal control, ethics and auditing

may deteriorate more in the earlier years and therefore reducing balance is appropriate. 11 Internal control comprises the methods of providing physical security and management control over an enterprise’s cash, inventories and other assets, and ensuring that management policies are adhered to. 12 The main components of internal control are: i Run the enterprise competently ii Establish clear lines of responsibility iii Maintain effective records iv Separate record-keeping from handling assets v Adequately pay and motivate employees vi Carry insurance on assets vii Physically protect sensitive assets. 13 Internal control over cash is so critical because it is the asset most susceptible to theft due to its liquid and generally anonymous nature. 14 Strong internal controls over inventory are needed by businesses whose inventory is valuable and easily transportable and when there is a market for the goods held. 15 Segregation of duties involves the separation of record-keeping from handling assets. Examples are: i One person collects the cash and another person maintains the cash records. ii One person maintains the general ledger with the total accounts receivable account, and another maintains the accounts receivable subsidiary ledger. iii One person maintains the general ledger with the inventory control account, and another maintains the perpetual inventory records; iv One person makes an order and another approves it. 16 Internal controls over cash i Payments should only be made for properly authorised documentation. ii Cheques should be signed by two staff members who are independent of invoice approval and accounting duties. iii Original invoices should be stamped ‘paid’ to ensure they are not subsequently represented for payment. iv Collecting cash (cashiers) are not involved in record-keeping. 17 There are limitations due to factors such as: • Misunderstanding of instructions • Errors in judgement • Carelessness • Collusion • Fatigue • Management override. 18 When designing an internal control system an important question for management is how much internal control is necessary. As each additional control is added, the risk of error and irregularity decreases, but there is a cost for implementing the controls. This relates to the law of diminishing returns. At some point additional controls will cost more than the benefits received from having the additional controls. Therefore, a cost–benefit analysis is required when designing an internal control system. However, this is difficult to do because the benefits of having the controls are often difficult to quantify. This becomes a matter of professional judgment by managers. 19 A properly designed system of internal control over cash should minimise employee theft of cash but will not prevent it. A fundamental aspect of internal control is to

Chapter 5: Annual reports, regulation, internal control, ethics and auditing

limit the range of duties carried out by each individual in such a way that errors or dishonest practices must come under the scrutiny of other members of the firm. Such actions may remain undiscovered if a number of employees combine to act dishonestly (i.e. collusion between employees). 20 The responsibilities for internal control and profitability are connected. A good system of internal control contributes to an efficiently run corporation, which in turn, contributes to profitability. The cost of the internal control system must be compared to the benefits. For example, it would not be worth spending $5000 to implement extensive controls over a $1000 inventory of office supplies. This $5000 would be better spent elsewhere to increase the return to the shareholders. 21 Certain occupations, including professional accountants, have established status as the professions. Part of the reason for this is that entry into each requires training and examination by practitioners, and members are bound by a code of conduct or professional ethics. Such groups have to convince the public (as represented by governments, for example) that they have expertise and appropriate codes of ethical conduct. In return for enjoying the privileges of being in a profession members have a social responsibility of discharging their duties competently and in accordance with the profession’s code ethics. Ethical guidance is necessary for members of a profession because professional codes of ethics involve not only behaving in a professional manner, i.e. with integrity and objectivity, but also maintaining the level of expertise required, in order to perform skilfully. Accountants will be continually encountering new situations where guidance will be needed as to the appropriate behaviour to be followed. A written code of ethical conduct is needed in such cases. 22 The questions of ethics and professional conduct are deep and complex: this problem is intended primarily as a consciousness raiser. Should professional accountants working within a company or in public practice meet the same standards of professional ethics? • yes because they are both members of the same profession and should uphold the same standards; • yes because ethics are just as important within a company as outside it; • yes because their professional membership gives them both status and a good shot at another job and so reduces the cost of being ethical; • yes because ethics are basically a matter of personal integrity and any accountant should have such integrity; • yes because the profession will support both of them; • no because their circumstances are different and ethics must be applied in those circumstances, not in the abstract; • no because the internal accountant is responsible to the company whereas the auditor is explicitly not (being considered independent); • no because professional codes of ethics do tend to hold public practitioners to a different (higher?) standard. 23 The purpose served by the auditor’s report is to provide a competent and independent opinion on the fairness of the financial statements. It is not a guarantee but rather an opinion that the financial statements have been properly drawn up to give a true and fair view in accordance with the provisions of the Corporations Act 2001 and applicable accounting standards. The auditor adds credibility to the financial information by reducing bias (increasing fairness and objectivity), reducing error, promoting adherence to

Chapter 5: Annual reports, regulation, internal control, ethics and auditing

standards of presentation, classification and calculation. Since the audit adds credibility investors can have more confidence in the financial information, this should help the investor who wants to trade shares to someone else, or the investor who is interested in buying shares. 24 The types of audit reports are unmodified or modified. An unmodified audit report indicates that the auditor believes the financial statements present a true and fair view and are in accordance with accounting standards and relevant legislation. A modified auditor’s report is issued when the auditor believes the financial statements contain a material misstatement, or when the auditor is unable to obtain enough evidence to form an opinion. The following are the different types of modified reports that can be issued: – qualified or ‘except for’ opinion - the opinion states the financial statements present a true and fair view, and are in accordance with accounting standards except for the effect of a specific matter or matters. – an adverse opinion- the opinion states that the auditor believes the financial statements do not present a true and fair view, and are not in accordance with accounting standards. – a disclaimer of opinion- the auditor cannot reach an opinion overall on the financial statements and therefore disclaims any opinion on it. 25 The credibility added to management’s financial statements should help the investor who wants to trade shares to someone else, or the investor who is interested in buying shares, have confidence in the financial information. The auditor’s report therefore should assist the capital market to function validly and smoothly. 26 Some limitations: – value is limited by the value of the financial statements themselves, for example the future is not predicted, nor is all important information in them; – the auditors’ report is not an opinion on the quality of management or the viability of the company; – the audit report does not guarantee that fraud does not exist; – the auditors must sample records and internal controls because it would be too expensive for the auditors to check everything, therefore the sampling might have missed something. 27 Independence helps to ensure that the auditors will bring a detached, professional view to their risk. If the auditors were not independent, they might ‘want’ the results to turn out a certain way so that they were better off (for example, if the audit fee was a percentage of net profit, then the auditors might go along with methods that make profit higher because they would benefit). Independence is difficult to maintain for several reasons. First, the auditors would not have the audit job the next year if the company were to fail, so they are likely to prefer that the company continue to exist, and might be tempted to agree to accounting methods that hide problems. Second, the auditors have to work closely with management, and may depend on management for other business (such as related services) that is nice to have. Third, though the auditors are officially appointed by the shareholders, a recommendation by management that the auditors be reappointed (or not) is likely to be accepted by the shareholders, who are not usually very close to the company or to the auditors. Fourth, the auditors are human and get to know and like the people they work with, such as the company

Chapter 5: Annual reports, regulation, internal control, ethics and auditing

management and employees, and usually would like such people to succeed – it’s hard to be detached all the time. 28 (a) In 27% of the areas of the audit files inspected, in the opinion of the inspectors, the auditors did not obtain sufficient appropriate evidence. (b) Numerous estimates need to be made in determining the value of assets (some of which involve estimates of future revenues and expenses) and so there can be differences in judgments of even well-trained professionals.

Chapter 5: Annual reports, regulation, internal control, ethics and auditing

Problems Problem 5.1 This is a ‘what-do-you-think’ type of question. Here are some thoughts: • Would manipulation occur if management were allowed to produce whatever information it wanted, using whatever principles it preferred? Would users be able to protect themselves without authoritative standards? • Who is responsible for the ‘demand for standards’? The users? The preparers? • What would happen if each individual firm had to report specific events in the same manner? Doesn’t an event have a different impact on each firm? Can you imagine how large the AASB and AAS Handbook would have to be to accommodate each business event? • Do users want the GAAP structure to ensure some degree of comparability and consistency among firms over time? Do GAAP heighten investor confidence?

Problem 5.2 a b c d

Yes, self-interest threat. Yes, self-review threat. No, not a close or immediate family so unlikely to be considered a familiarity threat. Yes, intimidation threat that could mean that insufficient evidence is collected.

Problem 5.3 1

2 3

There has been poor segregation of duties; in particular, record-keeping has not been kept separate from cash handling. Some sort of device with a locked-in record (such as a cash register to which the cashier does not have access) should be used to record over-thecounter transactions, while customers could be encouraged to insist on a receipt or some other evidence of payment. The cashier should not be responsible for record-keeping, particularly making entries in customers’ accounts. All write-offs should be approved by someone other than a cashier or bookkeeper. There appears to be inadequate authorisation. Payment should be authorised by another independent person. They should have picked up the fact that this was not for bona fide company operations. One method is that the cash from the vending machine goes into a locked container which can only be opened and counted when it gets back to the office. The cash counted should be reconciled to the items needed to refill the vending machine. Even just the second procedure should pick up the discrepancy. Her supervisor should authorise the time sheets and therefore this should be detected.

Problem 5.4 Labelling the components of internal control as in Section 5.5 of the text 1 to 5: 1 violates 1 2 violates 1, 2, 3, 5 3 none, provided the actions completed are reported back to management.

Chapter 5: Annual reports, regulation, internal control, ethics and auditing

Problem 5.5 Recommended improvements: • need for count to be done by more than one person (possibly rotating the group). • the record of the cash count should be filed and checked back to deposits by an independent person. • cash should be banked intact. • a petty cash fund should be established to pay the incidentals. • the banking should be done by someone else when the treasurer is overseas (interest is forgone if cash left in safe for long periods). • the banking and recording should be done by different people (segregation of duties).

Problem 5.6 1 a Payments should be made on invoice only basis. However, in situations where creditors only supply statements, control of cash payments may be strengthened by matching goods received advices or other evidence that good or service has been received. b Problem of no separation between record keeping and custodianship of the assets. Cashier should not be authorised to write off accounts.

Problem 5.7 The owner is correct that hiring the right people and letting them get on with managing the business is a good philosophy. However, as section 8.1 indicates top management must still be sufficiently involved to establish the appropriate tone for the whole company. Top management is responsible for the information contained in the annual report, for establishing an internal control system, and for liaising with the external auditor. Top management should also monitor directly, or via the internal audit department, the actions of the company’s accountants. Given that the company is successful, one could argue that neglecting these top management responsibilities does not matter. However, if the company ever starts to fail and is faced by difficult management choices, it would be better to establish appropriate controls and monitoring now.

Problem 5.8 1

Weaknesses Clerks could allow patrons to enter without paying

Clerks could not pass all cash on.

Non members could be using members cards for free admission. Proceeds in hands of one clerk only while cash delivered to accountant. Takings banked weekly. Cash receipts written up weekly based on contents of box rather than cash received. Accountant holds cash for one week.

4 5 6

Improvements 1&2 Pre-numbered tickets. Segregation of duties. One clerk gives ticket and another collects. 2 Large cash ($50, $100) put in a locked box, which clerks cannot open. 3 Photo ID or signature on cards. 4 5 6

Accountant should collect cash and bank it Key to money box could be held by bank). Bank daily. Reconcile cash with ticket stubs.

Bank daily.

Chapter 5: Annual reports, regulation, internal control, ethics and auditing

Problem 5.9 1 Integrity. 2 Confidentiality. 3 Objectivity. 4 Professional behaviour. 5 Professional competence and due care.

Problem 5.10 1 Familiarity: i.e. 20 years associated with the client. 2 Self-review: your firm developed the client’s new system. 3 Self-interest: work impacted by the fact that holidays could be adversely impacted. 4 Self-interest: share price may be impacted by your audit. 5 Self-interest.

Problem 5.11 1

An auditor does not guarantee the accuracy of financial statements but provides an opinion on whether the financial statements show a true and fair view and are in compliance with accounting standards. An ‘except for’ opinion.

Problem 5.12 1 Pat and the chief financial officer of Hardwood Emporium play golf together every two weeks. Whether this is a threat to independence depends on the relationship, it is fine to be friendly with the client, however it is important to maintain some distance from clients. If the relationship results in an inability on Pat’s part to objectively perform his work then his/her independence is compromised. 2 Pat’s accounting firm is hired by Hardwood Emporium to do a major redesign of the computer system. An audit includes procedures designed to determine whether effective controls are in place to ensure the accuracy and completeness of the accountancy information produced by the computer system. The redesign of the system would have included implementation of such controls. It is difficult to take an unbiased view of work performed by your own firm. This may jeopardise independence. On the other hand, since Pat’s accounting firm designed the system this may result in a more efficient audit because of enhanced understanding of how the system works. 3 Pat prepares the company income tax returns and bills the company separately for this service. This should not be a threat to Pat’s independence. Tax work is regularly performed by the same accounting firm that does the audit. This is efficient because information required to prepare the tax return would be included in the audit files. Separate billing of the work does not change the situation. The important thing is that in doing the audit the auditor is not checking their own work (often called a ‘selfreview check’). This would be a problem if the tax work was used in the financial statements and then later audited. 4 Pat’s former assistant is hired as chief financial accountant of Hardwood Emporium. It is very common for clients to hire members of accounting firms who are auditors of clients. This could cause independence problems if Pat has a close personal relationship with his former assistant because Pat may not be able to objectively

Chapter 5: Annual reports, regulation, internal control, ethics and auditing

evaluate his former assistant’s work. If Pat does not have a close personal relationship with his former assistant then it should not be an independence problem. 5 Pat submits a low bid for the audit because income from tax and consulting services would make up for the lower audit revenue. • Selling other services such as consulting to a client may increase the influence on the auditor to conform to management’s desires. • The magnitude of the fees charged for other services as compared to the annual audit fee is relevant when evaluating the effect these other services may have on auditor objectivity. • Rules of professional conduct do allow auditors to perform other services for clients as long as doing so does not impair objectivity. • Low price on the audit may result in lower quality audit work: this would indicate lack of objectivity.

Problem 5.13 This is a controversial and deep issue. The purpose of including it in an introductory accounting text is to provide a perspective on some of the characteristics of traditional historical financial statements by considering what would happen if the information were forward-looking forecasts instead. Also remind students that many numbers on the present balance sheet are forward looking. Here are some questions that might be raised with respect to the concepts mentioned in the problem: • the detailed knowledge needed to make and judge good forecasts may require the auditors to be ‘closer’ to their clients than might be comfortable to users who want the auditors to have an independent perspective; • would having attested to a forecast impair the auditors’ independence in reviewing the actual results the next year (e.g. would they feel the need to justify their position the year before, especially if the forecast turned out awry)? b information value • forecasts may have information value for some users and not others; • some users may not appreciate the element of judgement involved in forecasts and auditor’s reputation may suffer if targets are not achieved due to changed circumstances; c comparability • using standard financial statement format for the projections should help make them comparable to those of other companies or other years; • since projections of the future are inevitably chancy so the actual figures are unlikely to come exactly true, perhaps it is the assumptions and methods used to make the projections, rather than necessarily the projections themselves, that should be comparable. d agency theory • what role would projections play in contractual arrangements: do any of the company’s arrangements depend at all on audited plans or forecasts, or would only specific contract-based forecasts be useful (e.g. in pension contracts, cost of living forecasts may be useful but net profit forecasts may not unless there are implications to ability to pay promised amounts); • would forecasts introduce motivations (e.g. for managers) that would complicate or interfere with the smooth functioning of present arrangements? e capital market • as the capital market is interested in assessing the likely future performance, forecast information should be useful to it, and audited forecasts should have added credibility as compared to what management may say on its own; a independence

Chapter 5: Annual reports, regulation, internal control, ethics and auditing

f relevance

g representative faithfulness

h objectivity

• but the forecasts have to be relative to factors, and using assumptions, that the market finds relevant and traditional-format financial statements may not meet this demand; • many people already make forecasts and release them, so the capital markets would consider audited forecasts as having a marginal role to play in addition to, or perhaps replacing some of, the information already available: this could be a very small marginal role unless there is ‘news’ (something at variance with the market’s expectations) in the audited forecasts. • forecasts, as above, may be relevant to some users and not others; • making one forecast relevant to various users’ demands may be difficult, just as making one set of financial statements already is. • difficult to make sure that forecasts are free of error because there aren’t the opportunities for verification that exist with historical information; • will the auditor’s reputation for reliability in the traditional role transfer (in users’ perceptions) to this new role? • similar issues as in, independence, information value, comparability and reliability.

Chapter 5: Annual reports, regulation, internal control, ethics and auditing

Cases 5A 1 a pages 18–24 b pages 14-15 c pages 18–41 d pages 42–49 plus page 159 e pages 50–51 f pages 153–157 g page 152 h page 164 2 Deloitte Touche Tohmatsu. 3 Main items covered in auditor’s report: i Auditor’s opinion that the financial statements give a true and fair view and are in accordance with Corporations Act 2001, applicable accounting standards and other professional mandatory reporting requirements. ii Basis for the auditor’s opinion. iii Key audit matters: home improvement exit; carrying value of Big W Property, Plant and Equipment; inventory provisioning; accounting for rebates; IT systems. iv Other information. v Directors’ and auditor’s responsibilities in relation to the financial statements and the audit (pages 153–157). 4 Main items covered in the directors’ declaration on page 115: • Company can pay its debts as and when they fall due (solvency declaration) • The financial statements comply with International Financial Reporting Standards • Are in accordance with Corporations Act • They have obtained declarations as required by the Corporations Act (page 152). 5 Examples of items addressed in a corporate governance statement available online at: https://www.woolworthsgroup.com.au/content/Document/COSEC/2021%20Corporate%20Governance%20Statement%20Final.pdf • Board responsibilities and objectives • Board structure and composition • Corporate Ethical Standards • Audit, Risk Management and Compliance Committee • External and internal audit appointment and supervision • Risk Management • Diversity and Inclusion Policies. 6 Risk management policies are discussed on pages 36–41 of their annual report. The specific risks are: pandemic; safety, health and wellbeing; product and food safety; technology availability and cyber security; data management and privacy; sustainability, pay and entitlements; security and resilience; legal, regulatory and governance; customer and brand; strategy development and execution; strategic

Chapter 5: Annual reports, regulation, internal control, ethics and auditing

workforce planning; supply chain; digital and eCommerce; suppliers; financial, treasury and tax. 7 The Corporate Governance Statement (https://www.woolworthsgroup.com.au/content/Document/COSEC/2021%20Corporate%20Governance%20Statement%20Final.pdf) contains information about Woolworths’ core values, code of conduct and other policy around responsible business practices. 8 The answer would depend upon users selected, below are two examples: Investors make decisions about whether to continue to own shares in the company and whether to buy additional shares. They would be particularly interested in the future growth in share price and the ability of the company to pay dividends. Of particular interest will be the income statement but they will also have an interest in the balance sheet in order to assess financial stability. Lenders are particularly interested in the company’s ability to make repayments on the loans as they fall due. The balance sheet will be particularly useful here in looking at such relationships as debt to equity. The cash flow statement will also be useful in gaining an understanding of the company’s ability to meet its interest payments. 9 Yes, page 156.

5B 1 The Management are responsible for internal control. 2 Difficult to develop controls for unknown future actions. Key controls such as separation of duties are not effective if there is collusion. 3 Internal controls can ‘provide only reasonable assurance that business risks will be fully mitigated’ because there may be some unusual circumstances that are not anticipated or for which setting up elaborate controls does not seem cost effective. Some events, such as earthquakes or floods, may be entirely or mostly beyond management’s control. It may not be possible to carry insurance for certain events. 4 Staff working from home, and, therefore, supervision is more difficult; issues related to information security.

5C 1 Below are some examples of internal control procedures a company could put in place to protect their intangible assets. a Brand names – the objective is to set up internal controls to reduce the key risk of a decrease in the value of the company’s brand name for example: • In the airline industry safety is an important aspect of a company’s brand. Therefore, it would be important for a company to have controls in place regarding maintenance and other safety issues. For example, maintenance schedules and procedures documented, implemented and regularly reviewed. Another example would be the pilot guidelines including regular training, hours in the air and rest periods. • In the food industry quality is an important contributor to brand name. Any contamination incident can greatly affect a company’s brand reputation. Therefore, it is important to have controls in place to prevent incidents but also procedures in place to quickly manage any incidents, for example recall decisions and procedures. Regardless of whether food is produced and

Chapter 5: Annual reports, regulation, internal control, ethics and auditing

manufactured locally or imported, appropriate testing and reporting procedures must be in place. b Patents – The following are examples of internal controls that could be in place to protect patents: • Maintaining accurate records of existing patents • External monitoring of illegal copying of products covered by patents • Documented and agreed procedures in place on how to proceed if illegal copying has been identified so that action may be taken in a timely manner. • Confidentiality clauses in place with employees and third parties. c Trademarks/copyright – The following are examples of internal controls that could be in place to protect trademarks/copyrights: • use appropriate company trademarks and copyright notices on all correspondence, files, manuals, articles or other papers. • External monitoring of illegal copying of products. For example, in the music and film industries illegal downloads and illegal copying of songs and movies represents a significant loss of revenue for companies. • Documented and agreed procedures in place on how to proceed if illegal copying has been identified so that action may be taken in a timely manner. 2a Brand names Example: Quality testing of imported products to protect brand name from a contamination incident. Inexpensive control: Randomly selecting a small number of shipments for testing. Expensive control: Testing of 10% of all shipments. b Patents Example: External monitoring of illegal copying of products covered by patents. Inexpensive control: Send follow up letters to any infringements that are brought to your company’s attention. Expensive control: Proactively search on a regular basis for potential infringements. c Trademarks/copyright Example: For example, in the music and film industries illegal downloads and illegal copying of songs and movies represents a significant loss of revenue for companies. Inexpensive control: Placing warnings on all movies etc. Expensive control: Obtaining information on downloads from internet companies and follow up with prosecutions. 3 Cost Benefit Analysis Placing warnings on all movies, while inexpensive, is likely to have limited benefit if it generally known that prosecutions do not follow. Obtaining information on illegal downloads can be difficult and costly to achieve. Then follow up prosecutions are costly to proceed with and may be difficult to obtain compensation. On a cost benefit basis, a small number of prosecutions that are likely to attract press coverage may be the most cost beneficial way to proceed.

5D Answer depends on annual report selected.

Chapter 6 Financial statement analysis

Discussion questions 1 The purpose of financial statement analysis is to use the financial statements to evaluate an organisation’s financial performance and financial position. 2 The preparation of a common size statement is a method of explaining financial results. A common size balance sheet is prepared by calculating all figures on the original statement as percentages of total assets. Similarly, a common size profit and loss statement is prepared by expressing all figures in the original statement as a percentage of total revenue. Its use is most appropriate when comparing companies of different sizes and in identifying trends over time for a single company. 3 Before calculating ratios, the following information about a company may be gathered: i the nature of the enterprise, its circumstances and strategic plans. Some of this information may be provided in the descriptive sections of the company’s annual report, as well as the footnotes to the financial statements ii the nature of the decision or evaluation to which the analysis will contribute iii comparative information to provide a frame of reference for the analysis. This can include industry data, reports by other analysts, results for similar companies or the same company in other years iv other possible sources: – prospectus relating to new issue of shares or debentures – market research to ascertain acceptability of the company’s products or services – scientific examination of the company’s products – the financial press for stock exchange valuations of the company’s shares and comments on the annual report – government or trade statistics, which may indicate share of the market. 4 Much of this information is freely available online for publicly listed companies. For some information (e.g., newspaper articles, industry reports, analyst reports), there is a fee required to access the databases housing it. Only market research and scientific evaluations generally require access to internal company information, or commissioning this research directly. 5 To evaluate a company’s profitability, the following ratios would be calculated: i return on equity ii return on assets iii profit margin iv gross margin v earnings per share vi price to earnings ratio vii dividend payout ratio.

Chapter 6: Financial statement analysis

6 To evaluate a company’s activity or turnover, the following ratios would be calculated: i total asset turnover ii inventory turnover iii debtors’ turnover. 7 To evaluate a company’s liquidity, the following ratios would be calculated: i current ratio ii quick ratio iii interest coverage ratio. 8 To evaluate a company’s financial structure, the following ratios would be calculated: i debt-to-equity ii debt-to-assets iii leverage ratio 9 Main limitations of ratio analysis: i Future plans and expected results, not historical numbers, should be used in computing ratios, especially liquidity ratios. ii Current market values, not historical numbers, should be used for assets, debts and shareholders’ equity in computing performance ratios. iii Cash flow, not accounting profit, should be used in computing performance ratios. iv Stock markets and other capital markets adjust prices of companies’ securities as information becomes available; therefore, ratios based on publicly available information cannot tell you anything the markets have not already incorporated into security prices. v Ratios reflect any shortcomings in the data from which they have been derived. vi Ratios may be manipulated to provide a favourable impression for recipients of published reports. vii Financial statements and the ratios derived from them do not provide a complete picture of an organisation. In predicting performance, account must be taken of many other factors, such as general economic and industry prospects, market share, development of alternative or superior products or services, access to quality suppliers, and availability of skilled employees. 10 Some advantages and disadvantages of ratio analysis are listed below. Students probably will think of others. Advantages: – Ratios summarise the financial statements to provide information in a more concise way. This makes the information more accessible to decision makers than wading through all the detailed numbers. – Ratios are scale-free measures, so they can be used to compare enterprises of different sizes or the same enterprise over periods of time in which its size changes. – Ratios can be aggregated into industry and other groupings, facilitating comparisons of the enterprise to others. – Because they have both numerators and denominators, ratios can be usefully sensitive to changes in the underlying figures. – As summarised information, ratios may be easier for people with less sophisticated knowledge of the subject (or non-accountants in general) to understand than are the detailed financial statements.

Chapter 6: Financial statement analysis

– Because they are ratios, they can be related to the ‘relative return’ goal that is presumed to lie behind investors’ and creditors’ decision-making. Disadvantages and ways around them: – As they are summaries, ratios are only as good as the underlying data and so will not be meaningful if the data are not (way around this: establish that the financial statements are audited, with an unqualified ‘presents fairly’ opinion by the auditors). – If managers or others know that people will rely on certain ratios, they may strive to produce satisfactory ratios, such as by reducing maintenance expenses or not acquiring new assets, rather than focusing on the fundamental underlying business issues (way around this: use ratios with care and find out what managerial actions lie behind them). – Ratios are just numbers and have no meaning in themselves apart from the phenomena they summarise; for example, there is nothing magic about a current ratio of 2 (way around this: become very knowledgeable about the enterprise and its competitors, so that meaningful comparisons may be made). – There are many different ratios and alternative ways of calculating most of them, so that comparing ratios as calculated by others can be frustrating and not very informative (way around this: know how to calculate the ratios that are important to you and use those calculations, instead of using others’ versions when there are problems with those versions). 11 a Financial leverage is the use of borrowed money to earn money. The leverage is positive if the money earned is greater than the cost of borrowing (e.g. if $10 000 borrowed at 8% is used to earn a 12% return), and it is negative if the money costs more to borrow than the borrower can earn using it. b Such leverage is risky for two main reasons. First, the return earned might not be what is hoped, and, if it is less than the cost of borrowing, then the borrowing ends up making the borrower worse off than without borrowing at all. Second, the money obtained must be repaid, and the lender may take strong action, such as going to court, taking over management or taking assets, if the loan gets into difficulty. Here borrowing may result in the loss of more than the money borrowed. 12 a Ratios, such as those outlined in section 6.4 of this chapter, can be organised in various ways. That section classified the ratios into four interrelated types: i performance ratios, which convey information about how the company has performed, mostly as to profit relative to the size of its assets, equity, number of shares issued, market value of shares, etc. ii activity (turnover) ratios, which relate the company’s level of activity to its size iii liquidity and solvency warning ratios, which (as the category title says) warn about potentially dangerous financial conditions. iv financial structure ratios, which provide information about how the company has arranged its financial structure. b Check your interpretation and calculation by comparing the ratios illustrated in Section 6.5 for Transport Limited to those calculated from the financial statements of the company you chose. If your calculations produced a ratio very different from the corresponding ratio for Transport Limited, check your calculation because extreme ratios are rare. 13 Some thoughts about the manager’s complaint: i The manager has a point:

Chapter 6: Financial statement analysis

– Accounting financial analyses are based on past information. – The stock market does react quickly to information and is likely to have incorporated any ‘news’ included in the financial statements by the time they can be analysed. – Thoughtless mechanical calculation of ratios is not much good to anyone. ii However, there are some advantages to such analyses: – Even if the stock market has reacted to the information, just observing the stock market prices tells you little about the company. – Financial analysis is a useful way to develop a good understanding of the company, its financial and operating strategy and other such factors, both absolutely and in comparison to other years or industry competitors. – Stock market responses are not perfect and do not necessarily reflect your preferences as to returns and risks, so understanding the company’s performance helps you assess your own position with respect to the company. – Financial analysis does indeed reveal many business management factors that are important to the company’s success (is the manager nervous about having management’s performance analysed and revealed?). – Financial analysis can be useful to management too, in identifying strengths and weaknesses and planning strategies. – A retrospective review of performance is useful to verify that management has done the things it said would be done and generally has discharged its stewardship role. 14 Changing depreciation method changes depreciation expense. Net profit is changed, which means that retained earnings are changed. Retained earnings are part of equity, so equity is changed. Thus, the denominator (equity) of the debt-to-equity ratio is changed. 15 Retailer Profit margin Asset turnover Accounts receivable turnover Inventory turnover Other

Manufacturer of consumer durables High Low Low

Manufacturer of tobacco Mid Mid High

High

Low

Mid

Low quick and current ratios due to liquidity of stock and limited or no accounts receivable.

Relatively higher quick and current ratios due to illiquidity of stock and accounts receivable. Greater reaction to economic cycles

Low quick and current ratios due to liquidity of stock.

Low High High – may have no or few accounts receivable

16 a Anh Limited has a large number of current assets which are non-liquid (prepayments, inventory, accounts receivable) and the current liabilities require payment earlier than those current assets that will become liquid. b Bailey Limited has a large proportion of accounts receivable (the ratio excludes inventory), which will not be collected prior to the due dates for payment of liabilities. c Christine Limited has a fast receivable turnover or high cash levels, which allow for the payment of current liabilities when they are due.

Chapter 6: Financial statement analysis

Problems Problem 6.1 Return on equity = 25/300 = 8.33% (2021 – 12.26%) Earnings per share = 25/80 = 31.25 cents per share (2021 – 47.5 cents per share) Working capital = $395m (2021 – $380m) Current ratio = 1040/645 = 1.61 times (2021 – 1.73) Quick ratio = 590/645 = 0.91 times (2021 – 1.23) Debt-to-equity ratio = 900/300 = 3.0 times (2021 – 2.35) Decline in cash from $330 million to $50 million – suggests company may be using up cash faster than it can replenish it ii Receivables increased from $310 million to $540 million – suggests that company is having problems collecting its receivables iii Inventories increased from $260 million to $450 million – suggests that company is having problems selling its stock iv Accounts payable increased from $510 million to $630 million – suggests that company may be responding to cash flow problems by delaying payments to suppliers 3 Ms. Dawson’s statement does not give the complete story. Profit declined from $38 million to $25 million, current and quick ratios have declined showing the build-up in inventory and receivables. The debt-to-equity ratio has increased due to increased reliance on borrowings and creditors, etc. 1 a b c d e f 2 i

Problem 6.2 Woolworths Limited common size income statement Consolidated statement of profit or loss 2021 Restated 2020 Continuing operations Revenue from the sale of goods and 100.00% 100.00% services Cost of sales –70.68% –71.12% Gross profit 29.32% 28.88% Other revenue 0.21% 0.28% Branch expenses –17.66% –18.02% Administration expenses –6.79% –7.32% Earnings before interest and tax 5.07% 3.82% Finance costs –1.10% –1.26% Profit before income tax 3.97% 2.55% Income tax expense –1.08% –0.79% Profit for the period from continuing 2.88% 1.77% operations Discontinued operations Profit for the period from discontinued 0.96% 0.51% operations, after tax Profit for the period 3.84% 2.28%

Chapter 6: Financial statement analysis

After common sizing the income statement of Woolworths Limited for 2021 and 2022, we can see there has been an increase in profitability as a percentage of revenue from 2021 to 2022. Profit for the period as a percentage of total revenue (from continuing operations) has increased from 1.77% in 2021 to 2.88% in 2022. This is an over 1.1 per cent increase, and would be seen as significant as even small increases in a highly competitive industry are good. This increase seems to be driven mainly by a decrease in the cost of sales as a percentage of total revenue from 71.12% to 70.68%, and decreases in branch expenses and administrative expenses, as well as a slight decrease in finance costs.

Problem 6.3 1 a b c

EBIT Total assets Sales Total assets

2022 1,440 = 16% 9,000 9,000 = 1.0 times 9,000

2021 1,056 = 16.83% 6,275 8,125 = 1.29 times 6,275

OPAT Sales

900

650

OPAT Shareholders’ equity

CA/CL

Quick ratio

Cost of goods sold Inventory

365 days Inventory turnover

Sales Accounts receivable

365 days Receivables turnover Debt Equity

k l

EBIT Net Interest

9, 000

= 10.0%

900 = 38.3% 2,350 4,050 = 1.50 times 2,700 1,650 = 0.61 times 2,700 6,300 = 2.63 times 2,400 365 = 138.8 days 9,000 = 5.45 times 1,650 365 = 66.97 days 6,650 = 283.0% 2,350 1,440 = 3.6 times

= 8.0% 8,125 650 = 20.6% 3,150 2,250 = 2.00 times 1,125 1,500 = 1.33 times 1,125 5,687 = 7.58 times 750 365 = 48.2 days 7.58 8,125 = 5.42 times 1,500 365 = 67.3 days 5.42 3,125 = 99.2% 3,150 1,056 = 4.13 times 256

2 With respect to profitability: – Profit margin has increased due to selling costs being reduced. – Asset turnover has fallen because inventory has risen, and an increased investment in long-term assets has not yet produced a sufficient gain in sales. – Return on assets has dropped slightly due to the fall in asset turnover. – Return on shareholders’ equity has risen sharply due to increased leverage. – Overall, the underlying profitability has not improved.

Chapter 6: Financial statement analysis

Turning to activity and liquidity ratios: – Debtors’ turnover seems satisfactory and has little changed over time. – Inventory turnover has fallen sharply. This may be a threat to liquidity and future profits. – The inventory build-up appears to have been financed from trade credit. Will suppliers be able to be paid? – Liquidity ratios have declined. This is a cause for concern when considered together with the substantial decline in inventory turnover. The quick ratio looks particularly worrying. Concerning financial stability: – Leverage has increased sharply due to increased borrowings, both long- and short-term, combined with a reduction in retained earnings. – It appears a substantial dividend has been paid. – Due to the increased leverage and a static return on assets, the times interest earned ratio has declined. Summary: There has been no real increase in profitability, but shareholders’ returns have been increased through leverage. Risk has risen dramatically. Due to the increased leverage and declining liquidity, the risk of insolvency is high. Corrective action should be taken immediately to: 1 reduce stock levels 2 reduce leverage, especially short-term debt 3 review dividend payout levels.

Problem 6.4 1 2 3 4 5 6

7 8

Transaction analysis  Cash  Loan payable  Inventory  Cash  Loan  Cash  Retained profit  Dividends payable  Cash  Loan  Cash (28 000)  Expense (2 000)  Investments (30 000)  Cash  Share capital  Cash  Accounts receivable

Current ratio Increase

Quick ratio Increase

Debt-to-equity ratio EPS Decrease No effect

No effect

Decrease

No effect

Decrease

No effect

Decrease

Increase

No effect

Increase

No effect

Decrease

Increase

Decrease

Increase

Decrease

No effect

Chapter 6: Financial statement analysis

Problem 6.5 Impact of transactions on ratios: Transaction analysis 1  Accounts receivable  Inventory  Sales  COGS 2  Accounts payable  Cash 3  Land revaluations surplus  Asset (noncurrent) 4  Retained profits  Cash 5  Sales revenue  Cash or accounts receivable

Current ratio Decrease Due to Accounts receivable > Inventory therefore a decrease in current assets. Increase Due to a decrease in both current assets and current liabilities No effect

Inventory turnover Decrease Due to a decrease in COGS and an increase in inventory

Decrease Due to decrease in current assets Increase Due to an increase in current assets

No effect

Debt/assets ratio Increase Due to Accounts receivable > Inventory therefore a decrease in current assets. Decrease Due to a decrease both total liabilities and total assets Decrease Due to an increase in total assets Increase Due to decrease in assets Decrease Due to an increase in total assets

Problem 6.6 1 Decrease 2 Decrease 3 Ratios that are based on profit and/or total assets would be affected. For example, return on assets, asset turnover, and any of the financial structure ratios.

Problem 6.7

Company X

Company Y

ROA

Profit margin

245 + 42 2,061 13.9%

245 + 42 4,069 7.1%

168 + 18 1,149 16.2%

168 + 18 4,130 4.5%

Asset turnover

4,069 2,061 1.97 times

4,130 1,149 3.59 times

Y is the discount chain because of the lower margin and higher asset turnover.

Chapter 6: Financial statement analysis

Problem 6.8 1 Current ratio

334 000 / 117 000 = 2.85 times

Quick ratio

124 000 / 117 000 = 1.06 times

Inventory turnover

494 000 / 210 000 = 2.35 times

A/R turnover

790 000 / 79 000 = 10.00 times

2 Must include: Dividend payout

26 000 / 31 000 = 83.9%

May include: Return on assets (61 000 + 15 000) / (494 000 + 466 000 / 2) = 15.83% Return on equity 31 000 / (232 000+237 000/2) = 13.22% Earnings per share 31 000/90 000 = 34.4 cents per share PE ratio 2.70 / 0.344 = 7.85 times 3

Possible answers: i Ratios are based on historical data, which may not accurately forecast the future. ii Financial statement items are shown at historical costs, which may not reflect changes in asset values. iii Year-end figures shown in the financial statements may not accurately reflect the true financial condition of the company. Management can manipulate some ratios by engaging in certain transactions at year-end. Averages such as inventory and accounts receivable balances may not reflect the normal levels of these accounts during the year. iv One-off items can affect some of the profitability measures, although analysts can choose to ignore one-off items in calculating the ratios.

4 Other tools used by analysts are trend analysis, comparisons across companies within a particular industry, common size financial statements (vertical analysis), and management disclosures during the year.

Problem 6.9 ROA =

2021

2022

EBIT Sales EBIT = x TA TA Sales 30

750 30 x 300 750 300 10% = 2.5 x 4% 48

800 48 x 400 800 400 12% = 2.0 x 6% =

Chapter 6: Financial statement analysis

1 – Increased margin – Reduced turnover – Without the revaluation, ROA would have been 13.3% – Possible reasons for increased margin: • Increase in sales prices • Large number of items sold • Reduction in expenses • Change in accounting techniques. In questions 2 and 3, the ratios can be interpreted in a number of ways. Other interpretations are acceptable. 2 The short-term financial position as indicated by the working capital ratio shows that the organisation’s short-term liquidity has deteriorated (200% to 100%). However, we are told that the level of current liabilities has remained unchanged. The organisation’s current assets have fallen. It is probable that the reduction in working capital is due to less inventory as the quick asset ratio has remained unchanged. Debtors are probably at a similar level to 2021. 3 The organisation’s long-term financial position has remained relatively unchanged, although it has increased shareholders’ funds by 40% during the period. If the 2022 debt-to-assets ratio is adjusted for the revaluation (i.e. shareholders’ equity adjusted to make them comparable with 2021), the debt-to-assets ratio in 2022 would be: Liabilities 260 100 = x = 72% 360 1 Total Assets We know that current liabilities have not altered and the organisation’s debt-toequity ratio has increased from 66.7% to 72% (after revaluation). Long-term liabilities have increased by $60 000. It seems that the purchase of noncurrent assets of $110 000 has been financed in part by increasing noncurrent liabilities. Also, the organisation is able to cover interest payments more effectively: EBIT

Interest

= 3 times (2021) = 3.6 times (2022)

As shareholders’ equity has remained unchanged (ignoring revaluation) 100% of profits have been distributed. Long-term financial position has remained stable. 4 The main emphasis of the answer should be on differences in accounting policies between organisations. Mention can also be made of off-balance sheet items and the effect of transactions near year-end.

Problem 6.10 1 Neither (share capital increases and reserves decrease) 2 Both (asset increases and reserves increase) 3 Both, ROE (interest expense increases (i.e., profit decreases but no impact on EBIT); cash decreases or interest payable increases); ROA (if interest expense is paid, cash will decrease and therefore total assets will decrease with EBIT unchanged, if interest payable increased then no change) 4 ROE (share capital increases and loans decrease) 5 Both (depreciation expenses increase and accumulated depreciation decreases)

Chapter 6: Financial statement analysis

6 Neither (equipment increases and cash decreases) 7 Both (LSL expense increases and provision for long service leave increases) 8 ROA (equipment increases and liability increases)

Problem 6.11 1 Decrease in ROE (no change to profit; shareholders equity increases) 2 Decrease in quick ratio (no change to cash, accounts receivable and short-term investments; increase in current liabilities due to increase in accounts payable) 3 Increase in current ratio (current assets increase due to a greater increase in cash than decrease in inventory; total liabilities remain unchanged) 4 Decrease in debt-to-equity (total liabilities remain unchanged; total shareholders’ equity increases) 5 Increase in debtors’ turnover (credit sales remain unchanged; accounts receivable decreases) 6 Increase in ROA (profit remains unchanged; total assets decrease as cash decreases) 7 No effect on profit margin (profit and sales remain unchanged)

Problem 6.12 Effect of various transactions on financial statements ratios Transaction Current ratio Rate of return on Debt-to-equity shareholders’ equity ratio A No effect (1) Increase B Increase Increase Decrease C No effect No effect No effect D No effect (2) Decrease E No effect Increase No effect F Increase Decrease Increase G Decrease Increase Decrease H No effect Decrease Increase (1) The current ratio would remain the same if it were one to one prior to the transaction, decrease if it were greater than one, and increase if it were less than one. (2) The current ratio would remain the same if it were one to one prior to the transaction, increase if it were greater than one, and decrease if it were less than one.

Chapter 6: Financial statement analysis

Problem 6.13

N/E

Cash flow from operations N/E

INCREASE

N/E

INCREASE

N/E

INCREASE

N/E

INCREASE

N/E

INCREASE

DECREASE

N/E

DECREASE

N/E

INCREASE

DECREASE

N/E

Profit before tax

Current ratio DECREASE

Problem 6.14 The impact of expensing previously capitalised R&D expenses will decrease noncurrent assets, and increase expenses (which will reduce profit and retained profits). There is also a tax effect of 30% of this transaction, which will decrease current liabilities (income tax payable) and an increase in profit and retained profits (due to reduced income tax expense). On the balance sheet, there will be a decrease in noncurrent assets of $500 000; a decrease in current liabilities of $150 000 and a decrease in retained profits of $350 000. On the income statement there will be an increase in software development expense of $500 000 and a decrease in income tax expense of $150 000, overall a $350 000 decrease in profit (which is reflected in the decreased in retained profits). 1 Decrease (decrease in operating profit after tax and decrease in shareholders equity, but the change in operating profit after tax is proportionately larger) 2 Increase (no change in current assets, increase in current liabilities).

Problem 6.15 1 a b c d 2 a

Profitability: Return on assets (ROA), Return on equity (ROE), Gross margin Activity: Inventory turnover, Receivables turnover, Days inventory on hand Liquidity and solvency: Quick ratio, Current ratio, Interest coverage Financial structure: Debt-to-equity ratio. The company’s ROA and ROE appear to be high. Gross margin and ROA have increased in 2022. The fact that ROE is greater than ROA in both years indicates that leverage is being employed to the advantage of shareholders, though this was done to a greater extent in 2021 than in 2022. b The company is operating more efficiently than it did in 2021. The modest increase in receivables turnover suggests that customers are paying the

Chapter 6: Financial statement analysis

company a little faster. Also, inventory turnover has increased indicating that inventory is being turned over at a quicker rate. c The company’s current ratio is well above 1 for both years, and this suggests it is quite liquid, though this depends on the industry Financial Insights Ltd is in and the industry norm. Both the current and quick ratios have dropped in 2022 however, indicating that the company is less liquid than it was in 2021. d The company’s debt-to-equity ratio shows that it is financed by debt. The fall in the interest coverage ratio in 2022 suggests that the company is less comfortable in covering its interest obligations in 2022 compared to 2021. Limitations: Lack of information about the company – e.g., in what industry does it operate? What are the industry norms? What kind of inventory does it stock (e.g. perishables)? Helpful information: Industry data. 3 a ROA shows the return managers are earning on the assets under their control. In contrast, ROE indicates how much return the company is generating on the historically accumulated shareholders’ investment. It captures the combined effect of assets and leverage that the company uses to create shareholder returns. b As ROA then enables managers to analyse where shareholder returns are being derived (e.g. is it from the company’s sales and the use of its assets, or is it from leverage), and to identify the areas for improvement. 4 a These ratios show how efficiently the company’s inventory is being managed. More specifically, inventory turnover shows how much sales volume is associated with a dollar of inventory; while days inventory on hand calculates how many days, on average, inventory is held. b A limitation of these ratios is that they do not necessarily reflect how well a company is performing. For a company whose operations are based on a premise of low turnover and high profit margin, a low inventory turnover ratio may be sustainable. Therefore, these ratios must be interpreted within the context of the nature of the business and norms for companies in the same industry which compete in a similar way. 5 Debt-to-equity Inventory turnover Quick ratio Gross margin Interest coverage Current ratio Receivables turnover Days inventory on hand Return on Assets Return on Equity

Decrease No effect No effect No effect No effect No effect No effect No effect Decrease Decrease

Problem 6.16 1 The inventory turnover ratio shows how many times the inventory held is sold (or turned over) during the year. It helps in identifying slow moving inventory and thus perhaps the need to write down.

Chapter 6: Financial statement analysis

2 3.79 means a very slow turnover of inventory (i.e. only 3 to 4 times each year). The turnover of 3.79 in 2021 is equivalent to average days inventory on hand of 96.3 days (i.e. 365 / 3.79). 3 No, average days inventory on hand of 140.6 days is equivalent to an inventory turnover ratio of 2.60 times, which is a worsening of the position. 4 Factors to consider are the nature of the industry, industry averages, past performance of this company, future projections, seasonal impacts, product mix changes, competitive changes in the market, and management style (and policy) changes.

Problem 6.17 1 The general manager is correct as far as what was specifically said. Working capital has increased from $400 000 to $450 000, and operating expenses have decreased from $400 000 to $350 000. However, that is only part of the story and perhaps a misleading part. As to working capital, the increase is actually a warning signal, because it includes a 75 per cent decline in cash, a 150 per cent increase in accounts receivable and a 25 per cent increase in inventories. None of these are positive developments, especially when sales have decreased since 2021. Two ratios that suggest trouble: Days’ sales in ending accounts receivable (collection ratio): – 2021: $100 000 / ($1 500 000/365) = 24.3 days – 2022: $250 000 / ($1 200 000/365) = 76.0 days Inventory turnover (based on ending inventory): – 2021: $900 000 / $400 000 = 2.25 times – 2022: $780 000 / $500 000 = 1.56 times Therefore, the company appears to be having significantly greater difficulty collecting from its customers and its inventories are piling up. As sales are down, these are worrying indicators. As for sales and the rest of the income statement, we see first a 20 per cent decline in sales from 2021 to 2022 and a 65 per cent decline in net profit. Common size income statement show the following (rounded):

Sales Cost of goods sold Gross profit Operating expenses Income taxes Net profit

2022 100% 65% 35% 29% 1% 5%

2021 100% 60% 40% 27% 3% 11%

Therefore, profit margin has dropped dramatically, percentage gross profit has declined, and operating expenses, which the general manager described as falling, have actually increased as a percentage of sales. All this indicates that, contrary to what the general manager implied, the company had a poor year in 2022 and appears to be in some trouble. 2 Some other information that might be requested:

Chapter 6: Financial statement analysis

–

– – – – – –

a statement of cash flows to indicate the full reasons for the decline in cash: mostly probably the poor 2022 results and the rise in receivables and inventories, but there may have been more going on a complete balance sheet to reveal the rest of the assets and liabilities details on receivables and inventories to indicate what the quality of those assets is and why they have increased so much explanation for the decline in sales revenue explanation for the decline in gross profit percentage and increase in operating expenses percentage an auditor’s report indicating that the financial statement figures are reliable and fair a business plan showing how it intends to work itself out of its difficulties.

Problem 6.18 Several issues are illustrated in the information provided. To provide some analysis relative to the general manager’s concern about cash, a start might be to estimate what the company’s ability to generate cash has been. You could also start with other ratio analyses illustrated later in this outline. The 2022 and 2021 statement of cash flows follow (the statement of cash flows for 2020 cannot be prepared without the 2019 balance sheet). Marketable securities, but not bank loans, are included in our definition of cash equivalents. This allows us to focus on cash, given the issue of interest is extending the bank loan. Statement of cash flows 2022 Cash flows from operating activities Receipts from operations Payments to suppliers and employees Payments for income tax Net cash outflows from operations

3 076 (3 157) (99)

2 637 (2 563) ( 100) (180)

Cash flows from investing activities Purchase of land Purchase of buildings Purchase of equipment Net cash outflows from investing activities Cash flows from financing activities Dividends paid Bank loan Net cash inflows from financing activities Net decrease in cash for year Cash and marketable securities – beginning Cash and marketable securities – end

2021

(26) (100) (150) (250)

– (80) 255

(500) (70) 570

175 (5) 61 56

500 (26) 87 61

Chapter 6: Financial statement analysis

The above statement of cash flows indicates several problems, as follows: 1 Receivables have been increasing faster than profit. Further analysis of this situation shows: Increase in sales over previous year Increase in receivables Days’ sales in ending receivables (Receivables/(Sales/365))

2022 14.3% 29.5%

2021 19.7% 63.4%

2020

As receivables have grown so much, the cash flow that would have been expected from the sales and profit has not occurred. 2 Similarly, problems exist in the management of inventories: Gross profit percentage of sales Increase in sales over previous year Increase in inventory Inventory turnover (COGS/ inventory)

2022 21.9% 14.3% 65.6%

2021 23.2% 19.7% 39.3%

3.00 times

4.27 times

2020 23.1%

Inventory is growing dramatically and gross profit percentage is slipping. The company is piling up inventory and selling prices have been squeezed: to reduce the inventory, now more than twice what it was two years ago, would probably produce even more pressure on selling prices and reduce profit. The company has got itself into apparently serious difficulty. 3 The increased receivables and inventories, payment of dividends, and $500 000 of noncurrent assets in 2021, have been financed partly out of cash generated from profit but largely from short-term borrowing. The increase in accounts payable is moderate, but the company’s reliance on its bank loan is enormous: $825 000 over the two years 2021 and 2022. 4 The situation is also revealed by examining the company’s working capital: Current assets Current liabilities Working capital ‘Quick’ assets Current ratio Quick ratio

2022 $’000 1 433 1 255 178 600 1.14 .48

2021 $’000 984 917 67 481 1.07 .52

2020 $’000 705 269 436 344 2.62 1.28

Clearly the company is not in a strong current position. The general manager knows this, but may not realise the risk to the company from its lack of liquidity. The quick (acid test) ratio shows that the company’s ability to meet current debts is strained and declining, but even that ratio may understate the problem because the quick assets include receivables and the company’s collections are not very quick. Some suggestions for the general manager from the above about getting cash: i Reduce production or purchasing until inventory has substantially reduced. ii Increase collection efforts or change credit terms to get receivables down. iii Increase share capital or obtain long-term financing to reduce the reliance on short-term borrowing (though these options would reduce returns to present owners and might not be popular with the shareholders).

Chapter 6: Financial statement analysis

iv Raise selling prices a little to protect returns from the effects of any further borrowing (may not work if price competition is strong, of course).

Problem 6.19 Jeans F’ All (JFA) uses FIFO and straight-line depreciation. Jeans ‘R’ Us (JRU) uses LIFO and diminishing value depreciation. Ratio 1 Current ratio (CA/CL)

Which company will report the higher ratio? Assumptions – Depreciation method will have no Rising prices (inflation), if impact on the current ratio. Inventory students have assumed falling policy will have an impact on inventory prices, the opposite answer is valuation on the balance sheet. correct. – JFA uses FIFO and therefore will have inventory at current prices on the balance sheet. JRU uses LIFO and therefore will have inventory at historic prices on the balance sheet. – Assuming inflation, JFA will have higher asset values and therefore a higher current ratio. 2 Inventory turnover – Depreciation method will have no Assuming increasing prices (COGS/Inventory) impact on the inventory turnover ratio. (inflation), if prices are falling, Inventory policy will have an effect on the opposite answer is correct. both COGS and inventory balances. – JFA uses FIFO and therefore will have inventory at current prices on the Balance sheet and historic prices in COGS. JRU uses LIFO and therefore will have inventory at historic prices on the balance sheet and current prices in COGS. – JRU will have a higher COGS figure and a lower average inventory figure; therefore, will report a higher inventory turnover. 3 Profit margin – Inventory method and depreciation – Assumes that the (OPAT/Sales) method will both have an impact on depreciable assets are OPAT. Neither method will have an in the first half of their impact on sales. JFA will report a useful lives. Inflation higher profit (lower COGS and lower is also assumed. depreciation using straight line method) – If assets are in the than JRU. second half of their – JFA will therefore report a higher profit useful lives, JFA will margin ratio. report a higher depreciation expense than JRU. 4 ROA – Depreciation and inventory methods – Assumes that the (EBIT/Assets) will have the same effect on EBIT as depreciable assets are for OPAT. JRU will have lower total in the first half of their assets (historic inventory values under useful lives. Inflation LIFO and lower written down values is also assumed.

Chapter 6: Financial statement analysis

–

for depreciable assets due to higher depreciation). JFA is likely to have a higher ROA (higher profit, negated by slightly higher asset values).

–

Dollar difference in profit is likely to be a greater percentage of profit than dollar difference in assets.

Problem 6.20 1 One example would be that in the education sector, the student-to-staff ratio is used as one of the measures to assess the quality of education delivered in a classroom. 2 The ratios used in a particular industry depend on the nature of the industry and its key performance indicators. The ratios covered in this chapter are based on financial numbers, as we are examining businesses. Thus, the ratios used to measure and assess organisational performance are specific to the industry being examined and depend on what are considered to be the key performance indicators in that industry, as shown in Question 1.

Chapter 6: Financial statement analysis

Cases 6A 1 Ratio 1. Return on Equity 2. Return on Assets 3. Alternative Return on Assets 4. Profit margin 5. Alternative profit margin 6. Gross margin 7. Cash flow to total assets 8. Earnings per share 9. Price-earnings ratio 10. Dividend payout ratio 11. Total asset turnover 12. Inventory turnover 13. Days in inventory 14. Debtors’ turnover (NB: Gross trade debtors used; other answers may be acceptable) 15. Days in debtors (as above) 16. Current ratio 17. Quick ratio 18. Interest coverage ratio 19. Debt-to-equity ratio 20. Debt-to-assets ratio 21. Leverage ratio

2022 calculation 6 425 / 77 780 6 425 / 216 661 10 985 / 216 661

2022 result 8.26% 2.97% 5.07%

2021 calculation 3 752/50 319 3 752 / 198 522 9 150 / 198 522

2021 result 7.46% 1.89% 4.61%

6 425 / 36 480 10 985 / 36 480

17.61% 30.11%

3 752 / 47 259 9 150 / 47 259

7.94% 19.36%

(36 480 – 23 656) / 36 480 –6 847 / 216 661

35.15%

18.37%

–3.16%

(47 259 – 38 577) / 47 259 –35 / 198522

6 425 / 76 583 0.95 / 0.084

8.4 cents 11.31 times

3 752 / 55000 0.98 / 0.068

6.8 cents 14.41 times

3 / 8.4

35.71%

4 / 6.8

58.82%

36 480 / 216 661

16.84%

47 259 / 198 522

23.81%

23 656 / 61 467

0.38 times

38 577 / 41 659

0.93 times

365 / 0.38

961 days

365 / 0.93

392 days

36 480 / 27 432

1.33 times

47 259 / 23 119

2.04 times

365 / 1.33

274 days

365/2.04

179 days

79 564 / 53 789 (3 804 + 13 758) / 53 789 10 985 / 3 255

1.48 times 0.32 times

1.04 times 0.36 times

3.37 times

64 530 / 62 035 (73 + 22 107) / 62 035 9 150 / 3 165

138 881 / 77 780

1.79 times

148 203 / 50 319

2.95 times

138 881 / 216 661

0.64 times

0.75 times

216 661 / 77 780

2.79 times

148 203 / 198 522 198 522 / 50 319

–0.02%

2.89 times

3.95 times

Chapter 6: Financial statement analysis

i. – – –

–

ii. – –

– iii. –

– iv. – –

Profitability ratios: In general, profitability ratios have increased over the year. However, ROA is very low (2.97%) Profit margin and alternative profit margin both increased. This is due to better margins being captured, even though sales have decreased – costs have been well-managed. Cash flow to total asset ratio has also decreased dramatically, this may explain the significant decline in the dividend payout ratio. Although profitability has improved, its ability to generate cash has deteriorated affecting the amount available for distribution to shareholders. A decrease in price-earnings ratio reflects market expectation of poorer performance in the future (this may reflect a downturn in general market sentiment, rather than company-specific factors). Activity ratios: Total asset turnover declined over the year, indicating less efficient use of assets in generating revenue. Inventory turnover experienced a substantial decline to 0.38 times per year (i.e. on average, beer is held for 961 days – this presents a clear potential obsolescence issue, as beer might not taste too good after being held for 2.5 years). There is a significant build-up of inventory (nearly three years’ worth of sales at current rates), which may increase storage and holding costs. Debtors’ turnover has declined from 2.04 times to 1.33 times suggesting that urgent action is required to collect debtors and assist with cash flow. Liquidity/solvency ratios: The current ratio increased, while the quick ratio declined. This indicates that the increase in current ratio is due to inventory building up. This is consistent with the analysis above and so while the current ratio has increased, this is not necessarily good news. Quick ratio below 1 indicates the company may have trouble paying its bills as they fall due, unless they can continue to convert inventory to cash. Financial structure ratios: All of the financial structure ratios have decreased over the year. The decrease in the use of debt may indicate less reliance on debt financing; hence, reduces the riskiness of the company. Also, a slight increase in the interest coverage ratio reflects the company’s ability to meet its finance cost. It is critical to be concerned about short run liquidity (as long run might never happen, if the company fails in the short term).

Chapter 6: Financial statement analysis

6B Illustrative performance ratios – government departments Self-sufficiency Revenue from independent sources × 100 Total operating expenses Government funding Revenues from government × 100 Net cost of services Tax administration costs Net cost of services Number of tax returns Benefits administration costs Net costs of services Number of benefit payments Average employee costs Employee expenses Average number of employees Employee support costs Administration expenses Average number of employees Rate of change Change in item or total × 100 Previous year item or total Change in composition Change in % item to total

Shows the reduction in budget dependency resulting from user charges and asset sales

Shows the extent to which the net cost of producing goods and services is funded by government

Shows the net annual administration cost for each tax return

Shows the net annual administration cost for each benefit payment (e.g., pension payments, unemployment) Shows the average annual employee cost (including accrued entitlements)

Shows the annual administration cost for each employee (e.g., rent, power, depreciation of plant and equipment)

Highlights material changes in the amounts of items that may warrant further inquiry (e.g., above a particular threshold) Highlights material changes in the composition of revenues and expenses that may warrant further inquiry

(Source: Department of Finance, The New Financial Reports of Agencies, 1994, p. 49.)

Chapter 7 Reporting and managing cash flows

Discussion questions 1 Managing cash flow is important because in our economy cash is the medium of exchange by which business is done. An organisation must have sufficient cash inflow to cover its need for cash outflow to pay bills, buy new assets, pay dividends and so on. In the short run, or at difficult times of the year, managing cash flow may be more important than managing overall performance as measured by the accrualbasis income statement. 2 Yes. A company can show good net profit, but if it does not collect its accounts receivable, or if it buys too much inventory, so cash is either not coming in from customers or is ‘tied up’ in inventory, the cash from operations can be smaller than net profit. 3 Because net profit includes substantial non-cash expenses (depreciation, especially) that decrease profit but do not affect cash from operations, for most companies, net profit will be lower than cash profit (cash from operations). 4 a – Cash received from customers – Cash paid to suppliers – Cash paid for taxes b – Issue of shares – Dividend distributions – Repayment of borrowings c – Purchase of property, plant and equipment – Acquisition of other companies – Sale of property, plant and equipment 5 Cash flow from operations can be negative when net profit is positive because of differences between cash and accrual amounts, e.g., if a company purchases inventory for $1000 cash and sells it on credit for $1500 but at the end of the period has not received that amount then cash flow from operations would be negative $1000 while accrual profit would be plus $500. 6 Companies are most likely to have a net cash outflow from investing activities. Companies, as a minimum, must replace existing fixed assets (and possibly expand with the purchase of additional fixed assets). This purchase of new assets will involve a cash outflow greater than the cash proceeds from the sale of old assets. While companies might, on occasions, have net cash outflows from operating and financing activities, this is unlikely to be the case over a number of years. In fact, continuing negative CFO is a signal the company has major financial difficulties. For companies that are growing cash flow from financing, is likely to be increasing.

Chapter 7: Reporting and managing cash flows

7 Some points that might be raised: • analysts pay attention to profit performance already – it is not ignored in favour of cash flow information, but rather that information adds to the understanding of performance; • monitoring management’s performance is an important activity, springing from a belief by investors and others that managers should not be just left to work on their own – the interest in cash is a natural part of this; • there’s more to managing cash than just daily attention – such important (but not usually frequent) activities as making investments in long-term assets, raising long-term financing and issuing share capital are also involved; • profit performance and cash flow performance can be quite different, so it is not satisfactory to make presumptions about cash management based on profit performance. 8 Points for discussion: • statements of cash flows are not costly to prepare. They are not based on the accounts in the way the income statement is; they are an analysis of the income statement, balance sheet, and retained profits information. • users of financial information could reconstruct the cash flow statement using the balance sheet and income statement information. (Not in quite as much detail as that provided by management.) • accrual accounting measures performance over time by measuring changes in profit. • changes in profit do not equal changes in cash. • the statement of cash flows measures another aspect of performance, i.e., the managing of inflows and outflows of cash, so that the entity has enough cash to pay its bills, finance its growth and keep borrowing under control. • cash situation of the entity can be obscured by accrual accounting. • statements of cash flows report three main kinds of changes in cash, cash from operations, cash from investing activities and cash from financing activities. • cash from operations is basically a cash flow income statement. • the income statement does not give information about the financing and investing activities of the entity. • the statement of cash flows provides information about the solvency and liquidity of the entity. The income statement does not provide this information.

Chapter 7: Reporting and managing cash flows

Problems Problem 7.1 1 2 3 4 5 6 7 8 9 10

Financing - increasing Operating- increasing Investing- decreasing Operating- decreasing Operating- decreasing Financing - increasing Investing- increasing Operating- decreasing Financing - decreasing Financing - decreasing

Problem 7.2 Sutherland Limited Cash flow statement for the year X (Direct method) Operating activities Cash receipts ($31 610 + $797 640) Cash disbursements ($8920 + $14 920 + $513 600 + $238 530) Cash generated by operations Investing activities Noncurrent assets acquired ($81 000 + $44 000) Proceeds from disposal of noncurrent assets Cash used in investing activities Financing activities Bank loan obtained Repayments on borrowings Shares issued Dividends paid Cash obtained from financing activities Increase in cash for the year Cash on hand at the beginning of the year Cash on hand at the end of the year

$ 829 250 (775 970) 53 280 (125 000) 7 000 (118 000) 70 000 (80 500) 110 000 (20 000) 79 500 14 780 78 840 93 620

Chapter 7: Reporting and managing cash flows

Problem 7.3

Net Profit Before Tax Increase $40,000

Cash Flow Cash Flow From From Operations Financing Increase $19,000 No effect

Decrease

$2,500

No effect

Increase

$300,000 No effect

Decrease $85,000

Decrease

$80,000 No effect

No effect

Increase

$30,000 No effect

No effect

Decrease

$35,000 No effect

No effect

Decrease $30,000* No effect

No effect

Increase

$20,000

Decrease

No effect

Decrease

$220,000

No effect

Decrease

$180,000 No effect

$900

Cash Flow From Investing No effect

* Book value = 300,000 – 250,000 = 50,000 Sold for 20,000, therefore loss on sale of 50,000 – 20,000 = 30,000

Problem 7.4 1 (a)

(b)

(c)

Operating: Cash received from customers (45 000 + 8000) Cash paid to suppliers (8000 +27 000 + 30 000) Cash paid to employees

53 000 (65 000) (24 000)

Investing: Purchase of equipment

(90 000)

Financing: Issue of shares Dividend paid

250 000 (20 000)

Cash flow from operations are negative for the month. This appears to be the result of the slow collection of accounts receivable. There is a much higher percentage of accounts payable being paid in the month as compared to receipts from accounts receivable. While this is only one month, actions need to be taken to ensure this improves.

Problem 7.5 Six possibilities are listed. 1. Cash flow from operations are negative in both years and becoming more negative. 2. Company continues to invest. 3. Negative CFO and CFI are financed mainly by borrowings. 4. Company has stopped paying dividends. 5. Borrowings doubled and move from share issue to borrowings. 6. Final cash balance very low.

Chapter 7: Reporting and managing cash flows

Problem 7.6 Company A

Company B

Company C

Negative cash flow from operations but still investing so it needs to borrow to cover both operations and investing. This cannot continue indefinitely. Has a positive cash flow from operations but this only partly covers the cost of investing and so still needs to borrow. It may be a company in the growth stages. This company has a very strong cash flow from operations enabling it to not only cover its new investments but also reduce debt.

Problem 7.7 1 Using the 2021 and 2022 numbers we can make the following observations: a Como Limited had a positive cash flow from operations of over $154 million in 2021. In 2022 cash flow from operations fell to $118 million even though cash receipts from customers increased substantially but not as much as the combined increase in cash payments in the course of operations as well as the large increase in taxes paid. b In 2022 there were outflows of cash for both investing and financing activities. The total of these outflows approximated the cash inflows from operations. c Cash outflows from investing activities were much smaller than in 2021 consisting mainly of $44m for the purchase of property, plant and equipment. The change in cash flow from financing activities compared with 2021, was mainly due to the large repayment of borrowing of $126.5 million. 2 Its cash flow from operations was sufficiently positive to cover its outflow from both investing and financing in 2022.

Problem 7.8 1 Contracting as cash flow from investing activities is positive (i.e., selling off assets, etc.) 2 Issue of shares or borrowings. 3 As it has high negative cash flow from operations it has raised funds (borrow or share issue) and sold off assets to cover these outflows. This cannot continue in the long run. Therefore, it is suggested that it is a declining business.

Problem 7.9 1 2 3

–160,000 +20,000 +10,000 = –130,000 +5,000 100,000 + 200,000 = 300,000

Chapter 7: Reporting and managing cash flows

Problem 7.10 1 This information allows users of financial statements to make decisions about the liquidity and solvency of the company and about the long-term viability of the company. Information about the ‘cash profit’ of the company allows comparisons to be made with the accrual profit information provided on the Income Statement. 2 Adelaide Airways Strengths Weaknesses Positive cash flow from operations/cash profit Cash flow from operations declines substantially from 2021 to 2022 Higher levels of equipment Significant levels of asset sales (investments and purchase/replacement in 2022 compared to equipment) which are higher than reinvestment 2021 Net $57 000 repayment of short-term loans has Dividend payment has decreased in 2022 occurred during the year (what about long-term financing – or are they only borrowing shortterm to finance long-term assets – a potential concern?) Overall cash balance has declined from 2021 to 2022 Perth Express Strengths Weaknesses Borrowings (short-term and long-term) have Large positive cash flow from operations and increased during 2021 and 2022. Need to watch increasing levels of borrowings overall Significant reinvestment in purchase of new equipment – indicates expansion of operations or more efficient equipment. Small inflow from proceeds on sale of equipment in both 2021 and 2022 Cash balance has increased from 2021 to 2022

Problem 7.11 1

Cash flow cycle: 50 + 1 – 30 = 21 60 +10 – 40 = 30 3 + 30 – 30 = 3

X has all sales by cash or credit and holds inventory for 50 days. An example of this could be a furniture or electrical retailer. Y holds inventory for 80 days so it is likely a company where supply of goods is uncertain, e.g. importer who sells to the public (cash or credit cards) but also sells to companies with a longer collection period. Z possibly sells fresh food (i.e. 30 days in inventory) to retailers who pay the wholesaler months ….

All companies collect reasonably quickly and pay quickly. X and Y have the advantage of receiving cash quicker than they pay out the cash. Days in inventory is high for X and Y which has the disadvantage of needing to be financed.

Chapter 7: Reporting and managing cash flows

Problem 7.12 1

The purpose of this question is to illustrate that higher current and quick ratios are not always a good thing. Both the current and quick ratios are impacted by high accounts receivable (long days in receivables due to generous payment terms and slow payers) and accounts payable decreasing the terms of payment (30 to 14). The current ratio is also higher to the build up of inventory for which there are costs such as obsolescence and storage. The big cost relates to increased financial costs, particularly when interest rates are high. Issues related to inventory (obsolescence, storage costs) and accounts receivable (high bad debts). – Better controls over debtors collection. – Discuss delivery terms with suppliers of inventory so that delivery is more certain and less inventory needs to be held. – look for alternative suppliers who give more normal payment terms.

Problem 7.13 1

Received in December from November credit sales: 240,000 x (0.95)(0.4) = $91,200

January budgeted cash receipts: Cash sales

$60,000

from credit sales in: December (360,000 x 0.95 x 0.4)

136,800

January (180,000 x 0.95 x 0.6)

102,600 $299,400

Purchases in November (0.7 x 460,000)

$322,000

Purchases in December (0.7 x 240,000)

$168,000

Payments in December for: November purchases (322,000 x 0.75)

$241,500

December purchases (168,000 x 0.25)

42,000 $283,500

Problem 7.14 1 2 3 4

$36,448 (5,100 + 19,000 + 12,348) $40,812 (5,700 + 21,000 + 14,112) $14,800 (8,400 + 6,400) $16,800 (9,600 + 7,200)

Chapter 7: Reporting and managing cash flows

Problem 7.15 GH Company Cash Budget For the Month of April 2022 Beginning cash balance Collections: Cash sales (0.3 x $565,000) April with discounta without discountb Marchc Februaryd Sale of old equipment Total cash available Less disbursements: Raw materials: Aprile Marchf Direct labour Operating expenses Dividends Equipment Total disbursements Minimum cash balance Total cash needs Excess of cash available over needs Ending cash balance

$12,500 169,500 116,277 118,650 70,000 42,000 13,000 $541,927

$60,000 56,500 50,000 143,000 65,000 80,000 $454,500 10,000 $464,500 77,427 $ 87,427

(0.7 x $565,000) x 0.6 x 0.5 x .98 (0.7 x $565,000) x 0.6 x 0.5 c (0.7 x $500,000) x 0.2 d (0.7 x $300,000) x 0.2 e April requirements (0.2 x $565,000) Desired ending inventory (0.2 x $600,000) 120,000 Total requirements Less: Beginning inventory Purchases April payment: $120,000/2 b

$113,000 $233,000 113,000 $120,000

$113,000/2 (purchases for March are computed as shown for April)

Chapter 7: Reporting and managing cash flows

Problem 7.16 1 The concept of ‘time value of money’ is that people wish to be rewarded for waiting to receive cash. This reward is called interest and is calculated as a function of the amount of money and the passage of time. Because of this concept, it can be said that an amount of money received after a period of time is ‘worth’ less than if it were received now, because if it had been received earlier it would have earned interest by the later time. Therefore the ‘present value’ of an amount of money changing hands later is less than that amount, because of the implied interest included in the later amount. Business people are sensitive to this because money changes hands at all sorts of different times, for example money is borrowed now and paid back later. Therefore, the interest charged, or implied, must be taken into account when comparing cash flows that occur at different times. To ignore this would mis-state the value of future flows in comparison to present ones. 2 a b

PV PV

= = =

$1000/(1 + .10) = $909.09 $1000/(1 + .12) + $1000/(1 + .12)2 + $1000/(1 + .12) 3 $893 + $797 + $712 = $2402

$2486

3 The present value is higher than in part 2b, though the rate is lower, because the implied interest included in the total $3000 cash flow is lower and therefore when it is removed, the resulting present value is higher. This illustrates an important rule: the higher the interest (‘discount’) rate, the lower the present value because the more interest is presumed to be included in the future cash flow(s) and when it is removed, the remaining present value is lower.

Problem 7.17 1 Net present value of lease option. NPV= $113 724 Net present value of buy option = $140 000 (cash price) Therefore, lease the truck. 2 Net present value of lease option remains the same: $113 724. Net present value of buy option: Initial payment Selling price at end of five years 35 000 (1.10)5

$ 140 000 (21 732) 118 268

Answer would not change: Speedy Trucking should still lease the truck. 3 Important assumptions: • That the appropriate interest rate is used. If the appropriate interest rate is lower, the net present value of the lease option will be higher. • That the truck can be sold at the end of five years for $35 000. If the selling price of the truck is lower or higher at the end of five years this will affect the analysis.

Chapter 7: Reporting and managing cash flows

Problem 7.18 Y0 (400,000) (50,000)

(450,000)

300,000 (105,000) 45,000 240,000

300,000 (40,000) 260,000

NPV = -450,000 + (240,000 X 0.9259) + (240,000 X 0.8573) + (260,000 X 0.7938) = -450,000 + 222,216 + 205,752 + 206,388 = 184,356

Problem 7.19 Year 0 Annual cash flows: Purchase equipment Modification Revenues – cash flow Cash operating costs Labour savings Old equipment Taxes paid Net cash flow PV factor PV amount Net present value

Year 1

Year 2

Year 3

(200,000) (55,000) 190,000 (90,000) 30,000

190,000 (90,000) 30,000

(15,000) 115,000

(15,000) 130,000

0.909 104,535

0.826 94,990

0.751 97,630

21,000 (234,000) 1.000 (234,000) 63,155

Problem 7.20 Note: for all solutions below the PV factors were calculated in Excel. If you are using PV factors from a table with 3 decimal places there will be a rounding difference. 1 NVP = $164,063 based on a discount rate of 8%. 8% Initial investment Additional Revenue Operating costs Disposal value Cashflow PV factor (Excel) PV of cash flows NPV

0 -500,000

300,000 -30,000

200,000 -30,000 60,000 -500,000 270000 270000 230000 1 0.925926 0.857339 0.793832 -500000 250000 231481.5 182581.4 164062.8969

Chapter 7: Reporting and managing cash flows

Problem 7.20 (continued) 2

NVP = $141397 based on a discount rate of 10%. 10%

Additional Revenue

300,000

200,000

Operating costs

-30,000

Initial investment

0 -500,000

Disposal value

60,000

Cashflow

-500,000

270000

230000

PV factor (Excel)

0.909091

0.826446

0.751315

PV of cash flows

-500000

245454.5

223140.5

172802.4

Additional Revenue

300,000

200,000

Operating costs

-30,000

-600,000

270000

230000

PV factor (Excel)

0.925926

0.857339

0.793832

PV of cash flows

-600000

250000

231481.5

182581.4

Additional Revenue

300,000

200,000

Operating costs

-30,000

NPV

141397.4455

3a NPV = $64,063 8% Initial investment

0 -600,000

Disposal value

60,000

Cashflow

NPV

64062.89692

3b NPV = $114,063 8%

Initial investment

-500,000

Modifications

-50,000

Disposal value

60,000

Cashflow

-550,000

270000

230000

PV factor (Excel)

PV of cash flows

-550000

0.925926

0.857339

0.793832

250000

231481.5

182581.4

Additional Revenue

300,000

200,000

Operating costs

-80,000

NPV

114062.8969

3c NPV = $35,208 8% Initial investment

0 -500,000

Disposal value Cashflow

60,000 -500,000

220000

180000

PV factor (Excel)

0.925926

0.857339

0.793832

PV of cash flows

-500000

203703.7

188614.5

142889.8

NPV

35208.04755

Chapter 7: Reporting and managing cash flows

Cases 7A 1 The main components of cash flow from operating activities are: Receipts from customers Payments to suppliers and employees

$million 72,688 (66,526)

2 The main components of cash flow from investing activities are: Proceeds and advances from the sale of property, plant and equipment Payments for property, plant and equipment and intangible assets Payments from the purchases of businesses

$million 389 (2,389) (209)

3 The main components of cash flow from financing activities are: Repayment of the principal component of lease liabilities Proceeds from borrowings Repayment of borrowings Dividends paid

$million (1,158) 971 (1,525) (1,104)

4 The opening and closing balance of cash in the balance sheet are represented at the bottom of the cash flow statement, i.e. the cash flow statement reconciles the change in cash.

Chapter 8 Extensions to financial reporting: assets, liabilities, capital markets, contracts and accounting standards

Discussion questions 1 Some points that might be made: • As in other areas of society like health and education, standards provide some protection against abuse; • It is not easy to figure out how to prepare good financial statements, so GAAP help preparers do a good job; • The existence of GAAP helps everyone’s efficiency because once you know GAAP, you don’t have to take the time and money to solve every problem from the beginning; • GAAP help make various companies comparable to each other and comparable to themselves over time, thus clarifying performance measurement; • There is a credibility problem if managers prepare information about their performance on any basis they like, so GAAP help good managers because users are more likely to believe the information; • GAAP provide rules ahead of time, which makes for a smoother system than if there were no rules and dissatisfied people had to sue or fight each other after the information came out; 2 The Framework defines assets as resource controlled by an entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits. Based on this definition, assets need to have three essential characteristics: i Future economic benefits ii Control by the entity iii Occurrence of past transactions or other past events. 3 The Framework defines a liability as a present obligation of the entity to transfer an economic resource as a result of past events. Based on this definition, liabilities need to have three essential characteristics: i A present obligation exists ii An obligation to transfer an economic resource iii The present obligation exists as a result of past events. 4 See description in section 8.2.

Chapter 8: Extensions to financial reporting: assets, liabilities, capital markets, contracts and accounting standards

5 Two of the methods suggested for valuing assets and liabilities are value in use and value in exchange. The concept of value in use considers that value flows from the way the business will use the asset to generate future cash flows. Value in use is usually estimated by calculating the ‘net present value’ of future cash inflows expected to be generated by the asset, or cash outflows that it will make unnecessary. By contrast, value in exchange records individual assets and liabilities t their current market value. It focuses on the individual values of the assets and liabilities items, assuming that value is market determined and that profit should be measured using changes over time in market values. 6 Here are some possible arguments. First, for the proposition: • Users are interested in the future and so a picture of what happened in the past is not useful. • The current market value of assets, liabilities or whole companies is relevant to decisions about buying and selling interests in those things or about lending or borrowing money related to them, not their cost. • Cost is relevant before you spend the money but afterwards it cannot be changed (‘sunk cost’) and so is irrelevant to decisions (more about this in management accounting courses). • Because of continuous price changes (such as inflation), cost cannot be interpreted without knowing when it was incurred, which the financial statements do not disclose, instead of mixing together costs from different times like apples and oranges (for example, cost of a building bought for $100 000 in 1980 is added to the cost of one bought in 2020 for $100 000, even though the two buildings must be very different). • Historical cost is determined following various accounting rules that users don’t know about and therefore can’t appreciate and use intelligently in decision-making. Now some arguments against the proposition: • Users are interested in evaluating performance and that requires looking back, so a historical accounting system is entirely relevant for performance evaluation. • Historical cost figures are based on actual events, not on potential events as market values are, and therefore are more reliable, verifiable and otherwise trustworthy. • Historical cost accounting’s rules and standards help users because they provide a systematic, consistent measurement basis, which can be used, and compared with other companies, with confidence. • Virtually all companies in most countries use historical cost accounting, so this suggests that such accounting must be useful (unless the accountants are pulling a huge fraud on the whole world!). These various pro and con points are a reminder that accounting information has various users and uses, and, while it may not be helpful for some, it may be very relevant for others. 7 The role of information in a capital market may be considered under two headings: i General information-based trading. Companies whose shares are traded are part of a general economic system, and some general events may change people’s views on the wisdom of investing in anything, and so cause changes in all or most shares traded on the stock exchange. Examples of such general

Chapter 8: Extensions to financial reporting: assets, liabilities, capital markets, contracts and accounting standards

events are changes in national interest rates, wars or elections that change the party in power. ii Specific information-based trading. Information specifically about a particular company’s future prospects may cause changes in the willingness of people to buy or sell its shares. It can be said that the share market ‘prices’ the information, in that the change in the trading price of the shares is a measure of the value of the information to the market. 8 Efficient market hypothesis is a proposal that capital markets actually are ‘efficient’ responding quickly, smoothly and appropriately to information. 9 The major purpose of a stock exchange is to facilitate the buying and selling (‘trading’) of shares among investors. Trading is not confined to the shares of companies. There is also trading of rights to buy or sell shares in the future, to convert from one kind of share to another, to receive dividends and to perform a wide variety of other future actions. 10 ‘Agency theory’ is concerned with relationships between people in which one or more of them (the agents) is or are entrusted with acting on behalf of one or more others (the principals). Agency theory tends to focus on the stewardship role of accounting information. ‘Stewardship’ is the concept that some persons (such as management) are responsible for looking after the assets and interests of other persons (such as shareholders), and that reports should be prepared that will be suitable to allow the ‘stewards’ to be held accountable for the actions taken on behalf of the other persons. 11 Some of the many points that might be made: i If the market responds quickly and efficiently to information, it indicates the efficient allocation of capital resources. Money flows toward viable companies and away from less viable ones. So accounting information assists in this allocation process. ii There are systematic and unsystematic risks in a stock market. Accounting information can help in assessing a stock’s unsystematic risk. 12 Some of the many points that might be made: i Information is used in a ‘stewardship’ role in order to maintain contractual arrangements. Accounting therefore assists in the effective administration of contracts in the economy. ii Changes in the contractual arrangements will cause changes in the accounting information that is required. Accounting’s use responds to the nature of the control/administration role assigned to it. 13 Some reasons managers might be motivated to ‘manage’ their companies’ financial disclosure and accounting: • as has been noted earlier in this book, accounting and disclosure are important to managers’ pay, promotion and job tenure, so they are naturally interested in what is revealed about their management and may wish to influence what is revealed; • managers manage various aspects of their companies: that is their job, and including accounting and disclosure in that management may seem natural; • accounting and disclosure are not precise and the fact that there is room for judgment forces managers to make some choices, so the choices might as well be advantageous;

Chapter 8: Extensions to financial reporting: assets, liabilities, capital markets, contracts and accounting standards

• •

managers may feel they understand the company better than do accountants or outside accountants and that they therefore can make better choices about accounting and disclosure; managing accounting and disclosure may be seen as a way to help the company in its struggles with competitors, unions, taxation authorities, regulators, news media and others.

Chapter 8: Extensions to financial reporting: assets, liabilities, capital markets, contracts and accounting standards

Problems Problem 8.1 Some points that might be made (discussion will raise more): • it is true that managers and shareholders have very different arrangements with the company (the managers within, the shareholders outside) and their information needs do differ; • managers work for shareholders, at least in principle, so their interests may not diverge as much in the long run as the chairperson suggested; • in fact the two groups do get different information, in particular there are the whole disciplines of management accounting and management information systems to help managers, so it’s not necessary for the official financial statements to meet managers’ needs particularly; • even if the contractual arrangements are different, both parties may share an interest in the basic adequacy of the information (such as verifiability, consistency, timeliness); • meeting contractual needs is only one purpose of financial statements, so they probably do not meet all other needs equally well and it should not be demanded of them that they meet all the contractual needs equally well either; • both parties seem to coexist mostly amicably with financial statements as they are, so the evidence is that perhaps more needs are being met than the chairperson suggests; • the evolution of accounting reflects give and take among parties, so if either managers or shareholders don’t like the financial statements they get, they are free to do something about that (including lobbying for changes, or writing their contracts to take into account things they dislike, such as asking that their bonuses or dividends be related to cash flow if they don’t like the way profit is measured).

Problem 8.2 Here are some examples with a few words about why each is useful (paraphrased, brief and to the point, as Jason would want them). a

Term Understandability

Relevance

Comparability

Why useful • Here is something for Jason: accounting information is supposed to be understandable to those it is to help. • But accountants are entitled to assume users have some preparation, so Jason does not have to spend money to educate the users of his financial statements. • Like other criteria above, this idea is that the accounting information should be useful to those it is intended for. • Jason should be aware that the information is intended to help people decide, not to make their decisions for them. • To be relevant, information should help people predict or learn and should arrive in time to be helpful in their decisions, which is why there often is time pressure in the preparation of Jason’s financial statements. • Financial statements are more useful if they permit different companies to be compared, such as Jason’s and similar businesses, to better judge financial performance and position.

Chapter 8: Extensions to financial reporting: assets, liabilities, capital markets, contracts and accounting standards

Timeliness

• In order for financial statements to provide information useful to users, they must be provided to those users on a timely basis. • Jason would like this because he likely doesn’t wish to wait for information that he needs to make decisions.

Problem 8.3 1 2 3 4 5

b f a a b

a liability none of the above – not recognised in the accounts an asset an asset a liability

Problem 8.4 a b c d e f g

No No No Yes – Inventory $1140 No Yes – Cash (amount equals to the amount of grant received) Yes – Machine $850 000

Problem 8.5 Under Australian accounting standards, research costs should be expensed. Under particular circumstances, development costs can be capitalised (i.e. made an asset).

Problem 8.6 General principle – the cost of an asset includes all those costs required to make it suitable for its intended purpose. 1 The invoice price of the machine – include in cost, not a current year’s expense, will benefit future periods. 2 GST paid on machine – include in cost, this is part of the purchase price. 3 Shipping charges to get the machine to the company’s factory – include in cost, necessary to make the machine suitable for its intended use, i.e. you can’t use it if it isn’t in the factory. 4 The cost of the factory manager’s trip to the machine manufacturer’s plant to choose the machine – may include in cost if the factory manager’s trip was necessary in order to acquire the asset. 5 The cost of painting the machine light green, as other machines in the factory are painted – probably do not include in cost because the machine can be used whether it is painted light green or not. 6 Estimated revenue lost because the machine was late arriving – do not include in cost because this is not a cost required to make the machine suitable for its intended use. 7 Cost of substandard products – include in cost, because these costs are necessary to make the assets ready for use and are required to obtain benefits from the asset. 8 Interest on bank loan used to finance machine – do not include in cost, this cost is not required to get the asset ready for its intended use.

Chapter 8: Extensions to financial reporting: assets, liabilities, capital markets, contracts and accounting standards

9 Cost of moving three other machines to make room for new one – include in cost, machine cannot be used if there is no place in the factory to put it, therefore this is a cost required to make it suitable for its intended use.

Problem 8.7 Note: It is usual to keep the land and the building in separate accounts, since the building will depreciate and the land will not. Book value of: Land $ 175,000 0

Building $ 0 690,000

20,000

460,000

40,000

195,000

1,190,000

The purchase price was for the site (land). Only $690,000 should be included as the building asset, since $10,000 was wasted and did not ‘better’ the building. Machinery installation should not be a part of either land or building, but in a separate location on the long-term assets part of the balance sheet under a heading such as ‘machinery asset. Grading and draining make the land suitable to build on without causing damage to the structure. There are many choices in regard to this issue, as with events in accounting. We chose $460,000 to be appropriate, since it is the market value of the work done. However, most companies wouldn’t bother figuring this out and would just record the $500,000 paid. As with machinery installation, the purchase of machinery and delivery charges should not be included in either land or building but in a separate noncurrent asset account. Parking lots make the land, and therefore the site, usable. This classification is difficult because parking lots are part of the land, but they depreciate because of weather and use. Smith Co. would probably record it as a third, separate asset and so did we. Replacement of windows is a maintenance expense and therefore not part of the asset. This classification depends upon whether the architect worked on the land and/or the building. Since most of the work was likely for the building, it was added to the building’s value. Total book values

Problem 8.8 1 2 3 4 5 6 7

Yes, prepayment, 10.5/12 x 10,000 = $8,750 Yes, patent, $100,000 No asset Yes, land. It could be revaluated at cost $500,000 or revalued to $750,000. Yes, printing machines $500,000; goodwill $400,000 Nil, internally generated goodwill is not recognised as an asset. Yes, $700,000

Chapter 8: Extensions to financial reporting: assets, liabilities, capital markets, contracts and accounting standards

Problem 8.9 Essential characteristics of assets: i Potential to produce economic benefit ii Control by the entity iii Occurrence of past transactions or other past events

1 The purchase of equipment on credit 2 receipt of cash from a cash sale 3 Payment of a yearly insurance policy in advance 4 A department store receives goods from a .... 5 Land donated to a sporting association 6 A grant from the local council to a sporting .... 7 Purchase of a patent for cash 8 Expenditure on research and development which is .... 9 Hiring a new general manager who has the .... 10 Purchase of BHP shares for cash 11 A council swimming pool which ratepayers can .... 12 A luxury resort which paves a gravel road from the .... 13 A new printing press is acquired 14 A piece of equipment with a written down value of ....

1 2 3 4 5 6 7 8 9

Essential characteristics i ii iii Y Y Y Y Y Y Y Y Y N Y Y Y Y Y Y Y Y Y Y Y Y N N N Y Y Y Y Y Y N N N

Asset recognised in the balance sheet Asset recognised in the balance sheet Asset recognised in the balance sheet No asset. The entity does not control the future economic benefits Asset recognised in the balance sheet Asset recognised in the balance sheet Asset recognised in the balance sheet Asset not recognised in the balance sheet. Lack of potential for future benefits. No asset since the general manager can leave at any time. The entity would not be in a position to control the future economic benefits 10 Asset recognised in the balance sheet 11 Asset recognised in the balance sheet 12 No assets. The entity does not control the future economic benefits 13 No assets. There is no potential to produce economic benefits

Chapter 8: Extensions to financial reporting: assets, liabilities, capital markets, contracts and accounting standards

Problem 8.10 (Note: this question anticipates several issues to be examined in more depth in later chapters. Answers should be based on reasoning from the basic principles of this chapter, and exploration of the ambiguities of applying those principles to specific situations should be encouraged.) 1 Probably not recorded as an asset as it would have developed slowly over time. If the company bought the list outright from another company, it may well be shown as an asset (and if not paid for yet, a liability too). 2 A liability (noncurrent except for pensions payable in the next year). The funds (cash) would be in the company’s bank account (an asset). If those funds have been turned over to a trustee to manage (as is often, perhaps usually, the case), neither the cash would be shown as an asset nor the amount collected shown as a liability because both would be the trustee’s responsibility rather than the company’s. 3 Not recorded in the accounts at all. 4 Possibly a liability if the company expects to have to pay. More likely not recorded at all, because no guilt will have been admitted; instead if it is significant (‘material’), just a note to the balance sheet pointing out the potential liability (‘contingent liability’). 5 An asset (still owned). Possibly a current asset if transfer of title is expected within a year. 6 Not recorded in the accounts at all. 7 The people are not recorded, but aspects of the contracts may be, such as amounts paid to acquire players (assets) or amounts to be paid according to the contracts for services already received (liabilities). Future wages are not a liability because the players have not earned them yet. 8 The cash would be in the company’s bank account (asset) and the same amount would be shown as a liability (probably a current one) for service not yet performed. The liability might be called ‘unearned revenue’, ‘customer deposits’ or ‘deferred revenue’. 9 This is the equity account called Retained Profits. (These retained profits could have been used to acquire assets like inventory or production equipment, or to pay debts, so there is unlikely to be cash in the bank equal to this equity account.) 10 An asset. For a retailer, parking is just as necessary as the store in which the goods are sold. 11 As long as the company does not appear likely to have to make good on the guarantee, it would not appear as a liability on the company’s balance sheet. There would be a note explaining the potential liability (‘contingent liability’) if it is significant (‘material’).

Chapter 8: Extensions to financial reporting: assets, liabilities, capital markets, contracts and accounting standards

Problem 8.11 1 2 3 4

No, it is not probable that the future sacrifice of economic benefits will be required. No, it is not probable that the future sacrifice of economic benefits will be required. No, the amount of the liability cannot be measured reliably. While the amount of the liability still cannot be reliably estimated, it appears that it will be at least $1 million and therefore this amount could be taken up at present as a liability/expense. Yes, a liability and an expense of $400,000 should be taken up. It appears that the remainder of the liability cannot be reliably estimated at this stage.

Problem 8.12 1 Recognised; called ‘Income tax payable’ 2 Recognised; called ‘Wages payable’ 3 Possibly recognised; called: ‘Warranty repairs payable’, or ‘Provision for warranty repairs’ 4 Recognised; called ‘Unearned revenue’ 5 Not recognised; no services yet provided 6 Not recognised, but should be disclosed as a contingent liability 7 Possibly recognised; called ‘Provision for environmental restoration’.

Problem 8.13 1 No record – contract is executory 2 Increase bonus expense; decrease cash 3 It is probable that future sacrifice of economic benefits will be required Increase the expense called Loss on guarantee of subsidiary loan for $800,000 and increase the liability Guarantee payable for $800,000 4 Increase Warranty repairs expenseand Provision for warranties 5 No, but may be recorded as a contingent liability.

Problem 8.14 1 2 3 4

Loan $10,000 Accrued expenses (or electricity payable) $230 Unearned revenue (or revenue received in advance $3,000) Nil.

Chapter 8: Extensions to financial reporting: assets, liabilities, capital markets, contracts and accounting standards

Problem 8.15 1 Effect on balance sheet – depends whether market value is above historical cost. If above, net assets would increase, if below net assets would decrease. Note equity would increase or decrease by the same amount as net assets increased or decreased. 2 Effect on profit and loss statement – again this depends whether market value is higher or lower than historical cost. When a noncurrent asset is revalued upwards, the increment must be credited direct to Asset Revaluation Reserve. Thus, it is not regarded as a profit or gain. However, when a downward revaluation takes place the decrement must be treated as a loss. 3 Does it matter what we do? It should be noted that accounting standards do not require a company to revalue its assets nor does it specify the basis of valuation to be employed, e.g., fair value, current buying or selling price. If there is no revaluation, market price may be disclosed in the financial statements if it is considered useful to users. Note here difficulties with appraisal values. These are estimates, and if estimates are not very reliable or real estate prices fluctuate up and down with regularity this information may not be very reliable and thus may not be very useful. 4 More likely that the manager is talking about value in exchange as he talks about wide swings in real estate value (i.e. what they sell for). 5 Present value of future revenue from the land or historical cost adjusted for inflation.

Problem 8.16 This is a ‘what-do-you-think’ type of question. Here are some thoughts: • Would manipulation occur if management were allowed to produce whatever information it wanted, using whatever principles it preferred? Would users be able to protect themselves without authoritative standards? • Who is responsible for the ‘demand for standards’? The users? The preparers? • Having more GAAP rules would certainly make accountants busier and more valuable, but would it create any social benefits? • What would happen if each individual firm had to report specific events in the same manner? Doesn’t an event have a different impact on each firm? Can you imagine how large the AASB and AAS Handbook would have to be to accommodate each business event? • Do users want the GAAP structure to ensure some degree of comparability and consistency among firms over time? Do GAAP heighten investor confidence?

Chapter 8: Extensions to financial reporting: assets, liabilities, capital markets, contracts and accounting standards

Problem 8.17 1 October 31 2021 • Share prices will react on this date if the market expected earnings for the year to be different from the analysts’ predictions. If the market expected higher earnings than those predicted, share price would go down. If the market expected lower earnings than those predicted, the share price would go up. December 31 2021 • Share price should not change because no new information has been released. February 27 2022 • Share price should go down, because based on the analysts’ predicted earnings the market expected earnings per share to be higher than they actually were. This assumes that no other information about earnings was released between October 31 2021 and February 27 2022. 2 • Auditors are primarily responsible to the shareholders of the company. • Auditors are initially hired by the Board of Directors of the company, usually on the advice of management, therefore one might say that the auditors are hired by management. The appointment is ratified by the shareholders at the annual meeting but this is often a formality. Market investors would expect that auditors would report impartially on how the managers have performed, i.e. how the managers have managed the assets and liabilities of the company on behalf of the owners (the shareholders). Since auditors are essentially hired by management it may be difficult for the auditors to remain independent of management and report impartially on management performance to shareholders. 3 • Note – many contractual relationships are possible. The contractual relationship between the manager and owners will be discussed here. • Within the context of agency theory the shareholders can be thought of as the principals and the manager can be thought of as the agent. The manager is hired by the shareholders to manage the company owned by the shareholders. The shareholders would like the manager to maximise the value of the company because this is consistent with maximising the value of the shareholder’s investment. The shareholders cannot perfectly observe management performance. If the manager is paid a fixed fee for his services, the manager may prefer not to work very hard (because work is costly), thus not maximise the value of the company and not acting in the shareholders best interests. Since the shareholders cannot perfectly observe management performance, they cannot determine whether the manager has provided a high or low level of effort on their behalf. To overcome this problem, managers of large corporations are rarely paid a fixed fee for their services. Rather, management compensation is based partially on salary (fixed fee) and partially on a bonus. The bonus amount is computed with respect to some measurement of company performance such as net profit and or share price. The idea is that the incentives offered by bonus-based compensation will overcome the manager’s reluctance to provide high effort, thus resulting in a convergence of manager and shareholder interests.

Chapter 8: Extensions to financial reporting: assets, liabilities, capital markets, contracts and accounting standards

Problem 8.18 This problem is intended to prompt discussion and some attention to the annual report of whichever ‘large, well-known corporation’ is chosen. Some general ideas: 1 Capital markets likely to be important to the company can be determined by looking at the company’s capital structure (liabilities and equity), for example: • What share markets are the company’s shares traded on? The annual report usually says this somewhere, likely at the back, or business newspapers may be reviewed for listed shares. • Does the company have traded debt, such as bonds? Bond markets would therefore be important to the company. • Other forms of debt may also be subject to market forces, for example mortgages and bank financing. • Some assets may also be considered part of capital markets, such as marketable securities and accounts receivable that may be discounted, factored or sold. 2 Generally, it is thought that the participants in capital markets form expectations about company performance and other factors affecting the prices of traded securities. If information is unexpected, people buy or sell based on this news: presumably ‘good’ news causes prices to rise as people become more interested in the security, and ‘bad’ news causes prices to fall as people become less interested in it. If the markets expected the information, there will be no price change because such information isn’t really news so people don’t become more or less interested. (All these effects are averages: there will always be some people who find any information news, so there may be some trading as the people adjust their expectations. If, on average, expectations are in line with the news, this trading will not cause prices to change much because the people who think the information is good news will be about balanced by people who think it is bad news. They will trade among each other at about the present price: it would take a preponderance of people thinking it good (or bad) news to push the price up (or down), and such a preponderance would imply that, on average, there is news in the information.) 3 Here are some possible contractual relationships important to the company’s success: • between top managers and the board of directors; • between the board of directors and the owners; • between the company and its managerial employees other than the top group; • between the company and its production, marketing, administration and other employees (unionised or not); • between the company and its customers; • between the company and its suppliers of goods and services; • between the company and its lenders: banks and other suppliers of capital; • between the company and regulatory bodies, government and other such public agencies; • between the company (or owners) and its auditors.

Chapter 8: Extensions to financial reporting: assets, liabilities, capital markets, contracts and accounting standards

Cases 8A 1 Only the financial statements are included in the Appendix. For other statements it is necessary to go to the full annual report available at: https://www.woolworthsgroup.com.au/icms_docs/195984_annual-report2021.pdf. a summary data on the company’s performance is found on page 2 b a letter to shareholders from the company’s chairperson of the board of directors is found on page 10 2 Some examples of valuation from the Woolworths’ 2021 Financial Report: ▪ Trade debtors are stated at fair value, less an allowance for impairment. See note 3.1. ▪ Inventories are valued at the lower of cost and net realisable value. See note 1.2.2. ▪ Property, plant and equipment are valued at cost less accumulated depreciation and impairment losses See note 3.3. You often hear companies state that ‘our greatest asset is our staff’. You may have expected some asset related to the value of management or staff. Other ‘assets’ of a firm would be knowledge, know-how and a safe working environment, yet these do not directly appear on a balance sheet. The reason for the distinction between the assets that accounting recognises and records on the balance sheet and these other ‘assets’ is that there are objective, standard measures for, and economic control of, the first group but not the second. For example, inventory is owned by the enterprise and has a dollar cost that can verified. A happy employee is, in theory, more productive than an unhappy employee, but it is difficult to measure with any consistency how much more productive a very happy employee is compared with an only mildly happy employee. 3 Value in use is used in relation to estimates of value of properties. Fair value is used for financial assets and financial liabilities. 4 Australian Stock Exchange, 1,267,652,417 ordinary share (Note 4.3), share price depends on the current date. 5 • Profit increase above what is expected. • Increased dividends above what is expected. • Cost cutting program. 6 Yes, short term incentives in the form of an annual cash incentive and deferred share rights are based on group financial results, customer satisfaction and safety and are differentiated based on individual performance. Long term incentives are driven by performance measures based on relative total shareholder returns, sales performance per square metre and return on funds employed. These are long term equity incentive options vesting after three years (details found on page 34 onwards in the annual report). 7 Page 43 lists retail markets; governance; risk management; strategy; social responsibility; digital data and technology; financial acumen; people and culture; and regulatory and public policy.

Chapter 8: Extensions to financial reporting: assets, liabilities, capital markets, contracts and accounting standards

8B 1 The writedown is of the goodwill associated with the purchase of Carnation. That is when Northcorp purchased Carnation and paid more than the fair value of the net assets, the difference went to goodwill. As these benefits now appear to be less, the value of the asset needs to be written down. 2 Two key concepts would be relevance and faithful representation. The information is clearly relevant to investors. It could be argued that the measurement of the asset without the writedown is no longer a faithful representation. 3 The argument for a liability is that the obligation presently exits, (i.e. the decision has been made to restructure) and it will involve a future payment (i.e. sacrifice of future economic benefits). 4 ↑ Goodwill writedown ↓ Goodwill (i.e. profit decreases, asset decreases) ↑ Brand name writedown ↓ Brand name (i.e. profit decreases, asset decreases) ↑ Restructuring expenses ↑ Provisions for restructuring (i.e. profit decreases, liability increases) 5 DR CR DR CR DR CR

$ 642.5

Goodwill writedown Goodwill 642.5 Brand name writedown 240.0 Brand name 240.0 Restructuring expenses 95.0 Provision for restructuring 95.0

8C The answer will depend on which articles students find.

Chapter 9 Sustainability reporting

Discussion questions 1 Traditional financial reporting concentrates on financial information, but information related to areas such as strategy, future plans, sustainability issues (e.g. safety, environment, community) are not recorded in the financial systems. 2 Main criticisms: – One dimensional view of the firm from an economic perspective – Does not fully reflect the organisation’s value; ignores value creating assets such as innovation, creativity, staff morale and social capital / relationships – Short-term view of the firm’s performance – Emphasis on historical information, reflecting past events. 3 See section 9.3, ‘Do stakeholders require more than financial reporting?’ 4 Sustainable development is development that meets the needs of the present without compromising the ability of future generations to meet their own needs. A sustainability report provides information on the impacts that an organisation has 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. Sustainability reporting helps stakeholders understand the effects the organisation has and contributions it makes to sustainable development through its strategies and activities. Why does it matter? – The need to accurately value all resources – e.g. intellectual capital, intangible assets; strong relationships with suppliers, customers. – Depletion of natural resources – fishing, forests, oil, gold – Impacts (both positive and negative) on the community – e.g. mining in remote regions, gambling, alcohol, cigarettes, landfill, pollution, asbestos – Workplace health and safety risks and costs (e.g. profits over safety, such as on construction sites or in oil refineries) – Management approach to human resources; ‘short-termism’. 5 Costs: – Time and effort intensive to gather and report required data – Reports are not always positive and unfavourable disclosures can adversely impact the company. Benefits: – Reporting can improve internal business functions, procedures and activities, encourage innovation, and break down silos. – Reporting can improve external relations with stakeholders (stakeholder engagement), which in turn may improve business performance and attract long-term capital. – See section 9.4, ‘Why do organisations produce sustainability reports?’ 6 See section 9.3, ‘Do stakeholders require more than financial reporting?’ 7 Accountants have acquired skills in the practice of financial reporting and they have well-developed processes, procedures and standards for measuring, recording and

Chapter 9: Sustainability reporting

allocating monetary values to account for assets, liabilities and costs, and in the presentation of the organisation’s performance and financial position to internal and external stakeholders. 8 See the list of reasons organisations provide sustainability reports in section 9.4. 9 The information is provided in Exhibit 9.3. 10 Answers will depend on the key disclosure category chosen from Exhibit 9.3 and should consider the extent to which the disclosure/s selected provide valuable information to key stakeholders. 11 Voluntary: – The decision by an organisation to disclose is informative in itself – Allows companies to select what information they believe is most useful to shareholders. Mandatory: – Allows users to compare across organisations – More likely that companies will address issues on which they need to report. 12 The key tensions are that specialist sustainability assurers are likely to have greater subject matter knowledge, but auditors are more aware of processes for auditing and are supported by a strong set of professional ethics standards, including independence guidelines. 13 Accountants have acquired skills in the practice of financial reporting and they have well-developed processes, procedures and standards for measuring, recording and allocating monetary values to account for assets, liabilities and costs, and in the presentation of the organisation’s performance and financial position to internal and external stakeholders. Non-accounting professionals bring subject matter expertise, including knowledge of Global Reporting Initiative (GRI) Standards, United Nations Sustainable Development Goals (SDGs), and sustainability strategy. 14 Supply chain management may include implementing controls over suppliers of goods or services – e.g. not using child labour, minimising energy consumption. 15 Reporting consistency allows organisations and their key stakeholders to compare sustainability performance over time and across different industries and countries. However, allowing organisations choice means they can select the sustainability disclosures that provide useful information for their key stakeholders. 16 Alignment with SDGs enables organisations to contribute to a broader set of societal objectives, and can create opportunities for growth and risk management. Reporting on alignment with the SDGs then allows the management team to communicate the organisation's long-term purpose within society to its key stakeholders, which can motivate stakeholders to contribute to this purpose and may attract capital. 17 Integrated reporting explains how an organisation uses the resources and relationships available to it in order to create and sustain value in the short, medium and longer term, including how the organisation has performed in the past and plans to perform in an uncertain future. 18 See ‘What is driving the move towards integrated reporting?’ in section 9.8. 19 Major challenges: – The whole process of changing legislation and the present accounting standards – Audit-related issues given the breadth of information types contained therein, and the scope and flexibility of the integrated reporting approach. – Legal liability for future projections. 20 Existing users of financial statements are likely to be the main users. These stakeholders are likely to have different levels of skills and competencies to understand the different content of the reports.

Chapter 9: Sustainability reporting

Problems Problem 9.1 One approach to answering this question would be to go through the qualitative characteristics listed in the Framework issued by the AASB covered in Chapter 1 (see section 1.9 on ‘Qualitative characteristics of useful financial information’). The two key qualitative characteristics are relevance and faithful representation. For sustainability reports there will be a wide range of users and the relevance of the information is likely to vary greatly between those users. For example, water usage is likely to be particularly relevant to people living in the local area. Safety issues are likely to be relevant to employee groups. Issues such as greenhouse gas (GHG) emissions will likely be relevant to wide group of users. Measurement issues are challenging in some areas of sustainability reporting. For example, there can be difficulties in measuring indirect energy source emissions; as a result, there can be issues related to faithful representation of the information reported.

Problem 9.2 While there are a range of criteria that can be used, the most common one is the GRI Standards.

Problem 9.3 1 Benefits: – Reinforcing the credibility of sustainability reports for stakeholder and investor groups – Enhanced quality of the reported information – Improved reporting processes following the decision to assure. 2 The coverage of the audit of financial reports is legislated and adheres to auditing standards. At present, sustainability reports are not included but could and may be in the future (see section 9.9 on ‘Consistency of sustainability reporting’). 3 Reasonable versus limited assurance as covered in Chapter 5 (see section 5.9 on ‘The external auditor’s report’).

Problem 9.4 Generally, employees will be interested in items related to the continuance of the organisation and its profitability, as they affect future rewards. Therefore, they may be interested in net profit and cash earnings. Many employees are also interested in the impacts that the organisation for which they work has on sustainability and their community. Therefore, they may look at investment to support communities through crisis and recovery and the colleague engagement score.

Problem 9.5 Answers will depend on the current year of the sustainability report selected. Part 1 should be easy to find. Part 2 is generally disclosed in the sustainability assurance report. Part 3 is usually reflected using SDG images placed near the organisation’s reported goals, progress and outcomes. Part 4 generally appears near the end of the sustainability report (e.g., Westpac in 2021), but when sustainability content is presented within the annual report, this is sometimes referred to within the annual report but appears as a separate document on the website (e.g., CSL in 2021). © 2022 Cengage Australia Pty Limited. All Rights Reserved.

Chapter 9: Sustainability reporting

For part 5, a large variety of answers can be expected. Students should be thinking about some of the following issues: – For the particular industry, what are the key indicators? For example, in mining it is often water usage; for the construction industry, employee safety is important, particularly the reporting of fatalities and injuries; for the banking industry, customer equity and hardship assistance are important. – Any unfavourable trends are important. – Companies often provide targets, so large difference to targets are important. – Whether the report provides a balanced representation (i.e., both positive and negative impacts) is also important.

Chapter 9: Sustainability reporting

Case 9A The following answer is based on the 2021 Sustainability Report. 1 From the CEO and Chairman’s message found on page 3 of the Woolworths 2021 Sustainability Report: –

In late 2020, Woolworths released its Sustainability Plan 2025: Working together to make a better tomorrow – our new program of positive change for our people, our planet and our products. This moves from limiting the negative impacts of its operations to creating positive change in the business and its value chain. – Woolworths plans to take an Agile approach to its Sustainability Plan, reviewing and revising annually to continuously raise its ambitions. – Woolworths is pleased to have reached several milestones, including achieving the Workplace Gender Equality Agency’s Employer of Choice for Gender Equality citation for the first time and establishing a $50 million Future of Work fund to equip employees with new skills for the future. – Woolworths has negotiated its first renewable energy purchase agreement, with a target to power the business 100% with green electricity by 2025. – Woolworths acknowledges that it has made mistakes (highlighted by an Independent Panel Review) in its approach and commitment to reconciliation. It is committing to quality engagement with local indigenous communities. 2 Woolworths indicates alignment with the SDGs by displaying images of the relevant SDGs beneath each people-related goal in the breakout box at the top of the page (for Goals 1-5, see pages 8, 11, 14, 15 and 18 respectively). 3 2021 carbon emissions: 27 per cent below 2015 levels (page 3). 4 Woolworth states it has reduced its carbon emissions through a program of LED lighting, refrigeration upgrades and replacements, as well as solar + battery storage installations (see page 6). 5 From the Woolworths’ responsible sourcing and human rights due diligence framework found on page 16: – – – – –

The Responsible Sourcing Program begins with stakeholder engagement in the ‘Communicate’ stage. This includes supplier and employee surveys, supplier workshops, customer research, investor roadshows and industry roundtables. During 2021, Woolworths surveyed 2,694 employees to understand their COVID-19 related concerns. Woolworths’ suppliers are segmented into four risk categories. With audits required for three of these categories, 561 social compliance audits were conducted in the Woolworths’ supply chain during 2021. Supplier non-compliance with the Responsible Sourcing Standards resulted in Woolworths ceasing to trade with suppliers in 3 cases during 2021. Woolworths manages the remediation of issues identified by its suppliers too. Grievance investigations conducted in 2021 resulted in 9 management action plans being agreed with suppliers to identify the causes of identified issues.

The following answer is based on the 2021 Sustainability Report Appendix. 1 Woolworths’ sustainability and workplace metrics are shown on pages 4-5 and 613, respectively, of this report. The sustainability metrics include: –

total CO2 emissions

Chapter 9: Sustainability reporting

– electricity use – emissions from facilities – transport emissions by use – waste (tonnes) and waste intensity. The workplace metrics include: – –

Board of Directors by age Ratio of basic salary and remuneration of female to male employees by employment category – Number of substantiated claims of discriminatory conduct – Headcount by business unit, employee type, region, and age – Work related injuries – Business close calls (near hits) 2 Woolworths uses the GRI Standards, as well as the United Nations Global Compact principles and the reporting requirements of the Taskforce on Climaterelated Financial Disclosures (TCFD). 3 Yes, by Deloitte – details can be found on pages 20-24.

Chapter 10 Record-keeping

Discussion questions 1

Journal entries are the first records of an accounting transaction in the accounting records. The aim is to ensure financial records include all relevant transactions.

A chart of accounts is a listing of the titles of all the accounts of an entity. Each account is assigned a number. The number of account names listed in the chart of accounts is determined by the number of accounts contained in the entity’s accounting records. The chart of accounts includes every account used by an entity. The more detailed information the company wants the more accounts it will have.

Journal entries provide in chronological order a record of all transactions recorded by an organisation. Ledgers categorise transactions according to the account they affect, and therefore split the journal entries up amongst the different ledgers. By having a journal, every debit and credit of a specific transaction is recorded in the one place.

A trial balance is a standard bookkeeping procedure to check whether certain errors have been made in posting the journal entries to the ledger. It is a test to see whether total debits equal total credits.

Closing entries formally transfer the balances of the revenue and expense accounts to a profit and loss summary and then to retained profits. Closing entries also reset the revenue and expense account balances to zero to begin recording these items for the next accounting period.

The basic point is that accounting records and financial statements need not be complex or expensive to be useful. Every manager needs to know how the business is performing and to be able to explain that to bankers and others. This performance goes beyond mere sales records, even if sales are the lifeblood of the firm. The accounting system provides information about profitability, cash flows, debts and other factors important to the business besides sales. Bankers and tax authorities want to know about such things, even if the businessman claims not to. It should be said also that the entrepreneur mentioned may well have an accounting system that fits the modest needs of his/her business well. He/she understands costbenefit: accounting, like everything else, should be worth its cost. But he/she should ask himself/herself if he/she could be a better manager if he/she had more information, and perhaps accounting could help him/her there.

Chapter 10: Record-keeping

Given the equality of debits and credits in a trial balance, the following errors may still remain in a set of accounting records: i an inaccuracy in the amount of the initial recording; ii a case of incorrect analysis of transaction; iii posting the correct amount to the wrong ledger account; iv failure to post both the debit and credit sides of one or more entries; v a compensating error, i.e., where a mistake in one transaction is exactly offset by a second error in another transaction in such a way that equality of debits and credits in the system as a whole is maintained; and vi recording a fictitious transaction. These errors should be guarded against by supervision or systematic checking, e.g. i checking journal entries and ledger posting; ii perusing items in the trial balance; iii comparing amounts in the current trial balance with the figures in the trial balance for the previous period; and iv checking that all entries are based on authorised source documents. 8

The following types of errors may be detected from a perusal of the items in a trial balance: i the appearance of a debit balance among liabilities or revenue or the appearance of a credit balance among the assets or expenses; ii the discovery of a balance which is exceptionally large or unduly small in relation to its type of normal amount; iii errors in addition of the trial balance; iv error in transferring or failure to transfer ledger balances to trial balance; v error in computing the ledger balance; and vi failure to post, or error in posting to ledger account. To locate the source of the discrepancy the following procedure should be followed: i check the additions in the relevant ledger account and the extraction of the balance; ii check the postings from the journal to the ledger account; and iii check the journal entry to ensure that the data on the source document has been correctly recorded. 9.

Most accruals are estimates which can be made with varying degrees of accuracy. For example, accrued wages and accrued interest can usually be quite precise. However, accrued electricity is a bit more difficult as the company has to estimate the amount of electricity used towards the end of the year for which they do not have an invoice. Many accrued revenue items can be difficult to estimate, for example, construction revenue on building a tunnel. So if these expenses or revenues are underestimated in one year they will end up as revenue or expenses in the next year. So keep in mind that profit involves many estimates around which period revenues and expenses go into. In some rare circumstances involving very large dollar amounts, accounts may need to be restated but this would normally involve ASIC.

Chapter 10: Record-keeping

Problems Problem 10.1 1 2

No transaction as a service has not yet been provided, so no entry. DR Cash 20 000 CR Bank loan 20 000 The interest expense will be recorded periodically during the two years.

3 4

No transaction yet as no services have been supplied, so no entry. DR Cash 400 CR Unearned revenue 400 (or Customer deposits liability) DR Prepaid insurance 1200 CR Cash 1200

5 6

No transaction as the supplies have not yet been received, so no entry.

Problem 10.2 Reasonable assumptions here may lead to different answers. Particular account names may vary. 1

3 4

It is a transaction: an exchange of cash and a promise to repay. DR Cash (Current assets) 500 000 CR Bank loan (Noncurrent liabilities) 500 000 Bank loan, recorded as a noncurrent liability because payment is not due for three years (could also be considered a current liability, because of call feature). The deposit is a transaction, but the order itself is not as there has been no exchange yet. DR Prepayment (Current assets) 10 000 CR Cash (bank) (Current assets) 10 000 Deposit sent with inventory order. No transaction because no exchange yet. Exchange comes with occupancy over time. No transaction. The legal charge is not an exchange until it is settled or settlement can be predicted. The decline in share price is not an exchange involving Southward as an entity, just its owners. The dividend is a transaction as the declaration creates a liability to owners. The share price change again does not involve Southward, just its owners. DR Retained profits (Shareholders’ Equity) 500 000 CR Dividends payable (Current liabilities) 500 000 Declaration of a dividend of $0.50 per share on the 1 000 000 issued shares, to be paid in one week.

Chapter 10: Record-keeping

Problem 10.3 1 Information needed to enable a suitable accounting system to be designed • Nature of enterprise i Nature of activities – whether equipment to be manufactured or repaired ii Nature of products or services – whether shop will handle equipment for skiers, campers, etc. iii Organisation structure and staffing iv Sources of supply of products v Nature of market, type of customers, whether sales to be cash, credit and / or mail order vi Proposed systems for purchasing, time-keeping, inventory control and administration vii Means of processing data viii Sources of finance, etc. • Information requirements i Frequency and promptness of reports ii Recipients of reports iii Whether separate results are required for particular activities or departments iv Types of decision, planning and control activities for which management require information v Whether information to be provided to shareholders is to exceed the minimum required by law. 2 Source documents i ii iii iv v vi vii viii

Cash sale docket, or cash register Duplicate of cash receipt Cash payments listing Copy of invoice issued to customer Invoice received from supplier Copy of credit note issued to customer Credit note received from supplier Internal journal voucher

Transactions Cash sale made to customer Cash received from customer Cash payment Credit sale Credit purchase Goods returned by customer Goods returned to supplier Internal transactions (e.g. depreciation, bad debts).

The Great Outdoors Ltd. Chart of accounts Current assets (1 – 9) Revenue (50 – 59) 1 Cash 50 Sales 3 Accounts receivable 51 Discount revenue 4 Provision for doubtful debts 52 Commission from Youth Hostel 6 Inventory Association

Chapter 10: Record-keeping

Noncurrent assets (11 – 19) 11 Shop fixtures 12 Accumulative depreciation – Shop fixtures 14 Office equipment 15 Accumulative depreciation – Office equipment

Expenses (60 – 89) 60 Cost of goods sold 62 Advertising 64 Shop rental 66 Sales salaries 69 Depreciation on shop fixtures 71 Office expenses 73 Office salaries 75 Depreciation on office equipment 78 Postage and telephone 81 Bad debts 83 Bank charges 84 Discount expense 87 Interest on overdraft

Current liabilities (20 – 29) 20 Bank overdraft 22 Accounts payable Noncurrent liabilities (30 – 39) 30 Long-term loan Shareholders’ equity (40 – 49) 40 Share capital 42 Retained profits

Problem 10.4 1

RST Ltd General journal $ 80 000

(a) DR CR

Accounts Receivable Sales

(b) DR CR

Cash Accounts Receivable

60 000

Wages Other Expenses Cash

50 000 10 000

(d) DR CR

Electricity Expenses Accounts Payable

5 000

$ 80 000 60 000

60 000

Posting to the ledger accounts

Cash (c) (c)

5 000

(b)

OB Accounts Receivable CB

10 000 60 000 10 000

(a)

Sales

Accounts receivable 80 000 (b) Cash

20 000

Wages Other Expenses

50 000 10 000

60 000

Chapter 10: Record-keeping

Sales (a)

Accounts Receivable

80 000

Electricity Expense

5 000

10 000

Wages (c)

Cash

50 000

(c)

Cash

Other Expenses 10 000

(d)

Accounts Payable

Electricity Expenses 5 000 Accounts payable (d) Share capital

RST Ltd Trial balance

Cash Accounts receivable Accounts payable Share capital Sales Wages expenses Electricity expenses Other expenses 4

Preparing closing entries

$ 10 000 20 000

50 000 5 000 10 000 95 000 $ 80 000

DR CR

Sales Profit and loss summary

DR CR

Profit and loss summary Wages expenses Electricity expense Other expense

65 000

DR CR

Profit and loss summary Retained profits

15 000

$ 5 000 10 000 80 000

95 000 $ 80 000 50 000 5 000 10 000 15 000

Chapter 10: Record-keeping

RST Ltd Income Statement

Sales Operating expenses Wages expenses Electricity expenses Other expenses Net Profit

$ 50 000 5 000 10 000

Note showing change in retained profits Opening retained profits Plus net profit Less dividends declared Closing retained profits

$ 80 000

65 000 15 000 0 15 000 0 15 000

RST Ltd Balance Sheet at year end $ Assets Cash Accounts Receivable Total Assets Liabilities Accounts Payable Shareholders’ Equity Share Capital Retained Profits

10 000 20 000 30 000 5 000 10 000 15 000 25 000 30 000

Total Liabilities and Shareholders’ Equity

RST Ltd Statement of Cash Flows $ Cash received from customers Payments to employees Other payments Net change in cash Cash at beginning of the year Cash at end of the year

60 000 (50 000) (10 000) 0 10 000 10 000

Chapter 10: Record-keeping

Problem 10.5 1 Journal entries: Hoad Ltd General journal

No a

Description Cash

Debits

Credits

$ 200,000

Share capital b

200,000

Inventory Cash

20,000

Rent expense Cash

4,000

Inventory Accounts payable

30,000

Advertising expense Expenses payable

1,000

Accounts receivable Sales Cost of goods sold Inventory

90,000

Accounts payable Cash

25,000

Cash

30,000

20,000

4,000

30,000

1,000

90,000 40,000 40,000

25,000

Accounts receivable i

30,000

Wages expense Cash

15,000

Sales commission Cash

900

15,000

900

Office equipment Cash Accounts payable

6,000

Wages expense

2,000

Expenses payable

3,000 3,000

2,000

Chapter 10: Record-keeping

2 General ledger postings: Hoad Ltd General Ledger Cash a

Share capital

200,000

Inventory

20,000

Accounts receivable

30,000

Rent

4,000

Closing Balance

g Accounts payable

25,000

Wages

15,000

Sales commission

900

Office equipment

3,000

162,100 Accounts Receivable

Sales

90,000

Closing Balance

60,000

h Cash

30,000

Inventory b

Cash

20,000

Accounts payable

30,000

Closing Balance

10,000

f Cost of goods sold

40,000

Office Equipment k

Cash

3,000

Accounts payable (noncurrent)

3,000

Closing Balance

6,000

Accounts Payable g

Cash

25,000

d Inventory

30,000

k Office equipment Closing Balance

3,000 8,000

Expenses Payable

e Advertising

1,000

l Wages

2,000

Closing Balance

3,000

Chapter 10: Record-keeping

Share Capital a Cash

200,000

Sales f Accounts receivable 90,000

Cost of Goods Sold f

Inventory

40,000

Rent Expense c

Cash

4,000

Advertising Expense e

Expenses payable

1,000

Wages Expense i

Cash

15,000

Expenses payable

2,000 17,000 Sales Commission

Cash

900

Chapter 10: Record-keeping

3 Trial balance: Hoad Ltd Trial balance as at 30 November 2022 Account

Debit $

Cash Accounts receivable Inventory Office equipment Accounts payable Expenses payable Share capital Sales Cost of goods sold Rent Advertising Wages Sales commission

162,100 60,000 10,000 6,000 8,000 3,000 200,000 90,000 40,000 4,000 1,000 17,000 900 301,000

4 Closing entries:

DR Sales CR

90,000

P & L Summary

DR P & L Summary

90,000

62,900

Cost of goods sold

40,000

Rent

4,000

Advertising

1,000

Wages

17,000

Sales commission

DR P & L Summary CR

Retained profits

Credit $

900

27,100 27,100

301,000

Chapter 10: Record-keeping

5 Hoad Ltd Income statement For the month of November 2022 $

Sales

90,000

Less Cost of goods sold

40,000

Gross profit

50,000

Less Operating Expenses Rent

4,000

Advertising

1,000

Wages

17,000

Sales Commission

900 22,900

Net Profit

27,100

Hoad Ltd Balance sheet as at 30 November 2022

Current Assets

Current Liabilities

Cash

162,100 Accounts Payable

5,000

Accounts Receivable

60,000 Expenses Payable

3,000

Inventory

10,000

8,000

232,100 Noncurrent Liabilities Noncurrent Assets Office Equipment

Accounts Payable

3,000

6,000 Total Liabilities

11,000

Shareholders’ equity Share Capital

200,000

Retained Profits

27,100 227,100

Total Assets

238,100 Total Liabilities and Equity

238,100

Chapter 10: Record-keeping

Problem 10.6 1 Date 2022 July 1

July 5 July 6 July 8 July 11

July 13 July 15 July 16 July 18 July 19 July 23 July 24 July 28 July 29 July 29 July 31

General journal Cleaner Pools Ltd Description

Posting Debits Credits $ $ reference Rent expense 52 800 Prepayments 04 1 600 Cash 01 2 400 Note this could have been accounted for by having two entries. One on 1 July DR Prepayments 2400 and CR cash 2400 and then having a second entry at the end of the month to account for the using up of the asset (DR rent expense 800, CR Prepayments 800). Accounts receivable 02 1 400 Consulting revenue 41 1 400 Cash 01 100 Repairs revenue 42 100 Furniture and fittings 11 2 400 Accounts payable 20 2 100 Cash 01 300 Cash 01 2 700 Sales 40 2 700 Cost of goods sold 50 1 600 Inventory 03 1 600 Accounts payable 20 3 500 Cash 01 3 500 Cash 01 4 000 Accounts receivable 02 4 000 Furniture and fittings 11 3 000 Cash 01 3 000 Advertising expense 56 400 Accounts payable 20 400 Photocopier rental expense 57 400 Cash 01 400 Motor vehicle expenses 53 50 Cash 01 50 Stationery expense 54 100 Cash 01 100 Accounts payable 20 400 Cash 01 400 Salaries expense 51 2 200 Cash 01 2 000 Accrued expenses 22 200 Cash 01 1 400 Accounts receivable 02 1 400 Depreciation expense – Furniture and fittings 55 100 Accumulated depreciation – Furniture and fittings 12 100

Chapter 10: Record-keeping

Ledger Cash

July

1 6 11 15 29

Opening Balance Repairs revenue Sales Accounts receivable Accounts receivable

3 000 100 2 700 4 000 1 400

July

01 1 8 13 16 19 23 24 28 29 31

Rent expense Prepayments Furniture and fittings Accounts payable Furniture and fittings Photocopier rental expenses Motor vehicle expenses Stationery expense Accounts payable Salaries expense Closing Balance

Accounts receivable July

1 5

Opening Balance Consulting revenue 31 Closing balance

4 000 1 400 0

July

15 29

Opening Balance

4 500

Closing Balance

2 900

July

Cash Cash

July

8 8 16

Cost of goods sold

1 600

Accounts payable Cash Cash Closing balance

Furniture and fittings $ 2 100 300 3 000 5 400

Accumulated depreciation – Furniture and fittings 31

1 28

Cash Cash

3 500 400

July

Depreciation expense

Accounts payable July

1 600

Cash

July

4 000 1 400 03

Prepayments July

50 100 400 2 000 950 02

Inventory July

800 1 600 300 3 500 3 000 400

100

20 1 8 18 31

Opening Balance Furniture and fittings Advertising expense Closing Balance

3 500 2 100 400 2 100

Chapter 10: Record-keeping

Accrued expenses July

22 29

Salaries expense

Share capital July

30 1

Balance

Retained profits July

Balance

Cash

Accounts receivable

Inventory

Cash

Cash Accrued expenses

Cash

July

24 31

Cash

100 Depreciation expense – Furniture and fittings

Accumulated depreciation

Accounts payable

Cash

54 55

400 Photocopier rental expense

July

100 Advertising expense

July

50 Stationery expense

July

800 Motor vehicle expense

July

2 000 200 2 200 Rent expense

July

100

1 600 Salaries expense

July

1 400 42

Cost of goods sold July

2 700 41

Repairs revenue July

2 000 40

Consulting revenue July

6 000 31

Sales July

200

400

Chapter 10: Record-keeping

Cleaner Pools Ltd Trial balance as at 31 July 2022 Account

No. 01 03 04 11 12 20 22 30 31 40 41 42 50 51 52 53 54 55 56 57

Cash Inventory Prepayments Furniture and fittings Accumulated depreciation – furniture and fittings Accounts payable Accrued expenses Share capital Retained profits Sales Consulting revenue Repairs revenue Cost of goods sold Salaries expense Rent expense Motor vehicle expense Stationery expense Depreciation expense – furniture and fittings Advertising expense Photocopier rental expense

Debit $ 2 900 1 600 5 400

1 600 2 200 800 50 100 100 400 400 15 550

Credit $ 950

100 2 100 200 6 000 2 000 2 700 1 400 100

15 550

4 Cleaner Pools Ltd. Income Statement for the month of July 2022 $ Sales of pool filters Less cost of goods sold Gross margin on pool filters Consulting revenue Repairs revenue Less operating expenses Salaries expense Rent expense Motor vehicle expense Stationery expense Depreciation expense – furniture and fittings Advertising expense Photocopier rental expense Net loss

2 200 800 50 100 100 400 400

$ 2 700 1 600 1 100 1 400 100 2 600

4 050 (1 450)

Chapter 10: Record-keeping

Current assets Inventory Prepayments

Cleaner Pools Ltd. Balance sheet as at 31 July 2022 $ Current liabilities 2 900 Bank overdraft 1 600 Accounts payable 4 500 Accrued expenses

Noncurrent assets Furniture and fittings Less accumulated depreciation

5 400 100 5 300

Shareholders’ equity Share capital Retained profits

9 800

$ 950 2 100 200 3 250 6 000 550 6 550 9 800

Problem 10.7 1

Roche Ltd General journal a b c d

e f g h* i j k

DR Accounts payable CR Cash DR Cash CR Accounts receivable DR Inventory CR Accounts payable DR Accounts receivable CR Sales DR Cost of goods sold CR Inventory DR Administrative expenses CR Cash DR Depreciation expense CR Accumulated depreciation DR Other expenses CR Prepayments DR Retained profits CR Cash DR Long-term loan CR Cash DR Cash CR Share capital DR Wages expense CR Cash

$ 100 000 300 000 200 000 700 000 450 000 30 000 10 000 10 000 20 000 100 000 500 000 50 000

* Alternatively (although ledger postings based on the above)

DR Retained profits CR Dividend payable DR Dividend payable CR Cash

20 000 20 000

Chapter 10: Record-keeping

Ledger

Closing Balance

Cash $ 110 000 a 300 000 e 500 000 h i k 610 000

Opening Balance Sales Closing balance

Accounts receivable $ 410 000 b Cash 700 000 810 000

Opening Balance Accounts payable Closing Balance

Inventory $ 610 000 d 200 000 360 000

Opening Balance Closing Balance

Prepayments $ 80 000 g Other expenses 70 000 Equipment $ 610 000

Opening Balance Accounts receivable Share capital

b j

Balance

01 Accounts payable Administrative expenses Retained Profits Long-term loan Wages

Cost of goods sold

Accumulated depreciation – Equipment f

Cash

Opening Balance Depreciation expense Closing Balance

$ 300 000

$ 450 000

$ 10 000

$ 140 000 10 000 150 000

Accounts payable $ 100 000 Opening Balance c Inventory Closing Balance

Long-term loan $ 100 000 Opening Balance Closing Balance

Share capital j

$ 100 000 30 000 20 000 100 000 50 000

$ 210 000 200 000 310 000 $ 310 000 210 000

21 Opening Balance Cash Closing Balance

$ 910 000 500 000 1 410 000

Chapter 10: Record-keeping

Retained profits h

Cash

20 000 Opening Balance Closing balance

$ 250 000 230,000

Sales

31 d

Inventory

$ 700 000

Accounts receivable

Cost of goods sold $ 450 000

Cash

Administrative expenses $ 30 000

Accumulated depreciation

Depreciation expense $ 10 000

Cash

Wages $ 50 000

Prepayments

Other expenses $ 10 000

Roche Ltd Trial balance as at 30 September 2022 Account Debits Cash Accounts receivable Inventory Prepayments Equipment Accumulated depreciation – equipment Accounts payable Long-term loan Share capital Retained profits Sales Cost of goods sold Administrative expenses Depreciation expense Wages Other expenses

Credits $

610 000 810 000 360 000 70 000 610 000

450 000 30 000 10 000 50 000 10 000 $3 010 000

150 000 310 000 210 000 1 410 000 230 000 700 000

$3 010 000

Chapter 10: Record-keeping

Problem 10.8 1 General journal Date

Particulars

Ref

2022 April 1 Cash at Bank Share capital 2 Delivery truck Loan from Finance Co. 4 Inventories Sundry creditors 7 Delivery truck expenses Cash at Bank 10 Cash at Bank Sales Cost of goods sold Inventories 15 Sundry debtors Sales Cost of goods sold Inventories 25 Salary – Shop assistants Cash at Bank 27 Office expenses Cash at Bank 29 Cash at Bank Sundry debtors 29 Sundry creditors Cash at Bank 29 Interest expense Cash at Bank

30 1 35 15 32 10 45 30 30 20 40 32 31 20 40 32 42 30 47 30 30 31 10 30 49 30

Ledger of Carlson Ltd

DR $ 150 000 80 000 200 000 4 800 50 000 30 000 120 000 70 000 8 000 26 000 90 000 100 000 800

CR $ 150 000 80 000 200 000 4 800 50 000 30 000 120 000 70 000 8 000 26 000 90 000 100 000 800

1 Share capital April 1

Cash at Bank

150 000

Inventories

200 000

Delivery truck.

80 000

Cash at Bank. Sundry Debtors

50 000 120 000

9 Profit and loss 10 Sundry creditors April 29

Cash at Bank

100 000

April 4

15 Loan from Finance Co. April 2 20 Sales April 10 15

Chapter 10: Record-keeping

30 Cash at Bank April

1 10 29

Share capital Sales Sundry debtors.

150 000 50 000 90 000

April

7 Delivery truck exps 25 Salary – Shop assistant 27 Office expenses. 29 Sundry creditors. 29 Interest expense

4 800 8 000 26 000 100 000 800

31 Sundry debtors April 15

Sales

120 000

April 29

Cash at Bank

90 000

Cost of goods sold 15 Cost of goods sold

30 000 70 000

32 Inventories April 4

Sundry creditors

200 000

April 10

35 Delivery truck April 2

Loan from Finance Co.

80 000 40 Cost of goods sold

April

10 15

Inventories Inventories

30 000 70 000 42 Salary – Shop assistants

April 25

Cash at Bank.

8 000

45 Delivery truck expenses April 7

Cash at Bank.

4 800 47 Office expenses

April 27

Cash at Bank .

26 000 49 Interest expense

April 29

Cash at Bank.

800

Chapter 10: Record-keeping

Trial Balance

1 Share capital 9 Profit and loss 10 Sundry creditors 15 Loan from Finance Co. 20 Sales 30 Cash at Bank 31 Sundry debtors 32 Inventories 35 Delivery truck 40 Cost of goods sold 42 Salary – Shop assistants 45 Delivery truck expenses 47 Office expenses 49 Interest expense

Closing entries Date

April 30

150 400 30 000 100 000 80 000 100 000 8 000 4 800 26 000 800 500 000

CR 150 000 100 000 80 000 170 000

500 000

General journal Particulars

Sales Profit and loss Transfer of closing balance Profit and loss Cost of goods sold Salary – Shop assistants Depreciation on delivery truck Delivery truck expenses Office expenses Interest expense Transfer of closing balances Profit and loss Retained profits Transfer of net profit for April 2016

Posting ref.

DR $

20 9

170 000

9 40 42 43 45 47 49

139 600

9 2

30 400

CR $ 170 000 100 000 8 000 4 800 26 000 800

30 400

Chapter 10: Record-keeping

Ledger of Carlson Ltd 1 Share capital April 1

Cash at Bank.

150 000

Profit and loss

30 400

Sales

170 000

April 4

Inventories

200 000

April 30

Balance

100 000

Delivery truck

80 000

10 15

Cash at Bank. Sundry Debtors

50 000 120 000

Delivery truck Expenses Salary – assistants. Office expenses Sundry creditors Interest expenses

4 800 8 000 26 000 100 000 800

Cash at Bank

90 000

Cost of goods sold Cost of goods sold

30 000 70 000

2 Retained profits April 30 9

Profit and loss April 30

Cost of goods sold Salary – Assistants. Delivery truck exps Office expenses. Interest expense. Retained profits

100 000 8 000 4 800 26 000 800 30 400

April 30

Sundry creditors April

Cash at Bank.

100 000

15 Loan from Finance Co. April 2 20 Sales April 30

Profit and loss.

170 000

April

30 Cash at Bank April

April

April 15 April 30

Share Capital

10 29

Sales Sundry debtors

150 000 50 000 90 000

April

Balance

150 400

Sales Balance

31 Sundry debtors 2 120 000 April 29 30 000

25 27 29

32 Inventories April 4

Sundry creditors

200 000

April 30

Balance

100 000

April

10 15

Chapter 10: Record-keeping

35 Delivery truck April 2

Loan from Finance Co.

80 000 40 Cost of goods sold

April

10 15

Inventories Inventories.

30 000 70 000

April 30

Profit and loss

100 000

Profit and loss

8 000

Profit and loss.

4 800

Profit and loss

26 000

Profit and loss .

800

42 Salary – Shop assistants April 25

Cash at Bank.

8 000

April 30

45 Delivery truck expenses April 7

Cash at Bank

4 800

April 30

47 Office expenses April 27

Cash at Bank.

26 000

April 30

49 Interest expense April 29 5

Cash at Bank

800

April 30

Carlson Ltd Income Statement for month ended 30 April 2022 $

Sales Less: Cost of goods sold Gross margin Less: Operating expenses Salary – Shop assistants Delivery truck expenses Office expenses Interest expense Net profit 6 1 2 10 15 30 31 32 35

$ 170 000 100 000 70 000

8 000 4 800 26 000 800

39 600 30 400

Post-closing entry trial balance at 30 April 2022 $ $ Share capital 150 000 Retained profits 30 400 Sundry creditors 100 000 Loan from Finance Co. 80 000 Cash at Bank 150 400 Sundry debtors 30 000 Inventories 100 000 Delivery truck 80 000 360 400

360 400

Chapter 10: Record-keeping

Carlson Ltd Balance sheet at 30 April 2022 Assets Current assets Cash at Bank Sundry debtors Inventories

$ 150 400 30 000 100 000 280 400

Noncurrent assets Delivery truck Liabilities and shareholders’ equity Current liabilities Sundry creditors Long-term liabilities Loan Shareholders’ equity Share capital Retained profits Total liabilities and shareholders’ equity

80 000 360 400 100 000 80 000 180 000 150 000 30 400 180 400 360 400

Problem 10.9 1 Assets Current assets Cash Accounts receivable Supplies inventory Noncurrent assets Office equipment cost Accum. depreciation Total

Fergama Production Ltd Balance sheet as at the end of last year $ $ $ Liabilities and equity Current liabilities 23 415 Accounts payable 37 778 89 455 Taxes payable 12 250 10 240 123 110 Noncurrent liabilities Long-term loan 24 486 Shareholders’ equity (11 134) 13 352 Share capital 20 000 Retained profits 51 434 136 462 Total

50 028 15 000 71 434 136 462

Chapter 10: Record-keeping

2 Entries to record the activities: Debits a b c d

e f g h i j k

$ 216 459

Accounts receivable Revenue Production expenses Cash Accounts payable Depreciation expense Accumulated depreciation Supplies inventory Accounts payable Supplies expense Supplies inventory Income tax expense Taxes payable Retained Profits Dividend payable Cash Accounts receivable Accounts payable Cash Taxes payable Cash Long-term loan payable Cash Dividend payable Cash

Ledger

156 320 2 680 8 657 12 984 12 319 25 000 235 260 172 276 18 400 5 000 25 000

Cash Production expenses Accounts payable Taxes payable Long-term loan payable Dividend payable

Opening Balance Accounts receivable

23 415 235 260

Closing Balance

26 712

Opening Balance Revenue Closing Balance

Accounts receivable 89 455 Cash 216 459 70 654

Opening Balance Accounts payable Closing Balance

Supplies inventory 10 240 Supplies expense 8 657 5 913

Balance

Office equipment 24 486

Credits $ 216 459 11 287 145 033 2 680 8 657 12 984 12 319 25 000 235 260 172 276 18 400 5 000 25 000

11 287 172 276 18 400 5 000 25 000

235 260

12 984

Chapter 10: Record-keeping

Accumulated depreciation Opening Balance Depreciation expenses Closing Balance Cash

Cash

Cash Cash

Dividend Payable

Accounts payable 172 276 Opening Balance Production expenses Supplies Inventory Closing Balance Taxes payable 18 400 Opening Balance Income Tax expense Closing Balance

11 134 2 680 13 814 37 778 145 033 8 657 19 192 12 250 12 319 6 169

Dividend payable 25 000 Retained Profits

25 000

Long-term loan payable 5 000 Opening Balance Closing Balance

15 000 10 000

Share capital Balance

20 000

Retained profits Opening Balance Closing Balance

51 434 26 434

25 000

Revenue Accounts receivable Cash

Production expenses 156 320

Accumulated depreciation

Depreciation expenses 2 680

Supplies inventory

Supplies expense 12 984

Taxes payable

Income tax expense 12 319

216 459

Chapter 10: Record-keeping

Ending trial balance:

$ 26 712 70 654 5 913 24 486

Cash Accounts receivable Supplies inventory Office equipment Accumulated depreciation Accounts payable Taxes payable Dividend payable Long term loan payable Share capital Retained profits Revenue Production expenses Depreciation expense Supplies expense Income tax expense

13 814 19 192 6 169 0 10 000 20 000 26 434 216 459

156 320 2 680 12 984 12 319 312 068

312 068

Fergama Production Ltd Income Statement for this year $

Revenue Less expenses: Production expense Depreciation expense Supplies expense Profit before income tax Less income tax expenses

156 320 2 680 12 984

Net profit for the year

$ 216 459

171 984 44 475 12 319 32 156

b Fergama Production Ltd Balance Sheet as at the end of this year Assets Current assets Cash Accounts receivable Supplies inventory Noncurrent assets Office equipment Accum. depreciation Total

$ 26 712 70 654 5 913 24 486 (13 814)

103 279 10 672 113 951

Liabilities and equity Current liabilities Accounts payable Taxes Noncurrent liabilities Long-term loan

19 192 6 169

25 361

Shareholders’ equity Share capital Retained profits Total

20 000 58 590

10 000 35 361 78 590 113 951

Chapter 10: Record-keeping

Fergama Production Ltd Note showing change in retained profits for this year Retained profits, end of last year Add net profits for this year Deduct dividend declared Retained profits, end of this year

$ 51 434 32 156 (25 000) 58 590

5 Substantial net profit was earned this year. The company has increased its net resources (assets – liabilities). Most, but not all, of this profit was paid as a dividend to the owners, so retained profits are higher this year. Working capital was $73 082 last year and is $77 918 this year. The working capital ratio was 2.46 last year, 4.07 this year. Thus the company can comfortably pay its debts as they fall due.

Problem 10.10 The trial balance will detect errors that result in the number of debits and credits posted being different. 1 Would not be detected. The amount on invoice is incorrect, but the incorrect amount from the invoice was properly posted and then paid. 2 Would be detected. Two accounts were credited and no account was debited, so debits do not equal credits. 3 Would be detected. Debits do not equal credits. 4 Would not be detected. 5 Would be detected. Debits do not equal credits. 6 Would not be detected. 7 Would not be detected. Total debits equal total credits, for the two misstated items.

Problem 10.11 1 OB AP CB 2 Cash 3 OB Sales CB 4

Inventory 35 000 COGS 45 000 70 000 60 000 Accounts Payable 55 000 OB 30 000 70 000 CB 45 000 Accounts Receivable 65 000 Cash 124 000 130 000 71 000 Retained Profits OB 10 000 NP 26 000 CB 36 000

Chapter 10: Record-keeping

Problem 10.12 1

Rosewall Ltd General journal $ 250 000

(1) DR CR

Cash Share capital

(2) DR CR

Inventory Accounts payable

43 000

(3) DR CR

Rent expense Cash

8 000

(4) DR CR DR CR

Accounts receivable Sales revenue Cost of goods sold Inventory

110 000

(5) DR CR

Advertising expenses Accrued expenses

2 000

(6) DR CR

Inventory Cash

27 000

(7) DR CR

Accounts payable Cash

30 000

(8) DR CR

Wages expenses Cash

24 000

(9) DR CR

Cash Accounts receivable

45 000

(10) DR CR

Commission expense Cash

1 100

(11) DR CR CR

Machinery Cash Loan payable

9 000

(12) DR CR

Wages expenses Accrued expenses

3 500

(13) DR CR

Depreciation expense Accumulated depreciation

1 000

(14) DR CR

Interest receivable Interest revenue

6 000

(15) DR CR

Cash Unearned revenue

8 000

$ 250 000 43 000 8 000

45 000

110 000 45 000 2 000 27 000 30 000 24 000 45 000 1 100 4 000 5 000 3 500 1 000 6 000 8 000

Chapter 10: Record-keeping

2 (1) (9) (15)

Posting to the ledger accounts Cash (3) (6) (7) (8) (10) (11)

Share capital Accounts receivable Unearned revenue

250 000 45 000 8 000

208 900

(4)

Sales CB

Accounts receivable 110 000 (9) Cash 65 000

(2) (6)

Accounts payable Cash CB

Inventory 43 000 (4) 27 000 25 000

(14)

Interest revenue

Interest receivable 6 000

Cash Loan payable CB

Machinery 4 000 5 000 9 000

(11) (11)

Rent expense Inventory Accounts payable Wages expenses Commission expense Machinery

Cost of goods sold

Accum. depreciation (13) Depreciation expense

(7)

Cash

Accounts payable 30 000 (2)

8 000 27 000 30 000 24 000 1 100 4 000

45 000

1 000

Inventory CB

43 000 13 000

Advertising exp. Wages exp. CB

2 000 3 500 5 500

Cash

8 000

Loan payable (11)

Machinery

5 000

Share capital (1)

Cash

Accrued expense (5) (12) Unearned revenue (15)

250 000

Chapter 10: Record-keeping

Sales Revenue (4)

Accounts receivable

110 000

Interest Revenue (14)

Interest receivable

6 000

(3)

Cash

8 000

(10)

Cash

Commission expense 1 100

(8) (12)

Cash Accrued exp.

Wages expenses 24 000 3 500

(5)

Cash

Advertising expenses 2 000

(13)

Accum. dep.

Depreciation expenses 1 000

Rosewall Ltd Trial balance at end November 2021

Cash Accounts receivable Inventory Interest receivable Machinery Accumulated depreciation Accounts payable Accrued expense Unearned revenue Loan payable Share capital Sales Revenue Interest Revenue COGS Rent expenses Advertising expense Commission expense Wages expense Depreciation expense

$ 208 900 65 000 25 000 6 000 9 000

45 000 8 000 2 000 1 100 27 500 1 000 398 500

1 000 13 000 5 500 8 000 5 000 250 000 110 000 6000

398 500

Chapter 10: Record-keeping

4 Preparing closing entries

$ 110 000 6 000

DR DR CR

Sales Revenue Interest Revenue Profit and loss summary

DR CR

Profit and loss summary COGS Rent expenses Advertising expense Commission expense Wages expense Depreciation expense

84 600

DR CR

Profit and loss summary Retained profits

31 400

116 000 45 000 8 000 2 000 1 100 27 500 1 000 31 400

5 Post-closing Trial Balance Rosewall Ltd Trial balance at end November 2021 Cash Accounts receivable Inventory Interest receivable Machinery Accumulated depreciation Accounts payable Accrued expense Unearned revenue Loan payable Share capital Retained profits

$ 208 900 65 000 25 000 6 000 9 000

313 900

1 000 13 000 5 500 8 000 5 000 250 000 31 400 313 900

Chapter 10: Record-keeping

6 Rosewall Ltd Income Statement for the month ended 30 November 2021 $ $ Sales Revenue 110 000 Cost of goods sold (45 000) Gross profit 65 000 Interest Revenue 6 000 Operating expenses Rent expenses 8 000 Advertising expense 2 000 Commission expense 1 100 Wages expense 27 500 Depreciation expense 1 000 (39 600) Net profit 31 400 Rosewall Ltd Balance Sheet as at 30 November 2021 Current assets $ Current liabilities Cash 208 900 Accounts payable Accounts receivable 65 000 Accrued expenses Inventory 25 000 Unearned revenue Interest receivable 6 000 Noncurrent liabilities 304 900 Loan payable Noncurrent assets Machinery Accumulated depreciation Total assets

9 000 (1 000) 8 000 312 900

Shareholders’ equity Share capital Retained profits Total liabilities and equity

Problem 10.13 Closing journal entries: DR CR

Sales Profit and loss summary

320 000

DR CR CR CR CR CR CR CR

Profit and loss summary COGS Depreciation expense Rent Salaries expense Insurance expense Telephone expense Electricity expense

255 000

DR CR

Profit and loss summary Retained profits

65 000

320 000 190 000 2 000 10 000 37 000 5 000 5 000 6 000 65 000

$ 13 000 5 500 8 000 5 000 250 000 31 400 281 400 312 900

Chapter 10: Record-keeping

Problem 10.14 This problem in ‘reconstructing’ journal entries is meant to give students practice in understanding existing accounting data, as distinct from creating the data themselves. Sanderson uses perpetual inventory accounting for its main inventory and periodic for its supplies, but the problem requires sorting out more than just the inventory entries. DR

a b c

d e

g h i j

Cash Share capital Issue of shares for cash. (Number of shares unknown.) Inventory Accounts payable Purchases of inventory, on credit. Equipment Cash Notes payable Purchase of equipment, partly for cash. Supplies expense Accounts payable Supplies expense, not yet paid for. Accounts receivable Sales revenue Credit sales. Cost of goods sold expense Inventory Cost of the goods sold on credit. Cash Accounts receivable Sales revenue Credit sales with down payment. Cost of goods sold expense Inventory Cost of the goods sold with down payment. Cash Accounts receivable Collections on customer accounts. Accounts payable Cash Payments to suppliers. Supplies Supplies expense Supplies on hand at end of the month. Interest expense Notes payable Cash To record payment of interest and principal on notes.

$ 30 000

30 000 5 000 3 600

700 900

540 1 300 1 400 1 620 650 1 000 300 60

5 000 1 200 2 400 700 900

540

2 700 1 620 650 1 000 300 500 560

Chapter 10: Record-keeping

Problem 10.15 1

Wan Chai Ltd Journal entries Account a b

c d e f g

h i j

l m n o

Accrued wages Cash Accounts receivable Sales COGS Inventory Accounts payable Cash Inventory Accounts payable Prepaid insurance Cash Cash Accounts receivable Cash Sales COGS Inventory Interest expense Interest payable Unearned revenue Sales Wages expense Cash Wages expense Accrued Prepaid rent Cash Rent expense Prepaid rent Administrative Expenses Cash Depreciation Expense Accumulated Depreciation Commission expense Commissions Payable Interest receivable Interest revenue Insurance expense Prepaid insurance

Debit ($) Credit ($) 264,000 264,000 1,254,000 1,254,000 750,000 750,000 1,020,000 1,020,000 480,000 480,000 504,000 504,000 1,680,000 1,680,000 270,000 270,000 192,000 192,000 10,000 10,000 348,000 348,000 186,000 186,000 60,000 60,000 144,000 144,000 144,000 144,000 126,000 126,000 54,000 54,000 13,200 13,200 10,000 10,000 42,000 42,000

Chapter 10: Record-keeping

General Ledger

Jul 1 Opening balance 6 Accounts Receivable 7 Sales

Closing balance

Jul 1 Opening balance 2 Sales Jul 31 Closing balance

Cash 324,000 1,680,000 270,000

Jul 1 3 5 10 11 12

Accrued Wages Accounts Payable Prepaid Insurance Wages Expense Prepaid Rent Admin Expense

264,000 1,020,000 504,000 186,000 144,000 126,000

30,000

Accounts Receivable 906,000 Jul 6 Cash 1,254,000 480,000

Jul 1 Opening balance 4 Accounts Payable Jul 31 Closing balance

Inventory 1,332,000 Jul 2 Cost of Goods Sold 480,000 7 Cost of Goods Sold 870,000

Jul 31 Interest Revenue

Interest Receivable 10,000

Jul 1 Opening balance 5 Cash Jul 31 Closing balance

Prepaid Insurance 42,000 Jul 31 Insurance Expense 504,000 504,000

1,680,000

750,000 192,000

42,000

Chapter 10: Record-keeping

Problem 10.15 (continued) Jul 1 Opening balance Cash Closing balance

Prepaid Rent 144,000 Jul 31 144,000 144,000

Jul 1 Opening balance

Buildings and Equipment 3,240,000

Rent Expense

144,000

Accumulated Depreciation Jul 1 Opening balance 31 Depreciation Exp Jul 31 Closing balance

804,000 54,000 858,000

Loan Jul 1 Opening balance

Jul 3 Cash

Jul 1

Cash

Jul 9 Sales

1,200,000

Accounts Payable 1,020,000 Jul 1 Opening balance 4 Inventory 31 Closing balance

1,620,000 480,000 1,080,000

Accrued Wages 264,000 Jul 1 Opening balance 10 Wages Expense 31 Closing balance

264,000 60,000 60,000

Unearned Revenue 348,000 Jul 1 Opening balance Closing balance

348,000 0

Interest Payable Jul 8 Interest Expense

10,000

Commissions Payable Jul 31 Commission Exp

13,200

Share Capital Jul 1 Opening balance

1,420,000

Chapter 10: Record-keeping

Problem 10.15 (continued) Retained Profits Jul 1 Opening balance Sales Jul 2 Accounts Receivable 7 Cash 9 Unearned Revenue

Interest Revenue Jul 31 Interest Rec.

Jul 2 Inventory 7 Inventory

Cost of Goods Sold 750,000 192,000 942,000

Prepaid Rent

Rent Expense 144,000

Prepaid Insurance

Insurance Expense 42,000

Jul 31 Acc. Depreciation

Depreciation Expense 54,000

Jul 31 Interest Payable

Interest Expense 10,000

Jul 31

Jul 10 Cash Accrued Wages

Jul 12

Jul 31

Wages Expense 186,000 60,000 246,000

Cash

Administration Expense 126,000

Comm. Payable

Commission Expense 13,200

332,000

1,254,000 270,000 348,000 1,872,000

10,000

Chapter 10: Record-keeping

Problem 10.15 (continued) Trial Balance Account Cash Accounts Receivable Interest Receivable Inventory Prepaid Rent Prepaid Insurance Buildings and Equipment Accumulated Depreciation Accounts Payable Accrued Wages Interest Payable Commissions Payable Loan Sales Interest Revenue Cost of Goods Sold Rent Expense Insurance Expense Depreciation Expense Interest Expense Wage Expense Administration Expense Commission Expense Share Capital Retained Profits

Debit $

Credit $

30,000 480,000 10,000 870,000 144,000 504,000 3,240,000 858,000 1,080,000 60,000 10,000 13,200 1,200,000 1,872,000 10,000 942,000 144,000 42,000 54,000 10,000 246,000 126,000 13,200

6,855,200

1,420,000 332,000 6,855,200

Income Statement for the month ended 31 July 2022 $

$ 1,872,000 10,000 1,882,000

Sales Interest Revenue Total Revenue Less Cost of Goods Sold Gross Profit Operating Expenses Wages Interest Rent Commissions Depreciation Insurance Administration Net Profit

942,000 940,000

246,000 10,000 144,000 13,200 54,000 42,000 126,000

635,200 304,800

Chapter 10: Record-keeping

Problem 10.15 (continued) Wan Chai Limited Balance Sheet as at 31 July 2022 $ Current Assets Cash Accounts Receivable Interest Receivable Inventory Prepaid Insurance Prepaid Rent Total Current Assets Noncurrent Assets Buildings and Equipment Less Accumulated Depreciation Total Noncurrent Assets Total Assets

$ 30,000 480,000 10,000 870,000 504,000 144,000 2,038,000

3,240,000 (858,000)

2,382,000 2,382,000 4,420,000

Liabilities Current Liabilities Accounts Payable Interest Payable Commissions Payable Accrued Wages Total Current Liabilities

1,080,000 10,000 13,200 60,000 1,163,200

Noncurrent Liabilities Loan Total Noncurrent Liabilities Total Liabilities

1,200,000 1,200,000 2,363,200

Shareholders’ Equity Share Capital Retained Profits Total Shareholders’ Equity

1,420,000 636,800 2,056,800

Total Liabilities and Shareholders’ Equity

4,420,000

Chapter 10: Record-keeping

Problem 10.16 1 31 December 2021, Adjusting Entries: a

Depreciation expense ................................................................... 4,000 Accumulated depreciation .............................................

4,000

Insurance expense......................................................................... 450 450

Prepaid insurance .......................................................... Wages expense ............................................................................. 1,100 Wages payable.................................................................

1,100

Supplies expense .......................................................................... 500 Supplies ...........................................................................

500

Income tax expense ...................................................................... 2,150 Income tax payable ........................................................

2,150

2 PRS LTD Income Statement For the Year Ended 31 December 2021 Operating Revenue: Service revenue

$48,000

Operating Expenses: COGS Depreciation expense Insurance expense Wages expense Supplies expense ($1,300 – $800) Total expenses Operating Income Income tax expense Net Income

32,900 4,000 450 1,100 500 38,950 9,050 2,150 $6,900

Chapter 10: Record-keeping

Problem 10.16 (continued) PRS LTD Balance Sheet At 31 December 2021 Liabilities and Shareholders’ Equity

Assets Current Assets: Cash Accounts receivable

Current Liabilities: $19,600

Accounts payable

$ 7,500

7,000

Wages payable

1,100

Supplies

800

Income tax payable

2,150

Prepaid insurance

450

Total current liabilities

10,750

Total current assets

27,850

Equipment

27,000

Accumulated depreciation Other assets (not detailed)

Total assets

(16,000)

Shareholders' Equity

5,100

Share capital

16,000

Retained earnings*

17,200

Total shareholders' equity

33,200

Total liabilities and SE

$43,950

*$10,300 + $6,900 = $17,200.

3 Service revenue ............................................................................ Retained profit................................................................. COGS ............................................................................. Depreciation expense ...................................................... Insurance expense ........................................................... Wages expense .............................................................. Supplies expense ............................................................. Income tax expense .........................................................

48,000 5,900 32,900 4,000 450 1,100 500 3,150

Problem 10.17 Scanlon Ltd Worksheet Acc. No.

Trial Balance Account Name

Debit

Adjustments

Credit

Debit

Adjusted Trial Balance

Credit

Debit

Profit and Loss

Credit

Debit

Credit

Balance Sheet Debit

1,430,000

880,000

5,000

300,000

30,000

70,000

20,000

60,000

1,000,000

Credit

Cash

Accounts receivable

Accrued revenue

Inventory

300,000

Prepaid insurance

100,000

Prepaid rent

80,000

Equipment

1,000,000

A7.1

Accumulated depreciation

200,000

Accounts payable

300,000

Revenue received in advance

100,000

Income tax payable

Loan

570,000

OE1

Share capital

400,000

OE2

Retained profits

320,000

2,265,000

5,000

10,000

100,000 0

210,000

300,000

Chapter 10: Record-keeping

Scanlon Ltd Worksheet Acc. No.

Trial Balance Account Name

Debit

Adjustments

Credit

Debit

Profit and Loss summary

Sales

Service fee revenue

Interest revenue

Cost of goods sold

Commission expense

Insurance expense

Depreciation expense

Rent expense

Salaries expense

Other expenses

Credit

Adjusted Trial Balance Debit

6,800,000

Credit

Profit and Loss Debit

6,800,000

100,000

5,000

3,000,000

600,000

30,000

10,000

20,000

1,200,000

100,000

$8,690,000

NET PROFIT(LOSS)

$165,000

Credit

6,800,000

3,000,000

$8,690,000

Balance Sheet

$165,000

$8,705,000

$8,705,000 $1,945,000

Debit

Credit

$3,745,000

Problem 10.18 1 DR Cash CR

200,000

Share capital

200,000

DR Inventory CR Accounts payable

35,000

DR Accounts payable

28,000

35,000

Cash

28,000

DR Accounts receivable CR Sales

270,000

DR COGS

60,000

CR Inventory DR Cash CR

270,000 60,000 52,000

Accounts receivable

52,000

DR Prepaid rent CR Cash

12,000

DR Depreciation expense CR Accumulated depreciation

80,000

DR Dividends declared CR Cash

30,000

DR Cash

100,000

CR Long term debt DR Interest expense CR CR

12,000 80,000 30,000 100,000 5,000

Cash Interest payable

4,000 1,000

DR Prepaid insurance CR Cash

24,000

DR Wages expense

90,000

CR Cash DR Wages expense CR

90,000 20,000

Accrued expenses

DR Cash CR Interest revenue DR Unearned revenue CR

24,000

20,000 5,000 5,000 27,000

Revenue

27,000

DR Interest receivable CR Interest revenue

2,000

DR Insurance expense

4,000

2,000

Prepaid insurance

DR Rent expense CR Prepaid rent

4,000 11,000 11,000

Chapter 10: Record-keeping

Closing Balance

Cash 21,000 Accounts payable 200,000 Prepaid rent 52,000 Dividends declared 100,000 Interest expense 5,000 Prepaid insurance Wages expense 190,000

Opening Balance Sales Closing Balance

Accounts receivable 39,000 Cash 270,000 257,000

Opening Balance Accounts payable Closing Balance

Inventory 40,000 COGS 35,000 15,000

Opening Balance Cash Closing Balance

Prepaid rent 11,000 Rent expense 12,000 12,000

Opening Balance Cash Closing Balance

Prepaid insurance 0 Insurance expense 24,000 20,000

Opening Balance Interest revenue Closing Balance

Interest receivable 0 2,000 2,000

Opening Balance

Land 100,000

Opening Balance Share capital Accounts receivable Long term debt Interest revenue

Opening Balance

52,000

60,000

11,000

4,000

Property and equipment 400,000 Accumulated depreciation Opening Balance Depreciation expense Closing Balance

Opening Balance

28,000 12,000 30,000 4,000 24,000 90,000

Intangible assets (net) 90,000

80,000 80,000 160,000

Chapter 10: Record-keeping

Problem 10.18 (continued) Accounts payable 28,000 Opening Balance Inventory Closing Balance

27,000 35,000 34,000

Unearned revenue 27,000 Opening Balance Closing Balance

32,000 5,000

Interest payable Opening Balance Interest expense Closing Balance

0 1,000 1,000

Accrued expenses Opening Balance Wages expense Closing Balance

0 20,000 20,000

Long-term debt Opening Balance Cash Closing Balance

0 100,000 100,000

Share capital Opening Balance Cash Closing Balance

520,000 200,000 720,000

Retained profits 30,000 Opening Balance Profit and loss summary Closing Balance

42,000 34,000 46,000

Cash

Dividends declared 30,000 Retained profits

30,000

Profit and loss summary

Sales 270,000 Accounts receivable

270,000

Cash

Revenue

Dividends declared

Chapter 10: Record-keeping

Problem 10.18 (continued) Profit and loss summary

Interest revenue 7,000 Cash Interest receivable

5,000 2,000 7,000

Profit and loss summary

Revenue 27,000 Unearned revenue

27,000

Inventory

COGS 60,000 Profit and loss summary

60,000

Cash Accrued expenses

Wages expense 90,000 20,000 Profit and loss summary 110,000

Cash Interest payable

Interest expense 4,000 Profit and loss summary 1,000 5,000

110,000

5,000

Prepaid rent

Rent expense 11,000 Profit and loss summary

11,000

Prepaid insurance

Insurance expense 4,000 Profit and loss summary

4,000

Accumulated depreciation

Depreciation expense 80,000 Profit and loss summary

80,000

Chapter 10: Record-keeping

Problem 10.18 (continued) COGS Wages expense Interest expense Rent expense Insurance expense Depreciation expense Retained earnings

Profit and loss summary 60,000 Sales 110,000 Interest revenue 5,000 Revenue 11,000 4,000 80,000 34,000 304,000

270,000 7,000 27,000

304,000

3 DR Sales

270,000

DR Interest revenue

7,000

DR Revenue

27,000

Profit and loss summary

DR Profit and loss summary

304,000 270,000

COGS

60,000

Wages expense

110,000

Interest expense

5,000

Rent expense

11,000

Insurance expense

4,000

Depreciation expense

80,000

DR Profit and loss summary CR

Retained profits

DR Retained profits CR

34,000

Dividends declared

34,000 30,000 30,000

Problem 10.18 (continued) 4 Canberra Ltd Worksheet Trial Balance Account Name

Debit

Adjustments

Credit

Debit

Credit

Adjusted Trial Balance

Income Statement

Debit

Credit

Balance Sheet Debit

Cash

190,000

Accounts receivable

257,000

Inventory

15,000

Prepaid rent

23,000

11,000

12,000

Prepaid insurance

24,000

4,000

20,000

Interest receivable

2,000

Intangible assets

90,000

Land

100,000

Property and equipment

400,000

Dividends declared

30,000

Accumulated depreciation

80,000

Accounts payable

34,000

Unearned revenue

32,000

Interest payable

80,000

27,000 1,000

Credit

160,000

34,000

5,000

1,000

Chapter 10: Record-keeping

Canberra Ltd Worksheet Trial Balance Account Name

Debit

Adjustments

Credit

Accrued expenses

Debit 0

Credit

Adjusted Trial Balance

Income Statement

Debit

20,000

Credit

Balance Sheet

Credit

Debit

Credit

20,000

Long term debt

100,000

Share capital

720,000

Retained profits

42,000

46,000

Sales

270,000

Interest revenue

5,000

2,000

7,000

27,000

Revenue COGS

60,000

Wages expense

90,000

Interest expense

60,000

20,000

110,000

4,000

1,000

5,000

Rent expense

11,000

Insurance expense

4,000

Depreciation expense

80,000

$1,283,000

NET PROFIT (LOSS)

$145,000

$1,386,000

$1,086,000 $34,000

$1,086,000

Problem 10.18 (continued) 5 Canberra Limited Income statement for the year ended 31 December 2021 Sales

270,000

COGS Gross profit

(60,000) 210,000

Other revenue: Interest revenue

7,000

Revenue Operating expenses:

27,000

Wages expense

(110,000)

Interest expense Rent expense

(5,000) (11,000)

Insurance expense

(4,000)

Depreciation expense Net profit for the period

(80,000)

34,000

(210,000) 34,000

Canberra Limited Balance sheet as at 31 December 2021 Assets

Liabilities

Current assets

Current liabilities

Cash Accounts receivable

190,000 257,000

Account payable Unearned revenue

34,000 5,000

Inventory

15,000

Interest payable

1,000

Prepaid rent

12,000

Accrued expenses

20,000

Prepaid insurance Interest receivable

20,000 2,000

Total current liabilities

60,000

Total current assets

496,000

Noncurrent liabilities

Noncurrent assets

Long term debt

100,000

Total noncurrent liabilities

100,000

Total liabilities

160,000 766,000

Land Property and equipment

100,000 400,000

Accumulated depreciation Intangible assets (net)

(160,000) 90,000

Net assets

Total noncurrent assets

430,000

Shareholders’ equity

Total assets

926,000

Share capital

720,000

Retained profits Total shareholders’ equity

46,000 766,000

Chapter 10: Record-keeping

Problem 10.19 $ 1

Accounts receivable Prepaid expenses Inventory Cash Accrued revenue Total current assets

$ 295,000 20,000 200,000 60,000 20,000 595,000

Accounts payable Income tax payable Revenue received in advance Accrued wages Total current liabilities

120,000 40,000 10,000 25,000 195,000

Property, plant and equipment Less: Accumulated depreciation Total noncurrent assets

1,000,000 400,000 600,000

Sales Less:

Cost of goods sold Depreciation expense Other operating expenses Income tax expense Net profit after tax

750,000 50,000

Add: Opening balance of retained profit Closing balance of retained profit

150,000 200,000

Balance accumulated depreciation 31 December 2022 Less: Depreciation expense 2022 Balance 31 December 2021

400,000 20,000 380,000

Problem 10.20 1 2 3 4 5

800,000 500,000 20,000 150,000 80,000

18 000 (17 000 + 3000 – 2000) 8000 5000 (4500 + 3000 – 2500) 2000 (0 + 2000 – 0) 1000 (2000 ÷ 2)

Chapter 10: Record-keeping

Cases 10A Woolworths Limited

1 This is an example of a chart of accounts for Woolworths Limited. 1 3 3A 4 6 9 11 12 13 30 31 31A 32 32A 33 33A 51 52A

Assets Cash Trade receivables Provision for impairment Other receivables Derivatives Inventories Prepayments Listed equity securities Investments in associates Developmental properties Freehold land, warehouse, retail Accumulated amortisation - warehouse Leasehold improvements Accumulated amortisation on leasehold Plant and equipment Accumulated depreciation – plant & equipment Goodwill Accumulated amortisation – goodwill

2 No. a b c d e f

Description Cash Sales Inventories Trade payables Wages expense Cash Shop fittings Trade payables Trade receivables Management fees revenue Cash Trade receivables

Debits 38 3 000 1 000 000 800 000 1 000 000 1 000 000

Credits 38 3 000 1 000 000 800 000 1 000 000 1 000 000

Chapter 10: Record-keeping

10B Accounting Records 1

It appears that the liabilities were not recorded. Note that some liabilities are recorded when invoices are received, e.g., DR expense CR accounts payable. While it is possible these were not recorded it is more likely that certain accruals have not been recorded.

If liabilities are understated it is likely that expenses are understated and, therefore, profit is overstated.

Chapter 11 Accounts receivable and further record-keeping Discussion questions 1 The following are examples of accounts that would be included under the heading ‘Receivables’ in the balance sheet: accounts receivable, interest receivable on loans, commissions earned and unbilled revenues. 2 An accounts receivable is an asset that occurs when a company bills the customer for a good or service that has been provided but cash will not be received until a later period. Accrued revenue can be calculated when a good or service has been provided but the customer has not yet been billed. For example, assuming the company has a customer is on a three-month billing cycle for a service provided and then has 30-day terms from when the bill is processed to pay. At the end of one month the company could recognise an accrued revenue for the service provided for that month, however no accounts receivable would be created yet as the customer has not been billed. At the end of the three-month billing cycle, an accounts receivable (along with a decrease in accrued revenue to the same amount as the accounts receivable increase) would be created once the bill has been issued. Another example of an accrued revenue, as stated in the chapter, would be accrued interest where interest has been earned but is not paid until the end of the loan period. 3 Woolworths would have lower accounts receivable compared with sales than CocaCola and QBE Insurance. For Woolworths, customers pay at the time of the sale. Looking at the financial statements, trade receivables was less than half a per cent of total sales. Coca-Cola is more likely to be selling to retailers on terms, and, looking at the annual report, for Coca-Cola trade receivable are approximately one-fifth of total sales. For QBE Insurance, while it would be expected that the company would receive premiums in advance, its trade debtors for premiums receivable is around 10 per cent of gross written premiums. 4 At the end of the financial year, companies estimate the percentage of accounts receivable that they do not believe are likely to be collected (doubtful debts); these are normally recorded as ‘DR bad debts’ or ‘CR allowance’ for doubtful debts. Sometimes an organisation finds out that an account is definitely a bad debt (i.e. it will not be collected). As the expense has already been recognised, this amount is then written out of the accounts receivable balance (‘DR Allowance for Doubtful Debts CR Accounts receivable’). 5 Accounts receivable need to be recorded at net realisable value. The allowance for doubtful debts is an estimate of the amount of the accounts receivable that are likely not to be collected. It is deducted from gross accounts receivable to get net accounts receivable. This figure is shown on the face of the balance sheet.

Chapter 11: Accounts receivable and further record-keeping

6 The income statement approach calculates the balance of the bad debts expense account. The income statement approach relies on the historical relationship (or an estimate of the current relationship) between credit sales and the amount of those sales unlikely to be collected. For example, past experience might suggest that bad debts are about 1.5 per cent of net credit sales each year. This percentage is then multiplied by net credit sales to estimate the bad debts expense. Once the bad debts expense is calculated the following journal entry would be created: DR Bad debts expense (1.5% of net credit sales) CR Allowance for doubtful debts (1.5% of net credit sales) 7 The balance sheet approach calculates the balance of the allowance for doubtful debts account. The balance sheet approach is based on the belief that the older the account receivable, the greater the probability that the amount will not be collected. The important step to remember in this approach is that the allowance for doubtful debts is a balance sheet account and will have an opening balance that will need to be considered in the determination of the amount of the journal entry. The amount of the increase required to move the allowance for doubtful debts to the calculated amount will be the bad debts expense for the period. For example, the allowance for doubtful debts, calculated based on the aging of account receivable and the probability of collection, is to be $2 900. The opening balance of the allowance for doubtful debts is $2 500, therefore the allowance needs to increase by $400 and the journal entry would be: DR Bad debts expense 400 CR Allowance for doubtful debts 400 8 The purposes served by special journals are to: i allow an efficient recording process for common transactions ii enable amounts to be posted to the general ledger as totals rather than as individual journal entries iii enable information such as invoice of receipt number to be recorded in special columns provided for the purpose As a result of the use of special journals, the following control information could more readily be made available to management: i credit sales to date and cost of goods sold ii credit purchases of inventory, fixed assets or items charged to expense accounts iii cash receipts from customers, cash sales and discount allowed iv cash payments to customers, cash purchases, discount received and various expense accounts. 9 A special journal should be brought into use, rather than placing entries in the journal when transactions with common elements occur frequently (e.g. cash collections or credit purchases). The need for a general journal is never eliminated, since it is needed for: – opening entries – closing entries – balance day adjustments – correction of errors. 10 Special analysis columns to be included in the cash payments journal should be selected on the basis of: i frequency with which particular ledger accounts are involved in transactions. For example, if there is a large number of cash payments involving wages and © 2022 Cengage Australia Pty Limited. All Rights Reserved.

Chapter 11: Accounts receivable and further record-keeping

salaries the provision of a separate column for this item will minimise postings to the expense account, wages and salaries ii information requirements; for example, if details of commission expenses incurred to date are likely to be required frequently, the provision of a separate column will enable this need to be met. 11 The only transactions recorded in a simple sales journal are credit sales of goods in the ordinary course of business. Entries are made from copies of sales invoices and a fairly simple routine can be established for ensuring that all such sales are appropriately recorded and all postings correctly made. If transactions involving the sale of fixed assets were included, the economy of postings may be lost and the recording procedure would be more complex. As sales of fixed assets are relatively infrequent in the case of most business enterprises, the simple sales journal is not designed to cope with them. Being unusual transactions, such sales are best handled in the general journal. When there are frequent sales of fixed assets, a special journal may be employed or a complex sales journal may be designed to handle both the disposal of trading goods as well as fixed assets. This could be useful where plant or vehicles were used for relatively short periods of time and were sold to regular customers. 12 a b c d e f

Transaction Cash sales Credit sales Receipts from debtors Payments to creditors Cash purchases Credit purchases

Special journal Cash receipts Sales Cash receipts Cash payments Cash payments Purchases

13 A subsidiary ledger collectively represents a detailed analysis of one general ledger account classification. The relevant ledger account in the general ledger is known as a control account. 14 The advantages of a subsidiary ledger are as follows: i direct responsibility for specific sub-systems ii errors localised and detected more easily iii detailed records are available without expanding the general ledger unduly iv ledgers containing confidential information may be maintained by senior staff v different data processing methods appropriate to the respective volumes of transactions may be employed for recording the various ledgers vi internal check can be strengthened by separation of duties and comparison of independently prepared records. 15 If a customer’s account in the debtors’ ledger shows a credit balance, this does not necessarily indicate that an error has been made. Other possible reasons for the credit balance are: i goods returned after they have been paid for ii customer has neglected to deduct discount from her cheque iii payment made after account written off as bad iv overcharge corrected after payment by customer in full v general overpayment or duplicated payment by customer. 16 The double-entry principle of an equal value of debits and credits in the system does not cease to apply when subsidiary ledgers are being employed. At first sight, the three postings made as a result of a single transaction may appear to involve a departure from the principle of double-entry. For instance, the payment of cash to a © 2022 Cengage Australia Pty Limited. All Rights Reserved.

Chapter 11: Accounts receivable and further record-keeping

creditor necessitates debits to the individual creditor’s account as well as ‘Sundry creditors’ account and a credit to ‘Cash’ account. However, the double-entry is maintained in the general ledger where there is one debit and one corresponding credit. The subsidiary ledger is merely an analysis providing details of the control account and is not involved independently in the double-entry equation. 17 This statement is misleading. Subsidiary ledgers do not involve unnecessary duplication. It is true that amounts posted in detail to the subsidiary ledger are posted in total to the control account, but this is certainly not unnecessary. It provides an internal check and also results in the availability of total information as well as details of individual accounts. Both sets of information are required for the efficient management of an enterprise. Subsidiary ledgers do not increase the opportunity for error, in fact they reduce it. With subsidiary ledgers, errors are more easily detected and localised, thus reducing the time taken to balance the accounts. There is no breach of the double-entry principle. In the general ledger, there is a debit for every corresponding credit. The subsidiary ledger is a supporting record, which provides details of the balance of the control account in the general ledger. The use of subsidiary ledgers can be justified in circumstances where there is a large number of similar transactions and both detailed and total information is required. 18 The purpose of the bank reconciliation statement is to explain any differences between the bank balance at the end of the period as shown in the bank statement and in the firm’s ledger, respectively. Any errors discovered may be rectified before completing the journals and postings for the period. 19 The bank reconciliation statement verifies the accuracy of both the firm’s and the bank’s records. 20 The purpose of this question is to raise issues. There is obviously not one right answer, and we do not believe we should necessarily impart our ethical views on other instructors. It appears that this is the sort of problem on which an accountant should contact his/her professional body for advice. For example, some students may be aware that telling the general manager that she/he is wrong and going ahead and notifying the bank may have serious implications for their future career. They may decide to notify the bank anonymously, so the discovery comes from the bank to the company. This could, however, have legal implications.

Chapter 11: Accounts receivable and further record-keeping

Problems Problem 11.1 1

Revenues: Sales revenue Interest revenue Other revenue*

340 000 9 500 251 000

*256 000 – 5 000 (Opening balance of unearned revenue – Closing balance of unearned revenue)

Expenses: Rent expense COGS Depreciation Interest Insurance Wages Bad debts

88 000 120 000 320 000 15 000 22 500 174 000 4 000

31-12-2021 OB Share issue AR

Loan

31-12-2021 OB Sales

A/R CB

Ledger accounts Cash 168 000 Accounts payable 300 000 Dividends 106 000 Interest Insurance Wages 150 000 31-12-2022 CB 724 000

Accounts receivable 324 000 30-06-2022 Cash 340 000 Allow. doubtful debts 30-06-2022 CB 664 000

Allowance for doubtful debts 3 000 31-12-2022 OB 13 000 Bad debts exp 16 000

56 000 50 000 13 000 30 000 160 000 415 000 724 000

106 000 3 000 555 000 664 000

12 000 4 000 16 000

Inventory 31-12-2021 OB Purchase

320 000 70 000

31-12-2022

390 000

Sales CB

120 000 270 000 390 000

Chapter 11: Accounts receivable and further record-keeping

Problem 11.1 (cont.) Current assets: Cash Accounts receivable (net of allowance of 13 000) Inventory Prepaid insurance (30,000 x 3/12) Interest receivable Total

415 000 542 000 270 000 7 500 9 500 1 244 000

Problem 11.2 1 a b

Increase expenses (bonus expense) Increase expenses (insurance expense) Increase revenue (interest revenue) Increase one expense (stationery expense) Increase an expense (bad debt expense), increase a contra asset (allowance for doubtful debt) Increase an asset (office equipment)

Increase revenue (commission)

Increase expenses (electricity expense)

c d e

2 a DR Bonus expense CR Bonus payable b DR Insurance expense CR Prepaid insurance c DR Interest receivable CR Interest revenue d DR Stationery expense CR Advertising expense e DR Allowance for doubtful debts CR Accounts receivable DR Bad debt expense CR Allowance for doubtful debts f DR Office equipment CR Office expenses g DR Unearned commission CR Commission h DR Electricity expense CR Electricity payable © 2022 Cengage Australia Pty Limited. All Rights Reserved.

Increase liabilities (bonus payable) Decrease assets (prepaid insurance) Increase assets (interest receivable) Decrease another expense (advertising expense) Decrease an asset (accounts receivable) Decrease an expense (office expenses) Decrease a liability (unearned commission) Increase liabilities (electricity payable) $12 000 $12 000 $1 800 $1 800 $450 $450 $900 $900 $350 $350 $1 558 $1 558 $4 500 $4 500 $120 $120 $92 $92

Chapter 11: Accounts receivable and further record-keeping

Problem 11.3 Transaction 1 2 3 4 5 6 7 8 9

Net profit before tax No effect No effect No effect Increase Decrease No effect Decrease Increase No effect

Total assets Decrease Increase Increase Increase Decrease No effect Decrease Increase No effect

Problem 11.4 1

Bad debts expense

Allowance for doubtful debts Estimated collectable value of receivables

= $53 000 provided during the year plus $45 000 additional provision = $98 000 = $74 000 preliminary balance plus $45 000 additional provision, minus $30 000 written off = $89 000 = $425 000 original receivables minus $30 000 written off minus $89 000 provision = $306 000

(Note in the last calculation that the written off accounts receivable are deducted from the total receivable balance because the balance was prior to the write-off journal entry. The $30 000 write-off has not affected this net realisable value figure of $306,000. If there were no write-off, the receivables would have totalled $425 000, the provision would have totalled $119 000 and the net amount would still be $306 000.)

Problem 11.5 1 2 3 4 5 6

$1 693 784 $1 599 005 $8 293 $9 117 $331 106 – $12 738 = $318 368 Accounts receivable = $244 620 + $1 693 784 – $1 599 005 = $339 399 Allowance = $11 914 + $9 117 = $21 031 Collectable value = $339 399 – $21 031 = $318 368 (same as part 5)

Problem 11.6 Morton Limited

01-07-2021 OB 30-06-2022 Sales

Ledger accounts Accounts receivable 53 000 30-06-2022 Cash 432 500 30-06-2022 Allowance for doubtful debts 30-06-2022 CB 485 500

417 400 1 200 66 900 485 500

Chapter 11: Accounts receivable and further record-keeping

Allowance for doubtful debts 1 200 01-07-2021 OB 4 200 30-06-2022 Bad debts exp 5 400

30-06-2022 A/R CB

1 Estimated collectable value at 30 June 2022

3 100 2 300 5 400

= $66 900 – 4 200 = $62 700

2 Bad debts expense for the year = $2 300 as calculated below: Allowance for doubtful debts account Opening balance

Expense

–

BD written off

Closing balance

3 100

Expense

–

1 200

4 200

Expense = $2 300 3 i To show estimated collectable amount rather than gross debtors ii To match expense (bad debts) to revenue recognised for the period while leaving accounts receivable unaltered while attempts are still being made to collect the debt

Chapter 11: Accounts receivable and further record-keeping

Problem 11.7 1 General journal 2022 June 30 a Debtors Sales (May sale omitted) b Sales salaries Office salaries Expenses accrued (Three days’ salaries accrued to 30 June 2022) c Electricity Expenses accrued (Electricity expenses accrued to balance date) Postage and telephone Expenses accrued (Telephone expenses in respect of calls accrued to balance date) d Expenses prepaid Rent (Two weeks rent paid in advance) e Depreciation on office equipment Accumulated depreciation on office equipment (Twelve months’ depreciation on office equipment) Depreciation on sales demonstration equipment Accumulated depreciation on sales demonstration equipment (Twelve months’ depreciation on sales demonstration equipment) f Expenses prepaid Interest on loan (Interest on loan paid in advance to 30 September 2022) g Allowance for doubtful debts Debtors (Bad debts written off as irrecoverable) Bad debts expense Allowance for doubtful debts (Provision increased to 2% of debtors – (407 700 + 800 – 700) x 2 / 100 – 8 100)

$ 800

1 221 285 1 506 350 350 200 200 600 600 2 400 2 400 2 805 2 805 4 800 4 800 700 700 56 56

Chapter 11: Accounts receivable and further record-keeping

Problem 11.7 (cont.) 2 R James Electronics Ltd Income statement for year ended 30 June 2022 $

$ 1 106 600 689 900 416 700

Sales Less: Cost of goods sold Less: Expenses Advertising Sales salaries Depreciation on sales demonstration Equipment Electricity Postage and telephone Rent Office salaries General office expenses Depreciation on office equipment Interest on loan Bad debts expense Net profit

81 800 107 021 2 805 5 750 9 500 15 400 25 085 3 500 2 400 14 400 56

267 717 148 983

R James Electronics Ltd Note showing change in retained profits for year ended 30 June 2022 $ 61 500 148 983 210 483

Retained profits 1 July 2021 Add net profit for year ended 30 June 2022 (from Income Statement) Retained profits as at 30 June 2022 3.

R James Electronics Ltd Balance Sheet as at 30 June 2022 $

Current assets Accounts receivable Less: Allowance for doubtful debts Inventory Prepaid expenses Noncurrent assets Office equipment Less: Accumulated depreciation Sales demonstration equipment Less: Accumulated depreciation Total Assets Current liabilities Accounts payable Accrued expenses Noncurrent liabilities Long-term loan Total liabilities Net assets Shareholders’ equity

407 800 8 156

24 000 7 200 22 000 6 105

399 644 145 000 5 400

550 044

16 800 15 895

160 200 2 056

32 695 582 739

162 256 160 000 322 256 260 483

Chapter 11: Accounts receivable and further record-keeping

Share capital Retained profits

50 000 210 483

260 483

Problem 11.8 1 a

Allowance for doubtful debts 8 000 Accounts receivable 8 000 To record write-off of bad debts Bad debts expense 11 680 Allowance for doubtful debts 11 680 To record the increase in the allowance for doubtful debts (4% of accounts receivable = $592 000 × 4% = $23 680) Allowance pre to adjustment 20,000 – 8 000 from journal entry a. Allowance increased by $11 680 ($23 680 – $12 000)

2 OB

A/R CB

Allowance

a. Accounts receivable 600 000 Allowance for doubtful debts CB 600 000

8 000 592 000 600 000

b. Allowance for doubtful debts 8 000 OB 23 680 Bad debts expense 31 680

20 000 11 680 31 680

c. Bad debts expense 11 680

Problem 11.9 1% x $3 200 000 = $32 000 DR Bad debts expense 32 000 CR Provision for doubtful debts 32 000

Chapter 11: Accounts receivable and further record-keeping

Problem 11.10 1% x $85 000 3% x $25 000 15% x $9 000 35% x $5 000 60% x $2 000

$850 $750 $1 350 $1 750 $1 200 $5 900 Present balance of provision for doubtful debts account: $300 DR DR Bad debts expense $6 200 CR Provisions for doubtful debts $6 200

Problem 11.11 1 Journal entries: Date

Journal entry

01/10/22

DR Salaries payable 2 040 25 000 CR Cash 1 010 To record payment of salaries DR Accrued expenses 2 060 12 400 CR Cash 1 010 To record payment of sundry payables DR Accounts receivable 1 020 78 650 CR Sales 4 000 To record credit sales of $78 650 DR COGS 5 010 60 500 CR Inventory 1 040 To record cost of goods sold 78 650 / 1.3 = 60 500 DR Cash 1 010 17 849 CR Sales 4 000 To record cash sales DR COGS 5 010 13 730 CR Inventory 1 040 To record cost of goods sold 17 849 / 1.3 = 13 730 DR Interest payable 2 020 48 000 CR Cash 1 010 To record payment of interest on bank loan DR Bank loan 2 100 12 000 CR Cash 1 010 To record payment towards the principal DR Prepaid advertising 1 070 2 000 CR Cash 1 010 To record deposit for an advertisement DR Cash 1 010 109 456 CR Accounts receivable 1 020 To record payment from debtors DR Advertising expense 5 070 250 CR Prepaid advertising 1 070 To recognise expense for advertising (2 000 / 8 = 250)

03/10/22

06/10/22

07/10/22

08/10/22

11/10/22

12/10/22

13/10/22

Account no. 25 000

12 400

78 650

60 500

17 849

13 730

48 000

12 000

2 000

109 456

250

Chapter 11: Accounts receivable and further record-keeping

Date

Journal entry

14/10/22

DR Cash 1 010 9 815 CR Sales 4 000 To record cash sales DR COGS 5 010 7 550 CR Inventory 1 040 To record cost of goods sold 9 815 / 1.3 = 7 550 DR Accounts payable 2 010 86 250 CR Cash 1 010 To record payment to creditors DR Accounts receivable 1 020 104 546 CR Sales 4 000 To record credit sales of $104 546 DR COGS 5 010 80 420 CR Inventory 1 040 To record cost of goods sold 104 546 / 1.3 = 80 420 DR Advertising expense 5 070 250 CR Prepaid advertising 1 070 To recognise expense for advertising (2 000 / 8 = 250) DR Inventory 1 040 117 920 CR Accounts payable 2 010 To record purchase of inventory DR Cash 1 010 1 534 CR Sales 4 000 To record cash sales DR COGS 5 010 1 180 CR Inventory 1 040 To record cost of goods sold 1 534 / 1.3 = 1 180 DR Allowance for doubt debts 1 030 14 230 CR Accounts receivable 1 020 To write off uncollectible accounts receivable DR Advertising expense 5 070 250 CR Prepaid advertising 1 070 To recognise expense for advertising (2 000 / 8 = 250) DR Income tax payable 2 030 47 000 CR Cash 1 010 To record income tax payment to the ATO DR Cash 1 010 819 CR Sales 4 000 To record cash sales of $819 DR COGS 5 010 630 CR Inventory 1 040 To record cost of goods sold 819 / 1.3 = 630 DR Cash 1 010 86 000 CR Accounts receivable 1 020 To record payment from debtors DR Provision for employee 2 050 5 500 entitlements CR Cash 1 010

15/10/22

18/10/22

20/10/22

21/10/22

25/10/22

27/10/22

28/10/22

29/10/22

30/10/22

Account no. 9 815

7 550

86 250

104 546

80 420

250

117 920

1 534

1 180

14 230

250

47 000

819

630

86 000

5 500

Chapter 11: Accounts receivable and further record-keeping

Date

Journal entry

Account no.

To record payment of annual leave

Chapter 11: Accounts receivable and further record-keeping

Problem 11.11 (cont.) 2 Ledgers: 01/10 07/10 12/10 14/10 21/10 28/10 29/10

OB Sales Accounts receivable Sales Sales Sales Accounts receivable

Cash (1 010) 106 000 01/10 17 849 03/10 109 456 08/10 9 815 08/10 1 534 11/10 819 15/10 86 000 28/10 30/10 31/10

Salaries payable Accrued expenses Interest payable Bank loan Prepaid advertising Accounts payable Income tax payable Provision for employee entitlements CB

331 473

01/10 06/10

OB Sales

18/10

Sales

Accounts receivable (1 020) 147 000 12/10 Cash 78 650 25/10 Allowance for doubtful debts 104 546 29/10 Cash 31/10 CB 330 196

25 000 12 400 48 000 12 000 2 000 86 250 47 000 5 500 93 323 331 473

109 456 14 230 86 000 120 510 330 196

Allowance for doubtful debts (1 030) 25/10

Accounts receivable

14 230 01/10

14 400

31/10

5 496 31/10

Bad debts expense

5 326

19 726

01/10 21/10

OB Accounts payable

19 726

Inventory (1 040) 251 000 06/10 117 920 07/10 14/10 18/10 21/10 28/10 31/10 31/10 368 920

COGS COGS COGS COGS COGS COGS Inventory writedown expense CB

60 500 13 730 7 550 80 420 1 180 630 4 800 200 110 368 920

Chapter 11: Accounts receivable and further record-keeping

Problem 11.11 (cont.) 01/10

01/10

01/10 11/10

OB Cash

Prepaid insurance (1 050) Insurance expense 12 000 31/10 31/10 CB 12 000

800 11 200 12 000

Prepaid rent (1 060) 45 000 31/10 Rent expense 31/10 CB 45 000

5 000 40 000 45 000

Prepaid advertising (1 070) 0 13/10 Advertising expense 2 000 20/10 Advertising expense 27/10 Advertising expense 31/10 CB 2 000

250 250 250 1 250 2 000

01/11

Buildings (1 100) 1 400 000

01/11

Motor vehicle (1 200) 45 000

15/10

Cash CB

Accumulated depreciation – buildings (1 105) 01/10 OB 31/10 Depreciation expense – buildings 01/11 CB

175 000 2 917

Accumulated depreciation – motor vehicle (1 205) 01/10 OB 31/10 Depreciation expense – motor vehicle 01/11 CB

9 000 375

Accounts payable (2 010) 86 250 01/10 OB 125 670 21/10 Inventory 211 920

177 917

9 375

94 000 117 920 211 920

Chapter 11: Accounts receivable and further record-keeping

Problem 11.11 (cont.) 08/10 31/10

28/10 31/10

01/10 31/10

30/10 31/10

03/10 31/10

08/10 31/10

Cash CB

Interest payable (2 020) 48 000 01/10 OB 46 000 31/10 Interest expense 94 000 Income tax payable (2 030) 47 000 01/10 OB 0 47 000 Salaries payable (2 040) 25 000 01/10 OB 22 500 31/10 Salaries expense 47 500 Provision for employee entitlements (2 050) 5 500 01/10 OB 8 500 14 000 Accrued expenses (2 060) 12 400 01/10 OB 11 660 31/10 Sundry expenses 24 060 Bank loan (2 100) 12 000 01/10 OB 888 000 900 000 Share capital (3 010) 01/11 OB

31/10 31/10

Retained earnings (3 020) Profit & loss summary 50 925 01/10 OB CB 216 275 267 200

48 000 46 000 94 000

47 000 47 000

25 000 22 500 47 500

14 000 14 000

12 400 11 660 24 060

900 000 900 000

400 000

267 200 267 200

Chapter 11: Accounts receivable and further record-keeping

Problem 11.11 (cont.) Sales (4 000) 06/10 07/10 14/10 18/10 21/10 28/10

06/10 07/10 14/10 18/10 21/10 28/10

Inventory Inventory Inventory Inventory Inventory Inventory

Accounts receivable Cash Cash Accounts receivable Cash Cash

Cost of goods sold (5 010) 60 500 13 730 7 550 80 420 1 180 630 164 010

Interest payable

Interest expense (5 020) 46 000

31/10

Salaries payable

Salaries expense (5 040) 22 500

31/10

Accrued expenses

Sundry expenses (5 060) 11 660

31/10

13/10 20/10 27/10

31/10

Prepaid advertising Prepaid advertising Prepaid advertising

Prepaid insurance

Prepaid rent

Advertising expense (5 070) 250 250 250 750 Insurance expense (5 080) 800

Rent expense (5 090) 5 000

78 650 17 849 9 815 104 546 1 534 819 213 213

Chapter 11: Accounts receivable and further record-keeping

Problem 11.11 (cont.) 31/10

Bad debts expense (5 100) Allowance for doubtful 5 326 debts

Inventory writedown expense (5 110) 4 800

31/10

Inventory

31/10

Depreciation expense – buildings (5 120) Accumulated 2 917 depreciation – buildings

31/10

Depreciation expense – motor vehicle (5 130) Accumulated 375 depreciation – motor vehicle

31/10

Profit and loss summary (6 000) 31/10 Sales Cost of goods sold 164 010 Interest expense 46 000 Salaries expense 22 500 Sundry expenses 11 660 Advertising expense 750 Insurance expense 800 Rent expense 5 000 Bad debts expense 5 326 Inventory writedown 4 800 expense Depreciation expense – 2 917 buildings Depreciation expense – 375 31/10 Retained earnings motor vehicle 264 138

213 213

50 925 264 138

Problem 11.11 (cont.), part 3 Psyche Books Ltd worksheet Adjusted Acc. No.

Trial balance Account name

Debit

Adjustments

Credit

Debit

trial balance

Credit

Debit

Income statement

Credit

Debit

Credit

Balance sheet Debit

1 010

Cash

93 323

1 020

Accounts receivable Inventory

120 510

204 910

4 800

200 110

12 000

800

11 200

45 000 1 250

5 000

40 000 1 250

1 100

Prepaid insurance Prepaid rent Prepaid advertising Buildings

1 400 000

1 200

Motor vehicle

45 000

1 105

Accumulated depreciation – buildings Accumulated depreciation – motor vehicle Allowance for doubtful debts Accounts payable

1 040 1 050 1 060 1 070

1 205

1 030 2 010

Credit

175 000

2 917

177 917

9 000

375

9 375

170

5 326

5 496

125 670

Chapter 11: Accounts receivable and further record-keeping

Psyche Books Ltd worksheet Adjusted Acc. No. 2 020

Account name

2 100

Interest payable Income tax payable Salaries payable Provision for employee entitlements Accrued expenses Bank loan

3 010 3 020

Trial balance Debit Credit

Adjustments Debit Credit

Balance sheet Debit Credit 46 000

22 500

8 500

11 660

888 000

Share capital

400 000

267 200

216 275

4 000

Retained earnings Profit and loss summary Sales

213 213

5 010

COGS

5 020

Interest expense Income tax expense

2 040 2 050

2 060

6 000

5 030

46 000

Income statement Debit Credit

46,000

2 030

trial balance Debit Credit

0 0

22 500

8 500

11 660

164 010

213 213

164 010

46 000

Chapter 11: Accounts receivable and further record-keeping

Psyche Books Ltd worksheet Adjusted Acc. No. 5 040 5 060 5 070 5 080 5 090 5 100 5 110

5 120

5 130

Account name Salaries expense Sundry expenses Advertising expense Insurance expense Rent expense Bad debts expense Inventory writedown expense Depreciation expense – buildings Depreciation expense – motor vehicle

Trial balance Debit Credit

Adjustments Debit Credit

trial balance Debit Credit

Income statement Debit Credit

22 500

11 660

750

800

5 000

5 326

4 800

2 917

375

$2 086 753

Net profit (loss)

$99 378

$2 175 531

Balance sheet Debit Credit

$1 911 393

$2 175 531 $50 925

$1 911 393

Chapter 11: Accounts receivable and further record-keeping

Problem 11.11 (cont.) 4 Adjusting entries: 31/10 DR Inventory writedown expense CR Inventory

5 110 1 040

4 800

5 020 2 020

46 000

5 120 1 105

2 917

4 800

To record decline in value of inventory

31/10

DR Interest expense CR Interest payable

46 000

To record interest charges for the month

31/10

DR Depreciation expense – buildings CR Accumulated depreciation – buildings

2 917

To record depreciation charges for the month (1 400 000*0.025) / 12 = 2 917 (rounded)

31/10

DR Depreciation expense – motor vehicle CR Accumulated depn – motor vehicle

5 130 1 205

375 375

To record depreciation charges for the month (45 000 / 10) / 12 = 375

31/10

DR Rent expense CR Prepaid rent

5 090 1 060

5 000

5 080 1 050

800

5 000

To record rent expense for the month

31/10

DR Insurance expense CR Prepaid insurance

800

To record insurance expense for the month 12 000 / 15 = 800

31/10

DR Bad debts expense CR Allowance for doubtful debts

5 100 1 030

5 326 5 326

To increase allowance for doubtful debts (183 196*0.03) – (14 400-14 230) = 5 326

31/10

DR Salaries expense CR Salaries payable

5 040 2 040

22 500

5 060 2 060

11 660

22 500

To record salaries expense for the month

31/10

DR Sundry expenses CR Accrued expenses

11 660

To record accrued expenses for the month 2 760 + 8 900 = 11 660

5 Refer to the worksheet in part 3. 6 Closing entries: 31/10 DR Sales CR Profit and loss summary DR Profit and loss summary CR Cost of goods sold CR Interest expense CR Salaries expense CR Sundry expenses CR Advertising expense CR Insurance expense CR Rent expense CR Bad debts expense CR Inventory writedown expense CR Depreciation expense – buildings CR Depreciation expense – motor vehicle DR Retained earnings CR Profit & loss summary

4 000 6 000 6 000 5 010 5 020 5 040 5 060 5 070 5 080 5 090 5 100 5 110 5 120 5 130 3 020 6 000

213 213 213 213 264 138 164 010 46 000 22 500 11 660 750 800 5 000 5 326 4 800 2 917 375 50 925 50 925

Chapter 11: Accounts receivable and further record-keeping

Problem 11.11 (cont.) 7 Post closing trial balance Account name Cash Accounts receivable Allowance for doubtful debts Inventory Prepaid insurance Prepaid rent Prepaid advertising Buildings Accumulated depreciation – buildings Motor vehicle Accumulated depreciation – motor vehicle Accounts payable Interest payable Income tax payable Salaries payable Provision for employee entitlements Accrued expenses Bank loan Share capital Retained earnings

Account no. 1 010 1 020 1 030 1 040 1 050 1 060 1 070 1 100 1 105 1 200 1 205 2 010 2 020 2 030 2 040 2 050 2 060 2 100 3 010 3 020

Dr 93 323 120 510

5 496 200 110 11 200 40 000 1 250 1 400 000 177 917 45 000

1 911 393 8 Income statement: Account name Sales Cost of goods sold Gross profit Operating expenses: Interest expense Salaries expense Sundry expenses Advertising expense Insurance expense Rent expense Bad debts expense Inventory writedown expense Depreciation expense – buildings Depreciation expense – motor vehicle Profit (loss) for the period

9 375 125 670 46 000 0 22 500 8 500 11 660 888 000 400 000 216,275 1 911 393

213 213 164 010 49 203 46 000 22 500 11 660 750 800 5 000 5 326 4800 2 917 375

100 128 (50 925)

Chapter 11: Accounts receivable and further record-keeping

Problem 11.11 (cont.) Balance sheet: Account name Assets Current assets Cash Accounts receivable Allowance for doubtful debts Inventory Prepaid insurance Prepaid rent Prepaid advertising Noncurrent assets Buildings Accumulated depreciation – buildings Motor vehicle Accumulated depreciation – motor vehicle Total assets Liabilities Current liabilities Accounts payable Interest payable Income tax payable Salaries payable Provision for employee entitlements Accrued expenses Noncurrent liabilities Bank loan Shareholders’ equity Share capital Retained earnings Total liabilities and equity

93 323 120 510 (5 496)

1 400 000 (177 917) 45 000 (9 375)

115 014 200 110 11 200 40 000 1 250

1 222 083 35 625 1 718 605

125 670 46 000 0 22 500 8 500 11 660 888 000 400 000 216 275 1 718 605

Chapter 11: Accounts receivable and further record-keeping

Problem 11.12 2022 Jul 1 31

2022 Jul 31

Debtors’ control $ 2022 4 850 Jul 31 Cash 22

OB Freight outwards Sales

8 626

Cash Discount revenue CB

$ 9 673

Discount expense CB

13 498

3 747 13 498

Creditors’ control $ 2022 6 575 Jul 1 OB 56 31 Purchases

$ 3 976 6 945

4 315 10 946

25 10 946

Interest expense

Problem 11.13 1 a

A Ltd (opening balance): A Ltd debtors’ ledger OB Sales

24 326 25 365 51 156

Cash

CB 100 847

30 000 22 365 19 050 29 432 100 847

Opening balance: $24 326

N Ltd (opening balance):

OB Sales

N Ltd debtors’ ledger 24 376 Cash 15 000 CB 21 463 11 270 72 109

Opening balance: $24 376

24 376 47 733

72 109

Chapter 11: Accounts receivable and further record-keeping

Problem 11.13 (cont.) c

Y Ltd (closing balance – before write-off): Y Ltd debtors’ ledger OB 29 924 Cash Sales -------0 CB 29 924

9 924 20 000 29 924

F Ltd (sales): F Ltd debtors’ ledger OB Sales

65 147 68 836

Cash CB

133 983

Sales: $68,836 e

Accounts receivable control (opening balance):

A Ltd N Ltd Y Ltd F Ltd

24 326 24 376 29 924 65 147 143 773

(a) (b)

Accounts receivable – opening balance: $143 773

Total credit sales for 2022:

A Ltd N Ltd Y Ltd F Ltd

76 521 47 733 – 68 836 193 090

Total credit sales for 2022: $193 090

(d)

15 677 23 742 94 564 133 983

Chapter 11: Accounts receivable and further record-keeping

Problem 11.13 (cont.) g

Allowance for doubtful debts (closing balance):

ADD

= 3% of credit sales (f) = 3% * 193 090 = 5,793 (rounded)

Allowance for doubtful debts – Closing balance: $5 793

Bad debts expense for 2022:

Allowance for doubtful debts (c) (g)

Y Ltd 20 000 CB 5 793 25 793

7 552 18 241 25 793

Total bad debts expense for 2019: $18 241

2. a

Write off the remaining balance of Y Ltd’s account Debit

Allowance for doubtful debts

20 000

A/C Rec – Y Ltd

Credit

20 000

Recognise the bad debts expense for the year Debit

Bad debt expense (h) Allowance for doubtful debts

Credit

18 241 18 241

Chapter 11: Accounts receivable and further record-keeping

Problem 11.14 1

a OB Sales Sales

24 810 26 653 53 561

Anna Cash Cash Cash CB

30 220 23 356 19 016 32 432 105 024

105 024 Anna – opening balance: $24 810 b OB Sales Sales Sales

26 269 14 978 23 286 10 060 74 593 Natalie – opening balance: $26 269

Natalie Cash CB

25 763 48 830

74 593

c OB

28 674

Yuki Cash CB

10 249 18 425 28 674

28 674 Yuki – closing balance (before write-off): $18 425 d OB Sales

56 841 71 951

Fred Cash Cash CB

14 788 24 427 89 577 128 792

128 792 Fred – sales: $71 951 e Accounts receivable control (opening balance): Anna 24 810 Fred 56 841 Natalie 26 269 Yuki 28 674 136 594 Accounts receivable – opening balance: $136 594

(b)

f Total sales for 2022 Anna Fred Natalie Yuki

(d)

80 214 71 951 48 324 – 200 489

(a)

Chapter 11: Accounts receivable and further record-keeping

Problem 11.14 (cont.) Allowance for doubtful debts (closing balance) ADD = 3% of credit sales (f) = 3% of 200 489 = 6 015 (rounded) Allowance for doubtful debts — closing balance: $6 015 Bad debts expense for 2022: (c) (g)

Allowance for doubtful debts 18 425 OB 6 015 Bad debts 24 440

Yuki CB

7 982 16 458 24 440

Total bad debts expense 2022: $16 458 Using the general journal format, complete the following journal entries (as at the end of 2022): 2 Write off the remaining balance of Yuki’s account Debit 18 425

Allowance for doubtful debts (c) A/C Rec – Yuki Recognise the bad debts expense for the year

Credit 18 425

Debit 16 458

Bad debt expense (h) Allowance for doubtful debts

Credit 16 458

Problem 11.15

Date

Particulars

3 June 2022 8 June 2022 15 June 2022 29 June 2022 Total

Milky Way Cash sales Mars Constellation

Date

2 June 2022 10 June 2022 16 June 2022 30 June 2022 Total

Particulars

Venus Sun Cash purchases Mercury

Jupiter Ltd Cash receipts journal Bank Discount allowed DR DR $ $ 1 070 30 500 6 900 100 7 800 200 16 270 330 Jupiter Ltd Cash payments journal Bank Discount received CR $ 6 000 3 960 3 000 5 000 17 960

CR $

Accounts receivable CR $ 1 100

Cash sales CR $ 500

7 000 8 000 16 100

Accounts payable

DR $ 6 000 4 000

5 000 15 000

500

Cash purchases DR $

3 000 3 000

Chapter 11: Accounts receivable and further record-keeping

Problem 11.15 (cont.)

1/6/22

30/6

CRJ

Accounts receivable control $ 27 000 30/6 CRJ 30/6 CB 27 000

$ 16 100 10 900* 27 000

30/6 30/6

Accounts payable control $ 15 000 1/6/22 OB 7 000* 22 000

CPJ CB

Discount allowed $ 330

Discount received

Sales

Purchases

30/6

$ 500

CRJ

30/6

CRJ

30/6

CPJ

Cash at bank $ 16 270 30/6

CPJ

$ 22 000 22 000

$ 40

$ 3 000

$ 17 960

Accounts receivable subsidiary ledger

1/6/22

Milky Way $ 3 000 3/6 30/6 3 000

Mars CRJ CB

$ 1 100 1 900 3 000

1/6

$ 14 000 14 000

15/6 30/6

CRJ CB

$ 7 000 7 000 14 000

Chapter 11: Accounts receivable and further record-keeping

Problem 11.15 (cont.) 1/6

Constellation $ 10 000 30/6 30/6 10 000

CRJ CB

$ 8 000 2 000 10 000

Schedule – 30/6/19 Accounts receivable $ 1 900 7 000 2 000 10 900

Milky Way Mars Constellation Accounts payable subsidiary ledger Venus 2/6/22

CPJ

$ 6 000

1/6

Mercury $ 0

30/6 30/6

$ 5 000 5 000 10 000

CPJ CB

Sun 10/6 30/6

CPJ CB

$ 4 000 2 000 6 000

1/6

$ 6 000 6 000

Schedule – 30/6/22 Accounts payable Mercury Sun

$ 5 000 2 000 7 000

1/6

$ 10 000 10 000

Chapter 11: Accounts receivable and further record-keeping

Problem 11.16 2021 July 2019 June

2022 June

Debtors’ control $ 2021 15 425 June 30

Sales

Cash Discount revenue CB

101 700 117 125 Creditors’ control $ 2021 45 280 July 1 560 2021 35 650 June 30 81 490

Discount expense Cash CB

$ 725 61 590 54 810 117 125 $ 9 870

OB Purchases

71 620 81 490

Problem 11.17 1 2022 Apr

2022 Apr

1 30

OB Sales

Cash & disc.

1 13

OB Sales

37 Accounts receivable $ 2022 2 060 Apr 30 Cash & disc. SJ17 6 500 CB 8 560

CPJ 29

21 Accounts payable $ 2022 3 200 Apr 1 2 950 6 150

Accounts receivable ledger 37/B1 Brown $ 2022 900 Apr 15 SJ17 2 400 30 3 300 37/G1 Green 2022 $ Apr 700

CRJ35

$ 2 080

OB Purchases

PJ21

Cash & disc. CB

CRJ35

10 30

Cash & disc. CB

CRJ35

25 30

Cash & disc. CB

CRJ35

700

2022 Apr

Sales

SJ17

37/R1 Ruby $ 2022 Apr 1 700 1 700

$ 2 260 6 300 8 560

4 070 6 150

$ 900 2 400 3 300

$ 200 500 700

$ 700 1 000 1 700

Chapter 11: Accounts receivable and further record-keeping

Problem 11.17 (cont.)

2022 Apr

1 2

Sales

OB Sales

Accounts receivable ledger (continued) 37/S1 Sage & Co $ SJ17 1 160

SJ17

37/W1 White $ 2022 460 Apr 1 240 1 700

Accounts payable ledger 21/B1 Blue $ 2022 Cash & discount CPJ29 1 700 Apr 1 OB 16 Purchases 1 700 21/G1 Grey 2022 Apr

2022 Apr

14 30

Cash & disc. CB

CPJ29

21/R1 Red $ 2022 1 500 Apr 1 2 000 3 500

21/S1 Sage & Co. 2022 Apr 20

2. Schedule of accounts receivable 37/B1 37/G1 37/R1 37/S1 37/W1

Brown Green Ruby Sage & Co. White

$ 2 400 500 1 000 1 160 1 240 6 300

Schedule of accounts payable 21/G1 21/R1 21/S1

Cash & disc. CB

Grey Red Sage & Co.

$ 750 2 000 200 2 950

Purchases

CRJ35

PJ21

Purchases

$ 580 1 120 1 700 $ 750

$ 1 500

OB Purchases

$ 460 1 240 1 700

PJ21

2 000 3 500

$ 200

Chapter 11: Accounts receivable and further record-keeping

Problem 11.18 1 Bank reconciliation statements are prepared: – to explain any differences between the bank balance at the end of the period as shown in the bank statement and in the ledger of the bank’s customer respectively – to detect errors in the records of the customer or the bank – to enable the cash records of the customer to be brought up to date. It would be unnecessary to prepare a bank reconciliation statement when all transactions had been recorded correctly by both parties, and thus the balance of the ‘Bank’ account in the customer’s ledger was equal to but opposite the balance of the customer’s account in the bank ledger. 2 and 3 Swift Company Bank reconciliation statement 30 June $ Balance as per bank statement Add: Outstanding deposit Switch company cheque charged against Swift company’s account

$ 16 860.30

2 300.00 19 160.30 6 185.90 12 974.40

12 644.40

1 880.00 420.00

Less: Unpresented cheques Adjusted balance as per cash at bank account Ending balance per company records Add: Increase reported on the bank statement but not entered on company records: Correction: Cheque for $480 incorrectly recorded as $840

360.00 13 004.40

Deduct: Disbursement reported on the bank statement but not entered on company records: Bank charges Adjusted balance as per cash at bank account

30.00 12 974.40

4 General journal June

Bank charges Cash at bank Cash at bank Advertising expense

$ 30.00

360.00 360.00

Chapter 11: Accounts receivable and further record-keeping

Problem 11.19 1 ASB book balance

Less Add

Indicated balance (per books) NSF cheque Bank Service Charge

$ x (400) (50)

Cheque recording error Reconciled balance

90 $4 800

Balance per ‘Cash’ account before reconciliation = $4 800 – 90 + 400 + 50 = $5 160

2 ASB bank balance

Less

Indicated balance (per bank) Outstanding cheques

$ x (3 000)

Add

Deposits in transit

2 100

Reconciled balance

$4 800

Balance per bank before reconciliation = $4 800 – 2100 + 3000 = $5 700

3 General journal June

Bank charges Cash at bank Accounts receivable Cash at bank Cash at bank Accounts receivable

$ 50

400 400 90 90

Chapter 11: Accounts receivable and further record-keeping

Problem 11.20 1 AAA Ltd book balance Less Add

Indicated balance (per books) NSF cheque

$ x (400)

Interest revenue Reconciled balance

30 5 000

Balance per Cash account before reconciliation = $5 000 – 30 + 400 = $5 370

2 AAA Ltd bank balance Add Less

Indicated balance (per bank) Deposits in transit

$ x 2 000

Outstanding cheques Reconciled balance

(3 000) 5 000

Balance per bank before reconciliation = $5 000 – 2 000 + 3 000 = $6 000

3 General journal June

$ 400

Accounts receivable Cash at bank Cash at bank Interest revenue

$ 400

30 30

Problem 11.21 1 General journal $ 18

Cash Interest revenue Bank Charges Advertising expenses Cash

$ 18

11 270 281

2 Bank reconciliation statement as at 30 September 2022 Credit Plus

Balance as per bank statement Outstanding lodgement 29 September

Less:

Unpresented cheques

$ 5 553 6306 183 463 479 481

170 240 345

Debit balance as per ‘Bank’ account in ledger Ending balance per Covington Ltd’s records Add: Interest Deduct: Bank charges Advertising expenses – error in cheque 486 Adjusted cash balance: Covington Ltd’s records

$ 11 270

755 5 428 5 691 18 5 709 281 5 428

Chapter 11: Accounts receivable and further record-keeping

Problem 11.22 Anthea’s Homewares Bank reconciliation statement as at 30 April 2022 $ Balance as per bank statement Add: Outstanding deposit

1 831 246 2 077

Deduct: Unpresented cheques

562 579 580 Adjusted balance as per ‘Cash at bank’ account Ending balance per business records (2 594 + 3 053 – 4 444) Add: Bill receivable Interest on bill Interest revenue

650 46

Deduct: Cheque dishonoured – Bond Enterprises Correction – cheque no. 574 – Inventory Bank charges Adjusted balance as per ‘Cash at bank’ account General journal Cash at bank Bill receivable Interest on bill Interest revenue Sundry debtors – Bond Enterprises Inventory Bank charges Cash at bank

159 311 293

696 58 421 198 24

763 1 314

1 203

754 1 957 643 1 314

754 650 46 58 421 198 24 643

Problem 11.23 Betty’s Boutique Bank reconciliation statement as at 30 November 2022 $ Ending balance as per bank statement Add: Unpresented cheques: 719 520 722 566 729 2 492 Deduct: Outstanding deposit Adjusted balance: Cash at bank in ledger Ending balance per company records (27 044 – 19 508 – 4 930) Add: Decreases reported on the bank statement but not entered on company records Bank charges Correction of error – cheque 728 N.S.F. cheque – J Pindar © 2022 Cengage Australia Pty Limited. All Rights Reserved.

$ 2 446

3 578 6 024 3 884 2 140 2 606

8 396 30

434

Chapter 11: Accounts receivable and further record-keeping

3 040 Deduct: Receipts reported on the bank statement but not entered in company records Direct credit – bill and interest Interest Adjusted balance: Cash at bank in ledger

816 84

900 2 140

Journal 2022 Nov 30

Cash at bank Bill receivable Interest revenue Interest revenue Bank charges Inventory charges Accounts receivable – J Pindar Cash at bank

$ 900

$ 800 16 84

8 396 30 434

Chapter 11: Accounts receivable and further record-keeping

Cases 11A 1 Trade and other receivables are included in Note 3.1 Trade receivables $137m Loss allowance $(6)m Net trade receivables $131m 2 In Note 3.1 information is provided about the loss allowance. This loss allowance is comparable to an allowance for bad debts. 2021 2020 Loss allowance (for trade receivables) 6 10 (Impairment provision balance) This has decreased by $4m between 2020 and 2021. 3 If journal entries had been made during the period to record bad debts and an actual write-off it would appear as the following: Dr Allowance for doubtful debts Cr Accounts receivable – Journal entry to increase provision: Dr Bad debts expense Cr Allowance for doubtful debts

11B 1 The following percentages were calculated based on allowance made

Not past due Past due 0–30 days Past due 31–60 days Past due 61–90 days Past due 91–120 days Overall

2021 % 1.10 6.98 13.10 22.73 76.39 3.80

2020 % 0.94 0.45 1.42 10.11 58.05 3.46

2 The percentages do change across the years. Telstra states in the notes to the financial statements: ‘We have used the following basis to assess the allowance for doubtful debts for trade receivables: – a statistical approach to apply risk segmentation to the debt and applying the historical impairment rate to each segment at the end of the reporting period – an individual account by account assessment based on past credit history – any prior knowledge of debtor insolvency or other credit risk.’ For example, there is an increase in the percentages from 2020 to 2021 for the allowance on accounts not past due (0.94% in 2020 to 1.10% in 2021) and past due 91–120 days (58.05% in 2020 to 76.39% in 2021). Based on the statement above, you could assume that when Telstra performed an account by account assessment of the creditors in these brackets, based on their past credit history and credit risk, it believed there was a higher risk that the company © 2022 Cengage Australia Pty Limited. All Rights Reserved.

Chapter 11: Accounts receivable and further record-keeping

would not receive payment from the creditors in 2021 compared with the creditors in the same bracket in 2020. Another example would be the increase in percentages from 2020 to 2021 for accounts past due 31–60 days (1.42% in 2020 to 13.10% in 2021) and past due 61–90 days (10.11% in 2020 to 76.39% in 2021). Again, based on an account-by-account assessment, it would seem that Telstra believed there was a higher risk that some accounts would not be paid in 2021 compared with the same bracket in 2020.

Solutions Chapter 12 Inventory Discussion questions 1 The periodic inventory system is a method of calculating inventory that uses data on beginning inventory, additions to inventory, and an end-of-period count to deduce the cost of goods sold. No records are maintained for individual inventory items. By contrast, the perpetual inventory system is a method of controlling inventory that maintains continuous records on the flow of units of inventory. 2 In the past, many organisations that had a large number of sales, particularly of items with relatively low value, used the periodic inventory method because of its lower costs. However, with the considerable increase in computer-based inventory systems, most organisations now use the perpetual system because of its advantages in the control over inventory. For example, many retail companies have cash registers that use optical scanners to read the barcodes attached to products. These read the sales price and also update the inventory records. 3 Under the perpetual inventory system, it is necessary to make an assumption regarding the flow of costs through the business, for example, whether the first items acquired are the first ones sold or whether ending inventory and cost of goods sold are composed of a mixture of old and new items. At the time of sale a record is made of the cost price of the goods based on the cost flow assumption. Thus, the accounting records provide a record of the cost of goods sold. However under the periodic inventory system there is no continuous record of cost of goods sold. At the end of each accounting period it is calculated by adding purchases for the period to opening inventory and then deducting closing inventory. 4 The periodic inventory system lacks the parallel record-keeping that gives the perpetual method its value. Although it is simple and cheap to operate, it provides no way to reconcile inventory accounts to records in order to detect errors. Recordkeeping provides no control, although other features of internal control may be present such as physical protection and insurance. Under the perpetual inventory system, there is available a continuously updated figure for the amount that should be on hand. If a physical count of the inventory fails to show that quantity, the business knows that some have been lost or stolen, or that there had been an error in the records. The records provide accounting control in addition to any physical protection. 5 The perpetual and periodic inventory systems will give the same cost of goods sold figure if there is no inventory shortage or surplus. Whether purchases are treated as an asset or an expense, opening inventory plus purchases make up the goods available for sale. This must be split between goods sold and closing inventory. The same result will be obtained regardless of which is calculated first.

Chapter 12: Inventory

6 Under the perpetual inventory method a continuously updated figure is available for the amount of inventory that should be on hand. If a physical count of inventory fails to show that quantity, the business knows that some have been lost or stolen. With the periodic inventory method the records do not provide accounting control. Some other forms of control needs to exist to indicate shortages. For example, an unexpected change in the ratio of cost of goods sold to sales may indicate a loss or theft and should be investigated. 7 Under accounting standards the cost of inventory includes all the costs of purchase, costs of conversion and other costs incurred in bringing inventory to their current location and condition. This means that the cost of inventory includes in addition to the purchase price, any taxes on the purchase, as well as transportation and handling costs. Costs of conversion are relevant if inventories are manufactured and include costs of production such as labour and overheads. Costs that are not included in the cost of inventory include administrative costs, selling costs and costs of storage. 8 The term ‘inventory cost flow assumption’ is the assumption made about the order in which units of inventory move into and out of a business. It is used to compute inventory asset values and cost of goods sold expense based on assumptions about the flow inventory. Examples are first in first out, weighted average and last in first out. 9 FIFO, weighted average and LIFO are assumptions made about the order in which units of inventory flow through the business. FIFO assumes that the first items acquired are the first ones sold and, therefore any ending inventory on hand consists of the most recently acquired units. Thus the older costs will appear in cost of goods sold and the more recent costs on the balance sheet. Weighted average assumes that ending inventory and cost of goods sold are composed of a mixture of old and new units. LIFO assumes the opposite of FIFO. Recent costs will appear in cost of goods sold and the older costs in the balance sheet. The three methods will give similar profit figures if inventory prices are fairly constant. They would give identical profit figures if cost prices of opening inventory and purchases remain unchanged throughout the financial period. 10 The concept of lower of cost and net realisable value states that the value of inventory should be written down from the cost price to net realisable value in situations where net realisable value is below cost. Thus any fall in value below the original acquisition cost is recognised as an expense in the period in which the fall occurs. 11 The valuation of inventory is important to managers because it affects cost of goods sold (and therefore profit) as well as the balance sheet via the value of inventory. Managers’ performance reports are affected by both profit figures and balance sheet figures. Thus managers need to understand the effect of different cost flow assumptions on both financial statements across time. 12 Inventories are current assets if they are expected to be sold within the next year, or next business cycle. Sometimes assets that might be inventories are held for a longer time, for example if the company is hoarding or speculating on future prices or is holding products that take time to mature (e.g. wine or some liquors), and such items may (should) not be considered to be current assets. 13 Opening inventory plus purchases constitutes a pool of inventory available for sale. If management overstated the valuation of closing inventory this would

Chapter 12: Inventory

automatically reduce the value of cost of goods sold. This would increase the profit for the year.

Chapter 12: Inventory

Problems Problem 12.1 1. FIFO Date 1 July 8 July 12 July 13 July

In $ per 6.00

# 300

500

5.00

$ 1 800.00

200

Out $ per

50 150

6.00 6.00

300.00 900.00

100 300 100

6.00 5.00 5.00

600.00 1 500.00 500.00

100 50

5.00 4.00 COGS

500.00 200.00 4 500.00

2 500.00

20 July 22 July 24 July

4.00

800.00

29 July

Sales

200 @ $7 400 @ $6 100 @ $5.50 150 @ $5 Less cost of goods sold (see above inventory card) Gross profit 2. LIFO Date

In $ per

1-July 8-July 12-July 13-July

300

6.00

1 800.00

Out $ per

$ 300.00 900.00

20-July

400

5.00

2 000.00

22-July 24-July

100

5.00

500.00

150

4.00

600.00

GOGS

4 300.00

200

4.00

29-July

Sales Less cost of goods sold Gross profit

2 500.00

800.00

$ 5 100 4 300 800

200 100 100 200

5.00 5.00 5.00 4.00

1 000.00 500.0 500.00 800.00

150

4.00

600.00

5 100 4 500 600

6.00 6.00

5.00

Balance $ per $ 6.00 1 800.00 6.00 1 500.00 6.00 600.00 6.00 600.00 5.00 2 500.00

1 400 2 400 550 750

50 150 500

# 300 250 100 100 500

# 300 250 100 100 500 100 100 100 100 200 100 50

Balance $ per 6.00 6.00 6.00 6.00 5.00 6.00 5.00 6.00 6.00 4.00 6.00 4.00

$ 1 800.00 1 500.00 600.00 600.00 2 500.00 600.00 500.00 600.00 600.00 800.00 600.00 200.00

Chapter 12: Inventory

Problem 12.2 1 Cost of goods sold under perpetual inventory system = 865 000 @ $5 = $4 325 000 2 Cost of goods sold under periodic inventory method: Inventory at beginning Add: Purchases Deduct: Inventory at end Cost of goods sold

$ 500 000 4 250 000 4 750 000 350 000 $4 400 000

3 In this case, the comparison of #1 and #2 shows that Emerald has an inventory shortage: COGS should be $4 325 000 but based on the ending inventory count it would be deduced to be $4 400 000. The latter figure includes $75 000 of unexplained shortage. On a per-unit basis, only 865 000 units were sold, but 880 000 are gone: those 15 000 units represent lost income of $11.00 – $5.00 = $6.00 each, for a total lost income of $90 000. So, it appears that Emerald needs better control over its inventory. Whether a perpetual inventory system is the answer, or rather just better physical control to stop theft or losses of units, is not clear from the sparse data. A perpetual system does not prevent loss, as we can see here, because such a system is being used and there are still losses, but it does identify loss, and management may feel that information (and the threat of discovery to anyone tempted to steal) is worth the cost.

Chapter 12: Inventory

Problem 12.3 1 Topaz Ltd General journal

a Perpetual inventory Inventory Accounts payable Credit purchases during the period Accounts receivable Sales revenue Sales on credit during the period Cost of goods sold expense Inventory Cost of goods sold expense: 50% mark-up 180 000 x 100/150 = $120 000 Inventory shortage expense Inventory Shortage: record indicates inventory should be $30 000 + $110 000 – $120 000 = $20 000 but only $18 600 is on hand Operating expenses Cash Expenses paid in cash Profit and loss summary Cost of goods sold expense Inventory shortage expense Operating expenses Closing entry Sales revenue Profit and loss summary Closing entry Profit and loss summary Retained profits Transfer of net profit

DR$ 110 000 180 000 120 000

CR$ 110 000 180 000 120 000

1 400 1 400 35 000 156 400

180 000 23 600

35 000 120 000 1 400 35 000 180 000 23 600

Chapter 12: Inventory

Problem 12.3 (continued) b Periodic inventory Purchase expense Accounts payable Credit purchases during the period Accounts receivable Sales revenue Sales on credit during the period Operating expenses Cash Expenses paid in cash Profit and loss summary Purchase expense Operating expenses Inventory (1 July 2021) Closing entry Inventory (30 June 2022) Sales revenue Profit and loss summary Closing entry Profit and loss summary Retained profits Transfer of net profit

2 a

Topaz Ltd General journal

DR$ 110 000 180 000 35 000 175 000

18 600 180 000 23 600

CR$ 110 000 180 000 35 000 110 000 35 000 30 000

198 600 23 600

Perpetual inventory Topaz Ltd Income Statement for year ended 30 June 2022

Sales Less:

Cost of goods sold Inventory shortage Gross profit Less: Operating expenses Net profit

$ 120 000 1 400

$ 180 000 121 400 58 600 35 000 23 600

b Periodic inventory Topaz Ltd Income Statement for year ended 30 June 2022 Sales Less:

Cost of goods sold Inventory 1 July 2021 Purchases Available for sale Less: Inventory 30 June 2022 Cost of goods sold Gross profit Less: Operating expenses Net profit

$ 30 000 110 000 140 000 18 600

$ 180 000

121 400 58 600 35 000 23 600

Chapter 12: Inventory

Problem 12.4 Periodic:

Available = $30 000 + $125 000 On hand at end We must have sold inventory costing

= = =

$ 155 000 38 000 117 000

Perpetual:

Available inventory is the same Cost of inventory sold We should have inventory at end costing But our count shows Inventory shortage

= = = = =

155 000 114 000 41 000 38 000 3 000

So, we can say that one effect on the accounting policy choice is that by using perpetual you can know that your inventory is short (lost, stolen, or has strayed) $3000. Using periodic, you’d have only the count and would presume COGS equalled $117 000, when in fact $114 000 appears actually to have been sold. From the general manager’s point of view the perpetual method provides better information. Outside users of the financial statements might also get better information if the company disclosed the shortage separately from cost of goods sold expense. If the company didn’t disclose this, it would show cost of goods sold as $117 000 ($114 000 + $3000) shortage), which is the same as it would be using the periodic method. In that case, the choice would make no difference to outside users.

Problem 12.5 1 (1500 x 11) + (900 x 12) + (400 x 14) = $32 900 Note: Since FIFO is being used, the answer is the same irrespective of whether a perpetual or periodic system is being employed. 2 (200 x 15) + (1500 x 13) + (200 x 14) = $25 300 3 Sales (300 x 20) + (1800 x 20) + (700 x 22) = $57 400 Less: Cost of goods sold $32 900 $24 500 4 The gross profit is unchanged as the increased purchase only affects ending inventory.

Chapter 12: Inventory

Problem 12.6 1

Subsidiary Inventory Record Card

Item: Prams A LIFO Month LIFO Jan Feb Mar Apr May

Units 20

Purchases Price per unit $ 5

Amount $ 100

180

245

June

Units

Sales Price per unit $

Amount $

180

210

Cost of Sales =

465

Units

Sales Price per unit $

Amount $

5 25

5 6

25 150

5 25

6 7 Cost of Sales =

30 175 455

Units

Sales Price per unit $

Amount $

5.86

175.80

6.86

205.80

Balance Price per unit $ 5 5 5 6 5 5 7 5 7

Amount $ 100 25 25 180 25 25 245 25 35

20 5 5 30

Balance Price per unit $ 5 5 5 6

Amount $ 100 25 25 180

5 5 35

6 6 7

30 30 245

Balance Price per unit $ 5 5 5.86 5.86 6.86 6.86

Amount $ 100 25 205 29.30 274.30 68.60

Units 20 5 5 30 5 5 35 5 5

B FIFO Month FIFO Jan Feb Mar

Units 20 30

Purchases Price per unit $ 5 6

Amount $ 100 180

Apr May

245

June

Units

C Moving average Month Mvg Avg Jan Feb Mar Apr May June

Units 20

Purchases Price per unit $ 5

Amount $ 100

180

245

Cost of Sales =

456.60

Units 20 5 35 5 40 10

Chapter 12: Inventory

Problem 12.6 (continued) 2 15 @ 10 30 @ 11 30 @ 12

$ 150 330 360 840

LIFO Sales Less Cost of Sales Gross Profit

$ 840 465 375

FIFO Sales Less Cost of Sales Gross Profit

$ 840 455 385

Moving Average Sales Less Cost of Sales Gross Profit

840 456.60 383.40

Sales

3 Specific Identification Method involves the identification of each item issued with its purchase price. In many circumstances it is not feasible to identify each lot separately and the method can become laborious and expensive if there are frequent purchases at different prices, particularly if the records are kept manually. NB: Students could also describe the standard cost method. 4 a In periods of rising prices LIFO provides a lower inventory valuation, a higher cost of sales figure and thus a lower net profit figure than FIFO. b In periods of falling prices LIFO provides a higher inventory valuation and a higher net profit figure than FIFO.

Chapter 12: Inventory

Problem 12.7 1a LIFO - Perpetual Purchases

Date Units

Sales $

Units

Balance

1 May 2 May

1,200

8,400

11 May 22 May

800 900

7.5

5,600

6,750

900 200

30 May

7.5 7

6,750 1,400

Units

1,000

6,000

1,000 1,200

6 7

6,000 8,400

1,000 400

6 7

6,000 2,800

1,000 400 900

6 7 7.5

6,000 2,800 6,750

1,000 200

6 7

6,000 1,400

13,750

Ending Inventory: Cost of Goods Sold

$7,400 $13,750

1b Weighted Average - Periodic Cost of goods available for sale Number of units available Unit Cost

$21,150 3,100 $6.82

Cost of Goods Sold (21,150 – 8,184) Ending Inventory (1,200 x 6.82)

2a Net Realisable Value

$12,966 $8,184

$6.50 x 1,200 = $7,800

Cost of Inventory using LIFO Perpetual $7,400 Since net realisable value is greater than cost, there is no need to make an adjustment. 2b Net Realisable Value

$6.50 x 1,200 = $7,800

Cost of Ending Inventory using Weighted Average Periodic Adjusting Entry DR Inventory Write-down Expense CR Inventory

$8,184

384 384

Chapter 12: Inventory

Problem 12.8 1. FIFO

COGS

Ending inventory Gross profit Sales COGS Gross profit

= 1,800 x 56 + (200 x 56 + 2,200 x 55 + 100 x 52) + (1,700 x 52 + 300 x 50) = 341, 600 = 2,700 x 50 = $135,000 = 1,800 x 60 + 2,500 x 65 + 2,000 x 63 = 396,500 = 341,600 = 396,500 – 341,600 = 54,900

2. LIFO COGS Ending inventory Gross profit Sales GOGS Gross profit

= 1,800 x 55 + (1,800 x 52 + 400 x 55 + 300 x 56) + 2,000 x 50 = 331,400 = 1,700 x 56 + 1,000 x 50 = 145,200 = 1,800 x 60 + 2,500 x 65 + 2,000 x 63 = 396,500 = 331,400 = 396,500 – 331, 400 = 65,100

Problem 12.9 1 a and b FIFO 600 1 625 2 225 6601 1 565

Opening inventory Plus purchases Less:

1 2

Ending inventory Cost of goods sold

LIFO

600 1 625 2 225 6002 1 625

4  165 4  150 [LIFO]

Date 1/1 3/3

Balance Purchase

9/4

COGS

10/5

Purchase

22/8

COGS

Out

160

800

165

5 1

160 150

800 150

165

660

825

1 625

Ending inventory = $615; COGS = $1610

1 610

$ 4 4 5

Balance $ $ 150 600 150 600 160 800

3 3 5 3 1

150 150 165 150 165

450 450 825 450 165 615

Chapter 12: Inventory

Problem 12.9 (continued) d [FIFO] Date

1/1 3/3

Balance Purchase

9/4

COGS

10/5

Purchase

22/8

COGS

Out

160

800

165

4 2

150 160

600 320

3 1

160 165

480 165 1 565

825

1 625

$ 4 4 5

Balance $ $ 150 600 150 600 160 800

3 3 5

160 160 165

480 480 825

165

660 660

Ending inventory = $660; COGS = $1565 2 a Cost NRV Cost  NRV

$615 608 7

(4  152)

Profit will be reduced by $7; as will Inventory (Current assets) in the balance sheet. b Cost NRV Cost  NRV

$660 620 40

(4  155)

Profit will be reduced by $40; as will Inventory (Current Assets) in the balance sheet. c Cost NRV Cost < NRV

$600 608 8

(4  152)

No effect on financial statements.

Problem 12.10 1. Company A uses weighted average, Company B uses FIFO. Company A refers to the weighted average cost of inventory (net of discounts) and logistic expenses, whereas Company B refers to direct costs (direct materials and direct labour) and production overheads. 2. Assuming rising prices, Company B would have the higher profit (FIFO versus weighted average). Company B would have the higher ending inventory.

Chapter 12: Inventory

Problem 12.11 1 Highest profit Lowest profit Difference Effect on net profit (70%)

2022 LIFO FIFO $22 000 $15 400

2021 FIFO AVGE $13 000 $ 9 100

2020 FIFO LIFO $23 000 $16 100

2 The company should choose an inventory cost policy that is fair and appropriate for its circumstances and stick with it. The fact that various methods might produce higher or lower profits in various years is not a proper criterion for choice of a method.

Problem 12.12 1a

Inventory cost, 31 December 2022 for Print X, FIFO basis. $

First calculate units in ending inventory: Beginning inventory

Purchases (10 + 15)

Sales

(23)

Ending inventory Ending inventory value: 6 × $330 = $1 980 b

Cost of goods sold 2022, for Print Y, Average basis. Units

Cost

Total cost

Beginning inventory

500

5 500

Summer purchases

480

12 000

Autumn purchases

510

15 300

Goods available for sale Cost of goods sold: 38 ($32 800 ÷ 66) = $18 885.

32 800

Ending inventory value Print Y: $ Market value (100 – 10) Units remaining (11 + 25 + 30 – 38)

90 × 28

Inventory value 2 520 Accounting standards require that inventory be valued at the lower of cost and net realisable value i.e. selling price less any costs required to complete the sale. Since this amount is lower than cost, the inventory must be written down.

Chapter 12: Inventory

Problem 12.13 1

DR Inventory write-down expense CR Inventory DR Inventory write-down expense* CR Inventory

$40m $40m $3m $3m

* This is an expense account that could be given a number of different names

A write down in inventory is treated as an expense which reduces net profit for the period. This unexpected decrease in profit is likely to lead to a drop in share price. The market may also have a negative reaction to managements handling of the situation.

Cases 12A 1 In 2021, Inventory is recorded on the balance sheet at $3,132M. 2 With the development of computer-based inventory systems, a perpetual system is likely to be used. Woolworths have cash registers that use optical scanners to read the barcodes attached to products. This reads the sales price and also updates the inventory records. 3 Yes, as noted in Note 1.2.2 on Inventories: “Inventories are valued at the lower of cost or net realisable value”. 4 As stated in Note 1.2.2 “Cost is determined on a weighted average basis after deducting supplier rebates and settlement discounts, and includes other costs incurred to bring inventory to its present condition and location for sale”.

12B 1 The income statement will overstate sales and probably COGS with an overstatement of net profit. In the balance sheet accounts receivable will be overstated. Whether inventory is over-stated or not will depend on the entries of inventory, whether they actually ever had the disks in inventory, etc. 2 Not normally as it would take a lot of collusion in the fraud to avoid it being detected, e.g. someone would need to cover up incorrect accounts receivable (i.e. the company would not get paid), etc.

Solutions Chapter 13 Noncurrent assets Discussion questions 1 The components of the cost of an asset include all those costs that are required to make it suitable for the purpose intended. 2 The aim of recording depreciation is to allocate the cost of an asset as a deduction from profit over the useful life of the asset. 3 Asset values are initially recorded at historical cost however as assets (e.g. equipment) wears out over time deducting accumulated depreciation gives users an indication of the age of the equipment. It should be noted that the main purpose of depreciation is profit determination rather than balance sheet valuation. For example the value of an asset can be above the amount shown in the balance sheet (Cost – Accumulated depreciation) because some assets, such as buildings, can increase in value. 4 In calculating, depreciation managers and accountants need to make the following judgements: i estimate useful life of the asset ii estimate ‘salvage value’ iii economic use pattern of the asset over its life 5 The following methods of depreciation are available: i straight-line ii reducing balance iii units-of-production. With the straight-line method, depreciation expense is the same each year of the asset’s useful life, so profit is reduced by the same amount each year. With the reducing balance method, expense is larger in the earlier years than in the later years, so profit is reduced by larger amounts in the early years of the asset’s life. With the units-of-production method, the expense depends on each year’s volume of production, so the reduction in profit varies according to the amount of production achieved. 6 If, when an asset is disposed of, the proceeds are more than book value there is a gain, which increases net profit. If the proceeds are less than book value there is a loss, which reduces net profit. In the balance sheet, the asset disposed of reduces, cash may increase and retained profits changes. 7 The purpose of performing an asset revaluation is to provide users of financial statements with relevant and reliable information for evaluating the performance, financial position, financing and investing of the organisation. 8 When land is revalued upwards, both the land account and the revaluation surplus account are generally increased and there is no effect on profit. However, if an increment reverses a revaluation decrement previously recognised as an expense in

Chapter 13: Noncurrent assets

the profit and loss account in respect of the same class of assets, the increment would be recognised as revenue and profit would be increased. 9 A ‘recoverable amount’ refers to the net amount that is expected to be recovered through the cash inflows and outflows arising from an asset’s continued use and subsequent disposal. 10 Five different types of intangibles are: – patents, copyrights, trademarks and other such legal property – brand names – franchises and distributorships – deferred charges such as incorporation costs – research and development costs. 11 Goodwill arises when more is paid for a group of assets, such as a whole business, than the assets are worth individually. It is valued in the balance sheet as the difference between the price paid for a group of assets and the sum of their apparent fair (market) values. 12 Examples of deferred expenditure are: – incorporation costs – financing costs – casino license. They appear in the balance sheet under the heading ‘Intangible assets’. 13 Research and development costs should generally be expensed when incurred, except where future benefits related to the costs are expected to be greater than the costs ‘beyond any reasonable doubt’. In the latter case, development costs, they should be capitalised and expensed over subsequent years as the benefits are obtained. 14 You may get some idea as to the age of the assets, how worn out they are and whether many of the assets will need to be replaced soon. It is possible to have a better understanding of changes in the productive capacity of the firm. (Depreciable) assets are usually much more important to the company, and in evaluating it, than are things like prepaid expenses. 15 The objective is to represent the usage pattern of the asset: a an even consumption pattern (a warehouse truck) b reducing balance – decreasing benefits (e.g. an airplane or computer, which is used more in the early years) c units of production – uneven consumption (e.g. a paving machine is used seasonally and more in some years than others). This is often used by mining companies where mines are closed down for periods when production is uneconomical (e.g. a gold mine). 16 Depreciation has been defined as a ‘process whereby the decline in service potential of an asset through wear, tear and obsolescence is progressively brought to account as a periodic charge against revenue’. In each period in which the asset is used to generate revenue, a portion of its cost is ‘matched’ against that revenue, i.e., it is treated as ‘depreciation expense’. Cost is taken as the basis of depreciation numbers on the assumption that the acquisition cost of an asset reflects its ‘value’ at the time of acquisition. Depreciation, as well as being an allocation of cost over the useful life of the asset, also reflects the decline in the ‘value’ (= ‘service potential’) of the asset over its useful life. ‘Value’ here implies ‘value-in-use’, i.e., the asset will be used in the ongoing operations of the entity viewed as a ‘going concern’, i.e., one, which is expected to continue its operations into the future. According to this view, if an asset

Chapter 13: Noncurrent assets

is acquired to be ‘used’ its ‘exchange’ value (market selling price) is irrelevant – by definition the asset was not acquired to be re-sold. Also, until the asset is sold then there is no transaction that can provide ‘objective’ information as to its ‘exchange’ value. On the other hand, the residual value of the asset is not ‘depreciated’. By definition, ‘residual value’ refers to the value of the asset at the end of its useful life. At this stage the asset will be disposed of and its carrying amount is matched against any revenue from disposal. At this point it is its ‘value in exchange’ rather than ‘value in use’ which is relevant; so that it is appropriate that some portion of the cost of the asset remain ‘unallocated’ so that it can be matched against revenue from disposal (if any). 17 The advantage of capitalising is that although intangible assets do not have a physical existence as do land, buildings etc., they can provide future economic benefits to the company. As such intangible assets can be considered a resource of the company and included on the balance sheet. The disadvantage to capitalising is that these assets are intangible and their existence and value may be doubtful and difficult to measure. This includes doubt about future economic value. 18 If costs of a development project are recorded as a ‘deferred cost’ asset, this means they have not been expensed. Thus, net profit is higher because expenses are lower and balance sheet assets are higher. 19 Accounting standards require that leases be capitalised when the company is deemed to have almost the same rights and obligations of ownership as if they had purchased the asset outright. The idea is that, if the lease transaction is almost the same as the purchase of an asset, the two transactions should be recorded in the same way. 20 If a lease is treated as a finance lease, the present value of the minimum lease payments will be recorded as an asset. A liability will also be recorded in the same amount at the inception of the lease. Thus assets and liabilities will be higher when a lease is treated as a finance lease rather than an operating lease. In the income statement, for finance leases, depreciation expense is recognised based on the recorded value of the leased asset, and interest expense is recognised based on the recorded value of the lease obligation. Lease payments are not deducted from net profit when the lease is treated as a finance lease. When a lease is treated as an operating lease only the lease payments are expended in the income statement. 21 It should be noted that in many areas, the rules for taxation can differ from accounting standards. As a result, taxation profit and accounting profit can be different. Depreciation can be one such example. The company will not have trouble with the taxation department providing it follows taxation guidelines. For example, these guidelines may give the normal period over which certain classes of assets should be depreciated for taxation purposes. If the company believes they are inappropriate they can get a ruling from the taxation department.

Chapter 13: Noncurrent assets

Problems Problem 13.1 1 2 3 4 5 6 7 8

Asset $27 500 Asset $300 000 Asset $18 000 Asset $1 500 Expense Asset $23 000 Expense Expense

Problem 13.2 1 2 3

Total cost of the asset

= $1 000 000 + $17 000 + $23 000 = $1 040 000 Depreciation expense = $1 040 000/10 = $104 000 Accumulated depreciation = $104 000*2 = $208 000

Problem 13.3 1 Asset = All costs required to make delivery vans suitable for purpose intended = $182 000 2 – Asset = $150 000 + $15 000 training costs (costs required to make system suitable for purpose intended) – Expense = $10 000 additional training costs (no betterment of the asset) 3 Asset, if future benefits related to the costs are expected to be greater than the costs ‘beyond any reasonable doubt’; otherwise, expense 4 Asset because productive capacity has been increased

Problem 13.4 1 a Van $30 000 + $5 000 + $1 000 = $36 000 (costs of making ready for use) b Cost not market value – i.e. $3 200 2 a Depreciation for the van = (Cost – Salvage value) / Useful life = (36 000 – 800) / 4 = $8 800 b Due to interpretation of the question, two alternative answers have been given: – Rollers will last for 2 years Year 1 = 50% x 3 200 = 1 600 or – Rollers last for balance of 2022 and all of 2023 financial year Year 1 = 9 / 12 x 50% x 3 200 = 1 200

Chapter 13: Noncurrent assets

Three-year licence, but purchased on 1 February, therefore 11/36 amortisation $1 375 is the amortisation expense 3 Van: property, plant and equipment; paint rollers: property, plant and equipment; licence: intangible assets

Problems 13.5 1

Accumulated depreciation at the end of the second year. i Straight-line: Depreciation 40 000 / 5 = $8 000 per year Accumulated depreciation 8 000 x 2 = $16 000 ii Reducing balance (25 per cent rate): Depreciation Y1 40 000 x 0.25 = $10 000 year 1 depreciation Depreciation Y2 (40 000 – 5 000) x 0.25 Accumulated depreciation iii Units of production: Depreciation 40 000 / 5 000

2 3

= $8 750 year 2 depreciation = $18 750 = $8 per lawn

Depreciation Y1 500 x 8 = $4 000 year 1 depreciation Depreciation Y2 1 000 x 8 = $8 000 year 2 depreciation Accumulated depreciation = $12 000 The units of production method would result in the highest retained profits at the end of the second year because the expense for the first two years taken together is lower, resulting in net profit for the two years taken together being higher. Estimation of loss on sale: Cost Accumulated depreciation

$20 000 (15 254) $4 746

Proceeds Less NBV Loss on disposal

$100 $(4 746) $(4 646)

Depreciation 40 000 / 5 000 Depreciation Y1 500 x 8 Depreciation Y2 1 000 x 8

= $8 per lawn = $4 000 year 1 depreciation = $8 000 year 2 depreciation

Depreciation Y3 1 200 x 8 Depreciation Y4 1 800 x 8

= $9,600 year 3 depreciation = 14,400 year 4 depreciation

Problem 13.6 1 Purchase price of new machine Freight and installation charges Cost of machine for accounting purposes

$135 000 $ 25 000 $160 000 4 10 000 Reducing balance = 1 − √ 160 000 = 50% per annum

Chapter 13: Noncurrent assets

Year ending 31 December 2019 2020 2021 2022

Straight-line $ 37 500 37 500 37 500 37 500 150 000

Reducing balance $ 80 000 40 000 20 000 10 000 150 000

2 DR Depreciation expense CR Accumulated depreciation

42 000 42 000

𝟕 𝟎𝟎𝟎 ( 𝟐𝟓 𝟎𝟎𝟎 x $𝟏𝟓𝟎 𝟎𝟎𝟎 ) 3 Raven & Son should use the depreciation method that approximates the use pattern of the asset. While the choice of depreciation method will affect annual profit figures and financial position during the life of the asset, it will have no effect over the asset’s life.

Problem 13.7 1 a Straight-line (812 500 – 32 500) / 4 = 195 000 (i.e. $195 000 each year) b Reducing balance: 2019: 40% x 812 500 = 325 000 2020: 40% x (812 500 – 325 000) = 195 000 2021: 40% x (812 500 – 520 000) = 117 000 2022: [the remainder] 812 500 – (325 000 + 195 000 + 117 000 + 32 500) = 143 000 2 A depreciation method should be appropriate to the nature of the asset and its expected use. The basis chosen is that which best reflects the underlying physical, technical, commercial and, where appropriate legal facts. Salvage value: 32 500 Implied depreciation rate (using formula): 55% stated depreciation rate per P13.6 Yr 1 40%

Cost

Accumulated Carrying depreciation value

812 500

325 000 195 000 117 000

Yr 2 Yr 3

40% 40%

812 500 812 500

325 000 520 000

487 500 292 500

Yr 4

40%

812 500

637 000

175 500

Stated Depreciation Yr 4 salvage expense depreciation value expenses

32 500

143 000

Chapter 13: Noncurrent assets

Problem 13.8 1 100 000 / 10 = 10 000 DR Depreciation expense 10 000 CR Accumulated depreciation 10 000 to record depreciation expense for 2022 using the straight-line method. 2 2021 depreciation expense 100 000 x .20 $20 000 2022 depreciation expense (100 000 – 20 000) x .20 16 000 Required ending balance – Accumulated depreciation $36 000 DR Depreciation expense 16 000 CR Accumulated depreciation 16 000 to record depreciation expense for 2022 using the reducing balance method. 3 a Income statement effects of moving to reducing balance in 2023: 2023 reducing balance depreciation expense: (100 000 – 20 000 – 16 000) x .20 = 12 800 Increase in depreciation expense (12 800 – 10 000) $ 2 800 Decrease in net profit before tax $ 2 800 b Balance sheet effects: End of 2023 Reducing balance Straight-line Increase in accumulated depreciation Decrease in deferred income tax liability (40%) Therefore: Decrease in total assets

$ 48 800 30 000 18 800 7 520 11 280

End of 2022 $ 36 000 20 000 16 000 6 400 9 600

4 If the asset is expected to benefit earlier periods more than later periods the reducing balance method is more appropriate than the straight-line method because it will result in better matching of revenues and expenses. If an asset is expected to benefit in each period evenly throughout its useful life, the reducing balance method would not be appropriate.

Problem 13.9 1 Depreciation on truck #4: 2019: (.20)($46 000)(.5) = $4600 depreciation. Book value December 31 = $46 000 – 4 600 = $41 400 2020: (.20)($41 400) = $8280 depreciation Book value December 31 = $41 400 – $8280 = $33 120 2021: (.20)($33 120) = $6624 depreciation Book value December 31 = $33 120 – $6624 = $26 496 2022: (.20)($26 496)(.5) = $2650 depreciation Book value June 30 = $26 496 – $2650 = $23 846 Total depreciation = $4600 + $8280 + $6624 + $2650 = $22 154 (Check: $46 000 – $23 846 = $22 154) © 2022 Cengage Australia Pty Limited. All Rights Reserved.

Chapter 13: Noncurrent assets

DR Cash 15 000 CR Trucks cost 46 000 DR Trucks accumulated depreciation 22 154 DR Loss on sale* 8 846 *$15 000 proceeds – $23 846 book value = $8 846. 3 Total depreciation = (.15)($46 000 – $6000)(3) = $18 000. (This is $3000 for 2016, $6000 each for 2017 and 2018 and $3000 for 2019.) DR Cash 15 000 CR Trucks cost 46 000 DR Trucks accumulated depreciation 18 000 DR Loss on sale 13 000 4 Expenses for 2022: Reducing balance method (part 1) Straight-line method (part 2) Difference

Depreciation $ 2 650 3 000 350

Loss $ 8 846 13 000 4 154

Since these differences are in the same direction, profit would be $4 504 higher ($350 + $4 154) if the reducing balance method were used, compared to the straightline method. 5 Different depreciation methods affect profit and net noncurrent assets but do not affect cash flow. If an investor is concerned about profit and/or profit-based ratios such as return on assets, choice of depreciation method might matter. On the other hand, if an investor, and especially a creditor, is concerned about ability to pay debts, choice of depreciation method would not matter. (This assumes that depreciation method does not affect income taxes, because generally in Australia, depreciation is computed according to tax rules and so the company’s accounting method choice is ignored for tax purposes.) 6 Such differences are mitigated by: – consistent use of a chosen depreciation method over time (the same as consistency in other accounting policies) – disclosure of depreciation expense, accumulated depreciation and method used permits those who want to compare different companies to estimate necessary adjustments.

Problem 13.10 $150,000

Accumulated depreciation 350 000 OB 800 000 Depn 150 000 600 000 950

Dr Cash 700 Dr Acc. Dep. 350 Cr Gain on sale 150 Cr Equipment 900

Chapter 13: Noncurrent assets

Problem 13.11 1 55 383 – 50 000 = 5 383 2 a Overstated b No effect c Non-current assets overstated because accumulated depreciation is understated 3 59 778 – 57 850 = 1 928

Problem 13.12 The cost and depreciable amount of the additional equipment purchased is calculated as follows: Price Less:

Less:

$ 120 000 30 000 90 000 7 500 2 500 100 000 4 500 95 500

Trade discount Freight charges Installation and testing Cost Salvage value Depreciable amount

Depreciation for the ‘year’ ended 30/6/21 is calculated as follows: 1 Reducing balance: 6 $100 000  50%  12 2 Straight-line: 1 6 $95 500   5 12 3

= $25 000

= $9 550

Units-of-production method:

$96 875  (80 000 / 850 000)

= $9 117.65

Problem 13.13 1 Schedule showing annual depreciation expense and end of year carrying amount for both methods:

Year Acquisition 1 2 3 4

Straight-line Depreciation expense Carrying amount $ 200 000 200 000 200 000 200 000

$ 810 000 610 000 410 000 210 000 10 000

Reducing balance Depreciation Carrying amount expense $ $ 810 000 540 000 270 000 180 000 90 000 60 000 30 000 20 000 10 000

2 Factors likely to influence the useful life of a depreciable asset: i physical factors, such as wear and tear ii technical factors, such as obsolescence of the asset

Chapter 13: Noncurrent assets

iii commercial factors, such as changes in the demand for the product or other output produced by the asset iv legal factors, such as the term of a lease or patent. Factors likely to influence management’s choice of a depreciation method include the effect that the method will have on the firm’s financial statements, income tax laws, information needs of management and statement users, the clerical cost of applying a particular method, and requirements of professional accounting standards.

Problem 13.14 Part A 1 Sound system cost Depreciation for year end 31 December 2022

$ 30 500 = 30 500 x 20% x ¾ = 4.575

Written-down value

= 25 925

Lighting system cost Depreciation for year end 31 December 2022 Written-down value

44 000 = 44 000 x 25% x ¾ = 8 250 = 35 750

2 If 150% of straight-line method were employed, the depreciation would be higher and the profit would be lower. Part B 1 May 2022 1 Oct 2022

DR $ 700

Repairs and maintenance expense Cash Sound system Cash

CR $ 700

5 000 5 000

Problem 13.15 DR Cash DR Accumulated depreciation (see T-account) DR Loss on sale CR Equipment

120 000 40 000 20 000

Accumulated depreciation 40 000 OB Depn

180 000

320 000 120 000 400 000

Chapter 13: Noncurrent assets

Problem 13.16 DR Cash DR Accumulated depreciation (balancing amount) CR Equipment CR Gain

Equipment opening balance + Purchases 700 000 + 200 000

60 000 40 000 80 000 20 000

– Disposal at cost – x x

= Closing balance = 820,000 = 80,000

Problem 13.17 1 DR Cash DR Accumulated depreciation CR Delivery truck 2 DR Cash DR Accumulated depreciation CR Gain on sale CR Delivery truck 3 DR Cash DR Accumulated depreciation DR Loss on sale CR Delivery truck

$19 000 $39 000 $58 000 $29 000 $39 000 $10 000 $58 000 $7 100 $39 000 $11 900 $58 000

Problem 13.18 1

The pizza truck does have the potential to generate future economic benefits. It is controlled by the entity. There are past events of payments to build and prepare for use the pizza truck. It is probable that future economic benefits will flow from the use of the pizza truck whereby customers will pay for the pizzas created by the truck. The cost of the truck can be measured reliably through the receipts and payments for creating the truck ready for use. Therefore, directly attributable costs of creating and preparing for use of this pizza truck will be capitalised. 2 The replacement of tires does not substantially enhance the useful life of the pizza truck and does not increase its value. This tire replacement can be classified as regular maintenance and would be recorded as an expense. Only if an expenditure enhances the useful life or increases its value will it be capitalised to the asset. If the replacement tires are capitalised rather than expensed this would increase the company’s asset of Pizza truck (Dr Pizza truck; Cr Cash or Payable) and would decrease the company’s expenses (not recording: Dr Tires expense XX; Cr Cash or Payable). In turn the Net Profit would be higher. Managers may have an incentive through bonuses linked to net profit to prefer capitalising over expensing treatment. 3 DR Maintenance and repairs expense CR Cash DR Pizza Truck CR Cash

$5 000 $5 000 $25 000 $25 000

Chapter 13: Noncurrent assets

4 A – 5 000 (cash)

SE – 5 000 (maintenance and repairs expense)

– 25 000 (cash) + 25 000 (pizza truck) 5 DR Depreciation expense $10 500 CR Accumulated depreciation $10 500 ((135 000 + 55 000 + 25 000) – 5 000)/20 years = $10 500

Problem 13.19 General journal 1 2

Accumulated depreciation – buildings Accumulated depreciation – machinery Accumulated depreciation – machinery Machinery Gain on sale of machinery Delivery equipment Purchases Depreciation expense – delivery equipment Accumulated depreciation – delivery equipment Car park lighting Maintenance expense Depreciation expense – car park lighting Accumulated depreciation – car park lighting

$ 2 140

16 000 14 500 1 500 7 900 7 900 875 875 12 000 12 000 1 500 1 500

Chapter 13: Noncurrent assets

Problem 13.20 Hogarth Limited General journal 1

Accumulated depreciation Loss on sale Store fixtures (Correction of error) Fence (or land improvements) Maintenance expense (Correction of error in posting) Depreciation expense – fence Accumulated depreciation – fence 1  (Adjusting entry)  6 x x $9,000  12 10  Motor vehicles Purchases (Correction of error in posting) Depreciation expense – motor vehicle Accumulated depreciation – motor vehicle (Adjusting entry – 40%  $10 000) Revaluation surplus Loss on revaluation of land (or profit and loss summary account) Land (To record revaluation of land)

8 500 2 300 10 800 9 000 9 000 450 450

10 000 10 000 4 000 4 000 5 000 5 000 10 000

Problem 13.21 1 Carrying amount of building =

2 DR CR DR CR

Building Less accumulated depreciation Carrying amount Accumulated depreciation 60 000 Building 60 000 Building 260 000 Revaluation surplus 260 000

$ 200 000 60 000 140 000

Chapter 13: Noncurrent assets

Problem 13.22 1

2023 July 1

2024 June 30

July 1

Loss on devaluation of land Land Revaluation of land Accumulated depreciation Plant and equipment Transfer of accumulated depreciation on revaluation Plant and equipment Revaluation surplus Revaluation of plant and equipment

20 000

Depreciation on plant and equipment Accumulated depreciation Straight-line depreciation at 10% p.a. Accumulated depreciation Plant and equipment Transfer of accumulated depreciation on revaluation Revaluation surplus Loss on devaluation of plant and equipment Plant and equipment Revaluation of plant and equipment

14 000

20 000 30 000 30 000 20 000 20 000

14 000 14 000 14 000 20 000 6 000 26 000

4 Kingfisher Ltd (Extract from) balance sheet as at 30 June 2025 Noncurrent assets $ Land Plant and equipment 100 000 Accumulated depreciation 10 000

$ 300 000 90 000 390 000

Problem 13.23 1

a 10 – 6 = $4 million b $3.5 million (i.e. higher of 3.5 present value and 3.0 fair value) c $3 million d $3.5 million $4 million – $3.5 million = $0.5 million

Problem 13.24 1 2

4 5

(a) $4 000; (b) $4 550; (c) $2 600; (d) 0 (a) $60 000 – (2 x 4000) = $52 000; (b) $45 500 – (2 x 4 500) = $36 500; (c) $65 000 – (2 x 2 600) = $59 800; (iv) $235 000 (assuming Pharma Ltd did not impair any of its intangible assets) The patent value would be impaired due to the loss of exclusive right to manufacture being lost. Impairment amount: = $60 000 – ((3 x 4000)+((4000/12) x 2 months) = $47 333 Decrease in net profit due to recording of impairment loss ($47 333 impairment loss compared to $4 000 annual amortization of patent). The patent will be recognized on the balance sheet with the sum of the accumulated amortisation and accumulated impairment losses offseting the carrying amount. The asset balance will be lower by $43 333 than if the patent did not expire early.

Chapter 13: Noncurrent assets

Problem 13.25 1 If the other business were continuing as a corporate entity, it might be shown as an investment asset at the cost of $200 000. However, as the business will become a branch, its components would probably be spread out across Foofaraw’s assets and liabilities (similarly to consolidation) as follows: Debit Tangible assets increased Goodwill ($200 000 – $187 000) Accounts payable increased Net total

$ 237 000 13 000 (50 000) 200 000

2 Now the net total would have to be $185 000. There would be no goodwill and the tangible asset increase would be reduced to $235 000.

Problem 13.26 Journal entry (start with the easy accounts first): DR Inventory DR Land DR Building DR Equipment DR Rights CR Loan DR Goodwill * CR Cash CR Long-term debt

$ 280 000 1 500 000 1 800 000 470 000 40 000

130 000 240 000 1 000 000 3 200 000

*Represents the difference between the purchase price and fair value of net assets

Chapter 13: Noncurrent assets

Cases 13A 1 Plant: Lifts, air conditioning units, fire protection systems Equipment: Shopping trolleys, forklifts, shop fittings (Note 3.4) 2 Buildings are depreciated on a straight-line basis over 25–40 years (Note 3.4) 3 Total depreciation and amortisation for the year: $1045 million (Note 3.4) 4 Accumulated depreciation and amortisation (from Note 3.4): Accumulated depreciation Accumulated amotisation (from Note 3.5) Total accumulated depreciation and amortisation

2021 ($m) 1045 335 1380

2020 ($m) 992 308 1300

Increase = $80 million 5 The answers to questions 3 and 4 are not the same because property, plant and equipment were sold or transferred to assets held for sale during the year. 6 Method of cost allocation to determine depreciation: straight-line basis over the estimated useful life of the asset (Note 3.4) 7 Sale of property, plant and equipment: – Woolworths sold property, plant and equipment in 2021 – net loss on sale was $11 million (Note 3.4, footnote 1 to 2021 section) – this loss would be the proceeds received if less than book value. 8 In Note 3.4, there is no mention about revaluation of property, plant and equipment. The table in Note 3.4 does not show any increase or decrease of property, plant and equipment during either 2020 or 2021. Assume Woolworths recognises property, plant and equipment at cost. 9 Intangibles (Note 3.5): – Goodwill: $2 993 million. This represents the excess of the purchase consideration over the fair value of identifiable net assets acquired at the time of acquisition of a business. Goodwill is stated at cost less any accumulated impairment losses. It is not amortised, but tested for impairment annually and whenever an indication of impairment exists. Any impairment is recognised immediately in the income statement and is not subsequently reversed. – Liquor and gaming licences: $0 million. Liquor and gaming licences are valued at cost. They are considered to have an indefinite useful life. As a consequence, no amortisation is charged. They are tested for impairment annually and whenever an indication of impairment exists. Any impairment is recognised immediately as a loss. Woolworths transferred the liquor and gaming licences to the Endeavour Group Limited. During 2020 the Endeavour Group Limited exited the Woolworths tax group and in 2021 was demerged. During 2021 – Brand names: $265 million. As per the above liquor and gaming licences, brand names are considered to have an indefinite useful life and no amortisation charged. Annual testing for impairment is conducted and if detected impairment is recognised immediately as a loss. Intangibles are located in the balance sheet under ‘Non-current assets’. 10 Woolworths does have leases and Note 3.3 provides information about the accounting treatment of the company’s leases. The carrying amount of total

Chapter 13: Noncurrent assets

leases decreased from $12 062 million in 2020 to $9 553 million in 2021. Decrease of $2 509 million. 11 See Note 3.6. 12 Discussed in Note 3.6 (e.g. calculation of recoverable amount).

13B 1

Acquisition:

Increase property, plant and equipment Increase payables or decrease cash

Disposal:

Decrease property, plant and equipment Decrease accumulated depreciation Increase cash Increase gain/loss on sale

Leasing – Finance lease: Operating lease: Depreciation:

Increase leasehold assets Increase leasehold liability Increase lease expense Decrease cash

Increase depreciation expense Increase accumulated depreciation

2 – Property, plant and equipment: Straight line basis over their expected useful lives – Quarry stripping assets: Expected life of the identified resources using the units of production method. Assume equipment has a life of 10 years. Under straight-line, each year is charged with 10 per cent of the total costs as depreciation. This amount would be more if the production during a particular year is greater than 10 per cent of total production of the machine over its life. The total depreciation will be the same under both methods the timing differs. 3 Some required judgements: – what to include in the asset – depreciation method – life of the asset – residual value – operating or finance lease. 4 – Lengthening the life of the asset – Capitalising instead of expensing – Change in depreciation method

13C 1 a Basically, the heading and its format at the top of the front page of the newspaper b For example, the Sydney Morning Herald, The Age, the Financial Review c http://www.smh.com.au, http://www.domain.com.au, http://www.drive.com.au

Chapter 13: Noncurrent assets

d Customer lists e Unidentified intangible assets, which is the difference between fair value of the net assets acquired and the cash paid for the acquisition 2 Because they will provide future economic benefits 3 Treat them as an expense. There will be greater expenses in the first year and consequently profit will be reduced in that year. The reverse effect will happen in subsequent years. 4 Amortisation is normally based on useful life. 5 There would be a smaller expense in the income statement in each of the first four years than if the intangibles were amortised over two years.

13D 1 In calculating the value of the asset, the future cash flows from using the asset are calculated. If profit falls, valuations will fall. 2 Higher expense figures and lower asset figures (because of higher accumulated depreciation) in the early years. 3 Because it provides future economic benefits. There will be a decrease in assets and an increased in expenses.

13E The key judgements made by management that would effect profit are: – the estimated useful life of the assets – the residual values of the assets – the amount of impairment of any assets.

Solutions Chapter 14 Liabilities Discussion questions 1 The Framework defines liabilities as ‘present obligations of the entity to transfer an economic resource as a result of past events’. 2 Four categories of liabilities are payables, interest-bearing liabilities, tax liabilities and provisions. 3 When expenses are incurred either cash will decrease or liability will increase. Examples: receive electricity bill for last month’s electricity, owe wages to employees at year end for work done, accrue expenses for repair work completed by contractors, increase the provision for long service leave, accrue interest on a long term loan. 4 It is particularly important in assessing the ability of an entity to repay its current debt i.e. current liabilities. 5 Liabilities are future sacrifices of economic benefits that the entity is presently obliged to make to other entities as a result of past transactions or other past events. • Provision for warranty is classified as a liability because it is the estimated future cost of providing any promised long-term warranty service for products already sold. • Provision for LSL is classified as a liability because it is an estimate of future long service leave payments. • Unearned revenue is classified as a liability because it refers to cash received in advance of earning revenue. • GST payable is classified as a liability because it refers to goods and services tax collected from customers on behalf of the government. • Income tax deductions due is classified as a liability because it is the amount due to be paid to the government calculated as a percentage of profit before income tax. 6 Liabilities such as bank loans or notes payable represent money borrowed where an agreement is in place to repay the principle plus interest. These are classified as interest-bearing liabilities. For other liabilities such as accounts payable or provisions there is no interest required to be paid. 7 Provisions are liabilities for which the amount or timing of the future sacrifice of economic benefits that will be made is uncertain, for example the provision for warranties. For other liabilities such as accounts payable the amount to be paid will be known from the invoice received; while accruals (for example accrued wages) may involve some uncertainty they can be calculated with a high level of reliability. This uncertainty is generally insignificant and therefore does not create major measurement problems. 8 Examples include provisions for warranty and employee entitlements 9 Most common examples are annual leave and long service leave.

Chapter 14: Liabilities

10 It depends on whether there is a present or possible obligation and if there is a probable outflow. See Figure 14.3. 11 Contingent liabilities do not appear on the balance sheet because they are contingent on a particular event occurring that has not yet happened. Example: i A company provides a guarantee to a lender for a loan taken out by a supplier and the capacity of the supplier to repay the loan is uncertain at the end of the financial year. ii A lawsuit against a company where the likely amount to be paid on the claim cannot be reliably determined. 12 Liability: The company has admitted that they were in the wrong. They have made an offer and are still negotiating final settlement. Contingent liability: The company has been sued but the outcome of the case and dollar amounts are uncertain. 13 Sometimes companies will arrange for sources of financing that do not meet the accounting definition of a liability or an equity item and, as a result, this source of financing does not appear on the balance sheet. Companies may prefer to use this sort of financing because if it was included in the balance sheet it would affect ratios such as debt to equity and debt to asset. Increases in such ratios indicate higher levels of risk for the company. 14 Liabilities include more than just debts. Debts are legally enforceable obligations, based on existing agreements regarding purchases, bank borrowings and other borrowings. Liabilities also include estimates of future cash expenditures stemming from present activities, especially from present expense incurrence. Such estimates are not yet legal debts, but they are included as part of the expense recognition process in accrual accounting. They include deferred income tax, warranty liability and short-term accruals for things like interest building up or power being used. 15 The cost of the LSL is incurred now (when the work is done). The future cost can be estimated. The estimate of the future long-term obligation is based on assumptions and historical trends.

Chapter 14: Liabilities

Problems Problem 14.1 Accounts payable Accrued salaries Unearned revenue Provision for holiday pay Total current liabilities

$ 35,000 7,000 10,000 8,000 60,000

Problem 14.2 1a Inventory .......................................................................................... Accounts Payable ......................................................................... b Cash.................................................................................................. Unearned revenue......................................................................... c Cash.................................................................................................. Note payable................................................................................. d Unearned revenue............................................................................. Service revenue ............................................................................ e Electric expense................................................................................ Electric payable ............................................................................ f Cash.................................................................................................. Unearned Revenue ....................................................................... g Wage expense................................................................................... Wages payable..............................................................................

16,800 16,800 18,000 18,000 900,000 900,000 8,000 8,000 24.200 24,200 20,600 20,600 23,000

2 30 June 2022: There would need to be an entry for interest. It depends on the number of months. Assume loan at 1 March. Interest expense. ............................................................................... 27,000 Interest payable ............................................................................ ($900,000 x 9% x 4/12 = $27,000). 7,200 Unearned Revenue. .......................................................................... Rent Revenue ............................................................................... ($21,600 /3 = $7,200)

23,000

27,000

7,200

Chapter 14: Liabilities

Problem 14.3 Payables: may include trade creditors, accrued expenses, accrued capital expenditure, accrued interest and other creditors. Provisions: may include employee entitlements, workers compensation, restructuring, warranties and dividends. Employee entitlements consist of amounts of annual leave, long service leave and redundancy payments to employees. Revenue received in advance: may include customer deposits and other payments received in advance of the provision of goods/services. Interest-bearing liabilities would include short term borrowings.

Problem 14.4 1 Total current assets are unaffected (the cash came in and went out in one day). 2 Total assets increase by $50,000,000 (the additional equipment). 3 Total current liabilities decrease by $25,000,000 (reduced short-term bank loans). 4 The working capital ratio would be improved because the denominator, current liabilities, would decrease without there being any effect on the numerator, current assets. 5 No change in shareholders’ equity. 6 No direct effect on profit from this transaction. However, there will be increased interest and amortisation expenses in the future. So, unless the additional equipment generates more revenue than that, profit and shareholders’ equity will be reduced in the future.

Problem 14.5 1 Yes, provision for warranty. 2 Yes, provision for warranty. 3 Yes, bonus payable. 4 Yes, provision for holiday pay. 5 No liability, the supplier has not yet provided the service. 6 No liability, no probable loss.

Problem 14.6 1

Cash

20,000 Notes Payable

Notes Payable Interest Expense Cash *$20,000 × 9% × 60/360 = $300

20,000 20,000 300* 20,300

Chapter 14: Liabilities

Problem 14.7 1 a Merchandise Inventory Interest Expense Notes Payable b Notes Payable Cash 2 a Notes Receivable Sales Interest Revenue b Cash

500,000 500,000 500,000 500,000 487,500 12,500 500,000

Notes Receivable 1

487,500 12,5001

500,000

$500,000 × 10% × 90/360

Problem 14.8 1 Recreation Leave – Holiday leave or annual leave. Extended Leave – Long service leave. 2 $98 515. 3 Recreation Leave $51 315 (extended leave $830). 4 Recreation Leave $67 875 (extended leave $51 884). 5 Staff only took a very small amount of extended leave ($830) during 2022 but became entitled to $51 884 worth of extended leave. This caused the provision to increase.

Problem 14.9 1 Present obligation as a result of a past event - There is no present obligation. Conclusion - No provision is recognised. The cost of replacing the lining is not recognised because, at the reporting date, no obligation to replace the lining exists. The need to replace the lining is dependent on the entity's future actions. Even the intention to replace the lining depends on the entity deciding to continue operating the furnace. Instead of a provision being recognised, the depreciation of the lining takes account of its consumption, that is, it is depreciated over five years. Re-lining costs when incurred are capitalised and the consumption of each new lining is recognised as depreciation over the subsequent five years. 2 Present obligation as a result of a past event - There is no present obligation. Conclusion - No provision is recognised. The costs of overhauling aircraft are not recognised as a provision, for the same reasons that a provision is not recognised for the cost of replacing the lining. 3 Present obligation as a result of a past event - There is no present obligation because there is no past event either for the costs of fitting smoke filters or for fines under the legislation. The entity can avoid the costs of fitting smoke filters by its future actions (for example by changing its method or operation, discontinuing the operation or selling the assets concerned). For the same reason, the entity can avoid the costs of fines under legislation that comes into force after the reporting date. Conclusion - No provision is recognised for the cost of fitting the smoke filters.

Chapter 14: Liabilities

Problem 14.10 1 Each year the company will debit holiday leave expense and credit the provision for holiday leave. When they take leave there is a debit to the provision account and credit to cash. If they don’t take leave there is a debit to salaries expense and a credit to cash, i.e. unless they take the leave the provision stays on the balance sheet. 2 a As the debit goes to provision for holidays instead of wages, net profit is increased b liabilities are reduced and retained profits increased c no impact on cash

Problem 14.11 1 Product Warranty Expense (3% × $600,000) Product Warranty Payable 2 Product Warranty Payable Wages Payable Supplies

18,000 18,000 770 460 310

Problem 14.12 1

Product Warranty Expense Sales

Estimated Warranty Expense as a % of Sales

$226 ,000 ,000 $29,398 ,000 ,000

0.77%

Product Warranty Expense Product Warranty Payable

226,000,000 226,000,000

Problem 14.13 All amounts in $000. 1 Accounts payable (for raw materials), salaries payable, income tax payable. 2 Notes payable becomes a current liability in 2022. 3 Provision for warranty: OB + Warranty Expense – Warranty Paid = CB $6.962m + Warranty Expense – $6m = $8.404m Warranty Expense = $7.442m 4 Provision for employee leave entitlements would include: • Annual leave • Long service leave • Vested sick leave It is both a current and a noncurrent liability because some items are expected to be paid within the normal operating cycle of an enterprise (usually one year) and others are expected to be paid more than one year in the future. DR CR

Journal Employee leave entitlements expense Provision for employee leave entitlements

Chapter 14: Liabilities

Problem 14.14 1 a b c 2 a b c 3 a b c

(12 × $11,200) – $61,232 = $73,168 $842,500 – $73,168 = $769,332 $61,232. $232,200 – $189,400 = $42,800 $189,400 $60,000 – $42,800 = $17,200. 12 × $1,500 = $18,000 $87,436 – $18,000 = $69,436 $25,674 – $18,000 = $7,674

Problem 14.15 1 Report contingent liability: not possible to estimate, therefore not a liability; most likely a contingent liability. 2 Not reported: No reason to believe that loss is probable. 3 Report liability: Amount can be estimated and loss seems probable. 4 Report liability: A note disclosure might be sufficient, but most likely it would be recorded as a liability. 5 Report liability: Amount is known and loss is probable 6 Report contingent liability: amount of the liability cannot be reasonably estimated.

Problem 14.16 1 Damage Awards and Fines EPA Fines Payable Litigation Claims Payable

DR 420,000

CR 170,000 250,000

Note: The “damage awards and fines” would be disclosed on the income statement under “other expenses.”

2 The company experienced a hazardous materials spill at one of its plants during the previous period. This spill has resulted in a number of lawsuits to which the company is a party. The Environmental Protection Agency (EPA) has fined the company $170,000, which the company is contesting in court. Although the company does not admit fault, legal counsel believes that the fine payment is probable. In addition, an employee has sued the company. A $250,000 out-of-court settlement has been reached with the employee. The EPA fine and out-of-court settlement have been accrued. There is one other outstanding lawsuit related to this incident. Counsel does not believe that the company will be found liable in this action. Other lawsuits and unknown liabilities may arise from this incident.

Problem 14.17 It is not recorded as a liability but is included as a contingent liability in the notes. • It can be argued that it is not probable that economic benefits will flow from the entity (i.e. the company believes it has meritorious defences against the suit). • The amount of any liability cannot be measured with reliability.

Chapter 14: Liabilities

Problem 14.18 6,000 x 10% + 3,850 / 11 – 2,000 x 10% = 600 + 350 – 200 = $750

Problem 14.19 GST on sales 24 000 1 less input tax credit 950 2 GST to pay 23 050 1 Exports are GST-free supplies so there is no GST to collect on the credit sales of spice mixture. Payment for the restaurant meals is received in cash and GST collected is $264 000/11 = $24 000. 2 There is no GST collected on the supply of fresh food. Total GST paid on acquisitions during September is $100 on the grinding machine and $900 on other purchases. Given that business usage of acquisitions is estimated to be 95%, only this part can be claimed as an input tax credit, that is, 95% of $1000 = $950.

Chapter 14: Liabilities

Cases 14A 1 It consists of trade payables ($4832m), accruals ($1271m) and contract liabilities ($364m). Trade payables would be mainly amounts owing to the suppliers of the goods sold by the company. Accruals are likely to relate to wages owing at year end, electricity, etc. Contract liabilities are defined as ‘consideration received for performance obligations not yet satisfied primarily related to the Group’s loyalty program and gift cards’. For example, gift cards are a form of unearned revenue as described in Chapter 4. 2 Provisions are a liability recorded where there is uncertainty over the timing or amount that will be paid but the expected settlement amount can be reliably estimated by the Group. The main provisions held are in relation to employee benefits, self‑insured risks, restructuring, onerous contracts, and store exit costs.

Current Employee benefits Self-insured risks Restructuring, onerous contracts, store exit costs, and other Total current provisions Non‑current Employee benefits Self-insured risks Restructuring, onerous contracts, store exit costs, and other Total non‑current provisions Total provisions

2021 $M

2020 $M

1,228 169 121 1,518

1,533 207 141 1,881

108 422 274 804 2,322

111 430 377 918 2,799

3 Employee benefits In estimating the value of employee benefits, consideration is given to expected future salary and wage levels (including on-cost rates), experience of employee departures, and periods of service. The assumptions are reviewed periodically and, given the nature of the estimate, reasonably possible changes in assumptions are not considered likely to have a material impact. Included in employee benefits is the team member remediation provision which represents the Group’s best estimate of the expenditure required to settle the obligation in accordance with the General Retail Industry Award (GRIA) and the Hospitality Industry (General) Award (HIGA). The calculation of this provision involves a substantial volume of data and a significant degree of complexity, interpretation, and estimation. In June 2021, the Fair Work Ombudsman issued a statement of claim to the Group challenging the Group’s interpretation of certain clauses of the GRIA in its calculation of team member remediation payments. The Group is defending this claim however it is at an early stage of the proceedings and the potential outcome and total costs associated with this matter are uncertain. The Group’s exposure may change materially based on the outcome of the legal proceedings.

Chapter 14: Liabilities

4 Woolworth’s noncurrent liabilities include borrowings, other lease liabilities, provisions, and other noncurrent liabilities. The main noncurrent liabilities are lease liabilities ($10,521m), borrowings ($2,753.0m) and provisions ($804m). 5 Contingent liabilities include (note 6.1 not included in the Appendix): 6.1 Contingent liabilities The Group has entered the following guarantees however the probability of having to make a payment under these guarantees is considered remote: • Guarantees in the normal course of business relating to conditions set out in development applications and for the sale of properties; and • Guarantees against workers’ compensation self-insurance liabilities as required by State WorkCover authorities. The guarantees are based on independent actuarial advice of the outstanding liability. No provision has been made in the Consolidated Financial Statements in respect of these contingencies, however there is a provision of $591 million for self-insured risks (2020: $637 million), which includes liabilities relating to workers’ compensation claims, that have been recognised in the Consolidated Statement of Financial Position at the reporting date. As at 27 June 2021, there are class action proceedings against the Group, on behalf of several representative applicants, seeking payments in favour of salaried team members, covered by the General Retail Industry Award, working in Supermarkets, Metro, and BIG W stores. From time to time, entities within the Group are party to various legal actions as well as inquiries from regulators and government bodies that have arisen in the ordinary course of business. Consideration has been given to such matters and it has been determined that these matters are not at a stage to support a reasonable evaluation of the likely outcome

14B 1

2 3

Estimates of future costs of warranty relates to the sales made during the current accounting period. The estimate would be based on past experience and expectations of the level of warranty. Provisions made during the year are greater than payments made during the year for warranties. Provisions for sick leave, holiday pay, long service leave and sometimes superannuation (where the entity is responsible for a defined benefits scheme).

Chapter 14: Liabilities

14C 1

Provision for employee benefits is a duty or responsibility that obligates the entity to future payments to employees, leaving it little or no discretion to avoid settlement.

Provision for restructuring costs is a duty or responsibility to others that entails settlement by future transfer of economic resources.

Provision for product claims is a duty or responsibility to others that entails settlement by future transfer of economic resources.

Provision for workers’ compensation is a duty or responsibility that obligates the entity to another, leaving it little or no discretion to avoid settlement.

Provision for restoration and rehabilitation is a duty or responsibility to others that entails settlement by future transfer of economic resources.

Provision for carbon emissions is a duty or responsibility to others that entails settlement by future transfer of economic resources.

14D 1

This indicates when the liability needs to be repaid. It is important for shareholders to assess whether the company has the funds to repay the liabilities when due.

Directors have a fiduciary responsibility to shareholders regarding the contents of the financial statements. It is suggested that in this case the disclosure of whether a liability is current or noncurrent could have a major impact on the decisions of shareholders and therefore is an issue directors need to consider.

Solutions Chapter 15 Equity, revenues and expense recognition Discussion questions 1 Examples of reserves: i General reserve is an amount transferred from retained profits. The purpose is often to indicate to shareholders that the amount of the transfer is unlikely to be paid out in dividends. ii Revaluation surplus is credited when assets are revalued upwards. iii Foreign currency translation reserve is an account arising as a consequence of the method used to convert foreign operations’ accounting figures into Australia dollars for the purpose of combining them with the figures for Australian operations. 2 If a company decides to split its existing shares in half this will have no impact on the balance sheet. The number of shares available is doubled but the balance of each of the shareholders’ equity account is unchanged. 3 Liabilities are obligations and estimates of obligations to people outside the enterprise, whereas equity is the residual ownership interest in the enterprise after considering such obligations to have the first claim on the resources (assets). Equity is what would be left after all the bills were paid, assuming that the assets were disposed of at book value and the liabilities were paid off, also at book value. Owners can be creditors too (for example, for dividends or management fees) but such obligations will have been deducted from equity (as dividends or expenses) and so, to the extent that owners are also creditors, they have less equity. 4 The following conditions must be met before a final cash dividend may be paid to ordinary shareholders of a company: – There must be adequate cash resources on hand. – Profits must be legally available. – The sum due to preference shareholders including any arrears of preference dividend must have been appropriated. – The requirements of the Company constitution and the Corporations Act 2001 with respect to resolutions by directors and shareholders must have been satisfied. The directors must recommend that a dividend be paid and the shareholders in general meeting must approve. They cannot approve a dividend larger than recommended by the directors. 5a The decision to issue bonus shares is usually taken as recognition of increased earning potential. Existing shareholders benefit from the issue of bonus shares if the annual cash dividend is maintained at the same rate as previously or at least falls less than proportionately to the increase in the nominal value of each shareholder’s holding. The result will then be to increase the cash annually paid, as dividends to shareholders and the total market value of the shares will probably increase. In such circumstances shareholders will be in a position to make a profit from the sale of all or part of their

Chapter 15: Equity, revenues and expense recognition

increased holdings. However, if total dividends do not change there is no obvious benefit to shareholders. b Future shareholders may benefit if the accumulated profits and reserves converted to additional share capital are employed to good advantage with improved stability and/or profitability. c The company benefits from the issue of bonus shares if the operations have expanded to such an extent that the assets represented by the reserves are permanently required within the business. Also, if the bonus issue is made in place of the normal cash dividend, funds are retained within the enterprise, at least temporarily. Reducing the overall individual share price via the bonus issue may make more investors interested in the company’s shares. 6 A subsidiary has to be consolidated with the parent’s accounts because this represents the economic are business circumstances more faithfully than would reporting a separate statement for the subsidiary and leaving the user to add the subsidiary’s accounts to the parent’s accounts. 7 A consolidated balance sheet shows the total assets under the control of the holding/parent company’s board of directors, the total debts owed by the consolidated economic entity to outsiders are the owners’ equity in the assets. Thus, a consolidated balance sheet presents a stronger financial picture than the parent’s unconsolidated balance sheet does. However, while there is a consolidated entity for accounting purposes, there is no consolidated entity for most legal purposes. Creditors and outside equity shareholders of a subsidiary have legal claims only against the resources of the subsidiary. 8 Goodwill on consolidation on the consolidated balance sheet means the factors taken into account by the parent company in agreeing to a price for the subsidiary’s shares. Examples of the factors are: good managers, good location, faithful customers, economics of scale with the parent, reduced competition or other items and it indicates that the parent company is buying something not on the subsidiary’s balance sheet. 9 Transferring amounts from retained profits to reserve serves the purpose of indicating to shareholders that the directors intend to retain the profits within the enterprise. Although the amounts may be transferred back and distributed as dividends if the directors so decide, the investing public is given an indication that the present policy is for retention of these profits. 10 Neither affects total shareholders’ equity. However, a bonus issue increases paid-up capital and reduces a reserve account or retained profits. A share split does not affect these accounts, but merely increases the number of shares on issue. 11 An example of a trade-off between relevance and reliability for revenue recognition: recognition of revenue prior to cash collection (i.e. at the point of sale) is more relevant for decision-making compared to if recognition was delayed until cash had been received. However, the latter may be more reliable. 12 Criteria used to recognise revenue: i All or substantially all of the goods or services to be provided to customers have been provided or performed. ii Most of the costs to generate the revenue have been incurred, and those remaining can be measured within reasonable accuracy. iii The amount of the revenue can be reasonably measured in dollar terms iv Cash, a promise of cash or other asset that can be measured with reasonable precision has been received. 13 Revenue under over time method (input method) can be recognised during production. This method entails determining what proportion of the project has been

Chapter 15: Equity, revenues and expense recognition

completed during the period and recognising that proportion of total expected revenue, expenses and therefore profit. Under the completion of contract method, the recognition of revenue is delayed until the work is all done. 14 According to the Framework, a revenue should be recognised when and only when two factors are satisfied: i It is possible that the inflow or other enhanced or saving in outflows of future economic benefits has occurred. ii The inflow or other enhancement or saving in outflows of future economic benefits can be measured reliably. 15 According to the Framework, an expense should only be recognised when and only when two factors have been satisfied: i It is possible that the consumption or loss of future economic benefits resulting in a reduction in assets and/or an increase in liabilities has occurred. ii The consumption or loss of future economic benefits can be measured reliably. 16 Examples of changes in equity other than those resulting from transactions with owners as owners: i increase in asset revaluation reserve ii gain on the translation of the financial statements of self-sustaining foreign operations iii increase in retained profits on adoption of a new Standard. 17 The friend should be advised that the advantage of his system of recognising 10 per cent of profit each week is that profit is spread over the life of each job and distortion between periods is avoided. However, there is a danger in failing to make allowance for problems that may arise during construction such as bad weather, shortage of materials and industrial unrest which could extend the construction period. In addition, there may be problems in obtaining payment from some clients. Accordingly, the friend should be advised to review each job before recognising revenue, making sure that costs are reasonably determinable, that the contract price is reasonably certain and there is reasonable assurance of payment. Where a loss on a particular job is possible, no revenue should be recognised. 18 In accordance with the Framework, the following criteria have been established as to when revenues will be recognised. A revenue shall be recognised in the operating statement, in the determination of the result for the reporting period, when and only when two factors have been satisfied: i It is probable that the inflow or other enhancement or saving in outflows of service potential or future economic benefits has occurred. ii The inflow or other enhancement or saving in outflows of service potential or future economic benefits can be measured reliably. Probability of occurrence and reliability of measurement are presented as the two criteria for revenue recognition. The Framework states that for many entities, the majority of revenues will result from the provision of goods and services during the reporting period. There will be little uncertainty that the revenue has occurred since the entity will have received cash or will have an explicit claim against an external party, as a result of a past transaction. One alternative to recognition at the point of sale is recognition at the time goods are produced (i.e. production). This possibility is more likely to occur in an alternative accounting system to the historical cost system. Such a basis may be used

Chapter 15: Equity, revenues and expense recognition

also by an entity mining precious metals where the product is readily saleable, and most of the operating cycle is complete once the metal has been extracted. 19 The matching principle refers to the recognition of expenses in the same period as the revenue which they generate for the purpose of determining periodic profit. The Framework defines an expense as the consumption of economic benefits. For an asset to be recognised there must be future economic benefits (which are probable and able to be measured reliably). The matching principle was used to justify deferral of the recognition of expenses until recognition of the revenue, with which it was to be matched. The Framework states that the definitions of assets and liabilities override the matching principle and so if an asset drops in value (e.g. obsolete inventory) the expense is recognised then. 20 A large writedown of inventory that has become obsolete would not be included as an expense because of the decrease in the value of the asset. 21 The main benefit of providing separate disclosure of significant items is that such disclosure is relevant in explaining the financial performance of the company. Its disclosure is likely to be relevant to users in understanding financial performance and in making decisions.

Chapter 15: Equity, revenues and expense recognition

Problems Problem 15.1 Zincdale Ltd General Journal Date 2022 July 1 July 28 Aug 15

Aug 15

Aug 31 Sept 1 Sept 30

Description

Debits $

No entry DR Cash trust 174 000 CR Application ($0.30 x 580 000) DR Application 24 000 CR Cash trust (Refund to unsuccessful applicants $0.30 x 80 000) DR Cash at bank 150 000 CR Cash trust DR Application 150 000 CR Share capital DR Allotment 75 000 CR Share capital ($0.15 x 500 000) DR Cash at bank 75 000 CR Allotment DR Call 200 000 CR Share capital ($0.4 x 500 000) DR Cash 194 000 CR Call Zincdale Ltd Capital structure at 30 September 2022

Authorised capital 500 000 shares @ $1.00 Issued capital 500 000 shares @ $1.00 each Less: Uncalled capital 500 000 shares @ $0.15 each Called-up capital 500 000 shares @ $0.85 each Less: Calls in arrears 15 000 shares @ $0.40 each Share capital

$ 500 000 500 000 (75 000) 425 000 (6 000) 419 000

Credits $ 174 000 24 000 150 000 150 000 75 000 75 000 200 000 194 000

Chapter 15: Equity, revenues and expense recognition

Problem 15.2 $ 1a

10 October 2022 DR Cash CR Share capital [$200 000  $2.90] 15 October 2022 DR Cash trust CR Application

580 000 580 000

1 800 000 1 800 000

DR CR

Application Cash trust

300 000

DR CR

Cash at bank Cash trust

1 500 000

DR CR

Application Share capital

1 500 000

DR CR

Cash trust Application

1 000 000

DR CR

Cash at bank Cash trust

1 000 000

DR CR

Application Share capital

1 000 000

DR CR

Allotment Share capital

250 000

DR CR

Cash at bank Allotment

250 000

DR CR

Call

250 000

DR CR

Cash at bank Call

300 000

1 500 000

1 000 000

250 000

Share capital

Shareholders’ equity Share capital Retained profits Total shareholders’ equity

250 000 250 000 250 000

1 500 000 100 000 1 600 000

Problem 15.3 1 2 3 4

Loss for the period, payment of dividends, transfer to general reserves General reserve, revaluation surplus, foreign currency translation reserve, etc. Most likely it is an issue of shares Total shareholders’ equity would remain constant. It is likely that share capital would increase and reserves decrease by the same amount.

Chapter 15: Equity, revenues and expense recognition

Problem 15.4 1 2 3 4 5

The number of shares issued multiplied by their issue price Consolidated includes parent and all subsidiaries that the parent controls Revaluation surplus and foreign currency translation reserve Most likely a profit for the period Non-controlling interests represents the interests of the shareholders who have shares not owned by the parent company They may have increased because of an increase in the size of the net assets of a subsidiary.

Problem 15.5 1 It is when a company buys back its own shares. 2 Some possible reasons: – If the share price is low, it is one way of increasing demand – Increases EPS as number of shares decreases (assuming profit does not drop proportionally) – Move considered important part of capital management. 3 More likely if share price is depressed 4 Cash decreases; a shareholder equity account decreases (e.g. retained profits). Profit is not affected, but EPS will increase as the denominator falls (i.e. the number of shares). 5 Profit is not affected, but EPS is likely to increase as there are now less shares assuming the company continues to make the same profit.

Problem 15.6 – – – –

Capital: Results from capital profits (e.g. sale of investments). General: Created by the transfer of profits from retained profits. Asset revaluation: Results from the upward revaluation of assets. Foreign currency translation: Results from unrealised foreign currency gains.

Chapter 15: Equity, revenues and expense recognition

Problem 15.7 $ DR Cash trust 120 000 CR Application Application money in respect of 80 000 shares DR Application 75 000 CR Share capital Application money due in respect of 50 000 shares allotted together at $1.50 per share DR Application 45 000 CR Cash trust Refund of application money DR Cash at bank (overdraft) 75 000 CR Cash trust Transfer on allotment of shares DR Freehold premises 80 000 CR Revaluation surplus Revaluation of freehold premises to $350 000 as per resolution of directors DR Bonus issue declared 75 000 CR Bonus issue payable Declaration of bonus issue (200 000 + 50 000) / 5 x 1.50 DR Revaluation surplus 75 000 CR Bonus issue declared DR Bonus issue payable 75 000 CR Share capital

Cash trust

Ledger Inventories $ 10 000 Trade debtors $ 20 000 Plant $ 100 000 Freehold premises $ 270 000 Balance 80 000 350 000 350 000 Cash trust $ 120 000 Application Cash at bank 120 000 Cash at bank/overdraft $ 75 000 Balance

Balance

35 000

Balance Balance Balance Balance Asset revaluation Reserve Balance Application

$ 350 000 350 000 $ 45 000 75 000 120 000 $ 40 000

$ 120 000

75 000

45 000

75 000

80 000

75 000

75 000 75 000

Chapter 15: Equity, revenues and expense recognition

Problem 15.7 (cont.) Trade creditors Balance Bonus issue payable $ 75 000 Bonus issue declared Share capital $ Balance Application Bonus issue payable

Share capital

Share capital Cash trust

Bonus issue declared

Bonus issue payable

Application $ 75 000 Cash trust 45 000 120 000 Revaluation surplus $ 75 000 Freehold premises Balance Bonus issue declared $ 75 000 Revaluation surplus Retained profits $ Balance

Current assets Bank Trade debtors Inventories Noncurrent assets Plant (at cost) Freehold premises (as revalued)

Impact Ltd Balance sheet as at 30 June 2022 $ $ Current liabilities 35 000 Trade creditors 20 000 Shareholders’ equity 10 000 65 000 Share capital Retained profits 100 000 Revaluation surplus 350 000

450 000 515 000

$ 60 000 $ 75 000 $ 200 000 75 000 75 000 350 000 $ 120 000 120 000 $ 80 000 5 000 $ 75 000 $ 100 000

60 000

350 000 100 000 5 000

455 000 515 000

Chapter 15: Equity, revenues and expense recognition

Problem 15.8 1 Nora Ltd Income Statement for year ended 31 May 2022 $ Profit before tax Income tax expense Net profit after tax Add: Retained profits 1 June 2021 Profits available for distribution Less: Dividend paid 4 680 Transfer to general reserve 2 100 Retained profits 31 May 2022

$ 142 000 65 000 77 000 20 000 97 000 6 780 90 220

2 Nora Ltd Balance sheet as at 31 May 2022

Current assets Cash (26 100 – 4 680) Accounts receivable Inventory Prepayments Total current assets

21 420 7 400 84 450 620 113 890

Noncurrent assets Plant Accumulated depreciation Land Government bonds Goodwill Total noncurrent assets Total assets

180 000 (55 000) 100 000 10 000 15 000 250 000 363 890

Current liabilities Accounts payable Accrued expenses Income tax payable Total current liabilities

5 200 470 65 000 70 670

Noncurrent liabilities Mortgage Total noncurrent liabilities Total liabilities Net assets

27 000 27 000 97 670 266 220

Shareholders’ equity Share capital General reserve Retained profits Total shareholders’ equity

156 000 20 000 90 220 266 220

Chapter 15: Equity, revenues and expense recognition

Problem 15.9 1 2

Percentage of completion method or completed contract method On receipt of cash, the asset account ‘Cash’ would increase and the liability account ‘Revenue received in advance’ would also increase. Each month, at time of issue of the magazine, the liability account would decrease by 1/12 and a revenue account would increase. 3 Probably on delivery; what is considered delivery is likely to be in the contract 4 On delivery of each job 5 On completion of each installation 6 At the time the call is made 7 Generally, not until the customer has taken the flight; if a non-refundable ticket, at the date the flight takes off 8 Generally, at the time of sale 9 Similar to (2) above, except that as work is completed, the revenue account would be credited 10 At the time of the cash sale (i.e. handing over the pie)

Problem 15.10 1 No, issue of shares is not revenue. 2 Yes. 3 Yes. 4 Yes. 5 No, not until it is delivered. 6 No, the service has not yet been provided.

Problem 15.11 1 Prepayment insurance 2 Wages payable 3 Accounts payable 4 Not an expense 5 Supplies asset 6 Accumulated depreciation

Problem 15.12 1 Revenue: Sales (50 x 5 000) 250 000 2 Expenses: Rent (9 000 / 3) 3 000 Wages (60 000 + 5 000) 65 000 Interest (10% x 12 000 x 1/12) 100 Depreciation could be included if we know the life of the equipment (400 000 + 20 000 would be depreciated over the life).

Chapter 15: Equity, revenues and expense recognition

Problem 15.13 The suggestions below are written at a general level, suited to those with an introductory level of knowledge. Students or instructors who are familiar with companies or industries like those below may wish to add more specifics. 1 Recognition would be at the point of delivery of the coffee (probably coinciding with receipt of cash or credit card). 2 Recognition would be based on either ‘percentage completion’ (revenue recognition during the production of the houses) or ‘completed contract’ (recognition once the house is finished and ownership transferred to the buyer). 3 Recognition would be either as gas is delivered (based on meter readings) or based on a convenient ‘cycle billing’ system by which customer billings are spread out over the month to remove billing peaks and associated billing costs, based on estimates of usage if necessary, and revenue recognised as customers are billed. 4 Recognition would probably be as each week’s magazines are delivered. 5 This probably differs for season tickets and other seats: for the former, recognition as each performance is held (or on a ‘run’ or monthly basis for convenience) for the latter, as performances occur. 6 When goods are on consignment, the potter does not give up title to them and so would recognise revenue only when the craft shop sold the pottery (probably even later, when the craft shop sends the potter a cash payment at the end of the month or other period). 7 An appropriate point would be to recognise revenue from TV advertising when the advertising airs. 8 Point of delivery of products to customers seems appropriate – no unusual circumstances are indicated (a matching expense recognition of likely customer service and warranty costs may be done at the same time). 9 Recognition would be at point of delivery of the products to customers. 10 Recognition would be at the point of the customer’s taking possession of the clothing, assuming estimates of returns and doubtful accounts are possible when financial statements are being prepared. 11 The kinds of choices would be as in (2): probably upon billing at the completion of the contract. This is because earlier bases are risky due to weather problems, plants dying, customer satisfaction.

Problem 15.14 Review of different companies’ financial statements will result in different discussions of these issues. 1 The nature of the company’s business is frequently described in the introduction to the annual report. The directors’ report usually indicates how revenue is earned and expense incurred. This information may be segmented over different parts of the organisation and may be accompanied by photographs and charts. 2 The notes to the financial statements will disclose policies with respect to recognition of important revenues and expenses. In the majority of cases revenue will be recognised at the point of sale.

Chapter 15: Equity, revenues and expense recognition

Problem 15.15 1 Outback Gold: – The company can sell its entire inventory of gold at any time at the prevailing market price. This means that the amount of revenue can be measured in dollar terms. Although the gold has not been provided to customers, sales are basically guaranteed. – Since mining and refining are the major costs of producing and selling gold, these costs have been incurred or are estimable at the end of the production process. – There are no collectibility problems. Therefore, recognise revenue when the production process is complete. 2 Crazy Freddie Co.: – Goods have been provided to customers when they take delivery. – Cost of the goods has been established by purchase by Freddie from the wholesaler. – Amount of revenue is estimable by the selling price of the goods. – There are severe collectability problems because of customer defaults. Therefore, recognise revenue when cash is received. 3 Tom and Mark’s Construction: – Revenue can be reasonably measured because contracts are for a fixed fee. – Not likely to be a collection problem because there has never been a problem in the past. – Costs can be measured with reasonable accuracy. – Although all of the services have not been performed until construction is complete, the customer has already been identified and it is usually the case that as construction proceeds, the purchaser obtains an interest in the partially completed asset. Therefore, recognise revenue as construction proceeds using the percentage of completion method for accounting for long-term construction. 4 Cecily Cedric: – Costs to generate revenue have been incurred by the time the toys are shipped. – Once the toys are shipped, the goods have been provided to the customers. – Revenue is established by the selling price of the toys. – Collection problems are minimal and can be estimated; thus, the amount of cash or receivables can be measured with reasonable accuracy. Therefore, recognise revenue at the time the toys are shipped.

Problem 15.16 1 Amcor: Cost of advertising for new employees. This would be an expense of the current period. While the new employees will likely benefit future periods, the cost of the advertising was likely minimal in relation to the operation of the company. In addition, it is difficult to estimate how long an employee will remain with the company. 2 National Australia Bank: Costs of renovating branch. If the renovations are expected to prolong the useful life of the branch or improve service at the branch, they would be treated as an asset and be amortised to expense over an appropriate period. This is because they are expected to benefit future periods. If the renovations are maintenance to keep the branch in useable condition, they would be expensed in the current period because they are not expected to benefit future periods. 3 Woolworths: Increased value of land. This is neither a revenue nor an expense of the current period. Accounting rules place restrictions on write-ups in the value of assets and require a reserve account to be credited. A gain can only be recorded if the land is

Chapter 15: Equity, revenues and expense recognition

sold to an outside party. This would of course, also necessitate the sale of Woolworths’ department stores. 4 Subway: Food sold on credit. This would be recorded as revenue of the current period. Subway has performed the service by providing the food, therefore, the collection of cash is basically guaranteed. 5 Harvey Norman: Money paid by customers in advance on special furniture orders. When the money is initially received, Harvey Norman has not manufactured the furniture nor delivered it to the customers, therefore revenue cannot be recognised at this point. To the extent that the furniture has been manufactured and shipped to customers prior to year-end, revenue can be recognised. 6 Ford Motor Co.: Income taxes paid in US. To be liable for US income taxes it must be the case that the company derives some of its revenues from operations in the US. The US income taxes are a cost of doing business in the US. To the extent that the income taxes paid are related to current periods earnings in the US, they would be an expense of the current period. 7 BHP: Special good-performance bonus promised this year but not paid until next year. To the extent that the good-performance bonus relates to performance in the current period, this would be an expense of the current period regardless of when it is paid. 8 BHP: Special dividend to owners who are also employees. Dividends are considered a distribution of profit to owners, not an expense of producing profit, therefore they are not recorded as either revenues or expenses. It makes no difference that employees are also owners of the company. 9 Amcor: Costs of scientific research aimed at developing new products. This would be an expense of the current period despite the fact that it may benefit future periods. Because there is no identifiable product associated with the research there is no guarantee that it will benefit future periods, nor is it possible to ascertain which future periods the research might benefit. Because of this it is expensed in the current period even though the research clearly does not directly benefit the current period. 10 Rio Tinto: Estimated amount of money needed to provide long service leave to this year’s employees in the future. The portion of this that would be a current period expense would be the long service leave liability arising from the employees’ employment in the current year. Liabilities arising from past years’ employment would previously have been expensed. Long service leave is a cost of maintaining a work force in the same way that salary expense is. 11 Coles: Goods lost to shoplifting. This is an expense of the current period and may be included in cost of goods sold expense. 12 Coles: Salary of floorwalker. This is an expense of the current period. Although the floorwalker does not generate revenue, he/she hopefully reduces the amount of goods lost to shoplifting, thus increasing net profit.

Problem 15.17 1 2 3 4 5 6

No (purchase of shares; i.e. investments) No (prepayment or deposit) No (inventory, asset assuming perpetual) No (no transaction yet) No (no work done yet) No (inventory is an asset)

Chapter 15: Equity, revenues and expense recognition

Problem 15.18 1 Several points at which GSP’s revenue could be recognised: i when the order is received ii when the toy manufacturer is notified (GSP having done its job) iii when the manufacturer ships the toy iv two weeks after the estimated time the customer receives the doll. Recommending one of the above (or others) should be based on the key criteria for recognising revenue: i All or most of the products or services have been provided. ii Most of the costs have been incurred, and the remaining costs can be measured. iii Revenue can be reasonably measured in dollar terms. iv Cash has been received or is reasonably assured, or a promise of cash can be relied upon. The application of these criteria to this situation is certainly discussable, and different conclusions based on different judgments about the situation are to be expected. In this case, as GSP has the cash early on, it may be quite acceptable to recognise revenue at point (i). There is not much doubt the order will be filled, but if the manufacturer is falling behind and quality/delivery might suffer, and/or if returns are likely to be significant, a later point (even point (iv)) may be indicated. In any case, if an earlier point is used, the revenue recognition should be reduced by an allowance for returns and other problems. 2 Several points at which the manufacturer’s revenue could be recognised: i when the order is received from GSP ii when the order is shipped iii two weeks after customer’s estimated date of receipt of order iv when payment is received from GSP. 3 The two components of the payments to football players would be accounted for differently: i The lump sum would be treated as an asset of GSP and then would be amortised (depreciated) over the period of time each particular football player’s name is expected to be helpful in selling dolls, to match the amortisation expense to the revenue recognised. (It might be hard to estimate this period, as player popularity can fall quickly, so if the lump payment is not very large it might just be expensed immediately, or over just one football season or two.) ii The royalty payments would be charged to expense as paid, or more appropriately (but requiring more accounting effort), accrued as an expense when the revenue from the relevant dolls is recognised.

Problem 15.19 1 Net profit would go down $46 900 (i.e. $67 000 x [1 - 0.30]). 2 No immediate cash flow effect, but a cash saving within a year due to lower income tax.

Chapter 15: Equity, revenues and expense recognition

Problem 15.20 1 Franchise revenue recognised by each company (assuming no discounting of future cash flows):

2015: 2017 2021: 2022:

PC $50 000 x 8 CD $20 000 x 8 PC $50 000 x 5 CD ($20 000 x 5) + ($6000 x 8) PC no sales CD $6000 x 13 PC no sales CD $6000 x 13

Pickin’ Chicken $ 400 000 250 000 nil nil

Country Delight $ 0 160 000 148 000 78 000 78 000

2 Any of the three possibilities could be chosen with a careful analysis based on the four main revenue recognition criteria: i All or most of products/services provided? ii Most costs incurred, the rest estimable? iii Revenue reasonably measurable? iv Cash received or reasonably assured? However, it is unlikely that such an analysis would support PC’s method (all revenue recognised upon signing). It is not generally acceptable in franchising because of the great initial uncertainty that a new franchisee can make a go of it (criterion d) and about how much help the franchisee will need (criterion b). Recognition over the life of the franchise agreement would be the usual method, and recognition as cash is received would be indicated if there is substantial uncertainty about the viability of the franchises and/or the franchisees’ ability to make the promised payments to the franchiser.

Problem 15.21 Item a b c d e f g h i j k l

Yes No No Yes No No Yes Yes Yes No No Yes

Chapter 15: Equity, revenues and expense recognition

Problem 15.22 This policy is following general revenue recognition rules: – a transfer of control of the goods or services passes to the customer – the price is fixed or determinable – proceeds offered by the customer as consideration reflect what could be reasonable expected in exchange for the goods or services The difficult issue is exactly when the title passes from the seller to the buyer. For the sales of commodities this is normally the bill of lading date which is the date the commodity is delivered to the shipping agent.

Problem 15.23 1 $300 000: 20% of $1 500 000 2 $750 000: 50% of $1 500 000 3 $450 000: 30% of $1 500 000 4 $1 500 000 (i.e., 8m– 6.5m)

Problem 15.24 1 30% x (5.5m – 4.5m) = $300 000 2 35% x (5.5m – 4.5m) = $350 000

Problem 15.25 Effect on net income: ($2 650 000 – $265 000) x .70 = $1 669 500 higher Effect on cash flow from operations: Increase in net income $1 669 500 Increase in amortisation add-back 265 000 Increase in income tax payable (2 350 000 – 235 000) x 25% 715 500 $2 650 000 higher There would also be a $2,650,000 decrease in cash from investing, so the net effect on cash flow is nil.

Chapter 15: Equity, revenues and expense recognition

Cases 15A 1 The following was found in Note 4.3: 2021 Number (m) Share capital 1 267 652 417 fully paid ordinary shares (2020: 1 263 091 936) Movement: Balance at start of period Issue of shares as a result of the Dividend Reinvestment Plan Demerger distribution Balance at end of period

1 263.1 4.6 0 1 267.7

6 197 173 (904) 5 466

Number of shares issued during 2021 was 4.6 million. 2 Woolworths does not have a general reserve account (Note 4.4). It has a category for the tables in Note 4.4. called 'Other reserves’ and this column includes movements during the year for: asset revaluation reserve; equity instrument reserve; and other reserve.

15B 1 Notes to the accounts show it is a buyback of shares. 2 Non-controlling interests appears separately in the shareholders’ equity section of the consolidated balance sheet. It represents the interests of the shareholders who have shares not owned by the parent company. For example, a company may only buy 90 per cent of the shares in another company and someone else then owns the other 10 per cent. 3 In this case, the change results from the difference between net profit and dividends.

15C 1 Examples: Notes 1.2.2 contains information about determining the cost of inventories. Other significant accounting policies can be found within specific notes – for example, Note 2.1 for revenue recognition, Note 3.4 contains information about the policy on depreciation of property plant and equipment. 2 i Note 3.4. an alternative to property, plant and equipment being depreciated using the straight-line method is to use a reducing balance method. This would result in depreciation in the earlier years being higher than if the straight-line method were used. This would increase profit for the year. ii An alternative to the method in Note 3.5 would be to amortise liquor and gaming licenses over a period of 20 years. This would result in lower profits for the year, unless there was an impairment during this period. iii Note 1.2.2 Inventory valued by the weighted average basis could instead be valued using FIFO. If inventory prices are rising, this would increase profit for the year. 3 The dollar value for the following items is as follows: © 2022 Cengage Australia Pty Limited. All Rights Reserved.

Chapter 15: Equity, revenues and expense recognition

a b c d e f

Total sales revenue $55 694m (I/S) Cost of goods sold $39 366m (I/S) Depreciation (total depreciation and amortisation) $1 380m (Notes 3.4 & 3.5) Interest expense (Note 2.3) $231.5m (I/S) Income tax expense $630m (I/S) Net profit attributable to outside equity interests $65m (I/S) (Non-controlling interests) 4 Non-controlling interests refers to the share of profit earned by a consolidated company that is attributable to owners other than the parent company. 5 The consolidated statement of comprehensive income starts with the profit from continuing operations and discontinued operations from the consolidated income statement showing the profit for the period ($2 139m for 2021). Then adjustments are made for ‘items that may be reclassified subsequently to profit or loss’ (including movements in translation of foreign operations taken to equity and movement of fair values) as well as ‘Items that will not be reclassified to profit or loss’ (including loss on equity investments designated as at fair value and actuarial losses on defined benefit superannuation plans). This then gives the total comprehensive income for the period ($2 139m for 2021).

15D This case raises some very interesting revenue recognition issues and there can be lots of debate between students about what is the appropriate amount of revenue or expense to be recognised in the period. I did receive this offer in the mail and it did get me thinking about the complications of revenue recognition: 1 When you receive these offers in the post the normal procedure is that if you wish to order you send in the order form together with your cheque or credit card details. In the first circumstance where the Trust is the promoter of the limited edition prints it would appear that the most likely time for the Trust to recognise revenue is when it sends out the prints. Note that another possibility is when it receives the order and the cash but in this case the argument would be that it has not yet provided the good or service and therefore revenue should not yet be recognised. 2 The Trust included an offer to give a refund of $200 if the purchaser was not fully satisfied. The issue arises whether they should only recognise the amount above $200 when they send out the print (i.e. $75 or $50 depending whether the person was a Trust member) and the remaining $200 would then be recognised when the twomonth period after dispatch occurs. This would be a rather conservative method of recognising revenue and an alternative would be to recognise all revenue when the item is dispatched and create some sort of provision against possible returns. The answer probably depends on the likelihood of people returning these. The past history indicates that this is a very rare event and the most probable method of revenue recognition would be at the point of delivery. 3 In this case the Trust is only the promoter and its revenue really is the commission it gets – i.e. $55. In this situation, the role of the Trust is to send out the brochures, collect the order forms and pass the orders onto the promoter. It therefore could be argued that the Trust has fulfilled its obligations once it has received the orders and passed them onto the promoter and therefore revenue could be recognised as each order is received and passed on to the promoter. 4 In answering this question it needs to be determined what skills are needed in order to provide the certificate of authenticity. It appears in this case it is necessary to collect

Chapter 15: Equity, revenues and expense recognition

evidence that only 1 500 of these limited-edition prints are actually signed by Steve Waugh and Mark Sofilas and that each of these prints are given a number from 1 to 1 500. Auditors in particular have developed skills in obtaining evidence to support the validity of the statements being made. It is also important that the public has confidence in the independence and trustworthiness of the person signing the certificate of authenticity. The accounting profession has a code of ethics that incorporates these factors and generally has a high reputation within the community of such independence. It is likely that the Trust or other promoters would use members of the accounting profession. For example, PricewaterhouseCoopers presently provides such a service for many such products. 5 Cost of goods sold would consist of labour and materials that goes into the production of the prints together with a share of the production overheads. For example, the materials to form part of the prints will be included, cost of the artist and any costs assembling the materials. In addition, there is likely to be some production overheads, such as factory rent, electricity, etc. and these prints would get a share of this depending on usage. 6 If Steve receives a flat fee for signing the prints the conservative option would be to take up all the expense in this accounting period. Another alternative is to match the expenses with the revenues and therefore only take up the percentage of expense determined by the percentage of the prints that are actually delivered during that period, e.g. a third of the prints were ordered and delivered in that period then a third of the flat fee would be taken up in that period. A decision would also have to be made of whether the fee forms part of cost of goods sold or was included in other operating expenses. 7 If Steve gets paid a commission based on sales the most likely time to recognise this expense would be as each print is sold (i.e. delivered).

Solutions Chapter 16 The statement of cash flows Discussion questions 1 Cash and cash equivalents are cash on hand and in banks plus assets that are really holding places for temporarily unneeded cash (such as term deposits and other temporary investments) minus very short-term borrowings, repayment of which could be demanded in cash at any time (such as money market funds and bank overdrafts which are repayable on demand). 2 a. Decreasing cash flow from operations (particularly negative CFO) Positive cash flow from investing as it means the company failing to invest Financing cash flows resulting in increasing in borrowings compare to equity b. Similar to part a but more concerns related to whether CFO can cover interest payments; concerns whether increase borrowings can be managed. 3 Cash flow from operations can be reported using either the direct or indirect method. The direct method reports, gross cash inflows and gross cash outflows. Under the indirect method the accrual-based profit figure is adjusted to get the cash flow from operations by adding or subtracting: • adjustments to remove accruals for non-cash expenses or revenues arising from noncurrent asset changes such as depreciation expense and profit or loss on the sale of noncurrent assets; • adjustments to remove accruals from uncollected revenues, revenues received in advance, prepaid expenses and unpaid expenses represented by changes in non-cash working capital accounts. 4 a Depreciation reduces operating profit, but does not impact on operating cash flows. b The managing director’s comment is not valid. The increased depreciation expense, all other things being equal, will reduce operating profit, but have no impact on operating cash flows. 5 Managing cash flow is important because cash is the medium of exchange by which business is done. An organisation must have sufficient cash inflow to cover its need for cash outflow to pay bills, buy new assets, and so on. In the short run, or at difficult times of the year, managing cash flow may be more important than managing overall performance as measured by accrual accounting.

Chapter 16: The statement of cash flows

Problems Problem 16.1 1 2 3 4 5 6 7 8 9 10

Operating- increasing Investing- decreasing Operating- decreasing Financing - decreasing Operating- decreasing (could also be classified as financing) Operating- decreasing Financing - increasing Operating- decreasing Financing - decreasing Financing - increasing

Problem 16.2 Express Ltd Cash Flow Statement for the year ended 30 June 2022 $ Cash flow from operating activities Receipts from customers (450 + 63) 513 Payments to suppliers and employees (135 + 45 + 25 + 85) (290) Net cash inflow from operating activities 223 Cash flow from investing activities Proceeds from sale of equipment Purchase of equipment Net cash outflow from investing activities

36 (165) (129)

Cash flow from financing activities Repayment of loan (125 – 90) Dividends paid Net cash outflow from financing activities

(35) (16) (51)

Net increase in cash held Cash at 1 July 2021 Cash at 30 June 2022

43 50 93

Accrued Expense 85 O/B 30 75 C/B 20

O/B C/B

Prepaid Insurance 25 30 45 40

Retained Profits 16 O/B 85 96 165

O/B C/B

100 150 70

Inventory 180

Accounts Receivable O/B Sales

60 470

C/B

Cash Receipts 450

Accounts Payable 135 O/B 35 150 C/B 50

Chapter 16: The statement of cash flows Rent Rec in Advanced 60 O/B 15 63 C/B 18

Wages Payable 25 O/B C/B

DR Cash DR Loss on Sale DR Accumulated Depreciation CR Equipment Accumulated Depn 160 O/B 140 110 C/B 90

15 35 25

36 4 160 200

O/B C/B

350 165 315

Equipment 200

Problem 16.3 1 DR Cash DR Accum Depn (see T account below) CR Gain on Sale CR Equipment

100 213 30 283

Acc Depn 213 245 300 332

Workings for 2, 3 and 4 Accounts Receivable 150 520 (2a) 700

Inventory 260 87 97

330

2(c)

270

Wages Payable 88 52 100 64

3(b)

Equipment 585 283 (from part 1) 285

190

Land 480 40 3(a) 20 540

(4)

Acc Depn 213 245 300 332

Retained Profits 130 150 140

587

Accounts Payable (2b) 267 360 97

160

Borrowings 488 258 746

(4)

Chapter 16: The statement of cash flows Prepaid Insurance 5 30 2(e) 35

Share Capital 240 10

2a b c d

(4)

250

$520,000 (see accounts receivable account) $267,000 (see accounts payable account) $88,000 (see wages payable account) Rent expense = rent paid ($9,000) as there is no prepayment or accrual in the balance sheet related to rent. $35,000 (see prepaid insurance account)

3a b

$20,000 (see land account) $285,000 (see equipment account)

4 LL Ltd Cash Flow from Financing Issue of Share Capital Final Dividend Paid Repayment of Borrowings

Dividends

Retained Profits 130,000 O/B N/P C/B

10,000 (130,000) 258,000

138,000

150,000 140,000 160,000

Problem 16.4 Accounts Receivable 265,000 905,000 880,000 240,000 Cash received = $905,000 Inventory 380,000 620,000 580,000 340,000 Cash paid to suppliers = $610,000 Salaries Payable 40,000 50,000 70,000 80,000 Salaries paid = $40,000

Accounts Payable 610,000 310,000 580,000 280,000

Interest Payable 110,000 10,000 110,000 10,000 Interest paid = $110,000

Chapter 16: The statement of cash flows

Income Tax Payable 80,000 80,000 95,000 95,000 Tax paid = $80,000

Problem 16.5 1

DR Cash DR Accumulated depreciation CR Gain on sale CR Equipment

75,000 22,000 13,000 84,000

(given) (see T-account) (75,000 – 62,000) (missing figure)

2 Equipment 192,000 84,000 20,000 128,000 Equipment purchased = $20,000

Accumulated Depn 22,000 40,000 17,000 35,000

Problem 16.6 Issue of share capital (368,000 – 321,000) = $47,000 Retained Profits 26,000 198,000 38,000 210,000 Dividends paid = $26,000

Problem 16.7 Sandra Limited Statement of cash flows for the year ended 30 June 2022 Cash flows from operating activities $000 Payments from customers 4 843 Payments to suppliers (2 320) Interest paid (40) Other expenses paid (1 470) Insurance paid (10) Income tax paid (390)

$000

613

Cash flows from investing activities Proceeds from sale of land (65 + 180) Proceeds from sale of equipment Additions to equipment

245 350 (875)

(280)

Cash flows from financing activities Dividends paid Borrowings repaid (1100 - 770) Proceeds from issue of shares (330 - 210)

(170) (330) 120

(380)

Net decrease in cash held Cash held at the beginning of the year Cash at the end of the year

(47) 240 193

Chapter 16: The statement of cash flows

Accounts Receivable O/B 470 4843 Sales 4800 27 (DD) C/B

Allowance for doubtful debts 27 47 O/B 30 Expense

400 Accounts Payable 2320 290 O/B 2240 (Inv) 210 C/B

50 C/B

C/B 420

Prepaid insurance O/B 40 20 10

O/B 620 Reval 50

C/B 30

C/B 605

Income tax payable 390 680 O/B 490

Interest Payable 40 40 O/B 40

780 C/B

40 C/B

Accrued other expenses 1470 140 O/B 1450 120 C/B

DR Cash 350 DR Accumulated depreciation 70 CR Equipment CR Gain on sale of equipment

Inventory O/B 380 2200 (COGS) 2240

Equipment O/B 1455 300 875

Land 65

Retained profits 170 128 670 628 Accumulated depreciation 70 560 O/B 200

C/B 2030

690 C/B

300 120

Problem 16.8 Accounts Receivables 95 000 300 000 70 000 Inventory 90 000 425 000 95 000

20 000 305 000

420 000

1 $305 000 2 $435 000

Allowance for Doubtful debts 20 000 13 000 12 000 5 000 Accounts Payable 435 000

70 000 425 000 60 000

Chapter 16: The statement of cash flows

Problem 16.9 1 Net cash flow from operations is positive both years but has decreased. 2 The decrease in cash flow from operations was due to the increase in cash payments to suppliers, service providers and employees ($2,213m to $2,357m). 3 Cash flow from operations in both years is high enough to cover cash outflows of investing. 4 More investing in PPE in 2022. 5 Significant increase in share issue. 6 Repayment of borrowings.

Problem 16.10 Below are four possible responses, there may be others.

1. Cash flow from operations is negative and the situation has deteriorated across the two years. While the cash received from customers increased in 2021, there was a significant increase in cash paid to suppliers. 2. The net cash inflow from financing is required to fund both the cash flow from operations and investing net cash outflows. 3. In 2020 the company relied on the proceeds from the issue of shares, however in 2021 there was a significant increase in borrowings. 4. The company did not pay a dividend in 2021 (there was one paid in 2020).

Problem 16.11 1

Net cash flow from operating activities = Net profit + Depreciation expense – Increase in inventory – Decreased accounts payable = 30,000 + 5,000 – 15,000 – 12,000 = $8,000 Net cash flow from investing activities = Purchase of equipment = $(10,000) Net cash flow from financing activities = Increase in long term loan – Dividends paid = 10,000 – 14,000* = $(4,000) * Dividends Paid = Net profit – Change in retained profit = 30,000 – (36,000 – 20,000) = 30,000 – 16,000 = 14,000

Chapter 16: The statement of cash flows

Problem 16.12 • •

•

• •

•

Cash began and ended negative in spite of much activity, but the change in cash was positive so the situation improved. Cash from operations was more than twice net profit so that is good, but increased accounts receivable (possible collection problems) and inventories (possible selling problems), combined with increased payables (possible problems keeping up with bills), suggest difficulty with managing the day-to-day cash and with working capital management. Investing activities were almost twice the cash from operations, and given the lack of cash on hand, the company had to get substantial financing to support the asset acquisitions. Not much cash was obtained by selling noncurrent assets, so management seems to be building up the company’s plant and equipment. Depreciation expense was twice the profit and almost equal cash from operations, but only half the new long-term investment. This supports the idea that the company’s productive capacity is growing and being kept up to date. Financing activities seemed to be complicated by substantial debt repayments – another demand on cash (we don’t know if the debts had come due or if the company chose to repay them, perhaps to refinance and get lower interest rates); therefore, almost $550 000 of new financing was required. This was raised mostly through debt, but also additional shares were issued (perhaps to keep the debt– equity mix from becoming too much weighted to debt). The company chose to pay out over 40% of net profit as dividends. If that had not been done, there would have been almost no cash deficit at the end of the year.

Problem 16.13 1

Cash flows from operating activities—indirect method Net loss Depreciation expense Loss on sale of equipment Accounts receivable decrease Salaries payable increase Other accrued expenses decrease Net cash from operations

$ (4,500) 15,000 2,000 16,000 3,000 (4,000) 27,500

2 The reasons for the difference between net income and cash flow are important because they help the financial analyst determine if the trends are sustainable or whether they represent one-time events. The main two reasons are: - depreciation which impacts net profit but not cash flow from operating activities (and therefore is added back) - the decrease in accounts receivable

Chapter 16: The statement of cash flows

Problem 16.14 1. $25,270 – $21,656 = $3,614 2. $389,863 + 20,000 = $409,863 3. $375 – $250 = $125 4. Opening Interest Payable + Interest Expense – Interest Paid = Closing Interest Payable $3,712 + Interest Expense – $21,514 = $2,154 Interest Expense = $19,956 5.

Gain on sale AR increased

Problem 16.15 1 BORACHIO LTD Statement of cash flows for the year ended 30 June 2022 $000 Cash flows from operating activities Cash receipts from customers 1492 Cash paid to suppliers (1055) Cash paid for income taxes (67) Cash paid for insurance (12) Cash paid for other expenses (69) Cash receipt from dividends 5 Cash paid for interest (25) Total operating cash flows 269 Cash from Investing Activities Cash paid for purchase of equipment Cash paid for purchase of land Cash received for disposal of land Cash paid for investments Total investing cash flows

(12) (83) 42 (42) (95)

Cash from Financing Activities Cash proceeds from issue of shares Cash paid for redemption of bonds Cash dividends paid Total financing cash flows

70 (150) (76) (156)

Net change in cash over period Cash at beginning of financial period Cash at end of financial period

18 144 162

Chapter 16: The statement of cash flows

2 BORACHIO LTD Reconciliation of Net profit and cash from operations for year ended 30 June 2022 $000 $000 Net profit 110 Add: Depreciation expense 65 Loss on disposal of land 18 83 Adjustments for changes in operating assets and liabilities Increase in accounts receivable Increase in allowance for doubtful debt Decrease in inventory Increase in prepaid insurance Increase in accounts payable Increase in accrued expenses Increase in income tax payable Cash from operations

(17) 4 15 (3) 40 16 21

Problem 16.16 There are many ways cash flow can be manipulated, the following are three possibilities. 1 Operating cash flows • Defer inventory purchases, i.e. allow inventory levels to run down. • This increases cash flow from operations. • May be necessary because of cash shortages or decreases in demand. • On the other hand, if there is no cash shortage and demand has not decreased this can hurt the company. The company may not be able to supply customers, thus alienating the customers and causing a decrease in sales. • Unethical if the manager just does it to make himself look good. 2 Investing cash flows • Defer acquisition of new assets. • May be necessary because of cash flow problems. • May hurt the company if existing equipment is wearing out. • May hurt the company if there is an opportunity for expansion, thus increased sales, that the manager is not taking advantage of. • Unethical if the manager does it just to make himself look good. 3 Financing cash flows • Defer redemption of bonds when interest rates are falling. • May be necessary because of cash flow problems. • May result in the company making higher interest payments in the long run than they otherwise would have had to. • Unethical if cash is available for redemption and manager fails to redeem bonds in order to make himself look good.

76 269

Chapter 16: The statement of cash flows

Cases 16A 1 The main components of cash flow from operating activities are: Receipts from customers Payments to suppliers and employees Payments for the interest component of lease liabilities Finance costs paid on borrowings Income tax paid

$million 72,688 (66,526) (687) (113) (738)

$million 389 (2,389) (209)

3 The main components of cash flow from financing activities are: Repayment of the principal component of lease liabilities Proceeds from borrowings Repayment of borrowings Dividends paid

$million (1,158) 971 (1,525) (1,104)

4 The company defines as cash and cash equivalents Cash and cash equivalents comprise cash balances and call deposits with an original maturity of three months or less (Note 4.5) 5 The opening and closing balance of cash in the balance sheet are represented at the bottom of the cash flow statement, i.e. the cash flow statement reconciles the change in cash. 6 The following observations can be made: 1 Cash flows from operations is large, positive and increasing. 2 However, in 2021 cash flow from operations is not large enough to cover the cash outflows from investing and financing activities resulting in a net decrease in cash and cash equivalents. 3 Payments for property, plant and equipment and intangible assets are a large component of the outflow of cash within CFI. 4 In 2021 borrowing has decreased and repayments of borrowing has increased. 5 Dividends paid have decreased.

Chapter 16: The statement of cash flows

16B 1 The following observations can be made from the Qantas statement of cash flows:

• • •

Cash flows from operations is positive in both years but has decreased substantially from $3,164m in 2019 to $1,083m in 2020. Cash flows from investing activities are pretty constant. Cash flow from financing activities was negative in 2019 but was positive in 2020. The main difference was the proceeds from share-issuance that only occurred in 2021 and increase in proceeds from interest bearing liabilities.

2 The largest two differences are: • Significant drop in cash generated from operations (cash receipts from customers – cash payments to suppliers) which would be of concern to the company. • Proceeds from share issue

16C 1 From One.Tel’s statement of cash flows you can see the size of the business is getting larger between 1999–2000, with most of the cash inflows and cash outflows being substantially bigger amounts. Receipts from customers increase substantially but then payments to suppliers and employees increase at a larger rate. As a result in 2000 the company continued to have a negative net cash from operating activities, i.e. it is outlaying more cash in its operating activities than it is receiving in. This is a situation that can’t continue indefinitely for any company because it means that additional financing needs to be arranged to pay for the negative cash flow from operations. During 2000 the company outlaid $525.6 million for the payment of spectrum licences and these would have been necessary in order for the company to expand its operations in the telecommunications industry. We can also see that while the company did borrow $139.8 million in 2000, the major source of its borrowings was from the issue of new shares amounting to $808.5 million. 2 The main factor that indicated the company may fail in the next year is the continued negative cash flow from operations but while this may be considered a negative factor few would have predicted that the company would have failed within the year particularly given that at the end of the year there was a total cash balance of $325.7 million, which is more than twice the negative cash flow from operations for the year. Also, the continued investment in the company by a number of major shareholders indicated that shareholders had confidence in the company at that point.

Chapter 16: The statement of cash flows

16D The cash inflows from operating activities is large and positive in both years with an increase from $7,010m to $7,231m. There are net outflows from investing activities in in both years ($2,976m in 2019 and $2,344m in 2020). This change is mainly caused by a decrease in the outflows of payments of PPE. The net cash outflow in financing activities has increased slightly from $4,138m to $4,236m. The significant reduction in proceeds from borrowings that were offset by a reduction in the repayment of borrowings. The company has continued to maintain a consistent dividend payout with $1,903m in 2019 and $1,902m in 2020. The cash and cash equivalents at the end of the year have increased in 2021 by $651m.

16E 1 Myer has a positive net cash inflow from operations in both years. This has increase from $191.6m in 2020 to $277.0m in 2021. Receipts from customers has increased while payments to suppliers and employees have also increased. Harvey Norman’s cash flow from operations is positive in both years but has decreased significantly from $1,057m in 2020 to $544m in 2021. The main changes are a decrease in the net receipts from franchises, while the increase in cash received from customers was offset by the increase in payments to suppliers. 2 Harvey Norman’s statement is more informative as it provides more detail and in particular breaks down the main cash inflows between those from franchisees and customers.

Solutions Chapter 17 Measuring and managing organisational performance Discussion questions 1 Financial statement ratio analysis uses the financial statements to evaluate an organisation’s financial performance and financial position. From this we learn how the organisation is performing compared with the prior period, and the key financial components of this change in performance. 2 The DuPont system of ratio analysis connects financial ratios together to conduct integrative ratio analysis. The benefits of this approach include enabling us to analyse how financial ratios fit together to explain an organisation’s overall financial performance and financial position, and identifying which of the various means available to the organisation has caused the changes in its performance. 3 Financial statement ratio analysis provides information on the historical financial performance of an organisation. It examines the organisation’s profitability, activity, liquidity, and financial structure. While this information is valuable for managers and investors, it does not provide a complete reflection of the organisation’s performance. By complementing financial statement ratio analysis with non-financial performance measures, managers and investors then have information available on how the organisation’s future financial performance is expected to be achieved. In addition, non-financial performance information enables these users to evaluate how the organisation is performing within its business system, by taking into consideration its interactions with customers, suppliers, employees, and other key stakeholders. 4 Non-financial performance measures enable understanding of why a financial outcome has (or has not) been achieved and provide guidance for the future on how to improve or maintain performance. Managers can monitor how the organisation is delivering its strategy by measuring the performance of its operational activities and investors can monitor how managers are behaving as they undertake the activities required to deliver its strategy. 5 Disclosing non-financial performance information in a company’s annual report provides key stakeholders, including current and potential investors, with valuable information on how the organisation is delivering its strategy and the drivers of its future financial performance. Disclosing this information enables stakeholders to make a more complete evaluation of the organisation and compare this with both prior period performance and key competitors. However, disclosing non-financial performance information also makes this information available to key competitors, providing them with valuable insights into the organisation’s strategy, key activities, and drivers of future financial performance.

Chapter 17: Measuring and managing organisational performance

6 It is vital for managers to evaluate strategic performance to ensure they are meeting their current financial objectives and delivering on the activities required to achieve future financial performance. The balanced scorecard (BSC) framework is beneficial for managers as it combines financial and non-financial performance information in a clear structure that is linked to the key strategic objectives of the organisations. This means they can evaluate the outcomes of actions taken, as well as assess the drivers of future financial performance. 7 The four perspectives are: i Financial – e.g., Revenue growth; Profit margin (%). ii Customer – e.g., Net promoter score; Perceived service quality. iii Internal business process – e.g., Distribution lead time; Average staff productivity. iv Learning and growth – e.g., Participation rate in operational training; Employee satisfaction index. 8 Accountants have skills in measuring, reporting, and assuring information. These skills are vital for identifying appropriate performance measures for each strategic objective captured in a BSC. In addition, conducting analysis such as integrative ratio analysis equips accountants to identify the drivers of current financial performance, which is valuable when identifying the strategic objectives and performance measures that are expected to drive future financial performance. 9 Preparing a strategy map ensures that the performance measures selected to evaluate the performance of an organisation’s strategy – both now and in the future – are reflective of the strategy they are designed to evaluate. In practice, organisations find that the strategy map is also valuable for communicating strategy, for articulating how an individual or business unit’s activities contribute to achieving the organisation’s overall strategic and financial objectives. 10 Challenges include insufficient leadership support (this is required to ensure effective communication of the organisation’s strategy and strategy map), applying the BSC framework at different levels across the organisation (ideally, the scorecard should first be developed for the highest level in the organisation that has a clear business strategy), and failing to adapt the BSC framework to reflect changes in the organisation’s strategy (as an organisation’s strategy adapts to address changes in the dynamic business environment in which it operates, so too should its strategy map and associated performance measures). 11 This may be the result of time delays (it takes longer for a performance measure in a lower BSC framework perspective to lead to performance improvements for measures in higher BSC framework perspectives), incorrect linkages (the causal relationship linking a lower perspective strategic objective with a higher perspective strategic objective may not exist in practice), or changes in the business environment (where such changes invalidate a previous causal relationship). 12 The strategic objectives and associated performance measures communicate the story of an organisation and how its strategy will enable it to create value for the future. While this information is valuable for current and potential investors, it is also valuable for other key stakeholders, including competitors, capital providers, and suppliers. These other parties may then use this information to their own strategic advantage either in competing or negotiating with an organisation. 13 Big data is described as ‘data sets whose size or type is beyond the ability of traditional relational databases to capture, manage and process the data with low latency (IBM 2021). Data analytics is the process of analysing raw data to obtain insights that inform our analysis of a business problem. Data analytics is required for the effective use of big data sets to inform and address business problems.

Chapter 17: Measuring and managing organisational performance

14 An analytics mindset is the ability to: i Ask the right questions ii Obtain relevant data iii Apply appropriate data analytic techniques iv Interpret and share results with stakeholders 15 While accountants may not complete all four processes required of an analytics mindset, it is vital that they understand these processes to contribute to and/or manage the processes and work effectively with data analysts.

Chapter 17: Measuring and managing organisational performance

Problems Problem 17.1 1 i Debt-to-equity ratio ii Interest coverage ratio 2 i Profit margin ii Return on assets 3 i Inventory turnover ii Profit margin Note: In Problem 17.2 point 3, you will consider some non-financial performance information that will also be useful to manage the performance of this company. 4 i Days in inventory ii Return on assets

Problem 17.2 1 i ii 2 i ii 3 i ii 4 i ii

Employee retention rate Perceived service quality Percentage of new hires with viticultural qualifications awarded in past 3 years Number of new innovations implemented Percentage of technical support staff completing CS training program Customer support satisfaction index Net promoter score Average delivery time

Chapter 17: Measuring and managing organisational performance

Problem 17.3 Strategy map for Kamilaroi restaurant

Problem 17.4 1 i Leading: Investment in specialist sales staff training ii Lagging: Perceived service quality 2 i Leading: Number of employee wellbeing initiatives ii Lagging: Employee wellbeing index 3 i Leading: Average time to address customer complaints ii Lagging: Customer satisfaction index 4 i Leading: Sales staff compliance with company service code ii Lagging: Perceived service quality 5 i Leading: Investment in new product development ii Lagging: Number of new products released 6 i Leading: Investment in team scheduling system ii Lagging: Average team project delivery time

Problem 17.5 Ask the right questions – After DeliverSafe implemented a series of wellbeing initiatives, workplace safety performance had declined. What aspect/s of the wellbeing initiatives may be associated/correlated with motorcycle accidents? How might these initiatives impair safe motorcycle riding? Are rates of motorcycle accidents higher for individuals completing wellbeing initiatives than those who have not completed these initiatives? ii Obtain relevant data – Data to gather may include the following: Individuals completing these wellbeing initiatives, individuals not completing these wellbeing initiatives, and individuals who have had motorcycle accidents; timing of motorcycle accidents and timing of each type of wellbeing initiative. i

Chapter 17: Measuring and managing organisational performance

iii Apply appropriate data analytic techniques – Conduct statistical analysis to examine correlations between those completing training and rate of motorcycle accidents, versus those who have not completed training. Examining correlations between when a wellbeing initiative was completed and when a motorcycle accident occurred. iv Interpret and share results with stakeholders – Share this analysis and the findings with employees and their managers. In a different product delivery industry, data analytics found that the rate of motorcycle accidents increased significantly in the week following an annual leave break. After discussing this analyses with employees and managers, the company resolved to have managers send a safety reminder email the day prior to employees returning to work. This was sufficient to significantly reduce this workplace safety issue.

Cases CASE 17A 1 Ratio a. Profit margin b. Gross margin

2021 calculation 2 139 / 55 694 16 328 / 55 694

2021 result 3.84% 29.32%

2020 calculation 1 209 / 53 080 15 330 / 53 080

2020 result 2.28% 28.88%

These ratios indicate Woolworths’ profitability has improved from 2020 to 2021. 2

a. Items in the Consolidated Statement of Financial position that vary significantly include: – Current assets held for sale or distribution – 3191% increase from $333m in 2020 to $10,959 in 2021. See footnote 5.3.1. – Other non-current financial liabilities – 8267% increase from $3m in 2020 to $251m in 2021. See footnote 3.2. – Reserves – 1887% decrease from $391m in 2020 to ($6,989m) in 2021. See footnote 4.4. b. – The first line item (current assets held for sale or distribution) impacts the following ratios: ROA, Cash flow to total assets, Total asset turnover, Current (working capital) ratio, Debt-to-assets and Leverage. – The second line item (other non-current financial liabilities) primarily impacts the Debt-to-equity and Debt-to-assets ratios. – The third line item (reserves) impacts ROE, Debt-to-equity and Leverage. The material changes in these line items means there is limited value in comparing the above ratios (particularly relating to profitability and financial structure) from 2020 to 2021. c. Given the impact of the material changes discussed in parts a and b above, integrative financial ratio analysis would be more informative to examine each year separately, or once the line items relating to the demerger of the Endeavour Group no longer appear (i.e., 2022 balances).

CASE 17B 1

The operating divisions of the Coles Group are: Coles Supermarkets, Coles Online, Coles Liquor, Coles Express, flybuys and Coles Financial Services. In the Coles Group Annual Report these divisions are combined into three reportable segments: Supermarkets (including Coles Online and Coles Financial Services), Liquor, and Express. In contrast, the operating divisions of the Woolworths Group are Woolworths Supermarkets, Everyday Rewards, Financial Services and Insurance, Countdown Supermarkets, and Big W. In the Woolworths’ Annual Report, these divisions are combined into three reportable segments: Australian Food (comprising Woolworths Supermarkets, Everyday Rewards and Financial Services and

Chapter 17: Measuring and managing organisational performance

Insurance); New Zealand Food (Countdown Supermarkets); and Portfolio (Big W). The Supermarkets and Australian Food segments are geographically and operationally similar (although the former does not include the Coles Group loyalty program, flybuys). With the demerger of Woolworths’ Endeavour Group, the remaining reportable segments are not directly comparable. 2 Ratio ROE ROA Alternative ROA Profit margin Alternative profit margin Gross margin

2021 calculation 1 005 / 2 813 1 005 / 18 123 1 873 / 18 123

2021 result 35.73% 5.55% 10.33%

2020 calculation 978 / 2 615 978 / 18 349 1 762 / 18 349

2020 result 37.40% 5.33% 9.60%

1 005 / 38 932 1 873 / 38 932

2.58% 4.81%

978 / 37 784 1 762 / 37 784

2.59% 4.66%

10 159/ 38 932

26.09%

9 741 / 37 784

25.78%

Across the set of ratios in point 2, profitability of the Coles Group is relatively consistent from 2020 to 2021. ROE and Profit margin have declined slightly, while Gross margin and ROA has increased slightly. Using EBIT, both Alternative ROA and Alternative profit margin have increased slightly.

Using the DuPont formula: ROE = ROA x Leverage 2021: 35.73% = 5.55% x 6.44 2020: 37.40% = 5.33% x 7.02 Looking at the various components of this formula shows that Assets fell from 2020 to 2021, while Equity increased. Therefore, despite profit rising for the period, the larger increase in Equity has resulted in an overall reduction in ROE.

CASE 17C 1

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Cretail seems to have difficulty growing its business. In 2021, sales growth dropped from 19.43% to low single digit 2.33%. In 2022 it continues in low single digit growth of 3.62%.

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Cretail seems to have trouble passing on cost of goods increases to customers, or to price its items at sufficient discounts to draw in customers. Gross profit growth was 25.15% in 2021 and grew at only 4.6% in 2022. This is confirmed by lower gross margins of around 23% in 2021 and 2022, down from 25.44% in 2020.

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Can take steps to improve net profit margin Can easily borrow or do share buyback to increase leverage If so, can obtain ROE of 25.53% (2.68% x 3.75 x 3.31)

Chapter 17: Measuring and managing organisational performance

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Can continue to invest more in supply chain/ logistics to reduce cost of doing business Could reposition businesses to consolidate and rebrand General Merchandise stores (e.g. Wesfarmers pays fees to US brand name owners for Kmart and Target) Could grow by acquiring more businesses in line with existing businesses Could grow by setting up more stores Improving net profit margin looks like the key to increasing ROE, as per Du Pont analysis.

CASE 17D 1

The two major categories in the 2021 Sustainability Report Appendix are sustainability metrics and workplace metrics. As discussed in Section 17.6 of the book, sustainability performance measures can be presented as a fifth perspective in a BSC framework or captured as a separate sub-section in the top perspective, alongside Financial and Social measures. As can be seen for Woolworths, it is less clear within the existing four-perspective BSC framework, where sustainability metrics are best placed – some fit within Learning and growth, while others may be captured in the Internal business process perspective. In contrast, workplace metrics generally fit within the Learning and growth perspective. These measures help address the question: How can the organisation continue to improve and create value?

2 a First focuses mainly on enhanced asset utilisation, as well as revenue growth. Second and third focus on revenue growth. Fourth encompasses some joint revenue growth goals between the Endeavour Group and Woolworths, alongside better cost management through synergistic relationships. Fifth also focuses on both revenue growth and better cost management. Sixth is a risk managementfocused strategic priority, with elements of enhanced asset utilisation and better cost management. b For each strategic priority, ensure the ultimate outcome to be achieved is captured in the lagging measure, while your leading measure captures the actions that Woolworths is taking now to progress this strategic priority.

17E The Commonwealth Bank presents four strategic priorities. The first and second priorities focus on building a better future for customers and creating more value for customers, respectively. These should have most impact initially in the Internal business process perspective, then the Customer perspective. The third priority focuses on building deep and trusted customer relationships, which will impact the Customer perspective; however, it aims to achieve this priority by investing in capabilities and system, so will have most impact in the Learning and growth perspective. The fourth priority aims to keep the bank strong and safe and should have the greatest impact in the Internal business perspective.